by Santosh Nair
The rattled FIIs rallied under the banner of the Asian Securities Industry and Financial Markets Association (ASIFMA) and wrote a strongly worded letter to Finance Minister Pranab Mukherjee, warning that they would pull out en masse if the ‘tax uncertainty’ was not resolved. This was the first instance of foreign investors writing an explicitly threatening letter to the finance minister that I was aware of. India does need foreign capital, but it cannot have foreign investors dictating its financial policies.
ASIFMA had a suggestion for the minister with respect to GAAR: don’t apply GAAR to ‘small investments’. By ‘small investments’, ASIFMA meant a stake of 10 per cent or less in a listed Indian company. But that was absurd, since no FII could anyway hold more than 10 per cent in a listed Indian company. In effect, ASIFMA was saying that GAAR should not be applicable at all on stock market transactions by FIIs, whether or not some of them were abusing the Mauritius route to dodge short-term capital gains tax. To its credit, the government stood by its decisions while assuring foreign investors that the tax rules would be fairly interpreted.
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A New Entrant to the Game
After many regulatory hurdles and much legal wrangling, MCX-SX finally launched its equity trading platform in February 2013. Market conditions were far from ideal for a third stock exchange, though Jignesh Shah & Co were forever arguing that investors were getting a raw deal from incumbents BSE and NSE. Jignesh was convinced that the entry of his exchange would help grow the number of investors in the country. Not for once did I believe that theory. Not that I doubted Shah’s acumen or his zeal. I mean, people don’t start investing in shares just because there is a new exchange on the block. To me it appeared more likely that as the economy grew and more companies raised capital, the universe of investors would expand, benefiting stock exchanges like MCX-SX. It would not be the other way round, with a new exchange encouraging companies to go public and fire up the economy! At best, MCX-SX would be able to snatch business from rival exchanges by offering incentives to traders and investors. But that would not be the same as growing the market.
The rivals had deeper pockets and were well placed to promptly match any inducements that MCX-SX may have to offer. The broking industry was in a terrible shape because the client base had shrunk considerably after the meltdown of 2008, and brokerage firms were poaching each other’s clients by offering ridiculously low rates. They still could not win client loyalty as the client would trade with whichever broker offered him the best rate. Of course, the profit margins for stock exchanges were much fatter – 35-40 per cent – than for brokerages. Some market observers were worried that it would turn out to be a race to the bottom if the stock exchanges decided to relax margin requirements to attract more members.
Given Shah’s impressive track record in the commodities market, many anticipated he would rewrite the rules of the stock exchange game too. After all, he had managed to take on the powerful regulator SEBI and had emerged successful from the scrap. Shah’s business sense, ambitiousness and political connections would see MCX-SX outstripping its rivals in the not-so-distant future, they thought.
For MCX-SX, the key to success lay in how soon it would be able to crack the liquidity code. More than anything else, it is the depth of the order book (liquidity, in market parlance) that is the deciding factor for a trader’s or investor’s choice of exchange to place his trades on. The more liquid or the more the number of buyers/sellers in a stock, the easier it is to trade large chunks of shares without impact on the price.
But creating the optimum level of liquidity is the toughest part. If an exchange is not able to do it quickly enough, it will be doomed to trail the market leader. Liquidity has the potential to perpetuate virtuous cycles as well as vicious ones. Once depth on a certain scale is achieved, it attracts more players, and this further improves the depth, which in turn attracts more players. On the downside, lack of liquidity prompts players to look elsewhere for better spreads, leading to even lower liquidity, which in turn deters even more players.
BSE’s F&O segment is a classic example of how much liquidity matters. Having ceded the first-mover advantage to NSE in this space through its own blundering, BSE has not been able to catch up despite doing everything possible to attract trading members.
With MCX-SX flagging off operations, high-volume traders like me were in demand. The exchange wanted us to route a small part of our business through it. Competition in any industry is welcome, and though it would be a while before MCX-SX came anywhere close to matching the depth on NSE and BSE, quite a few traders agreed to help out the exchange. Of course, it was not purely out of charity. If MCX-SX grew in strength it would increase the bargaining powers of traders and brokers as they would now have a third exchange to choose from. Also, if the exchange did well in a couple of years’ time, people like me who had supported it during its initial days could stake claim to a favour or two.
There were limits to which we could help, simply because the market had been quite volatile since the start of the year. The macroeconomic and policy environment was terrible, to say the least, and it did not look as though things would change any time soon.
Adding to the swings in the market was Fed chief Ben Bernanke’s statement that the Fed was planning to cut down on the quantum of its monthly bond purchases that served as a monetary stimulus for the economy. Global markets went into a tizzy, as large dollops of liquidity resulting from the Fed’s easy money policy had found their way around the globe and inflated asset prices. With the Fed calling time on its quantitative easing (QE) programme, investors were worried about a sudden drying up of an important source of global liquidity.
The dollar suddenly strengthened as foreign investors pulled out money from emerging markets – hurting their currencies – and put their money in US government bonds on which they were getting better yields. As the rupee weakened, FIIs started pulling money out of Indian equities, setting off a vicious cycle. The more heavily FIIs sold, the greater the pressure on the rupee, which in turn led to another round of selling as other FIIs tried to take out their money before the rupee weakened further.
