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.