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Thursday, Nov 25, 2004

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Leave it to the market

IT IS JUST as well that the Government has rejected the proposal of a section of stock brokers for setting up an official fund for stabilisation of the market. The proposal is bereft of any conceptual merit and operationally infeasible. The fundamental difficulty is in deciding what constitutes fair value for the market as a whole which when breached could warrant state intervention via the market stabilisation fund. This presupposes that the price just ahead of the intervention is the correct value. But this is without any real basis. After all, if the market is regarded as capable of erroneous pricing or suspected of manipulation then it might well be the case around the date of setting up the fund and the subsequent decline is nothing more than market correction. The fact is volatility in asset prices is inherent to all markets and is due to the conflicting perceptions among the players about future cash flows. As fresh evidence surfaces, perceptions get altered and the market moves on to operate at a new level of reality. To intervene in the belief that stability is the natural order of things is at variance with the true character of markets and is bound to fail.

This is not to suggest that markets are not gripped by speculative excesses but that, more often than not, such events are caused by some flaw in the policy framework as happened at the time of the Harshad Mehta scam; it was triggered primarily by the procedural weaknesses in the accounting for Gilt-edged securities transactions. A regulatory mechanism that can detect such flaws and initiate remedial action promptly is a better bet than actual intervention. Anyway, there is no guarantee that such an intervention will help restore equity values to their earlier levels. For instance, the massive intervention by the Hong Kong administration in August 1997 may have temporarily stabilised the local market but could hardly be described as a success considering that five years down, when it withdrew from the market, the equity values were still 40 per cent lower than that prevailed in July 1997. In fact, there were complaints that the frequent bouts of selling by the monetary authority kept the market sluggish.

But conceptual difficulty apart, the stabilisation fund proposal also bristles with operational difficulties. It needs independent fund managers to manage the portfolio. Insulating the process of selection from political interference and securing autonomous functioning are by no means easy. The travails that the Unit Trust of India went through as a public financial institution actively playing the market is too fresh in the public mind to believe that the Government's management will be any different now. Perhaps the present Government was affected by the stock market's initial pessimism about its ability to manage the economy that it even entertained such a suggestion in the first place. But, then, with the market now hitting levels not seen since the days of `India Shining' campaign, the Government needs no further reassurance that it is better off leaving the market to find its own level.

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