Though Reserve Bank of India (RBI), through monetary instruments succeeded in protecting Indian commercial banks from global financial crisis, the Securities and Exchange Board of India (SEBI) did not succeed as much to protect the stock markets. From January to September 2008, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) jointly lost Rs. 56,47,685 crores in terms of market capitalization which amounted to more than Gross Domestic Product or Aggregate Liquidity Stock of India. The regulators of stock market presumably did not pay enough attention to this loss, probably because it is not a debt based entity and they saw no need to bail it out. But does this loss have anything to do with economic growth of India? Or has Indian regulators ever thought about converting this amount into real capital formation instead of paper assets?
A sincere thought may suggest that India needs strong regulators to attain sustainable growth in financial sector; otherwise there would be mismatches between the financial and real sectors in terms of growth. Dr. D. Subbarao, Governor, Reserve Bank of India at the RBI-BIS Seminar on “Mitigating Spillovers and Contagion – Lessons from the Global Financial Crisis” at Hyderabad on December 4, 2008 raised following five questions:
i) How do we manage global imbalances?
ii) Is self-insurance a viable option for emerging economies?
iii) How do we reform financial sector regulation?
iv) How do we address regulatory arbitrage?
v) How do we keep the financial sector in line with the real sector?
Though his focus was mainly on capital account management after global financial crisis, it is good to see that he is willing to review the Indian financial regulations as well. Certainly time has come up to act upon such issues because some lapses in this regard pull us down. During the years 2006-07 and 2007-08, the growth rate in financial sector has been higher than other reality sector growth rates. We have now reduced demand of credit and RBI Governor opines that it is due to slow down of economic growth whereas practically the higher cost of credit during global recession has restricted growth in credit demand.
There is a correlation between the growth of financial and real sectors; and wherever the financial sector growth rate exceeds than the growth rate of other real sectors, the appreciations in financial sector might start eating up economic growth potentials of other sectors. It might be apprehended that this is what has been happening in India where capital market appreciations, growth in aggregate deposit at Scheduled Commercial Banks (SCBs) and credit growths have surpassed growth rates in real sector. The confidence and financial strength of enterprises declined considerably due to poor monetary and economic policies and some instruments designed to counter the side effects of poor policies. If the monetary policies will not be in accordance to national plans, the economy will not grow according to set plans and planners may need to review the plans. The pro and cons of prevalent monetary policies and instruments may need separate debate.
RBI launched the capital market and with development of capital market SEBI was formed to regulate capital market. Since the strategy was not very clear to develop an investment market instead of capital market, SEBI could not develop the stock markets into market for investment funds; rather it developed the stock market as OTC to transact equities. Despite the fact that in due course of time, the values of stocks in capital market surpassed the total deposits in all banks; SEBI still finds itself on back bench to regulate the financial sector because the monetary policies are mainly regulated through RBI. This approach of financial sector has yielded boom in speculation business as the trade of equities has just enabled the speculators make money through screen touch pricing at stock markets and the invested funds in stock market were not delivered to production units. Instead, it was, absorbed by appreciated equity prices and increased values of derivatives.
Unable to attract even 10% of national domestic household savings form less than 2% Indians, with liberalization of capital account, the Indian stock market has been mostly heated up with portfolio investments by Foreign Institutional Investments (FIIs). After liberalization of capital accounts in 2004-05, with increased foreign inflow the stock indices started picking up new heights due to increased trade volumes; but after sense of global financial crisis, the decline in indices is also noticed at faster rate with rapid outflow of capital from stock markets. The stock markets are now more exposed to international capital market, thus the global financial boom and crisis considerably affected the Indian stock market. Now any appreciation or deflation in stock market indices up to 5% in a single day is a normal rate of fluctuation. Now the question is how successful these stock markets in economic growth of India?
An Investor is basically speculative by nature, but excessive role of speculation in financial sector is not only dangerous for the financial sector alone. It also entails dangers for real economic growth. The development of screen based trading for primary and secondary markets was needed to invent prices at daily basis, but it also increased uncertainty in the stock prices where instead of companies real business trend, the speculator’s temperament depending upon capital inflow and outflow decides the stock prices. Further the market capitals are not flowing towards real enterprises because the focus is on speculation based trade of equities instead of real term investments.
With liberalization of capital account, Indian regulators were not prepared to divert the capital inflow towards productive units, and thus the immediate concentration of inflow capital in secondary market increased the volumes of equity trade which inflated the values of equities, stock indices and market capitalization. These increased values of equities, indices and market capitalization did not favoured economic growth rather created pressure for inflation. The liquidity absorption capacity of Indian stock market failed to control the pressure of increased volume of equity trades through screen touch price mechanism and Indian economy observed appreciation of capital resources at stock markets. We failed to grab economic advantage of financial boom in stock market and thus could not retain the growth momentum and the capital market started falling after boom.
