India - Trajectory of Interest Rates

The Trajectory of interest rates in India is likely to be predicated on the movement of the currency more than the inflation numbers.

Inflation appears to have peaked in April 2022 and has declined subsequently. It is likely to trend lower in the coming months - sticky around the 7% level in the months of Aug and Sep and then start declining towards 5.80% in December. I’m generally guided by average of 10y historical mom spreads to outline the trajectory. The risk to inflation come from spike in prices of paddy (10%) and pulses (2%).

Liquidity – Liquidity surplus stands at 84K crore ( LAF ) as on aug 17, 2022. The system has a durable liquidity surplus of 464K crore. LAF + Government Cash balance equal durable liquidity, hence government cash balances stand at 380K Crore. The LAF number would improve as RBI starts spending. In the months ahead till December, CIC leakage is estimated at 110K crore - 3% - 3.50% on account of currency leakage during festival season and 2 state elections of Himachal Pradesh (nov) and Gujarat (dec).

The liquidity situation is likely to worsen if USDINR continues to trend higher. Another $ 40 bn intervention in spot will wipe away the liquidity from the market which implies short term rates could trend higher.

For the balance of the year, government borrowing program is likely to keep the downside limited on rates. 55% of the borrowing program (11 lac crore) is yet to be completed.

In an environment of higher global rates, pressures are building up in the economy, rates are likely to trend higher.

Intervention –

RBI reserves have fallen from a high of $ 642 bn end of Oct to current $ 564 bn (19 Aug 22). $ 78 bn decline in FCA can be explained through $ 23 bn through spot intervention; $ 26 bn depreciation of non USD FCA ( non USD FCA assumed at 30%, decline in val 15%); $ 29 bn of spot intervention in July and Aug. To double check this number, Fx reserves have declined $ 34 bn from $ 606 bn to $ 564 bn. Fx spot intervention was nil during this period, valuation accounts for $ 16 bn depletion. So intervention could be closer to $ 26 bn. Estimated intervention stands between $ 24 bn - $ 29 bn for July and August.

In addition, the outstanding forward book has declined by USD 19 bn in the 3m – 1y bucket and now stands at $ 30 bn.

In terms of liquidity, $ 23 bn (spot intervention upto june) + $ 25 bn (July and august) + $ 19 bn (forward book) has been sucked out due to spot intervention amounting $ 67 bn which is close to INR 5 lac crore. End of October liquidity was closer to 8 lac crore / durable liquidity was 12 lac crore. Currently, it stands at 80k crore / 480k crore. 2.5 lac crore is currency leakage and 5 lac crore has been withdrawn due to intervention.

How much can the RBI intervene?

On a 40 currency basket, NEER basis, INR has depreciated (92) and on a REER basis (103.65), INR has appreciated which shows that export trade gains on depreciation are not likely to come by and the trade deficit would continue to be under pressure.

RBI may not be able to maintain the pace of intervention as the import cover and debt ratio worsen.

External sector

Trade deficit and Invisibles – For the first four months trade deficit stands at USD 100 bn. At crude price of $ 100 - $ 110/bbl, trade deficit assumed at $ 25 bn pm. Est trade deficit for the year $ 300 bn. Invisible surplus at $ 150 bn ( services surplus at $ 9 bn pm is $ 108 bn ; transfers assumed at $ 75 bn (last 3 yr avg) and income outflow assumed at $ 33 bn ( last 3 yr avg). That leaves us with a current account deficit of $ 150 bn.

Capital Account – FDI at $ 40 bn for the year (3 yr avg) , FPI stands - $ 10 bn ( the current risk off sentiment does not indicate a pick up is likely in the immediate but towards the end of the year we could end up at a net positive of $ 5 - $ 10 bn). NRI deposits $ 10 bn ; Borrowings $ 20 bn Capital account is assumed at $ 70 bn.

Balance of payment est is at - $ 300 bn + $ 150 bn + $ 75 bn = - $ 75 bn Balance of payment deficit.

There is pressure on the foreign exchange. If the external sector continues to show signs signs of deterioration and evolve on expected lines we could see pressure on domestic rates. Run down in fx reserves has been the first line of defense which has limitations. The second line of defense could be interest rate rise to stem the currency depreciation.

Till factors materialize for a reversal in trade deficit numbers / crude oil prices / bond index inclusion we continue to favor longs on USDINR and pay rates on dip.

Comments

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