DON’T BELIEVE THOSE WHO SAY

THE RUPEE WILL KEEP FALLING – Given the Current Account Deficit situation and the inability of exports to pick up despite the sharp underperformance of the INR against most competing currencies a theory is gaining ground these days that the INR is overvalued and it should fall more to make imports unattractive and exports more attractive. Keeping rates high has also been cited as a reason by RBI to keep rates high. Most of these are without basis. The facts are –

INR has fallen hugely against most competing currencies – If we look at the performance of the INR since the beginning of the year 2011 the currency has fallen nearly 22% against the USD. In the same time period the Chinese Yuan has appreciated 6%, Korean Won is flat, Thai Baht is up 3%, Indonesian Rupiah is down7% etc. Similar is the movement of most other EM currencies except for the Brazilian Real that has fallen almost as much as the INR. Under the circumstances it is difficult to argue that the INR is overvalued.  The reasons for poor export growth lie more in the issues that most exporters are facing due to the slowdown in the domestic market and high interest rates which are making Indian exports uncompetitive as they do not have the ability to provide cheap export credit at a time when most of the competing countries have record low interest rates. Moreover the reason also lies with higher imports due to one the inability of the domestic production to keep up with growing consumption specially in products like edible oils where imports are up from $2 billion to $ 10 billion plus over the last 3-4 years, Coal where imports are up from around $ 4 billion to over $ 12 billion and also due to mining ban on Iron Ore across the country where exports are potentially down by nearly $ 8-10 billion. The other two factors i.e. high gold and oil prices are well documented.

Under the circumstances while most people argue that the INR is going to fall going forward a combination of several factors actually point to the other side.

–Falling commodity prices are INR positive – As I wrote in a previous article the commodity cycle seems to have peaked out for at least medium term duration as of now. Falling commodity prices in Coal, Steel, Oil, Edible Oils, and GOLD etc are hugely positive for the INR as they reduce the government’s Fiscal Deficit as well as the country’s trade deficit. Fall in gold prices and reduced consumption by itself will reduce the CAD by nearly $ 10 billion this year.Infact Brent Crude prices are on the verge of breaking below the trend line that started from the March 2009 bottom.

­-inflation to fall big time – The sharp fall in global commodity prices and stability in food prices combined with the total lack of pricing power with domestic manufacturers is likely to lead to a sharp fall in headline inflation going forward. One is that this will reduce the inflation differential with the rest of the world and secondly it will push RBI towards growth both of which are INR positive.

­-fdi flows will eventually pick up as constraints ease – India is one of the largest economies where the FDI potential is most underutilized. This is due to poor governance as well as lack of policy clarity across a large number of sectors. However the reality is that the high nominal rates that Indian investments offer to investors are very high relative to any other competing economy. Elections are atmost a year away and either before that (hope) or after that (certainty) FDI gates will be opened up big time.  This will lead to strong flows into India at a time of abundant global liquidity. As such long term flow potential is also high.

GOLD PRICES WILL KEEP ON FALLING – I called the peak of the current gold price appreciation cycle in my article on gold on the 19^thof December 2011. At that time and for the following one year after that this was a thought that was totally alien to most people.  However the reality is that when an asset class becomes the most fancied asset, when there are hedge funds that invest upto 85% of their assets in gold or gold linked products, when mutual funds instead of pushing equities that were extremely cheap at that time push gold, when hybrid products like triple advantage funds come up etc etc it clearly shows euphoria.  As such the peak of the gold cycle was very apparent to me. Now we are nearly 30% off the peaks and now we see that most analysts and commentators are coming out with reports to exit gold immediately.

The logic for further decline in gold prices still exists. Investment into gold and gold backed products is still very high with an amount of nearly $ 300 billion with these kinds of products. Besides this there are the uncounted assets of lot of hedge funds. Under the circumstances my view always was that first we will have long unwinding and then short buildup. So the key is to see what lies in store for precious metals.  If we go back into history precious metals had a period of nearly 15 years of sideways movement from the late 1980’s where the prices remained largely in a range. However that was also at time of high nominal interest rates and not so intense currency wars. Today we have a situation where nominal interest rates are very low with 10 year bonds of the US, Germany, Japan being at 1.7, 1.3 and 0.5% respectively.  Moreover instability in various economies still exists with the scope of black swan events still being there.

