Mumbai/New Delhi: The rupee strengthened on Thursday a day after hitting a new low, spurred by an unexpected improvement in the current account deficit amid warnings sounded by the central bank about the increased threats facing India’s banking system due to a liquidity squeeze and loans turning bad in the context of a gloomy economic backdrop.
Shares rose, prompting some analysts to say that investors could be re-examining US Federal Reserve chairman Ben Bernanke’s comments about the end of the Fed’s bond-buying programme, concluding that the winding up of stimulus spending may not be such a foregone conclusion as had been previously considered.
The twice-yearly Financial Stability Report (FSR) of the Reserve Bank of India (RBI) said Thursday that risks to the banking sector are on the rise amid tight liquidity and deteriorating asset quality concerns, and the credit quality of commercial banks could deteriorate further if the current macroeconomic situation persists.
It added that external sector vulnerability is emerging as a major risk to the financial system.
However, even under severe stress, Indian banks’ high capital base is lending “resilience” to the financial sector, RBI said.
The report, which gauges financial system vulnerabilities, said risks built up over the past five years of excess liquidity in the global system are now surfacing and emerging market economies “need to be prepared for spells of high volatility and uncertainty going ahead”, India being no exception.
Markets in emerging economies bled and currencies rapidly slid in value, after the US Fed indicated on 19 June that it would gradually withdraw its bond buyback programme starting at the end of 2013.
As a precursor to what may be in store at the end of the year, the domestic currency fell to an all-time low of 60.73 to the dollar on Wednesday. RBI, which has sold more than $60 billion since 2008 to defend the rupee, stopped selling dollars once the rupee breached the 60 level.
The rupee recovered on Thursday to close at 60.19 per dollar after the surprising improvement in fourth-quarter current account deficit (CAD) numbers. The rupee, under pressure from a strong dollar globally and a wide current account deficit locally, has depreciated by more than 7% in June till date. It has also fallen against other currencies.
The narrowed CAD will provide some relief to policymakers battling the weakening rupee but a steep rise in external debt, especially short-term debt, threatens to increase the country’s vulnerability to external sector shocks.
CAD, the sum of the balance of trade and invisibles such as remittances and software earnings, stood at 3.6% of the gross domestic product (GDP) in the January-March quarter compared with 4.4% in the year-ago period and a record 6.7% in the September-December quarter, according to the balance of payments data, also released by RBI on Thursday.
Full-year CAD was at 4.8% of GDP, as against 4.2% in 2011-12.
Markets cheered the improvement in CAD. Besides, the US government slashed its estimate for first-quarter economic growth on Wednesday to 1.8% from 2.4%.
Bernanke had said that ending the stimulus would depend on the US economy improving.
India’s finance ministry said too much shouldn’t be read into the CAD numbers.
“The short-term increase or decrease in CAD should not be a cause for either optimism or pessimism. We must look at the figure at the end of the year where the CAD stands,” it said. “Markets have been over-reacting as we have seen in the case of prediction for CAD last year, which were much higher than 5% and we have seen that it is much lower than 5%.”
Indian shares advanced on Thursday on short-covering on the expiry of monthly derivative contracts. Short-covering is the purchase of stocks that have been sold short, to avoid losses when prices rise.
“There is a feeling now that Bernanke may not withdraw stimulus, which pushed the markets higher. Lower-than-expected CAD also boosted investor sentiment,” said Ambareesh Baliga, managing partner, global wealth management, at Edelweiss Financial Services.
“Markets will consolidate at the current level. There is no reason to rally and at the same time all the known negatives are already in the price,” said Nirmal Jain, chairman of India Infoline Ltd, in a phone interview.
The 30-share benchmark BSE Sensex closed 1.75% higher at 18,875.95 points. The 50-share NSE Nifty closed 1.68% higher at 5,682.35 points.
Export-focused software companies led gains as they stand to benefit from the depreciation of the rupee. Sector leader Tata Consultancy Services Ltd and rival Infosys Ltd closed 3.9% and 3.3% higher, respectively. Wipro Ltd closed 0.04% lower.
The rupee strengthened despite RBI refraining from selling dollars, dealers said.
“The market was not expecting this good CAD numbers. I think stabilization will happen before the rupee starts strengthening. For the next couple of days, the rupee should hang around these levels before some meaningful strengthening can be expected. We had overshot and exporters are still not selling their dollars—they should in a couple of days,” said Harihar Krishnamoorthy, head of treasury at FirstRand Bank.
The yield on the benchmark 10-year bond dipped two basis points (bps) to close at 7.56%. One bps is one-hundredth of a percentage point.
“Bond yields are more or less aligning with global yields and are more concerned about inflation now rather than anything else,” said Krishnamoorthy.
Still, the improvement in CAD is no guarantee that risks are alleviating. Risks, if at all, have increased since the last FSR published in December, RBI said.
