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The Greenspan & Reddy show

N Mahalakshmi & Pallavi Rao | June 28, 2004

If you're wondering what's happened to all the bullishness in the stock markets in just six weeks, don't blame it all on the UPA. Try the USA instead.

While the Sensex declines in May and June have coincided with the defeat of the NDA and the installation of the Congress-led United Progressive Alliance in power, the real reason for all the gloom is the global shift in perceptions about what the US Federal Reserve Board will do with interest rates.

Normally, good news in America should be good news for the world economy and global stocks. For the past few quarters, the US economy has been growing like gangbusters (4.7 per cent expected in 2004), but instead of causing celebrations all around, it has brought worries that the US Fed will now be forced to raise interest rates - forcing a shift in investment allocations across markets and asset classes.

Interest rates have so far not been raised anywhere except Australia, but bond prices almost everywhere have gone Down Under to align yields with the new interest-rate expectations.

The stock markets are feeling the heat as investors are reassessing the benefits of staying with high-risk assets like equities when fixed-interest securities are beginning to look better.

Foreign fund managers are also reworking the risks of staying invested in emerging market equity when the action is hotting up in the Mecca of capitalism. In just the last four weeks, the emerging markets have seen outflows of $4.7 billion - and the stampede may not be over.

The upshot: Over the next few months, the markets - both at home and abroad - will be looking less at P/E ratios and industry fortunes and more at what Alan Greenspan, chairman of the US Fed, and Y V Reddy, the Reserve Bank governor, are up to.

Every utterance will be dissected for hidden hints on what they think about interest rates. For the record, this is what they have said in their last major statements.

Greenspan: The Federal Reserve is ready to raise interest rates more aggressively than the slow, measured pace it has been projecting if inflation or market conditions require.

That conclusion is based on our current best judgment of how economic and financial forces will evolve in the months and quarters ahead.

Should that judgment prove misplaced, however, the FOMC (the Fed) is prepared to do what is required to fulfill our obligations to achieve the maintenance of price stability so as to ensure maximum sustainable economic growth.

Reddy: Between May 18 and now (June 14) there is certainly evidence of interest rates hardening in the developed world. (The) financial markets are already factoring in this... if global trends exceed what we have assumed, there would be a case for revisiting (the idea of raising interest rates).

None of this sounds deadly enough to cause market mayhem, but the markets are creatures of expectations - not reality.

And right now the expectations are that US interest rates could rise by around two percentage points over the next 12 months; in India, the direction of interest rates will be determined by what the US Fed does, how exchange rates and forex inflows behave (the rupee is weakening), how inflation shapes up (the rate is close to six per cent, a level where price increases become politically unacceptable), and what a tightening of liquidity will do to the government's borrowing programme, domestic growth and bank balance-sheets (all with negative implications for the markets).

One good place to look for clues on the future is the past. When the US entered a similar monetary tightening cycle about a decade ago, it had severe consequences.

Among other things, it led to the bankruptcy of Orange County and a financial crisis in Mexico that required a $50 billion IMF-backed bailout to assist US banks and financial institutions that had lent money.

Given that the world economy is now far more dependent on cheap money, economists fear that even moderate hikes in rates could lead to an unexpected crisis somewhere.

In its Global Financial Stability Report released in April, the IMF drew parallels between 1994 and 2004. The report said: "The outlook for interest rates in the US was benign at the beginning of 2004, just as in 1994. While inflation and nominal yields are substantially below those prevailing a decade ago, the shape of the (bond) yield curve at the beginning of 2004 was similar to that prevailing in 1994." The IMF also observed that:

  • The increase in short-term interest rates priced into futures markets at the beginning of 2004 was broadly comparable to the increase priced in a decade ago. However, for longer-dated contracts, the magnitude of interest rate increases expected at the beginning of 2004 exceeded those of 1994.
  • The US treasury yield curve was extraordinarily steep during both episodes. This unusual steepness has provided strong incentives to seek leverage and build carry trade positions. Carry trades involve borrowing at low short-term rates to build positions in the high-yielding longer-dated bonds.
  • Abstracting from bond price movements, such positions yielded three percentage points on an average during 2003, estimated as the differential between the yield on 10-year US treasury bonds and the three-month Libor. This differential reached a 10-year high last year, underscoring the potential for volatility from an unwinding of carry trades in response to rising short-term rates and a flattening of the yield curve.

