Cogencis, Thursday, Dec 3, 2020

By Pratigya Vajpayee and Bhaskar Dutta

NEW DELHI - Currency traders have been puzzled and at times exasperated by the Reserve Bank of India's foreign exchange intervention strategy that has turned the rupee into an underperformer among its Asian peers over the last few months.

Some say the RBI is aiming for export competitiveness, others say it is merely shoring up its reserves, but Parul Mittal Sinha, managing director and head – Macro Trading India and South Asia Financial Markets, Standard Chartered Bank, is of the opinion that the central bank is looking to check currency overvaluation that stems from high inflation.

"Our strategists' calculations show that from a valuations' perspective, even as we see a 4.5% year-on-year decline on year in NEER (Nominal Effective Exchange Rate) terms, the REER (Real Effective Exchange Rate) has declined only by a modest 0.6% year-on-year," Sinha told Cogencis in first ever media interaction in her current role.

"This difference in REER and NEER impact on INR is reflective of the high inflation we've seen in India vis-a-vis other countries. And which, to my mind has been the main driver of the RBI's intervention policy. It's more to prevent any sharp appreciation, rather than to drive depreciation."

Latest available data shows that the rupee's real effective exchange rate based on a 36-currency basket rose to 118.13 in October from 113.05 in June. During this period, the rupee lagged most Asian currencies, mainly due to the RBI's persistent intervention.

Sinha expects inflation to remain elevated even after the easing of supply disruptions that have caused the recent jumps in inflation prints. Consequently, she does not see room for the RBI to loosen its monetary policy any further.

"Going forward, even as supply-side disruptions might fade away, bringing food inflation lower, other factors are likely to take hold," she said. "Commodity prices are on the rise, and demand may start to normalise, especially as COVID-19 vaccines start getting administered next year." 

High inflation would also mean that real returns on Indian debt assets are now negative, which makes these an unattractive proposition for foreign investors, Sinha said. 

She warned that the recent collapse in money market rates, if allowed to sustain, could lead to a build-up of asset-liability mismatches as banks move towards longer term securities in search for higher yields.

"Over time, this can result in banking sector's asset liability mismatches increasing, and induce sharp market moves when reversal of easy liquidity takes place," Sinha said.

Having worked in multiple international financial market centres since she began her career in 2007, Sinha said traders in Indian markets have relatively greater opportunities to build their expertise across products.

Sinha, a sports enthusiast who captained the basketball team at Indian Institute of Technology, Delhi, scored her wins at the trading desk this year.

"Standard Chartered Bank's Financial Markets team has delivered good performance across products," she said. "2020 has been a volatile year that offered many opportunities for traders to capture."

An alumnus of Indian Institute of Management, Ahmedabad, Sinha started out as a trader of European rates and cross currency swaps with Merill Lynch, London. After various roles in what is now Bank of America Merill Lynch, she went on to head local markets trading at Deutsche Bank, where she worked prior to joining Standard Chartered Bank in 2019.

Below are edited excerpts from the interview with Sinha:

Q. You started out your career in London, which is a highly developed financial market, and later moved to India, which has some way to go. How would you compare the two experiences?

A. I started my career with Merrill Lynch in London, where I did market making in vanilla euro and Scandinavian swaps to begin with, and then moved on to market making G-10 cross currency swaps.

London being the centre of cross border capital flows across the US and Europe kept the G-10 cross currency swaps book extremely busy. The experience of working in developed market currencies with deep market liquidity, thin bid offers, large ticket sizes, high turnover and big book sizes was exhilarating and a fantastic launching pad for me.

From London, I moved to Singapore and then to India internally with Merrill Lynch, which had become Bank of America Merrill Lynch by then.

I have enjoyed trading across local fixed income and currencies markets in London, Singapore and India. As a global financial hub, markets in London are very deep and vibrant. The trading desks are very big. It is not unusual to have hundreds of traders sitting on the same floor, spread across multiple products and currencies.

