The unprecedented bull run
on the Bombay stock exchange which took the Sensex
beyond consecutive 1000-point hurdles in a matter
of days rather than weeks or months has little to
do with economic fundamentals. Rather, huge foreign
capital inflows over a short period of time have pushed
up equity valuations to levels that would normally
be considered unsustainable. Between August 21 and
October 29, the price earnings ratio for the 50 S&P
CNX Nifty stocks had risen from 18.4 to 26.4 or by
more than 40 per cent. Such a sharp rise to unusually
high levels over a two-month period can hardly be
attributed to improved earnings expectations. Thus,
the RBI has had to admit in its recently released
Report on the Trend and Progress of Banking in India
that: “Although the macroeconomic fundamentals are
strong as also the corporate earnings, large demand
by FIIs given the limited supply of domestic assets,
is putting pressure on the equity valuations.” For
the record, net FII inflows during the first 10 months
of 2007 had touched $18.9 billion as compared with
the $10.9 billion it had touched in 2003-04, the maximum
for any full financial year.
While fundamentals cannot explain stock market buoyancy,
the role of foreign capital inflows in explaining
such buoyancy can work against fundamentals. Huge
capital inflows have resulted in an appreciation of
the rupee, from its Rs. 46-to-the-dollar level in
mid-September 2006 to Rs.39.3 on November 1, 2007.
The damage this has wrought on the exporting sectors
is only being assessed as yet. Such appreciation has
occurred despite the central bank’s intervention aimed
at stalling the currency’s rise. While intervention
has failed to fully realize its objective, it has
resulted in the continuous accumulation of foreign
exchange reserve assets with the central bank. This
makes it difficult for the RBI to manage money supply
and use the monetary lever to pursue other objectives.
A strait-jacketed central back is hardly good for
the economy. Finally, in its effort to balance the
accumulation of foreign exchange assets by retrenching
government securities deposited with it by the central
government (under the Market Stabilization Scheme),
the RBI has taken on deposits of such securities to
the tune of more than Rs.180,000 crore. Since the
interest due on those securities has to be met from
the central budget, the Centre may be burdened by
as much as Rs.12,500 crore over a full financial year.
This would make fiscal management difficult as well.
The outcome may be a further cutback in capital and
social expenditures.
Given these consequences of the FII surge, justifying
the open door policy towards foreign financial investors
has become increasingly difficult for the government
and for non-government advocates of such a policy.
The one argument that still sounds credible is that
such flows help finance the investment boom that underlies
India’s growth acceleration. There does seem to be
a semblance of truth to this argument. Between 2003-04
and 2006-07, which was a period when FII inflows rose
significantly and stock markets were buoyant most
of the time, equity capital mobilized by the Indian
corporate sector rose from Rs.67,622 crore to Rs.177,170
crore (Chart 1).
Chart
1 >> Click
to Enlarge
Not all of this was raised through equity issued in
the stock market. In fact a predominant and rapidly
growing share amounting to a whopping Rs.145,571 crore
in 2006-07 was raised in the private placement market
involving negotiated sales of chunks of new equity
in firms not listed in the stock market to financial
investors of various kinds such as merchant banks,
hedge funds and private equity firms. While not directly
a part of the stock market boom, such sales were encouraged
by the high valuations generated by that boom and
were as in the case of stock markets made substantially
to foreign financial investors.
The dominance of private placement in new equity issues
is to be expected since a substantial number of firms
in India are still not listed in the stock market.
On the other hand, free-floating (as opposed to promoter-held)
shares are a small proportion of total shareholding
in the case of many listed firms. If therefore there
is a sudden surge of capital inflows into the equity
market, the rise in stock valuations would result
in capital flowing out of the organized stock market
in search of equity supplied by unlisted firms. The
only constraint to such spillover is the cap on foreign
equity investment placed by the foreign investment
policy of the government. Thus, as per the original
September 1992 policy permitting foreign institutional
investment, registered FIIs could individually invest
in a maximum of 5 per cent of a company’s issued capital
and all FIIs together up to a maximum of 24 per cent.
But much relaxations has occurred since. The 5 per
cent individual-FII limit was raised to 10 per cent
in June 1998. Further, as of March 2001, FIIs as a
group were allowed to invest in excess of 24 per cent
and up to 40 per cent of the paid up capital of a
company with the approval of the general body of the
shareholders granted through a special resolution.
