The last two
weeks’ rupee sell-off has been nothing but brutal. But then by now
we should have gotten used to such episodic scares. It’s the fourth
since 3Q11. In each of these episodes the market has hoped for a
quick trend reversal. And each time the hope was dashed with the
reversal being partial and temporary. Instead, every episode saw a
new lower floor for the rupee being set only to be ratcheted down
in the next sell-off.
This
time too the pattern seems to be repeating. The USD/INR, which
appeared to have settled in the 53-54 range, has fallen nearly 10%
since early May. As in earlier episodes, there is still hope that
the sell-off is temporary and will be fully reversed when global
financial markets settle down. However we fear that, just like in
earlier episodes, the rupee is unlikely to revert to its previous
range, and instead settle to a new lower range of 57-58—5% lower
than the average over Oct12-Apr13.
It
is this ratcheting down of the rupee that is disconcerting. While
some would see a silver lining in the rupee weakness on the ground
that it improves competiveness, as we have argued several times in
the past, price sensitivity of India’s export basket is very weak.
Rupee weakness does little to increase the demand for India’s
exports. Instead, our fear is that the weaker rupee will reignite
inflation, stress corporate balance sheets, and increase the
budget’s subsidy bill.
Serial ratcheting
down of the INR
Not too long ago in the
post-Lehman world, USD/INR remained fairly range bound averaging
around 46.5. Then came the US credit downgrade in August 2011 and
in the global risk blow-up the rupee slid close to 54 by
mid-December. A barrage of capital controls and the subsiding of
global risk aversion after the ECB’s announcement of the LTRO
program helped the rupee partially recover to just below 49. But
the INR did not make it back to 46-47 despite the sell-off being
largely attributed to collateral damage from the rise in the global
risk aversion. Instead it remained range bound around 49-50. More
importantly the rupee strength did not last long. A very damaging
2012-13 budget, along with rising concerns over economic
governance, triggered another round of rupee weakness that lasted
till September when a new economic management team was put in
place. By then the rupee had already tested a new low of 57. The
reform blitz and the fiscal tightening that followed helped the
rupee to make up some ground, but again it did not manage to break
out of the 53-54 range.
This brings us to the
latest rupee scare triggered by the re-pricing of EM assets in the
wake of rising fears that the Fed might taper its asset purchase
program sooner than expected. As such, majority of EMs have
experienced heavy bond outflows resulting in a bleeding of their
currencies, with the CAD economies suffering the most.
Last week we discussed
the drivers of this round of rupee depreciation in detail
(see INR: slip sliding
away again,
Morgan Markets, 13 June 2013). This week we focus on the widely
held market hope that the rupee should eventually recover. The RBI
could help in the process by intervening strategically in the FX
market. An interest defense would help to discourage further short
rupee positions but we doubt that the RBI will do so. The
government has raised the FII limit on government debt by $5bn.
Although this is unlikely to have an immediate impact it will help
to shore up sources of funding the current account deficit. Beyond
if the monsoon parliamentary session manages to advance the long
delayed legislative agenda (land acquisition, pension and insurance
reforms) sentiment in the equity market would be bolstered. All
these are likely to help the rupee recover some of the lost ground,
but we fear that as in the previous episodes only part of the
depreciation will be reversed and the rupee is likely to settle in
a new lower range, probably around 57-58.
Depreciation unlikely
to boost exports
If indeed this happens
then the rupee will have depreciated another 5-7% from its previous
6-month average. It is easy to argue this is not all bad and that
the depreciation will further improve export competitiveness and
help lower the CAD. As we have argued several times in the past
(e.g., see What’s happening
to India’s growth drivers: exports? Morgan Markets 13 May 2012),
India’s export basket has changed dramatically from a decade ago.
India’s traditional, labor-intensive,
small-scale-industry-dominated exports such as leather and textiles
have lost significant share within the export basket. These have
been replaced by the higher tech, more mechanized, more
differentiated engineering goods (automobiles, auto parts, capital
goods) and chemical products, which together constitute almost 60%
of the manufacturing goods (ex. oil) basket.
At the aggregate
level, India’s exports are significantly more responsive to changes
in external demand than to price. The coefficient of external
demand suggests that a 1% increase in external demand would
increase export volumes by 4.4%. In contrast, the price elasticity
is neither statistically nor economically significant. A 1%
increase in India’s REER would reduce export volume by 0.7%, but
this estimate is not statistically significant.
