Raghuram Rajan’s exit could trigger outflows in the short term

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Financial markets hate uncertainty. So when Raghuram Rajan put in his papers over the weekend, it just sparked this sentiment that the market participants dread the most. Talk of Rajan going back to Chicago has been doing the rounds for a while but very few on Dalal Street expected the government to allow him to leave.

After all, cricket-crazy sections of the market were likening the Narendra Modi-Rajancombine’s management of Indian economy in difficult times to the Sachin Tendulkar-Rahul Dravid pair’s adept handling of fiery pace bowlers on bouncy tracks. Now, with one of them bowing out, the feeling in the market is that the situation has created an undesired window of vulnerability when the going was good.

Catch all the reactions, views and news on Rexit here

In addition to the announcement, it is the timing that has caught market participants by surprise. The market is already on the edge ahead of the UK’s vote on European Unionmembership — popularly known as Brexit — next week and the repayment deadline for the $26 billion worth of forex deposits raised under a special scheme in 2013.

Though there is very little that the government or RBI can do to prevent short-term shocks to the market — mainly currency — in the event of instances like Brexit, the presence of Rajan — highly respected in the global investment community — brings in a certain confidence that the economy is in safe hands. In short, his departure, as a fund manager put it, has sparked the ‘known unknown’.

The bigger point here is how foreign investors will react to Rajan’s exit. Will the hot money — hedge funds and exchange traded funds (ETFs) — use this as an excuse to dump Indian stocks? Possible: Indian stock market valuations have breached all levels of comfort and foreign investors’ holdings in India are probably at the highest levels ever.

Till date, foreign investors mostly held back from cutting their ‘overweight’ on India because there was no real reason to sell as it looked like the economy was poised to stand out in a floundering global environment. Now, funds may be tempted to relook at their Indian portfolio.

The stability in the rupee was a key factor for foreigners to hang in there. The stability in the Indian currency ensured that their domestic holdings were not eroded. If the new RBI governor and government are unable to infuse enough confidence into the forex markets, India will remain vulnerable to strong outflows as global central banks look to tighten their monetary policies.

Economic purists on Dalal Street fear that the government could announce a fiscal stimulus to revive economic activity while the RBI, under the new governor, could be a lot more liberal at cutting rates. While such moves can spark sporadic bull rallies, any jump in inflation due to these measures could dent the long-term growth story.

On Monday, there is a possibility that the market may not react much to Rajan’s exit that may prompt the congenital optimists to praise India’s ‘underlying strength’.

But, that should not lull investors into complacency as India still has many more adversities to deal with in the coming months.