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G. Ramachandran

WHATEVER may be said of India's effectiveness in dealing with public finances, it can be safely argued that individuals act with great discernment while dealing with their personal savings. Many state-owned and publicly-owned banks routinely invest a very large part of their customers' deposits in securities issued by the Government of India.

Banks know how some companies treat other people's money. Market participants too know how these companies treat other people's money. So, most households prefer to invest a significant part of their savings in gold. Quite clearly, stocks are inferior to gold, bank deposits and government securities.

That is a body blow against capital flows into India Inc. Gold, bank deposits, government securities and India's stock futures were discussed by the author recently at a conclave of financial economists and regulators. The phenomenal success of equity derivatives — stock futures, in particular — was presented and discussed as the victory of rational market participants in their battle against agency costs in India Inc.

The `going à la carte' by market participants was presented and discussed as the vital capability of market participants to appreciate the information dynamics pertinent to corporate performance, earnings and cash flows.

Also, the fact that stock derivatives account for more than 80 per cent of equity derivatives activity was presented as an extraordinarily vital capability of market participants. This capability pertains to the assessment of the `absolute price of risk', the `relative price of risk vis-à-vis the broad market' and the payoffs from bearing absolute and relative risk.

Information dynamics and risk dynamics are the two principal dimensions of modern capitalism. India's market participants continue to demonstrate a keen understanding of the two. Only a few other countries possess such magical powers to work information and risk to their advantage.

To save capitalism from pretentious capitalists, and to help capitalism and financial markets get the best out of other people's money and the skills of corporate managers, SEBI could put to use these magical powers. It could allow the listing of stock futures and stock options on all listed stocks! The sophisticated criteria that are currently used to select stocks for futures and options trading will not save India's famed capitalism from its pretentious capitalists.

If stock derivatives are thought to have a favourable impact on agency costs, cost of capital and capital flows, such benefits should be made available to all companies.

If stock derivatives do not produce such a favourable effect, all stock derivatives should be made illegal and withdrawn.

The logic is clear. Listed stocks deliver their best in terms of information dynamics and risk dynamics, but are beset by probable failures of corporate diligence, ethics and controls.

Hence, there is little liquidity in stocks that are prone to these failures. Information dynamics and risk dynamics then break down.

There are numerous stocks in the Indian stock market where both information dynamics and risk dynamics have broken down.

It is not surprising that some companies have chosen to get their stocks off the exchanges' list. Therefore, the pricing of new offerings has become terribly messy.

Stock derivatives deliver their best in terms of information dynamics and risk dynamics, but are not beset by probable failures of corporate diligence, ethics and controls. Hence, they can remain liquid. Once stock derivatives gain some minimum liquidity, the costs of probable failures of corporate diligence, ethics and controls can be estimated.

Information dynamics and risk dynamics will then not break down. And the pricing of seasoned and new offerings will be easier. Financial markets will then save India's famed capitalism from its pretentious capitalists, and promote the 'my money, my play' ethos. 'My money, my play' is India's run of play.

Agency costs: Financial economics has emerged as an interesting branch of orthodox economics in the last 35 years. It has examined the circumstances that describe investments by households, stock and capital markets, capital flows, corporate finance, and managerial decisions by managers of companies.

It has been very successful in modelling risk preferences and risk perceptions, life cycle needs, and the goal-driven actions of households, investors, speculators, intermediaries and regulators in the short run and over the long term.

Financial economists have honed their skills year after year and have contributed to the emergence of this branch of economics as a reliable guide that explains empirically observable phenomena. There is little that is normative in financial economics. It merely describes empirical phenomena as verifiable results of hypothesised models.

In particular, financial economics attempts to offer plausible explanations of how, why and when corporate managers and investors do what they do. Agency costs offer plausible explanations of what corporate managers and investors do.

Agency cost literature argues that corporate managers act first in their self-interest, and then in the interests of shareholders and lenders only when such action is either in the interests of corporate managers or if corporate managers expect to lose their jobs and future employability.

The events at Enron, WorldCom and Xerox show that corporate managers are quite effective in seeking their own welfare even if such pursuits may jeopardise the wealth of lenders, shareholders and employees.

Corporate managers know that they can spend other people's money on perquisites, mergers, acquisitions, technologies and top-management pensions.

If things go wrong, shareholders, lenders and employees will pick the tab. If things go right, corporate managers will survive to promote their own welfare.

Other people's money changes perspectives and preferences. Normative economics would have naively said corporate managers should treat other people's money with great care and concern, and that corporate managers should promote and preserve the wealth of lenders, shareholders and employees.

Financial economics, in general, and agency costs, in particular, hypothesise that corporate managers may not necessarily promote and preserve the wealth of lenders, shareholders and employees.

Financial economics deals with real life. So do India's investors and market participants, and very effectively too!

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