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Aarati Krishnan
Suresh Krishnamurthy

AFTER stints at Citibank, Pioneer ITI and SBI Cards, Mr Ajay Bagga, the newly-anointed CEO of Kotak Mutual Fund, appears to be at ease with the ups and downs of both the stock and debt markets. Business Line met up with him practically in the eye of the storm, on Wednesday, as the markets were rebounding from this Monday's historic crash. He shares with us some interesting insights on what triggered the crash and why he thinks FIIs will not bail out of India in a big way. Excerpts from the interview:

What really triggered the sharp swings in the equity markets over the past week?

Our analysis shows that FII selling didn't happen in a very big way. Volumes on Monday were very thin. There may have been some hedge funds which exited the markets on that day, as they faced redemptions back home

But the turnover on the cash segment on Monday was Rs 9,000 crore; FIIs accounted for about Rs 2,500 crore, mutual funds accounted for say, Rs 800 crore. There is no data yet on where the rest of the selling came from. It is possible that the fall did begin with some FII selling. This was probably exacerbated by the margin calls going out and stop-losses being triggered.

Basically, before the election results, expectations that were built into the market on the basis that NDA would come back to power, and that reforms would continue. This change has taken everybody by surprise. So political uncertainties, coupled with statements by alliance partners, destabilised the markets. There were also external factors at work, which were very important.

Did the FII selling happen because of domestic political uncertainties?

One should look at the fall in light of four broad global themes, apart from the domestic political scene. One is the spike in oil prices. The second is China's slowdown. China always tends to overshoot both the investment cycle and the tightening phase. It happened in 1993 and it is happening now. The third move is the US Fed move on interest rates. The fourth is the geo-political uncertainties revolving around Iraq and its impact on oil prices. All these have added on to the recent political happenings in India. So it is difficult to say if the FII selling was on account of the Indian political risks alone.

In fact, India has seen relatively small amounts of FII selling when compared with the Taiwanese or the Korean markets. We have seen outflows of less than a million dollars, while markets of Taiwan and Korea saw outflows of $3 billion or so. This was probably because India is, fundamentally, a more solid story than those markets.

Maybe we've just seen the beginning of it. Could FII selling accelerate in the coming days?

I believe that much of the FII investment in India is in for the long term. I don't see a strong sell-off from the FIIs. Of an FII investment of $40 billion, just $0.5 to $0.7 million has gone out over the week, but look at the impact cost! The structure of shareholding in the Indian markets is such that none of big players can really exit without a significant impact cost. After all, FIIs hold $40 billion in Indian stocks, domestic institutions such as the LIC and mutual funds have between them - Rs 80,000 crore and the public holds about $33 billion. So it is clear that none of the big investors can pull out in any significant way, without a huge impact cost. So by definition, they have to be long-term players.

Another plus, that we have a very strong regulator in SEBI. That we have gotten through Monday's fall smoothly, without any payment problems, shows that we have really resilient exchanges and systems. . The FIIs are not likely to have missed this.

How correlated are our markets to the other emerging markets? Is the correlation rising?

Our stock markets will tend to move in the same direction as other emerging markets, because they are all driven by FII flows.

But fundamentally, the Indian economy is still a pretty closed economy. 90 per cent of our GDP comes from domestic consumption. Thanks to a far-sighted RBI, which has not moved completely into capital account convertibility, we are not that vulnerable to a crisis in other Asian economies. China is now so big, many countries now depend on it substantially for growth. If you look at Australia, Taiwanese or Korean economies, their export growth is heavily dependent on China. So these countries have seen FII outflows, as underlying emerging market funds got sold and part of the money was shifted into Eastern European economies such as Russia. Pullouts from India were much smaller, because we are less vulnerable to the Chinese slowdown. But yes, this correlation will increase over time as exports from India pick up.

Did your equity funds move into cash before the election results were announced?

We did not switch from equities into cash. But we did receive sizeable inflows over the previous week and held the money in cash. We foresaw some volatility after April 26 and held it in cash, not to time the market, but to tide over any redemptions. I am not comfortable with taking a cash call to time the markets, as it is very difficult to read where the market is headed.

We would normally hold about 4-5 per cent in cash on a daily basis; but with the inflows this would have peaked at about 20 per cent, just before the crash. We have moved some of this money into stocks on Friday and Monday, when markets fell sharply. That would have been true of most funds. Most funds would have probably held 10-12 per cent in cash.

The recent announcements appear to have pegged up downside risks in policy-heavy sectors such as oil and gas. Oil/gas and banking were the top exposures in your equity fund by end-March. Have you changed your sectoral preferences?

These sectors are no longer our top exposures. But the growth story continues. We will be looking at growth stories (such as pharma and IT), these may now be preferred over cyclical growth stories. The third sector I would define as a defensive proposition would be consumer goods. By this, I am not referring only to FMCGs, but to products such as two-wheelers and four-wheelers as well, which are proxies for consumer demand. FMCG valuations are attractive now, maybe not for the frontline companies; but for some of the smaller players. Even within PSUs and banks, there will continue to be stocks which are good investments. You would have to take a call on each stock based on its valuations. There are good dividend-yield stocks within the universe of PSUs. In banking, the retail credit boom will continue to drive growth and there will be stocks which will benefit from this.

What do you think will set the market direction now?

I don't see any movement in interest rates right now. The recent credit policy also reinforced the same thing- stability. For the equity markets, the budget may be the big milestone to look forward to. As I see it, there would be three milestones which will determine market direction: The first will be the composition of the Cabinet, the second would be the contents of the Common Minimum Programme- how reformist it is, whether it leans towards the Left and the third, will be the budget. The budget may be the key driver for the markets, going forward. I expect the budget to be out by June.

What do you think a small investor should be doing now, especially since the downside risks to stocks appear to have risen sharply since December?

The risks (of investing in equities) have definitely gone up. The risk-return equation is more finely balanced now than it was in December. But what an investor should do now, will depend on his investment horizon. If you are prepared to stay invested for the long term, you can invest in equities in instalments spread out over a period of time. If you already have equities in your portfolio, you may have to review it and re-balance your portfolio, if the equity portion is high. Again, when you withdraw, do so in phases through systematic withdrawal plans and not at one shot.

Somebody very near to retirement or very risk-averse, should probably stay away from equities right now. It doesn't not matter if you lose a 10 per cent upside, you can protect against a sharper downside, by waiting for clarity on the policy front. But the equity strategy will really have to change from person to person; I am not for offering blanket advice.

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