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August 2007
SUMMARY
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The nature of politicians (charitably speaking) is to believe that what's good for them is good for the country. This belief reached its apogee with Indira Gandhi, but the fact is that all politicians believe this, which is why much policymaking is so directly against the public interest. Anything that could create circumstances that would threaten the gaddi is, almost by definition, off the table.
The government's recent move to close the capital account is a case in point. Making a mockery of the Finance Minister's oft-stated belief that 10% growth is quite readily achievable, the government clamped down on ECB's, ensuring that India Inc's borrowing costs will rise. And, as usual, smaller companies will suffer more than larger ones because (a) many large companies had already recently accessed international markets for “cheaper” borrowings, and (b) the poorly developed domestic debt market hits lower credits disproportionately in terms of pricing. Again, given that supply, and particularly of infrastructure, is the primary constraint on growth, this policy will ensure that wherever growth ends up it will be much lower than potential and certainly lower than the 10% dream.
So, why? Why was this done?
Well, it has become increasingly clear India's attractiveness to global investors has been threatening RBI's efforts to do the impossible – viz., manage inflation and the exchange rate in the face of a relatively open capital account. That the government chose to simply try to slam the doors –even if temporarily – on the capital account is evidence that it is unable to do its job effectively. Making the central bank independent and giving it the exclusive task on managing inflation, for instance, would, in the current political environment, take a long time. Ditto for increasing the pace of deregulation of the financial sector, retail, real estate, what have you. So, since the government can't do what it should, it does what it can – no matter that this is not in the best long-term interest of the economy.
I mean, it should be clear that a strong rupee would keep inflation controlled, bring borrowing costs down (as wider swathes of Indian business learned how to access international markets), speed up the development of infrastructure, and generally ensure that we could achieve our potential growth – easily 10%. But, if the rupee shot higher, and there were job losses in some sectors, many small businesses may go under, providing fodder to the currently-flat-on-its-back BJP?
On the other hand, if the exchange rate were tightly controlled, inflation would certainly get out of hand, leading to perhaps greater political trauma – and, let's not forget that there's a general election in a little over 18 months.
Well, perhaps I am being too judgmental. Perhaps discretion is the better part of valor, and these curbs will turn out to be temporary and will be lifted as soon as the economy – or, more correctly, the economy's managers – get a breather.
The tragedy, though, is that, while the government has lost credibility by backtracking, this new policy is unlikely to have much effect. Even if the ECB spigot is completely turned off – which is neither intended nor likely – our capital account surplus will still exceed the current account deficit, maintaining the pressure on the rupee/inflation. The demand for India is strengthening as we speak – over the past four months, reserves rose by $ 26 billion, despite rupee being as strong as it is.
The only things that these curbs will achieve is to a) bring about some rebalancing of the net short dollar positions in the Indian market, which is good b) increase the cost of borrowing for India Inc, which is bad c) increase the use of derivatives to improve borrowing costs, which could turn out to be bad for some companies (who mismanage the risk) and good for others (like banks and ourselves) d) increase the profitability of banks at the cost of the corporate sector, which is good or bad, depending on where you sit e) increase the uncertainty in the market (note I didn't say volatility but uncertainty, which I define as volatility of volatility), which is bad However, the biggest negative for the central bank's market management is the VERY LOUD statement this makes that the “free market” value of the rupee at today's productivity levels is higher – and, perhaps, substantially higher – than the current 40 to the dollar. Speculators will doubtless take note. Already, the price action the morning after the curbs were announced – the rupee opened weaker at 40.80, but quickly reverted to its pavilion around 40.50 – shows that the market has largely shrugged off this news. In my view, trying to prevent the market from achieving equilibrium is like spitting at heaven –sooner or later, it will fall back onto your face. Far better to face the music today – whatever the tune –than wait for it to come back tomorrow, when the flows will be larger and the tune will be louder.
The smartest thing the government ever did was in 1991 when, under the duress of the balance of payments crisis, it devalued the rupee and began the process of deregulating the economy. Unfortunately, the government isn't quite feeling a similar pressure right now, but its clear from the way the wind is blowing that there's another crisis brewing.
So where do we go from here?
The price action immediately after the ECB curbs were announced, when the rupee opened weaker at 40.80, but quickly reverted to its pavilion around 40.50, shows that the market has largely shrugged off this news, and is convinced that the rupee can only get stronger. Indeed, the fact that the rupee has obstinately stayed between 40.20 and 40.50 since May, despite feverish dollar buying by RBI, confirms the sentiment.
