Themes > Current Issues
08.04.2000
The Fragile World of Finance
C.P.
Chandrasekhar
Judging by government and media responses, finance holds the key to
improving economic performance in India. Consider, for example, the
response to this April's Black Tuesday. On 4th April, India's most active
stock market, the Bombay Stock Exchange, displayed nerves of cotton
wool. The BSE Sensex, which closed at 5,052.94 points the previous day,
collapsed to an intra-day low of 4666.95, and recovered only marginally
to 4691.46. This single day loss of 361 points was reportedly the "seventh
largest single day loss in India's capital markets", and the highest
decline since the stock market scam of the early 1990s. It was when
that scam was revealed and leading player Harshad Mehta arrested, that
the Sensex fell by 570 points in a single day on April 28, 1992. That
was a Black Tuesday too, but one which came in the wake of an engineered,
speculative boom in the stock markets. This time around there is no
obvious scam to nail, though the volatility in the markets on, prior
to and after that day suggests that speculation rules India's financial
markets. We must recall that the Sensex which stood at 5375.11 at the
end of the first trading day this year, fluctuated around that level
till early February, then rose dramatically from 5313.59 at the end
of February 4 to 5933.56 by the end of February 13, and then slipped
gradually to reach its April 4 closing of 4691.46.
The evidence pointing to speculation is in fact abundant. In February, price-earnings ratios in the case of many stocks, especially those from the much-celebrated new economy, had touched levels that were not warranted by even the most optimistic estimates of future earnings of the firms concerned. Few believed that such prices were "real" or could be sustained. But yet prices remained high because those bereft of such stocks wanted in, and those holding them dared not dump them for fear of losing out on further highs. The collapse, euphemistically termed "correction", of that speculative rise in stock price, had to wait for the weakest nerves to give. And Tuesday the 4th they did.
In normal circumstances, speculative losses are considered just recompense for those taking more from the till than their palms can hold. But not so in post-liberalisation India. Virtually ignoring the obvious role of speculation, the government set about searching for reasons to explain market nerves, so as to respond to them. Two came in handy. First, notices served by India's income tax department, on a set of foreign institutional investors, demanding payment of close to Rs. 9 crores, in view of their avoidance of capital gains tax. The IT department's notices were based on a presumption that companies that were not eligible to avoid paying tax in India under the terms of the double taxation agreement between India and Mauritius, had claimed such benefits. And, second, signs of a collapse of a similar boom in the Nasdaq, the New York index of high tech stocks.
The response to the first was indeed appalling. It is now well known, that using the benefits of India's double taxation treaty with a quasi-tax haven like Mauritius, companies were routing all their investments through that country. According to reports there are now around 150 companies "based" in Mauritius that have investments in Indian markets. According to one estimate, these firms accounted for close to two thirds of the cumulative $11.4 billion portfolio inflow into India till April 4. However, given the income tax departments reading of the terms of the treaty, it had made clear that it did not consider all these companies as meeting the criteria rendering them eligible for the benefits of the treaty. In fact, in assessments conducted thus far, there are 24 companies that have been allowed the benefits, and a similar number of companies who have been certified as ineligible. It was to some of the latter that the notices had been served.
It is indeed completely acceptable that when large speculative capital gains are being raked in by foreign institutional investors on Indian soil, the Indian government should have the right to tax away some of those gains, just as it does in the case of Indian investors. In fact, till last year's budget the Finance Ministry had been discriminating against Indian investors and in favour of foreign players by setting the capital gains tax imposed on the latter at a lower level. While the long term capital gains tax on residents stood at 20 per cent, that on non-residents had been brought down to 10 per cent. Good sense prevailed, and that discriminatory policy was done away with, even though it involved reducing the capital gains tax rate for Indian players, rather than increasing it for foreign ones. If despite this, foreign investors still had a relative advantage, because they could use the Mauritius route, what was necessary was to renegotiate that treaty to correct for the anomaly.
In practice, however, when the Income Tax Department chose to launch limited action against those it felt were wrongly using the terms of the agreement, an expected "correction" of a speculative boom in the market was attributed to FII disappointment with the action. The fact of the matter is that, FII investments hardly turned negative in the wake of that action. It is true that net FII investments fell from $99.3 million on 2 April 2000, to $24.3 million on April 4, the fateful Tuesday. But a positive net investment can hardly be a cause for a collapse in the Sensex. Moreover, such volatility is typical of FII net investment flows, which, for example, fell from $363.2 million over December 1999 as a whole to $34.8 million in January 2000, only to rise sharply to $639.4 million in February and fall again to $244.1 million in March. In any case, the rather moderate rates of capital gains taxation in India can hardly dampen investor sentiments.
