Credit crunch, did someone use the expression credit crunch?
Monday, December 24, 2007
Merry Xmas and A Happy New Year
Well, a Merry Xmas and a Happy New Year to all my readers. Thank you for taking the time and trouble to pass-by. This blog will now - failing major and surprising new developments in the global economy - be offline till the end of the first week in January, or till after the festival of Los Reyes Magos in Spain (for those of you who know what this is all about). Come to think of it, maybe this is just what our ever hopeful central bankers are in need of even as I write - some surprise presents from the three wise men - but I fear that this year if these worthy gentlemen do somehow show at the next G7 meet, the star in the east which draws them will not be the one described in the traditional texts, but in all likelihood the rising star of India.
Credit crunch, did someone use the expression credit crunch?
Credit crunch, did someone use the expression credit crunch?
Sunday, December 23, 2007
Capital Inflows into India and Rupee Appreciation
Well, this is headed I think to become topic of the year again in 2008. Arpitha Bykere has a post up today on RGE Monitor, and I had a piece on Friday up on India Economy Blog.
I think here that perhaps three charts tell it all. First we have the capital inflows themselves:
And then secondly we have the changing relative dollar values of global GDP, which is a topic that takes us straight into the whole debate about "decoupling" and "recoupling". Basically there seem to be two versions of the "decoupling" thesis knocking about. The first of these (which is now very definitely going out of fashion very fast) was based on the idea that the global economy was finally decoupling itself from the US one due to the fact that key global engines among the G7-type economies - and in particular Germany and Japan (and following in both cases lengthy periods of structural reforms) - were finally coming out of a long period of sub-par economic growth and achieving "home grown", domestic-demand-driven, sustainable recoveries in a way which would enable them to take more of the global strain
But there is another sense of "decoupling" (which is the one Claus Vistesen and I prefer to call "recoupling" - although this is not, it should be noted - recoupling in the way in which Nouriel Roubini (for example) uses the expression, which seems to refer to some form of renewed coupling to a US economy which is basically on its way down, not in GDP growth terms - although there may of course be a recession - but in dollar share of world GDP terms) and this is to do with the way in which certain emerging market economies (the EU 10, Ukraine, Russia, China, India, Turkey, Brazil, Argentina, Chile etc) are now accounting for a very substantial proportion of global growth (Claus and I have yet to do the detailed numbers on this, but suffice it to say that India, China and Russia alone will account for over 30 % of the growth in the global economy in 2007). This is a far cry from the central role which the US economy was playing in global growth in the late 1990s. So in this sense something fundamental has changed, and this is what Claus and I are calling "recoupling".
So now back to those capital flows. As Arpitha Bykere points out, the rupee rose by around 15.5% against the dollar between Sep 2006 and Oct 2007. The RBI and Indian government have been busying themselves trying to use the various tools they have at their disposal to try to manage the inflows and their potential impact on liquidity and inflation with a variety of forms of FX intervention and sterilization.
Bank reserve requirements have been raised eight times this year, from 5% in December 2006 to 7.5% in October 2007.
The repo rate been raised seven times from 6% in April 2005 to 7.75% in March 2007 while the reverse repo rate has been increased five times from 4.75% in March 2004 to 6% in July 2006.
The increase in reserve requirement acts as a kind of tax on banks (and this makes their work even more difficult for them to increase their deposit base given the pressures for funds which exist in the consumer market and the attractive returns available elsewhere. Further, RBI rules that effectively force them to hold a quarter of their deposits in govt bonds and to purchase the low return sterilization bonds make for added pressures in the conventional banking sector).
India's central bank on December 14 also curbed bank loans to mutual funds by mandating that these loans will be treated as lenders' direct investments in stock and bond markets. The central bank has also accelerated the pace of the sterilization via issuance of market stabilization scheme (MSS) bonds. Using such techniques the RBI has managed to sterilize about 58% of the foreign inflows, according to estmates by Chetan Ayha. The sterilized liquidity (excess liquidity) stock - which includes reverse repo less repo balances, MSS bonds, government balances with the RBI and the increase in the cash reserve ratio - has shot up to US$77 billion as of end-October 2007 from US$19 as of end-October 2006, according to the same estimates.
Banks are currently required to limit investments in capital markets to less than 40 percent of their net worth, while funds may borrow from banks only to meet ``temporary liquidity needs'' and as per the capital market regulator's guidelines.
