2014-15 was a comeback year for the India Rupee. After having been one of the worst performing currencies during most of FY14, Rupee managed to only lose 4.3% of value against the US Dollar, being one of the best performers in the world.
One can always argue that Rupee could have had an even better run, if not for the active selling of the local unit by the local central bank. A year, when US Dollar gained significantly against most currencies globally, Rupee along with likes of Chinese Yuan and Thai Baht managed to hold out.
A change in the political configuration back home and also significant reduction in the number of headwinds got foreign investors flocking towards the Rupee.
However, we also have to thank the ongoing reflation of money supply from major global central banks. In fact, the effort to monetise debt, through large scale asset purchase program have now entered their 8th year, a no small time period by any standard. It feels amusing as well as alarming, but definitely not surprising, that global policy makers still appear short on policy tools but never short on hope.
Many have argued that we have reached a point where monetary policy lead re-engineering of global economy is well past their expiration date but that has not deterred fresh new recruits in the central banking arena to delve in them with outmost reverence towards economic miracle.
RBI has been a busy bee over FY15, using every opportunity to not only build foreign exchange reserves but also contain volatility in the Indian Rupee. We find a sizable 24% jump in FX reserves since lows of August 2013.
However, when one consider the negative impact of a stronger US Dollar on the non-US Dollar part of the reserves, the actual accumulation of US Dollars appear even larger.
The above chart shows how the foreign exchange policy of RBI has changed under Dr. Rajan’s leadership. A crises prone global economic environment has compelled RBI to intervene more actively on both sides of the market, thereby containing volatility and also augmenting FX reserves.
It can be said that Indian Rupee is now much more a dirty float than was during the previous 10 years. Over the medium term, we can see further increase in the foreign exchange reserve, as RBI tries to maintain a fine balance between Rupee competitiveness and low imported inflation.
However, purchasing US Dollars from the foreign exchange market is not a free lunch, as it comes with financial and economic costs. For every 1 US Dollar RBI decides to purchase in the cash market, it ends up infusing 62/63 Indian Rupees into the domestic economy, which, if not sterilized, can add to money supply and become inflationary.
At the same time, every Rupee RBI decides to sterilize, either through forwards or through interest bearing securities, comes with a 6/7% of price tag.
Therefore, it will be a fine balancing act which the RBI will have to do. In case the central bank continues to pursue such a policy over a long period of time, it not only can pose challenge to its monetary policy management but also carve a hole in its yearly profits.
Turning our attention to the global economic cross currents, we continue to be vindicated on our stance of a slower US economy. We have been arguing for some months now, that a multi-pronged effect of shale burst, stronger US Dollar, challenging global economic environment and diminishing returns of monetary policy medicine will drag the US growth lower.
Have a look at the real time forecast of the US economic growth for Q1’15 from the Atlanta Federal Reserve.
They are forecasting GDP growth for Q1 at near zero level. In fact, last Friday, when most markets were closed, US labour department released the February non-farm employment data.
NFP registered a biggest miss since Q4 of 2013. However, wage growth showed improvement. Trend for wages remain divergent in the private sector, with top layer of corporate America showing improvement vis a vis the workers in middle and lower down the income pyramid. As a result, the averages hourly wages have remained within a broad range of 1.8-2.3% y/y for the last few years.
US Dollar took a sharp tumble post NFP, as a crowded long positioning in the Greenback has now made it vulnerable to any indication of delay in rate hike from the US Fed.
Over the last few months, we have argued against a Fed hike any time soon, as we have highlighted the weak economic trend as the reason that can keep Fed at a bay.
Now some sections of the market have started discussing the possibility that there may not be any hike this year. However, we do not envy the position US Fed which it has got itself into.
With almost 8 years into the post credit crises recovery, economic growth is still anemic and it appears more and more likely, that without the artificial life support, some of the world economic heavy weights might just rollover. The question that comes to mind is if the current economic weakness turns into a slowdown, how exposed the major central banks would appear.
Infact, some of the ex-Fed officials have expressed concern that US Fed needs to get out of the emergency policy of zero rates soon, so that they have some room left to maneuver if the economy enters a soft patch, god forbid a full scale recession. At the same time, the very policy of supply side augmentation is ignoring the root cause of economic malaise, that is, debt driven deflation.
A major part of the world economy had a debt lead economic prosperity for the last few decades. The massive surge in debt financed consumption and investment has now lead to a situation where there is excess supply and weakening demand.
Deflation, a fallout of excess supply, is making the situation worse for the leveraged entities like governments and consumers. However, the financial repression which central banks have done, through their monetary policies have only bought time.
Now corporations which might have had to shut shop and take their capacity offline, are still managing to float around, thanks to the artificially lower rates in credit markets and lax lending standards.
Fiscal space appears limited, as decades of entitlement spending and post GFC rescue has taken a toll on public finances. Businesses, who had the wherewithal to borrow and invest, have done the former but mostly to finance share buybacks or do mergers and acquisitions.
Therefore, we have reached stage in the global economy, where throwing more debt at an artificially lowered interest rates is not helping solve the problem of already too much of debt.
Add to this the fact that, easy money has stimulated financial assets to levels, where investors have started questioning the sustainability of the same. In fact, the longer they continue to expand on top of a weakening global economic structure, the greater the risk of an abrupt mean reversion sometime in the future.
It is a dangerous experiment of trying to use the tail to wag the dog. The policy of manufacturing a financial asset boom to get animal spirits flying to achieve an economic nirvana is now looking more and more costly. We are in uncharted waters and over the next couple of years, investors and risk managers have to be prove their mettle in managing financial and economic risks that may come their way.
Over this week, Rupee and bond traders will keep a close eye on the RBI monetary policy and the situation in Greece. RBI is expected to remain pat on repo rate but may tinker with liquidity measures to improve pass through of previous rate cuts. Greece is living by the day as some reports suggest that the country may not have funds to meet repayment obligations over this month.
We remain quite bullish on Indian sovereign debt, as we expect Indian economy to largely muddle along the path of economic recovery. A deflationary impact of a bursting of the last domestic credit cycle is taking a toll on public and private finances, and may continue to delay the economic take-off.
A deflationary economic slowdown in the world economy is adding to the burden for India. However, we are pleased to see Indian government and policymakers take steps in improving the long term health of the country but the fruits may take a very long time to bear.
In such an environment, domestic asset prices, especially equity market’s fortunes will largely be driven by the sustainability of the global equity and credit market boom. Domestically, the hard assets are under pressure and that has adversely impacted wealth and income of private citizens, local governments and even some parts of the corporate India.
Over the next couple of weeks, Indian Rupee is expected to traverse a path of a range bound activity, with 61.30/70 acting as a strong demand zone for the US Dollars and 63.00/64.00 as a zone of Rupee demand. Indian Rupee can remain well supported around 70.00/71.50 levels against the Euro on spot and against the GBP, we expect 95.00/96.00 to act as a selling zone.
JPY is expected to remain well supported around 51.00/52.00 levels, and over a period of time, we can see JPY reach levels of 54.50/55.00 levels on spot.
