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Hope crypto craze is not like Tulip mania and has a softer landing when the froth corrects: Viral Acharya

In recent times, perhaps the biggest game changer in financial markets is the emergence of crypto currencies – a medium of exchange which upturns the traditional approach of central banks controlling supply of money in the economy. Given the degree of wealth created for those who have successfully timed their investments in such forms of exchange, a valid question is whether the age of fiat currencies (where the sovereign is the ultimate entity in currency transactions) is coming to an end. spoke to a former policymaker in Mint Street, Dr Viral Acharya, who was the Deputy Governor in charge of Monetary Policy for the Reserve Bank of India from 2017-2019. We caught a glimpse of what the former central banker had to say about digital currencies when they were still at nascent stages and how they might impact the global currency chain, especially for emerging markets. “One of the reasons why emerging markets have put some of these capital shields or capital controls around them is because they want the currency to stay inside and not

fly out of the country in search of foreign currencies,” Acharya said in a chat with
Edited excerpts:

The US Fed has given signals that it will start tapering by November. We have seen a degree of rupee volatility ever since the US central bank struck a more hawkish note. Though we are now in a better position in terms of reserves, in terms of the taper, what do you think will happen to India?
Just to put things in perspective, rupee volatility is still very low. At best, it may be 4-5% annualised percentage change volatility. As of now, I think the rupee volatility and movements are being managed very well.

Coming to the broader question of what impact the Fed normalisation will have, the biggest elephant in the room is how much froth there is in the markets all over the world. This relates to the stock market in particular, but to an extent it also relates to the bond markets.

But let us focus on the stock markets. At least in many countries including India, there is some divergence between the stock markets and the real economic performance on the ground.

The only way to rationalise the stock market run ups is that there is a very bright future and the stock market is basically some discounted value of that bright future. However, post-pandemic, we are at a point which is bigger in terms of size of the GDP than pre-pandemic levels.

In the case of India, the froth has potentially two sources.

One source of froth is the FPI money which has been pouring in. It has been huge since the outbreak of the pandemic and to justify that, our market corrected very sharply by losing more than 50% of its value at the outbreak of the pandemic. But it has rebounded now, not just back to its pre-pandemic level but another 50% on top of that. So it has been a spectacular run up.

And one source of froth could be because of this global preference for a China plus one economy in the geopolitics of the world. It could also be because of the Chinese crackdown; especially on its tech sector, which seems to have benefited the Indian tech sector in a variety of ways – at a minimum through some technical flows.

The second source of froth, however, could just be that the Federal Reserve has acted as a global lender of last resort and pumped tonnes of dollars into the world.

Now, of course, this money is chasing all kinds of higher yielding assets. Real rates are negative in fixed income all over the world and so people are flocking to equities.

There have been PLIs or production linked incentives for various sectors. The tech sector is doing very well because of the transformation to the digital economy post the pandemic and I would say perhaps the intent and the conviction as well as execution on privatisation of state owned enterprises has now shown some success. But we need to see a little bit more than just Air India.

The debt has been rolled over at low costs given the huge surplus of liquidity in the financial system.

But to me, the froth in the equity markets is the biggest source of vulnerability as far as India is concerned from the taper or a normalisation of the Fed policy.

Just to make things a bit more concrete, FPI flows have probably been $60-80 billion over the last two years. That is pretty large. It is a very significant portion of the overall build-up of the central bank reserves over this period.

The good news is that reserves have also been built up through FDI flows for indirect investment flows which do not reverse and are more stable.

Historically there has been a view that even foreign portfolio investments in equity are a permanent or a stable flow. I am questioning that. I am saying we should do some stress tests which consider even that flow as fickle because it could be because of just the dollars that are being pumped by the Fed and the dollars that are seeking India because of some rebalancing away from the Chinese equity markets.

To sum up, in my view, the equity markets look too frothy, too buoyant compared to the ground realities. Look at the three-day equity market run pre-Dussehra from 18,000 to 18,500 on the Nifty index. Globally the news was bad on the energy sector all over and yet the Indian markets were just on a tear.

I have no way to make sense of this other than that it is just a technical-flow-driven run up.

I think the real rates in India are extremely negative; deposits and fixed income instruments are not earning much. Bankers and mutual fund managers are probably calling households every single day and telling them to move their money into equity and other kinds of SIPs. In my view, we have to be careful.

How much of a risk do you think inflation presents at a global level? What can central banks do to mitigate these risks?
We have a fiscal stimulus in the United States which is on a scale beyond the scale of the new deal stimulus of 1933.

It is being pushed by one arm of policy to create demand in the economy. The second arm of the policy is simultaneously trying to shift the economy to be more carbon-emission friendly and both of these are simultaneously facing lower supplies through the disrupted supply chains of the world.

The bottom line is that inflation is much higher than what anyone thought it might be at this time post pandemic. Remember everyone was talking about risks of deflation and what we are actually facing is surging inflation to the point that people are talking of stagflation. They are certainly not talking about deflation. So I would say that this is a non-trivial global risk.