This move was a response to the discovery by an apparently astonished RBI that the financial records of some banks showed they had extended "large loans to various mutual funds and also issued irrevocable payment commitments to stock exchanges on behalf of mutual funds and foreign institutional investors". Such transactions were found to have been widespread, but were not included by the banks as part of their declaration of capital market investments.
As a result the Securities and Exchange of India has ruled that a mutual fund may borrow only up to 20 percent of its net assets and for periods of not more than six months.Also the RBI has ruled that banks must not give loans or other forms of financial assistance, such as payment guarantees, to foreign institutional investors. Domestic banks have now been given six months to comply with the instructions.
RBI’s control over monetary policy has evidently been gradually weakening. Initially RBI followed an independent monetary policy of targeting the interest rate while maintaining a competitive exchange rate with partial capital controls. But as the economy has gradually accelerated to around a 9% average over the last three quarters, and as the sub-prime blow out has added to the attraction of strongly growing emerging economies with relatively higher interest rates and the prospect of strong relative currency apprecaiation, the consequent ineviatable arrival of large capital inflows has lead to RBI to acquiesce its ongoing appreciation, and control over the value of the rupee has to some extent been sacrificed in an atempt to keep control over the interest rate. But as the rupee has steadily approached the 40 USD pain threshold level the RBI has shifted its efforts towards control over the capital account, imposing soft controls on inflows and easing outflows. Moreover, the use of interest rate is constrained by concerns about unnecessarily slowing growth in one direction, and accumulating inflationary pressure (including food, manufacturing, asset inflation) in the other.
In theory the RBI could allow exchange rate appreciation to offset the liquidity injection (buying dollars and selling rupees, for example). But a case can well be made that the Indian exchange rate is already somewhat over-valued. The 36-country real effective exchange rate was about 8.5% above the ten-year mean as of September 2007.
More importantly, the 12-month trailing trade deficit has shot up to 6.7% of GDP as of September 2007, resulting in an adverse impact on job creation in the manufacturing sector. Total goods exports growth has decelerated to 4.3% in rupee terms as of September 2007. In our view, small and medium enterprises would have been growing at an even slower rate, as the large companies would have been able to maintain their growth better.
Even if one were to consider the services sector exports, the trailing four-quarter sum of the current account deficit (excluding remittances) is at 4.2% of GDP as of June 2007. The headline current account deficit, however, is at a manageable level of 1%, primarily on account of the rising remittances from non-residents. The four-quarter trailing sum of non-residents’ remittances has shot up to US$30 billion (3.2% of GDP) as of June 2007. For assessing the impact of the exchange rate on the domestic output balance, we believe that we should exclude remittances, which represents transfer of income generated in foreign countries. Having to stand back and watch any further appreciation of the exchange rate will be a testing moment for policy makers considering the potential adverse impact on domestic growth and job creation.
Another important source of capital inflows has been Portfolio Investment which rose from $2.8 b in FY2000 and $12.5 b in FY2005 to $18.5 b Apr-Sep 2007. According to the IMF Foreign Institutional Investment (FII) has risen from $1.8 b in FY2000 to $8.7 b in FY2004 and to $15.5 b during Apr-Sep 2007. Moreover, the number of FIIs registered in India doubled to 1,050 between Mar 2001 and Jun 2007, and there are now around 3,336 FII sub-accounts. FII equity inflows have increased from $9.8 b in 2004, to $11 b in 2005, and now to over $16 b in the year so far of 2007.
India's stock market - buoyed by strong corporate performance and the aforementioned inflows - has risen 43% to date in 2007. According to Citigroup, FIIs holdings in the Bombay Stock Exchange 500 companies rose from 12% in March 2001 to around 22% in June 2007, which is greater than the holdings of domestic mutual funds.
In mid-October, the RBI reacted to some of this by banning foreign investment in the stock market via off-shore derivatives in the form of Participatory Notes (PN). Such derivatives had been habitually used by foreign investors who were not officially registered in India (say hedge funds) to indirectly invest through registered investors. Between Mar 2004-Aug 2007, the number of FIIs/Sub Accounts that issued PNs rose from 14 to 34. The share of PNs in total foreign portfolio flows is believed to have increased from 32% during 2006 to about 55% by Oct 2007, with hedge funds accounting for around 50% of the PNs. It has, however, been suggested that the real motive behind the October RBI measure was not so much to restrict investment as to improve the transparency of capital inflows and that restricting inflows via PNs is likely to have little or no impact on the overall inflows entering India in the medium term.
