Economics
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DBS Focus
Indian rupee’s overvaluation and ample buffers
Economics/Growth/India
DBS Group Research
30Taimur Baig Radhika Rao
Chief Economist Senior Economist
Chang Wei Liang
Macro Strategist (FX and Credit)
Please direct distribution queries to
Violet Lee +65 68785281 violetleeyh@dbs.com
• Sticky inflation and negative real
rates due to economic stress, and
yet strong capital inflows have
created conditions for a strong INR
at a time of certain weakness in
fundamentals
• Improved balance of payments has
kept the INR steady against the
USD, pushing up the REER as a
result. Appreciation would have
been greater if the RBI had not
intervened vigorously
• Based on our currency valuation
model, the INR is modestly
overvalued
• Ongoing structural reforms could
help competitiveness metrics,
offsetting the risk stemming from
an overvalued currency.
June 29, 2021
During the 2013 taper tantrum episode, India
was a part of the “Fragile Five,” representing a
group of emerging market economies which
were running weak external accounts and had
poor cover for the external funding. As a result,
the taper tantrum related capital flow volatility
dragged their currencies lower sharply.
Between May and August 2013, the Indian
Rupee (INR) depreciated by 23% against the
USD, prompting a crisis of confidence among
investors and painful policy response.
As the Fed begins to consider asset purchase
taper and eventual policy normalisation, there
is considerable concern that emerging markets
are ripe for another dislocation. Should we
worry about the INR again?
There are compelling reasons to argue that the
rupee can be counted out of the fragile pack
this time. Also, circumstances are rather
different this time. Unlike 2013, when growth
was slow relative to trend, it was nothing like
the deep contraction of recent quarters.
Currencies associated with sticky inflation and
negative real rates due to economic ought to be
facing depreciation pressure, but it has been
the opposite thus far, owing to a marked
improvement in the balance of payments.
Indeed, despite the ongoing economic malaise,
rupee would have appreciated substantially
had the RBI not intervened vigorously.
The prevailing peculiar juxtaposition of a weak
economy and strong currency need not
sustain. Indeed, we see the dynamics of a
gradual depreciation path.
Refer to important disclosures at the end of this report.
Indian rupee’s overvaluation and ample buffers June 29, 2021

Surge in capital flows

Two developments have propped up India’s

balance of payments – a healthier current
account balance and strong portfolio/
investment pipeline.

Firstly, the pandemic-led softer domestic

demand resulted in import compression last
year, which alongside soft commodity prices
will lead to a current account surplus (DBSf:
1.1% of GDP) in FY21. Into FY22, as the
economic impact of the second wave ebbs and
commodity prices rise (particularly crude oil),
the current account deficit is likely to return,
albeit by a smaller measure – FY22 gap to
USD20bn (-0.7% of GDP), half of the pre-
Reserves build-up
pandemic gap.
Consistent FX reserves accumulation has been a
Second, portfolio and investment flows were at
key tenet of the Reserve Bank of India’s (RBI)
multi-year highs in FY21, notwithstanding the
framework to ensure stability in the financial
pandemic. Foreign portfolio inflows into equity
markets. India’s reserves stock is the fourth
surged to USD37bn, even as flows into debt
largest in the world at a record high of
were lacklustre (-USD4.6bn). Concurrently,
USD608bn, behind China, Japan, and
gross FDI inflows were at a record high of
Switzerland. India’s reserves are the second
USD81.7bn, lifted by a great extent by
highest in Asia, up USD140bn since 2020. We
investments into new subsidiaries of the
expect Indian markets to be partly de-risked
country’s biggest conglomerate. Net FDI inflows
owing to the high foreign reserves stock as
were USD54.7bn.
well as improved adequacy, just as the
Some of this strength is likely to spill over into discussion on timing of the US taper tantrums
FY22. After a hiatus in Apr-May, foreign equity gains traction.
investors returned in June with over USD2bn
inflows. FDI flows for the Jun quarter has also • Amongst conventional ratios, imports
started on a strong note with USD4.6bn in April. coverage is high at 12-13x, doubling from
levels during the 2013 taper tantrum.
From an estimated USD95bn BOP surplus in
FY21, the FY22 balance is likely to halve but
• Ratio of total external debt now accounts for
register a strong USD45bn.
0.9 of reserves vs 1.4 in 2013, with short-
The basic balance of payments (basic BOP) i.e. term obligations (original maturity) at 0.17
current account plus FDI is also expected to stay vs 0.34, respectively, displaying lower
positive, signifying a healthy flows pipeline.

