Easing tensions between the Indian government and its central bank have reinvigorated investor confidence, boosting the rupee and lowering yields on sovereign debt.
In recent months, there had been growing disquiet among emerging-market investors that the government sought to impinge on the independence of the Reserve Bank of India, or RBI. The central bank resisted calls to boost liquidity to stimulate economic growth ahead of next year's general elections, leading to the government to threaten to invoke section 7 (1) of the RBI Act. The never-before-used measure gives government the right to direct the central bank, a red flag for investors.
Central bank independence, or the lack thereof, has been at the heart of investor concern in Argentina, Turkey and South Africa, as emerging-market governments have been notorious for printing money to pay off debts. But tensions in India de-escalated somewhat at the RBI board meeting Nov. 19, with the most contentious issues deferred to a number of committees.
"Even if the government was not completely out of bounds legally in requesting dialogues with the RBI on certain matters, its mode of doing so was not judicious," said Priyanka Kishore, an economist at Oxford Economics. "Investors are likely to keep a close eye on the situation and the onus is on the government to preserve faith in the central bank’s operational autonomy going forward," she said.
The Indian rupee was the worst hit of the Asian currencies in the rout on emerging-market economies earlier this year, shedding 14% of its value in the first 10 months of 2018 to a low of 74.25 rupees on Oct. 10. But the currency has been bolstered by the U.S. softening its stance on sanctioning the main buyers of Iranian oil, including India, and the easing of tensions between RBI Governor Urjit Patel and the government. This has seen the rupee recover to 70.87 as of Nov. 27.
Rumors that Patel, who became head of the RBI in 2016, would resign amid pressure on the bank's independence proved to be false, which was a relief to the market as the bank's monetary policy committee was "beginning to gain credibility," Kishore said. "We think this would have been a big blow to confidence."
The dispute began earlier in the year when the government's then-chief economic adviser, Arvind Subramanian, made a case for the RBI transferring its excess capital to the government, which also wants the RBI to relax lending rules for a number of public-sector banks to stimulate investment.
The situation came to a head when Deputy Governor Viral Acharya pleaded the case for RBI’s independence in an Oct. 26 speech, and warned the market would take a dim view of apparent government oversight.
Support has crept back into government bonds with yields on 10-year Indian debt trading at 7.72% on Nov. 26, having fallen steadily from a peak of 8.18% on Sept. 11.
Importance of state banks
Liquidity has dried up in India as the central bank limited lending by state banks until they clean up their balance sheets. The demonetization program in November 2016, which involved the cancellation of high-denomination currency notes, weighed further on liquidity and slowed economic activity.
In its October monetary policy committee meeting, the bank hinted at further tightening to tackle inflation, changing its policy stance on rate setting from neutral to calibrated tightening, but it stopped short of a rate rise, even as the currency depreciated. Analysts note that the subsequent strengthening of the rupee makes a policy hold more likely at the early-December meeting.
Inflation has largely defied the weakness in the exchange rate, with the consumer price index rate falling below the RBI's 4% target in October to 3.69%. However, the fiscal deficit — which analysts expect to exceed the 3.3% of GDP target — would suggest an increase in inflation going forward. "We have recently scaled back our RBI view from a rate hike at the last meeting of the year in December to no more hikes this year. We do, however, expect the RBI to resume tightening once the elections are out of the way by mid-2019," ING economist Prakash Sakpal wrote Nov. 27.
State banks have dominated Indian infrastructure financing as the country's underdeveloped bond market forces companies to seek loans. But the number of nonperforming loans has been rising. According to the RBI, the gross nonperforming advances ratio of commercial banks increased to 10.2% from 9.6% between March and September 2017 and were expected to reach 11.1% by September 2018.
Some 25% of total loans were granted by nonbanking financial institutions such as Infrastructure Leasing & Financial Services Ltd., which defaulted earlier this year. This led to concerns about the entire shadow banking sector, which relies on short-term bonds for funding the long-term loans they issue to housing and infrastructure companies.
"Against a backdrop of tightening financing terms globally, the cost of financing for these institutions is rising, and the payment default of IL&FS, a semipublic institution, has brought to light liquidity issues," according to a research note by Candriam, a New York based investment fund.
Yet India is an increasingly attractive prospect for investors. The spate of nonperforming loans has resulted in banks forcibly restructuring heavily indebted industries, such as the steel sector, which led to the sale of family-run Essar Steel India Ltd. to Luxembourg-headquartered ArcelorMittal, the world's largest producer.
Global investors such as Blackstone Group LP and Apollo Global Management LLC have set up funds in India to buy businesses in need of restructuring, while Emso Asset Management is entering the market with a local partner.
The relatively underdeveloped bond markets may also grow and appeal to yield-hunting investors. "The banks’ experience of infrastructure-related nonperforming loans and relatively cheap financing available through bonds means issuance has been increasing rapidly," wrote Omar Ene and Tzoulianna Leventi of Aberdeen Standard Investments.