People's Democracy

ECONOMIC NOTES

Whimsical Investors And Volatile Markets

C P Chandrasekhar

AT then end of May, the good news in the US is that the news was not as good as expected. Some analysts had predicted that the first revision of the preliminary estimate of GDP growth during the first quarter of 2006 would take the figure from 4.8 to 6.2 per cent. If growth was running as high as that, the Fed was expected to cool the economy by raising interest rates. This was because, in a global environment where high oil prices were already raising costs and prices, buoyant domestic demand would result in inflation that the monetary authorities would be forced to contain.

There appears to be a consensus that this expectation of a possible rise in interest rates had resulted in a retreat from speculative investments in equities. The result was the downturn in stock markets, initially in the US and then across the globe, with emerging markets like India, Indonesia, Russia, South Korea, Taiwan and Turkey being hit hard. So when data released on May 25 placed the revised first-quarter growth rate at 5.3 (as opposed to 6.2) per cent and news was out that consumer spending and the US housing market was cooling, “investors” ostensibly heaved a sigh of relief. According to the financial press, the pressure on the Fed to raise interest rates was seen as clearing, allowing for a return to “normalcy” in markets after what would be a mere correction and not a meltdown.

SYNCHRONISED MARKET MOVEMENTS

What needs to be noted is that while the figures at issue are GDP growth, consumer spending and interest rates in the US, the market movements being referred to are global. This is because the evidence makes clear that market movements across the globe are now synchronised. When the downturn occurs it is generalised worldwide, and when the recovery begins all markets catch up. The old-fashioned idea that investors include instruments from different markets in their portfolio of investments in order to hedge their positions is no longer true, since such hedging is possible only when markets do not move in tandem.

One factor that accounts for the synchronisation of market movements is that a few, large global players, which control a disproportionate share of the funds available for investment, invest in and drive all markets. Since these financial entities tend to behave in herd-like fashion, rushing together into particular markets and instruments when the going seems good and withdrawing together when uncertainty strikes, their decisions determine the buoyancy or lack of it in most markets.

Not surprisingly, in all the emerging markets the downturn since the middle of May and the collapse on May 22, 2006 were related to withdrawal of investments by foreign investors. According to the Financial Times (May 26, 2006), about $5 billion of foreign funds had flowed out of Asian emerging markets over the previous week, with around three quarters of it coming from South Korea and Taiwan. The other market to be afflicted badly by this syndrome was India. By May 26 the Mumbai Sensex had fallen by as much as 16 per cent relative to its May 11 peak. Foreign institutional investors are estimated to have pumped in $10.7 billion into India’s markets in 2005 and a further $4 billion this year. So when they decided to pull out around $550 million over four days in mid-May, a sharp downturn ensued.

THE REAL QUESTION

Thus the real question is: why should the danger of higher interest rates in the US weaken sentiments in equity markets worldwide, resulting in the generalised downturn in global markets? In particular, why is the US market affected adversely? In the past, a rise in interest rates in the US was seen as a factor that would trigger a rise in American capital markets as it would result in a rush of capital into dollar denominated assets, by improving the relative return of investments in the US. 

However, for some time now this positive relationship between US interest rates and capital flows to the US has not held. Throughout the recent period when US interest rates were easy, dollar denominated assets were preferred by investors as a safe haven, given the confidence in the US economy and the dollar, which remains the world’s reserve currency. Capital kept pouring into the US, triggering initially a stock market boom and, subsequently, because of their role in keeping interest rates down and rendering credit cheap, a housing market boom.

It has been held for some time now that, because the stock and housing boom stimulated by capital inflows inflated the value of assets owned by Americans and therefore of their past savings, US residents were encouraged to spend more of their current incomes on consumption and even to borrow to finance their spending. The result has been a collapse of household savings rates to negative levels. The obverse of this trend was buoyant domestic demand that helped sustain a creditable rate of GDP growth, despite the leakage of demand abroad reflected in larger imports and significant trade and current account deficits in the US balance of payments.

It could, therefore, be argued that if interest rates go up making borrowing more expensive, the domestic consumer spending and housing boom could be quickly reversed, resulting in a slow down of growth in the US and a loss of faith in the strength of the US economy. To the extent that this could adversely affect investments in US assets, the fear that extremely high rates of growth in the US or excess speculation in the housing markets could force the Fed to raise interest rates, is seen as setting off shivers in stock markets as well.

The difficulty with this argument is that if it were true, then the downturn should have been restricted to US stock markets alone. In fact, the exit of investors from the US should have been accompanied by a shift to other markets, which should have attracted more investments and witnessed a boom. Thus, the fact that the recent boom and slump were synchronised makes the argument linking the downturn in the US market to the likely adverse effects of higher interest rates on domestic demand and growth an inadequate explanation of global trends.

One way in which the relationship between interest rate expectations and the synchronised downturn could be explained is to trace the link between the preceding synchronised boom in global markets and low interest rates. The boom seems to have been triggered by a few major players. If they were making debt-financed investments in shares with already inflated values in the expectation of attractive short-term returns, then the threat of interest rate increases could encourage such speculators to unwind their investments, triggering a downturn. And if it is the same set of investors who are driving markets worldwide and they are adopting similar strategies in all markets, then the unwinding of debt-financed investments would occur in more markets than one, resulting in the generalised downturn witnessed recently.

CURB SPECULATIVE BEHAVIOUR

These developments once again raise an issue that has been a source of controversy in the past. The US Federal Reserve and central banks elsewhere have always been concerned about commodity-price inflation but not asset-price inflation. The Fed has in the past been unwilling to raise interest rates to dampen speculative price increases in stock and even real asset markets, while holding that its principal role is to rein in inflation. The indication that the threat of an interest rate hike as a result of developments in commodity market triggers a downturn in equity markets, makes clear that central banks must play a role in using the interest rate to curb price increases in asset markets as well in order to prevent a speculative bubble that can burst with damaging consequences for real economies. 

Closer home, the above developments make clear that all talk attributing stock market volatility in India to the inadequacy of “reform” or the obstacles to reform set by Sonia Gandhi or the Left is that much nonsense. The Indian market is driven by global decisions, which in turn are determined by the speculative activities of key investors the government seeks to attract. Once we recognise that financial volatility is the result of the speculative behaviour of these firms, measures to reduce the presence and influence of these investors seem to be the need of the day.