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Indian rupee’s overvaluation and ample buffers
vulnerability. The current stock fares well on
the IMF’s ARA framework as well
RBI intervention
In wake of sustained capital inflows, the RBI has
acted to maintain a stable-to-weaker rupee. As
dollar purchases inject primary rupee liquidity
(if left unsterilised), specifically owing to spot
market operations, the RBI has been active in
the forwards space which will impact liquidity
with a lag i.e. when the transactions mature and
aren’t rolled over.
Official data shows that for nearly two years to
Jul20, the RBI held net shorts in INR forwards,
before switching to long positions, which has
taken the net forwards to a fresh peak of
USD73bn in Feb21 before easing over the next
two months (latest data available).
Tenor-breakdown shows that majority of these
forwards are parked in the less than one-year
bucket. Strong presence in the forwards
markets has not been without impact, as
forward premiums have consistently risen,
especially in the 3M contracts, which in turn
deterred importers from hedging their currency
June 29, 2021
exposure as well as slowing interests into the
debt market.
The authorities have changed tack lately. The
intensity of intervention in forwards has eased
off, as evidenced by a fall in forward premia as
well as a pullback in the total net forward
contracts, suggesting the RBI is opting not to
rollover rather take delivery. This decision may
have been influenced by an unexpected
quickening in inflation as well as need for
cheaper hedging costs that temporarily
upstaged liquidity considerations. Still, the RBI
is likely to maintain presence in the spot
markets to guide the currency, in conjunction
with liquidity-absorption tools e.g. market
stabilisation bonds (MSS).
As they continue to juggle multiple objectives,
the objective will stay responsive to change in
priorities, which implies that during occasions
of high inflation, pockets of INR strength might
be tolerated. Beyond such occasions, the
overarching bias will be to keep the rupee on
track for gradual depreciation.
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Indian rupee’s overvaluation and ample buffers
Reserves accumulation strategy
Even as total reserves are at record highs, we
see reasons for this accumulation to continue.
• DBS gauge of reserves to global external
financing requirement ratios for India, along
with Indonesia and Malaysia, are amongst
the smallest vs the regionals, underscoring
the need for better buffers
Reserves to Gross External Financing
South Korea
Philippines
Thailand
2021F
China
India 2013
Indonesia
Malaysia
0 1 2 3 4 5 6 7 8 9 10
Source: IMF. World Bank, country authorities, DBS
• Rising foreign reserves co-exist with a net
negative international investment position
(IIP). This balance shows the value of
financial assets of residents of an economy
that are claims on non-residents and stands
at -USD340bn by end-2020 (-12.9% of GDP).
Reserve assets account for 68% of the total
IIP assets (see chart). This imbalance is likely
to keep the central bank keen to further
strengthen the buffer, also providing a key
ammunition to fight-off short-term volatility
in global developments. – see chart
June 29, 2021
The June RBI post-policy commentary pointed
to an elevation in reserves accretion as a
priority for the central bank, not merely
conjoined with the FX movements. To establish
whether there is a specific threshold in mind,
we are of the view that in addition to the above
two factors that make a case for further buffer,
the authorities likely see it necessary to
strengthen this cushion at least for the duration
of the ultra-loose global policies, which have
translated into strong inflows into EM assets,
including India. Upcoming US Fed taper and
hiking cycle thereafter will test the markets’
defences.
Competitiveness considerations
India sharpened its focus to boost its
manufacturing sector last year as we discussed
in Understanding India: Manufacturing push – a
reset, with a competitive currency to
complement this push. While rupee’s historical
moves vs key trading partners (particularly
China) do not display material benefits from
currency movements, official preference is to
keep the INR aligned to regional FX movements
and cap volatility.
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Indian rupee’s overvaluation and ample buffers June 29, 2021

