Mumbai could not have given a better welcome to new Reserve Bank of India (RBI) governor Raghuram Rajan. The rupee has regained some of its lost lustre, rising 6% over the past seven days even as the Sensex has moved up roughly 10% after the former International Monetary Fund (IMF) chief economist took charge at Mint Road last Wednesday.
Rajan’s clear enunciation of RBI’s goalposts and the use of credible policy tools to achieve them have helped restore calm in the currency markets. There have been decisive signs of change in New Delhi, too, which have helped in removing some uncertainties, and boosted stock prices. For one, Parliament just finished one of its most productive sessions, which saw the passage of the long-pending Bill on empowering the pension regulator. The telecom regulator’s latest recommendation lowering the spectrum prices also appear more in tune with market reality than the knee-jerk reactions of the past, and explain the rise in telecom stocks.
But will the party last? A lot will depend on the decision of the US Federal Reserve on the tapering of quantitative easing. US President Barack Obama’s call on Syria will also be a critical factor to watch, given the impact on oil prices and hence on India’s twin deficits: fiscal and current account. Still, irrespective of which way the wind blows in Washington, it is possible that the trajectories of the rupee and the Sensex will diverge in the coming weeks and months.
There are fundamental reasons behind the rupee’s weakness and they will continue to act as a drag on the currency. The high inflation over the past few years is now finding reflection in the external value of the currency, which was possibly overvalued for some time.
The headline inflation is unlikely to soften much immediately, given the impact of higher import prices. Overall economic growth will be tepid and very few expect gross domestic growth to exceed 5% in the current fiscal. Factory output growth has already crashed to near-zero levels and is unlikely to witness a sharp recovery.
The trade deficit continues to be uncomfortably high although there are initial signs of moderation now. The latest trade data shows a contraction in the trade deficit but that has been possible only with the fall in the rupee’s value.
A further correction could be possible but it will have to rest on the legs of a weak currency rather than a sharply appreciating one. The medium-term prognosis for the rupee will be even gloomier if one goes by the consensus view about a tapering announcement by the US Fed.
Yet, going by the Sensex’s recent history, Indian stock markets and their bellwether index may not do as badly.
While foreign investments in equities reversed in June after net inflows worth $15 billion in the first five months of the year, the pace or volume of outflows from Indian equities were not sharper than other emerging market peers.
In contrast, debt market outflows from India were much more sudden, contributing to the sharp currency depreciation. The Sensex has, in fact, beaten the MSCI emerging markets index for most of the year in rupee terms, and after a couple of months of underperformance, the gap between the Sensex and its emerging market peers is narrowing again. Foreign ownership of Indian stocks is at an all-time high.
The resilience of the Sensex even in the wake of rapid deterioration in the economy appears puzzling at first glance.
But one answer to this puzzle lies in the growing foreign earnings of Sensex companies. The weakening of the local currency and green shoots in global recovery means rising earnings for nearly half of the Sensex companies. The foreign subsidiaries of companies such as Tata Steel, Tata Motors and Hindalco are a natural hedge against a domestic slowdown. The other source of earnings gains will be in sectors such as information technology and materials, which earn a major chunk of revenue abroad. Unless the proportion of bad debts rises dramatically, which could pull down bank stocks, the Sensex earnings downgrade cycle could ease in the coming months.
For the broader market, things might not be as rosy, which explains why the BSE small-cap and the BSE mid-cap indices have underperformed the Sensex. Many of these companies have a greater exposure to the domestic market.
In the case of mid-sized firms that have a foreign exposure, much of it is unhedged, as an August report by India Ratings pointed out. The road ahead for such mid-sized companies will be the toughest.
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