According to the IMF, the current circumstances exhibit a number of major differences from those prevailing in 1994. These include:

  • Foreign holdings of US treasury securities reached an historic high at around end-2003, accounting for 43 per cent of the stock of marketable debt outstanding.
  • Real interest rates were low in January 2004 compared to 1994. This could come under pressure if demand for capital from the private or public sector were to exceed expectations.
  • The macro-economic backdrop for financial markets was substantially different at the beginning of 2004 from a decade-ago. While the current recovery has been more forceful, inflationary pressures are more subdued. Consequently, the pressure on yields to rise was limited in early 2004, notwithstanding the widening fiscal deficit and the need to boost issuance (of treasury bonds).

The IMF, thus, concluded that the world should be preparing for rate hikes. "At the very least we should be preparing the way in the United States for higher interest rates so that the markets are not surprised, and as we see stronger signs come in, eventually those rates will have to move up. So I think certainly the time is now for preparing the markets for higher interest rates," said Raghuram Rajan, the IMF's economic counsellor, at a recent press conference hosted by the IMF to discuss the World Economic Outlook.

That's one reason why Greenspan has been talking of the possibility of rate hikes, and the chances are that the US Fed will increase interest rates at its June 29 meeting.

The benchmark federal funds rate, which is now ruling at a 46-year low of 1 per cent, could well be more than the already-discounted rise of 0.25 per cent.

Speaking to the IMF earlier this month, Greenspan had said that strengthening US economic outlook means that the "ample liquidity" provided to the financial system through very low rates "will become increasingly unnecessary over time."

If there's no question rates will be hiked, the real debate is about its quantum - and pace of change. According to Merrill Lynch's Global Fund Managers' survey in mid-June, "investors are becoming increasingly convinced that global monetary policy is too stimulative."

On an average, equity fund managers believe that Fed policy would be back to neutral (neither stimulative nor restrictive) when the Fed Funds rate is back to three per cent (from the current one per cent). More than 70 per cent of the panel believed that a neutral stance meant having a rate of three per cent or higher.

The question is: how fast will Greenspan bridge the two per cent gap between current rates and the three per cent level seen as neutral?

Markets around the world are nervous about the potential threats, given that easy credit has either been a growth stimulus or been helping keep delinquencies low in the last three years.

Domestic credit as a percentage of banking assets is fairly high in many large economies, including the US (164 per cent), UK (140 per cent), Korea (110 per cent), Malaysia (155 per cent), Germany (147 per cent), China (140 per cent), South Africa (167 per cent), Thailand (112 per cent) and Singapore (102 per cent).

This not only means that the banking sector across the world is at higher risk, but also that growth in other industries which have been thriving on easy credit could suffer.

Emerging markets also face higher risks. Apart from the threat of an unwinding of carry trades - which could mean outflows of foreign funds - growth could be affected.

Says Bandi Ram Prasad, chief economic advisor, The Stock Exchange, Mumbai: "In emerging economies, banks play an important role in determining capital funding since equity funding is just about 12-15 per cent of total funding. Therefore, any change in interest rates will have a greater impact on growth on emerging markets."

Writing in Financial Times (May 30 issue), Chicago-based international economist David Hale noted that while the financial markets had been hit by shocks from the Middle East, rising interest rates could pose greater problems.

"The real risk to world markets is that the speculative bubbles and carry trades that have developed as a consequence of American monetary policy over the past year will unravel as the US Federal Reserve moves to increase interest rates," Hale said.

