Trading desks should prepare for much lower liquidity surpluses: B Prasanna

Expects rupee to trade in the range of 78-80 per US dollar in the near term because of still relatively weak BoP fundamentals

The recent sharp decline in surplus liquidity in the banking system could have been by Reserve Bank of India’s (RBI’s) design as it seeks to push up short-term money market rates and ward off speculation against the rupee, says B Prasanna, ICICI Bank’s head of global markets. As the three-day Monetary Policy Committee (MPC) meeting kicks off, in an interview to Bhaskar Dutta, Prasanna says with the central bank moving towards the removal of accommodation, trading desks should prepare for more frequent episodes of liquidity tightness. Edited excerpts:

Q. There has been much commentary, including from within the RBI itself, of rate hikes being front-loaded in the current tightening cycle. How much of a rate hike are you expecting in the August policy and what is your expectation for the terminal repo rate?

A. Global central banks have front-loaded rate hikes on account of persistent inflation driven by rising commodity prices, higher aggregate demand, as well as supply-side distortions. The US Federal Reserve (US Fed) is at the forefront with two large-sized hikes of 75 basis points (bps) at its last two meetings. The European Central Bank (ECB), too, played its part by hiking by 50 bps in July as against the expectations of 25 bps.

Most central banks have been busy hiking rates, but going forward are likely to adopt a normal pace amidst the recent peaking of commodity prices and fears of a global slowdown/recession.

In India, too, upside risks to inflation seem to be abating with consumer price index (CPI)-based inflation likely to stay in the 6.7-7.3 per cent range in the next two quarters and fall below 6 per cent in the fourth quarter of financial year 2022-23 (Q4FY23) leading to a more dovish outlook for monetary policy.

Concerns around a worsening current account deficit and a steep rate hike path of the US Fed, could weigh on the policy decision. We feel that a 50-bp hike is ideal for the RBI to do while what it might end up doing is a 35-bp hike. This could be on account of the recent softening seen in the dollar. We, however, expect a terminal repo rate of 6 per cent.

Q. The RBI’s actions in the foreign exchange market have contributed to a sizable shrinking of the liquidity surplus in the banking system and higher money market rates. We are approaching the festive season during which there is a natural tendency of currency leakage. Should trading desks start pricing in lower liquidity?

A. We have definitely seen liquidity tightness in the last couple of weeks as the RBI has lost reserves in a bid to defend the rupee. At the end of June, the banking system liquidity surplus was at around Rs 2.7 trillion, which fell to Rs 89,500 crore as on July 28. Most of the drainage has happened due to RBI’s forex interventions as seen in reserves, which fell to $571 billion as on July 22, from $ 593 billion at June-end.

However, what is surprising is that the RBI has not been proactive in easing tightness in the system through measures such as the Variable Rate Repo (VRR). So, now there is definitely a possibility that this liquidity tightness could be by design and not due to frictional liquidity. Keeping the short end of rupee rates elevated to keep short rupee speculators at bay is a valid objective and the RBI is also possibly incentivising banks to borrow more in dollar terms.

However, given the large government-borrowing programme this year, it would be difficult for auctions to go through if liquidity remains tight and, hence, it remains to be seen if the RBI continues with this kind of ‘stealth tightening’.

Nevertheless, treasuries should definitely prepare for much lower liquidity surpluses going forward and more frequent episodes of liquidity tightness, given that the central bank is on a path towards removing accommodation.

Q. To what extent would the RBI’s fresh moves on liberalising forex bring in flows to the Indian markets? On the ground, do you see a significant shift towards internationalisation of the rupee after the additional measures to permit trade settlements in the local currency?

A. It is definitely a step in the right direction, though there is a long way to go. Since the RBI has waived the statutory liquidity ratio (SLR)/cash reserve ratio (CRR) requirements for foreign currency non-resident accounts (FCNR) and non-resident external rupee (NRE) deposit liabilities, we expect banks to push these products with their offshore customers. Though the onshore rates are still cheaper than the landed cost of these offshore deposits, we expect some inflows in the medium term.

Additionally, some of India’s trading partners would definitely welcome trade settlements in the rupee and this could lead to greater acceptance of the INR for international settlements, especially if importers are encouraged with financial incentives. More significant changes, however, are needed on the INR’s capital account convertibility, like inclusion in bond indices, before we can aspire to true internationalisation of our local currency, but we do think that the government and the RBI are proceeding towards that goal with calculated, measured steps.

