Feb 4th 2005, C.P. Chandrasekhar and Jayati Ghosh

2004 was one more unusual year in India's stock markets. It began with the Sensex still at a high and above the 6000 mark. It witnessed a decline to a low in mid-May of around 4500, delivered ultimately with the market's single day loss of close to 565 points. It then registered a recovery that turned into a bull run, which took the Sense to 6679 on the first trading day in the new year. And then it witnessed an abrupt end to the bull run, signalled by a 316-point intra-day decline in the Sensex on January 5. (Chart 1).

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.

Chart 1 >> Click to Enlarge

There are two messages that this experience sends out. The first is that, if market expectations can turn so whimsically, the signals or rumours on which they are based must lack any substance since any ''fundamentals'' on which they could be anchored have not shifted so violently. The second is that there must be some unusually strong force that is determining movements in the market which alone can explain the wild swings it is witnessing.

The combination of these two factors is indeed a disconcerting phenomenon, since if some force has the ability to lead the market and the others can be taken along without much resistance, the market is in essence being subjected to manipulation, even if not always consciously. Not surprisingly, recent market developments have once more focused attention on the volatility that has come to characterise India's stock markets.

Movements in the Sensex during the 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 (not necessarily just FIIs) 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 exceeded 40 per cent of the total.

As Table 1, shows matters have not changed significantly more recently. As of September 2004, which is the last quarter for which information is available, FII shareholding in the 30 companies included in the Sensex stood at an average of 19.6 per cent. What is noteworthy, however, is that this proportion varied from a low of 2.52 per cent to a high of as much as 54 per cent in the case of Satyam Computers and 63.17 per cent in the case of HDFC. If FIIs as a group chose to move out of the stock concerned, a collapse in the price of the equity is inevitable.

Table 1: FII Holding in Sensex Companies End-September 2004
	FII Holding	Total Stock	FII Share
Associated Cement   Companies Ltd.	40900718	178277669	22.94
Bajaj Auto	16330247	101183510	16.14
Bharti Tele	221015179	1853366767	11.93
BHEL	53591202	244760000	21.90
Cipla Ltd.	52682658	299870233	17.57
Dr.Reddy's Laboratories   Ltd.	12809188	76518949	16.74
Grasim Industries Ltd.	19113076	91671233	20.85
Gujarat Ambuja Cements   Ltd.	41620922	179399951	23.20
HDFC Bank Ltd.	76402122	286232913	26.69
Herohonda M	46161349	199687500	23.12
Hindalco IN	17828040	92475275	19.28
Hindustan Lever Ltd.	278289559	2201243793	12.64
Hindustan Petroleum   Corp. Ltd.	66559789	339330000	19.62
Housing Development   Finance Co	156482326	247703418	63.17
I T C Ltd.	37548907	247924902	15.15
ICICI Bank Ltd.	359488564	735928149	48.85
Infosys Technologies   Ltd. - ORDI	108676702	267860670	40.57
Larsen & Toubro Ltd.	24048087	129902937	18.51
Maruti Udyog	34644938	288910060	11.99
Ong Corp Ltd.	93054697	1425933992	6.53
Ranbaxy Laboratories   Ltd.	41321691	185831140	22.24
Reliance	319138099	1396377536	22.85
Reliance ENR*	32896582	185572799	17.73
Satyam Comp	171632507	317593572	54.04
State Bank of India	60294540	526298878	11.46
Tata Iron and Steel Co.   Ltd.	66306238	553472856	11.98
Tata Motors	76364625	358485286	21.30
Tata Power	26069920	197897864	13.17
Wipro Ltd.	17630021	698951673	2.52
Zee Telef Lt	154980521	412505012	37.57
Total Sensex Cos	2723883014	14321168537	19.02

Table 1 >> Click to Enlarge

Table 2, which provides the frequency distribution of Sensex companies according to the size class of FII shareholding proportions at the end of the first three quarters of 2004, suggests that FIIs do shift in and out of particular shares, just as they are known to shift in and out of particular markets. Between end-March and end-June FIIs were reducing their exposure in Sensex companies, wheras by end-September they had once again begun to increase their exposure. If at the end of June there were 5 companies in which the share of FIIs in total equity was less than 10 per cent, this figure had fallen to 2 by end-September, whereas the number of firms in which FII exposure was 10-20 per cent had risen from 12 to 14 and those with 20-30 per cent exposure from 8 to 9. Given the short period in which this had occurred and the small proportion of floating shares in the case of many companies, these changes are indeed significant.

Table 2: Frequency Distribution of FII Holdings in Sensex Companies
	March 2004	June 2004	September 2004
< 10 per cent	3	5	2
10-20 per cent	13	12	14
20-30 per cent	9	8	9
30-40 per cent	1	2	2
> 40 per cent	4	3	3

Table 2 >> Click to Enlarge

Given the presence of foreign institutional investors in Sensex companies and their active trading behaviour, 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 provide additional incentives for FII investment and in the first instance encourage further purchases, 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 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,

On the other hand if FII investments constitute a large share of the equity capital of a financial entity, as seems to the case with HDFC, an FII pull-out, even if driven by development outside the country can have significant implications for the financial health of what is an important institution in the financial sector of this country.

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 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. The poor showing of the markets on the IPO front in most years during the 1990s is adequate confirmation of this. 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 the 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.