SUB PRIME CRISIS

Sub-prime and side effectsIf the US, which has a 25 per cent share of global GDP, slows down, it will definitely have an impact on the Indian economy. The next couple of months are definitely going to be crucial.Anil SinghviThe last couple of months, capital markets around the globe have been going through somewhat uncertain times on account of the sub-prime problems affecting the American banking industry. It now appears to be spreading to the UK as well. It’s a problem much bigger than it looks as it is more qualitative than quantitative.It is important to understand how the sub-prime problem is causing a great concern to the global financial markets and the recent decision of the US Federal Reserve to reduce the lending rates by 50 basis points had made it even more pronounced. Perhaps this was a rather surprise move, and Wall Street has taken this as a pointer towards a stock rally.Since last Tuesday, all stock markets worldwide have rallied on account of this announcement by the Fed. A similar situation is prevailing in India as well, where, in just four trading sessions, our benchmark index, the Sensex, has gone up about 1,000 points. One fails to understand this euphoria in global equity markets and, more importantly, how this is benefiting the Indian growth story for the stock market to rally the way it has.But, first, let us examine how the sub-prime crisis is likely to affect the confidence of global markets in the months to come. The last few years, global markets have been awash with excess liquidity — a classical problem of plenty that created hyper-valuations for all asset classes and, more significantly, for real-estate in the US. The declineAs interest rates started falling due to excess liquidity, house prices started rising rapidly, creating a pool of wealth in the hands of Americans, which they unlocked by contracting mortgage loans. It benefited them in two ways — they got huge liquidity at inflated housing prices and at interest rates that were practically lowest in the last 20 years. This became a virtuous cycle, resulting in a very high consumer spending and obviously fuelling global growth.As interest rates started rising in the US due to inflation concerns, this virtuous cycle came to a standstill and the demand for houses started tapering. This resulted in lower prices for houses and many were unable to cover the mortgage loans. It has now hit the entire banking industry in the US and the virtuous cycle is becoming a vicious cycle.The excess liquidity is slowly evaporating and premium on risk is reappearing. It has started causing problems for Americans in the form of job losses, less consumer spending and the fears of a slowdown, if not recession. A similar situation may develop in the UK, where housing prices during last five years have risen very rapidly, creating a wealth effect just as in the US. But prices there have now started correcting. This has a contagion effect and we may see a huge write-off by banks doing business in the US and the UK.Implications for IndiaWhat does all this mean for the Indian capital market? To my mind, this will reduce the flow of capital coming to the Indian stock market. India was always considered one of the robust emerging markets, but definitely with certain political and economic risks.These risks, in recent times, were not priced into equity valuations as the excess liquidity was chasing emerging market exposures and India became the investor’s darling, after China. Now, with the sub-prime crisis, excess liquidity will vanish and the market will correct for the price of risks. Now let’s look at domestic fundamentals. Indian markets will see a correction on account of high oil prices, high interest rates, slowing down of exports on account of the slowing down of the US economy and rupee appreciation. This will definitely have an impact on the GDP growth rate.The stock market has, in the recent past, rallied largely on account of global cues and has almost completely ignored the local issues. With liquidity drying up, the market will now focus on local issues, including political uncertainties and corporate earnings. It is natural to expect that, finally, fundamentals will rule over technicals, and the market will look at ground realities.We saw that the July 2007 IIP numbers were much lower than expected. And we are seeing a slowdown in the automobile sector, some slowing down is already being witnessed in the real-estate segment and, with exports coming down, it will not be too long before we see the same in textiles, jewellery and other areas as well.We are yet to hear the last word on the sub-prime issue. Uncertainty in the global markets on this issue is similar to the case of Enron. Everyone knew there was a problem but nobody knew where it was until Enron went belly-up.Perhaps a similar story will unfold in the next couple of months for these lenders who have lent big money into the sub-prime markets and one or more banks will fold, just like Enron did, resulting in a huge crisis of confidence.It would be naive to wish away this major problem inflicting global markets and to presume that the Indian market is decoupled. If the global super-tanker, the US, which has a 25 per cent share of global GDP, slows down, it will definitely have an impact on the Indian economy.The next couple of months are definitely going to be crucial and the best course of action in these uncertain times should be ‘wait and watch’.(The author is Managing Director, Ican Investments Advisers Ltd., Mumbai.)
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