By: Punam Sharma
The RBI has announced yesterday that it will offer a forex swap window to meet entire daily dollar demand of the 3 oil marketing companies (OMCs). Under this facility, the central bank will undertake sell/buy USD-INR forex swap for fixed tenor with OMCs via a designated bank. The tenor of swaps offered were not specified with the announcement.
1. Apart from the INR defense already mounted via hiking cost of carry, the other desperate need was to enhance dollar supply to the market. The forex swap addresses this problem to a significant extent since OMCs have the largest and most consistent demand for dollars. Estimates peg their monthly dollar demand at USD 8 billion odd which will temporarily get met by the RBI. This should make the demand –supply dynamics for USD/INR much more favorable. Admittedly though, this is not immediately showing in prices given the much larger overhang with respect to India specifically and emerging markets generally. A heightened geo-political risk environment is also not helping matters.
2. The forex swap line leads to further tightening of spot rupee liquidity in the banking system, since the RBI buys rupees and sells dollars in the first leg. To quantify this, supposing the swap facility remains in place for the next 2 months, rupee system liquidity will deteriorate by an additional USD 16 billion or INR 1 lakh crores. As at last count, system liquidity deficit had already breached INR 1 lakh crores. Over the very near term the system will see some inflows from seasonal reversals in currency with public, month end government spending, as well as bond maturities. However, over the next month or so deficit will rise again and will become more pronounced with RBI’s forex operations in place. This implies that the RBI may be able to reduce or eventually even eliminate issuances of cash management bills (CMBs) to the market and still be able to keep overnight rates anchored to the MSF rate of 10.25%, so long as it keeps selling spot dollars .
3. At some juncture when the RBI unwinds the current rate defense on rupee, it will presumably revert to its earlier framework of managing liquidity deficit at approximately 1% NDTL of banks. In order to defend this target against seasonal increases in currency with public, the RBI most likely would have resorted to sizeable OMO purchases over the second half of the year. Indeed, it had to do OMOs worth INR 75,000 crores last year during this period. Further, if the dollars sold on account of currency defense (whether through swaps or outright) aren’t recouped by then, the RBI will have to further neutralize the negative impact on liquidity from this source by doing even more OMOs (or cutting CRR). For instance, over late 2011 – early 2012 when the RBI had last sold sizeable dollars to defend INR it had to not only cut CRR but also do OMOs worth INR 135,000 crores between November 2011 – March 2012 in order to somewhat defend its liquidity framework. Hence, assuming that at some point the RBI reverts to its normal liquidity framework this should imply large OMO purchases over second half of the financial year. As seen over past few years, this leads to strong performance in government bonds even without policy rate cut expectations in the market.
Other Recent Developments:
1. The rupee has been horribly massacred this week, standing out in its weakness even against other troubled emerging market peers like Indonesia, Turkey, Brazil, and South Africa. Apart from on-going macro-economic and policy concerns, a proximate issue is the escalating geo-political risk with respect to a possible US attack on Syria. If this happens, it can potentially lead oil prices to rise more in the near term. From an investments perspective, we would advise against reacting to short term event based triggers.
2. The finance minister has unveiled a 10 point program around economic revival. While there is nothing much new here, it is somewhat hopeful to see the top 3 items there as containing fiscal deficit to 4.8%, containing current account deficit to USD 70 billion and financing it fully, and taking steps to add to forex reserves via enhancing capital flows. On the fiscal deficit front, we would make the following observations: One, while we wouldn’t completely write-off the 4.8% target yet, it is a much more difficult ask this year than it was in the last. Furthermore, it is almost certain that it cannot be done without expenditure cuts. Therefore, the finance minister’s contention that growth will be better on higher government spending as well that 4.8% on fiscal deficit will not get breached, don’t sit well together. On CAD target of USD 70 billion, we would think it is quite achievable given the substantial compression in trade deficit that seems underway this year. This is happening on account of import compression (lower demand and gold imports falling) and some rebound in exports (presumably stronger US and Europe contributors here along with weaker rupee). Finally, the continued focus on forex accretion and reiterations of ‘all options being on table’ suggest that an NRI bond kind of issue can be considered sooner or later.
3. With oil prices rising and rupee falling to historic lows, OMC under-recoveries have spiked sharply thereby potentially increasing government’s oil subsidy burden. In order to partly mitigate the effect, a substantial hike in diesel prices is being contemplated along with possible other measures. These will likely get announced post conclusion of Parliament session in early September. Furthermore, the oil minister has apparently been tasked to work out ways to save USD 25 billion on the oil import bill. He is slated to announce solutions by mid-September as per media reports. If true, this will be significantly positive for our CAD. On impact of diesel price hike, we would focus more on the fact that it would lead to further demand destruction in an already weak economy rather than on the upward pressure on inflation that it may cause in the near term. Further, it would be a step further in the structural adjustments that the country needs to undertake. Hence, we would look at it as a bond bullish development.
The Disclosures of opinions/in house views incorporated in this document is provided solely to enhance the transparency and should not be treated as endorsement of the views expressed in the report. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. The recipient should take this into account before interpreting the document. This report has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / Board of Trustee/ IDFC Asset Management Co. Pvt. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.