Tuesday, 24 September 2013

To taper or not to taper, that is the question!

The Federal Reserve surprised almost all of the market participants last week by deciding to maintain its current pace of asset purchases, at $85 billion per month, rather than "taper".  Having guided the market in May to believe, that it will commence its taper by reducing its bond buying program later in the year, its last week’s decision to carry on with its current bond buying program unchanged threw the markets into turmoil.

So what led to this dichotomy in expectations vs. reality?

Earlier in the year, in May 2013, Ben Bernanke guided the market that FED will commence to wind up the QE as and when the unemployment rate falls to 7 percent, with the expectation that that this might happen by mid-2014.  FOMC members repeated those details in speeches, some emphasizing "as early as September."

When the unemployment rate fell in August to 7.3 percent, not far from the threshold and with no caution from the Fed, the die was cast for “Septaper”, as far as markets were concerned.  As a result of the earlier guidance, the market interest rates started to rise in expectation of tighter money conditions with 10 year UST’s yield rising by almost 90bps over this period, in the process impacting economic activity, including home buying.

So when the FED announced on September 19, 2013 to keep its bond buying program unchanged, it caught market participants wrong footed and caused significant volatility in the global financial markets.  Asian equities, Emerging Market currencies and bonds rallied strongly while the UST’s and bonds bled with US equities recording a very modest change.

So, why did the FED decide to delay the taper?

To be fair to Bernanke, he did say that any decision to taper has to be backed by data confirming steady gains in the economy, in particular continued job growth and labour market strength.

Looking a bit deeper in to the data, there are 5 good reasons why the FED decided against the taper:

1.       Unemployment rate is misleading

The unemployment rate continued to fall, aided by reductions in the labour-force participation rate. As Mr Bernanke indicated last week, the Fed sees the unemployment rate as an incomplete measure of labour-market health. Guidance that QE3 would be complete roughly when the unemployment rate touches 7% seems no longer a good idea.

Fed has now declared that rates will stay low until unemployment is down to at least 6.5%, it may in fact leave rates low as unemployment falls well below that figure, so long as inflation remains in check. The current GDP growth rate of 2% is not strong enough for a sustained improvement in the labour market conditions.

2.       Payroll trends weakened during the summer

When Fed began to indicate its taper program the economy, was consistently adding jobs at a rate of about 200,000 per month. But subsequent reports revised down spring job gains and showed much weaker hiring over the summer. It has therefore reacted to the weakening job growth despite its earlier use of unemployment-rate thresholds as guideposts.

This has led many to argue that the Fed is losing its credibility. In my view, it’s far more important to do the right thing for the economy than being popular or pursue populist actions. Fed needs to be comfortable backing off guidance if it isn't likely to achieve its dual mandate. However, it’s communication of forward guidance to the market needs to get better.

3.       Inflation is trending below target

The FED Chairman considered that an inflation floor might be a useful thing to add to forward guidance. Depending on where the floor is set that could be an extraordinarily important development. The big failing of the forward guidance so far has been that it is entirely consistent with continued stagnation: saying rates will stay low until a particular unemployment threshold is met does not rule out stagnation, high unemployment, and low rates forever (e.g. Japan). An inflation floor, if set high enough, changes that by demanding additional action if the economy is not on pace to close the gap. A temporary inflation floor of around 2% would be a consistent with an intended normal growth rate for the economy.

4.       Fiscal cliff and Debt ceiling debates looming in the horizon

The Fed is rightfully worried that the "fiscal cliff" could seriously harm the American economy. Unfortunately politics is influencing monetary policy.  There is a strong possibility of a deadlock in debt ceiling negotiations potentially leading to government shutdown, Sequester causing deeper impact and a prolonged debt-ceiling discussion. The Fed has erred on the side of caution and has taken the approach of better-safe-than-sorry for now. 

5.       The Housing recovery has paused

Figures in 000s

The real estate sector has contributed close to 1/3rd of the GDP growth rate.  Recent data is indicating slowdown in housing activity as a result of the interest rate increases over the past few months. FED has an eye on the long term interest rates to ensure Mortgage interest rates do not spike up threatening the economic recovery.

The continued strength in the housing sector is critical for both labour market recovery and strong economic growth.

Is QE damaging?

