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Investment Insights

Suyash Choudhary

The RBI has announced yesterday that it will offer a forex swap window to meet entire daily dollar demand of the 3 oil marketing companies (OMCs). Under this facility, the central bank will undertake sell/buy USD-INR forex swap for fixed tenor with OMCs via a designated bank. The tenor of swaps offered were not specified with the announcement.
 
 
 
Implications:
 
1. Apart from the INR defense already mounted via hiking cost of carry, the other desperate need was to enhance dollar supply to the market. The forex swap addresses this problem to a significant extent since OMCs have the largest and most consistent demand for dollars. Estimates peg their monthly dollar demand at USD 8 billion odd which will temporarily get met by the RBI. This should make the demand –supply dynamics for USD/INR much more favorable. Admittedly though, this is not immediately showing in prices given the much larger overhang with respect to India specifically and emerging markets generally. A heightened geo-political risk environment is also not helping matters.
 
2. The forex swap line leads to further tightening of spot rupee liquidity in the banking system, since the RBI buys rupees and sells dollars in the first leg. To quantify this, supposing the swap facility remains in place for the next 2 months, rupee system liquidity will deteriorate by an additional USD 16 billion or INR 1 lakh crores. As at last count, system liquidity deficit had already breached INR 1 lakh crores. Over the very near term the system will see some inflows from seasonal reversals in currency with public, month end government spending, as well as bond maturities. However, over the next month or so deficit will rise again and will become more pronounced with RBI’s forex operations in place. This implies that the RBI may be able to reduce or eventually even eliminate issuances of cash management bills (CMBs) to the market and still be able to keep overnight rates anchored to the MSF rate of 10.25%, so long as it keeps selling spot dollars .
 
3. At some juncture when the RBI unwinds the current rate defense on rupee, it will presumably revert to its earlier framework of managing liquidity deficit at approximately 1% NDTL of banks. In order to defend this target against seasonal increases in currency with public, the RBI most likely would have resorted to sizeable OMO purchases over the second half of the year. Indeed, it had to do OMOs worth INR 75,000 crores last year during this period. Further, if the dollars sold on account of currency defense (whether through swaps or outright) aren’t recouped by then, the RBI will have to further neutralize the negative impact on liquidity from this source by doing even more OMOs (or cutting CRR). For instance, over late 2011 – early 2012 when the RBI had last sold sizeable dollars to defend INR it had to not only cut CRR but also do OMOs worth INR 135,000 crores between November 2011 – March 2012 in order to somewhat defend its liquidity framework. Hence, assuming that at some point the RBI reverts to its normal liquidity framework this should imply large OMO purchases over second half of the financial year. As seen over past few years, this leads to strong performance in government bonds even without policy rate cut expectations in the market.

 
 
Other Recent Developments:
 

1. The rupee has been horribly massacred this week, standing out in its weakness even against other troubled emerging market peers like Indonesia, Turkey, Brazil, and South Africa. Apart from on-going macro-economic and policy concerns, a proximate issue is the escalating geo-political risk with respect to a possible US attack on Syria. If this happens, it can potentially lead oil prices to rise more in the near term. From an investments perspective, we would advise against reacting to short term event based triggers.
 
2. The finance minister has unveiled a 10 point program around economic revival. While there is nothing much new here, it is somewhat hopeful to see the top 3 items there as containing fiscal deficit to 4.8%, containing current account deficit to USD 70 billion and financing it fully, and taking steps to add to forex reserves via enhancing capital flows. On the fiscal deficit front, we would make the following observations: One, while we wouldn’t completely write-off the 4.8% target yet, it is a much more difficult ask this year than it was in the last. Furthermore, it is almost certain that it cannot be done without expenditure cuts. Therefore, the finance minister’s contention that growth will be better on higher government spending as well that 4.8% on fiscal deficit will not get breached, don’t sit well together. On CAD target of USD 70 billion, we would think it is quite achievable given the substantial compression in trade deficit that seems underway this year. This is happening on account of import compression (lower demand and gold imports falling) and some rebound in exports (presumably stronger US and Europe contributors here along with weaker rupee). Finally, the continued focus on forex accretion and reiterations of ‘all options being on table’ suggest that an NRI bond kind of issue can be considered sooner or later.
 
