Reserve Money: A Tale of Two Countries post Lehman-event

Many market observers are surprised by the sustained increase in stock values across the globe since the lows hit in early March 2009.
At the same time, many Indian analysts are wondering why the credit cost to mid-sized corporate is not budging even after the significant rate cuts by RBI.
A partial answer to both the queries can be found in the development of reserve money in the USA and in India since Sept 2008 till date.
I produce below two very interesting charts, sourced from data provided by the Fed and the RBI.
First the growth in Reserve Money in USA, in % change yoy,


Note that the growth rate moved up from low single digits to more than 100% post Lehman.
Now, look at the growth in Reserve Money in India, in % change yoy,
Note that the growth rate moved down from 25% to less than 5% post Lehman.
This distinctly different path of Reserve Money has deep implications on how the two central banks will respond to ongoing crisis in the medium term, and more importantly, how the relative asset prices will move in the near future in India when compared with USA.

What is the logic of Market Stabilisation Scheme Balances as of 31st March 2009?

I have been following the Reserve Bank of India (RBI) since 1991. From late 1990s, I can count on my fingertip a few occasions where I could not understand the logic of monetary or regulatory moves of RBI. I sincerely believe that for last one decade RBI is one of the best Central Bank’s in the world.
However, the latest action of RBI on Market Stabilisation Scheme (MSS) fails any tests of logic and propriety. RBI announced yesterday that it had refrained from de-sequestering MSS worth Rs. 330 billion and the closing balance of MSS as of 31st March 2009 (year-end for Indian Government, but not for RBI, which follows June year end) was Rs. 888 billion.
Many of the readers may be aware that MSS costs significant money for Indian taxpayers. I estimate the cost of current balance of MSS at Rs. 65 billion per annum, or around Rs. 60 per Indian per annum. Given that around 40% of Indians live on less than $1.25 per day, RBI is snatching away one day’s bread from around 40% of our population.
Does RBI have a strong reason to snatch one day’s bread from our poorest brethren? I believe not. Why do I say that?
Lets look at the reason d’être for conceiving MSS:
RBI announced MSS on 23 Feb 2004, with the following logic:
“…the intention of introducing MSS is essentially to differentiate the liquidity absorption of a more enduring nature by way of sterilisation from the day-to-day normal liquidity management operations. The total absorption of liquidity from the system by the Reserve Bank will continue to be in line with the monetary policy stance from time to time” ( emphasis mine)
My question to RBI is why we need to have “liquidity absorption of a more enduring nature” to the tune of INR 888 billion, when:
1. WPI is near zero for last one year, with no sign of inflationary pressure for next six months at least
2. CPI is near zero, in my estimate, in the second half of FY09 (Oct 08 to Mar09)
3. Asset prices are experiencing strong downward trend
4. Unemployment is increasing across entire India, and across all sectors
5. Exports are experiencing 20% or more fall
6. Reserve Money growth is around zero for last one year
Also, the monetary policy of RBI has been extremely easy since Oct 2008, which demands an explanation as to how can the current levels of MSS balances be explained by “the monetary policy stance”.
Finally, RBI on 31st March 2009, gave the following reason for refraining from de-sequestering MSS:
“In view of its comfortable cash position, the Government of India (GOI), in consultation with the Reserve Bank of India, have now decided not to transfer the balance amount of Rs.33,000 crore from the MSS cash account to the normal cash account of the Government of India in the current fiscal year…”
Clearly, if the genesis of MSS was not in level of cash balances of GOI with RBI, then its demise should not be linked to the levels of cash balances of GOI.
If RBI does not de-sequester the entire amount of MSS outstanding before starting the market borrowings on behalf of GOI for FY10 (April09 to March10), then it would be doing a great disservice to the citizens of this country, as the current balances of MSS have no basis for existence in the current monitory policy regime.

I still believe RBI is the best Central Bank in the world, and it actions in near future will either correct this anamoly or provider solid reason for its current (in)action.