The biggest argument made against QE when it started was that money-printing would necessarily lead to inflation. Surprisingly, that has not happened yet, and in any case, benefits of continuing the QE in for sustaining the economic growth is arguable.  However, the policy has painful side-effects, which is why the Fed wants to exit, albeit gradually with minimal market disruptions. Some of the unintended consequences of QE are:

Poor capital allocation and increased systemic risk

Lower rates, driven by QE, make it easier for inefficient companies to prolong its existence. This means that inefficient enterprises continue to receive credit resulting in poor capital allocation.  As the chase for higher yield spreads, risks to the financial system are increased manifold.

Asset price bubbles

Low interest rates will inevitably lead to asset price bubbles as buyers’ tend to take bigger mortgages driving the demand for housing further leading to the creation of conditions of next cycle of defaults as interest rates rise.

Currency volatility

QE has resulted in large scale capital flows into emerging economies resulting in significant credit expansion in some of these emerging markets.  The announcement of taper demonstrated its impact on some of these emerging economies causing significant currency and capital markets volatility.

Structural reforms take a back seat

QE also helps governments avoid necessary structural adjustments. Taper talk, starting in May, contributed to a sharp run on several emerging market currencies, with those of India, Turkey, Indonesia and Brazil prominent among them.

The market impact was focused on those countries that had fundamental problems, in the form of high current account and fiscal account deficits. This was not solely an issue of an indiscriminate shift in financial flows. The postponement of tapering raises the risk that adjustment will be painful when the end of QE finally comes.

Pensioners and savers suffer

By reducing bond yields, QE impacts the returns for pension funds. Any situation where many pension funds remain far short of meeting their commitments is undesirable. Senior citizens relying on fixed income from investment in bonds continue to suffer.  There has been a massive amount of wealth transfer from savers to borrowers resulting in perverse incentives.  The sooner the QE ends the better it is.


On balance, the FED’s decision to delay the taper at this point seems well founded.

However, improved forward guidance is desirable in order to avoid the gyrations in markets that resulted from the taper talk. The Fed did reckon that those gyrations and the rise in bond yields in particular, were damaging enough to warrant an action —through the choice not to taper.

The FED is rightfully focussed on achieving sustained labour market improvement as full employment will perk up wage growth, which is the kind of inflation the economy would do well with. A period of strong wage growth and higher labour participation rate will be the reassuring signs the Fed needs before allowing rates to rise.

As Bernanke hands over the mantle to the next FED Chairman in January 2014, it is highly unlikely that FED will make a move until Q1/2014 with its taper.  Even otherwise, the underlying data have to supportive for a move and the following factors will determine the timing the taper:

·         Unemployment rate to fall below 7%;
·         A rise in labour participation rate;
·         Inflation expectations above 2.5% p.a. driven by wage pressures;
·         GDP growth rate > 2.5% p.a.

So, in the final analysis, to taper or not to taper will depend on a combination of factors listed above and data is not likely to improve over the next few months on all fronts. 

The precise timing of the taper is a $42 question.  As 42 is the answer to the Ultimate Question of 'Life, the Universe, and Everything'!!!  [If you believe The Hitchhiker’s Guide to the Galaxy J].

Wednesday, 21 August 2013

Indian Rupee in Free Fall

Rupee in Free Fall
The Indian Rupee has been on a slippery slope ever since the FED announced its intent to taper its Quantitative Easing (“QE”) program. 
Most EM currencies with the exception of Thai Baht and the Philippines Peso have also suffered large declines. 

The Rupee plunged to 64.55 to the dollar on 21 August 2013 before closing at 64.11.  Over the last 3 months, the Indian Rupee has declined by a whopping 17%.  The Indian stock market has plunged 5.7% in two days eroding over USD100bn in value.

Ever since the announcement of QE tapering by the FED, the US Treasuries 10 year yield has spiked by over 85bps (from ~2% p.a. to 2.84% p.a. YTM). 
Such a whiplash move eroded the market confidence with equity and bond markets recording massive correction triggered by the significant unwinding of carry trades. 
Foreign investors have unloaded over US$10 billion of Indian debt since May 22, when the U.S. Federal Reserve first signalled its intention to begin scaling back its quantitative easing leading to bond yields to exceed 9% p.a.

