An announcement on the tapering of US stimulus measures is expected to have a significant ripple effect on global markets.
Back home, RBI Governor Raghuram Rajan is likely to have already formulated several strategies to mitigate any adverse impact on India.
A report by Bank of America Merill Lynch (BoA-ML) evaluates the possible courses of action that will be adopted by Rajan in three tapering scenarios, namely a token taper of $10-15 billion, a hawkish taper of over $20 billion or deferring the tapering strategy altogether.
Scenario 1
In the first scenario, envisaging a token taper of $10-15 billion, BoA-ML predicts that Rajan will persist with fiscal tightening measures that started out in July, till December, keeping in mind the fragile rupee.
This is in line with Prime Minister’s Economic Advisory Council Chairman C. Rangarajan’s statement on September 13 that the current tight monetary policy should continue until stability in the Indian rupee is achieved.
In particular, the RBI will only be able to ascertain how much its NRI deposit-cum-swap facility has raised on November 30.
Given that data shows that the central bank sold $5.9 billion in July and estimates peg August dollar sales at $2.5 billion, the RBI will not be able to add more than $5 billion to forex reserves in FY2014 even if the FCNRB deposit-cum-swap facility nets $10 billion.
But this will open up the way for the RBI to step up open market operations (OMOs) to meet the rising liquidity demand in the busy season if a token taper stabilises the rupee at the current 63 a dollar level.
This, in turn, should pull down the yield on 10-year gilts to 8 per cent by March 2014.
BoA-ML says a continuation of the tightening measures and OMOs for Rs 1.2 lakh crore will be necessary in the first scenario as the Rs 30,000 crore of OMO that the RBI has conducted since April has been more than offset by $8 billion of forex intervention.
Furthermore, deposit growth, at 13 per cent, is trailing loan demand of 17.1 per cent.
Scenario 2
In the second scenario of a hawkish taper of $20 billion, BoA-ML expects the RBI to sell foreign exchange to prevent sharp depreciation of the rupee.
But it predicts that the rupee will still fall below 65 a dollar as forex intervention will be limited by the falling import cover.
The investment bank asserts that the RBI will be hard-pressed to sell more than $20 billion at a time when each round of the forex crisis costs $10-15 billion.
It is also unlikely that the RBI will hike the liquid adjustment facility rate by 300 basis points to the 10.25 per cent marginal standing facility rate to protect the rupee, keeping in mind this could hurt growth expectations by 100-150 basis points rather than shore up the domestic currency.
In this regard, the report notes that FIIs’ equity portfolio of $220 billion, which responds to growth, is far larger than their $30-billion bond portfolio, which may respond to rates.
Scenario 3
The best possible scenario for India is for the Fed to defer tapering. In such a situation, the RBI could roll back tightening measures if the rupee appreciates, with BoA-ML estimating that 10 per cent depreciation leads to 1 per cent inflation. This would open up scope for a 25 basis points cut in bank lending rates ahead of the October-March busy season. It could also allow growth to recover to about 5 per cent in FY14, compared to its 4.6 per cent projection in case of a token taper.