The market volume of an individual product in developed market economies is extremely high, and traders develop deep product expertise by handling large volumes at a high pace. The analytical and pricing tools available are highly sophisticated, which enable traders to identify relative value trades easily and to handle large client volumes. Use of data analytics for predicting client behaviour is quite common.

On the other hand, in India, trading desks are much smaller, products are fewer; traders sit close to each other, and have the luxury of knowing what is going on across all products – be it foreign exchange, forwards, bonds, swaps, or options. It gives a much wider product exposure and a multidimensional view to an individual trader, and therefore, the learning experience is quite rich.

Q. The next big event we have coming up is the RBI policy. What are your expectations from that? Are we in denial about persistently high inflation?

A. Inflation in India has recently come in higher than market expectations - with headline CPI close to 7.5%, and core inflation close to 5.5%.

India's experience with inflation has been in contrast to that of other Asian economies, where CPI fell substantially due to COVID impact.

In India's case, the push higher due to supply side disruptions seem to have outweighed the demand side pull lower on inflation – contributing to the high food inflation.

Another contributing factor has been that the sharp decline in global oil prices was not passed on to the consumers in India.

Going forward, even as supply side disruptions might fade away bringing food inflation lower, other factors are likely to take hold - commodity prices are on the rise, and demand may start to normalize; especially if the COVID-19 vaccines get developed and start getting administered next year.

I do not expect to see sub 5% headline inflation numbers going forward, and don't expect any let up in core inflation from current levels. With real interest rates running in negative territory since Dec 2019, fear of high inflation expectations becoming entrenched is quite real.

With this backdrop and given both inflation and growth outcomes are higher versus RBI estimates in the previous meeting of the Monetary Policy Committee, I do not see any room for further policy easing going forward.

At the upcoming MPC meet however, I expect RBI to maintain status quo, in line with the guidance given in previous MPC meet to continue with the accommodative stance at least during the current financial year and into the next financial year. 

Q. At some point there will be a reversal of accommodation, when do you foresee it happening?

A. I expect Jan-Mar 2021 to be a very interesting phase for markets – we will get clarity on size of additional fiscal stimulus in the US, COVID vaccines will likely get developed and start getting administered, and the latest wave of COVID infections in the US and Europe will likely start subsiding.

We have already started seeing rotation of money from technology to real economy stocks, and the steady rise in global commodity prices.

Our economists have recently upgraded their 10-year US Treasury yield forecast for Dec 2021 to 1.4% from 1,0%.

Closer home, RBI will have sufficient data by Mar 2021 to recalibrate monetary policy response.

I expect RBI to revisit the current accommodative policy stance and move to neutral at the April 2021 MPC meet – which is technically the earliest window to do so after the guidance 'to continue with the accommodative stance at least during the current financial year and into the next financial year' was given at the last MPC meet. This will mark the beginning of a calibrated rollback of the monetary stimulus extended by RBI so far.

Q. The other signal awaited from the RBI is on liquidity. Does the present situation of excess liquidity and collapse of money market rates warrant a response from RBI?

A. Continuation of large scale foreign exchange reserve accretion and open market operation purchases have led to an unprecedented level of liquidity surplus in the banking system.

Weighted average call rate has dropped around 25 bps below reverse repo rate, overnight collateralised borrowing rate is averaging 50 bps below the reverse repo rate, and most money market instruments-- T bills, certificates of deposit and commercial papers are trading below reverse repo rate.

Recently the 182-day T-bill rate also moved below reverse repo rate of 3.35% to 3.25%.

I am sure RBI is monitoring the conditions quite closely and may not be comfortable with a continuation of this level of liquidity surplus over an extended period of time.

We are beginning to see impact of excess liquidity creep up the yield curve - 1-year T-bill trading close to reverse repo rate, 2-year government bonds trading below repo rate.

Banks will need to keep going up the yield curve in search of yield. Over time, this can result in banking sector’s asset liability mismatches increasing, and induce sharp market moves when reversal of easy liquidity takes place.

