#1: Essential to build up on the current import cover of 7-8 months
Indias import cover of ~7 months is low compared to long-term average of ~10 months (Exhibit 3). We note that the import cover during 2003-07 at ~14 months was higher than the long-term average. In CY2004-07, with capital flows being strong, the RBI bought Dollars at an average pace of ~US$2.5 bn every month, leading to an increase in FX reserves to US$275 bn from US$100 bn. Currently, FX reserve are at US$294 bn but might not be adequate if the extent of build-up of short-term external debt is also taken into consideration. Recent experience highlights that even small doses of nervousness can have a large contagion effect on EM economies, thereby requiring the RBI to accumulate FX reserves to provide stability to INR. Our BOP estimates indicate that there would be opportunity for the RBI to intervene and build up on the reserves in FY2015, effectively restricting the pace of USD/INR appreciation.
#2: Known unknown of Fed policy by end-CY2014
Talks of the Federal Reserve taper have been more detrimental (given markets pricing in the event) than the actual taper as far as flows to the EMs are concerned. Assuming that the Federal Reserve continues with US$10 bn taper every month, the asset purchases will end by October. Beyond that, the pace of US recovery will determine the timing of the US policy interest rates moving up. Given Yellens press conference after the last policy meeting (and assuming ceteris paribus), risks on EM currencies will likely emerge once the interest rate hike expectations are back (likely in 3QFY15). This will also be much after the election phase in India when (hopefully) markets will focus back on the economic cycleaway from the more myopic political cycle.
#3: Probability of the favorable outcome in elections still low
Fair amount of the recent capital flows could be related to expectations of a favorable election outcome. However, if the opinion polls are to be relied upon, most of them hint at NDA having to go with more temperamental allies to form a Government. The outcome of the elections and policies thereafter could have a significant bearing on Indian rupee trends. For instance, flows could weaken if the likely election outcome is not seen. Further, there have already been talks of easing restrictions on gold imports by a new government and this could affect the CAD dynamics.
#4: Risks of poor monsoon and weak growth
Latest data (March 23) indicates that the Southern Oscillation Index has dropped to (-)12.6. While a drought scenario is not yet obvious, the risks cannot be ignored, especially as this might upset the economic momentum. In case of a drought scenario, agriculture GDP growth will be lower by 250-300 bps while GDP growth will be lower by ~50 bps. CPI inflation could be higher by 150-200 bps and more importantly, most of the manufacturers will not have pricing power to pass on higher prices to the consumers. Weaker growth prospects in effect could upset the momentum of flows in the equity markets and hence lead to reversal in the INR trend.
Marginal adjustments to BOP: Lower exports and higher FII flows
We continue with our stance of robust CAD and BOP position in FY2015 and highlight that this is one of the main reasons for the strength in Indian rupee against all the negative risks. Our earlier main assumptions were (1) exports growth of 4.5%, (2) non-oil non-gold imports growth of 1% and (3) FII flows of US$10 bn. Given the recent trends in exports and FII flows, (1) we lower our exports growth rate closer to 3% (US$11 bn increase compared to FY2014) and (2) FII flows are assumed at US$15 bn.
We note that most of the increase in exports growth was between July and October, after which the growth has petered out and for February was at (-)3.7%. For FY2014, the growth is estimated at 4.5%. With global growth in FY2015 not likely to have much incremental improvement over FY2014 along with currency remaining on a relatively strong footing, exports growth is unlikely to be much robust. Our crude price assumption remains at US$102/bbl for FY2015. However, we note that with crude price at US$107.5/bbl (similar to FY2014 levels), FY2015 CAD widens to US$30.8 bn (CAD/GDP of 1.5%) compared to our base-case assumption of US$25.1 bn (CAD/GDP of 1.2%).
We have also increased FII flows to US$15 bn factoring in the current momentum of flows. Most of the debt flows (~US$4-5 bn) had come in through the T-bill route and these flows can fall off a bit in the near term as the RBI has restricted FPIs from buying G-Secs of less than 1-year maturity. The demand for more long-term G-Secs from the FPIs had been low and will likely remain so in the near term unless there is a better clarity on fiscal and interest rate dynamics.
Despite the above changes in our BOP estimates, our FY2015 BOP surplus is still robust at US$26.9 bn, which will be supportive of current Indian rupee trends.