This economic number shows all that is wrong with Indian economy

rupeeVivek Kaul 
The Reserve Bank of India released the financial stability report on June 27, 2013. The page 14 of the points out “Gross Domestic Saving as a proportion to GDP has fallen from 36.8 per cent in 2007-08 to 30.8 per cent in 2011-12.”
In the year 2004-2005, the total domestic savings had stood at 32.4% of the gross domestic product. Hence, there has been a tremendous drop in savings during the time the Congress led United Progressive Alliance (UPA) has governed this country. And this as we shall see is one number that is a broad representation of all that is wrong with the Indian economy in its current state.
The total amount of money that a country saves essentially comes from three sources: households, the private corporate sector, and the public sector. The worrying thing here is that household savings have fallen dramatically during the last seven years.
As the Economic Survey released in February 2013 pointed out “On average, households accounted for nearly three-fourths of gross domestic savings during the period 1980-81 to 2011-12. The share declined somewhat in recent years, and in the period from 2004-05 to 2011-12, it averaged 70.1 per cent of total savings.”
The other worrying factor is the dramatic fall in financial savings, which have pushed down overall domestic savings as well. As the RBI report points out “A large part of this decline has been due to fall in financial savings of households which have declined from 11.6 per cent of GDP to 8 per cent of GDP over the corresponding period (i.e. between 2007-08 to 2011-12.” Financial savings essentially accounts for savings in the form of bank deposits, life insurance, pension and provision funds, shares and debentures etc. In fact between 2010-2011 and 2011-2012, the household financial savings fell by a massive Rs 90,000 crore.
So the question is why have households savings and within them household financial savings, fallen so dramatically over the last few years? A straight forward answer is high inflation. The high inflation that has plagued the country during the course of UPA’s second term has meant that people have had to spend more money to buy the same basket of goods as they were doing the same. And this has meant lower savings. What this also tells us is that newspaper stories that talk about salaries in India going up in double digit terms, need to be taken with a pinch of salt, given that inflation has also more or less gone up at the same rate.
Also high inflation has meant that the real rate of returns after adjusting for inflation on products like public provident fund, bank deposits and post office deposits, which pay out a fixed rate of interest every year, have gone down. In fact, a fixed deposit paying an interest of 8-9% per year currently has a negative real rate of return in an environment where the consumer price inflation is greater than 9%. “Much of the financial savings of the household sector are in the form of bank deposits (around 30 per cent in the 2000s)..These were also the years when the real rate of interest was generally declining,” the Economic Survey pointed out.
In such an environment a lot of money has gone into gold and real estate which had a prospect of giving higher returns. As the Economic Survey pointed out “The last three years have seen a substantial rise in gold imports (the value of gold imports increased nine times between January 2008 and October 2012)…Gold imports are positively correlated with inflation.” High inflation reduces the ‘real’ return adjusted for inflation on other financial instruments and leads to people buying gold.
Given that a lot of savings have gone into gold and real estate, this has pulled down overall financial savings. As financial savings have fallen dramatically the interest rates on loans has been high for the last few years. In fact this is one reason why Indian businesses have been borrowing a lot of money abroad rather in India over the last few years. 
As the Business Standard reports “Beginning 2004, the central bank(i.e. RBI) has approved nearly $220 billion worth of external commercial borrowings and foreign currency convertible bonds (FCCB), at the rate of a little over $2 billion a month. Nearly two-thirds of this amount was approved in the past five years.”
Both gold and external borrowings have added to India’s dollar problem. India produces very little gold. Hence, almost all the gold that is consumed in the country is imported. Gold is bought and sold in dollars internationally. And every time an Indian importer buys gold, dollars are needed. This pushes up the demand for dollars in the market and puts pressure on the rupee. Gold imports are one reason why the rupee has lost value against the dollar through much of this year.
The finance minister P Chidambaram has been asking people time and again not to buy gold, without addressing the basic problem of “inflation”. Gold is finally just a symptom of the problem i.e. inflation. “The rising demand for gold is only a “symptom” of more fundamental problems in the economy,” the Economic Survey pointed out.
As far as foreign borrowings by Indian businesses are concerned, they need to repaid. To do this, Indian businesses will have to sell rupees and buy dollars, and this will push up the demand for dollars and put further pressure on the rupee. As the 
Business Standard points out “Much of this external commercial borrowing will come up for repayment this financial year, putting further pressure on the rupee.”
So financial savings going down due to inflation has created several problems for the country. Another reason for the financial savings being hit is the tremendous mis-selling of insurance by insurance companies. The RBI report says that the “credibility of the financial institutions” has been hit “in the wake of mis-selling of products and financial frauds”. The government hasn’t been able to do much on this front as well.
The article originally appeared on on June 28, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Rupee fall: Why India's struggle for dollars will continue

3D chrome Dollar symbolVivek Kaul
The question being asked yesterday was “why is the rupee falling against the dollar”. The answer is very simple. The demand for American dollars was more than that of the Indian rupee leading to the rupee rapidly losing value against the dollar.
This situation is likely to continue in the days to come with the demand for dollars in India being more than their supply. And this will have a huge impact on the dollar-rupee exchange rate, which crossed 60 rupees to a dollar for the first time yesterday.

Here are a few reasons why the demand for dollars will continue to be more than their supply in the days to come.
a) The United Nations Conference on Trade and Development (UNCTAD) recently pointed out that
the foreign direct investment in India fell by 29% to $26 billion in 2012. When dollars come into India through the foreign direct investment(FDI) route they need to be exchanged for rupees. Hence, dollars are sold and rupees are bought. This pushes up the demand for rupees, while increasing the supply of dollars, thus helping the rupee gain value against the dollar or at least hold stable.
In 2012, the FDI coming into India fell dramatically. The situation is likely to continue in the days to come. The corruption sagas unleashed in the 2G and the coalgate scam hasn’t done India’s image abroad any good. In fact in the 2G scam telecom licenses have been cancelled and the message that was sent to the foreign investors was that India as a country can go back on policy decisions. This is something that no big investor who is willing to put a lot of money at stake, likes to hear.
Opening up multi-brand retailing was government’s other big plan for getting FDI into the country. In September 2012, the government had allowed foreign investors to invest upto 51% in multi-brand retailing. But between then and now not a single global retailing company has filed an application with the Foreign Investment Promotion Board (FIPB), which looks at FDI proposals.
This scenario doesn’t look like changing as likely foreign investors struggle to make sense of the regulations as they stand today. Dollars that come in through the FDI route come in for the long run as they are used to set up new industries and factories or pick up a stake in existing companies. This money cannot be withdrawn overnight like the money invested in the stock market and the bond market.
b) There has been a lot of talk about the Reserve Bank of India(RBI) selling bonds to Non Resident Indians (NRIs) and thus getting precious dollars into the country. The trouble here is that any NRI who invests in these bonds will carry a huge amount of currency risk, given the rapid rate at which the rupee has lost value against the dollar.
Lets understand this through a simple example. An NRI invests $100,000 in India. At the point he gets money into India $1 is worth Rs 55. So $100,000 when converted into rupees, amounts to Rs 55 lakh. This money lets assume is invested at an interest rate of 10%. A year later Rs 55 lakh has grown to Rs 60.5 lakh (Rs 55 lakh + 10% interest on Rs 55 lakh). The NRI now has to repatriate this money back. At this point of time lets say $1 is worth Rs 60. So when the NRI converts rupees into dollars he gets $100,800 or more or less the same amount of money that he had invested. His return in dollar terms is 0.8%. The real return would be much lower given that this calculation doesn’t take the cost of conversion into account.
Hence, the NRI would have been simply better off by letting his money stay invested in dollars. This is the currency risk. To make it attractive for NRI investors to invest money in any such RBI bond, the interest on offer will have to be very high.

c) While the supply of dollars will continue to be a problem, the demand for them will continue to remain high. A major demand for dollars will come from companies which have raised loans in dollars over the last few years and now need to repay them. As the Business Standard reports “Beginning 2004, the central bank(i.e. RBI) has approved nearly $220 billion worth of external commercial borrowings and foreign currency convertible bonds (FCCB), at the rate of a little over $2 billion a month. Nearly two-thirds of this amount was approved in the past five years. Much of this ECB will come up for repayment this financial year, putting further pressure on the rupee.”
A lot of companies have raised foreign loans over the last few years simply because the interest rates have been lower outside India than in India. These companies will need dollars to repay their foreign loans as they mature.
The other thing that might happen is that companies which have cash, might look to repay their foreign loans sooner rather than later. This is simply because as the rupee depreciates against the dollar, it takes a greater amount of rupees to buy dollars. So if companies have idle cash lying around, it makes tremendous sense for them to prepay dollar loans. The trouble is that if a lot of companies decide to prepay loans then it will add to the demand for the dollar and thus put further pressure on the rupee.
d) India’s love for gold has been one reason behind significant demand for the dollar. Gold is bought and sold internationally in dollars. India produces very little gold of its own and hence has to import almost all the gold that is consumed in the country. When gold is imported into the country, it needs to be paid for in dollars, thus pushing up the demand for dollars. As this writer has argued in the past there is some logic for the fascination that Indians have had for gold. A major reason behind Indians hoarding to gold is high inflation. Consumer price inflation continues to remain high. Also, with the marriage season set to start over the next few months, the demand for gold is likely to go up. What can also add to the demand is the fall in price of gold, which will get those buyers who have not been buying gold because of the high price, back into the market. All this means a greater demand for dollars.
e) India has been importing a huge amount of coal lately to run its power plants. Indian coal imports shot up by 43% to 16.77 million tonnes in the month of May 2013, in comparison to the same period last year. Importing coal again means a greater demand for dollars.
The irony is that India has huge coal reserves which are not being mined. The common logic here is to blame Coal India Ltd, which more or less has had a monopoly to produce coal in India. The government has tried to encourage private sector investment in the sector but that has been done in a haphazard manner leading to the coalgate scam. This has delayed the bigger role that the private sector could have played in the mining of coal and thus led to lower coal imports.
The situation cannot be set right overnight. The major reason for this is the fact that the expertise to get a coal mine up and running in India has been limited to Coal India till now. To develop the same expertise in the private sector will take time and till then India will have to import coal, which will need dollars.

f) The government’s social sector policies may also add to a huge demand for dollars in the time to come. The procurement of wheat by the government this year has fallen by 33% to 25.08 million tonnes. This will not have any immediate impact given the huge amount of grain reserves that India currently has. But as and when right to food security becomes a legal right any fall in procurement will mean that the government will have to import food grains like wheat and rice, and this will again mean a demand for dollars. While this is a little far fetched as of now, but is a likely possibility and hence cannot be ignored.
These are fundamental issues which will continue to influence the dollar-rupee exchange rate in the days to come and do not have easy overnight kind of solutions. Of course, if the Ben Bernanke led Federal Reserve of United States, decides to go back to printing as many dollars as it is right now, then a lot of dollars could flow into India, looking for a higher return. But then, that is something not under the control of Indian government or its policy makers.

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

India is screwed, no matter what RBI does on rupee

Vivek Kaul
The Reserve Bank of India(RBI) finally threw in the towel today. Over the past several days it had been selling dollars in the foreign exchange market and had thus managed to hold back the rupee to under 60 to a dollar.
The RBI tried halting the fall of the rupee by selling dollars today as well. 
A report on points out that The Indian central bank(i.e. the RBI) intervened by selling the dollar at 59.98, earlier in the day, according to currency dealers, who added that a foreign bank had aided RBI by selling dollars in the market.”
This helped the rupee to recover to around 59.93 to a dollar. But it soon crossed 60 to a dollar. 
At the end of trading today, one dollar was worth Rs 60.73.
