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Indian Rupee: Weakness to persist

Currency Special

Key points

� Rupee among worst performers: After falling by 20% in the last five months, the Indian

Rupee (INR) has turned out to be one of the worst performers among the major currencies

vs the US Dollar (USD).

� Both global and domestic factors contribute to weakness: The reasons that have led

to a sharp decline in the Indian Rupee can be classified under two major categories:

A. Global factors boosted the US Dollar due to the following reasons:

a) Demand for USD driven by its rising risk of sovereign debt crisis in Europe. Thus,

there is a shift away from the Euro to the USD despite the sluggish growth in the US

economy.

b) In addition to the fragile global economy, the stubbornly high inflation and moderating

growth in emerging markets are also hurting sentiments and boosting demand for

the USD.

B. Intrinsic weakness of the domestic currency: This weakness is coming mainly from

two factors

a) Deterioration in the fiscal health with a much higher than expected twin deficits

(fiscal and current account) of the country.

b) Capital outflows due to slowdown in the growth and risk aversion in financial markets.

� Rupee to remain weak: We see a potential threat of further depreciation of 7-8% for the

INR from the current level of Rs53.3/USD due to the above-mentioned factors. However,

the movement would be relatively restrained as the government is expected to attract

foreign inflows into tax-free bond issuances by infrastructure companies and raise

overseas borrowing by pledging assets of SUUTI (Specified Undertaking of the

Unit Trust of India).

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2 currency special

Indian Rupee

The aforementioned bearish factors for the Indian Rupee have been discussed below:

Decline of the Indian Rupee

The spot Indian Rupee (INR-USD) fell from Rs43.855/USD level on 27/07/2011 to Rs54.3050/

USD on 15/12/2011.

The pair started the year at the level of Rs44.7050/USD.

1) Global factors: These factors could be categorised into two major issues as

discussed below.

For a detailed discussion on the global macro-economic scenario and sovereign debt

issues kindly refer to the “Sell” report on “Lead” released on December 23, 2011.

a) Sovereign debt issues in major economies

b) Impending slowdown in global economy

� Sovereign debt issues in the major developed economies like the US, the euro zone, and

Japan pose a risk to the global economy and are leading to risk aversion. We think that

the worse is yet to come.

� Europe – The rising yields in European bonds show the impact of the debt crisis. Greece’s

government’s bond yield of two years rose to an all time high of 123.394% on December

15 2011.

� The euro zone sovereign debt crisis could culminate in disintegration, or else the leaders

would have to opt for enormous money printing. There is a thin possibility of outside

help.

� Japan – Moody’s lowered the nation’s credit rating in August. Japan has got the highest

debt/GDP ratio in the world.

� The US - S&P cut US’ rating to AA+ from AAA on August 5 this year. US treasuries and the

US Dollar Index rallied despite the downgrading, which reflect the role and strength of

the USD.

Indian Currency Spot rate movement

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3 currency special

Indian Rupee

The US Dollar Index is up 7.04% since the S&P cut the US credit rating.

Strength in DXY: As a safe haven (up nearly 10% since May 2011)

b) Worsening global macroeconomic scenario means the US gains – Focus on slowdown

in BRIC (Brazil, Russia, India, China) nations, recession in Europe

� The global economy is in a fragile state as the euro zone slips into a recession, China

and other BRIC nations witness a slowdown and as the US economy faces a risk of

falling into a recession next year.

� The GDP in the four BRIC countries rose at the slowest pace in almost two years last

quarter.

� The average economic growth in the BRIC countries will decelerate to 6.1 per cent

next year from a high of 9.7 per cent in 2007, according to September estimates by

the International Monetary Fund. That would narrow the gap over America’s expansion

to 4.3 percentage points, the smallest since 2004, the International Monetary Fund

(IMF) data shows.

� BRIC funds recorded $15 billion of outflows this year as the MSCI BRIC Index sank

23%, EPFR Global data shows. The gauge, which beat the S&P 500 by 390 percentage

points from November 2001 through September 2010, has trailed the measure for

five straight quarters.

� China’s growth is getting affected due to slowing exports to Europe and government

restrictions on real-estate investment. India’s growth has been hampered by the

fastest interest-rate increases since 1935 and the rupee’s decline to a record low,

amid high inflation. This has deterred foreign investment in the nation. Brazil and

Russia face risk due to falling metals prices and slowdown in China.

