## Thursday, April 23, 2009

### What happened after 15 September in India

On 14 October 2008, Jahangir Aziz, Ila Patnaik and I released a short note on what was going on. It was titled The current liquidity crunch in India: Diagnosis and policy response.

On Monday (20th April 2009), Ila Patnaik has an article in Indian Express with one more piece of evidence that the APS story was basically on the right track.

Today, when we look back at the APS paper, it seems mild. But I distinctly remember at the time, the world was much more confusing. Lehman died on 15 September. After that, there was a `fog of war' problem: a lot was going on, there was information overload in many ways, lots of critical information from within RBI is not released into the public domain in a timely manner or is not released at all, and the statistical system has such long lags that on 10 October, when we started writing, almost nothing was known about the period immediately after 15 September.

Speaking for me personally, I had the right starting conditions in terms of being oriented towards the themes of de facto convertibility, Indian multinationals, etc. I should have got the story quickly after 15 September. But still, it took me a long time to understand what was happening.

Similar problems -- on an immensely magnified scale -- have afflicted crisis responses everywhere in both the private sector and governments. Whether it was Northern Rock, Bear Stearns, or Lehman: analysts and decision makers have been ambushed by difficult questions, very little time within which to make calls, and bad information at the time. With the benefit of hindsight, it's easy to criticise what was done, but this stuff is hard.

1. Liked the paper overall. Just a few questions and comments:

1. "Dislocations in the operating procedures for monetary policy when tax payments take place need to be avoided. The short term response would be to cut CRR for the fortnight of the tax payments. The long term solution lies in shifting the work of collecting taxes and transferring these to the
government from RBI to commercial banks."

My comments: Why not just conduct open market operations. Much simpler. CRR still has some element of signalling.

2. "The pricing of dollar swaps or repos could be adjusted to market circumstances. Ideally, the interest rate used should reflect the level of domestic funding distress and not represent a subsidy to borrowing banks. One
could, for example, use the interest rate implied by domestic interest rates and spot and forward exchange rates (which is currently much higher than
corresponding LIBOR rate).

My comments: What does this mean?

Are you suggesting that INR cash collateralized dollar borrowing should happen at the INR rates implied through forwards?

3. Exchange rate policy

My comments: INR going to 45 or 50 has no meaning from a policy perspective. What is happening to a broad-based real effective exchange rate?

4. "This is an example of the general principle that exchange rate management generates instability of capital flows."

My comments: I understand your point, but you need to also understand that "Momentum" is now a well established factor deemed to be driving asset class returns. There are empirical studies out there that I would encourage you to read.

There are numerous hedge funds/CTAs out there who trade on this factor. Clearly, a move in a direction, will lead to further capital flows in the same direction.

The development of an options market also has the potential of accentuating moves in the same direction. Do not forget the 1987 crash.

In my previous, post I briefly recounted the history of post-Bretton Woods world. That does not support your point either.

5. "By and large, this is the job of the currency derivatives market. In the long term, India needs to press forward on the establishment of transparent and liquid currency and interest rate derivatives markets as part of what has been termed ‘the Bond-Currency-Derivatives Nexus’. In the short term, we have to accept that fact that these markets are missing or inadequate, and design
government interventions as a consequence of these inadequacies."

My comments: There is no missing market here.

There is a forwards market. Anyone who wants to buy or sell forward can do so. So there is no question of someone carrying mismatches without deciding to do so.

The only question is the pricing. Prices are not consistent with CIP because the capital account is not open. Remove caps and pricing will be proper.

6. "RBI needs to hence support this process by standing ready in the currency derivatives market, offering to buy dollars in large quantities on the INR/USD swap, forward, and futures markets. The idea here should not be to distort the price of the derivatives, but to stand ready on the trading
screen with large quantities at prices consistent with covered interest parity, so as to avoid incomplete markets. "

That suggestion is equivalent to opening the capital account.

The RBI will lose monetary independence if the spot is not allowed to float.

Also, deviation from no arb pricing is not = no markets.

7. "More importantly, the inflationary expectations visible in the market for inflation indexed bonds in the US has shown a sharp deceleration from 3.4% in July to 0.95% on 15 October."

Please note: LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.