When the Market was moving upward, during nine months period Market Capitalization at BSE increased by 102.25% (from Rs. 35,45,041 crores in March 2007 to Rs. 71,69,985 crores in December 2007) and by 94.32% in NSE (from Rs. 33,67,350 crores in March 2007 to Rs. 65,43,272 crores in December 2007); financial experts were quite happy to cite the growth rate in stock indices. Pity to observe that this tremendous increase in stock Market Capitalization has not helped the GDP growth rate to move north, instead during this period, the GDP growth rate has declined from 9.2 in the first quarter to 8.8 in the third quarter during 2007-08. Since this considerable increase in Stock Market Capitalization was not chanalized to productive system, rather restricted to speculative trade only which could not last long without real economic growth, by January 2008 onwards the Stock Market started falling and during a period of nine months, Stock Market Capitalization of BSE declined by 41.91% (amounted as Rs. 41,65,384 Crores by September 2008) and NSE by 40.39% (amounted as Rs. 39,00,185 crores by September 2008).
During growth of market capitalization at BSE and NSE, unprecedented amount of money been invested in stock derivatives. These trades and investments in stock and derivatives did not helped GDP growth, rather created inflationary pressures in India. Since the real economy could not grow by speculations and derivatives businesses, with global recession and fall in GDP growth rate, the stock market started falling. While empirically it is proved that screen touch price mechanism of stocks could allow growth of speculative business only, and not the real business, the regulators have to think about means to convert the stock market capitals into real assets for production units instead of paper assets. After corporatization and demutualization of stock exchanges, stock exchanges itself has became an attractive business and the stock market intermediaries put all efforts to boost trade volumes instead of mobilizing real investment funds because on every trade they get commissions. So we cannot expect market ethics from stock markets intermediaries, and thus SEBI should set norms for trade of equities and put targets for issuance of IPOs to make balances in ethics and business, so that the stock market could succeed in meeting capital requirements of Indian economy. The motives of generating capital resources for enterprises has left behind motives to earn commissions on every trade and the stock market intermediaries are more conscious about falling trade volumes instead of capital formations. SEBI need to pay immediate attention on such issues. The system of free-float market capitalization of just 30 companies instead of all listed companies to calculate index value does reflects good index while market is moving north, but create unfavourable environment when market moves to south. Moreover it never reflects the overall strength of capital stock. The stock market capitalization does not help the companies get advantages because the value of market capitalization increases due to increased stock prices after increased trade volumes and it do not increases the liquidity of companies. Even 100% growth in stock market capitalization has not helped the GDP grow at 10% because stock market capitalization is not really boosting domestic capital formation due to high intensity of trade compared to investments. Provision to buy stocks against borrowed securities is allowing the speculators make faster trading which misleads the real growth of stock market. It simply reflects provision of excess liquidity in stock market which inflates the stock prices. The introduction of short term capital gain tax is not enough to control business of speculation because last year the amount of share delivered were only around 30% of transacted trade values. Moreover the uncertainty in stock markets is forcing investors pull their hands back during financial crisis causing chaos. The provision of reserving some shares from free float and putting rest on market price risk is unfair in terms of general investors. The condition of limited liability by subscribing shares is also not helping the corporate to mitigate risks of liquidity crisis, which has caused many financial giants to collapse despite having large share subscribers. The listed companies should not be allowed to take debt based credits and equity finance simultaneously; rather the listed companies should be allowed to raise more capital through equity only because it should be the right of share subscribers to know financial risk of listed company which increases if companies take debt based credits. The data on FDI shows that India is still a popular economy for Investment; and there is neither scarcity of investors nor avenues for investments in India, condition we provide security to investors against uncertainty in the stock market which is more due to speculation compared to real economic factors. Increase in FDI and outflow of portfolio investments by FIIs reflects that investors realizes that India has the business potential, but stock markets are not safer to invest at the time of global financial crisis when rumours act faster than other market forces. SEBI must come up with assuring higher returns in terms of dividends over shares despite global financial crisis. After global recession since the current account balances is bound to decline, the growth potential for multinational companies will decline, however Indian domestic market is strong enough to compensate the losses if we make due regulatory changes in financial sector. With capital outflow the shortage of credit is observed by corporate sector and with declining demand in global market; they might find it difficult to accept debt based credits. There is no sane in promoting interest based banking as alternative to equity finance because the lower financial risk mitigating capacity of unorganized sector enterprises does not allow them have interest based credits; and under pressure of decreasing sales and higher input costs, even corporate sector might not increase their debt based credit demands. So, it is obvious that with global recession, the stock market will decline and so does the debt based credit demands. Till now the unorganized sector enterprises in absence of adequate capital labour ratio, art of technology and facilities of equity finance have been finding unfair grounds to compete with the organized sector. It is time for Indian financial regulators and planners to evaluate potentials of unorganized sector and introduce