Flat On Its Back

It’s ironical that a just a day before the country celebrated its 72^nd Independence Day, the rupee crossed the 70 mark against the greenback. On June 28, the rupee breached the 69 per dollar mark for the first time ever, and hit a new low at 70.40 on August 16. When the rupee was first devalued in 1966 and pegged to the American currency, it equaled 7.50 rupees. While the INR’s “once-upon-a-time story” has often gone viral on social media, the fact is that the rupee has been depreciating at a CAGR of 4.46% since it was first devalued.

In the ensuing decades, the US dollar’s dominance in global trade and finance has been absolute. Though, according to the IMF, the dollar’s share of global forex reserves has fallen to 62.7% in 2017 from a peak of 72.7% in 2001, there is no denying that the dollar continues to be the king of currencies. Despite just 5% of India’s imports originating from the US, 86% imports are dollar denominated. Similarly, 85% of our exports are invoiced in the greenback despite shipping only 15% goods to the US.

However, the rupee’s recent woes – down 10.57% year-to-date from 63.84 to 70.59 (Aug 29) – traces its roots to a worsening macro and the protectionist stance of US president Donald Trump. While India has not been impacted by the trade wars that the US is unleashing on the EU and China, what is hurting us more is the threat of punitive sanctions against Iran, one of the biggest suppliers of crude oil, and the economic crisis in Turkey. Compounding the crisis is the strengthening economic outlook in the US that has prompted the Fed to hike interest rates seven times since the end of 2015 to 1.92% (see: On the road to recovery). Importantly, over the same period, it began unwinding its quantitative easing (QE) by selling treasury securities and mortgage-backed securities from $10 billion-a-month in Q32017, to $30 billion in Q2CY18 before hitting a high at $50 billion a month in Q3CY18. The greenshoots of recovery thus prompted investors to pull money out of emerging markets (EMs) and plough it back home.

China, in a bid to offset the impact of tariffs slapped on it by the US, has resorted to devaluing its pegged currency by 8% thus far to 6.83 against the dollar. China, which only imports about $150 billion of goods from the US against its $506 billion exports, has retaliated with counter tariffs. The biggest casualty of this political whiplash is the Turkish lira, which has tumbled more than 45% this year following its worsening ties with the US over the war in Syria. Turkey has borrowed $467 billion in foreign currency, of which $95 billion has been raised by the government and the balance by Turkish corporations and banks. With investors pulling out, debt repayment has become more expensive. Trump has further upped the ante by threatening to double its tariffs on Turkish steel to 50% and aluminium to 20%. Similarly, to force Iran to give up on its nuclear programme, the US is imposing sanctions that are expected to impact crude exports of the Organization of the Petroleum Exporting Countries’ third-biggest producer.

This lethal geopolitical concoction has roiled EM currencies since the beginning of this year with the rupee being no exception (see: Domino effect). As with earlier years, the single biggest external threat for the rupee continues to be the rising crude price.

Not slick enough

The BJP government started off on a strong wicket when it came into power in May 2014. It got a substantial fiscal gift, thanks to the dramatic collapse in crude prices from its triple-digit perch – from a peak of $115 per barrel in June 2014 to $52 per barrel at the end of December 2016, after a low of $29.8 per barrel early that year. “The slump in crude prices was a blessing in disguise for the government and ensured the fiscal situation started looking good,” opines Tirthankar Patnaik, India strategist, Mizuho Bank.

Indeed it was, for India’s net crude import bill more than halved (52%) from $98 billion in FY13 to $47 billion in FY16, pruning its trade deficit from $190.3 billion to $118.7 billion. Over this period, the average Indian crude price had fallen from $105 a barrel to $46.17. But in FY18, the gap widened back to $160 billion, as oil prices hit a high of $80 early this year. As a result, the current account deficit worsened sharply from 0.6% of GDP in FY17 to 1.9% of GDP, and the fear is that the number will touch 2.8% of GDP ($75 billion) in FY19, with trade deficit burgeoning to $188 billion.

