The Sensex reflected the upbeat mood in global markets on Tuesday as investors hoped that the recent panic had resulted in the formation of a market bottom. There are several reasons for that view.
First among them have been the better-than-expec-ted results from banks such as Goldman Sachs, Lehman Brothers Holdings Inc. and Morgan Stanley, giving rise to the suspicion that perhaps they haven’t been hurt as badly as was feared.
The second reason has been the Fed’s takeover of the impaired assets of Bear Stearns Companies Inc., the terms and conditions being that if the assets sell for less than the currently valued $30 billion (Rs1.2 trillion), then, apart from the first $1 billion in losses that will be borne by JPMorgan, the rest will be borne by the Fed. That sends out a clear message that the US central bank will not hesitate to use unconventional methods to support the financial system. Among those methods has been the broadening of the range of collateral it will accept in exchange for funding banks and primary dealers, which includes mortgage-backed securities. Taken together with the Fed rate cuts, these are very strong signals.
The big question is: Will it work? Well, here are a few straws in the wind that indicate that the measures have made an impact. Credit default spreads have tightened and the investment grade iTraxx Europe index is at 109, 23 basis points tighter than last Thursday. In the US, the yields on high-grade AAA-rated bonds have gone down to levels not seen since the beginning of February. Yields on medium-grade Baa-rated bonds, too, have gone down a bit. Best of all, the rates on US mortgages have started to fall, with Bloomberg data showing that rates on both 15- and 30-year mortgages are below what they were a month or three months ago. These are heartening signs because earlier, even though the Fed funds rate was going down, these rates were not. They are evidence that the current bout of panic is over. Back home, sentiment was also affected by the fact that foreign institutional investors, or FIIs, have been net buyers in the last few trading days, taking the cash and futures market together.
Will the rally sustain? Deep-seated problems remain in the US housing sector and in the real economy. In India, the combination of slowing growth and inflation cannot be wished away. And as far as the credit market is concerned, while they have shifted from panic mode, it’s worth recalling that three months ago, the iTraxx Europe was at 53. In fact, the best way to gauge whether we’re on our way out of the mess is to track the credit and mortgage indices in the Western markets.
A timely boost to consumption
What will be the impact on economic growth of the Sixth Pay Commission bonanza for the government employees? The obvious precedent to look at is what happened after the Fifth Pay Commission after the government announced a revision in pay scales in September 1997. Growth in the “public administration and defence” component of GDP went up from 6.8% in fiscal 1997 to 14.5% in fiscal 1998 and remained at an elevated level for several years thereafter.
Of course, the government’s deficits went up and that affected public savings. But what’s interesting is that it was made up by a rise in household savings. Forexample, net domestic saving as a percentage of GDP actually went up from 18.6% in fiscal 1997 to 19.7% in fiscal 1998 and was 19.1% in fiscal 1999. At present, with the improvement in railway finances, even public sector savings shouldn’t be so badly affected.
There are significant differences between today’s economy and that of 11 years ago. GDP now is much higher than what it was at the time, so the impact of the extra cost to the exchequer is lower. Interest rates, too, are lower, so the effect of extra borrowing by the government will not be quite so much. The financial position of the states has improved dramatically, the majority of them now run fiscal surpluses and they have been parking their excess funds with the Reserve Bank of India. And finally, there has been a reduction in employee strength among both state and Union government employees. Based on the budgeted estimate for the number of Central employees (excluding defence personnel), there has been a reduction of 11.4% in the headcount since 1997.
There’s no doubt that the extra expenditure will lead to a rise in consumption. “Much depends on the multiplier effect,” says Ajit Ranade, chief economist of the Aditya Birla Group, who believes that the boost to consumption comes at the right time, when sentiment is low because of a global slowdown. He points out that pensioners, who consume rather than spend, stand to benefit a lot from the pay commission recommendations. “The timing of the fiscal expansion is perfect,” says Gaurav Kapur, economist with ABN Amro in Mumbai. He believes that the boost could easily contribute an extra 0.5% to GDP. Inflation, however, may be a problem.
The increase in consumer demand should provide a shot in the arm to corporate balance sheets in the FMCG, consumer durables and auto sectors. More importantly, as Ranade points out, it may serve as an antidote to the current gloom and doom.
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