Indian Capital Market Recent Developments and Policy Issues

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					       Indian Capital Market
Recent Developments and Policy Issues



                         Yoon Je Cho




    Yoon Je Cho is Professor, Graduate School of International Studies,
                    Sogang University, Seoul, Korea.
112     A STUDY OF FINANCIAL MARKETS




      Introduction                                                   spite the rules it set, problems continued to exist, in-




                                                                 ○
                                                                 ○
                                                                     cluding those relating to disclosure criteria, lack of




                                                                 ○
                                                                 ○
      There are 22 stock exchanges in India, the first be-           broker capital adequacy, and poor regulation of mer-




                                                                 ○
                                                                 ○
      ing the Bombay Stock Exchange (BSE), which be-                 chant bankers and underwriters.




                                                                 ○
                                                                 ○
      gan formal trading in 1875, making it one of the old-             There have been significant reforms in the regula-




                                                                 ○
                                                                 ○
      est in Asia. Over the last few years, there has been           tion of the securities market since 1992 in conjunction




                                                                 ○
                                                                 ○
      a rapid change in the Indian securities market, espe-          with overall economic and financial reforms. In 1992,




                                                                 ○
                                                                 ○
      cially in the secondary market. Advanced technol-              the SEBI Act was enacted giving SEBI statutory sta-




                                                                 ○
                                                                 ○
      ogy and online-based transactions have modernized              tus as an apex regulatory body. And a series of re-




                                                                 ○
                                                                 ○
      the stock exchanges. In terms of the number of com-            forms was introduced to improve investor protection,




                                                                 ○
                                                                 ○
      panies listed and total market capitalization, the In-         automation of stock trading, integration of national




                                                                 ○
                                                                 ○
      dian equity market is considered large relative to the         markets, and efficiency of market operations.




                                                                 ○
                                                                 ○
      country’s stage of economic development. The num-                 India has seen a tremendous change in the sec-



                                                                 ○
                                                                 ○
      ber of listed companies increased from 5,968 in March          ondary market for equity. Its equity market will most


                                                                 ○
                                                                 ○
      1990 to about 10,000 by May 1998 and market capi-              likely be comparable with the world’s most advanced

                                                                 ○
                                                                 ○
      talization has grown almost 11 times during the same           secondary markets within a year or two. The key
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                                                                 ○




      period.                                                        ingredients that underlie market quality in India’s
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                                                                 ○




         The debt market, however, is almost nonexistent             equity market are:
                                                                 ○
                                                                 ○




      in India even though there has been a large volume                • exchanges based on open electronic limit order
                                                                 ○
                                                                 ○




      of Government bonds traded. Banks and financial                     book;
                                                                 ○
                                                                 ○




      institutions have been holding a substantial part of              • nationwide integrated market with a large num-
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                                                                 ○




      these bonds as statutory liquidity requirement. The                 ber of informed traders and fluency of short or
                                                                 ○
                                                                 ○




      portfolio restrictions on financial institutions’ statu-            long positions; and
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                                                                 ○




      tory liquidity requirement are still in place. A primary          • no counterparty risk.
                                                                 ○
                                                                 ○




      auction market for Government securities has been                 Among the processes that have already started
                                                                 ○
                                                                 ○




      created and a primary dealer system was introduced             and are soon to be fully implemented are electronic
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                                                                 ○




      in 1995. There are six authorized primary dealers.             settlement trade and exchange-traded derivatives.
                                                                 ○
                                                                 ○




      Currently, there are 31 mutual funds, out of which 21          Before 1995, markets in India used open outcry, a
                                                                 ○
                                                                 ○




      are in the private sector. Mutual funds were opened
                                                                 ○




                                                                     trading process in which traders shouted and hand-
                                                                 ○
                                                                 ○




      to the private sector in 1992. Earlier, in 1987, banks         signaled from within a pit. One major policy initiated
                                                                 ○
                                                                 ○




      were allowed to enter this business, breaking the              by SEBI from 1993 involved the shift of all exchanges
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                                                                 ○




      monopoly of the Unit Trust of India (UTI), which               to screen-based trading, motivated primarily by the
                                                                 ○
                                                                 ○




      maintains a dominant position.                                 need for greater transparency. The first exchange to
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                                                                 ○




         Before 1992, many factors obstructed the expan-             be based on an open electronic limit order book was
                                                                 ○
                                                                 ○




      sion of equity trading. Fresh capital issues were con-         the National Stock Exchange (NSE), which started
                                                                 ○
                                                                 ○




      trolled through the Capital Issues Control Act. Trad-          trading debt instruments in June 1994 and equity in
                                                                 ○
                                                                 ○




      ing practices were not transparent, and there was a            November 1994. In March 1995, BSE shifted from
                                                                 ○
                                                                 ○




      large amount of insider trading. Recognizing the im-           open outcry to a limit order book market. Currently,
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                                                                 ○




      portance of increasing investor protection, several            17 of India’s stock exchanges have adopted open
                                                                 ○
                                                                 ○




      measures were enacted to improve the fairness of               electronic limit order.
                                                                 ○
                                                                 ○




      the capital market. The Securities and Exchange                   Before 1994, India’s stock markets were domi-
                                                                 ○
                                                                 ○




      Board of India (SEBI) was established in 1988. De-             nated by BSE. In other parts of the country, the fi-
                                                                 ○
                                                INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES              113


nancial industry did not have equal access to mar-             practices. The court system and legal mechanism




                                                           ○
                                                           ○
kets and was unable to participate in forming prices,          should be enhanced to better protect small share-




                                                           ○
                                                           ○
compared with market participants in Mumbai                    holders’ rights and their capacity to monitor corpo-




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                                                           ○
(Bombay). As a result, the prices in markets outside           rate activities. Second, the trading system has to be




                                                           ○
                                                           ○
Mumbai were often different from prices in Mumbai.             made more transparent. Market information is a cru-




                                                           ○
                                                           ○
These pricing errors limited order flow to these mar-          cial public good that should be disclosed or made




                                                           ○
                                                           ○
kets. Explicit nationwide connectivity and implicit            available to all participants to achieve market effi-




                                                           ○
                                                           ○
movement toward one national market has changed                ciency. SEBI should also monitor more closely cases




                                                           ○
                                                           ○
this situation (Shah and Thomas, 1997). NSE has                of insider trading. Third, India may need further inte-




                                                           ○
                                                           ○
established satellite communications which give all            gration of the national capital market through consoli-




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                                                           ○
trading members of NSE equal access to the mar-                dation of stock exchanges. The trend all over the world




                                                           ○
                                                           ○
ket. Similarly, BSE and the Delhi Stock Exchange               is to consolidate and merge existing stock exchanges.



                                                           ○
                                                           ○
are both expanding the number of trading terminals             Not all of India’s 22 stock exchanges may be able to

                                                           ○
                                                           ○
located all over the country. The arbitrages are elimi-        justify their existence. There is a pressing need to de-
                                                           ○
                                                           ○
nating pricing discrepancies between markets.              ○
                                                           ○
                                                               velop a uniform settlement cycle and common clear-
   Despite these big improvements in microstructure,           ing system that will bring an end to unnecessary specu-
                                                           ○
                                                           ○




the Indian capital market has been in decline during           lation based on arbitrage opportunities. Fourth, the
                                                           ○
                                                           ○




the last three years. The amount of capital issued             payment system has to be improved to better link the
                                                           ○
                                                           ○




has dropped from the level of its peak year,1994/95,           banking and securities industries. India’s banking sys-
                                                           ○
                                                           ○




and so have equity prices. In 1994/95, Rs276 billion           tem has yet to come up with good electronic funds
                                                           ○
                                                           ○




was raised in the primary equity market. This figure           transfer (EFT) solutions. EFT is important for prob-
                                                           ○
                                                           ○




fell to Rs208 billion in 1995/96 and to Rs142 billion in       lems such as direct payments of dividends through
                                                           ○
                                                           ○




1996/97. The BSE-30 index or Sensex, the sensitive             bank accounts, eliminating counterparty risk, and fa-
                                                           ○
                                                           ○




index of equity prices, peaked at 4,361 in September           cilitating foreign institutional investment. The capital
                                                           ○
                                                           ○




1994 and fell during the following years. A leading            market cannot thrive alone; it has to be integrated with
                                                           ○
                                                           ○




cause was that financial irregularities and over-              the other segments of the financial system. The global
                                                           ○
                                                           ○




valuations of equity prices in the earlier years had           trend is for the elimination of the traditional wall be-
                                                           ○
                                                           ○




eroded public confidence in corporate shares. Also,            tween banks and the securities market.
                                                           ○
                                                           ○




there was a reduced inflow of foreign investment                   Securities market development has to be supported
                                                           ○
                                                           ○




after the Mexican and Asian financial crises. In a             by overall macroeconomic and financial sector envi-
                                                           ○
                                                           ○




sense, the market is now undergoing a period of ad-            ronments. Further liberalization of interest rates, re-
                                                           ○
                                                           ○




justment. Thus, it is time for regulatory authorities to       duced fiscal deficits, fully market-based issuance of
                                                           ○
                                                           ○




make greater efforts to recover investors’ confidence          Government securities, and a more competitive bank-
                                                           ○
                                                           ○




and to further improve the efficiency and transpar-            ing sector will help in the development of a sounder
                                                           ○
                                                           ○




ency of market operations.                                     and a more efficient capital market in India.
                                                           ○
                                                           ○




   The Indian capital market still faces many chal-
                                                           ○




                                                               Capital Market Reforms
                                                           ○




lenges if it is to promote more efficient allocation
                                                           ○
                                                           ○




and mobilization of capital in the economy. First,             and Developments
                                                           ○
                                                           ○




market infrastructure has to be improved as it hin-
                                                           ○




                                                               Reforms in the Capital Market
                                                           ○




ders the efficient flow of information and effective
                                                           ○
                                                           ○




corporate governance. Accounting standards will                Over the last few years, SEBI has announced sev-
                                                           ○
                                                           ○




have to adapt to internationally accepted accounting           eral far-reaching reforms to promote the capital
                                                           ○
114     A STUDY OF FINANCIAL MARKETS



      market and protect investor interests. Reforms in the             Most stock exchanges have introduced online trad-




                                                                   ○
                                                                   ○
      secondary market have focused on three main ar-                   ing and set up clearing houses/corporations. A de-




                                                                   ○
                                                                   ○
      eas: structure and functioning of stock exchanges,                pository has become operational for scripless trad-




                                                                   ○
                                                                   ○
      automation of trading and post trade systems, and                 ing and the regulatory structure has been overhauled




                                                                   ○
                                                                   ○
      the introduction of surveillance and monitoring sys-              with most of the powers for regulating the capital




                                                                   ○
                                                                   ○
      tems. (See Appendix 1 for a listing of reforms since              market vested with SEBI. The Indian capital market




                                                                   ○
                                                                   ○
      1992). Computerized online trading of securities, and             has experienced a process of structural transforma-




                                                                   ○
                                                                   ○
      setting up of clearing houses or settlement guaran-               tion with operations conducted to standards equiva-




                                                                   ○
                                                                   ○
      tee funds were made compulsory for stock ex-                      lent to those in the developed markets. It was opened




                                                                   ○
                                                                   ○
      changes. Stock exchanges were permitted to expand                 up for investment by foreign institutional investors




                                                                   ○
                                                                   ○
      their trading to locations outside their jurisdiction             (FIIs) in 1992 and Indian companies were allowed




                                                                   ○
                                                                   ○
      through computer terminals. Thus, major stock ex-                 to raise resources abroad through Global Depository




                                                                   ○
                                                                   ○
      changes in India have started locating computer ter-              Receipts (GDRs) and Foreign Currency Convertible



                                                                   ○
                                                                   ○
      minals in far-flung areas, while smaller regional ex-             Bonds (FCCBs). The primary and secondary seg-


                                                                   ○
                                                                   ○
      changes are planning to consolidate by using cen-                 ments of the capital market expanded rapidly, with

                                                                   ○
                                                                   ○
      tralized trading under a federated structure. Online              greater institutionalization and wider participation of
                                                                   ○
                                                                   ○




      trading systems have been introduced in almost all                individual investors accompanying this growth. How-
                                                                   ○
                                                                   ○




      stock exchanges. Trading is much more transparent                 ever, many problems, including lack of confidence in
                                                                   ○
                                                                   ○




      and quicker than in the past.                                     stock investments, institutional overlaps, and other
                                                                   ○
                                                                   ○




         Until the early 1990s, the trading and settlement              governance issues, remain as obstacles to the im-
                                                                   ○
                                                                   ○




      infrastructure of the Indian capital market was poor.             provement of Indian capital market efficiency.
                                                                   ○
                                                                   ○




      Trading on all stock exchanges was through open
                                                                   ○
                                                                   ○




      outcry, settlement systems were paper-based, and                  Stock Market
                                                                   ○
                                                                   ○




      market intermediaries were largely unregulated. The               PRIMARY MARKET
                                                                   ○
                                                                   ○




      regulatory structure was fragmented and there was                 Since 1991/92, the primary market has grown fast
                                                                   ○
                                                                   ○




      neither comprehensive registration nor an apex body               as a result of the removal of investment restrictions
                                                                   ○
                                                                   ○




      of regulation of the securities market. Stock ex-                 in the overall economy and a repeal of the restric-
                                                                   ○
                                                                   ○




      changes were run as “brokers clubs” as their man-                 tions imposed by the Capital Issues Control Act. In
                                                                   ○
                                                                   ○




      agement was largely composed of brokers. There
                                                                   ○




                                                                        1991/92, Rs62.15 billion was raised in the primary
                                                                   ○
                                                                   ○




      was no prohibition on insider trading, or fraudulent              market. This figure rose to Rs276.21 billion in 1994/
                                                                   ○
                                                                   ○




      and unfair trade practices (see Appendix 2).                      95. Since 1995/1996, however, smaller amounts have
                                                                   ○
                                                                   ○




         Since 1992, there has been intensified market re-              been raised due to the overall downtrend in the mar-
                                                                   ○
                                                                   ○




      form, resulting in a big improvement in securities trad-          ket and tighter entry barriers introduced by SEBI for
                                                                   ○
                                                                   ○




      ing, especially in the secondary market for equity.               investor protection (Table 1).
                                                                   ○
                                                                   ○
                                                                   ○




       Table 1:       Issues in the Primary Market
                                                                   ○
                                                                   ○
                                                                   ○




                                          Public                          Rights                              Total
                                                                   ○




        Year                   Number    Amount (Rs billion)   Number    Amount (Rs billion)        Number Amount (Rs billion)
                                                                   ○
                                                                   ○




        1994/95                 1,342        210.44             350           65.88                  1,692       276.32
                                                                   ○




        1995/96                 1,426        142.39             299           65.64                  1,725       208.03
                                                                   ○
                                                                   ○




        1996/97                   753        115.65             131           27.19                    884       142.84
                                                                   ○




        Dec 1997                                                                                        59        21.99
                                                                   ○
                                                                   ○
                                                                   ○




        Source: Reserve Bank of India.
                                                                   ○
                                                                       INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES                             115


   Total market capitalization as of 1997/98 was




                                                                               ○
                                                                                    Figure 1: Price and P/E Ratio for the Sensitive




                                                                               ○
Rs5,898 billion (Table 2), equivalent to about half of                                        Index of the Stock Exchange




                                                                               ○
                                                                               ○
India’s annual gross domestic product (GDP) for the




                                                                               ○
                                                                                      BSE Sensex                                                    P/E Ratio




                                                                               ○
same fiscal year. India compares favorably with other                                 5,000                                                               60




                                                                               ○
                                                                               ○
emerging markets in this respect. The market capi-                                                                                                         50




                                                                               ○
                                                                                      4,000




                                                                               ○
talization-GDP ratio at end-1995 was 22.4 percent




                                                                               ○
                                                                                                                                                           40




                                                                               ○
                                                                                      3,000
for Brazil; 12.6 percent for Hong Kong, China;




                                                                               ○
                                                                                                                                                           30




                                                                               ○
40 percent for Indonesia; 41 percent for Korea;                                       2,000




                                                                               ○
                               1                                                                                                                           20




                                                                               ○
and 37.1 percent for Mexico. It was higher how-




                                                                               ○
                                                                                      1,000                                                                10




                                                                               ○
ever, in Malaysia (281.9 percent), Philippines                                                       Sensex




                                                                               ○
                                                                                                     P/E Ratio




                                                                               ○
                                                                                          0                                                                 0
(81.3), Singapore (233 percent), and Thailand




                                                                               ○
                                                                                              1991    1992       1993   1994   1995   1996   1997   1998




                                                                               ○
(152.9 percent).



