India Stocks: When Will the Party End?

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In the past year, Indian companies have raised about $13.5 billion in debt and equity from global markets, according to data tracker Prime Database.

Conversely, SEBI wants foreigners listing locally. It plans to introduce Indian depository receipts for foreign companies to list on the Indian bourses, similar to the American depositary receipts or global depository receipts traded in the West. To make the markets more efficient, plans are under way to speed up the time for first-time listings through electronic initial public offerings, or e-IPOs, saving on transaction costs.

Blue Chips Drove Recent Rally

Unfortunately, not many investors have confidence in the SEBI, given the mess that the participatory notes announcement caused and the chronic lack of in-house expertise in modern exchange systems. Foreigners are still smarting from last month's indiscriminate curbs on participatory notes, which restrict their market access and their ability to leverage and play with stock futures. Investors dismiss the government’s ability to control capital inflows. "I'm not sure the government can do much to rein in market forces," says Seema Desai, analyst at Eurasia Group in London. In the short term, she says, the government can impose mild controls such as increasing the time during which foreign funds must keep their funds locked into India or imposing some form of tax.

That the market needs strengthening is clear. The recent rally was not a broad market impulse shared by the 6,500 stocks listed on the Indian exchange. Rather, it was driven by a handful of blue-chip stocks from some of India's fastest-growing sectors like infrastructure, banking, real estate, oil and gas, energy, and telecom. The big winners were infrastructure builder and equipment maker Larsen & Toubro, Oil & Natural Gas Corp., and ICICI Bank. (See slide show.)

But there were also the usual market movers, mostly Reliance group companies such as petrochemicals player Reliance Industries, Reliance Petroleum, Reliance Communcations, and Reliance Energy, whose traded volumes have been the largest. On Nov. 1 the top 10 stocks accounted for half of the $10 billion in trading volume on the Sensex. The six Reliance group companies alone accounted for 38% of the beauty parade.

Signs of a Market Correction

Of course, India is not unique in having a boom in capital inflows. Neighboring China, which has a newer stock market and weaker regulatory controls, has also seen huge investments, with the central bank raising cash reserve ratios for banks as a means to dampen the exuberance a little. But while China does not depend on its stock market as the primary source of foreign investment, India does. So monitoring the market is vital to India's economic interest. "If the financial system continues to allocate capital efficiently through such periods of excess, it will be able to deal with the risk of a sudden reversal," says Sanjeev Sanyal, senior economist at Deutsche Bank (DB) in Hong Kong.

There are clearly caution signs up ahead. Ashu Dutt, in the October edition of his monthly newsletter The Boom & Bust Journal, feels that a market correction could—and should—happen quickly. "If we wait for the market to touch 25,000 [before the correction takes place], the ramifications may be serious enough to affect consumption patterns," he says. He is not far off the mark. Already interest rate increases by 1.5% this year have been taking their toll on home and auto loans. On the other hand, the appreciation of the Indian rupee, up 11% against the dollar this year, is affecting exports, particularly the textile sector.

Then there is the U.S. subprime crisis, which could have a ripple effect on India. "Big fault lines have opened up in the U.S. with the subprime crisis. If the U.S. goes into a recession, then Asia will not be the oasis of prosperity, and Asian stock markets will be vulnerable, as is yours in India," said Stephen Roach, chairman of Morgan Stanley Asia (MS), at a luncheon meeting in Mumbai on Nov. 2.

Even Merrill Lynch's normally optimistic Holland expects 2008 to be a difficult year for markets globally. Rising oil prices and slow growth in developed economies like the U.S. will result in "a lot of risks and volatility," he warns. Don't expect those giddy, demand-driven 30% returns from the Indian markets to continue endlessly, he says.

Lakshman covers India business for BusinessWeek .