Beware the tranquility

Business Standard, 3 January 2007

What was the outstanding feature of the end of 2006? I think the most remarkable feature of where we stand is the eerie tranquility of financial markets.

Let me start with global conditions. An excellent measure of global financial volatility is the predictions of future volatility embedded in the S&P 500 options market. While this reflects the future uncertainty of cashflows of US corporations, it is a good proxy for the world economy for two reasons. All large US corporations are multinationals, drawing revenues from the whole world. In addition, difficulties in the US economy play an important role in shaping the outlook for the world economy. Hence, the `implied volatility' embedded in the options market on the S&P 500 is particularly interesting from the viewpoint of the world economy.

This graph shows that after the 9/11 attacks, there was substantial uncertainty with implied volatility rising up to 40% and more. In the event, timely expansionary fiscal policy in the US (tax cuts coupled with war expenditures) and timely expansionary monetary policy in the US were very effective in pulling the world economy out of an imminent recession. As uncertainty receded, the S&P 500 implied volatility dropped dramatically.

The confidence in world financial markets in the post-2003 period, as seen in the S&P 500 implied volatility, is nothing less than remarkable. Expected volatility has generally been in the 10% to 15% range, often hovering near 10%. These are roughly the lowest values ever seen.

In India, a good measure of implied volatility from the Nifty options market is not available owing to difficulties with SEBI and NSE policies. We use a backward looking measure: the volatility of Nifty seen in the last quarter. This shows two powerful spikes. The first took place in 2004 when the UPA won the election. The second spike took place in 2006 when there were jitters about the world economy and emerging markets. Apart from this, Indian equity volatility has also been very low by historic standards.

Risk perceptions in global financial markets are also low when measured by currency volatility, credit spreads, etc. The picture is one of remarkable tranquility.

Why is there such tranquility? One element is the genuine decline of the volatility of GDP growth worldwide. One by one, countries are adopting sound macroeconomic policies. Fiscal rules are putting an end to irresponsible deficits. Monetary policy is being put on the right track through the combination of convertibility, floating exchange rates and inflation targeting. This has helped to stabilise GDP growth worldwide. Another element is the role of IT systems in improving the management of corporations, particularly on inventories, which play an important role in the business cycle.

In June 2006, Raghuram Rajan offered some important new ideas where the difficulties of the fund management industry lead to a quest on the part of fund managers for high risk and illiquid assets when interest rates are low. This leads to an exaggerated sense of tranquility when interest rates are low. Monetary policy the world over has been tightening last year, and there could be dramatic increases in liquidity premia and risk premia when conditions return to normal.

Could global financial speculators be wrong in their perception of future risk? Many wise economists do not share the comfort of financial markets, and think this is a very difficult time in terms of both economics and geopolitics.

Geopolitical risks include flashpoints such as Iraq, Iran, Afghanistan and North Korea. Iran could well proceed on the path of building nuclear weapons. Israel then has strong incentive to attempt an attack - as was done successfully with Iraq in 1981 - to destroy the Iranian nuclear program [link].

In terms of economics, a series of negative developments are underway. Germany has just implemented a 3 percentage point increase in the VAT rate, which should induce a slowdown in Eurozone. American GDP growth has slowed to the region of 2%. With this, three major blocks of the world economy - the US, Japan and Eurozone - are going to have feeble GDP growth in 2007 of two to three percent. US monetary policy continues to face challenging conditions, with a weakening home economy (which requires lower interest rates) coupled with stubborn inflation (which requires higher interest rates). In the background, of course, is the damocles sword of how jittery global investors will react to persistent dollar depreciation.

As we saw in mid-2006, when conditions change, volatility can flare up dramatically. As the graph shows, India appears to be particularly vulnerable to shifting into a regime of very high volatility. The pathology that may be at work in India is as follows. In a mature market economy, when news breaks, adjustments take place in currencies, interest rates, credit spreads and stock prices. In India, three of these four markets have been stifled. Adjustments are not allowed to take place with currencies and interest rates, and the corporate bond market is not liquid enough to support fluctuating credit spreads. As a consequence, the brunt of adjustment falls on stock prices. Because exchange rates, interest rates and credit spreads adjust less, stock prices have to adjust more. This leads to periodic dramatic flareups of equity volatility.

South Korea and India now have the distinction of being the two most liquid and sophisticated emerging markets with speculative price discovery. Under normal circumstances, this helps India, which is able to attract disproportionate capital flows and support a higher P/E ratio than most emerging markets. However, when global risk premia and liquidity premia change, this will lead to adjustments in valuations of emerging markets. The South Korean and Indian markets are the theatre where speculative price discovery of the global `emerging markets factor' takes place. The impact of international news upon the global `emerging markets factor' will hence be played out, to a significant extent, in India.

In summary, the remarkable tranquility that global financial markets are presently enjoying is not something which will keep. Volatility, risk premia and liquidity premia are at unprecedently low levels, while economic and geopolitical risks are substantial. The global economy could switch back to higher volatility, higher risk premia and higher liquidity premia, in response to global news. This would have a sharp impact on prices of risky and illiquid assets. 2007 could be a roller coaster, quite unlike the peace and calm we feel today.

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