Treasury Economics Research
INR: Unlikely to break out of its range yet
INR: Ranged trade with a depreciation bias
In recent weeks, the INR has witnessed some support on account of an improvement in global risk
appetite. The turn in sentiment has been driven primarily by investors pricing in a higher
probability of monetary easing in the near term by both the European Central Bank (ECB) and the
Federal Reserve (Fed). This risk-on sentiment in the global markets has translated into an increase
in portfolio flows providing some much needed relief to the INR.
Graph 1: Portfolio flows have picked up in recent months
Note: Data is updated till 21-August-2012.
This rally could persist for a few more days and take the USD-INR pair closer to the 55 mark.
However, we are not convinced that capital flows will pick up on a sustained basis as yet.
Instead, we see a number of risks both on the domestic and global front that could impinge on
capital flows in the near term. While there has been some improvements in the current account
position that did help in reducing pressures on the INR at the margin, we do not expect this alone
to support further appreciation. In fact we expect some of the gains on the current account to
dissipate going forward. Hence, we expect a trading range of 55.00-57.00 with a depreciation bias
in the near term on account of an adverse balance of payments. This will change only if: (a) there
is concrete action taken by EU policymakers to tackle the sovereign crisis and (b) aggressive
monetary accommodation by both the ECB and Fed. However, we do not see either of the two
measures before November-December 2012.
Improvements in the current account unlikely to be enough
A key development in FY13 so far has been a sharp fall in the merchandise imports bill that is
visible across every major category of imports. The pace of growth of crude oil imports has
moderated on the back of the fall international crude oil prices witnessed in 1QFY13. Gold imports
have plummeted because of the elevated level of international gold prices and the government’s
decision to hike import duty on gold. At the same time, non-oil imports excluding gold have also
slowed on account of both a slowdown in growth (and hence reduced need for imported inputs)
and some import substitution. Import substitution has come on the back of depreciation in the
exchange rate over the last year that has forced some domestic entities to switch away from foreign
inputs and seek domestic alternatives. The reduction in the imports bill has helped in reducing the
trade deficit in 1QFY13.
Graph 2: Imports have softened across the board
Source: Ministry of Commerce & Industry, Government of India.
However, the improvement in the trade balance is unlikely to continue at the pace that we saw
in April-June, 2012 period. For one, global crude oil prices have started to head higher rising by
around 13% in July and around 10% so far in August. This should push crude oil imports up that
could offset (at least partly) the effect of import substitution and decline in gold imports. On the
other hand, exports have clearly been hit by weak global growth and are likely to contract at a
faster pace than aggregate imports. The upshot is that despite dwindling imports significant
improvement in the trade balance is unlikely going forward.
Graph 3: Soft exports will likely… Graph 4: ….restrict any major improvements in the trade balance
in USD mn
In YoY %
Source: Ministry of Commerce & Industry, Government of India, RBI & HDFC Bank.
Turning to the current account, the net invisibles component is likely to grow at a strong pace
driven principally by continued traction in private transfers. This improvement in invisibles along
with some improvement in the trade balance could help in pushing the current account deficit
(CAD) from 4.2% of GDP in FY12 to 3.5% of GDP in FY13. Our sense is that this improvement in
the CAD is priced into the current levels of the INR. Besides, while it is certainly represents an
improvement, the fact is that in absolute terms it remains high and has to be funded through
capital flows. Thus the improvement in the CAD alone cannot drive a reversal in the INR’s path.