There are multiple tools at RBI's disposal to mop up excess liquidity – issuance of MSS bills, introduction of SDF window, to name a couple.

Q. They do have tools at their disposal, but by using these tools, don't they risk signaling a reversal of the accommodative stance if they start mopping up liquidity?

A. RBI did a fantastic job of communicating openly and guiding markets recently –- we saw market yields come down by 25 bps after the last MPC meet, driven by dovish language, assurance of support for bond markets and forward guidance on accommodative stance.

There is a high level of trust and belief among market participants that RBI will keep supporting the bond market at least until the end of the current fiscal year.

I believe RBI can easily use the tools at their disposal to mop up the excess liquidity without negatively impacting the broader market sentiment. The shorter end of the yield curve will see some re-pricing higher, but that will be by design.

Q. What will be the trading themes for rates and foreign exchange in 2021? How do you see Indian debt and the rupee faring versus other emerging markets?

A. From now until Jan-Feb 2021, global markets will likely trade sideways - on the one hand economies will likely grapple with the second and stronger wave of COVID, while on the other, news of various COVID vaccines getting approved will keep positive sentiment alive

March 2021 onwards - we may see sharper moves - as the world comes closer to vaccines getting administered, confidence on demand recovery will increase.

Under such a scenario, we expect equities to perform well - 'technology stocks outperformance versus real economy stocks' will unwind, commodities will do well.

US dollar will continue to weaken –- risk-on sentiment will drive inflows into emerging markets. Market reports suggest nearly $800 bln of funds sitting in the US money market funds are waiting to get deployed post the elections.

Unfortunately, when foreign investors compare debt markets in Asia, Indian bonds are not seen favourably as the real yield offered is much lower when compared to other Asians bonds. I don't expect foreign investors to rush to buy Indian bonds in the short term.

Q. Based on current macro themes, what would be your recommendation in terms of trading strategy; which part of the yield curve are you most constructive on?

A. This has been a year of strong monetary policy easing, and normalisation of risk premia.

The high banking system liquidity surplus has been very positive for the shorter end of the yield curve - for Indian government bonds, state development bonds, and corporate bonds. So far, we've liked the three-month to three-year segment of all these curves.

From here on, in the short-term, we like receiving one-year foreign exchange forwards - they offer good value as they are at elevated levels compared to other short tenor money market instruments due to sterilization-related paying seen in forwards.

In the medium term, we are neutral on bonds, as we may be nearing the end of easing cycle. We are positive on the rupee, because of strong pipeline of foreign direct investment inflows, INR-positive seasonality in December and March, and expectations of a weaker US dollar globally.

Q. What has been your breadwinner this year?

A. Standard Chartered Bank's Financial Markets team has delivered good performance across products. 2020 has been a volatile year that offered many opportunities for traders to capture.

Q. Public debt in India has been increasing at a rapid pace over the last few years, and household savings are not. Clearly, we need external capital. To what extent would global bond indices help?

A. The move towards inclusion in Global Bond Indices is a welcome step. Inclusion in global bond indices will require us to ease many operational and policy constraints for foreign investors, in addition to opening up investment limits.

RBI has been fairly proactive on that front, bringing in a host of draft regulatory guidelines in 2020, aimed at liberalisation of foreign exchange and rates markets.

Based on experience of other nations with bond inclusion, India is probably 2 years away from index inclusion related foreign inflows commencing.

Based on outstanding of fully accessible route (FAR) securities, we expect a weight of 10% in JP Morgan's GBI-EM-GD (Global Bonds Index- Emerging Market- Global Diversified) which is also the cap for a single country.

This will entail approximately $20-25 bln worth of indexed bond inflows.

Inclusion in the Barclays Global Aggregate Bond Index is expected to drive only around $5 bln of foreign bond inflows based on FAR securities being allowed for foreign investment.

I don't think global bond index inclusion should be seen from a narrow lens of addressing India’s debt financing problem. The move towards global bond indices is a part of a much bigger plan to integrate closely with global markets, and it induces a high level of responsibility for the government, regulators, and market participants to maintain fiscal and monetary discipline.

