RBI is behaving like a football goalkeeper

RBI-Logo_8
 
Vivek Kaul
A former well respected governor of the Reserve Bank of India (RBI) once told me that in a “moment of crisis the central bank can’t be seen to be doing nothing” even if “do nothing” might be the best strategy to follow.
This might well be the spur behind the RBI’s recent defence of the rupee. It started its defence when the currency first closed in on the 60 per dollar mark, by selling dollars.
But selling dollars couldn’t go on indefinitely. India’s foreign exchange reserves are around $280 billion – equal to around six-and-a-half months’ imports. Such low levels of forex reserves haven’t been seen since the 1990s.
Then the central bank tried to squeeze out rupee liquidity by severely limiting the amount of money that banks could borrow from it at the repo rate, or the rate at which the RBI lends to banks, now at 7.25%.
Banks are now allowed to borrow only up to 0.5% of their deposits at the repo rate. Beyond that, they need to borrow at the marginal standing facility rate, which is at 10.25%. That’s 300 basis points (one basis point equals one hundredth of a percentage) higher than the repo rate.
This has started to push up interest rates in general.
Banks are also supposed to maintain an average cash reserve ratio of 99% with the RBI on a daily basis, against the earlier requirement of 70%.
The RBI had hoped that all these moves would squeeze rupee liquidity out of the market and help it gain value against the dollar.
But nothing of that sort happened. On Tuesday, the rupee lost further value to hit an all-time low of 61.80 to the dollar intraday, before recovering to close at 60.81, again, with RBI intervention.
Several economists have now come around to the view that the rupee will continue to lose value against the dollar. Rajeev Malik of CLSA, for one, sees the rupee hitting 65-70 to the dollar by next year.
Given this, the RBI’s intervention might at best postpone the inevitable.
But the central bank can’t stop trying, can it?
Albert Edwards of Societe Generale has a very interesting analogy explaining this. As he pointed out in a report earlier this year. “When there are problems, our instinct is not just to stand there but to do something… When a goalkeeper tries to save a penalty, he almost invariably dives either to the right or the left. He will stay in the centre only 6.3% of the time. However, the penalty taker is just as likely (28.7% of the time) to blast the ball straight in front of him as to hit it to the right or left. Thus goalkeepers, to play the percentages, should stay where they are about a third of the time. They would make more saves.”
But they rarely do that. “Because it is more embarrassing to stand there and watch the ball hit the back of the net than to do something (such as dive to the right) and watch the ball hit the back of the net,” wrote Edwards.
The RBI is like a football goalkeeper right now. It can’t just stand pat.

The article originally appeared in the Daily News and Analysis dated August 7, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

India is screwed, no matter what RBI does on rupee

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 www.livemint.com 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 www.firstpost.com on June 26, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Chidamabaram didn’t start the rupee fire, but India is burning because of it

