India's new central banker to face impossible choices

India is about to get a new new central bank governor, Raghuram Rajan, a University of Chicago economist with outstanding academic credentials. He is expected to start this Thursday, smack in the middle of a financial crisis the likes of which have not been seen in India since the early 90s. He will be dealing with a no-win situation in which he is faced with just two key choices:

1. Let the currency continue to fall and face a dramatic rise in inflation and a corporate sector struggling with increasing import prices. That could lead to a rise corporate failures as margins are squeezed. The currency fall would be exacerbated by the fact that several large Indian firms carry some of their liabilities in dollars. Furthermore, the government deficit will rise further as it continues to subsidize ever more expensive fuel imports.

2. Tighten liquidity further and raise short-term rates risking credit contraction and potentially a recession.

Up to now the RBI has tried to run with #2, but so far it hasn't worked. The rupee traded near all-time lows again today.

Source: Investing.com

And now we are seeing this uncertainty and tight liquidity quickly spill over into the "real economy". The GDP growth slipped to nearly a decade low (see chart) and yesterday we saw the manufacturing sector contracting in August for the first time since the Great Recession.

Source: Markit

The RBI of course could also use its foreign reserves to defend the currency. But once the markets sense that the reserves are running low, debt downgrades and market panic will ensue, with the 1991 nightmare scenario (see post) becoming a reality. At this stage the RBI will avoid using its reserves in outright rupee purchases as much as possible. The central bank could also perform some sterilized operations (see post), but these tend to be fairly short-lived.

India's new central banker certainly has his work cut out for him. He is expected to be more transparent with the markets and provide better leadership, hoping to instill some much needed confidence in India's central bank. Unfortunately what India faces is a structural issue, driven by a massive current account imbalance resulting from funding the trade deficit with foreign capital inflows. This capital from foreign investors however has recently turned into outflows. To solve that will take time. The economy will need to be restructured in order to reduce this dependence on imports and some of the nation's controlled domestic markets will need to become more flexible. But time is something the RBI and its new governor do not currently have.

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RBI sells dollars directly to oil importers; kicks the can down the road

India's central bank, the RBI, is trying new measures to stabilize the rupee. One of the key sources of pressure on the currency is the nation's need to import fuel. Oil companies have to buy dollars (sell rupees) in order to purchase crude oil in the international markets (including from Iran) to meet the nation's massive energy needs.

Rather than having these oil firms go into the foreign exchange markets to buy dollars (which have become more expensive by the day) the RBI wants to sell them dollars directly. And it would do so at some rate which is better than what these firms can get in the spot market. The goal is to keep these large importers from flooding the market with rupees.

Reuters: - The Reserve Bank of India will provide dollars directly to state oil companies in its latest attempt to shore up a currency that has slumped to a record low, reflecting the stiff economic challenges facing the country in an uncertain global environment.

The Reserve Bank of India announced late on Wednesday a special window "with immediate effect" to sell dollars through a designated bank to Indian Oil Corp Ltd, Hindustan Petroleum Corp, and Bharat Petroleum Corp "until further notice".

The RBI last opened such a window during the 2008 global financial crisis, although it had been widely expected to re-implement the measures after last month telling oil companies to buy dollars from a single bank.

The steps are the latest in a series of extraordinary measures undertaken by the RBI to combat a currency fall of more than 20 percent this year, by far the biggest decline among the Asian currencies tracked by Reuters.

The announcement of this decision stabilized the rupee - for now.

USD/INR (source: Investing.com)

Many observers view this action as having only a temporary effect. According to Reuters, the RBI will "sterilize" the dollars it provides to India's large energy firms. As it sells dollars to the oil companies, it will simultaneously buy dollars in the forward market to replenish its foreign reserves in the future. The central bank is doing what it can to avoid a repeat of 1991, when foreign reserves dwindled - forcing India to seek help from the IMF (see post).

Reuters: - Officials familiar with RBI thinking told Reuters the dollar sales for state-run oil companies would be offset by positions in forward markets.

That means that although the RBI would need to dip into its currency reserves, it had the prospect of replenishing the lost dollars at a future date by redeeming the forward contracts from oil companies when the rupee stabilises.

The offsetting positions would essentially make these dollar loans, designed to reduce concerns about reserves that at $279 billion, cover only about seven months of imports.

The action further cements the role the central bank is taking to combat the fall in the rupee, as the government has yet to unveil steps that can convince markets it can stabilise the rupee and attract foreign investment.

However when those forwards mature, the RBI will take the dollars back and release the rupees into the market, putting downward pressure on the currency again. Of course the central bank can roll the forwards for a long time, but the more dollars it sells to the oil firms, the more dollars it will need to purchase in the forward market. The RBI is simply kicking the can down the road, creating a growing overhang of rupees that will eventually have to hit the market (as RBI gets the dollars back.)  The hope is that by then the pressure on the currency won't be as great as it is now.