In addition to the above growth is at a decade low, trade and current account deficit are at record highs, fiscal deficit is high and retail price inflation is in double digits.  And to top it the price of onions and the Fx rate are in a race to get ahead of each other!  Meanwhile, the government is engaged in pushing its fiscally irresponsible populist policies with an eye on the forthcoming elections in 2014.

Is it Deja vu ?

So, there is a sense of déjà vu amongst commentators on the recent slide in the India Rupee with many likening this to the 1991 Balance of Payments Crisis.  While there are some striking parallels of this to the earlier crisis, the underlying factors are quite different.  In 1991, India was staring at a sovereign default as the Foreign exchange reserves had dwindled to less than two weeks worth of imports. Then, the government had resorted to draconian measures such as direct import curbs, ultimately mortgaging gold reserves with the IMF to raise emergency funds.

Now, there is no such risk. Despite the recent fall in reserves, India's foreign currency assets are at USD 280bn is enough to cover seven months imports.   On the questions around the ability to meet the Current Account Deficit whether its USD 60bn or USD 80bn, the foreign x reserves at around USD 300bn can fund it.  A bigger issue could be the refinancing requirement of USD 170bn odd coming up in 2014.

Also, software exports and other invisible inflows in 2012-13 were equivalent to more than half of India's trade deficit that financial year. On the eve of the 1991 economic crisis, inflows of invisibles were negligible; these were negative in 1989-90. This essentially rules out the possibility of a 1991-like economic crisis, when the gross domestic product (GDP) growth collapsed from a healthy 5.3 per cent in 1990-91 to 1.4 per cent the next.  

In summary, 1991 was a Balance of Payments Crisis while in 2013 it’s a confidence crisis arising from policy paralysis, fractious government, corruption scandals and misplaced policy priorities.  In essence, the Indian Rupee has become the barometer of the current UPA government’s performance in many respects.

The high economic growth over the past decade led to an increased affluence as well as certain amount of hubris.  While the fundamentals are much stronger now than they were in 1991, the stakes are much higher now and hence the fear of losing the new found affluence has set in.

In order to arrest the slide of the Rupee the government has been announcing a series of measures to very little effect.

So do the measures announced add up ?

India’s Finance Minister announced that he expects USD 11bn of additional capital inflows during the remainder of FY14 (ends March 2014) once the following new measures are implemented:
1.       easier overseas borrowing norms, especially for oil companies (USD 6bn);
2.       liberalisation of the non-resident India (NRI) deposit scheme (USD 1bn);
3.       issuance of quasi-sovereign bonds (USD 4bn); and
4.       import duty hikes.

While fresh US dollars (USD) will be raised, some areas of concern are outlined below :

Liberalisation of the NRI deposit scheme to add another USD 1bn

While formal notification is awaited, in his press conference the FM announced that the interest rate on foreign currency-denominated NRI deposits of more than three years maturity will be deregulated.  This should allow banks to set higher interest rates for its foreign currency deposits.

As is to be expected, it's a wild range as no one can yet get a steer on government's strategy.  But impact of some of the actions on INR are assessed below :

The RBI announced more measures to contain the net outflows from India

While accurately quantifying the impact is little difficult (estimate it as at least USD 2-3bn) but these measures together with several other announced measures till date should ease the pain on funding a wider Current Account Deficit.

First, it has reduced overseas direct investment limit for an Indian company in all its joint ventures/ wholly owned subsidiaries to 100% of their net worth (as per the last audited balance sheet) versus the earlier limit of 400%. Few publics sector companies like those in oil sector are exempted from this restriction. If a company wants to invest more than 100% of its net worth it will now require RBI’s approval.  However, breakdown on specific type of outflows are not available. However, in FY13 India witnessed USD12.6bn of FDI outflows and even if this has a 10-15% impact this should provide some relief.

Second, it reduced the limit for outward remittances by resident individuals by 60% from USD 200k to USD 75k only. Also, use of such remittances for acquisition of immovable property is not allowed any more. In FY13, Indian remitted INR1.2bn under this scheme out of which INR 80mn was for acquisition of immovable properties (see snapshot below). During the April-May 2013, India remitted INR300mn.The outflows should reduce unless more individuals start remitting in other names (eg, close relatives). Innovative Indians will find a way by using their relatives and friends!