                                                                               ○
                                                                                    Data from January 1991 to January 1998.




                                                                               ○
                                                                                    Source: Bombay Stock Exchange




                                                                               ○
 Table 2:          Number of Listed Companies and Market

                                                                               ○
                   Capitalization
                                                                               ○
                                                                               ○

                                        Number                 Amount of       ○
                                                                                   the monthly average Sensex P/E ratio was 15.65
                                        of Listed            Capitalization
                                                                               ○




  Year                                 Companies              (Rs billion)         while the figure for October 1993 was 38.76.
                                                                               ○
                                                                               ○




  1995/96                                 9,100                   5,723
                                                                               ○




                                                                                   Risk Management System
                                                                               ○




  1996/97                                 9,890                   4,883
                                                                               ○




  1997/98                                 9,833                   5,898
                                                                               ○




  1999a
                                                                                   SEBI has taken several measures to improve the
                                                                               ○




                                          9,877                   5,741
                                                                               ○




                                                                                   integrity of the secondary market. Legislative and
                                                                               ○




  a As of March.
                                                                               ○




  Source: Reserve Bank of India, Report on Currency and Finance, 1998–1999.
                                                                                   regulatory changes have facilitated the corporatization
                                                                               ○
                                                                               ○




                                                                                   of stockbrokers. Capital adequacy norms have been
                                                                               ○
                                                                               ○




EQUITY PRICE                                                                       prescribed and are being enforced. A mark-to-mar-
                                                                               ○
                                                                               ○




For the past 12 years, equity prices have seen two                                 ket margin and intraday trading limit have also been
                                                                               ○
                                                                               ○




extended periods of declining prices and two periods                               imposed. Further, the stock exchanges have put in
                                                                               ○
                                                                               ○




of rising prices. Between April 1986 and March 1988,                               place circuit breakers, which are applied in times of
                                                                               ○
                                                                               ○




Sensex decreased from 589 to 398, or by 32 per-                                    excessive volatility. The disclosure of short sales and
                                                                               ○
                                                                               ○




cent. Prices also fell between March 1992, when                                    long purchases is now required at the end of the day
                                                                               ○
                                                                               ○




the monthly closing level of Sensex was 4,258, and                                 to reduce price volatility and further enhance the in-
                                                                               ○
                                                                               ○




April 1993, when the level was 2,122, a decline of                                 tegrity of the secondary market.
                                                                               ○
                                                                               ○




50.5 percent. Prices generally rose for extended pe-
                                                                               ○
                                                                               ○




riods from March 1988 to March 1992 and from May                                   MARK-TO-MARKET MARGIN AND INTRADAY LIMIT
                                                                               ○
                                                                               ○




1993 to August 1994. The monthly closing level of                                  Under the current clearing and settlement system, if
                                                                               ○
                                                                               ○




Sensex climbed from 398 in March 1988 to 4,285 in                                  an Indian investor buys and subsequently sells the
                                                                               ○
                                                                               ○




March 1992, an increase of more than 10 times. In                                  same number of shares of stock during a settlement
                                                                               ○
                                                                               ○




the second period of extended rising equity prices,                                period, or sells and subsequently buys, it is not nec-
                                                                               ○
                                                                               ○




Sensex increased 1.16 times. Since 1995, it has fluc-                              essary to take or deliver the shares. The difference
                                                                               ○
                                                                               ○




tuated around the 3,000-4,000 mark (see Figure 1).                                 between the selling and buying prices can be paid or
                                                                               ○
                                                                               ○




In April 1998, it hovered around 3,000.                                            received. In other words, the squaring-off of the trad-
                                                                               ○
                                                                               ○




   In the period of declining prices, from August 1994                             ing position during the same settlement period re-
                                                                               ○
                                                                               ○




to March 1998, the price-earnings (P/E) ratio fell                                 sults in nondelivery of the shares that the investor
                                                                               ○
                                                                               ○




more sharply than prices (Figure 1). In March 1998,                                traded. A short-term and speculative investment is
                                                                               ○
116     A STUDY OF FINANCIAL MARKETS



      thus possible at a relatively low cost. FIIs and do-              cent of the notional loss, assuming that the broker’s




                                                                    ○
                                                                    ○
      mestic institutional investors are, however, not per-             funding cost is about 24-36 percent (Endo 1998).




                                                                    ○
                                                                    ○
      mitted to trade without delivery, since nondelivery               Thus, speculative trading without the delivery of




                                                                    ○
                                                                    ○
      transactions are limited only to individual investors.            shares is no longer cost-free.




                                                                    ○
                                                                    ○
          One of SEBI’s primary concerns is the risk of                     Each broker’s trading volume during a day is not




                                                                    ○
                                                                    ○
      settlement chaos that may be caused by an increas-                allowed to exceed the intraday trading limit. This limit




                                                                    ○
                                                                    ○
      ing number of nondelivery transactions as the stock               is 33.3 times the base minimum capital deposited with




                                                                    ○
                                                                    ○
      market becomes excessively speculative. Accord-                   the exchange on a gross basis, i.e., purchase plus




                                                                    ○
                                                                    ○
      ingly, SEBI has introduced a daily mark-to-market                 sale. In the event of brokers wishing to exceed this




                                                                    ○
                                                                    ○
      margin and intraday trading limit. The daily mark-to-             limit, they have to deposit additional capital with the




                                                                    ○
                                                                    ○
      market margin is a margin on a broker’s daily posi-               exchange and this cannot be withdrawn for six




                                                                    ○
                                                                    ○
      tion. The intraday trading limit is the limit to a broker’s       months.




                                                                    ○
                                                                    ○
      intraday trading volume. Every broker is subject to



                                                                    ○
                                                                    ○
      these requirements.                                               CIRCUIT BREAKER


                                                                    ○
                                                                    ○
          Each stock exchange may take any other mea-                   SEBI has imposed price limits for stocks whose mar-

                                                                    ○
                                                                    ○
      sures to ensure the safety of the market. BSE and                 ket prices are above Rs10 up to Rs20, a daily price
                                                                    ○
                                                                    ○




      NSE impose on members a more stringent daily                      change limit and weekly price change limit of 25 per-
                                                                    ○
                                                                    ○




      margin, including one based on concentration of busi-             cent. BSE imposes price limits as a circuit breaker
                                                                    ○
                                                                    ○




      ness.                                                             system to maintain the orderly trading of shares on
                                                                    ○
                                                                    ○




          A daily mark-to-market margin is 100 percent of               the exchange (Table 3).
                                                                    ○
                                                                    ○




      the notional loss of the stockbroker for every stock,                BSE’s computerized trading system rejects buy
                                                                    ○
                                                                    ○




      calculated as the difference between buying or selling            or sell orders of a stock at prices outside the price
                                                                    ○
                                                                    ○




      price and the closing price of that stock at the end of           limits. The daily price limit of a stock is measured
                                                                    ○
                                                                    ○




      that day. However, there is a threshold limit of 25 per-          from the stock’s closing price in the previous trading
                                                                    ○
                                                                    ○




      cent of the base minimum capital plus additional capi-            session. The weekly price limit is based on its clos-
                                                                    ○
                                                                    ○




      tal kept with the stock exchange or Rs1 million, which-           ing price of the last trading in the previous week,
                                                                    ○
                                                                    ○




      ever is lower. Until the notional loss exceeds the thresh-        usually its closing price on the previous Friday.
                                                                    ○
                                                                    ○




      old limit, the margin is not payable.
                                                                    ○
                                                                    ○




          This margin is payable by a stockbroker to the
                                                                    ○




                                                                        SHORT SALES AND LONG PURCHASES
                                                                    ○
                                                                    ○




      stock exchange in cash or as a bank guarantee from                SEBI regulates short selling in the stock market by
                                                                    ○
                                                                    ○




      a scheduled commercial bank, on a net basis. It will              requiring all stock exchanges to enforce reporting
                                                                    ○
                                                                    ○




      be released on the pay-in day for the settlement pe-              by members of their net short sale and long pur-
                                                                    ○
                                                                    ○




      riod. The margin money is held by the exchange for                chase positions in each stock at the end of each
                                                                    ○
                                                                    ○




      6-12 days. This costs the broker about 0.4-1.2 per-               trading day.
                                                                    ○
                                                                    ○
                                                                    ○




       Table 3:      Bombay Stock Exchange Price Limits
                                                                    ○
                                                                    ○




                                                                                                         Price Limit (percent)
                                                                    ○
                                                                    ○




        Category                                             Market Price of Share                    Daily              Weekly
                                                                    ○




        A Group Shares                                       Over Rs20                                 10                 25
                                                                    ○
                                                                    ○




        B1 & B2 Group Shares                                 Rs10 up to Rs20                           25                 25
                                                                    ○
                                                                    ○




                                                             Rs1 up to Rs10                            50               No Limit
                                                                    ○




                                                             Up to Rs1                                 75               No Limit
                                                                    ○
                                                                    ○
                                                                    ○




       Source: Endo (1998).
                                                                    ○
                                              INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES            117


Stock Lending                                                management, were often performed by one body,




                                                         ○
                                                         ○
A scheme for regulating stock lending was intro-             usually the fund sponsor or its subsidiary. The regu-




                                                         ○
                                                         ○
duced in February 1997, following changes in tax             lations prescribed disclosure and advertisement norms




                                                         ○
                                                         ○
regulations. Stock lending can take place through            for mutual funds, and, for the first time, permitted




                                                         ○
                                                         ○
an intermediary registered for this purpose with             the entry of private sector mutual funds. FIIs regis-




                                                         ○
                                                         ○
SEBI, and which has a minimum capital of Rs500               tered with SEBI may invest in domestic mutual funds,




                                                         ○
                                                         ○
million. Lenders and borrowers of securities have            whether listed or unlisted.




                                                         ○
                                                         ○
to enter into agreements with the intermediary. Stock            The 1993 Regulations have been revised on the




                                                         ○
                                                         ○
lending facilitates the timely settlement of transac-        basis of the recommendations of the Mutual Funds




                                                         ○
                                                         ○
tions on the stock exchanges, especially in an envi-         2000 Report prepared by SEBI. The revised regula-




                                                         ○
                                                         ○
ronment where physical delivery of certificates is           tions strongly emphasize the governance of mutual




                                                         ○
                                                         ○
required for settlement.                                     funds and increase the responsibility of the trustees



                                                         ○
                                                         ○
                                                             in overseeing the functions of the asset management

                                                         ○
Introduction of Derivatives Trading
                                                         ○
                                                             company. Mutual funds are now required to obtain
                                                         ○
                                                         ○
At present, there are no exchange traded deriva-         ○
                                                         ○
                                                             the consent of investors for any change in the “fun-
tives or over-the-counter derivative markets in the          damental attributes” of a scheme, on the basis of
                                                         ○
                                                         ○




country. However, a new law has been passed per-             which unit holders have invested. The revised regu-
                                                         ○
                                                         ○




mitting the trading of derivatives. This followed rec-       lations require disclosures in terms of portfolio com-
                                                         ○
                                                         ○




ommendations for the establishment of a regulatory           position, transactions by schemes of mutual funds
                                                         ○
                                                         ○




framework for derivatives by a committee chaired             with sponsors or affiliates of sponsors, with the as-
                                                         ○
                                                         ○




by L.C. Gupta. It is expected that derivatives trading       set management company and trustees, and also with
                                                         ○
                                                         ○




will soon form part of the Indian securities market.         respect to personal transactions of key personnel of
                                                         ○
                                                         ○




                                                             asset management companies and of trustees.
                                                         ○




Institutional Investors
                                                         ○
                                                         ○
                                                         ○




MUTUAL FUNDS                                                 FOREIGN INSTITUTIONAL INVESTORS
                                                         ○
                                                         ○




Indian investors have been able to invest through            FIIs have been allowed to invest in the Indian secu-
                                                         ○
                                                         ○




mutual funds since 1964, when UTI was established.           rities market since September 1992 when the Guide-
                                                         ○
                                                         ○




Indian mutual funds have been organized through the          lines for Foreign Institutional Investment were issued
                                                         ○
                                                         ○




Indian Trust Acts, under which they have enjoyed             by the Government. The SEBI (Foreign Institutional
                                                         ○
                                                         ○




certain tax benefits. Between 1987 and 1992, public          Investors) Regulations were enforced in November
                                                         ○
                                                         ○




sector banks and insurance companies set up mutual           1995, largely based on these Guidelines. The regula-
                                                         ○
                                                         ○




funds. Since 1993, private sector mutual funds have          tions require FIIs to register with SEBI and to obtain
                                                         ○
                                                         ○




been allowed, which brought competition to the mu-           approval from the Reserve Bank of India (RBI) un-
                                                         ○
                                                         ○




tual fund industry. This has resulted in the introduc-       der the Foreign Exchange Regulation Act to buy and
                                                         ○
                                                         ○




tion of new products and improvement of services.            sell securities, open foreign currency and rupee bank
                                                         ○
                                                         ○




The notification of the SEBI (Mutual Fund) Regula-           accounts, and to remit and repatriate funds. Once
                                                         ○
                                                         ○




tions of 1993, brought about a restructuring of the          SEBI registration has been obtained, an FII does not
                                                         ○
                                                         ○




mutual fund industry. An arm’s length relationship is        require any further permission to buy or sell securi-
                                                         ○
                                                         ○




required between the fund sponsor, trustees, custo-          ties or to transfer funds in and out of the country,
                                                         ○
                                                         ○




dian, and asset management company. This is in con-          subject to payment of applicable tax.
                                                         ○
                                                         ○




trast to the previous practice where all three func-             Foreign investors, whether registered as FIIs or
                                                         ○
                                                         ○




tions, namely trusteeship, custodianship, and asset          not, may also invest in Indian securities outside the
                                                         ○
118     A STUDY OF FINANCIAL MARKETS



      FII process. Such investment requires case-by-case                                 Since 1993/94, foreign portfolio investment has so




                                                                                 ○
                                                                                 ○
      approval from the Foreign Investment Promotion                                 far exceeded foreign direct investment, which has also




                                                                                 ○
                                                                                 ○
      Board (FIPB) in the Ministry of Industry and RBI,                              increased rapidly (Table 5). Investment through FIIs




                                                                                 ○
                                                                                 ○
      or only from RBI depending on the size of invest-                              constituted the bulk of portfolio investment. Annual




                                                                                 ○
                                                                                 ○
      ment and the industry in which the investment is to                            inflows have been about $1.5 billion-$2 billion from




                                                                                 ○
                                                                                 ○
      be made. Investment in Indian securities is also pos-                          1993/94 to 1996/97 through FIIs, while inflows through




                                                                                 ○
                                                                                 ○
      sible through the purchase of GDRs. Foreign cur-                               GDRs have declined after peaking at $1.8 billion in




                                                                                 ○
                                                                                 ○
      rency convertible bonds and foreign currency bonds                             1994/95. In 1996/97, India received $5.6 billion in for-




                                                                                 ○
                                                                                 ○
      issued by Indians that are listed, traded, and settled                         eign investment of which $1.9 billion was through FIIs.




