The end of a financial year (and incidentally the end of a government’s term) may be an appropriate time to undertake a review of economic developments of the recent past. Such a review could highlight not only the high marks and achievements of the past few years but can also point to what needs to be improved upon for better performance in the future. This article undertakes such a review of recent developments in a particular segment of the Indian economy - viz. the financial markets - and attempts to assess its high points and, more importantly, highlight those areas which need to be improved upon.

It may also be appropriate to have this review cover a period longer than the past one year. The reasons are obvious. It is well known that the current global financial markets crisis has upset long established trends and relationships in financial markets across the globe. The magnitude of movements (and losses) in various markets - such as stocks, commodities, bonds, currencies - in the past 18 months has, therefore, been unprecedented and in the financial industry’s jargon, much beyond what is predicted in normal times, or rather, by the normal curve! Just looking at the past 1 year / 18 months may, therefore, project a more unfavourable picture of the overall scenario than may be warranted.

Short and long-term in India – does it matter much?

While a review covering a period longer than a year may be appropriate in the global context, it appears that such a qualitative distinction between a short-term and long-term review does not matter much in the Indian case!

The short-term developments of the past year / 18 months broadly fit into a pattern which has been well established over a period of time. Indian financial markets - particularly stocks and currencies - have been quite volatile over the long-term and developments in the past 18 months have not varied much from that pattern. While the global crisis may have added to the level of volatility (losses), it should not make us complacent, given the underlying long-term patterns noticed in Indian markets.

A key takeaway and an agenda for action for policy makers is therefore to produce greater stability of financial markets in India. Greater financial markets stability – which should cover stocks, currencies, bonds and interest rates – in turn could contribute to greater economic stability as households and firms can save, borrow and invest with greater confidence. We may not have a situation where economic growth is 9 per cent in one year but drops 50 per cent in the next year. We may also not have a situation where inflation is 12 per cent at a point in time but drops to near zero in a span of few months.

It may be easy to attribute such sharp fluctuations in real economic performance (the level of GDP growth, inflation, etc) to volatility induced in financial markets by global factors. The larger agenda, though, should be to structure domestic policy in such a way that local markets are not unduly affected by global trends.

Long-term volatility in stocks

As the accompanying table shows, Indian stocks have been historically volatile and 2008’s deep losses have only fitted well into that pattern. The table shows the annual returns on the Nifty index of 50 stocks on the NSE.

As can be seen, the simple average of annual returns on the Nifty in the last 10 calendar years has been 19 per cent. But the average rate of growth in the index over the entire 10 year period (called the compounded annual average) is much less at 13 per cent. The compounded average is lower because of the fairly high degree of variability in the year to year returns of the index. A statistical measure of this variability - the standard deviation - between 1999 and 2008 is as much as 38 per cent. A standard deviation of 38 per cent means that the Indian stock market is quite likely to decline 38 - 19 = 19 per cent in a year OR rise 19 + 38 = 57 per cent in a year. More precisely, there is about a 30 per cent chance that there could be a decline bigger than 19 per cent OR a rise larger than 57 per cent.

Leaving out the 2008 performance, if one looks at the Nifty from calendar years 1999 to 2007, the picture does provide some comfort, but not much. The simple average of annual returns in this period is higher at 27 per cent and the risk measure (standard deviation) is also lower at 31 per cent. The nine year period up to 2007, therefore, has produced higher returns at lower risk. But it is still a fact that a risk level of 31 per cent is quite high. As can be seen, there is a 1 in 3 chance that there could be a loss much higher than 4 per cent. And sure enough, that 1 bad year in 3 seems to have been 2008 when stock market losses were an astounding 55 per cent - nowhere close to the expected 4 per cent loss based on standard statistical analysis of historical performance. This is surely a telling example of the ‘fat tails’ or the ‘black swan’ phenomenon.

In sum, high variability is a unique feature of the Indian stock market. The key to producing higher annual average returns over the long term in this scenario is to develop the ability to better time the entry and exit from the stock markets. That can minimize the adverse effect, on an investment portfolio, of the volatility of the overall stock market. Therefore, even if investments in a portfolio were to mirror the market index, there is still a case for active portfolio management!

Rupee move fits with long term pattern

Much the same dynamics as in stocks ie the 2008 performance being in line with the long-term historical patterns - apply in the case of the Indian rupee also. The Indian rupee posted some fairly steep losses in the second half of 2008 losing nearly 25 per cent of its value in the space of 5 / 6 months. Risk aversion and the resultant withdrawal of portfolio capital and the drying up of external loan capital (ECBs) in the wake of the global crisis were the prime drivers behind the significant loss in the rupee. To be sure, a loss of something like 25 per cent in value in a span of 6 months indeed is quite sharp.

But a study of long-term movements in the rupee would show that such compressed moves in the currency are quite the pattern. The Indian currency has exhibited a long term pattern of trading within short ranges for extended periods of time. Substantial corrections – either upward or downward – then come about in a fairly short length of time. This has been the case since at least mid 1993 when the rupee’s exchange rate was unified and it was ‘left’ largely to market forces to determine its value. Prior to the sharp move in the rupee in the second half 2008, the last time such significant movements occurred was in the second quarter of 2007 when the Indian currency appreciated 8/ 9 per cent in the space of about 3 months. That upward move in the rupee was preceded by a fairly long period – around 2½ years – of range bound moves between 44 and 46 against the US dollar as the accompanying chart shows.

There is no gainsaying the difficulties which such volatility in the currency market can pose for companies with foreign exchange exposure (our textile exporters, for example). Variability in operating parameters - the exchange rate being one critical operating parameter - surely is to be reckoned with and has to be anticipated and budgeted for. But it is also true that a consistent official policy with respect to the exchange rate can go a long way in enabling better exchange rate risk management by user companies.