Reversing defective reform

The recent intiatives by the government and the Securities and Exchange Board of India to curb stock market practices that facilitated speculation signify a belated retreat on the reform front.

THE Securities and Exchange Board of India (SEBI), the official stock market regulator, has taken more than two steps backward in the march towards financial liberalisation. Faced with pressure to respond to evidence of market manipulation, price rigging and excessive speculation, SEBI has decided to do away with carry-forward operations available through a number of schemes, as of July 2. In order to curb speculative practices, this decision has been combined with others such as a move to permit rolling settlements in a much larger range of scrips and the imposition of a synchronised settlement system across stock exchanges.

The most common among the schemes which allow market players to carry forward their transactions without settlement is badla trading. In that scheme, the stock exchange acts as an intermediary for loan finance at variable interest rates provided to those making share purchases without outlaying the required capital. The buyer, through his broker, undertakes the transaction without settling his bill, by agreeing to pay interest to a lender who finances the transaction for a period of up to 70 days. Depending on the demand for badla trading in the stock concerned, the interest rates vary. Since buyers expecting a short term increase in the prices of particular shares can choose to resort to badla transactions in the hope of selling out the stock within 70 days and settling their debt as well as booking a profit, badla was an institutionalised form of support to speculation.

This, however, was not the only form in which broking entities could, on behalf of themselves or their clients, increase their exposure to shares to an extent far in excess of their immediate capacity to pay. There were other means such as the offshoots of the Securities Lending Scheme introduced in 1997. These included the Automatic Lending and Borrowing Mechanism (ALBM) in the National Stock Exchange and the Borrowing and Lending Securities Scheme (BLESS) introduced in the Bombay Stock Exchange. Under these schemes, holders of dematerialised securities lodged as per statutory requirement with the Stockholding Corporation of India Limited (SHCIL) could 'lend' these shares to brokers or other trading entities for specified periods at pre-specified interest rates. This allowed traders to get access to shares that they did not own for varying periods of time, which they can trade, subject to their meeting interest costs as well as their commitment to return the shares to the SHCIL on behalf of their rightful owner. Thus traders expecting a fall in prices of shares ruling high currently can trade in borrowed shares at the current high price, expecting to buy the same shares at a lower price when the time comes to settle their transaction under the share lending scheme. These schemes too allowed brokers to increase their exposure to an extent far in excess of their net worth for speculative purposes.

The inherent tendency of deferral or carry-forward schemes like these to facilitate speculation is aggravated in markets that are prone to speculation. India's markets are indeed prone to speculation because they lack depth. Shares of only a small proportion of companies are listed in these markets, and of those only a few are actively traded. Yet these companies are able to use a high stock price to garner huge premia from share issues and the promoters of these companies benefit substantially from high share values when going in for mergers and amalgamations. The promise of such benefits encourage price rigging, through the agency of bull operators like Ketan Parekh, as was allegedly the case with the shares of Global Trust Bank in the run-up to its aborted merger with UTI Bank. Price rigging was also resorted to in the now notorious BPL-Videocon-Sterlite share-rigging episode, in which SEBI dragged its feet about taking penal action despite the incriminatory evidence yielded by its investigations. Those rigging prices used their own capital, borrowed funds and exploited schemes like badla trading to achieve their goals.

The problem becomes acute when manipulation of this kind is countered by other brokers and trading entities. At moments when a few players are willing to make purchases to drive share prices upwards, other brokers or trading entities reading the signals right or obtaining insider information, believe that the prevailing price is artificially high. This encourages them to sell shares which they do not own, by exploiting the stock lending scheme. Their sales at the prevailing high prices are expected to drive prices down, so that the same shares can be bought back at much lower prices, allowing the traders concerned to book a profit, before returning the borrowed shares.

Thus in shallow markets that are prone to manipulation, the so-called deferral or carry-forward schemes engender speculation of a kind in which the gains of some must necessarily involve losses for others. This makes such markets prone to a high degree of volatility, resulting in periodic price collapse.