Any appreciation from current levels will have to come on the back of a jump in capital flows. If
instead there is a shortage of capital flows, the CAD will ensure that the INR is vulnerable to
Graph 5: Current account deficit likely to remain elevated
In the near term we do not expect a pick-up in capital flows to any substantive degree. In fact we
identify risks that could induce ‘risk-off’ and hinder capital flows. This could lead to episodes of
depreciation. That said, we believe that there is a high probability of a reflation trade by the year-
end that could lead to some pick-up in capital inflow and push the INR below its 55-57 trading
Why capital flows could remain weak in the near term
We believe that the INR will likely remain a victim of global risk aversion and investor
apprehensions about the domestic macroeconomic landscape. A number of risks are likely to weigh
on the INR for the next two to three months:
1. Anxieties about domestic fundamentals and Indian sovereign downgrade: While the new
finance minister seems committed to fight the economic slowdown and the policy gridlock that
has contributed to this, the government, in our view, still remains reluctant to take credible
(and politically contentious) measures that are required to improve the fiscal position. Some of
the measures that the market is looking for are: (a) hike in diesel prices that will help in
reducing the subsidy bill and (b) clarity on how fiscal slippage from drought mitigation
measures will be managed. Besides, the actual growth rate is likely to be a lot lower (around
5.5%) than the 7.6% GDP growth assumed by the government in its FY13 fiscal deficit
calculations. Lower than assumed growth will hit revenue targets ensuring there is significant
fiscal slippage of around 0.8% to 1.0% of GDP. Hence, market apprehensions about fiscal
prospects are likely to intensify going ahead especially as both S&P and Fitch have placed
Indian sovereign ratings on negative watch for a possible downgrade to ‘junk’ status. The
upshot is that lingering concerns about the fiscal situation and a prospective rating
downgrade will likely force investors to remain circumspect towards investing in domestic
2. Grexit: Greece is back on the market’s radar screen. The region continues to be trapped in a
deep austerity driven recession. The recession will adversely affect revenue income and is
likely to ensure that Greece will yet again fail to meet the troika’s (EU/IMF/ECB) public debt to
GDP targets in either 2012 or 2013. Fiscal slippage will result in Greece requiring some form of:
additional aid, further restructuring of debt or some leeway in terms of meeting its public debt
to GDP targets.
There is considerable uncertainty about how Greece’s economic woes will be handled going
forward with some policymakers in core nations stressing that they may not be willing to
provide additional aid to Greece this time around. The first test of this will come in September
when the troika reviews Greece’s fiscal health that is followed by another review in December.
Any signs of reluctance of EU policymakers to provide further relief could force markets to
price in Greece exiting the Euro-zone. Such a scenario will hit market confidence and result
in acute global risk aversion. While we maintain our stance that European policymakers
would want to avoid this situation due to significant losses that it could generate particularly
for the banking sector, recent commentary suggests that the tail risks of a Grexit cannot be
totally ruled out.
3. US fiscal cliff: The so called US ‘fiscal cliff’ could be the next big risk factor that could start to
dampen both global growth and risk appetite. The fiscal cliff involves the tightening of US
fiscal policy at the beginning of 2013 by around USD 630 billion (equivalent to around 4% of US
GDP) due to a series of tax cuts that are scheduled to expire by the end of 2012 as well as
automatic spending cuts that are due to take effect at the beginning of 2013. Even though we
expect most of the expiring tax cuts to get extended by at least another year and that should
ensure that the magnitude of fiscal consolidation does not derail growth, there are two
Table 1: Will the US economy fall off the fiscal cliff?
Fiscal tightening based on current law in 2013
Measures % of GDP Amount (USD billion)
Bush tax cuts 1.4 238
--High income 0.3 56
--Low income 1.1 185
Payrolls tax cut 0.7 109
Unemployment benefits 0.2 34
Sequestration 0.5 86
Affordable care act 0.2 27
Alternative minimum tax 0.8 132
Total fiscal tightening 3.8 626
• The first is that any major decisions on fiscal policy are likely only after the US
presidential elections in November. Hence decisions regarding the future course of
US fiscal policy are unlikely to be known before December-January. However,
until there is clarity the uncertainty about future US growth prospects and
potential fiscal tightening will likely result in risk aversion in the near term.
• The other pertains to the growing partisan face-off between the Democrats and the
Republicans party about what measures to take to rein in US public finances. This
division threatens to jeopardize negotiations or comprises that are required to be
achieved for the timely passage of the new fiscal bill. The upshot is that the
partisan brinkmanship will keep markets nervous and result in risk aversion.
4. European sovereign concerns persist: After the measures that were announced in the June EU
Summit, further progress has been limited. The lack of more aggressive action to address the
sovereign crisis will to add to the market’s list of anxieties. Furthermore, we think that concerns
about Spain could re-surface again in October as it formally requests for a bailout due to an
escalation in its sovereign yields on the back of fiscal slippage concerns. Although Spanish and
Italian sovereign yields have softened in recent weeks in response to rumours that the ECB
could intervene aggressively in the bond market, we do not think that the ECB will do so in the
near term that could push sovereign yields back up.
