Why rupee, Sensex have plunged on Fed's comments

Why rupee, Sensex have plunged on Fed's comments

The Indian rupee hit a record low of 59.94 on Thursday, June 20, 2013, while the BSE Sensex plunged over 400 points after U.S. Federal Reserve Chairman Ben Bernanke confirmed that the Fed would begin reducing its stimulus spending later this year. Fed's overnight comments were a confirmation of what markets feared since May 22, when Mr Bernanke first signalled that the Fed may cut the pace of bond purchases at the next few meetings.

Here's why markets are nervous:

 Overnight interest rates in the U.S. have been near zero since December 2008 when the Fed initiated its bond buying programme. As a result of this ultra-low interest rate regime and abundant liquidity, money has flown out from the U.S. to emerging countries like India, where interest rates are comparatively higher. Foreign institutional investors (FIIs) have pumped almost $14 billion into India so far this year and $22.2 billion last year.

    The Fed is now contemplating to reverse its policy because the U.S. economy seems to be coming back on tracks. Any tapering of bond-buying by the Fed could mean interest rates in the U.S. could start rising and money will flow back to government debt bonds in the U.S.

    Fearing a reversal in the Fed policy, FIIs have turned sellers. FIIs have sold equities totalling over Rs. 4,000 crore over the last seven sessions. FIIs have sold Indian debt totalling $4.7 billion in 18 consecutive sessions.

    A reversal of portfolio flows results in falling equity prices. Since May 22, the BSE Sensex is down nearly 6 per cent, while the Nifty has broken the 5,700 mark.

    The withdrawal of funds has hit the rupee hardest because India runs a large current account deficit (the difference between inflows and outflows). Conversely, a weak rupee makes investment in Indian stocks unattractive.

    Corporates with unhedged forex exposure could suffer increased losses as the rupee inches lower. This will further weaken investor sentiments.

    Outflows from equity and debt markets raise concerns about financing of the current account deficit. An estimated $90 billion is required to fund the gap in India's balance of payments (export minus imports) in the current financial year.

    Asset price volatility and a slowdown in capital inflows would hurt investment, as uncertainty further delays a revival of the capex cycle, global investment bank Nomura says.

    The Reserve Bank of India, which has warned of upward risks to inflation on account of the rupee weakness, may be forced to hold on to its rates. This will further hurt stock markets. All this would delay India's GDP growth, which hit a decade low in the last fiscal.

  The only positive from the Fed's reversal will be a fall in commodity prices, including gold, which will also help bring down high current account deficit.