Vijay Kumar Gaba: Interest rates

Showing posts with label Interest rates. Show all posts

Friday, February 25, 2022

Kya lag raha hai?

“Kaya lag raha hai?” (How is it looking?) I am sure most of the financial market participants must be overwhelmed by this question in the past week. Obviously there is no accurate answer to this question in the present uncertain and volatile times. Regardless, every market participant is trying to answer this inquisition to the best of their ability and understanding of the situation. As the situation is still evolving and new complexities are getting added with each passing day, it is natural that the answers to this question will keep changing every day, and sometimes even within the same day.

If I have to answer this question as someone who is an independent observer of the markets, I would prefer to take a myopic view of the market rather than getting influenced by the hourly news flow. Also, I would mostly remain focused on the Indian markets, as my lenses do not show me the long distance view. For example, I am incapable of commenting on the likely effect of the Russia-Ukraine conflict on US and European economies and geopolitics.

In my view, presently the stars are stacked against the Indian economy and therefore markets. It will take a very strong political will, economic acumen and divine help for us to get out of this situation.

The perfect storm developing

India’s tax to GDP Ratio is the same as 2007 level, i.e., no improvement in the past 15years. However, the Interest Payments to GDP has grown by more than one third from 5% to 6.5% of GDP. As per FY23BE, the central government will be spending more than 20% of its budget only on interest payment. Obviously, the budget for development, social sector spending and subsidies is contracting. Given the elevated inflation and negative real yield on savings; higher indirect tax burden on middle and lower middle class, and lower social sector spending/cash payouts – the consumption has been hit. There is nothing to suggest that there could be any reversal in this situation anytime soon.

To make the matter worse, the government is faced by this global geopolitical crisis. Russia and Ukraine are not only large suppliers of oil & gas, but also edible oils. A substantial part of India’s edible oil import also comes from these two countries. A blockage in the supply chain (due to war or sanctions) could lead to material rise in edible oil inflation, further hurting the common man.

The market price of transportation fuel and cooking gas has not been revised since November, apparently to suit the political convenience. Natural Gas and Crude oil prices have risen substantially since. Strict sanctions on Russia may cause further sharp up moves in global energy prices. This is a Catch-22 type situation for India. If the government decides to fully pass on the crude prices to consumers, inflation may see a sharp spike and consumption demand may collapse further. On the other hand, if the government decides to take a hit on fiscal, the deficit, borrowings and interest burden will rise substantially over the budget estimates. This will happen when the non-tax receipts from disinvestment etc. may not materialize and revenue expense may rise due to dearness allowance etc. Obviously the primary premise of the budget, i.e, sharp rise in capital expenditure will collapse. The global agencies will put sovereign rating under review, making cost of borrowing even higher. Financial stress may rise, abruptly ending the asset quality improvement cycle for banks.

This all might keep FPIs motivated to continue dumping Indian equities and debt, pressuring the current account and INR.

Higher inflation, lower incomes, weaker INR and higher cost of capital - this all is plausible together for some time.

How would you make a case for investment under these circumstances?

I do not accord much significance to the aggravating Russia-Ukraine conflict. My understanding is that this conflict has been persisting at least since the disintegration of the former USSR. The hostilities had deepened in 2014 when Russia annexed Crimea, one of the key Ukrainian provinces. I believe either Ukrainian president Volodymyr Zelenskyy would resign and a Russia friendly president would be installed in Ukraine; or the local conflict would continue with Russia and NATO supporting the opposite factions with money and arms for years, as has been the case with Afghanistan. I also feel that any sanctions imposed on Russia would remain ineffective as has been the case in the past five decades. The over dependence of Europe on Russian energy, metals, wheat and minerals supply makes these sanctions unviable for Europe at least.

My premise is that the situation for the Indian economy was bothersome even before this geopolitical issue aggravated in past three weeks. This conflict has only added a couple of new dimensions to the problem.

So to answer the primary question – “Abhi toh achha nahin lag raha hai” (For now at least it is not looking good).

The follow up question could be kya karna hai? Or Su karva nu? Or What to do?

Will address this question next week.

