Date:30/05/2006 URL: http://www.thehindubusinessline.com/2006/05/30/stories/2006053000341100.htm

Back Explaining the stock market correction

C. P. Chandrasekhar
Jayati Ghosh

The second fortnight of May witnessed a much needed though still inadequate correction of the recent unprecedented rise of the Sensex. Yet, in the blame-game that followed, inadequate "reform" stemming from political opposition has been seen by some observers to have caused a "loss of wealth" In this edition of Macroscan, C. P. Chandrasekhar and Jayati Ghosh examine the context and nature of the downturn and the validity of these arguments.

In an accelerated climb, the Bombay Sensex rose from 5,054 points on July 22, 2004 to 6,017 on November 17, 7,077 on June 21, 2005, 8,073 on November 2, 9,067 on December 9, 10,082 on February 7, 2006, 11,079 on March 27, 12,219 on May 2, 2006 and 12,435 on May 11. The implied price increase of more than 37 per cent over the last five months is indeed remarkable. The rise in the first four-and-half months of 2006 alone was around 14 per cent (Chart 1).

A reasonable assessment would have been that this rise was unsustainable and unwarranted by actual corporate performance. A correction, therefore, was in order and did occur in the second half of May, even if to an inadequate extent. The Sensex fell from its May 11 peak of 12,435 to 10,482 on May 22, only to rise once again to 10,809 on May 26.

Worries over reforms

One response to this minor correction has been that the obstacles set by the Left and even Ms Sonia Gandhi to the advance of economic reform have generated uncertainty in the markets, leading to the loss of paper wealth which should not have been accumulated in the first place. Thus, the Wall Street Journal Europe recently (May 24) suggested that Ms Sonia Gandhi's "actions as leader of the Congress Party and chairwoman of the governing coalition are causing increasing worries among investors as to the pace of economic reforms." It quotes one Indian market research consultant, who is by no means a disinterested observer, as saying that "the major obstacle to reform is Sonia Gandhi". This response is in keeping with the overall perception that liberalisation policies that speculative fever of the kind seen in the markets should not be tempered in any way, as it hurts investors and can trigger a retreat that can be damaging.

The problem with this argument is that it ignores the fact that the May downturn was not restricted to India alone but was a global phenomenon. As Chart 2 shows, recent movements in the Sensex have closely followed the Nasdaq index. Further, the decline witnessed in May was not confined to India, but affected many emerging markets, including Russia, Turkey, Indonesia South Korea and Taiwan.

Global downturn

Many analysts have argued that this global downturn was triggered in the first instance by expectations of a rise in US interest rates. With GDP growth rates in the US placed at well above 5 per cent in the first quarter of 2006, the Federal Reserve was expected to cool the economy by raising interest rates. This was because of the perception that in a global environment where high oil prices were already raising costs and prices, buoyant domestic demand leading to high growth rates would also result in inflation that the monetary authorities would be forced to contain.

In the event, the expectation of a possible rise in interest rates had resulted in a retreat from speculative investments in equities and commodities. The result was the downturn in stock markets, initially in the US and then across the globe, with emerging markets such as India, Russia, Turkey, Indonesia South Korea and Taiwan being hit hard. So when the first revision of the preliminary estimate of GDP growth in the US during the first quarter of 2006, released on May 25, placed the revised first-quarter growth rate at 5.3 per cent (not 6.2 per cent as originally expected) and news was out that consumer spending and the US housing market were cooling, "investors" ostensibly heaved a sigh of relief. According to the financial press, there would be less pressure on the Fed to raise interest rates, allowing for a return to "normalcy" in markets after what would be a mere correction and not a meltdown.

Synchronised movements

What needs to be noted is that while the figures at issue are GDP growth, consumer spending and interest rates in the US, the market movements being referred to are global. This is because the evidence makes clear that market movements across the globe are now synchronised. When the downturn occurs it is generalised worldwide, and when the recovery begins all markets catch up. The old-fashioned idea that investors include different markets in their portfolio to hedge their positions no more seems true, since that is predicated on markets not moving in parallel.

One factor that accounts for the synchronisation of market movements is that a few global players drive all markets, centralising in themselves the funds available for investment. Since these financial entities tend to behave in herd-like fashion, rushing into particular markets and instruments when the going seems good and withdrawing together when uncertainty strikes, their decisions determine the buoyancy or lack of it in most markets.

