The Taper Tantrum Series: Taking Cognisance of the Risks Involved
This is part two of the taper tantrum series, in which we explore the risks involved for India's economy and the stock markets. The first part can be accessed here.
Taper tantrum, or the US Fed signaling that it’d reduce printing and supplying new money, could spell tough times for India’s economy and stock markets.
Firstly, note that India’s equity markets are heavily influenced by foreign money flowing in or out in the form of institutional or portfolio investments.
During the 2020’s bull market, for instance, the foreign institutional investors (or FIIs) bought Rs 64000 crore of equities while domestic institutional investors (or DIIs) sold Rs 36000 crore worth of equities.
In 2021 so far, as well, we see a similar trend – while DIIs have sold Rs 10,000 crore worth of equities till May 2021, FIIs poured in Rs 31000 crores.
A significant chunk of these FII flows have been a direct result of the US Fed’s ultra-easy monetary policy, which led to its benchmark interest rate, the fed funds rate, dropping from 1.58% in Feb 2020 to 0.5% in May 2020.
Remember, as discussed in first part of the series, lower interest rates – as a result of money printing by the central bank -- may not only make it cheaper for individuals and corporates to borrow and spend, but they also make it cheaper for investors, especially the FIIs, to borrow and invest those funds at higher yields.
Lower interest rates in the US also means US investors now must search for higher yields elsewhere, particularly in riskier assets. One of those riskier assets is the stock markets of emerging economies such as India’s.
This explains the heavy FII flow, and the resulting bull rally, seen in India’s equity markets in 2020 and 2021 till date.
Outflow of capital from India
But what happens if this flow of cheap money is stopped? It could lead to US interest rates, which have been kept low through easy monetary policy, spiking.
Higher interest rates in the US, could in turn lead to foreign investors – who chased Indian equities in search of relatively higher yields – selling and deploying those proceeds in their home country.
In the three months of 2013 for instance, from June to August, FIIs had sold roughly Rs 18000 crore worth of Indian equities, the highest consecutive months of selling since at least 2008.
Depreciation of the rupee and costlier imports
This selling could also lead to the rupee depreciating (falling). This is because convert their rupee investments into dollars, foreign investors must first sell rupees. This increases rupee supply in the market, thus putting pressure on its exchange rate.
For the Indian economy, this spells tough times because a depreciating rupee could spur inflation.
This is because India’s imports, especially crude oil, would now get costlier – India must pay more rupees per dollar to import an equivalent amount of goods and services that it did earlier. Remember, India presently imports a staggering 84% of its total crude oil requirements from abroad.
A depreciating rupee could further encourage foreign investors to sell more investments to book their profits, lest rupee depreciates further.
Consider this example: If I have invested $ 1,00,000 in India at an interest rate of 6% when the exchange rate was Rs 70, then I’d earn Rs 4.2 lakhs at the end of the year.
Assuming the exchange rate remains Rs 70, my $ profit would be $6000. But what if the rupee depreciates during the year to Rs 75 per $? My profit would be lower at $5600 instead.
So, as a foreign investor, I’d rather sell and lock in my profits before the rupee depreciates further.
Higher borrowing costs
To shield the country from capital outflows, the RBI may increase domestic interest rates – in an attempt to lure foreign investors.
But this could in turn increase borrowing costs for Indian companies and individuals, thus negating the growth benefits achieved in previous years of low interest rate.
In fact, even those domestic companies that have borrowed from abroad – through the external commercial borrowings channel – could see a spike in their interest costs.
Note that in March 2021, Indian companies had borrowed about $9.23 billion from abroad, an increase of 24% over the previous year.
Higher borrowing costs could have especially dire implications for the banking sector, which have already been reeling under the bad loan stress caused by the second wave of the pandemic.
Borrowers may struggle to service their floating rate loans, thus putting stress on banks’ balance sheet.
Even the government may see its borrowing costs spike. Note that India is already going to spend roughly half of its tax revenues on interest payments this year, as per the latest Union Budget.
Higher interest rate implies an even greater portion of revenues being spent servicing interest payments – and less left to spend on more productive expenditures. This could have implications on the broader economic growth.
Higher interest rates means lower valuations and lower stock prices
For those in finance, remember that a major assumption in the popular discounted cash flow method of valuing equities involves the discount rate, which is based on the risk-free rate i.e. yields on government bonds.
If the interest rate across the economy increases, then that implies higher yields on government bonds, and therefore also a higher discount rate.
A higher discount rate reduces the present value of the expected future cash flows of companies. This could mean a de-rating of many companies, whose valuations have skyrocketed owing to a cheap liquidity.
Higher forex reserves with the RBI may provide cushion this time around
To be sure, India is better placed on two fronts: One, the RBI has built up sufficient forex reserves this time around, at $592 billion, compared to 2013 when it hit a low of $275 billion.
Greater forex reserves with the RBI means more firepower to fight any sharp disruption to the stability of the rupee.
For instance, if the rupee depreciates suddenly, the RBI may intervene in the currency market and sell dollars to prop up the rupee exchange rate. This could have less adverse effects of “imported” inflation on the economy.
The impact on borrowing costs, however, may remain elevated.
Investors must additionally grapple with the equity and bond market repercussions of the impending taper tantrum.