Nov 30th 2007, C.P. Chandrasekhar.

The unprecedented bull run on the Bombay stock exchange which took the Sensex beyond consecutive 1000-point hurdles in a matter of days rather than weeks or months has little to do with economic fundamentals. Rather, huge foreign capital inflows over a short period of time have pushed up equity valuations to levels that would normally be considered unsustainable. Between August 21 and October 29, the price earnings ratio for the 50 S&P CNX Nifty stocks had risen from 18.4 to 26.4 or by more than 40 per cent. Such a sharp rise to unusually high levels over a two-month period can hardly be attributed to improved earnings expectations. Thus, the RBI has had to admit in its recently released Report on the Trend and Progress of Banking in India that: “Although the macroeconomic fundamentals are strong as also the corporate earnings, large demand by FIIs given the limited supply of domestic assets, is putting pressure on the equity valuations.” For the record, net FII inflows during the first 10 months of 2007 had touched $18.9 billion as compared with the $10.9 billion it had touched in 2003-04, the maximum for any full financial year.

While fundamentals cannot explain stock market buoyancy, the role of foreign capital inflows in explaining such buoyancy can work against fundamentals. Huge capital inflows have resulted in an appreciation of the rupee, from its Rs. 46-to-the-dollar level in mid-September 2006 to Rs.39.3 on November 1, 2007. The damage this has wrought on the exporting sectors is only being assessed as yet. Such appreciation has occurred despite the central bank’s intervention aimed at stalling the currency’s rise. While intervention has failed to fully realize its objective, it has resulted in the continuous accumulation of foreign exchange reserve assets with the central bank. This makes it difficult for the RBI to manage money supply and use the monetary lever to pursue other objectives. A strait-jacketed central back is hardly good for the economy. Finally, in its effort to balance the accumulation of foreign exchange assets by retrenching government securities deposited with it by the central government (under the Market Stabilization Scheme), the RBI has taken on deposits of such securities to the tune of more than Rs.180,000 crore. Since the interest due on those securities has to be met from the central budget, the Centre may be burdened by as much as Rs.12,500 crore over a full financial year. This would make fiscal management difficult as well. The outcome may be a further cutback in capital and social expenditures.

Given these consequences of the FII surge, justifying the open door policy towards foreign financial investors has become increasingly difficult for the government and for non-government advocates of such a policy. The one argument that still sounds credible is that such flows help finance the investment boom that underlies India’s growth acceleration. There does seem to be a semblance of truth to this argument. Between 2003-04 and 2006-07, which was a period when FII inflows rose significantly and stock markets were buoyant most of the time, equity capital mobilized by the Indian corporate sector rose from Rs.67,622 crore to Rs.177,170 crore (Chart 1).
Chart 1 >>

Not all of this was raised through equity issued in the stock market. In fact a predominant and rapidly growing share amounting to a whopping Rs.145,571 crore in 2006-07 was raised in the private placement market involving negotiated sales of chunks of new equity in firms not listed in the stock market to financial investors of various kinds such as merchant banks, hedge funds and private equity firms. While not directly a part of the stock market boom, such sales were encouraged by the high valuations generated by that boom and were as in the case of stock markets made substantially to foreign financial investors.

The dominance of private placement in new equity issues is to be expected since a substantial number of firms in India are still not listed in the stock market. On the other hand, free-floating (as opposed to promoter-held) shares are a small proportion of total shareholding in the case of many listed firms. If therefore there is a sudden surge of capital inflows into the equity market, the rise in stock valuations would result in capital flowing out of the organized stock market in search of equity supplied by unlisted firms. The only constraint to such spillover is the cap on foreign equity investment placed by the foreign investment policy of the government. Thus, as per the original September 1992 policy permitting foreign institutional investment, registered FIIs could individually invest in a maximum of 5 per cent of a company’s issued capital and all FIIs together up to a maximum of 24 per cent. But much relaxations has occurred since. The 5 per cent individual-FII limit was raised to 10 per cent in June 1998. Further, as of March 2001, FIIs as a group were allowed to invest in excess of 24 per cent and up to 40 per cent of the paid up capital of a company with the approval of the general body of the shareholders granted through a special resolution. This aggregate FII limit was raised to the sectoral cap for foreign investment in the concerned sector as of September 2001. These changes obviously substantially expanded the role that foreign financial investors could play in the market for corporate equity.

