Key Points

We remove our cautious view on INR (see IndiaPulse: Turning more Cautious on INR), and now see USDINR at 81.5 by calendar 2024 year-end (from 82.0 previously). While INR should still underperform other Asian currencies given active FX intervention by the RBI, we now think the balance of risks skew towards a stronger INR from here. There are 3 key reasons for our sanguine view.

First, we now forecast a smaller current account deficit for India at 1% and 1.3% of GDP for FY24 and FY25 respectively (from 1.7% and 1.5% previously). India’s services surplus has widened by more than we anticipated, driven by gradual improvements in IT services exports, together with weak services imports from lower transport costs. Meanwhile, oil prices have declined by more than our bank’s earlier estimates. Both these factors have offset robust imports from strong domestic demand.

Second, portfolio inflows should remain strong with bond index inclusion and good growth, assuming policy continuity post the upcoming General Elections. Equity flows have picked up, in part because markets are pricing in a higher probability of another term with the incumbent BJP as the majority government - the party led by PM Modi (see India State Elections Dec 2023). Meanwhile, bond funds have started to front-run inclusion of India’s government bonds into the JPM GBI-EM bond index. We think these inflows can continue into the rest of the year.

Third, FDI has finally started to rebound, and we assume this improves gradually in 2024 given the strong investment commitments pipeline. Lastly, on the global front we assume the Fed has space to cut rates and the Dollar weakens modestly, which will be helpful for other inflows such as External Commercial Borrowing.

We think RBI will look to accumulate FX reserves further through 2024, thereby limiting the extent of INR appreciation. This is partly because RBI sees the source of deficit funding in 2024 as driven by volatile flows arising from bond index inclusion.

Key risks to our view would come from a surprise result in the upcoming General Elections, an escalation in the Middle East crisis, coupled with a spike in oil prices. We believe the vast majority of market participants, including ourselves, expect policy and structural reforms to continue in India post the upcoming General Elections in April/May 2024. Markets will likely have to reassess that view if a coalition government is needed, which we stress is not our base case. Meanwhile, the current supply chain disruptions in the Red Sea, if sustained, has the potential to raise services import costs for India and lengthen delivery times. We assume that the negative impact remains well below what we saw during the peak supply disruptions in 2022, but this is certainly a risk to watch for (see Chart 1). Lastly, we pencil in some gradual rise in oil prices in our base case as per our commodity research team’s forecasts.

INR to strengthen on manageable current account deficit and strong capital inflows

USDINR at 83.0 in 3 months and 81.5 in 12 months

We have been relatively cautious on INR’s near-term outlook since October 2023. This was due to our expectation for India’s current account deficit to widen, coupled with a soft patch seen in capital inflows (see IndiaPulse: Turning More Cautious on INR). This view has played out to some extent with INR underperforming Asian FX in 4Q2023, although this came in part because high-beta Asian FX strengthened relatively more as the Dollar weakened, and also because RBI has continued to be aggressive in intervening on both sides of the FX market, thereby keeping USDINR within a very tight range (see Chart 2 and 4 above).

Moving forward, we think the balance of risks now tilt towards a stronger INR from here, and we remove our cautious view on INR.

We now forecast USDINR at 83.0 in 3 months and 81.5 in 12 months (from 83.3 and 82.0 previously), and also continue to expect RBI to accumulate FX reserves through 2024, thereby limiting the extent of INR appreciation.

There are a few reasons for our view.

First, we lower our current account deficit forecast to 1% and 1.3% of GDP for FY2023/24 and FY2024/25 respectively (from 1.7% and 1.5% previously). For one, India’s services trade balance has widened, helped by both a gradual improvement in services exports as the IT services sector picked up, together with weakness in services imports due in part to lower sea freight costs. Moving forward, we think that modest low single-digit recovery in services exports looks likely (Chart 7). Meanwhile, we pencil in some moderate rise in services imports amidst supply chain disruptions in the Red Sea, but for the negative impact to remain well below the peaks of what we saw in 2022 during the Russia Ukraine war.

India’s goods deficit should see some relief in the near-term from lower oil prices. Our commodities research team lowered their oil price assumption to $81/bbl for calendar year 1Q2024 (from $91/bbl previously), but overall still expects a gradual rise in oil prices to $92/bbl by the March 2025 quarter (see MUFG Commodities 2024 Outlook). We pencil these oil price assumptions into our forecasts. Looking beyond oil prices, we think India’s non-oil non-gold trade deficit and imports should remain large given strong domestic demand, and this strength should continue post the April/May General Elections (see Chart 9 and 10). Meanwhile, we could see some gradual moderation in India’s gold imports as inflation expectations in India trend down over the next 6-12 months.

Capital flows have also picked up on state election results and front-running ahead of bond index inclusion in June 2024

The second reason for our more positive view on INR is a stronger and earlier than anticipated pick up in portfolio inflows, which we think will continue through FY2024/25, even if not at the same magnitude. We think this is in part due to recent State Assembly Election results, with markets now likely pricing a higher probability of a win by the incumbent BJP – the party led by Prime Minister Modi (see India State Elections Dec 2023). As a result, foreign equity flows have risen further since December 2023. Meanwhile, there has likely been some front-running of flows by active managers ahead of the recent inclusion of Indian government bonds into the JPM GBI-EM Global Diversified Index in June 2024 (see India Bond Index Inclusion – Finally it has happened). While we were previously of the view that the flows would come later given operational frictions in investing in IGBs, these inflows have come in earlier than we anticipated. Moving forward, we think these portfolio inflows can continue through 2024, assuming no surprises in the upcoming General Elections in April/May. As a base case, we assume that Indian Government Bonds are not included in the Bloomberg Global Aggregate Index in FY2024/25 given the recent announcement that they may be included in the far smaller Bloomberg EM Local Currency Index, but any indication otherwise could result in further bond inflows.

