Stocks, Bonds,
Rupee and Inflation
How are they interconnected?
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Rama Krishna Vadlamudi, HYDERABAD
10 October 2011
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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
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Closing
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Commodities
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Closing
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7-Oct-11
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7-Oct-11
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Dow Jones
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11 103
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Nymex
Crude ($/barrel)
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83
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Nasdaq
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2 479
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Brent
Crude ($/barrel)
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106
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S&P
500
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1 155
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Gold
($/ounce)
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1 651
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FTSE 100
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5 303
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Silver
($/ounce)
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32
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Dax
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5 676
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Nikkei
225
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8 606
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Currencies
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Hang Seng
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17 707
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GBP-USD
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1.56
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Shanghai
composite
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2 359
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EUR-USD
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1.34
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Sensex 30
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16 233
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USD-JPY
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76.73
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Nifty 50
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4 888
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USD-RMB
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6.38
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US dollar
index
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78.7
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USD-INR
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49.16
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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:
