The visible hands - The Honest Truth By Ajit Dayal
Investing in India - Honest Truth by Ajit Dayal
The visible hands A  A  A

The US economy is in deep trouble.
The US government debt has increased.
The local consumers there are bankrupt.
The largest financial companies have gone bankrupt.
The largest auto manufacturers and airlines are on the verge of bankruptcy.
The US economy is probably already in recession - the statisticians will figure that out one of these days.

By the way - many people use the word "recession" without really knowing what it means.
A rule of thumb is that a "recession" occurs when an economy slips backward.
In reverse gear.
For two successive quarters.

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So, when India’s GDP declines from a +8% rate of growth to a +7% rate of growth - that is not a "recession". The growth rates are still positive.
If India’s GDP slipped into a negative rate of growth at, say, -2% for the quarter ended December, 2008 and then again slipped by -1% for the quarter ended March 2009 - then one can say that India is in a "recession".
A slow down in GDP - but still a positive rate of growth is not a "recession".
It is a slow down.

But people like to fool you - to show you how smart they are.
So they use the very serious word: "recession".

Indian economy will be affected
Sure, the rate of growth in the Indian economy will slow down.
India has its fair share of problems but the Indian economy is likely to grow between 6% per annum and 7% per annum.
That may be a slower rate of growth than the 9% number we have been brainwashed into believing as our birthright.

Don’t get me wrong - positive brainwashing is good. For 30 years India was stuck in what the late economist Raj Krishna called the "Hindu" rate of growth. The Indian economy - unlike the Asian Tigers - was growing at 3.5% per annum between 1950 and 1980. It could not break out.

That was then.
Now we are the New India; of the !ncredible kind.

We are less concerned about religion these days.
Or caste.
Or what state we originate from.
Or what language we speak.
Well, most of the time.

So, the Indian economy has grown by an average rate of 6.2% every year since 1980.
For 28 years.

From 2004, we grew at 8.4% per annum.
The recent economic turmoil in the world will see our growth slow to a 6% to 7% range.

190 of the 195 countries in the world would give an arm and a leg to have that fabulous > 6% rate of growth for their economy.

If expected rates of growth in GDP were the sole reason to invest in a stock market, India would be one of the better markets in the world to invest in.

Hedge funds gambled their growing pool of money on an India bet

Spot the stock market!

Chart A Chart B

Source: Bloomberg

Chart A shows a market that is down -27% between January 1, 2008 and October 31, 2008 this year in US Dollars.
Chart B shows a market that is down -61.3% in that same time period in US Dollars.

Now tell me which chart is the BSE 30 Index of Dalal Street?
And which chart is the Dow Jones Industrial Average of Wall Street?

The Chart B is the BSE 30 Index. It has lost -61.3% since the start of the year.
It has done worse than the US stock market, which has lost -27% in the same time period.
Surprising, isn’t it?

We just figured out that the economic problems in USA are a lot worse than the problems in India.
So, why has the Indian market performed so badly?

I have a guess.
Look at Chart C: this represents the annual size of the hedge fund industry.
Look at Chart D: this represents the annual flow of FII money into India.

Hedge funds gambled their growing pool of money on an India bet

Chart C Chart D

Source: Hennessee Group LLC., Google

Source: SEBI

The FII - Foreign Institutional Investor - regulations were supposed to attract long term capital to fund India’s long term economic growth.
Hence the word "Institutional".

We got parts of it right.
We got the foreign money - though many allege that the source of the funds may be Indian cash re-routed through some washing machines.

This money was from investors - though probably of the short term nature.

And they were "institutional" to the extent that the broking houses that were wrongly given a FII license were large broking companies that acted as conduits for hundreds of hedge funds to make bets on the direction of the Indian stock market.

How did a broker become an investor?
Because we are so confused about our own policy that we don’t know cricket from gilli-danda.

The joke is: we have no idea who the P-Note holders are.

We know everything about the millions of investors in this country who wish to invest Rs 50,000 in any mutual fund.

We know that the Income Tax department can send anyone who invests Rs 2 lakh a year in mutual funds a standardised love note asking for a lot of information.

But the P-Note fellow - we know nothing about them!
All my focus on P-Notes may be totally wrong.
They may be the longest of longest shareholders.
They may be really nice folks who never sell any share - they only buy.
They may be really nice folks who really wish to provide capital to let India develop as opposed to making a bet on the direction of the stock market.
The way you make an impersonal bet in a casino and bet on "red" or "black".

I wish I had the data to prove myself wrong.
But I don’t have any data on them.
In fact, no one really knows much about them.
For all the transparency in our markets, we have this Phantom.

