Charles Wilson was a CEO of General Motors and later Eisenhower’s Secretary of Defense from 1953-57. He was reported to have said that whatever was good for General Motors was good for the USA. Closer home, free market absolutists assure us with straight faces that whatever is good for market valuations is good for India. However, post the crash of September 2008, even die-hard supporters of unregulated markets cannot make such claims with any credibility. This article reviews prospects for Indian capital markets in 2011 in the light of the multiple risks ahead.
It is a bit early to quantify the economic fallout of the devastating earthquake in Japan for the rest of the world. However, it is clear that the uncertainty in West Asia and North Africa (WANA) will have negative consequences for markets. Even if India has hedged against oil price rise through longer-term contracts, oil import costs will go up if spot prices remain at elevated levels. As a country, which imports two-thirds of its oil consumption, higher oil prices would have a roll on impact on inflation. Further, if the disturbances were to seriously affect the Gulf countries from where higher concentrations of Indian workers send back the bulk of our inward remittances, the adverse impact on our current account would be higher. It follows that under such scenarios the fiscal deficit targets announced in the budget would be difficult to achieve. Increased government borrowings would exert upward pressure on interest rates leading in turn, to a slowdown in growth.
Another imponderable is the sovereign debt overhang in the Eurozone and the vulnerability of European banks. In mid-March 2011, the spreads of ten-year government bonds issued by Greece, Ireland and Portugal to those of comparable maturity German government bonds had lurched to record levels. It is almost inevitable that at a future point of time the sovereign debt of Eurozone periphery countries will need to be restructured. Therefore, banks in triple A rated European countries, which have government securities of vulnerable Eurozone countries on their books may need to be recapitalised. The next round of stress tests for European banks is being led by the European Banking Authority (EBA). If the possibility of sovereign debt restructuring and consequent haircuts on government bonds is included in the stress tests, European banks are likely to need additional capital. The results of these tests are to be announced in June 2011. If higher than currently anticipated levels of recapitalisation are required, India should expect outflows from FII accounts. Given that floating stock levels for Indian companies are relatively low, past experience has repeatedly demonstrated that FII purchases/sales have a disproportionate upward/downward impact on market valuations.
As housing prices continue to decline in the US, it is not clear that the bottom has been reached. The growing negative equity of home-owners may end up eating into the risk capital held by Fannie Mae and Freddie Mac. If that happens, at the margin, higher volumes of US government securities would have to be issued to provide additional capital to these mortgage giants. In this context, Pacific Investment Management Company’s (PIMCO) flagship total return fund amounting to $237 billion has cut its holdings of US Treasuries to zero in March 2011. Bill Gross, the high-profile manager of this bond fund, is betting that US interest rates will rise once the Federal Reserve’s $600 billion quantitative easing (QE2) programme comes to an end by June 2011. On a related note, China is exploring every avenue to reduce its holdings of US Treasuries. Consequently, absent yet another round of quantitative easing, US$ interest rates could go up after the summer, triggering outflows from FII accounts.
Another source of risk is that Indian stocks are relatively overvalued compared to competitor countries in Asia. For instance, at the end of December 2010, the average price to earnings ratios (P/Es) for benchmark Indian stock indices was around 24 compared to 21 in Indonesia, 17 in Malaysia and 15 in South Korea (Source: NSE, BSE and Bloomberg). In 2010, net FII investment in Indian stocks and bonds was $29.4 billion and $10.1 billion respectively, adding up to $39.5 billion. A reduction in FII interest is already evident in the first few months of 2011. From 1/1/2011 to 15/3/2011, FII outflows from stocks was $1.6 billion and debt inflows amounted to $3.1 billion resulting in a net inflow of only $1.5 billion (Source: SEBI). It is possible, therefore, that in calendar 2011, FII inflows, stocks plus debt, may not be more than $15-20 billion i.e. a drop of 50 per cent or more from 2010. Currently, the cumulative cap on FII investment in government securities and corporate bonds is $10 billion and $20 billion respectively, namely $30 billion in all (Source: Economic Survey 2010-2011). On 15 March 2011, cumulative FII investment in these two categories of debt stood at $20.7 billion i.e. there is not that much more room in the bond category for FII inflows.
Ideally, detailed information on stock and bond markets should be readily and publicly available to enable individual investors to make informed choices. For example, it is difficult to find reliable information on defaults, rescheduling or tardiness in repayments in the corporate or state government owned PSU bond market. Further, attention has not been paid to-date to provide current and historical P/E ratios across different categories of Indian assets along with comparable numbers in Asia, Europe and the US. This information plus past history on dividend payments per share, rates of return obtained by holding individual stocks over differing investment horizons should be made easily accessible on the websites of our stock exchanges and the regulator.
It is in the best interests of individual investors for them to keep a close eye on markets both before and after making investment decisions. It is particularly important that retail investors do their pre-investment analysis personally. If the persons concerned do not have the time, interest or ability to do so they would be better off investing their savings in fixed deposits. It is a cynical refrain among asset managers that mutual fund schemes are promoted and sold by them and not bought by investors. Therefore, SEBI’s past ruling to not allow mutual funds to impose an initial fee was a fair decision. j.bhagwati@gmail.com
The author is India’s Ambassador to the European Union, Belgium and Luxembourg. Views expressed are personal