On 8 November, Prime Minister Narendra Modi surprised investors and consumers by declaring that 86% of the nation’s money stock would no longer be a medium of exchange or store of value. In meetings in Mumbai and New Delhi recently, I learned that the move was intended to ferret out illegally garnered funds, and that the prime minister’s action took aim at the national pastime of avoiding income taxes. Large bills of Rs1,000 and Rs500 could only be exchanged at banks by providing documentation of how the wealth had been acquired.
The move to freeze or annul a large part of the money stock had been expected to cripple the consumer-oriented economy—household consumption accounts for 60%of gross domestic product in India, compared with 37% in China. With less usable cash on hand, equity markets had also been expected to take a hit—he opposite of what the Federal Reserve’s quantitative easing has done for US stock prices since 2009. Such expectations are consistent with economic theory.
If you apply the Monetary Approach to the Balance of Payments proposed by the Nobel Laureate Robert Mundell to India’s demonetisation, it would mean fewer rupees in circulation, causing an appreciation of the currency and, as households consume less, result in the central bank accumulating reserves.
But here’s what actually transpired. The Nifty 50 index of large Indian companies closed at 8,561 on 31 January, returning to its pre-demonetisation level after plunging to a low of 7,908 on 26 December. Also, the rupee traded at 67.87 against the dollar on 31 January, slightly weaker than the 66.62 quoted on 8 November. Foreign currency assets with the Reserve bank of India amounted to $339 billion on 27 January, slightly less than they were on 4 November.
Is this a case of market behaviour contradicting economic theory? Not at all. Mundell’s prescription suggests that investors and consumers take into account not only domestic monetary developments, but also external factors. The net impact on financial markets would be felt after balancing domestic forces against global factors, according to the Monetary Approach.
After the demonetisation move, foreign institutional investors were major sellers of equities because they feared an economic slump, as well as higher US interest rates, resulting in the initial slump in the stock market. The fall in equities continued through December as the Fed threatened to increase rates three times during 2017. Global factors were supplementing the impact of domestic factors in pushing down Indian equity prices.
In terms of exchange rates, investors were balancing expectations for Fed action against moves that might be carried out by the Reserve Bank of India, which had been on an easing mode. Looser policy at home, combined with tighter policy abroad (the Fed) should result in a weaker home currency and a loss of foreign-exchange holdings with the central bank, according to Mundell. That is precisely what happened in India.
Markets followed theory again on Wednesday. The RBI unexpectedly held interest rates—an overwhelming consensus of analysts had expected a cut. That resulted in the appreciation of the rupee. This is in line with expectations from Mundell’s approach since any effort at monetary tightening, by itself, should cause a currency appreciation.
In a Bloomberg View article last month, I suggested that the Fed would not be able to hike three times this year after all due to the adverse impact of tightening on capital outflows from China and the euro zone. As this becomes discounted in investors’ expectations, the rupee’s depreciation should be limited, as would any decline in the RBI’s foreign exchange holdings.
Expect Indian equities to benefit from the fiscal responsibility shown in the national budget that was presented on 1 February. Just as important, the moderate US wage growth that was suggested by the January jobs numbers will strengthen market expectations that any Fed hike will be very gradual, and this too will be a positive for the Nifty 50.
India is an important destination for investors in emerging markets. As they factor in the relative impact of monetary factors in India and the US, it bodes well for likely returns from Indian equities. And if the rupee’s depreciation is limited by Fed action, the returns are likely to be attractive in dollar terms, too.