By Indranil Sen Gupta
The ongoing US/global slowdown is different from the past. After all, the US is seeing inflation driven by cheap money after almost 40 years. As a result, the Fed will have to tighten to fight inflation rather than ease to support growth as well as markets. This poses a downside risk to India’s growth, although domestic demand will cushion the impact of a slowing US/world economy. Second, tightening by the US Fed will force RBI to hike policy rates. Finally, the Indian stock market is much more vulnerable to global/US impulses than growth.
So, why does the US Fed matter for the Indian economy? Our growth is obviously linked to the United States’ growth, although less than most because of the cushion of domestic demand. Second, Fed quantitative easing (QE)/quantitative tightening (QT) drive foreign portfolio investor (FPI) inflows/outflows. Finally, US market moves drive expectations in Indian and other emerging markets. After all, there is a very high correlation between, say, the S&P 500 and Nifty 50. During recent bear markets, we find that Nifty 50 has fallen as much or slightly more than the S&P 500.
And, why is 2022 different? Because the Fed is not in a position to come to the aid of growth and the markets as it has to bring down inflation. After all, cheap money—M2 growth crossed 20% vis a vis the 7% long-term average—is surely a major cause of high US inflation (9.1% in June versus 2% Fed target).
Monetary history tells us that money-driven inflation is far more difficult to cut down than inflation caused by a supply shock. During the 2000 recession/‘bear’ market, the S&P 500 fell 37% over 546 days, with the Fed cutting after a 14% fall in the S&P 500. In 2008, the S&P 500 fell 52% over 408 days, with the Fed cutting after a 1% fall in the S&P 500. In 2020, the S&P 500 fell 34% over 33 days, with the Fed cutting after a 11% fall in the S&P 500. In sharp contrast, the Fed can be expected to hike rates by another 100-125 basis points despite the S&P falling 16% over 206 days.
Against this backdrop, the estimate is that an US recession will shave 100 basis points from India’s growth. (with US recession being defined as zero export growth.) Thus, a 100-basis point downward risk to CLSA’s already below-consensus 6.7%/5.5% FY23/ FY24 growth forecasts is foreseeable.
RBI monetary policy committee (MPC) can be expected to hike another 115 basis points, atop 130 basis points done, to quell high inflation and match Fed hikes to support the rupee.
It should cut 50 bps in 2H23 as growth and inflation come off. RBI will likely need to hike to maintain an interest differential of, say, 200 basis points between its repo rate and the US federal funds rate.
A bit of good news is that inflation should peak off to 6.3% by March 2023 and 5.5% in FY24 from the 7% levels now, looking through the jump on base effects in September. After all, a shallow recovery constrains pricing power. Second, RBI has contained money (M3) growth, in sharp contrast to the Fed. Third, a good monsoon should cool agri-inflation, with buffer stocks taking care of any shortfall in the rice crop due to poor rains. Fourth, Fed QT should cool off commodity prices. Finally, high FX reserves should support the rupee against global shocks.
Bonds continue to seem as a falling knife despite the recent rally. The 10-year yield can be expected to go up to 8% this fiscal and then come off to 7% by mid-FY24. As noted above, RBI can be expected to hike policy rates. Finally, the large excess supply of government paper due to the high fiscal deficit also needs to be pointed out. A saving grace is that RBI should be able to conduct large scale open market operations (OMO) as it will likely end up selling almost $80 billion (assuming oil prices at $115/barrel).
The standing call that RBI Governor Shaktikanta Das’s high FX reserves will protect the rupee from global shocks bears reiteration. Yes, the rupee has depreciated 7% against the dollar since September. This, however, reflects the spike in the dollar on Fed tightening. In fact, the rupee has appreciated 5.7% versus the euro. RBI can be expected to allow the rupee to stay at 79-80 to the dollar rather than waste FX reserves against a cross currency move at a time of adverse seasonality and high oil prices.
As the dollar peaks off, the rupee will likely recover to 76 to the dollar by March as the seasonality turns and oil prices come off. This bakes in: 1) 3% of GDP FY23 current account deficit; 2) $20 billion foreign portfolio investor (FPI) outflow; and 3) another 115bp of RBI rate increases.
FX reserves could persist at around $600 billion, which can be deemed appropriate. A $590 billion (including forwards) reserve at 1.10 EUR-USD by March 2023 is projected, from, say, $610 billion now. Although headline FX reserves have fallen by about $60 billion since September, the actual outgo is estimated at, say, $32 billion, adjusted for RBI’s forward transactions, changes in bank nostro balances and revaluation.
Governor Das can be expected to hoard FX reserves amid extreme uncertainty, like Governor YV Reddy in 2006. RBI then sat out the dollar spike on Fed hikes as it had sufficient FX reserves, like now, to stop runaway depreciation. RBI can be expected to change the cost of export/import finance atop raising the FCNRB deposit rate cap ($5 billion inflow CL) to support the rupee. If foreign portfolio investor (FPI) outflows persist ($20 billion CL), Delhi could offer infra bonds from the National Bank for Financing Infrastructure and Development (NABFID) to non-resident Indians to raise $20-25 billion.
The writer is head of India research at CLSA. Views are personal.