It has been an extraordinary week for the Indian stock market. Let’s look at the less discussed index: Nifty. On Tuesday the 21st, Nifty was roughly stable at 3200. Less than a week later, the intra-day low on Monday was 2350. Nifty dropped on Wednesday, Thursday, Friday and Monday. Such a succession of large declines is rare. The pain has been concentrated in a few sectors. Commercial vehicles, air transport, and housing construction are the industries where the strongest declines have been seen. The market was relatively shallow on Monday. The October Nifty futures contract showed a bid-offer spread of roughly 75 paisa. At the same time, the open interest in this contract rose by 13%, thus suggesting that many players were not scared off by these declines; they were willing to enlarge their positions. Also, the Sensex recovered somewhat rapidly, justifiably raising question whether some white knights were at work. But of course the broad recent trend is sharply negative. So it is important to remember somethings. The broad market P/E (the CMIE Cospi index) stood at 13 and the broad market P/B ratio stood at 1.6. These values remain substantially higher than what we have experienced for sustained periods before, with single-digit P/E ratios. The CMIE manufacturing index had an even stronger P/E of 18. In other words, while the recent decline in stock prices appears catastrophic, the market remains fairly optimistic about the outlook for earnings growth, particularly for manufacturing companies.
The most important thing that investors need to do is to not panic. Equity investment has always been a sensible proposition keeping the long-term in mind. A person who purchased the German index fund in 1933—when Hitler came to power—had outperformed the correponding bond investor by 1955, even though the devastation of the second world war took place from 1939 to 1945. Equities fluctuate from day to day, and precisely for this reason, deliver the highest returns over long time horizons. The utterly horribly almost impossibly pessimistic scenario about a downturn in India probably involves 4-5% GDP growth for at most two to three years. In this case, nominal GDP growth will be roughly 10%. The corporate sector will then register 13-15% sales growth. This will be slow when compared with the torrid pace of recent years. But it will not be like the worst fears being expressed today. Years from now, we will probably look back at Nifty and Sensex as being the buying opportunities. While Indian firms do not, as a whole, carry a lot of leverage, some promoters may be leveraged. These promoters could experience considerable financial stress, and there government responses become important. Blind bail outs are bad. But in extraordinary times, big collapses are probably worse.
From the viewpoint of public policy, the most important thing that the government has to do is to decide how to support the system. There will be and should be debates about this, for example, the one going on about short selling. There’s a debate about the extent of government intervention in currency markets as well. Here the case for periodic intervention seems getting weaker every time RBI spends a bunch of dollars to defend the rupee at the rupee slides. As these columns had argued before, this is not a bet RBI can most likely win. The same goes about direct public money support for asset prices. Forget theory, this is what it translates into: if the market is propped at a certain level, FIIs can then sell that level and cut their losses and take out their money. That’s a government subsidy to foreign portfolio investors—not a good policy surely. Unorthodox solutions must not be discouraged in extraordinary times but all times government intervention must remember the rule of not creating the expectation of an one-way bet in the market—then there’s no win.
The government must stay focused on its business of doing economic policy. This involves ensuring ample rupee liquidity (and the recent tightening of the money market suggests that there is a lot to be done here), ensuring ample dollar liquidity, and ensuring that the currency derivatives offer ample opportunities to remove currency mismatches. Capital controls need to be removed, so that more foreign capital can come into the country and assist firms. The most important counter-cyclical lever that the Indian government controls is economic reforms. If India makes a break with the recent years, and embarks on economic reform, then the private sector will have the best reason to invest in India. Remember that in the last slowdown, 1997-2002, structural reforms had happened and that was the reason the economy took off when the cycle turned. The same policy followed now, coupled with system-supporting policy when required, can make India a fine place to invest—never mind the Sensex and the Nifty today.