India Economic Watch Message from Friday’s sell off: FX, FX... FX :: BofA Merrill Lynch

India Economic Watch
Message from Friday’s sell off:
FX, FX... FX
Bottom line: Recouping FX reserves key to INR stability
Friday's market sell off supports our standing call that the INR will not stabilize
until the RBI recoups FX. We fully sympathize with Delhi that it did not intend to
"capital control" with its FX measures. Yet, the harsh reality is that markets will
only get more nervous till import cover reverts to the 8-10 months critical for
stability. We publish our replies to recent client queries. How much more can the
RBI sell? US$25bn, but every US Dollar sold will only breed further questions
about the adequacy of FX reserves. Second, what more can the RBI do? Issue
NRI bonds (US$20bn) or sovereign bonds (US$5bn a year) to hold Rs58-62/USD;
expectations are otherwise climbing to Rs65/USD. The present FX measures will
likely add US$5bn to FX reserves. Finally, how long can the July tightening last?
We see FY14 growth plummeting to 4.8% if the RBI persists with them into the
busy October-March industrial season. Do read our Rupee Dilemma report here.
8-10 months' import cover critical for investor confidence
Friday's market sell off supports our standing call that the INR will not stabilize
until the RBI recoups FX. We fully sympathize with Delhi that it did not intend
"capital control" with last week’s FX measures. Yet, the harsh reality is that
markets will only get more and more nervous till import cover reverts to the 8-10
months critical for stability (Chart 1), in our view. In the past 5 years, it has halved
to 7 months, trailing BRIC levels (Table 1). Chart 2 shows how much this has hurt
the INR. For the same US Dollar of 1.32/€, the INR has depreciated as the import
cover has come off. Do read our last Battle for Rs60 report here.
It is quite usual to vary FX limits up or down depending on capital flows. We thus
do not see reducing overseas direct investment under automatic route to 100% of
net worth from 400% (impact US$2bn BAMLe) or restricting the funds residents
can send abroad to US$75,000 from US$200,000 (impact: US$0.5bn BAML) as
capital controls. Banning residents from buying property abroad under the LRS
probably qualifies, but barely US$77mn has left on this head in FY13. That said,
investor confidence will likely not stabilize till the RBI rebuilds FX.
1. RBI can sell US$25bn; barely enough for 1 more FX crisis
How much more can the RBI sell to calm the market? US$25bn, but every US
Dollar will only breed further questions about the adequacy of FX reserves. Each
FX crisis costs US$15-20bn. There, thus, is just about enough to last one more
bout of FX volatility. It will be recalled that we had estimated that the RBI can sell
US$30bn at the beginning of the present round; since then, the RBI has sold
about US$5bn. And why US$25bn? Because the import cover will dip then to 6
months, last seen in 1993!. FX reserves will also come off to just 1.5x of 1-year's
short-term external debt, only barely higher than the Greenspan-Guidotti rule of
1x

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2. NRI/sovereign bonds to arrest falling import cover
What else can the RBI do? Issue NRI bonds (US$20bn) or sovereign bonds
(US$5bn a year) to hold Rs58-62/USD; expectations will otherwise climb to
Rs65/USD. We have welcomed last week's measures to compress the current
account deficit or expand capital inflows as steps in the right direction. At the
same time, we estimate that they will add only US$5bn to FX reserves (Tables 2-
3). While the ongoing hikes in FDI limits or proposed FII equity limits for PSU
banks will help medium term, immediate shock-and-awe options to raise FX
include:
NRI bonds (US$15-20bn BAMLe): Re-issuing 7-9% 5-year FX-denominated NRI
deposits, with INR risk borne by the RBI or the government, a la 1998 Resurgent
India Bonds or 2001 India Millennium Deposits that raised about US$5bn each.
Sovereign USD debt (US$5bn a year BAMLe): This could also mobilize US$5bn
a year if listed on the JP Morgan EMBI Global Diversified Index (Table 4).
3. 4.8% growth if July tightening persists after October
How long can the July 15/23 tightening measures last? Growth will likely plummet
to 4.8% if the RBI persists with them into the busy October-March industrial
season. Do read our collateral damage report here.
Call at 10.25% for now. The RBI has again announced another 27-28 day
Rs220bn Cash Management Bill auction over Monday and Tuesday. Our liquidity
estimates show that this will further push banks up to the MSF and stick call at
10.25% for now (Table 5). At the same time, we are relieved that it has been
careful to ensure that CMBs cover the Rs620bn of redemptions in the next one
month but mature just before the advance tax outflows in mid-September.
Key watch this week: ECBs, FII debt flows, Parliament
We advise investors to monitor three key developments this week:
ECB liberalization: We await guidelines on liberalization of external commercial
borrowings announced by the Finance Minister last week. This may fetch US$3-
5bn. Media reports suggest that the government may allow ECBs for: (1)
corporates repaying INR debt; and (2) PSU banks for capital raising. Third, it
could hike the caps of the less-than-3 year tenor to US$300mn from US$20mn
and the automatic route (of up to 5 years) to US$1.5bn from US$750mn. Finally,
Indian arms of MNCs could be allowed to raise working capital from their parents.
Are FII debt inflows returning? Only a trickle so far, although a major argument
in favor of tightening is to arrest the falling rate differential to bring back FII debt
inflows (Chart 3). On our part, we see FII debt outflows as part of the EM debt sell
off rather than due to narrowing differentials, which at 500bp, were quite high
even before July 15.
Will Parliament pass reforms? There are media reports that the Parliament may
pass some 'reforms' bills - the Land Acquisition Bill and/or well as the Pension Bill
- in the monsoon session ending this week.

Appendix: Recent measures to
support INR
June 4: Import of gold on consignment basis restricted.
June 5: Import duty on gold hiked to 8%.
July 8: SEBI tightens rules on FX derivatives trading, doubling loss margins for
USD/INR contracts; RBI bars banks from proprietary trading in FX futures,
exchange-traded FX options.
July 15: RBI raises both marginal standing facility and bank rate to 10.25% from
8.25%; caps daily lending under liquidity adjustment facility (LAF) to 1% of bank
book and announces bond sale through open-market operations.
July 22: RBI rationalised import of gold by making it incumbent on all nominated
banks/entities to ensure that at least one fifth of imported gold is exclusively made
available for the purpose of exports. Any import of gold under any type of scheme
will have to follow this 20/80 formula.
July 23: RBI further limits banks’ access to cash under LAF to 0.5% of net
demand and time liabilities; raises daily balance requirement under cash reserve
ratio to 99% vs 70% effective July 27; announces Rs60bn auction of cashmanagement bills.
Aug 08: RBI announces plan to sell Rs220b rupees of cash-management bills
each week.
Aug 13: Government raises import duties on gold and platinum to 10% from 8%,
silver to 10% from 6%.
Aug 14: RBI cuts the amount local companies can invest overseas without
needing approval to 100% of their net worth from 400%; residents can remit
$75,000/yr abroad vs $200,000 earlier. It exempts additional foreign-currency
deposits held locally by Indians living abroad from banks’ cash reserve ratio and
statutory liquidity ratio requirements. RBI also further tightens gold-import rules,
saying imported bullion to be supplied to domestic users against full upfront
payment.
Source: Bloomberg, RBI.