THE GENESIS OF CAPITAL MARKETS CRASH

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.