India: prepared, not immune
DBS Group Research
16 December 2015
Markets put the odds of US rate lift-off this week at over 70%. A 25bp hike is thus largely priced in but guidance on the pace of normalization next year will dictate market reaction. The US dollar has gained on these expectations and Indian markets are unlikely to be immune to volatility. In the run-up, the Indian rupee has fallen to a two-year low against the US dollar and equity markets remain under pressure (Chart 1).
Indian markets were volatile back in 2013 when the US Fed signaled tapering of QE purchases. This time around, the Fed is at the cusp of tightening policy, though at a slower pace than in the 1993/94 and 2004/06 hiking cycles. Risks of a stronger dollar accompanied by a rise in US real rates are under watch. If this materializes, India will face pressure on a) current account funding needs • Ahead of the impending US rate hike, foreign sentiment is under
• Improvement in India’s current account balance has lowered reliance on hot-money flows
• Foreign reserves have risen, but are low compared to regional peers, especially compared to external debt
• Rising non-government external debt remains a point of concern • Any stress on external debt obligations could aggravate domestic
le-verage ratios 58 60 62 64 66 68 20 22 24 26 28 30
Jan-14 Jul-14 Jan-15 Jul-15 SENSEX - rhs USDINR (rev) - rhs Chart 1: Equity price action vs USDINR
000s, Index USDINR (reverse)
0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.6 1.8 2 2.2 2.4 2.6
Jan-15 Apr-15 Jul-15 Oct-15 10Y UST yields - lhs 2Y UST yields - rhs Chart 2: Short-term US rates inch up on hike expns
and b) weakened external debt profile. India’s current account balance has im-proved significantly but reserves remain low and debt high.
Rising FDI flows provide stable source of financing
Low commodity prices have improved India’s terms of trade, which should help keep the current account deficit below 2.0% of GDP for a third consecutive year. A past IMF study pegged India’s sustainable current account deficit at a range of 1.5-2.5% of GDP, based on assumptions .
In nominal terms, the deficit has shrunk from USD 88bn in FY12/13 to USD 28bn in FY14/15. Funding needs have accordingly moderated, with net FDI at USD 33bn in FY14/15 sufficient to fund the current account gap on its own. In other words, the basic balance of payments (current account deficit plus net FDI) con-tinues to improve. The basic balance recovered to 1.2% of GDP in 1H15 from -0.2% in 2014 (Chart 3).
Given the recent relaxation in FDI ceilings in insurance, banking, construction, defence and civil aviation etc., inflows are expected to strengthen. The empha-sis on ease of doing business coupled with the government’s efforts to forge deeper international ties will also be a shot in the arm for investment flows. Moreover, foreign holdings of government bonds is capped at 5% of the out-standing issuance (INR terms), limiting exposure to hot-money flows. With higher FDI providing a more stable source of financing the current account gap, reliance on short-term flows has eased. This has provided a cushion against ex-ternal volatility.
Higher FX reserves act as a buffer ...
The Reserve Bank of India remains concerned about US interest rate normaliza-tion and this has prompted the bank to focus on building a stronger foreign reserves buffer and maintain macro-stability.
Capitalizing on the favorable market environment, the RBI has absorbed capi-tal inflows and rebuild its foreign reserves. Reserves bottomed at USD 275bn in Aug13 at the worst point of the US taper tantrum and were up to a record high of USD 355bn by Jun15. Since then, effort to contain rupee depreciation has trimmed the reserves stock by USD 3-4bn. This is a modest fall compared to the nearly USD 80bn increase over the past two years.
India’s import cover (reserves vs months of imports) at 8-9 months is higher than the global norm of 3x and consistent with the 3-7x seen across most de-veloping countries.
FY15/16 current account deficit will stay below 2% of GDP for the third consec-tive year -8 -6 -5 -3 -2 0 2 3 -40 -30 -20 -10 0 10
Jun-09 Jun-11 Jun-13 Jun-15
Basic BOP (CAD+FDI) % of GDP (RHS)
USD bn % of GDP
However, despite the sharp rise, the reserves stock is low compared to the Asian counterparts (Chart 4). At 16% of GDP, India leads only Indonesia at 11%. Most other countries’ holdings hover at 30%-50% of GDP. Quality of the reserves build-up is also debatable as we discuss below.
Higher reserves but higher liabilities too
Although foreign exchange reserves have risen, India’s foreign debt (and other liabilities) has also risen. Liabilities have primarily taken the form of higher for-eign portfolio investments (up USD 50bn in Sep13-Jun15) alongside increase in short-term credits and offshore borrowings. Non-resident deposits are also up another USD 16bn, receiving a hand from the RBI’s concessional swap arrange-ment in late-2013.
This has left India’s net international investment position (NIIP) in the red (Chart 5). The NIIP widened from USD 63bn in Mar07 to USD 366bn in Mar15.
