Bondster

Enter the Dragon: Industrial and Commercial Bank of China tip toes into India

China took its first cautious step in entering India's banking market. On Monday, 23 May 2011, the Reserve Bank of India (RBI) approved the opening of a branch of the Industrial and Commercial Bank of China (ICBC), China's largest bank. ICBC's branch is expected to begin operations in six months.   

ICBC had formally made an application after Chinese Premier Wen Ji Bao's India visit in December 2010. This is not ICBC's first foreign operations. ICBC, where U S investment bank Goldman Sachs holds a 3 per cent stake, already has presence in the US, Europe and Asia. This is however, the first time after a Communist government took control in 1949 that a Chinese bank has made a presence in India.

The RBI approval for an ICBC branch in the country was more in the nature of reciprocity. Four Indian banks --– State bank of India, Punjab National Bank, Bank of India, Canara Bank and Allahabad Bank – already have branch presence in Shenzen, Shanghai and Beijing. Some more Indian banks are awaiting approvals for opening either representative offices or branches in China.

Bondster

Ma'am India! Your wrinkles are showing!

For more than decade, Indians were drilled to believe their country was shining. It was showcased by flashy cars, spanking new apartment blocks and soaring stock markets.

Alas! All that high is fast evaporating. The spit and polish shine is wearing thin and the rust in the " I" of BRICS is beginning to show!   The Indian government is finally veering around to the stark reality. Hints that inflation and economic distress were becoming problems were finally conceded by India's government and the Reserve Bank of India (RBI). The intensity of the Inflation impact though is still in a state of deniability.

What is toted out is headline inflation at 8.9 per cent. This is a misleading number, since it includes a whole set of products that include typewriters and mobile phones that fail to capture economic distress. Food price inflation is shown as 7.7 per cent. In reality it remains in double digits. This is despite the base effect, -- high prices last year and slower increases this year. The 52 week average increase in food prices is 15 per cent.  Consumer price index is at least 400 BPS more.

Rates up but the bubble grows?

Effectively the inflation meant that at least 50 per cent of the average Indian's income goes to meet food items alone. This is despite a record 235 million tonnes of cereals output. In the case of lower income states, the situation is even worse. The ratio is higher than 80 per cent. 

It was ostensibly to decelerate inflation expectations the RBI intervened 10 days ago, hiked policy rates (Repurchase rates) by a whopping 50 basis points. But before singing hosannas on the intervention, hang on! The actual increase appears cosmetic. Policy interest rates are still inflation negative. The one year and the ten year yields on government securities are 75 bps and 50 bps below the head line inflation. For the consumer price index, add another 400 bps more. 

With real rates still negative, the inflation response appears weak. But negative interest rates are positive for the country's stock markets already heavily over valued by massive cross border flows fleeing shrinking tax havens in Europe. Forecasts are out that the domestic equity markets could continue to boom. Angel Broking Lalit Thakker's expectation are that markets could touch new records.  

Obviously, more flows could be on their way, inflating an already over blown bubble. India's listed companies contribute barely 15 per cent to the GDP. Ironically the market capitalization of the companies is over 120 per cent of the GDP or a Price to Earnings ratio of 22.5 times. That is the trailing earnings will take at least 22.5 years to amortise current prices.    

The inflows are in addition to Non-resident capital fleeing European insolvencies. Non- resident deposits with the banks have jumped $3 billion. For the fiscal year ended March 31, 2011, the outstanding NRI deposits, in all categories, both Rupee and foreign currency amounted to $ 51.63 billion or (3.5 per cent of the GDP). NRI flows are not looking for a safe haven. Most NRI repatriations are from those returning home for good with crushed European and American dreams. 

Only some are yield hunters. A one year sovereign bond in India gives out at least 800 bps. A $ bond may give out only 0.18 bps. So even assuming a 5 per cent exchange rate appreciation, it would mean a cool 300 bps return.

Yield hunters prowl

Yield hunters are not necessarily looking low risk highly regulated investments.  The banking sector, both public and private is under close surveillance from domestic and global regulators. Entry of flight or round tripped capital is into lesser regulated financial markets, equity funds, corporate debt funds and commodity funds and to some extent real estate, far from prying eyes. Trails, paper or electronic, are difficult or cumbersome to trace in these sectors.

Funds coming through the Participatory Notes (Origin of the investors is unknown even to regulators) were $39 billion, a $ 7 billion increase over the March 2010. These funds invest in mutual funds, including commodity funds. Some PN buyers or Foreign Institutional investors are leveraged investors.

Leveraged trading in markets also has a nasty impact on emerging markets -- excessive volatility. Since the leveraged trading by yield hunters is done across national borders, volatility spills into the foreign exchange market. The result: An appreciating Rupee against the U S $. There are already incipient signs of an appreciation reflected in the Non-Deliverable Forward exchange markets—a market that deals in emerging market non-convertible currencies. NDF exchange rates at Rs 45.11 against the $ are lower than the domestic one month forward premium. The domestic one month $ was Rs 45.30.

High volatility also translated to escalating hedging costs. Hedging costs of one $ for one month is currently 8 per cent. Three years, ago the costs were less than 2 per cent.  For the exporter rising hedging costs mean income shrinks.