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Policy in context
A few clarifications are in order here:

  1. I have little interest whether stocks go up or down on any given day or week or month or year.

  2. I have been against speculative flows from international "investors" irrespective of the level of the Index. So, this is not a case of crying "foul" because the markets have declined. One day, they will rise again - hopefully, without any P-Note money.

  3. I believe that policy needs to be written with an end objective - and not for the sake of writing policy to prove an academic assumption or endorse some empirical evidence. Policy has to be written in the context of what the objective is. For example, India has 500 million poor people. We don’t write policy that says let those 500 million people fend for themselves. Let them figure out how to survive. The empirical evidence - a wonderful tool used to prove the correct policy that needs to be written - suggests that poor people will probably have less chance of success. The free-market policy would say: let the 500 million people eat crumbs. But India’s economic policy - thank God - is written to improve the lot of the 500 million. In defiance of "empirical evidence".

  4. The markets are not an end in themselves - or to themselves. Markets - like policy - are subservient to an objective. The capital markets were created as a conduit for those with savings (the investors) to find a way to channel these savings to those who need the capital; the companies that need capital to expand and set up businesses. A "perfect" market in that context is not the market that exists in a text book, but one that takes care of the stated end objective. The price at which transactions take place is "price discovery". We set the framework under which "price discovery" functions. We can determine who all will set the price of any product - and under what conditions. The way we determine that there is some sort of minimum wage to protect the poor. Left to the free markets, the cost of most manual labour would be zero. Like slave labour. So, there is no harm in saying that P-Note holders should not participate in any "price discovery" exercise. We have a right - and obligation to set rules and decide who all can participate.

State the objective - then write the policy
India’s objective should not be to build the most "perfect market" where capital is free to come and go as it chooses.

Where "price discovery" is the end objective.

India’s economic objective is to build a solid economy over the long term.

And for that you need long term capital - foreign or domestic.
Change the rules that allow this long term capital to enter and exit India in a more rational way.
Within that framework we can have rules that allow for "price discovery" among those players that have been allowed to participate.
Have your short sellers.
Have the derivatives market. And make the derivatives market delivery based.

And continue to be proud of the fantastic clearing house and settlement systems we have. They are truly world class!

But, short-term capital has made the Indian stock markets into a wild casino.
When the Index was at 20,000 levels - we looked like a casino to the providers of long term capital.
At a 9,000 Index we look like a casino where the house just made some wrong bets.

Some pretty big wrong bets.

Instead of being a safe haven in times of global turmoil, the Indian stock markets are hostage to price discovery rules that have been built in a policy void.

It is time to define the objectives and then frame the rules.
Shut down the P-Notes.

The lobby is powerful
In addition to the academic argument of free markets - to allow anyone to buy and sell at any time and further the cause of "price discovery" - there is a more powerful lobby.

The broking community.
The larger Indian brokers and the foreign brokers - the "FII brokers" as we call them.

They are in the P-Note business.
They use their FII license to create and deal in P-Notes.
And they make a lot of money.

How much?
The average daily trading volume by these fake "FIIs" in India is approximately USD 1 billion every day.
Rs 5,000 crore per day.
The brokers typically earn a commission of 0.25% on the trading of the P-Notes.
That is Rs. 12.5 crore per day.
Multiply that by some 220 trading days and you get Rs 2,750 crore each year.
Not a small sum of money.
The commission the brokers earn could send 9 spacecraft to orbit the moon - every year.

But what they have done is to help send our stock markets into orbit.
And now a crash landing.

The revenues from the broking commissions allows for a lot of lobbying power.

Let’s assume that some boring pension announced they were investing in India.
Let’s say they invest USD 100 million into India. This amounts to Rs. 500 crore.
Being pension funds, they will typically hire a fund manager who owns shares for 5 years. They are long term investors.
What this means is that every year 20% of the portfolio gets changed (the inverse of 5 years, expressed as a percentage).
Now imagine you are broker to this pension client.

The pension invests Rs. 500 crore in India.
Broker gets 0.25% commission.
That works out to Rs. 1.25 crore.
That was commission earned for the initial corpus of money invested on its way in.

Then every year the pension fund’s manager changes 20% of the portfolio.
That means Rs 100 crore is traded every year.
The broker gets Rs. 0.25 crore commission every year.
For five years.

Over a 5 year period, the broker will service the Rs 500 crore of pension money and may get a total commission of Rs. 2.5 crore.
That is Rs 2.3 lakh per day.
So, if 10 pensions land up as his client, the broker gets Rs 5,000 crore of buying power to service and earns Rs 23 lakh per day.

On Rs 5,000 crore of P-Note money traded every day, the brokers get Rs 12.5 crore.

