India Bonds & FX - Wounds, Medication & Sluice Gates

With all the activity in our bond and currency markets, this is a season ripe for blog sequels. Here are two for the price of one. 

Bond markets – self-inflicted wounds & self-medication

(See https://ananthindianmarkets.blogspot.in/2018/04/mpc-yesterday-jules-verne-caesars-wife.html)

Indian bond yields have yo-yoed the past six months – 10-year GOI yields moved from 6.80% to 7.78% down to 7.13% and are back again to over 7.70%. These are big, jagged moves by any standards. 

Yes, the macro context has changed in the interim. Our combined fiscal deficit has expanded, current account deficit (CAD) has widened, crude oil prices are higher, political outlook is murkier, and yields and volatility have risen globally. It is only natural to expect an increase in our own bond yields and market volatility. 

However, a big chunk of the whipsaw in our bond yields is homebrewed – by the government, RBI, MPC, and dealers, alongside weak communication all around.

The central government first announced a larger borrowing program, then reduced the quantum just 20 days later, then presented a budget that left the bond market unimpressed, and finally, in March, produced an exceptionally friendly FY19 first half bond issuance calendar that likely postponed the pain to the second half. 

In between, the RBI publicly castigated banks for holding too much bond duration (supplied, ironically, by the RBI), not learning to manage their market risk, and then seeking bond loss forbearance from the regulator. After that stinging lecture, huffed public sector bank (PSB) treasuries turned their backs on bond markets. Less than three months thereafter, RBI acquiesced and allowed accounting forbearance after all. To date though, banks – who own over 40% of outstanding bonds - continue to be conspicuous in the market by their obvious disinterest. And finally, the RBI appears to have now started to intervene and buy bonds in the secondary market. 

For its part, the MPC managed to wrong-foot markets with a dovish statement (with soothing inflation projections unusually underlined for emphasis), followed just two weeks later by minutes that were just plain hawkish.

To market participants, this cycle of self-inflicted wounds followed by self-medication can mean either of two things. One, perhaps the powers-that-be do not understand Indian markets and market communication, and/ or don’t care. Two, perhaps they’re fully conscious and cognizant of what they’re doing. It is difficult to choose which of these is actually worse.

So, does it really matter if bond yields are volatile? Beyond a clutch of institutions and armchair commentators, who really tracks them anyway? 

Excessive volatility does matter. Market participants – especially portfolio investors – track volatility-adjusted returns. Increased volatility and reduced confidence in the market will push investors to demand higher returns, and reduce risk appetite. This is not good news for borrowers – neither the government nor India Inc. 

As things stand, it is difficult to hazard what the fair 10-year GOI bond yield ought to be – the picture is clouded by this accompanying soap opera. 8% looks excessive, and 7% looks low – so maybe a mid-way 7.50% is as good a guess as any. 

The RBI is right in asking the market to develop risk management tools. For their part, maybe the powers-that-be need to coordinate better amongst themselves, and at least try to engage in open two-way communication with market participants. 

Currency markets – controlling the sluice gates

RBI’s likely recent bond market intervention coincides with their likely selling USD in the currency markets. 

In 2018 to date, INR has weakened by 3.5% against USD, 6.5% against EUR and nearly 8% against GBP. 

There are three themes that are weakening INR at the moment.

First, our net permanent foreign currency flows have turned negative. In FY17, our CAD of $15B was more than covered by $36B of FDI inflows and $8B of FPI into equity. In contrast, in the first nine months of FY18, we have seen a sharply increased CAD of $36B, while net FDI and FPI in equity only amounted to $23B. 

Second, this trend of negative permanent flows could persist, alongside a reduction in transient inflows as well. Between disappointing export growth and high oil prices, our CAD could stay high. FDI and FPI in equity could remain weak given a combination of rising global cost of funds and uncertainty around global markets, geopolitics, and domestic politics. Given all this, even less-permanent carry-seeking flows such as FPI in debt, NRE deposits, net exporter selling and speculative INR longs might not be as forthcoming as in the past.

Lastly, there is an overhang of vulnerable INR carry positions that have built over time (see https://ananthindianmarkets.blogspot.in/2018/01/the-great-inr-carry-trick.html). When our macro trend looked favorable during the past four years, with reducing energy prices, reducing inflation, reducing twin deficits alongside high real interest rates, we saw increased carry-seeking inflows across all categories mentioned above. Judging by the FX intervention by RBI over the period, the cumulative carry trade amounts to over $110B. While they have remained stoic so far despite bond and FX volatility, these carry positions could be bleeding and nervous. 

On the flip side, we have two positives for INR. First, RBI has plenty of FX reserves to manage short-term volatility. Second, given still relatively high interest rates in India, it isn’t cheap for importers or carry speculators to buy USD. 1-year forward premia, for instance, is close to INR 2.70 now. Ironically, relatively high real INR interest rates brought in speculative carry flows. We now might have to retain high real interest rates to restrict sharp reversals. Our monetary policy framework, of course, continues to practically turn a blind eye to the impact of our policy choices on our external sector. 

As a base case, all this could actually end well. Ideally, we should see a reduction in complacent carry positioning, causing INR to weaken, in a manner controlled by a judicious use of RBI’s FX reserves. Already, with this broad-based INR weakening in 2018, the 36-country INR real effective rate (REER) has corrected from over 120 to below 116 now. 

These speculative carry inflows have earlier strengthened INR, and pushed the REER to record highs. While some economists insist that INR strength or weakness has little to do with our export competitiveness, one hopes that a more competitive INR will at least help our domestic industry produce viable alternatives to the made-in-China trinkets that we buy at our markets. 

Hopefully, therefore, this ongoing FX move would eventually help increase our permanent FX inflows, while reducing speculative positioning. It would also help get Uncle Sam's Treasury off our back, as RBI turns to supporting INR, rather than weakening it. 

The trick is that we need all this to happen in a non-disruptive manner. Opening the sluice gates to reduce large carry positioning is a great idea, but this can be a delicate operation in fairly uncertain weather conditions today.