RBI’s communication – Like Chinese Arithmetic

Monetary policymaking is not only about analyzing economic conditions and devising appropriate responses. It is equally if not more important for the central banker to correctly communicate the policies and their rationale in order to build investor confidence. Market participants closely watch and listen to monetary policy makers. They pay attention to the central bankers’ confidence or lack thereof while communicating. They try to unearth the hidden messages under each sentence spoken and what they imply for the market. The market’s verdict is immediate and most often it is unforgiving of gaffes and missteps.

In December 1996, then Federal Reserve Chair Alan Greenspan asked a seemingly innocuous question during a banquet about irrational exuberance, escalating asset prices and appropriate policy action. Over the next few days, stock indices across Japan, Europe and US sold off. Or let’s recall a more recent incident involving ECB President Christine Lagarde. In March 2020 and in response to a journalist’s question, Lagarde rashly stated that “we are not here to close (sovereign debt) spreads”. Bond yields across European economies rose in reaction to this alarming statement.

Emerging market central banks are under even greater scrutiny given the lack of equivalent confidence in their institutions compared to developed markets. In this context, it is interesting to examine the Reserve Bank of India (RBI)’s communication with the market in recent years.

India entered the Covid-19 crisis on a relatively weak footing, with an elevated fiscal deficit, government debt and inflation. Foreign portfolio debt inflows had been declining since 2015 on the back of market concerns around deteriorating fiscal finances. With the government restricted in its actions, the RBI was responsible for much of the heavy lifting to steer the economy and market through this crisis. And while it did a good job of boosting systemic liquidity, offering credit guarantees to small businesses and suppressing bond yields, its communication was somewhat lacking.

This or that?

The RBI’s mandate is price stability while keeping in mind the objective of growth. In certain instances, the market was unsure about the RBI’s priority. For instance, in December 2019, the RBI decided to maintain the policy rate given high inflation. Simultaneously, it revised down its growth forecast to the lowest in over a decade. The market had been expecting further easing from the RBI, taking cues from its tone in the past meetings. Throughout 2019, the RBI had expressed concern over weakening industrial activity, service sector output and investment. Additionally, it had cut the policy rate by 135 basis points that year to support growth. The sudden switch to inflation control surprised the market as investor confidence building necessitates consistency of messaging.

The RBI is under a similar dilemma this year. CPI inflation exceeded its 2-6% target band in May and there are signs of further price pressures. RBI Governor Das brushed aside inflationary pressures in June by arguing that demand pull inflation is lacking. He reiterated the RBI’s accommodative monetary policy stance to revive and sustain growth. However, market participants continue to remain wary of the RBI’s next move. The money market is already pricing in 99 bp hike to the policy rate over the next year, indicating that the market does not buy the RBI’s commitment. The other aspect to note here is the lack of clarity over what the RBI is prioritizing. Is it growth or CPI inflation? This or that?

To be fair to the RBI, the Philippines central bank, Bangko Sentral ng Pilipinas, is facing a similar quandary this year. Like the RBI, the BSP’s primary mandate is to maintain low and stable inflation within the 2-4% target range. Year to date, headline CPI inflation in the Philippines has averaged 4.5% y/y. Even though Q1 GDP contraction was worse than consensus expectation, the BSP maintained the policy rate. This rate hold was in line with market expectations given previous comments by BSP Governor on the appropriateness of policy setting and growth optimism. The messaging was consistent throughout.

The list of priorities is growing.

Since 2020, India has received massive foreign direct investment flows which boosted the capital account balance and strengthened the currency (please refer to my previous blog post on the relationship between capital account balance and currency). The RBI absorbed these capital inflows by building its FX reserves buffer and in the process controlled the Indian Rupee (INR)’s appreciation.

The RBI’s arguments were that currency appreciation hurts exports and lumpy capital inflows are vulnerable to reversal. It wanted to build a war chest of reserves to prevent currency weakness during periods of external risk-off. And again, to be fair to the RBI, it is haunted by the developments during the 2013 Taper Tantrum and 2018 Fed rate hike, when the INR sold off massively.

