Why money is flowing into India

In the past two months, the common refrain of stockmarket watchers has been that we are no longer insulated from events in other parts of the world. There is little doubt that interdependence has increased across economies, but perhaps, as is always the case with markets, we are overreacting to global forces.

During the height of the tech boom, the Indian markets always looked up the Nasdaq of the previous day, and the correlation between the Sensex and the Nasdaq Composite Index was too high. Almost everyone, who would have been driven to accepting then that the US tech sector near completely drove the Indian tech sector, has reconciled to the differences today, and admits to exaggerating the dependencies.

Perhaps we are seeing a repeat performance of this global obsession, in a different hue.

The seeds of the boom in asset markets across the world were sown when large economies like the US and Japan brought their interest rates (cost of money) down to abnormally low levels to revive their economies.

In the US, the rates went to 1 per cent in 2002, and Japan took it to zero. This unleashed a large amount of money into the global financial system, creating an unprecedented demand for all kinds of assets, including those in emerging markets like India.

As too much money chased the assets, these economies found that inflation was moving up, along with some signs of growth. Therefore, they began to increase interest rates again. The US began two years ago, taking the rates up to 5.5 per cent and Japan began last week, hiking the rates from zero to 0.25 per cent.

The increase in interest rates means two things: One, the cheap money chasing the global assets would become expensive, making leveraged players unwind positions that are no longer profitable.

Two, if large and stable economies offer a good return on their bonds, the willingness of investors to take risks in volatile investment opportunities, like emerging markets, reduces.

When the US, which was expected to end its interest rate tightening at 5 per cent, signalled in May that there was more to come, markets went into a tailspin. The flow of money in and out of emerging markets has this technical twist linked to the cost of money.

The fundamental story is, however, different. The large economies that hold sway over capital and consumption have weakened over time. If it is the lack of savings and a huge deficit for the US, it is rigid labour and uncompetitive costs for Europe. Japan just seems to be coming out of a 10-year-long recession.

In the meantime, the economic prowess of countries like China, Russia, Brazil and India has increased significantly. Strengthened by reforms, their economies are growing at sustained high rates. They need the capital that the developed economies have, and are willing to invest, given the immense opportunities.

Therefore, the secular trend is one of capital flow into these economies, and expansion of the smaller economies driven by exports to the others, leading to a gradual rebalance in the economic equation of the world. But this process, like all rebalancing phenomena, will be spiked with uncertainties and reversals.

The markets are volatile because technical factors are not getting subservient to the fundamentals. As long as there is only a limited amount of money that can be deployed for a limited amount of time, players will have to protect their losses in the short term. If uncertainty increases, the focus is always on the immediate.

The Nasdaq touched 5,000 levels in 2000 and is now hovering in the 2,000s, as the large IT firms of the US have been reporting mixed earning numbers. The Sensex is almost twice its 2000 levels, and markets cheer the IT earning numbers. Surely it was tough to see this coming in 2000. It is tough being long term, but always well worth it.