Dollar

Asleep At The Wheel : Why Re Valuations Are A Crisis

Sanjeev

Sanjeev

I am amazed that few people are talking about it, and I certainly don’t see enough noise being made about it. If the Dollar:: Re parity was 12% undervalued, I am sure that it would be on the cover page of Femina.

Declaimer: This article was originally in April 2017, and some of the data points may be outdated

Let’s start at the beginning

Let’s start at the beginning. Raghuram Rajan often said that Re overvaluation cycles have always led to a subsequent currency crisis. This was seen thrice in recent memory, in 2008, followed by 2011, then 2013. Each time, the Re went into a cycle of overvaluation about 12-15 months before the crisis.

Rajan used to insist that these carry trading flows (my words, not his) caused mayhem when they reversed and that banks should be hedging most of their clients’ Dollar payables, against which India Inc. was hedged only about 15% of their total payables.

In 2014, he said clearly that we he was comfortable with the Re trading at 60-62.5 against an REER of Rs.60 in 2014, the time of the first ‘Modi Mania’, in May 2014. If we add structural inflation differentials to that, moderated by estimated productivity growth (of around 1.5%), we find that the Re is way overvalued.

Based on a simple interpretation of the trajectory of differential inflation vis-à-vis the Dollar, most analysts were projecting Rs.69-70 as the target value of the Dollar:: Re. Not a single analyst saw the coming mayhem, when the Re would appreciate almost 9% from those levels, at a time when the Chinese Yuan is at 6.9, up 9% from its pre-crisis level of 6.3.

So who is correct, the market or the analyst? Let’s examine how this happened, and what it indicates:
  • Most of the money came bunched up, with a spectacular $19 bn in 3 months, $8.7 bn in March, and $2.47 bn in the first few days of April.
  • There’s a crack in the charts, a ‘gap’ usually taken in all charts as an irrational, emotional surge in the market, which should get reversed. In most deep markets, it usually does get reversed.
  • There’s a sharp increase in volatility, as knock-on effects have triggered panic among exporters.
  • A clear indication of some RBI intervention is seen, with evidence of reserve accumulation. However, the reserves have not been to the same extent as the capital flows, because of concerns over injecting too much liquidity into the domestic money markets.
  • Shockingly, the RBI did not do much to soak up the excess liquidity in its 6th April, Credit Policy meeting.

None of the above indicates an orderly discovery of the correct value of the Re. We have other indicators of frothiness in other markets, particularly equities, where about half the money went.

Anecdotally, Dmart is trading at a Market Cap of Rs.300 cr per store. Looking at the size of the store, there is no way it justifies a valuation so steep. RBL Bank has a PE of 75. On a particular day, 313 stocks hit the upward filter on the BSE, and P-Es are at levels exceeded only 4-5 times in history.

The RE underperforms

Normally, the Re underperforms the Forward Curve in the Dollar, by a small margin, on the belief that India’s productivity growth will allow its exporters to survive at the lower Dollar::Re prices. But a 10% drop from those prices is inconceivable. There is no historical precedent for such a steep overvaluation of the Re.

Could it be that this is a repeat of the same phase of equity bullishness that we saw in 2007-08, accompanied by those grandiose notions of our economy’s greatness (remember the “decoupling” argument/)? In Nov 2007, in the middle of the equity peak, there were these projections of then-prominent industrialists that Re would reach Rs.35 to the dollar, and we know what happened after that.

Quite obviously, fundamentally, the Re is grossly overvalued. Technically, the crack in the charts is suggesting a wave of irrationality which must reverse in the not-too-distant future.

So what should an investor do? Most equity investors look for the last bear market’s valuation in the current bull market. They won’t find it, but the seeds of the next bear market are already sown in the current bear market in the Dollar::Re.

I don’t think that equity markets are yet in a bubble, although anecdotal evidence of overvaluation in some markets is available. So markets will underperform over the short and medium term, and the best they will do is to time-correct, maybe not price-correct.

So the biggest value just now is to buy the Dollar against the Re. Even after paying the forward premia, there is significant upside left, if the Re corrects back the fair value. If the reversion is quick, the carry cost will be just about a Re, while the upside is about Rs.4.

Go back to 2007, when the Nifty was at 6300 and the Dollar was at 42, going down to 40. A year later, the Nifty was at 2300 and the Dollar was (with a time lag) at 52. If a person had exited the equity market at that time and bought dollars, he would have been a very rich man.

This time, if there’s a crisis, it will come from global cues, particularly an American recession. Strong domestic flows will put a bottom to the Indian equity markets, which caps the downside to about 10%. The Re also won’t go into crisis, but it will certainly be bullish.

Brazil had talked of a Tobin Tax on the kind of irrational flows that went into the Real and created a 36% appreciation in the currency. Can you imagine what would happen to India, if similar irrational flows came into Indian Re just now?

What are these flows betting on? The current BJP government is going to stay around for a long time, and that would give India a reformist govt for a substantial period. And that this would raise productivity growth, to justify such steep currency overvaluation. While the underlying premise is probably true, it is simply not possible that such productivity gains can be justified.

Currency Valuations

And that’s the nub. Stocks can be undervalued for long periods, and you depend on market forces to correct them. But a currency cannot be overvalued like this, because the economy can develop serious distortions if capital flows are allowed to distort currency valuations.

In the last 32 years, the Re has dipped below its 200-DMA only when it is returning from a previous currency crisis. And of course, the Greenspan years. This is the first time when it has been driven by over-excitement about the Indian economy. These flows have to be sterilized, in the same manner, that Raghuram Rajan very deftly did in 2014, when he accumulated reserves very aggressively, to communicate to the markets that the RBI would follow a visible Forward Curve, allowing both importers and exporters to plan their hedging levels, year to year.

Why has the RBI allowed the Re to pierce those levels? Does it believe that expectations of such productivity gains are justified and that the Re deserves such a valuation premium? How can that be, when inflation targets were hiked in the same meeting that RBI stayed mute on liquidity-hardening measures?

This is no longer a valuation issue, but an issue of macro-management, which has the potential to seriously distort the competitiveness of Indian exporters, especially in an environment when our most important trading partner is seeing a softer currency. Going by the technical indicators above, this is the first time that RBI has communicated to the currency markets that it is comfortable with serious Re overvaluation, eroding its credibility in managing the “dirty float” of the Re. The credibility will not be easy to retrieve, and India will be targeted for more such “currency attacks”, which will increase volatility in the Re, exactly what the RBI is trying to prevent.

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