India's Sensex comes of age

By DALE JACKSON
November 9, 2007 at 6:27 AM EST

November marks the start of the wedding season in India and this year there's plenty to celebrate. October was the most profitable month for the country's main equity index in nearly four years. The value of the Bombay Stock Exchange Sensitive Index, or Sensex, grew 14.7 per cent during the month, topping the 20,000 milestone for the first time. The benchmark index has doubled in less than two years.

It was also an unsettling month. On Oct. 17 the Sensex plunged nearly 10 per cent in a relative blink of an eye after the Securities and Exchange Board of India (SEBI) proposed a plan to curb foreign investment. The one-minute panic wiped out more than $120-billion (U.S.) of market value.

It was a plunge that had subprime-jittery equity markets around the world bracing for a 1997-style Asian equity crisis that never came. The freefall ended when trading was halted for one hour. By the end of the day the Sensex managed to regain most of its lost ground as investors focused on the continuing parade of strong economic news that has been contributing to average annual growth of 8.5 per cent and annual earnings growth as high as 35 per cent over the past four years.

The SEBI move was prompted by concern over a record $17-billion in foreign funds that flowed into the country in the first 10 months of this year, pushing the rupee to a 12.6-per-cent gain over the same period. Roughly half of those funds came into the capital markets through speculative derivative instruments known as participatory notes or P-notes. Short-term investors, such as hedge funds, prefer P-notes because purchasers remain anonymous and can avoid India's cumbersome regulatory process.

When the SEBI eventually restricted the use of P-notes a few days later market reaction was muted. Since then the Sensex has tested new highs and that infamous one minute of panic has been largely forgotten by international equity markets.

Many large domestic traders, on the other hand, view Oct. 17 as the day India's equity market came of age. Birla Sun Life AMC Ltd. senior fund manager Ajay Argal says the P-note clampdown benefits long-term investors. "We believe there could be more measures to control the flows into the country," he says. "The chance of a full-blown currency crisis is negligible as the central bank has done a good job consistently."

Birla Sun Life has $8.5-billion under management. Mr. Argal says India's rapid economic and market growth does not concern him as long as the growth is balanced. "We believe there is no cause to worry as long as corporate profits continue to grow at a fast clip," he says.

He admits investors can become mired in regulatory red tape but says that's changing. "With passing time, more knowledgeable and open-minded bureaucrats are coming to the fore and all the political parties now see the need for development - especially in the awfully inadequate infrastructure area," he says.

Birla's investment style can be described as defensive - focusing on bank, oil and gas, telecom and software stocks. "We remain confident that our disciplined approach to investing will stand us in good stead in the longer term," Mr. Argal says.

India isn't the only emerging market to be punished this year for trying to control an influx of speculative foreign capital. On Feb. 27 Chinese equities plummeted 8.8 per cent when a rumour circulated that China was about to introduce a capital gains tax. Over half of the loss was reclaimed the following day when the Chinese government published a front-page article denying the rumour. Even after the plunge the Shanghai Index had shot up 8 per cent in the first two months of 2007 after doubling the previous year.

"It's very hard for emerging markets to keep complete control over their monetary systems and currencies," says KBSH Capital Management international portfolio manager Drummond Brodeur. He says emerging market countries take that risk when they allow their currencies to float. "It puts them at the whim of global liquidity markets," he says.

This week China took steps to reduce its exposure to the U.S. dollar by diversifying its $143-trillion in foreign reserves away from the U.S. dollar to stronger currencies such as the euro. Mr. Brodeur says much of the money flowing into emerging markets is from investors looking to dump the low greenback. Mr. Brodeur only holds a small portion of his international equity portfolio in the Indian market and says that won't change with the restrictions on P-notes. Although he credits India for taking steps to prevent a crisis, not enough has been done to straighten the country's bureaucratic maze. "It's making India a little less accessible than it was before," he says.

Instead KBSH prefers to get its emerging market exposure through China by taking advantage of the decades-old regulatory infrastructure set up by the British when they ruled Hong Kong. The island nation was handed over to China in 1997 but the trading system remained relatively intact. "We have much more exposure to China because it's simpler to invest through Hong Kong," he says.

Investors looking for exposure to emerging markets can choose from several emerging market mutual funds offered by most major fund companies. Some companies offer pure-play Chinese equity funds and one - Excel Funds - offers a pure-play Indian equity fund. Investors might also want to consider one of several exchange-traded funds that track emerging markets as a block or individually.