Surjit S Bhalla: MoF and RBI: Get Real

IT DOESN'T MATTER

In passing the buck, everyone is worse off.

The recent financial market crisis in India has all the appearances of a murder mystery""all the usual suspects are crying foul play and blaming the other guy. Some are even chanting, as would make MAD's Alfred E Neumann proud, what crisis? Was there a crisis?

Most market participants (in contrast to the regulators) believe that the Indian stock market was very close to a meltdown, if not actually in one. Ditto for us being in the midst of a systemic crisis. But that is in the nature of market participants""when they make money, they call it market efficiency and when they lose money, they, like the regulators, want to blame someone else.

The other response of the MoF-RBI combine is that what happened in India was just following the world markets. Global markets went up, so did we; global markets went down, so did we. And indeed, India rallied more, so it should be expected to drop more. So who is MAD""the ministry of finance (MoF), the RBI or investors?

The figures in the table can help shed some clarity on this contentious issue. Since the end of December 2004, some 18 months ago, the rise in the Indian market was comparable to South Korea, Brazil, and Mexico, with each market gaining, at its peak level, between 60 and 80 per cent. Russia gained an extraordinary 185 per cent. However, in terms of our collapse, and speed, our stock market is most comparable to Russia, with both economies declining by more than 20 per cent (22 and 25 per cent, respectively) peak to trough. Our comparators, Brazil, Korea and Mexico, all did better, much better, declining by only 10 to 15 per cent. Our rise was one-third of Russia; our fall almost equal to a stock market fuelled by only oil.

Then why did India collapse as it did? Three reasons have been mentioned""an MoF circular on taxation of capital gains, a severe liquidity crunch (RBI - bank lending for margin payments), and an increase in volatility margins (Sebi).

Of the three witches, the one from Sebi seems to be the most benign. There are rumours that margin payments approached 114 per cent, but that is mathematically unlikely. The available evidence suggests that, at worst, the margin fractions doubled from about 20 to about 40 per cent. The margin fraction schedule is a function of volatility, and for such calculations, it is immaterial whether the market is moving up or down. Such calculations work for 99.99 per cent of the time; they do not work, and are indeed counterproductive, for that .01 per cent when there is a financial crisis. But on these occasions it is the central bank that has to take the lead (after all, most financial crises are also banking crises).

In my view, the most likely trigger for the crisis was the rogue CBDT circular. It is time the MoF realised that in this instantaneously capital mobile world, financial tax systems in one country cannot significantly vary from those elsewhere. And ours has many errors of commission; in particular, the concept of "permanent establishment" (PE) and associated with it the deliberate confusion between "capital gains" and "business income". An example of a broker can illustrate the conceptual missteps in the circular. A broker provides brokerage services; that is its business. In exchange, the broker receives income, and on this, he should be taxed at the corporate income tax rate. If the brokerage firm chooses to also make investments in the stock market, that income should constitute as "capital gains". End of story.

The capital gains tax reduction to 10 per cent for the short term was done in exchange for the introduction of the securities transaction tax (STT) in July 2004 (by Mr Chidambaram). Earlier, the government had gathered no more than Rs 1,000 crore from all the soak-the-rich high taxes on capital gains. Last year (2005-06), the government collected three times that amount through the STT. This tax is paid by an individual regardless of whether she makes a profit or not, whereas the capital gains tax is only paid if profits are made.

Given this background, whether you are a domestic or an FII investor, clearly it is worrisome if on capital gains, one is forced to pay 33 per cent (domestic investor) or 41 per cent (foreigners). So both domestics and foreigners reacted, and wanted to get out before the tax rules got changed. This was the cause for the extra selling that occurred in India. Quite unnecessary, and, more than quite, irresponsible. In May 2004, others precipitated a stock-market crisis; ironically, two years later and almost to the day, the UPA government scored an own goal; or more realistically, "apne pair pe apni kulhadi".

The MoF-triggered crisis led to a rash of sell orders. Because of leverage, each fall required sales of additional stock to meet margins. In a matter of days, the market collapsed 23 per cent from its highs, and on May 22, it fell limit down""10 per cent. Regardless of what the cause was, the reality of a crisis was apparent. Investors needed short-term loans. When a similar crisis occurred in the US in 1987, and in India in 2004, the central bank intervened to provide "easy" liquidity. In 2006 India, the banks refused to extend credit to brokers and individuals, as they had been told by the RBI not to exceed their normal lending limit even in their wildest dreams (or nightmares). No authorisation to temporarily exceed their lending limits was given to the banks. Worse, the banks complain that the RBI has yet to send a circular ratifying its own April credit policy (lending for the capital market to be 8 per cent of net asset value or 40 per cent of net worth). So the banks did not lend, because the regulator told them they could not. Everybody was being extra careful, which in a crisis situation can be precariously close to stupid.

Like with all crises, some reform does occur""afterwards. When the RBI does not act, it is up to lesser mortals to stand up and help. So that other regulator Sebi (market-savvy, because it has to be unlike the MoF and the RBI) decreased margin requirements, which helped provide liquidity that helped provide confidence and which was helped by an improving international environment. What if global markets had slipped further? We may never find out; but we did find that only in moments of crisis, the men are separated from the boys.

ssbhalla@gmail.com