Correction scenario

With the huge surge of dollars into the country showing no signs of abating (reserves grew by $8billion last month and by 1.9 billion in the first week of this month), some alarm bells have already begun ringing at the prospects of what would happen if the money begins to flow out, as it should whenever US interest rates rise.

Traditional arguments that foreign institutional investors will not pull out since this will cause a huge fall in the Sensex and therefore in their own asset values, may not hold water since FII trades are often programme-driven, which is why the herd tends to move in the same direction.

If perceptions about India change — and who is to say that things will always look rose-tinted — the money could begin to flow out as fast as it’s coming in right now.

So it is a reasonable assumption to make that the markets will tank in the event of an FII exit, the rupee then will go the same way, and there will be that much less liquidity in the system.

While a combination of such events is usually enough to get the government into panic mode, the government would be well advised not to do the usual things in the event such a scenario does unfold.

For one, with a Sensex price-earnings ratio of under 16 at the moment, the Sensex doesn’t look terribly over-bought and so it is plausible that if an FII exit sees it dip below current levels, there will be other investors willing to step in.

A fall in the value of the rupee, again, may not be a bad thing for the country’s exporting community, especially since most have been arguing that the rising rupee has hit their competitiveness.

As for the resultant fall in liquidity which will occur once FIIs decide to exit and take their funds back home, commercial banks are sitting on excess liquidity (witness their SLR holdings vis-a-vis the statutory requirements) so it may not pose too much of a problem, even at a time when both the government and the private sector are upping their spending at the same time.

In short, other than keeping a watchful eye, the government may not actually need to do anything.

Though the danger of a possible Tobin tax has receded after the RBI governor clarified his stand on the issue two months ago, there is another danger, that of the government not allowing a natural correction to happen.

In order to preserve the feel-good factor, captive organisations such as the Life Insurance Corporation may be asked to step into the space vacated by the FIIs — in which case, the FIIs will find a good value for their shares even while exiting and LIC will be left carrying moderately over-priced stock.

Though it is true that small investors do get hurt in the event of a market correction, getting LIC to step in would be foolish. For one, its ability to put in funds is unlikely to be able to match what the FIIs can take out.

Second, and more important, a lot more people are at risk from an LIC which buys expensive stock as compared to those that take a hit if the Sensex tanks.

The government would do well to keep that in mind and let the market correct itself.