Soaring Sensex

At the Bombay Stock Exchange. - PAUL NORONHA

The stock markets are on song, but their volatility and the rampant speculation deter genuine investors from venturing into the market.

THE Indian stock markets are sizzling. The primary measure of the mood in the markets, the Bombay Stock Exchange's (BSE) Sensex, appears to be on steroids. Between June and September 2005 the Sensex rose by more than 1,500 points, the sharpest climb since the United Progressive Alliance (UPA) assumed office in New Delhi in 2004. Analysts and self-appointed market pundits predict the Sensex will be at 10,000 by the end of the year. Citing recent economic performance, which shows that the Indian economy grew by 8.1 per cent in the first quarter of 2005-06, they say international investors see India as a promising destination for investment. Sceptics remain muted amid the feel-good in the markets. Although there is plenty of evidence to show that the markets have turned extremely volatile, no one, it seems, wants to be seen as spoiling the party.

Meanwhile, Indian markets continue to remain scam-prone. On September 21, the markets tumbled by over 200 points. Although the Sensex recovered ground during the day, it collapsed again the following day. The Sensex fell by more than 250 points on September 22, shaken by reports of raids by the Income Tax Department on brokers in Ahmedabad. The attempt to get domestic financial institutions (FI) to prop the market failed. The media, which have generally aided the bull run in the bourses, reported that that the Prime Minister's Office (PMO) was tracking the happenings. There were reports that the Intelligence Bureau (I.B.) and other regulatory agencies were investigating.

The government denied reports that the I.B. was involved in the investigations. But what it admitted was even more embarrassing. In a hastily convened press conference in New Delhi on September 22, U.K. Sinha, Joint Secretary in the Union Ministry of Finance, said the government was only investigating the sharp increase in the price of "penny stocks" - dud companies whose share prices have appreciated by as much as 1,000 per cent in a matter of days in some cases. Earlier, on September 17, Union Finance Minister P. Chidambaram said Indian markets were in the "comfort zone". He asserted that there was "no scam in the offing".

Chidambaram said he was not particularly concerned about the movement of the Sensex. He said he would rather place emphasis on the price-earnings ratio (P/E), a measure of the earning potential of equities in relation to their prices. Chidambaram said that as long as P/E ratios remained in the "comfort zone", there was no cause for worry. He pointed out that the current P/E ratios were about 16.5, compared to the level of 30-40 during the two biggest scam-tainted bull runs of the past, in the early 1990s (associated in public perception with Harshad Mehta) and in early 2000 (when Ketan Parekh was widely seen as the primary driver of the scam). Chidambaram said the government maintained a close watch. The Reserve Bank of India (RBI), he said, was ensuring that banks' exposure to equities did not go beyond the limits set. The central bank, he said, was also ensuring that non-banking finance companies, which were believed to be a key source of funding in the markets, were operating within the parameters set by it. Meanwhile, the Securities and Exchange Board of India (SEBI) was looking into the sharp increase in the price of penny stocks, he said.

ALTHOUGH the Sensex recovered ground, gaining more than 400 points by September 29, several worrying issues remain unattended. First, there is growing evidence that the volatility in Indian markets has increased significantly in the past few years: in fact it is not only increasing but is far higher than that in most other markets worldwide. Data put out by the National Stock Exchange and SEBI show that the intra-day fluctuation in share prices has increased significantly in the last few years.

Secondly, the stranglehold that foreign institutional investors (FII) have established in Indian markets in recent years not only exposes investors to greater volatility but also greatly destabilises markets. By September 22, when the markets collapsed, FII inflows into Indian markets in this calendar year had crossed $8.45 billion; in comparison, $8.5 billion was invested by FIIs in the whole of 2004. Indeed, market players recognise that there are no counterweights to the FIIs. Between June and September 28, 2005, FII investments in equities in Indian markets amounted to Rs. 22,504 crores, more than double the level during the same period in 2004.

