Saturday, May 19, 2012

Rupee Fall: No flight of capital – only speculation

The prevailing theory doing the rounds is that the fall in the rupee is led by the flight of capital outside the country and that RBI and Government can’t do much about it. However the data and the past experience with power of state does not support such a conclusion .

Data seems to suggest that the sharp fall in the rupee is driven by speculation. Here are the key reasons:-

1. FII net investment in equity markets does not show any exodus.

2. RBI says so.

3. Economic growth numbers show recovery in progress.

FII Net Investment

Take a look at the chart below (Daily FII net flows into equities from 1st March to 18th May).  Which is a correct interpretation – FII in exodus mode OR FII flows moderating? I rest my case.

FII investment in equities

RBI Says So

The central bank has directed exporters to convert 50% of their foreign currency holding with banks into rupee balances within a fortnight. This move, although not having a major impact on flows, has more symbolic importance. It’s the RBI’s way of warning speculators, “Behave, or else….”  If large companies playing the speculating game do not get the message, then between the RBI and Government, they have a whole arsenal of tools to break the backs of speculators.

Here’s how the speculation works: whenever the rupee falls and there is an overall expectation of the fall to continue, exporters, including software companies, start to hoard their dollar reserves. They do it in two ways:

- By not converting their Forex reserves into rupees.

- By asking customers to delay dollar payments (this is a bigger one).

The RBI’s current moves give the appearance of targeting the first one, but it is actually passing on a message to the second one. Not only that, this is the RBI’s way of passing on a message to the whole speculator community.

Economic growth numbers show recovery in progress

The Market seems to have gone into a panic when it saw a negative IIP number. However it’s likely that most market participants are not interpreting the numbers correctly. My analysis shows that  IIP is tracking a very normal pattern of recovery, not one of contraction. Just take a look at the chart below – which gives a correct interpretation – that IIP is contracting, or possibly that IIP is in a recovery mode after a phase of moderation. Again, I rest my case.

IIP trends India

What about current account deficit, fiscal deficit etc etc

So what could be causing the majority of market participants to believe that there is something structurally wrong with the Indian economy?

Of course we have an issue surrounding the current account deficit; similarly we have issues with oil subsidies, but all those issues have been with us for as long as I can remember. Nothing negative of major importance has happened in the past few months, and definitely nothing has happened in the past few weeks.

My hypothesis is that the prevalent view is driven by one of the most common phenomena in equity markets – herd mentality. And yes, fund managers, analysts and economists are also prey to it. And of course, speculators are having a field day.

What’s the outlook

The fall might continue a bit longer, however I don’t expect it to have any significant impact on corporate profitability. The reason for this is that, at some point, the RBI and the government will crack down hard on speculators and that would be the end of the Rupee fall. The RBI has already issued a veiled warning to speculative interests. The next set of measures would be far harsher. Those who seem to underestimate the absolute power that a state commands, do so at their own peril. Ask Vodafone.