Why Hindenburg report, short-selling are a blessing in disguise

Short-selling is a legitimate trading practice all over the world, including India. But the meltdown in the Adani group’s stocks following the US-based investment research firm Hindenburg’s report (January 24, 2023) has brought it more infamy than appreciation for its role in accelerating price corrections, checking pricing anomalies and facilitating liquidity. The dangers of overvaluations creating bubbles in the stock market is far too well known to the world for nearly a hundred years – from the 1929 Great Depression to the 2007-08 Great Recession – to blindside one to condemn short-selling as either predatory or immoral.

There is no disputing that the Indian stock market is way too overvalued compared to global peers, and for a long time. Overvaluation may reflect excessive exuberance of investors for various reasons but more often than not, it is also a function of weak financial fundamentals, accounting and auditing manipulations and other bad corporate governance practices – which eventually causes the bubbles to burst. This is a live experience.

Here is how overvalued the Indian stock market is.

Overvalued Indian stock market

The Economic Survey of 2022-23 says the Nifty50 with its PE multiple (price to earnings ratio) of 21.8x in 2022 was “expensive” compared to its global peers – the PEs of MSCI World (capturing large and mid caps of 23 developed economies) was 17.3x and MSCI EM (capturing those of 24 emerging economies) 14.6x in the same year. It also shows how overvalued it was in the previous five years between 2017-2021: PE of Nifty50 averaged 27.4x, against MSCI World’s 19.4x and MSCI EM’s 14.6x.

In 2023, the trend endures.

As on January 31, 2023, the PEs of MSCI World and MSCI EM stood at 18.18x and 12.83x, respectively. But the Nifty50’s PE was 20.73x at the time. Even after the Hindenburg report came, the Nifty50’s PE averaged 20.86x at the end of February 2023 – higher, not lower, than it was before January 24, 2023. One may take satisfaction in the fact that the meltdown in Adani group companies didn’t dent the broader market and also that the Nifty50 has substantially corrected itself from a PE multiple of 38x during January-April 2021 and the peak of more than 40x during February-March 2021.

If the Adani group companies are considered (Hindenburg report alleged seven of its 10 companies were overvalued by 85%), there has been a sharp decline. The PE multiple of its flagship Adani Enterprises has fallen from 320.8x on January 24 2023 to 75.7x on February 28 (the Adani Gas’ PE falling the most, from 844x to 140.8x, during the same period). Some experts do see further downside risks in these stocks because of its high debt and liquidity constraints, for example. Just for comparison, the Ambani group’s flagship Reliance Industries’ PE was far low at 25x at the end of February 2023.

If you think the Economic Survey of 2022-23 was worried about overvaluation, banish it. It was actually celebrating with phrases like “India outperformed its peers during FY23 (April-December)” and “Indian Benchmark Indices witnessed swift recovery”. The reference here is to both Nifty50 and S&P BSE Sensex. The report didn’t explain why the overvaluation or what steps should be taken to tame it.

The capital market regulator Stock Exchanges and Securities Board of India (SEBI) is not known to be concerned about overvaluations, not even after the Hindenburg report hit. All it said was that it was looking into the “unusual price movement in the stocks of a business conglomerate”. The RBI, the other key regulator, has kept quiet too even though, many times in the past, its Governor Shaktikanta Das warned against the uncalled-for market buoyancy. During the boom amidst all-round economic ruin in FY21 (GDP growth plunged to -6.6%), he reminded that there was (i) “disconnect” between ‘real’ economy and stock market and that such booms posed “risks to financial stability” and (ii) market was “buoyant” because of “so much liquidity” and the boom was “definitely disconnected with the real economy”. Not just in India, stock markets boomed across the world when millions were losing their lives and livelihoods, sending the world into a tailspin (-3.1% fall in global output).

How is short-selling relevant here?

Short-selling as counter to market manipulation

Short-selling of equity is not very well known in India (except in F&O where hedging is intrinsic). The SEBI allowed institutional investors to short-sell for the first time in 2007 – until then only retail investors were allowed. Even then, the Hindenburg-type episode is a first.

The SEBI defines short-selling as “selling a stock which the seller does not own at the time of trade”. It involves selling a borrowed stock by an investor who expects the price to fall and when that happens, the investor re-purchases the very stock at the lower price to return it to the original owner – the difference is pocketed as profit. But if the price goes up, the investor books a loss.

There is nothing unethical or immoral about short-selling; profit-making underlines investment in the stock market. Not to forget, many capitalist-liberal economists, like Keynes, Stiglitz and Krugman, have likened the stock market to “casino”. Before allowing institutional investors to short-sell, a SEBI discussion paper of 2005 argued why it was needed.

