India in Eye of GEM Currency Storm…

27th August 2013

Does history repeat itself, as if we learn nothing from one crisis to another?”

Duvvuri Subbarao, outgoing head of the Reserve Bank of India, speaking recently

Or rather another 1991 in India’s case. It’s remarkable how complacent GEM bond and equity investors have been regarding deteriorating external balances, a key factor which I’ve highlighted repeatedly over the past year as a driver of portfolio allocations. Korea or China might have had relentlessly negative earnings momentum, but no risk of a destabilizing margin call from global markets. We saw endless sound bites in recent years about how much stronger GEM solvency and fiscal dynamics were versus developed world, justifying the dramatic re-rating of EM debt. In fact, stripping out China and the Gulf oil exporters, the aggregate current account balance of emerging economies has slumped from a 2.3% of GDP surplus in 2006 to about a 0.75% deficit this year, the biggest since 1998. In recent months, that stark reality has begun to be reflected in divergent risk premia.

India has been a focus of that re-pricing; FX reserves now cover its CA deficit and short term debt (by residual maturity) by just over 100%, down from 400% in 2005. Coverage of total external debt plus the CA is down to just 60%. Only South Africa and Turkey are in such a weak funding position within major GEM economies; in contrast, Brazil’s reserves are double its gross financing needs.  Indonesia is in an ever weaker coverage position and saw the most savage selloff last week, with the IDR down 6% against the USD and the JSE down almost 9%. Policymakers in both India and Indonesia are flailing around with new policy initiatives to stem the panic. However, curbing the voracious local appetite for BMW imports in Jakarta with import tax hikes isn’t going to help much, and rates have to move positive to stem the rout, implying further hikes of at least 100-150bps and GDP growth slowing to sub 5% next year. As highlighted in several notes since last December, the country was a prime candidate for a panic like this.

About $22bn in private sector debt repayments are scheduled for H2 in Indonesia; the $119bn increase in total external debt position from 2006 to 2012 included private sector external debt rising by $48bn. The debt/export ratio stands at a current 120%, reflecting weak commodity export prices. Short-term Indonesian external debt by residual maturity stood at almost 59% of FX reserves as of end July. In other words, the panic is far from irrational as GEM portfolio inflows have reversed sharply since mid-May, and the question now is whether it feeds on itself or gradually calms. There are plenty of reasons to be relatively sanguine, not least the unseemly scramble by previously bullish but as ever momentum chasing IB analysts to slash FX and equity market targets.

Private sector debt as a ratio of exports was about 50% higher in Korea in 1997 than it is in India now; while India’s fiscal deficit is much bigger than those across Asia in the 1990s crisis, high nominal GDP growth means that India’s debt/GDP ratio has been declining even as deficits have remained high to about 66% now on IMF estimates. However, the debt situation is more ominous for the private sector should rates spike/funding dry up; many Indian companies have been on a borrowing binge. Since 2007, borrowing by the country’s 10 most indebted companies has risen from $20bn to about $120bn, with much of that denominated in foreign currencies as the offshore corporate bond market has boomed. Total short-term external debt has risen from $80bn to $170bn. Private firms that owe the bulk of India’s foreign debt will be under intense solvency pressure if the rupee stays below 60 for long. This makes the balance sheets of India’s state-owned banks ever more shot to pieces; they already have bad loans equivalent to 10-12% of their loan books, but in reality above 20% adjusting for ‘restructured loans’.  That second round impact of a weak rupee is one factor complicating the RBI’s task in focusing on growth.

The rupee’s fair value, taking into account India’s relative inflation and productivity is just under 60 versus the USD and after overshooting toward 70, we should eventually see the market stabilize at around that level by early 2014. Total FDI and portfolio investments amount to over 25% of GDP and sustaining foreign investor confidence will be key in coming months. The current account should start improving to sub 4% this FY on a belated export response and weaker gold imports (and gold prices in rupee terms are also at a record). The longer-term solution to the CA deficit has to be India’s domestic manufacturing sector, and industrial exports.

