Hexagon Wealth

August, 2013
Market Watch

The Sensex jumped to a 30-month high on July 23rd but finished the month in the red – the second consecutive monthly decline. The rupee’s weakness and redemptions by foreign institutional investors (FIIs) weighed on equities.



The S&P BSE IT index was the best performer and rose nearly 20% in July. Shares of IT companies rallied after TCS and Infosys reported strong earnings for the first quarter of the current fiscal. Wipro’s positive revenue guidance also contributed to the rally.

However, rate-sensitive indices – the S&P BSE Bankex and the S&P BSE Capital Goods Index – fell during the month.

The first-quarter results showed worsening non-performing assets (NPAs) which spooked the Bankex. These stocks may gradually recover after the second quarter.

Most banks are aggressively finishing write-downs, while net interest margins (NIMs) are healthy.

Bonds fell during the month after the RBI announced liquidity-draining measures to restrict the volatility in the rupee. The benchmark 10-year government bond had a rollercoaster ride and rose by 73 basis points during the month.

The weakness in the equity markets may continue as bad governance is compounding India’s high current account deficit and the pressure on the rupee.


An interest rate hike, but not quite

In July, the rupee fell by 1.7% - the third consecutive monthly fall. The currency fell to a record low of Rs 61/21/$ on 8th July but recovered marginally later in the month and closed at 60.40/41 against the dollar on 31st July. The RBI imposed emergency liquidity tightening measures to stabilise the currency and discourage speculation in the rupee. On 15th July, the RBI imposed a cap on banks' borrowing at the repo rate and hiked the marginal standing facility (MSF) rate to 10.25%. The central bank also announced that it would sell bonds worth Rs 12,000 crores through open market operations (OMOs). The RBI enhanced these measures on 23rd July when it raised the daily cash reserve ratio (CRR) requirements for banks to 99% from 70%. Additionally, the overall limit for access to funds under the liquidity adjustment facility (LAF) by each individual bank was set at 0.5% of the bank’s own net demand and time liabilities (NDTL).

The RBI has effectively raised interest rates indirectly by restricting liquidity and raising the cost of borrowing for banks. If successful, the central bank’s tactics may reduce the volatility in the currency as interest rates may rise in the short to medium-term. This may attract FIIs as foreign investors may benefit from higher yields by investing in Indian fixed income instruments. India is dependent on foreign investment to fund the current account deficit which rose to a record high in 2013.

The central bank’s shock tactics led to volatility in the fixed income markets. As shown below, short-term yields reacted sharply to the central bank’s announcement. Nevertheless, the impact was not restricted to short-term instruments as long-term rates also rose.


The returns of debt funds of various maturities (including money market funds) fell after the central bank’s announcement. Some of our recommended income and dynamic funds have managed to restrict losses and have outperformed the Crisil Composite Bond Fund Index. This was partly because the fund managers of these schemes reduced the exposure to government securities (the prices of G-Secs usually drop more than the prices of comparative corporate bonds when yields rise) and increased cash levels in portfolios.

Investors in these funds may eventually benefit from higher accrual returns (as carry yields have increased) after stability is restored. Markets may be unpredictable in the short-term but bond valuations are very favourable after the steep rise in yields. Income funds may generate capital appreciation if the RBI unwinds its temporary measures when the currency stabilizes.

A sustained rise in long-term interest rates is unlikely as the RBI’s move targets the currency, rather than interest rates. In the monetary policy review on 30th July, the Governor announced that the bank’s measures “would be rolled back in a calibrated manner as stability is restored to the foreign exchange market, enabling monetary policy to revert to supporting growth with continuing vigil on inflation”. Consequently, rate cuts may be delayed but a reversal in the interest rate cycle is unlikely because of the economic slowdown which may be prolonged in the short-term because of the central bank’s unexpected measures. The silver lining is the good monsoon which may ease food inflation and lead to an increase in rural consumption which may support growth.

The government announces reforms but the measures lack teeth

FDI Reforms

The RBI’s actions on 15th and 23rd July are temporary measures which may stabilise the currency in the short-run and may ensure that India attracts enough foreign investments to fund the current account deficit (CAD).

Nevertheless, the recent turbulence in the rupee highlights the dangers of relying on volatile FII inflows to finance the CAD. The RBI stated that India needs to use relatively more stable foreign direct investment (FDI) to fund the deficit.

