Most of us would like to believe that all?s well, now that the US Fed discount rate cut of 50 basis points last week to 5.75% will bring about the much-needed liquidity for banks to tide over the post subprime home loan defaults.
The feel-good factor, that the US central bank is there to bail out banks in crisis and that its support would continue, buoyed up the Indian stock market intermittently.
Does that indicate our market will boom? Not yet. The market across the world is still figuring out the quantum of subprime crisis.
The Fed discount rates were eased so that banks could have access to funds and carry out their day-to-day banking business. The Fed had to find an alternative money supply mechanism because information about which banks have suffered losses were not forthcoming and banks stopped lending to each other, suspecting each to be a potential subprime home loan-plagued bank.
Some of these banks also are promoters of mutual funds or hedge funds and this doubled up suspicions of default certainty by other players.
As a result, the US overnight market came to a grounding halt. To prevent a market collapse and protect banks to meet its liquidity requirement, the Fed had to step in an open a discount window at a lower rate.
This, however, may not prompt a cut in the Fed rate, which is always lower from its discount rate and currently at 5.25%. The Fed rate is a benchmark rate at which bank lend overnight funds to each other. A lowering of rate at this juncture could mean an invite for weaker banks accessing such funds.
But our stock markets, oblivious of what is happening, yo-yos because punters propagate the ?no impact? theory. Their theory is based on the grounds that India is well-insulated and free from exposure in subprime home loan derivatives. True, India is protected. Also, the fact, that domestic banks hardly have any stake in the mortgage-backed home loans notes or the US collateralised debt obligations (CDOs) as commonly known, is well acknowledged.
But what is not taken into consideration, however, is the hard-hitting impact our domestic markets, equities and currency especially, will face as a fallout of this crisis.
So long domestic bourses have been propped up by foreign institutional investors (FIIs) and the market had discounted future value, up to two years. So was the case with the rupee appreciation against the dollar, where the Reserve Bank of India (RBI) was intervening almost daily to prevent steep appreciations.
For, if the Sensex peaked ridiculous heights of 15,776 (July 26 2007), purely on heavy capital inflows and accelerated the rupee-appreciation to a nine-year high of 40.29 a dollar, (around the same time) isn?t it only logical that levels must recede when FIIs pull out?
The FII attitude towards risks has now hardened and in the hierarchy of risks, equities win hands down. As a consequence, FIIs are first exiting emerging equity markets only to park their funds in safer havens like the US treasuries.
In the month of July alone this year, FII inflows to the equity market was $5.9 billion?the same month Sensex zoomed to create a new record and the rupee touched nine-year highs. Contrast this to the current month to date (from Aug 1 to Aug 23), the FII outflows were $2.12 billion or Rs 8,558 crore. This trend is expected to continue and hence there is no way that equities here will stay at current levels or protected for that matter.
The size of the sub prime home loan market is roughly $1000 billion. It is now estimated that about 25 % of this size is likely to come under defaults over the next 18 months or so. Some studies also indicate that the defaults could be as high as 40% of the market size, meaning $400 billion!
But what the market is yet to take into account is the underlying interest rate `reset? clause, that could have another dampening impact on the markets worldwide. Reset clause or the periodic rate revision as in floating rates, are pre-agreed at the time of loan disbursals. They come into effect, on account of two major factors, one, the hardening of economy and second, under circumstances where the lender needs to recover losses or reduce losses owing to increased cost of funds.
In the US, rates have risen and the falling property prices only make the cause for resets more urgent.
So when a reset occurs in this case, the propensity to default will only be higher than the current estimates besides the nagging concerns on where or which country, defaults would emerge from. A recent report quoting the official announcement made by the Bank of China Ltd, the country?s (China?s) second largest bank, said the bank had an exposure of $9.7 billion of securities backed by US subprime loans.
This only reiterates the argument that such assets are scattered across the globe and there is no single authority to regulate them unless banks start declaring themselves voluntarily.
Central banks, therefore, will have to get together and then work towards regulating operations under their geographical ambit, akin to a situation where countries cooperate to tackle an epidemic. This also implies, in the days to come, that more central banks of various countries would announce bail-out packages and induct the liquidity needed to carry out day-to-day functioning of banks through overnight or money markets.
Defaults are inevitable and since CDOs are not widely traded, marking them to market rates without a benchmark rate is another nightmare. Most bank assets, except CDOs, are marked to market so that losses or gains get estimated at regular intervals. These assets also find easy entry into hedge funds or pension funds that are constantly on the look out for long-term assets. The appetite is high particularly among pension and hedge funds as there are not many of its kind in the market.
Such assets usually are held till maturity, so the concept of mark-to-market does not become applicable in such a case.
Similarly, the movement of domestic currency, rupee, will undergo a change and perhaps for the benefit of trade and exporters in particular.
The rupee has been appreciating largely till the alarm bells became louder last week. Huge capital inflows so long, had even left the RBI pondering over how to strike a balance between a daily appreciating currency, the rupee liquidity induced by it through dollar-buying ( intervention) and controlling short-term rates that were erratic and wild.
Monetary measures recently announced by the RBI helped in usurping surplus liquidity and restrict inflows (external commercial borrowings by corporates that were not allowed to be repatriated) . This brought about major relief in the otherwise uncertain domestic money markets. However, exchange rate now doesn’t seem to worry the market especially after the US subprime defaults came into being.
This crisis, in a way, helped domestic currency depreciate significantly as FIIs began pulling out and net capital outflows began to show up this month.
To what levels the currency would depreciate further is a difficult task to predict but the currency that was rapidly inching towards 40 a dollar level last month is now witnessing a reversal mode. Thanks to the subprime fiasco, the currency is currently at 41.05.
In the short-term, movement of funds will determine the currency level and in the long-term, it would be competitiveness of a free market? where the currency depreciates if the interest rate is higher than that of the trading partner country.
It would be a dream come true for those who want the buoyancy back. In times to come, more worms will crawl out of the can, as subprime home-loan defaults emerge from specific markets.
