Category Archives: Currencies

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May 07

Indian Rupee and its Melancholy

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Predicting currency movements is perhaps one of the hardest exercises in economics as it has many variables affecting the market movement. And this phenomenon has tested the expertise and nerves of many analysts and bigwigs including the Government of India’s (GoI) wizards in the last two years.

When INR started depreciating against USD in late July 2011 from the level of 43.9485, very few have imagined that this is going to be a new historical milestone in the journey of Indian Rupees. And within one year, by the end of June 2012, INR touched the all-time high of 57.2165. Some experts were explicitly vocal about Rupee going to touch the low of 70 against the USD. RBI though denied any intervention to put any check on nose-diving Rupee, yet some Open Market Operations (OMOs) and some other measures were taken to avoid the deteriorating CAD situation.

Current Scenario

Since last six months or say with the start of the 2013, it seems that Rupee is trying to stabilize at 54-55 level. GoI is having sigh of relief as CAD situation is not worsening any more courtesy falling prices of crude oil and gold. But did our government adopt the right approach while dealing with the matter? In an open market economy a government should not intervene in the foreign exchange market. That’s true. But has the GoI shown its sensible and logical approach when it left the worsening CAD situation unnoticed and went on with its populist measures. And when things got out of control all the government machinery involved in its quick-fix measures and they named it reforms.

In its present stint, P. Chidambaram as finance minister has been lauded for so-called reforms, but increasing FII investment limits in debt, or allowing FDI in retail or aviation is hardly reform. They are intended to rescue bankrupt airlines and a bankrupt economy where the CAD was headed for a new record. Without these changes, the Rupee was crashing, so, these are survival tactics, not reforms.

The Current Account Deficit

In recent years, the fiscal condition of the government has worsened. With growth slowing, government tax revenues stagnant as a fraction of GDP, and spending high, fiscal deficits remain high.  At the same time, private consumption, especially in rural areas, is growing strongly on the back of rising incomes, strong credit growth, and continuing government transfers and subsidies.

This has led to a large gap between savings and investment. The worsening in public finance has diminished savings. The gap between savings and investment is the amount of capital that has to be imported. This is the current account deficit. We have a capital shortfall within India, so we are importing capital. And in these conditions, if there is even a short hiccup in capital inflows (as appeared when the GoI proposed to modify the Mauritius route, and more generally with the problems of governance), it yielded sharp Rupee depreciation.

We import a lot of capital; government policy actions interrupt that flow of capital; and the Rupee depreciates. This is not mis-behaviour of the financial system. The system is not malfunctioning; it is behaving as it should.

Inflation: The Mother of All Evil

Inflation has remained in the uncomforting zone for RBI hovering around 9-10% for almost two years now. Even inflation after Dec-11 is expected to ease mainly because of base-effect but the fact is that, inflation still remains high with core inflation itself around 8% levels. It is important to recall that the episode of 2007-08 when despite high inflation and high interest rates, capital inflows were abundant. This was because markets believed this inflation is temporary. Even this time, investors felt the same as capital inflows resumed quickly as India recovered from the global crisis. However, as inflation remained persistent and became a more structural issue, investors reversed their expectations on Indian economy.

India was receiving capital inflows even amidst continued global uncertainty in 2009-11 as its domestic outlook was positive. With domestic outlook also turning negative, Rupee depreciation was a natural outcome. Depreciation leads to imports becoming costlier which is a worry for India as it meets most of its oil demand via imports. Apart from oil, prices of other imported commodities like metals, gold etc. also seen rising and pushing overall inflation higher. Even after global oil and gold prices declined, the Indian consumers are not benefitting that much as Rupee depreciation is negating the impact. Inflation was expected to decline from Dec-11 onwards but Rupee depreciation has played a spoilsport.

RBI’s job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation’) of 4–5%. When tradeables become costlier, domestic CPI inflation goes up. So the Rupee depreciation has made RBI’s job harder.

