If you have dollar payments to make, you should beware of the Ides of May. The behaviour of the exchange rate in May 2018 has been eerily similar to that in May 2013, the month that marked the onset of the ‘ taper tantrum’.
Sliding by more than 6% against the U.S. dollar since the beginning of 2018, the rupee now figures among the worst-performing Asian currencies. The slide has been accompanied by the cocktail of factors that always roil the exchange rate.
In 2013, hints from the U.S. Federal Reserve that it was planning to taper its bond-buying programme saw the rupee slide by more than 20% against the dollar in a mere three months from May to August. This led India to the brink of a crisis and forced RBI to take drastic intervention measures such as raising interest rates and curbing gold imports.
Should we now brace for a repeat of the episode? Comparing key exchange rate drivers between then and now shows risks to the rupee are rising, but the situation is not as dire as in 2013.
CAD under control
The main reason why the rupee is always on a sticky wicket is that India runs a persistent Current Account Deficit (CAD). That is, the country’s dollar outflows towards import of goods and services (and other short-term payments), usually exceed its dollar earnings from exports.
The wider this gap between the greenbacks flowing in and those flowing out, the more is the scramble for dollars in India, leading to a weaker rupee. This is why the absolute and relative levels of CAD are critical to judge whether the rupee is in hot waters. On both counts, India is better off today than it was in May 2013.
When taper fears hit global markets in 2013, India was in the midst of an unbridled import binge. In FY13, India splurged roughly $41 billion a month importing oil, gold, capital goods and miscellaneous items. It earned only $25 billion a month from goods exports. After adjusting for services trade, it ran up a CAD of $87.8 billion for the full year. That translated into 4.8% of GDP, well above the comfort zone of 2.5%.
Today, India’s imports are far lower, while its exports are much the same. In FY18, the import bill averaged $38 billion a month while exports brought in about $25 billion. At the end of the first nine months of FY18, therefore, India’s CAD stood at $36 billion, which is estimated to go up to $48-49 billion for the full year. Forecasters expect India to close FY18 with a CAD just short of 2% of GDP, well below the alarming levels of FY13.
Given India’s perpetual dollar shortage, RBI stockpiles forex as a buffer against payment exigencies. It also draws from this war-chest to sell dollars, if the exchange rate turns unduly volatile.
A rule of thumb measure used to gauge the adequacy of these forex reserves, is the number of months worth of imports they finance. RBI held foreign currency assets of $396 billion (excluding gold) last week, which covered India’s monthly import bill about 10 times. In May 2013, RBI’s foreign currency assets had covered its monthly import bill by a precarious 6.5 times. India’s record forex kitty also gives RBI enough ammunition to intervene if there is a speculative run on the rupee.
Oil imports, accounting for 25-30% of India’s import bill, is a key determinant of the size of the CAD. In 2013, global oil prices (WTI crude) were already on the boil ruling at $90-100 a barrel for two years before the taper tantrum hit. Between May and August 2013, they further shot up to $110 a barrel, worsening the deficit.
In 2018, oil prices, after staying at $30-$60 a barrel from 2015 to 2017, have just begun to simmer. Fired up by a host of factors — the OPEC’s production cutbacks, tensions in West Asia, the crisis in Venezuela and renewed U.S. sanctions on Iran — crude prices have increased from $60 in January to over $71 in May.
Various forecasters estimate that every $10 per barrel increase in crude oil prices can expand India’s CAD by 0.5% of GDP. Therefore, while soaring oil is bound to worsen the CAD, the extent of that deterioration is hard to predict, given that oil price moves are seldom orderly. For now, India is expected to end FY19 with CAD at about $70 billion or about 2.5% of GDP, a significant deterioration from 0.7% in FY17, but still only at half the levels seen in 2013. But oil prices will remain a to-watch factor to gauge the rupee’s direction.
Iffy foreign flows
The above analysis shows that the fundamental factors driving the rupee aren’t flashing red yet. But foreign investment flows can turn out to be the make-or-break variable.
When a country regularly spends more dollars than it earns by way of trade, the gap has to be made up by foreign investors pumping in dollars, either by way of Foreign Direct Investments (FDI) or Foreign Portfolio Investments (FPI).
FDI has been flowing into India at a brisk pace in the last four years. Data from the DIPP tells us that India attracted about $36 billion in FDI flows in the first nine months of FY18. The year, therefore, will end with roughly twice the $22 billion FDI inflows seen in FY13.
But then, FDI flows can be quite lumpy and political uncertainties, such as looming elections can certainly act as a dampener. Volatile FPI flows are even more of a wild card factor. FPIs invested in India in fits and starts in 2017. NSDL data tells us that the country received $31 billion in net FPI investments, of which just $8 billion came into equities, while $23 billion flooded into bonds.
The first five months of 2018 have seen these flows reverse completely, with FPIs pulling out $3 billion. May alone has seen FPIs withdraw $2.6 billion from India’s stock and bond markets. This was probably a key factor precipitating the rupee’s recent slide.
Looking ahead, only the most foolhardy soothsayers would try to predict whimsical FPI flows. But FPI equity investments are broadly influenced by the growth prospects of Indian companies and their valuations relative to emerging market peers. Here, the prognosis is not rosy as Indian equities trade at a stiff premium to other EMs after the four-year bull run.
Bond purchases by foreigners depend on how interest rates in India compare with those in ‘safer’ developed markets, after accounting for currency risks. The rate differentials between Indian bonds and developed market ones were quite wide until the U.S. Fed began raising its rates.
But market interest rates on the 10-year U.S. treasuries recently topped 3%, narrowing the differential with Indian gilts which trade at about 7.8%. A narrowing gap between the two rates can prompt FPIs to pull away from Indian bonds. The strengthening dollar also prompts pullouts.
What muddies the FPI outlook further is India’s upcoming general elections next year. Political upheavals usually send foreign investors into fence-sitting mode.