It's About Federal Reserve Ignorance, Not Tightening
You’ve probably heard of the butterfly effect. A small, seemingly trivial change in some unrelated place triggers massive systemic upheaval elsewhere. One pioneer of the chaos theory branch of mathematics, Edward Lorenz, was speaking about the exact path of a tornado being altered by little more than a butterfly flapping its wings. It’s not really about weather but the unpredictability of even deterministic systems. Nonlinearity and the sensitivity to initial conditions are the seeds of what appears to be random chaos.
On March 2, 1991, two policemen were arrested in New Delhi outside the home of former Indian Prime Minister Rajiv Gandhi. The two, Prem Singh and Rah Singh, were constables in the neighboring state of Haryana’s Criminal Investigations Department. They were not sent on any official criminal matter, rather they were reportedly sipping tea outside Gandhi’s home on a mission to loosely obtain information.
The government of then-Prime Minister Chandra Shekhar at first claimed this was nothing more than routine activity, just regular intelligence gathering to ensure the overall integrity of the free democratic process. It didn’t take much imagination to figure out exactly what was going on, especially as sourced rumors expanded upon who it might have been that ordered the two men to take their afternoon tea in that conspicuously odd location. It was, in short, a case of the government spying upon a political opponent.
Just four days after the arrests, Shekhar was forced to resign leading to yet another political crisis in India. At that particular moment in its history, the country could not afford so much open, well, chaos. The economy was a disaster, India’s international standing poised upon the brink of the worst case.
Not once since its independence from Britain had the nation defaulted on its obligations. It was a point of pride to the point of policy for a country whose identity was shaped upon post-colonial self-reliance. For much of its early history as a separate nation, India was closed off from the world except for a trickle of exports largely to the Soviet Union and its allied states.
But as Communist Russia teetered in the eighties (on food shortages, no less, the seemingly only guaranteed outcome of Communism) and then dissolved in the early nineties, that left India vulnerable. Its biggest buyers, and therefore sources of dollars, were no longer so dependable. Since the Indian economy depended largely upon Middle Eastern oil, they would have to find those dollars somewhere else.
In May 1980, India’s external debt was around $20 billion. By the time of the political crisis in 1991, it had ballooned to more than $70 billion, an absolutely enormous sum for a nation that could never put together much in short-term financing. Much of it was floated in the second half of the decade as its Communist clients’ travails forced this alternative method of funding. Only Brazil and Mexico owed more at the time, and they were both in deep trouble, too.
The year before 1991, in June of 1990, an Iraqi butterfly had flapped its way uninvited into Kuwait. While other nations around the world gathered military forces to eject Saddam Hussein’s military from one of the world’s richest oil states, the price of the commodity skyrocketed. It was almost the last straw for India’s already perilous international finances.
In the middle of that intense election campaign, the remaining government did the unthinkable. The IMF had originally offered aid, in dollars, in January 1991. But that first $1.8 billion emergency line of funding credit had been quickly used up. The political turmoil of May closed the door for any more, not just via the IMF but for pretty much anyone and everyone. With the country’s economy threatening deep collapse, the political system coming apart, India was all risk.
Rajiv Gandhi was assassinated on May 21, ironically the first day that the interim Indian government “sold” 20 tons of gold in secret. UBS bought the metal which was airlifted under the cover of night on a covert chartered plane, the circumstances of which belonged in some high-end spy novel.
In June 1991, Narasimha Rao became Prime Minister appointing Manmohan Singh as his Finance Minister. Rao, it has been said, knew absolutely nothing about economics. In the past, he had shown consistent nationalist and socialist tendencies supporting India’s traditionally closed approach. But what he did know, like Singh, was that something had to give, the situation no longer tenable.
Either India had to change, or it was to become an international pariah outcast from the rest of the increasingly global economy. Though already a poor country, it could get worse from there.