Of course, sentiment can turn on a dime and the very function of financial markets is to make the conventional wisdom appear foolish. To try and find an alternative view, we turned to our technical analyst who believes that the dollar has reached bottom and will “shortly” correct and correct sharply, and that the rupee will also suffer from this renewed dollar strength.
What follows is a transcript of a discussion between our technical analyst and JM, a redoubtable forecaster, who most often uses his not insubstantial gut to make judgments.
TA: Technical analysis is defined by the belief that it's never different. Markets move in cyclical patterns over and over again – the trick is to be able to decipher the patterns, since, most of the time, they are somewhat altered, slightly different than before.
JM: In other words, history never repeats itself
exactly… 
TA: …but it has a rhythm. And the rhythm right now has the dollar on the brink of a turnaround.
The graph shows how the dollar index (DXY, traded on the New York Board of Trade, NYBOT) has moved since 1971. The index, which was reset after the launch of the Euro, is most strongly influenced by the European currencies, with EUR and GBP comprising nearly 70% of the index, JPY about 15% and the others (CHF, CAD and SEK) the balance. The index has always bounced back from the support line running nearly horizontally around the 80 level; today (Aug 9) it stands at 80.30, after having hit a low of 79.96 on Aug 6. Significantly, the rally has always been very sharp, with the index rising to between 91 and 97 within a year – that's a gain of about 12-15%.
JM: You mean you really believe the dollar is going to shoot that much higher? In a year or so?
TA: It could get worse – or better – depending on your perspective. The one time the dollar did not rise that sharply was in 1995-96, which actually turned out to be the beginning of a 6-year dollar bull market that carried it 50% higher to 121.
JM: But that's nuts, that can't happen.
TA: Well, the Euro strengthened by more than 50% between 2001 and now. And technically the dollar is ripe for a rally.
JM: What do you mean the dollar is ripe for a rally? It's not a fruit.
TA: Well, to understand this, we have to get a bit technical.
We already saw that the DXY appears to have bounced off its long-term support. Let us look now at charts of the Fed's broad dollar index (which covers 37 currencies, including, incidentally, the rupee, with a 1.5% weight). The lower chart shows the RSI (relative strength index), which is a measure of market momentum. In simple terms, if the RSI is falling it means that the momentum for dollar weakness is increasing, and vice versa.
To understand the implications of these charts, we first note the absolute level of the broad dollar index, at 103.08, is at its lowest level since 2000, and is nearly 5% lower than it was in 2004, when it last hit bottom. What is significant is that the RSI has turned back upwards quite sharply over the past couple of weeks to the point where it is now just out of the oversold range. This suggests that momentum is turning around.
Another point to note is that the RSI bottomed out at a (slightly) higher level than the last time (in 2004). This means there is a divergence between the two charts –i.e., the dollar index is hitting lower lows each time it bottoms, while the RSI is hitting higher lows each time it bottoms.
JM: What does that mean?
TA:
This is called a positive divergence, which hints at the possibility of a big rally over
the next six to 12 months.
JM: Hold on, hold on. You've lost me there. Why does this divergence suggest that the dollar will rally in the near future?
TA: It's difficult to explain, without referring to history: whenever a pattern of this type has been seen, it has signaled a turning point sooner rather than later.
JM is shaking his head.
TA: But look, there are other indicators. I'm sure that even you would agree – look at the top graph now –that if the broad index bounces off the support line, it can – note I said, can – rise all the way up to the upper horizontal line, which is at 112.50, about 8% higher than today's level. At the very least, it could rally up to the lower horizontal line at 108, which is a nearly 5% rise in the broad index.
JM: Well, that's better. A5% rise I can understand.
TA: And, of course, if – no, when – that happens, it stands to reason that the components of the broad index that rose the most would fall the most. Thus, the Australian and Canadian dollars will take the biggest hit.
JM: So, you mean the Candy and the Aussie would fall by more than 5%, while the Euro and sterling would fall less – say, 4% or so, which would take them to 1.3250 and 1.9650, respectively?
TA: Indeed, in the week since the credit crisis exploded, the Aussie has already fallen by over 3%, and the dollar's rally is still not really in progress.
JM: What about the Asian currencies? They've certainly been very strong against the dollar.
TA: Here, we need to look at the Asian currency index – the ADXY, which was launched by JP Morgan in 2004. Incidentally, this has a 5.5% weightage for the rupee – higher than the broad index, but, in my view, still too low.
The ADXY is currently at the top of a channel, as shown in the weekly graph below, which, indeed, suggests that it is about to turn lower.
