Neelkanth Mishra | September 4, 2015, 6:46 AM
(This was published in the Economic Times: link)
Before one starts to find solutions, it is important to frame the problem well. The coverage of the recent market volatility has focused primarily on the slowdown in China. While that may have been one of the triggers of the recent episode, the underlying drivers seem far bigger and structural.
Commodity prices are back to 2004 levels, as demand slowed earlier than expected. But supply continued to get added. While China has indeed been leading the demand disappointment, the worst affected commodities are ones where supply addition has been robust: oil, iron ore, natural gas, coal and steel. Without what is effectively a dismantling of the oil cartel, oil prices would not have fallen as much.
The second order effects of lower commodity prices are now being felt through dramatic changes in global trade flows. Oil exporters are seeing large current account surpluses transition to deficits, and deficits in commodity exporters like Brazil and South Africa have widened. This has two implications.
The first is on capital flows. Economic theory says that current-account surplus economies are capital exporters, and current-account-deficit countries need external capital. Oil producers, for example, used to export capital through their sovereign wealth funds (SWFs). They were the ‘priceinsensitive’ buyers who, among other things, were purchasing Indian equities even in 2011-13 when the Indian economy’s near-term prospects were at their bleakest.
However, at current oil prices, their combined current account moves from a surplus of $400 billion to a deficit of $100 billion, a swing of half a trillion US dollars. Flows from them may be reversing, not just slowing, likely explaining the redemption-type selling seen lately. Just as they were ‘price-insensitive’ buyers on the way in, they are ‘price-insensitive’ sellers on the way out.
Countries like India, Britain, China, Japan and Germany that gain from lower commodities do not have institutionalised mechanisms for sequestering and then deploying this capital.
The second impact is on global growth. Countries seeing a sharp increase in their current account deficits are unlikely to get the capital to fund them. They, thus, need to shrink these deficits. That is happening through a sharp decline in currencies. Currencies have been the canaries in the mine shaft, just like bonds and credit default swaps (CDSs) indicated stress in the 2008 and 2011 episodes.
Investors should be looking at currencies and commodity prices as leading indicators. Weaker currencies make exports more competitive and imports more expensive. Given a dearth of global demand, exports are unlikely to pick up. Instead, currency devaluations would destroy domestic demand in these stressed economies.
Recently, unable to maintain its dollar peg, Kazakhstan had to dismantle the peg. Its currency fell nearly 30%. Currencies of relatively large economies such as Russia, Brazil, Turkey and Mexico are down 30-80% against the dollar versus their 2014 averages. Global nominal GDP in dollar terms could be down more than 5% this year, the weakest since 2001. For example, the nominal value of the Russian economy has more than halved from $2.1 trillion to about a $1 trillion. While that is not an accurate reflection of total demand, it does indicate the severity of the trend.
This demand destruction cannot be quick or painless. In some of these economies, it can also trigger further problems for corporates or banks caught on the wrong side of the trade.
Further, the magnitude of the change in trade and capital flows, as well as the large number of moving parts, also increases the risks of policy error. It is this heightened uncertainty for global growth that is driving stock prices down globally.
The Indian economy has low global linkages, with largely intrinsic growth. It should benefit from low energy prices. However, Indian markets are linked to the global turmoil: 51% of Nifty revenues are not in rupees. Companies with global commodity exposure are most at risk. Of the companies that have purely domestic revenues, a large part are banks that have lent to metal companies that are stressed.
Further, when an emerging market fund sees redemptions, it would sell all the markets it has positions in. It could choose to sell what it can, and not what it should. So, India being relatively better off fundamentally could see a somewhat higher share of selling. Selling of passive index-tracker exchange-traded funds also increases risks on stocks whose fundamentals may be sound, but that would still see selling pressure.
In the medium term, these will turn into opportunities. The problems of fund-flow plumbing should help accelerate India becoming an asset class by itself. But that is unlikely to be fast enough to avoid near-term turbulence.