Market Under Fire: The Sensex During Indo-Pak Showdowns

By Giri Durga Prasad

A Critical Analysis of the Performance of the Stock Market During India-Pakistan War

A stock market is generally believed to be a reflection of the economic well-being and investor mood of a nation. World financial markets always react in uncertainty and volatility whenever political tensions escalate to the level of armed conflicts. India and Pakistan have fought rather too many wars since they both got their independence in 1947, which have had a major impact on the economy and financial markets of the subcontinent. In this paper, we provide a detailed analysis of how the Indian stock market has behaved during the numerous India-Pakistan wars, such as investor reactions, market trends, sectoral effects, and economic policy reactions in such testing times.

War's Effect on Indian Stock Market

Increased Volatility and Market Fluctuations

Throughout history, Indian stock markets like the Bombay Stock Exchange (BSE) have experienced greater volatility under conditions of conflict. The prices of stocks are subject to rapid fluctuations as a function of investor uncertainty regarding the war's duration, outcome, and economic consequences.

For example, the BSE Sensex fell by about 10% during the time of the 1965 war. Trends were the same in the 1971 war when the market saw high volatility and intra-day price fluctuations of as much as 7–8%. Fear of inflation, economic disruption, and changes in government expenditure priorities caused this volatility.

Rumors and speculation tend to increase market volatility during war, as price movements increase since investors respond to the most recent information. Furthermore, as investors become more fearful, liquidity dries up, and bid-ask spreads and price gaps widen.

Flight to Safety and Risk Aversion

Investors tend to trim exposure to equities during hostilities and switch money to less risky assets like government bonds, gold, or fixed deposits. Gold is the most sought-after safe haven during times of uncertainty.

While investors attempted to protect themselves from the risks that came with the war, facts reveal that Indian gold prices rose by approximately 20% when the war was waged in 1971. At the same time, as a reflection of a risk-averse investor base which did not want to take risks at times of geopolitical uncertainties, stock market trading volumes fell overall.

Moreover, international investors tend to exit owing to geopolitical risks, resulting in a significant relocation towards domestic government bonds, as they are perceived to be more secure. Such cross-border capital flight may increase downward pressure on share markets.

Sector-Specific Performance Variations

Conflicts affect various industries differently.

• Defence and Allied Industries: A rise in government defence spending typically helps firms that produce equipment for the military, weapons, and ammunition. In anticipation of continued military expenditure, defense stocks did better than the overall market by more than 15% during the 1999 Kargil War.

• Energy and Infrastructure: These industries sometimes yield mixed outcomes. Demand may increase due to increased logistical requirements in the case of war, but supply chain disruptions will create instability.

• Consumer Products, Hospitality, and Tourism: These industries usually decline during wars because of a decline in consumers' confidence and a decline in demand generated by security concerns or travel bans. For instance, the tourism industry experienced a steep decline during the 1965 and 1971 wars, and associated equities fell by 10 to 15%.

• Financial Services: During times of wars, financial institutions and banks will most likely be exposed to the risk of escalating inflation and economic uncertainty. As companies lose money, non-performing assets may rise, and therefore, prudent lending and less credit growth.

Macroeconomic and Policy Impacts

Wars require higher government expenditure, especially on the military, that tends to lead to fiscal deficits and inflationary forces.

• Defence Expenditure: India's defence budget usually increases steeply in the event of war. For instance, during the war in 1971, defense spending as a proportion of GDP rose from around 1.5% to more than 2.5%. Such an increase in spending puts pressure on the finances of the government and can displace private investment.

•inflation and Interest Rates: Inflation will tend to accelerate in times of conflict as a result of government expenditure and supply chain disruptions. The Indian wholesale price index (WPI) increased by around 5% during the 1971 war, indicating elevated commodity prices. Higher inflation makes central banks raise interest rates, which can inhibit business growth and consumer spending.

•Foreign Investment and Capital Flows: Wars tend to lead to capital flight as foreign institutional investors either exit or scale down their exposure because of geopolitical risk. During the Kargil war, India saw foreign portfolio investment outflows amounting to nearly $200 million in a couple of months, putting downward pressure on share prices.

•Exchange Rate Pressures: Geopolitical tension and capital flight have the potential to devalue the domestic currency. For example, amidst conflict, the Indian Rupee has frequently weakened against the US Dollar, making imports dearer and accelerating inflation further.

Market Resilience and Recovery Post-Conflict

The Indian equities market has in the past proved to be resilient after conflicts have been resolved. Following the initial shock to markets and risk-off after wars, peace and stability in politics have a tendency to revive investor confidence, fueling market rallies.

Following the 1971 war, the BSE Sensex rebounded sharply within six months, gaining over 25% as optimism returned with the war’s successful conclusion and enhanced political stability. Similar recoveries were observed post the 1999 Kargil conflict, with the market recovering lost ground within a few months.

This alternating pattern is due to the market's propensity to first overreact to geopolitical tensions, only to ultimately conform to economic underlying fundamentals. The rebound periods tend to get visited by value investors who take advantage of cheaper stock prices to accumulate positions, thereby driving the market recovery.

Broader Economic Implications

Stock markets have been the only casualty so far of wars with Pakistan, but the aftermath of wars has also left a long-term footprint on India's overall economic landscape. Excess defense expenditure during wars tends to create fiscal deficits, which limit the economy's growth.

Additionally, the conflicts tend to interrupt trade flows, especially with Pakistan and regional nations, leading to supply chain disruptions that impact industrial manufacturing and consumer good supplies. Inflationary pressures at such periods cut into real incomes, lowering domestic spending and business activity.

Further, increased geopolitical risk tends to prolong foreign direct investment (FDI) inflows, which are key to infrastructure development and modernization of industry. Investors tend to go on wait-and-see mode, further dampening prospects for growth.

Apart from these challenges, India's increasing domestic market size and economic fundamentals have assisted in balancing the long-term economic cost of conflicts. The strength of Indian institutions and the economy's diversification also facilitate faster recoveries post-geopolitics' shocks.

Conclusion

India-Pakistan wars of 1947-48, 1965, 1971, and 1999 have had far-reaching impacts on the stock market performance of India and the overall economy. Every war added high volatility, investor risk aversion, and shifts in sectors within the stock market. Although sectors like defence experienced increases, industries such as tourism and consumer discretionary lost out.

Wartime policies, especially increased defence expenditure and resulting fiscal deficits, have added inflationary pressures and impacted capital flows. Foreign investors often exit during conflicts, compounding market pressures. However, the Indian stock market has consistently demonstrated resilience, rebounding strongly post-conflict as political stability returns and investor confidence improves.

Knowledge of these patterns gives us essential insights into the impact that geopolitical conflicts have on financial markets. It highlights the need to track macroeconomic indicators, government policy reactions, and sectoral trends in periods of geopolitical tensions.

With India strengthening as a significant emerging economy, the behaviour of the stock market during such pivotal moments not only indicates the risk generated by external conflicts but also the intrinsic strength and resilience of its financial system.