Who Is Remote Controlling Dr. YV Reddy?
It may seem presumptuous, but it is fairly possible that the RBI Governor is
being remote controlled by the North Block. For a person adjudged as the finest
Finance Minister in Asia in 2007, Dr. Reddy seems to be lost in the wilderness
of financial markets. The Rupee has lost 10 per cent against the US Dollar in a
matter of days, the Inflation is rocketing without an Oil price hike and the RBI
seems to be adopting a cavalier attitude to Interest rates.
We have a situation where a double digit inflation figure and negative real
interest rates will ensure a drop in Savings during FY09. The scenario calls for
the Central Bank to reveal its hand. Interest rates have to be raised so that
unnecessary expansion in Capital Intensive projects goes away, Real Estate slows
down and Construction activity reduces. While the GOI cannot influence supply in
the short term, it can atleast reduce demand in the short term. The RBI cannot
simply go on and relax ECB norms as a panacea for a disease that is rapidly
spreading. Dollar borrowings taken alongside currency depreciation will mean the
same rate of Borrowing for the local industry..this is no solution to
controlling inflation.
The Repercussions can be severe
We are probably the first people in India to let all investors know that GDP
will not grow by 7 per cent in FY 2009, but may infact dip towards 5 per cent
for the year. Not a single analyst till date has accepted that a Rs 950 earnings
forecast for the Sensex companies is unachievable. With higher Steel, Cement,
Coal, Fertilisers and Oil prices, the Sensex earnings may be dramatically lower
in the Rs 600-Rs 700 range. If this be so, then the market even at a level of
16000 for the Sensex is still 23 times FY09 earnings, and not 16 as is being
portrayed by most people on the Blue Channels.
The situation on the Rupee front needs closer inspection as an additional
weakening could mean signs of pain that we have not been able to detect.
Rupee fall is unlikely to be simply due to market forces
There is pressure on India’s balance of payment. High oil and fertilizer
prices could cause a 1.5-2% rise in India’s trade and current account deficits
in this fiscal period.
Capital flows – due to external borrowings and portfolio investments – could
be lower by another 2-3% of GDP compared with last year. In the worst case
scenario, forex reserves could decline by more than USD20 bn over the next year.
If the INR were a completely market-driven currency, the above circumstances
would have caused the rupee to weaken in occasional bursts throughout this
period. However, the sharpest moves in reserves have seldom caused the rupee to
move meaningfully in the same direction in the past.
The point is that the rupee is a managed currency most of the time. There have
been periods, famously in 2Q2007, when the exchange rate was left to market
forces, but these are exceptions rather than norms.
Even after such episodes, policymakers tend to again exert their influence
beyond a point. Once again in recent history, this was seen when the rupee
remained steady between Oct-07 and Feb-08 despite reserves increasing by USD50
bn during the period.
Rupee fall hurts inflation and subsidy bills
The 10 % INR fall in the past month is the highest monthly decline since
Jun-1998. The extent of the move cannot be explained away merely by the global
currency moves or domestic fundamentals.
The central bank’s currency support absence is particularly puzzling given
that the fall adversely affects the two biggest policy goals: inflation
containment and limiting the government burden of oil, food and fertilizer
subsidies.
A 1% rupee depreciation causes an approximately 3% increase in oil
under-recoveries. Together with a fertilizer deficit, we estimate a 1% rupee
fall to cause an additional Rs70bn+ in government deficits, about 0.15% of GDP.
In an environment where oil, food and fertilizer deficits are nearly double
those of the same time last year, the burden is costly, not just for the
government but for the entire economy.
The rupee fall also exerts pressure on inflation through cost-push factors.
This is despite the caps placed on the prices of many resource products. In
India’s import basket are petroleum products, coal, iron ore, non-ferrous
metals, etc – many of which are raw materials whose prices are not capped.
Except for exporters, particularly in the services sector, the prospects of
other corporates could materially suffer because of multiple factors.
The impact is relatively muted owing to translation losses on external debt
(even if completely unhedged, a 1% rupee fall would cause less than a 0.8%
decline in market EPS for FY09 on this factor).
Domestic and import-dependent businesses would also suffer owing to increased
difficulty in tapping funds in global capital markets if the rupee is seen as a
weakening currency.
The impact is also due to potential liquidity tightening in the local
financial markets. We do not believe that the central bank would allow the
currency to remain weak simply to benefit exporters now.
Even if supporting local economic growth or corporate profitability were not a
priority, inflation side effects are at cross-purposes with what policymakers
are trying to achieve. A currency reversal, as a result, should be around the
corner.
That said, the extent of the move is so ferocious that one cannot ignore the
possibility of something else afoot. Neither should one overlook the earnings
impact of the fall.
Net Net Expect a Bigger fall in the Sensex, that ends in mass capitulation
last seen in Feb-March 2001.
Nothing in this article is, or should be construed as, investment advice.
Rohit
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