Domestic assets to remain under pressure in 2018

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1 Apr-18 May-18 Jun-18 Apr-18 May-18 Jun-18 Currency Outlook: INR Treasury Research Group For private circulation only Domestic assets to remain under pressure in 2018 June 25, 2018 Shivom Chakravarti Tel no: Even as pressures from global crude oil prices could subside, global risk aversion could mean that the depreciation pressures on the INR remains intact over the remainder of We see multiple factors that could result in capital outflows: (a) Global trade wars intensifying particularly in a run-up to the US mid-term elections in November-2018 (b) Concerns about China could intensify that could be accompanied by a move higher in the USD/CNY pair (c) Fed continuing to tighten policy We watch developments in the USD/CNY pair very carefully as it could emerge as an important guide for trading EM Asian currencies like the USD/INR. RBI is likely to continue to intervene to curb volatility but not reverse the trend. We subsequently raise our USD/INR range and do not rule out the pair breaching its previous record high in 2013 and move towards the 70 mark. However, we think the pressures on the INR could abate going into end-fiscal year and focus could shift back to the USD s twin-deficit problem. Domestic bond yields could move higher over 2018 responding to inflation concerns and currency depreciation but witness some respite in H2 as RBI steps up its OMO purchases. Pressures from crude oil prices could subside. Please see important disclaimer at the end of this report The initial bout of INR depreciation can be traced to the sharp rise in global crude oil prices that began around April Rising crude oil prices had a dual effect of resulting in a wider current account deficit and increasing investor apprehensions about the domestic macroeconomic landscape that resulted in FPI related outflows. The net result was unrestrained INR depreciation. However, we think that crude prices are unlikely to work as a substantial negative going forward. The possible increase in the supply of global crude post the recently concluded OPEC meeting coupled with bouts of global risk aversion could restrain the upside potential in prices resulting in range-bound trading. We expect Brent crude oil prices to average around USD bbl for Hence, the pressures at least from crude oil prices could subside. Chart 1: Outflows in EM markets have intensified (USD bn) Emerging markets Equity flows Debt flows Chart 2: FPI outflows from domestic markets have continued (USD bn) Domestic markets Debt flows Equity flows Source: IIF, Bloomberg & ICICI Bank Research. but the INR is expected to remain under pressure Even as the upside potential in crude prices is likely to remain capped, we are not revising our call for continued depreciation in the INR in the near-term. We see new sources of risks emerging that will keep up the pressures on the INR.

2 MYR CNY HKD THB TWD SGD MXN KRW INR PHP ZAR RUB BRL TRY BRL SGD MYR TWD CNY INR TRY PHP MXN RUB THB KRW ZAR (a) Global trade war fears have intensified: The initial response to tariff announcements in April-May had a limited response as investors assumed that there would be negotiations followed by a compromise deal. However, protectionism related risks have increased raising investor concerns in response to the US going ahead with its plans to impose tariffs and other nations announcing retaliation measures. The bottom line is that trade tensions have escalated faster and further than we previously anticipated with the main focus on the US-China battle. The US is planning another round of tariffs against China that is estimated at USD 200 billion with the list due to come out over the next couple of months. China for its part has announced that it could consider retaliating again. The US administration is also considering imposing tariffs on auto imports from Europe. In short, the trade battle is not showing any signs of abating. While our base-case is for a trade-related skirmish not a full-blown trade war, ongoing uncertainty and negotiations are likely to ensure that global risk sentiment remains weak. We suspect that the US President would want to continue this battle in a run-up to the US mid-term elections that are due in November-2018 to appease his base. Hence, prospects of sustained relief is likely to remain low implying that fund flows into EMs could remain weak in such a climate. Chart 3: The INR has emerged as one of the weaker EM currencies in 2018 but is not at the bottom of the pack (%) Performance against USD 2018 YTD Chart 4: INR s position in the EM basket has marginally improved over the last week (%) Performance against USD over the last week Note: The performance of all EM currencies is with reference to the USD Source: Bloomberg & ICICI Bank Research (b) The China factor: The by-product of the trade skirmish is that it introduces substantial downside risks to the growth outlook with China facing the brunt of the burden at least in the near-term. Growth related concerns have forced Chinese policymakers to allow the USD/CNY to move higher and ease monetary policy subtly through RRR cuts and liquidity injections undertaken over the last month. Right through 2017 and in March-2018 whenever the Fed hiked its policy rates, the Chinese central bank (PBOC) raised its reverse repo rate but refrained from doing so this time around in June Policymakers cannot be seen to be easing policy on an outright basis. However, we are in no way suggesting that China will undergo a hard-landing or slow down substantially. We expect Chinese policymakers to continue to engineer a modest slowing of growth with a shift in the composition from investments to consumption. However, we do acknowledge that the risks and concerns about Chinese growth prospects could in the process undermine EM assets and currencies, specifically in the Asian region. We attribute the sell-off in EM currencies over the last week to developments in the USD/CNY pair as Chinese policymakers eased policy to combat the downside risks from a possible full-blown trade war. A move higher in the USD/CNY pair represents an implicit terms of trade shock for most of EM Asia. This is the case because of strong trade links that China has with the region on aggregate and the fact that EM Asia is also a trade competitor subsequently implying that USD/CNY has the more pronounced effect of pulling USD/AXJ (AXJ= Asian excluding Japan) higher across the board. The upshot is that as long as the uncertainty about trade-wars persist, most AXJ (Asia excluding Japan) currencies are likely to remain under pressure. We implicitly build this into our forecasts for the INR. 2

