Another widely mentioned reason is what is perceived as the collapse of a bubble in commodity prices. Commodity prices may have undergone a correction but, with global growth still strong, it is hard to see prices collapsing. In any case, commodity prices do not seem to have had a disproportionate impact on either the rise in the Sensex in the period 2003-06 or in the decline in May. The market cap of the commodity stocks in the Sensex (shown in bold in Table 3) rose by 356 per cent in 2003-06. This was not very different from the rise in market cap of 328 per cent for all Sensex stocks. In May when stock prices fell, the commodity stocks fell by 22 per cent against a decline in the Sensex of 18.5 per cent.

As for the supposed impact of the Central Board of Direct Taxes (CBDT) circular about the imposition of a 41 per cent tax on income of FIIs, the subsequent clarification that this was not intended should have reversed the sell-offs. But this has not happened.

The most plausible explanation is that, after the prolonged rise in prices, foreign investors judged that the market was overvalued and decided to book profits. They might have been pushed towards doing so by the rise in interest rates in the industrial economies and the expectation that the rate rise has not run its course. FIIs are always having to compare risk-free returns in their home economies with risk-adjusted returns in emerging markets.

Table 1: Dizzying RiseTable 1: Dizzying RiseTable 1: Dizzying RiseTable 1: Dizzying RiseTable 1: Dizzying Rise

Date Sensex Months for Each 1000

August 19, 2003 4000 4 November 3, 2003 5000 3 January 8, 2004 6000 2 June 21, 2005 7000 5 September 8, 2005 8000 2.5 December 9, 2005 9000 2 February 7, 2006 10000 2 March 27, 2006 11000 1 April 29, 2006 12000 1

T

able 2: Sensex Valuationable 2: Sensex Valuationable 2: Sensex Valuationable 2: Sensex Valuationable 2: Sensex Valuation

As of May P/E

2003 13.2 2004 17.3 2005 14.9 2006 20.4

Figure:Figure:Figure:Figure:Figure:

Sensex MovementSensex MovementSensex MovementSensex MovementSensex Movement

portfolio flows. As Table 6 shows, the proportion of portfolio flows for developing countries as a whole was 20 per cent while it was a staggering 69 per cent for India. Portfolio flows are more volatile than FDI. Hence India is exposed to more volatility than the rest of the developing world – and this explains why the recent decline in stock prices as well as the earlier rise in India has been sharper than elsewhere. Policies for managing capital

3625136342364343652636617367083680036892369823707337165372573734737438375303762237712378033789537987380783816938261383533844338534386283871838808

inflows must squarely address this fact. The biggest question in the minds of investors is whether the fall in stock prices

It is understandable that, with the present trends in interest rates and at the current valuations in emerging markets, there should be a preference for pulling out funds from emerging markets.

Selling by FIIs in May was heavy – net investment by FIIs turned negative and was – $ 1.6 bn. The portents were there in April itself when net inflows were only $ 117 mn. Nevertheless, net investments by FIIs for the calendar year 2006 remains positive as of June 9, 2006 at $ 2.5 bn.

The fall in stock prices in India in May was part of a decline in equity prices worldwide with investors exiting many emerging markets. The decline in the period May-June 2006 was greater in emerging markets than in the industrial economies and, amongst emerging markets, the decline in India was greater than elsewhere. As Table 4 shows, the decline in most emerging markets was 10 per cent or less and in the US it was a mere 1.37 per cent. The Indian market declined by 17 per cent. This is because the rise in the period May 2003-May 2006, as Table 4 again shows, had been greater in emerging markets than in industrial economies, with India having among the highest increases in stock prices. The reversal was commensurately larger.

The rise in equity prices in emerging markets has happened on account of a surge in foreign inflows in recent years. India is part of this surge but that, as we shall see, is cold comfort. The World Bank’s Global Development Finance (Chapter 5, 2006) documents the surge in inflows into developing countries in the period 2002-05 and contrasts it with the surge that took place in 1992-97 and ended with the east Asian crisis. Net portfolio equity flows have nearly doubled in the period – from $ 30 bn to $ 61 bn (Table 5).Two facts stand out where India is concerned.

