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

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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.

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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