The senseless, irrelevant Sensex

Diwali saw the Sensex at an all-time high 21,196.81. Equally high are fiscal deficit, current account deficit, inflation and corruption!

How is that investors in markets have gained confidence to drive it high, even when the economy is struggling to recover and households are reeling over increasing price rise? The answer lies in understanding the structure of both market and household savings.

Market structure

Out of 11.60 lakh companies registered in India, less than 5,800 (0.5 per cent of the total) are listed on the BSE! A small portion of these listed companies is actively traded. Even among actively traded shares, the ‘free-float’ shares, that is, shares available for trading in the market (excluding promoters’ holding, strategic holding, and other locked-in shares) are too low.

According to a committee appointed by the Securities and Exchange Board of India (SEBI), the number of listed companies in the BSE remained around 5,800 only, after taking into account new listing and de-listing.

Surprisingly, the trading volumes have gone sky-high in the last one decade. The Sensex has gone up seven times from 3,100 in March 2003 to about 21,000 in 2013!

How is that when the number of listed companies is too low — and among them the actively traded shares are still lower, that too with minimum ‘free-float’ shares — the market is booming?

Liberalisation as part of economic reforms in August 1992 permitted foreign institutional investors (FIIs) to enter Indian stock trading.

Individual FII was permitted to invest up to 5 per cent of a company’s issued capital (now increased to 10 per cent) and all FIIs as a group were permitted to invest up to 24 per cent (now increased to 40 per cent), with the approval of shareholders of the company by a special resolution.

Tax policy was also liberalised selectively for listed securities only. Total exemption was granted from long-term capital gains tax, levied at 10 per cent on listed stocks.

This significant tax concession virtually made the Indian stock market a tax haven for foreign investors.

Add to this the huge liquidity in developed countries, which enabled foreign investors to access capital at near-zero interest rate to invest in the stock market. Given the situation of too little float of stocks chased by many, the demand increased, raising the prices of stocks.

This position encouraged volatile FII investments, only for short-term gains. The index also increased on investments and collapsed with exits. Consequently, investors in the short term gained, compared with medium-term and longer-term investors.

Thus, foreign investors in the capital market with access to cheap money take advantage of India’s liberal economic and tax policies. The next question is, how does the Indian household see investments in stock markets?

household savings

The Reserve Bank of India report of the Working Group on Savings during the Twelfth Five Year Plan explains that during the 40-year period from 1950-51 to 1990-91, the gross domestic savings increased by about 13 percentage points (from 9.5 per cent of GDP to 22.9 per cent). But after structural reforms were initiated from 1992, it increased more rapidly. The gross domestic savings rate rose from 22.9 per cent in 1990-91 to 34 per cent of GDP in 2010-11, or in just two decades.

For the period 2005-11, the composition of savings in gross financial assets reveals that bank deposits (49.9 per cent), life insurance (19.9 per cent), provident/pension fund (10.3 per cent) and small savings (3.5 per cent) aggregated to 83.6 per cent of total investment in financial assets. Investment in shares is only a meagre 4.3 per cent! From this, two things are clear: the overall savings rate is on a steady rise and Indian households prefer guaranteed investments to the risky capital market.

Of a population of over 1.2 billion, barely 18 million invest in equity market. Only 10 cities contribute to over 80 per cent of trading volume in 2010 ( Business Today April 2011).

The National Council of Applied Economic Research (NCAER) confirmed in July 2011 that Indian households have only been marginal investors in the stock market. They are extremely risk-averse.

The report finds that in times of economic crisis, investments in bank deposits, life insurance funds, provident and pension funds increase substantially, as they are relatively safer means of saving.

This remains so even as income from such safe investments, adjusted for inflation, is either low or even negative. It is also understandable, as households need to provide for themselves in the absence of social security (unlike in the West), particularly in an adverse economic environment.

The stock market is physically Indian, but financially foreign in character. The economic theory that portfolio investment would reward an active capital market, and therefore ultimately spur investments, has been proved wrong in the Indian situation.

In fact, given the structure of the market (its narrow economic and demographic base) and the nature of portfolio investors (read “hot money”), the investment risk is high. In view of the merits of savings over Sensex, one would expect supportive policies to boost the former.

Goldman Sachs has observed that household savings in India would increasingly reduce the relevance of foreign investments for building infrastructure.

In May this year the Prime Minister stressed the need to put household savings to productive investments. A SEBI-appointed consultant recommended that there should be greater focus on mobilising household savings into capital markets.

The attempt to direct household savings into the capital market is a Western notion that is being mechanically applied to the Indian reality.

Such imported theories are bound to fail; ultimately, the government depends largely on the savings of households.

(The author is a practising advocate and a fellow of ICAI.)