As a failed prophet, I may not have much credibility when I make stock market predictions. In late 1998 I expressed the view that the US stock market was grossly over-valued, and that a crash in that market could send ripples round the world and worsen the Asian financial crisis. In fact, the US markets kept rising to new heights, US consumer spending rose to record levels, and Asian countries recovered from the crisis faster and more emphatically than anybody predicted. Zany college kids who indulge in day trading between classes proved more prescient than me (and grew much richer than me) in the last year.
And yet, at the risk of being declared a dinosaur, I would like once again to express worries about the inflated state of markets in India and the whole world. I am at the very forefront of those proclaiming that we are entering a revolutionary new knowledge era. Yet I remain astounded by price-earnings ratios of 200 to 500, which seem grossly inflated to me.
I am also worried by the way brick-and-mortar industries have been given the thumbs down treatment by investors. No matter how revolutionary the knowledge era proves to be, we will always need basics like steel, cement, paper, soap and TV sets. It makes sense for some countries like the US to move out of these sectors altogether, leaving them to the Third World, so US producers of basic goods may indeed have a dim future. What makes no sense is for investors in Third World countries to treat these basic industries with the same contempt. If the West is getting out of these industries, they should be regarded as boom industries in the third World.
Yet we have entered a copycat era where investors in bourses the world over mimic investment fashions in the US. Technology stocks everywhere dance to the tune of Nasdaq. This is not because portfolio capital has become truly global. Foreign portfolio investment in Third World markets is still tiny — compared with investment in western markets. What we are witnessing is a wholesale copying of American trends by investors in all other bourses. This has led to self-fulfilling prophecies: the very fact that so many people are copying Nasdaq ensures that copying Nasdaq is indeed a successful investment strategy.
This further reinforces copycat tendencies.
The Mumbai Sensex may have fallen from 6,000 to 5,000, Infosys and Zee Telefilms may be one-third below their peak value, but the fact remains that the underlying trend in stock markets remains bullish. This has less to do with local factors and more to do with the fact that bourses the world over are now dancing to the tune of Nasdaq. Despite the 10 per cent fall in Nasdaq last week (causing similar ripples in Mumbai), the index was still up 15 per cent since the beginning of the year, and similar tales can be told the world over.
Never in history has so much money entered stock markets globally, and never before have markets been so closely correlated. There was a time when the Mumbai Sensex bore no resemblance whatsoever to the Dow Jones Index or Nasdaq Composite Index, for the simple reason that India was ring-fenced with capital controls and import controls. So were many other countries. This was good for overall stability; it meant global investors (though not Indian investors) could diversify their risks by investing in several different markets, ensuring that what they lost on the swings could be gained on the roundabouts. Alas, that is no longer possible. The mania for high-tech and media stocks has become global, no less than contempt for traditional brick and mortar industries. This has a sombre downside implication. If Nasdaq collapses one day — and most euphoric booms do collapse — then we will see a tidal wave crashing through markets the world over, the like of which has never been seen in history. In some ways it will rival the Asian financial crisis of 1997-99. Yet I believe the impact will be less disastrous.
The 1997 crisis originated in massive short-term loans which precipitated an outflow of capital, drained forex reserves, and caused currencies to collapse in a vicious downward spiral. If Nasdaq crashes, copycat domestic investors will pull out of stock markets everywhere. Foreign portfolio investors will also try and pull out, forcing the market further down. Yet this will be nowhere near as disastrous as the pull-out of short-term loans in 1997. This is because short-term loans are repaid at face value, whereas panic selling of stocks involves huge losses for those pulling out. They can exit, but at the cost of leaving behind most of their baggage. So while the bourses will be hard hit, the impact on foreign exchange reserves will be more modest.
During the Asian financial crisis, capital controls in China and India meant these countries were relatively insulated. They will have no such insulation if Nasdaq crashes. This is because the damage will be done by domestic copy-cats in stock markets, quite independently of the reaction of foreign portfolio investors.
What should India and other Asian countries do to safeguard against a Nasdaq collapse? First and foremost, they need to pare short-term foreign borrowing to the bone. This is money that flows out without any penalty in a crisis. Portfolio investment in shares can flows out only after paying a hefty penalty in the form of stock market losses. So no country need curb portfolio investment. Second, all countries they must limit financial sector lending for stock market binges. The 1997 Asian crisis started with short-term dollar loans being used by Thai banks to finance a speculative bubble in real estate.
Malaysia, Hong Kong and Indonesia had similar problems. Prudential regulation of the financial sector has improved now in most Asian countries, though glaring flaws remain.
I have long been critical of the fact that the RBI allows so little bank financing for stock purchases. Financial repression of this sort creates many distortions, and enfeebles markets that need nurturing. However, financial repression has a silver lining: it also represses the financing of speculative binges. Given the threat of a Nasdaq collapse, RBI curbs are probably the right policy for the time being.
