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Deleveraging wave threatens markets

Deleveraging wave threatens markets
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First Published: Mon, Sep 15 2008. 11 56 PM IST

Updated: Mon, Sep 15 2008. 11 56 PM IST
The impact of Lehman Brothers Holdings Inc.’s bankruptcy and the possible demise of American International Group Inc., America’s largest insurance company,
can be summed up in one ugly word: deleveraging. The problem is not confined to one, or two financial institutions. Since all of them are highly leveraged, those who have lent money to the firms going under will be hurt. That could prompt investors in these firms, in turn, to rush for the exits, leading to a vicious circle and a seizure of the credit markets. As Mohammed El-Erian, co-CEO of Pacific Investment Management Co., which oversees around $812 billion (Rs37.27 trillion) in assets, has been quoted saying in an interview, “Recent developments highlight the extent to which the banking system as a whole lacks sufficient capital to comfortably navigate this period of sharp deleveraging.” It is now up to the US Federal Reserve and the US treasury to ensure that the system continues to work. At the time of writing, the cost of insuring European corporate debt against default had soared.
Even if they succeed in doing that, risk aversion is likely to go up. That flight to safety is seen from the fact that despite the turmoil in the US financial markets, the US dollar gained against the euro after an initial sell-off on Monday. Banks that are struggling to stay afloat are not only likely to curtail new lending, but could also sell assets to meet their liabilities. That will exacerbate the withdrawal of liquidity from emerging markets. These fears pulled down Indian equities on Monday, although the markets recovered from their lows on the back of short-covering (or investors covering their short positions by buying stocks). The long-drawn-out and tortuous process of going through Chapter 11 will lead to offloading bits and pieces of Lehman’s portfolio and the outcome may lead to a write-down of assets across the banking system. The opinion of many brokers in the market is that this crisis is not going to go away in a hurry.
That tightening of liquidity is likely to lead to a downward revision in earnings. Several economists now say they will be reducing their growth estimates for FY10. Estimates show that while there has been some downward revision in earnings for the current year, EPS (earnings per share) growth for the Sensex for next year continues to be at 19.2%, according to Bloomberg consensus estimates. Now that it’s evident that we haven’t yet put the worst of the credit crisis behind us, next year’s earnings, too, should be revised downwards. However, that revision may not be the main reason for lower market levels in the future — that will likely be more the result of a compression in valuation multiples, the consequence of increased risk aversion.
There are essentially two views about the markets. The predominant one is that a huge amount of uncertainty lies ahead of the markets and there’s still a lot of pain to come. The other view is that the issues with the US financial sector were well known and the Lehman bankruptcy provides a sort of closure. As Gaurav Kapur, a senior economist with ABN Amro Bank NV, said, “The worst is out of the way.” Others say unlike at the time of the Bear Stearns bailout, the Fed now has an idea about the extent of exposure that different banks have to the toxic paper and that it must have taken the repercussions into account when it allowed Lehman Brothers to fail. The issue with that view, however, as Indranil Pan, chief economist with Kotak Mahindra Bank Ltd, points out, is that nobody knows when, or where the next bit of bad news is going to come from. Nor has the US central bank shown itself particularly adept at managing the situation so far.
The tightening of liquidity could impact the Indian economy as a whole, given that a major portion of incremental GDP comes from investment demand. And although consumption demand is strong, thanks to a good monsoon, the farm loan waiver and the Sixth Pay Commission, it won’t make up for the expected drop in investment demand.
The worst hit, of course, are sectors that have the largest funding requirements. It’s no wonder the already affected real estate sector was the worst hit on Monday. The Bombay Stock Exchange’s (BSE) Realty index fell more than 7.5%, more than double the drop in the Sensex.
Firms in the capital goods sector may not necessarily need to tap the market for large funding, but if liquidity is a problem and funding costs are expected to rise, their clients are likely to go slow with new orders. BSE’s Capital Goods index fell less than 4%, perhaps reflecting the markets’ confidence in the bulging order books of most such firms. Besides, as one sector analyst points out, firms such as NTPC Ltd get funding from the Asian Development Bank and export-import banks. Firms such as Tata Power Co. Ltd have already achieved financial closure for their large projects, and wouldn’t be affected. It’s firms who still need to tap the market, especially companies that need to tap the overseas markets for tying up large amounts, whose growth plans will derail.
Companies such as Tata Motors Ltd and Hindalco Ltd have already had to alter their equity fund-raising plans. After the crash on Monday, their share prices are just 13% and 16.5% higher than the announced rights issue prices. At the time of announcement, their respective share prices were 20% and 30% higher.If the current prices sustain, or if things get worse, these firms may have to dilute their equity further.
Exporters will also be hit badly, with the large economies of the world at the brink of a recession. Already, firms such as Satyam Computer Services Ltd have been hit badly because of exposure to some of the beleaguered banks. Since consumer demand in the US depends largely on availability of credit, even segments such as textile exporters would be hit. The sharp depreciation in the rupee is little consolation, as demand and pricing of contracts itself are under threat.
With risk-aversion rising, the rupee breached the 46 mark. A. Prasanna, an economist with ICICI Securities Ltd, said the Reserve Bank of India (RBI) may start intervening, especially as the rupee is no longer overvalued in terms of the real effective exchange rate. He pointed out that the intervention, by selling dollars and buying rupees, could add to liquidity pressures in the debt markets.
However, as Kapur said,the domestic system has a buffer, as RBI may well start reducing the SLR (statutory liquidity ratio that defines the minimum amount of liquid funds banks need to keep) and CRR (cash reserve ratio that defines the amount banks need to keep with the central bank) if domestic liquidity becomes an issue.
The Chinese central bank obviously believes that the lack of growth is a bigger concern than inflation at the moment, which is why it cut its policy rate on Monday, as oil prices nosedived.
The markets also believe that the Fed funds rate may be cut. The Indian 10-year government bold yield fell to three-month lows on Monday, as markets speculated that RBI would be forced to follow suit.
Write to us at marktomarket@livemint.com
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First Published: Mon, Sep 15 2008. 11 56 PM IST