One or two sell-offs a year in EMs can be handled: Citi

Below is the interview of Pankaj Vaish with CNBC-TV 18’s Udayan Mukherjee

Udayan: What do you see dominating the foreign institutional investors (FIIs) mood at your conference because a few question marks have come back on the table in the last few weeks?

A: You are absolutely right. In fact even our own strategists at the end of last year were quite bullish on emerging markets. Their thought was that the EM-developed market (DM) underperformance has gone on for quite some time. That magnitude had become pretty large and they thought that over the course of the entire 12 months, some of that will come back.

What has happened is every time you get this Fed taper, first talk and then the real action, people almost have a directory mentality that they go through emerging markets and say which one has a lowest coverage in terms of short-term debt to forex reserves and so those countries come under pressure. That is why you see the disparate nature of a Turkey and a South Africa and Hungary.

A Hungarian economist is like we have done nothing wrong, our macros are pretty good but it is a directory effect. You are third in the row and so that can happen. So from that point of view, I think India was relatively in a better shape.My view is these sort of one or two sell-offs in a year on specific EMs can be handled and right now most FIIs are still in that hope that these can be handled.

Nobody is wildly bullish, everybody is still extremely cautious. My own sense is this one or two sort of sell-offs can be handled but if that comes hand-in-hand with a serious China slowdown, which is something I have been concerned about for quite some time now and given the developments that have taken place in the last two-three months, in fact ever since the new leadership has come in and this new leadership is quite impressive.

Xi Jinping is quite focused on that there are imbalances in the financial sector. Some of the spikes that you have seen in the funding cost for banks in China are not an accident. So there is something bigger brewing there. If that can be contained then that is okay but otherwise if that China river comes and meets this isolated EM river then that could be pretty bad for the whole year.

Udayan: Do you see a lot more clients talk about this China phenomenon on what shape it could take or is it being brushed under the carpet, it will sort itself out?

A: What happens on China is people have seen so many years of them being able to manage the situation that people still feel that these guys will be able to do it. My own view is a little less sanguine and I think given the confidence of the new leadership and how concerned they are and they realised the magnitude of the issue -- so let us just talk about that for 60 seconds maybe.

There is a lot of wealth management products that have been rolled out in China to get around the deposit caps and some of those wealth management investments have gone into mining companies and all that. So we saw one episode of that two weeks ago when the Industrial & Commercial Bank of China (ICBC) trust had to be bailed out basically. Our China colleague said that if this were to happen across the whole industry, there may not be enough capital in the banking system to be able to absorb that. That is a big if.

My counter part in China, his view is that the Chinese authorities are very good at making sure, we don’t have to mark-to-market the whole sector. They feel that Lehman was a mistake because what happened is when Lehman went down, every bank had to mark-to-market to that price whereas in China their belief is let us throw another USD 100 billion after this even though it is a USD 3 trillion problem but this way we don’t have to mark everything down to that price. That has worked quite well for them. Some of these arguments we used to hear about Japan in the late 80s.

The fact of the Shanghai Composite just trade close to its 2008 lows makes me a bit concerned. I think some people are beginning to talk about this a little bit more, they are beginning to ask for more research on this but nobody is still signed on to oh, my God, China is coming to a standstill.

Udayan: If you had to bet so early in the year, would you bet on EM outperforming DMs this year or is it a tough call today?

A: There is just a huge conditionality on that question now. Normally, I would give you a very straight answer and my answer coming into the year was EM should outperform the DM this year. But I think China is the wild card and it has the potential to take many EMs with it and on pure valuation. China, Korea, Hong Kong; they look so cheap and they make the overall EM averages look so cheap but there may be a good reason behind it which is China; I think that is the wild card and we will need to see how that plays out politically -- China, how will they tackle this problem.

Udayan: What is positioning like right now from people that you speak to going into the year?

A: People are out of EMs. They are either close to the benchmarks or underweight, our Latin American strategist did a dinner in New York two weeks ago and he was writing to us that these were 16 prominent some of the largest investors in the world. He said not one was bullish on EM.

Udayan: Is it a good thing or a bad thing?

A: Normally, we are very contrarian about these things saying that maybe the last guy has sold but even that contrariness has its ups and downs. It is not necessary to be a bullish thing, the wild card is China but in terms of positioning to answer your question, people are not heavy on EMs at all. They are still quite concerned.

Udayan: What has also thrown a few investors over the last few weeks is the way interest rates are moving in the emerging market spectrum but a lot of people have talked about Turkey, the last couple of instances in our own market have been a bit of a surprise for investors. How much of a role would that play in determining market performance here?

