Global blues and the Sensex

WORRIED INVESTORS LOOKING at the monitor outside the Bombay Stock Exchange on January 22. - PAUL NORONHA

The crash is driven by heavy selling by FIIs following evidence of losses stemming from the U.S. sub-prime mortgage crisis.

IT was expected, yet sudden, steep and surprising. After having ruled over 20,000 during the first 15 days of this year, the Bombay Stock Exchange Sensitive Index (Sensex) seemed to reflect some caution over the next three days, falling to 19,013 at the close of trading on Friday, January 18. But when markets opened on the following Monday (January 21) a collapse occurred. The market opened at 18,919, only to sink to an intra-day low of 16,851, involving a loss of 1,968 points or more than 10 per cent in its value. Though the index recovered to 17,605 by close of trading, uncertainty prevailed. Despite reassuring statements from the Prime Minister and the Finance Minister, the Sensex fell further to 16,730 at close on January 22, recovered to 17,594 at close on January 23 and fell once again to 17,222 by the end of January 24 (see Chart 1).

Overall, the closing value of the Sensex had declined by 3,652 points (or 17.5 per cent) relative to its previous peak on January 8. The increased uncertainty comes through in the difference between intra-day highs and lows, which fluctuated between 1,000 and 2,000 points during the four days ending January 24, as compared with levels below 500 in all but two days during the first half of January.

To put the decline in perspective, it is useful to compare it with the gains the Sensex has registered in recent times. In proportionate terms, it is less than half of the increase (37 per cent) the index registered between February 7, 2006, when it first closed above 10,000 and the end of that year. It is only around two-fifths of the proportionate increase (45 per cent) registered during 2007. This makes the decline appear less dramatic. The only distinguishing feature of the recent fall is that it has been sharp, having occurred in less than a fortnight, though there have been times during the bull run of recent years when a fall of similar magnitude occurred within a few days.

Equity markets being what they are, and increasingly dominated by speculative punters looking for capital gains rather than dividend incomes, deciphering what drives sentiment is near impossible. Relying on statements by market players is of no help because they are partly second-guessing their rivals and partly hoping to influence the market. Yet, there seems to be consensus on the fact that the collapse was driven by heavy selling by foreign institutional investors (FII) plagued by growing evidence of losses stemming from the sub-prime mortgage crisis in the United States and by fears of a recession stoked by statements emanating from the U.S. President and the chief of the Federal Reserve.

The slump triggered by these investors is not without its lessons. What it shows is that the much-celebrated rise of the Sensex from its 10,000-level early in 2006 to its higher-than-20,000 level in recent times was driven by FII inflows. FII net purchases of equity, which rose from just $740 million to $6.6 billion in 2003, $8.5 billion in 2004 and $10.7 billion in 2005, fell marginally to $8 billion in 2006. It then shot up to a huge $17.2 billion in 2007 (Chart 2). Besides the liberal policies with regard to foreign investment in the stock market, there were three factors that were responsible for these inflows.

The first was the supply-side push created by the excess liquidity in the global system resulting from easy money policies in the U.S., foreign exchange surpluses in many developing countries, and higher oil revenues and surpluses. This liquidity found its way to institutions seeking to profit from purely financial transactions, and some of it flowed from them to the so-called emerging markets such as India.

The second was that the rise in stock prices in all emerging markets resulting from this supply-side push attracted speculators. That is, the inflation in financial asset prices was self-reinforcing. It was generated in the first instance by foreign capital flows to emerging markets, and once realised encouraged further such flows.

Finally, in most emerging market countries, the huge inflow of foreign capital that ensued resulted in an appreciation of their currencies. This in turn encouraged further speculative inflows. Foreign investors buying into equity in India (for instance) did not just expect high returns from stock price inflation but an additional return because the rupee was expected to be worth more in terms of foreign currency by the time the transaction was complete. This meant that the rupee value at which equity was sold yielded more dollars than it would have garnered at the time when the stock was first purchased. Domestic currency appreciation inflates returns further.

The massive increase in FII presence in Indias stock markets that these factors triggered was responsible for the Sensex crossing consecutive psychological peaks to double in value, from 10,000 to 20,000, in less than two years. This 100 per cent appreciation in value made nonsense of the propaganda unleashed by financial interests and supported by the Finance Ministry that Indian markets were behaving the way they were doing because of strong fundamentals and robust corporate performance. Fundamentals, however strong, cannot justify asset price inflation of this magnitude. Further, this was not just an Indian phenomenon. That the boom was largely supply-side driven also came through from the fact that it was not just in India but in a large number of emerging markets that financial asset prices were soaring.

