Fitch Solutions has revised its forecast for the Indian rupee to average stronger at Rs 75.50 per US dollar in 2021 from Rs 77 previously, and Rs 77 in 2022 from Rs 79 previously to account for a stronger 2021 forecast.
"We expect the rupee to trade only slightly weaker over the near term from current levels," it said.
"We see depreciatory pressure on the rupee due to worsening terms of trade from rising oil prices, further monetary easing and bouts of risk-off sentiment being partially offset by US dollar weakness and central bank foreign exchange intervention to combat imported inflation."
Over the longer term, said Fitch, the over-valuation of the rupee in real terms and higher inflation in India vis-a-vis the dollar should exert weakening pressure for the rupee.
With India having a crude oil import dependence of more than 80 per cent of its needs, rising global oil prices driven by a global economic recovery in 2021 will see a worsening of India's terms of trade, and put depreciatory pressure on the rupee.
Brent oil is expected to average 53 dollars per barrel in 2021 versus the 2020 year-to-date average of 43.18 dollars per barrel.
"We also expect another 50 basis points worth of cuts to the RBI's policy repurchase rate which currently stand at 4 per cent in 2021. This will also exert some downward pressure on the rupee," said Fitch.
Meanwhile, positive news on Covid-19 vaccines as well as US President-elect Joe Biden's victory at the November elections have improved risk sentiment and equities rose to new highs in many markets.
Considering still-elevated uncertainty around the recovery outlook given a resurgence in Covid-19 infections in major economies in Europe, Asia and record infection counts in the United States, markets may have overpriced positive news recently so the risk of correction lingers over the coming months.
"Given the rupee's status as an emerging market currency positively correlated to risk, the rupee is likely to weaken during such risk-off period."
Fitch said two factors will partially offset the depreciatory pressure on the rupee. First, loose US fiscal and monetary policy will likely continue exerting downside pressure on the dollar into 2021 which will partially offset rupee weakness.
Second, the Reserve Bank of India with a foreign exchange reserve position of 578 billion dollars as of December, representing an import cover of around 19 months, will likely intervene to prevent excessive rupee weakness to manage imported inflation to reduce the risk of high inflation derailing India's recovery in 2021.
Fitch added that the rupee's real effective exchange rate index shows that the currency is overvalued, trading 4.6 per cent above its 10-year average. Currency overvaluation will incentivise imports and drag on exports by as they are less competitive than peers with more attractive valuations, hence pressuring the rupee weaker.
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