With capital inflows chasing every possible asset, inflationary conditions are not likely to recede. In fact they are likely to worsen, admitted RBI. The paradox is that the consequent inflation contributed to appreciating exchange rates with an impact on the current account deficit. India's current account deficit for the first nine months of fiscal year 2011 was 3.1 per cent of the GDP. So long as leveraged capital flows remain unhindered, inflation and exchange rate appreciation are likely to continue cohabitation. European insolvencies, to top it all are likely shrink Indian export markets, even as import prices continue to spiral. These are pressure points on the current account deficit.

More liquidity tightening

The continuing high inflation therefore means that the M3 (Currency with the public, demand deposits, deposits with the Central Bank and Time deposits with the banking system) containment is far from over. The velocity of M3 estimated by the RBI is assumed at 1.2 times of the nominal GDP. 

M3 velocity has been steadily falling since 2004-05. So if the Finance Minister Pranab Mukerjee said that growth was likely to be compromised, it clearly sent out a message. India was prepared to risk a slow down. However, it may not be just a slow down. It may very well be severe slow down along with high inflation. 

Perhaps, there may be more intervention rate hikes. But unlike China, India is not likely to change the Required Reserve Ratio. India's Cash Reserve Ratio is 6 per cent. China's, after the 50 bps, hike is 21 per cent. A CRR hike would result in expanding the RBI's liabilities that in turn could translate to further squeezing liquidity in the system.

Instead India's Reserve Bank may opt for a hike in the Statutory Liquidity Ratio by 100 bps. This ratio mandates bank investments into designated government securities. This is the most likely option, since there is no RBI balance sheet expansion either on the liability or on the asset side. An SLR hike has multiple benefits, keeping government borrowing costs low, transmitting the balance sheet expansion directly to the banks. Above all, government borrowings during the first half of the year would most likely proceed unimpeded with minimum cost escalations. At the same increased net bank credit to the government, shrinks credit availability to the commercial sector and contains liquidity expansion.

Indian bond markets have already begun factoring the severity of such a slow down. The one year yield is 8.15 per cent and the ten year yield is 8.45 per cent manifesting an expectation of tight short term liquidity conditions ahead. In March end both these yeilds were 25 bps lower. 

The narrow spread between yeilds also reflected the intensity of the expected slowdown. Similarly, in the corporate bond markets there is an inversion revealing the massive working capital requirements. One year corporate bond yields are over 10 per cent and five year yields are 9.75 per cent.  The bond markets point to a storm cloud gathering rather than just a severe slow down.   

-

  References :

¹  RBI Bulletin, May 2011

² Economic Survey, 2004-05, 2005-06, 2007-08, 2010-11

³ Food and Agricultural Organisation

Bondster

U S Fed's QE shadow on Reserve Bank of India

India's central bank, Reserve Bank of India reacted on predictable lines, hiked policy intervention rates,- Repurchase and Reverse Repurchase rates 50 basis points, ostensibly to combat inflation.

Even after the pass through hikes by the domestic banking system real rates would still be negative. One year real yields are still negative by at least one per cent lower than whole sale price derived inflation.

The significant action was in reduction of the broad money supply target or M3 (Currency with the public, demand deposits, deposits with the RBI and Time deposits with the banking system) to 16 per cent for the fiscal year 2011-12. India follows a 12 month fiscal year that begins in April. For fiscal 2010, the growth projected was 17.1 per cent. The actual M3 growth though for the period was just about 15.9 per cent.

QE3 Alert!

The lower than targeted money growth last year was on account of the absence of intervention in the foreign currency markets. If the Rupee was allowed to appreciate, M3 growth tends to be low, as interventions increase reserve money. Besides, demand deposits in the banking system shrank one per cent. A compressed M3 target has a message.

A low M3 growth projection this fiscal year betrays an underlying RBI assumption of a further $ liquidity expansion—U S Fed's Quantitative Expansion (QE). QE2's $600 billion is due to expire in June this year. The QE3 anticipation was driven by the FOMC statement on April 27 and Fed Chairman Ben Bernanke's press conference on the subject. U S bond markets have consequently factored QE3 in. Bond market vigilantes have pushed down five year yields below 2 per cent for the first time in since last year. Ten year Treasury yields are down to 3.25 per cent, down 25 basis points, from the beginning of April this year.

For India, a Fed QE3 means, inflationary pressures remain high. Therefore, preemptive action was to keep M3 growth on a tight leash. The action implied that the Indian establishment was unwilling to allow domestic liquidity expansion and fuel inflation expectations. Therefore, there is likely to be little or no intervention in the foreign exchange markets, despite the Rupee appreciation. Domestic liquidity expansion would be inevitable if the RBI intervened in the foreign exchange markets. Non-intervention means exactly the opposite, no infusion of primary liquidity.

M3 freeze a Rupee booster?

The underlying signal in the reduced M3 target with the consequent exchange rate impact appears to convey that cross border speculative capital flows were not welcome. Such speculative flows come in when the Rupee-$ exchange rate is weak and exit when the reverse begins to happen. With the reverse repo rate at 6.25 per cent though there was substantial scope for cross border arbitrage operations. Such funds have actually have come in the past and are not likely to stop. Overnight flows however, has little impact on domestic money supply, since such funds are mostly in the nature of swaps. Such flows elevate  the Rupee against the Greenback.