The question being asked is could the RBI have continued to sell dollars and help stem the fall? 
As on June 14, 2013, India had foreign exchange reserves of $290.66 billionThis is tenth largest in the world.
So it seems that the RBI has enough dollars that it can sell to halt the rupee’s fall against the dollar. But things are not as simple as that. Indian imports during the month of May 2013, stood at $44.65 billion. This basically means that the current foreign exchange reserves are good enough to cover around six and a half months of imports ($290.66 billion of foreign exchange reserves divided by $44.65 billion of monthly imports).
This is a very low number when we compare it to other BRIC economies(i.e. Brazil, Russia and China),which 
have an import cover of 19 to 21 months. What does not help is the huge difference between Indian exports and imports. In May 2013, Indian exports fell by 1.1% to $24.51 billion. This meant that India had a trade deficit (or the difference between imports and exports) of more than $20 billion. The broader point is that India is not exporting enough to earn a sufficient amount of dollars to pay for its imports.
In this scenario the RBI can use only a limited portion of its foreign exchange reserves to defend the dollar. An estimate made by Bank of America- Merrill Lynch suggests that the RBI can use upto $30 billion to defend the rupee. If it chooses to do that the foreign exchange reserves will come down to around $260 billion, which would mean an import cover of around 5.8 months ($260billion divided by $44.65 billion of imports). This will be a very precarious situation 
and was last seen in the early 1990s, when India had just started the liberalisation programme.
This is one reason behind why the RBI cannot stop the rupee from falling beyond a point. More than that it does not make sense for any central bank (unless we are talking about the People’s Bank of China) to obsess with a certain currency target against the dollar. This was the learning that came out from the South East Asian crisis of the late 1990s.
Various South East Asian currencies were pegged to the dollar. The Thai baht, was pegged to the US dollar with one dollar being equal to 25 Thai baht. The Philippines peso was pegged at 25 pesos to the dollar. The Malaysian ringgit was pegged at 2.5 ringgits per dollar and so was the Indonesian rupiah, which was pegged at 2030 rupiah to a dollar.
The central banks of these countries ensured that there currencies continued to remain pegged. In case the market suddenly had a surfeit of baht, and the baht started to lose value against the dollar, the Thai central bank started to buy baht and sell dollars. In a situation where the market had a surfeit of dollars and the baht started to appreciate against the dollar, the Thai central bank intervened and started to buy dollars and sell baht. This ensured that the value of the baht against the dollar remained fixed.
But when the South East Asian crisis started, investors started to exit these countries lock, stock and barrel. So if an investor sold out of the Thai stock exchange he was paid in Thai baht. When he had to repatriate this money abroad he needed to convert these baht to dollars. So suddenly the foreign exchange market had a surfeit of Thai baht. In the normal scheme of things, the value of the baht would have fallen against the dollar. But the baht was pegged to the dollar. So as a logical step the Thai central bank started to sell dollars and buy baht, in order to ensure that one dollar continued to be worth 25 Thai baht.
In May 1997, the finance minister of Thailand was fired. The new finance minister made a secret visit to the central bank and realised that the country had more or less run out of dollars trying to defend the dollar-baht exchange rate
The bank had run through nearly $33billion of foreign exchange reserves trying to defend the exchange rate.
On July 2, 1997, Thailand decided to stop supporting the baht and let it fall. It was estimated that the baht would fall by around 15%, but instead by the end of July it had already fallen by 20% to 30 baht a dollar. A year later the exchange rate was down to 41 baht to a dollar. And within two weeks of Thailand setting the baht free, others followed. The Philippines peso’s peg with the dollar broke on July 14. The peg of the Indonesian rupiah and the Malaysian ringgit also broke the same day.
A year later the Indonesian rupiah was at 14,150 to a dollar. It had been at 2380 to a dollar. The Malaysian ringgit was at 4.1 to a dollar, down from 2.5. And Philippines peso was at 42 to a dollar against 26.3 a year earlier
That is the problem with trying to defend the exchange rate. It needs an unlimited amount of dollars, which no country in the world other than the United States (and to a certain extent China which has nearly $3.3 trillion foreign exchange reserves) has. And only the Federal Reserve of United States, the American central bank can print dollars. No other central bank can do that.
