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30/3/2014 Mrunal [Fed Tapering:Part1 of 2] Meaning of Fed Tapering, its Negative Impact on Indian Economy, Worst case scenarios, Balance of Payment Crisi…

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[Fed Tapering:Part1 of 2] Meaning of Fed Tapering, its Negative Impact on IndianEconomy, Worst case scenarios, Balance of Payment Crisis, explained

1. Prologue

2. What is Fed tapering

3. Why is it called Fed Tapering?

4. How can Fed Tapering affect India?

5. Worst case scenario [WCS] by Fed Tapering

1. WCS1: Hot money gone / Flight of Capital

2. WCS2: Weaker Rupee= bigger CAD + bigger inflation

3. WCS3: Exports may not increase

1. Dushmani 4DEVYANI= less EXPORTs

2. Special 301 report & Priority status= less EXPORTs

6. BoP crisis: How can that happen?

7. Can Fed Tapering “really” cause BoP crisis?

Prologue

1. you already know about Quantitative easing and its impact on Indian economy. Click me.So far we know that:

2. in this article, we’ll learn the basics of Fed tapering and its (possible) negative impactson Indian Economy.

3. in the next article= Steps taken by RBI +Government to immunize Indian economyagainst the negative impacts of Fed Tapering (currency swap agreements etc.) click me

What is Fed tapering

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In the first article, we saw that:

Subprime crisis:

Investors money stuck in mortgage backed securities and other toxic assets.You may visualize this as a “Draught” of dollars.

Quantitative Easing

American RBI (US Feds) launched a program to buy toxic assets and governmentsecurities from market.Result? Dollar supply increased. (Because central bank is buying stuff from someoneand paying them in dollars.)You may visualize this as American RBI opened all gates of the dam to send maximumquantity of water (dollars) to American farmers. Although lot of that water- went toChinese and Indian farmers as well!QE was carried out in three phases. Finally in Dec 2012, Chairman Ben Bernankeannounced that he’ll stop this water-supply when EITHER unemployment rate is <6.5%OR inflation is >2.5%. Because each condition implies that American farmers arebooming, hence no need to give them lot of irrigation water (dollars) under Rajiv GandhiSinchaai yojana Quantitative Easing.Dec 2013: Finally Chairman Ben Bernanke sees American farms are booming, there isno need to release lot of water from dam (dollar supply). [in reality – unemploymentrate became lower than 6.5%]

https://www.flickr.com/photos/97816112@N02/13449419105



So, he starts closing dam-gates one after another. Result? water supply (dollar) reduced.This is fed tapering. Observe

Time Bond Buying Program (Billion USD)

Dec 2013 85

Jan 2014 75

Feb 2014 65

March 2014 55

At this rate, canal doors should completely shut down @October 2014. (Because now the newChairman Jenet Yellen is reducing the water supply (dollars) by 10 billion USD per month.)

Why is it called Fed Tapering?

In above graph, observe that the “Width” of canal / graph is decreasing constantly. (inother words, Dollar supply is decreasing).“Tapering” is a mechanical term, to describe such constant decrease in width.And since this is being done by US Federal Reserve, so we call it “Fed Tapering”.Formal definition: Fed tapering is the gradual reduction in the bond buying programof the US Federal Reserves.

How can Fed Tapering affect India?

From Mexican drugloards to Hongkong smugglers to Russian arms dealers to ItalianMafias to Indian Bookies n Match fixers- everyone uses dollars. So any increase ORdecrease in dollar supply affects all economies.In last article, we saw the effect of Quantitative Easing (=increased dollar supply) onIndian Economy.

Let me summarize that in a table:

Indian point ofview

DollarSupply

FDI-FII ExchangeRate Export

Rs. becomesStrong Down due to Subprime +




Quant. Easing HIGH Increase ’09=50’10=44

Greece/Eurozone crisis.

Since QE = increase dollar supply and Fed tapering= decrease in dollar supply, so by commonsense, every effect should become reverse, right?

