Going by the measured approach the Reserve Bank of India governor D Subbarao has taken in the monetary policy, the broad consensus seems to be that a rate tightening is coming sooner than expected. The money markets seemed fairly well prepared for the move as yields did not go berserk after the policy announcement, but the stock markets seemed to have been caught unawares. The new provisioning norms came as a jolt to banking and realty stocks that took a severe beating, contributing almost 3.7 per cent to the Sensex fall on the day of the policy announcement.

The question for stock market investors really is whether the party is coming to an end. To answer that first let’s look at what kick-started this rally since March. The most accepted explanation is the gush of foreign inflows – about $13 billion this year – that almost negated all the outflows that caused the confidence shattering fall last year. Those foreign inflows were largely a result of the liquidity brought in by the Federal Reserve and accommodating role played by central bankers in other parts of the world.

"So all this while, be it an easy policy, accommodating policy or a hawkish one, the local policies have been dictated largely by the US."

And then the government measures here helped the economy gain back some traction. So you had industrial production coming back closer to normal levels, corporates gaining some confidence which lent stability to job markets – and, of course, the election results ensured that India got its due share (possibly more) of foreign flows.

So the important thing to watch is what happens to the $13 billion that has come in. Will this money continue to stay put, or go back entirely or in part. Already, in the past one week, FIIs have sold shares worth $500 million. Further action might have more to do with what happens around the world, and much less in India.

In several other emerging markets the dilemma facing policy makers today is the same: how to stem inflation as also the asset price bubble. In China, even the top brass admit that 60 per cent of the stimulus money has found its way into real estate and stock markets. Policy makers in Korea and Shanghai are tightening the provisionary belt to stem asset inflation. If this gathers momentum, then the much-talked about reflation trade may no longer be tenable. So while you may expect a tightening in the developing world, it’s not the same story in the US from where bulk of the world’s capital originates. For the US, hiking interest rates does not seem to be an option; it would not like to do so as it would mean having to bear the burden on fresh issuances. And more importantly, raising rates could hit already weak consumer spending, the revival of which is vital for its growth and for the rest of the world too. So, if the US keeps interest rates where they are, the dollar carrytrade could play out for an extended period. It also means that asset bubbles that emerging markets are trying to wriggle out of, will not be an easy task.

Unfortunately, the Federal Reserve governs the way the world financial system functions – call it the central bank of central banks. But the rest of the world even collectively cannot dictate terms to the US. So all this while, be it an easy policy, accommodating policy or a hawkish one, the local policies have been dictated largely by the US. So, while each country can devise its own fiscal and monetary measures to target inflation and prevent asset bubbles, they will not be able to do so without resorting to drastic measures like capital controls. Remember the move by Chidambaram to curtail “copious flows” aka participatory notes? We know what happened to markets then. While that may sound drastic, it could be the only option in the face of increasing capital flows and our inability to deploy them without stoking asset bubbles.

For now, the question that is haunting us is whether the government will play ball with the RBI and let any kind of tightening happen. What applies to the average borrower also applies to politicians when they approach the markets to fund their profligacy.

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mahalakshmi AT outlookindia.com