UNIT 13 SOURCES OF REVENUE:

TAX AND NON-TAX

Structure
13.0 Objectives
13.1 Introduction
13.2 Tax Revenue - Concepts and Classification
13.2.1 Direct Taxes
13.2.2. Indirect Taxes
13.3 Non-tax. Revenue
13.4 Sharing of Receipts with States
13.5 Resource Mobilisation over the Years
13.6 Let Us Sum Up
13.7 Key Words
13.8 References
13.9 Answers to Check Your Progress Exercises

13.0 OBJECTIVES
After reading this unit, you should be able to :
state the concepts and classification of tax revenue
discuss the components of non-tax revenue
describe the sharing of receipts with states; and
explain trends in resdrce mobilisation over the years.

13.1 INTRODUCTION
Mobilisation of resources is a sine-qua-non for planned economic development of the
economy. It becomes the means to the attainment of growth. The term resource
mobilisation covers much more than taxation. It covers the income from public
services, public enterprises and public utilities. A development plan, in order to be ,

,uccessful, should accord the highest priority to the generation of sufficient surplus
from the ccrrent revenues of the government, its departmental units and the public
enterprises. As development proceeds and the level of income in the economy rises,
it should be able to mop up additional resources in the form of public borrowings
and small savings. It may also be necessary to resort to deficit financing (about which
we will discuss in detail in Unit 15) primarily to provide money for increasing
transactions in the wake of rising incomes and growing monetisation of the economy.
But at the same time care should be taken to ensure that it does not become
inflationary. Similarly external assistance may be necessary as long as domestic
resources do not prove adequate to finance the developmental programmes.
In this unit, we are concentrating mainly on two sources of revenue-tax and non-tax
for resource mobilisation. The compdnents of tax and non-tax revenue will be
discussed and as an example provisions in regard to Budget of 1991-92 relating to
resource mobilisation will be given.

13.2 TAX REVENUE - CONCEPTS AND

CLASSIFICATION
The income of the government may be defined either in a broad or narrow sense. In
a broad sense it includes all 'incomings' or 'receipts' and in the narrow sense only
those receipts which are included in the ordinary concept of revenue. The, chief
elements which are included in the concept of public receipts but excluded'from that
of public revenue, are receipts from public borrowings hnd from the sale of public
assets.
The most important source of government revenue is from taxes. A tax is a
compulsory charge imposed by a public authority, like for example income tax.
Sometimes description of taxes cover penalties for offences. The distinction between
taxes and penalties is one of motive; a pubIic authority imposes taxes mainly to obtain
revenue and resorts to penalties mainly to deter people from doing certain things.
Therefore, a tax is a compulsory contribution imposed by a public authority,
irrespective of the exact amount of service rendered to the tax payer in return, and
not imposed as a penalty for any legal offence.
The commonest classification of taxes is between direct and indirect taxes. Direct tax
is imposed and collected directly from the person on whom it is legally imposed while
an indirect tax is imposed on one person, but paid partly or wholly by others. Thus
an indirect tax is conceived as one the incidence of which can be shifted or passed on
to another person, while the incidence of the direct tax falls on the person concerned
and cannot be shifted or passed on to another person.
Now let us discuss in detail the types of direct and indirect taxes.

