Sharp build-up was seen in forex reserves in Q3 due to lower trade activity and rise in foreign investment flows, providing the RBI enough liquidity ammunition to inject in the system and curb the volatility in the rupee. The reserves have further increased to cover 12 months of imports till Feb’20.
CAD at 14-month low: Amid lower trade activity, CAD narrowed in Q3FY20 to 0.2% of GDP. Commodity-oriented imports witnessed a sharper decline in Q3. This was supported by stronger services imports and remittances.
Capital account surplus at 3.1% of GDP: Strong FDI and FII investment have contributed to a rise in capital flows. Although the ECB has tapered off from Mar’19, it is still higher to somewhat compensate for the fall in bank credit growth.
RBI to Intervene to curb currency volatility: The sharp depreciation in the INR to ~74 levels, coupled with excess forex reserves (higher than optimal levels), was a clear indication that the RBI is likely to intervene to protect the currency. As a starter, the RBI has announced a USD2bn dollar swap. We believe that foreign flows have been under pressure in Q4 due to Covid-19 and geopolitical issues relating to oil – but India is comparatively better off than other EM countries. Foreign flows, remittances and services exports might be under pressure in the near term due to risk aversion and lower global growth prospects, while ECB funding might remain high.
Favorable CAD on low trade growth: Lower merchandise trade activity reduced the CAD to 0.2% of GDP (USD1.4bn, the lowest in the last 14 months – when crude oil was hovering around USD44/bbl). This indicates that narrowing of CAD is more a function of lower demand rather than improvement in exports. Merchandise deficit stood at 4.8% of GDP vs. 5.4% in Q2FY20 on account of falling commodity prices and a drop in non-oil imports. Invisibles growth strengthened on the back of higher growth in remittances; however, with the sharp drop in crude oil prices, the risks to remittances have risen. Net services exports strengthened in absolute terms to a record-high level due to the rise in net earnings from software services and travel. Covid-19 is likely to impact net earnings from services in Q4-Q1FY21. Structural support indicators, under the heads of invisibles, net FDI and NRI deposits, increased to 6.0% of GDP, but is still low when compared with 10.3% in Sep’13.
Capital account surplus surges to 3.1% of GDP: Capital account surplus in Q3FY20 witnessed a surge to 3.1% of GDP, on account of higher foreign investment flows and the ECB. We believe that tight credit conditions and lower yields globally were the reasons behind the surge in ECB flows. Going forward, due to the rise in interest rate differentials (rise in negative bond yields AUM), we should expect ECB flows to remain elevated. NRI deposits of USD0.8bn might witness a slight moderation with the possibility of weakness in oil-producing nations (on sharp plunge in oil prices on the break-up of the cartel) and weakness in global demand conditions as a result of Covid-19.
Foreign exchange reserves surged by USD21.6bn in Q3FY20 and has further surged by USD24bn as of Feb’20. We believe that, by end of Mar’20 this is likely to come off due to the sharp increase in net outflows by FII of USD2.2bn.
Outlook: Covid-19 and rise in geopolitical issues increased external vulnerabilities in Q4: Until mid-2019, trade war between the US and China was affecting overall global trade activity. A respite from this was overturned by events such as Covid-19 and geopolitical uneasiness due to break-up of oil cartel. In the near term pressure on foreign flows, remittances and services exports is likely to remain. With ample forex reserves, India is not in a tight position; however, volatility in foreign flows is likely to keep the INR on an edge.