On India in the Financial Express

Column: Time to be cautiously optimistic

Indian assets have been under a lot of pressure in the last few days. The combination of a rapidly depreciating rupee, monetary tightening by RBI and decelerating growth have triggered a very sharp fall in Indian equities. The Nifty 50 index has declined about 11% in the month since RBI’s monetary policy tightening late July.

The recent fall in Nifty masks much deeper cuts in the broader markets. It has been nothing short of a bloodbath in most of the sectoral indices—banking, real estate, infrastructure were all down over 20% with individual names falling by as much as 40-50%.

To add insult to injury, several international and domestic brokerages have started downgrading Indian bonds and equities. Earning per share (EPS) estimates are being cut, the GDP baseline growth rates have been revised to between 4% and 5%. One hears of targets on the rupee coming in the range of 70 to a dollar; wild estimates of downsides on the Nifty abound daily on the markets. It is a bear market!

While there is serious pessimism surrounding the economy, it is important to keep in mind that markets usually price-in most publicly available information. To the extent expectations have moved lower, prices move lower as well and there is less room for negative surprises. Looking at the major issues weighing on the minds of institutional investors and assessing their reflection in prices is useful in determining whether or not to buy equities.

Pessimism on growth & rupee
 
The biggest disappointment in India has been with growth. India has long been viewed as a growth story with low correlation with global growth owing to strong domestic consumption and favourable demographics. GDP growth, and especially investment as a percentage of GDP has been falling. Various scams and political agitation in 2012 caused policy paralysis which led to a sharp slowdown in investments as clearances stalled, projects were delayed, and the government machinery literally came to a standstill. Subbarao’s war on inflation continued to brutalise growth prospects. The death blow to residual growth expectations in India came after RBI announced liquidity tightening measures in July. Most analysts have downgraded their base case GDP growth expectations to about 4.8-5%. The bear case scenario comes in between 4% and 4.5%.

The rupee also poses a rather serious problem. Foreign investors have a strong distaste for countries with depreciating currencies. Rupee depreciation elicited monetary tightening by the central bank. Higher interest rates exert further downward pressure on growth and on the banking system—it is a vicious cycle. As argued in my previous article (FE, August 6, http://goo.gl/gP9X1d), RBI’s measures were misguided. They failed to have a meaningful impact on the rupee while wreaking havoc in the money markets.

There is hope
 
RBI seems to have realised this. It has announced infusions of fresh liquidity to the tune of Rs 8,000 crore in the banking system and adjusted prudential limits to permit more liberal marking of banks' bond portfolios as the losses “could be expected to be largely recouped going forward”. Further, the central bank reduced its damaging communication with the markets on its purported policy stance on the rupee while stepping up on its interventions in the currency markets.

A month ago, extreme price targets for the rupee ranged from 61 to 63. Some offshore NDF desks expected the range for the rupee to shift upwards to the 60 to 65 zone. This, too, has materialised. Many foreign investors find value in the rupee at spot levels above 60, but are fearful of investing in India till they see signs of growth or investments picking up.

Further, indications of reversal in liquidity will certainly be helpful in this respect. RBI governor-designate, Raghuram Rajan, offers much hope to investors in India; he is seen as strongly pro-growth. Expectations of pro-growth rhetoric and action from him in September are increasing.

Investors do not expect overnight miracles from India. The fiscal and current account deficits are here to stay. They understand the dynamics of the Indian election cycle—most private sector investments and projects are usually put on hold till after the elections. Scams being scrutinised by the Supreme Court will delay policy measures in those areas. Recent analyses indicating a hung Parliament in 2014 weigh on investors. While tail risks remain, the fear of imminent sovereign downgrades has been mitigated as Moody’s and S&P affirmed their ratings on India in August.

