In the past few days, the Securities and Excahnges Board of India (SEBI) has announced a slew of measures aimed at liberalizing the equity markets, thereby improving its breadth and depth and increasing market liquidity. The latest measure permits short selling by all categories of investors, which had been completely banned since the Ketan Parekh scam in 2001. Short selling is the practice of selling stocks which the seller does not own at the time of the sale. He borrows the stock(s) from another party, with an undertaking to deliver it back within a pre-determined time. He then sells it in anticipation of falling prices, so that it can be bought from the open market when the prices fall and delivered back. The short seller would thus make a handsome profit in this transaction.
This follows other measures like reducing the minimum lot size for derivative contracts, so as to encourage more retail investors to enter the derivatives market and hedge their positions. It has eased the stringent listing requrements, so as to make it easier for a select group of companies to raise money. It has also permitted stock exchanges to offer derivative contracts for foreign exchange, which enables buyers settle derivatives contract in foreign currencies.
While all these measures are inevitable and are clearly aimed at improving the efficiency of the financial markets, questions have to be asked about the timing and phasing of these measures. Consider the scenario. The Indian equity markets are in the middle of a massive bull run, which has seen it breach the 20000 mark recently. In 2007, it has risen by over 45% in rupee terms and over 60% in dollar terms. Questions are being asked about the valuations of Indian stocks, with sceptics pointing to the higher than normal PE and PB values. (Sensex PB value is 6.6 and PE multiple 27, while the BSE 500 ratios are 6.4 and 27.5) Further, the year end is time of the year for profit booking and market stabilization.
The past few months have seen unprecedented activity by Foreign Institutional Investors (FIIs) in the emerging markets. India has been at the forefront of this trend in attracting FIIs. While Indian markets attracted $27 bn in 2006, FII investment has crossed $45 bn till December 2007. With a weak dollar, low bond yields, high US current account deficit, inflationary expectations, and a looming recession in the US, emerging markets investments continue to look excellent. Unlike China and the rest of Asia, Indian economic growth appears relatively decoupled from the US and Europe. In the circumstances, India will, in all probability, continue to attract FII investment for the foreseeable future.
Introducing measures that would only fuel the bull run at this point of time may look a little inconsistent with the standard prescriptions. But the other dimension to the arguement is that the markets appear to be nearing the end of the bull run, and any shorting opportunity will only give the market players an ideal opportunity to hedge themselves against any downside.
The extremely volatile nature of the financial markets makes them vulnerable to even small shocks. Under the circumstances, timing and sequencing becomes a critical factor in the introduction of any new regulations or policies. The present round of liberalization has to be seen in that context.
Could SEBI have waited for the bull run to end or for atleast a small market correction, before introducing these measures? Will these measures engender an "irrational exuberance" in Indian equities? Or is there enough room to sustain the bull run, given the relative insulation of Indian economy from the US financial crisis? Could the SEBI not have waited for the emerging market craze to die down before opening up further to foreign currency investments? Only time will tell whether SEBI was right in pushing through these reforms now or not!
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