Indianpoint ofview

DollarSupply

FDI-FII ExchangeRate Export

Quant.Easing

HIGH Increase

Rs. Becomes Strong

2009: $1=50rupees.2010: $1=44rupees.

Down due toSubprime +Greece/Eurozone crisis.

FedTapering

Medium Decrease

Rs. Becomes Weak

March’13: $1=55May 13(rumor ofFed taperingstarts)Sep ’13: $1=66Rs.

Not as high as expected. (moregiven in later paragraphs)



Let’s not waste more time in ball by ball commentary and jump directly to:

Worst case scenario [WCS] by Fed Tapering

Every once in a while, Rajan and Chindu make press statements that Indian economy isstrong enough to survive the negative effects of Fed tapering.Meaning, atleast one expert in the whole world -believes that Indian economy is bogusand we’ll be thoroughly devastated by Fed Tapering. (otherwise Rajan/Chindu did nothave to keep giving such explanations to media.)So let’s check the possible worst case scenarios. How can Fed tapering hurt Indianeconomy?




WCS1: Hot money gone / Flight of Capital

FIIs takeout their money from India to reinvest in USA (Because Fed tapering impliesthat US economy is recovering. So, American investors may want to re-invest in USA.)

Result?

Sharemarket may go down (may even crash- if there is largescale exit of FIIs)=> desiinvestors’ money lost.Rupee will weaken further. How?

Suppose an American FII (say Morgan Stanley) invested in Reliance infra.shares. But now hewants to exit.

Morgan sells those shares= get gets paid in rupeesBut he wants to re-invest money in USA = he needs dollars. Not rupees. Therefore, he’llsell those “rupees” to get dollars (onion).

Supply of onion(dollars)

Decreased because of fed tapering. (recall those dam gates are beingclosed one by one)

Demand ofonion (dollars)

Increased because FII is exiting from Indian market.

Result?Onion (dollar) gets more expensive. $1=65=>$1=70….. In other words,dollar strengthens and rupee weakens.

WCS2: Weaker Rupee= bigger CAD + bigger inflation

FII gone = Rupee weakensWhile weak rupee = good news for Exporters. But bad news for importers.Weaker rupee = we’ve to pay more amount of rupees, to get same amount of crude oil =Current Account deficit (CAD) gets Higher. Rupee weakens further.As crude oil gets more expensive =petrol diesel gets more expensive= transport chargesincrease= milk, veggies everything gets more expensive. (Including raw material.)Raw material gets expensive= input cost of exporters increased = they cannot fully takeadvantage of the new demand created by USA customers/US importers.

WCS3: Exports may not increase

Fed tapering = US feds has started decreasing water supply (dollar) from their canal (Bond-buying program). This implies that USA economy is recovering. So, If US economy isrecovering = American juntaa will buy more = Indian exporters will see more demand. (This isthe positive thinking assumption.) but there are two errors in this positive thinking.

1. Weak rupee = expensive crude oil =Cost of raw material increases. Hence our exportprices may not get that competitive yet, (compared to China, Thailand etc.)

2. Dushmani 4 DEVYANI (Explained below)

Dushmani 4DEVYANI= less EXPORTs

American MNCs love India only as long as we are their call center guys and allow themto open malls and e-commerce sites in India.But as soon as our companies compete in their hometurf @USA, these American MNCswill use every trick in the book to prevent “our” entry.Indian government mishandled Devyani case- annoyed the Obama administration,creating some bitterness in relations.



Now, American business lobbyists are using this negative-sentiment to get Americanregulatory bodies to teach us a “lesson” and get tit-for-tat. Observe:

USbody

“Lesson” taught to Indians during Feb 2014

USFAA

Federal Aviation administration. In Feb 2014, They reduced India’s airline safetyratings from level I to level II.

When Indian flights go to USA, their officers will do more safety checking =more time will be wasted, inconvenience to Desi passengers.Jet airways’ share prices fell down.Domino effect: Singapore’s aviation authority also started inspecting Indianaircrafts. The aviation regulators of EU, Japan, UAE will also reduce our rating.

Consequences: Indian aviation will not bring *that much* dollars as expected.

