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How inflation control measures by the US may impact FII flows to India

Dhananjay Sinha

Managing Director & Chief Strategist, JM Financial Institutional Securities

He comes with over 20 years of research experience in the areas of macro economies and financial markets research, including equities, fixed income, commodities and currencies. Sinha has successfully extended his macro research work towards application-oriented themes covering automotive, rural, and real estate sectors among others.

US President Joe Biden’s pointed response following the 6.2 per cent inflation print for Oct’21 puts the objective of controlling high inflation as a top priority for the administration. Since he believes that inflation is now hurting “Americans pocketbooks” the message will likely knock off the Federal Reserve’s filibustering around the semantics of “transient” and “more enduring transient” high inflation.

The President’s statement corroborates our latest assessment that the stringent conditions set for rate lift-off by the Fed will be met sooner than expected.

Four things that emerge pointedly from Biden’s statement:

  1. High inflation is now costing him politically and hence, it is not just the Fed’s responsibility. The persistently high inflation is beginning to override the accolades his administration has gained thus far for the steepest decline in unemployment in 80 years, speedy vaccination, robust rebound in consumption power of US households, and exponential gains in their net-worth through higher savings and asset value.
  2. On the recent spurt in energy prices, which has the largest share in the latest high inflation print, his administration has asked the “Federal Trade Commission to strike back at any market manipulation or price gouging in this sector”. This sounds like recent measures taken by China to penalize commodity hoarders and price riggers.
  3. With respect to inflationary pressures caused by the persistent mismatch between strong consumption recovery and lagging supply responses, Biden intends to use his Infrastructure Bill to remove supply rigidities. While this may also be an attempt to garner greater support for the recently passed infrastructure plan, its potential to address inflation in the short term may be limited.
  4. And most importantly, there are no political fetters on the Fed to proactively take steps in combating high inflation. This is probably the most explicit direction for the Fed coming from the administration in recent times.

Overall, Biden’s statement indicates a multi-pronged approach to tame inflation, including structural measures and quicker normalization of the Fed’s ultra-easy monetary policy. Thus, Fed officials may be now seen getting more vocal on the normalization process ahead of the next FOMC meeting. Advanced communication and a predictable path will likely prevent market jitters.

Implications for Indian markets

From India’s standpoint, the combination of a strong dollar, higher yields, and quicker normalisation could impact portfolio flows into India; FII flows (debt and equity) have been very sporadic since Mar’21 after a monthly average of $3 billion during Jun’20-Mar’21.

Inflation control measures by the US may keep FII flows into India modest (USD bn, monthly rolling sum)

In our global comparative analysis, India’s valuations are second richest after the US and are strongly correlated with retail (and domestic) participation in equities. This is explained by surplus banking sector liquidity due to the accommodative monetary stance, aggressive forex reserve build-up by the RBI, and low credit growth.

We expect a decline in RBI’s forex reserve in response to the onset of US tapering and lower FII flows, widening current account deficit, RBI’s normalization, and pick in domestic credit growth will collectively reduce surplus domestic liquidity in the coming months, thereby leading to valuation normalization, especially in the small- and mid-cap space.

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