Some Other Factors

Apart from difficulty in capital inflows & inflation, Indian economy prospects have declined sharply. It has been a shocking turnaround of events for Indian economy. Both foreign and domestic investors have become jittery in the last one year or so because of following reasons:

  • Persistent fiscal deficits: The fiscal deficits continue to remain high. The government projected a fiscal deficit target of 5.1% for 2012-13 but later revised it to 5.3% and this too is likely to be much higher on account of higher subsidies.
  • Deteriorating CAD: Current Account Deficit for the 3rd quarter of the 2012-13 soared to the record high of 6.7% of the GDP against 4.4% for corresponding quarter of 2011-12. CAD for Oct-Dec quarter widened to $32 billion from $20 billion in the same corresponding quarter of the previous financial year.
  • Lack of reforms: There have been very few meaningful reforms in the last few years in Indian economy. Moreover, the policies seem to be getting increasingly populist. The government wanted to reverse this perception and announced FDI in retail but had to hold back amidst huge furor from both opposition and allies. This has further made investors negative over the Indian economy. As FII inflows are going to be difficult given the uncertain global conditions, the focus has to be on FDI.
  • Continued Global uncertainty: This is an obvious point with global economy continuing to remain in a highly uncertain zone. This has led to pressure on most currencies against the US Dollar.

All these reasons together making it tough for the Rupee to appreciate or even sustain against USD.

A Vicious Cycle

Growing Indian economy has led to widening of current account deficit as imports of both oil and non-oil have risen. Despite dramatic rise in software exports, current account deficits have remained elevated. Apart from rising CAD, financing CAD has also been seen as a concern as most of these capital inflows are short-term in nature. Boosting exports and looking for more stable longer term foreign inflows have been suggested as ways to alleviate concerns on current account deficit. The exports have risen but so have prices of crude oil leading to further widening of current account deficit.

As far as policy signals concerned, the situation is more chaotic. While balancing current deficit by attracting foreign funds could be a solution, it is easier said than done. A slew of corporate scandals and inaction on policy and reform front is keeping foreign investors at bay. Forget inflows of foreign funds, Indian markets are witnessing selling pressure and forex reserves are falling. Unless the Government bites the bullet and goes for economic reforms, hardly any strategy is likely to bear stable results. An action is long due with regards to reforms on subsidies, taxation, state run companies and increasing transparency and accountability. Anything less will amount of piecemeal intervention that might just smooth the fall but not avert it.

The Possible Solution

We got into this mess because of inappropriate fiscal and monetary policy. We need to solve these — monetary policy must get back to the business of delivering low and stable inflation, we have to fight inflation until we see y-o-y headline inflation going to the 4–5% range. Alongside this, fiscal policy needs to correct itself. Each of these has a clear direction to move in, and movement on any one is valuable regardless of what the other does.

There are five sensible paths government can take, in this situation:

  1. We need to see that at heart, this is a problem of macroeconomics. The root cause of the current account deficit is the fiscal deficit. If we want a lower CAD, we need a lower fiscal deficit.
  2. To ensure the smooth capital flow into the country, we should not spook foreign investors. We should bring certainty about taxation to foreign investors, and resist the temptation to levy new retrospective claims.
  3. We should not interfere with the de-facto residence-based taxation framework which India is giving foreign investors, as long as they come through Mauritius. This policy framework is, in fact, in India’s best interests.
  4. Deeper problems about the loss of confidence of foreign investors, owing to governance problems, need to be solved by strengthening governance. There is no quick fix other than improving governance.
  5. Efforts have been made to invite FDI but much more needs to be done especially after the holdback of retail FDI and recent criticisms of policy paralysis. We should open up more to FDI where feasible, because FDI is a safer form of financing. Without a more stable source of capital inflows, Rupee is expected to remain highly volatile shifting gears from an appreciating currency outlook to depreciating reality in quick time.

Apr 19

Currency War: Devaluation of Currencies

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Note: In one of our class on NISM currency derivatives a NISM exam aspirant inquired about the Bank of Japan’s announcement of doubling money supply and its after-effects. This leads to some good discussion and we thought to share our points of view in a refined way to help other students and professionals. So, test the impact of the cold war weaponry…..

Currency War: Devaluation of Currencies

A currency war sounds weirdly abstract, like a game played by rival politicians – but it can have devastating effects in the real world. It is a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their own currency. This policy is also referred to as “Beggar Thy Neighbour”.

