Limiting market distortions

The consultation paper floated by the two leading stock exchanges, the BSE and the NSE, has renewed the debate about the heavy tilt in the listed stocks universe towards a few sectors and the inability of the Indian stock exchange to act as a mirror of the economy. While it is not right to expect the Indian equity market to accurately represent economic growth, given the construct of the listed stocks universe, it might be a good idea to impose sectoral caps in the benchmark indices such as the Nifty 50, at sufficiently high levels, to prevent speculative activity from distorting the picture. The discussion papers of the exchanges follow concerns raised of late about the increasing weight of the financial sector in the benchmark indices; banking and financial services accounted for 37 per cent weight in the Nifty 50 towards the end of March 2019. The exchanges are, therefore, seeking public comments about imposing limits on sectoral weights on benchmark indices, the extent of such caps, and so on.

There is little that can be done to make the Indian stock market reflect economic reality as it functions as a free market where only profit-making and professionally-run businesses can attract investors and thus list on the exchanges. In an economy such as ours, where agriculture accounts for around 16 per cent of the economic output and the SME sector for around a third, a large part of the economy is not represented in the stock market. That said, the benchmark indices have an important role to play in capturing the trend in the stock market as a whole and in reflecting investor expectations. The concern regarding the over-representation of the banking sector in the Nifty 50 is therefore not misplaced as this sector could be crowding out other sectors from the index, thus sending wrong signals. The skew is a result of the importance given to trading activity in selecting stocks forming the Nifty 50 index. The largest 50 stocks as measured by free-float market capitalisation, that are most traded and have derivatives attached to them are part of the Nifty 50 index. Excessive trading in any sector can therefore result in more stocks from that sector finding a place in the Nifty 50. That could be the reason why the weight of the banking sector has increased from 22 per cent in 2009 to 37 per cent now. The problems hounding the financial sector in the last few years and the possibility of a solution emerging through recapitalisation or the IBC route have made traders converge towards this segment.

A perusal of the Nifty sector weights since 2009, as put out in the NSE discussion paper, shows that sector weights have seldom crossed 20 per cent in the past. It might therefore be a good idea to impose 30 per cent limit on sector weights in the Nifty 50, to correct anomalies. This limit is high enough not to interfere with the market forces in normal circumstances, but can check misrepresentation caused by speculation.