But there are flaws in the RBI’s logic and communication style. Currency weakness brings with it imported inflation, which an inflation targeting central bank is well aware of. Additionally, since 2019, Indian inflation has exceeded the RBI’s inflation targeting band.

Secondly, the RBI has not been clear about what magnitude of reserves are considered sufficient. India’s FX reserves have risen to a historical high of over USD 600 billion, the fifth largest globally. They are enough to cover anticipated capital outflows as well as almost 12 months of imports. Despite this robust cover, the RBI recently opined that reserves were insufficient in covering imports compared to Switzerland, Russia and China. Should the RBI be competing with other central banks or considering domestic needs? And like other good communicators, should it not clarify the parameters it is considering?

Finally, currency control appears to be an added priority on top of inflation targeting and growth support. This exacerbates the earlier point on the market’s confusion over RBI’s policy goals.

Will you be there when I need you the most?

The Covid-19 induced fiscal relief packages have weakened the Indian government’s fiscal profile. The government’s debt is estimated at 90% of GDP and it needs the RBI to control bond yields. The RBI stepped in nicely by buying government bonds in the secondary market and executing operation twist (buy long dated and sell short dated bonds to flatten the yield curve and ameliorate the government’s debt servicing needs).

For the most part, the RBI has been successful in suppressing yields. Moreover, its liquidity enhancing policies have massively cushioned the blow to the economy, particularly given the government's limited fiscal space. These have included credit lines and easier loan terms to consumers and SMEs, much needed financing to the struggling shadow banks and loan restructuring schemes to stressed segments.

What it has been less successful at is winning bond investors’ trust. At several points throughout 2020 and 2021, bond investors were unsure about whether the RBI will step in to keep yields low. Indian CPI inflation has been stubbornly high due to food prices and several rating agencies cut India’s sovereign rating and outlook. These factors necessitated higher bond yields and raised valid questions from bond investors.

The RBI has tended to step in when yields crossed a certain threshold, making its intervention reactive rather than proactive. Look at it this way, Mario Draghi’s comment “we will do whatever it takes to save the Euro”, singlehandedly calmed the market and prevented a sovereign debt crisis. This is the power of words and good communication personified.

The RBI has also been forced to cancel several bond auctions because the market was unwilling to accept low yields. The fundamentals were unsupportive and without the RBI’s explicit support, Indian bonds were not a comforting bet. Drawing parallels with other central banks, Bank Indonesia and BSP were more forthright in their government debt purchases. The BSP announced an arrangement with the Bureau of Treasury and secondary market purchase of government securities. The Indonesian government announced legal changes to allow primary market government debt purchase by BI and a burden sharing agreement as well. These were bold, unprecedented measures which were needed during unprecedented times. Although the market was concerned about institutional autonomy and exit strategy, it had the necessary information to forecast future policy actions. This was a major difference to the RBI.

All these arguments are not to belittle the quality of monetary policy in India or its makers. Rather, it is to point out the areas that still need improvement. Particularly since the adoption of inflation targeting, the investor community has been impressed with central banking in emerging Asia and the RBI is no exception. The RBI's efforts to clean up the non-performing debt in the banking system and its financial stability reports are well regarded and widely read by the investor community and policy analysts. Not to forget, the hugely important role that the RBI has played in steering the economy through this crisis.

It is precisely why the market has formed an expectation about the RBI’s monetary policy making. That it is good and well though out (most times). And when expectations are high, it doesn’t take much to lower them.

Currency case studies

This post is a follow-up to my previous article, which laid out the economic framework to forecast currency performance. In that note, I had emphasized on the importance of currency evaluation in the investment decision making process. Currency returns need to be accounted for in the overall investment return and simple economic variables can be utilized to make an assessment about a currency’s direction over the investment horizon.

We identified 7 economic and policy variables to guide the currency outlook. In this note, we will apply the variables to forecast actual currencies. These case studies will assist you in building your thought process around currencies, when to buy and sell them and how to apply economic variables to understand the market. Please note that currency forecasting based on economic fundamentals is appropriate for medium to long term forecasting and identifying currency cycles.

