Your currency, our problem!

Source:http://economictimes.indiatimes.com/opinion/columnists/mythili-bhusnurmath/Your-currency-our-problem/articleshow/6681352.cms

It's the silly season for currency interventions. Last week, Guido Mantega , finance minister of Brazil warned an 'international currency war' has broken out. As Brazil's central bank scrambled to buy close to $1 billion a day for almost two weeks - about 10 times its daily average - Mantega was only voicing what many governments have already expressed privately. That for all the calls for collective action and bonhomie displayed at various G20 meetings, when it comes to ground realities, it is each country for itself!

So, what's new about that? What is new is that unlike in the past when 'currency intervention' was always a developing country refuge, a third world stratagem that first world countries eschewed, this time round, first world countries are nothing loath to join the game.

Last month, Japan joined Switzerland in intervening in the foreign-exchange market. As the yen surged to a little short of 90 to the dollar, the strongest in 15 years, the central bank, fearing a strong yen, would jeopardise recovery, sold an estimated $20 billion yen. The last time it intervened to sell yen in the foreign-exchange market was in 2004, when the yen was around 109 per dollar.

It is not the only one. The Swiss central bank has been intervening to prevent the appreciation of the Swiss franc against the euro for close to six months now. The last time it intervened was in 2002. The Japanese and the Swiss are not alone. South Korea, host to the next G20 meet, has shown as much alacrity in intervening to keep the won weak; so have Taiwan and Singapore.

In the developing world, meanwhile, currency intervention has become much more frequent. China, an old hand at the game, has been joined by Brazil, the Philippines, India and Malaysia, to mention just a few. The danger is if intervention becomes the norm, rather than the exception, the resultant 'currency war' will not leave any winners. Worse, it will mean goodbye to any hopes of rebalancing the world economy.

Why is that important? Because as long as the global economy remains perilously unbalanced, the next crisis is not far away. Orderly currency realignment is, therefore, critical to rebalancing. But that calls for coordinated action by the major world economies (read G20) - not haphazard, beggar-myneighbour intervention of the kind that seems to be the fashion now.

The reason is simple. Cheap money policy in the US that causes the dollar to weaken against other currencies will help boost US exports and rein in the US current account deficit. Provided no country intervenes! So, left to itself, this realignment in currency values is a part of the remedy the world is seeking.

But this is where the catch lies! China, the world's largest exporter, continues to suppress the value of the renminbi. In the pre-crisis days, when economic growth was strong, most countries were prepared to look the other way and restrict their response to jaw-jaw. Not any longer! Today, as countries struggle to remain competitive in the global market, many seem to have decided to copy the Chinese. Hence the proliferation of currency interventions aimed at making currencies cheaper in order to boost exports.

Inflation.. & everything around it

Consumer price inflation in India has been close to or above double digits for nearly two years, and the more cyclically sensitive wholesale price index, after dipping into deflation territory last year, has been steadily rising to surpass double digits.

The puzzle is simply this: why is inflation in India so stubbornly high and so much higher than other emerging markets, even those that are supposedly overheating, such as China, Korea and Indonesia, where inflation is closer to 3 per cent?

First we consider a few standard explanations.
1. The supply shock factor - relates mainly to agriculture. The weather Gods failed us last year, India’s agricultural output suffered a sharp drop as a result, supply declined and prices rose. The monsoon is looking better this year, so the agricultural shock factor will not have the same bite going forward. And fuel price increases should be of a one-off nature rather than an ongoing source of inflation. Moreover, rising prices are not restricted to agricultural goods and have now spilled over into other commodities: double-digit price increases are no longer confined to agricultural commodities.

Cure : Well, no one can do anything when Gods go crazy..!!

2. Policy shock - Prices of fuel have recently been increased, which is contributing to overall price inflation. Minimum support prices for agriculture have also been increasing. Further, in the face of agricultural supply shocks, price smoothing by the government through greater imports and faster depletion of domestic stocks has been woefully inadequate.