13.2.1 Direct Taxes

Income Tax, Corporation Tax, Capital Gains Tax, Estate Duty, Gift Tax, Wealth
Tax come under the category of direct taxes. In the case of direct taxes the liability
is determined with direct reference to the taxpayer's tax-paying ability, while in the
case of indirect taxes, this ability is assessed indirectly. For instance, in case of
incometax which is a direct tax, the amount of tax to be payable by a person, is
determined on the basis of that person's income.
Let us discuss in detail the various direct taxes. These form source of revenue for the
Union Government.
a) Income-Tax : This is the tax which is levied on the total income of the tax payer
after reducing prescribed deductions. In India, the first Income Tax Act was passed
in 1886. Later in 1922, a comprehensive act was passed. In 1961, this Act was
repealed and a new Income Tax Act was passed. Under the Income Tax Act, income
includes salaries, interest on securities, profits and gains of business and professions,
capital gains, value of any benefit or perquisite., any winnings from lotteries, other
games etc. But income derived from agricultural activities is exempted from income
tax till date.
There are changes made in the rates of income tax from year to year. Also under the
Indian Income Tax Act certain incomes are totally exempt from tax. Some of these
include, accumulated balance of recognised provident fund, death-cum-retirement
gratuity, house-rent allowance upto a certain limit, scholarships granted to meet
educational costs, post-office savings etc.
The budget 1991-92 proposed certain major changes in the rate structure of
income-tax. The exemption limit for personal income tax was raised from Rs. 18,000
to Rs. 22,000 i.e. income tax will be levied only on annual incomes exceeding Rs.
22,000. Any person getting an annual income upto Rs. 22,000 need not pay any
income tax. The lowest tax rate of 20% has been extended from the existing
limit of Rs. 25,000 to Rs. 30,000. Under the new system introduced for 1991-92, a
person contributing to provident fund, Life Insurance Corporation etc., can now be
entitled only to a tax rebate calculated at the rate of 20% on such savings.
b) Corporation tax : In India, the companies are subjected to tax on their incomes
which is called Corporation tax. Apart from this, the companies deduct tax at source
from the dividends of shareholders and deposit them with the authorities. Hence
whatever dividend a shareholder gets is the amount received after deduction of tax.
The Corporation tax which is levied on the income of the Company is different from
this. This is levied at a flat rate and subject to a number of rebates and exemptions.
These rebates and exemptions vary according to activities, criteria, types of corporate
income.
The Budget of 1991-92 reduced the tax rate for widely held domestic companies from
the existing rate of 50% to 40%. As a measure of relief the deduction for setting up
new industries was raised from 25% to 30% in the case of companies and from 20%
to 25% in the case of others. This benefit can now be availed-of for 10 years as against
8 years.
 c) Tax on Capital Gains : This is the tax levied on the sale of any asset like land, :
Sources of Hrvcl~ue
building etc. when the price at which it is sold or transferred exceeds the price at Tax and Non-Tax
which it was purchased or acquired. In India. any profits or gains arising from the
transfer of a capital asset are taxed under the head 'capital gains'. However, certain
capital assets have been excluded from the purview of this tax, like consumable
stores, raw materials, furniture etc.
d) Expenditure Tax : Thi$ tax was introduced in 1958 in India. The tax was levied
on persons and Hindu Undivided Families whose income from all sources during the
relevant previous year, after deducting all taxes on such income, exceeded Rs.
36.000. It was introduced on the recommendation of Prof. Kaldor who felt that
expenditure was easily definable than income as the basis of taxation and it was a
better index of taxable capacity. But later in 1962, it was abolished, as it failed in
curtailing extravagant consumption or checking the evasion of other taxes. Again in
1987, the Expenditure Tax Act was introduced which provides for levy of a tax on
expenditure incurred in hotels where the room charge for any unit of accon?modation
is Rs. 400 or more per day per individual. The rates of expenditure tax have been
raised w.e.f. 1.6.1989 from 10% to 20% of expenditure incurred in connection with
provision of any accommodation, food, drinks and certain other categorics of
services. It will not apply to expenditure incurred in foreign exchange or in the case
of persons enjoying diplomatic privileges.
e ) Wealth Tax : The Wealth Tax Act, 1957 provides for levy of a tax on the net
wealth of every individual, Hindu Undivided Families and companies which are
closcly hcld. Agricultural property is not included in the net wealth of an individual.
But possession of amount of wealth to a certain limit is exempted from wealth tax.
The Finance Act of 1985 enhanced the basic exemption under the Wealth Tax Act
from Rs. 1.5 lakhs to Rs. 2.5 lakhs in respect of individuals and Hindu Undivided
Families. The maximum rate of tax was also lowered' from 5% of the taxablewealth
to 2% if the assessable wealth exceeds 30 lakhs in -respect of individuals and Hindu
Undivided Families.
f) Estate Duty : The estate duty was introduced in India in 1953. It was levied on the
total property passing or deemed to pass on the death of a person. The duty was
leviable on all property belonging to the deceased which included cash, jcwcllery.
household goods etc. A slab system was fixed according to which tax was lev~cd.Later
many changes were brought about under various acts in the rate of tax.
The Estate Duty (Amendment) Act 1984, discontinued estate duty on agricultural
land. The levy of estate duty in respect of property (other than agricultural land)
passing on death occurring on or before 16 March, 1985 has also been abolished under
the Estate Duty (Amendment) Act, 1985.
g) Gift Tax : Gift tax was introduced in India in 1958. It is a tax imposed on gifts
made by individuals, Hindu Undivided Families, Corporations, on the value of the
taxable gifts made by them during the year. It is paid by the person giving the gift.
Initially gifts upto Rs. 10,000 were exempted from the tax. Later changes were
brought about in the exemption limits. According to the 1991-92 Budget, gift tax is
levied on gifts exceeding a value of Rs. 20,000, subject to certain exemptions. These
exemptions include gifts to charitable institutions, female dependents on the occasion
of marriage, gifts to spouse etc.
The direct taxes as discussed above are the sources of revenue to the Central
Government. The proceeds of some of the above taxes though collected by the Union
Government are distributed between the Union and states. We shall be discussing
about these provisions in Section 13.4 of this unit. The direct tax revenues of the
State governments include the State's share of income tax, estate duty, la'nd revenue,
urban immovable property tax etc.

