India’s stock market has been on a roller-coaster ride for a decade, roiled by a series of scams. The market is up again. Is it for real this time?
By Lincoln Kaye
March 2002
In the waning hours of 2001, Harshad (Big Bull) Mehta, 47, was rushed from prison - where he’d been remanded to custody for the third time in a month on charges stemming from a 1992 illegal arbitrage scandal - to a nearby hospital. Ever the optimist - about his health as well as about India’s equity markets - Mehta made light of his chest pains. Asked if he’d been experiencing any tension lately, he jovially assured his doctors, in Hindi: “None at all. It’s become perfectly routine for me, all this going in and coming out [of jail].”
With that he dropped dead, just 40 minutes into the last day of the year - a gruesomely fitting finale to a decade of melodrama on the Indian stock exchanges.
Since 1991, when India began liberalizing its socialist economy - loosening the bureaucracy’s stranglehold on economic activity and opening the door to foreign competition - investors have been subjected to one of the most jarring roller-coaster rides in any of the world’s equity markets. Giddy speculative run-ups have been followed by lurid scandals (see story below) and precipitous declines, only to be succeeded by renewed euphoria. Pushed by mercurial stock promoters like Mehta, strong economic growth from sweeping liberalization of the economy and the growing global popularity of Indian software and technology services, the widely watched sensitive index, or Sensex, of the Bombay Stock Exchange, Asia’s oldest, rose from 982 in 1991 to successive highs of 4,546 in 1992, 4,588 in 1994 and an all-time peak of 5,447 in early 2000, according to data provided by Advani Share Brokers. Each new high, however, has been followed by a stomach-wrenching decline of at least 35 percent.
To be sure, India’s stock market has had its share of accomplishments. Market capitalization has risen from 753.5 billion rupees ($44 billion) in 1991 to Rs6.4 trillion in early 2001. It recently stood at Rs6.26 trillion - providing much-needed capital to growing companies. Daily trading volume soared from Rs2 billion in 1993 to Rs140 billion in 2000, according to Susan Thomas of the Indira Gandhi Institute of Development Research, or IGIDR. Listed firms like Infosys Technologies, Satyam Computer Services and Wipro have become global technology leaders, while older, more established companies like Reliance Industries and Ranbaxy Laboratories have prospered as well.
As the markets and economy improved, so too have conditions for the world’s second most populous country. More than 200 million people now have sufficient income to afford some of the luxuries of life; a million or more live as well as any rich person anywhere. Many millions even have sufficient savings to invest in the stock market. From the poky 3 percent “Hindu rate of growth” (a term reportedly coined by University of Chicago-trained Indian economist Raj Krishna) that slowed India for its first 40 years of independence, the growth rate has risen to about 6 percent.
The boundless enthusiasm of an energized investing public awakened macroeconomic planners to the stock market’s potential to solve a host of problems, from infrastructure finance to income security for a rapidly aging population to the improved management of loss-making public enterprises. One Indian government after another, including the current administration, embraced classic liberal market reforms from privatization of state-run companies to large cuts in tax rates and easing of restrictions on foreign investment.
But to achieve these ends, first India will need to win back the confidence of investors who have grown tired of the markets’ booms and busts. Last year’s roller-coaster ride only added to the public’s jitters. Under sharp pressure from the global stock market swoon and faltering technology stocks, the Sensex plummeted, losing 42 percent of its value from mid-February through September 21. Then it promptly turned around late in the year to end 2001 down only 17.5 percent. This year it’s up 13.8 percent.
Behind this scary swing was yet another scandal. Bombay broker Ketan Parekh, who ran seven investment firms, attempted to use a brief market uptick last February to unload a wildly overpriced and hugely overleveraged tech portfolio. Rival brokers, aware of his problem, mercilessly sold the tech shares short in Bombay and on the regional Calcutta Stock Exchange. The selling frenzy overwhelmed India’s informal badla share finance and carryforward trading system - essentially, a way to constantly roll over unmargined positions using high-priced debt (see box, page 88). That eventually drove the Sensex down to a 28-month low of 3,184 on April 12. Parekh’s defaults brought several of his bank financiers to the verge of collapse and landed him in jail on fraud charges.
