Hong Kong-based executive director and head of equity strategy at BNP Paribas Securities (Asia) LtdClive McDonnell came wearing shorts for the interview at the Taj Mahal hotel in Mumbai. Not for long. He quickly changed to formal wear when he had to pose for a photograph.

Grim picture: Clive McDonnell expects similar declines in other markets in the region, particularly China. Abhijit Bhatlekar / Mint

In a September report, McDonnell said the market is most likely to suffer the most from a withdrawal of liquidity is India, and that the country has replaced China as the biggest “underweight" in the region. Edited excerpts:

How much further downside do you see in Indian markets?

Well, under our worst-case scenario, the Sensex could hit 9,500. We have assumed that earnings could be cut by 20% from here. Also, ... we see the interest rate policy being maintained, (as) our economists (also) say, until the first quarter of the next (calendar) year.

This (the 9,500 level) is our 12-month target. However, we expect these to be met before the end of the year (calendar 2008) as these problems grow.

But it’s not just India. We expect similar declines in other markets in the region, particularly in China, sooner rather than later, for calendar 2009.

We have assumed that markets trade at true bear market levels, which for India is 11.5 times (price-earnings multiple). Which represents close to one standard deviation below its long-term average. All the markets in the region apart from Korea and India are trading close to one standard deviation below, or more than one standard deviation below their long-term averages. I see no reason why Korea or India should be any different from that.

One of the major issues I have with India at the moment... the interest rate policy is inappropriate. Earliest April 2009 (is when) we will see interest rates cut.

There must be some surprises that can force an upside review?

If the RBI changes policy and cuts interest rates, and if we did see index moving towards our target, and if the global situation improves, then we will definitely review our outlook on India.

However, there are four very big ifs—valuations, interest rates, the liquidity story and the global back drop. All four of them are scoring negatively in India.

The earning or the valuations story could improve in India, but when the index (Sensex) meets our downside target (of 9,500). If you look in China at the moment, there is one factor positive – interest rates. In Singapore, there are two – interest rates and earnings. Based on data today, China could be upgraded before India.

In other words, interest rates are cut dramatically, currency weakens further and inflation number picks up. That will still result in 9,500 (Sensex levels) in our mind. However, the medium-term outlook is very different. By cutting interest rates, you see some pressure coming off the corporate sector.

Overall, in terms of economic growth, India should be able to see an improvement in the second half of 2009, dependent on the global backdrop, of course. But I would interpret it very positively. That’s the essence of my view. Either way, the index is going to come down in my mind. Our view is 9,500. Whether it is achieved or not, you have to wait and see.

So, either the base case or the alternative scenario, the market will be under pressure.

What, to you, is the most crucial factor influencing market movement?

It all comes back to the issue of liquidity. Many issues we discussed in the report (McDonnell’s recent strategy report, where he recommends to ‘sell India’) can be traced to the global credit crunch and the withdrawal of liquidity in the emerging markets.

Whether it’s the index target itself, whether it’s our view on the corporate sector, whether it’s our view on the current account, it all goes to back to liquidity. And different interpretations of what’s taking place in the liquidity environment.

Specifically, our concerns center on three issues — (based on which) recently India has replaced China as No.1 underweight. Firstly, the current account deficit situation—the current account has been in deficit for a long time. That’s not news. The issue is liquidity (the second issue).

Liquidity in current account aspect refers specifically to the financing of the current account — the fact that India has a savings deficit. Savings as a percentage of GDP are 33%. Investments as a percentage of GDP are 35%. The gap there must be funded by foreign capital. And that capital, that liquidity, is globally at the moment being withdrawn from emerging markets.

So, as we saw in the balance of payments data that came out yesterday (1 October), the funding of the current account became a lot more problematic. Still, fully funded as we noted in our report. We don’t believe that India cannot fund its deficit. India can, but India does have an undue dependence on foreign flows, short-term flows, and as we saw yesterday’s BOP numbers, those numbers resulted in a substantial drop in BOP surplus for the last quarter ... specifically portfolio flows.

So, in the current environment, India stands out in the Asian context because India is the only market in Asia that has a current account deficit. And that is a significant issue at a time when investors are not willing to take any risk and adopt a fortress attitude. Emerging markets tend to suffer as a result and India is currently suffering disproportionately.

What I am talking about is already starting to be reflected in the market and discounted by the market. What’s interesting is the next step that we talk about. That’s something that two weeks ago would have been unthinkable. Today, we are seeing many commentators on the Indian market talking about RBI policy and how appropriate it is (the third issue). So that is also something that’s new or fresh in terms of our interpretation of what’s taking place. There’s general acceptance at the moment that India is at a little bit of risk.

So how did India outperform world markets these past few months.

From the valuation perspective it hasn’t come down like the rest of Asia. But the equity market itself is the worst performing market in the region. Down till last Friday (26 September) by 40%.

