Indian equities have corrected by more than 10 per cent from their recent May 17 peak of 6,187 for the Nifty. Among the many reasons being attributed to this rather steep and sudden correction is the immediate likelihood of the US Fed beginning tapering of the $85-billion per month quantitative easing (QE) that has been on since September 2012. The ongoing QE programme is, in fact, the third in the series of such measures initiated by the Fed to counter the effects of the global financial meltdown of 2008 with the intention of preventing the US economy from sinking into a depression. Pumping liquidity into the economy by sustained buying of treasury and mortgage-backed securities from banks results in cash injection into banks and lowers interest rates which in turn should lead to larger lending and a boost to economic activity.
India has been a significant beneficiary from the capital inflows that can be sourced to monetary easing in the developed world. In 2012, India received as much as $88 billion of capital inflows, despite deteriorating macroeconomic conditions, as also weak corporate fundamentals, quite largely attributable to global monetary easing. The impending QE tapering should, therefore, have consequences for India and this is unlikely to be painless, especially when the current account deficit (CAD) for 2013 is unlikely to be much less than $100 billion.
How exactly could this play out? The immediate impact would be on the rate sensitive bond market where foreign institutional investors (FIIs) had some $30 billion of investments. With an outflow of just under $10 billion by FIIs from their Indian bond investments since June 2013, there has been veritable turmoil in the Indian currency market with the rupee plunging in excess of 10 per cent against the dollar during the period. The rupee fall has started affecting the equity market, too, with weakening corporate fundamentals. Unabated global liquidity on the back of QE has led to firm commodity prices, which in turn worsened India's CAD, increased inflation, reduced domestic savings and moderated profit margins. In addition, a significant portion of the some $170 billion of foreign currency short-term borrowing remains unhedged. Even a modest outflow of capital, some $10 billion from the bond market and about $3 billion from equities that has happened since June 2013 - out of the net inflow in excess of $200 billion over the last 20 years - has dramatically heightened asset price volatility which is unlikely to subside till QE is completely unwound, possibly by sometime in the middle of 2014. As a result, the onset of the investment and capex cycle that India hopes to revive in order to overcome the economic slowdown is likely to be substantially delayed. The rupee could continue to be under pressure if the outflows intensify and the financials of corporate India could be further weakened.
There could however be some positives over the medium term. With global commodity prices likely to soften further on the back of QE unwinding, India's trade balance is likely to improve since it is a large importer of global commodities. Moreover, US interest rates will harden further with the unfolding of the QE taper and this could lead to a reallocation by global funds with some rotation out of fixed income securities to equities. The traditional long-only funds could see some significant inflows as a result and Indian equities could be beneficiaries of this development provided the government is able to press ahead with reform measures and usher in some confidence in the economy. In addition, over the next few quarters rupee depreciation of the magnitude that we have seen over the last three months would lead to a natural correction of our trade imbalance with a pick-up in exports and drop in imports, especially if the increased import prices of commodities such as oil are passed on to consumers. Moreover, even if the US Fed starts the QE taper as early as September 2013, central banks elsewhere in the developed world are likely to more than compensate for the QE taper till at least early 2014 by continuing to expand their balance sheets with the Bank of Japan taking the lead.
The short point, however, is that the impending QE taper is likely to hurt India in the short run, before the resilience of the Indian economy comes into play over the medium term through a natural adjustment of the trade imbalance with a more competitive rupee. The timing of the QE taper is especially detrimental to India because it has already entered election mode for federal elections in early 2014. The government's pre-occupation - with the possible exception of the finance minister who appears to be fighting a lone battle - is in implementing expensive and unaffordable social empowerment plans through a creaky and leaky delivery infrastructure. If the government is serious about its 4.8 per cent fiscal deficit target and financing its $70-billion CAD target, given the continuing economic slowdown, it can only be at the cost of plan expenditure and sizeable quasi-sovereign foreign currency borrowing, both of which are clearly sub-optimal solutions. The government would do well to urgently address issues that can bring back some confidence in the Indian economy, issues such as getting the mining ban lifted, ensuring an adequate flow of raw materials to industry - coal, iron ore, sand, natural gas etc - push through approvals for stalled projects, facilitate land acquisition for large projects, clear overdue receivables due to vendors from the government and its agencies and provide regulatory clarity in several sectors like telecom, electricity, oil & gas etc. Addressing these issues would moderate the possible negative impact of the QE taper and Indian equities may attract attention from both domestic and foreign investors, especially after the recent correction. Albert Einstein's famous quote - "Life is like riding a bicycle. To keep your balance you must keep moving" is as much applicable to life as to the Indian economy at the current juncture.
The author is managing director, Dalton Capital Advisors