Fed Impact on Indian Economy

Introduction:

The US Federal Reserve takes centre stage in the coming week, eclipsing industry data from China, another grim inflation reading from Euro Zone and rate decisions in Japan and Switzerland. An unexpected drop in the jobless rate to 5.1% and upward revision in

second quarter growth 3.7 % support calls for a hike as the labour market tightens and utilization is at its best level since the global financial crisis.

So, after seven long years, is it finally time for Janet Yellen to raise interest rates this week?

She is under immense pressure not to do so. The International Monetary Fund (IMF) has urged her not to raise rates, at least until next year. World Bank chief economist Kaushik Basu says a rate rise now could cause "panic and turmoil". The markets have had a nervous breakdown at the mere thought of a rate rise.

But there are voices on the other side, too. Peru's central bank governor has said most emerging markets want the Fed to raise rates as soon as possible to put an end to the uncertainty. And the most authoritative voice that has consistently asked for higher interest

rates is the Bank for International Settlements (BIS).Market participant have already priced .25% rate hike and confident of timing will not dampen long term bets.

Concerns for India:

The imminent worry with regards to hike in federal fund rate is 'carry trade', a process where investors try to leverage their position by borrowing in low interest currencies and investing in risky assets on global level. The moment there is hike in US interest rates; investors

will try to calibrate their holdings. This will trigger the process of disposing risky asset class which in turn will propel abrupt outflows leading to a temporary phase of mismatch in currency positions and currency depreciation. This 'dollar carry trade' is already under pressure as the dollar has appreciated almost 30 per cent since 2009-low. This means that borrowers will have to pay more of the local currencies to repay the dollar loan. Two, as interest rates start moving higher, the spreads will reduce, resulting in a rush to pay back these loans. This will involve selling assets purchased with the money.

At Global level, US dollar demand is eternal. With the interest rate hike in US, liquidity of US dollars will diminish. ECB's for Indian Companies will face pressures for repayments of principal and interest payments.

According to the Reserve Bank of India, external commercial borrowings towards end-March 2015 stood at $182 billion. This is up from $57 billion towards end-December 2007. The proportion of debt denominated in dollars has risen from 54 per cent in December 2007 to 59 per cent by December 2014. All this implies bad news for Indian companies as they will have higher outgo when they repay their loans or pay the interest, if dollar appreciates further. The higher cost of borrowings on future dollar loans will also impact operating margins.

If the European Central Bank and the Bank of Japan too begin raising rates in tandem, it will further make worse the growing cost of funding.

India, a Long Term Growth Story with Fundamentals intact:

On the brighter side, Indian economic growth story is likely to be on track after initial jerks as fundamentals outweigh interim global events.

*         Since the new government formation, international events are having a less of an impact as investors focus on government steps to revive the economy and the RBI moves based on macro data such as inflation, GDP growth rates, IIP etc. RBI Governor Raghuram Rajan is of the opinion that there would be some volatility in the emerging economies once the Fed decided to raise the interest rates, but India is equipped to deal with the volatility that comes with the raise. IMF Chairperson, Christine Lagarde too seconded RBI head. RBI Governor has sent a clear message that Indian central bank is pretty much done in devaluing the currency and its fiscal reform is the responsibility of PM Narendra Modi who is completely focused on making the country friendlier with international investments and this is feeding in the economic data.

*         India is a major importer of resources. The drop in global commodity prices will be a major benefit.

*     Exports as a percentage of GDP is low for India and exports to China are small.

*     The CAD and inflation are reducing dramatically which can help stabilize and strengthen the currency in medium term.

*    In comparison to EM's, Indian companies have actually outperformed over the last 12 months. If investors are looking for diversification, the low correlation between Indian stocks and other global markets should provide strong incentive. The economic situation is much better than it was 2-3 quarters ago. India has taken some of the major steps compared to its EM peers to control currency movement and increase foreign exchange reserves.

*   Indian growth story is backed up by multiple drivers. Economic growth in India is supported by strong demographics. India has a large middle-class population and age dependency ratio is expected to decline until 2040.

