Do it yourself

Economists, monetary policy experts and market commentators have been talking about the dilemma the Bank of Japan (BoJ) is facing for the past few months. As the BoJ simultaneously fights both the inflationary and deflationary pressures in the Japanese, it finds striking a balance between JPY exchange rate and Japan Government treasury bonds (JGT) yields a big challenge.

The Japanese economy has been facing a deflationary trend for more than three decades. After the global financial crisis, the trend accentuated further. In 2016, the Japanese authorities decided to trigger inflation by keeping policy rates below zero. Massive “free money” was pumped in the economy to boost economic activity by achieving a sustained inflation rate of 2%.

Consequent to the ultraloose monetary policy, the debt in Japan has swelled to 250% of GDP. It was not a major problem till the major trading partners like the US were also keeping the interest rates close to zero and following an expansionary monetary policy. However, once the US Fed started to unwind the monetary stimulus by hiking rates and tightening money supply, the yield differential between the US treasuries (UST) and JGT started to rise. This has put pressure on JPY, pushing it to the lowest level vs USD in three decades.

A weaker JPY makes Japanese imports expensive, raising a threat of runaway inflation that may force the Japanese authorities to hike the policy rates and tighten the money, pushing the economy back into deflationary abyss.

This is not the kind of situation BoJ has envisaged in its policy deliberations. They wanted a sustained 2% inflation primarily driven by improvement in growth trajectory led by rise in demand and higher wages. Instead, the specter of inflation is looming due to weakness in JPY and higher energy cost.

The BoJ faces a dilemma – whether to allow bond yields to go higher by hiking policy rates and protect JPY to check imported inflation; or protect low bond yields and counter JPY sell off through aggressive market intervention and other market and policy tools.

Allowing bond yields to go higher in tandem with UST yields, may severely impact the fiscal balance as the interest liabilities of the government would rise sharply. Allowing JPY to weaken further may push the economy deep into stagflation. Continued market intervention to protect
JPY (QE), will increase the money supply further and extend the deflationary trend seen since 1990s.

 

While BoJ endeavors to resolve its dilemma, the following questions would need deeper examination.

1.    Could the US Fed also face a similar situation in the next few years?

2.    Does “unlimited QE” actually has limits?

3.    Have developed economies already hit the wall in terms of fiscal leverage?

The Bank of Canada (BoC) has added some more fuel to the debate over the efficacy of monetary tightening in maintaining inflation-growth equilibrium under the current economic conditions. BoC hiked its key policy rate by 50bps to 3.75% on Wednesday, instead of the expected 75bps. BoC explained its decision to slow the pace of policy tightening in light of growing worries about a deeper global economic downturn. In the post policy statements, BoC said, “Future rate increases will be influenced by our assessments of how tighter monetary policy is working to slow demand, how supply challenges are resolving, and how inflation and inflation expectations are responding”.

Many observers are reading the change in stance of BoC as a template that may be followed by other central bankers also, especially the US Fed. It is pertinent to recall that two members of the Monetary Policy Committee (MPC) of RBI had also expressed similar views in the last meeting of the Committee. Obviously this development adds more interest to the next week’s (1-2 November) FOMC meeting and RBI’s reaction to the latest stance of US Fed.

In my view, BoC’s latest policy stance may not particularly influence other central bankers; but we may see more and more central bankers pursuing an independent monetary policy, congruent with the local conditions rather than towing the line of the US Fed. Notably, the Bank of Japan (BoJ) and the People’s Bank of China (PBoC) have refrained from tightening in the recent past.

‘If’ we see more divergence in the monetary policies stance of major central bankers across the world, one of the collateral could be material rise in volatility in the currency markets; which have already been volatile for the past two years. This higher probability of rise in currency volatility brings gold and cryptocurrencies to the centre of investment and trading strategies.

In this context the following are noteworthy:

·         Bloomberg has recently reported that “large volumes of metal are being drawn out of vaults in financial centers like New York and heading east to meet demand in Shanghai’s gold market or Istanbul’s Grand Bazaar.”

New York and London vaults have reported an exodus of more than 527 tons of gold since the end of April, according to data from the CME Group and the London Bullion Market Association. At the same time, gold imports into China hit a four-year high in August.

The Reserve Bank of India has been a big buyer in 2022. Its total gold reserves now stand at 782.7 tons, ranking it as the ninth-largest gold-holding country in the world. The Reserve Bank of India has purchased over 200 tons of gold in the past five years.

