Respite as opportunity

Indian Express, 24th October 2013

Before the next wave of volatility, emerging markets must set their house in order.

The recent slowdown in GDP growth and some of its causes are not unique to India. While a lot of our problems appear homegrown, it is interesting to note that several emerging economies are facing similar downturns. This sudden deceleration of growth in emerging markets (EMs) poses challenges for the world economy. EMs had contributed significantly to global growth and a slowdown in these economies could result in a downturn for the world economy. Global growth forecasts have been cut primarily due to the sluggish growth in emerging economies.

This slowdown was the focus of many a debate at the annual meetings of the IMF and the World Bank earlier this month. Almost all EMs are now showing a decline in GDP growth. Further, most forecasts for EM growth have been cut. The discussion suggested that emerging economies will face three major challenges in the coming months: high volatility of capital flows, a cyclical downturn and structural problems.

The high volatility of capital flows in recent times stems from the anticipation of decisions that are yet to be taken by the US Fed. Everyone understands that the Fed must cut back on its asset purchases. Indeed, it is argued that they are no longer necessary, as the balance sheet of the Fed is large enough to support much greater credit growth if there was enough demand for it. The money multiplier has fallen sharply. While there is an increase in reserve money growth, the corresponding growth in money supply, which happens only when there is demand for credit and lending by banks, is much lower. However, the asset purchase programme of the Fed has also become a signalling device. As long as the Fed is buying assets, people believe that long-term interest rates in the US will remain low.

Ben Bernanke's carefully drafted May 22 communication, that the Fed must now start devising a strategy to reduce its asset purchases, was read by jittery financial markets as an announcement of the programme's withdrawal. The nervousness of the markets, and the perception that the Fed's purchases must be reduced and eventually stopped has created a tense situation. Every tiny bit of information about the US economy has the potential to induce the entry or exit of waves of capital in the US. The impact on EMs has been far greater and more sudden than what was initially expected. Not only is there no prior example of such unconventional monetary policy, the inflows and outflows of capital from EMs are not symmetric. When the Fed purchases started, the inflow into EMs was slower and less dramatic than the outflow has been now.

Some observers believe that the May-July drama was only a trailer of what is to come when the Fed actually starts tapering its bond purchases. Market participants and investors seem to be bracing themselves for higher volatility. Others believe that the markets have already factored in the effect of a US tapering - the corrections that were to be made in investor portfolios and EM currencies have already been made. Policy-makers, especially among emerging economies, prefer to think that the worst, in terms of market volatility, is over. This is understandable, as there is a limited menu of possible responses.

The most common opinion appears to be that before the next wave of volatility hits financial markets, that is, before the US Fed starts talking about tapering again, emerging economies with weak macroeconomic fundamentals should set their house in order. As of now, EMs have got some respite. This is mainly due to two reasons. First, US unemployment numbers showed a reduction in labour participation, suggesting that the labour market is not healthy, so a reduction in the unemployment rate cannot be taken literally. Second, the fiscal contraction in the US has slowed down the expected pace of recovery.

Setting one's house in order is not easy, especially since growth is expected to be slower. For example, even though slower growth is forecast, both for cyclical and structural reasons, the IMF has suggested that EMs undertake fiscal consolidation. India, for example, overdid its fiscal stimulus in 2009 and 2010 and a correction for this would entail fiscal contraction. This could, however, impact emerging economies' growth rates adversely. On the monetary policy front, while the IMF did not say that emerging economies should maintain a tight monetary stance in response to higher US interest rates, it did recommend that countries with high inflationary expectations put in place a sound framework for monetary policy. However, in many countries, such as India, this would mean a tightening of monetary policy. A framework may not be credible or capable of pulling down inflationary expectations unless such a tightening were undertaken. But tighter monetary policy could mean a further contraction in output.

In the aftermath of the recent volatility, two distinct sets of countries seem to have emerged. First, those that have sound macroeconomic fundamentals - small fiscal and current account deficits, and low inflation. Second, those that had witnessed fiscal expansions and inflation that was higher than world inflation in recent years. Countries like Mexico and Chile appear to be well prepared for the tapering, with sound fiscal and monetary policies in place, but they have slowed down for structural reasons. They need to undertake structural reforms. Other EMs have to counter the impact of tighter fiscal and monetary policies. Structural reforms like building infrastructure, creating greater labour flexibility and a good business environment can increase growth. But such long-term reforms are a political process. In democratic countries like India, Turkey and Brazil, they require building political consensus and are not quick and easy.

The only instrument that might help is currency flexibility. An assessment of currency mismatches suggests that emerging economies are better placed and more resilient today than in the past. Countries that allow currency depreciation might be in a better position to take advantage of the pick-up in the US economy and world trade than those that do not. For emerging economies like India, the coming months might witness slower growth, higher volatility, contractionary fiscal policy and monetary tightening.

