Rate cut and MSCI overweight; China worries continue for India…

When China cut rates by another 25 basis points effective October 24, it marked the sixth consecutive rate cut in the last 11 months. The rate cut by China is not great news for emerging markets in general and India in particular. India will have worries on two fronts. Firstly, the rate cut by China is going to have its own medium term implications for Indian equities. Secondly the decision by Morgan Stanley Capital International (MSCI) to include Chinese and Hong Kong ADRs in the MSCI emerging market basket is also not great news as it will lead to a lower MSCI allocation to India. Remember, MSCI Emerging Markets Index is the undisputed benchmark for emerging market allocations, especially among ETFs, Index funds and other active and passive portfolio managers.

Rate cut is an admission of a China slowdown…

The 6th successive rate cut by China in 11 months is a tacit admission by the Chinese authorities that the Chinese economy is slowing. In fact as a canny tweet on Twitter said it all, “The rate cut by the People’s Bank of China (PBOC) is an official admission that the central bank of China itself does not believe the credibility of the statistics put out by the Chinese government.” What it means is that actual Chinese growth could end up being much lower than the 6.8% that is currently being projected. But why is this important?

Firstly, a slow Chinese growth will spur the Chinese currency to lower levels. Remember, China is trying to reduce its intervention in currency markets as it gets closer to an IMF-SDR inclusion. That will put pressure on all emerging markets including India. Secondly, a weak China will try to export its way out of trouble. Of course, a weak Yuan will help them push exports; but the problem could be that a global economic slowdown may not give them much leeway to boost exports. That would mean that China may respond by dumping Chinese products at lower prices. Indian steel, radial tyres and capital goods are already being pushed to the corner by cheap Chinese exports. A slowdown in China can only worsen the situation.

It could signal the beginning of a currency war…

Dr. Raghuram Rajan has raised serious objections to the practice of large economies practicing quantitative easing. The US did it for five years and other countries like Japan, China and the EU are still practising it. Competitive quantitative easing has an effective impact that is almost akin to competitive devaluations. As QE gains momentum, the nation’s currency loses momentum. We have seen the Euro and the Japanese Yen losing substantial value as an outcome of quantitative easing.

When China, the second largest economy in the world, joins the race it is the beginning of a currency war. With a global slowdown evident, most countries will try to weaken their currencies to boost exports. Once the large developed nations resort to this competitive devaluation of their currencies, the emerging markets will have no choice. We saw in August that a devaluation of the Yuan by China forced a devaluation of almost all emerging markets across the globe. History is testimony that every currency war has had a bloody ending. Despite the apparent strengths of the Indian economy, if it comes to an all-out currency war, the Indian rupee and the Indian economy are unlikely to be spared.

Now MSCI adds a twist to the tale…

The recent decision by the MSCI to include Chinese and Hong Kong ADRs in the MSCI basket can have long term and larger implications for the Indian economy and the Indian markets. Let us understand a few of them. The inclusion of Chinese and Hong Kong ADRs is likely to increase China’s share in the MSCI Emerging Markets Index. China already accounts for close to 1/4th of the emerging markets weight on the MSCI EMI. This inclusion of Chinese and Hong Kong ADRS will have the effect of increasing Chinese weight in the MSCI EMI by another 2.5%. That higher weight will obviously have to be re-allocated from other countries. In the process, India’s allocation in the MSCI EMI is likely to come down by 25-30 basis points.

Some of the world’s largest ETFs, index funds as well as other active and passive funds use the MSCI EMI as the benchmark for allocating funds to emerging markets. Typically, the active and long-only portfolio managers do not act immediately. But ETFs and Index funds, which account for a larger share of global asset allocations, tend to adjust their holdings very quickly to changes in the MSCI EMI. In the process, India may actually see FPI outflows to the tune of $1 billion. That is not great news at a time when emerging markets are already fighting for a share of flows. This problem becomes more pronounced as FPIs are already feeling that Indian stocks are rich and closer to the higher end of mean valuations. With Chinese stocks available at much cheaper valuations, there may be a perceptible shift in portfolio allocations from India to China. That is a major risk for India.

To sum it up, China has left India with quite a few worries in the coming month. It surely needs a good set of fundamental drivers to ensure that FPIs do not take the shift too seriously. For the time being the big worry for India is China!

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