There are other positives in the M3 tightening and consequent exchange rate adjustments. Exchange rate appreciation masked the inflation impact last year. Food price inflation currently is running at 17 per cent on a 52 week average basis, defying determined efforts at containment. During the same period, the 3- currency ($, € and ¥) real effective exchange rate appreciated by 13 per cent. Obviously, the inflation impact would have been far higher if the $-Rupee exchange rate were allowed to depreciate.

Limiting cross border flows also appeared to be drawn from lessons of the past. Three years ago, when the RBI had aggressively intervened in the foreign exchange markets to support the Rupee, the sterilization of the liquidity was done through issue of government securities(Market Stabilisation Securities), translating into a fiscal cost. In addition, the dollars bought from the intervention were parked in the U S Treasuries.  With 10 year $ Treasuries at 3.4 per cent and 30 days at 0.05 per cent large reserves acquisition from interventions were expensive. The deficit, (difference between the yield on U S treasuries and MSS yields) would be almost 6 per cent that exacerbates the fiscal cost.

This year, fiscal conservatism is the rule. Projected fiscal deficit is 4.6 per cent of the Gross Domestic Product. Allowing an exchange rate appreciation eliminated the need for sterilisation (Removal of Rupee liquidity as a result of foreign exchange market interventions) through MSS. In turn it implied the fiscal costs would be limited.

Fiscal costs

However, there are hidden fiscal costs for offsetting exchange rates. If in China, the exchange rate was used to support foreign trade, India took to using taxation instruments to support exports. Such offsets are necessary, since exports as a component of the GDP are growing. In the last financial year alone, 18 per cent of the GDP comprised exports. Profits from exports are tax exempt under the Income Tax Act, (Sections 80 HHC, 80 HHD, 80 HHE and 80 HHF). Inclusive of export credit interest subsidies, the actual fiscal impact was Rs 57.80 billion ($1.3 billion). But this could be even higher than the estimates. The government's receipts budget candidly admitted, "The actual revenues foregone in 2010-11, may be higher than the estimates.1 In 2011-12, the subsidy costs are unlikely to be lower."

The effects have already begun to show. Government borrowing costs are beginning to rise. The yield on the 10 year bonds is 8.25 per cent a 40 basis points increase from the end of the last financial year. This is a clear anticipation that actual borrowings are likely to face slippages from the targeted Rs 4.17 trillion ($92.67 billion) in a tight liquidity situation. The one way of holding down government borrowing costs was to restrict private borrowings. RBI's has in fact pared growth in credit to 19 per cent this year, by restricting money supply target.

Inflation battle wilting?

Yet, despite these steps inflation is still unlikely to be tamed. That it was already out of control was admitted frankly by the RBI' governor, Duvvuri Subbarao, "If inflation remains at an elevated level for the first six months we will not be surprised. But that should give no indication one way or other about our possible action."

Inflation partly was on account of soaring energy prices induced by the Fukushima effect. Energy imports have grown at 12 per cent CARG since the beginning of this decade. India requires an average of 3.3 million barrels per day based on consumption data between April 2010 and March 2011. These import figures are far higher than the IEA estimate of 2.6 million barrels per day. At the current import basket price of $120 a barrel, the daily oil import bill is $396 million per day. A shift of just $5 escalates the bill by at least $34 million per day.

Energy import costs have so not been passed through fearing cascading effects of inflation. The high import prices shrink the foreign exchange reserve coverage. At current oil import prices, the reserve coverage is approximately 22 months. If product imports are also included, the coverage shrinks further to about 18 months.

That leaves little option other than building up $ reserves. It also essentially means that high inflation and exchange rate appreciation are unlikely to vanish in the immediate future, unless the Fed back tracks from QE3.

-Ends—

References

¹  Receipts Budget 2011-12

²  Monetary Policy Statement

³ Federal Open Market statement, April 27

 --

Bondster

Inflation ruins India's Financial Inclusion

India's raging food price inflation is threatening to overwhelm an ambitious government project – Financial Inclusion. 
India is home to 135 million financially excluded households.  Financial Inclusion initiated in 2005, required every household to have access to financial savings and risk services. Although this was one of the objectives  for the first and second rounds of the bank and insurance sector nationalizations initiated in 1969 and in 1980, success was limited in view of the prevalence of an unregulated money lending and deposit collection sectors. The redefined aim of financial inclusions was to mitigate rural indebtedness, increase the Credit to GDP (Gross Domestic Product) ratio in the country and bring the figure close to the Asian average

In the initial stages the Financial Inclusion project showed some elements of success. Banks and financial institutions reported full inclusion in all the command areas earmarked to them. This success though was mainly in account opening. Almost all the Public sector banks opened no frill accounts for citizens in the regions assigned them.

The inclusion project was also largely supported by the government's rural welfare programmes National Rural Employment Guarantee Scheme, where all the wages were disbursed through bank accounts. Even states were asked to route their payments for social welfare schemes through banks. The success of the project partly manifested in an increase the savings to GDP ratio to 37 per cent in 2007-08. House hold savings alone contributed to about 23 per cent.

