The month of Oct-23 started on a sombre note amidst flaring up of geopolitical conflict. With fast escalation of a war-like situation in Israel and Palestine, global trade (that is still facing lingering disruptions from Russia-Ukraine war, which started in 2022) is bound to witness another jolt. In this newsletter, we assess the potential implications of Israel-Palestine war on India’s trade. This is followed by a quick assessment of US monetary policy along with the outlook on Indian rupee.

1. Trade implications of Israel-Palestine conflict

Over the last ten years, India-Israel merchandise trade has increased from USD 6.1 bn in FY 2013-14 to USD 10.8 bn in FY 2022-23. For the last reported financial year, Israel’s share in India’s merchandise trade stood at 0.9%, with India running a trade surplus of USD 6.1 bn. India is Israel’s 7^th largest trade partner globally. Major exports from India to Israel include petroleum products, gems & jewellery, machinery items, etc. Major imports by India from Israel include gems & jewellery, chemicals, machinery items, etc. Potash (used in fertilizers) is a major item of Israel’s exports to India, with India fulfilling a significant share of its requirement from Israel.

• Post Prime Minister Modi’s visit to Israel in Jul-17 (marking the 1^st visit by an Indian PM) the relationship was upgraded to a strategic level with seven Agreements/MoUs signed in the fields of technological innovation, water, agriculture, and space.
• Subsequently, Israel’s PM Netanyahu, made a visit to India in Jan-18 during which agreements on cyber security, oil & gas cooperation, film co-production and air transport were signed, along with five other semi-government agreements.

Table 1: India-Israel trade: Key headline numbers

Source: CEIC, QuantEco Research

Table 2: Snapshot of key commodity groups involved in India-Israel trade

Source: Ministry of Commerce, QuantEco Research

Overall, Israel’s commercial importance for India goes beyond official merchandise trade statistics as: (i) G2G defence trade is not reflected (and Israel happens to be amongst the key suppliers of military equipment to India), and (ii) services trade between the two nations have started to pick-up in areas of cyber security, homeland security, and R&D in high-tech sector.

Meanwhile, merchandise trade between India and Palestine is conducted through Israel and therefore, comprehensive trade statistics are not published by India’s Ministry of Commerce. As per the Palestinian Central Bureau of Statistics, India-Palestine merchandise trade stood at USD 67.8 mn in 2020 (out of which, Indian exports and imports were USD 67.2 mn and USD 0.6 mn, respectively).

As long as the conflict continues only between Israel and Palestine, wider global trade disruptions are likely to be minimal. However, it is important to be vigilant as the situation could potentially turn into a proxy war with involvement of neighbouring countries like Syria and Lebanon, along with some mild unrest in the wider Middle Eastern region. In a worst-case scenario, escalation could turn into a full-fledged war if countries like Iran, Egypt, Jordan, etc. are drawn in – in such a scenario, the unrest in the Middle Eastern region could intensify, with the likelihood of a serious setback to global trade.

Chart 1: Involvement of neighbouring countries in the ongoing Israel-Palestine conflict would be detrimental for the world economy, and India

Source: CEIC, QuantEco Research

For India, there could be a double whammy in case of widespread escalation as the spike in geopolitical risk would cause crude oil prices (India sourced ~49% of its petroleum product requirement from the Middle Eastern region in FY 2022-23) to move in tandem, thereby aggravating the growth-inflation balance further. In addition, this could also impact remittance inflow from the Middle East (which accounted for ~29% of total inward remittances in FY 2020-21) and drive portfolio outflows from the country amidst global risk aversion.

