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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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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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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Ever since overnight money rates in the Indian money markets have crashed, sometimes to as low as 0.01% per annum, analysts have been expecting measures from the Reserve Bank of India to bring it back to normal levels (within the LAF band of 6% - 7.75%). Surprisingly, except for the odd small additional government borrowing (which is managed by the central bank), RBI has maintained complete silence on the issue.

Many analysts have even expected (or called for) another hike in the cash reserve ratio (CRR).

In my view, the central bank would be very wary of using a blunt instrument like an increase in the CRR. It’s ability to conduct open market operations is also limited, since the amount of securities held on its books are generally insufficient to effectively conduct one. And, on the issue of market stabilization bonds (MSS), it is fast approaching the limit it set for itself. It therefore has little choice but to let the liquidity remain within the system.

A consequence of the humongous liquidity, is that this effectively puts a break on the upward bias of the Indian rupee (INR) in the currency market. Personally, I feel that the central bank has allowed the excess liquidity to remain in the system to ensure precisely this. In other words it is focusing on a policy of exchange rate management rather than liquidity (in other words inflation) management, at least for the time being.

The softening of the inflation readings (the last figure came in at 4.28%, well within the comfort zone of the central bank) has also helped them to continue following this policy.

Overnight rates should head back to normalcy, once the stake held by RBI in the State Bank of India is transferred to the Government, before the end of this month. This transaction is worth more than INR 350 bn. Effectively that much money will leave the banking system.

All the more reason why I do not expect a hike in the CRR.

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The Reserve Bank of India (RBI) seems to have changed tactics in the conduct of its monetary policy. There is a distinct shift in focus that is quite evident if one analyses the events of the last week or so.

Let’s recall what’s happened in this time

• The Indian rupee (INR) hit a 9 year high (breaching 40.50 to the US dollar on Tuesday) only to retrace sharply to close at 40.85 on Wednesday.
• Overnight money rates (in the collateralized segment) hit new lows with several deals being struck at 0.10% p.a. levels (Reminds me of Japanese interest rates)
• Overnight money rates have fallen sharply on the back of a liquidity infusion of INR 200 bn on account of the maturity of a government bond. In spite of being aware of this, the RBI opted not to conduct an open market sale of security under the market stabilization scheme (MSS).

To most marketmen, the fact that RBI would take measures to sterilize the large liquidity infusion was an almost foregone conclusion. The absence of an MSS issuance meant that the marketplace is now contemplating a hike in the Cash Reserve Ratio (CRR).

In my view, however, an immediate hike in the CRR is probably unnecessary, clearly unjustified and unlikely to be resorted to in the near future. We should remember that CRR is a blunt instrument which has a systemwide impact in equal measure. It does not differentiate between the big and small, the liquidity surplus or liquidity deficit entities. Further it pays no return whatsoever on the impounded cash, and thus has an adverse impact on banks’ finances.

Why, then, has the central bank allowed the surfeit of liquidity to continue and allowed overnight rates to hug near zero levels. The answer probably lies in the shifting focus of the monetary authority.

While liquidity and interest rate management had received priority in recent times (ostensibly to rein in runaway inflationary expectations), it appears that the focus has now tilted appreciably towards exchange rate management.

By allowing the surfeit of rupee funds to perpetuate in the system, the central bank has eased the pressure on the appreciating rupee, thus partly achieving its objective of managing exchange rate to promote export competitiveness. The voices from the export community had become shriller almost every day, and the central bank seems to have decided to listen to them.

This also signifies that the RBI in general and the Governor Mr. Reddy in particular seem to believe that inflation (or at least that part of inflation that monetary policy can influence) is not so much of a concern now. Some of Mr. Reddy’s recent comments seem to echo this view in a way. He has been making soothing noises on the inflation front - about how inflation volatility is coming down et al.

While it is clear that RBI has changed tactics, what interests me most is to see how long would they persist with this. It wouldn’t surprise me a bit if they change focus again within the next few weeks or even days. Hasn’t that been the hallmark of the conduct of monetary policy in the last few months?  

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The Indian Rupee fell sharply in the last hour of trading in Mumbai’s fx market on Monday.

The USD-INR rate which was hovering around 40.60 for most part of the day (after touching an intra day peak of 40.54) closed at 40.80 on clear signs that the Reserve Bank of India (RBI) was active in the markets again.

The Indian central bank’s actions have, of late, become more and more unpredictable. While there was a time when intervention in the fx markets was a given, the central bank had seemed to signal, in recent times, that it has made a marginal shift in its currency policy.

In recent months, it had stayed away from the markets for substantially long periods of time, driven more by its difficulties on sterilizing the liquidity generated by its actions in the fx markets than a desire to witness an appreciating rupee. Given a choice, the central bank would still favour a depreciating rupee.

Monday’s market action (and indeed those on a few other days too) seem to suggest that RBI is willing to intervene at times, if only to mark its presence. If such tactics continue in the future, it would only be a matter of time before it is forced to resort to using extraordinary measures to sterilize the resultant magnetization.

With limited spare capacity on sterilization through issue of MSS bonds, I can foresee the central bank resorting to blunt measures like a hike in the cash reserve ratio.

Of course, a reversal of capital flows would be most welcome from a central banking perspective, something that the RBI has been actively encouraging in recent times.

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The Indian rupee (INR) continued its streak of hitting new highs in the fx market for the third day running.

The absence of intervention from the central bank has helped the local currency on its way.

INR closed Monday’s spot trading session at 1 : 41.90 to the US Dollar, close to a decade high.

The strong momentum displayed by the rupee has been backed by large portfolio flows which show no sign of abating.

