Bank of America Merrill Lynch: What Will RBI do After Rs 62/USD?

Bottom line: RBI to hold Rs58-62/USD; USD may breach temp

We have grown more confident of our call that the RBI will hold Rs58-62/USD with lower oil prices and gold import curbs offsetting US Dollar strength. At the same time, there is a rising possibility of a temporary breach of Rs62/USD if the US Dollar appreciates to, say, 1.20/€ (1.25/€ in December BAMLe). In this report, we look at the RBI's potential response. We think the RBI will sell a token US$500mn-US$1bn to signal Gov Rajan's Rs60-62/USD preferred range if the INR crosses Rs62/USD levels. Second, it will likely explain the need to live to fight another day by ignoring cross-currency pressures from a stronger US Dollar in the Rs63-65/USD zone.  

Finally, it will likely mount a full barreled defense to anchor INR expectations, at Rs65/USD, selling, say, up to US$20bn, if need be. On balance, we continue to expect Gov Rajan to continue to recoup FX reserves to guard against contagion. Our estimates estimate that the RBI needs to pick up US$30-35bn to maintain 8 month import cover in March. Our Asia FX strategist, Adarsh Sinha, sees the INR at Rs 61/USD in December. Do read our last INR report here.

RBI to hold Rs58-62/USD; recoup FX for 8-mth import cover

Our call that the RBI will hold Rs58-62/USD has held so far, although the stronger US Dollar may force a temporary breach. By and large, USD strength should continue to be offset by falling oil prices and gold import restrictions. Given gold import curbs, we forecast the current account deficit at a manageable 1.5% of GDP for the current fiscal at our house US$100/bbl Brent forecast (Table 1). Note US$10/bbl in Brent price swings the CAD by US$8bn (0.4% of GDP).

We continue to expect RBI governor Raghuram Rajan to recoup FX reserves to guard against contagion. After all, we estimate that the RBI will need buy US$30-35bn just to maintain 8 month import cover in March 2016 (Chart 1). In fact, the RBI has added US$2.6bn (net) to its forward book even in September (Table 2).

#1. Rs62/USD: Token defense of Rs60-62/USD

We expect the RBI to mount a token defense, selling, say, US$500mn-US$1bn, if the INR breaches Rs62/USD with the US Dollar hardening towards 1.20/€, which is not our house call. It would ideally want to hold Gov Rajan's preferred Rs60-62/USD zone. At the same time, it will not spend too much of precious FX at a time the INR has outperformed most BRIC/TIM currencies (Table 3). With US Dollar strength pulling down oil prices in US Dollar terms, there is a natural offset. In our view, the RBI may not be required to exert itself too much if the US Dollar settles at 1.25/€ as our FX strategists expect. At the same time, some FX intervention may be needed as the RBI has virtually bought banks' nostro cover forward.

Forwards to be rolled over if US$9bn FX loans are not: We expect banks and corporates to roll over the maturity of FX loans and bonds of US$9.3bn until March 2015 (Chart 2). In case of any difficulty, the RBI will roll over its forwards with banks.

Hedging: The RBI is repeatedly cautioning the market and corporates to hedge their FX exposures. In our view, they could ask banks to provide a higher capital charge for loans to borrowers with large unhedged exposures in the December 2 policy.

#2. Rs63-65/USD: Highlight cross-currency pressures

The RBI will likely explain the need to live to fight another day by ignoring cross- currency pressures from a stronger US Dollar in the Rs63-65/USD zone. While USD-INR accounts for about 85% of trade transactions, it is, after all, scarcely possible to fight a rising Dollar, with a low import cover of 8.3-months. In any case, the RBI did not usually fight cross-currency pressures in the past when the import cover was much higher.

Can the RBI hold INR expectations beyond Rs62/USD? Yes, we believe that Gov Rajan will be able to anchor INR expectations if he takes the FX market into confidence. During bouts of cross-currency pressures in the past, Govs Jalan and Reddy were able to anchor INR expectations, without even selling FX at times, by driving home the difference between cross-currency pressures and, say, BoP weaknesses.

INR does better when RBI focusses on FX reserves: Experience tells us that the INR ultimately came to grief in end-2011 as the RBI allowed the INR to appreciate by suspending FX buying in the preceding years. Charts 1 and 3 shows that the INR appreciated from Rs48/USD levels in end-2009 to Rs44/USD levels by mid-2010 and stayed there until end-2011 as import cover fell in the absence of FX buying. This policy of unsustainable appreciation eventually led the INR to depreciate by close to 50% until last August.

