Understanding Stock Market Crash in May, 2006

The financial sector constituting of banks and the securities markets finance economic growth as they channelise savings to investments and thereby decouple these two activities. But, Banks and the Securities Markets are two competing mechanisms to channelise Savings to Investments. The banks have always managed to score over the Securities market, keeping the risk averse psychology of the Indian investor in mind, in terms of guaranteed return and low risk.

On the other hand, the securities markets score over banks in terms of allocation efficiency, as it allocates savings to those investments which have potential to yield higher returns. This inevitably leads to higher returns to savers on their savings and higher productivity on investments to enterprises. Hence to the extent economic growth depends on the rate of return on investments, securities market promotes economic growth.

The Sensex has shown high volatility since the start of the present bull run (March 2003). In the recent times, in the month of May 2006, the BSE Sensex lost 1705 points and the BSE lost around $100 Billion in market capitalization. The Net FII for the same month in BSE was an outflow of Rs. 2488 Crores. During the same month, the Mutual Funds reported a drop in their Assets under Management by around Rs. 45.17 Billion. U.S. Federal Interest Rate, FII Flow, Overheated commodities market, Global Meltdown of the Capital markets were some of the reasons put forth by many analysts for the Sensex plunge of May, 2006. According to recent estimates (as on October 5, 2006), the current foreign exchange reserves are around $150 Billion and the current market value of the FII portfolio is roughly $130 Billion dollars. These astounding figures not only put a big question mark on the stability of the returns of the Indian Capital market, they also add on to the uncertainty about the sustainability of the Indian Growth Story.
Literatures on the empirical investigation about the impact of foreign interest rates on the
economy of emerging markets are now documented. It is thus possible to understand the episodes in the Indian context. On introducing a shock to the Federal Interest Rate an immediate response from the MSCI (Morgan Stanley Capital Index) Index is witnessed. The American Indices have a substantial percentage in the MSCI world index and hence, any shock in the federal rate would effect the domestic US indices and hence the MSCI World Index. The Indian government also reacts in coherence and hence, a significant effect in the MIBOR (Mumbai Interbank Offer rate) can be noticed with the effect staying up to 18-20 months. As interest rates and inflation go hand in hand, even WPI shows a significant reaction to the shock with effect tapering off only after 18 months. Exchange rate, being a managed float, does not show a very significant change but even for this variable, the effect tapers to zero only around the 16th month. Due to the effect on the domestic macro-economic variables, the Index of Industrial Production also shows a significant reaction but the effect on this variable is the shortest lived with the effect minimizing from the 8th month. Finally, it can be viewed that the Sensex also shows a significant response to the shock in US Federal Interest Rate and this can be attributed to the effect of the macro-economic variables on the Capital markets.


It is also possible to study the causes of variation (due the above mentioned variables) in the Sensex returns. The Impulse response functions showed that the shock in the US federal interest rate causes a change in Indian macro-economic variables such as MIBOR, WPI, Exchange Rate and the Index of Industrial Production. The shock introduced to the federal interest rate also produced a significant response from both the BSE Sensex as well as the MSCI World Index. T`he above shows that the MSCI Return followed by the WPI has the maximum effect on the variation of the BSE Sensex. Federal Interest Rate and MIBOR have a gradual and a similar effect on the variation of the BSE Sensex. The exchange rate also has significant effect. The Index of Industrial Production has the least effect on the variation in the BSE Sensex returns.


Hence, it appears that the variation in the Indian Capital markets and the various macro-economic components can be explained by the movements in the US Federal Interest Rate and the World Indices.

The above investigation, of the effect of U.S. economy and Globalization on the Indian economy, can have a plethora of policy implications for India. There can be two schools of thought on this issue as there have been in the past for the effect of globalization. US is the largest and most technologically powerful economy in the world, with a per capita GDP of $42,000. Its GDP in terms of PPP is the highest in the world at $12.36 trillion followed by European Union. India ranks at 6th on this list behind China and Japan. According to the BRIC report (Wilson et al, 2003), of the G6 only U.S. and Japan will be among the top 6 economies by 2050. Currently, India’s export to US has the maximum share of the total Indian exports. The current and the past governments have tried to maintain as well enhance the relationship with U.S. in order to maintain the export led growth and also since, the main growth in the world consumption is U.S. driven (currently, 40% of the total consumer spending in the world is by U.S.).

On the other hand, an overdependence on the U.S. market can have dire implications on India’s growth. The US Federal interest rate has been on the upswing since January 2004, where it was around 1%, to the present where it is around 5.25% (September , 2006). U.S. ranks second in terms of cumulative Foreign Direct Investment (around $5.3 Billion from August, 1991 to July, 2006) after Mauritius in India and also accounts for around 40.5% of the total $25.3 billion FII flow (as on June 30, 2004) into India. May 2006 saw the biggest plunge ever in the Indian Capital markets, which is said to be fuelled by FII outflow (Rs. 8.2 Billion net outflow for May, 2006) following an increase in the U.S. federal interest rate, where a lot of Indians lost their lifetime savings. Conversely, only around $2 billion (up to 2004-2005) direct investments from India are to U.S., which is the maximum outward Indian investments followed by Russia and Mauritius. This, hence, brings in the concept of Immiserizing growth that whether the current growth experienced by the Indian economy is working towards social welfare or not and also questions the sustainability and equitability of the growth experienced in the recent years.
The government needs to take quick as well as gradual policy decisions to make the Indian growth story more domestic sector (Infrastructure, industry etc.) driven than external sector (Trade flow, exchange rates, etc.) driven. The need of the hour is to make the Indian growth story more inclusive. The current Bull Run of the Sensex (post May 2006-November ,2006) has seen only three sectors in the positive zone – Telecom, Infrastructure and Banking. The government needs to formulate policies so as to increase the purchasing power of the Indian consumer. Increase in the domestic demand would help the existing companies to achieve the economies of scale and would also attract new businesses to mushroom. To increase the per-capita consumption expenditure the government can either work towards increasing employment or take some liberal steps for the financial services sector. If the financial services sector policies are made more liberal, new businesses would be encouraged and also consumer demand shall increase (owing to availability of credit at easier terms), thus allowing the existing industries to increase both their bottom line as well as the top line and hence, expand. The government also needs to increase the accessibility and coverage of credit and banking services to the bottom of the pyramid. Out of the total loans passed on by the Banks only 8% are consumer loans compared to 13% and 26% in other developing nations like Thailand and Malaysia. Emphasizing on growth in Domestic savings is also imperative for sustainable and inclusive growth. In 2005-2006, 46% of the household assets were in the form of Bank deposits while around 20% were in real estate and only 5% as shares and debentures. The government needs to take steps for increasing the domestic savings (In 2002-2003, Household savings were 22.65% of the Indian GDP)so that the funds generated can be channelised to the productive sectors to attain the desired growth objectives. This would also help the government achieve the objective of increasing the employment prospects and this further drives in the argument of increasing the financial service sector penetration to attain inclusive growth.

Every developed or developing nation directly or indirectly is dependent on the U.S. because of the consumer base it has. India, cannot escape the effect of globalization and neither can totally immunize itself from it. But, it can learn from the boom-bust stories of the other emerging countries and hence, develop policies and framework to ensure that the higher growth is more inclusive so as to make the growth story sustainable. But, the Indian investor as well as the government would need to brace itself for any harsh reaction following any of the policy decisions targeted towards increased inclusive growth and reduced participation from the foreign institutional investors (Recent Thailand case in context). But, till than one can only expect an appreciating rupee and a Sensex scaling newer heights and also, more volatility as the sensex moves with the mood swings of these Institutional investors.