The expected Fed tapering of bond buying or quantitative easing, coupled with a prolonged policy paralysis at home, are the main two causes for the current state of affairs in India.
Whenever US long-term rates have gone up and monetary tightening occurs it creates a ripple effect across the globe and more so, in emerging markets (EMs). Hence, most EMs are haunted by the spectre of balance of payments (BoP) crisis. Countries with a large current account deficit such as India, Brazil, Indonesia, Turkey and South Africa have witnessed large depreciation of their currencies as the global tide of liquidity reversed amid fears of Fed tapering.
The only way to counter the dollar appreciation trend in the medium to long term is - by way of increased savings and improvement in productivity. In the short term, tweaking domestic interest rates is a possible tool, but it hasn't been effective and is unlikely to be so effective as to counter rupee depreciation. If one were to assume that US rates remain in the current vicinity (give or take 50 basis points), India has to choose between a weaker currency (hence high inflation) and higher interest rates. High imported inflation coupled with sluggish growth is not easy to deal with, creating real policy dilemmas. I think the new RBI Governor, Raghuram Rajan, is more likely to weigh in favour of a weaker currency than higher interest rates, but of course appear to be balancing both. This is likely to keep market upbeat for some time.
However, sagging economic growth coupled with high inflation, has put us in a stagflation-like situation. Given the current GDP growth of 4.4 per cent scenario due to poor investment cycle, policy paralysis, high inflation and falling savings, there is an urgent need to give India measures to a boost economic growth. For economy to kick start, we need to have - first, easy monetary policy; second, investment supportive policy scenario and; third, productivity improvement measures. Each of them, especially the latter two, requires political efforts and a 'will' to reform and push forward the growth agenda. Can the government do a lot with the limited time frame they have before elections? Or the limited fiscal resources they have at disposal? (Current priority for resources seems to be on the political side than economic side). I have my doubts. I don't think we can expect structural solutions like power reforms, mining reforms, infrastructure development, labour reforms, etc., so soon. Hence most responses from the government are more likely to be tactical than really structural. But the Jury is still out.
In absence of strong policy change in core sectors, banks, saddled with non-performing assets, will struggle to keep their balance sheet healthy and be very risk averse. Hence the credit cycle is unlikely to pick up in a hurry.
The silver lining, in my opinion, is it will bring exports and manufacturing back to the centre table. The entire decade of 1990 was focused on exports and manufacturing and then got left behind in the following decade, now I see that coming back to the forefront. We will see renewed investments in this area, albeit in some time.
The markets in the short term might cheer from interest rate easing, if it happens as I expect. Beaten-down stocks and sectors might bounce back leading to renewed market interest. However, in medium term they will struggle to deliver in absence of economic growth and sustained imported inflation. Also risk of international events such as Fed tapering, Syria attack, etc. can create intermittent volatility and extreme risk as well.
In the current situation, it makes sense to remain invested in the sectors, dependent on the developed markets (where growth is returning) and forex earnings. Sectors focused on domestic demand are likely to remain underperformers. Hence, IT, pharma and metals remain the best bets in a market like this for next three to four quarters.
The author is CEO, wholesale capital markets, Edelweiss Financial Services Limited