Rajan vs RBI

Financial Express, 22nd October 2013

The Reserve Bank of India (RBI) is said to be gearing up to initiate an interest rate futures market yet again. Will the product be a success, or will it fail like the previous attempts? The most important factor that favours success this time is Governor Raghuram Rajan. The most important factor that works against it is the old RBI mindset that fundamentally mistrusts markets.

Why might this time be different? In contrast to the earlier approach of micromanagement, Rajan's view as indicated in the Raghuram Rajan report indicates that exchanges should have the freedom to design products. It says:

Exchanges should have the freedom to structure products according to market needs. The issue of removal of 'segments' of exchanges becomes particularly important with interest rate derivatives.

This time we may thus expect that RBI will change its policy of control and command and dictating the product it wants traded regardless of the market for it.

Second, in the past, a key method that has been used to prevent the emergence of a market has been to interfere with rules about participation. Certain kinds of financial firms are cut off from accessing the bond depository (which is run by RBI), or the CCIL, or currency futures trading, etc. This is a contrast with the strategy of the equity market, which is open to everyone. If a market has to get liquidity it needs all kinds of participants. For example, if there is demand from foreigners who are buying government bonds to hedge, then they will bring liquidity to the currency and interest rate futures markets and should be allowed to participate.

What is different this time? Again, the difference may lie in Rajan's approach. The Rajan report says:

The architecture of trading with SEBI-regulated exchanges is conducive to free entry for financial firms and free entry for participants. As an example, currency and interest rate derivatives could become immediately accessible to all financial firms and all market participants (for example, FIIs) by bringing them into the existing policy framework of SEBI-regulated exchanges.

Third, in the past, the market design of the product has prevented 'cash settlement' of interest rate derivatives.

In contrast, the Rajan report says:

Exchange-traded interest rate derivatives using both cash settlement and physical settlement should be permitted. These can trade alongside equity derivatives on NSE and BSE.

Fourth, in the past, it was claimed that the existence of interest rate derivatives interfered with the conduct of monetary policy.

The Rajan report says:

Monetary policy involves changes in the short-term interest rate by the central bank; the Bond-Currency-Derivatives Nexus would enable the 'monetary policy transmission' through which changes in the short-term policy rate reach out and influence the economy through the market process of changes in all other interest rates for government bonds and corporate bonds.

It may, therefore, be expected that this time the development of the interest rate derivatives market will be seen as something RBI will see as a help to improving monetary policy transmission, rather than something that weakens it.

Fifth, in the past, it was believed that short-selling is bad and speculation and arbitrage is evil. A liquid interest rate futures market, and an arbitrage-free yield curve, requires the ability to borrow government bonds and sell these borrowed bonds. These were discouraged. Hedging was permitted, but you could not buy derivatives unless you held the underlyings. So only banks holding government bonds could buy interest rate derivatives. This way, the market did not get diverse positions or liquidity.

The Rajan report says:

In a well functioning financial system, all these prices-exchange rates, interest rates for government bonds and interest rates for corporate bonds-are tightly linked through arbitrage. The key policy goal in this area lies in fully linking the markets, and for these markets to (in turn) be linked to other financial markets such as the equity market. When India achieves a well functioning BCD Nexus, this would have a number of implications. It would enable funding the fiscal deficit at a lower cost and with reduced distortions.

There are, of course, prudential concerns about this and they are addressed by the mechanism that is being used for borrowed shares. In India, the clearing corporation becomes the legal counterparty when shares are borrowed. This eliminates counterparty credit risk. This identical mechanism can be easily used with bonds.

Sixth, in the past, policymakers have muzzled the market when they do not like what the market is saying. Of essence for the future is a more mature perspective, where the market is viewed as a aggregator of the views of the economy. When the message from the market is bad, shooting the messenger only makes it worse.

Indeed, the bond market and the currency market are powerful sources of accountability for the government. When policymakers make mistakes, which will induce bad outcomes in the future, the market makes a net present value about future outcomes and reports it as the price right now. This generates a feedback loop which gives short-sighted policymakers immediate responses when mistakes are made that will lead to damage in the long run. If we want economic policy in India to fare better, it is important to unmuzzle the Bond-Currency-Derivatives Nexus.

The Rajan report says the following about the BCD nexus:

It would produce sound information about interest rates at various maturities and credit qualitie...

In summary, we may expect the outcome on RBI's initiative on interest rate futures to be different if the Governor's view prevails over the old RBI mindset in which the command and control instinct dominated. If, instead, in the old style, ways are found to restrict, stifle, manipulate, control and micro-manage the interest rate futures market are found by the staff used to dealing in the old way, this could become another failed attempt.

Forming new bonds

Indian Express, 16th October 2013

India must lift restrictions on foreign investment in rupee denominated debt

The global financial crisis has heightened fears about integration with global financial markets. For a country like India, which should inexorably open up further to global markets, an important task of policymaking is to identify the path of this integration. It lies neither in shutting out foreign capital, nor in recklessly opening up to dollar denominated debt, which has landed many a country in trouble.

