It’s rather grim out there

The uncertainty prior to the looming Lok Sabha polls, an impending earnings collapse and the impact of pursuing unsustainable business models do not afford much scope for the market to recover soon, says U R Bhat

OVER the last five months inflation has fallen from a near 13% level to less than half the level now and economists of all hues have a rare consensus view that it will moderate further to near 2% levels over the next few months. In tandem with this, market interest rates have also collapsed with the10-year gilt quoting at a yield of under 6%, a steep fall from the 9.5% level obtaining five months ago. The Reserve Bank of India has pumped in liquidity in excess of Rs 200,000 crore into the system during this period and signalled a soft interest rate regime leading to banks beginning to trim interest rates. The economic stimulus initiatives announced by the government covering indirect tax cuts, increased social sector spending and making credit available to infrastructure creation, commercial vehicles, housing and exports are expected to soften the impact of the economic slowdown.

There is no denying that the government and the RBI have been proactive in dealing with the consequences of the economic slowdown. Falling interest rates should help banks post substantial gains on their investment book in the December 2009 quarter and coupled with market valuations that have corrected steeply over the last one year, several market participants believe that there is a case for a sustained rally in the Indian equity markets in 2009.

It is useful to analyse the potential impact of the recent monetary and fiscal measures on the likely course of the equity markets in 2009. Soft interest rates and increased liquidity need to be seen as only two of the several factors that can influence investment or the willingness to borrow. For a potential house buyer, in addition to the confidence that he will continue to be gainfully employed over the next couple of decades or more, the price-rent-EMI (equated monthly instalments) equation needs to be in his favour to enable him to decide on a purchase.

A commercial vehicle operator would look to expand his business based on an assessment of the interplay between factors like freight rates, maintenance costs, traffic potential and vehicle acquisition costs in addition to financing costs and the level of depreciation allowable for tax purposes. Similarly, for a corporate contemplating new capacity creation, in addition to low enough interest rates, what is critical is the confidence on optimum capacity utilisation once the capacity is in place. For a commercial bank, in addition to lower deposit costs, what is critical is the ability to lend at rates that adequately price the risks relating to the economic environment and the capacity of the borrower to service the loan. In short, a low enough interest rate environment can hardly force entrepreneurs or house buyers to borrow or for banks to lend unless there is enough confidence in favourable economic outcomes in the future.

The inability of the system to quickly translate abundant liquidity to increase bank lending at money market related interest rates to all sectors of the economy can therefore be seen to be caused by a rational assessment of the bleak prospects of most businesses in a slowing economy. In addition, a network effect is at play wherein the working capital cycle is influenced by the flow of credit to all the parties involved, whether the vendor, the manufacturer, the service provider or the customer. If the financing needs of one or more in this chain are unmet owing to credit or solvency-related concerns, the working capital cycle comes to a grinding halt resulting in potential losses to other credit providers.

MONETARY policy measures typically work in long cycles subject to the financial transmission mechanism remaining efficient. As long as banks remain fundamentally sound, lower funding costs would eventually lead to credit creation and rise in investment that should ultimately result in accelerated economic growth. The return of business confidence can facilitate this transmission mechanism but pending this, given the seriousness of the current impasse, it may be necessary for the authorities to go beyond providing liquidity by way of refinance and even interest subventions and consider some form of credit enhancement or risk sharing.

In the international context, it is obvious that a deep synchronised recession is casting its ugly shadow on the industrialised world. Deleveraging is the dominant theme in the global financial markets and for the over-indebted households in the US, this means a dramatic change in their spending habits from unbridled consumption to building up savings. For the large number of undercapitalised international banks, deleveraging requires them to substantially shed assets and garner more risk capital, possibly from the respective governments.

These processes by their very nature are slow and therefore it is reasonable to expect that a sustained global economic recovery is quite some time away, at least not until 2010. Against this background of painful deleveraging, including the near collapse of the hedge fund industry, risk appetite is unlikely to rise any time soon. Our expectations of fresh inflows into the Indian equity markets need to be seen in this context.

Given that foreign portfolio investments, on the margin, have been the important determinant of market direction, the implications for the Indian equity markets in 2009 are obvious. It is also fair to expect that the magnitude of the global meltdown in 2008 and its transmission into India through the channels of trade and investment would leave behind a longer trail of corporate defaults than we have witnessed thus far. This in turn would eventually leave a mark on the health of the banking system, albeit with a lag, despite some deft tweaking of the NPA norms.

As they say, it is only when the tide turns that you know who was swimming naked. Bernie Madoff and Ramalinga Raju are unlikely to be the only ones found doing this. The increased uncertainty prior to the parliamentary elections looming large, an impending earnings collapse and the impact of pursuing unsustainable business models even among several large businesses do not afford much scope for the market to recover strongly any time soon.