Hey Aussies - Add another 3% p.a. to your India investment?

Whilst the average rate of depreciation of the INR-AUD cross has been just over 3% p.a. (over the last 20 years), it is our view that the future looks more volatile for the AUD and more stable for the INR. The Reserve Bank of India’s hawkish stance on inflation and tailwinds of lower oil and stable food prices, as well as an improving economic environment, has led to a more resilient currency.

If we expect oil prices to remain low and monsoons in India to be reasonable then it is likely that the INR can hold its ground against an increasingly susceptible AUD, which is highly leveraged to Iron-Ore, Coal and falling interest rates relative to the Fed.

In this environment, we foresee no need to hedge the AUD-INR position, whilst maintaining a watchful eye on oil and food prices in India and iron-ore/coal prices and interest rates in Australia. We expect that the INR can reach levels between Rs.40-45 to AUD over the next 12-24 months.

Introduction

With investors in every part of the world considering overseas investment due to a weakening local currency, it becomes harder to find an investment region with the potential for gains from an appreciating currency.

Central Bank policies of lower interest rates leads to capital markets being flush with liquidity and nations trying to engineer weaker currencies to be more competitive in their exported goods and services. However, what leads to the appreciation of a currency? In our view, we see the following as typical reasons why a country’s currency would appreciate:

·        Strong demand through rising or higher interest rates

·        Lower inflation making goods and services more competitive

·        Positive sentiment

·        Current account surplus

·        Higher economic growth

·        Central bank purchases

·        Improving Credit Ratings

·        Foreign Direct and Portfolio Investment

The only factor favouring Australia amongst those above would be lower inflation.

When we consider the AUD/INR currency cross, we assess it through analysis of the AUD/USD and USD/INR crosses, which are far more liquid and traded. Since the start of the year the INR has strengthened significantly against the USD (4.9%) and AUD (2.9)%. This has been driven by a weakened USD across most crosses and a strong INR, given foreign flows, strong economic data and recent election/budget results. 

Indian Economy – RBI 

The more hawkish stance by the RBI, has aided the improvement in the INR’s carry trade appeal. The government has continued to make some progress on the reform front. The recent Union budget highlighted its resolve for fiscal consolidation while implementing pro-growth policies. The results of assembly elections will be seen by many as a clear vote of confidence in the government and its reform agenda. All this should help INR to be an outperformer in Asia on a total-return basis, however a material move lower in USDINR could be difficult from here, with much of the good news already priced in.

A more hawkish RBI did surprise the market at the beginning of the year when they kept rates on hold and decided to shift their outlook from accommodative to neutral. This is a positive result for those in the stronger INR camp and should be supportive of the currency in the face of a tightening US FED. Overall, the above should lead to a constructive view on the INR, the currency offers attractive carry and a strong domestic reform story with limited FX intervention – characteristics that should help the INR to be an outperformer within Asia.  

Macro Fundamentals

• India’s current account deficit has improved to 0.5% of GDP from over 5% in 2012. Once seen as a country with a twin deficit issue, has now focused on trying to reduce its reliance on oil building energy security through investment in renewables, solar, wind energy.
• India’s Government has shown increasing fiscal restraint and is now focused on a target of 3% of GDP, whilst ensuring spending occurs in the required areas. Currently at 3.7%, a substantial improvement from 6% in 2012.
• Forex Reserves are higher than anytime this century (just below US$400bn) with well over 12 months import cover to shield external influences and uncontrollable consequences.

Another positive is the broad range of financial inflows which have supported the INR so far, have potentially further to run. FDI inflows are likely to remain healthy on the back of better growth and the further easing of restrictions on inbound flows, such as the abolition of the Foreign Investment Promotion Board (FIPB). 

The Australian Economy 

The AUD has been the recipient of positive global sentiment and rebounding commodity prices (until the last month). It’s relationship against Iron ore prices has been very strong and the recent outbreak saw the AUD remain predominantly flat, suggesting weakness in the AUD. Iron ore prices have subsequently fallen sharply (below $70/t) perhaps with the view that the commodity price movement was a cyclical squeeze.

The twelve-month surge seen in commodity prices from February 2016 to February 2017, especially in Iron Ore has supported Australian terms of trade and the currency. While the currency didn’t appreciate materially during this time, it was supported and didn’t depreciate either. 

With falling iron ore price, it is likely that the AUD will come under increasing pressure, especially against a rate hiking US FED. The RBA itself has come out in its minutes and states that they would be more comfortable with a lower AUD to help alleviate some pressures on the economy, perhaps helping to rebalance and soften the impact of an over reliance on commodities. Industries like Education and Tourism can pick up some of the slack if the AUD depreciates.

The AUD is currently holding its own against the USD. The yield differential that has made the currency so attractive to carry trade/yield junkies is fading fast. The RBA is firmly on hold, caught between inflating the red hot residential housing market further by cutting rates and an inability to raise rates in the face of sluggish growth and inflation.

However, a reversal in commodity prices like we have seen recently will see the currency under more downward pressure, While the temptation might be to get overly bearish on the Australian dollar we need to keep in mind that AUD has been resilient recently in the face of a lot of negative influences. From here it’s reasonable to think that the Australian exporter community will view any moves below 0.75 area as attractive for repatriating commodity earnings.  

Inflation Differential – A Guide

When looking at the historical levels of appreciation of the AUD against the INR, the inflation differential has been a key driver. From here it looks like India’s inflation will remain in the RBI forecast band of 4-6%. Currently inflation is perhaps artificially low given lower oil prices, a good monsoon last time around. However, as infrastructure bottlenecks are eased over time perhaps the structural move on inflation is to the downside. Hence differentials are likely to remain lower than typical from the past, which may drive lower depreciation relative to the AUD.

Volatility of the Crosses 

Volatility of the INR is also dropping quite substantially, particularly since 2013, where it was part of the fragile five. The stabilisation policy of the RBI in conjunction with the tailwinds of falling oil and food prices has led to the build-up of significant foreign exchange reserves and there for over 12-month worth of import cover.

The INR now appears far less volatile that the AUD:

• AUD/INR Volatility 60-day 7.01%
• AUD/USD Volatility 60-day 7.83%
• USD/INR Volatility 60-day 4.25%

Source:Bloomberg