MacroScan (Printable Version) - The Stock Market Meltdown: A Preliminary Note

1. The Stock Market experienced its biggest intra-day fall ever on 22nd May 2006, with the BSE Sensex sliding by 1111.70 points. Trading had to be suspended for an hour due to the sharp fall (the index-based circuit breakers came into play). After some reassurances from the Finance Minister, SEBI and the RBI, the market recovered and finally closed at 10,481.77, which still meant a net fall of 456 points. This comes after a fall of 826 points on 18th May and 452 points fall on 19th May. This was the biggest stock market meltdown experienced in India. Although a further decline could be prevented, mainly on account of buying by the public financial institutions like the LIC and UTI as well as Mutual Funds, the stock markets continue to witness gyrations.

2. On 24th May, the Finance Minister issued a statement in Rajya Sabha on ''Recent Developments in the Stock Market'' where he sought to downplay the market crash and reiterated that the rise in the interest rate in the US due to inflationary expectations and a global fall in metal and other commodity prices were the prime reasons for the market meltdown. These factors have no doubt contributed to the crash. It is also true that stock markets globally have witnessed downturns over the past one week. However, the market crash in India stands out both in its magnitude as well as its specific underlying causes.

3. The Finance Minister's statement says, ''Data from the markets received yesterday confirm that Mutual Funds have been net buyers. Even FIIs have been overall net buyers with large purchases in the derivatives market''. Question naturally arises that if both the FIIs as well as the Mutual Funds, who are the main movers of stock market, were net buyers, then why did the crash occur at all? Which were those entities whose heavy selling led to the crash? The fact of the matter is that while the FIIs may have invested large sums in the Futures and Options segment (derivatives) on 22nd May as claimed by the Finance Minister, but they were net sellers in the stock market.

4. Data from the SEBI show that FIIs' net investment stood at - 2200.30 crore rupees for the entire month of May till 23rd May 2006. FII net investment on 22nd May, i.e. the day of the crash was - 1361 crore rupees. It is clear from the data that heavy selling by the FIIs caused the market meltdown. This is further corroborated by the fact that the exchange rate has declined continuously in the month of May in keeping with the withdrawal of funds by the FIIs. The rupee which stood at Rs 44.90 against a dollar on 2nd May 2006 slided to Rs 45.73 by 24th May 2006, indicating the capital flight. The Finance Minister is clearly trying to shield the role of the FIIs in the market crash by making misleading statements in Parliament.

Daily Trends in FII Investments upto May 23, 2006

Reporting Date	Debt/Equity	Net Investment (Rs. Crores)
02-MAY-2006	Equity	60.90
02-MAY-2006	Debt	0.00
03-MAY-2006	Equity	218.50
03-MAY-2006	Debt	- 50.00
04-MAY-2006	Equity	907.20
04-MAY-2006	Debt	0.00
05-MAY-2006	Equity	322.60
05-MAY-2006	Debt	0.00
08-MAY-2006	Equity	1108.10
08-MAY-2006	Debt	0.00
09-MAY-2006	Equity	366.50
09-MAY-2006	Debt	0.00
10-MAY-2006	Equity	460.50
10-MAY-2006	Debt	0.00
11-MAY-2006	Equity	322.90
11-MAY-2006	Debt	0.00
12-MAY-2006	Equity	- 1199.10
12-MAY-2006	Debt	396.90
15-MAY-2006	Equity	18.60
15-MAY-2006	Debt	0.00
16-MAY-2006	Equity	- 728.40
16-MAY-2006	Debt	- 199.50
17-MAY-2006	Equity	- 533.40
17-MAY-2006	Debt	127.90
18-MAY-2006	Equity	-423.50
18-MAY-2006	Debt	0.00
19-MAY-2006	Equity	-810.60
19-MAY-2006	Debt	43.10
22-MAY-2006	Equity	- 1361.30
22-MAY-2006	Debt	-52.70
23-MAY-2006	Equity	- 929.80
23-MAY-2006	Debt	0.00
Total for May	Equity	- 2200.30
Total for May	Debt	265.70

Source: Securities and Exchange Board of India

Exchange Rate (Rs/$)

Date	Rs.
24/05/2006	45.7300
23/05/2006	45.5200
22/05/2006	45.6800
19/05/2006	45.4600
18/05/2006	45.4800
17/05/2006	45.3400
16/05/2006	45.6100
15/05/2006	45.3900
12/05/2006	45.0500
11/05/2006	45.0700
10/05/2006	44.9300
09/05/2006	44.9600
08/05/2006	44.8800
05/05/2006	44.8800
04/05/2006	44.9700
03/05/2006	44.8600
02/05/2006	44.9000

Source: Reserve Bank of India

5. The stock market has experienced an unprecedented bull run since the UPA Government came into office. While the Sensex was around 4500 in May 2004, it crossed 7000 points in June 2005, 8000 in September 2005, 9000 in November 2005, 10000 in February 2006, 11000 in March 2006 and 12000 in April 2006. This abnormal price appreciation was a bubble that kept growing with the Finance Minister justifying and celebrating it in terms of the strong ''fundamentals'' of the economy.

