Measures announced are too generic and far-fetched
The rupee rallied sharply over the week-end after a touching a low of 72.91/$ to close at around 71.85/$. Even the 10-year bond yield tapered on expectation that the weekend package to revive the rupee would do away with the need to hike rates for the RBI. But the package announced by Arun Jaitley, was patchy and slightly utopian in nature. First let us look at the highlights of the package.
What the package does?
The so-called rupee package announced by Arun Jaitley is rather long on intent but fairly short on delivery. Firstly, the package will review the mandatory hedging condition for infrastructure loans. The package will also allow the manufacturing companies to access the ECB market up to $50 million with a 1 year maturity rather than a 3 year maturity. This concession could be a ticking problem for the markets and in the event of any sharp fall in the rupee it will only lead to a rush to cover. Effectively, it will only exacerbate the problem that it was intended to resolve. The package will only remove the limit of 20% of FPIs to bonds of a single business group. This is unlikely to give a boost considering that FPIs have their own internal checks and balances. Lastly, the package tries to boost the Masala Bond market by exempting from withholding tax. Masala bonds are rupee bonds and they will be in demand only if the INR is strong and stable. Also the challenge of group funding remains.
What about the NRI package?
The rupee falling by 14% since the beginning of the year is not a normal event. It is clear that the INR is under tremendous pressure after the trade deficit and the CAD have reached levels of discomfort. What was expected by the market was a clear signal to NRIs to invest in India via a special deposit scheme. What India requires at the current juncture is a quantum push to dollar inflows and not some stop gap measures. The rupee is unlikely to get any relief out of these moves. Like in 2013, in the midst of a currency crisis, the government should have gone ahead and announcement a special NRI deposit scheme at an attractive rate. That would have immediately stemmed the fall in the INR.
What if CAD touches 3%?
The big challenge for the government is the CAD touching the psychological mark of 3%, which could most likely happen in the second half of the year. That would put pressure on the INR and also on the external ratings. With oil prices likely to stay buoyant, the oil import bill will not see any let-up. Add to that, if the US Fed again hikes rates in September then we could see another bout of risk-off flows. The measures announced may at best be a sentiment booster for the INR. With limited leeway for the RBI to intervene, these measures may be too half-hearted!
IL&FS Fiasco
Has India once again been caught napping?
When IL&FS defaulted on its ICD with SIDBI for the second time on Friday, the alarm bells surely started ringing. In fact the warnings were already out when IL&FS first defaulted on its ICD to SIDBI a couple of weeks ago. That was the time most of the credit rating agencies rushed to downgrade IL&FS debt to Junk category. But that has only exacerbated matters as most of the bond holders are now sitting on huge losses on their books. But, what exactly is this IL&FS fiasco?
How IL&FS got here?
The problems at IL&FS first came to light when analysts started questioning the ability of IL&FS to service the $500 million of debt that was payable in the next few months. IL&FS only had liquidity of around $27 million leaving it with a huge shortfall of close to $473 million. That was the time the problem first came to light. The SIDBI default was the trigger that set of a series of downgrades. But IL&FS has financed assets against these loans, so what is the problem. That is exactly the problem. Most of IL&FS assets are locked up in road assets or toll assets which are illiquid and cannot be monetized easily. Also, finding ready buyers would come at a huge cost in the form of haircuts. With the recent downgrade, IL&FS is unlikely to get funding from any of the institutions. The question is whether we could see another implosion in India?
Why IL&FS really matters
The problem with IL&FS is that it is not any other company. It is deep in debt and most of the funds are deployed in deep infrastructure assets with limited short term visibility. IL&FS is not a deposit taking company but funds itself through institutional money. The ripple effect could be huge. It has issued bonds to the tune of $12.5 billion and its buyers include insurance companies, provident funds and domestic mutual funds. In addition, the LIC has a 25% stake in the company and that also makes the company systemically important. How the situation is remedied remains to be seen even as IL&FS has put its BKC headquarters on the block. But then, there are bigger questions that come up here.
Where were the gatekeepers?
The question is back to the basics; where were the gatekeepers in this case? The auditors were obviously caught napping with little to offer by way of explanation. What were the rating agencies doing since all the debt is rated by the agencies? Lastly, why did the lenders and bankers not flag off the issue to the RBI and why were no such points found in the routine scrutiny that is conducted of systemically important intermediaries? If this company is allowed to crumble, it could be India’s Lehman moment. India surely cannot afford such an eventuality!
Inflation tapers
But will it change RBI’s interest rate strategy?
Retail inflation as measured by the CPI inflation tapered to 3.69% for the month of August. That is a 10-month low and that is the good news. But will it really change the outlook of the RBI with respect to interest rates and is it an assurance that rates will not be hiked from the current levels?
Inflation is not yet in control…
The fall in CPI inflation, combined with a fall in WPI inflation, indicates that the base effect is becoming favorable for India. But that is not great consolation. Firstly, the CPI inflation was driven down by food prices and we are yet to see the impact of 150% assured MSP. Secondly, fuel inflation continues to be sticky with global crude oil prices hovering around the $80 mark. Iran sanctions will only make it worse. Lastly, Kharif data is yet to come out and any shortfall in the overall output will also put pressure on CPI inflation.
It is more about INR and flows
The reason the RBI actually hiked rates in the last two monetary policies was less due to inflation and more due to the weakening rupee. Even after the second hike in August, the rupee has fallen close to the 73/$ mark. That means the RBI will have to keep its options of another couple of rate hikes entirely open. More importantly, it will also be about flows and the US rates trajectory. If the US Fed hikes rates by another 25 bps in September, then the RBI may have to follow suit in October to prevent any risk-off flows out of India. The INR has lost nearly 14% since the beginning of the year so the 50 bps rate hike since June only compensates for the weakening of the rupee. That equation could change if the US Fed hikes rates or gives a hawkish view. The moral of the story is that rupee may matter more than inflation as RBI reviews rates!
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