Have Investors Lost Confidence in the Indian Rupee?

Summary:

• The Indian rupee has lost almost 5 percent since May 16.
• The new budget did not live up to investor expectations, even though it was a good beginning.
• Modi must get the current account deficit down in order to stabilize the rupee against risk aversion.

Ever since Narendra Modi came to power as the prime minister of India, back in May, the rupee has lost just under five percent against the U.S. dollar. Why? What is behind this dramatic selloff and will it continue?

First off, the rupee, as of close yesterday, was trading at $61.09 versus the dollar. This is way off the May high seen at $58.22. The rupee started losing ground days after the May 16 election results were announced.

There are some factors coming to head here supporting the currency’s weakness. Heading this are investor’s lack of confidence with Modi and his BJP led government instituting the needed economic reforms to combat inflation. Right now, the market is not happy with the new budget and the lack of follow through and initiatives being taken. Since Modi came to power, there has been close scrutiny on how fast and what reforms he would initiate to bring the country’s inflation under control. India is Asia’s third largest economy.

In July his first budget failed to meet expectations of big bang reforms. While it was a step in th right direction it fell short to deliver on some key issues. Especially on how India plans to target a fiscal deficit of 4.1 percent of the gross domestic product (GDP). The current figure is at 4.5 percent, as of last year.

There is also higher risk aversion in the Asian Forex markets thanks to geo political tensions in the Ukraine and Middle East. We are also seeing stresses as when the U.S. Federal Reserve (Fed) will tighten its monetary policy as it ends its massive bond buying program and their economy returns to normal. The Indian rupee is sensitive to risk aversion. Why? India is still running a current account deficit. Another issue Modi must deal with soon.

While the current account deficit has narrowed quite a bit, it is still at nearly two percent of the GDP. This means the rupee is still exposed to risk volatility in the Forex market as capital flows can still be effected. More so than other Asian currencies.

Still, the weakness can be contained and it will likely be so. We are expecting new reform announcements from India’s government which should bring the currency’s rally back on track. Over the next several months, we should get clarity about the reform agenda which will settle the market down. Which means, we could see a yearend close near $60 to $61.

By the time December rolls around, we will have details on their fiscal consolidation plan. This will include a new goods and services tax and this could restore some lost investor confidence. As long as we get announcements that clarify their plan and no more periods of risk aversion, the rupee should renew its run higher over the next few months. This recent downtick has been more of a pause, markets taking a breather. Investor confidence is far from shaken and positive announcements to open the economy should open the doors for the rupee to make some gains towards the end of the year.