In the graph (check below) Indian rupee can be counted amongst the outperformers. Indian rupee has only depreciated by 1% but if it was not for $35 billion purchases in the spot markets and some more through the forward market, rupee would have appreciated instead of depreciating. Indian economy is an interesting mix of many drivers. On one hand, there are people in rural and urban areas who derive their livelihood from production and mining of commodities and processing of same and on the other there are vast populations whose livelihood is not directly dependent on commodity prices. At the same time, lower oil prices help the government to lower its deficit and country to export less of foreign currency. This interesting mix in the economy has enabled India to stand out in this commodity carnage. We also need to thank the central bank, who after a decade or so has refocused on maintaining a healthy spread of interest rates over retail inflation (a real return on savings for the capital saver). High real rates and strong control over money supply has made Rupee an interesting bet. Add to that the singular focus of RBI to destroy any sign of volatility. Would not the world, awash with artificial liquidity and running out of sensible risk adjusted investible assets, gun for such a “slum-dunk” trade.
In economics there are no free lunches and therefore there are no economic events which are absolutely good or absolutely bad. There are only winners and losers from such economic inter-plays. RBI, in keeping the Indian rupee in such a tight leash, has helped corporates over the recent past. However, at the same time, it has bred complacency amongst the same segment. Though one can argue that the degree of complacency may not have reached levels since before 2011, when very few imagined the possibility that rupee can weaken over the near future. As a result, a lot of out of money call options were sold with expiry far out in the future, which were blown to smithereens when the rupee depreciated.
Corporates, who have foreign currency exposure, be it in the form of net imports or in the form of foreign currency borrowings, are not looking to hedge their currency risks. Some are assuming the low rates on US Dollar or Euro or Yen is some kind of a way-out of the high rates prevailing within the domestic market. Complacency sows the seed for the unraveling of the status-quo. However, RBI has been building its war chest, to act as a buffer is a material unwinding risk emerges in the future. But 2008 has shown that no amount of RBI FX buffer or rate barrier can prevent a material slide in the Rupee, if foreign investors cue up en masse to withdraw funds out of India. We do not know, when or if at all RBI will be tested like it was during 2008, 2011-12 and 2013. However in order to figure that one out, one has to keep an eye on the domestic equity and debt markets, where sizable amount of sticky and hot money, both have entered since end of 2013.
Let us turn our attention to some key economic events over the past week. Growth in the eight core sectors — coal, crude oil, natural gas, refinery products, fertiliser, steel, cement and electricity — slowed to three per cent in June after a six-month high of 4.4 per cent in May, mainly on account of contraction in crude oil and natural gas production. One can blame the high base of 2014 but still the overall data is not so impressive. Industrial economy remains weak, as weak consumption environment is taking a toll on corporate investments plan and industrial consumption as well. However, there are encouraging signs of recovery in the road sector which is spilling over into increased demand for transport goods. However, the recovery is not so broad based that it can negate the weakness in other sector.
Government agreed to infuse 70,000 crore rupees of capital into the PSU banks over a period of 4 years. Though stock markets have cheered the move but we are not so enthused. The total stressed assets in the banking system are between 11-13% of total advances. Add to the need for banks to raise funds to meet Basel III capital requirement, and the 70,000 crore rupees pales in comparison. Govt may not be having the funds to meet such large scale capital requirement of the PSU banks, and hence it is time to make some bold moves. It is not a good practice that tax payer funds should be used in such massive amounts to inject life into the PSU banking system. Possibly it is time now to ask the question, should government be at all in the business of running the banking business. A mix of privatization of the public banking system and also designing comprehensive plan for recovery of stressed assets needs to be done. An effective bankruptcy law needs to be framed. At the same time, recognition of bad assets and recovery of funds, through liquidation of collateral and other assets of the borrowers need to be undertaken. Remember, a financial system is like an engine of the economy. Unless the engine can be brought back into strong health, economy may face breakdown from time to time.
Over the next, traders will be keeping a close eye on the US jobs reports, where any soft reading can cause Rupee to appreciate towards 63.60/70 levels on spot. Domestic traders also have the RBI policy to digest. I believe RBI still has the room to lower rates over the near term, as inflation would remain subdued. However, rate cuts have little impact on Rupee, but greater impact on the credit market. Incase of a rate cut, though Rupee may move towards 63.60 levels on spot, but long bonds can appreciate meaningfully. However, lack of rate cuts or a hawkish tone can cause a sell-off in bonds and Rupee. We are eyeing a range of 63.30/50 and 64.30/50 on USD/INR over the medium term and 7.70-7.90% on the new 10 year bond.
Author is an analyst at Kotak Securities.