India: parsing the impact of rupee depreciation :JPMorgan

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The last two weeks’ rupee sell-off has been nothing but brutal. But then by now we should have gotten used to such episodic scares. It’s the fourth since 3Q11. In each of these episodes the market has hoped for a quick trend reversal. And each time the hope was dashed with the reversal being partial and temporary. Instead, every episode saw a new lower floor for the rupee being set only to be ratcheted down in the next sell-off.

This time too the pattern seems to be repeating. The USD/INR, which appeared to have settled in the 53-54 range, has fallen nearly 10% since early May. As in earlier episodes, there is still hope that the sell-off is temporary and will be fully reversed when global financial markets settle down. However we fear that, just like in earlier episodes, the rupee is unlikely to revert to its previous range, and instead settle to a new lower range of 57-58—5% lower than the average over Oct12-Apr13.

It is this ratcheting down of the rupee that is disconcerting. While some would see a silver lining in the rupee weakness on the ground that it improves competiveness, as we have argued several times in the past, price sensitivity of India’s export basket is very weak. Rupee weakness does little to increase the demand for India’s exports. Instead, our fear is that the weaker rupee will reignite inflation, stress corporate balance sheets, and increase the budget’s subsidy bill.

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Serial ratcheting down of the INR

Not too long ago in the post-Lehman world, USD/INR remained fairly range bound averaging around 46.5. Then came the US credit downgrade in August 2011 and in the global risk blow-up the rupee slid close to 54 by mid-December. A barrage of capital controls and the subsiding of global risk aversion after the ECB’s announcement of the LTRO program helped the rupee partially recover to just below 49. But the INR did not make it back to 46-47 despite the sell-off being largely attributed to collateral damage from the rise in the global risk aversion. Instead it remained range bound around 49-50. More importantly the rupee strength did not last long. A very damaging 2012-13 budget, along with rising concerns over economic governance, triggered another round of rupee weakness that lasted till September when a new economic management team was put in place. By then the rupee had already tested a new low of 57. The reform blitz and the fiscal tightening that followed helped the rupee to make up some ground, but again it did not manage to break out of the 53-54 range.

This brings us to the latest rupee scare triggered by the re-pricing of EM assets in the wake of rising fears that the Fed might taper its asset purchase program sooner than expected. As such, majority of EMs have experienced heavy bond outflows resulting in a bleeding of their currencies, with the CAD economies suffering the most.

Last week we discussed the drivers of this round of rupee depreciation in detail (see INR: slip sliding away again, Morgan Markets, 13 June 2013). This week we focus on the widely held market hope that the rupee should eventually recover. The RBI could help in the process by intervening strategically in the FX market. An interest defense would help to discourage further short rupee positions but we doubt that the RBI will do so. The government has raised the FII limit on government debt by $5bn. Although this is unlikely to have an immediate impact it will help to shore up sources of funding the current account deficit. Beyond if the monsoon parliamentary session manages to advance the long delayed legislative agenda (land acquisition, pension and insurance reforms) sentiment in the equity market would be bolstered. All these are likely to help the rupee recover some of the lost ground, but we fear that as in the previous episodes only part of the depreciation will be reversed and the rupee is likely to settle in a new lower range, probably around 57-58.

Depreciation unlikely to boost exports

If indeed this happens then the rupee will have depreciated another 5-7% from its previous 6-month average. It is easy to argue this is not all bad and that the depreciation will further improve export competitiveness and help lower the CAD. As we have argued several times in the past (e.g., see What’s happening to India’s growth drivers: exports? Morgan Markets 13 May 2012), India’s export basket has changed dramatically from a decade ago. India’s traditional, labor-intensive, small-scale-industry-dominated exports such as leather and textiles have lost significant share within the export basket. These have been replaced by the higher tech, more mechanized, more differentiated engineering goods (automobiles, auto parts, capital goods) and chemical products, which together constitute almost 60% of the manufacturing goods (ex. oil) basket.

 At the aggregate level, India’s exports are significantly more responsive to changes in external demand than to price. The coefficient of external demand suggests that a 1% increase in external demand would increase export volumes by 4.4%. In contrast, the price elasticity is neither statistically nor economically significant. A 1% increase in India’s REER would reduce export volume by 0.7%, but this estimate is not statistically significant.

