Vijay Kumar Gaba

 One of the elementary principles of economics is that the price of anything is determined by the equilibrium of demand and supply. Though sometimes, in the short term, a state of inequilibrium may exist leading to higher volatility in prices; the equilibrium is usually restored by operation of a variety of factors. This principle usually applies to all things having an economic value, including currencies, gold and money (capital). The traits of human behavior like "greed", "fear", "complacence", "renunciation", and "aspirations" are usually accounted for as the balancing factors for demand and supply and not considered as determinants of price as such.

However, the case of currencies and capital is slightly complex given currency’s dual role as a medium of exchange and a store of value; and use of money as a policy tool to achieve the objectives of price stability, financial inclusion, poverty alleviation, social justice etc.

As a medium of exchange, price of currency is mostly a function of demand and supply of that currency at any given point in time. Higher supply should normally lead to lower exchange value and vice versa. The demand of the currency as medium of exchange is determined by the factors like relative real rate of return (interest), terms of trade (Trade Balance etc.), and inflation, etc. in the parent jurisdiction.

As a store of value, the price of a currency is, however, materially influenced by the faith of the receiver in the authority issuing such currency. For example, to the transacting parties, promise (since the currency is nothing but a promissory note) of the US Federal Reserve may hold much more value than the promise of, say, the Reserve Bank of Australia; regardless of the fact that the Australia runs a current account surplus, has lower interest rate, a similar inflation profile and a much stronger central bank balance sheet (as compared to the US Federal Reserve) and public debt profile. (1.50AUD=1USD)

Similarly, price of money (Interest rates) is usually a function of demand and supply of the money in the financial system. Demand for money is usually impacted by the factors like level of economic activity and outlook in the foreseeable future; whereas supply of money is mostly a function of risk perception; relative returns and policy objectives.

In Indian context, exchange value of INR, 10yr benchmark yield and crude oil prices evoke much interest. Interestingly most economic growth forecasts appear predicated on these, whereas logically it should be the other way round. Politically also, the USD-INR exchange rate is a popular rhetoric of the politicians on all sides of the Indian political spectrum. Recently, the rise in the international acceptability of INR has become a popular plank of the incumbent government; though there is little evidence of this happening as yet. The politicians refuse to acknowledge that INR depreciation is a normal economic phenomenon, and there is nothing at present that can reverse it.

To further emphasize my point, I may reiterate the following narration from one of my earlier posts.

“In the summer of 2007, I had just moved to the financial capital Mumbai from the political capital Delhi. The mood was as buoyant as it could be. Everyday plane loads of foreign investors and NRIs would alight at Mumbai airport with a bagful of Dollars. They would spend two hours in sweltering heat to reach the then CBD Nariman point (Worli Sea link was not there and BKC was still underdeveloped), and virtually stand in queue to get a deal where they can burn those greenbacks.

Mumbai properties were selling like hot cakes. NRIs from the Middle East, Europe and US were buying properties without even bothering to have a look at them. Bank were hiring jokers for USD 100 to 500k salary for doing nothing. I was of course one of these jokers!

That was the time, when sub-prime crisis has just started to grab headlines. Indian economic cycle started turning down in spring of 2007, with inflation raising its head. RBI had already started tightening. Bubble was already blown and waiting for the pin that would burst it.

INR had appreciated more than 10% vs. USD in the first six months of 2007. However, since January 2008 (INR39=1USD) INR has depreciated over 112% till now (INR82.6=1USD). In the meantime, the Fed has printed USD at an unprecedented rate; and there has been no shortage of supplies of EUR, GBP and JPY either.

The point I am making is that in the present times when the balance sheets of most globally relevant central bankers are running out of space to accommodate additional zeros and their governments are still running fiscal deficits are with impunity to service the mountains of their debts and profligate policies, the value of currency is definitely not a function of demand and supply alone. Regardless of economic theory, it is the faith of people in a particular currency that is the primary determinant of its relative exchange value.

