INR: A new exchange-rate regime? – Standard Chartered

Analysts at Standard Chartered points out that the strong INR rally since early February has caught market participants by surprise (accustomed as they are to a low FX vol environment amid two-way RBI intervention).

Key Quotes

“The rally raises two key questions: (1) why the Reserve Bank of India (RBI) has not made a more determined effort to cap INR gains amid elevated real effective exchange rate (REER) levels; and (2) whether this suggests we might have entered a new exchange-rate regime for the INR.” 

“Since the mid-2013 ‘taper tantrums’ (coinciding with Raghuram Rajan’s term as RBI governor), the RBI’s currency policy appears to have been driven by three objectives: keeping USD-INR realised vols subdued; maintaining INR REER stability; and improving FX reserves adequacy.”

“Valuation: A key concern among market participants has been the RBI’s willingness to allow USD-INR to drift lower even as the INR REER (36-currency trade-based) has climbed to new all-time highs. Earlier in the year, we noted that even though the REER-36 was at elevated levels, it was difficult to argue that the INR was overvalued. The RBI has noted that India enjoys at least a 2% annual productivity differential versus its trading partners (our calculations suggest it is slightly above 2%). Consequently, a 2% annual appreciation of the INR REER is unlikely to lead to a loss of competitiveness or to concern the RBI. Unsurprisingly then, while the REER-36 has been on a consistent uptrend over the past three years, REER adjusted for productivity has remained within a very tight range.”

“While sharp INR appreciation early this year has increased downside risks to our USD-INR forecasts, we do not believe there has been a change in the exchange-rate regime or that the central bank will tolerate significant INR appreciation. We remain wary of negative INR seasonality in Q2 and see only limited room for a further USDINR down-move in the near term.”