Despite all this, the government responded with unusual alacrity to (engineered?) market rumours that the tax notices had set off the April 4 slide and issued a clarification that very day that the action would be put on hold. Clearly the fact that the government faces a fiscal crunch and that the tax-GDP ratio had been declining during the years of reform, necessitating additional resource mobilisation, seems less important to the Finance Ministry, then the presumed adverse consequences of a tax collection effort on foreign institutional investor sentiment. This implicitly amounts to sacrificing fiscal sovereignty at the slightest hint of FII resentment. By ensuring large FII flows through financial liberalisation, the government has rendered India vulnerable to a sudden withdrawal of such capital. This vulnerability is now being provided as the reason for subordinating domestic policy to the requirements set by perceived FII sentiment.
"Perceived" because in hindsight, it appears that the second of the factors quoted above, namely "Nasdaq sentiment," appears to have been the likely cause for the April 4 slide. Through March, new economy stocks in the US have been under stress, as investors who were betting on companies that had been toting up losses for months on end, had begun to loose nerve. This was aggravated by two other developments. A spate of auditor's reports pointing to questionable accounting practices as well as clear signs of lack of viability in the case of a number of "new economy" firms. After a number of days of almost repeated losses, on Tuesday the 4th, the Nasdaq plunged 13 per cent by mid-day. Though the index recovered subsequently, it was clear that the high-tech stock boom in the US had lost its vigour, even if it had not fully collapsed.
This experience should have had only a marginal impact on India. The growing number of internet-based, dotcom companies are yet to dominate the market here, being predominantly financed by venture capital firms, whose funds were being poured into advertising in order to attract clients and consumers to new sites and portals. However, there were other factors that could have resulted in the Nasdaq developments influencing market sentiment in India. To start with, much of the recent boom in the market has been focused on "new economy" firms from the IT and entertainment sectors. As a result, as mentioned earlier, price earnings ratios in the case of these firms had reached astronomical levels, making it clear that there was little likelihood of the actual performance of these companies matching the expectations implicit in those ratios. The losses of dotcom firms that appeared to be spiking the internet bubble in New York, had a parallel here in the form of the inadequacy of actual relative to implicitly expected profits of a few new economy firms that dominated the market. At the peak of the February boom, one such firm (Wipro) accounted for 15 per cent of market capitalisation in the BSE and the combined market value of around 150 software companies accounted for 32 per cent. This compares with the fact at the beginning of the 1990s, these companies hardly featured in the BSE.
Further, at the margin, it was clear that if the boom in the market had to be sustained, the newly emerging dotcom companies in India had to play a role. In the face of disillusionment with available new economy stocks, investors were not returning to older companies which dominated the market, but turning their attention to these dotcom companies. Every major fund manager had created a special fund for investment in what were seen as hitech stocks. The realisation that such stocks were not the best buys would, therefore, have affected market sentiment at the margin.
A more reasoned response would therefore have been that the April 4 slide per se was not much cause for concern. The real problem is why old economy stocks have for quite some time now been performing relatively poorly, resulting in significant changes in the relative shares in market capitalisation of old and new economy firms. One major reason for this sluggishness in the old economy is the fact that stock values there seem far more tethered to trends in the real economy. Recent evidence of a modest recovery in the index of industrial production notwithstanding, the overwhelming impression is one of sluggishness in the industrial sector. Non-oil imports are virtually stagnant, despite the post-liberalisation increase in the import-intensity of domestic production. Investment rates are low and so are imports of capital goods. The recovery of industrial production appears to be due to the lagged effects of a good agricultural year and the implementation of the Pay Commission's recommendations. Since, agricultural growth is likely to be lower in 1999-2000 and the stimulus provided by higher salaries and salary arrears would soon weaken, capacity utilisation is expected to return to lower levels. As long as this sluggishness persists, stock market trends would remain skewed and speculation prove crucial for stock market buoyancy.
Thus even a government concerned with financial market (as opposed to real) indicators would be keen on engineering an industrial revival. However, even here the government appears to be relying only on financial levers. Obsessed with the fiscal deficit while handing out fiscal concessions, such as that on capital gains referred to earlier, it has had to cut expenditures, especially capital expenditures. This at a time when unutilised capacity in industry, slow agricultural growth, persisting poverty, large foodstocks and comfortable foreign exchange reserves make a strong case for higher spending aimed at triggering an industrial revival.