On real effective exchange rate basis, the rupee

India: Real interest rates
depreciated beyond one standard deviation 6.0
from the 10Y average back in 2013, but that has
since corrected, and is hovering around the 4.0
neutral mark since the pandemic.
2.0
Having built fairly strong buffers, the other
option available to Indian authorities is to 0.0
Term Deposit
pursue structural reforms that solidify the
attractiveness of Indian assets. This would -2.0 364 Day T Bill
include improvement in the investment Bank Rate
environment, enhancement of physical and -4.0
human capital, and support for modernisation 2015 2017 2019 2021
Source: CEIC, DBS
of various sectors in the economy. These would
enhance productivity and real returns on
Risks
capital, keeping foreign capital destined for
India. Ongoing structural reforms could help Few risks to keep an eye on which could trigger
India’s competitiveness metrics, offsetting the abrupt weakness in the currency include, a)
risks stemming from an overvalued currency. sharp current account deterioration if growth
recovers strongly without commensurate
supply/ capex growth and commodity prices
(particularly crude oil); b) hefty bond purchases
program which might be construed as debt
monetisation, just as overall debt levels jump;
c) strong USUSD rebound owing to faster than
anticipated pace of US Taper; d) flows exhibit
volatility due to shifts in global policies; e)
uncertain Covid-19 situation.

INR valuation

To ascertain if the INR is misaligned from long-

term fair value, we calculate its valuation and
compare it against its peers In a nutshell, the
DBS Equilibrium Exchange Rate (DEER) model
factors in a country’s productivity and terms of
trade differentials against its trading partners to
derive long-term exchange valuations. DEER
valuations are calculated with the following
equation:

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Indian rupee’s overvaluation and ample buffers June 29, 2021

log⁡(𝑅𝐸𝐸𝑅𝑖 ) − ⁡ 𝛼𝑖 − ⁡ 𝛽 𝑝𝑑𝑡𝑦 𝑃𝐷𝑇𝑌𝑖 − ⁡ 𝛽 𝑡𝑜𝑡 𝑇𝑂𝑇𝑖 INR: DEER valuations (%)

%
Where 𝑅𝐸𝐸𝑅𝑖 : real effective exchange rate of 𝑖 10 Over-valued
𝑃𝐷𝑇𝑌𝑖 : productivity differential of 𝑖 8
𝑇𝑂𝑇𝑖 : term of trade differential of 𝑖 6
𝛽 𝑝𝑑𝑡𝑦 , 𝛽 𝑡𝑜𝑡 : DEER model parameters 4
𝛼𝑖 : intercept term of 𝑖 2
0
-2
INR looks over-valued based on its DEER fair
-4
value, and also ranks as more expensive
-6
compared to regional peers such as CNY and
-8
IDR. Its small over-valuation (+5%) is likely due -10
Under-valued
to sizable foreign equity inflows, which have 11 12 13 14 15 16 17 18 19 20 21
reached a cumulative USD8bn year-to-date. Source: DBS

FX: DEER valuations (24 Jun 2021) Despite INR’s overvaluation, it is by no means as
expensive as where it was in 2017, when
16%
USD/INR reached record lows. For one, INR
11% DEER valuation looks attractive relative to the
9%
5% 5% 6% 6% USD (unlike 2013), and this should help to
3% 4% 5%
restrain against a surge in USD/INR.
Furthermore, India’s external financing needs
-2%-2%-2% today have fallen due to a smaller trade deficit,
-4%
while FX reserve buffers have also increased
-11% significantly. INR risks should thus be contained.
-15%
KRW
JPY

CAD
GBP

INR

AUD
THB

USD

PHP
MYR

TWD
CNY

EUR

NZD
IDR

CHF

Source: IMF, CEIC, DBS

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Indian rupee’s overvaluation and ample buffers June 29, 2021

Group Research
Economics & Macro Strategy

Taimur Baig, Ph.D.

Chief Economist - Global
taimurbaig@dbs.com

Chang Wei Liang Radhika Rao

FX & Credit Strategist Economist – Eurozone, India, Indonesia
weiliangchang@dbs.com radhikarao@dbs.com

Nathan Chow Irvin Seah

Economist - China, Hong Kong Economist - Singapore
nathanchow@dbs.com irvinseah@dbs.com

Violet Lee Samuel Tse

Publications Economist - China, Hong Kong
violetleeyh@dbs.com samueltse@dbs.com

Eugene Leow Daisy Sharma

Rates Strategist Data Analytics
eugeneleow@dbs.com daisy@dbs.com

Chris Leung Duncan Tan

Economist - China, Hong Kong Rates Strategist
chrisleung@dbs.com duncantan@dbs.com

Ma Tieying, CFA Philip Wee

Economist - Japan, S Korea, Taiwan FX Strategist
matieying@dbs.com philipwee@dbs.com

Sources: Data for all charts and tables are from CEIC, Bloomberg and DBS Group Research (forecasts and transformations)

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