13.2.2 Indirect Taxes

I
Having dealt with the various types of direct taxes, which form the source of revenue
to the Central government let us now discuss about the indirect taxes. In our taxation
1 system a heavy reliance is laid on indirect taxes which amount to around 83%.
i
Indirect taxes include sales tax, excise duties, entertainment tax, customs duties etc.
i One of the important reasons for increasing revenue from indirect taxes is with
b u m Mobllisstion
increasing financial requirements of revenue, it is easier to impose and revise the
indirect taxes than direct taxes.
a) Customs Duty : These are taxes imposed on goods entering (import duties) or
leaving (export duties) a customs area. Taxes imposed on goods imported from
abroad are import duties while those levied on goods exported from the country are
export duties.
There are broadly three types of customs duties - import duties, export duties and
cesses on exports.
i) Import duties : These are levied according to the rates of duty prescribed under
Schedules I and I1 of the Indian. Tariff Act 1934. A commodity schedule
prescribes the different rates of import duties leviable on different commodities.
Generally luxury items are charged the highest with a view to discouraging their
import while low rates are charged for essential items.
The net customs revenue has been estimated at Rs. 20,800 crore during 1990-91
and Rs. 26,410 crore in 1991-92 after taking into account the changes brought
under the Finance Act 1990.
As against the original estimate of Rs. 21,213 crore, revised estimate for 1990-91
with regard ro import duties, is placed at Rs. 20,562.65 crore. The estimated
decrease in gross revenue is mainly on account of less revenue realisation from
project imports, electrical machinery, iron and non-alloy steel, stainless steel,
non-ferrous metals, motor vehicles and parts thereof, organic and inorganic
chemicals, glass and glassware etc. This decrease in estimated revenue realisation
is likely to be balanced to a great extent by increased collection of import duties
from crude oil and other petroleum products, machine tools, plastics, rubber
products, railway locomotives and materials etc.
Anticipated import duty realisation (net) in 1991-92 shows an increase of Rs.
5,508.79 crore as compared to the revised estimate of 1990-91. The increase in
gross revenue is expected mainly from crude petroleum and other petroleum
products, electrical and nonelectrical machinery, project imports, chemicals,
transport equipment. Budget estimates for 1991-92 take into account the impact
of adjustment of exchange rates effected in July 1991.
ii) Export duties : Export duties before World War 11, were levied with the prime
objective of mobilising revenue. Later, during the post war period, they have
been levied for other purposes. According to the Report of Taxation Enquiry
Commission (1953-54), "several duties have been imposed for preventing the
impact on domestic markets of inflationary conditions abroad, or for stabilising
domestic prices, while other duties have been imposed for protective purposes."
In the initial years of planning, the share of export duty in the total indirect taxes
was quite high as during that time India had a foreign market monopoly for the
staple products. But later, due to decline in India's monopoly in staple products,
it became essential to reduce the rates of duties on many commodities like jute,
tea, textiles and by the end of the third plan, these duties had to be practically
abolished. Later again in 1966, these export duties were reimposed on many
items due to competitive position of goods in international market.
Export duties are increased, reduced or abolished by the government from time
to time keeping in view various factors like the production of the commodity, its
exportable surplus, its demand and prices in international market, etc. But the
share of export duties in total indirect taxes is showing a downward trend, mainly
due to expansion in revenue from the union excise duties.
The revised estimate of net collections from export duties in 1990-91 is placed at