The development comes at a time when the Centre’s assumption for the current fiscal was an average of $65 a barrel for the Indian crude basket. The falling rupee and rising oil prices will combine to push up India’s annual crude oil import bill by about $26 billion in FY19. Sanjeev Prasad, senior executive director and co-head at Kotak Institutional Equities (KIE), is cognisant of the risk. “A $10/barrel change in the crude oil price results in 50 basis points impact on the current account deficit and 30 basis points impact on inflation,” he says. Though a wider current account deficit (CAD) doesn’t necessarily imply a weaker rupee, India’s situation was also compounded by the sudden flight of capital flows. While a benign crude helped the fisc and inflation, it also attracted foreign inflows into the debt and equity market.

Back from brink, to brink

Just a year before the BJP government had come into power, the rupee, in August 2013, had touched a then all-time low of 68.85, prompting the currency to be categorised by Morgan Stanley as one of the “fragile five” currencies owing to its vulnerability to capital flight. Between April-end and August 28 in CY13, the rupee slumped 28% against the dollar. Forex reserves, too, were much lower at about $275.5 billion.

To stabilise the currency, the central bank introduced a swap deal in September 2013, encouraging banks to raise money through FCNR (Foreign Currency Non-repatriable) bonds to attract dollar inflow. Against the targeted $10 billion, the RBI ended up mopping up over $30 billion, prompting the-then RBI governor Raghuram Rajan to confess later in 2016 that it was one of the worst ideas but turned out to be brilliant at the end.

Between August 2013 and October 28, 2016, the central bank bought and sold $415 billion dollars, 5x more than what it had transacted over the previous three years. The intervention curbed the currency’s average daily trading range to about 0.20, the narrowest since 2007 and less than half of what it was in 2013. For investors, the relative stability meant that borrowing in dollars to purchase rupee assets earned them the highest return in Asia. According to Bloomberg data, dollar investors stood to gain 7.5%, including interest, on rupee purchases by the end of 2017, the highest total return in Asia.

For the first time since 2010, the currency appreciated 6.34% to end at 63.87 against the dollar in 2017, much higher than the 4.07% rise seen in 2010. A weak dollar and higher inflows into the debt market drove the rupee’s ascent. “As a result, foreign portfolio investment (FPI) flows jumped to 120% of foreign exchange reserves by end of 2017 from 80% in FY08,” stated Indranil Sengupta, economist at Bank of America Merrill Lynch, in a report. This hyper-active dollar buying also brought it under the scrutiny of the US Treasury. In its biannual report (April 2018), the Treasury stated that it planned to monitor India’s forex practices following a sharp jump in its reserves to $400 billion.

India popped up on the US Treasury’s radar because the central bank’s net forex buying in the first three quarters of 2017 had touched $56 billion, close to 2.2% of GDP, and also because India had a trade surplus with the US, amounting to $23 billion. The forex purchases by RBI were also necessitated by the fact that over the three quarters, the country had seen foreign direct investment of $34 billion and portfolio flows of $26 billion.

Central banks usually do not interfere as long as the exchange rate is determined in an orderly manner. The RBI’s earlier intervention was to stop appreciation and ensure export competitiveness; this time around its hand was forced as the rupee was headed to the other extreme. Over the past couple of months, the RBI did try its best to defend the currency but without much success. Jamal Mecklai, a currency market veteran and who runs treasury risk-management firm Mecklai Financial Services, says, “The RBI for a long time has been trying to protect the 69.20 level, which is now broken. So, who is to say what’s going on? ”Some of that futility was evident when the present RBI Governor Urjit Patel in a column in The Financial Times in June urged the Fed to carry out its monetary tightening in a manner that does not put more stress on EMs.

