What is in store for Calendar Year 2014

Highly speculated US Federal Reserve is finally putting an end to uncertainties surrounding the Federal Reserve action. Though the anticipated quantum of the tapering was to the extent of USD5 billion has been exceeded with and now it stands at USD 10 billion. The reasons for the action is well justified with the fact that US economic recovery seems stronger and the recent GDP data and other data like the unemployment and inflation data reflects a resilient recovery in the economy. Though, Janet Yellen seems quite savvy in dissipating the QE reversal with a caveat that the whole quantitative easing policy withdrawal hinges on the kind of recovery they see in the economy. 

Emerging market like India were eyeing the Fed action with a hawkish eye as the general perception remains that the stimulus withdrawal and its quantum will decide the foreign money flowing into Indian shores and equities and also its effect on Current account deficit (CAD) and currency. The announcement as of yet didn’t have any meaningful impact on the currency per se, which is the immediate indicator of the kind of impact it could have on Indian economy. More so, the credit goes to Raghuram Rajan, for taking charge at the helm of RBI and since then adopting measures and steps which not only controlled the rowdy INR at that point in time but also brought in fundamental changes in India’s macro picture by reining in the boisterous CAD. The data in table below gives a clearer picture of the material changes happened in the past couple of months. 

This has been a major reason for the market not reacting to the taper news in a jiffy. The general conclusion of a QE”s gradual winding going forward would be the USD strengthening, long-term real interest rates in US becoming more attractive and CAD deficit countries to see their currencies depreciating against USD. It all depends on how swift the FED wants the withdrawal to take place and how the economic data pans out. But the general trend should be one of a strong US market and weaker emerging market currencies, till the time they don’t have material difference to their trade deficit figures.

For Indian markets in calendar year 2014, a couple of domestic events will be the key deciding factor apart from the global events like the FED action and the Euro-zone economic recovery. 

First would well be the General Election likely to be held in May’2014. A strong and stable government is the desired outcome. BJP coming with full majority will be the ideal one for the market and the economic recovery. A coalition government will be the biggest risk to economic recovery and hence market will dislike and drive down the market on this outcome. Generally early stages of any economic recovery or a emerging bull market coincides with political uncertainty, high NPA’s in the banking system, weak currency, high inflation and low retail appetite for investing in stock market. This time it’s nothing different. Though the election impact has had major short term gyrations but they haven’t predicted the course of economy or the market in any meaningful way. During the P. V. Narshima Rao regime, some of the finest reforms were laid down and economy was liberalized and that was the time of a unstable coalition government. Market was knocked down sharply when NDA went out of power in 2004 but during the UPA-I regime we saw one of the finest spell of Indian economy and the equity market. When UPA-II regime got re-elected market was locked in upper circuit and we saw one of the worst performance of the economy and the market and also big time scams got un-earthed during this regime.

Second, would be the Inflation factor. Inflation remains elevated for a long time and the driving force to reckon with is the primary article inflation. Manufacturing inflation trajectory remains quite low and well below the comfort zone of RBI. It’s the food inflation which makes the overall WPI looks bloated and CPI remains elevated because of the major weight of food inflation in it. So in that sense, a better monsoon would do well to inflation and drive down interest rates which will then have a cascading impact on the investments and other moving parts of the economy. Expectation is for a declining trend in inflation mid-year and at present it seems to be peaking out.

Third would be the supply of papers with primary market comming with supply of papers worth USD 6 billion in first half of the calendar year 2014.

Outperforming Theme for 2014

First half of 2014 will be highly volatile for obvious reasons like the legislative election, expectation of monsoon and tapering effect of US Federal Reserve. But the yearend will be 7000 plus in Nifty, on back of growth returning, interest rates coming lower and inflation remaining benign. Serious outperformance of the market hinges upon the legislative election results and monsoon. At present if we look Nifty as a absolute number, index may look too high but from a valuation standpoint, we are trading at 14 times one year forward p/e and other valuation metrics like the p/b, dividend yield and earning yield to bond yield ratio, Nifty is trading below its long-term average multiples and hence remains undervalued. Expansion of valuation metrics will be the key driving force and those will come back once the companies start delivering growth at 15% plus i.e., above the average nominal GDP growth potential.

We think Information Technology, financials (on interest rates coming lower and economy picking up) and beaten down infrastructure stocks (to add beta to the portfolio since they are down significantly from their peak) will be the biggest outperformer for calendar year 2014. IT seems to be the most confident of all and is completely insulated from vagaries of domestic turbulences if any. We think that with US growth coming back will benefit IT companies the most. As the discretion spending power comes back with the multinational companies on better growth prospect, IT spend by the companies will rise and pricing power will come back for Indian companies. Along with it, INR settling at newer levels is an added boon to the IT companies. If incase any untoward political and economic development happens in the domestic space (whether it is political uncertainty, or lack of reforms, or tapering of bond purchase programme leading to flight of capital and risk averse) the direct impact will be the weakening of INR which will benefit IT companies the most. So, US growth picking up will lead to increasing business volume along with operational efficiencies and uncertainty in domestic market if any will lead to weakening of INR which will again be beneficial for IT companies. More importantly along with all these factors, IT companies across the sector is reasonably valued hence gives you ample amount of margin of safety. Infosys looks to be the star performer for calendar year 2014. In the midcap space NIIT Technology and Zensar Technology looks promising. Other stocks we choose for this year are FDC Ltd and Bajaj Finserve.

