False notes

Recent events in the markets confirm the suspicion that the stock market tail is wagging the economy dog as never before.

THAT the Indian stock markets have lost their moorings in the economic fundamentals is now a clich. What is not as readily recognised is that the economic fundamentals have been impacted adversely by foreign institutional investors (FIIs), the main drivers of the unprecedented stock market boom. Recent gyrations in the markets confirm the apprehension that the government is willing to appease the big guns of global speculative finance even at the cost of economic logic. Indeed, recent events confirm the suspicion that the stock market tail is wagging the economy dog as never before.

On October 16, after the markets closed for the day, the Securities and Exchange Board of India (SEBI), the market regulator, issued a discussion paper setting out a road map to wind up the issuance of Participatory Notes (PN), which, even according to a large section of market participants, are opaque instruments (see separate story). SEBI sought the views of market participants on the issue by October 20.

SEBI proposed that FIIs and their sub-accounts stop issuing PNs with immediate effect and sought that they unwind their current positions over an 18-month period. It also sought the discontinuance, with immediate effect, of fresh issue of PNs by broker sub-accounts of the FIIs. Clearly, the move was aimed at weeding out PNs and the 18-month period was to ensure that the markets did not crash as a result of bunched unwinding of positions.

For a long time several regulatory agencies, notably the Reserve Bank of India (RBI), have called for a halt to the issuance of this instrument, which has been used primarily by hedge funds to enter the Indian markets. For the RBI, the issue was not one of merely curbing excessive speculation in stock prices, which have driven share prices to unprecedented levels in the past few months (graphic below). The notion of throwing sand in the wheels of the market an expression made famous by Nobel laureate (1981) James Tobin in the context of the East Asian crisis a decade ago was appealing to the RBI not merely because it would curb speculation. More critically, the central bank saw it as a measure that would offer it respite from dealing with the macroeconomic imbalances posed by the influx of large volumes of portfolio investments.

The RBI found that the flood of money not only rendered ineffective its monetary policy the institutions raison dtre but also exposed the economic system to instability.

Mayhem followed the SEBI announcement, on October 17. In the Bombay Stock Exchange, trading halted minutes after it commenced, as the bellwether, the Sensex, dropped by 1,700 points. The markets recovered 1,000 points but not before Finance Minister P. Chidambaram made a statement. He said the government was not in favour of banning PNs. We have simply placed a cap on the proportion of money coming through PNs, he said.

Although Chidambaram refrained from mentioning anything adverse about the instrument itself, he gave some idea why the government had resorted to the move. In particular, he stressed that SEBIs proposals were intended to moderate capital inflows, which have been copious in the past few sessions.

Outside the Bombay

Reacting to the sharp fall in share prices, Chidambaram assured investors that sobriety would set in. Before the day is over, everybody will think it over and the market will cool down, he said. And, indeed, the Sensex recovered nearly 1,000 points by noon. But what really set the markets moving up again was a clarification from SEBI that there was no bar on PNs being renewed, provided they were done within 18 months.

The Sensex, which had breached the 19,000 mark on October 15, took fewer than ten more trading days to top 20,000, which it did on October 29. In effect, the Sensex registered a whopping 33 per cent growth since July 2007. No other asset, not even the highly speculative real estate business, currently offers comparable returns. Later, SEBI chairman M. Damodaran reiterated that the use of PNs would be restricted. However, he made two important concessions. The first related to allowing proprietary sub-accounts of the FIIs, which are formed to invest their own funds, to issue PNs provided they register themselves with SEBI within 24 hours. The other was to put FII registration on the fast track. Damodaran also said SEBI would consider broadening the list of categories of investors that can enter Indian markets as FIIs.

Although initial indications were that SEBI would not allow investors who were not regulated in their own country to be registered here, Damodaran later said that they may be allowed if they gave regulatory comfort about the nature of funds and the kind of investments made in India. He added that SEBI may waive the requirement that entities need to be regulated in their home country for being registered as an FII in India.

Damodaran also said that SEBI may allow foreign individuals with an investment kitty of over $50 million to operate as sub-accounts to invest in the Indian equity market. He said the condition that a foreign entity should have a one-year track record for getting registered as an FII might be reviewed.

The SEBI chiefs statements since the collapse of October 17 and the upward climb of stock prices since then give the impression that the FIIs have managed to wrangle a good deal from what appeared to be a weak position. Between October 17 and October 22 the FIIs liquidated (in net terms) more than Rs.6,000 crore in equities. However, between October 23 and October 30 they made net investments of more than Rs.3,300 crore in equities. Clearly, for them the India Story still looked good.

Statements of several FIIs, welcoming the SEBI move to weed out PNs, indicated that they now had other avenues of investing in Indian markets. The promised liberal approach towards registration is likely to open the doors to entirely new classes of investors pension funds, universities and charitable societies among others. The move is also likely to favour the larger FIIs, leading to greater concentration within the FII class of investors. The experience with FII investment indicates that larger funds have greater ability to effect volatility in the Indian markets, much more than what has been seen in the past few years. The recent developments indicate that FIIs have finally had their way. Even if PNs are phased out, they may still have the last laugh.

For some years now the RBI has been grappling with the problem of a copious inflow of foreign exchange. The inflow has played an important part in bolstering the foreign exchange reserves. In March 2005, about a year after the United Progressive Alliance (UPA) assumed power, the reserves stood at about $150 billion.

By the end of March 2006 they were almost $200 billion, an increase of one-third in a year, and as of October 19, 2007, they amounted to $261 billion, a nearly 25 per cent increase in six months since the end of the last financial year (March 31, 2007).

