US Fed pause prolongs uncertainty

I expect the US Federal Reserve to pause on October 28. As a result, capital flows will continue to stall till markets price in three event risks: (1) a Fed hike, (2) Bihar poll results and (3) possible earnings downgrades in this result season. Still, one does not see outflows. In fact, 2015 is a historic year, as India will overtake Brazil and Russia to emerge as the second largest BRICS nation, after China.

I expect the first hike on December 16, though softer growth data have lowered the odds. There will likely be three hikes in 2016. In our view, Fed hikes are actually good for India. First, they will re-affirm US recovery, supporting export demand. Second, they contain commodity prices, pulling down 'imported' inflation and narrowing twin deficits in India. Finally, they whet risk appetite for high-growth emerging markets like India, although there can be a sell-off as the first knee-jerk reaction.

I continue to expect Reserve Bank of India governor Raghuram Rajan to anchor Rs 65 a dollar expectations, as he has indicated Rs 62-64 a dollar as fair value. Given his concerns about competitive easing, that one fully shares, RBI should recoup FX reserves in any relief rally following the US Fed pause, PBoC (People's Bank of China) easing or renewed quantitative easing by the European Central Bank. Yet, it is unlikely to waste precious FX reserves on any cross-currency pressure from a strong dollar. There is, after all, little fundamental case for depreciation as lower oil prices make up for the lack of foreign portfolio investor (FPI) flows. Even if FPI equity flows dry up, the capital account surplus should be sufficient to fund our projected current account deficit of 1.3 per cent of gross domestic product.

Experience suggests stock markets typically struggle when FPI equity flows dry up if valuations are on the higher side. Adjusted for earnings downgrades, the BSE Sensex is trading at a 12-month forward PE of some 17.5x, somewhat higher than the average of 14.5x.

I see bonds well-supported as debt FPIs will continue to subscribe to RBI's recent hike in government security limits. While the finance ministry has warned of fiscal slippage, this should get funded by deferring expenditure or drawing down the Centre's surplus with RBI. I also expect RBI to cut rates a final 25 basis points in February, as Consumer Price Index (CPI) inflation meets its under-six per cent mandate. Although we led the Street in calling for rate cuts last year, there is, however, limited scope now. Real policy rates are turning negative; with the RBI repo rate at 6.75 per cent, dipping below the seven per cent average CPI rise that we use as a proxy for inflation expectations.

Finally, the most important question for fixed income markets surely is how RBI will generate the permanent liquidity of $30-35 billion ($3 billion so far) needed this financial year. If capital inflows revive, it will obviously buy forex. In case, FPI equity flows continue to stall, it will have to resort to buy G-secs via open market operations in the March 2016 quarter.

The author is chief economist, India, Bank of America Merrill Lynch