                                                                                 ○
                                                                                 ○
      overseas are mainly denominated in dollars. Foreign                            During 1997/98, FIIs’ investment fell while foreign




                                                                                 ○
                                                                                 ○
      financial service institutions have also been allowed                          direct investment rose. Improvement in inflow of for-




                                                                                 ○
                                                                                 ○
      to set up joint ventures in stockbroking, asset man-                           eign investment raised India’s foreign exchange re-




                                                                                 ○
                                                                                 ○
      agement companies, merchant banking, and other                                 serves from $17 billion at the end of 1994/95 to $29.3



                                                                                 ○
                                                                                 ○
      financial services firms along with Indian partners.                           billion at the end of June 1997.


                                                                                 ○
                                                                                 ○
         Foreign portfolio investments in Indian companies                               Following the changes to the 1995 SEBI (Foreign

                                                                                 ○
                                                                                 ○
      are limited to individual foreign ownership at 10 per-                         Institutional Investors) Regulations, an FII is allowed
                                                                                 ○
                                                                                 ○




      cent of the total issued capital of any one company                            to set up an investment fund to invest in Indian bonds
                                                                                 ○
                                                                                 ○




      and to aggregate foreign ownership at 30 percent of                            if it registers the fund with SEBI as a new separate
                                                                                 ○
                                                                                 ○




      the total issued capital of any one company.                                   FII or its new subaccount. In 1996, SEBI approved
                                                                                 ○
                                                                                 ○




         FIIs’ net investment was positive until October                             nine debt funds with a cumulative investment expo-
                                                                                 ○
                                                                                 ○




      1997 and their cumulative investments reached $9.1                             sure of $1.278 billion for investment in securities.
                                                                                 ○
                                                                                 ○




      billion in the same month. But since then, it has turned                           FIIs seem to have a strong impact on equity price
                                                                                 ○
                                                                                 ○




      negative due to the Asian financial crisis (Table 4).                          movements in India. Trend analysis has shown a sig-
                                                                                 ○
                                                                                 ○




      As of May 1998, 496 FIIs were registered with SEBI,                            nificantly positive relationship between BSE Sensex
                                                                                 ○
                                                                                 ○




      with a cumulative net investment of $9.2 billion in                            and the lagged net investment by FIIs. Figure 2 sug-
                                                                                 ○
                                                                                 ○




      the Indian securities market.                                                  gests that monthly net investment has been taking
                                                                                 ○
                                                                                 ○
                                                                                 ○
                                                                                 ○




       Table 4:      Investment by FIIs in Primary and Secondary Marketsa
                                                                                 ○
                                                                                 ○
                                                                                 ○




                                                  No. of                                                                            Cumulative
                                                                                 ○




                                                Registered                                                                              Net
                                                                Gross Purchase            Gross Sales           Net Investment
                                                                                 ○




                                                   FIIs                                                                             Investment
                                                                                 ○




         Year/Month                            (cumulative)   Rs billion $ million    Rs billion $ million   Rs billion $ million    ($ million)
                                                                                 ○
                                                                                 ○




         Jan–Mar 1993                                18           0.17      5.6           0.04        1.3        0.13        4.3          4.2
                                                                                 ○




         1993/94                                    158          55.92 1,782.8            4.66     1,48.7       51.26    1,634.1      1,638.3
                                                                                 ○




         1994/95                                    308          76.31 2,431.2           28.34     9,02.9       47.96    1,528.3      3,166.6
                                                                                 ○
                                                                                 ○




         1995/96                                    367          96.75 2,858.6           27.51     8,22.9       69.42    2,035.7      5,202.3
                                                                                 ○




         1996/97                                    439         154.57 4,364.6           69.73    1,957.5       84.84    2,407.1      7,609.5
                                                                                 ○
                                                                                 ○




         1996/97 (Apr-Jan)                          429         127.01 3,595.6           52.15    1,467.0       74.86    2,128.6      7,331.0
                                                                                 ○




         1997/98 (Apr-Jan )                         476         143.82 3,979.4          102.12    2,807.4       41.69    1,172.0      8,781.5
                                                                                 ○




         Total (since Jan 1993)                     476         527.57 15,422.2         232.43    6,640.6      295.32    8,781.5      8,781.5
                                                                                 ○
                                                                                 ○




         Oct 1997                                    471          16.0      442.0         9.66      267.0         6.33     174.9      9,090.3
                                                                                 ○
                                                                                 ○




         Nov 1997                                    475         10.93      295.4        15.05      406.7       (4.11)   (111.3)      8,979.0
                                                                                 ○




         Dec 1997                                    476          9.34      251.0        14.60      392.3       (5.26)   (141.3)      8,837.7
                                                                                 ○




         Jan 1998                                    476          6.52      175.2         8.62      231.5       (2.09)    (56.3)      8,781.4
                                                                                 ○
                                                                                 ○
                                                                                 ○




         FII = foreign institutional investor.
                                                                                 ○




         ( ) = negative values are enclosed in parentheses.
                                                                                 ○




         a Data include debt instruments.
                                                                                 ○




         Source: Securities and Exchange Board of India.
                                                                                 ○
                                                                           INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES                                         119




                                                                                         ○
 Table 5:      Foreign Investment Inflows ($ million)




                                                                                         ○
                                                                                         ○
                                                                                         ○
   Item                                                 1991/92             1992/93               1993/94               1994/95                1995/96                1996/97




                                                                                         ○
   Direct investment                                         150                 341                  566                  1314                  2,133                 2,696




                                                                                         ○
                                                                                         ○
     Government (SIA/FIPB)                                    87                 238                  280                   701                  1,249                 1,922




                                                                                         ○
     RBI                                                                          42                   89                   171                    169                   135




                                                                                         ○
                                                                                         ○
     NRI                                                       63                 61                  217                   442                    715                   639




                                                                                         ○
   Portfolio investment                                         8                 92                3,649                 3,581                  2,748                 2,864




                                                                                         ○
                                                                                         ○
     GDRs                                                                         86                1,602                 1,839                    683                   918




                                                                                         ○
     FIIs                                                                          1                1,665                 1,503                  2,009                 1,926




                                                                                         ○
                                                                                         ○
     Offshore funds and others                                 8                   5                  382                   239                     56                    20




                                                                                         ○
   Total                                                     158                 433                4,215                 4,895                  4,881                 5,560




                                                                                         ○
                                                                                         ○
                                                                                         ○
   FII = foreign institutional investor, FIPB = Foreign Investment Promotion Board, GDR = global depository receipt, NRI = nonresident Indian, RBI = Reserve Bank of India,




                                                                                         ○
   SIA = Secretariat for Industrial Assistance.




                                                                                         ○
   Source: Reserve Bank of India, Report on Currency and Finance, various issues.




                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
Figure 2: Monthly Net FII Investment and BSE-30 Index                                           • depositories, participants, custodians of securi-
                                                                                         ○
                                                                                         ○



 US$ million                                                        BSE-30 Index
                                                                                         ○
                                                                                         ○
                                                                                                  ties, FIIs, credit rating agencies, and other such
 1,000                                                                     5,000
            Net FII investment                                                                    intermediaries who may be associated with the
                                                                                         ○




            Sensex
                                                                                         ○




  800                                                                        4,000                securities market in any manner; and
                                                                                         ○
                                                                                         ○




                                                                                                • venture capital funds and collective investment
                                                                                         ○




  600                                                                        3,000
                                                                                         ○




                                                                                                  schemes, including mutual funds.
                                                                                         ○
                                                                                         ○




  400                                                                        2,000
                                                                                                However, the registration system is far from com-
                                                                                         ○
                                                                                         ○




  200                                                                        1,000           plete. For some professional categories such as sub-
                                                                                         ○
                                                                                         ○




                                                                                             brokers, the registration system is in place, but limi-
                                                                                         ○




     0                                                                            0
                                                                                         ○




                                                                                             tations to SEBI’s enforcement power permits hun-
                                                                                         ○
                                                                                         ○




                                                                                             dreds of thousands of unregistered subbrokers to
                                                                                         ○




 BSE = Bombay Stock Exchange, FII = foreign institutional investor.
                                                                                         ○




 Source: Securities and Exchange Board of India, Annual Report, 1995/96.
                                                                                             conduct their securities businesses, while registered
                                                                                         ○
                                                                                         ○




                                                                                             subbrokers are not effectively regulated. There is no
                                                                                         ○
                                                                                         ○




the lead in changing market sentiments as reflected                                          registration system at all for investment advisors.
                                                                                         ○
                                                                                         ○




in the market index movements.                                                                  The capital adequacy requirements for registered
                                                                                         ○
                                                                                         ○




                                                                                             market participants are surprisingly low. Conse-
                                                                                         ○




Policy Issues
                                                                                         ○




                                                                                             quently, entry barriers are also low. This is probably
                                                                                         ○
                                                                                         ○




                                                                                             because the vested interest of existing market par-
                                                                                         ○




Regulatory Framework
                                                                                         ○




                                                                                             ticipants cannot be totally ignored since the Indian
                                                                                         ○
                                                                                         ○




REGULATION OF INTERMEDIARIES                                                                 capital market would stop functioning without them.
                                                                                         ○
                                                                                         ○




Participants in the Indian capital market are required                                       The majority are thinly capitalized. As a result, SEBI’s
                                                                                         ○
                                                                                         ○




to register with SEBI to carry out their businesses.                                         limited resources are spread too thinly to register
                                                                                         ○
                                                                                         ○




These include:                                                                               many small participants and regulate them.
                                                                                         ○
                                                                                         ○




   • stockbrokers, subbrokers, share transfer agents,
                                                                                         ○
                                                                                         ○




     bankers to an issue, trustees of a trust deed, reg-                                          Stockbrokers
                                                                                         ○
                                                                                         ○




     istrars to an issue, merchant bankers, underwrit-                                          The Indian law defines a stockbroker simply as
                                                                                         ○
                                                                                         ○




     ers, portfolio managers, investment advisers, and                                       a member of a recognized stock exchange. There-
                                                                                         ○
                                                                                         ○




     other such intermediaries who may be associ-                                            fore, a registered stockbroker is a member of at
                                                                                         ○
                                                                                         ○




     ated with the securities market in any manner;                                          least one of the recognized Indian stock exchanges.
                                                                                         ○
120     A STUDY OF FINANCIAL MARKETS



      Stockbrokers are not allowed to buy, sell, or deal in              • majority of subbrokers are not registered with




                                                                  ○
                                                                  ○
      securities, unless they hold a certificate granted by                SEBI; and




                                                                  ○
                                                                  ○
      SEBI. At the end of March 1997, they numbered 8,867.               • the function of the subbroker is not clearly de-




                                                                  ○
                                                                  ○
         Each stockbroker is subject to capital adequacy                   fined.




                                                                  ○
                                                                  ○
      requirements consisting of two components: basic                   No subbroker is supposed to buy, sell, or deal in




                                                                  ○
                                                                  ○
      minimum capital and additional or optional capital              securities, without a certificate granted by SEBI.




                                                                  ○
                                                                  ○
      related to volume of business.                                  Nevertheless, there were only about 2,593 sub-




                                                                  ○
                                                                  ○
         The basic minimum capital requirement varies                 brokers registered with SEBI as of end-June 1997,




                                                                  ○
                                                                  ○
      from one exchange to another. A SEBI regulation                 while the number of stock subbrokers in India was




                                                                  ○
                                                                  ○
      requires stockbrokers of BSE or NSE to maintain a               estimated in the range of 50,000 to 200,000 (Endo,




                                                                  ○
                                                                  ○
      minimum of Rs500,000 (about $14,000), which is the              1998).




