If the National Stock Exchange (NSE) triggered reforms in the Indian stock market, the credit should go to Dr R. H. Patil, its first Managing Director. He was responsible for the growth and the development of the NSE, the first Indian online exchange, which not only brought transparency in stock trading but also brought down the cost of trading. Dr Patil was also closely associated with the setting up of other institutions such as NSDL (National Securities Depository Ltd) and CCIL (Clearing Corporation of India Ltd), which he now heads. Dr Patil thinks the Indian market does not need the speculative FII money. In an interview to Business Line, Dr Patil spoke about the rise and fall of the Indian equity market and the role played by FIIs.

Excerpts from the interview:

Do you think our market is over-dependent on FIIs?

I don’t know why we are so dependent on FII money. The real question is: Do we need so much speculative FII money in our stock market? It is basically this money that pushed our market sky high before it collapsed. There was basically no justification for the market to have gone that high. And since the market level was highly unsustainable it did not require much time to collapse.

Do you think it reflects a lack of depth in the market that FIIs took it all the way up and now have taken it all the way down?

I would not buy this logic beyond a point. The basic question that we need to address is: Why do you buy stocks? According to me, investment in equity is made with an expectation of future returns which we believe are generally higher than other modes of investment.

As the profitability of a company increases, shareholders’ returns by way of dividends and the market price also go up. The market price of an equity should have some relationship with the earning capacity of the company. Hence we say that the price-earning ratio should be in a meaningful range if the market price is not manipulated or that shareholders reflect their irrational exuberance.

When the Indian market heated up, P/E ratios for many companies were in excess of 30, and some of them even touched the 40-50 range. This happened because of huge FII capital chasing Indian equities. If we had been more cautious about the entry of FII money, possibly we could have avoided the steep fall of the equity market. There is plenty of Indian money that is attracted to equities. If we do not want investor sentiment to be badly shaken by too steep and sudden fall of the market we should avoid unfettered access to FII money.

Does it not indicate a shallowness in the market without FII investments?

It is a relative question. It all depends on your perception as to what should be the level of the index and the volume of churning in the securities markets. Some amount of speculation, especially calculated and studied speculation, is necessary for any market to attract large number of investors.

But there would certainly be a serious problem when excessive speculation becomes the mainstay of the market. For example, assume that on rational considerations the right price an equity should have been Rs 1,000, but that the market manipulation has pushed up its price in stages to Rs 3,000.

It is but natural that one day the euphoria will fade and the price will slide back to Rs 1,000. You cannot then complain that there is no depth in the domestic market. Many of the discerning domestic investors will exit the stock when it moves towards the unrealistic level of Rs 3,000.

When the market reached its peak and remained around that level, trading was happening mainly among institutional investors, and dominantly the FIIs. At the peak level, most of the retail investors were not in the market at all. The market manipulation was mainly institution driven.

Do you think investment through P-Notes is desirable?

It is one of the worst features of our securities market. While all the authorities say from the rooftop that Know Your Customer (KYC) guidelines are absolutely necessary it is difficult to understand why the pernicious P-notes were permitted in the Indian market.

More than a half of FII investments are through P-notes and we do not have any information as to who these investors are. I fail to understand how the government goes on boldly defending such a non-transparent system. There is a strong lobby of foreign investment bankers behind this. A handful of large foreign investment bankers-cum-brokers have minted hundreds of millions of dollars by running P-note books.

In a way, they are running their own private stock exchanges abroad as these P-notes are actively traded. Regulators who object to unauthorised trading outside the stock exchanges have merrily blessed P-note trading for such a long period of time.

The RBI is certainly not comfortable with P-notes. Recently, the Tarapore Committee on Capital Account Convertibility, of which I was also member, strongly opposed continuation of P-notes, which continue to be the bane of the Indian securities markets.

The Finance Minister himself was worried about FIIs?

However, insofar as P-notes are concerned he has not found anything wrong with them. His concern appears to be more about the exit of FII money from the Indian markets. One interesting reaction among almost all the Indian Finance Ministers is that they get worried when the market goes down and are very happy when it goes up.

In my opinion, the market level most often has very little to do with the state of the economy. In India we have seen market booms in periods when the economy was not doing that well. If excessive amounts flow into the market, it rises beyond rationally justified levels. During the recent past, there was some economic justification as to why the market went up. But that did not justify P/E ratios of 30-50. The market was certainly overheated and, therefore, had to crash.

Do you think we need to introduce delivery-based futures?

I am a strong believer of delivery-based futures, especially the stock futures and stock options. In fact the delivery-based futures were postponed only because we did not have the capability to handle its complications. One of the requirements is an active stock lending/borrowing scheme. Exchanges also need appropriate software and clearing and settlement procedures to handle delivery-based futures. Since we were in a hurry to introduce futures it was decided to go ahead with cash-settled futures.