The inclusion also supported the government borrowing borrowings. Inclusion pulled down the costs of government borrowings. In 2006, the average yield on the 10 year yield ranged between 6.9 per cent and 7.42. This was because with accretion in deposits, banks took to investing in government securities under the mandated preemption of 25 per cent. With incremental costs of funds from inclusion accounts at 3 per cent investing in sovereigns was highly profitable for the banking sector.  

Financial Inclusion: Objectives and Reality

The Financially Excluded

Yet progress achieved in the financial inclusion project is at best dubious. Credit to GDP ratio in India was barely 50 per cent in March end 2011. In 2005 it was 40.37 per cent. ( see Chart 1). If the food credit (Credit provided to state owned agencies for buffer stock food grain procurement) is included, then it is one per cent lower. So much for the financial inclusion hype.

Most Indians like to compare with the Western nations or with China. Credit to GDP ratios in these regions are far higher, over 100 per cent. Even during peak of the credit crisis in 2008, when across the world, monetary and fiscal stimulus was the rule India's credit to GDP ratio remained low at 61 per cent.

The purpose of Financial Inclusion, despite the lofty aims, were however actually more than increasing the savings to GDP ratios or just bringing in rural India into the banking network. Financial inclusion also aimed to bring widen the coverage of savings into other sectors, capital markets, mutual funds and government securities and ostensibly to improve the returns of rural savers.     

Chart 1

The purpose was partly to sustain the upward momentum in the equity markets and create a floor against foreign outflows. This was expected to be done through creation of domestic institutional investors as a counter weight against foreign institutional investors and insulate domestic financial markets from external shocks. Since banks seldom directly invest into equity markets, most of the funds were routed through mutual funds. Indian banks outstanding investments in mutual funds was a huge Rs 470 billion (US $ 11 billion).

Another hidden agenda in the pursuit of financial inclusion was to suppress borrowing costs for India's private corporate sectors. As rural savings in the banking sector improved, costs of working funds remained low. This was because most funds under the NREG or any welfare programme was in the savings account rather than term accounts. The jargon used by government and public sector banks is CASA (Current and savings account)accounts. Savings deposits are seen as a long term funds by the bankings and cheap since the effective interest payout is 3.5 per cent. Inclusion led deposit accretions in turn was helped keep the price of credit low, after factoring in a net interest margin of 3 per cent.

The objectives also included creating safety net for India's powerful Information Technology companies who are completely reliant on western markets for sustenance. A TCS document on Financial Inclusion said, "Achieving  sustainable  financial  inclusion  will  require  a  systemic  effort  which  leverages  technology,  regulatory framework and appropriate business models cohesively!"

Inflation strikes Financial Inclusion

However, Inflation in 2010 has driven the financial inclusion objectives haywire. Food price inflation in 2010 averaged 13 per cent as measured by the Wholesale price index. If the consumer price index is factored, inflation impact is far higher abount 4 per cent more, particularly for rural folk. In some of the wealthy states like Andhra Pradesh, Karnataka, Punjab and Haryana, the average per capita income is Rs 140 per day ($3.1). Given the current pace of the food price inflation, the food and primary articles budget in an average house hold translated into a little over 60 per cent of the daily income. In 2005 inflation, the food basket expenditure was less than 40 per cent.

Chart 2

Per capita income though is misleading in view of the wide income disparities prevalent. In reality the actual wages of the majority is about $ 2 a day. That essentially implied high food price inflation impact was on lesser privileged classes leaving no surpluses after meeting the basic essentials. Obviously, savings cannot happen at the cost of meeting more pressing expenditure.

Financial inclusion also implied credit support to farmers and rural labour. But according to the RBI's own admission, agriculture growth has actually  slowed down to 5.3 per cent since the beginning of the fiscal 2010-11. In other sectors credit expansion including real estate remained in double digits for the same period.

For tenant farmers that have never benefited from the government fiscal largesse of debt forgiveness, reliance remains on the non-banking lending sector, with no escape from indebtedness. This class of farmers and rural folk were expected to benefit from cheap credit availability through financial inclusion. 

The Financially Included

The reality however is damning,  particularly for rural landless labour with no access to subsidized lending. The fiscal largesse of the government did not include the small farmers, instead stayed focused at only land owning farmers. Small farmers therefore continue to borrow at rates of over 20 per cent from informal lending institutions, some of whom have morphed into usurious Self Help Groups/micro finance institutions.  Risk averse banks prefer routing funds to farmers through MFIs, under the guise of priority sector lending. Quite obviously indebted farmers cannot afford to save. As a result shot gun accounts opened remain unutilized.

The fallout

With accretions to low cost deposits substantially decelerating, Indian banks reliance on volatile high cost funds have increased. In 2006 high cost Certificate of Deposits (CD) contributed to barely 11 per cent of the incremental working funds. In 2011 March the figure was 64 per cent.

Chart 3

The obvious impact was on the weighted average cost of working funds. The cost of working funds for the Banks' have increased upwards to 8.8 per cent or by 350 basis points since the inception of financial inclusion.

