Negatives/risks progressively on the rise

We initially reduced the size of this position (two-thirds of our notional on 18 September) because of both external and local risks. Externally, we were concerned the US FOMC (Federal Open Market Committee) meeting would result in a repricing of Fed hikes as it announces the start of its balance sheet normalisation.

Indeed, the Fed’s balance sheet reduction announcement and a likely strengthening of DM monetary policy normalisation momentum in coming months should highlight the vulnerabilities of broad EM FX (including INR and IDR) to potential capital outflows.

Locally, the recent negative developments that supported our decision to reduce our long INR risk included weaker-than-expected GDP growth (released on August 31) and a larger-than-forecast current account deficit for Q2 2017 (released on September 15). In addition, more evidence emerged that the Reserve Bank of India (RBI) was stepping up its USD buying intervention. Spot USD/INR from April to July was held in a tight range of around 1 per cent, with RBI FX intervention and FX forward book data showing an average monthly $ 6.9 billion of net US dollar buying (it peaked at $ 12.3 billion in July). This FX intervention has led INR NEER (nominal effective exchange rate) to depreciate by 3.4 per cent over the same period.

That said, after reducing our risk by two thirds, we exited our remaining long INR position following reports that the government could relax its fiscal stance (FY18 fiscal target at 3.2 per cent of GDP) and start prioritising support for growth over fiscal consolidation. This would occur at a time when the government is already facing several other challenges from potential bank recapitalisation, subsidies, boosting investment etc. Although we anticipate the government will provide some clarification on its fiscal stance, the risk in the near term is that these actions may reduce the scope for the RBI to cut its policy rate (next RBI meeting is on 4 October) and raise some concerns from rating agencies.

 We remain positive over the medium term

The current combination of external risks from DM (developed markets) policy normalisation and local negatives from fiscal and current account deficits and slower growth keep us on the sidelines with respect to INR. However, as the market continues to price in a December 2017 US Fed hike (now around 70 per cent probability from 53 per cent before the 20 September FOMC) and the market largely prices in a possible fiscal deterioration, we believe INR appreciation will re-emerge.

We do not believe we are there yet, but the signs are become more clear. Aside from the 1.3 per cent INR depreciation (vs. USD) in the week (to September 27) – which erased all the INR spot gains (vs. USD) since the BJP won the Uttar Pradesh elections earlier this year – the fiscal slippage risk is relatively well telegraphed

Foreign equity outflows have also been substantial in Q3 2017 (thus far) at $ 2.1 billion, which is close to the largest quarterly outflow of the past 10 years.

Furthermore, there likely has been some unwinding of short USD/INR recently, as our daily positioning index has risen rather rapidly since September 19, although this elevated positioning could still persist in the near term. We note that there was a build-up in the daily short USD/INR positioning between December 2016 and April 2017.

Lastly, on market concerns over growth and the current account deficit,: 1) the growth slowdown is likely to be transitory (GDP growth to rise to 7.4 per cent in H2 vs. 5.9 per cent in H1) considering a private services turnaround, ongoing remonetisation, post-GST restocking, state pay commission hikes and the lagged effects of lower lending rates.

2) Although, the Q2 current account deficit widened by more than expected to 2.4 per cent of GDP (0.6 per cent in Q1) and the 2017 deficit will widen to around 1.5 per cent of GDP ($ 37 billion; 0.6 per cent of GDP in 2016), net FDI inflows (by itself) should be able to finance the current account deficit (2017 net FDI forecast at $41.8 billion.

 Source: Nomura Asia Insights