Outbreak of 'yellow fever'

Central banks have started buying gold in large quantities and selling US dollars

The Reserve Bank of India (RBI) has used dollar-rupee swaps two months in a row to impart liquidity. The April auction collected $5 billion (bn) easily, with over $18 bn offered by banks.  But the three-year premium was appreciably higher in April than in March.

There’s a liquidity deficit despite the infusion of $10 billion rupee-equivalent (about Rs 70,000 crore) into the domestic bond market in the last two months. One reason is high government borrowing. Another is lower government spending with programmes stalled due to elections. This has meant lower payment disbursals into the system. The elections themselves have also led to higher demand for cash. The end of the election process should lead to some liquidity easing — government spending would restart, and cash withdrawals dip.

The low current demand for corporate credit has also controlled the liquidity deficit but bankers say that the RBI will need to impart extra liquidity through the first half of 2019-20, with swaps, and Open Market Operations.

The long-term cost of swaps is hard to assess. Three years later, when the swaps are unwound, somebody could lose a lot of money. There is little chance that the rupee rate will be stronger in 2022 than in 2019. If the dollar-rupee rates of 2022 range close to the premiums in the swaps, nobody gains or loses much. If the rupee is weaker, the banks gain and the RBI loses. If there’s a big discrepancy between spot rates in March-April 2022 and the premiums paid in 2019, the central bank may well decide to take the rupee closer to free-float.

Higher liquidity through April-September 2019 could coincide with rising inflation. The current low inflation is caused by low crude prices and low food prices. Core inflation, ex-food and fuel, is quite a lot higher than the consumer price index and core inflation has not abated to any great extent.

Unfortunately, the Iran–US tensions have pushed crude higher with a direct impact on India, which sources about 11 per cent of energy imports from the Islamic Republic. Food prices could also rise if the monsoons are below-par, as forecasts indicate.

So we may get a six-month period when inflation is rising, (off a low base), and the RBI is pushing liquidity into the banking system and holding interest rates down. To add to complications, the non-banking financial companies’ segment will remain high-risk until the IL&FS shock dissipates. That combination of trends will lead domestic investors to focus more on equity. If India remains in the top decile of global growth, foreign portfolio investors will also keep betting on Indian equity.

We have a situation where earnings growth has slowed in the past three quarters and it appears as though January-March 2019 isn’t going to see much acceleration. Take the auto sector as the bellwether for the domestic economy. The auto industry has a very long value chain and it reflects demand across both rural and urban markets. The Q4, 2018-19 results have been uniformly poor for auto companies and the industry associations have pessimistic 2019-20 forecasts.

At the same time, the market indices continue to march northwards, with valuations moving beyond price-to-earnings multiple of 26. This creates a very awkward situation for prudent investors. Debt is unattractive. Equity is overpriced. There is likely to be a period of policy uncertainty and populism and maybe higher inflation, regardless of which political formation comes to power.

This is the kind of situation where gold starts looking attractive. The precious metal is a good store of value since most investors consider it a safe haven in uncertain times. Gold has been sitting near its 2019 low as investors anticipated a higher dollar. However, it could start moving up again. Global volumes traded in January-March 2019 were about 7 per cent higher, year-on-year. One interesting signal is that central banks – including the People’s Bank of China, Qatar and Russia  – have started buying gold in large quantities and selling US dollars.

Global gold prices are inversely linked to the strength of the dollar. A weaker dollar means higher prices. The latest policy review from the US Federal Reserve held rates unchanged. That caused a dip in gold prices since bulls were expecting a rate cut, which would in turn have led to a weaker dollar.   This might create an opportunity to diversify into the metal.