Cure : Better, more thought out policies, or counter policies. <please pour in your thoughts>

3. Overheating: the supply capacity of the economy is simply unable to match the demands on that capacity - Overheating in India can be an agricultural phenomenon or an economy-wide pathology. In either case, there is cause for worry because the implication is that the economy’s current growth rate of 7-8 per cent is above its potential or trend growth rate. In this view, and unless capacity can be significantly increased, attaining China-type double-digit growth rates will remain elusive.

In agriculture, a scissors effect seems to be at work. On the one hand, productivity growth, especially in pulses, is anaemic and possibly weakening further. On the other hand, purchasing power and hence demand are accelerating, courtesy the NREGS (which is increasingly looking like a pure cash-transfer programme).

For the rest of the economy, they could be inadequate investment in infrastructure, inadequate supplies of skilled labour (always a possibility in India because its growth model is so skills-reliant), slow total factor productivity growth or some combination of all the three.

Cure : Given the capacity situation, aggressive monetary policy action will be warranted to bring inflation below 5 per cent..where political pressures come into play while tightening rates, etc.

4. A type of cost-push inflation - Serious micro-economic distortions afflict the land market . In itself, this distortion cannot cause inflation because presumably the distortion leads to a one-off increase in the price of land as an input. In other words, the distortion, unless it is continually worsening, will have increased the price level but cannot cause price inflation.

(meaning of the above para in a more layman language, correct me if I have explained it wrong: that due to whatever reason prices at some places may be sold at higher rate than the market rate, which keeps happening all the time, but that does not mean that the market prices have changed)

But suppose that these micro-distortions interact with macroeconomic factors such as surging capital inflows into real estate and housing. Such surges will lead to sudden increases in the price of land and related inputs, raising the cost of production in the economy as a whole.

A whole range of services, such as retail, construction, entertainment, education and finance — which account for progressively larger shares of the economy — use significant amounts of land as an input, a fact that gets overlooked in inflation discussions, which tend to focus on agriculture and manufacturing (this may also explain why inflation in consumer prices, which reflect services to a greater extent than wholesale prices, has tended to be above wholesale price inflation).

Generalised cost-push inflation could then be a natural consequence with the push resulting from the interaction between a pre-existing microeconomic distortion and a macroeconomic factor that serves to aggravate this distortion, converting a price-level effect into an inflation effect.

Cure : Microeconomic : Clearly, the first best solution is to eliminate the distortions in the land market of which there are many, including urban land ceiling and tenancy laws. The resulting boost to productivity would increase the overall supply capacity of the economy, making inflation less likely. Structural reforms of the land market will thus be good for inflation and good for growth.

Macroeconomic : But if land market reforms are infeasible, and inflation continues to be above acceptable levels, policy-makers may have little choice but to address the macroeconomic factors that aggravate the underlying distortion. In some cases, this may require dampening foreign capital flows, especially those going to real estate and housing; or they may involve other prudential measures such as higher provisioning requirements for real-estate lending.

Types of Financial Risk

These are some specific types of risks that financial institutions come across when we talk about stocks and bonds. Most of us already know these given below, but still, it may be useful at some point in time

Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. 

Government bonds, especially those issued by the federal government, have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates. 

Bonds with a lower chance of default are considered to be investment grade, while bonds with higher chances are considered to be junk bonds. Bond rating services, such as Moody's and S&P, allow investors to determine which bonds are investment-grade, and which bonds are junk. 

In India, ICRA is the premier agency to do the rating. Following is the link to their current rating methodology. It might be updated according to business environment changes.

http://www.icra.in/Files/Articles/2009-October-Rating-Corp-Rating-Methodology.pdf

Country Risk - Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit. (For related reading, see What Is An Emerging Market Economy?) 

Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreign-exchange risk applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you are a resident of America and invest in some Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the American dollar. 

Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks. (To learn more, read How Interest Rates Affect The Stock Market.) 

Political Risk - Political risk represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment. 

Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the the day-to-day fluctuations in a stock's price. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or "temperament", of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction.

More additions to be done shortly....