As such I do expect gold to correct more, maybe to the $1200-$1300 levels. However at that stage we could see interest again come back into gold from Sovereign Funds that are still overexposed to US Bonds.  Interest from other investors who have poured money into gold ETF’s as well as Hedge Funds however might not revive for some time. On the other hand we could see physical demand revive again as economic growth improves and incomes improve. Greater confidence, especially in a country like India will not only lead to more flow into risky assets but also into buying of gold.

STAGFLATION BOGEY &INTEREST RATES DO NOT MATTER FOR ECONOMIC GROWTH – The kind of commentary that we see on India being in a stagflationary spiral is laughable at best. High policy rates have had a marginal impact on headline inflation as the drivers for inflation lie more in food price inflation and the correction in regulated power & fuel prices along with the INR depreciation of 2011. As the base impact of these wears off going forward inflation will come off.

Manufacturing inflation is below 4% at this stage, while food, fuel & power segment inflation are not linked to interest rates in any way. There is a total lack of pricing power in the economy today. There is no way that this is symptomatic of a stagflationary economy. Those who propound the theory of stagflation need to study their economics once again.

High rates not being responsible for economic slowdown is a theory propounded by lot of arm chair economist as well as the RBI. While it is true that the responsibility for the big downturn in domestic growth lies with the government due to their poor decision making across a wide spectrum of issues as well as the various scams that have spoilt the investment climate, it is also true that interest rates go a long way in deciding the viability of a project.  Why would Western Central banks and now the BOJ focus on driving long term interest rates down if it had no impact on economic growth.

The stress in a large number of projects that have already been awarded to various companies lies to a great extent on the environmental delays and policy uncertainty. It also lies in the inability of companies to fund the projects in a viable manner given the extremely low equity valuations, high debt on their balance sheets as well as high debt servicing costs. We have seen the market capitalization of a large number of infrastructure oriented companies come down to 5-10% if their peak valuations (not without reason) and also the debt on their balance sheets expand as some of them kept on expanding debt without thinking. However a lot of them also took debt as a bridge finance which was to be replaced by either equity in the company or project specific equity investment from PE companies or other investors.  With stock markets being in doldrums this did not fructify and the stress on the balance sheet grew.

RBI will of course take credit for the fall in inflation as it happens, however it is OK if they finally start focusing on growth. Inflation projection of the RBI will go wrong as usual, hopefully starting from today’s data that will come out later in the day.

Consumer demand in interest rate sensitive’s like Automobiles & Consumer Durables has also got impacted by tight liquidly and high rates. Negative car sales after 10 years are a testimony towards that.  

INVEST IN DEBT FUNDS – I find it ridiculous to see Mutual Funds putting out advertisements pushing Debt Funds these days. Till a year ago they were pushing gold products similarly. This is not the time for debt, but for risky assets as the macro indicators for the domestic economy have bottomed out and the huge fall in global commodity prices has improved Indian growth prospects hugely. As I wrote on my article on China and commodities earlier during the month the probability is very high that inflation will remain ranged for a prolonged period of time now. Under the circumstances I would like to remind investors of the fact that

 

“THE ACTUAL RISK OF INVESTING IN AN ASSET CLASS IS NORMALLY THE LOWEST WHEN THE PERCEPTION OF RISK IS THE HIGHEST”

Meeting with a large number of big investors over the last few days has indicated that a large amount of money is now going into pre booking of new real estate projects or real estate back interest rate instruments. The view that such prebooking investments will yield a return as the bookings open will again turn out to be a fallacy as project delays and lock ins make this extra return minimal or nothing.

A similar fancy was seen for structured products post 2008. In most of these products investors have been hugely disappointed as these products have matured after 3 to 5 years.

When I wrote on the market outlook the last time the view was for a possible 3-5% downside with a 15-20% upside subsequently. As macro developments have turned out subsequently this view has been further reinforced. Whereas risk aversion in the short run has created a scenario of foreign fund outflows, the longer term picture for inflation, interest rates and economic growth have actually improved. Volatility will continue for the duration of the results season, however downside risks have moderated significantly.  If the Cabinet Committee of Investments gets working to move projects on the ground over the next 1 or 2 months we could enter a virtuous cycle in India. In the absence of an actively working government the market moves will be much more slow and steady.