Indian rupee to stay under pressure from surging greenback

Dubai - Fund managers must slash exposure to emerging markets debt

Trump's election, a trillion dollar bond market meltdown and the BJP government's draconian currency reform have lead to predictable outflows of offshore money from Dalal Street. Fund managers must slash exposure to emerging markets debt when the US dollar surges to 14-year highs, the US Treasury 10-year note spikes up 50 basis points and the Federal Reserve is on the precipice of at least four rate hikes in December. This has led to a depreciation in the Indian rupee to almost 68, a post Modi low. Depository data suggests FII outflows from the Indian government bond (G-Sec) markets are comparable to those witnessed during the "taper tantrum" and rupee freefall in August 2013.
While Indian government bond yields have plummeted 120 basis points in the past year and Modi's currency monetization will swell banking sector deposits, broaden the tax base and deal a deflation shock that enables another RBI repo rate cut, India cannot remain immune from Fed risk, Trump risk and dollar risk as the world's bond markets are linked together by trillion dollar daisy chains of leverage. As Trump's economic policy agenda is fiscal stimulus and increased Uncle Sam deficits, US inflation and interest rates will continue to rise in 2017.
This global scenario is bad enough but Modi's anti-black money blitzkrieg has taken out 86 per cent of the currency in circulation and dealt a literal fresh "cash shock" to Asia's third-largest economy. While $50 billion in fresh deposits in the Indian banking system will cause investment demand for G-Secs to rise, this is offset by the outflows from the Indian debt and even equity markets as offshore money scrambles back to Wall Street.
Emerging markets debt has been leprosy since Trump became President-elect of the United States. Yields on Mexican, Brazilian, Turkish, Indonesian and South African sovereign debt have risen at least 50-60 basis points since November 8 though, ironically, Modi's cash shock meant Indian G-Sec yields have actually fallen. Yet even though the yield on the ten year Indian G-Sec note has fallen to 6.45 per cent, the Indian rupee has fallen two per cent in the past three trading session alone. My guess? Offshore hot money is fleeing Dalal Street, given the extreme positioning in India's debt market. Bharat Mata, of course, is the most crowded consensus macro trade in emerging markets - and crowded consensus spells danger.
As fish caught in the Bay of Bengal rots in Calcutta docks, as money lenders in Andhra Pradesh and Karnataka face financial ruin, as homebuilders in NCR and jewelers in Bombay's Zhaveri Bazaar find their black market cash loot vanish to money heaven, the Indian economy will fact its worst consumption shock since the early 1990's. Like the Fed on 9/11, the RBI must immediately cut interest rates by 100 basis points as Modi's merry men did not issue enough 100 rupee bills to compensate for the money multiplier cash shock.
This gross incompetence would never have happened if the BJP high command had extended Dr. Raghuram Rajan's term as RBI Governor.
In retrospect, Modi's crackdown against black money, tax evasion and endemic corruption has been a spectacular success yet it can also plunge the economy into a protracted slump and spawn a political backlash.
With 90 per cent of Indian workers in agriculture, the informal sector, agricultures, retail trade, shops and small home factories, the cash squeeze has led to monumental economic and psychological pain. The Keynesian multiplier will choke consumption and choke economic growth. India faces a GDP hit of at least one per cent. The BJP's small trader vote banks in the Hindi heartland are also enraged - and this creates UP election risk. The mismanagement of the banknote demonetisation could well raise political risk for the GST in the Lok Sabha. These political and financial storm clouds will pressure the rupee to 70. The rupee is still a carry winner against the South Korean won and the Japanese yen, which feel the full impact of Trump, Fed rate hikes and the slump in world trade.