The unconventional FED requires further unconventional thinking to succeed

Yesterday, the US FED announced its intentions to buy the long-dated US Treasuries, after a gap of nearly four decades. The Treasuries rallied exuberantly after the decision. (Last week, we in India, worried about the volatility of Government of India Bonds yields going through roof. Now, US Treasuries have joined the bond yield volatility party. Welcome to the club.)
The question is, will the action of buying of Treasuries and all the other assorted assets by FED help the economy, by itself, or does USA needs something else?
The answer lies in the chart below.

This chart shows the balances held by commercial banks with FED. Clearly, after Sept 2008, the commercial banks have stacked up their cash with FED. Why do they need to keep cash with FED, at nearly zero yield? Clearly, the only logical reason, in normal times, is to manage transaction flows. However, these are not normal times. Banks are piling up the cash with FED as they do not want to lend to anybody else, be it corporate or another bank.
So, if FED buys more bonds from market, the banks will keep more money with FED. The net effect will be zilch.
What’s the solution? Simple. Charge banks “Safe-Keeping Charges” (SKC). FED should say that banks will be allowed to keep funds up to maximum of 0.10% of their liabilities overnight with FED without any charges. These balances are kept for transaction purpose. For any additional funds parked with FED, FED should charge 7.5% per annum SKC.
What is the logic of SKC at 7.50%. The logic flows from Taylor Rule, which suggests that the current interest rates in USA must be negative in the range of -3% to -8%, depending on what assumptions you put into the model. At 7.50% SKC, banks will face -7.50% per annum interest rate for their excess cash.
This can get credit flow in the US economy kick-started even without further buying of treasuries or agency bonds by FED, as banks themselves will go and buy these & other instruments.

Predicting the Value of Indian Rupee

INR was under considerable pressure till Nov 2008 and since then the level of INR/USD has stabilized till date. It would be interesting to see how the Indian unit will play out till March 2010. The factors that we would consider for predicting the value of INR against USD are:
1. India is a low ICOR country, as compared to most other emerging nations, especially China. If we apply an ICOR of 4.3x to our predicted GDP growth rate of 7% for FY10, we get autonomous investment of 30.5%. (The actual investment rate can be higher or lower)
2. We predict a savings rate of 31% for India for FY10.
3. This gives an autonomous surplus of 0.5% of GDP for investment – savings gap for FY10.
4. In other words, if required, India can repurchase foreigners’ capital of approximately USD 5 billion in FY10 without affecting her growth rates.
5. The fall in crude oil prices, and expected stability of crude oil at the current level, given extremely dire global conditions, means that India will reduce her oil imports by at 3% of GDP in FY10, as compared to FY09.
6. This fall in crude oil imports can provide good cushion for expected marginal increase in gap in goods export versus non-oil imports.
7. The worsening labour conditions will reduce the propensity for regular remittance inflows. However, we expect that to be compensated by increasing spreads over LIBOR for variety of NRI (non-resident Indian) products, recently allowed by RBI; and also by one-time transfer of accumulated capital by returning Indians.
8. India holds foreign exchange reserves to the tune of 25% of her GDP, while the mismatch in trade and current accounts are predicted to be quite miniscule for FY10.
9. The propensity of foreign capital to exit the country will depend on the relative growth rates in India versus rest of the world, and the level of interest rates in India versus rest of the world. India compares well on both the grounds.
10. Also, the banking system in India is both, liquid and solvent. This is not true for the banking system in USA, UK, Germany, and PIGS. This means that if somebody is looking at a country with respectable growth rates, respectable banking system, low inflation, enforcement of law and order then there is India has to figure in that list.
11. The only negative for India is her high fiscal deficit. However, since India does not depend on foreign capital to meet her Government borrowing needs, this factor should not cause a big worry, when predicting the level of INR.

So, where should INR trade one year in March 2010. This level will not be dictated by the net current or capital flows, as RBI can manage those flows through its reserves. However, RBI may consider depreciating the currency in order to maintain some sort of parity with the movement in other developing countries. Many currencies of other developing countries, especially emerging Europe have been ravaged recently. RBI would be careful in protecting the value of currency during periods of extreme fear like the current conditions show; as it knows quite well that a bleeding currency in the fearful market is like a bleeding person is shark infected water. RBI has spent approximately USD 1 billion per week during last one year in managing the currency movement, and it can continue to do so, if required, for one more year without any significant issues on credibility of doing so. Also, expected disinflation in the domestic economy means that RBI can easily replace the rupees lost during intervention in currency market by providing liquidity through other sources.

