Indian fifty and ten rupee banknotes are arranged for a photograph in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

Rupee Bearing The Burden Of Balance Of Payments Adjustment, Says Credit Suisse’ Neelkanth Mishra

India’s Monetary Policy Committee left interest rates unchanged at its latest review on Oct.5. The decision, based on an assessment of domestic inflation in line with the committee’s mandate, rattled the currency markets.

That’s because higher interest rates may have, to some extent, helped bear the burden for an adjustment in India’s balance of payments. With the MPC choosing to hold rates steady, that adjustment will continue to happen through the route of a weakening currency, said Neelkanth Mishra, chief India economist & strategist at Credit Suisse in an interview with BloombergQuint. With currency weakness likely to persist, Mishra is not surprised to see the selling in equity markets where foreign investors would choose to exit and, perhaps, re-enter at a later stage.

While the MPC did not draw a link between its interest rate decision and the ongoing strain in the domestic non-bank financial services industry, Mishra acknowledged that concerns about domestic financial stability may have been one consideration at play in the rate decision.

Edited excerpts of the interview below:

Rupee & The CAD Adjustment

What did you make of the status quo on interest rates from the MPC and the reaction in the currency markets?

There was a discussion happening in the run-up to the MPC meeting that the committee’s mandate is only inflation. Governor Patel was the chairman of the committee which drafted the mandate. There were views that they will only think of the mandate. There are other agencies looking at other aspects of economy and that the MPC, given its legislative mandate, should be looking at inflation. This is what was explained in the post policy press conference as well.

From that viewpoint, what they did was right. But it puts the burden of the balance of payments (BoP) adjustment completely on the currency, which can be destabilizing.

The adjustment that the economy needs to make right now is of its balance of payments. There are 3-4 ways of doing it. First is to weaken the currency. Everything becomes expensive. But the government has slowed down that process with the latest decision to cut auto fuel prices. If domestic fuel prices don’t rise, then the demand adjustment doesn’t happen and the BoP deficit then rises on.

The second way to deal with the BoP is to hike import duties, which was attempted on a very small set and I don’t think it makes bigger difference.

The third is you slow down aggregate demand. Sometimes that can be counterproductive. It can slowdown the activity of exporters and it can worsen your balance of payments problem. It is not an advised technique but given the size of the BoP adjustment we need to make, it may need to be considered.

In March, when we started worrying about the rupee, we thought that BoP deficit was $20 billion. Even before oil prices went to $85/ bbl in the last three months, for which we have data, the annualized BoP deficit was $40 billion and now that oil is at $85/bbl, it could be $50 billion. That’s nearly 2 percent of GDP worth of adjustment which needs to be made.

If only the currency has to bear it, and that to at a time when transmission mechanism of pricing is not going to work for petrol and diesel because elections will be on calendar for next 6 months, I am not surprised that the currency market panicked.

The commentary suggested that the RBI is comfortable with the adjustment in the Rupee. Earlier, government officials suggested they were ok with a weaker currency. Can that feed into market expectations and lead to a spiral for the currency?

Yes. The difference between market like equities where you have earnings or a book value or a cash flow that you can value something against, a currency has no anchor. It is what the crowd believes. If the crowd panics, then it starts to create some damage. So long as the depreciation is controlled, and no one is saying ‘fire’ in crowded hall, then the adjustment can happen, and it had been happening, without too much damage. There have been instances of importers hedging indiscriminately and of exporters reluctant to bring back dollars. But the 2013-type phenomenon where people were being sold ridiculous products by banks etc, that kind of activity has not happened so far.

I hope panic does not set in currency market. Because now, the adjustment mechanism seems to be only the currency.

So with no help from the fiscal and monetary side, the currency will continue to bear the brunt?

On the fiscal side, the government said that they will maintain their fiscal deficit target. Despite the disappointment on GST in the last two months, fiscal deficit wise we are okay. The problem I have is with price transmission not happening in petrol and diesel prices. See, the only way you can curtail demand is by raising prices so that people buy less cars and motorcycles and they start carpooling.

