Saurabh Mukherjea

Over the last six quarters GDP growth in India has fallen continuously. As of Q1FY18, growth fell to 5.7 percent. This has led to mounting discontent as evidenced by the September 27, 2017 piece by former NDA Finance Minister Yashwant Sinha in the Indian Express.

Given the Government’s response in expediting action on policy concerns in the wake of falling economic growth (multiple pullbacks in the GST regime, banking recap, MSP hikes), it would not be unfair to say the NDA is at present a reactive administration.

The above pattern of events is leading investors to believe there is a Modi put in play; i.e. when GDP growth slows down, the NDA will go into overdrive mode to reflate the economy.

Given India’s sliding economic growth and weak earnings per share (EPS) growth (Sensex EPS growth has been in single digits for the last four years), the Modi put is as good an explanation as any for the Sensex’s surreal valuation of 24x trailing earnings, two standard deviations above its long term average.

The sequence of events which has transpired in India over the past couple of years is reminiscent of what happened in America in the decade running up to the Lehman crisis when the US markets believed there was a Greenspan put in play; i.e. whenever it looked as if the US markets were facing a challenge (e.g. the LTCM crisis in 1998, the aftermath of 9/11), Greenspan would come to the rescue with monetary easing.

These interventions by the US Fed emboldened investors to take increasingly risky long bets in the US stock and bond markets until that party ended in 2008. So, can PM Modi underwrite returns for Indian equity investors?

The challenge: The trilemma

Macroeconomic theory says it is impossible for an economy to have all three of the following at the same time:

1. A fixed foreign exchange rate2. Free capital movement, and

3. Independent monetary policy

In India’s case, if the RBI wants to keep the INR at around the Rs 65/US dollar-mark, and if the country wants to continue to have free capital movement then the RBI has to reconcile itself to losing control of monetary policy.

In the current context it means that were economic growth to stay weak, it is unlikely the RBI can support a recovery through rate cuts given that India’s current account deficit is running at around 2 percent of GDP.

Hence, India needs capital inflows of around 2 percent of GDP to keep the INR stable.

Exhibit 1: The INR depreciates when Balance of Payments (current + capital account) is negative

In fact, where things could get tricky for India – and where the trilemma could come to the fore – is if:

(a) Global commodity prices keep rising:

Crude oil, petroleum gas, and copper are India’s largest imports. They account for 37 percent of India’s import of goods. While the price of oil has risen by 13 percent per annum over the last two years to USD 61 a barrel (as of October 31, 2017), copper has risen 16 percent per annum in the past two years.

This has had a direct impact on the current account deficit, which has widened (see exhibit below). If this trend continues, India will have a problem on its hands as the RBI might have to tighten monetary policy even with a weak economic backdrop in India.

Exhibit 2: Rising oil prices worsen India’s current account deficit (CAD) as evinced by the episode spanning CY09-CY13 and the CY07 episode

(b) Inflation rises:

Inflation in India usually picks up in the run-up to General Elections. In specific, a historical analysis of inflation cycles in India suggests the average inflation tends to be higher in the last two years leading up to a General Election (GE).

For instance, average CPI inflation was higher by 80 basis points (bps) in the last two years leading up to a GE in the case of the last 5 election cycles.

Such a rise in CPI inflation would not only forestall further rate cuts from the RBI, it would also push up bond yields and thus, increase the cost of capital (against the backdrop of a sluggish economy).

Since inflation erodes the value of the currency, rising inflation would also trigger capital outflows thus putting pressure on the INR.

(c) Global liquidity tightening:

The US Fed has hiked rates three times since late 2016 and seems all set to hike one more before the end of 2017. On November 3, 2017, the Bank of England raised rates for the first time in a decade by a quarter of a percentage point to 0.5 percent.

Concerted tightening of monetary policy by the Western central banks would bring to an end the post-Lehman era of almost free money sloshing around the world, which has resulted in the S&P500 (16 percent annualized returns in USD terms since March 1, 2009) and the Sensex (17 percent annualized returns in INR terms since March 1, 2009) hitting record highs in spite of fairly ordinary underlying economic performance.

As this era of central bank liquidity gradually winds down in 2018, EMs including India will have to answer tricky questions regarding Balance of Payments.

If the Indian economy is not able to get export growth firing again, then global liquidity tightening and/or rising commodity prices would compel the RBI to tighten monetary policy.

Such a move by the RBI should shore up FII inflows (which seem to track real interest rates) but would exert further pain on a sluggish economy.

Exhibit 3: India’s real interest* has been rising, driving capital flows

Source: CEIC, Ambit Capital research. * We define real interest rates as the nominal interest rate minus the CPI

Investment implications

The illusion that the Indian Government holds the country’s destiny entirely in its own hands has been facilitated by a combination of circumstances.

Some of these circumstances, to the NDA Government’s credit, are of its own making; e.g. fiscal rectitude in all of the budgets that this Government has presented so far, and an attack on black money.

However, India has also benefited enormously from benign oil prices alongside the liquidity generated by Western central banks.

This has allowed us Indians to have our cake (in the form of consistent inflows of foreign capital in our financial system) and eat it too (in the form of low CPI inflation and low-interest rates).

This divine combination – of capital inflows into India alongside low Indian interest rates – cannot sustain indefinitely. As the Western economies recover, not only are commodity prices likely to rise globally but also foreign capital inflows into India could slow down.

Alongside this, if the NDA were to let its fiscal rectitude slip in a bid to win more elections over the next 17 months, then the outlook for the market could change very quickly.

Saurabh Mukherjea is the CEO of Ambit Capital and the author of “The Unusual Billionaires”. The views expressed are personal. The views and investment tips expressed by the expert on moneycontrol.com are his own, and not that of the website or its management.