How the West's central banks' turbulence will affect India

A strong stock market and higher-than-expected job growth have put the US Federal Reserve and its governor, Ben Bernanke, under pressure to outline a possible road map for an exit from this extraordinary policy accommodation, notes Akash Prakash

We are beginning to see active discussions about an exit from the extraordinarily low interest rates and quantitative easing policies in both the United States and the United Kingdom, even though both countries are still experiencing high unemployment rates.

These discussions have begun since both economies seem to have stabilised and there is concern that excess use of these policies will lead to unintended side effects that may outweigh the benefits.

A strong stock market and higher-than-expected job growth have put the US Federal Reserve and its governor, Ben Bernanke, under pressure to outline a possible road map for an exit from this extraordinary policy accommodation.

This is a topic of great significance to equity and bond markets.

Can they continue to keep going up in the absence of the Fed stimulus?

When will Mr Bernanke start to taper off the stimulus? What would be the implications if the Fed stopped buying securities?

How will the Fed reduce its current gargantuan holdings of these instruments? All these issues and more are the top priority for most investors.

Indeed, at the first sign of a hint from Mr Bernanke that these unconventional policies may be removed, markets have faltered.

The International Monetary Fund has come out with an interesting paper in this regard, titled 'Unconventional Monetary Policies -- Recent Experiences and Prospects'.

The paper argues that while quantitative easing may have been the right way to respond to the broad-based economic crisis, its impact on the macroeconomy was quite limited and was declining with time.

The paper highlighted that any exit from these policies was going to be difficult and would potentially create volatility in all asset markets.

The IMF economists have also tried to project the losses each major central bank will take on its stock of government bonds as economic conditions normalise and interest rates rise.

For example, they estimate that if we follow the pattern of 1993-94, when the Fed began to normalise interest rates from a starting level of three per cent, central bank losses would equal between two per cent and 4.3 per cent of gross domestic product for the US, UK and Japan.

These figures are the capital losses on the central banks’ government bond portfolios as rates rise and push bond prices lower.

These losses will also be a one-time fiscal burden on the governments concerned, as they will end up paying for them either through reduced central bank dividends or through recapitalisations.

Just to put things in context, in 1994 Alan Greenspan, Fed chairman at the time, raised the federal funds rate from three per cent to 4.5 per cent, which pushed 10-year US Treasury bond yields up by 200 basis points.

Just a 200-basis-point rise was seen as a 'bloodbath' by bond market participants, and a similar rise would again cause the type of losses highlighted above.

The scary thing, of course, is that in this cycle we are starting with the federal funds rate at effectively zero, and 10-year yields below two per cent.

To get anywhere near normality, the amount of adjustment required this time is far greater than in 1994.

The bigger the adjustment, the more the scope for volatility, losses and sharp moves in asset prices.

The IMF report also contains estimates of the damage if the central banks’

exit strategies failed, triggering a potential loss in confidence in the central banks and their currencies.

In such a scenario, the losses for Japan from exiting these unconventional monetary policies would rise from two per cent to as much as 7.5 per cent of GDP. The losses for the US would rise from three per cent to nearly 4.5 per cent of GDP.

In its first round of quantitative easing, the Fed conducted all its operations in the short-term money market; this will be much easier to wind down.

QE2 and QE3, however, used long-term government bonds and are, thus, much harder to unwind and could create serious disruption.

The scale of the potential losses implies that this whole concept of asset purchases by central banks -- while easy to initiate, and cheered by the markets when they started -- will end up being messy.

One of the consequences of these QE programmes globally is that, as Merrill Lynch points out in a recent report, $19.4 trillion of government bonds (almost half of the entire global market) are now trading at yields below one per cent. There is a desperate search for yield -- and possibly the biggest beneficiaries of this have been emerging market bonds.

Every single new emerging market bond seems to be met by insatiable demand, with investors seemingly throwing all caution to the wind for any yield pickup.

If Rwanda can raise $400 million to build a convention centre, and the bond was in hot demand, something is clearly wrong here.

As QE is wound down and bond yields start to normalise in the West, emerging market bonds are going to be in serious trouble.

We already saw a trailer of this in the first quarter of this year, when US treasury yields started to rise -- and immediately dollar-denominated emerging market bonds had their worst quarterly performance since 2008.

And this was before we even began to talk of the winding down of QE.

I bring this up because India has also been a huge beneficiary of the search for yield, and of easy liquidity conditions in both our debt and equity markets.

We have found it quite easy to finance our gaping current account deficit of almost $100 billion.

This should not lull us into a sense of complacency about the current account.

These are unusual times; unconventional monetary policies are disguising our vulnerability.

It will be far more difficult to attract flows of this magnitude as monetary conditions normalise.

If QE is wound down, fixed income markets turn volatile and those buying Rwandan bonds in search of yield get hammered, we may find money flowing out of our country as markets readjust to a new monetary reality.

Just because we have been able to attract $100 billion of capital inflows in a time of unprecedented monetary easing and liquidity globally does not mean we can do so on an ongoing basis as liquidity conditions and yields normalise.

I am especially worried about our vulnerability as the markets go through turmoil, adjustment and investor losses -- all associated with the winding down of QE programmes globally.

We have a short window to improve our external vulnerability, and we must use it to improve the policy framework.

Otherwise we may pay a heavy price and be an unintended casualty of the winding down of QE.

As an aside, both the government and corporate India should aggressively use the coming months to raise as much external capital -- especially debt -- as possible.

This gravy train of any company/sovereign being able to raise as much debt as it wants, at any rate, is coming to an end.

The writer is fund manager and CEO of Amansa Capital