Financial Repression in China and India

Raghuram Rajan, Economic Counselor and Director of Research, International Monetary Fund says that “uniquely among fast-growing Asian economies, China has not raised its share of value added coming from high-skilled industries significantly, even as its per capita GDP has grown” and that the inadequacies of the Chinese financial system are to blame for this:

It is unlikely the chairman of a state owned corporation, cash rich because he no longer has to meet his social obligations to workers, will prefer to return cash to the state via dividends rather than retaining it in the firm, particularly when banks are under orders to restrain credit growth. And with financial investments returning so little, far better to reinvest cashflows in real assets. Indeed, liquidity plays a greater role than profits in determining real investments.

Similarly, the chairman of a private firm knows that financing from either the stock market or the state-owned banks is very uncertain. So he too will be unlikely to pay dividends, preferring instead to retain the capital for investment. Again, instead of storing this as financial assets and awaiting the right real investment opportunity, given the poor returns on financial assets, he has an incentive to invest right away.

These tendencies imply a lot of reinvestment in existing industries especially if cashflow in the industry is high, which inexorably drives down their profitability. And they imply relatively little investment in new industries. The inadequacies of the financial system would thus explain both the high correlation between savings and investment and the oft-heard claim that over 75 percent of China's industries are plagued by overcapacity. They also suggest why uniquely among fast-growing Asian economies, China has not raised its share of value added coming from high-skilled industries significantly, even as its per capita GDP has grown.

This is an interesting argument against financial repression. It is useful to remind ourselves once in a while that the occasional stock market scandal that we have seen in India since the beginning of economic reforms is a small price to pay for getting rid of financial repression. It is also necessary to recall that as a percentage of GPD, the annual losses to Indian households from financial repression were higher than the amount involved in even the biggest of the stock market frauds since 1991. For example, during 1980-81 to 1989-90, time deposits at commercial banks averaged over 25% of GDP. I have estimated that financial repression in the 1980s was about three percentage points. This implies that holders of time deposits at banks lost 0.75% of GDP annually. If we add the losses on other repressed financial assets (especially life insurance and provident funds), the total would certainly exceed 1% of GDP annually. By comparison, the total amount of fraud in the scam of 1991-92 (involving Harshad Mehta and others) was about 0.75% of GDP. The total amount of fraud in the scam of 2000-01 (involving Ketan Parekh) was less than 0.2% of GDP.

Posted at 2:26 pm IST on Mon, 16 Jan 2006         permanent link

Categories: corporate governance, equity markets

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Some interesting titbits

The new year has brought with it a number of interesting titbits related to financial markets

• Andrew Ross Sorkin (“To Battle, Armed With Shares”, New York Times, January 4, 2006) reports on the emergence of hedge funds as activist investors. I have long been convinced of the Michael Jensen thesis that the US got its takeover regulations badly wrong in the 1980s. In my posting early last year, I argued that the US still has to get its regulations right in this area. The emergence of hedge funds as major players in the market for corporate control may force me to change my view on this. Sorkin also states that large once-conservative mutual funds are now prepared to side with hedge funds and against incumbent managements. This has the potential to change corporate governance in a fundamental way.
• The Financial Times reports (“Korea becomes king of derivatives hill”, Anna Fifield, January 4, 2006) that Korea has overtaken the United States to become the largest equity derivative market in the world.
• Floyd Norris reports (“In 2005, Companies Set a Record for Sharing With Shareholders”, New York Times, January 7, 2006) that the amount that the companies in the S&P 500 returned to shareholders in the form of dividends and buyback in 2005 represented 4.6% of the market capitalization of the index at the end of the year. This was the same percentage as in 2004. The figures show that buybacks were about one and half times the dividends. Norris also points out that “the big surge in such buybacks came only after one major advantage of buybacks - in the tax code - was removed. Now the United States taxes both dividends and capital gains at a 15 percent rate.” This presents a challenge to corporate finance theory unless as Norris speculates “Or perhaps all those buybacks are simply an indication that corporate America has good profits now, but a dearth of attractive investment opportunities for all that cash.”
• Andrew Ross Sorkin (“Sometimes, Two Is Less Than One”, New York Times, January 8, 2006) quotes a Goldman Sachs study that looked at 10 big companies that split up between 1994 and 1999, and found that the average company's shares fell 6 percent between the announcement and the actual split. One reason offerd for this phenomenon is that big-cap investors no longer want to own a collection of small-cap or midcap companies. The other possible reason is that investors interested in one unit are unlikely to be interested in the other. Sorkin suggests that these are short term phenomena and that the jury is still out on whether split-ups add value in the longer term.

