Intelligentguess

The US Dollar gets into a free fall against most other assets after a Chinese official hints at diversifying deployment of reserves into stronger currencies

• The Euro sped past 1.47. It appears it’s only a matter of time we see 1.50
• Crude nudges $100 per barrel. Still a little short of it but not much
• Gold goes past $845 /oz and is within reach of an all time high of $850 / oz

I could go on and on….

Amidst all this we see some evidence of decoupling

The Australian Central Bank raised interest rates today. The ECB is expected to maintain a hawkish stance on monetary policy
Amidst all this the Reserve Bank of India has announced that it has loaded up on more ammunition to defend the Indian Rupee against the deluge of dollar flows. The ceiling for issuance of Market Stabilisation (or MSS) bonds has been raised to INR 2.5 trn. That’s almost two times the gross yearly government borrowing (in other words the fiscal deficit).

It’s time they realise that such measures only add to the flows, emboldening potential investors of the near surety that the currency would not depreciate. In addition it allows them to test the limits of the abilities of the central bankers in managing these flows.

It’s time RBI realises that these measures are an exercise in futility.

Remember the “Impossible Trinity“.

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That’s the headline for a piece i wrote for DNA.

The full piece is reproduced below

The mid term review of the monetary and credit policy is noteworthy not only for what it did (namely hike the CRR) but also for missing an opportunity for fast forwarding improvements in and developing the market structure, especially those related to the interest rate markets.

While the intent (of improving market structure to enable innovation) is stated, precious little is visible in terms of concrete actions.

It is widely acknowledged that our government bond markets are shallow and the market for corporate bond market hardly exists. Intoduction of interest rate derivative instruments has been considered as a necessary condition for the market to move towards greater maturity. However, the regulatory regime has continued to drag its feet on introduction and development of interest rate derivative instruments.

Take the case of interest rate futures. They were first introduced in 2003 without much discussion with market participants. This resulted in faulty design. In addition RBI, for some inexplicable reasons, prohibits banks from taking open positions in interest rate futures. Effectively this means that banks can  only go short (since SLR requirements and other related considerations ensure that banks are always long underlying bonds) in the futures segment. Naturally, considering that banks are the largest players in the Indian bond market, no trading took place.

The solution to the problem was simple. Revamp product design in discussion with market participants (not a very difficult thing to do) and allow banks to develop expertise in market making. However, even after four years since rate futures were supposed to have been introduced, we now have one more committee (or is it called a working group) to examine the lessons that have been learnt all these years and revisit the issue from scratch. It appears that we have one more interminable wait.

Similar is the story with Credit Derivatives. The initial draft discussion paper on credit default swaps (CDS) were issued on March 26, 2003 and feedback / comments were solicited. No further action was taken for more than four years until a couple of months ago when another set of draft guidelines were issued for feedback. A revised set of guidelines has now been put in the public domain last week. Hopefully, concrete action on these guidelines would be forthcoming before the calendar year end.

Even the revised guidelines place significant restrictions like insistence of a credit rating and inclusion in the rating transition matrix etc. which could hamper the development and growth of the market even before it has come into being. Another matter of note is that entities like insurance companies and mutual funds which are important in the context of the development of the market would have to wait till their respective regulators understand the instrument and allow them access to it. If one goes by historical precedance, this is not a prospect that would excite many.

Globally, CDS has become a tool of choice to take a view on credits. The CDS market has become the prime indicator of an entity’s creditworthiness.This was facilitated by derivatives trading not being limited by supply (all you need is a willing counterparty) and market standardization – instead of having to pick from several different bonds of an entity, you have one CDS curve traded across the market.  As a result the volume of CDS trades have exceeded the volume of bonds outstanding,  unleashing further innovation in the form of credit event auctions for settlement instead of the standard physical settlement.

And does anybody even remember STRIPS (Separately Traded Registered Interest and Principal Securities). STRIPS are important constituents in developing a long term zero coupon yield curve,  which works towards providing the market and policymakers with clear price signals. Several committees worked on this and some initial movement was also made in the roadmap to the introduction of these instruments. It now, seems to have been confined to the dustbin.

The lessons that we draw from all this is clear. Financial market regulators need to move with alacrity. Lethargy and delay is something we can ill afford, if we intend to foster a culture of innovation.

