Monday, November 21, 2022

Forex reserves and RBI intervention

I pinched myself in disbelief when I saw a news item that said the RBI may have BOUGHT $8 bn dollars in the market in the past month. 

So the RBI is causing the dollar to strengthen vis-a-vis the rupee, meaning it wants the rupee to depreciate In the previous months, the RBI had been doing quite the opposite- it had dipped into its forex reserves to SELL dollars in order to contain the depreciation in the rupee. As a result, India's forex reserves fell by about $ 85 bn in the period April-September 2022. 

But that was not entirely because of sale of dollars by RBI. Dollar sales are said to account for about a third of the decline in reserves. The rest of the decline was because of revaluation of reserves. The RBI holds large amounts of bonds in foreign currency, especially US Treasury bonds. These holdings have been falling in value thanks to rising interest rats.

As you know, we've had people howling about RBI's market intervention. Many were worried about the fall in our forex reserves. They said: why intervene? Let the rupee fall. It would be good for exports. 

The RBI Governor gave a fitting response recently. About the fall in reserves, he said that is what the reserves are meant for- for a rainy day. They are not, he said, meant to be a 'showpiece'. As for export growth, I doubt that rupee depreciation will do much to help in the current situation. The export markets are down, so it's unrealistic to expect a big boost to exports. Our major imports, such as oil, as price inelastic, so imports will shoot up with rupee depreciation. Chances are BoP will worsen, not improve, with rupee depreciation. 

That apart, it makes no sense to let the market dictate the exchange rate entirely. It may dictate the direction of the exchange rate but not the magnitude. The RBI is committed to containing rupee volatility. It has an unstated objective, namely, containing the Real Effective Exchange Rate (REER) of the rupee within a band of plus or minus 5 per cent. Excess volatility in the exchange rate makes investors jittery. 

Net portfolio investment flow into India  turned hugely positive in August reversing the trend of the previous months. It turned negative in September and October but has turned positive thus far in November. If portfolio investors sense that the rupee is in a free fall, they will head massively for the exit, causing the rupee to plunge. Rupee volatility must always be managed.

I wonder what is going to happen to the forecasts of the forex pundits who saw the exchange rate headed towards Rs 85 to the dollar or even above that. The rupee is now less than Rs 82 having touched Rs 83 on October 19. The trend has reversed in recent weeks. Inflation in the US has begun to respond to earlier rounds of tightening. There is a sense now that the Fed may not have to tighten as much as thought until now.  

Overshooting of exchange rates is a well-established phenomenon. There are periods when the rate goes above or below the equilibrium value before returning to equilibrium. Some of the depreciation we have seen in recent months falls in the category. The necessary correction may be happening, helped by perceptions about future rate moves in the US. As interest rates in the US correct downwards, the value of US Treasuries will rise and with that India's FX reserves.

I wouldn't be surprised if the exchange rate at the end of FY 22-23 is closer to Rs 80 than to Rs 85.( Caveat: I'm assuming no serious escalation in the Ukraine conflict).  I won't be apologetic if I'm proved wrong: the tribe of economists has long claimed a divine right to be wrong in its forecasts. 


Friday, November 18, 2022

Central banker jokes

RBI Deputy Governor Michael Patra's recent speech on monetary policy transmission will be of interest to many. The part I liked best was where he cracked a couple of jokes at the expense of central bankers.

These are not the best times for central bankers to wax eloquent. From being knights in shining armour during the pandemic, they have become much maligned and are held responsible for the darkening outlook globally. The story is told of a man stuck in a traffic jam in the capital of a major economy. He asks a policeman about what is going on, and is told that the Governor of the central bank of the country is so depressed about the economy that he wants to douse himself with gasoline and set himself on fire. So, in sympathy, the crowd has decided to take out a collection for him. “How much has been collected?” asked the man. The answer: “40 gallons”.

Here's another one:

A man needs a heart transplant. The doctor offers the heart of a five-year old boy. “Too young!” says the man. “How about the heart of a 40-year old treasury head?” “He doesn’t have a heart”. Then how about the heart of a 75-year old central banker?” “I will take it!” “But why?” “It’s never been used!” 

 If a central banker can laugh at himself, there is still hope for the breed.

