| I have argued earlier in this column that the exchange and interest rate of the dollar would probably get decided more in Beijing and Tokyo, than in Washington. Should Beijing, for instance, stop supporting the dollar in the exchange markets and/or start diversifying its trillion dollar reserves, the dollar could fall sharply, also steepening the unusually flat to negative yield curve in the process. (At present, however, the interest futures markets are factoring in one, if not two, drops in the federal funds rate before the end of the year.) It now seems as if, not just the exchange and interest rate for the dollar, but also worldwide equity prices would be determined, not quite in Beijing, but in Shanghai. The 10 per cent drop in equity prices in Shanghai on February 27 triggered a fall in equity prices in all the major markets in the world, including Europe, the US and, of course, Asia, including India. Some commodity prices also have softened, and the yen strengthened during the last couple of weeks. While a case can be made for why what happens in China would influence commodity markets, surely its equity market is not all that relevant for the rest of the world? |
| But the fact is that the Shanghai fall did trigger a worldwide reaction. To be sure, such correlation can be purely coincidental, and does not necessarily imply a cause and effect relationship. In this particular case, however, there is a good chance of cause and effect because, in complete defiance of the basic assumptions of economic theory, markets too often move on sentiment "" greed and fear "" rather than rational analysis. Did Shanghai change investor sentiment, from exuberance to caution? Quite possible, as equity prices had perhaps become unsustainably costly in terms of the ruling P/E ratios. Indian equities too had been looking costly for some time, but the prices were being justified, or rationalised, on the basis of a continued increase of 20-25 per cent per annum in corporate profitability. This is a questionable assumption. First, in the long run, corporate profits would grow in alignment with nominal GDP. Second, I often get a feeling that much of the low hanging fruit, in terms of productivity of both labour and capital, has been plucked, and that further improvements would be difficult and, in any case, slower. While many Indian fund managers have, after the fall, been arguing that a correction was overdue, the industry was also busy launching new funds: for some at least, the risks of not investing with the rest of the herd, were probably perceived to be more than the risk of investing at the top of the market! |
| Be that as it may, the worldwide reaction to the price falls in Shanghai evidences how globalised markets and investor sentiment have become, and how the traditional justification for cross-border investment "" namely, diversification of risk "" is becoming less and less tenable. For all one knows, the recent falls may well have ended, and a rebound could well be in progress. Overall, the global economy is strong, but there are question marks about the US economy: major problems in the housing sector, and factory orders in January witnessing the largest fall in the last six and a half years. While the Federal Reserve sees no reason for any action in response to the equity price fall, and expects the US economy to grow 2.5-3 per cent in the current year, its former chairman, Alan Greenspan, recently quantified the chances of a recession at one in three. Obviously, Greenspan is making far clearer statements after leaving the Fed! |
| Turning to currency markets, over the last two weeks, we have broadly seen the dollar appreciating against the euro, but falling against the yen. The latter phenomenon is attributed to reversal of the carry trade in which hedge funds were participating enthusiastically. But, on further thought, the Japanese resident investors and households were engaging in the carry trade on a far larger scale than the hedge funds, by investing in high-yielding assets abroad on an unhedged basis "" just as by far the largest speculative position in the domestic market carry trade, is taken by the Indian corporate sector! |
| But to come back to the yen, the traditional demand by Japanese corporates for repatriating profits from subsidiaries abroad ahead of the fiscal year-end, may well further strengthen it. But the interest differential still remains very attractive, particularly when domestic inflation is zero and the Bank of Japan has gone out of its way to say that further interest rate changes would be very gradual. But this apart, it should not be forgotten that in modern financial markets, there are too many participants who act in the direction of the trend (buying a currency when it strengthens for example: to stop losses, to follow the trend, to finance the increased delta on written options and so on), and too few acting counter-cyclically. The result? Any trend tends to continue longer than it needs to. |
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