Friday, October 24, 2014

Is the rupee a one-way bet?

Interesting set of graphics from Research Associates (ht: Barry Ritholtz) on real 10-year expected returns on a variety of asset classes. The one on currencies was of particular interest since unhedged returns on rupee investments (borrow abroad in dollars and invest in short-term rupee bills, and keep rolling them over) topped all other currencies.
India has one of the highest inflation rates among all emerging economies and its inflation trajectory is not expected to subside dramatically. Therefore the prospects of any sharp decline in its high interest rates is not promising. This, coupled with the liquidity trap conditions in developed economies, again likely to persist for some time, points to attractive carry trade potential from borrowing in dollars and investing in rupee assets. This short-term one-way bet and the consequent vulnerability it imposes by way of capital flows and sudden-stops makes capital account management an important macroeconomic challenge for the country.

A comparison of the cyclically adjusted PE ratios (real price divided by average of real EPS over the past ten years), CAPE, reveals that Indian equity market is among the most volatile and remunerative. 
Finally, a comparison of real 10-year expected returns indicate that among all asset categories, emerging market assets occupy the top three places - equity, local debt, and currency 
The importance of this graphic comes from the attendant capital flows related vulnerabilities that emerging markets face from cross-border capital as they search for yield in an environment of ultra-low interest rates.

Friday, October 17, 2014

Last mile gaps - financial inclusion and toilet usage

Last mile gaps are pervasive with many social policy issues. Two flagship programs of the government are most certain to be only the latest to realize that supply-side strategies are unlikely to address this challenge to any degree of satisfaction.

1. Jan Dhan Yojana aims to increase financial inclusion, thereby enabling access for the vast majority of unbanked Indians to formal financial institutions.

2. Total Sanitation Campaign aims to address India's shameful open-defecation problem by provision of heavily subsidized toilets to those without toilet facilities.

In both cases, formidable last mile gaps come in the way of access to bank accounts translating into actual usage and new toilet owners using their toilets. Such gaps can be overcome only through massive social mobilization involving painstaking and long-drawn campaigns that resist the temptation for targets-driven quick wins and band-aid solutions. Does the Indian state have the capability to successfully manage such efforts?

Saturday, October 11, 2014

India's growing corporate external borrowings risk

In a speech early this week, the RBI Deputy Governor, HR Khan, had this to say about the rising share of unhedged foreign exchange exposure of Indian corporate,
In India, there is emerging anecdotal evidence of reduced propensity to hedge foreign exchange exposures arising out of a sense of complacency. The unhedged exposures in respect of External Commercial Borrowings (ECBs)/ Foreign Currency Convertible Bonds (FCCBs) lead to large scale currency mismatches in view of the bulk amount borrowed by domestic corporates for longer tenors with limited or no natural hedges. Further, the increasing use of bond route for overseas borrowings exposes the domestic borrowers to greater roll-over risk. As per indicative data available with the Bank, the hedge ratio for ECBs/FCCBs declined sharply from about 34 per cent in FY 2013-14 to 24 per cent during April-August, 2014 with very low ratio of about 15 per cent in July-August 2014. Large scale currency mismatches could pose serious threat to the financial stability in case exchange rate encounters sudden depreciation pressure.
Hedging or not, the fundamental reality has been the sharp increase in ECBs in recent years. ECB as a share of external debt has doubled since 2007. As I have blogged earlier, the government has consistently, in response to rising external imbalances, relaxed the ECB norms.
Similarly, short-term debt too has risen sharply in recent years. The portfolio of international bonds of all maturities, mostly raised by corporates and financial institutions, has risen dramatically since 2008. 
The decline in hedging has been attributed to the growing belief that the rupee value is likely to stabilize at Rs 60-62. Recent stability in rupee despite continuing turmoil in many other emerging market currencies, prospects of economic recovery, declining commodity prices (and consequent downward pressure on current account deficit), and a perception that RBI would aggressively defend the currency are thought to underpin this belief.

However, these optimists overlook India's persistent high inflation, easily the highest among all major emerging economies. This is unlikely to decline to the levels in other emerging economies anytime in the near future. The consequent depreciation of real exchange rate is not only inevitable, but also desirable. Further, as the US Fed exits quantitative easing and given the relative strength of US economy in comparison to the economic weakness in Europe, the recent trend of strengthening US dollar is likely to persist for the near future, thereby adding more downward pressure on the rupee.

If these trends play out, as they look likely to, then a depreciating rupee will leave the unhedged corporate borrowers in serious trouble. Once the US economic recovery takes firmer hold and interest rates start rising, coupled with a depreciating rupee, a backlash by way of capital flight, in whatever scale, is a real possibility. It would leave the Indian economy, especially its banking sector, exposed to problems similar to that experienced by countries like Thailand and Indonesia in the late nineties and Spain and Portugal just recently, albeit on a smaller scale.

