India’s Financial Economy: Part 2

In this week’s analysis we will delve into India’s external sector, principally to understand how we can positioned there amidst the ongoing COVID crisis.

A good starting point for this analysis is to reflect on India’s stated exchange rate regime. According to IMF’s classification, India falls under the managed float regime with no-predetermined path for the FX rate. The technical definition of the “managed floating” regime is that the exchange rate is market determined on a day to day basis but the monetary authority in this case, the RBI reserves the right to intervene in the market to influence the same. RBI’s stated stance is that they intervene in the markets to “contain volatility” and “ensure orderly functioning”. However past actions have often belied this stated stance and the RBI has often intervened with a bias towards adding to their foreign exchange reserves. But this has to be reviewed in the context of MPC that was established in 2014, which formalized the inflation target between 2% to 6%. In a way the combination of MPC and Liquidity Management Framework has reduced RBI’s flexibility in intervening in the FX markets since it directly impacts reserve money and can distort both inflation and liquidity considerations in the short to medium term horizon. We will look at RBI’s FX market interventions in just a bit.

We will break our analysis into two parts; the short term: which reflects the day to day dynamics of the Foreign Exchange Markets for the Rupee and then the medium to long term: which reflects the dynamics of the macro-economic fundamentals that feed into the Exchange Rate.

The Short Term Dynamics has two components: India’s Actual Balance of Payment Situation and the role of the Reserve Bank. Balance of Payment refers to the overall capital inflow/outflow into the country over a given time frame. This arithmetic has a few parts. We start with the Current Account, which is essentially the net balance of Merchandise Export and Imports. India has typically been a net importer, with imports exceeding exports. Then we come to the Capital Account, which is the net inflow of capital into the country, primarily through FPI, FDI and Direct Lending routes. The final component is invisible ‘s which is essentially the sum of Remittances and Export of Services. Below we will delve into each of these components:

1. Imports: India’s Import Bill has two main components: Petroleum Products (~30%) and Manufactured goods (~55%). Both of these items have shown a sharp contraction (around 60%) in the month of April. Even as the economy stabilizes, India’s Oil Import bill will come down since the crude price has structurally come down. Overall India’s Import Bill will likely do down about 15–20% over FY20
2. Exports: The export basket is much more diversified. Petroleum products constitute ~14% of India’s Pre-COVID exports. Jewelry and Pharma constitute 12% and 5% of the export basket. The stabilization of export revenue will depend on incipient issues such as a smooth opening up of the economy, revival of credit flow to export oriented sectors and finally a resolution to the migrant labor issue. But it is safe to assume that exports will decline this year given that the lock down has extended well into May.
3. Invisible: This primarily refers to services exports, remittances and income of foreign assets in India. Services export, most of which is technology services will broadly remain stable despite the headwinds. There is some headwinds expected in the remittance flows both because of an economic slowdown in GCC area because of the oil price crash and some Indian expatriates coming back to the country because of the COVID lock down. Overall this is also likely to contract over the course of this year.
4. Capital Flows: The main components of the capital flow accounts are FPI, FDI, NRI Deposits and External Debt. This year we have already seen some Foreign Portfolio Outflows on both the Debt and Equity segments to the tune of 3 Billion USD. However this has been more than offset by FDI inflows primarily led by the ongoing stake sale in Reliance Jio. ECB and NRI deposit segments are much more fluid and difficult to call right now. Therefore despite being a relatively bad year for the markets India will likely end up with positive Capital flows.

Overall we can say that India’s Trade Deficit will contract by about 200bps due to the sharp fall in crude. And because of services export and relative stability in capital flows, we will likely end up with a BoP surplus. In addition to this India’s External Debt to GDP is fairly low at 20% and only a small fraction of this is short term debt.

Now lets look at the central banks activity in the FX markets. In March and April, RBI has been a net seller of dollar in the spot and futures market to the tune of 11 Bn Dollars. However from the latest filing by RBI we see that RBI’s FX Reserve has gone up from 450 Bn USD to 500 Bn USD. Although we don’t know how much is because of MTM gains, but it does seem that RBI has been a net buyer of US Dollar in the month of May and June. This also enables RBI to expand reserve money and thus augments their liquidity expansion steps.

Next we come to the long and medium term drivers. One way to think about this is to look at our exchange rate as the product of two independent functions. The Real Exchange Rate and Relative Monetary Function (P:Domestic/P:External). The Real Exchange rate between two currencies, is defined as the ratio of the price of a similar basket of goods in two countries. This goes one step above the Nominal Exchange Rate by adjusting for the inflation and purchasing power parity. RBI publishes REER data for the basket of currencies that India trades with. Going by this we can clearly see that the Rupee has been appreciating in real terms from ~104 in 2014 to 117 in May. The obvious reason for this is the fact the India’s exchange rate has not been depreciating fast enough vs the inflation differential. But we must step beyond that rationale to consider why is it the case despite India running a sufficiently large trade deficit. In India inflation rate has persistently been higher than the developed world and this is not because of structural reasons such as productivity gains. At the same time India has maintained a higher Real Interest Rate than the rest of the world. This is a combination of India’s stance to run a fairly independent Monetary policy and a long period of monetary accommodation in the developed world, which has led to negative to Zero real interest rates in the developed markets. Thus as long as this divergent trend continues India Real Exchange Rate will likely continue to appreciate. Recent data on inflation shows that India is also in a Zero Real Rate territory and RBI stance on buying dollar is also a logical step towards ensuring that the Rupee reaches an appropriate level on real terms. This is a necessary but not sufficient steps towards improving our trade competitiveness and thus providing a boost to the export sector.

Now lets superimpose this with changes on the monetary side. The Monetary Side of the Equation is more medium-term. As monetary policy dynamics in India and Developed markets change these interactions find their way into the exchange rate by way of capital flows, which is seeking risk adjusted yields in different parts of the world. For the purposes of this analysis we will consider the India vs United States paradigm. Post the COVID-19 Crisis breaking out in March the monetary authorities of both countries have dramatically expanded money supply and have brought down interest rates. Interest rates of the 10 year government bond in the US are down from ~2% to 0.70% while in India it has come down from ~6.5% to 5.8%. Thus despite very active monetary intervention by the RBI the interest rate differential has marginally widened. This is also a risk-off environment wherein investors prefer to hold assets in the most stable currency, which is the dollar. The Dollar Index has appreciated about 2.5% since the virus broke out. RBI has also been an active buyer of the dollar as we have explained in the earlier section. This too has helped them expand the base money supply and enables them to shore up reserves in case of an exigency.

Over the course of the last few months, the INR has depreciated 4%. In this article we looked at the main drivers behind our currency starting from short-term demand-supply aspects on the FX Market to medium-term drivers set by monetary policy and long term structural drivers that affect India Real Exchange Rate. Our hypothesis is in the short term the demand supply situation is comfortable since India will be in a marginal BoP surplus. The monetary channel could pose weakness for the INR since further Interest rate easing in India could be challenging owing to the increasing fiscal deficit of the government and India nearing a negative real rate environment owing to a spike in inflation.