Vijay Kumar Gaba

For many weeks, global markets have been behaving in a very desynchronized manner. Non-congruence is conspicuous even in the behavior of the same investor/trader operating in different market segments, e.g., equities, bonds, commodities, currencies, cryptocurrencies, etc.

For example, until a month ago an investor with a balanced 50:50 debt-equity asset allocation invested in bonds as if a soft landing was imminent leading to a series of policy rate cuts over the 12-15 months. The same investor invested in equities believing that earnings growth would surpass the estimates and stocks of top technology companies would continue with their dream run. The investor was content investing in USD assets assuming green greenback would strengthen and at the same time he was buying bitcoins expecting the demise of the extant monetary system by independent crypto or digital currencies.

Last week in the US, equities reached their all-time high levels as if all is well in political, geopolitical, climate, economic, and financial spheres. It felt that the Fed was about to begin a sharp rate cycle, earnings growth had rebounded, Sino-US relations had normalized, the Gaza ceasefire had been announced, and El Nino had ended. However, across the street, the bond market was selling off as if prices were going out of control forcing the Fed to push the rate cuts to 2025. Back street, the bullion market announced that a recession was imminent. Across the Ocean, crude prices were rising as if a war was imminent with Iran threatening to escalate. In dark streets, crypto traders were laughing at conventional investors/traders rushing to bullion markets to hedge against recessionary weakness in USD.

Back home, last week equity indices reached their all-time high. Nifty Small Cap 100 gained over 7%. Commodity stocks rallied as if a bullish commodities cycle was imminent. Ignoring RBI's concerns over prices and credit, bond prices corrected only marginally. No one bothered to care about political manifestoes which are promising fiscal profligacy of gigantic proportion. USDINR appreciated marginally ruling out any pressure on the current account and balance of payment due to the sharp spike in energy & gold prices (two major imports of India) and FPI flow reversal due to the narrowing yield differential between India and developed market yields. People are also rushing to buy Silver (up 10% last week) to make some quick gains.

One of the largest asset management companies is running equities weight close to the lowest permissible in their balanced fund. It has also restricted flows to their smallcap fund. The top fund manager at this AMC is one of the most respectable names in the industry. Considering that the Smallcap index was up 7% last week against the 0.8% rise in Nifty, it seems, no one is listening to his sane advice.

We have all heard the story of an elephant and six blind men. It goes like this.

Once upon a time, there lived six blind men in a village. One day the villagers told them, "Hey, there is an elephant in the village today."

They had no idea what an elephant is. They decided, "Even though we would not be able to see it, let us go and feel it anyway." All of them went where the elephant was. Every one of them touched the elephant.

"Hey, the elephant is a pillar," said the first man who touched his leg.

"Oh, no! it is like a rope," said the second man who touched the tail.

"Oh, no! it is like a thick branch of a tree," said the third man who touched the trunk of the elephant.

"It is like a big hand fan" said the fourth man who touched the ear of the elephant.

"It is like a huge wall," said the fifth man who touched the belly of the elephant.

"It is like a solid pipe," Said the sixth man who touched the elephant's tusk.

They began to argue about the elephant and every one of them insisted that he was right. A wise man was passing by and he saw this. He stopped and asked them, "What is the matter?" They said, "We cannot agree on what the elephant is like." Each one of them told what he thought the elephant was like. The wise man calmly explained to them, "All of you are right. The reason every one of you is telling it differently is because each one of you touched a different part of the elephant. So, the elephant has all those features that you all said."

"Oh!" everyone said. There was no more fight. They felt happy that they were all right.

The story's moral is that there may be some truth to what someone says. Sometimes we can see that truth and sometimes not because they may have different perspectives which we may not agree to.

But I am witnessing a different phenomenon. No six blindfolded men are feeling different parts of an elephant this time. It is only one person who sees different parts of an elephant with open eyes and is not able to tell that it is an elephant.

The Reserve Bank of India constituted an Inter Departmental Group (IDG) in December 2021 “To examine issues related to Internationalisation of INR and suggest a way forward”. The Group submitted its recommendations in October 2022; and the same have been made public last week. The following are some of the highlights of the IDG recommendations.