What investors want is for India’s growth not to fall below 4% levels. The government seems to have understood that piecemeal measures will not work, and that growth is crucial. Constrained on the fiscal side, and knowing that the private sector will stay away till after elections, public sector enterprises with cash-rich balance sheets are being instructed to take the lead in stimulating the economy. According to the economic affairs secretary, Arvind Mayaram, the finance ministry is monitoring investments by PSU firms on a monthly basis. The government is working overtime to grant clearance to stalled projects and redress the problems plaguing many ongoing private sector projects. In desperate attempts at attracting FDI, the government has increased limits and liberalised FDI across sectors and reduced red-tapism by moving several sectors to the automatic route.
What we have at present is a stalled economy, weak currency, a large array of economic reforms, a government desperately issuing clearances and approvals, and a pro-growth governor taking the helm at RBI. The largest problem facing the Indian economy is a lack of confidence—from both, domestic and international investors and corporates. The present prices largely reflect these negative sentiments and the data surrounding the Indian economy.

Come FY15, we will see investor confidence return as a new government takes charge at the Centre and policymaking becomes more decisive, and unconstrained by electoral objectives. The government will take office with a liberal FDI regime, a lot of project backlog cleared, investments being stimulated by PSU, and reduced pressure to divert revenues to social schemes. While it is not a clear case for either the Congress or the BJP, it is clear that we will not have a third-front forming the government.

The formation of a stable government will be the trigger to the beginning of a new bull run in Indian equities. Equities will remain volatile in over the next two quarters reflecting the fluctuating sentiments of market participants due to global and domestic factors. Indeed, we may see a further from these levels in the Nifty index. However, this period of pessimism should be used as an opportunity to accumulate good quality Indian stocks selling at distress valuations. To quote Warren Buffet, “be fearful when others are greedy, and greedy when others are fearful.” India is in the process of bottoming out.


The author is managing director, Bullero Capital, a Sebi-registered portfolio manager

Raghu, what can we expect from you?

Finally. Something to be optimistic about on India! Raghu's appointment fixes one part of the problem. His background - IIT, IIM, MIT, Chicago - is encouraging in that he will speak to the right people, and have a more nuanced understanding of the world we live in. 

My expectations on the policy front

• Growth will be emphasisedNear term, his policy actions may not be dramatic, but the rhetoric from the central bank will change significantly. He will certainly talk more about growth, and de-emphasise the need for monetary tightening. This isn't to say that he'll roll back the measures on the rupee immediately - thats a nice hole dug up by Subbarao; will take some effort getting out of.
  
• RBI will be dovishHe won't try to bring down international commodity prices and demand for food by raising interest rates. Unfortunately, he can't do away with the Minimum Support Price (MSP) system or the government's vote-for-populism strategy. What he can do is bring rationality to monetary policy again.
  
• Greater coordination with the Finance Ministry
  Monetary and fiscal policy will be more coordinated - there won't be media transmitted spats between the FM and the RBI as Raghu is very much a Finance Ministry man.

• Measures on the rupee will be rolled back once we get to around 58 on the spot. This can happen rather soon - say in 2 to 4 weeks.

On the rupee in the Financial Express,

Column: Don’t kill the messenger, read the message

Varun Khandelwal

The government and RBI have taken several measures to check the depreciation of the rupee. Both have made several references to the non-deliverable forward (NDF) markets as a source of speculative activity against the rupee.

NDFs are derivative contracts that do not require the delivery of the underlying asset. NDF markets exist for most emerging market currencies that are not freely convertible on the capital account. They allow market participants across the global to speculate freely, while remaining outside the purview of the regulatory structure of the country in question.

A thriving NDF market exists for the rupee in Hong Kong, London, New York and Singapore. According to estimates by an NDF market maker, these markets trade about $5-7 billion daily. The onshore markets, derivatives and spot, used to trade approximately $4-6 billion.

After RBI’s recent measures to curb speculation, the onshore volumes for the rupee have declined by about 50% to $2-3 billion. Effectively, the NDF markets are now responsible for about 60-70% of daily rupee trading from about 40-50% earlier. According to data from a December 2011 report by HSBC on emerging market currencies, the NDF markets had a share of only 20% in rupee trading. Clearly, offshore rupee volumes are on a rising trend.

This is a pain point for RBI. RBI has a myriad of regulations on the convertibility and trading of the rupee in India. As the entities offering NDF products are offshore, RBI’s regulations and Indian laws such as the Foreign Exchange Management Act (FEMA) do not apply.

Usually, the NDF forward prices trade 20-30 pips higher than onshore futures on the NSE. Further, the derivatives on the NSE trade at a premium to the interbank spot rates. The extent of this difference is determined by interest rate differentials and market liquidity conditions. This difference offers an arbitrage opportunity to entities that can trade both the markets.

