stocks and the impossible trinity.

Asset prices especially of our stock markets seem to be at an all time high and there are no signs of it ebbing. The Sensex has now made a run from 14000 to 19000 in a matter of 2 months, a rise of 35%. Usually monetary policy is directed towards balancing an expansionary or contractionary markets ergo if markets are growing too fast monetary policy is directed to limit its growth to a manageable level, if markets are lack luster monetary policy is directed towards expansionary or growth policies. Thus monetary policy is balancing these 2 forces in an economic market.

In our case however the stock asset prices have increased on account of foreign inflows. These inflows are justified on the phenomenal growth of corporate earnings in India and expected growth and opportunity in Indian markets at least that is what we are led to believe. Inadvertently however, the foreign inflows have been appreciating the rupee (12% appreciation in the past quarter) which is affecting exports. Exports are getting expensive on account of lower dollar realization, a revision upwards of exports prices is netting fewer buyers in the world market and we see that exports in this quarter have slumped.

Generally a rapid and high growth market is soothed by increasing interest rates. Increased interest rates would encumber new investments, limiting growth and maybe in turn lowering assets prices. However when foreign inflows are increasing stock asset prices, an increased interest rate in the market further propels inflows into the country. So we are in a situation where we can’t affect interest rates, so foreign inflows will continue and the rupee will continue to appreciate v/s the dollar. Most economists call the dilemma the Impossible Trinity viz exchange rates, capital movement and interest rates. Economists believe you can choose only 2 out of 3.

What may be of importance to note is that SEBI, the stock exchange regulatory authority had issued a clarification or comment on foreign inflows using participatory notes. The day of comment evoked a 1700 point slide on the sensex. Mr. Damodaran, SEBI Chairman promptly retracted his statement, and dutifully the sense reverted by 1500 points that very same day. Maybe Mr. Damodaran doesn’t want to be the man behind a stock market crash only time will tell. Let’s wait & see.