Election of Market Direction

Upcoming Lok Sabha election in 2014 would set the direction of the Indian equity market as well as decide the growth prospects of the country. Recent ongoing polling analysis shows that BJP will come in ruling seat by defeating Congress party in majority vote. However it is very tough to predict the election outcomes, especially in politically uncertain environment. The 16th Lok Sabha election in India most probably will be held on May 2014, however the state elections in four states will gauge the response to Narendra Modi led BJP’s elevation as Prime minister. Going forward, it is believed that the election could act as a catalyst to boost the nominal gross domestic product (GDP) growth and return on equity.

Importance of 2014 election

India’s economic condition is going through hard times with GDP growth touching new lows and creeping inflation is not giving room for RBI to lower the key policy rates (repo rates). Moreover, the rupee has plunged against the US dollar, increasing current account deficit and refraining foreign investors from investing in India. Moreover it is witnessed that corporate profitability is shrinking on quarter on quarter basis. These domestic macro concerns put the upcoming 2014 elections in a different context compared to the last three elections held in India. The responsibility of the new government will be to reverse the economic free fall, which will require strong policy action to encourage investments. Hence a government with big majority is best placed to drive India’s growth revival and for that a clear and decisive mandate from voters is needed to allow such government to pursuing reforms with greater vigor and meaningful impact.

Stock market always reacted to the outcomes of the elections held in India. It has been seen that the electoral results have had strong impact on the stock market, following the 2009 election results, the market rallied 17% over two days as the ruling congress won the election with a clean majority sweep. In 2004, after BJP lost decisively to Congress coalition (supported by left-wing parties) unexpectedly, market plunged 17% in two days, proving that there is a strong correlation between election results and stock market as the strong and clear majority government would be able to improve the macro economic conditions of a country. The new government in the country is likely to set the tone for policy and growth over the next five years, deciding the country’s economic growth prospect. The current UPA Government’s populist agenda including the National Rural Employment Guarantee Scheme (NREGS) has been the hallmark of its five year term. However, in contrast, the BJP is more fiscally conservative, with a development focused agenda

                        

                                     

The uncertainty around the election is always a key risk to the Indian economy, when an unclear mandate emerges. This happened when Congress formed government with much weaker mandates in 2004 (145 seats) and 2009 (206 seats). It has been seen that a weak leadership largely made up of regional parties, each with their own agenda were incompetent of pursuing the bold reforms needed to kick start India’s economic growth. In this scenario, it would lead a period of prolonged weak and patchy policy making.

Economic downfall during UPA -II regime

The biggest failure of the current government has been on the economic front, with GDP growth slowing down from an average of 8.5% over FY04-FY11 to 4.4% in 1QFY14 due to lack of policy reforms, delay in large projects approval, resulting in stalled projects and inability to pick up investment cycle. Moreover, the slowing growth is compounded with rising inflation, which is eating the profitability of the corporate as well as lowers the savings of the common people. Headroom for the central bank to respond has been limited due to inflation, high fiscal and current account deficits and rupee depreciation (down 43% in the current government’s rule to an all-time low). Even in 2012, April, the economic condition has been so severe that rating agency Standard and Poor downgraded India’s international ratings outlook to negative, which caused a serious threat to economic growth of the country. Besides economic slowdown, two major scamps which come to the forefront are the 2G spectrum allocation and coal blocks allocation.

Current India’s Parliamentary structure

Opinion poll shows BJP might have an upper hand

The latest opinion poll shows that the electorate is giving a more decisive mandate in favour of BJP with 175 seats as opposed to the findings of July 2013 poll which suggests’s that the base case was of a BJP led coalition forming the Government in the Central. The prediction of BJP getting the 175 seats and at the same time forming the Government, BJP would likely garner the support from seven regional parties namely Shiv sena, Akali Dal, Trinamool congress, AIADMK, BSP, BJD and TDP, thereby generating a tally of 273 seats. Thus it is expected that BJP coalition would form the government, breaching the 272 seat mark comfortably. On the other hand it is expected that the Congress is likely to get 233 seats (Congress + UPA allies + Left Front + SP + DMK + JDU + TRS + YSR Congress + JDS). Narendra Modi’s pro business approach getting popularity among young generation and survey shows that Modi leads popularity by a very wide margin when it comes to first-time voters. The survey only covers the currently enrolled voters and it is expected that the enrolments amongst first time voters are likely to increase as the General Election will approach. This dynamic could increase the number of seat counts for BJP in coming Lok Sabha election.

India opinion polls (seat projection for 2014 election)

State Elections in four states is an important event to watch out

Before the general elections in April 2014, state assembly elections will be held in Chhattisgarh, Rajasthan, Madhya Pradesh and Delhi and the outcomes of these elections is important to gauge the response to Narendra Modi’s elevation as the BJP’s prime ministerial candidate. The opinion polls of the four state elections show that BJP is set to win 3 of the 4 election bound states. The results of all the four state elections will be announced on 8 December 2013, which seems to be an important event from a stock market perspective. Market will factor the outcomes of the elections and any deviation from the expectation would have an adverse effect on the stock market. Of these four states, Rajasthan is the state that will be a litmus test of the pro BJP sentiment. If on 8 December 2013, it becomes clear that the BJP wins Chhattisgarh, MP as well as Rajasthan then the market is likely to factor in BJP’s victory in General Election. Though there are many slip in between the lip and the cup and predicating a concert election outcome is impossible. Only probabilities can be assign to the outcomes. 

Opinion polls of four state elections

The momentum of the Indian stock market would sustain for prolonged period if the 2014 election outcomes comes in line with the expectation. The 2014 General election could act as a key catalyst for Indian economy as the economy is facing of number macroeconomic challenges following with slowing growth, rising inflation, lack of policy reforms and large number of stalled projects. A strong, sustainable and pro active government in the Central would improve the macro factors of the country and also resume the investment cycle which as of now remains sluggish. Implementation of reforms at different levels would regain the investors’ confidence and thus boost economic growth of the country. Whilst it is expected that India would attract more foreign investments and the stock market could witness more inflows from abroad, which could drive the index to a newer orbit altogether.

