While things might appear bleak right now, don?t let this bother you unduly. Continue to invest according to your asset allocation. If it is any comfort, the Indian economy, which is driven by domestic demand, is among the best positioned to bounce back once things stabilise in the West

What a week it has been. Three of the most iconic financial institutions of Wall Street almost went bust. Lehman Brothers, unable to get the much-needed injection of capital, filed for bankruptcy. Merrill Lynch took shelter under the aegis of Bank of America at a throwaway price of $50 billion. And AIG, once the world?s largest insurer by assets, was bailed out by the Federal Reserve (Fed) with a bridge loan of $85 billion. As these tectonic shifts change the US financial world, what do they augur for the Indian investor? Is your money at risk in any way? Will Indian markets and economy be able to weather this storm?

Genesis of the problem
Giant financial institutions are tumbling one after the other today because of lack of long-term capital and short-term liquidity. The root of the problem lies in the sub-prime mortgage market. To profit from the boom in real estate markets, banks started granting loans to sub-prime borrowers who had poor credit ratings. These sub-prime loans were further repackaged into derivatives and sold off to banks and investment houses. Eventually, these derivatives saw huge erosion in their value due to the losses in the sub-prime markets (when sub-prime borrowers failed to repay their loans). This in turn led to a huge dip in the portfolio values of banks that were holding these securities.
Over time the problem from the sub-prime mortgage market snowballed into a credit crisis. Financial institutions that found their portfolios eroded due to sub-prime related losses needed capital infusion to keep going. But since lenders became wary of the borrower?s ability to repay the loan, they would not lend money. When such borrowing and lending stops, the pace of commercial transactions slows down. So institutions that had fallen into an abyss had little chance of survival unless some other institution bought them out.

The Fed?s role
One entity that has huge funds at its disposal and can bail out troubled institutions is the Federal Reserve (the regulator of the US banking system). But the Fed has had to wrestle with two contrasting imperatives: on the one hand was the need to prevent the crisis from snowballing to proportions where it posed a risk to the entire financial system. On the other, the Fed could not possibly spend an unlimited amount of the US taxpayer?s money on bailing out private institutions that have got into trouble because of the greed and poor judgement of their principals. Already, there is talk of ?privatisation of gains and socialisation of losses? (i.e., private entities profit when their risky bets pay off, while the poor tax payer picks up the tab when those bets fail).
The Fed?s criterion for whom to bail out and whom not to has been based on avoiding systemic risk. Where an entity was deemed too large to be allowed to fail (as was the case with Fannie Mae, Freddie Mac and AIG), the Fed stepped in. Since the failure of Lehman Brothers was not deemed to pose systemic risk, it was allowed to go under.

According to economists, the crisis could well spread to other parts of the world. ?It has spread to the UK and the European markets. We will see European banks come under pressure next,? says Abheek Barua, chief economist at HDFC Bank.

Possible solutions. On Thursday, the central banks of Europe, Japan and the US together injected $250 billion of liquidity into the system in a bid to help out banks that are having trouble raising short-term funds from other banks. They can approach their central bank and get liquidity after pledging securities as collateral. This has been reasonably successful in abating the anxiety that had enveloped markets around the world till Thursday.

Other solutions are also being mulled. One is the setting up of a government-owned asset reconstruction company, in which the US Treasury will take on the really dodgy assets of different financial institutions, rework the asset structure, and resell them at an opportune time.
But by no means can one conclude that the worst is over. Says Barua: ?The huge systemic problem that has underpinned the current situation is getting resolved to a slight extent. That?s the good news. But more potential bad news could come in.?

Impact on India
According to economists and market experts, while the developments abroad will have some effect, they are unlikely to deal a fatal blow to the Indian economy and markets.

Economy. The biggest cause for concern for the Indian economy will be the tighter liquidity situation. But the Indian economy?s growth rate will still be better than that of most other economies.
?Despite whatever is happening globally, India will definitely have a GDP growth rate of 7.5 per cent or somewhere around that. For a country of our size, this is a pretty high number,? says U.K. Sinha, chairman and managing director of UTI Mutual Fund. ?India is driven more by domestic consumption, rather than by exports or outside demand. Our growth continues to remain robust and our economy is better positioned to face global challenges, as compared with some other countries.?