                                                                  ○
                                                                  ○
      largest requirement among the stock exchanges.                     The Indian law defines a subbroker as any per-




                                                                  ○
                                                                  ○
      However, BSE and NSE require their respective                   son, not being a member of a stock exchange, who



                                                                  ○
                                                                  ○
      members to deposit with them larger amounts. The                acts on behalf of a stockbroker as an agent, or oth-


                                                                  ○
                                                                  ○
      additional or optional capital and the basic minimum            erwise, to assist the investors in buying, selling, or

                                                                  ○
                                                                  ○
      capital combined have to be maintained at 8 percent             dealing securities through such a stockbroker. Based
                                                                  ○
                                                                  ○




      or more of the gross outstanding business in the ex-            on this definition, the subbroker is either a stock-
                                                                  ○
                                                                  ○




      change (the gross outstanding business means the                broker’s agent or an arranger for the investor. Thus,
                                                                  ○
                                                                  ○




      cumulative amount of sales and purchases by a stock-            legally speaking, the stockbroker as a principal will
                                                                  ○
                                                                  ○




      broker in all securities at any point during the settle-        be responsible to the investor for a subbroker’s con-
                                                                  ○
                                                                  ○




      ment period). Sales and purchases on behalf of cus-             duct if a subbroker acts as his or her agent. How-
                                                                  ○
                                                                  ○




      tomers may not be netted but may be included to                 ever, the market practice is different from this le-
                                                                  ○
                                                                  ○




      those of the broker.                                            gally defined relationship. In reality, the stockbroker,
                                                                  ○
                                                                  ○




         There is no mandatory qualification test for stock-          in general, issues a contract note of a transaction
                                                                  ○
                                                                  ○




      brokers and other market participants in India, unlike          even to a registered subbroker, thus treating the lat-
                                                                  ○
                                                                  ○




      other countries such as Japan, United Kingdom, and              ter as a counterparty. This implicitly denies the
                                                                  ○
                                                                  ○




      United States.                                                  stockbroker’s privity with the investor.
                                                                  ○
                                                                  ○




                                                                         NSE does not officially allow its members to trans-
                                                                  ○
                                                                  ○
                                                                  ○




         Subbrokers                                                   act with end-investors through a subbroker. This is
                                                                  ○
                                                                  ○




         Most stockbrokers in India are still relatively small.       probably because NSE has liberal membership cri-
                                                                  ○
                                                                  ○




      They cannot afford to directly cover every retail in-           teria and its computerized trading network can eas-
                                                                  ○
                                                                  ○




      vestor in a geographically vast country and in such a           ily provide geographically scattered stockbrokers with
                                                                  ○
                                                                  ○




      complex society. Thus, they are permitted to trans-             direct access to trading on NSE. Nevertheless, many
                                                                  ○
                                                                  ○




      act with subbrokers as the latter play an indispens-            trading members of NSE have been using registered
                                                                  ○
                                                                  ○




      able role in intermediating between investors and the           and unregistered subbrokers.
                                                                  ○
                                                                  ○




      stock market.                                                      To sort out this confusion, SEBI enforced the fol-
                                                                  ○
                                                                  ○




         An applicant for a subbroker certificate must be             lowing measures in March 1997:
                                                                  ○
                                                                  ○




      affiliated with a stockbroker of a recognized stock                • initiation of criminal actions on complaints re-
                                                                  ○
                                                                  ○




      exchange. A subbroker application may take the form                  ceived against unregistered sub-brokers in suit-
                                                                  ○
                                                                  ○




      of sole proprietorship, partnership, or corporation.                 able cases;
                                                                  ○
                                                                  ○




         There are two major issues concerning subbrokers                • revival of the institution of “remisier” under rules
                                                                  ○
                                                                  ○




      in the Indian capital market:                                        and bylaws of the stock exchanges; and
                                                                  ○
                                                 INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES          121


  • prohibition of stockbrokers in dealing with un-             The merchant banking industry in India has many




                                                         ○
                                                         ○
    registered subbrokers or unregistered remisiers          problems, the main ones being that there are too many




                                                         ○
                                                         ○
    after 1 June 1997 (this deadline was later ex-           merchant bankers, and that they are considered to




                                                         ○
                                                         ○
    tended to 1 July 1997).                                  be relatively incompetent.




                                                         ○
                                                         ○
  In spite of these actions, the confusion has re-              Only 20 merchant bankers account for 60-85 per-




                                                         ○
                                                         ○
mained. There is a need to address the basic is-             cent of the merchant banking business, while 148 of




                                                         ○
                                                         ○
sue of clarifying the role of the subbroker and to           them are in business only on paper. In May 1997, a




                                                         ○
                                                         ○
operationally define its relationship with the stock-        substantial number of merchant bankers were found




                                                         ○
                                                         ○
brokers.                                                     to be professionally imprudent or negligent (Endo




                                                         ○
                                                         ○
                                                             1998). SEBI listed 134 merchant bankers of Cat-




                                                         ○
                                                         ○
   Merchant Bankers                                          egories I, II, and III who broke their underwriting




                                                         ○
                                                         ○
   Under the old regulations, there were four cat-           commitments for possible disciplinary actions. Of this



                                                         ○
                                                         ○
egories of registered merchant bankers with differ-          number, 95 were in Category I. Furthermore, there

                                                         ○
                                                         ○
ent minimum net worth requirements (Table 6). Un-            have been records of listing delay or rejection of ini-
                                                         ○
                                                         ○
der the new regulations, the categories were abol-       ○
                                                         ○
                                                             tial public offerings (IPOs) in the recent past.
ished. Among other provisions, a merchant banker
                                                         ○
                                                         ○




applicant is required to have a minimum net worth of         FRAGMENTATION OF REGULATORY
                                                         ○
                                                         ○




Rs50 million.                                                AUTHORITIES
                                                         ○
                                                         ○




                                                             The present functions and powers of regulatory agen-
                                                         ○




Table 6: Capital Adequacy Requirement for
                                                         ○




         Merchant Banker Applicant (old regulations)         cies for the securities market seem to be fragmented.
                                                         ○
                                                         ○




                                                             SEBI is the primary body responsible for regulation
                                                         ○




                                 Minimum Amount of
                                                         ○




  Category                      Net Worth (Rs million)       of the securities market, deriving its powers of regis-
                                                         ○
                                                         ○




  I                                      50                  tration and enforcement primarily from the SEBI Act.
                                                         ○




  II                                      5
                                                         ○




                                                             There was an existing regulatory framework for the
                                                         ○




  III                                     2
                                                         ○




  IV                                      ..                 securities market, provided by the Securities Con-
                                                         ○
                                                         ○




                                                             tract Regulation (SCR) Act and the Companies Act,
                                                         ○




  .. = nil
                                                         ○




  Source: Endo (1998).
                                                             administered by the Ministry of Finance and the
                                                         ○
                                                         ○




                                                             Department of Company Affairs (DCA) of the Min-
                                                         ○
                                                         ○




   The new regulations have drawn a clear-cut line           istry of Law, respectively. SEBI has been delegated
                                                         ○
                                                         ○




between the merchant banker and the nonbanking               most of the functions and powers under the SCR
                                                         ○
                                                         ○




finance company (NBFC). Under the old regulations,           Act, and shares the rest with the Ministry of Finance.
                                                         ○
                                                         ○




a merchant banker is permitted to carry out fund-            It has also been delegated certain powers under the
                                                         ○
                                                         ○




based activities such as deposit-taking, leasing, bill       Companies Act. RBI also has regulatory involve-
                                                         ○
                                                         ○




discounting and hire-purchasing. The new regulations         ment in the capital market regarding foreign exchange
                                                         ○
                                                         ○




no longer allow a merchant banker to engage in these         control liquidity support to market participants and
                                                         ○
                                                         ○




fund-based activities except for those related exclu-        debt management through primary dealers. It is RBI
                                                         ○
                                                         ○




sively to the capital market such as underwriting.           and not SEBI that regulates primary dealers in the
                                                         ○
                                                         ○




The merchant banker is required to cease such ac-            Government securities market. However, securities
                                                         ○
                                                         ○




tivities within two years. Correspondingly, an exist-        transactions that involve a foreign exchange trans-
                                                         ○
                                                         ○




ing NBFC performing merchant banking activities is           action need the permission of RBI.
                                                         ○
                                                         ○




required to relinquish such activities after a certain          So far, fragmentation of the regulatory authorities
                                                         ○
                                                         ○




period of time.                                              has not been a major obstacle to effective regulation
                                                         ○
122    A STUDY OF FINANCIAL MARKETS



      of the securities market. Rather, lack of enforce-           Over-the-Counter Exchange of India (OTCEI) also




                                                               ○
                                                               ○
      ment capacity by SEBI has been a more significant            provides a nationwide electronic system for trading




                                                               ○
                                                               ○
      cause of poor regulation. But since the Indian stock         relatively smaller stocks. BSE has introduced its own




                                                               ○
                                                               ○
      markets are rapidly being integrated, the authorities        screen-based quote-driven trading system. However,




                                                               ○
                                                               ○
      may follow the global trend of consolidation of regu-        the market is still fragmented and needs further inte-




                                                               ○
                                                               ○
      latory authorities or better coordination among them.        gration.




                                                               ○
                                                               ○
                                                                      The international trend is to consolidate and merge




                                                               ○
                                                               ○
      SELF-REGULATORY BODY                                         existing stock exchanges rather than to set up new




                                                               ○
                                                               ○
      Self-regulatory organizations (SROs) have been               ones. In the UK, there were about 20 stock ex-




                                                               ○
                                                               ○
      adopted in many countries to regulate various par-           changes in the late 1960s, which were reduced to




                                                               ○
                                                               ○
      ticipants in the securities market. Members are bound        about half a dozen in 1972 and further down to one,




                                                               ○
                                                               ○
      by the SRO’s bylaws and codes of conduct. Through            i.e., the London Stock Exchange, in 1986. NSE has




                                                               ○
                                                               ○
      the SEBI Act of 1992, SROs were introduced in the            already provided connectivity to more than 100 cit-



                                                               ○
                                                               ○
      Indian capital market, but they are not yet opera-           ies, and other major stock exchanges are in the pro-


                                                               ○
                                                               ○
      tional. A clear regulatory framework has yet to be           cess of extending their trading terminals outside their

                                                               ○
                                                               ○
      set up, and relevant market participants are not ready       places of operation. Thus, it is questionable whether
                                                               ○
                                                               ○




      to regulate themselves for professional purposes. The        India needs as many as 22 stock exchanges, even
                                                               ○
                                                               ○




      only securities-related SROs in India whose regula-          taking into account the vastness of the country.
                                                               ○
                                                               ○




      tory frameworks have been well established and
                                                               ○
                                                               ○




      which are actually functioning are the recognized            SPECULATIVE INVESTMENT
                                                               ○
                                                               ○




      stock exchanges. Participants in the Indian capital          Turnover in the Indian stock exchanges is high, im-
                                                               ○
                                                               ○




      market seem to have successfully preserved the spirit        plying that they are dominated by speculative invest-
                                                               ○
                                                               ○




      and practice of self-regulation or self-governance in        ments, which is not unusual in emerging markets.
                                                               ○
                                                               ○




      the old stock exchanges such as BSE. However, it is          However, trading volumes in the Indian capital mar-
                                                               ○
                                                               ○




      true that the old stock exchanges have been rife with        ket are fairly large compared to those in other emerg-
                                                               ○
                                                               ○




      vested interests of member brokers who are not fully         ing markets. While price levels have been depressed,
                                                               ○
                                                               ○




      friendly to investors.                                       the total turnover on BSE and NSE has been increas-
                                                               ○
                                                               ○




                                                                   ing. The combined turnover for 1996/97 was almost
                                                               ○
                                                               ○




      Stock Market
                                                               ○




                                                                   three times the level of the previous year. Figure 3
                                                               ○
                                                               ○




      FRAGMENTED MARKET                                            shows the total turnover of stock trading on all 22
                                                               ○
                                                               ○




      Of the 22 stock exchanges in the country, 17 have            stock exchanges in India. The annual average growth
                                                               ○
                                                               ○




      introduced screen-based trading. With the expan-             rate from 1994/95 to 1996/97 was 56 percent in nomi-
                                                               ○
                                                               ○




      sion of trading networks of BSE and other stock              nal terms.
                                                               ○
                                                               ○




      exchanges beyond their original jurisdictions, an in-           Table 7 compares the dollar turnovers and liquid-
                                                               ○
                                                               ○




      creasing number of investors in different parts of           ity ratios on BSE and NSE with stock exchanges in
                                                               ○
                                                               ○




      the country are within the reach of a national mar-          other economies in 1996. The combined turnover on
                                                               ○
                                                               ○




      ket system. This has raised informational efficiency         BSE and NSE, which are both located in Mumbai,
                                                               ○
                                                               ○




      and helped rapid market integration.                         exceeded that of some other stock markets in Asia.
                                                               ○
                                                               ○




         NSE, which provides a screen-based order driven           This is because of the remarkably high liquidity ratio
                                                               ○
                                                               ○




      system, has already extended its network to more             on NSE. Considering that the majority of about 6,000
                                                               ○
                                                               ○




      than 100 centers in the country that are connected to        stocks listed on BSE have low liquidity, it can be in-
                                                               ○
                                                               ○




      its central computer via its satellite network. The          ferred that a group of the 1,500 most traded stocks
                                                               ○
                                                                         INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES                                      123


                                                                                            stitution of at least 5 percent of the total project




                                                                                        ○
 Figure 3: Turnover of Stock Trading in India




                                                                                        ○
                                                                                            cost. There has been a debate on whether this en-




                                                                                        ○
                                                                                        ○
    Rs billion
                                                                                            try condition is too restrictive. But the measure




                                                                                        ○
    8,000




                                                                                        ○
                                                                                            seems necessary to help recover investor confidence




                                                                                        ○
                                                                                        ○
    6,000                                                                                   in the corporate sector.




                                                                                        ○
                                                                                        ○
                                                                                               The process of public subscription in the Indian




                                                                                        ○
                                                                                        ○
    4,000
                                                                                            market is lengthy and fraught with uncertainty. For




                                                                                        ○
                                                                                        ○
                                                                                            domestic equity issues, the process requires compul-




                                                                                        ○
    2,000




                                                                                        ○
                                                                                            sory fallback underwriting, setting up of 30 manda-




                                                                                        ○
                                                                                        ○
          0                                                                                 tory collection centers across the country for col-




                                                                                        ○
                    1994/95               1995/96               1996/97




                                                                                        ○
                                                                                            lecting subscriptions from investors, and price deter-




                                                                                        ○
                                                                                        ○
 Source: Securities and Exchange Board of India, Annual Report, 1995/96 and 1996/97.
                                                                                            mination of at least 45 days before the date of issue.