It said: (i) short-selling was allowed “in most countries and in particular, in all developed securities markets” (ii) vibrant market should “necessarily provide” for lending and borrowing of securities, enabling investors to earn returns on “idle securities” (iii) most jurisdictions recognise that it had contributed “significantly to market liquidity” (iv) it provided “safeguards” to “prevent any abusive/manipulative market practices” and (v) there was “no level playing field” between various classes of investors without it.

There have been many misgivings about short-selling, which include its (a) potential to destabilise market (b) exacerbate market falls and (c) lead to manipulative activities etc. Therefore, the SEBI allowed ‘regulated’ short-selling for institutional investors. It put several checks: (i) ban on “naked” short-selling (selling without first obtaining (verifiably) the borrowed stocks leading to delivery failures) (ii) ban on day-trading (squaring-off transactions intra-day) (iii) “framework” regulating lending and borrowing of securities and (iv) deterrents against brokers for failing to deliver securities at the time of settlement. Market volatility is also checked through (v) circuit breakers.

But bans on short-selling are not unknown.

It happened during the 2007-08 stock market meltdown in the US and elsewhere, but not in India as the SEBI and the government stood their ground. The US did it, regretted it and reversed it. The chairman of its regulator Securities and Exchange Commission (SEC) Christopher Cox declared that they “would not do it again” (“the costs appear to outweigh the benefits”) and revealed how corporates pressured him not only to reinstate the ban but shut stock market altogether.

More recently, it happened in 2020 when the pandemic hit. Some European countries and India did so (during March 23 to October 29, 2020) while the market was on the downswing. But soon, stock markets boomed in India and across the world to unprecedented levels (moderation happened in early 2022 because of high inflation, high interest rate and the Russia-Ukraine war).

This time, it provoked immediate and strong reaction from the World Federation of Exchanges (WFE), of which the NSE is also a member.

Banning short-selling hurts market

In a paper circulated in April 2020, the WFE presented the findings of global studies to conclude that a ban actually does the opposite of what is intended. It argued:

· Evidence “almost unanimously” shows that a ban is “disruptive” and hurts market as it “reduces liquidity, increases price inefficiency and hampers price discovery”.

· Bans have “negative spillover effects” on other markets, like option markets.

· During price decline and heightened volatility, short-sellers do not behave differently from any other traders, and contribute less to price declines than regular ‘long’ sellers.

· Bans are “more deleterious” to markets having high presence of small stocks, low levels of fragmentation and fewer alternatives to short-selling.

· Emerging markets should be “particularly wary” of bans on short-selling.

In 2021, a Yale University study said the same: “…research has consistently shown that banning short selling during stretches of particularly volatile equity market activity intensifies the volatility. Such prohibitions impede investors from determining accurate prices of assets and reduce market liquidity. Moreover, short-selling bans in one market can increase volatility in other markets as some investors try to circumvent the ban.”

Why India stands to benefit from Hindenburg-type act

All those arguments are not the only reasons why short-selling should be promoted in India, rather than condemned.

India’s market behavior is one-sided and conducive to over valuations and bubbles: Buy a stock, hold it for long and then sell to make money. Tax policy encourages this too. For years, income from capital gain from stocks was tax-exempt if the stock was sold after 12 months (long-term capital gain) but not if sold before 12 months (short-term capital gain). From FY19, this has changed and long-term capital gains are taxed too but at 10%, against 15% for short-term capital gains.

Price rigging, financial and accounting frauds and bad corporate governance practices (shell companies, tax havens and a maze of subsidiaries to evade tax, round-trip funds, hide related-party transactions, insider-trading, high debt and masking debts by pledging overvalued stocks and violation of 25% public float etc.) don’t get the attention they deserve in spite of the fact that these are illegal and criminal activities.

India has seen a series of big-ticket stock market and corporate frauds in the new millennium – from the Ketan Parekh to Chitra Ramakrishnan episodes; from the Satyam Computers to PNB, PMC, ICICI-Videocon, IL&FS, DHFL, HDIL, ABG Shipyard scams involving corporate and banking frauds and the list of fugitive business tycoons is long: Vijay Mallya, Nirav Modi, Mehul Choksi, Jatin Mehta, Sandesara brothers etc. Barring a few, these events reflect massive systemic failure over a long time.

The current political climate too is against checks and balances or scrutiny and action. Hindenburg sparked a strong backlash: denial and ‘nationalist’ counter-narratives; refusal to allow parliamentary debate (whatever was heard was during the motion of thanks to the President’s address) and parliamentary probe (JPC) and comments from several experts branding its action as “predatory” and inimical to India’s nation-builders.

Short-selling is recognised as an efficient tool for accelerating price corrections, checking pricing anomalies and facilitating liquidity. By exposing the underlying fundamental weaknesses in corporate entities, it also promotes good governance and aid regulatory oversight. It may not be the panacea for all the ails afflicting financial markets but useful nonetheless.

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