Key Points

We turn more cautious on INR in the near-term, and now see USDINR at 83.7 in 3 months before recovering to 82.0 in 12 months. USDINR is likely to trade in a higher range between 82 and 84. We expect RBI to intervene meaningfully to prevent sharp spikes in USDINR, and as such capping FX volatility.

Current account deficit to widen with strong domestic demand and higher oil prices: One reason for our near-term caution on INR is a widening current account deficit. First, India’s import needs are rising further, with strong domestic demand and infrastructure spending. Second, the rise in oil prices above US$90/bbl should raise the oil trade deficit in coming months. Third, IT services exports continue to be soft. Lastly, we are entering a seasonally strong period for imports with upcoming festivals.

Slower capital flows near-term before bond index inclusion kicks in next year: More importantly, foreign capital inflows into India are hitting a soft patch at the same time as the current account deficit is widening. Foreign investors have started selling equities after strong year-to-date inflows of US$17bn. While bond inflows have picked up, they typically pale in comparison with equity flows, at least until bond index inclusion kicks in next year. Meanwhile, FDI flows have not seen any improvements after this year’s slowdown, and ECB registrations have also moderated. Global factors such as a hawkish Fed and higher US rates may be driving some of these moves.  

RBI on an extended rate pause, with 1^st rate cut in the Sep 2024 quarter. Banking liquidity to remain tight near-term: We push out our 1^st RBI rate cut forecast to the Sep 2024 quarter (from June 2024 previously), and continue to see RBI remaining hawkish for longer. Food inflation pressures have seen some relief from lower vegetable prices, but upside risks to inflation remain, given a weak monsoon, robust growth, and higher global oil prices. As such, we think RBI will keep a hawkish bias amidst a challenging global environment, hawkish Fed and a strong Dollar near-term.

INR’s FX flows should improve in the medium-term, and is reflected in our forecast for USDINR to recover to 82 next year. First, we continue to expect the US Dollar to weaken next year as the Fed cuts more than priced. Second, the current account deficit should narrow, with a recovery in IT services exports, lower oil prices as our base case, normalising domestic demand, and a pickup in goods exports. Third, bond index inclusion should bring at least US$20bn of flows starting June 2024 or even earlier. Lastly, FDI should improve given strong existing investment commitments.

We continue to be positive on India’s long-term structural macro prospects: While we have turned more cautious on FX in the near-term, we remain positive on India’s long-term macro outlook. India has one of the best macro stories in Asia, being a beneficiary of structural reforms, stronger bank and corporate balance sheets, and increasing FDI and investment flows.

Robust domestic demand, supported by infrastructure and consumption

India’s growth momentum remains strong and supported by infrastructure spending and private consumption: India’s growth indicators have generally been robust based on our tracking, and point towards some near-term pickup in momentum in both private consumption and infrastructure spending. For instance, private consumption indicators such as domestic passenger vehicle sales rose further to 27%yoy in August from 18%yoy the previous month (see Chart 3 below).  Meanwhile, domestic air passenger traffic grew by around 30%yoy in September as proxied by high frequency daily data, while power demand was also resilient growing steadily at around 10-15%yoy. Infrastructure and investment indicators accelerated further, with steel consumption growing by 22%yoy in August from 17%yoy previously, while capital goods imports and railway freight both picked up based on latest indications (Chart 4).

Rural activity and IT services remain soft so far, but should not detract meaningfully from strong growth: Rural economic indicators such as tractor and two-wheeler sales have moderated recently, and may partly reflect the weak monsoon. In addition, IT services growth have remained soft. Overall, we see strong consumption and infrastructure more than offsetting softer rural activity and IT services exports.

We raise our FY2023/24 GDP forecast to 6.7% from 6.5% driven up by strong domestic demand. We continue to expect gradual moderation in economic activity next fiscal year: We generally remain positive on India’s growth prospects, with forward-looking business surveys continuing to point towards improving economic activity. We see 4 drivers of economic optimism. First, input costs have already come off meaningfully, with both WPI and CPI inflation declining notwithstanding the recent increase in food prices. Second, the negative impact of previous rate hikes should increasingly fade with RBI likely on a prolonged rate pause. Third, the government’s infrastructure rollout will also crowd in private investment over time. Fourth, increasing investment commitments by manufacturers both domestic and foreign should also result in stronger investment over time.