·         Earlier this week, the House of Commons in the U.K. voted in favor of recognizing crypto assets as regulated financial instruments and products in the country. The new PM of UK, Rishi Sunak is widely seen as pro-crypto by the market participants.

Couple of weeks ago, The US based bank J. P. Morgan announced cryptocurrencies as their “preferred alternative asset class in replacement of real estate”. Many other large banks like Goldman Sachs and US Bancorp have also increased their engagement with cryptoes materially in the recent past.

 A recent Reuter’s article (see here) drew attention towards some ominous signs emanating from the bond pricing of emerging markets that are more vulnerable to default on their sovereign obligations. Noting the signals like weakening currencies, bond spread widening beyond 1000bps, and dwindling Fx reserves, it concludes that a record number of developing economies might be “in trouble” now.

More than US$400bn worth of sovereign debt could be facing default. While the countries like Russia, Sri Lanka, Lebanon, Zambia etc. have already defaulted on their obligation, the usual suspects like Argentina and Pakistan etc. appear on the precipice of a default. The serial defaulter Argentina (US$150bn); Ecuador 9US$40bn); and Egypt (US$45bn) may actually default much sooner. If the war drags on for a couple of more months, Ukraine may also default on US$20bn debt payments.

Of course, the sovereign defaults are not new and the US$400bn default might not look massive in the context of trillions of dollars of new money created in the past one decade. Nonetheless, so many countries defaulting in a short span of time could have serious consequences for the global financial system. For one, it could trigger a contagion if some large global institution like Lehman Brothers collapses under the weight of such default. The worst however would be if the ‘default’ loses the moral stigma attached to it, and many profligate nations find it convenient to default and start afresh.

It is pertinent to note that the Bank of Japan (BoJ) owns more than 50% of the debt taken by the Government of Japan. This effectively means that Japan has borrowed about USD one trillion from the JPY printing press in the three years 2020-2022. Considering the deteriorating demographics and anaemic growth over the past three decades, it is obvious that Japan is ‘riding a tiger’. Many developed countries like Italy and Greece are also trapped in a vicious low growth high debt cycle. Obviously, getting out of this trap is not feasible in the normal course of business.

The most relevant question at this point in time therefore ought to be “how the global economy gets out of this extortionate high debt-low growth trap?”

Historically, the following methods have been used by the governments to break out of the low growth high debt trap:

1.    Currency debasement by stimulating high inflation for long or devaluing the currency.

2.    Financial suppression by keeping the real rates negative for long.

3.    Fiscal tightening by increasing taxes disproportionately and/or reducing public spending.

4.    Incremental improvement by gradually tightening the monetary policy.

5.    Defaulting on debt obligation and negotiating waivers with the lenders.

 In the past couple of months there has been a visible rise in the reports expressing fears of an implosion in Japanese, Chinese and Russian economies. The reasons behind these fears are quite diverse. Of course there is nothing new in these reports. Experts have been predicting an implosion in the Japanese economy since the early 1990s’ in the Chinese economy since 2008 and the Russian economy since 1917.

Personally, I do not subscribe to any of the theories that forecast implosion in the Japanese, Chinese and Russian economies in the near future. Nonetheless, I believe that the study of the growth, fiscal and indebtedness profile of Japan is important from two viewpoints, i.e., (i) impact on the global economy, should the BoJ losses control over the situation; and more importantly (ii) impact on the global economy if the US economy (consumption, growth, fiscal profile, etc.) follows the Japanese economy and gets trapped in this vicious cycle of high debt and low growth; and the consequences if USD loses its prominence as the global reserve currency.

I noted a few pointers for this study from some recent reports relating to Japan. These simple and most visible pointers indicate where the US economy could head if a new set of innovative monetary and fiscal policies are not implemented soon. This would be as imperative as the first set of innovative monetary and fiscal policies implemented in the wake of the global financial crisis.

Japanese Debt – the vortex

As per some recent reports the Bank of Japan (BoJ) now owns over 50% of $12.2trn debt issued by the government of Japan. The public debt of Japan is now 266% of GDP. The Public Debt to GDP ratio of Japan has consistently worsened since 1992, when it was below 70%. Considering that the GDP of Japan is rising at a snail pace of 1-1.5%, and the debt is growing at a faster rate, it is most likely that the debt situation may worsen further.

The sharp rise in debt has not been much of a problem so far as it has been accompanied by consistent fall in bond yields. In fact the yields have been negative during 2015-2020. Moreover, since most of the government debt is bought by BoJ and local banks and funds, Japanese yields have been insulated from global trends for the past 3 decades. Even during the global financial crisis, the Japanese bond market remained mostly unaffected by the global turmoil.

