Vivek Kaul
Ben ‘Shalom’ Bernanke is the Chairman of the Federal Reserve of United States, the American central bank. In the Monetary Policy Report to the Congress issued on March 1,2011, the Bernanke led Federal Reserve had assured the world at large that they had the tools needed to “remove policy accommodation at the appropriate time.”
In simple English what it meant was that as and when needed the Federal Reserve would stop printing money and at the same time be able to gradually withdraw all the money that they had printed and pumped into the financial system. This could be done without much hassle.
In the aftermath of the financial crisis starting in mid September 2008, the Federal Reserve of United States had started to print dollars and pump them into the financial system. This was done to ensure that there was enough money going around and thus interest rates continued to remain low. At low interest rates the hope was that the American consumer would start borrowing and spending money again. And this spending would help revive the American economy, which had slowed down considerably in the aftermath of the financial crisis.
This process of printing money in the hope of reviving economic growth came to be referred as “quantitative easing”. The risk with quantitative easing as is the case with all money printing was that too much money would chase the same number of goods and services, and push up their prices considerably. Hence, there was a risk of high inflation. Given this, at an appropriate time the Federal Reserve would have to stop money printing and gradually pump out all the money they had printed and pumped into the financial system.
Speaking to the media on June 19, 2013, Bernanke said “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.”
What he meant by this was that if the American economy keeps improving and growing, the Federal Reserve would reduce money printing gradually later this year and would totally wind it down by the middle of next year. The Federal Reserve prints $85 billion every month to buy both private and government bonds. It pays for the bonds it buys by printing dollars. This is how it pumps printed money into the financial system and ensures that interest rates continue to remain low.
The idea of the Fed first going slow on money printing and then stopping it totally, has sent markets (stock,bond and commodity) around the world into a tizzy. When the Federal Reserve started printing money to keep interest rates down, the hope was that it would manage to get the American consumer borrowing and spending again.
But that did not happen at the same pace as the Federal Reserve hoped it would, given that the American consumer was just coming out of one round of a huge borrowing binge and wasn’t in the mood to start borrowing all over again. Meanwhile the financial system was flush with money available at close to 0% interest rates. This led to big financial investors (the investment banks and the hedge funds of the world) spotting an opportunity.
They could borrow money at very low interest rates and invest it all across the world, and make huge returns. This trade, where money was borrowed in American dollars and invested in financial assets all across the world, came to be referred as the dollar carry trade. 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.
The dollar carry trade would work only as long as the interest rates in the United States continued to remain low. Bernanke’s recent statement made it very clear that chances were that the Federal Reserve would gradually wind down on money printing. This meant that the financial system would no longer be flush with money as it had been, in turn leading to higher interest rates. Or as Bernanke put it “if interest rates go up for the right reasons – that is, both optimism about the economy and an accurate assessment of monetary policy – that’s a good thing. That’s not a bad thing.”
This is as clear as a central banker can get and has led to a bloodbath in markets all over the world. The Dow Jones Industrial Average, America’s premier stock market index fell by 353.87 points to close at 14,758.32 points yesterday. The BSE Sensex fell by 526 points to close at 18,719.29 points yesterday.
Stock markets in other parts of the world fell as well. This was primarily on account of the unravelling of the dollar carry trade. With American interest rates expected to go up, investors were busy withdrawing their money from various markets and repatriating it back to the United States.
The wave of selling in the Indian bond market was so huge that the market had to be briefly shut down yesterday when there were only sellers and no buyers in the market. This also had a huge impact on the rupee dollar rate. When foreign investors sell out of Indian financial assets they get paid in rupees. When they repatriate this money back into the United States the rupees need 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. Yesterday one dollar was worth close to Rs 60. It touched Rs 59.98 during the intra day trading.
In fact the big financial investors are even selling out on American government bonds. The return on 10 year American treasuries rose to 2.42% yesterday as investors sold out of these bonds. The 10 year American treasury is a bond issued by the American government to finance its fiscal deficit or the difference between what it earns and what it spends. In the beginning of May, the return on the 10 year American treasuries was at 1.63%.
It is important to understand here that interest rates and bond prices are inversely correlated i.e. an increase in interest rates leads to lower bond prices. And given that interest rates are expected to rise, the bond prices (including that of the 10 year American treasury) will fall. Hence, investors wanting to protect themselves against losses are selling out of these bonds. When investors sell out on bonds there prices fall. At the same time the interest that is paid on these bonds by the government continues to remain the same, thus pushing up overall returns for anybody who buys these bonds.
