December 18, 2020
Liquidity is fuelling the stock market rally, says everyone. What is this
liquidity? How does it get created? How does it fuel stocks, commodities?
Let’s start with the basics.
Why does inflation increase?
Most feel because of higher demand and lower supply but that’s not the only factor.
Imagine there is a shortage of laptops w.r.t. the demand, but there is no liquidity in
the market (people don’t have money). Will the price of laptop increase? No.
So, Inflation takes place because the demand supply situation is accompanied by
liquidity, people have the money to spend and hence the price goes up. Inflation does
not take place only because of the demand supply gap.
What role does RBI play?
It is RBI’s job to keep inflation under check. RBI is comfortable keeping Inflation
between 2-6% currently. So, if Inflation is increasing, how can RBI control it? Can
RBI do anything to demand and supply? Nothing.
So, the only tool available with RBI to control inflation is controlling liquidity. If RBI
is able to reduce liquidity in the market, less money will chase the goods and hence
Inflation can be expected to stabilise.
What does RBI do?
As liquidity is provided to the market by banks, RBI tries controlling banks by
increasing interest rates (Repo Rate). It expects that if Repo Rate goes up, the
spiralling effect will reduce liquidity in the market.
How?
Repo rate is the rate at which banks borrow from RBI. If Repo increase, the cost at
which banks borrow is expected to increase. Also, the MCLR/Base rate for banks
includes the repo rate for calculation and hence it is expected that if Repo increase,
banks will increase their lending rates.
So, if inflation goes up, efforts are made to increase interest rates by which
expectation is that individuals will take lesser loans and hence demand for products
will reduce and hence inflation will stabilise.
The reverse is also true, when inflation falls, interest rates are reduced so that the loan
becomes cheaper and more loans are borrowed and hence demand for products will
increase and hence inflation can increase over a period of time. This is the current
situation.
So, what happens when there is an economical problem? 1987, 2001, 2008, 2020?
Suddenly demand for products fall, business reduces and that leads to job loss.
What do the governments/central banks do?
Reduce interest rates to entice individuals, corporates to borrow so that there is at
least some demand maintained. All economic crises, central banks have reduced
interest rates. In 2008, repo rate was reduced by about 4%.
What’s happening right now?
In the fear of crises, all global economies (specifically US) are doing the following:
a. Stimulus – Giving more money in the hand of ‘individuals’ through various
schemes like unemployment benefits etc.
b. Interest rates – Keeping it close to zero so you can borrow more and increase
demand. ‘Corporates’ have cheap loans available now.
c. Bond buying program – US is buying $120B of bonds each month and giving
cash to the market, specifically the ‘Financial Institutions’ who are selling the
bonds.
Now, individuals, corporates and financial institutions, all have money.
What will they do with it?
a. Interest rates in their country is close to zero so they won’t invest in debt as
there are no returns to be made. All that liquidity is invested in equity and
commodities.
b. The choice of Equity investment is either domestic (US) or Emerging Markets
(EM).
Why would they choose to invest in EMs?
Why does the liquidity flow to EMs?
The answer is $. Lower $ propels this EM trade.
Before we move to understanding how the lower $ propels EM trade, let’s understand
why the $ falls in the first place?
If the Fed is continuously printing $ and supplying it to the market, the supply of $ is
high and hence $ falls. More the $ printed, less the value.
Lower $ is positive for EMs.
Why?
Say, 1$ = 75 becoming 1$ = 70.
How does this help?
a. EM companies who have taken loans in $ will have to pay less rupees (from 75
earlier to 70 for every $ loan taken) and hence increase in profitability.
b. Imagine FIIs investing when $1=75. So, they convert 1$ to 75 rupees and invest
the 75 rupees. Let’s assume the 75 investment becomes 82.5, a 10% profit.
While taking the investment back, FIIs will convert 82.5 back into $. If they do
that when $ falls to $1=70, they will receive $1.18.
$1 invested and $1.18 received is an 18% return on investment in $ where as in rupees
the return was 10%. Which is why a falling $ is a boon for FIIs.
But wouldn’t $ falling and rising Rupee make Indian exports uncompetitive? For
every $ in export you were making 75, it will become 70 now.
RBI, to avoid this situation, is on a $ buying spree which is leading to liquidity being
created locally.
The more the $ RBI buys, the more support $ gets from falling against the Rupee. RBI
has bought $97B since April! So, when RBI buys $97B, it gives to the market close to
6L cr of rupee liquidity and that’s RBI’s liquidity infusion in the system.
RBI has also bought some bonds from the market to infuse liquidity but that’s a small
number. In Oct-Nov the data was:
40,000 cr OMO bonds
20,000 cr OMO SDLs
30,000 cr Operations twist
Liquidity has pumped rates very low in India.
a. Overnight rates between 2 banks is 1.15% lower than repo
b. 3 months T-bills are trading at 0.90% below the repo
c. CPs and CDs trading below repo
Whereas Repo was designed to be a base rate above which there should have been
other rates.
This global as well as local liquidity is driving the stocks and commodities market.
a. Crude has increased 40% from October lows
b. Copper 6 years high
c. Aluminium 3 years high
d. Nickel 17 months high
e. Wheat 6 years high
f. Rubber 4 years high
g. Soyabean 6 years high
Some other observations:
a. 2020 has seen 6 times more liquidity than 2008
b. Every 1 point drop in $ index is worth at least $3B in FII inflows.
c. $ index from its peak of 103 in march is below 90 right now.
So, this rally is not stopping till $ starts moving up!
