For the RBI, a time to worry about ¥ ‘carry’ flows

There are fresh signs of yen carry trades across markets with India being one of the recipients of such capital flows.
Over the last couple of weeks, the Japanese currency has weakened against the dollar by around 4%, while other Asian currencies such as the South Korean won has gained around 6%. The euro has risen 2% in the same period.

The currency movements have been accompanied by rising equity and commodity prices. Equity markets across the globe have rallied by 3-5% in the last couple of weeks, while oil prices have touched multiyear highs with Brent crude darting up over 3% to close last week at $118.70 per barrel.

India has benefited from portfolio flows. Foreign institutional investor (FII) buying has taken the Sensex up by 8% over the last eight days, while the rupee has gained around a percent against the dollar.

FIIs were net buyers of equity in March by about $1.5 billion. These purchases came against net sales of around $2 billion in January-February.

The yen and the dollar are classical funding currencies. Japan, in the face of an unprecedented natural disaster, will keep its monetary and fiscal policies ultra loose. The government is heavily indebted too — outstanding debt stands at twice Japan’s GDP.

The country’s policies are likely to keep the yen pressured and there will be a greater tendency to borrow in yen to fund asset purchases abroad.

The US Federal Reserve has indicated that it will keep policy rates at all-time lows till it sees economic recovery gaining hold. It will first stop using tools such as quantitative easing before embarking on policy tightening and that is still a long way off despite positive data on the manufacturing and employment fronts.

US manufacturing gained the most in seven years in March and unemployment fell to 8.8% from 9.8% seen six months back.
On the other hand, central banks across China, Brazil and Russia are tightening to fight rising inflation expectations.

The Reserve Bank of India (RBI), too, has been on a tightening spree with the latest rate hikes coming in March. India’s central bank has indicated more is in store to quell rising inflation expectations. Inflation as measured by the wholesale price index is trending at over 8% levels, and the RBI’s comfort zone is below 5% levels.

The tightening bias coupled with a projected 8% GDP growth will see money coming in a flood if the yen carry trade gains currency.
The government has also opened its doors to the flows by upping bond limits in the 2011-12 Union Budget to $50 billion (government plus corporate debt including infrastructure bonds) from $30 billion previously. It has also enabled foreign nationals to invest in Indian equities directly.

There is enough room for money to come in based on rate and growth differentials. Unfortunately, the RBI, which is already fighting rising inflation expectations, will have to bear the brunt of the flows.

Offsetting the flows can be tricky as we have seen during the 2008 credit crisis in the aftermath of which the Sensex tanked 50% from its all-time highs.