India Liquidity Watch

India Liquidity Watch

Risk Spread, Liquidity and more..

One of the measures of investor's desire to take risk is something known as the "spread".

The "risk spread" is the difference between the estimated rate of return on 2 alternative investments, identical in tenure (the time horizon of an investment) but differing in risk.

"Liquidity" is essential to keep any economy moving along, just as it is essential to keep your house from functioning. Every day you need to pay bills to keep your home from functioning like a home with food and milk and daily houselhold needs.

Similarly, the US economy needs some level of liquidity to keep running on a daily basis. Companies have access to this liquidity via short term Commercial Paper. These 3-month instruments are issued to the banks and other investors (who have surplus cash) and are used by the companies to pay salaries, short-term expenditures like buying paper clips or spare parts - "working capital" in financial jargon. These 3-month loans are normally seen as very low risk and are issued by financially strong companies.

The chart below shows how the "spread" between what a US investor in a 3-month government security (the Treasury Bill which has zero risk) widened suddenly as investors decided to move away from any risk. These invstors were willing to park their money in these 3-month T Bills and were happy to take a lower interest rate (see the sharp decline in the yellow line).

It is important to note that the rate of interest paid by the borrowers increased - but only marginally. The widening of the spread (the difference between a risky asset and the less risky asset) was more due to the fact that investors shunned risk and had no desire to lend money to any company - irrespective of its financial strength.

The 0.5% cut in the US Federal Reserve's discount rate (from 6.25% to 5.75%) was intended to allow banks to start taking money from the Fed and use these extra funds to go out and supply liquidity to the companies in the real economy.

This graph is important because it highlights what can happen to international capital flows into India. Since nearly 50% of the FII flows into India is reportedly via P-Notes and consists of short-term capital, India is unfortunately, linked to changes in short-term interest rates and, more importantly, changes in short-term assessment of risks.

If these short-term investors decide they wish to be in less risky assets, they can - very quickly - retain their extra funds in assets which give low returns and sacrifice the returns they could get from assets like the Indian stock market.

So, a 3.0% annualised return on 3-month loans to the US government is more attractive than a possible 15% annualised return from buying Indian stocks.

Its not that India has become less attractive - its just that international investors with short-term investment time horizons want less risk.

However, if the recent stalemate between the coaltion partners over the Indo-US nuclear deal continues, then these short-term investors will consider India a more risky investment proposition.

These investors will then demand more return for staying on - or entering - India's more risky stock markets.

That is why, while most stock markets around the world recovered in a "relief" rally on Tuesday, August 21st, the Indian stock markets saw a -3% slump.

How long will this last?

We don't know - but what we do believe is that as long as India encourages short-term capital flows via P-Notes, our stock markets will be linked to these global cues. On the upside and the downside.

This is great for the brokers and the TV channels that need to see some activity every second - but not good for your heart.

China: Liquidity, Liquidity, Liquidity

Denise Yam | Hong Kong

Liquidity trends appear to have dominated the discussion of macro outlook for the Greater China economies of late. The relationship between liquidity and each economy has rather different characteristics, and we offer a descriptive account of each of them in this note.

China— managing excess liquidity. The Chinese government has been claiming success in macro tightening, reporting slower economic activity in response to administrative controls in the last few months. However, China has not yet resolved the fundamental problem of excess liquidity from the large trade surplus and capital inflows. The cost of capital remains too low, leaving the economy vulnerable to a revival in overheated and speculative investment. Recent PBoC rhetoric has shifted the policy focus to liquidity management, through lifting reserve requirements and/or issuing bonds. In 2006, the PBoC has hiked interest rates twice and raised reserve requirements on Renminbi deposits three times. Meanwhile, issues of central bank bonds have been kept up to absorb liquidity from the banking system. However, these measures have not been enough to offset the supply of liquidity from the balance of payments surplus.

Each percentage-point increase in the reserve requirement supposedly locks up Rmb320 billion of banking system liquidity. However, financial institutions' deposits with the PBoC totaled Rmb3.8 trillion at the end of September, already covering 11.6% of total deposits, exceeding the requirement. In other words, the "required" ratio of 9% has not been a binding constraint on liquidity. In fact, subsequent to the sharp increase in reserve deposits in 4Q03 following the first tightening move (August 2003), which brought loan growth down effectively over 4Q03-2Q04, the actual reserve ratio has again drifted downwards since early 2005, allowing or possibly contributing to the reacceleration in loan growth.

Because the reserve requirement has not been a binding one, the total achieved sterilization (increase in actual reserve deposits and central bank bonds outstanding) has fallen short of the intended sterilization (increase in required reserves and bonds) as well as the BoP surplus. The BoP surplus of US$207 billion in 2005 met with only a US$146 billion (71% of the surplus) increase in reserve deposits and bonds. In 2006, sterilization remains incomplete, at 76% in 1H06 (US$122.1 billion BoP surplus vs. US$92 billion achieved sterilization) and worsened to 59% in 3Q06 (US$46.8 billion increase in FX reserves vs. US$27.4 billion sterilization). The unsterilized surplus since 2005 therefore totaled US$110 billion.

