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Economy Update
Institutional Equities
Indian Rupee – Revised Outlook
8 January 2016
USDINR Set To Weaken Further, But REER To Remain Overvalued
Indian Rupee (INR) weakened for the fifth consecutive year against US Dollar (USD) in 2015.
However, what has been entirely ignored but more important is the fact that INR was broadly
flat against USD (and also Chinese Yuan or CNY) in real terms. Notably, INR strengthened
~20% in real terms against Euro (EUR) last year as a result of which India’s real effective
exchange rate (REER) against major currencies gained ~7%. In this report, we have revised
our (nominal) USDINR estimates derived from real exchange rate (RER), which is a barometer
for competitiveness of the economy in international trade. Our model indicates that even if
INR weakens another 3.6% (to an average 67.5) in nominal terms against USD in FY17, the
former will remain unchanged (versus FY16) in real terms. Based on expected continuation of
subdued global environment and related weakness in India’s exports, we expect USDINR - in
nominal terms - to weaken at least 4.4% (to an average 68.1) in FY17 and another 3.3% (to an
average 70.4) in FY18, implying slight weakness in real terms also, but the index is expected
to remain above 100. It also implies that INR will touch 70 against USD in CY17. Nevertheless,
our model also suggests that INR will strengthen against EUR and CNY in real terms, which
means India’s REER index will increase further and remain overvalued in FY17. Notably, we
believe that INR must remain overvalued (or strong) in real terms as the economy is still
trying to deflate and has a high share of inelastic imports.
Nikhil Gupta
[email protected]
+91-22-3926 8110
Understanding nominal versus real exchange rate: Usually, we look at USDINR spot rate level.
Nevertheless, apart from nominal exchange rate (NER), domestic inflation also affects foreign trade.
Just like the exchange rate is understood as domestic currency relative to a foreign currency, what
also matters for foreign trade is domestic inflation versus inflation in a trading partner country (or
inflation differential). Thus, what matters (for foreign trade) is real exchange rate (RER), which is
NER adjusted by inflation differential. Let’s take an example of USDINR. If the inflation differential is
constant, i.e. if the fall (or rise) in India’s inflation is exactly equal to the fall (or rise) in US inflation,
the change in nominal and real bilateral exchange rate will be the same. However, inflation
differential is rarely constant. In 2015, while INR weakened ~5% in nominal terms against USD, it
was largely flat in real terms because inflation differential increased by ~5% (Exhibit 1). In other
words, the benefits of a weak INR, in nominal terms, were entirely offset by higher inflation
differential, leading to unchanged competitiveness, as suggested by RER.
There is more than USDINR to exchange rates: Secondly, it is important to note that what matters
for the economy is effective exchange rate (EER) against a basket of currencies rather than a single
currency. Notably, EUR and CNY have highest weight in India’s trade-based EER followed by USD.
With EUR weakening significantly last year, INR strengthened against the basket of currencies while
it was broadly flat against USD (Exhibit 2).
Exhibit 1: Differential between nominal and real USDINR
Source: Reserve Bank of India (RBI), CEIC, Nirmal Bang Institutional Equities Research
Exhibit 2: Differential between India’s REER and real USDINR
* Broad index; against 36 major trading partners
Source: RBI, Nirmal Bang Institutional Equities Research
Institutional Equities
We expect INR to weaken further against USD…: Based on our real exchange rate model, we found out that
even if INR, in nominal terms, weakens 3.6% to an average 67.5 against USD in FY17, bilateral real exchange rate
(RER) will remain unchanged. This is primarily because the inflation differential (based on our projection on India’s
inflation and Bloomberg consensus estimate on US inflation) is expected to widen further in FY17. Thus, if INR
weakens less than 3.6% in FY17, it will strengthen against USD in real terms. Considering the continuation of
subdued global environment and related weakness in exports, we believe that USDINR is likely to witness more
pressure, weakening in real terms, implying a nominal depreciation of more than 3.6%. Our base case scenario
therefore is depreciation of at least 4.4% in INR against USD (to an average 68.1) in nominal terms in FY17,
implying bilateral RER of 100.5 as against 101.2 in FY16. Therefore, while USDINR is likely to weaken in real terms
in FY17 versus FY16, it will remain overvalued in absolute terms (index > 100). Moreover, along similar lines, we
expect USDINR to fall another 3.3% (and average at 70.4) in FY18, implying bilateral RER of 100.2.
