Rupee update as of November 2015: Despite the recent fall of the rupee against the US Dollar, India’s currency has performed well and is overvalued

Using the foreign exchange reserves to defend the rupee on a sustained basis should be avoided

RBI Watch                                                                                              Indian Rupee

Below are the usual two tables I produce each month - the idea being to see how the rupee has performed not just against the US Dollar, which can be misleading, but against a basket of currencies.  Why? When we look at inflation in India, do we measure it by just what has happened in the price of a mobile phone? No, to get the correct picture we measure inflation against a basket of goods typically consumed by a household in India.

I emphasize this because a few days ago the rupee fell against the US dollar to 67 rupees, a level last seen in August 2013, when worries about India's burgeoning current account deficit pushed the rupee to a historic low of 68.4. The rupee has fallen by over 7% against the US dollar in the last year. Most of this fall has occurred this financial year – a fall of 6%.

But let's see how the rupee has performed against a basket of currencies, representative of the countries India trades with actively. 

The Reserve Bank of India publishes this data every month.  I use that data for creating my monthly tables. 

Against a basket of currencies (Net Effective Exchange Rate), the rupee has actually strengthened by about 1% over the last one year. However, during the current financial year - in India we start this on April 1 - the rupee has fallen by about 3%. This is a remarkable performance considering that over the last one year most emerging market currencies have fallen sharply - many to record lows.

To get the full picture lets also look at the rupee in real terms (Real Effective Exchange Rate), after adjusting for inflation with India's principal trading partners. By this measure, over the last one year the rupee strengthened by 3%. During the current financial year, the rupee in real terms has fallen, but by a negligible 0.2%. The bottom line is that in real terms the rupee continues to be overvalued - an index level of 100 suggests that the rupee is somewhat fairly valued, and many consider an index level above 110, a 10% overvaluation, a case of significant overvaluation.

Overvaluation can persist for long periods of time. I would be really concerned if the index, REER, was in the 120 range.

The picture of the rupee suggests that, on balance, economic agents – domestic and foreign – have confidence in the currency. India has seen foreigners invest more in India – both in setting up factories and services as well as investing in India’s financial markets, such as bonds and equities. From a trade perspective, the picture has not been rosy. Weak world growth and a slowing economy at home have seen significant declines in exports and imports. India’s current account deficit is low and manageable, but one that comes from falling exports and imports is less positive than a higher current account deficit, which results from a rise in exports and imports, in my view

A more competitive rupee would be a bonus for the country.

The Federal Reserve has announced two days ago a rise in the target federal funds rate. Interest rates are expected to rise in the USA in 2016. There could be some unexpected twists in the world’s financial markets and economy next year.

The RBI could be well served to avoid the temptation to use India’s foreign exchange reserves to defend the rupee on a sustained basis. Although India’s reserves have increased, the truth is that any amount of reserves in not enough. Look at China sitting on 3.4 trillion dollars of reserves. In two months in the recent past, reserves fell by more than a whopping 80 billion dollars – last month the fall was $87 billion, and in August it was $ 94 billion!

Fifth Bi-Monthly Monetary Policy Statement on December 1, 2015 by Governor Rajan: RBI opts for the status quo

RBI to use the breathing space to improve the monetary policy transmission

RBI Watch                                                                                    Monetary Policy 2015-16

RBI made no change in the repo rate and related rates. This is what was expected by most RBI watchers and me.

I expect RBI to ease further only in the next financial year. Please read my blog of October 8, 2015 for RBI’s current stance and the future course of the repo rate.

RBI has made no significant changes in its projections of inflation and output going out to March 2016, the end of this financial year.

Governor Rajan stated that his focus now would be on getting banks to pass on more of the 1.25% reduction in the repo rate since January – banks have passed only by half of this in terms of a lower lending rate to customers, although deposit rates for customers have come down significantly.

Within a week’s time, he promised fresh guidelines on bank lending based on the marginal cost of funds. I do not believe that RBI should be mandating this. Please read my blog of April 14, 2015 on this subject. He indicated that RBI is working with the government to link the rate on the government’s savings schemes to the market rate of interest. Finally, to get banks to lend more he wanted banks to further recognize and deal with bad debt.

The real question now is what could prompt RBI to change its monetary stance – surprisingly shift to a tightening monetary stance. This needs to be a shock of some sort, I guess. I hope to write a blog on this in a week or so.

