The Impact On The Rupee In an earlier background note, I mentioned that US demand for world savings is falling off a cliff. Their twin deficits, the Fiscal Deficit and the Current Account Deficit, which used to be $560 bn + $ 700 bn = $ 1.2 trn, has seen the Current Account Deficit come down by 70%, to $ 240 bn. If private demand for world savings is reflected in the Current Account Deficit, while public/ Govt demand is reflected in the Fiscal Deficit, then quite obviously, the deleveraging of the US Consumer reflected below, would show up in the Current Account Deficit. The United States trade deficit with China is down by about 14 percent or $20 billion, compared with one year ago. The nation's trade deficit with Japan has shrunk by almost 20 percent, and its deficits with Mexico, Canada and the European Union are down more than 40 percent, because of the sharp recent appreciation of these currencies. This stems mainly from the staggering collapse in trade. With credit markets frozen and Americans facing the highest unemployment in more than 30 years, US imports have dropped precipitously. In short, the supply of domestic savings has increased, with the Savings Rate near 9%, while demand for overseas savings (as reflected in the Current Account deficit) has come down by 70%. Since the Govt Fiscal Deficit is financed by Deficit Financing, there is now almost no US demand for the traditional sources of world savings to fund its erstwhile twin (revenue) deficits, i.e. Japan/ China/ Asia. As already pointed out earlier, these countries have seen a drop in their savings (especially in Japan), or are seeing an increase in the domestic demand for savings, i.e. domestically funded investment demand. In short, the imbalances created till 2007 are corrected spectacularly. This is the story of Dollar FUNDAMENTALS, which way SHOULD the Dollar be going. With US demand for world savings dropping, the issuance of Dollars to overseas investors should be falling; with domestic savings taking their place, US Govt bonds are being bought back by US investors from the Asians. So there should be lesser Dollars available overseas, right? Then why is the Dollar depreciating? Meanwhile, the Feds pump billions into the banking system @ 0.25%. But instead of making loans to the private sector, the banks take the money and buy long-dated US Govt bonds yielding over 4%. Result: banks make money; but there is no Corporate lending. American savings could be quickly replacing Asian savings, but there is an old stock of about $ 2.6 trn of US Govt debt held by Japan/ China, which could be pulled out. That would mean rates of 15% to 20% (like in 1987)...It's a question of who will bridge the gap if these countries pull out. The fiscal condition of the United Sates has deteriorated dramatically during the last several years. On the basis of current obligations, US indebtedness totals only about $12 trillion. But with the present value of future obligations like Social Security & Medicare for its ageing population - US indebtedness soars to $74 trillion, more than six times US GDP. Let me take you through what the bond markets are thinking. But first: think of bond investors as people who finance Govt deficits; and Govt deficits are the P & L Accounts of Govts, funded by Current Liabilities, i.e. T- bills or long-dated Govt debt. Hence, bond market pricing depends on 2 very important factors: the Fiscal Deficit (i.e. the deficit in the P & L Account) and the Debt: GDP ratio (i.e. the total stock of indebtedness, like the Debt : Equity ratio of a company). So, just like a banker looks at the profitability of a co, and its Debt : Equity ratio, a bond investor looks at the same 2 ratios of a Govt. The chart below tracks the federal budgets for both America and Brazil as a percentage of each country's GDP. Back in 1998, the US ran a budget surplus, while Brazil was running a deficit equal to 9% of GDP. But the two nations have traded places. At last count, the US budget deficit totalled an astounding 9% of GDP, while Brazil's deficit totalled only 3.3%. And yet, the US government pays only 3.28% in interest per year to borrow money for 10 years; while the Brazilian government must pay 5.05% to attract investors to its 10-year bonds. Thus, the yield spread between these two borrowers is 1.77 percentage points. Quite obviously, bond investors should be selling US bonds (putting further pressure on US savers to buy those bonds with their new-found domestic savings) and therefore, US Dollars and buying Brazilian Real and then investing it in Brazilian bonds. This will create a self-fulfilling prophecy: the US Dollar drops, and the Brazilian investor not only gets higher interest rates, but also an appreciating currency. This creates a ‘feedback loop’, which leads to ‘carry trading’, i.e. non-savers start doing this, accentuating the trend till expectations change. This is what is going on now. Bond markets price specific bonds relative to other bonds, known as the "yield spread." (A very common yield spread comparison is made relative to Treasury bonds). So for example, if a certain 10-year bond issued by another Govt or a company is yielding 5.28% at the same time that the US 10-year note is yielding 3.28%, that bond is said to be trading 200 basis points (i.e. 2.00%) over Treasuries. The higher the spread over Treasuries, the riskier the debt is perceived to be. The yields on foreign government bonds have been falling closer to US yields for several years. Are foreign sovereign issuers becoming MORE credit-worthy or is the US government becoming LESS credit-worthy? Or is it a little bit of both? Remember what I said above: that 2 important metrics drive this pricing, i.e. the Fiscal Deficit and the Debt : GDP ratio. In case of India, our Fiscal deficit is the worst among the BRIC nations (6.8% national, 9.8% including the States) but our Debt : GDP ratio is still about 83% although it is rising. With GOI debt going at 7%, there is some scope for carry-trading, which tells me that the Govt should be following an easy money policy till the US stimulus packages work themselves out, or till Indian inflation becomes a bigger scare, which should happen sometime next year. OECD interest rates are converging toward US rates. Canadian and French sovereign 10-year interest rates, for example, have been moving closer to US rates for several years. This narrowing of yield spreads is not only evident among issuers like Canada and France, but also among emerging market issuers, especially the rapidly emerging market issuers like Brazil. Some investors might infer, therefore, that emerging market bonds are too expensive, relative to Treasuries. Risk-free Treasury bonds are not as risk-free as they used to be, especially for international bond investors, who deal with currency-adjusted returns. Increasingly, they are driving currency movements; India is yet not too exposed, because FII investments are not freely allowed in Indian Govt bonds. But through the ECB route and corporate bonds, this money flows into India. This money was the real culprit in the 2008 collapse of the Rupee. At the moment, this is the money which will drive Rupee appreciation, besides the huge drop in our Forex outgo because of the Reliance/ Cairn oilfields, as we turn BoP surplus next year. As these 2 factors kick in, the Rupee could break all barriers, which is why we should sell at all levels, but NOT too much at any point in time. It is impossible to predict the exact number at which the Rupee will stop, till we get a fix on what is happening to the international bond markets. And the reversal will also come from a bond market collapse, when the FUNDAMENTAL changes going on in the US Dollar kick in. Difficult to predict, yes. But if you are looking at the right places, you will be first off the mark to get out of the way. NOT LOOKING is not the answer…!!!
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