The biggest risk to the recovery

The unemployment rate in the US is at 8.5% and the last six months alone saw 3.7 million job losses. National income is shrinking in much of the Western world. US GDP for the first quarter of 2009 shrank 6.1%. Credit flow remains weak and car makers like Chrysler and GM are either filling for bankruptcy or radically scaling down their operations.

Some large American banks did post profits in first quarter of 2009 that were higher than expected but much of the improvement was just accounting smoke and mirrors. A number of them are still technically insolvent or desperately need capital. Default on loans, particularly retail loans is rising. The likelihood of another banking crisis on the back of spiraling credit card delinquency in the US or large scale bankruptcy in one of the central European economies (European banks had financed the credit fuelled growth bubbles in these economies) remain high. The IMF estimates that cleaning charges for global banking system will come to about $4 trillion and a large significant portion of the bill of the bill remains unpaid.

The biggest risk to the recovery going forward stems, ironically enough from the fact that governments are pulling out all stops to get their economies going. This essentially means two things. Budget deficits are climbing sharply and central banks are sweating their note printing machines. High budget deficits have to be funded and governments are borrowing huge sums in the bond market and will continue to do so. If private demand for credit picks up, the competition between the private sector and government will push up interest rates and might make it unviable for a number of private investors to borrow. Thus the necessary conditions for textbook crowding out are in place.

Economists also tend to fret over the large quantities of surplus cash sloshing around in the financial sector. This breeds the risk of a sharp in inflation at the first confirmation of a recovery Lenders would expect to be compensated for this and thus this could also lead to harder interest rates. The bottom line is that interest rates could poop the party just as things begin to perk up a little.

Let me cut to the chase and offer my view on what’s likely to happen. The worst of the global financial crisis is over. We now have systems in place (both monetary and fiscal) that will stem the panic even if another wave of bad news were to wash ashore. Economies too are close to a bottom and the recent traction in stock markets is reflecting the hope of post bottom recovery. Inflation and interest rates might move up a tad at the whiff of a recovery but are unlikely to derail things completely. However the recovery will neither be quick nor large. We might be in a period of slow mend where economic data continues to be weak for the next couple of years but every new month or quarter shows improvement at the margin.

Indian markets hinge on how global fund managers are likely to manage their international portfolios in the current environment. At the risk of sounding repetitive, this has essential features. One, the perception that the worst is over for economies and the financial sector is driving an improvement is risk appetite. Thus, money managers are no longer content to hold cash or low return US treasury bonds and are seeking higher yields. Second, even if the worst is over, the developed economies of US and Europe will remain sluggish and perhaps even contract some more before a sustained recovery sets in.

The logical strategy, given these two somewhat conflicting factors, is to seek markets that are less dependent on the global business cycle and are thus likely to post better growth and profit figures. India is an obvious candidate with a domestic consumption driving 60% of GDPO. Thus, there is more to the current rally in the sensex and the Nifty than just a technical adjustment following months of battering.

This does not mean that the sensex is back on a one way street. It is quite likely that indices will shed some of their recent gains before rising again. Markets are expected to remain volatile but the trend is likely to move north over time. But the headiness of 2006 and 2007 is unlikely to return in a while.

Real GDP forecast in Key Economies
(In Y-o-Y %)

2009 2010

Global economy – 1.3 1.9
US -2.8 0
Japan -6.2 0.5
Euro area -4.2 -0.4
Germany -5.6 -1.0
France -3.0 0.4
Italy -4.4 -0.4
UK -4.1 -0.4
Developing Asia 4.8 6.1
China 6.5 7.5
India* 6.5 5.8
Russia -6 0.5

Fiscal Deficits as percentages of GDP:

2009 2010

United Sates -10.2 -11.9
Japan -6.8 – 8.4
Germany -4.5 -6.8
France -6.6 -8.3
Euro area -5.4 -7
United kingdom -12 12.5
OECD countries -7.2 -8.7
India 6.0 6.5

Policy rates (All figure are in %) as on May 5, 2009:
Country Benchmark Jan 09 Current

US Fed Funds rate 0-0.25 0-0.25

Europe Main refinance rate 2.0 1.25

UK Official bank rate 2.0 0.5

Japan uncollateralized overnight call rate 0.1 0.1

South Korea Bank of Korea base rate 2.5 2.0

Australia Cash rate 4.25 3.0

India Repo rate 5.5 4.75

India Reverse repo arte 4.0 3.25 —

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