“Domestic growth risks, external risks, and corporate vulnerabilities have increased, while, risks from global growth, domestic inflation, fiscal stance and households have receded,” the report said, adding risks have increased in the Indian foreign exchange market, equity markets and the banking sector while it has receded in the debt market
The Indian economy is facing several challenges, both internal and external, at a time when global growth is subdued and global environment is “uncertain”, RBI said. In the third quarter of fiscal 2013, the domestic economy grew at a 15-quarter low of 4.7%. The 5% growth pace for fiscal 2013 was a 10-year low.
“Domestic supply bottlenecks, policy uncertainty, consequential dampened investment sentiment and slackening external demand contributed significantly to the slowdown though fall in inflation has provided some relief,” RBI said.
The key challenge in this context is to contain the size of high CAD and finance it in a non-disruptive manner, RBI said. This will not only manage the external sector, but it will help especially in “mitigating its vulnerability to global shocks”. An added source of concern though is the composition of flows, particularly those dependent on portfolio and short-term debt.
Net of purchases, foreign institutional investors have sold $1.63 billion in equities and $5.25 billion in debt in June so far.
“While lower commodity prices and moderation in gold imports could have a positive effect on the current account balance, high CAD in a sluggish economy poses difficult macroeconomic policy challenges,” the fiscal stability report said.
Separate data released by the central bank showed that India’s external debt has risen to $390 billion (21.2% of GDP) as of March end, an increase of $44.6 billion from the year-ago level of $345.5 billion (19.7% of GDP).
More worryingly, the share of short-term debt in total debt in terms of residual maturity (debt that has to be repaid in the next one year) stood at 44.2% of the total debt at $172 billion.
“Short-term residual maturity debt—short-term (ST) debt and long-term debt due in the next one year—is on the rise,” Sonal Varma, India economist at Nomura Financial Advisory and Securities, said in a note.
“With global risks on the rise, we expect difficulty in rolling over debt to put pressure on net capital inflows, which remains a bigger risk for the currency this year,” she said.
In general, the external sector vulnerability indicators have shown a worsening trend, the stability report added.
In the March quarter, India’s current account deficit declined to $18.1 billion from $21.7 billion (around 4.4% of GDP) a year earlier. The trade deficit narrowed to $45.6 billion in the quarter from $51.6 billion as exports grew and imports contracted. While merchandise exports increased by 5.9%, merchandise imports fell 1% mainly on account of a drop in non-oil non-gold component of imports.
In a sign of pressure on the services sector, net invisibles declined 7.7% compared with a growth of 27.5% in the year-ago period. This was mainly on account of moderation in growth of services exports, on account of a decline in other business services such as research and development, professional and management consulting, technical and trade-related services, RBI said.
Services exports increased by 0.4% to $37.8 billion in the quarter as against an increase of 6.8% in the year-ago period.
Though net capital flows moderated because of pressure on portfolio flows, they were sufficient to finance the current account deficit and there was no drawdown on the foreign exchange reserves, RBI said.
Economists, however, said that the financing of CAD in the current fiscal will be a challenge given the possible tight global liquidity if the US Federal reserve starts winding up its bond purchase programme. They expect India’s CAD to be around 4.1-4.5% of GDP in 2013-14.
Bank asset quality risks
RBI’s fiscal stability report said there has been improvement in the asset quality parameters of Indian banks. The gross non-performing loans (GNPL) of banks improved to 3.4% of total loans at the end of March against 3.6% at the end of September 2012. After provisions, the net non-performing assets ratio declined to 1.4% from 1.6% in the same period. “This decline in NPA was attributed to the lower slippage, improved recovery and higher write-off during the quarter. Change in classification for restructured advances with effect from 1 April 2015, may have some adverse impact on the NPAs, unless banks take preventive measures in this regard,” the report said.
Public sector banks continued to record the highest level of NPAs followed by foreign banks.
Under normal circumstances, GNPL ratio of all scheduled commercial banks is expected to rise to around 3.8% by September 2013 whereas, under the assumed improved macroeconomic condition for the financial year 2013-14, GNPL ratio may decline subsequently to 3.5% by March 2014.
“However, under severe stress scenario, GNPL ratio may rise to 4.4% by March 2014,” RBI cautioned, adding that the bank-level capital adequacy, or capital as risk weight to loans, could decline to 12.2%. However, this will “still remain above the regulatory requirement of 9%,” the report said, indicating that Indian banks are well capitalized even under a severe-stress scenario.
Still, banks will have to face more stress in case the restructuring of old loans continues.
The restructured standard loans of banks as a proportion of their total loans have registered a marginal decline from 5.9% at the end of September 2012 to 5.7% at the end of March 2013.
Iron and steel, textile, infrastructure, power generation and telecommunications, “have become a cause of concern in recent times”. Aviation, though, is a low risk as its share of bank credit is relatively low.
Rising life expectancy will also cause fiscal stress in coming years as “defined benefit” pension fund schemes and other pension schemes have shown weakness in liability computation, the report said. The fiscal stress will materialize in years when there are large payouts.
The 2013-14 budget estimated a total outflow of Rs.707.26 billion on pensions of Union government employees alone, an increase of 10.79% over the revised estimate of Rs.638.36 billion for 2012-13, the report said, adding: “The outflows are expected to rise as the cohort of recruits between 1970s and 1980s retire”.