Government fiddles while the market is manipulated  

August 25, 2005

The government is reportedly making plans to raise the barriers to unregulated foreign entities from accessing investing in the Indian capital market. It plans to do this by tightening the use or misuse of a whopping Rs 40,000 crore of Participatory Notes (PNs) that have been issued overseas to investors and hedge funds that are either not eligible to invest in India, or find it too tedious to go through the formalities required to invest directly. The government also plans to restrict sub-accounts of Foreign Institutional Investors (FIIs).

On the face of it, this move seems to be a response to the dangerous speculation in the market. In fact, a report by Credit Lyonnais Securities (CLSA) on Thursday predicted a 14 to 20 per cent correction because of over-speculation in the Indian market. Clearly, even the bullish foreigners are beginning to acknowledge that the bull  run has now entered dangerous territory.  Unfortunately, the Finance Ministry and the market regulator seem unsure whether any action is warranted. Or, whether Foreign Institutional Investors (FIIs) even dominate the market as much as is claimed.

So the government set up an expert committee under the Chief Economic Advisor Ashok Lahiri to find ways of “Encouraging FII inflows and checking the vulnerability of capital market to Speculative Flows”. The report was submitted to the Finance Ministry last month. But astonishingly, it is nothing but a lengthy narrative on the history of FII investment in India and the regulations that govern it. After quoting academic studies from around the world, it says “there is some evidence that the impact of international portfolio flows on stock prices depends on whether such flows are ‘expected’ or ‘unexpected’ and composition of such investment”.

It also says, based on more academic studies, “One of the worries stemming from the informational asymmetries between foreign investors and domestic investors is the problem of herding and overshooting”.  What this means is that the dominance of foreign investors could create a problem if they act in a herd-like manner. And this must be counter-balanced by restoring domestic investor confidence, so that they act as a “built-in cushion against possible destabilising effects of sudden reversal of foreign inflows”.

This view is a big joke. Domestic retail investors, badly burnt by successive scams are ready to run at the first sign of a falling market. Domestic Indian Mutual Funds, which remained in cash through most of the bull run and seem to have turned aggressive buyers at its peak. If they are left holding the baby, then retail investors who have rushed to catch the bull run through mutual funds will only end up hurt by ‘cushioning’ the impact of exiting foreigners. 

However, all these discussions are made irrelevant by the conclusion that there is no sign of FII induced volatility in the Indian market. In fact, other government officials have been pointing out that FIIs do not even dominate trading because they account for barely 13 per cent of overall volumes. In fact, FIIs themselves admit that they own over 40 per cent of the BSE Sensex stocks and hold 75 per cent of the floating stock.

If that is not all, there is a growing body of evidence about the most blue chip global  FIIs providing a front for Indian speculators re-routing their unaccounted money to India. 

Using these fronts, big industrialists and shady scamsters are busy manipulating stocks, especially in the more vulnerable mid-cap segment where floating stock is low and public information is extremely limited. This makes it easy for unscrupulous operators to plant false reports in the media about potential mergers and acquisitions to induce volatility.

For instance, last Wednesday, CNBC television carried and ‘exclusive’ report about Geojit Financial Services Limited acquiring UTI Securities. When asked, Geojit told the stock exchanges, "We are not aware of the basis for the said news. Neither have we approached UTI Securities nor they have approached us in connection with the acquisition as of now".

The stock however jumped 20 per cent and hit the upper circuit filter. Will investors, who were fooled by the report, hold CNBC responsible?

On the same day three other fake stories were nailed when stock exchanges asked questions. But this is usually too late to protect those who have rushed to buy the shares based on mere rumours. It does not also protect investors who put their faith in rights issue for companies such as G.V.Films, where the regulator’s scrutiny is itself called into question.

All this points to an increasingly unhealthy and volatile market, which is badly in need of a correction. But the government seems determined to ignore these signals in preference for academic studies that come up with vague conclusions. Meanwhile, some lobbyists are saying that the solution is to free all entry barriers to FIIs by scrapping the registration process if necessary and ignoring the fact that Indian investors will not have the same freedom to invest abroad until there is capital account convertibility.

This column appeared in Divvya Bhaskar, in Gujarati on August 22,2005