Multinationals, foreign banks, custodians, some domestic banks, large export houses, etc, which have presence both onshore and offshore, are able to arbitrage this difference by selling the NDF and buying the futures on the NSE or, in some cases, buying the spot itself. This regulatory arbitrage trade is preferably executed using derivatives as the cash outlay is lower and leverage can be used to enhance the returns. While there exist RBI regulations to deter this sort of regulatory arbitrage by offshore subsidiaries of Indian companies, these regulations are difficult to implement in practice due to limited scope of scrutiny of offshore companies by RBI.

Instead, RBI has tried to crack down on this trading by sharply curbing domestic trading. The drastic reduction in permissible open interest on exchange traded derivatives has reduced the capacity of market participants to speculate on the rupee. It also limits the extent to which the NDF arbitrage can be carried out using the derivatives on the NSE since the domestic leg of the transaction cannot be carried out in large volumes.
Additionally, RBI raised the average daily CRR requirements, capped the liquidity under the Liquidity Adjustment Facility (LAF) and raised the spread between the Margin Standing Facility (MSF) rate and the repo rate from 100 bps to 300 bps, bringing the effective rate to 10.25%. Since RBI announced these measures, overnight call rates rose from 6-7% to about 10%, approximately the same as the MSF. Higher interest rates raise the opportunity cost of holding dollars instead of rupees. The monetary tightening created forced sellers of some domestic banks whose treasuries sold dollars to raise rupee liquidity which is now substantially more expensive and needed to fulfil stringent CRR requirements. These measures caused the rupee to appreciate by 2-3% for a short while before resuming its move down.

The monetary tightening that resulted in temporary support to the rupee will prove very costly to the Indian economy. Overnight interest rates are higher by 400 bps, there is a severe liquidity crunch in the money markets, and the stock markets have fallen about 8%, with bank stocks correcting between 20-40%. This creates a very inhospitable investment climate in India.

The reduced volume in the onshore market threatens to make the rupee more, not less, volatile. Further, these restrictions may move more rupee trading volumes offshore as market participants prefer that the rules of the marketplace are not changed to hurt them. This will move an ever larger fraction of the market outside of RBI’s jurisdiction, threatening to make the transmission of policy measures tougher.

There are strong reasons why the rupee is not stabilising. India’s poor governance, declining growth, high current account deficit, and high fiscal deficit have made the rupee the currency of choice to bet against in the emerging markets basket. Additionally, the threat of reduction of quantitative easing in the US has put all emerging market currencies and bonds under stress. RBI’s own poor communication skills add to the problem. Statements about them being “concerned with exchange rate volatility, not rupee level” invite bets against the rupee as the implication is that the central bank does not care if the rupee goes to 61, 64 or 67!

If the rupee is to be stabilised, RBI needs to communicate less often, and more effectively. Policy measures should be followed up with strong interventions in the FX markets. The central bank and the finance ministry should keep their disagreements private. The government is naive to expect the investment sentiment to improve in the face of slowing growth, looming elections, unimplemented liberalisation, inaction on industrial revival, and unbridled populism exemplified by the Food Security Bill.

The NDF markets are outside RBI’s jurisdiction, and no manner of domestic restriction will diminish their existence. Markets are messengers of underlying problems, not the cause. If drastic measures are on the table, why not temporarily ban gold imports instead of murdering the economy? Pakistan just did. Probably a ban on gold will damage perceptions more for the ‘aam aadmi’ and some mumbo-jumbo in the credit and currency markets.
The author is managing director, Bullero Capital, a Sebi-registered portfolio manager

RBI's demolition of the Indian economy, in a futile, confused defence of the rupee

India faces an imminent macroeconomic crisis. The rupee has been rapidly depreciating, faster than most other emerging market currencies. A rapidly depreciating currency is unhealthy - foreign investors find it very risky to buy equity or debt in the face of significant currency risks.
 

Given the inelastic nature of India's import portfolio, and low elasticity exports to exchange rate depreciation, there is little hope of a meaningful improvement in the CAD. India is confronted with the reality of entering a death spiral where a depreciating rupee leads to a wider CAD which in turn fuels a further weaker rupee.