A similar situation is playing out in India right now. Foreign investors are looking to exit the country. They have sold off more than $5 billion worth of bonds since late May. They have also sold off stocks worth $1.39 billion in June, after buying stocks worth $4 billion in May. These investors are now trying to convert there rupees into dollars, and that has led to the rupee rapidly depreciating against the dollar.
The RBI tried to halt this fall by intervening in the foreign exchange market and selling dollars. But as the South East Asian experience tells us, obsessing with a certain target against the dollar is not a great idea.
So given that the RBI has got it right by not obsessing with the target of Rs 60 to a dollar. But the trouble is 
that a weaker rupee will have several negative consequences in the days to come (This is discussed in detail here).
First and foremost will be higher inflation as India will pay more for imported products. Oil will become expensive in rupee terms. If the government passes on the increase in price to the end consumer, then it will lead to higher prices or inflation. If it does not pass on the increase in prices to the end consumer then the government will run a higher fiscal deficit as its expenditure will go up. Fiscal deficit is the difference between what a government earns and what it spends. It will also mean that the government will have to borrow more to finance its expenditure and that in turn will mean that the high interest rate scenario will continue.
India imports a lot of coal which is used for the production of power. 
With the rupee losing value against the dollar the cost of importing coal will go up. Coal in India is imported typically by private power companies to produce power. The government owned Coal India Ltd, does not produce enough coal to meet the needs. The Cabinet Committee on Economic Affairs recently decided to allow private power companies to pass on the rising cost of imported coal to consumers. This again will add to inflation.
Companies which had borrowed in dollars and have not insured themselves against the fall of the rupee, will have to pay more. 
Economist Arvind Subramanian points out in the Business Standard that there will be “a decline in the profitability of all those enterprises that have borrowed heavily in foreign currency and have not insured themselves against a rupee decline (“unhedged borrowing”).”
This cost “will manifest itself in reduced investment by these companies and hence lower aggregate growth; it will also manifest itself (eventually) in a worsened fiscal situation because the government will have to support these companies directly or the banks that have lent to them,” writes Subramanian.
The broader point is that India is screwed both ways irrespective of whether RBI defends the rupee or not.

The article originally appeared on on June 26, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Is the Chinese credit bubble starting to unravel?


Vivek Kaul
One of the fundamental rules of forecasting is to make as many forecasts as possible and then publicise the ones you get right. A little over two weeks back I wrote a piece titled “Is China getting ready for the next big financial crisis?
On June 24, 2013, the Shanghai Composite Index,
China’s premier stock market index fell by 5.3% to close at 1963.22 points. The fall continued on June 25, and at one point of time the index reached a four year low of 1849.65 points. Though by the end of the trading day, the stock market had managed to recover the losses and was quoting at around 1960 points.
The stock market plunged in response to the Shanghai interbank offered rate (or Shibor) going up dramatically towards the middle of last week. Shibor is the interest rate at which banks lend to one another. It had spiked to 25% on June 20, 2013.
Despite this rapid rise in Shibor,
the People’s Bank of China, the Chinese central bank, refused to intervene. In fact in a statement dated June 17, 2013 (but issued only on June 24, 2013) the central bank said “current liquidity in our country’s banking system is overall at a reasonable level.”
This statement was what caused a panic in the stock market on June 24, 2013. The interpretation was that the People’s Bank of China was sending out a message that the days of “easy money” in China are over and the central bank would now get into a tightening mode as far as the easy availability of credit was concerned. If one were to use the language of those who follow every move that a central bank makes, the central bank had just turned hawkish. The stock market falling was a response to that.
