"The economy is relying on hot money flows"

Don’t get carried away by the rally as structurally things are still looking pretty scary, feels Neelkanth Mishra of Credit Suisse

Sanjit Kundu

You are among the most bearish on the Street with a FY13 target of 13,500 on the Sensex, but the market has rallied…

It is a global re-risking rally and is not specific to India. As we showed in a recent note, the sectors that have done well in India are also the ones that have outperformed in Asia. Also, note that commodities such as oil, copper and aluminium have flared up, too. The extent of mean-reversion seen in this rally is absolutely unprecedented. So, the question to be asked is whether we are seeing a fundamental change in India. I believe the answer to that is — not yet. I have seen much commentary that pre-poll surveys indicate a positive outcome in the ongoing state elections. While more legislative strength could be a positive on the margin for a government in power, why pick on the most favourable outcome and then start investing? In a four-way election it is hard to predict anything. So, attempts to justify the rally on the grounds that the Reserve Bank of India (RBI) is going to cut rates, that files are moving in Delhi, or that the UP poll outcome will be positive are meaningless.  

You were also bearish on the rupee…

The rupee has to weaken, given the structural weakness in the economy. The RBI and the government are trying their best to control that but they can only do so much. A good analogy for the situation is best described by this TV ad for woollen inners, which shows an old man being pushed away from a wooden bed by his family as they need to burn the wood to keep them warm from the winter chill. A family member then asks, “Today’s need is fulfilled, but what about tomorrow?” Then, the others look at a wooden crutch held by another family member. This is precisely the RBI’s and the government’s approach. First, FII limit in bonds was hiked, which resulted in inflows of about $7 billion in two months. Later, in January, NRE deposit rates were deregulated. Besides, there was talk of RBI intervention as well. It is quite possible that the rupee will strengthen against the dollar as the US and the EU look to devalue their currencies, but it is likely to weaken materially against most other currencies. 

So, do you believe that artificial props are supporting the rupee?

I think the government and the RBI are trying to do their bit. But the underlying problem is out of their control because it is both political and fiscal in nature. In general, we tend to have too much faith in the monetary authorities, not just here but globally as well. The RBI, too, does not have an option — not just on the rupee, but also on inflation. Recently, the RBI governor elaborated on how, in environments like these, central banks are forced to choose the lesser of the two evils. Regulators are trying to stabilise the currency but in doing so, I feel, they are making the economy unstable. 

Could you elaborate?

Let me give you the framework. When India’s economic policy was set in the early ’90s, the assumption was that we could sustain a current account deficit. The assumption was that on the public side the fiscal deficit or surplus would be insignificant and on the private side, we will invest more than we save. It’s like if I have to build my house only when I have enough savings for myself, then I may build my house in my 50s. But if a bank can give me a loan, I can do it now and become more productive. At the same time, it was decided to open up the capital account as we needed foreign money to come in. Initially, the policy makers were averse to foreign debt, so they opened up the equity route. As a result, we saw more equity flows that were reasonably sticky till 2007. But from 2008 onwards, with an eye on the elections, the government waived farm loans, went ahead with the Sixth Pay Commission proposals and also hiked minimum support prices (MSPs) for crops.

Naturally, the fiscal deficit turned out to be much higher. The financial crisis compounded matters as the government had to further cut duties, among other things. Thus, instead of the public side being insignificant, as was the plan, we saw larger deficits; government expenditure on the consumption side ended up being higher, while capital expenditure started falling. So, while the government vacated the infrastructure development space for the private sector, at the same time it began crowding it out and slowed down reforms. Though foreign investors, as a whole, aren’t saying that they will not put money into India because it is the fiscal deficit that they are funding, it is being reflected in
individual decisions.  

So, are you sceptical of the inflows we have seen thus far in CY12?

With the economy slowing down, there is a dearth of foreign equity capital and, hence, an increasing reliance on debt flows. There are two kinds of debt flows: one, where Indian companies go out and borrow and the second, where foreigners come to India and invest. The latter is a far-more volatile market and can swing to extremes very quickly. The Tarapore committee on capital account convertibility was against opening up the capital account till the deficit was below 3.5% and inflation between 3% and 5%. That is because if you open up the capital account when the deficit is high — for example, if the deficit is seen coming at 6%-plus for the next fiscal — bond yields will spike.

As a consequence, FIIs, who have herded into government bonds, will start pulling out. The net result: the rupee will weaken and the cycle will get accentuated. Now also look at non-resident external deposits, which are nothing but interest rate arbitrage because once the RBI cuts rates, the money will start flowing out. In effect, the economy is now relying on short-term hot money flows. I think the efforts by the RBI and the government will only delay the inevitable but won’t solve the eventual problem — which is the burgeoning fiscal deficit. 