Terms of References

The terms of reference of the IDG were as follows -

·         To review the extant framework for use of INR for current and capital account transactions and assess their current levels;

·         To review the extant position of use of INR for transactions between non-residents and the role of off-shore markets in this regard;

·         To propose measures, consistent with the desirable degree of capital account liberalization, to generate incentives for use of INR for trade and financial transaction invoicing and denomination, official reserves and vehicle currency for foreign exchange intervention after analyzing data obtained from AD Banks on INR invoiced trading;

·         To propose measures to bring greater stability in the exchange rate of INR determined by market forces and deep and liquid market with availability of wide range of hedging products, efficient banking system and world class infrastructure with easy accessibility to both residents and non-residents;

·         To recommend measures to address concerns, if any, arising of the Internationalisation of INR;

Internationalisation of currency

“An international currency is used and held beyond the borders of the issuing country for transactions between residents and non-residents, and between residents of two countries other than the issuing country. Currency Internationalisation has thus been described as the international extension of a national currency’s basic functions of serving as a unit of account, medium of exchange and store of value. In other words, the internationalization of a currency is an expression of its external credibility as the economy integrates globally.”

Why Internationalisation?

Internationalisation of a currency helps both the government as well as the private sector the issuing currency, by—

·         allowing a country’s government to finance part of its budget deficit by issuing domestic currency debt in international markets rather than issuing foreign currency instruments;

·         allowing a government to finance part, if not all, of its current account deficit without drawing down its official reserves;

·         allowing the country’s exporters and importers to limit exchange rate risk by allowing domestic firms to invoice and settle their exports/imports in their currency, thus shifting exchange rate risk to their foreign counterparts;

·         permitting domestic firms and financial institutions to access international financial markets without assuming exchange rate risk;

·         offering new profit opportunities to financial institutions, although this benefit may be offset in part by the entry of foreign financial institutions into the domestic financial market (to the extent that the government permits it); and

·         reducing the cost of capital and widening the set of financial institutions that are willing and able to provide capital; thus, boosting capital formation in the economy thereby increasing growth and reducing unemployment.

Cost of internationalisation

The internationalisation of a currency does not happen without a cost. Besides resulting in higher volatility in the exchange rates, it usually has monetary policy implications as the obligation of a country to supply its currency to meet the global demand may come in conflict with its domestic monetary policies, popularly known as the Triffin dilemma. Also, the internationalisation of a currency may accentuate an external shock, given the open channel of the flow of funds into and out of the country and from one currency to another.

The costs also emanate from the additional demand for money and also an increase in the volatility of the demand. International currency use can also have an undesirable impact on the financing conditions.

The process of internationalisation

The IDG felt that internationalisation of INR is a process rather than an event. A series of continuous efforts would be needed to achieve the long-term goal of INR internationalisation. There is a need to build upon the small steps already taken.

Many factors play a role in internationalisation of a currency. The prerequisite for internationalisation is however “widespread use of a currency outside the issuer’s borders”. To popularize the international use of a currency, the factors like size of the economy; centrality to global trade; capital account openness, macroeconomic stability, and depth of financial markets, which provide global investors with a safe store of value, etc. are considered important.

The roadmap for internationalisation therefore includes:

·         Removal of all restrictions on any entity, domestic or foreign, to buy or sell the country’s currency, whether in the spot or forward market.

·         Domestic firms can invoice some, if not all, of their exports in their country’s currency, and foreign firms are likewise able to invoice their exports in that country’s currency, whether to the country itself or to third countries.

·         Foreign firms, financial institutions, official institutions and individuals can hold the country’s currency and financial instruments/assets denominated in it, in amounts that they deem useful and prudent.

·         Not only are foreign firms and financial institutions able to issue marketable instruments in the local currency, but the issuing country’s resident entities are also able to issue local currency-denominated instruments in foreign markets.

·         International financial institutions, such as the World Bank and regional development banks, can issue debt instruments in a country’s market and use its currency in their financial operations.

Internationalisation of the INR and capital account convertibility are processes which are both closely and symbiotically intertwined with each other.

Recommendations of IDG

In view of the IDG over the long term (5yr and above), India will achieve higher level of trade linkages with other countries and improved macro-economic parameters, and INR may ascend to a level where it would be widely used and preferred by other economies as a “vehicle currency”. The IDG recommended that keeping in mind the long run goal of inclusion of INR in IMF’s SDR basket, the following measures should be taken in the short and medium term.

