Currency Imbalance: Redux

At the current juncture most of the SE Asian, East Asian and Latin American (Brazil primarily) are facing an acute problem of balancing inflation and currency appreciation effects on their economies. This problem is being further aggravated by the reluctance of China in appreciating its Yuan. Most of the countries in these regions were primarily exporters to the US or China (commodities) in the pre crisis era taking into advantage the lopsided currency imbalances during that period. Economies of these countries are well on the path to recovery on the back of economic stimulus packages implemented by the respective governments. South Korea had the fastest quarter on quarter growth in the 3rd quarter 2009 (due to strong domestic growth), Australia had a exports growth in the third quarter 2009 on the back of rising exports of raw materials, Singapore has also shown a pick up in GDP growth after contracting in the first half of 2009.

With the pickup in economic activity, most of the countries are now looking forward to tackling the twin issues of inflation and currency appreciation. With most of the growth seen due to the domestic growth which was facilitated due to the stimulus packages. As the economic activity rises, the increasing liquidity in these economies will lead to strong inflationary pressures. The governments may look at tackling these pressures by slowly removing the stimulus packages or raising interest rates. Few of the countries have already started increasing interest rates or are having more hawkish stance with regard to interest rates. Australia has increased the interest rates twice in last two months.

Increasing interest rates brings another major issue in front of the countries. The carry trade that is being seen currently. With the US forecasting a low interest rate regime for a long time period, most of the countries which are contemplating a rate increase have to contend with foreign money flows. Most of these countries are increasingly undertaking market operations to ensure that the currency appreciation relative to their competing export countries is not very high. Leading to a situation of accumulation of currency reserves. Appreciation of currencies in these economies is very important to reverse the trade imbalances seen in the 2003-08 period. But with the fear that increased currency appreciation, would only reduce their export competitiveness vis-a-vis other exporting countries thus limiting export growth, is leading to many countries artificially keeping their currencies low. The situation is being aggravated with the dollar peg of China, the biggest of the lot. Lack of interest from China on the appreciation of the Yuan will only precipitate the matter further.

This issue is one which can derail the little economic growth that is being seen. If the countries do not raise interest rates in the fear of increased inflows, then they might face a situation of asset bubbles returning back and causing more pain going forward on there bursting. In case they allow currency to appreciate, then the economic recovery might be short lived as their main engine of growth (exports) may not recover and domestic consumption may be able to sustain itself.Many countries have started thinking of using different means by which they are able to contain the inflow of money into their economy. Brazil has started a sort of Tobin tax on the inflows. Other countries may raise barriers to investment. Limiting the investment flow is an option which many end being counterproductive. It is pertinent to remember that the impact of the currency appreciation has not been felt as strongly by the commodity exporting countries on their exports yet.

Gold, Dollar and et al

An analysis of dollar and gold price movements over the last one year,Sep 08 to Sep 09 provides us with very interesting information. The gold price has moved from $850 per ounce (Sep 08) to above $1000 as on date (Oct 09) and dollar index has moved from 73.48 (Sep 08) to 78.22 (Sep 09). The overall movement of the dollar and the gold is show in figure 1. We can clearly see three main segments of this movement. Each period provides us with good indication about the prevailing sentiments in the global economy. The periods are Sep 08 till Dec 08, Jan 09 till April 09 and May 09 till Sep 09.

1. Sep 08 till Dec 08

Let us step back and see what was the prevailing sentiment during this period. Lehman had collapsed, credit ratings plunged and risk premiums sky rocketed. There was a perception of the global economy moving towards dooms day. Investors started moving towards safe assets. Equities worldwide faced a meltdown with most of the equity assets being sold off and money moved into safe assets like Gold.In the immediate aftermath, Gold price increased from $740 per ounce(11 Sep 08) to % 902 per ounce(26 Sep 08). Yields rose during this period (Figure 3). Once the fear of imminent economy and currencies got reduced, the money started moving into US treasuries. Figure 3 shows the impact of this movement. Yields plummeted across all the tenures. $ strengthened on the back of this buying of US treasuries. Gold prices fell in face of this sustained dollar rise. The correlation between US $ index and gold during this period was -0.689. The movement of Dollar index and Gold price is shown in Figure 2.

