Themes > Current Issues
24.01.2005
India's Volatile Stock Markets
C.P. Chandrasekhar
The
expected but abrupt end to the bull run in India's stock markets, signalled
by a 316-point intra-day decline in the Sensex on January 5, once more
focused attention on the volatility that has come to characterise India's
stock markets. This volatility has been visible in the medium and long
term as well. From a low of 2924 on April 5, 2003, the Sensex had risen
to 6194 on January 14, 2004, only to fall to 4505 on May 17, before rising
to close at a peak of 6679 on January 3, 2005. These wild fluctuations
have meant that for those who bought into the market at the right time
and exited at the appropriate moment, the average return earned through
capital gains were higher in 2003 than 2004, despite the extended bull
run in the latter year.
Movements in the Sensex during these two years have clearly been driven by the behaviour of foreign institutional investors (FIIs), who were responsible for net equity purchases of as much as $6.6 and $8.5 billion respectively in 2003 and 2004. These figures compare with a peak level of net purchases of $3.1 billion as far back as 1996 and net investments by FIIs of just $753 million in 2002. In sum, the sudden FII interest in Indian markets in the last two years account for the two bouts of medium-term buoyancy that the Sensex recently displayed.
At one level this influence of the FIIs is puzzling. The cumulative stock of FII investment, totalling $ 30.3 billion at the end of 2004, amounted to just 8 per cent of the $383.6 billion total market capitalisation on the Bombay Stock Exchange. However, FII transactions were significant at the margin. Purchases by FIIs of $31.17 billion between April and December 2004 amounted to around 38.4 per cent of the cumulative turnover of $83.13 billion in the market during that period, whereas sales by FIIs amounted to 29.8 per cent of turnover. Not surprisingly there has been a substantial increase in the share of foreign stockholding in leading Indian companies. According to one estimate, by end-2003, foreigners had cornered close to 30 per cent of the equity in India's top 50 companies - the Nifty 50. In contrast, foreigners collectively owned just 18 per cent in these companies at the end of 2001 and 22 per cent in December 2002.
A recent analysis by Parthaprathim Pal estimated that at the end of June 2004 FIIs controlled on average 21.6 per cent of shares in Sensex companies. Further, if we consider only free-floating shares, or shares normally available for trading because they are not held by promoters, government or strategic shareholders, the average FII holding rises to more than 36 per cent. In a third of Sensex companies, FII holding of free-floating shares exceed ed 40 per cent of the total.
Given this presence of foreign institutional investors, their role in determining share price movements must be considerable. Indian stock markets are known to be narrow and shallow in the sense that there are few companies whose shares are actively traded. Thus, although there are more than 4700 companies listed on the stock exchange, the BSE Sensex incorporates just 30 companies, trading in whose shares is seen as indicative of market activity. This shallowness would also mean that the effects of FII activity would be exaggerated by the influence their behaviour has on other retail investors, who, in herd-like fashion tend to follow the FIIs when making their investment decisions.
These features of Indian stock markets induce a high degree of volatility for four reasons. In as much as an increase in investment by FIIs triggers a sharp price increase, it would in the first instance encourage further investments so that there is a tendency for any correction of price increases unwarranted by price earnings ratios to be delayed. And when the correction begins it would have to be led by an FII pull-out and can take the form of an extremely sharp decline in prices.
Secondly, as and when FIIs are attracted to the market by expectations of a price increase that tend to be automatically realised, the inflow of foreign capital can result in an appreciation of the rupee vis-à-vis the dollar (say). This increases the return earned in foreign exchange, when rupee assets are sold and the revenue converted into dollars. As a result, the investments turn even more attractive triggering an investment spiral that would imply a sharper fall when any correction begins.
Thirdly, the growing realisation by the FIIs of the power they wield in what are shallow markets, encourages speculative investment aimed at pushing the market up and choosing an appropriate moment to exit. This implicit manipulation of the market if resorted to often enough would obviously imply a substantial increase in volatility.
Finally, in volatile markets, domestic speculators too attempt to manipulate markets in periods of unusually high prices. Thus, most recently, the SEBI is supposed to have issued show cause notices to four as-yet-unnamed entities, relating to their activities on arund around Black Monday, May 17, 2004, when the Sensex recorded a steep decline to a low of 4505.
