Inflationary pressures, inelastic gold and electronics demand and existing FTAs with japan & korea make import-curbing measures less effective.
The MoF/RBI must take steps beyond import duty hikes on gold, electronics that the media has reported the government is considering and the measures announced last weekend to support the rupee. Possible inflation impact also limits the magnitude of tariff hikes. Gold demand may not react to small tariff hikes, especially in face of MSP hikes during a reasonable harvest. Steel tariff hikes will likely not scale down imports from Japan and South Korea (33% of total) given free trade agreements. Finally, the secular increase in import demand for electronics items may not be that price-sensitive. Looking ahead, the MoF/RBI will have to step up support for the rupee with RBI’s ability to sell FX limited to $25-30 bn.
If FPI flows do not revive, especially with the US-China trade war escalating, RBI will have to sell another $10-15bn by March itself. Of the two key alternatives reported in the media, NRI bonds, raising $30-35 bn, are preferable over a RBI rate hike. NRI bond issuances—in 1998, 2000, 2013—have always stabilised the rupee. On balance, RBI should step up FY19 OMO to $50 bn (from $6 bn FYTD) if FPI flows do not revive.
Gold demand is not likely to react to 5-10% tariff hikes, in face of MSP hikes during a reasonable harvest, and a step up in loan waivers to $40 bn (BofAML estimate) from $25 bn so far. The accompanying graphic shows that it takes very large swings in prices to impact gold demand (after adjusting for 2013 gold import ban and demonetisation effects). Note, a 5% increase in gold import tariffs raises inflation by 5bps.
The secular increase in demand for electronics items, like cell phones, may not be that price sensitive. A5% increase in their tariffs impacts inflation by 4bps.
Steel tariff hikes may not scale down imports from Japan and South Korea (33% of imports) with which India has free trade agreements, although they reduce risk of dumping from China.
We expect the MoF/RBI to take further steps, some of which are listed here, to stabilise the rupee in the face of a rising BoP gap. NRI bonds could raise $30-35 bn, amidst rising global uncertainty.
We cannot rule out an October RBI rate hike to ‘support’ the rupee. RBI rate hikes, however, typically hurt the rupee as FPI investments in equity, at $500 bn, are eight times that of FPI in debt. RBI tightening has succeeded only once—1998—of the three times it has been attempted.
Canalising oil import payments through an RBI window is unlikely to help as this will still draw down FX reserves.
Measures—like curtailing net open positions and rebooking of cancelled forwards or hiking the cost of trade finance—have been typically tried in the past before major RBI FX intervention. We are not sure if the MoF can really meaningfully hike import tariffs to contain rising electronics imports or clamp down on gold imports.
Edited exerpts from DSP Merrill Lynch’s India Economic Watch report, September 18, 2018
-The writer is India economist, DSP Merrill Lynch (India). Co-authored with Aastha Gudwani