Stresses, known and unknown

Global markets are in turmoil. Some volatility is normal: Existential issues generally crop up every year or two, causing the “buy on dips”  philosophy to be questioned for long enough, to cause a sell-off in risky assets. But the speed and quantum of price changes seen over the past month remind many of the turbulent months a decade back. There appear to be three big questions financial markets are struggling to answer, and, as always, it is the uncertainty in quantifying their impact that is more troubling than the problems themselves. The first is the impact of coronavirus on global economic output, the second is the effect of the sharp drop in oil prices, and the third is the stress in global financial markets driven by the first two.


Credit Suisse global economists and money market strategists have flagged funding pressures created by disruptions caused by coronavirus, first in China, and then in the rest of the world. As activity levels drop, the velocity of money slows: Customers stay home, or production slows because of some parts being in short supply; some can take credit, but for many informal sector workers, income and thence consumption drop immediately. Other households and some firms have higher cash balances, as they stay at home (no movies, eating out) and generally spend less than normal (e.g. travel bans, cancellation of conferences). This happens at a global level. While within countries the respective central banks can address this, when it comes to global payments, which are primarily in US dollars, the US Federal Reserve (Fed) needs to act. Before it acted on Wednesday last week, providing effectively unlimited liquidity, there were tell-tale signs of stress reminiscent of the early days of the 2008 crisis, and last seen during the Greek crisis in 2011. For example, the gap between the price that a seller of US government bonds (USTs) asked for and the price that the buyer was willing to pay (called the bid-ask spread) rose to record highs. For “liquid” (that is, heavily traded) securities, this gap is generally low, and USTs are the most liquid securities in the world. But the Fed’s action so far does not help non-US firms: For that, the swap lines used during the 2008 crisis may need to be opened up again.


This lack of liquidity has been the primary driver of the record high outflows from emerging-market equity funds: The last 30 days have seen $36 billion go out, significantly higher than that seen even during the 2008 crisis. For markets like Brazil and Turkey, which have historically been susceptible to fund outflows, these are the worst on record. For India, $4 billion stampeding out over the past month ($2 billion over the past week) is close to the worst seen in 2008, though as a share of market capitalisation the ratio is a bit better.

Illustration: Ajaya Mohanty
There is a natural mean-reverting trend about short-term flows — after one burst, sellers balk at the sharply lower prices, and some new buyers begin to get interested. Some regulatory actions like the short-selling ban imposed by markets like Korea also help in the near term. But these do not last long: Even as the markets rebound from the sharp correction over the past month, one must remember that the key risks remain unchanged.


There is no easy antidote to the income lost due to travel bans and cancellation of public events that are necessary to slow down the initial spread of the virus. It may be several weeks, if not months, before it becomes possible to quantify the loss of income. Unlike delayed purchases of items like cars and televisions, most of the income lost from services not consumed is income lost forever. Just lower interest rates may not suffice to counter this. Very few countries would have the logistical ability to deliver the type of stimulus that Hong Kong gave (10,000 Hong Kong dollars to every adult), even if they were to arrive at political consensus to consider it.


The rising gap between the yields on Italian and German sovereign bonds in the last few weeks also points to markets fearing renewed debates on how higher fiscal deficits in Italy, which may be inevitable, given the scale of the epidemic, would be perceived by other nations in the European Union. The fact that past epidemics have driven political change would not be lost on investors.


The sharp drop in oil prices adds another layer of uncertainty. At a global level, the oil price is just a transfer price from the producer to the consumer, and though producers get hurt by lower prices, consumers gain. A $30 drop in the price of Brent crude, for example, can mean $42 billion of annual savings for India, which is nearly 1.4 per cent of gross domestic product (GDP). More than half could flow directly to consumers if taxes were not raised, becoming the consumption stimulus that is needed to stem the downward spiral triggered by slowing credit growth in India; once sequestered as taxes, it becomes challenging for the government to distribute it as widely.


However, for several oil-exporting economies, the drop in income could be debilitating. The cuts in capital expenditure in further exploration and extraction of oil, and the potential risk to lenders exposed to oil producers or service providers, is perhaps easier to quantify. The bigger risk is that several of the smaller producers (but where oil revenues are a very large part of national income) could see the government losing its ability to provide even basic services like law and order and health, running the risk of a descent into anarchy. The larger producers have built up buffers over the past two decades, and may not have this risk unless low prices sustain for several years.


It may be a few months before the markets are able to “draw a circle around these problems”, meaning that the costs are quantified, and the allocation of these costs is broadly understood. In all this global turmoil, the India-specific problems of a financial system short of capacity, effective interest rates that are still ahead of the nominal GDP growth, and poor consumer and investment sentiment, have slipped from headlines, but still need to be addressed. The coming weeks and months will require cohesive and speedy action by policymakers: The challenges could very well be turned into opportunities.



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