� China’s GDP forecast of 2011 has been cut to 9.2% from the previous forecast of

9.4% while growth forecast for the next year is around 8.00%. China’s GDP in the

first three quarters slowed down to 9.4% as compared to 10.4% (year on year [YoY])

in 2010.

� European banks facing Dollar funding stress: The cost for European banks to fund

in dollars rose to the highest in three years in November as the euro- region’s debt

crisis worsened. Gold lease rates turned negative in November as the European

banks rushed for the US Dollar leasing out gold.

Dollar Index movement

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4 currency special

Indian Rupee

� Dollar benefits on being the global reserve currency: Nearly two-third of the global

trade is conducted in the US Dollar.

� The US Net Treasury International Capital (TIC) long-term inflows increased to

$54.040B in September 2011, the highest level in 12 months, which shows demand

for US assets, which in turn spells bullishness for the greenback.

Performance of major currencies vs the US Dollar

US Long-term Treasury International Capital Inflows

Currency January As on Dec. 28 Change (in %)

INR 44.715 53 -18.53

Euro 1.3361 1.3072 -2.16

GBP 1.5489 1.5685 1.27

JPY 81.7400 77.6100 5.05

AUD 1.0291 1.0192 -0.96

CAD 0.9938 0.9835 -1.04

NZD 0.7734 0.7774 0.52

CHF 0.9334 0.9332 -0.02

CNY 6.6070 6.3256 4.26

RUBLE 30.5520 31.6600 -3.63

PESO 12.2488 13.9676 -14.03

REAL 1.6472 1.8590 -12.86

RINGGIT 3.0638 3.1690 -3.43

RUPIAH 8988.0000 9175.0000 -2.08

BAHT 30.0800 31.4600 -4.59

SGD 1.2848 1.2937 0.69

WON 1126.2500 1156.0000 -2.64

5 currency special

Indian Rupee

Among all the major currencies as depicted in the table given above, the Indian Rupee has

declined and fared the worst in the past 12 months. The domestic currency is one of the top

most losers among world currencies, second only to South Africa's Rand.

The fact that the Indian Rupee has performed even worse than the European currencies

speaks volumes about the weakness in the domestic currency.

2) Local Factors – Focus on twin deficits, capital flows, inflation

1) India’s trade deficit can worsen

India’s trade deficit of $19.60 billion recorded in October this year is the widest in the last

17 years, while the overall trade deficit for April-October 2011-12 was estimated at $93.69

billion, which was higher than the deficit of $85.65 billion during April-October, 2010-11.

Significance of crude oil prices - With nearly 80% of the nation’s crude oil requirements met

by imports, the oil import bill has climbed steeply from $79.55 billion in 2009-10 to $106

billion last year. Selling pressure on the Rupee has accentuated as Indian oil refiners bought

US dollars.

India’s crude oil imports during October were valued at $10.08 billion, up 20.73% from

$8.35 billion in the same month last year. This fiscal year so far until October 31, India’s oil

import bill grew 40.82% to $81.92 billion as against $58.17 billion in the corresponding

period last fiscal.

India’s state-owned refiners are borrowing the most dollars on record as the rupee’s slump

makes oil imports more expensive while local borrowing costs remain near three-year highs.

Firms can save 300 basis points by borrowing dollars, according to Indian Oil Corp., which

paid 9.28% on five-year rupee debt this month.

Yields on AAA-rated five-year rupee corporate bonds are currently at 9.52%, 269 basis

points more than the average dollar yields for Indian companies, according to data compiled

by Bloomberg and HSBC Holdings Plc.

“Refiners are under pressure from all sides, making this an extremely challenging time for

them,” K. Ravichandran, co-head of corporate ratings at ICRA Ltd., the local affiliate of

Moody’s Investors Service, said in an interview on December 22. “Crude-oil prices have

gone up, the rupee has dropped and their debt and its cost are increasing. They’ll continue

to prioritise dollar funding because that’s cheaper.”

India merchandised Trade Balance

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6 currency special

Indian Rupee

Average oil price assumed at the time of budget was $90/Bl for this fiscal.

India’s oil import bill was $106 billion in 2010 at average Brent crude oil price of $85. This

year the average price of Brent crude oil has been around $110 so far.

Overall demand for dollar from oil importers at year-end remains noticeable.

Rising crude oil prices threaten to widen the trade deficit further.