To add to the misery, 22 million individual investors learned in July that because of the market collapse, they would not be permitted to redeem their shares from the government-run US-64 fund, the flagship of the Rs582 billion Unit Trust of India. With its net asset values running well below its guaranteed repurchase prices, the open-end fund could no longer afford to buy back its shares. After a management reshuffle, UTI’s new chairman,
M. Damodaran, negotiated an emergency injection of liquidity from the Finance Ministry (UTI’s second such transfusion in three years) to allow a limited buyback of customers’ US-64 shares.
With local institutions, speculators and longer-term investors largely on the sidelines, foreign institutions were virtually the only buyers through most of the summer. Then came the September 11 terrorist attacks on New York and Washington. In the ensuing weeks foreign institutions pulled out of virtually every emerging market, including India’s.
“September 11 changed everything,” says S.K. Agarwal, senior president of VLS Finance in New Delhi, which represents several foreign banks and runs a Luxembourg-based Indian equity fund, the Iris India Fund. “With foreign institutions in a liquidity crunch of their own, foreign fund managers can no longer afford to hang in here just to play with each other.”
Underlying this retreat by investors is an abiding concern over how well the authorities are monitoring the market and enforcing its rules. India’s bourses have shown an amazing resilience since the market bottomed out. The Sensex has jumped more than 40 percent since its September trough, as domestic investors returned to buy shares in proven companies. A modest technology comeback overrode pressing geopolitical concerns - not least the December 13 terrorist attack on Parliament in New Delhi. But nervous investors have all too frequently seen such powerful runups quickly give way to scam-induced woe.
“The question is whether regulators are doing their job properly. They are not very market-savvy,” says Arindam Bhattacharjee, portfolio manager at Arlington, Virginia-based Emerging Markets Management, a $3.5 billion emerging-markets equity fund with investments in India. “It has been very easy to manipulate the system. There are always loopholes, and disclosure has been a problem. Regulators have been reactive.”
Reactive they may be, but to the dismay of many local brokers comfortable with the older, easier-to-manipulate practices, India’s stock market regulators have gamely tried to seize on each successive crisis as an opportunity to modernize and reform the market. In July the Securities and Exchange Board of India, or Sebi, outlawed the form of badla financing that had hastened Parekh’s fall and introduced new derivative instruments in its stead along with tightened settlement procedures. “We have taken steps to increase transparency: rolling settlement, corporate governance of our stock markets - no brokers serving as office bearers anymore. And we’re steadily improving accounting standards,” boasts Sebi chairman D.R. Mehta. “India is one of the few countries in the world where companies have to declare results quarterly, including earnings per share, all deferred tax payments, complete consolidation of all subsidiaries.”
These reforms are just part of an impressive modernization program that’s given India an advanced electronic network tying all of its exchanges together. It has also introduced online, real-time trading, electronic recordkeeping of shareholdings and automated clearing processes.
Although some skeptics believe that regulators simply offer stopgap measures, others believe that India’s continuing efforts to address repeated scandals have given it the most modern market among emerging economies and one arguably more efficient than those of some developed countries. “When global appetite for equity revives, international investors will find our markets more efficient, transparent and institutionally up to date than many in the developed world,” says economics professor Ajay Shah of IGIDR in Bombay, an unabashed supporter of the market reforms.
Perhaps, but investors will also approach them with trepidation. Put off by scandals, not to mention the ensuing losses, investors spoke with their feet last year. Through the last nine months of the year, trading volume amounted to just 16 percent of its year-ago levels.
Investors not only want clean markets, they need a reason to participate. As VLS’s Agarwal says, “Ultimately, we need to see concrete signs of economic revival.” The 2002 budget announced for the fiscal year beginning April 1 is unlikely to foster such a revival. With its mix of higher taxes and increased government borrowing, it is, scoffs former Finance minister P. Chidaambaram,"without a clue on how to stimulate an economic recovery.”
Economic growth since 1991, while tangible and impressive, has flagged in recent years, down from 8 percent in the early 1990s to 6 percent today. Although many have thrived, a number of major Indian companies have been hurt by foreign competition and have tried to slow down reforms, such as permitting hostile takeovers. A succession of weak coalition governments has had to make deals to stay in power. Thus they have been unable to move ahead with such unpopular but necessary reforms as privatizing money-losing state-owned enterprises and loosening India’s restrictive layoff policies.