So, what is the conclusion? The most likely value for INR in March 2010 versus USD is 50 (current levels) based on India’s own fundamentals. However, RBI will take the currency up or down depending on how other currency pairs, mostly in emerging markets behave. However, the most likely prediction for other currencies is not good. RBI will allow some rub off of this weakness on INR over a period of time, especially during periods of calmness in financial markets. Hence, we can witness stability in INR during extreme conditions in global financial markets and marginal weakness during periods of relative calm in global financial markets.

May be the last point on this topic can be a possibility of SBI issuing a global retail offering at around 6% to 7% dollar coupon if the global financial conditions worsen significantly from here. In that case the US-10-year would have gone below 2%, the policy interest rates in UK and Europe would have gone below 1%, making this offering by SBI an attractive option for investors. For Indian residing abroad, the rating agencies saying India is just one notch above investment grade is not a factor while considering personal investments in India. This can attract significant money if managed well.

The risks to the above forecasts are mainly geopolitical risks:
1. How the unraveling of the failed state of Pakistan, with current establishment of Taliban rule in SWAT will affect India? The above prediction assumes that the world polity will force Pakistan to control Taliban.
2. The possible negative outcome from the general elections in India in May 2009. The above prediction assumes that the new power structure in India will have minimum acceptable economic literacy.

Strong Disinflation Predicted for India in July-Sept 2009 Quarter

The figures for WPI (Wholesale Price Index) for first week of February 2009 have just been published for India. Based on the internal model at Dawnay Day AV Analytics, we now predict the inflation for July-Sept 2009 quarter at minus 3% (-3%) or lower on yoy basis for India.

The implications of this prediction for monetary policy by Reserve Bank of India are quite significant.

Whether this trend results in a full scale transition from disinflation to deflation for India depends on how the US, UK, Germany, and Emerging Europe handle their banking crisis and how fast they nationalize their banks.

Excess Cash in the economy

In my last blog I referred to an innovative measure of financial stability for emerging economies developed by Dawnay Day AV Analytics, “Excess Cash in the Economy”.

The chart below shows the behavior of this measure for India.

There are a few interesting takeaways from this chart. India built up excess cash at great speed during the early part of current global crisis which started in the Summer of 2007. As the ripple effects of this crisis started hitting Indian Shores in the later part of 2008, India drew down the excess cash to insulate the economy from the external shock. The most important point is that India has nearly four times excess cash now, as compared to March 2003, the bottom of previous stock market cycle.

Obviously the excess cash can be used over a period of time to offer protection to the economy for coming quarters.

The Indian Demand Dynamics in the times of Global Financial Crisis

Last few days have been truly remarkable in terms of the news-flow from the Indian Hinterland. This news-flow, more or less, confirms my long-held belief that India has sufficient excess cash on hand to come out of this crisis winner. (The measure of excess cash in economy is a proprietary measure developed by Dawnay Day AV Analytics, which I will explain on some other day)
1. The Government of India announced excess borrowing for the month of March 2009. Now, the excess borrowing for FY09 is just below Rs. 1 trillion or USD 20 billion or just around 2% of GDP. The global credit rating agencies, rumbled about the possibility of a cut in India’s credit rating. The question comes to my mind, the US government & its arms, like the FED, have agreed to spend or guarantee in excess of US$10 trillion or nearly 2/3rd US GDP in last six months. Why is the US rating not cut for a potential new exposure to the tune of 2/3rd of GDP, while we talk about cutting India’s rating for a 2% excess borrowing? Anyway, this is another topic for another day.

2. I love a 2% stimulus in a matter of four months. This effectively underwrites the enterprise confidence for India, especially when the money is effectively coming in from past savings (read: MSS – Market Stabilisation Scheme of RBI), and not new borrowings!

3. This February marked the first complete-one-year period for India since 1991, when
a. There is a global economic / financial / confidence crisis, and
b. The interest rates, CRR (Cash Reserve ratio), SLR (Statutory Liquidity Ratio) are lower after one year, than at the start of the crisis.
I believe this is truly a great change for the dynamics of the future demand patterns in India.
4. The consumer durables, both brown goods and electronics, are rumored to have grown by 15% in Jan 2009 compared to the previous year. A strong rural demand has supported the growth, according to reports.

