The reduction in US Federal Reserve's policy rate by 25 basis points and the European Central Bank's decision to resume asset purchases is likely to augur well for short-term foreign portfolio investment (FPI) flows to economies such as India which continue to provide a relatively high real interest rate differential, according to India Ratings and Research (Ind-Ra).
However, risks related to ongoing geopolitical tensions in the Middle East coupled with imminent downsides risks to domestic economic growth in the absence of a pickup in household demand could continue to impinge on investors' sentiment in the near term.
In a report titled 'Tepid FPI Flows to Limit Demand for Debt Papers', Ind-Ra said that despite the rollback of excess surcharge and a relatively accommodative monetary policy stance, FPI flows will continue to be undermined by a weak global and domestic consumption demand outlook.
The agency continues to believe that in the long term, a shrinking current account surplus in key exporting economies including China coupled with the muted household consumption will continue to weigh on FPI flows.
The second rate cut by the US Fed since January 2019 comes against the backdrop of a weakening global demand outlook and slowing exports in the United States. Ind-Ra believes this rate cut by itself is unlikely to stimulate long-term FPI flows amid the system-wide risk aversion build-up globally.
Additionally, relatively neutral communication or non-committal approach from the US Fed about the future course of action might keep the US dollar exchange rate firm.
Ind-Ra expects that with the ECB's decision to resume asset purchases, cumulative liquidity infusion by the top four global central banks (ECB, US Fed, Bank of England and Bank of Japan) is likely to be higher at about 230 billion dollars compared with the previous estimate of 186 billion dollars.
This is, however, still likely to be significantly lower than the quantum infused by these banks from 2014 to 2017 and even the relatively lower amount (354 billion dollars) infused in 2018.
Nonetheless, given that additional 20 billion dollars is being infused each month by the ECB beginning November 2018 along with the third round of targeted long-term refinance operations, liquidity is likely to temporarily improve globally.
Despite temporarily improved global liquidity conditions, FPI flows into India are unlikely to benefit corporate issuers meaningfully in the medium term. Ind-Ra, in its report on FPI flows, highlighted that the domestic institutional appetite for government securities itself has dwindled over the last one year.
In such a scenario, the majority of short-term capital flows is likely to be concentrated on the government securities market and to highly rated issuers with relatively liquid debt instruments. This is likely to be on account of a continued build-up of risk aversion amidst mounting economic uncertainties.
The escalating geopolitical tensions in the Middle East have put pressures on crude oil prices. Higher fuel costs not only affect India's current account deficit but also stoke inflationary pressures domestically and could well impact the fiscal condition adversely.
While this is not yet Ind-Ra's base case, if the crude oil prices remain elevated, the agency envisages three key challenges that could be realised and dampen overall investor sentiment.
First, the operating expenses for sectors with high freight and logistics expenses -- such as metals, fast-moving consumer goods, logistics, packaging and auto. Second, demand by itself could be further depressed in case inflationary pressures persist. Third, amid a weakening non-oil current account deficit, pressures on oil prices could further strain the current account.
The agency believes on account of volatile FPI and foreign direct investment flows, financing this deficit could pressurise domestic interest rates as well as corporates' credit metrics. These factors together are likely to increase economic uncertainties over the medium term and thereby dampen FPI flows further.
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