Obviously other financial sectors have not remained unaffected. Borrowing costs during the period have increased. Borrowing costs by the government  increased 200 basis points during the period. 

As if that was not enough, institutional preference shifted to shorter tenure securities. This is partly because of the volatile nature of the CD liabilities. Borrowing costs by private corporates increased by 300 basis points during the period.

Chart 4

The rising costs indicate that credit availability is beginning to be squeezed. A credit squeeze environment translates into loss of employment, as investments get deferred. This in turn shows up in deceleration in savings rates. Gross domestic savings is already down to 32 per cent.

The option normally would be to compensate reduced private sector investments with stepped up government expenditure. Fiscal obsessions any exercise of this option. Without government expenditure neither rural incomes nor financial inclusion are likely to move forward. That essentially implies that India's expectations of playing catch China or with the rest of the world will remain a distant dream for the foreseeable future if fiscal conservatism is the means.

--0--

References :

1.K C Chakrabarty, Dy Governor, Reserve Bank of India Inclusive Growth- Role of Financial Sector

2.K C Chakrabarty, Dy Governor, Reserve Bank of India, Pushing financial Inclusion issues, SKOCH Summit, 2009

3. Rajdeep Sahrawat, Senior Genl Manager, Tata Consultancy Services, From Obligation to Opportunity

BONDSTER

Have a laugh!! – S&P threat to downgrade U S national debt.

            

1)   Rating agency Standard & Poor issued a negative outlook on April 18, 2011 on U S Government debt that made headlines around

the world.

But wait who is S&P kidding?  Have S&P analysts forgotten one fundamental fact? Only the U S government can ever print Greenbacks! No other nation can do so, certainly not legal $ tender. Apply that simple logic. Therefore national government ratings for domestic currency borrowings will always be Triple A plus. All other ratings, will be lower in the pecking order.

It is a different matter if the U S sovereign borrowings are in Euro or in Yuan or in other currency. A down grade would have been perfectly in order, because, the U S would neither be able to earn in these currencies or service debt in these currencies without export earnings or capital account flows. So in Euro or in Yuan or for that matter in any other world currency U S sovereign rating will not be Triple A plus. It could be far lower. The reverse is also true.

In August of 1971when President Richard Nixon unilaterally abrogated the gold standard. It was a sovereign default. S&P came into existence in 1860 and the the first sovereign credit rating of the U S was in 1916.But there were no rating surveillance in 1971. Instead the greenback became Eurodollars!      

2)   U S external and internal debts are denominated in $. So the US government can afford more monetization of its debt with little or no increase in taxes. U S Federal debt is currently 93 per cent of the GDP. Japan is 210 per cent. Japan continues to remain AAA.

U S has a tax to GDP ratio of just 9.5 per cent, which is the same as that of India. Even tiny Madagascar, riled by the global media, has ratios higher than the U S at 13 per cent. Yet S&P rating on Madagascar is "B" five notches below investment grade. So will S&P bring the U S sovereign below Madagascar?

3)   Dollar devaluation ploys

The threat to review rating appears to be to clearly motivated to deflate the value of the $ and a follow up to more quantitative expansions. A $ sell off by the rest of the rest of the world, China, Japan would automatically result in pushing the value of the $ or strengthening the Yuan and the Yen. Neither of these steps is likely to happen, since all of China's, Japan's and for that matter the rest of the world's exports are invoiced in greenbacks. So the $'s supremacy is not likely to be challenged in the foreseeable future.

4)   S&P steps : Credit Rating Agencies lack credibility and integrity.

Credibility: One year U S treasury yields remained at 0.24 per cent, one BPS below the Fed Funds Target rate. Five year debt is 2.09 per cent, 20 bps below what it was a month ago.  A rating drop would have normally scrambled bondsters to a sell off. So much for S&P's outlook on U S debt.

                             

Besides there was no downgrade of AIG before the collapses began. It was only in September 2008, when AIG stuck with the Credit Default Swaps went almost belly up that rating agencies got together.  

Integrity:

And Citi, JP Morgan Chase, and Bank of America continue to be in A, AA and A categories respectively.  These institutions still have white washed toxic assets on their books. The combined toxic assets of the top 25 U S banks are $13 trillion. These assets range from dud mortgage backed securities, Collateralised Debt Obligations and Credit Default Swaps. So more bailouts, by way of Fed purchases of toxic assets appears likely, that will inevitable translate into QE3. There are no bailins by the share holders, instead all the top executives continue to draw fat bonuses. It is only the borrowers and home owner that have insolvency and despondency staring at them.

5)   Rating agencies have always benefitted from Regulatory Forbearance, lots of power without any accountability. Not to mention the billions of $ fees collected in Ponzi rating schemes for beguiling investors around the world. Time to downgrade the raters? Or is S&P also on the way to insolvency and is making an attempt to salvage reputation in an intensively savage ratings market? Or is internecine rating agencies' competition becoming a repeat of Coke vs Pepsi battles?

Bondster

U S – China currency conflict exposes Indian economy's underbelly

"The $ is our currency but your problem". John Connolly, U S Treasury Secretary in 1971

---------

The escalating war of currencies between the U S and China has exposed the India's vulnerabilities and caught economic policy makers in a cleft.