However, the main focus will be on the German constitutional court ruling on the ESM
treaty on September 12, 2012. The court needs to approve the treaty before the ESM can come
into operation. Were the court to rule that the treaty needs to be re-written, there could be a
delay in the ESM coming into force. This will have the more obvious negative implications for
Table 2: Major events in Europe
Europe: The dates that matter
6-Sep-12 ECB monetary policy meeting
11-Sep-12 European commission delivers proposals for a single banking union supervisory authority
12-Sep-12 German constitutional court ruling on ESM treaty and fiscal compact
14-Sep-12 Eurogroup meeting
Sep-12 Troika completes review of Greece bailout program
4-Oct-12 ECB monetary policy meeting
8-Oct-12 Possible disbursement of Greek aid by the troika
8-Oct-12 Eurogroup meeting
18-19 Oct-12 EU Summit: Policymakers meet to prepare initial report on EMU fiscal/political/banking union
8-Nov-12 ECB monetary policy meeting
6-Dec-12 ECB monetary policy meeting
12-13 Dec-12 EU Summit: Full report on EMU fiscal/political/ banking union-- road ahead
The bottom line is that we do not see a sustained surge in capital flows going forward. In fact
there are many triggers for sudden stops in capital flows that could trigger depreciation
pressures. Given the myriad risks on the horizon, we expect the USD/INR to trade with an upside
bias in a possible range of 55.00-57.00 in the August-October 2012 period.
Table 3: FY13—Another Balance of payments deficit
Balance of payments forecasts
Brent @ 87 Brent @ 112 Brent @ 105
(in USD billion) FY11 FY12 % Y-o-Y FY13f % Y-o-Y
Exports 250.5 309.8 23.7 300.5 -3.0
Imports 381.1 499.6 31.1 491.0 -1.7
Oil 106.9 141.9 32.7 150.4 6.0
Non-oil 274.2 357.7 30.5 340.6 -4.8
Gold imports 35.3 61.5 74.2 36.9 -40.0
Non-oil ex gold 238.9 297.7 24.6 303.7 2.0
Merchandise balance -130.6 -189.8 45.3 -190.5
Software exports 53.3 61.0 14.4 64.1 5.0
Private transfers 53.1 63.5 19.6 76.2 20.0
Other invisible categories -21.8 -12.9 -40.8 -16.0 -24.0
Net Invisibles 84.6 111.6 124.3
Current account -46.0 -78.2 -66.2
CAD % of GDP -2.7 -4.2 -3.5
FDI 9.4 22.1 15.0
Portfolio flows 30.3 17.2 13.0
External loans 28.4 19.3 18.0
--External assistance 4.9 2.3 2.0
--ECB 12.5 10.3 11.0
--Short-term trade credit 11.0 6.7 5.0
Banking capital 5.0 16.2 14.0
--NR Deposits 3.2 11.9 12.0
Other capital flows -11.0 -6.9 -2.0
Total capital account 62.1 67.8 58.0
Errors & Omission -3.0 -2.4
Overall BOP 13.1 -12.8 -8.2
Source: RBI, Reuters & HDFC Bank
But global reflation trade could induce a reversal in the INR
Given the lack of policy options for either reviving growth or effecting fiscal correction, the onus
will ultimately fall on the two major global central banks to take rear-guard action. However, both
the ECB and Fed are likely to remain reluctant to ease monetary policy in the immediate future.
Thus the current rally that appears to be premised on somewhat quick action from the Fed and
ECB could be a case of the markets running ahead of themselves and is likely to fizzle out.
At present, there are two reasons why the ECB will be unwilling to intervene in the sovereign bond
markets. First, intervention in the bond market is likely to compress sovereign yields that might
force some of the peripheral nations to renege on their austerity commitments. Lower sovereign
yields will allow a member nation to fund its deficit via the market with ease and subsequently
reduces the pressure to take necessary action to curtail public debt to GDP ratios. This is exactly
what had happened last year when Italy shelved some of its fiscal consolidation measures in
response to the ECB purchasing Italian debt. The ECB will not want a repeat of this scenario and
would instead look to put pressure on EU policymakers to pass the requisite structural reforms.
Second, unlimited ECB financial support can be construed as central bank financing of sovereign
deficits that goes against the ECB’s mandate.
However, the recent proposals made by ECB President Draghi provide a path to circumvent these
constraints. The ECB would probably want struggling nations to request for aid from the
EFSF/ESM 1. By doing so, that nation would be forced to accept an austerity package that would
entail structural reform and as part of the package the ECB could commit to purchase sovereign
debt. Thus, we see a possible sequence of events that leads to liquidity infusion by the ECB:
• ESM comes into operation around September/October.
• A large peripheral economy like Spain seeks official aid.