Short term (upto 2yrs) measures

·         Designing a template and adopting a standardized approach for examining the proposals on bilateral and multilateral trade arrangements for invoicing, settlement and payment in INR and local currencies.

·         Making efforts to enable INR as an additional settlement currency in existing multilateral mechanisms such as ACU.

·         Facilitating LCS framework for bilateral transactions in local currencies and operationalising bilateral swap arrangements with the counterpart countries in local currencies.

·         Encouraging opening of INR accounts for non-residents (other than nostro accounts of overseas banks) both in India and outside India.

·         Integrating Indian payment systems with other countries for cross-border transactions.

·         Strengthening financial markets by fostering a global 24x5 INR market and promoting India as the hub for INR transactions and price discovery.

·         Facilitating launch of BIS Investment Pools (BISIP) in INR and inclusion of G-Secs in global bond indices.

·         Recalibrating the FPI regime and rationalizing/harmonizing the extant Know Your Customer (KYC) guidelines.

·         Providing equitable incentives to exporters for INR trade settlement.

Medium-term measures (2 to 5yrs)

·         A review of taxes on Masala bonds.

·         International use of Real Time Gross Settlement (RTGS) for cross border trade transactions and inclusion of INR as a direct settlement currency in the Continuous Linked Settlement (CLS) system.

·         Examination of taxation issues in financial markets to harmonise tax regimes of India and other financial centers.

·         Allowing banking services in INR outside India through off-shore branches of Indian banks.

The IDG discussed in detail the steps already taken by the government and RBI to achieve the larger objective. From the recommendations however it appears that the steps already taken are too small. The government needs to accelerate the process to earn the confidence of domestic and international businesses and investors to improve the acceptability of INR over the next five years. The most important step seems to be “decontrol”; something the incumbent government has not been very fond of. The volatility, opacity and subjectivity in the policy making seems to have led to erosion of faith in INR. These are perhaps the factors which prevented IDG from categorically saying that INR could be internationalised in the next 10yr or so.

Also see: Internationalisation of INR - 1

This summer Americans drove less than the summer of 2020 when many office goers were working from home and the economy was partially shut down. The situation is no better in Europe. Higher fuel and food cost is driving the cost of living higher in most of the world, significantly disturbing the household budgets.

Many emerging and underdeveloped markets were struggling with higher inflation even before the pandemic. But pandemic and adverse weather conditions in the past two and half years have made the situation worse.

Whereas many emerging markets, especially in Africa and Latin America, have been struggling with higher inflation and rise in the cost of living for a couple of decades, it is a relatively new phenomenon for the post 1980s developed western economies. The present generation in these economies had gotten used to cheap and easily available money and marginal food and fuel inflation in the past two decades. For them this sudden and sharp rise in basic cost of living is nothing less than a major shock. Most of them may not be financially sufficient, economically trained, socially skilled and/or mentally prepared to deal with this problem.

On the other hand, the modern asset pricing models may also not be suitable to the situation where interest rates are rising at record pace. Many valuation models used for making investments in "startups" - having very long payback period in terms of conventional asset pricing techniques; not differentiating between revenue and capital cashflows for operating purposes; usually funded by professional private equity investors with little own skin in the game; and having high leverage debt as the ultimate source of funding – may not work at all in a scenario where USD is depreciating and cost of USD borrowing is running in excess of 6%.

The current spike and persistence of inflation has been attributed to the logistic constraints due to the pandemic; adverse weather conditions; Russia-Ukraine war and fiscal support extended by various governments to mitigate the hardships faced by the citizens. Initially most central bankers believed that the inflation is transitory and will wane as these conditions change. However, in the past six months a realization seems to be dawning upon them that the trillions of dollars in new money, printed over the course of the past 2yrs, may also have a key role to play in this episode of high inflation. Apparently, it took 215yrs for the US government debt to reach US$7trn. It has added the same amount in just the past 27months.

Inarguably, the problem of inflation has many more dimensions. Hiking rates and withdrawing quantitative tightening will take more than 25yrs to reach a sustainable level of debt. Manufacturing a recession by sharp hikes will only destroy demand for various commodities and weaken the inflation. However, the inflationary forces will keep coming back, much stronger than now, as and when the growth begins to revive.

