Rewind. Some ‘what if’ questions

After a near-20 per cent fall in the Sensex — from a high of just under 30,000 to a recent low of just under 24,000 — it is but natural for investors to ask whether there is a buying opportunity or if the stock markets are likely to fall further.

The India story is still good but the risk of a further fall would come from global factors. So, it’s a good time for investors to ask some ‘what if’ questions.

One what if question is ‘What if the Saudis removed the dollar peg?’ For years there was an understanding between the US and the Kingdom of Saudi Arabia under which, in return for pricing its crude oil in the US dollar, the US would provide it protection. This created a huge pool of petrodollars, raised global demand for its currency and helped it become, in effect the reserve currency. This enabled the US to spend beyond its means and have other countries save on its behalf and then lend money to the US through purchase of its Treasury Bills.

But now, the US is not very dependent on Saudi crude, thanks to its shale oil production. So, it is cosying up to Iran and has lifted sanctions on it, allowing a further flood of crude oil into the market, further depressing prices. The Saudis are hopping mad.

The execution of an Iranian cleric by Saudi Arabia led to further exacerbation of tensions. Saudi Arabia ran a deficit of nearly $100 billion in 2015. Its foreign exchange reserves will not last long. Its leaders recently met with Xi Jinping, and China Petroleum to start a new refinery in Saudi Arabia. The meeting led to speculation about the possibility of Saudi Arabia going off its dollar peg, (3.75 riyals to the dollar). The investing community is asking ‘what if the peg was removed?’

The Chinese would be happy with this — if crude were sold in renminbi, it would move a step closer to becoming the globally accepted currency. China already has an agreement with Russia to buy Russian oil invoiced in renminbi. Saudi Arabia is a much larger producer. Such a ‘what if’ situation would cause turmoil in currency markets and, ultimately, weaken the dollar.

But it is a moot question whether Saudi Arabia would take such a drastic step. It currently imports everything and if the peg is removed, and the riyal is thus devalued, its expenses would shoot up.

The other ‘what if’ question being asked by investors is ‘what if China has a hard landing?’ This is a more worrying scenario, as China accounts for 17 per cent of world GDP.

This is because the country’s central bank has enlarged its balance sheet to $4 trillion from $4o billion, over the past 20 years. This easy, low-cost money has led to the creation of excess capacities in several industries.

For example, the steel industry grew from a production of 70 million tonnes in the 1990s, to 825 million tonnes in 2014. Now that the construction boom is over, the excess steel is being dumped globally. The construction industry is another example.

These stressed assets are showing up as non-performing assets on the balance sheets of banks, all around the world. In India, Bhushan Steel received a restructuring package for its ₹40,000 crore loan and apparently generates ₹200 crore of free cash flow a year. Perhaps the banks giving the loans should have subjected themselves to a ‘what if steel prices crash’ scenario.

So, a hard landing by China is a worrying scenario for investors, which explains the large exit of FIIs from that market.

Perhaps in anticipation of some such problems, the US Federal Reserve did not increase interest rates at its latest meeting. It may do so at its next meeting, in March.

The Sensex has rallied from its low of just under 24,000. There may be a little steam left in the rally yet. But then, global factors, such as the two ‘what if’ scenarios, or maybe some other, would tend to weigh it down again. Also, according to a CRISIL study of corporate results declared so far, net profits in the December quarter are up a mere 1 per cent over last year. Hence, it would be better to tread with caution.

The writer is India Head, EuroMoney Conferences

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