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THE stock markets are sitting on an avalanche, which, as it gathered momentum in mid-May, pulled down with it the market’s bellwether, the Bombay Stock Exchange’s Sensitive Index (Sensex). During the month the Sensex lost more than 1,800 points. Foreign Institutional Investors (FIIs), who have over the last few years gained a stranglehold on the markets and the ability to leverage economic policy, triggered the crash. In May, FIIs withdrew Rs.8,247 crores from the equity markets, the first net withdrawal in a month since October 2005 (Rs.3,800 crores). The slide started soon after the Sensex touched its best-ever closing level of 12,612 on May 10; the fall from peak to trough in May was a whopping 2214 points. Heavy selling by FIIs triggered the crash. Although the Sensex recovered on June 2, it remained below the levels reached on May 22.
Market watchers, who like to imagine that the stock markets follow some logic, had ready explanations for the slide. Among these were the fall in base metal prices, the expectation of an interest rate hike in the United States, falling prices in stock markets around the world, and a technical "correction" for "over-valued" stocks in the Indian markets. The "liquidity crisis" arising out of margin trading, which essentially enables speculators to acquire shares by paying only a fraction of the value of the shares, was also blamed. However, all of them agreed that the Indian "growth story" still remained good. The diehard ones even said this was the time for ‘bargain shopping’.
Although the big guns did not fire from their own shoulders, the speculation was that FIIs were withdrawing from the Indian markets because of their - apprehensions about being taxed. The Central Board of Direct Taxes (CBDT) had issued a set of draft instructions to its staff, which essentially set guidelines based on court rulings. Although FIIs did not speak directly, tax analysts saw these guidelines as having implications for FIIs in terms of having to pay tax.
Any market crash is preceded by a phase of euphoria and this slide too needs to be placed in a context. The Sensex closed above the 6,000-mark for the first time in November 2004 and at double that number in April 2006. It reached its peak a month later, implying an annual rate of return in excess of 50 per cent. However good the "India story" may have been, there was no way this rate of return could have held except in the shortest of periods. In fact, the ‘technical correction’ explanation feeds on this logic to impart its own spin to happenings in the market.
Government response
A nervous policy establishment responded to the crisis with alacrity. Soon after the slide started, Finance Minister P. Chidambaram tried to talk the market up. His statements had three significant elements. The FIIs, as market movers, were the first section to be addressed. On May 18, when the Sensex crashed by 826 points compared with its previous close, he categorically said that FIIs were being treated as investors and not as traders, in response to the speculation that FIIs were jittery about the possibility of being taxed. In an interview to a business television channel after the crash on May 22, he said "no FII had complained to him about the [CBDT] circular". He said, "No one has doubted India’s growth story."
Chidambaram also suggested that retail investors "stay invested", surely a risk-laden homily in the context of the extreme volatility in the market. Addressing the problem of "liquidity" in the market, he said banks and other institutions would be forthcoming in addressing the needs of those making margin calls. He also said that "those who do not have the margin money will be provided liquidity."
Market sources later told Frontline that since private banks were the main sources of margin funding, and since they were unlikely to heed the Minister’s fiat, the burden may well fall on public sector banks. In that eventuality, public sector banks may well ask whether financing a purely speculative adventure is as important as funding development.
The other significant, and controversial, statement of the Finance Minister on May 22 was that mutual funds and FIIs were buying. When the figures trickled in later, as they usually do with a lag, from the Securities and Exchange Board of India (SEBI), this statement turned out to be only partially true. True, mutual funds had made a net investment of Rs.402.75 crores that day in the equities market, but this was overwhelmed by FIIs, which sold nearly Rs.930 crores that day. The little resistance that was registered by mutual funds resulted in salvaging the drop in the Sensex, which otherwise would have been steeper.
The Left parties took up the issue with the Finance Minister, who on May 23 made a statement in the Rajya Sabha suggesting that FIIs were still net buyers. Chittabrata Majumdar, CPI(M) MP, referred to a report by the Comptroller and Auditor-General (CAG), which stated that FIIs were avoiding paying tax on their incomes by using the provisions of double taxation avoidance treaties.