2005-2007 was the time when the Indians had developed good faith in their currency, due to high economic growth. Local people were happy retaining their wealth in INR assets, despite liberal remittance regulations and NRIs were eager to convert a part of their USD holding in INR assets. The situation changed in 2010 onwards. There is no sign of reversal yet. Despite the huge popularity of the incumbent prime minister amongst overseas Indians, we have not seen any material change in remittance patterns in the past six years. Despite tighter regulations, local people appear keen to diversify their INR assets. Most of the USD inflows have come from "professional investors" who invest others' money to earn their salaries and bonuses. These flows are bound to chase the flavor of the day, not necessarily the best investment. Whereas the outflows are mostly personal, or by corporates with material promoters' stakes. Even FDI flows have reportedly slowed down in the past one year.

In my view, no amount of FII/FDI money can strengthen INR if Indians do not have faith in their own currency. Yield and inflation have become secondary considerations.

Recently, the Reserve Bank of India released the “Report of Inter Departmental Group on Internationalisation of INR”. The IDG recommended a pathway to be followed for inclusion of INR in IMF’s SDR basket in the “long run”. Tomorrow, I shall discuss the recommendations of IDG tomorrow, in light of my assumptions.

 The Financial Stability Report released by the RBI a few weeks ago, highlights the external sector challenges being currently faced by the Indian economy. The report however seeks to dispel the fears of any balance of payment crisis like 2013. It also assures about the adequacy of reserves to handle the present situation and stability of the INR.

External sector facing challenges

India’s merchandise trade deficit increased to a staggering US$198.3bn during April-November 2022, as compared to US$115.4bn in the corresponding previous period. Strong headwinds emanating from still elevated commodity prices, global economic slowdown, volatile capital flows and higher imports due to adverse terms of trade shock continue to exert pressure on India’s external account. 

Rising oil import bill limits policy flexibility; CAD rises sharply

India’s share in global crude oil consumption increased from 3% in 2000 to 5.2% in 2021. India presently accounts for almost 20% of each barrel of incremental global crude demand. Weakness in USDINR is further amplifying the pressure on imports.

Given the structural dependence on the imported crude oil, India continues to remain a price taker in the global oil market. This limits the scope of policy manoeuvrability in managing the trade deficit. Consequently, the current account deficit has widened to a worrisome 4.4% of GDP in 2DFY23 (2.2% in 1QFY23 2.2% and 1.2% in FY22).

Net capital flows were inadequate to fund the current account deficit, resulting in depletion of forex reserves to the extent of US$30.4bn in 2QFY23. The flows improved in 3QFY23, resulting in improvement in forex reserves.

Repayments of ECBs (rise in refinancing cost, withdrawal of liquidity in global markets, improvement in domestic corporate balance sheets) also contributed negatively to the balance of payment.

External debt situation comfortable

India had an external debt of US$610.5bn at the end of 1HFY23. The short term debt (residual maturity less than one year) comprised 45% of this debt. 55.5% of the external debt was USD denominated at the end of September 2022 (53.2% at the end of FY22); while 30.2% debt is INR denominated.

As of September 2022, about US$173bn worth of ECBS were outstanding with an average maturity of 5.6yrs. About 81% of all ECBs are USD denominated.

Out of this about 50% (US$87.6bn) were the USD loans owed by the Indian private enterprises; the rest being outstanding of subsidiaries of foreign parents (US$28.5bn); INR denominated ECBs (US$15.1bn); ECB by PSUs (US$53.2bn). Out of US$87.6bn Non INR, Non FDI ECBs, about 55% is hedged while most of the balance has a natural hedge against receivables.

Given the current Forex reserve of over US$565bn, the external payment default risk is negligible; and so is the collapse risk for INR.

 One of the most important and fundamental principles of economics is that “in a ‘free market’ current price of anything having an economic value is a function of demand and supply of such things at that particular point in time.” Of course there could be multiple factors that may impact the demand and supply of a thing; but usually nothing impacts the “price” directly other than the factors demand and supply.

In a ‘controlled and/or manipulated market’ the prices of things are fixed by the controlling authorities (or forces); regardless of the demand and supply for such things. In such markets, usually demand and supply of things are controlled and/or manipulated; or demand and supply duly get adjusted to the fixed/manipulated prices.

If we apply this core principle of economics to the world around us, we may discover that a significantly large part of global markets is presently either controlled or manipulated. The free market may only be prevalent in textbooks, policy documents and political speeches.

In the modern world, money is arguably the largest factor of production in the world. The price of money (interest rate) should ideally be a function of demand and supply of money. In case of excess supply the interest rates should be lower and vice versa.

