Nifty snapped a 6-day winning streak on mixed earnings and global cues... Nifty snapped a 6-day winning streak on mixed earnings and global cues ahead of Fed Read more

Summary

RBI may hike +0.50% on 5th August

India’s benchmark stock index Nifty closed around 16631.00 Monday; slipping -0.53% and snapping a 6-days winning streak on mixed earnings and global cues ahead of Fed. Nifty slumped around -88 points Monday, whereas index heavyweight RIL alone caused -67 points to slide on the subdued report card. Kotak bank also caused -10 points to slump in Nifty after muted report card. On Monday, India’s Dalal Street was also boosted by reports of Chinese infra stimulus; metal shares like Tata Steel surged.

Nifty soared +4.18% last week on positive global cues coupled with hopes of less hawkish RBI tightening and blockbuster earnings for Q1FY23. Overall, the Nifty jumped +5.39% (till Monday) boosted by banks & financials, FMCG, automobiles, techs (IT), metals, and also pharma stocks to some extent. Last week, the Nifty was also boosted as the government dialed back windfall tax/export duties on steel and refined petroleum products.

On Monday, India’s Nifty Future tumbled after Wall Street tumbled Friday on the renewed concern of an outright recession after July flash PMI data shows unexpected contraction of the U.S. service sector, the main engine of the world’s largest economy. Also, the overall report card (earnings and guidance) was mixed from Wall Street. The risk-on sentiment was also under stress on Fed’s faster tightening as Fed is set to hike +0.75% on 27^th July.

Now from global to local, India’s RBI is also set to hike +0.50% on 5^th August. On 22^nd July, RBI Governor Das said in a prepared speech:

Macroeconomic Situation - where we stand today

We are living in turbulent times. The continuing war in Europe and the pandemic have rendered the global macroeconomic outlook highly uncertain. Countries are facing unexpectedly high inflation including food inflation, supply chain disruptions, and demand-supply imbalances in product and labor markets. Central banks are tightening monetary policy at a rapid pace, raising fears of an imminent recession.

Commodity prices have eased somewhat from their June high, but remain elevated. Higher interest rates in the US along with increased risk aversion among global investors have fueled safe-haven demand and strengthening of the US Dollar. Currencies of Emerging Market Economies (EMEs) and even of some Advanced Economies (AEs) are depreciating vis-à-vis the US dollar. Consequently, inflationary pressures are building up and external funding conditions are becoming tighter, posing financial stability challenges in emerging market economies. Overall, the global situation remains grim amidst a fluid geopolitical situation while the war and the pandemic add to the forces of disintegration and fragmentation of the global economy.

In such an environment, the Indian economy remains relatively better placed, drawing strength from its macroeconomic fundamentals. The financial system is well-capitalized, asset quality indicators have improved, balance sheets are stronger, and banks have returned to profitability. We are also seeing a healthy pickup in credit demand. The external sector is well-buffered to withstand the ongoing terms of trade shocks and portfolio outflows. The recently released Financial Stability Report of the RBI highlights that the Indian financial system remains resilient and supportive of the ongoing economic revival. Banks are well-positioned to withstand even severe stress scenarios without falling below the minimum capital requirement. The Reserve Bank continues to remain watchful of the headwinds and shall be proactive in taking measures as necessary to ensure financial stability.

Recent developments in the forex market have generated intense debate, including predictions of the rupee dropping to record lows as foreign portfolio funds exit India. I would like to address the issue in a balanced and factual manner.

First, it is important to recognize that spillovers from the global monetary policy tightening, the geopolitical situation, the still elevated commodity prices – especially crude – and the lingering effects of the pandemic, all coming together, have become overwhelming for all countries in the world over. Even reserve currencies such as the Japanese yen, the Euro, and the British pound sterling have not been spared. Portfolio funds are selling off assets and fleeing to a haven. Emerging market economies (EMEs) are particularly affected by capital outflows, currency depreciation, and reserve drawdowns, complicating macroeconomic management in these countries.