Rs. 1.00 crore as against the original estimate of Rs. 6.15 crore. The budget
estimate for 1991-92 has been placed at Rs. 0.10 crore.
b) Union Excise Duties : These are taxes or duties imposed upon the domestic
productjon of commodities for sale or consumption within the country. In India,
under the Constitution, excise duty can be levied only by the Union Government,
other than those on alcoholic liquor, opium, narcotic drugs etc. on which the state
governments levy state excise duties. In recent years, excise duties have becom, an
important source of revenue for the Government of India because of growing
indiopnen~~c
nrndwtinn nf mmmndities
 Sources d Revenue :
Excise Duties can be specific or ad valorem. It is specific when levied at a specified Tax and Non-Tax
rate per unit of the physical product. 'Ad Valorem' duty is related to the monetary
value of the commodity and levied at certain percentage of this value.
Union excise duties are levied on commodities covered by the Central Excises and
Salt Act 1944 and other special acts enacted from time to time. The commodities are
grouped into 139 budget heads. A number of commodities are however exempted
from duty. The receipts during 1990-91 are estimated at Rs. 24,500 crore as against
the budget estimate of Rs. 25,125.03 crme (after taking into account the effect of
changes made in the Finance Act 1990) showing a decrease of Rs. 625.03 crore.
The decrease in basic and special excise duties in the revised estimate of 1990-91 as
compared to the budget estimate is mainly on account of less revenue realisation from
cess on crude oil, petroleum products, iron and steel, rubber products, etc.
c) Other Taxes and Duties : In addition to the above taxes there are other taxes such
as foreign travel tax, inland air travel tax, foreign exchange conservation tax, water
cess etc. These taxes do not fall directly in any of the categories. These taxes are
classified under the head 'other taxes'.
i) Foreign Exchange Conservation (Travel) Tax : In terms of this Act, a person
drawing exchange for travel abroad is required to pay, Foreign Exchange
Conservation (Travel) Tax at the rate of fifteen per cent on the rupee equivalent
of the foreign exchange released to them. This has been made effective from 5th
October 1987. An authorised dealer or a money changer collects the tax from a
traveller in respect of all foreign exchange released by himher.
However, the following categories of foreign travel are exempted from payment of
the tax :
a) Medical treatment
b) Studies abroad
c) Haj and Ziarat pilgrimages
d) Visits to Sikh shrines in Pakistan and Bangladesh
e) Visits to Kailash Mansarover
ii) The Foreign Travel Tax Scheme was introduced with effect from 15 October,
1971 through Finance Act, 1971. This was further amended by the Finance Act
1989. The amended scheme provides for a levy of a tax of Rs. 300 per passenger
for international journey, (Rs. 150 for journey to the neighbouring countries).
One per cent of the collection made, less refund, is paid to the carrier as
collection charges.
iii) Inland Air Travel Tax was introduced through Finance Act 1989. The tax which
was levied earlier at a rate of 10% of the basic fare is n'ow levied on the full fare.
iv) Water (Prevention and Control of Pollution) CesS is levied on industries and local
authorities on use of water, under the Wafer Cess Act, 1977. The receipts are
initially credited to the Consolidated Fund of India. The net proceeds are
distributed to the state water pollution boards under a prescribed formula.
The indirect revenues of state governments include state's share of union excise, state
excise, general sales tax, motor vehicles tax, entertainment tax, electricity duties and
I
other taxes and duties.
Check Your Progress 1
I
Notes : i) Use the space given below for your answers.
I ii) Check your answers with those given at the end of the unit.
I

II 1) What do you understand by direct taxes? State the types of direct taxes levied by
the Union Government.
2) What is Corporation Tax?