Haven for speculators
Although the Sensex recovered to close at 10,482, a net decline of about 450 points when compared with the previous day’s closing levels, the volatility left the market bruised. Intra-day volatility was sharp in the following week, but the trend was definitely downward, with the Sensex ending the month a little over 1,800 points lower.
It does not take rocket science to tell a potential investor that it is difficult to predict peaks and troughs. One does not know the peak until it is passed and one does not know the trough until one is out of it. To draw an analogy from football, one does not know if Ronaldinho is at peak form until he actually scores the goals, and his poor form is only evident when he stops scoring them. When stock prices peak, driven by euphoric predictions of how good India’s growth story is, investors are in no mood to sell. And when the markets bottom out, how is the investor to know that the trough has definitely arrived?
FIIs are, however, in a different league. Unlike ordinary investors, they have profits to book. They have a worldwide portfolio to balance and the fact is that they enjoy overwhelming market dominance in India, which gives them enormous leverage, and they are not satisfied with notional profits. The rise of the Sensex, from just above 5000 in July 2004 to its peak in May 2006, by itself was not good enough for them. The money actually had to be encashed. This is what they did in May.
Since their holdings of the bluest of blue chips are a substantial portion of the floating stock available in the market, they stand to lose if they liquidated their holdings in a single wave of selling.
In fact, even as the market crashed, they picked up shares in the futures segment, which propped up prices. Any hope that prices would recover was belied soon when the next wave of selling happened. This explains the tremendous volatility in prices throughout May.
Today there are no countervailing forces to FIIs. Although mutual funds have been touted as a possible counter, there is a tremendous difference in - their relative strengths. On the face of it, they appear evenly balanced. For instance, in May, while FIIs sold about Rs.8,247 crores worth of equities in net terms, mutual funds bought equities worth about Rs.7,600 crores. However, in terms of volumes the turnover of FIIs was almost four times that of mutual funds.
L.C. Gupta, a follower of the capital market, says that the Indian stock market suffer from severe "architectural weaknesses". The most important of these, according to him, is the fact that single-stock futures dominate trading in the market. Essentially, these allow speculators to buy shares by paying only a fraction of the share’s price. In fact, he argues that FIIs should not be allowed to trade in these instruments.
The volatility in Indian markets is exacerbated by the fact that they lack both breadth and depth. The lack of depth, reflected in the lower level of interest among the middle-class sections in the last decade, particularly after what is referred to as the Harshad Mehta and Ketan Parikh scams, is striking. As Prithvi Haldea of Prime Database points out, these sections are definitely out of the market. Higher volatility means greater risk and this keeps investors out, leaving the field open to speculators.
The road ahead
The overwhelming dominance of FIIs has important implications even if large sections of the people are outside the ambit of the market. The question whether FIIs are in India for the long haul is a misplaced one. The point is that they have a stake in the Indian "growth story". And that is not tied merely to the gains they can make in the share market but how and at what pace the "reforms story" proceeds. The policy establishment also recognises the clout of FIIs because it comprehends the impact that the movements of funds to and from the country can have on other macro variables, such as the exchange rate.
By virtue of their hold on the equities market, FIIs are also interested in reforms because they give them access to the inside track on policy issues. The dichotomy that is often portrayed between FIIs and foreign direct investment (FDI) is an artificial one. The fact that FIIs have shown interest - or exerted pressure - to open up crucial sectors such as telecom, real estate, retail and insurance to FDI illustrates this false dichotomy. Of course, the fact that FIIs’ holdings in companies in these sectors gives them the possibility of making a killing if and when reforms gather pace is merely the icing on the cake.
The pullout of FIIs has to be seen in the context of how much they brought in. Between May 2004, when the UPA government assumed power, and April 2006 the net FII inflows have more than doubled. The Rs.8,247 crores they have withdrawn in May 2006, when seen in the context of the net cumulative investment of Rs.1,62,251 crores, shows that they are still interested in the India story - perhaps more on the reform story than the growth story.
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