We have to worry about the impact of the J-curve. Even as the rupee falls, in first few months the trade deficit or CAD widens. The Indian economy has changed so much in the last 30-35 years that I haven’t seen a reasonable economic study quantifying the time over which a worsening of the trade deficit happens. It is very hard to say how much the J-curve is in action or if the currency needs to fall more.

The wider current account deficit is coming at a time when capital flows to fund that deficit have also slowed. Will we need extraordinary measures like the FCNR scheme of 2013?

There is a longer term issue here – part of it is India specific and part of it is global. As a percentage of GDP, our capital flows are at 2002 levels. Even if there is a cyclical rebound and we have foreign portfolio inflows, the maximum amount of capital you can get is $80-85 billion which is not enough to fund the current level of CAD.

There has been a cyclical decline of capital inflows for every country in the last 8-10 years. There was spike at the time of QE (quantitative easing) but after that there has been a very steady decline in almost every country.

There are multiple factors behind why it has slowed. The countries exporting or deploying capital are the countries which have a current account surplus. Different countries deployed differently. If you are an oil exporting country from West Asia, generally you are a small country and there is not much of strategic interest. It is like saving for the future, so you put it into a portfolio investment and give it to portfolio manager to manage. If you are Japan or China, you try to do something strategic with it. In case of Germany, the surplus accumulates with banks as corporates put their savings in bank and then banks give loans. If the countries which have surpluses deployed into portfolio investments come back or say China’s insurance funds become very big in international markets, then possibly the flows will come back. But right now, it is not happening. So, you cannot expect that to happen.

The FCNR (Foreign Currency Non Resident Deposits) option which has been considered and debated, it only kicks the can down the road. It is to be used when the liquidity problem is turning to a solvency problem. So, when people start raising questions and there is indiscriminate hedging, you can use it to stall a stampede. It is not meant to solve the problem.

The problem is that, on a sustainable basis, the capital flows are not coming and the CAD is higher than the sustainable flow. So, you either bring down CAD or you raise sustainable capital flows. So if you find that your CAD is $100 billion and you have sustainable capital flows of only $50-60 billion and you raise $40 billion in FCNR deposits, it will solve your problem only for 3 months. But the investors will get jittery again soon.

The NBFC Strain

Could the status quo on rates have been driven by the strains in the domestic financial system and NBFCs?

That could have been one consideration. Lets understand what lead to ALM (asset liability mismatch) problem in NBFCs? It was that, as a system, we lost control of bond yields. If you have a term-premium which is at a record high, where the 10-year bond yield goes up by 150 basis points but the repo rate doesn’t change, it is natural that people who are seeking funding will go there, so long as rating agencies are not looking at duration risk.

That gap between the overnight rate and long term bond yields is still very wide. We need to bridge that gap. Despite the fact that the RBI is conducting open market operations now, the 10-year bond yield is not coming down.

So, the stress in NBFCs could have been a driver. It is hard to judge unless it is stated as to what may have been the mindset behind it. The problem is liquidity. RBI was clear that we provide liquidity. Rs 36,000 crore a month is lot of liquidity. It could have been the reason. It is hard for me to say it was.

What is the degree of strain in NBFC space?

If you see the markets in the last 20-25 years, there have been phases where NBFCs have grown very rapidly and then a very large number of them have disappeared.

There are issues on multiple fronts. There are some issues which are specific to few companies but they are not systemically important. It was a gold rush. So, anyone was starting an NBFC and was getting funding, which is great for financial innovation. These kinds of booms are sometimes good for the economy. But now when everyone is scrutinizing the NBFC exposure in mutual fund before putting in money in bond fund, it is creating incentives for bond fund managers to not buy NBFC paper. Banks which were unable to lend were shooting from the shoulders of NBFCs, saying go and lend to them. They have said that they will not do so now.

For some of the smaller NBFC there is going to be no option to survive. The good thing is that, systemically  it doesn’t matter. It hurts those firms, which is fine.

