This year, look out for the rise of the rupee

Kathleen Brooks
WHO would want to be an emerging market central banker at the moment? Having stormed ahead of their
Western rivals during the financial crisis, economies in Asia and Latin America are now facing the prospect of rising prices. The authorities face an unenviable task – they need to strangle inflation without derailing growth.

In these countries, the risks of inflation are even greater than they are in the West. In India, for example, nearly three quarters of the 1.2bn population live on less than $2 per day. Rising inflation can be the difference between life and death. The bank’s first duty is to keep it under control. A strong rupee will be one of the stories of 2010.

Other BRIC countries, including China and Brazil, have already implemented measures to reduce inflationary pressure in recent weeks, and India cannot be far behind. The governor of India’s central bank, Dr Duvvuri
Subbarao, said in his Monetary Policy Review last week that the spectre of inflation in India “loomed larger” this year and he added that food and commodity prices were both showing signs of firming up in recent months. This puts more pressure on the Reserve Bank of India, which raised its inflation forecast for this year to 8.5 per cent last week.

As a precautionary measure to try to curb inflation, the bank raised the cash reserve ratio by 75 basis points, which was more than the markets expected. The interest rate, however, was left at its current level of 3.25 per cent.

The bank hopes that its action will anchor inflation and keep prices stable without hurting the economic recovery.
But this is a big ask. Commodity prices including oil and sugar remain at elevated levels. Another failed monsoon in India could push up food price inflation even more. This would increase the need for more extreme tightening of monetary policy, which in turn would cause the rupee to strengthen.

There are other reasons to expect a strong rupee, too. For example, the Indian government is not as resistant to a strong currency as some other emerging markets. As India is moving ever closer to becoming a net food importer, the Indian authorities might well prefer a stronger rupee, which will reduce the price of imported produce. The bank might be unconcerned about damaging exports, which make up just 13 per cent of the country’s GDP.

The rupee could also benefit from greater risk appetite among investors. Barclays Capital analyst Kumar Rachapudi recently wrote that investors’ perception of the rupee as a risky currency is declining.
So how do you trade the rupee? Outside India, it is mostly traded as a non-deliverable forward (NDF). This means that you buy a forward contract with an implied yield, which then gets settled in cash when the forward expires. Yields are different for onshore forward rupee contracts because the Reserve Bank of India controls the amount of currency that is issued outside the country.

The difference between the NDF’s implied yield and the onshore forward yield determines the risk premium offshore investors demand to hold rupees. A wide spread suggests that offshore investors view the rupee as a risky investment. In the first weeks of January this spread has narrowed considerably. As you can see on the chart opposite, it is in fact now negative.

Investors like yield and ways to reduce risk in their portfolios. For those wanting to get some exposure to emerging markets through foreign exchange, the rupee ticks both of the those boxes.