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Amid global and local crosscurrents, we answer six key questions on inflation, rupee, and reserves, that have risen in recent weeks.

#1 Are concerns over India’s inflation near its peak?

Few developments in recent weeks have raised expectations that the peak of inflationary concerns is behind us.

Firstly, global commodity prices have corrected from highs. The UN FAO index in June is down 3% from its peak, pulled lower by the vegetable oil sub-segment (-15%), besides other farm products. Brent is down ~16% from the year’s high to stabilise around $100-$110bbl. On the domestic front, CPI inflation in June was steady from the month before at 7% yoy and down from 7.8% in May, alongside moderating core readings. WPI inflation also pulled back from a record high, reflecting easing pressure from tradables. Non-food manufacturing WPI inflation eased to 10% from 11.4% in May. Besides two rate hikes, there had been a host of administrative measures to provide interim relief (see note). 

Our projected CPI inflation path points to a peak this quarter before decelerating to 5.5% in Mar23. Stable-to-weaker commodity prices, besides a hawkish central bank, are also likely to have a salutary impact on inflationary expectations. If the correction in the commodity complex is viewed as a harbinger of global slowdown worries, there is bound to be a concomitant impact on risk sentiments and the growth outlook.

Nonetheless, it will be premature to go easy on the inflation fight. Firstly, easing concerns are mainly on account of moderating supply-side pressures, with any fresh signs of strain on geopolitics or letdown in China’s zero-covid strategy could provide a lift to the energy complex (oil & gas).

Secondly, the pass-through of higher input prices from corporates is likely incomplete in this cycle, as evidenced by the wholesale price index movements for food and tradables. According to the Business Inflation Expectations Survey (by IIM Ahmedabad) in the April round, over 66% of the participating firms in the survey perceive a significant (over 6%) cost increase for the consecutive three months. Over 36% perceive costs have increased by over 10%. In addition, service producers are likely to reflect higher prices as the reopening trend is near complete, signaling remnant price pressures.

Finally, the recent rupee depreciation will lower the net beneficial impact of softer imported pressures. A past RBI study had shown that a 5% depreciation in the rupee vs the baseline could push inflation higher by roughly 20bp and vice versa. The April 2022 Monetary Policy Report used INR76/US$ as the baseline assumption. This also explains the central bank’s preference to anchor the exchange rate so as not to aggravate supply-side price pressures.

All this necessitates the monetary policy committee to incrementally tighten policy in rest of FY23

#2 Where is RBI’s terminal rate in this cycle?

We expect the RBI monetary policy committee to stay focused on price stability over the next two quarters. June 2022 Minutes cited Governor Das saying “…to note that the repo rate is still below the pre-pandemic level and the liquidity surplus is still higher than what it was prior to the pandemic. As our policy in recent months has been unambiguously focussed on withdrawal of accommodation, both in terms of liquidity and rates, the change in the wording of stance should be seen as a continuation and fine-tuning of our recent approach”. Factoring in peak inflation in the Jul-Sep22 quarter, we now expect a 35bp hike in August, followed by three 25bp for the terminal rate to level off at 6% by end-FY23 (vs 6.15% before). This will leave the real rate (inflation-repo) in a small positive by Mar23.

Admittedly, the combination of an aggressive US Fed and cautious RBI has led to significant compression in the policy rate differential. With our in-house expectation for the US Fed rate to peak at 3.5% by end-2022 and India’s repo rate at 5.75% by Dec-22 (6% by Mar-23), the spread will narrow to 2.25-2.5% in this hiking cycle, compared to ~500bps on average between 2014 to 2019. While narrower policy differentials will be a part of the central bank MPC’s dashboard, domestic considerations are likely to play a dominant role in determining the quantum and speed of the rate hiking cycle. Plus, the smaller presence of foreign investors in the rate-sensitive debt space has also lowered the sensitivity toward these metrics.

#3 Is the recent fall in the Indian rupee a cause of concern?

The Indian rupee depreciated to a record low at 80/US$ this week, taking the year-to-date weakness to 7% against the dollar. This bout of rupee underperformance has understandably revived memories of the adverse fallout of the 2013 ‘taper tantrum’.

We argue that from the various lens, the currency’s fall is more contained this time around and backed by better fundamentals.

Firstly, the rupee has consistently been and remains in the middle of the AXJ performance ladder on a YTD basis, with the Thai Baht, Philippine peso and South Korean won down by a larger 8.8-9.5% vs the dollar. Much of this depreciation pressure stems from sharp gains in the US dollar as the latter benefits from wide rate and policy differentials.