Chart 2: Oil could be the prime casualty for India in case Israel-Palestine conflict escalates into a regional war

Source: Ministry of Commerce, QuantEco Research

2. Outlook on US monetary policy

Since the Sep 20^th Fed policy review meeting, there has been significant upward pressure on US yields. However, the pressure is concentrated at the mid-long tenor bonds, with short dated bonds remaining almost unfazed (between Sep 20^th and Oct 20^th, while the 10Y UST yield has jumped by 54 bps, 6M UST yield has seen a modest increase of 2 bps). We believe this to be an outcome of the following factors:

• While market participants expect the Fed to be close to the peak of its rate hiking cycle, expectations with respect to aggressive rate cuts in 2024 and 2025 are now being unwound. In other words, US rates could stay at higher levels for longer.
• Fiscal concerns have risen in case of US, resulting in market participants demanding higher yields for longer medium-longer dated bonds.
• Bank of Japan’s partial relaxation of its Yield Curve Control policy is creating a marginal upward pressure on US yields.

Market participants are currently attaching a ~21% probability to a 25 bps rate hike by the Fed by Dec-23. While there is room for one final round of rate hike before 2023 ends (between the two policy reviews scheduled on Nov 1^st and Dec 13^th), elevated US yields for medium-long tenors could obviate the need for incremental monetary tightening. This is going to be a close call. Going forward, market participants expect the Fed to commence its rate easing cycle from Jun-24 onwards.

Chart 3: Upward pressure on long term yields reflects expectations of rates remaining ‘higher for longer’

Data: Refinitiv, QuantEco Research

3. Outlining our expected rupee trajectory

Notwithstanding the Indian rupee’s tendency to sporadically flirt with its record low levels in FY 2023-24 so far, the price action continues to be marked by extremely low levels of volatility. In fact, with a 1.2% depreciation on FYTD basis, INR stands out as one of the best performing major currencies (barring Brazilian riyal and Polish zloty).

While India’s relatively strong post COVID economic recovery continues to provide an anchor for INR, there are concerns building up in the near-term.

• US economic resilience has been a positive surprise, which has benefitted the dollar.
• Adverse geopolitical developments have resulted in crude oil price jumping from its recent low of USD 75 bp in May-Jun 2023 to USD 92 pb levels currently.

This makes us believe that the currency is likely to create a fresh low of close to 84 levels against the dollar by Dec-23. If Israel-Palestine conflict remains contained, going forward, we expect the INR to partially reclaim lost ground and move towards 82 levels in Mar-24 amidst favorable Q4 seasonality and anticipated USD weakness as market participants position for a pivot in US monetary policy cycle by mid-2024.

Chart 4: Since Jul-23, dollar and crude have moved against India’s favor

Data: Refinitiv, QuantEco Research

4. CYTD price change in key commodity groups and shipping cost

Note: (i) Price change is between Oct-23 and Dec-22; (ii) Oil price is represented by Brent; (iii) Agriculture Items, Industrial Metals, and Precious Metals are represented by respective Bloomberg Commodity indices.

Data: Refinitiv, QuantEco Research

As India concluded a successful G20 Leaders’ Summit in Sep-23, we look at its implications for global trade as well as India. This is followed by taking stock of the change in direction in India’s merchandise trade deficit, followed by a quick assessment of US and India’s monetary policy along with our outlook on rupee.

1. G20 and trade implications

The G20, comprising of 19 countries and the EU, together accounts for 67% of world population, 75% of world trade, and 85% of world GDP. The G20 Trade and Investment Ministers’ Meeting (TIMM) reached consensus on five key areas:

