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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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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As we had predicted, Indian money market rates have retraced to saner levels after hitting ridiculous lows of 0.01% p.a. on a sustained basis for the past couple of weeks.

Overnight rates climbed to levels of 8.25%, higher than the central bank’s repo rate, the rate at which it infuses funds. No wonder the RBI received bids worth more than INR 100 bn under its daily lending facility available at the rate of 7.75%.

Rates are expected to remain firm, as the transfer of the stake in the State Bank of India from the RBI to the Central Government takes place today.

With the US Fed’s rate decision (No change in policy rates; some concerns expressed on inflation) now out of the way, focus of market participants shifts to RBI’s monetary policy review, due on July 24.

Personally, I do not forsee any change in policy rates in India at least for the time being. Things seem to be going the way policymakers would like to have it. Inflation readings are low enough, the relentless appreciation in the Indian rupee seems to have been halted for the time being, credit growth seems to be moderating and banks are now laying greater focus on credit quality.

Under these conditions, the RBI Governor may want to hold his horses for the time being. Of course, we have seen his penchant for surprises in the past. The market would therefore continue to remain wary.

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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 Stock markets traded weak on Wednesday, May 23. The weakness was led by banking sector stocks.

These stocks were weak on rumors floating around in the marketplace that the Reserve Bank of India (RBI) may hike the cash reserve ratio (CRR) – the proportion of deposits that commercial banks have to set aside as a statutory pre-emption. Banks do not earn any interest on these pre-empted funds.

The trigger for the story seems to be the large inflow (in excess of INR 200 bn) expected into the system due to the maturity of a government bond (11.90% - 2007).

Step back to a few weeks ago (I forget the exact date). Bank stocks were on fire (with most of them gaining by as much as 5% on that day). And the story that led to that move was that the RBI was contemplating a cut in the CRR. Ironically, overnight money rates on that day were ridiculously low (less than 0.50% per annum). Precisely the kind of conditions that preclude any cut in the reserve ratio.

However, strange are the ways of the marketplace – the rumor was allowed to perpetuate for the whole day. By the evening, when it was pretty clear that a CRR reduction was never going to be in sight, the story promptly switched to a possible reduction in the statutory liquidity ratio (SLR) – the proportion of deposits that commercial banks have to compulsorily invest in government securities. The SLR story was more credible, I should add.

Coming back to present day moves, what puzzles me is how marketmen react to a piece of information (the upcoming bond redemption) that is known for ages. Weren’t markets supposed to discount all publicly available information (the efficient market hypothesis)? Or is it, that the stock markets are getting around to the RBI Governor Y V Reddy’s penchant for springing surprises.

A CRR cut when overnight money rates were ruling at Japanesque levels – that would have been the coup de grace!

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In a previous post I had mildly chided the Reserve Bank of India for sticking to its commitment on releasing the draft guidelines for trading in Credit Default Swaps by May 15.

These guidelines have now been released. The circular can be found here. The full text of the guidelines is here (pdf document).

So after all, they missed the deadline, but just by a day.

To begin with only “banks” and “primary dealers” are being allowed to trade in CDS. These are entities directly regulated by the RBI. Insurance Companies and Mutual Funds would be allowed once the respectively regulators of these entities permit them to do so. It’s now upto the insurance industry to lobby with IRDA and for the mutual fund industry to lobby with SEBI to get the needful done.

Key highlights of the draft guidelines :

• Only plain vanilla CDS allowed. Total return swaps, Credit linked notes, Credit spread options are not being allowed.
• Reference entity has to be a single, resident legal entity.
• Only rupee denominated transactions are being allowed. Even the underlying asset /obligation has to be denominated in Indian rupees.
• Credit rating has been made mandatory for the underlying reference. Further only live ratings are allowed.
• Banks barred from trading in derivatives which include “materiality thresholds” (I have to figure out what this means)

There are quite a few other conditions, but that would take a lot of space here.

As usual, it’s an extraordinarily cautious regulator. The guidelines are now in the public domain for comments / suggestions. Let’s hope that the regulator displays a little more adventurism by the time the final guidelines are formulated.

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The Reserve Bank of India (RBI) had, in its annual policy statement, stated that guidelines for trading in credit default swaps (CDS) in the Indian markets would be released by May 15.

Well, today happens to be May 15, and the guidelines are yet to be released.

Marketmen await with bated breadth. There are still a few more hours to go before the day ends.

Update :  May 15 has passed by. No guidelines forthcoming from RBI. So, they haven’t kept their word. Not surprising to some of us, though it must be a puzzle to many (why commit a deadline if you can’t meet it). Of course, no explanations for not meeting the deadline too. Why bother about such niceties? When you are the central bank, who is going to question you.

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So, the US Fed has, expectedly, decided to keep policy rates on hold. It also appears that the Fed is unlikely to raise rates in the near future too.

It would be interesting to watch the reaction from other major central banks in the days and weeks to come. Personally, I feel that other central banks are unlikely to ape the move. Their decisions are likely to be based almost entirely on local considerations. Having said that, policy rates still seem to be (at least for most major markets) at or close to their near term peaks. The same seems to hold true of the Indian markets too.

Talking about Indian markets, Wednesday’s trading session was a study in contrasts. Overnight money rates crashed on abundant liquidity. Rates in the collateralized CBLO segment fell sharply to near zero, while call money rates were in the range of 2%-2.5% at close. This led many (money) market participants to speculate that the central bank (RBI) might react with some harsh measures, including possible a hike in the cash reserve ratio (CRR) - a method of prempting bank funds. Knowing RBI’s penchant for surprising markets, nobody is ruling out anything nowadays.

In contrast, the equity markets seemed to have taken this penchant to the other extreme. Their were rumors of a reduction in CRR leading to a rally in banking stocks. The Bombay Stock Exchange’s bank index gained approximately 1.5% on the day.

Money rates have opened at 1% levels in the CBLO segment and 2% levels in the call money segment on Thursday. Given these conditions it’s difficult to forsee a reduction in the cash reserve ratio

Personally, I’m inclined to go along with the money market mandarins.

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