Investors may be wary of excesses on the exchanges today, but, ironically, it was speculators like Mehta who actually helped popularize the Indian equity market. Using highly leveraged multistock plays and interexchange arbitrages, Mehta took advantage of India’s antiquated and lengthy bond sale settlement process to borrow from the badla market and banks and play the float in the stock market. A self-described Pied Piper, Mehta inspired a speculative frenzy among millions of middle-class Indians. He loudly expressed his optimism about the market, and his lavish lifestyle - a fleet of expensive cars; a $6 million, 15,000-square-foot oceanfront penthouse with a 10,000-square-foot garden; glittering parties with the elite of Bombay’s film industry - and huge investments gave him a worshipful following. During his 1991-'92 heyday, share prices soared. The Sensex rocketed from 1,270 in June 1991 to 4,546 in April 1992. Market volume trebled as well. But it was too much of a good thing. The speculative bubble burst and Mehta’s shares crashed, taking the market down with them and helping to prompt reforms.
To this day, investigators are still sorting through the ruins of Mehta’s collapsed debt pyramids, shadow accounts and insider trades. Although his assets were seized when he was first charged in 1992, he was jailed again just last November on suspicion of using nominee names to allegedly sell a huge number of impounded shares. At the time of his death, he faced 28 outstanding indictments and had received one conviction. He’d been permanently barred from equity trading and sentenced, pending appeal, to five years of “rigorous imprisonment” (read: hard labor) - none of which deterred him or his many imitators from attempting new ploys.
The most enterprising of these imitators was Parekh, a 42-year-old broker who allegedly used unsecured out-of-state bank overdraft facilities to leverage his positions. The assault on his portfolio (the so-called K-10 group, a play on Parekh’s given name and the ten companies he focused on) precipitated his default on loans and a general market crash. As shares plunged in mid-April, Anand Rathi, then president of the Bombay Stock Exchange and also a broker, ordered up Parekh’s trading records from the exchange’s surveillance department - not for oversight purposes, Sebi later charged, but rather to use privileged information to trade for his own account. Facing an insider-trading indictment, Rathi resigned his BSE post, though the charges were later dropped. Rathi adamantly denied he had done anything wrong. Regulators have plugged the newly discovered holes that allowed these scams to take place. Aside from hauling in Parekh for repeated interrogation on charges of price-rigging and fraud, they’re also looking at allegations that members of a so-called Calcutta bear cartel conspired to artificially depress prices, hastening Parekh’s downfall and triggering the crash.
In July the Finance Ministry, along with Sebi and its chairman, banned badla and carryforward at the urging of reform-minded bureaucrats and academics. They pledged to put in its place a phased introduction of options and futures contracts on stock indexes and individual shares. Sebi also ordered rolling settlement to replace carryforward; trades must be completed immediately rather than on periodic settlement days.
Some of these reforms had unintended consequences. With their financing more limited, many speculators stepped away from the market, driving prices still lower. That caused problems for Unit Trust of India and brought to light still another scandal. Charges arose that UTI’s chairman, P.S. Subramanyam, had flouted prudent norms to invest US-64 funds in companies controlled by his corporate cronies. He subsequently resigned.
Brokers on the regional exchanges protested the elimination of badla operations with a one-day trading strike. “It takes years to build up investor confidence in a market and then just one ill-considered policy, like the badla ban, to wipe it out,” grouses BSE director and broker Motilal Oswal, reflecting a grievance that is widespread among the brokerage fraternity. According to the strike manifesto of the hastily convened Securities Industry Association, the “undue haste” of the July reforms makes India’s 22 regional exchanges “100 percent redundant” and will mean “mass retrenchment” among the 2 million Indians employed in stockbroking.
“So what? It’s a healthy rationalization,” says IGIDR’s Shah, who sees the latest badla and settlement changes, which eliminate the time lag between a transaction and settlement, as the last pieces in India’s stock market reform. “We’ve now closed a window of unhealthy arbitrage of funds between the present and future time periods. In its place we’ve substituted a much more wholesome derivatives market.”
