Rupee could weaken even if risk appetite holds up

After hitting an all-time low in April, the rupee has strengthened by 3% against the US dollar as risk appetite has returned to global financial markets. But while we think risky assets generally – and most EM currencies – will continue to advance as the global economy gets back on its feet, there are reasons to think that the rupee’s resilience won’t last. First, commodity prices should also resume making up lost ground, which would weigh on India’s terms of trade. Second, India’s failure to contain the virus could weigh on sentiment. Indeed, after recovering in May and June, there has been a net outflow of capital so far in July. In all, we are forecasting the rupee to depreciate to 78/$ by end-2020 and 80/$ by end-2021, from around 75/$ currently. There should be limited economic fallout from this. The pass through from a weaker currency to inflation is very mild, and India has a very low burden of FX debt, meaning that renewed currency weakness won’t exacerbate strains in the banking sector.