With the worsening current account and fiscal deficits and rushed policy-making, Nomura feels that Indian economy will have a tough time bouncing back, with balance of payments issues to be the cornerstone of her recovery

In a Special Report, Nomura Singapore is bearish on the Indian economy, critical of the Reserve Bank of India (RBI) policies and sees the Indian rupee (INR) depreciating to 75 to the US dollar, from current levels. “Based on our FX valuation analysis, INR is still around 10% overvalued, which means that spot USD/INR could move toward 75 to reach an equilibrium value,” said the note.
 

Nomura feels that economic recovery would be difficult considering that the current account deficit (CAD) and fiscal deficit have grown too large, putting the economy in a precarious position from a policy-making perspective. “The ability of the government to stabilise INR over the medium-term will be more difficult than Indonesia (another country suffering from similar economic dilemma), as the country suffers from both a large current account and fiscal deficit. According to Nomura, the cumulative current account deficit has worsened from -4% of the gross domestic product (GDP) in 2008 fiscal to a whopping -16.7% of the GDP in 2013 fiscal. This is expected to lead to balance of payments (BoP) pressures within the next three to six months, resembling the 1991 economic crisis.
 

However, Nomura feels that the RBI (and the government) has damaged its credibility in its fight to stem the rupee slide by taking several ‘reactionary’ and short-term measures which are of little value in the long-term. The note says, “Apart from the liberalisation of FDI caps, most of the government measures were quick-fix solutions and are unlikely to yield major long-term gains. The RBI’s interest rate defence has also failed. An interest rate defence is never a costless strategy. The RBI wants to control FX but without any collateral damage to growth, which is impossible to achieve. In our view the problem is that the RBI is trying to achieve inconsistent goals, which sends confusing signals, increases volatility, and damages the RBI’s credibility.”
 

The ability to contain he deficit without damaging long term prospects is a key challenge for both the government and the RBI, particularly the challenge of repaying some of the short-term bonds maturing in FY14, amounting to $172 billion. Another key issue is question of cross-border loans, which are almost the same levels of the reserves, at $273 billion. Unlike portfolio flows (equity and debt), cross-border loans are related to bank operations, investments and trade credit. Yet, if you consider our foreign exchange reserves, it is low compared to the obligations. India’s foreign exchange reserves are currently worth $278.8 billion, down 6% from the beginning of the year. “Foreign equity holdings as a percentage of market capitalisation is at a multi-year high of 24.7%. However, India’s vulnerability relative to Indonesia’s looks even higher once cross-border loans and short-term external debt are taken into consideration. The risk of outflows (especially for India) is growing given slow growth, the prospect of rising inflation and mounting risks of negative credit events,” warned the report.
 

It is also pertinent to note that India has just roughly 6-8 months of import cover, the lowest levels since late 1990s. In other words, India has enough reserves to guarantee imports for the next six months if the economy were to come to a standstill or currency crisis blows over. The threshold level is four months.
 

To plug the current account deficit gap and raise funds, Nomura believes there are six options for the government and policy makers to consider, apart from exports.
 

• • Dipping into FX reserves:  With sufficient cover of six months, RBI is unlikely to intervene heavily and risk further capital outflows.
   
• • Bilateral swap agreements: This is an agreement between two countries to trade for dollars with local currency, with some strings attached. Nomura believes that this option is open and may not be ruled out. It believes India could consider swap agreements with countries like US, China, EU, UAE to name a few. Currently, India has a swap agreement with Japan, with an option to obtain $15 billion, only with IMF support.
   
• • NRI bond: This option is probably the most feasible one as RBI has already liberalised, partly, the interest rate of FCNR (B) deposits in 3-5 year maturity and exempted them from statutory requirements. More bonds—Resurgent India Bonds or India Millennium Deposits—may be announced.
   
• • Sovereign bonds: There were talks of India issuing quasi-sovereign bonds, though this is expected to be the last option. For this to work, India would need to work very hard to commit to an aggressive fiscal consolidation programme or risk sovereign downgrade and tougher bond repayment terms, as a result, which may lead to default, economic collapse and loss of credibility.
   
• • Gold options: There’s an option of RBI leasing gold in the international market for dollars and bring in at least $20 billion if foreign exchange reserve dips rapidly and debts are rolled over. But Nomura sees a low probability of this happening
   
• • IMF credit lines: Taking an IMF credit line, especially when there ample reserves, would be a sign of panic and would also lead to stringent terms from IMF. There would be a stigma attached to India that it requires external help.
   

With the election year coming up next fiscal, Syrian crisis blowing over and, more importantly, the Federal Open Markets Committee (FOMC) meeting coming up mid-September to decide the quantitative easing tapering timeline, there is only so much room for policy makers to manoeuvre and wriggle India out of the crisis in terms of capital inflows and outflows. India needs to export a lot more than normal. A lot depends on Rahuram Rajan and his actions when he becomes the RBI chief. But he does not have magic bullets.
 

“Continuing concerns on the growth outlook, rising credit risks, deteriorating bank asset quality and worsening fiscal pressures suggest that risks remain skewed to the downside over the next six months. Thus, we maintain our negative view on India’s economic outlook,” the report concluded.