RBI may shift purchases to the forward market to create room for OMOs to fund GoI’s fiscal deficit. It would need to inject durable liquidity of $45bn in FY21.
The RBI’s reasonably high FX reserves (of US$487bn) are surely India’s main bulwark against the deepening global slowdown. We have always believed that the Jalan-Reddy policy of building FX reserves is our only insurance against contagion. RBI Governor Das recently pointed out that “… so long as currency is stable, then people…can take better quality decisions…” He has raised US$57.7bn, since December 2018, with oil prices falling (Chart 1). This should help keep speculative attacks on the INR (rupee) at bay. Second, sufficient FX reserves provide foreign portfolio investors the comfort to invest in Indian markets. Finally, this also allows Indian corporates the option of raising project finance from international markets at cheap rates.
So, how much of FX can the RBI buy? Our balance of payments estimates suggest that it should be able to add US$31bn in FY21 if the current account deficit shrinks to 0.7% of GDP with oil averaging US$47.5/bbl. (US$10/bbl swings the current account deficit by US$11bn.) This obviously puts India in a far safer position than, say in 2013, or in 2018. Given the disruptions large depreciations bring, the opportunity cost of about 0.6% of GDP is surely an acceptable price to pay. So, why has the INR depreciated by 4% in 2020? This is broadly in line with the 2.4% appreciation of the Asian Dollar index. The RBI has typically never squandered precious FX reserves to counter a rising US Dollar. It is surely better to live to fight another day. In any case, INR depreciation is far less than that of other BRIC nations (ex China) (Chart 2).
Reasonable FX reserves accord the RBI the ability to steady the FX market with USD/INR sell buy swaps of US$4bn to fund recent FPI sales of US$6.1bn. In truth, this is not strictly necessary as banks hold nostro FX balances of about US$30bn. A central bank with sufficient FX reserves typically does not have to sell FX reserves to anchor expectations. If FX reserves are not perceived to be sufficient, FX interventions only stoke the fear that the policy maker’s ability to support the currency is weakening. It is for this reason that a build-up of FX reserves actually supports the INR in the medium term.
Can India insulate herself from the deepening global slowdown? We think she will be relatively less impacted, a la 2008, as the economy is largely domestically driven. Still, contagion does travel through disruptions in markets. We ourselves see FY21 real GVA growth at an anemic 5.1% (4.4% in case of a global recession.) So, how will Delhi contain economic contagion? The first line of defence is certainly the RBI’s ability to intervene in the FX market if needed. Second, the RBI MPC should cut policy rates by 25bp each before/on April 3, June and October with inflation expectedly peaking off and the Fed cutting 150bp. Finally, the government can support consumption demand by cutting oil prices to release `500bn/US$6bn /0.2% of GDP, even its `3 excise duty hike. Given the additional tax revenue it has garnered, the government could offer a 2% subvention to micro and small industries to shield them from rising real lending rates at a minor fiscal cost of 0.1% of GDP. Although nominal MCLR has fallen 54bp, on RBI easing, since March, real MCLR has shot up 67bp with core WPI inflation falling 135bp.
So, is the RBI done? I would hope that the RBI continue to build FX reserves, at every opportunity, even at the cost of a slightly weak INR. While sufficient to ward off speculative attacks, I reckon that a conservative central banker would like to stockpile US$550bn of FX reserves. This is arrived at by taking the average of the following three metrics:
Import cover: 1-year forward import cover has slipped to 11.1 months from 14.4 in the last upcycle. The reason it looks relatively high is that low growth has pulled imports to 16.4% of GDP from the average 21.9% since FY06. We place ‘conservative’ FX reserves at US$535bn at 10-month 1-year forward import cover at imports of 20% of GDP. Experience tells us INR depreciates if it falls below 8 months.
FPI investments/FX reserves: FPI investments, on MTM basis, rose to 113% of FX reserves in September 2019 from 82% in 2007. 100% FX cover currently requires US$521bn of FX reserves.
FX reserves/short-term debt of 1-year residual maturity + FPI debt investments: This slipped to 1.5x in September 2019 from 3.8x in 2007. At 2x (twice the Greenspan-Guidotti rule), the RBI needs US$594bn of FX.
Can the RBI contain yields to support growth if it buys FX reserves at this pace? We expect it to shift purchases to the forward market to create room for open market operations to fund the Centre’s fiscal deficit. We estimate that the RBI needs to inject durable liquidity of US$45bn into the economy in FY21. If it buys US$31bn of FX reserves, as noted above, it can barely buy US$14bn of government bonds. This will not be sufficient to fund our estimated G-sec market gap of US$32.9bn, unless the RBI buys US$18.9bn forward.
The writer is India economist, BofA Global Research
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