On November 1, the Bombay Stock Exchange “sensitive index” touched an all-time intra-day high of 21,294, overshooting its previous record of 21,208 realised as far back as in January 2008. The latest peak and the rally that preceded it are, however, quite different from that experienced in 2008. The latter record was set after a five-year climb of the Sensex from a low of 3,000 in March 2003. The current peak comes after a much quicker spike from a level of around 15,500 at the end of 2011, or less than two years back.
A fragile boom
Moreover, the rise that preceded the 2008 peak coincided with a real economy boom during which India recorded annual rates of GDP growth of eight per cent or more. The latest record comes at a time when economic conditions are at their worst since 2003. The economy is mired in stagflation, with GDP growth below five per cent and consumer price inflation above nine per cent per annum. While no sensible analyst expects the stock market to truly reflect so-called ‘fundamentals’, this degree of deviation in real economy trends and stock market performance is not just surprising, but reflective of the fact that the boom is fragile. Even Finance Minister P. Chidambaram, desperate to find early signs of buoyancy in a sluggish economy, cautioned equity investors against excessive exuberance.
The source of fragility is the role of foreign institutional investment (FII) in driving the boom. The infusion of cheap liquidity as a policy response to the recession, especially by the Federal Reserve in the U.S., has enhanced capital flows to emerging markets like India. Investors access cheap liquidity at home and look to investment opportunities to earn higher returns. A part of that liquidity flows to developing countries, triggering a boom in their asset markets. Not surprisingly, when the Fed signalled that it plans to ‘taper’, or gradually withdraw its policy of injecting liquidity by buying bonds worth $85 billion every month, investors held back; some left in panic. This led to stock price declines. Responding to that volatility and the criticism it gave rise to, the Fed has said a ‘taper’ is not imminent, resulting in a revival of capital flows and markets.
What is noteworthy, however, is that fluctuations in capital flows to and prices in emerging markets induced by such changes in the metropolitan centres are largely independent of conditions in the country where the investment occurs. Thus, in 2008, when economic conditions in India were still favourable, but foreign institutional investors chose to book profits and repatriate capital to meet commitments and cover losses resulting from the financial crisis at home, the Indian stock market collapsed. But once the policy of quantitative easing was instituted, providing investors with large volumes of near-zero interest finance, capital moved again to India, even causing the rupee to appreciate. Now, spurred again by the promise of continued access to cheap liquidity, FII is flowing into the stock market and triggering a boom even though economic conditions are poor.
A caveat is necessary at this point. The mere volume of FII inflows cannot explain the recent rise of the Sensex. There were at least three months in the first half of the year during which net inflows of FII investment were significantly higher than during September or October. Net flows totalled $4.1 billion each in January and February as compared with $2 billion and $3 billion in September and October. But the Sensex was on the decline during the first two months of 2013.
It is clear that contributing to the recent spike in the Sensex was the fact that FII was concentrated in a few stocks. The Sensex itself is an index constructed using the prices of just 30 stocks, which is a small fraction of those listed. The idea is that these are the most actively traded stocks and their prices adequately capture the momentum in the market. However, in the recent rally, only eight stocks out of the 30 were responsible for close to three quarters of the increase in the Sensex from its previous low at the end of August, with only one (ITC) explaining a big chunk of the increase. Other gainers included stocks of Infosys, TCS, ICICI, HDFC and Reliance Industries, which are already ruling at relatively high levels. On the other hand, 12 of the 30 Sensex stocks actually recorded a decline in price during this period. Moreover, other indices capturing non-Sensex companies, such as the BSE Small-cap and Mid-cap indices, had fallen 58 and 40 per cent respectively during the first 10 months of 2013, as compared to a rise of 10 per cent in the Sensex over this period.
Shallow in two senses
This reflects a larger feature of the equity market in India. It is thin or shallow in at least two senses. First, only stocks of a few companies are actively traded in the market. Thus, although there are more than 5,000 companies listed on the stock exchange, the BSE Sensex incorporates just 30 companies. Second, in the case of a significant number of these stocks there is only a small proportion that is available for trading, with the rest being held by promoters, financial institutions and others interested in corporate control or influence. The net result is that any large inflow of liquidity into the market results in a spike in prices, especially if purchases are limited to a few stocks as happened recently.
This makes the recent rally even more puzzling. While excess liquidity, especially in the U.S., imparts a supply-side push to investments, there is no obvious reason why those investors should choose a country that is performing poorly, and take the risk of investing in a few stocks that are already very highly valued. Especially given the political uncertainty that a general election due in a few months generates.
Speculation provides an explanation. Recent movements in the Sensex suggest that when stock prices decline below some threshold, investors often buy into Indian equity in the expectation that the fall would reverse itself and offer opportunities for profit. Their actions, by enhancing demand for equity, ensure that the expected short-term gains are realised. But when they choose to book profits, prices decline again. Such an investment strategy implies that there is a temporary floor and ceiling to the prices of actively traded stocks, depending on the levels at which such investors choose to buy and sell. As a result, other than during the global crisis in 2008-09, the Sensex has fluctuated within the 15,000 to 20,000 range since 2007, irrespective of real economy trends.
While this could offer part of the explanation for the recent spike, the fact remains that India has also been favoured by investors relative to other emerging markets in the region and elsewhere, which seem to be still affected adversely by fears of the Fed tapering its bond purchase policy. There is clearly something more that investors are betting on in India. This is possibly the evidence that, in response to the slowdown the government is desperate to adopt measures aimed at winning investor confidence, keeping capital flowing in, enhancing demand and shoring up profitability in the private sector. Under consideration and/or implementation are measures such as further concessions to exporters and foreign investors; price increases to ensure the profitability of infrastructural projects; faster clearances to remove “obstacles” to acquiring land and obtaining environmental clearances; and capital infusion into public sector banks to enable them to lend at cheaper rates for the purchase of automobiles and durables. Investor expectation may be that these measures would make a difference to profitability even if they prove inadequate to revive growth, and that even if an NDA government comes to power, it would follow the same trajectory.
Thus, if India, which feared capital flight a few months back, is being favoured by investors with speculative intent, it is not because the economy is performing well, but because poor performance is seen as forcing the government to incentivise foreign and domestic investors and firms. But if that does not occur in adequate measure or does not yield the expected results, flight may indeed occur. Especially if the Fed also opts for the taper it sees as inevitable. That would only compound the current crisis.
(C.P. Chandrasekhar is Professor of Economics at Jawaharlal Nehru University, Delhi.)