These results are not inconsistent with the events over the last two years. Even though the price elasticity is small, the 25% depreciation against the US dollar (even before the recent depreciation) and the 10% depreciation of the real exchange should have boosted export growth. Instead, export growth has been positively correlated with the real exchange rate suggesting that the causality runs the other, i.e., as exports rise or fall driven by global demand, the CAD narrows or widens, appreciating or depreciating the exchange rate. This is consistent with a high income and low price elasticity, with the impact of the former swamping the latter.

Of course one can argue that much of the 25% nominal depreciation has been largely offset by the large inflation differential India has run against its trading partners such that the real depreciation has been much less. And here is a dramatic example of this. Since August 2011 the INR has depreciated over 20% against the RMB as the latter steadily appreciated against the US dollar. However, much of the price advantage has been offset by the significantly higher CPI inflation in India. In real terms, the INR remains about 2% more appreciated although this has fallen over the last two years.

Inflation impact modest but significant

And this is good segway to how the depreciation might impact inflation. The role of the exchange rate in India’s inflation dynamics remains controversial. At one end of the spectrum, the RBI grudgingly acknowledges some role of the exchange rate in determining inflation, while some academics (e.g., see Rudrani Bhattacharya, Ila Patnaik, and Ajay Shah, “Exchange rate pass-through in India”, NIPFP, March 2008) have consistently argued that the INR plays a significant role in inflationary dynamics.

Our analysis suggests that the impact is modest but significant (for details see India’s exchange rate pass-through redux, Morgan Markets, 26 November 2012). Controlling for lagged inflation, global commodity prices, and the output gap, which are all statistically significant, a 10% depreciation of the currency raises quarterly headline and core inflation by 1% and 0.8% respectively. For comparison, 10% higher global commodity prices raises India’s headline and core inflation by 1% and 0.5% respectively in the same quarter, while a 1% of GDP higher output gap increases headline and core inflation 0.3% and 0.35% respectively. Although the interest rate has the right sign, i.e., higher rates reduce inflation, in the presence of the output gap it is rendered statistically insignificant. This largely reflects the mechanism by which interest rates affects inflation, namely by suppressing demand or lowering the output gap.

Based on this, the move from USD/INR 53-54 to USD/INR 57-58 range would increase inflation by around 0.6-0.8%-pts. This is not alarming given that not too long ago inflation had raged close to 10% and now it has declined to below 5%. But what it does is to change the trajectory of the inflation dynamics. While previously one had expected inflation to slow further and bottom out in 4Q13 given the more slowdown in global commodity prices and the modest negative output gap (estimated around 1% of GDP at present), now the inflection point could be brought forward to 3Q13. And if indeed the inflation path reverses course, it could put further monetary easing on hold for longer.

Budget takes the biggest hit

The most damaging impact, however, will likely be on the government budget. Recall, a critical element of the government’s efforts to stave a ratings downgrade and to restore investor confidence was a sharp fiscal tightening. The FY13 budget (year ending March 2013) envisaged a deficit of 5.1% of GDP. But soon it was clear that the slowdown in growth and the currency depreciation would push the fiscal outturn closer to 6% of GDP.

The new economic management team that took over in September made fiscal consolidation a key part of its strategy to stabilize the economy. The tightening perhaps was more than intended as the final fiscal outturn was deficit of 4.9% of GDP, even lower than the budgeted target, which is a rare occurrence in India. Among the many measures that the government adopted central was liberalizing retail petrol and raising administered diesel and cooking gas prices.

The FY14 budget targets a deficit of 4.8% of GDP. To achieve this the government will need to keep overall subsidies close to the budgeted level of 2% of GDP. Of this 1.3% of GDP (spilt equally) is on account of fuel and fertilizer subsidies. Both depend on what happens to the price of imported petroleum. While the government has not made its oil price and exchange rate assumptions explicit, based on past patterns it would appear that reaching this target hinges on global oil price (India basket) averaging around $95/bbl and the USD/INR around 53-54.

And this is where trouble is already brewing. Since the start of the fiscal year, the price of India’s crude oil basket in dollar terms has fallen about 5%. But the INR depreciation has more than wiped out all the gain. In fact, in INR terms crude price is just 1% shy of its high in July 2008 when the equivalent dollar price was $143/bbl compared to $104/bbl at present! So if crude oil averages $105/bbl for FY14 (as projected by J.P. Morgan) and USD/INR around 57-58, it would imply an import price about 15-20% higher than what appears to have been used in the budget projection.

