Rupee takes a plunge

Recently rupee rolled down against the dollar, with the dollar being valued at over Rs. 63. This devaluation comes at a prime time when I've started working and so it certainly is a boon. Though it's important to understand why this is happening, is it a big deal and what is the future going to look like.

The value of Dollar vs Rupee is a simple case of supply and demand. The rise of the Dollar's value against the rupee implies that people are converting Rupees into Dollars. This cash flow is happening for a number of reasons -
The US Federal Bank is probably going to cut down on it's quantitative easing. (Quantitative Easing, or QE, is a phenomena in which Fed buys central bonds and hence maintains their high price which keeps the rates low. This incentivizes people to invest their money elsewhere like in stocks or maybe buy a house or a car. This helps in revitalizing the economy) With the Fed suspected of cutting down on this venture, investors plan on flocking back to the US bonds as a safety haven and hence taking their money out of other countries.
The Indian economy also doesn't seem to be doing to well. It's account deficit (which is the net value of imports - exports) has ballooned to about 4.8% of GDP, i.e. $88.2 bn. The stock markets seem sluggish and there are impediments to FDI in different sectors. The economy grew at just 5% in 2012-13, the lowest in a decade. This is leading foreign investors to take their money out of India which is leading to a drop in the Rupee.

As a result, Indian bonds have become less attractive and hence the yields have risen. Foreigners have taken out $10bn since May 22 and the 10 yr bond yields have risen to 9.23%. This means that the central govt will pay interest @ 9.23% if it borrows from anyone. This rise in interest has also led to a rise in interest across the board with both savings and loan interest rates rising that will make getting a loan more expensive.

Now, on the other hand we have a strong 25 million Indian diaspora that is taking advantage of this rate and pumping their homeland with much needed foreign reserves. Volumes in the last few months have been 20-30% than that seen during regular months.
The Indian government also recently introduced certain fiscal changes that restricts foreign investment by Indian citizens and corporations and it also restricted imports of gold that led to a jump in the price of the bullion.

It seems clear that the solution is a higher growth to attract the Foreign Investors back. The Rupee will probably continue to slide to 64-65 and maybe to 67 but then certain sectors need to be opened to FDIs and exports should be energized so interest in the Indian growth story is back.

Until then.. NRIs - Cash Out!!

How much money do you need?

Very recently the United States government averted the Fiscal Cliff, allegedly the biggest catastrophe that would have drawn its economy back into a recession. Now, you may ask, how would that have happened?It's simple - Bush, during his tenure, had passed on a bill for a tax reduction that was going to expire on 31st Dec 2012 after which the taxes would have gone up. In parallel, the government had raised the debt ceiling in July 2011 that came with a clause to implement a series of discretionary spending cuts beginning 2013 if the Congress is unable to bring down the deficit, which it couldn't. When these two forces combine together it would have caused an increase in the tax rates and at the same time would have lowered government spending that would have threatened to stall economic growth even before it could begin.

In simple terms, the government needs money to function and implement it's policies. That capital comes from income which are largely composed of tax revenue. With the financial crisis and the multiple wars that the Congress had to battle its reserves have been drying up faster than they could have been replenished that led US to borrow consistently. The tax cuts have further reduced its income stream while the unaltered spending has kept its appetite at its peak. Now the debt ceiling is a self proclaimed limit imposed by the Congress on the amount they can borrow which can only be changed by a majority ruling. Although politically complex, economically if US borrows over it's ceiling then it is considered a technical default that can results in a chaos about which I'll talk in a while. To avoid the ensuing chaos and for the government to be able to carry out its activities the debt ceiling was raised in July 2011. Just as it was raised US was deemed a slightly incredible entity to lend money to by one of the rating agencies which is not really surprising since the move is just an artificial measure to increase its borrowing capacity. But what is also surprising is that there was demand for such debt because in the middle of the Euro Crisis it was still considered a safe haven and US sold about $240bn of debt in one day, the largest such sale ever. This also helped keen the interest rates to a very low level.

During 2012 US managed to stay under the modified debt ceiling even after the QE rounds by Fed and the interest rates remained extremely low. The intent was to stimulate the economy and bring it on the path of growth and as we see it did manage to provide the markets with one of the best years that they had seen. But the future of such growth now remains uncertain as with the mismanaged deficit US seems to be drawing close to a debt crisis that could threaten the financial powerhouse of the world.

As for the tax cuts, Bush had enacted the law in 2003 when no crisis was looming and then Obama had a choice of either extending them or letting them expire in Dec 2010. After careful deliberation and analysis it was computed that an increase in rates would lead to an annual increase of about $3000 in middle class income taxes. At the time when the middle class was already grappling with the after effects of the crisis it would certainly have been a challenge, more political than economic, to thrust the public with a larger tax bill. And now, two years later, the same situation looked at the Congress in the face again and this time with an added sword of fiscal deficit hanging on its neck.

As the tax increases are coupled with a fiscal deficit, this time the Congress heeded to Obama's proposal of letting the taxes stay low for the middle class while allowing the tax increase to go into affect for the rich. It indeed seems to help bring in much needed income over the next couple of years while still not taking away any disposable income from the middle class. But the Congress did not get to any agreement on the debt ceiling and it only has two months before it can take a decision on its limit. Now it can be debated whether the increase in taxes would serve the purpose it is meant to as some studies show that the rich were more inclined to pay taxes when the rates were lower than when they are up. But the markets still haven't digested the brunt of the news and are aware of the looming danger of the debt in the coming months. This has led to a drop in the prices of US bonds as investors express their fear in US debt.

I think that this can have an enormous impact on the economy. US debt has been blatantly increasing since the turn of the previous decade without any focus on increasing the revenue. A weak economy led it to ease the burden on the troubled households by lowering the taxes which it was forced to increase a few days ago.  The effects of such actions are not felt in a day or two but they pile up only to explode at some stage. How can the country which cannot pay its obligations assure me of my bank's obligations towards me in the form of deposits? Bank deposits are insured by FDIC and so it might lead to a bank run which would further threaten the entire financial system.

The US debt has been enjoying a stable position with high prices and high demands, especially because of $ being the reserve currency but it seems like that notion is in its reversal. I think that in the next couple of years US treasuries will drop in value and with economic growth yet to come the true value will only be seen in real assets. Gold and other commodities and growth in developing nations would probably be the next target on investors' radar. I think US has started to realize that it needs to tighten it's reign and we should see some contraction in its spending in the coming few months. It's hard to balance that with an ailing economy but it's even hard to lose the faith and trust of being a financial powerhouse.

It is debatable as to what would happen. It's not easy to lose faith in US. As China works to keep US bonds in its reserves and investors around the world don't find a safe asset to invest in, US would continue to enjoy the position of being a safe haven.


[Update]
An interesting read: http://www.bloomberg.com/news/2013-01-02/ten-things-you-should-know-about-the-cliff-deal-so-far-.html