Several recent global and domestic developments have led investors to take some risk off the table but they have not hit the panic button yet.
The flight of interest-rate sensitive flows has spooked debt and currency markets but equities have been fairly resilient so far, especially the benchmark indices.
Gradual withdrawal of USD liquidity and rate hikes by the US Federal Reserve has caused cracks in several EM economies, especially those with weak current account positions and looming political concerns.
The Argentine Peso, Brazilian Real, Mexican Peso, Turkish Lira, Russian Ruble and more recently the South African Rand have all depreciated significantly.
Many central banks have responded by hiking rates to combat the outflows and some are considering and in fact, would be compelled to do so.
The Rupee too has seen significant depreciation pressure. In April and May put together, FPIs have pulled out net USD 3 billion and USD 1.5 billion out of debt and equity markets, respectively. FPI limits in debt that were close to full utilisation now stand at 70 percent.
The RBI has used its FX Reserves well so far to ensure that a runaway move does not happen in the Rupee. It has intervened with intent in OTC as well as exchange-traded futures to crush speculative longs.
This explains why the volumes have not spiked up to the extent they usually do and as has been seen on instances when Rupee has depreciated in the past. The RBI in its June monetary policy managed to restore the confidence of market participants as it hiked the repo rate by 25 bps while keeping the policy stance neutral.
The hike is preemptive in nature considering inflationary pressures mainly on account of higher crude prices and hikes in MSPs and is consistent with the RBI’s inflation targeting framework.
Funding the twin deficits at this point is the major challenge on the domestic front. The CAD for FY19 is likely to be around USD 70 billion.
FPI outflows and the slowdown in FDI and foreign currency borrowing is likely to leave a hole of around USD 15-20 billion in BOP (unless the tide turns and capital again starts flowing back into EM economies). This is the major risk for the rupee.
On the fiscal front, as we head into an election year, the government can ill afford to cut down on spending. Government spending was the major contributor to the Q4 GDP growth that came in at 7.7 percent.
With GST revenues not yet stabilised and Air India divestment not likely to go through, there are risks of fiscal slippage. Nationalized banks have not been buying duration as they would not want to squander away the precious resolution capital in MTM losses.
Private banks’ demand for duration could also reduce as the RBI has increased the FALLCR carve out from SLR. FPIs too are not utilising their debt limits to full capacity.
The concern, therefore, is how will the supply be absorbed. (The yield on the 10-years benchmark touched 8 percent briefly on Friday and is 175 bps above the repo rate).
The RBI would have to do so through OMO purchases to the tune of Rs 1,20,000 crore. Until the announcement of further OMOs, domestic bonds could continue to remain under pressure.
RBIs decision to change the valuation of SDLs to market linked rates from flat 25bps over corresponding tenor G-sec could reduce demand for SDLs as well, further widening the supply-demand gap.
Whether the concerns on both the above deficits exacerbate or recede would depend to a large extent on where crude prices head from the current level.
On a positive note, with the output gap closing and supply chains getting repaired post the shocks of demonetisation and GST, we can see a pick up in private CAPEX and exports. Quick resolution of NPAs is vital to ensure that capital is available for banks to be able to lend to fund this CAPEX.
On the global front, trade-related tensions, developments in Spain and Italy, and Brexit related headlines would continue to set the tone for risk sentiment. The US has extended tariffs to its allies Mexico, Canada, and EU as well. Any retaliatory tariffs imposed by EU could further escalate trade tensions.
On the Brexit front, EU chief negotiator Barnier had commented recently that the backstop would be applicable only to Northern Ireland and not the whole of UK. This would be unacceptable to the UK government, as it would imply having a border within the UK.
The House of Commons is scheduled to vote on amendments suggested by the Lords on Tuesday, which were intended to give the parliament more control over the Brexit negotiation process rather than the cabinet.
Theresa May does not have a majority in the Commons and a few pro-EU conservatives could even side with labor in the vote to keep the amendments in place. With all the uncertainty around, Sterling is likely to remain extremely volatile and headline driven.
The right-wing parties Northern League and M5S together formed a government in Italy. The pickup in expenditure and tax cuts due to populist policies of this government would risk destabilizing the EU.
The Spanish parliament toppled Prime Minister Rajoy through a no-confidence vote and the new PM Pedro Sanchez is a socialist. Any departure from fiscal prudence in peripheral economies would not go down well with Germany or Brussels.
It would be important to track the yield spread between Italy and other peripheral nations against the yield on corresponding maturity German Bunds. Any unusual spike in yields spreads would be negative for the Euro.
To summarize, on the domestic front, The RBI has been preemptive and has ensured that Rupee depreciation does not hit headlines and create panic. It intervened aggressively even before Rupee could hit an all-time low.
Whenever Rupee depreciation has been out of whack with other Asian/EM currencies, the RBI has intervened to align the rupee with its peers.
The RBI may endeavor to keep the rupee somewhere in the middle of the EM pack and may allow gradual depreciation of the Rupee if global USD strength continues.
Technically, 66.70 is an important support. Break of 68.10 would be essential for momentum to build upon the upside and this time around that could possibly lead to a new all-time low for the rupee against the US dollar.
MORE WILL UPDATE SOON!!
