Why the Indian rupee is under structural stress

India recorded its largest trade deficit in history this week for fiscal year 2011 at $184.4 billion or 9.9% of GDP. This yawning trade deficit could continue to pose problems for the subcontinent going forward.

Image courtesy Jeet221990: http://commons.wikimedia.org/wiki/File:Mumbai_skyline88907.jpg

Bandra-Worli Sealink with the Mumbai skyline in the background

India’s current accounts deficit stems largely from its need to import both commodities: Oil and gold accounted for a significant chunk of the deficit.

As oil prices look to remain high for the near future, there is no immediate remedy at India’s disposal to ease the deficit without hampering growth.

On the other hand, gold imports may slow down in the near-term as the result of a weak rupee and a potential increase on the levy for gold.

However, this still does not obviate India’s very real, structural macroeconomic issues. A perpetual trade deficit is not sustainable, and with domestic energy supplies (namely, coal) withering as the result of insufficient infrastructure, India is unlikely to start running surpluses anytime soon. Eventually, this will pressure foreign currency reserves, and, in turn, the strength of the rupee (INR, quote).

Although a weakened rupee might temper the desire for foreign gold, demand for oil is likely to remain intact. As a result, it’s hard to determine to what degree a swoon in gold demand due to a weakened rupee would ameliorate India’s trade deficit, as dollar-denominated oil would become increasingly expensive in this scenario.

As well, India’s central bank lowered its key interest rate by half a point — its first cut in three years — in an attempt to bolster Indian economic performance. India’s growth rate has suffered as a result of the aforementioned infrastructural impediments, as well as a highly dysfunctional government that has thus far been unwilling or unable to implement the necessary reforms to liberalize the economy.

As a result of rate cuts and perpetual trade deficits, as well as a desire to keep the rupee’s value depressed in the short-term to make exports more attractive, the rupee is set to weaken against the dollar over the short-to-medium term. Traders should look for the rupee to move further lower and test its 52-week low of 53.7 INR to the dollar. A breach of support there could see the rupee head further lower in light of these macroeconomic headwinds.  

Considering that Indian ETFs like INDY (quote) have had a positive correlation with the rupee recently, this could mean a move lower in this time frame for INDY as well.

chart

Leave a Reply