Is the market not oblivious to that fact?

There is this optimism in the market that inflation will come down. I think inflation will come down only if growth falls off. The fiscal deficit also impacts inflation. If you plot the 50-year inflation chart in India, you will see that historically it was very high and volatile. Only in 1996-2007 was the average inflation at 5% with very low volatility. This happened because deficit monetisation [creation of money by the RBI to fund the deficit] had come off. I am not saying that inflation will be evenly higher in the current environment, but that it will be volatile and high enough to kill growth.

Indian and global markets are highly


Look at the amount of monetisation being done: the liquidity adjustment facility balance plus the open market operation (OMO), which is effectively the amount of money printed by the RBI, as a percentage of GDP, is at a 20-year high of 2.5%. There is enough academic evidence over the past 15-20 years that concludes inflation is mostly a fiscal phenomenon, while we have all grown up learning that it is a monetary phenomenon. Just to extend the argument a step further, money printing happens either to fund the fiscal deficit or to protect the currency from sharp appreciation. If money printing happens due to the fiscal deficit, then that is a problem.  

What is it that the market is missing?

In February 2011, the feeling was “if everyone is feeling bearish then why will the market fall?” But we did see the market fall after that, which only goes to show that people weren’t bearish enough. I feel the market seems oblivious to the gravity of the fiscal side. Look at bond yields — they have been falling. People say bond yields have to fall because repo rate is falling or could be cut. Why? It is like saying the Italian sovereign yield should fall because the ECB is going to cut policy rates. There is something called credit risk. I am surprised when people say that there should be no credit risk because the RBI can print and it is not as if the government is going to default. But if that were the case, then the government would have kept spending and the RBI would have kept printing… then none of us would have to work. Eventually, it will also result in stress at the balance of payments (BoP) level, and which is already visible.

Half of all claims on India is by

European banks

Money printing will also cause inflation to go up structurally. So, if inflation expectations are at 5-6%, then bond yields at 7.5-8% make sense. But if inflation expectations are at 7.5-8%, then bond yields have to trend much higher. In 2002, bond yields were in double digits — even at that time the RBI could print as much as it wanted. Till 1997 it actually was mandated to respond to ‘ad-hoc treasury bills’ issued by the government. So, I think the market is glossing over this part. We are trying to prevent inflation expectations from getting re-anchored, but I fear that we have lost the battle: if you have high inflation for three or four years, they start getting re-anchored. I think the RBI, too, is worried that non-food inflation is sticky at 7.5%. 

Has the central bank ever clearly stated how much deficit monetisation is it doing?

Whether it says it or not, if you look at the governor’s speeches, he has been very defensive about OMOs. It is worth asking that you are trying to raise the cost of funding for private enterprise but, at the same time, by printing money, you are bringing down the effective cost of borrowing for the most unproductive and profligate part of the economy: the government. But that said, the central bank does not have any option: if the government bond yield is at, say, 10%, then there would be a far greater sense of crisis.

I don’t think the RBI has that flexibility; if bond yields go to 10% then it has a bigger problem. The governor has tried to explain that this is only a liquidity enhancing measure and is not targeting bond yields. Unfortunately, in doing so, bond yields have only been coming down. In other words, the RBI is forced to engage in higher and higher monetisation just to keep bond yields where they are. Central banks can only delay the problem, but the issues have to be resolved by the politicians.  

Do you see that happening?

As a policy, the Congress believes that giving cash in hand or incentives to rural people gets them the votes. The big question is that there is some anecdotal evidence that suggests the rural economy is slowing down sharply. If that were to happen, then economic growth has to come down. If rural consumption slows off, food inflation comes down. But if the government raises MSPs again, as it wants to fight an election in 2014, then it is a Catch-22 situation. In a more generic sense, you can win elections, but to govern you need the right administration and the right organisational structure. For now, the whole set-up is not working for India and whenever it does change, I think that will be a good turning point for the economy. 

Against such a backdrop, do you see the rally sustaining?

So far we haven’t talked about whether the US, Europe or China is going to disappoint meaningfully. It is a very India-specific problem. But in case the European crisis is contained or if China really holds up or if US growth really accelerates, it will have a bearing on India as well. What may happen is that if the global economy recovers and exports start picking up, the stress on the BoP will ease. But that’s an external factor, I don’t think the underlying problem in India is getting resolved.

Central banks globally are in currency devaluation mode to get out of the debt crisis. That can have unforeseen impact on asset prices as well as inflation. I don’t see much changing on the ground but, eventually, fundamentals will matter. So, I remain bearish but would rather not comment on whether this rally will end tomorrow or the day after.


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