Bond yields rose and the rupee hardened against the US dollar as a consequence of the Reserve Bank of India (RBI) move to hike the cash reserve ratio (CRR) by 50 basis points. As A. Prasanna, economist with ICICI Securities Ltd says, the move is a pre-emptive one, aimed at combating the increased inflows that are likely if the US Fed cuts its policy rate at Wednesday’s meeting. The risk, as HDFC Bank Ltd’s chief economist Abheek Barua points out, is that if the curbs on participatory notes (PNs) already have an impact on inflows, then the lending rate cuts by some banks for the festive season may not be extended.

Add to that the decidedly hawkish tone of the policy document. RBI has flagged the risks to inflation from high oil prices, higher money supply, the rise in the fiscal deficit and, most importantly, the central talks about a medium-term inflation target of 3%, a signal not to expect RBI to cut interest rates.

All this unsettled the stock markets and investors took the opportunity to book some profits in interest-sensitive sectors, such as banks and autos. At the end of Tuesday, the BSE Bank index was down 0.94%, while the auto index was lower by 3.12%. RBI has clearly indicated that it will defend the rupee and, therefore, needs to use the CRR weapon to mop up liquidity. Why then should the rupee go up?

Gaurav Kapur, senior economist at ABN Amro Bank, explains that since liquidity in the rupee market will go down, banks will be selling dollars to generate rupee funds. That drives up the rupee in the short term. What will be the immediate impact on liquidity? Kapur points out that banks had parked Rs18,000 crore in reverse repos with RBI. All that the CRR hike will do is take away Rs15,000 crore of that liquidity.

At the same time, RBI is also warning corporates that they need to hedge their exposures and has, therefore, increased the hedging opportunities for them. Everything depends on the strength of the inflows. If dollars continue to pour in, liquidity is likely to remain ample and bank deposit and lending rates may drift lower. As Morgan Stanley’s Chetan Ahya puts it, the US central bank’s decision is far more vital for markets.

Supply-demand gap

Why are Chinese and Indian stocks among the most expensive in the world? Independent global research outfit BCA Research’s emerging markets strategy service makes an interesting point in this regard. It says, “The scarcity of available market capitalization relative to foreign investors’ demand for plays on growth in China and India is one reason behind the stampede into the Chinese and Indian stock markets." While interest for Chinese and Indian stocks is ever increasing, the supply of listed stocks seems to be far from enough.

In terms of gross domestic product (GDP)—adjusted for purchasing power—BCA Research notes that China and India respectively account for 15% and 7% of the world share. But Bloomberg data shows that the total market capitalization of all listed Chinese and Indian stocks account for just 6% and 2.5% of world market cap.

Free-float market cap, or the value of stocks that are available for purchase by minority investors, would be much lower, given high promoter stakes and restrictions/limits on foreign investment. The free-float market capitalization of the Bombay Stock Exchange (BSE) 500, for instance, is just 42.5% of the total market cap of the index. The rest is primarily made up of promoter holdings.

What’s more, since institutional investors put their money in the most liquid stocks, the choice becomes even more limited. BCA Research points to Morgan Stanley Capital International (MSCI) data, which suggests that the investable market cap in China and India represents a share of just 1.6% and 0.7% in world markets, respectively.

Clearly, the supply of stock is far too low. And unless promoter groups start offloading stakes to foreign investors on a large scale, either by way of a primary market listing or a private placement, demand can be expected to remain higher than supply for Chinese and Indian stocks.

SAIL premium

Shares of Steel Authority of India Ltd (SAIL) have outperformed those of Tata Steel by about 60% since last October—the time when news of the latter’s interest in Corus became public.

The logic was that SAIL had captive iron ore and would hence benefit the more from rising steel prices. Tata Steel, however, has become a buyer of iron ore after the Corus acquisition, and it was hence felt that the gains from higher price realizations would be partly offset by higher input costs. But the company’s latest results don’t support that view.

To start with, average price realizations turned out to be lower than analysts’ expectations. According to Bloomberg, analysts expected revenues of Rs9,614 crore last quarter, but reported numbers were about 5% lower at Rs9,163 crore. Worse still, reported net profit was nearly 10% lower than consensus estimates.

Analysts point out that higher cost of imported coal has eaten into margins. But whatever the reasons, based on the firm’s results for the six months until September, it’s unlikely that some of the bullish earnings estimates for the year will be met.

Given this background, there’s little reason why SAIL should continue to trade at a considerable premium to Tata Steel. The 5.6% drop in the stock on Tuesday could only be the beginning of a larger correction exercise.

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