One, India’s share of portfolio equity flows has more than doubled from 8.5 per cent to nearly 20 per cent. The troubling aspect of the rise in India’s share is that

Table 4: Gains and Losses in DevelopedTable 4: Gains and Losses in DevelopedTable 4: Gains and Losses in DevelopedTable 4: Gains and Losses in DevelopedTable 4: Gains and Losses in Developed

it has been fuelled substantially by partici

patory notes (PNs). PNs in the last two

years have accounted for nearly 50 per cent Percentage Change May 2003-May 2

of FII flows (which account for most of

May 2006 June 1, 2006

portfolio flows). This does call into question the thesis that the surge in FII flows Developed markets

into India is the result of FIIs having

Japan 83.60 -9.60brought into the India growth story in a Emerging markets

big way. The shift in FII perceptions, as Brazil 172.17 -8.70 Mexico 178.81 -9.30

distinct from PN inflows, may be rather

Malaysia 38.17 -2.20 Two, the composition of total equity Indonesia 168.81 -10.50

flows of private capital in India is at variance South Korea 108.03 -9.70 India 326.00 -17.60

with that of developing countries as a whole. Total equity flows comprise FDI and Source: Yahoo Finance.

Table 3: Commodity Stocks and Market CapitalTable 3: Commodity Stocks and Market CapitalTable 3: Commodity Stocks and Market CapitalTable 3: Commodity Stocks and Market CapitalTable 3: Commodity Stocks and Market Capital

of Sensexof Sensexof Sensexof Sensexof Sensex

(Per cent)

CompanyCompanyCompanyCompanyCompany

NameNameNameNameName

(1) (2) April 1, 2003 (3) May 10, 2006

Associated Cement CosAssociated Cement CosAssociated Cement CosAssociated Cement CosAssociated Cement Cos

Gujarat Ambuja CementsGujarat Ambuja CementsGujarat Ambuja CementsGujarat Ambuja CementsGujarat Ambuja Cements

Hindalco IndustriesHindalco IndustriesHindalco IndustriesHindalco IndustriesHindalco Industries

Finance 8423.75 33986.86 25563.11 28099.65 ICICI Bank 8263.7 58909.87 50646.17 47796.29

ITCITCITCITCITC

Oil and Natural Gas CorpnOil and Natural Gas CorpnOil and Natural Gas CorpnOil and Natural Gas CorpnOil and Natural Gas Corpn

Reliance IndustriesReliance IndustriesReliance IndustriesReliance IndustriesReliance Industries

Tata SteelTata SteelTata SteelTata SteelTata Steel

Total for Sensex companiesTotal for Sensex companiesTotal for Sensex companiesTotal for Sensex companiesTotal for Sensex companies

312910.51312910.51312910.51312910.51312910.51

13402561340256134025613402561340256

1027345.491027345.491027345.491027345.491027345.49

328.32328.32328.32328.32328.32

1092499.751092499.751092499.751092499.751092499.75

-18.49-18.49-18.49-18.49-18.49

Total for commodity stocksTotal for commodity stocksTotal for commodity stocksTotal for commodity stocksTotal for commodity stocks

120560.25120560.25120560.25120560.25120560.25

550580.05550580.05550580.05550580.05550580.05

430019.8430019.8430019.8430019.8430019.8

356.68356.68356.68356.68356.68

429585.61429585.61429585.61429585.61429585.61

-21.98-21.98-21.98-21.98-21.98

Note: The comparison between 2003 and 2006 leaves out three companies that figure in 2006 but did not figure in 2003.

Economic and Political Weekly June 17, 2006

in India has run its course. A comparison of valuations in the Indian market with those of other markets is not reassuring on this score (Table 7). In May 2006, the Indian market was trading at virtually the same multiple as the American market – in May 2003, it had been trading at a discount of 30 per cent. It had also overtaken Mexico and Malaysia in terms of valuations and its premium relative to South Korea had become much bigger. The Sensex is currently trading at a multiple of 18. Even if one allows for the improvement in economic outlook since 2003, the valuation appears to be high in relation to historical levels as well as other markets.

Developing countries 30.6 61.4 India 2.6 12.2 India’s share (per cent) 8.50 19.87

Source: Global Development Finance (2006)

Table 6: Portfolio Flows and Total EquityTable 6: Portfolio Flows and Total EquityTable 6: Portfolio Flows and Total EquityTable 6: Portfolio Flows and Total EquityTable 6: Portfolio Flows and Total Equity

Flows in 2005Flows in 2005Flows in 2005Flows in 2005Flows in 2005

Developing countries 299 61 20.40 India 17.7 12.2 68.93

Source: Global Development Finance (2006).