Second, the impact of these overwhelming spillovers on India has been relatively modest. The Indian rupee is holding up well relative to both Advanced and EME peers. This is because our underlying fundamentals are strong, resilient, and intact. The recovery is gradually strengthening. The current account deficit is modest. Inflation is stabilizing. The financial sector is well-capitalized and sound. The external debt to GDP ratio is declining. The foreign exchange reserves are adequate.

Third, in recognition of the fact that there is a genuine shortfall of supply of forex in the market relative to demand because of import and debt servicing requirements and portfolio outflows, the RBI has been supplying US dollars to the market to ensure that there is adequate forex liquidity. After all, this is the very purpose for which we had accumulated reserves when the capital inflows were strong. And, may I add, you buy an umbrella to use when it rains!

Fourth, a predominant part of the outstanding ECBs is effectively hedged. Let me elaborate. According to the June 2022 Financial Stability Report (FSR) of the RBI, of the outstanding ECBs of the US $ 180 billion, 44 percent or US $ 79 billion is unhedged. This includes about the US $ 40 billion liabilities of public sector companies – mainly in the petroleum, railways, and power sectors - which have assets with a natural hedge character. Besides, being public sector entities, their foreign exchange risk – if any – can be absorbed by the government. Such a contingency is unlikely to arise.

The remaining US $ 39 billion ECB represents 22% of the total ECBs outstanding; Even this includes borrowings of those companies which have a natural hedge, i.e;  Earnings in foreign currencies. This would leave a very small portion of the total outstanding ECBs that are truly unhedged.  

Corporate entities eventually face a trade-off: if they hedge their forex exposure completely, the cost of borrowing goes up and the advantage of cheaper borrowing in foreign currency is lost. On the other hand, to the extent they do not hedge, debt servicing can go up when the exchange rate is under pressure. This has led to the concept of the optimal hedge ratio which calculates the proportion of hedging that minimizes the variance of the portfolio.

For India, our internal research estimates the optimal hedging ratio at 63 percent. Taking into account natural hedges and the exposure of public sector companies, the optimal hedge ratio condition is comfortably satisfied in the case of the stock of ECBs in India’s external debt.

Due to the RBI's actions, including measures to encourage inflows, the movements of the rupee have been relatively smooth and orderly. By eschewing sudden and volatile shifts, we have ensured that expectations remain anchored and the forex market functions in a stable and liquid manner. We will continue to engage with the forex market and ensure that the rupee finds its level in line with its fundamentals. I would like to reiterate that we have no particular level of the rupee in mind, but we would like to ensure its orderly evolution and we have zero tolerance for volatile and bumpy movements.

Further Das said in the Q&A session:

·         The current flexible inflation targeting mechanism is helpful during an unusual crisis like COVID when RBI reduces the rate along with other liquidity boosting measures

·         But maintaining assigned price stability is of paramount importance for financial stability, sustainable economic growth, and a healthy financial market

·         Persistently too high negative interest rates for savers may eventually distort the investment climate of the economy

·         RBI will not shift the inflation/price stability goalpost to just suit its convenience because the larger requirement of the economy and the financial sector is to have such a framework.

·         RBI’s official mandate is to maintain price stability, keeping in mind the objective of economic growth

·         RBI will now prioritize price stability instead of growth unlike during COVID times (exigencies)

·         RBI sees a soft landing in India despite tighter financial conditions (consecutive rate hikes) unlike the recession perception (hard landing) on both sides of the Atlantic (U.S./Europe)

·         Various high-frequency indicators are suggesting an upbeat Indian economy despite higher inflation and various global headwinds

·         RBI will deal with inflation (demand side) by calibrated tightening for a soft landing

·         Hot global crude oil prices are not under the control of RBI

·         Eventually, RBI will try to bring inflation down to near the 4% target with minimal/manageable impact on the GDP growth rate

·         Despite successive rate hikes, the policy rate is now at +4.90% still lower than pre-COVID +5.15%

