Inflation price levels and relevant factors

Not in itself an indication of aggregate economic activity, the price level measures the degree to which the nominal rate of growth in GDP is attributable to the factor of inflation. The secular inflation rate in the Indian economy has been around 7 percent till the late 1990s with wide year-to-year fluctuations. In recent years, the inflation rate has fallen significantly.

The effect of inflation on the corporate sector tends to be uneven. While certain industries may benefit, others tend to suffer. Industries that enjoy a strong market for their products and which do not come under the purview of price control may benefit. On the other hand, industries that have a weak market and which come under the purview of price control tend to lose.

On the whole, it appears that a mild level of inflation is good for the stock market.

Interest rate:

Interest rates vary with maturity default risk, inflation rate, productivity of capital, special features and so on. The interest rates on money market instruments (short term debt instruments) like Treasury bills which are virtually risk free tend to be the lowest. Long dated government securities generally carry slightly higher interest rate. Finally, corporate debentures which have some default risk associated with them carry still higher interest rates.

Traditionally the interest rates in India were fairly high and most of the interest rates in the organized sector were regulated. In the last decade several interest rates have been deregulated. More important, in the last few years interest rates have softened significantly.

A rise in interest rates depresses corporate profitability and also leads to an increase in the discount rate applied by equity investors, booth of which have an adverse impact on stock process. On the other hand, a fall in interest rates improves corporate profitability and also leads to a decline in the discount rate applied by equity investors, both of which have a favorable impact on stock prices.

Balance of payments, Forex Reserves, and Exchange Rates:

The balance of payments deficit is equal to:

Balance of trade deficit (imports minus exports) + Balance on invisibles like tourism and interest rates (payment on account of invisibles minus receipts on account of invisibles) + Balance on account of capital account (repayment on account of loans minus receipt of loans).

A balance of payments deficit depletes the forex reserves of the country and has an adverse impact on the exchange rate; on the other hand a balance of payments surplus augments the forex reserves of the country and has a favorable impact on the exchange rate.

If the rupee weakens vis-à-vis the dollar it hurts importers but benefits exporters and vice versa.

Foreign investment:

Foreign investment in India comes in two forms, foreign direct investment and foreign portfolio investment. The former represents investments for selling up new products and hence is long term in nature; the latter is in the form of purchase of outstanding securities in the capital market and hence can be reversed easily.

Although foreign direct investment is more desirable than foreign portfolio investment, India has received more of the latter to date. In recent years foreign institutional investors who make portfolio investment have emerged as a powerful force on the Indian capital market. In the calendar year 2004 alone, the net foreign portfolio investment has exceeded $ 8.3 billion.

A surge in net foreign portfolio investment has a buoying effect on the stock market. By the same token, a net foreign investment outflow has a dampening effect on the market.

Role of foreign Institutional Investment:

As at the end of September 2004, the value of foreign institutional investment in the Indian equity market was $ 38.5 billion, accounting for about 30 percent of the free float market capitalization.

Huge inflows of foreign institutional investment in the Indian equity market has raised two kinds of concerns:

At the micro level, the concern is that too much money is chasing too few stocks thereby leading to a possible liquidity bubble.

At the macro level, the concern is that India’s ability to absorb huge forex inflows is low as it does not allow free forex outflows. Countries like Taiwan absorb inflows better, thanks to easier capital account convertibility. The cost of accumulating forex reserves has to be borne by the Reserve Bank of India.