Three risks that the equity markets may not be fully pricing in

A weaker Rs, slower growth, and higher inflation could lead to investors focusing on export-oriented stocks

The Reserve Bank of India (RBI) has embarked on Quantitative Easing (QE) with the Government Securities Acquis­ition Programme (GSAP). This commits the central bank to buy Rs 1 trillion of government bonds off the secondary market in the first quarter (Q1) of financial year 2021-22 (FY22). If it runs at the same rate through the fiscal, this will significantly exceed RBI purchases of Rs 3.1 trillion in FY21.

In addition, RBI is holding policy rates low, and conducting open market operations such as “Operation Twist”. Here it sells short-term treasuries and buys long-term debt to control yield curves.

What are the aims of GSAP? The buyback releases liquidity for the purchase of new bonds (or other purposes). The primary aim is to support government borrowing. It may also encourage institutions to extend corporate credit if there’s any liquidity left over.

The sheer scale of government borrowing does suggest corporate debt will nevertheless be crowded out. The central government will borrow at least Rs 12.05 trillion (gross) in FY22. States will also raise substantial amounts. Net of repayment, the Centre will borrow Rs 9.3 trillion. In FY21, commercial credit grew at just about 6 per cent – it would need to jump to about 18-20 per cent to fuel double-digit GDP growth.

If yields stay low and inflation rules high, the real return on G-Secs may be negative, or very low. RBI’s liquidity injection may, in itself, fuel some inflation. This would make rupee debt unattractive. At the same time, the second wave and lockdowns have led to downgrades of Q1 growth prospects. That makes equity less attractive. In combination, this could lead to FPI outflows. Thus far in April, FPIs have sold Rs 5,300 crore of equity, while buying Rs 1,500 crore of debt.

The rupee would remain under pressure. Economic recovery in the US has led to a dollar bull run against other currencies. The rupee has been amongst the worst performers, falling from 72.30 to 75.45 versus USD. This trend of a weaker rupee could continue through the fiscal.

The market response to GSAP has been muted. Yields dropped initially but hardened again. In the last auction (April 9) primary dealers couldn’t find takers for Rs 10,930 crore of the Rs 11,000 crore of 2026 G-Secs on offer. Yields on the 10-year G-Sec (2030 maturity) are still well above 6 per cent. CPI inflation is 5.52 per cent (March 2021) while WPI inflation is at 7.39 per cent.

RBI has not committed to a continuation of GSAP beyond Q1. But it’s rational to assume it will. The combination of a weaker rupee, slower growth, and higher inflation could lead to investors focussing heavily on export-oriented stocks. If FPIs do trim their exposures, there could be an overall correction.