A different market now

The stock markets have weathered a hurricane in the past few days. Now that the worst is over, it's time to look back and draw a few lessons from the unprecedented volatility.

The first thing that needs to be said is that the market stood up very well to the panic; settlements went through smoothly, sellers receiving their cash and buyers receiving their shares right on time.

Part of the reason, of course, was sustained buying by domestic financial institutions, who helped provide a floor to the market. Another saving grace was that the free fall in the market on Monday was on very low volumes. But, on the whole, the system passed the test with flying colours.

The circuit breakers worked and the suspension of trading helped restore calm, as did the Reserve Bank of India's reassurance that it stood ready to provide liquidity to the settlement banks.

The RBI's decision to lower margin requirements also helped, as it arrested the cascading effect of margin calls leading to a vicious cycle of selling. Soothing comments by Dr Manmohan Singh played their role too, although the panic was started in the first place by leftist leaders making irresponsible and unnecessary statements.

One important lesson that emerges is that political leaders need to be extremely careful about holding forth on matters that affect the market.

Politicians must realise that the markets hate uncertainty, and they need to take steps to ensure that uncertainty is kept to a minimum. Whether that is possible in a coalition government beset by contradictions is, of course, another matter.

The other key observation that can be made is that foreign institutional investors have been net sellers this month. It would be wrong to pin the entire blame for FII selling on political uncertainty, since they have been sellers in all emerging markets.

Emerging market funds have seen billions of dollars flow out in the last three weeks as a result of heightened risk aversion. The prospect of higher interest rates in the US, high oil prices, a slowdown in the Chinese economy and heightened geopolitical risk have resulted in reduced appetite for emerging market assets.

It's no surprise therefore that most emerging market equity indices are now pointing sharply downwards. In other words, the virtuous cycle of lax monetary policy and fiscal policy in the US and other leading economies, which had led to a sea of liquidity buoying asset prices across the world, is now being reined in; as money supply tightens, there's a movement of capital away from emerging markets.

The IMF has drawn attention to the parallels with 1994, when savage hikes in US interest rates sent emerging markets into a tailspin. Till recently, there was some hope that the attractions of the India story to foreign investors would temper selling from India, and it's true that selling by India funds has so far been much lower than in the rest of Asia.

But there is no doubt that there has been a major change in global market conditions in the past few weeks. To be sure, there will be rallies here and there, but last year's upbeat conditions no longer hold true.