The 'perverse' effect on the rupee

The rupee-dollar relationship is expected to be equally volatile with unclear directional trends in July

As a member of a certain generation, I must confess that it feels strange to parse speeches by US Federal Reserve officials for clues to Indian economic trends. The rupee making a spectacle of itself, bouncing up and down, also seems unsettling. The economy used to be so rigidly controlled and insulated that Indians ignored global trends. Of course, this insulation made the nation dirt poor, but it also made investment decisions easier because there were so few variables to track.

The connections between global events and trends in Indian financial markets have grown stronger. Sadly, some of the correlations are perverse. Last fortnight highlighted the perverse aspect. First, a US recovery triggered sell-offs across the globe. Then, when revised US gross domestic product (GDP) numbers for January-March 2013 were weak, markets rebounded in joy. This was followed by another small sell-off in the US on June 28 (Friday), after several Fed officials said confusing things.

The issue is timelines in the Fed's QE3 programme. QE3 pumps out about $85 billion of liquid cash every month. This monopoly money enables punts on risky assets, including emerging markets.

On June 20 (Thursday), after a meeting of the American FOMC (Federal Open Markets Committee), Fed Chairman Ben Bernanke reiterated that, as US recovery grew stronger, QE3 would be tapered off. One threshold is unemployment falling below seven per cent. The US unemployment rate was down to 7.6 per cent in May 2013, from above 8.2 per cent in May 2012.

The markets crashed on the fear that QE3 would taper earlier than expected. On June 26 (Wednesday), revised data showed US GDP growth was 1.8 per cent in January-March 2013, lower than the initial estimates of 2.4 per cent. This was interpreted (probably correctly) as a new lease of life for QE3. The markets jumped.

On Friday, several Fed officials said conflicting things. One said, more monetary stimulus may be ineffective. Another said the FOMC may set timelines for tapering at the September meeting. Note that this doesn't mean tapering will start in September. The next key number is US jobs data, which is due on July 5 (Friday, or Saturday for India). If the jobs data is encouraging, the market will probably drop.

Foreign institutional investors (FIIs) sold over $5 billion of rupee debt and equity in June. The impact was spectacular. The Nifty crashed 250 points in two sessions. The rupee dropped below Rs 60 a dollar and slid to nearly 61. It's been a steep fall from Rs 54 a dollar in early May.

FIIs halved their rupee debt exposure, selling over Rs 31,000 crore in June. The Reserve Bank of India (RBI) decided to hold status quo on policy rates. That was pragmatic. Higher rupee prices of imported fuel will push inflation.

Once the weaker revised US data came in, the market rebounded as spectacularly. FIIs returned last Friday and their buying, alongside domestic bulls, drove the Nifty up again. The rupee also regained a little lost ground. Attitudes may change again, once the possibility of tapering timelines being set in September is absorbed.

Fears of an impending crisis may accelerate some reforms. The government has revised gas pricing, which pushed up energy sector valuations. It has also made encouraging noises about fast-tracking spectrum auctions. But it didn't provide much clarity on subsidy mechanisms in power and fertilisers in the wake of higher gas prices.

The Securities and Exchange Board of India has tweaked its registration norms for overseas investors. FIIs will become foreign portfolio investors (FPIs), and the renamed FPIs will have a much easier time meeting easier Know Your Customer norms. Cynically speaking, the reduction of red tape should help political parties round-trip hawala money back to India for the 2014 elections.

Any inflows will be welcome now, regardless of provenance. The balance of payments (BoP) is dire. The rupee and the BoP may be key to economic recovery. India has short-term external debt of $171 billion due for repayment inside 12 months. The current account deficit (CAD) was $89 billion, or 4.8 per cent of GDP, in the financial year 2012-13. The CAD dropped to "only" 3.7 per cent of GDP ($18.1 billion) in the quarter of January-March 2013, which is a good sign. However, anything over 2.5 per cent is unsustainable in the long run and the CAD could well deteriorate again.

Discounting bullion amounting to some $30 billion, the RBI has normal reserves of $260 billion. If FII inflows are strong and there is foreign direct investment also coming in, we may still see reserve drawdowns of some $30-35 billion in 2013-14. If FII selling continues, the reserves position will get tight, and there is a small but real chance of panic. A sober look at the BoP suggests the rupee will fall more. If the move is relatively smooth, the markets will absorb the depreciation. Sudden crashes and equally sudden bounces are a different matter.

On the corporate front, the rate of growth in earnings per share (EPS), adjusted for inflation, improved a lot in the fourth quarter of 2012-13. This is mainly because inflation slowed. But Q4 EPS did grow quicker than expected.

An interesting situation will arise if GDP growth picks up, while FIIs are selling due to fears of tapering. Given guarantees of political instability till mid-2014 at the least, domestic investors are cautious. This means asset prices will decline. That may lead to a disconnect of falling stock prices coupled to rising EPS over the next 12 to 18 months.

July is likely to be volatile with unclear directional trends as of now. The Nifty is just above its own 200-Day Moving Average. It swung 450-odd points between a high of 6,011 and a low of 5,566 in June. Expect similar volatility in July. Watch the rupee-dollar relationship. Be prepared for sudden massive swings.