The Indian Rupee: Fresh Record Lows Await says RBC Capital Markets

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- INR to see new record lows in 2019 says RBC Capital Markets.

- As political and economic headwinds mount in an election year.

- Oil prices, government meddling at RBI a key focus for markets.

The Rupee will fall to new record lows against the Dollar in 2019, according to the latest forecasts from RBC Capital Markets, as political and economic headwinds return with vengeance to haunt the Indian currency. 

In some respects, the RBC team paint a picture for 2019 that looks a lot like a rerun of 2018, although India's forthcoming general election and escalating market concerns over the independence of the central bank mean

"Our forecasts imply independent INR weakness," says Sue Trinh, Asia head of currency strategy at RBC. 

RBC forecasts that oil prices will rise from the depths of their November 2018 lows with vengeance in 2019, taking the Brent crude price up from $61 per barrell Wednesday to around $85 by the end of next year.

That means more Rupees being dumped on international markets so Indians can pay for increasingly expensive Dollar-denominated imports. It also means higher inflation and a wider current account deficit; all negatives for the currency.

But discord between government and Reserve Bank of India (RBI) top the list of headwinds for 2019, given governor Urjit Patel resigned this week, quite apparently over political meddling in the affairs of the central bank.

"We expect tensions to drag on for some time, impacting the credibility of the RBI, which is already in question. The Bank has come under fire in the past year for its frequent policy u‐ turns, slow policy responses and poor communication," says Trinh, in a note to clients Wednesday.

This year's 40% devaluation of the Turkish Lira demonstrates perfectly what markets think of compromised central banks. And the government's decision to appoint an ally of Prime Minister Narendra Modi, in Shaktikanta Das, to the top job means markets have reason to fear further interference in RBI policy. 

Above: U.S. Dollar relative to Turkish Lira in 2018.

Former RBI governor Urjit Patel cited personal reasons for his resignation, although that has fooled nobody given earlier speculation that he would walk, which followed a month-long period of pressure from government officials. 

"Mr Das’s appointment raises the risk that inflation heads higher over the medium term," says Shilan Shah, an economist at Capital Economics. "The central bank has succeeded over the past five years in lowering and anchoring persistently high inflation. Anything that undermines confidence in the RBI’s commitment to keeping inflation low will be regarded negatively by markets."

Shaktikanta Das held numerous roles in the finance ministry before 2015 and has since represented the Modi government in international forums like the G20.

The finance ministry had used a clause in the Reserve Bank of India Act 1934 to pressure the RBI into relaxing regulations designed to reduce the stock of bad loans washing around in the financial sector, and handing "excess" foreign exchange reserves over to the government.

Government demands for laxer controls on lending and for more money from the RBI come ahead of a general election due to take place in 2019 and in the wake of three unrelated regional polls that saw Modi's Bharatiya Janata Party receive a drubbing this December as voters opted for alternatives. 

"Government has been pushing the RBI to take steps that would boost aggregate demand. The government has called for lower policy rates, looser restrictions on bank lending, and a larger dividend payment," Shah explains. "The chances of the government demanding even more growth-enhancing measures has increased following a disappointing set of state election results."

Shah and the Capital Economics team had projected a third interest rate hike from the RBI over coming months but they now say this is unlikely to happen, suggesting they think the RBI's Das will not want to upset the government by tightening monetary policy and slowing the economy ahead of 2019's election.

Above: USD/INR rate shown at daily intervals.

Bond and currency markets have a severe aversion to political meddling in the affairs of central banks given the risk that politically-motivated decisions can pose to financial stability and creditors of sovereign governments.

Governments can easily be tempted to pressure central banks into keeping interest rates low for electoral reasons, but such decisions almost always give rise to fears over the inflation outlook. This leads creditors to demand even higher rates than they otherwise would have when lending to governments.

"We forecast USD/INR will trade toward 80 by the end of 2019. While part of this is a USD/rising US rates and slowing Chinese growth story, our forecasts also imply independent INR weakness given its external liquidity profile and broader concerns," says RBC's Trinh.

Trinh and the RBC team are forecasting a new record high for the USD/INR rate, which is a new low for the Rupee, and that the Pound-to-Rupee rate will rise to 100 before the end of the 2019 year.

India's Rupee has already fallen by a double-digit percentage in 2018 due to a combination of higher oil prices as well as the impact of U.S. interest rate policy which has damaged currencies across the entire developing world. 

Above: Pound-to-Rupee rate shown at daily intervals.

Higher U.S. interest rates have sucked capital out of, and diverted it away from, the emerging world in 2018. With American borrowing costs and bond yields expected to rise further in 2019, the Rupee will remain on its back foot.

"Our oil price forecasts imply further widening in the current account while election uncertainty will keep FDI sluggish and policy normalisation in the US and G3 will weigh on portfolio investment," Trinh explains. 

Current account balances measure both the amount of funds flowing into and out of a country as well as the extent to which a nation is reliant upon borrowing from the rest of the world in order to finance themselves.

Those countries that run large deficits in part because they are borrowing money from international markets will be left exposed to the whims and sentiments of investors that can change at the drop of a hat.

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