September 06, 2015

Behind The Volatile Market

C P Chandrasekhar

INDIA’S stock market is passing through a volatile phase. While the 1625 point collapse of the Sensex on August 24, 2015, which was the largest decline in six years, was followed by a return to stability and even moderate buoyancy, the mere announcement of a half of a percentage point decline in the quarterly GDP growth rate during April to June, was enough to precipitate a more than 500 point decline on September 1, 2015. Clearly uncertainty pervades capital markets providing the opportunity for speculators to jump in when stock prices are falling, trigger an artificial rise and exit before the next downturn. In doing so they pick on and highlight any bit of news that suits the bet they are making.

While stock markets are by nature whimsical and are only ‘analysed’ by punters, even to reasoning observers three factors do seem to underlie and explain the uncertainty implicit in the behaviour of the investor community. First, few in that community believe that the highs the market touched during the recently concluded boom is sustainable. The Sensex, for example, has risen too fast in too short a time, driven substantially by foreign institutional investors. Till the end of 1990, the Sensex hovered at extremely low levels below 1200. Even after 1990, while there was a jump in the level of the Sensex, till end 2003 it fluctuated between 2500 and 5500. Since then there have been two boom bust cycles, one in which the index peaked at levels above 20000 in early 2008 and late 2010 and fell to troughs of less than 9000 and 15000 respectively in early 2009 and late 2011. Subsequently, the Sensex rose to a new peak of close to 30000, having experienced an upturn in what is proving to be a third cycle which has entered its downward phase. The downturn may have been delayed by the expectations raised by the Modi campaign. But that is now proving to be little but hype and investor sentiment is finding new lows.

Second, there is much uncertainty about prospects for the world economy and about the impact that would have on flows of financial capital to the so-called emerging markets in general, and India in particular. The fears that have overcome investors in recent times seem more significant because of the factors prompting them. These include: evidence and implications of a major slowdown and crisis in China; the consequences of that for emerging markets, especially commodity producers and countries that have attracted large capital flows during the period that followed the financial crisis of 2008-09; and, the resulting spin-off effects on the US, and the negative feedback loop that would be triggered by the likely US response to its predicament.

As a result of such fears the capital surge to emerging market countries resulting from the monetary infusion or infusion of liquidity in the developed countries in response to the Great recession is unwinding. According to an estimate by investment bank NN Investment Partners reported by the Financial Times (August 19, 2015), net capital outflows from the 19 largest emerging markets amounted to close to a trillion (940.2 billion) in the 13 months to the end of July. That was double the $480 billion that flowed out of these countries during the worst three quarters of the 2008/09 crisis. It is also about a half of the net $2 trillion capital inflow into these 19 markets in the six years following the crisis from July 2009 to end June 2014. Capital exit from emerging markets had clearly begun and even accelerated around a year back.

The exodus has reduced liquidity in financial markets and adversely affected debt-financed demand growth in these economies. It has also weakened currencies in these markets substantially, increasing the pressure to reduce the current account deficit and manage potential inflation. Russia, Turkey, Malaysia and Taiwan, for example, have seen their currencies hit by worsening market sentiment. That too affects growth prospects adversely. Finally, these problems have been compounded by the collapse in commodity prices, led by oil and copper, and driven by poor growth in China and elsewhere in the world.

It is in this context that the shock depreciation of the Chinese yuan over three days starting August 11, which brought its value down by a little more than three percent relative to the US dollar, triggered a renewed round of investor panic. That depreciation signalled that the Chinese economy too is troubled, and the dampening effect that decelerating Chinese growth has been having on the rest of the world would intensify. Moreover, there is the danger that the recent yuan depreciation is an indicator that the Chinese authorities would “allow” the yuan to depreciate to stimulate exports as a response to growth deceleration. Such measures seem to assume a sense of urgency because of the collapse of the bubbles in the housing, real estate and stock markets in China.

Further yuan depreciation would force new rounds of depreciation in countries elsewhere, in order to neutralise the impact of the Chinese move on imports into their economies and the competitiveness of their exports. Yuan depreciation would make Chinese exports cheaper in foreign markets and imports into China more expensive. The result would be increased uncertainty and even slower growth in the aggregate. The depressing effect this would have on global demand would impact the weak US recovery, especially given the fact that the dollar is now gaining strength against all currencies, besides the yuan. If all of this accentuates investor panic and capital flight to safety in dollar-denominated assets, India is likely to experience a withdrawal of capital too.

Finally, the Indian economy is also performing poorly, with most indicators barring the recently released ‘revised and improved’ GDP numbers, pointing to poor or indifferent performance. Given global recessionary trends and the fact that the IMD’s prediction of a deficient monsoon is coming true, things can only get worse. Not surprisingly, even a small deceleration reflected by the ramped up GDP series for the April to June quarter of this year proved enough to trigger panic. Growth in that quarter has been estimated at 7 percent, which is lower than the 7.5 percent in the previous quarter and significantly lower than what the government was declaring growth would be. But still differences of perception persist. The headline in BBC News for the story on the announcement of the new numbers read, “Indian economic growth slows to 7 percent”, with Simon Atkinson reporting that: “There will be plenty of people disappointed with this number. Some economists I've spoken to recently thought GDP growth would be closer to 8 percent - streaking ahead of China's.” On the other hand, the Wall Street Journal website story led with the view that: “India’s economy, defying weakness in developed countries and elsewhere in emerging Asia, expanded 7 percent in the April-through-June quarter, making it one of the world’s fastest-growing as China downshifts.” Such differences influenced by editorial inclinations notwithstanding, market perceptions do seem pessimistic. The Modi government’s hype and diversionary emphasis on matters such as cleanliness and digitising India is, understandably, unable to reverse such pessimism. 

So while nothing can explain the outcomes of the behaviour of differently motivated players participating in the stock markets, it is indeed true that there are enough grounds for investors to be overcome by uncertainty, which induces an element of bearishness into the markets. In India’s case (as also the other emerging markets) this problem is particularly intense because of the accumulated legacy capital in the form of foreign institutional and other forms of financial investment. So even if domestic factors don’t result in panic that spurs uncertainty, investors can withdraw, rendering the market bearish and prone to volatility. So any sign that foreign investor interest may be adversely affected is enough for a sharp swing in the Sensex. That is the price to be paid for having liberalised capital flows and capital markets.