*      Inflation is subsiding and the CAD balance is improving due to lower oil and commodity prices. The adoption of formal inflation targeting by the RBI, government intervention in local markets to boost food supplies and sharp decline in oil and commodity prices have helped inflation under control.

*     CPI inflation index has moderated significantly from a high of 11.3% in November 2013. RBI has ample room to cut rates. Lowering of interest rates could reduce cost of capital to companies. There is a huge potential seen in cyclical recovery CAPEX cycle pickup.

*     As fiscal deficit is reducing, there can be a room to fund for infrastructure projects - if government is able to combat roadblocks 

*     On a totality basis, India is possibly the only market in the emerging market basket, where a 15 per cent to 20 per cent earnings growth is reasonable to expect and the economy recovery looks robust with GDP move from 5 per cent to 7.5 per cent in three to five years' time being almost a surety,

*       The market has already factored in a prospective 25 basis points rise by the Fed.

*      On rational grounds, money may not flow out of India so easily. From 2009 till now, the Sensex is up more than 200 % but the gain in dollar terms is just 116 per cent. Again, many of the listed stocks have delivered poor returns since 2008. An analysis of the change in market capitalization of various countries between 2008 and now in dollar terms shows that Indian market cap is down 11 per cent since January 2008. This is despite the Sensex trading 37 per cent above this level currently. The difference is largely explained by the

currency movement. According to this metric, US market capitalization has gained the most, up 38 per cent from January 2008. It is, therefore, likely that many global investors preferred US equity markets due to the better economic prospects and the sexy tech and social media stocks where possibility of heady gains were brighter. This renders US equity more vulnerable to a decline if de-leveraging begins.

*      Real estate regulations within India do not allow foreign investors to invest directly in realty, thus insulating this segment from the Fed monetary tightening. Foreign investors have invested in real estate, start-ups and unlisted companies through private equity and venture capital funds but these are long-term investors who are unlikely to churn their assets or face redemption pressure following a US interest rate hike.

*     Currently market share of private sector banks is 30%. In the next 10 years it is expected to increase to by 50% - it has potential to capture 60%. Private Banks are safer bet as compared to PSU's when it comes to combating NPA's. Off-late PSU's had a severe

hammering because of NPA's. Private sectors have done well when it comes to managing NPA's. RBI chief and Indian government are trying to decipher the mounting NPA's and way forward seem to initiate stern action classification of defaulters and tame the same within expected limits. Indian banking and financial industry is in most of vibrating stage capitalizing on digital banking initiatives, prudent risk controls and positive cost ratio. With increasing middle class, urbanization and infrastructure facilities, banks are now offering or

trying to outreach the most pocket area in India and thereby increasing customer and network base.

*       Indian IT Companies continue to gain global market share. They are growing faster than industry average while retaining a good level of profitability. Their key competitive advantages include high quality management, reputation with global clients and progress moving up with the value chain.

*     Capital spending is recovering from a cyclical low driven by an increase in government spending on infrastructure, projects announced in collaboration with foreign countries and private sector growth CAPEX.

*     The Indian Healthcare sector is benefiting from increase penetration of global market and growth of domestic market. Their key competitive advantage is lower cost of production in both generics and specialty products.

*     There is a positive view on corporate earnings way forward. The downgrade cycle may just stabilize and growth is likely to accelerate. With the increase in cyclical recovery, margin expansion could resume.

*    In a research published in a leading daily, the greenback soared nearly 178% and Indian stock market skyrocketed nearly 1100 %. So greenback seems to be working for Indian market. 

Please refer details below.

1982-2000 - Greenback Phase

Greenback

Stock Market

Job creation

178%

1099%

40 Million

 2001-2011 - Decline in Dollar

 Job Creation

 GDP Growth

 23 Million

 Averaged 2% as compared to boom high of 3.5%

With this, I wish you all to stay invested as India Incorporation is gearing up for a rewarding journey (after initial turbulences) in the next global economic phase to commence.

Happy Investing.

Note: Above Article is Contributed By Our Active Member CA.Falgun Shah.