Abheek Barua: The Great India Story ? a requiem?

Short-term asset prices need not stay in line with long-term optimism

With the Sensex losing roughly 18 per cent since January and the rupee hovering at around forty-six to the dollar, the "Great India Story", touted so zealously a few months by the previous government and blue-chip American investment banks (remember the BRICS report?) seems to have taken a bit of a knock.

A slew of hard news about a decisive recovery in the US economy has taken the shine off emerging markets, India being no exception. Thus, the forecasts of the rupee climbing up to forty-two to the dollar or the Sensex moving to a level of 7000 (quite ubiquitous six or seven months back) seem in retrospect, well a little silly.

The problem with the overdose of enthusiasm last year about the future of the Indian asset markets does not lie in the basic analysis that went behind it.

There are visible elements of a somewhat positive story that is likely to pan out in the economy over the long term as this analysis pointed out "" demographic transition is evidently pushing a larger fraction of individuals into the labour market.

If they were to be gainfully employed and spend on goods and services, product markets are likely to grow exponentially. And so would company profits and the price of their shares.

No hitches in the plot thus far. Where the "India zealots" went wrong was in trying to link this essentially long-term story to the short-run behaviour of asset markets "" for instance, the direction of the stock market over the next few months and the level of exchange rate.

Asset markets are by their nature fickle "" they do not wait for long-term structural changes to unfold. Fund flows are determined by how returns in particular markets fare relative to other markets at a particular moment. Thus if US bonds offer better returns at the moment than Indian stocks, that's pretty much where the money goes.

Much of this extreme "short-termism" in fund-flows can be explained by the microstructure of the global fund management industry.

International fund managers are constantly benchmarked against each other and against major indices "" this evaluation takes place on a quarterly and at times even on a monthly basis. There is simply no room to invest in a stock or a market and wait for its fundamentals to germinate.

The bottom line is that views on the stock market or currency have to be based on a very short-term dynamic assessment of the relative performance of markets and instruments. Long-term stories or rationales may appear very comforting when the market is going through a bullish phase "" they tend to fall out of favour if things get a little pear-shaped.

Given the dynamics of the global economy today, I would put my money on just a moderate rise in the Indian stock-market indices over the next few months and a little depreciation in the rupee against the dollar. Interest rates are clearly on the rise and though they may not go through the ceiling, Indian bond prices are on the way down.

There is of course a possibility of a market getting "re-rated". Re-rating refers to the process by which valuations (read price-earning multiples, P-E for short) move up on a permanent basis.

Thus, for instance, instead of trading in a band of say 12 to 20, the Sensex permanently jumps to a P-E band of 20 to 30. Thus, stock prices for the market as a whole rise as a result of re-rating.

Re-rating reflects the diminished perception of the risk associated with a market and typically follows some aggressive reform both at the macro-policy level and by corporations. Credible initiatives to aggressively prune the Budget deficit or to clean up the banking systems' books could, for instance, drive a re-rating.

Could the Budget on July 8 trigger this kind of re-rating? Unlikely. My guess is that given the conflicting pressures on the incumbent government, the Union Budget is unlikely to provide the kind of radical reform blueprint that a re-rating of the market warrants.

The kind of initiatives that institutional investors would want to permanently upgrade the Indian market would be, for instance, a drastic slash in EPF rates or a reduction in import duties to Asean levels within a year.

I am not ruling out the possibility of a mild rally post-Budget if the finance minister reaffirms his commitment to reforms and announces a couple of sops for the market. These would however not be adequate to move the Sensex to a new, higher ballpark. The rally will be followed by a decline and the average will remain pretty much where it is.

What about the Fed's decision to raise the target Fed Funds rate just by a quarter of a percentage point on June 30 instead of by a larger quantum? Doesn't that provide succour for the emerging markets? Not quite.

Most analysts point out that the Fed has actually "fallen behind the curve" in raising rates. That is, most forward looking instruments such as US "interest rate futures" have actually priced in a much larger increase in rates over the year. The Fed is simply trying to pace this out over a period of time. Thus, the market expects that further interest rate hikes are overdue over the next year.

As long as this expectation persists, investors are likely to wait and watch, keep their emerging market exposures light and make a beeline for the US markets as rates move up further.

Let me end by pointing out another critical problem with long-term stories that seek to justify the attractiveness of a market. Most of these assume a certain kind of "automaticity" about the process of growth and income generation. I'll try and explain this in the Indian context. Much is made of the fact that the fraction of the population in India eligible for the work force is likely to grow continuously for the next decade or so.

Given that they will spend on goods on services, this demographic transition is meant to augur well for these markets. This assumes that the new entrants into the market will be gainfully employed and earn incomes "" it is this critical assumption that I refer to as automaticity.

It is quite possible that unless suitable measures are taken to generate investments and open employment opportunities, this demographic transition will lead to rampant unemployment and a serious political crisis.

To be credible, long-term views on India will have to take into account the exact mechanisms of transition, particularly the policy measures that go with it. Asset markets have a tendency to be little careful about these interim issues. And that's why their enthusiasm about the "bigger picture" pitches for India has flagged over the last couple of months.

(The writer is a senior economist at the Crisil Centre for Economic Research)