In the past three years (2020-2022), nominal world GDP is estimated to have grown by less than 19%; whereas the money supply has increased by more than 50%. In spite of recent marginal contraction in money supply, the supply must be exceeding demand. Thus, there is no economic case for rise in interest rates; but it is happening. Obviously the money market is a controlled/manipulated market where central bankers and other major lenders may be controlling/manipulating the price of money to meet their other economic, political and/or geopolitical goals. (I refuse to accept the argument that money supply manipulation is happening to control inflation. There is no evidence of money supply impacting inflation in the past 15years at least. Else we should have 10% CPI inflation in 2010-12.) 

This distortion in the price of money has material repercussions in the market for goods and services across the world. It is impacting demand and supply (and therefore prices) of almost everything.

A significant part of the global trade is priced in terms of US dollar (USD). In a free market the price of USD (exchange rate) should also be a function of its demand and supply. In the past 33 months the supply of USD (M2) has increased by more than 50%, from $15.5trn at the end of 2020 to 21.7trn at the end of September 2022. In this period, we have seen global demand for USD diminishing, as reflected by the fall in global forex reserves. As per IMF the demand for USD by global central bankers is down to 25yr low. (see here) 

Under these circumstances the price (exchange rate) of USD must fall materially. To the contrary it has strengthened against most currencies. Obviously, the price of USD and some other dominant currencies is also manipulated.

Same argument could be extended to the prices of energy, gold, travel, wages in many jurisdictions, communication, education etc.

Under these circumstances I do not find it hard to believe that in the extant global order, ‘free market’ is a myth; and if we earnestly accept this premise, few things will remain the same insofar as the investment strategy and valuation methods are concerned.

I believe that we might soon need to adjust valuation models and investment strategy to factor in probabilities of frequent and strong state interventions; diminishing competition; radical policy shifts and sudden collapses.

 In the next couple of days, the market participants world over will be focused on the FOMC statement on Fed rates, inflation & growth outlook and guidance for the monetary policy direction in the near term (next 3-6months). The “active” market participants in India, in particular, would be staying awake till late midnight on Wednesday to hear what Fed Chairman Jerome Powell has to say.

The fact that Thursday happens to be the monthly derivative settlement for July contracts, makes the Fed decision, and likely reaction in our markets on Thursday morning, even more pertinent for the derivative traders in India.

Besides the derivative traders, the currency traders; bond traders and corporate treasury managers who need to actively manage their Fx exposure, would also staying awake to see how the US Dollar, EUR and US Treasuries behaves post the FOMC statement and try to assess how Indian bonds and INR may react in near term.

Our markets may however be relieved to a great deal if the RBI makes an unscheduled rate decision on Wednesday morning itself, just like it did on 4 May 2022, preempting the pressure on Indian bonds and INR post FOMC decision. For records, in his recent statement, the RBI governor has already spoken about the inevitability of further rate hikes. It would be better if it is done tomorrow rather than a week later (04 August 2022) when the MPC of RBI is scheduled to make a statement on monetary policy.

The European Central Bank (ECB), for example, hiked 50bps last week – their first hike in 11 years- to preempt further slide in the Euro. ECB hiked despite signs of accelerated slowdown in growth and rising fiscal pressures on peripheral Europe.

Since the FOMC decision would be known in less than two days, I do not find any need to speculate on the likely outcome and the market reaction to that outcome. Nonetheless, it would be appropriate to say that the market is pregnant with the hope of a unambiguous ‘pause’ signal from the Fed and consequent weakness in USD and a rather dovish MPC. The chances of disappointment are therefore marginally higher than the chances of positive surprise, in my view.

What should be the strategy of an investor under these circumstances?

In my view, the first thing an investor should do is to have a good dinner on Wednesday; go to bed early and not watch the markets, including business newspapers & TV channels and investing handles on social media, on Thursday.

Second, investors should focus on performance of the companies in their respective portfolio, rather than bothering too much about the general impact of global macro developments. They should assess the ability of the companies in their portfolio to manage the impact of rate and currency volatility on their respective businesses. The history indicates that better managed companies in India have managed this volatility very well without letting it materially impact their performance beyond a couple of quarters in the worst case.

Third, if the change in global rate and currency outlook materially alters the investment argument for a company in their portfolio, they should place a “sell” order for it today itself.

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).