Rupee won't go into free-fall even if CAD widens to 3-3.5%: BoA's Mehta

RBI needs to be fourth buyer in the bond market, says senior executive

India has enough foreign exchange reserves to ensure that the rupee holds its ground even if the current account deficit were to triple this financial year, said Jayesh Mehta, Bank of America’s India country treasurer, in an interview.

India reported a current account deficit of 1.2 per cent of the gross domestic product in 2021-22 (April-March). The widening import bill has caused the rupee to test new lows against the US dollar.

“We believe, the forex reserves being where they are, even if we were to have a current account deficit, which is around 3-3.5 per cent, we will be able to manage the situation and the rupee will not go into a free-fall,” Mehta told Bhaskar Dutta.

What follow are edited excerpts from the interview.

What is your view on the trajectory of the rupee?

Our thinking is that it’s not about the rupee weakening as much as dollar strengthening. Because of that every currency is struggling. Having said that, we should not become complacent. The dollar index is mainly against developed market currencies, which are not doing well while emerging markets are doing a lot better.

They are also much better placed than the previous taper tantrum days in terms of reserves. RBI [Reserve Bank of India] has been especially proactive.

From that perspective, we should not be too worried about the rupee.

If the dollar continues to strengthen, then, of course, the emerging market currencies, including the rupee, would be impacted. We believe, the forex reserves being where they are, even if we were to have a current account deficit, which is around 3-3.5 per cent, we will be able to manage the situation and the rupee will not go into a free fall.

By when could we expect the overseas flows to materialize, after the RBI’s steps to further liberalise the forex market?

You need some time to gather FCNRB [Foreign Currency Non-Resident Bank (B) account]. To do that, you have to either keep the forwards sustainably down or you have to announce an auction for a buy-sell swap. FPIs are market players, and they are watching this. The moment they see that the forward points have come off, even during the day, they can invest. They are all set up.

Basically, FPIs need to make some 1.15 per cent arbitrage after their borrowing cost and hedged cost.

Their hedged cost will come down only if the forwards come down. So, if the forwards are at money market rates, then there is no arbitrage. Here, we are not talking about the real money FPIs but the arbitraged FPIs which can come in. It is, of course, not a real net inflow because they are short-term players, but at least the short-term dollar requirement can come down.

When these FPIs come in, or even the FCNRB, it’s not a net inflow for the country; it is an inflow with an outflow which is already set. It’s a zero-sum game. But, at least, on a spot basis, we are getting dollars immediately.

Was the bond market prepared for the turn in the rate cycle and the pace at which the RBI has acted since May? What is your expectation for the terminal repo rate?

In terms of market expectations, foreign investors are expecting the terminal rate to be around 7.50 per cent. The local houses are looking at 6-6.50 per cent while we have a more benign view; maybe, 5.50-5.75 per cent for the terminal rate. The RBI Deputy Governor has repeatedly spoken about front-loading the rate. We think the RBI would front-load it, maybe, till August, and then see how things pan out globally.

That was one of the reasons why they (RBI) hiked the rate in May, instead of waiting until the June policy.

Of course, the sharp rate hike on May 4 came as a surprise and people started pricing in the possibility of the repo going to 5.50% in a very short span of time, maybe in three months. That would have been around 125-150 bps of rate hike in that period, something market participants expected to happen in seven to eight months.

Everyone thought there would be a calibrated shift. But in view of the Russia-Ukraine war, which broke in February, and the next policy right after that in March, the RBI had hinted at moving either way.

In hindsight, I think what everyone in the market missed was the palm oil export move by Indonesia, which upped food inflation in India and came as a bit of a shocker. Barring crude and coal, all other commodities including palm oil from that time have come off. There have been coal shortages globally and crude has been volatile due to geopolitical disturbances.

Moreover, the trajectory of these two commodities is unknown and monetary policy cannot do much about it. From that perspective, I don’t really see the RBI chasing rate hikes too aggressively. And, I think we have, more or less, seen the worst of inflation.

Having said that, this is geopolitics. Can crude go to $150? That’s unknown. But we should be fine if it remains in the $100-130 range per barrel.

Amid the rate hike cycle, where would you see the 10-year bond yield over the medium term, say, by the end of 2022?

As a firm, we firmly believe, there will be a fourth buyer in the bond market. That fourth buyer could be FPIs, although it doesn’t look like that at this juncture unless certain things change dramatically.

Otherwise, the RBI needs to be the fourth buyer.

When we say fourth buyer, basically we refer to the large supply of government bonds and almost 100% of borrowing covered locally. We have insurance companies, some mutual funds, banks and provident fund trusts, but their participation is not very large. The total of their requirement is less than the supply coming in. Therefore, we need a fourth buyer – either the RBI or FPIs.

The RBI, at some point of time, will have to look at it. How, when and what, we will have to see. Maybe, they could carry out Operation Twist and take the duration out of the market. From that perspective, though we are bullish on the policy rate, we are not so bullish on bonds at the moment.