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Rupee's weakness may help exports but could do damage elsewhere

Indian rupee's slide to record lows has been extraordinary. It's been driven by weakness across emerging markets and rising rates in the US. As foreign investors exit (accompanied by domestic accumulation of dollars), India's central bank has been reluctant to intervene in order to halt the rupee's slide.

USD/INR (rupees per one dollar)

While this is expected to help companies in service export sectors (IT services, etc.), it will compress margins for other firms. Weaker currency raises input prices for firms that import parts, materials, etc. who are often not in a position to increase their output prices. The divergence between input and output prices in India is already visible.

Source: JPMorgan

Moreover, firms such as Reliance and Bharti Airtel who borrowed in other currencies, are watching their liabilities rise when converted into rupees.

Perhaps the most troubling aspect of this rupee weakness is the chart below which shows Brent crude oil denominated in rupees. For India, oil prices currently stand at recent record highs (except possibly the oil India buys from Iran at a discount). Given that domestic petroleum is generally subsidized by the government, this spike is sure to put significant pressure on India's fiscal balance.

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India's stubborn inflation trend puts RBI in a bind - rate likely on hold

India continues to struggle with stubbornly high inflation levels. In spite of slower economic growth, the Wholesale Price Index (WPI) clocked at 7.81% in September, putting the RBI in a real bind. The central bank needs to cut rates as growth has moderated, but it is difficult to do with inflationary pressures unresolved.

The Times of India: - The Wholesale Price Index (WPI) inflation figures are out but those looking for repo rate reductions in the forthcoming October 30 monetary policy announcements by the RBI may be in for some disappointment. According to economists, the WPI figure, though certainly better than the 10%-odd inflation numbers that the economy was totting up till recently, is still not good enough for the RBI to cut rates. In other words, things aren t as bad as before but they are not good enough to merit a growth-inducing repo rate reduction by the RBI.

Part of the issue with India's stubbornly high inflation is that it has been elevated for an unusually prolonged period.

GS: - India has experienced a sustained period of high headline inflation since late 2009. In this period, inflation, as measured by the Wholesale Price Index (WPI), has averaged 9% and has not fallen below 7%. Indeed, the high inflation period can be seen from 2007, with a blip due to the GFC between February and November in 2009. This prolonged period of high inflation has not been witnessed since the early-1990s.

The problem that often accompanies long periods of inflation is the establishment of deeply rooted inflation expectations. Households now fully expect double digit near-term and longer term inflation. The recent rise in food prices is only going to exacerbate these expectations. And as central banks learned from past experiences, inflation expectations create a feedback loop with the actual inflation that is extremely difficult to break. That's why RBI is likely to be on hold for some time.

Source: GS

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India needs to cut fuel subsidies to avoid fiscal deterioration

India's government took action today to stem the currency declines, as INR reached all-time lows on Friday.

Reuters: India announced steps on Monday to bolster the embattled rupee, including a $5 billion increase in the foreign investment cap in government bonds, but disappointed markets hoping for bolder action to prop up a currency that hit a record low on Friday.

And here is the result:

INR per one dollar

The market pretty much shrugged it off, leaving the INR to USD exchage rate almost where it was before the new policy was announced. Too little, too late.

Beyond India's economic deterioration, one of the things that's spooking investors (and keeping the currency weak) is the government's fiscal situation. With strong GDP growth, government debt levels looked acceptable. But the slowdown will materially increase risks to sovereign bondholders (particularly as RBI becomes a key buyer - remember subordination? ).

Deutsche Bank has proposed a good solution - cut fuel subsidies, especially for diesel, which is the most subsidized fuel.

DB: - It is imperative that a fuel price adjustment is made to prevent serious deterioration of the fiscal outlook, which is under the scrutiny of ratings agencies. Policy actions to raise fuel price, expedite asset sales, pushing through some investor friendly reforms are needed sooner than later. Global oil price decline is a necessary but not sufficient development to turn around India at this juncture.

India's government has been financing growing fuel subsidies, creating market distortions as the usage of diesel vs. other fuels spiked.

Source: DB

Over time as government price increases failed to keep up with the market, the subsidies became ever more expensive, putting the government budget at risk.

Source: DB

DB: - Diesel constitutes almost 55% of the fuel subsidy bill on an average, followed by LPG (25%) and kerosene (20%). Lower global oil prices will help to reduce the subsidy bill, but a weak rupee and rising consumption (in the absence of price hikes), will tend to dilute some of this beneficial impact and keep the pressure on the fiscal intact.
...
In FY11/12, when real GDP growth slowed substantially to 6.5% (from 8.4% in FY10/11), fuel consumption growth in fact rose to 4.9%, up from 2.3% in FY10/11, led mainly by a surge in diesel consumption (7.8% vs. 6.8%).

