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expected but abrupt end to the bull run in India's stock
markets, signalled by a 316-point intra-day decline
in the Sensex on January 5, once more focused attention
on the volatility that has come to characterise India's
stock markets. This volatility has been visible in the
medium and long term as well. From a low of 2924 on
April 5, 2003, the Sensex had risen to 6194 on January
14, 2004, only to fall to 4505 on May 17, before rising
to close at a peak of 6679 on January 3, 2005. These
wild fluctuations have meant that for those who bought
into the market at the right time and exited at the
appropriate moment, the average return earned through
capital gains were higher in 2003 than 2004, despite
the extended bull run in the latter year.
Movements in the Sensex during these two years have
clearly been driven by the behaviour of foreign institutional
investors (FIIs), who were responsible for net equity
purchases of as much as $6.6 and $8.5 billion respectively
in 2003 and 2004. These figures compare with a peak
level of net purchases of $3.1 billion as far back as
1996 and net investments by FIIs of just $753 million
in 2002. In sum, the sudden FII interest in Indian markets
in the last two years account for the two bouts of medium-term
buoyancy that the Sensex recently displayed.
At one level this influence of the FIIs is puzzling.
The cumulative stock of FII investment, totalling $
30.3 billion at the end of 2004, amounted to just 8
per cent of the $383.6 billion total market capitalisation
on the Bombay Stock Exchange. However, FII transactions
were significant at the margin. Purchases by FIIs of
$31.17 billion between April and December 2004 amounted
to around 38.4 per cent of the cumulative turnover of
$83.13 billion in the market during that period, whereas
sales by FIIs amounted to 29.8 per cent of turnover.
Not surprisingly there has been a substantial increase
in the share of foreign stockholding in leading Indian
companies. According to one estimate, by end-2003, foreigners
had cornered close to 30 per cent of the equity in India's
top 50 companies - the Nifty 50. In contrast, foreigners
collectively owned just 18 per cent in these companies
at the end of 2001 and 22 per cent in December 2002.
A recent analysis by Parthaprathim Pal estimated that
at the end of June 2004 FIIs controlled on average 21.6
per cent of shares in Sensex companies. Further, if
we consider only free-floating shares, or shares normally
available for trading because they are not held by promoters,
government or strategic shareholders, the average FII
holding rises to more than 36 per cent. In a third of
Sensex companies, FII holding of free-floating shares
exceed ed 40 per cent of the total.
Given this presence of foreign institutional investors,
their role in determining share price movements must
be considerable. Indian stock markets are known to be
narrow and shallow in the sense that there are few companies
whose shares are actively traded. Thus, although there
are more than 4700 companies listed on the stock exchange,
the BSE Sensex incorporates just 30 companies, trading
in whose shares is seen as indicative of market activity.
This shallowness would also mean that the effects of
FII activity would be exaggerated by the influence their
behaviour has on other retail investors, who, in herd-like
fashion tend to follow the FIIs when making their investment
decisions.
These features of Indian stock markets induce a high
degree of volatility for four reasons. In as much as
an increase in investment by FIIs triggers a sharp price
increase, it would in the first instance encourage further
investments so that there is a tendency for any correction
of price increases unwarranted by price earnings ratios
to be delayed. And when the correction begins it would
have to be led by an FII pull-out and can take the form
of an extremely sharp decline in prices.
Secondly, as and when FIIs are attracted to the market
by expectations of a price increase that tend to be
automatically realised, the inflow of foreign capital
can result in an appreciation of the rupee vis-à-vis
the dollar (say). This increases the return earned in
foreign exchange, when rupee assets are sold and the
revenue converted into dollars. As a result, the investments
turn even more attractive triggering an investment spiral
that would imply a sharper fall when any correction
begins.
Thirdly, the growing realisation by the FIIs of the
power they wield in what are shallow markets, encourages
speculative investment aimed at pushing the market up
and choosing an appropriate moment to exit. This implicit
manipulation of the market if resorted to often enough
would obviously imply a substantial increase in volatility.
Finally, in volatile markets, domestic speculators too
attempt to manipulate markets in periods of unusually
high prices. Thus, most recently, the SEBI is supposed
to have issued show cause notices to four as-yet-unnamed
entities, relating to their activities on arund around
Black Monday, May 17, 2004, when the Sensex recorded
a steep decline to a low of 4505.
All this said, the last two years have been remarkable
because, even though these features of the stock market
imply volatility, there have been more months when the
market has been on the rise rather than on the decline.
This clearly means that FIIs have been bullish on India
for much of that time. The problem is that such bullishness
is often driven by events outside the country, whether
it be the performance of other equity markets or developments
in non-equity markets elsewhere in the world. It is
to be expected that FIIs would seek out the best returns
as well as hedge their investments by maintaining a
diversified geographical and market portfolio. The difficulty
is that when they make their portfolio adjustments,
which may imply small shifts in favour of or against
a country like India, the effects it has on host markets
are substantial. Those effects can then trigger a speculative
spiral for the reasons discussed above, resulting in
destabilising tendencies. Thus the end of the bull run
in January was seen to be the a result of a slowing
of FII investments, partly triggered by expectations
of an interest rate rise in the US.
These aspects of the market are of significance because
financial liberalisation has meant that developments
in equity markets can have major repercussions elsewhere
in the system. With banks allowed to play a greater
role in equity markets, any slump in those markets can
affect the functioning of parts of the banking system.
We only need to recall that the forced closure (through
merger with Punjab National Bank) of the Nedungadi Bank
was the result of the losses it suffered because of
over exposure in the stock market,
Similarly, if any set of developments encourages an
unusually high outflow of FII capital from the market,
it can impact adversely on the value of the rupee and
set of speculation in the currency that can in special
circumstances result in a currency crisis. There are
now too many instances of such effects worldwide for
it t be dismissed on the ground that India's reserves
are adequate to manage the situation.
Thus, the volatility being displayed by India's equity
markets warrant returning to a set of questions that
have been bypassed in the course of neoliberal reform
in India. The most important of those questions is whether
India needs FII investment at all. With the current
account of the balance of payments recording a surplus
in recent years, thanks to large inflows on account
of non-resident remittances and earnings from exports
of software and IT-enabled services, we don't need those
FII flows to finance foreign exchange expenditures.
Neither does such capital help finance new investment,
focussed as it is on secondary market trading of pre-existing
equity. And finally, we do not need to shore up the
Sensex, since such indices are inevitably volatile and
merely help create and destroy paper wealth and generate,
in the process, inexplicable bouts of euphoria and anguish
in the financial press.
In the circumstances the best option for the policy
maker is to find ways of reducing substantially net
flows of FII investments into India's markets. This
would help focus attention on the creation of real wealth
as well as remove barriers to the creation of such wealth,
such as the constant pressure to provide tax concessions
that erode the tax base and the persisting obsession
with curtailing fiscal deficits, both of which are driven
by dependence on finance capital.
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