Hedge and mutual and pension funds activity have all been growing in India. Hedge fund investment in India has risen 400% from $2.8 b in Sep 2005 to $13.97 b as of July 2007 with over 90% of these investments in equities accruing high returns. According to the Financial Times, private equity deals have surged from $3.9 b in 2006 to around $ 5.9 b ytd in 2007.
FDI has also risen significantly from the low level of $3.8b in FY2004 to $16 b in FY2006. In addition, cross border M&A deals increased to 226 deals worth $15.3 b in 2006 from 192 deals worth $9.5 b in 2005. More importantly, investment by non-resident Indians in foreign currency deposits and rupee accounts has risen over the years from $21.7 b in FY2000, $33 b in FY2004 to $41.2 b in FY2006, leading the RBI to cap interest rates on the latter. Moreover, remittances have increased from $12.9 b in FY2000 to $20.5 b in FY 2004 and $27.2 b in FY 2006.
According to the IMF India's external debt rose 22.6% to $155 b in FY 2006 (with the appreciating rupee contributing to 10% of this increase) and now is equivalent to 16.4% of GDP. Around 56% of the increase in external debt was due to ECBs and 16% of the increase was due to NRI deposits. India's Net International Investment Position has improved somewhat in the recent years due to increase in assets (rising outward FDI), even as liabilities have continued to grow. Rising FDI and equity portfolio inflows have helped non-debt creating inflows to rise from 27% in FY2000 to 47% in FY2006, but FDI inflows are only up from 14.7% in FY2000 to 25% in FY2006.
I think here that perhaps three charts tell it all. First we have the capital inflows themselves:
And then secondly we have the changing relative dollar values of global GDP, which is a topic that takes us straight into the whole debate about "decoupling" and "recoupling". Basically there seem to be two versions of the "decoupling" thesis knocking about. The first of these (which is now very definitely going out of fashion very fast) was based on the idea that the global economy was finally decoupling itself from the US one due to the fact that key global engines among the G7-type economies - and in particular Germany and Japan (and following in both cases lengthy periods of structural reforms) - were finally coming out of a long period of sub-par economic growth and achieving "home grown", domestic-demand-driven, sustainable recoveries in a way which would enable them to take more of the global strain
But there is another sense of "decoupling" (which is the one Claus Vistesen and I prefer to call "recoupling" - although this is not, it should be noted - recoupling in the way in which Nouriel Roubini (for example) uses the expression, which seems to refer to some form of renewed coupling to a US economy which is basically on its way down, not in GDP growth terms - although there may of course be a recession - but in dollar share of world GDP terms) and this is to do with the way in which certain emerging market economies (the EU 10, Ukraine, Russia, China, India, Turkey, Brazil, Argentina, Chile etc) are now accounting for a very substantial proportion of global growth (Claus and I have yet to do the detailed numbers on this, but suffice it to say that India, China and Russia alone will account for over 30 % of the growth in the global economy in 2007). This is a far cry from the central role which the US economy was playing in global growth in the late 1990s. So in this sense something fundamental has changed, and this is what Claus and I are calling "recoupling".
This situation can be observed quite clearly in the two charts which follow, which are based on calculations made from data available in the IMF October 2007 World Economic Outlook database. Now, as can be seen in the first chart the weight of the US economy in the entire global economy has been declining since 2001 (and that of Japan since the early 1990s). At the same time - and again particularly since 2001 - the weight of the soc called BRIC economies (Brazil, Russia, China and India) has been rising steadily. This is just one example - and a very crude one at that - of why Claus and I consider that demographics is so important, since it is precisely the population volume of the BRIC countries (and the fact that they start their development process from a very low base, ie they were allowed to become very poor comparatively, for whatever reason) that makes this transformation so significant.
