Short-Term Outlook (three-to-six months)
The Indian rupee has appreciated by 3.9% since  September 2018 forecast. This is on the back of improving terms of trade following a sharp drop in global oil prices. The rupee’s average of INR68.40/USD in 2018 is largely in line with our INR68.50/USD average forecast for the year. We forecast the rupee to average  INR73.00/USD in 2019, ending the year around INR73.00/USD.

Our view for rupee weakness is driven by four factors:
First, we expect that a rebound in oil prices over the coming months would cause India’s terms of trade to worsen again, putting downside pressure on the rupee. Our Oil & Gas team forecasts the Brent oil price to average USD75.00 per barrel (/bbl) in 2019, up
from USD72.00/bbl in 2018. As such, a rebound from the current spot price of USD50.00/bbl over 2019 is likely. Given that India relies on imported oil for 80% of its requirements, the rise in oil prices should result in a corresponding deterioration in terms of trade.

Second, Indian credit default swap spreads remain on a steady uptrend as high levels of non-performing assets still rest within the balance sheets of India’s public sector banks despite the government’s efforts to accelerate bankruptcy proceedings.
We also expect political uncertainty to play a key role in the country’s risk profile and in the rupee’s weakness over the coming months as we see a close race between the BJP-led National Democratic Alliance (NDA) and the opposition ‘Grand Alliance’ in the 2019 Lower House elections, which must be held by May 2019. This follows the BJP’s drubbing at the state legislative assembly elections in three of its strongholds in November and December 2018, which was in stark contrast to its string of victories over the opposition in the state elections during 2017. The risk of policy discontinuity in the event of an opposition victory will likely weigh on the rupee ahead of the elections. Furthermore, we also believe that the government is likely to rely on further fiscal stimulus in the run-up to the elections, which would result in a fiscal slippage and e xert downside pressure on the rupee. The government slashed the GST rate across a number of consumer goods on
December 22 2018.

The government will also be seeking parliamentary approval for an extra INR410bn infusion into public sector banks, to be funded via recapitalisation bonds, to improve
credit flow to micro, small- and medium-sized enterprises.
It has also sought to spend an extra INR859bn (0.5% of GDP) in FY2018/19 (April-March). We therefore forecast the deficit to stand at 3.5% of GDP for FY2018/19, slightly wider than the government’s 3.3% projection.

Long-Term Outlook (six-to-24 months)
We are revising our forecast for the Indian rupee to average  INR75.00/USD in 2020, from INR78.90/USD previously. While we expect downside pressure on the rupee to stem from the currency’s overvaluation and higher long-term inflation outlook relative to the US, depreciatory pressures are likely to be limited by potential dollar weakness mainly due to simultaneous US dollar overvaluation and the potential for interest rates to peak given a mature Federal Reserve (Fed) rate hiking cycle.
On a valuation perspective, the Indian rupee’s real effective exchange rate is now marginally overvalued relative to its 10-year average. This suggests room – albeit limited – for further rupee downside. We forecast inflation in India to average 4.9% and 4.6% in FY2019/20 and FY2020/21 respectively versus 2.3% in 2019 and 2020 in the US. This is lik ely to support a continued narrowing of real interest rate differentials between
India and the US, particularly as we expect India to raise its policy repurchase rate by only 25 basis points (bps) to 6.75% by the end of 2019, compared to a 75bps hike in the Fed fund rate to 3.25% over the same period.
We believe that food and fuel will be the main sources of inflationary pressures over the coming months. Inflation has slowed to 2.3% y-o-y in November 2018, a significant drop from 4.9% y-o-y in June 2018, on food deflation and slowing fuel inflation. Given that
oil prices are likely to head higher in 2019, based on our forecasts, this should also translate to a pickup in fuel inflation.
Furthermore, the collapse in food prices due to existing oversupply will likely prompt farmers to cut back on their production in the 2019 growing seasons, which would support a price recovery in food crops over the coming quarters.
That said, the potential for moderate dollar weakness over 2019 could limit the extent of rupee depreciation. The Fed appears to be adopting a more dovish rhetoric, which suggests that interest rates are likely to peak in 2019, which  would cap dollar gains.