The Genesis of Capital Markets Crash

THE GENESIS OF CAPITAL MARKETS CRASH

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Last one year has pulled down the hopes of most of the investors in the stock markets, who had hoped that the slowdown in the world economy would not impact the Indian economy beyond a limit. The initial contention of the Finance Minister, as well that of the Reserve Bank of India was also based on this belief only. The Prime Minister’s Office, which till July 2008 was maintaining that the growth rate of the economy could be around eight per cent during the current fiscal, has now changed its projections to around seven per cent.

It was after the fall of Lehman Brothers and liquidity crisis in some of the biggest investment banks in USA that the policy makers began to take the crisis seriously. It was the time when the Indian government had failed to control the inflation rate which continued to be in double digit for almost one year, several Indian companies had began to hand over ‘pink slips’ to their employees, lending rates had skyrocketed and the real estate prices had registered a fall upto 40 per cent. All these developments resulted in reverse flight of the Foreign Institutional Investment (FII) and the bloodbath in the Indian stock exchanges continued unabated.

The phenomenon of capital market crash was not peculiar to India only. The markets all over the world witnessed similar trends. The crumbling of the stock markets all over the world re-affirmed the fears of deepening recession in the world. While the US economy had already been in the recession mode, the Europe also began to fear the worst. Global data with the International Monetary Fund (IMF) revealed that the US economy would be in recession between the periods of second half of the year 2008 to the first half of the year 2009. This suggests that the worst has just begun. Such a forecast would certainly continue to spook the stock markets all over the globe.

Why Crash?

Rise and fall of the markets is part of normal economic activity in any market. But ‘crash’ of the markets is quite different from routine ‘fall’. Recession and capital markets have some cause and effect relationship and it may be extremely difficult to establish as to which one of the two is responsible for the other. In fact, both the economic phenomena supplement each other. But more than that is the factor of human psychology that is responsible for the crash.

As per economic theory, the economic systems grow with cyclical fluctuations when every recession is followed by recovery and up-swing of the economy, to be again engulfed by the recessionary tendencies. The only thing not known is the time of the switch. All investors love the ideal situation and pray for the bullish trends in the markets. But the collective attitude of the society undergoes change during the bullish times and people wishfully hope that the markets would continue growing for all times to come. The investments are made with this attitude and hope.

But the bearish trends are inevitable at such a stage, as the economic cycle has to take full turn. Several economic factors play a major role in determining the timing of the downward trend to begin. Liquidity position in the economy, the effective demand, the interest rates, money supply, inflation rate and overall global economic situation are some of the factors that determine this timeline. With the advent of downswing, comes the downward trend in the capital market and the euphoria of the investors turns into downright pessimism.

It is said that in the financial markets, the majority is always wrong. Since the stock market operations are a zero-sum game and for every gain there is a loser, it is not possible for everyone to win in the markets. But the euphoric investors during the boom times fail to appreciate this fact. When the inevitable begins to become a reality, the average investor starts losing the money and the panic strikes the markets.

As the US markets began to display the continuing downward trend, the Indian stock markets also pressed the panic buttons. While the global deceleration was the prime cause, the projections about the slowdown in India also acted as fuel to the fire. The sectors and sub-sectors having extreme global dependence and exposure began to get jittery. Reduction in recruitment by the software companies and the staff reduction initiatives by the aviation and financial sector set the ball rolling for the crash of the stocks. The artificially inflated markets began to lick the dust and the prices of the stocks began to locate their true economic price. The reverse flight of the FII did the rest.

Actions Taken and Required

The role played by the RBI to take timely actions to inject more liquidity in the market and to reduce the lending rates to push up the investment activity, has been laudable. The monetary policy measures taken by the RBI were part of extremely difficult options, particularly in the face of mounting inflationary pressures. Reductions in the CRR and repo rate released the desired liquidity in the markets. The parleys of the Governor of the RBI with various bank chiefs to reduce the lending rates not only resulted in building up the confidence but also reduction in the lending rates.

While the monetary policy measures of the RBI have been appreciated by the banks as well as the investors, the role of the SEBI in sustaining the faith of the common man in the Indian stock exchanges is a big suspect. At the time when the stocks were crumbling, the SEBI failed to convince the investors that this was the time to invest in the stocks. If the investors were properly guided at that stage, the resultant buying activity in the market would have helped in expediting the upswing of the markets and the economy.

Indian markets as well as the economic system are facing a dilemma. While the liquidity is low, there appears to be a need to release more money supply into the economy. But at the same time, with inflation close to the double digit, increase in liquidity may fuel the inflation rate, which is already at a level higher than the desirable. The government agencies have so far treaded the corrective path very carefully.

Compared to the great depression of 1929, the situation is much better this time. During 1920s, there were no strong and robust Asian economies on the global economic scene. Today, the vibrant and resilient economies of the ASEAN countries, including those of Japan, China, South Korea, Indonesia, Malaysia, and even India, would ensure that the recession is not allowed to hit the world as hard as it did eight decades ago.

Asian economies would certainly help in quicker turnaround of the world economy. After all, it cannot go on for ever, and if the recession comes, can the upswing be far behind? The current period of recession is marked by virtually no credit and lack of equity, as there is no aggressive lending or stock buying activity. This also implies that the corporate sector would undergo a phase of consolidation and in a short time would be ready to bounce back, duly consolidated.

The government would need to support the corporate world by sacrificing some of its revenues and reduce the tax and duty rates for a while. It would also be the duty of the government to create favourable conditions for investment, reduce the interest rate, control the inflation, create more employment opportunities and balance the liquidity in the economic system.

Positive reforms in the financial sector, higher public investment in the social and infrastructure sectors and streamlining the procedures could be some of the items on the action plan of the government to revive the economy and resultantly the capital markets. Changes in the FII policy by providing for some lock-in period may also prevent the reverse flight of the foreign investment and may go a long way in checking the crash of the markets in future. It is felt that the price of stocks in India had been artificially high in the past which also triggered the sudden crash. To prevent such occurrence, there has to be some checks on speculative trading of stocks by the SEBI.