Stock prices collapsed more than nine per cent on Wednesday morning and trading had to be suddenly suspended after the country’s stock market regulator proposed curbs on the use of what are known as offshore derivative instruments through which foreign funds have been flowing in.
Over the past two months, India’s stock exchanges have been witnessing an unprecedented bull run.
The 30-share sensitive index of the stock exchange at Mumbai, the country’s commercial capital, has soared by over 5,000 points since mid-August to touch record levels despite domestic political uncertainty.
Much of this boom has been fuelled by foreign investors who have pumped in more than $4.5bn in Indian blue-chip stocks over the last fortnight alone. This year, net inflows by foreign portfolio investors have exceeded $17.5bn.
Scorching growth
The significance of the inflows taking place can be gauged from the fact that the amount that came in during two weeks in October was more than the total annual inflow a decade ago.
The Indian economy has grown by more than nine per cent for two years in succession - the first time that has happened for six decades.
Also, for the first time since independence, gross domestic product (GDP) has grown by an average of more than 8.5% a year for four years in a row.
What is attracting foreign funds to India is not merely the prospect of lucrative returns on investments in the shares of a clutch of rapidly-expanding companies.
India’s stock markets have been bullish
Their financial returns have been bolstered by the appreciation of the Indian rupee compared to the US dollar.
Over the last nine months, the rupee has gained roughly 15% against the American greenback and India’s currency is stronger than it ever was in nearly a decade.
In other words, the strengthening rupee has offered alternative opportunities to international investors who do the bulk of their business in US dollars.
The sharp rise in stock indices has, however, left substantial sections of India’s one billion-plus population cold.
Barely five per cent of Indians have any part of their savings in shares, including mutual funds.
The overwhelming majority of Indians prefer to keep their savings in bank deposits and in post offices, even if such deposits attract relatively low rates of interest.
India’s central bank reckons less than five per cent of total household savings find their way into the stock markets.
Vulnerable
Indians are parsimonious - roughly a third of the country’s GDP is saved and invested.
Yet, for many middle-class people, the share markets are perceived as gambling dens where prices are manipulated by speculators.
Such perceptions were reinforced by two major financial scandals that took place in 1992 and 2001.
Stock market punters nevertheless point out that India has become one of the world’s most attractive destinations for foreign funds because of its fast growing economy.
Certain sectors, including information technology, automobiles and pharmaceuticals, have been expanding at a particularly fast pace.
Barely 5% of Indians invest in stocks
On the other hand, the Indian economy remains vulnerable to high oil prices since the country imports three-quarters of its total requirements of crude oil, two-thirds of it from the Middle East.
In recent years, over half of the foreign funds that have come to India have been through "participatory notes" or PNs.
These notes are offshore derivative instruments issued by foreign institutional investors (FIIs) against underlying shares and securities that can be traded on the country’s bourses.
The "advantage" derived by users of PNs is that they can be individuals or firms who are not legally entitled to buy or sell shares in Indian stock markets but who operate through one of more than 1,000 FIIs registered with the market regulator, the Securities and Exchange Board of India (Sebi).
The fact that Sebi can lift the "corporate veil" only up to a point to identify the true beneficiaries of transactions using PNs, has made a number of Indian officials and analysts argue that the government should place restrictions on the use of such financial instruments.
’Hot money’
Senior government functionaries, including India’s National Security Adviser, have suggested on more than one occasion that stock market transactions should become increasingly transparent to ensure that flows of "hot" money - or funds obtained through illegal means - do not find their way into the country through stock exchanges and end up financing terrorist organisations.
It has also been argued that part of the money that is coming into the country actually belongs to persons of Indian origin who had kept their money abroad at a time when the government used to have stringent restrictions on the use of hard currency.
Mr Chidambaram has expressed concerns about the market
Such "round-tripping" funds are now returning to Indian through tax havens like Mauritius, it is contended.
Wednesday’s meltdown in the stock markets was a direct consequence of Sebi’s proposal to impose a slew of curbs on the use of PNs for share transactions.
Last week, market indices blinked after Finance Minister Mr Chidambaram wondered aloud why the markets seemed to be on an unstoppable roll.
At that time, the markets became spooked with speculation of early elections and ongoing political instability against the backdrop of a political standoff between the ruling Congress party and its communist allies over supporting a nuclear deal with the US.
But the markets resumed their upward journey again - until Wednesday.
So will the markets resume their bull-run or has the bubble burst?
No-one really knows for sure.
