BofAML: India Economic Watch: 3 reasons why yields are peaking

Bottom line: RBI OMO, eventual July roll back triggers
Are gilt yields really peaking? clients ask. Yes, in our view, panic sell offs apart.
We think the 10y should come off to about 8% by March 2014. The RBI will likely
OMO about Rs1600bn by March 2014 to support 15% loan demand. RBI OMO,
since April, has been almost entirely neutralized by FX intervention. Second, we
expect Governor designate Raghuram Rajan – and we wish him all the very best -
to eventually roll back the July 15 tightening measures if the INR settles down
about Rs65/USD. As it is, we have cut FY14 growth down 120bp to 4.6% since
July 15. Finally, FX intervention to support the INR should create greater scope
for OMO to offset fiscal slippage (of Rs200bn BAMLe) due to depreciation. And
what about INR impact on inflation? Depreciation poses 50-75bp risk to our 6%
March inflation forecast. This is why we do not expect the 10y to back rally to preJuly 15 sub-7.5% levels. Do read our Rupee Dilemma report here.
#1. Rs1600bn RBI OMO to support gilts; 10y ~8% by March
We expect RBI OMO to support gilts in 2HFY14. Our liquidity model estimates
that the RBI will need to buy about Rs1600bn of gilts to fund 15% loan demand
(Table 1). The RBI's OMO (and auction cancellations) of around Rs320bn, since
April, have been almost entirely neutralized by FX intervention. Against this
backdrop, we are relieved that the RBI has resumed OMO purchases reversing
the July 15 announcement of OMO sales. Its initiative to soften the impact on
bank balance sheets is doubly welcome. Do read our RBI OMO report here.
We do not think that the RBI has a lot of time. After all, a Re1 of OMO injected
today will take about 6 months to generate about Rs5 of deposits. This will take
us almost to the end of the busy season of October-March. As it is, M3 growth, at
12.2%, is running way below optimal 15-16% levels. Not surprisingly, India is that
rare economy in which lending rates are still close to their 2008 peak. It is for this
reason we have cut FY14 growth down by 120bp after the July 15 measures were
announced.
#2. July tightening roll back if INR stabilizes ~Rs65/USD
Will the RBI roll back the July 15 measures? clients ask. Yes, if the INR stabilizes
about Rs65/USD for now, in our view. After all, they have pushed back lending
rate cuts and led us to slash FY14 growth to 4.6% from 5.8% before July 15 (and
FY15 to 5.5%). Do lead our last growth report here.
In any case, we have always argued that the INR will stabilize only when the RBI
begins rebuilding FX reserves - rather than hiking rates. In fact, Chart 1 shows
that the INR has typically appreciated when the RBI has cut rates to support
growth. This is because FII equity inflows, that respond to growth, are, at about
US$220bn, far larger than FII debt inflows, at about US$30bn, that may respond
to higher rates. Higher rates actually have - expectedly - not been able to attract
back FII debt flows as the outflows were driven by the on-going EM debt sell off

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We have revised the money market deficit for September to Rs1731bn from
Rs1475bn (Table 2). In reality, this simply reflects the arbitrage of borrowing funds
at the 10.25% MSF rate to invest at higher yield Cash Management Bills.
Key watch: BRICs fund, NRI/sovereign bond/FCNRA, Fed
Can the RBI really roll back July 15 measures? We think that this will be possible
only if policy measures calm FX markets. Event risks include:
1. BRICS fund. There is some expectation that the G-20 will announce a BRICS
FX fund to intervene in offshore markets on Thursday or Friday.
2. NRI/sovereign bond/FCNRA deposits: The RBI may issue NRI or sovereign
bonds or FCNRA-type deposits to arrest recoup FX reserves. After all, import
cover has halved to 7 months - last seen in 1998 - below the 8-10 months needed
to stabilize the INR. We estimate that the RBI's/government's recent FX initiatives
will add about US$5bn to FX reserves (Table 5). Note under the old FCNRA
deposit scheme, banks offered NRIs FX denominated deposits in which the INR
risk was borne by the RBI or the fisc,
3. Fed: The INR will see a relief rally if the Fed does not taper on September 17-
18 or the market decides that tapering is priced in. Our US economist, Ethan
Harris, still expects the Fed to begin tapering only in December although he
acknowledges September will be a close call. He sees non-farm payrolls
expanding by below consensus 165k (175k consensus) on Friday. Do read Ethan
here.
#3. FX intervention to trigger OMO to fund fiscal slippage
We expect FX intervention to support the INR to create greater space for OMO to
offset incremental fiscal slippage (of about Rs200bn) due to depreciation. This
assumes that the INR averages Rs60/USD for FY14. Tables 3-4 calculate that the
gilt market will clear if the RBI OMOs Rs1600bn – already needed to fund 15%
loan demand. It will be recalled we had similarly argued - and correctly - that the
10y spike beyond 9% was overdone in 2008.
How does this work? The RBI needs to put in a certain amount of reserve money
by way of CRR cuts, OMO and FX operations to fund growth. The very INR
depreciation that adds to the oil subsidy will, in turn, also result in FX intervention
sales. To inject the same amount of liquidity, the RBI can then to conduct larger
OMO.
Inflation to prevent large-scale gilt rally
We expect rising inflation, induced by INR depreciation, to prevent a large scale
gilt rally to pre-July sub-7.5% levels. 10% depreciation typically leads to 1%
inflation. This poses a 50bp upside risk to our 6% March 2014 inflation forecast. In
any case, we had always expected inflation to go up in 2HFY14 on hikes in prices
of coal, electricity and diesel. It is for this reason we never shared the pre-July 15
bullishness in the gilt market