Nitin Desai: Will the party go on?

Global stock markets are booming but policymakers must prepare for less favourable conditions.

The stock market boom continues apace and has now lasted for four years from the time the Sensex started rising in mid-2003. Since then it has risen fivefold, with some judders in May 2004, when the change of government took place and again in May 2006 and February 2007. Two massive IPOs have been absorbed recently and this year the Indian market may rank fourth in terms of IPO volume.

The strength of the Indian stock market is clearly based on domestic economic factors--sustained high growth, booming exports, rising corporate earnings, rising investment rates, moderate inflation. The crystal ball suggests that these positive factors continue to operate but with some slowing down of export growth because of rupee appreciation. The recent report of the Prime Minister's Economic Advisory Council reinforces this optimism. But the effect of rupee appreciation on import competing production and of high interest rates on demand is the cloud in the crystal ball.

The risk factors are mainly external. The Indian market is now clearly linked to a globalised capital market. The flow of FII money into the Indian market is now running at about a billion dollars a month on average and the cumulative stock of FII holdings in India should be around $50 billion now, which is half as large as the $100 billion managed by domestic mutual funds. The other big inflow into the capital market is from NRI deposits, which now amount to around $40 billion. A major shock in any globalised capital market could spill over into India and the FII money may "fly to safety". Given that foreign exchange reserves are now over $200 billion, this will not pose an international liquidity problem. But the impact on domestic capital markets, domestic liquidity and investor sentiment could be more serious.

Should we start worrying? The IMF's March 2007 Global Financial Stability Report says: "Favorable global economic prospects, particularly strong momentum in the euro area and in emerging markets led by China and India, continue to serve as a strong foundation for global financial stability." However, like a good banker it qualifies this by saying that "some market developments warrant attention". These include the yen carry trade, the problems with mortgage lending to poor credit risks in the US, the impact of a flood of leveraged buyouts on corporate debt profiles, the markets improved appetite for risk and the long-standing problem of how the US deficit is financed.

Right now global financial markets are in good shape and have shaken off fears created by the rise in long-term interest rates in June 2007. Part of the explanation lies in the benign economic conditions with steady growth, low inflation and few geo-political shocks. But some part of the explanation lies in the supply of liquidity because of a global imbalance with a huge US deficit matched by large surpluses in Japan, China, Saudi Arabia and elsewhere. The ratio of net foreign assets to GDP is positive and rising in Japan, Emerging Asia and Oil Exporters, and negative and falling in the US and the euro-zone. This is expected to continue and the flow of liquidity will not change any time soon.

What we are seeing now is a globalised financial system driven by this liquidity and wider options for hedging and sharing risks. The problems that the IMF Report identifies are a product of this globalisation. Investors balancing their portfolios across different risk-return classes are acting rationally when they borrow in yen and invest in higher-return assets elsewhere or when they put some of their money into higher-return and higher-volatility equity markets. The sub-prime lending problem is partly a result of the growing sophistication of financial engineering made possible by derivatives.

Exchange risks are the weak element in the system. They, even more than interest rates, are the key link between finance and product markets. Central bankers struggle to maintain these rates, which are increasingly influenced by capital flows, to meet the needs of the exporters and producers or to contain inflationary pressures. The current rupee appreciation in India and the RBI's efforts at containing it are an example.

The exchange risk in the yen carry trade is perceived to be small as the Bank of Japan operates a regime that keeps the yen undervalued so that rising exports can pull the Japanese economy out of stagnation. During 2006, when the Bank of Japan moved from its zero interest policy, there were frequent crash alert announcements. But the sky did not fall. Japanese interest rates remain low, the yen is still undervalued and the carry trade continues.

The extent to which FII flows into India depend on the yen carry trade is not known. The vast bulk of the carry trade is directed at the purchase of relatively safe options like US treasuries and developed country bonds, and only a small part is directed at emerging country markets. If the punters need to unwind their trades what will they get out of first--their investments in supposedly less safe emerging markets or their lower spread investments in the US and elsewhere?

A sudden reversal of the yen carry trade is more likely to arise because of a sharp appreciation of the yen from its current level of 120 to a dollar than from any narrowing of interest rate differentials. Hence the signal to watch is the yen-dollar exchange rate. But if the rupee continues to appreciate, the adverse impact of this on Indian markets would be lower.

In a globalised system, investors have many options and a country that is open to global investment flows must aim at building a stable investor base. Central bankers and financial authorities must judge their words and deeds in terms of the potential impact on investor expectations of return and risk. This requires efficiency, transparency and predictability in the regulatory environment. Most important of all, in the words of the IMF Report, "policymakers should use the current 'good times' to prepare for a period when conditions are less favorable".

So for the moment the party will continue and the sky does not look as if it will fall. But when you sleep in the open air it is always good to wake up every now and then and check whether it is time to go indoors.

nitin-desai@hotmail.com