Short Rupee as India Slowdown Here to Stay, UBS’s Narain Says

(Bloomberg) — UBS Group AG is asking investors to short India’s rupee and go underweight on the country’s stocks.

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The Swiss lender’s investment-bank research group says India’s $4 trillion economy has entered a structural slowdown that can’t be explained by cyclical factors like oil-price hikes or slow government spending. The deceleration is underpinned by a long-term moderation in credit growth, foreign direct investment, export competitiveness and earnings potential — all set to worsen after Donald Trump takes over as US president.

“Conventional wisdom that India is ‘far removed’ from Trump risk compared to other emerging markets is debatable,” said Manik Narain, the London-based head of EM strategy research at UBS. “A potentially higher for longer US yield environment poses challenges to India’s growth, with one of the highest debt service-to-revenue ratios in the major EM space.”

Indian stocks have erased almost $500 billion in market value in the past month, with MSCI Inc.’s index for the nation making the worst start to a year since 2016. The rupee has fallen to successive record lows against the US dollar, marking the worst performance in Asia. The country’s bonds are witnessing the fastest outflows since 2020 as euphoria over their inclusion in global bond indexes wanes.

Market losses follow a slackening of India’s real GDP growth over successive quarters, showing the economy slipping below the 7% average expansion notched up in the years before the Covid pandemic. Disappointing business updates, following a decade of failure by companies in the Sensex index to sustainably meet analysts’ earnings expectations, have underscored the bearish turn. Mounting external risks, especially from Treasury yields, has also kept policymakers from prioritizing a growth recovery.

Narain says the moderation in India’s earnings growth is spreading to even defensive parts of the economy such as the consumer-staple sector, showing that temporary factors such as government capital expenditure are not the only reasons behind the slowdown.

Among longer-term factors are:

Credit Moderation — The equilibrium growth rate in India’s credit markets will fall to about 10% per year, from the average of 16% in the past two years, as the loan-to-deposit ratio is getting stretched to the highest on record, at 80%, Narain said. That means future credit dynamics will increasingly depend on deposit growth if lenders want to avoid bad loans.
China Deflation — A devaluation of the yuan in real terms and a drop in China’s export prices are challenging India’s industry by way of stiffer competition in overseas markets and cheaper imports, according to Narain. Data compiled by Bloomberg show that despite the recent selloff, the rupee trades more than two standard deviations stronger than its average, while the Chinese currency trades almost two standard deviations weaker than its own mean.
Slowing FDI — While the country’s external account has raised investor worries, Narain said, a bigger issue of concern for UBS was slowing FDI flows – to only $3 billion in the past 12 months — hinting at stalling equity investments amid growth strains.
Market Participation — Calculations by UBS suggest that equity holdings represent 23% of the financial assets of Indian households and 60% of bank deposits. That means the market can no longer be termed “underpenetrated,” Narain said.
Valuation — Based on the bank’s valuation methodology, the country trades at a 72% premium to the rest of emerging markets, a premium “unheard of even 12 months ago.”

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All this has pushed UBS investment bank to go underweight on the Indian component of the MSCI Emerging Markets Index.

As these long-term factors weigh on the investment landscape, the Reserve Bank of India also faces a short-term dilemma in terms of whether or not to cut interest rates.

“The RBI is facing a tough balancing act, with high US rates meaning that monetary easing may erode rupee carry and hot money capital flows at a time when FDI and equity flows don’t quickly come in to compensate,” he said. “Yet, the economy needs stronger growth help.”

Narain said investors should buy bearish options in the rupee, pricing in a further 2.6% depreciation this year. However, the bank also recommends rate-receiver positions, via five-year swaps to benefit from an eventual 75 basis-point rate reduction.