India imports nearly 220 MMT of crude oil, which converts to nearly 1.5 billion barrels, depending on the specific gravity of the crude. The average price of the Opec basket was $52.5 a barrel in 2017, which was 30 per cent higher than the average price of $40 a barrel in CY2016. The oil continued its northwards movement in CY2018 to hit $84 by Oct and softened thereafter to $70 last week. The average price for CY18 till date is nearly $70. Every $10 rise in crude oil price adds $15 billion to India’s trade and current account deficits.
This puts additional pressure on the fragile exchange rate dynamics. With nearly 17 per cent drop in crude oil prices from their peak, the rupee has recovered nearly 2.25 per cent. Since the beginning of the year, INR has lost 17 per cent to touch its historically lowest level at 74.1 against the greenback and recovered thereafter by 2.25 per cent to trade at the current level of 72.5.
The impact of oil price is evident on current account deficit, which is projected to touch $70 billion in FY19 resulting in CAD of more than 2.5 per cent of GDP. This figure in isolation may not be an alarming macroeconomic indicator, but the pace of widening CAD from nearly 1 per cent of GDP to 2.5 per cent in less than two years leads to serious concerns of fragility.
CAD in India is funded historically by the capital account surpluses. However, owing to rising interest rates in US, followed by the EU and other developed economies, the capital funds have partly moved from emerging economies to the developed economies, India being no exception to it. This has resulted in a sharp fall in INR’s exchange rate Vs USD.
Initially, it helped improve export competitiveness that had been impacted adversely by INR’s almost 7 per cent appreciation against USD in CY17.
The entire benefit did not accrue to the exporters, who had sold forward dollars in 2017-18 for hedging a major part of their forex exposure in 2018-19 following the consistent INR appreciation during the major part of the year (CY2017). Despite such events of high volatility in exchange market repeating itself every 3-5 years in last 20 years (1995/ 1999/ 2008/2011/ 2013 and now 2018), Indian merchants have not taken to forex options in a big way, which could have been quite an effective hedging tool for such a volatile market.
Options have a cost to pay upfront, but they simultaneously provide the right to deliver or rescind. In scenarios where such sharp moves impact the real economy with short-term shocks, these hedges come quite handy and save the day.
Let’s now observe the movement in forex reserves. After having touched an all-time peak of $425 billion at the beginning of FY19, RBI has been using the reserves to stem volatility in the currency market. The forex reserves have since fallen to $393 billion as on November 2, 18 (Source: RBI WSS data). Although this reflects a fall of $31 billion over April first week figures, the reserves have fallen by just $5.6 billion over the full year (Oct’18 over Oct’17) period.
Accretion of forex reserves by RBI during the previous year when INR was strengthening helped build a buffer ammunition for forex interventions (sale of FC) during the current year to prevent extreme volatility. This has resulted in lower turbulence in India vis-à-vis some of our peers like Turkey, South Africa or Argentina.
However, the intervention during the current FY resulted in the rupee liquidity getting sucked to the extent of nearly Rs 2.1 lakh crore. Additionally, the currency with public also increased by Rs 1.2 lakh crore between March 30, 2018 to October 26, 2018 (Source: RBI WSS). This liquidity deficit is being progressively addressed through temporary measures like term repos and also, through durable liquidity infusion measures like open market purchase operations by which RBI buys outright sovereign bonds from the system to inject permanent liquidity.
The market is expecting an infusion of Rs 1.5 to 2 lakh crore of rupee liquidity through OMOs. However, if the currency strengthens further with a fall in oil prices or, a fresh wave of FDI/ FPI inflows, RBI may resume building up the forex reserves. That would also turn out to be a tool for liquidity infusion on a durable basis.
The rate market has also heaved a sigh of relief with oil prices easing and inflation coming under control. The government has repeatedly given an indication of sticking to the budgeted fiscal deficit target. Supply issues of G-secs have been addressed by OMOs conducted for maintaining adequate liquidity. Insurance companies are increasing their market share in SLR holding at the cost of banks, despite the addition of new small finance banks (SFBs). This may in turn provide RBI ample space for further reduction in SLR for banks without disrupting the market with permanent demand destruction from banking sector.
The 10-year benchmark sovereign yield has softened to 7.77 per cent at last week’s close (Friday, 09/11/18) against 7.85 per cent on October 31, 2018 closing and 8.03 per cent at the end of September’18.
Source an article in Economic Times
By Ashutosh Khajuria and ET CONTRIBUTORS