Forex party is ending

India’s problem of plenty on the external sector – too many dollars coming into the country relative to those going out – appears to be coming to an end. After nearly two years of ultra-accommodative monetary policy, the US Federal Reserve (Fed) at its December meeting announced it will double the pace of its balance sheet tapering and end its net asset purchases by mid-March 2022, three months ahead of its earlier schedule. The median projections also show more front loaded rate hikes in 2022 (three hikes) and eight cumulative hikes by the end of 2024. US monetary policy plays an important role globally. Experience since the 2008 global financial crisis has shown that, when the US eases (cuts interest rates and expands balance sheet), it triggers a global financial upcycle: capital inflows into emerging markets, EM local currency appreciation and higher asset prices. When US monetary policy heads towards the exit, the reverse occurs. The spillover effects on EMs from US balance sheet policies are also much larger than those from conventional policy, due to the liquidity effects. Yet, the immediate market reaction to the substantial ‘hawkish’ pivot from the US Fed can best be described as ‘meh’. In India, equities rallied and INR is largely unchanged against USD – in contrast to the 2013 taper tantrum experience – and for some good reasons. First, the Fed has gone out of its way to communicate its intention to the market. This transparency has prepared the markets for the coming change, in contrast to the sudden shock effect in 2013. Second, India’s external vulnerability is much lower today. The rupee is not overvalued (relative to fundamentals), as was the case in mid-2013. The current account recorded a surplus in FY21 and in Q1 FY22 (versus a deficit of nearly 5% of GDP in FY13), and FX reserves currently cover nearly 12 months of imports (versus around six months in May 2013). Despite these comforting factors, there are reasons for caution. For one, current account dynamics have already begun to change. The monthly merchandise trade deficit has widened to a record high of $22.9 billion in November and has averaged over $20 billion since September. This is occurring against a backdrop of sharply rising exports and reflects an even stronger jump in imports. Higher imports partly reflect price effects: higher commodity prices such as crude oil, metals have boosted the value of imports, but other factors are at play too. Gold imports have surged over the last year, rising to $55 billion in the 12 months ending November 2021, its highest since 2013. While gold prices are steady, volumes appear to have rebounded, reflecting mainly pent up consumption demand (weddings and festivals), but possibly also higher investment demand. Import volumes of coal and fertiliser remain low, but could increase in coming quarters due to domestic shortages. Price effects alongside the improvement in domestic demand are also supporting higher import growth in metals, chemicals and electronics. medium nocaption The net impact of all these factors is a widening of the current account deficit to an underlying trend of around 2% of GDP, which is still low but reverses the surpluses brought about by the collapse in commodity prices and the slump in domestic demand. One measure of whether the financing of the current account deficit can be sustained is the basic balance of payments (BBOP) or the sum of current account and net FDI inflows, as the latter is a more stable form of capital inflows. India’s BBOP swung from a deficit of $26 billion in FY19 to surpluses in both FY20 and FY21. Our estimates show that the BBOP surplus will shrink in FY22 and swing back to a deficit of around $20 billion in FY23. Thus, net FDI inflows will not be enough, and the reliance on other ‘more volatile’ capital inflows to fund the current account deficit will increase, making the external sector more vulnerable to fluctuations in global risk appetite in coming quarters. The other risk is inflation. Although it is nowhere near the double-digit range, as it was in 2009-13, if we strip out food and fuel, the underlying ‘core’ inflation is hovering above 5.5%. This might look benign compared to the US, but India’s export competitors are based in Asia, where inflation is still relatively low. India’s high relative inflation could erode export competitiveness, even if the nominal exchange rate is steady. It could also lead to more imports, if consumers believe that domestic products are more expensive than imported goods. While these are slow-moving changes and won’t happen overnight, if the internal value of the rupee (inflation) erodes, it would reflect in its external value (foreign exchange rate) over time. On the whole, we do not expect a 2013-style tantrum, as India’s external position is on a much sounder footing, but this should not give way to any complacency. Just as the US Fed begins to reverse its monetary policies, domestic fundamentals are also shifting beneath the surface. Fasten your seatbelts for what will likely be a more volatile 2022! The writer is Chief Economist for India and Asia (minus Japan) at Nomura Illustration by Ajit Ninan