6. In December 2004, when the Sensex was above 6000 points the Finance Minister had said: "I don't react. As long as the Sensex is driven by the fundamentals of the economy, I am very happy." In July 2005, when the Sensex had crossed 7000 he said: ''If the Sensex crosses 8000, then I think that I would be concerned." In September 2005, after the Sensex crossed 8000 he said: "We are looking at the price-earnings (PE) ratio (of Sensex and Nifty). At this level, they look comfortable." In December 2005, when the Sensex had crossed 9000 he said: "I expect the Sensex to rise with investor and business confidence rising. However, SEBI and I watch the movement carefully to see if there is any manipulation...My impression is that mutual funds are quite active in the markets, meaning thereby that small investors are putting their money in the mutual funds.''

7. When the Sensex went down by 463 points on 16th May, The Finance Minister said: "I will put it as a correction provoked by reasons which are quite understandable. All metal prices are down and there is some impact of cement prices...and increases in US Fed rate. All markets are doing the same." On 18th May, when the Sensex had experienced a sharp fall he remarked: "Everyday movement in the stock markets does not require a comment." After the crash of 22nd May, the Finance Minister is seen to be desperately advising investors not to panic and ''stay invested''. It is obvious that the public financial institutions are being instructed to buy heavily in the stock market in order to prevent any further fall of the indices.

8. FIIs were also behind the market crash of ‘Black Monday' (17th May 2004), when the Sensex had fallen by 565 points. Enquiry into the crash revealed that the instrument of Participatory Notes (PN) [which are like contract notes issued by the FIIs to overseas clients who are otherwise not eligible for investing in India] was misused by the FIIs. The SEBI had issued notices to 12 FIIs for not complying with its rules on furnishing details about PNs issued to overseas investors. However, it could pin down only one FII, UBS Securities Asia, following its probe into the stock market crash of 17th May 2004 and imposed a ban on its issuing PNs for a year. Despite efforts the SEBI could not get details of the other FIIs and investors who had withdrawn huge funds and contributed to the market crash.

9. The Finance Ministry had set up an Expert Group ''On Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative flows'' [Chaired by Dr. Ashok Lahiri], in order to suggest concrete measures to meet the objective of encouraging FIIs while reducing the vulnerability of the financial system to the flow of speculative capital as laid down in the National Common Minimum Programme. In its Report submitted in November 2005, the Expert Group observed that, ''Participatory notes (PNs) are instruments used by foreign funds, not registered in the country, for trading in the domestic market. They are a derivative instrument issued against an underlying security, which permits the holder to share in the capital appreciation/income from the underlying security. PNs are like contract notes and are issued by FIIs, registered in the country, to their overseas clients who may not be eligible to invest in the Indian stock markets. PNs are used as an alternative to sub-accounts by ultimate investors generally based on considerations related to transactions costs and record keeping overheads. In recent times, the anonymity afforded by the PN route has led to concerns about the desirability of PNs. With effect from February 3, 2004, overseas derivative instruments such as PNs against underlying Indian securities can be issued only to regulated entities and further transfers, if any, of these instruments can also be to other regulated entities only. FIIs/sub accounts have been required to ensure that no further downstream issuance of such derivative instruments is made to unregulated entities.''

10. The Expert Group recommended, ''The current dispensation for PNs may continue. SEBI should have full powers to obtain information regarding the final holder/beneficiaries or of any holder at any point of time in case of any investigation or surveillance action. FIIs may be obliged to provide the information to SEBI''. The RBI representative in the Expert Group disagreed with this view. In his comments he wrote, ''The Reserve Bank's stance has been that the issue of Participatory Notes should not be permitted. In this context we would like to point out that the main concerns regarding issue of PNs are that the nature of the beneficial ownership or the identity of the investor will not be known, unlike in the case of FIIs registered with a financial regulator. Trading of these PNs will lead to multi-layering, which will make it difficult to identify the ultimate holder of PNs. Both conceptually and in practice, restriction on suspicious flows enhance the reputation of markets and lead to healthy flows. We, therefore, reiterate that issuance of Participatory Notes should not be permitted.''