View on crude oil prices – Crude oil market remains in balance. Going forward we expect

the Libyan output to be fully restored in the next six months, hence we can expect downward

pressure on crude oil prices considering the fact that the global economy doesn’t look very

strong. However, the US and Europe striving to impose sanction on Iran over its nuclear

program give rise to the possibility of a huge event risk.

Iran produces around 3.56 million barrels per day, while the spare capacity available with the

OPEC stands at 3.19 million barrels per day. Thus, in case of Iranian supply going off the

market crude oil prices can surge violently. It is to be noted that non-OPEC nations don’t have

spare capacity. Crude oil prices can jump 30% to 50% should Iran attempt to play its oil card.

2) Fiscal deficit – likely to escalate

Brent Crude Prices

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India Govt Fiscal Deficit

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7 currency special

Indian Rupee

� India's fiscal deficit widened to Rs3.07 trillion during April-October 2011 from Rs2.92

trillion until September, as revenue flows remained sluggish even as spending continues

at a brisk pace, as per Controller General of Accounts.

� The deficit during April-October works out to just over 3.4% of GDP compared to 4.6%

target for the full year 2011-12 (April-March).

� The revenue deficit was at Rs2.43 trillion until October, or 79.1% of the budget aim.

� During April-September, total expenditure was Rs6.8 trillion, while receipts stood at

Rs3.73 trillion leaving a fiscal gap of Rs3.07 trillion.

� Oil firms are required to sell fuels below cost under a government plan to cap consumer

prices. The firms may lose as much as 1.3 trillion rupees from such sales in the financial

year ending March 31, Oil Secretary G.C. Chaturvedi said on November 22. The three

biggest refiners reported a combined loss of 141 billion rupees for the three months

ended September 30, the most on record.

� Every one-rupee drop in the Indian currency against the dollar boosts annual revenue

losses for government-owned refiners by 80 billion rupees, Oil Minister S. Jaipal Reddy

said on October 10.

� India’s subsidy set to double in 4 years by 2012 end - The subsidy bill is projected to

double (Rs1,43,570 crore) by the end of 2012 due to increasing subsidies on petroleum

and food items. This is as per the projection given by the India’s finance minister. The

greatest share of the subsidy allocation is for the three main segments viz food, fertiliser

and petroleum.

Item Projected subsidy Actual subsidy in Revised subsidy in

in 2011-12 (Cr Rs) 2007-08 2010-11

Food 60573 31328 60600

Fertilizer 49998 32490 54976

Petroleum 23460 2820 38386

Total 134031 66638 153962

Revised estimate for the current fiscal is Rs1,64,153 crore.

Dwindling growth in tax receipt: CBDT sources on December 28, 2011 stated that they may

miss FY2012 direct tax targets by Rs15,000-20,000 crore.

� Failure to raise capital through divestments: Owing to poor secondary market conditions

the government was unable to meet the disinvestment target of Rs40,000 crore for

public sector units (PSUs). So far, the government has raised only Rs1,145 crore through

the sale of its equity in Power Finance Corporation.

� Fiscal deficit can cross 5.60% in this financial year.

� Rising fiscal deficit increases the borrowings of the government, which in turn puts an

upward pressure on the interest rates, thus in turn putting a downward pressure on the

growth. This can lead to further widening of the fiscal deficit.

8 currency special

Indian Rupee

India's 10 year Govt Generic Bond Yield

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India’s 10-year bond yield was 8.95% in November, near its highest level since 2008 as the

government tried to sell a record amount of debt at a time when relatively faster inflation

is limiting demand for the securities.

The combination of trade deficit and shrinking confidence in the government’s ability to

rein in record bond sales pushed the benchmark 10-year debt yields to 9%, the most among

Asia’s ten biggest economies. This brought wide currency swings in the forex market.

3) Risk to growth increasing

India's economic growth in July-September was slowest in nine quarters at 6.9% (quarter on

quarter [QoQ]) as successive rate hikes choked industrial expansion. The growth has been

significantly slower than the 7.7% expansion seen in the April-June quarter.

Containing inflation top priority for RBI - The central bank has raised the key policy rate 13

times since March 2010, with effective tightening of 375 bps. Headline inflation has hovered

around the double-digit mark for 20 months despite a series of rate hikes by the RBI.

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9 currency special

Indian Rupee

India’s benchmark wholesale price index (WPI) based inflation has held above 9% for 11

months; it accelerated to the fastest pace among the G20 nations to 9.78% in August while

the Consumer Price Index (month on month [MoM]) has already reached double digit levels

ie at 10.1%. Higher oil prices fanned inflation. This high inflation is hurting the sustainable

growth prospects. Weakening currency adds to the adding inflationary pressure.

