India's dollar buyer likely to step back as capital inflows drop

Traders counting on the Reserve Bank of India (RBI) to keep buying dollars may have to think again.

The central bank bought $36 billion of foreign exchange in the 12 months to January, seeking to stem the rupee’s appreciation. That’s likely to change given India’s widening current-account deficit and slowing capital inflows, with Rabobank saying the RBI may instead look to use some of its $420 billion of reserves to plug the dollar spending gap.

India is losing some of its red-hot appeal to foreign investors as a bank scandal, a widening fiscal deficit and the prospects of faster rate hikes by the Federal Reserve erode the allure of its higher-yielding assets. The rupee is the second-worst performing currency in Asia and global funds have turned net sellers of its bonds this year.

“A sudden stop of inflows would lead to declining FX reserves in 2018,” said Hugo Erken, a Utrecht-based senior economist at Rabobank International. “We could be looking at a shortage of $18 billion to cover finance requirements.”

Foreigners have offloaded $405 million of bonds this year, while equity inflows have slowed to $1.5 billion. Global funds bought a combined $11.2 billion of equities and debt in the first quarter of 2017.

“It’s hard to imagine strong flows in 2018 into India if you put together the combination of global and domestic headwinds,” said Shashank Mendiratta, an economist at ANZ in Bengaluru. RBI’s intervention to cap rupee gains will “likely taper off over the next few months,” he said.

Rupee turns

As the rupee advanced 6.4 per cent in 2017, the RBI was a net buyer of dollars for almost every month. It also purchased $7.4 billion this January, according to recent data. The currency’s 2.4 per cent decline from the start of February suggests the trend may turn.

India's financing requirements will keep the rupee vulnerable to rising US rates this year, especially if the hikes weigh on global equities, according to a Tuesday note from DBS Bank. It expects the rupee to decline toward 67 to a dollar this year. The currency is trading at 65.18 at 12:07 p.m. in Mumbai.

The nation's current-account deficit widened to $13.5 billion in the October quarter as oil prices surged, almost doubling from the $7.2 billion gap in the previous three months, according to RBI data on Friday.

The risk of much wider current-account deficits, driven partly by higher oil prices, will increase the importance of portfolio flows, said Hamish Pepper, head of a forex and emerging market-macro strategy for Asia at Barclays Bank Plc in Singapore.
              
“It will likely require a cheaper rupee exchange value than we thought earlier this year, given heightened political and macroeconomic risks,” said Pepper. “Equity flows will be critical, given near-exhausted foreign portfolio investment in debt limits.”

Still, dipping into RBI's reserves to sell dollars will be easier said than done.

At a time when domestic money market liquidity has tightened, selling dollars could see short-term rates advance and push up the entire yield curve. That will put the nation’s economic recovery and the government’s new borrowing plan at risk.
“Domestic liquidity is tight, so there will remain a floor to how much rupees RBI can take out of the system,” ANZ’s Mendiratta said.