R Ravimohan: Turbulent markets not a cause for panic

The developments will facilitate a restoration of the markets closer to their fundamental valuations.

The past couple of months have seen a great deal of turbulence in financial markets around the world as a reaction to the heightened stress in the sub-prime mortgage practice in the US. Markets remain nervous and continue to display extreme volatility, as they are not yet sure whether the problems relating to the sub-prime market have been contained and whether these developments will impact other markets. Here is an assessment of likely implications for the global markets and their impact on Indian markets.

Given the massive excess liquidity in the system during the past five years, money was lent with relative ease to borrowers with indifferent or low credit standing. A large number of financial intermediaries also played their part in building the sub-prime market to its present level by buying mortgages from those primary lenders and creating exotic structured products and selling them to managers of hedge funds, pension funds, endowment trusts, commercial banks and a wide variety of financial players seeking to invest their excess liquidity in higher-yielding assets. Those borrowers have suddenly become unable or unwilling to pay their dues, giving rise to credit losses to those lenders and those who bought the structured products. Also hurt are those credit derivative swaps and insurance providers, who picked up the credit risk in these papers and insulated the holders of the papers from credit losses.

These credit problems have also brought in liquidity concerns as markets, unsure if the last of the credit problems has passed, are wary of lending money. The sudden dryness after years of easy liquidity has strained the markets and is engulfing even those markets and assets that are not directly affected by the sub-prime stress. Central banks in Europe, the US, and Japan have stepped in to infuse liquidity. Rather than contain anxiety these moves seem to have exacerbated it. Players with liquidity would prefer to keep it until normalcy is restored and those that don't are desperately hunting for liquidity. This has made the yield curve steep, making longer-tenure debt papers relatively expensive and widened the gap between the rates at which a safer borrower can borrow and the rate at which a riskier borrower can borrow. In market parlance, the spreads have widened considerably. In some cases the spreads have widened from 45 basis points to 450 basis points, but it is generally expected that they have moved between 10 and 20 per cent in the past two months. There is continuing volatility even in the fixed-income market and these spreads are still moving about.

Also in question are the causes of delinquencies in the sub-prime market suddenly rising, and whether they indicate a wider concern regarding slowing retail spending and income levels. The consumer data released yesterday in the US did show some degrowth. Retail giants Wal-Mart and Home Depot have issued guidance to the market that they are experiencing a slowdown in their sales. But that is another story for another day.

The widened interest rate spreads would potentially shave off values from fixed-income portfolios, make access to cheap funds difficult for sectors such as hedge funds and the real estate sector that are habitual raisers of this money, and make project financing more difficult than before. Portfolios of fixed-income investments, whether held by the banks, mutual funds, hedge funds, pension funds or endowment trusts, corporate treasuries either directly or through funds, will show a loss in value and some of these entities will be required to make a mark-to-market provision by the regulators, which will hit their bottom line at the end of this quarter. Given the loss of access to cheap debt funds, real estate property holders and developers will now be encouraged to sell rather than hold, causing property prices to fall. Similarly, some of the other exotic asset classes such as derivatives will be devalued. Mergers and acquisitions and project financing will now become more expensive and difficult as the number of players such as private equity providers will now retreat.

On the positive side, financial markets are sitting on good profits made year-to-date. That should facilitate most players to fund and absorb the recent losses and move on, and should help in containing the impact to those areas suggested above and not fan it in a random fashion across the board. It should also help markets to stabilise and recover quickly from this period of uncertainty. The plentiful liquidity that was sloshing around in the system is unlikely to return, but nor is it all likely to vanish. Once the market stabilises, there will be reallocation of the investible surplus that is currently held as insurance against the unknown. That reinvestment is likely to be in assets that are considered safe and will also happen at more prudent valuations. These should include mainstream companies, growth stocks, growth markets like India and China, moderate to high safety assets and conventional financing for viable projects.

Within the Indian market, both due to tightening spreads in the overseas market and recent restriction imposed by the Indian authorities on access to external commercial borrowings, the dependence on domestic rupee resources will increase. While India is likely to benefit from a continued investment flow, albeit at a more sedate level, interest rates are likely to increase moderately and get more closely aligned with credit ratings. Real estate prices are likely to abate with inventories needing to be liquidated to erase the debt overhang that was availed of during the period of excess liquidity. The rupee is likely to weaken a bit in response to the moderate slowdown in the rate of inflow. Most of their collective concerns of the regulators such as credit growth, the strengthening of the rupee and unhealthy market practices would also be naturally curbed by this market correction. Hence they are more likely to guide the consolidation in the market going forward, instead of imposing fresh restrictions. Buoyed by continued economic growth and benign corporate performance, equity markets are also expected to weather this global turbulence with relative insulation. However, since corporate India is in the midst of an ambitious expansion drive through both the greenfield projects and the mergers & acquisition routes, this disruption in the global financial markets is likely to affect some of their funding plans.

All in all, these developments will facilitate a restoration of the markets closer to their fundamental valuations instead of the liquidity driven over-valuations. Correction in property prices and the right pricing of loans and assets and moderate weakening of the rupee augur well for continued progress in corporate India's progress and larger economic growth of the country.

The author is Managing Director & Region Head, South Asia, Standard & Poor's. The views expressed in this article are his own and he can be contacted at r_ravimohan@standardandpoors.com