India Confronts the Impossible Trinity: Elara

Caught on the wrong side
Indian policymaking is struggling in the maze of
impossible trinity. The choice between pegged
exchange rate and an independent monetary
policy becomes important since the Indian
business cycles may not be fully aligned with that
of the US. Now that US yields have firmed up,
either INR can remain a float or pegged to the
USD, the later involving monetary tightening and a
loss of monetary independence. Central banking in
India is inclined towards the later for now while
keeping doors for former wide open. Clearly, the
choice to pursue the middle path may be
distortionary and would inherently include very
short-term patchwork policymaking.
CAD funding: the 21bn dollar question
Looming BoP crisis for India stems from the fact
that capital account, for all optimistic assumptions
may fail to fund the deficit of USDbn88.9 in FY14E.
Assuming more-than-expected long term flows in
(FDI+ Loans + NRI deposits); our estimates show
that there is excessive reliance on "hot money"
flows of around USDbn21 over FY14E. As the US
yields rise and narrow the gap between India and
US paper, the possibility of outflows in debt (early
indication seen in last three months) may be a
prolonged reality. Equity inflows, meanwhile could
suffer a vicious cycle of weakening INR and a
worsening outlook on overall business cycle.
Flows
ETF flow direction has seen an increased
concentration towards US, Japan and European
markets as investors look to avoid the volatility of
Emerging Markets and commodities in the short
term. Recent FII net outflows have significantly
countered the strong YTD start and is now
pushing Indian bourses into a delayed sell off as
hiding places become exposed.
Investment Strategy
The Model Portfolio has seen an outperformance
of 200 bps in the last 3 months. Our contrarian
picks have been working well for us. The structural
construct has remained unchanged and our
preferred investment categories are Oil & Gas,
Automobiles, Power and Consumption. Our
underweights in banks continue and we expect
the benchmark index to see another 10-15%
correction. We would like to highlight that under
recovery theme might reverse with the INR looking
to hold its levels in the current quarter. Notably, as
is the market we have only OWs and UWs and no
Neutral positions.

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Tough times warrant realistic outlook
Executive Summary
 India's problems are first order: Policymaking would better address the structural bottlenecks within primary agents of economic activity
viz. land, labor, capital, and business sentiments. In absence of this, restoration of pre-crisis growth will remain purely aspirational. There is
a need to understand the difference between cyclical and structural revival and that a lower rate regime led cyclical revival is passé for
India.
 Fed decides course of Indian policy: The liquidity tightening stance of CB in India has resulted in prioritization of “volatility management
in INR” over other mandates in its multiple indicator approach. CB’s successive moves is ample indication that policy has moved in a
direction from where quick reversal is not a natural option. In due course, CB has also removed the confusion about "short-term" nature
of these moves. We see a clear message that the current stance is here to stay, atleast till mid-Sep i.e. when US Fed clarifies on quantum
and direction of QE withdrawal, if any.
 India not ready for another devaluation: Fundamental devaluation as an option to overcome the current crisis is largely ruled out as
interplays between various factors in the external and domestic economy cast a shadow on the success out of such a move. Income
effect led price-inelasticity on imports together with negative real rates and dieselization of the economy has meant that currency
weakening may not yield otherwise standard results. Fact remains that government policies and finances are in such shape that any illthought move may probably boomerang with a sovereign downgrade to junk.
 Global Flows Go Further West: Although there has been some change in the complexion in the top ETFs, we still note the top ETFs (in
flow terms) are US centric and the trend shows no clear sign of turning. The major SPDR S&P ETF garnered more flows in July (USD 12
bn) than it had done in the last 6 months (USD 10.4 bn) whilst US ETFs accounted for 83.4% of the top 15 flows for July as the
concentration narrowed further.
 Delayed Sell Off Exposes India’s Hiding Places: Money moves have continued to flow away from Emerging Markets and commodity ETFs,
with over USD 40.5 bn of selling in the last six months. The withdrawals are now having a knock on effect in India as FIIs move to net
sellers and the Index supports give way. Increasingly, turnover and OI share are being concentrated in a handful of blue-chips, a trend
which is showing few signs of a slowdown, leaving the rest of the market to the mercy of increasingly volatile moves.
 Beyond the payment crisis: We see the ensuing 3-months as very critical for the markets, which will largely decide the course over the
medium term i.e. two years. If India weathers the payment crisis, Indian equities might well see a big ‘sentiment’ rally which exposes the
current weak INR trade to risks. Though the purge is not fully complete, ‘Value’ has seemingly become more broad-based even as the
market seems to be ignoring the benefic effects of a good monsoon.