The more the better

Increased supply of paper to absorb foreign flows will correct secondary market valuations

Money chases a market that is fairly valued even on one-year forward earning for two reasons: dearth of other investment avenues and opportunity for arbitrage. The near zero interest rates in many developing countries point to risk aversion. The absence of instruments to park their funds are prompting institutional investors to look east and south. The flow could accelerate if the US Federal Reserve resorts to another round of injection of liquidity to spur the economy. Not surprisingly, there is once again that familiar sinking feeling after the initial euphoria over the torrent of foreign portfolio investment flowing into the country. Besides heating up the economy, foreign flows also boost the local currency, blunting export earnings. Second, the inflow could turn into outflow on any trigger in the developed economies or if emerging markets impose controls to regulate and even restrict the flow. In 2008, the collapse of the mortgage-based securities market in the US resulted in a credit crunch and withdrawal of funds by investors across the globe. Now, increase in interest rates by central banks of western countries on recovery gaining ground could provide the signal for foreign funds to look at their domestic markets. The Indian market lost 1,500 points in the three days till 19 October 2007, when Sebi proposed phasing out of promissory notes (PNs), through which unregistered foreign institutional investors take exposure to the Indian market, in 18 months. The regulator had to rescind the ban a year later. Brazil’s stock market witnessed withdrawal symptoms on the imposition of 2% tax on overseas investors’ stock purchases late October 2009.

Taxing foreign investment to discourage hot money and imposing lock-in to prevent sudden flight of capital are the two most common barriers erected by many emerging countries to stem the excessive overseas liquidity making its way into local markets. Foreign investors do not like sudden disruptions in policies and tax regime. The remedy, thus, could prove worse than the cause. Fortunately, India was saved from taking any action in 2008 by the collapse of Lehman Brothers and the resultant meltdown in the financial markets later that year. Two years on, India once again has to confront the dilemma if it does not want asset bubbles. Buying dollars by the Reserve Bank of India could fuel inflation on release of rupees in the system. Instead, structural adjustments could be a preferred alternative. One of the immediate steps would be to revist the ban on PNs. Sebi insists on know-your-client norms for Indian investors. So why not for foreign investors? A major factor for stock valuations going for a toss on deluge of dollars is the lack of depth and liquidity of the Indian market. There is just not enough paper to allow the huge pension and sovereign funds to participate in India’s growth. Besides the 50 stocks in the Nifty including those in the Sensex, institutional investors’ universe extends to another 100 or so counters. The remaining stocks have very small public float or have corporate governance issues to contend.

There are two ways of going about to meet the demand: encourage more companies to list and those listed to raise more capital. The viability of this strategy was evident from the way the market took a pause when the Coal India IPO was open for subscription last fortnight. This would allow investors waiting on the sidelines to enter the market. The present time is right for the government to speed up its stake-sale in PSUs as foreign investors are particularly partial to divestment programs. It should also draw up a timetable, as was done when companies were mandated to switch their physical shares into electronic, by categorizing those with low public float as per market cap to ensure orderly supply of paper. More companies will list or raise capital if the market sentiment is friendly. Dilution will not remain a concern if the economy continues with its trail-blazing growth. The market’s response will hinge on the experience of investors with the earlier IPOs/FPOs. Tepid listing or erosion in wealth by even one or two large issues can puncture investors’ enthusiasm. The last time the primary market busted was when the huge Reliance Power issue, the biggest till Coal India IPO came along, that opened mid January 2008 failed to translate its marketing hype into reality by closing 17% below the offer price on listing. The responsibility of ensuring that the foreign fund inflow is sterilized to cap inflation and the rupee is not only with the Indian government and the central bank but also with investment bankers to curb promoters’ and their greed to prevent the economy from stalling.

MOHAN SULE