In the last fortnight, the RBI has taken several steps to support the rupee. It has raised the average daily CRR requirements to 99 per cent from 70 per cent during the fortnight. This effectively forces Indian banks to deposit approximate Rs 560 billion with the RBI to fulfill their statutory requirements.

Further, the RBI has capped the total amount of funds that an individual bank can repo at 7.25 per cent with the RBI at the Liquidity Adjustment Facility (LAF) window to 0.5 per cent of their Net Demand and Time Liabilities. This implies that the individual banks in shortage of liquidity to meet their now higher CRR can turn to the LAF only for limited relief.

The RBI also raised the spread between the Margin Standing Facility (MSF) rate and the repo rate effective for LAF form 100 bps to 300 bps, bringing the effective rate to 10.25 per cent. Banks, which ran into shortage of funds due to the higher CRR requirement, now have to borrow funds at 10.25 per cent from the MSF or from the overnight call money market. The RBI has achieved monetary tightening without raising the repo rates. Since the RBI announced these measures, overnight call rates from around 6 - 7 to about 10 per cent. Yield on the 10 year Government of India bond rose from 7.20 bps to about 8.5 bps.

Position limits in the domestic currency derivatives markets  were also drastically reduced forcing many brokers to go into liquidation only mode for rupee trades for both clients and proprietary positions. The margin requirements for onshore currency futures was also doubled thereby reducing the leverage in the currency markets by half. As a consequence, onshore trading volumes fell by 50%.

Both these measures reduced the pressure on the rupee. The monetary tightening created forced sellers of some domestic banks while the substantially lower position limits curbed domestic speculation on the rupee. The rupee appreciated by 2 to 3 per cent and it seemed that the RBI was serious about defending the currency. It was an opportune situation for the RBI to aggressively intervene in the USD/INR markets; this would have created panic amongst deferred buyers of dollars such as importers, corporate hedgers, and potential debt investors waiting for the currency to stabilize.   

These measures were also intended to target the offshore Non Deliverable Forwards (NDF) markets where the rupee forwards usually trade at a premium to the onshore markets. A very popular carry trade amongst particularly foreign banks and domestic banks with offshore trading operations was to sell the contracts in the offshore market and buy them cheaper onshore to earn an arbitrage profit. By reducing the position limits on the domestic exchanges and sapping domestic liquidity, RBI hoped to reduce the speculation on the NDF markets.

Unfortunately the RBI stopped short, and adopted a dovish tone. Subbarao reiterated that they are “concerned with exchange rate volatility, not rupee level”. Further, the central bank clarified they were “anxious to roll back liquidity tightening measures as anyone else but getting locked into a timeframe of rollback is not feasible due to the volatility in the forex market”. The rupee depreciated over 2 per cent in two trading sessions and came very close to its lows again.

There is an inherent contradiction in the RBI’s defense of the rupee. The RBI has been taking drastic steps to check the depreciation in the Rupee while maintaining that it is “targeting the volatility, not the levels” of the currency. Making such statements is a mistake. These leave the doors open to speculators to bet against the rupee as the implication is that the RBI does not care if the rupee goes to 60, 61, or 65! There is nothing that markets love more than an asset moving one way with low volatility. So speculators simply load in whenever the rupee appreciates a little. The RBI makes it an easy trade.

The economy will pay dearly for the monetary tightening in defence of the rupee. These measures came at a time when industry was looking to the RBI for relief, not higher rates. With the GDP growth already at the 5% handle, India simply cannot afford such cheap sacrifice of growth. Low growth begets weaker exchange rates. Depreciating rupee leads to higher fuel costs or subsidy bills, which by the RBI’s admission causes higher inflation. Higher inflation induces the RBI to keep interest rates high which continues to put downward pressure on growth. The cycle is vicious.

The present policy stance does precious little to promote currency stability. The RBI needs to decide whether it wants to defend the rupee or not. What it certainly should not do is make incessant, ineffective statements.

'Grexit' next week? Probably Not.