If you are referring to why the worst performing equity market in the region, why its valuations are in line with the long-term average, why it’s also not the worst, the simple reason is earnings.

Forecasts have also been cut (for earnings). So, if earnings remain unchanged, if you see a 40% correction, there is a potential — a lot of other factors do influence valuations — that India could be the most attractive market in the region. But the reality is that earnings have been cut. It has the effect of not making the market as attractive as one ordinarily given the drop.

What is your outlook on inflation?

Yeah, inflation still remains a problem. Everyone talks about the inflation rate coming down, but it’s still stuck at 12%. (As per the latest data, inflation rose 11.99% in the year to 20 September.)

The reason why I say that interest rate policy or monetary policy is inappropriate is because we believe that the RBI is repeating the mistakes made during the Asian crisis. The key mistake made during the Asian crisis was to maintain high interest rates as a way to try and support the currency and bring down inflation.

That policy proved unsuccessful. Why was it unsuccessful? Because it was throttling growth, wasn’t really having the desired effect on the exchange rate. It did achieve some goals on inflation but the key thing was it didn’t achieve the final target on the exchange rate and it was also throttling growth in the economy.

And very very soon after, within months, this policy was rejected.

Soon after it was established to be unsuccessful, authorities across the region cut interest rates significantly. The currency did weaken further, the currency was weakened anyway. And inflation did surge ahead. But thereafter, the important impact on the economy and the corporate sector was that the economy did not see as much of a drastic downturn that potentially could have been the case and the corporate sector received some relief.

So I believe that RBI is making the mistake of ... what is known as the Washington consensus towards monetary policy. And I believe the authorities should, as was the case with 1997-98, reject that and cut interest rates, except that the exchange rate and would weaken and except — most controversially — inflation would accelerate. Probably to 15% from where we are at the moment.

... The alternative is that growth will decelerate quite significantly. And on the corporate side, we have seen for the non-banking finance sector, what’s happening on the Mumbai interbank (rate) at the moment, they have been really squeezed quite dramatically. (Call money rates have shot up to 17.50%.)

That will peter out through the economy over time. Non-bank finance companies will have to pass on higher rates to their customers, and that will have a negative effect on the corporate sector ... see a pick-up in bankruptcy.

The main issue that Asia faces today is lack of liquidity. If liquidity issue is resolved, then a lot of other issues would tend to be cured.

What can lead to a resolution of this liquidity crisis?

This is about deleveraging in the financial sector. This isn’t about deleveraging in the corporate sector.

Previously, 1997-98 was about deleveraging in the corporate sector.

In terms (of) what would improve the liquidity environment, we have to look to Europe and the US for a stop to the rot in the financial system there, and only thereafter can we consider some improvement in the liquidity.

So, we are two places removed from improving the liquidity at the moment because the disease is still in place.

But the good news is that if they pursue the interest rate cutting option, given examples we have seen elsewhere in the region during 1998, the medium term will see significant improvement and also the currency comes back. Eventually. Within 12-18 months.

The lesson of the Asian crisis is that currencies do recover. There are also other positive benefits associated with this policy. That is the expansion of the export sector. Export sector in India is only 30% of GDP compared with 80% for other Asian countries.

Isn’t that a positive factor for India in a time like this?

It is a positive factor, I agree, having less exposure at the moment. But for the long term, it is inappropriate. It is unusual for an economy with such huge labour resources to have a small export base. I think that expanding that will have a potential of raising the growth rate of the economy and align it to the global cycle.

Where is the capital flying after the meltdown in the commodity complex?

The capital is clearly going to the US. We can say it confidently by looking at what is happening at the US treasury markets, where we are seeing a huge rally. Whether it is 3-year treasury bonds or the 10-year bond yields that have seen a huge drop in their yields. Flight to quality is primarily helping the US, and (to a) lesser extent, Switzerland and Singapore, in terms of the fund flows we have seen in the equity markets.

The outlook for gold is definitely attractive. It is a beneficiary of the flight to quality. But the global inflation scare is over and the commodity boom is clearly over. You can see that in the price of oil, the outlook of steel and other metals.

Does oil play any role in the direction of the Indian stock index?

In the case of India, the immediate impact of lower oil prices is not flowing through the WPI (wholesale price index). Looking at 2009-10, we are aware of the expansion from Reliance Industries in the gas side. The increasing oil supply domestically ... will help the current account deficit.

Next year, we expect the current account deficit to narrow but it is the short-term crunch that we need to be worried about. Good news in deficit next year will help rupee next year, not this year. Because of the liquidity story, people are not willing to discount any potential good news in the future. There is heightened risk aversion. So it is simply not possible to sell bull stories now. Investors do not want to hear those.

All that they want to know is how to protect money. In the past nine months nobody has made money. People want to minimize their loss; it is the reality.