RBI / Governments Dilemma

Total inflows into Indian Equities by foreign investors in calendar year 2010 = USD 18 billion
Total outflow from domestic mutual funds in the same time = Approx USD 4-5 billion

As a follow up of my article on the rising current account deficit, the recent spike of FII inflows into the Indian equity markets creates another dilemma for policy makers in light of the rising trade deficit. Although capital flows are good so as to take care of the current account deficit, however the pace of the current inflows, specially after the markets have gone to new highs for the last 3 years and the pace of the flows suggests that some part of this money is likely to be trend following hot money. As a result of the strong flows the Indian rupee over the last 4-6 weeks has appreciated by 5%.

Now this appreciation of the currency at a time when the exports are as it is under pressure and imports are strong will again make imports cheaper and exports more uncompetitive. The Chinese Yuan despite the noise around it has only appreciated by around 1.5% over the last 2-3 months. As such in case the inflows keep on coming in at the same rate then it will further pressure the rupee to appreciate and thus create a scenario where the currency becomes extremely vunerable to short term flows. Services exports and remittances are as it is under pressure due to the slow down in the export destinations and lower income levels of NRI’s.

The figures for the Balance of payments released by the RBI two days back show an disturbing (if not alarming) picture. The CAD has gone to nearly record highs and Net Invisibles has actually shown a decline of 3.5%. It is just capital flows (and a small minority in the form of FDI) that is sustaining the BOP.

The rising concerns on the current account deficit also recently led the Government to relax the limits on corporate and government bond purchases by FII’s. This limit has been increased by USD 10 billion.
The dilemma now is that all of us know that short term rates are likely to remain low in the developed world for a prolonged period of time and incase the carry trade continues at this pace then it can lead to an overheating of asset prices much beyond any fundamental justifiable value. Under the circumstances the government can look at imposing some sort of Tobin tax on short term flows, however that will be taken very negatively by investors.

The way out in my view is to promote the flow of this capital in the form of FDI where the flows would typically be of a long term horizon. For example the recent Petrobras issue that raised USD 70 billion in the biggest public fund raising has raised long term money for investment into the Brazilian economy. Similarly the time is ripe for the Government to either disinvest some part of the already listed PSU’s or come out with issues of other large unlisted PSU’s faster than planned. The second form of investment which would essentially involve a reduction in red tapism is direct investment into various infrastructure projects. For example huge investments are required in road and power projects. Both equity and debt participation in these projects should be eased out considerably so as to get cheap money into the development of the country’s infrastructure. This can also be in the form of long term infrastructure bonds being raised by any of the large PSU banks or Infrastructure Finance Companies. Given the huge appetite for investment into India USD 10-20 billion can easily be raised through this route.

Recently there was an initiative to allow foreign investors to invest directly into India without having to go through the FII route and the entire registration process. This move if implemented will also diversify the flows and reduce volatility of flows over the medium term.

There are also a number of Sovereign Wealth Funds that are today looking at non dollar denominated assets in emerging markets. These Funds can be approached for investment into such funds. In fact an Infrastructure Private Equity fund backed by the Government of India and floated by any of the large Public Sector banks could also get huge commitments at this point of time.
I think time has come for RBI to again step in and buy dollars as it did during the previous bull market. Incase it does not want to pump in liquidity into the economy due to inflationary concerns it can again resort to MSS bond issuance’s to suck out the liquidity. Continued rupee appreciation due to hot money flows into the equity markets can be detrimental to the real economy over the medium term.

Markets – The markets have continued to rally strongly backed by strong flows from Foreign investors. It is time to be cautious now as near term valuations look overextended and technically markets are looking heavily overbought. Although overbought situations can continue in the markets for some time eventually it is followed by a corrective move. A 10-15% correction should follow the current up move. By base case at this point of time is a corrective move over the next 4-6 weeks followed by a new market high by December/January (The huge momentum of the market could infact take us to a new high before the correction sets in, however that is not my view at this stage). The month of October is also the results season and we will have a reality check on the Fundamentals of the markets for the near term as the results come out.

I’ll go anywhere as long as it’s forward.” – David Livingstone

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