India has been in the eye of the emerging market (EM) storm in the middle of 2013. Among EM economies, India has one of the largest current account
deficits—at -5% of gross domestic product (GDP)—which is driven primarily by its trade deficit
. As we mentioned in a previous blog post
, in today’s market environment, countries with large external vulnerabilities have come under pressure. Given that India’s principal imports are oil and gold, the trade balance is particularly sensitive to rises in commodity prices.
However, the Indian rupee’s recent performance has not been driven solely by domestic factors. Speculation that the U.S. Federal Reserve (Fed) would begin tapering
its bond-buying programs caused interest rates to rise for a four-to-five-month period from early May to September 18—the day the Fed decided to delay its tapering decision. Coinciding with a global rise in interest rates, the Indian rupee declined by over 15% from the beginning of May up until September 181
. With the Fed surprising markets, we believe the India rupee may be undervalued at current levels.
Fed’s Inaction Delivers a Reprieve to India
The Fed’s decision not to taper, announced in its September 17/18 Federal Open Market Committee (FOMC) meeting, has supported prices in both equities and currency in India. In September, the MSCI India Index
appreciated approximately 6.5%, while the Indian rupee appreciated over 4%.
In addition to the Fed’s action, the Reserve Bank of India (RBI), under the stewardship of its new governor, Dr. Raghuram Rajan, raised its main policy rate
(i.e., the reverse repo rate
) in its September 20 policy meeting to combat inflationary pressures in India2
. As a result, higher rates could further support the currency in the months ahead as investors seek higher carry
Relative Value in the Rupee Still?
The rupee has depreciated 40% against the U.S. dollar since early 2008, the most of any Asian currency3
. To contrast this with one of its prime competitors, the Chinese yuan, the rupee reached all-time lows in 2013 whereas the yuan has continued to reach new all-time highs. In our view, the nearly 50% divergence between these two currencies could have a significant impact on trade, especially compared to China. Even though China’s currency does not freely-float
in value against the U.S. dollar, the fact remains that the significant depreciation of the rupee makes India’s goods and service exports cheaper compared to China’s. Should inflation remain contained, a weaker currency could help the economy get back on track.
Focusing now on one broad gauge of the currency’s value, the real effective exchange rate is used by market participants as a way to gauge a currency’s value on a relative basis. The real effective exchange rate
takes into account the measure of a currency’s performance versus its major trading partners after adjusting for inflation.
Figure 1: Exchange Rate Historically Cheap Compared to its Trading Partners [09/30/2003 – 09/30/2013]
For definitions of terms in the chart, please visit our Glossary.
• We evaluated the current exchange rates in the context of their history over last 10 years and show, using a measure of standard deviation from its average rate over this period, how low or high the exchange rate values are compared to their own history.
• The real effective rupee exchange rate is approximately 3 standard deviations
below its 10-year average. In other words, the rupee has traded at such inexpensive valuations relative to the U.S. dollar less than 0.1% of the time in the past 10 years!
• The broad nominal rupee, a measure of the currency versus its trading partners’ (without taking into account inflation), is also at historically cheap levels.
• The rupee has the most attractive valuations
relative to its peers, as indicated by the largest negative bars in the chart above.
In our view, the rupee weakness should translate into improved exports over time, especially if some of the key trading partners such as Europe return to more positive growth. The European Union and North America together comprise almost 30% of India’s exports; improved growth in these regions combined with the rupee’s depreciation has the potential to be helpful to its exports. This could release pressure from the current account deficit situation and provide additional support for the currency.
For foreign investors, the Indian rupee has faced a substantial headwind in recent years. At current levels, we believe the rupee and rupee-denominated assets offer a comparatively attractive way to play a rebound in the Indian economy. With the recent appointment of Dr. Rajan as the head of the Reserve Bank of India, we believe that market sentiment has begun to turn. Although we acknowledge that a turnaround is far from certain, a combination of a historically cheap currency with attractively priced equities and bonds may pave the way for a rebound in the coming months.
Source: Reserve Bank of India (RBI), As of 9/20/2013