Thursday, November 17, 2022

Missile attack on Poland : no takers for Ukraine story

 A missile landed in a village in Poland yesterday killing two persons. Ukraine was quick to denounce it as a Russian missile attack on a NATO country. If true, it could lead to the invocation of  Article 5 under which the attack would be deemed to have happened against all of NATO and could provoke a suitable retaliation.

Well, that's not happening in this case. Poland says the missile is not Russian. NATO boss Jens Stoltenberg thinks the missile probably emanated from Ukraine. Biden has said it is unlikely the missile was fired from Russia. So, at the moment there is no prospect of NATO getting dragged in. 

Former CIA analyst Larry Johnson provides an interesting analysis. He contends that it was probably a 'false flag' operation by Ukraine intended to get NATO involved

  • The missile landed in the Polish village of Przewod√≥w in the east of the country, about four miles from the Ukrainian border. ....
  • The closest Russian ground forces, who in theory could have launched this missile, are located east of Kherson. The distance from Przewodow to Kherson is 613 miles. That distance exceeds the capability of the S-300 by a factor of 3.5.
  • The S-300 was fired by Ukrainian forces located somewhere to the west of Kiev. It is highly likely that U.S. and Russian satellites recorded this launch. In other words, both sides know where the S-300 originated.

    It is highly unlikely — hell, impossible — that this was an “errant” missile that Ukraine fired in a moment of desperation trying to take down an in bound Russian missile. Why? The Russian missiles are flying from the south to the north or from the east to the west. That means if Ukraine is firing an anti-missile defense system at those inbound missiles the Ukrainian missile would travel from west to east.

    But that is not what happened here. The S-300 traveled east to west. Unless the Ukrainian operator who launched the S-300 was drunk on his ass, it is impossible to “accidentally” fire this air defense missile in the wrong direction.

Johnson provides a possible motivation for Ukraine's misadventure:

I believe this is another indicator of Zelensky’s growing desperation. Think about it for a moment. If Ukraine really had Russia on its heels, why fabricate an easily disproved claim that Russia attacked Poland with a missile? This was sloppy trade-craft. If Ukraine had used another Russian missile capable of flying the distance from current Russian lines to that farm in Poland, then the circumstantial evidence might have ignited the desired fire among the NATO members.

Johnson is among the analysts who believe that Russia is poised for a major offensive and that the end game in Ukraine is probably not very far off.

Friday, November 11, 2022

Global economic crisis? Banks are unfazed


The world economy faces, perhaps, the worst shock since the global financial crisis (GFC). But the world’s global banking system seems not have noticed! How come?

During GFC, regulators banks woke up to the realization that they did not have the capital (in particular, equity capital) needed to survive a major shock. Governments everywhere blew up enormous amounts of tax payer money on saving banks.

After the GFC, the Bank for International Settlements (BIS) put in place higher capital requirements. These were pretty modest. For instance, core equity capital (what we understand as equity in accounting terms) requirement was raised to just 4.5 per cent of risk-weighted assets.

Bankers howled at the time. The cleverer ones realized quickly that the market rewards banks with high capital adequacy through higher valuations. So they built up capital buffers well above the regulatory requirements.

The global average for CET 1 (or core equity capital) is now 14.1 per cent, well above the 4.5 per cent mandated by regulation. This means that we can have an economic crisis but that won’t translate into a banking crisis. Banking crises are the most difficult to get out of, so that’s good news for the world economy.

Not to pat myself unduly on my back, but students of my banking courses at IIMA (SPB and MFI) will remember that I had emphasized that higher capital was crucial to competitiveness and valuation in banking post the GFC.

My article in BS, Global Banking is a bright spot.


Global banking is a bright spot

 T T Ram Mohan

The Ukraine conflict poses the biggest challenge to growth since the global financial crisis (GFC) of 2007. The world economy will grow at 3.2 per cent in 2022 and 2.7 per cent in 2023, says the International Monetary Fund (IMF).  Growth in 2023 will be the lowest since 2010, leaving aside the pandemic year of 2020.

Slow growth and rising interest rates are bad for banks. Slower growth spells an increase in bad loans. Rising interest rates translate into losses in the bond market.   

The astonishing thing is that it appears that the global banking system does not face any high risk of collapse even in these trying times. There is thus hope that the global economy can get back to normal after 2023. Assuming that we escape nuclear annihilation.