It remains to be seen if the central bank intervenes in the markets during Tuesday’s trading session.

High money rates (or at least expectations of high rates) have kept the movement in forward rates in relative check when compared to the spot.

Three month forward premia are in excess of 6.5% annualised while the one year premia is also in excess of 5% pa.

To me, the market seems to be bracing for more monetary tightening from the RBI, possibly a further hike in the cash reserve ratio.

Personally I feel any such move, if at all forthcoming, would probably be announced only in the annual monetary policy statement due on April 24 and not earlier.

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The Reserve Bank of India issued a press release announcing to the world at large that :

• it now has the power to set the cash reserve ratio (CRR) - the proportion of bank funds that it pre-empts - at any level. The floor and cap of 3% and 20% respectively no longer stand. The central bank thus has the flexibility to keep the reserve ratio at any level desired; and
• it does not, now, need to pay any interest on the funds so pre-empted.

Thus, Indian banks will now not make, even, the miniscule 0.5% p.a. that they used to make on CRR balances.

This announcement comes on a day when :

- it was revealed that India’s foreign exchange assets have, for the first time ever, crossed USD 200 bn. This puts India in a select group of countries with reserves in excess of 200 bn.

- The Indian rupee (INR) touched a new 9 year high against the US dollar (1 : 42.50).

- Overnight money rates are close to historic lows. Rates for collateralised borrowing had collapsed to as low as 0.10% p.a. on Thursday.

A couple of days ago, RBI also revealed that it had bought close to USD 12 bn in the currency markets in the month of February. This is a record, unthinkable until even recently. The figures for March will be revealed in May, though they are likely to be lower than the February figure.

All this, when the central bank is supposedly trying to tighten monetary policy and remove accomodation.

To me, RBI has lost “control of its monetary policy.”

Now, where did I hear this before!

Oh yeah! isn’t it one of the pillars of the “Impossible Trinity”

The Impossible Trinity

(Impossible Trinity Diagram Source : Wikipedia)

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The Indian Rupee (INR) suffered its sharpest one day fall for more than a decade on Thursday.

At close of local trading in Mumbai, INR fell approx. 1.6% relative to the US Dollar. It closed the trading session at 1 : 43.75 against the greenback. It had closed the previous trading session at  1 : 43.05 to the USD.

This comes after a period of sustained rise witnessed during the month of March. In fact the INR had hit a 7 year high at close on Wednesday.

A chart (Source : Bloomberg) displaying the movement of the currency during the past few months is given below. The chart is in inverted scale (meaning a downmove on the chart reflects weakening USD or strengthening INR and vice versa)

The chart was taken mid session on Thursday and therefore does not reflect the full fall in the value (it stops at 43.42 whereas the actual close was at 43.75)

The primary trigger for the sudden move came from easing money rates. Inter bank overnight money rates eased to single digits (9%) after having hit a high of 30% in the previous trading session.

The initial move in the currency (pictured above) during the morning trading session therefore came from banks who rushed in to cover their short dollar positions, as rupee resources became abundant (possibly as a consequence of government spending finding its way into the banking system). This is corroborated by the fact that the forward premia moved in the opposite direction to the spot rate, confirming suspicions of short covering.

The afternoon trading session was characterised by possible intervention by the central bank. RBI which had been keeping away from the fx markets (very unlike them) for the past couple of weeks is rumored to have intervened (back to their old ways) in the marketplace today buying dollars and therefore amplifying the fall in the value of the local currency.

Software exporters sitting in their naturally cool offices in places like Bangalore must be heaving a sigh of relief. 

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Overnight Call Money rates rose in the Indian money market today to over 25% p.a. Rates for borrowing against collateral are at a relatively modest 9.5%. Remembering that it was not too long time ago that rates were in their low single digits, that these things can be put in perspective.

While genuine liquidity tightness might be a reason, the pressure on banks to show growth in balance sheet size on the reporting date of March 31 is also contributing to the situation. This is corroborated by the fact that banks are offering juicy rates for short term deposits of 7-15 days (primarily to crossover the financial year end on March 31). Some banks have been rumored to offer rates as high as 20% per annum for some of these short term deposits.

Corporates have pulled money out of liquid mutual funds, a part of which may have been used to take advantage of these relatively high returns. Funds have therefore been forced to look at liquidating short term assets to meet these cash needs. This has in turn led to an increase in yields on short term money market instruments.

Remarkably, bond prices have not fallen much in spite of the tightness. They have actually risen today (more on this subject in a separate post).

The impact of tight money is also being felt in the fx market. The local currency (INR) now trades at 43.10 to the US dollar, a 4 year high. The cash shortage has forced banks to sell dollars. Some arbitrage money may also have found its way from offshore locales accentuating the upward pressure on the local currency.

It appears that the Reserve Bank of India (RBI) has, for the time being, allowed INR to appreciate. A motive for this could be to maintain the pressure on short term rates which would in turn force banks to become less complacent about credit standards. It would also act to retard runaway growth in credit. Relaxation of credit standards and runaway credit growth has been one of the concerns of the central bank. The current bout of silence on market conditions seems to reinforce the fact that RBI is reasonably happy with the current situation.

The liquidity tightening appears to be deliberate (on the part of RBI) and seems to have the blessings of the government too. Government spending would normally ameliorate the situation of cash shortage, something that does not seem to be happening.

Has the central bank moved away from its primary focus of managing exchange rates, and has tilted towards managing money supply / interest rates / credit growth?

My guess is we’ll have to wait some more time to get a clear answer to this question. For the time being though, either endure the pain or enjoy the ride depending on which side of the table you sit on.

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