                                                                                        ○
                                                                                        ○
                                                                                            Once an issue has been subscribed, postsubscription

                                                                                        ○
                                                                                        ○
on BSE would also have a considerably high liquidity                                        procedures require 60 days to elapse before the se-
                                                                                        ○
                                                                                        ○
ratio (Endo 1998). The substantial increase in turn-                                    ○
                                                                                        ○
                                                                                            curities are listed. Investors are forced to remain il-
over may be attributed primarily to the recent ex-                                          liquid during that period, or resort to the gray market
                                                                                        ○
                                                                                        ○




pansion of the NSE’s trading network. But this also                                         to meet liquidity needs. The cost of delay is likely to
                                                                                        ○
                                                                                        ○




reflects the fact that the Indian stock market is domi-                                     be incorporated by investors in the price at which
                                                                                        ○
                                                                                        ○




nated by speculative investments for short-term capi-                                       they are prepared to subscribe to an issue. This raises
                                                                                        ○
                                                                                        ○




tal gains, rather than long-term investment.                                                costs to an issuer, besides encouraging clandestine
                                                                                        ○
                                                                                        ○




                                                                                            activities such as gray markets.
                                                                                        ○
                                                                                        ○




BARRIERS TO INITIAL PUBLIC OFFERINGS
                                                                                        ○




                                                                                            Transaction Costs in the
                                                                                        ○




In April 1996, SEBI announced a policy initiative
                                                                                        ○




                                                                                            Secondary Market
                                                                                        ○




that makes access to the primary market more re-
                                                                                        ○
                                                                                        ○




strictive. SEBI requires that a firm that wishes to                                         Screen-based trading introduces a greater degree
                                                                                        ○
                                                                                        ○




go public should have a three-year track record of                                          of transparency and reduces spreads. Market ma-
                                                                                        ○
                                                                                        ○




dividends. If this is not satisfied, it should at least                                     nipulation becomes more difficult with screen-based
                                                                                        ○
                                                                                        ○




have a project with investment from a financial in-                                         trading and easier to investigate on account of the
                                                                                        ○
                                                                                        ○
                                                                                        ○




 Table 7:        Turnovers and Liquidity Ratios of Indian and Foreign Stock Exchanges, 1996
                                                                                        ○
                                                                                        ○




   Item                                                                                       Turnover ($ billion)a                                     Liquidity Ratiob
                                                                                        ○
                                                                                        ○




   Indian Stock Exchanges
                                                                                        ○




     Bombayc                                                                                             26.5                                                0.22
                                                                                        ○




     Nationalc                                                                                           69.1                                                0.65
                                                                                        ○
                                                                                        ○




   Foreign Stock Exchanges
                                                                                        ○




     Hong Kong, China                                                                                  182.6                                                 0.48
                                                                                        ○
                                                                                        ○




     Jakarta                                                                                            32.6                                                 0.41
                                                                                        ○




     Kuala Lumpur                                                                                      183.0                                                 0.68
                                                                                        ○




     London                                                                                            390.1                                                 0.25
                                                                                        ○
                                                                                        ○




     New York                                                                                        3,728.4                                                 0.58
                                                                                        ○




     Singapore                                                                                          51.9                                                 0.27
                                                                                        ○




     Thailand                                                                                           51.3                                                 0.43
                                                                                        ○




     Tokyod
                                                                                        ○




                                                                                                       885.7                                                 0.28
                                                                                        ○
                                                                                        ○




   aConverted into dollar amounts, using the simple averages of the year-end rates in 1995 and 1996; foreign companies and investment funds are excluded.
                                                                                        ○




   bTurnover/average market capitalization.
                                                                                        ○




   cStocks listed and permitted to trade.
                                                                                        ○




   dThe first section only. The second section was not included.
                                                                                        ○




   Source: Bombay Stock Exchange, National Stock Exchange, and Nikko Research Center.
                                                                                        ○
124    A STUDY OF FINANCIAL MARKETS



      transparent audit trails that are established. As esti-        tains a Subsidiary General Ledger in its Public Debt




                                                                 ○
                                                                 ○
      mated by Shah and Thomas (1997), the total trans-              Office. Transfer of ownership takes place through




                                                                 ○
                                                                 ○
      action costs in India’s equity market have been re-            book entry transfer in this ledger. In the case of




                                                                 ○
                                                                 ○
      duced by half, i.e., from 5 to 2.5 percent since the           corporate securities, the issuer maintains a register




                                                                 ○
                                                                 ○
      introduction of screen-based trading (Table 8). But            of members or holders of securities, and the issu-




                                                                 ○
                                                                 ○
      this is still high compared to advanced markets.               ers or their register or transfer agents have to physi-




                                                                 ○
                                                                 ○
         When depository, derivatives, and indexation are            cally receive the securities from a transferee ac-




                                                                 ○
                                                                 ○
      fully in place, the transaction costs of the Indian eq-        companied by a transfer deed signed by the transf-




                                                                 ○
                                                                 ○
      uity market could be even lower than those of most             eror before a transfer is effected. There are no




                                                                 ○
                                                                 ○
      advanced countries.                                            bearer securities in India. The majority of the settle-




                                                                 ○
                                                                 ○
                                                                     ment of transactions in the securities market con-




                                                                 ○
                                                                 ○
      CLEARING, SETTLEMENT, AND DEPOSITORIES                         tinues to be based on physical movement of certifi-




                                                                 ○
                                                                 ○
      Account settlement period of stock exchanges that              cates. This results in delays, bottlenecks, and an



                                                                 ○
                                                                 ○
      earlier had a 14-day trading cycle has been short-             increase in transaction costs besides creating vari-


                                                                 ○
                                                                 ○
      ened to seven days (effectively five days because of           ous risks for market participants such as bad deliv-

                                                                 ○
                                                                 ○
      two intervening no trading days on Saturday and                ery, fraud, and theft. Because the clearing and
                                                                 ○
                                                                 ○




      Sunday). Both BSE and NSE process net obliga-                  settlement infrastructure in the stock exchanges
                                                                 ○
                                                                 ○




      tions over a five-day account period and complete              cannot keep up with the flow of paper, especially
                                                                 ○
                                                                 ○




      the settlement on the 15th day from the commence-              as trading expands to different parts of the country,
                                                                 ○
                                                                 ○




      ment of trading for an account period. Other stock             the exchanges have been unable to shorten settle-
                                                                 ○
                                                                 ○




      exchanges are also moving into this cycle. In the              ment cycles or move to rolling settlement, which
                                                                 ○
                                                                 ○




      case of NSE, the National Securities Clearing Cor-             are essential to reduce settlement risk.
                                                                 ○
                                                                 ○




      poration, Ltd., its wholly owned subsidiary, provides             The Depositories Act of 1996 allows for demate-
                                                                 ○
                                                                 ○




      a settlement guarantee. In the case of BSE, the clear-         rialization of securities in depositories and the trans-
                                                                 ○
                                                                 ○




      ing house is operated by Bank of India Shareholding            fer of securities through electronic book entry. As
                                                                 ○
                                                                 ○




      Ltd., which is jointly owned by BSE and the Bank of            the depository network expands and the proportion
                                                                 ○
                                                                 ○




      India.                                                         of dematerialized securities in depositories increases,
                                                                 ○
                                                                 ○




         In India, certificates of securities are registered         the benefits are expected to extend to the vast ma-
                                                                 ○
                                                                 ○




      with the issuer. For Government securities, the
                                                                 ○




                                                                     jority of market participants. The National Securities
                                                                 ○
                                                                 ○




      record of ownership is kept by RBI, which main-                Depository, Ltd. (NSDL) has been granted a certifi-
                                                                 ○
                                                                 ○
                                                                 ○




      Table 8:        Comparison of Transaction Costs Between Indian and New York Equity Markets (percent)
                                                                 ○
                                                                 ○
                                                                 ○




                                                                      India                                      New York
                                                                 ○




        Component                                Mid-1993            Todaya         Future Scenario               Todaya
                                                                 ○
                                                                 ○




        Trading                                  3.75                 0.75               0.40                      1.23
                                                                 ○




          Brokerage                              3.00                 0.50               0.25                      1.00
                                                                 ○
                                                                 ○




          Market impact cost                     0.75                 0.25               0.15                      0.23
                                                                 ○




        Clearing
                                                                 ○




          Counterparty risk                      Present             In part             0.00                      0.00
                                                                 ○
                                                                 ○




        Settlement                               1.25                 1.75               0.10                      0.05
                                                                 ○




          Paperwork cost                         0.75                 0.75               0.10                      0.05
                                                                 ○
                                                                 ○




          Bad paper risk                         0.50                 1.00               0.00                      0.00
                                                                 ○




        Total                                    5.00 (+ risk)        2.50               0.50                      1.28
                                                                 ○
                                                                 ○




        a 1996-1997
                                                                 ○
                                                                 ○




        Source: Shah and Thomas (1997).
                                                                 ○
                                                                       INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES               125


cate of commencement of business by SEBI. As of                                        MARK-TO-MARKET




                                                                                   ○
                                                                                   ○
May 1998, 197 issues (about 50 percent of market                                       Banks tend to hold Government securities to matu-




                                                                                   ○
                                                                                   ○
capitalization) have applied for dematerialization and                                 rity to avoid a capital loss on the balance sheet. Until




                                                                                   ○
                                                                                   ○
about 10 percent of them have been dematerialized.                                     1996, only 40 percent of the portfolio of Government




                                                                                   ○
                                                                                   ○
In contrast, only three issues had signed for the same                                 securities had to be marked-to-market. Starting fis-




                                                                                   ○
                                                                                   ○
as of November 1996. If about 300 to 400 issues                                        cal year 1996/97, the requirement has been raised to




                                                                                   ○
                                                                                   ○
apply for dematerialization, they will cover about 90                                  50 percent for existing banks and 100 percent for




                                                                                   ○
                                                                                   ○
percent of trading volume. As of May 1998, there                                       the new private sector banks.




                                                                                   ○
                                                                                   ○
were 52 depository participants, which include bro-                                       The pattern of ownership of Government secu-




                                                                                   ○
                                                                                   ○
kers, banks, and custodians—an increase from 22                                        rities is shown in Table 9. The biggest holders of




                                                                                   ○
                                                                                   ○
participants in 1996. Thus, it is expected that dema-                                  both central and state Government securities are




                                                                                   ○
                                                                                   ○
terialization of trade will proceed quickly although its                               commercial banks, with more than two thirds of



                                                                                   ○
                                                                                   ○
completion may still take some time.                                                   the total. Life insurance companies have also in-

                                                                                   ○
                                                                                   ○
                                                                                       creased their holdings of Government securities.
                                                                                   ○
Debt Market                                                                        ○
                                                                                   ○
                                                                                   ○
                                                                                       Banks and life insurance companies are captive
HIGH STATUTORY LIQUIDITY REQUIREMENT                                                   markets for Government securities due to the port-
                                                                                   ○
                                                                                   ○




The debt market is not well developed in India. Even                                   folio restrictions imposed on them. Meanwhile, the
                                                                                   ○
                                                                                   ○




though the volume of Government bonds outstand-                                        market for private companies’ debentures is not
                                                                                   ○
                                                                                   ○




ing is large, banks and other financial institutions                                   yet well developed.
                                                                                   ○
                                                                                   ○




hold a substantial part of these bonds as liquidity
                                                                                   ○
                                                                                   ○




requirement. The statutory liquidity requirement (on                                   PRIMARY DEALERS
                                                                                   ○
                                                                                   ○




top of cash requirement of 10 percent) has been                                        Table 10 shows the market borrowings of the cen-
                                                                                   ○
                                                                                   ○




reduced from 25 to 23 percent. But this is still high                                  tral and state Governments. The total issue of Gov-
                                                                                   ○
                                                                                   ○




and should be further decreased to activate the pri-                                   ernment securities and net borrowing of the Govern-
                                                                                   ○
                                                                                   ○




vate debt market.                                                                      ment have increased.
                                                                                   ○
                                                                                   ○
                                                                                   ○
                                                                                   ○




 Table 9:     Pattern of Ownership of Gilt-edged Securities (percent)
                                                                                   ○
                                                                                   ○




   Item                                      1969           1980            1990        1991     1992      1993      1994     1995      1996
                                                                                   ○
                                                                                   ○




   Central Government
                                                                                   ○




   Securities
                                                                                   ○




     Reserve Bank of India                  37.5           20.3            22.6         24.8    22.3      10.6       3.0       2.5       9.0
                                                                                   ○
                                                                                   ○




     Commercial banks                       20.4           44.9            53.4         55.1    59.9      64.6      71.9      68.0        na
                                                                                   ○




     LIC                                    11.5           11.8            12.9         13.4      na      16.3      16.9      17.2      17.8
                                                                                   ○




     PPF                                    23.3           15.3             1.1          0.0     1.1       0.8       0.6       0.5       0.6
                                                                                   ○
                                                                                   ○




     Others                                  7.3            7.7            10.0          6.7      na       5.2       0.4       3.3        na
                                                                                   ○




   Total                                   100.0          100.0           100.0        100.0   100.0     100.0     100.0     100.0     100.0
                                                                                   ○
                                                                                   ○




   State Government
                                                                                   ○




   Securities
                                                                                   ○




     Reserve Bank of India                   0.3            0.0             0.0          0.0     0.0       0.0       0.0       0.0       0.0
                                                                                   ○
                                                                                   ○




     Commercial banks                       37.9           56.5            79.5         78.6    79.1      72.7      74.8      73.0        na
                                                                                   ○




     LIC                                    24.0           19.1             6.0          6.9     7.8         9      11.1      11.8      12.2
                                                                                   ○
                                                                                   ○




     PPF                                     3.1           21.0             2.7          0.0     3.4       2.9       2.8       2.8       4.0
                                                                                   ○




     Others                                 34.7            3.4            11.8         15.5      na      15.5      11.2      12.4        na
                                                                                   ○




   Total                                   100.0          100.0           100.0        100.0   100.0     100.0     100.0     100.0     100.0
                                                                                   ○
                                                                                   ○
                                                                                   ○
                                                                                   ○




  na = not available.
                                                                                   ○




  LIC = Life Insurance Corporation of India, PPF = Public Provident Funds.
                                                                                   ○




  Source: Reserve Bank of India, Report on Currency and Finance, various issues.
                                                                                   ○
126    A STUDY OF FINANCIAL MARKETS




                                                                                          ○
       Table 10:      Market Borrowings of the Government of India (Rs billion)




                                                                                          ○
                                                                                          ○
                                                          Total                                      Subscription                         Net




                                                                                          ○
              Year                                       Issues                          Cash        Conversion       Total            Borrowing




                                                                                          ○
                                                                                          ○
                                                                              Central Government




                                                                                          ○
                                                                                          ○
           1970/71                                        4.0                           2.3             2.0            4.3                 1.3




                                                                                          ○
           1975/76                                        6.0                           4.7             1.9            6.6                 4.5




                                                                                          ○
                                                         26.3                          27.3             1.4           28.7                26.0




                                                                                          ○
           1980/81




                                                                                          ○
           1985/86                                       53.3                          55.5             2.1           57.6                50.0




                                                                                          ○
           1990/91                                       89.9                          85.3             4.6           89.9                80.0




                                                                                          ○
                                                         89.1                          78.4            10.7           89.1                75.0




                                                                                          ○
           1991/92




                                                                                          ○
           1992/93                                      138.9                         137.4             1.5          138.9                47.9




                                                                                          ○
           1993/94                                      490.1                         490.1                          490.1               261.5




                                                                                          ○
                                                        381.1                         381.1                          381.1               200.7




                                                                                          ○
           1994/95




                                                                                          ○
           1995/96                                      405.1                         405.1                          405.1               267.9




                                                                                          ○
           1996/97                                      296.2                         296.2                          296.2               200.0




                                                                                          ○
                                                                                State Government




                                                                                          ○
                                                                                          ○
           1970/71                                         1.4                          1.2             0.3             1.6                1.0




                                                                                          ○
           1975/76                                         2.5                          2.7                             2.7                2.7




                                                                                          ○
                                                           3.0                          2.8             0.5             3.3                2.0



                                                                                          ○
           1980/81



                                                                                          ○
           1985/86                                        12.8                         11.9             2.3            14.1                9.7


                                                                                          ○
           1990/91                                        25.6                         25.7                            25.7               25.7

                                                                                          ○
                                                          33.4                         33.6                            33.6               33.6
                                                                                          ○
           1991/92
                                                                                          ○



