RBI can probably spend about $50 billion more before FX reserves dip into the IMF’s Assessing Reserve Adequacy (ARA) range (100-150% of the metric).
HSBC Global Research has raised its USD-INR forecasts to 76 (from 73) for end-2018 and 79 (from 74) for end-2019. The INR weakened beyond our previous year-end forecasts (73 and 74 for this and next year, respectively) in early October.
Although the INR is the fourth worst performing currency in EM year-to-date (outperforming only the ARS, the TRY and the ZAR), we think it is premature to think about undervaluation and recovery. In the first place, the current value of USD-INR is still within the 67-79 fair value zone of HSBC’s Little Mac Valuation Range.
More importantly, we believe the drivers of the exchange rate recently—the current account deficit (CAD) and foreigners’ portfolio outflows—are only going to get more disadvantageous for the INR in the coming quarters.
HSBC’s economists expect India’s CAD to widen from $16 billion, or 2.4% of GDP in April-June, to a total $75 billion, or 2.8% of GDP for the whole of FY2019. And the risk is for a higher deficit, since the underlying assumption is that the Brent oil price averages $75 per barrel in FY2019 (which requires oil prices to stay around $73 per barrel for the next six months—a tall order) and since India’s oil demand may become less price elastic as the government is now trying to limit the pass-through of high oil prices to consumers.
It will be difficult to fund the current account deficit with just net FDI inflows. These have ranged between $30 billion and $36 billion over the past four fiscal years. It is also common for FDI inflows to decline in the quarters just before an election, which is due in April or May 2019.
Meanwhile, there have been $13 billion of portfolio outflows by global investors in FY2019 so far—split roughly evenly between bonds and equities. The INR’s yield advantage versus the USD is probably seen as relatively low—from both an historical perspective and compared to other EM currencies—amid subdued risk sentiment and EM contagion fears. In this context, the Reserve Bank of India’s (RBI) unexpected decision to keep rates unchanged on October 5 does not help. Even if RBI hikes rates by a total of 50bp in December and in Q1 2019 as HSBC’s economists expect, this would only just match the rate hikes projected by the FOMC.
As for equity outflows, those accelerated after the default by a infrastructure financing company in mid-September, which raised concerns about banking asset quality and a potential credit crunch (since the non-bank financial companies have been extending credit to the economy).
We also see signs that RBI is becoming somewhat more accommodative of the INR’s weakness. FX reserves were basically flat through September. In contrast, FX reserves fell by about $2 billion on average per week in April-June when the INR depreciated sharply and there were large portfolio outflows too. Governor Urjit Patel’s comment about the INR’s fall as “moderate” after the MPC meeting on 5 October was also worrisome, in our view.
RBI could be thinking that some of the measures announced recently to support the INR—allowing companies to borrow more external debt, relaxing some restrictions on foreigners’ investments in corporate bonds, and raising customs duties on select imports—are enough.
But we think not. First, raising external debt can be regarded as a sub-optimal option for plugging the current account deficit as local corporates will have to bear the cost of INR depreciation and they may FX hedge. Second, notwithstanding the regulatory changes, foreigners’ demand for INR corporate bonds may, nevertheless, remain soft due to weak risk sentiment and if funds were to see redemptions. Third, HSBC’s economists note that the products affected by higher custom taxes comprise only a small portion of total goods imports and demand could be relatively price inelastic and so the trade deficit may not fall by much. RBI may also be reluctant to draw on FX reserves because it wants to preserve a very high level of reserve adequacy so as to maintain confidence among foreign investors and residents.
That said, by our calculations, RBI can probably spend about $50 billion more before FX reserves dip into the IMF’s Assessing Reserve Adequacy (ARA) range (100-150% of the metric). This buffer was not available during the “taper tantrum” in 2013, which was one reason why the FCNR (Foreign Currency Non-Resident) deposit scheme was helpful then. There have been talks about re-launching that FCNR programme recently. In our view, it is premature to do so. RBI should preserve some policy ammunition since it could be playing a long game here. HSBC’s analysts expect the Fed to pause only after June 2019, oil prices could stay elevated until 2020, and there could be some $30billion more of foreign portfolio inflows (accumulated since late 2014) to unwind if risk aversion persists.
In conclusion, we are not extremely bearish on the INR. We believe the path of least resistance for USD-INR is higher for now, given our forecast that the USD will stay strong on growth and yield divergence with the rest of the world, India’s widening current account deficit amid high oil prices, and the scarcity of FDI and portfolio inflows due to subdued risk sentiment globally. However, we are note that India has policy options—more than sufficient FX reserves—to stem severe INR depreciation, if necessary.
Excerpted from HSBC Global Research’s October 15 Asia FX Focus report, INR: Thrown a Googly
By- Paul Mackel, Ju Wang, Joey Chew and Madan Reddy. Mackel is head of emerging markets FX research, Wang is senior FX strategist, Chew is senior Asia FX strategist and Reddy is Asia FX strategist, HSBC Global Research