When price increases are not passed to the consumer, there is no incentive to decrease usage and subsidies can grow out of control (supply/demand fundamentals are out of balance). Here is an example. Remember the bankruptcy of Pacific Gas and Electric Company (PG&E) in California?

Wikipedia: - In 1998, a change in the regulation of California's public utilities, including PG&E, began. The California Public Utility Commission (CPUC) set the rates that PG&E could charge customers and required them to provide as much power as the customers wanted at rates set by the CPUC.

When the wholesale power price spiked (partially driven by manipulation - which would be much harder to pull off without the subsidies), the utility was unable to pass it on to the customer. And the consumer cranked up the power with little regard for the overall implications because power was so cheap. Subsidies forced on PG&E's ended up putting it into bankruptcy. 

Making cheap fuel available to the country at the expense of rising debt levels may look like a popular political solution, but it will not end well. A gradual reduction in these subsidies (as painful as it may be) will be critical to restore confidence. And while crude prices are subdued, this may be the best time to do it.

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India's currency spirals out of control

The Rupee hit a lifetime low against the dollar as flow of capital out of the country accelerates. The RBI (central bank) has been selling record amounts of dollars to slow down INR's fall, but so far has been unable to do so.

Reuters: - Traders said the central bank likely sold $250-300 million dollars on Friday to rescue the Indian currency.

INR per one dollar

The authorities are looking for ways to stem the declines.

Bloomberg: Indian Finance Minister Pranab Mukherjee said the government and central bank will announce measures on June 25 to halt a slide in the rupee after the currency sank to a record low two days ago.

Investors now lack the confidence that the RBI will be able to accomplish much, as the central bank tries to battle India's stagflation. "Take your money out first, ask questions later", one investor said.

The Economic Times: - Not much has changed in the last few months, India's high current account deficit, high fiscal deficit, slowing economy; rising inflation are factors that are hurting the local economic growth.

Some speculate that India will launch government guaranteed deposit accounts and loosen foreign investment rules in order to attract capital. The hope is also that at some point property markets may become attractive to foreigners (in dollar terms) and capital will start returning. But so far that has not been the case. The cash settled forward (NDF) market for rupee is indicating expectations for the exchange rate to get worse - with another 2% depreciation over the next 3 months. 

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India's QE would even make Bernanke jealous

Expectations were high last week that India's central bank would cut rates. After all, the slowdown in growth has become quite visible.

Reuters (last week): - ... supporting bond prices are expectations the RBI will cut interest rates by 25 basis points this month after recently weak January-March economic growth data. Some analysts expect an additional cut in the cash reserve ratio, or the money banks must park with the central bank.

Instead we got no change in rates today with the following statement:

RBI - ... notwithstanding the moderation in core inflation, the persistence of overall inflation [CPI is above 10%] both at the wholesale and retail levels, in the face of significant growth slowdown, points to serious supply bottlenecks and sticky inflation.

Inflation indeed remains sticky. With the rupee at 56 to the dollar (near all-time low), risks of food inflation are still substantial, while labor costs continue to grow (wage inflation has been a real issue).

It seems however that some of these inflationary pressures and currency weakness may be caused by RBI's own policies of balance sheet expansion.

Reuters: - The OMOs [open market operations] from the Reserve Bank of India would resume bond purchases after a two-week absence, helping offset the impact of expected outflows as corporates start paying taxes ahead of the June 15 deadline.

The RBI is injecting funds to facilitate tax payments? If so, that would be a one shot transaction that later gets "mopped" up. But the RBI has not been selling the bulk of its securities back into the market. In fact the recent aggressive rate of net purchases has been nothing short of a full blown quantitative easing (QE).

Credit Suisse: - In FY13, the RBI has bought Rs687 bn of bonds until 12 June. This annualises to an unprecedented Rs3.4 tn of bond-buying, and at 3.4% of the GDP, it is a level of monetary stimulus that is rare even in these times globally. To put things in perspective, the Fed’s bond buying in 2011 was 3.9% of US GDP.

The central bank seems to be targeting to lower long-term rates (the 10-year is at 8.2%) - similar to what the Fed has been doing but without selling the equivalent amount of short-term securities.

Credit Suisse: - What is worrying for us is that the un-announced purchases continue to be meaningful. Only Rs480 bn of the Rs687 bn has been through pre-announced Open Market Operations (OMOs), and the rest through un-announced unsterilised interventions. The latter can be seen as an attempt at yield management by the central bank.

The chart below shows the cumulative securities purchases by the central bank since 2008.

Purchases - Sales - Redemptions (cumulative since 1/1/2008)

This policy of QE could certainly explain the currency weakness and inflationary pressures the nation has been facing. So far this approach has resulted in a stagflationary environment that will be increasingly difficult for the RBI to overcome.

