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Money without brains

MARKET MANIAC

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Jamal Mecklai Mumbai
Last Updated : Jun 14 2013 | 2:53 PM IST
Like water, money has no brains. Both, being "natural" resources, act under the influence of natural forces. Water, under the influence of gravity, continuously seeks the lowest level. Money, under the influence of arithmetic, continuously seeks the highest risk-balanced level.
 
Of course, both of these natural resources can be harnessed or regulated, and the purpose of regulation "" whether by building dams or setting up financial controls "" is to drive each of these to specific purpose.
 
However, when regulation is poorly designed, these natural inclinations (of water or money, as the case may be) can become unduly constrained and begin to behave unpredictably, often leading to explosive disaster.
 
Thus, sensible ecologists (or, for that matter, sensible free marketeers) would advise a constant vigil on these very simple but ultimately uncontrollable natural forces.
 
Of course, maintaining this vigil is not easy. Sometimes, these forces remain quiescent for a long time apparently signaling comfort with the regulatory regime. But the nature of these forces is to be restless and volatile, moving to a now-you-know-it-now-you-don't rhythm. So, if they are quiet for too long, the sensible arbiter will begin to worry.
 
Since we are "" currently at least "" more interested in money than in water, let us apply this analysis of the "natural inclination" of money to capital flows into India and try to assess whether the current regulatory regime needs to be altered.
 
At the start of 2003, the one-year US T-bill was yielding about 1.5 per cent, one-year euro-bonds were yielding about 2.75 per cent and one-year Indian gilts yielded about 5.5 per cent. Now, as mentioned earlier, the natural inclination of money is to flow in the direction of the highest risk-balanced yields.
 
Thus, to understand the natural flow of money, we need to build in a risk factor that measures the likelihood of loss of value that could be caused by fluctuations in the exchange rate.
 
The Sharpe ratio is one such widely used measure; it is defined as the return on an investment over and above the risk-free return divided by the volatility of the return. I'd like to reiterate that the Sharpe ratio does not speak to any market view. Let us remember that money, in its natural state, has no brains, no market view.
 
The average volatility of $/EUR during 2002 was around 11.3 per cent, while the average volatility of Rs/$ was around 1.2 per cent. Thus, from a dollar base, the Sharpe ratio at the start of 2003 for investing in US gilts was 0 (the baseline), in euro-denominated government bonds was 0.11 and in Indian government securities was 3.42!
 
Clearly, then, if there were no market view and no regulatory constraint, money would flow unabashedly into Indian gilts. And it did.
 
Despite the regulatory barriers, which constrain inflows, our foreign currency reserves grew by over $30 billion during 2003, putting significant upward pressure on the rupee and, in turn, on RBI's attempts to keep monetary policy unaffected.
 
(Note that there was a very mild preference for euro investments as compared to dollar investments; in general, this would be an expected conclusion "" in highly liquid markets, any significant risk-based advantage would rapidly be arbitraged away.)
 
As things turned out, the rupee appreciated by 5 per cent against the dollar over 2003. Thus, the actual returns from investing in India were even better than anticipated. (The euro rose by over 20 per cent, so the actual returns from investing in euro-denominated bonds was much higher.
 
However, on a risk-weighted basis, the total return on investing in India [Sharpe ratio "" 7.69] was still substantially better than the total return on European investments [Sharpe ratio "" 1.89].)
 
Looking forward, and, again, brainlessly "" i.e., without any market view "" it is clear that money will still be pouring into India in 2004. Yields have fallen across the globe, and while the volatility of Rs/$ has risen (to 2.3 per cent), the Sharpe ratio for Indian gilts (at 1.29) in January 2004 is still substantially higher than that for euro-denominated government bonds (0.09).
 
Build in a market view "" the excellent current and prospective performance of the Indian economy, reinforced by the rash of upgrades we have just seen "" and it is clear that inflows will remain at least as strong and pressure on monetary policy will continue in 2004.
 
With inflation showing some signs of life "" and despite the government's conviction that the base effect will bring inflation down to the 4.5 per cent range by March "" it is clear that Indian gilt yields cannot fall any further. Thus, the only meaningful way to slow down brainless (i.e., natural) money flows is to lower the Sharpe ratio by increasing the volatility of Rs/$.
 
And the only sustainable way to increase the volatility of Rs/$ is to increase the diversity of views in the forex market. And the only way to do that is to permit a much wider array of entities access to the domestic forex market.
 
Some call that capital account convertibility. I call it being sensitive to the natural inclinations of money.

jamal@mecklai.com

 
 

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First Published: Feb 06 2004 | 12:00 AM IST

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