India's current account deficit to widen with strong growth and higher oil prices, slower capital inflows in the near-term before bond index inclusion

We raise our Current Account Deficit forecasts to 1.8% of GDP for FY2023/24 and 1.4% of GDP for FY2024/25 on average:  The flipside of strong domestic demand is the current account deficit is starting to widen more meaningfully, and potentially annualising above US$70bn over the next few quarters. There are three key reasons driving our forecasts for a wider current account deficit. First, India’s import needs are rising further, with strong domestic demand and infrastructure spending, and this has been reflected in a meaningful pickup in non-oil imports and the non-oil trade deficit (see Chart 1 and 5) Second, the rise in oil prices above US$90/bbl should raise the oil trade deficit in coming months. Petroleum and oil import volumes have been unusually weak, and this is unlikely to sustain with strong domestic oil consumption. Third, IT services exports continue to be soft, which has weighed on the current account deficit in the near-term. Last but not least, we are also entering a seasonally strong period for imports with upcoming festivals.

Slower capital flows near-term before bond index inclusion kicks in next year: For INR, what’s as important is also whether the current account deficit can be funded. We see near-term headwinds for capital flows, coming at the same time as the current account deficit is widening. On the portfolio flow side, equity investors have started selling equities after strong year-to-date inflows of US$17bn. While bond inflows have picked up, these flows typically pale in comparison with equity flows, at least until flows from the JPM GBI-EM bond index inclusion kicks more fully in next year (see India: Bond Index Inclusion). Our understanding is that there remains operational and tax related frictions, which may mean that actual inflows from bond index inclusion may not materialise so soon. Meanwhile, FDI flows have not seen any improvements after this year’s slowdown, while ECB registrations have also moderated. Global factors such as a hawkish Fed and higher US rates may be driving some of these moves.

RBI hawkish and on extended rate pause, 1st cut in Sep 2024 quarter, with somewhat tight liquidity

RBI on an extended rate pause, with 1^st rate cut in the Sep 2024 quarter: We push out our 1^st RBI rate cut forecast to the Sep 2024 quarter (from June 2024 previously), and continue to see RBI remaining hawkish for longer. Food inflation pressures have seen some relief from lower vegetable prices, but upside risks to inflation remain, given a weak monsoon, robust growth, and higher global oil prices. As such, we think RBI will keep a hawkish bias amidst a challenging global environment, hawkish Fed and a strong Dollar near-term.

Banking liquidity may remain tight near-term: Apart from actual RBI policy settings, liquidity conditions in the banking system has been affected by two key factors. First, RBI implemented the 10% Incremental Cash Reserve Ratio (CRR) in its 10 August meeting, which was expected to mop up around INR1 trillion in liquidity, although the actual impact may have been greater. This has now been gradually wound down, with 25% of funds released on 9 September, another 25% on 23 September, and the rest on 7 October. This may help to lower upward pressure on short-term rates. The second factor may be RBI’s FX intervention, where the central bank has likely been selling Dollars to prevent USDINR from rising too fast over the past month. With the Dollar expected to remain strong in the near-term, and the current account deficit likely to widen over the next few quarters, we may see FX outflows before we see relief later next year.

RBI likely to continue to cap USDINR FX volatility. This is reflected in our forecasts for only gradual INR weakness to 83.7: The RBI continues to be one of the more aggressive Asian central banks in capping INR volatility against the US Dollar on both sides. We estimate that from Jan to July 2023, the RBI has accumulated close to US$35bn in US Dollar purchases on a valuation adjusted basis, together with around US$13bn in its forward book. With Dollar strength, spikes in oil prices, coupled with slower portfolio inflows, RBI has taken the other side of the trade by selling close to US$5bn in FX reserves, while allowing US$9.4bn in its forward book to roll over, all the while allowing USDINR to rise gradually above 83. We think RBI will remain in the FX market to prevent sharp spikes in USDINR, hence capping FX volatility.

INR’s FX flows should improve in the medium-term, and our forecast for USDINR to recover to 82 next year reflect these. First, we continue to expect the US Dollar to weaken next year as the Fed cuts more than priced. Second, the current account deficit should narrow, with a recovery in IT services exports, lower oil prices as our base case, normalising domestic demand, and a pickup in goods exports. Third, bond index inclusion should bring at least US$20bn of flows starting June 2024 or even earlier. Lastly, FDI should improve given strong existing investment commitments.

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.