Beginning of Fed Taper – Impact on India and other Emerging Markets

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Two major events scheduled on the 18th of December, were seen as deciding factors for the stock market movement in India by the end of 2013.

First was the announcement of monetary policy by the Reserve Bank of India (RBI) governor. Raghuram Rajan beat the market expectations of a hike in interest rates and surprised the markets pleasantly with no changes to the current monetary policy. RBI kept the repo rate unchanged at 7.75 % , the reverse repo at 6.75%, the cash reserve ratio at 4% and the marginal standing facility and the bank rate at 8.75%. Markets reacted favorably to the announcement.

Later on the same day, US Federal Reserve Chairman Ben Bernanke initiated pullback from Quantitative Easing (QE) before the end of his term in 2014, with Janet Yellen taking over as the Chairperson of Federal Reserve. As the size of the taper, $10 bn was in line with what the market had expected back in September, 2013,  the announcement saw the US markets shooting up.

 

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Diversification Dilemma

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Diversification has given way to focus in developed countries like the United States and the United Kingdom,  and has often been correlated with lower performance. In contrast, diversified business groups have been hugely successful in most emerging markets, particularly in Asia.

Since the mid 1980s, strategists in countries like the United States and the United Kingdom have mostly advocated the use of focused strategies for businesses and have advised companies to ‘stick to their knitting’. Many diversified conglomerates in these advanced economies have been dismantled since 1980s to focus on one or a few core businesses.

A look at the motives with which companies diversify reveals some of the reasons why diversification by conglomerates yields benefits in the developing markets as against the discount associated with diversified conglomerates in the developed economies.

Growth is a primary motive for diversification

However growth does not always translate into higher profitability. Since management status and power is correlated more closely with the size of assets under management, management (the ‘agent’) may have the incentive to diversify for pursuing growth in preference to profitability, which is not in the best interest of shareholders.

Reducing risk

Having different businesses in their portfolio can potentially balance differences in the industry cycles and thus it increases the stability of a company. But the value of diversification advantage to the company may be offset by the high transaction cost associated with acquisition. Moreover shareholders can themselves reduce the risk of their portfolio by holding diversified portfolios. This is another argument against diversification in the developed economies.

Diversify or not

Corporate parenting advantage

Effective corporate management is given as the reason for existence and success of diversified conglomerates in the developing markets. The differences in the institutional context—i.e. a country’s capital markets, labour markets, consumer awareness, regulatory and legal system  that influences business practices and ethics,  infrastructure etc favours the presence of diversified conglomerates in developing countries.

Profitability

Corporate advantage due to diversification exists if the portfolio performance is greater than sum of performances of individual businesses. In the developing economies, diversified conglomerates wield considerable economic and political clout. Being a part of a diversified group increases the overall stability of the company’s cash flow.

Thus, diversification is context specific. “Stick to your knitting” may not be the best recommendation for firms in high-growth markets or regions that have strong corporate advantages.

Currency crisis in the Emerging Markets

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The year 2013 has seen a global sell off resulting in the fall of currency in most emerging markets including Brazil, India, South Africa, Indonesia and Turkey. The charts below show the currency movement of the emerging nations versus the US Dollar in the last 5 years. (Source: http://www.xe.com/currencycharts )
 
 
 
 

Brazilian Real has fallen more than 14%  against the USD.

 

 
 

Indian Rupee has fallen about 20% against the dollar in 2013 and hit a lifetime low 68.85 per USD.

 

 
 

South African Rand hit the R10/$-mark for the first time since 2009, the lowest value in four years as poor economic data and labor market tensions weighed on sentiment.

  
 
 

Indonesian Rupiah has slid nearly 12% in 2013.

  
 
 
 

 The Turkish Lira has fallen to a record low of 2 to the US Dollar, the lowest level record since 1981.

  

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