Quantifying the impact of sterilization against the BoP surplus helps explain why the monetary tightening measures so far have not been sufficient to lift the cost of capital meaningfully, which we believe is vital in discouraging wasteful fixed investment. The bond issuance program has been far from aggressive in recent months, suggesting that the PBoC remains reluctant to lift interest rates significantly. We believe that this incomplete sterilization underpins the friendly liquidity environment in China, leaving lending, investment and overall economic activity vulnerable to a rebound. Although government policy continues to target slower growth, ample liquidity amid incomplete sterilization of the expanding BoP surplus should limit the harshness of the deceleration.

Hong Kong — enjoying liquidity inflows, but wary of volatility. Liquidity conditions and asset market performance have a strong influence on real economic activity in Hong Kong. The influence has further stepped up this year on the back of the increase in large-size listings of Chinese enterprises in the Hong Kong stock market. The HK$-denominated financial asset base has grown significantly, powering monetary expansion far ahead of economic growth. Capital inflows, absorbed by the banking system in the form of an expanding net foreign asset position (US$25 billion over the 12 months ending Oct-06), have resulted in a downtrend in the HK$ loan-to-deposit ratio, and lower HK$ interest rates (against their US$ counterparts) in recent months, further supporting asset market valuations and gains.

The expansion of Hong Kong’s financial asset base in the last few years has been driven by China’s increasing appetite for international capital. The performance of the asset markets is not so directly representative of Hong Kong’s domestic economic fundamentals, but ironically has become the driver of monetary conditions and economic sentiment. Stock market capitalization has surged to HK$12.1 trillion, more than 8 times GDP. In other words, each 1% rise or fall in the stock market represents an amount equivalent to 4% of broad money M3, or 8% of GDP.

We have seen robust pickup in consumption and investment on the back of asset appreciation and low interest rates in the last couple of years. Consumption has been lifted by the positive wealth effect, while employment, wages and household income have only been catching up in the last two quarters. Consumer businesses have also turned more positive on expansion plans amid stronger consumption. However, it worries us that, as a small, open economy with a fixed exchange rate, Hong Kong’s strong leverage on liquidity conditions and asset market performance results in volatile business cycles driven by non-domestic factors.

The imminent crossing of the RMB/US$ and HK$/US$ exchange rates upon further RMB appreciation has lifted expectation that the HK$ will follow. We sympathize with the psychological impact of the RMB breakthrough on the HK$, but believe it will prove to be temporary. We believe that the expanding HK$ financial asset base is the dominant factor behind the current low interest rate environment, meaning that low interest rates could be sustained even beyond the speculation for HK$ appreciation subsides. While we are reluctant to make purely speculative forecasts on further deviation of HK$ interest rates from their US$ counterparts (hence sustained strength in asset prices), it is quite possible that anomalous monetary conditions sustain for even longer.

Taiwan— reliant on foreign liquidity. Amid sluggish domestic demand and continuous outward investments by local enterprises and individuals, asset markets in Taiwan have been supported by loose monetary conditions, made possible by the accommodative stance of the central bank, the current account surplus, and sustained foreign interest in Taiwan’s financial assets. Balance of payments trends clearly demonstrate Taiwan’s increasing dependence on external demand and foreign portfolio investment. The persistently large current account surplus, likely to reach 6% of GDP in 2006, reflects the output gap amid structural weakness in domestic consumption and investment. In the financial account, Taiwan has been a net exporter of direct investment capital, totaling US$10.7 billion since 2004 and US$20.7 billion since 2001. Portfolio flows, on the other hand, are characterized by local investors investing increasingly abroad but partially cushioned by foreign investments in Taiwan equities. Foreign portfolio inflows totaled as much as US$13 billion in 4Q05, buoyed partly by the MSCI re-weighting, but these have been offset by accelerated outbound investments by locals since 2004, leaving the overall financial account barely in balance since 2004. The overall balance of payments surplus since 2001 has contributed a great deal to the easy monetary conditions in Taiwan and the recovery in asset prices. Ample liquidity in the banking system has kept interest rates low. Rates are low even at the long end, with the 10-year government bond yield hovering around 2% at present, keeping financial assets afloat even amid a weak domestic economy.