The US Dollar is likely to weaken:

The USD is the most traded currency in the global economy. In 2019, the USD was involved in 88% of all FX transactions. Additionally, as the global reserve currency, the dollar is held by almost all central banks and institutional investment firms. Given the importance of the USD in the global FX market, we start applying our economic framework to forecast its direction.

1. US trade balance is likely to worsen: The United States has historically seen trade deficits (where imports > exports) since 1992. It is a consumption-based economy, relying on imports to fulfill domestic demand. As the US economy is exiting the pandemic, pent up consumer demand is likely to boost imports and worsen the trade deficit. This should weaken the USD.

2. US capital account balance is likely to worsen: The United States is the largest source of private sector capital in the world economy. As a response to the economic shock from COVID-19, the US Federal Reserve (Fed) slashed policy interest rates to 0% in 2020. With domestic interest rates at record low, US based investment firms have the incentive to allocate capital overseas in search of higher yields. This is likely to worsen US’ capital account balance and weaken the USD.

3. The Fed will allow inflation to run high: In August 2020, Fed Chair Jerome Powell announced an important shift in the Fed’s monetary policy. Since 2012, the Fed had been targeting 2% inflation. In August 2020, Chair Powell tweaked the Fed’s inflation targeting mandate from long-term inflation targeting to average long-term inflation targeting at 2%. Quoting Chair Powell – “following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time”.

This shift in monetary policy is important because it suggests that the Fed will let inflation exceed 2% in some time periods, as long as inflation averages 2% over the long term. With pent up demand in the US coming back, higher US inflation is likely to weaken the USD.

4. US money supply growth is at a historic high: In response to the COVID-19-induced economic shock, the US government and central bank unveiled massive stimulus programs. These were aimed at boosting consumer spending and private investment. At the same time, the stimulus measures pushed M2 money supply growth to a historic high of 24.8% y/y in December 2020!! To provide you some context, M2 money supply during GFC peaked at 10% y/y in March 2012. Such high money supply growth is likely to weaken the USD.

As per our framework, the USD is likely to weaken.

In the subsequent case study, we will assess the currency’s direction relative to the USD.

Korean Won’s fundamentals have been improving.

1. Korea’s trade balance is improving: Semiconductors comprise ~20% of Korean exports. Semiconductor prices are cyclical in nature, with each cycle generally lasting 2 years. The last cycle bottomed out in August 2020 and the pandemic has simultaneously boosted demand for electronic products made using semis. This suggests that semiconductor prices are likely to rise over the next 1-2 years and boost Korean exports. This will strengthen the KRW.

2. Korean inflation is below US inflation:

Ageing demographics is an important driver of lower Korean CPI. In 2020, Korea's fertility rate fell to 0.84, the lowest globally. This compares against 1.73 in the US and 1.42 in Japan. Korea's population fell for the first time in 2020, suggesting a downtrend in consumption and inflationary pressure in the economy over the coming years.

Relative to the US where the Fed may let inflation run high, Korean CPI is likely to be weak due to structural factors. This will weaken the USD against KRW.

3. US money supply exceeds Korean money supply: Against 18% y/y M2 money supply growth in the US (after peaking at 25% last year), Korean money supply peaked at 11% y/y. Lower Korean money supply is likely to strengthen the KRW against the USD.

4. The Bank of Korea is likely to hike the policy rate soon: To provide you some context here, the BoK is a conservative central bank. By conservative, I mean that it has hawkish tendencies and is averse to extra loose monetary policy conditions. Such conditions lead to macro prudential risks such as asset bubbles. The BoK is especially concerned about rising house prices in Korea and household debt being over 100% to GDP. With the economy reverting to normal post the 2020 crisis, the BoK sounded hawkish at its last policy meeting. An eventual policy rate hike will strengthen the KRW.

