Inevitable fall

AT A TRADING house in Kolkata, on May 22, when the markets crashed.. - ARUNANGSU ROY CHOWDHURY

Attributing stock market volatility to the inadequacy of "reform" or the obstacles set by Sonia Gandhi or the Left makes no sense.

IT was inevitable, yet it took many by surprise. In May, the Bombay Sensex, the benchmark index for India's stock markets, fell by more than 1,800 points or by close to 15 per cent of its value, after experiencing a near-relentless climb over the preceding months. The decline began after May 10, when the market closed with the Sensex at an all-time high of 12,612. The decline from that day to June 1 amounted to 2,541 points or more than 20 per cent. A fifth of paper wealth created from nothing disappeared in a matter of three weeks.

Any disinterested observer, not influenced by those talking the market up, would see this decline as inevitable. In the preceding rise, moderated occasionally by limited volatility, the Bombay Sensex had moved from 5054 on July 22, 2004 to 7,077 on June 21, 2005, 9,067 on December 9, 2005, and 12,612 on May 10, 2006. This implies an increase of 35 per cent in the second half of 2004, a smaller 8 per cent in the first half of 2005, 31 per cent in the second half of 2005 and 33 per cent in the period between January 1 and May 10, 2006.

This persistent and rapid rise had taken the price-earnings (P/E) ratio of Sensex companies from 14.5 on July 1, 2004 to 22.2 on May 10, 2006. If investors expect a reasonable return of 15 per cent on their investments and the price to earnings ratio reflects expected earnings from holding equity, P/E ratios in May would indicate that investors believed that average returns from holding shares would rise by more than 300 per cent. Since this was unlikely, investments that triggered the boom must have been driven by expectations of capital gains from share price appreciation, and therefore, been largely speculative.

Yet, the euphoria generated by this rise in stock prices spawned a number of arguments on the implications of the rise. The first was that the stock market was merely reflecting the confidence generated by the robust performance of the Indian economy, with growth rates moving to the 8-9 per cent range. Second, that this economy-wide performance was leading to much better corporate performance, so that the appreciation in the share prices of individual companies was warranted by their expected profitability. Third, that these features made the Indian stock market experience different from that in other emerging market countries, in that the boom was warranted and should provide no cause for concern. And, finally, that all this suggests that financial liberalisation has taken the Indian stock market to maturity, making it a good indicator of the health of the economy.

What the substantial volatility and downturn in May proves is that none of these arguments is valid. It is indeed true that the rate of growth of the Indian economy has improved, though the extent of the improvement may be exaggerated by modifications in methods of computation. But in explaining this improvement, what needs to be taken into account is the rise in government expenditures supported by increased receipts, the change in the composition of government expenditure and an improvement of exports of both goods and services.

The contribution of the stock market to these factors is virtually nil: market players are more beneficiaries of tax concessions rather than contributors to government receipts; market sentiment is in favour of reduced rather than increased government expenditures and there is no direct way in which stock market activity can influence export performance.

That there is no relationship between growth performance and stock market activity was demonstrated amply by the fact that the revised estimates of GDP (gross domestic product), released on May 31, showing a creditable 8.4 per cent growth during 2005-06 and a remarkable 9.3 per cent during the first quarter of 2006, did little to stop the market's decline. Expectations that drive the market seem to have little to do with the actual performance of the economy.

If it is not growth in the real economy but speculation that triggered the boom, it is not surprising that the downturn did occur in Indian markets, as it did in other emerging markets that have experienced speculative booms in the past. This, contrary to what was argued, makes the experience in India similar to that in other liberalised "emerging markets". In fact, what is striking about the recent slump in the Indian market is that though steeper it was synchronised with similar declines in markets worldwide. Led by the United States, the downturn occurred in a number of emerging markets, including Russia, Turkey, Indonesia South Korea and Taiwan. India is as vulnerable as these countries to periodic booms and busts.

The most-quoted reason why global investors have gone bearish on all markets, resulting in the generalised downturn, is the expectation of a rise in interest rates led by rates in the U.S. This is indeed surprising since, in the past, a rise in interest rates in the U.S. was seen as a factor that would direct capital flows to and generate a boom in U.S. financial markets, while inducing sluggishness elsewhere. The reason why this has not happened this time is that investments during the recent speculative boom have been financed with borrowing. As Financial Times of May 30 reported: "Low interest rates in the developed world would have allowed investors to leverage, borrowing cheaply to pick up the higher returns on offer elsewhere. It is these investors who are likely to have unwound trades over the past fortnight, weakening stocks and local bonds." Thus, it is not speculation alone that is at issue, but leveraged speculation, which makes expectations of a rise in interest rates the cause for a global downturn.