Regulators have to respond aggressively, but they also have to learn how to deal with the legal problems more expeditiously, says C.B. Bhave, head of of the National Securities Depository. “To rebuild confidence,” he says, “we need to know that scams will be punished and that their victims will get adequate and timely compensation. We can rely less on courts and more on negotiated settlements. In this, we learn from the U.S. Most cases [there] wind up with a deal struck whereby the accused neither accepts nor denies guilt. Instead, he agrees to some limited remedy, such as paying a fixed amount to an investor protection fund. Face is saved all around, and we can move on.”
Indeed, a senior Finance Ministry bureaucrat in New Delhi suggests that the scandals are part of the growth process in any market. “They’re normal and unavoidable, even in healthy, mature, developed markets,” he says, “We can’t let them shatter confidence as they did in the past.”
Adds Sebi chairman Mehta, “Regulation and enforcement alone can’t prevent scams any more than the mere existence of a criminal law code and a police force can prevent crime.”
Aside from aggressively pursuing crooks and eliminating inefficiencies, regulators are relying heavily on one of India’s biggest strengths - technology - to make markets more efficient. In 1993 the all-electronic National Stock Exchange of India came into being. It is, says the relentlessly upbeat Shah, “a textbook case of what a market should be. " According to R.H. Patil, the NSE’s first head, “a transparent, fully automated exchange makes it perfectly safe for complete strangers to trade with each other. That’s why we’ve been able to recruit whole new populations into equity investment. Ultimately, the exchange exists mainly to benefit investors and stock issuers, after all, not brokers.”
The investors on the NSE are not so much a new population as an influx lured away from less transparent exchanges. Individual middle-class investors much prefer to see their trades executed live online rather than disappear into the fathomless trading pits of the older exchanges. Within a year of its establishment, the NSE became India’s dominant stock exchange, by every measure. The BSE and the regional exchanges were forced to follow suit and upgrade technology at great expense, putting many brokers out of business. Eventually, India’s panoply of local stock exchanges will merge into one or, at most, two national markets. “They’ll succumb to market forces, just as the regional exchanges did in the U.S. long ago,” Sebi’s Mehta says. “Regional brokers will always have a role, but not regional trading floors.”
Now India needs investors to return to the newly cleaned up markets. Streamlining the exchanges will hardly do enough to revive turnover. “For that, we need to replace the missing speculators and domestic financial institutions with whole new categories of large-scale, long-term players,” says economist Shah. Former Sebi chairman Surendra Dave, like liberal reformers the world over, knows who should take up the slack. “Pension funds and insurance companies are ideally suited for this role because of their investment time frame. All that is needed is to authorize them to shift over to equity investment.” Such investments, however, are currently strictly limited by law: Pension funds may invest no more than 20 percent in equities, with the rest going into more conservative instruments like bonds and government securities.
India still needs to offer investors - particularly foreign ones - more compelling reasons to participate. It has to provide some evidence that it can overcome its many economic problems. Unfortunately, the news on that front has not been good. Last August both Moody’s Investors Service and Standard & Poor’s warned of a negative outlook for the government’s local currency debt, pointing to a continuing budget deficit and growing government borrowings in the domestic market. The sovereign rating remains unchanged.
To bolster business sentiment, economic policy spokesmen for Prime Minister Atal Bihari Vajpayee’s shaky 13-party right-wing coalition government periodically suggest a variety of pump-priming options: accelerated infrastructure investment, liberalized labor laws, the oft-discussed fire sale of state-owned enterprises and a rollback of government price subsidies to rein in the fiscal deficit.
But even these measures might not be enough to rekindle confidence. Although Finance Minister Yashwant Sinha continues to reaffirm the government’s commitment to extending the liberalization program in his speeches - most recently, in his 2002 budget speech - Bombay broker Parag Parikh doubts the government can “find the political will and intellectual heft to live up to its own budget pledges. How ironic that we should wind up right back where we started before all this pain.”
By late February India’s markets were defying logic once more. With 1 million heavily armed troops staring at each other across the tense India-Pakistan border, conceivably risking the first nuclear exchange in history, skeptics might have expected the BSE to be in free fall. But even the December 13 terrorist attack on India’s Parliament and the military mobilization that ensued failed to unnerve the Sensex. Through the first eight weeks of 2002, in fact, the Sensex was up about 13.8 percent, among the stronger performances in any global marketplace. Investors know that Indo-Pakistan alarums are frequent and rarely lead to more than bellicose rhetoric and the occasional small-scale firefight. Moreover, the major Indian technology companies are beginning to rebound as orders pick up. Domestic investors are returning to the market, buying the oversold shares of real companies with real earnings.
