Volatility dangers

A few months ago, the long-standing problems of "global imbalances" appeared to be abating, with a soft landing involving a dropping dollar and slow US GDP growth. Now, fears about global macro-economic worries are back on the front pages. Three major things have changed in recent weeks. The trouble in US housing has turned out to be much worse than was earlier felt to be the case. Many financial firms have failed""in the US and elsewhere. Credit spreads have risen sharply and risk perceptions have been revised upwards.

Stock prices fared very well in the last year, with the Nifty gaining 35 per cent and the S&P 500 gaining 12 per cent. Now fears about the world economy have led to lower stock prices. Home construction is the worst-performing industry in the US; shares of companies in the field have lost 60 per cent over the last two years. In addition, the projections embedded in option prices show an upsurge of volatility. The S&P 500's implied volatility has surged to 25 per cent, the highest in three years. In India, so far, the implied volatility is at 27 per cent, which is modest for India's markets. The relative numbers suggest that India's markets have some ground to lose before they stabilise.

An opinion poll conducted by the Wall Street Journal shows that as many as 66 per cent of the respondents believe the US will now have a recession. This conveys the gloom in the US. Will the US Federal Reserve mount a rescue by swiftly cutting interest rates? It is unlikely. The Fed is a de facto inflation-targeting central bank. The expected inflation embedded in the prices of inflation-indexed bonds in the US is at 2.3 per cent, which is above the 2 per cent target. Until future inflation softens perceptibly, the US Fed is unlikely to cut rates. At present, the derivatives markets are showing a 20 per cent probability of a rate cut by the Fed by September and a 40 per cent probability of a rate cut by October. In India, all these financial markets are missing, and the central bank's objectives are not clearly specified, hence it is not possible to anticipate what the RBI will do.

How would India be affected in an unhappy scenario? A recession in the US would lead to soft prices of tradeable goods worldwide, particularly given the massive investment boom in China focused on producing these tradeables. Hence, profits rates of Indian firms producing tradeables would be adversely affected. This would apply not just for companies exporting goods, but also for a company producing goods for the domestic market which are priced by import-parity pricing. The net profits of Indian companies have grown remarkably from 2002. The unhappy scenario would dent this profit growth. It would also diminish optimism, and thus investment demand.

A feature of recent weeks has been the robustness of global financial capitalism. A few hedge funds have gone bust, with losses of billions of dollars. A few very rich customers of the hedge funds have suffered big losses. Barring that, nobody seems to have got hurt. Hedge funds are, thus, shaping up as an important new shock absorber in global capitalism. In India, this shock absorber is lacking, through longstanding efforts by policymakers at preventing a hedge fund industry from coming about. The key tool for confronting future events, then, remains price flexibility. If there is bad news, the government should not prevent stock prices and the rupee from losing ground. These are the essential equilibriating responses of the system of financial markets.