Strategy- The Old Man and the QE: Kotak Sec

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Strategy
The Old Man and the QE. We see several negative implications for the Indian
economy of the US Federal Bank’s recent decision to pursue a second round of
quantitative easing program (QE2). (1) India’s CAD may widen further, (2) inflation may
be higher versus expectations, (3) oil under-recoveries may be significantly higher versus
FY2011E levels and (4) India’s central bank may be forced to respond with unintended
monetary policies. We do not rule out a likely bubble in the Indian equities




Cover page bullet. QE2 is not good for India fundamentally
We see higher commodity prices, particularly of crude oil, arising from the Fed’s QE2 program
hurting India’s CAD and GFD (if oil prices are not raised proportionately, which is unlikely). India is
vulnerable to high crude oil prices with a US$1/bbl increase resulting in additional outflow of
US$800 mn. Crude oil prices have risen US$15/bbl since September 1, 2010 when the market
started building in expectations of QE2 following the Fed Chairman’s August 27, 2010 speech.
India’s CAD/GDP could slip by 0.5% in FY2012E (to 4%) if crude oil prices average US$90/bbl
(US$10/bbl higher versus YTD FY2011 levels) and fiscal deficit could also be modestly higher.

QE2 may have serious implications for Indian government policies
The Indian government and central bank have limited defenses against large capital inflows and
higher commodity prices. A moderate level of capital inflows is welcome given India’s large CAD.
However, excess inflows may result in (1) rupee appreciation (not good for exports and not a good
outcome if other competing countries engage in currency wars), and (2) unintended monetary
action (rupee versus interest rates). Also, higher commodity prices may result in (1) higher inflation
from higher ‘imported’ inflation (and possibly wealth effect) and (2) delay in ongoing reforms in
the oil sector; we can rule out diesel deregulation if oil prices are above US$90/bbl in FY2012E.

QE2 could create an equities bubble if large FII inflows continue
Additional portfolio inflows may push valuations of stocks to beyond the current fair-to-full levels
to ‘bubble’ valuations. India has seen US$14 bn of inflows from September 1, 2010 and could
potentially see more inflows. At 18.9X FY2011E ‘EPS’ and 15.7X FY2012E ‘EPS’ (BSE-30 Index),
Indian market is fairly valued with pockets of rich valuations; valuations could spiral up with
additional FII inflows. Capital account inflows may offset current account outflows but that leaves
more assets in foreign hands with attendant risks of volatile capital flows.




Dramatized conversation with my old man to explain QE2 and its implications
We present the implications of the Fed’s QE2 program on the Indian economy through a
dramatized conversation between the author of this report and his father (henceforth
referred to as the Old Man). The conversation is fictitious but highlights the issues faced by
investors and the Indian economy.
Old Man (OM): Hey son, the Indian stock market has gone up a lot over the past two
months. Is there anything going on that I should be aware of?
Self: Dad, the Fed just launched QE2 after two months of speculation since late August,
2010.
OM: What’s QE2? Isn’t it a ship?
Self: Very funny, dad! Now I know where I got my sense of humor from. No, QE stands for
quantitative easing program of the US Federal Reserve Bank and since it is the second one, it
is known as QE2.
OM: What is it exactly? How does it work?
Self: The Fed essentially prints currency and uses the same to buy US government bonds
from holders of the bonds. In the current round of QE, the Fed will buy US$600 bn of bonds
at about US$75 bn every month.
OM: Wow! That’s quite neat! We could all get quite rich like this. Why don’t more
governments do the same? I could do with some more money.
Self: It’s not that simple, dad. If there is money in the system, prices of everything will adjust
upward. If the government increased the amount of money held by Indian citizens overnight,
it wouldn’t help anybody since the amount of products and services in the Indian economy
would still remain the same; prices would simply adjust upward. Suppose everybody in the
Indian economy had 2X of their current bank deposits and currency. In that case, the price
of every product and service will also double.
OM: That’s too bad. How does QE2 help in that case?
Self: Nobody knows but the US Fed believes that it will help bring down long-term interest
rates and encourage companies and individuals to invest more in businesses and other assets
that yield more returns rather than in US government bonds only. US policymakers are
grappling with high unemployment rates currently and they are keen to use all available
resources to revive economic activity and employment. Also, it will help increase inflation in
the economy and avoid the dangers of deflation that can be terrible for a seriously indebted
economy.
US academicians and economists and even officials within the US Federal Reserve Bank are
quite divided on the subject. (1) Some think it is the only option for the US government
having exhausted its normal monetary and fiscal programs to stimulate the economy. The
Fed’s Federal Funds rate (rate at which banks lend to each other) is already near zero for the
past 22 months. (2) Others think that it will not work and will only create asset bubbles in
other parts of the world.
We certainly know that the US Dollar is the reserve currency of the world to a large extent
and its value will depreciate with respect to other currencies in the world leading to US
exports hopefully becoming more competitive. Also, prices of most commodities will move
up since they are mostly priced in US Dollars. Remember the earlier part of the conversation,
where I had highlighted that more money will push the prices of products and services
upwards.



