The Hindu Business Line : From irrational exuberance to deep despair

"Architectural weaknesses in the system" are blamed for the stock market crash. Besides more reforms, there is a need to create a deeper bond market.

PUTTING SAFEGUARDS in place is vital as too much reliance is placed on the stock market. — Paul Noronha

"It is only when the tide turns that one knows who was swimming naked."

— Warren Buffet

The latest stock market crash has shocked the middle-class investor no end. All that goes up must necessarily come down. True, but the extent of the fall was not expected.

It was unexpected because world GDP has been growing at an annualised rate of more than 4 per cent for 11 consecutive quarters, the strongest upturn in more than 30 years.

Reasons and Reasons

Analysts are still working out the reasons for the crash. Economists have attributed it to India's current account deficit of about 2.1 per cent of GDP, bulk of it being financed through portfolio inflows. India has attracted, according to foreign observers, disproportionate amounts of flighty portfolio inflows and was, therefore, bound to suffer.

At the height of the controversy, the Finance Minister said that the Foreign Institutional Investor was being treated only as an investor and not a trader. FIIs had made gross purchases of Rs 49,338 crore and sold Rs 57,585 crore in the stock market in May, resulting in a net outflow of Rs 8,247 crore. It only shows that even if you reduce the long-term capital gains tax to zero, the FIIs will continue to remain fair-weather friends.

Irrational exuberance has yielded place to deep despair.

Apart from the problems of margin money, the fear of rise in interest rates was a dampener. Low interest rates, pointed out the Financial Times, allowed investors in the developed world to leverage, borrowing cheaply to pick up higher returns on offer elsewhere. These investors have unwound trades, weakening stocks and local bonds. Huge inflows from the FIIs were responsible for the stock market surge.

Architectural weakness

Dr L. C. Gupta, an authority on the capital market in India, attributed the crash to several "architectural weaknesses in the system". Volatility in India is thrice as much as that in the UK. The trading structure, according to Dr Gupta, is dominated by the single-stock futures, which fuel speculation. Paying a small margin you can invest heavily in stocks and shares. Prices can be manipulated and the FIIs act as cartels.

Speculators have been carrying on without physical settlement. Day traders are allowed to settle the difference between the purchase and the selling price.

Dr Gupta points out that all this is not allowed in the US, and that it is in India to accommodate the brokers. Delivery based trades represented only 25 per cent in India; in other countries it is 100 per cent. The FIIs may be investing only about 1 per cent of their portfolio, but even that 1 per cent is huge by Indian standards.

China considers Foreign Direct Investment to be more important; India has chosen the easier route of FIIs. They are allowed to operate through sub-accounts of brokers and used the mechanism of Participatory Notes (see Frontline, June 16).

Financial Sector Reforms

The truth is that we have placed too much reliance on the stock market. The stock market developed hand-in-hand with capitalism since the 17th century, constantly growing in importance and complexity. Its primary function is to secure rational allocation of scarce private capital into productive channels. This needs a healthy financial sector in a broad sense.

The McKinsey Global Institute has called our financial system inefficient. The system allocates most of the capital to the least productive parts of the economy. Reform of the financial sector can easily free $48 billion of capital a year, representing about 6 per cent of GDP, and raise the growth rate by 2.5 per cent.

Indian banks lend only 61 per cent of the deposits compared with 130 per cent in China and this finance is also going to wrong places. Banks have to lend 36 per cent directly to the `priority sector' to help small borrowers and these loans almost never come back. They are also forced to invest 25 per cent in government debt.

This tight position with regard to lending is made even more difficult by the latest direction to the banks to be liberal in accommodating brokers with margin money.

The Bond Market

The burgeoning foreign exchange reserve is also a source of funds for the FIIs. Asian countries have parked their reserves in American treasuries. The Economist points out that the funds find their way back to Asia as institutional portfolio flows. Bond markets are neglected in India because of dependence on bank finance. An expansion of the bond market can be an insurance against recurring financial crisis prompted by excessive reliance on fickle international investors. A strong bond market would persuade private investors to shift cash from bank deposits into bonds. The ADB has raised local currency bonds in China, the Philippines, Thailand and Malaysia. The FIIs are rarely interested in local currency bonds.

The Government had appointed a high level expert committee on corporate bond. The report of the committee has to be implemented as its recommendations have been accepted. The latest Budget increased the limit on FII investments in government securities from $1.75 billion to $2 billion and that in corporate debt from $0.5 billion to $ 1.5 billion. There will be anxious expectation about the steps the Government will take to create a single, unified exchange-traded market for corporate bonds.

The development of the bond market will open many options to the Government to issue bonds linked to a suitable price index and also gauge the public mood on interest rates as the bonds near the maturity date. The Government can also think of granny bonds for future pensioners and the bearer bonds. Bearer bonds need not necessarily be issued with an eye on tax avoidance; they can control capital movements and provide legal checks on money laundering. Corporate houses, however, can think of junk bonds with high rates of interest.

The US learnt a lot of lessons from the Black Monday of October 1987. A prolonged bull market has pushed shares in recent months to high price-earning ratio and the Government ought to have cautioned the investing public instead of adding to the euphoria.

Next time the market rises, the investing public will surely be wiser but sadder. It would have learnt the cautionary lessons for the future.

(The author is a former Chief Commissioner of Income-Tax.)

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