The current credit crisis has demolished quite a few cherished myths.
It has exploded the fairy tale, assiduously peddled by US salesmen, that financial markets know best, that they disperse and therefore reduce risk and that they are self-stabilizing. It has destroyed the belief that government regulation is always harmful for the markets. And it has knocked down the belief that globalization, through some magic mantra, had suspended the working of the business cycle, eliminating its downward swing. Much of what was attributed to the marvels of globalization turned out to be merely the result of increased leverage.
The attention has so far been focused on the West, because that’s where the drama is unfolding.
Yet, there could be some emerging-market investment nostrums that need to be examined closely to check whether these too are myths. Was the flow of funds to emerging markets really the result of higher growth in these countries, or was it also merely an offshoot of higher leverage? Even more worrisome could be the question: was the spectacular growth of countries such as India the result of capital inflows, rather than the other way round?
There’s little doubt that we have benefited from capital inflows. True, they’ve been somewhat of a headache to the Reserve Bank of India (RBI), but, on hindsight, that now appears to have been a minor ailment.
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The capital inflows have kept liquidity in the system high, led to lower interest rates and boosted growth. Now that the capital flows are in the reverse direction, we’re seeing a drying up of liquidity, made worse by the central bank selling dollars, which sucks up rupee liquidity. Hence the need for the recent cut in the cash reserve ratio (CRR).
Analysts are divided over whether RBI has enough ammunition to deal with the liquidity crunch. Those who believe it can’t make a difference point to the high inflation rate and say that the central bank will be reluctant to reduce interest rates. They also say that, in an environment of capital outflows, RBI has no alternative but to continue to sell dollars and this will continue to keep liquidity tight. And finally, with the elections near, the government has been loosening its purse-strings and that will have a negative impact on the fiscal deficit and therefore on interest rates.
The economists in the other camp believe that lower oil and commodity prices will improve the government’s overall deficit and reduce inflationary pressures, that RBI can always cut CRR and statutory liquidity ratio to infuse liquidity, that the new government after the elections has several methods of raising money, such as the telecom third generation, or 3G, auctions, and from disinvestment and that the inflow of gas and oil from the Godavari basin from the next fiscal year will also help the current account enormously.
But repatriation of funds by foreign investors is hardly done because they are overly concerned about the rate of growth of the Indian economy or indeed of the Chinese economy. Even if these economies grow at 6% and 8%, respectively—their worst case scenarios—they’ll still be doing better than the core economies that have had a credit implosion.
Relatively speaking, the differential between their growth and that of the developed economies is likely to remain the same. In fact, that was the reasoning that led to the surge of funds to markets such as India in the second half of 2007, as these economies were seen to be relatively safe havens from the credit crisis. So what has changed?
One reason for the outflows was that valuations became too high in markets such as India, which led, in turn, to a flight to commodities and to markets such as Brazil and Russia. But valuations are no longer an issue.
The fact remains that our markets had gone up on a sea of liquidity and are falling because that liquidity is being withdrawn. As the leverage created by the derivative structures collapses, liquidity will shrink. That will mean less money for investing in all asset classes, not just in emerging markets. At the moment, of course, we’re seeing a panic rush to the safety of US treasury bills, a panic that will continue until the credit markets return to a semblance of normalcy.
But shouldn’t capital flows to relatively high-growth emerging markets resume when the credit markets are unclogged? Well, the flows are likely to be much less, because the global pool of liquidity will have shrunk considerably and leverage will not go back to the pre-crisis levels in a hurry.
But there’s another reason why flows may not resume soon: In a recent research note, Morgan Stanley economists Stephen Jen and Spyros Andreopoulos write: “Global growth is an important determinant for capital flows. Our simple regression of these variables suggests that global growth is, interestingly, about twice as important a driver for private capital flows into EM (emerging markets) as EM’s growth. In other words, the ‘push’ factors are more important than the ‘pull’ factors, and the developed world will need to be healthy and, presumably, be in a risk-taking mood for capital flows to be buoyant. What this means is that even if we have partial and temporary decoupling between the EM and the developed economies, capital flows are likely to abate, if this historical relationship is still a useful guide.”
In other words, no matter how well our economy does relative to the recession-hit economies of the West, the bear market is likely to continue till the Western economies recover.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at email@example.com