Let's hope this provides a good case study for the FOMC as they prepare for the June meeting.

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India facing stagflation

India (as discussed back in December) is now struggling with one of the most difficult environments an economy could face - stagflation. Here are the latest four economic trends:

1. India's export growth is declining.

India: Merchandise Exports YoY

2. Industrial production is down sharply.

India: Industrial production YOY

3. Yet wholesale inflation is staying stubbornly high, driven by food inflation. Food inflation can be particularly devastating for developing economies where food costs are such a high proportion of household expenses.

India: Wholesale Inflation YOY

4. But the most worrying sign is the rupee weakness. INR hit new lows against the dollar - below the levels reached in December (the chart below shows how many rupees can be bought with one dollar).

USD-INR exchange rate

Rising import costs (particularly food inflation) are nearly impossible to control when the currency weakens this much.

Credit Suisse: With India looking rather stagflationary at present, the Reserve Bank of India faces somewhat of a dilemma. Does it ease policy further on the basis that economic growth is very weak and core inflation soft or keep rates unchanged as it worries about headline inflationary pressures?

The Reserve Bank of India (RBI) will likely cut rates again, simply because the core inflation remains relatively tame (core inflation as measured by RBI actually declined 0.1% due to a slowdown in manufacturing demand). But the outlook for growth is far from certain. With currency weakening, inflation could become difficult to control while growth is showing signs of slowing. These are the signs of stagflation.

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India struggling with slower growth and rising costs

India's GDP had taken a turn for the worse in Q4, with growth rate of 6.1% - below analysts expectations. The correction in growth looks similar to the 08-09 period.

India GDP growth (Bloomberg)

This is particularly troublesome, given that inflation remains high. Even as food inflation has receded somewhat, wholesale inflation ex-food remains high.

Source: ISI Group

Corporate staffing costs continue to grow at double digit rates and a weaker rupee combined with the recent increase in oil prices is putting upward pressure on fuel costs in India. In addition, with government bonds still yielding above 8%, corporations are struggling with high funding costs. In effect these high government bond yields are crowding out corporate debt. All this adds up to declining corporate margins.

Given the reduction in GDP growth, it is likely that RBI will lower rates on March 15th. But the central bank continues to be in a tough spot trying to balance these inflationary pressures with slower growth. Risks of a "hard landing" in India remain high.

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RBI intervenes in the currency market

Here is a quick followup to a recent post called “India's central bank - between a rock and a hard place”

Last night the RBI reacted swiftly to address the severe pounding the currency has been taking recently. INR (the rupee) is a “controlled” currency – not freely traded the way something like JPY trades. The banking system is also quite tightly regulated. Therefore the RBI was able to take a somewhat unorthodox action – restrict in trading of currency forwards.  This is in addition to capping the amount of outright FX exposure Indian banks can maintain.

The Times of India: Dealers said the sharp recovery of the rupee was due to restrictions imposed by the RBI on forward trading in the local currency by FIIs and traders, besides the cap fixed on banks' exposure to the forex market. 

The impact on INR  was immediate – see chart.

USD/INR (Bloomberg)

However the currency is still down on the week and continues to stay weak relative to historical levels. What’s more troubling is that the stock market has weakened to new recent lows (see chart) – indicating rising risks of a slowdown in India's economy.

NSE NIFTY Index (Bloomberg)

The latest GDP growth figure was 6.9%.  This indicates the next reading may be lower.

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India's central bank - between a rock and a hard place

The Reserve Bank of India (RBI) is in a tough spot. With the headline wholesale inflation coming in at 9.1% and the core at 7.8%, the standard approach would be to keep tightening. But how much tighter can the monetary policy get before choking off growth?

MarketWatch: In late October, India’s central bank delivered its 13th hike in interest rates since March 2010, raising its key lending rate to 8.5% and its borrowing rate to 7.5%. But it signaled that a pause was likely at its next meeting.

And now RBI faces another problem: the rapid sell-off in the rupee, driven by capital outflows.

Chart shows stronger USD vs. INR (Bloomberg)

The weaker currency is going to exacerbate the inflationary pressures driven by more expensive imports. India imports crude oil, machinery, fertilizer, and chemicals – which may drive fuel and food prices higher. Another product that India imports is gold. So when people scratch their heads as to why gold is down over 5% in a single day, the answer should be simple – risks around a slowdown in Asia.

In addition to inflationary issues, as foreign capital flows out, there is some concern that certain banks or corporations may run into a liquidity problem. RBI is expected to address these quickly, but investors don’t want to take chances.

MarketWatch: There has also been mounting concerns that India’s regulated banking system, along with many Indian firms, might be facing borrowing and liquidity issues, given high interest rates domestically, shrinking global investments, and the sliding rupee.

Given the importance of India as a major global economy, this development is of significant concern for global growth.

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