Stocks, Bonds, Rupee and Inflation-VRK100-10Oct2011

Stocks, Bonds,

Rupee and Inflation

How are they interconnected?

Rama Krishna Vadlamudi, HYDERABAD    10 October 2011
www.ramakrishnavadlamudi.blogspot.com

Stocks, Bonds and Rupee are declining, but Inflation remains ruthlessly high, why? This is a case of everything affecting everything. Recent decline in stock prices is partly attributed to Indian rupee’s unexpected decline against the US dollar. Rising fiscal deficit is also causing concern in the stock markets not to speak of persistent inflation driven first by higher food prices and later by manufactured products. Let us delve deeper and tackle inflation first.

Inflation – A Way of Life

What causes inflation? Textbooks tell us that price rise is caused by excess demand chasing limited supply. So, what is causing this higher demand and lesser supply?

If we look back at history, we find that prices are always up. In India, we are used to higher and higher prices in the last five to six years. This period coincides with enormous wealth creation (though restricted to only a small chunk of population), rising procurement prices of food grains, increasing wages in the economy, boosting rural incomes, galloping real estate prices, soaring commodity prices, climbing stock prices, maverick monsoons and others.

The wealth effect and the wage/income effect seem to have prompted people to spend an increased portion of their incomes on all sorts of goods and services – resulting in stubborn inflation. Rotting food grains in the government warehouses have not helped matters either. Agriculture yields are stagnant for a few decades.

However, preening ourselves in this shining glory, we have failed to anticipate such a trend of persistent inflation. This neglect has created supply chain bottlenecks and posing problems in reining in inflation. Milton Friedman famously said, “Inflation is always a monetary phenomenon.” The central bank has dutifully raised interest rates by 12 times sticking to its primary dharma of price stability, but to no avail. The governments caught up in their own scandals have forgotten to act on expenditure control or clearing up bottlenecks.

Rising fiscal deficit:

The biggest culprit seems to be fiscal deficit, which is on the ascendant. In the last four years between 2008-09 and 2011-12, the central government’s market borrowings – which are raised from the banks, insurance companies and others – have been rising at an alarming rate. The yearly average net market borrowings of the central government for the last four years are at Rs 3,42,000 crore, which is 3.8 times the yearly average of Rs 91,000 crore between 2004-05 and 2007-08. This does not include borrowing by state governments.

Inflation is traditionally measured in three ways – wholesale price index (WPI), consumer price index (CPI) and GDP deflator. In India, we follow the WPI measure while the advanced economies mostly follow CPI measure. Services are not included in India’s WPI.  

Stock markets are highly volatile

Stocks are reacting very violently to all kinds of events or news items – be it scandals, mining bill imposing new tax on mining companies, land acquisition bill, government’s perceived policy paralysis, GDP growth slowdown, IIP numbers, growing NPA menace in banks, shrinking order books, soaring prices, etc.

Market will be looking to cues from the oncoming corporate results. The quarterly results are expected to be weaker. Also, the markets will be looking at inflation and IIP numbers that will be announced next week.

The HSBC India Purchasing Manager’s Index (PMI), based on a survey of 500 companies, fell to 50.4 in September 2011 from 52.6 in August and 53.6 in July. The September figure is the lowest since March 2009.

The range-bound movement of Indian stock indices will continue for some more time till the Indian government takes some serious policy measures or more clarity comes on project clearances or further cuts happen in global commodity prices especially crude oil or some credible solution seems to be emerging in the eurozone’s sovereign debt crisis.  

Indian Rupee on the Decline

Indian rupee has turned a high-beta currency of late. Pressure on rupee is coming from outflow from Foreign Institutional Investors (FIIs) who are selling in Indian stock market; sudden appreciation of US dollar against major currencies, like, euro and pound sterling; higher demand for dollar by Indian companies; and bunched up payments of short-term external debt by the end of this fiscal year.

