Nomura’s latest forex report on India says that the rupee is likely to remain weak, with very few tools available at the disposal of the RBI
Nomura estimates that despite net portfolio outflows of $6.7 bilion, largely from debt over the last month, foreign positioning in India in equity remains high. In fact, foreign equity ownership actually rose about 0.4% in June.
While it is commonly perceived that the recent depreciation of the rupee by about 9% against the dollar has brought it closer to its fair value, Nomura’s analysis shows that it is still overvalued by about 17.6%. Higher import prices from the rupee’s weakness are likely to keep the Reserve Bank of India (RBI) on hold for some time, lowering growth expectations and limiting foreign equity flows.
The fact that the rupee has breached the 60-mark could elicit a government response soon. Without solid reform, Nomura expects the rupee to remain weak. One suggestion it offers that can be implemented quickly and lead to a sharp halt in the rupee depreciation is an announcement of a large NRI bond issuance.
Nomura expects India's current account deficit to ease out to 4.3% of GDP in 2014 from 5% in 2013 due to lower gold imports, maintaining, however, that financing the deficit is going to be an immense challenge. The steadily worsening external vulnerability indicators suggest that the RBI has little agency to exercise. Aggressive intervention would only increase the vulnerability of further capital outflows.
The brokerage suggests real sector reforms such as clarity on gas pricing policy, raising FDI limits in certain sectors and relaxing external commercial borrowing limits further.
Nomura's expectations for the next few months are bleak, with a weak currency increasing imported cost inflation and hurting the corporate sector with un-hedged loans.
Domestic supply-side constraints, weak global demand and inelastic imports make it unlikely that even a weak currency could substantially help the trade deficit. Financial stability is likely to be of primary concern to the RBI, with a possible delay in rate cuts and tighter liquidity further hurting the prospects of domestic growth.
Prudent fiscal policy combined with structural reform is the way forward and the Indian economy simply cannot afford the Food Security Bill, says Nomura
The sharp downturn that the rupee’s trajectory has taken recently has sparked off concerns about an interest rate hike as a possible policy response. The rationale for that would be to raise interest rates to contain aggregate demand to address the current account deficit and attract more capital inflows in order to help the balance of payment.
According to Nomura however, conventional theory may not be applicable to India's present macro-economic situation for three reasons. For one, Nomura says that the problem that needs to be addressed is not one of a high aggregate demand, but of a lack of supply. Next, it remains debatable as to whether capital flows into India are growth or interest sensitive. Finally, domestic demand has already collapsed, with non-oil/non-gold imports declining, suggesting the presence of weak private demand. Nomura says that the cost of hiking interest rates could do more harm than good, given rising domestic leverage on corporate balance sheets and their inter-linkage with banks.
Nomura invokes the theory of the impossible trinity, according to which a country can only have two out of the three from among an open capital account, a fixed exchange rate and an independent monetary policy. Given a low risk of capital controls, Nomura holds that the Reserve Bank of India (RBI) will have to decide between letting the currency adjust on its own or losing control over its monetary policy. Nomura’s recommendation is that the RBI should let currency adjust gradually, given limited forex reserves and a dismal domestic growth outlook.
Nomura says that while the competitive gains of the rupee depreciation are limited by supply-side considerations, the negative implications of higher imported inflation, delayed rate cuts, high asset price volatility, the increased cost of foreign currency debt, etc are many.
Nomura's report suggests that India's issues stem from a lack of fiscal and structural reform, with the rupee depreciation being a by-product of that. The brokerage recommends that the ideal response would be to implement a prudent fiscal policy, along with structural reforms that would put a check on consumption demand, ease inflationary pressures and eventually allow the RBI to re-focus on growth. The report explicitly says that government spending is budgeting to rise 16.4% this year, and with the Food Security Bill also being prepared, the Indian economy simply cannot afford this at the moment.
In today's Asia Chart Alert, Nomura expressed serious concern for India's rising short-term debt, even with a fully funded current account deficit, as it has increased India's external vulnerability
Short-term debt and long-term debt due in the next one year are on the rise. As per the Reserve Bank of India (RBI) figures, this has increased to $172 billion in March 2013, up from $147 billion a year ago.
Excluding NRI deposits, short-term residual maturity debt amounts to a massive 42% of total forex reserves. While this is not as alarming as the early nineties, Nomura notes that it is indeed a steep rise from a low of 16% in 2004.
While debt capital inflows help finance the current account deficit, they could also worsen the balance of payments situation. According to Nomura, with global risks on the rise, difficulty in rolling over debt could put pressure on net capital inflows, thus leaving the currency vulnerable.