For almost two years now, the U S has been fighting to push down the value of the green back that has bipartisan support. But in a free currency float regime, devaluations are technically difficult. Quantitative Expansion (QE) therefore serves as the route. Quantitative Expansion implies releasing more $ liquidity into the global financial system – well in this case, it simply means printing more $. The U S Federal Reserve Board (Fed) has used bond purchase mechanisms for pumping in liquidity. Since 2008 to date a record $2.42 trillion of liquidity has been pumped into the global financial system through such bond purchases.

For China, the main rival of the U S, the compulsions are exactly the opposite. China needs to keep the exchange rate stable. The U S $ is currently worth 6.56 Renminbi Yuan. Accretions to the current account surplus, of nearly $400 billion per year have left China with foreign reserves of nearly $ 3.05 trillion (Rs 137 trillion). The burgeoning surpluses and resultant reserves are exerting pressure on the Yuan to appreciate. Exports comprise at least 30 per cent of China's GDP. The compulsion therefore was to allow capital exports to neutralize the upward pressure on the Yuan. In the initial stages, China's capital exports were to the U S and in $ Treasury debts. The sustained purchases of the U S Treasury debt since the middle of the last decade has seen, China including Hong Kong, accumulate U S Treasury debt of over $ 1.2 trillion (Rs 49.5 trillion).

But the Fed's QE initiatives have made parking China surpluses in U S Treasuries extremely expensive. At the beginning of the millennium China's investments in 10 year U S public debt earned yields (annual rate of return on investment) as high at 6 per cent. It is now 3.58 per cent. A dip in the $ yields indicate appreciation in China's $ treasury investments' value. Incremental investments at these yields, however for any astute treasury manager translate to low returns, with potential depreciation risks.

Consequently, mandarins in China Investment Corporation and State Administration for Foreign exchange (SAFE) have begun reallocation of the portfolios. The preference is for shorter term $ treasury investments. Inter yield spreads between six months and 10 years is 346 basis points (3.46 per cent), as a result. The spreads were 70 bps in 2000.

Besides, there are incipient signs that Uncle Sam may attempt a flirt with QE3⁽¹⁾  as well, to depreciate the $. The Federal Reserve System's Vice Chair of the Board of Governors Janet L Yellen, at the Economic Club of New York speech said, "An accommodative monetary policy continues to be appropriate because unemployment remains elevated, and, even now, measures of underlying inflation are somewhat below the levels that FOMC participants judge to be consistent, over the longer run, with our statutory mandate to promote maximum employment and price stability." 

Bondsters have already factored QE3 element (a potential escalation of the currency conflict) and have begun driving down short term yields. Six month $ Treasury yields are falling fast. They are down to 0.12 per cent or lower than the overnight Fed Funds target rate and half of what it was a year ago. 

$ Yuan conflict begins to pinch.

It is this $ –Yuan conflict that has trapped India. The Reserve Bank of India (RBI), the country's central bank has already begun seeing red in this competitive currency depreciation battle. The RBI's concern came out in an internal paper. "By keeping RMB undervalued against the USD and depreciating it in line with the USD in the international market without taking into account the economic fundamentals of China, it invariably and distinctly provides competitive advantage over its trade competitors and trade partners including India." ⁽²⁾

The cheap dollars from QE1 and QE2 have led to massive capital inflows into the country, especially from highly leveraged cross border portfolio investors and Foreign Institutional Investments (FII). In fiscal 2011 (April 2010 to March 2011), FII investments in India's capital markets equaled $ 32.226 billion (Rs 1.44 trillion). On the face of it portfolio flows don't add to external or national debt. However, they have contributed to India's liabilities. Even a whiff of a Fed reversal would result in a FII cash out.

An anomalous situation was created by these large portfolio inflows. Market capitalization of all the listed companies at the March 31 Sensex of 19445 was over Rs 78 trillion ($1.6 trillion) or equal to the nominal Gross Domestic Product for the last fiscal The market capitalization is  from listed companies that contribute to barely 15 per cent of the country's GDP.

The risk of foreign portfolio capital inflows leading disruptions was conceded by the RBI. The RBI's Financial Stability Report  said, "Prolonged period of financial system fragility, weak economic growth outlook and worsening fiscal strains in advanced economies have together created a climate that is not congenial for financial stability. The current policy support, both implicit and explicit, has not helped in addressing such risks. Funding risks could crystallize with a spill over into India, especially in view of the growing significance of the finance channel."⁽³⁾

Some of the problems are already discernible. Two elements have begun to coexist in the domestic economy, Exchange rate appreciation along with high inflation. Since September 2010, the Rupee has appreciated by 5 per cent against the $.

External account pressures mount

Exchange rate appreciation is an ego booster for politics, but is clearly not good for the external sector. India' current account is now under pressure and most likely ended  at a record 5 per cent of the Gross Domestic Product this fiscal year (2010-11) high oil bill. This number could deteriorate if the oil bill rises further.

India currently consumes about 3.2 million barrels and imports the equivalent of about 2.4 million barrels of crude a day. At $119 a barrel, the daily oil bill is $ 286 million (Rs 12.623 billion) per day, at current exchange rates. For every $ increase in prices, India' oil bill increases by $2.6 million per day. At current foreign exchange reserve level of $ 300 billion plus, this translates into a coverage ratio of a little over 2.5 years.