NIFTY Inching towards 7000!

Most of the market participants are unprepared for an extended rally from these levels and hence it becomes that much easier for the market to keep surprising the market participants and scale newer highs. Above new high a vertical run-up in Nifty upto 7000 is not ruled out and probably this will take most of the market participants with awe and dumb-struck moment. Technically as well we have reached to an inflexion point where the triangle pattern of last six years is about to breach, which will make the indices take a bigger and larger leap.

Last couple of weeks the market is in a cheerful mood. Price action seems quite confident of scaling and kissing the all-time high. As Diwali is in the offing, market generally tends to hit Diwali with a bang. Moreover, at times there has been the case that Diwali generally coincided with a major trend setter as far as sentiment goes and usually marks the crescendo. The seasonal festivities started with Dr. Raghuram Rajan officially taking the seat as a Governor of RBI and the market warmly welcomed him with a rally, unflinching, so far. Moreover, post this event certain steps were taken by RBI, which has marked an intermediate bottom in the INR and at the same time, current account deficit of India started its corrective course. This has undoubtedly relieved some of the pressure off the market sentiment which was otherwise low. This resulted in improving macro and the FII’s took a positive stance on Indian equities post the developments. FII’s generally tend to take a top down approach on emerging market and macro factors certainly weighs heavily in their top-down approach which is definitely being noticed in the kind of FII inflows which we are witnessing in the last couple of days.

It could be a cracker of Diwali with foreign funds splurging and also cherry picking stocks and Rupee stablizing. FIIs have pumped in $15 billion into Indian equities so far this calendar year. More so, the expectations that the Federal Reserve will keep its stimulus in place for longer, following the confidence sapping US fiscal impasse. This impasse will certainly keep the bond buying programme postponed to early next year and this also adds up the extra zing in the emerging market basket 

Currently, Sensex is trading close to the14x on a one-year forward P/E. On one-year forward P/B, Sensex is currently trading at 2.6x, a discount to the historical average of 2.8x

BSE Sensex trailling P/E and BSE Sensex trailling P/B 2006 - 2013

The major call one needs to take in the market is whether all-time high to be conquered this time and the Nifty & Sensex gives a successful closing above it. Though in the last couple of attempts, Nifty has faltered in its attempt and market participants are skeptical this time as well to take a call on the market beyond all time high as most of them perceive that the fundamentals are not conducive for a market sustaining beyond that. We have in last couple of times highlighted the fact that all time high simply remains a psychological mark and the relevance of it is diminishing with every passing year because the P/E multiple, P/B and other valuation metrics of the Nifty in 2007 and today are hugely different. From there till now Nifty stocks have grown at a compounding annual return of of 7% and all the valuation metrics in 2007 at a euphoric state were quite exorbitant and today, in dismal economic state, is lying highly depressed, despite approx 8% CAGR in EPS of Nifty and Sensex in last six years.

The P/E multiple compression is because of slowing down of economic activity, GDP decelerating and higher inflation and interest rate in the system and more importantly growth of corporate India slowing down considerably from 25 per cent compounding earning growth from FY2003-2008 to roughly 8 per cent compounding annual growth rate in earnings from FY2008-2014E. The companies which have announced their results for the quarter ended September 30th have shown an annual increase of 17.2 per cent in revenues, reversing a declining trend seen in the past quarters. Net profits have grown 9.11 per cent; a tad lower, as rising input costs are beginning to squeeze bottom lines. Around 40 per cent of the BSE Sensex earnings buoyancy is due to the information technology and other export-driven sectors, where the currency has had a positive impact and is driving the initial optimism, a trend evident in the chart attached.

Looking with optimist’s view of the glass being half full, currently, both margins and sales growth have bottomed out already and if mean reversion of margins is assumed, the earnings are estimated to double in four years. Markets generally anticipates a improvement in earning cycle or some other major developments, six months in advance and starts building on it. At present it seems that the market is in a state to conquer the all-time high and probably if that were to happen, it will lead to a vertical run-up to election. Most of the market participants are unprepared for an extended rally from these levels and hence it becomes that much easier for the market to keep surprising the market participants and scale newer highs. Above new high a vertical run-up in Nifty upto 7000 is not ruled out and probably this will take most of the market participants with awe and dumb-struck moment. Technically as well we have reached to an inflection point where the triangle pattern of last six years is about to breach, which will take the indices take a bigger and larger leap.

At the time, when the Indian currency has stabilized on back of concrete steps taken on FCNR-B and tier II banking capital norms, it has successfully fetched more than USD 10 billion. Other major developments include the initiation of an idea to induct India on the JP Morgan bond index, which could be a game changer, and expected to bring larger dollar inflows of more than USD 15 billion in Indian kitty. Along with the currency stabilization, CAD has improved on back of gold imports slowing down, exports picking up and imports stabilizing and contracting. Many positive measures are being taken by the Government recently and hopefully faster reforms in 2014 will put the economy back on a high growth trajectory. Election next year is the most awaited event trigger for the market.