3 =100 (Base Year) Feb 2011 Jun 2011 Oct 2011 Feb 2012 Jun 2012 Oct 2012 Feb 2013 Jun 2013 Oct 2013 Feb 2014 Jun 2014 Oct 2014 Feb 2015 Jun 2015 Oct 2015 Feb 2016 Jun 2016 Oct 2016 Feb 2017 Jun 2017 Oct 2017 Feb 2018 Jun =100 (base year) (c) US Growth and Monetary policy cycle: Even as trade related uncertainty has picked up, the underlying dynamics in the FX market of the Fed moving ahead with its plans to tighten policy in response to above trend level of growth is likely to remain in place for the time being. The new Fed Chair has through recent press conferences and speeches made it clear that the Fed will focus on its domestic mandate subsequently implying that further tightening policy with the combination of rate hikes and balance sheet contraction is on the cards. Concerns expressed by some EM central bankers about the Fed moving ahead with tightening policy posing downside risks to local growth prospects, presumably given the build-up of USD debt in EM balance sheets over the last decade, has had a limited effect in influencing decision making. In short, tighter US monetary policy and near-term outperformance of the US economy will likely ensure that the USD remains in demand. Although EM central banks have already and are likely to tighten policy further, it is likely to only act to limit depreciation not alter the trend. (d) INR s still an overvalued currency: The INR s fundamental vulnerability of overvaluation remains in place even as in nominal terms it has depreciated over The MSP hikes that are expected over the coming week could yet again reinforce these overvaluation concerns considering that the inflation trajectory is expected to move higher. Improving domestic growth prospects could also work to keep core inflation elevated. Chart 5: INR still remains in overvalued territory RBI REER 36 currency Fair value (Overvaluation) (Undervaluation) Source: RBI & ICICI Bank Research Chart 6: AXJ currencies have moved into overvalued territory given nominal appreciation witnessed over 2017 REER (60 currency index) AXJIC AXJI Fair-value (Overvaluation) (Undervaluation) Note: AXJIC = Asian currencies excluding India and China AXJI = Asian currencies excluding India Source: Bank for International Settlements & ICICI Bank Research 3

4 Jun-15 Aug-15 Oct-15 Dec-15 Feb-16 Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 Aug-17 Oct-17 Dec-17 Feb-18 Apr-18 Jun-18 To sum-up: The INR view While the INR felt a dual hit from both the current account and capital account over the April-June period, the main source of vulnerability is likely to come from the capital account on the back of global risk aversion going forward over the remainder of There is also likely to be more sensitivity to movements in the USD/CNY pair. While the USD/INR pair could move higher in line with the USD/AXJ (Asian excluding Japan) currency pack, it is unlikely to emerge as the outright underperformer within the group as long as sentiment is driven trade related fears. Most of the other Asian economies are more trade dependent and have strong links with China than the Indian economy that could start to get reflected in relative currency performance. We subsequently raise our USD/INR projection to an equilibrium range of over the remainder of We continue to believe that the main risk stems from global trade and protectionist related concerns. Although our basecase scenario is for a trade skirmish, the fear of a full-blown trade war could result in acute risk aversion weighing on all EM assets that could push the USD/INR pair towards a record high. We would not rule out an upside of 70 for the USD/INR pair if global risk aversion intensifies substantially. The RBI for its part could continue to intervene to limit volatility but not engineer a trend reversal. Concerns about the future inflation trajectory could also emerge as a major stumbling block for the INR. Chart 7: USD/AXJC tracks the USD/CNY pair USD/AXJC USD/CNY (RHS) Note: AXJC = Asian currencies excluding China All currencies are re-based to 100 with 2010 as the base-year Source: BIS & ICICI Bank Research However, we are not reversing our medium-term projections given our expectations that a full-blown trade war is avoided and that the market focus shifts back to the USD s twin deficit problem. Hence, we would expect the USD/INR pair to move towards the range by March Domestic bond yields: Ranged trading in the near-term While the INR remained under pressure, domestic bond market yields have softened over the last fortnight. The knockon effect of risk aversion that has pushed global bond yields lower, fall in global crude oil prices and an OMO announcement have improved sentiment in the domestic fixed income market. We continue to believe that the risks are to the upside given the pending MSP announcement, another rate hike by the RBI in either August or October, tighteness in domestic liquidity and FPI related debt pull-out resulting in currency depreciation. Hence, we see an upside possibility of 8.20% for the yield on the benchmark 10 year yield. However, we think the more prominent medium-term driver is likely to be OMO purchases of the RBI. Were the RBI to over the course of the fiscal year conduct OMO purchases that compensates for outflows expected from a balance of payments perspective and increase in the currency in circulation seen already in the fiscal year, the upside potential could be more moderate. Based on our projections, we are looking for a figure of at least another INR 1 tn worth of OMO purchases in aggregate over the course of the year that could in turn push 10 year yield lower likely in H2 FY

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