India markets prepare for fall

Although the bombing outrage in India two days ago caused widespread condemnation, surprisingly it had very little effect on the stock market in India itself – the Bombay Stock Exchange instead focused on economic factors and the Sensex index closed up at 10,930.

There may be a bigger crisis looming though, and this time the problems could come from Japan. Tomorrow the Bank of Japan will decide whether to increase rates from zero to 0.25 percent or more, bringing to an end cheap cash – cash which the Hedge funds have been using to fuel the markets in India.

On June 1 the European Central Bank (ECB) warned of the risks to market stability from what it called the – correlation of hedge-fund returns. If all the hedge funds are doing the same thing – such as placing huge leveraged bets on the Indian stock market, a major casualty of the post-May 11 global sell off – then all their returns will be – correlated – or, in non-economist terms, similar. ECB vice president Lucas Papademos stated: The increasingly similar positioning of individual hedge funds … is another major risk for financial stability.

The bets are on at the moment that this means the Hedge funds will look to quickly withdraw from the more risky emerging markets – the two most likely at the moment being those most fuelled by cheap Japanese cash. Any resultant outflow of cash back to Japan is likely to cause a rapid decline in stock values.

As we all know, it is the riskier markets that benefit most in the good times, and decline the fastest in the bad times. We expect that rapid Indian and Turkish market declines are a ‘sure thing’ if the Bank of Japan does raise interest rates – the only question is how much leverage the Hedge funds have at the moment and how quickly the money will pull out of the markets.