Rupee movement between 2003 and 2011:

From a level of 47.50 in April 2003, rupee against the dollar appreciated to 39.30-level by the first week of January 2008. During this same period, the BSE Sensex (the benchmark index of Indian stock market) rose from 3,000 to 21,000.

From 39.30-level in January 2008, the rupee depreciated to 51.50 by the first week of March 2009. This time around, the Sensex fell from 21,000 to 8,000 in just 15 months stampeded by the global financial crisis.

And from 51.50-level in March 2009, the rupee gained substantially and touched a level of 44.20 against the dollar by the first week of November 2010 in lock step with Sensex which reached a peak of 21,000 again in November 2010.

From November 2010 till now the rupee again weakened and now is quoting at Rs 49.20 per dollar – while the Sensex is now at 16,200. The broad pattern here is that the Sensex movement is upwards whenever there are FII inflows and vice versa. And the FII inflows are causing the general appreciation of rupee against the dollar. Many studies have confirmed this broad trend.  

The current rupee depreciation is increasing the cost of imported crude oil which may drive up inflation to some extent as the Government is increasing the price of petrol if not diesel, LPG and Kerosene.

Rupee movement is also dictated by inflows through Foreign Direct Investment (FDI) and overseas investment by Indian corporates; and ECB/FCCB inflows.  

RBI intervention:

There are intermittent rumours of RBI intervention in the foreign exchange market to arrest rupee decline. But the official RBI position is: “We don’t target a level of exchange rate. The exchange rate is determined by the forces of supply & demand and other factors. We may intervene if there is excess volatility.”

Kaushik Basu, Chief Economic Advisor, made an interesting point about RBI intervention recently. He says that if you sell US dollars to prop up rupee, we have to spend our foreign exchange reserves which may get depleted very fast. If you buy US dollars to weaken rupee, it can be done theoretically without limits, which may result in flood of rupees in the system. RBI resorted to massive intervention and bought $78.2 billion of foreign exchange in 2007-08 to prevent steep rupee appreciation.   

Weaker rupee’s impact on Indian companies:

Indian banks sold wrong derivative products to greedy corporates in 2007. RBI pensalied 19 banks in April 2011 for violation of derivatives norms in 2007. The penalty ranged from Rs 15 lakh to Rs 5 lakh each. While the losses to corporates were estimated at around Rs 20,000 crore, the banks seemed to have escaped with minor penalties overall.

Companies like, HCL Technologies and Himatsingka Seide, suffered heavy losses due to their unhedged foreign currency exposures in 2007/2008. Jamal Mecklai, veteran currency market expert, says Indian companies will see blood on their profit and loss accounts and balance sheets this time around in 2011.

This time too many skeletons may tumble out of the companies’ cupboards as India Inc. is likely to suffer some losses due to the unexpected rupee depreciation against the US dollar of about 10 per cent in the last two months.

Risk management seems to be weak in Indian companies, especially, when it comes to managing dollar-rupee volatility despite repeated caution from RBI. If imports are left unhedged, the impact of rupee weakness will be negative on them. Companies with external payment obligations arising out of ECBs and FCCBs will face trouble. In contrast, if exporters leave their receipts unhedged, they will be benefited by weaker rupee.

The real impact of rupee weakness on exporters will also depend on the relative weakness of our competitors’ currencies against the US dollar, euro or other major currencies of world trade. Asian and Latin American currencies too weakened against the dollar in the last one or two months by five to 15 per cent.

Bond Prices are Hurtling Downwards

The Government, at the end of September 2011, announced an extra borrowing of Rs 53,000 crore from the market during second half of 2011-12. The bond market is clearly stunned by the announcement with yields rising from 8.34-per cent level to 8.57-per cent level by 5 October 2011 for the 10-year benchmark 7.80% government bond maturing in 2021.

On 7 October 2011, on behalf of the Government, RBI sold central government bonds worth Rs 15,000 crore. But the bond auction ended in partial failure as a total amount of Rs 898 crore devolved on primary dealers due to lack of enthusiasm for long-dated bonds. The bond market is apparently nervous with the extra borrowing of Rs 53,000 crore.