He noted that US monetary policy had resulted in "significant price gains during 2003 and 2004 in emerging market debt, high-yield debt, government bonds and property, as well as equity."

Over the last quarter, emerging market equities have lost ground across the board. The MSCI Emerging Markets Index lost 10.55 per cent, while MSCI Emerging Asia Index lost 12.33 per cent. India, despite having weaker links to global economies and markets compared to many other nations in the region, has not been spared.

In fact, it was the highest loser among Asian emerging markets, with a loss of 17.64 per cent, with post-election economic policy concerns weighing heavily on the markets.

In 2003, the Sensex was among the largest gainers in emerging markets with foreign investors pouring $10 billion into Indian equities.

A rate hike in the US would not only mean that cheap money will no longer be available to finance investments in emerging market, but investors could dump emerging market assets to deploy the same in better yielding assets in the US.

And the India story may not be treated as an exception, particularly after the twist to the India Shining story post-elections.

As for the bond markets, one school of thought is that domestic liquidity is comfortable and does not warrant a hike in local interest rates.

"Even if US rates start moving up, domestic rates are unlikely to rise. There is no one-to-one correlation between global rates and domestic rates. The question of a rate hike in India does not arise for at least another 12-18 months. There is too much money in the system which is not yet absorbed," says Rajiv Anand, head of investments at Standard Chartered Mutual Fund.

The fact is that domestic bond yields have not been moving particularly in tandem with US treasury yields for the past few months. Yet, there has been a small correlation (0.6) between the two over the last three years.

Economists feel that while a modest increase in US rates may not warrant any tinkering with local rates, it may become necessary if the hikes are tangible. How much increase in the US can the domestic markets absorb? Experts declined to stick their necks out on this one, but anything more than 50-100 basis points could warrant a hike in domestic rates.

On the other hand, domestic worries about inflation may add another dimension. Ten-year bond yields are currently just about level with the WPI inflation rate - so if the message from the bond markets is that yield rates have to go up, Reddy cannot decline to take note of the need for a rate increase.

Ten-year yields have already risen sharply over the last two months. After bottoming out in mid-April around 5.01 per cent, yields are up at 5.89 per cent (June 24), indicating that the markets are expecting a hike in India as well.

Assuming Reddy will have to bite the bullet sooner or later, what is the damage this can do? Unlike most emerging economies, retail debt as a percentage of GDP is still not very high in India, but it has been growing frenetically.

Over the past five years, the total retail loan market has been growing at a compounded annual rate of 34 per cent. Credit cards and housing loans have been the fastest growing segments with growth rates of 83 per cent and 43 per cent respectively.

Personal loans have been growing at 32 per cent while two-wheeler loans have been growing at 32 per cent. Obviously this has helped volumes growth in sectors like autos and consumer durables.

If interest rates now start rising, one can except some slowdown in these sectors. And the banking industry as a whole would see tougher times if non-performing assets on the retail side start growing and the value of their holdings of government securities starts eroding.

Some corporate fundamentals will also start weakening. The corporate sector has been a major beneficiary of a declining interest rate regime as loan servicing costs declined over the last three years. If this trend reverses, it may not impact bottomlines immediately, but the markets will start factoring it into its calculations.

With the dynamics of the global economic scenario changing, the corporate sector is now less worried about a rapid appreciation in the rupee as was the case earlier this year. This means good news for export-oriented companies.

Analysts expect that industries like pharma and infotech could outperform in a otherwise lacklustre market.

The biggest risk for the equity markets is fund flows. The recent performance of emerging markets provides little reason to believe that India will be an exception to the general trend of outflows, never mind what the domestic pluses are (good monsoon, reasonable corporate fundamentals, adequate liquidity, prospects of more government investment in infrastructure, etc).

When global winds blow the other way, few fund managers are willing to swim against the tide. That's why, Greenspan and Reddy matter to the markets than they did last year.

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