Indian Rupee outlook : RBC

RBC Capital Markets notes:

1-3 Month Outlook - Limited room to underperform

INR was a middle of the road performer in May, dropping 0.63% against the USD. The modest weakness was partly attributable to follow through selling from FInMin Jaitley's announcement in late April that he planned toretrospectively tax foreign institutional investors on capital gains made in previous years. 

The government expects the plan to raise about USD6.5bn, providing a cushion to public finances. Some foreign funds have appealed against the ruling in the Supreme Court, the only way to overturn the decision. In order to appease foreign investors, the Indian government has set up a panel to suggest ways to resolve the debate and some other tax issues. 

The RBI cut the repo rate by 25bps to 7.25%. The Statement acknowledged three risks to inflation: (1) a below-normal southwest monsoon which would drive up food inflation; (2) firming crude prices; and (3) volatility in the external environment driving INR lower. 

RBI noted that it could have waited for more certainty surrounding the monsoon, but decided to be pro-active and front-load the rate cut in June, likely taking advantage of the recent slowing in CPI inflation (4.87%y/y in April). The Statement cast doubt on further easing this year and the risk to consensus expectations of a further ~25bps rate cut by year end is that the RBI does not cut, which suggests limited scope for INR underperformance from lower rate expectations.

6 - 12 Month Outlook - INR a relative outperformer, implementation of the reform agenda crucial

We favour INR outperformance within the region in the coming year. Low inflation and stronger growth supportour overweight view. Structural reform under PM Modi may have disappointed those expecting a "big-bang"approach, but the incremental gains to date lay the groundwork for lifting potential GDP by driving industrial growth and clearing infrastructure bottlenecks. 

Downside risks to our view are: (1) sustained negative export growth and the RBI's proclivity to accumulate FX reserves; and (2) capacity utilisation in the energy sector. Closing the energy deficit is imperative if India is to live up to growth expectations. 

The World Bank recently lifted its projection for Indian GDP growth to 7.5% in 2015/16, followed by further acceleration to 7.9% in 2016/17 and 8% in 2017/18.