Fiscal cliff decoded

A terminology / situation currently gripping the market is "fiscal cliff".  Suddenly Euro zone's debt crisis and China's slowing growth are on back burner for the market watchers.  What is both important and urgent is resolution to fiscal cliff by the US lawmakers.  

What is fiscal cliff?

Fiscal cliff is a term that describes an economic situation which is a combination of tax increase and spending cuts scheduled to kick in on 1st January 2013, if existing laws are not changed before end of 2012.  For all practical purposes, year ends in a week and a resolve is nowhere in sight. Hence all the sturm und drang!

What caused this?

Bush tax cuts expires by end 2012 and spending cut (under the Budget Control Act of 2011) takes effect from 2013;  these are two main contributors to fiscal cliff. There are also other laws such as those governing temporary pay roll tax cuts and federal unemployment benefits amongst others expiring end of this year, worsening the situation.

Possible scenarios and effect?

Going ahead with original plan is scenario 1.  With increase in tax revenues and spending cuts, this will considerably reduce deficit as a % of GDP. On the flip side this would bring down GDP significantly and push the economy into recession.  An alternate fiscal scenario could be arrived at by changing some of the laws.  While this would result in not so steep tax increases and spending cuts, it would result in higher deficit.

What is holding up a resolve?

Political divide.  Republicans have proposed that Bush tax cuts be extended in its entirety.  Democrats want more targeted approach where tax cuts would end for people in high income bracket and would continue for others. Neither of these has gotten through, creating a logjam. Negotiations are on, now with a tough timeline.

Can congress buy more time? 

Yes, laws could be changed retrospectively, if a consensus is reached after the deadline. So fiscal cliff need not necessarily be an impediment to growth, if a mid path is agreed on even after 2013 has already begun. However cost of indecision will affect spending pattern of individuals and corporations in anticipation of changes taking effect. Longer it takes to resolve, higher will be the impact on GDP. 

Hope market receives a timely christmas gift!!

Too much is too bad!?

Massive injection of stimulus by world's largest central banks is the highlight of the week.  European Central Bank has pledged to buy debt from Euro zone countries to contain borrowing costs earlier this month.  This was followed by US Federal Reserve's open ended QE3 (announced last week) through which the central bank would buy $ 40 billion a month in mortgage backed securities until the economy recovers. BOJ's decision to opt for easy money policy is not only to give impetus to ailing economy but also stop yen from appreciating any further to help protect country's exporters. It's highly likely that Bank of England would soon unveil additional measures to stimulate growth.  

The ultimate goal of intervention by central banks is to be able to influence prices and return on financial assets and hope to have an impact on businesses by lowering borrowing costs and also encourage households to spend in order to boost the economy.  Inflation and asset price bubble (triggered by easing) are concerns but global economy that is on life support currently is a bigger concern. Concerted effort by major central banks increases the potency and this time around we may see demand getting spurred. Investors and financial markets across the globe have been exuberant and they expect central banks' actions to play out for considerably long period. 

What is quantitative easing? Central bank plays an active role in the economic and financial functioning of it's country through monetary tools.  Most widely used tool is setting short-term interest rates in order to influence economic trends.  As we all know low rate policy is prescribed when growth needs to be stimulated and interest rates are set higher when inflation needs to be contained.  Growth is the need of the hour; however Federal Reserve for one has set the interest rate close to zero (for some time now) leaving no room for further reduction to boost growth.  The next  available option is to pump more cash into the system.  This cash is intended to buy bonds and financial assets from banks, leaving the banks liquid so they in turn justify their existence by continuing to lend to businesses.  Business expansion is expected to result in increased employment opportunities and everyone lives happily ever after; well, at least in an ideal world.  

How is easy money elsewhere, is affecting us at home? Since last week, amid flurry of freebies from central banks, Indian equities and Rupee have been beneficiaries.  Investors are flocking to countries and assets which promise more attractive returns than rock bottom rates offered by the US, Euro zone and Japan.  Now with the promise of printing money to infinity (well, close to it), there is more cash (likely) chasing Indian and other emerging market assets.  This hot money would push our central bank to review it's monetary policy in order to (1) keep inflation at bay which is an immediate concern (2) fight against untoward rupee appreciation (as and when).  

Will the easy money push inflation up in US and Euro Zone without any positive impact on demand and output?  Once the factory activity is in full swing and unemployment is under an acceptable level, it is more likely that  (continued) monetary stimulus could prove to be inflationary.  It looks like we are quite a few quarters (if not years) away to get there.  Till then, too much money doesn't seem too bad, honey!

What's in store for Euro zone?