Further the MACD (which is another momentum indicator) is showing a negative divergence – higher tops on the index and lower tops on the MACD – which means that the upward momentum is slowing sharply; this, again, suggests a correction is on the cards –indeed, current price action shows it has already begun.
On the monthly charts [not shown], however, there is no divergence visible, which indicates that the strength in Asian currencies is likely to persist, and possibly accelerate, for several years. Of course, there would be intermediate corrections – as the one we appear to be now seeing – each of which could last several months or even a year. The long-term target for the index would be above 120, the level from where it had a vertical collapse during the Asian crisis in 1997.
Fundamentally, this makes sense since much of the US trade deficit is concentrated with the Asian countries and the oil producers.
JM: I don't know if you've noticed that US exports have been
growing for the past few months; perhaps, which confirms your case – that the dollar
has weakened enough to start having an impact on trade. 
TA: True, and the trade deficit has also improved from last year's levels. But getting back to the weekly ADXY charts, the rapidly slowing momentum and the resistance at the top of the channel make it clear that a fairly severe correction is on the cards – the index could fall to either the bottom of the channel, at about 100 (which would be a 12% drop), or at least to the intermediate support line at about 104 to 105, which would be a 7% drop.
JM: Hmm. Actually many of the Asian currencies have already lost 2-3% since the credit crisis took hold.
TA: In fact, and this is the crucial part for us … Greater China (China, Hong Kong and Taiwan) accounts for more than 50% of the index and since the Chinese yuan at least is unlikely to depreciate substantially, others will have to take up the slack.
The rupee makes a pretty easy target given its sharply rising trade deficit and dependence on external capital flows.
JM: So, we finally come to the rupee. If all this madness does come about – and, hey, the market is the market – what does this suggest for the rupee?
TA: Well, for the rupee, I'd first like to point out that its correlation with all the dollar indices is currently extremely high (over 90%) and that the correlation with the ADXY has risen steadily over the past three years.
JM: But correlations are highly unstable.
TA: I accept that. But I've got some charts on the rupee, too, if you'd like to look at them.
JM: Oh, well, all right.
TA: Great, look at this. First of all, the MACD is at its lowest level since 2000, which suggests that the negative momentum (for the dollar) is huge. However, it has bounced off the trend line, which does suggest the trend could have turned around.
More importantly, if you look at the Elliott wave count, the five-year dollar bear market is clearly a complex correction, which is taking the form of a double zigzag (ABC-X-ABC). The second B is about to begin and could take the dollar to 43.75 over the next several months. If the fundamental backdrop were to get really murky, the dollar rally might stretch up to the trend-line at 45.50-46.
JM: Yo, yo, yo, yo, yo! Wait a minute. [By good fortune, our conversation is interrupted by Dr. Risk, who has just walked into the room. Dr. Risk is our most celebrated market guru, and, not surprisingly, understands a bit about technical analysis as well.] Dr. Risk, do you have anything to say on this?
DR: Well, first of all, while the MACD has turned around, it is still very negative, which means that momentum for dollar weakness is still pretty strong.
Secondly, your technical view of a sharp, short-term rupee decline to 44 (or, even to 46) is based on the assumption that the rupee rally is just a correction of the multi-decade bear market. What if the rupee has embarked on a new, multi-year, bull market, not an impossibility given the India story, 9+% growth, et al?
One
could then argue, from a technical perspective, mind you, that the rupee strength from 46+
till now is the 3rd wave of a 5-wave move, which, in my view, may not be complete. If so,
this 3rd wave could extend to 38 or so…
JM: That would be great. Back in 2003, I had forecast the rupee would be 38 in 5 years…that would be next year.
DR: It could happen. But then, once it topped out at, say, 38 (or a bit higher), it could likely turn down again – a 4th wave correction to also keep TA happy – to around 41.50, after which – the 5th wave – it would rise again to at least 36.
JM: Well, that sounds more reasonable to me – but what about a time line for all this?
DR [laughing]: Haven't you heard the first rule of forecasting? You can forecast the rate but not the timing.
JM: You mean like Heisenberg's principle of uncertainty – you can know either the position or the speed of an electron at any point in time, but not both?
DR: Precisely. Which is why risk management is such a complex subject – it's more about avoiding unaffordable losses when you are wrong than about making big money when you are right.
JM: And you, Mr. Technical Analyst, any closing comments?
TA: Well, all I can say is that I've never seen any currency embark on a secular uptrend when the country has a per capita income less than $1000 and an uncompetitive manufacturing base. Autumn is approaching, and it's time to shed old leaves and mindsets, to make space for the new.
