After the fall

Buoyant economic growth has produced strong stock market returns. As Finance Minister P. Chidambaram has emphasised, all eyes are now on the second quarter results which will soon be out. In recent weeks, SEBI has been attacked on the question of “penny stocks”. They are insignificant on the larger scale of the equity market but a fraud is a fraud, regardless of how small it is, and it is SEBI’s job to prevent fraudsters from profiteering.

At the same time, there is a need to strike a balance between blocking fraud and killing liquidity among small companies. Imposing all manner of restrictions on the trading of small companies — which is easy for SEBI to do — will cut them from equity financing. All small companies will suffer, the ethical ones and the unethical ones. What is needed, and this is the hard part, is for SEBI to discriminate between them and take action against the crooks. Its chairman has struck the right note by emphasising the importance of short selling and derivatives trading. The first and most important check against a manipulator is the rational speculator. If a price goes up “too much”, owing to manipulative behaviour, then speculators smell profit opportunities. Short selling and derivatives trading give these speculators the tools to adopt a position on the market, which will make money when prices go down, and thus act as a check against the manipulator. The best achievement of the equity market is that millions of small speculators are participating in the market, and have ample incentive to perform this role. But India has a history of dubious market mechanisms, such as “badla”, which can create trouble. The market needs therefore well-designed short selling mechanisms for all stocks.

The biggest stocks in the country have enormous liquidity in the market. A manipulator requires vast resources to artificially influence these prices. Manipulative schemes are not the best use of capital for a person who commands such large resources. By enlarging the list of stocks where derivatives trading takes place, by easing restrictions on the derivatives market, and by building a short selling mechanism, SEBI can help higher liquidity coming about in a larger group of stocks. This will spread the benefits of the equity market to more companies, and reduce the dangers of a serious manipulative scandal.