Financial fraud and the ethos of liberalisation

The post-Budget collapse of India's stock markets only proves that financial liberalisation aggravates the inherent tendency of shallow markets to foster excessive speculation and worsens the systemic consequences of such speculative activity.

REVELATIONS of fraud, evidence of insider trading and a consequent collapse of investor interest have led to an almost unstoppable downturn in India's stock markets since the presentation of Union Budget 2001. This link with the presentation of the Budget is not coincidental. Judging by the coverage of recent budgets in much of the print and electronic media, there is a widely prevalent belief that budgets are best assessed by financial market spokesmen and by their impact on financial markets. This premium on 'market responses' (meaning thereby purely financial market responses), even if overdone, is a fallout of economic liberalisation.

One of the much-emphasised benefits of liberalisation was to be the positive impact it would have on financial inflows into the country. The reason why speculative financial investments, as opposed to greenfield foreign direct investment (FDI), should be inherently positive is of course unclear. But let us drop such scepticism for the moment. The point to note is that the concern with attracting foreign capital flow has been reflected in the government's fiscal, monetary and financial policies in recent years. Financial liberalisation has not just permitted, but eased and rendered more attractive, foreign financial investment in India. And budgets have been framed with the intent of not just satisfying financial investors from abroad but of attracting them by keeping the financial markets buoyant.

The spoken responses of financial agents and the activities as reflected by market indices were therefore seen even by the Finance Ministry, and not just by the media, as an indicator of success in budget formulation. This has meant that the pressure to please financial players has had a major role in shaping recent budgets though, given the whimsical demands of finance, success is never guaranteed.

Paradoxically, for the speculator in the stock market this has provided another counter to bet on. Would the Budget trigger a sharp rise in financial markets, however short-lived, or would it not? Differing answers to that question would elicit different speculative responses. This was the question which Ketan Parekh, the most recent incarnation of the perennial 'Big Bull' in India's stock markets, had set himself and answered in the positive in February this year. What followed is now history.

Expecting to be able to offload the stocks of a select set of companies at higher prices in the wake of the Budget, Parekh built up large positions in these scrips. In normal circumstances, this very act of investment by a market-mover like Parekh should have provided a spur to the Sensex. It in fact did. Both just before the Budget was presented and immediately thereafter prices did rise. But that very signal gave cause for a bear cartel to turn suspicious. Allegedly consisting of stock market insiders, including the president of the Bombay Stock Exchange himself, who in violation of SEBI norms checked out from the surveillance department as to who was making large purchases and of which stocks, this cartel discovered that the rise in the index was the result of speculative purchases of select shares. In a world where financial gain, however garnered, is the indicator of success, the cartel chose to offload large volumes of the very same stocks acquired at prices much lower than those prevailing in the market driving prices down.

There must have been a brief period when Parekh struggled to keep the prices of his favourite stocks buoyant in the wake of the bear hammering. But if he did, his effort obviously failed, paving the way for the slide of all stock market indices. This simple tale of a speculative bout between bulls and bears turns more complex and bizarre when a set of related questions begin to be asked and the consequences of the market collapse begin to be assessed.

LET us begin with the related questions. What explains the fact that a few operators, who in one way or another are market insiders, can make and break India's much-celebrated financial markets? Analysts attribute this to the fact that markets in developing countries like India are thin or shallow in at least three senses. First, only the stocks of a few companies are actively traded in the market. Second, of these stocks there is only a small proportion that is routinely available for trading, with the rest being held by promoters, the financial institutions and others interested in corporate control or influence. And, third the number of players trading these stocks are also few in number. According to the Report of the SEBI's Committee on Market Making, "The number of shares listed on the BSE since 1994 has remained almost around 5,800, taking into account delisting and new listing. While the number of listed shares remained constant, the aggregate trading volume on the exchange increased significantly. For example, the average daily turnover, which was around Rs.500 crore in January 1994 increased to Rs.1,000 crores in August 1998. But, despite this increase in turnover, there has not been a commensurate increase in the number of actively traded shares. On the contrary, the number of shares not traded even once in a month on the BSE has increased from 2,199 shares in January 1997 to 4,311 shares in July 1998." The net impact is that speculation and volatility are essential features of such markets. According to one analyst, the role of speculation is visible in the high ratio (3:1) of trading volumes to market capitalisation in what is otherwise a shallow market.

