MacroScan - Ignoring Asset Price Inflation

The recent action taken by the Reserve Bank of India to hike repo and reverse repo rates has been interpreted as a shift in focus to inflation control resulting from a combination of comfortable growth figures and disconcerting increases in the prices of goods, especially food articles. What is surprising is that little concern is being expressed and action being taken with regard to the sharp increase in asset prices, especially equity prices. India's stock market recovery over the last year and a half is a bit too remarkable for comfort (Charts 1 and 2). From its March 9, 2009 level of 8,160, the Sensex at closing soared to touch 19,594 on September 17, 2010. This is not far short of the 20,870 peak the index closed at on September 1, 2008. This steep increase the index has registered in recent months occurs when the after effects of the global crisis are still being felt in various parts of the world where the recovery has been halting and unemployment still rampant.
Chart 1 >>

This rapid rise in stock prices cannot be justified by movements in corporate sales and profits. In fact, the price earnings ratio of many Sensex companies now stands at levels which many market observers see as unsustainable, resulting in recommendations that investors should book profits and hold cash till the market corrects itself. 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. However, there are obvious reasons for caution. In the coming months the once-for-all component in the stimulus that the Sixth Pay Commission's recommendations provided would wane. And once the windfall gains from privatisation and spectrum sales are inadequate to reduce the deficit on the government's budget, a cutback of government expenditure is likely. Finally, 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. 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.
Chart 2 >>

This implies that the current bull run can be explained only as being 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 a year 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 $14.84 billion by foreign institutional investors during crisis year 2008, they had made net purchases of equity worth $17.23 billion during 2009. During 2010 that figure had touched $15.62 billion by the middle of September. In fact figures on FII investment do not tell the whole story on the effects of foreign investors on equity prices. Figures from the RBI indicate that not only did foreign portfolio investment, which fell from $27.3 billion in 2007-08 to a negative $13.86 billion in 2008-09, bounce back to $32.38 billion in 2009-10, but foreign direct investment has risen consistently from $34.83 billion to $35.18 billion and $37.18 billion over these years. In the event total foreign investment was close to a record $70 billion in 2009-10. Since any investment equal to or exceeding 10 per cent of stock in a company by a single investor is defined as direct investment, a significant amount of purely private investment gets treated as direct investment in the figures. Thus, speculative financial investments could have been significantly higher in recent months.
Chart 3 >>

It is not surprising that foreign institutional investors have returned to the 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 at near-zero interest rates. Financial firms have chosen to borrow and invest this money in markets where returns are promising so as to quickly turn losses into profit. Some was reinvested in government bonds in the developed countries, 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.
Chart 4 >>

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. In their case the ''carry trade'' appears extremely profitable. Not surprisingly, 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 not so long ago. What is more, that bubble is being expended by the strengthening of the rupee that the capital inflows result in, which promises even higher returns on carry trade investments.

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. The problem is that while the error was made largely in the developed countries, where the so-called stimulus involved injecting liquidity and cheap credit into the system, the effects are felt globally including in emerging markets like India. 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.