Recovery in euro zone, China & Japan remains uncertain: Nizam Idris

Interview with MD, Head of Strategy, Fixed Income and Currencies, Macquarie Bank

US Federal Reserve’s taper and developments in China have rattled global equity and currency markets, especially in the emerging markets (EMs). Nizam Idris, managing director, head of strategy – fixed income and currencies, Macquarie Bank, tells Puneet Wadhwa an implosion in any of Turkey or South Africa from the ongoing capital outflows may cause rippling effects through global EM markets. The dollar-rupee value could rise back to 64 level in the first half of this year, with risks to the upside to 66 should the EM risks intensify, he adds. Edited excerpts:

We now have a lot of clarity as to how the US Federal Reserve (US Fed) and the Reserve Bank of India (RBI) are likely to approach the Monetary Policy in 2014. What is your assessment of the recent statements coming from these two central banks? Do you think there could possibly a shift in stance and if so, what could trigger it?

I do not see a change in RBI and the US Fed’s monetary policy stance for now. India needs to build up a risk premium in the local rates market through higher real interest rates (nominal rates less expected inflation), while the Fed is gradually unwinding quantitative easing (QE) on better data. This is likely to continue for now and it is probably too early to expect a change in course from either central bank. While the RBI could stand pat for now on rates, there is no room for easier policy in the near-term.

What did you make of the collapse that we have seen in some of the emerging market currencies? Do you think a market like India might be overreacting? How would you approach the EM universe and a market like India?

The way we look at EM right now can be summarised in four points: a) current account balance, b) real rates or risk premium built into domestic rates, c) amount of foreign funds invested onshore and d) growth.  With funds now looking wearily at EM assets given currencies’ volatility, we expect portfolio inflows to slow even as the Fed pumps less money into the system. In that environment, countries with current account deficits will see pressure to depreciate.

Do you think emerging markets are exposed and have become more vulnerable now to the risk of a sudden stop in capital flows?

The two ways to attract funds, even in this environment, is through strong growth prospects luring equity flows or decent real rates to attract bonds flows. For the latter, we expect most Asian central banks to need to hike rates in the months ahead. India has hiked rates since July to remain ahead of the inflation curve. Inflation fell meaningfully in December. Meanwhile, talk of financial sector reform continues to boost portfolio inflows. This should provide some support for the rupee. We, however, think India remains vulnerable when acute risk aversion returns given the sheer size of its current account deficits.

Do you think there is more pain in store for the fragile five – Brazil, India, Indonesia, South Africa and Turkey – in terms of how their economic conditions, currency and equity markets play out over the next few quarters? Which among these is relatively better placed and why?

I think there are risks not only to the fragile five but also to other EM markets if risk aversion turns more acute. An implosion in Turkey or South Africa from the ongoing capital outflows may yet cause rippling effects through global EM markets.

The fragile five were identified as potential triggers for wider EM crisis. For now, I think the risks are highest in Turkey and South Africa given the lack of economic reform, dwindling reserves and still massive foreign funds stuck in these economies. Of these, Turkey is the bigger market with greater risks of systemic contagion.

But Turkey’s central bank has acted by raising rates massively last week. This is helpful in attracting funds into the bonds market, stabilising the market somewhat. The risks, however, linger until confidence returns in a big way.

What is your assessment of how things are panning out across the Euro zone, China and Japan?

We think the recovery in Euro zone, China and Japan remains uncertain. While progress has been made – they have eliminated most tail risks in their respective economies – they are still struggling to hit escape velocity.

What is your expectation of how the bond yields will pan out in the emerging markets, especially India? How much worse can the rupee get from here on?

I think EM yields will rise from here given rising EM inflation and potentially higher US Treasury yields too as the Fed ends QE3. EM needs higher real interest rates and build greater risk premium in the respective domestic interest rates markets. This could be achieved either with lower inflation expectation or higher nominal interest rates. We think for now the risk is for rates to head higher across the EM space.

We think the USD will be strong this year as the Fed begins to end QE. The strong dollar will lead to higher USD/EM in general. But reactions will be differentiated based on the four factors listed above.

The higher growth and real rates will attract funds into a country and reduce the risks that the currency will weaken in a big way against the USD. Positive current account dynamics – how current account is changing at the margin – would also be key.

Based on our views of these factors, we think USD-INR could rise back to 64.0 in the first half of this year, with risks to the upside to 66.0 should the EM risks intensify.

The twin deficits – CAD and the fiscal deficit have become a challenge for the Indian government, especially as we head closer to the General Elections in India. What are the key figures you are working with as regards these deficits and what’s the road ahead?

We think India current account deficit could fall to around 2.5% of GDP or slightly below $50 billion. This is a significant improvement from earlier forecasts of around 3.5% deficit to GDP (gross domestic product).

But we are concerned about the impact on import restrictions on the true deficit numbers. If smuggling of items with import ban, such as gold, were to intensify, the BoP (Balance of Payments) numbers may not capture the actual outflows of funds from imports of merchandise. This would mean the official BoP data understates the current account deficit. The error and omission component of the BoP data should be watched for tell tale signs of such smuggling.

What is your strategy at Macquarie given these developments and economic scenario? What are you advising your clients at the current juncture?

At Macquarie, we are suggesting to clients to begin hedging a higher percentage of their dollar exposure or dollar needs, as we expect USD/INR will continue to rise from here in the months ahead.