The markets sneeze in the USA and the Indian bourses catch a cold. This clich? seems to have become chronic in India nowadays when happenings in the US markets and also other markets seem to be having a direct impact in pulling down or even buoying the Indian equity and other asset markets.
The walls that protected the Indian asset markets have steadily been crumbling and India is now extremely vulnerable to global happenings. This is the reality that Indian investors will have to live with. ?India has witnessed sustained buying by global funds and has seen a sustained rise in asset prices. This was the positive side of globalisation. Now, investors will also see the flip side, which is when funds move out, there could be stronger corrections. Investors need to factor this in,? says a fund manager with a global fund.
Indeed, Indian markets have traversed a long path to reach the current status of a favoured global investment destination. The pre-90s period saw the domestic financial institutions like LIC, GIC, HDFC and ICICI banks and mutual funds as big investors, calling the shots. Several experts of the yesteryears recall how the big institutional investors actually sat across the table to decide the extent of the Sensex movement.
Increasing global exposure started with the foreign institutional investors (FIIs) plunged into Indian markets with alacrity and a definite objective. Even then, developments overseas hardly made an impact on Indian markets. India remained untouched by massive currency crises that maimed South East Asian markets in the mid-nineties.
Global flows
With Indian corporates demonstrating tremendous potential and also delivering on them caught global investors? attention. Steadily, India?s allocation in the global fund portfolio increased. And so have the flows. Till date, FIIs have invested up to $57 billion in the Indian equity market. On an average these institutions invest between $5 billion to $9 billion a year in Indian markets.
This makes India a very important part of the global fund village. Global fund flows in and out of India have therefore become critical drivers of the equity markets. With restrictions on institutions being lifted in other asset markets like debt, commodities and real estate, these asset markets will also be vulnerable to global happenings that impact fund flows.
Dominated by investors in the US, funds that have investible corpus in excess of several trillion dollars (hedge funds are more than a trillion dollars) track global opportunities to generate returns. These funds are generated from investors in insurance funds, pension funds, and hedge funds and even select private equity funds.
Research analysts keep tracking global opportunities in all sorts of markets. While some follow very strict quantitative techniques that involve crunching data across markets to bring about an optimum portfolio exposure, there are others who take wild bets as well. And all these funds have varied investment objectives.
So when there are global tremors, the impact on India will be felt, as is being noticed since the past few years. The first clear impact was felt in the 2000-01 sell-off in the US market over the technology bubble burst. The S&P index and Sensex tanked in tandem. The May 2006 sell-off in global markets saw overseas players pull off from India and cause a melt-down here as well.
A report by Goldman Sachs says, ?Indeed, there is a tendency for declines in US stock indices to be more synchronised with global stock markets than increases, and hence we take the 2001-2002 episode. Stock markets may have become even more synchronized in recent years as evidenced by the May 2006 and February 2007 sell-offs.?
Fund focus
For investors, the key areas to watch out for would be factors that impact fund flow into and out of Indian markets. There are several factors here. One of them is clearly the relative valuation of the Indian market, as compared to other global markets. ?When there is no crisis brewing, this is by far the most important factor,? says Hasit Pandya, partner in Twin Earth Securities, a Mumbai-based stock broker.
Overseas investors would typically look at the earnings-growth and the price-earnings ratios across markets to arrive at a risk and return model that enable them to make a decision to take an exposure in India. The model will typically compare other similar opportunities. At the moment, India does feature amongst the top emerging market destinations purely due to its growth potential.
Then there are others who use simplified index-based passive investing techniques where funds are apportioned according to the composition of a global benchmark. Here, the Morgan Stanley Capital International Index is considered the most popular. This index and its variants for emerging markets allocate weights to markets and also sectors. Many fund managers simply piggy-back these indices. And so when the index weightages and compositions change, so does their portfolio. So you could actually see a sell-off in a particular company that is doing well, because the relative weightages in the MSCI indices changed.
Typically, there is a tendency of the Indian markets to dive southwards in the last moths of the calendar year and return back to action by February. This is purely because several institutions liquidate positions to book profit and re-start investments when fresh sectoral allocations are made in early part of the year. In 2006, a situation of excess global liquidity saw fresh allocations being made in December itself.
Carry trade
Then there are the global investment trends that also have a telling impact. The much talked about subprime imbroglio is one of them. Hedge funds that had purchased collateralised debt obligations from financial institutions, which in turn had lent to poor quality borrowers, were in a fix when the borrowers defaulted on their payments.
Hedge funds, private equity funds and even other safer funds that had an exposure to such bad loans panicked. They started pulling out of these bad loan products and also from other markets to reduce their risk and show returns to their investors. Add to this the yen carry trade crisis.
Currency carry trade works this way: Investors borrow low-yielding currencies and lend high-yielding ones. It hinges on global exchange rate stability, and retracts in use during global liquidity shortages.
For example, a trader borrows 1,000 yen from a Japanese bank, converts the funds into US dollars and buys a bond for the equivalent amount. Assuming the bond pays 4.5% and the Japanese interest rate is set at 0%, the trader stands to make a profit of 4.5% (i.e. 4.5% – 0%), as long as the exchange rate between the countries does not change. And hence leverage can make this type of trade very profitable.
If the trader above uses a leverage factor of 10:1, then he/she can stand to make a profit of 45% (i.e. 4.5% * 10). However, if the US dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Furthermore, because of the leverage, small movements in exchange rates can magnify these losses immensely unless hedged appropriately.
The biggest risk of carry trades is the change in the foreign exchange rates, and an investor has to pay back more expensive currency with less valuable currency. In theory, carry trades should not yield a predictable profit because the difference in interest rates between two countries should match with the expectations of investors, considering the fluctuations in the exchange rates during the period of re-conversion.
Hedge funds had substantial exposure to yen carry trades and when the trades were unwinded, they had to pull out of Indian markets, a strong destination for deploying carry trade monies. According to estimates, hedge funds accounted for 30 to 35% of the total FII transactions in Indian equity markets in the past couple of years. And market experts concede that around 90% of the sales happening in the market at the moment are orchestrated by hedge funds.
Macro linkages
Investors, therefore, need to factor in fund flow impacting events. Clearly, interest rates in the US and other factors that are linked to this have a telling impact. Then there are other linkages that call for attention. One can never rule out the impact of crude oil prices. They deal a telling blow to inflation in India as well as the US, and therefore corporate earnings and rate changes.
Overall, the impact of global commodity prices, like that of aluminium London Metal Exchange (LME) price on the share price of Hindalco, is well documented. Experts believe that the price movement of aluminium on LME has a direct correlation with the share price of Hindalco and Nalco.
The factor that investors need to watch is that the Indian economy and the equity markets get hit harder in the event of a downturn. ?We believe that, in the event of a sharp risk aversion in the global financial markets and or a global hard landing, India?s growth cycle is far more vulnerable than the rest of Asia,? says a Morgan Stanley Research report.
The Goldman Sachs report adds, ?We use our GS India Financial Conditions Index to enable us to quantify the impact of a fall in the US stock market on economic activity. Assuming a 10% fall in the S&P 500, we estimate the impact on growth in India to be -0.17%.? The report also mentions that a single percentage point reduction in US growth rates would reduce growth in India by about 0.25%.
For Indian investors there are more parameters to track. There will still be more in the next few years when the Indian rupee gets fully convertible on the capital account, and Indian funds and investors also have larger exposure to global assets. While it seems challenging and arduous at the moment, investors can start warming up to the fact that they are now being seriously inducted into the global investing village.