All this said, the last two years have been remarkable because, even though these features of the stock market imply volatility, there have been more months when the market has been on the rise rather than on the decline. This clearly means that FIIs have been bullish on India for much of that time. The problem is that such bullishness is often driven by events outside the country, whether it be the performance of other equity markets or developments in non-equity markets elsewhere in the world. It is to be expected that FIIs would seek out the best returns as well as hedge their investments by maintaining a diversified geographical and market portfolio. The difficulty is that when they make their portfolio adjustments, which may imply small shifts in favour of or against a country like India, the effects it has on host markets are substantial. Those effects can then trigger a speculative spiral for the reasons discussed above, resulting in destabilising tendencies. Thus the end of the bull run in January was seen to be the a result of a slowing of FII investments, partly triggered by expectations of an interest rate rise in the US.
These aspects of the market are of significance because financial liberalisation has meant that developments in equity markets can have major repercussions elsewhere in the system. With banks allowed to play a greater role in equity markets, any slump in those markets can affect the functioning of parts of the banking system. We only need to recall that the forced closure (through merger with Punjab National Bank) of the Nedungadi Bank was the result of the losses it suffered because of over exposure in the stock market,
Similarly, if any set of developments encourages an unusually high outflow of FII capital from the market, it can impact adversely on the value of the rupee and set of speculation in the currency that can in special circumstances result in a currency crisis. There are now too many instances of such effects worldwide for it t be dismissed on the ground that India's reserves are adequate to manage the situation.
Thus, the volatility being displayed by India's equity markets warrant returning to a set of questions that have been bypassed in the course of neoliberal reform in India. The most important of those questions is whether India needs FII investment at all. With the current account of the balance of payments recording a surplus in recent years, thanks to large inflows on account of non-resident remittances and earnings from exports of software and IT-enabled services, we don't need those FII flows to finance foreign exchange expenditures. Neither does such capital help finance new investment, focussed as it is on secondary market trading of pre-existing equity. And finally, we do not need to shore up the Sensex, since such indices are inevitably volatile and merely help create and destroy paper wealth and generate, in the process, inexplicable bouts of euphoria and anguish in the financial press.
In the circumstances the best option for the policy maker is to find ways of reducing substantially net flows of FII investments into India's markets. This would help focus attention on the creation of real wealth as well as remove barriers to the creation of such wealth, such as the constant pressure to provide tax concessions that erode the tax base and the persisting obsession with curtailing fiscal deficits, both of which are driven by dependence on finance capital.
Movements in the Sensex during these two years have clearly been driven by the behaviour of foreign institutional investors (FIIs), who were responsible for net equity purchases of as much as $6.6 and $8.5 billion respectively in 2003 and 2004. These figures compare with a peak level of net purchases of $3.1 billion as far back as 1996 and net investments by FIIs of just $753 million in 2002. In sum, the sudden FII interest in Indian markets in the last two years account for the two bouts of medium-term buoyancy that the Sensex recently displayed.
At one level this influence of the FIIs is puzzling. The cumulative stock of FII investment, totalling $ 30.3 billion at the end of 2004, amounted to just 8 per cent of the $383.6 billion total market capitalisation on the Bombay Stock Exchange. However, FII transactions were significant at the margin. Purchases by FIIs of $31.17 billion between April and December 2004 amounted to around 38.4 per cent of the cumulative turnover of $83.13 billion in the market during that period, whereas sales by FIIs amounted to 29.8 per cent of turnover. Not surprisingly there has been a substantial increase in the share of foreign stockholding in leading Indian companies. According to one estimate, by end-2003, foreigners had cornered close to 30 per cent of the equity in India's top 50 companies - the Nifty 50. In contrast, foreigners collectively owned just 18 per cent in these companies at the end of 2001 and 22 per cent in December 2002.
A recent analysis by Parthaprathim Pal estimated that at the end of June 2004 FIIs controlled on average 21.6 per cent of shares in Sensex companies. Further, if we consider only free-floating shares, or shares normally available for trading because they are not held by promoters, government or strategic shareholders, the average FII holding rises to more than 36 per cent. In a third of Sensex companies, FII holding of free-floating shares exceed ed 40 per cent of the total.