In all the emerging markets, the downturn since the middle of May and the collapse on May 22 were related to withdrawal of investments by foreign investors. According to the Financial Times (May 26), about $5 billion of foreign funds had flowed out of Asian emerging markets over the previous week, with around three quarters of them coming from South Korea and Taiwan. The other market to be afflicted badly by this syndrome was India. By May 26 the Sensex had fallen by as much as 16 per cent relative to its May 11 peak. Foreign institutional investors are estimated to have pumped in $10.7 billion into India's markets in 2005 and a further $5 billion by May 11 this year. So when they decided to pull out around $2 billion between May 11 and May 25, a sharp downturn ensued.

FII pullout

While it has been acknowledged that FII investments have been primarily responsible for the surge in India's stock market, it is true that domestic investors including mutual funds have sought to profit from the stock market boom. As a result while earlier, cumulative FII investments in the Indian market closely tracked movements in the Sensex, more recently the index has tended to outstrip growth in cumulative foreign institutional investment. But, as Chart 3 shows, the FII pullout has played a dominant role in explaining the decline in the Sensex.

This being the case, what is puzzling about recent market behaviour is the fact that global investors have gone bearish on all markets, resulting in the generalised downturn. In particular, why should the danger of higher interest rates in the US weaken sentiments in equity markets worldwide? In the past, a rise in interest rates in the US was seen as a factor that would stimulate the American capital market as it would result in a rush of capital into dollar denominated assets, by improving the relative return of investments in the US.

US economic dynamics

However, for some time now this positive relationship between US interest rates and capital flows to the US has not held. Throughout the recent period when US interest rates were low, dollar-denominated assets were preferred by investors as a safe haven. Capital kept pouring into the US, triggering initially a stock market boom and, subsequently, because of their role in keeping interest rates down, a housing market boom. It has been held for some time now that, because the stock and housing boom inflated the value of assets owned by Americans and therefore their level of savings, US residents were encouraged to spend more of their current incomes on consumption resulting in a collapse of household savings rates to negative levels. The obverse of this trend was buoyant domestic demand that helped sustain a creditable rate of GDP growth, despite the leakage of demand abroad reflected in large trade and current account deficits in the US balance of payments.

It could, therefore, be argued that if interest rates go up making borrowing more expensive, the domestic consumer spending and housing boom could be quickly reversed, resulting in a slow down of growth in the US and a loss of faith in the strength of the US economy. To the extent that this could affect investments in US assets, the fear that extremely high rates of growth in the US or excess speculation in the housing markets could force the Fed to raise interest rates, is seen as setting off shivers in stock markets as well.

The difficulty with this argument is that if it were true, then the downturn should have been restricted to US stock markets alone.

In fact, the exit of investors from the US should have been accompanied by a shift to other markets, which should have attracted more investments and witnessed a boom. However, recently equity markets worldwide, including the emerging economies, were rising when the US market was rising and declining even more sharply, with a short lag, when the US market slumped. This clearly makes the argument linking the downturn in the US market to the likely adverse effects of higher interest rates on domestic demand and growth an inadequate explanation of synchronised global trends.

Interest rate-downturn link

One way in which the relationship between interest rate expectations and the synchronised downturn can be explained is to trace the link between the preceding synchronised boom in global markets and low interest rates. If the boom, which seems increasingly to be triggered by a few major players, was the result of debt-financed investments in shares with already inflated values in the expectation of attractive short-term returns, then the threat of interest rate increases could encourage speculators to unwind their debt-financed investments, thereby triggering a downturn. And if it is the same set of investors who are driving markets worldwide and they are adopting similar strategies in all markets, then the unwinding of debt-financed investments would occur in more markets than one, resulting in the generalised downturn witnessed recently.

These developments once again raise an issue that has been a source of controversy in the past. The US Fed and central banks elsewhere have always been concerned about commodity-price inflation but not asset-price inflation. The Fed has in the past been unwilling to raise interest rates to dampen speculative price increases in stock and even real asset markets, while holding that its principal role is to rein in inflation.

The indication that the threat of an interest rate hike as a result of developments in commodity market triggers a downturn in equity markets, makes clear that central banks must play a role in using the interest rate to curb price increases in asset markets as well in order to prevent a speculative bubble that can burst with damaging consequences for real economies.

Closer home, the above developments make it clear that all talk attributing stock market volatility in India to the inadequacy of "reform" or the obstacles to reform set by Ms Sonia Gandhi or the Left is that much nonsense.

The Indian market is driven by global decisions, which in turn are determined by the speculative activities of key investors the government seeks to attract.

Once we recognise that financial volatility is the result of the speculative behaviour of these firms, measures to reduce the presence and influence of these investors seem to be the need of the day.

If either the Sonia Gandhi camp in the Congress or the Left is calling for caution and holding back policies that feed such speculation, they are only doing the nation good.