Even speculators are apparently finding ways to operate amid the new regulations. “When rolling settlement was first introduced, it looked like all the speculators would just abandon the market,” says VLS’s Agarwal. “Instead, many of them have simply turned into day traders. And they adapted surprisingly well to the newly introduced derivatives.”
Similarly, long-term individual investors have managed to look beyond the UTI debacle and are increasingly turning to mutual funds rather than taking chances on stock selection. “Based on current trends, we should end the accounting year [in March] with a gross total of $25 billion raised in mutual funds, which might net out to $3 billion after allowing for redemptions, withdrawals and such,” says Sebi’s Mehta. “These figures compare with a gross of $19 billion and a net of $1.5 billion the previous year.”
Foreign institutions are also standing by to reenter the market when the global economy begins to recover. “Whenever it comes, India - or at least particular Indian companies - will be well positioned to take advantage,” says Mihir Doshi, CEO of JM Morgan Stanley Securities, a merchant bank in Bombay. “This is a very stock-specific market. Nobody gets into it to make a macro bet on India as such. But specific companies here enjoy prospects that should entice any investor. India’s competitive edge has all along been in areas like technology and pharmaceuticals. The sectors we’re strong in are precisely those that led the global economic slump. But they’re also the ones that will presumably lead the recovery.”
Adds EMM portfolio manager Bhattacharjee: “Stocks in general are very cheap, and earnings are picking up on a cyclical rebound. The futures exchange will bring more foreign participation.”
There has been encouraging news about privatization: Three companies were privatized at the end of 2001. In January India’s dominant long-distance and Internet service provider, Videsh Sanchar Nigam, was privatized, as was petroleum products merchant IBP Co. Small stakes in both were already publicly traded. Says broker Parikh: “To revive sentiment, we need some exciting new scrips on the market. If we were to privatize some of our public sector units, then we might see some action.”
But no one’s getting too carried away over the prospects for a massive privatization program that might truly stimulate market interest. Mahesh Vyas, executive director of the Bombay-based Centre for Monitoring Indian Economy, doesn’t see that occurring. “Every time the weak coalition government brings a privatization proposal before Parliament, opposition lawmakers shoot it down on the basis of their inflated notions of what these assets are worth. And if ever a worthwhile government company does come up for bidding, rival commercial groups would sooner abort the privatization process altogether than see a competitor win the bid.”
Privatization will not immediately benefit the stock markets, anyway, says Y.V. Reddy, deputy governor of India’s central bank, the Reserve Bank of India. Government stakes will be divested through private placement and find their way onto stock markets only later, if at all. On the other hand, by improving the state of government finance and business confidence, any such move would surely have a positive - if indirect - effect on the market.
Taking the broad view, Reddy downplays the whole notion that recurring scams have unduly hurt the market. He guesstimates that 50 percent of India’s equity slump simply reflects the global stock market downturn, especially in technology stocks. A further 30 percent of the decline, he says, stems from the heightened competition - foreign and local - that accompanied liberalization and forced older companies to go through a painful adjustment. Disappointment with the lack of follow-through on the government’s promising 2001 budget is responsible for an additional 10 percent or so of the downturn, says the central banker. “So you see, that leaves only about 10 percent to chalk up to individual misbehavior. Scams aren’t the decisive factors, after all,” says Reddy.
Maybe not, but they sure haven’t helped investors’ confidence - except to force needed reforms that may finally take the market to the next level.
Quiet days at the ‘badla’ exchange
L iveried doormen still man the brass-handled portals of the Calcutta Stock Exchange building, but the grandiose, colonnaded lobby stands empty. On each landing of the stairway, cuspidors are crusted with red gobs of betel-nut spit.
Hardly anybody climbs the stairs these days to Rajesh Varma’s narrow office overlooking the chimney-pot roofscape of Calcutta’s centuries-old business district. So he has plenty of time to reminisce about the quaint folkways of the CSE, especially badla, the Indian system of share finance and forward trading, which - until it was banned in mid-2001 (story) - had been the Varma family business for three generations.
