The European Central Bank Finally Learns From The US Federal Reserve...

The former US Treasury Secretary, John Connally, had once famously remarked to a group of worried European Finance Ministers that "the US dollar is our currency, but your problem"

In spearheading a (banker friendly) bailout of the US economic and financial system, the US Federal Reserve Chairman Ben Bernanke has made ample use of this dominance - the facts that the US dollar is the most traded currency in the world, the largest reserve currency as well as the largest currency of denomination for assets.

Finally, the European Central Bank under Mario Draghi has realized that all those things are applicable to the Euro as well - just add "2nd".

Through quantitative easing, Bernanke weakened the US currency to keep domestic US interest rates low. Effectively, the credit risk premiums on US assets got reflected in the weakening of the currency rather than in the rising of interest rates. This improved the situation for US entities - Govt, Banks, Consumers - to borrow.

Who suffers in such a case? It is the creditors / investors in US assets who do. China, Japan, Middle East et al And because the US dollar is their problem (the TINA factor - There Is No Alternative), they don't have much of a choice. They can't diversify out of their US dollar assets because the holdings are simply too large. Of course, they have held US assets for their own benefit - China to keep its own currency undervalued and boost exports, the Middle East for political ties and so on.

Now, the ECB through its 3 year Unlimited Repo has done pretty much what the Fed did, with a European flavour of course.

Unlike the US which is fiscally and monetarily integrated, Europe isn't. Hence, while the Fed could lend to the US Govt by buying US Govt Bonds through pure money creation, the ECB has been unwilling to do so (at least in the same form)

What it is willing to do is lend to banks. Under the guise of liquidity support. Unlimited loans at 1%, for 3 years.

The numbers don't make sense. The Italian Government borrows from the market at 7%, while Italian banks can borrow from the ECB at 1%. Clearly, 1% seems to be a ridiculously low rate at which to lend money to banks.

Further, I don't understand how a period of 3 years constitutes liquidity support. Basically, its a medium term loan, given very cheaply.

What happens when banks get funds at very low rates (lower than what they should be)? They get into carry trades - use those funds to buy or speculate on higher yielding assets. We have seen massive carry trade cycles with the Yen & the US Dollar in past years (The Subprime Crisis being partially a fallout of this).

Surely the ECB would know that banks are no angels. Then why is it doing this?

The answer is that by doing this, ECB can lend to the European Govts, which it otherwise has been unwilling to.

Banks, flush with cheap cash, can now buy more of Eurozone Govt Bonds. Ideally, going by pure economics, they wouldn't want to. But there will be other considerations which will make them buy. For one, the banks and governments are very closely aligned in Europe. Further, the fortunes of the two are inextricably linked. Both have to display confidence in each other to survive.

And the number lent is quite staggering, for a Central Bank that professes to follow the lineage of the inflation-killing Deutsche Bundesbank. The amount as reported is a whopping 489 Bn Euros (nearly 650 Bn USD). That exceeds the amount of QE2. And there's another auction still to go, in February.

What will be the effect on the EUR of this? Slightly tricky question to answer. In case of the USD, the answer was more straightforward - it had to weaken. However, in case of the EUR, the effects could be mixed.

And this will pan out very differently from a normal carry trade. In a normal carry trade, the growth outlook is good, so people use funds raised in the low interest rate currency and invest in higher yielding assets. That weakens the low interest rate currency.

In case of the EUR, I can think of 4 sets of flows which could take place;

 - Due to repressive measures or otherwise, a large portion of the loans availed could end up getting deployed in assets (Govt Bonds etc) within the Eurozone itself, rather than being used to buy international assets (effect on EUR: Neutral to positive)

 - People could sell the Euros raised in exchange for dollars and use it to pay off dollar liabilities (EUR weakens)

 - People could sell the Euros raised in exchange for higher yielding currencies (EUR weakens)

- Due to more confidence or whatever, Eurozone assets see more investments from international investors (EUR strengthens)

The relative extents of these 4 factors will determine what happens to the value of the EUR.

RBI's Severely Regressive Foreign Exchange Regulations

Today, the RBI has notified a new set of rules for foreign exchange, which are to come into effect immediately.

I glanced over them, and I am glad that I am not longer in FX markets, if only because I don't have to deal with them!

Among the key measures:

- Companies can no longer rebook forward contracts for FX exposures (with INR as one leg)

- Past performance underlying has been reduced to just 25% of the average 3 year exposure for importers. For both importers and exporters, settlement can only be on a deliverable basis

The regulations take a very narrow and static view of market risk management, and India's needs in that regard.

Market risk management is not and cannot be a fire & forget type function. It is dynamic in nature.

This is because as the state of knowledge evolves, prices fluctuate in markets and views and expectations keep changing accordingly.

Thus, even genuine hedgers need flexibility in entering and exiting into hedges.

The RBI is letting a temporary slowdown in the Indian economy affecting its broader vision for the economic internationalization of the country.

Consider, for one, the sheer size of India's international dynamics. We are aiming for exports of  USD 300bn in 2011-12 (might not be met, but gives a sense of the order of magnitude).

We hope to finance half of our fabled USD 1 trillion investment in infrastructure over 2012-17 through the private sector, with much of it by foreign investors.

How can such numbers be achieved if the RBI adopts policies more suited to the autarkic pre-1991 days when every economic parameter in India was less than a 10th of what it is today? For further internationalization, controlled sophistication in financial hedging instruments is the need of the hour. You can't tell a person he should avoid diabetes by starving himself.

The timing and lack of warning is another issue.

In an already challenging period such as the current one, how does the RBI expect companies to have the resources and manpower to spare on changing their risk management functions depending on the vagaries of the venerable gentlemen on Mint Street?

They may say this is a short term measure, but that is precisely the point - market participants cannot be made to bear such heavy costs and policy uncertainty when short term volatility is to be addressed. That is the job of the regulator - a job which the RBI is clearly shirking from. They could have intervened verbally, supplied OMCs directly with dollars and so many more things. But they choose to take a great leap backward.

And if they think this will curb speculation - they are completely wrong. This will, if anything, only increase speculation. Most hedgers will hesitate in taking hedges now, knowing that they have zero flexibility once they take the hedge. Speculators meanwhile will continue to run amok on the exchanges, in the NDF markets and other avenues.

Liquidity will go completely for a toss. There will be huge mismatches between the exchange rates in the OTC market and those on the exchanges.

A very retrogade step indeed, and one which will further dampen the international community's confidence in the Indian economy.