AJIT RANADE: Chief economist, Aditya Birla Group

It all started with rumours swirling around at the Shanghai stock exchange. The Chinese market has been red hot, rewarding investors with returns of 130 per cent in 2006 and hitting new highs this year. Since the beginning of the year, however, fund managers started questioning whether the high valuations of Chinese companies were sustainable. The nervousness increased in early February, when a vice-chairman of the China National People’s Congress said that people should be wary of investing at current prices. Foreign investors in China and Greater China equity funds lost no time in cashing out, pulling out $627 million in the first week of February.

On 27 February, a day after the Shanghai Composite index hit an all-time high, rumours started circulating that the authorities were about to impose a capital gains tax on equity transactions. The market dropped precipitously by more than 9 per cent, a fall not seen in the Chinese market for the last 10 years. That tremor was felt around the world, with other Asian and European markets taking a big hit. But it was in the US that the Chinese flu took its biggest toll, with the Dow Industrials ending the day with a massive 546 point decline.

Why should the US market be affected so badly by a meltdown in Shanghai? “It seems bizarre that there could be such a worldwide reaction to a fall in the Chinese market, which is closed to foreign investors,” says Adrian Mowat, chief Asian and emerging market equity strategist, JP Morgan. Others point out that in 1998 the trouble started with a Russian debt default, and the contagion spread across the globe, pulling down hedge fund Long Term Capital Management in its wake. The meltdown in world equity markets last May was preceded by a collapse of the Icelandic krona. Markets today are so closely correlated that contagion spreads like wildfire. With the mushroom growth of hedge funds and exotic derivatives, leverage in the markets has soared and even minor corrections can spread panic. The Shanghai rumours were merely the trigger for a market correction. In India, the market had been weak even before 27 February. “The Indian markets had already fallen by 8 per cent before the China event, so a fair bit of correction has already taken place,” says Sanjay Sinha, head (equity), SBI Mutual Fund.

“The problem is that people forgot what risk was all about,” says Ajit Surana, managing director, Dimensional Securities, an investment firm based in Mumbai. Years of easy liquidity have led to asset prices shooting up and valuations in markets such as China and India are high. The liquidity surge has also led to a big rise in risk appetite. One measure of that is the emerging market bond yield spread, which was at an all-time low of 164 basis points on 22 February, an indication of just how cheaply markets were pricing emerging market risk. On 27 February, the spread widened to 193 basis points. Another measure is the Chicago Board Options Exchange Volatility Index, or the Vix, aka the ‘fear gauge’, which has been bumping along the bottom hitting 13-year lows, implying a tremendous sense of complacency. The Vix spiked 64 per cent on 27 February.

As the party continued, new theories were invented to show that ‘this time it’s different’. These ‘new paradigm’ theories essentially said that the global economy had entered a new “not-too-hot, not-too-cold, Goldilocks” phase. But in early February, Merrill Lynch warned in a report that the global liquidity growth rate, which reached a peak of 25 per cent in late 2005, had gone down to 10 per cent and was falling further. Says Chetan Ahya, Indian/Asean Economist at Morgan Stanley, “Both Indian markets and the Indian economy are vulnerable to a reduction in global liquidity. The latest data show that G7 money supply growth is now lower than the growth in nominal G7 GDP, denoting that global liquidity is in danger of drying up.”

Critics like Stephen Roach, chief economist at Morgan Stanley, have for long warned that the current system where debt-fuelled consumption in the US supports export-led growth in countries like China, which pile up dollars only to invest them back into the US, is poised on a knife-edge and that America’s huge current account deficits are not sustainable. These fears have been exacerbated by the weakness in the US housing market, by a meltdown in sub-prime mortgages there and by Alan Greenspan’s warning that the US may be headed for a recession.

ADRIAN MOWAT: Chief Asian and emerging market equity strategist, JP Morgan

Unfortunately, even central bankers became enamoured of the Goldilocks theory. “The hope was that the G8 would orchestrate a gradual unwinding of imbalances. Since that didn’t happen, the risks of a hard landing have increased,” says Ajit Ranade, chief economist of the Aditya Birla group.

Goldilocks first sighted the bears in May 2004, when the markets were rattled by the prospect of rising US interest rates. The worry then was that the carry trade of borrowing cheap US dollars and investing the proceeds in high-yielding assets would be unwound, with disastrous effects on liquidity. That fear proved unfounded and Japan soon supplanted the US as the fountainhead of cheap money. Last May, when the Bank of Japan started tightening and fears of an inflation in the US were raised, global markets again collapsed, only to climb higher when they realised that the Bank of Japan had no intention of rapid monetary tightening. This time, in February, both the Japanese yen and the Swiss franc, another carry trade originator, have seen a sharp appreciation. Recall that it was a sudden appreciation in the value of the yen that was one of the causes of the 1998 global collapse.

ABN AMRO India chief economist Abheek Barua, however, believes that once the initial knee-jerk reaction is out of the way, appetite for India will come back, based on its fundamentals. And although FII inflows may be weak, that can be made up by external commercial borrowings, FDI and remittances. But as Mowat says, “The issue with valuations in India is that even at the 12000 levels, the Indian market would be one of the world’s most expensive markets. This would be fine if economic growth and earnings growth were to continue at current rates. But given the pressure on the interest rate front, earnings estimates are likely to be revised downward.”

To cut a long story short, while it may too early to say whether Goldilocks has been eaten by the bears, there is little doubt that many assets, including the Indian equity markets, could do with a healthy price correction.

------------------------------------------------------------------------------------------------------------------------- With inputs from Mobis Philipose