However, the emergence of currency wars came from different sets of policies. The huge stimulus from developed economies’ central banks flooded the markets with their currencies leading to lower value of their currencies. This concern especially picked up in Sep-2010 when it became apparent that Fed would initiate another round of quantitative easing (or QE2). Brazilian Finance Minister Guido Mantega termed the practice of trying to keep currencies undervalued as ‘Currency War’ and this sentiment picked up after his comments.

It can be defined as competitive devaluation of a country’s own currency so that exports become more competitive and imports become costly. As a result imports are expected to reduce and exports are expected to go up. As a further result, employment within the country goes up and employment in the competing country may go down. The country which devalues its currency may get net trade surplus (exports more than imports) and its foreign exchange reserves go up.

Mechanism of Currency Devaluation: How it works?

In order to understand the mechanism and outcome of the currency devaluation game – let’s imagine a pair of brothers together owns a honey-making business in Lahore, (undivided) India. After the partition, one brother decided to move to India, just a few miles away to Amritsar, while the other one decided to stay back – so they divide the company in two.

Now, assume that both businesses make the same honey, sold in a 1 Kg. jar; priced the same, Rs. 1 per jar. When the partition happened and the brothers moved apart, the Indian and Pakistani Rupees were at parity, so a jar of honey – regardless of where it was made – was worth both 1 INR and 1 PKR.

All goes well, until….CURRENCY DEVALUATION! The brothers wake up, and find that 1 PKR is now worth just 0.50 INR! Or, to put it another way, 1 INR is worth 2 PKR. And now an Indian consumer can buy two jars of Pakistani honey as his 1 INR will now buy him 2 PKR.

The currency devaluation allows him to get two jars of honey for the price of one. It is great news for Indians, as it is a good deal; and it is great news for the Pakistani honey company, also, since the cheap Pakistani currency has allowed it to boost its share of the market.

But this is really bad news for the elder brother and his Indian honey company as he can’t afford to compete in given situations. Unless the government does something to weaken the INR, he’s going to go out of business, which means he’ll have to lay off honey workers and sell off those bees. And this will be happening all over the country, eroding India’s manufacturing base and accelerating unemployment.

History of Currency Devaluation
An important episode of currency war occurred in the 1930s. As countries abandoned the Gold Standard during the Great Depression, they used currency devaluations to stimulate their economies. Since this effectively pushes unemployment overseas, trading partners quickly retaliated with their own devaluations. The period is considered to have been an adverse situation for all concerned as unpredictable changes in exchange rates reduced overall international trade.

Following the turmoil of 2007-08 crisis, states engaging in competitive devaluation have used a mix of policy tools, including direct government intervention, the imposition of capital controls, and, indirectly, quantitative easing. As the price to buy a particular currency falls so too does the real price of exports from the country. Imports become more expensive. So domestic industry, and thus employment, receives a boost in demand from both domestic and foreign markets. However, the price increase for imports can harm citizens’ purchasing power.

This policy can trigger retaliatory action by other countries which in turn can lead to a general decline in international trade, harming all countries. While many countries experienced undesirable upward pressure on their exchange rates and took part in the on-going arguments, the most notable dimension of the 2010-11 conflict was the rhetorical conflict between the United States and China over the valuation of the Yuan.

Recent Woes
Japan has also joined the money printing spree like its peers from the developed world. The Bank of Japan (BoJ), in a statement released on April 4, 2013, said, “The Bank will achieve the price stability target of 2% in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years. It will double the monetary base.”

In plain language what the statement means is that the BoJ will try and create an inflation of 2% in the earliest possible time with an overall limit of two years.

Japan’s decision of doubling its money supply to $2.71 trillion in order to propel its economy out of two decades of stagnation eventually devaluing her currency, sparked concern of a possible second 21st century currency war breaking out, this time with the principal source of tension being not China versus the US, but Japan versus the Eurozone and other Asian nations.

Rationale behind this megalomania
For the period of three months ending December 2012, the Japanese economy grew by a minuscule 0.5%. In three out of the four years for the period between 2008 and 2011, the Japanese economy has contracted. To get over this, Japanese politicians have wanted to create some inflation so that people will start spending again.

