INR - Should RBI let it be...?
The global FX landscape is undergoing dramatic shifts. The global hawkish wave is testing even the most dovish central banks (SNB, BoJ) and tightening financial conditions. Meanwhile, recession anxieties have been rising amid lingering uncertainties and a global dollar liquidity slump. Unsurprisingly, USD tends to act as a countercyclical bet during downturns. But with DXY up 13%YoY and expectations of ultra-elevated inflation risks, the prospect of so-called “reverse currency wars” looms large as the world scrambles to tame inflation. However, the EM risk premia is still likely to rise further, keeping investors underweight on EMFX. The H2CY22 outlook is challenging as tightening US financial conditions are likely to weigh on capital flows at a time when CA deficits have widened and EM real yields are too low.
INR pressures intensify but RBI stands strong…
INR’s fate has been no different, down 5.6% against USD in the past one year and seeing a fresh all-time low of 78.39 last week. The INR’s performance has been caught between worsening external terms of trade led by oil, a fast-changing global risk environment, sharp FPI (equity) outflows (one of the worst in EM Asia) and the RBI’s FX stance. The RBI has been supporting INR by strong interventions to counter the impact of outflows. This has led to a significant fall in FX reserves, but given a robust accumulation of the FX war chest over the years, INR has still been holding up better than EM peers, albeit with consistent interventions by the RBI. We believe India's external position remains relatively healthy, but with portfolio outflows expected to continue amid weakening global equity performance, and further deterioration in BoP in coming months, the risks of INR underperformance cannot be discounted. Historically, weaker INR has moved in sync with the BoP deficit. We see a sharp BoP deficit of US$61bn and CAD/GDP at 3.2% (US$112bn) in FY23E.
…with somewhat more scope to intervene vs. past bouts of INR depreciation
The RBI has more room to intervene in this cycle vs. previous bouts of INR depreciation (2013, 2018). While 2013 saw an aggressive interest rate defense to protect INR from speculative positioning, 2018 saw a relatively shallow rate hike cycle. However, policy communication
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…but for how long and at what cost?
Globally, bouts of dollar funding stress are evident from widening Libor-OIS spreads. Meanwhile, back home, a shortage of cash dollars has been compounded by the RBI’s heavy forward intervention, pushing onshore 1-yr forward premiums to almost decadal lows of sub 3%. The narrowing rate differential with DMs has also pushed premia lower. On net, the shortage of cash dollars and lower forward premia could become self-perpetuating for INR: (1) making carry trades less attractive for FPIs, implying fears of unwinding of these trades; (2) with importers starting to hedge aggressively with a weakening INR bias despite the RBI’s support and, of course, such cheap premiums. These factors could pressurize spot INR, further compounded by exporters also holding on to their earnings in anticipation of a further INR slide. This will also likely lead to onshore-offshore NDF/O arbitrage exploitation by foreign banks. Thus, at some point, the RBI would need to rethink its intervention strategy to correct this dislocation of premiums.
Should RBI let INR be?
Consistent INR intervention has again pushed REER into the overvalued zone. But falling FX reserves, persistently high commodity prices, limited exchange rate pass-through to inflation and elevated INR valuations will likely tilt the balance toward a less interventionist FX policy in the coming months. Given that somewhat hot money inflows tend to fund our consumption-oriented imports (energy, gold, electronics, machinery, chemicals, plastics etc.), a large currency overvaluation is not desirable for domestic output and employment creation. Assuming that the new global energy order implies extended oil market pains, India will have to respond even more strongly in the interim, with enhanced exports and reduced imports. Otherwise, the repeat of RBI currency buffers falling to 15% of GDP (a recipe for external instability, as seen during the 2013 ‘taper tantrum’) cannot be ruled out in coming years. Thus, allowing INR to gently weaken over time is the right strategy, giving CAD space to improve. Thus, we believe the RBI may eventually let the exchange rate
adjust to new realities, albeit orderly, letting it act as a natural macro stabilizer to policy reaction functions.