Sentiment Dominated Economy

International Tax

and Finance Groups'

Convention 1998

14th August, 1998 to 16th August 1998
The Meadows, Aurangabad

Rashmin Sanghvi

Bombay Chartered Accountants' Society

Sentiment Dominated Economy

Back

In this debate , let us consider -
How the current Economy is dominated by Sentiments;

How fundamentals get low priority in our perceptions;

and

What are the consequences.
An example - South East Asian Crisis can explain this phenomenon more easily.
In a B.C.A. conference, I had made a presentation on the reasons for the crisis. In this paper, let us go into the reasons - for the reasons.

For those who could not participate in the earlier conference; an excellent transcript of my talk prepared by Shri Mayur Nayak is given as an annexure.
As modern economy develops, reality is taking a back seat and is being represented by symbols.
The first stage symbols are then, further represented by a second stage of symbols.

At each stage of symbols, there are assumptions which go behind the symbols.

Common men do not understand the assumptions.

"Smart men" violate the assumptions and make merry.

By the time, 3rd stage of symbols arrives, the economy is so far removed from realities that it is largely like a castle made out of playing cards.

For a castle of playing cards, it is most essential that each card is strong enough, there is no wind and no one pulls out a single card.

In practice, these assumptions do not work.

Hence the castles collapse - As happened in U.S.S.R. and South East Asia.

The falling cards take down with themselves, even the steady cards till everything meets dust.

Let us see a few examples at a few different levels to understand why South East Asia (SEA) collapsed.

I. The Building Blocks of the Castle.

1. Money is a symbol.

1.1 Money has replaced barter trade - which was the real thing.

Money would be of no value but for the expectations that - it will have stability of value ; it is good for storage of value and is convenient in use.

The "stability" and the "store" functions depend upon the assumptions that :

The authority issuing currency notes (Central Bank of the Country) is a wise and honest authority. It has tremendous knowledge of complex workings of monetary economics and fiscal equations ; and is totally honest in its dealings.

The next assumption is that the Government will listen to the Central Bank ; that the Government will not resort to deficit financing ; and will allow the Central Bank to be truly independent.

1.2 Why should Central Banks be independent?

Because Governments are ruled by politicians. More often than not, the politicians are neither honest, nor wise.

Practical men do not make assumptions which are impractical. You can not assume the Government for ever to be wise and honest.

So segregate the monetary functions ; give these to a separate authority and ensure that the authority fulfills all assumptions.

1.3 A country which ensures that these assumptions are a reality, grows without inflation. Rest go down under.

1.4 Money is the ground floor of the castle of cards.

1.5 Common man does not understand economics. He simply uses the money and hopes for the best.

2. Shares are symbols.

2.1 When you hold land, buildings, gold etc. ; you are holding real assets. When you hold shares, you are holding a certificate which is the symbol of :

(i) Assets owned by the company; and/or

(ii) Earning power of the company; etc.

Shares mean different things to different people. Suffice it to say that shares are symbols.

2.2 Some of the assumptions that go behind shares are :

The company is collecting money from the shareholders for doing business (Not for foreign cars and foreign tours.)
The directors and other managers are honest and good business men. They will do business, earn money and share the same with the shareholders.
The auditors are honest and capable experts. They will not be influenced by the directors ; they will search out the truth and convey the truth to the shareholders.
Government and its regulatory authorities are capable to deal with the enormous number of companies; experts to understand the games that are played in the Board rooms; strong enough to punish the guilty and compensate the victim.
Courts will give effective justice.

2.3 A country in which these assumptions are realities of life, can see a healthy and vibrant investment market. Where some or all of the assumptions prove wrong; the country stagnates as is happening today in India.

2.4 Shares are valued in terms of money.

One symbol (share) is represented by another symbol (money).

Share market is the second floor of the castle of cards.

2.5 Common man does not understand share market. But he does want to make millions in the market. The greed makes him - forget the realities of life, and run after the dreams being sold.

3. Index.

3.1 Bombay Sensitive Index - or any other market index is a 3rd level of symbol.

To be truly representative, a share market index has to fulfill the following assumptions:

The index is truly representative;

It is not manipulated by anyone;

It is constantly updated to remain representative in a changing world.

3.2 People having a study of the markets know how easy it is for some people to manipulate the index ; and since 1991, how many times the index has been manipulated and to what extent.

3.3 A wise man who understands that none of the assumptions hold good, would stop looking at market indices - whether they are built and published by BSE or CRISIL or some news paper.

4. Savings

At this stage, let me clarify that -

4.1 These assumptions are not exhaustive. There are many more requisites for the successful operation of any scheme. A sample of a few important assumptions helps in understanding the theme.

4.2 The pre-requisites or assumptions have varying degrees of importance for different people. Common man does not bother about these pre-requisites.

5. Derivatives and options in indices are the 4th floor of the castle of cards.

At this stage, the castle collapses by its own weight.

