Eurozone crisis & Indian bull market

The economic growth momentum in India continues to be strong and barring a mass exodus by foreign investors on account of external events, India should prove to be an attractive investment destination.

The downgrading of Greek government bonds to junk grade over the last fortnight by international credit rating agency Standard and Poor's has precipitated a crisis in the European credit and equity markets and a ripple effect on other markets, including India.

S&P has also downgraded Portugal from A+ to A- while Spain remains at AA+ having been last downgraded a year ago. Despite a massive 110 billion euro bail out package announced jointly by the major eurozone countries and the International Monetary Fund that should be adequate to cover Greece's debt service obligations over the next two years, the market does not seem to be convinced that Greece has tided over the crisis.

This is partly because of stiff opposition put up by Greek citizens — workers, bureaucrats and pensioners — against the austerity measures introduced by the government.
    
The measures include the abolition of the 13th and 14th salaries in a year payable as bonus to employees and some pruning of state pensions in addition to other deficit reduction measures like moderate tax hikes.

The market is uncertain about the Greek government's ability to follow through on the commitments made to the bailout package providers because the inability to implement the deficit reduction agreement can only postpone the day of reckoning which is an eventual default.

As a result, the Greek government bonds continue to trade at yields around a stupendous 925 bp above the corresponding German euro currency bonds, while the government bonds of Portugal and Spain — widely believed to be next in line for a potential financial crisis — are trading at yields higher by 345 bp and 170 bp respectively.
    
Several economists have opined that the Greek financial crisis is the closest sovereign equivalent of the Lehman Brothers crisis that hit the global financial markets in September 2008 with disastrous consequences.

The end game in the Greek saga may well be an eventual exit from the European Union and a possible unraveling of the euro as a currency. In any case, the unfolding European drama is likely to have significant consequences worldwide though there are differing opinions on the extent of its impact.
    
Where does this leave India and its efforts at accelerating economic growth which is partly funded by foreign inflows?

The received wisdom from several experts is that the risk of contagion from the Greek crisis to countries like India is minimal because of India's insignificant trade with the country and the concerted efforts of the international community to prevent a repeat of the after effects of the Lehman collapse.

While these arguments are indeed valid, the larger risk to the Indian market comes from the potential fall in risk appetite and the possible reversal of the risk trade that has been partly funding growth in India.
    
It is well known that anywhere between a third to half of the foreign portfolio inflows into India over the last one year have been broad-based India bets through exchange-traded funds financed by cheap dollars available on account of the near zero interest rate policy adopted by the US.

These flows are footloose by their very nature and can reverse quickly if the global risk appetite falls on account of external factors like the Greek conundrum.

Given that domestic institutions in India have been consistent net sellers in the equity market for the last eight months and the retail interest has been anaemic during the period, the mainstay of the 13% move in the Nifty over this period is clearly the foreign portfolio inflows amounting to nearly $16 billion.
    
This trend has been visible over the last few years with an inflow of $17 billion buoying up the Nifty by 76% in 2009 and a similar inflow in 2007 lifting up the Nifty by 55%, whereas an outflow of $13 billion in 2008 brought down the Nifty by 52%.

Hence the course of foreign portfolio flows that is significantly influenced by the risk appetite among international investors is a key determinant of the direction that the Indian equity market is likely to take over the coming months.

Continuing uncertainty over an extended period in fixing the problems in Greece and other vulnerable European countries can therefore have serious consequences on foreign portfolio flows into and out of India.
    
That said, there are several factors that are supportive of a continuing secular foreign institutional interest in India. Inflation, which has been the bugbear of India for the last several months now, is likely to start moderating on the back of a good agricultural harvest and a potential softening of food prices.

With lower infrastructure spending and tightening credit in China, commodity prices are likely to ease and this could have a benign influence on Indian inflation as well.

At current levels, the Indian interest rate differential over global rates is already quite high and further tightening of Indian rates can hurt Indian exports on the back of a strengthening rupee. Supply-side issues relating to inflation are beginning to be addressed by the upswing in the Indian capex cycle.
    
Given the potential buoyancy in tax and non-tax revenues, the Reserve Bank of India may be in a position to stop and possibly reverse the interest rate tightening cycle sooner than what the market seems to suggest.

The market is now trading at levels that were last seen two years ago and with corporate earnings having caught up in the meantime, at less than 13x FY12 earnings, valuation can offer some level of comfort to new investors.

The economic growth momentum in India continues to be strong and barring a mass exodus by foreign investors on account of external events like a possible credit market seizure, etc, India should prove to be an attractive investment destination.
    
It is however useful to remember that in the long run, equity markets generate super normal returns when governments reform their economies and build efficient and credible institutions, thus enabling the corporate sector to unleash its entrepreneurial capabilities to generate profits for shareholders.

Needless to say, this is still work in progress in India and redoubling our efforts in this direction would make our markets more resilient and keep the foreign capital inflows coming.