'RBI will continue to intervene for quite some time'

Shekhar Sathe, CEO, Kotak Mahindra Asset Management Company, has been closely involved with all the three markets. Investment Editor Niraj Bhatt catches up with him to find out what he thinks of the recent developments and his advice for investors.

The rupee seems to be finding a new bottom every week. What is the reason?

Actually, the rupee is behaving very predictably. The rupee's fall should not surprise anybody. The question was what would be the speed of its fall and the reaction of the RBI, who is the manager of the rupee.

The RBI has made its preference known that it would not like to see the rupee depreciate rapidly. That is one of reasons why it came out with the interest rate hike a few days. The RBI has cited domestic and international developments including the foreign exchange market. So rupee is only one part of the measure.

The other part is the domestic financial market, which -- in my view -- is a technical factor. There was this sudden burst of liquidity in July, especially in the last week, and more in August, due to the maturity of government securities. If the RBI had not come out with these measures, the market would have got away with its craving for higher interest rates. So the RBI has, sort of, pre-empted that and pushed up the interest rate.

Interest rates would have risen irrespective of RBI's hike?

Yes. But the benefit of the RBI doing it is that it can always make it a temporary hike. The RBI has done a smart thing - it has mopped up liquidity from the system by the CRR hike and it has reduced refinance. Reduction in refinance is an indirect way of mopping up liquidity; the money it was supplying by refinance has been halved. So it is getting that liquidity out of the system. And with this money that it sucked out, it made a private placement with itself and put it in the open market window. On the balance, the liquidity is not bad for August.

The other impact of the half per cent CRR increase would be that it would suck that much more liquidity from future deposit growth, too.

But what is perplexing is that RBI is intervening in the forex market and it also has the open market window on securities. So in the forex market, it supplies dollars and takes out rupees; and in the open market window, it is buying securities and bringing rupees in the system. Whether the RBI has been successful in meeting its objective or not, is not very clear yet. The rupee crossed 45 today (August 1). But I think that the RBI will continue to intervene for quite some time.

So it will be a managed depreciation…

Yes. The problem with the Indian market is that the supply of dollars is minuscule compared to demand for dollars. Supply and demand are technical words, because they do not restrict themselves to supply of physical dollars and demand of physical dollars. Most of the demand for dollars is future dollars as commitments like imports or loan repayments are all in the future. And any fear of rapid depreciation of the rupee forces those importers or borrowers to buy dollars in advance.

So the future demand gets advanced to the present and that puts pressure on the rupee. It is reflexive and is not necessarily speculative. People are not buying dollars to make profit, but they are buying dollars to prevent losses in the future. Look at India's total export bill of about $35 billion against an import bill of $40 billion, leaving a trade deficit of $5 billion. But the outstanding borrowings are of $90 billion. Technically, these are future payables and can come to the present if everybody wants to cover their dollar outflows. So there is no way that this equation can be sorted out unless we get supply of future dollars like foreign direct investments.

Thus, the RBI will have to manage the sentiment and prevent people from advancing their need for future dollars. The market mechanism takes care of it as the premiums for forward dollar go up, and it becomes neutral whether the rupee actually depreciates or people buy forward dollars at a higher cost. So that balancing will happen. The premiums have increased after the new measures but they are not very high.

You will also not get the volatility that used to be there in the forex market three-four years ago. Premium moving from 3.5 per cent to 5 per cent is a steep rise and that could become a deterrent and persuade people against buying dollars. But if people expect the depreciation of the rupee to be faster than that, then they will pay the extra price. So that is the balancing that the RBI will have to do.

Do you think it will fall further?

The real effective exchange rate (REER) does suggest that the rupee needs to depreciate further. It is about 2-3 per cent overvalued, which is not much. This kind of a differential is acceptable. So when the RBI says it does not target an exchange rate, I do believe it. The RBI shouldn't mind a normal rupee movement in a band of plus/minus 10 per cent of REER. What it would mind or would like to prevent from happening is the change of sentiment because if the pressure starts building up, it's like the gates of a dam breaking and there will be a flood. So that is what they are trying to contain.

What will be the impact on interest rates?