AAA-chhoooo! With the credit markets freezing up in response to the lead fallout from the U.S. sub-prime crisis, market players everywhere are shivering and sneezing, while most analysts are scurrying about mouthing I-told-you-so's [even our January special report asked “Will global risk aversion rise in 2007?”]. And while it may take a few weeks (or months) for the terror to subside, it is important that we learn the right lessons from this current (mis)adventure. To recap, a few weeks ago, Bear Stearns announced that two of its hedge funds had suffered heavy losses as a result of defaults in the sub-prime mortgage market. There had been a few tremors reported earlier, but it seemed like the Bear Stearns announcement focused the markets attention sharply on what was soon to come. And sure enough, more skeletons started tumbling out of the closet, and CDO investment rapidly dried up (from over $ 40 bn in June to less than $ 2 bn in July). The sudden increase in risk aversion sent US Treasuries – still the ultimate safe haven – screeching higher and corporate borrowing spreads widened sharply. The sudden increase in nervousness spilled into equity markets, with a particularly vicious focus on companies that had been labeled or announced take-over targets. With the Dow falling sharply, equities around the world tumbled as well. The yen shot higher as increasing risk aversion led to huge unwinding of the carry trade, with the Aussie and the Kiwi taking the biggest beating. The dollar rallied against most currencies (other than the yen), probably linked to the huge buying in US Treasuries. This terror – an appropriate response to market excess – had its roots in the huge increase in risk appetite over the past few years, driven by the ready availability of very cheap money. This very cheap money was being manufactured in Wall Street factories, making structured products, like collateralized debt obligations (CDOs), by bundling together pools of assets – say, a group of mortgages, some (sometimes all) of which were of low credit quality – and breaking them up into parts with different risk/return characteristics. The very low risk (AAA) parts were sold to conservative investors while the super high risk (and super high return) parts were sold to hedge funds. The magic in all this is that the overall cost of these now-obviously-mispriced CDOs was very low, so banks could use them to provide cheap finance to all manners of companies, notably buy-out firms, whose hectic activity was a key fuel to the rapid rise in equities, particularly in the US. Now, the niggling nub of it all was that the AAA portions of the CDOs – acknowledged as such by the major rating agencies (for fat fees, I might add) – behaved quite differently than other AAA instruments, like, say, bonds issued by GE. Not only did they respond differently to interest rate movements, but they also responded differently – and sometimes dramatically – to changes in volatility, or, of course, if there was even a single default within the pool of assets underpinning the CDO. Thus, there were now totally different instruments floating around the market that looked the same from a ratings standpoint. Of course, while markets were calm, they behaved quite similarly – only as differently as, say, AAA sheep and AAA goats. But when markets got volatile, one type (straight AAA bonds) continued to behave like sheep – perhaps simply lifting its head from grazing – while the other – oh, my – turned into something out of a mathematician’s nightmare. Not only did the prices of these quasi-goats fall sharply, but, since these were very thinly traded, there was no real price discovery available. And, so, if someone had to bail out of a CDO by selling one of the tranches at a distressed price – as many funds, notably the ones managed by Bear Stearns, had to – this new price would, according to accounting standards, have to be used to value the continued holdings, which in turn led to valuation losses, margin calls, and the worst mathematician’s nightmare. Clearly, the credit rating companies, who so blithely gave away their credibility (yet again) are partly to blame. But, I would ascribe greater blame to regulators who permitted – indeed, encouraged – credit rating companies to continue to run with a fundamentally conflict-ridden business model. Let's look at it from first principles. If a company gets a AAA rating, it gets to borrow cheaply. The investor who lends to the company depends on the rating to make his investment decision. So, who should pay for the rating? It would seem obvious that is should be the entity that depends on the rating – the investor. Instead, the business model is structured so that the company being rated pays for the rating. This by definition is a conflict of interest, which, sooner or later is bound to lead to a crisis. Incidentally, the same flaw continues to pervade the audit cost business model, even though the last time it blew up – remember Enron – it took one of the then most respected auditing companies with it. This structural flaw needs to be addressed immediately. For listed bonds, a simple expedient would be to have the exchange pay for the rating, which cost it could recover from trading fees (ultimately from investors). For illiquid bonds, it's much trickier – one idea could be to get investors (in primary issues) to allocate the rating component of their fees to the agency it felt provided the most reliable valuations. It isn't easy, but that's no reason not to do it. Failing which, of course, the next time the conflict of interest triggers an explosion, we may all come down with much more than a cold. AAAchhoooo! |
A stronger rupee seems on the cards
Notwithstanding our Technical Analyst's poetry, it is hard not to agree with Dr. Risk's view that the rupee will continue strong, most likely breaching 40 by next year. It is extremely difficult – and appears silly – to look beyond the huge global investment interest in India, bolstered as it is by strong domestic growth.
