Market Maniac

Deregulate to Generate Much-Needed Volatility
Apr 17, 2017

Exports grew by 28% y/o/y in March, and while much stronger POL exports (because of higher oil prices) were part of the reason, it is significant to note that exports have risen for seven straight months. In fact, annual exports, while still about 10% shy of the 2014-15 target of $ 300 bn, rose (albeit by a modest 4.7%) for the first time in three years.


While global growth is clearly back – most other countries have also shown strong exports – the rupee’s recent sharp surge may end up aborting this positive development. For instance, engineering exports, which rose in March by a huge 47%, would normally be priced at least eight to twelve months earlier; at that time the rupee was over 68 so they were likely costed at 63 or 65 to the dollar. Hopefully, most – or, at least, some – of these exposures have been hedged and would be in the money today. However, with spot below 65, companies would need to cost at 60 or below which my render many exports uncompetitive. Data out over the next few months will tell the tale.


Equally concerning is the fact that several competing currencies, including the yuan and even the Euro, have weakened against the rupee, making competition in the domestic market much fiercer, threatening the already limp Make in India initiative. Perhaps evidencing this, imports in March grew by a massive 47% y/o/y.


Meanwhile, RBI is finding its hands tied on intervention because of the extraordinary overhang of rupee liquidity courtesy demonetization. While the government may see this as simply collateral damage to its gambit for the UP election, its recent political successes result in backing FX policymaking into a corner.


The sharply improved perception of political stability as a result of the UP election led to a record surge in foreign portfolio investment in March (over $ 9 bn). And with the BJP apparently blindly focused on consolidating its political stranglehold – Orissa is next in Mr. Shah’s sights – the “threat” of stronger portfolio flows could continue. Several prominent global investors have pronounced India one of two or three prime investment desinations, the GST jubilation is yet to come, and the global investment environment is still benign, despite several known and unknown unknowns.


Indeed, I was recently surprised to discover that there is already a small pool of institutional investors who are getting attracted to masala bonds, which provide 7 to 8% (or more) dollar returns for carrying USD/INR risk. For a pension fund with tens of billions in assets, the risk/return for, say, $ 100 or $ 200 mn – which is a serious amount for Indian companies – may appear quite favorable. While there have thus far been a small number of such transactions, there is little doubt that this window will widen in years to come.

Thus, we may all have to start getting used to a stronger rupee.


Unless, of course, and there’s always an unless or many, Marine Le Pen continues the populist/nationalist trend that seems to be driving the world and becomes President of France and follows through on her promise to leave the Euro. The first round of voting is on April 23.


OR Trump’s sudden international belligerence precipitates a major conflict, which, given North Korea’s unpredictability could happen at any time.


OR Trump’s tax cutting initiatives runs aground in Congress, like his Obamacare replacement initiative, or the plan that does come out is seen as either inadequate to generate jobs or to control the deficit, in which case equity markets will tank.


OR the nervous Nellie monsoon watchers turn out to be correct, pushing domestic inflation higher, which could threaten both political stability and the rupee


OR the conflict between Mr. Modi’s forward-looking development agenda and his rapidly-backward-looking social agenda results in one or many ugly explosions; while Kashmir may be an outlier, the government’s iron fist approach suggests that any equilibrium we see is unstable; in any event, FDI, which has been the brightest spot in India’s macro-picture, will likely slow down the longer this nervous equilibrium prevails; outward investment flows will also increase


OR…


You get the drift – any of a multitude of things can happen to suddenly undercut the rupee’s apparently intrinsic strength, which has caught most companies on the wrong FX foot. Rupee volatility has risen a little recently with its sharp rise, but it remains below its long-term average. Sustained higher volatility is necessary to push companies to hedge more prudently and RBI needs to walk the talk on that.


The only thing they can do, to my mind, is to permit different entities – PDs, mutual funds, insurance companies, etc. – to directly access the FX market. Globally, over 50% of market liquidity comes from such non-bank financial institutions; in India, the share is zero. Allowing different entities with different types of balance sheets into the market may be the only way to generate demand for dollars from time to time to at least partly offset the strong capital flows that are boxing RBI into a corner. This can be structured as a controlled move towards capital account convertibility since these entities do not naturally have FX exposures.


Regulators often act only when their backs are to the wall; the time is now.




Archives

Deregulate to Generate Much-Needed Volatility
Apr 17, 2017

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