It has been an intriguing one month for financial traders in India. The combined effect of “demonetisation” and “Trump” has impacted several financial assets in contrasting ways. Indian equity markets have under performed most global markets, whereas, bonds have completely ignored the massive sell-off which engulfed global debt market.
Indian Rupee has put up a stellar show, appreciating against 20 of the 24 major currencies in the emerging market basket. A strong rupee and a strong bond have come about even after FPIs have sold USD 8.5 billion over the past four weeks (USD 6 billion in debt and USD 2.5 billion in equity segment). Underlying message is quite clear. There are five dominant narratives shaping these markets:
1) Election of Donald Trump as US President is being seen as supportive of policies which increase US debt and improve US growth and raise protectionist policies. The result could be US growing at the expense of emerging market nations. It has already a shift of funds away from the bond market into the equity markets. The shift has tightened the financial conditions for emerging market corporates and the financial sector, who are dependent on cheap dollar funding. A rising bond yield in USD and strengthening US Dollar makes US Dollar funding costlier.
2) Demonetisation is negative for domestic growth. Though the intent behind the move is laudable but it will create its own share of unintended consequences. Non availability of cash has affected almost every industry adversely. Much of this impact may fade with time, as availability of lower denomination of currency improves. Headwinds to growth has triggered under performance of Indian equities, as Indian SMEs are seen as more exposed to this situation than large corporates.
3) Prices of goods, services, labour and land have either fallen or may fall as the government enact more such measures to tackle the black economy. Thanks to the growing trend of disinflation, Indian bond prices have benefited. However, at the same time, urban India is expected to benefit more than rural India from these measures.
4) Demonetisation is a part of a series of steps which have been taken or will be taken by government to formalise the economy. Informal economy is seen as less efficient and escapes the tax net. However, informal economy provides bulk of the employment in India and shares half of the services sector and quarter of the manufacturing sector. Informal financial sector is also a quarter of the formal economy in size. It can be argued that as the economy formalises, there can be displacement of labour as business shut down, as they may become unviable in a tax compliant economy. In such an environment, over the medium term, unemployment may rise. On the positive side, tax base will improve and tax burden on the formal sector will fall.
5) Government will now go after the real estate sector as it is seen as a major beneficiary of the black economy. An attack on real estate will expedite the unraveling of the great Indian real estate bubble, which peaked a few years back. Readers of my column, will be be aware of my two themes: “ shift from hard assets to financial assets, since 2014” and “urban India outperforming rural India over the past two years”. Real estate and construction sector provides a chunk of the employment in the informal sector and is deeply linked with hundreds of sector in the economy. It has provided wealth effect to urban and rural consumers. It has bankrolled the books of several financial institutions and state governments. However, the cost of land has become prohibitive and is now impeding industrial and business activity. A lower cost of land would be seen as positive for long term growth. However, over the medium term, there can be collateral damage to the economy.
It is not just the above factors which will continue to impact the Rupee and the Indian bond market. There are other global factors over the horizon which will impact these two markets over the foreseeable future. Over the past week, traders reacted to the outcomes from RBI and ECB monetary policies and at the same time a historic agreement between Opec and non-Opec to balance the oil market. RBI disappointed the market by not reducing the interest rates but ECB positively surprised the market by committing to extend QE till December 2017. Post RBI, Indian bond yields rose as money market re calibrated their expectation of future policy rates of RBI. Over the next two months, the gap between domestic bond yields and global bond yields are expected to narrow. A combination of factors can ensure a sizable rise in the Indian bond yields:
a) Effort of OPEC and non-OPEC along with the expected bonhomie of Russia and US may help push oil prices much higher. This can increase the inflationary pressures in the domestic economy. Industrial commodity prices have already inched higher.
b) In absence of large scale revenue windfall from demonetisation, government may opt for sizable fiscal push to revive the economy. This may happen at a time, when the new committee on FRBM may relax the fiscal deficit targets. Both together may offer MoF more space to spend and expand the federal budget. This come increase the supply of sovereign bonds in the market and push yields higher.
c) As the US yields rise, foreign investors in debt market may find dollar denominated debt attractive over richly priced Indian bonds. As a result, on every decline in yields in Indian Goisecs, FPIs may remain a seller. Add to the fact, that Rupee has remained strong relative to its EM peers. A richly valued currency and richly valued bonds has made Indian bonds unattractive for FPIs.
An unattractive domestic bond market and concerns over domestic growth may cap the gains in the Rupee value against the US Dollar. At the same time, US Dollar continues to gain ground against major global currencies. As a result, over the near term, possibly till end of December, we can see USDINR form a base between 66.90/67.25 levels on spot and then inch towards 68.00 levels. We expect central bank to remain an aggressive player in the market to cap losses beyond 68.00. However, the gains in the Rupee should be utilized by importers to hedge their payable for next couple of months.