Financial Markets in India: A Snapshot

—This article originally appeared in the Aug/Sep 2006 edition of The Reporter, newsletter of the Managed Funds Association.

When I was in India in July 2005, the Sensex had just crossed 7,000 and a local brokerage firm was handing out celebratory chocolates – “Sensex 7000” read the high-relief exclamation. In May, 2006, the index crossed 12,600 and now stands at 10,300. Local investors feel like Derek Jeter does in the playoffs: that monthly returns of 5-10% are their birthright.

There does seem to be a “country myopia” running rampant through India. To be fair, investors in the U.S. lived with the same mania in the late 90s through early 2000. Indian investors cannot export investment funds to other asset classes, so all they know is India. This perspective affects transaction in extra-India investments including foreign exchange. There is a maximum that one can invest outside the country and that is $25,000 per year, per person. At an exchange rate of INR 45 = $U.S. 1, that amounts to Rs 11,25,000 (how they write 1,125,000) or as they say, “11 lacs.” From that perspective, one might conclude that Indians are not a great target market for investments made outside their country, unless they have money outside of India already – and that is not readily available information.

Despite the massive run-up in the market, most investors feel that scrips (what Indians call stocks) will continue to burgeon as will their account balances. The power of the emerging middle class shows no sign of slowing either. Investors can tell you their exact holdings and the prices that they own them and why they bought them. I speak with corporate treasurers and institutional investors. On a few occasions I have asked them “when do you know when to sell?” They either say “Never, because growth will never slow” or “I don’t know, maybe after it doubles.”

At this moment I recall my old professor, the economist Jagdish Bhagwati, telling the story of when his wife Padma Desai, a brilliant economist in her own right, was being interviewed during Naturalization: “Ms. Desai, can you tell us the significance of July 1776?” the interviewer asked. She said, “That’s so easy, it is when Adam Smith wrote Wealth of Nations!” “Uh, we were thinking more along the lines of the signing of the Declaration of Independence?” “Oh, yes of course. How could I have missed that one?”

I asked the investor if he knew what March 10, 2000 stood for or if he’d heard of “Black Monday.” He didn’t know either, but he guessed they were “auspicious dates” since I singled them out. I said “For some.” “I know but one sure tip from a broker. It is your margin call.”(Jesse Livermore, How to Trade in Stocks.)

The Reserve Bank of India (RBI) has been tightening credit at least in part to assuage the disintermediation (hemorrhaging) that has occurred over the last few years. But this has not slowed down the demand to borrow funds for the purpose of investing. There is ample availability of cash. India is lending at margin interest rates between 10.5% and 16%. And the local investors are lined up to borrow. These rates are for what they call “Loans against Scrips.” In other words, these are collateralized loans! Initial margin on scrips is between 10% and 15% of the market value. They must really be bullish: when they can’t borrow versus their scrips, they borrow unsecured amounts at interest rates as high as 24%.

The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) determine which scrips have loan value. Together, they have created a list of about 400 scrips which they call the “A Group” which are marginable. Initial margin for commodity futures is typically 6% of notional value, but can be expanded due to increased volatility. Such is the case with the metals. Initial margin for silver is 12%, for example. It has not slowed down the interest in the metal.

Yet the FMC has tried another method for curbing volatility in commodity futures trading. On May 10, 2006, the FMC instructed the MCX and the NCDEX to reduce the level of the maximum daily price fluctuations across several commodities. These upper and lower circuits, known as limit moves in the U.S., have been reduced from 6% and 3% to 4% and 2%, for the first circuit breaker level and the second level respectively, once trading is resumed from a mandatory 15-minute break.

Meeting the demand for information on investing are two new financial news channels which have launched in the past few months. Joining NDTV and CNBC-18 are “Times Now” (a news channel from Time of India) and “IBN Live” (joint venture between CNN and IBN). The advertising rupees must be there. According to the securities regulator, the Securities Exchange Board of India (SEBI), there are 10 different stock exchanges in India. They are regulated by SEBI as is the trading and listing of scrips. They act much like the SEC here in the U.S.