“It’s not that RBI has not intervened. But it would be absurd in these times to talk of managing a currency level. You could have said so before the 1990s, but today it’s the market that is calling the shots,” says Mecklai. The extent of RBI’s intervention can also be gauged from the fall in reserves – from a record $426 billion in mid-April to $401 billion as of August 24 (see: Crunch hour). However, Mecklai points out that all of $25 billion would not have been deployed in buying the dollar. “The tricky part of the decline in foreign currency assets (FCA) is that the dollar has strengthened, which mean assets held in euros and other currencies would have shrunk,” says Mecklai.

The other reason for the RBI not splurging its reserves on shoring up the rupee: import cover has fallen from a high of more than 11 months in April 2018 to 9.9 in August. Though much higher than the 7-month cover in 2013, the reserves are way below the pre-2008 global financial crisis level of 14.4 months.

Despite its efforts, RBI’s dollar sales could not match the velocity of the current FPI outflow, just as it failed in 2013. Five years ago, they had pulled out a record Rs.800 billion as the rupee fell from 53 in January 2013 to 61 by the year-end, having hit a then all-time low of 68.85 in August 2013. The exodus had been triggered by the then Federal Reserve chairman Ben Bernanke’s comments on QE tapering. The central bank could do little as it needed the dollars to plug the current account deficit, which had hit a high of 6% of GDP even as forex reserves fell to a 39-month low of $275 billion by September 2013.

This time around, year-till-date (Aug 29,2018), FIIs have pulled out Rs.371 billion from the debt market  (see: Timely exit). The reason, as Sen mentioned in his report was that most of debt inflows were unhedged. However, Mahesh Nandurkar, India strategist at CLSA mentions that FIIs who invest in debt always make their bets based on currency calls. “India was in a rate-cut cycle and, with a steady currency, it was an ideal time to hold bonds also. They were making at least 7.5-8% in dollar terms,” says Nandurkar.

Besides, debt investors, usually, don’t hedge their bets as doing so would be a zero sum game. “If the US 10-year yield is around 3% and India’s 10-year yield is around 8%, and with cost of hedging coming to around 5%, where would they have made the return? There is no money to be made,” elaborates Nandurkar. Mizuho’s Patnaik agrees, “Between 2013 and 2017, the rupee was remarkably stable, and that meant portfolio investors were making the most of the interest rate differential.” While hot money may have started to pull out, India Inc now faces the prospect of higher repayments owing to a weak rupee.

More of the same

Post the 2008 credit crisis, the glut of liquidity in global markets has resulted in the country’s external debt doubling from $224 billion in FY08 to $530 billion in FY18. Indian companies made the most of the easy liquidity, accounting for 80% of the external debt.

Nearly $222 billion of short-term debt is due to mature by the end of March 2019, which is more than half of India’s foreign exchange reserves. The number seems alarming, but Patnaik of Mizuho Bank believes it’s not cause for concern. “A substantial part of this amount is trade credit and the silver lining is that this is a rolling number. At every point in time, people take loans and repay loans.”

The only challenge that corporates face is that the outgo will be much higher than anticipated. “How would INR depreciate by March 2019 is the question. Assuming a 5% fall till March, companies will end up paying an additional $11 billion over the $222 billion due,” says Patnaik, adding that the entire burden though is not concentrated but spread out among several corporate borrowers.

Incidentally, over the past one year, overseas borrowing cost has spiked up by more than 100 basis points owing to higher cost of hedging currency risks. According to ICRA, the weak rupee has resulted in the 3-month forward annualised hedging premium increasing from 3.97% in April 2018 to 4.48% now.

The good news is that, unlike in 2008 when the crisis caught India Inc unaware, this time the pain is not expected to be widespread. One reason is that with the private investment cycle in the doldrums, companies did not feel the need for much external commercial borrowing. “ECB for the past five years is hardly anything. Hence, we are not seeing any pain in the balance sheet and the P&L from the currency side, unlike in Turkey where both the government and corporates have borrowed aggressively in dollars,” says Prasad.

