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FINANCIAL SCENE

It is seen that stock exchanges the world over are not ‘decoupled’ from one another but policy makers, as in India, pursue their own objectives.

Granted that in a globalisation era some measure of interdependence and consequent synchronisation of key policies is to be expected, recent events in India suggest that it need not always march in step with U.S. policy making. And for very good reasons.

A recent policy statement, the RBI monetary policy review (January 29), was made in the context of a significant downturn in the U.S. economy.

As always, there are other domestic as well as external factors in the reckoning. This time the economic problems of the U.S. were seen overshadowing all other concerns.

At the beginning of this year the World Bank had forecast a lower global economic growth in 2008, primarily because of the slowdown in the developed economies. Developing countries, including India and China, would continue to grow, albeit at a slightly slower pace than hitherto.

In any case, they will not be able to offset the declines on account of the U.S. and the other developed countries.

A global economic slowdown is no doubt a major worry for India but it is its primary cause — the U.S. economy sliding into a recession — that makes policy making in India particularly challenging. The U.S. sub-prime crisis and the housing market crisis first surfaced in July 2007 and have since assumed menacing proportions with major consequences for the rest of the world too.

The crises have unleashed enormous turbulence in the financial markets everywhere. Within the U.S. there has been considerably less financial leverage, which means the ability to borrow has come down sharply. There is reduced credit availability and as previously bloated asset prices fall drastically, a negative wealth effect comes into play. In turn, these have impacted consumption and growth.

All these have prompted strong expansionary monetary policies in the U.S. and many other developed countries.

The U.S. Federal Reserve, after pumping in money to increase liquidity, has been cutting its interest rates.

In a span of just eight days the Fed funds rate was brought down from 4.25 to 3 per cent. The 0.75 percentage point reduction on January 22 was particularly significant in that it was announced well ahead of a scheduled Fed meeting. Its magnitude also caused some surprise.

The contextual significance is what makes the Fed moves very relevant to India. On January 21, Indian stock markets along with many other Asian markets plunged.

Global cues, especially from the U.S., caused this spectacular correction. Besides the grave financial market crises — which incidentally show no signs of ending — there has been a resurgence of inflation the world over, on top of high oil and commodity prices. However, for stock markets in emerging countries, the beneficial consequences of the U.S. rate cut have proved ephemeral. By the second week of February the Sensex and the Nifty, continuing to remain volatile, seem to have settled at levels considerably below their all time highs.

Significantly, they continue to track U.S. economic numbers, rising when there is good news in the U.S. and falling quite dramatically soon after.

Over two days in the middle of last week, February 6 and 7, the Sensex lost more than 1,000 points.

The important point is this: even as the stock markets in India and the rest of Asia are demonstrating a high degree of synchronised movements with the American stock markets, the RBI has steered clear of the Fed moves and avoided interest rate cuts at the time of its monetary policy reviews.

An interest rate reduction in India had been considered inevitable by many. One argument in support was that widening interest rate differentials would cause a surge in fund flows into India in search of higher returns. Even as interest rates fell sharply in the U.S., the RBI remained unmoved.

That the expected rush by foreign funds has not yet happened is a partial vindication of RBI’s stance, at least over the short-term.

The fact is, in the wake of a major shake up in the financial sector, risks and rewards will be constantly reappraised.

Despite their higher returns, emerging markets may be downgraded. Early indications are that funds are flowing into debt instruments within the U.S. and Europe.

Besides, there are very good domestic reasons supporting the RBI’s stance.

The economy is still in good shape and the slowdown seen in select sectors does not warrant monetary policy stimulus in the form of lower rates. Liquidity has been good and the RBI has nudged banks to reduce their rates even without the policy signals.

Second, inflation remains a big worry. Both economic growth and low inflation remain desirable objectives.

In India, the authorities would definitely opt for lower inflation in preference to high growth that comes without reasonable price stability.

Explaining the RBI’s ‘inaction’ on interest rates may be the easier part.

More difficult is to understand the extent of linkages between India and the U.S.

How relevant is the ‘decoupling’ theory in the light of recent Indian experiences. The theory holds that because of certain seminal developments in the global economy — the rise of India and China and growing bilateral trade between China and Europe — the connection between the U.S. and the rest of the world has become much weaker today.

So in a variation of conventional belief, when the U.S. sneezes others need not catch cold.

Yet stock markets at least remain ‘coupled’ and since the U.S. economy will retain its pre-eminence for a long time to come it will continue to exert significant influence on others.

The effects of a U.S. recession will be painful to India but perhaps not severely and immediately as before.

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