To short the rupee go to London and Singapore

Rajan Goyal, Rajeev Jain and Soumasree Tewari have an interesting paper in the RBI Working Paper series on the “Non Deliverable Forward and Onshore Indian Rupee Market: A Study on Inter-linkages” (WPS(DEPR):11/2013, December 2013).

They use a error correction model (ECM) to measure the linkages between the onshore and offshore rupee markets. The econometric model tells a very simple story: in normal times, much of the price discovery happens in the onshore market though there is a statistically significant information flow from the offshore market. But during a period of rupee depreciation, the price discovery shifts completely to the offshore market. (While the authors do not explicitly report Hasbrouk information shares or Granger-Gonzalo metrics, it seems pretty likely from the reported coefficients that the change in these measures from one regime to the other would be dramatic).

My interpretation of this result is that the exchange control system in India makes it very difficult to short the rupee onshore. The short interest emerges in the offshore market and is quickly transmitted to the onshore market via arbitrageurs who have the ability to operate in both markets:

1. A hedge fund with a bearish view on the currency might short the rupee in the offshore market depressing the rupee in the offshore market.
2. A foreign institutional investor with a relatively neutral view on the currency might buy the rupee (at a slightly lower price) in the offshore market from the bearish hedge fund
3. This foreign institutional investor might then offset its offshore long position with a short position (at a slightly higher price) in the onshore market (clothed as a hedge of its existing Indian assets). This would transmit the price drop from the offshore market to the onshore market with a small lag.

On the other hand, during the stable or appreciation phase, there is no need to short the rupee and divergent views on the rupee can be accommodated in the onshore market in the form of differing hedge propensities of exporters, importers and foreign currency borrowers.

Short sale restrictions in the onshore market have two perverse effects:

1. They contribute to the migration of the currency market from onshore to offshore.
2. They make currency crashes more likely because they prevent rational bearish investors from contributing to price discovery in the build up to the crash. (This is a standard argument about short sale restrictions: see for example Harrison Hong and Jeremy Stein(2003) “Differences of opinion, short-sales constraints, and market crashes”, Review of financial studies, 16(2), 487-525.)

Rating Agencies: What changed in 2000s?

Consider three alternative descriptions of what happened to the big global rating agencies during the early 2000s:

1. Kedia, Rajgopal and Zhou wrote a paper last year presenting evidence showing that the deterioration of Moody’s credit rating was due to its going public and the consequent pressure for increasing profits.
2. Bo Becker and Todd Milbourn wrote a paper three years ago arguing that increased competition from Fitch coincides with lower quality ratings from the incumbents (S&P and Moody’s).
3. Way back in 2005, Frank Partnoy wrote a highly prescient paper describing the transformation of the rating industry since the 1990s that turned “gate keepers” into “gate openers”. He attributed the very high profitability of the gate openers to three things: (a) the regulatory licences that made ratings valuable even if they were uninformative, (b) the “free speech” immunity from civil and criminal liability for malfeasance and (c) the rapid growth of CDOs and structured finance.

I find Partnoy’s paper the most convincing despite its total lack of econometrics. The sophisticated difference-in-difference econometrics of the other two papers is, in my view, vitiated by reverse causation. When rating becomes “a much more valuable franchise than other financial publishing” as Partnoy showed, there would be greater pressure to do an IPO and also greater willingness to disregard any adverse reputational effects on other publishing businesses of the group. Similarly, the structural changes in the industry would invite greater competition from previously peripheral players like Fitch who happen to hold the same regulatory licence.

Day dreaming about electronic money

Earlier this week, the Reserve Bank of India published the report of the Nachiket Mor Committee on financial inclusion (technically the Committee on Comprehensive Financial Services for Small Businesses and Low Income Households). Its first recommendation was that “By January 1, 2016 each Indian resident, above the age of eighteen years, would have an individual, full-service, safe, and secure electronic bank account.”

The Committee’s mandate was obviously to look at financial inclusion within the context of the current financial architecture and so it could not by any means have recommended a change in the core of that financial architecture itself. But for us sitting outside the Committee, there is no such constraint. We are entitled to day-dream about anything. So I would like to ask the question: if we were designing everything on a completely clean slate, what would we like to do?

