Over the past couple of weeks, Indian rupee has lost some its sheen, against most currencies, including the US dollar. Some may have been left scratching their heads as to why, at a time when US dollar has lost over 5% of its value against Euro and Pound, has the rupee weakened so much against the Greenback.
However, people who have been following my previous columns, would recollect I had explained the great divergence many a times in the past, right from the time, when not many were discussing about the impending shift in the carry trade from the US dollar into the other non-dollar currencies.
Around the time the US Federal Reserve started its operation of taper, or reducing the flow of liquidity in the financial markets, way back in January of 2014, global levered funds started looking away from the US dollar as the source of borrowing money to invest and speculate (source of carry trade), towards currencies like the Japanese Yen and especially the Euro.
Since 2009, zero rate policy in US and the subsequent rounds of monetary easing, along with its stature as the global currency, had made US dollar the first choice currency for doing the carry trade. As a result, a weaker US dollar became entwined with rising asset prices, be it financial asset or the hard asset.
For a currency to be comfortably used as a source of carry it needs to have global availability, high liquidity, low or no interest rate and weaker price trajectory. Any hint that the currency can enter a phase of sustained appreciation or the money supply can become less accommodative can make that currency unattractive for carry.
However, around the time of the taper, asset managers had to find an alternative to the US dollar as a source of carry trade. They saw Euro and the Japanese Yen as the alternative. The bank of Japan and the European central banks were either infusing greater levels of their currency into the system or were ready to do so.
There was an explicit encouragement from those central banks to speculators to come and devalue their respective currencies, Euro and the Yen, and engineer an asset reflation in their home country. As if the baton got passed in the global liquidity relay race. Asset managers borrowed in Euro and Yen, and sold them to buy other currencies to invest in the various countries.
India too became a beneficiary of the new carry trade. In India that time, depressed valuations in financial assets, improved monetary and fiscal management and hope for a better political change triggered a massive “gold rush”. Indian debt prices and debt prices spiraled higher. The spiraling occurred just around the time the US dollar strengthened significantly, 20-25% against most developed market currencies. Hard assets were out of favour, and once again something we had warned since last summer, made the commodity currencies weaken against the US dollar. However, India was benefiting from the hard asset deflation.
Therefore, Indian financial markets received an overkill of speculative hot money, as India was being perceived as both a beneficiary of the global carry trade as well as a beneficiary of the global hard asset doom. (However, we had also warned that beyond the short to medium term, there will be a negative fallout from the hard asset deflation into rural economy and into the mining economy as well as the multiplier chain of real estate).
Hence, the rupee moved inversely to the global US dollar trend and as a result, the rupee strengthened significantly against non US dollar currencies, causing adverse impact on the exporters, an emerging market curse, where relative attractiveness attract so much of hot money in such short period, that it causes currency over valuation and asset over valuation, leading to drag on the real economy and markets, when the tide ebbs. It is well understood fact that the domestic economy, needs time to heal.
According to IMF, at an aggregate level corporate leverage remains elevated in India. A disinflationary scenario is not healthy when leverage is high. We have to understand, both inflation and deflation has its share of plusses and minuses. None of them is absolutely good or bad, it only has its share of winners and losers.
Over the last 10/12 years, the inflationary environment and an above average growth, enable nominal GDP to rise at a fast pace. Earnings in real world is tied to that nominal growth. For a human, comparing nominally is easier than in real terms. At the same time, debt repayment is fixed nominally and hence in an environment of high nominal growth, driven by higher levels of inflation, debt servicing can become easier, as long as real growth has not collapsed alarmingly.
High inflation can mask future insolvency. Especially, if the high inflationary environment occurs when credit growth is high, it can propagate a cycle of immense leverage, resting on masked insolvency.
Disinflation and low real growth can put the above cycle in a dead reverse. As nominal growth falters, debt servicing capacity dwindles and beyond a point masked insolvencies hits the system. In a way, disinflation to deflation and low real growth, is the healing process we find ourselves in. It is wonderful for the economic agents who are not over levered or not levered, as savers see less erosion of savings (as long as they can shield themselves the default cycle).
Asset overvaluation and asset bubbles can face the full brunt of gravity when real growth falters and there is little or no inflation to offset. That is the reason why central banks from the developed world, where both public and private sector has high levels leverage, abhors deflation.
Disinflation, deflation and low relation growth can adversely affect government’s ability to pump prime the economy. Remember, government earns most of its revenues through taxes. A weak nominal growth affects tax growth. At the same time, a major part of our government expenditure is nominally fixed in nature, for e.g., interest rates, pensions and salaries.
Therefore, unless the government is willing to bear a higher fiscal deficit, it finds it difficult to spend much in areas of asset creation or social sector. GOI has rightly talked about bringing down the fiscal deficit, but it comes at a cost. Remember in economics, there are no free lunches, there are only trade-offs. Here the trade-off is low fiscal support from the government.
Therefore, in concluding remarks I would say that it was not surprise to see the economy slowing down as we have discussed the above factors in the past, when markets were confusing reduction of headwinds with structural upturn in the economy. We believe the healing process is natural and if handled well, can put Indian economy at a place, from where it can enter the next leg up of leveraging and economic boom.
However, in the interim, thanks to the ongoing global monetary experiment, where central banks have lost much of economic common sense, we can see months of sharp equity upswings, but that would appear phony for a long term asset investor.
Indian rupee remains entwined with the asset reflation phase and being an emerging market currency is also vulnerable to jumps in volatility. In our ensuing write ups, I will try to touch upon how regulation can go a long in reducing the low liquidity driven risk for the Rupee through BCD nexus.
Technically, it is still within its 16 month range of 61.50/62.00 and 64.00. However, we would continue to advocate importers and FCY borrowers to use the decline to cover their risks, as history suggests that long periods of low volatility and overvaluation can suddenly give way to high volatility and under valuation. Technically, a sustained close above 64.30/50 is needed to trigger a breakout above the 16 month old range, in which case it can eye for 66.00/66.50 levels on spot.