The Indian equity market after the attacks

Nifty fell sharply after the attacks, from the 11th September closing price of 1023 to the low of 872 on 17th September, a fall of 15% over four days. It was the sharpest four-day fall in Nifty's history, which consists of a consistent series starting from 1990.

Valuation. The first and foremost question on the minds of everyone watching the market is: What is the impact of these events on India's macro-economy?

Economists have a contrarian perspective on isolated events like a bombing or a plane crash. These events look spectacular on the TV screen; they dominate the public imagination. However, their economic impact is miniscule at best when viewed on the scale of macro-economics. The outermost estimates for the cost of reconstruction in New York are between $10 billion to $20 billion. These are simply insignificant numbers when compared with the annual US GDP of around $20 trillion or the stock of assets in the US, which is several times larger.

The impact on the US economy would take place through (a) Loss of work for a few days, and (b) Impact on consumer spending. The US financial markets have voted that this impact is worth roughly 6% off the S&P 500 index.

What about the impact on India? We can make two arguments about this impact.

Payments crisis? In the good old days with badla and weekly or fortnightly settlement, a 15% drop in Nifty over a four--day period might have been accompanied by defaults by brokers, defaults by clients, the atmosphere of a payments crisis, accusations of market manipulation, tension prior to the badla session, urgent meetings by exchange elders, attempts to utilise some mutual funds to bail out some brokers, etc.

Instead, we had peace and quiet. This is a reflection of the superiority of the new market design on the equity market.

Liquidity. The best measure of liquidity is the impact cost when doing a trade on the entire Nifty basket. The impact cost, for a Nifty trade of Rs.5 million, was 0.27% in the month of August. This was the lowest level seen in any month of 2001. This suggests that the new market design is also working well in terms of delivering liquidity.

New modes of price discovery. The most interesting difference between this recent week, as compared with previous episodes of Nifty volatility, was the role of the derivatives market in price discovery and hedging. It was crystal clear that this news was about the overall Indian economy, and not news about individual stocks. Hence, the Nifty futures and Nifty options provided the ideal venue where speculation and price discovery took place.

The recent week will be remembered as the week where the Nifty futures and options market took off. In this week, we have often seen bid/offer spreads on the near futures of below 0.01%, making it the most liquid product in India's equity market. The aggregate turnover on products based on Nifty has reached levels where it is the highest turnover when compared with any individual share in the country.

In keeping with India's experience with several other innovative market mechanisms, the success of the Nifty futures and options market has taken place without significant participation from the banks, mutual funds and foreign investors of south Bombay. The adoption of this market has been pioneered by the supposedly unsophisticated individual investors across the country. This is yet another reminder of the primal role that individuals, and the rest of India, can play in the financial system if the market design does not block their access.

Hedging using the index. Nifty fell by 15% over a period of four days, owing to macro-economic news. This is a powerful episode which should upgrade interest levels in using index derivatives, to hedge away index exposure.

A speculator who has purchased Satyam, because he feels that Satyam will report good results, is also carrying a exposure to Nifty. Anyone with an equity portfolio has a risk profile which is dominated by the movements of Nifty. Many firms, ranging from merchant bankers to five-star hotels, find their business is adversely affected with Nifty goes down.

All these economic agents can greatly reduce their risk profile by hedging away their index exposure. This can be done by selling Nifty futures, or buying Nifty put options. This is a new frontier where economic agents can reduce their unhappiness by utilising these new opportunities for insurance.

Very few people in India have as yet understood these opportunities and started utilising them. These applications are the next frontier on the equity derivatives market, now that we have a liquid index futures market.

What can policy-makers do? A question that is frequently heard today is What can we do about the stock market?. The unspoken assumption is that some government interventions should be conjured up to make stock prices go up.

First and foremost, we should be extremely careful to avoid interfering with the price discovery of the market. SEBI could have done a lot of damage by closing the market, or banning short sales. It is to their credit that (this time around) they have not executed such authoritarian policies. Instead, they have brought back 10% price limits and are about to clamp down with position limits on the derivatives market. These small pieces of authoritarianism are quite ill-conceived; our prime goal in public policy should be to preserve market liquidity and price discovery.

There is a bureacratic instinct to clamp down on the market which should be resisted. If we fear that the market is going to give us bad news, then muzzling the market (with price limits or bans on short sales or market closure) is surely not the answer.

The government seems to have made some progress on long-term policy issues: (a) going about creating a new management team for SEBI, where there is a search for a new chairman and three new full-time board members (b) correcting the mistakes in existing regulations about the interplay between banks and securities markets, and (c) increasing the limit on foreign shareholding to 74%. All these are extremely sensible and important initiatives. But they obviously have nothing to do with the immediate aftermath of the attacks on New York.

Conclusion. The recent week has been a remarkably important one for the equity market. The new market design has worked well in this period. The 15% drop in Nifty is hard to reconcile with India being a continental economy, insulated from fluctuations in the world economy. However, we should be careful to avoid the administrative interference in the functioning of the market.

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