Fwd: FW: JP Morgan: INR: the 25-billion-dollar question - A must read
Awesh Bhornya
From: Vishal G. Pujari <pujari...@gmail.com>
Date: Sun, Jul 14, 2013 at 5:07 PM
Subject: FW: JP Morgan: INR: the 25-billion-dollar question - A must read
To: Harshil Suvarnkar <harshil....@gmail.com>
INR: the 25-billion-dollar question - A must read
INR: the 25-billion-dollar question
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Much has been written about the causes and consequences of the 11% Rupee depreciation over the last two months. But the burning question is whether there is more to come? Or has the move been overdone? Are we in a self-fulfilling spiral? Or are these fundamental imbalances playing out? While the Rupee’s fair value will matter in the medium term, its fortunes in the coming quarters will be inextricably linked to how the balance of payments pans out. And this is where the news gets sobering. India’s current account deficits have become increasingly rigid, driven both by low price elasticity of India’s exports but equally by a structural deterioration in trade balances related to policy and regulatory logjams at home (coal, iron-ore, scrap metal, fertilizers). As a consequence, the CAD has continued to balloon despite significant nominal and real depreciation over the last two years. Therefore, even after making relatively conservative assumptions on oil prices, gold imports and exports, the CAD is likely to remain in the $80-85 billion range this year. In light of this, the worry is that the more stable source of financing typically only finance $50-$55 billion of the CAD. Instead, the BoP has been dependent on $20-25 billion of volatile portfolio flows for each of the last three years. However, attracting such a quantum of portfolio flows in the current environment of rising US treasury yields, weak growth at home, and an approaching general election appears ambitious to say the least. That then underpins the Rupee’s woes. That we are staring at a $20-25 billion hole in the BoP that would need to be financed either through other sources (which is challenging), aggressive RBI intervention – something the central bank (correctly) seems disinclined to do – or more policy tightening (something the government will be wary off). Absent these measures, the brunt of the adjustment to equilibrate the BoP would have to be borne by the Rupee. No wonder than that no level of the Rupee appears sacrosanct any more. Because, given the low price elasticity of India’s CAD, nobody has any conviction on what the needed currency adjustment will have to be to fill gap. Rigid current accounts, reliance on volatile capital flows, and sudden stops of capital never offer easy choices for policymakers. And therein lies the Rupee’s problem. Over done? Not enough? More to come? Much has been written about the causes and consequences of the sharp Rupee depreciation over the last 8 weeks. Some facts are beyond dispute: INR depreciation was triggered by worries about Fed tapering. INR is not the only EM currency to have depreciated. But it is the second worst-performing currency – after Brazil – weakening 11% since May. But all that is water under the bridge. The burning question today is that – having already depreciated so sharply – is there more to come? Or has the move been overdone? Is INR stuck in a self-fulfilling spiral? Or are these fundamental imbalances underpinning Rupee weakness? Answering these questions will inevitably involve an assessment of INR’s fair value. As we have previously argued, the fair value is a function of India’s growth and inflation differential with our trading partners. Yet, assessments of fair-value are medium-term, equilibrium concepts. On a more immediate basis – absent sustained or aggressive FX intervention by the RBI – BoP fundamentals drive the Rupee (see chart). To be sure, these concepts are not divorced. Overvaluation or undervaluation will also influence BoP dynamics which, in turn, should push the currency towards its fair-value. But the lags can be significant and exogenous factors (e.g. sudden stops) can also shape near term BoP dynamics. The question therefore in the current environment -- in which INR has already depreciated by 11%, gold imports have seemingly abated for the moment, US treasuries have surged by 100 bps and Fed tapering expected soon -- what will India’s BoP look like over the course of the year? Because these fundamentals, more than anything else, will determine INR’s fate in the coming months. RBI and SEBI clamp down Before addressing BoP dynamics, however, it is undoubtedly the case that some of the recent Rupee weakness was – as is often the case in India – on account of self-fulfilling expectations. Therefore, in an
