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09 August 2013 For Professional Clients and Institutional Investors Only. India’s “impossible trinity” trilemma Caught in “impossible trinity” trilemma, monetary policy focus has shifted toward stabilising the INR and managing external risks, prompting the RBI to take liquidity tightening measures even as growth remains anemic Monetary tightening, if it persists, would have a collateral impact on the real economy. We believe the interest rate defence of INR is intended to buy the government some time to come up with more fundamental solution to increase longterm capital inflows and curb current account deficit INR volatility, external risks, and domestic macro headwinds will likely dominate the markets and sentiment in the near term, as the political calendar intensifies heading to the general election next year But Indian stock valuations are turning attractive, especially in some cyclical sectors. The market has discounted a high level of risk, and any concrete progress on structural reforms and improvement on the macro fundamentals will be positive in the medium term India’s “impossible trinity” The “impossible trinity” is a trilemma in international economics which states that it is impossible to simultaneously have free capital movement, a stable exchange rate and an independent monetary policy. In India’s context, the authorities have taken a cautious and calibrated path to capital account opening over the past two decades. By now, the capital account has been quite open and reversing this is not a viable option, and India needs to continue its gradual capital account liberalisation to facilitate foreign capital inflows to finance the country’s large current account deficit. Between 2000 and 2008, the Reserve Bank of India (RBI) intervened heavily in the FX market to prevent the rupee (INR) from appreciating in the face of strong capital inflows. The increase in FX stability was associated with less monetary policy autonomy. Since 2008, following the global financial crisis, India had allowed greater flexibility in the exchange rate by intervening in a very limited manner, which had acted as a shock absorber during times of volatile capital flows, and regained monetary independence. Monetary policy was predominantly shaped by the domestic growth-Inflation dynamic over the past two years, although concerns over worsening external imbalances also had a growing influence on policy calibration over the past year. The RBI has also ensured that the monetary policy is aligned with fiscal consolidation. Policy focus shifted toward external risks However, in the recent months, market expectations of Fed QE tapering and the consequent increase in real interest rates in the US have fuelled the concern over capital flight from emerging markets (EM) and created challenging external financing conditions for vulnerable economies such as India. The global financial backdrop and India’s deteriorated external imbalances have led to a sharp and swift depreciation of the INR since May to record lows against the USD – down over 11% over the past three months. The INR was the worst performing EM Asian currency year to date, although its weakness has been largely in line with other current-account-deficit EM currencies. INR exchange rates 120 2004-05=100 35 40 110 45 100 50 90 80 REER (RBI), lhs 55 NEER (RBI), lhs INR/USD (avg.), rhs 60 70 65 01/04 03/05 05/06 07/07 09/08 11/09 01/11 03/12 05/13 Source: Bloomberg. As such, the focus of monetary policy has recently shifted toward stabilising the INR and more generally managing external risks and facilitating capital inflows, at least for the time being until stability of the INR is restored. The RBI has decided to forfeit some monetary policy discretion, as stated in its July policy statement. Growth momentum has stalled, wholesale price (WPI) inflation has moderated, and real interest rates based on WPI have slowly trended up, albeit still low. However, the RBI took liquidity tightening measures and hiked the rate on the marginal standing facility, used by banks to obtain emergency funds, by 200bp to 10.25% in July to lift short-term interest rates sharply, making it much more expensive for investors to short the INR by borrowing USD, while holding the policy repo rate at 7.25%. Despite the liquidity tightening measures, the INR remains under pressure as the fundamentals are weak, given its high current account deficit; a gradual erosion of FX reserves in relation to imports and short-term external debt over the past three years; persistently high CPI inflation; and falling productivity growth. Indian FX reserves 350 USDbn 300 250 200 150 100 50 25 20 15 10 5 0 0 1Q01 3Q02 1Q04 3Q05 1Q07 3Q08 1Q10 3Q11 1Q13 FX reserves, lhs Cover of S-T external debt (times), rhs Import cover (months of imports), rhs Source: CEIC. Consequently, the government continues to look to other ways to boost the currency, mainly through attracting FX inflows and curbing the current account deficit. The government has taken and is mulling some measures to increase long-term capital inflows. These include further liberalisation of foreign direct investment (FDI) policy; measures to attract longer-term funds from non-resident Indians (NRIs), relaxation of longer-term overseas borrowing rules for companies, and easing of rules for long-term investors such as sovereign wealth funds and pension funds, etc. The government has tightened gold import rules and it will take more measures to curb imports of non-essential items. Economic implication Liquidity tightening, if it persists, would have a collateral impact on the real economy through tightening of the credit