Rupee Collapse Reinforces Growth Concerns


BMI View: The collapse of the Indian rupee has reinforced our concerns that the country is unlikely to enjoy a forceful economic bounce in the coming quarters, and justified the decision to downgrade our real GDP growth projections back in April. While we are constructive over the unit's prospects over the medium term, its extreme volatility and weakness since early May is likely to put a slight dampener on economic activity in the near term - via the risk of imported inflation and its impact on overall confidence, amongst other channels. Although we have yet to see clear signs that an economic bounce is on its way, we are holding on to our forecasts for the time being.

The collapse of the Indian rupee, which has fallen by about 12% against the greenback to current levels from its highs in early May, has reinforced our concerns that India is unlikely to enjoy a strong economic bounce, and justified the decision to downgrade our growth projections a few months ago (see 'Cyclical Bounce Capped By Lingering Twin Deficits', April 5). Crucially, a major reason why the rupee was one of the worst hit emerging market currencies in the recent bout of global risk aversion is India's still-sizable current account shortfall and the considerable amount of foreign financing the country needs in order to fund such a deficit.

The Weakest Link
Asia - Major Currencies, Total Return (%) Since May 1 To Date

Near-Term Impact Of Rupee Plunge

While we are broadly constructive towards the currency over the medium term (see 'INR: A Constructive Case For The Rupee', June 27), its extreme volatility and weakness over the past few weeks is likely to put a slight dampener on economic activity in the near term. Given the recency of this latest rupee plunge, its full impact has yet to truly surface in the latest economic data. Nonetheless, below, we briefly discuss the likely transmission mechanisms of a weaker rupee on economic growth. We highlight that this most recent episode of extreme currency weakness poses a downside risks on our projections for growth.

Stalling Of RBI's Easing Cycle: The central bank has slashed interest rates by a cumulative 125 basis points (bps) to 7.25% since April 2012, with the bulk of the cuts having only recently taken place. The continued easing of monetary policy by the Reserve Bank of India (RBI) is certainly one of the main casualties of the sharp rupee sell-off. Indeed, despite having loosened its stance in the three consecutive meetings prior and even with the headline inflation rate nearing four-year lows, the RBI decided to hold rates in its June review, citing the weakening of the rupee as one of the main factors for the pause. While the broad consensus is still for further loosening - with some expecting the benchmark repo rate to be at around 6.00% in twelve months time - we maintain that further cuts are unlikely for the rest of the fiscal year. In the worst case scenario, should the rupee embark on another sustained sell-off, it could leave the RBI with no option other than to hike interest rates.

Imported Inflation Risks To The Fore: On a related note, the rupee's recent collapse poses an upside risk to future inflation, which could mean that the current spate of disinflation comes to a temporary end. The rising threat of imported inflation is likely to add pressure on balance sheets as imports of goods and services are roughly a third of GDP. In particular, we highlight India's substantial oil imports, which equate to around about 35% of the country's import bill. For all intents and purposes, the rupee's sudden loss has imposed a significant one-off hike in the price of this essential commodity. This is likely to negatively impact the prices paid by domestic end user as the government has progressively allowed domestic oil prices to rise since January. Overall, this would be detrimental to consumption activity, which has already been hit hard by the prolonged slowdown of the broader economy.

Mind The Fiscal Risk: Nonetheless, oil is still very much subsidised by the government, and as such, the sell-off in the rupee also creates an upside risk to the government's fiscal deficit (which, in itself, poses an inflationary risk). Even though the government has managed to curtail the rise of its budgetary shortfall, we note that it remains stubbornly high, with the twelve-month rolling average central government deficit (12mma) ranging between INR400-500bn since June 2011.

Corporate Repayment Pressures
India - External Debt Metrics

External Debt Servicing Pressure: While the government is unlikely to face a substantial increase in external debt servicing costs (due to the weaker rupee) given that its external liabilities only make up a infinitesimal proportion of its total obligations, we highlight that Indian corporates, on the other hand, are likely to be hit hard on this front. Crucially, external commercial borrowings as a percentage of total external debt have risen substantially over the years, rising from 21% in end-2004 to 30% by end-2012 (see chart). The problem is exacerbated by the fact that short-term external debt has also risen dramatically, increasing from just 6% to 24% in the same period. With external debt servicing and roll-over cost adjustments on the rise, corporate spending on investment could remain on the back burner. Business confidence, which has already been on a prolonged downtrend since peaking in Q211, could also take a hit from weaker balance sheets.

Confidence Shaken (And Stirred)
India - Composite Business Optimism Index

Sending A Bad Signal: Finally, the rupee's rapid fall is likely to temporarily dent foreign investor sentiment and confidence towards India as it serves as a stark reminder of the economy's inherent vulnerabilities. Indeed, aside from the questions it raises regarding the future of monetary and fiscal policy (as discussed above), anxiety over the final value of repatriated returns could dissuade foreign investment activity in the near future.

Data Review: Yet To Show Clear Signs Of A Bounce

Looking at the latest data, although our official growth projection of 5.5% for this fiscal year (FY2013/14 [April-March]) implies a slight bounce in growth, we have yet to see clear and decisive signs that such a bounce is on its way (see charts). Instead, what we have continued to observe over the past few months is more indicative of a continued bottoming out of economic activity, rather than an actual improvement in economic conditions. To be sure, it is still too early to tell in the fiscal year whether this sluggishness will persist long enough for us to reassess our growth forecasts.

We expect several factors to contribute to slightly stronger growth this fiscal year. Firstly, India is midway through its positive inventory cycle, which we expect to continue on for a few more quarters. The build-up started in FY2012/13 and it typically lasts for at least two years. Secondly, mindful of its lagged impact, the RBI's additional interest rate cuts from January to May (75bps of easing) should feed further into the broader economy going forward, lowering credit cost pressures across the board. Thirdly, a favour summer monsoon bodes well for the production of the main Kharif season crops in 2013/14 (see 'Favourable Monsoon Keeps Export Restrictions Away', June 19), bolstering rural incomes.

Waiting For That Bounce
India - GDP, Purchasing Managers' Indices, Industrial Production

Fourthly, the recently formed Cabinet Committee on Investment's (CCI, established in January) expedition of major projects should see an upturn in activity on several specific fronts. For example, in its May brief, it was reported that 4000km of road projects have been permitted to be taken up for upgrading on an engineering, procurement and construction (EPC) basis, while in the preceding month, the CCI cleared 13 (out of 20) power projects with a rough value of INR330bn. And finally, while no decision has yet to be made, the likely silver lining of the rupee's recent collapse is that it may have jumpstarted the government's reform agenda. In particular, there appears to be strong momentum building towards the further relaxation of foreign direct investment (FDI) regulations in the multi-brand retail sector.

This article is tagged to:
Sector: Country Risk
Geography: India