3. With oil prices rising and rupee falling to historic lows, OMC under-recoveries have spiked sharply thereby potentially increasing government’s oil subsidy burden. In order to partly mitigate the effect, a substantial hike in diesel prices is being contemplated along with possible other measures. These will likely get announced post conclusion of Parliament session in early September. Furthermore, the oil minister has apparently been tasked to work out ways to save USD 25 billion on the oil import bill. He is slated to announce solutions by mid-September as per media reports. If true, this will be significantly positive for our CAD. On impact of diesel price hike, we would focus more on the fact that it would lead to further demand destruction in an already weak economy rather than on the upward pressure on inflation that it may cause in the near term. Further, it would be a step further in the structural adjustments that the country needs to undertake. Hence, we would look at it as a bond bullish development.

 
 
Disclaimer:
The Disclosures of opinions/in house views incorporated in this document is provided solely to enhance the transparency and should not be treated as endorsement of the views expressed in the report. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. The recipient should take this into account before interpreting the document. This report has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / Board of Trustee/ IDFC Asset Management Co. Pvt. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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IDFC Mutual Fund

Over the last couple of days a number of events have occurred impacting investor capital across asset classes. The latest being the certainty of bond yields going up in the US. What we are seeing unfold is not anything that has happened in India before. The closest correlations were to events in the 90’s with the Far East Asian crisis. This time around all the panic is centered on the BRIC nations countries a club of four countries that saw an above average growth rates driven by easy liquidity. The crisis facing some of them now is the withdrawal of this liquidity.

 

A lot of Governments have responded with policy action and in context to India things are just not working in the right direction. While everyone does have a view on how the central bankers should evolve their direction, these events will play its course through the next couple of months. There is a lot of media attention, and the change in the environment is a lot unnerving even for Investment Mangers and Advisors. Nothing seems to be under control for now but more importantly things will stabilize and when they do, we need to know what we are investing in.

 
 

Is India still a Growth economy?

Our best years are behind us! In the next couple of months it won’t take an economist to tell us that a 6% growth rate is going to be a tall task. Just like no one talks about 8% growth rates anymore. That in retrospect may not be such a bad thing. But the years 2007 -2013 saw massive capital spends in corporate India. Corporate India’s balance sheet BSE 500 companies ex banks grew 4x over this period of time. While it is unlikely that this will ever happen again in the near term, making them productive is the key challenge. The focus thus shifts to policy and administrative reforms of removing hurdles to making them productive.

 
The answer to the above question has to linger around making assets profitable and not just driving balance sheet expansions. So India may not be a growth economy but higher profitability is what is required to revive the environment. We have the capacities, now we have to find the profitability.

 
 
In a capital starved economy can capital come cheap? If so who will provide it and for how long?
When we have high deficits we are spending more than we earn. This year, with the turmoil in the currency markets, debt on balance sheets is going to spike. Corporate India may just need to learn to live with expensive capital for some time and so would the Government. This would push them to lower their spends.
 
These periods coincide with efficient capital. There would be fewer new ventures, lower competitive intensity higher mortality rates. Consolidation of market shares would lead to productive capital. Not a good thing for the customer but great for the bondholders and shareholders.
 
 
Socialist Economy or a Capitalist Economy?
If this question is posed to anyone in the financial services industry, they would prefer the latter. There are no Socialist driven nations that have economic dominance and prosperity (defined by growing per capita incomes).
 
India loves a crisis. And this may not be the last one we will see. The early 90’s was a painful one for those who lived through it. But it bought about significant changes in the way India evolved. The current crises can do the same. We have outlived our time as a subsidized economy. And a crisis like this should be a wakeup call! If we do wake up, rebuilding it all should not be a tall task. But it’s an election year. We won’t have clear answers to this till that event is over and done with. To also answer that in the words of Jim Rogers- “It’s for the Indian people to decide on the future of their country”
 
 
Imported Inflation has to start hurting
The fall out of the currency is imported inflation. This will have severe long-term effects on the lower income group of society. And all this will start showing up in the second half of the financial year.
 
 
Where are the Returns?
What does this mean for equities? It is one big macro event. The capacities are there – the policies are not. And the latter as it is with India is not an easy thing to fix. Especially going into the elections.
 