These features of the market have a number of implications. To start with, Foreign Institutional Investors (FIIs), whose exposure in Indian markets is an extremely small share of their international portfolio, making India almost irrelevant to their international strategies, have an undue influence on the performance of the markets. The sums they invest or withdraw can move markets in the upward and downward direction, as recent experience has amply demonstrated. This forces governments that are keen to have them constantly making net purchases and driving markets upwards to bend over backwards in appeasing them. A corollary of this influence of the FIIs is that any market player who is able to mobilise a significant sum of capital and is willing to risk it in investments in the market can be a major influence on market performance. This explains the importance of operators like Harshad Mehta and Ketan Parekh, the Big Bulls of the 1990s, who rose from being small traders to become crorepatis and were lionised for their resource mobilisation and risk-taking abilities, which made them movers of markets. Ketan Parekh is reported to have risked his investments on a few sectors (the so-called technology stocks) and few firms, and till the recent debacle always seemed to come out right in terms of his judgment. He had, it now appears, a major role to play in rigging share prices, as he allegedly did in the case of Global Trust Bank (GTB) shares prior to the aborted merger of UTI Bank and GTB.

THIS brings to the fore the second related set of questions and concerns. What were and are the sources of funds of these domestic bulls who take risks and drive markets, for at least some time, and of the bears who on occasion even hammer them out of business? Brokers, we must recall, deal only marginally with their own resources. Their primary role is to convince investors to provide them funds to realise strategies they believe would yield quick and large returns. Media reports on the events that led to Ketan Parekh's fall from grace have focussed on the funds he fraudulently acquired from Bank of India and other commercial banks. That story is now well known. Parekh was issued pay-orders, which are in the nature of demand drafts, by the Ahmedabad-based Madhavpura Mercantile Cooperative Bank (MCCB), without any reciprocal pay-in of funds either directly in the form of cash or indirectly in the form of deposits that could serve as collateral for a loan.

This was not without any reason. In the past the MMCB must have benefited immensely from its association with Parekh, as is evident from reports suggesting that its total exposure to Parekh was in the range of Rs.800 crores. Clearly Parekh and the MMCB management saw the issue of around Rs.200 crores worth of pay-orders as a form of temporary accommodation that would be made good by Parekh as soon as his speculative trades had been completed. A reading of Budget 2001, which provides a range of sops to render markets buoyant, does in fact suggest that his gamble was not all to wild. It failed, rendering the MMCB pay-orders worthless, not so much because of the judgment on which it was based but because of the concerted move by the bear cartel to exploit unfairly obtained knowledge of Parekh's manoeuvres by dumping the shares on which Parekh was placing his bets.

But, given Parekh's access to resources and acumen, he must have made an attempt to counter these moves of the cartel. Hence, the collapse in prices could be explained only by the ability of these operators to supply an adequately large sum of these and related shares.

What, then, was the source of the riches of the bear cartel, which finally won out? While a final judgment on the matter must await SEBI's report on the basis of its investigation, there are a number of strands of the answer that have been revealed. Being regular operators, it is quite possible that the bear operators had in their pool significant amounts of these crucial stocks, not necessarily belonging to them, but which they were trading on behalf of the investors they represented. It is true that under the recently framed rules relating to trading and settlement in dematerialised form, these stocks have to be lodged with a depository against the name of the actual owner. However, in practice many brokers carry large volumes of stocks in their pool accounts.

Various reasons, such as the use of stocks as margin deposits by clients, delay in the flow of instructions from the client's depository participant to the broker's depository participant and intentions to sell in the subsequent settlement period, have been used by broking houses to explain away the unusually large pool accounts. In the event, there are a large number of in-transit shares that brokers have access to, even if they do not have legal ownership right to trade in them.

THIS pool, however, does not limit the trading ability of the bear cartel. It could use a number of avenues afforded by stock market rules, framed in the wake of liberalisation, to increase liquidity in the market. One such is the practice of borrowing and lending stocks. Under the Securities Lending Scheme introduced in 1997, holders of stocks lodged with the depository, like Stockholding Corporation of India Ltd (SHCIL), could come to an agreement, implemented through the intermediary, to lend these stocks to others for a specified period of time for an interest. Some holders of stocks, like FIIs and institutions like the Unit Trust of India (UTI) and insurance companies often have large volumes of individual stocks in their kitty. So long as members of the bear cartel have information as to which players have large volumes of specific stocks, they can work out a deal to borrow these shares, providing them access to the shares even if they do not have the right to trade in them.

