Short-selling should be an accepted part of the capital markets, but regulators’ fascination with rising stock markets makes short sellers a much-abused breed.
The long and short, pun intended, of capital markets is that market forces should decide asset prices instead of regulators or politicians interfering and trying to establish a floor to an asset value. The common story across the globe, possibly the only issue where all ideologies, political or economic, and rhetoric, unite is in unanimously endorsing unbridled asset price appreciation, and in going to great lengths to keep prices buoyant. Irrational price appreciation is, however, more often than not, accompanied by severe asset price erosion. Short-selling—the practice of selling securities the seller does not own, in the hope of repurchasing them later at a lower price—is the force that keeps markets in equilibrium and prevents this froth, and also often uncovers fraudulent enterprises, for a rising tide does lift all boats, sometimes even leaky ones! Short sellers, however, continue to face the wrath of regulators and remain at the receiving end of public ire.
The witch-hunt for short sellers is perhaps best illustrated by what happened in Malaysia in the late 1990s. When the Asian currency crisis caused the ringgit to crash, then Malaysian prime minister Mahathir Mohamad, launched a crusade against billionaire hedge fund manager George Soros, even seeing a religious conspiracy behind the crash.
But what was perhaps most irresponsible was Mahathir’s plan to inject $20 billion (Rs85,600 crore currently) in the stock market to “defend his economy”. A sum of $20 billion in those days was Malaysia’s entire fiscal budget and would have almost certainly caused interest rates to rise. The fascination with stock prices was entirely inexplicable at a time when propping up the stock market certainly shouldn’t have been the first priority. Short-selling was banned in Malaysia for nine long years and Mahathir had vowed to publicly cane short sellers!
Mahathir, however, wasn’t the first political figure obsessed with stock prices, and certainly won’t be the last.
Closer home, Pakistan pulled a “Mahathir” earlier this year. In June, Pakistani regulators banned short-selling for a month, restricted stock declines to up to 1% in a trading day and set up a Rs3,000 crore fund to lend support to the stock market. Strangely enough, this initiative came inspite of the fact that Pakistan had been one of the better performing emerging markets until then.
Our very own finance minister P. Chidambaram suddenly found his pro-growth fangs when the Indian stock market began its slide, nudging the Reserve Bank of India to consider cutting rates in line with global central banks. Of course, since then Chidambaram has flipped, flopped, and now, flipped again on the matter of policy interest rates, and in the face of all this, the central bank has remained admirably stoic. We wonder if Chidambaram or the Securities and Exchange Board of India (Sebi) did not see something amiss when India, a traditionally high beta market, remained artificially propped up in November and December because of a ban on foreign institutional investors issuing participatory notes, even as the global equity slide had started. What is it that makes every few percentage points on the market worth the time and attention of Indian politicians and bureaucrats we wonder—concern for corporates raising money it is not, for with pristine balance sheets and depressed stock valuations, equity offerings are likely to be few and far between.
Short-selling is, of course, still a farce in India. Although, on the face of it, institutional investors can finally short after a seven-year-long hiatus, Sebi’s new stock lending system is too impractical for short-selling to truly get off the ground. The market’s slide only means that Sebi’s resolve to endorse short-selling will keep weakening.
As global stock market woes deepen, regulatory interference to stifle short-selling has become the rationale du jour. The US would have got a clean chit, but recently Christopher Cox, chairman of the Securities and Exchange Commission, banned “naked” short-selling on 19 financial stocks. Prior to this, naked short-selling was illegal; now it is really, really illegal! Question for Cox—in all due fairness, if the banks themselves had no clue about the value of their assets and have had to take endless writedowns, then why shouldn’t bank stocks trade at below book value? (When enterprises trade below shareholders’ equity, it implies that they will not earn their cost of capital for the foreseeable future.)
Short-selling also identifies frauds, and, of course, the perpetrators, the company managements in most cases, don’t take kindly to the short sellers either. Richard Grubman, an alleged short seller, asked for the quarter-end balances on Enron Corp.’s enormous trading book during an earnings conference call—a perfectly legitimate question. In response, the now infamous chief executive officer of Enron, Jeffrey Skilling, replied that the balance sheet was not ready. He also followed it up with a crisp “Thank you, assh***”! The rest, as we know, is history.
Well, long story short—markets should be allowed to function freely without excessive interference. Where they do come in handy is in uncovering rumour mongering or insider trading, but restricting trading in any form or moving away from free markets isn’t in anybody’s interest.
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They write every other Thursday. Send your comments to firstname.lastname@example.org
To read Rajeshree Varangaonkar and Bharat Indurkar’s earlier columns, go to www.livemint.com/globalbeat