»Straight from the hip by Jawahir Mulraj

Reward and Responsibility
26 OCTOBER 2013

Jane Austen has written several wonderful books, including Pride and Prejudice and Sense and Sensibility. Were she to have written about India's financial sector as it is today, she may have well considered titling it Reward and Responsibility. The two normally go together. Sadly, in India, they don't, and this is testimony to just how badly the country is governed.

Let's start with mutual funds. In India the mutual fund industry has not grown as large as it has in the US, where it controls assets exceeding the banking industry in size. To give a perspective, Blackrock, the largest fund house in the world, controls assets of over $ 3 trillion, far larger than India's GDP.

Now, the fund managers, all over the world, get paid on the basis of performance relative to a benchmark, irrespective of whether or not they make money for investors. Thus, if the benchmark drops, say, 20% in a year, and one fund manages to drop only 10% the manager may get a bonus for 'outperformance'. This reminds one of the joke about two fund managers who, out hunting, run across a bear. One of them starts to wear jogging shoes, causing the other to remark 'don't be silly, you can't outrun a bear'! The first guy coolly replied 'I don't need to outrun the bear, only to outrun you'!

Reward and Responsibility.

Given that the industry can grow larger in size than the banking industry, and can garner assets under management (AUM) that's something to meditate over ?. The linking of fund manager pay to (short term) performance breeds several ills. For one, it leads to short termism, with fund managers reluctant to invest in companies developing longer term solutions, for fear of underperforming and getting a smaller bonus. The most celebrated case that illustrates this is Lucent Technologies, the erstwhile Bell Labs, which was the font of innovation at AT&T before the company was split. Lucent, as Bell Labs, had, prior to listing, developed technologies that would be successful in the long term but, under pressure from fund managers who held a majority of stock, abandoned these in favour of short term fixes. It nearly went bankrupt.

Or take the banking industry. As this column in the Hindu points out, the banking industry is weighed in favour of larger players and is completely anti the small depositor. This is stated by no less an authority than the outspoken deputy RBI Governor, Chakrabarty. The moneys taken as deposits belong to the bank on deposit, and not to the depositor. The status of the depositor is that of an unsecured creditor. The banking industry, worldwide, works on the principle that it is an intermediary, facilitating the transfer of money from those who have it (the savers) to those who need it (industry, trade and commerce) with the risk of losses borne, ultimately, by the depositor. When the lending goes extremely bad, as it did in Cyprus, the Government simply instructs the banks to give depositors a free haircut (40% of the deposits were gone, overnight, in the case of Cyprus). This can easily happen in India too.

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Reward and Responsibility.

The political class in India seem to have only rewards, but no responsibilities. Few, if any, charge sheets are brought against them, though reputedly honest bureaucrats like erstwhile Coal Secretary, Parakh, have FIRs filed against them.

This is leading to dire consequences. Senior IAS officers met last week with the Prime Minister, to tell him about the consequences. None would be willing to take any decisions, for fear of being 'investigated' at any time until their death, for taking one. Nobody can be hauled up for not taking a decision. The resultant policy and administrative paralysis will destroy what is left of economic growth prospects. There are 250 projects awaiting various approvals and clearances, involving an investment of Rs 12.5 lac crores, or 20% of GDP.

Reward and Responsibility.

Let's have a look at Exchanges.

The largest stock exchange is the NSE, the oldest is the BSE. Both are, as yet, unlisted and thus have no shareholder overview, making them less transparent, even as the exchanges themselves strive hard to encourage a greater transparency for companies listed on them.

Having said that, listing per se is not the panacea, without good governance and proper oversight. The commodity exchange, MCX, is listed, although it is now embroiled in a controversy about another, unlisted, entity in the group, the NSEL (National Spot Exchange Limited) as a result of which the group is in danger of losing its 'fit and proper' status to run exchanges.