Knowledge of the existence and source of the required shares can encourage the practice of short-selling, or sale of shares not owned by the trader, in the belief that prices are going down and the shares can be made good to the actual owner by buying them back at much lower prices at a later date.

That this practice was resorted to by the bear cartel is clear from the fact that SEBI decided to ban short sales in the wake of the collapse in stock indices in March. Thus the bear cartel clearly required little by way of own resources to indulge in the activities that led up to the collapse of the markets.

The bear cartel's activity borders on bravado because of the consequences that the slump in prices resulting from its actions have had. First, to the extent that bulls like Parekh suffered losses, they needed to settle their dues with additional resources. In Parekh's case the dues were ostensibly the wherewithal needed to ensure that MCCB could honour the pay-orders it had issued to him without any down payment either in the form of cash or deposit collateral. In other cases, brokers had expected to settle dues either through the sale of shares they held or borrowing against those shares. "Settlement" requires a pay-in by those who accept deliveries of scrips that they have agreed to buy, and a pay-out to those who have submitted the shares for delivery as agreed. Delayed settlement possibilities, permissible under the modified carry-forward scheme (MCFS) operating in Indian stock markets, can lead to settlement problems because they encourage excessively high speculative positions on the part of brokers expecting to be able to realise the required funds when the settlement day arrives. But in many cases the collapse in the interim of the value of the shares they hold make the settlement impossible to ensure, leading to payments problems, which were particularly acute in the Calcutta Stock Exchange (CSE), located far away from the centre of Parekh's activities.

Second, the effects of the speculative collapse soon spread to the banking system. To start with, banks like the MCCB which had accommodated the loser and others that had invested in the MCCB or had made large deposits with it for services such as clearing, which includes a number of other cooperative banks in Gujarat, found themselves saddled with worthless, real or intangible assets, resulting in weakness of a kind that triggered a run on these banks. Further, even regular commercial banks, which had lent against shares as collateral, found that the value of that collateral had fallen substantially relative to the sums lent, forcing them to demand an increase in collateral to protect loans made in many cases to brokers who had suffered losses in the wake of the bear hammering. The full effects of the scam on the banks, and the distribution of loss provisions amongst them would be clear only later. What needs to be noted is that once the process of divesting public equity in banks proceeds further this can have larger implications. Even now, the shares of a number of public sector banks that have diluted their equity are ruling below par. If the same occurs in the wake of large-scale dilution, they would be ideal candidates for take-over as part of a process of financial consolidation that would put control of large volumes of household savings in a few hands.

Third, small investors holding safe securities either directly or indirectly through agencies like mutual funds find the value of their investments eroded for reasons that are neither legally valid or within their control or even ken. This would naturally undermine their faith in stock investments. But this occurs precisely at a time when a liberalisation-driven effort to cut interest rates on long-term deposits and small savings schemes is forcing them to participate in the markets.

Finally, this loss of faith in stock markets is only being aggravated by the fact that the viability of these markets is being challenged by the consequences of speculative losses. Faced with settlement problems, and unable to postpone settlement indefinitely, the CSE has found even its Settlement Guarantee Fund (SGF) inadequate to cover the shortfall. The management of the exchange has saved face only by getting some 'friendly' financial institutions to pick up large volumes of stock at a discount in order to provide brokers the funds needed to meet their settlement obligations.

All of this reveals the fragility of the financial system that is being provided greater room for manoeuvrability by the financial liberalisation that seeks to attract foreign investors into India's shallow markets. What is more, by increasing manoeuvrability and by allowing banks to support trading activity indirectly, and by privileging stock market buoyancy as an indicator of economic success, liberalisation is increasing speculative activity and aggravating the fragility of the system. In the effort to shift the focus away from the folly of liberalising markets so prone to speculation, the government is now pointing its fingers at the inadequacies of the regulatory authority. What is missed here is the fact that the ethos of liberalisation that gives the financial markets the pride of place in assessments of the success of the economic policy forces the regulatory authority to be flexible and even formulate rules providing room for manoeuvre to private operators in order to keep markets buoyant even when the real economy slows down. The point to note is that the only players who need these markets are the speculators, a few large corporates and, of course, the FIIs who in the wake of the collapse are busy picking up shares at huge discounts.