87) Tackling excess volatility in the stock market

Markets are volatile by their very nature. There is, therefore, little point in decrying volatility, although an excess of it is certainly not desirable.

The Indian stock market is among the most volatile in the world. Between November 2006 and October 2007, the volatility of the Sensex and Nifty were 1.54 and 1.59 respectively as against 0.88 of Dow Jones, 1.06 of FTSE and 1.13 of Japan. Except the volatility of 1.69 of IBOV of Brazil, the volatility of the Sensex and Nifty during the same period were higher than that of indices of other developing markets such as MEXBOL of Mexico (1.33), JAISH of South Africa (1.15) and K LCI of Malaysia (1.05).

While the volatility of the Sensex and Nifty during December 2007 was relatively steady, during January 1-25, 2007 , it was abnormal with the Sensex fluctuating from a high of 21,113 on January 9 to a low of 15,332.42 on January 22.

It needs, however, to be noted that markets are volatile by their very nature. There is, therefore, little point in decrying volatility, although excessive volatility is not desirable. It, indeed, needs to be curbed.

Fall not unexpected

It is not as though that the fall in stock prices was unexpected. Price earnings of the Sensex and Nifty had sky rocketed to 28.17 and 27.01 respectively on January 9, 2008 as against the PEs of most of the global markets hovering around 15-20. This should have cautioned the regulators.

The drama witnessed in the latter half of January was not normal volatility but hyper volatility with a strong bearish undertone.

The overall fall in Sensex by 16.9 per cent from 20,728.05 on January 14 to 17,221.74 on January 24, 2008 was mainly due to massive sales by foreign institutional investors (FIIs), resulting in a fall in net investment by as much as Rs 12,735.50 crore.

With strong fundaments, both macro and micro, the steep fall witnessed in stock prices was not justifiable. It is true that sub-prime rate crisis in the US and also the slight slow down in corporate profits in the third quarter of FY 2007-08 would have some effect on the stock prices. Both these factors could have affected stock prices by, say, 5 per cent, but certainly not to the extent witnessed.

While there is universal acceptance of the imperative need to reduce volatility, there are differences in the approaches to do so. Here are some, both long-term and short-term measures, that merit serious consideration by the authorities concerned.

Curb FIIs’ holdings
The growth of shareholdings by FIIs needs to be curbed. With the net cumulative investment of over $65 billion, they account for about 25 per cent of the floating stocks and about 30 per cent of the deliveries.

The least that can be done is to reduce the share of qualified institutional buyers (QIBs) in IPOs from 60 per cent to 50 per cent and to peg the share of FIIs in the QIBs quota at 25 per cent, with the share of domestic mutual funds and other financial institutions at 25 per cent.

The share of retail individual shareholders can then be raised from 30 per cent to 40 per cent and the balance 10 per cent can be earmarked to non-institutional investors.

Besides, IPOs to retail investors should be mandatorily required to be offered at a discount of 5 per cent to the offer price to others. Floating stocks should be increased, which can be done by raising the minimum percentage of public offer for listing from 25 per cent to 40 per cent of the issued capital of a company. Even this is much lower than the 60 per cent that was the norm prior to the SEBI dispensation in June 1992. In addition, the requirement of holdings by the public in listed companies at 25 per cent/10 per cent should be rigidly enforced.

Finance to Stock Brokers
In an hour of crisis, stock brokers and investors need to be financed liberally by commercial banks. Most of the stock brokers demanded demand drafts or even cash for purchases.

It is worth recalling that when Dow Jones Index lost 507 points (22.6 per cent) wiping out about $500 billion on October 19, 1987 in a matter of hours, the then US Fed Chairman, Mr Alan Greenspan, ensured that the stock markets were flooded with liquidity. The markets recovered soon thereafter.

The RBI could have also ordered a cut in interest rates in this hour of crisis which would have stemmed the rot to some extent, in tune with the cut in the US Fed rate by 75 basis points to 3.5 per cent.

Moderate Margins
Another time-tested instrument to reduce the volatility of the market is to moderate the rates of margin, both in a sharply declining market and in a sharply rising market, which was heavily relied upon, prior to regulation by SEBI.

In a sharply declining market, margins on the short side should be higher so that it acts as a deterrent against sales and lower on the long side, while being adequate to cover the risk of a further fall in prices, encourages purchases. Similarly, in a sharply rising market, margins should be high on the long side and lower on the short side.

This instrument, among other instruments, such as curtailing the exposure limits, limiting speculative holdings, and so on, were heavily relied upon, with the approval of the Ministry of Finance, both during the bull phase from June 12, 1992 till April 22, 1992 when the Sensex rose by a phenomenal 243.0 per cent and also during the bear phase thereafter till November 1992 when the Sensex fell by 44.5 per cent.

These measures not only moderated volatility but also helped in ensuring that not a single default occurred during this period. What is essential is not to prohibit entry and exit at any point of time but to make it stiffer for purchases in a rising market and stiffer for sales in a declining market.

Market Stabilisation Fund

It is time that the proposal mooted in 2004 in the wake of Black Monday Crash on May 17, 2004, when the Sensex crashed by 842 points, to have a Market Stabilisation Fund, is reconsidered.

There is already a Market Stabilisation Scheme, aggregating to Rs 80,000 crore launched in 2004 to mop-up excess liquidity to sterilise the effects of foreign exchange accumulation resulting from large capital inflows.

There is no reason why a similar fund should not be set up to weather the shocks of stock market vibrations. A free market can occasionally be disastrous, as it has been seen several times in the various global markets, beginning with the South Sea Bubble in 1720 and including the great Wall Street crash in 1929.

The Indian stock market is no exception to this general rule. The crash that occurred in the wake of the border conflict with China in October 1992 and the disaster that followed the promulgation of Dividend Restriction Ordinance on July 6, 1974 are some of the instances of this general rule.

Shrewdly operated, the Market Stabilisation Fund should be able to make handsome profits, buying as it will in a steeply declining market and selling in a market dominated by irrational exuberance.

Stagger IPOs
The crash in stock prices in January 2008 was also caused by massive flow of funds into the IPOs of Reliance Power and Future Capital Holdings for which most of the investors, including QIBs, had to sell the existing share holdings. To avoid similar incidents , it is worth considering staggering the issues, as used to be done prior to the SEBI dispensation.

India claims to be an advanced market on a par with, or even a shade better, than the markets of developed countries.

Yet, we have a long way to go in dealing with matters such as reducing volatility of stock prices, enhancing the shareholding population, curbing the monopolistic trend, injecting full transparency in stock market operations, educating the investing public, and curbing several stock market malpractices such as manipulation of prices and insider trading.

M. R. Mayya

(The author is a former Executive Director, Bombay Stock Exchange.)