What drives currency movements is one of the most misunderstood concepts in the financial markets. Most economists and analysts are still fixated on the interest rate differential theory which has outlived its utility in most situations except in crisis situations where Central Banks increase rates by substantial magnitudes inorder to support their currency.
Back around the third quarter of 2018 the pessimism on the Indian Rupee was at the peak and when the INRUSD crossed 74 the projections were at 78-90 levels. My view at that time was that the pessimism around the Emerging Market currencies seemed to be at the peak and it was time to take a contrarian view. Subsequently as the US FED also turned to a neutral stance we have seen a substantial rally in Emerging Market currencies including the Indian Rupee.
In my view the two biggest drivers of currency movements are the Carry Trades and the relative growth rate of economies rather than interest rate differentials. Political uncertainty is another big factor which affects currency movements along with trade deficits or surpluses. However we have seen that the US Dollar has been quite strong over the last many months except for just the last few weeks driven by the fact that it is the reserve currency and at a time when there is greater uncertainty most people flock to the US Dollar irrespective of the yield.
In this context we need to understand the future direction of the rupee. In my view the growth prospects in India today are one of the best among all major economies of the world. This combined with one of the highest real rates in the world is attracting both risk as well as low risk money into India. Money is flowing into the bond markets as Nominal yields in India are very high and there is an easing bias by Central Bankers globally. With the ECB again back to an easing bias, significant money printing by the BOJ and expectations of no action from the US FED carry trade has again picked up and is driving Emerging Market assets.
The other two factors working for India are the fact that India clearly will grow atleast 1-1.5% more than China this year and twice that of the Global GDP growth. Recent trends indicate that the NDA Government might also come back driving political stability. On top of that Export and Remittances flow is the greatest in the January to March Quarter.
Going forward the INR should still appreciate to around 65-66 levels over the next few months. However given our Trade Deficit we need a weak currency and that factor will start coming in and we should go back to a trend depreciation of 3-4% per annum.