The BoJ has been struggling with persistent deflationary pressures for most of the past three decades. For most part of the past two decades, the inflation in Japan has been in negative territory. Inflation has persisted below the target 2% rate, except for a brief violation in 2014 in recent months.

Though the BoJ has not taken the path of monetary tightening to ward off the inflation, the local bond yields have risen to positive territory. Moreover, the reversal in the monetary policy of the global central banker has materially widened the gap between the Japanese and global bond yields. Nothing new in this, but the questions about sustainability of Japanese public debt are hitting the headlines again. Recently, it was reported that “The Bank of Japan may have been saddled with as much as 600 billion yen ($4.4 billion) in unrealized losses on its Japanese government bond holdings earlier this month, as a widening gap between domestic and overseas monetary policy pushed yields higher and prices lower.”

In recent years, the household debt in Japan has also started to rise. Household debt in Japan had reached a high of 78.7% of GDP in 2000. It subsequently declined to a low of 59.9% in 2015. As per the latest available data, it had again reached 67.4% of GDP in December 2021. Japanese households owe a debt of US$3.2trn; which is 23% of total domestic credit of US$13.5trn. A rise in lending rate could further slow the economic growth in Japan; besides enhancing the stress at household level.

In July 2007, investment bank Bear Stern announced that couple of its hedge funds have gone bust. These funds were primarily investing in derivative securities with home mortgages as their underlying. It was later unfolded that the underlying for these derivatives were actually a web of complex financially engineered instruments where actual underlying security was of very poor credit quality. This was the first time when “sub-prime” entered the popular market jargon; which essentially meant that though a derivative financial instrument is rated of investment grade, the actual security underlying that derivative is of sub-standard quality.

The market briefly took note of this event correcting sharply. However, the event was soon forgotten as a standalone instance that could not have impacted the overall markets. Subsequent months witnessed one of the sharpest global markets rallies.

In January of 2008 it was realized that Bear Stern was just a tip of the iceberg. The malaise of sub-prime was all pervasive and had impacted trillions of dollars in derivative instruments. What started with Bear Stern, soon engulfed the entire world. Many large banks and hedge funds were found to be infested with this termite. Not only banks, it has hollowed finances of many sovereign governments like Portugal, Iceland, Italy, Greece, and Spain (PIGS) etc.

What followed was total chaos. The global market froze. Trade and commerce was hit as banking channels were shut and credit frozen. The giants like AIG, CITI Bank, The Federal National Mortgage Association (commonly known as Fannie Mae) and Federal Home Loan Mortgage Corp (commonly known as Freddie Mac) etc came to the brink of disaster. Some of the top US investment banks like Lehman Bros, Countrywide and Merrill Lynch etc. could not survive.

To mitigate the disaster, the central banks and governments devised some innovative monetary policies (commonly known as Modern Monetary Theory or MMT). Under these large central bankers started an unprecedented quantitative easing (QE) program, which is nothing but an euphemism for printing new money and buying stressed assets with that money to support the market from collapsing. US Treasury also unveiled a US$800bn Troubled Asset Relief Program (TARP), under which it financed the stressed lenders by infusing equity or extending liberal credit. TARP was unwound in 2014 with US Treasury actually earning some money out of this.

The QE program has been extremely successful in at least one of its stated objective, viz, ensuring financial stability. The sovereign default crisis in peripheral Europe was totally averted. Global markets reopened immediately and credit flow restored. The asset prices were not only normalized but exceeded their fair value in couple of years. The other objective of faster sustainable growth is however yet to be achieved.

The Central Banks, primarily US Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ), however continued their QE program, though the extent of printing money has been tapered. To mitigate the impact of pandemic, central bankers have again started to expand their balance sheets (printing money).

Back at home, RBI had resisted any QE in the wake of global financial crisis. The stimulus given by the government of India was also very limited, as Indian economy was not directly impacted by the crisis. None of our institutions were meaningfully involved in global Ponzy schemes of sub-prime mortgages and credit default swaps (CDS). Overseas branches of few banks lost some money in forward forex contracts and underwriting sub-prime papers, but nothing to threaten their existence or impact the domestic financial system meaningfully.

The economic crisis due to pandemic is however very different. It has directly impacted our economy and financial system. Besides, the financial system was also struggling with the lingering impact of the large credit defaults of IL&FS etc. RBI therefore has to step in along with the central government. While the central government has done multiple tranches of fiscal stimulus, RBI on its part has started its own version of QE program, with the hindsight gained from the global experience of past one decade.

