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The spreading contagion

The uncertainty that has gripped stock markets worldwide, leading to sharp declines in the stock indices, shows no signs of ending. Only on a few occasions in the past have global developments caused such sharp swings in stock market indices the world over, including in India. Last week’s share price movements across the world’s leading bourses have had significant lessons for investors, regulators, and governments. The causes for the general slide in stock pri ces are well known — the escalating crisis in the U.S. credit markets was said to be the trigger. As far back as in February a few big international banks reported losses in their sub-prime mortgages portfolio. The problem has since manifested itself worldwide dragging down all the financial markets. Last week, it came to light that some big European banks have run into significant problems with their home loan investments, a direct outcome of having bought securities that had been parcelled out and sold to a wider section of investors. Sub-prime mortgages are a class of high-return but risky assets, representing home loans to borrowers who are considered less credit worthy. The excess liquidity that was sloshing around the world’s financial markets leading to inflated prices of financial assets and real estate has made many of these lenders assume risks that would have been unacceptable in normal times. The flip side to the generally beneficial effects of globalisation is seen now. No one is able to say accurately how deep the problem runs or from where bad news would originate next.

Though India has no direct connection to the U.S. credit market, the impact has been no less severe. There is evidence of the dominant foreign institutional investors pulling out to make up for the losses suffered elsewhere. The role of hedge funds that have an opaque structure and face minimal regulation in their countries of domicile will come under scrutiny. They have recently been very active in India too. Their voracious appetite for risky assets such as securities covering sub-prime mortgage securities and the fact that even mainline banks were eager to fund them have meant that what should have been a localised problem has assumed global ramifications. There will inevitably be a reassessment of risks and emerging markets including India might carry a higher risk premium. Central banks the world over have been pumping in enormous amounts of liquidity. How all these will affect India over the near term is still a matter of conjecture. What is clear however is that, apart from market capitalisation suffering a sharp erosion, even prime Indian borrowers may have to pay a higher price on their overseas borrowings.

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