Battered India rupee lacks a warchest
The Indian rupee’s plunge this week to record lows will have surprised no one. After all, the currency has been inching towards this for weeks, propelled by the government’s paralysis on vital reforms and tax wrangles with big foreign investors. These are leading to a drying up of FDI and accelerating the exodus from stock markets. Industrial production and exports have been falling. High oil prices have added a nasty twist to that cocktail. If the euro zone noise gets louder, a balance of payments crisis may loom. The rupee could fall further to 56 per dollar, most analysts predict.
True, the rupee is not the only emerging currency that is taking a hit. But the Reserve Bank of India looks especially powerless to stem the decline. (See here for an article by my colleagues in Mumbai) . One reason the RBI’s hands are effectively tied is that India is one of the few emerging economies that has failed to build up its hard currency reserves since the 2008 crisis and so is unable to spend in the currency’s defence. Usable FX reserves stand now around $260 bilion, down from $300 billion just before the 2008 crisis. See the following graphic from UBS which shows that relative to GDP, India’s reserve loss has been the greatest in emerging markets.
But there is worse. The relative decline in reserves since 2008 coincides with a ballooning in India’s external debt, both private and public. Comprising mostly of corporate borrowing and trade credit, the debt stands at $350 billion, up from $225 billion four years back.
No wonder investors have upped their bearish bets on the rupee: a Reuters poll of Asian fund managers shows these at a six-month high and significantly higher than any other Asian currency. For now, the trade looks worryingly like a one-way street.
Buy more yen… to increase reserve returns
Japan has not been a sexy destination for investment. In an environment of rising sovereign risk, Japan’s huge debt burden (+200% and rising) and lack of triple-A rating (Japan is rated AA-, Aa3 and AA by the main rating agencies) are not something that would attract the world’s investors, including the powerful central bank reserve managers.
However, the yen is a different story. Enjoying a safe-haven status, the Japanese currency is staying just below its all-time high around 75.90 per dollar, while it also rose to an 11-year peak against the euro in January.
JP Morgan,whose asset management arm manages $70 billion for 65 official sector clients including central banks and sovereign wealth funds, says reserve managers have been diversifying into non-G4 currencies but the strategy has not performed well.
Instead, it says, they should buy more yen.
“Diversification has targeted cyclical assets such as commodity currencies, which impart more leverage than safety to a portfolio. A much higher allocation to structural funding currencies such as the yen is required for reserve managers concerned with volatility and drawdown,” JPM says in a note to clients.
According to the latest reserve data from the IMF, central banks — which control reserves of over $10 trillion worldwide — hold 60 percent in dollars, 27 percent in euros and 4 percent in sterling and yen respectively.
This would have returned 1.5 percent in the past two years and 2.9 percent in the past five years.
The Big Five: themes for the week ahead
Five things to think about this week:
HOLDING UP — FOR NOW - A good run in equities has so far been helped rather than hindered by U.S. company results. Some are questioning how long the upward momentum can be sustained given cost-cutting rather than improved revenue streams flattered profit margins. The European earnings season, which cranks up a gear this week, and the release of U.S. Q2 GDP data could be potential triggers for a pullback, but the sensitivity to bad news may depend on how much money is chasing the latest push higher.
EARNINGS - European earnings flooding out in the coming weeks may paint a less rosy picture of the banking sector than seen on the other side of the Atlantic. While investment and trading activities should be supportive, bad loan provisions will be particularly closely scrutinised, as will the central and eastern Europe exposure of the likes of Erste. The supply/demand outlook for key commodities plans will also be in the limelight given the battery of oil and chemical firms reporting in Europe and the U.S.
CORRELATIONS - There are signs of some breakdown in the lockstep moves that financial markets had become accustomed to seeing in FX/stocks or stocks/bonds. Calyon research shows correlation between the bank’s proprietary risk aversion barometer and exchange rates has been less robust in the past month. While this correlation nevertheless remains stronger than that between FX and interest rate differentials, the markets’ thoughts are turning to new linkages that might prove better trading guides.
RESISTING CARRY TRADES - The interest in carry trades has grown as investors have become more willing to venture out of the most liquid markets in the quest for returns but the subsequent appreciation in currencies such as the Australian and New Zealand dollar is provoking a push back from the central banks concerned. This suggests that others could be, or have been, tempted by tactics deployed by the Swiss National Bank, whose latest reserves data shows how actively it has sought to keep the Swiss franc in check. Australian reserve data suggest the Reserve Bank of Australia is already taking a leaf out of the SNB’s books, which will keep the market on toes in the coming weeks, while the Reserve Bank of New Zealand meeting this week will offer another chance for central bank rhetoric to counter the prevailing market trend.
U.S-CHINA TALKS - FX reserves, U.S. and Chinese foreign exchange policy, who should do what to correct global imbalances, and trade issues will be on traders’ minds as the U.S.-China Strategic and Economic Dialogue kicks off early in the week. Chinese officials will be keen to avoid sending any signals that would jeopardise the value of the U.S. holdings in their $2 trillion-plus reserves but markets are alert for clues on how Beijing plans to play its medium-term drive for a multi-polar reserve universe.
