Sucheta Dalal :Regulators on the alert over market manipulation (21 July 2003)
Sucheta Dalal

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Regulators on the alert over market manipulation (21 July 2003)  

The Finance Minister and the capital market regulator have probably greeted the two-day correction in stock prices with some silent relief. The over-heated market has been a big source of worry, especially because it was difficult to fathom the cause of such aggressive foreign investment and the quality of that money. Sources say that every regulatory and investigative agency in the country is on the alert, and asked to watch out for market manipulation and illegal diversion of funds in and out the country. Whether or not the government ultimately stays on top of market developments and prevents a bust of the sort witnessed in 1992, 1998, and again in 2001, is to be seen. But one has to give it full marks for trying its best from the very beginning.

What worries the government and its regulators—the Securities and Exchange Board of India (Sebi) and the Reserve bank of India (RBI)—is the source of large chunks of foreign money flowing into the country. Is it genuine foreign institutional investment (FII), which now sees a turnaround in the India story? Or is it domestic money being re-routed by way of Participatory Notes? Or have aggressive hedge funds decided to target the Indian market for their pump and dump moves? The known facts do not reveal much. Foreign money, under the generic head of FIIs has pumped in over $2 billion into the Indian market this year, of which nearly $1.5 billion has been invested in equity, while the rest has gone into derivatives and debt. In fact, 25 new FIIs have been registered in recent times with multiple sub-accounts each, and nobody is quite sure about the quality of their money. At the same time, domestic mutual funds have relatively tiny net purchase positions.

Interestingly, investment through PNs and Overseas Corporate Bodies (OCBs), were exposed for their links with scamsters during the Joint Parliamentary Committee’s (JPC) investigation in 2000-01. However, the JPC itself was happy to let the investigation drift. This time OCBs have been barred from secondary market investment, but PNs seem to have become the favoured vehicle for investment by hedge funds. PNs are financial paper issued to overseas investors, representing a basket of underlying securities purchased in the Indian market. It allows investors, who are not otherwise eligible to invest in India, to participate in the domestic market. Some brokers estimate that over half of the investment through PNs in India is by hedge funds.

Almost all top FIIs, including Merrill Lynch, Morgan Stanley, Credit Lyonnais and Salomon Smith Barney issue, who are registered in India issue Participatory Notes (PN). Way back in October 2001, Sebi had asked FIIs to reveal the beneficiary owners of PNs, but there was little compliance. Sebi has recently reactivated this effort, but it is not clear whether the regulatory agency will make better headway this time, or if queries will only lead to more faceless investment companies.

What are hedge funds and why are they such a worry? Hedge funds are a favourite investment instrument for the super-wealthy, who can afford risks with some of their money. They operate like a closed club, with high value individual investments and fewer disclosures. As the name suggests, they play in the derivatives market to hedge their risk in one investment with hedging investments in others. Essentially, they look for high risk-high-return investment opportunities. They swoop down on arbitrage opportunities created by imperfect market conditions and get in and out of markets with quick short term investments.

Remember Mahathir Mohammed’s attempts to save Malaysia from the impact of their exit during the 1997-98 South East Asian crisis? He called them ‘highwaymen of the global economy’. But his protestations made little difference.

During the Asian crisis, Indian policymakers were smug about our insulation from global capital flows. The story is different this time. The government has to pan how to deal with the impact of exiting hedge funds—if it were to happen. But so far, nobody even knows who sold the FIIs, including hedge funds Rs 7,000 crore worth of stock this year. Financial derivatives are usually the favourite investment vehicle of hedge funds. But their investment in the Indian derivatives market is a small percentage of their total exposure. Strict, marketwise trading limits imposed by the major exchanges are probably a deterrent. But it hasn’t stopped the brokerage community to lobby with the regulators to permit the entry of pure US hedge funds in India.

Relatively immature equity markets like India, which are easy to rig and to manipulate are the ideal hunting ground for the short-term operations of hedge funds. The worry is that hedge funds may be providing a cover for Indian scamsters; or are being advised on investment opportunities by such discredited brokers and market operators. After all, these funds operate exactly like the big bull operators who caused massive losses to investors when their artificial rallies collapsed. But the good news is that hedge funds are just as likely to go bust when their risky investment strategies fail. According to one estimate, nearly 20 per cent of global hedge funds have failed, either due to operational failures or bad investment decisions. The danger is that disguised as global hedge funds they could destabilise the market and the economy if they exit India by ruthlessly dumping stock. Already, the two-day correction in prices is attributed by sections of the media to hedge funds booking short-term profits. The question before the regulators is to determine beneficial ownership and regulate their operations. But an environment which encourages free movement of capital, provides little leeway for a government that has opened its doors to foreign investment. Recently, several governments have followed Mahathir’s example and expressed concern about hedge fund tactics. The best that the Indian regulators can do is to work hard to ensure that India’s hoards of black money are not re-routed to destabilise our own markets.

-- Sucheta Dalal