RBI Governor Raghuram Rajan has expectedly voiced his concerns—one that we fully share—about competitive monetary easing after ECB QE. RBI, in its February 3 policy, cautioned that “The announcement of massive quantitative easing by the European Central Bank (ECB) in late January has reinvigorated financial risk taking… boosting stock markets across the world, even though many market participants have read the softness in crude prices and the ECB’s announcement as signifying a weaker global economic outlook. Financial markets remain vulnerable to uncertainty surrounding monetary policy normalisation in AEs as well as possibly weaker growth in China and oil exporting EMEs…”
In the post-policy conference call with analysts, Rajan pointed out, “…I think the hope that a number of central bankers have is that they are building a bridge to the future and that they walk off the bridge fairly easily because the deep ravine or chasm is bridged. My fear has always been that the bridge stops halfway and we have to exit it at a time that we have not reached the other side, and then we know that there is a deep fall… So we just have to prepare for volatility…”
And in an interview with the Economic Times, he reiterated that: “I do worry about the whole point in monetary policy (such as QE in Europe)… If QE works largely through a more competitive exchange rate, then it is something for the world to be concerned about because this is a form of beggar-thy-neighbour monetary easing… The assumptions (by ECB and Fed) are that unconventional monetary policy is demand-creating. If it was, I would be less worried because at least it is putting the economy on track. But if it is demand creating in unsustainable ways, it is creating a wealth effect because the stock market and bond prices boom only to go away when you shift policy. Then you get stuck in a chakravyuh… So I worry these are placebos not real medicines.
For India, this means a lot of money seeking returns. India is a good story. We welcome the money (seeking) to participate in that story because it is going to stay for a longer term. But we worry about the money that basically says I need to find a return for the next six months until interest rates go up in the West….”
Against this backdrop, we expect Rajan to continue to recoup FX reserves to fight possible contagion when the Fed raises rates in September (as our US economists expect). Besides spot purchases, RBI has bought $39 billion in forwards since April. If it consistently buys FX, our BoP forecasts that RBI can reach 10-months import cover by March 2016, well above the critical eight-month import cover needed for the stability of the rupee. This assumes oil at $55/bbl in FY16, but $10/bbl swings $8 billion on the current account deficit.
We welcome the news that the government will cut import duty on gold by 2-4% in the Budget to be presented on February 28 as a step long overdue. This is already factored into our current account deficit projection of 0.7% of GDP.
Can RBI cut rates if the Fed hikes? Appreciation since January 15 supports our standing view that RBI rate cuts typically support the rupee. This is because the FII equity portfolio, at $330 billion, is six times the FII debt portfolio. In addition, July 2013 shows that expectations of marked-to-market gains on perceived rate peak-off led to FII debt inflows. That said, we expect RBI to take no chances and remain on hold around the first Fed hike. That is why we expect it to cut 25 bps each in April and June, pause for the Fed hike of September, and resume cutting in February and April 2016.
We continue to expect the RBI to hold the rupee at 60-65 to the dollar unless the dollar appreciates, say, by another 20% hereon. After the ECB QE, our forex strategists have changed the euro-dollar forecast to 1.10 by end-2015 and 1.05 by end-2016, from 1.20 and 1.15 respectively. Jayant Sinha, minister of state for finance, has also told the media that the government is comfortable with a 60-65 to the dollar band for the rupee.
In the light of this, we project what the RBI course of action will be in the following FX scenarios. If the rupee approaches the 60-62 band to the dollar, RBI will buy FX as it is doing now.
In a case of the rupee approaching 63-64 to the dollar, it will likely offer token defence selling, say, of $500 million-$1billion, as it did last month. RBI should ideally want to hold the rupee in the 60- 62 to the dollar zone that Governor Rajan prefers. At the same time, it will not spend too much of precious FX at a time when the rupee has outperformed most BRIC/TIM currencies. However, at a 65 to the dollar situation for the rupee, we see a full-scale FX intervention of, say, $15 billion.
We expect a limited $5 billion hike after the February 28 Budget. This will likely include the $1.5 billion that will come in after FPIs have been allowed to re-invest coupons even if their investment limit—currently set at $30billion – is hit. Despite strong demand for Indian G-Secs, RBI will likely continue to err on the side of caution until markets price in Fed rate hikes that we expect in September.
By Indranil Sen Gupta & Abhishek Gupta
Excerpted from the BofA, Merrill Lynch India Economic Watch report, February 6, 2015
The authors are India Economists with DSP Merrill Lynch (India)