Why has the rupee held up so well amid the ongoing sell-off in emerging markets? Because many foreign exchange investors believe India is ahead of its Fragile Five (Brazil, Indonesia, South Africa, Turkey) peers in the pain cycle. We continue to expect the rupee to settle at ₹60-65 per dollar if the dollar trades at about 1.30/euro. In fact, many investors are trading the ₹61.5-63 per dollar range for now. Relative value trades – buying rupee, selling other 'Fragile Five' currencies – are also gaining currency. The good news is that sentiment indubitably favours the rupee.
The RBI is seen to be taking steps to raise FX reserves, with $34-billion raised through the FCNRB-cum-swap scheme. Indeed, RBI’s Patel committee recently recommended that it build "… an adequate level of foreign exchange reserves... in terms of... existing metrics... (and) intervention requirements..." Needless to say, this buttresses our standing view that the RBI needs to build FX reserves, as it did in the Jalan-Reddy years, to anchor rupee expectations. Furthermore, global investors are clearly enthused by Governor Raghuram Rajan's adoption of inflation targeting. As we fancy ourselves hawks, we too have welcomed this as a step in the right direction.
The bad news is that the rupee is still vulnerable to a prolonged sell-off in emerging markets. After all, the import cover (months of imports FX reserves can fund) has halved to 7.5-8 months in the past five years. This is well below the 10 months necessary for rupee stability. At the same time, the rupee is staring at three headwinds. First, about $7-billion (net) of FX swaps that the RBI contracted with oil companies during the last FX crisis mature by April. Second, banks and corporates need to repay FX loans of $4.8-billion in March. A saving grace is the bulk comes from banks and blue chip companies that should surely get a roll-over. Finally, restrictions on gold imports will likely be withdrawn after March, with inventories running down. This should widen the current account deficit to 3 per cent of GDP from 2.5 per cent in FY14.
Looking ahead, we see three swing factors. First, global bond investors are anxiously awaiting listing of Indian gilts on EM bond indices. We forecast this could fetch above $20-billion from benchmark funds that track such indices. This will add teeth to the RBI's FX intervention. Second, the coming General Elections naturally pose an event risk. Nonetheless, the rupee is far less sensitive to polls than stocks. It depreciated only 0.3 per cent in 2004 although the BSE Sensex dropped 15.9 per cent. In 2009, it appreciated only 3.1 per cent, while the BSE Sensex jumped 15 per cent. Can a stable government attract large capital inflows? We doubt this, as global liquidity is shrinking with the Fed tapering. In fact, India accounts for a third of the equity inflows in emerging markets for the past four years.
Finally, we advise investors to watch the coming monsoon as food accounts for over 50 per cent of CPI, the proposed nominal anchor of monetary policy.
We estimate that a 5 per cent drop in agricultural growth pushes up CPI inflation by 270 basis points. If rains are indeed normal, we expect CPI inflation to ease well below the RBI's 12-month target of 8 per cent.
This will allow it to cut rates to support growth and attract FII inflows. The Southern Oscillation Index, a key indicator of rains, is currently neutral between La Nina (that brings rain clouds into India) and El Nino (that drives away rain clouds).
Given the RBI's limited ability to sell FX, could rate hikes ward off contagion? Not really. Yes, some FX investors have welcomed January 28's 25 basis points surprise RBI repo rate hike as a pre-emptive strike even before the Central Bank of Turkey or the South African Reserve Bank acted. Nonetheless, the rupee is different.
The $220-billion FII investment in equity, which responds to growth, is far larger than the around $15-billion FII investment in debt, which may respond to higher rates. In the past few years, equities accounted for 80 per cent of portfolio flows to India, compared to 10 per cent for Turkey.
Against this backdrop, a CBT-type spike in rates will weaken the rupee further, as in July, by pushing back recovery further and driving away FII equity inflows. We do recognise the difficulty the RBI faces in acquiring say, the $80-billion to $100-billion necessary for Indian rupee stability in a short span. Still, FX market expectations largely move on intent, rather than actualisation. Not surprisingly, Governor Rajan's initiatives to raise FX reserves are supporting the rupee.
(The writers are India economists at Bank of America Merrill Lynch)