European debt crisis, simply put, is inability of some of the countries (Greece, Portugal, Ireland, Italy and Spain) in the region to pay back bondholders. Slow down in global economy made it unsustainable for countries with loose fiscal discipline. Greece for instance, (which historically ran high budget deficit) was the first to go under with its growth and tax revenues falling.  With increased sovereign risk, investors' expectation of returns has been going up pushing the bond yields of some of the countries in the region.  This is a vicious cycle -  higher bond yields mean higher fiscal strain which prompts the investors to demand even higher yields and this could go on.  

EU (along with IMF and EFSF) has been bailing out Greece, Portugal and Ireland.  European Central Bank announced a plan to purchase government bonds in order to contain the spiraling bond yields of countries like Spain and Italy.  Also through it's LTRO (Long Term Refinancing Operation) made credit available to troubled European banks at very low rates.  While these help stabilize the financial markets in the short term, they have been "kicking the can down the road" and postponing a more decisive step to a later date. 

So where is  EU and Euro headed? Nouriel Roubini, the economist credited with having foreseen the credit crunch has warned that euro zone will collapse within this year;  Nassim Taleb (author of Black Swan) also opines that the end of common currency is no big deal.  Structural flaws that remain in the European Monetary Union need to be addressed; but does the measure have to be extreme?  There are a number of ways that this crisis could play itself out.  We briefly discuss here a few scenarios that could be potential resolution to this now almost three year old crisis. 

Greek (Or peripheral)  exit: Tax payers of other nations (Germany for instance) of the union may push for this.  The short term impact for Greece may be quite severe; however in the long run they may be able to rebuild credibility through tighter fiscal measures and sustainable competitive advantage.  Euro zone may not be significantly impacted by Greece exit per se, provided it works on preventing contagion effect. 

New improved European union Or a full break up: The existing union with its structural flaws seems unsustainable and may pave way to a new, core and better regulated currency union. The resultant "new" euro (or its derivative) could be a far stronger currency.  The weaker members who leave the union may have to devalue their currencies to remain competitive.  But will this be the preferred path with export heavy Germany currently benefiting from a weak euro? Or all this pressure of austerity will lead to a full break up of the union?  

Fiscal union Or monetary expansion:  Fiscal union in the real sense of the term, I mean. Will there be political will to give up sovereignty and readiness to issue what you may call, Euro bonds? Else, Significant monetary expansion or liquidity injection by ECB to protect vulnerable banks and countries could be a potential resolution.  However what will this do to inflation is anybody's guess!

The probability of Greek exit and / or use of monetary expansion as preferred tool seem high, at least in the near term.  Break up of the union? Nah, what with ECB President Mario Draghi claiming (this evening) that "Euro is irreversible" and that "Fears of Euro reversibility are unfounded"!

Libor rigging: what is it all about?

Libor manipulation scandal dominating the news lately is one more example of corporate greed and unethical ways of  profit hungry banks.  This latest financial scandal is another blow to already ailing banking industry.  So what's it all about?

What is LIBOR?

Banks borrow / lend regularly amongst themselves  to manage their balance sheet.  Libor or the London Interbank Offered Rate  is the benchmark rate for this borrowing / lending.  A panel of banks publish the interest rate at which they are willing to borrow everyday for different maturity;  this is collated, the top & bottom 4 quotes are eliminated and the average of the rest is published by BBA (British Bankers Association) everyday, before midday UK time. This rate is then used to fix the interest liability on borrowings of corporate, credit cards, mortgages, car leases, bank deposits and such.  Libor is published everyday for 10 currencies and 15 maturities (ranging from overnight to one year) for each currency.

Barclays' doing?

It is reported that between 2005 and 2009, Barclays traders influenced the pricing of these rates.  Initially, apparently a small number of individual traders submitted an overstated interest rate, to boost profit of their desk. During credit crisis period of 2007 and 2008, Barclays lowered its libor submission in order to protect the reputation of the bank from (1) negative speculation which arose as a result of its earlier overstating came under scrutiny and (2) also to make the bank look healthier and therefore able to borrow at lower rates. 

The bank has been slapped a fine of  over US$ 450 million by the UK and US regulators and gained huge public and political attention.  Barclays Plc decided to offer its Chairman Marcus Agius (married into Rothschild dynasty, incidentally) as a sacrificial lamb; but for once the authorities were quick to act and get appropriate guys to pay the price.  Bob Diamond and Jerry Del Missier who were at the helm of affairs at Barclays Capital at the time of libor scandal (till recently, the CEO and COO of Barclays group) have both resigned under duress.  One can't be heading a top investment bank and look to get away saying  "I had no clue of what a bunch of my traders were doing" or "every bank did it" or "most days no requests (to rig) were made" .  The Economist which generally is never out of line observes "this was rather like an adulterer saying that he was faithful on most days".