attempt to clamp down on speculative activity and anchor expectations, RBI and SEBI announced a series of steps yesterday,
including barring banks from taking proprietary trading positions in the
currency futures and exchange traded currency options markets. Any
transaction in these markets will now necessarily need to be on behalf of
clients. In addition, the RBI has advised state oil-companies to purchase dollars from a designated state bank each. Ostensibly, this is to anchor expectations in the FX market but is unlikely to have sustained impact (unless it becomes a conduit for the RBI to intervene) because it does not alter the fundamentals in the FX market. These moves are clearly designed to reduce speculative behavior, increase transaction costs, reduce liquidity and thereby also increase the efficacy of any potential intervention by the RBI. But, we’ve seen this before. Back in December 2011, when INR was under pressure, regulators introduced a series of steps to dampen speculative behavior. As was the case then, the moves could help reduce some of the “froth” in the market but, unless the fundamentals are addressed, the impact of these technical measures is typically temporary. Furthermore, by increasing transactions costs for everyone, frictions are being introduced even for genuine investors. CAD becoming increasingly price inelastic Therefore the larger, more fundamental, question remains. Will the pressure on the BoP persist? The starting point is forecasting the CAD for this year. We forecast that even after accounting for the fall in gold prices, assuming that oil prices average $105 and building in a meaningful pick-up in exports, the FY14 CAD is expected to stay in the $85 bn range. But isn’t this too high? Won’t the CAD narrow in light of the depreciation over the last 6 weeks. In theory it should. But, as we have painfully seen over the last two years, several rigidities are building up in India’s CAD that are making it increasingly price-inelastic. Between 2010-11 and 2011-12, for example, the Rupee depreciated almost 5 percent, yet the CAD surged from $46 bn to $78 bn. Part of this was undoubtedly because of rising commodity prices but, as we discuss below, also because of India-specific factors. Last year’s example is even more damning. Between 2011-12 and 2012-13, the Rupee depreciated almost 12%, crude prices actually fell, and gold imports actually moderated in value terms. Yet, the CAD increased further by another $10 bn to $88 billion. What’s going on? Why is the CAD not more responsive to sharp currency movements? As we have previously pointed out, the problem is two-fold. On the export side, our merchandise exports are far more income elastic than price elastic. Global growth fell from 3.1% in 2011 to 2.4% in 2012. Predictably, our exports contracted, despite the 11% nominal depreciation that period (though the real depreciation was far more muted given much higher inflation levels in India vis-à-vis its trading partners). More generally, however, the lack of competitiveness of our exports has meant that the economy has not been able to exploit nominal and real currency depreciation. But this is only part of the story. Worryingly, policy and regulatory logjams have meant that several rigidities have built up on the import side. As we have previously analyzed (see, India: uncomfortable and unspoken truths about CAD, MorganMarkets April 2t, 2013), coal imports have more than doubled over the last 5 years, iron ore exports have fallen off from $6 billion to virtually zero, scrap metals imports have doubled and fertilizer imports have risen by 33% over the last three years. The deficit on these fronts rose from $22 billion to $38 billion between 2010-11 and 2011-12 – driving 50% of the CAD increase during that year. More worryingly, on some of these fronts, things are likely to get worse before they get better. To be fair, there has been some import-substitution for more discretionary goods from currency weakness (driving a partial J curve) – but that has been swamped by the impact of the aforementioned forces. All told, there is a worrying rigidity to the CAD that has developed over the last few years, with the CAD becoming increasingly inelastic to exchange rate movements.