It is therefore important that the RBI and government make corporates to periodically share the details of their external exposures. This will enable, as Paul Tucker recently pointed out, banks to deploy more prudent macro-prudential norms in their lending to corporates with larger unhedged external exposures.

Postscript : Nice article in Business Standard highlights the risk.

Thursday, October 9, 2014

India's Economic Challenge in Two Graphs

As the Indian economy continues on its uncertain recovery path, it is worth looking back at where things went wrong. The following two graphs are instructive.

The first graphic tells us that investment and credit growth have fallen precipitously since the Great Recession struck. The decline in gross fixed investment has been alarming, falling sharply from 33% in 2007 to just above 27% estimated for 2014. In the 2008-14 period, credit growth has nearly halved from its peak in 2008.
The twin effect of this decline on the economic growth becomes evident from the second graphic. Consumption and fixed investment, two bulwarks of growth for much of last decade, have tanked dramatically. Investors have virtually gone missing over the past two years. Inventories, a good proxy for business confidence, has shown negative or no growth since 2010.
In simple terms, consumers have to spend more and businesses have to invest more, thereby generating the virtuous circle which can sustain a high growth trajectory. In the face of formidable headwinds - high interest rates, high inflation, deficient infrastructure, weak global cues, and bruised bank balance sheets - the prospects for either looks bleak. 

Wednesday, October 8, 2014

Inequality fact of the day

From Guardian, on a recent Oxfam report,
The richest 85 people across the globe share a combined wealth of £1tn, as much as the poorest 3.5 billion of the world's population... The wealth of the 1% richest people in the world amounts to $110 tn (£60.88 tn), or 65 times as much as the poorest half of the world... Winnie Byanyima, the Oxfam executive director who will attend the Davos meetings, said: "It is staggering that in the 21st Century, half of the world's population – that's three and a half billion people – own no more than a tiny elite whose numbers could all fit comfortably on a double-decker bus."
As the report writes, such staggering inequality invariably translates into political capture.

The politics of widening inequality

Most of the discussions surrounding the global debate on widening inequality has focused on its fairness and its implications on the prospects for future economic growth. A more immediate and pernicious concern is how it affects politics, governments, and the nature of public policies.

Whether we like it or not, any economic policy decision involving regulation, investment, contracting, recruitment, and incentives is essentially a political decision. They generally benefit one group or other, often at the cost of another. Such decisions are invariably influenced by the predilections of those holding the reins of power. And as the graphic below, from a Washington Post article, shows, political activity increases with income levels, for every metric of political engagement.
This is most certain to reinforce the already strong economic influence wielded by those at higher income levels, thereby translating economic power into political influence. As the Post article writes,
Our representative democracy is not as representative as it could be. Relative to other income groups, the wealthy are over-represented in the political process simply because they're more likely to participate in it. This means that political debates - and political outcomes - are much more reflective of the interests of a wealthy minority than they are of the middling majority.
This is increasingly true of most countries today, including India. This dynamic which is disruptive of democracy itself is the most disturbing part of the widening of inequality.

Monday, October 6, 2014

Bank's are no different from other borrowers

Simon Johnson has an excellent article in Project Syndicate where he points to the improper framing of the debate on bank capital requirements. Supporters of higher capital requirements argue that it is necessary to align incentives and ensure that the bankers have their skin in the game, thereby reining in irresponsible lending. Critics claim that higher capital reserves take away from the amount of capital available for lending, thereby adversely affecting the bank's profitability and limiting lending volumes.

Fundamentally, as Simon Johnson argues, the supporters view capital reserves as a liability whereas the critics view it as an asset. When viewed in this frame of reference, the issue gains much needed clarity.

Consider this. When you visit a bank to borrow money to finance your business, the first level of due-diligence for the banker is to examine the share of owner's equity in the total investment. In a balance sheet, this equity is treated as a liability, or what is owed to shareholders. As a rule of thumb, even the most aggressive banker will demand that the owner put in atleast a fifth of the investment as equity. You will find scarce a business owner who complains that this restriction is adversely affecting his business.

In contrast, when it comes to banker's themselves, it appears to be a case of what is sauce for the goose is not sauce for the gander. Banks borrow from depositors. It is therefore only natural that depositors should demand a similar share of owner's equity from their bank borrowers as lenders to other businesses do. The capital base is the cushion that lenders (in this case, depositors) demand from banks. In other words, it is the explicit restriction that lenders place on the bank's leverage. But banker's, oblivious to this and unlike all other business borrowers, feel that this restriction is detrimental to their business prospects. Somewhere in time, bankers have come to forget that depositors are their lenders, and lenders demand capital/equity stake from owners.

In fact, as the Global Capital Index database shows, very few banks have a capital reserve ratio of even 5%. In other words, banks have been borrowing from their lenders (or depositors) by putting forward less than 5% as equity. And now when someone calls out on this egregious anomaly, bankers turn around and cry foul. Clearly, the critics are being disingenuous.