Loans given by banks and other financial institutions have grown at a very rapid rate since 2007. As Edward Chancellor and Mike Monnelly of the global investment management firm GMO point out in a white paper titled
Feeding the Dragon: Why China’s Credit System Looks VulnerableBetween 2007 and 2012, the ratio of credit(i.e. loans) to GDP climbed to more than 190%, an increase of 60 percentage points. China’s recent expansion of credit relative to GDP is considerably larger than the credit booms experienced by either Japan in the late 1980s or the United States in the years before the Lehman bust.” As of the end of 2012, the total lending by banks and other financial institutions as a proportion of the GDP ratio stood at 198%. And this growth in loans continued unabated even in 2013. During the first three months of the year, the loans grew by 20% in comparison to the same period last year.
Ambrose Evans-Pritchard of The Daily Telegraph comes up with a very interesting data point in a recent blog which shows very clearly how big the Chinese credit bubble really is. As he writes “China has increased credit from $9 trillion to $23 trillion since late 2008. The increase is equal to the entire US commercial banking system.”
This lending by banks and other financial institutions is reflected in the rise of private sector debt in China.
A recent World Bank report puts the ratio of private domestic debt to GDP at 160%. This is the highest among all the nations categorised as emerging markets. The credit rating agency Fitch puts this ratio at 200%.
This rapid increase in credit, which has had the blessing of the People’s Bank of China, has been a major reason behind China continuing to grow at a very high rate even though economic growth all over the world has slowed down.
But the trouble is with so much money being lent, the efficiency of lending has broken down i.e. more money has to be lent now to create the same amount of growth, in comparison to the past.
As Wei Yao of Societe Generale writes in a report titled China’s missing money and the Minsky moment “a fast rising debt load of an economy suggests either deteriorating growth efficiency or high and rising debt service cost, or in many cases both. There is clear evidence that China is suffering from both of these.”
Wei Yao estimates that China has “a shockingly high debt service ratio of 29.9% of GDP, of which 11.1% goes to interest payment and the rest principal….At such a level, no wonder that credit growth is accelerating without contributing much to real growth!”
In fact so much money has been lent that ghost cities where no one lives have been built. “
Miles upon miles of half-completed apartment blocks encircle many cities across the country. Official data suggest that the value of the unfinished housing stock is equivalent to 20% of GDP and rising..Developments in the infamous “ghost city” of Ordos, in Inner Mongolia, reveal the vulnerability of China’s credit system to an overblown housing market. The Kangbashi district of Ordos is a totem for China’s property excesses. Kangbashi has enough apartments to shelter a million persons, roughly four times its current population,” write the GMO authors.
A lot of these loans have (and continue) to be made in the shadow banking system.
As an article in The New York Times points out “Banks borrow at the low interbank rate, then lend to trust companies and smaller banks who in turn make riskier loans. The fear among some analysts is that the vast amount of bad debt and hidden liabilities the shadow banking system masks could start sinking banks. Those excesses could start a chain of other economic setbacks.”
Money raised and lent by the shadow banking sector has also been responsible for the massive property bubble in the country.
As an article in the LA Times points out “Chinese authorities are trying to rein in the nation’s so-called “shadow banking” sector, in which smaller banks and trust companies borrow from bigger state-run banks with easy access to credit. Those entities relend money at high interest rates to property developers and businesses, often with tight connections to the Communist Party, driving speculation and asset bubbles.”
And the People’s Bank of China cannot let this run forever. Hence the recent statement is being seen as a warning to banks and other financial institutions to go slow on lending money.
Also Shibor, acts as a benchmark interest rate to other kind of loans from home loans to credit cards. And a rise in Shibor could slowdown lending further. As Goldman Sachs said in a recent note “The recent tightening of the interbank market has sent a strong policy signal that the strong credit growth earlier in the year will likely not continue.” For any bubble(and China has a huge property bubble that is currently on) to sustain itself it is important that money keeps coming in. And the Chinese central bank seems to have turned the tap off as far as “easy money” is concerned.
Another possible explanation is being offered for the recent hawkish statement made by the People’s Bank of China. The new Chinese President
Xi Jinpingand Premier Li Keqiangare said to be interested in initiating financial sector reforms by opening up the Chinese bond markets and also freeing up the interest rates.