Even in sectors where the restrictions on foreign investment or constraints on foreign investor rights are severe, as in the print media and banking, investors have evinced unusual interest. This is because the process of liberalization keeps alive expectations that the caps on foreign direct investment would be relaxed over time, providing the basis for foreign control. Thus, acquisition of shares through the FII route today paves the way for the sale of those shares to foreign players interested in acquiring companies as and when FDI norms are relaxed.

One obvious consequence of FII investments in stock markets is that the possibility of take over by foreign entities of Indian firms has increased substantially. This possibility of transfer of ownership from Indian to foreign individuals or entities has increased with the private placement boom, which is not restrained by the extent of free-floating shares available for trading in stock markets. Private equity firms can seek out appropriate investment targets and persuade domestic firms to part with a significant share of equity using valuations that would be substantial by domestic wealth standards and may not be so by international standards. Since private equity expects to make its returns in the medium term, it can then wait till policies on foreign ownership are adequately relaxed and an international firm is interested in an acquisition in the area concerned. The rapid expansion of private equity in India suggests that this is the route the private equity business is seeking given the fact that the potential for such activity in the developed countries is reaching saturation levels.

The point to note, however, is that these trends notwithstanding, equity does not account for a significant share of total corporate finance in the country. In fact, internal sources such as retained profits and depreciation reserves have accounted for a much higher share of corporate finance during the equity boom of the first half of this. According to RBI figures (Chart 2), internal sources of finance which accounted for about 30 per cent of total corporate financing during the second half of the 1980s and the first half of the 1990s, rose to 37 per cent during the second half of the 1990s and a record 61 per cent during 2000-01 to 2004-05. Though that figure fell during 2005-06, which is the last year for which the RBI studies of company finances are as yet available, it still stood at a relatively high 56 per cent.

Among the factors explaining the new dominance of internal sources of finance, three are of importance. First, increased corporate surpluses resulting from enhanced sales and a combination of rising productivity and stagnant real wages. Second, a lower interest burden resulting from the sharp decline in nominal interest rates, when compared to the 1980s and early 1990s. And third, reduced tax deductions because of tax concessions and loop holes. These factors have combined to leave more cash in the hands of corporations for expansion and modernization.
Chart 2>>

Along with the increased role for internally generated funds in corporate financing in recent years, the share of equity in all forms of external finance has also been declining. An examination of the composition of external financing (measured relative to total financing) shows that the share of equity capital in total financing that had risen from 7 to 19 per cent between the second half of the 1980s and the first half of the 1990s, subsequently declined 13 and 10 per cent respectively during the second half of the 1990s and the first half of this decade. There, however, appears to be a revival to 17 per cent of equity financing in 2005-06, possibly as a result of the private placement boom of recent times.

What is noteworthy is that, with the decline of development banking and therefore of the provision of finance by the financial institutions (which have been converted into banks), the role of commercial banks in financing the corporate sector has risen sharply to touch 24 per cent of the total in 2003-04. In sum, internal resources and bank finance dominate corporate financing and not equity, which receives all the attention because of the surge in foreign institutional investment and the media’s obsession with stock market buoyancy.

Thus, the surge in foreign financial investment, which is unrelated to fundamentals and in fact weakens them, is important more because of the impact that it has on the pattern of ownership of the corporate sector rather than the contribution it makes to corporate finance. This challenges the defence of the open door policy to foreign financial investment on the grounds that it helps mobilize resources for investment. It also reveals another danger associate with such a policy: the threat of widespread foreign take over. Many argue that this is inevitable in a globalizing world and that ownership per se does not matter so long as the assets are maintained and operated in the country. But there is no guarantee that this would be the case once domestic assets become parts of the international operations of transnational firms with transnational strategies. Those assets may at some point be kept dormant and even be retrenched. What is more, the ability of domestic forces and the domestic State to influence the pattern and pace of growth of domestic economic activity would have been substantially eroded.
Chart 3>>

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