Those of us who predicted a bottom for the financial markets earlier this year have reason to be contrite. The fall in asset prices over the past few weeks has been particularly vicious and financial markets, be they in India, Europe or the US, have seen new lows.
Between the middle of January and the second week of March, the Sensex has shed over 20 per cent. There has been a recovery in the equity markets over the last couple of days driven by news that American banks have fared better than expected in the current quarter. But this up-tick has all the makings of a bear market pull-back that could just fizzle out after a couple of days and bring a lower market bottom in its wake.
It might be worth your while to read my explanation of why I went wrong in my prediction. Some of it is pretty obvious. The hope and hype built up around President Obama's entry into the White House had lent some stability to the markets across the world in December and January.
I had expected that to sustain as the new president announced his fiscal and banking 'packages' and pushed these legislations through the US Congress. This hasn't quite happened. Instead, the markets have begun to fret about a number of things. For one, a badly haemorrhaging central and eastern Europe (that in the past guzzled credit from western Europe and, in turn, provided a growing market for the west's goods) has led to questions about the fate of European banks and indeed of the monetary union itself.
On the issue of the efficacy of the US fiscal package, no one seems to be too convinced that it is either adequate in terms of the money allocated to them or that it is focused enough on the right sectors that could drive a recovery.
Besides, there are a couple of ramifications of government action that are making the markets nervous. Let me focus on two of them.
After initially cheering the bailout of banks by governments, the market has suddenly woken up to the fact that government money means more control and that could mean politicians calling the shots for everything ranging from executive salaries to credit decisions. Markets have seldom felt comfortable with the heavy hand of the government and it is not surprising that the prospect of extensive nationalisation of banks and financial institutions has led to selling pressure in the market.
The other anxiety stems from the fact that bailouts cost money and the government will get this money by floating bonds. This has led to a sharp up-tick in government bond yields. As government bond yields have risen, they have pulled up corporate bond yields along.
Ironically, this has come at a time when these economies are entering a phase of deflation and deflationary expectations are building up. The result: real yields have gone through the roof. The AAA corporate bond yield in the US is trading at its highest level since 2002. My earlier argument that the thaw in the inter-bank market that became visible towards the end of November would translate into lower long-term borrowing costs seems to have fallen flat on its face.
A couple of things have happened as a result of the up-tick in real yields. High real yields have diverted funds from riskier asset classes like equities to the safety of the lowest risk bonds. They have also diluted the prospect of any recovery in 'physical' investment either in housing or no-residential assets.
The recent episode of asset sell-off has resurrected fears of the syndrome (at least a variant of it) that economist Irving Fisher discussed in the 1920s, referred to usually as the 'Fisher trap' in the literature. In its current avatar, it focuses on the rates of decline in asset prices and the rate of debt reduction or 'de-leveraging' if you like jargon. (Remember here that in the current scenario asset holdings have been built on large amounts of debt or leverage; de-leveraging sets off a fall in asset prices that encourages more de-leveraging and so the spiral goes). Economists argue that if the rate of decline in asset prices is lower than the rate of de-leveraging it would set a floor to both asset prices and the level of leverage in the system.
What is scary though is a situation when the decline in asset prices exceeds the rate of de-leveraging. As this happens, investors keep reducing their debt at an increased rate that then feeds a sharper decline in asset prices setting off a race to the bottom. Analysts argue that the last round of asset sales had all the makings of this sort of implosive spiral. To cut a long story short, equity and other asset value could keep going down on the back of another round of rapid reduction.
What is the way out of this mess? Central banks and governments are trying every trick in the book but this does not seem to be working. Perhaps they need to announce a cap for critical bond yields (10 year bond yields, for instance) and do enough open market operations to ensure that these caps are not busted. A combination of quantitative easing and explicit yield targets could work better in harnessing the rise in real interest rates than simply cranking up the money machines.
The other somewhat extreme option is for the central bank or government to actually start intervening directly in equity markets or the housing market. Recently there were rumours that the Japanese policy authorities would start this sort of direct intervention in the stock-market. If asset markets start melting down again and economies head towards a Fisher trap, this might just be the only option left for governments.
The author is chief economist, HDFC Bank. The views expressed here are personal.
