Volatility in Markets

Dollar carry trade, Dubai World or capital controls?
Tue Dec 1, 2009

By Nipun Mehta

In my last article on Dollar carry trade (on which innumerable interesting reader responses were received – Thank you), we concluded that the carry trade was unlikely to reverse in a hurry unless the USD suddenly appreciated against the rupee or various major currencies, or interest rates in USA started rising fast.

In the interim Dubai World happened and once again there are concerns all round, partly justified. What if there are capital controls imposed by some Governments? How do all these contribute to global currency flows or create uncertainty in say the Indian equity markets?

It is important to reiterate here that it is these external factors which are creating sharp volatility in emerging markets or specifically the Indian capital markets.

This is because fundamentally all these economies, particularly India, are internally strong enough to sustain reasonable growth through domestic consumption growth.

Firstly, events like the carry trade and Dubai World create sharp currency volatility which can actually leave global businesses vulnerable.

Secondly, if a large industry like the Dubai real estate can collapse, it can have its repercussions on the Paint industry, the Cement industry, the tile industry, on Indian and global turnkey project companies who had the Dubai exposure and who could face working capital pressures, and of course on raising unemployment there.

Thirdly, local Banks in Dubai can lose credibility since in recent times many of them had been issuing Bonds at high interest rates and may just end up in serious payment delays/ defaults. Any leverage created against such Bonds will start facing Margin calls, another bad memory of the 2008 days when leveraged Bond investments were sold at huge losses due to investor inability to pay margin calls. Surely there will be some Banks who could face some losses on such lending.

What about capital controls? Central Banks in the past have imposed capital controls on entry or exit of foreign capital, particularly hot money flows. Is that a possibility today?

Well not in India where forex reserves appear to be reasonably comfortable though they will get affected by potentially lower flows from NRIs in Gulf States. However such a possibility cannot be ruled out for fundamentally weaker economies with more vulnerable forex reserves.

Some European Governments have been known to impose restrictions on local funded Banks for lending to domestic auto majors for their expansion plans in other countries.

Can all this have a material impact on Indian corporates? For one, some Indian companies and Banks do have a marginal exposure to Dubai. It will give them a reason to make provisions for the December and March quarter.

Earnings of select companies in industries listed above could settle for some write offs. The ripple effect could be there, the fallout, minimal.

Effectively, neither of the above yet appears to be an immediate serious threat to any specific emerging market or to the Indian equity markets. What they will surely create is greater unpredictability, instability and volatility. Equity markets going forward may not be for the weak hearted, but were they ever supposed to be?

http://in.reuters.com/article/economicNews/idINIndia-44370620091201?sp=true