There is growing concern that the size of these players can have serious consequences for Indian markets, investors and regulatory structures. Sceptical analysts and market-watchers point to the fact that the huge size of these funds has no matching countervailing domestic force. This is particularly because financial liberalisation has not only weakened Indian financial institutions but led to the collapse of some of them, such as the Unit Trust of India, one of the biggest players in equity markets before the advent of the FIIs.

L.C. Gupta, director, Society for Capital Market Research and Development (SCMRD), Delhi, says that FIIs are the "principal drivers" in the stock market. Domestic FIs such as the Life Insurance Corporation and mutual funds play "a relatively minor role". Studies conducted by the SCMRD show that in the last two to three years, domestic FIs bought only 1 per cent of the value of equities bought by the FIIs.

Assets held by domestic FIs in equity schemes have declined, yielding to assets in income schemes. "In effect, bonds have become more attractive compared to equity," said Gupta. This perhaps also reflects investors' unease with the stock market. They probably prefer lower yields in the face of the greater risk that volatile markets imply.

Prithvi Haldea, managing director of Prime Database, which specialises in providing information services on the primary market, told Frontline that India was a "hot investment destination" for FIIs. "Basically, once the chase starts, it gains momentum. Some FIIs invest, then the market starts looking good, and several others join in and the chase begins," he said, referring to the herd instinct of FIIs. Haldea warns that FIIs "can pull out just as fast as they arrived". That, he says, is the real risk of hot money flowing in. If that happens the markets could crash "by several hundred points".

FIIs hold more than 25 per cent of the top 100 scrips (in terms of turnover). This has implications for the increasing volatility in the Indian stock markets. Since holdings are more narrowly distributed and because FIIs enjoy immense clout by virtue of their ability to bring in dollars to swamp the markets here, stock prices tend to be held captive to their whims and fancies. Since the world is their stage, happenings in other markets will influence Indian bourses, primarily through the FII mechanism. There is a growing perception that "good" stocks are in short supply and too much money is chasing too few stocks. This explains the sharp upsurge in stock prices. Haldea points out that the Initial Public Offer (IPO) market, unlike the secondary market, has been quiet. This, he explains, is why the stock markets are ablaze.

Ranjit Dongre, a Mumbai-based investment analyst, estimates that "almost 60 per cent of the funds have come from FIIs based in Asia, unlike in the past when funds came mostly from FIIs based in the West. He believes that the upsurge in the market is mainly "liquidity-driven".

The third issue relates to the regulatory structures in Indian markets. L.C. Gupta says that the government seems to equate increased turnover in the stock markets with the healthy development of the capital market. "Our systems are not very sound," he says. Political authority, whether it is the previous National Democratic Alliance (NDA) regime or the present UPA, does not want to do anything that will result in lower trading volumes. This, says Gupta, has become a "political gimmick". "The NDA government concentrated on the Shining India, Shining Markets theme. This government too seems to be doing the same," he says.

The volatility in the markets and the rampant speculation that accompanies it have been aided by a lack of regulatory oversight. For example, single stock futures were introduced in November 2001. Since such trades deal with a physically deliverable asset (unlike index futures, which are notional), positions that remain outstanding on the settlement date (when the contract expires) should be settled by actual deliveries. In 2001, single stock futures were introduced mainly to placate the broking community after the badla system was abolished in the face of severe opposition from brokers. The government readily succumbed to the pressure; even the U.S. at that time did not allow single stock futures.

The then SEBI Chairman announced that the requirement of physical settlement would be implemented in six months. But almost four years later, it has still not been done. Gupta says: "This is an unsound system, which encourages excessive speculation. The system of trading in the Indian markets is like gambling. It also discourages investors from taking a long-range (of at least five to10 years) view of the companies they are investing in. Instead, investors are primarily interested in returns over the next few days, weeks or months."

Data from the Central Statistical Organisation (CSO) and the RBI show that the proportion of household savings in the form of equities has been declining in the last few years. Gupta says that recent surveys of household investors conducted by the SCMRD indicate that the investor's biggest worry is the volatility in the markets. Says Gupta: "This is not difficult to understand. Investors who buy shares and often find that prices fall by 3-5 per cent within the day (sometimes even 10 per cent) feel cheated."

- With inputs from Anupama Katakam