dollar depreciation carry trading

Carry On Trading : Finally, A Ray Of Intelligence



I have long thought that I am too old for hero worship. Given the history of Central Banks that look the other way while bubbles inflate all around them, I am always amazed at how the RBI moves incorrectly, time and again. Greenspan once reminded us of Pontius Pilate: “It is not possible to locate an asset bubble until after the fact (i.e. after it has burst)”, clearly absolving himself of any responsibility for the serial bubble-blowing that marked his tenure.

Disclaimer: This article was written originally in October 2007, so some data points may be outdated.

The moral hazard that he created seems to have become a tradition at the Fed. Witness the sub-prime crisis, where Helicopter Ben has stepped in with a steep 50 bps cut. This time, the bubbles erupted in emerging markets like India, Egypt, and of course, China.

The role of the good CFO

The CFO of a co is supposed to monitor and regulate the liquidity in the co, just like the RBI holds currency liquidity and money markets in the country. When the Marketing Head wants to give too much credit, the CFO asks about the probability that the money will come back with a margin that exceeds the cost of borrowing the excess debt. Similarly, when the CEO wants to add Fixed Assets, the CFO asks whether the incremental return will exceed the cost of capital.

Trouble starts when the answer is NO. People look at their own silos and develop vested interests in maintaining the good health of their respective silos. The Marketing Head is only concerned that Sales keep moving, whether they are profitable or not (or whether the money is recovered or not). He sometimes makes the mistake of thinking that if he has won the battle with his CFO, his job is done (especially if he wins the battle against a good CFO).

CFOs, therefore, need to look into the future and recalculate the risks of what the rest of their co/ country is doing. And they need to fight their other constituents, including their (political) bosses. In the case of the RBI, there is a good case for an independent “judiciary-like” immunity to be granted to them by the Constitution.

The RBI has long been struggling to hold down liquidity and supply-side inflation through currency management. It is the best CFO in the world, in my opinion. When Central Bankers across the world say things like what Greenspan said above, we can see CFOs losing their battles (and sometimes their jobs) in Japan, the US, Bank of England. “Save me current pain, and I will be better next time”, say the monkeys in the markets.

RBI as the CFO of India

It is not for the RBI to calculate the cost of capital and see whether investors are setting the prices of stocks properly. Markets are meant to AID price discovery, with bad price-setters dying (or losing their shirts) and the good ones getting richer…..till THEY, in turn, get it wrong. Markets do NOT exist to make you rich, they exist to give you what you deserve.

If you buy a power co at Rs.20 cr per MW in an industry where new capacity costs Rs.4 cr per MW, you will get just desserts. Someday. You will be right, you will be right and you will be right……till you are wrong. No matter, no tears will be shed over your death. The RBI will not notice you. It is not looking to be the rescuer of over-exuberant markets. But that is because they are CFO in India.

Yet look at how different this is from what is happening to US money markets, which look shamelessly to the Fed to create a Moral Hazard every time they need to face the consequences of their over-exuberance. Why (and when) does this happen?

Biases of Markets:

When the markets become larger than the economy, when their vested interests preponderate over that of the larger economy, why not? The media gives them a voice much louder than the poor laborer who suffers from the resultant inflation.

Markets have a peculiar bias. The crowd is naturally bullish, always looking to linearly project current reality into the future. This optimism eats at itself to create irrational exuberance.

When this turns on itself and fear takes over, the pain starts. Free markets, if allowed to function FREELY, have naturally corrective mechanisms that ensure contrarianism, when a climate of extreme greed creates (in some) its own fear, and a climate of extreme fear creates (in some) its own greed.

It is when the crowd screams…….when there is too much pain…..that the other human characteristic (of pain aversion) takes over. The screaming brings in a democratic, ‘sensitive’ Govt, always wanting to mollycoddle a large enough segment of voters with disproportionate lung power.

Things have changed, and for better:

That is why the FM had to rush in to calm markets, assuring them that “nothing has changed”. But they have. The huge profits that India offers, the predictable, bullish story, with an ever-appreciating currency have started to attract the attention of the carry traders. Rumour has it that banks are writing OTC derivatives betting on the linear assumption of Rupee appreciation, i.e. puts are being sold across the world at the money, paid for by leveraged out-of-the-money calls (at 41+) bought from the poor sheep. On the opposite side are the Hedge Funds, which are behind the huge inflows carried traded into India.

It will be easy to reverse this sharply, as we are seeing in the markets just now. Rupee intra-day volatility has spiked up (vols are at 8% in the overseas markets). Nobody in India will complain when the Rupee pulls back sharply, IT cos will breathe a sigh of relief and all exporters who have not pre-sold their exports will be happy.

For once, the RBI found that it was unable to stem the flows coming into the country, and the equity markets are attracting the wrong kind of attention. I am not too optimistic that the Govt will allow too much blood-letting.

Remember, markets are meant to DISCOVER prices, not make them. One of the big criticisms of capitalism is that this is often forgotten, and markets (especially bull markets) take on a life of their own. America is learning the lessons of what happens when this distortion goes on for too long.

The Leftists had it right when they saw how the distortions of the market affect the real economy; just their solution was equally wrong, not the identification of the problem. An absence of a market does not meet the shortcomings of markets.



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