Potential Policy Response: Stock Stabilisation Fund

Hello all.. Below are my thoughts on setting up a stock stabilization fund by emerging economies such as India, China for their own stock markets.. Let me know what your think?

The recent sell-off in equity markets around the world has created a heightened sense of fear and panic amongst equity investors to the extent that investors, most of whom have already lost anywhere between 20-60% of their capital, are have turned extremely risk averse and continue to stay away from equities despite them being at historically low valuations. One measure of risk aversion, the Chicago Volatility Index (VIX) touched 89.53 intra-day on Oct 24th; the earlier high made by the VIX – 49.5 – was in October 1998 during the LTCM crisis.

An environment of fear and panic is not conducive for investments in equity markets. The process of global de-leveraging has led to sharp cuts of over 20% in the last two months alone. While deleveraging is an inevitable outcome of the credit bust, the speed of the process has led to markets overshooting what many analysts would consider cheap valuations. Sharp falls in asset values has led to panic selling even by unleveraged entities which are otherwise not directly affected by the credit crisis. The consequence is that many markets have become relatively thin with few buyers and many sellers – even a smaller volume of selling pushes equity prices down sharply leading to mark-downs in investor’s books leading to further panic selling.
While equities are risky assets and it is in the nature of equity prices to volatile, the current decline has been, by many counts, the most vicious in financial history. The sharp fall in asset values lead to a negative wealth effect on institutional and individual balance sheet. The negative wealth effect start second round effects of declining private spending and investment which lead to contraction/slowdown in GDP. The second round effects are already underway in Europe and USA where consumer spending has started showing signs of declining and economies are headed towards recession.

Emerging economies which have been growing strongly thus far have once again become victims of financial contagion. Between August to October, South Korea’s stock market lost as much as 37% the currency as much as 35%. The Indian rupee weakened 18% and the equity markets fell 45% in the same period. China, a market already down 53% from its 2007 highs, fell a further 38% in the August – October period, a total fall of 72% from its previous high. While one can argue, and correctly so, that the emerging economies will experience slower growth in the coming years (as was evident from South Korea’s and China’s recent GDP numbers) and that this will naturally be reflected in the equity markets, the magnitude of the fall is extreme compared to the American and European economies which will experience potential GDP contraction.
In such extreme circumstances, we argue that extreme steps are required.

Specifically, we argue that in emerging markets, governments with high levels of reserves parked in European and American gilt securities ought to redeploy the reserves towards domestic equity markets with the aim of bringing back stability to the markets. We further argue that the cost of setting up a fund need not be very high. In India, for example, foreign investors have sold stock worth $13bn in 2008 leading to a stock market decline of over 50%; the total amount of portfolio investment remaining in India is in the region of $75bn). The amount held by the country in reserves is in excess of $250bn. Even if the government were to deploy $25bn in the equity markets with a publically stated aim of buying stocks at stress case valuations (which it is not hard to argue that equities are prices at), it would return confidence in the market and encourage private investment once again. Such a policy was adopted by the Hong Kong Monetary Authority in 1998 to prevent the financial system from collapsing. Not only were they able to successfully stabilize the financial system and the economy, the government was able to profit from its investments in the stocks.

Since the acceleration of the credit crisis in 2008, the US Federal Reserve has, rightly so, employed a wide variety of policy measures – unlimited bank lending, currency swap lines, buying commercial paper, helping money market funds, brokering and guaranteeing acquisitions (Bear Stearns), etc – to prevent the financial system from collapsing and acutely affecting growth. It may not be a bad idea that emerging markets, where financial markets are being subject to the headwinds from developed markets, take some extraordinary measure of their own to sustain growth and stability.