As interest rates started falling due to excess liquidity, house prices rose rapidly, creating a pool of wealth in the hands of Americans, which they unlocked by contracting mortgage loans. It benefited them in two ways — they got huge liquidity at inflated housing prices and interest rates that were practically lowest in the last twenty years. This became a virtuous cycle, which resulted in very high consumer spending, obviously fuelling global growth.
As interest rates started rising in the US due to inflation concerns, this virtuous cycle came to a standstill and the demand for houses started tapering. This resulted in lower prices for houses and many were unable to cover the mortgage loans. It has now hit the entire banking industry in the US and the virtuous cycle is becoming a vicious cycle.
This subprime crisis has inevitably become an election issue, and the Democratic presidential candidates have outlined plans to address it.
Obama’s stand, which avoids direct government spending, is more conservative and impractical, as compared to Clinton’s, who has promised to allocate federal reserves to resolve the crisis.
What does all this mean for the Indian capital market? For one, the flow of capital coming to the Indian stock market will be reduced. India was always considered one of the robust emerging markets, but definitely with certain political and economic risks.
These risks, in recent times, were not priced into equity valuations as the excess liquidity was chasing emerging market exposures and India became the investor’s darling, after China. Now with the subprime crisis, excess liquidity will vanish and the market will correct for the price of risks. Let us also look at domestic fundamentals. Indian markets will see a correction because of high oil prices, high interest rates, slowing down of exports because of the slowing down of the US economy and rupee appreciation. This will definitely have an impact on the GDP growth rate.
The stock market has, in the recent past, rallied largely because of global cues and has almost completely ignored the local issues. With liquidity drying up, the market will now focus on local issues, including political uncertainties and corporate earnings. It is natural to expect that, finally, fundamentals will rule over technicalities, and the market will look at ground realities.
A slowdown can be observed in the automobile sector, some slowing down is already being witnessed in the real-estate segment and, with exports coming down, and it will not be too long before we see the same in textiles, jewellery and other areas as well.
Perhaps a similar story will unfold in the next couple of months for these lenders who have lent big money into the subprime markets. One or more banks will fold, just like Enron did, resulting in a huge crisis of confidence. It would be naive to wish away this major problem inflicting the global markets and to presume that the Indian market is decoupled. If the global super-tanker US, which has a 25 per cent share of global GDP, slows down it will definitely have an impact on the Indian economy.
Only time can decide which policy becomes successful. More importantly, no one can predict a change of plans in the Oval office.
[image by : http://www.flickr.com/photos/joe_13/470327864/]