Tuesday, September 18, 2007, was being awaited with bated breath by investors all over the world. They could hardly have had a more fulfilling day. The US Federal Reserve cut its benchmark federal funds target rate by half a percentage point. The cut was made that much sweeter by an equivalent trimming of the discount rate charged on direct loans.
The 50 basis points cuts were actually more than what most had bargained for. Overjoyed equity markets rejoiced by posting strong gains. The lacklustre Dow Jones sprang to life, gaining 2.5%. This was the first daily 300-plus point gain by the blue-chip index since October 15, 2002. Closer home, in Asia, Hang Seng (Hong Kong), Nikkei (Japan), Kospi (South Korea) and Straits Times (Singapore) gained 2.8%-3.8% on Wednesday, September 19. Not to be left behind, the 30-share BSE Sensex broke the 16,000 barrier, rising by 4.2%. The broader market Nifty at the NSE also gained almost as much.
Ben Bernanke?s attempt to inject a fresh dose of life in the moribund US economy has been lauded across the globe. The rate cuts are obviously meant to restore order in a US financial market rocked by the sordid subprime mortgage saga. The prolonged housing market depression had started taking its toll on economic activity, with August 2007 figures showing a drop in US employment. The Fed had little option other than slashing rates. Yet, inflationary risks continue to loom large on the horizon. But the Fed has obviously decided to sacrifice its emphasis on price-stability in favour of a more expansionary policy stance, given the sluggish growth expectations for the US economy.
The euphoria in Asian and Indian markets is hardly surprising. For most emerging market investors, the move signals a comeback for the US equity market. Rising interest rates and falling real estate prices had forced institutional investors holding US mortgage-based securities to sell assets to meet margin requirements. A large chunk of these investors have significant exposures to Asian markets. Since the outbreak of the subprime crisis, Asian markets have experienced periodic bouts of heavy selling. With the Fed lowering rates, investors expect subprime borrowers in the US to clear their debts more easily. These repayments will shift resources from debt to equity. The unlocked resources are most likely to flow to high-yielding equity markets in India and Southeast Asia.
Whether these expectations will materialise or not is still not clear. But if they do, then the Indian market must get ready to live with an even stronger rupee. The 654-point rise in the Sensex on Wednesday saw the rupee rising to 39.90 per greenback. For the statistically inclined, this is the highest the rupee has risen against the US dollar in the new millennium. But the bigger question is whether the hardening will encourage the RBI to start buying dollars or not. A fresh round of sterilisation?buying dollars by releasing equivalent amount of rupees and mopping up the same by issuing bonds?might not be what the doctor would order at this point in time. Such steps, particularly issuance of more market stabilisation bonds (MSBs) will push up the costs of liquidity management which are already inflating budgetary liabilities and internal debt.
On the other hand, the rupee?s northward march is likely to arouse fresh calls for intervention from exporters. Much of the RBI?s short-term monetary management will now be guided by how it envisages the impact of a rising rupee to unfold on liquidity. The rupee is unlikely to soften in near future. This is not only because of more equity flows. Cheaper funds in the US market might prompt Indian corporates to raise more debt overseas. This will push up the rupee further and increase liquidity.
The stock market won?t mind a stronger rupee as long as institutional investors keep buying. By now, most IT companies have hedged themselves against risks arising from their exchange rate exposure. To that extent, IT stock counters might not see as subdued responses as many expect them to. Also, the ongoing cost-cutting efforts in the US economy might result in more outsourcing business for the industry in the months to come. But what the stock market is really looking forward to is a rate cut by the RBI when it announces its mid-term policy in just over a month from now.
Will interest rates come down?
Industrial output and infrastructure growth have started slowing. The drop in consumer durables growth underlines the effect of harder interest rates. The residential property market is also feeling the heat. Are higher interest rates finally beginning to spoil the growth party? The chorus for a cut is growing louder.
But what about inflationary expectations? Will short-term seasonal supply-side aberrations and liquidity pressures force the RBI to sterilise and keep interest rates unchanged? Or will it respond to the worrying signs of a perceptible slowdown? The choice is pretty clear. The policy stance has to tilt either towards growth or price stability. The Fed has chosen the former. It?s now up to RBI to take a call. But whichever direction it moves, risks remain, as they do for Ben Bernanke as well.
?The author is a visiting fellow at Icrier. These are his personal views