On markets and scams -D. MURALI

India's political and social structures have preserved entrepreneurs, if not exactly cut them loose, observes Raghav Bahl in Superpower? ( www.penguinbooksindia.com). Even as the state invested in big-ticket capital assets in the early decades after Independence, land continued to stay in private hands, he reasons in the chapter titled 'Entrepreneurs, consumers and English speakers'.

"India's sprawling rural economy has always been entirely 'capitalist' in its orientation. Even the urban economy allowed private enterprise to grow under a somewhat draconian regime of licences and approvals… The Bombay Stock Exchange (BSE) is among the oldest in Asia. Capital and credit have always been available, albeit for a 'price,' for private enterprise."

Harshad Mehta episode

Of interest to finance professionals is a section in the chapter, captioned 'the story of two stock markets,' opening with how Harshad Mehta, who, in his late thirties, 'pulled off a stock market scam in India which would have put Bernie Madoff to shame.' The year was 1992 and there was much excitement around a freshly minted, rapidly privatising economy, the author narrates.

"It was easy to spin get-rich-quick stories in an unregulated casino. For a man who had barely scraped through his accounting studies at college, Harshad Mehta was a deadly combination — a legendary crook and a master storyteller. He siphoned off a billion dollars from several Indian banks to rig the stock prices of ninety blue chips."

As some of you may recall, 'stocks doubled, trebled, quadrupled, and Mehta became the cult deity of wealth.' But his house of cards collapsed when the bubble burst. "He died in custody on the last day of 2001 as India's biggest defaulter, owing nearly $170 million to several banks. He also left behind an unsolved mystery of 2.7 million missing shares and seventy-two cases of conspiracy, cheating, and fraud."

Shock therapy

Looking back, Bahl says that the Mehta scam was a shock therapy for India's stock markets. Although over a century old, the BSE — set up under a banyan tree in 1875 — was little more than a privileged brokers' club in the early 1990s, he reminisces.

"It traded for barely a couple of hours every day on the outcry method. Shares were held in physical form, and trades were squared off once in fifteen days. Upcountry brokers were forced to transact on a rickety phone network. Companies could cancel share transfers on the flimsiest of excuses, like signatures not matching or papers lost in transit." As a result, the system was prone to delay, abuse, price fixing, insider trading and frequent breakdowns, informs the author.

Jolted by the scam, the government set up a tough securities regulator, but wealthy brokers continued to defy it, one learns. The breakthrough came in the form of NSE (National Stock Exchange), a digitally savvy exchange with equity put up by government financial institutions. The 'game changer,' which began trading in 1994, allowed the same equity instrument to be traded on both exchanges in the same city and across similar trading hours, and banked on dematerialised shares and electronic depositories.

"Over ten thousand terminals in over 400 cities gave instant trading access to members. In eleven months flat, the new exchange logged up higher trading volumes than its 120-year-old competitor. The transaction settlement period dropped from fifteen to two days. To survive, BSE had to set up its own electronic system." Bahl is proud that today the Indian stock market is among the largest in the world, next only to NYSE in terms of the number of shares listed, deals transacted and the size of retail investor participation.

Stock exchanges in China

What has been the story in China, where stock exchanges took birth around the same time that we were reinventing ours? The aim of the Shanghai Stock Exchange (SHSE) set up in December 1990, and the Shenzen Stock Exchange (SZSE), set up in April 1991, was to sell shares of State Owned Enterprises (SOEs), but 'an inexperienced China opted for a very complex system,' recounts the author.

Sample this, from his description: The same company could not list on both exchanges — it had to choose one. Five different types of shares could be issued: A-shares (sold in local Chinese currency to local individuals); B-shares (sold in either US or Hong Kong dollars to foreign investors); C-shares (issued to Chinese state institutions or departments, but tradable only 'over the counter' in institution-to-institution sales, rather than on the main exchanges); H-shares (equity issued by mainland companies on the Hong Kong stock exchange); N-shares (issued on the NYSE); and 'a sixth — and the strangest — category was 'non-tradable' shares held by the government or its agencies.'

Silos in markets

So, the majority of shares in early listed companies were not floated, with only the shares sold to the general public being tradable, and thus making for very thin volumes and huge price volatility, explains Bahl. Since China wanted to keep a tight control on its currency and foreign capital flows, it was forced to create these silos to isolate each currency, geography and class of investor, he notes.

"The early years were wracked by a dizzy gyration in stock prices… Contributing to the messy situation was a 'quota system' for selecting SOEs to float their shares; each province was given a fixed quota of companies they could bring to the market." What suffered was the quality of paper floated as an effect of 'the shadow of politics' or 'the unseen hand of political patronage,' which explains the non-failure of any initial float, and non-delisting of any publicly listed company.

'Grey' transactions

Such a fragmented structure created frictions at each margin, besides creating a playground for 'grey' transactions that illegally moved capital across prohibited boundaries to profit from price differences, finds Bahl. "A company with A, B and H shares today has three wholly different valuations; often, A-shares have traded at three times the value of B-shares or H-shares, puzzling investors."

He points out that while common sense dictates that B-shares should command a premium, as foreign investors have superior access to information and analytical skills, that is not the case, perhaps due to 'a speculative frenzy in China's domestic stock market that has taken A-shares to 'bubble' levels.'

The book cites Morgan Stanley's statistics that a third of reported corporate earnings in China in 2007 came from speculative gains in stock markets.

"For instance, the apparel company Youngor had earned nearly 99 per cent of its profits from subscribing to shares of China Life, Bank of Ningbo and Citic Securities. Although some norms have been tightened, banks in China have lent freely at very low rates to help companies build up their investment portfolios."

Five more crises

To those who dismiss the Indian bourses as unhealthy, post Harshad Mehta's scam in the early 1990s, it may come as a surprise that Indian markets have weathered five crises since then, as Bahl chronicles.

In 1995, the BSE was closed for three days after payment problems on a company which had crashed, he begins. "In 1997, a mutual fund closed shop after defrauding investors; in 1998, the president of the BSE was sacked for allowing prices of three companies to be manipulated; in 2001, another price-rigging scandal by another ambitious broker was busted; and finally, in 2005, thousands of fake accounts were unearthed, that were getting illegal allotments of newly floated shares under the quota reserved for individual investors." Stating that wherever there is a stock market, there will be a scam, Bahl avers that since 2005 no major scandal has erupted in India's stock markets.

What is the scene in China? It is still in the throes of a learning curve, grappling with frequent scams in its still maturing stock markets, he feels. An example cited in the book the November 2009 arrest of 39-year-old Huang Guangyu, the chairman of Gome Electrical Appliances, the country's biggest electronics retailer.

"Forbes had listed Huang as China's second wealthiest individual, estimating his worth at $2.7 billion. Caijing reported that Huang was detained for an alleged stock manipulation case involving a company controlled by his elder brother. He was eventually fined $120 million and handed a fourteen-year jail term…"

Engaging comparison of two countries, in crisply-written chapters.