Impact?

The exact amount of detriment caused by Barclays' rate manipulation is hard to assess. It is being argued that it only made a few basis points difference (one basis point is one hundredth of a percentage); in the context of enormous financial market there is no "just a little".   Global derivative market is estimated to be $350 trillion; assuming libor was manipulated by one basis point, the financial implication is $35 billion a year.  We are neither putting a number to the magnitude of manipulation nor suggesting that all gains went to Barclays.  However whether they overstated or understated libor, it affected  financial market end users viz. savers or borrowers.

What's more?

Barclays has been the first to be assessed by the regulators.  What is worse is that we are probably going to find out that most major banks have been involved in this scam. There will be a huge wave of lawsuits because of this scandal and that will drag on for decades.  At a time when confidence in global financial markets is already declining, this certainly is no good news. Barclays and its partners in crime have completely destroyed the legitimacy and trust which are the very basic fabrics of financial intermediation.   

Stagflation?

What is stagflation? A condition of slow economic growth and relatively high unemployment accompanied by rise in prices / inflation - basically, a period of stagnation. 

Are we headed towards stagflation? Our growth has been declining nine quarters in a row and recent headline inflation is north of 7.5% in May. Though rupee depreciation has been playing a role in WPI inflation, it is a concern, nonetheless. Two of the text book criteria for stagflation are being met and we have no recent reliable statistics on unemployment. 

The fact is that, scary 'S' word is doing its rounds in the recent times.  Global financial services firm Moody's has also recently stated that Indian economy is facing stagflation; According to senior economist of Moody's analytics, India's economy is in stagflation, with notably weaker growth but inflation still stubbornly high.  

Given the concerns of inflation, RBI put rate decision on hold and continued status quo in its meeting on Monday.  While there is a lot of criticism on RBI's decision (or lack of it) not to cut interest rate / not providing a lift to the sagging economy, I don't think reduction in interest rate alone will give thrust to growth. The blame game continues (as opposed to claims) and there has to be concerted effort between RBI and government as suggested by RBI guv today.

Creating an environment that is investor friendly is the need of the hour.  It goes without saying that investment would push up growth and employment; policy log jam over key factors of production and lack of infrastructure spend have been the major party poopers of investment climate. 

It is not too late to thwart stagflation or rising fears of economic downturn. If we are done playing political games, could we start focusing on country and it's people?

News and views

Rupee closed at a record low yesterday and opened weaker today. RBI continues to mix administrative steps with intervention to control the pace of rupee depreciation.  Reportedly, one of the senior officials from RBI said that RBI can't manage exchange rate, the external situation and liquidity at the same time.  It is what you call the phenomenon of  'impossible trinity' and RBI's intervention in foreign exchange market is only a temporary reprieve. Widening trade deficit and diminishing foreign exchange reserves limit RBI's ability to intervene effectively. Deepening debt and political crisis in euro zone is pushing the dollar up, risky assets down and rupee under more pressure. 

Euro continues to be under pressure due to rising bond yields, European banks' increasing vulnerability to growing loan delinquencies, and political impasse in Greece. Euro is likely to remain under pressure with potential Grexit (exit of Greece from EU). This would dampen the investor sentiment and all asset classes and markets considered risky, would be further dumped.

Another financial disaster stares at us -  JP Morgan Chase's CEO said their losses on the synthetic credit portfolio had reached $2 billion so far this quarter and could grow further.  The investment bank's shares lost more than 10% since the bad news hit the market.  So what caused this?  In CEO Dimon's (convoluted) words "the synthetic credit portfolio was a strategy to hedge the firm's overall credit exposure, which is our largest risk overall in this stressed credit environment.  We are reducing that hedge.  But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored.  The portfolio has proven riskier, more volatile and less effective as an economic hedge than we thought".  So was this a hedge or a speculation and the have they come out clean with all the basic facts?  More importantly, are there still big banks there which are ticking time bombs for US (and global) economy?

RBI, help avoid stampede

Rupee is under pressure, yet again.  RBI made FCNR deposits more attractive by pushing up the interest rate caps and left it to banks to decide the interest rates on PCFC (packing credit in foreign currency).  Also government delayed controversial tax rules for foreign investors (GAAR) by a year. Indian equity and currency markets were euphoric but it was short lived.  

Recent happenings in Euro region has affected global risk sentiment heavily.  Uncertainty in formation of Government after voters in France and Greece voted out their governments in the recent election to indicate their unhappiness over ongoing austerity measures is the latest in the list of euro region's debt woes.

