The Indian Demonetization Gambit

On the evening of November 8th 2016, the Indian PM Narendra Modi mounted an offensive, one that caught many off guard. Starting the very next day, currency notes of the 500 & 1000 Rupee denominations would no longer be valid legal tender. The high denomination notes can be exchanged by the end of the year, deposited in bank accounts or spent on government utility bills but each such transaction will require an ID proof. In the course of a 40 minute speech, PM Modi touched upon the need to tackle unaccounted and counterfeit money circulation and gave out a strong signal to tax evaders that the state can call their bluff and be a step ahead of them. I was just getting started for the day while on travel out of India and there I knew the first question of the following day’s meeting “How do you expect demonetization to work?”. Damn! I had 8 waking hours to think of an answer while income tax evaders in India counted their cash. I managed to get through that question with some spiel and logic that none of my education had prepared me for. In fact, getting away with the ego bruised was a good result in my own estimate. So, with the ego intact, I spent the better part of the evening watching America vote Trump into the presidency over food and drinks. Fortunately, I’ve had some time since then to compose my thoughts and this post is an effort at working through as many angles. Let me warn you that this is a long note and a mug of strong brewed coffee would surely help.

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Going sub zero with interest rates: Weird is now normal for monetary policy

Would you pay someone to borrow money from you? Rest easy, I’m not hinting at the prospect of a mafia don on the other side of the transaction. Rather, would you pay your central bank 100 bucks today in return for 99 bucks a year from now?

Those of you who think I’m laying out a scam, ease up and don’t get your panties in a bunch. Sample these news stories instead.

“German consumer goods group Henkel sold € 500m of two-year debt with a yield to maturity of minus 0.05 per cent while French pharmaceutical business Sanofi sold € 1bn of three and a half year debt, also at a yield of minus 0.05 per cent”

“Roughly €706 billion of Eurozone investment-grade corporate bonds traded at negative yields as of September 5th or over 30% of the entire market, according to trading platform Tradeweb, up from roughly 5% of the market in early January”

“Around $13 trillion worth of bonds traded with a negative yield in late August, according to J.P. Morgan Asset Management. At the beginning of 2014, the figure was close to zero” Continue reading

Return of the Fed Rate Hike

wp-1450881823981.jpegThere was a sense of calm before key officials of the US Federal Reserve met on the 16th of December. Most analysts I’d tallied notes with were unanimous in the view that the rate hike was a given. But the most watched central bank in the world had shown Hamlet like indecision in the run up to this rate hike. Back in September, as the Chinese slowdown typhoon threatened, Fed officials were in a quandary and restrained themselves. But this time around, markets had already factored in a hike. Any move to the contrary would have played spoilsport with the Santa Claus rally that markets were awaiting. Francis Bacon was quite an insightful man when he said “Hope is a good breakfast but a bad supper”.

As it happened, the FOMC voted unanimously to hike the target range for the new Federal funds rate to between 0.25% and 0.50%. The range was earlier 0 to 0.25%. Policy makers separately forecast a target of 1.375% by December 2016, implying four quarter point increases in the coming year. The Fed also affirmed an intention to maintain the size of its balance sheet until normalization of rates is well underway.

The decision was pivotal mainly because 18 months ago, markets would have come unglued merely at the thought of it. Now, there are many who view the rate hike as a macro error and its timing to be wrong. For one, oil and commodity prices have been crashing and there are no visible signs of inflation. The US unemployment rate fell to 5% in 2015 from 5.6% but hidden behind the statistic is a high level of underemployment. At 62.5%, the labour force participation is the lowest since 1977.

There is also a pervasive belief that most growth in the US economy is the result of monetary stimulus. I wrote about this in my last blog post and here’s a very short recap. The reliance on QE has added $3.5 Billion of purchases to the Fed’s balance sheet. While ostensibly QE was adopted to counter deflationary pressures and stimulate economic recovery, the operation has largely played out by weakening the Dollar. A net beneficiary was the US manufacturing sector that improved its export competitiveness. But a race among central banks on who can ease more is turning the tables around. Central banks of the Eurozone, Japan and China are all in stimulus mode and arguably in a contest to weaken their currencies. There’s no doubt that this will be the status quo for many more months, perhaps years. A rate hike now is bound to drive capital flows to the US, strengthen the Dollar and thereby increase the probability of a stunted recovery in US manufacturing.

Those who support the Fed decision take the view that central banks ought to remove the punchbowl before the party gets rowdy. They allude to the failure of 3 rounds of QE in reviving demand within the real economy. Though my last blog post was in the Eurozone context, one of my arguments was that QE infusions were making their way into equity and bond markets, allowing asset price bubbles to build up. This year, CNN Money expects the total value of stock buybacks and dividends to hit 1 trillion dollars for the first time – a figure that’s higher than projected profits of corporate America.

My own conviction is that the Fed rate should’ve come much earlier because the economy was in much better shape 18 months ago than it is now. But there is indeed one compelling reason for me to believe that the decision was made precisely to counter a possible recession. Writing in The Telegraph, Ambrose Evans Pritchard summed it up most eloquently.

“Mrs Yellen has no margin for error as she tries to right the ship and slowly restore the US economy to a “Wicksellian” natural rate of interest, without detonating the debt-bomb in the process. If she fails, the world is in trouble. We have never been in a predicament where a global recession began with rates already near zero. The Fed typically needs 350 basis points of monetary ammunition to fight a downturn.

The only way out then would be “helicopter money”, a potent use of QE to fund fiscal spending directly and inject stimulus straight into the veins of the economy. But that is a saga for another day. She has not failed yet.”

Well, for now markets have taken the rate hike in their stride. The sentiment in emerging markets especially is one of relief for getting the uncertainty off their back. It does seem like the street’s biggest fear was always about the hurricane that would be unleashed if the Fed were to shrink its balance sheet. Danielle DiMartino Booth has written a wonderful piece on how it may never have been about a measly rate hike. Danielle is a former Fed official and knows more than many other commentators. Here’s an extract of her argument.

“What if it really is all about reinvestment and not one teensy quarter-point rate hike? Over the next three years, some $1.1 trillion in Treasurys could roll off the Fed’s balance sheet if reinvestments were to cease. Tack on the potential for mortgage backed securities (MBS) to prepay and/or mature and you’re contemplating a figure that approaches $2 trillion.

Make no mistake, shrinkage of the Fed’s balance sheet to half its current size is much more feared by market participants than a slight tick-up in interest rates. Taking the step to not reinvest would increase the supply of Treasurys and MBS available to investors and reduce the Fed’s support of the economy. The higher the supply on the market, the lower the price and hence, higher the yield, which moves opposite price.”

In a following post, I’d like to take up this angle. Its been an eye opener for me as well to know how the Fed will effect rate hikes in reality.

An annual holiday beckons. This time it’s to head to ‘Gods own Country’ – my home state of Kerala (India). The hot & sultry weather here is a far cry from that in Bangalore but this time I go in search of childhood memories and quality time with loved ones. Wish you all Happy Holidays. Do share the post if you find it interesting.