..........................................................................................................
3) What do you understand by Wealth tax?

.........................................................................................................
...........................................................................................................
4) Distinguish between specific and ad valorem excise duties.
.........................................................................................................
.........................................................................................................

13.3 NON-TAX REVENUE

The non-tax revenues of the Union Government include (A) Administrative receipts
(B) net contribution of public sector undertakings; (i) Railways (ii3 Posts and
Telegraphs (iii) Currency and mint and (iv) others. (C) Other revenues which include
revenue from forests, opium, irrigation, electricity and dividends due from
commercial and other undertakings.
Administrative receipts include state plan loans advanced to states by the Centre. In
pursuance of the recommendations of the Ninth Finance Commission as accepted by
the government, the state plan loans advanced to states during 1984-89 and
outstanding as at the end of 1989-90 have been consolidated for 15 years with-9%
rate of interest. The interest receipts from the state governments are estimated at Rs.
5,576.53 crore in the revised estimate of 1990-91 and Rs. 6,789.5 crore in the budget
estimate of 1991-92.
Table 1

Interest receipts, Dividends and Profits

(in Rs.'Crores)
Budget Revised Budget
1990-91 1990-91 1991-92
a) Interest Receipts 9,519.09 9,572.74 11,008.82
b) Dividends and Profit 720.89 779.55 967.12

Sources : R.B.I. Report, ~ u d b e t1991-92and Economic Survey 1991

Interest on Ldans to Union Territory Governments : The interest receipts during

1990-91 is estimated at Rs. 16 crores and Rs. 18.71 crore in budget estimates of
1991-92 on loans advanced to Union Territory of Pondicherry.

Interest payable by Railways : In terms of the recommendations of the successive

Railway Convention Committees (RCC) o f Parliament, the Railways paid a fixed
dividend to General Revenues on the capital invested in the Railways as computed
annually.
 S w m of RLvcnw :
Other Interest Receipts : The estimates under 'other interest receipts' are in respect Tax and Non-Tax
of interest on loans advanced to public sector enterprises, port trusts and other
statutory bodies, cooperatives etc. and on capital outlays on departmental
commercial undertakings.

Table 2
International Financial Institutions

I 1) International
Budget
1990-91
Receipts Discharge Net
Revised
1990-91
Receipts Discharge Net

Monetary Fund 509.40 0.05 509.35 549.98 326.18 223.80

2) International Bank for
Reconstruction and
Development 115.77 14.00 101.77 115.77 18.00 97.77
3) International Development
Association - 0.60 (-)0.60 0.00 0.60 -0.60
4) International Fund for
Agriculture 4.49 1.85 2.64 4.49 1.85 2.64
5) Asian Development Bank - 0.10 (-)O.lO - 0.40 (-) 0.40
6) African Development Fund
and African Development
Bank 7.44 4.80 2.64 7.44 4.70 2.74

Total 637.10 21.40 615.70 677.68 351.73 325.95

S.D. 1,250.17 1,033.73 216.44 2,736.26 2,562.35 173.91

Source : Budget 1991-92 .

As a result of evaluation of Fund's holdings of Indian currency as on April 30,1991
the budget estimates for 1991-92 provide Rs. 1,805.03 crore as expenditure for this
purpose with corresponding credit under securities account.
India is a participant in the Special Drawing Rights (SDRs) Department of the IMF.
During the year 1990-91 the net cumulative allocation of SDRs to India remained at
SDR 327.00 million as there was no fresh allocativn of SDRs.
As in the case of Union Government, the non-tax revenues of the state governments
include administrative receipts, net contribution of the public sector undertakings
grants-in-aid and other contributions. 1

13.4 SHARING OF RECEIPTS WITH STATES

-/
Indian Constitution is quasi-federal and the country has a three-tier government, the
central government, the state governments and the local governments. As the local
public authorities are directly under the state government, no separate allocation of
taxation rights has been done to them. T o avoid any dispute between the centre and
states in the fields of taxation, the following constitutional provisions have b e v a d e .
1) There is no tax which can be levied by both the centre and the states. The Lustom
duties and the corporation tax fall within the purview of the central government
and they account for about 50% of its tax revenue. States have power to levy .

