Recent INR Measures : Quick Takes

The government announced some weekend measures to support the INR. These are largely to do with relaxations around external commercial borrowing (ECB), foreign portfolio investor (FPIs) holding concentration, and masala bonds. By themselves the measures have largely underwhelmed as reflected in the sharp depreciation in the INR on Monday morning. The other (unrelated) material development was the announcement of INR 10,000 crores of open market operation (OMO) bond purchases by the RBI, to be held this week.
We outline below our broad thoughts with respect to these announcements:
1. The issue never was the depreciation in INR per se; but rather the pace of depreciation. Over the past few years, INR had become distinctly overvalued. Thus the correction now is welcome from that standpoint. However, the pace of depreciation has been sharp lately. This, combined with unhelpful media comments from officials expressing no view or discomfort with INR, had given market forces a field day. Thus, whether or not the weekend steps were deemed effective, what is clear now is that the pace of depreciation has been noticed at the highest levels of policy making and measures are being taken finally. One understands that more measures are in the offing. All that is required is that the pace of depreciation gets arrested and INR starts performing in line with other similar emerging market (EM) peers. This is a reasonable expectation going forward.
whether or not the weekend steps were deemed effective, what is clear now is that the pace of depreciation has been noticed at the highest levels of policy making and measures are being taken finally. One understands that more measures are in the offing. All that is required is that the pace of depreciation gets arrested and INR starts performing in line with other similar emerging market (EM) peers. This is a reasonable expectation going forward.
2. While some re-pricing of future rate expectations from bond market perspective is natural given the sharp pace of depreciation, bonds have been lately matching INR movement almost paise to paise. This is basis a sharp re-pricing of rate expectations (swap curve pricing in more than 3 back to back hikes from here) and an emerging view that RBI will drastically change their liquidity stance. Indeed, emergency 50 bps hikes have also been discussed in certain quarters. In our view, as discussed here in previous notes, this is the wrong framework to apply in the current situation. The starting point of real rate is much different courtesy the CPI targeting regime put in place more than 4 years ago. Indeed, an interest rate defense now will be an implicit admission of a failure of the CPI targeting regime. Rather, the RBI / MPC will evaluate the impact on CPI from recent depreciation of INR (and rise in oil) and act preemptively if their forward CPI trajectory is changing materially. It must be remembered that the August policy was perceived to be somewhat dovish insofar that CPI risks had been scaled down to ‘evenly balanced’ while the trajectory had only been modestly bumped up. Since then, INR has depreciated by 6% while India’s oil basket is up USD 5 per barrel. RBI’s Monetary Policy Report (MPR) of April 2018 assumes a 5% depreciation in INR adds 20 bps to CPI while a USD 10 move in oil adds 30 bps. The combined moves in INR and oil since August policy hence cumulates to a 40 bps impact on CPI. Against this, the July – September average CPI is currently tracking almost 60 bps lower than that forecasted in the August policy (note this undershoot also reflects in future CPI readings unless there is a future ‘reversion to mean’). Hence, the sum total of these developments at best merits an additional rate hike from the base line (in our case 2 instead of 1 till March 2019). However, there is enough reason to believe that the current more than 3 successive rate hike pricing is probably exaggerated.
targeting regime. Rather, the RBI / MPC will evaluate the impact on CPI from recent depreciation of INR (and rise in oil) and act preemptively if their forward CPI trajectory is changing materially. It must be remembered that the August policy was perceived to be somewhat dovish insofar that CPI risks had been scaled down to ‘evenly balanced’ while the trajectory had only been modestly bumped up. Since then, INR has depreciated by 6% while India’s oil basket is up USD 5 per barrel. RBI’s Monetary Policy Report (MPR) of April 2018 assumes a 5% depreciation in INR adds 20 bps to CPI while a USD 10 move in oil adds 30 bps. The combined moves in INR and oil since August policy hence cumulates to a 40 bps impact on CPI. Against this, the July – September average CPI is currently tracking almost 60 bps lower than that forecasted in the August policy (note this undershoot also reflects in future CPI readings unless there is a future ‘reversion to mean’). Hence, the sum total of these developments at best merits an additional rate hike from the base line (in our case 2 instead of 1 till March 2019). However, there is enough reason to believe that the current more than 3 successive rate hike pricing is probably exaggerated.
3. An associated view of the market is that the RBI will now significantly tighten liquidity. In some quarters the OMO view has been jettisoned altogether. The last Friday announcement of the next OMO should help calm some of these fears. Again, just like in the case of rate hike pricing the question here is not whether directionally market is right in pricing in more hawkishness, but whether it is currently overdoing it. Thus as we have argued before, even if RBI wants to take rupee liquidity to -1% of net demand and time liabilities (NDTL), it will still need to conduct more than INR 1 lakh crores of OMOs over the second half of the financial year. We see no reason to change this estimate. However, what is also important to acknowledge is that these OMOs are necessary to alleviate crowding out in the bond market. Put another way, the policy attention now seems to have come on the rupee and the widening current account. With some hits and misses built in, we may now be in the last leg of the outlier INR adjustment and the associated panic. However, policy may as yet be underestimating the potential problem of crowding out that lies ahead of us. Such an environment argues for widening of spreads, and substantially so for lower rated assets. This tightness in wholesale financing will very likely be a large differentiator for credit profiles going forward. This is why one has to be very particular in where to invest. To reiterate, our preference runs from sovereign to AAA to lower rated. The ‘real credit, high yield’ space is best avoided in a financing environment such as this.
just like in the case of rate hike pricing the question here is not whether directionally market is right in pricing in more hawkishness, but whether it is currently overdoing it. Thus as we have argued before, even if RBI wants to take rupee liquidity to -1% of net demand and time liabilities (NDTL), it will still need to conduct more than INR 1 lakh crores of OMOs over the second half of the financial year. We see no reason to change this estimate. However, what is also important to acknowledge is that these OMOs are necessary to alleviate crowding out in the bond market. Put another way, the policy attention now seems to have come on the rupee and the widening current account. With some hits and misses built in, we may now be in the last leg of the outlier INR adjustment and the associated panic. However, policy may as yet be underestimating the potential problem of crowding out that lies ahead of us. Such an environment argues for widening of spreads, and substantially so for lower rated assets. This tightness in wholesale financing will very likely be a large differentiator for credit profiles going forward. This is why one has to be very particular in where to invest. To reiterate, our preference runs from sovereign to AAA to lower rated. The ‘real credit, high yield’ space is best avoided in a financing environment such as this.

Published by prashanti forex

Prashanti Forex is managed by a certified treasury professional with an experience of more than 15 years in Finance and Advisory Business. His expertise come from various organisations, where he has gained knowledge and deep understanding of financial environment. His Principle Objective is providing customised advise with excellent service, committing a relationship based on integrity, understanding, honesty and trust. We are glad to offer you a boutique of services which will enable your organisation to enhance the profitability and efficiently manage the business risks. Our Services are : Treasury & Risk Management Solutions Trade Finance Wealth Management

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