• Digitalization of trade documents: This adoption of non-binding agreement will recognize electronic trade documents as equivalent to paper documents, thereby reducing trade costs and lowering barriers to entry for MSMEs.
• Enhancing access to information for MSMEs: The G20 TIMM adopted ‘Jaipur Call for Action for Enhancing MSMEs’ Access to Information’. This is about using the latest technologies to upgrade the Global Trade Helpdesk, a joint initiative of the ITC (International Trade Centre), the WTO (World Trade Organization) and the UNCTAD (UN Conference on Trade and Development) to provide analytical, user-friendly and easily accessible trade information for MSMEs.
• Generic mapping framework for Global Value Chains (GVCs): The trade ministers endorsed this framework that contains key building blocks of data, analysis, and representation of GVC data. The framework also advocated to identify key dimensions to help evaluate the resilience of GVCs both at the sectoral and product levels.
• Voluntary sharing of best practices on MRAs (Mutual Recognition Agreements) for Professional Services: The compilation of good practices will spur MRAs that will enable recognition of technical qualifications for professional service providers like doctors, nurses, lawyers, architects, etc. by all member countries. It will help Indian professionals in providing their technical services across the world.
• G20 Standards Dialogue: To reduce regulatory divergences and associated trade costs, and monitor trade and investment-related measures, G20 Standards Dialogue in 2023 will be held to bring together members, policymakers, regulators, standard-setting bodies and other stakeholders to discuss topics of common interest such as good regulatory practices and standards.

Besides the G20 New Delhi Declaration (that highlights pertinent trade related aspects above), the Summit also served useful for making progress on trade deals/treaties.

• India has signed an MoU with Saudi Arabia, UAE, European Union, France, Germany, Italy, and the US to establish the India Middle East Europe Economic Corridor (IMEC). This will be a transnational rail and shipping route spread across two continents, which is expected to stimulate economic development through improved connectivity and economic integration between Asia, Arabian Gulf and Europe. For India, this holds immense promise of reducing export related costs to the Middle East and Europe. However, the gains are likely to accrue in the longer term.
• From FTA perspective, progress is currently underway on individual agreements with UK, EU, and Australia. To recall, India & Australia already have Economic Cooperation & Trade Agreement in place, effective December 2022. Among these, the India-UK FTA is expected to go through first.

Meanwhile, India and Canada have “paused” their negotiations on the bilateral FTA on account of ongoing political tensions between the two countries. As per media reports, there is currently no timeline for resuming the India-Canada talks on the Comprehensive Economic Partnership Agreement (CEPA).

Chart 1: G20 partners have ~64% share in India’s merchandise trade

Note: Figures in parenthesis indicate respective % share in India’s total merchandise trade

Data: CEIC, QuantEco Research

Nine items that dominate India’s exports with G20 partners: (i) Mineral fuels and products, (ii) Organic chemicals, (iii) Nuclear reactors, boilers, machinery & appliances, (iv) Electrical machinery, (v) Pharmaceutical products, (vi) Vehicles & parts, (vii) Iron & steel, (viii) Aluminium & articles, and (ix) Misc chemical products.Chart 2: Top commodity exported by India to G20 partners in FY23

Data: Ministry of Commerce, CEIC, QuantEco Research

2. India’s monthly merchandise trade deficit is gradually expanding

India’s merchandise trade deficit has been gradually expanding and touched a 10-month high of USD 24.2 bn in Aug-23 (up from USD 18.5 bn in Jul-23, while close to USD 24.9 bn in Aug-22). Increase in commodity prices in recent months has been one of the key reasons behind the same – we note that the CRB Commodity Index averaged at 311 in Aug-22 as well as in Aug-23!

• However, on FYTD (Apr-Aug) basis, trade deficit is cumulatively running lower by USD 14 bn. This is largely due to narrowing of the deficit on account of Ores & Minerals and Petroleum Products.
• From country perspective, the cumulative narrowing of FYTD merchandise trade deficit is being driven by Iraq and Saudi Arabia.

Chart 3: Comparison of FYTD performance of India’s merchandise trade deficit

Data: CEIC, QuantEco Research

3. Outlook on US monetary policy

Along expected lines, the US Federal Reserve left monetary policy rate unchanged at 5.25-5.50% in its Sep 20^th review meet. Interestingly, while the revised dot plot* continues to highlight room for one more round of rate hike in 2023, it now suggests a greater emphasis on interest rates being ‘higher for longer’. As per the Sep-23 dot plot, the FOMC (Federal Open Market Committee) now projects 50 bps rate cut in 2024, lower than the projected 100 bps rate cut as per the previous dot plot of Jun-23.

