The Nirav Modi scam has a direct impact on the forex market. Foreign branches of Indian banks have closed down the buyers’ credit window to protect themselves from getting caught out by fake LoUs. SBI overseas branches, for instance, have been “instructed not to extend buyers credit to any PSB/private bank in India till further instructions.” Other PSBs have issued similar instructions. The cost of financing imports has risen by 50-75 bps, in some cases. This will have a significant impact on the rupee. The finance ministry recently (September 17) reported that short-term trade credits in the system were $91 billion (`6 lakh crore), of which about $60 bn had a maturity of 6-12 months. This means that the outstanding buyers’ credit maturing over the next 6 months will be even more than $60 bn, since some of the credits were already rolled over before the scam. Given that rollovers have all but stopped, a larger percentage of this than usual will translate to spot USD demand over the next few months.
Since everyone can see this happening, the rupee has slipped about 2% over the past 10 days or so. Complicating the matter is the fact that RBI has been doing buy-sell swaps, buying dollars to infuse liquidity to prevent the market for rupee funds from drying up, due to which “extra” demand has created additional pressure on the rupee. On the other side and part of its determination to control volatility, RBI has turned into the elephant in the market and—in the same week—has been selling dollars to prevent the rupee from weakening too much! This has been a windfall for trading banks and inter-bank brokers, but leaves firms even more uncertain about what would constitute a “fair” intra-day price—so much for policy assisting the final users of the market.
The big question is why the rupee hasn’t weakened even more? There is, of course, the fact of the prodigious political skills of the Modi/Shah tag team, seen performing in the Northeast last week. But, on the down side, in addition to l’affaire Modi, the macro picture, at least from an FX point of view, is not too good. The trade deficit has been widening despite strong global growth, confirming that there is something structurally off on the export front. The reversion to increasing import tariffs in the budget and the expected fiscal slippage will add to the macro woes. Both of these, compounded by the pathetic picture of our banking sector, could weaken investment interest in India. FPI flows are already reflecting this – they pulled more than $2 bn out of India in February, the bulk of which was from equity. Debt outflows have, thus far at least, been relatively modest, but the equilibrium appears quite tentative. The new chairman at the US Fed, who is an ex-banker rather than an economist, was expected to be both more market-savvy and more sympathetic to market players. However, in recent testimony, Chairman Powell has made it clear that he isn’t going to be a pushover for the market—in fact, the probability of four rate hikes (rather than three) this year has increased since his most recent testimony.
Equity markets are very nervous—the average absolute daily move in the Dow since the start of February has been around 1.5%. This is huge—the first time it has been so high since October 2011; long market experience suggests that such high volatility is often the precursor of a major market move.
The US unemployment report on March 9 will be watched even more eagerly. A continuation of strong numbers, particularly on wage increases, could re-ignite US Treasury yields, which would kick equities even lower. In parallel, Trump’s tariffs, which have succeeded in upsetting much of American industry and many of its trading partners, if sustained, could turn the ongoing correction into something much worse. Indeed, it seems likely that markets may fall sharply next week, if only to signal to Trump that he needs to backpedal on tariffs, as he has on virtually everything else. The dollar, which has been benefitting from the expected rise in US yields, is poised for a technical break-out upwards. But the tariff imbroglio, plus comments from the US Treasury, suggesting that the US administration wants a weaker dollar, could keep markets unsettled—FX volatility will increase till some kind of trend forces itself onto the scene.
The rupee is walking its own tightrope between increased dollar demand, on one side, and RBI’s obeisance to volatility control, on the other. If global markets calm down—say, the employment report is soft, or some “unknown unknowns” reason—things could quieten down and the rupee could again climb back to above 65. If, however, things get more difficult globally—and, unfortunately, to someone who thinks about risk, that always seems more likely—RBI’s volatility management will be pressured and we could see the rupee head lower, and, possibly, much lower. As I have said innumerable times earlier, there are sound arguments on both sides, best to build and implement a risk management system that delivers acceptable value whatever path the market takes.