Moral hazard explains situations where one party takes risks, knowing that the consequences will be borne by another. A well-known example was created by central bank behaviour during the era of Alan Greenspan, chairman of the US Federal Reserve between 1987 and 2006. Greenspan had a one-size fits all policy: Increase money supply. He did it so often that it became jocularly known as the Greenspan Put. The easy money policy continued under his successors and it was adopted by other central banks after the subprime crisis of 2008. The assumption by traders is that the easy money policy will continue indefinitely. This is leading to high risk behaviour. Instead of money being used to create real assets, it is being used to speculate.
The liquidity has been a prime factor in moving markets. So, long as the taps remain open, and even more importantly, so long as there's consensus that the taps will stay open in future, markets will be buoyed up. This moral hazard has created an asset bubble where valuations across multiple markets are at historically dangerous levels.
Importantly, the normal relationship between interest rates and valuations has also been disturbed. In normal circumstances, we find an inverse relationship between domestic interest rates and valuations. That is, if local interest rates fall, equity valuations rise because investors who are receiving lower returns from debt are prepared to take risks and buy equity in the hopes of higher returns. Vice-versa, equity valuations fall if interest rates rise. This is often quantified by looking at earnings divided by price - the inverse of the PE ratio and comparing the E/P ratio to the available returns from debt.
The breakdown in the relationship has occurred because investments flow are global in nature and not necessarily dependent on the local domestic interest rates for valuations. Domestic interest rates are important to corporates seeking loans and in terms of working capital, etc.
But, when it comes to investment, the players with the really deep pockets shop around across many countries and regions. They must contend with exchange risks and with interest rates of course. But, the FPI could be looking at US Treasuries, or Nigerian corporate debt or Australian mining shares. The local interest rates are only one of many input variables in their investment models.
The moral hazard created by excessive liquidity will play itself out one day. It may do so in catastrophic fashion, with some so-called hard currency going into collapse, or a major central bank suddenly hiking interest rates to cope with some sort of shock. It may also happen gradually as inflation rises and the global economy reverts to a normal growth pattern. Or, it may happen in some other way. But, the globalised investment circuit is here to stay. FPIs will continue to shop around the world for the best returns and the lowest risks. That is a key difference in terms of investment climate. This specifically impact Emerging Markets like India, where the local currency is not “hard” and the local investors don’t possess resources to match the FPIs.
Every FPI will have its own way of interpreting currency risk and valuing stocks in Emerging Markets. But, there should be broad similarities in such valuations. For example, an FPI which sources most of its corpus in dollar will look at dollar interest rates and at the dollar to rupee currency risk before it makes a judgement call on India as a market, or it values a specific Indian stock. It may be a worthwhile exercise to input a combination of variables like expected changes in exchange rates and overseas interest rates when trying to calculate valuations of Indian companies.
The author is a technical and equity analyst
