Selling Government Bonds

An article I wrote for "Wealth Insight" for June. Still remains relevant, though much more retrograde measure have since been announced

 

Trouble in the foreign currency markets

The big story in financial markets over the past few days has been the withdrawal of over $3bn by foreigners from the Indian bond markets. Government bond yields increased, the rupee weakened significantly against the dollar, and the stock markets went into a funk.

The government response ranged from the inane – “we are watching the situation” – is it a spectator sport? to the pathetic – “other emerging markets with high current account deficits have suffered similarly”. Mismanaging the economy is alright if others do it too.

Knee Jerk reactions

The Finance minister addressed the market holding out the possibility of raising inflation in the near term. While that is not what he mentioned, that is indeed the effect of the policies he promised. A key promise was to increase prices of gas in India with consequent price rises in user industries. Another was allowing Coal India to offer blended prices of coal to its purchasers – perhaps over ruling many a contract and allowing for a general increase in power tariffs across the country. As if this was not enough, he seemed to suggest that making it easier for foreigners to invest would solve the problems of foreign investors exiting their positions – much like a hotel manager with poor occupancy - driven by poor service - seeking to increase the size of the door to allow guests to come in.

Arbitrage vanishes – driving away the bond investor

A fundamental driver of financial markets is the assumption that arbitrage cannot exist for sustained periods of time. If investors can borrow at 0.5% per annum, and cover currency risk at, say, 5% per annum, they would invest in a market offering a yield of approx 7.5% – since this leads to a risk free return of 2%, thereby narrowing the arbitrage. This, more than any action of the government, was what drove investors to India in the recent past. A lot more would have come if the investment climate was less murkier.

A slight change in interest rates globally raised the cost of borrowing. Couple this with lower interest rates in India, and higher forward rate for currency cover - and the arbitrage vanishes. No amount of credit rating upgrades, or the ease of investing is going to change the fact that arbitrage is no more – and with that, the bond investor.

 Restore the arbitrage?

If India really wants the bond investor back, we need to restore the arbitrage – ie, raise real interest rates. This flies in the face of the demand of industry and stock markets. Commentators, including government functionaries who should know better, have been blaming the RBI for being almost cussed in its slow lowering for policy rates. It is almost as if lower policy rates would magically restore the economy to health. The reality, as almost always, is far from perception.

RBI has actually maintained a negative real interest rate (nominal rates – inflation) for most of the past 5 years. It has been ahead of the curve in cutting policy rates. This amounts to a huge stimulus to the economy. Along with this, The Reserve bank has, through use of liquidity enhancement methods, resorted to an unannounced “quantitative easing” program in India – where its balance sheet has increased 50% in less than 3 years since 2010. In addition, the government has run a constant deficit – leading to pump priming economic growth. Yet, common wisdom, especially in policy circles continues to blame the “high interest rate” as a reason for “demand destruction” and poor GDP growth.

The need for higher interest rates

India has been suffering from high inflation for over 4 years. Low real interest rates have caused low deposit growth of about 13%, and caused credit to deposit ratio to rise to 79% -the highest in the last 15 years. Savers seek to protect their money value by investing in shadow “foreign currency” in the form of gold. The rupee is under pressure. All this would suggest that real interest rates need to rise. However, try telling this to anyone in policy formulation or market analysts. The demand for the punch bowl to be returned to those drunk on negative real rates is unrelenting as it is vociferous.

Address the disease not the symptoms

The attempt of Indian policy makers seem directed more at the symptoms than improving the reality of doing business in India. If India is such a compelling growth story why is it that every major Indian group has invested and continues to invest significant amounts of cash overseas? The latest acquisition announcement of Apollo Tyres of a take-over of Coopers is a case in point.

The reality is unpleasant. Policy nightmares continue to prevent large projects from coming to stream – leading to restructured loans – and reducing the capability of Indian banks to lend further. The judicial system moves at glacial speed preventing rapid resolution of commercial disputes. The government arms move in opposite directions – with the taxman prompting retrospective amendments, while some other departments attempts to talk up investments. Coupled with a dithering and corrupt bureaucracy and polity, the India growth story seems to be a chimera. Keep your fingers crossed on what the next elections will throw up.