This, added to our own high interest rate regime, lack of fresh investments, ever widening current account deficit and negative balance of payment, is not painting a pretty picture.  Corporates that I have been speaking to are yet to see reduction in interest rate of their borrowings. Benefits of CRR and Repo rate cuts so far this year are yet to reach customers' pockets.  

Spiralling dollar against rupee is further worsening balance of payment hence investor sentiment.  In the absence of foreign capital flowing in, rupee would remain under pressure making the vicious cycle more complex and painful.

These are economic issues that we have been living with for sometime now and will get over them sooner than later.  What really worries me is RBI speak.  Yesterday we have had a very senior RBI official say "RBI is conscious of the extreme volatility in the rupee exchange rate and has a variety of tools to guard against such fluctuations" but also said " RBI's role in protecting the rupee's slide is limited".  Foreign investors sold close to a billion dollar (net) yesterday alone.  

We believe (1) RBI has reasonable fire power to intervene in FX markets and (2) Rupee will continue to be under pressure given the global and domestic realities and (3) Government needs to do a lot more to ensure RBI's slew of measures is successful.  However what is completely within RBI's control is to maintain its credibility.  As we have seen yesterday, late last year and in earlier instances, statements from RBI could cause wild movement in Rupee.  In this (what almost seems like) an inevitable one way street, what we could certainly do without is, a stampede. Silence is Golden?!

Three cheers to RBI

IPL cheer leaders were seen doing a jig outside RBI yesterday and why not? In it's annual monetary policy announced on Tuesday, RBI took the market by surprise and cut rates by 50 bps.  RBI raised rates 13 times between March 2010 and  October 2011 in its struggle to contain inflation and in the bargain maiming economic growth which was at a meager 6.1% in quarter ended December 2011, it's slowest in three years. 

Policy highlights:

• Repo rate was reduced from 8.5% to 8%, reverse repo is at 7% and CRR remains unchanged at 4.75%
• Lower inflation figures in March and sharp fall in industrial production brought about the drastic change in RBI's stance from being cautious to reducing interest rates aggressively (twice of market expectation)
• This move of RBI clearly indicates that focus has shifted to growth and would remain so as long as growth - inflation dynamics remain in the right direction
• This somewhat sharp cut is to prod banks to swiftly transmit benefits to customers.  
• RBI is comfortable with current liquidity conditions but is watchful and prepared to take necessary steps if and when warranted
• RBI's Baseline expectation for GDP for FY 13 is 7.3% compared to projected 6.9% in FY 12 which just ended.  Headline inflation is expected to end the current year at 6.5%
• RBI also underlined the need to decontrol diesel, LPG and kerosene prices despite risk of inflationary pressures.  This would cap subsidy burden and ease ballooning  fiscal deficit 
• Central bank has proposed removal of foreclosure charges or prepayment penalties on home loans bearing floating interest rates.  Though some banks are following this already, this has now been formalised

So what's in it for us?  Imminent reduction in deposit and lending rates though reduction in home loan rates may not be immediate.  Reduced interest cost will be a huge relief to ailing India Inc. Also falling interest rate should boost investment which is much needed to bolster growth and does not pose immediate  inflationary pressure. Though it is made to look like a front loaded move and Governor seems to signal pause for the rest of the year, we expect further reduction of 50 to 75 bps later this year.  This sounds very optimistic, but isn't that the need of the hour?  

Hippity hip hurrah!

Spain, the next pain?

One more euro zone country makes headline.  Spanish bond yields surged (close to 6%) to a level which triggered some of the other European countries to seek bailout measures.  This is despite the austerity measure that the Spanish government announced recently.  Italian bonds also surged fueling concerns that euro zone's debt crisis is worsening. ECB recently had two tranches of liquidity infusion to ease tension.

Fourth largest economy of  euro zone Spain, is a part of PIIGS (Portugal, Italy, Ireland, Greece and Spain), countries worst affected by European debt crisis . As recently as January this year, S & P downgraded Spain's credit rating by two notches and set its outlook to "negative".  

Spain's public debt (as a % of GDP)  at 68.5% (2011) is lower than euro zone average of 90% and much lower than the other larger economies in the zone. Germany and France are above 80% and Greece close to 140%

GDP grew albeit at a slow rate of 0.7% last year as against Greece and Portugal's economies which registered -6.9% and -1.6%. However Spain's economy is expected to contract this year and continue to deteriorate as there are  deep spending cuts in its recent austere budget 

Deficit (as a % of GDP) is at a level comparable to Greece, Portugal and Ireland whereas unemployment at a whopping 23.6% looks worse than most of the other countries.  Spain is likely to miss its 2012 budget deficit goal approved by the EU. 