Assuming that the extant policy of raising retail diesel prices by Rs 0.5/month continues for the whole year, there is no material price increases in other subsidized petroleum products given that this is pre-election year, and the government as before covers 50% of the losses made by the distribution companies, our calculations suggest that the subsidy bill for oil and fertilizer would need to go up by 0.3-0.4% of GDP. And this would imply a deficit of 5.1-5.2% of GDP against the budgeted target of 4.8% of GDP.

Add to that the distinct possibility of revenues falling short of budget targets because of lower growth and weak capital markets and the likelihood of additional spending on account of the Food Security Bill that could get passed in parliament in the upcoming monsoon session. Keeping to the budgeted deficit target would then call for another round of very sharp reduction in expenditures as in 2H12. However, this time with elections round the corner the space for another round of spending cuts appears limited. A higher deficit than budgeted is unlikely to go down well either with investors or rating agencies. Thus, damage from the rupee depreciation could be telling on the budget this year

Pressure on corporate balance sheet rise

Since 2007, Indian corporates have increased their foreign borrowing significantly as domestic interest rates has outstripped global rates. In particular, external commercial borrowings surged been 2010 and 2012 – when India embarked on a tightening cycle in response to double-digit inflation even as the world was easing monetary policy. Consequently, the current stock of ECB’s estimated at $115 billion constitutes a 60% increase over the $70 bn in 2010 – just three years ago. What this has meant is that annual refinancing needs have increased very sharply in recent years. For example, total amortization and interest repayments on ECBs rose to a hefty $26 bn in FY13 and the RBI estimates that principal and interest payments in FY14 will still amount to slightly over $20 billion – and further creep up over the next few years.

It’s one thing if this growing stock of ECBs was largely hedged but, in fact, estimates indicate that anywhere between 60-65 % of ECBs remain unhedged and therefore very vulnerable to INR movements. And this is why INR/USD settling at 57/58 versus 53/54 can increase corporate balance sheet stress for companies that are not naturally hedged.

The aggregate numbers may not pose a systemic risk: a 10% depreciation of the Rupee will increase ECB repayment costs in FY 14 by between $1-1.5 billion. The balance sheet impact is expectedly larger – with a 10% depreciation expected to stress corporate balance sheets by $6-7 billion – assuming 60-65% of the stock is unhedged.

Yet the aggregate impact masks the more worrying distributional implications. A number of companies in the infrastructure and capital goods sector – that have no natural hedge to Rupee movements – are vulnerable to Rupee depreciation. A 10% depreciation has the potential to cause significant stress to the P&L and balance sheets of these corporates. Recall, the investment cycle is current languishing under the weight of implementation and execution bottlenecks. Adding financial stress to corporates in the infrastructure and capital goods sector is likely to exacerbate matters and further push-out any hopes of an investment pick-up.

In addition to the infrastructure sector, a number of mid-caps companies across the board also appear to be very externally-leveraged, and if the Rupee remains at current levels, it could cause significant stress to their individual balance sheets. So even though the aggregate impact of sharp Rupee depreciation on the corporate sector may not be alarming prima-facie, it can have very adverse sectoral implications.

All told, the latest ratcheting-down of the Rupee is unlikely to fully-reverse and the resulting depreciation is likely to impart a stagflationary shock to the economy – re-fuelling inflationary pressures and dampening growth prospects. And this is a pity. Six weeks ago, a semblance of macroeconomic stability had finally returned to India. Inflation was moderating, the fiscal consolidation was even more impressive than had been expected, and the only debate was how much space the RBI would have to ease monetary policy. How quickly things can change. The INR shock over the last six weeks has dramatically changed the nature of the conversation.

 

Projected Debt Service Payments (US$ million)

Year	Principal	Interest	Total
2012-13	21,440	4,655	26,095
2013-14	16,135	3,985	20,120
2014-15	18,677	3,624	22,301
2015-16	21,176	3,101	24,277
2016-17	21,750	2,399	24,149

Source: Ministry of Finance, RBI

Note: Projections include external assistance, ECB and FCCB