Why the Indian stock markets are expected to see some more correction before real value emerges. Some thoughts:
In its mid-quarterly monetary policy review announced on Thursday (17th March), the Reserve Bank of India (RBI), on the basis of its assessment of the current macroeconomic environment made the following announcement:
· increase the repo rate under the liquidity adjustment facility (LAF) by 25 basis points from 6.5 per cent to 6.75 per cent with immediate effect; and
· increase the reverse repo rate under the LAF by 25 basis points from 5.5 per cent to 5.75 per cent with immediate effect
It has, however, kept the CRR unchanged at 6%.
To me, an interesting part of the statement is their acceptance that the inflation for the current financial year (Apr’10-Mar’11) will be higher than they previously anticipated. It would be useful to remember that in my article dated 26th January (RBI falling behind the inflation curve), I insisted that RBI has been under-estimating the inflation numbers for India. In the recent review, their estimate of inflation for end March’11 has been increased from 7% to 8%. Rarely has one seen inflation estimate for a particular period going up by as much as 100 basis points within less than two months. And, that too by a central bank.
To a certain extent, I sympathise with the RBI. In the same statement, RBI talked about fears of inflation emanating from narrowing output gap. I have been maintaining that India is a supply constrained economy and any endeavour to jack up growth rates would lead to building up of inflationary pressure. In essence, what is required is to continue with structural reforms, invest more in agriculture and other physical infrastructures, remove roadblocks and reduce leakages that put pressure on deficits. Unfortunately, while the solutions are known, not much headway is made in these regard leaving RBI to use monetary policy as the only instrument to fight inflation. Problem is, squeezing credit availability or raising interest comes at the cost of growth, leaving RBI to try and bring about a fine balance between growth and inflation. This becomes more problematic in a situation when there’s enough and more uncertainty about global growth prospects.
2011 will be a weak year for Europe reeling under large scale austerity measures across nations. In addition, with inflation rising, ECB may opt for higher rates, further impacting the growth.
In case of the US, although inflation is yet to reach concerning levels, there is a clear threat for a rise through the import channel. Their Import Price Index has been rising, as has been the Producer Price Index (PPI). There is now a glaring difference between the US PPI and the CPI. The NFIB Small Business Optimism Index showed that the percentages of respondents raising average selling prices continued to gain ground in January. In addition, January’s Morgan Stanley Business Conditions Index yielded a new 31-month high in the number of survey participants whose firms had charged higher prices relative to a year ago.
Remember, US debt/GDP ratio is to touch 1005 this year. With the country building up on debts when the interest rates were at its lowest, It is only a matter of time that the situation will deteriorate as the interest rates bottom out and start moving up.
The latest round of quantitative easing in the US was all about the desire to purchase US treasuries. With exit from the QE becoming a distinct possibility, the moot point is, where will treasury find support from, going forward?
Certainly not PIMCO. PIMCO, the world's largest bond fund became bearish on the prospects of the United States and going to the extent of selling all of its U.S. government-related debt holdings. Bill Gross' $236.9 billion PIMCO Total Return fund sold of its entire holding in the US treasuries as they were clearly bearish on the burgeoning deficit of the US and its inflationary impact.
The U.S. budget gap estimated at around US$1.65 trillion for 2011 along with clear signals of emerging inflation have made them very jittery. How the US government fights inflation going forward, will be interesting.
While I feel that Fed should first look at the option of exiting from QE at the earliest before they think of raising the interest rates – bottomline is, there is no escaping the hike in interest rates. It can only be delayed. And, with the debt levels soaring, rising interest rates will be debilitating for the prospects of the US economy. Unlike Europe, the US does not seem to believe in austerity measures. And with the country building up on debts when the interest rates were at its lowest, It is only a matter of time that the situation will deteriorate as the interest rates bottom out and start moving up. This year, the US debt to GDP ratio is definitely going to cross 100%. With the yield expectations rising, the US is in for a real tough time. The recent rebound in growth numbers seems to be the last hurrah for an economy entering into a troubled phase.
Any why not? When two thirds of the economy believes in spending by running up debts as does the government, the growth can only hide the soft underbelly till it reaches the tipping point. Turbulent weather ahead guys.