Further, the continuing improvements in infrastructure will continue to improve productivity, which will (a) increase India's attractiveness as an investment destination, and (b) off-set the impact of a strong rupee on export competitiveness.
To be sure, export competitiveness is taking something of a beating, and the trade picture has deteriorated sharply. The April to June quarter showed a deficit of $20.6 bn (as opposed to $11.8 bn last year); the full year deficit on trade is forecast to cross $70 bn. Nonetheless, it is important to note that exports grew at 14% in the Apr-Jun quarter, which, while lower than last year's 18% (and the previous years' 20+%), is still higher than overall GDP growth. Further, exports comprise around 15% of GDP, and it is not clear why public policy should favor this minority of the economy. Granted, exports create jobs, but then we could argue that lower inflation creates more buying power and, perhaps more importantly, the lower interest rates that result from lower inflation can increase the speed of infrastructure development.
In any event, the reality is that RBI, in its last monetary policy, has acknowledged that it will have less flexibility on the exchange rate, since inflation control is clearly its number one priority. Dr. Reddy pointed out that higher volatility in both currencies and interest rates are here to stay and that users of Indian financial markets need to improve their hedging activities to protect themselves against this.
It is significant that the bursting of the credit bubble over the past couple of weeks has affected the rupee far less than other currencies. The chart shows how different currencies have moved this year, and in the week since the crisis hit. All the currencies that had appreciated as much or more than the rupee since the start of this year have fallen by as much as 3 to 7%; the rupee has given up less than 1% of its gains, confirming its resilience at the current levels.
Of course, it is conceivable that the current global financial crisis could turn into something really serious. With the vast overhang of liquidity already squeezed and inflation still a real threat, tighter money everywhere could lead to lower growth and weaker equity markets. Investors may be compelled to sell “good” assets to make up for losses and/or margin calls in more dicey markets, and, as a result, even the golden boy investment that I believe India is could suffer. While we do not expect this fall-out – markets appear to be calming down already – we believe that even in a very bad global situation, India would be one of the least affected of the “alternative” assets.
The primary reason is that the current crisis is really more about the failure of credit rating agencies to properly value the risk of complex structured products. If they had built the liquidity risk into their ratings, it is more than likely that many of the CDOs at the heart of this crisis would not have gotten off the ground. This would have meant lower asset values and lower growth over the past few years, but no trauma right now. The point of all this is as credit rating agencies (once again) lose credibility over this crisis, their rating of India as sub-investment grade would also mean very little. Investors would have to do their own due diligence and, in my view, India would still come out smelling like a rose.
To my mind,
even if the dollar does strengthen overseas, as the charts predict it will, it would not
materially affect the rupee's trend unless India begins to feel expensive – whether
as a result of rising asset prices, a stronger rupee, or both. I mean at 25 rupees to the
dollar, investment flows would stop dead, for damn sure. At 35, probably. At 38, perhaps.
But at today's 40+ rupees to the dollar, Indian assets still look attractively priced, particularly as the hottest ones – real estate, in particular – appear to have topped out.
Thus, it seems clear that RBI's efforts to prevent rupee appreciation will remain ineffective, as we have seen both in March this year (when inflation shot higher as a result of the surge in money supply from RBI's dollar intervention) and, again, earlier this month, when the almost draconian ECB curbs had virtually no impact on the rupee.
We believe it would be much better for the economy if RBI were to let the market take the currency to its balancing point and then let it rise under the influence of the stronger dollar. Face the music today –frightening as it may seem, it will be sweetness compared to what it may sound like in the future.
Putting it all together
We forecast a strengthening rupee over the next 18 months, to a level of around 38 to the dollar; however, the strong dollar overseas would certainly create volatility, and we would temper this view with a stop loss of two successive closes above 41.50.
Of course, it is impossible – and, in fact, not even sensible – to plan your business hedging based on this (or any other forecast). The real goal of this analysis is to point out that there could be substantially different views, any or none of which could be correct.
The only prudent course of action is to use derivatives more actively, since they provide both the ability to hedge risk and capture opportunity, which is sometimes critical to sustaining margins.