Posted at 1:16 pm IST on Mon, 9 Jan 2006         permanent link

Categories: miscellaneous

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Trading Error at BSE, India

Another new listing, another country, another trading error and a strange resolution. It is much smaller than the Mizuho trade that I have blogged about here and here. But its resolution is utterly strange.

On listing day a trader placed a sell order for about 400,000 shares of Tulip IT Services Limited at a price of Rs 0.25 at the BSE in Mumbai when the market price was around Rs 170. Since circuit filters do not apply on listing day in BSE, the trade executed causing a modest loss of about US $ 2.6 million.

What is interesting is the way that the exchange has resolved the issue. It says that:

1. The buy orders at a price higher than Rs.96/- and matched against the said order, shall be deemed to have been transacted at such prices at which the trades were executed. The cut-off price of Rs.96/- has been arrived at by applying circuit filter limit of 20% on the issue price of Rs.120/- on the lower side on the lines of the existing practice of application of standard Circuit Filter of 20% in the regular market.
2. All other existing orders below Rs.96/- and which got executed against the said sale order will be deemed to have been transacted at a price of Rs.171.15. The said price of Rs.171.15 has been arrived at by taking the weighted average price of the trades executed at or above Rs.96/- against the said sale order.
3. All other orders placed subsequent to said sale order and which were matched against the said sell order will be deemed to have been transacted at a price of Rs.171.15.

In response my first Mizuho blog, Piyush Mishra commented that an erroneous trade is due to “the lack of oversight on the part of the broker/dealer” I agreed with that and wrote that “By nullifying erroneous trades, exchanges may actually be reducing the incentives for traders to install and use such software checks.”

I have therefore little sympathy for the BSE bailing out the offending trader by changing the traded price at all. But putting that objection aside for the moment, the solution adopted is still perverse. A trader who bought at Rs 97 pays Rs 97 while another who bought at Rs 95, is asked to pay Rs 171.15. That two traders in very similar situations are treated so differently is manifestly absurd and unfair. That the person who bid a lower price pays higher makes the solution even more ridiculous.

I recall a similar situation in the US in 2001. A hedge fund offered to buy Axcelsis Technolgies at $95 instead of $9.50 on the Nasdaq. Nasdaq cancelled all trades at prices below an arbitrary threshold of $22 and let the other trades stand. Floyd Norris wrote (“At the Nasdaq Casino, the Winners Get Stiffed”, New York Times March 2, 2001) about a day trader who sold into the erroneous trade and then covered his short position at a profit of $145,908. When the Nasdaq cancelled the trades selectively, this trader found that his share sales had been cancelled while his purchases stood producing a loss of $130,065 instead of the profit of $145,908. That the offending hedge fund was bailed out while an innocent day trader was penalized was clearly absurd. In a scathing comment, Floyd Norris wrote ”Nasdaq looks a lot like a casino that values a customer's business only until he starts winning.”

Clearly exchanges can not be trusted with the discretion that is vested in them. The rule should be very simple. Traders should bear the responsibility (and the losses) of their erroneous trades.