What was facing them, however, was a menu of only painful options. Among them was currency devaluation, a tactic that the Indian government had used a quarter-century before. On June 6, 1966 (6.6.66), under Indira Gandhi the rupee was struck from Rs 4.76 to the dollar to Rs 7.50. It was, to put it most charitably, a controversial decision (though a somewhat understandable one).
Both men knew that devaluation was probably necessary, but by itself it would never have been enough. The rupee would be sacrificed but the Indian economy would swing wide open as an offset. Accompanying devaluation was a policy of substantial economic reform and liberalization. Modern India was born in July 1991.
It was far from easy, though after only a few years India was booming. The first part of devaluation took place on July 1, 1991, and it unleashed a storm of criticism as it had for Indira Gandhi in 1966. At that time, there wasn’t yet the outline of reforms and opposition was particularly intense. As Manmohan Singh recalled in July 2016 on the occasion of the 25th anniversary of these events:
“So I said by July 3 [1991], we must complete the full thing. C Rangarajan was the Deputy Governor [of RBI]. Even then there was opposition. And Prime Minister Narasimha Rao had doubts over the second instalment of the exchange rate adjustment and told me, in fact, to stop it.”
But the second devaluation was already in process despite official reservations. It went ahead, as did a second secret planeload of Indian gold. This time, 46.91 tons were on its way into the hands of the Bank of England as well as the Bank of Japan. It is important to note that these were not sales but repos (technically leases), as what was demanded of India wasn’t really gold but gold as collateral of last resort to be used in obtaining dollars (a practice that continues globally).
When news of the gold movements finally got out, the new government of Narasimha Rao came under significant political pressure to answer for them at an unbelievably crucial moment in the country’s reform movement. Singh again in 2016:
“By the time the government took over, one instalment of gold had already been mortgaged and dispatched abroad. I allowed the second one to go without much fanfare. That really shocked the country… the mess that the economy was in. I used that occasion to honour the commitment of the previous government to mortgage gold but at the same time, I sensitised the country on how serious the economic situation was, and that if we do not want to go down the disastrous path, reforms were the only answer.”
It was enough, Indians finally awakened to their precariousness of their situation. Perhaps in that way the 1991 gold shock ended up being beneficial, as was the political crisis that in many ways necessitated it. If the spying hadn’t been uncovered, Chandra Shekhar’s government may have stayed afloat long enough to secure more international aid and the modern, prosperous Indian economy might never have materialized (or it may have taken many more years and many more additional crises to reach its more settled state).
Though it all took place more than twenty-five years ago, for many maybe even most Indians it was something to remember, lessons never to forget. There is a sensitivity to these kinds of things that are taken for granted elsewhere, especially in the United States where we’ve been wholly, completely desensitized to the many often troubling issues of the modern dollar, really eurodollar.
With that in mind, it was in many ways very heartening to find an op-ed from Urjit Patel in last Sunday’s Financial Times (and to witness the minor controversy it caused). Dr. Patel is the Reserve Bank of India’s Governor, the head of that country’s central bank. He used his afforded newspaper space to urge the Federal Reserve to alter its current policies, beginning by stating what isn’t obvious to most in the West but should be.
“Dollar funding of emerging market economies has been in turmoil for months now.”
As a central banker, Dr. Patel views the monetary system as all the others do, which is to say that central banks are the most obvious source of money in the system. In this case, since it is another dollar crisis, their suspicion immediately falls upon Federal Reserve actions.
Mildly chastising the current monetary policy trend, Dr. Patel believes it is the combination of the US central bank winding down its balance sheet (so-called quantitative tightening) along with the US federal government’s increased budget deficit due to tax reform that is to blame for India’s suddenly precarious position inside this “turmoil.”
These claims are easily disproved, particularly any role of T-bills in supposedly crowding out of EM funding. His explanation is not what is important, though it will be expressed and shared widely. People are often open only to the simplest correlations, meaning in this case the Fed says it is tightening and lo and behold there is tightness in dollars.