So, will Spain seek bailout?  A lot depends on its fiscal discipline.  Also tighter budgets (read reduced public spending) and high unemployment rate is not an exciting combination.  Significant part of bank loan has been extended to construction and real estate sectors which continues to be at a serious risk of default. This is only pushing up credit risk and borrowing costs further. While Spanish government is doing it's homework to put its house in order, Spain is likely to be dull and prolonged pain. 

Ws of Foreign Exchange Risk Management

WHY?

When risk management motivations are forgotten, problems begin. Defining the objectives of a currency risk management program can be tremendously beneficial for all stakeholders. Articulation of these goals in form of a policy with ongoing education (on the importance of an agreed approach) ensures that  foreign exchange activities are aligned with primary business activities and organisation's risk tolerance. 

WHEN?

The more the time elapses between when an exposure is identified and when an offsetting hedge is placed, the greater the financial risk. Allowing subjectivity could mean more risk.  It is important that time lines are clearly defined on when exposures must be reported internally and when offsetting positions (hedges) must be entered into.  

WHO?

Accountability is key. Functions and levels of responsibility should be clearly stated while developing risk management system. Many a times such responsibility starts and stops with financial decision makers such as CFO or treasurers.  However decisions that carry financial implications are made at other levels such as procurement  and sales teams. These are primary sources of uncertainty and the process should ensure accountability for communicating actual and expected foreign exchange exposure on a timely basis. Similarly treasury front and back office responsibilities should be defined categorically to ensure that all deals are reported, confirmed with counterparties to avoid financial implication due to process slippage.

WHAT?

Effectively managing market risk requires using hedging tools in a dynamic but disciplined manner. Risk management system / policy should not only define set of instruments that may be used by treasury but also describe criteria to be used to decide on their applicability under different market conditions.

HOW?

Ensure compliance with extant regulations by regulatory authorities and internal guidelines and the policy should detail the same.  Performance should be measured against set objectives to ensure tweaking (if necessary) of existing approach. 

Ever increasing market volatility calls for a comprehensive risk management approach. Go for it! Well begun is half done!

Wishing you all a successful and profitable FY 2012 - 13!

Know your options

Foreign exchange transactions are entered into either for hedging a risk or to trade / speculate.  If it is hedging, treasury (based on budgeted rate or FX target rate) decides the timing of transaction.  If it is one of speculative trading, then it is dependent on internal view.  I came across (what appears to be) a simple structure which left me confused as to what could be the objective of entering into a transaction such as this.  Let me take you through an example before we go further.

Indicative market quotes

USD/INR spot        - 51.00

1 month forward    -  51.50

Option strategy / structure

Buy USD put    @ 51.50 (A)

Sell USD call   @ 51.50 (B)

Sell USD put    @ 51.00 (C)

Maturity              1 month

cost                     zero

The strategy under discussion is a combination of options A, B and C.  This structure hedges export exposures (dollar receivable). Option A and B together is nothing but a synthetic forward, (i.e) if USD/INR at maturity is below 51.50 option A gets exercised and and if USD/INR is above 51.50 then option B gets exercised; whichever way, the effective rate would be 51.50 making it work like a forward.  This strategy also has a third leg (option C).  Below is a comparison of  this strategy with a simple forward contract (51.50) under two scenarios:

(1) if market at maturity is <51,

• this strategy is 50 paise better than spot (at maturity) 
• whereas a forward contract will be better than spot (at maturity) and above structure.  For instance, if  USD/INR spot, at maturity is 45, forward contract is Rs.6.5 better than market  whereas the above strategy is Rs.0.50 better than the market (spot at maturity)

(2) If market at maturity is > 51, then the above structure works just like a forward

This strategy CAPS YOUR GAIN AT 50 PAISE BUT YOU COULD LOSE A WHOLE LOT.  An option which has a limited upside and a substantial risk - Beats the purpose?

Going back to where we began, why would a corporate enter into this transaction?  I wouldn't think it's for hedging as this does not protect any particular level. If it is speculation, what is the view?  If the view is one of rupee depreciation, this strategy doesn't work; if  it is otherwise, forward is a better bet. Or it's the "zero cost" temptation? Beats me! 

 "Zero cost options" have been around for a long time and could turnout to be most expensive in hindsight.  It is important for corporates to check (1) if the offered strategy meets their hedging needs and / or confirms to their view and (2) scenario analysis before closing the trade.  

