Fitch must be regretting outlook upgrade of India: CLSA

Indian markets have been resilient on the back of global liquidity conditions, so long-term investors may still find the ongoing correction attractive, says Rajeev Malik of CLSA.

The "band-aid" measures taken to address current account deficit (CAD) and  protect the free falling rupee have failed to yield desired result making India vulnerable to ratings downgrade, says Rajeev Malik of CLSA.  Finance minister P Chidambaram's promise on Wednesday to contain fiscal deficit (FD) at 4.8 percent in FY14 appears far-fetched since India's fiscal deficit in the April-June quarter came in at 48.4 percent compared to 37.1% in the previous year. It remains to be seen if the present rate of inflows can add  the USD 80 billion projected by the finance minister.

“The government has to take stern steps to fix the underlying rupee problem. Given macro economic mess we don’t need temporary solutions. Relative to the issues faced, the steps undertaken have been inadequate. Fitch must be regretting its outlook upgrade," he told CNBC-TV18 in an interview.

In June, Fitch had upgraded India's sovereign ratings outlook to "stable" from "negative" citing government measures to contain the budget deficit and the progress made in improving investment and economic growth.

However, he added that Indian markets have been resilient on the back of global liquidity conditions, so long-term investors may still find the ongoing correction attractive.

Meanwhile, CLSA maintains its 2014-end rupee target at 65/USD. Malik believes that rupee’s deprecation may not stop there. The Indian currency has tumbled 9 percent in the last one quarter against the US dollar.

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Below is the edited transcript of Malik's interview to CNBC-TV18.

Q: This last fortnight it feels like the economy has been hit with a tidal wave of sorts and there has been no boat that is spared. What have you made of the events as they have unfolded?

A: A couple of things come to mind irrespective of whether the idea about going in for an interest rate defense originated in Delhior Mumbai. Both the implementation and the communication have been rather convoluted and confusing. People are still holding out that this is going to be temporary and in a few weeks time, it will be rolled back.

That is not necessarily a foregone conclusion at all. One of the differences that Indian approach offers is while places like Indonesia, Turkey and Brazil formally went ahead with increase in policy rates and policy levers, India has gone about in a rather round about convoluted manner. Not to mention what the long end of the yield curve has suffered as well.

In the final tally, one needs to look at the level of the rupee and some of the volatility indicators will suggest that it is an approach that is necessarily not paying any dividend which leaves policymakers in a tight spot. Do they come in with more tightening measures? This should not be ruled out or after some initial fight they are more likely to give up and let the rupee slide further. So, it is really being between the devil and the deep blue sea.

Q: You would have heard the Finance Minister's communication yesterday. In that he said that even if the Current Account Deficit (CAD) is USD 80 billion, between Foreign Institutional Investor (FII), Foreign Direct Investment (FDI) and External Commercial Borrowings (ECB) it would not be a problem at all in bridging that. 7 months have passed this year and we have got USD 20 billion FII plus FDI put together. In the remaining five months does it look likely to you that we will be able to bridge the deficit?

A: The Finance Minister is an exceptionally smart chap. I would think there is perhaps some error in some of the numbers he has suggested, because the addition just does not work.

Q: He also went onto say that the next target could be the offshore trading market for the rupee. Do you think these clamps will work, because the domestic clamp clearly has not worked with the rupee hitting 61 again?

A: They cannot work. This is just a continuation of a series of own goals and band-aids to really try and fix broken limbs. Which country can go ahead and try and fix the offshore market, but not really do all that is relevant and meaningful to fix the underlying weaknesses and imbalances? Trying to get after speculators in India is a politically correct way of disrupting market price discovery. It is not going to fix the underlying problems at all.

Q: Investors have gone through a period of concern with this market, but now it feels like India has just fallen off the radar, particularly because of this macro mess. Is that something you hear seconded when you talk to people looking at emerging markets (EM) or Asian markets? Are people just not interested in India because of how the route has moved this year?