There are several problems with that notion, which I’ll only deal with briefly here before getting to what’s really positive about all this.
The issue everyone seems to miss, as I wrote elsewhere this week, is how the global monetary system is not supposed to be a zero-sum game.
“…basic economics describes a situation where if the price of something rises (in this case, either by interest payment or, in FX, getting paid more via a lower counterparty currency) the supply of that something will respond in kind. That’s clearly not happening here, to the point that EM currencies are, like the hugely negative basis (XCurrSwaps) of 2015-16, suggesting that global banks are leaving huge potential profits on the table. If the US government is indeed the elephant in the room, global banks should be falling all over themselves at the opportunity to service EM funding needs (like they were last year). At the stroke of a pen (or computer terminal key), any bank can create the funding each country requires.”
India’s economy, unlike, say, Brazil’s, is relatively healthy and experiencing the balanced risks that US monetary officials can only write about with nervous hands and speak about in hushed tones. If the rupee is being drawn in like other weaker EM countries, such as Brazil’s real, then this suggests extraordinary problems of the nature I describe above.
This isn’t QT – because there isn’t QT.
From India’s perspective, which is hard not to share, they did what they were supposed to do back in ’91. They’ve largely lived up to the international standards and they were rewarded for it. India’s economy today is nothing like it was back then, and that’s an unqualified good thing. Why should they be stuck on the wrong end of the “dollar” in 2018 as if 1991 never happened as it did?
And not for the first time, either, but in a more rapid and intense repeat of 2013-14. Though India’s economy largely survived the “rising dollar”, the sudden rush of inflation and currency trouble at the initial end of it had already upset the country’s political dynamic. We in the West might think the populist revolt began with Brexit and Trump in 2016, but in May 2014 Narendra Modi’s outsider campaign didn’t just win in India, it won huge.
With the rupee again being pressured in a way not seen since then, Dr. Patel’s written plea stands out for what it suggests about the global orthodoxy and the evolving notions of global money. In broader terms, he is trying to get US central bankers to pay attention to what they have always steadfastly refused to acknowledge. In short, he is saying, “hey dummies, you should probably start to consider all dollars especially those in offshore markets.”
Again, his proposed solutions, coming from, as they do, a mistaken idea of how that offshore system works, would be fruitless and ineffectual (as everything central banks do). Yet, given how much time has passed and so little progress has been made, this tiny step of awakening stands out as something to view positively. The world just may be awakening to the global dollar. That’s a good thing.
In response to the rupee’s recent decline, the Reserve Bank of India only days after Dr. Patel’s global petition felt compelled to raise its own benchmark rates for the first time since 2014 in order to try to stem the rupee’s decline. The last rate hike before this one was the final in a series ending in January of that year, mere months before Modi’s shocking victory. Clearly, monetary officials in India think there are considerable risks to their situation due to some problematic offshore dollar imbalance (however it might be derived).
I’ve always written that no matter how much time passes, we are still stuck on Step 1. It is 2018 and we are observing all sorts of ten-year anniversaries for some of the most consequential events in modern world history, and yet we know so very little about what really happened. Most people today have still never heard of a eurodollar let alone have they realized the 2008 panic was of Lombard Street (offshore dollars, really “dollars”) and not so much Wall Street (except by collateral consequence; pun intended).
The more we all talk about offshore, are forced to talk about it, the more it will make sense for all that has happened not just since 2008 but for decades before then. Maybe Dr. Patel’s misguided but understandable pointing of the finger will be just the butterfly the world needs, the necessary statistical chaos to rescue us from the understated prospects of some real bedlam. The problem isn’t Federal Reserve monetary “tightening”, it remains Federal Reserve monetary ignorance.
If everyone needs to get to the latter by first thinking through the former, blaming the US central bank for something it didn’t do in order to understand decades of negligence it did commit, it almost seems non-random.