Market participants are currently attaching a ~31% probability to a rate hike in the next policy review in Nov-23. As of now, market participants expect the Fed to commence its rate easing cycle from Jun-24 onwards, with likelihood of a cumulative 75 bps rate cut before the end of 2024.

Chart 4: Fed is emphasizing on interest rates being ‘higher for longer’

Data: FOMC, QuantEco Research

4. Outlining our expected rupee trajectory

The Indian Rupee weakened to a record low in Sep-23 on the back of a combination of factors:

• Monetary policy divergence between the two largest countries (US poised for one final round of rate hike while China just delivered two rate cuts) is resulting in a stronger USD and a weaker CNY. Both are individually weighing upon INR.
• Recent jump in global commodity prices, esp. crude oil, from an average of USD 75 pb in Jun-23 to USD 92 pb in Sep-23 (so far) would put trade deficit under pressure.

We expect the above-mentioned factors to persist in the near term because of which INR could weaken towards 84 levels within the next 3-months. Going forward, we expect the INR to partially reclaim lost ground and move towards 82 levels amidst favorable Q4 seasonality and anticipated USD weakness as market participants position for a pivot in US monetary policy cycle by mid 2024.

4. Key CYTD changes in price

Note: Price change is between Aug-23 and Dec-22 for respective generic indices

Data: World Bank, Refinitiv, QuantEco Research

Aug-23: Global Trade Check | US Fed Rate & Rupee Outlook | New Infographics on Commodity Trends.

1. Global trade review

Global trade volume registered a contraction of 2.4% YoY in May-23. This marked the sixth annualized contraction in trade volume in seven months. Basis, UNCTAD’s nowcast model, we project global trade volume to see an average contraction of 0.9% in Jul-Sep 2023 quarter, marginally better than the estimated contraction of 1.3% during Apr-Jun 2023 quarter.

Chart 1: Volume of global merchandise trade to remain weak in the near-term

Data: CPB Netherlands, UNCTAD, QuantEco Research

From India’s perspective, we note that key trading partners in developed economies have shown contraction in their import volume in 2023 so far. The forecast of contraction in global trade volume does not augur well for real demand from these economies. Nevertheless, the value of India’s merchandise trade might find some support from firming up of global commodity prices in the last two months.

Chart 2: India’s key export market showing signs of stress

Data: CPB Netherlands, QuantEco Research

Chart 3: Recent pick-up in commodity prices if sustained, will push annualized growth in CRB index to positive territory

Data: Refinitiv, QuantEco Research

The commodity wise run rate for India’s exports shows a divergent behaviour, although the distribution is negatively skewed on a cumulative basis. For e.g., at one end is Electronics Items, which has outperformed others by posting a robust expansion 37.7% YoY (Apr-Jul FY24 over Apr-Jul FY23), while on the other end of the spectrum is Petroleum Products, which is proving to be a drag with 35.7% YoY contraction.

• The spectacular performance of electronic exports derives support from government’s PLI scheme that has helped it to raise its annualized share in India’s merchandise export basket to 6.1% as of Jul-23, up from its pre COVID level of 3.7% (as of Feb-20).
• A sizeable contraction in petroleum exports is primarily reflective of decline in price. India Crude Basket dropped from an average level of USD 109 pb in Apr-Jul FY23 to USD 78 in Apr-Jul FY24, marking a fall of ~28%.