Monitoring the NaMo Bull Market in Stocks: Update as of November 2015

Indian Stock Market Watch

Please refer to my blog of July 9, 2014 for the original note on using TMV/GNP ratio to gauge whether the market  is cheap or expensive. 

The value of the Rupee: update as of October 2015

RBI Watch                                                                                                 Indian Rupee

Please also read my April of 2014 blog titled "Is the Rupee fairly valued?" 

   

The Federal Reserve should raise the target fed funds rate at its December meeting

Central Bank Watch

Employment numbers in the U.S.  suggest that the country is at near full employments levels. There is some evidence appearing of wage increases.

GDP continues to grow steadily at about the 2% level, less than the trend growth of about 3% before the 2008 financial crisis. Inflation continues to run below the Federal Reserve’s target of 2%. This looks like the ‘new normal’. Note the expansion in the US economy post-crisis is now one of the longest in US since 1900.

The situation in China is currently stable. The government recently announced that families would be permitted to have two children. China’s central bank announced another round of easing. There is a shift in the economy from investment to consumption.

The Federal Reserve now needs to start normalising interest rates in the U.S. At 1.5% inflation, the fed funds rate would normally be in the region of 2.5 to 3%. Keeping interest rates unusually low for extended periods will create major distortions in the U.S.  economy and the rest of the world. Please read this paper by Paul Mason on this subject.

To get to a fed funds rate of 2.5 to 3%, the Federal Reserve needs to do it in gradual steps over the course of the next two years. The sooner it starts the better.

A China or an emerging markets shock is still possible. If the Federal Reserve believes it needs to respond to it, it can when interest rates are at the normal level. Similarly the Federal Reserve can respond to a recession in the U.S. – a recession can well be on the cards in the next two years after one of the longest expansions in U.S. history.

Monitoring the NaMo Bull Market in Stocks: Update as of October 2015

Indian Stock Market Watch

Please refer to my blog of July 9, 2014 for the original note on using TMV/GNP ratio to gauge whether the market  is cheap or expensive. 

Margin trading investors on the NSE - an update as of Spetember 30, 2015

Indian Stock Market Watch

Please see my earlier blog dated July 7, 2015. Below are the updated numbers. There is nothing major to report in the last three months.

Will margin funded investors get it right on Suzlon this time? An update as of September 30, 2015

Indian Stock Market Watch

Please see my earlier blog on Suzlon dated July 22, 2015. I had then given numbers 

(as of the last day of each month) for Suzlon till June 30, 2015. Below are the updated numbers from the NSE - the bottom line is that Suzlon continued to be among the top five companies in which investors were most heavily invested using margin funding.

 

The value of the Rupee: update as of September 2015

RBI Watch                                                                                                 Indian Rupee   

                                                    

                                       

What a wonderful world: This is 2018 - companies are borrowing at 8.5 %, home buyers get loans are at 9.5% and the Sensex is hovering at 32,500

For the Sensex to be higher significantly some problems that may convert into shocks must abate or India must contain them

Is it realistic to expect the RBI to achieve 4% inflation by end March 2018?  I believe the answer is yes. Why? Here I quote from my last blog:

“Demand conditions in India are weak: capacity utilisation is estimated at 70-72%. The world has suffered a commodity shock, and commodity prices are expected to remain soft. World demand is also very weak.”

Plus the RBI has the right monetary stance – an accommodative monetary policy with real rates under close watch.

In two years, India’s economy will be growing faster – but not likely at a superhot pace, by which I mean a return to the pre 2008 financial crisis growth rate of 9%.  Given the environment as stated above, it is unlikely to create inflationary pressures.

In my last blog I had put forward my projections for the repo rate by end March 2017 and 2018 assuming the RBI achieves its interim and final target for inflation. I reproduce those projections along with ballpark projections of the base rate, one year fixed deposit rate and home loans. The rates today are also below for readers to get a picture of the change that could take place over the next two years.

So in two years’ time, a depositor could be receiving about 6.5% on a one year deposit – about 1.25% less than today.  Businesses should be able to borrow cheaper by 1.5% at about the 8.5% level. Families looking at buying a house could take out home loans about 1% lower in the region of 9.5%.

On balance, we could then be entering a virtuous cycle, with lower rates all round giving another boost to the economy.

It definitely looks like a more cheerful world, but for the depositor. Will depositors move their money into stocks and bonds (via mutual funds)?

Markets typically move in advance of events. Barring a shock – China or emerging market debt or unanticipated Federal Reserve tightening - I feel that savers should take this opportunity to judiciously shift some of their savings to equities – either using an index or picking stocks of companies with strong brands, steady profits, and sustainable competitive advantages.