It is of course true that financial markets the world over are prone to failure. However, the speculative disease to a far greater extent afflicts shallow markets, such as those in India. That is not the only problem. In some developed country contexts, such as the United States, a number of benefits are seen to flow from the functioning of their stock markets. First, they are seen as means of efficiently channelling household savings to firms undertaking productive investments. Second, since poor financial performance adversely affects the share values of firms, share prices are seen as signals for penalising errant managers as well as ensuring that poorly managed firms are taken over by better performing firms that exploit the low equity value relative to the actual worth of some companies. And, third, since share prices tend to move in tune with trends in earnings, the signals generated by stock markets are seen as means of attracting savings to the most deserving sectors.

It is true that even in the developed countries informational failures ensure that these expectations with regard to benefits expected from the stock markets are not always realised. But in shallow markets like India's, which are more manipulated than autonomous and where a few players dominate the markets, these benefits are virtually absent. The big and not always efficient firms and traders dominate markets and garner benefits at the expense of medium and small players. Further, small players often gain at the expense of ordinary investors. Small firms, for example, manage to mobilise capital only when the market is in the midst of a speculative fever. And at such times many of these firms are fly-by-night operators seeking to mobilise money from investors who burn their fingers when the collapse ensues. This is precisely what happened during the early 1990s.

GIVEN these features of India's markets, SEBI's decision to ban badla trading and other deferral products facilitating speculation cannot be faulted. The real criticism of SEBI and the government relates to their willingness either to allow such practices from the past to continue, even in a modified form, as in the case of badla, or to introduce them into the market, as was true of the stock-lending schemes. In fact, as part of the process of stock market 'reform' during the 1990s, the government at times actively encouraged such practices.

The proximate reason for the government's support of practices that facilitated speculation was the need to increase liquidity in the market in order to sustain its buoyancy. In fact, it is after the stock market lost the vibrancy it had displayed during the scam years in the early 1990s that the badla market was sought to be revived, stock-lending schemes were instituted, and banks were encouraged to invest in and lend against shares. These were all seen as means to increase liquidity in the market, in order to perk up trading volumes and prices.

But given the shallow nature of the stock markets in India, making it a limited source of capital for productive investment, why was there so much concern with activity in the stock market? In fact, a number of observers have pointed out that on many an occasion the monetary and fiscal policies of the government seemed to be obviously influenced by the desire to win the favour of market players. The government itself sought to explain the importance it gave to markets, by arguing that these markets can play the same roles of mobilising and allocating savings on the one hand and monitoring and disciplining corporations on the other.

In actual fact, however, the concern with stock market performance was driven by the need to keep foreign institutional investors (FIIs) happy. Among the presumptions that underlay the strategy of liberalisation were two of significance for this discussion. First, that in the medium term liberalisation would trigger a boom in Indian exports, which would help finance the higher import bill that it may entail. This was to occur because liberalisation would facilitate, by providing easy access to imported capital and technology and attracting foreign direct investment(FDI), the restructuring of domestic economic activity along internationally competitive lines.

The second presumption was that in the interim, liberalisation would ensure the inflow of foreign portfolio and direct investment, allowing the country to finance without difficulty the higher deficit on the current account that it may entail. This was seen as crucial since the accelerated liberalisation of the 1990s was triggered by the foreign exchange crisis of 1990-91, which showed that India was vulnerable on the balance of payments front. When the expected export boom does not materialise, as has happened with India, the strategy of attracting foreign investors becomes the bedrock of reform.

Thus, inflows of foreign investment were a critical component of the neo-liberal reform strategy. And a vibrant stock market was seen as a prerequisite for such inflows. Financial sector reform was seen as an important means to facilitating the entry of foreign investors into the country, as well as a device to ensure that India was an attractive destination for such investors. In this framework, debt-financed trading through the use of deferral products was a mechanism by which stock market vibrancy was to be sustained and foreign investors placated. It was for this reason that the encouragement of such practices was an essential part of financial sector reform.

However, shallow stock markets and speculation make crises as much a consequence of such liberalisation as temporary vibrancy. Periodic crises have made clear that such markets do not serve the objectives of mobilising and allocating capital and disciplining traders and corporations. It is this realisation, brought home once again by the post-Budget stock market crash, that has forced the government to retreat on carry-forward trading. In that sense, the recent initiatives are a retreat on the reform front. Fortunately, even if they do not help discipline private players, the markets seem to be capable of disciplining an errant government driven by a faulty perspective.