#3. Rs65/USD: Full-scale FX intervention

We expect the RBI to mount a full barreled defense to anchor expectations, at Rs65/USD, selling, say, up to US$20bn, if need be. Given the low import cover, the INR has tended to fall below the previous low in each successive rounds of volatility. The INR dropped to Rs53/USD during the end-2011 European crisis. It fell further to Rs57/USD during the 2012 Greek crisis. The INR collapsed to Rs68/USD during the taper tantrum of 2013. Against this backdrop, Gov Rajan will not want to take chances with INR expectations beyond Rs65/USD.

So, why not sell early at Rs62/USD itself? The RBI has typically taken guard at a later stage of INR depreciation to conserve ammunition even when it had more- than-sufficient import cover. Barring the ill-fated FX crisis of 2013, it has virtually never ever given up a level that it has decided to defend.

How much can the RBI sell? We would estimate that it can sell ~US$35bn to defend the INR and still maintain 8-month import cover by March 2016 as per our BoP estimates (Table 1). Bouts of FX volatility typically cost US$20bn to stabilize. Below 8-month import cover, selling FX only goes to weaken the INR further as it raises a question mark over the adequacy of FX reserves.

INR responds more to USD than Brent; gold swing factor

Our phase-wise analysis shows that the INR is more sensitive to USD than falling oil prices (Charts 4-5). Falling Brent episodes have had a strong correlation with strengthening USD. The INR has typically been unable to withstand this cross- currency pressure despite a favorable movement in Brent. So, what’s different now? Gold import curbs that are compressing the current account deficit for the time being. Just as importantly, the INR may have over-reacted during the 2013 FX crisis.

2007 Fed easing cycle: After the Fed paused the tightening cycle in August 2006 and began easing in 2007, the USD depreciated all the way to 1.6/Euro by mid- US$140/bbl levels. Despite that, strong FII inflows during this period coupled with weakening USD led the INR to appreciate appreciated from Rs47/USD in July 2006 to Rs39/USD levels in October 2007, despite the RBI buying about US$70bn during this period.

2008 financial crisis: The collapse of the US economy appreciated the US Dollar to 1.20s/Euro as it was seen as a safe haven. With global growth in question and a stronger USD, Brent collapsed to US$40/bbl levels. Despite the positive impact of falling Brent price on Indian macro, the INR depreciated to Rs50/USD levels as FII equity investors pulled out over US$10bn in FY09. In response, the RBI had to sell about US$35bn to stabilize the INR.

2009 US QE1: As the US unveiled its quantitative easing program in end-2008, easy liquidity once again funneled into commodity markets with Brent recovering to US$80/bbl levels and the USD depreciating to 1.5/Euro levels by end 2009. With FII inflows resuming again, the INR appreciated from Rs50/USD levels to Rs46/USD levels by end-2009 as the RBI stopped buying FX.

2010-2011 European debt crisis and Fed QE2: The only time the INR did not respond to US Dollar strength was during 2010-2011. The INR hovered around Rs46/USD as the Euro weakened and appreciated the US Dollar to 1.2/Euro levels initially by mid-2010. Post that as the Fed undertook QE2, it once again led to USD weakening amidst increasing liquidity that fueled Brent prices higher. This time around INR appreciated mildly as RBI continued to stay away from intervention in FX markets. Depreciating USD and RBI inaction should logically have appreciated the INR a lot more during this period. However, as FDI inflows slowed and import bill increased due to rising crude and higher commodity prices, the overall BoP situation limited further INR gains. RBI’s policy of not building FX reserves during this period eventually resulted in a sharp depreciation in late 2011 as import cover fell.

2013 Fed tapering: With the Fed announcing its intentions of QE tapering, there was a sudden pullout from Indian debt and equity markets that led to a big depreciation of the INR. The weakening rupee was further confounded by the domestic policy of raising interest rates by almost 300bp that killed growth and pushed back a fragile recovery that seemed to be underway. Brent was largely stable during this period even though the USD depreciated against the EUR during this period. INR largely depreciated due to domestic policy mistakes during this period aggravating the impact of the taper tantrums.

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Address – Mafatlal Centre, 8th Floor, Nariman Point, Mumbai, India. 400021

Tel : +91 22 6632 8000

Contacts:

Indranil Sen Gupta                     

+91 22 6632 8653

India Economist

DSP Merrill Lynch (India)

indranil.sengupta@baml.com

Abhishek Gupta                        

 +91 22 6632 8682

India Economist

DSP Merrill Lynch (India)

a.gupta@baml.com