Foreign money seeking Indian shores through FCNR-B Deposit scheme

Market seems to be in a roller-coaster ride with swings on either side getting wild. The rise which we witnessed in the month of September was fast and furious and was equally sharp as the decline prior to the rise. Monetary policy these days have been seriously impacting market direction. Post, the induction of new RBI Governor, Raghuram Rajan and his first day formal speech triggered a sense of optimism and the markets flared up on the announcements. The key announcement was with the FCNR-B (Foreign Currency Non-Resident) bank deposit scheme where the dollar deposit will be hedged by RBI with swap line fixed at a concessional rate of 3.5% p. a. for three years or more. This is almost half of one year forward rates to hedge the currency inflow. Add to it the interest rate provided in the FCNR deposit of 4.5% to 5.5%. The effective cost of funds for banks comes around 8.5% to 9% and this does not requires SLR and CRR. Hence, they can lend this new source of fund at 11% plus and hence a lucrative proposing which will propel dollar-carry trade. FCNR deposit is estimated to flock in hoards and many of the bankers are expecting fund flow in range of $10 billion to $20 billion in few weeks as the window remains open till 30^th November 2013. Reasons for non-resident Indians to put money in FCNR deposit account is because of lucrative returns through leverage which is significantly higher than the interest return generated in developed countries. This was the real trigger, apart from the optimism of an experienced and learned personality like Raghuram Rajan coupled with measures of FCNR deposit and OMC dollar swap, which led the INR mark a bottom around the 70 mark and retrace back swiftly. Equity market also around that time marked an intermittent bottom around the 5118 mark in Nifty. After it, Fed Chairman Ben Bernanke’s decision of not tapering the bond buying programme of $85billion, because of sub-par growth, low inflation, slowing consumer spending and weaker job market, led to market opening gap up and kissing the 6000 mark in Nifty in an extremely euphoric state.

The RBI policy recently announced was a true shocker with the repo rate hiked by 25 bps to 7.50%. On the other side there was a rollback of its currency stabilization measure. The Marginal Standing Facility (MSF) which stood at 10.25% now has been rolled back by 75 bps and stands at 9.50%. At present majority of the banks is borrowing money at the MSF facility which is capped at 2.5% of NDTL, over and above their requirement of 0.50% of NDTL(Net Demand and Time Liability) from repo window under the LAF(Liquidity Adjustment Facility). It is important to note that the 25 bps hike in repo rate can be construed that the new RBI Governor is more targeted to control inflation rather than support growth for macro-economic stability. It sees continuing sluggishness in industrial activity and services. The pace of new project announcements have slowed and consumption is weakening, including the rural areas. Consequently, according to the RBI, growth is trailing below potential. Looking ahead, it believes that brighter prospects for agriculture, an upturn in exports, and implementation of infrastructure projects expedited by the Cabinet Committee on Investments (CCI) will support growth in the second half of the fiscal year. For spurring growth it is left best at the hand of the government policies for fiscal and structural reforms. With higher rate decision by the RBI, it also intends to support the INR by keeping the hope alive for dollar-carry trade and interest rate arbitrage. This probably will support dollar flows into Indian shores and thereby aid the current account deficit. But the higher interest rate regime impedes growth and also raises the risk of corporate defaults for companies which are highly debt laden. Report indicates that the corporate default will rise to 4.5% in comparison to around 0.50% three years back. Moreover, it’s clearly evident from the fact that Non-Performing Assets of banks rising to above 10% (NPA+Restructured Assets) are a precursor to the ailing health of Corporate India. If we look at the Corporate Debt Restructuring (CDR) cell numbers, the stress in the banking system is elevated. Total of 14 cases have been referred to the CDR cell in the first two months of the second quarter amounting to Rs. 26,000 cr. And the fact remains that CDR cell cases accounts only 30% of the total restructuring which happens outside the purview of the CDR cell. Second interesting thing to note for the banks is their credit/deposit ratio which remains elevated at 78%. It indicates that the banks don’t have any other choice except to hike deposit rates and garner more deposit. Credit growth though have moderated but still remains higher than the deposit growth and hence banks would be seeking for hiking base rate so as to adjust with the new cost of funds.

                           * RHS & LHS in Rs Billion

With the policy stance being taken by RBI, (OMC dollar swap, FCNR deposit swap fixed at 3.5%, increase in foreign debt ceiling and gold import curbs) it has stabilized INR. But the hike in repo rate by 25 bps will certainly mark down the Sensex earnings estimates. Though the earnings of companies related to good monsoon will certainly be reflected in selected companies but the sticky inflation situation, rise in input cost, slowing down of industrial activities and overall anemic economic growth and capex showing no signs of green shoots are going to weigh down heavily on corporate earnings and a downgrade risk in corporate earning persists. So our sense is that the rallies in the equity market are more to do with liquidity flows (likely to remain robust because of FCNR-B deposit scheme with swap line with RBI at concessional rates till 30^th Nov 2013) and global developments. With certain major developments like the FCNR deposit, OMC dollar swap, and interest rate differential will certainly keep the foreign fund flows on robust ground and support the market which is more of technical in nature rather than any significant fundamental changes. One year forward P/E of Sensex stands at 14 times, which looks reasonable and mean reversion trade seems to be the practical conclusion. Though earning downgrade may make the P/E looks bloated. Tactically, positioning on the long side with well chosen cyclical when the market falls more than 10% and again seeking defensives when the market rises more than 10% is the contra-trading  strategy worth applying. Geopolitical tensions with Syria is overblown and hence crude may cool down in coming months which would be a potential trigger for the market to scale back to 6300 in Nifty, since the whole macro-economic dynamics of India changes along with it. 

Nearing the bottom....

US monetary policy to remain loose, Syria tensions overhyped, most populist Indian bills priced in. Indian inventory growth is flat, while the J-curve should show up soon.

We are not quite at the bottom, but we are nearing it. The rupee has fallen and the dollar has risen rather dramatically - no need to retell that story, just see the graph below - but the equity markets have held up relatively well (at least in rupee terms). This is not a recommendation to start catching falling knives. This is a call to remain alert and consider becoming less bearish.

