Tag: Hotel California

In response to the last column a reader wrote in on Twitter saying “shudder to think what would happen [to the stock market] if FIIs[foreign institutional investors] packed their bags and left.” Since the start of the financial crisis in September 2008 and up to October 2014, the FIIs have made net purchases (gross purchase minus gross sales of stocks) close to Rs 2.76 lakh crore in the Indian stock market. During the same period, the domestic institutional investors(DIIs) made net sales of Rs 95,219 crore.
The FIIs have continued to bring in money even during the course of this year. Between January and November 10, 2014, they had made net purchases of stocks worth Rs 65,751.25 crore. During the same period, the DIIs had made net sales of stocks worth Rs 30,136.32 crore.
Over and above this, the FIIs own around 26% of the BSE 100 stocks. Deepak Parekh in a recent speech estimated that after excluding promoter shareholding and the retail segment, which do not have too much liquidity, FIIs dominate close to 70% of the stock market.
What all these numbers clearly tell us is that the foreign investors run the Indian stock market. But that we had already established in the last column. In this column we will try and address the question as to what will happen if foreign investors packed their bags and left? The simple answer is that the stock market will fall and will fall big time. The foreign investors control 70% of the stock market and if they sell out, chances are there won’t be enough buyers in the market.
Nevertheless, the foreign investors also know this, so will they ever try getting out of the Indian stock market, lock, stock and barrel? This is where things get a little tricky.
Let’s try and get deeper into this through a slightly similar situation in a different financial market. Over the years, the United States(US) government has spent much more than it has earned and has financed the difference through borrowing. As on November 7, 2014, the total borrowing of the United States government stood at $ 17.94 trillion dollars. The US government borrows this money by selling financial securities known as treasury bonds.
A little over $6 trillion of treasury bonds are held by foreign countries. Within this, China holds bonds worth $1.27 trillion and Japan holds bonds worth $1.23 trillion. Even though the difference in the total amount of treasury bonds held by China and Japan is not much, China is clearly the more important country in this equation.
Why is that the case? James Rickards explains this in great detail in Currency Wars—The Making of the Next Financial Crisis. The buying of treasury bonds by the Japanese is not as centralized as is the case with China, where the People’s Bank of China, the Chinese central bank, does the bulk of the buying. In the Japanese case the buying is spread among the Bank of Japan, which is the Japanese central bank, and other institutions like the big banks and pension funds.
The United States realizes the importance of China in the entire equation. Right till June 2011, China bought American treasury bonds through primary dealers, which were essentially big banks dealing directly with the Federal Reserve of the United States. But since then things have changed. The treasury department of the US (or what we call finance ministry in India) has given the People’s Bank of China, a direct computer link to its bond auction system.
Also, there is a great fear of what will happen if the Chinese ever decide to get out of US treasury bonds, lock, stock and barrel. It will lead to a contagion where many investors will try getting out of the treasury bonds at the same time, leading to a fall in their price.
A fall in price would mean that the returns on these bonds will go up, as the US government will continue paying the same interest on these bonds as it had in the past. Higher returns on the treasury bonds will mean that the interest rates on bank deposits and loans will also have to go up.
This can lead to a global financial crisis of the kind we saw breaking out in September 2008. Nevertheless, the question is will China wake up one fine day and start selling out of US government bonds? For a country like China, which holds treasury bonds worth $1.27 trillion, it does not make sense to wake up one day and start selling these bonds. This as explained earlier will lead to a fall in bond prices, which will hurt China as the value of its investment will go down. China has invested the foreign exchange that it earns through exports, in treasury bonds.
As on September 30, 2014, the Chinese foreign-exchange reserves stood at close to $3.89 trillion. Hence, nearly one third of Chinese foreign-exchange reserves are invested in US treasury bonds. Given this, it is highly unlikely that China will jeopardise the value of these foreign-exchange reserves by suddenly selling out of treasury bonds.
What China has done instead is that since November last year its investment in US treasury bonds has been limited to around $1.27 trillion. Also, some threats work best when they are not executed.
Hence, when it comes to the Chinese and their investment in treasury bonds, the situation is best expressed by the Hotel California song, sung by The Eagles: “You can check out any time you like, but you can never leave.”
Now let’s get back to the FIIs and their investment in the Indian stock market. Isn’t their situation similar to the Chinese investment in US treasury bonds? If they ever try to exit the Indian stock market lock, stock and barrel, it is worth remembering that they control nearly 70% of the market. When foreign investors decide to sell there won’t be enough buyers in the market. Hence, stock prices will fall big time, leading to foreign investors having to face further losses on the massive investments that they have made over the years.
Given this, are the Chinese in the US and foreign investors in India in a similar situation? Does the Hotel California song apply to foreign investors in India as well? Prima facie that seems to be the case. But there is one essential difference that we are ignoring here.
Nearly one third of Chinese foreign-exchange reserves are invested in US treasury bonds. Hence, China has a significant stake in the US treasury bond market. The same cannot be said about foreign investors in India’s stock market, at least when we consider them as a whole.
As Deepak Parekh said in a recent speech “India ranks among the top 10 global equity markets in terms of market cap. However, India accounts for just 2.4% of the global market capitalization of US $64 trillion.” Given this, in the global scheme of things for foreign investors, India does not really matter much.
Hence, if a sufficient number of them feel that they need to exit the Indian stock market, they will do that, even if it means that they have to face losses in the process. As mentioned earlier, in the global scheme of things, these losses won’t matter. Also, a lot of money brought into India by the FIIs has been due to the “easy money” policy run by the Federal Reserve of the United States and other Western central banks.
These central banks have printed money to maintain interest rates at low levels. The foreign investors have borrowed money at low interest rates and invested in the Indian stock market. Once these interest rates start to go up, it may no longer make sense for them to stay invested in India. Of course, it is very difficult to predict when will that happen.
Nevertheless, it is worth remembering what Steven Pinker writes in his new book The Sense of Style—The Thinking Person’s Guide to Writing in the 21st Century: “It’s hard to know the truth, that the world doesn’t just reveal itself to us, that we understand the world through our theories and constructs, which are not pictures but abstract propositions.”
And whatever I have written in today’s column is my abstract proposition. Hence, the question still remains: Will foreign investors ever sell out of the Indian stock market, lock, stock and barrel?

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)

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