The Great Liquidity Crunch

pkapadia · #1 (**permalink**) 29th May 2008, 06:13 PM

Following is an excerpt from A S Hameed's page on stock market analysis which I found to be interesting.

HSBC has been soft on India forecasting WPI inflation at 8 per cent for 2008. In reality this should be running at double digits by now. An
acceptance to this effect came when the RBI Governor woke up at his Old Age Home, and confirmed that the GOI Current Account Deficit and Fiscal Deficit figures are understated. As if taking the cue the SBI raised 5 year Interest rates on Deposits by 50 bps to 9 per cent per annum.

Foreign Banks like Standard Chartered and private domestic banks like Kotak are already offering these rates for similar maturities.

And yet, if one considers 10 per cent as the correct inflation level, every investor is losing 1 per cent per annum on his Assets.

Worse, more interest rates hikes will follow making investing in Equity even more of a futile exercise. Why should an investor take
the Risk on his shoulders, when the market is in a slow and consistent fall? Not helping the cause of the Domestic investors are the FIIs which are averaging about $ 100 mn in sales daily for the last one week, with occassional big sell-offs that range in the $ 250 mn range.

If we focus on the domestic availability of credit, we would notice that a 10 per cent fiscal deficit of the Centre and State Government
put together would mean a borrowing or deficit finance through printing new currency notes of the magnitude of $ 80 bn per annum.

In such an environment hiking SLRs and CRR will make Rupee lending even more tighter for corporates which need it to survive and grow.
The result of this crowding out by the GOI will force more FII selling, as growth begins to wane, corporate profitability begins to fall, inflation keeps getting uglier, the Rupee weakens against the Dollar and a shaky coalition at the Centre has ever more sleepless nights.

Already the minority government in New Delhi has to face elections in about 10 months and it is panicking. A slew of duty cuts and price
freezes have been announced on Steel, apart from the tight control on Oil price increases that has been in place for most of the past 5 years.

A fall-out of decreasing manufacturing activity, collapsing BPOs and declining profits at Pharma exporters, rising Rupee Dollar cross will
lead to the End Game-Credit Squeeze. The worst segment to suffer of diminished liquidity and risk aversion would be Real Estate, which as a sector has been besotted with home flippers and speculators backed by easy money from Banks and Housing mortgage institutions.

These two sectors would become prime picks to avoid.

The Fed has duly delivered on the Rate cuts anticipated by the markets, the RBI cannot. The Fed could not afford to disappoint in the current environment but the RBI led by its political masters has to toe a political line.

However, the real message of the last two weeks of trading is, that the most aggressive rate cuts in the world cannot support liquidity
if no-one wants to lend.

The end of the chain is mortgage rates. Fixed US Dollar mortgage rates have been rising since mid-January and increasingly floating rate loans are now starting to become more expensive as banks try and cover losses from rising mortgage deliquencies.

Availability is declining also as the ability to securitise new loans falls in line with liquidity in the secondary market for Mortgage backed assets. The mortgage bankers association estimates a 15 per cent fall in mortgage issuance this year for this very reason.

This is what a credit crunch looks like. Risk free rates are becoming more and more irrelevant because fewer and fewer borrowers are believed
to be free of risk. In such an environment it pays to be sceptical of the benefits of interest rate cuts. Bear Stearns was not concerned about
the cost of funds that it could access. The problem was that it could not access them at all.

And recessions destroy "liquidity" because they reduce the risk appetite that fuels it. Again simple human nature is the root here. As asset prices fall capital preservation becomes more important than maximising return.

The premium placed on "good" companies/economies/asset classes increases (because if their price still falls atleast the underlying asset is "good").

The same thing happens in banks, among corporate bond holders and ultimately savers. The supply of credit therefore shrinks during a recession.

Retail participation in stock market falls. People suddenly become more willing Renters of Capital than Buyers. In general terms asset prices
perform poorly but while during booms peripheral assets outperform the core, in recessions core assets outperform the periphery.

Of course interest rates are typically being cut at this point reducing the cost of funds. But if monetary policy is an inefficient lever to slow a boom it is an even less efficient lever to moderate a recession.

No matter how cheap the interest rate taking on a loan involves taking on risk.

The lowest interest rates in the world don't help if no-one is willing to borrow. One of the biggest mistakes in the markets now is to make a
bullish property market call on the ground of interest rate cuts.

To do so implicitly assumes that rates fall while risk appetite remains at its current high level. In reality risk appetite is falling when rates are being cut-and risk appetite is more important than interest rates.

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The Great Liquidity Crunch

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