Nevertheless, easy monetary conditions and low rates should not be assumed indefinitely. Foreign capital inflow is a crucial factor in the current delicate monetary balance. Monetary conditions, and, hence, asset prices, are extremely vulnerable to an abrupt turnaround in foreign portfolio flows. The size of and swings in short-term capital flows have increased significantly in the past decade amid increasing global financial integration. Quarter-on-quarter swings in short-term capital flows could be as great as 20% of GDP and could be extremely destabilizing for financial markets. Needless to say, measures to slow the pace of capital exporting by local investors or even encourage repatriation of earlier outflows would be ideal, although the unfavorable political climate and business uncertainty prior to the drawing up of a concrete roadmap governing cross-strait exchanges are to be blamed for the persistence of the outflows at present. Fortunately, in Taiwan’s favor is the buffer of excess liquidity stored in NCDs (outstanding NT$3.74 trillion, or US$113 billion), which the central bank can release to the money market to maintain accommodative conditions and low interest rates in the face of unfavorable capital flows. Moreover, the US$260 billion-strong foreign exchange reserves provide an additional shock absorber.

The 2007 outlook for all the three Greater China economies is very much dependent on global liquidity trends. The correction in commodity prices and apparent taming in inflation expectations have caused markets to expect a more dovish monetary policy stance from the major central banks. Specifically, our US economists now believe that the Fed is done with tightening, and easing could kick in as soon as 2H07. Nevertheless, it would still be irresponsible to deny the growing risk of a contraction in global liquidity that could have a greater impact than in the past. Upside surprises to inflation continue to haunt the industrialized world, heightening risks of further tightening. In the much-feared scenario of global stagflation, investment fund flows to emerging markets will unlikely avoid an adverse turnaround, drying up funds for China’s investment, and forcing asset prices to correct in Hong Kong and Taiwan.

Sensex riding on optimism

Continued strong corporate earnings growth remains the key driver of the market rally.

At a lifetime closing high of 13,282.91 (10 November), the barometer BSE Sensex is up 41.3% in calendar 2006 so far.

`The market sentiment is positive, as investors seem to have already revised the earnings' estimates upwards for FY07 and look poised to discount FY08 earnings, which is evident from a strong of 77% rollover of October futures to November’, notes Nilesh Shah, Chief Investment Officer, Prudential ICICI Mutual Fund in the latest October 2006 monthly fact sheet.

For Q2 September 2006, the aggregate net profit of 3,096 companies surged 46.7% to Rs 52,272 crore, on 30.8% growth in net sales (sales include other income for banking and finance firms) to Rs 5,14,841 crore.

With expectations that the momentum of earnings growth would be sustained, FIIs have stepped up buying. Strong global liquidity has aided the surge in inflows. By the first few days of November 2006, FII inflow has reached Rs 2,237.90 crore (till 9 November). In the month of October 2006, when the earnings poured in, their net inflow totaled Rs 8,013 crore compared to an inflow of Rs 4,643 crore in August and Rs 5,428 crore in September. FII-inflow in calendar 2006 so far has reached $7.14 billion. In calendar 2005, FII inflow was a record $ 10.7 billion.

A section of the market attributes the solid surge on the Indian bourses to increasing recognition of India’s long-term growth prospects. India’s growth drivers are a favourable demography (large share of young population), robust domestic consumption and acceleration in infrastructure creation. Prime Minister Mahmohan Singh has promised a complete policy on infrastructure, including regulatory and institutional framework, to make it attractive for private participation in the near future. The market has soared in the past two years. From 4,644 on 23 June 2004, it has galloped 186% in less than two and a half years.

Not only earnings but also corporate restructurings, demergers and foreign acquisitions, have lifted investors' confidence in India Inc. In recent months, some big ticket overseas acquisitions were made by Dr Reddy’s Lab and Tata Coffee. If Tata Steel’s planned $8 billion acquisition of Anglo-Dutch steelmaker Corus goes through, it will be the biggest acquisition by an Indian company overseas. Besides, there have been a slew of small and mid-sized overseas acquisitions by Indian firms over the past couple of years.

Indian markets continue to trade at a premium over its regional peers. The premier index, BSE Sensex, trades at a PE multiple of 21.7 based on its trailing 12-months September 2006 earnings.

Market men expected volatility to emerge on the bourses in the near term following a solid surge over the past few months. `Investors may encounter short-term volatility as the market tries to scale further highs or even sustain the current levels, and hence, investors should remain patient and have a long-term investment horizon’, says Prudential ICICI’s Shah.

In its October 2006 monthly fact sheet, HSBC Mutual Fund’s fund manager states that inflation remains the single biggest risk for the Indian equity markets. It was the data that showed cooling off of inflation for the last week of October, which boosted the bourses on Friday (10 November). Yet, the last week of October has been the fourth week in a row that wholesale prices-based inflation stood above the 5% mark. RBI raised its key short-term interest rate by 25 basis points in its latest credit policy on 31 October.

What could suck liquidity from the secondary market in the near term would be some large IPOs that are in the pipeline in the next two months, especially by DLF and Cairn Energy.