As, indeed, they ought to lose it. The NSEL has proved guilty of outright fraud through forgery, had not accredited their godowns as they should have, under WDRA, and not monitored stocks purportedly lying in their godowns; the regulator, FMC (Forward Market's Commission) did not do the job of supervising them, as stated by the Minister, K V Thomas himself and had lent moneys to companies without any due diligence. Joint Commissioner of Police, Himanshu Roy, has stated "Roy said during preliminary investigation, it was found the selection of borrowers by the exchange was arbitrary and the management of the exchange was running a pure financial scheme." With proven fraud, negligence, misrepresentation and abysmal governance standards, how can the group not be deprived of its 'fit and proper' status, is a question that is baffling. Unless there is hidden protection, of the political kind, working behind the scenes?

Reward and responsibility.

The FMC is trying to shirk its responsibility by saying that it was not the regulator for the exchange. The Court has negated this. And, if it was not the regulator, did the Government permit an unregulated exchange to function? In that case it is the Ministry of Consumer Affairs that has to be hauled up, and the Minister who, in 2007, gave NSEL certain exemptions. Is the Minister being questioned or prosecuted?

Reward and Responsibility.

Contrast this with experiences in other countries, which have stronger regulation and a speedy judicial system that breeds fear in the minds of wrongdoers, unlike in India. JP Morgan has agreed to a $ 13 b. settlement with the US Government for misrepresenting investors. It has, in addition, agreed to a $ 6 b. settlement for misleading investors in selling to them sub prime mortgages. It had informed investors that securitised sub prime mortgages were safe, whereas they weren't. JP Morgan had not, as NSEL has done, do fraud, nor did they have empty warehouses, nor did they lend money to companies with little chance of recovery. Yet they agreed to two settlements, simply because the US is better governed and has a strong judicial system that wrongdoers are petrified of being caught in. India should, if it wants to attract investors, take a cue.

In corporate news of interest, Idea Cellular's Rs 3,000 crores QIP offer is being lapped up by investors, indicating that there is appetite from foreign investors for well managed companies with good businesses. Similarly, L&T Infra Development Projects, a subsidiary of L&T, is to raise money in Singapore by listing some of its road projects. Several road projects are amongst those stuck for want of various clearances.

Bereft of protection by the Government and its agencies, the small investor is missing from equity markets. The retail investor accounted for 34% of volume in 2013, as against 83% a decade ago.

The BSE-Sensex dropped 199 points last week to end at 20,683 and the NSE-Nifty fell 44 to close the week at 6,144.

For stockmarkets the good news is that the Government, together with SEBI, is considering changes in policy to permit mutual funds to manage pension funds, which are now managed by State owned bodies. This could see more money flowing into equity markets. The competition ought to also ensure a better return for pensioners. Provided, of course, that the Government is alert to its responsibility of overseeing the funds.

The Government has also announced its intention of raising foreign currency reserves to $ 300b. by year end, in preparation for a tapering off of QE by the US Federal Reserves, and the consequent likely outflow of funds. Remember, the mere pronouncement of a likely taper had led to an outflow from both debt and equity markets in India, and to a significant fall. Should the taper commence, a similar fall will occur. Whether it will, is arguable.

The bad news for the stockmarket is that, given the rebellion of the IAS officers, perhaps rightly so, any anticipated clearances of projects would continue to be slow. On Dec 8 we will know the mood of the electorate, when results to 5 state elections are going to be declared. The ensuing political uncertainty, can stall any further rally, especially if the taper starts. Hence, tread with caution.

J Mulraj is a stockmarket columnist and observer of long standing. His weekly column on stockmarkets has run for over 17 years. An MBA from IIM Kolkata, he has been a member of the BSE. He is now India Representative for Institutional Investor. A keen observer of events and trends, he writes in a lucid yet readable style and takes up issues on behalf of the individual investor. Nothing pleases him more than a reader who confesses having no interest in stockmarkets yet being a reader of his columns. His other interests include reading, both fiction and non fiction, bridge, snooker and chess.

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The authors, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same.
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