Unfortunately, a higher fiscal deficit, just as much as a higher tax rate, is considered anathema from the point of view of the foreign portfolio investor. In the event, the government has chosen to rely on the twin monetary measures of pumping in greater liquidity and reducing interest rates to spur industry. Recently, Reserve Bank of India Deputy Governor Y.V. Reddy reportedly declared before Reuters Television cameras that: "Our preference and the preference of most of the market participants is to have an easier interest rate regime at this stage of development." In keeping with this perspective, the government launched on a series of concerted efforts, involving reductions in the Bank Rate of the RBI, and in the CRR and SLR of banks, aimed at bringing down interest rates.
As a result, after the debilitatingly high levels that interest rates touched during the stabilisation of the early and mid-1990s, they have been moving downwards. The prime lending rate, or the rate at which banks claim they lend to their best clients (which came into operation in October 1994), stood at an average of 15 per cent in 1994-95 and 16.5 per cent in 1995-96. Needless to say most ordinary borrowers would have been charged rates which were between 2 and 3 percentage points higher than this. Since then the PLR has indeed declined, to 14.5-15 per cent in 1996-97, 14 per cent in 1997-98, 12-13 per cent in 1998-99 and between 12-12.5 per cent in September 1999.
As should be clear, this lowering of rates has done little thus far to reverse the sluggishness in the industrial sector. Yet, the government has stuck to this strategy. One more initiative in this direction was the reduction in the cash reserve ratio (CRR) of banks by one percentage point in the monetary policy review for 1999-2000, which, by releasing liquidity to the tune of Rs.7000 crore was expected to help ease interest rates. At Budget time the Finance Minister announced a cut in interest paid on small savings schemes like the public provident fund and national savings certificates. More recently, on April 1, the RBI once again cut the Bank Rate, the CRR and the repo rate by one percentage point. This has further encouraged major banks to reduce their lending and deposit rates.
While there is an observed lack of responsiveness of investment to interest rate reductions, these cuts are resulting in two other tendencies. First, they are encouraging at least some small savers to move out of bank deposits and government savings schemes and into the stock market. Second, they are encouraging a range of players to borrow at lower interest rates and bet on equities. In sum, in the midst of the speculative boom in the markets, the government is channelising more money into stock market investments. This together with the signal it sent out by putting the tax notices on hold, have encouraged new investments in the market, resulting in a reversal of the April 4 decline in the Sensex. That reversal has only been aided by the fact that further news of robust growth in the US has resulted in a mild revival of the Nasdaq.
As a result both the Nasdaq and the Sensex have recouped some of their losses. This may be good news for now, but it implies that the much-needed "correction" in markets here and in the US is being postponed. In India this means that attention would continue to be diverted away from the real economy and the measures that are urgently need to spur real growth and deal with persisting poverty. That is the price the nation pays for being governed by those who are focused on shoring up the fragile world of finance.
The evidence pointing to speculation is in fact abundant. In February, price-earnings ratios in the case of many stocks, especially those from the much-celebrated new economy, had touched levels that were not warranted by even the most optimistic estimates of future earnings of the firms concerned. Few believed that such prices were "real" or could be sustained. But yet prices remained high because those bereft of such stocks wanted in, and those holding them dared not dump them for fear of losing out on further highs. The collapse, euphemistically termed "correction", of that speculative rise in stock price, had to wait for the weakest nerves to give. And Tuesday the 4th they did.
In normal circumstances, speculative losses are considered just recompense for those taking more from the till than their palms can hold. But not so in post-liberalisation India. Virtually ignoring the obvious role of speculation, the government set about searching for reasons to explain market nerves, so as to respond to them. Two came in handy. First, notices served by India's income tax department, on a set of foreign institutional investors, demanding payment of close to Rs. 9 crores, in view of their avoidance of capital gains tax. The IT department's notices were based on a presumption that companies that were not eligible to avoid paying tax in India under the terms of the double taxation agreement between India and Mauritius, had claimed such benefits. And, second, signs of a collapse of a similar boom in the Nasdaq, the New York index of high tech stocks.
The response to the first was indeed appalling. It is now well known, that using the benefits of India's double taxation treaty with a quasi-tax haven like Mauritius, companies were routing all their investments through that country. According to reports there are now around 150 companies "based" in Mauritius that have investments in Indian markets. According to one estimate, these firms accounted for close to two thirds of the cumulative $11.4 billion portfolio inflow into India till April 4. However, given the income tax departments reading of the terms of the treaty, it had made clear that it did not consider all these companies as meeting the criteria rendering them eligible for the benefits of the treaty. In fact, in assessments conducted thus far, there are 24 companies that have been allowed the benefits, and a similar number of companies who have been certified as ineligible. It was to some of the latter that the notices had been served.