5. The Dec 2008 IIP numbers were marginally negative as expected. India seems to have shown the brightest performance in the world in Dec 2008.

6. The most interesting aspect of Indian Demand is the collapse of demand for Gold. Indians - the perennial buyers of Gold – may just turn net marginal sellers of Gold in Feb 2009. Is there any message to be read into this? The “uninformed” ill-educated people bought gold from $300 level and now, they are selling, when everybody else is buying the glittering commodity. BBC TV show attributed the Gold Selling to hardships faced by people due to collapse of world trade. However, I think I have seen more severe periods of hardships for Indian people, and they never sold Gold – they pledged it, if required to raise, fiat money.

I would eagerly await the data for Jan-Mar 2009 to slowly trickle down, and see if the market expectations turn favorable.

Disclosure of Promoters' Loan Against Shares

In the wake of the corporate scandal at Satyam, one of the regulatory changes proposed by the Indian securities regulator, Securities Exchange Board of India is to make the information on the pledges of the promoter holdings of listed companies public.
This is, in itself, a laudable measure. The non-promoter shareholders have a right to know the actual net wealth that the promoter has left in the listed entity after deducting the borrowings. In the long run, this rule will make Indian market more efficient than other emerging markets.
However, in the short-run, this rule may have devastating effect on some of the companies and their management. In the UK, FSA has similar rule for making public the pledges of promoter shareholding. Carphone Warehouse, the British mobile phone retailer, can be considered as an interesting case study for the effect of non-adherence of the rules on disclosure of the pledging of promoter shareholding.
On 8th Dec 2008, the company announced that its co-founder, David Ross, had pledged a substantial part of his shareholding in the company without informing the shareholders, and more importantly, none of the loans are in default. Also the company announced that he does not intend to sell his shares. Mr. Ross resigned from the board on the same day.
Within hours of this announcement, which apparently has no long-term impact on the business of the company, the stock price fell, leading to a 10% underperformance of the stock, compared to FTSE100. Clearly the stock market does not like promoters pledging their holdings without informing shareholders.
Given that, in India, there is absolute secrecy about the promoter pledging; the publication of this information is going to create huge ripples in the market. Corporate raiders may use this information to drive down the value of shares significantly, in order to trigger a sale by the lenders to the promoter. Even when there is no corporate raider in sight, non-promoter shareholders will exit the company where promoters have pledged a large proportion of their holding, fearing such corporate raiders in future.
Am I opposing SEBI for enforcing this measure? No. Don’t get me wrong. I am just bringing out one of the possible outcomes, and however unpleasant this outcome seems, the long-term benefits of this announcement exceeds any short-term dislocation.
In the long-run, this measure will restrain, to a large extent, promoters’ interest in manipulating the stock price, as they will not be able to use the market value of their holdings as ATM, just like subprime borrowers in USA were using the rising value of their houses as ATM through home equity loans.

