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Mumbai high noon, Delhi new dawn
- Crystal gazers wonder if investors will keep buying into the most expensive emerging market

Who would have thought, at the end of 2004, that the dollar would rise like a Phoenix in 2005, or that gold would reach an 18-year high or that the Sensex would soar 40 per cent'

The concerns a year ago were very similar to the ones that worry investors today. These included the fear that interest rates would rise in the US, reducing FII inflows, the apprehension that the US economy would slow down thus affecting global growth and equity markets and worries that the huge US current account deficits would be difficult to finance.

At home, Corporate India's sizzling rate of growth was widely expected to slow, and interest rates were expected to rise. Rising oil prices, higher commodity prices and a slowing down of the Chinese economy were other concerns. On the positive side, investment demand in India was supposed to boost the economy, and a falling dollar was expected to be good for non-dollar assets.

What actually happened in 2005' Interest rates in the US did go up, and its current account deficit widened so much that it requires nearly $3 billion a day to finance it. But that didn't affect flows to emerging markets, which rose much higher than in 2004. The dollar not only stopped depreciating but rose against all currencies, yet money continued to flow to non-dollar assets. Oil and commodity prices also rose, but had a negligible impact on global growth.

In India, corporate margins were squeezed, and earnings growth decelerated but that didn't stop FIIs from continuing to pour money into the market.

So, the questions that investors face today are the ones they faced at the beginning of last year----whether liquidity will remain buoyant and whether corporate earnings growth will continue to be high.

To take the issue of liquidity first, if inflows to emerging markets have increased in spite of the Fed Funds rate going up from 1 per cent to 4.25 per cent, then it's very likely that they will continue even if the US Fed tightens by another 50 basis points or so. The Fed has already indicated that it is near the end of its tightening cycle, and inflation remains subdued although oil prices have risen so steeply. And if inflation remains tame, why should central banks bother to hike rates'

Local liquidity is likely to be higher because domestic investors seem at long last to have started participating in the rally, and inflows into equity mutual funds in 2005 have already exceeded the cumulative inflows in the preceding five years. On the other hand, there will also be an increased supply of capital issues.

India Inc's earnings growth is likely to decelerate. A Morgan Stanley study had showed that earnings growth of 72 companies, representing 56 per cent of market capitalisation, had fallen to a two-year low in the September quarter. Much of the earlier growth in earnings had come about by the extraordinary increase in operating efficiency of Indian companies. That scope is much reduced. While capacity expansion will lead to higher volumes, that will take time. Mergers & acquisitions are a more promising route to quick returns. Higher rural demand, too, will help.

On the economic front, while GDP growth is expected to be robust, the current account deficit seems set to widen. This will put further downward pressure on the rupee. But high foreign direct investment will offset some of that.

In short, if the Indian stock market is to repeat its 2005 performance, two things need to happen. One, global liquidity must continue to be abundant. That is very probable. Two, strong foreign fund inflows must continue even though average share prices in India are trading at a 40 per cent premium to those in other emerging markets. That seems unlikely.

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