All that glitters… In that context, lots of hope is being pinned on gold imports abating sharply in June. But it’s hard to separate the wheat from the chaff just as yet. As the chart below shows, June volumes are always low for seasonal reasons. So we should not prematurely heave a sign of relief. The real-test of whether gold demand has abated will be in September when the demand for gold is expected to pick up sharply. That said, the price adjustment of gold (a 30% reduction over the last 9 months) will certainly help. But even assuming, gold import values fall to $45 bn (assuming relatively muted demand in the coming months since gold imports amounted to $16 billion in just the first two months of the year), the CAD is still expected to print at $85 bn. A $25 billion funding gap, ex ante Bottom line, we will have to live with a CAD of $80-85 billion over the current year. The question is whether this can be funded in the current environment? As we have previously pointed out, the more stable sources of funding (FDI, ECBs, trade credits, NRE deposits) have averaged about $48 billion over the last three years. But averages can be mis-leading because the trend has been rising. Last year these sources contributed $62 billion versus $50 billion the year before, but the pick-up was driven exclusively by trade-credit as lending condition in Euro area banks normalized. Prima facie, attracting even last year’s quantum from these sources will not be trivial. FDI flows have remained range-bound over the last few years, but can be expected to pick-up if the government were to increase caps in different sectors. Conversely, however, gross ECBs can be expected to come under pressure, as US treasuries have hardened by 100 bps and credit spreads have widened. Offsetting this is a possible pick-up in NRI deposits on account of the weaker rupee. All told, we assume that these risks offset each other, and we end up another $60-62 bn dollars from these sources. But this still leaves us with relying on $20-25 billion of portfolio flows (equity and debt) that will be needed, ex ante, to fund this year’s CAD? The question, therefore, is in a world marked by debt outflows in EM markets, US treasury yields at a 2 year high, concerns about the stability of the Rupee, no discernible signs of a growth pick-up in India, and a general election months away, will India be able to attract close to this quantum of portfolio flows this year. Net portfolio flows for the first quarter of the fiscal year were -$0.4 billion. So attracting $20-25 billion in the remaining three quarters will clearly be an uphill task.
Something has to give And that is the bottom line. That we have been relying on $20-25 billion of volatile portfolio flows to finance a bloated and rigid CAD in a world fuelled by monetary accommodation. At some point the party had to end, and these volatile flows would stop (equity) or reverse (debt). And so – faced with a sudden stop of capital flows to EMs -- we are left with a large hole in the BoP? Either we would need to fill this through other sources of financing (which would be challenging in the current global environment) or the exchange rate would need to adjust to equilibrate the BoP. But given the limited price elasticity for exports and aggregate imports, the Rupee adjustment would likely need to be disproportionately large to equilibrate the BoP. There is, of course, another way to take the pressure off the Rupee. To tighten policy, slow demand further to reduce imports, and attack the problem at its root, i.e. narrow the CAD. But the political appetite for this will presumably be limited given already anemic-growth and the fact that this is a pre-election (or election) year. Absent this, the exchange rate would need to bear the brunt of the adjustment. No wonder than that no level of the Rupee appears sacrosanct any more. Because frankly there is no conviction on what the needed level of currency adjustment is to fill this $25 billion gap. And given this lack of anchor, the climate is ripe for self fulfilling spirals. Will (should) the RBI fill the gap? All of this presumes that the RBI will not intervene aggressively to cover the $20-25 billion gap. Thus far, the RBI has indicated a proclivity to intervene to smooth volatility but not protect any particular level (evidenced by the fact that the Rupee easily breached the psychologically-important level of 60). Should RBI then intervene aggressively to bride a large part of the gap? The theoretical case for intervention rests on the fact that either the REER is significantly undervalued at current levels or the macroeconomic consequences from sharp depreciation are very severe, and so the central bank needs to slow down the pace of depreciation. With India’s growth differentials narrowing and inflation differentials high, it’s hard to argue that the REER is sharply undervalued. The case for destabilizing macro consequences is stronger – the depreciation is likely to fuel more inflation, play havoc with some corporate balance sheets and stress the fiscal deficit. But even so, should the RBI be expending 10 percent of its reserves to finance a CAD? After all, reserves have been accumulated through capital flows – as opposed to current account surpluses in the rest of Asia – and so there are corresponding liabilities in the economy. Should the RBI therefore be expending these reserves to fund a CAD? A case can be made if the time that this intervention buys is used to address the structural imbalances in the CAD. However, if there is little adjustment on the CAD, and the global backdrop does not change, expending a sizeable fraction of reserves would just reduce reserve cover (which has already fallen as a percent of gross financing reserves), and make the economy more vulnerable to BoP pressures a year from now. Rigid current accounts, reliance on volatile capital flows, and sudden stops of capital never offer easy choices for policymakers. And therein lies the Rupee’s woes.
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Thanks & Regards
Prof Awesh A Bhornya
9892941879
awesh.bhornya&gmail.com
Anjuman-I-Islam's Allana Institute of Management Studies
Faculty for IT & Marketing
MMS (IT)