Advantage India: Why our markets will outperform the West

Indian equity and bond markets are set to outperform their global counterparts in the next one year. The reason is that the Reserve Bank of India (RBI) can cut rates and infuse liquidity into the system once inflation cools off, while the US and eurozone economies do not have policy tools nor the fiscal capability to infuse growth.

Indian equity and bond markets performed poorly in the last one year as the RBI and the government were trying to contain rising inflation expectations. The Sensex and Nifty have given almost no returns over the last one year while the benchmark 10-year bond yield has risen 40 basis points (100 basis points make 1 percent) in the same period.

The US markets, on the other hand, have performed much better with over 10 percent returns for equity indices and bond yields have dropped by almost 130 basis points over the past one year.

The European markets had, till July, outperformed Indian indices with over 10 percent returns, but August wiped out all returns due to sovereign debt issues in the eurozone. UK gilts have performed well with drops in yields of around 90 basis points while German bund yields have remained flat in the same period.

The Indian repo rate (the rate at which the RBI lends to banks) is at 8 percent while the CRR (cash reserve ratio) is at 6 percent. Inflation as measured by the WPI is trending at 9.5 percent levels and this is expected to come down to 7 percent levels by March 2012.

If inflation is seen as more benign going forward on the back of global worries on growth, the RBI can start cutting policy rates. Lower policy rates coupled with higher systemic liquidity will help the economy along the growth path.

As opposed to RBI’s policy tools, central banks and governments in the US and Eurozone have limited policy options. The positive response from the RBI and the lack of response from central banks in developed markets will lead to outperformance of Indian markets.

The Jackson Hole conference ended with all the central bankers concerned urging governments to act quickly to bring the economies out of a slump. Central bankers’ tools are limited to bring economies out of the woods, especially as they have used most of the ammunition they have.

The US Federal Reserve (Fed) has pledged to keep interest rates at near-zero levels for two more years. The European Central Bank (ECB) has raised its policy rates by 50 basis points over the last five months but the rates are still close to all-time lows.

The Bank of England has kept policy rates unchanged for the last two-and-a-half years at all-time lows despite inflation running way above targets. The Bank of Japan is running an ultra loose policy stance post the tsunami, which hit Japan earlier this year. All the central banks mentioned here are buying or have completed buying government bonds to add liquidity into the system.

Yet the real economies in US, UK, Eurozone and Japan are all coming under a cloud on the back of debt issues, lack of government initiatives and high unemployment. Economists have revised downwards global growth forecasts for the next two years by around 30-70 basis points.

The issue is what can governments do. Sovereign debt is becoming a big issue and all indebted countries in the developed world are implementing or have already implemented austerity measures to bring down debt. The US is planning spending cuts of over $ 2 trillion in the years to come while countries from the UK to Italy and France are all trying to bring down budget deficits.

Tax reduction is out of question and spending on infrastructure is uncertain due to budget constraints. The developed world has to live with anaemic growth till budget deficits stabilise. However for deficits to stabilise, economies have to grow and if economies do not grow due to lack of government spending it leads to a catch-22 situation. Unless there is significant private sector activity it is unlikely that the catch-22 deadlock will be broken.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.