Foreign institutional investors have poured into the Indian cash market a staggering $6.7 billion (about Rs26,330 crore) between 18 September, when the US central bank cut its policy rate by 50 basis points, and 10 October.
Stocks, of course, have soared skywards, riding on this tsunami of liquidity. But, as can be seen from what is happening to the information technology (IT) stocks, there is also a darker side to the story. The appreciating rupee is hurting exports and could soon lead to a redirection of resources away from the export sector to the domestic economy. That rotation is already under way in the stock markets: money is being rotated away from IT into real estate and capital goods. But a similar reallocation of resources in the real economy could have far wider implications.
That is the subject of one of the chapters in the International Monetary Fund’s (IMF) World Economic Outlook, released recently. It attempts to answer how surges in capital inflows should be dealt with and the policy options open to recipient countries. IMF points out that there have been two great waves of capital flows to emerging markets in the last two decades: one of them began in the early 1990s and ended with the Asian crisis, while the second one began in 2002 but has gathered strength recently. Will the current wave also end in tears and years of lost growth, as the earlier one had done? How can a country’s exports remain competitive when inflows drive up the local currency? What is the best way of engineering a soft landing when the inflows dry up? These are some of the questions IMF has tried to answer by looking at earlier episodes of capital inflows and finding out which were the policies that worked.
Here are the results: “First, countries that experience more volatile macroeconomic fluctuations—including a sharp reversal of inflows—tend to have higher current account deficits and experience stronger increases in both aggregate demand and the real value of the currency during the period of capital inflows. Second, episodes during which the decline in gross domestic product (GDP) growth following the surge in inflows was more moderate tend to be those in which the authorities exercised greater fiscal restraint during the inflow period, which helped contain aggregate demand and limit real appreciation. Third, countries resisting nominal exchange rate appreciation through intervention were generally not able to moderate real appreciation in the face of a persistent surge in capital inflows and faced more serious adverse macroeconomic consequences when the surge eventually stopped. Fourth, tightening capital controls has, in general, been associated neither with lower real appreciation nor with reduced vulnerability to a sharp reversal of inflows.”
In India, the central bank has been buying dollars hand- over-fist (it bought more than $11 billion in July) in an attempt to stop the currency from appreciating.
At the same time, it has resorted to sterilization or mopping up the rupees generated by its buying dollars. IMF points out that sterilization often does not work, because it is designed to maintain higher interest rates, which serve as a magnet for attracting more funds.
However, if sterilization is not resorted to, liquidity increases, pushing up prices. The IMF prescription is to reduce government spending, which may be good advice but is unlikely to be practical in India, with elections around the corner. Tightening capital controls could well end up killing the goose that lays the golden eggs. In short, the Reserve Bank of India (RBI) governor is likely to be suffering from a huge headache and it could be only a matter of time before the central bank is forced to increase the cash reserve ratio to mop up the liquidity.
So far, in spite of all the money coming in, the move upwards has been concentrated in a few sectors.
Between 18 September and 11 October, while the Bombay Stock Exchange (BSE) Realty Index has gone up 27.6%, the Oil & Gas Index (read Reliance) is up 26.2%, the Capital Goods Index is up 24.8%, other sectors—such as fast-moving consumer goods up (5%) or health care (up 5.6%)—have hardly moved. Metals and IT were up 8.6% and 8.7%, while the BSE Auto index and the Bankex were in middle territory, having risen 13.8% and 15.4%.
The divide partly reflects the dichotomy in the real economy, with a buoyant capital goods sector, negative growth in consumer durables and a slowdown in exports. Moreover, since commodity prices are determined internationally, a stronger rupee also affects the commodity sector adversely, because imports become cheaper. In short, the economy seems to be hopping forward on one leg—that of investment demand. In the stock market, the net effect is that because of the concentration on one or two sectors, their valuations are far above that for the rest of the market. For instance, the BSE Capital Goods Index was trading at a trailing price-earnings multiple of 46 on 11 October, while the health-care sector’s multiple was around 21. No wonder the market is so volatile. Also, with interest rate sensitive stocks on an upward march, the stock market seems to be betting that RBI will leave at least part of the liquidity on the table, which will push down interest rates. But the latest round of interest rate cuts by banks seems to be a tactical move, aimed at increasing market share.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular.
Comments are welcome at email@example.com