Note: This is an archive for Capital Mind Premium subscribers, sent on 03.12.2013.
While I’ve been bearish for a long time, the time has come to admit certain facts as data comes in. You don’t fight a central bank. And India’s central bank has just declared its intention to ensure things seem rosy.
In this post that is longer than usual, Capital Mind makes the case that if you’re not going to fight the RBI, it might be time to join them.
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RBI switched off the FCNR swap on Nov 30, and the OMC swaps went offline yesterday.
The FCNR swap was where RBI let NRIs deposit foreign currency with Indian banks, and offer a low cost (3.5% per year) hedge against the rupee to the banks. The banks could then convert the incoming foreign currency to rupees, use it for lending, and then not have to worry that much about having to convert it back to dollars – the hedge cost was 3.5%, they offered another 5.5% on the deposits, so their net cost of this fund was 9%, similar to a local deposit.
This provided a massive leverage to non-residents, who could borrow at 3.5% and then deposit it at 5.5%, effectively earning a 2% arbitrage. This is akin to raising interest rates, which in an ideal economy should cause foreigners to buy debt, but doesn’t work in India because of our arcane restrictions on foreign ownership of debt and registration requirements.
There was yet another swap. Banks could now borrow in foreign currency, and the RBI would let them hedge the dollar at a rate 1% lower than market. If the market rate was 7% per year for a three year $100 million hedge, banks could use the swap from the RBI instead at 6%. This reduced their cost of funds.
Note that neither of these measures directly impacted the market. The dollars that came in flowed straight into the RBI coffers, at an exchange rate given as the RBI “reference rate”, a once-a-day snapshot calculated through polled bids and offers by the RBI at 12 noon.
These two measures raised $34 billion. This $34 billion should have directly added to forex reserves, but there are two things that make sure it wont – if RBI were to sell those dollars in the market, and if RBI were to give it to oil companies as the OMC swap.
RBI had asked Oil Marketing Companies (OMCs) to buy dollars from the RBI, and then pay it back in dollars at a later date – between Feb and Apr 2014. This kept the dollar demand of oil refiners – a massive $8bn a month – off the forex market, which then stabilized.
Yesterday, it announced that the OMC “swap” was not required anymore, and that they’d been using the markets for their dollar demand since last week.
What we don’t know is how many dollars RBI has sold to OMCs. There isn’t any layer of transparency from the RBI, which might release this information much later to avoid us babies reacting in panic, as we are a society often mollycoddled to death. But I digress.
The dollar has reacted nicely to the two swaps:
While the FCNR swap hasn’t hit the market, the lack of oil refiner dollar demand in the market definitely helped the rupee.
Effectively, what is got from the FCNR swap goes to the oil refiners.What’s left, adds to forex reserves of the RBI.
So $34 billion came in through FCNR/Bank swaps into forex reserves. Oil company demand from Sep to Nov 2013 would have been $24 billion ($8 bn a month). Let’s assume most of that has been fulfilled by the RBI from its reserves. Till November 22, the reserves grew about $12 bn, in line with this assessment.
Note that forex reserves do not include what the RBI needs to pay as part of forward swaps (or receive from OMCs). RBI does indulge in forward trading with banks. So while they may have dollars they might have to pay them out as part of “forward” contracts, the data of which is released only with a two month lag.
The fear though, is that the entire sum total of this gives us only $10 billion in forex reserves(which is just a 3% addition to reserves) and has only helped because the oil companies have been off the market in the last three months.
Instead of waiting till Dec 31 – the last day of the quarter when it usually announces the previous quarter’s trade deficit, the RBI decided to reveal the information today. This coincides with the exit of the OMC swap and is just after th
e FCNR swap expiry.
The data itself is fairly positive – with the current account deficit dropping from $21 billion in Q1 to $5 billion in Q2. But the timing of releasing this today tells us that the RBI wants to create an positive feeling.
Banks were borrowing the full repo limit (at 7.75%) overnight from RBI everyday, and then borrowing in the 14 day term repo market, and then further borrowing from the MSF window. This borrowing has come down substantially.
Now this could be temporary as corporations prepare to pay taxes in Mid December (60% of the year’s taxes should have been paid by 15 December). This will take out cash from banks and put it inside the RBI, squeezing liquidity a little. Given that the government is loath to spend right now, with the fiscal deficit looking scary, that money might not come out so easily.
Secondly, note that the increase in forex reserves, even by $10 billion, is an indication of increasing money supply. This could be looked at as easing liquidity today, but will push inflation higher in 6 months.
Recent reports of increasing inflation were anecdotally supported by rising onion and vegetable prices for a sustained period. This has now subsided, with onions down to Rs. 35 per kilogram, after the Rs. 70 to Rs. 100 per kilogram levels recently. This should help both perceptions of inflation and headline numbers.
But there is a lot of latent liquidity sloshing around, due to all the drama created for protecting the rupee. This will impact inflation in a few months. Unlike the US, where excess liquidity is actually being stored back at the central bank as excess reserves, India manages to lend out much of what exists, so the multiplier effect is strong (money printed by the RBI “multiplies” in the banking system).
This is an indicator we built at Capital Mind. It is the number of Nifty Stocks Above their 20 day moving averages, minus the number of stocks below. The resulting net number is smoothened by taking a simple average over 5 days and charted.
A typical bottom comes when the CM MA20 index moves below -30 and then starts to go back up. While this particular move is not strongly bullish the price trend might move up until the indicator goes back to serious positive territory.
This chart above shows us the direction to be is bullish, but to confirm that, we must break above the last high, which is at 6317. This is only 2% away. This indicator is bullish in the extreme short term.
The HSBC Markit Purchasing Managers Index for Manufacturing (PMI) for Nov 2013 is now in territory that shows expansion (below 50 is contraction) after three months.
They have something about inflation:
Inflationary pressures in the Indian manufacturing economy softened in November. The rate of charge inflation was slight and eased since the previous month, while purchase prices increased at the weakest pace since August.
This is, general, adding to the theory that things are looking better.
These are green shoots visible in the economy today. Inflation will look like it’ll come down.Liquidity is freely available. The Trade Deficit has come down. The RBI and governmentseem keen to kick up sentiment towards India. Sentiment expecting a strong political result in elections this month might also help the markets get more money.
Sentiment affects everything; and we’re starting to see retail investors get back into the markets through mutual funds. For the next few months, at Capital Mind we expect news to drive markets upwards, and that it’s best for traders to position themselves long. If this situation changes, we’ll have another post.
There are a number of things that can derail the hypothesis, including the US taper (which will be confirmed only by mid-December), or a spike in oil prices, or the rupee going back down after the oil refiner demand goes back to the market.
Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.
Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.