RBI needs to explore bond issuances in order to arrest rupee?s downfall
We continue to emphasise that foreign exchange reserves hold the key to rupee stability. Adequate FX reserves will provide investors the comfort that the Reserve Bank of India (RBI) can defend the rupee against external contagion. At present, we ourselves estimate that it will be hard-pressed to sell beyond $30 billion at a time when each round of FX instability costs about $15 billion. With import cover (i.e., months of imports FX reserves can pay for) falling rapidly, we hope that RBI will try to attract chunky flows?such as by issuing non-resident Indian bonds?to replenish its armoury against any threat of a potential run on the rupee.
The rupee?s woes are, by no means, only its own. The 10% rupee depreciation since mid-April has not been much out of alignment with, say, South Africa (10%) or Brazil (8.3%). Even from September 2011, the 32% rupee depreciation we have witnessed is still lower than the Brazilian real?s 38% or the South African rand?s 52%. In this round of FX volatility, the rupee has also been hurt by seasonal weakness as imports tend to do better than exports during the summer and the monsoon seasons.
At the same time, there is no denying that India?s balance of payments indicators are rapidly beginning to trail those of other BRICS. Import cover, for example, has halved to seven months in the past five years while it still remains well over a year for Brazil or Russia. Similarly, FX reserves have halved to 1.7 times the short-term debt of one-year residual maturity in the past five years, way below Brazil?s and Russia?s. Mercifully, this is still above the 1x minimum proposed by the Guidotti-Greenspan rule. It, therefore, is hardly surprising that the rupee always ranks among the worst hit among BRIC and TIM (Turkey, Indonesia and Mexico) currencies.
In fact, the rupee is falling even though the fundamentals are turning in its favour: the current account deficit is peaking, gold and oil prices are stabilising or coming off, good rains should douse agflation and Unilever will likely bring in, say, $3-5 billion to buy back Hindustan Unilever stock. Although investors are selling it in fear of ?tapering?, 2004 demonstrates that the rupee actually appreciates when the Fed tightens. After all, the very growth that drives up Fed rates also whets the risk appetite to invest in BRICS like India.
True, our current account deficit has almost doubled to 4.8% of GDP in the past four years. At the same time, the hard fact is that we will all have to live with a high current account deficit as long as we live in a world of low growth?constraining engineering and textile exports?and high liquidity, keeping the oil import bill high. In fact, most economies are seeing their current account balances weaken. At the same time, we continue to point out that the current account is statistically over-estimated by about 1.5% of GDP. Trade data seem to be overestimating oil imports. Further, recent hikes in NRI deposit rates have led non-resident Indians to switch to NRI deposits (expanding the capital account surplus) from remittances (expanding the current account deficit by reducing invisibles). Besides, return on RBI?s FX reserves has also shrunk to 1.5% from, say, 4.5-5% five years ago, as interest rates have fallen globally. This has also widened the current account deficit by about 0.5% of GDP.
It is but natural that rupee depreciation is raising concerns about repayment of external obligations. We had strongly argued?and correctly?that such risks were grossly overdone in end-2008 and end-2011 as our FX reserves would be sufficient to maintain investor confidence in the rupee. At the same time, there is no doubt that stresses are rising as FX reserves come off. Still, we do not expect much of a problem this year as a good part of the repayment will come from banks.
Against this backdrop, RBI will need to rebuild FX reserves to defend the rupee in a troubled world. After all, every 10% depreciation of the rupee generates 100 bps of inflation and ends up delaying rate cuts and, by extension, economic recovery. Although some talk of strong monetary action, like January 1998, the differential between RBI and Fed rates, at 150 basis points, was far lower than today?s 700 basis points. This begs the question, can RBI really buy FX now? It had rightly begun to do so, in our view, before the present sell off in emerging markets, if only to retire its FX forward liability book. Yet our balance of payments forecasts suggest that RBI will not be able to buy more than, say, $5 billion in the normal course this fiscal. It will thus have to augment this by some one-off big bang mobilisation. One tried and tested way to do this is surely to mobilise, say, $20 billion of non-resident savings through an issuance like Resurgent India Bonds of 1998 or India Millennium Deposits of 2011. After all, the on-going sell-off in emerging market debt will limit the ability of hikes in FII debt limits to attract inflows in the immediate future. Other proposals?such as hiking FDI limits in telecom and other industries?are probably too medium term to provide much needed immediate succour.
The author is India economist at Bank of America Merrill Lynch
