Money that has flowed into the Indian stock markets over the last few months, and more particularly over the last few weeks has origins which India as a nation has neither any clue about nor any control on. But, at the same time, the Reserve Bank of India (RBI) has had to scramble around in the forex markets to keep the Rupee from wildly appreciating thanks to these huge inflows. On the flip side, it added to the domestic money supply that spurs inflationary tendencies (look at the Consumer Price Index if not the cost of fruits and veggies in the open markets). To stem inflation, domestic interest rates had to be higher which is slowly strangling the domestic economy. While all this is happening in India, the original anonymous operator is sitting pretty overseas getting fatter margins as his call on the currency is further validated by the Rupee strengthening.
The Securities and Exchange Board of India (SEBI) discussion paper on Offshore Derivate Instruments (ODI, also popularly called participatory notes or its diminutive 'p-notes') is yet another committee making its recommendations on a subject on which others have been doggedly asking for some sense to prevail. The Reserve Bank of India and the R. H. Patil Committee among many others have been open in their uneasiness about the flow of money into India that cannot be traced back to particular firms or individuals.
The numbers are mind-boggling
Among the 1,056 (as on July 2007) Foreign Institutional Investors (FIIs) registered with the SEBI, just a handful few, 34 FIIs/sub accounts to be exact, have issued these p-notes.
- Notional value of p-notes outstanding as a percent of Assets Under Custody (AUC) has more than doubled from 20% in March 2004 to 52% by August 2007 - Of the total AUC of all the registered FIIs that numbers US$ 172 bn (marked to market), about 52% or US$ 89 bn has flowed in through the p-note route as of August 2007.
Almost 30% of the total p-notes issued (US$ 30 bn) are derivatives based.
The SEBI paper has asked the Ministry of Finance to:
- Ban derivative-based p-notes completely while giving eighteen months to wind down existing issuance.
Has asked it to disallow FIIs from issuing p-notes through sub accounts with immediate effect.
FIIs, whose p-note issuance has already exceeded 40% of their AUC, should stop issuing p-notes of all kinds altogether. Those who are yet to reach the 40% limit can issue p-notes only up to 5% of their incremental assets.
Impact on the economy
The RBI has purchased US$ 12 bn of inflows in the five weeks beginning September 2007. This added Rs 4,818 bn or 14% to the money supply. Since then, the total FII purchases in the stock markets have released another Rs 215 bn into the Indian system. With a majority of the inflows coming in through the p-note route, if the recommendations are taken seriously, we should see FII inflows reducing to levels manageable for the economy.
Frankly speaking India's image will not tarnish if the punters are kept away. If anything, the kudos that the RBI has won for its monetary policy from the MD of the International Monetary Fund, Mr. Rodrigo de Rato, will be spread to the Ministry of Finance too. The loss of face in diplomatic circles thanks to the nuclear deal fiasco of the UPA government will be glossed over by its tough and correct economic stance if it flows these recommendations. And we see no party opposing these. With retail participation in the Indian stock markets at an all time low of 10% of market capitalization (as at the end of June 2007), any re-rating following the flight of the p-note money will at least allow Indians to participate in their own country's rags to riches story.
The most visible and immediate impact will be on the exchange rate. We have always maintained that with a yawning current account deficit of 2% of GDP, the Indian Rupee is not intrinsically strong yet. We hold on to our existing view of 7% to 8% depreciation in the Rupee's value from here onwards especially as the crude oil prices keep testing the skies. The impact on money supply and interest rates will be more gradual and should take at least six months to filter through. There will be further increase in the pressure on domestic petroleum product prices with crude oil imports becoming a tad more expensive.
What to expect?
Well, you would have been an underperformer since the BSE-Sensex took off from 13,800 till its journey to 19,000, if you have not been into the Reliance pack of stocks. These stocks, which have accounted for nearly 23% of the total turnover in the last 7 trading days, seem to have evoked much interest owing to some sudden reasons (which experts give) like "being undervalued", "unlocking value" and "having tremendous growth potenial." Well, all that is fine. But what makes a stock from an old economy sector like power deliver almost 4 times in a span of less than 3 months? The company is merely "talking" about its 10-year plans and people have sort of factored in everything to be executed successfully!
Anyways, moving on from the "R" sector to some of the other ones like pharma, technology and hospitality, which have not really performed during this period, largely due to one micro factor that impacts their financial performance – the Rupee's appreciation against the US dollar. Nothing else seems to have changed for companies from these sectors. For technology, it is not really the rupee's appreciation against the US dollar but the pace of it is what seems to have unnerved investors.
As a matter of fact, the rupee appreciated from Rs 49 to a dollar in 2002 to Rs 43 to a dollar in 2006 but that appreciation was much more anticipated and companies were prepared to deal with it. But the appreciation from Rs 43 to Rs under Rs 40 has been faster than anticipated. Apart from this, nothing much has changed for these companies in terms of business fundamentals – volumes continue to rise and pricing environment remains stable with an upward bias. There seems to be no reason for investors to worry about the performance of these companies over a 3 to 5 years period and we remain positive on their stock performance for a similar time frame.
As for the pharma sector, we believe that the pressure on the governments across the world to reduce healthcare costs, the rise in the aged population in the developed markets and the increase in the number of drugs going off patent are the cornerstones of the India generics story. Pricing pressure due to rising competition is expected to continue and we believe that this concern has already been factored in the stock prices.
Some other sectors where we maintain our long-term positive stance are hospitality and FMCG, where increased consumption and higher levels of discretionary spending will aid the growth process. We, however, remain concerned on valuations of stocks from sectors like power, realty and capital goods. Though we like selective stocks from each of these sectors, the overall view is that of caution.
On an overall basis, what you, as an investor, can do is take this market volatility as a way to build a long-term portfolio of solid companies with credible managements. Try not following a herd mentality into buying anything that others are 'relying' on. Rather make your choice by way of doing your own groundwork, follow the same with conviction and discipline, and leave aside greed and fear. There is probably no other way of generating wealth from stock market investing. In the meanwhile, we shall continue to wonder if we are getting too arrogant about the sustainability of the 'India story'!