U.S. investors typically utilize a master/feeder structure for making equity (scrips) investments in India as a foreign institutional investor (FII). The feeder fund may be based in such tax efficient jurisdictions such as Cayman or BVI (as LPs), which in turn would invest in a master fund based in Mauritius (as a company expressed as “Ltd”). The latter would make direct investment into India as an FII. This is true for equity investment only. Non-Indians are currently precluded from trading in local commodities.

Indians, like U.S. investors, are obsessed with gold and crude oil, especially since the financial TV channels have added gold and crude oil prices to the scrolling ticker on the TV screen. They love the “internationally-linked” commodities because they trade seemingly all day. No one had spoken about channa (chick peas) when they traded at historical levels.

To that point, the exchanges have made commodity data more readily available. The Multi Commodity Exchange (MCX) has a day session and a night session so that the contract can trade in parity with other markets such as LME and the COMEX divisionof NYMEX. All trading is done on the screen though, there is no outcry market. But that is only for this exchange.

The MCX currently lists four different gold contracts and the NCDEX lists one. One has ample liquidity and the others act as “spoilers,” like in politics. My guess is that if they did away with the “also rans” you’d get better liquidity in the one.Accordingly, we study volume and open interest daily to look for pockets of liquidity. Getting into a position is easy, getting out is another story.

According to the NCDEX Web site, “the NCDEX is a nationlevel, technology driven de-mutualized on-line commodity exchange with an independent board of directors and professionals not having any vested interest in commodity markets. It is committed to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.” The NCDEX is one of three national multi-commodity exchanges.

Forget going long gamma or vega, you can’t do it yet. Currently there are no puts or calls traded on commodities. Options on futures were on the agenda for the FMC meeting on June 8, 2006, as is a discussion on stock index futures and the participation of mutual funds in commodities. Not much has been released on the discussions. For further updates visit www.myiris.com.

There are, however, derivatives on equity scrips, as well as a phenomenal single stock futures (SSF) market that is very mature and robust. In fact, selling SSF is the only short selling that is allowed right now. Only delivery-based trades are allowed. FIIs that wish to “lend” securities must only do so through an approved intermediary that will do so in accordance with the stock lending scheme of SEBI. (Source: Nishith Desai &Associates)

Commodity trading is dominated by hedgers and small speculators, but the trading is mostly retail, broker-assisted accounts. I would expect the volume of contracts traded and open interest to increase dramatically once the government allows the trading of options on futures and once they allow banks and foreign investment in commodity futures. Commodities are regulated by the Forwards Market Commission (FMC) www.fmc.gov.in/Default1000.html.

India has a whopping 21 regional commodity exchanges and three national multi-commodity exchanges. Perhaps, similar to the U.S. a few decades ago, some of them will either fold or merge with one of their counterparts, especially given that most of the markets are not connected electronically. Out of these the MCX, NCDEX and NMCE are large exchanges and MCX is the biggest among them. (Source: FMC) Many of the exchanges are highly specialized. They only trade one commodity contract. An example of this is the Ahmedabad Commodity Exchange Ltd. which trades solely castor seeds. Castor seeds are ground to create castor seed oil which is used to make everything from plastics, to components for shatter-proof glass to cosmetics and related products.

One can understand how this exchange came into existence in 1952. Although China and Brazil produce castor seeds, a full 40% of the world’s output is created in Gujarat, the state where the exchange in located. This is not unlike how the exchanges in the U.S. came to be. They are centralized meeting places where participants can buy and sell risk and get price discovery.

Training of personnel for futures commodity trading is also on the rise. India has its equivalent to the Series 3, called “NSE Commodity Module.” The NSE stands for “National Stock Exchange.” It was reported in the Business Standard, a Mumbai-based newspaper, the Forward Markets Commission may sign a memorandum of understanding with the U.S. Commodity Futures Trading Commission for information sharing and training programs.