Servicing the P-Note investor gives the broker 54 times more commission!

What business would you like to be in: peddling P-Notes or travelling for months to get some order from long term pension funds?

Elementary, my dear Watson
If you were a broker and you had invited policy makers to speak at a conference in New York, London, Hong Kong or Tokyo - who would you invite to be the audience?
Would you want the policy makers to meet the pension fund or the P-Note investor?

The invisible hand of Adam Smith allows the broker to choose the higher commission business.
The P-Note rules encourage that decision.

The Colombian drug lords have a fabulous business peddling high margin drugs.
If FEDEX could peddle drugs - they probably would have a better logistics capability. And they would gain market share. And it is a great stock to own.
But FEDEX cannot peddle drugs.
The laws in the USA, Europe, and India have been set up that way.
So FEDEX has to sell the lower margin products of office documents, spare parts, and baggage.

The global broking houses have built a fabulous distribution system.
They can distribute anything.
They exported USD 270 billion of toxic loans manufactured in USA to an unsuspecting banking industry in Europe.
That power to peddle toxic waste was a selfish act - not in the global interest.

The Invisible Hand of Adam Smith is based on self-interest; not national interest.
The broker chase of P-Notes is based on their selfish interest: there is nothing wrong with that.
Provided that is we as a country really want.

This chase for the P-Note money has happened across governments and across policy making teams - there is no single government that is to blame.

The broker interest is not necessarily the national interest.
The free market interest is not necessarily the national interest.

The question to be asked is: what is the national interest?
Long term flows of capital that allows companies to build businesses?
Or speculative pools that exaggerate the rise and fall of the stock markets?

Yes, markets will always spike and fall.
And we should let them.

But shouldn’t we step back and ask - why have we brought this wonderful, sliding chart upon us?
Most investors did not ask questions on the sharp movements on the upside.
Now that the markets are falling, we are in shock.

Well, the world is in trouble - there is no doubt about that.
I have no empirical evidence to prove that the markets would have risen less sharply or fallen less sharply if P-Notes were never around.

But, then again, I have no empirical evidence to figure out that leaving 500 million people to eat crumbs and look after themselves will cause a bloody revolution.

But I do have this empirical evidence.

I have just returned from a dinner with 6 pensions who represent USD 1 trillion of capital.
And I am not even a policy maker.
And I was not fit enough to be invited to meet the PM or the FM.
Yet I got to spend 2 hours with these pensions.
That is probably more time than most of the policy makers have spent with pension funds. After 16 years of FII rules, we still don’t know these long term owners of capital.

There were over 40 pensions represented from many countries.
Total pool of money in that conference: over USD 3 trillion.
Most Asian countries were represented.
Bhutan, China, Japan, Malaysia, Mongolia, Singapore, South Korea, Thailand, and many others.

But no one from India.
No Indian policy makers.

No one to carry the Indian flag of why these pensions should invest in India.
No one.

They were probably busy being introduced to P-Note punters by the brokers.

My apologies
I have nothing against brokers.
I have nothing against any policy maker.

But I have a strange feeling that our policy has been adrift.
Left to stumble and evolve on its own.

And I am upset because India had yet another opportunity to showcase the inherent strength of our capital markets, our wonderful settlement systems, our fabulous trading mechanisms, and our pretty resilient economy.

We had an opportunity to yell to the world that India is a "safe haven" for their long term capital.

But we are so caught up in our brilliance that we expect the world to come fluttering to us.
We were so caught up in our self interest that we nearly blew ourselves up as an economy.

Don’t get me wrong - we did get some investors - the P-Note holders.
We built a wonderful casino where they could make their bets every day: black for "up" and red for "down".
The trouble is that we set ourselves up to be just another dinky emerging market. And see that red sign on your TV screen - that is their footprint as they rush for the exit.

With so many incomplete projects littering India’s landscape, it is time to build a casino for the P-Note money.

And let’s get back to building a capital market for developing India’s long-term economy.

Suggested allocation in Quantum Mutual Funds
Quantum Long Term Equity Fund Quantum Gold Fund
Quantum Liquid Fund
Why you
should own it:
An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation (New)** 46% 12% 42%
Suggested allocation (old) 80% 15% 5%
** Assumes 2 years of expenses are kept in safe places like liquid funds.

Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"

Note: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt Ltd and Quantum Asset Management Company Pvt Ltd.. Views expressed in this article are entirely those of the author and may not be regarded as views of the Quantum Mutual Fund or Quantum Asset Management Company Private Limited.

Mutual Fund Investments are subject to market risks. Please read the offer documents of the respective schemes before making any investments.

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