To deter speculation in the rupee, RBI started announcing measures to make it costlier to borrow. Anybody who is bullish on the dollar, and by extension bearish on the rupee, needs to sell rupees first to buy those dollars. It is a rewarding trade as long as appreciation of the dollar more than offsets the cost of borrowing rupees. When the borrowing cost of the rupee increases, returns from this trade become unattractive.
The impact of this development was felt in the stock market. Many traders, including I, had been heavily long on private sector banks for the last many months since mid-2012. The bets had paid off handsomely, as the stocks kept climbing higher after periodic corrections. Within the banking sector, private sector players were the clear favourites of the market because of the superior quality of their books compared with those of their hapless public sector counterparts. For too long now, private sector banks had become a sort of one-way bet for traders; you had to be really unlucky to lose money on them.
It was a rude awakening for the bulls then, when RBI’s measures pushed up the cost of wholesale deposits on which the private sector players were so heavily dependent. The hardest hit were the so-called new-generation private sector banks like Yes Bank, IndusInd Bank and Kotak Bank, which had much smaller savings and current account bases.
The stocks dropped off the cliff, and for many of the bulls in these stocks, a big chunk of the profits made over the last year were wiped out within a few days. The fall in these stocks was exacerbated by the leveraged positions built up in the derivatives segment, as too many bulls had piled on in the hope of making some easy money. There is never an assured-return stock in the market, and everybody is only too aware of it. But once in a while, players tend to forget this rule and it is then left to the market to harshly remind them about it.
RBI continued to put other curbs in place to bolster the rup
ee, such as higher duties on gold to deter imports, but the currency still continued to sink slowly. With the stock and currency markets in a tizzy, conspiracy theorists had a field day. One theory doing the rounds was that the government was holding RBI back from aggressively defending the rupee. While the RBI was announcing one measure after the other to prop up the rupee, some currency traders read between the lines to conclude that the signals from RBI suggested its heart was not in the battle.
These theorists reasoned that politicians and industrialists were looking to bring back their illicit funds stashed abroad, and the rupee was being allowed to weaken so that they could convert their dollars at the best exchange rate. And the black money was being brought back because the secrecy laws were no longer the bulletproof shield of immunity they had been in the past, said the theorists. Governments globally were putting pressure on banks in tax havens to disclose the details of customers to check for their residents suspected of flouting tax rules. The black money was being routed back to the country to also feed the politicians who would need hard cash to fight the general elections coming up in April 2014, they added.
The furore over black money in India had resulted in authorities here knocking at the doors of countries that were popular destinations for black money. Nothing came out of these expeditions, but suddenly there was nothing like a safe haven any more as far as black money account holders were concerned.
In the monetary policy review on 30 July, the RBI policy document had admitted that the country was caught in the classic ‘impossible trinity’ trilemma, where it was grappling with weak growth, high inflation and a weak currency. RBI said it was temporarily shifting focus away from growth and inflation to address the weakness in the currency. But just a few lines above this the document said the current policy stance was intended to address the risks to the rupee and thereby to the economy, address risks to growth, guard against inflation and ensure adequate liquidity in the system.
‘That was a dead giveaway that the RBI is juggling too many balls at the same time, and would have to drop at least one of them,’ my friend Sherlock said a couple of months later at one of our beer sessions. ‘And that ball is most likely to be currency, despite the central bank’s claim to the contrary.’
Among the factors blunting RBI’s counter-attack was the steady increase in crude oil prices because of the conflict in Syria. The country could do without gold imports, but not without oil imports. Matters on the currency front climaxed on 28 August when the rupee crashed 256 paise against the dollar in a single day, the steepest fall in over eighteen years. It touched a new low of Rs 68.85 to the dollar, and many foreign banks were predicting that it would sink somewhere close to Rs 75 to the dollar by the end of the year. Stocks went into a free fall as doubts arose about the ability of the government to service its foreign debt. Companies with sizeable dollar debts were hammered on the bourses.
One of the stock market maxims is to buy when there is blood on the streets. Looking at the prices some quality stocks were going for, there could not have been a better opportunity to load up if you were willing to take a two-three-year view. I am no whiz at reading balance sheets, studying industry trends and then investing for the long term. For that I usually rely on the wisdom of some of my analyst friends, whose judgement I respect. I bought decent chunks of a few old-economy stocks, which I thought were going cheap.
But every panic seems like a different one, just as every bull market appears to be different from the previous one. There had been panic on this scale in 2008 and again in early 2009. On those occasions the problems were largely confined to stock market players and some highly dubious companies. There was nothing hugely wrong with the economy. This time, the problem was the economy itself. If the country suffered a rating downgrade and struggled to service its foreign debt, there was no saying how ugly things could get.