Equities normally react positively to rate cuts by the central bank. Equity markets have not responded to the already 1.25% cut in RBI’s repo rate, but as the cloud clears on the Indian economy and some of the international uncertainties abate, they will. As investors anticipate another 1% cut by the RBI over the next two years, equity markets could move up significantly higher. A 30% rise in the Sensex over the next two years is a good possibility.

Long term bonds – treasuries – are also likely to give good returns. The price of a bond rises when yield (rate of interest) falls.  In anticipation of a fall in the repo rate, the 10 year treasury bond yield could fall by 1% to about 6.5%. This could lead to total return (price plus coupon) in excess of 20% over the next two years.

On property, I am not so positive. Data on Indian property indices come with considerable lag, so it is difficult to get a good picture on property.  Most places that I visit, I sense that there is considerable property inventory in stock. Of course, this would not apply to a specific location, where some special factors may create an attractive investment opportunity.

Fourth Bi-Monthly Monetary Policy Statement on September 29, 2015 by Governor Rajan: Key takeaways

RBI projects inflation at 5 to 5.5% over the next year

RBI Watch                                                                                    Monetary Policy 2015-16

Governor Rajan announced a 0.5% cut in the repo rate to 6.75%. A cut of 0.25% had been widely expected, so the larger cut was welcomed by borrowers and investors. In my blogs of September 2 and September 18, I had suggested that the RBI should reduce the rate.

Before I go into the key takeaways from the bi-monthly monetary policy statement (MPS), let me recap RBI’s mandate from the government as per the Monetary Policy Framework agreement of February 20, 2015. The RBI’s mandate is to bring CPI inflation down to 6% by January 2016, and then in all subsequent financial years down to 4% with a band of +/- 2%. 

Here are the key takeaways from Rajan’s statement and the media/analyst conference call.

The MPS states RBI’s new interim target in getting to the final target of 4% inflation rate: by end of fiscal 2016-17, the RBI will aim to bring inflation down to 5%. 

  

The RBI has been following a real interest rule of 1.5 to 2%. The question that then arose is which instrument’s interest rate it is looking at to determine whether the rule is being met. For example, is it the 3 month deposit rate or is it the 2 year treasury bond? At the media call, Rajan revealed that the RBI’s bench mark instrument is the rate on the 1 year treasury bill. He indicated that normally this rate is about 0.25% above the repo rate.

Where does RBI see inflation over the next 1 year? RBI’s projected inflation is in the region of 5 to 5.5%. Why? In the MPS, Rajan asserts that after the 0.5% reduction in the repo rate, the 1 year treasury bill rate will be consistent with a real rate of 1.5 to 2%. This means that he expects, all things being equal, for the treasury bill rate to move a little downwards to 7% - 0.25% above the new repo rate of 6.75% - and this would then lead to a real rate of 1.5 to 2%. This leads to a projected inflation rate of 5 to 5.5% over the next one year.

RBI’s one year projected inflation rate also explains why the RBI took the step of cutting the repo rate by 0.5% and not 0.25% as most people had expected. Let’s look at the key factors that support this reduction. Demand conditions in India are weak: capacity utilisation is estimated at 70-72%. The world has suffered a commodity shock, and commodity prices are expected to remain soft. World demand is also very weak.

So if all goes according to plan, I expect no change in the repo rate or at best another 0.5 % cut in the repo rate over the next twelve months. The next cut may well come in the next financial year. 

The RBI will use some of this breathing space to develop better mechanisms to make sure that banks pass on the bulk of the 1.25% cut in the repo rate to its customers. While deposit rates have come down, banks have been reluctant to pass on fully the cut to borrowers –it is estimated that banks till now had passed on only 0.3% of the 0.75% cut in the repo rate before the September 29 MPS. 

One measure that the RBI is considering is forcing banks to price their loans on the basis of marginal cost of funds. I wonder whether this is the right approach. Please see my blog of April 14, 2015 on this subject. Another measure could be to reduce the rates on government’s small savings or rather to get the government to pay interest in line with market rates.

Below are my projections for the repo rate going up to the end of financial year 2017-18. If RBI achieves its target of 4% inflation by March 2018, the repo rate should be in the region of 5.25 to 5.75%. 

Monitoring the NaMo Bull Market in Stocks: Update as of September 2015

Indian Stock Market Watch

The estimated total market value of BSE stocks as a percentage of GNP has fallen steadily since February this year, and is now, based on our estimate, at the lowest level since the Modi Government came to power. 

