Treasury heads at the Business Standard BFSI Insight Summit said on Monday that high oil prices and foreign capital outflows will keep the rupee and bond markets under pressure. Experts noted that India’s reliance on imported oil and global interest in AI investments caused these challenges for the Indian economy.
Treasury heads at the BFSI Insight Summit warned that elevated crude prices, foreign capital outflows and high global yields could keep the rupee and bond markets under pressure
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 breathing room, the experts said a durable improvement would depend on a moderation in oil prices and a recovery in capital flows.
India's dependence on imported oil makes the currency 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 noted. Foreign investors have pulled out nearly $60 billion from Indian equities over the past two years, including close to $10 billion in the last two months, they added.
"There are several factors leading to the rupee weakness. Global oil prices, energy prices have stayed high and longer than what most people expected. We being, of course, a very large importer of oil and energy, it does affect us negatively. Second, while India has been CAD deficit even in the past, I think our capital account has been positive and balanced this deficit. But at least for the last couple of years, what we have seen, there has been a lot of the global funds chasing the AI story. And because of that, we have seen large outflows from the FPI investments in India," said Aditya Bagree, head of markets, Citi India and Indian Subcontinent.
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He explained that while FCNR(B) deposits have been higher than market expectations, adding firepower to the RBI to manage depreciation, they give the country and the RBI time, as these deposits have to be repaid in three to five years.
On measures such as the Foreign Exchange Risk Reserve (FERR) introduced by the RBI to contain rupee volatility, Arup Rakshit, group head, treasury, HDFC Bank, said that it was making imports and hedging costly.
"Initially when FERR has been brought in, the hedging has continued because if the rupee appreciates by 2 per cent, the cost of the FERR is not that 2 per cent. So obviously if the budget cuts something, the importers will continue to hedge. Some of the potential speculation has gone out of the market. But as it stands, as you start settling down on the currency, some of the demand will actually not be there," said Rakshit.
He added that as the next trade cycle comes in, one may see demand coming down, which could be an impact of the FERR.
The rise in US government bond yields has also become more challenging for emerging markets, 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, India and South Asia, and co-head, macro trading ASA, Standard Chartered Bank, said that the US 10-year yield had hit the psychologically important level of 5 per cent.
"In this environment, the impact on emerging market economies is negative because the risk premium that the investor starts demanding or is getting in the developed market, they start demanding that in the emerging market as well. That is where the impact on currency in emerging markets starts becoming more negative," said Sinha.
On the 10-year government bond yield, treasury heads remained divided in their views.
While some experts said that it could move towards 7.75-7.8 per cent over the next three to six months if the current conditions persist, another expected it to remain in a narrower range of 7.4-7.6 per cent.
Tightening liquidity and the possibility of further rate increases are also likely to influence the trajectory of yields.
Comparing the current cycle of FCNR(B) deposits with that of 2013, Shailendra Jhingan, head of treasury and economic research, ICICI Bank, said that at that time, the interest rate differential between India and the rest of the world was fairly large, and the measures came at a time when several other measures had already been taken.
"This time we are in a different world. The US rates are already running very high. And of course oil prices have gone up recently. So the environment suddenly has become a little more challenging. I think the point is that FCNR is something which did not change the fundamental even in 2013. FCNR should be looked at something which, you know, buys you time. Last time what had changed was that oil prices, things started changing on the current account. I mean oil started coming down, capital flows started kicking up. Eventually those are the things. FCNR is not going to change the outlook for Rupee permanently," said Jhingan.
Jhingan cautioned that AI borrowing was very large, putting an additional strain on dollar liquidity.
"There is a scarcity of capital which 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 noted.
Sinha, however, added that the size of the FCNR(B) flows had surprised everyone -- a testament to the strong fundamentals of the economy, as it had been able to attract dollar flows in an environment where there was a chase for dollar funding.
"There were three factors hitting India simultaneously in the recent few months. First was the tariff story from the US, which was completely unexpected. Then the oil, the war and the conflict in the Middle East. And the third is the AI story, or the lack of it for India. So these three factors are combined. And if one or two of them resolve over time, we will see the positivity for India markets come back," Sinha noted.
Foreign investment in government bonds may take time to recover, experts said. Expectations of further rate increases in the US and relatively attractive yields in developed markets could limit immediate inflows. The rate cycle would need to stabilise before a clearer picture emerges.
The discussion also highlighted challenges for banks in managing interest-rate risk as a growing share of loans are linked to external benchmarks, while deposits tend to be fixed-rate.
"Approximately 60-65 per cent of the loans are now linked to external benchmarks, and largely it would be repo-linked. And, of course, there will be some repo-linked exposures as well. Whereas the deposits which banks mobilize tend to be fixed rate. That opens up a challenge, which sometimes gets very hard to manage. And the fact is that, you know, the only product which is available for hedging really, which is liquid and, where a lot of volumes happens is OIS. But OIS is not a perfect hedge for repo-link," explained Jhingan.
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 settlement through the wholesale digital rupee was described as a significant development.