India's central bank says 'boo.' Carry traders faint

What has been bringing carry traders to India, besides the chance to earn a three-month yield of 3.3 per cent, by swapping into rupees the dollars they borrowed at the three-month Libor rate of less than 0.2 per cent?

"India joins the money printers."That's how an ING Bank research note describes the Reserve Bank of India's explicit commitment to buy 1 trillion rupees ($14 billion) in government bonds this quarter. Since this new move has been given a fancy name - Government Securities Acquisition Programme - it will probably both extend and expand.

Large-scale bond-buying and money-printing may result in a glut of rupees, causing them to depreciate against the dollar. Which is why the foreign-exchange market pushed the dollar 1.56 per cent higher against the rupee, one of the largest one-day moves in the past decade.

Is this the start of quantitative easing? Robert Carnell, ING's head of Asia-Pacific research, thinks so: "QE, once the preserve of reserve currency central banks, is now becoming pretty mainstream," he writes. With its new programme, India has "joined the ranks of Indonesia and the Philippines in Asia who have dabbled with this policy."

Bond traders aren't all so sure. The yardstick for a monetary bazooka is Mario Draghi's "whatever it takes" moment at the European Central Bank in the summer of 2012, or Haruhiko Kuroda's bold 2013 campaign at the Bank of Japan to end 15 years of deflation. RBI Governor ShaktikantaDas'smanoeuvre isn't in the same league. It's just a formal announcement of open market bond purchases the authority does on an ad hoc basis anyway. How can you get excited about $14 billion of debt-buying this quarter, when the preceding three months' total was $20 billion?

QE, what QE?

Rather than chalk up the program as full-fledged quantitative easing, traders like Arvind Chari, chief investment officer at Quantum Advisors Pvt, are more comfortable calling it a yield-curve flattener, which should help the central bank manage a bloated government borrowing program. The benchmark 10-year yield has indeed shifted lower over the past two trading sessions.

The fixed-income folks probably have it right: This isn't the start of a new monetary policy regime. As for the unusually large move in the currency, Mumbai-based finance professor and Observatory Group analyst Ananth Narayan has a simple explanation. The carry trade in the Indian rupee has been getting crowded, he says.

These are bets where speculators borrow a low-yielding currency, such as the dollar, to buy a high-yielding emerging market currency. As long as what they're buying (the rupee in this case) doesn't drop like a stone, they come out ahead. A fall like Wednesday's would scare them off and lead to an unwinding of positions, which in Narayan's calculations had swelled in just five months through February to $40 billion.

What has been bringing carry traders to India, besides the chance to earn a three-month yield of 3.3 per cent, by swapping into rupees the dollars they borrowed at the three-month Libor rate of less than 0.2 per cent? Before Wednesday, they could be reasonably sure that the rupee, the best-performing emerging-market currency in the first quarter, would remain propped up by strong capital inflows: Overseas investors have plowed $37 billion into India's frothy equity market over the past year.

With inflation one percentage point above the mid-point of the central bank's 2per cent-6per cent target range, and local savers grumbling about unremunerative deposits, there was little risk that the RBI would go down the path of adventurism. The opportunity for unconventional action was last year, when Bank Indonesia decided to directly fund its government's fight against the coronavirus. Now, the markets are starting to expect the US Federal Reserve to raise interest rates sooner than it has indicated so far, leading to a flight of capital from emerging markets.

Carried away

This is a time for policy prudence, and currency stability. Or that's what the carry traders were betting.They were expecting the RBI to gradually withdraw the $89 billion of surplus domestic liquidity in the banking system. The monetary authority had opened the floodgates last year to fill the cracks caused by Covid-19 dislocation. Since removing this excess by selling interest-bearing central bank paper would entail a visible fiscal expenditure, the RBI was doing it by converting some of its spot dollar purchases (which keep the rupee competitive for exports) into forward purchases, accompanied by spot dollar sales. The latter sucked out rupee liquidity. The implied rupee interest rate involved in this little operation is much higher than the local money market rate, says Narayan, but it's not a cost that has to be explicitly acknowledged. The message to carry traders was clear: Who wouldn't want to buy a currency whose sole issuer wants them so badly as to implicitly pay a hefty premium to have them back for one year?

But then the RBI cried "boo" in a crowded room. Its bond-buying announcement came amid a sinister-looking resurgence of the pandemic that could drag out the recovery from last year's harsh lockdown. New cases reported Thursday spiked to a daily record of more than 126,700, and vaccine stocks dwindled to three days in Maharashtra, the worst-affected state and home to Mumbai, India's financial capital.

Carry traders were invited

Moody's Investors Service flagged this second wave as a risk to domestic air travel and to the credit quality of airport operators. ICRA Ltd., the local Moody's affiliate, said a jump in infections could spook investors, making it tougher for home financiers and other shadow banks to securitize retail assets. The banking system was in poor health even before the virus outbreak. Nonperforming loans this year could be at a 20-year high, Capital Economics says.

This sudden surge in economic uncertainty provided the RBI with elbow room to talk yields down. It took the chance, and unveiled what's billed as a big-ticket easing programme, but in reality may be more water pistol then bazooka. Carry traders got shocked, nonetheless. People are so jumpy nowadays. (Bloomberg)