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Will Indian yields buck the global hawkish stance?

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When the US sneezes, the world catches a cold, goes the saying. In the past year, we have seen many countries, along with US, catch a cold, but India has proverbially only “sneezed”. The year has seen global central banks fight persistent high inflation. This has led to a sharp rise in yields across the globe. India, too, has witnessed an increase in yields. To put this in context, India’s 10-year G-sec yield rose by 1.2%, whereas the US 10-year treasury yield increased by 2.7%. This difference may be attributed to higher US inflation (above 8%) when compared to that of India (around 7%). Moreover, this is accentuated as the US Fed has a lower inflation target compared to that of the Reserve Bank of India (RBI).

The rupee has also done well. While the rupee has depreciated against the dollar, it has held its own against other emerging market currencies. But can this trend continue? To answer this, we need to understand the peculiarities and drivers of Indian rates.

The RBI rate hikes have been lower than that effected by other central banks. The inflation basket in India is composed of volatile elements such as food and commodities. This makes inflation-forecasting difficult, and also reduces the impact that monetary policy can have on inflation. Thus, it is hardly surprising that high inflation in India is usually attributed to supply constraints. After all, the inflation basket is composed of commodities prone to supply shocks. Every time inflation rises, it is not unusual to hear arguments that RBI may not be able to contain supply-driven inflation with rate hikes.

Unsurprisingly, in the past year, RBI has raised the policy rates by just 2.5%, as compared to an increase of 3.25% by the Fed. In fact, most economists expect RBI to go for fewer rate hikes than the US Fed. Moreover, RBI has in the past been more tolerant to rising inflation than the depreciating rupee. In the past 10 years, RBI has hiked rates only twice (barring 2022). The first time was in 2013, when India’s inflation was well above 9%. Yet, this high inflation did not push RBI to hike rates. It was the sharp rupee depreciation that led RBI to act swiftly and raise the rates. The second time was in 2018, when India’s inflation was well within the target of 6%. Thus, RBI did not have an incentive to raise rates to curtail inflation. Rather, a sudden slide in rupee prompted RBI to raise rates. Prof Jayanth Varma has, in the latest September RBI MPC minutes, noted that RBI has used interest rate hikes in the past to curtail rupee depreciation.

Is India in the same boat as in 2013 or 2018 and will RBI need to hike rates to protect the currency? Probably not yet, but it is quite close. India’s forex reserves have depleted sharply to $528 billion. While one may argue that a large part of the forex reserve depletion is due to valuation and not RBI’s intervention, lower reserves nonetheless increase India’s external vulnerabilities. A slide in forex reserves to below $500 billion will bring it close to 2013 and 2018 levels—when compared against the International Monetary Fund’s reserve adequacy metric. Thus, a further slide may prompt the RBI to change its goal posts and hike rates to target currency, and not inflation.

While the Fed has been raising rates recently, it has also started reducing its balance sheet. The combined effect of higher US interest rates and a reduced Fed balance sheet may put further pressure on capital flows into India. The current account deficit is already high and is unlikely to reduce significantly if global growth tapers and affects India’s exports.

So far, RBI has resisted hiking the rates in step with the US Fed, which is likely to remain hawkish for more time. But, forex reserves have dwindled sharply. And, in such a scenario, RBI may not have an option but to raise policy rates in tandem with the US. In short, If the US does not cure its cold soon, then India’s sneezes may well turn into a full-blown cold.

Sandeep Yadav is head, fixed income, DSP Investment Managers

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