Make use of forex reserves
RBI’s primary use of forex reserves is twofold: As an emergency fund in case of a fiscal crisis or food crisis, and to help mitigate any significant volatility in the rupee
By, Adhvith Dhuddu
Recently, surpassing $2 trillion, China’s foreign exchange (forex) reserves make up close to one quarter of the total reserves in the global economy. Though a pittance compared with China’s reserves, India’s forex reserves have grown healthily over the last decade and a half and are in many ways a reflection of our success as an economy. With close to $260 billion—approximately 25% of our gross domestic product (GDP)—in forex reserves, our coffers are extremely well padded to tackle a crisis. But what’s disappointing is the Reserve Bank of India’s (RBI) reluctance to deploy these funds in creative and resourceful ways.
In his book, Making Globalization Work (2007), Nobel Prize winning economist Joseph Stiglitz dedicates a whole chapter to explaining how the global reserve system should be reformed for the greater good of the world economy. After analysing how Asian countries have accumulated significant reserves following the Asian financial crisis, Stiglitz says: “The money put into reserves is money that could be contributing to global aggregate demand; it could be used to stimulate the global economy. Instead of spending the money on consumption or investing the money, governments simply lock it up.”
Not surprisingly, India is a victim of this flawed strategy. RBI’s primary use of forex reserves is twofold: As an emergency fund in case of a fiscal crisis or food crisis, and to help mitigate any significant volatility in the rupee. In its half-yearly Report on Foreign Exchange Reserves, RBI states that, “safety and liquidity constitute the twin objectives of reserve management in India and return optimization becomes an embedded strategy within this framework.” Despite its stated intention, RBI conveniently chooses to ignore how return optimization will be achieved.
There are several ways to measure return optimization of forex reserves. One standard reliable way is to see if forex reserves meet, exceed or lag reserve adequacy ratios.
Some rule-of-thumb reserve adequacy ratios are: sufficient reserves to cover three-four months of imports; reserves that amount to 20% of M2, a broad classification of money supply; a reserves-to-GDP ratio of 10%; and reserves-to-total external liabilities ratio of 100%. Measured against all these global reserve adequacy standards, India’s forex reserves exceed the requirements. Our forex reserves can cover seven-nine months of import; they are at 85-100% of M2; at 25-27% of GDP; and cover our short-term liabilities five-six times over. By this count, the optimal level of forex reserves for India would be somewhere in the $170-190 billion range.
As a start, 10-15% of reserves can be invested in India for various purposes: infrastructure, agricultural loans, educational loans, and so on. Lawmakers and regulators should understand that deploying just $25-30 billion will in no way increase our external vulnerabilities and a sudden outflow of capital would still be manageable.
In fact, the Asian Development Bank endorsed this strategy in early 2008 and encouraged India to use forex reserves to augment infrastructure development. Recently, the India Infrastructure Finance Co. Ltd successfully tapped our forex reserves through its UK subsidiary to fund capital goods purchases for infrastructure projects. So, whether it’s creating special purpose vehicles for investment in India, forming a sovereign wealth fund (SWF) or allocating $100 million each to the best 100 investment ideas in India, the options available to RBI are abundant.
Creative deployment of forex reserves will have political hindrances —SWF investments, for instance, can be badly politicized. But as Stiglitz points out, the current alternative is “governments just (locking) up” these reserves without putting them to work. Old habits, such as investing heavily in government securities and staying satisfied with substandard returns for forex reserve funds, are hard to break.
Adhvith Dhuddu is an asset manager based in India and the US. Your comments are welcome at firstname.lastname@example.org
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- Senator Jim Bunning, December 2009
The rolling waves of internal market correction finally reached our shores in a violent fashion Friday, as many commodities and related stocks suffered a substantial selloff. As we have long warned our clients, positions in the precious metals industry are infamous for incredible volatility, and the past few weeks have certainly not disappointed in this regard. From the beginning of November, the HUI precious metals stock index was up over 36% into its peak reached this week. Friday ushered in a vicious one day decline of over 7% at one point on Friday. December gold futures declined over 6% from the Thursday peak of about $1,226 per ounce at their low on Friday.
The US dollar enjoyed a violent rally versus every major currency, as the US dollar index was up over 1.5% - a huge move for the index. It appears that the one sided anti-dollar trade finally attracted one too many adherents, at least in the near term, and the vicious process of the pendulum reverting in the opposite direction may have commenced.
It is always difficult to experience these types of violent moves regardless of how many times one has experienced them in the past. The better than expected November US employment report released Friday morning appears to be the major catalyst for this latest shift in markets. TEAM is busy trying to ascertain whether a fundamental and intermediate term inflection point may be developing or whether this is simply a nasty shakeout/correction that will serve to scare the you-know-what out of those who own these positions. At present, it is too early for us to offer a definitive “forecast”, but we can offer our initial take.
