World Markets Simplified

The joker in the pack this year has been the Indian rupee. At a time when the Indian and Chinese economies may be the last men standing, the rupee – unlike the Chinese yuan – is into steep decline and fall.

On Tuesday, the rupee hit a two-year low of 48.24 against the US dollar, suggesting that short-term demand and supply issues are determining its value when the macro-fundamentals should actually lead to a strengthening of the Indian currency.

The financial markets are clearly divorcing from reality – though in the long term they will surely correct.

There is, of course, one good economic reason for the rupee to fall. It's the growing trade deficit (imports minus exports), which hit $55 billion in the April-August period this year. Unless this deficit is bridged by capital flows, the rupee has to decline. Even the Reserve Bank cannot keep selling dollars – which it has shown no great inclination to do —to stem its fall.

The rupee's drop is complicating the fight against inflation. We are now importing inflation (whether it is through higher oil prices or something else), and this will push the Reserve Bank to keep raising rates till something gives.

As against this downer, two other macroeconomic indicators are a relative positive for us.

One of the key determinants of exchange rates is relative interest rates, adjusted for inflation. US policy rates are near zero, and will stay that way, while Indian rates are at 8.25 percent. The US inflation rate is 1-2 percent above the policy rate; ours is, too. This means there is no greater risk in the Indian currency than the US dollar. Sooner or later, capital flows should be headed our way, strengthening the rupee in the process.

Second, India scores on the growth potential front when compared to the US and Europe. No matter how much we slow down, we will still be growing 6-7 percent faster than both these big trading partners. This means capital should be flowing away from the dollar and eurozone, and towards India.

Then why is the rupee showing no spine?

Once inflation is down, the rupee will start moving up towards it medium trajectory of appreciation. Photo:Flickr/Creative Commons

One explanation, of course, is global risk-aversion, which is making capital seek safe havens. To be sure, there is no real safe haven in the world today, given the volatility of every currency, the threat of double-dip recession in the US, and the shakiness of most financial markets.

In fact, faced with the prospect of a eurozone collapse, money has been flowing into Swiss franc and the Japanese yen. This has forced the Swiss central bank to draw a line in the sand saying it will not allow the franc to rise above 1.2 against the euro. It will buy unlimited quantities of the euro to do this. The Bank of Japan also unleashed a tsunami of dollar purchases in August to prevent the yen from rising.

The joke is really on the concept of safe havens. Switzerland, whose banks handle assets that are six times its GDP, is really the most vulnerable of them all. A major bank collapse can bring down the Swiss economy, even as the world pressures the Swiss to wind down their support for global tax evaders. This is why the Swiss are planning to raise capital adequacy norms for banks to 19 percent.

Britain, which is home to huge global banks that are "too big to fail" and will need rescuing by the government in case there is a run on them, is planning to mandate at least 17 percent capital adequacy. The assets of British banks are 4.5 times its economy.

As for Japan, the less said the better. How can an economy with two decades of almost no growth and a domestic debt twice the size of its stagnant GDP, really be a safe haven? The only way Japan can keep the yen down is by unleashing another tsunami of yen debt – which will only worsen its macroeconomic stability. Japan is still an economy waiting for the ultimate implosion.

In that ultimate safe haven, the US, national debt more or less equals GDP, and the Obama administration is trying to cut down expenditure to make sure it stays solvent. But here's the sobering thought, according to David Rosenberg, who says the US economy is facing a double-dip recession, having accumulated $5 trillion of debt in just the last three years – to avoid a depression.

Europe is ticking time-bomb. The betting is that the euro will soon see some opt-outs like Greece and possibly Portugal. But even if Germany is blackmailed or cajoled into bankrolling the euro, the only consequence will be slower growth and economic uncertainty. Everyone knows that Greece is insolvent. The only way it can be rescued is by asking banks to take a "hair-cut" – that is write off some of their Greek debt. This, again, means German banks have to recapitalise themselves. They need capital.

In sum, the US isn't a safe haven, Europe isn't one, Switzerland does not want to be one, and Japan isn't anyone idea of a safe haven.

The only certainty is the prospect of slow growth, and a reduction is consumption and wealth, says Satyajit Das, a risk consultant and author of Extreme Money. In an article in DNA newspaper, he says:

"The proximate cause of recent volatility (in markets) is the down grading of the credit rating US (irrelevant) and the continuation of Europe's debt problems (relevant). The deeper cause is the realisation that future growth will be low and the lack of policy options."