rupee
Vivek Kaul
P Chidambaram, the finance minister, made the routine let’s not get worried statement, over the rupee’s recent fall against the dollar.“We are watching the situation. RBI will take whatever action it has to take. We will (do) whatever has to be done…My request is you should not react in panic. It’s happening around the world,” he said.
This was something that was reiterated by 
Arvind Mayaram, secretary of the department of economic affairs, in the ministry of finance. “No, I don’t think the government needs to take any measures…We are watching the situation closely…If you see weakening of all currencies vis-a-vis the dollar, the rupee is also not unaffected in that sense…this panic in the market is unwarranted.”
A finance minister and his bureaucrat are expected to defend a falling currency. And yes, it’s true a lot of currencies have lost value against the dollar recently. But does that make the pain any lesser for India? Are there no reasons to worry as Mayaram wants us to believe?
Chidambaram’s “it is happening around the world” argument can be tackled with a simple analogy. Let’s say one of your neighbours starts a fire by mistake, which eventually spreads to your house. What do you do in such a situation? You try and stop the fire from spreading further, rather than sitting and blaming your neighbour for it or saying that I should not panic because I did not start the fire. Irrespective of where the fire started, the damage is yours, if you do not work towards putting it off.
Even though the rupee is falling against the dollar because of 
certain actions taken by the Federal Reserve of United States, it is clearly damaging India.
A depreciating rupee means that India has to pay more in rupee terms, for its oil imports. The price of the Indian basket of crude oil was at around $98 per barrel at the beginning of June.
It rose to $104 per barrel on June 19, 2013. On June 20, 2013, it fell to $101.8 per barrel. The rupee during the same period has fallen to Rs 60 to a dollar(Rs 59.75 as I write this) from around Rs 56.5 at the beginning of .
What this means is that India’s oil import bill has gone up in rupee terms. If the government decides to pass on this increase to the final consumer in the form of an increase in the price of diesel, petrol and kerosene, then it will lead to inflation or higher prices.
In fact CNG prices have already been hiked in Delhi by Rs 2, because of a weaker rupee.
If it decides to take on a part of the increase then it means greater expenditure for the government. A greater expenditure in turn means a higher fiscal deficit for the government. Fiscal deficit is the difference between what a government earns and what it spends. A higher fiscal deficit means that the government has to borrow more to finance its expenditure and this leads to higher interest rates, which holds back economic growth.
Coal is another big import item. With the rupee losing value against the dollar the cost of importing coal is going 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 will lead to a higher cost of power, which will add to inflation. 
As Anand Tandon writes in The Economic Times “Inflation at the consumer level will start hotting up in the third quarter of the fiscal year as increases in power and fuel cost work their way through the system.”
A depreciating rupee will benefit Indian exporters, or so goes the argument. As rupee loses value against the dollar, an exporter who gets paid in dollars, gets more rupees, when he converts those dollars into rupees, thus boosting his profits.
This argument doesn’t really hold. 
The Economic Times quotes Anup Pujari, director general of foreign trade (DGFT), on this issue. “It is a myth that the depreciation of the rupee necessarily results in massive gains for Indian exporters. India’s top five exports — petroleum products, gems and jewellery, organic chemicals, vehicles and machinery — are so much import-dependent that the currency fluctuation in favour of exporters gets neutralised. In other words, exporters spend more in importing raw materials, which in turn erodes their profitability.”
The other thing that seems to be happening is that in a tough global economic environment, buyers are renegotiating contracts with Indian exports as the rupee loses value against the dollar.”The moment the rupee falls sharply against the dollar foreign buyers try to renegotiate their earlier deals. As most exporters give in to the pressure and split the benefits, the advantages of a weak rupee disappear,” Pujari told 
The Economic Times.
What this means is that a weaker rupee is unlikely to lead to higher exports. This means that the trade deficit or the difference between imports and exports will continue to remain high, which can weaken the rupee further against the dollar.
In fact, a depreciating rupee has rendered 
nearly 25,000 diamond workers in Surat jobless, reports The Times of India. “The depreciating rupee has resulted in nearly 1,200 small and medium diamond unit owners in shutting shops as they are unable to purchase rough stones whose prices have touched an all-time high. This has led to at least 25,000 workers being rendered jobless since last Thursday,” the report points out.
The rupee could have fallen to a much lower level against the dollar, but it did not. This is primarily because the Reserve Bank of India(RBI) has been defending the rupee, by selling dollars from its foreign exchange reserves, and buying rupees.
But the question is till when can the RBI keep selling dollars? “Foreign exchange reserves are barely sufficient to cover seven months of imports — the lowest it has been in the last 15 years. As a comparison, the other Bric members have 19-21 months of import cover,” writes Tandon. 
According Bank of America-Merril Lynch, the RBI can sell up to $30 billion to support the rupee.
The RBI cannot create dollars out of thin air, only the Federal Reserve of United States can do that.
Given this, there are reasons to worry. And yes, the Chidambaram’s UPA government did not start this rupee fire, but that does not mean that India is not burning because of it.