The Forbes quotes Carl Walter, who has spent 20 years working in Chinese banking sector as saying “There is a political message to all of this, which is don’t mess with the banking system…I think the People’s Bank of China and the big four banks are telling the new leadership to keep its hands off this sector.”
By letting the Shibor to rise, the banking interests want to show the new Chinese leadership of what is likely to happen if the interest rates are set free. As Walter puts it “By playing with Shibor, letting it go sky high, and watching these small banks squeal then politically you show strength…They are saying, ‘you want to liberalize interest rates, go right ahead, look what at what is happening to these smaller banks. We are too big to fool around with.”
Either ways, there is trouble ahead.
The article originally appeared on on June 26, 2013 

(Vivek Kaul is a writer. He tweets @kaul_vivek)

Why gentlemen no longer prefer bonds

marilyn monroe & jane russell 1953 - gentlemen prefer blondes - by frank powolny
Vivek Kaul 
Gentlemen prefer bonds” is an old bear market saying. It essentially refers to a scenario where investors sell out of the stock market and invest their money into bonds, particularly government bonds.
But we live in ‘interesting’ times where investors are selling out of both bond markets as well as stock markets. The yield or return on the 10 year American treasury 
bond rose to 2.66% on June 24, 2013. The treasury bond is a bond issued by the American government to finance its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.
Investors have been selling out on the American treasury bonds. When a spate of selling hits the bond market, bond prices fall. But the interest that the government pays on these bonds till they mature, continues to remain the same, thus pushing up the return or the yield to maturity for those investors who buy these bonds.
The return or the yield on the 10 year American treasury bond has gone up at a very fast rate since the beginning of May. As on May 1, 2013, the return stood at 1.64%. Since then it has jumped by more than 100 basis points (one basis point is equal to one hundredth of a percentage) to 2.66%.
The first repercussion of this is that the borrowing cost of the American government will go up in the days to come. Any fresh bonds issued by the American government to finance its fiscal deficit will have to match the current return on a 10 year American treasury bond. In fact, between May 1 and June 24, the return on the 10 year American treasury bond has gone up from 1.64% to 2.66%. This is a rise of more than 62%, which will ultimately reflect in the borrowing costs of the American government.
But that is not the major reason for worry. The return on the 10 year American treasury acts as a benchmark for other interest rates, including those on home loans (or mortgages as they are called in the United States). So if the return on the 10 year American treasury is going up, then the interest rates on all kinds of loans goes up as well. This is because lending to the government is deemed to be the safest and hence returns on all kinds of other loans need to be higher than the return made on lending to the government.
This has led to the interest on the 30 year home loans rising by around 100 basis points(one basis point equals one hundredth of a percentage) 
to 4.4%, writes Mark Gongloff on The Huffington Post, website. This rise in interest rates means higher EMIs (equated monthly instalments) on home loans. “It is the biggest single move in interest rates since at least 1962, according to Dan Greenhaus, chief global strategist at the New York brokerage firm BTIG,” writes Gongloff.
A higher EMI could put the housing recovery in the United States in jeopardy and thus impact overall economic recovery as well. At higher interest rates people are less likely to borrow and buy homes. Less home buying could slow down the increase in home prices. As Gongloff points out “The surge in rates will likely squeeze mortgage refinancing and borrowing and could smother the recent rebound in the housing market, which has largely been driven by investors taking out cheap loans to buy cheap houses.”
Home prices in the United States have gone up by nearly 10.9% between March 1, 2012 and March 1, 2013, as per the Case-Shiller 20 City Home Price Index. A demand for greater homes creates jobs in the real estate and ancillary sectors. And more homes are likely to be bought at low interest rates than higher.
Low interest rates also get the ‘home equity’ loans going. Home equity is the difference between the market price of a house and the home loan outstanding on it. American banks give loans against this equity. People are more likely to borrow against this equity when interest rates and EMIs are low.