Markets appeared to have priced in the base case assumption that the Federal Reserve would keep interest rates near zero through 2010 and even into 2011. Friday’s employment report appears to have re-introduced some anxiety over the wisdom of that assumption. We certainly understand the rationale behind this anxiety and respect the fact that markets often move violently once too many people have moved to one side of the boat – just a small number of people shuffling back to the other side can cause a rapid period of the boat tossing back and forth.
While the current reshuffling of the boat deck could certainly take a couple/few weeks to unfold, we do not yet see signs that the cyclical recovery in commodities is over. There has been a Pavlovian reaction from traders to sell commodities with any whiff of US dollar strength, which is something that historically is not a given. There have been many periods historically in which commodities rallied with the US dollar in relation to foreign currencies, and TEAM believes that a similar scenario is possible. In addition, this latest spike in the US dollar could end up being very temporary, though significant in percentage terms, before it resumes its downtrend.
We continue to retain our significant allocation to commodities and related stocks, as painful as doing so was on Friday, as we believe they continue to present a compelling risk/reward opportunity over the intermediate term. We were encouraged to see that precious metals stocks were down about in line with the metal itself. Often times during these types of violent moves the stocks will be down a multiple of the metal. This suggests to TEAM that the stocks may be poised to finally lead the metal once the current decline exhausts itself, whenever that may be.
We already know that firms have cut payrolls aggressively over the past two years, so if/when demand does pick up, even if it is modestly and regardless of whether it is being created by government stimulus, a cyclical “perfect storm” could unfold. With inventories extremely low and labor cut to the bone, production and labor pressures could emerge quickly. There is no question that the US has lost a huge amount of its manufacturing base to other countries, so employment trends in the US could continue to lag. However, whether a widget is manufactured in Malaysia or Michigan, the demand for raw materials is the same.
We believe this combination of low inventories, dramatically reduced work forces and incredibly loose monetary policies globally is likely to keep a significant wind in the sails of commodity prices. As we stated several months ago, leading indicators suggest the US service sector is poised to lead the US recovery, so service jobs and end demand may revive faster than most expect.
Since the financial crisis took full force last fall, central banks around the world have followed fiscal stimulus with monetary stimulus. Spending has increased by governments around the world while interest rates have been slashed. Fiscal deficits have exploded and rates have remained at record lows. The fact that two central banks have moved to begin removing some monetary stimulus is indicative of something we expected to be inevitable. Countries were never likely to maintain a uniform perception of reality or their self interests.
If we are correct, then we are likely early in the transition towards the third of the three crises. The financial crisis morphed into an economic crisis, and now we believe that government responses and policies around the globe are likely to usher in a global currency/funding crisis. While we may be in the beginning stages of this transition, it could take quite a period of time until the crisis becomes main stream and dramatically impact the broader economy and financial markets.
The major stock market averages are down about 6% from the peak reached just seven trading days ago. That rate of decline would be on par with the June-July mini-correction over the summer, but we expect this correction to be deeper. Our base case scenario is a correction to evolve into 10-15% decline from the recent peak around 1,100. Market sectors hit hardest in the initial stage of this correction have been those sectors that lead the March-October move higher. Financials, energy and materials have been hit the hardest. Small companies have been hit harder than large companies, and foreign (especially emerging markets) have been hit harder than domestic.
At this point, TEAM believes the unfolding correction may end up being similar to the 4-6 week correction markets suffered in May-June of 2006. Economic fundamentals remained strong on a global basis during that correction, which was largely a purging of excess optimism on an intermediate term basis. Major market rallies/bull markets often experience three major phases. Phase one is when the rising tide lifts all boats and low quality stocks tend to outperform. Phase two is typically ushered in via a correction in which many of the low quality stocks never recover. These stocks, as a group, typically make their peak at the end of phase one. Phase two unfolds with investors upgrading their portfolios into higher quality company stocks and leadership narrows in the market. Breadth and advance/decline indicators typically begin to diverge as fewer and fewer stocks participate in the advance. Phase two can include a new market high in the broad market averages, but it does not have to. Phase three includes the final stages of the exhaustion in the market and the transition to the beginning of the bear market.
At this point, TEAM believes that phase one has ended and that the current correction should usher in phase two. Client portfolios have been structured to weather this transition for several weeks – about two weeks premature as it turned out. While shorter term market forecasts are always treacherous, our base case is for the current correction to be quite violent in both directions and last into late November. We expect to maintain significant portfolio hedges until we see signs that the correction has exhausted itself. At that time, it is very possible that we may significantly reduce or even eliminate portfolio hedges and add addition positions to portfolios.