2. Jan 09 till April 09

With the collapse of the economies worldwide, brought about by the financial crisis, governments rolled out stimulus packages aimed at provided support to their respective economies. Banks and Financial institutions were provided support and money was pushed into the economies. This resulted in a slow built up of liquidity in the global economy. Once the fear of the Sep 08 till Dec 08 period was diminished, this increased liquidity resulted in a rise in equities and commodity prices. Asset prices across the spectrum started rising. A brief about his liquidity movement has been discussed in a previous post on Indian Equity markets price rise. Both dollar and gold rose simultaneously during this period (Figure 4), indicating that the fears of debasement of the US $ were very remote. With the recovery of the US economy still far away, dollar debasement due to the high fiscal deficits of the US government were not a concern.

3. May 09 till Sep 09

Global economy was expected to recover quickly and most of the fears seen in the period1 were removed. Emerging markets were expected to lead the recovery phase. Emerging market assets were being bought and money started moving into these economies. Risk appetite increased and this resulted in the fall in the US $. Also with the increasing confidence on the recovery, risks of higher inflation caused by the fiscal deficits were playing on the minds of the investors.The high fiscal deficits and inflation fears also led to the dollar losing value. Gold prices started increasing with the fall in the US dollar (as shown in Figure 5). The correlation between Gold price and Dollar index was back to -0.68.

Looking back we can see the movements and the reasons for these movements which can aid us in providing a glimpse of what may happen in the future. Going forward the main themes are,

a) The increase in the prices of assets caused by the liquidity push could lead to creation of a new bubble. This would only lead to increasing gold prices and dollar being sold off both on concerns of inflation and dollar becoming the new "yen" in carry trade

b) Recovery gets prolonged and the impact of high inflation is not felt. This would lead to the dollar regaining some of its strength.

My bet is more on (a) happening rather than (b).

Deficits and Interest rates

With the projected fiscal deficit of nearly 6.7% of the GDP, the focus has now shifted to the means of financing this deficit and the impact it would have on the interest rates. The government has decided to push growth through government spending. This is one of the appropriate steps that had to be taken considering the fallout of the financial crisis. The fiscal deficit would have many impacts. lets concentrate on one of them arising out of the probable financing of the deficit.

Following are the few ways traditionally used to financethe deficit,

1) Market borrowing:

Government's issue bonds and raise money from the market.

2) Monetisation:

The central bank may resort to money printing to fund the deficit.

3) Asset sale:

Proceeds from sale of assets like disinvestment program could also be used to fund the deficit.

Each of the above has a different impact on the Indian economy,

1) Market Borrowings

Over the last few years, the financing of the fiscal deficit has been primarily through market borrowings. This has been through issue of dated securities and 364 day treasury bills. Nearly 65%-75% of the financing has been through market borrowings. If going by the past history the government plans to raise money by issuing securities, the pressure on interest rates is going to increase. The borrowing program of the government may lead to lack of availability of credit to the private sector thus increasing the cost of money. We are currently facing a falling interest rate regime, due to subdued investment activity. With the economy expected to improve by early next year, the pressure on credit availability is expected to increase. This is might lead to a scenario of increasing interst rates by 2009 end of early 2010. The increase in interest rates is dependent on the return of economic growth.

2) Monetisation

Monetisation might be away of not pressuring the credit pool. Monetisation leads to an increase in money supply. This leads to potential inflationary pressures in the economy. This should be one of the last resorts of financing of the fiscal deficit.

3) Asset sales

Disinvesment in government companies woudl lead to reduction in the government borrowing program. Thus by not crowding out the private sector, the interst rates might be under control.

Currently the government has not indicated a dedicated program for disinvestment. But, this would definetly be one of the ways in which the government would finance its deficit.

