Saturday, August 11, 2007


Aug. 12, 2007 (The Hindu Business Line delivered by Newstex) -- T. B. Kapali

It has long been an axiom in global markets that when America catches a cold, the whole world sneezes. America seemed to have caught the ‘sub-prime’ cold earlier in this year when problems began to surface in the lower credit-rated borrower segment of the housing sector. These problems appeared to be localised initially as other segments of the US economy — household spending, business investment, and so on — continued to hold up fairly well.

However, the latest string of US economic data and, more importantly, developments in US credit markets in the past few weeks indicate that the infection is worsening and the damage is now spreading not only to the mainline banks/financial institutions in the US but to financial companies outside the country.

Nothing surprising here since in today’s integrated global markets, geographies and market segments matter even less than they did when the axiom (about America’s cold spreading to the world) was framed.

So, we have had equity markets across the world shivering and dropping sharply as investors re-assess the prospects for corporate earnings and investment returns in an environment of heightened risk perceptions.

Global bond markets too have contracted sharply in the face of a rush to the safety of government debt. Credit spreads for non-sovereign borrowers have widened dramatically across all markets and the asking price seems to be increasing by the day as the credit risk perception deteriorates.

There is a clear danger now that the problems in the financial markets could spill over to the real sector and drag real economic activity — consumption and investment — down. When that tipping point comes or is perceived to be imminent, one can expect global central banks to loosen their monetary strings and cut rates.

The earliest indications of this was seen last week when the European Central Bank announced its readiness to provide liquidity support to participants in the euro zone money markets and followed it up with actual fund injection. The Federal Reserve too has been compelled to inject more liquidity than in normal times into the US money markets through short-term repos to keep the overnight interest rate around its target 5.25 per cent as a credit/liquidity squeeze pushed rates upwards to 6 per cent on Friday.

Indian market reactions
Indian markets, with their increasing levels of integration with the international markets, have not been an exception to the corrections taking place in global markets now. But, as a consequence of the fact that our level of integration with the global markets is still only “increasing” and there is yet some policy restriction with respect to seamless flow of capital between the local and international markets, there have been differing reactions in various segments of the financial markets in India.

Equities have fallen quite sharply as the international exposure of the domestic stock markets is relatively much higher than that of the other key financial market segment, namely, debt.

The debt markets, dominated by government debt and with very limited international participation, have been influenced only by prevailing liquidity conditions (and perceptions about the same) in the domestic banking system.

Sovereign bond yields have moved up in the past couple of weeks, particularly in the last couple of days, as the Reserve Bank of India put in place some measures for broadly stabilising/restricting the liquidity level in the financial system.

Therefore, while equity markets have moved in sympathy with stocks globally, the Indian bond market has seen yields rising while globally sovereign bond yields have fallen substantially.

Disconnect and outlook
So, what is the outlook for the Indian markets in this scenario? Is the latest fall in stocks another temporary blip and will Indian stocks push higher with renewed vigour in due course? And, what is the prognosis for interest rates in this environment? Will Indian rates rise or will they remain stable, given that the Reserve Bank in its recent monetary policy review signalled its preference for stable interest rates, broadly around 8.5-9 per cent for bank deposits and around 11 per cent for bank loans?

It is quite clear from the differing reactions of the equity and bond markets that there is a broad disconnect between global and Indian markets and also between the different sub-segments of the markets in India. It is this disconnect which suggests that the latest downturn in Indian equities, while it may last somewhat longer, could provide good buying opportunities for the long-term investor in due course.

The disconnect arises at the macro level not only because of the measured steps India has been taking towards permitting free flow of capital into all market segments. It also is due to the fact that the Indian economy is not as dependent on the global economy’s (read US economy) fortunes as are other countries such as Korea or China.

Economic activity is driven largely by the strength of domestic demand rather than export demand which is the locomotive in countries such as Korea, Thailand or China. At $120 billion, Indian exports account for only around 10 per cent of the country’s GDP whereas exports are easily a quarter or more of the national output in the other Asian economies.

Also important from a corporate financial performance/stock market point of view is the fact that traditional exports — comprising primary agricultural and allied products, textiles and garments, gems and jewellery, ores and minerals, light engineering goods and the like — form around 50 per cent of total exports. This is a segment which is dominated by SMEs (small and medium enterprises) and non-listed mid-size companies whose performance or otherwise is not a matter of direct concern for the stock markets.

Domestic demand
Domestic demand and the way this influences the pricing power of companies is, therefore, the key to overall corporate financial performance. These do not seem to have been dented in any serious manner nor do they seem like being strained much in the ensuing period. Therefore, while it is quite possible for the domestic stock markets to trail global stocks in the near term purely on a sentiments note, these should be taken only as healthy corrections and laying the foundation for further medium-term appreciation.

On the interest rates front too, the different structural drivers of the domestic economy mean that the RBI is seen moderating liquidity (with a restrictive bias) while globally central banks may soon be forced into cutting rates.

Therefore, we see the Reserve Bank placing greater restrictions on the flow of overseas debt capital into the local markets and announcing other policy measures for withdrawing liquidity from the financial system. All these measures have the potential to bring about a better balance between demand and supply of liquidity in the financial system (at present, the balance is tilted in favour of supply) and could therefore provide a hard floor for interest rates in the system around their current levels for the immediate future. The floor could be ‘hard’ with a bias for even an uptick in interest rates since some of the liquidity curb measures the RBI has introduced (the ECB restrictions for instance) could sharply raise the level of demand for domestic bank credit.

An analysis of the external commercial borrowings (ECB) statistics for the past year shows that only for a couple of months (December 2006 and February 2007) was around 35 per cent of the total ECB mobilisations utilised for imports of capital goods. In all other months, the level of ECB monies utilised for capital goods imports ranged between 5 per cent and 15 per cent.

In other words, a high proportion of the ECB money has been utilised for domestic capex, projects and modernisation for a large part of the last one year. The pressure on domestic credit resources was consequently and to that extent lower. (The total amount of debt raised through the ECB route in the past year is around $25 billion).

It is obvious that in the absence of the ECB window, the demand on domestic bank credit would rise sharply if overall economic activity continues at the same pace of the past year or two.

The interest rates outlook for the medium-term in this scenario would seem to be influenced significantly by the outlook for the stock markets. If risk capital flows (meaning FDI and FII flows) make up even somewhat for the drying up of the ECB tap, interest rates may continue to remain broadly stable. If on the other hand, global risk aversion takes hold more strongly and there is greater withdrawal pressure from emerging stock markets, interest rates could rise sharply (if the rupee is not allowed to fall in the foreign exchange market) and hurt domestic economic activity in the absence of countervailing measures from the central bank.

Countervailing measures at that stage cannot mean opening up the ECB tap again. For in a scenario of pervasive risk aversion in global markets, liberalising ECB flows may not have any beneficial impact. Succour in such a scenario can come only from the central bank cutting rates.



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