The fall of stock markets, a global story

Last week?s fall in stock markets in India was part of a global story in which these markets fell all over the world, beginning with the US.

Why did US markets fall and why did Indian markets respond more sharply than anywhere else? Asset prices are ultimately made by the expectations of millions of investors across the globe. But in this situation, we can obtain a little insight through macroeconomics.

First, what happened in India? Nifty fell by 12.65% over six days. The decline on Thursday was the sharpest, when it fell by 6.77%. On Friday, it fell another 4.2%. Over the previous five days, US stock prices dropped 3%. Stock prices had done badly all over Asia. All Asian markets did badly on Thursday?Australia (-1.85%), Hong Kong (-2.1%), Indonesia (-4.2%), South Korea (-2.59%).

The indexes moved by a large amount in absolute terms. This merely reflected the fact that the indexes are at their highest levels ever. When the drop is expressed in per cent, this puts things in perspective. Even though bigger in absolute terms, the May 18, 2006, decline was smaller?in percent?than the famous market crash of May 17, 2004, after the general elections.

Why did this decline take place? There has been a lot of discussion about global imbalances?the twin deficit of the US, the trade surplus of China and undervaluation of the yuan, in recent years. What is new? First, there is recent data about low consumer confidence, a leading indicator of demand. Consumer confidence in the US has dropped to levels prevalent around September 2001.

Further, there is a softness in the US housing market: confidence among home builders is at the lowest level since 1995. People feel less wealthy when their houses are cheaper and spend less. With rising interest rates, mortgage payments have gone up over the past two years and higher oil prices have raised energy bills. All this squeezes expenditure by households.

In response to rising oil prices and dollar depreciation, US markets have been expecting higher inflation. This is ref-lected in the yields on 10-year bonds which have picked up, as have the inflation expectations visible in prices of inflation-indexed bonds. By some estimates, expected inflation in the US has risen to 2.75%, the level it was in mid-2004 when the Fed tightening began. This view, about higher US inflation, was validated by a data release on May 17 showing high US inflation. Hence, it is now felt that the US Fed will raise rates.

Higher US interest rates affect India in two ways. First, slower growth in the US economy affects Indian exporters. It will also accentuate pricing pressure from Chinese competitors. But equally important, in places across the world like China and India, which peg their exchange rates to the US, there is a lack of monetary policy autonomy owing to the use of the pegged exchange rate. These countries will also experience tighter monetary policy, in synchrony with tighter monetary policy in the US.

Intuitively, higher interest rates in the US will lead to capital leaving India, and could lead to a weaker rupee. And to the extent that India tries to prevent the rupee-dollar rate from moving sharply, we will be forced to raise rates to defend the rupee. Thus, tight monetary policy in the US coupled with an INR/USD pegged exchange rate will generate tight monetary policy in India.

But this cannot be the full explanation. After all, most Asian economies, like India, peg their currencies to the USD. So international macroeconomics can perhaps account for a 3% drop in Indian stock prices. The remaining 8% drop has to do with domestic news.

Recent news about policy in India has not been good. The quotas, the victory of the Left in West Bengal and Kerala, which may further weaken the move towards market-oriented reforms, and the insecurity created by the Sebi order against market participants who account for nearly 60% of customer accounts, could have been some of the factors shaping the large move seen in India. Obviously, GoI can do little to correct global imbalances. The only thing it can focus on is to keep reforms on track and help build confidence in stock markets in the country.