Interest rates have already firmed up and there is pressure for interest rates to rise further. If the situation goes out of hand, then interest rates will rise and the rupee will fall. That has to be managed. The rupee depreciating is a result that everybody will want to see, but with interest rates going up, I don't think anybody is interested in seeing that today. There are already signs of a slowdown with some sectors showing growth, but most sectors showing negative growth if you look at the latest CII survey. If the economy is turning towards the negative side, the industrial production and growth figures will also be revised. In that kind of a situation, you cannot expect interest rates to rise. Any sharp rise in interest rate will exacerbate the negative sentiment on industrial growth. Therefore, interest rates need to be contained. And inflation seems to be manageable right now.

What options does the RBI have?

Deft management. Money supply is already there. If you look at the broad flow of money into the system, they require Rs 1.17 trillion on a gross basis and 48 per cent of this has already been picked up from the market till the end of July. In the remaining eight months, they have to take out 52 per cent. No serious slippage on the Rs 1.17-trillion figure is expected. Tax collections have grown impressively in the first three-four months.

One incalculable factor is the divestment which has not been factored in in the Budget. Any divestment that actually occurs will be positive for all financial markets. Things are moving but very slowly, and one will have to wait and see the results and not conjecture. That will be a bonus.

Does it make you bearish?

Overall, if you look at the cash flow in the system, it seems to be balanced. But that balance is rather delicate; it is not a very comfortable balance. One of the main balancing elements is the foreign currency reserves. These reserves have shown a decline of close to $2 billion. It was $1.4 billion till July 15. During the last week of July, there have obviously been interventions. The RBI must have spent around $500-600 million in the market, which we will know on Monday when it publishes the numbers. So a fall in reserves of $2 billion means that rupee going out of the system in the order of Rs 90 billion. (If the reserves rise, rupee supply increases in the system and when they fall, rupee supply reduces.)

The balance is now so delicate that if it falls another $2 billion through the year, then another Rs 90 billion will be out of the system. So, if you are actually factoring growth and then you get a negative growth, the impact will be double. If you are factoring an increase of $2 billion and if reserves fall by $2 billion, then the gap is $4 billion, and that is Rs 180 billion. Then you will see a liquidity shortage.

The positive side is that you have seen valuations benchmark emerging in telecom (licenses changing hands, foreign partners coming in, etc) and that could result in inflow of dollars. Portfolio flows are also delicate.

So, the overall balance is there but it can tip either side. The vulnerability is on the negative side.

A question to ask is at what rate will the Government of India raise three-year money six months down the line. There lies the key to what will happen. That interest rates will rise is loose talk; how much they will rise is important. Today, three-year money is costing at 10.5 per cent. Will it borrow three-year money at 11.5 per cent? No. They have never done it in the past.

In this process of globalisation, the Indian interest rates have to converge with the rest of the world over the long term. This process will happen in fits and starts and, hence, the volatility. The long-term direction is absolutely clear; it has to converge otherwise we can't be globally competitive.

So you don't see a sharp rise in interest rates?

No. Inflation has seen a sharp rise when you compare it from 3 per cent to 5 per cent, it is a big jump. But 5 per cent is not bad. We think that the RBI and the policy makers have factored an inflation rate of 6 per cent. One of the major reasons has been the rise in oil prices.

What about the impact on the stock market?

Stock markets are driven as much by sentiment as by profits. So far, the profits have been good. So the question is, will the real economy sustain that kind of growth? The results have been good for software, pharmaceuticals and fast moving consumer goods. Software will continue to grow at the same rate. And if software growth accelerates, then it can reduce the pressure on the rupee actually. Whether it can accelerate and at what speed depends on how the companies actually do.

How have your funds done in this period?

Our equity funds have more or less performed with the market and with the peer group. In the technology and balanced funds, we have done better than the benchmarks. But that is not important, finally the investor would like to see a positive growth in their investment. In the technology sector, we expect that we will see this growth but it will not happen very quickly. For the market to resume their uptrend, we will have to wait for two-three months.

For debt investors, the interest rate-hike has impacted some of the net asset values. But broadly, the NAV impact has been contained between 1-2 per cent. If you look at it overnight, it looks alarming but, say, if the NAV has dropped 1 per cent, for you to recover that 1 per cent will take only a month. It is only the large investors who tend to get affected as they have mainly invested for the short term. If you are caught on the wrong foot in that period, then you have lost money though the loss may not be significant. But people who ride this out or people who enter now will benefit.