Another way in which the government might be able to reduce the impact of the deficit on interest rates would be to attract foreign investment into India. The availability of external funding for private sector would reduce their dependence on domestic funds. Thus keeping the interest rates low.

Ideally the government should look at using a mixture of the above means of financing.

Run up in Equities

The run up in equities over the last 30-40 days has been quite disconcerting to me. The prime reason being the pace and the lack of any change in the ground situation. Many reasons have been floated over the last 2 weeks on the reasons for the run up. One of the reasons have been indications that the Indian Economy is recovering. Three prime indicators that i have read mostly are car sales rising, industrial indexes rising, and rural economy kicking in. Most of the indicators only point to a temporary relief and not true recovery. The pay commission beneficiaries expenses will only lead to temporary spurt in consumption. Rural economy will grow at its own pace and this is definitely not going to be scorching one. Most of these indicators are only pointing to the fact that Indian economy has a minimum growth level below which it can't go. Also one needs to consider the fact that investment by companies is not rising.

My premise is that the run up is primarily global one and the money propping it is a suspect. Lets have a look at the FII investment and mutual data over the last 4 months. The first two months in the year, the net investments made by both the groups were negative,predictably the effect of the lehman crash was yet to wear off. Since March, with the lowering of risk aversion worldwide, the investments started rising. This also heralded the start of the current run up in equities. The stark contrast in the net investments being made by FII and mutual funds stands out in April.The net investment made by FII's in this month was INR 6508 Cr and by mutual funds was INR 38.6 Cr. The difference is too huge to ignore. This data points to the fact that the run up was primarily a FII driven one. Indian markets are just following the worldwide trend and there is no unique factor for attributing the rise to India alone. The month on month growth of MSCI EM index and the NSE both peaked in April.
Unless the source of money which is propping this run up is clear, the sustenance of this run up is a suspect.

Lending rates India Addendum

After publishing the last post,  I have read some articles on stickiness of PLR rates in India. One major issue for stickiness of the PLR is the linking of PLR to the various loans given to agriculture sector. But, this does not reduce the validity of point no1. in the previous post. Banks are worried about the ability to get back the capital lended and this is manifesting to a certain extent on the stickeness of the PLR.

Lending rates : India

Over the last one year, interest rate regime has changed from increasing to falling rate regime. Over the last one year, the Central Bank has used the two rate instruments it has to reduce interest rates and stimulate lending. The repo and the reverse repo rates have been decreased by 325 bps and 275 bps respectively oer the last 6 months. But the banks have not reduced the lending rates greatly, the spread between the deposits and the lending rates has only increased in the last quarter of FY 2008-09. The reasons for banks not being reduce the rates could be,

1. Reluctance to lend: 

The Banks, worried at increasing NPA's, are looking at reducing lending to sectors which they feel are really vulnerable to the economic slowdown. The are more willing to take hit on interst income rather than capital. With the current risk perception, Banks may be feeling that the interest rates should be high to cover the default costs. In the current scenario they seem to be comfortable parking funds with RBI. Nearly INR 100,000 Cr has been parked with the RBI under reverse repo window. The total investments in SLR was at 9.84 Lakh Crores as on Sep 26 2008 and 11.87 Lakh Crores as on Feb 27 2009. Another indication of the reluctance of bank lending has been the fall in the Credit Deposit ratio during the period from Sep 2008 till Feb 2009. The ratio has fallen by nearly 4%.

 RBI by reducing the reverse repo rates is specifically targeting this trend. With the current reduction the negative spread has increased to nearly 4.5% ( with respect to greater than 3 year deposit rate). 

2. High costs of funds:

Post the market fall in Jan 2008, the banking system has seen an increase in the deposits.The total Aggregate deposits with the banks in Feb 2009 was 38.51 Lakh Crores as against 31.85 Lakh Crores in Feb 2008. An increase of nearly  17%. Also an important fact to be noted is that during this period the deposit rates were very high. The high cost of funds is proving to be a major deterrent to the banks in lowering there lending rates.

