The Hindu Business Line : The FII `shock' to stock market

In keeping with the FII flows, the Sensex rose from 3,000 points in May 2003 to its peak on May 10 — up 420 per cent! Even as SEBI and the Finance Ministry celebrated the surge, there were warnings from abroad.

EVEN AFTER a decade of financial liberalisation, the market is still shallow and the FIIs have exacerbated it.

When the Sensex started its slide from its peak of 12,612, it was explained that the decline was `global.' Not wholly reassuring, if one were to judge by the erratic intra-day fluctuations since then. Moreover, brokers are not confident about the reversal of the weak trend.

The MSCI Emerging Market Index fell by 14.8 per cent since May 9. Brazil and India lost 20 per cent. Though the development seemed sudden, many analysts were worried about the sustainability of the surge into emerging markets months before the current turn of events.

For more than five years, the global economy has been growing without inflationary pressures. The New Financial Architecture attempted by the International Monetary Fund (IMF) to bring about data dissemination standards and disclosures, led to complacency over future financial stability.

Not many shared this belief. Doubts arose about the sustainability of portfolio flows fed by low rates of interest and inflation, strong demand in the US and elsewhere, high commodity prices and lower risk aversion of investors.

The Buttonwood Column (The Economist, August 23, 2005) queried: "If any of the above stops, or if the investors decide that they have run up emerging-asset prices far enough, will we see a repeat of the 1997-98 crisis?" She went on to add, "Globalisation may dim the appeal of emerging markets by increasing the correlation between developed and developing assets."

Pitch for stocks

Mr Andy Xie, Chief Asia Economist, Morgan Stanley, had also cautioned that the world's equity markets were surfing on a "tide of liquidity" due to the easy money policies of the US Federal Reserve (Fed) and other central banks. With low interest rates, no fund manager would invest in low-yielding money-market accounts. Stocks were the fashion of the day. The pitch for stocks in the emerging markets was queered by hedge funds aligning with banks and financial consultants. With low returns in home countries, pension and mutual funds also jumped on the bandwagon.

Net inflows into emerging market equity funds hit $20.3 billion in 2005 and were five times the level of 2004, according to Emerging Portfolio Fund Research. In January 2006 alone, global inflows into emerging market equities were $11.4 billion, which was more than half the inflow for the whole of 2005.

Inflows into India were in line with global flows into emerging markets and galloped after 2002-03 reaching $10.7 billion in 2005. They were expected to scale greater heights in 2006.

Surge in Sensex

In keeping with the FII flows, the Sensex rose from 3,000 points in May 2003 to its peak on May 10, 2006 — up 420 per cent! Even as the Securities and Exchange Board of India and the Finance Ministry celebrated the surge, there were warnings from abroad.

Around April, Mr Andy Xie felt that liquidity was slowing sharply and could be pricked by interest hikes like the tech bubble in 2000. The fear was that the rising interest rates might curtail the growth in equity prices eventually. As a columnist in Time Asia said, "India... is now a classic case of a market where sentiment may be trumping economics, given that the market has already tripled in the past three years." (April 10, 2006) The columnist did hope that though the euphoria over equity prices might worry central banks, "this party may last a while." Sadly, it did not and soon investors began picking their pieces. How did it come about?

Cyclical threats

There are fears of cyclical threats upsetting the current scenario. The Global Development Finance Report 2006 (GDF) of the World Bank, released on May 30, 2006, provides a wealth of data (p.152) correlating commodity cycles with capital inflows. The connection between the collapse of LME prices and the current stock market quotations has been well-documented. The other is the threat of interest increases in OECD countries, especially the US, and credit-tightening robbing interest differentials and driving carry trade back to the US Treasuries and Japan. What is significant from the Indian stock market perspective is the nature of the FII holding and how it would behave in the coming months.

As reported in the Financial Times (March 2, 2006), Mr Mark Mobius of Templeton Emerging Market Funds is uncertain whether emerging markets could weather a big economic or political shock. He goes on, "These markets are smaller and the weight of foreign money in them is greater."

What adds piquancy to the Indian scene is that, notwithstanding more than a decade of financial liberalisation, the market is still shallow. Though several companies are listed, the Sensex incorporates only 30. The traded shares are also limited. With such limitations, the market exhibits a high degree of volatility and the FIIs have exacerbated it.

As assessed by Joydeep Biswas (Indian Stock Market in Comparison, Economic and Political Weekly, May 6-12, 2006), "in the post-reform era, trading in the Indian stock market became increasingly concentrated in a few sectors and companies and the increase in turnover is attributable to greater concentration on a few companies and sectors." FIIs dominate the market through Participatory Notes (PNs). As reported by Lahiri Committee, PNs held Rs 78,390 crore or 47 per cent of cumulative FII investments as at the end-August 2005. It should have risen higher since then.

World Bank's warnings

Though the Bank's GDF views the impact of capital inflows, it warns of the risks attached to the surge in flows, especially that arising from price bubbles and how capital flows could be concentrated in a few better-known companies. The Indian stock market fits this description rather well. The major worry expressed in the report is that the markets are very young and could be derailed. A recent Wharton paper on ``May's Market Collapse'' (http://knowledge.wharton.upenn.edu/index. ID1492, May 31) captures it well: "Tremors in big markets can turn into earthquakes in smaller ones, largely because so many investors now have worldwide holdings."

A large part of the investment is from or for hedge and mutual funds. Hedge, mutual and pension funds are inter-locked directly or through investment advisers and there is opacity and lack of information governing their operations. In their hunt for returns, they have adopted strategies, which contain seeds of self-destruction should the underlying assumptions change.

The European Central Bank has gone into these developments in its recent report (Financial Stability Report 2006, June 2006). As the reports puts, "From a financial stability viewpoint, the main cause for concern about the hunt for yield is the fact that it seems to have made a variety of markets more vulnerable to risk reappraisal and abrupt price adjustments."

The vulnerabilities

The intention is not to convey doom. However, it is not prudent to ignore the vulnerabilities faced by the stock market as it is structured. Mutual funds and term institutions, do not have the power to counter the strategies of the FIIs, which have indeed lost the appetite for emerging market stocks. The question is: How will the FIIs unwind and rebalance their assets and how far can the government safeguard the country's interests against adverse consequences?

(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues.)

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