An interest-rate defence of R is a bad idea, junk it PDF Print E-mail
Tuesday, 18 September 2018 09:35
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If markets not too impressed by govt talk of achieving deficit target, it is because this runs counter to plans like MSP ones


Given how the rupee closed at 72.51 to the dollar versus Friday’s close of 71.86—10-year yields softened a bit at 8.098 versus Friday’s 8.127—it would appear the markets weren’t too impressed with the measures announced by the government over the weekend, from taking measures to curb “non-essential” imports of gold and electronics to ensuring that the fiscal deficit targets will be met while keeping capex untouched. This is not to say that measures like those announced to make it easier for corporates to raise funds overseas—including removing withholding taxes for masala bonds—are not a good idea. Of course they are, but the current volatility in the rupee is not just related to a weakness in India’s macros, it is part of global pressures brought on by a stronger dollar, the likelihood of the Fed continuing to tighten rates and the fear that the trade wars will continue to heighten.

While it is true the measures announced over the weekend are part of an overall confidence-building package—more are likely to be announced—what is not clear is why the government and RBI did not raise $30-40 billion from NRI bonds when it was first suggested several months ago; nor is it clear why, given how much forex they consume, a separate forex window was not created to keep oilcos away from the forex market.


Several analysts have been arguing for a rate hike by RBI, if need be, as a mid-term policy measure as a classic interest-rate defence. As the Fed hikes rates, the argument goes, India also needs to hike rates to ensure the differential doesn’t increase as this will ensure debt inflows don’t take place or outflows continue to rise. How an inflation-targetting RBI will justify a rate hike when the inflation outlook hasn’t worsened is not clear though. More than that, it should be apparent that a rate hike will only worsen capital inflows. As far as equity inflows are concerned, it is obvious that, ceteris paribus, an interest rate hike will hit inflows. A rate hike, however, will also hit fixed-income investors. For one, given how the rupee has depreciated over the past few weeks—3.9% over the last one month—investors are going to juxtapose any likely rate hike against the likely depreciation in the value of the rupee; given the sharp depreciation, it is unlikely a rate hike in itself will make debt investments look attractive since the gains from higher rates will be outweighed by the currency losses. For those already invested in debt—outstanding FPI debt investments are worth around $60 billion at today’s exchange rates—on the other hand, every hike in interest rates implies a capital loss. In which case, it is very likely that, should the RBI hike interest rates—either mid-cycle or at the time of the next review—this will only hit forex inflows.

The government, similarly, would be ill advised to raise import duties to curb “non-essential” imports since, at the end of the day, anything that raises prices on inputs—base metal imports rose 26% y-o-y in April-August and electronics 15%—will hurt overall economic growth as it will increase costs of local manufacturing. Also, apart from raising import duties at a time when India needs to be lowering its import duties in order to make Indian industry more competitive, it is not clear whether these will even lower imports since higher import duties will invariably result in more smuggling. Hiking import duties on mobile phones, for instance, will serve little purpose if all that this results in is more SKD imports that are then assembled in India. Imports of mobile phones, keep in mind, were down from 205 million in 2014 to 31 million in 2018, but the import bill shot up from $8.8 billion in 2014 to a likely $13.3 billion in 2018 as imports of components rose from $1.4 billion in 2014 to a likely $11.4 billion in 2018.

Markets are also confused over finance minister Arun Jaitley’s statement, after a review meeting with prime minister Narendra Modi on Saturday, that while the government would ensure the year’s 3.3% fiscal target would be met, there would be no cut in expenditures, especially capex; he also said that the government would be more aggressive when it came to meeting the Rs 80,000 crore divestment target, especially through strategic sales. Even though the government’s half-hearted approach—it could have taken over all of the debt instead of just half—ensured it was not able to privatise Air India, the fact that its SUUTI shares are still worth around Rs 38,000 crore right now (minus the portion that is already part of the Bharat 22 ETF) will allow it to move faster on the divestment targets; the fear though, is that with the bottom falling out of the stock markets, finding buyers could be an issue.

What is more worrying, however, is how the government plans to fund its election promises that have not been provided for in the budget. If you assume the government has capped its Ayushman Bharat contribution at Rs 1,400 per family, for 10 crore households, that’s an expenditure of Rs 7,000 crore for what is left of the year, And while FE has estimated the MSP-based deficiency payments scheme will cost as much as Rs 175,000 crore in a full year for all crops except sugar and horticulture—if, as is likely, market prices fell to 20% below the announced MSP—the government has allocated a much smaller amount. Not surprising then, that the market is not fully convinced of the government’s intentions so far.



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