• Aid is provided on the back of austerity conditions. The aid is supplemented by ECB
purchases of sovereign debt.
• This could be followed up by a more general liquidity infusion program such as the LTRO.
The sequence that we have identified is one of many possibilities. The important points to note are
that the ECB will not move unless it has a guarantee that the moral hazard of member nations
reneging on their commitments after getting liquidity support will not resurface. Second, the
establishment of a more permanent bailout mechanism is an important milestone. Third, the ECB
seems keen to act at some stage and whatever the specific form of action it takes it is likely to result
in two things: (a) a revival of the risk-on trade and (b) fresh EUR liquidity infusion. If this happens
at the year end, it could take the USD/INR pair down.
On the other hand, the Federal Reserve has already made it clear that it could ease monetary policy
if economic conditions deteriorate significantly. While the US economy has lost some momentum
The European Stability Mechanism (ESM) will be the permanent vehicle used to provide financial assistance
to stressed Euro-zone nations. The ESM will replace the current and temporary European Financial Stability
in recent months, it is still nowhere close to an outright recession that would warrant immediate
action. Hence, the Federal Reserve is unlikely to introduce QE 3 in the near term. However, even
if the fiscal cliff is avoided, there is likely to be significant fiscal compression in 2013-14 as the
US struggles with its public finances. This could raise anxieties about growth prospects forcing
the Federal Reserve to introduce QE 3 sometime towards end 2012 or early 2013. The market
could begin to price these expectations around end-2012.
The upshot is that capital flows should pick up later in the year in response to global policy
reflation ensuring that these flows are able to fund the current account deficit a lot more
comfortably. This could happen towards November-December 2012 when the first signs of
monetary easing by the two major central banks (or at least the expectation of this happening)
begin to reflect in market movements. This could continue into 1H2013. The improvement in risk
appetite is likely to help in pushing the USD/INR pair lower towards the 54.00-55.00 range in
November-January period and down to the 52.50-53.50 range in the April-May 2013 period.
Long-term: Depreciation is the new norm
Is significant INR appreciation on the cards over the longer term? With the INR depreciating by
around 22% against the USD in the last year alone, there are genuine concerns among investors
about whether depreciation is likely to be the new normal for the INR. We think that these fears are
legitimate considering that the current account deficit is likely to remain large for the foreseeable
future and that there is a strong risk of a rating downgrade. For one, it is worth noting that
depreciation has been more the norm in the last two decades. The depreciation trend started in the
post liberalization period in FY91 that lasted till FY03. The sharp spell of depreciation helped in
correcting the external imbalances by boosting export competitiveness that brought about an
improvement in the current account position.
The tide, however, turned from FY04 onwards. Capital flows picked up at a rapid pace due to easy
global liquidity conditions and new found euphoria towards the BRIC economies. At the same
time, the current account deficit widened reflecting the strong pace of domestic growth. However,
the current account deficit was more than compensated for by a gush of capital flows into the
domestic financial markets rendering a strong appreciation bias to the INR. This established the
capital account as the dominant driver of the INR.
Graph 6: INR: Moving to a new normal?
The three different phases:
Unrestrained depreciation corrects external imbalances
Current account back under pressure but negated by strong capital flows resulting in INR
Current account deficit widens and capital flows dwindle resulting in the INR coming under
significant pressure and moving to a record low against the USD.
However, the situation turned adverse last year. An acute bout of global risk aversion coupled with
concerns about the domestic macroeconomic landscape meant that capital flows dwindled quite
sharply. At the same time, the current account widened due to rising crude oil prices and gold
imports. This rendered a sharp depreciation bias to the INR. Not much is expected to change over
the next two to three years. We expect the syndrome of inadequate funding of the current account
to remain the dominant theme for a number of reasons:
• First, the current account deficit is likely to remain elevated. The weak global growth
backdrop will mean that any boost to exports from currency depreciation will remain
limited. Besides, oil imports tend to be somewhat inelastic (especially when they are
heavily subsidized) and will continue to prop up headline imports
• Second, the euphoria about the BRIC economies has died down considerably given that
each region is facing its own structural problems and a weaker growth outlook. This means
that the momentum of fund flows into the BRIC economies is likely to be a lot slower than
that witnessed in past years.
• Lastly, the structural problems in the G-7 world are unlikely to disappear in a hurry and
will from time to time adversely affect global risk sentiment. In fact, we expect fiscal
slippage in the European periphery coupled with the possibility of both Portugal and
Ireland requiring additional aid to resurface around 2H2013 weighing on global risk
The upshot is that after the brief rally in the INR driven by global policy reflation it is yet again
likely to trade with a depreciation bias. We see a possible range of 52.00-58.00 for the USD/INR
pair for the next two to three years.