These results are not
inconsistent with the events over the last two years. Even though
the price elasticity is small, the 25% depreciation against the US
dollar (even before the recent depreciation) and the 10%
depreciation of the real exchange should have boosted export
growth. Instead, export growth has been positively correlated with
the real exchange rate suggesting that the causality runs the
other, i.e., as exports rise or fall driven by global demand, the
CAD narrows or widens, appreciating or depreciating the exchange
rate. This is consistent with a high income and low price
elasticity, with the impact of the former swamping the
latter.
Of course one can argue
that much of the 25% nominal depreciation has been largely offset
by the large inflation differential India has run against its
trading partners such that the real depreciation has been much
less. And here is a dramatic example of this. Since August 2011 the
INR has depreciated over 20% against the RMB as the latter steadily
appreciated against the US dollar. However, much of the price
advantage has been offset by the significantly higher CPI inflation
in India. In real terms, the INR remains about 2% more appreciated
although this has fallen over the last two years.
Inflation impact
modest but significant
And this is good segway
to how the depreciation might impact inflation. The role of the
exchange rate in India’s inflation dynamics remains controversial.
At one end of the spectrum, the RBI grudgingly acknowledges some
role of the exchange rate in determining inflation, while some
academics (e.g., see Rudrani Bhattacharya, Ila Patnaik, and Ajay
Shah, “Exchange rate
pass-through in India”, NIPFP, March 2008) have
consistently argued that the INR plays a significant role in
inflationary dynamics.
Our analysis suggests
that the impact is modest but significant (for details see
India’s exchange
rate pass-through redux, Morgan Markets, 26 November 2012).
Controlling for lagged inflation, global commodity prices, and the
output gap, which are all statistically significant, a 10%
depreciation of the currency raises quarterly headline and core
inflation by 1% and 0.8% respectively. For comparison, 10% higher
global commodity prices raises India’s headline and core inflation
by 1% and 0.5% respectively in the same quarter, while a 1% of GDP
higher output gap increases headline and core inflation 0.3% and
0.35% respectively. Although the interest rate has the right sign,
i.e., higher rates reduce inflation, in the presence of the output
gap it is rendered statistically insignificant. This largely
reflects the mechanism by which interest rates affects inflation,
namely by suppressing demand or lowering the output
gap.
Based on this, the move
from USD/INR 53-54 to USD/INR 57-58 range would increase inflation
by around 0.6-0.8%-pts. This is not alarming given that not too
long ago inflation had raged close to 10% and now it has declined
to below 5%. But what it does is to change the trajectory of the
inflation dynamics. While previously one had expected inflation to
slow further and bottom out in 4Q13 given the more slowdown in
global commodity prices and the modest negative output gap
(estimated around 1% of GDP at present), now the inflection point
could be brought forward to 3Q13. And if indeed the inflation path
reverses course, it could put further monetary easing on hold for
longer.
Budget takes the
biggest hit
The most damaging
impact, however, will likely be on the government budget. Recall, a
critical element of the government’s efforts to stave a ratings
downgrade and to restore investor confidence was a sharp fiscal
tightening. The FY13 budget (year ending March 2013) envisaged a
deficit of 5.1% of GDP. But soon it was clear that the slowdown in
growth and the currency depreciation would push the fiscal outturn
closer to 6% of GDP.
The new economic
management team that took over in September made fiscal
consolidation a key part of its strategy to stabilize the economy.
The tightening perhaps was more than intended as the final fiscal
outturn was deficit of 4.9% of GDP, even lower than the budgeted
target, which is a rare occurrence in India. Among the many
measures that the government adopted central was liberalizing
retail petrol and raising administered diesel and cooking gas
prices.
The FY14 budget targets
a deficit of 4.8% of GDP. To achieve this the government will need
to keep overall subsidies close to the budgeted level of 2% of GDP.
Of this 1.3% of GDP (spilt equally) is on account of fuel and
fertilizer subsidies. Both depend on what happens to the price of
imported petroleum. While the government has not made its oil price
and exchange rate assumptions explicit, based on past patterns it
would appear that reaching this target hinges on global oil price
(India basket) averaging around $95/bbl and the USD/INR around
53-54.
And this is where
trouble is already brewing. Since the start of the fiscal year, the
price of India’s crude oil basket in dollar terms has fallen about
5%. But the INR depreciation has more than wiped out all the gain.
In fact, in INR terms crude price is just 1% shy of its high in
July 2008 when the equivalent dollar price was $143/bbl compared to
$104/bbl at present! So if crude oil averages $105/bbl for FY14 (as
projected by J.P. Morgan) and USD/INR around 57-58, it would imply
an import price about 15-20% higher than what appears to have been
used in the budget projection.
