If long-term yields continue to rise, vicious spiral ahead
Given how the foreign institutional investors (FIIs) continued to pull out funds with gay abandon in the first half of July—they pulled out more than $2.5 billion on the debt and equity side—and the rupee continued to plunge, it is no surprise the government and the central bank were compelled to sharply curtail liquidity on the night of July 15. Though it is true the rupee had stabilised a few days before this, it was never clear if this was just temporary—after all, the rupee had fallen 4% in the month prior to this, and 5% in the month before. So what began was the classic, if discredited, liquidity squeeze with a 200 bps hike in borrowing rates for banks who wished to get more money beyond a fixed limit. There were some hiccups in the sense liquidity wasn’t fully tightened for a bit, but the measures appeared to work initially. Apart from curbing speculation, the idea was that a hiked interest rate would bring back FIIs looking for higher debt yields—never mind that, as many argued, the higher hedging costs involved would more than wipe out the potentially higher yield. Not surprisingly, by the end of the month, the rupee breached the 60 limit once again and even crossed 61 on August 2—it ended at 60.86 to the dollar on August 8.
While the liquidity squeeze was thought to be temporary—there were enough in the government saying as much—the problem is the reality is quite different. For one, though the government has taken several reform steps, they aren’t seen as enough to attract investors; and, in any case, many other counter-measures, such as the Food Security Bill, always give the impression the reforms commitment isn’t absolute. In the event, liquidity tightening is one of the few tools the government has left—higher import duties, probably on the cards over the next few days, may curb imports a bit. But the problem is more deep-rooted since years of excessive CAD has left the rupee vulnerable to even the slightest stoppage in forex flows—more so since, with even trade credit slowing, India has a $20-25 billion gap that needs FII funding in FY14.
Not surprisingly, while FII outflows slowed to $180 million in the week of July 24 to 31, they are up to $623 million in the week from August 1 to 7. With government spending continuing to rise, this means RBI will continue to have to mop up liquidity, raising interest rates further—10-year GSec yields rose from 7.56% on July 15 to 8.14% on August 8. With consumer spending growth slowing, from 15.8% yoy in Q1FY12 to 12.5% yoy in Q4FY13, this means trouble. Which is why, on Thursday, RBI announced India’s version of Operation Twist, selling R22,000 crore of short-term bonds each week—the Cash Management Bills have the advantage of being so short-term, they don’t attract mark-to-market provisions. If the move works, raising short-term yields while keeping long-term ones untouched, that won’t kill what’s left of the growth story. But if long-term yields continue to rise, as they look like they will right now, a vicious slowdown loop looks likely—growth slowing means higher debt-service pressure on India Inc, more bank NPAs, less investment … Like it or not, apart from more reforms, the government has to raise overseas bonds (through its PSUs if need be) and look for IMF credit lines—the failure to do so in the late 1980s is what sharpened the 1991 crisis.