India – RBI focuses on INR stability with a hope of easing ahead  Standard Chartered Research

India – RBI focuses on INR stability with a hope of
easing ahead
 RBI leaves policy rates unchanged; a dovish policy statement focuses on currency stability
 Reversal of liquidity-tightening measures and a return to monetary policy easing depends on INR stability
 Presses for urgent action to reduce C/A deficit as RBI’s measures cannot help INR on a sustained basis
 We shift to a Neutral duration stance on GoISecs, from Underweight, and adjust our rates forecasts

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The Reserve Bank of India (RBI) left all policy rates – the repo rate, reverse repo
rate, marginal standing facility and cash reserve ratio (CRR) – unchanged at its policy
meeting, much in line with expectations. However, its dovish statement was
surprising, especially after recent measures to tighten Indian rupee (INR) liquidity and
its strong focus on stabilising the INR. Below we highlight three important takeaways
from this statement. We also shift our duration stance on GoISecs to Neutral from
Underweight and adjust our rates forecasts as outlined in Figure 1.
First, macro stability is the primary concern in today‟s RBI policy statement and
currency stability is a pre-requisite to achieve this. Any roll-back of the recent
liquidity-tightening measures and a return to an accommodative monetary policy
stance to support growth have been made conditional on stability in the FX market.
Second, the RBI acknowledges that its recent measures to support the INR will, at
best, provide breathing space for the government to take steps to reduce the current
account (C/A) deficit. This is similar to the views expressed in its macroeconomic
review released yesterday evening, where it stated that these measures alone cannot
reduce external sector vulnerability in the face of a still wide C/A deficit and fickle
capital flows. Hence its emphasis on the need to act urgently to reduce the
C/A deficit.

In our view the government could increase import duty on select commodities, such
as electronic goods, to reduce the import bill. The electronic goods import bill was
USD 31.5bn in FY13 (ended March 2013). A sharper hike in diesel prices, though
politically difficult, would also curb the oil import bill, which stood at USD 169bn in
FY13. In addition to measures to reduce the C/A deficit, we believe more measures
to attract stable capital flows will be important to check external sector imbalances.
Debt inflows encouraged by the higher interest-rate differential are likely to be volatile
and equity inflows are likely to be muted given the backdrop of Fed tapering fears
and a domestic growth slowdown. Policy makers will have to speed up their decision
to issue a sovereign/quasi-sovereign bond to convince the markets that the C/A
deficit can be funded comfortably. The timing and the actual type of instrument are
still undecided as the RBI governor does not favour a sovereign bond.
Third, the market was surprised that the RBI acknowledged explicitly that there is
room for monetary policy easing once stability returns to the FX market. Unlike its
previous monetary policy statement, today it stated that current growth-inflation
dynamics would have supported the case for continued monetary policy easing had
the INR not depreciated at such a rapid pace recently. This encourages us to
maintain our view of a 25bps repo rate cut in H2-FY14; we will revisit it once we have
more clarity on these factors.
It looks likely that the current stance will be maintained at least until the end of
September. The RBI will want to assess the market impact of any potential QE
tapering announcement that may come in mid-September. This could cushion the
impact of any disorderly flight of capital. Also, this would give policy makers enough
time to consider further structural measures to address the C/A deficit and its
funding. The likely change in the RBI governor in September could be another factor
influencing the duration of these measures. In any event, a reversal of the RBI‟s
monetary tightening measures will be difficult because of the risk of sudden debt
outflows following such a move. A calibrated exit strategy starting in October would
mean that there are downside risks to growth from a lengthy period of
monetary tightening.
Market impact
FX outlook
The shift in the RBI‟s tone has hurt the INR, with USD-INR swiftly trading back above
60 after the monetary policy statement. We maintain our view that unless policy
makers quickly implement follow-up measures to fund or curb the C/A deficit, INR
weakness will resume. USD-INR technicals indicate that the pair is basing ahead of
another leg higher. We maintain a short-term Neutral FX rating on the INR.
Rates outlook
We shift our duration stance on GoISecs to Neutral from Underweight. We adjust our
rates forecasts as outlined in Figure 1. In its monetary policy announcement the RBI
highlighted that the recent liquidity tightening measures will be rolled back in a
calibrated manner. Subsequently, the RBI expects monetary policy to revert to
supporting growth. Other key factors prompting our shift in stance are a slowdown in
outflows from debt markets and attractive GoISec valuations. However, heavy supply
in August remains a key concern.

Although the RBI‟s decision to keep the policy rates and CRR unchanged was in line
with rates market expectations, the market interpreted the RBI‟s guidance as dovish.
In response to the announcement, both OIS and GoISec yield curves drifted lower by
c.10-15bps and bullish steepened. Near-term, we expect both these curves to be
sensitive to movements in USD-INR, as rolling back of liquidity measures critically
depends on stabilisation in FX markets. We believe the recent liquidity-tightening
measures are likely to remain in place for another two months at least. During this
tight liquidity regime, we expect the long end of the rates curves to be range-bound
and the curves to trade with a bullish steepening bias. Specifically, we expect the
benchmark 10Y GoISec yield to trade between 7.90% and 8.20% as demand from
attractive valuations offsets concerns about heavy supply. Currently the benchmark
10Y GoISec yield is trading c.85bps higher than the repo rate. During the current
policy rate easing cycle (assuming it began on 1 January 2012), this spread has
averaged only c.15bps. Given that monetary policy will revert to supporting growth in
the medium term, long-end GoISecs currently appear cheap. This may also have
slowed foreign institutional investor (FII) outflows from Indian debt.
In the medium term, once the RBI rolls back its liquidity-tightening measures, we
expect the rates curves to drift lower, led by the short end. This should mean that
rates curves bullish steepen. We believe that once FX markets stabilise, domestic
growth-inflation dynamics and the monetary policy environment will remain
supportive of GoISecs. In such a scenario, we expect the benchmark 10Y GoISec
yield to stabilise at c.7.50%.
Rates strategy
Real-money investors
We recommend that real-money investors shift their GoISec duration stance to
Neutral from Underweight. In today‟s monetary policy announcement, the RBI
highlighted that recent liquidity measures are temporary, and in the medium term
monetary policy should revert to supporting growth. Current GoISec valuations are
attractive, but August is a month of heavy supply. We wait for FX markets to stabilise
and supply concerns to recede before shifting to Overweight GoISec duration.
Leveraged investors
We expect the OIS curve to bullish steepen once the RBI rolls back its recent
liquidity-tightening measures. However, we expect these measures to remain in
place for another two months at least. Given the RBI‟s relatively dovish policy tone,
we see limited scope for OIS to move higher. We look for early signs of stabilisation
in FX markets and liquidity easing in order to recommend OIS steepeners.