suitable banking and financial services so that the unorganized sector enterprises may avail advantages of equity based credit to grow faster and mitigate the overall loss in economic growth of India. Since their market is localized and unaffected by global recession, Indian financial sector regulators have to promote localized equity based banking and financial institutions for these enterprises that have ample market to grow. Equity finance for unorganized sector would let them afford increasing labour capital ratio and art of technology to produce qualitative products and services for domestic consumption at comparative prices. It would allow the unorganized sector grow at desired rate and compensate economic loss even if corporate sector growth rate declines due to reduced demand at international market. Thus RBI and SEBI should jointly focus on developing policies and schemes to promote equity finance for unorganized sector. This might be possible through linking small localized equity based banks with stock markets where investors might approach with funds for FDI. The local area small equity banking and financial institutions would be required to finance and closely monitor the business projects for returns. Local statutory audit team may be deployed to monitor the accounts of unorganized sector enterprises. This would help the unorganized sector enterprises get accustomed of standard accounting practice and allow them use art of technology and adequate capital labour ratio to perform at optimally. This would not only improve the infrastructure of the unorganized sector, but also ensure faster and inclusive economic growth of India. If our regulators do not open local equity based banking, the financial sector may face harsh situation in near future because the aggregate deposits are increasing at SCBs, especially the interest based term deposit are increasing against fall in capital market. The banks are already observing fall in growth of credit demand because the corporate sector and multinational companies cannot afford debt based credit because these companies cannot afford to increase the input costs with interest based credits under a condition that requires reduction in prices of products and services by reduction in their input costs. Whereas if banks starts promoting equity based banking, it would reduce the deposit mobilization costs for bank and allow these banks to offer equity finance to both organized and unorganized sector enterprises. This would not only allow the banks find new sources of funds but also provide economic viability under conditions of global recession. At present the stock market can’t rely on inflow of capital except FDI which might be linked to enterprises in domestic markets. But to do so, stock markets need to be much federal in nature comprising network of smaller exchanges linked with each others. It needs some revolutionary changes in nature of work and focus of SEBI which has been serving the corporate and multinational companies so far. The local equity based banks and smaller stock markets may not be developed immediately, thus instantly SEBI and RBI need to came together and develop understanding to promote equity based banking and finance which might open up scopes for smaller banks and stock markets at local levels. The nature of equity based banking might be different from capital market where investors used to transact equities through screen touch price mechanism. However for local equity based banking or interest free banking may interact with stock markets to get investment funds for local small enterprises where shares might not be sold at stock markets through mutual funds rather composite business projects could be offered for partnerships. The investment funds could be transferred to local banks that might finance and monitor the projects with help of local statutory audit teams and deliver returns to investors through stock markets and take its due share as management charges to administer the funds. The regulators should control the market through innovations and art of technology along with ethical supervision to protect the markets from excessive speculations. Economic rationality is needed to boost financial sector growth, but ethical norms should be well insulated into the system to protect it from excessive speculation. SEBI must make policies to promote IPOs instead of allowing stock markets to increase the trade volumes. Like, it may restrict that any investor can’t sell any particular purchased share in a specific period like one month or three months, similarly it may be regulated that no company can offer more than 10% equities to free float market. There should be efforts to find long term investors as subscribers of IPOs. With monetary instruments we may handle liquidity pressure for shorter period, but cannot avoid consequences of recession without policy initiative to allow interest free or equity based banking and finance which is meant to counter problems like higher input costs, default in lease finances and gap in transacted and transferred traded values. The focus of SEBI to promote stock market trading should now be shifted to arrange FDI on project basis instead of encouraging share trading. The investments should be canalized into genuine project finances on medium and long term basis instated of short term investments on equities. For short term investors arrangements could be made for investments in short term trade finances. And the derivatives have to be purified from business of speculation and shifted to real term business. This way we might resolve the problem of financial imbalances among sectors and economies. This would allow the unorganized sector to grow faster and help India attain desired growth even in case of unfolding global recession. Probably such regulations may help us get escape from loss of equity values worth over Rs. 56,00,000 crores in a period of just nine months. Rather it may help India double its national income through participation of unorganized sector enterprises who have been suffering in absence of equity finance and never find it easy to compete the formal sector that always enjoyed equity finances. I hope Indian regulators especially RBI and SEBI would find solutions for some concurrent financial problems associated with global economic recession. But if we have to allow our financial sector and real economy grow despite global recession, the interest based banking has more challenges compared to equity based banking which might help us find new emerging Indian economy under new financial sector regulations.