RBI to face new challenges in 2021 as Rupee, bonds lure overseas investors

Indian debt and rupee may lure overseas investors in 2021, just like the nation’s equities with one caveat: the central bank will face more challenges in curbing the local currency’s gains against the greenback.

Stocks have already attracted the biggest yearly inflows since 2012, adding to the woes for the Reserve Bank of India that has been buying up the deluge of dollars to curb the rupee’s gains. The resulting glut of cash in the financial system has caused short-term rates to crash, which, combined with high inflation, is dampening debt returns for foreign funds triggering a record outflow from bonds.

Sterilization has also caught the eye of U.S. monitors who added India to their watch list for currency manipulators and may force the Reserve Bank of India to let the rupee strengthen against the dollar. The rupee, Asia’s worst-performing currency against the dollar, may rebound along with flows into debt amid a recovery in risk appetite for higher-yielding assets. India was among the five most favored markets, according to a Bloomberg survey of emerging market outlooks for 2021.

“We are constructive on the Indian market next year as India is a high beta market in EM,” said Emily Alejos, chief investment officer at Cartica Management in Washington D.C. “We expect all EM to prosper.”

Adding to the appeal of Indian assets are efforts by the government and central bank to tackle a historic recession. India ramped up a support package last month to about 15% of the economy. The additional spending together with falling tax revenue means its budget gap will probably widen to 8% of gross domestic product according to economists’ estimates, more than double the annual target. However, Finance Minister Nirmala Sitharaman said she would not worry about a wider deficit because of the clear need to spend money.

Meanwhile, earlier this month, central bank Governor Shaktikanta Das promised to maintain an accommodative stance, ruling out rate hikes for as long as would be needed to revive economic growth.

Equities

Indian stocks are trading at more than 28 times one-year forward earnings, close to the highest since at least 2005, according to data compiled by Bloomberg. Despite high valuations and the first economic contraction in four decades, foreign investors’ interest is not cooling. Global funds poured $22 billion into Indian shares this year, the most since 2012, driving indexes to fresh highs even as they pulled money from all other major markets in the region other than China.

The Nifty 50, which gained 11% this year, still trails the MSCI AC Asia Pacific Index’s 14% advance, suggesting India has more room to catch up as the economy recovers next year.

“While the Indian market has hit a new high, it has only marginally grown from January 2020 levels,” said Huzaifa Husain, head of equities at PineBridge India Ltd. “There is still ample room for growth in the year ahead.”

Bonds

If retail prices cooling off last month marks the start of a trend, that will bode well for debt returns in 2021. Inflation should moderate to 4.8% by the end of next year, from about 6.8% this year, according to Sonal Varma, chief economist for India and Asia ex-Japan at Nomura Holdings Inc.

Yield Erosion

Another impetus could come from Indian assets’ potential inclusion in global bond indexes, which will draw in passive inflows even if the budget deficit widens as projected by economists. Nomura’s Varma estimates a 25% chance India’s sovereign debt rating could be downgraded to junk next year, though her baseline expectation is for no change.

Rupee

The rupee has been the worst performer among major Asian currencies this year, declining more than 3% against the U.S. currency amid the Reserve Bank’s dollar purchases.

Indian authorities should limit such intervention to periods of excessive volatility while allowing the rupee to adjust based on economic fundamentals, the U.S. Treasury Department officials wrote, while adding the nation to a watch list of currency manipulators. Traders are forecasting that the rupee will be one of the best performers among Asian currencies, bouncing back by the fourth quarter of next year. The Bloomberg consensus median forecast is for the rupee to appreciate to 72.05 per U.S. dollar by the last quarter of 2021.

“We expect the Indian rupee to be anchored at least in the short-term as external accounts are bolstered from weak oil prices, abundant global liquidity and a weakening U.S. dollar,” said Cartica Management’s Alejos.