Bondsale,fiscalpolicyandimpossibletrinity

First things first, the virus situation in India remains dire. The new daily cases close on the 380k mark for 28^th April. The daily deaths also rise. As the economy gasps for oxygen the markets however remain sanguine. The Rupee appreciated below 74 yesterday whereas the bonds traded in a range. The 10-year bond closed around 6.06. Today is the weekly auction for 26k Cr INR government bonds, the thing to watch out for prior to the bond sale would be the results of underwriting auctions which will set the tone for the bond sale. RBI announced yesterday another tranche of operation twist for 10k Cr INR. Globally the Dow ended in mild green whereas US yields remained stable. Euro touched the levels of 1.2150 which was its highest since end February.

Yesterday we had taken up the FOMC decision in detail. The primary discussion was that how this stimulus both in form of low rates and balance sheet expansion has resulted in generating a new form of economics. The very fact that the policies have not resulted in sky high inflation and the US bond yields also remain more or less tethered indicate the policy makers that may be the party can continue. Apart from the monetary policy support, the fiscal support is also continuing. The Biden administration just announced a close to 4 tn USD plan on infrastructure upgrade as well as relief in taxes to families and workers. The plan will only be partially paid by the increase in taxes on the wealthy.

Now let’s discuss the above in a bit of detail and try to examine the actions in the theoretical framework. The increase in spending won’t be exactly compensated by tax increase. This would essentially create more deficit which means more debt issuance. This should mean the yields especially the longer tenor ones should react unless and until there is a huge demand for the paper. One source of demand is directly from the central bank in the form of purchases of these bonds colloquially known as monetization of debt or money printing. The other is from across the world when other CBs buy the US debt as a form of liquid reserve. The US situation is unique and non-replicable for other countries.

Furthering the discussion, a country let’s say like Russia (you can replace any non-US name here) can’t print roubles to fund its infrastructure the same as the US. The international market would respond on the foreign exchange terminals depreciating rouble making the imports (capital equipment and other resources etc) costly. The net effect will be zero. The economic model which describes this phenomenon is known as the Mundell – Fleming Model. This model develops the theoretical relationship underlying the exchange rate, capital movement and monetary policy. The conclusion states that an economy cannot maintain a fixed exchange rate, free capital movement and an independent monetary policy at the same time. It has to leave at least one to the vagaries of market. This is also called an impossible trinity. Our argument is that the US so far is saved (or looks like) from the clutches of the Mundel- Fleming (because of the reserve currency status).

Readers would do well to think on two points, firstly what can change this (who is the possible contender, what event can change the game etc) and in which time frame this would change. For example, if you are a company with a huge exposure to the Euro and are assigned to deliberate on a long-term funding plan, this discussion becomes relevant to you. One might choose to hedge for the short-term and roll over periodically or one would go for a straight long-term complete hedge, depending on the view. We will pause here and present arguments on a possible replacement to the US Dollar in our future notes. Whether it will be the Euro, Yuan, Gold or some other form of digitized currency, we will discuss in detail. The conclusion however would remain contestable and contextual, as should be the case.