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Opinion - Foreign Institutional Investors
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Bad money drives good money out

Saumitra N. Bhaduri
S. Raja Sethu Durai

DALAL STREET is in a jubilant mood with the Sensex surging past the 10,000 mark. Yet, the volatility in the market continues unabated. The recent fluctuations mirror the whims and fancies of Foreign Institutional Investors (FIIs).

From the first week of November to the third week of December 2005 the Sensex gained more than 1,450 points. But within a week, by the end of December, the Sensex had crashed by about 300 points. Albeit their miniscule share in the total market capitalisation, the FIIs play an unduly critical role in the stock market. Consider:

The FIIs' gross purchase is 1.2 per cent and net investment about 0.13 per cent of the total market capitalisation that stands at around $513 billion and the correlation among the FIIs net investment and the Sensex exhibits as much as 0.63 over these years.

The recent surge is attributed mainly to FII hyper activity; there is nothing to indicate that they have subsided and the FIIs continue to be a force in the market.

To understand this hyper activity of the FIIs, the sources of the money have been put under the microscope and attempts made to understand why it is flowing so freely into India. But that is not an effective strategy to sanitise the hot money impact on the market. There is an efficient alternative of countering their hyperactivity with active participation of the domestic investors by increasing the depth of the market.

This lack of depth is a consequence of the perception that the stock market is a playground for speculators and small-term profit-seekers created by the two major scams that occurred within a decade, thereby scaring away potential long-term investors.

This made way for speculators to ride the changed pace of the Indian financial markets. Also, the face of Corporate India has changed significantly over the years. Also the consistent corporate results supported by a strong economy, signal the emergence of an energised stock market.

At this juncture two important questions arise. First, does the Sensex truly reflect the fundamentals? Second, is this bullish movement of stock market stable and sustainable?

A simple way to make the Sensex stable and sustainable is to replace the bad money — that moves in and out of the market — with the good money, that stays long in the market.

The real question, however, is, where is the good money? A glance at the household savings pattern will show that good money is aplenty, but barely shows up in the stock market.

Household saving pattern In India

The last decade saw a sizeable change in the savings pattern of households. Total domestic savings more than trebled but there has been a significant re-allocation between investments in shares and debentures, and small savings.

In 1993-94, the household investments in shares and debentures stood at 9.3 per cent of the total household saving, whereas the investment in small savings stood at 4.1 per cent. In 2003-04, this scene reversed as the investments in shares and debentures absorbed a mere 0.8 per cent compared to small savings' 8.5 per cent. This shows households' interest in long-term investments.

Had the 1993-94 pattern of investments in shares and debentures continued, the stock market would have had additional resources of around Rs 56,000 crore.

This would have been substantial enough to ensure the much required liquidity in the market to withstand the hyper activity of FIIs whose net investment in 2003-04 was Rs 44,000 crore. The bar graph depicts this pattern.

The Table gives detailed returns for an investment of Rs 1,000 with different alternatives.

The return on investment held at least for one year in the stock market is significantly higher than the five-year return from other investment options.

Yet, investors are parking their money elsewhere. This could mean that the perception of the stock market as not being safe has not changed.

To change this sceptical view, first, the Government has to resolve its cynicism about the stock market. The Government and the regulator have a strong case to act towards making the market a safer place, one that rides only on the fundamentals.

A better prescription

Recently the Government took a bold step towards resolving its cynicism about stock market investments. The New Pension Scheme, introduced in January 2004 under the Pension Fund Regulatory and Development Authority (PFRDA) Bill, moots investing in the equity market.

This will pump in resources into the stock market, which can, in turn, sterilise the effect of manic FII flows.

In most emerging economies, including China, pension funds are allowed to invest in the equity market. Increased tax benefits should bring in huge amounts to mutual funds.

A free hand to the banks in the equity market participation can bring further benefits. The Securities and Exchange Board of India (SEBI) has a bigger role in educating small investors to play safe in the market.

This is the right time for the Government, SEBI and the households to come together to take advantage of a strong economy and root the market in fundamentals.

(The authors are Associate Professor and Doctoral Student respectively at the Madras School of Economics, Chennai.)

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