The chaos theory

The safe-haven status of the dollar and food inflation in India have disrupted linkages between stocks and currency

By Mohan Sule
Once upon a time not far ago, there was a perfect world. The prosperity at the beginning of this century did not come out of the blue but was the result of different stages of evolution. Opportunity for a better life mutated into greed and transcended into lust. A dot transformed into a decimal, bloating into a balloon. Eventually, there was a bust. It took a few years for rays of hope to pierce the gloom that enveloped the globe, which had become closely entwined. Parts of a machine were produced in different corners and assembled in another location and sold someplace else. There was no false sense of nationalism. Instead the race was to build on the core strengths of demography, technology and market. For instance, an exporter of back-office services could be a voracious consumer of fast foods and luxury labels. A nuts-and-bolts hub of the world could have insatiable appetite for commodities. Money was cheap and plenty and sloshed around wherever it was needed. It looked like good times were here forever. Alas, it was not to be. Once again, living beyond means got the better of a prudent lifestyle. Money ran out even as debt piled up. The monetary earthquake shook the foundations of blue-chipped institutions. Some crumbled into dust. September 2008 was the turning point for the financial history of the world just as BC and AD are pegs to chart the age of the globe. A pre-Lehman Brothers has become a lexicon to conjure images of debauchery. It has become a marker for future generations to know that the world would never be the same again.

Going by textbooks, low interest rates encourage risk-taking. The US stock market is hitting record highs on near-bottom interest rates. But instead of plummeting because the US Federal Reserve still doubts the strength of the economic recovery and refuses to raise interest rates, the Dow Jones continues to surge. The picture in India is the reverse. Stocks are sprinting despite high cost of money. Reserve Bank of India Governor Raghuram Rajan has warned of outflow from India on a US bounce-back. The question that will arise on this possibility is: will the S&P 500 benchmark retreat because of competition from debt? And, in such a situation, will the RBI remain on course of lowering interest rates once food inflation falls? The interesting takeout is that India’s central bank will have to second-guess the Fed rather than follow a course dictated by India’s economic indicators. So there could be a strange paradox of the US playing by the rule book of keeping interest rates down to trigger growth and India’s central bank refraining from lowering interest rates on fear of exit of foreign money. The burden of preventing a major disruption in the market will be on the Indian government by ensuring that foreign investors earn return in excess of that back home. Take the comeback of bank stocks despite high non-performing loans. The market is re-rating them in the belief credit offtake will increase as thrust sectors such as infrastructure will have to rely on debt to fund capital expenditure. On the other side, a bubbly stock market is enabling highly-leveraged companies to become light by raising equity to retire debt.

Another lesson that has turned topsy-turvy is that the strength of the currency reflects the economy. Despite near-recessionary condition, the US dollar continues to rule. The acquisition of a safe-haven status means a bear attack drives investors to hoard the greenback and so also a bull-run. The Indian currency, confirming to textbook behavior, turned weak during the slump. Yet it also exhibits a contrary trend. High interest rates should bolster the rupee. Instead, a strong dollar is keeping it suppressed as also RBI’s mop-up from the market to fend of repercussions of any stampede. Now the question is will the rupee depreciate further if interest rates are pared? The Indian currency should gain due to the resultant acceleration in foreign investment on growth prospects getting a boost. If this does not fox traditionalists, then the recent phenomenon of narrowing trade deficit should. Growing imports signal industrial acitivity. A soft rupee, therefore, should widen the gap as India’s imports, particularly those of energy (US$ 450 million in FY 2014), exceed exports (US$ 312 million). Ironically, the chasm is shrinking because of squeeze in gold imports and cooling of oil prices despite tensions in the Middle East. The cause is the slowdown in China, whose FDI hit a four-year low in August. In fact, China, a major exporter of cheap goods, should be cranking up its wheels with consumption in the US poised to look up. Meanwhile, rising food intake, rather than the growing hunger for oil, on the back of economic expansion is keeping consumer inflation afloat in India. Indeed these crosscurrents are the new challenges for central banks and governments as age-old equations are giving way to a new chaotic order.