Column: UMP exit tremors not to rock India

Written by K Vaidya Nathan | K Vaidya Nathan | Updated: Oct 12 2013, 10:22am hrs
For global investors with a low appetite for systemic risks, a recent paper by IMF may whet their appetite for Indian financial markets. In a policy paper on the global impact of Unconventional Monetary Policy (UMP), India ranks quite low in terms of impact on its domestic economy. In the continuing great recession that started with the sub-prime crisis in the US, central banks of the US, UK, Japan and the Eurozone, have followed UMP to kick-start the economy time and again. The recent IMF report studies the effect of UMP on a sample of 13 countries including India. Let me explain the rationale of the indicators used by IMF and how India fares in relation to other economies. The first indicator IMF uses is the effect on domestic bond markets to tapering announcements in the US. The Fed indicated in May and June this year that it is going to end the easy-money policy by scaling down bond purchases, widely known as Quantitative Easing (QE). The US has been printing money and buying back its own bonds thereby resulting in greater supply of dollars in the economy and its central bank hinted in May and June this year of tapering of the QE program. The study shows that our bond markets had the second-lowest impact of the 13 countries studied. As a by-product, IMF measured the net outflows from the domestic equity and bond market following the UMP tapering announcements in relation to other economies. There isnt much evidence here either to suggest that there was much funds flow following the tapering announcements of the QE program. Another indicator is sensitivity of change in domestic bond yield to that of long-term US bond yield. The study reports a low correlation which indicates that our bond markets are not sensitive to external monetary shocks. More developed economies like Australia and Canada are more vulnerable to monetary shocks from UMP than India.

In terms of resilience in domestic market conditions, our economy fares quite well. India has a high market capitalisation to GDP ratio of 68.60%. An economy with a high market capitalisation like ours has less effect on asset prices from capital outflows. Moreover, Indian equity market has a high 54.63% turnover, a measure of the value of shares traded vis--vis average market capitalisation. With a relatively high turn-over, capital outflows tend to not have much effect on asset prices.

According to IMF, our dependence on foreign funding is low as compared to other countries. The foreign ownership of domestic equities as a per cent of GDP is only 7% and is the second lowest after China (3.19%). Korea, Australia, Canada and South Africa have a much higher dependence on foreign funding which exposes their equity markets to larger volatility. Our external debt is the third lowest at 20.90%. Even though our short term debt as a percentage of total external debt is the second highest at 27.13% after Turkey (36.89%), we need to keep in mind that the denominator, external debt, is itself low (20.90%) as compared to that of countries like Turkey (42.70%). A lower short-term debt entails less risk of funding shortages in case of capital outflows.

However, not everything is hunky dory. In terms of policy room, we do not have much manoeuvrability either in fiscal policy or in monetary policy. In fact, we have the lowest fiscal flexibility in terms of achieving our stated debt targets. With inflation higher than 6% and a negative output gap of -0.91%, we do not have much monetary policy room either. RBI has been fighting the twin battle of arresting growth slide and controlling inflation for long and doesnt have much flexibility left.

Some of the other measures where we fare badly are trade balance, foreign exchange (Fx) reserves, room for Fx adjustment, bank capital and non-performing loans (NPLs). Our trade balance as a percentage of GDP is the lowest at -7.63% among the 13 countries. Our Fx reserves is also one of lowest at less than 6 months worth of imports. China has the highest Fx reserves enough to cover more than one-and-a-half years of imports. Smaller Fx reserves indicate less room for intervention in currency markets to dampen potential excessive depreciation, like the way the rupee experienced in the last quarter. Our banking sector too isnt very healthy as compared to other countries which adds to the vulnerabilities in the economy. Bank capital is one of the lowest at just 6.9% of total assets and our banking sector has one of the highest NPLs at 3.1%.

The redeeming aspect is that on some of the measures like output gap, inflation, trade balance, achieving debt targets, bank capital or NPLs, the problems are mostly internal and our economy is insulated from outside shocks like that from UMP. We do have things to worry about but the only consolation is that they are less worrisome than some of the other countries.

Global rating agencies would do well to go through the IMF policy paper carefully. Among the 13 countries surveyed, India has the second lowest rating (BBB-) with a negative outlook. Even a one notch downgrade would take our rating to junk status. Countries like Thailand, Mexico, Brazil, Poland and South Africa have better sovereign rating than us but fare worse in the IMF study. As sovereign rating indicates the risk level of the investing environment of a country and is used by investors looking to invest abroad, the IMF study seems to corroborate what the Indian government has been saying for long that rating agencies outlook on India is unfortunate. Unfortunate rating notwithstanding, I hope the IMF report whets investor appetite for India.

The author, formerly with JPMorganChases Global Capital Markets, trains finance professionals on derivatives and risk management