FY2010 – A Watershed Year for India

The new calendar year of 2009 started with a big bang corporate fraud on which enough is being written already. There is pessimism all around. With less than 10 weeks to enter the new financial year FY2010 (April 2009 to March 2010), it would be really interesting to see what our crystal ball has to offer as predictions.
Here are a few predictions for FY2010:
01. We will enter the year with inflation below 1% and most of the first half of the year will see inflation below zero. A deflationary environment will be a first for India for the living memory.
02. The good news is that Deflation will not mean low GDP growth for India. Our worst case forecast for FY2010 is 7% GDP growth. This forecast is predicted on the following factors:
a. Buoyed by the falling prices, the young (and relatively thrifty) population of India will increase consumption by 5% in real terms. This is a full 3% lower than the growth in consumption observed in FY08. The factors that will contribute to consumption growth are:
i. Good Monsoon and High Farm Income given the increase in support prices in FY09
ii. Lower Interest Rates expected in FY10
b. Shocked by the credit crisis, the private sector investment growth will crimp to 2-3% in FY10, down from 18% observed in FY08. However, the planned renewed push into road building by the National Highway Authority of India may push the overall growth rate in investment to around 5%. This bit of prediction is subject to “execution” and political risks. We will delve on the political risks briefly in the last paragraph.
c. The collapse of the world trade will mean a fall in export of goods and services by 2-3%. This will be first full year degrowth in export in the living memory.
d. The imports will increase by 5% to support a 5% consumption growth.
e. The crude oil will remain range bound, given the dire global recession at USD 40 in FY10, a 50% reduction from FY08 average. This reduction in crude oil prices will add a full 3% to India’s GDP.
f. The recent commencement of Jamnagar Refinery, and expected gas flow from K-G and oil flow from Rajasthan will add around 1% to India’s GDP, not captured in any of the previous factors.
03. FY2010 will be first year in the living memory, to have a shortage of SLR securities in financial markets, if RBI does not reduce SLR from current level of 24%. For those who are un-initiated in Indian Banking, SLR refers to Statutory Liquidity Ratio, which stipulates, the percentage of fund which banks in India need to invest in the bonds issued by Government of India.
04. FY2010 will be the first year in the history of India to achieve 7% GDP growth without any support from FDI or FII flows. This is the first year in which I do not have to assume foreign inflows to support a huge 7% growth in GDP. Needless to say, when people buy into the 7% growth, the FDI and FII surge will happen into India, increasing the GDP further beyond FY2010.
In a true sense, FY2010 will announce the coming of age of India in the global landscape, and the next decade will belong to India; as people will be mesmerized by, the currently unexpected, stellar performance of India.
The above prediction does not include the effect of depreciation of INR versus CNY in last twelve months. At the current exchange rates, Indian manufacturing is as competitive as Chinese. As business adjust their supply lines in the next two-three years, this should give significant boost to Indian exports, at a cost to Chinese ones.
It would not be out of place, to have a special mention of the Indian Real Estate sector. The year 2006 marked the turning point, with the foreign investors’ discovery of the wonderland of Indian Real Estate sector. They all entered, and fell over each other, to buy Indian real estate through a narrow opening of Private Equity for Real Estate. I do not want to comment on the quality of investment due diligence done before launching of a plethora of very high luxury residential projects, befitting only the kings of the new world order.
Come the collapse of Lehman in September 2008, and it seemed that the cookie of Indian Real Estate has crumbled. Everybody talked endlessly about the execution risk and lack of buyers for the luxury projects. However, every crisis brings out best from people.
Some of the real estate developers, who had not put 100% of their bets on luxury projects, saw a great opportunity. The month of November saw the first launch of ‘affordable housing’ project on the outskirts of Mumbai. The project got sold in three days flat, and mind you the buyers were the people who plan to actually stay and not investors, who plan to flip. “Affordable housing” means projects which are relatively low priced per square foot, and have smaller houses than luxury home. In money terms, affordable houses cost between INR 2 million to INR 3.5 million in Mumbai. The demand for these houses is just tremendous from the middle class of India, who got left out in the property ladder during the mad boom of 2005-2007. I expect a slew of affordable housing projects in all major metros to be successfully launched in next six months, reviving the fortunes of construction industry in India. Most of the buyers of affordable housing are expected to be government employees, who have steady jobs and are not worried about the global slowdown.Finally, a few words of the biggest planned event that the world is going to witness in 2009, Indian Elections 2009 – The fabric of Indian Polity is ready to be rewoven in this election. The only prediction that one can make at this stage, is that no single party will win more than 25% of the total seats of Indian Parliament when results come out in May 2009. This hung Parliament offers ample scope for forming new alliances, and giving the new direction to the course of India economy, either for better or for worse. I personally believe that the far left, lead by various communist parties will have a poor showing in the election, given the faux passes committed by them, both in West Bengal and in Kerala. That should be, by itself, good news for the economy. However, who would be the next Prime Minister of the country? Nobody knows. I shudder at the thought of having some of the names, currently doing rounds as the probable prime ministerial candidates, as our next Prime Minister. All the economic analysis presented above is based on justifiable hope that the country’s political leadership will chose new Prime Minister with an acceptable level of economic IQ. This hope is based on the experience of 2004, when, we got Dr. Singh as our Prime Minister, almost by accident.