Through this program, it has successfully managed to keep bonds and currency market stable; supporting the government’s expanded borrowing program, improving the current account and comforting the foreign investors who could be panicked if INR exchange rates fluctuated wildly.

The collateral benefit of RBI’s QE program to the government has been huge interim dividend of Rs911bn for FY21. The RBI would have made huge profit in trading of (a) government bonds (LTRO, Twister etc.) in which it buys bonds of shorter maturities and sells bonds of longer maturities and (b) trading of INRUSD by selling spot USD (to keep INR stable) and buying longer term swaps, or the other way round.

Given that RBI usually buys the asset under some stress (bond or currency), has the ability to print money, and need not bother about the MTM losses on its positions, the chances of it losing money on its trades are remote. It is therefore reasonable to assume that RBI shall continue (and even increase) its trading activities in years to come. It is too easy and lucrative source of income and managing markets to give up easily.

There will be no surprises to see (a) the finance ministers providing higher dividend from RBI in years to come; and (b) senior bankers with rich experience in managing treasuries being at the helm of RBI.

 Inflation has been one of the central themes in global trading strategies in past one decade. During 2010-19, the central banks of developed countries (primarily US Federal Reserve, European Central Bank and Bank of Japan) struggled to build inflationary pressure in their respective economies, to attain a minimum level of inflation they considered necessary to motivate investments and sustainable growth. Incidentally, none of the Central Bank targeting higher inflation has so far been successful in their endeavor. Nonetheless, the sharp rise in global commodity prices in past few months has triggered a rush for “The inflation trade”.

 In Indian context, prices of all key commodities (metals, energy, food, cement, textile, and plastic etc), communication, healthcare and education, etc have seen strong inflation in past 6 months.

In its latest monetary policy statement, RBI admitted that “The outlook for inflation has turned adverse relative to expectations in the last two months”. The RBI expects the inflation to remain above its tolerance range for at least six months more. The policy statement reads, “Cost-push pressures continue to impinge on core inflation, which has remained sticky and could firm up as economic activity normalises and demand picks up. Taking into consideration all these factors, CPI inflation is projected at 6.8 per cent for Q3:2020-21, 5.8 per cent for Q4:2020-21; and 5.2 per cent to 4.6 per cent in H1:2021-22, with risks broadly balanced.”

The commodity sector has been one of the best performing sectors in the Indian stock markets in past 6 weeks. A number of brokerages have upgraded their outlook for steel, cement, gas, and chemical etc producers. Many have argued this to be a sustainable and durable trend and once in a decade opportunity to trade the inflation. For example, the brokerage firm Edelweiss expressed exuberance over steel prices and said, “Going ahead, we expect a blockbuster Q3FY21 with record margins in store. Furthermore, structural shortage of steel implies the rally in ferrous stocks has more legs despite their recent run-up. We remain positive on ferrous”.

I spoke with some steel and cement dealers, in Delhi, UP, MP and Bihar, in past two days. All of them appeared bewildered by the rise in prices. All of them cater to the small private construction segment, and none of them confirmed any sign of demand pick up in that segment. Being in trade for many decades, they were sure that demand is certainly one of the key factors driving the prices of steel and cement higher. They guessed, it could be a mix of supply chain disruptions, import restrictions, large inventory building by China and most importantly, the “understanding” between the domestic producers that could be driving the prices.

On the other side, Chinese Yuan has appreciated dramatically in past couple of months. This CNY appreciation has come along with first contraction in the Chinese consumer price index, since global financial crisis. At this point in time, it is tough to say how much of Chinese deflation is consequence of CNY appreciation, but it must certainly have some role. If the strength in CNY reflects the policy decision of Chinese authorities, we need to worry about deflation which China will be exporting rather than the inflation.

My take on the inflation trade, especially in Indian context, is as follows:

A large part of the global inflation in past 9 months could be the consequence of (i) supply disruption due to logistic constraints; (ii) inventory building by large consumers like China; and (iii) weakness in USD.

After reading and listening to views of various experts, I have concluded that that China might have built large inventories of all essential commodities (especially metals and energy) to hedge against (i) Trump victory and consequently intensifying trade war; (ii) longer lockdown due to pandemic Both these conditions have failed. Regardless of popular opinion, my view is that CNY strength is a Chinese gesture to US for ending trade dispute. If Biden reciprocates well to this gesture, inflation may not be a concern for next 10yrs at least.

I shall therefore avoid “The inflation trade” for now. However, if I see a sustainable pickup in demand next year, I shall be inclined to buy some domestic commodities like cement and chemicals (primarily import substitute).