On July 16th the government unleashed a second round of FDI reforms (the first round was in September 2012). This may help India attract more FDI in the medium-long term.

Furthermore, investors will now be allowed to use the automatic route in several sectors – which may expedite the investment process.

However, these measures alone are not sufficient to attract foreign investment as the government also needs to focus on improving transparency and corporate governance. Markets largely ignored the proposed changes to the FDI limits and speeches by government officials.

The government should also focus on reducing the quantum of the CAD to sustainable levels (2.5% of GDP). Recently, the government and the central bank took steps to discourage gold consumption and hiked import duties – this may increase domestic gold prices. In spite of this, the government is not tackling the real issues to reduce the CAD.

India’s current account balance has also deteriorated because exports have slumped. On 31st July, the Commerce and Industry Minster announced that the rate of interest on the subsidy scheme for exporters would be raised to 3% (the current rate is 2%). The government also plans to expand the scheme to cover more sectors. This may increase India’s exports and GDP and ease the pressure on the CAD. But the government also needs to improve India’s export competitiveness, particularly in manufacturing.

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Why does India need manufacturing?

In July, India’s manufacturing sector barely expanded as the HSBC Markit India Manufacturing PMI fell to 50.1 from 50.3 in June. The index is now just above the threshold of 50 which separates expansion from contraction. Furthermore, output fell for the third consecutive month in July. The fall was also reflected in the Index of Industrial Production. In May, the index fell by 1.6% - the worst performance in the last 11 months as the manufacturing sector (which accounts for 75% of the index) contracted by 2%. The decline in the manufacturing PMI was predominantly because of power shortages and the slowing pace of new orders.

Share of

The sector has also been adversely affected by sluggish demand and high interest rates. The graph suggests that the manufacturing sector in India has a long way to go before the goals in the National Manufacturing Policy are achieved. These objectives include increasing the share of manufacturing in GDP to 25% by 2022.

An expanding manufacturing sector is crucial for sustainable economic growth and job creation as India’s working age population is expected to rise by 125 million over the coming decade. According to the Boston Consulting Group, every job created in manufacturing has a “multiplier effect” and generally creates two additional jobs in other sectors. Hence, India needs to stimulate growth in the manufacturing sector.

In most other emerging economies, the manufacturing sector has grown faster than GDP. This phenomenon contributed to the success of the Asian Tigers between the 1960s and 1990s. China, in particular, has derived substantial benefits from being the world’s manufacturing hub. However, firms may choose to outsource manufacturing to other countries as wages in China have now risen. According to a McKinsey report, between 2003 and 2010, the manufacturing labour cost per hour rose by 16% to $1.8 an hour in China but only rose to $1.4 in India.

India can seize this opportunity to increase its manufacturing exports and its share in global manufacturing, if the government implements reforms to increase power generation and investment and expedites the approval process for new projects. This is crucial as in the World Bank’s Ease of Doing Business Index, India is currently ranked at 132/185 and is behind the other BRICS.

Eurozone: Is a recovery in sight?

Unemployment in the Eurozone fell for the first time in more than two years in June. The jobless total declined by 24,000 to 19.26 million in June. Furthermore, the manufacturing sector returned to growth as the Markit Eurozone Manufacturing PMI rose to a two-year high of 50.3 in July from 48.8 in June. Since 2011, the index has been below the threshold of 50 which separates expansion from contraction. The index of economic confidence in the Euro area also rose in July and rose to a 15-month high of 92.5. These indicators suggest that it may be the beginning of the end of the longest recession in the bloc’s history.  However, like India, the Eurozone’s recovery to growth will also be gradual. The overall unemployment rate is still at a record high of 12.1%. The IMF expects the Eurozone’s GDP to contract by 0.6% in 2013. But subdued inflation rates provide the European Central Bank (ECB) with room for monetary easing to stimulate growth.

Last week, the ECB announced that it would keep interest rates low for an extended period. The bank’s policy is in line with the IMF’s recommendation. The organisation also wants the Eurozone nations to implement structural reforms, particularly in the banking sector and in the labour market. These reforms are necessary for long-run economic growth. Nevertheless, the IMF expects the bloc to expand by 0.9% next year. An uptick in growth in the Eurozone may have some positive spillover effects for India as the region accounts for 13% of India’s exports.

Global Indices: Wall Street Journal
Domestic Indices: BSE/ Accord Fintech



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