America\’s Chairman is our Chairman

One of the traditional arguments for opening up capital markets is that it facilitates diversification of stock portfolios. Instead of keeping all their investments in just the national market, investors can buy stocks, bonds and mutual funds across the world,

Recent events have made this argument sound quite hollow. Thanks to globalization, stock markets across the world have become correlated to an astonishing degree. The Wall Street Journal recently quoted experts as saying that the correlation between the Dow Jones Index and emerging market indices could be as high as 90 %. Some other studies put the correlation at 80%.

This has some unexpected consequences. One is the similar behaviour exhibited by stock markets in all countries of South Asia. There may be little trade and zero investment flows between India and Pakistan, yet the stock markets of the two countries are highly correlated because both dance to the global tune.

Another consequence is that it makes no sense for Indians to investment abroad to the limited extent that RBI rules permit. High correlation across markets means that investing abroad does not get you a diversified portfolio. It can give you entry to markets that are less volatile than India\’s. But note than investors in India pay no tax on dividends or capital gains, both of which are taxable abroad. So, it is better to stay invested in India.

In the last month, waves of optimism and pessimism have swept across continents like a tsunami. The US is typically the trend setter. Consider a day when the US market falls sharply. Soon afterwards, markets open in Japan, and they will fall too. Other markets will open in turn, in Korea, Hong Kong, Singapore, Mumbai—and all will dip. Soon afterwards European markets will open and they too will fall, though with diminished intensity (just as a tsunami loses force with time and distance). And before the European markets close, the US markets open again, and the game starts all over again.

Many Indian companies are listed through American Depository Receipts (ADRs) in US stock exchanges. If the Dow dips sharply in the morning, Indian ADRs will dip too. And if the Dow then rises sharply in the afternoon, Indian ADRs will rise too. Let me not exaggerate: the correlation is not total. On some days, the Dow and Indian ADRs may move in opposite directions. But by and large they dance to the same tune.

High correlation between markets does not mean similar levels of volatility. When the Dow rises or falls 1%, some emerging markets rise or fall 2%, or even more. So, emerging markets can experience more euphoria as well as more despair than American or European ones.

Clearly, globalization has interlinked countries to such an extent that their stock markets have become linked too. Trade and capital flows between countries has grown to enormous volumes, and been magnified by leveraging. The US accounts for a quarter of world GDP, and so events there have an impact across markets because of the consequences for capital flows and trade. If consumer demand falls in the US, that has consequences for exports of all countries. If US companies step up investment aggressively, that boosts software development in India. A booming US economy leads to booming tourism the world over. Increased liquidity in US markets spills over into emerging markets. A bubble that forms in the US can envelop the world (as happened during the great IT bubble of 1999-2001).

The attack on the World Trade Centre on in September 2001 had cataclysmic consequences globally, and understandably so. But events far less dramatic have huge consequences too. In the last month, several members of the US Fed have hinted in speeches that they felt inflation in the US was becoming a matter of concern. Those expressions of concern have sufficed to send markets crashing across all emerging markets. Investors have interpreted this to mean higher interest rates, a slowing of the world economy, and possibly a bursting of the housing bubble.

To my mind, this is alarmism rather than analysis. Modest increases in interest rates should not have such sweeping consequences. But investors remember the 1990s, when investors looking for safe havens moved billions out of emerging markets. Much international capital switched from emerging markets to US bonds when US interest rates rose. Investors fear a similar outcome if US rates keep rising this year.

However, I do not see the US as a safe haven at all. High US current account deficits have converted the US into the world\’s biggest debtor. If central banks switch forex holdings out of dollars to other currencies, the dollar could crash. Merely because US interest rates rise a little, the risk of a dollar meltdown will not go away.

For that reason, I doubt if we will really see a cascade of money into US bonds if interest rates rise. But I admit that herd behaviour may dominate rationality in markets.

The Indian left complains that we are losing national control over our markets. I agree. Globalisation has many advantages, and Indian companies have gained enormously from access to global capital. Indian investors have gained enormously from the pressure that foreign institutional investors have put on the government to reform its capital markets. In place of the crony-ridden, rigged markets of earlier decades, India now has one of the best stock markets in the developing world, far better than China\’s.

But the flip side of this is a loss of national control. When RBI Governor YV Reddy hints or a rise in interest rates, the markets hardly notice. But if the Chairman of the US Federal Reserve Board, Ben Bernanke, hints about raising interest rates in the USA, Indian markets (and all emerging markets) can crash.

I remember back in 1969, when Naxalites rose in West Bengal, they used to chant, “China\’s Chairman is our Chairman.” Indian stock markets investors today seem to be saying that America\’s Fed Chairman is their Chairman too.


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