M.K. Venu 
Post COVID-19, global markets have produced strange distortions which have confounded both policymakers and market practitioners alike.
These persistent distortions erupted into a global stock market meltdown the past 48 hours, renewing fears of a recession in the US which could seriously impact other large economies. The Japanese stock market was down 12% in a day, sending shivers across global markets. US stocks were down close to 5%. Other emerging market stocks were also down 3 to 4%.
The core problem this time round was Japan, whose central bank had continued to keep its key interest rate at near zero even as the benchmark rate in the US has climbed to 5% plus from 0.25% in 2021. As the US came out of COVID-19 to normalise its growth process, it experienced unprecedented inflation of 7% in 2022 and therefore had to rapidly raise interest rates to 5.5% by July 2023. The Federal Reserve’s primary preoccupation was to put the inflation genie back in the bottle.
Japan, on the other hand, followed a totally different trajectory and continued to keep its interest rate at zero because it did not perceive any fear of inflation like in the US. The vastly contrasting conditions in the US and Japan created a massive arbitrage opportunity for global financial market players, mostly hedge funds. They borrowed Yen funds from Japan at near zero interest rate and started deploying them in the US and other emerging market assets offering much higher returns, whether in stocks or bonds. This flood of ‘easy’ money found its way to other emerging markets, including India.
Thought investors made money without any risk in the near term, over a slightly longer term capitalism does not work on the principle of picking up money free of cost to invest in assets yielding 5 to 7%. The story line was too good to be true.
This party had to end sometime. So it did in Japan which suddenly perceived a run on its currency and instantly hiked its interest rate from 0 1% to 0.25% to stem a further fall in its currency. This caused a domino effect.
The yen had depreciated massively against the dollar in the past two years, from 100 to 160 yen to a dollar. This made borrowing in yen even more attractive for US hedge funds as they ended up repaying much less in dollar terms. But when this trend suddenly reversed, it caused a stampede among those who had used borrowed yen funds to invest in stocks globally. Now they were selling their stocks to repay their yen borrowings before the Japanese currency started appreciating even more, thereby hurting their dollar returns.
The borrowing in yen to deploy in equity assets around the world is called carry trade and what we are seeing now is an unwinding of the carry trades of the past two years when the interest differential between Japan and US was at a multi-decade peak. The US has not seen a high of 5.5% benchmark rates in over 30 years and Japan has been at near zero benchmark rate forever. Now Japan is increasing the interest rate and the US Fed is talking of cutting rates. The two rates are thus converging again, causing a panic in the markets.
So what will happen now? Experts say the accumulated carry trades will take time to unwind. The financial distortions built over two years because of the wide gulf between Japanese and US interest rates will not go away in a day .
So there will be more pain in the months ahead. Expect continued volatility in both the stock and currency markets.
The Indian stock market also fell close to 3% and its currency went past Rs 84 to a dollar before recovering marginally. The real threat is how much the financial market distortions and gradual shrinking of asset bubbles affect the real economy. There is as yet little global literature on how financial markets affect the real economy.
One worrying data point in this regard is how the ratio of global financial asset value (equity and debt) to global GDP was 1:1 in the 1980s but has risen sharply to 4:1 today. The tail seems to be wagging the dog now. This shows how financialisation of assets has established its own global momentum quite independent of real output/productivity on the back of cheap money floating around in the West and Japan. Many experts have warned from time to time that we could be in bubble territory in many financial asset categories like stocks, commodities, real estate, etc.
India cannot be insulated from any global meltdown in financial assets although it can claim to be relatively more immune from the global liquidity virus simply because it is not so integrated with global finance capital via a fully convertible capital account or a fully floating currency. The rupee is still a managed currency.
But India’s real economy is quite integrated with that of the rest of the world via trade and investment flows. Any recession in the US will affect India adversely and hamper full recovery and normalisation post COVID-19.
This piece was first published on The India Cable – a premium newsletter from The Wire & Galileo Ideas – and has been updated and republished here. To subscribe to The India Cable, click here.