In reality, if the volatile component of the reserves, Non-resident deposits, external commercial borrowings and foreign portfolio investors, the import coverage shrinks to just two year. As oil prices go up, without concomitant export income increases, the coverage reduces progressively. Along with mounting global risk aversion the ability to finance a burgeoning deficit with capital account flows is under under increasing pressure.

India's current account deficit is presently 3.3 per cent of the GDP. This is a trigger for concern. It should, because this is highest deficit since the 90s when India pledged its gold reserves to the Bank of England and Bank of Japan to avert a financial crisis. At that time the current account deficit was $9.68 billion or 3.2 per cent of the GDP⁽⁴⁾. A decade earlier, a deficit of 4.2 per cent had driven India to the International monetary fund for a $ 5 billion structural adjustment loan. 

                             

Inflation pressure also escalates

Worse the burgeoning deficit is coexisting with high inflation. What has helped mask the inflation impact is exchange rate appreciation though at the cost of deteriorating exports.

Domestic inflation as measured by the Whole sale price index is close to 8 per cent per annum. Even this figure is misleading in view of what economists normally refer to as the base effect. Last year, the inflation for the same period was in double digits. Besides, what is actually of significance is the fact that the Whole sale prices for food grains actually remain in double digits.

That double digit food inflation is not likely to vanish in the foreseeable future. Skyrocketing Onion prices in December 2010 were attributed to crop shortfalls. But the inflation was also caused by traders' warehousing onions and other agricultural produce, funded by cheap cross border credit. Cheap short-term cross border credits have made stocking these items attractive options. Such credit flows were mostly from several foreign banks and to some extent from Exchange Traded Funds. Foreign banks borrow cheap six month funds, at rates as low 0.5 per cent and in turn lend to Indian entities. This partly contributed to the exchange rate appreciation and wide six month forward premium that are now close to 7.5 per cent.

To top it all international ETFs have also begun using Indian farm produce to drive up net asset values. Such cross border inter-market arbitrages are normal international practices, in coal, oil, food grains and sugar. The onion price spikes were just one manifestation of the havoc such games engender. Such flows show up in high food price inflation and exchange rate appreciation.

More troubles ahead?

The situation is likely to get even more complicated as China's sovereign wealth fund, China Investment Corporation, Chinese Banks and Peoples Bank of China subsidiary, State Administration of Foreign Exchange, push for investing into the Indian bond markets. An article in the influental the Chinese Communist Party organ, the Qiushi Journal said, "China should pick up courage and go for aggressive buying of other currencies, including the Indian Rupee hence taking the lead in affecting the market for US dollars." 

Chinese Premier Wen Ji Bao's visit to India in December last year was precisely for this purpose. With China's focused defense of the Yuan exchange rates to preserve its current account surplus, the option was capital exports and improved investment returns. India fits the bill, with 10 year sovereign yields at over 8 per cent and corporate yields another 300 bps more.   

But India's policy makers and financial markets are far from enthusiastic. This partly explains the series of statements from the RBI' on the status of the Yuan, all curiously coming after the Wen Ji Bao visit. It is apparent the worry is on further reflation of an asset bubble waiting to burst. That is not all. Even a small flow from China could damage exchange rates at a time when the current account is under pressure.

Therefore, one option was to prevent any large flows, through imposition of physical ceilings on investments in debt. This is already in place by the capital markets regulator, Securities Exchange Board of India.

Direct interventions to stabilise exchange rates as in the past could lead to accretion in exchange reserves with the attendant costs through an increase in money supply. Besides, the intervention, through purchase of $ would have to be parked only in low yielding U S $ or Euro liquid assets. At the same time the cost of sterilising the excess liquidity is about 5.5 per cent or even higher, (If unconventional approaches -- Market Stabilisation Scheme bonds are included). In any case it would still result in a deficit of at least 3 per cent, with little possibility of recovering the losses. So this option is out of fashion now.

There are other options: Tobin taxes (named after James Tobin, who originally proposed it). That step would mean a political intervention, or as the RBI's Financial Stability Report called it, "macro prudential measures."   There is a fourth option also – Devalue the Rupee. The risk of the fourth option is explosive - higher inflation.

---Ends—

References:

⁽¹⁾ Janet L Yellen, Vice Chairman Federal Reserve Board, speech on April 11, 2011, at New York.

 ⁽²⁾ S Arunachalaraman and Ramesh Goliat, Implications of Renminbi Yuan's revaluation on India's trade.

⁽³⁾  Second Financial Stability Report—Dec 2010, Reserve Bank of India,

⁽⁴⁾ Economic survey 1992-93

                              

Bondster

Goldman Sachs comes to Indian Bond markets Yield

“If we don’t show up Monday, it’s because we’ve hit the jackpot.”Lloyd Blankfein, Goldman Sachs CEO

Goldman Sachs has finally made its foray into the Indian sovereign bond markets and the forte of large banks only.