11. The opinion of the RBI, however, has been ignored and the proportion of PNs in total FII investments have been allowed to rise from 40% in 2005 to 52% by April 2006. This implies that more than half of the beneficiaries of FII investments in India are unknown overseas entities. In the wake of the current stock market meltdown, which has been precipitated through heavy selling by the FIIs, it is important to probe whether there has been any misuse of the PN route. The SEBI should immediately institute an enquiry into the matter and make all the relevant facts public.

12. Another important aspect of the stock market crash is the role of the Central Board of Direct Taxes [CBDT] circular, containing instructions to assessing officers to help them distinguish between share traders and investors. The prospect that taxes will rise by four times caused panic among the FIIs. Since then the Finance Minister has made a statement clarifying that the CBDT circular is not meant for FIIs and that the FIIs are outside the purview of such taxation since they do not have any permanent establishment in India. The Finance Minister has further stated that the CBDT circular was put out only to elicit public views.

13. It is noteworthy that the Comptroller and Auditor General of India (CAG) in a Report tabled in Parliament on 5th May 2005 had suggested that income of FIIs and their sub-accounts from stock market activities should be treated as business profit and taxed accordingly. The Report said that income of FIIs/sub-accounts was often being "erroneously categorised as capital gains and being exempted from tax by routinely invoking the Double Taxation Avoidance Agreements (DTAAs)." The CAG suggested, "The board (CBDT) may issue necessary clarifications to ensure correct and proper taxation of income arising to FIIs/sub-accounts". It specifically sought clarification on whether sub-account arrangements would constitute a `permanent establishment' under tax treaty. The CAG recommended that the CBDT should strengthen mechanism of coordination with regulatory bodies such as the SEBI and the RBI so that vital information relating to the income of FIIs/sub-accounts is obtained regularly and acted upon promptly by assessing officers with a view to bringing the same to tax. It also said that legislative amendments, if necessary, could also be opted for to achieve this objective.

14. The CAG report noted that the Income-Tax Department did not have any centralised or alternative effective mechanism to correlate or utilise the details available with SEBI relating to inflows and outflows of FIIs. The CAG has also been given to understand from SEBI that application for registration did not have details of an agent as provided under Section 163 of Income-Tax Act and no details such as local address were available relating to FIIs. Further, the CAG has recommended that the CBDT should ensure that a database of FIIs/sub-brokers relating to all entities operating in India be prepared and their "liability to tax examined critically so that benefits of DTAA are availed only by assesses actually and rightfully entitled to the same." While highlighting that cost-benefit analysis of DTAAs had not been conducted, the CAG report recommended that DTAAs be examined critically through a phased and well-monitored programme so that the interests of the revenue are safeguarded and one-sided concessions are avoided. The CAG suggested that the board may "assess the costs and benefits from each DTAA transparently and objectively, especially as DTAAs are not placed before Parliament''.

15. It is evident that the CBDT circular is in keeping with the eminently reasonable recommendations of the CAG. It is also clear that the effort to bring the enormous profits reaped by the FIIs within the tax net has led to this capital flight. The effort is to blackmail the Government into giving up any effort to tax such speculative gains. Media reports suggest that the Investment Company Institute, the Association of the US Mutual Fund Industry, had written to the Indian Revenue Department about a month earlier questioning the notices sent to several US Mutual funds by the Indian Income Tax department. The tendency of the Government, of course, is to surrender before the FIIs as is evident from the clarifications issued by the Finance Minister. This should not be allowed to happen. The CBDT should go ahead with the recommendations of the CAG, especially with regard to a cost-benefit analysis of the DTAAs. Moreover, the Government should reintroduce the long-term capital gains tax in order to correct the pro-speculation bias in the existent tax policy.

16. Although not a cause of immediate concern, potentially the most dangerous fallout of the stock market meltdown, particularly if it continues over a period of time with the FIIs pulling out of the market progressively, is its impact on the exchange rate. A secular depreciation of the rupee, in the backdrop of the continuing rise in international oil prices, is bound to cause inflationary pressures in the economy and hit the common man hard. The RBI has to remain vigilant in this regard.

17. The Government should also realize that the introduction of Capital Account Convertibility, which was enthusiastically advocated by the Prime Minister a few weeks ago, amidst the volatility that is being currently experienced by the capital market would be a sure recipe for large-scale capital flight and currency crisis. This move should be abandoned forthwith.