I believe that is the true impact of Global Bond Index inclusion for India.

Q. The short end of the curve has definitely benefited from surplus liquidity, but we still have a very steep yield curve. By when do you think that will be addressed, given that supply continues to be a problem, especially in the long end?

A. The bond curve in India is quite steep, with the 10-year bond at 5.95% trading a full 2% higher yield than the 2-year bond yield, and 3% above the prevailing overnight money market rates.

Even if we compare the curve steepness with other Asian markets, India’s bond curve looks quite steep. However, I expect it to remain steep because of the way inflation has panned out in India. We do have high inflation and the liquidity surplus and all the other measures have only helped the shorter end of the curve, so the steepness may continue.

Q. The pandemic has posed an unprecedented challenge for economic policy. What would be your recommendations for the government and for the RBI?

A. If I look at what the RBI has done this year, they have done a lot. They have worked very hard to ensure that both foreign exchange and bond markets function in an orderly manner.

This is the first time in my career that market participants don’t have any outstanding demands from the RBI. I think what has been delivered by RBI is sufficient to manage this year's borrowing programme and market conditions until the end of this fiscal.

Next year will be another challenge, and I'm sure we'll go back to RBI with a new set of demands. RBI's challenge will be to manage another year of high market borrowings in an environment of sticky inflation and rebound in growth.

RBI will likely need to roll back some of the monetary easing and liquidity surplus measures taken this year, which may make the task of keeping government's borrowing costs under control quite difficult.

Q. Do you think it's possible or desirable for the government to return to the path of fiscal consolidation anytime soon?

A. I expect this year's fiscal deficit to be 7.5-8% of GDP for the Centre and around 4.5% for states. It is neither possible nor desirable to the government to sharply reduce fiscal deficit next year.

Fiscal consolidation is desirable, but the pace needs to account for the fragility of economic recovery. The government has already been very prudent, almost too careful, with the timing and size of fiscal support this year. Any move towards sharp correction of fiscal deficit will be counterproductive for the economy.

Q. But on the flip side, have we carried the fiscal conservatism too far?

A. The response from the government has been quite targeted and calibrated, while RBI has delivered a strong easing response, which is a more broad-based response to the economic needs of the country.

The government's carefully calibrated fiscal packages showcase their ideology of fiscal conservatism. For comparison, US' fiscal deficit moved from 5% pre-COVID to nearly 14% currently, and is expected to hit 20% when the next round of stimulus gets approved.

In comparison, India’s centre-and-state combined fiscal deficit will likely move from around 7.5% in last fiscal to 12-12.5% in current fiscal.

While the government has initiated welcome reforms in agricultural and labour sectors, the positive growth impact from these will be felt in medium to long term.

Q. What do you make of the RBI's foreign exchange intervention strategy? In its quest to increase reserves, has the RBI gone overboard in making the rupee a laggard?

A. This year has been unprecedented in terms of the scale of Balance of Payments surplus we are expecting. Our strategists are looking at $100-110 bln of surplus this year.

On the current account deficit front, we are expecting a surplus of around $50 bln, and RBI has been aggressively absorbing these flows.

We've seen their foreign exchange reserves increase by an unprecedented $95 bln so far this fiscal. On the valuation front, however, we don't think the RBI is actively working to depreciate the currency, but rather to contain any sharp appreciation that may come with the dramatic increase in inflows that we are seeing.

Our strategists' calculations show that from a valuations perspective, even as we see a 4.5% year-on-year decline on year in terms of Nominal Effective Exchange Rate , the Real Effective Exchange Rate has declined only by a modest 0.6% year-on-year.

This difference in REER and NEER impact on rupee is reflective of the high inflation we have seen in India vis-a-vis other countries. And which, to my mind has been the main driver of the RBI’s intervention policy. It's more to prevent any sharp appreciation rather than to drive depreciation.  End

US$1 = 73.7400 rupees

Edited by Arshad Hussain