USFDA

They’ve Have cancelled licenses of Ranbaxy’s Punjab and Gujarat factories.Feb2014: USFDA commissioner came to India to inspect our pharma companies.USFDA’s “activism” = hurts our pharma companies, negative publicity = lessexport orders (From US customers, as well as EU, Japan- everwhere.)= less export= higher CAD.

USTR

United States Trade Representative. They lodged complaint against India, forgiving solar subsidies to desi companies. (Since Indian government gives subsidesto local companies under national solar mission program= American solarsystems automatically become expensive in India= cannot compete. Thus India isviolating the “non-tariff” barriers principle of WTO.

USITC Given below

US International Trade Commission (USITC)

It is a quasi-judicial body.US government uses their report to decide trade policy.Hence, if USITC writes negative report about India, then we’ll suffer indirectly in future(if Obama imposes tariff and non-tariff barriers on Indian goods and services).

At present USITC is conducting a hearing about “How Indian trade policies affect US jobs”.

Special 301 report & Priority status= less EXPORTs

United States Trade Representative (USTR) writes this report.Deals with IPR (intellectual property rights) related matters.US government also uses this report to decide future trade policy.Experts believe, India will also get negative review in this 301 report. Because Indianauthorities have hurt the IP-interests of Pharma MNCs. For example

Novartis SC rejected patent claim over their blood cancer drug (Glivec)

Bayer’spharma

Indian Patent office allowed NATCO to product the same blood cancer drug(NEXAVAR).

If we get negative review in Special 301 report = USTR can classify India as “Priorityforeign country”Priority tag sounds “VIP” right? Nope infact it is bad news.Because USTR has powers to penalize “priority” countries e.g they can to impose



higher duty/taxes and quota restrictions on Indian exports to USA. (and WTO may nothelp India in this case.)Since USA accounts for ~12% Indian exports. So imagine the negative consequences onBalance of Trade (Because export will decline).

Ofcourse, one can argue that Indian drugs are bad quality or that Indian IPR/Patent law sucks.Therefore, USA’s actions are justified. But we are the same country since last three years- yetuntil now American regulatory bodies did not take any action. BUT ONLY after Devyani caseand within just one month (February 2014) , they suddenly start all this “regulatoryactivism”=> something fishy, revenge mindset, will hurt Indian exporters.

BoP crisis: how can that happen?

In the worst-of-the-worst-case scenario, Fed tapering may cause Balance of Payment (BoP)crisis in India. How?

First let’s understand some background theory: when and how can BoP crisis happen?

1. Balance of Payment is a systematic record of all economic transactions betweenresidents and non-residents of a country.

2. BoP is divided into two parts. Current vs Capital. (and “incoming” vs “outgoing” moneyin each of them). click on following chart.

In each of them, further we’ve incoming money (credit) and outgoing money (Debit).

For the sake of understanding, let’s observe a BoP data from 2012-13 (USD million dollars).

[Table] BoP Current Account [2012-13]

Current Account, Million dollars Credit + Debit - Net

Visible Goods 300000 500000 -200000

Invisible

services 150000 80000 +70000

Income (Profit, Interest, Dividend) 10000 30000 -20000

Transfers (Remittance) 68000 4000 +64000

Balance of Current Account 528000 614000 -88,000

In other words, we had Current Account deficit of 88 billion $ in 2012-13.

[Table] BoP: Capital account




capital account Credit + Debit - Net

investmentFDI 215000 170000 45000

FII 175000 150000 25000

Borrowing Government +private 150000 120000 30000

Bank Capital Non-resident bank accounts 83000 67000 16000

Total Capital acct. +89300

In otherwords, we had Current account surplus of ~90 billion $ in 2012-13. Now let’s do total

2012-13 Million USD

Current -88000

Capital +89300

Error Omission +2689

Overall +4000 (Approx.)

What happens to this “overall” surplus 4 billion USD? Three things can happen

1. Do nothing.Then +4 billion USD = more “supply” of onions (dollarS) in the DesiForex market. This will change in rupee-dollar exchange rate, becauseof laws of supply n demand.

