The global factor

Financial Express, 23 May 2006

- Ila Patnaik

Last week's fall in stock markets in India was part of a global story

in which stock markets fell all over the world, beginning with the

US. Why did US markets fall and why did Indian markets repond more

sharply than anywhere else? Aasset prices are ultimately made by the

expectations of millions of investors across the globe. But in this

situation, we can obtain a little insight through macroeconomics.

First, what happened in India? Nifty fell by 12.65 percent over six

days. The decline on Thursday was the sharpest, when it fell by 6.77

percent. On Friday it fell another 4.2 percent. Over the previous five

days, US stock prices dropped 3%. Stock prices had done badly all over

Asia. All Asian markets did badly on Thursday - Australia (-1.85%),

Hong Kong (-2.1%), Indonesia (-4.2%), South Korea (-2.59%).

The indexes moved by a large amount in absolute terms. This merely

reflected the fact that the indexes are at their highest levels

ever. When the drop is expressed in percent, this puts things in

perspective. Even though bigger in absolute terms, the 18 May 2006

decline was smaller - in percent - than the famous market crash of 17

May 2004 after the general elections.

Why did this decline take place? There has been a lot of discussion

about global imbalances -- the twin deficit of the US, the trade

surplus of China and undervaluation of the yuan, in recent years. What

is new? First, there is recent data about low consumer confidence, a

leading indicator of demand. Consumer confidence in the US has dropped

to levels prevalent around September 2001. In addition, there is a

softness in the US housing market: confidence among home builders is

at the lowest level since 1995. People feel less wealthy when their

houses are cheaper and spend less. In addition, with rising interest

rates, mortgage payments have gone up over the last two years, and

higher oil prices have raised energy bills. All this squeezes

expenditure by households.

In response to rising oil prices and dollar depreciation, US markets

have been expecting higher inflation. This is reflected in the yields

on 10-year bonds which have picked up, as have the inflation

expectations visible in prices of inflation-indexed bonds. By some

estimates, expected inflation in the US has risen to 2.75 percent, the

level it was in mid-2004 when the Fed tightening began. This view,

about higher US inflation, was validated by a data release on 17 May

showing high US inflation. It is hence now felt that the US Fed will

raise rates.

Higher US interest rates affect India in two ways. First, slower

growth in the US economy affects Indian exporters. It will also

accentuate pricing pressure from Chinese competitors. But equally

importantly, in places across the world like China and India, which

peg their exchange rates to the US, there is a lack of monetary policy

autonomy owing to the use of the pegged exchange rate. These countries

will experience tighter monetary policy also, in synchrony with

tighter monetary policy in the US. Intuitively, higher interest rates

in the US will lead to capital leaving India, and could lead to a

weaker rupee. And to the extent that India tries to prevent the rupee

dollar rate from moving sharply, we will be forced to raise rates in

order to defend the rupee. Thus tight monetary policy in the US

coupled with a INR/USD pegged exchange rate will generate tight

monetary policy in India.

But this cannot be the full explanation. After all, most Asian

economies, like India, peg their currencies to the USD. So

international macroeconomics can perhaps account for a 3% drop in

Indian stock prices. The remaining 8% drop has to do with domestic

news. Recent news about policy in India has not been good. The quotas,

the victory of the Left in West Bengal and Kerala which may further

weaken the move towards market oriented reforms and the insecurity

created by the SEBI order against market participants that account for

nearly 60 percent of customer accounts could have been some of the

factors shaping the large move seen in India. Obviously, GOI can do

little to correct global imbalances, the only thing it can focus on is

to keep reforms on track and help build confidence in stock markets in

the country.

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