Sensex seems detached from the economy

Global liquidity drives Sensex to new high

On Wednesday, the BSE's benchmark Sensex hit a new record, crossing 28,000 for the first time. However, these heights appear somewhat detached from the current performance of the Indian economy - which, even though it looks to stand on the brink of a recovery, is still not in a position to promise the robust across-the-board earnings for listed companies that would justify these heights. Indeed the Sensex seems to be driven largely by surging global liquidity. True, the United States Federal Reserve has ended its third quantitative easing programme; but fears of tighter liquidity have been allayed by the decision of the Bank of Japan (BoJ) to expand asset-buying. The BoJ's governor, Haruhiko Kuroda, says its target is 80 trillion yen a year ($700 billion at current rates), a substantial increase over previous targets of 60-70 trillion yen. The BoJ will also triple its buying of equity funds; and Japan's Government Pension Investment Fund (GPIF), the largest in the world, will invest in alternative assets, along with local and overseas equity.

Naturally, financial markets worldwide have reacted favourably to the anticipated surge in liquidity, and brought India up along with them. The "Kuroda Put" is being referred to with gratitude in trading circles. The yen will lose value; traders now see yen carry trades as one-way bets. Hence, the incentive is to borrow in yen, convert and buy risky assets in other currencies. India is likely to be among the biggest beneficiaries of this largesse. Foreign institutional investors (FII) have stepped up their buying of Indian equities and the stock market indices have hit new highs on the BoJ stimulus. Indian treasury yields have also moved down.

In general, Dalal Street's dependency on FII inflows is very apparent. Since January, the Nifty-Sensex pair has moved up by 32 per cent on the back of Rs 60,000 crore. of net FII equity buying. This is despite domestic institutional sales of over Rs 27,000 crore.. The question is: how long will this easy liquidity last? Remember, it was the Japanese that invented quantitative expansion of the sort where the central bank releases money in exchange of financial assets that expand the bank's balance sheet. That money helps to maintain credit flows to the real economy. Over the past 25 years, Japan has experimented with many such quantitative easing programmes, while the economy has remained mired in deflation and zero-growth. This current effort is the triumph of hope over experience, and it is far from clear how long it will last in the absence of structural reform from Prime Minister Shinzo Abe's government.

The long-term consequences of adopting quantitative easing are unknown. This mode of financial re-engineering has led to the world's largest central banks holding huge quantities of high-risk assets. In practice, such programmes also seem to lead to money being directed primarily into riskier financial assets, rather than being disbursed as credit to real economy businesses. The BoJ's expansion is designed to push inflation up to two per cent, a level where it is assumed that economic activity will magically revive. The major risk is that Japan's government debt-to-GDP (gross domestic product) ratio is already over 2.5. But the ultimate success (or failure) of quantitative easing and Abenomics is scarcely the concern of traders. From their perspective, the "Kuroda Put" provides the ammunition for a variety of "risk-on" trades that can be undertaken till 2015. This should mean buoyant markets everywhere, including in India. Where buoyancy ends and bubbles begin is anyone's guess.