Resolving these two issues is primary to increasing the credit flow at viable rates to the commercial sectors. 

Nationalisation

The current policies of US government fail to evoke any strong feelings that we are going to get out of the rut. The current policies are looking more like rehased versions of early proposals. The dithering against reorganising of the banking strucutre is only going to make the problem more protracted.  I am strong supporter of nationalisation of the banking system in US. The main reasons for supporting nationalisation are

 a) It will remove focus of banks from survival to lending. Most of the banks are more concerned at buffering up there balance sheets and are not looking at lending. 

b) Private investors have already burnt their fingers in trying to take stakes in these banks.

c) Pumping more and more money at the problem is not going to solve the problem. Only create more problems later.

The main grouse against nationalisation i could perceive are

a) US is a capitalist country where market is supreme. This is a funny statement in the face of protectionist measures being taken by US. 

b) The government does not know business. In the current scenario, private investors have not glorified themselves. The government cannot do worse than them.

The continued dethering is only going to make matters worse. As i said earlier, the quickest way out of the mess would be for US to start exporting and Asian economies to start stimulating domestic consumption. It would mean fall in dollar and a "Default" by US on its payments.

Buy USA policy is bad

Two main articles that i have read over the last week, set the tone for this blog. One is on whether we are staring at a Hayekian recession(by Swaminathan in ET) and secondly the "Buy USA" policy attached to the fiscal stimulus package of US. 

The Hayekian recession broadly states that misallocation of resources in a system over a period of time leads to a situation of boom and bust which can only be corrected by removing the imbalances. Keynesian policy is different in this regard, as it formulated pumping of money into the system to recover the economy. I am of the view that Keynesian policies might not work this time round. The current situation has been brought about by a spending by US (and few other countries) and saving by exporting countries. This imbalance in the global economy led to booming asset prices and the aftermath. To recover form this situation, the solution as per Hayekian , is to make the exporters start spending ( ignite the domestic demand) and the US export. 

The next issue of "Buy USA" is linked to this as it is contradictory to the Hayekian solution. "Buy USA" would lead to a wave protectionism something which the world economy and US in particular cannot afford. Domestic demand in US is at its weakest and 'buy USA' policy  would not be able to stimulate the domestic demand sufficiently.  

The world not requires concentrated action by all the countries to get out of the mess in which the US has to lead, but the recent postures of US (smack with China on currency, protectionism measures) do not give a healthy sign in this regard.

View on US interest rates and Dollar

The main issue being faced by US currently is how to increase government expenditure without hampering the fiscal deficit to a great extent. As per the current statistics from Economist, the budget deficit is expected to rise to $1.2 trillion in the current fiscal, nearly 8% of the US GDP. This would be the highest post 1940’s and worse than the era of high inflation seen in the early 1980’s. Let us take a step backward to the post war era in US. This was a period of gold standards and Keynesian economics. Increased government expenditure finally made it difficult for US to hold onto the gold standard. The money supply expanded less than two fold during 34 years prior to Nixon action and after that action, money supply expanded 13 fold. The revocation of gold standard played an important part in the high inflation experienced in late 1970’s.

The current high fiscal deficit coupled with the increase in money supply being made by the Fed by taking in collaterals (Fed takes in collateral from banks and increases their deposits being held with the Fed. No actual money transfer takes place, but the banks have that amount of capital free to be deployed) has the ability to increase the inflation and interest rates in US going forward.

This is a phenomenon that has been seen across economies which have faced economic crisis. US has been immune to the problem of being able to find investors who would readily buy the bonds it issued. The current interest in US treasuries has been primarily due to the decreased preference for risk. My view is that the risk aversion would decrease and in case other economies start recovering earlier than US, then it will be tough for US to find investors at low yields. The era of strong dollar has come to an end. The performance of dollar going forward would mimic the economy’s performance vis- a-vis other economies coupled with inflation rates. The strong performance of the dollar over the last 3 months should not be viewed as a long term shift but rather a short term unstable shift.