What should Rajan do if US interest rates rise? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

What should Rajan do if US interest rates rise? 

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In this issue:
» Which is the world's Riskiest stock market?
» Will future disinvestment happen through this route?
» Will China back down on reforms?
» What does the failure of Abenomics tell about the global economy?
» and more....

Last week, all eyes were on the new US Federal Reserve chairwomen Janet Yellen, as she addressed her first press conference since taking over the role. As lieutenant to Bernanke, Yellen was a leading proponent of easier monetary policy, arguing forcefully that the central bank needed to do more to spur economic growth and bring down employment. As a result she was labeled as a dove.

A dove is someone who cares more about lowering unemployment than heading off potential inflation, and so is more likely to keep interest rates low to spur economic activity. A hawk is the opposite - a policymaker more inclined to raise rates sooner because of the fear of inflation.

The fact that Yellen kept tapering amid a slightly less rosy economic outlook and the ongoing disappointment in the economic data didn't exactly comfort the world markets. And finally, during her press conference, she let it slip that she expects the first short-term interest rate hike to come in the early part of 2015 -- sooner than the market had anticipated. As it turns out, however, Yellen is hardly the dove she is made out to be. She seems downright hawkish.

So what does this hawkish tone from the Fed chief mean for India? What should the RBI do to protect India's interest? India has been stable in the period of the actual taper, as a large part of the correction in the exchange rate took place after Ben Bernanke's taper speech. Since tapering began in mid-December, India has in fact received US $10.5 bn in new foreign institutional investment (FII) money. This has helped the rupee strengthen, bonds rally and the Sensex scale new highs. But any spike in US interest rates can quickly jolt India.

When US interest rates rise, investors will move capital back to the US and sell developing countries currencies. This will lead to Rupee depreciation. Hence the RBI must focus on keeping inflation low and stable. They also need to keep the current account deficit under control. It has been seen that countries with low fiscal deficits, current account deficits and inflation rates have been more stable in the time of the taper. India should focus on these fundamentals. This will ensure that, one, there is little pressure on the rupee, and two, even if there is pressure, India does not react in a knee-jerk manner with capital controls and restrictions on financial markets, as it did last time.

Thus the RBI governor may not be in a hurry to lower interest rates any time soon. As a result, companies in India might have to live with relatively higher interest rates until overall macroeconomic scenario improves. Companies with unreasonably high leverage ratios therefore cannot be a safe investment bet. Those who do not have high debt on their books are anyways not affected by movement in interest rates.

Do you think the RBI should change its stance on interest rates? Let us know in the Equitymaster Club or share your comments below.

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01:20  Chart of the day
The Fast Moving Consumer Goods (FMCG) Industry has been hit by slowdown in discretionary spending in 2013. As per Research agency, Nielsen, the FMCG industry posted a poor 1% rise in offtake in FY13. However in terms of value, FMCG sales grew by 9% backed by price-hikes by companies to counter inflation. In such a tough environment where FMCG companies have also invested heavily behind brands or promotional offers and price cuts to boost volumes, they have consciously gone slow on new product launches to keep expenses under control. According to research firm IMRB, growth in new launches in the FMCG space slowed down to 5% in 2013 from 35% in 2012. However, companies expect to step up new launches going ahead as input prices stabilize and consumer sentiment improves post elections. Even the study of the quarterly performance indicates that the worst may already be behind us. Reversal in sliding volumes in the December 2013 quarter bears testimony to this fact. Even a low base effect may enable a further recovery in offtake growth in 2014. But with price-hikes taken earlier, value-led growth may be limited during the year.

Will FMCG volume growth revive in 2014?

When asked to explain his phenomenal success, Warren Buffett is often seen crediting the US economic system. He argues that US may not have the most intelligent people on the planet but they have a system that is inferior to none. And therefore Buffett calls himself lucky to be born in the US. This more than anything underlines the importance of investing in an environment where the dice is not loaded against you. For if the system itself is against you, no amount of stock picking skills could perhaps help.