A sharp USD and EUR devaluation could perhaps be one of the more viable solutions left to (i) reduce the public debt materially in a short period of time; (ii) complete restructuring of the global terms of trade; (iii) rationalization of the global commodity prices especially energy; (iv) catalyze a new investment cycle led by US and European exports.

The investors in USD denominated assets would obviously suffer tremendous losses. No wonder large investors like the Chinese government have materially reduced their holdings of US treasury and USD. India is also trying hard to diversify its trade to include other currencies like Ruble, Riyal and Yuan, to contain its exposure to USD.

The questions that beg answer are:

(a)   What shall be the safe haven in case of a sudden USD decline. Whether it would be the traditional asset like Gold; a new age asset like digital currencies or traditional safe havens like CHF, CNY, SGD etc.?

(b)   Is there any actionable for a small investor, if this speculation does come true?

 One good thing about the Monsoon season in North India is that this is the season for new crops of fruits from hill states. We get fresh and juicy pears, plums, apples, cherries, peaches etc.; besides, juicier varieties of mangoes like Chausa and Langda. A visit to the fruit market in Gurgaon yesterday however left a little sour taste in my mouth. None of the seasonal fruit was selling at less than Rs100kg. Apples are more than Rs200/kg. Even mangoes are selling at a rate of Rs120-250/kg.

The vendors selling from carts and smaller shops are unhappy as sales are down notably due to higher prices; and a larger than usual quantity of their merchandise is going to waste due to rotting. The consumer is obviously unhappy as even the seasonal fruits are becoming unaffordable for many of them. The importers of fruits from South East Asia and Americas are also not particularly happy as the demand for expensive and exotic fruits is diminishing consistently due to higher prices. I shall make a trip sometime in September to find out how the farmers are feeling about it.

The food and energy inflation has often remained elevated in India for the past many years due to one reason or the other. Erratic weather (poor crop), depreciating currency (imported inflation), higher support prices, and geopolitics (higher energy prices) etc. The core inflation though remained mostly tamed, except for the sharp rise in input prices post Covid.

There is no evidence to suggest any direct correlation between wage inflation, especially farm wages and non-government urban worker wages. Nonetheless, the indicators like consistent decline in household savings rate; rise in demand for currency, rise in household debt, especially credit card outstanding, could be seen as pointers to indicate that wage hikes might not have matched the household inflation.

Notwithstanding the stagflation like conditions and low visibility of any material improvement in near future, we do not see common man protesting on streets in India. The protest, if any, are feeble and rhetorical, mostly by the politicians from opposition parties. The primary reason for this broader acceptance of high inflation, in my view, is the persistence of inflation for decades, with brief periods of relief in between.

Being an economy materially reliant on agriculture (weather) and imports (edible oil, energy, gold, defence equipment, technology) the population and policymakers both have significantly higher tolerance for food and imported inflation. The phrases like “Beyond control” and “Act of God” are often used by all to accept high inflation. The consumers, investors, money managers and policy makers usually do not consider an episode of high inflation as something that may require any structural change in their respective approaches.

However, this has not been the case for many developed economies like the USA, which are witnessing high inflation after a few decades. A large proportion of the current generation of consumers, investors, money managers and policy makers have not seen any episode of high inflation (and consequent higher rates). Their tolerance to inflation is obviously very low and thus their responses could be very strong. A casual chat with some friends in the USA and UK tells me how the common people in these countries are already feeling “devastated”, even after enhanced cash support from the government. The policy makers, investors and money managers also appear panicked and reacting in haste.

Being an investor in Indian assets only, I see no reason for panic. In fact, I find many reasons to feel optimistic about the future of Indian assets and markets. In the past few years many steps have been taken to contain the imported inflation. These steps shall definitely yield positive results in the next 4-5 years. For example—

·         Focus on renewables, biofuels, local electronic, defence and chemical manufacturing, multiple FTAs etc. should either reduce reliance on imports or at least protect from volatility in global prices. The impact of increased self-reliance (import substitution) could reflect in improved trade balance taking pressure off from the Indian currency.

·         Mission scale efforts to improve production and processing of oil seeds, pulses, fruits & vegetables (horticulture) and marine products etc. have already started to show some early results. The situation could improve materially in the next 4-5years.

·         The current war between Russia and Ukraine has emphasized and reinforced the idea of having a more diversified vendor base for the global businesses. We shall definitely see more bilateral agreements (FTAs etc.) between India and other countries, especially the developed countries that relied overwhelmingly on China and Easter Europe for sourcing their manufactured goods.