If the boom was driven by a supply-side push of capital into these countries, any development that cuts off or reduces supply is likely to stall and reverse the boom. And if the cut-off occurs all of a sudden, the reversal is bound to be sharp. This is what happened in the middle of January when expectations soured in global markets. If both the boom and its reversal were driven by foreign investor sentiments and decisions, the outcome should not be a cause for concern for domestic interests and the real economy. But there are many ways in which the foreign-finance-driven boom entangles domestic interests, making them unwilling to accept the collapse of the speculative bubble.

The immediate and frivolous reason is, of course, that the government has made the stock market and its indices indicators of economic health. If much was made of investor interest in Indias financial markets as an indicator of Indias economic success and global arrival, any loss of such interest threatens the legitimacy of the growth process and policies that were justified on the basis of stock market performance. But this alone cannot explain the panic at the highest policymaking levels, reflected in the Prime Ministers statement that sustaining orderly growth in the stock market was a priority concern for the government, or the Finance Ministers call for calm supported by the assurance that ample liquidity would be offered to support investors.

These statements could have been motivated by two factors. The first is the desire to stall a massive pullout by foreign investors sensing the start of a downward spiral that could trigger a financial crisis. This the government may have sought to do by telling them that through the many means it has at hand it would prop up the market for some time. Besides pumping liquidity into the system to encourage domestic players to pick up stocks at prices discounted relative to their previous peak, it could privately persuade the domestic financial institutions it controls to buy and stall the markets decline.

The second motivation could be the desire to placate domestic business and financial interests that can be adversely affected by the downturn. A long-term boom in stock markets inevitably attracts domestic corporates, high-net-worth investors and smaller players hoping to share the benefits of the boom. Some of them would have bought into the market at a time when prices were already high. If prices collapse, a significant reduction in gains or substantial losses is inevitable. This is bound to affect the legitimacy of a government that stoked the excessive optimism that an externally driven boom generates.

Domestic firms would also be disappointed by a downturn in markets. Some successful firms and even some not-so-successful ones have been able to exploit the boom by resorting to new capital issues involving high premiums, reducing the cost of capital to finance expansion substantially. Others hoping to imitate them would have to hold back or postpone planned public offers if the market slides.

Further, inflated prices of listed equity also increase the value of equity in unlisted firms. Exploiting that opportunity, many unlisted firms have privately placed large chunks of equity with financial investors at prices that would earlier have sounded exorbitant. A market downturn would deprive other firms of such an opportunity. It may also encourage sale of such equity with adverse implications for control by incumbent managements.

All of these imply that while the boom and the slump are driven by foreign investors, there are domestic players now with a strong interest in ensuring that stock markets remain buoyant. A downturn would be anathema. This increases the pressure on the government to seek ways of stalling the downturn, whether by enhancing liquidity, reducing interest rates or just getting publicly controlled financial institutions to work against the decline.

While there is no clinching evidence to establish the last of these, the fact that domestic institutional investors are net purchasers when foreign investors are net sellers is indicative. On January 24, for instance, FIIs were net sellers to the tune of Rs.2,254 crore, while domestic institutional investors were net buyers to the tune of Rs.1,117 crore. Given the herd instinct in markets, the normal tendency would be for domestic investors to cut losses also and exit, unless other influences persuade them to not just stay but increase their presence.

The point to note, however, is that if global factors result in FIIs persisting with their desire to exit, the downturn cannot be stalled by such counter-cyclical action by domestic institutional investors. The exit by FIIs could persist not only because the sub-prime crisis worsens or because the recession actually arrives, but also because these investors are forced to book profits here to meet commitments at home. In the event, domestic institutional investors may merely end up with losses that can affect their financial strength.

The lesson to be learnt is that emerging markets like India should put in place measures that prevent them from being the targets of supply-side-driven flows of capital into their equity markets that make them excessively vulnerable to global weaknesses. What is surprising is that Finance Minister P. Chidambaram is still stuck with the idea that this country is not vulnerable to global developments and can thrive on its strong fundamentals. While seeking to calm investors, he reportedly declared: Worries of the Western world should not be allowed to overwhelm us... our economy is very different from the economies of some developed countries. Our economy is a strong economy and the corporate sector is very strong.

It did not, however, take him long to retract from this decoupling theory. The steep 0.75 percentage point cut in interest rates by the U.S. Federal Reserve aimed at stalling a recession raises the possibility that there could be a revival of capital inflows seeking to profit from the increased differential between U.S. and Indian interest rates. This flow is likely to be in the form of debt rather than equity investment and could increase pressure on the rupee and worsen the difficulties created by large flows for macroeconomic management.

Recognising this, the Finance Minister appears to have quickly changed his tune. Speaking to presspersons at Davos, Switzerland, he reportedly said that the government and Indias central bank have taken and will take measures to moderate capital inflows but without hurting the flow of capital that stimulates the economy. This retraction, even if partial, is reassuring. But conflicting statements in quick succession do weaken confidence in the policy establishment.