Finally, regulators seem to be intent on using a heavy hand in discharging their obligations. On the contrary,  furious pace of innovation  in some of the global financial markets teach us that it is best to regulate with a light hand. Set up a fair set of rules and then watch Adam Smith’s invisble hand  take over and do the rest.

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The Reserve Bank of India has released its semi annual review of monetary policy.

Key measures

• Increase in cash reserve ratio (CRR) by 50 basis points.
• No change in policy interest rates

While many analysts are calling the policy statement neutral and attributing the CRR hike to liquidity management, the accompanying statements seem to convey a fairly hawkish view from the central bank of the country.

More on this later - possibly as an update.

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This is a guest post by KRG, treasury head of a leading financial institution in Mumbai, India.

As the October credit policy is round the corner, few thoughts on what we could expect from RBI….

To start with, there is some pressure from the global quarters, with the US Fed likely to cut the next day of RBI policy. This could however be countered by the argument that if China could continue to tighten reserve requirements so can we.

There is some perceived slowing of credit growth and headline inflation numbers. Are these good enough to “anchor inflation expectations”? With the strong Rupee, new peaks in Oil prices seem to be more manageable than before. The FM also wants the banks to reduce lending rates. May be there is no case to hike rates or reserve requirements.

But, how does RBI address the stronger-than-ever Fx inflows in all eligible asset classes? And that too, with reasonable costs of intervention, a new found monetary constraint. The chances of a stronger correction in asset markets thru the P-Note regulation seem to recede, while new theories of decoupling are being pushed to suggest investment in Emerging markets as a de-risking strategy to hedge the potential risks in developed markets.

And, the headline inflation will go back above 4.5% by next quarter if we were to extrapolate the recent WPI numbers. Can the Central bank slacken its tightening bias at this stage? Perhaps not. Hence there seems to be no case for a rate cut either.

Perhaps, the alternative left for the Central bank is to stay put on all fronts.

While this would help RBI buy time, the liquidity problem will keep coming back in some form or fashion. If the Fed cuts, the interest differential to existing Indian rates would be an added incentive for the Fx inflows to India. By not responding with a rate cut, RBI would be enlarging the scope of the regulatory arbitrage

Is there a better solution? May be, especially after the monetary policy changed track with reintroduction of CRR hikes, imposition of a ceiling on reverse repo amount for about 2/3 months (haven’t the fx inflows dried up in that period?), widening of LAF corridor and reinstatement of good old controls (risk weights, ECBs etc) whenever in doubt.

At the current juncture, our political economy does not and may be cannot control flows into equity markets, the main source of Fx inflows. The policy will have to then deal with the additional constraint of the debt markets having to undertake the entire burden of monetary adjustment.

What RBI could do is to go a few more steps further and widen the LAF corridor further by a cut in the reverse repo rate to discourage incremental flows. Lest this be mistaken for an easier monetary policy, it could introduce the good old incremental CRR. And, since CRR is a blunt instrument with LT effects, may be design this as a special deposit with RBI. And perhaps pay a small interest rate; say 1% below reverse repo. And banks could be allowed to use the deposit in special situations; say as an alternative to repo borrowing from RBI.

Will all this not take us back few years in terms of development of monetary policy? Yes. But we had taken the initial control route to manage the impossible trinity. Might as well keep going forward in the same path rather than trying to find non-existent alternatives.

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This is a piece I wrote that has been published in DNA.

The published piece has a few minor edits.

The full piece is reproduced below

Mervyn King, the Bank of England chief has had a tough few weeks.  Critics have decried his lack of timely action leading to the bailout situation with Northern Rock. On the other side of the Atlantic, Ben Bernanke has done more to cheer marketmen than anyone else. He too has his critics though. Many consider his rate cutting action as providing a lifeline to large American financial firms, considered amongst the most irresponsible in the world.

Noted investment guru, Jim Rogers has gone to the extent of calling the decision makers at the Fed clowns. Had Bernanke not done what he did, he would have faced the wrath of another Jim, the loquacious Cramer of CNBC and “thestreet.com”. Either way, there are both critics and backers.

