THE WORST IS NOW OVER:But global economic recovery is likely to be slow

But global economic recovery is likely to be a slow, drawn-out process. Indian markets should look up, but be prepared for volatility, warns

    I remember an English fund manager offering stock tips on a television channel in early January. The best investment strategy for 2009, he advised, was to buy a crate of scotch and retire to a cave in Wales for the rest of the year. I saw the same fund manager on the same channel a few weeks ago. He seemed his usual witty self, had obviously not retired to a cave and was talking of the green shoots of recovery.
    This is not meant to be yet another mildly annoying story about the fickleness of investment advisers. To be fair to our television friend, the wild swing in his view reflects, to a degree, the rapid pace change and volatility that have buffeted the global economy over the past few months. There is certainly much more optimism than in January, reflected in an up-tick in stock indices around the world. From their February lows, the Dow Jones is up 15%, the London FTSE by about 10% and our own Sensex is up by a healthy 30%.
    Financial markets have their own idiosyncrasies but they cannot de-link completely from the economic realities on ground. Thus the up-tick reflects the perception that economies are recovering and the worst of the crisis is behind us. Is this perception correct or rational?
    A quick review of the changes in the global economy over the past three months might be useful. Let's start with monetary policy. The US central bank (the Fed) and the Bank of Japan have dropped their policy rates to zero with the British and European central banks close on their heels. Our own Reserve Bank has cut the reverse repo rate (the short term policy rate) to an unprecedented 3.25% with more cuts likely.
    Central banks have not been content to drop rates alone. They have been buying back large quantities of bonds from banks, offering freshly printed money in exchange. This infusion of cash, low rates and the fact that banks have begun to trust each other again has meant a thaw in inter-bank markets and downward pressure on lending rates. The 30 year Jumbo American mortgage finance rate, the benchmark housing finance rate in the US has dropped by about one and quarter percentage points since October last year.
    There has been fiscal stimulus as well. The US government's massive fiscal package went through in early February and involves a government handout of about $800 billion on a motley mix of tax breaks, project spending and unemployment benefits. While the stimulus is designed to be spread over a period of 10 years, the bulk of it is concentrated in 2009 and 2010. While it is too early to judge its efficacy, analyses of the first three months of its inception are quite encouraging. China also has a rather hefty stimulus in place.
    There have been other quasi fiscal policies to complement these conventional measures. The American government has put together a plan to restructure the car companies badly battered by the recession and also seems to have a workable strategy to purge bank
balance sheets of their dodgy assets.
    Macroeconomic data seems to pick up some of the policy impact though I must point out that one has to look really closely to notice the improvement. The manufacturing sector might still be contracting in the US and most of Western Europe but the rate of contraction has diminished. Ditto for housing. Prices are still falling but the speed of the fall has slackened. Monthly home sales data (remember the US housing market was the epicentre of the crisis) have turned from uniformly dismal to occasionally encouraging.
    Those looking for bad news though don't have to try too hard. Unemployment in the developed economies is high and continues to rise. The unemployment rate in the US is at 8.5% and the last six months alone saw 3.7 million job losses. National income is shrinking in much of the Western world. US GDP for the first quarter of 2009 shrank 6.1%. Credit flow remains weak and car makers like Chrysler and GM are either filing for bankruptcy or radically scaling down their operations.
    Some large American banks did post profits in first quarter of 2009 that were higher than expected but much of the improvement was just accounting smoke and mirrors. A number of them are still technically insolvent or desperately need capital. Default on loans, particularly retail loans is rising. The likelihood of another banking crisis on the back of spiralling credit card delinquency in the US or large-scale bankruptcy in one of the central European economies (European banks had financed the credit fuelled growth bubbles in these economies) remain high. The IMF estimates that cleaning charges for global banking system will come to about $4 trillion and a large significant portion of the bill of the bill remains unpaid. Phew!
    The biggest risk to the recovery going forward stems, ironically enough, from the fact that governments are pulling out all stops to get their economies going. This essentially means two things. Budget deficits are climbing sharply and central banks are sweating their note printing machines. High budget deficits have to be funded and governments are borrowing huge sums in the bond market and will continue to do so. If private demand for credit picks up, the competition between the private sector and government will push up interest rates and might make it unviable for a number of private investors to borrow. Thus the necessary conditions for textbook crowding out are in place.
    Economists also tend to fret over the large quantities of surplus cash sloshing around in the financial sector. This breeds the risk of a sharp spurt in inflation at the first confirmation of a recovery. Lenders would expect to be compensated for this and thus this could also lead to harder interest rates. The bottomline is that interest rates could poop the party just as things begin to perk up a little.
    Let me cut to the chase and offer my view on what's likely to happen. I would argue the worst of the global financial crisis is over. We now have systems in place (both monetary and fiscal) that will stem the panic even if another wave of bad news were to wash ashore. Economies too are close to a bottom and the recent traction in stock-markets is reflecting the hope of post-bottom recovery. Inflation and interest rates might move up a tad at the whiff of a recovery but are unlikely to derail things completely. However, the recovery will neither be quick or large. We might be in a period of slow mend where economic data continues to be weak for the next couple of years but every new month or quarter shows improvement at the margin
    My prognosis for Indian markets hinges on how global fund managers are likely to manage their international portfolios in the current environment. At the risk of sounding repetitive, let me emphasise that this has two essential features. One, the perception that the worst is over for economies and the financial sector is driving an improvement in risk appetite. Thus money managers are no longer content to hold cash or low return US treasury bonds and are seeking higher yields. Second, even if the worst is over, the developed economies of US and Europe will remain sluggish and perhaps even contract some more before a sustained recovery sets in.
    The logical strategy, given these two somewhat conflicting factors, is to seek markets that are less dependent on the global business cycle and are thus likely to post better growth and profit figures. For those who like jargon I would call them the relative de-couplers. India is an obvious candidate with domestic consumption driving 60% of GDP. Thus, there is more to the current rally in the sensex and the Nifty than just a technical adjustment following months of battering.
    This does not mean that the sensex is back on a one-way street. It is quite likely that indices will shed some of their recent gains before rising again. I expect markets to remain volatile but the trend is likely to move north over time. But the headiness of 2006 and 2007 is unlikely to return in a while.
The writer is chief economist, HDFC Bank

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