Upon transacting a trade under the traditional system, a speculator used to have up to a week to settle his account by paying cash for purchases or delivering shares for a short sale. He could finance his position with a badla financier like Varma, pledging the shares as collateral. To carry forward an open position at the end of the week, the punter had only to pay the financier the difference between the opening and closing value of his net overall position. By continuously rolling over these carryforward positions, he could make a speculative bet on where the markets were heading or hedge against adverse contingencies - all for the relatively modest cash outlay needed to cover net price shifts.
But as repeated scams showed, the system made it all too easy for speculators to overextend themselves. Basically, badla encouraged unhedged bets with borrowed money. If the market turned suddenly, speculators could find themselves drowning in high-interest debt and default. The Securities and Exchange Board of India banned carryforward deals as of July and switched to a rolling settlement system, where all share transactions have to be paid for and delivered within the same trading day. Since then, daily turnover at the Calcutta bourse has dropped sharply, leaving Varma and his colleagues with time - and money - on their hands.
“Etymologically, the name ‘badla’ comes from a Hindi verb for ‘change,’ or ‘quid pro quo,’” Varma explains. “It can mean, simply, ‘interest.’ But it can also mean ‘revenge,’ and that’s what Sebi’s after now.” Varma’s convinced it’s a vendetta. “All we used to do was to match up cash-shy stock players with cash-rich financiers at mutually agreeable lending rates. What could be more harmless?”
How agreeable? Badla rates reportedly hit an annualized 100 percent last March as speculators in Calcutta sold short the overpriced stocks held by broker Ketan Parekh. And how harmless? The wave of short-selling and subsequent loan defaults triggered a market crash, slashing 2.09 trillion rupees ($44.8 billion), or 30 percent, in market cap by April 12, according to Business India magazine.
Reformers say equity derivatives will be a good substitute for badla. Varma’s office neighbor, senior broker Ajit Dey, scoffs at that. “Futures and options are for hedging, which is just one of the many functions - and a relatively minor one - that badla served. Mostly, it was a source of liquidity and cash management from one period to the next,” he says.
“It was the world’s second most profitable business, after narcotics,” Varma jokes, “and not even illegal, unless you transacted in cash so as to avoid taxes. But borrowers happily paid, not just for the anonymity but also because there were no margin requirements. You just kept topping up your collateral account. Of course, in a fast-moving market, you could wind up in big trouble, as Ketan Parekh learned.”
Dey’s family, descended from gold merchants, has been trading on the CSE ever since it was founded under a nearby neem tree 126 years ago. “There’s a big cultural difference between us traditional brokers and new-style ‘professionals’ like Harshad Mehta and Ketan Parekh,” he says. We see ourselves as trustees of our clients, but some of these MBAs and chartered accountants are nothing but get-rich-quick artists.” - L.K.
April 1992: High-living broker Harshad Mehta used time gaps in the bond market to generate a war chest to bid up equity prices. Before the bubble burst in April 1992, the Bombay Stock Exchange sensitive index rose 139 percent in eight months. In the next four months, the market slid 37 percent, costing investors 54 billion rupees ($1.87 billion).
February 1995: Before a rights issue, the dominant shareholder of M.S. Shoes East, Pavan Sachdeva, ran up the share price through large, leveraged positions on the Delhi and Bombay bourses, under his broker’s name. The share price crashed and the broker defaulted on Rs170 million. The company’s market cap fell 83 percent by mid-April.
January 1997: A bogus Bombay-based conglomerate, CRB - named for its creator, C.R. Bhansali - moved money from its nonfinance companies into its finance companies to run up share prices. With cooked performance numbers, the finance companies then raked in more funds from external sources. The pyramid scheme cost investors Rs7 billion.
August 1998: Harshad Mehta, star of the 1991-'92 scam, reappeared to run up share prices of high-tech companies BPL, Sterlite Industries and Videocon, allegedly with the help of the companies’ management. A sudden market downturn left Mehta without the Rs770 million he needed to support his leveraged positions. Top BSE officials tampered with trading records to cover up the problem. When caught, the bourse’s president, executive director and vice president resigned. Mehta was banned from equity trading for life, and the three companies were suspended from the capital markets.
March 2001: The implosion of Ketan Parekh, whose overleveraged investments in shaky technology companies triggered short-selling. That, together with September 11, caused the market to tumble 41.5 percent by September 21. Exactly who did what is still under investigation. - L.K.
