It’s the time for flight of Safety

Recently, there has been significant demand for US dollar across the globe despite S&P cut US rating by one notch due to rising debt and deficit. Most of the emerging Asian currencies such as Korean Won, Malaysian Ringgit, Thai Bhat, Indonesian rupiah and Singapore dollar dropped v/s the greenback last month. Asian economies are now witnessing sharp outflow of US dollar which has been causing deprecation of their domestic currencies. During September, the Indian rupee depreciated over 8% in line with other Asian currencies. Korean won fell over 12% v/s the greenback last month on safe demand for the US Treasuries.  

Actually, It all started from the Euro zone with fresh concern of Greece defaulting as their yield rose to some uncharted territory. Other blow came from IMF as they downsized the global economic growth target for 2011 and 2012.

There has been fear of a banking crisis in France, Germany and Italy as their banks are holding a huge chunk of Greece sovereign paper. Three major global financial powerhouse BNP Paribas, Societies General and Commerzbank are holding an estimated $14.5 billion of Greece sovereign debt. Italy’s largest insurance company Generali is holding almost $4 billion. Apart from that, holdings by IMF, European Union Loans, Eurosystem SMP and European Central bank are estimated around $150 billion.

The interest rate on Greek three-year government debt recently soared past 100% and the yield on 10-year bonds reached 22%. The Hellenic government needs to escape from it an otherwise it will be an impossible situation. Its debt is 150 % of GDP, rising by 10 % this year. GDP falling by more than 7% this year, pushing the unemployment rate up to 16%. The balance-of-payments deficit is around 8 % of GDP and banks are rapidly losing deposits. The only way out is the country to default on its sovereign debt. It must write down the principal value of that debt by at least 50%. After Greece, the next in line may be Portugal and Ireland which public finances are in a bad shape.

Apart from Euro zone, the US and China is slowing and fear of a double dip mounts. As per a poll conducted by Bloomberg, market believes that Chinese economic growth may drop below 5% by 2016. China, which saw its export, tumbled the most since at least 1979 amid the 2008-09 global crisis may not be able to rely on trade in any prolonged demand slump in Europe and the U.S. A recently released data showed, China's factory sector contracted for a third consecutive month in September as flagging overseas demand put the brakes on new orders. The HSBC flash Purchasing Managers' Index dipped to 49.4 in September from August's final reading of 49.9 and hovered below the 50-point mark for the third straight month. China's industry sector, which includes manufacturing and resource exploration, accounts for about 40% of the country's GDP.

These all are leading uplifting of US dollar. US treasuries have a tendency to attract fund when nothing goes right. The US economic fundamental has been poor but the Europe is worse. There is no other currency which can take the “Reserve Currency” status from US dollar. Swiss Franc and Japanese yen has been leaders in the FX market from past one year while cannot replace the US dollar with the status. In a crisis situation like fallback of Euro, the US dollar should get benefitted.

Though there has been fear in the market, but no signal of a liquidity crisis till now. The TED spread widened to 36.70 basis points from 36.34 basis points recently, but far below to suggest a liquidity crisis. The TED spread measures the difference in yield between the U.S. 3-month Treasury and 3-month LIBOR. Since September 2009, the TED Spread has ranged between 10 and 20 basis points. During economic crisis it spiked as high as 457 basis points in the fall of 2008, when Lehman and Bear Stearns collapsed. From May, through most of July this year, the TED spread ranged from roughly 20-25 basis points and broke out above 25 basis points from August. Currently, above 35 basis point -it’s just shy of its summer 2010 highs near 40 basis points.

However, with a high probability it may move higher on a European banking crisis. If Greece defaults there will be major ramifications for the global banking system. The inter-connected nature of global banking means no one knows how the situation would unfold. And if Greece defaults, what happens to Spain, Portugal and Ireland? Surely they would want some debt relief too. This would mean bigger hit for the global banking system.

Slowing of the global economy, fear of a banking crisis is leading pressure on the domestic economy. The Indian rupee depreciated at a rapid pace last month along with local stocks. The depreciation of home currency is signaling possible rising in import bill, rise in inflationary pressure in the economy.

Looking from the external sector perspective, things are not at all fine. The slowdown of the global economy will lead to a rise in current account deficit and also reduce the capital account surpluses.

The rise in crude oil imports bill due to sharp depreciation of US dollar along with weak overseas demand for Indian manufacturing and services may lead to further rise in current account deficit. In the invisibles segment, business and financial services has been showing outflows, during the second quarter of the calendar year. The outflow reached to the tune of 1.4 billion compared to 1.1 billion during the 1^st Quarter. Inflows from software services dropped almost 15% during the Q2 and in the Q3 it is expected to have dropped further.

Total inflows from invisibles have fallen about 12% and expecting a further slowdown by 15% in Q3, (keeping the merchandise trade constant- assumption) total current account deficit would have rose by 22% on QoQ basis. It is evident from the recent EU and US data that inflows to India from invisibles account must have slowed to a greater extent.

  

While in the capital account inflows rose due to rise in flows of loan, banking capital along with foreign capital investments (FDI and FII). A higher interest rate scenario has attracted a considerable capital to India but looks unsustainable if ant liquidity crisis like 2008 grips the market. The recent sell off in global asset classes has caused FII outflow from the domestic shares market in September. If situation continues like this, then capital account surplus may shrink to some considerable extent. Now the money is diverting towards what is called the “flight of safety”.

Looking at the Indian external sector developments and change in global economies, pressure on local currency is inevitable.  As Greece, Portugal and Ireland has a high possibility to default, outflow of US dollar may be seen from the domestic market and money will be drifting towards US treasuries and Gold and to other safe asset classes.

In a latest development dated 4^th October, Moody's lowered its rating on Italy's bonds by three notches. The agency downgraded Italy to A2 from Aa2, a lower rating than it holds on Estonia and on a par with Malta and kept a negative outlook on the rating. It said, European countries with debt ratings below the top Aaa level may see reductions in their rankings. Greece also has also failed to satisfy the terms of an international bailout.

Michael Lewis, an American non-fiction author and financial journalist who began his career exposing the culture of excess at Salomon Brothers in "Liar's Poker" is promoting his latest book "Boomerang: Travels in the New Third World,". He says” Greece will default on its debts, Ireland could too and Greek Prime Minister George Papandreou and German Chancellor Angela Merkel will be forced out as Europe's financial crisis plays out”

Amidst these situations, we are prone to a global shock and may see further deprecation of home currency. The Indian rupee may depreciate to a level of 53 by next 6-12 months. Local index based stocks may give only negative returns. Few investments that can give you return are FD, Recurring deposit, Gold and other safe haven instruments.