Chart 4: Notwithstanding the sectoral divergence in export performance, the overall skew is negative

Data: Ministry of Commerce, QuantEco Research

2. Outlook on US monetary policy

After raising monetary policy rate range from 0.00-0.25% in Mar-22 to 5.25-5.50% in Jul-23, the US Federal Reserve has delivered a cumulative rate hike of 525 bps in a span of 17-months. That is tantamount to having an average rate hike of 31 bps for 17-consecutive months. Besides other factors, this has contributed towards CPI inflation in US moderating from its peak of 9.1% in Jun-22 to 3.2% in Jul-23. Despite US economy showing signs of some resilience, monetary policy seems to be having the desirable impact (that of curbing inflation), albeit with a lag. As per last FOMC (Federal Open Market Committee) in Jun-23, the Fed members projected the median fed funds target range at 5.50-5.75% before the end of 2023. This implies scope for one more rate hike before the Fed reaches its interest rate peak in the current cycle.

Market participants are currently attaching a ~31% probability to a rate hike by Nov-23, followed by a pause until Mar-24. As of now, market participants expect the Fed to commence its rate easing cycle from May-24 onwards, with likelihood of a cumulative 100 bps rate cut before the end of 2024. This is in line with the FOMC projections made in Jun-23.

3. Outlining our expected rupee trajectory

The Indian Rupee weakened to a record low in Aug-23 on the back of a combination of factors:

• Monetary policy divergence between the two largest countries (US poised for one final round of rate hike while China just delivered two rate cuts) is resulting in a stronger USD and a weaker CNY. Both individually are responsible for weighing upon INR.
• Recent jump in global commodity prices, esp. crude oil, from an average of USD 75 pb in Jun-23 to USD 87 pb in Aug-23 (so far) would widen the trade deficit.

We expect the above-mentioned factors to persist in the near term because of which INR could weaken towards 84 levels within the next 3-months. Going forward, we expect the INR to partially reclaim lost ground and move towards 82 levels amidst favorable Q4 seasonality and anticipated USD weakness as market participants position for a pivot in US monetary policy cycle later in the year.

Chart 5: Adverse Q2 seasonality is catching up with rupee

(Data: Refinitiv, QuantEco Research)

4. Key CYTD changes in price

Note: Price change is between Jul-23 and Dec-22 for respective generic indices

( Data: World Bank, Refinitiv, QuantEco Research)

5. Key events worth tracking

Category wise share of exports is a function of prevailing price and quantity demanded. Four key product categories, viz. Petroleum, Chemicals, Base Metals, and Textiles constituted ~51% of India’s exports in 2021-22.  

Top 4 Categories have a share of ~51% in India’s export basket 

Share in export basket does not dictate performance or growth, which among others is a function of changes in macro environment, competitiveness, quality, and policy support. In 2022-23 so far (Apr-Nov), the Top 5 winners and losers from growth perspective are illustrated below. 

Top 5 and Bottom 5 commodity exports (basis YoY growth over Apr-Nov 2022-23)

Electronics has been a massive outperformer this year with 54.4% YoY growth over Apr-Nov period. The sector has benefitted from the Atmanirbhar policy thrust, with PLI (Performance Linked Incentives) Scheme acting as a differentiator amidst the geopolitical backdrop of key manufacturers opting for supply chain diversification (via ‘China+1’ strategy, Onshoring, Friend Shoring, etc.). 

As per our estimates, discretionary items¹ had a share of ~32% in India’s exports (excluding defence) in 2021-22. With World GDP expected to see a sharp slowdown in 2023² on account of accelerated tightening of interest rates and persistence of geopolitical uncertainty, demand for discretionary exports (like electronics, leather, textiles, etc.) could face severe challenges. 

Central banks: Rate hikes continue despite step down in monetary policy aggression  

Amidst deceleration in inflation from peak levels, most key central banks have moderated the pace of rate hikes in last 1-2 months. While monetary tightening continues across the globe, there are now subtle differences emerging. 

