The proposed bailout of the US financial system has already had a soothing effect on markets. The credit markets have eased, credit derivative indexes have tightened and stocks have rallied across the world. The question is: Will it last?

The $700 billion (Rs32.4 trillion) draft proposal put up by the US treasury will buy up dud assets from banks. That should infuse confidence back into the financial system, allowing the crucial inter-bank markets to start working. But while there is a guarantee that bad assets can be offloaded to the US treasury, much will depend on the price at which these can be sold. If the prices are not high enough, it could involve more write-downs in the banks and the need for more capital. If the banks are unable to raise capital from the market, then it’s possible that the government may have to step in to recapitalize the banks, just as many banks in India were recapitalized in the 1990s. But at the moment, confidence has returned to the financial markets, with the effective Fed funds rate at 0.75% in late trading on Friday, well below the 2% target rate, indicating plenty of liquidity.

Also SeeRescue Effort (Graphic)

The underlying issue is one of lower housing prices in the US, which will possibly be addressed by the recently nationalized mortgage banks Fannie Mae and Freddie Mac buying up mortgages. As long as the decline in house prices continues, however, mortgage-related assets on the books of the banks will suffer and may need to be offloaded to the new government asset management company. The process is going to take a long while, which is why the treasury has proposed a period of two years for the bailout. There will be uncertainty till the whole plan is finalized and even after it is being executed. And, there’s always the worst-case scenario of the US going the Japanese way.

Further, the plan as it now stands has no penalties for the bankers which have been instrumental in bringing the system down on its knees. Nobody is being sacked and the boards of the banks will remain in place. Such a course of action not only smacks of crony capitalism — Henry Paulson, the US treasury secretary, is a Wall Street insider—but sets up all the incentives for indulging in a repeat of the kind of behaviour that got the system into such a mess.

Moreover, all the plan does is staunch the bleeding. Asset prices have been marked down in the panic and the restoration of confidence should help more rational pricing. But, while the expectation is that banks will slowly start lending again, going back to the euphoria of the past few years is out of question.

In other words, while a bottom may have been put in place by the mother of all bailouts, risk aversion is unlikely to go back to its earlier levels. That means, the profusion of liquidity that buoyed asset prices across the world during 2003-07 is a thing of the past. That will hurt emerging markets, including India.

There are also larger macro questions involved. While the US treasury is bailing out the banks, who will bail out the US? In recent years, prosperity in the US has been the result of debt-fuelled consumption and the debt to gross domestic product ratio has been hitting new highs. Many feel that a period of de-leveraging will be good for the system, purging it of excesses. But if, as George H.W. Bush put it in 1992, “the American way of life is not negotiable", then we’re sure to see another bubble before long. America is, as many economists have pointed out, dependent on the kindness of strangers. But will the Chinese and the Arabs continue to bail out America?

Nevertheless, analysts have often compared the cycle in the markets with the five stages of dealing with grief. These are “denial, anger, bargaining, depression, acceptance". After the events of the last week, it’s doubtful if there’s anybody left who is still under any illusions regarding the staggering scale of the current crisis. We seem to be now entering the “acceptance" phase, which indicates the worst may be over.

Impact of the rescue act on Indian markets

What about the Indian market? There’s a big risk to which our market in particular is exposed to, the risk of inflation.

With the US government expanding its fiscal deficit, many expect a process of reflation. Derivatives expert Satyajit Das had mentioned to this columnist last January that the US would try and reflate its way out of the mess. Writing in June 2003, at a time when the huge boom of the last few years was just beginning, Marc Faber had this to say: “I wish to emphasize that if the inflationists, who are now, under the leadership of the Fed, in control of central banks around the world, have their way, a very dangerous economic policy course will be followed. This will result eventually in sharply rising inflation rates and a much lower US exchange rate, and will bring about a disastrous global recession, which could threaten the capitalistic system as we know it today."

And, if the fiscal largesse of the US government leads to a weaker dollar and to inflation, that would mean oil and commodity importers such as India would be badly hit. That would be even more so if other countries (especially the UK, which has a bursting housing bubble similar to that of the US) follows the US example and decided to bail out their banks as well. Nevertheless, it’s worth pointing out that despite the welter of bad news from the US last week, the dollar index has remained relatively stable, probably the result of safe haven money flowing back to the US.

India, like other emerging markets, has been the beneficiary of very low cost of capital. With liquidity scarce, that is going to change. It’s important to remember, however, that foreign direct investments (FDI) remain robust and that the recession of the early 1990s had no impact on FDI outflows from the US to developing Asia, unlike portfolio flows which turned negative. In short, as the International Monetary Fund deputy managing director John Lipsky said in a recent speech, “Put simply, emerging economies cannot defy gravity in an increasingly multipolar world. Still, they can exhibit some important degree of resilience. Activity gains in these economies are decelerating, but growth still is expected to remain near trend."

But even resilient economies have to go through the business cycle. As a fund manager said, Indian companies have had rates of profit growth far above that of GDP in recent years. It’s now time for some mean-reversion.

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