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Wednesday, July 19, 2006

How Bernanke can kill the Emerging Markets

By Yaser Anwar, CSC of Equity Investment Ideas

The repercussions of Fed's decisions are seen across the globe. Take for example the case of India; whenever the Fed increases the interest rate, the Indian central bank follows suit. During last one year the Reserve Bank of India has every time sheepishly increased the rate in the aftermath of the FOMC meeting. These rate hikes cause exactly the same sort of ripples in the financial waters in India as they do in the U.S.

In most of the emerging markets the largest players these days are Foreign Institutional Investors. Since they have access to huge funds, they are able to garner total control over such markets within a very short span of time.

In India within a decade of beginning their investments in India, the Foreign Institutional Investors - or FIIs, as they are known here - have about 17% share of total market capitalisation. In case you consider the prime stocks, the stocks which comprise of the Index, the share is more. The FIIs have about 40% of the free float stocks in the 30 companies that comprise the SENSEX, the most popular stock index in India.

People buy what FIIs buy and they sell what FIIs dislike. Even a good profit making company gets a low price-earnings ratio just because it is not fancied by the FIIs. On the other hand, even a leper is hugged because it is the darling of the foreigners.

Till a decade and a half back, Greenspan could increase the rates or lower, the Indian stock prices remained unaffected. Developing-country markets are tiny, compared to a shallow pool. Even if a small piece of rock falls in it, half the water drains out. Then there is yet another problem: in developing countries often the foreign institutional investors adopt a herd mentality. Most of them tend to run in the same direction. When they come to buy, they come in droves; when they make an exit, they do it en masse. Euphoria and panic are more common and much greater in such markets.

This herd behavior has sufficient potential to destroy the financial system of any third world country. When dozens of these FIIs sell shares in one go, there is no buffer system to save the market from ending up in the pits. Even good profit making companies, with consistent dividend paying record are available at PE multiple of 3 or 5 and yet there is nobody to buy them. During May 2004 when the FIIs sold stocks worth a mere $700 million it caused a fall of almost 600 points in the Sensex.

All this boils down to a simple fact: that the Federal Reserve doesn't just manage the finances of America but of more than half the world; and that Ben Bernanke can sink the emerging markets with a stroke of his pen.

Summarized from Resource Investor

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