Why? Five reasons - three factors that have been exaggerated, and two that have been underplayed:

1. The “Fed stopping the easy money” theme has been overdone. Yes, there has been a recovery in the US, but it is slowing. Consider some facts. Personal/consumer spending in the US was up just 0.1% in July compared to June (that is, 1.2-1.3% annualized). The 0.1% number was the lowest since April. What also rose just 0.1% from June to July? American prices (core price increase, excluding food and energy, was also 0.1%). Therefore, “spot” inflation (annualizing) is also around 1.2%. This number too - along with growth estimates - has come down compared to last month. What this means is that the Fed is now more likely than it was a couple of months ago to be more dovish on the margin. The likely replacement candidates for Bernanke - be it Janet Yellen or Lawrence Summers - are both dovish i.e. for easy/loose monetary policy (none of them are going to be a hawk like Paul Volcker, not that one is needed). Yes, Janet Yellen maybe more dovish than Larry Summers, but that is splitting hairs. The story is a bit different in Europe and Japan. Across the Atlantic from New York, UK consumer confidence data is higher and EU unemployment is marginally lower. In Japan too, Abenomics has finally got inflation to 0.7% (core CPI). But here is the thing - besides a couple of LTROs (Long Term Refinancing Operations) and other measures in EU, and the recent rush of QE from Tokyo - the global markets (at any rate the Indian one) are still predominantly focused on the Fed. This is not to underestimate the other two rich-world entities, but even there any tightening is implausible for the near future – especially in Europe.

2. Any serious, sustained invasion of Syria has a very low probability - and hence oil prices are probably near their short-term peaks. Even a one-off attack flaring up into some serious international crisis is unlikely. After the war-weary UK parliament, across party lines, denying their PM David Cameron the mandate to attack Syria, the US President Barack Obama just this weekend has also thought about his remaining anti-war, anti-interventionist street-cred and decided to go to the American House and Senate for authorization. The chances of those two august gatherings of the American representatives to quickly and decisively agree about anything is rather low - even on apple pie, it seems (motherhood? no chance). Russia and China have the UN veto, Israel does not want any protracted conflagration, and neither does Saudi Arabia or especially Iran. It will be made sure that just enough is done so that the American President can enter the coming mid-term elections as a “statesman”. In any case all this is relevant, especially for India, because it impacts the oil price (nobody cares about the Just War theory). Since the penultimate stage to Armageddon was already priced in, we all can breathe free. Moreover, there remains structural reasons to be short oil (in USD). Demand is peaking, while supply has unsurprisingly continued to surprise. Sub-100 prices on Brent is plausible by the end of the year. 

3. The great socialist republic of India is lurching towards two very enlightened acts on Food Security (FSB) and Land Acquisition (LAB). [“Act” here refers to pretense, not a piece of law] With the Minimum Support Prices (MSP) at which the Food Corporation of India (FCI) buys some grains, especially cereals, we are at a situation that many wheat farmers in India would first sell their produce to the central government at 14 Rs/kg, and then buy some of it back at Rs. 3/kg. It boggles the mind to see this kind of centralized waste and institutionalized corruption, but it does not really surprise. Instead of supporting food stamps and cash transfers, and allowing states to experiment, we have put on an additional gigantic fiscal obligation just when the rupee was panicking, and the central bank had no good option. Similarly, LAB fixes prices for land even for fully consensual decisions - and is going to lead to much more paperwork. But the only silver lining here is that the markets have already priced these scenarios, and any more large populist projects with substantial fiscal expenditures are unlikely over the next few months, though of course one can never be sure. Moreover, the FSB does not go towards implementation phase right away. The Indian fiscal deficit situation is being partially ameliorated by consistently raising petrol and diesel prices, even if under-recoveries remain. Moreover, as shown later – the Indian debt to GDP ratio has been falling/stabilizing for sometime now. The same inflation that is so politically toxic and economically inefficient can be fiscally wonderful – as it reduces the real value of the stock of government debt.

4. Indian inventory growth has collapsed, along with industrial production. The June 2013 year-on-year Inventory growth was a negative 0.4% in real terms, and 5.18% in nominal terms, which suggests that this downturn cannot last much longer. It also shows that we are in a much worse situation perhaps than some other indicators suggest. Corporate investment as a % of GDP was 10.6% in 2011-12 and has almost certainly fallen much below (in 2003-04 it was 6.6%, when the boom for the next five years was starting). CPI continues to be near double digits, and much higher than WPI (5.79%). Savings rate is not as high as it was in the boom, but purchases of gold should not be seen as necessarily unproductive. If loans are taken out against gold, as many entrepreneurs have been trying to popularize, the conventional modern financial system is not being fully bypassed. If not, then too it is simply a further squeezing of the monetary supply - and maybe the government can in that case consider adopting a dovish position with respect to the monetary base

In any case, the CPI is disproportionately focused towards food prices, which in turn are influenced by - as the economist Surjit Bhalla informs us - by minimum support prices (MSPs), which have seen populist hikes above the usual norm in the last few years. This also suggests that containing inflation in such cases through monetary policy may be, on the margin, using a hammer instead of a scalpel. Raghuram Rajan, in a past academic life, has talked about inflation targeting. But in the real life he is as likely to cut rates before increasing them. Caught between a falling rupee, almost double digit inflation, and 4 odd percentage GDP growth and, of course, coming elections - the options are all bad, and the status quo with some minor adjustments is likely to prevail in the next half a year on the rates’ side. Rajan will be more influential initially on the regulatory and macro-prudential side, and could contribute well on innovation regarding financial inclusion public policy.