However, it is not clear whether the lower rates will incite more investments in the US,
which will result in higher employment. That is the single most important problem for the
US economy at present with unemployment rates stuck stubbornly at around 9.6%.
However, interest rates are already quite low in the US and it is not clear as to how low the
rates should be before the economy turns around. The current yield on two-year US bond is
only 0.36% (see Exhibit 1). Most economists suggest 30-50 bps impact on 10-year yields
(currently at 2.51%).



It is not clear if that will be sufficient to encourage more investments in the US economy (US
companies are already sitting on large amounts of cash) or it will result in more money
seeking higher returns in other asset classes. Many emerging economies are quite worried
about large capital inflows and the destabilizing effect of the same on the country’s
exchange rate and economy.
OM: That’s a lot more complex than I had thought earlier. Wouldn’t other countries
be upset by a ‘devaluation’ of the US Dollar against their currencies leading to some
attempts by them to devalue their own currencies? Also, if money comes to
emerging markets, wouldn’t it be good for them?
Self: Right and wrong, dad. Several Asian countries have already expressed their displeasure
in varying measures at the recent policy measures. For example, the chairman of the
People’s Bank of China recently stated that, “We can understand the Fed's QE2 policy, from
the angle that it wants to revive the US economy and increase employment. But the problem
is the Dollar is the global reserve currency. It may not be the right choice for the global
economy, though it is a good option for the US economy.” Many emerging economies are
export-oriented economies and a devaluation of the US Dollar versus their currencies makes
exports from these countries costlier. The US Dollar has depreciated significantly against
other currencies ever since the market started building in expectations of QE2. Exhibit 2
shows the movement in the US Dollar Index over the past 24 months


On more money flowing into emerging markets, it creates problems if the inflows are more
than an economy can handle. Many countries are worried about this phenomenon and have
been actively considering capital controls to manage capital inflows better. We would see
more clarity on this issue when the G-20 heads of states meet in South Korea on November
11-12, 2010. If the money is absorbed as investments in productive assets, it can be a boon.
However, it is not easy to absorb so much money suddenly and the increased money supply
usually ends up in (1) stock markets in emerging markets,
(2) commodities and/or (3) property markets. In that case, it could be a bane.
Also, it encourages more irresponsible behavior if market participants believe that money
will continue to flow into their markets (whatever those may be). Investors may no longer
invest based on the fundamentals of the company, commodity or real estate market but
invest largely on the premise that prices will go up. This results in increased speculation that
eventually results in asset bubbles.
OM: Coming back to India, how will it impact India? Doesn’t India require capital
inflows?
Self: Based on my limited understanding of this rather complex matter, it could be
through several ways. You are right about the fact that India requires capital inflows.
However, the issue is the size of the inflows—the economy can handle moderate
quantities of inflows and indeed, it requires some inflows given our current account
and investment requirements. Very low capital inflows may result in a large BOP
deficit with negative implications for the Indian Rupee. Very large inflows can
counter-intuitively have a potentially destabilizing impact on the economy and
policies.
Let us look at the likely impact of QE2 and resultant additional inflows into the
Indian economy.