Emerging Markets Get a Wake Up Call From the Fed…

Just as the PBoC shocked markets last month (and perhaps itself) by engineering a record spike in interbank rates to instill some lending discipline, the RBI last week reversed course on easier policy as the INR broke the 60 level versus the USD, amid an ominous rally in oil prices. Growing concerns about bank asset quality and a looming surge in loan write-offs set against the backdrop of a structural economic slowdown is a narrative as relevant to India as China right now, although the key difference is in the huge divergence in their currency performance and capital flows. In real effective terms (i.e. trade weighted and relative inflation rate adjusted), the RMB has outperformed the INR by about 25% since early 2010, and the impact of FX moves as much as funding costs on sector selection has been critical in both countries (with an ongoing profit windfall for Indian exporters).  Indian bank NPLs reached 3.5% per at the end of the last financial year, with “restructured” assets now accounting for maybe 6% of loans. According to Fitch, the combination of bad and restructured debts will reach just under 12% of loans, or 3.5trn Rupees ($60bn), by next April, a level that has nearly doubled in just two years.

Short of reversing course and following Indonesia in raising the repo rate to stem the currency slide, this was a very aggressive attempt to draw a line at around 60 INR to the USD. The repo rate has been cut three times this year and was held steady at the RBI’s last monetary policy meeting in June. Given the risks of further global portfolio flow volatility, the rate cut cycle is almost certainly over for this year at least. In a statement published last week, the RBI said: ‘The market perception of likely tapering has triggered outflows of portfolio investment, particularly from the debt segment. Countries with large current account deficits, such as India, have been particularly affected despite their relatively promising economic fundamentals.’ India’s current account deficit was 4.8% of GDP at the end of the fiscal year to March, or $88bn, up from $78bn a year earlier.

Since the Fed suggested its Q4 exit strategy, foreign institutional outflows from the equity market have reached almost $3bn (although still up a net $12bn YTD) and from debt markets over $5bn, while the rupee has depreciated by about 10%. As in Indonesia, the 10-year yield has broken 8% and interest rate sensitive equities from real estate to banks have been hit hard. The proposed liberalization of FDI limits in important infrastructure sectors such as telecoms is a minor positive against this backdrop, and we are going to see a surge in government expenditure pre-election (spending is set to rise 16% y/y in the current FY to end March 2014, versus 9.7% in the last) but the situation remains dangerous until the currency/current account stabilize.

The RBI raised its Marginal Standing Facility interest rate (the cost of borrowing from the RBI using its emergency liquidity mechanism) by two percentage points to 10.25%, bringing it to 300 bps above the repo, its main policy rate. The RBI’s Bank Rate – the standard rate at which it lends to Indian banks was also raised from 8.25% to 10.25%. Funds available under the RBI’s liquidity adjustment facility – which helps banks adjust daily mismatches in liquidity at a softer rate of 7.25% – have been limited to about 750bn rupees ($12.6bn). On the other side of the world, India has had a glimpse of what a reformist, ambitious government can do.

Mexico, which is already the biggest beneficiary of China’s deteriorating manufacturing competitiveness as reflected in US export market share and has been tackling rampant corruption (for instance, in the notorious teacher’s union), unveiled an investment plan to upgrade the country’s key infrastructure, which including investments from the private sector, could hit 4trn pesos ($314bn) between now and 2018 or almost a third of Mexico’s annual GDP. As I’ve long highlighted, the ‘rising tide lifting all boats’ macro scenario for GEM via the positive terms of trade boost from China via commodity prices and the resultant capital inflows is over, the quality of governance matters more than ever for investors, as evidenced by the execution of structural and institutional reforms to boost productivity and domestic demand. Mexico and China are voluntarily starting down that road, Indonesia and India are being forced to by markets, but with questionable technocratic competence to deliver while Russia and Brazil look hopelessly behind the curve. This is all an overdue wake-up call for complacent emerging market policy makers and indeed investors in the asset class.