Assuming that the
extant policy of raising retail diesel prices by Rs 0.5/month
continues for the whole year, there is no material price increases
in other subsidized petroleum products given that this is
pre-election year, and the government as before covers 50% of the
losses made by the distribution companies, our calculations suggest
that the subsidy bill for oil and fertilizer would need to go up by
0.3-0.4% of GDP. And this would imply a deficit of 5.1-5.2% of GDP
against the budgeted target of 4.8% of GDP.
Add to that the
distinct possibility of revenues falling short of budget targets
because of lower growth and weak capital markets and the likelihood
of additional spending on account of the Food Security Bill that
could get passed in parliament in the upcoming monsoon session.
Keeping to the budgeted deficit target would then call for another
round of very sharp reduction in expenditures as in 2H12. However,
this time with elections round the corner the space for another
round of spending cuts appears limited. A higher deficit than
budgeted is unlikely to go down well either with investors or
rating agencies. Thus, damage from the rupee depreciation could be
telling on the budget this year
Pressure on corporate
balance sheet rise
Since 2007, Indian
corporates have increased their foreign borrowing significantly as
domestic interest rates has outstripped global rates. In
particular, external commercial borrowings surged been 2010 and
2012 – when India embarked on a tightening cycle in response to
double-digit inflation even as the world was easing monetary
policy. Consequently, the current stock of ECB’s estimated at $115
billion constitutes a 60% increase over the $70 bn in 2010 – just
three years ago. What this has meant is that annual refinancing
needs have increased very sharply in recent years. For example,
total amortization and interest repayments on ECBs rose to a hefty
$26 bn in FY13 and the RBI estimates that principal and interest
payments in FY14 will still amount to slightly over $20 billion –
and further creep up over the next few years.
It’s one thing if this
growing stock of ECBs was largely hedged but, in fact, estimates
indicate that anywhere between 60-65 % of ECBs remain unhedged and
therefore very vulnerable to INR movements. And this is why INR/USD
settling at 57/58 versus 53/54 can increase corporate balance sheet
stress for companies that are not naturally hedged.
The aggregate numbers
may not pose a systemic risk: a 10% depreciation of the Rupee will
increase ECB repayment costs in FY 14 by between $1-1.5 billion.
The balance sheet impact is expectedly larger – with a 10%
depreciation expected to stress corporate balance sheets by $6-7
billion – assuming 60-65% of the stock is unhedged.
Yet the aggregate
impact masks the more worrying distributional implications. A
number of companies in the infrastructure and capital goods sector
– that have no natural hedge to Rupee movements – are vulnerable to
Rupee depreciation. A 10% depreciation has the potential to cause
significant stress to the P&L and balance sheets of these
corporates. Recall, the investment cycle is current languishing
under the weight of implementation and execution bottlenecks.
Adding financial stress to corporates in the infrastructure and
capital goods sector is likely to exacerbate matters and further
push-out any hopes of an investment pick-up.
In addition to the
infrastructure sector, a number of mid-caps companies across the
board also appear to be very externally-leveraged, and if the Rupee
remains at current levels, it could cause significant stress to
their individual balance sheets. So even though the aggregate
impact of sharp Rupee depreciation on the corporate sector may not
be alarming prima-facie, it can have very adverse sectoral
implications.
All told, the latest
ratcheting-down of the Rupee is unlikely to fully-reverse and the
resulting depreciation is likely to impart a stagflationary shock
to the economy – re-fuelling inflationary pressures and dampening
growth prospects. And this is a pity. Six weeks ago, a semblance of
macroeconomic stability had finally returned to India. Inflation
was moderating, the fiscal consolidation was even more impressive
than had been expected, and the only debate was how much space the
RBI would have to ease monetary policy. How quickly things can
change. The INR shock over the last six weeks has dramatically
changed the nature of the conversation.
Projected
Debt Service Payments (US$ million)
|
|
Year
|
Principal
|
Interest
|
Total
|
2012-13
|
21,440
|
4,655
|
26,095
|
2013-14
|
16,135
|
3,985
|
20,120
|
2014-15
|
18,677
|
3,624
|
22,301
|
2015-16
|
21,176
|
3,101
|
24,277
|
2016-17
|
21,750
|
2,399
|
24,149
|
Source:
Ministry of Finance, RBI
|
|
|
Note:
Projections include external assistance, ECB and FCCB
|
|