Global Market Jitters Indicate Fragile Economic Recovery, Impacting India

These ongoing distortions have caused a sell-off in global stocks over the last 48 hours, reigniting fears about a possible US recession that might have a substantial impact on other major economies. The Japanese stock market fell 12% in a single day, sending shockwaves through the world’s markets. While stocks in emerging markets sank by 3 to 4%, US stocks fell by about 5%.The central issue this time was Japan, where the central bank maintained its key interest rate near zero, while the US benchmark rate had surged from 0.25% in 2021 to over 5%. As the US emerged from COVID-19 and worked to stabilize its growth, it faced an unprecedented inflation rate of 7% in 2022, leading to a rapid increase in interest rates to 5.5% by July 2023. The Federal Reserve’s main focus was to control and reduce inflation. Japan, in contrast, took a different path by maintaining its interest rate at zero, as it did not face the same inflation concerns as the US. This stark difference between US and Japanese economic conditions created a significant arbitrage opportunity for global financial players, particularly hedge funds. They borrowed yen at near-zero interest rates from Japan and invested in higher-return assets in the US and other emerging markets, including stocks and bonds. This influx of “easy” money also flowed into other emerging markets, such as India.

The party had to end eventually, and it did when Japan suddenly experienced a currency run and raised its interest rate from 0% to 0.25% to halt the yen’s decline. This triggered a domino effect.

Over the past two years, the yen had depreciated significantly against the dollar, from 100 yen to 160 yen per dollar, making borrowing in yen highly attractive for US hedge funds, who repaid much less in dollar terms. However, when this trend reversed, it led to a rush among those who had used borrowed yen to invest in global stocks, as they rushed to sell their investments to repay yen loans before the yen appreciated further, impacting their dollar returns.

This borrowing of yen to invest in global equity is known as the carry trade, and what we’re witnessing now is the unwinding of these trades from the past two years when the interest rate gap between Japan and the US was at a multi-decade high. The US has not seen benchmark rates of 5.5% in over 30 years, while Japan had maintained near-zero rates. With Japan now raising interest rates and the US Fed considering cuts, the convergence of these rates is causing market turmoil.

Experts predict that unwinding these carry trades will take time, and the financial distortions built up over two years will not disappear overnight. Expect continued volatility in both stock and currency markets.

In India, the stock market fell close to 3%, and the rupee dropped past Rs 84 to the dollar before making a slight recovery. The real concern is how these financial distortions and the gradual shrinking of asset bubbles will impact the real economy. There is limited global research on how financial markets affect the real economy.

One concerning data point is that the ratio of global financial asset value (equity and debt) to global GDP was 1:1 in the 1980s but has surged to 4:1 today. This indicates that financial markets have developed their own momentum, largely independent of real output or productivity, fueled by cheap money in the West and Japan. Many experts have cautioned that we might be in bubble territory across various financial assets like stocks, commodities, and real estate.

While India may be relatively more insulated from a global financial meltdown due to its less integrated capital markets and managed currency, its real economy is linked with global trade and investment flows. A recession in the US could negatively impact India, hindering its recovery and normalization post-COVID-19.

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