Prof. Jayanth R. Varma's Financial Markets Blog

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Indian coupling with global risk aversion in 2009

I wrote a column in the Financial Express today about why Indian markets were swayed by global developments in 2009.

Indian markets in 2009 appeared to dance almost completely to the tune of global developments, reminding us of how strongly integrated we are with world financial markets.

Unlike China, the Indian economy does not depend so much on exports for its growth. Collapse of global trade in 2008 and early 2009 did impact sectors like textiles, diamonds and software services, but collapsing exports did not crush the whole economy because many other sectors thrived on domestic demand.

India’s tight coupling with global markets was not due to trade linkages, but to its dependence on foreign portfolio flows for risk capital. Over the last few years, more and more Indian investors have sold their shares in Indian companies largely to foreign investors (but also partly to Indian promoter groups seeking to increase their stakes).

Foreigners might have bought because they are more bullish about our country than we are, or because their global diversification makes them less concerned about India-specific risks. What is important is that Indian asset prices are now increasingly determined by foreign investors.

This dependence has three implications. First, when foreign portfolio flows reversed, as in late 2008 and early 2009, risk capital disappeared completely. A few companies with strong balance sheets were able to raise modest amounts of debt locally, but those with weaker balance sheets found that they could not raise money at all.

When the corporate sector talked about a liquidity crunch in early 2009, it was really bemoaning the lack of risk capital. Banking system liquidity was probably adequate by early 2009, but this liquidity was not risk capital that could meet the needs of cash-strapped businesses. It was the return of foreign risk capital in mid-2009 that saved the day for these companies.

The second implication of India’s dependence on foreign risk capital is that asset prices in India depend on global risk aversion as much or even more than on domestic sentiment. Capital inflows can ignite asset-price bubbles and outflows can prick the bubbles.

Many of us worried about asset-price bubbles in India in 2007, particularly in the stock markets and in real estate. This view can be debated, but if it is accepted, some of the air went out of these bubbles in 2008 and early 2009, and the bubbles might have been inflated again in the second half of 2009. They could deflate again if global risk appetite reverses in 2010.

The third implication of reliance on foreign risk capital is that equity portfolio flows have a strong effect on the exchange rate. Reserve accumulation by the central bank dampens currency appreciation but does not eliminate it completely. A regime of managed exchange rates creates difficulties for the conduct of monetary policy.

Despite all these problems, foreign risk capital (unlike debt capital inflows) brings huge benefits to the economy. Even in the extreme scenario where all inflows are sterilised in the form of reserves, capital inflows provide dramatic risk reduction for the economy as a whole.

This benefit was clearly visible in late 2008 and early 2009 when foreign investors sold shares at prices well below what they had paid only months earlier and converted the rupee proceeds into dollars at exchange rates much higher than the rate at which they had bought rupees when they came in.

Whenever foreign investors sell cheap after buying dear, they make a loss and India as a nation makes a profit. More importantly, we as a country make a profit precisely when the economy is not doing too well. This is a wonderful risk hedge that is worth all the costs that come with it.

Looking forward to 2010, it is quite likely that the ups and downs of global markets will be felt in India as well. Major downside risks remain in the global economy and the question is how well positioned we are to cope with their impact on India.

The Indian corporate sector has used the recovery of 2009 to repair balance sheets in a variety of ways. A lot of the rebuilding of balance sheets has been made possible by foreign risk capital.

Some companies have raised new equity in 2009 largely in the form of private placements and sales to strategic investors. Many companies that found themselves struggling to roll over short-term debt in 2008 have taken advantage of benign conditions in 2009 to refinance short-term debt with longer-term debt.

A few companies have also addressed the problem of busted convertibles. The recovery of 2009 enabled them to successfully exchange old convertibles that had uncomfortably high conversion prices for more viable instruments. The re-emergence of mergers and acquisitions activity also allowed some companies to carry out asset sales to rebuild their balance sheet strength.

As a result of all this, the Indian corporate sector is better positioned to face new challenges in 2010.

Posted at 12:48 pm IST on Tue, 29 Dec 2009         permanent link