Wednesday, June 10, 2020

Lower interest rates not helping the economy

In past couple of years, there has been a strong demand for cut in the interest rates. The cacophony rises multifold closer to the scheduled meeting of the monetary policy committee (MPC) of RBI. Many experts have been persistently citing lower rates as panacea for accelerated economic growth. In past five years, since July 2015, RBI has halved its benchmark repo rate 8% to 4%. Despite this we have not seen any signs of acceleration in economic growth. The credit growth has remained low and is expected to plunge to zero by end of this year; as the supply of money (deposits) continue to outpace the demand (credit)

A couple of months ago I had shared some random thoughts on the utility of lower interest rates in the current economic environment. I mentioned that "Interest rates are usually function of demand and supply of the money in the monetary system. Demand for money is again impacted by the level of economic activity and outlook in foreseeable future; whereas supply of money is mostly a function of risk perception and relative returns"...and concluded that interpreting these lower rates as supportive for growth would be a huge mistake; just as it was with lower crude prices (see here). In fact in the present circumstances, low interest rates are likely to do more harm to the economy than help it. In next 12months, there is going to be hardly nay growth in investment demand irrespective of the interest rates. However, lower interest rates may damage the consumption demand as it may lead to lower interest and rental income for consumers, negative real return for savers, worsening income inequality.

Remember, lower interest rates because demand for money is less is as bad a thing as in case of anything else." (see full post here)

Friday, April 24, 2020

Cheaper is not always better

The elementary principle of economics is that the price of a thing that has any economic value is determined by the forces of demand and supply. Often in the short term a state of inequilibrium may exist leading to higher volatility in prices. However, the equilibrium is usually restored by operation of a variety of factors.

There is no denial that economics is youngest amongst the scientific discipline and pure scientists hesitate in admitting it as a discipline of science. Nonetheless it is evolving fast and becoming popular. Not getting into this academic debate, what I have understood is that in popular economics theory is that:

(a) Price of currency is usually 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 is determined by the relative real rate of return (interest) and structure of economic activity (e.g., current account balance and inflation) in the parent jurisdiction.

(b) Price for a particular commodity is determined by the demand and supply conditions of that commodity at any given point in time. The demand of commodities fluctuates as per the level of economic activity in the consuming jurisdiction, export demand and outlook for the foreseeable future. The supply of commodities may fluctuate due to a variety of reason - local to the producing jurisdiction as well global. Cost of production, weather conditions, civil and geopolitical disruptions, inventory levels & cost of carrying inventory, etc are some of the key factors that may influence the supply of commodities in the short term.

(c) Interest rates are usually function of demand and supply of the money in the monetary system. Demand for money is again impacted by the level of economic activity and outlook in foreseeable future; whereas supply of money is mostly a function of risk perception and relative returns.

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 determinates of price as such. This in my view is the cause of most problems facing global economy in the present times. Consequently, the business of forecasting and trading in currencies, money and commodities has become extremely difficult and fraught with risk. The huge volatility and irrationality in crude oil market in past 6 months is just an example of this.

In past three months I have seen hundreds of reports forecasting prices of commodities, currencies, and interest rates. Most of these forecasts appear mere extrapolation of the current price trend and hence do not inspire any confidence.

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.

INR depreciation is beyond economics

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 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. Every day one used to hear some mega property deal. NRIs from 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 appreciated more than 10% vs. USD in first six months of 2007.

Then INR depreciated over 75% during period from January 2008 to August 2013. This was the time when Fed was printing USD at an unprecedented rate. There was no shortage of EUR, GBP and JPY either.

The point I am making is that in the present times when most globally relevant central bankers are using unconventional policy measures with impunity to stabilize their respective economies, the value of currency is seldom a function of demand and supply alone.

Regardless of the economic theory, it is the faith of people in a particular currency that is primary determinate of its relative exchange value.

2005-2007 was the time when the Indians had developed good faith in their currency. 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 2010 onwards. There is no sign of reversal yet. Despite huge popularity of Narendra Modi amongst overseas Indians, we have not seen any material change in remittance pattern in 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.

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.

...so are interest rates

Yesterday, RBI auctioned 91 days and 182 days treasuries bills at far below the policy repo rate and lower than the recently reduced reverse repo rate. Even at ~3.6%, it accepted only one fifth of the bids received. SBI has reduced the rates on whole sale fixed deposits to 2.5%.

Obviously, the supply of money at this point in time is overwhelming higher than the demand. Like crude, banks have no place to park their deposits.

However, interpreting these lower rates as supportive for growth would be a huge mistake; just as it was with lower crude prices (see here). In fact in the present circumstances, low interest rates are likely to do more harm to the economy than help it. In next 12months, there is going to be hardly nay growth in investment demand irrespective of the interest rates. However, lower interest rates may damage the consumption demand as it may lead to lower interest and rental income for consumers, negative real return for savers, worsening income inequality.

Remember, lower interest rates because demand for money is less is as bad a thing as in case of anything else.