Since the 2008-09 recession, governments across the world have made it easier to borrow money to help revive growth. As a result, businesses happily kept loading up debt as costs were pretty low.
After all, who would say no to free (or very low cost) money?
This continued for years and situation today is such that entire world looks like a huge pile of debt. Just about all economic activities involve the flow of credit, in some form or the other. Also, it seems that the only way to have more economic growth is to introduce even more debt into the system!
This (almost) zero-rate regime in advanced economies has helped lift asset prices across emerging countries like India.
The money (borrowed at low-rates) had to find a place where it could earn better returns. So money started flowing into countries with higher growth potential, i.e. emerging nations. India too became a large beneficiary of this money-flow, which played a significant role in pushing Indian markets to new highs in 2015.
But governments are increasingly becoming aware of the risks of continued debt binge. In words of an expert, it is like riding a tiger not knowing how to get down without being eaten. Hence as a first step towards debt-prudence, governments are now looking to reduce the supply of low-cost credit.
The US Federal Reserve (Fed) has already started the process of rate tightening and in December 2015, increased the rates after several years. And as per Fed’s commentary, it will continue increasing rates further if economic factors permit.
But this would be easier said than done. The US is not growing as fast as expected. So increasing rates now will mean trying to accelerate with one foot on the brake.
The fear of a rate-hike stalling economic recovery was evident in the last Fed meet too in April this year, when the officials decided not to raise the rates for time being.
Whether the US actually does increase rates further or not, is debatable.
But one thing is clear that going forward, liquidity will not be like it has been in last 7-8 years (since 2008). The money which found its way into emerging markets till now, will slowly start moving back to developed economies like US. This is because of the reducing interest rates (or expected returns) differential.
But when it comes to inter-country flow of money, things are not that simple.
In spite of the last 0.25% rate hike in the US (in Dec-2015), cost of funds is still not very high. So even if some of the funds were to move out of India, chances of a major chunk moving out at the same time are pretty remote.
Rather, the fear is more about reduction in the new inflows.
But again, money needs to find better avenues for growth. And in a world economy that is slowing, India is one of the very few countries having real potential of long-term sustainable growth. This is something that all foreign investors have known for years.
Just have a look at what FIIs have been doing since start of 2000:
It can be safely said that in last 15+ years, they have been net buyers of Indian stocks, barring two years. This is despite all domestic and global problems that have occurred since 2000.
The point to understand here is that foreign investors need avenues to invest money and earn returns higher than risk-free rates.
And since Indian growth story is still strong, foreign investors don’t have much of a choice. On a long term basis, they need to remain invested in India. Of course, they might reduce/increase their exposure in short-term (which will cause volatility).
But net-net, the foreign investors understand the benefit of staying invested here. With very few similar investment opportunities available, the risk-to-reward ratio of staying invested in India is tilted in favor of reward.
But that doesn’t mean that a liquidity crisis will have no impact on India.
Globalization has ensured that the Indian economy cannot remain insulated from rest of the world.
But if liquidity crisis does take place, it’s safe to assume that the collaborative intervention by central banks of developed countries will inject liquidity. This in turn will reduce the unwinding of Indian investments held by foreign entities. Also, the Indian administration is not sitting idly. RBI is on track to reduce policy rates further to boost liquidity. If there is a need to inject more liquidity, it will not hesitate to do that via CRR/SLR cuts.
So the whole point here is that the fear of decreasing global liquidity is not entirely wrong. But it’s also true that India is in a very good position to manage the situation. India will continue to see FII interest – due to unavailability of suitable alternative investment opportunities elsewhere.
In short-term, stock markets might turn volatile and stocks with having high FII-ownership and foreign borrowings witnessing steep cuts. But this will offer a good opportunity for long term investors to buy shares of good business in times of temporary crisis (http://researchandranking.com/crisis-investing/). This has worked in past for successful investors and this is what will work in future too. The sooner smart investors realize this; better prepared they can be take advantage of such opportunities.