Fxreserves,capitalflowsandconceptofHysteresis

Whenever we try to explain any market movement our first port of call is to identify a global event or a cause. This is specifically true in the case of currency and equity markets. Bond markets also get impacted by global news but the local factors like growth, inflation, deficit etc also impact them in equal measure. Currency and equities however follow the global liquidity train much more closely. For example, even in a bad monsoon time if the foreign money keeps flowing in it will prop up in country assets as well as currency. The central banks then have to mop up those extra Dollars in the process building reserves.

As in India the forex reserves have touch 600 bn USD, one question which should be asked is that what is the optimal level of reserves? Or is it a moving target. The Fx reserves number that gets published weekly in the WSS report don’t cover the CB position in the forwards market. Any action in the spot market builds the reserves but also adds to INR liquidity in the system. On the other hand, the same effect of currency stability can be achieved by buying Dollars in forwards. However, the liquidity problem is not solved in this case, it only gets postponed till those forwards mature. The INR liquidity which gets generated through spot intervention has to be sterilized by issuing bonds which has its own costs.

Readers should also note that the first order impact of this capital flow is on asset price increase. This on its own will not add to the GDP growth but as the asset prices remain elevated, it gives rise to the wealth effect prodding the nouveau riche to spend and consume and hence adding to the GDP. But the policy makers are also aware of the pitfalls of such spending. When the price crash occurs on account of reversal of flows the impact can be devastating. As such phenomenon of global flows entry and exit follows a saw tooth pattern i.e. gradual rise followed by a sudden fall, the economy at the receiving end can experience a multi-year downturn. Economists have a special term for such events called hysteresis. The term originally borrowed from the field of physics aptly explains the post-crash behaviour in any economy. Even when the conditions which precipitated the crash have dissipated, the attitude of general public remains cautious and very circumspect for much longer time. The memory of hardship remains too acute and recent, prompting to delay consumption and suppress demand. The economy hence experiences a vicious cycle and pain aggravates. In such times governments are expected to help but their own finances are on shaky turf. Unlike DMs, the EMs can’t print their way to prosperity.

I would suggest that readers refer to one book by journalist Michael Lewis, the book’s name is Panic. They will find the section on Asian financial crisis to be interesting and instructive in equal measure. How the South East Asian tiger economies coped post the sudden flight of capital has been described in vivid detail. The reserve accumulation strategy hence is a bulwark against any such sudden flight of capital. The policy makers are aware that the costs in the short term on sterilising the excess liquidity is well spent in case it saves from years of depression hysteresis. That’s why any logical explanation of absolute reserves value like months of import cover, short term foreign currency loan payment is good to debate but the answer lies somewhere more deeper.

Readers however would see the pervert incentive inherent in this logic. More reserve creation by the emerging economies can prod the developed world to generate more debt and liquidity. It just the extend the free lunch hours for them. The longer it continues more entrenched it becomes.