So the government has succeeded in uninviting a good chunk of FII investments. It desperately wanted less foreign money flowing in and took just the right action that got it what it wanted. I just wish that if the day comes when we desperately need more investment flowing instead less, then it proves to be just as easy to turn the taps on as it was to turn them off.
It has been a long time since some people have been conjecturing how and when the great Indian bull run will end. All sorts of reasons from a general reversal of growth to a catastrophic terrorist attack have been thought the likeliest death-blow that will turn the markets downwards. But the truth, as always, turned out to be far stranger than fiction. No one could have possibly thought that the markets would finally turn downwards because of a government action specifically intended to do so.
But what is it exactly that has happened in the P-note affair? Isn't there some disconnect between what the government has done and the effect it has achieved? Let's step back and look at what's been happening. Since mid-September, the pace of FII money flowing into the stock markets has been unprecedented. While this led to a bubble-like growth in stock prices, what really alarmed the government was the way this was boosting up the rupee. Incidentally, much of this inflow was in the form of trading in derivatives using a mechanism called promissory notes. On October 16, SEBI proposed new rules that would limit the issue of P-notes by FIIs to 40 per cent of the investments done through them. Apparently, since a large proportion of recent inflows were through this route, the markets have deflated rapidly and FIIs inflows have turned into outflows.
It seems to me that the limitation on P-note activity has been implemented at this point because it incidentally does something that the government needed to do, namely, limit FII inflows. Specifically, limit FII inflows of the kind that is widely thought to be short-term 'hot money'. Clearly, this begs the question about what the government would have done to limit the flows had they been coming in through the non-P-note route. What will the government do if such a situation occurs in the future? I think the whole situation points to what is actually wrong-the India frenzy has led to more FII money coming in than the Indian stock markets can absorb. Like all market excesses, a strong positive feedback cycle has been created-inflows produce returns, which encourage more inflows. And since the inflows are foreign, they distort the currency movements in a way that the positive feedback becomes even stronger.
However, now the government has stepped in and cut the feedback loop, we could well go into a positive feedback loop in the reverse direction. Outflows will send the markets downwards which will encourage more outflows. What could interrupt this downward cycle? Everyone repeats the same mantras-strong growth, India story etc etc. That is fine except for a couple of problems. Firstly, whenever 'everyone' has the same opinion, everyone tends to be wrong. Secondly, no matter how wonderful the fundamentals, in the short-term market is driven by the balance of supply and demand. You'll hear all kinds of opinions about what is likely to happen some will turn out to be right and some wrong. But that will be by chance alone. The truth is that the stock markets are in for a phase of great uncertainty and any kind of prediction is just guesswork.
For the sensible investor, the choice that makes sense is the same as always. Ignore the news and keep (or add) only long-term money in stocks. And long-term means long-term, as in five years or more.