June 2, 2010 6:01 am

India is having a good European crisis

Indian equities have surprised market participants with its rather defensive behaviour through the latest crisis thus far. Will this last? We have argued over the past few years that India’s key vulnerability arises from the manner in which its current account deficit is funded, i.e., through flows sourced from financial markets. This came to the fore during the 2008 global financial crisis and Indian equities were among the worst performing in the world in that year. The recovery in global markets caused the opposite effect in 2009.

While at the margin the share of Foreign Direct Investment is rising in the capital flow mix, India remains susceptible to volatility in capital market sourced flows explaining its relatively high beta versus global equities. When the European sovereign debt crisis came to the surface, it seemed inevitable that Indian equities would lead the sell off in global equities. However, surprisingly Indian shares have outperformed emerging market and global equities.

This is not something many market participants would have predicted. A lot of things went in the market’s favour in May. The domestic macro was strong, and the government continued to push reform (the gas price increase is an example). The 3G auction proceeds implied that the government’s fiscal deficit targets will be met, even exceeded, easing the pressure on the 10-year bond yield - setting the road for a bullish flattening of the yield curve. Earnings continued to be strong, with two out of three companies reporting positive results, surprisingly positive in the ongoing earnings season. The fall in crude oil prices gave hope of an auto fuel price decontrol. The settlement of the Ambani family dispute was also a positive for the market.

India’s defensive behaviour through the latest bout of global turmoil seems to be driven by a combination of an improving policy environment, resilient domestic growth, healthy corporate balance sheets, an improving government balance sheet and a central bank that has not been hesitant to raise rates to ward off inflation threats.

However, if the European crisis deepens, and global markets, suffer another leg down, it will get increasingly difficult for India to remain defensive.

The writer is the Managing Director of Morgan Stanley in India

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