India Stocks: When Will the Party End?

New rules affecting foreign investors spooked the market in October, but the Sensex resumed its relentless climb, raising fears of a correction

by Nandini Lakshman

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For months, India's stock market defied gravity. On Oct. 29 the Sensex—the Bombay Stock Exchange's index of 30 top stocks—touched 20,000, up 1,000 points in just 11 trading sessions, and a gain of 41% since January. It has dropped 5% since, as markets worldwide have fallen amid renewed concern about subprime fallout from the U.S. Still, the stock market capitalization is now $1.3 trillion, much higher than India's gross domestic product of $900 billion.

Concerns about the Sensex's hard-charging run are barely audible on Mumbai's Dalal Street, where the exchange (the oldest in Asia) has been based since 1875. Domestic investors are on a high, putting money into newly emerging sectors like infrastructure, manufacturing, and real estate. Foreign investors are following close behind. According to the Securities & Exchange Board of India (SEBI), in October alone foreign inflows touched $5 billion, compared to the $17 billion total inflow this year. In all, about $30 billion worth of foreign investment has poured into the market since February, 2006.

Back then the Sensex was at 10,000 points. Now it's almost at 20,000. While some people worry about a correction, Andrew Holland, managing director of Merrill Lynch's (MER) Indian joint venture, DSP Merrill Lynch, is ecstatic about longer-term prospects. "I continue to be bullish on the market," he says. "GDP will continue to grow over the next five years, and corporate earnings will be strong."

New Rules Dampen Enthusiasm

Just a few weeks ago, it looked like the party was over. On Oct. 16, at the end of the trading day, investors were shocked by a notice from the securities regulator stating that new rules would curtail the use of derivatives called participatory notes, a strategy used exclusively by foreign investors. The SEBI's announcement resulted in a bloodbath the next day, with shares quickly dropping by 1,700 points. The fall was so severe that, less than an hour after the opening bell, the market closed. However, after Finance Minister Palaniappan Chidambaram made soothing noises the market rebounded and closed down just 360 points.

Sure, many foreign investors were spooked. But many more were waiting to get into India at lower prices. So were the flush-with-funds domestic investors, who put $2 billion over the following two weeks into the bourse, helping to take the market back to new highs. By the end of October, it was business as usual. "Nothing matters in a bull market, which is intrinsically long term and strong on fundamentals," says Shankar Sharma, vice-chairman of First Global Securities.

The conservative central bank concurs. On Oct. 30, the Reserve Bank of India, in its midterm monetary policy announcement, left interest rates unchanged. "The expected moderation has happened to balance demand and supply," said Y.V. Reddy, the central bank governor. "Over the next few months we don't see any possibility of domestic shocks." The only spoiler, he said, was global uncertainty. "But," added Reddy, "India's growth path will remain on course."

Real Estate and Telecom Attracting Private Equity

But what worries many is whether India's securities regulator is equipped to deal with a market growing at supersonic speed. Market analysts put India's total liquidity—money coming in through private equity, foreign inflows, initial public offerings, real estate, and foreign currency bonds—at around $30 billion. According to research and analytics firm Evalueserve, private equity investments in India alone will touch $13.5 billion by yearend, with much of the money going into sectors like real estate and telecom.

Still, the market regulator has a long prescription to improve the markets. "I would like to see more stocks being listed and more efficiency in the Indian market," says SEBI Chairman M. Damodaran. He also wants more companies to raise capital in India rather than go overseas for primary and secondary issues.