           1992/93                                        38.0                         37.1
                                                                                          ○

                                                                                                        1.0            38.1               34.7
           1993/94                                        41.4                         41.4                            41.4               36.4
                                                                                          ○




                                                          51.2                         51.2                            51.2               51.2
                                                                                          ○




           1994/95
                                                                                          ○




           1995/96                                        62.7                         62.7                            62.7               59.3
                                                                                          ○




           1996/97                                        65.4                         65.4                            65.4               65.4
                                                                                          ○
                                                                                          ○
                                                                                          ○
                                                                                          ○




        Source: Reserve Bank of India, Report on Currency and Finance, various issues.
                                                                                          ○
                                                                                          ○
                                                                                          ○
                                                                                          ○
                                                                                          ○




          A primary auction market for Government secu-                                       PRIVATE PLACEMENT
                                                                                          ○
                                                                                          ○




      rities has been created and six primary dealers have                                    The number of private placements has risen in re-
                                                                                          ○
                                                                                          ○




                                  2
      been authorized by RBI. However, the auctions still                                     cent years. It is estimated that about 40 percent
                                                                                          ○
                                                                                          ○




      do not seem to take place fully on a market basis,                                      of total resources mobilized by public and private
                                                                                          ○
                                                                                          ○




      mainly because Government securities are not is-                                        companies in the Indian capital market in 1995/96
                                                                                          ○
                                                                                          ○




      sued at completely market rates.
                                                                                          ○




                                                                                              was through private placement, and this increased
                                                                                          ○
                                                                                          ○




          Other factors seem to be inhibiting the market                                      further to close to 50 percent in 1996/97 (Table
                                                                                          ○
                                                                                          ○




      clearing mechanism in the primary auction market.                                       11). The share of the public sector in total private
                                                                                          ○
                                                                                          ○




      First, there is yet no preannounced notification amount                                 placements was about 70 percent in 1995/96, which
                                                                                          ○
                                                                                          ○




      in 364-day and 14-day auctions. This procedure en-                                      rose to about 84 percent in 1996/1997. There are
                                                                                          ○
                                                                                          ○




      ables RBI to determine in a flexible manner either                                      several advantages to tapping private placements
                                                                                          ○
                                                                                          ○




      the cutoff price or the amounts to be accepted. Re-                                     instead of resorting to public issues. However, cer-
                                                                                          ○
                                                                                          ○




      moving uncertainty by notifying auction volumes will                                    tain problems need to be addressed for the well-
                                                                                          ○
                                                                                          ○




      bring about more transparency in the auction proce-                                     directed and efficient functioning of the market.
                                                                                          ○
                                                                                          ○




      dure. Second, noncompetitive bids are allowed in 91-                                    At present, there is no transparency in this market
                                                                                          ○
                                                                                          ○




      day and 14-day Treasury bill auctions. Since state                                      and virtually little information. In developed mar-
                                                                                          ○
                                                                                          ○




      Governments are major noncompetitive bidders in                                         kets, the regulatory authorities indicate the frame-
                                                                                          ○
                                                                                          ○




      India, their participation in Treasury bill auctions                                    work within which private placements have to
                                                                                          ○
                                                                                          ○




      causes further uncertainty in auction volumes.                                          function.
                                                                                          ○
                                                     INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES                             127




                                                                  ○
 Table 11:          Private Placement in the Capital Market




                                                                  ○
                                                                  ○
                                                                                                      Total Resources      Percentage
                                                    Private Placement
                                                                                                        Mobilizeda




                                                                  ○
                                                                                                                            of Private




                                                                  ○
           Year                   Private sector      Public sector                Total                (Rs billion)       Placements




                                                                  ○
                                                   Amount (Rs billion)a




                                                                  ○
                                                                  ○
        1995/96                      40.71                92.90                  133.61                   339.98                39.3




                                                                  ○
        1996/97                      24.93               125.73                  150.66                   306.74                49.1




                                                                  ○
                                                        Share (%)




                                                                  ○
                                                                  ○
        1995/96                      30.50                69.50                  100.00




                                                                  ○
        1996/97                      16.50                83.50                  100.00




                                                                  ○
                                                                  ○
   a Provisional.




                                                                  ○
    Source: Submaranian (1998).




                                                                  ○
                                                                  ○
                                                                  ○
                                                                  ○
DEVELOPMENT OF SECONDARY MARKET                                       Table 12: Resources Mobilized by Domestic Mutual




                                                                  ○
                                                                  ○
While there has been increased activity in primary                              Funds (Rs billion)




                                                                  ○
                                                                  ○
debt issues, the secondary market for debt is yet to                    Period                                     Resources Mobilized



                                                                  ○
                                                                  ○
become active. The entry of FIIs into the debt mar-                     1964-1987                                         45.63

                                                                  ○
                                                                        1987-1992                                        329.77
                                                                  ○
ket and the launching of fixed income schemes and                 ○
                                                                  ○




                                                                        1992-1997
                                                                                  a
                                                                                                                         458.45
money market schemes by mutual funds are expected                       Total                                            833.85
                                                                  ○
                                                                  ○




to activate the debt market. Several technical im-
                                                                  ○




                                                                        a Until January 1997.
                                                                  ○




                                                                        Source: Submaranian (1998).
pediments that prevented more active secondary
                                                                  ○
                                                                  ○




market trading in Government securities have been
                                                                  ○




                                                                      Table 13: Resource Mobilization, by Type of Mutual
                                                                  ○




removed over the past few years. But still there are                            Funds (Rs billion)
                                                                  ○
                                                                  ○




significant barriers to the active development of the                   Item                              1994/95    1995/96     1996/97a
                                                                  ○
                                                                  ○




secondary market for fixed income assets.                               Public sector mutual funds          21.43        2.96          1.51
                                                                  ○
                                                                  ○




                                                                        Private sector mutual funds         20.84        3.12          3.46
                                                                  ○




Investors
                                                                  ○




                                                                        United Trust of India               95.00       59.00      42.80
                                                                  ○




                                                                        Total                             137.27        65.08      47.77
                                                                  ○




MUTUAL FUNDS
                                                                  ○
                                                                  ○




Table 12 shows increasing resource mobilization by                      a As of January 1997.
                                                                  ○




                                                                        Source: Submaranian (1998).
                                                                  ○




mutual funds. However, over the last few years, the
                                                                  ○
                                                                  ○




performance of mutual funds has not been encour-
                                                                  ○
                                                                  ○




aging. Investor confidence in mutual funds, which                     FOREIGN INSTITUTIONAL INVESTORS
                                                                  ○
                                                                  ○




ideally should be the most preferred investment ve-                   Accumulated net investment of FIIs contribute less
                                                                  ○
                                                                  ○




hicles for the lay investor, has been low and the luke-               than 7 percent of total market capitalization of the
                                                                  ○
                                                                  ○




warm response seen in 1995/96 continued in 1996/                      Indian capital market and less than 10 percent of
                                                                  ○
                                                                  ○




97 (Table 13). This could be attributed partly to mar-                the outstanding external debt of the country. India’s
                                                                  ○
                                                                  ○




ket conditions, which have affected the perception                    external debt position has shown considerable im-
                                                                  ○
                                                                  ○




of investors. With the revised SEBI (Mutual Fund)                     provement in the recent past. The debt-GDP ratio
                                                                  ○
                                                                  ○




Regulations of 1996, mutual funds have been given                     fell from 41 percent in March 1992 to 25.9 per-
                                                                  ○
                                                                  ○




greater flexibility to operate schemes. It is expected                cent in March 1997. Short-term debt and the vola-
                                                                  ○
                                                                  ○




that as a result of this liberalization, mutual funds will            tility of FIIs may well affect the performance of
                                                                  ○
                                                                  ○




introduce innovative products to attract investors. The               India’s stock markets, but would not yet pose a
                                                                  ○
                                                                  ○




revised regulations have also introduced greater trans-               significant threat to cause a foreign exchange cri-
                                                                  ○
                                                                  ○




parency and accountability, which is anticipated to                   sis. However, if these were coupled with an in-
                                                                  ○
                                                                  ○




boost investor confidence.                                            crease in nonresident Indian (NRI) deposits, there
                                                                  ○
128    A STUDY OF FINANCIAL MARKETS




                                                                                           ○
       Table 14:      India’s External Debt ($ billion)




                                                                                           ○
                                                                                           ○
                                                                                           ○
         Item                                                                1985         1990      1991    1992    1994    1995     1996    1997




                                                                                           ○
                                                                                           ○
         Medium- and long-term




                                                                                           ○
           External assistance                                             19.31         32.15    34.28    38.10   43.71   48.81   47.29    46.28




                                                                                           ○
           International Monetary Fund                                      3.93          1.50     2.62     3.45    5.04    4.30    2.37     1.31




                                                                                           ○
                                                                                           ○
           External commercial borrowing                                    5.56         13.74    14.78    16.08   17.57   19.62   18.27    18.85




                                                                                           ○
                                                                                           ○
         Nonresident Indian deposits                                        3.08         10.36    10.58     7.85   12.67   12.38   11.01    11.13




                                                                                           ○
         Short-term                                                           na            na     4.80     3.19    3.63    4.27    5.03     6.73




                                                                                           ○
                                                                                           ○
        Source: Reserve Bank of India, Report in Currency and Finance, various issues.




                                                                                           ○
                                                                                           ○
                                                                                           ○
                                                                                           ○
      may well be the potential for a currency crisis if                                       mobilization through primary market issues. Further




                                                                                           ○
                                                                                           ○
      India fails to carefully manage its macroeconomic                                        strengthening of investor protection, and improve-




                                                                                           ○
                                                                                           ○
      environment.                                                                             ments in transparency, corporate governance, and




                                                                                           ○
                                                                                           ○
                                                                                               monitoring will be necessary. The capital market in-



                                                                                           ○
      Policy Recommendations

                                                                                           ○
                                                                                               frastructure, such as accounting standards and legal

                                                                                           ○
                                                                                           ○
      Over the last few years, there have been substantial                                     mechanisms, should also be improved to this end.
                                                                                           ○
                                                                                           ○
      reforms in the Indian capital market. But there are                                  ○
                                                                                           ○
                                                                                               On the supply side, to encourage corporate firms to
      still many issues to be addressed to make it more                                        rely more on stock markets for their source of fi-
                                                                                           ○
                                                                                           ○




      efficient in mobilizing and allocating capital.                                          nancing, the issuing costs in terms of length of time
                                                                                           ○
                                                                                           ○




          Investor confidence in stock investment is low.                                      required and administrative burden should be stream-
                                                                                           ○
                                                                                           ○




      This must be regained in order to encourage capital                                      lined (Table 15).
                                                                                           ○
                                                                                           ○
                                                                                           ○
                                                                                           ○




       Table 15:      Matrix of Policy Recommendations
                                                                                           ○
                                                                                           ○
                                                                                           ○




        Issues                             Policy Recommendation
                                                                                           ○
                                                                                           ○




        A. Market infrastructure
                                                                                           ○




           1. Accounting                   • Improve accounting principles, make them consistent with international practice.
                                                                                           ○




              principles                   • Strictly enforce punitive measures for inaccurate accounting practice.
                                                                                           ○




                                           • Establish prompt and effective settlement of disputes to protect small investors’ interests.
                                                                                           ○




           2. Legal mechanism
                                                                                           ○




        B. Corporate                       • Grant institutional investors voting power.
                                                                                           ○




           governance                      • Allow hostile takeovers.
                                                                                           ○




                                           • Require consolidated balance sheets for conglomerates-affiliated firms to better monitor cross-
                                                                                           ○




                                             subsidization and internal transactions between affiliated firms.
                                                                                           ○
                                                                                           ○




        C. Cost of capital issue           • Streamline the procedure for public subscription of securities to reduce transaction costs in
                                                                                           ○




                                             terms of time lag and uncertainty.
                                                                                           ○




        D. Debt market
                                                                                           ○




           1. Diversification of           • Apply fully market-based interest rates for issuing Government securities.
                                                                                           ○




              investors                    • Further reduce statutory liquidity requirements.
                                                                                           ○
                                                                                           ○




                                           • Further enhance the credibility of credit rating agencies.
                                                                                           ○




           2. Stamp duty                   • Amend stamp duty regime by the Government of Maharashtra, where Mumbai is located, in the
                                                                                           ○




                                             form of one time levy or consolidated fee payable by National Securities Depository, Ltd (NSDL).
                                                                                           ○




           3. Private placement            • Indicate the framework within which the private placement has to function to protect investors
                                                                                           ○




                                             from risk associated with subscriptions in the private placement market.
                                                                                           ○
                                                                                           ○




        E. Integration of stock            • Provide favorable environment or some incentives for establishing central trading system through
                                                                                           ○




           exchanges and                     interconnectivity.
                                                                                           ○




           consolidation of                • Encourage the corporatization and merger of brokers and merchant bankers through tax
                                                                                           ○




           intermediaries                    incentives.
                                                                                           ○
                                                                                           ○




        F. Risk management                 • Securities and Exchange Board of India to more closely monitor and inspect the intermediaries
                                                                                           ○




                                             and stock exchanges and, if necessary, strengthen punitive measures.
                                                                                           ○




        G. Integration of the              • Banking system to establish a good electronic funds transfer (EFT) solution to enable direct
                                                                                           ○




           capital market with               payments of dividends to bank accounts, eliminate counterparty risk, and facilitate FIIs.
                                                                                           ○




           the banking sector              • Encourage sound competition between the banking sector and the capital market through more
                                                                                           ○
                                                                                           ○




                                             banking liberalization.
                                                                                           ○
                                                                                           ○
                                                                                           ○
                                                INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES              129


Market Infrastructure Improvement                               a practice not yet done in India. Furthermore, the




                                                            ○
                                                            ○
ACCOUNTING PRINCIPLES                                           authorities may enforce a consolidated accounting




                                                            ○
                                                            ○
The financial statements of an issuing company in its           principle for conglomerate-affiliated firms in order




                                                            ○
                                                            ○
disclosure documents are prepared in accordance                 to better monitor cross-subsidization and internal




                                                            ○
                                                            ○
with India’s generally accepted accounting principles           transactions between affiliated firms. These mea-




                                                            ○
                                                            ○
(GAAP). The increasing exposure of Indian listed                sures will greatly improve the capital market envi-




                                                            ○
                                                            ○
firms to international investors has compelled them             ronments for corporate governance.




                                                            ○
                                                            ○
to adopt more internationally acceptable accounting




                                                            ○
                                                                Reduction of Cost of Capital Issue




                                                            ○
principles. The Institute of Chartered Accountants




                                                            ○
                                                            ○
of India has issued a note to introduce new account-            Transaction costs involved in the public issue of se-




                                                            ○
                                                            ○
ing standards starting fiscal year 1995/96. Yet, In-            curities seem high due to the length of time required.




