Jul 17, 2013 08:33 AM IST | Source: CNBC-TV18

RBI's rupee protection could impact bond, stock mkt: Udayan

Measures taken by RBI to arrest the fall of rupee could have deep repercussions for the stock and bond market says CNBC-TV18's, managing editor, Udayan Mukherjee.

Measures taken by Reserve Bank of India (RBI) to protect rupee could have deep repercussions for the stock and bond market said CNBC-TV18's, managing editor, Udayan Mukherjee.

Tuesday will be an important day for all markets and all asset classes, and one can forget about their expectations of a rate cut from RBI because it has just sacrificed the interest of the bond and the stock market to protect the rupee market.

Huge tightening in liquidity could see interest rates go up in the system and bond yields head up too, he added.

Also read: RBI opens new attack to clamp rupee free fall

On possibility of a rate hike by RBI in July policy

We have been talking about this possibility for the last couple of weeks. People have been in denial that a rate hike cannot happen right now, but the signs were there. Other peer markets were doing it. Brazil was doing it. Indonesia was doing it and Brazil does not have any better growth prospects than India at this point. So, if they could do it why couldn’t we?

Therefore, today the penny will drop, the denial will be shaken. The Reserve Bank of India (RBI) has used its judgement and sacrifice, as I said the interest of the bond and the equity markets for the currency market. Time will tell, because this move by RBI will be hotly debated. In the least its contentious, some people might think it is a policy mistake as well given the kind of growth dynamics India is dealing with.

The good thing is that the rupee market will be salvaged atleast for the next few days, but at what cost is the big question? You have seen the Index of Industrial Production (IIP) numbers last Friday. We know that we are starring at five percent growth right now. At a time like this to curb liquidity to almost force banks to up rates, for an investment cycle which is completely moribund, for them to deal with the prospect of interest rates going up and what it does to sentiment all around in the system - those are big questions.

Although one can say that the RBI’s priorities are different and that is a different game. But I think it is very stock-negative and fairly bond-negative as we look at some kind of saving face in the rupee.

On foreign institutional investor (FII) flows

That is a million dollar question because there will be some capital losses for FIIs in the bond book right now because bond prices will fall this morning but what all emerging markets (EMs) are trying to do including India now is to make our country bonds more attractive for FIIs in the longer-term, which means we need to see some more FII flows in, for medium-term investors. That is the game clearly in raising interest rates at a time like this.

However, what it does to the perception of a country where growth is crumbling is a difficult call. Also, RBI is keeping an eye on the FII outflow from the bond market and it has been lulled into complacency into believing that there is money, which cannot go out of the equity market. Although the experience of last month says that it is bonds which hurt us more than equity outflows but if people start taking a dim view of India in the light of further tightening of liquidity interest rates and they say India will grow at 4 percent next year, then you could see a big outflow of money from the equity markets. This might more or less or even more than compensate for any inflows which come into the bond market.

So, it is a judgement call but this is a contentious call because you have just taken a decision with an eye on the rearview mirror because equity outflows will not happen in India. However, if suddenly we were to lose USD 10-20 billion of equity outflows, the kind of damage we could do to the system, to the market, to sentiment could be quite scary.

I hope it works out well but there is at least a one-third possibility that this could end up being termed a policy mistake.

On bond, rupee, equity markets

Bond and equity markets go together this morning because bonds yields heading in a direction of 8 percent is something which the market could not have conceived a few weeks back. It was a question of how quickly we go to 7 percent kind of levels. It was not even a debate whether rates will be cut, it is just by how much 50 bps or 100 bps. And now we are talking about hardening of interest rates, we are talking about the yield going to close to 8 percent, which is hugely negative for equities as well.

I fear for equity sentiment right now because growth numbers are still very terrible and this will lead to capital losses. Therefore, next quarter what will banks report because there will be trading losses now on their books. Public sector undertaking (PSU) banks already have got hammered out of shape. So, this is hugely negative Bank Nifty, it is hugely negative Nifty, it is hugely negative bond prices but positive for bond yields.

