>Capital Controls … Back in Vogue, Will India Follow? (CITI)

■ Flows to EMs results in appreciation, reserve accretion and controls — Growth and interest rate differentials are causing a renewed surge in capital flows to Emerging Markets. This has resulted in currencies appreciating, forex reserves rising (in most cases to pre-crisis levels) and some countries imposing controls on capital flows. How a country deals with capital flows depends on (1) its export dependence and (2) inflationary/sterilization costs associated with dollar inflows.

INDIA MACROSCOPE

■ India: What should one expect? — We believe that similar to FY08, the RBI could once again be caught in the trap of the ‘impossible trinity’. In response to rising flows, we expect (1) the initial goal would be to re-build reserves that were run down during FY09, (2) some INR appreciation to offset inflationary pressures, and (3) although we do not expect that India will impose ‘punitive controls’, one could see a reversal of some measures taken last year. This could include tightening ECB and banking capital norms, reducing interest rates on NRI Deposits, and encouraging capital outflows.

■ Macro – The good, the bad and the ugly — Starting with the good: upside surprises in industrial production could offset a weak summer crop; likely resulting in GDP growth of 6.2%YoY. The bad: drought relief measures, oil related subsidies/bonds and 3G auctions are potential pressure points on the deficit, but recent clarity on disinvestments could minimize slippage. The ugly: higher food/oil could result in WPI breaching 6% levels by March.

■ Monetary Policy and Financial Market Forecasts — While loan growth remains anemic, better-than-expected IIP data and rising WPI will likely prompt steps towards normalizing rates by early 2010. We maintain our call of a 125bps rise in rates in 2010, as inflation is primarily supply-driven and excess tightening would have implications for the INR. With the underlying theme of dollar weakness and relatively strong domestic growth, we see the INR trending to Rs44/US$ and Rs41/US$ in Mar10 and Mar11 respectively. However, similar to other EM assets, there would be a tussle between ‘risk on’ and ‘risk off’.

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