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Premium: The US Taper and The Rupee

Deepak Shenoy7 min read
Quick Facts
What is "Premium: The US Taper and The Rupee" about?
What category is this article in?
Premium
Who wrote this article?
Deepak Shenoy, Capitalmind's research team.
When was this article published?
Published 19 December 2013.
How long does this article take to read?
7 min read
What does the "A Summary" section say?
Swap Arithmetic: What has the RBI done? How huge FII investments have been, for the rupee. And we have a US Taper How does the US taper impact India Softening FII flows due to the taper are a rupee risk, but... ...in the short term, it's a party!
What does the "The Swap Arithmetic" section say?
RBI said the FCNR Swap raised $34 billion. RBI Governor Rajan mentioned recently that the net OMC Swap was $7 billion. The FCNR swap was banks getting dollars from NRI’s and selling it to RBI directly. The OMC swap was about RBI selling dollars directly to the oil companies.
What does the "Where did the remaining $5 billion go?" section say?
RBI can also sell dollars directly in the market. This $5 billion is what it must have sold in the last three months, to stabilize the rupee. This ploy seems to have succeeded, with the rupee reaching a much more stable lower level.
What does the "Where do we go from here?" section say?
What matters now is: without the FCNR and OMC swaps, the inflows are lesser and the outflows of dollars (since the oil marketing companies are buying dollars from the market), how does the rupee fare?
What does the "The Important of Being FII" section say?
To give you some context, FIIs have invested Rs. 62,000 cr, this year. And over 100,000 cr. in equity (they withdrew from debt). That's about $18 billion in equity.
What does the "And We Have A Taper" section say?
The US Fed decided on a $10 billion taper today. From buying $85 billion worth securities per month, they will buy only $75 billion worth, including $35 billion of Mortgage Based Securities (MBS) and $40 billion of government bonds.
What does the "But the Markets Went UP on the Taper!" section say?
The US markets went up 2%. Asian markets are up. Indian markets, too, will go up. The feeling is that long term interest rates are low, or close to zero, so let’s rejoice!
What does the "How does that affect India?" section say?
We’re so far removed from this stuff, this question begs to be answered. We are an indirect beneficiary.
What does the "The Effect of Softening FII Flows" section say?
The RBI has a huge task ahead if it wants to ensure stability in the forex markets. If these FII flows reduce, there’s a hole in the “financing” that we’ve seen has helped our currency. The RBI doesn’t really want to sell a lot of dollars, because they perceive a loss of reserves as a sign of weakness. We'll do another story on that.
What does the "The Play" section say?
The trader in me tells me play this on the upside - at least for stocks - while the music lasts. Wait for a consolidation, a period when we start getting complacent and say all will be well forever. And that will the time to slowly jump off. I wouldn’t trade the currency longer term; those are almost necessarily shorter term (<1 month) trades.

This is an archive for Capital Mind Premium Subscribers.

Read about the Indian Rupee, our macro position on it, and how the US Taper might affect us.

A Summary

  • Swap Arithmetic: What has the RBI done?

  • How huge FII investments have been, for the rupee.

  • And we have a US Taper

  • How does the US taper impact India

  • Softening FII flows due to the taper are a rupee risk, but…

  • …in the short term, it’s a party!

Let’s do some quick math on the rupee. The actions by the RBI has resulted in a lot of convoluted data, and we’re only beginning to see things unravel.

The Swap Arithmetic

RBI said the FCNR Swap raised $34 billion. RBI Governor Rajan mentioned recently that the net OMC Swap was $7 billion. The FCNR swap was banks getting dollars from NRI’s and selling it to RBI directly. The OMC swap was about RBI selling dollars directly to the oil companies.

So mathematically,** the net inflow was $34b - $7b = $27B.**

Now that the OMC and FNCR swaps are passe (no longer operational) after early December, if we look at the forex reserves on December 6, we should have seen reserves go up by $27B.

However, currency reserves went up only by $22 billion.

Where did the remaining $5 billion go?

RBI can also sell dollars directly in the market. This $5 billion is what it must have sold in the last three months, to stabilize the rupee. This ploy seems to have succeeded, with the rupee reaching a much more stable lower level.

Where do we go from here?

What matters now is: without the FCNR and OMC swaps, the inflows are lesser and the outflows of dollars (since the oil marketing companies are buying dollars from the market), how does the rupee fare?

Answer: It’s doing well in the first half of the month. Largely from awesome inflows from abroad.