Thirdly, FDI inflows are likely to improve further through 2024. Based on latest data, we note that FDI has finally bounced back up, after having been surprisingly weak through the 1^st 3 quarters of 2023 (see Chart 12). We think that further gradual improvement is likely, given the strong investment commitment pipeline into India. If this is right, this should be another source of flow support for INR moving forward.

India likely to experience comfortable balance of payments surplus in FY2024/25

Putting everything together, we forecast India to have a comfortable balance of payments surplus in FY2024/25 of around US$30-40bn. Part of our expectation also incorporates our view that the Fed will have the policy space to cut rates in 2024 as inflation moderates, while the Dollar weakens modestly. If right, this will be positive for flows such as External Commercial Borrowing (ECB), which saw some slowdown in 4Q2023 given the pickup in US long-end rates.

We expect RBI to continue intervening to absorb FX inflows, limiting extent of INR appreciation

We expect RBI to intervene to absorb inflows through 2024, in part because deficit funding comes through volatile portfolio flows: Certainly, no analysis on INR is complete without looking at RBI’s FX intervention strategy. RBI has been very active in intervening in the FX market in 2023. We estimate that the central bank sold Dollars to the tune of US$19bn in October 2023, but this was mostly through the forward market. RBI has since intervened to buy back close to US$25bn in FX reserves on a spot basis in December as the flow picture improved. This raises the obvious question of whether RBI has any specific levels in mind in FX reserves, given that by many metrics of FX reserve adequacy it looks more than enough (see Chart 14). In our view, we think RBI looks not just at the level of FX reserves, but also the composition of inflows and current account deficit funding. To the extent that India’s current account deficit funding in FY2024/25 comes through debt portfolio inflows from index inclusion, we believe RBI will view this as inherently volatile and fickle, and as such, something to build a buffer against.

Overall, we think RBI will allow USDINR to fall more once US Dollar weakness becomes clearer. We forecast USDINR at 83.0 in 3 months and 81.5 in 12 months.

RBI’s 1st rate cut likely in Sep 2024 quarter, with tight liquidity to continue in the near-term

RBI using the good times now to build macro buffers through implementing macroprudential measures

Looking beyond INR and FX policy, RBI has also implemented several macroprudential measures to contain fast growing consumer loans and risks in Non-Banking Financial Companies (NBFCs). These measures include raising risk weights for unsecured consumer credit loans of commercial banks and NBFCs, together with increasing risk weights for bank’s exposure to NBFCs. In addition, RBI has directed banks and NBFCs not to make investments in Alternative Investment Funds (AIFs) that have downstream investments in borrowers of these banks and NBFCs, to reduce interconnected risks. Overall, we view these measures as forward-looking moves by the RBI to contain any possible risk in the financial system.

Tight banking system liquidity has pushed up money market rates and tightened financial conditions: With RBI still maintaining a hawkish stance in its latest policy meeting, banking system liquidity has also been somewhat tighter than perhaps even the central bank has anticipated (see RBI Dec 2023 – Keeping a watchful eye). The weighted average call rate has fluctuated within the top half of the RBI’s interest rate corridor (see Chart 15 below), and this has also led to some banks raising their lending rates for some loans.

From an internal macro stability perspective, the good news is that inflation has shown good signs of moderating towards the RBI’s inflation target of 4%. For one, a range of underlying inflation measures are running slightly below 4%yoy (see Chart 18 below). These includes traditional core measures which remove various elements of food and energy, coupled with trimmed mean inflation which exclude volatile measures of inflation at both ends of the distribution. Second, high frequency food price data indicate components such as vegetables, pulses, and sugar have moderated moving into January, with slower growth in wheat prices.

We lower our FY2024/25 inflation forecast a touch to 4.7% (from 4.9%), reflecting generally better food price  and core inflation trends. We also lower our growth forecast a touch to 6.4% (from 6.5%) but to remain robust overall, to reflect the lagged impact of RBI’s macroprudential and liquidity tightening measures.

RBI on an extended rate pause, with 1^st rate cut in the Sep 2024 quarter: With the trend in inflation generally looking better and moving towards the RBI’s inflation target, we continue to expect RBI to cut rates by 50bps starting from the Sep 2024 quarter.

India Policy Tracker

India in Charts

Appendix: India Private Consumption and Investment Trackers

We introduce 2 growth trackers for India in this report, one for private consumption and another for investment activity. These indices incorporate the latest monthly real sector indicators such as passenger vehicle sales, petroleum and diesel consumption, steel production, and capital goods imports, coupled with key economic indices such as the industrial production and infrastructure industries index. We also track other monthly numbers such as GST revenue collection, rural wages and unemployment rates which give us a sense of the direction of travel, but are not as suitable to be included in an index.

Tracking these high frequency datapoints above is important for at least two reasons. First, the central bank tracks many of these data closely (for instance, see links here and here). Understanding their evolution will allow us to better forecast the central bank’s policy considerations, with a view to getting ahead of the curve. Secondly, having an updated view of India’s macro can allow us to better anticipate turning points in the economy and the associated market implications, given the significant uncertainty surrounding the global economy now.