Do you think the three markets (forex, debt and equity) have become closer now?

Yes. The linkages are becoming very evident and that should be the case., the markets are linked. If you try to artificially segregate them, the pressures in the system are bound to build up. If you allow freedom of movement between the three markets, then the pressures can reduce and balancing can happen. Like I was talking earlier about the open market operations and forex intervention: on the one hand, you are sucking out liquidity and on the other you are releasing it. So the markets are related and arbitrage may not be possible under the current dispensation.

A direct correlation between the stock market and interest rates has not been really proved in India because of the multiplicity of interest rates that exist in the system. So the impact is there, but we cannot see it and we can attribute only a part of it. For example, on the Bombay Stock Exchange, the badla interest rates are different for different stocks. So how the interest rate firming up in the money market translates to the stock market is very difficult to gauge. And the cost of finance for the stock market and cost of finance for the industry are two different things and there is such a wide variance of interest rates there. We will see the transmission happening once we see the futures market becoming deeper and more liquid. The difference between the futures rate and spot rate is reflective of the interest rate. Once this multiplicity of interest rates reduces, then the transmission will become clearer.

How is the mutual fund industry coping in this environment?

The mutual fund is still emerging as a victorious vehicle despite this fall. That is one lesson we must understand carefully and make the mutual fund a serious vehicle for savings and investment. I will never advocate trading on mutual fund units but I will not ask my investors to stay wedded to their mutual fund. These are vehicles of convenience and convenience is their first attribute and you should use that to your benefit. If the price goes up from Rs 15 to Rs 25 in six months, you have a return of 133 per cent annualised, and you should take it. If the underlying conditions are good, you should not get out entirely, but only pare. Because there will always be an opportunity to re-enter.

What is your advice to investors now?

It is never a simple answer for any investor because investment is a serious business. Investors should stick to the fundamentals of investing and that is asset allocation. And it is never a one-time asset allocation. Where do you get your investible surpluses from? It is your past savings and current savings. One lesson from these events in any financial markets is that investors should have some liquidity with him at all times. The liquidity can come by way of saving from current income, but it should be a significant portion and they should keep on changing this portion. This change should happen not after the market has moved, but before. You also can't expect the investor to see into the future.

So, I have a rule of the thumb to suggest: get back your liquidity when the returns are high and invest when the returns are low. So sell when the market is rising. You may miss opportunities. You may never catch the top and you may never catch the bottom, which is fine. And while you do that, you keep on changing allocations of your portfolio between equity and debt. You should either invest in diversified portfolios or if you are taking sectoral exposures, you must make sure your sectoral exposure indirectly doesn't become too high.

For example, you invest in a diversified fund with 50 per cent in infotech and you also have a technology fund, then your exposure becomes much higher. So you should avoid doing that. When you buy a balanced fund, you should ensure that the equity part of the fund is diversified and not again concentrated in infotech. So you have to carefully choose your portfolios based on the asset allocation that you have in mind.

You should also never marry an investment except where it is the family silver. There are some shares that you must own, they are not meant for selling. But you don't need to have an attachment to mutual fund units. You should buy when the markets are down and sell when markets are up.

This kind of a strategy will pay investors over a period of time.

At this point in time, debt funds, balanced funds and equity funds are all cheap. So should one buy and what?

Yes. Therefore, you should buy all three and fill your asset allocation. But what happens is that you may hesitate as you have invested in the past and made mistakes or you may not have liquidity. But if you follow the simple rule of getting back liquidity selling when you have made your money -- don't sit on paper profits -- you will always have liquidity to invest when markets actually fall.

Is this a market to be fully invested?

No market is ever to be fully invested because liquidity is the key portion of any portfolio. The first principle of any investment is that you must keep liquidity. There is also no formula on how much liquidity you should maintain. But as open-ended funds, all our equity portfolios will have 8-10 per cent cash. It is part of the investment strategy. The future is essentially unpredictable and no matter how good a fund manager you are, you can't look into the crystal ball. This liquidity needs to be shuffled and the best way to get liquidity is to sell when the market is high. You bide your time.

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