The asset class is almost in a low single digit to a negative return territory since early 2008. Unusual times but then if we step into the 90’s we can’t really say things were different. The macros today are more challenging. The economy is bigger and the problems larger. But from these spring smaller opportunities. And all good things start small.
 
India can export it way out of the problem or substitute imports to solve it foreign exchange crisis. Manufacturing may just kick start the capex cycle. As mentioned earlier a large part of the infrastructure assets are already on ground. Making them productive is the key challenge. Market capitalization will follow.
 
There is nothing broad based that can lead the environment. It’s picking up the survivors, the ones that are consolidating. It’s almost like starting from scratch. But it promises to be an exciting and a longer lasting cycle when it commences. In the last ten years – India has not thrown up any industrialist of any stature. It was easy liquidity that drove balance sheet creations. This time entrepreneurs do not have that luxury and their business models will and are already getting tested in these conditions.
 
Which means indices could be listless for sometime reflecting the broader macro environment. The currency cannot depreciate at the current pace forever. But it may be still vulnerable. As the economy slows foreign participation in equities will be cautious. Indian Investors will also tread cautiously as the bond markets offer lucrative fixed return products. This doesn’t seem to be any runaway market, but a gradual process of a buildup. Election can be the only spoilsport. The outcome could decide the trajectory of the economy either side.

 
 
Our Equity Portfolios
Consolidators, Cash Flow positive businesses and companies with low debt are what we have stuck with for the last couple of years. These have worked on a relative scale but have yet to deliver on an absolute basis for the last two year. We think where the markets and economy is positioned; our investing style should work for an absolute return over the next two years. The economy may not be in the best of shape but it’s time to pick the winners.
 
FY2007 and FY2008 it was difficult to find a company that made a loss. 2008 till date despite great corporate health, equities didn’t deliver return. Today there are a few with absolute positive cash flows. The rest of the companies are struggling and will repair themselves over the next few years. This is the cycle we will build our future portfolios on.
 
 

Disclaimer:

The Disclosures of opinions/in house views incorporated in this document is provided solely to enhance the transparency and should not be treated as endorsement of the views expressed in the report. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. The recipient should take this into account before interpreting the document. This report has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / Board of Trustee/ IDFC Asset Management Co. Pvt. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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Suyash Choudhary

After a 75 bps spike in 10 year government bond yields post first announcement of RBI’s liquidity tightening measures, there has been another similar move over the last 3 – 4 days. The intent of this communication is to explain the context of this last move, as well as market assessment over the near term. We will also use this opportunity to quickly reaffirm our medium term view.
 
 
What has happened over last few days?

We had noted in earlier communications that the RBI’s measures have to be seen as step 1 in a 2 step process. The RBI moved to kill speculation and dis-incentivize holding long dollar positions by substantially hiking carry cost of holding rupees. However, these measures by themselves were incomplete insofar as the bigger problem for the currency market is the lack of availability of dollars. Therefore, as step 2 in the currency defense process the government and RBI were expected to announce measures to ensure that the country gets near term supply of dollars. Had these steps been credible, they would have provided some relief to the rupee and triggered the market to start expecting a subsequent unwinding of RBI measures.
 
It is with respect to this step 2 that policy announcements have disappointed the market. It is true that the finance minister committed to compressing current account deficit to USD 70 billion this year (from USD 88 billion last year) and announced steps amounting to USD 11 billion worth of capital flows. However, most of the capital garnering measures pertain to additional bond issuances and external borrowings by PSU entities. There are two problems with these measures: One, these PSU entities have anyway been borrowing off-shore and to that extent the finance minister has not really outlined an additional step with respect to capital flows as far as this is concerned. Two, the market for off-shore borrowing is getting more challenged and there is deep suspicion on whether the quantum indicated can be mobilized in the foreseeable future. Additionally, the last set of measures announced by the RBI had briefly triggered fears of capital controls. While this was vehemently denied by authorities, a view that has sustained since then is that policymakers are truly scrapping the bottom of the barrel in their defense of the rupee. The other development co-incidental to market’s lukewarm response to policy measures has been a fresh round of weakness of Asian currencies versus the dollar and an accompanying rise in their bond yields. US treasury yields have also risen further over the past few sessions.
 
