The worldwide volatility in the equity market on October 28 and 29, was particularly remarkable from Indias perspective. This was the first episode of spillovers of foreign volatility into the Indian equity market. In earlier days, Indias markets were insulated from worldwide shocks. In October 1987 and 1989, months of high market volatility in the US had no impact upon the Indian market. Last weeks experience would suggest that the correlation between Nifty and the S&P 500 is now greater than what it used to be.
One immediate conclusion often heard is that this is a new source of volatility on Indias equity market; that this makes Indias equity more risky. This conclusion is incomplete. While globalisation has increased the correlation between equity markets worldwide, it has also yielded reduced vulnerability in Indias equity market to domestic fluctuations. Foreign investors are a stabilising factor in Indias market in many ways, as is evidenced by the positive FII inflows into India in each of the last 50 months. In an increasingly integrated world economy, two opposing forces are at work: Indias financial instruments reduced vulnerability to domestic shocks and their increased vulnerability to international shocks.
Fears of enhanced volatility on Indias markets are hence somewhat off-track. The most important consequence of an increased correlation between the NSE-50 and the S&P 500 is the reduced attraction of India as a destination for foreign investment. International investment has grown enormously over the last 20 years as investors have tried to obtain diversification, and has reduced exposure to the US equity market. International diversification yields superior risk-return tradeoffs for the investor.
However, spreading a portfolio over many assets yields the best reduction in risk when the assets are less correlated. If ITC and Tisco were highly correlated, then portfolios formed from ITC and Tisco would be no less risky than either stock in isolation. However, if ITC and Tisco fluctuate for different reasons, then investors get superior risk-return tradeoffs by forming portfolios which combine the two stocks.
This argument applies for all kinds of diversification: across stocks, industries, or nations. If India and Bangladesh are highly vulnerable to the same monsoon, then diversification between Indian and Bangladeshi stocks would yield small risk reductions. The major attraction of investing in India, up to two weeks ago, was the near-zero correlation between Indias market index and the S&P 500. This correlation could not last indefinitely: Indias globalisation on both product markets and financial markets was bound to yield a higher correlation. We are now at the onset of this process.
Globalisation has remarkable implications for the valuation of Indian securities: Indian stocks, which are less correlated with world fluctuations, require a lower capital cost. This is in contrast with an isolated India, where the risk generated by a stock was measured solely by using the correlation with Nifty. Analysts in India should now be increasingly concerned about the beta of Indian stocks against world market indexes.
Even if the correlation between the NSE-50 and the S&P 500 rises above zero, this does not mean that FII inflows will fall sharply. As long as the correlation is below one, diversification by using investment in Indian equity will be useful for foreign investors. In addition, the correlation between India and the US is amongst the lowest among all emerging markets. What is new is that the early phase of a near-zero correlation seems to have ended.
What are the implications of this for Indias economy, and what action can India take to cope with these challenges? Three major issues can be isolated.
Risk needs management: Where there is volatility, there is need for financial instruments which help individuals control their exposure to price fluctuations. The development of markets for financial derivatives in India would enable such risk management, since, at present, economic agents in India have no hedging mechanisms.
In the equity market, the pre-Diwali volatility served as a textbook example of the importance of index derivatives: when Nifty moved by 8 per cent, every equity portfolio was affected. The risk that derives from individual stocks can be eliminated by diversification. However, diversification cannot eliminate exposure to the market index; it is only futures and options on the market index which enable risk management at the level of equity portfolios.
The pre-Diwali volatility was essentially index volatility: if index derivatives had existed in India during these volatile days, they would have been intensively used for both hedging and as vehicles of price discovery.
Indias investors should look beyond India in risk management: The focus of institutional development of Indias derivatives industry has been on derivatives based on the equity index and the dollar-rupee rate. However, in a world where Indian firms and individuals are exposed to risks which are already addressed by financial derivatives available offshore, there is every reason to benefit from using these.
An important pay-off from capital account convertibility is hence the risk reductions that Indians can get by using foreign derivatives markets. Obvious examples of these are futures on the S&P 500 index or on US T-bills, but other examples abound. The most liquid wheat futures market in the world is in Chicago. As liberalisation in agriculture comes about, equalising Indian wheat prices with world prices is one of the best risk management alternatives for Indias wheat economy.
Trading hours in India should be extended: In a world where news of material significance to Indian stocks breaks outside Indian working hours, the price discovery on Indias markets (which only function during the day and are closed on Indian holidays) stands the risk of being disrupted. Positions adopted during trading time, which cannot be modified when news breaks offshore, increase the likelihood of a payments crisis.
One clear improvement would be to make stock markets run an additional evening trading session. Markets should have the main trading session from 10 to 3.30, and then reopen for a second session from 6 to 8 p.m. The evening session may present some difficulties with clearing and settlement, but these can be overcome by merging all trades of the evening session with the main trading session of the next day.
The advantage of an evening session is that it better overlaps with trading hours on European and US markets. On days when significant news does not break on these markets, the evening session would be inactive. However, on days of turbulence on international markets, the evening session would be of vital importance to Indian users.
The securities industry worldwide is increasingly moving towards round the clock trading. The Globex system of the Chicago Mercantile Exchange (CME) supplements daytime (floor-based) trading with electronic trading in off hours. The proposed evening session would be a step towards such round-the-clock price discovery.
