How to revive the stock market

Darks clouds are gathering on the financial horizon. The world economy is slowing, and may suffer a double-dip recession. Stock markets are plunging in India and the world over. Privatisation of HPCL and BPCL looks  off the agenda. Standard and Poor’s has downgraded India’s rupee-denominated debt to junk status.

The Finance Ministry needs to do something to salvage the economy. Yashwant Sinha, tried repeatedly but in vain to kick-start the economy. He proved that tax breaks and promises of reform that prove politically unfeasible cannot sustain a feel-good climate. The markets will welcome radical reforms, but Mr Jaswant Singh  clearly feels that these may be too painful and politically risky. What, then, can he do painlessly?

Start with the stock market. Stock prices are very low today, with much potential to shoot up. Notwithstanding the poor monsoon, industrial growth at 6 per cent is the fastest for two years, and exports are enjoying double-digit growth. Even after factoring in the sluggish global economy, Indian shares look a good buy.

In the bad old days the Finance Ministry might have ordered the UTI to prop up the stock market. Today, thank heavens, that is no longer possible. Trying to drive up the market with artificial props is always fraught with danger.

On the other hand the government should surely remove distortions that thwart a market revival. The biggest such distortion is the virtual ban on loans against shares. In all market economies, banks lend against shares as collateral. But the RBI has placed a ceiling of Rs 20 lakhs per individual on such bank lending. At a time when the daily turnover of our stock markets runs into thousands of crores of rupees, this is meaningless. Bears can borrow shares for selling, but bulls cannot borrow for buying. This depresses markets, artificially and pointlessly.

Why does India have restrictions that no other market economy imposes? Because of scams associated with Harshad Mehta and Ketan Parekh. However, this is a classic misperception of the problem. Harshad could rig the market because he alone had access to bank lending, illegally. If everybody had equal access, Harshad would have lost all power. Rigging is possible through monopoly access to credit. Open credit access to all,  and there can be no monopolies or rigging.

Even if the RBI insists on some ceiling per individual, it should surely be at least Rs 50 crore. That alone will be meaningful in a market with a daily turnover of thousands of crores. If gradualism is favoured, start with Rs 10 crore and raise the ceiling to Rs 50 crore in pre-announced phases over two years.

Banks  have suffered huge losses in lending to industry and new projects. They need new avenues for relatively safe lending. Lending against shares can be one such. It can be profitable with very acceptable risks provided automatic controls are in place to liquidate collateral. Liquidating the property of companies is legally messy and takes ages. But liquidating shares pledged as collateral can be done in minutes.

Harshad Mehta and Ketan Parekh could not repay their bank borrowings, and so went bust, taking the markets down with them. This is possible only in obsolete, uncomputerised systems. In the USA, investors have computerised, online trading accounts with broking houses like Fidelity or Schwab. These broking houses in turn have agreements with banks to provide credit on margin to their clients. The stock market authorities lay down margins for buying different classes of shares, and brokers may impose additional margins at their discretion. The shares are marked to market, not just at the end of the day but throughout the day, by computer. If the value of any investor’s portfolio falls below the margin threshold, the computer issues a margin call (that is, demands additional cash from the investor to cover his increased risk). The broker/banker bears very little risk of default since he is authorised, if margin calls are not met, to sell an investor’s entire portfolio to recover his dues. The investor cannot delay matters by saying he has not received due notice by registered post: everything is computerised and online. The broker/banker  can lose only if he neglects to issue margin calls or liquidate  the client’s stocks. But computerised programmes can do both automatically. This ensures that VIPs cannot pull strings to delay liquidation of their holdings: the computerised programmes are automatic. Such automaticity ensures safe lending.

In stock market can, in theory, crash so sharply that even a complete sale of a portfolio  may not cover an investor’s liability. So every broker/bank must keep an eagle eye on margins and raise them for any stock that looks like crashing. That is not difficult. Currently, trading is halted mandatorily by stock exchanges if the price of a stock falls by more 10 per cent or 20 per cent, depending on the class of shares. That rings alarm bells and provides time enough to adjust margins. Indeed, this too can be done automatically by a computerised programme.

In India, unlike in the USA, many big brokers (like Harshad. Mehta or Ketan Parekh) trade with their own money, not on behalf of clients. Such private gamblers cannot be relied on to impose prudential margins. How do we keep them out? Why, by starting the scheme with a short list of pre-qualified broking houses that are prohibited from trading on their own account.

So Jaswant Singh, please have a long talk with the RBI about this. Introduce computerised safeguards, and liberalise lending. Implement the program in phases in according to a pre-announced schedule. This will give confidence and continuity to investors, while providing you opportunities for mid-course fine-tuning. You will be rewarded with a booming market, satisfied voters, and, what’s more, a reputation.

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