• The US Federal Reserve moderated its pace of rate hike to 50 bps in Dec-22 policy review from 75 bps in previous four occasions. However, Fed’s projection of the terminal fed funds rate, i.e., peak monetary policy rate in the current cycle has now moved up to 5.00-5.25% (to be achieved by Mar-23) from 4.50-4.75% in Sep-22. In addition, the Fed has projected rates to remain unchanged thereafter in 2023 – in contrast to market expectation of at least one round of 25 bps rate cut before the end of 2023.  
• The Bank of England moderated its pace of rate hike to 50 bps in Dec-22 policy review from 75 bps earlier. The voting pattern appears mildly dovish (with 2 out of 9 members voting for no hike).  
• Back home, the RBI too moderated its pace of rate hike to 35 bps from 50 bps in previous three occasions. Like BoE, the voting pattern shows a mild tilt towards dovishness (1 member voted for no change in rates, while 1 is likely to have voted for a neutral policy stance). 
• While the European Central Bank too moderated its pace of rate hike to 50 bps in Dec-22 policy review from 75 bps in previous two occasions, the accompanying policy commentary was hawkish complemented by the announcement of the beginning of quantitative tightening³. 

INR: Correction in overvaluation⁴

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1: Discretionary items  exclude plantation products, industrial products, specialized products, and crude oil from total export basket 

2: As per the IMF, World GDP growth is projected to slow down to 2.7% from an estimated level of 3.2% in 2022. 

3: Quantitative tightening refers to the selling of securities by the central bank to curb domestic liquidity 

4: Real Effective Exchange Rate is used as one of the theoretical indices to judge domestic currency’s valuation vis-à-vis its trading partners. The index is adjusted for inflation differentials with trading partners. By virtue of construction, 100 is considered as the fair value for the domestic currency, with higher values signifying overvaluation, and vice versa 

We believe US Fed’s ‘higher for longer’ monetary tightness is likely to provide a key source of support to the dollar. In addition: 

• Going into 2023, the Fed will reduce its balance sheet by a further USD 1.1 trillion, way ahead of any other major central bank. This reduction of global dollar liquidity would continue to support the USD and cause INR to depreciate against the Dollar. 

• Build-up of recessionary risks in Europe and elevated geopolitical risk premium could sporadically boost safe haven appeal of the USD and cause volatility in INR. 

Notwithstanding our expectation of a sturdy USD, the recent softness has provided an opportunity to the RBI to shore up some of its lost foreign exchange reserves during Apr-Oct FY23. India’s FCA (Foreign Currency Assets) has risen by USD 26 bn since end Oct-22. With RBI’s active dollar purchases being one of the reasons behind recent increase in India’s foreign exchange reserves, INR has not been able participate in the rally in global currency market vis-à-vis the USD.  

On the contrary, INR has weakened against 34 out 40 currencies (used by the RBI to compute rupee’s real effective exchange rate) in Dec-22 so far. This underperformance is helping to correct INR’s overvaluation. As per our estimates, the REER for rupee has moved lower from 103.1 in Nov-22 to close to 101.0, its lowest levels in last 20-months. An orderly correction of overvaluation in rupee is welcome as it helps in improving export competitiveness in the medium term. 

Rupee’s overvaluation has seen a correction in last 2-months 

Our fundamental view of 84 on USDINR by Jun-23 continues to remain unchanged. US Fed’s indication of ‘higher for longer’ monetary policy rate, RBI’s penchant for opportunistic reserve accumulation, and our Balance of Payments (i.e., current account deficit adjusted for total net capital inflows) call of USD 50 bn deficit would continue to drive mild weakness in rupee. 

What should the Exporters Do ? 

• Look at diversifying new orders away from Developed economies – US, EU etc. where due to high interest rates, clearly there is going to be a drop in discretionary spend. Middle East esp. Saudi Arabia, UAE etc. seem to be performing quite well. South East Asia overall seems to be impacted far lesser as compared to western economies due to ongoing adverse macro-economic developments. 

• Ensure necessary due diligence on Buyers with relevant financial creditworthiness checks given the uncertain times, we are witnessing delay in shipment schedules across retailers with request to suppliers to hold back shipments post production even for confirmed orders. Working with Factoring companies for exports mitigates the buyer non-payment risk.