5. The J-Curve effect says that when a currency falls, the trade balance will first deteriorate before improving. It is possible that in India, while the imports will fall with a falling rupee but they are nonetheless more “sticky” or relatively inelastic (think petroleum demand etc.) while the exports (certainly manufacturing, even services) take some time to respond to a suddenly devalued currency. If true, this results in the J-curve effect for the trade balance, and the sudden weakeness in the rupee (in nominal terms) could lead to stronger exports and growth, other things being equal, in the coming quarter. In real terms (or measured by the Real Effective Exchange Rate), the rupee has actually not devalued that much against the USD because of the large inflation differentials between the two countries. Moreover, import restrictions and some capital account controls have been enforced – and while one may disagree with these from a long-term point of view, in the short term they will show results. Already, there are noises about the BPO industry getting a new lease of life in its competition with Phillippines etc, and the KPO and other industries also benefitting. For mass manufacturing exports to benefit though, we need labour and other reforms. Nonetheless, at least the import competition from China and Europe for local manufacturers – of everything from fans to heavy machines – has been substantially weakened. Watch out for stable imports and rising exports

These five reasons show that the pessimism has already been over-baked in the cake. But let us deconstruct the numbers a bit more. The latest sectoral quarterly growth (year-on-year) are as follows:

Personal and financial services have been doing great – and now with a weaker INR, will continue to do well (at least the export component, which is not a small element of services in India). The real problem is in mining and manufacturing – for which policy paralysis is directly to blame. The construction and trade/transportation heads also show that India is in the middle of a real estate slowdown, and the creaky infrastructure is not helping. A slow-motion property price burst could well be happening – at least in inflation adjusted terms. The Reserve Bank of India (RBI) should take some solace from this, and the incoming governor Raghuram Rajan may be emboldened to marginally ease, going against the international grain of emerging markets such as Brazil. Moreover, as market commentator Deepak Shenoy rightly points out that if we use the CPI instead of WPI for the GDP deflator, we are already close to a recession, if not in one. The nominal growth of the economy in many large sectors has been single digit, while the CPI has been almost double-digit. This combined with the knowledge that India’s core inflation (sans food, energy) has been not that high could provide the intellectual justification for dovishness. On the other hand, no monetary policy is super-effective in India – there is the usual lag, but even the transmission mechanism is weak. Perhaps a tightening is what is in order, but the real responsibility (and its dereliction) has been because of the inability of the government to pass many competition-enhancing supply-side liberal reforms. While spending is also a real concern, India’s tax to GDP ratio remains low – and more importantly the debt to GDP ratio has been falling (although the debt service ratio is not that benign given rising interest rates)

*Contributed by Harsh Gupta; Economist from Darthmouth University, CFA & Professional Financial Consultant in Singapore (as on 2nd September 2013)

RBI acting in a jiffy!

Belaying RBI

The rupee has been lamenting in the last few days and so has been everyone affected by it. Rising prices and the falling rupee has combined to make a volatile cocktail, exploding on the common man's face and giving the most nightmarish experience of daily living. Rupee has seen a drastic downward trend in the last couple of months, moving from bad to worse; it saw a life time low to 61.21 against dollar after the better than expected US jobs data raised anticipation of monetary tapering soon. Strengthening of dollar index overseas, strong importers demand, continuous capital outflows coupled with widening current account deficit has put pressure on the rupee. The over 13% depreciation of the rupee from the beginning of April has the markets jittery and the government worried. The sole supplier of money is trying all possible ways trying to save its product. The last month saw various actions by the RBI.

The life time low of rupee prompted immediate action by the RBI to ban all proprietary trading in currency futures and options by authorized dealer banks with immediate effect. While the RBI has barred authorized dealer banks from trading in currency futures and options (F&O) on their own, they will, however, be allowed to trade on behalf of their clients. The central bank also asked oil firms to buy dollars from a single bank to curb bunched up demand. July 15^th however saw major reform actions from the RBI front to prevent the clamp of the rupee from reaching the psychological dread figure of 60.These actions included the following:

      >The central bank restricted banks' borrowing through LAF (liquidity adjustment facility) to 1% of total demand and time deposits or Rs 75,000 crore, whichever is less. LAF is the combination of two auction routes: repo and reverse repo. While banks borrow from repo currently at 7.25 percent, they park their excess liquidity via reverse repo rate at 6.25 percent.

     >MSF (marginal standing facility) rate increased 200 basis points to 10.25% from 8.25%, i.e, 300 basis points higher than the repo rate. It is the rate at which banks can borrow money from the RBI pledging extra SLR bonds (the SLR rate is at present 23%).

      

       >OMO (open market operation) sales of 12,000 cr. on July 18^th.

The open market operation sale of bonds however, remained an unsuccessful paradigm. Much below the objective target, the Reserve Bank of India raised only Rs. 2,532 crore through the open market operation bond sale on 18th July, against the targeted Rs. 12,000 crore. The primary reason for RBI to not accept all bids for sale despite its objective to curb excess liquidity in the system was the uncomfortable nosedive in rates which would hurt investor sentiments adversely.

A Step Ahead

Actions undertaken seemed impotent and rupee still hovered around the 60 mark, more from the RBI end was required to defend the currency, further actions by the RBI on July 23^rd were as follows:

• RBI reduced the liquidity adjustment facility (LAF) for each bank from 1%of the total deposits to 0.5%, thus limiting the access to borrowed funds from the central bank with immediate effect. The earlier imposed cap on overall allocation of funds at Rs 75,000 crore under LAF stands withdrawn. For the system as a whole, 0.5 percent of total deposits mean Rs 37,000 crore.
• RBI has also asked banks to maintain higher average CRR (cash reserve ratio) of 99%of the requirement on daily basis as against earlier 70%. CRR is portion of deposits that banks are required to keep with RBI.
• RBI also capped the total amount of funds available to a standalone Primary Dealer under LAF at 100% of the individual PD's net owned funds as per the latest audited balance sheet.