But in the short term there could be some impact. ?Since India is an emerging market, we could have a shortage of liquidity in the short term. Risky asset classes are getting beaten down, so stock markets are being beaten down. Moreover, access to funds for Indian companies is going to be severely limited,? says Barua. ?The outflow of funds could have implications for the exchange rate. The rupee could depreciate more than is desirable at present, which could lead to liquidity problems. Apart from this, sectors like services and BPO sector could be adversely affected with demand slowing down in the US.?
With crude oil prices receding, the Indian economy is in a better shape today than it was a couple of months ago. The first quarter GDP number of 7.9 per cent, and July IIP figures of 7.1 per cent, both point to its resilience.

Markets. Over the next few months, the markets are expected to remain choppy. ?The markets will react to news, but eventually they will recoup as India is still going strong,? says Krishnamurthy Vijayan, chief executive officer, JP Morgan AMC.
One source of risk arises from foreign institutional investors (FIIs) pulling their investments out. FIIs hold a substantial chunk of the Indian stock markets and could start selling in order to deal with the capital needs of their parent organisations. On September 17, their net investment in the Indian markets stood at Rs 2,49,292 crore.

?There are trillions of dollars of US and G7 money floating around in Asia. They could pull out this money to recapitalise the losses sustained in their home countries, and to meet redemption pressures. This is likely to keep the markets beaten down for some time. There is no way that emerging markets will bounce back in a hurry,? says Barua. But the Indian market?s fundamentals are stronger than that of many other markets, so it should recover faster than developed markets, he adds.

What should you do
India is driven more by domestic consumption, rather than by exports or outside demand. According to experts, growth continues to remain robust and the economy is well positioned to withstand the global turmoil. Therefore, long-term investors need not lose sleep and should continue investing in the markets.

?The current market levels are very good for an investor to enter for the long term. However, my advice would be that if you are not well informed, don?t take direct exposure to equities and go through a fund house,? says Sinha. ?Investors should put a part of their savings in equities, as it gives the best returns in the long term. And one should invest for a relatively longer period: not for one year, but for more than two-three years.?

Sectors to avoid. If you have taken direct exposure to equities, a few sectors should be avoided. IT is one. ?With the slowdown in the US and Europe, IT stocks are getting hit,? says Ajay Bagga, chief executive officer, Lotus India Asset Management Company. ?Then there are sectors that have external linkages, i.e., export-driven sectors. Even though the rupee is depreciating, these will get hit because of the slackening of consumer demand in developed markets. So exporters of textiles could see a correction. Metal stocks should also be avoided. Metal prices are falling as demand destruction is happening in commodities. Also, avoid brokerages because trading volumes have gone down,? he adds.

Defensive sectors. There are two broad themes that you can play. ?One is the domestic consumption story, which includes FMCG, healthcare, and telecom. Then there are the beneficiaries of the global slowdown ? where the raw material that is used is a commodity that is imported. So you could be positive on the oil and gas sector. You could also invest in interest-rate sensitive sectors, like auto, consumer goods and banks,? says Bagga.
Experts speak: ?Don?t hack your existing positions. If you have an SIP going, continue with it. Don?t try to time the market because nobody knows where the bottom of the market is,? says Bagga. ?An SIP in a sectoral fund has much higher risk. Investment in a large cap diversified fund is better, while an index fund is the best option,? he adds.

According to Delhi-based financial planner Surya Bhatia, ?Investors should concentrate more on large caps right now. They are the best bet, because we are getting most large cap stocks at a 50 per cent discounted value. Besides, an investor in this kind of market also gets the benefit of the fundamental story getting stronger in large cap stocks. The rally that will come subsequently will be more fundamental driven rather than momentum driven. Direct exposure is not harmful but no one can predict the bottom. Therefore, investing through an SIP in a fund looks like an attractive option.?

Though market conditions may be adverse right now, you should not panic or grow impatient. Keep faith in the long-term potential of equities and keep your SIPs going. If you have an investment horizon of 15-20 years, this bear market should not bother you unduly.