One of the major drawbacks of the cash settled futures is that the markets can be easily manipulated as there is no obligation to back one’s position with actual delivery of stocks. The Indian markets are particularly subject to excessive manipulation as we have a huge individual stock futures market. In some ways the individual stock futures are riskier than even the much discredited badla system. During the recent past a large number of retail investors have lost huge amounts of money by playing in highly risky stock futures markets. Delivery-based futures should be compulsorily introduced. I do not see any difficulty in introducing such a system.

Has competition between exchanges reached an unhealthy level, with the Bombay Stock Exchange (BSE) crushed to a side?

The BSE has lost its position and continues to do so despite many changes that have taken place in its structure. In my opinion the problem lies with the BSE itself. It has not yet been able to respond to the competitive pressure that the NSE has been putting on it since early 1995. It is yet to completely overhaul its management structure to meet the growing challenges.

Is it because of its diffused nature of holding?

Not only that. The BSE succeeded in eliminating the not-so-healthy influence of the broker community on the management of the exchange. But it should have simultaneously professionalised the management below the board level. The BSE has before it a well functioning model of the NSE which has succeeded well and exists in the same city. I fail to understand why the BSE board cannot infuse some of the best features of the NSE. I feel SEBI should take a proactive interest in the BSE so that it becomes more efficient, providing constructive competition to the NSE.

It is not healthy to have one exchange dominating, don’t you agree?

Absolutely. Without competition no system can function efficiently. The main problem with the BSE prior to setting up of the NSE was that it did not have any competition worth the name. As a result, it became inefficient investor unfriendly. If we are keen to have an efficient and well-functioning securities market, we need to have exchanges that compete with each other vigorously to create social wealth.

SEBI has initiated several measures to develop the corporate bond market. Yet, the market is yet to take off fully. What is your observation?

The main problem is whether we really have a corporate bond market. This is because, almost all the issues are made through the private placement route. Most of the time, the number of investors in each issues is very small. A quick analysis of the last year’s issues (2007-08) indicates investors in most of the issues, both by number and value, were in the range of 2-10. When you have such limited number of investors in each issue you cannot create an active secondary market trading.

Another reason why this market did not develop was that neither SEBI not the Government were interested in the development of this market. Nearly three years have passed after I submitted the report. The Government had announced that they had accepted all the recommendations. But we are still in the process of implementing these recommendations. Unfortunately, the private corporate sector which would be a major beneficiary of an active corporate bond market has also not shown any interest in this subject and put the required pressure on the Government and SEBI for implementation of the recommendations.

Now more corporates may raise funds by issuing bonds rather than through the equity route. Will it help the bond market?

So long as this private placement market continues, it would be difficult to develop an active corporate bond market. There are so many regulatory incentives that are built in favour of the private placement route and as a result issuance of bonds through a more open route is not favoured by the issuers.

Should private placement be banned?

According to me, it need not banned; we can achieve our objective by making it less attractive through suitable regulatory changes. The scales should be tilted heavily in favour of the public issue route and against the private placement mechanism.

Do FMP crises also happen due to lack of depth in the market?

Many FMPs had invested in these bonds which have no secondary market. The Indian mutual fund industry will not grow fast and on healthy lines unless we make a serious attempt to develop an active corporate bond market. Recently I read in the newspapers that that LIC had to bail out the LIC Mutual Fund by buying out debt from it when there was heavy redemption pressure. LIC appears to have done it keeping investor interest in mind.

Should OTC (over the counter) trading be stopped?

OTC trading is difficult to stop. It is not in the interest of anybody to stop OTC trades. All investors, including banks and institutions, need OTC markets in all their bilateral dealings. All the same we should try to encourage trading as well as clearing and settlement through a mechanism similar to that of the stock exchanges. A number of regulatory initiatives are needed in that direction.

Today, the OTC market in equity is not officially banned and yet almost all the equity trading takes place on the stock exchanges. But equity trading on exchanges is attractive both because of the liquidity as also the regulatory incentives, like the more favourable tax treatment in respect of gains arising from exchange trading.

What do you feel should be done to improve the bond market?

We need to understand the basic features of the bond market well. In the second chapter of our committee report, there is a strong message: that bonds are not traded on a typical stock exchange in the same fashion as the equities. Bond markets are essentially institutional in character and require a trading system that need not be an exact copy of the equity market.

Even if we create a system as a part of our stock exchanges we need to design these systems to accommodate the needs of institutional investors. We should not try to put a square peg in a round hole. If tomorrow, we force all currency trading to take place only on the stock exchanges, by banning all inter-bank foreign exchange trading, foreign exchange will suffer. All over the world, trading in bonds and foreign exchange takes place on platforms which do not imitate the features of equity trading on exchanges. This part of the message of our committee report appears to be receiving less attention.