Yellentestimony,actbigandcostofreserves

In the US, President elect Joe Biden will take oath tomorrow, this will mark the end of the Trump era in which the world markets learned to gyrate and stabilize with every incoming tweet. The new dispensation in town will have its own idiosyncrasies and markets have already started vetting in detail the appointed teams. However, the special interest is reserved for the incoming Treasury Secretary.

Janet Yellen the former Fed chief who has been tapped for the role will be facing the Senate finance committee on Tuesday. In her prepared opening statement before the hearing, Yellen said that she appreciates the debt burden which the country has now but given the interest rates are at historic lows the smartest thing which we can do is to “act big”. Referring to the 1.9 trillion USD package announced by Biden last week. Now acting big means issuing more debt to finance the relief package. DM issues debt and EM’s subscribe to it. We wrote yesterday that how the FX reserve accumulation has become a sort of Hobson’s choice for the emerging market countries including India. Today let’s expand the discussion to see what the costs are attached to such a strategy.

In his 2014 book The Dollar Trap, IMF economist Eeswar Prasad writes extensively about the costs which the emerging market economies (EMEs) pay for the insurance which they are buying through reserve accumulation. Firstly, any intervention in the FX market has to be kept liquidity neutral i.e. any local currency made available against the Dollar purchases needs to be taken out (sterilized) otherwise it can cause inflation in the local economy. This sterilization can be done by selling local currency bonds to private investors (banks). These local currency bonds must pay the local yield. Just for example sake; let’s say the RBI issues INR 10-year benchmark bond as a sterilization instrument and purchases Dollar 10-Y treasury bills in its reserves. The yield differential 4.88% i.e. 5.98% (IN10Y bond) and 1.1% (US10Y bond) is the cost of this operation.

Now secondly if the local currency appreciates over the period then upon repatriation of reserves the EME will get those many lesser Dollars. For example, if the Dollar was purchased at 75 INR/$ and sold at 71.25 INR/$, this entails a 5% net loss. Lastly if the US Fed starts to stoke inflation then the yields will start going up and any existing bondholder will have to book losses on their investments. But all said and done as nothing in the field of economics is simple and straight forward, we also need to see the impact which the reserve accumulation has on the EME currency value and the corresponding export competitiveness. We will touch on this topic in our future notes.

In the market round up for the day, Hang Seng is up 3% in the trade today whereas Nikkei is up 1.4%. The Dollar Index is trading at 90.70 down from the highs of close to 91 yesterday. 10-year yield is at 1.11%. In India the 10-year yields have eased to 5.95 in the morning trade from 5.98 yesterday. After the OMO announcement for INR 10K Cr on Friday, market continues to scour for any hints on what is the comfortable liquidity level for the RBI. That will determine where the short-term rates will settle.