The foreign institutional investors have sold out $4.6 billion worth of bonds from the Indian debt market over the last one month. This is primarily because of the unwinding of the dollar carry trade.
In the aftermath of the financial crisis that started in September 2008, the Federal Reserve of United States, the American central bank, started printing truckloads of money. This money was flushed into the financial system. The idea being with enough money going around, the interest rates would remain low. At low interest rates American citizens were more likely to borrow and spend. And this spending would create economic growth, which had fallen dramatically in the aftermath of the crisis.
The trouble of course was that Americans were just coming out from a horrible round of borrowing binge which had gone all wrong. And given that they were in no mood to borrow more. They first wanted to pay off their existing loans. So the financial system was flush with money available at low interest rates but the American citizens did not want to borrow.
This led to banks and other financial institutions borrowing at very low interest rates and investing that money in different financial markets across the world. This trade came to be known as the dollar carry trade. Money was raised in dollars at low interest rates and invested in stock, bond and commodity markets all over the world.
The difference between the return the investors make on their investment and the interest that they pay for borrowing money in dollars is referred to as the ‘carry’ they make.
This trade has been a boon to big financial firms which were reeling in the aftermath of the financial crisis and has helped them back on their feet. But like all things which seem ‘good’, this might be coming to an end as well.
Later today the Federal Open Market Committee(FOMC) of the Federal Reserve will issue a statement in which it is likely to hint that it will cut down on further money printing. Ben Bernanke, the Chairman of the Federal Reserve, hinted about it in a testimony to the Joint Economic Committee of the American Congress on May 23, 2013.
As he said “if we see continued improvement and we have confidence that that is going to be sustained, then we could in — in the next few meetings — we could take a step down in our pace of purchases.”
The Federal Reserve pumps money into the American financial system by printing money and using it to buy bonds. This ensures that there is no shortage of money in the system, which in turn ensures low interest rates.
What Bernanke said was that if the Federal Reserve feels that the economic scenario is improving, it would taper down the bond purchases. This basically meant that the Federal Reserve would go slow on money printing.
If and when that happened, the interest rates would start to go up as the financial system would no lunger be slush with money. In fact the interest rates have already started to go up. The return on the 10 year US treasury bond has gone up. On May 2, 2013, the return was at 1.63%. As on June 18, 2013, the return had shot up to 2.19%. A US treasury bond is a bond issued by the American government to finance its fiscal deficit. The fiscal deficit is the difference between what a government earns and what it spends.
The return on 10 year US treasury acts as a benchmark for the interest rates on other loans. If the return on 10 year US treasury goes up, what it means is that interest charged on other loans will also go up in the days to come.
This means that those financial institutions which have borrowed money for the dollar carry trade will be paying a higher interest. A higher interest would mean a lower return on investment on their trade i.e. a lower carry.
This is the reason why these investors are unwinding their dollar carry trade. In an Indian context this has meant that they have been selling out on the bonds they had invested in. As mentioned earlier over the last one month the foreign investors have sold bonds worth $4.6 billion.
When the foreign investors sell these bonds they get paid in rupees. This money needs to be repatriated to the United States and hence needs to be converted into dollars. So the rupees are sold to buy dollars from the foreign exchange market.
When this happens there is a surfeit of rupees in the market and a huge demand for dollars. This has led to the rupee rapidly losing value against the dollar. Around one month back one dollar was worth Rs 55. Now its worth close to Rs 59 (around Rs 58.75 as I write).
The question that arises here is how are the foreign investors reacting in the stock market? They have much more invested in the stock market than they had in the bond market.
Over the last one month the foreign institutional investors have bought stocks worth Rs 382.88 crore, which is a low number, though in the positive territory. In the month of May 2013, the foreign investors had bought stocks worth Rs 14,465.90 crore. Since the beginning of this year they have bought stocks worth Rs 57,644.33 crore.
So that tells us very clearly that foreign institutional investors are going slow even on their stock purchases. But they haven’t sold out on stocks totally, as they have in case of bonds. The answer lies in the fact that returns in the bond market are limited. The return on the 10 year India government bond was at 7.28% as on June 18,2013. The borrowing costs for the foreign investors have gone up. A depreciating rupee also limits their overall return. So it makes sense for them to get out of bonds.
In case of the stock market there is no limit to the overall return that can be made. And that explains to some extent why the bond market has borne the brunt of the unwinding of the dollar carry trade. How things pan out from here depends on what the Bernanke led FOMC says later tonight.
The article originally appeared on www.firstpost.com on June 19,2013.
(Vivek Kaul is a writer. He tweets @kaul_vivek)