Day dreaming begins here.

In my day dream, India would embrace electronic money and give every Indian an eWallet. Instead of linking India’s Unique ID (Aadhaar number) to a bank account, we would link it to an eWallet provided by the central bank. We would simultaneously move to abolish paper money by converting existing currency notes (with their famous “I promise to pay the bearer”) into genuine promissory notes redeemable in eRupees delivered into our eWallets. Financial inclusion would then have three ingredients: a Unique ID (Aadhaar) for everyone which is more or less in place now, the proposed eWallet for everyone, and a mobile phone for everyone. All eminently doable by 2016.

The costs of creating all the computing and communication infrastructure for a billion eWallets would be huge, but could be easily financed by a small cess on all paper money and bank money. The cess would also serve to incentivize a rapid shift to eRupees. (At some stage, we could even decide to make demand deposits illegal just like bearer demand promissory notes are illegal today, but I think that a ban would not be necessary at all.)

The operating costs of eRupees would be easily covered by the seigniorage income on the electronic money. Because of its greater convenience, safety and liquidity, eRupees should become at least as large as M2, and probably would grow to 25-30% of M3, making it about twice as large as paper money. The operating costs of eRupees should be significantly less than that of paper currency, and the seigniorage income much greater. The government would earn a fatter dividend from the Reserve Bank of India after covering all the cost of eRupees.

A huge chunk of the current banking infrastructure is now devoted to the useless paper shuffling activity that constitutes the current payment system. If this infrastructure is re-purposed to perform genuine financial intermediation, this would support much higher levels of economic growth. Divested of a payment system, the banks would be more like non bank finance companies and would pose far less systemic risk as well.

All this would allow India to leapfrog the rest of world and create the most advanced payment system on the planet (something like a Bitcoin backed by an army). In a world that struggles to ensure that systemically important settlement systems like clearing corporations settle in central bank money, we would have a system in which every individual could settle in central bank money. It is even possible that eRupees would find international adoption in the absence of any competition.

Day dreaming ends here.

Tapering Talk: Why was India hit so hard?

Barry Eichengreen and Poonam Gupta have written a paper on how the “Tapering Talk” by the US Federal Reserve in mid 2013 impacted emerging markets.

In order to determine which countries were affected more severely, Eichengreen and Gupta construct a “Pressure Index” based on changes in the exchange rate and foreign exchange reserves. They also construct a Pressure Index 2 that also includes the impact on the stock market. By both measures, they find that India was the worst affected within a peer group of seven countries. The peer group includes all the countries that Morgan Stanley have called the Fragile Five (Brazil, India, Indonesia, South Africa and Turkey); in addition, it includes China and Russia. The Pressure Index 1 for India was 7.15 compared to a median of 3.46 for the peer group. Since the Indian stock market did not do too badly, the Pressure Index 2 for India was slightly better at 6.57 compared to a median of 4.63 for the peer group.

Turning to why some countries were hit harder than others, the paper finds:

What mattered more was the size of their financial markets; investors seeking to rebalance their portfolios concentrated on emerging markets with relatively large and liquid financial systems; these were the markets where they could most easily sell without incurring losses and where there was the most scope for portfolio rebalancing. The obvious contrast is with so-called frontier markets with smaller and less liquid financial systems. This is a reminder that success at growing the financial sector can be a mixed blessing. Among other things, it can accentuate the impact on an economy of financial shocks emanating from outside

In addition, we find that the largest impact of tapering was felt by countries that allowed exchange rates to run up most dramatically in the earlier period of expectations of continued ease on the part of the Federal Reserve, when large amounts of capital were flowing into emerging markets. Similarly, we find the largest impact in countries that allowed the current account deficit to widen most dramatically in the earlier period when it was easily financed. Countries that used policy and in some cases, perhaps, enjoyed good luck that allowed them to limit the rise in the real exchange rate and the growth of the current account deficit in the boom period suffered the smallest reversals.

Clearly, India’s increasing integration with global financial markets imposes greater market discipline on our policy makers than they have been used to in the past.