Why have markets been overreacting?

Dominant market opinions on key issues of debate over the last six months have turned to be incorrect. Brent crude was tipped to reach $100 by the end of the year but instead dipped below $60 in November. The INR/USD was expected to follow crude to 100. Instead, after reaching 75 it strengthened to 69.

The current account deficit (CAD) was expected to reach 3 per cent and financing problems were foreseen as inflows weakened and reversed. Instead, the CAD reduced and inflows revived.

The tenth anniversary of the Lehman crash in September brought many warnings of global risks and a possible repeat. The problems at IL&FS were flagged as India’s Lehman moment, but markets seem to have absorbed it without a major crash.

Over-reaction occurs because of a focus on short-term risks that ignores possible return to fundamentals, or contrary trends that prevent linear outcomes, or ways in which the current situation may differ from the past. Diversity reduces one-way movements since variability comes from multiple sources. The sections below illustrate these arguments.

Oil, rupee and CAD

Diverse trends were clearly there in oil markets, but were ignored. There were short-term political tensions, but long-term trends such as US shale production, the push for renewable energy, and slowing global growth implied softening. Once the November date for sanctions against Iran oil exports passed with some exemptions, the over-reaction was unsustainable.

The nominal exchange rate can be sustainable in the long term if it does not depart too much from its equilibrium or fair value that generates a sustainable balance of payments. India has a current account deficit, so a competitive real exchange rate is required to stimulate exports. But the real exchange rate appreciated since 2014.

In 2017 the REER index, which corrects only for inflation, showed 20 per cent overvaluation. But productivity differentials also matter, and productivity growth has been maintained in India despite a post global financial crisis (GFC) fall in most countries. Other factors affect the relative demand and supply of the rupee. It appreciated slightly against most competing EMs as all currencies depreciated against the dollar, but since 70 per cent of trade is invoiced in the dollar, competitiveness has improved and is probably better than that indicated by the REER alone.

Since global risk-on and falling oil prices led to excess inflows and rupee over-appreciation, depreciation in 2018, as oil prices rose and the dollar strengthened, was not surprising. Excess reserves accumulated in 2017 were used to mitigate depreciation. The RBI used some of the many effective intervention strategies available to reduce volatility but also wisely held back and let markets play out. Overshooting leads to correction, and inflows tip toe back on expectation of capital gains from a strengthening rupee and softening interest rates.

A REER value of 114 was consistent with high export growth in the past decade, and the September average nominal value of 72.22 gave a REER of 113.67. Further depreciation in October (low of 73.66 October 11) depreciated the REER to 111.72, indicating overshooting and a possible return to 69-71. Reserves should be rebuilt if inflows appreciate the rupee beyond that.

While falling oil prices will reduce the CAD, it was not just oil that was responsible for the CAD widening. High real interest rates, real appreciation, demonetisation, and GST all hurt firms’ production, and India’s consumption needs were increasingly met by imports. In these circumstances even India’s free trade agreements only increased net imports.

A correction of real overvaluation and a resolution of GST issues affecting small firms should encourage exports. There are signs of a recent revival in export growth, even as the fall in oil prices reduces the imports bill. A focused attention on removing export hurdles and encouraging sectors with export potential, better credit availability and lower real interest rates, will all help. Reviving inflows are returning the BOP to surplus. But for India’s vulnerabilities from a CAD to reduce, robust export growth is required.

Market liquidity

Another reason for risk-off outflows is the perception of large international risks and uncertainties. Although asset prices are high in the aftermath of quantitative easing, a distinction needs to be made between asset prices and excess leverage. The latter is much more dangerous.

The Basel III focus on regulating banks led to arbitrage towards lightly regulated shadow banks and hedge funds. Lending arms of equity funds substituted for banks. But loan funds leverage for all private equity funds is only 2:1, much less than the 30:1 that was common in banks in the pre-Lehman era. Long-term investors’ losses would occur if asset prices fell, but need not be systemic unless growth collapses. Moreover, if interest rates rise with higher growth, asset prices may not crash.

Annual cross border flows have decreased 53 per cent since 2007 (IMF and McKinsey data), the unsecured inter-bank market has shrunk and there are no large swaps outstanding as in 2008. There is a potential liquidity problem since shadow banks and hedge funds do not have access to high quality assets and lender of last resort facility, and banks are reducing their market-making role. Could markets freeze if financial conditions tighten, as the US Fed raises rates?

India has seen a similar arbitrage towards non-banking finance companies (NBFCs) as regulatory attention reduced bank lending. The IL&FS crisis raised concerns about NBFCs in general. But leverage is not high in the Indian financial system. There are no pre-GFC type risks. On the whole diversification of the financial system has added to its robustness.

The liquidity and refinancing issues of the better NBFCs are being resolved through the banking system using innovative instruments at a higher price that gives banks a profit opportunity. SIPs in mutual funds and their investments in commercial papers have resumed. The slowdown in growth of credit and rise in its price can be resolved through better provision of sectoral and aggregate liquidity, which is ongoing.

Perhaps the Indian experience can reassure the world that liquidity risk can be handled despite changes in the composition of the financial system.

The contrarian view

A contrarian is one who goes against current market trends. Contrarian positions against market perceptions of short-term risk and volatility would have done well in this period.

Apart from recognising diversity, contrary trends, and the different nature of risks today, markets should consider India’s robust long-term fundamentals bolstered by structural reform, growth and potential tax buoyancy. Large economies are less at risk from trade wars, and may possibly benefit from trade diversification. Peaking of the US growth cycle will reduce risk-off outflows for EMs. There are signs the US Fed interest rate has already reached neutral.

So if an investor is able keep her head, when all about her are losing theirs, she would prosper (with apologies to Rudyard Kipling).

The writer is a part-time member of EAC- PM. Views are persona

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