India is vulnerable this time

ISSUE/ Changes in the global economy and the turmoil in the bond and rupee markets

Aditya Birla Group

A few events have taken place which imply that there could be significant changes in the interest rate and forex outlook in the next several months.

First, the state of the global macro-economy has changed fundamentally. From being in an era of low global inflation and low interest rates, we are about to enter a period where developed economies are already picking up steam, as we are witnessing in Japan and the US, and inflationary pressures will be felt.

The US Federal Reserve is all but certain to increase rates at its next meeting. Once this happens and we enter a period of rising interest rates, liquidity will get sucked out of emerging markets, including India, and will impact the developing economies in many ways.

We saw that in the 1994 cycle of Fed rate increases as well as in 1997 when, after the Asian crisis, first Russia and then Brazil had to devalue their currencies.

India is vulnerable this time, not because of hot money of the short term debt variety, but more because of the large flows of hedge fund money that have entered the country.

The second big event that will impact India specifically is the policies of the new government. The apprehension is that with a commitment to increase spending in the rural areas and on social sectors such as education and health, the government's fiscal deficit may balloon.

Thankfully, those running the government's finances have a fiscally responsible record and the economic team is as strong as could be expected. Third is the oil price. Part of this has been passed on in the recent price increases, and is beginning to feed into the inflation numbers.

Fourth, India's balance of payments will move into a weaker position mostly because until confidence returns, capital will not. The jury is still out on the government's reformist tendencies.

In addition, as industrial activity picks up "" and all indications are that it will "" imports will increase leading to a worsening of the trade deficit.

What does all this mean for the interest rate and rupee? Taking the interest rate first, given that rates are now close to 6 per cent and so is inflation, on a real basis, 10-year rates are still close to zero.

This is not a sustainable position and chances are that as inflation ticks up, interest rates will need to rise further. If the government's fiscal deficit estimates for the current year "" to be announced in the Budget due on July 8 "" is based on what the market believes are unrealistic assumptions or is a high number to begin with, then rates are likely to rise in anticipation of the borrowing program. The bank rate may not increase substantially as it is already at 6 per cent.

However, there will be an increase in bond yields near term partly in sympathy to higher rates globally, and partly due to the bearish inflationary outlook.

The forex rate is driven by capital flows. We will have to see how confidence in this government develops before being able to make a good assessment.

Given that liquidity is likely to move out of the emerging markets, significant foreign institutional investor money is waiting to exit India at this stage, and Indian companies are likely to raise less money abroad, it is likely that the rupee will remain weak in the short term.

If the government's policies are eventually viewed positively by the market, then the rupee could strengthen in the medium term. Every thing depends on the government policies and the Budget.

Volatility to continue

MOHAN N SHENOI
Treasurer,
Kotak Mahindra Bank

In the very short term, a host of uncertainties are likely to keep the bond as also the exchange rate market confused.

Headline inflation is likely to go up further to factor in the recent domestic fuel price increases and traders would be betting on the future of economic reforms and follow the Budget numbers.

With Budget likely to reduce the public sector disinvestments target, the fear would be towards a reduction in the foreign inflows leading into a near-term depreciation of the rupee.

However, the depreciation is unlikely to be sharp as the Reserve Bank of India would monitor and prevent significant dollar demand-supply mismatches.

For the bond market, fears of inflation and turn in the global interest rates would prevent traders from initiating fresh positions. Despite all negatives, recent moves in the bond market appear exaggerated.

For the medium term, there are expectations of sentiments reviving from the current weak levels. First, data from US economy does not look extremely strong and the recent dip in core CPI for May is likely to hinder any chances of an aggressive rate increase in the US. There is still adequate slack in the labour market despite the recent gains in employment numbers.

Alan Greenspan in a recent statement indicated that "general view is inflationary pressures are not likely to be a serious concern in the period ahead." Hence, the Fed will be able to lift US interest rates at a "measured" pace this year, probably by 25 basis points this week.

What this means is that soon again US current account deficit problems will steal the limelight. Further, Japan looks to have mended ways after a decade long fight with deflationary trends and Euro-zone is also recovering slowly on the back of exports.

Hence, the US dollar is unlikely to significantly gain in strength if Fed fails to increase interest rates aggressively.

On the other hand, the fundamentals of the Indian economy remain strong as India is now also being targeted as a manufacturing hub by global manufacturers. Foreign inflows are thus expected to continue and domestic liquidity does not appear to be a risk immediately.

Moreover, Budget might not be too negative as the common minimum programme is a longer term goal of the UPA and is unlikely to be implemented immediately.

The UPA is also keen to implement Kelkar task force recommendations on tax reforms and is likely to view the services sector as a major revenue generation source.

In fact, in his recent address to the nation, Prime Minister Manmohan Singh indicated that the social objectives are unlikely to be at the cost of fiscal discipline. Hence, the Budget is not expected to increase the central government's borrowing programme significantly.

We do not expect any interest rate softening signals from the RBI. But, this is not to imply that repo rate will be raised soon despite strong inflation expectations as RBI allows the economic recovery process to take hold.

Overall, bond yields are expected to be volatile in the near term till it finds a new equilibrium level. Furthermore, the rupee-dollar exchange rate may appreciate modestly with continuing good inflows and lack of US Dollar strength against its majors.