In fact, extraction of home equity became a very important driver of consumption in the United States in the years running up to the financial crisis which started in September 2008. As is the case with any advanced economy, consumption formed a major portion of the US GDP. Home equity loans were used to buy SUVs, furniture, other consumer goods or simply to pay off the debt that accumulated on other expensive forms of borrowing like the credit card.
Charles R Morris writing in 
The Trillion Dollar Meltdown: Easy Money, High Rollers, And the Great Credit Crash explains this phenomenon: “Consumer spending jumped from a 1990s average of about 67% of GDP to 72% of GDP in early 2007. As Martin Feldstein, a former chairman of the Council of Economic Advisers, has pointed out, that increase was financed primarily by the withdrawal of $9 trillion in home equity.” Feldstein’s study was carried out for the period between 1997 and 2006. Home equity supplied more than 6% of the disposable personal income of Americans between 2000-2007, another study pointed out. In fact, by the first quarter of 2006, home equity extraction made up for nearly 10% of disposable personal income of Americans.
But this is possible only when interest rates are low. With returns on 10 year treasury bonds rising, the interest charged on home equity loans is likely to go up as well. Hence, this means that people are less likely to borrow against their home equity. Also, with home loans becoming expensive the price of real estate is unlikely to continue to go up at the same speed as it has in the recent past, because Americans will now buy fewer homes. If home prices don’t rise, there is lesser home equity to extract. All this means less consumer spending which in turn will lead to slower economic growth.
The rise in bond yields or returns is essentially a reaction to the decision made by the Ben Bernanke led Federal Reserve of United States, the American central bank, to go slow on the money printing operations. The Federal Reserve has been printing $85 billion every month to buy both government and private sector bonds. By buying bonds it pumped the printed money into the American financial system. With enough money going around, the Federal Reserve managed to keep interest rates low encouraging people to borrow and spend.
But now it wants to change track. As Bernanke told the press on June 19, 2013 “
If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year…And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.
Bernanke further said that “in this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7%, with solid economic growth supporting further job gains.”
Hence, if economic growth in the United States continues, the Federal Reserve will gradually slowdown and finally stop money printing by the middle of next year. The message that Bernanke wanted to give was two fold. One of course was the fact that the Federal Reserve would “taper” its money printing operations in the days to come. But the other more important message was that the Federal Reserve felt that strong growth was “finally” returning to the American economy.
But the markets (particularly the bond market) has bought only one part of the two-fold message from the Federal Reserve. The growth message clearly hasn’t gone through. The bond market has clearly come around to believe that the days of “easy money” will be soon coming to an end, as the Federal Reserve will stop its money printing operations.
This will lead to interest rates going up. Interest rates and bond prices share an inverse relationship. As interest rates go up, bond prices fall. And in the expectation of the interest rates going up and bond prices falling, investors are selling out of bonds, and thus driving up interest rates. 
As The New York Times reports “A bond sell-off has been anticipated for years, given the long run of popularity that corporate and government bonds have enjoyed. But most strategists expected that investors would slowly transfer out of bonds, allowing interest rates to slowly drift up.” That has clearly not happened.
In fact, Bernanke made it very clear that the Federal Reserve is only planning to slowdown and stop future money printing. It has absolutely no plans of withdrawing the money that it has already printed and put into the financial system. 
Or as Bernanke put it “akin to letting up a bit on the gas pedal.” “Putting on the monetary brakes would entail selling bonds out of the Fed’s portfolio, and that’s not happening any time soon,” Bernanke said.
But the bond market is already taking into account the Federal Reserve pumping out the money that it has printed and put into the financial system, in the days to come. As and when that happens, interest rates will rise sharply.
At a global level, it has meant a slowdown in the dollar carry trade. Interest rates on loans raised in dollars are going up, making it unviable for investors to borrow in dollars and go searching for high returns, all over the world. This has led to investors selling out from stock and bond markets across the world. And that is likely to continue in the days to come.
The article originally appeared on on June 25, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)