No free lunch

By Mohan Sule

Controls on the flow of capital to protect the domestic financial market are effective in the short term but result in prolonged volatility

Investors take into account many factors while entering a market. These include quality of stocks, market share, future potential, taxation regime and political stability. The most important is liquidity. Stock exchanges use two methods to meet the criterion. The obvious is to make the listing procedure stable and transparent. By laying down norms, exchanges segregate companies based on what sort of audience they want to attract. Some of the world’s biggest companies are traded on the NYSE. Tech companies opt to list on Nasdaq. The BSE has a separate platform for small and medium enterprises. The specialized set of companies attracts investors aware of the risk-reward equation. Stocks included in indices and the derivatives segment ensures a large number of participants. At each stage, picking stocks for special treatment implies wielding of control to retain the characteristic of a market. The process also means there is nothing like unfettered access to a stock or market. Circuit breakers are safety nets to prevent a blowout. In India, for instance, shareholders’ nod is required to determine the extent to which foreign investors can buy into a stock. The Securities and Exchange Board of India insists that market intermediaries know their clients. Premature withdrawal of fixed deposits invites penalties. Some equity and debt funds slap exit loads for redemption within a certain timeframe. A differential tax rate regime for long- and short- term capital gains is another hurdle.

Investors, too, understand the limitations. The problem arises when the regulators and the state machinery intervene to prop up or suppress the market. The two most recent examples of imposition of obstacles to change the course of the market are China and Greece. Worried about a bubble, China tightened the margin requirement to borrow to trade. The kneejerk reaction to the backlash that ensued was to reduce interest rates, ban IPOs, and order state institutions to buy shares from the secondary market. The meltdown has been contained, for now. The question is: for how long? The economy has to revert to double-digit growth for the Shanghai stock exchange to sustain once the artificial support is withdrawn. The curtain has still not fallen on the comic-farcical Greek drama. The shutdown of banks, then caps on deposits withdrawals and the five-week halt to trading did contain capital flight. The steepest fall of the stock market in a decade on opening indicates that the inevitable merely got postponed. Past experience suggests that economies hampering free flow of funds enter a period of ups and downs. After the debt crisis of early 1980s, the thriving Latin American economies had to struggle for more than two decades before the commodity boom of the early 2000s lifted them out of the rut. The growth of the Tigers of South-East Asia slowed down after the currency crisis of the late 1990s. The common thread is the intervention by their central banks to regulate the passage of capital. As the US Federal Reserve started buying bonds and kept interest rates near zero, cheap money found its way into the emerging markets of Asia and Latin America in the second half of 2009.

In response, Brazil levied tax on the purchase of financial assets by foreigners and Taiwan restricted overseas investors from buying time deposits. Indonesia implemented a one-month minimum holding period for certain securities. South Korea placed limits on currency forward positions. Mexico, Peru, Colombia, South Africa, Russia and Poland, too, tightened capital controls. India’s central bank was praised for keeping domestic institutions on a tight leash. Despite the obstacles, investors chase markets offering higher yields. Yet here is an undercurrent of concern. Most of the flow is from unstable sources such as hedge funds and arbitrageurs, who aim for absolute returns and not beating the benchmarks. Their participation, necessary for liquidity, increases volatility. The special investigative team probing the problem of black money created panic in the market recently when it noted the use of loosely-monitored participatory notes as one of the conduits. China’s stock market collapsed after easing entry to foreign investors recently. India’s shallow market has ensured that foreign investors have to take exposure to index and large stocks traded in the F&O segment. Amid the turbulence, one country stands out for not clamping down on the market even at the height of global credit squeeze. Inflows into the US, particularly from China with ambitions of the renminbi becoming the global currency despite rigorously calibrating the flow of overseas funds, continued due to the confidence that there would be no hindrance in taking out capital. So is it any surprise that the dollar remained firm against all other currencies even post September 2008?

The helpline

By Mohan Sule

Use forex reserves to buy bad loans of PSU banks so as to profit from low commodity prices and US recovery

Global financial markets took one step forward and two backwards last fortnight. Even as the Greece blowout was being contained, China’s stocks melted and there were indications that the US interest rates were set to rise. The dollar strengthened and commodities collapsed. So there is a strange spectacle of the US economy regaining health even as rest of the world is struggling. As a major consumer of commodities, India’s current account deficit will narrow further. Cheap metals will boost a host of industries including refineries, power distributors, capital goods, automobiles, consumer durables, paper and packaging, paints and FMCG. The margins of tech, pharmaceuticals, garments, jewellery and other services exporters might expand A weak rupee should be an incentive for global manufacturers to set up base in India to export. What could be a better booster dose for the prime minister’s Make in India project? The problem is that the Indian rupee’s depreciation against the dollar is on the lower side compared with those of other emerging economies including Russia and Brazil. Due to the scare about China slowdown, foreign investors have not completely abandoned India. The market is huge and so also the scope for reforms. Their presence is keeping the rupee range-bound. The other not-so-obvious explanation is the covert role of the Reserve Bank of India. A steep depreciation will leave little room for reduction in lending rates. The fall in oil prices will be somewhat blunted, frustrating the government’s efforts to reduce fuel subsidy. Besides good southwest monsoon, low prices of petroleum products are necessary to keep inflation in check.

The currency is not the only worry that is complicating India’s efforts to profit from the current scenario. A low interest rate regime at a time US bond yields are stiffening is similar to opening the stable doors for foreign investors to bolt. Pre-2008, it was the carry-trades (borrowing in cheap yen to invest in economies with high returns) that kept the stock market buoyant. Those expecting the RBI to embark on an aggressive cycle of rate cuts will have to contend with disappointment. More than the domestic economy, future action on access to money is likely to be calibrated with that of the Fed. As the cooling of food inflation will not be the only motivator for the central bank to cut rates, there will be no immediate easing of the troubles of infra companies and banks. The short-term solution will be capital infusion into banks and fund-raising by leveraged companies depending on investors’ sagacity to overlook the present problems for a long-term vision. Overseas acquisitions to expand might slow down as borrowing costs rise in the US. The impact of the miscalculation of those who had issued foreign currency convertible bonds to finance overseas acquisitions is still being absorbed by the shareholders. The bearish phase post 2008 meant that investors preferred redemption over conversion into equity.

The RBI has limited flexibility to ignite growth by keeping the cost of money low, balance the currency so as to not hurt importers and exporters and sustain foreign inflows. Besides, banks’ balance sheets are hindering the pass-through of interest rate cuts to customers. Unless the problem of bad loans is solved, softer interest rates will remain on paper. The tapering of supply of capital from overseas and domestic sources can stall the economy. Liquidity is essential to drive investment, direct or portfolio. The challenge will be to sustain and accelerate inflows from both to meet the capital expenditure requirement of the public and private sector during this difficult juncture till global markets adjust to the decoupling of the US and rest of world. The central bank had foreign exchange reserves of US $ 353.33 billion mid July. It can set up a special purpose vehicle to buy out at least 50% of the US$435-billion bad loans of PSU banks, leaving sufficient cushion to step into the market during volatility. The depletion of dollars will be at best temporary as these will get bulked up by export revenue from a healthy US market. Banks will get a breather to pass on base rate cuts and should write off at least a quarter of the remaining sour assets. In the process, they will become attractive to investors to contribute to their capital. The move will provide the much-needed propellant to lift the economy, without straining government finances, and hold the attention of foreign investors set to flee to the US. The SPV can sell the bad loans in small tranches at a discount to the face value to vulture funds and institutional investors. These investors can redeem them after an appropriate gap from the issuing bank or convert into equity of the borrower, thus gaining a voice in the future of the company.