Given the difficulty with estimating macro numbers, one should not rely too much on the accuracy of a number. At the same time, the larger message appears quite clear: the NaMo bull market is faltering. 

Please refer to my blog of July 9, 2014 for the original note on using TMV/GNP ratio to gauge whether the market  is cheap or expensive. 

RBI should reduce the repo rate at the next Bi-monthly Policy Statement on September 29, 2015

RBI Watch                                                                                    Monetary Policy 2015-16

Please read my blog of September 2, 2015. 

The August CPI figure confirmed that for the second consecutive month inflation was below the 4% level. RBI's projected path to January 2016 expected inflation to fall to 4%, and then a rise to 6%.

It looks very unlikely now that inflation will rise to 6% by January 2016.

My blog earlier today showed the unusually weak state of growth of bank deposits and lending. Till now the RBI's hands were tied down by the fact that inflation was high. But this is no longer the case now, even by the RBI’s own projections.  

The RBI, by most indicators, should now reduce the repo rate once again. Lending needs to be given another boost. As with many acts in policy making, everyone may not benefit.

Depositors are likely to receive less from banks. Or banks should be willing to reduce their margins; thereby attracting depositors, and resisting a further slowdown in their business.

Bank lending and deposits show an economy in very weak shape

Growth of lending and deposits at record lows in the last twenty years

RBI Watch                                                                                    Monetary Policy 2015-16

The graph below charts the growth of bank deposits and credit on a financial year basis from 1991, the year economic reforms were initiated in India.

During this period, the growth of bank credit peaked in 2004-05 at 31%. Two years later, in 2006-07, deposits also saw their peak at 24%.

Both the growth of credit and deposits has pretty consistently declined since. At the end of the last financial year, 2014-15, credit growth fell to 9% and deposit growth to 11%.

In fact, the deposit growth in 2014-15 of 11% is the weakest since 1990-91, and this is also the case with credit growth, barring 1991-92!

Are there signs of a change during the current financial year, 2015-16? The table below shows the numbers till August 21, 2015 – the last date up to which RBI data is available.

The picture is not encouraging, although better than the same period last year: credit has grown by just 2% and deposits by a modest 5%, when a month short of half of the financial year is behind us.

Federal Reserve chooses not to raise the Fed Funds rate

I refer to my recent blog on this subject, where I thought the Fed would not raise the rate. Please see the short statement from the Federal Reserve.

More when I get some time.

Martin Jacques' view: putting China's current economic situation in perspective

Please read this article that appeared in the The Guardian on September 14, 2015

The value of the Rupee: update as of August 2015

RBI Watch                                                                                               Indian Rupee

August was a momentous month in the currency markets: China moved towards a more market determined yuan rate - this led to a 2% depreciation of the currency on August 11, the largest in two decades.

During the month, the rupee weakened 3.5% against the US dollar, and also fell against the pound sterling, euro, and japanese yen.

Over the last one year, emerging market currencies have fared poorly against the U S dollar - some are at all-time or close to all-time lows. In this context, the rupee's performance has been relatively good. 

The last one year has also seen a huge outflow of capital from the emerging markets. Here again, India has fared relatively better.

As at the end of each month, the two tables below shows the rupee in nominal and real terms against a 36-currency trade weighted basket. The bottom line is that the rupee continues to be overvalued in real terms.

The RBI's stated policy is not to set a target level for the rupee against the dollar, but to only intervene in the markets to smoothen the volatility of the currency. 

Given the possibility of turbulent times in the financial markets in the months ahead - a rise in interest rates in the US, and the possibility of a China shock are two possible sources of turbulence – the rupee could well be under renewed downward pressure. Using the foreign exchange reserves to defend the currency could be appealing, but would be perhaps counterproductive. 

A more competitive rupee could give a boost to the economy, and given the falling inflation trend is unlikely, on balance, to create inflationary pressures.

Will the Federal Reserve at the FOMC meeting next week increase the repo rate?

Virtually everybody agrees that the Federal Reserve (Fed) needs to raise the repo rate. The question is will the Fed raise the rate next week or will it defer the decision to October/December or perhaps even early next year?

The argument for and against have been put forward recently in the Financial Times by two reputed economists.  Readers of my blog would best be served by reading it.

My view is that at this juncture it is perhaps better for the Fed to hold off raising rates till December.