Q. After considerable volatility in July, the rupee has to a certain extent stabilised against the US dollar. What is your outlook on the currency, given that the US Fed's tightening plan is far from over?

A. We think the current stability in the INR against the USD is emanating from a less hawkish outlook for the US and developed markets rates — both the US and the EU are facing the risk of a recession and the US Fed in its latest policy was less hawkish than expected.

However, amidst elevated energy prices, India’s current account deficit (CAD) is likely to deteriorate further — we are currently estimating CAD at around $110 billion (3.2 per cent of GDP) and a balance of payments deficit of $40-50 billion.

Though India has witnessed a slowdown on foreign portfolio investment (FPI) outflows and, in fact, a marginal inflow for last week, we are yet to see a significant change in global sentiment toward EM (emerging market) flows. Given that INR rates are still lower than hedged USD rates – most top-rated Indian corporates are also facing a challenge in this global macro backdrop.

RBI, however, has substantial reserves ($572 billion) to counter any sharp volatility in the local currency. Hence, against the changing view on the DXY (dollar index) and less hawkish outlook on global rates, but still relatively weak BoP fundamentals for the INR, we expect the rupee to trade in the range of 78-80 per US dollar in the near term.

Q. As the RBI has pointed out, certain high-frequency indicators suggest that growth is holding up despite global headwinds. How sustainable is the recovery in your view?

A. In FY23, India’s growth would be led by a strong revival in the services sector. This is visible in all service-related high-frequency indicators such as air and rail passenger traffic as well stamp duty collections.

While a favourable monsoon would be a positive for agricultural growth, the manufacturing sector would face lower thrust from exports due to the global slowdown while on the other hand incremental margins can get better due to falling commodity prices.

On the demand side, higher capital spending by the government and a higher capacity utilisation of the private sector would lead to a higher investment-to-GDP ratio at 33 per cent versus 30.5 per cent in FY21. Overall, we expect GDP growth to moderate to 7 per cent in FY23 from 8.7 per cent in FY22.

Q. From the perspective of trading positions in the bond market, how challenging was it to navigate the last couple of months, given that the RBI took markets by surprise with the rate hike in May. Where do you see the 10-year bond yield over the medium term?

A. With the surprise rate hike by the MPC, it has indeed been challenging for fixed income and foreign exchange markets. More than the surprise hike, it was the CRR hike that front-loaded the liquidity tightness and showed the intention of the RBI to arrive at neutrality faster that led to the re-pricing of the so-called safe short term ‘carry’ assets.

Advanced economies have been reporting very high inflation numbers as well, which have been surprising on the upside, while volatility in commodity markets have added to the uncertainty.

While markets were broadly anticipating rate hikes, the pace and the quantum of rate hikes did catch the market by surprise. We expect the 10 year G-sec (government security) to trade in the 7-7.50 per cent range in the medium term.

Q.  Which part of the bond yield curve holds value at the current juncture?

A. We would recommend the five-year point for most investors, given that it is medium duration, and even with an expectation of a terminal repo rate of 6 per cent, it would still give an adequate yield compensation of 1 per cent.

The five-year OIS (overnight indexed swap) at 6.3 per cent means that the five-year bond has a reasonable supply/fiscal yield premium built into it. For investors with a preference and requirement for higher duration, we would recommend the 14-year bond, which yields 25 bps higher than the benchmark 10-year bond, given that the curve really flattens out in even longer maturities when the rate cycle reverses.

Q. What is your reading of the fiscal situation? Goods and services tax (GST) trends seem optimistic, but the Centre has taken on a larger fertiliser subsidy while reducing excise on fuel. Are you concerned about extra borrowing?

A. In FY23, all major subsidies namely fertiliser, food, and petroleum are expected to exceed Budget estimates. On the revenue side, the government has also increased import duty on gold, export duty and domestic cess on petroleum. These, alongside robust GST collections, have cushioned the loss in excise duty collections from lower excise duty on petrol and diesel.

While the government should broadly meet the target of fiscal deficit at 6.4 per cent of GDP, we expect the fiscal deficit to be higher than the Budget estimate in absolute terms by around Rs 1 trillion purely on the back of a higher nominal GDP outcome. This, along with the small risk of actual fiscal slippage, could continue to be a negative overhang for bond markets till the government reveals its final borrowing figures in the second half of the fiscal.