Whither asset prices?

It's been some time since the party ended. The stock markets have been listless, moving a few points up or down on extremely low volumes. Ten-year bond prices have fallen to their lowest levels in nearly a year, and the rupee has dropped to an eleven-month low.

Commodity prices are weakening. Asset prices are deflating everywhere, and India is no exception. The reasons are not far to seek. For the last three years, central banks, under the leadership of the US Federal Reserve, loosened their purse strings in an effort to stave off recession.

The money unleashed a wave of liquidity across markets, boosting stock, bond and commodity prices, while driving down interest rates. Extremely low rates of interest in the United States led to a rise in risk tolerance, and yield-hungry funds moved out of the US into the emerging markets.

The conducive period for asset prices has now ended. With the US economy firing on all cylinders, inflation is the main worry and the Federal Reserve is all set to raise interest rates. The effect has been a reverse flow of funds away from the emerging markets.

The withdrawal of foreign investors has pushed stock markets down, tightened liquidity and increased the spread on emerging market bonds. In India, foreign exchange reserves have started to fall, NRI deposits have started to decline, liquidity is tightening and the shortage of dollars has led to a fall in the value of the rupee.

Is there a chance that the good times will return soon? The pointers from history are certainly not encouraging. Ten years ago, the emerging markets crashed when the US Federal Reserve savagely yanked interest rates up by three percentage points over 1994-95.

The IFCI Emerging Markets Index fell 29.1 per cent between September 1994 and March 1995. It was only in the first quarter of 1996 that net FII inflows into India reached the levels of early 1994, and the BSE lost a third of its market capitalisation between September 1994 and January 1996.

Of course, 2004 may not be 1994. The FIIs say that much of the selling has already happened, and a quarter percentage point rise in the US Fed funds rate every quarter has already been priced in. More importantly, emerging market enthusiasts build their case on US weaknesses "" and contrast it with the solid fundamentals of both India and China.

They point to the huge US current account deficit, which could exert further pressure on the dollar. They emphasise that the US recovery has been built on large doses of fiscal and monetary stimulus, and wonder what will happen when that stimulus is curtailed.

They talk about the relatively high valuations of US stocks compared to those of the emerging markets. They say that much of the job creation in the US has been for temporary workers and that a third of these jobs may have gone to low-skilled immigrant workers.

In short, their argument is that investment in this country is a better choice compared to investing in the US. But while all that may be true, the problem lies in persuading the majority of fund managers to agree. The Union Budget should be the first step in that giant effort.