By Pranjul Bhandari
We judge the resilience of India’s external sector. How is the current account deficit—a well-known Achilles’ heel—likely to behave? What if capital flows remain disruptive? Will the current stock of FX reserves be enough? The C/A deficit had narrowed to 0.2% of GDP for the quarter ended December 2019 (versus 0.9% at the end of the previous quarter). Capital inflows almost doubled, making way for record high FX reserves.
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We, too, look at reserve adequacy in a different light. We marry the traditional metrics with India’s idiosyncrasies. Our study of India’s reserve losses over four recent episodes (the Global Financial Crisis, debt crisis, taper tantrum and Fed tightening cycle) suggest that if similar draw-downs were to occur again, India’s current FX reserve holdings would be adequate.
We expect the Reserve Bank of India (RBI) to remain active over the next few quarters—delivering rate cuts (we expect 25-40bps of easing in April), infusing sufficient dollar and rupee liquidity, smoothing FX volatility and undertaking sector specific regulatory easing.
March has been unforgiving so far. India’s external balances have been confronted with several shocks:
* The spread of COVID-19 around the globe;
* The Yes Bank resolution episode leading to tighter financial conditions;
* Fall in oil prices coming as a positive terms-of-trade shock.
FIIs have turned sellers with $5.3bn of outflows and the rupee has weakened by 2.4% against the dollar. The equity market has fallen 11%, credit spreads have widened and the India VIX (volatility index) is at a record high.
The central bank released its C/A deficit numbers for October-December (Q3FY20) on March 12. The C/A deficit narrowed to 0.2% of GDP from 0.9% at the end of the previous quarter. All of the narrowing was led by the goods trade deficit. While exports slowed, imports (particularly non-oil and non-gold imports) slowed even more sharply. For the capital flows, growth sensitive flows, such as foreign direct investment, were strong while interest sensitive flows, such as the debt portfolio, fell. Overall, capital inflows almost doubled, and the basic BoP (C/A deficit + FDI) rose by 1% of GDP.
Including valuation gains, India’s foreign currency assets rose by $23.3 bn over the quarter, marking a strong 11 months of goods import cover versus the long-term average of nine-and-a-half months. The current run-rate of the trade deficit suggests that the C/A deficit for full-year FY20 will be in ballpark of the 1% of GDP, narrower than the 2.1% for the previous year.
And, this is not where it ends. The ~30% fall in oil prices over the past week is a large positive terms-of-trade shock for India. We estimate that for every fall of $10/bbl in oil prices, the trade deficit narrows by 25bps, all else being equal.
If oil prices were to average $45/bbl in FY21, we estimate that the C/A deficit could narrow by a further 0.3% of GDP in FY21, even after accounting for the adverse impact of falling remittances from the Middle East.
But, the C/A deficit is only one side of the BoP coin. Capital flows can be erratic at a time when the world is grappling with a crisis such as the spread of COVID-19. Remember the global financial crisis? In a matter of three quarters, India lost $76bn of FX reserves (including the forward position). To be fair, the C/A deficit was much wider then (2.7% of GDP versus ~1% now). Yet, that event does give a sense of how quickly things could change. The $5.3bn in FII outflows from India in the first 13 days of March this year raises concerns over where things could go.
Does India have enough FX reserves to tide through? At present, India has a record $486bn of reserves (including forwards, see Chart 1). But would this be sufficient to overcome a period of stress? There are many approaches to determine the optimal reserves a country should have. Going by some traditional adequacy measures, such as 1) the goods and services import cover, 2) the total and short-term external debt cover; 3) the combination of the short-term debt and C/A deficit cover; and 4) the broad money cover, India’s FX reserve holdings seem more than adequate vis-à-vis the thresholds of the International Monetary Fund. But, given that the global environment is marked by heightened uncertainty and that traditional IMF thresholds may be seen as a lower benchmark, we conduct a scenario analysis of India’s experience during recent periods of heightened volatility and marry our analysis with newly defined thresholds for reserve adequacy. This approach has the benefit of capturing India’s idiosyncrasies while still adhering to internationally accepted metrics.
RBI—the main game in town
In the face of the current turmoil, we expect the RBI to remain active over the next few quarters:
* Delivering rate cuts – We expect 25-40bps of easing in April;
* Infusing sufficient dollar and ruppee liquidity—To inject more dollar liquidity, the RBI has already announced a 6-month dollar sell-buy swap amounting to $2bn on March 12, and could potentially announce more;
* Smoothening FX volatility; and,
* Undertaking regulatory easing for sectors such as small- and medium-size enterprises, which could arguably be hurt more in the face of a growth slowdown.
Source: financialexpress.com