The weakening trend in bond prices will continue for some more time unless the RBI announces some buyback of government bonds in future.

We have to see whether long-term government bonds will fetch better prices once indications emerge from the central bank that interest rates are finally softening.

For the time being, money is invested in short-term bonds thinking that interest rates in the economy are yet to reach a peak. In the next few months, investors may get good returns if they move their money to long-term bonds. When interest rates decline, bond yields too will come down pushing up bond prices. Such a trend will benefit long-term bonds more.

If bond prices go up, bond yields will come down as they have inverse relationship. Falling bond yields will help stock markets substantially. But, investors need to wait patiently for such a scenario.

Global Markets

Italy’s rating has been downgraded, first by Standard and Poor’s and then by Moody’s. Moody’s has downgraded several British financial entities and Portuguese banks. Last month, three US banks – namely, Citigroup, Wells Fargo and Bank of America – were downgraded. The spate of downgrades continues unabatedly.

The monetary and economic union in Europe was a dream for several decades for many European countries. The Europeans dreamt of common currency, single central bank and monetary policy, free trade, seamless tourism and no taxes. That dream seems to have been in tatters now.

Political consensus is yet to emerge in the eurozone about ways of dealing with the after-effects of sovereign debt crisis. The money market mutual funds in the US have lent huge money to European banks. The US is facing its own problems of high unemployment, political bickering in the US Congress, high federal deficit and others. The world trade is dependent on the US and Europe and the ripple effects are reverberating across the rest of the world.

Conclusion

Despite a string of rate hikes by the Reserve Bank of India, conspicuous consumption seems to have been unaffected by higher interest rates – people are still buying more cars, motor vehicles and motorbikes; more gold and silver are being consumed and imported; DTH (direct-to-home) subscriber base is growing steadily; low-cost airlines are attracting large number of passengers; and more tourists are making trips abroad.

However, industrial production has suffered substantially as indicated by the IIP figures. Monsoon is good this year so far. Global commodity prices have softened a bit due to concerns about the much-feared global recession. If India is to benefit substantially, we need to expect further cuts in commodity prices.

The financial markets are more integrated now. If currency markets are in turmoil it is spreading to stock markets. If bond markets are in doldrums, it is affecting currencies and vice versa. Jittery commodity markets are impacting stock prices. As such, investors cannot see financial markets in isolation.

Global uncertainties have gone up. Even though India’s growth is more dependent on domestic growth rather than on exports, we cannot completely remain immune to global developments.

Investors need to develop a comprehensive view of the markets and act accordingly and protect their financial assets. Markets always surprise us.

Important Data

Indices	Closing		Commodities	Closing
	7-Oct-11			7-Oct-11
Dow Jones	11 103		Nymex Crude ($/barrel)	83
Nasdaq	2 479		Brent Crude ($/barrel)	106
S&P 500	1 155		Gold ($/ounce)	1 651
FTSE 100	5 303		Silver ($/ounce)	32
Dax	5 676
Nikkei 225	8 606		Currencies
Hang Seng	17 707		GBP-USD	1.56
Shanghai composite	2 359		EUR-USD	1.34
Sensex 30	16 233		USD-JPY	76.73
Nifty 50	4 888		USD-RMB	6.38
US dollar index	78.7		USD-INR	49.16

Abbreivations: BSE – Bombay Stock Exchange, ECBs – external commercial borrowings, FCCBs – foreign currency convertible bonds, FIIs – Foreign Institutional Investors, IIP – index of industrial production, NPA – non performing assets.

Note on author: Author is an investment analyst and writer. The views are personal and this is written only for information purpose. Readers are advised to consult their certified financial adviser before taking any investment decisions.

Author’s articles on financial articles can be accessed at:

www.ramakrishnavadlamudi.blogspot.com