The Hindu Business Line : Behind the correction

Global linkages, and not fundamentals, are causing undue volatility in stock prices in the short term. Domestic investors, too, seem partly to blame as their entire behaviour is reactive. Better industrial performance and higher economic growth can break this cycle, but fiscal and monetary policies should facilitate the right environment for this.

RICHLY valued stock prices, rising inflation, worries over a rise in interest rates, a possible slowdown in corporate earnings growth and fears of a tax-and-spend fiscal policy which would reflect in a weak rupee, form the background to the recent meltdown in stock prices.

The impact of global factors however, cannot be lost sight of. Unfailingly, local rallies and downtrends appear to be part of a global pattern that affects emerging markets.

The downtrend since October 5 is no different. Global liquidity appears to be a prominent driving force.

Emerging market meltdown: Since October 5, the NSE's market capitalisation is down about 10 per cent. Large-cap stocks have fared slightly better. This is reflected in the 7.3 per cent decline in the MSCI India Index.

The notion that local factors, such as pressure on the rupee, were solely behind this decline is discounted considerably when we see that the MSCI Emerging Market Index too lost 6.1 per cent during this period. The index for Emerging Market Asia too has shed 5.9 per cent.

It is not as if emerging market indices have been partners only in a declining scenario. They have been partners in progress too.

Since December 2004, the MSCI India Index is up 19.5 per cent while the Emerging Market Index is up 15 per cent. Even if we take a longer time horizon, linkages in price performance will not go away.

Since March 2003, the Indian index is up 146 per cent while the Emerging Market Index is up 99 per cent. Only the size of performance varies, the direction remains the same.

These linkages have more to do with global liquidity. India and several other emerging markets have been put into the same asset class.

Money flows in and out of this emerging markets asset class at the same time, creating similar price patterns.

Breaking the mould: It would not be unfair to say that these global linkages are causing undue volatility in stock prices in the short term. This volatility has nothing to do with fundamentals, although fundamentals do assert themselves in the long run.

The excesses on both the upside and downside cannot be value-enhancing for local investors and capital-seeking local companies. On the other hand, lower volatility could prove to be value-enhancing.

Local investors, too, seem partly to blame as their entire behaviour is reactive. It is built around the operations of foreign investors.

Domestic investors are reactive because it makes sense for them. They take stock prices to higher levels when FIIs buy and sell stocks to them at such higher prices. When FIIs sell, they bring down prices and buy from them at lower prices.

Unfortunately, the resultant price trends do not allow investors to invest systematically. Market timing and profit-booking becomes important. Retail investors who do not have the capability to time the market lose out. It would thus be in order if local households invest more in stocks. That could help reduce the importance of global liquidity trends.

A much more systematic way to break the mould lies in better industrial performance or, more broadly, better economic growth. If the economic growth is less cyclical and growth does stay above 7 per cent over the next decade, then global liquidity linkages will be broken automatically.

Now, there is no infallibly unique advantage to investing in India. If such an advantage is created, Indian fundamentals will dominate global factors. For such a situation to materialise, fiscal and monetary policies should be facilitating.

They should also be predictable to the extent possible. For instance, unpredictable interest rate policies and unreliable government borrowing targets do not facilitate investment.

A more predictable and facilitative environment would unleash investment impulses across the country and add to the growth prospects. The onus is now on the powers-that-be to deliver, and consistently.

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