II. Human Weaknesses

Why do intelligent people refuse to recognise the weaknesses in the system ?

There are several human weaknesses that all of us know about. What we may not realise is :
These weaknesses apply with equal force to - a common man, a SEBI director, a company promoter, Government of a country, the Central Banks of many countries, and auditors. All are human beings; or are managed by human beings.

A company director is supposed to be honest. We all know that the assumption is more often wrong than true.

An auditor is supposed to be capable. We know how easy it is to keep the truth away from him.
The next issue is, when it is so evidently clear that these assumptions (requisites) are not fulfilled, how do people still run after the market? After the dreams, rather than realities of life.
Answer is simple. A set of human weaknesses.
Most people are greedy. They expect unreasonable profits. So they keep aside reason. A greedy man indulges in wishful thinking and does not want to see logic.

A common man is impressed by the grandeur that company promoters and merchant bankers display.

The con-man (who comes in several different forms) knows the human weaknesses of the investors, the regulatory authorities and the judiciary. He exploits these weaknesses and makes money at their cost.
Since 1991 to 1998 -
Too many con-men in India -

Have cheated too many common-men in India -

Too many times.
Today, the share markets are dead.
What is the reason ? Is it one of the following:
1. The common man has realised all the weaknesses of the system and hence has stayed away from the market,
  or
2. He has realised that the 50% or more returns per year - that he expected earlier; simply can not be earned. Since his expectations/ greed can not be satisfied, he is not interested in investing.

III. South East Asia

Till 1997, Indonesia (and other SEA tigers) was doing well. It was a show-piece of how modern economies can progress fast. What happened suddenly that the Indonesian economy is in total shambles today ?
The three systems and their weaknesses over which we had a bird's eye-view (money, share market and index) are in India. The 4th system (derivatives) is still entering the Indian scene.
Indonesia had all these and more weaknesses.
(i) Government was corrupt.

(ii) Central Bank was not independent.

(iii) Share markets were incompetent.

(iv) FIIs were allowed a free play.

(v) Foreign exchange speculation was also allowed.
The FIIs came in countries of the SEA in the current decade. By FII standards, these were small economies and small investment markets. When the FIIs entered, their share markets went up. So FIIs invested more. So the share markets, the property markets and foreign exchange markets - everything perked up. They invested more and markets went up - a sort of cycle was going on.
Then some silly things happened. (Wind blew over the castle of cards.) Details have been explained in the annexure. When the FIIs realised that they could not make profits, in fact, they might make losses ; there was a race to get out faster than others. In the scramble that followed, the castles of cards collapsed - bringing down everything with them.
Another analogy that we have seen in my earlier talk - the forest fire got quiet only when everything that could be burnt was burnt down.
In our present talk we are not discussing the reasons of the collapse. We are looking at the reasons of the reasons.
The FIIs behaved the way they behaved because :

In short - FIIs are also human. They are greedy. They want to make a fast buck without contributing anything. They are gamblers. They go by "sentiments" and ignore fundamentals.

When everyone expected that markets will go up, when the sentiment was bullish, FIIs were also bullish. They fomented the bullish sentiment. Optimism fed on optimism and all prices went up. Everybody "felt" happy.

When somebody pulled out a card or two from the castle, the things started falling. The FIIS created a scramble to run away. They quickly forgot all the "accolades" that they had given to the SEA countries. Pessimism fed on pessimism and burnt down everything.

IV. Recreate the entire sequence of events in the Indian economy from 1991 to 1998 in your mental screen.

Why did suddenly the Merchant banking jobs became the most paying, the most sought after jobs? Young brilliant boys did not want to become engineers or industrialists who would produce goods. They did not want to become auditors or traditional bankers - who provide services.
Every one wanted to be in merchant banking and share markets. Why?
Because these markets are the farthest from reality. An engineer has to produce goods and deliver. A broker can simply sell dreams. For a dream - merchant who deals in symbols based upon symbols based upon symbols based upon symbols - fooling the greedy is the easiest thing in the world.
Honest workers, farmers, traders, industrialists, auditors and bankers - are the hard working people who build real castles.
Unfortunately, they have to deal with money and shares. Instruments which can easily be converted from real building blocks into playing cards.
Gamblers (whether in property, shares, foreign exchange or derivatives) are the people who build nothing but want to usurp things that are built by others. They are experts in exploiting public sentiments. These are the people who keep pulling out cards & running away. They destroy for more than they gain.
It is for us to judge how to save ourselves from the catastrophes that happened in SEA.

Conclusion

U.S. economy with plastic money, electronic - commerce and sophisticated derivatives & options is functioning fine - as it has well entrenched and independent regulatory system.

If these symbols of symbols are super-imposed in a corrupt/inefficient country, they can create a havoc.

Annexure

To read the annexure on the South East Asian Currency Crisis, click here.