The sell-off in the stock market on Monday was unexpectedly brutal. But the general downward direction of the market over the past 10 days should not have come as a surprise to informed investors.
There are clear signs that the clouds hovering over the world’s largest economy are growing darker by the day. The probability of a US recession has risen over the past few weeks—and this is very likely to hurt growth in other economies. China, too, is trying to cool down its overheated economy.
A global slowdown is on the cards. The only question is: How modest or severe will it be?
These warning signals have not started flashing all of a sudden. There have been signs of trouble ever since the developed financial markets were hit by subprime defaults and the subsequent credit crunch in the middle of 2006. Global risk measures such as the VIX volatility index were clearly showing that investors were jittery. Yet, the Indian market soared 51% from its 21 August 2006 low. Perhaps, a lot of the buying was done with borrowed money. High leverage may make the drops sharper than warranted.
Two questionable theories partly powered this rise. One, the emerging economies would decouple from the US. Two, that lower interest rates was all that was needed to pull the global economy out of trouble. Both these theories will be tested even further in the weeks ahead.
Let’s consider the decoupling thesis first. There was a widespread belief till very recently that the Indian economy would be buffered from global economic shocks. That is hard to believe. India is now a globalized economy. Its current account transactions with the rest of the world are almost 40% of its total GDP, not an insignificant amount. Also, India’s growing trade deficit and burgeoning foreign exchange reserves are being financed by global capital flows; a problem there could affect the rupee and domestic interest rates.
In these circumstances, it is hard to believe that India will be immune to the ill effects of a global contagion. Montek Singh Ahluwalia, deputy chairman of the Planning Commission, has already said a global slowdown will cut India’s GDP growth by 0.5%. This is not a large cut in itself, but certain sectors are likely to take bigger hits in the plexus. Till it’s clear how the negative impact of a global slowdown affects various sectors, investors have reason to worry.
The second specious argument was that markets would rise in Pavlovian fashion each time the Federal Reserve cut interest rates to prop up US growth. There is no doubt that monetary policy is an effective tool to combat a slowdown, but it doesn’t always work. Look at Japan, where years of near-zero interest rates have done nothing for economic growth.
Monetary policy works only as long as consumers and companies are ready to use cheap money to spend and invest. A risk-averse economy with large credit spreads is unlikely to respond easily to monetary stimulus. It is significant that US President George?W.?Bush and Fed chairman Ben Bernanke are now talking of a fiscal stimulus to keep the US out of recession.
India’s long-term growth story is unlikely to be dented by the recent turmoil in the global financial markets. The economy could continue to grow at 8% a year for many more years. Despite clear signs of a slowdown in corporate earnings, there is little doubt that companies are in the pink of financial health. India’s domestic consumption is also a source of strength.
But investors should not forget that we live in a global economy. To believe that India will not be affected by what happens elsewhere is unrealistic, to say the least. The sharp market correction over the past few days should be a wake-up call.
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