It is indeed completely acceptable that when large speculative capital gains are being raked in by foreign institutional investors on Indian soil, the Indian government should have the right to tax away some of those gains, just as it does in the case of Indian investors. In fact, till last year's budget the Finance Ministry had been discriminating against Indian investors and in favour of foreign players by setting the capital gains tax imposed on the latter at a lower level. While the long term capital gains tax on residents stood at 20 per cent, that on non-residents had been brought down to 10 per cent. Good sense prevailed, and that discriminatory policy was done away with, even though it involved reducing the capital gains tax rate for Indian players, rather than increasing it for foreign ones. If despite this, foreign investors still had a relative advantage, because they could use the Mauritius route, what was necessary was to renegotiate that treaty to correct for the anomaly.
In practice, however, when the Income Tax Department chose to launch limited action against those it felt were wrongly using the terms of the agreement, an expected "correction" of a speculative boom in the market was attributed to FII disappointment with the action. The fact of the matter is that, FII investments hardly turned negative in the wake of that action. It is true that net FII investments fell from $99.3 million on 2 April 2000, to $24.3 million on April 4, the fateful Tuesday. But a positive net investment can hardly be a cause for a collapse in the Sensex. Moreover, such volatility is typical of FII net investment flows, which, for example, fell from $363.2 million over December 1999 as a whole to $34.8 million in January 2000, only to rise sharply to $639.4 million in February and fall again to $244.1 million in March. In any case, the rather moderate rates of capital gains taxation in India can hardly dampen investor sentiments.
Despite all this, the government responded with unusual alacrity to (engineered?) market rumours that the tax notices had set off the April 4 slide and issued a clarification that very day that the action would be put on hold. Clearly the fact that the government faces a fiscal crunch and that the tax-GDP ratio had been declining during the years of reform, necessitating additional resource mobilisation, seems less important to the Finance Ministry, then the presumed adverse consequences of a tax collection effort on foreign institutional investor sentiment. This implicitly amounts to sacrificing fiscal sovereignty at the slightest hint of FII resentment. By ensuring large FII flows through financial liberalisation, the government has rendered India vulnerable to a sudden withdrawal of such capital. This vulnerability is now being provided as the reason for subordinating domestic policy to the requirements set by perceived FII sentiment.
"Perceived" because in hindsight, it appears that the second of the factors quoted above, namely "Nasdaq sentiment," appears to have been the likely cause for the April 4 slide. Through March, new economy stocks in the US have been under stress, as investors who were betting on companies that had been toting up losses for months on end, had begun to loose nerve. This was aggravated by two other developments. A spate of auditor's reports pointing to questionable accounting practices as well as clear signs of lack of viability in the case of a number of "new economy" firms. After a number of days of almost repeated losses, on Tuesday the 4th, the Nasdaq plunged 13 per cent by mid-day. Though the index recovered subsequently, it was clear that the high-tech stock boom in the US had lost its vigour, even if it had not fully collapsed.
This experience should have had only a marginal impact on India. The growing number of internet-based, dotcom companies are yet to dominate the market here, being predominantly financed by venture capital firms, whose funds were being poured into advertising in order to attract clients and consumers to new sites and portals. However, there were other factors that could have resulted in the Nasdaq developments influencing market sentiment in India. To start with, much of the recent boom in the market has been focused on "new economy" firms from the IT and entertainment sectors. As a result, as mentioned earlier, price earnings ratios in the case of these firms had reached astronomical levels, making it clear that there was little likelihood of the actual performance of these companies matching the expectations implicit in those ratios. The losses of dotcom firms that appeared to be spiking the internet bubble in New York, had a parallel here in the form of the inadequacy of actual relative to implicitly expected profits of a few new economy firms that dominated the market. At the peak of the February boom, one such firm (Wipro) accounted for 15 per cent of market capitalisation in the BSE and the combined market value of around 150 software companies accounted for 32 per cent. This compares with the fact at the beginning of the 1990s, these companies hardly featured in the BSE.
Further, at the margin, it was clear that if the boom in the market had to be sustained, the newly emerging dotcom companies in India had to play a role. In the face of disillusionment with available new economy stocks, investors were not returning to older companies which dominated the market, but turning their attention to these dotcom companies. Every major fund manager had created a special fund for investment in what were seen as hitech stocks. The realisation that such stocks were not the best buys would, therefore, have affected market sentiment at the margin.