                                                            ○
                                                            ○
dian GAAP is considerably different from that of                This time-consuming process also increases issuers’



                                                            ○
                                     3




                                                            ○
internationally accepted principles. To raise the cred-         uncertainty and tends to push them towards private

                                                            ○
                                                            ○
ibility of corporate financial statements and trans-            placements. Streamlining the procedure for public
                                                            ○
                                                            ○
parency, accounting principles should be improved           ○
                                                            ○
                                                                subscription of securities is necessary not only to re-
further to make them consistent with international              duce administrative burdens and transaction costs,
                                                            ○
                                                            ○




practice. In relation to this, the credibility of the ac-       but also to lessen firms’ uncertainty.
                                                            ○
                                                            ○




counting profession should also be enhanced through
                                                            ○




                                                                Activation of the Debt Market
                                                            ○




stricter enforcement of punitive measures for inac-
                                                            ○
                                                            ○




curate accounting practices.                                    Several policy measures have been taken to acti-
                                                            ○
                                                            ○




                                                                vate the debt market, such as competitive pricing
                                                            ○
                                                            ○




LEGAL MECHANISM                                                 of Government securities, initiation of open market
                                                            ○
                                                            ○




The problems of the court system and legal mecha-               operation including repo operation, and a larger per-
                                                            ○
                                                            ○




nism to settle disputes in India have been frequently           centage of mark-to-market valuation. These mea-
                                                            ○
                                                            ○




raised. After floating shares in the market, investors          sures have had a beneficial impact on the system,
                                                            ○
                                                            ○




should be able to monitor corporate performance                 such as greater market absorption of Government
                                                            ○
                                                            ○




closely to protect their interests. Prompt and effec-           securities, lower absorption by RBI, and increased
                                                            ○
                                                            ○




tive settlement of disputes is also critical. According         attention by investors to interest rate risk manage-
                                                            ○
                                                            ○




to a recent survey by Gupta (1998), 65 percent of               ment. For instance, RBI’s absorption of primary
                                                            ○
                                                            ○




those who brought complaints to court indicated that            issues was 13.3 and 16.6 percent in 1996/97 and
                                                            ○




                                                                         4
                                                            ○




the cases have not been resolved. Even though mi-               1997/98, respectively, as against 32.6 percent in
                                                            ○
                                                            ○




nority shareholders can now bring their complaints              1995/96 and 45.6 percent in 1992/93. However, fur-
                                                            ○
                                                            ○




to the court, they are discouraged from doing so be-            ther measures have to be implemented to encour-
                                                            ○
                                                            ○




cause the legal mechanism is very slow. Measures                age the development of the debt market, including
                                                            ○
                                                            ○




are therefore needed to expedite court decisions and            reduction of the 23 percent statutory liquidity re-
                                                            ○
                                                            ○




protect small investors’ interests.                             quirement ratio and 100 percent mark-to-market
                                                            ○
                                                            ○




                                                                valuation for all banks.
                                                            ○




Improvement of Corporate
                                                            ○
                                                            ○




Governance Environment
                                                            ○




                                                                DIVERSIFICATION OF INVESTOR BASE
                                                            ○
                                                            ○




To boost corporate governance, the authorities may              In order to increase liquidity of Government securi-
                                                            ○
                                                            ○




consider giving institutional investors voting power,           ties, diversification of the investor base with nontra-
                                                            ○
                                                            ○




which is prohibited now, and allow hostile takeovers,           ditional investor groups such as individuals, firms,
                                                            ○
130     A STUDY OF FINANCIAL MARKETS



      trusts, and corporate entities is necessary. Diversifi-        ment could be attributed to lower issuing cost and




                                                                 ○
                                                                 ○
      cation is also important to promote an active market           savings on issue management time lag, apart from




                                                                 ○
                                                                 ○
      in which investors’ buying and selling needs vary              the fact that private placement has not been subject




                                                                 ○
                                                                 ○
      across time. Banks, financial institutions, and provi-         to the strict regulatory provisions applicable to public




                                                                 ○
                                                                 ○
      dent funds are the predominant holders of Govern-              issues. At present, there is no transparency in this




                                                                 ○
                                                                 ○
      ment securities. To promote diversification of inves-          market, with virtually little information issued. In de-




                                                                 ○
                                                                 ○
      tors, mutual funds could be encouraged to establish            veloped markets, the regulatory authorities indicate




                                                                 ○
                                                                 ○
      gilt funds to invest in Government securities through          the framework within which the private placement




                                                                 ○
                                                                 ○
      tax incentives, and for primary dealers to diversify           has to function, such as the number of persons per




                                                                 ○
                                                                 ○
      the investor base. Fully market-based interest rates           placement, arrangements with only qualified inves-




                                                                 ○
                                                                 ○
      for issuing Government securities are also neces-              tors and strict regulations to access certain qualified




                                                                 ○
                                                                 ○
      sary. The credibility of credit-rating companies should        investors. The issue of extending the regulatory




                                                                 ○
                                                                 ○
      be further established.                                        framework to protect investors’ interests from risks



                                                                 ○
                                                                 ○
                                                                     associated with subscriptions in the private place-


                                                                 ○
                                                                 ○
      STAMP DUTY                                                     ment market needs to be addressed. With a proper

                                                                 ○
                                                                 ○
      With the establishment of NSDL, a sizable stock of             regulatory framework and more transparency, the
                                                                 ○
                                                                 ○




      private debt instruments and Public Sector Unit (PSU)          private placement market can develop further as an
                                                                 ○
                                                                 ○




      bonds was expected to be dematerialized and cov-               integral and important constituent of the primary
                                                                 ○
                                                                 ○




      ered by a secured payment and settlement system. At            market for raising resources by corporates.
                                                                 ○
                                                                 ○




      present, NSDL is able to dematerialize only those scrips           Furthermore, favorable tax treatment may be ex-
                                                                 ○
                                                                 ○




      that are exempted from stamp duty and are transfer-            tended to institutional investors to encourage indi-
                                                                 ○
                                                                 ○




      able by endorsement and delivery. As most bonds and            vidual investment in the private placement market
                                                                 ○
                                                                 ○




      other corporate debt instruments are not exempted              through professional fund managers, which can re-
                                                                 ○
                                                                 ○




      from stamp duty on transfer of bonds, NSDL has en-             duce asymmetric information and provide better in-
                                                                 ○
                                                                 ○




      countered difficulties in dematerializing them. In the         vestor protection.
                                                                 ○
                                                                 ○




      automated environment of the depository, it is not pos-
                                                                 ○
                                                                 ○




      sible for NSDL to keep track of them. Therefore, un-           SECONDARY DEBT MARKET DEVELOPMENT
                                                                 ○
                                                                 ○




      less the issue of the waiver of stamp duty on transfer         In order to activate the secondary market for debt
                                                                 ○
                                                                 ○




      of debt is settled with the state governments, NSDL
                                                                 ○




                                                                     instruments, several measures need to be undertaken.
                                                                 ○
                                                                 ○




      would not be able to extend its services to bonds and             Further deregulation of domestic interest rates,
                                                                 ○
                                                                 ○




      other private debt instruments. A suitable amendment           greater reliance on borrowing at market rates by the
                                                                 ○
                                                                 ○




      to stamp duty regime by the Government of                      Government and other quasi-state issuers, more utili-
                                                                 ○
                                                                 ○




      Maharashtra in the form of a one-time levy or con-             zation of open market operations as a tool for mon-
                                                                 ○
                                                                 ○




      solidated fee payable by NSDL could resolve the is-            etary policy, and better procedures for trading, clear-
                                                                 ○
                                                                 ○




      sue to a significant degree.                                   ing, and settlement will facilitate secondary market
                                                                 ○
                                                                 ○




                                                                     development. Investor groups should be further diver-
                                                                 ○
                                                                 ○




      PRIVATE PLACEMENT MARKET                                       sified in order to provide better liquidity, and statutory
                                                                 ○
                                                                 ○




      The proportion of total resources mobilized by gov-            liquidity requirement should be reduced. A suitable
                                                                 ○
                                                                 ○




      ernment and nongovernment companies through pri-               solution to stamp duty in relation to dematerialization
                                                                 ○
                                                                 ○




      vate placements has been increasing. In private                of nongovernment securities is also necessary. In the
                                                                 ○
                                                                 ○




      placements, bonds have emerged as the most pre-                case of Government securities, RBI provides deposi-
                                                                 ○
                                                                 ○




      ferred instrument. The popularity of private place-            tory, and coverage of book-entry holding is expand-
                                                                 ○
                                               INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES          131


ing. With respect to PSU bonds and corporate deben-           Risk Management




                                                          ○
                                                          ○
tures, which are held mostly in scrip form, a proper          The rules that have been introduced during the last




                                                          ○
                                                          ○
settlement system is yet to be put in place. As noted,        few years to contain market risks seem to have op-




                                                          ○
                                                          ○
NSDL was expected to dematerialize a sizable stock            erated reasonably well. Strict enforcement of these




                                                          ○
                                                          ○
of nongovernment debt but it has been able to dema-           rules is as important as the rules themselves to ef-




                                                          ○
                                                          ○
terialize only those securities that are exempt from          fectively manage risk. In this regard, SEBI should




                                                          ○
                                                          ○
stamp duty. Therefore, suitable amendments to the             more closely inspect intermediaries and the stock




                                                          ○
                                                          ○
stamp duty regime are necessary to reduce transac-            exchanges and, if necessary, strengthen punitive




                                                          ○
                                                          ○
tion costs in the secondary markets for private securi-       measures.




                                                          ○
                                                          ○
ties. This will also encourage the development of a




                                                          ○
                                                              Integration of the Capital Market



                                                          ○
repo market in nongovernment securities.




                                                          ○
                                                              with the Banking Sector


                                                          ○
                                                          ○
Integration of Stock Exchanges and

                                                          ○
                                                              Capital markets cannot thrive alone—they have to

                                                          ○
Consolidation of Intermediaries
                                                          ○
                                                              be integrated with the other segments of the finan-
                                                          ○
                                                          ○
A recent movement in India is the formation of the        ○
                                                          ○
                                                              cial system. Effective and efficient capital markets
Federation of Indian Stock Exchanges (FISE) by 12             require a stable and strong payment, settlement, and
                                                          ○
                                                          ○




regional stock exchanges and the setting up of a cen-         clearing systems. India’s banking system is yet to
                                                          ○
                                                          ○




tral trading system, the Indian Stock Exchanges Ser-          come up with good EFT solutions. EFT is important
                                                          ○
                                                          ○




vices Corporation (ISESC). If this materializes, there        for solving problems such as those related to direct
                                                          ○
                                                          ○




will be three entities of national stature: NSE, BSE,         payment of dividends to bank accounts, eliminating
                                                          ○
                                                          ○




and ISESC. The Government should make the envi-               counterparty risk, and facilitating FII investments.
                                                          ○
                                                          ○




ronment favorable and, if necessary, provide incen-              Global trends in recent years have seen a blur-
                                                          ○
                                                          ○




tives to facilitate this process.                             ring of borders between financial market segments.
                                                          ○
                                                          ○




   A related aspect is the consolidation of intermedi-        The traditional wall between banks and the securi-
                                                          ○
                                                          ○




aries. The number of intermediaries in the Indian             ties market is being eliminated, leaving banks with
                                                          ○
                                                          ○




capital market has mushroomed over the last 10 years.         greater investment flexibility. Banks are also in-
                                                          ○
                                                          ○




As a result, turnover per member is quite low and             creasingly providing long-term loans and entering
                                                          ○
                                                          ○




transaction costs are high in most stock exchanges.           the capital market to raise resources through eq-
                                                          ○
                                                          ○




Corporatization of broking, entry of foreign brokers,         uity capital and subordinated debt. India is experi-
                                                          ○
                                                          ○




drying up of retail investments, and increasing over-         encing the same trends and they are expected to
                                                          ○
                                                          ○




head costs have created survival problems, particu-           increase the competitiveness of its capital market.
                                                          ○




                                            5
                                                          ○




larly for the individual and small brokers. Also, the         However, the country should pursue further expan-
                                                          ○
                                                          ○




number of merchant banks (more than 1,000) seems              sion of banking activities in conjunction with fur-
                                                          ○
                                                          ○




large for the Indian capital market. The Government           ther efforts to liberalize the banking system, and
                                                          ○
                                                          ○




should consider favorable tax treatment for brokers           enhance asset quality to encourage sound competi-
                                                          ○
                                                          ○




and merchant bankers who want to engage in merg-              tion between the banking sector and the capital
                                                          ○
                                                          ○




ers and takeovers.                                            market.
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
132    A STUDY OF FINANCIAL MARKETS



      Appendix 1                                                       down conditions under which disclosures and




                                                                 ○
                                                                 ○
      Reforms in Indian Securities Market                              mandatory public offers are to be made to the




                                                                 ○
                                                                 ○
      Since 1992                                                       shareholders. Regulations further revised and




                                                                 ○
                                                                 ○
                                                                       strengthened in 1996.




                                                                 ○
                                                                 ○
      The development in Indian securities market since              • SEBI reconstitutes the governing boards of the




                                                                 ○
                                                                 ○
      1992 can be summarized as follows:                               stock exchanges and introduces capital adequacy




                                                                 ○
                                                                 ○
        • Capital Issues (Control) Act of 1947 repealed                norms for broker accounts.




                                                                 ○
                                                                 ○
          and the office of Controller of Capital Issues abol-       • Private mutual funds permitted and several such




                                                                 ○
                                                                 ○
          ished; control over price and premium of shares              funds already set up. All mutual funds allowed




                                                                 ○
                                                                 ○
          removed. Companies now free to raise funds                   to apply for firm allotment in public issues—also




                                                                 ○
                                                                 ○
          from securities markets after filing prospectus              aimed at reducing issue costs.




                                                                 ○
                                                                 ○
          with the Securities and Exchange Board of In-              • Regulations for mutual funds revised in 1996,




                                                                 ○
                                                                 ○
          dia (SEBI).                                                  giving more flexibility to fund managers while



                                                                 ○
                                                                 ○
        • The power to regulate stock exchanges delegated              increasing transparency, disclosure, and account-


                                                                 ○
                                                                 ○
          to SEBI by the Government.                                   ability.