The effect of these burgeoning reserves has been felt particularly on the value of the rupee vis--vis the dollar. The exchange rate was Rs.39.58 to a dollar on October 24. At this level, the rupee has appreciated over 10 per cent compared with the levels prevailing on March 31. The rupee is now at its highest level against the dollar in more than nine years.

Large swathes of the real economy, particularly those tied to exports, ranging from software to textiles and even automobiles, have been affected by the appreciation of the rupee. Almost all industrial lobbies, including the Confederation of Indian Industry (CII), the Associated Chambers of Commerce and Industry of India (ASSOCHAM), the Federation of Indian Chambers of Commerce and Industry (FICCI) and others representing sectional interests, such as garment manufacturers, have appealed to the government for a bailout of some sort.

More critically, the burden of the rupees appreciation is likely to fall on workers in these industries in the form of wage cuts and/or more onerous working conditions so that companies remain competitive.

The government faced criticism from the Left and the Right for its handling of the issue. The Bharatiya Janata Party demanded a Joint Parliamentary Committee to determine who and which entities profited from the extreme volatility in share prices after the SEBI announcement. Kirit Somaiya, the partys former Member of Parliament and founder president of the Investors Grievance Forum, criticised Chidambaram for issuing the clarification to investors on October 17 and accused him of acting irresponsibly.

The Communist Party of India (Marxist) demanded a ban on PNs, seeing its continued existence as a part of the governments resolve to continue with capital account liberalisation. It pointed out that even such a half-hearted measure by SEBI has led to massive pull-out of funds precipitating a huge fall in the markets. This, it observed, only reflects the defiance of the FIIs towards regulatory institutions in India.

The RBI, in an effort to stem the appreciation of the rupee, has been adding to its foreign exchange reserves by buying dollars. Although the RBI has undertaken measures to mop up excess liquidity resulting from its purchase of dollars, it is finding it more and more difficult to sterilise the excess liquidity in the system. Moreover, there is always the danger of the central bank not being able to cope with a sustained speculative attack on the rupee.

While defending the rupee, the RBI also has to ensure that the overhang of liquidity does not stoke inflation. In effect, the RBIs ability to impose its monetary policy on the economic system is seriously compromised because of these large and increasing volumes of inflows.

The option of using the reserves to expand productive capacity through public spending referred to as deficit financing is a strict no-no according to the Fiscal Responsibility and Budgetary Management (FRBM) Act.

It is estimated that FII inflows account for about one-fifth of all inflows in the current year. The move to curb PNs, even if it had not sealed all routes, would have at least sent a signal to foreign investors that the government would not hesitate to use any means at its command to arrest speculative inflows. The dilution of the move evidently opens the doors to speculative attacks on the rupee.

Although precise data on hedge fund operations in India are hard to come by, market sources reckon that they are among the main holders of PNs. Between September 18, when the U.S. Federal Reserve cut interest rates, and the end of October, net FII investment in equity markets amounted to $7.53 billion. It is widely believed that U.S.-based hedge funds are the major contributors to the fresh inflows.

It is well known in market circles that hedge funds prefer PNs as the vehicle of investment. Hedge funds very existence is based on moving large volumes of investments across the globe in search of the slightest possibilities for arbitrage. Moreover, they play two-way bets in multiple markets, resulting in their making profits irrespective of the direction in which the markets move. They are, in effect, investors who can enter multiple casinos with a single ticket and make profits in each one of them.

Recent reports indicate that several hedge funds have resorted to currency arbitrage under the pretext of equity investments. Nameless and faceless, these funds apparently bet on both the upward and downward movement of the rupee, all under the pretext of investing in equities. Although RBI rules do not permit hedge funds to place bets on the Indian foreign exchange market, they park their funds in Indian equities, which they liquidate when the targeted profits, determined on the basis of levels in the forex market, are reached.

On October 30, Chidambaram reaffirmed that the country did face a problem of capital inflows. This is a complex, new situation for us. We welcome capital, but we must learn to manage it and how to absorb it. We need to put in place appropriate regulations and risk management systems, he said. He also promised that the Indian regulatory system will not fall behind [financial] innovation.

The unwinding of the U.S. economy, which started with the sub-prime lending crisis, has since enveloped the housing sector. Recent forecasts indicate that these may result in a squeeze on consumer spending, which can have ominous consequences worldwide.

Meanwhile, market players appear less bothered about what the RBI Governor has to say than what the U.S. Federal Reserve will do about interest rates. The recent cut in U.S. rates by 0.25 percentage points and more cuts are expected is likely to drive portfolios scampering to emerging markets, India being a prime destination. Even without PNs the RBI is likely to come under greater pressure to defend the rupee as it rises against the dollar.

It is well known that FIIs rule the markets (Frontline, June 16, 2006). Since 1991, FII investment in Indian equity markets have amounted to nearly Rs.3 lakh crore. The current market value of these investments amounts to nearly Rs.7 lakh crore. The market value of holdings through PNs account for a little over half of all investments of FIIs. In fact, while overall FII investment has increased 4.3 times between March 2004 and August 2007, holdings through PNs have increased 11 times.

It is clear that a ban, or at least a series of steps aimed at enforcing a ban over a clearly defined time frame, is not only prudent from a regulatory perspective but also necessary for macroeconomic stability. The watered-down interpretation of the SEBI ruling is unlikely to achieve either objective. In effect, the demands of the casino economy have taken precedence over those of the real economy.