An immature market economy

Indian Express, 23 September 2005

The drama on the stock market have highlighted how India is yet an immature market economy. It is the job of the stock market to fluctuate, to move in response to expectations. But in the media and in official circles in India, this induces disproportionate hysteria.

To become a mature market economy, the government has to stop trying to manage prices. When prices fell, as on 17 May 2004, we do not need the government to "prop up the market" or to look for manipulators. And when prices have risen, we do not need for a coordinated assault on the market. The government must respect the process of speculative price discovery, and accept the valuations that come out of it.

Yes, we need to strengthen the surveillance process when it comes to the obscure, illiquid stocks. This must be done at all times, not with just when the market is rising. However, we must remember that these are just a tiny part of the stock market.

The total market capitalisation of the 4,644 listed firms is Rs.23.1 trillion rupees. The bulk of this -- Rs.22.2 trillion - is in the 2540 CMIE Cospi companies. These are the companies where trading takes place on atleast 75% of the days, where there is a modicum of liquidity. The remaining stocks, where problems might lie, account for just 3.8% of the market capitalisation.

It is not the Indian market alone that has been rising. The world economy is in a strong upswing. Indian companies have experienced 14 consecutive quarters of powerful growth in profits.

Of 41 big countries, over the last year, only five countries have got returns of worse than 10%. This suggests a strong positive global stock market. The BSE Sensex and Nifty score at rank 13, with roughly 50% returns. The broad market, measured by the CMIE Cospi index is at rank 9, with 61% returns.

The P/E of Nifty is 15.93. In a week, the 2nd quarter will end. Earnings growth of atleast 15% will take place in the 2nd quarter. The Nifty P/E will then drop to 15.17. The broad-market P/E (Cospi) is at 16.94, and would drop to 16.4. Stock prices are higher primarily owing to solid earnings growth, not owing to starry expectations about the future.

The 1991/1992 scandal involved fraud in RBI, banks and the BSE, and it was a major national event. The biggest stocks, such as ACC or ICICI, were involved. In later years, problem areas have steadily shifted to smaller stocks, which are less important on the scale of the country. Hence, the task of ferreting out scandals and focusing attention on them has become less important.

Given the weaknesses of SEBI in enforcement, there are certainly problems with the smallest stocks. But we should not allow these to affect our minds about the big stocks, which are the ones that really matter. For liquid stocks, the front line of defence against market manipulation is not the regulator but the ordinary forces of speculation on the market. The international experience shows that for liquid stocks, it is the market which does the bulk of the policing against mispricing.

When stock prices go up, they do not have to come down. In fact, over the decades, stock prices go up rather dramatically. Similarly, it is wrong to claim that for stock prices to go up, "there has to be some new money that is buying shares". Unlike markets for goods, asset prices respond to expectations. When speculators become more optimistic about the future, prices become higher, without requiring "new money" in the picture.

India has achieved world class procedures on trading. What we now need is the human elements of a modern market economy. We have to get used to the fact that prices fluctuate, from day to day, in response to the flow of news and changing expectations of speculators. What we need to avoid is a hysterical response, of looking for "scams" and "crises" in every movement of market prices.

Ila Patnaik

Ila Patnaik