Turning on a dime, the market has taken the government’s new-found focus with great enthusiasm. The stock market has shot to its highest level since July, with FII inflows of over $3.5 billion in September alone. The rupee, too, has been soaring, rising to its strongest level since the start of May, in the process breaking through several stiff resistances and apparently eliminating almost all of the negative sentiment built into its value as recently as a few weeks ago.
Many analysts are seizing the turned-around sentiment and forecasting 47 or 48 by, in some cases, as early as December. And certainly the price action these past few days has exporters suddenly awake and everybody, including myself, confounded.
If, indeed, sentiment is back to normal – cautiously optimistic, to use a cliché – the rupee should equilibrate at around 51 or 52. I estimate this number by starting at 45, the value at which the rupee appeared to be “correctly” valued in August 2011 and adding (a) the approximately 10 per cent rise in the dollar since then, and (b) a further five per cent or so rupee weakness that would be needed to offset the substantially weaker global demand as compared to a year ago — I note that exports have fallen in five of the last six months.
Of course, markets know nothing about equilibrium — by their very nature they overshoot, undershoot and bounce wildly around equilibrium values. Thus, even if this calculation is correct and sentiment remains OK, the rupee will likely fall below the 52 level, perhaps even breaking 50. In fact, as the government rolls out its disinvestment schemes – reportedly targeting Rs 10,000 crore in November – we could see the rupee sub-50 as investors rush in to lap up the goodies.
On the other hand, if the improved sentiment fails to hold, we could see a pretty serious elastic bounce-back to 55 or worse.
Clearly, Mamata Banerjee is pulling out all the stops and it seems that she will push a no-confidence motion when Parliament reconvenes in November. However, I don’t think Mulayam Singh Yadav will finally side with her, because he knows that she will be pushing for the top slot in a potential Third Front, and even if she relents to buy his commitment, she is certainly not someone anyone can count on. He has just won a strong majority in Uttar Pradesh and it would be foolish for him to take this kind of risk.
In the event, the United Progressive Alliance will likely win the no-confidence motion, particularly since Pranab-da will be controlling some part of the process/outcome. While this will bring some respite, the increasing sound and fury of political jockeying – let’s not forget Narendra Modi, who is flexing his muscles for a national role – will make investors edgy and markets, both equity and foreign exchange, volatile.
An indicator to watch is the newly refurbished havala rate, which, as a result of the sharp strengthening of the rupee in the past few weeks, is quoting at a serious premium after a long time. While this may simply be a reflection of the thinness of the havala market, it is worth noting that the arithmetic for gold smuggling – six per cent (customs duty plus value-added tax) on a gold price of $1,700 an ounce – has become quite compelling.
Gold demand is, of course, steadily increasing with India’s increasing wealth, particularly in smaller towns. Negative real interest rates are doubtless compounding this, and given the arithmetic in favour of smuggling, much of the demand for gold may have moved back off balance sheet, which would explain the smaller official import numbers.
Anyway, it seems clear that the next election is upon us — perhaps, it will be announced soon after the 2013-14 Budget. A widening of the havala spread will confirm this.
In this environment, it is difficult to see how the rupee can remain sustainably strong. Importers need to ride the current wave but prudently. While it is painful to hedge medium-term exposures at these premiums, particularly with the rupee suddenly strong, not hedging is still much too dangerous. Call spreads are the obvious answer.
Exporters should cover some part of near-term exposures taking advantage of still attractive premiums; put spreads for longer-term exposures would be a good idea.
The Reserve Bank of India should act on its commitment to financial inclusion and amend its Master Circular on risk management to permit small to mid-sized companies (with net worth less than Rs 100 crore) to use these products. And if the havala becomes a noticeable smell in the air, the government should, despite its fiscal constraints, reduce the customs duty on gold to prevent the gold smuggling beast from coming back to life.
