1128 words free essay on Foreign Investment and Volatile Sensex



Lately, volatility has come to characterize India's stock markets due to portfolio adjustment made by the Foreign Institutional Investors (FIIs), resulting in destabilizing tendencies in the country's system. This volatility has been visible in the medium and long term as well. From a low of 2924 in April 2003, the BSE Sensitive Index (Sensex) had risen to 6194 in January 2004, only to fall to 4505 in May 2004 and again rise to 6679 in January 2005.

While the Sensex crossed 21000 in January 2008, it even witnessed a low of 8000 in September 2008 before climbing to 17000 levels by the end of 2009. These wild fluctuations have meant that for those who bought into the market at the right time and exited at the appropriate moment, the average return earned through capital gains were higher in 2003 than 2004 and 2008-09, despite the extended bull runs in the latter years.

Movements in the Sensex during these years have clearly been driven by the behavior of FIIs, who were responsible for net equity purchases. At one level, this influence of the FIIs is puzzling. The cumulative stock of FII investment does not amount much when seen in terms of the percentage of the total market capitalization on the Bombay Stock Exchange. However, FII transactions are significant at the margin.

The cumulative turnover by FIIs amounted to a substantial per cent of the total volume of turnover whenever the Sensex sees high volatility. Not surprisingly, there has been a substantial increase in the share of foreign stockholding in leading Indian companies, even exceeding 40 per cent of the total free-floating shares in some of the companies.

Such presence of FIIs has given them a considerable role in determining share price movements. Traditionally, Indian stock markets are known to be narrow and shallow in the sense that there are few companies whose shares are actively traded. Thus, though there are nearly 5,000 companies listed on the stock exchange, the BSE Sensex incorporates just 30 companies, trading in whose shares is seen as indicative of market activity. This shallowness also means that the effects of FII activity is exaggerated by the influence their behavior has on other retail investors, who, in herd-like fashion tend to follow the FIIs when making their investment decisions.

These features of Indian stock markets induce a high degree of volatility for four reasons. In as much as an increase in investment by FIIs triggers a sharp price increase, it in the first instance encourages further investments so that there is a tendency for any correction of price increases unwarranted by price earnings ratios to be delayed. And when the correction begins, it would have to be led by an FII pull-out and can take the form of an extremely sharp decline in prices.

Secondly, as and when FIIs are attracted to the market by expectations of a price increase that tend to be automatically realized, the inflow of foreign capital can result in an appreciation of the rupee vis-a-vis the dollar. This increases the return earned in foreign exchange, when rupee assets are sold and the revenue converted into dollars. As a result, the investments turn even more attractive, triggering an investment spiral that would imply a sharper fall when any correction begins.

Thirdly, the growing realization by the FIIs of the power they wield in what are shallow markets, encourages speculative investment aimed at pushing the market up and choosing an appropriate moment to exit. This implicit manipulation of the market, if resorted to often enough, would obviously imply a substantial increase in volatility. Finally, in volatile markets, domestic speculators too attempt to manipulate markets in periods of unusually high prices.

The last few years have been remarkable because, in spite of high volatility, there have been more months when the market has been on the rise rather than on the decline. This clearly means that FIIs have been bullish on India for much of that time. The problem is that such bullishness is often driven by events outside the country, like the performance of other equity markets or developments in non-equity markets elsewhere in the world.

It is to be expected that FIIs would seek out the best returns as well as hedge their investments by maintaining a diversified geographical and market portfolio. However, when they make their portfolio adjustments, which may imply small shifts in favor of or against a country like India, the effects it has on host markets are substantial. Those effects can then trigger a speculative spiral resulting in destabilizing tendencies. For example, expectations of an interest rate rise in the US can slow FII investments and thus trigger the end of a bull run. It has very little to do with the performance of the companies listed on the stock exchange.

Further, financial liberalization has meant that developments in equity markets can have major repercussions elsewhere in the system, including banks. Hence, any slump in those markets can affect the functioning of parts of the banking system. The forced closure (through merger with Punjab National Bank) of the Nedungadi Bank is an example of how a bank can suffer losses because of overexposure in the stock market.

Similarly, if any set of developments encourages an unusually high outflow of FII capital from the market, it can impact adversely on the value of the rupee and set of speculation in the currency that can, in special circumstances, result in a currency crisis. There are now too many instances of such effects worldwide for it to be dismissed on the ground that India's reserves are adequate to manage the situation.

Thus, the volatility being displayed by India's equity markets warrant returning to a set of questions that have been bypassed in the course of neo-liberal reform in India. The most important of those questions is whether India needs FII investment at all. The capital accrued by FII flows does not help finance new investment either, as it is focused on secondary market trading of pre-existing equity. Also, shoring up the Sensex, which is inevitably volatile, merely helps create and destroy paper wealth and generate, in the process, inexplicable bouts of euphoria and anguish in the financial press.

In the circumstances, the best option for the policymakers is to find ways of reducing substantially net flows of FII investments into India's markets. This would help focus attention on the creation of real wealth as well as remove barriers to the creation of such wealth, such as the constant pressure to provide tax concessions that erode the tax base and the persisting obsession with curtailing fiscal deficits, both of which are driven by dependence on finance capital. Measures are needed to prevent the market from being excessively vulnerable to global weaknesses.