The government is reportedly planning to raise the barriers for entry of unregulated foreign entities into the capital market, by tightening the use or misuse of over Rs 40,000 crore of participatory notes (PNs). It is also planning to place some restrictions on sub-accounts of foreign institutional investors (FIIs). While this is an excellent move, it is disquieting that the finance ministry and the capital markets’ regulator, Sebi, seem unsure if this action is warranted. And whether FIIs really dominate the market.
So unclear is the government about the role of FIIs that it even set up an expert committee to study ways of encouraging FII inflows and on the vulnerability of the financial system to speculative capital flow. The report, primarily a lengthy recounting of the history of FII investing in India, weakly concedes that a dominance of foreigners could create a problem if they act in a herd-like manner. However, it also insists there is no sign of FII-induced volatility in the market and seems to measure FII dominance of price movements only in terms of the percent of their trades in relation to overall volumes. This is in line with the finance minister’s view that markets are not overheated.
However, this attitude signals a refusal to take cognisance of real and anecdotal evidence of FII dominance in the market. If FIIs hold 75% of the floating stock, they can potentially dictate prices, especially since institutional investors are known to often act in a herd-like manner. Domestic mutual funds and institutional investors are still insignificant players. The bulk of the volumes generated by hectic trading by retail investors is only noise. It hides speculative trails and attracts small punters. This fact is known to the capital market regulator and even finds mention in the July 2005 Action Taken Report (in connection with Dresdner Kliewort Benson’s brokerage operations) given by the finance ministry.
A government’s view that derivatives are used for price discovery, rather than hedging trades, is equally strange. In fact, there is plenty of actual evidence that the biggest and most blue-chip global financial entities are not averse to lending their names to re-route Indian money, or to profit by deliberately destabilising specific stock prices by pressing heavy sales. Over the past week, market volatility has in fact increased significantly, despite a slowing of FII investment. The validity of the report’s conclusion about influence of FII inflows—whether these have any dominance or not—will become clear only when inflows slow down.