􀁠 Stock prices may go up higher. If India continues to receive large FII inflows over
the next few months, it is quite likely that stock prices will go up from current
levels. Valuations are quite rich in India for most stocks but more demand for
stocks from foreign funds can push up their prices. India has already seen US$14
bn of FII inflows since September 1, 2010 (see Exhibit 3) and the stock market has
also gone up nicely over this period. I would highlight that the market hadn’t
moved up much since January 1, 2010 until August 31, 2010. Almost all the gains
in the current year have come from the movement in the market after the Fed
Chairman’s speech on August 27, 2010 at the annual economic symposium at
Jackson Hole, Wyoming.


􀁠 India’s BOP could potentially worsen. Commodity prices will likely go up since
they are mostly traded in US Dollars; that will be a negative for the Indian BOP
given India’s high imports of crude oil. A US$1/bbl change in crude oil price
impacts India’s current account by US$800 mn. If crude prices average US$90/bbl
in FY2012E, about US$10/bbl higher than FY2011E average prices, India’s FY2012E
CAD could touch nearly 4% of GDP. India may also see more foreign inflows due
to QE2, which may offset the impact of higher crude prices. Exhibit 4 gives India’s
FY2012E BOP under two scenarios (crude oil price of US$81/bbl and US$90/bbl).


Please note that crude oil prices have already gone up 21% since September 1,
2010, at the time the market started building in expectations of QE2. However,
the amount of foreign capital inflows is not certain. I expect the large amounts of
FII flows seen in the past few months to continue over the next few months due
to large global liquidity. However, that is not a given. These capital flows,
welcome as they are, do expose India to the vagaries of foreign capital flows.
􀁠 Inflation could remain high contrary to expectations. Higher commodity prices,
particularly of oil and steel, will likely lead to higher input prices for several fuels
and manufactured products. Also, large inflows may create artificially high prices
of equities and real estate leading to ‘wealth effect’ among households and more
aggressive consumption. This may push up prices of certain products and services
higher.
My analysis shows that India may have to raise diesel prices by `5/liter (that’s
12.5% of current selling prices) and gasoline prices by `4.7/liter (8.3% of current
selling prices) for oil marketing companies to earn reasonable marketing margins.
This will push up inflation in India since diesel is an important transportation fuel
for the economy.


However, the good thing is that inflation may come still come down from current
high levels due to a high base currently. Exhibit 5 shows likely inflation trajectory
with corresponding price increases in diesel and gasoline to match the increase in
global crude oil prices (average US$90/bbl in FY2012E). Low inflation in general in
FY2012E due to base effects may allow the government to raise prices of diesel
and limit the impact of higher under-recoveries on its own finances and those of
the government-owned oil companies.


􀁠 Oil under-recoveries will likely increase. Crude oil prices have already gone up
21% since September 1, 2010, at the time the market started building in
expectations of QE2. It is not as if global supply-demand balance of crude oil has
changed so dramatically over the past few months. However, speculators have
invested aggressively in crude oil futures (see Exhibit 6) in anticipation of QE2 and
depreciation of the US Dollar. Exhibit 7 shows the increase in crude oil prices and
depreciation in the US Dollar at the same time over the past few years; the
inverse correlation has been quite high over the past two weeks.


If capital inflows do not match the outgo arising from higher commodity prices,
then it may impact India’s BOP quite negatively leading to a possible weakening
of the Indian Rupee. I see low probability of this event—foreign inflows will likely
be large but as highlighted earlier, it does increase the exposure of the economy
and the stock market to volatile capital flows. An outflow of foreign capital will
likely be quite painful for the economy and the stock market.
It is more probable that India receives large foreign inflows. In such a scenario,
RBI may need to manage the Rupee against undue appreciation. The RBI may
have to intervene and buy US Dollars, which would push up domestic liquidity. It
may then have to issue bonds (known as Market Stabilization Scheme—MSS) to
absorb the surplus liquidity thus created. It can also use the CRR to reduce
liquidity in the system. However, the RBI’s decision to suck out liquidity through
issue of MSS bonds (sterilize, in other words) or not will depend on the aggregate
liquidity conditions.
OM: Hmm! I don’t understand most of this but this doesn’t sound like it is such a
good thing for India. What should I do with my stocks since you are the stock
market ‘expert’?
Self: I am sorry, dad. I can’t tell you that. You are not a client and my compliance
regulations strictly forbid me from sharing information and views with people who
are not our clients.