So are options bad?  Not if you know what you are getting into.  As cliched disclaimer goes  "please read the offer document carefully before investing". 

Non Deliverable Forwards

Indian Rupee is once again on a downward spiral; while oil importers' dollar demand is one key factor, what has been adding to rupee volatility is the offshore rupee market.  Popularly known as NDF (non deliverable forward) market , has been gaining volume and momentum over the last few years and a major price determinant of USD / INR.  This week's market talk is an attempt  at  exploring the how, why and what of NDF market.

NDF is an instrument to hedge foreign currencies which are not traded internationally and which do not have forward markets outside their countries.  This instrument only trades outside the country of the currency. NDF is typically a short term, cash settled, currency forwards between two counterparties. On the contracted settlement date, the profit or loss is settled  between the two, based on the difference between the contracted rate and a fixing (benchmark) rate. Fixing rate for rupee is RBI reference rate.  As the name suggests, there is no physical delivery of currencies and profit / loss is cash settled. NDFs are quoted from one month to one year.

NDF evolved as a result of restrictions in local forward markets.  It was mainly used to hedge currencies which could not be delivered offshore or unhedgeable in the corresponding countries.  Rupee is not fully convertible, there are capital restrictions and NDF market helps circumvent the issue.

Some of the Asian currencies which have active NDF markets are: Chinese Renminbi, Indian Rupee, South Korean Won, Malaysian Ringgit and Indonesian Rupiah. The main trading locations for NDFs are Singapore, Hongkong, Korea, Taiwan, New York, London and Tokyo.  

Offshore forward market now serves more as a platform to speculate and take advantage of arbitrage that exists between onshore and offshore currency forwards.  Offshore INR market is trading 24 * 7 moving from one financial center to another and reflects the views of international investors / speculators. Also as Indian market is not fully evolved  (due to capital restrictions), there are interest arbitrage and currency arbitrage that exists from time to time.  For instance, an Indian company which borrows in US Dollar (USD) and hedges forward may have an all-in borrowing cost that is lower than if it borrowed in rupees as rupee forwards is not function of interest differential between USD and  INR. 

This arbitrage opportunities exist between offshore (NDF) and onshore rupee forwards.  Many Indian companies with operations overseas, take advantage of this arbitrage by simultaneously entering in forward contracts onshore and offshore.  For instance if one month forward rate is 51.10 in India and the same is 51.20 in offshore NDF market, the offshore arm of the Indian company simply sells and the onshore (India) parent contracts to buy, making a neat 10 paise risk free profit.  On the settlement date, wherever the fixing rate is, this 10 paise (per dollar) profit is assured.  The more number of time this deal is churned, the more profitable it gets.  This has pushed up the volume of NDFs considerably.   

While the arbitragers come in only when there is a window of opportunity, speculators take more risk based on their view.  If global investors have a weak outlook of rupee, they sell the currency in the offshore market , arbitragers close the difference between offshore and onshore rupee exchange rate; this moves the rupee onshore (India) to reflect the view of global investors.  This in itself is not bad.  However an Indian entity with an actual exposure to currency risk, can do nothing about overnight rupee swings offshore and in a trending market it could prove detrimental as the currency may open with a huge gap the next morning in India.  

So NDF market has largely been determining the direction of rupee and rupee is now globally traded currency albeit non deliverable.  Why not open up the market and make it more efficient?  

Credibility is key!

It is a lackluster budget but is being perceived as one that hinges on credibility, pragmatism and reality.  Given the political, economic and global environment, an aggressive budget would have been a non starter.  

Highlights of union budget:

• No change in corporate tax structure, however the indirect taxes, both excise and service tax have been moved up to 12% from 10%. Also service tax now covers a wider spectrum.  These two have been aligned as a preparatory step towards GST. 
• Very modest change in personal income tax where exemption limit has been moved up to 2 lac from existing 1.8 lac and highest income tax rate made applicable for income above 10 lacs
• Agriculture, power, civil aviation and infrastructure sectors have received attention. Proposed measures are ECBs for working capital and to replace rupee debt, reduction in withholding tax on ECB and tax free infrastructure bond has been doubled and part of it would be allocated to (Venture capital) to MSMEs through SIDBI
• Large cars duty raised raised from 22% to 27%
• Government borrowing program is aggressive; with no clear cut direction on fiscal consolidation, interest rate easing would be slow paced, cost of fund and liquidity would be under pressure
• Import duty on refined gold has been doubled - this is a good move as investment could now move to more productive avenues and would also help current account deficit considering our gold import is substantial
• Fiscal deficit is pegged at 5.1% for FY 2012-13 which is lower than where we are likely to end this year (5.9%) but higher than what was projected for the current year (4.6%) in last budget
• GDP for FY 2012-13 is estimated at 7.6%
• There is no direction or timeline on FDI, deregulation on diesel, GST or DTC

It is a credibility building exercise after Government has floundered about in its projections (growth and fiscal deficit) for the current year, recent election results, not-so-cooperative coalition and other challenges.

