RBI will need to demonstrate its ability to recoup FX reserves rather than sell to anchor rupee expectations. Another $25-30bn of RBI FX intervention will take FX reserves to the eight-month import cover, on FY20 basis, which is key to rupee stability. This assumes that the CAD expands to 2.9% of GDP in FY20 from 2.6% in FY19 even as global/political uncertainty dries up FPI flows. The easiest is to step up RBI OMO, cool yields and reverse debt FI outflows ($6.4bn to date). Durable liquidity has contracted by $15bn to date this fiscal year. The MoF/RBI could also launch NRI bonds (raising $30-35bn ) if the rupee persists at 70+ to the dollar into the December quarter without FPI flows reviving. Finally, the MoF can likely raise $5bn via a sovereign bond. RBI hiking rates to cut CAD could kill growth and hence is not advised. Higher RBI rates end up hurting the rupee as FPI equity investments (at $500+bn), that are driven by growth, are 8x that of FPI debt investments. BofAML FX strategists estimate the rupee to stand at 72 to the dollar in December. If FPI flows do not revive, RBI will need to sell another $15-20bn by March 2019 itself.
RBI has to conduct OMO for $50bn by March, if FPI flows end flat. BofAML forecasts that RBI will have to inject $33bn of reserve money/durable liquidity in FY19. If FPI flows end flat, our BoP forecasts suggest that RBI would have to sell about $24bn ($20bn spot plus $6+bn forward) to fund a 2.6% CAD.
All three NRI bond issuances—1998, 2000, 2013—were able to fend off contagion. Experience shows that only one of the three monetary tightening actions—1998—had even partial success. Is a NRI deposit rate hike not good enough? This will surely be able to draw higher NRI savings. A NRI bond with an implicit RBI/sovereign guarantee typically enables the NRI to leverage global savings to augment the RBI’s FX coffers. The government could raise $5bn via a sovereign bond, but that would unduly expose domestic rates to global volatility. In any case, NRI bonds can raise 7x without MTM risks.
As it is, the rupee is the worst performing currency in Asia with higher oil prices fuelling the trade deficit. Although the June quarter CAD came in at a lower-than-expected $15bn, BofAML’s FY19 forecast stands at 2.6% of GDP on a higher trade deficit. Current external indicators are slipping towards 2013 levels with a rising dollar hurting FPI flows ($78bn since September 2013 vs $107bn in FY10-13). The share of FX reserves to GDP, at 16.3%, is pretty much the same as 2013. India’s BoP position remains among the weaker within the BRICS grouping at a time of rising BoP headwinds.
Estimated one-year forward import cover, at 9.4 months in FY19 and 8.9 months in FY20, is better than 2013’s 7 months, on lower oil prices, but well below the pre-2007 crisis 14 months. If a hung Parliament dries up FPI flows in FY20 as well, the import cover can well slip to 8.3 months, close to the 8 months deemed necessary for rupee stability. The ratio of FX reserves to short-term debt of residual maturity, at 1.9x (1.7x adjusted for FPI debt investments) now, is still better than the Greenspan-Guidotti rule’s 1x stipulation—$21.3bn of FX corporate debt mature by March. It is comparable to 2013’s 1.7x but well below 3.8x in 2007.
We estimate that RBI OMO could climb to US$60bn by March, if FPI flows do not revive at all, with durable liquidity contracting by US$15bn to date. With the money market slipping into deficit, RBI will likely step up OMO in coming weeks. NRI bonds still could offer fairly attractive pricing of approximately 4% to NRIs in dollar terms despite some uptick in US/global rates. The cost of a three-year NRI bond would need to be capped at, say, the SBI’s 7.3% three-year term deposit rate. If RBI bears half the in all swap cost of about 7%, the bank mobilising NRI bonds can offer 3.75% to the NRI, slightly higher than the SBI’s current 3.37% 3-year Foreign Currency Non-Repatriable deposit rate.
Given that NRI bonds have typically stabilised the INR, especially adjusted for the RBI’s returns on FX assets, we feel it is more important to raise larger amount of FX even if it means a higher subsidy on the swap cost. Experience, especially from mid-2013, suggests that RBI rate hikes depreciate the INR as FPI equity investments, that respond to growth, are far larger than FPI debt investments that theoretically respond to rate differentials. Even debt FPIs often hesitate to make further investments if they have just booked large MTM hits on their existing portfolio.
Edited and excerpted from BofAML’s India Economic Viewpoint report dated September 10, 2018