The most common debate doing rounds in the financial circles this week is whether or not Greece will be a part of the Eurozone a month from today? The prevailing view amongst macroeconomic observers is that Greece would exit the Eurozone eventually; the debate centres around whether the exit will be orderly or disorderly. The present conditions will not precipitate a Grexit. A Grexit cannot be orderly for Greece. It can be orderly for the EU, and indeed might be instigated by the EU, if a mechanism to stabilize the financial system can be agreed upon. Greece will initiate a move towards exiting the Eurozone only in circumstances resembling a revolution effecting a regime change. The present policy will be to award limited concessions to Greece. The focus will be on preventing the locking out of Spain and Italy from the bond markets. These are the most imminent risks to the future of the Eurozone.


The outcome of the Greek elections on June 17 is expected to be critical to the fate of Greece. The New Democracy is the market favourite as they intend to honour the existing bailout agreement while requesting for concessions in the existing terms. An extremely uncertain situation will emerge if the Syriza party wins the majority - they are openly critical of the existing bailout agreement and potentially intend to challenge, not request, the EU to ameliorate the terms of the bailout. The possibility also exists that the elections might be inconclusive like last time which would also leave market participants quite anxious. Whatever be the outcome of the Greek elections, there is very low support in Greece for abandoning the Euro or leaving the EU. 

The Greeks stand to lose a great deal from leaving the Euro. Their banking system will almost certainly collapse unless the exit is confidentially and immaculately planned with capital controls and withdrawal restrictions on existing Euro denominated bank deposits. Recent events makes it abundantly clear that the politicians in Greece, and elsewhere, are incapable of such planning. Further, a departure from the Euro will leave existing Greeks poorer by the 20% to 50% devaluation implied by the introduction of a new Drachma. This tantamounts to expropriation of wealth by the Greek state from the people of Greece - an unnecessary step unless the level of crisis escalates significantly. 

Further, an exit will cause the exclusion of Greece from international trade, tourism and international capital flows. The institution that normally step in to help a country after such a crisis, the IMF, is already fully engaged in Greece. Any exit from the Eurozone cannot be orderly for Greece; it will almost certainly lead to a strong negative economic shock.

The EU maintains that they will not negotiate or relax the terms of the bailout agreed to by Greece in the past. However, this seems like political posturing as EU has not denied the next bailout tranche though it is evident that Greece has not met completely its target for economic reforms and restructuring. The Greek bargaining position is further strengthened by the generous terms of the recent Spanish bailout. 

The EU will continue to indulge the Greeks and their demands as they have been unable to agree on a mechanism to prevent contagion from a Greek exit. An uncontrolled ‘Grexit’ would lock out Spain, and possibly Italy, from financial markets leaving the core countries, led by Germany, to foot the bill. This is precisely the situation that Merkel wants to avoid at all costs. However, once Germany is able to agree to a mechanism ensuring financial stability for ‘core’ and large economies like Italty and Spain, the PIIGS may be left to fend for themselves and a zero-tolerance policy may be adopted towards awarding further concessions. 

News flow from the Eurozone will continue to remain exciting with Greece being slowly overshadowed by Spain and Italy. There will be no exits from the Eurozone leading up to the summit at the end of June. The summit will probably fail in its objective of developing a mechanism for insuring the stability of the financial system in Europe. Instead of a concrete plan like the TARP in the US, the summit will conclude with promises of a commitment towards a resolution. In the meanwhile, the ECB will continue to provide liquidity to the banking system in Europe to keep it on life support. Credit markets will continue to remain frozen and GDP growth numbers will be negative for the Eurozone. We will continue to see phases of risk ‘on’ and ‘off’ in the markets depending on news flow from Europe.

The current policy of postponing the problem and spreading the losses over time might work. However, it is a dangerous policy with high chances of a sudden implosion. Bank runs have the tendency to work in jump functions - sentiment changes from a quiet mistrust leading to a sudden failure of a large number of institutions. Europe has not yet demonstrated the ability to competently deal with such exigencies. Deteriorating economic conditions, continued political unrest, an unstable government, high rates of youth unemployment are signs that often precede revolutions. Some of these can already be seen in Greece. 