September saw a change of guard at RBI. Former IMF chief economist Raghuram Rajan formally took charge as RBI governor, replacing Duvvuri Subbarao, who had had a tumultuous five years in the hot seat. The announcement had already been made in August, and the market had high expectations from the new governor, whose calling card was that he had warned of the sub-prime mortgage as early as in 2005, and that too at a gathering where the US Fed chief of the time Alan Greenspan was present.
On his very first day in office, Rajan announced a bunch of proposals that helped boost confidence in the money and stock markets. Two among them stood out. One was to attract deposits from NRIs and the other was to sell dollars directly to oil marketing companies, which needed the currency for importing oil. Oil companies had to buy dollars from time to time to pay their import bills, and whenever they bought dollars from the open market, it would push up the cost of the dollars. By selling the dollars directly to oil marketing companies, RBI could ensure that the rupee did not weaken further on account of the extra demand for dollars in the market.
Neither of these measures was unconventional; in fact, RBI had deployed them in the past whenever the rupee was under pressure. In August 1998, when the rupee had weakened following the economic sanctions by the US and some other developed nations after the Pokhran tests, RBI had issued Resurgent India Bonds to attract deposits from NRIs and People of Indian Origin. The response was overwhelming, with the RBI collecting around $4.2 billion through these bonds. But Rajan brought a crucial variation to the NRI deposit scheme. NRIs were paid 3.5 per cent above the market rate for their dollars. The move turned out to be a masterstroke though Rajan much later confessed that it was not his idea and that he had initially thought of it as a stupid measure.
There were many other measures announced by Rajan, such as the promise of announcing new bank licenses shortly, debt market reforms and permission to banks to raise more foreign capital. The stock market was fired up by these announcements. It was anyway looking for some confidence-boosting signals. Rajan already had an impeccable track record, and the proposals announced on his very first day in office sent out a clear message that here was a man in a hurry.
There was no looking back for the market after that. FIIs rushed in to buy, and bears were forced to square up their short positions, mostly at a loss. From 28 August – the day the rupee fell the hardest and to its lowest level – to the third week of September, the Sensex surged an astounding 3,000 points.
You might think that I am either bragging about getting my calls on the market right most of the time, or that I am incredibly lucky. Let me assure you, it is neither. The law of averages spares nobody, however skilled or lucky a person may claim to be. The gains from the September rebound helped me make up for the bruising losses I suffered in two stocks – Financial Technologies India Limited (FTIL) and MCX – just the month before. I had trading positions as well as a small investment in each of the stocks. The returns had been average, but I was acting as a market-maker in the stocks at somebody’s behest. I would buy shares when the price fell and sell them when it rose.
My losses would be compensated in cash, in case I were to incur any losses. If I made profits, I had to part with some of it. On the whole, it was a profitable transaction for me, since I was being paid to generate volumes in the stocks, and the fluctuations in prices did not hurt me much, even though they did not earn me gigantic returns.
But trouble erupted from the least expected quarter. FTIL had a subsidiary called National Spot Exchange Limited (NSEL), which had been operational since 2007. NSEL was an electronic version of the local mandi, meant to help commodity farmers and commodity traders find buyers from across the country for their produce at the best possible prices. As the name suggested, NSEL was to be a spot market where farmers/mill owners/traders could sell their produce directly to the buyers, collect their money and walk away. Forward dealings of any kind were banned. But in the absence of any regulatory supervision, NSEL slowly mutated into a forward market. Claiming to be a spot exchange, NSEL escaped the scanner of the Forward Markets Commission (FMC) for a long time, since FMC�
�s mandate was to regulate forward trading in commodities.
In theory, the sellers would deposit their produce in designated warehouses, and get a warehouse receipt certifying the quality and quantity of the produce. They could sell these receipts, and the buyers could go to the warehouse with the receipts and collect the wares. The commodities that could be traded included bullion (gold, silver, platinum), agri-products (cereals, fibres, spices, paddy, sugar) and metals (steel, copper).
NSEL’s first violation of the rules lay in allowing trading in products without government clearance. The second, and more damaging, violation was its introduction of ‘paired contracts’ to sidestep the rule banning forward contracts. NSEL was now no longer a pure spot exchange connecting sellers with buyers. It had become a platform where commodity farmers/traders could raise working capital till they managed to find a buyer for their produce at a price of their liking.
The paired contracts allowed them to borrow funds through a two-legged transaction. In the first leg, the seller would enter into a T+2 contract where he would sell his produce to the buyer at a certain price. The buyer had to pay up on the second day of the trade being put through. At the same time when this trade was being put through, the buyer would enter into a T+35 contract, selling the produce back to the commodity farmer/trader at a price slightly higher than he had bought it for. This, in effect, was the interest charge the seller was paying the buyer for the funds.
For example, a commodity seller would sell his produce to the buyer for Rs 100 in the T+2 leg and agree to buy back the produce from the buyer for Rs 101 a good 35 days later. Interestingly, the commodity seller never bought back the produce on the 35th day. The transaction would get carried forward, with the seller agreeing to pay additional interest. This cycle was repeated for months on end without the commodities ever moving out of the warehouses. The annualized rate of interest worked out to 14-15 per cent, which was much higher than traditional bank deposit rates.
