Download India`s “impossible trinity” trilemma

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.
The contents of this document may not be reproduced or further distributed to any person or entity, whether in whole or in part, for any purpose. All
non-authorised reproduction or use of this document will be the responsibility of the user and may lead to legal proceedings. The material contained
in this document is for general information purposes only and does not constitute advice or a recommendation to buy or sell investments. Some of
the statements contained in this document may be considered forward looking statements which provide current expectations or forecasts of future
events. Such forward looking statements are not guarantees of future performance or events and involve risks and uncertainties. Actual results may
differ materially from those described in such forward-looking statements as a result of various factors. We do not undertake any obligation to
update the forward-looking statements contained herein, or to update the reasons why actual results could differ from those projected in the forwardlooking statements. This document has no contractual value and is not by any means intended as a solicitation, nor a recommendation for the
purchase or sale of any financial instrument in any jurisdiction in which such an offer is not lawful. The views and opinions expressed herein are
those of HSBC Global Asset Management Macro & Investment Strategy Unit at the time of preparation, and are subject to change at any time.
These views may not necessarily indicate current portfolios' composition. Individual portfolios managed by HSBC Global Asset Management
primarily reflect individual clients' objectives, risk preferences, time horizon, and market liquidity.
The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested. Past
performance contained in this document is not a reliable indicator of future performance whilst any forecasts, projections and simulations contained
herein should not be relied upon as an indication of future results. Where overseas investments are held the rate of currency exchange may cause
the value of such investments to go down as well as up. Investments in emerging markets are by their nature higher risk and potentially more volatile
than those inherent in some established markets. Economies in Emerging Markets generally are heavily dependent upon international trade and,
accordingly, have been and may continue to be affected adversely by trade barriers, exchange controls, managed adjustments in relative currency
values and other protectionist measures imposed or negotiated by the countries with which they trade. These economies also have been and may
continue to be affected adversely by economic conditions in the countries in which they trade. Mutual fund investments are subject to market risks,
read all scheme related documents carefully.
We accept no responsibility for the accuracy and/or completeness of any third party information obtained from sources we believe to be reliable but
which have not been independently verified.
HSBC Global Asset Management is the brand name for the asset management business of HSBC Group. The above communication is distributed
by the following entities: in the UK by HSBC Global Asset Management (UK) Limited, who are authorised and regulated by the Financial Conduct
Authority; in Jersey by HSBC Global Asset Management (International) Limited which is regulated by the Jersey Financial Services Commission for
Fund Services & Investment Business and is licensed by the Guernsey Financial Services Commission for Collective Investments & Investment
Business. HSBC Global Asset Management (International) Limited is registered in Jersey under registration number 29656 with its registered office
at HSBC House, Esplanade, St Helier, Jersey JE4. HSBC Bank plc acts as settlement agent to HSBC Global Asset Management (International)
Limited. Approved for issue in the UK by HSBC Global Asset Management (UK) Limited; in France by HSBC Global Asset Management (France), a
Portfolio Management Company authorised by the French regulatory authority AMF (no. GP99026); in Germany by HSBC Global Asset
Management (Deutschland) which is regulated by BaFin; in Hong Kong by HSBC Global Asset Management (Hong Kong) Limited, which is
regulated by the Securities and Futures Commission; in Canada by HSBC Global Asset Management (Canada) Limited which is registered in all
provinces of Canada except Prince Edward Island and is also registered in the Northwest Territories; in Malta by HSBC Global Asset Management
(Malta) Limited, which is licensed to provide investment services in Malta by the Malta Financial Services Authority; in Bermuda by HSBC Global
Asset Management (Bermuda) Limited, of 6 Front Street, Hamilton, Bermuda which is licensed to conduct investment business by the Bermuda
Monetary Authority; in United States by HSBC Global Asset Management (USA) which is regulated by the Securities and Exchange Commission; in
India by HSBC Asset Management (India) Pvt Ltd. which is regulated by the Securities and Exchange Board of India; in United Arab Emirates, Qatar,
Bahrain, Jordan, Lebanon by HSBC Bank Middle East Limited which is regulated by Jersey Financial Services Commission. In Oman by HSBC
Bank Oman S.A.O.G Regulated by Central Bank of Oman and Capital Market Authority, Oman and in Singapore by HSBC Global Asset
Management (Singapore) Limited, which is regulated by the Monetary Authority of Singapore. HSBC Global Asset Management (Singapore) Limited,
or its ultimate and intermediate holding companies, subsidiaries, affiliates, clients, directors and/or staff may, at anytime, have a position in the
markets referred herein, and may buy or sell securities, currencies, or any other financial instruments in such markets. HSBC Global Asset
Management (Singapore) Limited is a Capital Market Services Licence Holder for Fund Management. HSBC Global Asset Management (Singapore)
Limited is also an Exempt Financial Adviser and has been granted specific exemption under Regulation 36 of the Financial Advisers Regulation from
complying with Sections 25 to 29, 32, 34 and 36 of the Financial Advisers Act.
Copyright © HSBC Global Asset Management Limited 2013. All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written
permission of HSBC Global Asset Management Limited.
3