This aggregate FII limit was raised to the sectoral
cap for foreign investment in the concerned sector
as of September 2001. These changes obviously substantially
expanded the role that foreign financial investors
could play in the market for corporate equity.
Even in sectors where the restrictions on foreign
investment or constraints on foreign investor rights
are severe, as in the print media and banking, investors
have evinced unusual interest. This is because the
process of liberalization keeps alive expectations
that the caps on foreign direct investment would be
relaxed over time, providing the basis for foreign
control. Thus, acquisition of shares through the FII
route today paves the way for the sale of those shares
to foreign players interested in acquiring companies
as and when FDI norms are relaxed.
One obvious consequence of FII investments in stock
markets is that the possibility of take over by foreign
entities of Indian firms has increased substantially.
This possibility of transfer of ownership from Indian
to foreign individuals or entities has increased with
the private placement boom, which is not restrained
by the extent of free-floating shares available for
trading in stock markets. Private equity firms can
seek out appropriate investment targets and persuade
domestic firms to part with a significant share of
equity using valuations that would be substantial
by domestic wealth standards and may not be so by
international standards. Since private equity expects
to make its returns in the medium term, it can then
wait till policies on foreign ownership are adequately
relaxed and an international firm is interested in
an acquisition in the area concerned. The rapid expansion
of private equity in India suggests that this is the
route the private equity business is seeking given
the fact that the potential for such activity in the
developed countries is reaching saturation levels.
The point to note, however, is that these trends notwithstanding,
equity does not account for a significant share of
total corporate finance in the country. In fact, internal
sources such as retained profits and depreciation
reserves have accounted for a much higher share of
corporate finance during the equity boom of the first
half of this. According to RBI figures (Chart 2),
internal sources of finance which accounted for about
30 per cent of total corporate financing during the
second half of the 1980s and the first half of the
1990s, rose to 37 per cent during the second half
of the 1990s and a record 61 per cent during 2000-01
to 2004-05. Though that figure fell during 2005-06,
which is the last year for which the RBI studies of
company finances are as yet available, it still stood
at a relatively high 56 per cent.
Among the factors explaining the new dominance of
internal sources of finance, three are of importance.
First, increased corporate surpluses resulting from
enhanced sales and a combination of rising productivity
and stagnant real wages. Second, a lower interest
burden resulting from the sharp decline in nominal
interest rates, when compared to the 1980s and early
1990s. And third, reduced tax deductions because of
tax concessions and loop holes. These factors have
combined to leave more cash in the hands of corporations
for expansion and modernization.
Chart
2>> Click
to Enlarge
Along with the increased role for internally generated
funds in corporate financing in recent years, the
share of equity in all forms of external finance has
also been declining. An examination of the composition
of external financing (measured relative to total
financing) shows that the share of equity capital
in total financing that had risen from 7 to 19 per
cent between the second half of the 1980s and the
first half of the 1990s, subsequently declined 13
and 10 per cent respectively during the second half
of the 1990s and the first half of this decade. There,
however, appears to be a revival to 17 per cent of
equity financing in 2005-06, possibly as a result
of the private placement boom of recent times.
What is noteworthy is that, with the decline of development
banking and therefore of the provision of finance
by the financial institutions (which have been converted
into banks), the role of commercial banks in financing
the corporate sector has risen sharply to touch 24
per cent of the total in 2003-04. In sum, internal
resources and bank finance dominate corporate financing
and not equity, which receives all the attention because
of the surge in foreign institutional investment and
the media’s obsession with stock market buoyancy.
Thus, the surge in foreign financial investment, which
is unrelated to fundamentals and in fact weakens them,
is important more because of the impact that it has
on the pattern of ownership of the corporate sector
rather than the contribution it makes to corporate
finance. This challenges the defence of the open door
policy to foreign financial investment on the grounds
that it helps mobilize resources for investment. It
also reveals another danger associate with such a
policy: the threat of widespread foreign take over.
Many argue that this is inevitable in a globalizing
world and that ownership per se does not matter so
long as the assets are maintained and operated in
the country. But there is no guarantee that this would
be the case once domestic assets become parts of the
international operations of transnational firms with
transnational strategies. Those assets may at some
point be kept dormant and even be retrenched. What
is more, the ability of domestic forces and the domestic
State to influence the pattern and pace of growth
of domestic economic activity would have been substantially
eroded.
Chart
3>> Click
to Enlarge
