India Update: INR Slumps, Policy Response Looming

As the dollar is in uncharted water against the INR, it is difficult to have much confidence technical levels of support or resistance. Talk of a new range for the dollar between INR54-INR56 seems reasonable, but the RBI may want to try to push the INR higher, breaking the one-way market and allowing corporations an change to adjust. Key dollar support is seen near INR50.

The Indian rupee is has recovered most of the nearly 1% it lost against the US dollar in the local session today, which made it the poorest EM currency. Subsequently, it surrendered that dubious honor to South Korea and South Africa. The rupee's slide accelerated in early Asia as local participants reacted to yesterday comments from officials suggesting the central bank did not have much room to intervene in the foreign exchange market. The rupee is the worst performing EM currency this month, off nearly 7%.

The recovery has been sparked by talk that the central bank is considering some type of macro prudential

capital controls. A concrete form may be a facility to provide dollars to oil importers, ostensibly so they do not have to pay record prices for the dollar. India imports more than three quarters of its fuel.

The weaker INR feeds through into inflation, with is already high (over 9% since late last year). The current account deficit is swelling, rising to $14 bln in Q2 after $5.4 bln in Q1.

Another policy option for the RBI is to boost its bond purchases. Last week, the RBI announced a program to buy INR100 bln of government bonds. Some investment houses forecast it to increase this by 10-fold as a way of providing more liquidity to the banking system. Overnight rates have surged, with benchmark rates rising to 3-year highs. And bank borrowings from the central bank are running around double what they were in Oct, according to BBG data.

Price pressures and the weakness of the INR prevents the central bank from cutting interest rates to ease the financial strains, leaving them to explore less orthodox measures.

Foreign investors bought Indian equities in the first seven months of the year. As of late July, they had bought about $2.3 bln worth of Indian shares. However, as the international investment climate has soured and India's macro economic picture deteriorated, foreign investors have turn to net sellers.

From August through early October, foreign investors sold nearly $3 bln of Indian shares. In line with the improved risk appetite in emerging markets in general foreign investors returned to the buy side in India in recent weeks,but over the past week have been sellers again (~$500 mln over the past 10 days).