By: Punam Sharma
RBI Governor Rajan hosted a media briefing today. The explicit objective seemed to be to calm market fears with respect to two points: One, the future of rupee once oil marketing companies (OMC) dollar demand is back into the market. Two, concern on RBI policy rates. We summarize takeaways from these below:
1. External account and the rupee: Rajan expressed satisfaction with the compression in trade deficit so far and gave an explicit estimate for the current year’s current account deficit at USD 56 billion. This is USD 32 billion lesser than last year. Additionally the RBI has already raised USD 18 billion via the recent initiatives under FCNR and banking capital. This, then, represents a USD 50 billion swing from last year. Given this context if FII flows, which were positive USD 26 billion last year, are negative this year of an equivalent magnitude even then the flow picture breaks even. Debt FII exposure in India is already down from USD 37 billion on May 21 to USD 19 billion today. The governor judged that most of what is left could be ‘more patient money’ but even if it were to leave, given its reduced size, it will not present a huge risk.
The other market worry is with respect to what happens to the rupee when OMC dollar demand is fully back in the market. As we have suspected for some time, the RBI has quietly let a large part of the demand already re-enter the market over the past few days without most of the market getting wind of it. The rest can be done in a phased manner. Finally, there are concerns about what will happen to the rupee when the OMCs are called upon to repay dollars that the RBI has been providing them directly so far. This is due between February and April of 2014. Again, the governor seems quite comfortable with how this can get managed. If the exchange market is calm by then they can buy from the interbank market and repay the RBI. If not, then the swaps can be rolled over for a more opportune time. Finally, the RBI can even ask for payment in rupees instead of dollars if the market continues to be weak. All in all then, the governor presented a largely sanguine picture of the external account and quite in line with a view that monetary policy can revert to looking at domestic growth versus inflation trade-offs. This will also involve the RBI restoring overnight rate anchor to the repo rate at some point in the near future.
2. Domestic market and RBI’s policy rate expectations: The governor was quite emphatic in addressing market concerns on the future direction of RBI policy rates despite much clarification provided in the recently concluded monetary policy review. These concerns had become more pronounced after the October CPI release yesterday (the print was higher than market expectations at 10.09%, largely on account of still rising fruits and vegetable prices). Rajan interpreted the CPI print as well saying that food inflation, though worryingly high, is still to see the effect of harvest. Furthermore, core CPI has fallen from 8.5% to 8.1% with a decline in momentum as well. Most importantly, he explicitly acknowledged market worries on future policy rates given such data. In this context he reiterated that RBI is concerned about the weak economy as well as high inflation. Furthermore, he emphasized RBI’s belief that the weak economy, increases in food supply, and recent policy rate hikes will provide a disinflationary impetus and that recent data had not dispelled this view. The RBI will watch the incoming data carefully, especially looking for the effects of the harvest on food prices as well as the second round effects of fuel price increases and exchange rate depreciation, before making further decisions on interest rates.
Finally, Rajan announced an OMO for next week for INR 8,000 crores quoting liquidity tightness as reflected in market interest rates.
• The analysis and conclusions presented by Rajan today are quite consistent with those in the policy just gone by and with what we have understood as the new RBI’s monetary policy framework (please refer our note “Objects in the rear view mirror: View ahead for bonds”, dated 7th November for details). As we had mentioned there, the policy stance is better summarized as ‘this tight for longer’ rather than ‘continue to tighten’. If anything, the governor has reiterated this in his statement today. He also continues to show some amount of patience for the disinflationary forces mentioned to reflect in inflation. Our own analysis (detailed in the previous note) suggests recent inflationary impulses are likely to be temporary. The benign effects on headline CPI from fading out of these impulses may start getting seen as soon as the next print itself. If this proves to be true, then repo rate could have topped out at the current level of 7.75%. At worse, we will look for one more hike to 8% if inflation for some reason proves to be more stubborn than is currently anticipated. More importantly, as the central bank gets fully comfortable with the volatility in the rupee it will steadily ensure that the overnight rate sets closer to the repo rate. Hence, even accounting for one more rate hike, directionally overnight rate setting will only head lower over the next few months. As the market gets more convinced of this, the current term spreads will look too attractive to ignore for most investors.
• The other near term worry for the market has been the heavy supply of INR 75,000 crores in November. However, as explained in our recent note, we expect this pressure point to also fade out between December and March. Given our liquidity calculations and our understanding so far of RBI’s liquidity framework, we were looking for at least INR 50,000 crores of OMOs between December and March. The first of these for INR 8,000 crores has been announced sooner than expected.
In summary, a gradual shift down in overnight cost of funds and easing of supply concerns from December should bode well for bond performance in the months ahead.
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