So how do you decide if the decision is good or not, especially if the decision is that of a bailout as it seemed to be in the case of Northern Rock.  Noted Economist Larry Summers has defended bailouts. Writing recently in the Financial Times he says

“A competent lender of last resort –one who lends freely at a penalty rate against good collateral – actually turns a profit, as the IMF did in its response to the financial crises of the 1990s.”

However another noted economist and Summers’ Harvard colleague, Gregory Mankiw has a different take

“The fact that this particular bailout was profitable ex post is, however, scant evidence that it was wise ex ante.”

In fact, individual decisions could be well thought through and be a failure or vice versa.

Take the case of  Misbah-ul-Haq in the T20 final. His decision to go for the “Ashraful” (as Michael Slater calls the flick over fine leg – though it was actually Zimbabwe’s Douglas Marillier who actually played this shot for the first time in an international match) proved to be a failure, though the process of shot selection could not be faulted. Fine Leg was up and the shot was clearly on. Several batsmen (except for, maybe, Gautam Gambhir) had played it successfully and to good effect. The only flaw in the choice probably lay in the fact that he had not contended for the lack of pace in Joginder Sharma’s bowling.  Had the shot come off, Misbah would have been a hero and we may have had crowds vandalizing Joginder’s home back home in India.

In contrast Dhoni’s decision to toss the ball to Joginder is being considered a masterstroke. If you look at it dispassionately, it may not have been so. The first ball in the over was a wide, displaying nervousness on his part (in contrast to Misbah’s calm and collected attitude) and the others balls too were nothing to talk about. In fact the ball that got him the wicket was also a rank long hop. But then, who’s looking at it that way. All that matters is the end result.

So thin is the line between success and failure.

Coming back to the subject of bailouts and moral hazard, Summers’ lays out some general guidelines of when bailouts are fine. He places a strong case for public action if it does not impose costs on taxpayers and the problem has substantial contagion effects. Further, the problem should be that of liquidity alone and not relate to solvency.

On all these counts, the British action to bailout Northern Rock or even the Fed instigated bailout of LTCM a decade ago pass the test. Both these situations did not involve use of public funds (Northern’s deposits have been guaranteed by the British Government, but the guarantee has yet to be  invoked. In all probability Northern Rock will be sold to a willing buyer and will not require the use of public funds to ensure its survival.)

The same cannot be said of the decisions that our politicians take, though.  We keep bailing out banks, shielding petrol consumers from price rises, showering largesse on our successful cricketers (who after all are only doing their job) all at the cost of taxpayers. And we rarely hear a murmur of protest at these decisions, except for probably from hockey players, who also wish to enjoy the largesse from the government at the expense of the taxpayer.

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The Reserve Bank of India has relaxed norms for money to flow out of the country.

This is an acknowledged attempt at relieving the upward pressure on the Indian Rupee (INR) in the foreign exchange market.

Specifically

a) Companies can now invest 4 times their net worth in overseas joint ventures

b) Mutual Funds are now allowed to invest upto $5 bn abroad instead of the current limit of $4 bn

c) ECB repayments would now be allowed upto $500 mn instead of $400 mn

d) Individuals can now remit $200,000 without any questions asked instead of the current $100, 000

e) Companies can now invest 50 percent of their net worth in portfolio investments abroad. Additionally the 10% reciprocal holding requirement has been dispensed with.

While these moves may have a temporary effect, the central bank should realise that given the relative attractiveness for money to come into rather than go out of the country, these measures would hardly yield long term lasting results. In any case the only significant measures are the first and the last ones listed above.

I call this one more half baked attempt at micro management. Let’s wait and see how the market reacts.

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The Reserve Bank of India has released a Manual on Financial and Banking statistics.

This 312 page tome is sure to become a wonderful reference for any analyst involved in analysing monetary, financial and banking aggregates in India.

Great job done, I should say.

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I wrote a piece for DNA after the release of the quarterly review of monetary policy by the Reserve Bank of India yesterday. This has been published in the Money section of DNA today

Given below is the full text of the piece

While governor Reddy has answered some questions through his policy actions, several others remain unanswered.

The hike in cash reserve ratio and removal of cap under the reverse repo facility is an implicit acknowledgement by the RBI of the futility of trying to manage exchange rates by keeping the money markets oversupplied with local currency.

