Taking Stock of Flows

• The best way to analyse markets is to view them from the perspective of ‘flows’ – the money coming in and out of the country. These can be categorised into either permanent (current account deficit (CAD) and FDI) or non-permanent (FII) flows.
• From USD 49 billion a year ago, India’s CAD is expected to widen to USD 80-95 billion in FY19, led by rising imports of oil, consumer electronics, gold and coal, which far exceeds its exports. Once the CAD crosses the USD 90 billion mark, India will have the world’s second-largest (after the US) current account deficit. Considering that net FDI came to USD 30 billion in FY18 and USD 36 billion in FY17, India is staring at a permanent outflow of over USD 50 billion in FY19. This implies that the RBI has to supply over USD 4 billion from its reserves every month.
• Non-permanent inflows have been robust, at USD 120 billion in FY18. Of this total, however, USD 20 billion has already flown out between April and June 2018, and of the USD 100 billion open positions, another USD 55 billion of FPI debt outstanding could on the brink of exiting on account of falling bond prices and the Rupee.

The Role of Monetary Policy….

Keeping rates low will make it less attractive for capital to stay in the country

In the long run, strong macroeconomic indicators matter more for a stable currency

• Monetary policy impacts the currency. However, going by the principle of the ‘impossible trinity’, no country can simultaneously have an independent monitory policy, a stable exchange rate, and free capital flows.
• Interest rates alone cannot solve currency problems, but keeping interest rates low aggravates the problem by making it less attractive for foreign investors to stay. When India kept its interest rates high over the last two years, it managed to attract flows. However, the RBI’s recent decision to not hike rates created a fix: now interest rates must go even higher to attract new capital and prevent existing capital from flowing out of India.
• A 2016 RBI study argues that higher interest rates do not bring inflation down, but, in fact, drive prices up. India is primarily a borrow-to-invest/produce economy, as indicated by its household debt-to-GDP (14%) and corporate debt-to-GDP (56%) ratios. Higher rates translate into higher input costs, which in turn drive inflation upwards.

…and Macros

• On the macro front, India faces challenges from a deteriorating fiscal deficit – the result of high oil prices, lower-than-expected tax collections, excise cuts, rising LPG and kerosene subsidies, and higher MSPs – and tightening credit environment on account of a troubled financial system. In the long run, macros determine currency stability more than micros do.
• India is witnessing a broadening of its domestic funding base as savings get ‘financialised’ into equity, mutual funds, and other financial instruments. The total inflows into balanced equity and mutual funds jumped from Rs 800 billion in 2016 to Rs 4 trillion in 2017. However, the capacity of the market to absorb these enormous funds is limited.

The Way Forward

The Rupee will remain under pressure in the near future and may further weaken

India’s USD 400 billion foreign reserves will help mitigate sharp currency movements

Given the high Rupee volatility, CFOs should partially hedge their positions

• In the short term, the Rupee is likely to remain under pressure, and may witness further weakening due to higher oil prices, deteriorating current account and fiscal deficits, and the RBI’s interest rate stance.
• However, India’s robust USD 400 billion foreign reserves will help mitigate any undue volatility in the foreign exchange market, and help the government buy time to address the core issues of falling exports, rising imports, and challenges with domestic manufacturing. However, the RBI needs to review its monetary policy carefully to adopt a more focused approach centred on stabilising the Rupee.
• Given the goodwill India enjoys among global investors, it can attract foreign capital through NRE fixed deposits, Non-Resident Ordinary (NRO) savings accounts, Foreign Currency Non-Resident (FCNR) deposits, and sovereign Funds. However, India should exercise these expensive options only when reserves fall below USD 300 billion.
• For CFOs, given the current political uncertainty, a formulaic approach to hedging may not work. Instead, they should smartly hedge their positions by buying a partial (30-60%) forward cover. This will provide a balanced hedge of price and volatility.