The phrase “when US sneezes, world catches a cold”, still holds true, more so for financial markets. As we draw closer to the June FOMC meeting, credit markets to equity markets, all have started shivering.
The million dollar question remains, will the US Fed finally embark on a prudent monetary policy.
It has been eight years running since the world financial markets thought it was “about to die”; the artificial life support remains in place and in even greater proportion.
For a fairly intelligent being, the very sight that a patient remaining in the ICU or in need of emergency measures, after such a long time, is an indication enough of how healthy that being is.
Therefore, there is little need to wait for the doctor to proclaim the fact.
Emerging market funds have suffered their biggest outflows since the 2007-08 financial crisis last week.
EPFR data shows that equity funds in the emerging world bled more than USD 9 billion. Out of that USD 9 odd billion, biggest slice came from China.
According to the figures available with NSDL, FIIs have sold between USD 730-750 million till date in June, after they had sold around USD 2.2 billion over the previous month.
In India, debt markets have witnessed an outflow of USD 2.07 billion since end of April 2015 and equity markets have witnessed a withdrawal of USD 1.46 billion.
Therefore, it is no surprise that 10 year bond yields in India have risen from the trough of 7.60/7.63% to above 8.10% now (considering the old bond) and Nifty too has lost over 13% with individual stocks falling between 5-40%.
However, thanks to spirited intervention from our central bank, Rupee has been fairly stable. USD/INR has been caught oscillating between 63.60 and 64.30, with bulk of the moves confined between 63.75 and 64.20.
Our external balances data was impressive as far as headline number goes. Current account deficit for Q4 FY15, shrinking to almost nil, at USD 1.28 billion or just 0.2% of GDP.
In my past articles I have discussed about the drivers of this improvement in current account balance. In this piece I will touch upon them.
One way of looking at current account is that there is a difference between how much the economy saves and how much it invests, domestically. If I expand that equation I will get something like this:
Current account is equivalent to total income in the economy less private consumption, less private investment, less government’s fiscal balances.
Over the past few years, governments has been forced to tighten their belts, by cutting down on expenditure and increase taxes.
At the same time, private consumption growth has slowed and so has investment growth. All in all, we have a situation, where private and public savings have improved, due to cut back on expenditure and higher taxes.
Also less of those savings have been deployed as investment. Naturally, the current account has flipped into a near surplus.
A similar recovery in current account surplus played out in the peripheral countries of Euro zone since Euro crises of 2010-11.
Countries like Greece, Spain, Italy and Portugal have tightened belts so much that their current account has flipped from large negative balances to positive now. Hence, a weak to collapsing economy has aided in the improvement in the current account.
Source: RBI
Source: RBI & MOSPI
Apart from the fact, that current account deficit remains low, a high real rates is also acting as a major supporting factor for the Indian Rupee.
RBI has willingly kept real rates positive and that has anchored the internal value of the Rupee.
At the same time, RBI also kept a tight leash on drivers of monetary inflation, that is money supply and government spending, former through direct intervention and latter, through persuasion.
Add to that, the constant intervention in the USD INR value, Rupee has shown immense stability against the US Dollar.
However, can the above factors be enough to ward off any future risk to the Rupee? I do not think so.
Indian Rupee faces a capital account risk. Ever since, Indian capital markets regained their mojo, ie. since end 2013, FIIs have invested around USD 57/58 billion in domestic equity and debt markets, with debt markets enjoying nearly 60% of the total inflows.
Out of that gross inflow, we have seen USD 3 billion get withdrawn over the past 6 weeks.
One can argue that a chunk of that money could be hot money or money which have large tendency to herd together.
Infact IMF itself had flagged a similar herding risk for global financial markets in its financial stability report released in April.
It means that Indian financial markets are far more interlinked to global risk trends that our economy is to global markets.
I have observed an erroneous belief amongst many market participants in India, that Indian financial markets are somewhat immune to global markets. However, history says something else.
Though the risk aversions between 2011 and 2013 can be blamed equally on global as well as domestic factors, it is the sharp collapse in equity markets in 2008 and 2006, which stands as a glaring example of our global inter linkage.
During the summer of 2006, a reversal of risk trends in global hard assets and financial assets, triggered a 30/33% drop in the Nifty.
Similarly, during 2008, our equity markets dropped to just one third its peak value and Rupee too dropped by 33% in 15 months.
Infact, during both those periods, our macro economy was on a song, with 7-9% real growth, benign inflation, no major stress on fiscal and current account.
Therefore, risk analysis should always be a 360 degree attempt of viewing things, and during that exercise, one should consider both domestic as well global factors.
We all be watching what the Fed has to offer and in case they “chicken out” and turn dovish, then it could come as a major short term relief for the emerging markets including India.
A dovish Fed can trigger a significant rally in the long term bonds, which are now around 8.10/8.11% and also in Rupee and domestic equities. Similarly, a hawkish Fed can do reverse.
We believe it is the right time for the US Fed to make an attempt towards normal monetary policy.
Fed should break the addiction of financial markets to the drug of easy money.
Just like no doctor would ever wait for the addict to say yes before his drugs are taken away, similarly, US Fed cannot wait for financial markets to cheer lead before it begins normalization.
However, that is what Fed should do, and there is many a time a yawning gap between what ought to be done and what can be easily done.
So let us wait and see, whether Fed sticks to the easy path or shifts to the right path.
By Anindya Banerjee, analyst, Kotak Securities