The Central banker's Moor moment!

The Reserve Bank of India governor, a former International Monetary Fund economist, Raghuram Rajan, has claimed that the India is prepared for an eventual hike in the U S interest rates. He was quoted in the Times of India on August 31, 2014 saying, "My sense is that even when the Fed withdraws, people after an initial bout of withdrawal, may consider India a good place to leave their money. We have plenty of reserves, but I see reserves as a second or third line of defence."

(Raghuram Rajan is also professor of Finance of Chicago University. This is the same university that gave Chile's military dictator Augusto Pinochet, the Chicago Boys a band of economists that led the country to insolvency in 1982.)

A hike in interest rates by the U S Federal Reserve Board means, an uptick in the U S federal funds (Fed Funds) rate from the present level of 0.25 per cent. This is the rate at which American banks lend or borrow overnight reserve funds from each other. The Federal Reserve Board uses this rate as its monetary policy instrument to signal all rate changes in the U S banking system, in reality across all the dollar linked economies of the world.

So are RBI governor Rajan's claims tenable?

Fact 1 : India has a large holding of U S government securities. A large component of India's reserve ares parked in U S treasuries securities that include treasury bills, Treasury notes (securities of tenors up to 10 years) and Treasury bonds ( securities of tenors of 10 years and above).

As on June 30, this year, the holdings of U S Treasuries amounted to $ 72.9 billion¹ comprising 25 per cent of the country's currency reserves. Since  Raghuram Rajan took over as RBI governor, the increase was $ 16 billion. Predecessor Duvvuri Subbarao had actually made efforts to bring down the exposure. Between June and September 2013, the RBI sold $ 4.4 billion worth of U S treasuries, brought down the exposure to 22.91 per cent of the currency reserves. That's it ! Subba Rao ceased to be RBI governor effective from September 2013. For Subbarao situation was similar to the Moor in Fredrick Schiller' play, Fiesco's conspiracy at Genoa. "The Moor has done has job. The Moor can go."

 

Source: Reserve Bank of India, U S Department of Treasury.

Fact 2 :  The increased investment in the U S treasuries have not earned the RBI any returns. In fact, the effective returns on such increased investments have actually shrunk for the RBI, a reality admitted by the RBI annual report of 2013-14². The RBI's returns on the investments that include, interest, discount and trading income was down Rs 197.68 billion (19768 crore) from Rs 207.46 (20746 crore) . Interest income implies interest/coupon payments on bonds. Discount is earnings when securities are picked at prices lower than face value, but redeemed at face value. Trading income implies profits from purchase and sale of securities).  That means the effective yield realized on all its foreign investments fell to 1.21 per cent from 1.45 per cent. But hold a sec! Aren't traders supposed to ride the yield curve, sell when security prices are high (low yields) and buy when prices are low ( when yields are high)? So why was the RBI buying U S treasuries when prices were high ?

Indian mainstream corporate media doesn't speak all these facts, since journalists or whatever they call themselves now are purveyors of faf to readers than fact! The primary occupation of newspaper editors and financial analysts is marketing Rajan, as the rockstar of financial sector reforms!

Fact 3:  In the event of a FED hike in rates, RBI's will actually lose money, since depreciation on those securities would have to be provided. The RBI marks to market all its foreign dated securities each month. Losses or gains are transferred in and out of the investment revaluation reserve. In the last financial year, RBI has seen its assets appreciate as reflected in investment revaluation account. That account was Rs 3791 crore (37.91 billion) or a Rs 1306 crore (13.06 billion) increase over the previous year. A Fed rate hike could very well reverse this account.
  

That is unless there is a mad rush to buy up dollars.  For now, though Uncle Sam and Comrade Russie are just fiercely staring each other. Comrade Russie blinks, the dollar rockets and RBI's dollar assets soars. Uncle Sam blinks, RBI is in trouble. It could very well sink the Rockstar Rajan's ratings !

Fact 4 : Most of RBI's balance income came from domestic sources. Income from high coupon securities contributed Rs 47000 crore (470 billion). Trading in domestic securities, (read sale of reissue securities) contributed another Rs 33137 crore. Then there was liquidity support to the banks purchase and sale back of securities. The overnight transactions are called Liquidity Adjustment Facility (LAF) that provided cash or removed cash from the banking system. LAF allowed banks to borrow by pledging the surplus holdings of government securities over and above the mandated Statutory Liquidity Ratio. Overnight lending gave the RBI Rs 5902 crore (59.02 billion) for 2013-14, a Rs 577 crore (5.77 billion) drop over the previous year. But MSF that allows banks to borrow up to 2 per cent of their deposits with a waiver on their mandated government security holdings. The cost of this borrowing higher, or for the RBI it rakes in more income. And the RBI earned Rs 1745 crore(17.45 billion) against Rs 11 crore (110 million).

So when the U S federal does reverse stance and begin hiking rates, it does not mean more interest income from foreign securities' holdings. The benefit of those higher returns would be restricted to only incremental additions. That means the benefit of higher interest incomes would be available only new securities' purchases. But the increased income would be hardly be sufficient to cover depreciation costs of existing securities holdings.

But a Fed Hike also raises the risk of a tight domestic liquidity conditions. This is because domestic liquidity is tied to foreign currency reserves. High foreign reserves means greater domestic cash. At the same time foreign asset depreciation restricts the ability of balance sheet expansion.

Unlike India's BRICs partners, reserves have been built by borrowings and increased liabilities in the form capital flows, that included borrowing by foreign borrowings by domestic corporate houses. The rest of the BRICs have built reserves with current account surpluses. That makes India the BRICs' outlier!

Rajan's marketing pitch notwithstanding, the reality is that India is vulnerable. Even government borrowing costs are closely linked to the Fed's action that could rise sharply.   Markets have already factored a potential increase evident from the hardening of the ten year Indian government security yields to 8.5 per cent an increase of 0.6 per cent over the corresponding period of last year. That means any Fed move clearly limits the ability of further reductions in the Statutory Liquidity Ratio. Unless, of course, India’s corporates badger the Government into ‘fiscal prudence’ so that it can continue to play around with cheap funds.

Should the RBI still go ahead and reduce the cost of cash and then will Rajan really be able to sustain Rs 52700 crore to the Government that it paid last year? That is precisely what could bring the Moor moment for Rajan!  

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Fundamental question: The RBI has consistently spoken about fiscal displine. But why is the RBI financing the U S fiscal deficit, after all it is funded by the Indian tax payer? Buying into U S Treasury bills, notes or bonds, after all, amounts to funding American expenditure, including defence. India's debt stock to GDP is 66 per cent and U S is 101 per cent. The answer obviously lies in the fact that most of India's foreign exchange reserves have been built through capital flows and therefore prone to extreme volatility.

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1. U S Department of Treasury- Treasury International Capital System

2. Reserve bank of India Annual Report, 2013-14.

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