The central bank remains vigilant against the inflationary expectations, which means that

monetary policy easing to stimulate growth could be delayed.

4) FII Inflows negative in 2011

� India has seen net foreign institutional investor (FII) outflows of $480 million this year

as on December 28. This is in sharp contrast to a net inflow of 29.32 Billion Dollars in

2010.

� The currency needs more stable global risk factors to benefit from supportive capital

flows. With rising risk aversion and slowing growth, that appears to be a low probability

case.

India's Monthly Inflation

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India Net FII in Equity

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10 currency special

Indian Rupee

The benchmark 30-share index, the Sensex, fell to 15135 on December 20 – the lowest level

in the year 2011- as investors pulled out funds from emerging markets on concern that the

euro-zone crisis may deepen as the Standard & Poor's and other rating agencies prepare for

more downgrades.

Since the start of this year the Indian market has fallen 21.62% as on December 27, while

global equities are down 9.09% in the same period.

Steps taken by the RBI and the Government of India to lessen the pressure on the

currency

RBI’s current stance is to limit the volatility in the currencies market.

a) Forward contracts once canceled cannot be bought again.

b) Foreign investors can roll over forex contracts before maturity.

c) Foreign investors can't book again forex contracts once cancelled.

d) The RBI said companies can’t enter into multiple forward contracts to cover a single

overseas transaction.

e) The central bank also said it will reduce the amount of open positions dealers can maintain

overnight. It would increase the transaction cost for the dealers.

f) The RBI eased rules in November for companies to borrow abroad and sell foreign

currencies through swaps and raised the interest rate on bank deposits for Indians

living overseas.

SUUTI pledge: The government is considering pledging the assets of SUUTI, or the specified

undertaking of UTI, to raise funds for buying the government equity in state-owned

companies. The move is expected to fetch the government enough money for meeting its

disinvestments target of Rs40,000 crore in FY2012.

Global financial services major Bank of America Merrill Lynch said in a report dated December

28 that a fiscal engineering exercise like pledging of SUUTI shares will only provide a bit of

fiscal relief as higher oil subsidies is expected to play a spoilsport. "We still expect Delhi to

overshoot its budgeted 4.6% of GDP fiscal deficit target by over Rs1,000 billion on higher

oil subsidies," the report said. The Bank of America Merrill Lynch has cut its FY2012 target

for the Indian government's fiscal deficit by 30 basis points to 5.8% of GDP.

Sensex

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11 currency special

Indian Rupee

Impact of steps taken by the RBI and the government - The Indian Rupee corrected nearly

4% after the steps taken by the RBI; however since then the Rupee has been inching mostly

lower.

RBI’s stance on intervention – RBI aims to control the volatility and has been mostly

intervening intermittently to break the momentum of the USD rally. However, the central

bank is not trying to reverse the trend as intervention is unlikely to work due to limited

reserves; also interventions rarely work in a huge market like foreign exchange, especially

when there are major factors at play. Hence, interventions by the RBI are unlikely to change

the major trend of the currency.

Risk to our bearish view on the Indian Rupee – Following factors can threaten our overall

bearish view on the domestic currency:

1) The US Fed embarking on the third round of quantitative easing should the US economy

weaken significantly.

2) The euro zone resorting to massive money printing to contain the crisis. However, with

Germany’s stand against that very idea and risk of moral hazard in the otherwise

dilapidated global financial system, the possibility is really low as of now.

3) The Indian government moving faster than expectations on reforms and disinvestments.

Conclusion - Another 7-8% decline looms

� The sharp decline in the INR below the 2008 level (Rs52.18/USD) is alarming as the

currency is faring the worst among its major peers; steps taken by the RBI don’t seem

to have much impact on the currency.

� The European zone sovereign debt crisis and high oil prices are the biggest threats to

the Indian Rupee.

� Inflation is likely to moderate to 7% by March; however the global scenario remains

highly uncertain, hence downside risk to the Rupee would persist.

Target - The Indian Rupee can decline to Rs55.20/USD in the next six months. The downside

can extend to Rs57.10/USD in the next nine to twelve months.

We have generated a buy call on the US Dollar on December 28 at Rs53.30 level for a target

of Rs57.10. The timeframe is six to nine months.

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