Evgeny Gavrilenko of Troika Dialog -
The most recent market correction, despite not being as deep as that in mid-2006, has caused a much more panicked response. But the global economy and emerging market countries in particular remain in good shape. The IMF has even upgraded its global GDP forecast for 2007 from 4.9% to 5.2% - a very high number.
On the back of strong economic growth worldwide, the corporate sector continues to generate profits. US economic statistics for the second quarter looked good, as the low consumer confidence caused by the sub-prime crisis was smoothed over by increased investment activity from the corporate sector and an improved balance of payments. On the whole, economic fundamentals continue to look very supportive for the markets.
Our analysis suggests that the origins of the recent market correction lay not in the so-called credit crunch and sub-prime loan crisis in the US, but rather in the more deep-seated problem of overly soft monetary policy in the US, the Eurozone and Japan in previous years. Money was cheap and abundant, and markets grew accustomed to that. Moreover, reduced lending standards for mortgages in the US increased uncertainty and risk worldwide, as did the widespread securitization of debt, which spread overseas as global financial institutions bought up US issued loan packages.
These problems were hidden for years as money continued flowing into the global financial system even after the Federal Reserve and the European Central Bank raised interest rates; Japan kept supplying the rest of the world with liquidity on a large scale.
Thanks to the stimulatory (if not loose) monetary and fiscal policies in developed countries that followed the September 11 terrorist attacks, global equity markets had grown steadily since early 2003. By mid-2007, major stock market indexes had almost doubled; volatility was generally low and corrections were rare. Before rebounding on Friday, August 17, the European market had fallen over 11% from its peak in July, while the US market fell by slightly more than 8% from its historical high.
The recent problems tied to sub-prime loans and mortgage-backed securities merely served to remind us that equity markets cannot ascend as fast as they have in recent years indefinitely, particularly in an environment where it is hard to evaluate risk.
Crisis of confidence
We think that the real threat the global economy faced in recent weeks was not the credit crunch, but a confidence crisis of sorts. It is not yet clear which financial institutions will suffer the most as a result of their exposure to asset-backed securities, though there is still enough liquidity in the global financial system, and interest rates in Japan remain very low. Financial institutions are rebalancing risk and lending activity is low due to high uncertainty.
Rebalancing risk will take time - a matter of weeks or a month - which is why liquidity injections by the ECB, Fed and Bank of Japan (BOJ) on August 10 were unable to stabilize the markets. That said, even the unexpected 0.5-percentage-point reduction of the discount rate on August 17 may also have only a short-term effect. Time is needed to verify the situation and rejig risk. Thereafter, markets will resume growth, as liquidity is still present within the system. Moreover, it looks as though all attempts to tighten monetary policies in the US and the Eurozone have failed; M2 in those areas is still growing quickly, as Japan has continued to lend to international financial institutions, while the carry trade mechanism's effects were for the most part limited to cross-currency exchange rates. As such, regional central banks like the Fed and the ECB have very limited abilities to control money supply growth. Should the global economy at some point require real monetary tightening, a concerted effort will be needed from all major global central banks, meaning that the divergence among those institutions' base rates should be minimized. The first signs of such an action surfaced recently, when the Fed, the ECB and the BOJ conducted their liquidity injections.
Russia's more mature market
The Russian market's reaction to the credit crunch serves as a new paradigm for the country's correlation with and susceptibility to global trends. Domestically, the correction was quite moderate (of similar depth to corrections on other markets), which comes in stark contrast to past movements that have been much more dramatic. Before rebounding at the end of the trading day on Friday, the RTS Index fell some 13.5% from the week before, correcting less than Japan's Nikkei, which had dropped more that 15.0%. In mid-2006, the Russian market corrected much more deeply, by around 30%.
The domestic market these days appears more diversified, more mature and thus fundamentally stronger than before. Russian financial institutions were not involved in mortgage-backed securities, and the country's economic fundamentals also look strong. Accelerated investment activity and strong industrial performance (up 7.7%in year in the January-July period) are pushing economic growth forward at greater rates this year than in years past. Indeed, today's Russian market represents a safe haven for investors.
It is also important that the Russian financial system is now larger than ever before, so that recent foreign capital outflows have had a much smaller impact on the market, as there was enough domestic capital to compensate for fleeing foreign money. Moreover, the overnight interbank rate increase last week was modest, taking the rate to just 6.5%. One year ago, that level was broached only for a few months at year-end. And with inflation clearly exceeding 8.0%, the overnight rate remains negative in real terms. Meanwhile, it is simply incorrect to talk about a domestic liquidity squeeze - commercial banks' voluntary reserves (deposits and correspondent accounts with the Central Bank) remain at roughly RUB900bn. Thus, there is around $35bn of spare liquidity in the Russian financial system.
At the same time, we are far from being able to paint a strictly rosy picture of the Russian economy and market. Even though fundamentals look strong, there are certain medium to long-term risks. In our Economic Monthly, we have suggested that the acceleration of economic growth this year is driven largely by heightened investment activity on the part of state-owned companies, which is financed to a great extent by foreign borrowing. This borrowing has expanded rapidly in the past 18 months on the back of nominal effective ruble appreciation "guaranteed" by the central bank. This effect was intensified as the dollar, the currency in which the bulk of nearly $400bn in outstanding corporate and banking sector debt is denominated, weakened globally. That said, recent developments on world markets demonstrate that under some circumstances, the dollar is able to strengthen (as it did against the euro and the pound last week). We think that this is a short-term fluctuation that should not affect Russian borrowers, but if at some point the dollar starts a prolonged phase of strengthening worldwide, the Russian banking and corporate sectors will be affected.
In the short term, we do not exclude a period of decelerating investment activity in Russia (global credit problems are unlikely to be resolved in a matter of days), which will nonetheless remain strong and post a double-digit growth rate. New borrowing from the corporate and banking sector will decelerate in the second half of the year, which will keep overnight rates higher on average than in the first half, most likely around 5%.
Evgeny Gavrilenko is chief economist at Troika Dialog in Moscow
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