The question is how will this inflation be created?
The BoJ plans to print Yen and double the money supply in the country. This money will be pumped into the financial system by the BoJ buying various kinds of bonds, including government bonds and exchange-traded funds from Japanese banks and other financial institutions. Banks can then go ahead and lend this money. As an increased amount of money chases the same amount of goods and services, the hope is that prices will rise and some inflation will be created. And this will put an end to the deflationary scenario that has prevailed over the last few years.

So by trying to create some inflationary expectations in Japan the idea is to get consumption going again and help the country come out of a more than two-decade-old recession. With prices of things going up people are more likely to buy now than later and thus economic growth can be revived.

There is another angle to this entire idea of doubling money supply, and that is to cheapen the Yen against the Dollar. As the BoJ starts printing the Yen to create inflation, there will be more Yen in the market than before. And this will lead to a fall in the value of the Yen against other currencies. A greater price competitiveness will ensure that exports pick up and that in turn will help revive economic growth. At least that’s how things are supposed to work in theory.
Neighbours, those are wary of becoming beggar…

The Japanese currency, the Yen, has dropped by 25% in value since the last government was voted in power in November 2012 as they pledged to kick start the economy by creating demand devaluing their currency. This has already given a major boost to Japanese goods and services. There is little confidence that the Yen will stop here as the government pursues an inflation rate of about 2% a year in order to end deflation and stimulate consumer spending.

With the price of Japanese exports becoming daily more attractive, neighbouring countries are weighing their options, and devaluing their own currencies is at the top of many lists. There is a good deal of outrage and anger among Japan’s neighbours. Not only neighbouring nations but even billionaire investor George Soros also criticize the Abe government and said, “If the Yen starts to fall, which it has done, and people in Japan realize that it is liable to continue, and want to put their money abroad, then the fall may become and avalanche.”

Although some of the strongest criticism of the Japanese program has come from China, the impact is unlikely to be felt as strongly there as in other parts of Asia. Most Chinese exports do not compete directly with Japanese products. Indeed, some Chinese companies may benefit from importing cheaper Japanese components.

The prospects for South Korea, whose manufactured goods from cars to washing machines do compete directly with Japanese brands, are much more troubling. About 60% of South Korea’s GDP comes from exports and the Seoul government has said it is very worried by the probable fallout from the Japanese stimulation program.

The barometer of currency values is also being watched carefully among the exporting countries of Southeast Asia.

Where it could go wrong?
In fact, by wanting to double money supply by printing the Yen, the BoJ is only doing what various other central banks around the world have already been up to. The Federal Reserve of United States has expanded its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank came to the party a little late and has expanded its balance sheet by around 98%. The BoJ has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the last four years.

What is apparent that central banks can print all the money they want, they can’t dictate where it goes? Central banks which have tried this path have managed to create very little inflation and economic growth. The money that they have been printing is being borrowed by large institutional investors at close to 0% interest rates and being invested in all kinds of assets all over the world into speculative oil futures, luxury real estate in major financial capitals, and other non productive investments.

So the question is what stops all the money that will be printed in Japan from meeting the same fate, as the money that was printed by other central banks? And the answer is, Nothing.

With the BoJ expected to buy all kinds of bonds from banks and other financial institutions, it means that the financial system will be flush with money. This along with a depreciating Yen is expected to unleash a massive Yen carry trade.

Investors will borrow in the Yen at very low interest rates and invest it in various kinds of financial assets all over the world. This is called carry trade because investors make the carry – i.e. the difference between the returns they make on their investment (in bonds or even in stocks for that matter) and the interest they pay on their borrowings in the Yen. This money will be invested in all kinds of financial assets around the world.

What is the fate of such printing mania?
This stance of easy monetary policies has already been greatly criticized. Huge monetary accommodation by developed economies is being blamed for sharp surge in commodity prices elevating inflation levels globally. This has been sharply criticized by developing economies who have recovered smartly from the crisis but growth prospects are being hurt by inflation. Hence, any more monetary accommodation via the currency route is not going to be appreciated.

The BOJ says it just wants to get inflation to 2%. It says it will buy assets with money that didn’t exist previously…and keep buying…until inflation reaches 2%.