·         Full operationalization of Dedicated Freight Corridors, development of multiple expressways along with industrial corridors shall improve the logistic infrastructure brining efficiency in supply chain and optimization of cost of productivity.

·         A leap forward has been taken towards INR convertibility by allowing Indian entrepreneurs to settle their cross border trades in INR. This shall in due course ease pressure on the current account and improve the terms of trade for Indian businesses.

In my view, the current phase of volatility and uncertainty in macro factors like inflation and trade deficit etc. is transient. We have successfully travelled from 12-15% inflation range to 4-8% inflation range in the past 3 decades. In the next decade inflation may stabilize in 3-4% range with materially better trade balance, and a stable INR and mostly neutral rates.

 On 29^th June 2022, Reuters reported a trade deal that could have material and far reaching implications for India’s external trade in particular and the global trade in general as well. As per the agency, it has accessed documents from the Indian Custom department showing that Ultratech, the largest cement manufacturer in India, has imported 1,57,000 tonnes of coal, worth USD25.81million (appx INR2000cr), from Russia. The consignment is invoiced in Chinese currency Yuan (CNY), implying that the payment will be made in CNY, without using the global payment network like SWIFT. The agency also reported that other companies have also placed orders for Russian coal using CNY payments. (see here)

This could be the first instance of an Indian company using CNY to make international payments. Apparently, this time the transaction could be to circumvent the international sanctions on Russia. Ultratech would be using USD to buy CNY in China or Hong Kong to pay the Russian coal producer SUEK. But the success of this transaction may encourage companies to explore INR-CNY and INR-JPY routes of payment in future. It is pertinent to note that Russia and China are successfully conducting CNY-RUB trade for many years.

In the fiscal year FY22, India had a trade deficit of USD79.55bn with China (including Hong Kong) and a trade surplus of USD32.8bn with the US. These two countries are India’s largest trade partners, accounting for 26% of India’s total foreign trade. Notwithstanding the persistence of geopolitical conflict and political rhetoric, China’s (including Hong Kong) share in our foreign trade has risen to 14.4% in FY22. China accounted for 18% of India’s total imports in FY22, against 7.6% for the USA. An INR-CNY payment system in bilateral trade could be extremely beneficial for India, as it may help in bridging the trade deficit with China by making our exports to China more competitive.

Besides, India runs a trade deficit of USD28bn (FY22) with Saudi Arabia, mostly on account of oil imports. Saudi Arabia in turn runs a trade deficit of similar magnitude with China. Successful INR-CNY trade with China and Russia could open doors for non USD settlements with other trade partners also. This could potentially reduce dependence on USD for payment settlement.

It may be argued, CNY could not be as reliable a currency as USD, given the reputation of the Chinese political system and authoritative government. The US has always accused China of manipulating its currency. However, so far not much irrefutable evidence is available to conclude that PoBC has unduly manipulated CNY or exploited its trade partners. On the other hand if we compare the strength in USD considering the amount of USD printed by the US Fed in the past one decade, reasonable doubts emerge over sustainability of USD’s present strength.

The Indian Express highlighted in its 17^th March editorial (see here), “The weaponization of trade, the imposition of sanctions and the exclusion from SWIFT (Society for Worldwide Interbank Financial Telecommunication) by the US could trigger a faster de-dollarisation as countries displaying diplomatic and economic autonomy will be wary of using US-dominated global banking systems.

The US dollar, which is the world’s reserve currency, can see a steady fall in the current context as leading central banks may look to diversify their reserves away from it to other assets or currencies like the Euro, Renminbi or gold.

The notion of de-dollarisation sits well in the thought experiment of a multipolar world where each country will look to enjoy economic autonomy in the sphere of monetary policy.”

V. Ganpathy, a global expert in international trade and technology transfer, also opined (see here) that “India operates a huge trade deficit in excess of $150billion. One of the best way to counter this trade deficit is by introducing Rupee trade for major imports.” Ganpathy believes that the benefits of Rupee trade substantially outweigh losses. He believes, “An aggressive international trade lobbying is required to actively promote Rupee trade with dominant economies.” If India wants to become a global trade player, “the local currency should be the preferred trading instrument.”

The Ultratech deal could just be a small beginning for a major change in India’s foreign trade paradigm.