High deficits, weak rupee causing FII pullout: Deutsche Bk

Sameer Goel of Deutsche Bank told CNBC-TV18 that the pullout of foreign institutional investors (FIIs) from emerging markets (EMs) was a pan-Asian phenomenon, fuelled by quantitative easing  sqeeze fears.

In India, high current account deficit and a fast-depriciating rupee were further aggravating the situation leading to FII exit.

Commenting on Standard & Poor's upgrade of US economy to "stable", he said it was due to improving economic, fiscal and political climate.

Also read: Rupee may stay in 57.80/$-58.30/$ range: IDBI Bank

Below is the edited transcript of his interview to CNBC-TV18.

Q: It is a pan-Asian phenomenon with the foreign institutional investors (FIIs) moving out of emerging market (EM) funds and into US yields. How does the logic work in India? Will a rate cut from Reserve Bank of India (RBI) worsen the process?

A: It is not just pan-Asian phenomena but a pan-emerging market phenomenon. This is important for the currency in India and the bond market. We are seeing an unwind of positions which have been driven by carry and in turn driven by the quantitative easing and the balance sheet expansion by the Fed over the years.

As the markets come face-to-face with a structurally higher level of volatility and the Fed potentially tapers part of that quantitative easing; all the positions which benefitted from that enhanced carry are coming under pressure.

India also stands out as having the twin-deficit problem of a bad current account (deficit) and poor fiscal picture. Therefore, it is bearing the brunt of this unwinding in carry.

Q: Does it seem like tapering off at all? Will it pull out a bit of debt capital and there it ends? We have not seen the contagion into FII equity funds?

A: It is encouraging to some extent. But it is also worrying as eventually the drawdown in the currency starts to impact the flows from FIIs into equity markets. This drawdown can potentially become a lot worse from here.

Q: You indicated that carry trades have been built over the past and we are seeing it’s unwinding. Is there more unwinding of such trades in store which could result in further pressure in all the EM currencies?

A: As far as the emerging market go, we have seen maybe the first episode of this unwinding carry. There is a lot of that unwind to go through. Now, India in some sense is fairly distinct.

As you mentioned at the beginning, we have necessarily not seen a lot of offshore engagement in fixed income markets. This is mostly as the access to fixed income markets was relatively limited.

So India will not necessarily have to react continually with the same degree of beta like the beginning. Since we are at the beginning of that adjustment process, the carry pressure obviously ends up impacting sort of rather indiscriminately at this stage.

Q: What are you prepared to see in terms of rupee value? Is there a lot to go or at some point it becomes attractive for other reasons?

A: The one thing about the rupee is that since it has been allowed to depreciate in response to this pressure point, it automatically trades at levels which are never seen before.

It becomes very hard to be able to gauge how worse or weaker it can get from here. Sixty is an obvious magnet simply because it is a psychological round figure level.

But, the weakness in the currency, as some of those positions flush themselves out, will give a natural resistance to how much further dollar/rupee can get from here.

Q: The S&P has upgraded the US to a stable from an earlier negative view. How should global markets, particularly the emerging ones, read it?

A: It is obviously linked to their assessment on how the fiscal position has changed in the US. S&P says that that US economic performance will match or exceed its peers.

It is a validation of improving economic and fiscal climate in the US and even political climate in the US. To that extent, only furthers the point that we will probably see a prolonged period of dollar strength.

It only further adds to the debate about the Central Bank in the US eventually unwinding part or a lot of the balance sheet lent out to the markets over the years.

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Q: What do you expect the RBI to do now? What can you cling to in terms of measuring whether the rupee has receded enough? Do you all look at the six countries’ Real Effective Exchange Rate (REER) at all?

A: The first impact from RBI perspective comes in terms of shifting policy math for rate-cut. There is more easing to come. But there is no doubt that this weakness puts into question the willingness of the RBI to ease policy at the same pace.

The RBI will have to take a view whether they are willing to ease policy further while concerns about the current account gap. And how weaker the currency at this stage is.

About valuation metrics, unfortunately for most EM currencies, the valuation models are not always the best case. They do lead to some long-term adjustment of values.

The rupee has already been considered as undervalued. To that extent it should be correcting stronger. The EM models give very little by way of the adjustment process or how long that process will necessarily be. So you can have fairly large and persistent overshoots for a period of time.

Q: Would you play for any level at all now on the rupee? Sixty, like you said before, is a nice psychological round figure?

A: This should not be seen as an India-specific event. This is a much wider context of an EM unwind. I don’t think India has either the fundamentals or the technical picture to completely offset or lean against the broader unwind.

While the pace of the move in India would naturally decelerate as we get closer to these key levels, it will equally meet resistance by RBI intervention or other investors finding a value to come into the market.

However, it is important to see the broader context and if that picture continues to weaken for a while, then the rupee will also remain under pressure.

Q: In the midst of all this, if food security bill was announced in the form of an ordinance, do you think we might just walk into a minefield?

A: The interesting thing about this broader global context is then people also have much less focus on the local domestic story.

So, to some extent a worsening of the political economics in India might not necessarily have much of a negative impact on market right now because there is a much bigger dynamic to take care of.

Q: Is the weakness in EM currencies a temporary one? Is there more of a structural nature to it? Should one get used to rupee levels being at 58-59/USD and significantly much lower levels for a longer period of time? Is this perhaps the new normal?

A: It is premature to argue that. From a structural standpoint, we are shifting into an environment of structurally higher volatility. So, markets will have to get used to this volatility. This had been suppressed for several years now by the whole quantitative easing by several central banks around the world.

Now that it looks increasingly like central banks might not be so willing to suppress volatility or at least that is the threat for markets. Levels are probably a bit too early to argue whether we are necessarily in a new normal of much weaker level of emerging market currencies.