Manas Chakravarty: What's keeping real interest rates low?

The stock market's all-time high has been met with a good deal of scepticism by local investors and mutual funds, which have been net sellers of equities.

The euphoria that has powered the market up has been entirely on the part of the foreign institutional investors, who have been buying Indian equities hand over fist.

Emerging Portfolio Research has pointed out that Global Emerging Market (GEM) funds are on a roll, and that India funds have been receiving a large chunk of the inflows.

But it's not just the Indian market that is scaling new peaks. In the US, the S&P 500 reached a four-year high last week, and the Nasdaq reached its highest level for the year.

The FTSE went up to a three-year high, as did European stocks. South Korean stocks climbed to a 10-year top, Singapore was at a five-year peak, and the Hang Seng was at a four-and-a-half year high. The South African index established a new all-time top last week.

This resurgence of global stock markets is happening at a time when oil prices, too, have topped $60 a barrel, when the US Fed has raised interest rates, when the dollar has strengthened considerably and when most economic forecasts have predicted slower growth in the world economy.

The latest warning comes from the banker's bank, the Bank of International Settlements (BIS), which has pointed to the unprecedented imbalances that exist in the global economy, ranging from the massive US current account deficit and the housing boom to rising levels of indebtedness and the risks involved in the rapid rise of hedge funds.

Yet it's clear that global investors are not buying the BIS' arguments, just as they have ignored all talk about global imbalances. Fund flows to emerging markets have taken scant notice of either the stronger dollar or the rise in the US Fed Funds rate.

One reason why higher interest rates have not started hurting is the low level of real interest rates. In the US, for instance, in spite of the Fed increasing rates several times, the real yield on the 10-year Treasury note is around 1.7 per cent now and it was 1.4 per cent a year ago.

In short, there has hardly been any change in real rates in the past year. And with real rates so low, borrowing is easy, the cost of capital is low and the markets can continue to ride on the wave of global liquidity, while the wealth effect induced by low real interest rates keeps sentiment bullish. In any case, "sentiment" is usually market shorthand for liquidity.

It's not only in the US that real interest rates are low. In the UK, the 10-year government bond has a real yield of around 2.3 per cent, compared to 3.5 per cent a year ago. In Japan, which has been teetering on the brink of deflation, the yield on 10-year government securities is about 1 per cent, as against 2.2 per cent a year ago, thanks to negative inflation then.

And in the Euro area, real 10-year yields have moved down to 1.1 per cent from 1.8 per cent a year ago. This is what has led some analysts to predict that the next leg of the carry trade will be in the Euro, if the US Fed raises rates any further.

To be sure, real interest rates are nominal rates minus expected inflation, not past inflation, but even if the expected inflation for 2005 is taken into account (as indicated by The Economist magazine's poll of economists), the real yields don't change very much.

Why are real interest rates so low? The latest explanation for that has come from Ben Bernanke, one of the governors of the US Federal Reserve. He says there is a global savings glut, and this sea of savings has depressed interest rates globally.

During Keynes' time a savings-investment mismatch would be resolved by higher government spending, which would raise domestic consumption and investment. The trouble is, in these days of globalisation, the savers reside in China, and the consumers in the US.

Chinese savings pour into US securities, which depresses US interest rates, which moves asset prices up and stimulates borrowing for consumption, which in turn leads to more imports and more savings in China. The implication is that it's only when this virtuous circle breaks down that asset prices will tumble.

Nobody knows when that will happen, but in the meantime, Indian corporations and the government should take advantage of the low cost of capital to raise resources and transmute some of that savings glut into much-needed fixed assets and infrastructure.