Divergent path of monetary policies between US and other major central banks is driving the US Dollar higher. Chinese Yuan too is feeling the heat, as outflows picked up from China in Q3. Interestingly oil prices are now moving in tandem with a rising a US Dollar, which is not common, but as long as it continues, it will be inflationary. Higher inflation improves the odd for a rate hike from Fed in December.
Indian Rupee, though relatively better placed than its peers in EM, cannot be immune to this unfolding trend. Indian Rupee can test the 67.00/67.20 levels against $ but against GBP and Euro it can continue to strengthen. However, we see little risk of any runaway depreciation in INR against US Dollar, not only because of improved fundamental narrative surrounding, but because of expected posture of RBI, as the FCNR payments occur. Over the next 8/10 weeks, over $ 20 billion would be redeemed by NRIs from their deposits in India.
At a time like this, RBI would remain vigilant and dampen any hint of an increase in downside volatility in the Indian Rupee. However, there is unnecessary panic surrounding the FNCR redemptions. We believe that FCNR was never a major risk for Rupee, as the entire payment would flow through RBI, and not through open markets. Instead, way back in 2013, if India had issued sovereign foreign currency bond, instead of the RBI sponsored FCNR deposit scheme, we needed to pay serious attention to any such lumpy outflows on account of redemption, as that would have flowed from the open market.
RBI has built enough of long positions in $ INR in the forward market to prevent any sharp plunge in reserves on account of the redemption. Therefore, over the couple of months, we can see volatile swings in the FX reserves as temporal mismatches in cash flows on account of delivery against forwards and payment against redemption impact reserves. Data on RBI’s forward cover is available till end of August and it shows that over October and November RBI had $ 12.9 billion long positions in $ INR and $ 22.4 billion of redemption commitment.
During December to January, RBI has around $13.27 billion of long positions compared with $ 2.27 billion of redemption commitment. However, over the past couple of weeks, RBI may have entered into foreign currency swap trades to shorten the maturity of their long forward cover from December and January to October and November. This is being done to ensure that cash flows can be matched and volatility in FX reserves can be reduced.
In the economic data, India’s merchandise exports rose by 4.6 per cent in September 2016 on a y-o-y basis, re-kindling the hopes of a turnaround. This is the second time exports have risen in the last 22 months. Exports had earlier risen in June 2016. Non-petroleum exports rose by 5.4 per cent in September 2016, as against a 1.2 per cent growth seen in June 2016.
This higher growth in exports is backed by a better performance of key items like engineering goods, ready-made garments and gems & jewelry, which account for nearly 50 per cent of India’s export earnings. Engineering goods recorded a 6.5 per cent rise in exports in September 2016, higher than the 2.2 per cent rise seen in June. The Engineering Export Promotion Council of India (EEPC) confirmed that the demand for India’s engineering goods exports from the European nations has begun to pick up. Exports are getting the benefit of a low base last year. According to CMIE, “What strengthens the case for revival in exports is that the growth in September was not restricted to these major sectors. It was a broad-base growth with commodities such as marine products, chemicals and electronic goods posting a rise in exports.”
A good monsoon and stability in global commodity prices should help our exports bounce back in FY17. There seems to be a shift occurring around the world away from monetary policy induced economic recovery towards a fiscal push. The need for such a shift is most needed in the developed world. However, we may have to wait for some more time, as the new Government in US has to lead that effort. If US government increases fiscal spending, without commensurate increase in taxes, we can not only see deficits rise but growth too.
However, the bond market could be in for a rough ride under such circumstances. Benign yield environment is what has inflated the valuation premium across the financial assets space. A rise in yields would be negative for equities and junk bond prices. However, the correction in financial asset prices may not too large as growth inducing fiscal push would cushion the blow.
Over the next 9 months, a few key political events too will have a major bearing on global asset prices. First it would be the US elections in November, followed by Italian referendum in December. Next year between April and September, France and Germany to see national elections. Spain too can see another batch of polls as political uncertainty plagues the nation. In all these election the fight is turning out to be between candidates who are either seen as championing the virtues of status quo and establishment and others, who want to bring down the establishment and start a new political order.
Brexit has given the edge to anti-establishment voices and now what needs to be seen is whether it gets further boost from these upcoming polls or not. If the anti-establishment forces win in most of these polls, then we can see political risk arise next year and that can have profound impact on financial markets. World is already reeling under the demise of the large great leveraging cycle or as Ray Dalio calls the “long-term debt cycle”. Slow economic growth and effect of automation is squeezing wage growth and employment growth. Financial inequality is on the rise around the globe. It is natural that such changes in the economic order also impact socio-political order as well. We as financial market participants, need to pay attention to such trends.