The Hindu Business Line : Borrowed money flees, triggering melt-down

As Indian investors come to terms with the carnage witnessed in stock markets on Friday, they can draw comfort from the fact that the 10 per cent decline in the Sensex was more due to de-leveraging by global investors than any fundamental factors relating to the domestic market.

Indian stock prices were swept lower in a global wave of panic selling that pulled the Nikkei down 9 per cent, the Kospi down 11 per cent and most of the European markets down between 6 and 8 per cent.

The Dow futures that are traded round-the-clock are down 6 per cent, that is the daily limit for this security.

The reasons cited for this leg of the decline are many.

It was the liquidity crunch and the freezing of the debt markets that caused the stocks to collapse towards the end of September.

Once liquidity eased, following trillions of dollars being injected in to the banks to enable them to stay afloat, the fears of recession and slow-down in global economies have taken over.

These are said to be behind the rout in stock prices this week.

Though the fundamental worries triggering the melt-down in stock prices can be many, it is de-leveraging that appears to be the prime reason behind this melt-down.

Investors often use borrowed capital or leverage to invest in stocks or commodities. Closing these debts in order to curtail further loss is de-leveraging.

The liquidity sloshing around in the financial markets over the last three years, pushing asset prices to unrealistic levels, was caused by investors’ ability to take on excessive debt and take leveraged bets on stocks.

With the sharp decline in asset prices, these debts either turned in to non-performing assets and had to be written down, or the assets had be sold off at a loss and the money returned to the lender.

Yen for yen

The fact that investors world-wide are selling their assets in order to close their debts is borne out by the strength in Japanese yen.

The Japanese currency hardened to 90.9 against the dollar on Friday, the level last visited in 1995. The low interest rate in Japan prompted the yen carry trade through which investors world-wide borrowed money in Japan to invest across the globe.

The yen strengthening denotes that these loans are now being extinguished as investors sell their assets and take the money back to Japan.

The other currency that has been putting up a stellar show over the last month has been the US dollar.

The dollar index traded on the Intercontinental Exchange has gained 14 per cent in just a month. The fact that the US and Japanese investors account for a major chunk of investments in stock markets world-wide could account for the strength in these two currencies as these investors ship the money back-home to re-pay their debts.