The International Monetary Fund (IMF) seems to have a nice sense of timing. A day before the crash in the US stock market and in the midst of all the worries about the defaults in the US subprime market spilling over into investment-grade assets, about hedge funds going belly-up and the closing of the private equity liquidity tap, the IMF decided to revise its projections for global growth upwards.
The global financial institution now says that world output will grow by 5.2% this year as well as the next, up 0.3 percentage points from the estimate it made last April. Projections for almost all regions have been revised upwards, except the US, Mexico, the Asean-4 countries and West Asia. For India, the prognosis is for 9% growth this year, a 0.6% increase from the April estimates.
With the outlook for growth so strong, why should stock markets be crashing across the globe? And if they are, does it imply that the underlying “fundamentals” of the world economy are fine and it’s just a question of time before the market bounces back?
It’s worth recalling that the big scares of the bull run that started four years ago have all been related to concerns about higher interest rates. Whenever interest rates and bond yields started moving up, as in May 2004 or May last year, the worry was that access to cheap funds, which had fuelled the rally, would be cut off.
This time, too, the worry is the same, only the origin of the problem has changed. On earlier occasions, investors were spooked by the prospect of central banks raising interest rates in order to fight inflation. This time, it’s slightly different—the problem lies in credit being tightened by commercial and investment banks, rather than by central banks.
Why are banks tightening credit? Because defaults by borrowers in the US subprime market have not been contained merely to the subprime mortgage market alone, but have spilled over into other assets. That’s because banks have cut up, dressed up and packaged these junk loans with other credits and sold them onwards to investors, aided and abetted by the rating agencies, who figured that a little bit of junk in a large collection of investment grade paper doesn’t matter. And so long as yield-hungry investors snapped up these packages, known in the jargon by a variety of acronyms such as ABS, CDO, CLO and so on, nobody was bothered.
The problem started when questions began to be asked after a couple of hedge funds, run by the rather aptly named Bear Stearns, went under and one of the creditors threatened to auction off their assets. That led to the realization that some of the fancy derivatives, supposed to be investment grade, were not worth the paper they were written on. It suddenly turned out that if the supposedly high quality paper that investors were holding had to be sold in the market, rather than at the price determined by investment banks’ fancy pricing models, they would be little more than junk.
Naturally, nobody wants to hold these assets any more. This time around, the rise in interest rates has occurred, not because of higher treasury yields (these are in fact falling as investors flee to the safe haven of government bonds) but because corporate spreads over treasuries have increased.
Also, when US mortgage lender Countrywide blamed its earnings decline on defaults by borrowers hitherto supposed to be in the “prime” category, people realized that the US housing recession was not confined to the subprime category. All these factors have led to a sharp drop in investors’ appetite for securitized assets and, as a result, banks have been forced to take these assets on their own books.
In the game of “passing the parcel”, the music has stopped and banks have been left holding some very toxic parcels indeed.
A Financial Times analysis shows that in recent weeks, bank balance sheets have absorbed more than $40 billion (Rs1.6 trillion) of high-yield debt for buy-out deals that were meant to be sold to investors. The upshot: a big source of liquidity has been shut off and a general re-pricing of risk is underway.
What are the consequences? Leveraged buy-out deals and stock buybacks, that have provided such a lot of support to the US equity markets, will be hit. Private equity will no longer find it easy to mop up the cash that has fuelled its global acquisition spree.
The credit contraction will hit all leveraged players and trades. And, as institutional investors lick their wounds, they will no longer be sending quite so much money across the global in their search for higher returns.
What hasn’t changed? Although the yen has become stronger as a bout of risk aversion takes hold, the carry trade is unlikely to die, simply because so much of it is now fuelled by Japanese retail investors seeking higher returns. Also, the central bank liquidity tap remains open as they mop up dollars and add to their foreign exchange reserves. The US employment numbers continue to hold up, which means that consumption growth is likely to remain healthy. And, as the IMF says, global growth is going to be stronger.
The IMF’s Financial Market Update, released together with the revision in the global growth numbers, sums up the situation succintly, highlighting the rise in credit and market risks, while at the same time pointing out that strong macroeconomic performance continues to underpin overall financial stability.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org.