The Telegraph
Since 1st March, 1999
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- How should India deal with market volatility'

In hardly two weeks the stock market collapsed to levels that were ruling a year earlier and is still behaving most erratically. The variations have been much more than the stock market fluctuations in other emerging markets. Investors knew that equity prices were rising far beyond those justified by price-earnings ratios. Analysts were persuaded by the pervasive hype about India and a chance to make quick profits. Investors, who held on, suffered. The market gyrations have become unpredictable and unreasonable. They are caused primarily by foreign institutional investors' inflows and outflows.

For weeks before the market started falling, it was clear that the rises were unjustified by the fundamentals of the economy and present and prospective corporate performance. We knew that interest rates in the United States of America were set to rise, as they were in Europe. This would affect stock prices adversely in those countries and investments in overseas markets. India also tried to hold on to low interest rates to push growth, but the prognosis for higher rates have been there for months.

During past oil shocks, oil producing countries imported goods and labour. This does not seem to be happening now. They also invested these windfall profits in US treasury bonds. Fears of confiscation under the Patriot Act or as punishment for raising oil prices appear to have diminished this to a trickle. Awash in liquidity, inflation is rampant in Arab producer countries. If they are to avoid political turmoil, they must find outlets for the new funds or cap oil prices. Latin American producers are taking over from foreign ' primarily American ' owners, or reducing their take, hoping to perpetuate a regime of high and rising prices. Oil prices are in turmoil and will remain unstable on a rising trend. This, unlike past oil shocks when prices reached a peak and there was a subsequent long period of stability. This is another potential source of instability to the global economy.

Indian stock markets remain hugely dependent on foreign institutional fund inflows and have yet diversified little. The Reserve Bank of India governor had warned a few months earlier that the foreign institutional inflows were volatile and delicately suggested considering a Tobin tax on such flows. The finance ministry compelled him to hold a press conference the same evening to deny that he proposed such a tax. In the last few days with the market in free fall, the governor stated that at least 75 per cent of foreign institutional fund flows were volatile. This huge influence of foreign funds on Indian equity prices has led to volatility in stock prices and falling rupee values, and will destabilize the Indian growth story.

India has held inflation back by compelling government-owned oil companies to absorb the cost increases. Their losses are mounting. Interest bearing and mortgageable bonds in lieu of higher price recoveries from consumers will suck that much liquidity out of the system. For the present, there is excess liquidity as the RBI buys dollars to prevent the rupee from falling dramatically. To control price inflation, the government will need to reduce other expenditures and raise further revenues. But forecasts of a poor monsoon and global shortage of foodgrains make inflation more likely. Rising food prices suggest we are already in an inflationary situation.

Interest costs have helped good corporate performance in India. Reports of annual results of companies below the top tier show that profits in recent quarters have been squeezed by market factors and now are further affected by higher interest costs. We must anticipate poor corporate performance in the coming months. This will also hurt the stock market and foreign fund inflows.

Japanese institutions had easy borrowings in Japan and poured money into Indian stocks. Japan is tightening on liquidity and Japanese investors were among the first to withdraw after booking profits at the peaks. Similarly, as higher American interest rates depress equity, property and fund flows into emerging markets, there will be further volatility. Indian mutual funds booked large profits and also invested the funds that had come in because of the high stock prices back into the stock market as it fell. Now as the prices have fallen further they have no funds to put in. Investment in funds is also not at earlier levels and so there are little new funds. Mutual funds cannot replace foreign flows. As they move freely in and out of India there will be sudden large rises and falls.

The pricking of the asset bubble in the US is certain to have adverse effects on consumer purchases (spending rose when asset prices rose as people felt rich due to high asset values). In the coming months, the uncontrolled government expenditures of the US and unparalleled rise in its balance of trade deficit will have adverse effects on all economies largely dependent on exports to the US; these include China, Europe and Britain. India will also be affected, perhaps not to the same extent, given the lower proportion of exports in our gross domestic product.

Rising Indian costs of housing loans and consumer finance will also prick our real estate boom. With the Indian asset price boom (equity and property) also pricked, demand for goods and services in the Indian domestic market might be affected. The over-hyping of a 'shining' India, with an irreversible growth trajectory, is now definitely under question.

The fragility of India's emerging economic situation is accentuated by a forecasted shortfall of 22 per cent in the monsoon that will affect agriculture adversely. Agriculture affects the GDP more than its contribution to it. The deficit in the balance of payments on current account has also been rising and, though not alarming, is a warning that the economy might be 'overheating', with excess demand running ahead of the supply response (in terms of export earnings). Policy responses could be rise in interest rates, reduction in fiscal deficit through lower government expenditures and a weakening of the rupee. All these are visible already to varying extents.

Interest rates are rising. Private investment will be affected by poor response to new primary issues. Public investment is not taking place at planned levels, for example in prestigious projects like the roads programme. The weakening rupee will reduce foreign fund inflows further. The surplus on capital account has also shown a decline since 2004. Our rising foreign exchange reserves do not reflect economic strength since they are rising due to the entry of volatile funds like foreign institutional equity investments, NRI deposits, and borrowings by Indian companies overseas, not trade surpluses.

The Indian economy has benefited from opening up to the world. It must also expect to be hurt by any decline in the global economy. On top of that are problems of our own, God-made and man-made. The political uncertainties and rigidities from a fractious coalition government and the crude attempts at social engineering that can further divide the country and adversely affect the economy are other problems. The extreme volatility of the stock market is a serious warning to us to get our act together before we face more serious consequences.

Like the suggested lock-in of three years in foreign property investment, the reintroduction of short-term capital gains tax on foreign fund flows into stock markets (but not for foreign direct investment) will compel foreign equity investors to stay invested for at least one year. Since FII flows are likely to be negative or poor because of the interest rate rise and liquidity squeezes in their countries, this may be a good time to do so. This will also correct the inequity that Indians now pay short-term capital gains tax but not foreigners. The proposal to differentiate between foreign traders and investors must be implemented. The 'Mauritius route' to tax free portfolio investment in India must be strictly regulated. We cannot allow the freedom of funds to enter and exit to destabilize the economy.

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