Ma'am India! Your
wrinkles are showing!
For more than decade, Indians were drilled to believe their
country was shining. It was showcased by flashy cars, spanking new apartment
blocks and soaring stock markets.
Alas! All that high is fast evaporating. The spit and polish
shine is wearing thin and the rust in the " I" of BRICS is beginning
to show! The Indian government is
finally veering around to the stark reality. Hints that inflation and economic
distress were becoming problems were finally conceded by India's government and the Reserve Bank of
India (RBI). The intensity of the Inflation impact though is still in a state
of deniability.
What is toted out is headline inflation at 8.9 per cent. This
is a misleading number, since it includes a whole set of products that
include typewriters and mobile phones that fail to capture economic distress. Food price inflation is shown as 7.7 per
cent. In reality it remains in double digits. This is despite the base effect,
-- high prices last year and slower increases this year. The 52 week average increase
in food prices is 15 per cent. Consumer
price index is at least 400 BPS more.
Rates up but the bubble grows?
Effectively the inflation meant that at least 50 per cent of the average Indian's income goes to meet food items alone. This
is despite a record 235 million tonnes of cereals output. In the case of lower
income states, the situation is even worse. The ratio is higher than 80 per
cent.
It was ostensibly to decelerate inflation expectations the
RBI intervened 10 days ago, hiked policy rates (Repurchase rates) by a whopping
50 basis points. But before singing hosannas on the intervention, hang on! The
actual increase appears cosmetic. Policy interest rates are still inflation
negative. The one year and the ten year yields on government securities are 75
bps and 50 bps below the head line inflation. For the consumer price index, add
another 400 bps more.
With real rates still negative, the inflation response
appears weak. But negative interest rates are positive for the country's
stock markets already heavily over valued by massive cross border flows fleeing
shrinking tax havens in Europe. Forecasts are out that the domestic equity
markets could continue to boom. Angel Broking Lalit
Thakker's expectation are that markets could touch new records.
Obviously, more flows could be on their way, inflating an
already over blown bubble. India's listed companies contribute barely 15 per
cent to the GDP. Ironically the market capitalization of the companies is over
120 per cent of the GDP or a Price to Earnings ratio of 22.5 times. That is the
trailing earnings will take at least 22.5 years to amortise current
prices.
The inflows are in addition to Non-resident capital fleeing
European insolvencies. Non- resident deposits with the banks have jumped $3
billion. For the fiscal year ended March 31, 2011, the outstanding NRI
deposits, in all categories, both Rupee and foreign currency amounted to $
51.63 billion or (3.5 per cent of the GDP). NRI flows are not looking for a
safe haven. Most NRI repatriations are from those returning home for good
with crushed European and American dreams.
Only some are yield hunters. A one
year sovereign bond in India gives out at least 800 bps. A $ bond may give out
only 0.18 bps. So even assuming a 5 per cent exchange rate appreciation, it would
mean a cool 300 bps return.
Yield hunters prowl
Yield hunters are not necessarily looking low risk highly
regulated investments. The banking
sector, both public and private is under close surveillance from domestic and
global regulators. Entry of flight or round tripped capital is into lesser
regulated financial markets, equity funds, corporate debt funds and commodity
funds and to some extent real estate, far from prying eyes. Trails, paper or
electronic, are difficult or cumbersome to trace in these sectors.
Funds coming through the Participatory Notes
(Origin of the investors is unknown even to regulators) were $39 billion, a $ 7
billion increase over the March 2010. These funds invest in mutual funds,
including commodity funds. Some PN buyers or Foreign Institutional investors
are leveraged investors.
Leveraged trading in markets also has a nasty impact on emerging markets -- excessive volatility. Since the leveraged trading by yield hunters is done
across national borders, volatility spills into the foreign exchange market.
The result: An appreciating Rupee against the U S $. There are already
incipient signs of an appreciation reflected in the Non-Deliverable Forward
exchange markets—a market that deals in emerging market non-convertible
currencies. NDF exchange rates at Rs 45.11 against the $ are lower than the domestic
one month forward premium. The domestic one month $ was Rs 45.30.
High volatility also translated to escalating
hedging costs. Hedging costs of one $ for one month is currently 8 per cent.
Three years, ago the costs were less than 2 per cent. For the exporter rising hedging costs mean
income shrinks.
With capital inflows chasing every possible asset,
inflationary conditions are not likely to recede. In fact they are likely to worsen, admitted RBI. The paradox is
that the consequent inflation contributed to appreciating exchange rates with
an impact on the current account deficit. India's current account deficit for
the first nine months of fiscal year 2011 was 3.1 per cent of the GDP. So long
as leveraged capital flows remain unhindered, inflation and exchange rate appreciation are likely
to continue cohabitation. European insolvencies, to top it all are likely
shrink Indian export markets, even as import prices continue to spiral. These are pressure points on the current account deficit.
More liquidity tightening
The
continuing high inflation therefore means that the M3 (Currency with the public, demand deposits, deposits with the Central Bank and Time deposits with the banking system) containment is far from over.
The velocity of M3 estimated by the RBI is assumed at 1.2 times of
the nominal GDP.
M3 velocity has been steadily falling since 2004-05. So if the Finance Minister
Pranab Mukerjee said that growth was likely to be compromised, it clearly sent
out a message. India was prepared to risk a slow down. However, it may not be
just a slow down. It may very well be severe slow down along with high
inflation.
Perhaps,
there may be more intervention rate hikes. But unlike China, India is not
likely to change the Required Reserve Ratio. India's Cash Reserve Ratio is 6 per cent. China's, after the 50 bps, hike is 21 per cent. A CRR hike
would result in expanding the RBI's liabilities that in turn could translate to
further squeezing liquidity in the system.
Instead India's
Reserve Bank may opt for a hike in the Statutory Liquidity Ratio by 100 bps.
This ratio mandates bank investments into designated government securities. This
is the most likely option, since there is no RBI balance sheet expansion either
on the liability or on the asset side. An SLR hike has multiple benefits,
keeping government borrowing costs low, transmitting the balance sheet
expansion directly to the banks. Above all, government borrowings during the
first half of the year would most likely proceed unimpeded with minimum cost
escalations. At the same increased net bank credit to the government, shrinks credit availability to the commercial sector and contains liquidity expansion.
Indian bond markets have already begun factoring the
severity of such a slow down. The one year yield is 8.15 per cent and the ten
year yield is 8.45 per cent manifesting an expectation of tight short term
liquidity conditions ahead. In March end both these yeilds were 25 bps lower.
The narrow spread between yeilds also reflected the intensity of
the expected slowdown. Similarly, in the corporate bond markets there is an
inversion revealing the massive working capital requirements. One year
corporate bond yields are over 10 per cent and five year yields are 9.75 per
cent. The bond markets point to a storm cloud gathering rather than just a severe slow
down.
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