This thought occurred to us courtesy a news item in a leading daily. It highlights how the Russian stock market has now become amongst the world's cheapest. Fears that the Crimean crisis could further escalate have had the investors running for cover. As a result, Russian stocks that were already cheap before the crisis, fell even further and are now trading at valuation that has only Greece ahead of it in terms of attractiveness.

Is this music to the ears of value investors? We don't think so. Investing based solely on statistical cheapness could be a recipe for disaster we believe. Qualitative factors which give us an idea about how the economic system works in Russia need to be thoroughly studied as per us. And only then should one arrive at some sort of conclusion. Otherwise there's a high risk that the so called value proposition could turn into a value trap.

A string of stake sales announced by the government in recent times had received a poor response from the investing community. As a result of which the government was woefully short of its disinvestment target. But disinvestment was important to the government because it was struggling under the burden of a high fiscal deficit. And so it came up with an innovative idea of selling shares of public sector companies by creating an exchange-traded fund (ETF). This has so far turned out to be a success The Rs.3,000-crore issue has been oversubscribed by 1.3-1.4 times.

According to Mint, one of the reasons why this ETF has done well is because the demand for shares of public sector companies has increased. This is not because the current government has done anything different. Indeed, most of these companies continue to grapple with infrastructure issues, slow process of getting clearances, projects getting stalled among others. But there are hopes that once the new government comes into power this May, all these issues will be addressed. And this would thereby bolster growth of public sector companies. Whether this will actually turn out to be the case remains to be seen. But it will be interesting to see whether any innovations in the disinvestment process will become the norm in the coming months.

Where is the global economy headed? Is there a durable recovery underway? Or are we staring into another major global crisis? Let's consider the case of Japan. The big QE gamble that Ben Bernanke undertook in the US, Japanese Prime Minister Shinzo Abe has repeated in Japan.

So Abenomics, as it is generally referred to, was about attempting to revive the economy my initiating a massive monetary stimulus coupled with fiscal incentives as well. The aim was to cause the value of the yen to drop and in turn give a boost to exports. This was expected to boost domestic job production and consumption.

This was a grand gamble to engineer a virtuous economic cycle. Has the stimulus package really worked? Not at all... In fact, it has significantly increased Japan's sovereign debt which is going to be very difficult to service. It could even push it to the brink of insolvency. The other economic indicators in Japan are also not encouraging. We had recently pointed how the misery index in Japan is set to shoot up to a 33-year high in the three months starting April when Japan increases it sales levy to 8% from 5%. Even the cost of living in Japan has shot up to a five-year high. If the so-called economic recovery is on such fragile grounds in Japan, it wouldn't be too difficult to extrapolate the state of the other such economies.

China is in news again for not so good reasons. With the recent release of economic data, the slowdown concerns regarding China have come to the forefront. The weakness in the real estate market and factory sector suggest that China may not be able to meet its growth target of 7.5% for the year.

Will China resort to quick fixes like cheap credit as it has been doing in the past? As per an article in CNN Money, China has realized that while the cheap credit can boost economy, the result comes at huge costs. The recent reforms like a crackdown on shadow banking are some of the corrective steps that China has taken to limit the ill effects of cheap credit. But amid this realization, if policymakers start taking focus away from the GDP growth, some of the key reforms might be put on hold. This will make things worse for not only China, but the global economy in the long run.

In the meanwhile, stock markets in India traded firm with the benchmark index, the BSE-Sensex trading well above the dotted line. At the time of writing, the index was up by about 290 points or 1.33%. Stocks from the banking, oil & gas and capital goods spaces were amongst the top performers, while those from the information technology and healthcare spaces were out of favour today. Stock markets in other Asian countries ended the day on a firm note with China, Japan and Hong Kong up by about 0.9%, 1.8% and 1.9% respectively. European stocks however started the day on a weak note.

04:56  Today's investing mantra
"All the math you need in the stock market you get in the fourth grade." - Peter Lynch
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1 Responses to "What should Rajan do if US interest rates rise?"


Mar 25, 2014

High inflation is making the life of lower and poor class miserable. Therefore controlling inflation should be the priority.As such there is no point to lower intt. rates unless inflation is tamed.

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