The rupee continues to weaken against currencies such as the dollar. Some might refer to it as a free fall. While regulators and the government are designing moves intended to defend the currency, the common man rues the lack of robust economic direction for India. Some complain about inflation and the price of onions, others refer to the sub-standard infrastructure of roads and lack of adequate public goods in the country, and yet others worry about another subsidy programme that gives a generous handout to the poor rather than empowering them to improve their own well-being.
None of these should come as a surprise to a keen observer of India. What should perhaps come as a surprise is that until recently, the investor view and pricing of India’s currency and markets hardly seemed to reflect the ground reality. The expansion of monetary base due to unconventional central bank policies in the Western economies, especially in the US, found its way readily into the Indian debt and equity markets. These flows, however, abruptly reversed themselves since the announcement in May of the potential tapering of the US Federal Reserve’s expansionary policies. The sentiment on India has since turned bearish, its asset and currency markets have suffered quick and massive depreciations, and its structural weaknesses for generating future growth have all of a sudden come to the fore.
Indeed, India has not been alone in facing the brunt of this reversal even if it is hurting the most. Many other countries and emerging markets are dealing with similar corrections. It begs the question as to why the negative sentiment was missing in the markets in the past few years. Where were the bears? While explanations abound, the one I find persuasive is that investors had gone bullish on emerging markets as they did not believe that any bearish bets will pay off in near future.
When an institutional investor such as a pension or hedge fund expresses a bearish view, it withdraws funds from a market or an asset class and it might even short it. These asset managers, however, face scrutiny of their financiers, who periodically assess their performance relative to benchmarks. An institutional investor expressing a bearish view thus needs to worry about whether the returns on the asset class they withdraw from would correct downwards sufficiently soon so that they look good relative to benchmarks, or whether the asset they short would depreciate in value quickly so that while covering the short position they make a gain and generate returns to their financiers. Such relative performance would generate future fund flows for these institutions.
In a world of frothy liquidity and especially when the central bank of a large economy such as the US has provided credible forward guidance of a phase of abundant liquidity, bearish investors are induced to shy away from expressing their views. They do not see market corrections in risky assets occurring soon. Such corrections may be counteracted with even more liquidity by central banks. Hence, the potential bears instead go long on such assets to mimic the benchmarks. A quiet phase ensues with a slow upward drift in level of asset prices and a low volatility of asset price movements.
Emerging markets have been huge beneficiaries of the resulting hot money flows of foreign funds into their debt and equity markets in the last few years. Unfortunately, and perhaps inevitably, governments and even some parts of the private sector in the emerging markets world wasted no time in attributing the foreign flows primarily to their relatively superior growth prospects. As the cost of borrowing remained low and their currencies and market prices became inflated, they expanded investments and spending. But lacking adequate market discipline from bears, these expansions were misguided in fairly consequential proportions, as seen in the mortgage binge in Brazil, the municipal debt explosion in China, and the programme after programme of subsidies being rolled out in India even as fiscal and current account deficits kept mounting.
As these gambles fuelled with hot money have gradually gone bad and the US found itself on a slow but steady path of mend, the bears have returned to markets. The foreign institutional investors are intensely scrutinizing different emerging markets for the worthiness of their policies and investments. Will they continue to deliver superior or even comparable risk-adjusted returns relative to those in the US? The economies that look most vulnerable in terms of likely slowdown of growth, such as India, are being punished the most with violent outflows, downward currency and stock market corrections, and substantial volatility.
While some of the recent market gyrations may seem excessive relative to fundamentals, it is hard to know by how much given that prices in the past few years were likely inflated relative to fundamentals. Governments and policymakers in India and the rest of the emerging markets world can spend some time trying to figure out the so-called fair prices and fight the bears. Evidence so far suggests that such tug of war is unlikely to calm or scare away the bears. In the Indian case, the stockpile of reserves is somewhat limited, making the battlefield for policymakers slippery and giving rise to a chaotic mix of policy responses.
It might thus be more prudent to think beyond the short-term and create a foundation for better long-term policies. How about reining in the fiscal imbalances through tough current decisions rather than engaging in cheap talk of when the growth will bounce back? Why not unlock aggressively the repressed sectors of the economy, and enable the private sector to attract stabilizing foreign flows?
At a minimum, the lesson for India and the emerging markets world is that open economies do not live as islands unto themselves. They benefit from the absence of bears in times of frothy liquidity in rest of the world; but if they squander away this benefit on wasteful expenditures and leave little gunpowder to deal with the reversal of liquidity, then they stand to face the wrath of bears when they return.
Viral V. Acharya is C.V. Starr professor of economics at the Stern Business School,
New York University.
New York University.