R Ravimohan: Where are the markets going?

We have a runaway bull market. All index stocks are registering go-go profit growth. No inflation as yet in sight; benign interest rates, strengthening currency, burgeoning forex reserves, climbing bank credit, and impressive economic growth rates.

The story could not be more positive; however, I see more forlorn expressions than revelry on the faces of market participants and regulators! Why so? Are there things we should be worrying about? What are the underlying trends and what do they foretell?

At the outset, I must compliment the Reserve Bank for India for bringing out an extremely incisive presentation of the economy and underlying trends when the Governor reviewed the quarterly monetary policy. It served as a great background for this article.

Clearly, demand for manufactured goods and services, both in the domestic and international markets, seems to outstrip supply by a wide margin. While capacities are now being contemplated and perhaps implemented, it is interesting to note that the dominant trend is to buy existing capacity, not create new ones.

From this, one can conclude that the present margins are so good that the sponsors do not want to waste time gestating new capacity, and would rather acquire capacity and flog it in these bullish markets. Organic demand in the meanwhile is continuing its growth. All of this point to a demand-supply gap persisting well into the medium term, which will keep the prices buoyant.

The interesting feature to note, however, is that this tightness is not translating as yet into inflation, as both global competition and productivity gains are ensuring that the value chain is able to absorb much of the cost hike, without passing it to the consumers.

The received wisdom is that there are yet few more ounces of productivity to be squeezed, and therefore inflation is more likely to rear its head later than sooner. This means that consumer demand is likely to sustain even though there is pressure from increasing input prices.

The global liquidity situation is also disarming. For nearly a decade, there was accumulation of surplus since companies desisted from investments, as the world was struggling to digest the avaricious capacity expansion of the early nineties. Only recently, this has just begun to be tapped for fresh investments.

However, the boom in prices is currently yielding extremely strong surplus, which is likely to incrementally increase the global liquidity rather than drawing upon it, even though the investment cycle is already under way. This means interest rates are not likely to face any undue upward pressure.

In addition to the benign global framework, India is fortunate in having three additional market-supporting forces. The Indian economy is sustaining one of the highest growth rates in the world.

Its diverse economic structure is enabling it to fire on all cylinders, whether it is the buoyant commodity-based industries, greater share of the exporting opportunity, or the relentless growth in the services sector. Lastly, all this is attracting both increased portfolio and strategic investment flows, thereby strengthening the market and rupee.

This definitely means good news for all those that go long on most commodities and securities. Markets are likely to remain in buoyant territory for some years. What needs to be watched for are the flotsam and jetsam that the high tide inevitably brings in.

There are definite signals of that happening both in the equity bank loan markets. Companies are accessing capital markets with high-priced IPOs, which are not likely to yield good returns to the investors. All IPOs are getting oversubscribed multiple times at these high prices. No recent IPO has been rejected by the investors.

Bank credit has also been rising incredulously. Last month witnessed the credit-deposit ratio rising sharply to over 100 per cent from the somnambulant 40 per cent, where it was stuck for the past decade. I hope that the pushback of CVC oversight in bank lending is not fostering licentious lending.

Tighter provision norms and risk-based capital requirements are hopefully disciplining prudential lending practices at the banks. New avenues of funding such as private equity and venture capital are adding to the liquidity in the system.

New banking centres around the world like Korea, Taiwan, and Japan have been roped in to fund the external commercial borrowing kitty. Credit appraisal and the appreciation of the Indian context by these new kids-on-the-block are yet to be ascertained.

They should look at the mixed experience that foreign lenders had the last time when there was a similar exodus of borrowers from India to foreign shores. To avoid some of those bitter experiences, they should consult credible India experts.

Regulators on their part have been in their own ways trying to keep on top of the situation. While the strong performance of the markets for an extended period, barring any accidents, should give them a relatively easy time, they would be well advised to be prepared on four counts:

coming to terms with the excesses, even if they are legitimate, like the burgeoning foreign exchange reserves;

cautioning adventurous players so that the overall market is not threatened by the concentrated action of a few rogues. This can be achieved by questioning large deals, ensuring trade trails are explained to their satisfaction, and a proper customer identification system is present;

increased oversight of market players on a routine basis, to encourage compliance and fear of discovery of deviations, and

greater cross-reference between regulators, as this has proved to be the weakest link that has been exploited in the past by the truant market players. The current bull market""much more than in the past""has strong linkages with international markets. The regulators will do well to ensure that these linkages are robust, authorised, and do not harbour any undesirable practices. There are also large off exchange derivatives, especially the interest swaps. These have also grown substantially, and can have a market wide impact if caught unawares by a shock.

Some caution, eagle-eyed regulators, and discerning investors and financial sector players will make this bull market sustain for some time to come.