The long and short of it

SMARTSHARE

The credit policy and the 25 basis point hike it incorporated in a key policy rate went along expected lines. In fact, the rupee recovered slightly in the aftermath of the announcement because traders had over-reacted to "hawkish" signals from the RBI.

The policy confirmed the RBI's take on the shape of things to come. It appears that the RBI is reasonably sanguine on the GDP growth front as well as in terms of domestic credit and deposit growth ratios.

It seems to accept that the rupee will continue to depreciate and rather than do something silly to shore up the currency, it will ensure depreciation occurs in a stable and predictable fashion.

On the external front, there are worries though these were understated in typical central bank-speak. The rise in crude prices has started to push up inflation and crude prices remain volatile. Commodity prices have also risen.

The forex market situation became more volatile in May. "Global imbalances" namely, the US deficits remain high and this is "reflected in misalignment of major currencies". "Financial markets are increasingly apprehensive about the risks of a disorderly adjustment" and this has led to a "visibly increased preference for debt".

Translated, the RBI expects continued volatility in the forex markets and perhaps a period of turmoil at some stage; it expects a gradual outflow of capital from Indian assets into hard currency sovereign debt.

It is prepared to risk slowdowns in Indian credit off-take to ensure that it's not exposed to another bout of Asian Flu. The 25 basis point hike is very likely to be followed by more hikes if global imbalances don't improve.

The implications for corporates are simple enough. Interest burdens will rise and any company relying on foreign currency debt or has net import exposures will hurt. Given commodity price rises, and the likely inability to pass these on fully to consumers, operating margins could also be hit for manufacturers.

For the financial markets, the relationship between shareprices, higher interest rates and possible currency risks is not linear. But it is clearly an inverse relationship.

Equity valuations drop as yields on debt rise. And, if FIIs are concentrating on hard currency debt, portfolio inflows into India will slow. Earnings growth should remain strong through 2006-7, so shareprices could stay stable despite lower PE valuations.

That combination makes it a difficult environment for medium to long-term investors. The long-term investor is hamstrung because shareprices are still quite high. The medium-term investor has to be cautious if the environment is going to worsen over the next 12-18 months.

From a top-down perspective, an investor could look for a net export profile preferably with debt-neutrality assured. That brings one back to the IT and BPO industries.

The possible negative is that US IT firms have registered lower growth in the past quarter. This could filter into lower growth for Indian firms. But the lower rupee could make them more competitive.

The other option for investors is to focus on businesses that have an excellent dividend history. Treat a corporate dividend yield exactly as you would treat yield from debt.

Go with companies, which have a five-year dividend history and a stable profit record. This would provide a cushion against shareprice dips. If you place a high weightage on dividends however, you may have to sacrifice growth prospects.