FII’s brought in a net Rs 11,600 crore in the earlier three months (September to November). Of this they invested 37000 cr. in equity ($6 bn) and exited 25,000 cr. in debt ($4 bn)

But the month of December is a big surprise. **FII’s have invested over 12,000 cr. ($2bn) in just the first 17 days of December! **Of this, 9,000 cr is equity and 3,000 cr. is in debt, and the first positive month for FII investments in Debt since May.

This is a huge positive for the rupee, which even dipped below Rs. 61 briefly.

Now how does the rest of the month go?

The answer depends on the US “taper”. We’ll get to that.

But it is obvious that at least in December it’s not the RBI that is supporting the rupee. FII flows are. The risk is, of course, that FII flows slow down again. They don’t need to reverse, just slow down and the whole house will start shaking again.

The Important of Being FII

To give you some context, FIIs have invested Rs. 62,000 cr, this year. And over 100,000 cr. in equity (they withdrew from debt). That’s about $18 billion in equity.

(Rs. Cr.)

The boom since 2010 has largely been on the back of cheap global liquidity. A taper in the US can introduce the lack of such liquidity.

And We Have A Taper

The US Fed decided on a $10 billion taper today. From buying $85 billion worth securities per month, they will buy only $75 billion worth, including $35 billion of Mortgage Based Securities (MBS) and $40 billion of government bonds.

This is accompanied with a strong statement that interest rates will remain at zero until inflation crosses 2.5%. The unemployment target is 6.5% or lesser. The visibility into this says: not till 2016 will we raise rates.

They also said they’ll continue to pay interest on reserves. So financial institutions can continue to borrow at near-zero, and put it back into the Fed at 0.25%; the free money game is still on.

But the Markets Went UP on the Taper!

The US markets went up 2%. Asian markets are up. Indian markets, too, will go up. The feeling is that long term interest rates are low, or close to zero, so let’s rejoice!

But a warning: Just in September, the US said they might not taper just yet. In June they said they might. Earlier, they said there was very little chance of it happening in the visible future. Well, we’re there now.

The point is: What they say as “for a very long time” can change very fast. If data shows inflation is rising, then the US will change course quickly. This taper will probably increase in size until, within a year, they buy zero from the market, but keep interest rates at zero, and quickly, rates can rise too.

How does that affect India?

We’re so far removed from this stuff, this question begs to be answered. We are an indirect beneficiary.

Consider this: The US Fed prints money to buy MBS and Govt Bonds. Those prices go up, yields go down. Others, like pension funds and insurers, who would otherwise have bought those bonds or MBS, now have to find other sources of greater yields. Money goes into risky securities. And higher risk countries like India.

This money flow results in just a trickle coming to India - it must account for part of the $1.5bn a month ($18 billion a year) into equities in 2013.

Two things now with the taper. There is **less of that “trickle” **that is available for higher risk investments, since the Fed is printing less money and putting less into the economy. However, this may be a lower risk - because if the economy gets better, banks will “multiply” the money supply through an expansion of credit, and the immediate curtailing of flow might not happen.

Secondly, when US yields go up, the US is a more attractive destination. If you face a currency risk of 10% for a return of 15%, you could just as well invest in the US for a return of 5%.

So the key to whether India continues to get money or not, is about how much yields go up in the US.

The Effect of Softening FII Flows

The RBI has a huge task ahead if it wants to ensure stability in the forex markets. If these FII flows reduce, there’s a hole in the “financing” that we’ve seen has helped our currency. The RBI doesn’t really want to sell a lot of dollars, because they perceive a loss of reserves as a sign of weakness. We’ll do another story on that.

So what can you replace FIIs with? FDI - that’s not happening. Net Exports - unlikely but there is a tiny chance (we either have to reduce imports or increase exports).

NRI Deposits - after $34 billion, not much chance that we can pull it off again, especially if yields go up. Remittances: these have already been going up a lot, and may not continue to rise.

If net exports don’t pick up substantially in the next quarter, the rupee will be in trouble again. I know I’ve said the markets look good - and they do for the next few months because of lowered inflation. But the stock and currency markets will eventually react to the lack of FII support, if that does happen.

The Play

The trader in me tells me play this on the upside - at least for stocks - while the music lasts. Wait for a consolidation, a period when we start getting complacent and say all will be well forever. And that will the time to slowly jump off. I wouldn’t trade the currency longer term; those are almost necessarily shorter term (<1 month) trades.

Markets are run on sentiment: greed and fear. Today, greed has overcome fear.

While it’s unwise to ignore the reasons for fear, the result of an investment balance sheet is the money you end up in your pocket - and the short-term (1 year) game says, there’s money to be made in buying stocks.