…but remain strong against EUR and CNY in real terms…: Nevertheless, with EUR and CNY expected to
weaken further against USD, INR is likely to weaken only marginally against these two currencies. Our model
indicates (incorporating Bloomberg consensus for Eurozone and China) that INR will weaken only 1% each against
EUR and CNY in FY17, implying appreciation in real terms. The latter will be a result of higher India’s inflation
differential with Eurozone and China. For FY18, with EURUSD and USDCNY expected to stabilise, INR is likely to
remain unchanged (versus FY17) in real terms against EUR and CNY.
…implying further overvaluation in REER terms: Conducting a similar exercise on Japanese Yen (JPY), Hong
Kong Dollar (HKD) and Great Britain Pound (GBP), we found out that INR is likely to strengthen against JPY and
GBP in real terms in FY17 but weaken against HKD. Consequently, India’s REER against six major currencies (or
the so-called narrow index) is expected to increase (or strengthen) ~2% in FY17 following ~4% rise in FY16. This
strength in REER index, to our mind, may tempt Indian authorities to support further weakness in USDINR, and
that’s why we say at least 4.4% depreciation. For FY18, INR (assuming Bloomberg forecasts for Japan, HK and
UK) may weaken by 1%-3% against these three currencies in real terms in FY18. Accordingly, we expect India’s
REER to weaken ~0.5%.
Remember two rules of thumb: All our projections include assumptions on inflation in trading partner’s economy.
The first rule of thumb is the higher the inflation in foreign economy (given India’s inflation), the lower is nominal
depreciation needed to maintain a constant bilateral RER or vice versa. As a corollary, the lower the inflation in
India (given the inflation in foreign economy), the lower the nominal depreciation needed to maintain a constant
bilateral RER or vice versa. Therefore, even if INR does not move in nominal terms against, say USD, but inflation
differential increases, it leads to appreciation in real USDINR, thereby implying lower competitiveness.
The second rule of thumb is that for any given level of inflation differential, the lower (higher) the nominal
depreciation, the less (or more) weak is the currency in real terms. In simple words, as we had stated earlier, with
inflation differential remaining unchanged, nominal and real exchange rates move in line with each other.
Given below are our forecasts on USDINR, EURINR, CNYINR and India’s narrow REER index for the next two
years:
Exhibit 3: INR to strengthen in real terms, but weaken further in nominal terms
USDINR
EURINR
CNYINR
REER*
FY15
61.1
77.5
9.9
106.0
FY16E
65.2
71.3
10.3
110.3
FY17F
68.1
71.8
10.4
112.5
FY18F
70.4
74.6
10.7
111.9
CY15
64.2
71.2
10.2
110.0
CY16F
67.6
71.3
10.3
112.2
CY17F
69.8
74.0
10.6
112.0
E = estimates, F = forecasts
* Narrow index (against six major currencies). This index is our calculation, which is slightly different from official REER index;
EUR and CNY estimates are arrived at by using Bloomberg consensus estimates on EUR-USD and USD-CNY.
Source: Reserve Bank of India (RBI), CEIC, Bloomberg, Nirmal Bang Institutional Equities Research
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Indian Rupee – Revised Outlook
Institutional Equities
Disclaimer
Stock Ratings Absolute Returns
BUY > 15%
ACCUMULATE -5% to15%
SELL < -5%
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Indian Rupee – Revised Outlook