channel. Slower growth could lead to further deterioration in banks’ asset quality and risk aversion in lending, and increase challenges in fiscal deficit management. A prolonged period of weak growth would increase the risk of a vicious cycle developing whereby growth concern could reduce confidence of foreign investors, exacerbating the external funding risk and causing more INR weakness, and macroeconomic and financial risks further pose downside risks to the growth outlook. Growth would also be adversely impacted if the INR continues to drop with excessive volatility, exacerbating fiscal and inflationary pressures and increasing corporate external debt servicing and input costs. Facing an exchange rate-growth trade-off, the RBI said that the liquidity tightening measures will be rolled back in a calibrated manner after stability is restored to the FX market, enabling monetary policy to revert to supporting growth with continued vigil on inflation. Growth has been anemic on persistent weakness in industrial activity and a weak global trade environment. The silver lining is the good monsoon that has improved the outlook for agricultural production, which could help support rural consumption demand. Investment has been lacklustre, due to such factors as supplyside bottlenecks and project execution impediments, weak domestic consumption and export demand, political and policy uncertainty (general election due May 2014), and funding constraints. There are signs of a marginal improvement in public investment as a result of the government’s effort to revive the investment cycle, but a continued slowdown in new project inflows suggests private corporate capex is likely to stay weak. That said, a post-election turnaround in the capex cycle is possible if the government continues to carry out policy reforms to resolve structural bottlenecks and reverts to pro-growth policy stance as INR risks subside. A weaker INR tends to worsen the trade/current account balance in the near term, given that price sensitivity of India’s export basket is low and India’s import demand is largely inelastic due to domestic supply-side constraints. Lower gold and oil imports and further domestic demand slowdown coupled with better global demand will likely lead to a narrower current account deficit in FY13/14 (to -4-4.5% of GDP vs. -4.8% of GDP for FY12/13), but it will likely remain much larger than -2.5% of GDP indicated by the RBI as a sustainable level. Binding supply constraints have encouraged imports but constrained exports. Improved outlook for farm output due to a good monsoon and a lower hike in minimum support prices bode well for near-term food price inflation. Weak demand conditions and deceleration in real rural wages help to curb inflation. However, the recent sharp depreciation of the INR poses the risk of imported inflation. The proposed food security bill is inflationary, the fiscal deficit is still one risk factor and global oil price development casts uncertainty over India’s inflation outlook. structural constraints on capacity and productivity will likely continue to put pressure on inflation. Slower growth and INR weakness will weigh on the fiscal deficit, through potentially lower tax revenue, higher fuel subsidy bill and difficulty in achieving the divestment target due to weak capital markets. Added to these are the proposed implementation of the food security bill and expected pre-election spending. Credible fiscal consolidation is critical to avoid spill-over risks on inflation and external balances and to avoid any negative rating action. Given the run-rate of the fiscal deficit in April-June, to achieve this fiscal year’s deficit target, the government will likely have to cut expenditure materially, which would be negative for growth. Investment implications The INR will likely remain volatile in the near term in the global environment of uncertainty about Fed QE tapering/higher US yields and EM capital outflows. We think stability of the INR may not be restored until the RBI recoups FX reserves (via large capital inflows) or India‘s external imbalances improve visibly. Some measures to increase capital inflows such as a NRI bond sale by state-run firms would help to stabilise the INR at least for a period of time. A smaller trade deficit would have a positive sentiment impact on the currency. However, INR stability on a more sustainable basis will require accelerated implementation of structural reforms to help adjust imbalances in the economy and improve its productivity dynamic and growth-inflation mix. INR volatility, external risks, and growth concerns/ macro headwinds will likely dominate the markets and sentiment in the near term, as the political calendar intensifies heading to the general election. However, valuations of Indian stocks are now turning attractive, especially in some cyclical sectors. The market has a high return on equity and has discounted a high level of risk. Any concrete progress on structural reforms to boost longterm growth prospects and on fiscal consolidation could be a medium-term fundamental catalyst for the markets, and provide opportunities in related sectors (e.g. energy and utilities). In addition, India’s long-term consumption and demographic story remains intact. Renee Chen Macro & Investment Strategist HSBC Global Asset Management 2 Important Information: For Professional Clients and intermediaries within all countries except Canada and the USA and for Professional Investors and Institutional Investors within Canada and the USA respectively. This document should not be distributed to or relied upon by Retail clients/investors. 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