On the possibility of banks passing through the interest rate hikes

We already know what basic demand for things are in the economy; what the car sales are like, it may hit real estate as well. It is a difficult call this morning. The only silver lining is that the rupee probably hardens to 59-58.50/USD but longer-term the rupee will move with how the deficits are moving and how the funding of the deficit is moving.

So, if over the next few months, you have a situation that a lot of FII money comes into the bond market that may salvage the rupee for some more time in a durable fashion. If in the next few weeks FII outflows start once again because of the India growth scare becoming more paramount, then the rupee will weaken once again despite these moves because funding of the deficit will still remain a big and humongous task to do.

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On Nifty

This is in the realm of the unexpected. I had thought maybe it will take six months odd before we see the first singing of the interest rate hike tune and it came in just six days. It changes sentiment quite a bit this morning. It is primarily sentiment because I do not think India's growth issue has to do with 25 bps hardening or 25 bps easing. However, to come at a time when one can hear the commentary coming in from Chief Executive Officers (CEO) across the country and when we are struggling with growth; it is just not picking up - you send a signal that interest rates are actually going to harden, generally the sentiment goes down quite a bit.

I think this morning there is a big sentiment issue out here. What global equity investors make of this is also going to be an interesting one, because now emerging market (EM) equities are beginning to look even more unattractive in a relative game. For somebody who was debating whether they should be deploying money in EM equities right now, while the rupee is being helped a little bit, their call on equities would become even muddier given what they are seeing in Brazil, India and Indonesia.

The Nifty may lose 100 points on the SGX as the SGX is suggesting, but eventually is this a turning point because people take a complete relook at prospects of growth from hereon. Whether Gross Domestic Product (GDP) expectations also get recalibrated on the way down which are not very high and we start working with a base case of something close to an 8 percent bond yield which is very different from a 7 percent bond yield in the system.

It will affect individual clusters of stocks as well. We were talking about PSU banks, but anybody who is exposed to wholesale funding in a big way gets whacked this morning and that would include some of the blue chip Non-Banking Financial Companies (NBFC) names as well. Therefore, you will probably see a bloodbath across the board in many of these wholesale-funded NBFCs as a totality. Most of them are wholesale funded.

It is going to be difficult for a few clusters of stocks, but generally for the equity market it has raised a lot of questions. We can still be floating around in a range, but the reasons to go and stay higher above 6000 just got less.

On Fed comments and the impact on emerging markets

Just when the market was beginning to stabilise a little bit because of Bernanke soothing comments, comes this whack. The way some of the other emerging markets central banks had moved in the last few weeks; now it is a bit of a herd mentality out here. All EMs are running scare that we do not have capital, we need to get in capital otherwise we have had it, our currencies are going for a complete toss and you can see that herd behaviour, which is playing out in most of the influential emerging markets particularly the ones, which have a deficit problem.

Time will tell if this is an expensive policy mistake or it is the right thing for the right time even if it hurts some of the asset classes like equities and bonds. There is no clear answer to it but I suspect if you pose this question to a lot of people this morning, perhaps because of vested interest too will tell you that this is not a good decision at this point.

On macro implications

Let us see what the RBI follows this up with. Yesterday was just a half a page of a communication, so the next step, is the next policy meet in which they will flesh out their thoughts on how they are going to approach policy going forward.

In that if we hear a very hawkish tone because of the rupee - we have been thinking about the possibility of a hawkish tone because consumer price index (CPI) was being slightly elevated etc but right now, they have signaled with yesterday’s move that they are going to go out and defend the rupee. That is a slight departure in their policy stance from the previous time.

Therefore if in the next policy meet, they sing an even hawkish tone tinker around with the cash reserve ratio (CRR) on the way up and basically tell the market that there could be more tightening if required, if these moves don’t work out then there is a shift in the macro once again. We need to sit back and think whether our macro has just turned for the worse for at least some markets like equities and perhaps even for bonds.

What it does to the rupee over the medium-term - once this effect plays out maybe it takes a rupee to 58/USD. This is also a very shallow market given what has happened in recent times. It maybe going to 58/USD now but eventually if we do not fix the current account deficit (CAD) problem and if we do start getting equity outflows from global investors because of these moves and a growth scare then I think the rupee could easily go back to 61/USD once again.

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