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Will the tide turn for the stock markets?

Posted by malvika15 on Monday, 3 November, 2008

 

The US Fed rate cut has acted as a tonic for the stock markets. The Asian stock markets rallied on Thursday last in response to the coordinated action by many central banks across the globe.

The US Fed cut its benchmark rate by 50 basis points on Wednesday, a move widely expected by the markets. This cut brought them to the same level the interest rate had reached in 2001 under the former Fed Chairman Alan Greenspan.

This cut was preceded by China’s rate cut by 27 basis points and was followed by rate cuts in Hong Kong and Taiwan. Japan’s central bank cuts its rate to 0.30 percent on Friday, its first cut in seven years.

 

Fund crunch is the issue

Despite the warm welcome given to this monetary measure, it’s debatable whether the reduction in interest rates will address the current crisis. The current problem is not about cost of funds but about lack of funds at any cost.

The problem lies in the fact that banks have stopped lending. They are saving up their cash waiting for another wave of bad loans to come, as the economy gets worse. As the data released in the US shows that it is technically in recession, its GDP growth declined by 0.30 percent in this quarter. The US could even someday lower interest rates to zero.

The economic theory behind zero rates, called quantitative monetary easing, is a toll with which the central bank focuses on money supply instead of the cost of the money, i.e., interest rates to induce growth in the economy. Japan’s experience about zero interest rates has been unproductive. Japan has spent five unproductive years at zero between 2001 and 2006, and since then has increased its rates to 0.50 percent till Friday’s cut of 0.20 percent.

Lifeline for emerging markets

A development, which is more significant than the reduction in rate, is the announcement that the US Fed would temporarily supply new lines of credit worth up to $30 billion to the central banks of South Korea, Brazil, Mexico and Singapore.

Under the agreements, the Fed will provide US dollar funds of up to $30 billion to the central banks of these countries, in exchange for their respective currencies. These countries were facing an acute the shortage of dollars in their domestic markets as foreign institutional investors (FIIs) sold their investments and converted it to dollars to take it back home.

International banks and institutions that had lent to companies in emerging markets in dollars were calling back their loans. Loans that had come up for rollover rolled over at higher costs or requested to be paid back. Many companies had not foreseen sudden withdrawal of funds and experienced severe liquidity problems.

Countries that had low foreign exchange reserves in dollars were ill prepared for the sudden surge in the demand for dollars. It is these countries that the new credit lines intend to help. The credit line of dollars from the Fed is available up to April 30, 2009. The rally was more pronounced in countries that are in the list of countries in the Fed list like South Korea and Brazil.

Lesson for us

Can India be in the same boat soon? May not be so due to the Reserve Bank of India’s (RBI’s) highly conservative policies. However, the drastic reduction in capital inflows from USD 110 billion in 12 months ended March 2008 to about to USD five billion or so now can have a significant impact on liquidity.

Capital inflows had supported the domestic credit growth from USD 150 million in March 2003 to about USD 575 billion now. As capital inflows came in, the real interest rates declined, leading to a strong credit growth and investment cycle.

But now, capital inflows have declined to a trickle and we can see its effect on domestic liquidity in the form of higher cost of borrowings and acute shortage of funds.

Domestic companies are facing liquidity issues due to a shortage of funds in the domestic markets as they try to raise funds locally to pay off their dollar debts. The sharp depreciation in the rupee to the extent of almost 25 percent led to a dramatic increase in the quantum of dollar denominated borrowings. If companies are not adequately hedged against external liability, the borrowings would have risen by 25 percent over the last nine months.

Moreover companies are exposed to different contracts whether in commodities or in exchange rate for exports, or for hedging of external liabilities.

Hence, corporate balance sheets are going through massive disruptions in this quarter. The extent of damage due to exchange rate fluctuations on the corporate balance sheets will be known when the December quarter results are declared.

However, you can rest assured even if the run on the dollar is very severe, the RBI’s massive foreign exchange reserves will prevent India from seeking a credit line from the US.

 

Source: The Economic Times 

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