Sucheta Dalal :The Crash and After
Sucheta Dalal

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The Crash and After  

May 19, 2004

Five factors caused the crash. None of them are short-term in nature

By Debashis Basu

Nifty, the 50-share index of National Stock Exchange was at 1804 on 7th May. 6 trading days later, at 11 am on the morning of 17th May, it hit 1292 when trading was frozen for the second time. This was a fall of 28% in less than 6 days. This kind of collapse has not happened ever in India. Even in the rest of the world, a 15% fall in the market index in just one day is a rare event. Investors are shell-shocked. Traders have lost thousands of crores overnight. What caused it? Just the Left pronouncement of putting reforms and privatisation on hold?

First, consider two facts. One, a severe downturn in a set of stocks can lead to a cascading effect involving all other stocks, when margin calls are triggered and mutual funds are hit by withdrawals especially when there is panic all around. Two, a sudden and severe market decline is an essential part of the markets all over the world, in every market. It happens in commodities, treasuries, currencies and stocks. It may happen once a decade or even rarely in each market but no market can escape it. Apart from these two facts there are five factors that caused the current crash in Indian stocks.

Too much too soon?: The Sensex was languishing at 2900 in April. Then suddenly global liquidity began to hit India and other emerging markets. FIIs started investing in India in a big way. When the Sensex was shooting up a few hundred points every week, culminating in a blow-out 800 point rise in December and a 400 point rise in the first two weeks of January, there was euphoria all around. This came after a 73% rise in the index over just 9 months, something quite unprecedented after Harshad Mehta’s exploits in 1991 and early 1992. There were doubts whether it was too fast too soon. But soon there were many credible stories underlining the fact that the rise in stocks was genuine, based on sound fundamentals. It looked durable because corporate performance was excellent too. There were growth stories for various sectors but as we have been saying, the rise in stock prices was far quicker and higher than justified by fundamentals.  

Market Structure: But since the boom was primarily created by foreign institutional investors through a transparent well-disclosed system, it was highly acceptable. Where did the FIIs get the stock from? Retail investors sold, did not put too much money into mutual funds (until much later), Indian promoters sold in little bits and pieces and finally the government supplied a huge amount of stock through IPOs. It was a market for only one kind of buyer: the foreigners, most of whom do not even live here. The implication of this was known, even discussed, the most popular form of which was “if the FIIs have to sell quickly for some reason, who will buy?”

We even heard a foreign fund manager crying in CNBC late last year that “we wish Indian investors would now buy.”

This is an issue of market structure, but usually never bothers analysts and fund managers. They are always looking for reasons to buy and so are too focused on individual stocks and sectors. But the market structure is as important to the valuation and volatility as earnings and growth. If it was not so, the index would not have been barely at 3000 last year when UTI was still selling, retail investors were out of the market, mutual funds had no money to invest and FII money was coming in driblets. What substituted this bleak picture on April 2003 partly explains what happened in the market in mid-May 2004.

The structure of the Indian market and players has been continuously changing since the early ‘90s. When Harshad Mehta was creating a 2000-point rally in a matter of months, an opaque, open outcry market was dominated by speculators, UTI and many small investors/punters. This led to a scam, regulations, an electronic market and the entry of a new set of players – the FIIs. The punters never went away and created another market top and a scam in 2000-01. After various scams of the 90s, the modern, globalised Indian stock market simply does not have a wide base of retail investors or domestic institutions. This time there were no big punters either, only FIIs, in a lopsided market, dancing at their whims.

Hedge Funds: Who are these FIIs? We don’t know for sure how much of the blowoff rise in December and January was result of pure global liquidity channelled by hedge funds for quick gains in emerging markets. Having come in last, this money was sitting on wafer-thin profits (or even losses) and was desperate to exit when the May 13th results upset all calculations and the Left leaders opened their stupid mouth. The market structure (absence of significant domestic base of investors) allowed this to happen. 

Global Situation: The timing of all this was terrible. The economic climate under which emerging markets were attracting money, was changing. Rising oil prices, rising interest rates, spectre of inflation and geo-political tension are making hedge funds risk-averse. Global emerging markets are losing flavour. On the day India crashed 11%, Indonesia, Taiwan, Korea and Thailand all fell between 11-5%.

Left at the Centre: And finally the trigger of it all, the most proximate reason, the new equation at the Centre. The impact of this was magnified by the Left leaders over two days but they were bound to do this anyway. Many Indians, much less foreigners, have no idea what the Left has reduced West Bengal and Kerala to. In fact, some economists-cum-fund managers like Surjit Bhalla falsely believe that the Left and the Congress have “no choice” but to follow the same economic policies of the previous government. The market did not have the same belief. So, it sold in haste. People like Bhalla will be forced to sell later.

-- Sucheta Dalal