OTHER RELATED STORIES

Two-Way Taxation

India's Oil Slick

Face it. Markets in India can be quite weird. And while the equity market (normally volatile) is relatively stable at the moment, the forex and bond markets (normally calm) have gone for a toss. Blame it on that old fear. The fear of India slipping back into the old era of high inflation, falling rupee and high interest rates.

Have we spoken too soon? Take a reality check. Inflation, by the latest figure, is nudging 6.5 per cent. The rupee has touched a low of Rs 46.50 to the dollar. And the benchmark 10-year yield has zoomed to 6.25 per cent.

Sure, these are but incipient signs. Like everybody else, we hope it's just a series of blips. But no investor can afford to dismiss evidence of a change in macro trends. The time to get cracking on implications is simple: straightaway.

What's Happening?

The dollar shortage has been perplexing. Are international factors at work-or domestic? The domestic case seems much clearer, given the timing. The dollar reversal coincided with the change in government, and the subsequent fracas over what the country's economic policies would be. Some market participants even think that the Manmohan Singh government is actually an exponent of a weak rupee as a strategic tool (his double devaluation has not been forgotten). Before the elections, dollars were being sold off. Now, they're being slurped up. Though the Reserve Bank of India (RBI) was supporting the Rs 46.30 level for some time, it has allowed even this line to be pierced.

The global story, however, is also important. The dollar's weakness, starting 2002, played a big role in the rupee's rise. But as the US economy turns around, the dollar has been strengthening- but only in bits and starts. In fact, the picture is far from clear. "Currency markets are in turmoil, and are expected to remain choppy till the US election," says Rajagopal V., Chief Dealer, Forex at Kotak Bank. "The forex market will be volatile for the next two-to-three months and during this period, the rupee may weaken further," concurs Jamal Mecklai of Mecklai Financial Services. To what levels? According to Rajagopal of Kotak Bank, "If the 46.50 levels are broken, it can weaken to Rs 47 in the short term-that is, in two-to-three months."

With the trend reversal, exporters are no longer in a hurry to sell dollars; they would rather wait for better prices. Businesses, mostly, are betting on the rupee weakening further. "In the short run, we don't see any major driver for the rupee to appreciate," says Deepak Sogani, Chief Investment Officer, Patni Computer Systems, who is in no mood to increase his hedged positions (around $100 million or Rs 463.7 crore).

Importers, meanwhile, are busy biting their nails. They had been quite relaxed all this while, and are now rushing to stack up the greenbacks for future payments. In all, the demand and supply scenario spells an annualised forward premium of 2 per cent. Just three months ago, this figure was negative.

Deeper Analysis

The big question is whether any of this means a slide back to the bad old days of perpetual rupee depreciation. It might gladden you to hear that most analysts do not think so. According to one projected scenario, the rupee will start regaining strength by the end of the year, after the US elections. Again: to what levels? "By March end, it should be back at Rs 46," surmises P.K. Rao, Assistant Vice President, (Foreign Exchange), UTI Bank.

But what about India's own inflation that tends to gnaw away the purchasing power of the currency? The RBI has recently spoken of 5 per cent as being the average rate for the foreseeable future. But independent economists expect a rate higher than that, given the continuing high oil prices and the knock-on effect of that. Second, the view that China's slowdown would dampen commodity prices (especially metals) is now being challenged. Many expect higher input prices instead. And lastly, a poor monsoon in the granary belts of North-west India is bound to push up prices of agricultural products. "Our earlier year end inflation target of 5-5.50 per cent will be revised upwards," summarises Subir Gokarn, Chief Economist, CRISIL.

Rising inflation also means rising interest rates-though with a lag, since banks in a competitive market do not like dissuading credit until they absolutely have to. The market, of course, has its own voice in the bond market, a good indicator of what's going on out there. The benchmark 10-year bond's yield rise (from a low of 5.05 per cent in mid-April) to 6.25 per cent is an acknowledgement of an upward shift in inflation (as also the rise in the US benchmark rate). But analysts do not expect the RBI to raise rates so sharply as to hurt the economy. "In the next one-two months, we don't expect any change in policy (that is, no rate increase)," says Naval Bir Kumar, Managing Director, Standard Chartered Mutual Fund, "but the steepening of the curve is expected to continue. On a sustainable level (not the shoots in the middle), the rates are not expected to go up much beyond current levels."

Market Impact

What does all that mean to you, the investor? Debt market investors could look at accrual products (such as floating rate funds and liquid funds), according to Kumar of Standard Chartered MF. Equity investors? This is tricky, and calls for enhanced discrimination between companies with different strategies.

The effect of the rupee is the most straightforward. Big exporters gain, and big importers lose. Here again, much depends on the financial strategies of different companies, and the tools they employ to counteract forex pressures. Straight off, though, it exporters stand to gain. "Most of the it companies are quoting in the range of 15-25 (forward P/E), but earnings growth prospects are 30-40. This is one of the few sectors where earnings upgrade possible," says Tridib Pathak, CIO, Chola Mutual Fund.

Inflation is trickier to understand. Overall, it distorts pricing across the economy, so its immediate effects are hard to gauge (long-term, price instability is bad because it results in gross resource misallocation). Still, equities respond to inflation in assorted ways. Some companies gain pricing power, but others suffer low demand caused by an erosion in people's purchasing power. Several FMCG companies, for example, may actually suffer from inflation-since the 'commodification' of their products has hurt their pricing power. "There is very high competition at the FMCG sector now, and they won't be able to pass on the inflation to the consumers," elaborates Pathak of Chola Mutual Fund. Yet, the job of marketing is to determine value-for-money perceptions, and not all brands are powerless.

Banks could suffer too, if demand for credit is dissuaded by higher rates. "The treasury profits of banks (especially the ones that hold large long term gilt papers) will be get affected," says Ashim Syal, Chief Investment Officer, ING Vysya Mutual Fund. Not to imply that banks cannot gain from higher rates; they could possibly play a smarter game of spreads under the new conditions, but that depends on their asset-liability matching flexibility among other factors such as persuasion skills. Business conditions may have changed slightly, but it is times like these that often separate the market value players from the bean-counters.