Table 7: Comparison of Market ValuationsTable 7: Comparison of Market ValuationsTable 7: Comparison of Market ValuationsTable 7: Comparison of Market ValuationsTable 7: Comparison of Market Valuations

Developed markets US 19.48 20.89 Japan 45.17 16.7

Emerging markets Mexico 16.96 12.86 Malaysia 18.72 16.00 Indonesia 7.42 19.24 South Korea 10.49 10.21 India 13.20 20.40

Source: Bloomberg.

on consumption, small even in industrial economies, is smaller still in India. Unlike in the US, housing loans, for instance, are not based on borrowings against shares or even other home ownership. They are based on future income, especially salaries. So, we can expect demand for housing loans, a strong driver of consumption, to continue to be strong.

But volatility in share prices does create problems of exchange rate management because it leads to volatility in exchange rates. Strong inflows cause the exchange rate to appreciate. Outflows cause the exchange rate to depreciate – and so does a decline in net inflows. Volatility need not take the form of inflows turning to outflows – this happens only in economies that face serious crises and it has happened only in one year in India since the market was opened up to FII flows. Volatility more commonly takes the form of sharp variations in net inflows and this suffices to cause asset price volatility.

As the GDF report notes, developing countries are much better equipped today to handle volatility in foreign inflows than they were during the surge of 1992-97. There is less dependence on external debt, countries have moved towards floating exchange rate regimes, real exchange rate appreciation has been mild in the face of large inflows, most countries have both surpluses on the capital and current accounts and, not least, have built up substantial reserves. India fits this pattern.

The RBI’s position has been that intervention to prevent excessive appreciation is necessary in the face of volatile flows such as FII. This position has been amply vindicated by recent events. However, sterilised intervention does impose significant costs in the form of a build-up of domestic debt. To be sure, there are benefits from FII flows but, whatever these benefits, do we need FII flows to be bolstered by the PN component? As mentioned earlier, PNs have accounted for 50 per cent of total FII flows in the last two years and are responsible for the sharp rise. The RBI, in its dissenting note to the Ashok Lahiri report published last year, made clear that it was not comfortable with PNs.

The RBI opposed PNs on the ground that the ultimate beneficiaries were hard to identify and such flows could be regarded as suspicious for that reason. The integrity of the financial system would be undermined if it was perceived to be lax in its handling of suspicious flows. This is, of course, true but there is also the apprehension that PNs represent “hot money” because a big chunk of it is domestic money that is laundered outside the country and then returned to take advantage of rupee appreciation.

Most FIIs would have reasonably long time horizons. Mutual funds are often required by their covenants to hold securities for fairly long periods. Insurance companies and pension funds tend to be long-term investors because their liabilities are of long duration. Only a small portion of FIIs, such as hedge funds, would qualify as traders. It is important to keep tabs on the different types of players among FIIs and to ensure that long-term players dominate. Also, there is every justification for distinguishing between FIIs and PNs and frowning on the latter. It would certainly be instructive to know how much of the selling in May 2006 was on account of PN holders.

The dizzying rise in stock prices over 2003-06 provided an opportune moment to grasp the PN nettle. Unfortunately, policy-makers are so much in love with rising stock prices that they are averse to taking any step that would spoil the party. Measures to manage volatile flows should now become a priority.

The Tobin tax on FII transactions may not be required as we already have a securities transaction tax but there are several other measures that can be taken to counteract the effects of volatile FII flows. To start with, once the market settles down, perhaps a beginning can be made towards phasing out PNs by at least not allowing any further accretion to PNs. Domestic institutional investors could be encouraged to invest more in foreign equity markets – this would check appreciation in the rupee as a result of strong inflows.

The growth of domestic institutions and especially the participation of domestic pension funds would help balance any big exit by FIIs. But, perhaps, the most sensible thing to do, along with phasing out PNs, is to bring the composition of net equity flows into India more in line with what obtains in other developing countries. The heavy tilt towards FIIs in overall equity flows needs to be corrected by enticing higher FDI. If the recent pronouncements of foreign CEOs about planned FDI investment in India are anything to go by, we can hope to see this happen in the coming years.

lli

Email:tttr@iimahd.ernet.in

Economic and Political Weekly June 17, 2006