Small Enterprises v Stock Markets
Hot Air Financial Balloons
The size of the balloon is decided by the person or persons filling air in it. If you’ve seen a hot air balloon you know the heated air rises up and fills the balloon in proportion to the increase or decrease of the heat source.
This is not very different from what happens to the stock prices and indices. They bloat and rise or shrink and decline based on the funds being pumped in or withdrawn.
Globalization & Foreign Funds- The Real Hot Air
If you want to put your finger on a particular year and say that was the start of globalization, maybe you should put your finger on 1948 when General Agreement on Tariffs and Trade(GATT) was formed. The General Agreement on Tariffs and Trade was the first worldwide multilateral free trade agreement. It was in effect from June 30,1948 until January 1,1995
The purpose of GATT was to eliminate harmful trade protectionism which had sent global trade down 65% during the Great Depression. By removing tariffs, GATT boosted international trade. It restored economic health to the world after the devastation of World War II.
The World Trade Organization officially commenced on 1 January 1995 under the Marrakesh Agreement, signed by 123 nations on 15 April 1994, replacing the General Agreement on Tariffs and Trade(GATT), which commenced in 1948. The World Trade Organization(WTO) is an intergovernmental organization which regulates international trade.
What GATT & WTO have done is to open the doors of Globalization by facilitating trade and the transfer of money/ financial assets without any hurdle. That is a major source of hot air.
How did we help? ADR & GDR
India, which was one of the most highly controlled economies of the world, was dragged kicking and screaming into the international arena when the country was almost bankrupt. With India’s foreign exchange reserves at $1.2 billion in January 1991 and depleted by half in June, barely enough to last for roughly 3 weeks of essential imports, India was only weeks way from defaulting on its external balance of payment obligations.
Government of India’s immediate response was to secure an emergency loan of $2.2 billion from the International Monetary Fund by pledging 67 tons of India’s gold reserves as collateral security. The Reserve Bank of India had to airlift 47 tons of gold to the Bank of England and 20 tons of gold to the Union Bank of Switzerland to raise $600 million.
India began the process of economic reforms in 1991. Since then, foreign portfolio investors and foreign institutional. Investors started buying the shares of Indian companies. Many developed countries follow loose monetary policy, that is creation of money without collateral security. The Government also allowed Indian companies to sell their shares in global market through American Depository Receipts(ADR) or Global Depository Receipts(GDR).
A Flood of Investment and a lot of hot air
Stocks are broadly classified as large-cap, mid-cap & small-cap referring thereby to the size of the capital. Subsequently, many small-caps became mid-caps and some mid-caps became large caps.
In the initial years foreign investors invested very heavily in blue chip companies, so-called because of their sustained growth in sales and profit through innovative and transparent management. The buying of shares in future blue-chip companies is a race which still continues. Most of the blue-chip shares which were accumulated by foreign investors were the constituents of major tradable indices such as ‘Nifty 50’, Nifty Bank & Nifty IT. All these blue-chip companies have very high, price to earning & price to book value multiples.
Over the years there was a churn and many large cap shares of yester years became mid-caps or even small-caps and were removed from the Index.
Facilitating the hot air through Derivatives?
For any investors it is very important to have smooth exit or escape for very high value financial assets. For this reason, liquidity is poor then a small quantity of sale/ purchase will pull down or pull up the value of the portfolio significantly.
It is to address the problem or risk of poor liquidity that foreign investors have pushed for and got introduced derivatives instruments in the stock market. The derivative segment was introduced in June 2000.
A derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the “underlying”. Derivatives are often used as an instrument to hedge risk for one party of a contract, while offering the potential for high returns for the other party.
In reality the retail derivative traders are facilitators of foreign investor. As per derivatives market rule the institutional investors cannot sell the derivative contract without having the underlying asset . So, the arrangement is that retail derivative traders usually take the long/buying position & obviously foreign investors takers the short position. This enable foreign investor to get rid of large quantity of financial assts. In others words, foreign investors can hedge their underlying asset.
This system provides some relief to foreign investors, but they cannot use it to get rid of their entire portfolio. Therefore, this is not a complete answer to sell the financial assets.
Mutual Funds- Channelizing Savings & Tax Savings
In the last decade the popularity of Mutual Fund Investment has grown by leaps and bounds. The MFs schemes are promoted & marketed in an innovative manner.
Through ‘SIP’ (Systematic Investment Plan) retail investors are buying the units of MFs. But at the same time, it is important to know that the counter part of SIP is SWP (Systematic Withdrawal Plan). The Participants on SWP side are selling their financial assets which are accumulated by them for several years.
In the last three years, Mutual Funds have collected funds in a big way. In the calendar year 2017 MFs scheme have mopped up around Rs. 60,000 Cr. This means the investors who have accumulated the units for some time are exiting from these investment at a very high price.
The collection of MFs schemes was approximately Rs. 1,20,000 crores in last three years.
If the 50% of this collection has moved out of the country then the Banking System has not received the same amount through various deposit scheme. It naturally follows that the banking system cannot lend money at lower interest rates.
Many small enterprises have to borrow the money at higher interest rates to meet their long-term capital requirement & also the working capital requirement.
How does this hit MSMEs?
The greater the flow of funds into the financial markets, the higher the repatriation of such funds, the less the flow of funds, the less the flow of funds into conventional banking channels in terms of fixed deposits etc., the greater the construction of the flow of funds for non-corporate MSMEs which are corporate MSMEs which are the majority of units.
The funds are also made available to them at higher cost.
Higher interest cost is a real threat for any business whose percentage component of ‘borrowed funds’. This situation seriously poses the threat of survival & sustainability of the business
Another serious impact of high dependence on borrowed funds. Our country has completely deregulated the current account convertibility long back. This means many large & medium size businesses are importing raw material, intermediated products at lower price. Burdened by high cost of borrowing many small enterprises finds it difficult to withstand global competition. Long term capital cost being very high it is difficult for small enterprises to expand their production capacity which would have helped them to slash the cost of their products through economies of scale and face the challenge of global competition.
Government seems to have woken up to the problem with the introduction of 10% Long Term Capital Gain Tax. More to the point, the Government has taken the view that the current regime is “inherently biased against manufacturing and encouraged diversion of investment to financial assets.”
That’s a rather neat way of saying that the balloon had to be punctured to remove some of the gas.
This has created a furore in the Stock Market with the Sensex tumbling from above the peak 36000-mark pre-Budget to 34757, a plunge of 1200 point in just 3 sessions post-Budget. Finance Secretary Husmukh Adhia has explained that the LTCG at 10% is a subsidized rate as such gains on sale of unlisted script and immovable property are taxed at 20%.
The Government is on the right back. There is a definite need to restrict to some extent what can be called “paper profits”, now digital profits, so that the bias against manufacturing is righted. This has to be done in tandem with positive steps tales to ensure the free flow of funds to MSMEs for legitimate investment, not only to boost manufacturing but also to expand the job market which is one of the great contribution made by the MSME sector.
Author: Prof. Ajit Karandikar
Prof. Ajit Karandikar is a B.sc with Diploma in Banking & Finance. He is a Professor of Finance and lectures on International Finance, Project Finance, Corporate Finance , Financial Management,
As published by Ministry of MSME, Government of India on 13th February, 2019 on pib.nic.in The Cabinet Committee on Economic Affairs, chaire...
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