With all these measures, the central bank will continue to closely monitor the markets, the liquidity situation and the macroeconomic developments. It will take similar measures as necessary, consistent with the growth-inflation dynamics and macroeconomic stability, said RBI, which further announced its first quarter (April-June 2013) monetary policy on July 31, 2013.This monetary review was marked by unchanged key rates as was expected by the markets. The Governor justified RBI’s stance by mentioning that there could have been monetary easing considering decelerating growth and a better inflation numbers but since the primary focus at the moment was exchange rate volatility, a STATUS QUO was preferred.

Were the liquidity curbs effective?

The question that now arises is that whether these measures were effective, and if they were what would have been their consequences:

• The benchmark 10-year bond yield hit a 14-month high of 8.50%, up 33 basis points on the day and 95 basis points since the RBI's first round of measures on July 15.
• The one-year overnight swap rate jumped to 9.30%, it’s highest since September 2008 when the collapse of Lehman Brothers was roiling global markets.
• Short-term debt markets issues, particularly commercial paper with tenors of up to 3 months have surged 200 basis points.
• Following the RBI's second round of measures, the rupee gained 65 paisa to 59.11 in late following day trade at the Interbank Foreign Exchange market.
• Bank stocks got pounded and they took down with them the Nifty and the Sensex. As on July 24^th, Nifty closed 1.44% lower and Sensex closed 1.04% lower, down by 87 and 211 points respectively.

The graphs below clearly show that the last few actions of the RBI have caused the interest rates (both in the government securities market and the swap rate) to rise. Also, as shown in the graphical representation, these liquidity restraining measures have given a bit of relief to the rupee which before these actions was depreciating abominably, but is still far from comfortable or better said affordable range

A typical Yield Curve

An unusual yield curve is seen in the current scenario (blue line in the graph below)-Inverted yield curve, a situation when short-term interest rates are higher than long-term rates. Recent actions by the RBI have surged the short term yields, the 3 month and 6 month yield have risen to 10.8% and 10.2% respectively as on July 25^th 2013. Under unusual circumstances, long-term investors will settle for lower yields now if they think the economy will slow or even decline in the future. An inverted yield curve can indicate an unhealthy economy, marked by high inflation and low levels of confidence.

Debt Mutual Funds Affected

Mutual funds are bracing for a fresh round of redemptions from their fixed income schemes after the liquidity tightening measures to contain excessive speculation in the rupee. Mutual fund officials are expecting outflows from most debt schemes, a category which has seen sizeable inflows in last few months. The mid month liquidity measures of the RBI resulted in the redemption of about Rs. 60000-70000 crore. On July 16^th, Mutual funds faced one of the highest single day outflows since October 2008.The second round of liquidity measures has, however, seen less redemptions (roughly about Rs.25000 Crores) because either a large chunk of outflows from debt schemes had already taken place or that people started believing the RBI measures as a short term phenomenon. Notably, RBI’s special liquidity 3 day window which allows banks to borrow a total of Rs. 25000 crore at 10.25% was not used, reasons cited were that they posited enough liquidity. But the more convincing reason can be that the banks are finding the borrowing cost of 10.25% too high.

So, is it enough?

Apart from the currency problem that is clouting RBI to monetary tightening actions, there’s a continuous pinch from the fiscal arm too. Fiscal deficit occurs when the government spends more than it earns and to fill the gap of budget deficit, one of the measures used by the RBI is sale of bonds. The fiscal target for this year has been 4.8% of the GDP (5050.24 billion rupees), more than 30% (1807 million rupees) of which has already been breached in the first two months. So, a further growth sacrificing and increasing interest rate phenomenon seems in store from the fiscal perspective too.

It is clear from the string of recent measures that the government does not want the currency to be trading meaningfully above 60.The biggest question that now arises is whether these actions are temporary. If the RBI is trying to achieve medium term currency stability then these measures are going to last for a while but if it is just about a shock therapy to cleanse up the system or if they believe that there are speculative positions in the system which will get cleaned up through this measure then it could be a relatively temporary measure and in that sense lending and deposit rates might not go up substantially. Unless a country has a relatively stable exchange rate it is very difficult to convince FDI’s and FII’s to invest in India. It can be concluded that these measures have been the ventilator and unless structural recovery takes place, it will be difficult for the financial life in the form of investor confidence to sustain.

Shivers in Cross-Currency Trades and Bond Markets

Last month saw some major developments in the financial markets. It’s no more confined to equity market but fixed income market, emerging market currencies, gold, crude and what not, is loosing steam. Probably we have come to a pass where asset classes across spectrum are giving disappointing returns. The central theme to focus on was emerging market currencies taking a hard knock and Federal Reserve’s comment on withdrawing stimulus in a gradual manner. These two triggers certainly have had major repercussions on varied asset classes. US 10 year bond yield scaling highs of 2.61% have certainly had the potential to spook emerging market asset class.

