If some market players have more information than others, that affects prices. If, in addition, a lot of money is concentrated in a few hands, the market structure gets skewed. Unfortunately, both conditions are true to some degree for most markets. Usually, the parties with deeper pockets also have greater access to crucial information.
This is especially true in India. The non-transparent, arbitrary policy-making process creates a powerful self-reinforcing cycle. Somebody with money can gain access to the corridors of power, and somebody with access to the corridors of power can make money off that access.
If an investor has neither money nor access, he must start guessing what the big boys will do. The policy decisions may be theoretically “right” or “wrong” but the smaller players just have to adjust their strategies to go along.
Let’s narrow things down to one specific area: interest rate policy over the next 6-12 months. Interest rates are the single-most crucial variable for any investor. All returns have to be benchmarked to interest rates, and all interest rates have to be benchmarked to a risk-free rate of return. What is more, interest rates affect currency rates directly.
RBI’s philosophy
Indian policy-makers have a simple philosophy regarding interest rates. Inflation is politically sensitive — it affects voting patterns. Whenever inflation hits a certain level, the Reserve Bank of India (RBI) raises interest rates. Once it starts raising rates, it continues to hike until inflation falls back to acceptable limits.
Personally I think this is wrong. Inflation in India has two key components. One is absolutely outside political control. This is the cost of energy, which varies with the global price of crude, gas and coal. If international prices rise, inflation will rise.
The other key component is the price of staple food items. Fixing the supply-demand imbalances in food would require very radical reforms in the agricultural sector, big investments in irrigation, and a total overhaul of the food procurement system. This is so politically sensitive, it will never happen. Instead there will be subsidies and support programmes, which are all subject to huge leakages. No government minds leakages for fairly obvious reasons!
Thus, the key factors driving inflation are unaffected by interest-rate changes. But in order to be seen as doing something, the central bank raises rates if inflation is high. The RBI has hiked through the past two years, more or less. The hikes started in February 2010, and RBI stopped hiking in December 2011. But it did not lower rates.
Rate hikes bite
Through the first part of that period, the economy was booming and rate hikes were absorbed with only mild complaints. In 2011, as the global economy went into a tailspin and India’s growth slowed drastically, the negative effects of continuous hikes became more obvious.
Interest payments cut sharply into profit margins. Expansion plans, and especially infrastructure projects, stalled as loans became more expensive. Banks saw rising NPA levels. There were more requests for corporate debt restructuring (CDR).
The Q2FY12 results saw quite a few corporates reporting losses, while CDR requests hit an all-time high. Many nominally profitable corporates also saw return on capital employed (RoCE) drop below the yield on government debt. If you can buy zero-risk treasury bills at a yield of 8.5 per cent, why take the risks of running a business that earns an ROCE of only 7.5 per cent?
Tough act
On January 24, before you read this, the RBI may have started to cut rates. Or it may not. Even if it does cut rates, we have to guess if it’s a one-time move or a policy reversal. Here are some of the things the RBI will have to consider.
The government of India (GoI) has its own borrowing programme, which it would like to fund as cheaply as possible. The GoI’s borrowing needs will grow in a year when tax revenues aren’t buoyant and there’s a huge fiscal deficit. That makes a case for cutting interest rates.
External debt is high — it’s somewhat higher than accumulated forex reserves at the moment. This is uncomfortable since the trade balance is also negative. Quite a large proportion of forex reserves consists of hot money (portfolio investments by FIIs and hedge funds, NRI deposits) that could exit in a day.
So the GoI would like to attract more forex inflows. One way to do so is to keep a large differential between rupee interest rates and hard-currency interest rates. If the RBI cuts rates, the differential narrows.
On the other hand, if foreign investors feel that rates are too high and are affecting corporate growth, they might abandon rupee equity exposure, causing more currency-related pressure. The RBI also has to measure the impact on currency rates. The rupee declined 22 per cent last year.
One large component of external debt is commercial borrowings by Indian industry. By the end of the first half of FY12, this stood at around 30 per cent of all external debt. Quite a lot of those borrowings will have to refinanced by rupee borrowings in FY13. Many of India’s largest companies will take an enormous hit. They will have to repay USD-denominated loans by borrowing devalued rupees at a much higher interest rate. They want rate cuts — and they have access to the corridors of power.
So, does the RBI bail out the GoI balance-sheet, offer relief to the banking system and enable India Inc. by starting a cycle of rate cuts? Or does it pay heed to the fact that inflation is still pretty high, and rate cuts might accelerate a trend of rising prices? After all, inflation will have an impact on key assembly elections through 2012 and political considerations may trump economic.
As of now, nobody is expecting a major rate cut in January. Most consensus estimates seem to be that the RBI will, at best, make a symbolic 0.25 per cent cut in January. Will it follow-through with further cuts? If it does, the stock market in general, and financials in particular, would have reason to rally. However, rates would have to drop at least 1-1.25 per cent (four or five cuts) before there is confidence that the RBI has reversed the rate cycle.
The big money valued the 10-year GoI bond at 8.22 per cent in the most recent auction, down from 9 per cent in November. That is a signal that interest-rate policy may indeed be due for reversal. If you think the policy is reversing, consider going overweight on financials.
This article was originally published on February 11, 2012.
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