FX impact: The announcement of the USD 11bn INR rescue plan on 12 August, provide the authorities another window of opportunity to come up with stronger steps to address Current Account deficit financing concerns. Before this the government had limited Gold imports and then levied 10% import duty.

Rising yields on government debt will also force banks to write down the value of their bond portfolios. To ease the pressure on banks, the RBI carried out Open Market Operations adding USD 1.2bn to the market liquidity by purchasing long dated bonds today (21 August 2013). The banks valuations were impacted by the series of measures taken earlier and today’s actions resulted in a strong rally in bank stocks.  The bond yields had risen to 9.47% (last seen during Lehman crisis in 2008) and with the current action it has fallen to 8.93%.

The latest moves partially reversed previous monetary tightening measures and led to accusations from analysts of Indian policy “flip-flops” just as the governorship of the RBI is passing from Duvvuri Subbarao to Raghuram Rajan, the former International Monetary Fund chief economist who takes over on September 5.

Market is not convinced

While these measures should help ease the upside pressure on USD-INR, market continues to await further announcements like import duty hikes, external bonds etc. before evaluating the impact of all measures.  USD-INR is expected to enter into a short phase of choppy range trading as India’s BoP dynamics are reassessed. There is a risk that international investors view these steps as retrograde leading to panic buying of USD-INR.

Powerless so far to rein in the wayward rupee, the government even pleaded with gold-obsessed Indians to stop buying the metal, because it drains foreign exchange reserves.

Far from reassuring investors, the mish-mash of measures has created the impression that the Indian authorities are floundering around for stopgap solutions rather than devising any long-term strategies for economic recovery. 

Amidst all this cacophony, the market is taking an extreme view as they see the government’s measures are with no clear policy direction and is ham handed.

What are some of the pundits saying?

The issue has caught everyone’s imagination and several self appointed ‘experts’ are advising the government!  Here’s what some experts are saying :

·         The PM and the FM to visit the holy shrine in Tirupati, not for praying as the headlines suggested, but to negotiate with the Trustee to deposit their 500 tonnes of gold with the State Bank of India; 

Some superstitious Indians have blamed the slump on the new symbol for the rupee, unveiled last year. Experts on “Vastu Shastra”, Indian version of “feng shui” say that the symbol debuted on an inauspicious day and that the horizontal line across the symbol appears to “slit the throat” of the currency!

What should the government be doing?

The immediate task is to improve its communication to the Market of its package of measures together with a strategic policy direction.  Markets hate uncertainty and to the extent this can be taken off the table, it improves the overall sentiment.

1.       The Government needs to address the cause rather than attack the symptom even as they take some tactical measures.  To start with create a predictable investment climate with no policy flip-flops (e.g. Vodafone tax case). Many potential investors have been frightened by an unexpected US$ 2.5bn tax demand levied on Vodafone after it acquired the Indian mobile operator Hutch.  Accept the Supreme Court verdict and create an environment of predictability of economic and fiscal policies.

2.      Reverse confidence destroying moves like limiting remittances by individuals. This can only result in panic reaction stemming from the fear of total capital controls leading to flight of NRI deposits.

3.     Address structural issues by investing in infrastructure projects and help drive business growth. The prospect of the return of strong growth will in itself result in strong inflows.

4.     Raise foreign currency funds through either corporate or sovereign bond issuance or by incentivising the NRI deposits.

5.  Consider appropriate monetary action to anchor long term interest rates to support credit and economic growth.

6.       Put fiscal discipline ahead of populist measures.


The long and short of it is, no one has a clue on where this train is headed but everybody is worried about a looming crash. Forever, the optimist, I reckon that the Finance Ministry and RBI would come up with the right medicine eventually to check and reverse the runaway slide. Until then Rupee will continue to test your nerve !

Near term outlook is that the Rupee might test 65 and worst case outlook is that it may even sink to 70 to dollar over the medium term.

Such an outcome will further burden the already strained corporate balance sheets, squeeze credit flow besides fuelling inflation and crippling growth.

The government’s pursuit of populist policies but fiscally irresponsible has wrecked the script of the India story and crippled the potential of what was once as the ‘fastest-growing free market democracy” as was touted in Davos not so long ago!