Indian markets on shaky ground, but well-cushioned

Indian markets tread on thin ice ahead of this month's US FOMC meeting where a rate lift-off seems imminent. The European Central Bank's underwhelming policy support also saw asset markets react uneasily late last week, with the renewed downturn in global crude prices stoking worries over the dire demand-supply dynamics. 

Domestically, the logjam in the winter parliamentary session has also added to the cautious mood. The benchmark equity index, SENSEX shed 0.9% yesterday extending losses from the past five sessions. Broader dollar strength lifted the USDINR briefly past two-year high 67.0 earlier this week and has since settled around 66.80-90. Limited room for further rate cuts, inflation uptick and strong issuance pipeline have meanwhile put a floor on 10y bond yields. 

Foreign portfolio investors have trimmed their exposure to the local asset markets, after a brief reprieve in Oct15. Equity markets witnessed over USD 1.0bn outflows in Nov followed by -USD 630mn yet far in Dec. Interests in the bond space have been relatively resilient with a smaller USD 570mn outflow in Nov and -USD 220mn this month. Over 98% of the foreign portfolio limit into government bonds has been utilised, accompanied by a 74.5% in corporate bonds. 

On year-to-date basis, equity inflows have moderated to USD 3bn from over USD 16bn in 2014. These were surpassed by bond flows to the tune of USD 8bn year-to-date, slowing from a whopping USD 26bn last year. These trends seem to suggest that portfolio adjustments shift away from emerging markets amid external volatility have also impacted flows into India. Foreign outflows are routinely of concern for economies with current account deficits, like India. The sharp decline in commodity prices and contained gold imports has significantly benefited its external balances. These deficits are likely to remain below the -2% of GDP for a third consecutive year in FY15/16 at -1.4% of GDP. A past IMF study pegged India's sustainable current account deficit at a range of 1.5-2.5% of GDP. 

Notably, India's basic balance of payments (current account deficit plus net FDI) continues to improve. The basic BOP recovered to 1.2% of GDP in 1H 2015 from -0.2% in 2014. With foreign investment flows playing a bigger role in funding deficits, reliance on short-term hot money flows have moderated, providing a cushion against external volatility. More recently, the reserves stock is off record highs but is still over three times the short-term external debt position. Some soft-spots remain. Rising non-government external debt, particularly external commercial borrowings is worrisome. To mitigate risks, the authorities have ensured heightened vigilance and encouraged timely hedging of FX exposures. The reserves coverage of total external debt is modest at 70%, weaker than few regional peers. 

The Indian rupee meanwhile has been largely stable as the authorities tap opportune times to build reserves, only to utilize them to fight volatility in the currency markets. Overall, the economy is likely to feel the heat from any broad sell-down in EM assets in wake of the US rate move, but the economy is clearly more resilient than in the past.