Now that the applause has died down a bit, sceptics are raising a basic question. Why should recent reform announcements by the Government make the Sensex surge a 1,000 points?

The question is a valid one. Just consider what the reforms seek to do — raise diesel prices, open up sectors such as retail, aviation, insurance and pensions to further foreign direct investment (FDI). They also approve sundry amendments to the Companies Act, Forward Contracts Regulation Act and Competition Act.

These changes may nevertheless help the economy over the long haul. For instance, raising foreign investment limits in the insurance and pension sectors could help them access capital that is critical to their long-term prospects. The amendments to the various laws could broadly strengthen consumer protection and give regulators more teeth.

What’s in it for the Sensex

But what difference does all this make to the immediate prospects or profits of Sensex companies? Not much, we have to admit.

After all, what toppled the Sensex from its 2010 high was not the infamous policy paralysis, but a poor profit outlook for India Inc.

In the recent April-June quarter, for instance, profits of 500 leading listed companies plunged 41 per cent. Sales growth has steadily lost momentum, from 27 per cent four quarters ago to 15 per cent now.

Profits for companies declined due to high input costs, caused by sky-high global commodity and fuel prices made worse by a sliding rupee. Rising interest rates played the villain for highly leveraged companies. Those who sought to sidestep this by borrowing overseas, landed in trouble as a weak rupee bloated their debt.

Regulatory activism on resources — from iron ore mining to coal block allocations — has made expansion projects risky. Consumers, responding to all this, cut back on their spending spree.

Liquidity can mend

Reforms, it is clear, cannot do much to solve these problems. But thankfully, there is something that can — liquidity.

Market observers often tend to dismiss liquidity as an inconsequential thing. They often intone — ‘‘This is a liquidity-driven rally. It has nothing to do with fundamentals’’.

But in the Indian context, liquidity can beget fundamentals. Here is how.

The euphoria over reforms has seen liquidity flooding the Indian markets in the form of foreign portfolio flows. This, combined with a lower current account deficit, has led to the rupee reversing direction and strengthening against the dollar.

In the last three months alone, the rupee has gained 9 per cent against the greenback.

The rupee effect

Now, the rupee’s gains, if sustained, can certainly make a big difference to India Inc’s profit picture.

To start with, companies in the listed universe are big net spenders of foreign exchange. Analysis of the top 500 companies shows that, in 2011-12, these companies spent a whopping Rs 11.8 lakh crore in foreign exchange to import inputs and fuel.

Weighed against this, they earned only Rs 6.5 lakh crore through exports. The import bill was thus 82 per cent higher than the export earnings.

This is because India Inc is almost as heavily reliant on imports as the economy. Oil refiners rely on imported crude oil for processing into petrol, diesel and petrochemicals. Power generators rely on imported coal and gas. Steel makers use imported iron ore and coking coal.

Fertiliser manufacturers depend on imported ammonia, phosphate and sulphur. And most heavy industries rely on fuel oil or coal from overseas to meet their energy needs.

As a result, companies that are big net spenders of foreign exchange contribute 70 per cent of the aggregate profits of India Inc. This is why a stronger rupee, which would trim the import bill, can deliver a sizeable boost to their profits.

Two, a stronger currency has the potential to alleviate the debt-related problems of Indian companies too. Companies which have taken heavy recourse to dollar-denominated loans to fund expansion or acquisitions, will see their loans cut to size with an improved exchange rate. Foreign Currency Convertible Bond holders, who faced a devil-or-deep sea situation at the beginning of the year, may earn reprieve too. They may now have to find less money to close out or refinance their loans.

The macro benefits of a higher rupee are quite evident too. A stronger rupee translates into a smaller oil import bill the country, automatically improving its trade balance and fiscal deficit.

Lower petrol and diesel prices can reduce transport and energy costs that cascade down to the inflation numbers. And in a virtuous cycle, a positive outlook for the currency in turn encourages more portfolio flows. With every increase in the rupee, foreign investors earn slightly better returns on their India portfolio.

Confidence-booster

Let’s also not forget the salutary impact that liquidity has on business confidence and market sentiment. The 25 per cent surge in the Sensex this year has seen large companies dust off and revive their IPO plans. The divestment programme looks to be gaining traction too.

Equity fund-raising can help companies de-leverage their balance-sheet and kick-start the investment cycle once again. The surge in both gold and equity prices sets off a wealth effect which can resurrect consumer spending too.

All this shows that the fine print on FDI in multi-brand retail or pension reforms may not really matter. It may instead be enough if the Government manages to keep buoyant sentiment alive by playing to the galleries with ‘reform’ announcements every few days.

After all, the point is really not about whether FDI in retail will, in practice, generate millions of jobs or whether Kingfisher Airlines will manage to attract foreign suitors.

If the announcements make enough affluent investors — both domestic and foreign — believe that all is well with the ‘India story’, that is all that is really needed.

As long as the liquidity keeps gushing in, the fundamentals will follow.

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