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The recent turbulence in financial markets around the world was triggered by the statements emerging from the US Federal Reserve System. First, there was Chairman Bernanke's speech, which was seen as a signal about the Fed's intent to "taper" its $85- billion-a-month bond purchase programme, otherwise known as QE3, the third tranche of its quantitative easing strategy. Then there was the press statement after the June meeting of the Federal Open Markets Committee, which explicitly indicated that the liquidity infusion was to wind down by year end.
The market behaviour seen over these weeks raises some disconcerting questions. Do these patterns demonstrate conclusively that the steady climb in equity markets over several months in the past year was entirely due to liquidity conditions? Are the stabilisation and signs of recovery in the real economy not being given any credence by investors? And, if even the suggestion that the liquidity infusions will be rolled back in the next few months can cause such a drastic revaluation across asset classes, how will markets react to the actual rollback?
I think that a "training wheels" metaphor is apt here. When kids learn how to ride a bicycle, they gain confidence and comfort from the presence of training wheels, which prevent them from toppling over. When the wheels are removed, there is inevitably a rise in nervousness, which is allayed for some time with an accompanying adult holding on to the bike from behind. At some point, he/she lets go and that is the moment of reckoning. Some kids realise that they're finally on their own and revel in their independence. Others are overcome with fear and topple. It could go either way.
The successive rounds of quantitative easing were intended to provide support to the economy while it found its balance. There was always the certainty that this support could not go on forever, that it would have to be withdrawn at some point. But, given that the entire QE strategy was venturing into uncharted territory, in practice and perhaps even in terms of its theoretical foundations, there is simply no way to predict the consequences of a rollback. Will the economy quickly find its balance after an initial wobble, or will it topple, requiring a restoration of support?
At this point, one could find indications of things going either way. On the positive side - that is, the prospects that markets will stabilise after the initial turbulence - the propensity for financial markets to "overshoot" is well known. The initial response to a shock is for investors to take no chances and redeploy as much of their portfolio as possible into safe haven assets. The preferred safe haven asset is the US treasury bill, because of its extremely high liquidity. This explains the retreat of virtually all currencies against the dollar. But once the initial shock has subsided, portfolios will be reallocated to achieve a more normal risk-return profile. This would mean that assets that look relatively attractive will see prices rising and the countries in which such assets are to be found will see their currencies appreciate.
The second source of comfort is the ongoing moderation of commodity prices. This could be the result of pessimism about future demand prospects, but it could also reflect the impact of an anticipated rollback in liquidity on valuations. In other words, the market perception of commodities as an asset class in themselves may be changing; going forward prices will be determined by real supply and demand conditions. If this is the case, profitability is certain to rise. This will induce new investment activity, which will in turn drive an economic recovery.
But there are also indicators in favour of the toppling view. The most important of these is the impact that a rise in interest rates will have, not just on borrowing costs, but on the balance sheets of financial companies. A sharp rise could inflict significant damage as these companies provide for mark-to-market losses on their portfolios. Loss-making financial companies are clearly not good for sustaining a recovery in the real economy, which will depend on predictable financial flows.
A second source of risk is that, even as markets normalise after the initial flight to safety, the allocations will be significantly different from what they were before the shock. Abundant liquidity is a great equaliser. It gives investors the comfort to diversify their portfolios much more than otherwise. Conversely, tighter liquidity conditions, which will emerge as QE3 is rolled back, will force investors to be much more selective. Some assets will recover as allocations normalise, but others will languish. There is no rising tide to hold on to.
I draw two sets of implications from these perspectives. First, from the viewpoint of managing the rollback, extreme caution and calibration are absolutely necessary. The Fed's efforts to reassure markets that it was thinking of a "taper" and not a "rollback" highlight its own concerns about moving too fast and by too much. Given the absence of a predictive model, it has to move one step at a time, gauge the response and then decide on the timing and magnitude of its next move. This will minimise the risks of a topple, even though nothing will completely eliminate them.
From the viewpoint of domestic macroeconomic management, the increasing selectivity in portfolio allocation by global investors means that the government will have to work even harder to attract capital inflows. Explicit plans and time frames accompanied by credible actions are now more critical than ever. In the positive global scenario, capital will begin to move out of safe havens over the next few months. Where it will go and whether it will come to India or not will depend entirely on the domestic policy environment. The costs of missing the bus on reallocations are high and the government simply cannot afford to hide behind the election schedule.
The writer is director of research, Brookings India, and former deputy governor, RBI. Views are personal
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