There is the recent argument that the Fed has created uncertainty in the minds of market participants: they were   expecting a rise, and now – given fear of a potential China shock and contagion – they are not sure whether the rise will materialise. The argument goes on to add that there will always be some unknowns for the Fed., so it is best to act now rather than wait.

While there is some truth to this argument, the fact is that the Fed has eased uncertainty for over a year: it announced that the next move in interest rates is going to be up about a year ago, and this gave participants time to take action – the massive and arguably unprecedented outflow of capital from emerging markets over the last year was partly a result of this guidance by the Fed. , and this has eased the transition process of the reverse flow of capital to emerging markets.

It is unlikely that, on its own, a Fed. decision to raise the repo rate next week will create a major furore in the financial markets. But if this is coupled with a China shock and contagion, then the result could very well be different. Recent turmoil in the financial markets is a warning sign.

Second, there is really no pressing imperative for the Fed to raise the repo rate: inflation in the US is very benign, and there is yet no clear sign that it is likely to surge ahead, and the world has witnessed a deflationary commodity shock, which by most accounts has not run its full course.

In fact we could be facing a ‘new normal’ in the US: a period of steady growth in the region of 2 -2.5% with inflation below the Fed’s target of a healthy level of inflation of 2%.

Yet, there is, I believe, a sound reason for the Fed to raise rates – the Fed needs to normalise interest rates. With inflation in the region of 1.5%, under normal circumstances, the Fed’s target for the repo rate would be 3 -3.5%, against a background of an economy growing at 2-2.5% with unemployment at low levels. Savers getting a cipher on their bank saving is creating distortions in the economy.  And it is just not fair.

If in October/December, purely on domestic grounds, the Fed gets clear signs that it is imperative to raise the repo rate and we have no China shock (even a hard landing is fine), then it should do so.

An inflation number below 4% for August may well prompt the RBI to reduce the policy rate

RBI Watch                                                                                    Monetary Policy 2015-16

The August CPI inflation number should be out in another two weeks. If the number is below 4%, just like the July number, then I believe the RBI will seriously consider another 0.25% cut in the repo rate.

The RBI expects inflation to fall to 4% and then increase to 6% by January 2016. In this scenario, a repo rate of 7.25% is appropriate, given RBI’s real interest rule of 1.25 to 1.5%.

If however inflation consistently undershoots the 4% level, then the RBI will revise downwards its projected level of inflation for January 2016. Once this happens, the RBI will be open to another cut in the repo rate. A projection of inflation at 5.75% or lower by January 2016 will give room to cut the repo rate by another 25 basis points to 7%.

Let’s also look at the real economy at home and abroad.

Demand conditions continue to be weak. The latest GDP number for Q1 of 2015 at 7% suggests that there has been some deceleration in the economy, and the economy is unlikely to achieve the target of 8% GDP for 2015-16 set by the government. China’s economy continues to slow. Both the USA and Europe show signs of slow growth. The inflationary environment is exceptionally benign in most of the world. Commodity prices, including oil, have fallen sharply.

All this suggests that inflation, even if it trends up in the coming months, will remain benign and I expect the level to be below 6% in January 2016. Looking back, since September of last year, inflation has consistently held below the 6% level.

Yet, there are two sources of worry for the RBI: the potential for a China contagion and the imminent Federal Reserve’s move on the repo rate. Will the slowdown in China lead to financial market instability, and will this spread to India? Last week’s sharp fall in China’s equity markets rattled financial markets, although some semblance of stability returned by the end of the week. But let us be clear that the China uncertainty factor has a long way to go before it clears up.

Two, how will investors respond if the Federal Reserve decides to raise the federal funds rate at the FOMC meeting on September 16-17? Even if it does not, and my sense is that the Fed will not raise the repo rate at this meeting, it is only a matter of time before the Federal Reserve begins to normalise interest rates. Some adjustment on this front has already been made by investors and corporates, as the Fed had made its intentions clear for about a year. However, a combination of a possible China contagion and an increase in US interest rates may spook investors.

As these events unfold, the rupee could weaken sharply, there could be significant outflow of FX reserves, and money market conditions could tighten. As volatility increased in the financial markets last month, call money rates in India rose by 0.5%.

Despite these factors the RBI may still go ahead and reduce the repo rate in September, but future moves may be put on hold. The RBI could well justify this on the ground that banks have not fully passed on the RBI’s cuts in the repo rate (banks have reduced the base rate by about 0.3%, although the RBI has cut the repo rate by 0.75%), and that the RBI’s next move would come only when this has happened.