Thursday, August 23, 2007

Integration may be a cushion against stock market declines - T. B. Kapali

By T. B. Kapali

It is during a crisis in the financial markets that the importance of integration and free movement among various sub-segments of the overall market is highlighted. In a market structure where the equity, debt and currency sub-segments are well-linked, an inflow/outflow of capital in one sub-segment can be matched by an outflow/inflow of capital in other sub-segment(s), leaving the overall market broadly stable. It is like portfolio diversification (and risk minimisation) being attained through the market’s sub-segments so that capital does not have to completely exit a particular market (read country).

In the absence of the free flow of capital between the different segments, the impact of an inflow/outflow of capital in one segment is accentuated. Markets overshoot — on either side — in such an environment. For instance, if capital inflow into debt is restricted but is allowed freely in equities, the stock market is bound to feel the upward pressure when the inflow environment is strong.

Stock valuations can easily be stretched in such a scenario, as capital has limited deployment avenues. A freer and more developed debt market, in this environment, may possibly draw some amount of incoming capital so that equity valuations are driven more by choice and discretion rather than by default.

Equally, during episodes of market turmoil and capital withdrawal, the correction in the stock market is bound to be severe and prolonged. While ‘home bias” will be the prime driver of where capital is headed during such turmoil and withdrawal, the availability of alternative investment avenues can arguably smoothen the withdrawal process and leave the local markets relatively more stable, in an overall sense.

Asian crisis of 1997

The Asian financial crisis in 1997 brought home the importance of well-developed and linked markets. The currency markets bore the brunt of the market corrections in many Asian countries — some currencies falling as much as 50 per cent against the dollar in the space of a few weeks — as the equity and bond markets were relatively underdeveloped.

Ten years on, as another crisis roils through global financial markets, one is certainly not envisaging corrections in the currency markets of the scale witnessed in 1997. (It is precisely to prevent a run on their currencies during such global turmoil that Asian central banks have, post 1997, accumulated huge foreign exchange reserves).

ButAt the same time, it is also clear that not much progress has been made in the development of the other sub-segments — particularly debt. In the event, it is quite possible for Asian stock markets to plumb further lows. While further falls would be welcome, to the extent that they could wring out more of the valuation “excesses” of the past three to four years, one cannot rule out an overshooting either — both in terms of the size of market moves and the time period over which they occur.

The debt markets, though, could be in a world of their own in the midst of all these corrections in the stock markets. They are not in a position to act as shock absorbers as capital withdraws from equities and is repatriated.

Indian markets

This view would seem to apply quite well in the case of the Indian financial markets also. Equities are witnessing a significant sell-off and possibly more is in store as a global investor shift to a risk-averse mode is yet to run its course. And even if investors are convinced about the underlying strength of Indian corporate financials and earnings prospects, they have no alternative investment vehicles that can cushion the impact from the fall in stocks and leave the macro-environment broadly conducive for a good recovery.

The foreign investment limit in Indian debt (Government debt) is capped at $2.6 billion. At these levels, the debt market is not in a position to meaningfully absorb the shocks emanating from the stock market. One sees, therefore, Indian bond yields — even short-term yields — actually moving up even as the stock market is undergoing a major downside correction. The rupee, consequently, has come under some pressure in the foreign exchange market as foreign capital withdraws from the stock market and is repatriated in the absence of competitive, alternative investment avenues.

In an ideal scenario, bond yields would have softened in the face of the on-going scale of stock market corrections, as investors shift into the safety of (Government) debt to ride out overall market turmoil. More so, if the perception about the underlying strength of corporate financials remains unchanged. From a purely returns point of view also, investments in short-term Indian debt at present offer a good yield pick-up of close to 2.50 per cent over that available on US Treasuries, the preferred safe haven during periods of market stress.

As indicated earlier, “home bias” would come into play during such periods of market turmoil and the bond markets may consequently not receive and absorb as much of the capital exiting the stock markets. But the enabling environment of a freer and more developed bond market would nevertheless go some way towards smoothening the overall market adjustment process.

The Indian bond markets, though, in the face of tight investment restrictions, have been responding only to the liquidity conditions in the domestic banking system and have been quite unmindful of the substantial softening that has occurred in bond yields globally.

Policy block in debt

To be sure, permitting greater levels of foreign investment in debt is easier said than done. Though currency risk will be borne by the overseas investor and, therefore, need not be classified as sovereign borrowing in foreign currency, the domestic interest rate market nevertheless will get exposed to the pulls and preferences of overseas investors.

How much of domestic interest rate independence can be sacrificed is the key question here. To answer that, one has perhaps to examine how much domestic interest rate independence is available currently — where capital is allowed to flow freely into the stock market, and the central bank of the country follows a policy of absorbing most of the incoming capital into its reserves, leaving the financial system with a level of liquidity which (the central bank itself feels) is not conducive to maintaining overall stability in interest rate markets.

If that policy hurdle can be overcome, one can possibly look at more brass-tack issues (such as the depth, liquidity, risk characteristics of the debt paper available for investment and turnover patterns in the debt markets) which can support increased foreign investment in debt and enable these markets to play a shock absorber role during crisis periods.

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