MUMBAI: India’s currency and government bond markets are likely to remain under pressure over the coming months as elevated crude oil prices, sustained foreign capital outflows, and high global bond yields weigh on sentiment, treasury heads of several banks said on Monday at the Business Standard BFSI Insight Summit.
While recent measures by the Reserve Bank of India (RBI) may help contain volatility and provide some breathing room, a durable improvement would depend on a moderation in oil prices and a recovery in capital flows, experts said.
India’s dependence on imported oil makes the rupee particularly vulnerable to a sustained rise in crude prices, while global investors’ preference for artificial intelligence (AI)-related investments has contributed to outflows from Indian equities.
The Indian crude basket was estimated at around $120 a barrel, one treasury head observed. Foreign investors have pulled out nearly $60 billion from Indian equities over the past two years, including close to $10 billion in the past two months, experts said.
“There are several factors leading to the rupee’s weakness. Global oil and energy prices have stayed high for longer than most people expected. Since we are, of course, a very large importer of oil and energy, this affects us negatively. Second, while India has run a current account deficit in the past, I think our capital account has remained positive and has financed this deficit. But at least over the past couple of years, we have seen a lot of global funds chasing the AI story. Because of that, we have seen large outflows from foreign portfolio investments in India,” said Aditya Bagree, head of markets, Citi India and the Indian subcontinent.
He explained that foreign currency non-resident (bank), or FCNR(B), deposits had exceeded market expectations, giving the RBI additional firepower to manage the rupee’s depreciation. However, he said, these inflows only bought the country and the central bank time, as the funds would have to be repaid within three to five years.
The changing hedging behavior of importers and exporters, who are increasingly anticipating a depreciation of the rupee, has also played a role, he added.
On the RBI’s foreign exchange risk reserve (FERR) measure to contain rupee volatility, Arup Rakshit, group head of treasury at HDFC Bank, said it was making imports and hedging more expensive. “Initially, when FERR was introduced, hedging continued because, if the rupee appreciates by 2 per cent, the cost of FERR is not equivalent to that 2 per cent. So, obviously, if the budget allows for it, importers will continue to hedge. Some of the potential speculation has gone out of the market. But as the currency stabilises, some of the demand may no longer be there,” Rakshit said.
He added that demand could decline as the next trade cycle begins, potentially reflecting the impact of FERR.
The rise in US government bond yields has also made conditions more challenging for emerging markets (Ems), treasury heads said. While higher US yields in the past were often driven by stronger growth expectations, the latest increase has been accompanied by concerns over fiscal conditions and rising risk premiums in developed markets.
Parul Mittal Sinha, head of markets for India and South Asia and co-head of macro trading for Asia and South Asia (ASA) at Standard Chartered (StanChart) Bank, said the 10-year US Treasury yield had reached the psychologically important level of 5 per cent. “In this environment, the impact on emerging market economies is negative because the risk premium that investors start demanding, or are getting, in developed markets is also what they start demanding in emerging markets. That is where the impact on currencies in EMs starts becoming more negative,” Sinha said.
Treasury heads were divided over the outlook for the 10-year Indian government bond yield.
Some experts said it could move towards 7.75-7.8 per cent over the next three to six months if current conditions persist, while another expected it to remain within a narrower range of 7.4-7.6 per cent.
Tighter liquidity and the possibility of further interest rate increases are also likely to influence the trajectory of yields.
Comparing the current FCNR(B) deposit mobilisation exercise with that of 2013, Shailendra Jhingan, head of treasury and economic research at ICICI Bank, said the interest rate differential between India and the rest of the world had been considerably wider at the time. The measures had also been introduced after several other steps had already been taken.
“This time, we are in a different world. US interest rates are already very high, and oil prices have risen recently. So the environment has suddenly become a little more challenging. The point is that FCNR(B) did not change the fundamentals even in 2013. It should be seen as something that buys you time. Last time, what changed was that oil prices started coming down and conditions in the current account began to improve. Capital flows also started picking up. Ultimately, those are the factors that matter. FCNR(B) is not going to change the outlook for the rupee permanently,” Jhingan said.
Jhingan cautioned that large-scale AI-related borrowing was putting additional strain on dollar liquidity. “There is a scarcity of capital that is affecting capital flows around the world, and India is also facing that challenge. AI is a bigger challenge than even oil prices in today’s world,” he said.
Sinha, however, said the scale of FCNR(B) inflows had surprised everyone, demonstrating the strength of the Indian economy’s fundamentals. India had managed to attract dollar inflows even as global investors competed for dollar funding, she added.
“There were three factors hitting India simultaneously over the past few months. The first was the US tariff story, which was completely unexpected. Then came oil, the war and the conflict in West Asia. The third was the AI story, or the lack of it for India. These three factors have combined. If one or two of them are resolved over time, we will see sentiment towards Indian markets improve,” Sinha said.
Foreign investment in government bonds may take time to recover, experts said. Expectations of further interest rate increases in the US and relatively attractive yields in developed markets could limit immediate inflows. The interest rate cycle would need to stabilise before a clearer picture emerges.
The discussion also highlighted the challenges banks face in managing interest rate risk as a growing share of loans is linked to external benchmarks, while deposits tend to carry fixed interest rates.
“Sixty to 65 per cent of loans are now linked to external benchmarks, largely the repo rate. Of course, there will also be some repo-linked exposures. Deposits mobilised by banks, on the other hand, tend to carry fixed rates. That creates a challenge that can sometimes be very difficult to manage. The fact is that the only product available for hedging that is liquid and sees substantial trading volumes is the overnight index swap (OIS). But OIS is not a perfect hedge for repo-linked exposures,” Jhingan said.
Treasury heads also discussed the potential for tokenisation to expand the use of digital settlement and improve secondary market transactions in corporate bonds.
The issuance of corporate bonds using distributed ledger technology and their settlement through the wholesale digital rupee were described as a major development.
Source: Business Standard
