RBI did well to pause. Here’s what will be more effective than RBI rate hikes in supporting the Rupee

Looking ahead, expect RBI to be on long hold, although another unsuccessful July 2013-type rate defence of the INR cannot be ruled out.

Written by Indranil Sen Gupta

New Delhi

October 9, 2018 02:55 IST

While depreciation poses a risk, NRI bonds, raising $30-35 billion, would be far more effective than rate hikes in defending INR. (Reuters)

RBI MPC did the right thing in holding policy rates and changing the stance to ‘calibrated tightening’ in a 5-1 vote. Inflation is also expectedly peaking off with September set to print at 4%. While depreciation poses a risk, NRI bonds, raising $30-35 billion, would be far more effective than rate hikes in defending INR. Looking ahead, expect RBI to be on long hold, although another unsuccessful July 2013-type rate defence of the INR cannot be ruled out. BofA’s liquidity model estimates that it will have to OMO another $35+ billion by March, atop the $5 billion announced for October even if FPI flows end FY19 flat ($10 billion outflow FYTD) NRI bonds would be far more effective than RBI rate hikes in supporting INR.

Continue to expect the MoF/RBI to raise NRI bonds (of $30-35 billion) with MofA’s Asia FX strategists now expecting Rs 75/USD by June with their oil strategists seeing $95/bbl then. All 3 previous NRI bond issuances—1998, 2000, 2013—were able to help fend off contagion. Experience shows that only one of the 3 rate hikes—1998—had even partial success. This is because FPI investment in equities ($500 billion+), that chase the India growth story, is almost 8x that in bonds.

Continue to expect inflation to peak off. September’s inflation should be at 4% (and the recent excise cut on petrol and diesel should damp October inflation by ~10 bps). RBI has cut H2FY19 inflation by 60 bps. BofA disagrees with RBI’s view that the output gap is closing as base effects buoying June’s 8.2% growth are reversing. Seasonally adjusted capacity utilisation levels are still weak.

RBI has brought out an OMO calendar committing Rs 360 billion/$5 billion in October to modulate tight liquidity. Our liquidity model estimates that it will have to OMO another $35+ billion between November-March even if FPI flows end FY19 flat ($10 billion outflow FYTD). RBI should inject $33 billion of reserve money/durable liquidity in FY19. BoP forecasts suggest that it needs to sell about $24 billion ($20 billion spot FYTD, $6+ billion forward) to fund our estimated current account deficit of 2.8% of GDP. Proposed liberalisation of FPI limits is not going to move the needle.

-Edited excerpts from BofAML’s India Economic Watch (Oct 10)
Co-authored by Aastha Gudwani

This article was first uploaded on October nine, twenty eighteen, at fifty-five minutes past two in the night.