The IMF, thus, concluded that the world should be preparing for rate hikes.
"At the very least we should be preparing the way in the United States for higher interest rates so that the markets are not surprised, and as we see stronger signs come in, eventually those rates will have to move up. So I think certainly the time is now for preparing the markets for higher interest rates," said Raghuram Rajan, the IMF's economic counsellor, at a recent press conference hosted by the IMF to discuss the World Economic Outlook.
That's one reason why Greenspan has been talking of the possibility of rate hikes, and the chances are that the US Fed will increase interest rates at its June 29 meeting.
The benchmark federal funds rate, which is now ruling at a 46-year low of 1 per cent, could well be more than the already-discounted rise of 0.25 per cent.
Speaking to the IMF earlier this month, Greenspan had said that strengthening US economic outlook means that the "ample liquidity" provided to the financial system through very low rates "will become increasingly unnecessary over time."
If there's no question rates will be hiked, the real debate is about its quantum - and pace of change. According to Merrill Lynch's Global Fund Managers' survey in mid-June, "investors are becoming increasingly convinced that global monetary policy is too stimulative."
On an average, equity fund managers believe that Fed policy would be back to neutral (neither stimulative nor restrictive) when the Fed Funds rate is back to three per cent (from the current one per cent). More than 70 per cent of the panel believed that a neutral stance meant having a rate of three per cent or higher.
The question is: how fast will Greenspan bridge the two per cent gap between current rates and the three per cent level seen as neutral?
Markets around the world are nervous about the potential threats, given that easy credit has either been a growth stimulus or been helping keep delinquencies low in the last three years.
Domestic credit as a percentage of banking assets is fairly high in many large economies, including the US (164 per cent), UK (140 per cent), Korea (110 per cent), Malaysia (155 per cent), Germany (147 per cent), China (140 per cent), South Africa (167 per cent), Thailand (112 per cent) and Singapore (102 per cent).
This not only means that the banking sector across the world is at higher risk, but also that growth in other industries which have been thriving on easy credit could suffer.
Emerging markets also face higher risks. Apart from the threat of an unwinding of carry trades - which could mean outflows of foreign funds - growth could be affected.
Says Bandi Ram Prasad, chief economic advisor, The Stock Exchange, Mumbai: "In emerging economies, banks play an important role in determining capital funding since equity funding is just about 12-15 per cent of total funding. Therefore, any change in interest rates will have a greater impact on growth on emerging markets."
Writing in Financial Times (May 30 issue), Chicago-based international economist David Hale noted that while the financial markets had been hit by shocks from the Middle East, rising interest rates could pose greater problems.
"The real risk to world markets is that the speculative bubbles and carry trades that have developed as a consequence of American monetary policy over the past year will unravel as the US Federal Reserve moves to increase interest rates," Hale said.
He noted that US monetary policy had resulted in "significant price gains during 2003 and 2004 in emerging market debt, high-yield debt, government bonds and property, as well as equity."
Over the last quarter, emerging market equities have lost ground across the board. The MSCI Emerging Markets Index lost 10.55 per cent, while MSCI Emerging Asia Index lost 12.33 per cent. India, despite having weaker links to global economies and markets compared to many other nations in the region, has not been spared.
In fact, it was the highest loser among Asian emerging markets, with a loss of 17.64 per cent, with post-election economic policy concerns weighing heavily on the markets.
In 2003, the Sensex was among the largest gainers in emerging markets with foreign investors pouring $10 billion into Indian equities.
A rate hike in the US would not only mean that cheap money will no longer be available to finance investments in emerging market, but investors could dump emerging market assets to deploy the same in better yielding assets in the US.
And the India story may not be treated as an exception, particularly after the twist to the India Shining story post-elections.
As for the bond markets, one school of thought is that domestic liquidity is comfortable and does not warrant a hike in local interest rates.
"Even if US rates start moving up, domestic rates are unlikely to rise. There is no one-to-one correlation between global rates and domestic rates. The question of a rate hike in India does not arise for at least another 12-18 months. There is too much money in the system which is not yet absorbed," says Rajiv Anand, head of investments at Standard Chartered Mutual Fund.
The fact is that domestic bond yields have not been moving particularly in tandem with US treasury yields for the past few months. Yet, there has been a small correlation (0.6) between the two over the last three years.
Economists feel that while a modest increase in US rates may not warrant any tinkering with local rates, it may become necessary if the hikes are tangible. How much increase in the US can the domestic markets absorb? Experts declined to stick their necks out on this one, but anything more than 50-100 basis points could warrant a hike in domestic rates.
On the other hand, domestic worries about inflation may add another dimension. Ten-year bond yields are currently just about level with the WPI inflation rate - so if the message from the bond markets is that yield rates have to go up, Reddy cannot decline to take note of the need for a rate increase.
Ten-year yields have already risen sharply over the last two months. After bottoming out in mid-April around 5.01 per cent, yields are up at 5.89 per cent (June 24), indicating that the markets are expecting a hike in India as well.
Assuming Reddy will have to bite the bullet sooner or later, what is the damage this can do? Unlike most emerging economies, retail debt as a percentage of GDP is still not very high in India, but it has been growing frenetically.
Over the past five years, the total retail loan market has been growing at a compounded annual rate of 34 per cent. Credit cards and housing loans have been the fastest growing segments with growth rates of 83 per cent and 43 per cent respectively.
Personal loans have been growing at 32 per cent while two-wheeler loans have been growing at 32 per cent. Obviously this has helped volumes growth in sectors like autos and consumer durables.
If interest rates now start rising, one can except some slowdown in these sectors. And the banking industry as a whole would see tougher times if non-performing assets on the retail side start growing and the value of their holdings of government securities starts eroding.
Some corporate fundamentals will also start weakening. The corporate sector has been a major beneficiary of a declining interest rate regime as loan servicing costs declined over the last three years. If this trend reverses, it may not impact bottomlines immediately, but the markets will start factoring it into its calculations.
With the dynamics of the global economic scenario changing, the corporate sector is now less worried about a rapid appreciation in the rupee as was the case earlier this year. This means good news for export-oriented companies.
Analysts expect that industries like pharma and infotech could outperform in a otherwise lacklustre market.
The biggest risk for the equity markets is fund flows. The recent performance of emerging markets provides little reason to believe that India will be an exception to the general trend of outflows, never mind what the domestic pluses are (good monsoon, reasonable corporate fundamentals, adequate liquidity, prospects of more government investment in infrastructure, etc).
When global winds blow the other way, few fund managers are willing to swim against the tide. That's why, Greenspan and Reddy matter to the markets than they did last year.
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Fed Funds rate could go up 2 per cent
India may be forced to hike rates
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