The spike in yields (and to some extent the rupee) over the past few days represents a break-down in market sentiment in response to what were perceived as largely inadequate measures for improving dollar supply. The trigger was strengthened due to a simultaneous weakness in emerging market currencies and bond yields.
 
 
What is the view over the near term?

The breakdown in sentiment over the past few days has substantially eroded appetite to take on new positions in the near term. In this environment, the market is fearing absorption of new supply over the next couple of weeks. As we have mentioned before, auction supply is heavy for the current month (net supply of INR 67,000 crs) which then subsides during September (supply in September is negative INR 5,000 crs). Given this, bond yields may remain under pressure in the near term if the RBI and government choose to issue the full auction supply to the market. However, given the speed at which yields are readjusting, it is possible that new sources of demand for government bonds also emerge for the supply that is due.
 
As a base case, investors should be prepared for continued volatility over the next few weeks. However, we would strongly recommend not reacting to this volatility.
 
 
What is the view over the medium term?

Bond yields currently are at levels seen in 2008. Repo rate at that time was at 9%, growth was averaging 9% plus and WPI inflation was beginning to print close to 11% readings (at that time there was no inkling that a global financial crisis will soon cause RBI to cut rates aggressively). At this juncture, repo rate is at 7.25%, growth may undershoot 5%, and WPI inflation will possibly average 5 – 6% this year. Hence, there can be little argument that bond valuations are standing out today in relation to RBI’s policy rate and India’s current growth-inflation mix.
 
As we have said on multiple occasions before, in our view there are 4 macro-economic triggers that define our situation today: 1> Growth versus inflation 2> Weak credit demand 3> External account vulnerabilities 4> Rising fiscal risks. The first 2 of these triggers are bullish whereas the last 2 are bearish. However, market has a tendency to focus on some of these triggers at a time to the exclusion of others. For instance, over May and June the first 2 triggers were dominant which caused a sharp rally in bonds and created views that called for much more. At this juncture, the exclusive focus is on external vulnerabilities. That is why despite growth triggers becoming even weaker and credit demand remaining very subdued, 10 year bond yields have shot up to more than 200 bps over repo rate. This, then, should be seen as a strong opportunity for medium term investors insofar as the market will sooner or later start focusing on the growth and credit triggers again. This will especially be true once the ‘temporary’ measures from RBI are lifted. In an environment of weak credit growth, this will induce banks to restart buying government bonds and take overnight funding from RBI against this position at 7.25%. Meanwhile, the biggest question would be: how long can these measures last? Admittedly, there is no clear answer with respect to the timeframe apart from an observation that already the cure is possibly proving to be more damaging than the disease. So even if currency stability remains the number one mandate with RBI, we would think that sooner rather than later the regulator will have to focus on the linkage that by killing growth expectation further it is hardly doing any service to the currency. However, even if there is no way to precisely make out how long the measures last, barring the near term volatility that gets created, medium term investors should focus on medium term triggers.So long as growth remains as anemic as it is today, it is hard to see a permanent reversal in monetary policy. If that be the case, in our view at current range of bond valuations investors are getting sufficient compensation for most macro-economic risks that one can see over the medium term.
 
 
What should investors do?

1. Current investors into bond funds should remain there, in our view. If the story is persuasive for new investors, it is equally so for existing ones irrespective of the losses suffered over the last 3 months.
2. Overall 2 way volatility will persist especially in the near term. Therefore, we would re-emphasize a point we have been making repeatedly over the last few months: risk appetite and investment horizon need to be matched closely with fund profile. Only investors desiring full participation even at the cost of bouts of large volatility should prefer income, dynamic and gilt funds. Others should choose more conservative medium and / or short term funds even if investment horizons are very long.

 
 

Disclaimer:

The Disclosures of opinions/in house views incorporated in this document is provided solely to enhance the transparency and should not be treated as endorsement of the views expressed in the report. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. The recipient should take this into account before interpreting the document. The recommendation provided herein may not be suitable for all investors and hence investors are requested to consult their investment/tax adviser before taking investment decision. This report has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / Board of Trustee/ IDFC Asset Management Co. Pvt. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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