Is the worst over for the stock market?

There was a chink in the armour, after all. As the head of a local brokerage put it, the Indian stock market's "aura of invincibility faded" as its untrammelled bull run came to a halt last fortnight.

Global factors played a role as fears of tightening liquidity led to a sell-off in emerging markets across the board. Kinks in the local financial system that led to large liquidations of leveraged investor positions made matters worse.

In fact, despite the turbulence in other emerging markets, it would perhaps be incorrect to characterise the steep fall in the Indian markets as part of a full-blown emerging markets sell-off.

As a proportion of their holdings in India, FIIs actually didn't sell much. Going by Sebi's figures, net sales by FIIs in the cash market between May 10 and May 22 were a little less than a billion dollars.

This was barely 1 per cent of the 100 billion dollars of outstanding investments that they hold in India at prices marked to market. One could construe this as bad news - it could mean that the worst is not over yet. If global risk premiums do rise on the back of diminishing liquidity and foreign investors (particularly the notoriously fickle hedge funds) sell larger amounts, there could be another phase of extreme turbulence.

The key risk that confronts overheated asset markets across the world is that of rising interest rates as central banks grapple with the problem of high growth spilling over to high inflation. The US Fed doesn't seem to be done with hiking rates and other major central banks like the European Central Bank, the Bank of England and the Japanese Central Bank seem primed to raise their policy rates. The apprehension of a global slowdown is somewhat secondary, at least at this stage.

As global rates move northward, the gains made from borrowing cheap in markets like the US and investing in risky assets like metals or emerging market equity (the so-called carry trades) diminish.

As this happens, investors could pull out of riskier markets and invest in things like US treasury bills and European bunds. There is some reason to believe that India could be hit a little harder than the others - there are a couple of risks that are specific to India that makes it, in the eyes of some investors, more vulnerable than others.

Indian economists and policy makers have made such a fetish of the fact that India's relatively low export-GDP ratio insulates us from a global economic slowdown that we forget that this "insulation" is being viewed by most fund managers as one of the critical risks of investing in India.

The flip side of having a low export-GDP ratio is that we don't export enough to pay for our imports - this creates large current account deficits in phases of high growth. It is precisely this large current deficit (about $19 billion for 2005-06 if I go by the consensus estimates) that most global investors see as one of the biggest risks of investing in Indian equity markets.

Other Asian emerging economies don't have this problem. In 2005, for instance, India and Thailand were the only major Asian economies to run current account deficits. (Thailand's deficit was incidentally minuscule.)

It might be useful to understand why international investors make such a fuss about the current account deficit despite the steady surpluses on the capital account of the balance of payments and the high level of foreign exchange reserves.

Their argument is that India's current account deficit did not lead to serious economic problems in the last couple of years because FIIs relentlessly pumped in money into the Indian markets.

There is some basis for this view. My estimate of the cumulative current account deficit between January 2005 and March 2006 is about $21 billion. In this period, FII flows added up to roughly $15 billion.

India has paid for its current account gap largely from short-term market sensitive capital flows. If these were to reverse, India could face a problem in financing its deficit.

Not only would stock prices suffer but inadequate funds could set off a spiral of depreciating currency, rising short-term interest rates and so on, which could affect economic growth.

Other Asian economies are unlikely to be affected as much simply since they do not have current account deficits. In fact, if a global slowdown doesn't seem imminent, their growth rates are unlikely to be hit, either. In this kind of scenario, India emerges as the "outlier".

While I don't entirely agree with this view, it can be dangerous to ignore it altogether. Investor perceptions, however irrational they may seem, are often far more important in driving asset markets than cold macroeconomic logic. The onus is on the government and the RBI to put in place safeguards to prevent this perception from manifesting in a stock market crisis.

What can the RBI do? Equity market crises are often accompanied by a run on the local currency, especially if there are apprehensions of a serious current account imbalance. It is for the RBI to signal that the rupee is not due to slide at the first signs of a panic.

It can, for one, address the perception that India has "fallen behind the curve" in raising interest rates. A quick increase in the short-term signal rates might just be in order. Second, it must intervene decisively in the currency market if the rupee turns volatile to signal that its war chest of reserves is more than adequate to thwart large devaluation.

Finally, the government could make a couple of policy announcements to step up the flow of non-portfolio capital - a hike, for instance, in the FDI limit for the insurance sector. And it certainly needs to put in place a mechanism to ensure that rogue circulars don't make the headlines.