A: I don't think equity guys are selling because of high interest rates. I think the high interest rates are happening in some isolated countries either because they need to attract even some short-term money. For example, in the case of Turkey, the ratio of Fx reserves to short-term debt is completely out of whack. I think it is 0.2 or something which is very low. They had done some unconventional measures so there they definitely had to hike rates and they did it in pretty dramatic numbers.

South Africa, Hungary they sort of went in sympathy because then it became that directory effect - I was saying, people were saying, will the next central bank do this? But these are short-term flows because even if you look at the Turkish Lira, after that 550 bps hike maybe it rallied for three hours and then it was back to prior weakness. Even now I think it is only up 1 or 2 percent from the post-hike thing. It is not a good situation but I don't think equity guys are necessarily looking at that. If you are an investor in any Turkish fixed income or equity position, you would be concerned about the macro situation. These Fx reserves are very small. So I don't think that is a trigger. In India's case, there are a lot of other issues. I think we just need to figure out where monetary policy is headed and of course elections, and that is what we will decide.

Udayan: I just wanted to scratch the point on fixed income investing in India this year. If you had to take a call right now given what you have heard from the Reserve Bank of India (RBI) governor, what would you tell your global clients to do with Indian interest rates?

A: I would tell them to wait to get a little more clarity on where the monetary policy framework ends up. It does look like in the last monetary policy report the press conference, it sounded like most of the practical recommendations looks like are being accepted whether there is a monetary policy committee or not, that of course the parliament will also get involved in because it may require change to the RBI act.

Interestingly even on the objectives, I am sure government will say that we should have an opinion too because it affects the country. That will probably get looked at. Governor Rajan has said that - his exact words were we are far away from accepting consumer price index (CPI) headline as the main target index but the policy measures that were announced and some of the numbers that were used using 8 percent sounds like that practically at least the market believes that that is the way RBI is headed.

Let us get full clarity on that and if that is indeed the case, I think people will wait because that is an upheld battle to get to 8 percent by 2015 when 57 percent of your index is not under your control. That just means that you will have to keep higher rates for longer. I think their bet right now is that headline inflation will come down enough on its own given the weakness in the economy and other disinflationary features.

They said they may be done for the time being but I think that is very hard to tell specially if you have signed on to headline inflation and 57 percent of that is clearly not under your control then I think it is going to be very hard to know when you have to stop.

Udayan: But what is your gut feeling? Having seen the Urjit Patel recommendations, what do you think is the most likely path that he will take?

A: It seems like the most likely path is that the governor will accept the recommendation of going to headline CPI. That is what clearly seems to be the implication from the press conference after the monetary policy announcement.

Udayan: Which means rates are not coming down this year?

A: I think the rates are not coming down for quite some time.

Udayan: This year, whole of 2014?

A: I don't know maybe by September-October. The thing in that is - and it is going to be totally random. That is one thing that still needs to be explained to the entire country. If 57 percent of your index is food and fuel, which we have no control over because the vendors, the big traders of sabji-mandis - they don't borrow at the LAF window. They do not necessarily have any push effect from that. Those markets are crazy markets in their own and I have traded natural gas in Russia and I will tell you trading onion or tomatoes for most people would be a completely random exercise.

If there is no control over that and we have seen it between 2010 and 2012 operating rates went from 3.25 percent to 8.5 percent. 525 bps hike and you plot that against inflationary expectations, which is basically the catch all reason why this is being done just to seek inflationary expectations and second round effects. If you plot this with inflationary expectations one year out, there was no impact whatsoever. Inflationary expectations did not come down in that period at all.

So you can hike another 525 bps but I think the outcome of tomato and onion price is totally random. It is exogenous to this exercise. So what needs to be explained specially since so much of this is going to be through inflationary expectations of households, households need to understand in simple terms what is the controlling mechanism? How are you finally getting this under control by targeting positive rates on headline CPI. I think that needs to be explained.

Otherwise people out of respect, out of difference will say, okay I can see RBI is on the job, let me lower my inflationary expectation for next year but suppose a year down tomato prices don't come down, potato prices don't come down and they hike another 200 bps, they are on the job, let me lower them further, they will come down. But you can only do this exercise for so long. After two-three years all you may get lucky and prices come down. That is fine but if there isn't an operating mechanism to bring them down then even your credibility can get hurt a little bit. So I am not saying there is no answer there, maybe it is, I couldn't find it in the 130 pages but I think it just needs to be - the exposition has to be more detailed so that people get that comfort.

You also then become totally susceptible to the volatility on these prices. As we saw in August-September-October prices went up 35-40 percent, on some goods even more and on the day of the state assembly elections, the day after that prices crashed. Clearly this was not a coincidence there was something going on there. There are people who can influence prices quite heavily. So now is our repo rate going to be almost as volatile as that? If not and we are going to keep using our judgment to weed out those instances then what is the need for a rule-based approach? So some of these things need to be discussed and perhaps some clarification will come out.

