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Bubble again

Print edition : Oct 22, 2010

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The signals from the highest policymaking quarters have helped talk up the Indian stock market, where equity prices outrace earnings and fundamentals.

OVER the week ending September 24, there were two days in which the Sensex closed at over 20,000. Having soared from its March 9, 2009, low of 8,160, the Sensex touched 20,045 at closing on September 17, 2010. This is not far short of the 20,873 peak the index closed at on January 8, 2008, after which it collapsed. It also amounts to a rise of around 150 per cent in a little more than 18 months. This steep increase occurred when the after-effects of the global crisis were still being felt in various parts of the world where the recovery has been halting and unemployment still rampant.

There is little disagreement on the fact that this spike in stock prices is the result of a sudden surge of foreign capital inflow into the stock market. Foreign Institutional Investors (FIIs) who opted for net equity sales of $14.84 billion during crisis year 2008 quickly returned to the Indian market and made net purchases worth $17.23 billion during 2009. During 2010 that positive figure touched $15.62 billion even by the middle of September.

The actual impact of FII investment on equity prices is much more than these numbers suggest. Figures from the Reserve Bank of India (RBI) indicate that not only did foreign portfolio investment, which fell from $27.3 billion in 2007-08 to a negative $13.86 billion in 2008-09, bounce back to $32.38 billion in 2009-10, but foreign direct investment (FDI) rose consistently from $34.83 billion to $35.18 billion and $37.18 billion over these years. In the event, total foreign investment was close to a record $70 billion in 2009-10. Since any investment equal to or exceeding 10 per cent of stock in a company by a single foreign investor is defined as direct investment, a significant amount of investment seeking capital gains gets treated as direct investment with a productive interest in the figures. Thus, speculative financial investments are likely to have been significantly higher in recent months.

The impact of such flows on a market that is neither deep nor wide is well known. There are a few firms whose shares are actively traded in the market and a small proportion of the shares of even these companies are free-float shares not held by the promoters and potentially available for trading. When there is a capital inflow surge, a lot of money pursues a relatively small number of shares. So, more than in other contexts, any sudden inflow of capital would result in sharp stock price increases. In the circumstances, there are two ways to approach the recent stock price boom.

One is to recognise that the market has become extremely volatile and that it is plagued by speculation and asset price inflation. The rapid rise in stock prices cannot be justified by movements in corporate sales and profits, and price earnings ratios of many Sensex companies stand at levels that many market observers see as unsustainable. In fact, otherwise bullish investment advisers are recommending that investors should book profits and hold cash until the market corrects itself. This implies that the current bull run can be explained only as being the result of a speculative surge that recreates the very conditions that led to the collapse of the Sensex from its close to 21,000 peak of around two years ago.

The other approach to these stock price movements is to treat the spike in prices as a sign of investor confidence and therefore of the health of the economy. Thus, Finance Minister Pranab Mukherjee had declared that while the Sensex is always a little bit unpredictable, he was happy that for the first time after January 2008 it had crossed 20,000.

Finance Secretary Ashok Chawla has gone even further. He is quoted as saying that the stock market boom reflects the confidence of investors in the India growth story, that it was a vote of confidence by FIIs, and that he does not see the surge in foreign capital flows into India's share market posing any problem as of now.

It is not surprising that FIIs have returned to the market. Since the crisis in the world economy, they have been seeking ways of recouping losses suffered at home during the financial meltdown. And they have been helped in that effort by the large volumes of credit provided at extremely low interest rates by governments and central banks in the developed countries seeking to bail out fragile and failing financial firms.

The credit crunch at the beginning of the crisis gave way to an environment awash with liquidity as governments and central bankers pumped money into the system at near-zero interest rates. Financial firms have chosen to borrow and invest this money in markets where returns are promising so as to quickly turn losses into profit. Some was reinvested in government bonds in the developed countries since governments were lending at rates lower than those at which they were borrowing. Some was invested in commodities markets, leading to a revival in some of those markets. And some returned to the stock and bond markets, including those in the so-called emerging markets like India.

Many of these bets, such as investments in government bonds, were completely safe. Others such as investments in commodities and equity were risky. But the very fact that money was rushing into these markets meant that prices would rise once again and ensure profits. In the event, bets made by financial firms have come good, and most of them have begun declaring respectable profits and recording healthy stock market valuations.

It is to be expected that a country like India would receive a part of these new investments aimed at delivering profits to private players but financed at one remove by central banks and governments. The carry trade where money is borrowed at low interest rates in one currency and invested in a foreign market with high returns would yield good profits, especially since the inflow of capital would itself drive price increases and push the value of the currency to higher levels.

India has received more than a fair share of these investments. One reason for this is the fact that India fared better during the recession period than many other developing countries and was, therefore, a preferred hedge for investors seeking investment destinations. The other reason is the expectation fuelled by statements by spokespersons of the United Progressive Alliance government that it intends to push ahead with the ever-unfinished agenda of economic liberalisation and reform. The UPA-II government has announced and begun implementing its decision to disinvest equity and/or privatise major public sector units. It is further relaxing caps on FDI in a wide range of industries. Corporate tax rates are likely to be reduced and capital gains taxes perhaps abolished.

In sum, whether intended or not, the signals emanating from the highest economic policymaking quarters have helped talk up the Indian market, allowing equity prices to race ahead of earnings and fundamentals. The net result is the current speculative boom that seems as much a bubble as the one that burst not so long ago. What is more, that bubble is being expanded by the strengthening of the rupee that the capital inflows result in, which promises even higher returns on carry trade investments.

The spike in stock prices and the strengthening of the rupee are signals that it is time the government acted to regulate and limit the capital inflows that are generating these speculative trends. But while the government and the central bank have responded to inflation in the prices of goods, they have chosen to ignore the much sharper inflation in asset prices. This amounts to ignoring the fact that India today is the victim of the decision of the developed countries to use liquidity injection and credit expansion as the principal instrument to combat the Great Recession.

This has resulted in a capital inflow surge that generates a speculative bubble as well as leads to rupee appreciation that affects the competitiveness of India's exports. Yet, goaded by financial interests and an interested media, the government treats the boom as a sign of economic good health rather than a sign of morbidity. The crisis, clearly, has not taught most policymakers any lessons.

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