Short selling in US and India

With the right policy, income from short selling Adani Group stocks and bonds could have accrued to Indians rather than the Americans

One main conclusion in the recent report by Hindenburg Research was that the shares of the companies in Adani Group were massively overvalued. Relatedly, Hindenburg Research participated in short selling of various relevant financial instruments. Subsequently, the combined value of the shares of the conglomerate fell precipitously by about $100 billion. The prices of their bonds have also fallen substantially. Hindenburg Research has, very likely, made good money.

The question is: Why didn’t some Indian organisations do the research and short sell shares and bonds of the companies of the Adani Group on a large scale? The income from short selling could have been earned by Indians rather than the Americans. It is true that we hardly have any specialist short selling research firms in India. However, there are other organisations.

Consider the mutual funds. They have the knowledge, experience, resources, and a direct interest. In fact, the mutual funds in India could have been at an advantage, given that the whole saga involved Indian companies. And, Hindenburg Research has not been a specialist in the Indian financial markets. Still, it was Hindenburg that took centre-stage and not the mutual funds in India.

It may be argued that at times being in the country can be a disadvantage rather than an advantage. However, this argument is stretched here. Why then did the mutual funds in India not benefit the way Hindenburg did?

It is interesting that the actively managed mutual funds in India owned very little of the shares of the Adani Group. Therefore, it is reasonable to believe that the fund managers in India did think that the shares of the Adani Group were overvalued. So, many mutual funds in India did avoid the big losses that have occurred. But they could have done better. They could have taken short positions and subsequently benefited from what could have been, and actually did turn out to be, a major fall in the prices. But they did not. Why?

The answer is simple. Regulations seriously discourage, if not ban outright, mutual funds from short selling in one way or another. The regulations are well-intentioned, but there is, nevertheless, a mistake. It is true that short selling can be quite risky, but that only implies enabling limited exposure rather than no exposure or negligible exposure. Limited exposure by each of the several interested mutual funds could have made a significant difference overall.

I have narrated the story of the mutual fund industry here but a variant of the argument applies more generally when we consider the other Indian financial institutions. Also, it is a story of not just regulations that are stated in black and white. It is also the story of the whole policy environment within which the financial institutions operate  in India. The difficulties are even more serious when we consider the mindset that somewhat pervades not just across public bodies like the Reserve Bank of India and the Securities and Exchange Board of India, but even amongst the governing boards of the financial institutions. Short selling is often, if not typically, viewed unfavourably. The consequence now is that the related big income has, in the aggregate, possibly gone to the Americans and not Indians.

The policy implication is clear. Excessive explicit and implicit restrictions on short selling need to be phased out. I should add here that short selling can be a case of stabilising, and not destabilising, speculation. Short selling can contribute to putting an end to a bubble in asset prices.

The point is not to pick on what is happening in India. Excess restrictions on mutual funds are present in other countries too, but there are other institutions there that are in a position to participate and provide a correction in the financial markets. This is much less the case in India.

It is true that the asset markets in India are not as well regulated as they are in, say, the US. And, there is a renewed call now for improved corporate governance and financial regulation in India, and rightly so. But there is another side of the story as well. The market mechanism is — often inadvertently — not allowed to work very well in India by the policymakers. This affects economic activity.

I am not saying that with reduced restrictions on short selling, India would make any major gains in gross domestic product. However, such a restriction is symptomatic of a plethora of curbs that somewhat pervade the Indian economy. It is important to deal with each of these one by one systematically and on a sustained basis. The overall and the cumulative effect over time can be substantial. 

The writer is visiting professor, Ashoka University. gurbachan.singh@ashoka.edu.in