A: That is generally the impression, but equally there are always investors who from a longer-term perspective could still find some of the ongoing correction more attractive. The question really is would you find even more attractive levels? Given some of the macro mess, Indian market still remained relatively resilient in the last couple of years partly because of easy global liquidity situation. I think the critical thinking should really be even if onshore policy action improves, but global liquidity cycle turns for the worse which should be the underlying assumption.

One could still have quite a few hiccups going ahead. This is where I believe that the rupee problems are not two months old. It has been in the doghouse for the last 2-3 years and we have just gone through a series of band-aid approaches to fix this and fix that rather than taking a holistic approach and really addressing the underlying structural problems. Rupee's problem is more than just gold for example.

Q: The growth problems are not two months old either. Now the fear is what we are looking at is a much more prolonged growth downturn in terms of a cycle. How much longer do you think this entire process has gotten extended? That is really where the drip poison is coming in from, such poor growth parameters.

A: That is where part of the confusion comes about. Go back to a few years ago when India started to slowdown after a good recovery following the global financial crisis, the initial assessment of why it was slowing down was misplaced and hence the policy response was misplaced.

Then, we went into dealing with inflation and it was all over the place and now it is with the exchange rate. So, I think the fact that growth is already low, the critical question is going to be what exactly is the defense. Is it an interest rate defense and the market is going to test Reserve Bank of India's (RBI) resolve which means is it going to come in with more tightening measures or is it just quickly going to fall back and give the impression, the perception which is very important that its approach has actually failed.

The whole recovery is going to be pushed out and is going to be weaker. At the end of the day it is a question of trying to figure out what exactly you want. Pussyfooting is not going to work. India did that with inflation versus growth and we seem to be doing that now with the exchange rate.

Q: Do you think if growth collapses to that 5.2 percent number that you have hinted at in your last report for FY14 that some have brought the number down to almost 5 percent already the ratings downgrade threat might come back on the table again?

A: The threat never really went away. Fitch must be literally pulling its hair out for having gone ahead and revised its outlook to stable from negative. The government used that opportunity to advertise what a good job it was doing. While the government deserves credit for some of the decisions that they have taken, even politically sensitive ones, relative to the issues we are facing, the response still remain inadequate.

For example, diesel under-recoveries are back to where they were earlier in the year. While a 50 paise adjustment keeps happening, maybe the government should think about catching the bull by the horns and going ahead with a far bigger quantum of increase to really send a message across that they are serious about some of these things. The question is will it find the gumption to do that.

Q: Do you see things getting worse? You have been quite circumspect over the last 6-8 months most among your peers perhaps, but do you think things could even get worse from here and all that notion of things having bottomed out and now just waiting for the recovery, may not actually be the right way to approach India's problems now?

A: The recovery gets pushed out for sure. A lot of us who were anticipating a better second half and then that following through into next year believe optically the direction would be somewhat similar but the magnitudes are going to be much lower. On the rupee, I still continue to maintain that people are misreading how things are evolving and 65 against the dollar by year end for 2014 very much remains our forecast and rupee is not necessarily going to stop there.

One has to put in context both the combination of Balance of Payments (BoP) risks, high inflation differential. Despite that, the government officials seemed to be talking about how RBI will begin to cut rates when rupee stabilises, growth differential is narrowing. Next year cyclical Asia would be recovering and if RBI's tightening measures are actually strengthened, growth is going to be a casualty. So, I think there are many factors that are coming in, not to mention the global liquidity cycle itself which will warrant the rupee to weaken and it is not just because of some idle speculation as such.

Q: What kind of global landscape do you think we have going for the next couple of months where there is a taper program that probably comes into place. There will be more tax debates in the US. There is round two of sequestration coming up. Do you think it is going to be a much tougher global setup that the market will have to move with?

A: It has to be. While parts of the Federal Open Market Committee's (FOMC) statement, atleast on the interest rate outlook certainly are dovish and rightly so, do not confuse that with the fact that tapering can still kick off in September. There is a distinction between tapering and tightening and the FOMC seems to be going out of its way to emphasize that difference. I do not think they would be doing that unless tapering was very much in the cards sooner rather than later.

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