A better New Year ahead, politics permitting

It is the time for New Year resolutions. There are plenty to suggest for the Indian government. For starters, the ruling coalition could give us a government of, and for, India. It raced against time to push through the constitutional amendment to reserve seats for SC/ST and minorities in unaided educational institutions starting from schools?one of the most retrograde measures in recent times. The same government is quite sanguine about the rising spectre of violence by internal and external terrorists.

Earlier this year, the government announced its intent to convert Mumbai into a global financial centre. Yet, recently the state government in Mumbai?led by some of the same coalition members that hold office at the Centre?backdated a law to defeat the court?s sincere attempt to facilitate the stated objective and allowed legalisation of illegal structures in Mumbai. It takes little imagination to guess the fate of the eviction drive in New Delhi. With three more years of malignant intervention, metropolises will be on their way to becoming mega and messy slums.

Yet, the Indian stock market has doubled since the ex-post coalition assumed office in May 2004. This partly reflects investor confidence in the country?s structural prospects bettered by two decades of economic reforms, carried out with minimal conviction, and even less articulation and public participation.

Conversely, one could argue that over-complacent investors are ignoring the structural perils a soft state implies and lack of further reforms entails. Fund managers concede, some publicly and some privately, that the valuation in the Indian stock market is now in bubble territory.

Indeed, it can be argued that the biggest risk to global stock markets in 2006 is not economics but politics.

The economics first: despite the significant run-up in the price of energy sources, inflation in the developed world has remained at low levels. This has allowed their central banks to gradually increase short-term policy rates in response to improving economic growth conditions. This, in turn, has meant long-term interest rates remain low relative to history, sustaining asset valuations.

Gradual policy tightening in the developed world has, so far, allowed developing countries to sustain relatively stable exchange rates and interest rates, thus sustaining their asset price booms.

These conditions could be bettered in 2006. Even if the US Federal funds rate rises to 5%, despite the marked reluctance of the markets to price in such a possibility, it is unlikely to cause anything more than temporary volatility in global financial markets. Further, Japan looks set to continue with its zero interest rate policy as its economic recovery is proceeding at a very unthreatening pace. Thus, the yen is likely to be a source of carry-trade?a role that the US dollar performed in 2003 and in 2004?at least in the first half of the year. Hence, financing costs would remain tolerable for borrowers globally.

China, now that it has deployed the statistical sleight of hand to better its economic status, can legitimately be pressured to revalue the currency. Americans would not be found wanting in that. Another round of yuan revaluation could be expected in the first quarter of the New Year. If not, protectionist rhetoric from the US could turn into reality. Either way, China should brace itself for lower growth, which would be a boon for the rest of the developing world.

China?s growth, as this column has often stressed, has sucked global resources and raw materials, making it difficult for others to grow. Any slowdown there would cause global commodity prices?particularly that of energy?to drop towards their equilibrium levels.

Further, the rise in the value of real assets?commodities?was anticipated, including by yours truly, as a possible counterweight to the implosion in global financial assets that American credit creation threatened. With America posting sustainable economic growth over the last four years underpinned by still-strong productivity trends, one concedes such a risk has diminished considerably. Global financial system risks are weaker than anticipated in 2004 and in 2005. Indeed, this makes any prediction of further rise in gold prices difficult.

Thus, the scenario for 2006 could hardly be more favourable for sustaining recent corporate profitability trends, both in the developed and the developing world. After a difficult start, perhaps, globalisation is beginning to live up to its billing?it?s a win-win situation.

There are two principal risks to this benign scenario. One is that this has almost been fully incorporated in consensus forecasts. Second is that this scenario could be threatened by politics almost everywhere. In the US, the incumbent could be emaciated by protectionism and the rise of Left-democrats in the Congressional elections. Elections in Brazil could undermine political stability there and the risk of financial market contagion, in its wake, cannot be ruled out. Political transition is crucial in the UK, while the true test of the grand coalition in Germany would be in sustaining growth while striving for improved public finances. China might refuse to play by international economic rules with respect to its currency, which might exacerbate global trade tensions. Of course, the world has to be watchful about a maverick Iran on the nuclear threshold and political stability in Iraq. Any, or some of these, could adversely affect the global economy.

In the New Year, global stock markets could have a volatile start, followed by a return of stability and gains in the first half. The second half could be marked by a return of volatility and meaningful corrections if politics trumps economics. If the latter prevails, then the author would be happily reduced to warning about similar risks for 2007, while most of the world?s poor became less poor and investors got wealthier in 2006.

?The writer is the founder-director of Libran Asset Management (Pte) Ltd, Singapore. These are his personal views