The Hindu Business Line : Fear not the fall of the Sensex

The decline in the Sensex is due to a liquidity crunch faced by the global banks that are up against huge losses from the housing market and want to repay the loans taken from Japan at low rates of interest.

The current decline in the Sensex cannot be blamed on a lacklustre Budget. The stock market index had opened at a loss of about 600 points on February 28 morning, before the Budget was presented. It closed the day with a loss of about 500 points. Thus, the Budget, if at all, had a positive impact of about 100 points. The decline also does not appear to be due to a fall in the Chinese market which lost about 9 per cent on February 27. That market fell on rumours that Beijing was planning to curb speculation and impose a capital gains tax. The low opening of the Sensex on Budget Day was surely triggered by this fall in the Chinese market. But since then the Shanghai Composite Index has returned to its pre-February 27 level of 3000-plus. The Sensex too should have climbed back to its earlier levels if indeed its decline had been in sympathy with the Chinese market.

The true reason for the decline of the Sensex appears to be the liquidity crunch faced by foreign institutional investors (FIIs). Till recently global banks were borrowing at low rates of interest in Japan and investing the money in the US housing market. A small part of these funds flowed to India as also other economies. This happy situation was upset by the dollar going weak.

Fed to the rescue

The US economy had entered a bear phase when the dotcom bubble burst in 2001. The astute actions by the US Federal Reserve Board, which lowered the interest rate from about 5.5 per cent to 1 per cent, had saved the day for the economy. Low rates of interest encouraged US consumers to borrow and invest, especially in real-estate. The impact of the dotcom bubble collapse was made up by the induced buoyancy in the housing market. The low interest rates did not prevent the loss of jobs, however. More cars continued to be produced in Thailand than in Detroit. The cost of production remained high in the US because the low interest rates only partly compensated the high cost of labour. The competitive advantage remained against the US. The Internet economy moreover led to loss of jobs at call-centres, research, design and clinical trials. As a result, the US consumers were not able to make their mortgage payments. The problem was compounded by the growing US trade deficit.

The US exports are less than imports by about $600 billion. The US needs to import this amount of world capital to pay for the imports. While the low rates of interest created demand for goods, it also discouraged investment in the US Treasury Bills by foreign investors with the result that the deficit started to widen.

The Fed had to step in and raise the interest rates to encourage foreign investors to continue buying US T-Bills. This undid the efforts to raise consumption through low interest rates. Now, the US consumer is faced with two problems. On the one hand, he is losing his job and income. On the other, he faces higher interest payments on mortgages. The number of defaults is increasing.

Last year, California's ResMae Mortgage filed for bankruptcy giving up the struggle to cope with defaults; it had $7.7 billion in outstandings. HSBC issued a profit warning that its non-performing assets stood at $10.6 billion against $8.8 billion reported previously. Many other banks are faced with similar losses.

Dollar devaluation ahead?

Till recently, these banks were borrowing in Japan at low rates of interest and lending to US consumers at a hefty margin. That was all right as long as the rate of exchange remained stable.

But the loss of competitive edge and high rates of interest in the US economy are ominous signs of an impending devaluation of the dollar. Banks are, therefore, rushing to repay the Japanese loans before the dollar crashes. They face a liquidity crunch here.

It takes time to sell non-performing mortgages while the Japanese loans are to be paid promptly. Banks need funds now. The sell-off in the Indian markets appears to be precipitated by this liquidity crunch. This situation is likely to continue for a while till the US banks are to set their house in order.

It is likely that the US economy will go into a recession because the fundamentals are not exactly robust. But that will still not impact India adversely. The decline in the US economy has two opposite impacts on India.

On the one hand, its exports will be hit and the country stand to lose from that. On the other, a decline in the US economy and the fortunes of American companies are likely to lead to more FII inflows into India.

It should be remembered that the dotcom bubble in the US was accompanied with a bear phase in the Indian share market. Investors fled from the BSE to the Nasdaq. The reverse is likely to happen if US markets enter a bear phase. Investors are likely to dump US securities and invest in India to profit from the basic buoyancy of the economy.

It appears that the present decline in the Sensex is due to a liquidity crunch faced by the global banks that are up against huge losses from the housing market and want to repay the loans taken from Japan at low rates of interest.

This short-run scenario will be soon overwritten by the inflow of funds into the Indian stock markets to escape from a US downturn.

(The author, a freelance writer, can be contacted at bharatj@sancharnet.in)

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