The central bank has been unusually tolerant of near-zero short-term rates for long periods, hoping that it would ease its job of exchange rate management.

The policy moves announced are an implicit acceptance of the failure of such a policy regime.

The withdrawal of the second liquidity adjustment facility window, which was introduced after persistent demand from bankers, would mean that banks would now have to bear the burden of intra-day liquidity management.

Expect more intra-day volatility in overnight rates.

These measures clearly bring out the primacy of liquidity management in the revised scheme of RBI’s policy formulation.

It also enables the RBI to get back control of the short-term interest rate, something generally considered sacrosanct in central banking circles.

In other words the central bank now at least has a semblance of control on monetary policy.

The experiment of abdicating monetary control has lasted a little over three months. Purely for the sake of policy clarity, it’s a good thing that this experiment has now come to an end.

What remains unanswered though is the type of exchange rate policy that the central bank would now pursue.

While all indications are that the policy of active intervention to protect a particular level of the rupee against the dollar would continue, the market would have expected the governor to dwell on this with a little more clarity and frankness.

Under normal circumstances a 50 basis point hike in CRR would have led market men to cry blue murder.

However, such is the nature of times that it barely registered as a whimper. However, using the CRR as a tool to impound liquidity has severe drawbacks. It imposes a banking system wide penalty and would generally add to the cost of funds for banks. To those, who are predicting a drop in short term interest rates, I say this is wishful thinking. And let’s not forget the RBI itself had a medium term target of moving the CRR to 3%.

A much more efficient method of liquidity pre-emption is through open market sale of bonds. This ensures that the costs, if any, are borne selectively. However, supply of bonds on RBI’s books have dwindled significantly and thus limits its capability to conduct these operations.

The MSS scheme, which was conjured to tide over this, involves fiscal costs, something that the government may not wish to bear endlessly.

Unusual situations require out-of-the-box thinking to generate out-of-the-box solutions. It may be time to think of allowing RBI to issue its own bonds.

This would require legislative change, but in the end may be worth the effort.

It would provide the central bank would another tool to carry out its policy prescription. Additionally, it would relieve the government of the burden of bearing the costs of monetary and exchange rate policy.

It would also serve to shift the costs to where they duly belong. There are examples of such central bank bonds in the global context.

The People’s Bank of China (PBC) regularly issues bonds to pre-empt funds. What’s more, the PBC bonds are compulsory purchase bonds for commercial banks. Of course, one does not need to go to that extent in India.The central bank issuing its own bonds would also provide the true meaning to the current misnomer, “RBI Bonds”.

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So, now the communists want the government (the government that they themselves support and ensure that it does not take any decisions) to roll back the decision to grant freedom to public sector undertakings to invest a portion of their surplus funds in public sector mutual funds.

Frankly, I support their demand.

But not for the reason that they cite. It’s hilarious. The commies say that this decision would only ensure that foreign investors heap handsome profits. This only serves to show their naivete when it comes to matters of economy and markets.

It needs to be rolled back or should I say modified so that public sector undertakings can invest in all mutual funds, not just those that belong to the public sector itself. This ensures that there is a level playing field for all. No undue or unfair advantage should be provided to select entities based on lineage. Let competition rein and performance decide the turn of events in the marketplace.

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Economist Ila Patnaik has written an excellent piece on the non tenability of India’s currency policy, specifically the Reserve Bank of India’s resolute defence of the Indian Rupee’s spot level against the US dollar.

Coming as it does on another addition of USD 3 bn to India’s forex reserves last week and the upcoming monetary policy statement on Tuesday, the lessons to be learnt from the article are timely.

In particular note the last two paras - repeated here:

A consistent monetary policy is one that is speculation-proof. The Bank of England never gets into a dogfight with speculators. It learnt its lessons in 1992. Now it calmly targets inflation. An inconsistent monetary policy invites speculative capital flows. The policy mistakes of the RBI are a source of risk. They induce unstable speculative capital flows.

The defence of the dollar is the root cause of these difficulties. The task of the credit policy announcement on July 31 is to show an exit strategy from this no-win situation. The goal must be to improve on the messy events of March 2007, when the rupee appreciation took everyone by surprise while the RBI stayed resolutely non-transparent. This requires improved transparency and communication by the central bank, and a programme to increase currency flexibility.

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