Risk Spread, Liquidity and more..

One of the measures of investor's desire to take risk is something known as the "spread".

The "risk spread" is the difference between the estimated rate of return on 2 alternative investments, identical in tenure (the time horizon of an investment) but differing in risk.

"Liquidity" is essential to keep any economy moving along, just as it is essential to keep your house from functioning. Every day you need to pay bills to keep your home from functioning like a home with food and milk and daily houselhold needs.

Similarly, the US economy needs some level of liquidity to keep running on a daily basis. Companies have access to this liquidity via short term Commercial Paper. These 3-month instruments are issued to the banks and other investors (who have surplus cash) and are used by the companies to pay salaries, short-term expenditures like buying paper clips or spare parts - "working capital" in financial jargon. These 3-month loans are normally seen as very low risk and are issued by financially strong companies.

The chart below shows how the "spread" between what a US investor in a 3-month government security (the Treasury Bill which has zero risk) widened suddenly as investors decided to move away from any risk. These invstors were willing to park their money in these 3-month T Bills and were happy to take a lower interest rate (see the sharp decline in the yellow line).

It is important to note that the rate of interest paid by the borrowers increased - but only marginally. The widening of the spread (the difference between a risky asset and the less risky asset) was more due to the fact that investors shunned risk and had no desire to lend money to any company - irrespective of its financial strength.

The 0.5% cut in the US Federal Reserve's discount rate (from 6.25% to 5.75%) was intended to allow banks to start taking money from the Fed and use these extra funds to go out and supply liquidity to the companies in the real economy.

This graph is important because it highlights what can happen to international capital flows into India. Since nearly 50% of the FII flows into India is reportedly via P-Notes and consists of short-term capital, India is unfortunately, linked to changes in short-term interest rates and, more importantly, changes in short-term assessment of risks.

If these short-term investors decide they wish to be in less risky assets, they can - very quickly - retain their extra funds in assets which give low returns and sacrifice the returns they could get from assets like the Indian stock market.

So, a 3.0% annualised return on 3-month loans to the US government is more attractive than a possible 15% annualised return from buying Indian stocks.

Its not that India has become less attractive - its just that international investors with short-term investment time horizons want less risk.

However, if the recent stalemate between the coaltion partners over the Indo-US nuclear deal continues, then these short-term investors will consider India a more risky investment proposition.

These investors will then demand more return for staying on - or entering - India's more risky stock markets.

That is why, while most stock markets around the world recovered in a "relief" rally on Tuesday, August 21st, the Indian stock markets saw a -3% slump.

How long will this last?

We don't know - but what we do believe is that as long as India encourages short-term capital flows via P-Notes, our stock markets will be linked to these global cues. On the upside and the downside.

This is great for the brokers and the TV channels that need to see some activity every second - but not good for your heart.