A more reasoned response would therefore have been that the April 4 slide per se was not much cause for concern. The real problem is why old economy stocks have for quite some time now been performing relatively poorly, resulting in significant changes in the relative shares in market capitalisation of old and new economy firms. One major reason for this sluggishness in the old economy is the fact that stock values there seem far more tethered to trends in the real economy. Recent evidence of a modest recovery in the index of industrial production notwithstanding, the overwhelming impression is one of sluggishness in the industrial sector. Non-oil imports are virtually stagnant, despite the post-liberalisation increase in the import-intensity of domestic production. Investment rates are low and so are imports of capital goods. The recovery of industrial production appears to be due to the lagged effects of a good agricultural year and the implementation of the Pay Commission's recommendations. Since, agricultural growth is likely to be lower in 1999-2000 and the stimulus provided by higher salaries and salary arrears would soon weaken, capacity utilisation is expected to return to lower levels. As long as this sluggishness persists, stock market trends would remain skewed and speculation prove crucial for stock market buoyancy.
Thus even a government concerned with financial market (as opposed to real) indicators would be keen on engineering an industrial revival. However, even here the government appears to be relying only on financial levers. Obsessed with the fiscal deficit while handing out fiscal concessions, such as that on capital gains referred to earlier, it has had to cut expenditures, especially capital expenditures. This at a time when unutilised capacity in industry, slow agricultural growth, persisting poverty, large foodstocks and comfortable foreign exchange reserves make a strong case for higher spending aimed at triggering an industrial revival.
Unfortunately, a higher fiscal deficit, just as much as a higher tax rate, is considered anathema from the point of view of the foreign portfolio investor. In the event, the government has chosen to rely on the twin monetary measures of pumping in greater liquidity and reducing interest rates to spur industry. Recently, Reserve Bank of India Deputy Governor Y.V. Reddy reportedly declared before Reuters Television cameras that: "Our preference and the preference of most of the market participants is to have an easier interest rate regime at this stage of development." In keeping with this perspective, the government launched on a series of concerted efforts, involving reductions in the Bank Rate of the RBI, and in the CRR and SLR of banks, aimed at bringing down interest rates.
As a result, after the debilitatingly high levels that interest rates touched during the stabilisation of the early and mid-1990s, they have been moving downwards. The prime lending rate, or the rate at which banks claim they lend to their best clients (which came into operation in October 1994), stood at an average of 15 per cent in 1994-95 and 16.5 per cent in 1995-96. Needless to say most ordinary borrowers would have been charged rates which were between 2 and 3 percentage points higher than this. Since then the PLR has indeed declined, to 14.5-15 per cent in 1996-97, 14 per cent in 1997-98, 12-13 per cent in 1998-99 and between 12-12.5 per cent in September 1999.
As should be clear, this lowering of rates has done little thus far to reverse the sluggishness in the industrial sector. Yet, the government has stuck to this strategy. One more initiative in this direction was the reduction in the cash reserve ratio (CRR) of banks by one percentage point in the monetary policy review for 1999-2000, which, by releasing liquidity to the tune of Rs.7000 crore was expected to help ease interest rates. At Budget time the Finance Minister announced a cut in interest paid on small savings schemes like the public provident fund and national savings certificates. More recently, on April 1, the RBI once again cut the Bank Rate, the CRR and the repo rate by one percentage point. This has further encouraged major banks to reduce their lending and deposit rates.
While there is an observed lack of responsiveness of investment to interest rate reductions, these cuts are resulting in two other tendencies. First, they are encouraging at least some small savers to move out of bank deposits and government savings schemes and into the stock market. Second, they are encouraging a range of players to borrow at lower interest rates and bet on equities. In sum, in the midst of the speculative boom in the markets, the government is channelising more money into stock market investments. This together with the signal it sent out by putting the tax notices on hold, have encouraged new investments in the market, resulting in a reversal of the April 4 decline in the Sensex. That reversal has only been aided by the fact that further news of robust growth in the US has resulted in a mild revival of the Nasdaq.
As a result both the Nasdaq and the Sensex have recouped some of their losses. This may be good news for now, but it implies that the much-needed "correction" in markets here and in the US is being postponed. In India this means that attention would continue to be diverted away from the real economy and the measures that are urgently need to spur real growth and deal with persisting poverty. That is the price the nation pays for being governed by those who are focused on shoring up the fragile world of finance.
© MACROSCAN 2000