The world’s financial system faces an intimidating set of challenges, apart from slowing growth and rising interest rates. The IMF’s Global Financial Stability Report (GFSR, October 2022) lists these challenges:

  • China’s housing market woes: Stringent lockdowns in China have impacted home sales. Buyers do not want to make advance payments for the purchase of properties. As a result, developers face liquidity pressures and many have gone bankrupt.   Banks’ exposure to the property is 28 per cent of total loans. (In India, a bank exposure of more than 10 per cent to the property market is considered risky). The IMF estimates that, in a sample of Chinese banks it looked at,  15 per cent (mostly small banks) could fail to meet the minimum capital requirement.  
  • Poor market liquidity: Central banks are tightening monetary policy and shrinking their balance sheets. This has meant less liquidity in the market. Investors would like to sell securities when interest rates rise.   When liquidity is limited, the fall in prices can be steep. Investors trying to exit their holdings of securities end up incurring losses that can trigger panic. 
  • Corporate debt at risk: Rising interest rates pose challenges for firms with high debt. The composite picture across advanced and emerging markets is not pretty. The IMF’s sensitivity analysis shows that under conditions of stress 50 per cent of small firms would have difficulty servicing debt. Banks are bound to be impacted. The IMF warns that government support may be required to contain bankruptcies at small firms.
  • Leveraged finance under pressure:  Leveraged finance is lending to companies with high debt or a poor credit history. It is, therefore, of the high-yield variety. An increasing share of leveraged finance in recent years is “private credit” or credit that is outside the regulated bank market and the financial markets and is of poor quality. As a result, in the US today, more than 50 per cent of leveraged finance is composed of firms with a B rating or relatively higher risk of default. The leveraged finance market is under increased risk in the present conditions.
  • Housing price declines: Rising interest rates could trigger a steep decline in housing prices worldwide. The GSFR estimates that in a “severely adverse scenario”, housing prices could fall by as much as 25 per cent in emerging markets over the next three years; in advanced economies, the fall could be 10 per cent. These orders of declines will have adverse implications for banks.


Now, that is a pretty serious set of risks that banks are exposed to. One would think that, in combination, these could spell disaster for banks. The big surprise in the GSFR report is that the world’s banks seem well-placed to cope with the very worst.

All growth forecasts at the moment are predicated on economic conditions continuing pretty much as they are today —that is, the Ukraine conflict remains at the present level, oil prices will be around $92 per barrel, inflation starts coming around to normal levels in the next couple of quarters, etc.

But what if conditions worsen? What if the Ukraine conflict escalates and the US and its partners impose secondary sanctions?  What if the risks listed above materialise together as a result? 

Obviously, global economic growth will be severely hit.  The IMF looks at a nasty scenario. Growth drops from the baseline projection of 3.2 per cent to below minus 3 per cent in 2023 before recovering to around 3 per cent in 2024. The global Common Equity Tier I ratio (the pure equity component) in banking falls from 14.1 per cent of risk-weighted assets in 2021 to 11.4 per cent in 2023 and 11.5 per cent in 2024. These are all well above the regulatory minimum of 4.5 per cent. 

Banks in emerging markets would face a serious problem: Banks accounting for a third of banking assets would lack the minimum capital required. Globally, however, banks that fall below the 4.5 per cent minimum would account for no more than 5 per cent of global banking assets. 

Suppose global growth turned out to be below the IMF projection of 3 per cent plus in 2024 in the adverse scenario. Even then, on the average, one can expect banks globally to be well above the regulatory norm. 

How do we explain these outcomes? Well, there has been a big change in the banking system following the GFC. Bankers have come to realise that it pays to have capital way above the regulatory norm. The market rewards them with higher price to book value ratios because it sees these banks as less susceptible to failure. As a result, banks have raced well ahead of the regulatory curve when it comes to capital adequacy. That is standing the banking system in good stead in these difficult times. 

That is true of the Indian banking system as well. Except that, far from being under stress like their counterparts elsewhere, Indian banks today appear to be on song. The 12 public sector banks together have reported a second quarter increase of more than 50 per cent in profit after tax (PAT) over the previous year. Private banks have reported a growth in PAT of over 65 per cent in the same period. Loans in the banking system are growing at 17 per cent. If the global economic outlook is grim, Indian banks haven’t noticed it!