Currency forecasting is simpler than we think it is. Sure currencies are volatile and prone to swings due to everyday events. But economic fundamentals can guide the medium to long term currency outlook and help look through the daily, weekly or even monthly volatility. Moreover, economic analysis can help enhance the investment decision making process for trading FX and other asset classes across economies.

Key takeaways:

1. Our analysis of the US Dollar (USD) based on the economic variables indicates that the USD should weaken in the medium term.

2. On the other hand, the same variables suggest Korean Won (KRW) appreciation.

3. Similar analysis on currencies can be utilized to identify attractive currency pairs where one currency has strong fundamentals and one weak. FX traders often use such analysis to go long (buy) and short (sell) currencies to make gains.

Using everyday economics to forecast currency movements

Currency forecasting is a useful exercise to complement investment decision making. Suppose as an investor, you are keen on gaining exposure to emerging or frontier markets for their growth potential. Financial and economic analysis will be the key inputs in the decision making. However, investors often forget that the final investment return will factor in the currency appreciation or depreciation of the investment asset as well.

If you are keen on making currency trades, timing the cycle of the currency and knowing its future direction will be important. Part 2 to this post will more directly address this question.

With these questions in mind, this article is a primer on using simple economic variables to forecast the direction of currency movement. I have provided data sources that are freely accessible, for your reference. By the end, you will have a good idea about how to approach currency forecasting without doing a PhD in economics!

1. Rising trade balance strengthens the currency

The trade balance measures the difference between the value of exports and imports of goods and services of a country. A positive trade balance reflects exports exceeding imports. When Singapore's exports are booming, there is rising global demand for its products. Higher demand pushes up the price of Singapore's goods and strengthens the Singapore Dollar (SGD) in the process.

When Singapore's imports exceed its exports, domestic participants are demanding foreign products, driving up the prices of foreign goods and weakening the SGD relative to foreign currencies.

Relevant example: In 2020, during the COVID-19 pandemic, Taiwan and Korea’s currencies outperformed peers (against the USD) in the region. Despite weak global demand, Taiwan and Korea offered products that were highly demanded at the time—work from home electronics. This boosted Taiwanese and Korean exports while their imports lagged due to weak domestic spending.

Data source: Trade statistics are published by trade ministries or national statistics offices.

2. Rising capital account balance strengthens the currency

A country’s capital account reflects the difference between capital inflow (in the form of inward investment by foreigners) and capital outflow (investment by domestic players abroad). The capital account is in surplus when a country receives more foreign capital investment than what it invests abroad. Capital account surplus strengthens a currency by augmenting investor appetite for domestic assets.

Relevant example: Walmart opening a factory in India is direct investment whereas Walmart’s investment team buying Indian stocks or bonds is portfolio investment. Either type of investment in Indian assets strengthens the Indian Rupee (INR).

Domestic asset managers’ investment strategy is a useful leading indicator of capital account dynamics. For example, Korea’s National Pension Service (NPS, Korea’s largest investor) announced its intention to enhance foreign asset allocation to boost investment returns. This would imply capital outflow from Korea and Korean Won (KRW) weakness.

Data source: Central banks publish data on portfolio and direct investment inflows. The International Monetary Fund (IMF) publishes capital flow data by country here.

3. Higher domestic inflation weakens the currency

Inflation refers to the rise in the price of goods and services in the local economy, over a period of time. When inflation increases, 1 unit of local currency can purchase fewer goods and services. This weakens the purchasing power of the local currency.

Relevant example: Emerging market economies such as Argentina, Brazil, India and the Philippines have seen their currencies weaken against the US Dollar (USD) over time, given that their inflation is higher than the US.

Data source: The national statistics agencies and central banks publish inflation data monthly or quarterly. The IMF’s World Economic Outlook database and the World Bank’s macro data pages contain a compendium of macroeconomic data by country.

4. Central bank policy rate hike causes currency appreciation

The central bank sets the country’s monetary policy. It decides the rate at which domestic banks borrow from it. As the central bank’s policy rate is the benchmark for other debt instruments in the economy (loans, bonds), domestic interest rates increase when the central bank hikes the policy rate. With domestic interest rates rising, foreign investors may take advantage of the higher policy rate by investing in the local debt instruments which now offer higher interest income. Foreign capital inflows seeking higher return in the domestic economy, lead to currency appreciation (as per point 2 above).

