By Illan Solot for BBH FX Strategy

NEW YORK ( BBH FX Strategy) -- The Indian Rupee's near 2% gain against the dollar since Wednesday does not change our negative view towards the currency.

The move was probably just an INR short squeeze triggered by the confluence of three factors: RBI sales of USD, new regulation curbing hedging activity (see below), and better risk appetite.

Given that pessimism towards Indian assets is already well ingrained and priced in by markets, we would not be surprised to see this current INR rally extend for the next few sessions if risk appetite holds up. This would provide an even better entry point for new short positions.

At this stage we are more inclined to play short INR in relative value trades against other Asia currencies in order to reduce market risk. Currencies such as SGD, IDR and even KRW, for example, offer much stronger economic fundamentals. More importantly, in this environment, the commitment of policy makers to defend their currencies against further depreciation is far more credible in all three other cases than it is in India.

Our INR/USD forecast for the first quarter of 2012 is 56.00, or 5.8% weaker from current levels, but the risks are for an even larger move. In contrast, we expect SGD to depreciate only 1.3%, IDR 1.8% and KRW 3.4% over the same time period.

The RBI meeting today was a non-event. The bank left the Repo rate on hold at 8.50% and, as expected, followed up previous dovish comments with a statement suggesting that the next move will be a cut. It also noted that the authorities remain vigilant on the external sector and that fiscal slippage is worsening the inflation outlook. Although markets are not trading on carry right now, the prospect of lower India rates, coupled with still-weakening fundamentals, supports our more bearish stance in the rupee.

The RBI announced new measures yesterday aimed at curbing further depreciation. Although in practice this measure will technically apply to both resident and non-resident players, it will have the most significant impact on local exporters. The primary change is that onshore FX forward contracts, once cancelled, cannot be rebooked as was previously permitted.

This measure could yield significant results in the short term as previously, local exporters found it very favorable to cancel their existing forward contracts then re-enter them at much better rates. As these positions tend to be quite large, these actions contributed to the fall of the Rupee which has been hit hard this year based on fundamental factors.

They still need to address their current account deficit and similar to other emerging markets, India has experienced a significant outflow of funds based on foreign investors reducing their holdings of local shares this year. Aside from exchange rate implications, this measure will have little impact on foreign investors as most offshore investors utilize non-deliverable Forwards for hedging purposes.
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