EUR: Further weakness in store
We expect the recent uptrend in the EUR/USD pair to remain short lived and expect it to move
lower as ECB does not intervene in the bond markets in the near term. The Euro is likely to remain
a victim of the sovereign crisis and a recession in the Euro-zone. Concerns about Spain needing
additional aid, concerns about Grexit and continued divergence in intra-European sovereign yield
spreads are likely to emerge as important factors that will add to the downside pressures on the
EUR for most of 2012. Even as we expect the ECB to step in, it will entail injecting significant
liquidity into the financial system. Hence, the EUR will have little yield support and is unlikely to
rally significantly on the back of an improvement in risk appetite towards end 2012 and 1H2013.
Besides it is important to keep in mind that the European sovereign crisis is likely to remain a
prolonged affair that will continue into 2013 and possibly even into 2014. We expect continued
fiscal slippage across the peripheral region to weigh not only the EUR but also on global risk
appetite. After concerns about Spain in 2012, focus could turn to Italy in 2013 that could be
followed by both Portugal and Ireland requiring additional aid. Hence, apprehensions about the
sovereign crisis are likely to weigh on the EUR in the medium to long term.
JPY: Trapped in a range
Global risk aversion and US treasury yields are likely to remain the dominant drivers of the
USD/JPY pair. Given our expectations that concerns about the sovereign crisis and the US fiscal cliff
are likely to persist, we expect the USD/JPY to trade with a downside bias in a possible range of
77.00-80.00 for the next three months. However, currency appreciation could exaggerate deflation
pressures that the Japanese economy finds itself currently engulfed in. Hence, the Bank of Japan
(BOJ) is expected to intervene aggressively and possibly increase the size of its asset purchases
program so as to inject yen liquidity into the financial system. These actions could limit the fall in
the USD/JPY pair. We think that the BOJ is unlikely to allow a significant move below the 76.50
level on a sustained basis. Going into 1H2013 as risk appetite improves and the BOJ maintains its
accommodative stance, we would expect the USD/JPY pair to head higher.
Over the long-term we are bearish on the JPY. We believe that the Japanese government will have
to resort to aggressive fiscal consolidation measures to rein in the gross government debt to GDP
ratio that is currently at around 240% of GDP. In fact, the Japanese government has already hiked
the consumption tax rate from the current rate of 5% to 8% in 2014 and 10% in 2015. Fiscal
tightening could ensure that growth remains subdued reducing the incentive for Japanese investors
to hold domestic assets. At the same time, the BOJ is likely to maintain its accommodative stance
that will provide little yields support to the JPY. The upshot is that the JPY is likely to weaken
significantly in the medium to long term. However, the weakness in the JPY is likely to set in more
around 2014-2015 when the aggressive fiscal consolidation measures start to kick in.
GBP: Some more downside in store followed by a reversal
After a strong start to the year, the GBP lost significant ground in 2Q2012 in response to substantial
monetary easing from the Bank of England and weaker UK economic indicators. We believe that
markets have more or less priced in anaemic growth in the UK economy and going forward the
GBP is likely to be driven more by broader global risk sentiment. Hence, we expect the GBP/USD
pair to move marginally lower in response to global risk aversion and trade in the 1.54-1.56 range
from August 2012 to October 2012. We do not expect significant downtrend below these levels
primarily because of continued diversification of funds from the Euro-zone periphery into UK gilts.
This flow of funds will cap any significant downside. However, we expect the GBP tide to reverse
in response to the global reflation trade towards end 2012 and beginning 2013. At this point, the
divergence in monetary policy between the Bank of England and the two major global central
banks (ECB &Fed) will ensure that the GBP enjoys significant yield advantage.
USD/INR EUR/USD GBP/USD USD/JPY
August-October 2012 55.00-57.00 1.22-1.26 1.54-1.58 77.00-80.00
November 2012- January 2013 54.00-55.00 1.19-1.21 1.55-1.58 77.00-80.00
February-March 2013 53.50-54.50 1.19-1.21 1.59-1.60 80.00-82.00
April-May 2013 52.50-53.50 1.21-1.22 1.61-1.62 82.00-83.00
End 2013 55.00-56.00 1.17-1.18 1.57-1.58 79.00-80.00
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