2. Give themto IMF

Balance of payment will become zero.

3. RBI shouldput them inforexreserve.

Same as above.

We took the third option. Observe.

2012-13 Million USD

A.Current account -88000

B.Capital account 89300

C.Error Omission 2689

Overall (from A+B+C) +4000 (Approx.)

Overall surplus sent to RBI’s forex reserve -4000

Balance of Payment 0

Meaning, as long as Capital account has more money than Current account, we’ll have surplus.

But what happens IF we don’t have surplus (i.e. capital account has less money than currentaccount)?

It happened in 1991′s BoP crisis. Observe the data

1991 (Apr-Sep) Million $$

Current -6634

Capital +4808

Overall Balance -1826


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In above table, We don’t have any surplus! See we had deficit of ~2 billion USD.(=pothole is created).IF we want to get final Balance of payment “ZERO” then someone (Rajan, Mohan,Chindu, Rajesh Khanna or Shakti Kapoor) must pour in +2 billion US dollars to fillupthis pothole.But in the 1991, RBI did not have sufficient forex reserve to fillup this pothole withdollars. (RBI had barely ~730 million USD, while pothole was ~2 billion).

If this pothole is not filled up, then what will happen?

1. Extreme shortage of onions (dollars) in Indian forex market. => price of 1 onion(dollar)will go as high as 500 Rupees or even more!

2. Then, We won’t have dollars to pay for our crude oil imports= economy collapses.

This is called Balance of Payment (BoP) crisis. Solution? We had to pledge ~65 tonnes ofgold to IMF to borrow ~2.3 billion USD. That money was used to fillup the BoP pothole. Wealso initiated LPG reforms, to ensure that in future we have sufficient capital surplus so BoPcrisis doesn’t happen again. Enough flashback of ’91, Back to original moving:

Can Fed Tapering *REALLY* cause BoP crisis?

There are three pre-conditions for BoP crisis to happen:

1. Huge current account deficit. (i.e. lot money outgoing in crude oil / gold / xyz importswhile exports don’t bring enough dollars)

2. Capital account surplus is not big enough to fill that Current Account deficit. (i.e. lessmoney coming via FDI, FII, ECB, NRI-bank deposits.)

3. RBI doesn’t have enough forex reserve to fill up the pothole created by #2 MINUS #1.

Preconditions4BoP Crisis?

Worst case scenario under Fed TaperingPreconditionmet?

#1: Huge currentaccount deficit

“Dushmani 4Devyani” angle, + weak rupee=inputcost high. So export may not bring that muchdollar.Outgoing dollars high because of crude oil +gold imports= CAD will be huge.

Yes,definitely

#2: Capitalinflow not bigenough.

Fed tapering= dollar supply decreased = less FIIthan earlier era (under Quantitative easing era)FII may pullout existing money from Indianmarket, to re-invest in USA or elsewhere.

Yes, may be

#3: RBI doesn’thave forexreserve.

Not correct. RBI has sufficient backup

RBI’s own Forex reserve: ~300 billion USDBRICS bank backup: 100 billionJapan Currency swap backup: 50 billion

= total atleast 450 billion USD backup. (more detailsafter few paras.)

Hell NO!


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Meaning,

1. Fed Tapering unlikely to cause BoP Crisis v2.0 in India2. because THIRD pre-condition is not met. (And that’s because RBI DOES have large

forex reserve + backup to fillup the pothole.)

Nonetheless, prevention is better than cure. In the next article, we’ll see the steps taken byRBI +Government ot immunize Indian economy against the negative impact of Fed Tapering.

Courtesy: Mr.Shivaram G. for inputs.

Visit Mrunal.org/Economy For more on Money, Banking, Finance, Taxation and Economy.

URL to article: http://mrunal.org/2014/03/fed-taperingpart1-2-meaning-fed-tapering-negative-impact-indian-economy-worst-case-scenarios-balance-payment-crisis-explained.html

Posted By Mrunal On 27/03/2014 @ 22:47 In the category Economy

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