When the Tsunami ebbs

FII attitudes to India will be a deciding factor, and that will be determined more by the Fed and the Bank of Japan than by the RBI

Tsunamis are triggered by mid-ocean earthquakes. Water displaced from the epicentre travels out in waves - each a metre or so in height. The waves move at great speed (600 kmph-plus) across long fronts (100 km-plus). As a wave approaches shallows near land, it slows and gains height. The shallower the shoreline, the higher the wave, and the greater the impact.

Stretching the analogy, when a tsunami of financial liquidity hits shallow markets, the impact is larger. Stretching the analogy even more, a financial tsunami also causes vast amounts of damage when it withdraws.

A tsunami of liquidity, the American quantitative easing (QE) programme, has washed through global markets since the subprime crisis. This week, the US Federal Reserve meets to discuss "tapering" off, or withdrawal of the QE. (Click for chart & table)

Sooner or later, the Fed will cut back the balance-sheet expansion, which is pumping $85 billion of liquidity into the global markets every month. The tapering will be gradual. It could start in two or three months, or be deferred till calendar 2014. When it does start, equity prices will slide everywhere. Bond yields will rise. Since the Fed's actions will be tied to the US economic recovery, money will flow back into dollar assets.

Like all emerging economies, India has relatively shallow equity markets and a very shallow bond market. The impact of tapering will be larger. Even the threat of tapering has hit rupee asset prices. In the short-term at least, the Fed's actions will dwarf domestic events.

Since June 2012, foreign institutional investors (FIIs) have bought Rs 1,68,000 crore of Indian equity and Rs 43,000 crore of rupee debt, the latter being mainly government securities. In the past two weeks, FIIs have sold Rs 3,000 crore of equity and Rs 15,000 crore of debt.

The debt sales are proportionately larger. In the last 10 sessions, FIIs have booked profits on over one-third of all the long-bond positions they built in the last 12 months. This strongly suggests they are going to cut India exposure. By some estimates, FIIs hold about $150 billion in equity and debt assets. That is roughly Rs 8,50,000 crore. How much will move out?

There are no counterparties to balance sustained FII selling. Domestic institutional investors (DIIs) have bought equity this month, and debt as well. But DIIs are under pressure owing to an established trend of net redemptions by households. In any case, DIIs simply don't have the resources to match FIIs. We may, however, have a situation where DIIs turn net equity buyers as FIIs turn net sellers, for what that is worth.

One possible counterbalance for the Fed tapering could be the Bank of Japan (BoJ) balance-sheet expansion. The BoJ pumps out about $75 billion per month. However, Japan's domestic economy seems to be stalling. The Nikkei has tanked a bit in the past fortnight, and Japanese investors may be looking at different asset allocation patterns.

The dollar has zoomed versus the rupee. That brings the current account deficit (CAD) to centre stage. The Reserve Bank of India (RBI) intervened at least once. It cannot afford to intervene on a regular basis since it must protect its reserves. It is, therefore, extremely likely that the rupee will fall further if FII selling continues, or gains in volumes.

Fears of an exploding CAD, and an associated bloat in the fiscal deficit, would be among the key variables D Subbarao considers before announcing the credit policy. The central bank's actions would be primarily designed to stabilise the rupee, rather than to enable growth, or control inflation. Inflation is falling anyway if the latest consumer price index and wholesale price index data are believed. Growth has also picked up a bit, if the index of industrial production is credible.

Here's the RBI's dilemma. Its highest priority is to induce forex inflows or at any rate, stem outflows via FII selling. It could cut policy rates, which will help growth along. Lower rates may induce FIIs to buy more equity. But it may also induce them to book more profits in the debt segment as rupee bond yields fall. If instead, the RBI increases rates, FIIs may increase debt exposures. But they will probably increase equity sales, as well.

On balance, I think the RBI will cut the repurchase rate, by a minimal 25 basis points. This is because FII equity exposures are larger than the debt exposures and FIIs are more likely to go long on equity, than long on debt at this stage.

Be prepared, however, for acts of desperation if the dollar rises much more. The RBI could be forced to raise rates massively at some stage in reaction. Or, it is possible that the government will attempt to reimpose capital controls.

Given these known unknowns, it is not surprising that the market has been distinctly nervous through the past fortnight. The Nifty travelled down, breaching the 200 Day Moving Average (DMA), and falling to 5,680. Then it bounced up again, back just above the 200 DMA at 5,810.

Next week might see another sharp correction to Nifty 5,600 or lower, or an equally sharp relief rally till above 6,000. The Bank Nifty will be super-sensitive. The financial index could move anywhere between 11,000 and 13,000 within the June settlement.

Domestic sentiment has little influence on the direction of the major indices. But breadth is poor with most midcaps and small-caps moving down even on sessions when the large-caps have seen upticks. Domestic confidence is low - as it has been for over a year. But the key to major movements will be FII attitude, and that will be determined more by the Fed and BoJ actions than by the RBI.