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Business News/ Opinion / Online-views/  Macro vulnerabilities are weakening the rupee
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Macro vulnerabilities are weakening the rupee

The corrections in global crude prices did not lead to a structural correction in India's external imbalances

Photo: ReutersPremium
Photo: Reuters

The widening of the external trade deficit to $17 billion in June, only marginally lower than the previous high of $19.1 billion in May 2013, is a leading indicator of the relapse of the balance of payment (BoP) deficit in the first quarter of the current fiscal (Q1FY19) after four years. The foreign currency assets (FCA) have declined by $20 billion since its peak of $400 billion in 18 March. The estimated $14-15 billion drain on FCA for Q1FY19 will be highest since December 2008, which marked the impact of the global financial crisis of 2008 (GFC 2008).

Importantly, the recovery trend in exports of goods since its bottom in mid-2016 at 14% compound annual growth rate is far less than the 22% for imports. While this trend suggests continued widening of trade deficit, at $161 billion in FY18, it exceeded the annual run-rate of $149 billion seen prior to the decline in global crude oil prices (2013-14). Based on provisional data, India’s current account deficit (CAD) is expected to rise to 2.5-2.7% on widening trade deficit (7% of gross domestic product, or GDP), during Q1FY19E. Widening external deficit is not necessarily bad for a developing economy like India. In a stable growth cycle, propelled by rising demand and capacity creation, widening CAD is a constructive outcome.

But, the recent sharp widening in trade deficit is different from the phase prior to GFC 2008. The current swelling in trade deficit is concerning investors, as it is reminiscent of the macro-economic instability seen in 2013-14, which was characterized by rising inflation, widening deficits, slowing growth and financial market volatility.

Prospective fears of receding global excess liquidity from the expected normalization of the ultra-loose monetary policy of the US Federal Reserve prompted the Reserve Bank of India (RBI) to build its FCA buffer since 2013, propping it up from $250 billion to the recent peak of $400 billion (18 March). Our analysis reveals two important inferences. First, rupee/dollar movement exhibited rising inflexibility post the taper tantrum of 2013, denoting RBI’s preference for accumulation of forex reserves. Second, India’s excess forex reserves (which is an estimated difference between actual FCA from estimated optimal FCA) swelled to a high of $110 billion in early 2016.

But, the corrections in global crude prices did not lead to a structural correction in India’s external imbalances. Volume growth of India’s exports at 4.4% since 2010 is nearly a third of the average during 2005-08. Net exports of services, transfers by Indian non-residents and income from abroad, which are collectively classified as “net invisibles" and act as a natural buffer against trade deficit, have declined to sub 4% levels compared to 8.6% in mid-2008. Also, despite the rise in foreign direct investment (FDI) flows to an annual average of $40 billion during FY15-18, the aggregate of invisibles, net FDIs and non-resident Indian (NRI) deposits was still lower at 5% of GDP in FY18 compared to 10% in FY08.

The current rebound in global crude prices to $73 per barrel and hardening of global interest rates (especially in the US) shows that the tide is clearly turning, even as India’s external sector indicators are still carrying the vulnerability of the 2013-14 period. Hence, the $20 billion drop in India FCA reserve since 18 March indicates deficit between actual and estimated optimal reserves.

The consequences are not hard to guess. As much as RBI’s build-up of excess FCA was responsible for creating positive market conditions, including equities, currency and lower interest rates, a reversal now will make financial markets more volatile.

The outcomes have manifested themselves in several ways. The rupee has depreciated to a new low of 68.6, 10-year government bond yield has hardened sharply by 140 basis points and the RBI is following up with hiking rates. The lofty valuations of India’s broader equity markets, which reached frothy heights earlier this year, have seen a significant meltdown, even though the benchmark equity indices show some stability, buoyed by just a handful of index stocks.

The outlook is expected to be volatile. On the positive side, if the recent recovery in global trade manages to override the burden of emerging global trade conflicts, there is a possibility of India’s macro conditions improving and sustaining beyond the current fiscal reflation-led recovery. Also, if the Fed tempers its normalization, the risk to capital flows can ease to some extent. However, the probability is skewed towards a stronger US dollar as the Fed continues with its policy normalization process. A sustainable recovery in global trade is at risk from widening trade conflicts between the US and China and, indeed, between most G-20 countries, including India.

Hence, the combination of widening CAD (amid risk to capital flows from narrowing global excess liquidity) and rising inflation (resulting in further overvaluation on real effective exchange rate basis) increases the possibility of rupee depreciation. Active drawdown in FCA by the RBI can be used to suppress volatility, but it may come at the cost of tightening domestic liquidity. The RBI is expected to utilize open market purchases (OMO) to infuse liquidity, but with rising inflation, its ability of active monetization will also be limited.

All in all, we are likely to see rupee breaching the upper bounds of the 68-70 target. Also, we expect another 50 basis points hike in the repo rate by the RBI during the rest of FY19. This will result in the government bond yield curve undergoing a bear flattening with the 10-year benchmark expected to inch up further to 8.4%. Currency depreciation is also likely to boost sales growth of companies. However, it is unlikely to have a lasting positive impact on the bottom line of Indian companies.

Notably, the rupee appreciated 14% during 2004-08 to a high of 39.5 against the dollar along with a rebound in corporate profit growth, compounding at 25% per year and real GDP rising to 9.5%. However, while the currency has depreciated by a massive 70% from its peak over the past 10 years, average profit growth for Indian companies has been much lower at 5-6% since GFC 2008. The delivery of growth has to be far stronger and sustainable to confront the tide of receding global liquidity.

Dhananjay Sinha is head of research, economist and strategist, at Emkay Global Financial Services.

Comments are welcome at theirview@livemint.com

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Published: 18 Jul 2018, 08:51 PM IST
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