The Indian Rupee has depreciated sharply in recent days which has fuelled fears of a sell-off in bond markets. Indeed bond yields have risen by 20-30 bps from the lowest levels seen in May. Let us take a look at the factors driving the currency depreciation and the implications for monetary policy and bond markets.
An emerging markets phenomenon
The Rupee’s fall has not been in isolation. A glance at other major emerging economies shows that there has been an across the board fall in emerging currencies since early May (see chart). As may be seen, countries having current account deficits have seen relatively larger depreciation than countries having current account surpluses. Having said that even countries with strong external accounts have seen their currencies depreciate. We must look elsewhere for the real reason for the depreciation.
Chart source: JP Morgan, The Financial Express
In fact the fall in emerging currencies has been driven by general US Dollar strength. The Dollar index has risen throughout May while giving up some gains recently (on the back of Yen strength). This rise in the Dollar has coincided with statements by officials of the US Federal Reserve that they may begin to reduce the pace of quantitative easing currently under implementation (tapering). Recall that the Fed is adding $85 billion per month through the QE program. Tapering of QE will reduce the amount of cash available that is currently flowing into emerging economies.
Since the talk of tapering started, US bond yields have begun to rise. At the same time, inflation expectations in the US have dropped. Note that normally lower inflation expectations should lead to bond yields falling. Here because the Fed has been buying bonds to create inflation, there has been a unique situation where bond yields were below inflation expectations. Therefore as there are expectations of lower QE, there is a simultaneous expression of lower inflation and higher bond yield. As the chart shows, for the first time in over a year, bond yields in the US are above expected inflation (i.e. providing positive real yields).
Negative real yields had made the US Dollar a favourite funding currency for cross-currency trades (carry trades). As US bonds moved back into positive real yields, carry trades began to reverse and money flowed out of higher yielding markets (emerging markets) to safe havens.
Source: Bloomberg. Inflation expectation is the break-even between nominal and inflation protected bond yield.
Emerging market bonds have consequently underperformed
As a consequence of carry trade unwinding, we have seen selling by foreign investors in emerging market bonds. For example emerging market bond funds saw an outflow of about US$1.5bn in the first week of June alone, the highest weekly outflow since October 2011 (source: EPFR, FT). Net redemptions in May are also estimated to have been around US$3 bn (source: EPFR, Forbes).
The selling by foreign funds has had the largest impact on countries where foreign investors have a large share of the bond market. As FIIs have a relatively small share of Indian bond markets, we have had a limited impact of foreign selling on our markets. Indian benchmark 10-year yield remains lower than from the beginning of May when the currency sell-off began. This is not to say that there is no impact on us, rather that our bond markets being more locally dominated have had a smaller impact on account of the carry trade unwinding.
For instance during the past fourteen trading sessions, FIIs have sold $3.2 bn of Indian bonds compared to a net purchase of $2 bn in the previous fourteen. These sales have been well absorbed by domestic investors (such as Banks and Mutual Funds) with limited impact on yields.
Impact on monetary policy
The currency depreciation will have an impact on the RBI’s monetary policy decision in the coming week. Even developed market central banks do not like to cut rates during currency weakness (witness the Australian central bank which held rates in the last meeting amid a 10% currency fall even though they had cut rates in the previous meeting). The reason for this is that a lower interest rate further reduces the attractiveness of carry trades, which could lead to further currency weakness.
In addition, Rupee weakness increases the cost of imported commodities and could have an adverse impact on inflation in the coming months. As the below chart shows, the current fall in the Rupee has nullified the fall in global commodity prices that we have witnessed in recent months. The chart shows the CRB index of commodities in Dollar and Rupee terms indexed to 100 in Dec-2011. As may be seen while commodity prices in Dollars have declined, in Rupees they have been marginally higher (ending index values 102 in Rupees, 93 in Dollars).
Source of data: Bloomberg.
In conjunction with the previous policy stance that there may be little room to cut rates, there is the possibility that RBI may not cut rates on 17 June. In the medium term the RBI cannot ignore domestic factors. With the fall in inflation, a large gap has opened up between the inflation rate and the policy rate. The RBI’s stated objective is to maintain a small positive real rate at the short end (i.e. the policy rate should be slightly above the inflation rate). With that objective, given the RBI’s forecast for inflation to average 5.5% this year, we should see substantial rate reductions in the coming months.
The weakness in the Rupee may only delay the rate cuts. It is unlikely to have an impact on the total quantum of rate cuts which would have more to do with domestic growth and inflation fundamentals.
So what of growth and inflation and the way forward?
Data that have come in since the start of the new financial year continue to portray an economy where growth is anemic and inflation is declining. Industrial Production continues to be weak (+2.0% y/y). Within IIP, consumer durables decreased by 8.3% y/y. No wonder when Passenger Cars posted the seventh month of declining sales (-12% y/y in May). Forward looking indicators such as Purchasing Managers’ Index (PMI) too indicate growth rates that are substantially below long term trends. PIM-Manufacturing at 50.1 is barely above the expansion threshold and compares to long term average of 55. PMI-Services at 53.6 compares to the long term average of 56.
Data on Gross Domestic Product indicate that growth has fallen to a decade low of 5% in FY13. For the last quarter, GDP growth at factor cost was at 4.8% the second quarter below the 5% mark, while GDP at market prices (expenditure based GDP) grew at a scant 3.1% (3.4% full year growth). The RBI forecasts that GDP growth for FY14 may only be 5.7% – and this too with some pickup in investment activity. From all accounts investment demand in the economy remains subdued.
Inflation too seems to be under control. WPI inflation for April broke below the 5% mark for the first time since November 2009 when we were still emerging from the crisis of 2008-09. CPI inflation has been below the 10% mark for the past two months compared to double digit rates for much of the last year.
In terms of foreign investors, the current spate of selling is of the nature of portfolio balancing based on what is happening in US yields. Eventually many of these same investors would re-look at India as one of the few major economies that is offering high yields and where the central bank is cutting interest rates offering possibilities of gains (compared, for example, to Brazil where yields are higher but interest rates are going up).
Note: This is based on a note I prepared for my employer. That note is publicly available.