On the assets side, reserves amounted to USD 343bn by Mar15. But this is coun-terbalanced by a sharp rise in liabilities in the form of portfolio inflows at USD 228bn and short-term credits worth USD 83bn.
Additionally offshore loans also climbed to USD 177bn by Mar15, which cumu-latively surpass the foreign reserves stock. In sum, even though authorities have focused on building buffers against external headwinds, its composition could be at risk if the global environment worsens.
High non-government external debt is a cause for concern
A stronger dollar and / or rise in real rates will hurt economies where reserves are low or debt is high. While India’s foreign reserves are rising, they remain low relative to external debt. Back in 2010, external debt  was fully covered by reserves. But by Mar15, external debt had risen to 1.42 times reserves. As a share of GDP, debt rose from 18% to 23% over the same period.
Encouragingly, short-term external debt is manageable. At 25% of foreign re-serves, short-term debt is consistent with ratios seen in other Asian countries. However, based on residual maturity (the part of total debt that matures with-in one year), it accounts for more than half of the reserves.
In addition, the rising share of non-government external debt is a concern. While government external debt has been stable at 4-5% of GDP since FY08/09, the share of non-government obligations is up from 13% of GDP to 19% in FY14/15. This rise is also responsible for the overall increase in external debt. Reserves are higher but so
are liabilities 0 10 20 30 40 50 1 2 Reserves
Others (incl s-t trade credits/ loans) Portfolio Inv
Chart 5: India's international Investment position % of GDP Assets Liabilities 0 20 40 60 80 100 120 ID IN SK MY CN TW SG 2013 2014*
*effective reserves (incl forwards) % of GDP
Chart 4: India's reserves are small vs Asian peers
Persistent rise in total exter-nal debt is led by rising non-government debt
Digger deeper, the biggest and fastest rising component of the non-govern-ment/ private sector debt is external commercial borrowings (include bank loans, notes and bonds raised overseas etc.). These have grown by two and half times since 2008 in dollar terms and now amount to 8% of GDP.
Currency swings and higher US rates could see unhedged foreign obligations emerge as a pressure point for the economy. Thankfully, moral suasion and regulatory tweaks have led to an increase in the hedging ratio to 39% of the total foreign currency exposure by Mar15 from 15% year before, according to the RBI.
Rising external debt could aggravate domestic leverage ratios
This increase in offshore borrowings is set against a backdrop of rising private sector domestic debt and a stressed banking sector.
Private sector debt ticked above 52% of GDP last year from 35% in FY04/05 (Chart 6). Higher corporate leverage and tough economic conditions, in turn hurt the banking sector, pushing up NPLs and restructured loans to 10-11% of total advances this year. Any signs of additional stress in external debt exposure could aggravate domestic leverage ratios.
A recent IMF study also echoed these concerns . The Fund cautioned that economies like India, along with other select EM peers face high FX leverage. Debt-servicing capability was also assessed, under which any shocks to borrow-ing costs and earnborrow-ings could see India’s median ICR (interest coverage ratio) weaken further from already low levels. The Fund estimated that around 60% of total corporate debt would be at risk if FX, interest and earnings shocks were dealt simultaneously (unhedged exposure).
Rupee to remain under pressure
Like most emerging market currencies, the rupee is vulnerable to higher US interest rates. We believe the INR will follow a managed depreciation path into 2016, driven by a stronger dollar bias and domestic developments (see “Economics-Markets-Strategy 1Q16”, 10Dec15).
This case is also strengthened by our long-held view that sharp INR apprecia-tion on real basis will see the authorities tolerate bouts of rupee weakness against the dollar (Chart 7, next page). The need to preserve competitiveness and support the “Make in India” manufacturing push will be a priority, whilst ensuring that the inflationary impact is contained.
10 20 30 40 50 60 70 80 90 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Private sector - domestic credit Government debt
Chart 6: Domestic leverage ratios - government and private sector % of GDP
Source: World Bank, IMF, RBI, DBS Group Research
The INR has appreciated 13% on the real effective exchange rate basis since 2014
The Indian markets are at a better starting point ahead of US rates lift-off than they were back in 2013. However, if the normalization cycle is accompanied by a stronger dollar, higher real rates and / or a bout of weak foreign senti-ment, India’s unfavourable external debt profile would emerge as a source of concern.
 IMF working paper, “Assessing External Sustainability in India”; 1999  RBI: US dollar-denominated debt is the largest component of India’s exter-nal debt at two-thirds of total debt, followed by the INR, SDR, JPY and EUR  IMF, “Spillovers from dollar appreciation”, 2015
All data are sourced from CEIC Data, Bloomberg, government, RBI and interna-tional agencies. Transformations and forecasts are DBS Group Research.
50 53 56 59 62 65 68 95 97 99 101 103 105 107 109 111 113 12 13 14 15
Chart 7: USDINR vs Real effective exchange rate movements
Index=100, 2013/14 USDINR (rev), mthly avg
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