It will put pressure potentially even on food prices and it is something that central banks especially in emerging markets simply cannot ignore.

Central banks typically have primacy of their inflation mandate and because central bank policy operates with lags, these inflation headwinds to growth will play out potentially as a faster than expected normalisation and tightening by the Federal Reserve; these are risks that cannot be taken very lightly at the present moment.

You were the DG in charge of monetary policy while you were at the RBI. Do you think that central bank interventions in bond markets have created a risk of mispricing? Is there a risk that we are not prepared for what will happen when the normalisation happens?

The world over, which central bank has found it easy to unwind from its quantitative easing?

The central bank balance sheets just keep moving to a new normal as far as their size is concerned which means that it is easy to pour in liquidity but it is much harder to actually take the liquidity out of the system.

And in a way, if this is the expectation of the market that the central bank will not unwind its policies or even if it wants, it will not find it easy to unwind its policies, then in some sense there is an explicit liquidity guarantee that is being built into the prices.

Certainly the debt and the credit spreads in the United States are very tight even as the risk free rates are rising at the longer end of the yield curve. The joke is that we cannot call junk bonds, junk bonds. We can call them speculative grade but we should not call them high yield bonds because the yields are so low right now.

In the case of India, my experience as the deputy governor was that one has to pay attention to two or three sources of vulnerability in the debt markets.

The first is that there is a tendency in the non-bank financial sector to shorten the duration of its bonds as interest rate increases become imminent. As they do not want to lock in a higher but steadier rate, they want to take the risk of a short rate which is lower because of the rising term structure. That creates a rollover risk for these non-bank financial companies. So, I would look out for liquid debt mutual funds and see whether they are funding short-term debt for non-bank finance companies.

Second, there is also seemingly a rise in floating rate fixed income instruments.

That is just another variant of wanting to take on a lower interest rate borrowing cost in the short run at the risk of facing a higher interest rate down the line.

So these are all signs of interest rate bets being taken on.

Third issue that always comes up in India is that our banks, especially public sector banks, own very large chunks of government bonds. Credit growth has not kept pace with deposit growth and that most likely means that an interest rate correction would have some bearing on their ability to buy more bonds and there could be mark to market losses. Historically that has always led to some forbearance but one cannot hide economic losses away forever.

So I think these are various channels through which interest rate hikes permeate into the economy.

Our large corporates have definitely benefited from higher inflation and lower borrowing costs.

There have been concentrated gains in the stock market and there could be corrections there as well. Globally, even sovereigns have started borrowing short term to bet on the lower interest rates being engineered by the central banks and there could be some fall-outs there as well.

I think there are multiple points of stress and froth in the fixed income markets. If I were a central bank, I would do serious stress tests right now to see how an interest rate hike would play out in banks, in non-banks and in stock market corrections for large companies which have been the beneficiaries of high inflation and low interest rates.

Would the sovereign debt rollover programmes play out with higher interest rates?

If these risks do not look very good, it would mean that you want to embark on a smoother interest rate hike trajectory rather than making it very back-loaded and then doing too much of it all of a sudden.

Do you think we have a problem with the debt/GDP ratio in terms of where we are right now? This is a global problem, but specifically for India, what is the magnitude of the issue?
I would say that the focus has to be on the sustained basis and not to get too greedy in the short run.

This requires a focus on structural reforms. I would say it has to be on infrastructure, health and education.

I would include the digital economy and access to bandwidth, the quality of the bandwidth and the quality of tech services that are being provided all over the country so that it does not become just the stock market and a formal sector benefit. We want to spread this benefit across.

I would stress the risk that I mentioned which is that if interest rates have to be raised too soon and very rapidly (because you have left checking inflation risks as a back loaded adjustment), then one runs the risk of a disorderly adjustment in the government borrowing costs and contrary of what everyone says, I think a steady but smooth adjustment of interest rates to inflation risks may do the benefit in the long run for the government borrowing programme. We have seen situations like the taper tantrums when one had to use interest rate hikes as an interest rate defence because too much had to be done in too short a period of time.

You do not want to take those kinds of risks. There is time. I think the growth rebound in India has been good. The government has put in place strong reforms — both on the structural side as well as on the fiscal funding side through privatisation push which reduces the reliance on the bond markets. That space can be used to have a smoother adjustment of interest rates to deal with inflation. That would be my preference if I were the central banker right now.

What is your prediction for as and when the global economy will recover? We saw recently that the IMF was slightly pessimistic in its outlook in terms of global economic growth. When do you think the economy will get back to pre-Covid levels?
Certainly the growth in developed economies is very robust, while the growth in emerging markets has been a bit patchy.

One runs the risk, as some people are saying; that emerging markets which had started converging towards the developed economies post the global financial crisis, right now runs a little bit of a risk of divergence. Emerging markets have limited ability to do fiscal stimulus of a scale that the developed economies like the US have availed. My sense is that in a year or two, the growth will normalise.

But I want to shift the focus to something else.

