The Hindu : Business : Stock markets do not vote

Online edition of India's National Newspaper
Monday, May 17, 2004

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Business

Stock markets do not vote

The stock markets were glued to the elections. Share price swings were erratic. While elections are indeed seminal events, is it useful to rely on share prices for guiding economic or other public policies, asks C. R. L. Narasimhan

ELECTORAL POLITICS have dominated the Indian stock market sentiment completely last week. The week which, in the stock market's perception, saw a stunning political upset, ended with stock prices virtually collapsing. Market analysts have attributed the precipitous fall to certain statements of Communist leaders who are expected to play a critical role in the new government.

Although they had merely repeated their well known opposition to certain aspects of economic reform as pursued by the outgoing NDA Government (mainly the disinvestment programme), the fact that they will be having a role in policy making made market operators jittery. In any case, market sentiment was understandably weak even before all this public statement of what a coalition partner might demand of the Congress party in return for its support.

Weak sentiment

Latent nervousness soon turned into panic. The financial press is full of horror stories of some impossibly large sums being wiped out through the market crash. By inference, investors have `lost' large amounts, although admittedly at this stage such loss is largely notional. Perhaps it would be enlightening to revisit some of the deficiencies of the capital market that have shown it to be — not by any means for the first time — a less than satisfactory mechanism for either testing or gauging the impact of major developments on the economy. Finance Ministers in the past, notably P. Chidambaram and Yashwant Sinha, had realised that the even well crafted fiscal measures need not always please the markets. Most explanations of market behaviour are rendered well after a fall (or rise) in stock indices.

Moreover, at any given time the health of the stock market depends on a number of factors. A healthy level of stock prices implies that they should not collapse suddenly and that too in reaction to political statements made in the early days of government formation. Capital market reform implies broad basing the investor community so that, unlike now, a few investors do not dictate market movements.

Indian stock exchanges have become largely dependent on foreign institutional investors and portfolio managers. It is likely these were caught off guard by the election results. In their scheme of things, India might have become a riskier place to invest and they would therefore prefer to sit out until the contours of the new economic policy become clearer.

Besides, there have been other factors that can depress investor sentiment. High oil prices, a general decline in other Asian markets and prospects of a strong economic recovery in the U.S. (drawing in dollars invested elsewhere) — all these matter but in this election season have been forgotten by those interpreting sensational stock price movements.

Not to be forgotten, India's economic fundamentals continue to be good. A chronological description of market behaviour over the week will help in understanding the stock markets better. Can they be relied upon, as a kind of barometer, for evaluating economic and political news?

At the start of the week, one could justifiably have asked the following questions: Are there enough number of investors who are politically conscious and savvy enough to interpret the exit polls? Are the exit polls foolproof? Even those who organised them concede that there is a margin of error. However, doubts over their accuracy vanished after the results of the Andhra assembly elections were announced on May 11. It became obvious that the exit polls, if anything, had understated the extent of loss the ruling TDP would suffer. Hedging one's bets is not uncommon when one is predicting election results. But the realisation that an extrapolation of the Andhra results on the national scene would mean very bad news for the NDA caused havoc in the stock markets.

Uncertainty factor

The dominant theme in the markets over this week has been the likely impact of the political uncertainty. In contrast to an earlier belief that this election was going to be a one horse race, meaning that the NDA's coming back to power was a foregone conclusion, knowledgeable opinion swung dramatically in the opposite direction. On May 11, there were more people betting on a hung Parliament. Either the NDA coalition would have to struggle to retain power or the Congress with the support of other parties would form the government.

The day the Andhra results were announced the indices had one of their biggest falls in the past four years, The Sensex dropped 230 points and the Nifty 60 points.

Markets as a rule abhor uncertainty. Of direct relevance to them are their perceptions of the economic programme of the new government. Economic reforms, especially the public sector disinvestment programme, may stall amidst uncertainty. Stocks of public sector companies, especially those in the oil sector, have naturally come under pressure.

Behaviour after the results

The defeat of the NDA was as comprehensive as it was unexpected. The stock markets had, especially after the Andhra assembly results, come to expect a hung Parliament. On May 11,when that State's results were out, the Sensex dropped 230 points, a reaction also to the possibility of the NDA doing badly in the Parliamentary elections.

Suddenly a non-NDA government at the Centre became a distinct possibility. Yet in early trading on Thursday, in the wake of electoral trends that soon established that the NDA would come only second, the market dropped sharply by 225 points dragging the Sensex down to 5200. However, in a day marked by extreme volatility, the index recovered to close 41 points up over Wednesday's close.

With the prospects of a Congress-led government becoming brighter as the day progressed, stock prices moved up. Political instability may not be a major worry for the market. However, the emerging consensus is that certain aspects of economic reforms, especially the privatisation programme, may not be so vigorously pursued as earlier.

The BSE PSE index lost 107 points and the Bankex 39 points reflecting the market's anxiety over the future of the public sector programme in these areas. Also, the prospect of subsidies continuing in many cases seems real. However in these early days of government formation, no one seems sure what direction the economic policy of the new formation will take.

Foreign institutional investors, including portfolio managers, will be guided by India's economic fundamentals over the medium term. In the short-term there could be some selling pressure originating from hedge funds among others. It is likely that Indian markets are increasingly seen as globalised entities. Electoral outcomes, however unexpected, may not upset well-established trends in the market place.

The markets will get a firmer direction as soon as the contours of the new government are known. To a large extent the profiles of those occupying key economic ministries will be a significant factor determining stock market behaviour. The Congress party has an impressive list of candidates to choose from. Also, it is the true author of economic reform in this country. But the fact that it will be dependent on the Left parties this time is a dampener.

On Friday, crushing uncertainty weighed down the market. The spokespersons of the Left parties on whom the Congress Party is expected to depend upon critically, publicly stated their position on the disinvestment programme. The stock indices recorded one of their biggest falls in living memory. The BSE Sensex fell by 330 points to 5070 (a 6.1 per cent fall). The biggest falls have been in the prices of PSE and bank stocks.

What next? Obviously the formation of the new government will be the time to read meanings into stock prices and their movements. It is unlikely that the market will react violently to any economic announcement, even more official ones. It is also likely that those in authority and others will learn to view the market movements with greater equanimity.

The real costs of stock market declines (of the type seen last week) lie elsewhere. Declining market capitalisation will send negative signals to investors and therefore blunt capital formation. The real danger, however, lies in the extreme volatility and the seeming helplessness of the market mechanism to counter it.

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