The entry through its subsidiary, Goldman Sachs India Capital Markets Pvt Ltd, was formally approved by the Reserve Bank of India (RBI) on April 15, an auspicious day for many in the country since it is the beginning of the sowing season.  Goldman Sachs starts operations on Monday or April 19, 2011. The entry brings in the action of leveraged capital into domestic bonds that was so far confined to only the equity markets.  Leveraged capital has played havoc in the equity markets, driving market capitalization of to over $1.8 well over India's nominal GDP.  It is not that Goldman Sachs is not already in the debt markets. They are there through the Foreign Institutional Investor route. This route is governed by a physical ceiling.

Leveraged Capital Action

The Goldman entry, with some flab from the Fed's QE1 and QE2, somewhat contradicts concerns expressed by the Reserve Bank of India.  At the Bank of International Settlements'  Special Governor's meeting in Kyoto in January this year, the RBI Governor D Subbarao said, "Our reserves comprise essentially borrowed resources, and we are therefore more vulnerable to sudden stops and reversals as compared with countries with current account surpluses."

Nevertheless the rules have changed from Monday, though the fundamental precepts remain the same, whether in financial markets or on the roads in the country - "Signal Left, turn right and vice versa!" 

With Goldman Sachs entry Indian bond markets traders can expect some real leveraged capital action. Leveraged capital means using borrowed funds. With the greenback as the currency for the global carry trade leveraged capital is the route to go. Goldman has the skill to bring cross border funds though multiple sources. With six month LIBOR at 0.46 per cent, the spreads are huge. Ten year yields as measured by the benchmark 7.80 per cent due April 2021 was 8 per cent.

Although, foreign investors in Indian debt don't contribute to any escalation in sovereign external debt costs, bonds are likely to turn extremely volatile. Volatility in bonds is already apparent. In just one week ten year yields on the newly issued 10 year bonds have moved up 20 basis points. Yield spreads between one and ten year are just 60 basis points implying a flat yield curve.

Technology driven volatility

Increased volatility is likely from Flash Trades or High Frequency Trading (HFT) with supercomputers and complicated algorithms, all Goldman specialties.  These are most likely to make their presence in the Indian bond markets. With the entry of the likes of Goldman, wild swings would inevitably spillover into the foreign exchange markets. These high technology trading arsenal are therefore essential kits if currency depreciation losses are to be minimized and returns are to be maximized. A foreign investor in Indian bonds benefits, if the Rupee appreciates against the U S $.  The cross border investor is able to lock into a favourable exchange rate and remain unaffected even if there is currency depreciation at the time of exit. 

Cross border investors also have access to enormous hedging tools. So foreign exchange markets volatility could also substantially escalate. Foreign exchange markets are already volatile. Since the beginning of April this year exchange rates have swung between Rs 44.04 to the dollar to Rs 44.61.

The RBI and the government want only long term funds.  But leveraged capital is not necessarily long term since they are float or callable funds. And purchases of ten-year or longer tenure bonds are not long term investments. Besides, Short selling is already permitted in bonds, through the "when issued route." This means that banks or institutions short sell a security before it is actually issued. If the yields at the time of allotment is high, then the short seller benefits.

But as many bidders found, short selling also could also result in losses. Bidder in the first auctions of this fiscal year found that out. At that time short sellers had pushed the 10 year YTM down to 8.1 per cent. With the cut off price at 7.80 per cent many banks including American and British Banks ended up with a 30 bps deficit.

Who benefits?

For government borrowings, Goldman Sachs and leveraged investor entry means the short run is likely to be beneficial. In the first half of the financial year, when the bulk of the government borrowings are expected to take place, borrowing costs are likely to be kept low. This year, before September, of the Rs 4.17 trillion borrowing target, at least Rs 2.5 trillion has to be raised .

That yields would not be allowed to rise during the period was evident from the extension of the Liquidity management measures. This measure instituted in December last year provides exemption to banks from the prescribed minimum investment in government securities against their borrowings from the RBI's repurchase (liquidity support) window. The prescribed minimum investment prescribed is currently 25 per cent of the outstanding deposits and some categories of subordinated debt. The exemption permits banks a one per cent shortfall without any penal levies.

The exemption was motivated from fear that yields could harden, although there are no bond market vigilantes as yet in this country.  

The fears were triggered by the Certificates of Deposit markets, where the cost of raising six month funds is 9.10 per cent, a 50 bps jump in just 7 days. Besides, Friday's (April 15, 2011) auctions saw devolvement to underwriters of Rs 8.75 billion as bids were rejected since they were lower than the cut off prices.     

             

If sovereign borrowing costs are rising then other borrowers are not raising funds cheap. Triple A rated corporate debt is currently at a spread of 150 basis points over sovereigns are among the highest in the world, implying high risk aversion. (One year TED spreads are just 75 bps). In the case of lesser credit worthy sectors, small industries and self employed sectors  the spreads are far higher or credit is simply not available.

Are Goldman Sachs and foreign investors expected to help correct the situation by increasing liquidity through increased bond trading using global resources? In the short term leveraged capital is likely to benefit both government and corporate borrowings.  Along with it, though comes a host of other risks; inflation is just one of them. Besides Goldman Sachs and their associates presence have also curiously coincided with an escalation of systemic risks. Greece is the latest casualty. There could be others in the making. Surely, we don't need to join them.