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.     

Ben Bernanke’s taper and India’s economy: Wait for recovery gets longer

My latest column of the 24 Jun in the Economic Times

The last few weeks were eventful in all the wrong ways for India. Floods in the north led many to suffer. Financial markets suffered too — though from fears of withdrawal of financial "floods" — now christened "tapering".

Over $3.5 billion was withdrawn from the debt markets in India this month on the back of statements from the US Federal Open Market Committee (FOMC) indicating that the US Fed may start reducing its bond-buying programme later in the year. The Indian debt market had to be shut as yields increased beyond the trading bands. NTPC pulled out its bond issue over pricing issues. The rupee collapsed to nearly 60 to a dollar.

Is Fed shutting off the tap?
Ben Bernanke was at great pains to explain that the bond-buying programme was not being shut down. Liquidity infusion (printing money) would continue — only slower. That too was contingent on reduced unemployment (targeted at 7%) and higher inflation. While the Fed has sounded off the market based on its forecast of recovery, it has also indicated that its policies remain dependent on the data as time passes. It is likely that the timetable for the "taper" may well be extended.

Rupee unlikely to recover except in short term:Our economic mandarins have suggested that the rupee fall has less to do with India and more to do with emerging markets as a whole. That is, indeed, partially true. Other emerging markets too have suffered a withdrawal of funds, and have had their currencies weaken. 

However, India is in a worse position than other Bric countries. Foreign exchange reserves are barely sufficient to cover seven months of imports — the lowest it has been in the last 15 years. As a comparison, the other Bric members have 19-21 months of import cover. The latest trade deficit figures reveal a weakness in exports. A decade of mismanagement with unfettered inflation, uncontrolled and wasteful government expenditure, falling savings rate and inflated asset prices have made India a high cost economy.


Fundamentally, the rupee is headed towards 70 to a dollar. However, this is unlikely in the near term. A sharp fall in gold prices globally will reduce the pressure on the rupee even if the demand for gold remains unchanged. Unilever's purchase of HUL's equity will bring in around $4.5 billion in the next few days. Combined, in the immediate term, this should shore up the rupee somewhat.

Need a driver at the seat
Last week, the Cabinet committee on economic affairs (CCEA) took certain decisions — some were aimed at improving coal availability to power projects. Coal will now be imported —and the higher cost will be passed to consumers. In itself, the decision is better than no decision at all. At least, the power situation in the country can improve.

However, the irony is that India needs to import coal, when known reserves are enough to serve the needs of industry for several decades. Coal India's mines are about 10% as efficient as mines of similar characteristics in say, Australia. What is really needed is management of public resources in a manner that maximises public benefit, not rent-seeking. But that requires leadership — and that is another story. Equities may partially recover for now, but the storm is not over:Over the next couple of months, the early onset of monsoons, coupled with sale of grain from the government granaries, may lead to lower food inflation. The pressure on the rupee will ease, as gold imports slow, and the fear of immediate taper reduces.

Commodity prices are likely to remain subdued. In India, this should lead to selective recovery. Export sectors should gain from the foreign exchange windfall, though with a lag. Domestic commodity producers will benefit from the additional protection, while power generators may start up production — making some of the investments productive. Lenders to power generation companies may see some benefits.

However, these gains are unlikely to be long-lasting. In an earlier column in this paper, I had mentioned the dichotomy between the macro (liquidity driven, hence up) and the micro view (slowing earnings-high valuations, down). With the markets dancing to the tune of "taper", the macro upside has become limited. The dominant theme will, therefore, be micro.

Inflation at the consumer level will start hotting up in the third quarter of the fiscal year as increases in power and fuel cost work their way through the system. Government deficit will rise as revenues lag projections due to a slow economy. Political parties will spend on voters to try and buy their loyalties. Welfare spend will likely rise too. The cash economy is likely to again fuel inflation in the second half of the year.

If the taper is on schedule, the external sector will remain pressured, with consequent negative effects on the Indian stock markets. The wait for a sustained period of economic growth just got longer.

Tracking US dollars in country reserves

Jeffrey Frankel is James W. Harpel Professor of Capital Formation and Growth at Harvard. He was appointed to the Council of Economic Advisers by President Clinton in 1996, and subsequently confirmed by the Senate.

His recent blog post on Dollar share in FX reserves of Central Banks is worth a read.

I am including the graph he puts in his article in this note. The US dollar (and the country) achieved international hegemony post World war II. A strong economy made a strong country and dollar became the "reserve currency". The world has come a full cycle. Arguments about - TINA - there is no alternative, will eventually have to face up to reality. When an alternative becomes a desperate enough need, it emerges.