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India well placed to deal with volatility: Hamish Pepper

LiveMint logoLiveMint 15-05-2014 Joji Thomas Philip

Singapore: India is much better placed now to deal with higher US interest rates and currency volatility because its foreign currency reserves have increased from September lows, the current account deficit has narrowed and inflation is lower than last year’s levels, said Hamish Pepper, vice-president and currency strategist at Barclays Investment Bank, in an interview. According to Barclays forecasts, the rupee is expected to trade at around 60 per dollar over the next three months and reach 61 in 12 months’ time. Pepper also said the dynamics driving Indian government bonds had changed, compared with the last fiscal year, and this could lead to a wide gap between demand and supply without a change in the Reserve Bank of India’s (RBI’s) monetary policy bias.

Edited excerpts:

We saw a bout of currency volatility earlier in the year—is the worst over in terms of currency crisis for emerging markets, including India?

Currency volatility has generally declined this year and remains well below the highs seen during the emerging-market sell-off in mid-2013. Since mid-2013, many emerging market countries have made important adjustments to address key vulnerabilities. In the case of India, we think it is now much better placed to cope with higher US interest rates and currency volatility. Forex reserves have increased almost $40 billion since their lows in early September last year, the current account deficit has narrowed sharply to $4.2 billion in Q4 2013 from nearly $32 billion a year back and the Consumer Price Index (CPI) inflation has fallen from more than 11% in November last year to 8.6% in April.

The rupee has strengthened around 15% from the August lows last year, is there further steam left in the rally?

We don’t think so. We think the significant decline in India’s vulnerabilities is now fairly priced, portfolio inflows have moderated, and RBI appears uncomfortable with further material currency appreciation. Recent forex reserve accumulation suggests RBI is in favour of a stable currency rather than further appreciation. This is supported by RBI’s updated real effective exchange rate (REER) index using CPI inflation, which shows the Indian rupee to be much closer to its multilateral relative PPP (purchasing power parity) valuation than the previous index calculated using Wholesale Price Index (WPI). As such, we forecast USD-INR to trade around 60 over the next three months.

What are some of the risks to the rupee rally?

Disappointing general election results i.e. where a BJP (Bharatiya Janata Party)-led NDA (National Democratic Alliance) coalition fails to secure enough seats to form a government, is a near-term risk to the rupee.

Further ahead, global geopolitical tensions that lead to increased volatility or widespread risk aversion are likely to weigh on the rupee, as well as unexpected or significant increases in US interest rates. However, a notable depreciation of the rupee remains unlikely, in our view, given the much-improved fundamental backdrop, led by a narrowing current account deficit, lower inflation and enhanced RBI policy credibility. Furthermore, we think the recent increase in foreign reserves has improved RBI’s ability to manage exchange rate volatility.

Is the US Fed tapering news completely discounted by the emerging markets? What if the US Fed decides to increase interest rates earlier than expected?

Yes, we think tapering is fully priced. Our US economists expect the Fed to begin hiking the Fed funds rate in June 2015, which is around three months earlier than Fed funds futures imply. We expect higher US yields to support the dollar over the coming year and, as such, forecast some modest weakness in the rupee against the dollar. We forecast USD-INR to reach 61 in 12 months’ time.

The foreign institutional flows into Indian debt turned negative in April, with outflows of $1.8 billion after witnessing four successive months of strong inflows. Is there a change in sentiment towards Indian debt paper?

We think two key dynamics driving Indian government bonds have changed, compared with the last fiscal year, and are likely to result in a wide gap between demand and supply without a change in the RBI’s monetary policy bias. Firstly, the RBI’s preference to use term repos over OMOs (open market operations) to inject base money has resulted in a shift in demand-supply imbalances in the bond markets. Secondly, the RBI’s bias is to push real rates higher, which has dampened domestic investors’ appetite for duration. These changed dynamics are likely to put upward pressure on bond yields and steepening pressure on the curve in coming weeks, in our view.

In addition, the sentiment in fixed income markets has also been dampened by lingering uncertainties. First, the risk of a less-than normal monsoon and the implications for inflation. Second, the RBI’s reduced support for bond markets via OMO purchases of bonds has supported the rise in bond yields. Third, uncertainty around the timing of the review of banks’ maximum allowed holdings in “held-to-maturity” accounts.

Further ahead, we see cyclical support for long-term Indian government bonds coming from fiscal consolidation, declining inflation coupled with the RBI’s new inflation targeting framework, and peaking LDR (loan-to-deposit ratios) for banks. However, given the near-term uncertainties, we recommend waiting for a stabilization in rates.

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