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January 19, 2000


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Devangshu Datta

Moral of the story

The concept of "moral hazard" is often invoked whenever the question of an economic bailout arises. The idea: If some risky economic activity is performed under the tacit assumption of an available safety net, then the people doing it are less likely to act with care. Moral hazard has been cited whenever the IMF bailed busted countries. It is often cited when weak banks are recapitalised or when UTI is in difficulties.

Well, I'd like to discuss "moral influence" rather than moral hazard. To coin a term, this is the multiplier effect that arises when a small incentive/disincentive is given to a system at a critical moment. Let's look at some typical instances in the Indian capital markets.

Ever since foreign institutional investors appeared on the scene, they have been the most crucial players in the Indian stock markets. It is largely due to their moral influence that balance-sheet transparency and clean trading systems have become the norm rather than the exception in the Indian environment. For example, "jumbo" transfer forms were created to handle the volumes in which FIIs normally took delivery. Then demat was instituted, thanks to FII lobbying. Both these reforms generally benefited all Indian investors who were, of course, well aware of the problems with the old systems. Yet it took foreigners and the lure of dollars to successfully change the system.

In the larger context, controls on the current account were also eased to induce FIIs to bring in money and to give them an exit route in times of need. This too has benefited many Indian importers/exporters who can manage their forex exposures with a greater degree of freedom. Also, the propensity of the FII for insisting on clean balance sheets and financial transparency has gradually wrought a change in attitudes. Company after company has been seduced by the possibility of increasing market value and consequently cleaned up its accounts and revamped its management style.

A look at FII inflows and outflows marked versus market index movements also shows clearly that their actions hugely influence market direction. Yet the actual impact ought to be much smaller. Last year, for instance, FIIs were net investors to the tune of Rs 6,300 crore. That seems like a large sum of money, but it is just about one day's trading volume in the Indian secondary market. Even if we allow for the fact that FIIs take delivery and most Indian operators don't, the actual impact should still be relatively insignificant. Can roughly 0.5 to 1 per cent of the total money annually circulating in the market influence prices to such a degree?

Obviously, it can. Enter the invisible hand of moral influence to paraphrase Adam Smith. Not only do FIIs make their own investments, every other big player in the Indian market tracks their moves and tries to second-guess them. This has the effect of strengthening whatever trends arise and perpetuating them for longer periods.

Another example of moral influence was the case of Ketan Parekh last week. Here was a big operator, perhaps the single largest operator in the market, being surveyed by the Income Tax officials. The market went into a tailspin-- down 292 points-- before it saw a recovery. It's true that it was settlement day on the NSE, which means that volatility would have been higher in any case;but the primary cause of panic was the survey on the "One-man Army's" assets.

Most estimates of Parekh's positions ranged upto an upper limit of around Rs 1,500 crore. Parekh usually takes delivery. Only a small fraction of his total commitments would have occurred during the specified settlement. So, the amount at risk would have been far lower.

Assuming the IT department had frozen his assets, Parekh would not have been capable of taking or giving delivery on commitments during that settlement. It would have been prudent for those who had dealings with him to reduce their other commitments to prevent the cascading default. But the news should not have sparked panic. Rs 1,500 crore, or a fraction of it, isn't that much money for an entire market to freeze.

But for the last year, everybody has been piggybacking KP's positions. Hence even a relatively small default would cause a cascade. Incidentally, I wonder whether Sebi and the exchanges have any systems in place to deal with default caused by IT investigations? A normal auction would be impossible in such cases since assets are usually frozen.

Let's come to another situation where I suspect moral influence plays a big role. The interest rate cut on Public Provident Funds by one per cent will save perhaps Rs 1,000 crore in government outflows and hence marginally reduce the fiscal deficit. However, the consequences are far larger than a linear analysis suggests.

First of all, this is a politically brave decision. It will alienate the middle class, which is a major BJP vote bank. Who knows, it may spur the government to take even braver decisions in the Budget like cutting the kerosene or LPG subsidy? That would save far more. Given the current situation of political stability, the BJP can reasonably expect to stick around long enough to ride out the inevitable backlash if it slashes subsidies.

The second thing is that a rate cut on PPF will spark further cuts. ICICI has already started the ball rolling. It's high time really given a wholesale price index rise of 3 per cent and a November consumer price index of 5 per cent. How high can you set real interest rates if you wish to fuel an economic recovery? Rate cuts may in fact already have been delayed beyond the point of maximum impact. If inflation creeps up, as it shows some signs of doing, real spreads could shrink further. Since Indian banks and institutions aren't lean, mean machines, they find it hard to live on thin spreads.

The third thing is that, the cut will change investment patterns in the middle-class. A lot of conservative people may crib. But willy-nilly "riskier investments" will become higher priority. Especially, since the market boom has hit a point where retail investors are already salivating all over trading screens. A one per cent rate cut may re-direct massive funding into the mutual fund industry. That is the natural place for the classic PPF investor to gravitate. Over the next year, I wonder how much of a moral influence a one per cent cut will have?

Devangshu Datta

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