Again, if we come to look at shares in world GDP growth we can see the steadily rising importance of these economies in recent years and the significantly weaker role of "home grown" US growth. The impact of the collapse of the Tech stocks/internet boom in 2001 is clear enough in the chart, as is the fact that everyone went down at the same time, and this is the old form of "coupling" wherein the US economy due, to its size (and hence specific weight) and "above-par" growth potential played a key role, and, as can be seen, when the US went down, then god save the rest. The present debate is really about what will happen if the rising dollar cost of oil and the ongoing difficulties in the financial sector caused by the sub-prime problem leads the US into recession in 2008. Will everyone else follow this time? In 1999 the US economy represented 30.91% of world GDP, and in 2007 this percentage will be down to 22.4% (on my calculations based on the forceast made by the IMF in October 2007). In 200 the US economy accounted for a staggering 40.71% of global growth, and by 2007 this share is expected to be down to 6.43%. So there are prima-facie reasons for thinking that this time round the impact of any US slowdown will not be as acutely felt in some parts of the globe as was the case in 2000, but which parts of the globe will be more affected and which less so?
So now back to those capital flows. As Arpitha Bykere points out, the rupee rose by around 15.5% against the dollar between Sep 2006 and Oct 2007. The RBI and Indian government have been busying themselves trying to use the various tools they have at their disposal to try to manage the inflows and their potential impact on liquidity and inflation with a variety of forms of FX intervention and sterilization.
Bank reserve requirements have been raised eight times this year, from 5% in December 2006 to 7.5% in October 2007.
The repo rate been raised seven times from 6% in April 2005 to 7.75% in March 2007 while the reverse repo rate has been increased five times from 4.75% in March 2004 to 6% in July 2006.
The increase in reserve requirement acts as a kind of tax on banks (and this makes their work even more difficult for them to increase their deposit base given the pressures for funds which exist in the consumer market and the attractive returns available elsewhere. Further, RBI rules that effectively force them to hold a quarter of their deposits in govt bonds and to purchase the low return sterilization bonds make for added pressures in the conventional banking sector).
India's central bank on December 14 also curbed bank loans to mutual funds by mandating that these loans will be treated as lenders' direct investments in stock and bond markets. The central bank has also accelerated the pace of the sterilization via issuance of market stabilization scheme (MSS) bonds. Using such techniques the RBI has managed to sterilize about 58% of the foreign inflows, according to estmates by Chetan Ayha. The sterilized liquidity (excess liquidity) stock - which includes reverse repo less repo balances, MSS bonds, government balances with the RBI and the increase in the cash reserve ratio - has shot up to US$77 billion as of end-October 2007 from US$19 as of end-October 2006, according to the same estimates.
Banks are currently required to limit investments in capital markets to less than 40 percent of their net worth, while funds may borrow from banks only to meet ``temporary liquidity needs'' and as per the capital market regulator's guidelines.
This move was a response to the discovery by an apparently astonished RBI that the financial records of some banks showed they had extended "large loans to various mutual funds and also issued irrevocable payment commitments to stock exchanges on behalf of mutual funds and foreign institutional investors". Such transactions were found to have been widespread, but were not included by the banks as part of their declaration of capital market investments.
As a result the Securities and Exchange of India has ruled that a mutual fund may borrow only up to 20 percent of its net assets and for periods of not more than six months.Also the RBI has ruled that banks must not give loans or other forms of financial assistance, such as payment guarantees, to foreign institutional investors. Domestic banks have now been given six months to comply with the instructions.
RBI’s control over monetary policy has evidently been gradually weakening. Initially RBI followed an independent monetary policy of targeting the interest rate while maintaining a competitive exchange rate with partial capital controls. But as the economy has gradually accelerated to around a 9% average over the last three quarters, and as the sub-prime blow out has added to the attraction of strongly growing emerging economies with relatively higher interest rates and the prospect of strong relative currency apprecaiation, the consequent ineviatable arrival of large capital inflows has lead to RBI to acquiesce its ongoing appreciation, and control over the value of the rupee has to some extent been sacrificed in an atempt to keep control over the interest rate. But as the rupee has steadily approached the 40 USD pain threshold level the RBI has shifted its efforts towards control over the capital account, imposing soft controls on inflows and easing outflows. Moreover, the use of interest rate is constrained by concerns about unnecessarily slowing growth in one direction, and accumulating inflationary pressure (including food, manufacturing, asset inflation) in the other.
In theory the RBI could allow exchange rate appreciation to offset the liquidity injection (buying dollars and selling rupees, for example). But a case can well be made that the Indian exchange rate is already somewhat over-valued. The 36-country real effective exchange rate was about 8.5% above the ten-year mean as of September 2007.