Leveraged borrowers such as the GVK group, which has debt of over Rs.24,000 crore, too are sitting pretty, because the entire borrowing is in rupee. Isaac George, group CFO, says, “Less than $30 million would be our exposure in overseas borrowings and that is just for one gas–based project. Importantly, since a portion of the tariff is also denominated in dollars, we have a natural hedge.” Though the company has bagged the Navi Mumbai airport project, George ruled out resorting to dollar borrowings. Instead, the company is looking to raise money by going public. The companies caught in a pincer are oil marketing companies, whose overseas borrowings account for more than 50% of their total debt.

The only sector that stands to gain from the fall is exports. But even the numbers there are hardly inspiring. Over the past five years, exports have been flat: $301 billion in FY13 and $302 billion in FY18. The country’s export to GDP ratio, too, hit an all-time low of 11.6% in FY18, the lowest in 14 years.

According to Exim Bank, four major labour-intensive sectors — textiles, gems and jewellery, leather and agriculture -— account for over 37% of the country’s exports. “In traditional export sectors such as gems jewellery, carpets handicrafts, and to some extent, leather, where there is less import-intensity, we have an edge. However, higher inflation owing to increase in wages and relatively higher logistics cost will hit our competitiveness,” laments Ajay Sahai, director general and CEO, Federation of Indian Export Organisation.

The other hitch for smaller exporters is that close to Rs.100 billion of input tax credit is still to be refunded by the government. “Since these firms operate on a very small scale, raising capital from banks is not easy either,” says Sahai. While the ramifications of the rupee’s fall are still being felt across the board, the outlook is far from rosy.

Groping in the dark

That the government is not too perturbed about the fall in the currency is evident when Subhash Chandra Garg, secretary of Department of Economic Affairs, mentioned that “even if the rupee falls to 80, it will not be a concern provided all other currencies depreciate in the same range.” What’s more, the RBI’s own 36-currency real-effective exchange rate index indicates the currency remains overvalued despite the 10% depreciation. The central bank’s six-currency trade-weighted real effective exchange rate (REER) with base year of FY05 shows the rupee, as of July, was overvalued by 23% while on a base year of FY17, it shows the rupee being fairly valued. REER is the inflation adjusted weighted average of a currency in relation to a basket of other prominent currencies and is arrived at by comparing the relative trade balance of a country’s currency against other country’s within the index.

However, Patnaik, believes, at the current level, the rupee’s overvaluation has come off. “REER is down from 120 to 112. Could it go down to 100? I think it’s unlikely as India has always maintained a premium because of its high growth rate,” says Patnaik. Even though the RBI has always stated that it does not target any particular exchange level and steps in only to curb undue volatility, could it have engineered a steady depreciation? The verdict is mixed. “The 10% correction from the top in just eight months looks scary. But the real economy has absorbed the impact quite well,” points out Bharat Iyer, head of India equity research, JP Morgan.

However, Prasad feels the rupee should have ideally been depreciating from the period of the 2008 global crisis. “Pre-crisis, the rupee was at 40 and post that it went to 52. Logically, the currency had to be at 52 because India runs a much higher inflation rate compared with other EMs. The rupee should depreciate every year on an interest rate differential basis, 3-4%, or whatever the difference is. Ideally, the 9% fall seen in CY18 should have happened over the past three years.” Going ahead, given the current macro challenge, the rupee is most probably headed south. But what’s perplexing is that equity investors seem smug about the headwind.

Unnerving Optimism

The BJP government may have voiced its commitment to fiscal consolidation but with elections around the corner, it has changed its stance. Against a fiscal deficit target of 3.2%, the revised estimate was higher at 3.53% in FY18. For FY19, the Centre has budgeted a deficit of 3.3% against the 3% mandated as per the Fiscal Responsibility and Budget Management (FRBM) Act.

The FRBM target has now been pushed over to FY20. A reason for that is the government’s profligacy: the recent pay commission hike, offering MSP at 1.5x the cost for 14 crops, which alone will increase expenditure budget by Rs.350 billion. What’s worse is that, in the event of an opposition coalition coming to power, the promise of providing unemployment allowance and continuing with farm loan waivers could only worsen the fiscal deficit. Given that the current GST collection is still short of the required monthly run-rate of Rs.1 trillion, the FY19 target of Rs.12.5 trillion could fall short.

