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Panic selling in global markets led to FIIs selling India

The events that unfolded last week were so extraordinary that the former Fed chief Allen Greenspan called it 'a once in a century occurrence'. In the latest Wall Street crisis investment bank Lehman Brothers filed for bankruptcy protection, the Bank of America took over Merrill Lynch and the Federal Reserve provided an USD 85 billion bailout for insurer American International Group, all of it happening almost at the same time.

In fact, the story of Lehman Brothers was scripted in the mortgage market crisis last year. The firm was a major player in the market for sub-prime and prime mortgages. The company had a relatively small balance sheet, and was heavily dependent on the mortgage and repurchase markets for short-term funding. As the mortgage markets did not recover, the company had huge write-offs.

Its efforts to raise capital failed. The company's expectations of being bailed out by the government did not work out. Lehman had reached its end, setting off a domino effect in the global stock markets. The global financial markets collapsed like a house of cards as the giant pillars of Wall Street went bankrupt. Unlike Lehman Brothers, AIG, Freddie Mac and Fannie Mae were luckier. The US bailed out some of its major financial institutions.

Currency issues

The upheaval on the Wall Street put pressure on the rupee. There was a shortage in dollar liquidity in both domestic and global markets. The overnight cash rates jumped to 14 percent on Tuesday here, the highest since April 2007, from around nine percent last week. They eased to around 10 percent on Wednesday. As the US dollar rose against other currencies it became unattractive to invest in emerging markets. On Tuesday, the central bank also allowed banks to borrow more by relaxing the statutory liquidity ratio (SLR), while expanding the liquidity adjustment facility scheme to avoid liquidity crunch that was developing.

The Reserve Bank of India (RBI) has sprung regularly to the rupee's defense, buying it in the currency market and removing a shortage. After the rupee's biggest one day fall in a decade on Tuesday, the RBI injected 47.36 billion rupees into the banking system. The Reserve Bank of India (RBI) has sprung regularly to the rupee's defense, buying it in the currency market and removing a shortage.

Flight to safety

The foreign institutional investors (FIIs) had been investing in India and other emerging markets in the form of carry trades. Many large institutional players who had borrowed in dollars and invested in India, faced a double whammy of unfavourable exchange rates and rising costs of funding. Investors had to sell off their investments to avoid negative returns. They also unwound currency swaps that had been used to fund their assets in India and elsewhere.

In the four weeks to September 14, foreign investors sold a net USD 7.9 billion of Asian stocks outside Japan. The finance ministry says, in India, the FII funds are flowing into debt markets, including government securities, even as there is slight pullout from the equity segment. Overall, the withdrawal of funds seems to be slight compared to the inflows in the past five years. In 2008, FIIs have withdrawn more than USD 7 billion so far. This is not too high compared to the inflows of USD 52 billion over the last five years. The question however remains whether they will pullout more funds during these 'extraordinary times'.

Prudence pays

India's large foreign currency reserves have helped in these times. It had swelled to nearly USD 300 billion, among the highest in the Asian continent. Indeed, the RBI was roundly criticised earlier for keeping such large funds idle. Now if the FIIs withdraw funds in large quantities the country will not face a solvency issue like many Asian countries did in 1990 during the Asian financial crisis.

The RBI is now being lauded for its prudent policies. The ADB's Asian Development Outlook Update said India's financial systems were healthy and had so far been relatively immune to the US credit crunch. However, it felt if the sub-prime crisis worsens significantly, India is bound to suffer some serious financial effects, including an abrupt reversal of the capital inflows that have held up well so far.

Focus shifts from inflation to growth

Many analysts are of the opinion that the interest rate cycle has peaked due to fall in the price of crude oil. The focus may now shift away from abating inflation to declining economic growth. The ADB report said growth in India was likely to expand only at 7.4 percent in 2008 against the April forecast of eight percent. In 2009, India's growth will be only seven percent according to the report. However, India's growth rate prediction seems to vary widely from nine percent quoted by the government to seven percent quoted by foreign entities.

Retail strategy

Currently, negative trading sentiments are outweighing economic fundamentals. But if history is any guide, buying good stocks when they are reasonably priced and hanging on for five years or more has tended to be the best thing you can do with your money.

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