This explains why the return on the 10 year American treasury bond has been going up. The trouble is that the return on the 10 year American treasury acts as a benchmark for interest rates on all kinds of loans from home loans to dollar carry trade loans. 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 the government is deemed to be safest lender and hence returns on all kinds of other loans need to be higher than the return made on lending to the government.
Rising interest rates could very well put the American economic recovery in a jeopardy, which wouldn’t have been the idea behind what Bernanke said two days earlier.
What this tells us is that investors and markets all around the world haven’t really liked Federal Reserve’s decision to wind down money printing in the months to come and are voting against it. Also, Bernanke had clearly said that the Federal Reserve had no plans of withdrawing all the money it had printed and pumped into the financial system. It was only planning to go a little slow on the money printing. 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.
As has been pointed out earlier, the Federal Reserve had been buying bonds to pump the money that it is printing into the financial system. When it wants to withdraw this money it will have to start selling back all the bonds that it has bought. But there are clearly no such plans.
So even the idea of the Federal Reserve slowing down money printing is not acceptable to the market and the big financial investors, who have got so used to the idea of ‘easy money’ and all the benefits that it has brought to them.
Imagine what would happen once the Federal Reserve wants to start sucking out all the money that it has printed and pumped into the market. Just the idea of going slow on money printing has led to a market mayhem all over the world. Ben Bernanke and the Federal Reserve are now finding out that removing the so-called policy accommodation is going to be nowhere as easy as they thought it would be more than two years back.
Or as the last few lines of Hotel California sung by The Eagles go “We are programmed to receive. You can check-out any time you like, But you can never leave.” Chances are Ben ‘Shalom’ Bernanke must be humming that number right now.
The article originally appeared on www.firstpost.com on June 21, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Dollar Carry Trade
Mr Chidambaram, India's love for gold is just a symptom, not a problem
Vivek Kaul
P Chidambaram, the union finance minister, has been urging Indians not to buy gold. But we just won’t listen to him.
In the month of May 2013, India imported $8.4 billion worth of gold, up by 90% in comparison to May 2012. This surge in gold imports pushed up the trade deficit to $20.14 billion in May. It was at $17.8 billion during April 2013. Trade deficit is the difference between the merchandise imports and exports. Commerce Secretary S R Rao said “As far as trade deficit is concerned, it is very worrisome…It is largely contributed by heavy imports of gold and silver.”
A trade deficit means that the country is not earning enough dollars through exports to pay for all that it is importing. To correct this, it either needs to increase its exports and earn more dollars to pay for imports or cut down on its imports. Indian exports have been growing at a very slow pace. In fact they fell by 1.1% in May 2013 to $24.5 billion. Imports on the other hand rose by 7% to $44.65 billion.
The trouble is that when India imports gold it pays for it in dollars. Indian rupees are sold to buy these dollars. Given this there is a surfeit of rupees in the market and a scarcity of dollars, pushing up the value of the dollar against the rupee. This leads to the country paying more for imports in rupee terms.
Hence, the logic goes that India should not be importing as much gold as it is. Or as Chidambaram said a few days back “I would once again appeal to everyone please resist the temptation to buy gold…If I have one wish which the people of India can fulfill is don’t buy gold.”
But the same logic applies to oil as well. India imported $15 billion worth of oil in May 2013. Of course, oil is more useful than gold, and we need to import it because we don’t produce enough of it.
And given that gold is as useless as something can be, we don’t need to import it. Or as Chidambaram said “I continue to hope and suppose if the people of India don’t demand gold if we don’t have to import gold for a year just imagine the whole situation will so dramatically change. Every ounce of gold is imported. You pay in rupees, we have to provide dollars.”
So what comes out of all this is that the government does not want Indians to buy gold. It recently increased the import duty on gold to 8% from 6% earlier. Chidambaram even set a personal example when he recently said “I don’t buy gold, I put my money in financial instruments and I am happy.”
There are multiple problems with what Chidambaram is saying. The first and foremost is the fact that buying or not buying gold is a free economic decision that people choose to make. Or as economist Bibek Debroy wrote in a column in The Economic Times “The gold policy is futile because buying gold is a free decision of rational economic agents and gold imports are a symptom, not the disease.”
And what is the symptom? The symptom is the high consumer price inflation that prevails. People have been buying gold to hedge themselves against that inflation. As the Economic Survey of the government for the year 2012-2013, released in February pointed out “Gold imports are positively correlated with inflation: High inflation reduces the return on other financial instruments. This is reflected in the negative correlation between rising imports and falling real rates.”
What this means is that because inflation is high the real rate of return on financial instruments is very low. Why would people invest in a financial instrument like a fixed deposit or a PPF account or a National Savings Certificate, at an interest of 8-9%, when the consumer price inflation is higher than that? So what do they do? They invest in gold because they have been told over the generations, that gold holds its value against inflation.