 It is a realistic budget, all right.  Let us hope our Government delivers in line with it's proposal if not more! 

Buyer beware and sellers too!

USD / INR reached well over 50 (50.75 intraday high) yet again.  Stock market slump, oil demand, a bit of panic and RBI intervention - just the same old story. Rupee staged a smart recovery on the back of investment flows earlier this year.  However fundamentally little has changed explaining Rupee's nosedive. 

Recent data showed the Euro Zone shrank 0.3% in the last quarter of 2011 worsening recession fears.  Despite second bailout package concerns remain whether Greece would manage to meet its deadline for debt restructuring.  

Crude continues to soar putting huge pressure on India's balance of payment. There seems to be no respite.

US data though increasingly encouraging, the recent testimony of Federal Reserve chairman continues to reflect skepticism - the pace of expansion has been modest and uneven and long term unemployment is near record high.  Given the restrained growth, the fed rates are likely to remain near zero for considerably long time.

At home, economic and political situation remain as challenging as it was yesterday or last week or last month.  Added to existing woes, the poll results seem to set an anti-incumbency trend raising further concerns on fate of policy decisions going forward.  

Volatility in Rupee is likely to remain high see-sawing between hot money chasing Indian shores and internal inability to retain investments.  Views and projections make an interesting conversation at a cocktail party; but decisions based on views may not bode well for business.  

Base your hedge decisions on exchange rate budgets and be extra cautious in setting budget rates for the coming financial year.  As the old adage goes, it is better to be safe than sorry!

Goldilocks budget - any chance?

Under normal circumstances, last day of February is "budget day"

However, budget this year is postponed to March 16, owing to polls in 5 states which extends up to March 4 after which counting starts.  Our Finance Minister has a tough task at hand.  Complex coalition government (the only thing that I recollect from the last year is inaction),  global situation being what it is, dwindling economic growth at home, prolonged period of high inflation and burgeoning fiscal deficit  - damned if you do and damned if you don't, Mr.Mukherjee! 

Challenges and high expectations aside, some of the likely outcome of the budget are:

• Individuals can expect a  modest increase in exemption limit, lower tax rates may be asking for the impossible but it is likely that highest income tax to be made applicable for those with annual income above Rs.10 lacs (as against existing 8 lacs)
• Tax deduction limit is likely to be increased on interest paid housing loans.  This might boost the real estate sector and balance the burden of increased interest rates for home buyers
• To give a boost to investment into infrastructure, the tax breaks is likely to be increased from the existing Rs. 20,000
• Exporters may not get any additional tax incentives in the form of excise duty exemption / reduction (select industry), service tax exemption on ECGC premium or currency conversion. 
• Corporate tax rate is likely to remain as it is but there may be higher depreciation benefit in the offing to encourage companies to replace assets and there by boosting infrastructure sector
• Airline Industry may get some relief with support packages being considered to help the cash strapped industry
• Service tax threshold may be increased and MSMEs may get additional attention 

On a broader perspective, market is expecting a Goldilocks budget, one which is pro growth, pro investment and one that deals with inflation and fiscal deficit.  Possible?

Hopeful! 

News and views

Euro zone finance ministers agreed on a much awaited Euro 130 billion bailout package for Greece to avoid defaults.  A major bond repayment is due in March; while this rescue package is facesaving for Greece (albeit temporarily), there are lingering doubts about Greece's ability to recover and more importantly avoid default in the future. EU had managed to stall immediate risk of contagion by forcing Greece to commit to unpopular austerity measures and pushing bond holders to take big losses.  It's hard to see how Greece would implement austerity measures / achieve new fiscal targets and ensure growth or in the absence of the latter how would the former be possible.  

Last week, BOJ announced sizeable quantitative easing to stem deflation.  BOJ's asset purchasing program is expanded by a further Yen 10 trillion where they will buy more long term Government bonds.  In a first time move, BOJ also set a numerical target for inflation.  This move coupled with the fact that  the market is more willing to wear a "risk on" hat (post Greek deal), Yen has lost considerable steam in the last week or so.

There is plenty of support to risk appetite.  Greek bailout has helped and the US economic data continues to be better than expected.  FED has committed to keep the rates near zero for a considerably long time. This increased risk appetite is evident; yesterday dow moved above 13k mark for the first time since May 2008. 