Both from the standpoint of the planet and the kind of climate and the environment, we are leaving behind for the future generations and because of the political consensus, the focus is going to be on sustainable growth going forward. It may or may not be up to the levels of the Paris Accord, but it is certainly going to be pushed for much more strongly than it was pre pandemic.

This means that the world has to focus now on equality of vaccination delivery in the emerging markets. These are the faster growing countries and they are the ones who are partly the bottlenecks in the supply chains. We need to find ways of getting vaccines for them for a variety of reasons. The focus has been more national in the early phase of the vaccination drives but we need to get the vaccinations over in other parts of the world to get the pandemic to subside everywhere else.

That would be the only sure path for getting whatever growth we can generate to be achieved in the next one or two years. I want to stress that in the medium to long term, we may have to accept lower growth levels than what we are used to in the transition to more environment friendly policies.

It is going to come with a shock of higher fuel prices along the way. That is an inflation risk which the central banks will have to manage but this idea that one arm of policy can just keep wanting higher and higher demand-pushed growth while the other arm of the policy is trying to reign in that growth through climate transition — I think there is some inherent, incongruence between them.

My sense is the world is going to have to accept that growth is likely to have to be more sustainable. That may mean slightly slower growth in the short run. We cannot just burden future generations with tons and tons of debt while we are trying to create growth.

I do not think the current challenge to the world is of rich people. The rich people have made even more money post pandemic through financial markets and otherwise. I do not think the challenge right now is how to get the rich people even richer. The challenge right now for the world is to ensure that growth is sustainable and there is equality of opportunity as the world adjusts to the transition risks of higher inflation, climate change and structural reforms in infrastructure, health, education, technology that the poor parts of the world.

The real challenge is ensuring that the poor parts of the economy are not left wanting in terms of equality of opportunity, I think to me is.

We have been seeing an explosion in crypto currencies. Right now, the US is in the process of launching an ETF which is based on Bitcoin; do you think that the age of fiat currencies is coming to an end?
They are certainly getting debased because of the extent of liquidity and money printing that is happening and that probably explains a part of why these other assets are coming in vogue.

There are also some other reasons; crypto assets offer better payment services.

Banks have been charging very high transaction fees especially for remittances and foreign exchange transfers. Crypto assets have become a preferred way of doing some of these transactions to avoid these transaction costs as governments have levied their own value added or sales taxes on top of these bank commission charges.

There are a variety of payments-related transaction costs which are good reasons why some other forms of payment mechanisms have evolved and crypto assets have taken some of this space.

Let me not leave out here that I think there is an inherent tax evasion, money laundering, funding of drug trafficking etc. which also happens through these vehicles. That also probably contributes to some inherent demand for them.

I have no doubt that some of this is froth and will correct itself as the real rates do not remain so negative or switch into the positive territory in developed economies and in emerging markets.

There is also a bit of froth because everyone is just taken in by new technology. We have seen this happen over and over again where financial innovations lead to “sort of bubbly assets and valuations”.

When they correct, when some sense comes into their valuations, no one knows — because no one wants to not be part of that bubble.

When it happens, everyone wants to be inside, because you do not know when the bubble is going to burst and no one wants to not be inside it.

Whether they understand crypto or not, people are investing in it just because it looks to be a very attractive speculation at a time when other assets do not seem to be giving very high safe returns. The primary risks to the fiat currencies from crypto assets and investments come on the financial stability front.

Historically, countries that had more porous capital accounts suffered when they had growth shocks because not only would there be a run on the banking system, there would also be an outflow of capital from the country and that led to a horrible adjustment where one had to deal with a very sharply depreciating currency, high inflation, low growth and a defunct banking system at the same time.

One of the reasons why emerging markets have put some of these capital shields or capital controls around them is because at least they want the money to stay inside rather than flying out of the country in search of foreign currencies. It needs to be carefully thought through by these countries and central banks as to what are the implications of investments in crypto for their capital account.

Could money seek to fly out of the country through these cross-border transactions at a very quick notice? Could that put pressure on the currencies? Could that put pressure on the banks if they try to counter this through introduction of central bank digital currencies?

Does that risk deposits flying out of the banks into the central bank digital currencies?

What sort of a central bank lender of last resort policy should that lead to for the banking system when that happens?

I think these are fairly challenging issues.

When we were at the central bank, we had preferred a slightly more guarded approach to the crypto assets. As a result of it, we had restricted banks from engaging on the other side of crypto transactions but that policy was struck down.

In my view, the growth of crypto has been too quick and emerging markets are more vulnerable to their growth because when things get an external shock, there could be some external sector ramifications of these crypto investments.

I would again recommend as a central banker to do a serious stress test scenario analysis of what could happen- what sort of things can fly out of the country? Where would the settlements be taking place? Are there parts of the banking system that we need to worry about when that happens?

These are some important questions right now. Everyone seems happy because everyone has bought some kind of a coin somewhere and it is appreciating in value but I hope it is not just like Tulip mania, I genuinely hope that it has a softer landing as and when the froth corrects.

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