India faces tough challenge to stem outflows

INDIA’S capital markets have faced intense selling pressure in recent weeks due to a combination of factors, including global macroeconomic headwinds, monetary tightening and a massive exodus of foreign capital.

While its central bank had raised its interest rates last week – the first in four years – the move is unlikely to be enough to bring foreign investors back in a meaningful way, with a weakening rupee, rising hedging costs and unfavourable global market conditions continuing to undermine returns from the country’s debt and equity markets.

Undoubtedly, the Reserve Bank of India’s (RBI) latest 25-basis-point increase could offer some support to the currency and reinforce confidence in its monetary policy.

But investors are likely to remain cautious unless the move is accompanied by clearer signals of further tightening and an improvement in global financial conditions.

A recent Reuters report notes that foreign investors have withdrawn a record US$30bil from Indian equities as at last week, while debt flows have turned negative since the beginning of September.

The latest rate increase may slow the pace of withdrawals at the margin, but reversing the trend will be a much bigger challenge, the newswire reports.

“It’s a good start. But is it enough? Probably not,” Carl Vermassen, a portfolio manager with the emerging markets fixed income team at Zurich-based Vontobel, tells Reuters.

“The central bank should have been more hawkish to alleviate the pressure on the currency.”

The RBI’s decision has done little to ease pressure on the rupee, which has become one of Asia’s worst-performing currencies year-to-date. The currency continues to weaken despite last Wednesday’s move by the RBI.

The bigger concern for overseas investors is the rising cost of protecting their investments against further currency losses. According to Reuters, one-year hedging costs surged by more than 60 basis points last week following the rate decision, further eroding the returns available from Indian assets.

Sat Dhura, portfolio manager at Janus Henderson Investors, which manages US$500bil in assets, says the rate increase could help slow withdrawals slightly by strengthening confidence in the central bank’s policy credibility.

“The hike may slow outflows at the margin by reinforcing policy credibility, but it is unlikely to reverse them on its own.”

“The direction of flows will continue to depend more on US yields, US dollar, oil prices, earnings and valuations than on a single 25-basis-point move,” Dhura adds, noting that the decision had not prompted his firm to start buying Indian stocks.

This leaves the RBI facing a difficult balancing act, Reuters notes. Higher interest rates could help support the rupee and make local assets more attractive, but effectiveness of monetary tightening will depend partly on developments beyond RBI’s control.

Narrowing yield advantage

One of the main challenges is India’s shrinking interest-rate advantage over other major economies, particularly the United States.

The premium offered by India’s 10-year government bonds over comparable US Treasury and German Bund yields has fallen to its lowest levels since 2004 and 2009, respectively.

Meanwhile, the gap between Indian and US policy rates has narrowed to a record low.

That makes Indian debt less attractive to foreign investors, especially when the rupee is weakening and hedging costs are rising.

Reuters has reported JP Morgan chief India economist Sajjid Chinoy as saying: “Very tight differentials could consistently pressure the exchange rate which, in turn, would have some implications for the domestic inflation outlook.”

With the central bank focused on domestic economic conditions under its inflation-targeting framework, the rupee could continue to bear the brunt of external pressures, he says.

Ajay Marwaha, head of fixed income at wealth manager Nuvama Group, says uncertainty over the currency’s stability and higher hedging costs would continue to weigh on the appeal of Indian equities.

“Lack of visibility of stability on the Indian rupee and a higher cost of hedging will mean that Indian equity assets will continue to be relatively less attractive,” he tells Reuters.

For bond investors, higher global bond yields and the narrowing interest-rate differential with the United States remain additional concerns, Marwaha adds.

More tightening ahead?

The RBI’s decision has broadly been viewed by economists as appropriate for India’s domestic growth and inflation conditions, with price pressures still driven by energy supply disruptions and higher food costs.

Inflation remains above the central bank’s 4% target, although it is still within its tolerance band of 2% to 6%.

The RBI says the second-round effects of higher food and fuel prices remained limited.

“While there is some evidence of elevated inflation expectations and generalisation of inflation, there are limited signs of supply side pressures getting embedded in pricing behaviour,” it reports.

However, further tightening could be needed if the rupee remains under pressure and imported inflation becomes a bigger concern.

State Bank of India chief economist Soumya Kanti Ghosh expects the RBI to raise rates by another 50 basis points in December.

He also sees merit in increasing the marginal standing facility (MSF) rate, an overnight borrowing facility for banks.

A higher MSF rate could push money-market rates upwards, improving the returns available from holding rupee-denominated assets and potentially making Indian debt more appealing to foreign investors.

Ghosh also favours cutting taxes for long-term foreign equity investors, following a tax reduction for overseas investors in debt earlier this year, according to Reuters.

Still, the RBI may have to tighten monetary policy more aggressively than domestic economic conditions alone would justify if external pressures persist.

“Higher developed-market yields and a stronger dollar constrain emerging-market central banks through currency weakness, imported inflation and capital outflows, even where domestic conditions might otherwise justify easier policy,” Dhura says.

For India, the coming months will therefore test whether higher interest rates can provide enough support to the rupee to improve investor confidence, or whether persistent global headwinds will continue to draw foreign capital away despite the RBI’s efforts.