India’s stock market recovery over the last six months is a bit too remarkable for comfort. From its March 9, 2009 level of 8,160, the Sensex at closing soared and nearly doubled to touch 16,184 on September 9, 2009. This is still (thankfully) well below the 20,870 peak the index closed at on September 1 2008, but is high enough to cheer the traders and rapid enough to encourage a speculative rush.
There are two noteworthy features of the close to one hundred per cent increase the index has registered in recent months. First, it occurs when the aftermath of the global crisis is still with us and the search for “green shoots and leaves” of recovery in the real economy is still on. Real fundamentals do not seem to warrant this remarkable recovery. Second, the speed with which this 100-percent rise has been delivered is dramatic even when compared with the boom years that preceded the 2008-09 crisis. The last time the Sensex moved between exactly similar positions it took a year and ten months to rise from the 8,000-plus level in early 2005 to the 16,000-plus level in late 2007. This time around it has traversed the same distance in just six months.
With firms just looking to exit from a recessionary phase, this rapid rise in stock prices cannot be justified by movements in sales and profits. In fact, as the Business Line noted in its editorial on September 9, 2009 [http://www.thehindubusinessline.com/2009/09/09/stories/2009090950560800.htm ], the price earnings ratio of Sensex companies now stands at 21, which is much higher than an average of 17, which itself many would claim is on the high side. Those comfortable with the market’s rise would of course argue that investors, expecting a robust recovery, are implicitly factoring in future earnings trends, rather than relying on earnings figures that are the legacy of a recession.
That would be stretching the case. Once the next round of arrears has been paid, the once-for-all component in the stimulus that the Sixth Pay Commission’s recommendations provided would wane. With the deficit on the government’s budget expected to reach extremely high levels this fiscal, a cutback of government expenditure is likely. Further, exports are still doing badly and the global recovery is widely expected to be gradual and limited. That would limit the stimulus provided by India’s foreign trade. And, finally, a bad monsoon threatens to limit agricultural growth and accelerate inflation. This would dampen the recovery in multiple ways. Given these circumstances, excessive optimism with regard to corporate earnings is hardly justified. The change in perception from one in which India was a country that weathered the crisis well to one that sees India as set to boom once again is not grounded in fundamentals of any kind.
This implies that the current bull run can be explained only as the result of a speculative surge that recreates the very conditions that led to the collapse of the Sensex from its close to 21,000 peak of around two years ago. This surge appears to have followed a two stage process. In the first, investors who had held back or withdrawn from the market during the slump appear to have seen India as a good bet once expectations of a global recovery had set in. This triggered a flow of capital that set the Sensex rising. Second, given the search for investment avenues in a world once again awash with liquidity, this initial spurt in the index appears to have attracted more capital, triggering the current speculative boom in the market.
While these are possible proximate explanations of the transition from slump to boom, they in turn need explaining. In doing so, we have to take account of the fact that, as in the past, foreign investors have dominated stock market transactions and had an important role in triggering the current stock market boom. As compared to the net sales of equity to the tune of $11.97 billion by foreign institutional investors during crisis year 2008, they had made net purchases of equity worth $8.75 billion in the period till September 11 during 2009. According to the Securities and Exchange Board of India, net purchases were negative till February, but turned positive in March with the net purchases figure being high during April ($1.3 billion), May ($4.1 billion), July ($2.3 billion) and August ($1 billion).
It is not surprising that foreign institutional investors have returned to market. They need to make investments and profits to recoup losses suffered during the financial meltdown. And they have been helped in that effort by the large volumes of credit provided at extremely low interest rates by governments and central banks in the developed countries seeking to bail out fragile and failing financial firms. The credit crunch at the beginning of the crisis gave way to an environment awash with liquidity as governments and central bankers pumped money into the system.
Financial firms had to invest this money somewhere to turn losses into profit. Some was reinvested in government bonds, since governments were lending at rates lower than those at which they were borrowing. Some was invested in commodities markets, leading to a revival in some of those markets, especially oil. And some returned to the stock and bond markets, including those in the so-called emerging markets like India. Many of these bets, such as investments in government bonds, were completely safe. Others such as investments in commodities and equity were risky. But the very fact that money was rushing into these markets meant that prices would rise once again and ensure profits.
In the event, bets made by financial firms have come good, and most of them have begun declaring respectable profits and recording healthy stock market valuations.
It is to be expected that a country like India would receive a part of these new investments aimed at delivering profits to private players but financed at one remove by central banks and governments. However, India has received more than a fair share of these investments. One way to explain this would be to recognise the fact that India fared better during the recession period than many other developing counties and was therefore a preferred hedge for investors seeking investment destinations.
The other reason is the expectation fuelled by the return of the UPA to government, this time with a majority in Parliament and the repeated statements by its ministers that they intend to push ahead with the ever-unfinished agenda of economic liberalisation and “reform”. The UPA II government has, for example, made clear that disinvestment of equity in or privatisation of major public sector units is on the cards. That caps on foreign direct investment in a wide range of industries including insurance are to be relaxed. That public-private partnerships (in which the government absorbs the losses and the private sector skims the profits) are to be encouraged in infrastructural projects, with government lending to or guaranteeing private borrowing to finance private investments. That the tenure of tax concessions given to STPI units and units in SEZs are to be extended. And that corporate tax rates are likely to be reduced and capital gains taxes perhaps abolished.
All of this generates expectations that there are likely to be easy opportunities for profit delivered by an investor-friendly government in the near future, including for those who seek out these opportunities only to transfer them for profit soon thereafter. These opportunities, moreover, are not seen as dependent on a robust revival of growth, though some expect them to strengthen the recovery. In sum, whether intended or not, the signals emanating from the highest economic policy making quarters have helped talk up the Indian market, allowing equity prices to race ahead of earnings and fundamentals.
Once the speculative surge began, triggered by the inflow of large volumes of footloose global capital, Indian investors joined the game financed very often by the liquidity being pumped into the system by the Indian central bank. The net result is the current speculative boom that seems as much a bubble as the one that burst a few months back.
There are three conclusions that flow from this sequence of events. The first is that using liquidity injection and credit expansion as the principal instrument to combat a downturn or recession amounts to creating a new bubble to replace the one that went bust. This is an error which is being made the world over, where the so-called stimulus involves injecting liquidity and cheap credit into the system rather than public spending to revive demand and alleviate distress.
The second is that so long as the rate of inflation in the prices of goods is in the comfort zone, central bankers stick to an easy money policy even if the evidence indicates that such policy is leading to unsustainable asset price inflation. It was this practice that led to the financial collapse triggered by the sub-prime mortgage crisis in the US. Third, that governments in emerging markets like India have not learnt the lesson that when a global expansion in liquidity leads to a capital inflow surge into the country it does more harm than good, warranting controls on the excessive inflow of such capital. Rather, goaded by financial interests and an interested media, the government treats the boom as a sign of economic good health rather than a sign of morbidity, and plans to liberalise capital controls even more. In the event, we seem to have engineered another speculative surge. The crisis, clearly, has not taught most policy makers any lessons.