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 had 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 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 has risen 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 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 no
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 which many market observers see as unsustainable.
In fact, otherwise bullish investment advisors are
recommending that investors should book profits and
hold cash till 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.
Chart
1 >> Click
to Enlarge
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 foreign institutional investors
(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 foreign institutional investors
have returned to the market. Since the crisis hit
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 counties and was therefore
a preferred hedge for investors seeking investment
destinations. The other reason is the expectation
fuelled by statements by spokespersons of the UPA
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 foreign direct investment
in a wide range of industries. And 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 policy making
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.
Chart
2 >> Click
to Enlarge
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 are responding
to inflation in the prices of goods they are choosing
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 our 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 policy makers any lessons.