The current mercantilist structure with Germany exporting goods to a periphery of less efficient economies is unsustainable without German support for the peripheral economies to the tune of 2 to 3 trillion euros either via joint-euro bonds, ECB monetization of debt, or other joint contingent liability mechanisms. Economic history has several examples where mercantilist exporters finance their exports by lending money to the importing nation. Germany need only look east towards China who is the largest holder of US debt today. Without this understanding in the German political establishment, political disagreements between the ‘core’ and the ‘periphery’ will eventually lead to the disintegration of the Eurozone and the potential shutting out of Germany from several European markets. In either case, the economic outlook for the Eurozone is negative and has potentially severe consequences for Asia.

Crystal Ball Gazing: adrenaline rush; remain Long

I've been meaning to write an elaborate post on the budget, monetary policy, politics, etc, for the last 10 days but just haven't had the time. Quickly summarizing what I am thinking in no particular order -

• Union Budget will be reformist. 
• Power sector will receive attention - SEB finances and coal policy rationalization
• Fuel prices will be hiked to manage finances... and this can add to reforms
• FDI in retail will most probably not be put forward - politically unpalatable. Mamta and Akhilesh will never agree
• Infra and roads will receive thrust 
• Education and health will get focus especially in tier II and tier III cities
• Fiscal deficit will not be cut - there is no benefit to the Government right now. Think of the electorate and the Government as growth junkies.. Fiscal deficit is probably going to be the concern for the next Government when they put the economy in 'rehab'
• Monetary policy
• Inflation - noises to the effect that inflation is cooling off but risks remain on account of potential rise in energy prices
• Growth concerns will be voices in the policy statement
• Monetary easing almost certain 
• 40% chance - rate cut of 25bps 
• 30% chance - rate cut of 25bps plus some relaxation in SLR
• 20% chance - rate cut of 50bps
• 10% chance - no easing but dovish noises
• Politics
• SP will form an alliance with the Congress at the Centre. Direct support, outside support, whatever, doesn't matter. Mulayam will probably get a Union Cabinet post.
• Mamta and Congress will patch up a wee bit more. The Congress will accommodate her more, leave Bengal to its miserable state and stay away from FDI in retail which will not go down well with electorates in both UP and Bengal so it will be hard to get political support for this.
• The Congress will try to push through popular reforms like roads, infra, etc which will get the growth momentum rolling. It will stay away from FDI.

Subbarao hints at easier policy. Why did markets not rally?

The RBI Governor, D Subbaroa, hinted at an easier monetary policy (see ET article on 6th Jan). The rate cycle turning will be positive for the economy and markets. Why did the markets not rally then? I think stagnancy in the markets is related to uncertainty about the date of rate cuts compounded by the risks posed by the earnings season.

The state of public finances is not exactly where the government wants, or the market expected. The government has overshot its fiscal targets and agencies like NHAI are making large bond offerings with more paper expected down the line. The prevailing sentiment is that the markets will not be able to absorb so much lending at lower rates and that the RBI, as the de facto debt management office of the government, will try to auction G-sec first and cut rates later. Essentially, this implies that rate cuts will not happen on the Jan 24 meeting but at some date after that.

To add to uncertainty related to the date of a rate cut, there are quite a few corporate earnings which will be announced in the two weeks leading up to the monetary policy meeting on the Jan 24. There is a fair degree of unease in the markets about corporate profits, bank asset quality, order book growth in infrastructure, regulation and scam in telecom, etc.

If you buy the markets today, and there are negative shocks to earnings between now and the policy, you don't really make any money. If the policy is good, you simply recover the intermediate loss. If they do not ease, well, then you lose some more. The compounded probability makes buying the market an unattractive proposition for risk averse traders.

Chances of a negative surprises for the dominant part of the NIFTY are low. The sectors with the highest weights in the NIFTY - financials (26%), energy and related (15%), pharmaceuticals (4%), software (14%), infra related (more than 5%) - have a small chance of further negative surprises with expectations already being very low, though IT can be complicated with the impact of the rupee still not known clearly. I think that there are low chances that the rate cuts will be deferred beyond the Jan 24 meeting - there is too much at risk for the government and the economy to be stupid about monetary policy any further.

This is a time to go long without leverage on quality large cap stocks which are oversold. Public sector financials and infrastructure stocks like Larsen and BHEL look good. Select midcaps like Biocon look very attractive as well.