How a Currency Dies

India is a prime example of a broken country and squandered potential. Years of mismanagement and interference has mutilated an economy which is now disintegrating before our eyes.

The fires of inflation destroy purchasing power

The volatility over the last year in Indian financial markets resulted from years of government monetary intervention and bureaucracy choking productive activity. In this post I want to explore the causes of dramatic currency depreciation and possible remedies.

Burning Down the House

Firstly, we have to look at how this happened. India was part of the infamous BRIC nations. Supposedly, India was a new engine of global economic growth that would unleash millions of middle-class consumers demanding more goods and services from the rest of the world. China was the poster child and India was its little brother waiting for its chance to live up to the high expectations set by its sibling. But as any free market or Austrian economist will tell you, economic growth can only occur when there is less government involvement in the economy.

Fundamentally, India has not escaped its historical communist influences. The government is strangling the private sector with a byzantine regulatory system, numerous taxes and a corrupt bureaucracy. The political actions of recent weeks epitomise the intrusive and destructive handling of the economy. By placing restrictions on gold imports and then banning currency derivatives resulted in greater capital flight and a greater loss of confidence. This then leads to a vicious cycle of more regulations and more capital flight until the government and society capitulate to reality.

A depreciating currency is always caused by loose monetary policy. Interest rates are kept too low, resulting in excess credit creation and eventually rising prices. Unless interest rates are raised to quash rising prices, the currency loses its integrity as a store of value. People quickly convert the depreciating currency into commodities (e.g. precious metals), hard assets and alternative currencies to avoid the loss of purchasing power. At some point, the government is forced to act correctly as social tension rises amidst a financial and economic crisis. If the government denies its prior economic mistakes and maintains loose monetary policy, hyperinflation and a complete loss of confidence is the inevitable conclusion followed by transition to a new currency. We have seen this throughout history and thus none of this is a revelation; it is the certain truth.

Eye-Watering Results

To give you an idea of the extent to which the Rupee has lost purchasing power, we will look at a staple of the Indian diet, onions. As seen in the chart below, onion output and productivity has dramatically increased and is a testament to India’s agricultural industry harnessing better farming techniques and utilising capital.

In a free market economy, such a large increase in onion production would result in lower prices but guess what prices have done:

This is exactly why Indians have an insatiable appetite for gold. Gold has always been a part of Indian culture and has become more sought after due to the realisation that gold is a better store of value than the Rupee.

Behind the Curve

When exactly did the Reserve Bank of India (RBI) commit the crime of inflating the money supply? At the same time most central banks did, in the aftermath of the global financial crisis of 2008/2009. Below is a graph showing the changes in the consumer price index which measures the average prices (dashed red line) in the economy compared to the interest rate set by the RBI (solid black line).

Before 2009, the CPI was slightly below the interest rate which means the cost of borrowing was very low. After 2009, the RBI slashed interest rates but made the fatal mistake of raising rates too slowly. During 2010, the CPI was increasing at 8-10% p.a. while interest rates were below 6% and slowly rising. Real interest rates were negative, which meant credit had no cost and resulted in a booming property and stock market. This attracted foreign capital as interest rates around the developed world were at or close to zero. There was a huge yield differential that could be exploited via borrowing in the US at a low rate and then investing in India at a higher rate. This caused upward pressure on the Indian Rupee as portfolio flows flooded Indian capital markets (bonds and stocks). Portfolio flows (equities, bonds etc.) were favoured over foreign direct investment (building factories, buying entire businesses etc.) because of India’s hostile business environment which made it easy and less risky to buy equity and debt in companies.

India is just the worst case out of all emerging markets. A few years ago, emerging markets joined the currency war. They were complaining about QE because it was causing all this hot money to flow into their economies. But instead of allowing their currencies to rise which would have ended the inflows. They bought USDs and US treasuries and sold their domestic currency to stop it appreciating. Now that USDs are being repatriated from emerging markets, their domestic currency has come flooding back.

Similarly in India’s case, what goes up must come down. The Fed’s rhetoric changed in late May with hints that asset purchases will taper. This sent a shockwave around the world as US treasury yields rose, narrowing the yield differential between the US and economies with higher interest rates. The Australian dollar was one currency that depreciated as the RBA cut interest rates. Likewise, other Asian and emerging market economies saw their currencies tumble. As the situation unfolded, the market became aware of the precarious position India was in and panic took over. But what can India do to stop the Rupee depreciation?

Do It! Do It Now!!!