Given this presence of foreign institutional investors, their role in determining share price movements must be considerable. Indian stock markets are known to be narrow and shallow in the sense that there are few companies whose shares are actively traded. Thus, although there are more than 4700 companies listed on the stock exchange, the BSE Sensex incorporates just 30 companies, trading in whose shares is seen as indicative of market activity. This shallowness would also mean that the effects of FII activity would be exaggerated by the influence their behaviour has on other retail investors, who, in herd-like fashion tend to follow the FIIs when making their investment decisions.
These features of Indian stock markets induce a high degree of volatility for four reasons. In as much as an increase in investment by FIIs triggers a sharp price increase, it would in the first instance encourage further investments so that there is a tendency for any correction of price increases unwarranted by price earnings ratios to be delayed. And when the correction begins it would have to be led by an FII pull-out and can take the form of an extremely sharp decline in prices.
Secondly, as and when FIIs are attracted to the market by expectations of a price increase that tend to be automatically realised, the inflow of foreign capital can result in an appreciation of the rupee vis-à-vis the dollar (say). This increases the return earned in foreign exchange, when rupee assets are sold and the revenue converted into dollars. As a result, the investments turn even more attractive triggering an investment spiral that would imply a sharper fall when any correction begins.
Thirdly, the growing realisation by the FIIs of the power they wield in what are shallow markets, encourages speculative investment aimed at pushing the market up and choosing an appropriate moment to exit. This implicit manipulation of the market if resorted to often enough would obviously imply a substantial increase in volatility.
Finally, in volatile markets, domestic speculators too attempt to manipulate markets in periods of unusually high prices. Thus, most recently, the SEBI is supposed to have issued show cause notices to four as-yet-unnamed entities, relating to their activities on arund around Black Monday, May 17, 2004, when the Sensex recorded a steep decline to a low of 4505.
All this said, the last two years have been remarkable because, even though these features of the stock market imply volatility, there have been more months when the market has been on the rise rather than on the decline. This clearly means that FIIs have been bullish on India for much of that time. The problem is that such bullishness is often driven by events outside the country, whether it be the performance of other equity markets or developments in non-equity markets elsewhere in the world. It is to be expected that FIIs would seek out the best returns as well as hedge their investments by maintaining a diversified geographical and market portfolio. The difficulty is that when they make their portfolio adjustments, which may imply small shifts in favour of or against a country like India, the effects it has on host markets are substantial. Those effects can then trigger a speculative spiral for the reasons discussed above, resulting in destabilising tendencies. Thus the end of the bull run in January was seen to be the a result of a slowing of FII investments, partly triggered by expectations of an interest rate rise in the US.
These aspects of the market are of significance because financial liberalisation has meant that developments in equity markets can have major repercussions elsewhere in the system. With banks allowed to play a greater role in equity markets, any slump in those markets can affect the functioning of parts of the banking system. We only need to recall that the forced closure (through merger with Punjab National Bank) of the Nedungadi Bank was the result of the losses it suffered because of over exposure in the stock market,
Similarly, if any set of developments encourages an unusually high outflow of FII capital from the market, it can impact adversely on the value of the rupee and set of speculation in the currency that can in special circumstances result in a currency crisis. There are now too many instances of such effects worldwide for it t be dismissed on the ground that India's reserves are adequate to manage the situation.
Thus, the volatility being displayed by India's equity markets warrant returning to a set of questions that have been bypassed in the course of neoliberal reform in India. The most important of those questions is whether India needs FII investment at all. With the current account of the balance of payments recording a surplus in recent years, thanks to large inflows on account of non-resident remittances and earnings from exports of software and IT-enabled services, we don't need those FII flows to finance foreign exchange expenditures. Neither does such capital help finance new investment, focussed as it is on secondary market trading of pre-existing equity. And finally, we do not need to shore up the Sensex, since such indices are inevitably volatile and merely help create and destroy paper wealth and generate, in the process, inexplicable bouts of euphoria and anguish in the financial press.
In the circumstances the best option for the policy maker is to find ways of reducing substantially net flows of FII investments into India's markets. This would help focus attention on the creation of real wealth as well as remove barriers to the creation of such wealth, such as the constant pressure to provide tax concessions that erode the tax base and the persisting obsession with curtailing fiscal deficits, both of which are driven by dependence on finance capital.
© MACROSCAN 2005