Then what? Well, we guess it will stop. And then what? Will the economy collapse when the money-printing stops? Or will the economy pick up…and the banks begin to lend…and the people go on a spending binge? Or will investors all over the world dump their Yen back onto the home islands…eager to get out of the Japanese paper money before inflation levels get out of control?

We don’t know. But neither do the Japanese nor for that matter other central bankers. As Reuters describes it is a ‘radical gamble’ and for a central bank to make a ‘radical gamble’ bespeaks desperation and lunacy.

Nov 06

Overview of Q2 monetary Policy 2012-13

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On Oct 30, 2012, Reserve Bank of India (RBI) announced its Q2 monetary policy. The whole industry was waiting for RBI to announce some measure to boost the economy. On that RBI slashed Cash Reserve Ratio (CRR) by 25 basis points from 4.50% to 4.25%.(CRR is the share of deposits banks must keep with the central bank). This reduction in CRR would inject 175 billion rupees of primary liquidity into the banking system. Industry was expecting that RBI would also reduce interest rates that can help industry and end consumers with reduced borrowing cost. But contrary to the expectation, RBI kept its key policy rates unchanged. So repo rate at 8.00% and reverse rate stays at 7.00%, the same level it has been at for the past six months. Repo rate is a mechanism of monetary policy at which the RBI lends money to commercial banks.Whenever banks have any shortage of funds they can borrow from RBI at the repo rate. A reduction in the repo rate helps banks get money at a cheaper rate and hence can further pass on the benefit to the users by reducing the prime lending rate. This is the 8th time CRR ratio has been changed since 2009 and 4th time this Calendar year. In 1992 CRR ratio was 15% of total deposits of banks.

The 25 basis point CRR cut will give room for more credit to the productive sector and, to some extent, impact the cost of banks but 0.75 percentages additional provisions on standard restructured assets surprised the banks. The benefits arising from CRR cut to banks will be offset by the additional provisioning requirements on restructured loans.

CRR%
DD/MM/YY
4.25
03/11/12
4.5
22/09/12
4.75
10/03/12
5.5
28/01/12
6
24/04/10
5.75
27/02/10
5.5
13/02/2010
5
17/01/2010
Table: 1- CRR% in last 3 years

RBI governor mentioned that interest rates are kept unchanged because the priority for him is also to manage inflation apart from economic growth of the country. In the last 2 years economic growth rate of India has slow down. The RBI lowered its FY2013 growth estimate to 5.8 per cent from 6.5% and raised its inflation estimate to 7.5 per cent from 7 percent.The markets have reacted quite negatively after the RBI’s decision to keep the interest rate unchanged. All the interest rate sensitive sectors have fallen sharply. Bank Nifty was down by 2.2 percent to 11222.8 (its lowest since September 21) while 1.1 per cent drops in the BSE Sensex. The rupee was, however, marginally up and closed a shade higher at 53.97 to the dollar after a weak beginning. The 10-year government bond traded at 8.18 per cent, down 5 basis points.

The RBI said in its guidance, “The reduction in the CRR is intended to pre-empt a prospective tightening of liquidity conditions, thereby keeping liquidity comfortable to support growth. It anticipates the projected inflation trajectory which indicates a rise in inflation before easing in the last quarter. While risks to this trajectory remain, the baseline scenario suggests a reasonable likelihood of further policy easing in the fourth quarter of 2012-13. The above policy guidance will, however, be conditioned by the evolving growth-inflation dynamic.”
RBI Governor said “We expect December inflation to peak at 8.5 per cent and come down to 7.5 per cent in March. This falling trajectory provides the RBI with an opportunity to implement “further policy easing” in 4QFY13, depending on the growth-inflation dynamics. We expect the RBI to ease repo rates by 50 bps in 4QFY13 based on our estimates of growth-inflation and CRR by 25 bps in the remaining of FY2013 (dependant on developments on liquidity) and balancing the current growth and inflation situation needed a calibrated approach which would support growth, easing of supply constraints but at the same time helping ease inflation.”

Now, RBI would prefer to watch the government’s policy reforms. If reforms go ahead as planned then inflation would come down. This in turn may prompt RBI to cut down the rate and it will encourage the economic growth of the country.