Has the party begun?

Debt servicing, dollar appreciation, and liquidity will determine the sustainability of global recovery

What would be the reaction if a fund manager promised investors to double their money in exactly a year’s time? The offer would be dismissed as a ponzi scam, or one of those dubious chit funds based in Uttar Pradesh and West Bengal. There was also a possibility of Sebi cracking down if the scheme was sponsored by a mutual fund or the Reserve Bank of India hauling the promoters if it was run by a non-banking financial company. Yet, this is what investors would have earned if they were to invest in an index fund on 9 March 2009. From a low of 8,160.40, the Sensex has risen over 100% since then. It is a moot point how many would have ventured into the market at that point of time, when seemingly sturdy financial institutions in the developed world had crumbled under the weight of non-performing assets, credit had dried up, and the backlash of debt default by even tiny nations such as Iceland could be felt around the globe. Though governments were announcing stimulus packages and central banks were pumping liquidity, only the brave could bet that the market had bottomed out at that juncture. There could not be a more stark contrast today to the bleak outlook a year ago. Despite the problems of excessive spending persisting in some pockets of the European Union, major economies except perhaps Japan are on the path to recovery. From Wall Street to Dalal Street, the markets have bounced back. Many governments are debating when stimulus should be rolled back rather than if it should be. Some like India have already begun the process. Central banks from Australia to China and India are tightening money supply.

Is the worst behind us? As Dubai and Greece have shown, it is foolish to become complacent. This is one of the important lessons of the global financial market meltdown, which had its roots in the belief of mortgage lenders and borrowers that home prices will always go up, commodity investors that oil could stay above $100 a barrel as China and India rack up above 7% growth rate, and hedge funds and private equity investors that P/E of 20 and above would be the norm as markets scaled new peaks. The markets appear have factored in these concerns as is evident from the recurring volatility. The cycle of market spurts followed by profit-booking is getting shorter as investors seem reconciled that another Lehman Brothers is waiting to implode. That even small countries have the potency to disrupt economic activity has increased the uncertainty. Last year’s financial crisis has exploded a myth that countries like China and India, with large domestic markets, were decoupled. The health of the US economy though is going to be keenly watched, particularly employment data and fiscal deficit. Apart from being the largest consumer market for the world’s exports, it is an important financial market to raise capital. Most countries’ reserves are also held in dollars.

A moderately strong dollar aids China’s exports and India’s requirement of capital. It is, hence, important for the consolidation of global recovery that the US bounce-back is quick and sustainable. This will happen if China allows its currency to appreciate. Yet, the liquidity flow to emerging countries could pose as much a hurdle for recovery as anemic manufacturing in the US. Just as the turning off of the credit tap squeezes companies implementing expansion and derails the infrastructure roadmap of countries like India, too much liquidity leads to the creation of asset bubbles and inflation could puncture not only domestic growth but also slow down global expansion as these regions flirt with capital controls. Foreign capital took a flight and markets suffered a setback on Brazil’s tax on foreign portfolio investment. Poised to follow suit, the eruption of the debt-default crisis in Greece and slowing of foreign inflows as a result buffeted India. Despite foreign capital being a function of global recovery, it also hinges on the recipient country’s fiscal health. Large deficits require the government to borrow from the market, pushing up interest rates and pushing off companies in need of credit. The current round off PSU disinvestments is crucial for the government to mop up resources to fund social welfare programs without enlarging deficit. So far, the track record has been mixed. The good response to share sell-off at the end of calendar year 2009 did not spill over to the FPOs of NTPC, REC and NMDC in 2010. Hopefully, good southwest monsoon will keep the market mood bullish to realise the government’s PSU divestment target for 2010-11 and consolidate India’s growth.