Relevant example: When the US Federal Reserve and European Central Bank (ECB) slashed policy rates during the global financial crisis in 2008, foreign investors seeking higher yield income, rushed to buy emerging market debt.

Data source: Central banks release their monetary policy statements on their websites. These statements provide useful economic snapshots and central bankers often comment on currency dynamics.

5. Higher money supply on a relative basis weakens the currency

Money is supplied into the economy through the government or central bank. When the government expands its expenditure plans, it pumps money into the economy. When the central bank lowers the policy rate at which banks borrow from it, banks lower lending rates and make it cheaper to borrow funds. This raises money in circulation. When supply of money exceeds demand, the purchasing power of currency in circulation weakens. In other words, too much money chases too few goods. There are several measures of money supply termed M1, M2, M3 and M4. The most practical term for our analysis is M2 which represents money in circulation (cash and coins), deposits made into savings accounts, money market securities and time deposits.

Relevant example: As a result of the COVID-19 pandemic and economic shock, the US Federal Reserve and government introduced significant stimulus into the economy. Both fiscal and monetary policy measures raised the currency in circulation. On a relative basis, the growth rate of M2 in the US (yearly or monthly basis) exceeded South Korea as the degree of stimulus in the US was far greater than in Korea. This implied that the USD should weaken again the Korean Won (KRW).

Data source: Data on M2 is available on central bank websites. Readers should compare M2 growth (y/y or m/m) rather than M2 levels. CEIC provides free data on M2 growth by country.

6. Central bank’s intervention to weaken the currency

Before we discuss central bank policies, we should link currency strength and weakness to imports and exports. In section 1, we observed that a rising trade balance strengthens the currency against its main trade partners. A stronger currency indicates that 1 unit of foreign currency will be able to purchase fewer goods from the exporting country, thereby reducing its exports. Central banks may be wary of sharp currency appreciation and its offsetting impact on exports.

Relevant example: In 2020, several Asian central banks implemented policies to prevent currency appreciation against the USD in order to maintain export competitiveness. The Indian central bank (RBI) prevented the rupee from appreciating by buying USD and shoring up its FX reserves. FX reserves build up is a good indicator of central bank intervention.

The central banks of China and Vietnam manage their currency within a band or by pegging the level. The Thai central bank eased policies to boost capital outflows in order to weaken the Baht. Sometimes governments may exert pressure on the domestic asset managers to allocate funds abroad in order to generate capital account outflows (see section 2 on capital account dynamics) and weaken the currency. Korea’s National Pension Service comes to mind.

The easiest way to understand central banks’ policy biases is by reading their commentaries, monetary policy statements and policy announcements.

Data source: FX reserves data is available on central bank websites as well as the IMF. The US Treasury’s semi-annual FX report provides useful analysis of the FX policies of US’ important trade partners.

7. Real effective exchange rate

The REER assesses a currency's value against the weighted average of other currencies of the country’s major trade partners. Rising REER indicates currency strengthening. This reduces export competitiveness.

Data source: The Bank for International Settlements (BIS) compiles REER indices for 60 countries, here. In the dataset, 2010 is considered to be the base year and BIS provides REER values for the past 5 years. You can compare the REER in the current month to its value over the past 5 years as well as against 2010. This exercise will indicate whether the currency is over or under- valued relative to its own history. REER indices help traders forecast the future movement of currencies towards their fair value.

Key takeaways from the article:

1. Currency forecasting can complement investment decision making, by helping investors identify regions or countries having good currency outlook. This can help investors narrow down their investment options.

2. Although currency performance is uncertain and dependent on various factors, simple economic concepts can be used to make judgements on the direction of currency movement.

3. The economic variables assessed in this article include trade balance, capital account balance and inflation among others. All variables are freely available on central bank websites and macroeconomic databases.