Why interest rates are low

The macro scenario and the implications for investors in terms of asset allocation.
By Morningstar |  11-01-21 | 

Bloomberg’s quarterly review of monetary policy stated that no major western central bank is expected to hike interest rates this year. China, India, Russia and Mexico are among those predicted to cut their benchmarks even further.

High-yield credit strategist Soham Das, CFA, explains what is going on in India and what investors must pay heed to.

Where it began.

The U.S. Federal Reserve, in its September 16, 2020 meeting, guided the market on a near-zero interest rate regime over the next three years.

Central bank communication and guidance serve as a tremendous source of signal in an otherwise noisy world of finance. The greater the credibility of a central bank, the more seriously market participants take its statements. As a result, the bank is able to achieve its objectives with minimum firepower.

A high amount of this assured liquidity pushes individual market participants to take higher and higher risk in order to earn yields. This sloshing liquidity found its way to high yield markets, one of them being India.

And therein lies the rub for India’s central bank.

The Reserve Bank of India, or RBI, has to manage this huge wall of flows while ensuring that the INR doesn’t appreciate too much. An appreciating rupee poses a threat to the terms of the trade for Indian exporters and has the ability to throw a spanner into the growth wheel.

The trilemma facing the RBI.

Consider three legs of the stool that symbolises the Indian economy:

  • The USD flowing in when excess in the global economy
  • Fixed Exchange Rate
  • Ability to set interest rates

This stool will always be unbalanced as the RBI can only choose any 2 of the 3 legs.

If the RBI chooses to control the interest rate (and hence low inflation) and fixed INR/USD rate, an open economy is not possible. This was the Indian economy prior to 1992.

If the choice is an open economy and an ability to set interest rates, the exchange rate cannot be fixed. The INR will fluctuate. This has been the case over the past few years.

Should the RBI balance growth with inflation while having free capital flows? Should it focus on having free capital and inflation, and sacrifice growth in the process?

How it has played out.

In March 2020, the RBI opened a Dollar/INR swap of $2 billion with first leg to be unwound in September 2020. Implying INR will be bought from the open markets in order to prevent INR from falling vis-a-vis USD.

The dollar inflow has resulted in forex reserves swelling. Implying that the rupee is appreciating. The RBI again intervened from September 2020, by selling INR in the spot market, to keep the rupee from appreciating.

These interventions in the currency market to stabilize the INR will impact the macroeconomics. 

The RBI will lose its ability to set interest rates if it fiddles with the exchange rate.

If the RBI chooses to stabilize the exchange rate while having free capital flows, it loses its ability to set the interest rates. Due to structural reasons, our interest rates have traditionally been higher than global average rates, keeping in view the inflation.

In essence, if the RBI opts and continues to manage the INR:USD exchange rate, then that is "fiddling with the exchange rate". It has done that in the past and has restarted it in 2020.

Because the RBI has chosen to have a 'fixed exchange rate' in an open economy (or, at least as fixed as markets would allow in an open economy), it is losing its influence on setting the market interest rate. That is why on January 6, 2021, the 91-day T Bill was at 3.03%, it inched lower than what the RBI set as the policy rate. (The current repo rate is 4% and the reverse repo rate is 3.35%.)

How must investors react?

Let’s look at it from an economic scenario where inflation is picking up.

For an asset allocation point of view, the prudent choice would be to allocate some capital to inflation-resistant assets, usually hard assets and precious metals (note the plural, not just talking about gold). I will leave the judgment to you and your financial adviser.

If growth trickles in, then a combination of equities and inflation-resistant assets like mentioned above can offer a satisfactory return.

Inflation has the potential to disproportionately reward businesses which are asset light and/or carrying intangible assets. Do note, these intangible assets may be on the balance sheet or hidden away from it. Investments in a brand-building can show up in balance sheet (sometimes), but investments in building “platforms”, “marketplaces” and “network effects” can disproportionately benefit from an inflationary environment.

Being asset light, they do not demand a lot of maintenance capital expenditures to maintain their competitive edge.  This is good news, in an inflationary environment which demand a high degree of capital efficiency.

For Indian investors with international exposure, buying a business that has competitive advantages which compound with time is highly desirable. Those are the only advantages they can have now, as traditional advantages like “economies of scale”, “high upfront investment” have withered away. They have been rendered ineffective due to low-interest rates in Western economies. Having exposure to currencies, like the Swiss Franc, where the central bank has been prudent has performed well in the previous crisis. My best guess is they will continue to perform going forward as well.

Allow me to conclude on a sensational note.

I remember Selina Kyle’s ominous words to Bruce Wayne In The Dark Knight Rises: 

There’s a storm coming, Mr. Wayne. You and your friends better batten down the hatches, because when it hits, you’re all going to wonder how you ever thought you could live so large and leave so little for the rest of us. 

Not as dramatic, but food inflation is rising and can unhinge the expectations in the coming months. Unhinged inflation expectations are sticky and can be self-fulfilling. That’s the risk, as fiduciaries of wealth, we have to navigate around.

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