The Python Under The Boat :Carry Trading Pressures in The Indian Re



Carry trading pressures in India are huge and terrifying. India had not financed its CAD from a capital account, leaving a gap of $ 10 bn to be funded from FPI money. Another $ 85 bn had come in from overseas Indians, which were also carrying trading money. Add $40 bn from FPIs into the domestic bond market. Since we were not part of the EM Bond Fund Index, these flows could be pulled out at any time. That’s a potential $120 bn of outflows, not counting the equity outflows. The potential total base was $ 240 bn, out of Reserves of $420 bn.

Declaimer: This article was originally in March 2018, and some of the data points may be outdated

Of this, some $90 bn came in during 2014, the Modi period. We have a grossly overvalued Re, and the RBI has taken upon itself the job of managing volatility, effectively handing over a moral hazard to the Indian importer. Exporters are generally sold 1 year forward (93% of annual exposures), and importers are hedged roughly 7% of their annual exposures.

The funny thing is, the RBI CANNOT hold down interest rates or drop them because it is caught in a Nash Equilibrium. One, inflation has an uptick, but two, the carry trading flows on which India is living, could reverse because of some interest-rate hardening anywhere else in the world (particularly the US and Europe). Or a dip in Japan’s trade surplus. Or a rise in Japan’s Fiscal Deficit, etc. It’s very fragile.

Hence, the inflation targeting of the RBI was with a wary eye on the hot money already sitting inside your financial system, like a python under your boat. If it raises its head, it could seriously rock your boat. Consumer credit was only 14% of GDP, while non-financial corporate credit was 56% of GDP. If you raise interest rates, you dampen consumer credit only marginally, with almost no impact on inflation. But you push up costs in the corporate sector, which flows into manufacturing inflation (provided capacity utilization is high, and they have enough pricing power). So you FEED inflation with your so-called inflation-targeting interest-rate hardening. The only thing you are doing with your interest rate hikes is to hold onto the carry trading flows.

A mere $20 bn of withdrawal of commodity funding limits in 2008 had tanked the market some 40%. As deleveraging accelerates, the probability of such a withdrawal has increased. Already, Indian LCs and LoUs are no longer being discounted, especially for PSU banks. This could lead to severe trade dislocations in the very short term.

How did we get like this? Because RBI took it upon itself, to start managing the volatility in the Indian Re. Given the ‘Impossible Trinity”, of an independent monetary policy, a fixed exchange rate and free capital movement being together impossible, India has free capital movement and a ‘fixed’ (read: low volatility, ‘managed float’ exchange rate) exchange rate. Hence it must give up its freedom in setting monetary policy.

So what is the MPC setting out to do? It simply cannot lower interest rates, or reduce real interest rates, because it (i.e., the RBI) has chosen to manage the Re instead.

And why are we choosing to manage the Re? Because Indian businesses are NOT (managing their exposures), so the Central Bank has decided to take that job on itself, effectively creating a ‘moral hazard’ for the average Indian importer. On average, less than a fifth of import exposures are hedged in general, over the years, leading to importer panics every time the Re spikes up. These costs (of complacency) are not fed into import costs, distorting the import-export balance. Many import-intensive businesses would have been domestic businesses (Chinese imports, edible oils, inorganic chemicals) if this ‘cost of complacency’ was a part of the Indian importer’s Cost Sheet, and he had had to pay the cost of carrying on his Dollar buying.

But look at the cost to the nation. Lower interest rates would drive out these carry trading flows, which would raise the Dollar: Re, creating barriers to imports, and raising the viability of domestic manufacturers. This would be a long-term increase in domestic competitiveness. These exiting flows would have to be financed by domestic savings, which would increase domestic credit growth and the usage of domestic savings. The CAD would balance, and pressure would be taken off the stock market, which is seeing too much domestic flow and has reached bubble proportions. Much of the flows would reverse from there and flow back into Bank deposits, which could then be used to replace the Buyers’ Credit lines that have created so much trouble (both in times of currency crises, Sep’13, or through the Nirav Modi incident).

Businesses would start to think in terms of domestic interest rates, instead of trying to arbitrage overseas lines of credit. With an equalization of interest rates, the RBI should come down heavily on unhedged lines of credit taken by importers, forcing them to pay the Forward Premium. This would reduce currency risk dramatically.

US fragility was very worrying, and higher structural inflation should be tanking markets, not pumping them up. ETFs are computer programs and will be forced to sell if there are withdrawals. That’s another potential $20 bn of outflows. The stresses in the system can only be ignored at your peril.

Volatility is guaranteed, and only humility will be the winner. The key risks are re-depreciation and even a currency crisis. If the RBI is raising interest rates (or keeping real rates high) simply with an eye on the carry trades, then EVEN if macros improve, it simply cannot lower rates, because it is riding a tiger. So in the middle of improving macros, we could be left with a currency crisis, because the consensus shifts towards a rate drop. So either we have high interest rates, or we have high-interest rates. And the only way this will correct will be after a currency crisis…..? The only question is WHEN, not whether this will happen.

Given that Bond Yields are at nearly 7.75%, and the Earnings Yields on equities are running at some 3%, there is significant space for money to flow back from equities to Bonds.

The problem is that this will not happen without significant pain, and nobody has the stomach to do that in an election year. But the agenda for a nationalist government under Modi should be (post-2019) to correct this huge distortion in our savings-investment structure, and treat the domestic saver fairly (vis-à-vis his foreign counterpart). Also, the interest of the domestic borrower is losing competitiveness because of the high-interest rates that are prevailing because of the appeasement of the Carry Traders.

It’s the aversion to this pain that is going to perpetuate this growing balloon. It can continue forever, as long as the domestic Indian borrower (and the saver) pays the price. But the idea that India is capital-starved is an old one. With the formalization of the economy, the next step is to reward the people who have just come into the system and help them with the returns that they should have been getting in the first place.

With one of the highest savings rates in the world, it is wrong to say that we should be capital-starved. Given the right environment, India can be self-sufficient in funding her investment needs. This model will work to make us a global power, not the Chinese export model (which also made China a leading supplier of savings to the US Bond markets). India can have a long period of low volatility, and domestically funded growth, while the world spends a lot of time sorting itself out.

There are many policy prescriptions, and artificial barriers to our bond market are one of them. A Tobin Tax would be a limited response (high withholding tax on bond coupons, for example). This would drive out carry trading flows from the Indian bond markets, which would be replaced with domestic flows. Policies like increasing the maturity of NRI bonds would achieve similar results. With a draconian mandate for importers to fully hedge their import payables. They don’t have to be done together, but a calibrated approach would be effective in changing the direction of the underlying (current) philosophy.

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