Secondly, the rupee’s weakness is more pronounced compared to the dollar but faring better when compared to other global currencies (EUR, GBP, etc.). On the trade-weighted or real effective exchange rate (REER) basis, the rupee is down a modest -1.0% in Jun22 vs Dec21. On a trend basis, INR REER is strong against trading partners, hovering close to 1% standard deviation and above the neutral 100 mark, as shown in the chart below.

Lastly, external debt, which is cited as a source of vulnerability, also has some inbuilt buffer against rupee depreciation risks (we discuss reserves vs external debt angle in the next section). As of Mar22, USD-denominated debt (rupee declined ytd) had a share of 53.2% of total external debt, with 31% in rupee, EUR at 2.9% (rupee up ytd) and JPY at 5.4% (rupee up ytd), with the rupee up year-to-date (rupee is stronger), which suggests that a weakening rupee does not automatically impact the entire debt book.

From a policy perspective, with the dollar appreciating in an environment of weak risk appetite and impending domestic balance of payment deficit, the evolving equilibrium will be to keep the currency on a gradually depreciating path as an adjustment mechanism. A more competitive currency will also be an additional tailwind for the external trade sector. The central bank's focus will be on facilitating this shift in a non-disruptive manner and in step with the regional action. Our FX Strategist does not dismiss more weakness if USD/INR breaks above 80, but a sharper upmove will be elusive if the USD reverses trend on US recession worries in 2H22.

#4 What defence strategy have the authorities adopted?

The RBI has already put up a strong defence against the currency’s slippage and more is likely to come. Active FX intervention has been the first line of defense, in the spot as well as the forward market. In order to preserve spot reserves, the outstanding forward book has been utilised, with the net forward position down at $49bn by May22 vs $63.8bn in Apr22. This strategy has however caused distortions, as the unwinding of the long forward position pushed forward premia down sharply (see note), to levels last seen in 2011. Such a scenario where lower premiums incentivise importers to aggressively cover their unhedged exposures and exporters have less motivation to step in to cover theirs tends to add to the rupee downside, adding to the depreciation pressures. This might explain why the central bank has returned to spot reserves for intervention purposes.

Besides outright intervention, several policy tweaks (see RBI takes steps to spur capital account flows) have been undertaken in recent weeks, including the decision to promote trade settlement in rupees (see note). The pressure to defend the rupee’s depreciation is not as high as back during the taper tantrum, nonetheless if pressures intensify, more steps including swap windows for oil marketing companies/defense purchases (to defer bulky dollar demand) might be considered, besides efforts to draw more inflows into government and corporate debt, attractive foreign deposit scheme, bilateral swap facilities, etc. 

#5 Foreign reserve stock is off record highs. Would this imply a smaller buffer against external volatility?

We have oft-discussed that India’s authorities have been deliberate and steadfast in building a strong foreign reserves buffer in the past 6-7 years. Compared to regional peers, India’s reserves have risen by the most since the taper tantrum shakeout in 2013 (see chart).

The RBI’s effort to fend-off depreciation as well as valuation effects has led the reserves stock to decline by ~$60bn from the record high in 3Q21. This drop has raised concerns about the adequacy of the stock to defend the currency. The current stock ranks well on most ratios:

a) import coverage is high at 9 months for total reserves and 8.2x for reserves (currency assets). This compares with 6x in 2013;
b) total external debt exceeds total reserves stock. Nonetheless, a more important measure of vulnerability is short-term obligations (original maturity), which make up only a fifth of reserves
c) short-term external debt (residual maturity) made up 44% of reserves as of Mar22, marking an improvement from the past four years (see table below);
d) Our preferred gauge of Gross External Financing Ratio (GEFR) still leaves India’s ratio at a higher point vs 2013.

While the current stock is still comfortable on most metrics, additional volatility could lower the FX reserves stock further. Using our GEFR matrix, reserves can potentially fall by another $100bn before the ratio falls below 1.0, leaving ample ammunition in the hands of the central bank for the time being.

#6 What are our views on the rewidening of the twin deficits?

Sharp widening in the June goods trade deficit to a record -US$26bn has raised questions on the health of the current account balance for the year. Our expectations have not changed since our note - India’s twin deficits: pressure, no panic. FY23 current account deficit is likely to widen past -3% of GDP this year, besides a modest overshoot of the budgeted fiscal deficit target. If commodities continue to decline, the CAD might see some downside risk. On the other hand, if oil prices display renewed vigour and are back above the $120bbl levels, the current account deficit could potential widen by another 0.8-0.9% of GDP, deepening the BOP gulf (risk: -$55-65bn vs DBSF: -$40bn) as capital account flows remain lukewarm. 

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