In the circumstances, the only way in which damaging financial crises can be avoided is to regulate the market and limit the presence and activity of speculative investors. There have been too many instances in East Asia, Latin America, Turkey and elsewhere where a financial crisis was preceded by a surge in capital flows other than foreign direct investment (FDI) and a simultaneous boom in stock and/or real estate markets. Independent of their inclinations, the exact causal mechanisms they identify and where they place the burden of blame, analysts of those periodic crises have accepted the reality that liberalised financial markets are prone to boom-bust cycles. Hence, there was little reason to view the India-boom as being "different" and "warranted by fundamentals", justifying further financial liberalisation in the process. Financial liberalisation driven by the belief that a boom was a sign of strength rather than vulnerability inevitably went bust.

Unfortunately, the Indian government seems committed to pursuing financial liberalisation without much caution. The result has been that while official spokesmen have listed periodically the gains that India can make from FDI, an overwhelming share of capital flows into India has been contributed by portfolio investors, especially foreign institutional investors (FIIs). The recent boom has been clearly the result of a surge in FII investments. Having averaged $1,829 million during the period 1999-2000 to 2001-02, and fallen to $377 million in 2002-03, FII investments surged thereafter. Inflows averaged $9,599 million a year during 2003-05.

More recently, FIIs are estimated to have pumped in $10.7 billion into India's markets in 2005 and a further $5 billion by May 11 this year. It is widely acknowledged that the stock market surge was the direct result of these investments, though it is true that domestic investors, including mutual funds have rushed to the market recently to profit from the boom.

In the course of the boom, the nature of the foreign investor has also changed with a growing presence in India of institutions such as hedge funds, which are not regulated in their home countries and are known to resort to speculation in search of quick and large returns. These hedge funds, among other investors, exploit the route offered by sub-accounts and opaque instruments such as participatory notes to invest in the Indian market. FIIs are permitted to invest on behalf of clients who themselves are not registered in the country. These clients are the `sub-accounts' of registered FIIs. Participatory notes are instruments sold by FIIs registered in the country to unregistered clients abroad and are derivatives linked to an underlying security traded in the domestic market.

By the end of August 2005, the value of equity and debt instruments underlying participatory notes that had been issued by FIIs amounted to close to half of the cumulative net FII investment. Through these routes, entities not expected to play a role in the Indian market have had a significant influence on market movements, even though the regulator often does not even know of their presence in the market. And their presence is determined by the objective of quick profit financed with borrowing, if necessary.

The damaging effect of these investors came through when, because of changed expectations, they decided to pull out around $2 billion between May 11 and May 25. In the event, a sharp downturn in the Sensex ensued. It is necessary to be clear as to why these expectations changed. They are primarily related to developments outside India, especially expectations of a rise in U.S. interest rates that could increase the cost of funds borrowed by speculators to make their investments. This also explains the synchronised decline in markets worldwide.

However, there is a concerted effort to divert attention from these features of markets post-liberalisation by focussing on internal reasons for the decline in stock prices. One argument advocated by protagonists of financial liberalisation is that the obstacles set by the Left and even Congress president Sonia Gandhi to the advance of economic reform have generated uncertainty in the markets, leading to the loss of paper wealth which should not have been accumulated in the first place.

Thus The Wall Street Journal Europe (May 24, 2006) suggested that Sonia Gandhi's "actions as leader of the Congress party and chairwoman of the governing coalition are causing increasing worries among investors as to the pace of economic reforms". It quotes one Indian market research consultant, who is by no means a disinterested observer, as saying that "the major obstacle to reform is Sonia Gandhi".

This response is in keeping with the overall perception that liberalisation policies that spur speculative fever of the kind seen in the markets should not be tempered in any way, as it hurts investors and can trigger a retreat that can be damaging.

The other argument, advanced in Financial Times of June 1, is that the decline in India's markets is because of concern over the deficit in the current account of the country's balance of payments, estimated to touch 3.6 per cent of GDP in 2006-07. The conclusion is that the country must attract more foreign investment to finance that deficit and must therefore continue with reform, including with financial liberalisation that explains the recent mayhem in the stock market. In fact, the same issue of Financial Times approvingly quotes a study by the consulting firm McKinsey that "calculates" that reform of India's banking sector can lift GDP growth to 9-9.5 per cent.

However, as the discussion above makes clear, all talk attributing stock market volatility in India to the inadequacy of "reform" or the obstacles to reform set by Sonia Gandhi or the Left is that much nonsense. The Indian market is driven by global decisions, which in turn are determined by the speculative activities of key investors the government seeks to attract. Once we recognise that financial volatility is the result of the speculative behaviour of these firms, measures to reduce the presence and influence of these investors seem to be the need of the day. If either the Sonia Gandhi camp in the Congress or the Left is calling for caution and holding back policies that feed such speculation, they are only doing the nation good.