In China, PMI (manufacturing activity) remains under 50 (contraction territory).  February data at 49.7 is better than 48.8 in January however it is been in a contraction zone for the fourth month in a row.  This would continue to keep the pressure on PBoC to keep the rates soft / ensure liquidity for a considerably long time.  

PMEAC (PM's economic advisory council) 's chairman C Rangarajan  said "we might be able to achieve 8% growth (12-13)on our esteem and if the world environment is favorable, we will be able to achieve higher growth rate".  Also according to him, excessive appreciation of rupee is not good. I wonder what is the point of reference for comparison - 54, 49 or 45?

Grexit

Greece economy shrank close to 7% in 2011 and it's entering its fifth year of recession.  It's efforts to push through a tough austerity measure may in all likelihood win it a bailout package (second time) from Troika (EU, IMF and ECB); but how this will help the country in the long run is the question.

Unemployment is north of 20% compared to 7.7% in 2008.  With more and more tightening that is being pushed down its throat, in return for a proposed Euro 130 billion package, Greece's GDP is likely to go down a whopping 20-30% over the next few years. Almost one half of Greek below the age of 25 are out of work and many of those who still hold a job have not been paid in months.

Even after Greece parliament has signed off for an harsh package of spending, wage and pension cuts, the troika sent Papademos back to the drawing to board to come up with further cut of 300 million Euros. Euro Zone finance ministers have called off a scheduled meeting and instead holding a tele conference today hopefully to decide the fate of Greece and a bailout package.

It is justified that troika is dragging its feet; Greece failed to implement reforms it promised in exchange for it's first bailout (110 billion Euros) more than a year back - missed targets for reducing budget deficits, still dilly dallying on privatizing state assets,  trimming the staff strength of public sector and such. Greece has done a remarkable job in bringing down primary deficit and private consumption but far from where they have to be!

Chief Economist at citigroup has coined a term Grexit (Greece exit) and they see a 50% probability of Greece exiting the Eurozone in the next 18 months. It could well be the best for Greece.  However, does Greece have the luxury to opt out? International lenders will withdraw aid and financial system would collapse.  It probably makes more economic sense for Greece to continue to swallow bitter medicine and bear painful side effects; which is precisely what the political leaders are opting for.  

However how long will Greeks put up with rising unemployment, negative output and increasing homelessness? That ultimately would decide Grexit and how quick!

Market knows the best

Indian Rupee and stock markets have risen close to 8% and 15% respectively since the start of 2012.  Rupee's rise is largely attributable to (1) RBI's measures to bring in stability to rupee and (2) foreign portfolio flows.  Foreign Institutions bought into Indian equities to the tune of $ 3.2 billion (net) in 2012; compare this with 2011's net outflow of $357 mio.  This explains the sharp recovery in Indian stock markets.  Why is investment pouring in?  valuation?  expectation of low interest rate regime?  factoring in investment / business friendly budget? 

My anxiety stems from the fact that nothing has changed significantly in the last month to justify this euphoric move.  We are still dealing with the overhang of Euro debt crisis and it's impact on emerging markets, internal policy logjam and Government's inaction, fiscal deficit, inflation (current levels seem unsustainable as seasonality factor looms large), CSO's (Central Statistics Office) latest growth projection of 6.9% for FY 2012 (India GDP was a much impressive 8.4% in 2010-11) and the list could go on. I don't want to sound like a naysayer; but this recovery has been so quick, I have trouble comprehending!

If we scratch the surface a bit more, we see recovery in industrial output, expanding manufacturing and service sectors, impending low interest rate regime and its positive impact on businesses and rupee's smart recovery - is a a turnaround  round the corner? Has the market got its instinct and timing right? 

Having spent close to couple of decades in (and trying to understand) markets, the one thing that I have learnt is, "market knows the best".  Financial markets are (said to be) efficient and prices in all information. Research shows that, when it comes to comprehending big picture of the economy,  market is more spot-on as it aggregates the information of millions of investors.  While we are fretting over statistics, is market (read group of investors) seeing a different and much better picture emerging? 

Is India about to shine again? Is the stock market and rupee rally likely to continue?  The answer is, I don't know.  The reality is, that  the assets are where they are today - rupee stronger, asian stock markets higher, gold well above 1700, euro (presently at 1.3275) defying fundamentals and Dow looking promising (a tad below 13k). 

So what do we do? Some thoughts till we market talk again next week:

(1) Market is reality, view is merely speculation

(2) If you want to gamble, Vegas may be a nice choice

(3) No one went broke booking profits