                                                                 ○
                                                                 ○
        • SEBI introduces regulations for primary and                • Over-the-Counter Exchange of India formed.
                                                                 ○
                                                                 ○




          other secondary market intermediaries, bringing            • National Stock Exchange (NSE) establishment
                                                                 ○
                                                                 ○




          them within the regulatory framework.                        as a stock exchange with nationwide electronic
                                                                 ○
                                                                 ○




        • Reforms by SEBI in the primary market include                trading.
                                                                 ○
                                                                 ○




          improved disclosure standards, introduction of             • Bombay Stock Exchange (BSE) introduces
                                                                 ○
                                                                 ○




          prudential norms, and simplification of issue pro-           screen-based trading; 15 stock exchanges now
                                                                 ○
                                                                 ○




          cedures. Companies required to disclose all ma-              have screened-based trading. BSE granted per-
                                                                 ○
                                                                 ○




          terial facts and specific risk factors associated            mission to expand its trading network to other
                                                                 ○
                                                                 ○




          with their projects while making public issues.              centers.
                                                                 ○
                                                                 ○




        • Listing agreements of stock exchanges amended              • Capital adequacy requirement for brokers en-
                                                                 ○
                                                                 ○




          to require listed companies to furnish annual                forced.
                                                                 ○
                                                                 ○




          statement to the exchanges showing variations              • System of mark-to-market margins introduced
                                                                 ○
                                                                 ○




          between financial projections and projected uti-             in the stock exchanges.
                                                                 ○
                                                                 ○




          lization of funds in the offer document and ac-
                                                                 ○




                                                                     • Stock lending scheme introduced.
                                                                 ○
                                                                 ○




          tual figures. This is to enable shareholders to            • Transparency brought out in short selling.
                                                                 ○
                                                                 ○




          make comparisons between performance and                   • National Securities Clearing Corporation, Ltd.
                                                                 ○
                                                                 ○




          promises.                                                    set up by NSE.
                                                                 ○
                                                                 ○




        • SEBI introduces a code of advertisement for                • BSE in the process of implementing a trade guar-
                                                                 ○
                                                                 ○




          public issues to ensure fair and truthful disclo-            antee scheme.
                                                                 ○
                                                                 ○




          sures.                                                     • SEBI strengthens surveillance mechanisms and
                                                                 ○
                                                                 ○




        • Disclosure norms further strengthened by intro-              directs all stock exchanges to have separate sur-
                                                                 ○
                                                                 ○




          ducing cash flow statements.                                 veillance departments.
                                                                 ○
                                                                 ○




        • New issue procedures introduced—book build-                • SEBI strengthens enforcement of its regulations.
                                                                 ○
                                                                 ○




          ing for institutional investors—aimed at reduc-              Begins the process of prosecuting companies for
                                                                 ○
                                                                 ○




          ing costs of issue.                                          misstatements and ensures refunds of applica-
                                                                 ○
                                                                 ○




        • SEBI introduces regulations governing substan-               tion money in several issues on account of mis-
                                                                 ○
                                                                 ○




          tial acquisition of shares and takeovers and lays            statements in the prospectus.
                                                                 ○
                                               INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES         133


  • Indian companies permitted to access interna-             • FIIs also permitted to invest in unlisted securi-




                                                          ○
                                                          ○
    tional capital markets through Euro issues.                 ties and corporate and Government debt.




                                                          ○
                                                          ○
  • Foreign direct investment allowed in stockbrok-           • The Depositories Act enacted to facilitate the




                                                          ○
                                                          ○
    ing, asset management companies, merchant                   electronic book entry transfer of securities




                                                          ○
                                                          ○
    banking, and other nonbank finance companies.               through depositories.




                                                          ○
                                                          ○
  • Foreign institutional investors (FIIs) allowed ac-        • Guidelines for Offshore Venture Capital Funds




                                                          ○
                                                          ○
    cess to Indian capital markets on registration with         announced. SEBI regulations for venture capital




                                                          ○
                                                          ○
    SEBI.                                                       funds become effective.




                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
Appendix 2                                                    • Stock Exchanges run as brokers clubs; manage-



                                                          ○
                                                          ○
The Indian Securities Market                                    ment dominated by brokers.

                                                          ○
                                                          ○
Before 1992                                                   • Merchant bankers and other intermediaries un-
                                                          ○
                                                          ○
                                                          ○
                                                          ○


                                                                regulated.
The Indian securities market before 1992 had the              • No concept of capital adequacy.
                                                          ○
                                                          ○




following characteristics:                                    • Mutual funds—virtually unregulated with poten-
                                                          ○
                                                          ○




   • Fragmented regulation; multiplicity of adminis-            tial for conflicts of interest in structure.
                                                          ○
                                                          ○




     tration.                                                 • Poor disclosures by mutual funds; net asset value
                                                          ○
                                                          ○




   • Primary markets not in the mainstream of the               (NAV) not published; no valuation norms.
                                                          ○
                                                          ○




     financial system.                                        • Private sector mutual funds not permitted.
                                                          ○
                                                          ○




   • Poor disclosure in prospectus. Prospectus and            • Takeovers regulated only through listing agree-
                                                          ○
                                                          ○




     balance sheet not made available to investors.             ment between the stock exchange and the com-
                                                          ○
                                                          ○




   • Investors faced problems of delays (refund,                pany.
                                                          ○
                                                          ○




     transfer, etc.)                                          • No prohibition of insider trading, or fraudulent
                                                          ○
                                                          ○




   • Stock exchanges regulated through the Securi-              and unfair trade practices.
                                                          ○
                                                          ○




     ties Contracts (Regulations) Act. No inspection
                                                          ○
                                                          ○




     of stock exchanges undertaken.
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
                                                          ○
134    A STUDY OF FINANCIAL MARKETS



      Appendix 3                                                      Department of Company Affairs




                                                                ○
                                                                ○
      Regulatory Framework                                             In 1947, the Capital Issues (Control) Act was en-




                                                                ○
                                                                ○
                                                                    acted, which formalized and continued initial con-




                                                                ○
                                                                ○
      INSTITUTIONS                                                  trols on the issue of securities that were introduced




                                                                ○
                                                                ○
        Securities and Exchange Board of India                      during World War II. This Act was administered by




                                                                ○
                                                                ○
          Securities and Exchange Board of India (SEBI)             the office of the Controller of Capital Issues (CCI),




                                                                ○
                                                                ○
      was set up as an administrative arrangement in 1988.          which was a part of the Ministry of Finance. In line




                                                                ○
                                                                ○
      In 1992, the SEBI Act was enacted, which gave                 with economic reforms, it was repealed in 1992 to




                                                                ○
                                                                ○
      statutory status to SEBI. It mandates SEBI to per-            liberalize capital issuance and pricing. While capital




                                                                ○
                                                                ○
      form a dual function: investor protection through regu-       issuance used to be regulated by the office of the




                                                                ○
                                                                ○
      lation of the securities market, and fostering the de-        CCI, both private and public companies were gov-




                                                                ○
                                                                ○
      velopment of this market. SEBI has been delegated             erned by the Companies Act of 1956, which was




                                                                ○
                                                                ○
      most of the functions and powers under the Securi-            and continues to be administered by the Department



                                                                ○
                                                                ○
      ties Contract Regulation (SCR) Act, which brought             of Company Affairs (DCA) under the Ministry of


                                                                ○
                                                                ○
      stock exchanges, their members, as well as contracts          Law, Justice and Company Affairs. Besides gov-

                                                                ○
                                                                ○
      in securities which could be traded under the regula-         erning the incorporation, management, mergers, and
                                                                ○
                                                                ○




      tions of the Ministry of Finance (see Figure A3 for           winding up of companies, this Act also specifies cer-
                                                                ○
                                                                ○




      the present regulatory structure of the Indian securi-        tain aspects concerning capital issuance and securi-
                                                                ○
                                                                ○




      ties market). It has also been delegated certain pow-         ties trading, particularly the issue of prospectus for
                                                                ○
                                                                ○




      ers under the Companies Act. In addition to regis-            public offers, contents of the prospectus, completion
                                                                ○
                                                                ○




      tering and regulating intermediaries, service provid-         of allotment, issue, and trading of securities, and
                                                                ○
                                                                ○




      ers, mutual funds, collective investment schemes,             transfer and registration of securities.
                                                                ○
                                                                ○




      venture capital funds, and takeovers, SEBI is also
                                                                ○
                                                                ○




      vested with power to issue directives to any person(s)          Stock Exchanges
                                                                ○
                                                                ○




      related to the securities market or to companies in              SEBI issued directives that require that half the
                                                                ○
                                                                ○




      areas of issue of capital, transfer of securities, and        members of the governing boards of the stock ex-
                                                                ○
                                                                ○




      disclosures. It also has powers to inspect books and          changes be nonbroker public representatives and in-
                                                                ○
                                                                ○




      records, suspend registered entities, and cancel reg-         clude a SEBI nominee. To avoid conflicts of interest,
                                                                ○
                                                                ○




      istration.
                                                                ○




                                                                    stock brokers are a minority in the committees of
                                                                ○
                                                                ○




                                                                    stock exchanges set up to handle matters of disci-
                                                                ○
                                                                ○




        Reserve Bank of India                                       pline, default, and investor-broker disputes. The ex-
                                                                ○
                                                                ○




         Reserve Bank of India (RBI) has regulatory in-             changes are required to appoint a professional, non-
                                                                ○
                                                                ○




      volvement in the capital market, but this has been            member executive director who is accountable to
                                                                ○
                                                                ○




      limited to debt management through primary deal-              SEBI for the implementation of its directives on the
                                                                ○
                                                                ○




      ers, foreign exchange control, and liquidity support          regulation of stock exchanges. SEBI has introduced
                                                                ○
                                                                ○




      to market participants. It is RBI and not SEBI that           a mechanism to remedy investor grievances against
                                                                ○
                                                                ○




      regulates primary dealers in the Government securi-           brokers.
                                                                ○
                                                                ○




      ties market. RBI instituted the primary dealership of
                                                                ○
                                                                ○




      Government securities in March 1998. Securities               DISCLOSURE
                                                                ○
                                                                ○




      transactions that involve a foreign exchange trans-           Similar to companies in capital markets in other coun-
                                                                ○
                                                                ○




      action need the permission of RBI.                            tries, a company offering securities in the Indian
                                                                ○
                                                                ○
                                                                ○
                                                                         INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES                              135


capital market is required to make a public disclo-                                          ers or the bondholders), and to the public (through




                                                                                         ○
                                                                                         ○
sure of all relevant information through its offer docu-                                     the exchange or the media), any information neces-




                                                                                         ○
                                                                                         ○
ments. These documents are as follows:                                                       sary to enable the holders of the listed securities to




                                                                                         ○
                                                                                         ○
   • prospectus,                                                                             appraise its position and to avoid the establishment




                                                                                         ○
                                                                                         ○
   • application form and the abridged prospectus (in                                        of a false market in such listed securities. Such in-




                                                                                         ○
                                                                                         ○
     case of an issue to the public), or                                                     formation include:




                                                                                         ○
                                                                                         ○
   • letter of offer (in case of a rights issue to exist-                                       • the date of the meeting of the board of directors




                                                                                         ○
                                                                                         ○
     ing shareholders or debenture holders of a com-                                              for corporate actions;




                                                                                         ○
                                                                                         ○
     pany with or without the right to renounce in fa-                                          • the audited financial results on an annual basis




                                                                                         ○
                                                                                         ○
     vor of other persons).                                                                       and the unaudited ones on a semiannual basis;




                                                                                         ○
                                                                                         ○
   After a security is issued to the public and subse-                                          • any proposed change in the general character




                                                                                         ○
                                                                                         ○
quently listed on a stock exchange, the issuing com-                                              or nature of the company’s business;



                                                                                         ○
                                                                                         ○
pany is required under the listing agreement to con-                                            • any alterations of the company’s capital; and

                                                                                         ○
                                                                                         ○
tinue to disclose in a timely manner to the exchange,                                           • any change of the company’s directorate, includ-
                                                                                         ○
                                                                                         ○
to the holders of the listed securities (the sharehold-                                  ○
                                                                                         ○
                                                                                         ○
                                                                                                  ing managing directors and auditors.

 Figure A3:        Regulatory Framework of the Indian Securities Market
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
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                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○




  DCA = Department of Company Affairs, FII = foreign institutional investor, SCR = Securities Contract Regulation, SEBI =Securities and Exchange Board of India.
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
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                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
                                                                                         ○
136     A STUDY OF FINANCIAL MARKETS



      Notes                                                            Misra, B. M. 1997. “Fifty Years of the Indian Capital Market:




                                                                   ○
                                                                   ○
                                                                         1947-1997.” In Banking and Financial Sector Reforms




                                                                   ○
                                                                         in India, Vol. 6, edited by Kapila, Raj and Uma Kapila.




                                                                   ○
      1Euromoney (1996).




                                                                   ○
                                                                   ○
                                                                       Rangarajan, C. 1997. “Activating Debt Markets in India.”




                                                                   ○
      2They are the Discount and Finance House of India




                                                                   ○
                                                                         Reserve Bank of India Bulletin. October.




                                                                   ○
      Ltd. (DFHI), the Securities Trading Corporation of In-




                                                                   ○
                                                                   ○
      dia (STCI), State Bank of India, Gilts Ltd., PNB Gilts           Reddy, Y. V. 1997. “The Future of India’s Debt Market.”




                                                                   ○
      Ltd., Industrial Credit and Investment Corporation of




                                                                   ○
                                                                         Reserve Bank of India Bulletin, November.




                                                                   ○
      India (ICICI) Securities, and Gilt Securities Trading Cor-




                                                                   ○
                                                                   ○
      poration.                                                        Reserve Bank of India. Report on Currency and Finance,




                                                                   ○
                                                                   ○
                                                                         various issues.




                                                                   ○
      3See Endo (1998) for comparison of Indian GAAP with




                                                                   ○
                                                                   ○
      those of the UK and US.                                          Securities and Exchange Board of India. 1995/96 and




                                                                   ○
                                                                   ○
                                                                         1996/97. Annual Report. India: SEBI.




                                                                   ○
      4Up to August 1997.




                                                                   ○
                                                                   ○
                                                                       Shah, Ajay, and Susan Thomas. 1997. “Securities Mar-



                                                                   ○
      5The one-time exemption on capital gains tax provided in



                                                                   ○
                                                                         kets—Towards Greater Efficiency.” In India Develop-

                                                                   ○
      the Union Budget 1997/98 should be of help to brokers for          ment Report, edited by K. Parikh. UK: Oxford Univer-
                                                                   ○
      corporatizing their businesses.
                                                                   ○
                                                                   ○
                                                                   ○
                                                                   ○
                                                                         sity Press.

                                                                       Subramanian, V. V. 1998. “Impact Assessment of Capital
                                                                   ○
                                                                   ○




                                                                         Market Reforms.” Draft paper submitted to Asian De-
                                                                   ○




      References
                                                                   ○




                                                                         velopment Bank.
                                                                   ○
                                                                   ○
                                                                   ○




      Endo, Tadashi. 1998. The Indian Securities Market—A              Tarapore, S. S. “The Government Securities Market: The
                                                                   ○




                                                                         Next Stage of Reform.” Banking and Financial Sector
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        Guide for Foreign and Domestic Investors. Vision
                                                                   ○




                                                                         Reforms in India, Vol. 4.
                                                                   ○




        Books. India.
                                                                   ○
                                                                   ○




      Gupta, L.C. 1998. “What Ails the Indian Capital Market?”         Euromoney. 1996. World Equity Guide. UK: Euromoney
                                                                   ○
                                                                   ○




        Economic and Political Weekly, 23 (29-30).                       Publications.
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