>CURRENCIES (MORGAN STANLEY)

INR: Revising Our Target Due to the Strong Election Outcome

Key take-away: We are upgrading our INR outlook, based on our India economics team’s belief that the election outcome is a “huge surprise” for their economic outlook. The four risk factors behind our previous bearish call − a negative macro-dynamic, deteriorating BoP, rising sovereign credit risks and a negative bank NPL cycle – have all greatly diminished following the election outcome, in our view. Instead, the new administration raises the prospect of a stronger growth outlook, economic reforms and a more prudent fiscal policy. We therefore change our USD/INR year-end target to 46 from 53.

General elections – huge surprise: The Indian general election results, announced on May 16, were a “huge surprise” according to our economics team (see India Economics: General Elections Verdict - Hope for a New Beginning, Chetan Ahya and Tanvee Gupta, May 17, 2009). The ruling coalition, led by the Congress party, returned to power by winning 260 of the 543 parliamentary seats (48%). The outcome was far in excess of our team’s ‘optimistic case’ scenario of 170-180 seats. As a consequence of this stronger political mandate, our economics team believes that the new administration will be able to accelerate the pace of economic reforms, including: 1) infrastructure spending; 2) privatization/deregulation; and 3) fiscal management. This, in turn, is likely to improve the growth outlook. Our economics team has raised its 2009 GDP forecast to 5.6% from 4.3% and the 2010 forecast to 6.6% from 6.1%.

INR’s downside risks fade away: The improved outlook for policy reform and economic growth changes our INR outlook to positive. The four risk factors behind our previous bearish call − a negative macro-dynamic, deteriorating balance of payments (BoP), rising sovereign credit risks and a negative bank NPL cycle – have now all greatly diminished, in our view.

Negative macro-dynamic to moderate: We believe that the INR has been undermined by a negative macro-dynamic over the past 12 months (i.e., below-trend growth and external deficit). The external deficit is already on a narrowing trend (we estimate -1.2% of GDP in 2009 versus -3.1% in 2008), but the macro-dynamic headwinds look set to moderate further with the improving growth outlook. As a result, we believe that as a key driver behind the INR’s weakness, the negative macro-dynamic will decline over the second half of this year, returning to a more neutral setting over 2010 (i.e., trend-like growth with a narrowing external deficit).

Safely unwinding the financial account bubble: While India’s current account deficit is likely to persist, the country’s overall BoP is set to improve, in our view. We had previously been bearish on the INR because of concerns of an unwind in India’s financial account bubble. Foreign capital rushed into India during the boom years, especially during the late part of the cycle in 2006-07. This surge of capital caused India’s financial account to balloon five-fold to INR5.3 trillion (11% of GDP) in 2007 from INR1.0 trillion (3.3% of GDP) in 2004. However, capital began to exit when the economic downturn began last year.

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