Not a good idea

It is difficult to understand the rationale for the Securities and Exchange Board of India's desire to set up, or encourage the setting up of, a 'contrarian' fund to counter FII inflows into (though not perhaps outflows out of) the country.

Does the market regulator think that the stock market is overheated, or that valuations are too high? The Hong Kong Monetary Authority, for instance, has conducted such controversial market support operations, but they were done at a time of crisis in the markets.

Every attempt by the government or any other empowered body to interfere in the normal functioning of the stock market only serves to create a false market, and misprices equity, leading (among other things) to the inefficient allocation of capital in the economy. It's possible that in times of severe crisis a case can be made for recourse to such severe remedies as a strictly temporary measure, but where is the crisis today?

It isn't only the Indian markets that have been inundated by foreign fund inflows "" all emerging markets have risen, and the Thai and Chinese H share markets have risen far more than the Indian indices.

Furthermore, is Sebi qualified to take a call on the level of the market that is appropriate? And even if the market regulator believes that it needs to cool the market, surely there are other, better methods of signalling to investors rather than committing public money to setting up a contrarian fund.

All the Sebi chief has to do is drop hints that he is concerned about equities having run up too far too fast. Or Sebi could, for instance, discreetly publicise reports that argue there's too much froth in the Indian stock market.

The danger with setting up a fund that will presumably defend a market level is that it is equivalent to underwriting the potential losses of investors, including FIIs, and will in fact merely facilitate their exit at a better price than they would have got in the normal course.

Sebi's concern appears to be prompted by what it calls a "lack of market counter-balancing". Till recently, however, an element of counter-balancing, albeit a minor one, was being provided by the domestic mutual funds, which were net sellers in the market.

Some financial institutions have also taken the opportunity to cash in. But in a rising market fuelled by liquidity (and this is true not only for the Indian market, but for markets across the world), there are precious few contrarians.

Markets in such circumstances are almost always one-sided, especially when their valuations continue to be relatively low. Nevertheless, there is an element of truth in Sebi's view that there's a need to counter the dependence of the market on FII flows.

The trouble is that there are few domestic long-term investors in the Indian equity markets. Pension funds, for example, are the largest investors in US equities, and pension reform in India and a higher allocation to equities will certainly help correct this problem.

However, we must also put in place adequate safeguards so that the pensioner's money doesn't disappear into vanishing companies. Investing in index funds may be a beginning.

Pension funds and life insurance companies have a long-term view of the market and could help stabilise the market, although, given the US experience during the tech boom, even that is doubtful.

Perhaps Sebi could make it easier to borrow stocks, so that short-selling increases and it is easier to take a contrary view.