Things India can do to turn the tide:

• Sell all foreign currency reserves (US$275bn) and gold (US$25bn) to buy rupees. Then destroy the purchased Rupees. The effect is a reduction in the Rupee money supply which will have an immediate impact on the exchange rate. It also sends a message to the market that the government is serious about a strong Rupee
•  Raise interest rates to squash inflation. There’s no balance between growth and inflation. The only way to get India growing again is to liquidate bad investments and rebuild after the recession has reset the economy. This is what Regan and Thatcher did in the 1980s.
• Fully deregulate the domestic economy. This will encourage long-term foreign direct investment instead of portfolio capital which can leave the country quickly
•  Reduce government spending to balance the budget. A good place to start is defence with India being the largest arms buyer in the world. By reducing the deficit, the government borrows less money from the private sector and therefore the private sector has more capital to invest in productive investments. A submarine is not a productive investment!

However, Indian elections are around the corner and reform measures are not popular. This is what happens if no reforms take place:

•  Rupee continues to plunge, which results in lower confidence and capital flight. Could result in a vicious cycle till the government is forced to act
• Import prices sky-rocket. Oil is already 50% more expensive in recent months
•  Long-term stigma and sovereign risk due to the perception of a dysfunctional economy

The only way India can seize its potential is by deregulating the entire economy and restoring faith in its fiat currency as a store of value. Both these actions are difficult given their political implications, which is why I am doubtful they will be done voluntarily. It will be the market who makes an offer they can’t refuse, and will be the driving factor behind change. Unfortunately, this episode has proven once again that the actions of the few in government torture the many living under India’s rule.

Banks Feed Off Inflation

Firstly let’s define inflation. Today’s common usage refers to inflation as rising prices either caused by an increase in aggregate demand with aggregate supply remaining static (demand pull inflation) or a decrease in aggregate supply while aggregate demand remains constant (cost push inflation).

So if there are tax cuts and there is more demand for all goods, is this considered inflationary? Yes by modern definition there will be an increase in aggregate demand causing demand pull inflation.

But my own view of inflation/deflation is the same as the classical definition of inflation which is an expansion of the money supply. The symptom of inflation is rising prices, which is why over time the factoid equating inflation to rising prices exists.

When the central bank adjusts interest rates, this affects the money held in bank reserve accounts and in turn affects a bank’s ability to make loans and increase the money supply.

When banks originate loans the money supply expands since a 10% reserve requirement will lead to banks using a $100 deposit to create a $1000 loan. This means when borrowers repay loans, the money supply contracts and similarly if a borrow defaults, the money supply really contracts. However, banks will use buffers to protect themselves against a default by first making sure the borrower is credit worthy, then requiring a deposit to banks are not taking the full risk, finally collateral will be linked to the loan (e.g. the property will be collateral for the mortgage loan).

As the money supply expands (inflation), asset prices rise since there is now more money chasing the same amount of goods. This in turn increases the demand for loans since people see asset prices rising and believe the economy is growing and additionally collateral value increases allowing potential borrowers to increase the leverage on their loan. Loan serviceability is another important factor when banks assess a potential borrower. Since all prices are increasing, including wages, pretty much all the factors a bank will look at to originate a loan improve in favour of the borrower.

This is the inflationary cycle that causes borrowing to lead to higher asset prices and then more borrowing. The central bank then tries to control this by increasing interest rates which should decrease the demand for new loans. However, there is a time delay in the effect and because the bulk of loans are long-term in nature (longer than a year) the economy doesn’t feel the full effect of a string of interest rate rises until a few years into the future. Eventually the economy begins to contract after a string of interest rate rises result in a fall in borrowing and then it is up to the central bank to re-start the game by slashing interest rates to begin a new cycle of borrowing and rising asset prices. This is how the business cycle works and is why under the current system any deflation is considered bad because if the central banks leaves the economy to contract and allow deflation to take hold, it will continue unabated until prices are so low that demand for loans increases. This could lead to a substantial contraction in the money supply and prices falling more than 10% in a single year.

The problem with this system is that banks depend on inflation the resulting loan origination to increase and maintain their current profits. If there is deflation, people demand less loans and repay their loans faster to reduce debt burdens. This causes a huge contraction in bank profits and when the economy really contracts, collateral values plunge as a vicious cycle of loan defaults and collateral devaluation takes place. One only has to look at what happens when a country has a bubble economy to see this scenario play out. Japan in the early 1990s, the US in 2008 and soon Australia will have its day of debt deflation.

Australia has hitched its wagon to the Chinese growth engine and Asia in general, which is where I fear the economic shock is likely to manifest itself. In many financial and economic crises we see banks come under severe stress and in many cases collapse as their reserves vanish via asset impairment, exposing their leveraged business model. Governments then become involved via bailouts and hence taxpayers are now proud owners of zombie banks.

This is exactly why substantial deflation (>2% deflation) will never be allowed to occur and why eventually rates will go to zero. Banks will not survive unless they dramatically increase their reserves, which I do not foresee happening during extreme economic uncertainty. The government will nationalise banks claiming that the economy will implode if nothing is done.

These are dire predictions and I am sure the majority will disagree with this forecast but is there really another outcome when the current solution to any downturn is to spur spending and borrowing via lower interest rates?