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Wednesday, June 07, 2006

Market Sell Off Impact: Higher Rates and Slower Growth?

Just when Indian economy started to crack the 9% self-imposed growth ceiling, the stock market turned south. As of today, the market is still up more than 10% for 2006, but it is off from its lofty gains of more than 40% until early May.

Indian GDP has finally crossed $800 billion mark and is working towards a respectable $1trillion economy by 2009. Now is the time accelerate, not slow down. Ever obliging Manmohan and Chidambaram take half a step forward and two steps back. Their brilliant ideas to fight the communist idiots are endless spin on their lack of reforms and quotas in IITs.

With no (even, slow) release from the government bureaucracy chock hold on the economy, will the economy slow down because of falling market?

There seems to be two schools of thought on this:

In a Morgan Stanley brief, their India analysts think RBI will have to increase rates, to hold the outflow of foreign funds, ending up slowing the economy.

India: Portfolio Flows - The Critical Macro Link

Chetan Ahya (Mumbai) and Mihir Sheth, (Mumbai)

What’s new: The recent sell-off in emerging market equities and outflow of portfolio flows have again brought to the fore the macro challenge presented by India’s over-dependence on portfolio flows. Portfolio flows have accounted for about one-third of the total capital flows into India over the last three years, and have been a key factor behind the low real interest rates during this period.

Implications: Rising US short-term rates and India’s current account balance swinging into deficit have already pushed real interest rates higher. Given portfolio equity outflows of US$2.6 billion over the last 15 trading days, there is now a risk of this low-real-rate-dependent, credit-driven growth cycle breaking.

Conclusion: We think the reversal of portfolio flows, which has been the anchor of India’s growth acceleration trend in the last three years, highlights the need to initiate bold reforms in the area of privatization, FDI and infrastructure (PFI reforms) to sustain the 8%-plus growth rates.

However, Ila Patnaik says, in her June 6th column, FIIs are not a major impact on Indian stock market – they are market seekers rather than market leaders - making up only 8% of market turnover.

To attribute domination to something smaller than 8% would be like asking the tail to wag the dog. On the equity spot market, too, the share of FIIs in trading works out to a value close to 8%.

If we add up, the total net sale by FIIs works out to an average of roughly Rs 500 crore a day. This is a small value, considering that on most days, the total volume (NSE plus BSE, spot plus derivatives) works out to roughly Rs 50,000 crore a day.

She also had an interesting note on what type of companies FII invest and how long they stay invested. (More in the paper she co-wrote with Ajay Shah.)

In total, FIIs own 11% of all companies. Their share has risen from 8.5% in 2001 to 11.1% in 2005.

Once companies achieve FII investment, this tends to stay. There is an 82% chance that a company with over 5% FII investment will continue to have this after a period of one year. This makes FIIs looks more like a stable source of equity capital than a capricious and unreliable bunch.

So what is RBI to do? Unlike Chidambaram, now apparently also the chief Indian market analyst, who is asking small investors to buy into falling market (would he dole out our taxes to pay for their loses?), RBI should ignore the markets and worry about, what else, inflation. The economy can grow at 10% or more, untouched by RBI, as long as inflation is contained. RBI should not be business of propping up market as MS analysts are hoping for. Market has been on the see-saw ride before and let investors and SEBI worry about it.