Udayan: I was going to ask you about elections next because that will come up in your conference, you have got some political speakers as well I see. What is the mood on that aspect of it for India?

A: That is the primary factor that will decide equities this year is my strong belief and perhaps the rupee away from the whole EM crisis.

Elections - it seems like the country is looking for some clarity. It clearly wants some decisive result and so do FIIs. Some of the rally in the September-October-November period partly was because the current account position was improving but partly also was we started getting those opinion polls, which were showing that some clarity will emerge on this.

Again this is another one that is going to be a plus one-minus one event. If you get hodgepodge of parties coming together, I think the market will be off 20 percent over few weeks. If you get a decisive clarity in the elections, it will decisively break out. So far it is not decisively broken out and people will be excited. That can start a positive sentiment cycle.

There are turns -- I just met 16 CFOs in Delhi last Friday from some of the top companies, everybody had strong opinions on elections and clearly there are people who will get incentivized to get involved in kick-starting some projects if there is some decisive leadership. That is going to be the single biggest event for India domestically.

Udayan: Do you think it is an even more powerful impulse than the global backdrop at that point in time or do you think it will create 10 percent plus or minus volatility and then will go back to tracking what is happening with the rest of the EMs?

A: No, I think these are the two major forces but I think the country because over the last few years has been such vocal desire for strong clarity on policy making that this will be a seminal event. It will probably cause a 20 percent rally if clarity on election came out. So far our FIIs have come back to shore, they have come back to close to their benchmark, nobody stuck their necks out in a big way. When the Aam Aadmi Party (AAP) came out, some people pulled back a little bit saying does this dilute the possibility of clarity. So people are very keen, they will jump in, some people will say even if I am only jumping in after a 12 percent rally but over the next year or so, this can rally 30 percent or something. There are people ready to do that. There are few brave souls, very few who have already stuck their necks out and said we think that the country is ready and we think this can happen.

The broader EM stuff has pulled their enthusiasm back a little bit. So these are the two forces that will work. The timing of them is slightly uncertain. We don't know when China is either all clear or some potential problem comes to the fore. Whether that happens before the election or after we don't know.

Udayan: Where do we have a base for the Nifty in your eyes, do you think around here 5,900-6,000 the 200 day moving average (DMA) or tough to say?

A: I think if we break here, we could go back down to 5,600 or something like that. If the EM still lingers on, China should open up in a meaningful way after a week long holiday, let us see how that behaves.

If EM problem even in the short-term resurfaces again then we could break down. We could go down. I don't mean any retrievable kind of a thing but I think just next technical levels probably will be lower, probably around 5,600. Then we have to see more opinion polls on the elections. If April 1 is the next RBI meeting, let us see if they say a little more clearly whether they are adopting this full measure or not and that will decide. I am not bearish on the Indian equity market because my base case still is election should lead to clarity because the whole country seems to be thirsting for it. I know a lot of people who have lot of friends in Delhi who voted for AAP in the state assembly elections but said for the Lok Sabha elections they wanted to go with one or the other clearer block. I think the country is thirsting for clarity, that will probably come and that will be a positive sentiment. The only unknown to me in all of this now is going to be China and the pace of clarity on the monetary policy committee report.

Udayan: Do you think we can still assume that ballpark give or take a bit this will be another year where India gets its share of USD 20 billion of flows or could that equation changed around a lot?

A: That one too depends on the whole EM story we were talking about. If China has a serious problem then no, we will not get USD 20 billion.

Udayan: That depends more on China than on any tapering news that we keep hearing?

A: I think so. Given the fact that Ms Janet Yellen is the new chairperson of the Federal Reserve means she is going to be very thoughtful, very deliberative -- the general view is that she is a little bit on the softer side but she is going to be very deliberative in terms of pulling back liquidity. So our view is that there is no chance the policy rates go higher throughout all of 2014. They know that unemployment rate has come off but a huge portion of that is because so many people have left the labor force.

The labor force situation in the United States is troubling. There is an article today in the Wall Street Journal, which is talking about a very - it had a number of 15 million or something of men between the ages of 15 and 59 who are out of work or have given up looking for work. That is not a healthy situation. There is a serious problem there and the FOMC is mindful of that. I feel very comfortable that the Fed is not going to spoil the party, I think they are going to be very careful and very thoughtful, if anything probably on the side of not pulling the plug too soon. So I worry about that less. I do worry about the China and other EM serious sell off, which would then mean that the risk appetite goes down tremendously and then India will not get USD 20 billion and then of course the election.