·         Despite ongoing liquidity withdrawal, it’s still higher than pre-COVID times

·         Overall monetary policy is still more accommodative than in pre-COVID times and RBI will first withdraw the same completely to normalize

·         After the complete withdrawal of COVID times extraordinary monetary accommodations, RBI will focus on managing inflation expectations (by hiking) and then will try to ensure a balance between demand and supply conditions

·         RBI will not follow Fed in providing dot-plots amid such extremely volatile and uncertain times as such dot-plots may create unnecessary expectations, which RBI may or may not fulfill in due course, leading to more confusion/uncertainties

·         RBI is providing the necessary forward guidance in the policy statement as well as MPC minutes

·         RBI is taking care of higher imported inflation (in its policy rates) because of local currency depreciation (higher USDINR) and higher global commodity prices

·         RBI rate hikes are also resulting in higher deposit rates in the system

·         RBI allowance to settle international trade in INR (as an option) is still now in the nascent stage (actual trade settlement), but the potential is good

·         Overall system liquidity including government cash balance is now around Rs.5.0-6.0T; without government cash, it’s around Rs.2.8-2.9T-quite comfortable for normal credit offtake for the economy for productive purposes

·         Going forward, RBI may provide more liquidity from the system but will ensure comfortable/adequate liquidity to take care of the overall credit need of the economy (including any higher government borrowings)

Overall RBI will follow Fed’s rate hikes sequence to manage policy/currency/real bond yield differentials and also domestic inflation. But RBI may not be so much aggressive in rate hikes as Fed due to different inflation, macro-economy, and geopolitical narrative. India has already had a high inflation economy for decades due to huge currency depreciation in the past and consistently high wage growth for a large section of the labor force. In any way, to balance inflation and growth, RBI may hike by +0.50% on 5^th August.

In June, India’s inflation (CPI) was +7.01%, almost unchanged from May’s +7.04%, but slows down from +7.79% scaled in April (y/y).

On a sequential (m/m) basis, India’s CPI grows +0.52% in June against +0.94% in May’22 and +0.56% in June’21 (1-year ago).

India’s core CPI for June was recorded at +5.961% from May print +6.080% and April high at +6.969%.

Overall, India’s CPI or even core CPI is much higher than RBI’s target of +4.0%. But there were also early signs of plateauing, although it may be seasonal. In any way, it seems that RBI’s primary target of core CPI is now around +4.75% on a sustainable basis (at around +0.40% sequential rate).

Overall, RBI may hike +0.50% on 5^th August against Fed’s high probable +0.75% rate hikes on 27^th July. then depending upon the actual Fed hikes in September, November, and December, (most likely +0.50%), RBI may also hike +0.25% each in September, December, and February for a terminal rate of +6.15% by Feb’23. If Fed further hikes in Jan’23, then RBI may also hike by +0.50% in Feb’23 to manage the real rate differential.

India is now providing positive real bond yield against deep negative in the U.S., EU, U.K., and also Japan. But at the same time, India is also paying almost 45% of its core revenue as interest on a public debt against around 9% by the U.S., 4.5% by Europe, and 15% by Japan. Having said that, India has negligible public debt in foreign currency and manageable current account deficit, and an overall stable macro-economic situation.

Overall, at around 813.60 TTM EPS (current), Nifty PE is around 20.4, at reasonable levels. Nifty EPS may grow by +15% in FY23 to around 876 and in that scenario, at around 20 PE, the fair valuation of Nifty may be around 17520; i.e. Nifty may scale around 17500 by Mar’23, supported by a stable macro-economic outlook, leveraged corporate balance sheet and adequate pricing power despite higher inflation, higher borrowing costs and various global headwinds.

Looking ahead, whatever may be the narrative, technically, Nifty Future now has to sustain over 16850-17050 for a further rally towards 17250-17400 levels; otherwise, sustaining below 16800, it may be correct again towards 15750-15175 zones.

Source of economic data in the above tables: tradingeconomics.com and respective central banks