Earlier Fed was carrying $85 billion monthly bond buying programme through the QE3, which artificially kept the yield suppressed in US. Now with stimulus withdrawal gaining momentum, yields have started shooting up for different maturities and this in effect have the potential to strengthen USD. Therefore higher yields in US and stimulus withdrawal will certainly pull back liquidity and will seek homeland where rates are hardening. Despite of lower inflation expectation, bond yields have been moving higher. Generally lower inflation leads to lower yields.  But just because of the QE programme, yields were suppressed in order to create inflation in the economy and this lead to negative real yields.  Negative real yields were fuelling cross currency trades with dollar being the funding currency. But now recently with the expectation of withdrawal of QE3 programme, bond yields have moved up sharply and there is a positive real yield. Hence dollar which was earlier used as a funding currency for carry trade (since the dollar funding cost was insignificant) and the liquidity which was seeking higher returns in emerging markets is now coming to a pause. Unwinding of carry trade will certainly knock down emerging market currencies because of the exodus of fund from emerging market to developed market. To add more to the currency decline were the already fragile state of economy of emerging markets and their wide current account deficit. As a result of which, a combination of factor lead to the more swift and furious decline in the currencies like the South African Rand, Brazilian Real, Turkish Lira, South Korean Won, Indian Rupee, Russian Ruble to name a few. In India itself, FII’s have withdrawn more than $5 billion from debt fund in last couple of weeks.

Emerging Market Currencies	USD	5 Day % Change	1 Month % Change	3 Month % Change	6 Month % Change	YTD % Change
South African Rand	10.0876	0.9626	-4.7306	-8.3171	-15.0333	-16.0008
Argentine Peso	5.3615	-0.4085	-1.7812	-4.5454	-8.5405	-8.3186
Indian Rupee	59.855	-1.9046	-7.1506	-9.1722	-8.3702	-8.1196
Korean Won	1153.58	-1.9929	-2.702	-4.161	-6.9609	-7.7307
Turkish Lira	1.933	-1.5934	-4.5318	-6.1873	-7.1961	-7.7289
Brazil Real	2.2139	-1.4635	-7.0825	-9.0835	-6.0482	-7.331
Russian Ruble	32.8349	-1.7874	-4.5107	-5.8758	-6.9094	-7.0349
Phillipines Peso	43.345	-0.4614	-3.922	-5.5785	-5.064	-5.3985
Malaysian Ringgit	3.1945	-1.3461	-5.1964	-3.1586	-3.9474	-4.273
Singapore Dollar	1.2717	-0.228	-0.8493	-2.4377	-3.743	-3.9239
Taiwan Dollar	30.086	-0.7944	-0.7346	-0.7578	-3.367	-3.5
Mexican Peso	13.2176	0.2088	-5.6652	-6.5587	-1.5729	-2.7562
Hungarian Forint	227.14	-1.3736	-1.5013	4.156	-2.4214	-2.7648
Indonesian Rupiah	10007	0.1899	-2.1385	-2.6881	-2.0785	-2.1385
Thai Baht	31.07	-0.1931	-3.8944	-5.6324	-1.384	-1.5449
Honkong Dollar	7.7571	0.0052	0.0825	0.0413	-0.0851	-0.0877
China Renminbi	6.1479	-0.3351	-0.4359	1.0394	1.4233	1.3452

*rates as on 26.06.2013

The tremors of it are felt in emerging market bond funds, which underperformed in last couple of weeks. Selling of debt fund will have larger impact where FII’s have larger share of bond market. Though the impact will be minimal in India as the FII’s have low share in the overall Indian bond market. It is more domestically dominated and hence it could be absorbed by local domestic players with limited impact on yields. But despite of it, the yield on 10-year government bonds has climbed 41basis points from a 44 month low in May to 7.52% as global funds cut local debt by $5.3 billion from a record $38.5 billion on May 21. Depreciation in rupee has put RBI on a pause mode from its softening stance. The difference between one year treasury (7.48%) and repo rate (7.25%) is now 23 basis point above the policy rate which was otherwise 18 basis point below the repo rate in last five months is indicative of a status quo on policy rate in next RBI meeting.

Now the biggest question lies in the fact that if bond funds are seeing redemption, as is evident from the rising yield specifically in US 10-year treasuries to 2.61%, up from historically 2013 low of 1.61% in May 1, which asset class the money will seek to rest in? Clearly, with the scheme of events unfolding, it looks as if treasuries return will be depressed for years to come. Money mangers foresee the end of a rally that began after former Federal Reserve chairman Paul Volcker vanquished inflation in the early 1980s and with the massive injection of quantitative easing for last couple of year’s reverses with economic improvement going forward. In this context stocks are likely going to be the asset class of choice over the course of next couple of years. The trend is already building up and most of the money managers, global influential banks and brokerage houses are recommending stocks over bonds. All these hinges upon economic improvement and inflation again setting in into developed economy otherwise deflationary forces will set in a new dynamics all together. Some glimpse of it is already on the anvil with commodities failing to perform, emerging market using foreign reserves to defend rupee and dollar surging on back of tapering of QE3 and rising yield despite of falling inflation in developed and developing economy.

India probably stands to gain in a lower commodity, gold, crude price regime. Government of India is hard pressed to put a break on gold import in India and last month RBI came out with a notification to restrict the import of gold on consignment basis by both nominated agencies and banks and also all imports will be 100% cash margin basis (will not be applicable to import of gold to meet the needs of exporter of gold jewellery). This is having serious implication for the importers of gold for retailing and along with it raising custom duty has also increased the cost of gold import. Coming months import figure of gold will be significantly lower than the average $8 billion monthly runrate of gold imports and will alleviate some concern on current account  deficit and INR. Not only this, Recently RBI bars loans against gold ETFs, gold mutual funds which will also act as a catalyst to rein in huge speculative gold demand and thereby aid in curbing gold imports.

So it seems that we have a larger complexity of moving parts in global financial market to deal with and time will tell which way the pendulum swung.