Shooting the messenger

A stock exchange should instill confidence in companies to list and investors
to trade

To enjoy the freedom of pricing issues, it is clearly understood that issuers have to be upfront about their track record. What if the Securities and Exchange of Board rejects the offer document on the grounds that disclosures are “dishonest”? The issuer has the option to contest the dismissal with the Securities and Appellate Tribunal. Irrespective of the outcome, there will be an intangible consequence: loss of investor confidence. This would be particularly worrisome if the applicant is a stock exchange, where investors expect transparency not only from listed companies but also in trading. One of the reasons for the decline of the Bombay Stock Exchange was interference by promoters, who also happened to be trading members, in its functioning. Subsequently the exchange restructured ownership in the process of becoming a company. The bone of contention now is the indirect shareholding of a stock exchange proposed by MCX, a commodity exchange, and Financial Technologies, a tech firm. Apart from each owning 5% equity as per regulation, promoters hold warrants convertible into equity amounting to 60% of the capital. These shares would carry no voting rights but rank on par with ordinary shares. It is possible that those in possession of the remaining equity could take control or even obstruct management if even half of them vote as a bloc. This would happen if the remaining shares are not allotted to associates and those favorably disposed to the promoters. In fact, Sebi feels all friendly shareholders together should not hold more than 5% equity and has accused the exchange promoters of “withholding material information on arrangements regarding the ownership of shares of its shareholders”.

Very few companies listed on Indian stock exchanges have two classes of shareholders as the market strongly disapproves of promoters’ sly attempts to keep control of their company and at the same time invite investors to share the risk without any say in its affairs. Foreign investors have shown reluctance for this sort of dual structure proposed by the government in the banking sector. In this case, promoters have controlling economic interest rather than voting power. This appears to be an attempt to occupy a seat at the table to enjoy listing gains rather than a safety net to thwart hostile bids. Instead of acting to comply with Sebi’s demands, the promoters have chosen the scorch-earth policy followed by retreating armies. They hint at conflict of interest: C.B. Bhave,the Sebi boss, was earlier the managing director and CEO of National Securities Depository, promoted by rival NSE. This sort of character assassination is a typical strategy employed in corporate warfare. Witness the muck being thrown around in the SSK Microfinance power struggle. It was even insinuated that Henry M Paulson, the US treasury secretary during the financial meltdown, influenced the decision to allow Lehman Brothers to collapse, put pressure on Bank of America to bail out bankrupt Merrill Lynch at a very high price, and assisted J P Morgan Chase to buy Bears Stearns at bargain price due to this ties with Goldman Sachs.

By extension of this logic, all decisions on banks and mutual funds taken by previous Sebi chairman M Damodaran should be reviewed because of his stints with IDBI Bank and UTI. If O P Bhatt, the current chairman of SBI, is selected to succeed Bhave, should he recuse himself from rulings that may impact, say, ICICI Bank? Or, going forward, can a software company allege foul play against disciplinary action for violating the listing agreement with the new exchange whose promoter is in the IT space? In the appointment of Damodaran and Bhave, the government had made a cautious beginning of inducting IAS officers with some market experience to head Sebi. After this episode, do not be surprised if a vanilla bureaucrat is once again selected to head the watchdog. Another crucial question is: do we need a third stock exchange? Competition brings down trading costs and throws up arbitrage opportunities. At the same time, investors prefer a platform that has the weight of volume. For this reason, there has been a wave of consolidation between bourses in Europe and in the US. Online trading has made niche presence to attract regional investors redundant. NSE’s success also hinges on its ability to flag off derivatives trading before BSE could get its act together. This does not mean there is no place for another efficient and transparent bourse that will appeal to foreign investors. To succeed, the exchange should set an example by adhering to not only the letter but also the spirit of the law.
MOHAN SULE

Moody markets

Sustainability of the rally will hinge on the world becoming flat once again

Just like meteorologists, those in the profession of mapping the market mood are becoming predictable. The forecast for the day following a thunderstorm typically is an extension of the previous day. The situation is exactly the opposite for the markets. Red flags are raised about heated markets and overvalued stocks following a few days of aggressive buying, while a declining trend is promptly declared a buying opportunity. During the last bull-run however, money managers had started mimicking weather forecasters and were predicting greater heights for the benchmarks even as they were breaching new records on liquidity flow from foreign funds and low interest rates. During the current recovery, market intermediaries reverted to their cynicism and were cautioning against rich valuations based on trailing earning. In hindsight, both projections were off the mark. Soon after crossing 21,000 in January 2008, the market began sliding on credit crunch in the US. Rather than correcting to the historical median level based on trailing earning growth, stocks sprinted forth in September 2010 even as market watchers debate over the triggers and how far they would head as foreign investors scramble to buy the India story. The act of defiance seems surprising coming so soon after the Reserve Bank of India once again nudged up policy rates to tame inflation as the double-digit annual expansion in the Index of Industrial Production over the month of July signaled the heating up of the economy. The behavior of the market, which is fairy discounting even one-year forward earning, seems to be at odds with traditional economic theories.

Any rise in interest rates is usually followed by fall in stock prices across the board. Higher cost of money not only makes borrowing expensive for investors to buy stocks and for consumers to finance non-durables but also for companies to fund expansion undertaken to meet demand that goes up in a booming economy. The domestic currency appreciates as a result, denting exports. Imports become cheaper, hurting local manufacturers. Hiking of interest rates sets off a chain reaction and has to be undertaken after careful calibration to ensure that growth merely slows down and is not derailed. For this reason perhaps, the RBI has left untouched bank rate since 2002, but has been tinkering with short-term borrowing and lending rates. High long-term interest rates and high growth rates cannot coexist. Foreign investors seem to have recognised the central bank’s caution as temporary. Normal monsoon is expected to cap foodgrain prices as kharif crops start arriving in the market and bolster rural purchasing power, spinning off into higher topline growth for a host of sectors including automobiles, real estate, cement, consumer non-durables, fertilisers, and banks. Despite the hardening, interest rates are still low than the 2007-08 level. More emerging economies like India raise interest rates, more attractive they will become until recovery takes root in the western countries.

The recent rally is at odds with the theory of a flat world, which suggests prosperity will spread from one corner of the globe to the other as trade barriers crumble and funds slush around to find the most lucrative investment opportunities. Also, stocks become cheaper if the currency is weak. Instead, there is unidirectional flow of funds from the US with a weak dollar to the developing economies with stronger currencies. The sustenance of the market surge, thus, will hinge on three factors. First will be the pace of bounceback in the US and Europe. Recession in the US was officially declared to have ended in 2009 though recovery is still weak and another fiscal stimulus package may be required to shake up the economy. This seems unlikely in view of the huge fiscal deficit. Till then, emerging economies will continue to attract hedge funds rather than serious long-term money from pension funds, which would fret about valuations in relation to growth. Once this happens the market will gain at a steady clip rather than at a furious pace like in the last leg of the rally that ended in January 2008. Second will be the signal from commodities. Still subdued despite the spurt in consumption by China and India, oil’s rise on demand from developed economies could slow down the bull-run in emerging economies. On the other side, investors flocking back to the NYSE and Nasdaq could soften gold, currently scaling new peaks. The third, and related, signpost would be the US Federal Reserve resuming raising discount rate. This would strengthen the dollar and free the RBI to aggressively tackle inflation rather than doing this in bits and pieces. Till the time the world returns to becoming flat once again, there will be continued unease over the continuation of the current rally.

MOHAN SULE