Even more unnerving is the manner in which equity investors are overlooking the pitfalls, with the benchmarks at an all-time high (see: Rose-tinted glasses). India’s weight in Morgan Stanley Capital International Emerging Market (MSCI EM) Index increased by over 100 basis points to 9% by August-end largely because of the rally in the Sensex and the Nifty. The Sensex has gained 12% thus far this year, emerging as the best performing global benchmark index. The euphoria can also be gauged from the fact that over the past 12 months, while the overall world market cap has increased by 7.1% ($5.2 trillion), India’s market cap is up 8.6%.

Foreign investors might lap up the long-term story, but in the short term, volatility in crude price, rupee’s fall and upcoming elections is food for thought. FIIs continue to play safe and are not overweight to the extent seen in 2014 when they were overweight on India by 450 basis points versus the MSCI EM benchmark.

Prasad of KIE believes the benchmark indices effervescence is superficial as only a handful of stocks have been fuelling the rally. “A narrow basket of stocks is holding up the index and, paradoxically, the rupee fall has lifted IT stocks which account for a larger share of the benchmark indices. One of the big reason portfolio managers are struggling is that, despite the market going up on paper, they are all underperforming because more the stocks they own, higher is the underperformance.”

Also, in dollar terms investors are not looking smart either. “While in dollar terms, the 30-share Sensex is up 3-4 %, the Nifty 50, though up 19%, is flat in dollar terms. Beyond the large-caps, the mid-cap and small-cap indices are all in the red,” explains Prasad. Though consensus earnings estimates have been downgraded for FY19, the expected growth over FY18-20 appears considerably optimistic. “We expect the earnings downgrade to continue,” says Prasad. Though IT stocks have been on a roll, Prasad believes that a one-time re-rating has already materialised, leaving practically no pockets for investors to choose from. Patnaik points to the yield differential between the Nifty’s 4.7% and the 10-year bond’s 7.9%. “Why would anyone want to invest in equities when the earnings yield is down? Investors would rather put money in bonds where the yields are higher,” he says.

Amidst the run-up, FIIs have been net sellers in equities year-to-date. In August, while FIIs have invested around Rs.24 billion in equities, in debt they have invested Rs.49 billion. However, the big question is: with the global central banks on a tightening spree, will the inflows peter out? As things stand, two more Fed hikes are anticipated this year — in September and December, followed by two additional hikes in 2019, slated in March and June. If the world is not upside-down, by end of 2019, the Fed rate could be closer to 3%. According to estimates, India has received $190 billion of FII money since the advent of QE (2009-2017) in the debt to equity mix of 36:64. As cheap money gets drained, investors would start laying greater emphasis on India’s political and macro-economic stability. SBI group’s chief economic adviser Soumya Kanti Ghosh believes India’s balance of payment could turn into a deficit for the first time in seven years given the combined pressure of higher crude and capital outflows (see: Reversal of fortune).

CLSA’s Nandurkar, too, is not sanguine about India’s prospects. “On whether we will see inflows like last year into the debt market, I think the answer is no. Macros are still not conducive.” The base case scenario, as reflected by two leading foreign brokerages, indicate that the rupee’s tryst with 70s is here to stay. CLSA is looking at rupee ending at 70-71 in CY18 and at 73-74 by end of 2019. “It’s the new normal now. The days of 65 are over, unless the dollar weakens considerably,” adds Nandurkar. Though Prasad sees the rupee rightly valued at the current level, he is cautious in his outlook. “We do not know how oil will behave once the sanctions come into effect in November as Iran’s oil exports of 2.2 million barrels/day is quite large compared to available spare capacity of OPEC. And, if the US-China talks fail, then the rupee could end up overshooting much beyond its fundamental level.” If Trump goes slow on his trade tirade, there could be some pullback in the rupee. But predicting what’s on Trump’s mind might just be beyond Donald Trump himself.