Source: Yahoo Finance
In May, 2014, the Indian rupee (or INR) appreciated to 58.28 against the U.S. dollar (or USD) as the National Democratic Alliance (or NDA) government was voted to power with a strong majority. This appreciation was led by capital inflows from Foreign Institutional Investors (or FIIs), who have invested over $25 billion in India since the beginning of the year. The FIIs have invested about $12.16 billion (INR 729.61 billion) in the equity market, and about $13.44 billion (INR 806.63 billion) in the debt market. The trend for the INR has reversed in the last 2 months. On August 1, 2014, the INR touched above 61 against the USD. The downward trend may continue in the remaining months of the year due to a couple of factors.
In FY 2013/14 (April 2013 to March 2014), India's external debt increased 7.8% to $440.6 billion compared to FY 2012/13 (April 2012 to March 2013). The major components of the external debt include external commercial borrowings (33.3%), Non-Resident Indian (or NRI) deposits (23.6%), and short-term debt (20.3%). The rise in NRI deposits was due to the swap scheme introduced by RBI last year. In 2014, Indian companies have raised $10 billion from overseas bonds. The foreign currency debt of many Indian companies (or India Inc) is un-hedged, which is a matter of concern. In 2013, India Inc had exposure to $100 billion un-hedged foreign loans.
Foreign exchange reserves
The Reserve Bank of India (or RBI) has foreign exchange reserves of $317.85 billion. However, it is sufficient to cover only 8 months of imports, below the import cover of 15 months in February 2008 when the global financial meltdown took place. The foreign exchange reserves as a percentage of the external debt is about 72%, while it was 140% in May 2008. The country's Q1 trade deficit for FY 2014/15 (April 2014 to March 2015) is $33.1 billion, down 31% compared to Q1 of FY 2013/14 due to reduction in gold imports. The trade deficit for FY 2014/15 would be $95.62 billion assuming it is 31% down compared to FY 2013/14 trade deficit of $138.59 billion. Thus RBI will have to build foreign exchange reserves to maintain its import cover.
In June 2014, consumer prices rose 7.31% year-over-year (yoy), while wholesale price index (or WPI) rose 5.43% yoy. The consumer price index (or CPI) should fall below 8% by January 2015 for interest rate reduction by the RBI.
The major hurdles for inflation reduction are poor monsoon, and Middle East crisis. In June 2014, the El Nino effect lead to rainfall deficit of 43% compared to average, while it was 10% below average in last month. The rainfall in the next two months is important for the agriculture sector. The efforts of the Indian government to curb food inflation have a limited effect. The vegetable prices in the country have spiked on account of poor monsoon, which will increase CPI and WPI in the coming months.
Recently, crude oil prices have slipped below $100 per barrel. However, the unrest in Iraq, and Gaza are yet to resolve. The ongoing crisis could prevent crude oil prices from cooling further, which will prevent inflation reduction in India. High inflation will prevent the RBI from reducing interest rates which will affect the growth of the Indian economy, which is expected to grow 5.5% in FY 2014/15. Lower economic growth will also lead to lower tax receipts. The fiscal deficit for Q1 of FY 2014/15 has touched $49.2 billion or 56.1% of the full-year target. Thus the Indian government will face difficulty in achieving the fiscal deficit target of 4.1% of gross domestic product (or GDP).
Indian securities market
FIIs have exhausted 99.6% of their investment limit of $20 billion in short-term Indian government bonds (1 to 3 years maturity). However, they have utilized only 22.86% of their $10 billion limit in long-term bonds. Last month, the RBI raised the debt limit for FIIs in short-term maturity bonds by $5 billion and reduced the limit in long-term bonds by $5 billion. This is done on the condition that the incremental $5 billion investment will be done in government bonds with a minimum residual maturity of three years. There is no change in the total limit for FIIs in the government debt segment. The FIIs have no lock-in period and are free to sell these bonds along with bonds with less than three year maturity to domestic investors. This move will help in attracting more foreign investment in the debt segment.
The sovereign credit rating of India is BBB-, while the 10-year bond yield is about 8.5%. India's current economic situation is better than last year, when FIIs pulled out nearly $8 billion from the debt market. However, FIIs preference for short-term bonds over long-term bonds increases a sell-off risk if the Indian economy doesn't meet investor expectations in FY 2014/15.
The one year forward P/E of MSCI India is 16.3x, a five-year high premium compared to other emerging markets. FIIs have invested in the Indian equity market this year hoping that the NDA-led government will take bold measures to revive the Indian economy, which the previous government failed to achieve.
In my opinion, it is difficult to achieve GDP growth rate of 5.5% as the government continues to spend on certain subsidies and schemes that have leakages. The ruling government should reduce these wasteful expenditures, and increase spending on infrastructure projects to revive the economy. The Indian equity market is ignoring risks like the inflation, slow economic growth, capital scarcity and bad loans of public sector banks.
US economic data and Fed tapering
The U.S. economy grew at an annual rate of 4% during the second quarter of 2014. Consumer spending also increased 2.5% during the same quarter. The Federal Reserve will conclude its bond buying program in October this year. Last month, the Fed announced to cut its bond purchases from $35 billion to $25 billion a month. This may reduce capital inflows to emerging markets like India.
I would conclude by saying that the INR appreciated in the first half of 2014 on account of huge investment in the country's debt and equity market. The FIIs have high expectations from the ruling government to revive the economy and solve issues like high inflation, fiscal deficit, and current account deficit. If the expectations aren't met, then I expect the INR to depreciate above 63 against the USD by the end of 2014.
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