A recent Sebi study on foreign investment in government bonds has recommended the removal of quantitative restrictions on foreign holdings of rupee denominated debt and moving towards a framework similar to the one for foreign portfolio investment in equity. In this study, my co-authors and I find that India's capital controls continue to be guided by concerns about debt and its maturity, rather than its currency denomination. For example, India has placed many restrictions on foreign investment in rupee denominated bonds, even though this is one of the safest areas to open up. This is because the currency risk is borne by the foreigner and there is a foreign appetite for rupee denominated debt. Currently, the restrictions include caps on the total amount of rupee denominated bonds that a foreigner is permitted to hold as well as limits that vary by investor class, maturity and issuer. These have been implemented through a complicated mechanism for allocation and reinvestment. The restrictions fail to meet the objectives of economic policy today and must be removed.

In 1991, India embarked on its integration with the world economy through trade and capital account liberalisation. A key idea behind the early decontrol measures was that debt inflows were dangerous and, therefore, strong restrictions need to be placed on them. Restrictions were imposed to shift the composition of capital entering India towards non-debt-creating inflows and to regulate external commercial borrowings (ECBs), especially short-term debt. As a consequence, while the framework for FDI and portfolio flows is relatively liberal, India has a number of restrictions on debt flows.

Over the past decade, the global thinking on debt flows has changed. The macroeconomic and financial instability in emerging markets following the crises of the late 1990s has led to increased efforts in these countries to develop local currency denominated bond markets as an alternative source of debt financing for the public and corporate sectors.

In the 2000s, emerging economies' domestic bond markets have grown substantially. The outstanding stock of domestic bonds now exceeds $6 trillion, compared to only $1 trillion in the mid-1990s. Along with this, foreign participation has also increased substantially over the last decade. In contrast, the Indian policy framework on debt flows, characterised by quantitative restrictions on foreign participation, has resulted in limited foreign investment. There is a strong case for opening up the local currency government and corporate debt market to foreign investors.

The present arrangement governing foreign borrowing comprises two parts. First, dollar denominated debt: India raises capital through foreign currency denominated debt via government borrowing (both bilateral and multilateral), ECBs by firms (including foreign currency convertible bonds and foreign currency exchangeable bonds) and fully repatriable NRI deposits. Second, rupee denominated debt: Foreign investment in rupee denominated debt takes the form of foreign investors buying bonds in the Indian debt market, which is denominated in rupees. This is subject to an array of quantitative restrictions. There are different limits for foreign investment in government and corporate bonds. This arrangement is further complicated by sub-limits across assets and investor classes.

The share of outstanding government bonds that are owned by foreign investors has risen through the years. As of March 2013, it stands at 1.6 per cent. In absolute numbers, foreign investors own Rs 700 billion or approximately $11 billion of Indian government bonds. At present, the quantitative restriction on foreign investment in government bonds stands at $30 billion. The small scale of foreign ownership implies a substantial upside potential. The internal debt of the government stands at Rs 48.7 trillion. Government securities account for 90 per cent of this amount. Even if the ownership of foreign investors went up by ten times overnight, to $110 billion, it would only amount to 16 per cent of the existing stock of bonds.

A comparison with other emerging economies shows that India greatly lags behind in the proportion of government bonds owned by foreigners. This raises questions on the structure of capital controls in the rupee denominated bond market.

The Working Group on Foreign Investment, chaired by U.K. Sinha, pointed out that the existing regulations create incentives for Indian firms to favour foreign currency borrowings over issuing debt denominated in rupees. It recommended easing the restrictions on rupee denominated debt as a safer way to manage globalisation. The Committee on Financial Sector Reforms, chaired by Raghuram Rajan, also recommended the steady opening up of rupee denominated government and corporate bond markets to foreign investors.

The Sebi study recommends that the existing framework of quantitative restrictions be dismantled. This will encourage greater engagement of foreigners in the government debt market. Since this is rupee denominated, the concerns associated with "original sin" and liability dollarisation do not arise.

If restrictions have to be imposed, the existing quantitative ones could be replaced by percentage limits on foreign ownership. This will enable greater foreign participation as the size of the government bond market increases. Foreign ownership should be capped at a certain percentage of the outstanding government debt, such as at 10 or 15 per cent. The government debt market should be made operationally similar to the equity market. The regulator should allow unrestricted investment till the prescribed limit is reached.

Under this framework, there should not be any distinction between asset classes within the prescribed umbrella limit. In addition, the framework should not create artificial distinctions between investor classes such as foreign institutional investors, qualified foreign investors, sovereign wealth funds, etc. The recent increase in the foreign investment limit in government securities to $30 billion is only applicable to specified classes of foreign investors. These restrictions should be removed. In addition, foreigners should be allowed to participate in onshore currency futures markets so that they can hedge their currency exposure.