All this has happened within 2-3 week so it looks like a crisis, but it is not. It is repricing. If you move from short term to long term funding, the liability cost will be 1 percent and your earnings fall by 20-30 percent and you can’t beat banks as you have to go borrow from banks. So, you can’t grow fast and multiples come down. A stock being beaten down by 30-40 percent looks huge, but it is easy to understand. It doesn’t mean there is a crisis.

There are some red flags to watch.

The commercial paper market on the non-NBFC side is starting to look liquid again. There are people borrowing and transactions are happening. I don’t think it is freeze. But there is reluctance in lending to NBFCs. There have been concerns around the loan against property (LAP) markets. Some of the better known NBFCs have withdrawn from it and reduced their exposure. Some of them stepped up the exposure to the LAP segment as it was the easiest way to grow their loan book. Some people have gone into unsecured SME financing and grown books rapidly. It is very hard to say whether those loans are good.

Everyone thought that CIBIL was a great point of discipline but it does not give assurance as it has no income linkage. You don’t know whether the income is growing or borrowers are rotating loans from one place to other. There are also issues with specific NBFCs with developer loan books. Easy liquidity was allowing them to hide it but as liquidity dries up, you will see who is exposed. That is the risk which is not quantified yet and it is making people jittery. The objective is to quantify that risk so that everyone knows where the risk lies. Right now, no one knows who holds which company’s papers. Once you have done it, the problem is easier to understand.

But growth for NBFCs will be impaired for a while. The assumption that people made that some of the NBFCs can have Rs 2-3 trillion in assets will be challenged. You can’t be wholesale funded and have such large asset books.

Will it impact the flow of financial resources to the economy?

It will impact the flow of financial resources. See, SME financing, it slowed. If NBFCs are not going to get liquidity, then that financial flow slows.

The banks need to have products to pick up that business, which they don’t right now. Cost of funding was one reason but, in many cases, banks were lending to NBFCs because of an absence of products.

Till 5-6 years back mortgages were only available to salaried people. Now, non-salaried people were getting mortgages. That was innovation. You can do loan against property and there were other types of innovative products being introduced. I don’t think banks will do that.

Now, the lending has to be done by the 3-4 banks which are standing. If there were five buckets – large PSU banks, other PSU banks, the private corporate lenders, the private retail lenders and NBFCs – of these NBFCs and private retail lenders were growing, along with the larger PSU bank. Now, suddenly even the NBFCs have gone. So, banking system capacity is constrained. There will be problem in availability of financing.

Equity Market Correction

Have you been surprised by the current equity market correction?

No. For foreign portfolio investors, 80 percent of their holdings are in the top 60-70 stocks. They hold 27 percent of top 50 stocks. They own 60 percent of the free float of those 50 stocks. Domestic shareholding is a lot more in the smaller stocks.

In the Nifty and BSE 100, there is a significant amount of dollar revenue exposure. If the rupee weakens, it is good for them. Analysis has shown that after the steep rupee fall, 12 months after it, the Nifty is higher.

Right now, foreigners are going out as they think the rupee will fall. If you see the nature of the decline, it is someone basket selling out of India. While NBFCs have been incrementally part of funding, but it is not a structural problem. People view India as a structural growth story, as it should be. Many good things happening — the tax-to-GDP ratio is up, inflation is moderate, so on and so forth.

So when I see a large number of stocks down by 3 percent, we think it is basket selling happening. It happens because they worry about a sharp decline currency and want to front run it. They say if it stabilizes, we will be back.

The problem will be much more prolonged one in the tail, as it is funded by domestic investors. Once the panic sets in, then it is hard to find buyers and they are very concentrated holdings. I will be concerned about those names.

Domestic flows are already getting tested. Most of the small, mid cap funds are down 18-20 percent year-to-date. Many of broad-based funds have underperformed the index. So, there is risk aversion. The whole cycle is starting to play out and it may not end quickly.

Also there is global uncertainty. The escalation of issues between U.S. and China, the trade wars are now getting serious, there are fiscal issues emerging in Europe and it is driven by politics. Those are the things which adds layers to de-risking from a global perspective.

Watch the full conversation below: