Liquidity bubble may burst soon

New Delhi: Fears of a global liquidity recession are mounting with interest rate hikes being taken up by central banks world over, warn analysts.

Global equity research major Morgan Stanley said in a report on Sunday that the downslide across the world markets is not just another correction and the global liquidity bubble might be bursting.

Morgan Stanley's economist Andy Xie said in a latest report on the Asia-Pacific region that the US Federal Reserve and other central banks across the world are turning to fight inflationary pressure and further rate hikes are necessary to stop inflation.

The Reserve Bank of India on Thursday raised the repo rate - the rate at which RBI supplies liquidity to the money market - by 25 basis points to 6.75 per cent, while the reverse repo rate - at which RBI absorbs excess liquidity from the market - was raised by 25 basis points to 5.75 per cent.

European central bank and other central banks including those of Thailand, Korea and South Africa have also increased their benchmark interest rates in the past few days.

Moreover, the market observers said RBI might further hike rates during its next monetary policy meeting in July.

RBI said while raising the interest rates that the hike was based on a review of current macro-economic and overall monetary conditions though the key driver remain the global rate movements.

RBI Governor Y V Reddy told reporters on Saturday that we can not remain aloof to global factors and they would play a major role in determining monetary policy.

Indication of further rate hikes in the US on the back of fears of slow-down in economy and inflationary pressures has also led to a frenzy among global banks to raise rates, market sources said.

The expected interest rate hike in the US will lead to an increase of money in the US treasury, which will tighten the global liquidity, a leading technical analyst said here.

Morgan Stanley's India-based analysts Chetan Ahya and Mihir Sheth said in a separate report on Sunday that the US Federal Reserve would continue to hike the rates and RBI was likely to keep pace with the Fed.

RBI is likely to raise the reverse repo rate by another 50 bps to 6.25 per cent by the year end, the report said.

However, if the Fed hikes its benchmark rate beyond the current forecast of 5.5 per cent, the RBI would have to follow with larger rate hikes than current expectations, it added.

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Morgan Stanley's London-based economist Stephen Jen said interest rates are more relevant measures of global liquidity and rising interest rates, not drop in currency rate, should impact the mix of inflation, growth and corporate profits going forward.

Andy Xie said that several one-off disinflationary factors such as weak emerging markets and Japan's banking reforms over the past five years have allowed major central banks to maintain low interest rates, despite strong economic growth.

However, as these disinflationary factors are vanishing, the central banks would have to decrease liquidity to stop inflation, Xie added.

Terming the present liquidity situation as artificially high, Xie said that several hot markets of today could decline by 50-70 per cent before global asset prices come back to normal levels.

The report added that the sell-off during the past four weeks has been mild so far, as compared to the preceding boom in the emerging markets.

Morgan Stanley's economist said that part of the strong growth in the past three years was borrowed from the future

and as the liquidity situation normalises a global recession in 2007 becomes a distinct possibility.

As the liquidity bubble unwinds, the currencies should weaken and inflation should accelerate, while leading to central banks embarking upon aggressive rate hikes to avoid a crisis, which could push the economies into recession, the report added.

The concern over potential inflationary pressure and the RBI's resolve to keep it within 5-5.5 per cent might have led to the unexpected rate hike on Thursday, the analysts said.

The analysts are also warning that if the interst rates go too high it could consequently lead to deceleration of the global growth regime or even a worlwide recession.

In addition to this, corporate India's profitability growth may come under pressure on the back of higher interest costs on debt taken for expansion purposes, they said.

The banking sector, which is already facing liquidity pressures, have taken steps with leading private bank ICICI bank raising its interest rates by 50 basis points on Friday.

Although, the rate hikes would ensure long-term inflation expectations to remain anchored at levels consistent with price stability which would support the economic growth in the future, the analysts said.