More importantly, the 12-month trailing trade deficit has shot up to 6.7% of GDP as of September 2007, resulting in an adverse impact on job creation in the manufacturing sector. Total goods exports growth has decelerated to 4.3% in rupee terms as of September 2007. In our view, small and medium enterprises would have been growing at an even slower rate, as the large companies would have been able to maintain their growth better.
Even if one were to consider the services sector exports, the trailing four-quarter sum of the current account deficit (excluding remittances) is at 4.2% of GDP as of June 2007. The headline current account deficit, however, is at a manageable level of 1%, primarily on account of the rising remittances from non-residents. The four-quarter trailing sum of non-residents’ remittances has shot up to US$30 billion (3.2% of GDP) as of June 2007. For assessing the impact of the exchange rate on the domestic output balance, we believe that we should exclude remittances, which represents transfer of income generated in foreign countries. Having to stand back and watch any further appreciation of the exchange rate will be a testing moment for policy makers considering the potential adverse impact on domestic growth and job creation.
Another important source of capital inflows has been Portfolio Investment which rose from $2.8 b in FY2000 and $12.5 b in FY2005 to $18.5 b Apr-Sep 2007. According to the IMF Foreign Institutional Investment (FII) has risen from $1.8 b in FY2000 to $8.7 b in FY2004 and to $15.5 b during Apr-Sep 2007. Moreover, the number of FIIs registered in India doubled to 1,050 between Mar 2001 and Jun 2007, and there are now around 3,336 FII sub-accounts. FII equity inflows have increased from $9.8 b in 2004, to $11 b in 2005, and now to over $16 b in the year so far of 2007.
India's stock market - buoyed by strong corporate performance and the aforementioned inflows - has risen 43% to date in 2007. According to Citigroup, FIIs holdings in the Bombay Stock Exchange 500 companies rose from 12% in March 2001 to around 22% in June 2007, which is greater than the holdings of domestic mutual funds.
In mid-October, the RBI reacted to some of this by banning foreign investment in the stock market via off-shore derivatives in the form of Participatory Notes (PN). Such derivatives had been habitually used by foreign investors who were not officially registered in India (say hedge funds) to indirectly invest through registered investors. Between Mar 2004-Aug 2007, the number of FIIs/Sub Accounts that issued PNs rose from 14 to 34. The share of PNs in total foreign portfolio flows is believed to have increased from 32% during 2006 to about 55% by Oct 2007, with hedge funds accounting for around 50% of the PNs. It has, however, been suggested that the real motive behind the October RBI measure was not so much to restrict investment as to improve the transparency of capital inflows and that restricting inflows via PNs is likely to have little or no impact on the overall inflows entering India in the medium term.
Hedge and mutual and pension funds activity have all been growing in India. Hedge fund investment in India has risen 400% from $2.8 b in Sep 2005 to $13.97 b as of July 2007 with over 90% of these investments in equities accruing high returns. According to the Financial Times, private equity deals have surged from $3.9 b in 2006 to around $ 5.9 b ytd in 2007.
FDI has also risen significantly from the low level of $3.8b in FY2004 to $16 b in FY2006. In addition, cross border M&A deals increased to 226 deals worth $15.3 b in 2006 from 192 deals worth $9.5 b in 2005. More importantly, investment by non-resident Indians in foreign currency deposits and rupee accounts has risen over the years from $21.7 b in FY2000, $33 b in FY2004 to $41.2 b in FY2006, leading the RBI to cap interest rates on the latter. Moreover, remittances have increased from $12.9 b in FY2000 to $20.5 b in FY 2004 and $27.2 b in FY 2006.
According to the IMF India's external debt rose 22.6% to $155 b in FY 2006 (with the appreciating rupee contributing to 10% of this increase) and now is equivalent to 16.4% of GDP. Around 56% of the increase in external debt was due to ECBs and 16% of the increase was due to NRI deposits. India's Net International Investment Position has improved somewhat in the recent years due to increase in assets (rising outward FDI), even as liabilities have continued to grow. Rising FDI and equity portfolio inflows have helped non-debt creating inflows to rise from 27% in FY2000 to 47% in FY2006, but FDI inflows are only up from 14.7% in FY2000 to 25% in FY2006.
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