Is the risk of repeat of 1995-1997 Asian financial crisis real?

Risk from reverse of carry trade flows

There is build-up of worries (and concerns) in Emerging Markets (not excluding India despite domestic euophoria) on the risk of repeat of the severe 1995-1997 Asian financial crisis, the worst memories of which still in mind! The answer to the question is obviously, yes! However, uncertainty is on the extent of downside risks! This is one among other critical factors that made me switch sides while NIFTY at 8585-8635, Rupee at 61.20-61.70 and 10Y bond yield at 7.75-7.85%, calling these levels as hot-to-hold valuation and seen good to unwind exposure risks to cash-out (external, leveraged carry-trade) liquidity driven rally in 2014, thus completing the chase from 7700-7750 and 8.40-8.65%. Since then, there is setup of bearish momentum on the Indian financial markets.

Let us focus on India; the operating environment since 1995-2000 and now is very different. The macroecomic fundamentals are seen good since May 2014. Investor confidence (and appetite) is huge, customer sentiment (and exuberance) is positive, and fear of sovereign rating downgrade has turned to expectation of upgrade in 2015. The issues around policy paralysis, regulatory irritants and administrative bottlenecks are no more relevant. The Modi Government vision to script economic and social well-being is firm; bureaucracy is geared up to build tactics around this vision and the administration is cautioned to step up speed on execution - all combined to realise the dreams into reality at lower end of the pyramid. While execution risks are not completely ruled out, the high confidence on the India Inc CMD & CEO Narendra Modi dilutes the risk in play to set up huge growth (and prosperity) expectation on India in this decade (from 2015 to 2025). At this stage, it is safe to assume that risk from politics and execution is low.

What about economic and monetary risks? While it is safe to assume that the worst is behind on key macroeconomic factors - growth, inflation, fiscal consolidation and current account deficit, there is doubt on momentum build-up into the right side of set target ambitions - GDP growth at 5.5-7.5%, CPI inflation at 4-6% and twin-deficits at 2-4% when growth pressures in developed economies may stay valid for long. The risk mitigant for India is to scale up domestic consumption through infrastructure build, make-in (and for)-India vision, higher contribution to GDP from manufacturing and agriculture sectors. This outlook (and opportunities) will be in India's favour to attract stable long-term FDI flows for investment, and stay less dependent on speculative FII carry-trade, fair-weather flows. The monetary conditions are good, much better to what was there in 1995-1997. RBI's foreign currency reserves is good to give comfort and avoid panic on sharp Rupee weakness, and there is adequate domestic liquidity to replace off-shore lenders and stay less dependent on FC debt. All taken, India was fragile (and weak) in 1995-1997 and now resilient (and strong) to withstand pressures from FII reverse flow (and/or from external liquidity squeeze). This outlook (and comfort) sets up strong support in NIFTY at 7700-7750, 10Y bond at 8.25-8.40% and Rupee at 64.65-65.00, seen as cheap-to-acquire value for consolidation between set hot-to-hold and cheap-to-acquire zones; at this stage, do not see sustainable break-out either-way!

Should EMs ring-fence financial markets from carry-trade risks?

Who are the beneficial stake-holders on carry-trade inflows? The major contributor to carry-trade inflows are FIIs,  long-term ECB borrowers, short term trade finance and Rupee borrowers shifting exposure to USD through FCNR loans or non-funded synthetic derivative products. Needless to say, when it gets in, it is huge. RBI can't stay as silent observer and forced to act; resort to combined acts of $ purchases and sell Gilts to balance system Rupee liquidity. The end result is that the carry-trade advantage (to stakeholders) is paid by the RBI, taken with a pinch of salt as social cost to keep Rupee exchange rate competitive to exports and to maintain demand-supply equilibrium. What is the need to encourage such carry-trade opportunities at the expense of RBI?

When the tide turns and when what goes up comes down, the impact is worse! The unhedged carry-trade exposures emerge as serious threat not only on the financial markets, but on the entire economy shaking out the investor (and consumers) confidence. When the herd instinct turns from inflows to pull-out, RBI has no defence mechanism. If at all, why give cheap dollars to speculators? The resultant one-shot double-digit Rupee depreciation is systemic risk, not only hurting macroeconomic fundamentals but also hurting the P&L of corporate entities and pain for the lenders. The worst hit are the retail investors and SME business enterprises, who do not have financial muscles to manage this crisis, which is unforseen, sudden and big! If all these are put together, should the regulators encourage this carry-trade operations without any ring-fence? There is need to protect small fishes from the sharks in the financial markets?

It is high time for the Government and RBI to find ways and means to control carry-trade operations and ring-fence the system from the sudden shift in direction of carry-trade flows. While globalisation (with cross-border bonding) in trade & services and long term capital market (debt & equity) investments is good and stable, need to review speculative operations from short term carry-trade operations. Till then, sudden burst of excessive market volatility from opening and unwind of carry-trade flows can't be ignored; protection can only be from being prudent, overcoming greed! It is good to stay in caution when markets tend to rally against fundamentals.

Thinking aloud for powers that be to listen and act!

Moses Harding