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Indian Capital Market

Indian Capital Market

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Published by: Vijay Bhasker on Nov 29, 2008
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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
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Introduction
There are 22 stock exchanges in India, the first be-ing the Bombay Stock Exchange (BSE), which be-gan formal trading in 1875, making it one of the old-est in Asia. Over the last few years, there has beena rapid change in the Indian securities market, espe-cially in the secondary market. Advanced technol-ogy and online-based transactions have modernizedthe stock exchanges. In terms of the number of com-panies listed and total market capitalization, the In-dian equity market is considered large relative to thecountry’s stage of economic development. The num-ber of listed companies increased from 5,968 in March1990 to about 10,000 by May 1998 and market capi-talization has grown almost 11 times during the sameperiod.The debt market, however, is almost nonexistentin India even though there has been a large volumeof Government bonds traded. Banks and financialinstitutions have been holding a substantial part of these bonds as statutory liquidity requirement. Theportfolio restrictions on financial institutions’ statu-tory liquidity requirement are still in place. A primaryauction market for Government securities has beencreated and a primary dealer system was introducedin 1995. There are six authorized primary dealers.Currently, there are 31 mutual funds, out of which 21are in the private sector. Mutual funds were openedto the private sector in 1992. Earlier, in 1987, bankswere allowed to enter this business, breaking themonopoly of the Unit Trust of India (UTI), whichmaintains a dominant position.Before 1992, many factors obstructed the expan-sion of equity trading. Fresh capital issues were con-trolled through the Capital Issues Control Act. Trad-ing practices were not transparent, and there was alarge amount of insider trading. Recognizing the im-portance of increasing investor protection, severalmeasures were enacted to improve the fairness of the capital market. The Securities and ExchangeBoard of India (SEBI) was established in 1988. De-spite the rules it set, problems continued to exist, in-cluding those relating to disclosure criteria, lack of broker capital adequacy, and poor regulation of mer-chant bankers and underwriters.There have been significant reforms in the regula-tion of the securities market since 1992 in conjunctionwith overall economic and financial reforms. In 1992,the SEBI Act was enacted giving SEBI statutory sta-tus as an apex regulatory body. And a series of re-forms was introduced to improve investor protection,automation of stock trading, integration of nationalmarkets, and efficiency of market operations.India has seen a tremendous change in the sec-ondary market for equity. Its equity market will mostlikely be comparable with the world’s most advancedsecondary markets within a year or two. The keyingredients that underlie market quality in India’sequity market are:exchanges based on open electronic limit orderbook;nationwide integrated market with a large num-ber of informed traders and fluency of short orlong positions; andno counterparty risk.Among the processes that have already startedand are soon to be fully implemented are electronicsettlement trade and exchange-traded derivatives.Before 1995, markets in India used open outcry, atrading process in which traders shouted and hand-signaled from within a pit. One major policy initiatedby SEBI from 1993 involved the shift of all exchangesto screen-based trading, motivated primarily by theneed for greater transparency. The first exchange tobe based on an open electronic limit order book wasthe National Stock Exchange (NSE), which startedtrading debt instruments in June 1994 and equity inNovember 1994. In March 1995, BSE shifted fromopen outcry to a limit order book market. Currently,17 of India’s stock exchanges have adopted openelectronic limit order.Before 1994, India’s stock markets were domi-nated by BSE. In other parts of the country, the fi-
 
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INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES
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nancial industry did not have equal access to mar-kets and was unable to participate in forming prices,compared with market participants in Mumbai(Bombay). As a result, the prices in markets outsideMumbai were often different from prices in Mumbai.These pricing errors limited order flow to these mar-kets. Explicit nationwide connectivity and implicitmovement toward one national market has changedthis situation (Shah and Thomas, 1997). NSE hasestablished satellite communications which give alltrading members of NSE equal access to the mar-ket. Similarly, BSE and the Delhi Stock Exchangeare both expanding the number of trading terminalslocated all over the country. The arbitrages are elimi-nating pricing discrepancies between markets.Despite these big improvements in microstructure,the Indian capital market has been in decline duringthe last three years. The amount of capital issuedhas dropped from the level of its peak year,1994/95,and so have equity prices. In 1994/95, Rs276 billionwas raised in the primary equity market. This figurefell to Rs208 billion in 1995/96 and to Rs142 billion in1996/97. The BSE-30 index or Sensex, the sensitiveindex of equity prices, peaked at 4,361 in September1994 and fell during the following years. A leadingcause was that financial irregularities and over-valuations of equity prices in the earlier years haderoded public confidence in corporate shares. Also,there was a reduced inflow of foreign investmentafter the Mexican and Asian financial crises. In asense, the market is now undergoing a period of ad- justment. Thus, it is time for regulatory authorities tomake greater efforts to recover investors’ confidenceand to further improve the efficiency and transpar-ency of market operations.The Indian capital market still faces many chal-lenges if it is to promote more efficient allocationand mobilization of capital in the economy. First,market infrastructure has to be improved as it hin-ders the efficient flow of information and effectivecorporate governance. Accounting standards willhave to adapt to internationally accepted accountingpractices. The court system and legal mechanismshould be enhanced to better protect small share-holders’ rights and their capacity to monitor corpo-rate activities. Second, the trading system has to bemade more transparent. Market information is a cru-cial public good that should be disclosed or madeavailable to all participants to achieve market effi-ciency. SEBI should also monitor more closely casesof insider trading. Third, India may need further inte-gration of the national capital market through consoli-dation of stock exchanges. The trend all over the worldis to consolidate and merge existing stock exchanges.Not all of India’s 22 stock exchanges may be able to justify their existence. There is a pressing need to de-velop a uniform settlement cycle and common clear-ing system that will bring an end to unnecessary specu-lation based on arbitrage opportunities. Fourth, thepayment system has to be improved to better link thebanking and securities industries. India’s banking sys-tem has yet to come up with good electronic fundstransfer (EFT) solutions. EFT is important for prob-lems such as direct payments of dividends throughbank accounts, eliminating counterparty risk, and fa-cilitating foreign institutional investment. The capitalmarket cannot thrive alone; it has to be integrated withthe other segments of the financial system. The globaltrend is for the elimination of the traditional wall be-tween banks and the securities market.Securities market development has to be supportedby overall macroeconomic and financial sector envi-ronments. Further liberalization of interest rates, re-duced fiscal deficits, fully market-based issuance of Government securities, and a more competitive bank-ing sector will help in the development of a sounderand a more efficient capital market in India.
Capital Market Reformsand Developments
Reforms in the Capital Market
Over the last few years, SEBI has announced sev-eral far-reaching reforms to promote the capital

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