Chidambaram has asked people not to buy gold and even gone to the extent of saying that he does not buy the yellow metal and puts his money in financial instruments. Of course, being the finance minister of the country he is unlikely to face any problems while investing in financial instruments.
But here is a small suggestion. Chidambaram should try investing in a mutual fund once on his own without going through a bank or an agent. And the bizarre number of requirements that need to be fulfilled to invest in a mutual fund, will give him a real flavour of how difficult it is to invest for an individual to invest in a mutual fund.
Or take the case of a senior citizen who invests his retirement funds in the senior citizen savings scheme run by the post office and is given a thorough run-around every time he has to go and collect the interest on the money that he has deposited.
Or take case of the spate of smses banks recently sent out to their customers asking them to furnish documents and account opening recommendations, even when customers have had accounts for more than a decade.
Given this, it is not surprising that people buy gold which is available hassle free over the counter. The Economic Survey nailed it when it said “The overarching motive underlying the gold rush is high inflation and the lack of financial instruments available to the average citizen, especially in the rural areas. The rising demand for gold is only a “symptom” of more fundamental problems in the economy. Curbing inflation, expanding financial inclusion…and improving saver access to financial products are all of paramount importance.” Hence, people will continue to buy gold when they want to, irrespective of the appeals made by Chidambaram.
Inflation is something that the government of this country has created. And when people protect themselves against it, you can’t hold them responsible for creating other problems.
When a country runs a trade deficit it doesn’t earn enough dollars to pay for its imports through exports. What happens in this situation is that dollars coming in through other sources like foreign direct investment, foreign institutional investment and citizens living abroad, are used to finance imports.
In India’s case remittances a well as deposits made by NRIs play an important part in filling up the trade deficit gap. As Andy Mukherjee points out in a column in the Business Standard “For every rupee of time deposits that Indian banks have raised from residents in the past year, 13
paise has come from the estimated 25 million people of Indian origin who live in other countries.”
World over interest rates on savings deposits are at very low levels. The same is not true about India where interest rates continue to remain high and hence it makes sense for NRIs to invest money in India.
But this investment carries the currency risk. Lets understand this through an example. An NRI decides to invest $100,000 in India. At the point of time he gets his money into India, one dollar is worth Rs 50. So he has got Rs 50 lakh to invest. He invests this in a bank which is offering him 10% interest. At the end of the year he gets Rs 55 lakh (Rs 50 lakh + 10% interest on Rs 50 lakh).
Now lets say a year later $1 is worth Rs 55. So when the NRI converts Rs 55 lakh into dollars, he gets $100,000 (Rs 55 lakh/55) or the amount that he had invested initially. Hence, he does not make any return in the process. This is because the Indian rupee has depreciated against the dollar, which is something that has been happening lately. This is the currency risk.
In this scenario, the NRIs are likely to withdraw their deposits from India because if the rupee keeps losing value against the dollar, chances are they might face losses on their investments. When NRIs repatriate their money, they sell rupees and buy dollars. This leads to a surfeit of rupees and shortage of dollars in the market, and thus leads to the rupee depreciating further.
This is a scenario that is likely to play out in the days to come. Over and above this there is also the danger of foreign institutional investors continuing to withdraw money from the Indian debt market, as they have in the recent past.
This danger has become even more pronounced with Ben Bernanke, the Chairman of the Federal Reserve of United States, the American central bank, announcing late last night that they would go slow on money printing.
As he said “the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year.”
The Federal Reserve prints dollars and uses them to buy bonds to pump money into the financial system. This ensures that interest rates continue to remain low as there is enough money going around.
As and when the Federal Reserve goes slow on money printing, the American interest rates will start to go up (in fact they have already started to go up). Given this the investors who had been borrowing in the United States and using that money to invest in India, would be looking at a lower return as they will have to pay a higher interest on their borrowing.
A prospective lower return could lead to some of these investors to sell out of India. In fact as I write this the bond market has come to a halt because there are only sellers in the market and no buyers. Such has been the haste to exit India.
When foreign investors sell out of bonds (and stocks for that matter) 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 60 ($1 equals Rs 59.9 to be precise).
A lower rupee means that the price of gold is likely to go up in rupee terms. And this can attract more investors into gold pushing up India’s gold import bill further. But then do we blame for the gold investor for that? And if that is the case why not ban all speculation, starting with real estate.
The article originally appeared on www.firstpost.com on June 20, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Before Bernanke’s statement: Why foreign investors are selling out on bonds
Vivek Kaul
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)