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The python under the boat

The huge amount of carry-trade money sitting in the Indian financial system makes it fragile

The python under the boat

Carry-trading [carry trade, practised especially in currency markets, is an investment strategy in which one borrows at a low rate of interest and invests the money in an asset which provides a higher rate of return] pressures in India are huge and terrifying. India had not financed its current account deficit (CAD) from capital account, leaving a gap of $10 billion to be funded from FPI (foreign portfolio investor) money. Another $85 billion had come in from overseas Indians, which was also carry-trading money. Add $40 billion from FPIs into the domestic bond market. Since we were not part of the Emerging Markets Bond Index, these flows could pull out any time. That's a potential $120 billion of outflows, not counting the equity outflows. The potential total base was $240 billion out of the reserves of $420 billion.

Of this, some $90 billion came in during 2014, the Modi period. We have a grossly overvalued rupee, and the RBI has taken upon itself the job of managing volatility, effectively handing over a moral hazard to the Indian importer. Exporters are generally sold one-year forward (93 per cent of annual exposures) and importers are hedged roughly 7 per cent of their annual exposures.

The funny thing is that the RBI cannot hold down interest rates, or drop them, because it is caught in a Nash equilibrium. One, inflation has upticked, but two, the carry-trading flows on which India is living could reverse because of some interest-rate hardening anywhere else in the world (particularly, US and Europe). Or a dip in Japan's trade surplus. Or a rise in Japan's fiscal deficit, etc. It's very fragile.

Hence, the inflation targeting of the RBI was with a wary eye on the hot money already sitting inside your financial system, like a python under your boat. If it raises its head, it could seriously rock your boat. Consumer credit was only 14 per cent of GDP, while non-financial corporate credit was 56 per cent of GDP. If you raise interest rates, you dampen consumer credit only marginally, with almost no impact on inflation. But you push up costs in the corporate sector, which flow through into manufacturing inflation (provided capacity utilisation is high and they have enough pricing power). So you actually feed inflation with your so-called inflation-targeting interest-rate hardening. The only thing you are doing with your interest-rate hikes is to hold onto the carry-trading flows.

A mere $20 billion of withdrawal of commodity-funding limits in 2008 had tanked the market some 40 per cent. As deleveraging accelerates, the probability of such a withdrawal has increased. Already, Indian letters of credit and letters of undertaking are no longer being discounted, especially of PSU banks. This could lead to severe trade dislocations in the very short term.

How did we get like this? Because RBI took it upon itself to start managing the volatility in the Indian rupee. And why are we choosing to manage the rupee? Because Indian businesses are not managing their exposures. But look at the cost to the nation. Lower interest rates would drive out these carry-trading flows, which would raise the dollar-rupee exchange rate, creating barriers to imports and raising the viability of domestic manufacturers. This would be a long-term increase in domestic competitiveness. And these exiting flows would have to be financed by domestic savings, which would increase domestic credit growth and the usage of domestic savings. The CAD would balance and pressure would be taken off the stock market, which is seeing too much domestic flows and hence has reached bubble proportions. Much of the flows would reverse from there and flow back into bank deposits, which could then be used to replace the buyers' credit lines that have created so much trouble.

Businesses would start to think in terms of domestic interest rates, instead of trying to arbitrage overseas lines of credit. With an equalisation of interest rates, the RBI should come down heavily on unhedged lines of credit taken by importers, forcing to pay the forward premium. This would reduce currency risk dramatically.

US fragility was very worrying, and higher structural inflation should be tanking markets, not pumping them up. ETFs are computer programs and will be forced to sell if there are withdrawals. That's another potential $20 billion of outflows. The stresses in the system can only be ignored at your peril.

Volatility is guaranteed. The key risks are rupee depreciation, even a currency crisis. If the RBI is raising interest rates (or keeping real rates high) simply with an eye on carry trades, then even if the macros improve, it simply cannot lower rates because it is riding a tiger. So, amidst improving macros, we could be left with a currency crisis because the consensus shifts towards a rate drop. The only question is when, not if this will happen.

Given that bond yields are at nearly 7.75 per cent and the earnings yields on equities are running at some 3 per cent, there is significant space for money to flow back from equities to bonds.

The problem is that this will not happen without significant pain, and nobody has the stomach to do that in an election year. But the agenda for a nationalist government under Modi (post-2019) should be to correct this huge distortion in our savings-investment structure and treat the domestic saver fairly (vis-a-vis his foreign counterpart). This will also serve the interest of the domestic borrower, who is losing competitiveness because of the high interest rates that are prevailing because of the appeasement of carry traders.

There are many policy prescriptions, and artificial barriers to our bond market is one of them. A Tobin tax would be a limited response (high withholding tax on bond coupons, for example). This would drive out carry-trading flows from the Indian bond markets, which would be replaced with domestic flows. Similar policies like increasing the maturity of NRI bonds would achieve similar results, along with a draconian mandate to importers to fully hedge their import payables.

They don't have to be done together, but a calibrated approach would be effective in changing the direction of the underlying philosophy.