India - Bearing the brunt of the outflows
The long term fundamental macro story of increasing consumption and attractive demographics for India may still hold true, but in the short term, the proverbial Indian dream seems to be turning into a nightmare. The dramatic slide of the Rupee in recent times has tested the patience of the most ardent of Indophiles.
As Praveen Jagwani, Managing Director of UTI International says with frustration: “Virtually every investment option in India is on hold. Foreign investors who invested in India during the past five years have had their returns and principal eroded by the currency and there seems to be no bottom in sight for the rupee.”
India’s ‘trilemma’ Investors may be hoping that Raghuram Rajan, the former IMF chief economist, who has been appointed as Governor of the Reserve Bank of India, may be able to find a solution to the “trilemma” that India faces that any economy cannot simultaneously maintain a) fixed exchange rates, b) independent monetary policy, and c) capital movements, but as one wag put it, “great jockey, shame about the horse!”
“It is sad to see India unravelling just when it should have been getting its act together to counterbalance the slowdown in industrialized nations. Unfortunately, this is occurring just at a cyclical low point for emerging markets,” says Jagwani. For the short term at least, India’s focus is clearly on damage limitation.
Fed Chairman Bernanke’s comments on tapering of Quantitative Easing in May led to a general flight from emerging markets at a particularly inauspicious time for India and led to the rupee plunging over 12% against the US dollar during the next three or so months.
The RBI may have felt it had no choice but to react to a crisis, but the RBI’s currency intervention has been at tremendous cost and Jagwani argues that until the central bank recovers the dollars it spent stabilizing the rupee, things will look uncertain: “The RBI spent close to $75bn in the last 5 years buying rupees but evidently it was not enough. India’s dollar reserves are now (as at August 2013) only sufficient to cover seven months of imports. In the past, the world has looked kindly upon India when it had 8-10 months worth of import cover. So the RBI needs to buy dollars to shore up the reserves, but it faces the Catch-22 situation that this would put further pressure on the rupee.”
Conserving dollars What India is doing, explains Jagwani, is attempting to conserve dollars in various ways. It is buying oil from Iran and paying in rupees whilst some quasi sovereign entities are raising dollar bonds and India is increasing duty on gold.
Many would argue that any attempt to control the exchange rate is foolhardy in any case: “The damage caused by waging war on the rupee dwarfs the near-zero impact that was obtained,” argues Ajah Shah, a Professor at India’s National Institute for Public Finance and Policy. He adds: “In 2013, rupee fluctuations were not odd. There has been a 12% rupee depreciation. Roughly half of this is simply about fluctuations of the dollar, euro and yen. An India-specific component of six percentage points in this year is in line with high inflation in India and weakening conditions in politics and the economy. When compared with other emerging markets, the rupee is roughly in the middle of the pack. The data does not show `free fall’ or `speculative froth’. The rupee has done many such moves before.”
But the problem that India faces, points out Jagwani, is that with no definitive measures to control the Current Account Deficit in place, India faces the risk of an unrestrained slide in the currency: “International investors at this moment are seeking a restoration of confidence.”
The new RBI Governor The appointment of Rajan is certainly a positive step. He led a committee that produced the 2009 report “A Hundred Small Steps” on reforming India’s financial system. As its name implies, the report argues for many changes which, to anyone resident in a developed free market, would see both as natural and sensible. This encompassed liberalisation of markets including steadily opening up investment in the rupee corporate and government bond markets to foreign investors after a clear monetary policy framework is in place.
The RBI should have a focus purely on ensuring inflation is kept within a narrow bound and capital controls would be relaxed to enable domestic institutions to invest abroad: “His report advocated what is generally seen as common sense and is general knowledge” says Jagwani, but as he adds: “The difficulty is implementation.” As India substantially tightened its capital controls in August, dramatically restricting Indian corporates and individuals from investing abroad, the gap between Rajan’s recommendations and their likely implementation seems to be widening.
India is the world’s largest democracy, while the US is the world’s most powerful democracy. Unfortunately for themselves and the world at large, what they both also have in common in their political environment is complete impasse.
“In India, the Government does not have the majority to pass legislation, whilst the opposition is only interested in ‘Opposing’ everything”. The gridlock in New Delhi is setting the country back by years” says Jagwani. Some countries, Italy being a good example, have thrived for years with governments in continuous turmoil. What they do have is effective institutions, both public sector and private sector that enable the country to function well, even when strong government may be lacking.
Loss of optimism India today, is immeasurably better than two decades ago. But it still has far to go. As Shah remarks, there is a remarkable loss of optimism in India today: “For investment to take place, private decision makers have to feel confident on long time horizons. All too often, a bad faith principle is afoot: the private sector assumes that the government will do harmful things in the future. Addressing this requires deeper reform of laws and public bodies, around three key principles: restrict government meddling to market failures, the rule of law, and accountability of government agencies.”
India has not shaken off its post-Independence central planning mindset and as a result, as Shah argues, Government ends up meddling in the economy with unchecked powers: “This meddling is creating acute political risk, and is entirely inappropriate for a mature market economy. We need to refocus government upon identifying and addressing market failures. Every proposal to meddle in the economy should satisfy this test: What’s the market failure and how do you think this intervention will address it?”
Foreign direct investment requires a solid basis of law that ensures that foreign companies can operate and invest with certainty. Moves such as India’s attempts in 2012 to claim capital gains tax retrospectively are counterproductive as they deter future investment by firms who worry that the legal environment they operate in will be changed retrospectively.
Shah also argues the RBI’s recent actions attacking currency exchanges were primarily about grabbing turf at the expense of the rival authority, the Securities and Exchange Board of India (SEBI): “RBI is able to do such things as nobody knows what RBI is supposed to do and there is no mechanism for holding RBI accountable.”
India is heading to a general election next May, so little movement can be expected in terms of political initiatives before then. Local current bond investors have already seen currency depreciation wipe out any interest rate advantages: “From our perspective, the probability of further interest rate cuts has reduced. Thus investors in Indian fixed income will continue to earn higher interest rates for a little longer. However the downside for such investors, as we have seen, has been the depreciating rupee” says Jagwani.
HSBC Global Asset Management in an August note argues that valuations of Indian stocks are now turning attractive, especially in some cyclical sectors. The Indian market has a high return on equity and they argue it has discounted a high level of risk: “Any concrete progress on structural reforms to boost long-term growth prospects and on fiscal consolidation could be a medium-term fundamental catalyst for the markets, and provide opportunities in related sectors (e.g. energy and utilities).”
But structural reforms although much talked about, have proved to be frustratingly slow in practice to implement. The insurance sector was opened up to foreign investment almost 20 years ago when foreign firms were able to have up to an initial 26% of an Indian joint venture with the expectation that this figure would be increased to majority control within a short time. That figure has not budged despite the years of reform. Indeed, some suspect that political parties would need to see kickbacks to them before allowing any legislation to pass through.
Rajan’s appointment to the RBI does appear to be something to celebrate for potential foreign investors to India but it remains to be seen if he will have the freedom to give policy expression to his views. The long term strength of the rupee will ultimately depend on the success of structural reforms to the economy that requires some degree of political consensus. India may be an investment destination that cannot be ignored indefinitely, but for many investors, it may now be on hold till at least next year.