Part I of our post described why the American stock markets have been choppy over the last ten days. Good economic news has led to fears of higher inflation, and thus higher interest rates. This caused a quick decline in American markets, which was compounded by the unwinding of a trading strategy that bet on a decrease in volatility.
The decline in American markets was reflected across the world, particularly in India, where we saw the BSE Sensex swing wildly over the course of the past month. In this post, we take a look at why the Indian markets are moving in this way, and how we should think about it in the context of our own investments.
The first and most direct cause, as the aphorism goes, is that when the American stock market sneezes, Indian market catches a cold. Despite the growing importance of domestic investors, India remains a market dominated by foreign portfolio investors (FPIs). FPIs still control more equity assets than Indian mutual funds and insurance companies combined.
Most of this money comes from the United States. Over ₹1,000,000 crores have been invested in India through America. Mauritius is next, with half that amount, followed by Luxembourg with a quarter. Considering the tax haven status of those countries, most of the money is probably American money routed to India via these transit destinations.
Given the volume of American investments in our markets, it's not a surprise that domestic conditions in the US have a great deal of influence on the Indian markets. As we established in our last post, the American economic fundamentals look strong. So it is likely that their stock market correction is temporary. However, the same factors that are good news for America might be bad news for India.
An increase in American interest rates hurts Indian markets, both on the equity and debt side. American government debt is considered the safest asset in the world. If the safest asset gives you a higher return, why would you invest elsewhere? In isolation, an increase in American interest rates results in more money flowing to American debt, which means less money for the rest of us.
More money flowing into American debt results in a stronger US Dollar, and correspondingly, a weaker Indian rupee. This is particularly pernicious for India, as we are a net importer. India’s largest import is the basic raw material needed for economic growth - crude oil. But most crude oil is priced in dollars. When the US dollar gets stronger, it becomes more expensive for us to import.
Expensive oil sets us on the path of a vicious cycle. The more we import, the weaker the Indian rupee gets, and so the more expensive the next barrel of oil becomes. But there’s no alternative - there is no way we can produce oil domestically because we don’t have oil reserves in India. Expensive oil will increase inflation in India, and as the cost of the basic raw material increases, prices of everything else moves in lockstep. And higher inflation further depreciates the currency, making oil even more expensive.
As we saw in the last post, inflation can be tamed by increasing interest rates. So in order to get us out of this vicious cycle of inflation and currency depreciation, the RBI is expected to increase interest rates. But this leads to slower economic growth, in turn dampening the stock market.
Where does this leave us, as individual investors?
The good news and the bad news is that we don’t have many alternatives to investing in the markets. This is good because the more domestic investment we get, the more resilient our markets will become to foreign shocks. Indeed, this recent crash would have been much worse if not for the volume of domestic investment that is already present in the Indian markets. The bad part is that we continue to remain at the whims and fancies of the West Texas Intermediate oil price!
With growing awareness about investing in financial markets, and the decline in real estate and gold returns, Indian investors are sitting on a lot of cash at the moment, waiting for the right time to buy. When the markets go down sufficiently, many of these investors are likely to make an entry, causing the drop to be arrested. The markets should bottom out sooner rather than later, as the dry powder gets deployed.
At this present moment, India’s economic fundamentals look strong, boding a good future for our financial markets. We probably need to grow faster than we are right now, but as long as India’s economy grows, our companies will produce products that people want to buy, and our stock markets will rise in the long run. Stock markets will continue to remain a good investment strategy, and panic-mongering is not warranted during corrections such as the current one we're experiencing.
Newsmedia and the need for constant eyeballs necessitates that we sensationalize each event that happens. Few things provoke as emotional a reaction as losing a lot of money very quickly. Market crashes are fascinating to study, given how complex the global economic machine has become. But, just remember that all of these jitters were triggered by a single, early estimate number, being slightly higher than expected. Not every tinder causes a fire.
Click here to Read Part I - Why are Global Markets Crashing?
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