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Markets need the oxygen of money

Arjun Kapur

Millions of Indians have a stake in the stockmarket. Media coverage of stock markets is here to stay. Each rise and fall of the Sensex affects public mood.

Buoyancy in the stock market is key to the elusive feel good factor!

Economic reforms have propelled the Indian economy from a 2 per cent growth rate to 4-5 per cent. However, this is not enough. Acceleration to 8 per cent growth is necessary to tackle poverty and social injustice.

Economists estimate that India needs investment of around Rs 6 lakh crore (Rs 6 trillion) annually for the next decade.

All economic activity requires two types of capital. One is equity capital invested by the entrepreneur, or raised from the public. In addition, enterprises raise debt capital from banks, public issues of debt etc.

A reasonable ratio of debt to equity is 2:1. This means that India needs Rs 2 trillion annually of fresh equity capital and Rs 4 trillion of debt capital.

Out of Rs 2 trillion, India attracts roughly Rs 0.25 trillion ($5 billion) foreign direct investment. The remaining Rs 1.75 trillion has to be generated within India.

Assuming one-fourth of the equity capital is the entrepreneurs' contribution, the balance three-fourth has to be raised from domestic Indian savings as primary equity issues.

This implies primary market IPOs of Rs 1.3 trillion annually. Recent experience is that not even one-hundredth of the required equity capital is being raised from the primary market.

In 2001-02, Rs1,082 crore (Rs 10.82 billion) were raised, and this year until June only Rs 2.09 billion has been raised.

The reason for poor performance of the primary market is obvious! The stock market in India, where an investor in primary issues sells his investment for profit, is notoriously weak

. Today our stockmarket is below its level 10 years ago in rupee terms; and is less than half in dollar terms. The Sensex stocks trade at an average P/E of 11, about the lowest compared to other countries. The US S&P 500 stocks trade at a P/E multiple of 37, China at 32.

Paradoxically, at the same time, perceptive strategic investors are buying large blocks of equity in Indian companies even at 100 per cent premium to stockmarket prices.

Examples are recent block deals in ACC and L&T, and prospective block sales of ITC and other shares at hefty premium by UTI to strategic investors.

ADRs and GDRs of Indian companies command substantial premiums in international stock markets. Entrepreneurs, frustrated by the depressed prices, resort to buyback and delisting of their shares from India's stock market.

They move to friendlier stock markets in other countries where their shares are valued higher. The trend of delistings, even by Indian promoters, is a symptom of this.

The Indian stockmarket has come a long way in the past five years. Computerised screen based trading gives transparent trade execution with a nationwide network. Depositories and dematerialisation have reduced paperwork.

Clearing Corporation provides counterparty guarantee and efficient settlement of trades. Rolling settlement on T+3 basis has speeded payment and delivery. Derivatives provide a sophisticated hedging tool.

Professionalisation of market intermediaries has improved market ethics. Mutual funds are well regulated. Insider trading regulations and corporate governance standards have been introduced and are being tightened.

India can today boast one of the finest and most technologically advanced stock markets in the world.

If, after all this progress, we still find that the price discovery in our stockmarket is flawed, and results in unduly depressed share prices, we need to examine our financial system.

Money is what makes the stock market run; and if the flow of money is blocked, the stock market becomes comatose and listless.

Stray bits of news ignite a fledgling rally in select stocks, only to quickly dissipate in one or two days; and then the market again slowly sinks to lower lows. Our stock market today is clearly showing the symptoms of a patient deprived of the oxygen of money.

Bank finance against shares: RBI restricts bank loans against shares to Rs 20 lakh (Rs 2 million) per borrower. The Securities and Exchange Board of India, however, permits unlimited stocklending by approved intermediaries against money deposited by the borrower.

Shares borrowed by speculators from stocklending intermediaries were used for bear hammering to bring down markets in March-April 2001 and on other occasions. This causes a downward bias in stock prices.

The short seller can borrow unlimited quantity of shares, and short sell with a view to profit from the resulting fall in prices. On the other hand, the buyer is restricted to a loan of only Rs 2 million from banks to buy shares to profit from a rise in prices.

This keeps stock prices depressed. Occasionally an errant "bull operator" tries to bypass the banking system to beat the downward bias. He finds dubious sources of finance (inter-corporate loans and overseas corporate bureaux in one case, cooperative banks in another) and uses this 'stolen' money to bid up prices of his targeted stocks. The resultant boom and bust run up in prices of select stocks hurts investors, which we then call a 'stock market scam.'

Absence of a transparent and legal source of finance for purchasing shares is a systemic flaw in our financial system, making shares an asset of inferior grade.

The government should address this fundamental issue. The capital market reforms have made the stock markets safe for RBI to relax the restriction on bank lending against shares.

Margin trading for liquidity: After banning the Badla/ALBM systems last year, liquidity has suffered. Trading volumes have declined and stock markets are illiquid and anemic. Institutions have difficulty executing trades of substantial size in most stocks.

Consequently, FIIs are losing interest in Indian stocks. They find the Indian economy attractive, but are taking their investment dollars to other Asian markets like China, Korea, and Malaysia.

The stock markets there give them satisfactory entry and exit opportunities.

Today unregulated private financiers are financing stock market trades behind the scenes. Such financing puts the stockmarket system at risk and can result in another scam.

The stock market needs a transparent, regulated margin trading system through the stock exchanges and Clearing Corporation.

Such systems exist in Japan and Korea where, like India, the banking system is incapable of providing effective margin trading liquidity, unlike the more developed banking system in USA.

This will provide liquidity and buoyancy to the markets. The stock market trading system will transparently execute margin trades. These trades will be settled by delivery of stocks and money as per the cash market T+3 settlement, but the stocks and money involved in margin trades will be impounded with the Clearing Corporation as custodian.

The Clearing Corporation will conduct risk management of margin positions on a daily mark-to-market basis, a function for which it is already equipped. Daily public dissemination of data on margin positions will lend transparency and assist regulation.

Retail participation by all is the very essence of an efficient capital market. It should be ensured that even the smallest investor is afforded the opportunity to participate in the margin trading system, either as a buyer or seller on margin, or as a borrower or lender of stocks and money.

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