Remember all those daily rumors (prmarily courtesy of the FT) that either China, or Japan, or Europe itself would bailout Europe (yeah, don't ask). Well we can put them all to rest…for at least a few more hours. Because in the battle of inverse counter disinformation, it is important to refute the rumors you yourself have created just so next time the same rumor is spread it has some impact…. Unfortunately said impact will be less, much less, with every single iteration, until just like central bank intervention, its impact is lost in the noise. Per Businessweek: "Officials from China and Japan, the world's second- and third-biggest economies, indicated that their support for Europe will have limits and the region needs to solve its own debt crisis.Japanese Finance Jun Azumi said in Washington today that while his nation can buy European Financial Stability Facility bonds if needed, there is no blank check. "At the margin we can do quite a bit to help," Chinese central bank Deputy Governor Yi Gang said in a panel discussion yesterday at the International Monetary Fund in the same city. At the same time, "the real solution of the European sovereign debt crisis has to be done by Europeans themselves." Good luck in that whole Europeans coming up with a solution: after all it was mere hours ago that France's Baroin said that the Eurozone is "open to support from others." Translation: "Show us the money." In other news, the countdown for the latest European bailout rumors from the FT is now on.

More:

Group of 20 finance chiefs today pledged coordinated efforts to tackle rising risks as Greece teeters on the brink of default and stocks plunge around the world. Weak growth, high unemployment, sovereign stresses and turbulence in financial markets are "renewed challenges facing the global economy," the officials said.

Azumi said that euro-area nations had "said that this is a euro-area problem, and that the euro-area nations should be the ones to solve the problem." "We don't reject that view, we respect it," he said.

Yi Gang's remarks came amid investors' expectations that China may help stabilize the euro region, after Italy this month followed Spain, Portugal and Greece in seeking investment from the world's fastest-growing major economy. Chinese Premier Wen Jiabao, facing calls to widen support for indebted European countries, signaled this month developed nations should cut deficits and open markets rather than rely on China to bail out the world economy.

Also this month, other Chinese officials indicated the country is prepared to offer assistance. Zhang Xiaoqiang, vice chairman of China's top economic planning agency, said the nation is willing to buy euro bonds from countries involved in the sovereign debt crisis "within its capacity."

In the panel discussion yesterday, Yi said his nation's involvement could be at the country level or with the European Union, and could also extend to cooperation with the IMF.

As to why we are sometimes baffled by why everyone automatically assumes the Chinese are ultra clever:

It is unlikely that the global economy will slide into another slump, in part because "the whole world is still at a very low level" of activity, Yi said. "We have a very moderate recovery" following the financial crisis, which indicates global growth "won't decrease too much," he said.

"The probability of that is still rather limited," Yi said, referring to a double-dip recession. With the right combination of policies, countries can manage the debt crisis and "we can still have moderate growth" in the global economy, he said.

Steve Mandel's hedge fund Lone Pine Capital says there are major concerns for global financial markets going forward. In their second quarter letter to investors, Lone Pine identifies two major concerns: the Euro and China's bad debt:

"The European Union (EU) is a structurally flawed concept and the euro is therefore doomed. This is a trickier issue because of the absence of a currency depreciation "escape valve", the vastly different fiscal condition of individual EU members (the structural flaws), the scale of public and private sector indebtedness and therefore even more convoluted politics. The consequences of failure are so high for all concerned, though, that compromises most likely will be made to preserve the EU and the euro. These will almost certainly involve financial pain on the part of France and, particularly, Germany (and, of course, the countries with shaky credit). In addition, a long and protracted road to financial health will require patience from the electorates in both creditor and debtor nations.

China has massive amounts of unrecognized bad debt that will ultimately lead to a crisis. While Chinese banks (and non-bank lending) are opaque, the high level of central government reserves and the absence of external sovereign debt make the odds of a financial crisis very low. There will undoubtedly be high profile frauds, scandals and bankruptcies, but for these to snowball into a systemic problem is unlikely. In a country with a closed capital account, though, one side effect is inflation. This has the potential to harm the "social contract" with the populace, an outcome which must be closely monitored."

Their point on China is not the first time we've heard this cautious approach. Grandmaster Capital's Patrick Wolff has called China a debt-fueled investment bubble. Kleinheinz Capital also believes that inflation is the biggest threat to emerging markets. And lastly, hedge fund manager Jonathan Ruffer also put out commentary that he'sworried about China.

But at the same time, there are other prominent investment managers that take the other side of the argument. We've covered previously how Maverick Capital is focused on China's importance and how Warren Buffett has said China will be a big driver of growth for the next 10-20 years. At the Delivering Alpha Conference, Xerion fund's Dan Arbess debated against Kynikos Associates' Jim Chanos as to whether China is a bubble or bonanza.

While big names stand on either side of the argument, only time will tell who is ultimately proven correct.