Jamal Mecklai: Measuring sentiment

Like love, “sentiment” is an intangible and can’t really be measured. Its impact, however, is profound; when aroused, sentiment can completely overturn your life or, more prosaically, financial markets.

While measuring sentiment accurately is, by definition, impossible, I like to put on my Don Quixote hat from time to time and tilt at such lovely curiosities. I’ve been doing that with the sentiment for the rupee and my ramblings may, perhaps, throw some light (or more confusion) on the subject.

Between January and August 2011, the rupee moved between 43.95 and 46.15 against the dollar, with an average value of about 45. Exports were growing like gangbusters, averaging 46 per cent growth over the previous year. Imports clocked an almost-equally impressive 33 per cent rise. Hardly surprisingly, there was no rona-dhona or gnashing of teeth from either exporters or domestic manufacturers (other than in a few long-standing sectors). All this suggests that the exchange rate was “correctly” valued at the time, considering both the state of the global economy and Indian competitiveness.

Sentiment, however, was beginning to weaken, as a result of the steadily conflagrating European crisis, the difficult inflation situation in India and the increasing “policy paralysis” we were facing. The stock market, reflecting all this, fell by about 15 per cent over the period.

From September onwards, the rupee, too, went into decline, driven partly by the strengthening dollar and – ta da! – deteriorating sentiment. To try and isolate the impact of sentiment, I extrapolated the value of the rupee from September 1 if it had moved completely in sync with the dollar index (DXY), in which event, it would have been at 51.16 today (June 25) instead of the actual 56.60. Since all changes in the global market would be reflected in the DXY, this suggests that the impact of negative sentiment as of today is more than Rs 5 (around 10 per cent).

Of course, this huge impact took time to build up and was certainly not linear in its evolution. By December 15, the spread (call it the CONS, or cost of negative sentiment) had risen (from zero on September 1) to Rs 4. All – or almost all – of this was driven by the deteriorating global environment, which was loudly brought home in early December, when November exports fell year-on-year for the first time since 2009. With the rupee in near-free-fall, the Reserve Bank of India (RBI) stepped in with a slew of policy measures. These had an immediate positive impact, squeezing the CONS back by about a rupee by the end of the year.

By good fortune, as 2012 dawned, strong US data turned global sentiment upside down, the risk-on trade came back into favour, Indian equities rocked and the rupee – amazingly – strengthened. By the end of February, the CONS was almost down to zero — global enthusiasm was balancing negative India sentiment.

It continued to edge around between zero and Rs 1 for a few weeks, and then came the Budget!

From about 50 paise on March 15, the CONS shot up by over Rs 2 by the end of the month. By April, when Europe fell flailing back into its deep funk, the CONS rose further, reaching the exorbitant Rs 5-plus we are seeing today.

All this explains that the immediate impact of the government’s retrospective taxation proposal was about Rs 2 on the dollar. The additional Rs 3-4 in the CONS was separately the result of the European crisis — importantly, this impact could have been larger except for the fact that the RBI’s December 15 clampdown appears to be preventing any additional position build-up. The analysis also indicates that the CONS at about Rs 5-plus is at, or close to, a peak — and if the government gets its act together on retrospective taxation and all other things being equal, we could see the Rs 2 dump in the dollar-rupee exchange rate (USD/INR) reversed quite easily.

Of course, all other things are never equal. If the dollar were to rise by another five per cent – DXY at 86 or so – the base value of the rupee could slip by five per cent, taking it to 54; adding in the Rs 5 CONS (again, assuming no other changes) would take USD/INR to 59+. Conversely, if the dollar were to weaken overseas, all other things being equal, the rupee would strengthen to 49+5, or 54, to the dollar.

Some sort of meaningful resolution of the euro crisis could reduce the CONS, but this looks increasingly unlikely in the near term. To my mind, the least painful way out would be for Angela Merkel to acknowledge that Germany is in another league from its current partners and go it alone. Short-term uncertainty would ratchet higher, increasing the CONS as well as strengthening the dollar (and the new/old Deutsche mark). In such a circumstance, even 60 (USD/INR) would not hold.

 

jamal@mecklai.com