Posted at 5:17 pm IST on Sat, 7 Jan 2006         permanent link

Categories: exchanges, failure, regulation, technology

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Tokyo Stock Exchange Trading System: Why Not Open Source?

The Financial Times reports that “The Tokyo Stock Exchange is considering replacing its trading system, even though it is merely a year old, following computer problems that have shattered the exchange's reputation and damaged Tokyo's status as a financial centre.”

Clearly the Mizuho trading error that I blogged about last month has been the main driving force behind this move. I would argue that open source is the better way to go if the goal is to make the trading system more robust.

I have been reading the official explanation that the Tokyo Stock Exchange (TSE) put out on the Mizuho incident. As I understand it the sequence of events was as follows.

• At the beginning of the first day of listing of J-COM (December 8, 2005), a special bid quote of 672,000 yen was being displayed in order to determine the initial listing price. Special quotes are used at the TSE during the call auction (Itayose method) that is used to determine the initial listing price of stocks that have never been traded before at the TSE or at any other exchange. The Guide to TSE Trading Methodologygives the details of this process.
• At 9:27 am while this special quote was being displayed, Mizuho mistakenly placed a sell order for 610,000 shares of J-COM at 1 yen, instead of the intended 1 share at 610,000 yen.
• The Mizuho order allowed the conditions for execution of the special bid quote to be fulfilled and the trade was completed. The call auction (Itayose method) requires that all market orders as well as all orders on one of the two sides of the order book should be executed and that the volume executed should be a minimum of 1000 trading units. The Mizuho order was large enough to meet all these conditions.
• This trade established the inital listing price of 672,000 yen as also the lower price limit for the day of 572,000 yen. The Tokyo Stock Exchange has computed that in the absence of the Mizuho order, a price of 912,000 yen per share would have prevailed.
• The remaining part of the Mizuho order was now deemed to be an order at the lower limit price of 572,000 yen (“deemed processing”) and started executing against various buy orders.
• “Meanwhile, Mizuho Sec. made several attempts to cancel the order, but as these cancel orders were made while executions were being processed, an irregularity occurred in which the target order was not canceled. This is an irregularity that arises when deemed processing is applied to an order, and a corresponding opposing order exists.”

Summing up the nature of the problem, the Tokyo Stock Exchange states:

“This is an incident that occurs when an issue is newly listed on the TSE directly and, as in this case, while a special bid quote is displayed, such a large amount of orders is placed that the net amount exceeds the number of the special quote order, and many sell orders still remain after the initial price is determined, to which deemed processing is then applied and then orders are placed at that price. As such, we are committed to strengthening supervision of newly listed issues in the near future and conduct extensive, detailed investigations of our system while considering the possibility of this and all other cases in the future, in ensuring irregularities such as this do not occur again. Also, the TSE will conduct a prompt, thorough analysis of the details of the cause of this recent irregularity in cooperation with the trading system developer, Fujitsu, Ltd.”

It appears that the irregularity that was observed would have occured only under very special circumstances that may never be repeated in future. It is also evident that in a complex trading system, the number of eventualities to be considered while testing the trading software is quite large. It is very likely that even a reasonable testing effort might not detect all bugs in the system.

Given the large externalities involved in bugs in such core systems, a better approach is needed. The open source model provides such an alternative. By exposing the source code to a large number of people, the chances of discovering any bugs increase significantly. Since there are many software developers building software that interacts with the exchange software, there would be a large developer community with the skill, incentive and knowledge required to analyse the trading software and verify its integrity. In my view, regulators and self regulatory organizations have not yet understood the full power of the open source methodology in furthering the key regulatory goals of market integrity.

Also, there is a case for simplifying the trading system. The trading system at TSE is unnecessarily complex because of the existence of price limits and the complex combination of call auction (Itayose method) and continuous auction (Zaraba method). TSE needs to question the very need for special quotes.

Posted at 2:37 pm IST on Wed, 4 Jan 2006         permanent link

Categories: exchanges, technology

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