CLSA: Rupee Depreciation The Biggest Risk That May Force An FII Sell-Off!

It would be tempting to conclude that, if foreigners have not sold now, then they are never going to sell. But with GREED & fear's base case still being a "euroquake", that is too complacent a conclusion. Meanwhile, it may be the case that a currency-triggered market panic is what the Congress-led government needs to wake up and address the challenge to India's growth in a more proactive fashion.

 

The bad news is a lack of action so far in what is probably the biggest infrastructure issue in India right now. That is the lack of progress on energy. Thus, as one speaker told Forum attendees this week, energy consumption is growing at a rate of 6-7% annualised whereas domestic sources of energy are growing at a rate of only 2.5-3%, resulting in a continued reliance on imported energy.

 

The main explanation for this deficiency is the lack of the necessary incentives for private capital given that the cost of coal and natural gas within India is still about half world prices. The power issue is, therefore, a growing constraint on growth.

GREED & fear assumes, as is traditionally the case in India, that the more media noise generated on this issue the more likely action will be forthcoming. Still for now it is not really possible to point to dramatic concrete action taken.

Indeed the most effective GREED & fear has been made aware of this week has again been an initiative by the RBI, which in September told the banking sector to stop lending to loss-making state electricity boards (SEBs) unless they raised tariffs. The purpose of this move is to put pressure on the state governments either to provide more funding for the SEBs out of their own budget – remember India is a federal system – or to raise prices. 

If the above are the issues, they are also largely reflected in the stock market. Consumption stocks have performed dramatically better than the likes of bank stocks or infrastructure plays during the course of the 20-month-long monetary tightening cycle. Thus, the BSE Consumer Durables Index and the BSE FMCG Index have risen by 46% and 48% respectively since the end of March 2010 following the first interest rate hike, while the BSE Bankex Index and the CNX Infrastructure Index are down 2% and 27% over the same period. This reflects both the buoyant rural economy, courtesy of rising income growth, as well as the weakness in investment and related concerns about NPL risk in the infrastructure lending area, most particularly again in the energy sector.

 

For the reason that much of this is by now discounted.

  

GREED & fear would advise against becoming too bearish. Indeed the more the investment data weakens from here the more will the political pressures grow to do something about it. Still GREED & fear would recommend a barbell strategy where positions are maintained in the highly rated consumption sector while building investments in the relatively depressed banking and infrastructure area. The reason to build positions rather than jump in aggressively is two fold. First, there is the likelihood of rising asset quality problems in the banking sector. Second, there is the probability, sooner or later, of renewed Euroland risk aversion.

 

That same external risk issue also raises the issue of the rupee which so far in 2011 has been Asia's weakest currency. Thus, the rupee has depreciated against the US dollar so far this year to Rs52.73/US$.

GREED & fear was interested to hear from CLSA's India economist Rajeev Malik that the RBI has been running a predominately hands-off policy towards the currency since 2010. Still this raises the risk of a sudden drop significantly beyond the 50 level should a renewed wave of Eurozone-triggered risk aversion lead to a deleveraging driven US dollar surge.

The point to be aware of here is that Indian corporates have increased their borrowing of dollars during the recent monetary tightening cycle because it has meant cheaper funding, as well as because some of them have had foreign acquisitions to finance.

Thus, total external commercial borrowings have risen by 48% over the past two years from US$63bn at the end of 2Q09 to US$93bn at the end of 2Q11. Still a reassuring point is that accounting rules now require companies to take currency-related losses through their profit and loss accounts on a quarterly basis.

 

The potential for rupee weakness is also clearly driven by India's perennial current account deficit. Thus, India's current account deficit rose from 0.4% of GDP in FY05 to 2.6% in FY11 and is expected by Malik to rise to 3% this fiscal year. This is not an issue when growth is robust and risk tolerance is high. But with renewed external risk aversion likely sooner or later, at a time when there is a question mark on Indian growth for domestic reasons, there is clearly every reason for renewed currency weakness.

 

This raises the issue of India's dependence on foreign capital, and the related large proportion of that foreign capital comprising potentially fickle foreign portfolio equity investment rather than FDI. Thus, the capital account surplus was US$60bn in FY11, with US$30bn in net portfolio investment and US$7bn in net FDI. On this point, foreign institutional investors bought a net US$24.3bn worth of India equities and US$7.9bn of Indian debt securities in FY11.

 

This is why one of the amazing features so far this calendar year has been the lack of net selling by foreign equity investors given the deteriorating external environment and the relative underperformance of India within the Asian ex-Japan context. Indeed foreigners have, remarkably, been net buyers of US$800m worth of Indian equities year to date, after having bought a net US$29bn in 2010.