Riding on hope

As the Sensex scaled new highs, driven first by hope of political change and then by optimism about the BJP’s ability to transform the economy with its decisive majority, many commentators saw this as nothing more than an unreal bubble. All right, the argument went, foreign institutional investors (FIIs) may have pumped $13.5 billion into India in this calendar year, but so what? The real deal is the real economy, which the data suggests is in something of a shambles with the annual IIP (Index of Industrial Production) shrinking, domestic consumption languishing, and India Inc burdened by high debt and poor demand.

What this line of thought overlooks is that liquidity and sentiment have the power to alter fundamentals. For one, there is the currency effect. The surge in FII flows has triggered a 15 per cent appreciation in the rupee against the dollar since last September. This has the potential to reduce costs, lift profit margins and trim corporate debt. A recent report by rating agency Fitch noted that the top 500 companies earned only a fifth of their revenues in dollars, but incurred 42 per cent of their costs in foreign currency. Therefore, every one per cent depreciation in the rupee shaved off 1.3 per cent from their operating profit margins. As the same companies carry much of the foreign currency debt too, a weakening rupee also bloated their interest and loan repayments. Clearly, the rupee’s recent winning streak can reverse this and bring about an equally dramatic rebound.

A robust stock market can also help companies fortify their balance sheets by raising new equity capital to replace debt. Moreover, liquidity and sentiment can raise demand and increase real consumption. By reducing import costs, a stronger rupee makes a range of goods from fuel and edible oils to gold and industrial components cheaper, thereby relieving inflation pressures and stimulating demand. The tendency of affluent Indian consumers to put off big-ticket purchases such as cars, jewellery and durables in recent times was as much a problem of consumer confidence as affordability. After all, the slowdown notwithstanding, incomes in India’s organised sector have expanded at a healthy 15 per cent in the last three years.

Finally, even investment decisions of companies rely, not so much on interest rates as corporate chieftains would have us believe, but on the likely return on investment. So, if margin pressures ease off and consumer confidence revives, those corporates that are not debt-burdened may well look to invest in new projects. This will allow the virtuous cycle of investment, expansion and growth to be set in motion once again. Summing up, liquidity and sentiment have already won half the economic battle for this government. It is up to it to manage the rest.

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