If the normalisation cycle of the US interest rates is accompanied by a stronger dollar, higher real rates or a bout of weak foreign sentiment, India’s unfavourable external debt profile would emerge as a source of concern
Markets put the odds of US rate lift-off this week at over 70%. A 25 basis points (bps) hike is thus largely priced in but guidance on the pace of normalization next year will dictate market reaction. Although, India is prepared for the possible rate hike by the US Federal Reserve (Fed), the markets are unlikely to be immune to volatility, says a research note.
According to a research report from DBS Bank Ltd, Indian markets were volatile back in 2013 when the US Fed signalled tapering of quantitative easing (QE) purchases. "This time around, the Fed is at the cusp of tightening policy, though at a slower pace than in the 1993-94 and 2004-06 hiking cycles. Risks of a stronger dollar accompanied by a rise in US real rates are under watch. If this materializes, India will face pressure on current account funding needs and weakened external debt profile. India’s current account balance has improved significantly but reserves remain low and debt high," the report says.
Rising FDI flows provide stable source of financing
DBS said, low commodity prices have improved India’s terms of trade, which should help keep the current account deficit below 2.0% of GDP for a third consecutive year. A past IMF study pegged India’s sustainable current account deficit at a range of 1.5-2.5% of GDP, based on assumptions.
In nominal terms, the deficit has shrunk to $28 billion in FY14-15 from $88 billion in FY12-13. Funding needs have accordingly moderated, with net foreign direct investment (FDI) at $33 billion in FY14-15 sufficient to fund the current account gap on its own. In other words, the basic balance of payments (current account deficit plus net FDI) continues to improve. The basic balance recovered to 1.2% of GDP in first half of 2015 from -0.2% in 2014.
"Given the recent relaxation in FDI ceilings in insurance, banking, construction, defence and civil aviation etc., inflows are expected to strengthen. The emphasis on ease of doing business coupled with the government’s efforts to forge deeper international ties will also be a shot in the arm for investment flows," the report said.
"Moreover," it added, "foreign holdings of government bonds is capped at 5% of the outstanding issuance (in Indian rupee terms), limiting exposure to hot-money flows. With higher FDI providing a more stable source of financing the current account gap, reliance on short-term flows has eased. This has provided a cushion against external volatility.
According to DBS, the Reserve Bank of India (RBI) remains concerned about US interest rate normalization and this has prompted the central bank to focus on building a stronger foreign reserves buffer and maintain macro-stability.
Capitalizing on the favourable market environment, the RBI has absorbed capital inflows and rebuild its foreign reserves. Reserves bottomed at $275 billion in August 2013 at the worst point of the US taper tantrum and were up to a record high of $355 billion by June 2015. Since then, effort to contain rupee depreciation has trimmed the reserves stock by $3-4 billion. This is a modest fall compared to the nearly $80 billion increase over the past two years.
India’s import cover (reserves vs months of imports) at eight-nine months is higher than the global norm of three times and consistent with the three to seven times seen across most developing countries, the report says.
Higher reserves but higher liabilities too
Although foreign exchange reserves have risen, DBS said, India’s foreign debt and other liabilities has also risen. Liabilities have primarily taken the form of higher foreign portfolio investments (up $50 billion in September 2013 to June 2015) alongside increase in short-term credits and offshore borrowings. Non-resident deposits are also up another $16 billion, receiving a hand from the RBI’s concessional swap arrangement in late-2013.
This has left India’s net international investment position (NIIP) in the red (Chart 5). The NIIP widened to $366 billion in March 2015 from $63 billion in March 2007. On the assets side, reserves amounted to $343 billion by March 2015. But this is counterbalanced by a sharp rise in liabilities in the form of portfolio inflows at $228 billion and short-term credits worth $83 billion.
Additionally offshore loans also climbed to $177 billion by March 2015, which cumulatively surpass the foreign reserves stock. In sum, even though authorities have focused on building buffers against external headwinds, its composition could be at risk if the global environment worsens, the report from DBS says.
Rupee to remain under pressure
Like most emerging market currencies, DBS feels the Indian rupee is vulnerable to higher US interest rates.
"We believe the Indian rupee will follow a managed depreciation path into 2016, driven by a stronger dollar bias and domestic developments. This case is also strengthened by our long-held view that sharp Indian rupee appreciation on real basis will see the authorities tolerate bouts of rupee weakness against the dollar (Chart 7, next page). The need to preserve competitiveness and support the 'Make in India' manufacturing push will be a priority, whilst ensuring that the inflationary impact is contained," it concluded.