Of course, it is possible that we’ve reached a major market peak and that the market will simply crumble into a major collapse. While this is a very low probability in our opinion, we always approach market declines with a disciplined process that waits for some signs of stability prior to increasing portfolio risks.
- Rodney Dangerfield
For those readers who actually have a life and don’t follow such things closely, much of the bond market trades on what is known as a “spread basis”. Essentially, the value of a bond is gauged relative to what is considered a “risk free equivalent”. For example, company XYZ may issue a new 10 year bond and its spread to the 10 year US Treasury bond may be 2%. The current yield on the 10 year US Treasury is 3.384%, so a 2% spread would result in a yield of 5.384%. Many bond investors worry mostly about this RELATIVE spread far more than they worry about the ABSOLUTE yield of bonds. TEAM hopes most of our clients know by now that our primary obsession is focusing on absolute returns in general – i.e. whether the stock market is up or down 50% in any given year, our goal is to make reasonable positive returns. We view bonds through a similar “absolute return” lens.
The Federal Reserve has purchased well over ½ of the massive amount of US Treasury bonds issues in the past 3 months. TEAM is left to wonder where Treasury yields would be if this artificial demand was not in play. As we’ve chronicled in the past, the Fed is printing money out of thin air in order to monetize/buy these Treasury bonds. Would yields be .5% higher or 1% higher if this wasn’t occurring? We have no idea, but we suspect they would be higher.
In our opinion, those bond investors relying on spread relationships in order to invest may be making a terrible mistake. We believe there is a tremendous risk that US Treasury yields will head significantly higher over the next 3-5 years. We’ve identified a US “funding crisis” as the next potential crisis to face investors, and part of such a potential crisis would likely include significantly higher Treasury yields.
For anyone who has invested for more than the past 10 years, or at least is familiar with market history (yes I admit to being in my mid 30’s!), a 10 year Treasury yield of 7-8% would be considered reasonable. Many may remember when yields were in the mid double digits in the early 1980’s. My colleague, Sam Lindenberg, is fond of telling the story about his 15% mortgage when he bought his house when he moved to Central PA (much like the old “I walked to school in 3 feet of snow stories” some of our seasoned citizens share!). Money market rates have commonly been in the 4-6% range over time.
Many bond investors appear willing to lock up money for 10 years at mid single digit returns and justify it because they are getting an “adequate” risk spread over US Treasuries. TEAM has seen this game before on several occasions. Relativism can be a very dangerous practice as an investor. There were dot com stocks in 1999 that were “cheap” relative to other dot com stocks. There were Las Vegas condos that were “cheap” relative to other Vegas condos in 2006.
One of the most pernicious and morally reprehensible components of our government’s current policy is what it is doing to otherwise conservative savers who are now being “forced” to take risk. We witnessed this with horror during the 2003-2007 period as many seniors rushed into bank preferred stocks and other vehicles that subsequently "blew up". A senior living off of a 10 year CD that may have been at 6% may be finding out that a comparable CD may only yield 3% today. In a quest to preserve their income for such gratuitous items such as medications, food and shelter, is it any wonder why someone in that situation may be willing to move out the risk curve to try and preserve that level of income? Why not buy a “conservative” bond mutual fund that yields around 5%?
Despite all of the crazy market developments since 2000, investors haven’t faced a good old fashioned bond bear market in a long time. There was a relatively brief flirtation with one in 1994 before Alan Greenspan folded (as he always did) to the Wall Street bond traders screaming for mercy. Prior to that time, it has been since the late 1970’s and early 1980’s that bond traders/investors have had to deal with persistently higher interest rates. While mob rule can get one run over if one tries to stand in the way of the stampede, they almost always end badly. We don’t yet have a good feeling as to when the current stampede may end. However, just as prior stampedes have left the masses with deep regrets (rushing into tech stocks in 1999 or flipping houses in 2007), rushing into bonds at the moment is likely to be bad for one’s financial health over the long run. We suspect those rationalizing bond purchases using relative metrics will eventually learn the expensive lesson of absolute value.
Of course, this is just one day, but given the proximity of the major stock market averages to one of our longer term target areas, next week is likely shaping up to be very important to TEAM as to how we adjust client portfolios. At present, client portfolios remain positively exposed to stocks and commodities, but at a dramatically lowered level due to extensive portfolio hedges. This is due to our research and model indicating that there is a high probability that the US dollar is poised to enjoy at least a multi-week rally and that stocks will eventually relent and correct in price at the same time. Our current allocation should be fairly well positioned to weather such a scenario. Importantly, should things not develop as we expect, then we may need to swiftly shift portfolio exposure and scale back some of our hedges.
We recognize this kind of account activity can be unnerving to many clients, but it is a critical part of our flexible strategy that has enabled us to provide consistent absolute returns over time. As always, we are happy to address any client questions or concerns regarding portfolio holdings or activity.