If we look at 7.40-7.45 per cent yield on a 10-year bond, it’s a great rate to invest in from a medium-term perspective because inflation is going to come down. But because of the demand-supply mismatch, till the time the fourth buyer comes in, for the next couple of months, people will try to test around 5 basis points higher at every auction. So, technically, can we go to 7.75-8.00 per cent?

Maybe, but would the yield stay there? The answer is no.

From our point of view, the bigger point is the demand-supply mismatch in the market irrespective of the Russia-Ukraine war. It has been there since February, from the time the Union Budget was announced.
 

Which part of the sovereign yield curve would you recommend for investors at the current juncture?

It depends on whether you are a retail investor, a medium-term investor or a saver. We would still look at the longer end as being better: 7.40-7.50 per cent is great. Of course, you have to see your own investment plan, whether directly through the retail platform or as a tax-paying entity; maybe, mutual funds would be better.

Purely from a rate perspective, we would say that if you are investing, start now so that if there is any peak in the yield, you can never catch the peak and for medium-term investors last 25-30 bps should not matter.

Are there signs of the bond market showing fatigue while absorbing the government’s record-high borrowing programme? A portion of a recent sovereign debt auction landed on the books of underwriters.

In the recent auction, the devolvement for the floating rate bond (FRB) had more to do with a demand-supply mismatch for that product. Even though we don’t have a developed market for FRBs, investors still went for it mainly because of rising interest rates. When the RBI saw the demand, they gave such a huge supply of FRBs--Rs 84,000 crore plus Rs 4,000 crore every fortnight.

But the absorption capability is just not there in the market. What the apex bank did in the last auction was to devolve in a way to show that they were not comfortable with the yields demanded by the market.
 

From a trading perspective, is the short end of the government bond yield curve still looking risky to you, given the likelihood of more rate hikes by the RBI?

Yes. We think a lot of people have burned their fingers already. In terms of market positioning, people lost a lot of money on the short end because they were expecting calibrated moves from the RBI. We do not think there is enough risk appetite at this point. Again, the short end depends a lot on the rate hike trajectory. While we are expecting it (repo) to be 5.50%, others feel 6-6.25%. We don’t know where it settles.

The short end is more vulnerable than the long one, but 6 per cent rate is priced in.

How is the second half of the fiscal year looking to you? Are you concerned about the government having to borrow more?

Not really. I think, there was an expectation of around Rs 2 lakh crore extra because of the conservative Budget announcements on the tax front. Maybe, the extra subsidy would come to around Rs 1 lakh crore.

Or, with the current GST regime, we could be surprised on the upside.

Purely on a fiscal deficit-to-GDP basis, we will be able to manage with what the Budget has said.

Perhaps on a notional basis, we may shoot up a bit, but it all depends on where the cycle is. In the second half, from September, I do expect the RBI to support the bond market.

The RBI has over the last few months significantly increased its currency market interventions in segments such as forwards while announcing measures to bring back foreign capital. How have you handled the volatility in different market segments?

The RBI has taken two important enabling measures.

One is the circular enabling a lot of short-term borrowing and investment by way of FPIs, FCNRB and ECBs. All these are enablers and not measures that would attract capital on their own and this links to the forwards. If that cost, plus the forwards, are below the money market, then people can do arbitrage, pulling in the money.

In market operations, if the RBI wants to, it can bring the forwards down through the swap window; through a buy-sell swap, instead of a sell-buy swap. The apex bank can do it through an auction or in the market. The RBI can bring down the forwards by selling and creating arbitrage opportunities, and that way people will come in. However, they would do it only if required, which is why we think, it’s more of an enabler. The RBI need not come out with a separate policy window as was done in 2013 for the FCNRB scheme with a special concessional window by the RBI.

Two, the rupee invoicing, which was always there. Only thing is that the RBI has now allowed the balance in a Vostro account to be invested. We think this can have an effect immediately.

At what point would yields on government securities be attractive for real money FPIs?

Some sovereign funds--in fact, a few real money players--are investing regularly in government securities, and they are still doing it, but we don’t see those players coming en-masse till India gets into a global bond index. That is a difficult choice at this juncture. As far as India is concerned, we have provided many enablers – FAR (Fully Accessible Route) has been done, Euroclearability has been approved, but there is a tax issue.

Our view is that the issue of long-term capital gains doesn’t get enough revenue anyway. Every third or fourth year, we have banks asking for relaxation on HTM. So where is the gain? A major part of fixed income is actually made on the coupon.

So why make an exception only for foreign investors? Make an exception for everybody.

Remove the LTCG tax on government bonds for domestic as well as foreign investors. Not for everything, only for government securities including state government bonds.

One may say from a government perspective, that revenue versus savings and cost is one and the same, but it does get you a much wider investor base.