Need to Enhance Liquidity and Funnel Savings into Equity

Many a time, our policy makers confuse speculation with manipulation. They put too many restrictions that curb even healthy speculation. I have heard even comments like we should encourage genuine investors but not speculators.

In FII-led euphoria, we should not forget the importance of domestic money for equities through individuals, mutual funds, insurance companies etc.

According to RBI data, flow of domestic savings into equity dwindled from 7.4% of GDP in 2007-08 to as low as 0.5% in 2013-14. Let us look at some more data points in the five years from March 2009 to March 2014. Shareholding of FIIs in Indian-listed companies has increased from 13.8% to 22.4% whereas domestic equity mutual fund has witnessed a net outflow of $6 billion. FII investment in Indian equity has averaged less than $20 billion per annum. Compare this with domestic savings averaging $373 billion, including financials savings of $144 billion. Its obvious that domestic pool of savings is large enough to easily counterbalance the FII volatility.

Yet, our market is over-dependent on FII money. If FIIs flee for reasons purely external such as global liquidity squeeze, unviability of carry trades, crisis in their home countries, the impact will be disastrous on Indian markets. For a typical global fund, India is a small investment and can be dumped in crisis. It would cause havoc here by way of sudden losses immediately, but worse, loss of investor confidence for several years, thereby making it difficult for entrepreneurs to tap equity markets, slowing investment, employment and so on.

Nobody would disagree that we need growth and for growth, we need investment. And also that for investment, the foundation has to be of equity capital which can be leveraged by loans from banks and other sources. In contrast to FIIs penchant for large caps, domestic investors tend to invest more in small and mid-cap stocks. For inclusive growth, small and medium enterprises need impetus. To attract domestic investors, tax sops have little utility.

What they need is a liquid vibrant market, where an investor can enter and exit easily. Unlike investment in real estate or other assets classes such as gold, ownership and management are separated in equities. Therefore, liquidity is the most fundamental requirement for equity markets.

Many a time, our policy makers confuse speculation with manipulation.

They put too many restrictions that curb even healthy speculation. I have heard even comments like we should encourage genuine investors but not speculators. Genuine investors i.e. two sets of people who simultaneously get fundamentally bearish and bullish from a long-term perspective will be few and far between. Even in a stock like Reliance, they will meet once in a few months.

They will also not transact if the markets are not liquid. Without speculative trading, genuine investors will also not come to equities. Also, many a time, speculators moderate the event risk by building up positions in anticipation of events. For instance, this set of speculators starts expecting very good or very bad results, and the real impact of announcement of results will not be a spike or a crash but relatively moderate.

Our government and regulators can do the following to improve liquidity and encourage domestic investors to go for equities:

a) Remove STT and CTT completely: For any liquid market at any given point in time, spread between buy and sell price should be as narrow as possible. The incidence of STT and CTT increases this spread artificially, impacting liquidity, and therefore, attractiveness for genuine investors as well. STT contributes a minuscule amount to exchequer of less than $1 billion. The market will not mind even some increase in capital gains tax in lieu of removal of STT and CTT.

b) Encourage financing of equity investment: Sebi should simplify margin funding norms. The current reporting norms are too cumbersome to make the scheme popular. RBI should enhance banks limits for funding retail equity investors. There can be safeguards in terms of eligibility of scrips for funding and margin ratio.

c) Enhance EPFO and retirement funds limits for equity investment from the current 15% to 30%: Over long term, its well established that growth markets like India will offer equity investors much higher returns than fixed-income investors.

But there is risk in stock selection as well as timing of investment. Our regulators and market participants have done a great job of enhancing investor education and the effort continues.

Now, they should address the key issue hindering flow of domestic money into equities market. This will help domestic investors participate in wealth creation that equities typically allow when economic growth accelerates.