What is the impact of political developments on the financial markets?

ISSUE

Continuity, certainty key

H V Sheshadri
Managing director & CEO
Development Credit Bank

In most economies, markets have often demonstrated that the political environment significantly influences them. The same holds good in the Indian context as well.

While it is true that Indian companies have recorded large profits and have had fundamentally strong backgrounds, equity markets are primarily based on analysing future trends and the valuation of that scenario being factored into today's price.

What boosted the market and its performance over the last few years has been political stability. This seems to at least momentarily been affected.

For a healthy and vibrant economy and market a stable government is the key ingredient.

In an uncertain political atmosphere rife with speculation and a fractured mandate, the impact on the markets could often be quite damaging.

There has been some speculation on some of the policies that so far have favoured the markets and what the likely impact could be if they are stalled or discontinued.

Key among them are decisions on:
Levels and direction of fresh investment: This would mean that a significant source of funds for infrastructure and other spending will be closed or directed to other sectors. This could also discourage participation of large players.

Increase in subsidies: This will result in increased burden on government expenditure and may result in increase in the tax rates.

Slowdown in the pace of disinvestment: The markets would perceive pressure on government finances due to lower disinvestments receipts. The move would compel the Centre to look at other avenues of raising money to keep the fiscal deficit manageable, such as increasing the tax rates.

Small savings' rate: Because of populist measures, the government may be forced to increase interest on small savings investment. This may result in an increase in interest rates, which, in turn, will have a direct impact on corporate performance and inflation.

Pressure on the rupee: Because of non-reformist measures, foreign institutional investors may be discouraged. This may result in money moving out and thus end up putting pressure on the local currency.

The result of this will be reduced liquidity in the system, thereby making a case for increase in interest rates and yet again fuelling inflation.

With stability returning to the political system, there has been a positive recovery in the market, which further substantiates the requirement of a stable government to ensure sound market performance.

The bottomline is the markets seek continuity and certainty. Whenever these elements may be perceived as missing in the agenda of a new government, they react.

It's all about sentiment

Janak Desai
Country head (treasury)
IDBI Bank

The exuberance in the Indian financial markets over the past 12 months was unprecedented in many ways. Equity indices doubling in a year, fixed income yields at historic lows and the strengthening of the rupee.

All of this was on the back of double-digit GDP growth in the last quarter of the previous fiscal. It seemed like a party that would have participants jiving for a long time to come. Everything that was happening seemed music to the partying crowd!

And then everything came to a screeching halt suddenly as the world's largest democracy went to polls and the exit polls took participants and observers by surprise.

Suddenly the music seemed to stop and people began assessing the implications of the possible change in the political decision-makers.

Just as the markets were making such assessment, statements on future economic ideology from some key potential allies of the new government seemed to put the locomotive that appeared to be racing ahead at a scorching pace suddenly in turnaround mode.

Fixed income yields went up, rupee touched a low of 46 to a dollar from a high of 43.20 and the equity markets tanked with no buyers in sight. The panic that gripped the equity markets seemed to suggest that the blooming 'India Shining' story had prematurely ended.

So, what really changed in 24 hours? Sentiment! Initial pre-poll surveys had projected the ruling coalition to win upwards of 300 seats in the coming elections and have even a stronger majority in the Lower House of Parliament.

The market had, therefore, concluded that the ruling coalition, which had clearly demonstrated its resolve to carry out significant economic reforms, would be even better positioned to continue on that path.

It was a coalition of parties that despite its differences had learnt to live together! The exit polls and then the results suddenly changed all of this. The noises coming from some potential supporters of the new coalition in power were clearly not music to the ears of the 'party crowd'.

Fundamentally, nothing had changed. However, market sentiment had done an about turn due to a combination of various factors. A number of rationale economic explanations have been touted to justify this change in sentiment - the selloff in Asian equities being just one of them.

It wasn't a demonstration of preference for the policies of the NDA versus the UPA. It was more a realisation that the economy was going through a phase of uncertainty, which had not been fully factored into the markets. Financial markets shrug uncertainty like plague.

The risk of uncertainty was much more than what the markets had factored in. As with most such events, markets tend to over-react.

If markets operated only on rationale, the uncertainty associated with the outcome of the poll process should have been factored in before the electoral process.

The decibel in the on-going party was too high for participants to take notice and price in the event risk. Markets, after the humongous volatility of the past couple of weeks, have stabilised and it would be fair to say that the risks are today better factored into most markets.

Going forward, with confidence and sentiment bruised, participants will closely watch the words and more importantly the actions of the new powers that be.

The health and performance of the financial markets today stand at a critical juncture and actions of the political masters will determine which direction and what pace the Indian economic juggernaut and the markets move.