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.