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Correction ahead for stocks?

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An expected global liquidity crunch, higher supply of stocks through IPOs, and India's high valuations compared to the US are, according to international analysts, reasons enough to go slow on the Indian stock market. This view may be heretical but cannot be ignored.

EVEN WHEN there is a crunch in global liquidity, it does not follow that FIIs will take their money out of Indian stocks.
EVEN WHEN there is a crunch in global liquidity, it does not follow that FIIs will take their money out of Indian stocks.

Ranabir Ray Choudhury

If respectable and reliable international opinion is of any value, it would seem that foreign institutional investors will go slow in their operations in the Indian stock market in the months ahead.

To many this may seem heretical considering the actual performance of foreign funds inflow during the recent past, but then this is precisely what makes the prodding by important international broking firms to go slow on Indian stocks so very unconventional and interesting.

First, what has been the actual FII flow in India the past 12 months, and how does it compare with the trend? According to an end-December report in this newspaper, in calendar 2005 the net FII flows touched a record $10.57 billion against $8.52 billion in 2004, $6.59 billion in 2003, $740.30 million in 2002 and $2.84 billion in 2001.

If the actual inflow in January this year is considered (when the inflow was more than $800 million), the performance in calendar 2006 could again be in the region of $10 billion. Another report says that a record $3.4 billion has already been invested in India till now in 2006, which would imply that, pro rata, the economy is in for FII flows in excess of $12 billion during the calendar year.

THE FOUNDATIONS

What has this scale of FII flows been based on? Are its foundations weak in the sense that the determinants can change easily, or are they more solid and decisive, the inference being that they are there here to stay leading to a consistent inflow of foreign institutional investment resulting in the continuance of a firm stock market?

This newspaper has reported the views of market analysts who feel that the good times are here to stay because the decision to invest in India is based on long-term factors.

According to one view: "Fundamentals and nothing else matters eventually. Yes, global liquidity plays its part, but then not all emerging markets have fared well in this period," the point being added, "Foreign investors are not fools to stick money into non-performing economies. They didn't warm up between 1994 and 2003 barring the 2000 technology boom period. Now that they find India hot, and it is for good reason. The reasons for being bullish about India in 2006 are the same as they were in 2005."

HERE TO STAY

Another point of view has it that the scale of the inflow is here to stay for some time because (to quote a

Business Line

report) "Large portions of the FII inflows come in broadly through four to five categories. The first comes through India-dedicated funds (which are raised from investors with a specific mandate to invest in the Indian markets). The second category of investments comes in as part of the allocation to India from emerging market funds. The third segment of inflows are through the hedge funds, which are also currently long-term investments, considering the Indian market offers higher returns than any other market in the world. Further, there are long-term pension funds such as Fidelity, which also take five-seven-year calls. All these segments will stay invested for a longer term (and) only the money that comes in through the Promissory Notes (PNs) has a tendency to go out."

It is against this background that Morgan Stanley's latest advice to investors to get out of Indian stocks has to be seen, its concomitant suggestion being that money should be put into South Korea instead.

It is not a little suggestive of the ebb and flow of international stock-investible funds that three years ago, the fund-flow was just the reverse with investors scurrying to transfer their money into so-called defensive markets such as India and China from aggressively active export-driven economies such as South Korea and Taiwan, the fortunes of which are inextricably linked to the value of the dollar (which at that point of time was weakening). Briefly, Morgan Stanley has listed seven specific reasons why investors should scale down their exposure in the Indian market. Among these are an expected global liquidity crunch, a tight domestic liquidity scene (both of which could jack up interest rates), higher supply of stocks through IPOs, etc, and India's high valuations compared to even the US.

DEBATE ON LIQUIDITY

There is some debate on the importance of the global liquidity scene for the performance of the domestic economy, with one school believing that though it is important it is not the most crucial determinant in the Indian growth matrix. The further point has been made, namely, that even when there is a crunch in global liquidity it does not necessarily follow that FIIs will take their money out of Indian stocks. After all, the converse has been true, namely, that when the going has been good on the global liquidity front, not all emerging markets have benefited to the same extent

vis-à-vis

FII flows.

One may not be wide off the mark in suggesting that the expected global liquidity crunch could affect Indian's economic fundamentals by making it more difficult to tackle the increasing current account deficit, which has deteriorated from a $3.2-billion surplus position in the third quarter of 2003 to a $7.7-billion deficit in the corresponding quarter of 2005. The swing has been calculated to represent 5.4 per cent of the 2005 GDP annualised. Since exports will not be able to produce the required result, capital inflows will have to be resorted to so as to tackle the burgeoning current account deficit, a task which will become increasingly difficult in the midst of a global liquidity crunch. As has been argued, "India's economic momentum, therefore, depends on capital inflow that sustains credit growth that sustains demand growth."

(This article was published in the Business Line print edition dated March 20, 2006)
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