Akash Prakash: A Changing of Guard

An institution like Morgan Stanley having to sell a stake to the Chinese state is unprecedented.

The raising of capital among global capital market intermediaries continues unabated, with the latest instance being Merrill Lynch, which is in advanced discussions with Singapore's Temasek Holdings for a potential $5 billion capital infusion. If the Merrill deal were to go through, as seems likely, it would join the ranks of Citigroup, Morgan Stanley, Bear Stearns and UBS, all of whom have accessed capital from sovereign funds over the last month and in a quantum exceeding $30 billion (including a potential Merrill deal). The speed, quantum and nationality of capital raised have significant implications for investors everywhere.

First of all, for any investor still unconvinced of the growing power and relevance of the sovereign wealth funds (SWFs), there could be no better demonstration of their clout. To cut cheques of $9-10 billion, take decisions within a few days and be prepared to have effectively no governance rights "" I can think of no other type of institution which could have done these deals. We all have to accept that the SWF has arrived and is a new source of long-term equity capital, which on the margin will compete with private equity. These institutions on the margin also are a huge incremental source of capital for global equity and corporate bond markets. The quantum of flows expected to be redirected from sovereign paper into riskier assets by the SWFs will be huge and have the ability to swamp smaller asset classes.

As an aside, given the aggression demonstrated by the Chinese, West Asian and Singaporean funds in this recapitalisation of the OECD financial system, one continues to wonder at the lack of interest among Indian policy makers in setting up an India SWF "" an entity which would target building up asset stakes in strategic sectors of long-term relevance to the Indian economy. The weakness of the dollar, flows of capital into India and the strong possibility of a recession in the west "" all make it an opportune time to set up and activate such an institution to serve Indian strategic interests. It remains surprising we have seen no movement on this front, nor any debate on this issue in India.

The quantum of capital raising also indicates to me that all these institutions expect a very difficult year ahead and that we have not seen the end of this whole credit market turmoil. The stock prices of all the above-mentioned entities have significantly underperformed over the last 12 months and are down in absolute terms 25-30 per cent. For them to have diluted, and that to such a great extent (up to 10% of equity), at these stock prices demonstrates their fear of what could happen going forward.

In the mind of the CEOs and the boards, they must have had absolutely no choice, nor any chance of making it through the coming 12 months without additional capital. For, the last thing any financial institution wants is to raise large chunks of equity at the bottom of the market. If we accept that given the low stock prices these institutions would want to raise as little capital as they can, the amounts raised indicate a need to strengthen balance sheets for potentially much more difficulties to come. An alternative explanation is that all these smart capital market-savvy players raised money, while in their mind it is still available, irrespective of cost. Either explanation should send a chill down the spine of any market participant.

This series of fund raisings will also, I think, force the remaining players to do the same as there is no longer any stigma attached to such transactions (if Morgan Stanley can sell a stake to the Chinese, anything is possible), and also the likes of Credit Suisse or Lehman may now be at a competitive disadvantage from a capital perspective. The only possible holdout may be Goldman, which has till date weathered this storm better than most.

These transactions will also further embolden the emerging market bulls, they can argue even more forcefully that the economic centre of gravity is shifting, and even faster than we can contemplate. Capital markets and investment banking is one sector where there is truly no emerging market company of any global standing; it is a sector with huge entry barriers where the west dominates. If a significant portion of the bulge bracket is now owned by emerging market entities, it can only be a precursor to what will happen across industries, is the bull argument.

We also have to contemplate the possibility that all this recapitalisation will shorten the adjustment phase and reduce any further possible downside in financials. The strength of the US economy remains its ability to adjust, swallow the bitter pill of rationalisation and move on. One would have thought that we would see a huge wave of equity paper and new issuance from the affected financial institutions in the west and that this would act as a dampener to equity markets. However, in a matter of weeks, almost $30 billion has been raised and with no recourse to the capital markets. Could this mark the bottom for the capital market players? Can all this new capital combined with the actions of the Fed, ECB and the US treasury debottleneck the financial system?

Despite all of the above, I still continue to feel we are in for very rocky and volatile times over the coming 12 months. This will be the first consumer-driven recession in the US in decades, and will extract its price in terms of global growth, irrespective of what all the decoupling bulls have to say. Whether emerging markets continue to deliver positive absolute returns in such an environment is a very tough call as the emerging market asset class has a lot of resilience already priced in.

An environment wherein an institution as proud and blue-blooded as Morgan Stanley has to sell a piece of itself to the Chinese state in order to recapitalise is unprecedented. Such a transaction would have been unthinkable even a month ago. We should recognise that in many ways we have entered uncharted territory, and it would be silly to pretend otherwise. Be prepared for volatile and exciting times.