The article originally appeared on www.firstpost.com on June 25, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why interest rates do not follow Newton's third law of motion

newton
Vivek Kaul
Newspaper editors are great believers in Newton’s third law of motion i.e. every action has an equal and opposite reaction. So if the Reserve Bank of India (RBI) governor Duvvuri Subbarao cut the repo rate by 0.25%, it should immediately translate into banks cutting interest rates on their loans as well. Repo rate is the interest rate at which RBI lends to the banks.
So if you are the kind who still reads newspapers you would have come to the conclusion by reading today’s edition of almost any newspaper that equated monthly instalments(EMIs) on loans are about to take a dip. The logic being that now that the RBI has cut the repo rate and that will lead to banks cutting the interest rates on their various loans as well and passing on the benefits to their current consumers and prospective customers.
Now only if it was as simple as that. Lets try and understand why.
The basic business model of any bank is very simple. It raises money as deposits at a certain rate of interest and then lends it out at a higher rate of interest. The difference in interest rate at which it lends and the interest rate at which it borrows is the money that a bank makes.
So for a bank to be able to cut interest rates on its loans it should first be in a position to cut interest rates on its deposits. Now this is where things get interesting.
The loans of banks (non food lending i.e.) over the last one year (between January 13, 2012 and January 11, 2013, which is the latest data available) have grown by around 15.7%. During the same period the deposit growth of banks has been at 12.8%.
Over the last period of the last six months (i.e. between July 13, 2012 and January 11, 2013) the trend is similar. The lending by banks has grown by 6.8% whereas the deposits have grown by 5.1%.
What this means in simple English is that banks are lending money at a much faster rate than they are able to raise through deposits. Hence, money is tight and banks will need to continue offering high rates of interest on their deposits. Given this, they will have to keep charging higher rates of interest on their loans.
And hence lower EMIs won’t be possible despite the firm belief of newspaper editors in Newton’s Third Law of Motion.
What is interesting is that this trend has been playing out for a while now. In 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012) bank deposits grew by 13.8% whereas loans grew by 16.3%. In 2010-2011 (i.e. the period between April 1, 2010 and March 31, 2011) the deposits grew by 16.7% whereas loans grew by 23.3%.
The other metric to look at here is the incremental credit deposit ratio. For the period of the last six months this stands at 99.3%. This means that for every Rs 100 that the bank has raised as a deposit in the last six months it has given out Rs 99.3 as a loan.
Now this is a problematic situation to be in. For every Rs 100 raised as a deposit the bank has to maintain a statutory liquidity ratio of 23% i.e. invest Rs 23 in government bonds. Governments bonds are basically bonds issued by the central government to finance its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.
Banks also needs to currently maintain a cash reserve ratio of 4.25% with the RBI i.e. for every Rs 100 raised as a deposit the bank needs to maintain Rs 4.25 with RBI as a deposit. The CRR will come down to 4% from February 9, 2013.
So what does this mean? It means that for every Rs 100 raised as a deposit Rs 27.25 (Rs 23 + Rs 4.25) cannot be given out as a loan. The remaining Rs 72.75 (Rs 100 – Rs 27.25) can be loaned out. Even there the bank needs to maintain some cash in its vaults to pay people who may be withdrawing money from the bank.
So given all this for every Rs 100 that a bank raises as a deposit it can basically loan out around Rs 65-70. But in the last six months the banks have loaned almost every rupee that they have raised as a deposit.
How has that been possible? That has been possible because banks have been withdrawing money that they have invested in government bonds in the previous years and giving that money out as loans.
This is something that may not be possible forever because banks needs to maintain a SLR of 23%. They can’t go below that. As T N Ninan wrote in the Business Standard sometime back “In the last two of these years, the credit growth rate (i.e. the loan growth rate) outpaced that of deposits; as should be obvious, this cannot go on indefinitely. And here’s the thing; nearly 40 per cent of the lower credit growth over the past year has been financed by a drop in banks’ investment in government securities; so a good bit of the money that has been lent has not come from customer deposits. Banks could continue to pull money out of government securities, but if they did that the government would not be able to finance its deficit.”
In this scenario where banks are lending out almost every bit of the money they are raising as deposits it is difficult for them to cut interest rates on their deposits and hence on their loans.
The only way bank interest rates can come down is if the government borrowings come down. And that is only possible if the government is able to manage its burgeoning fiscal deficit. Whether that happens on that your guess is as good as mine.
Meanwhile, newspaper editors will continue to believe in Newton’s third law of motion.

The article originally appeared on www.firstpost.com on January 30, 2013, with a different headline
(Vivek Kaul is a writer. He can be reached at [email protected])