some other taxes to finance their activities. The important taxes falling in this
category are sales tax, land revenue, state excise duties, entertainment tax etc.
2) Some taxes are levied by the central government but their proceeds are divided
between the centre and the states. Union excise duties and taxes on income other
than agricultural income belong to this category. The basis on which these taxes
are divided between the centre and {he states is recommended by the Finance
Commission.
3) The power to levy and collect certain taxes is vested in the centre, whereas their
revenue proceeds are to be distributed among the states. Estate duty on property
other than agricultural land, duty on railway freights and fares, terminal tax on
goods and passengers carried by railways o r purchase of newspaper and
. . . . - - -.
Though some taxes are levied by the central government, the responsibility to collect
them is on the state government. For instance, stamp duties other than those included
in the Union list and excise duties on drugs and cosmetics have been included in this
category.
There is need for decentralisation of functions for encouraging local initiative, for
securing promptness in decision-making and efficiency in its implementation, and for
allowing for a variety of experiments to suit varying needs, tastes and temperaments
- this is implied in the federal nature of the Constitution which ensures immediate
effective resource mobilisation and maintenance of national perspective.
According to 1991-92 budget, current situation of sharing of receipts with states is as
follows :
Table 3
Tax Revenue

Budget- Revised Budget

1990-91 1990-91 1991-92

Total Tax Revenue 59,778.57 58,916.01 66,217.73

Less states share:
Taxes on income 4,064.31 4,120.48 4,467.91
Union Excise Duties 10,361.44 10,414.00 11,175.47
Total States Share 14,425.75 14,534.91 15,643.38
Less :Transfer of Union territory taxes and 58.83 63.25 79.43
and duties to local bodies
Centre's Net Tax Revenue 45,293.99 44,317.85 50,494.92

Source : Budget 1991-92

There exists a conflict between the transfer of finances made in accordance with the
Finance Commission's recommendations and that of Planning Commission. T o avoid
this, Financ.e,Commission should be recognised as a permanent statutory body. Its
scope and functions must be widened by suitable constitutional amendments.
The devolution of revenues from centre to states should be in conformity with
economy, administrative convenience and efficiency. It should be able to provide
national minimum to people. The ideal way of achieving this is to transfer resources '
from richer to poorer states. While transferring resources to states, population, -
climate and rainfall, state of economic development should be kept in mind.
Central Government should not make directly any loans to states. State Governments
should be encouraged to borrow directly from the public as much as they can.
An important development in the sphere of centre-state financial relations in the
recent years relates to the states taking recourse to unauthorised overdrafts with the
RBI. Two factors, namely, temporary difficulties because of the uneven flow of
receipts and expenditures and chronic imbalances between their functions and
resources have been behind this trend. Of late repayment of and interest on debts
falling due every year are Causing a great drain on the state governments' budgetary :0

resources. Most of the projects on which the state governments invested capital by
borrowing from the centre are not yielding the desired rate of returns. This calls for
more determined efforts to improve the performance of public sector projects. But
some of the non-plan loans have become dead weight debts which need to be
remitted.
Centre-state financial relations need review and readjustment. States should learn to
live within their means and should exploit their resources fully.

India has done extremely well in terms of tax effort. In 1950-51 when the planning
process was initiated, t h ; ~ a x - ~ e National
t Product (NNP) ratio was as low as 6.4%;
since then it has been risiqg steadily and s t a n d a t 25% (approximately) today. For
a developing country like Itidia which started its development effort with a very low
per capita income and has recorded an extremely modesyrate of growth (i.e. around
 1.370 per annum increase in NNP per capita), this record in mobilising tax revenue Sourees of Revenw :
is remarkably good by any standard. In India all the major taxes, except personal Tax and Non-Tar
income tax and land revenue, have recorded buoyancy greater than unity. In recent
years buoyancy of excise duty and sales tax has been as high as 1.51 and 1.41
per cent respectively. This has enabled far greater mobilisation of resources through
taxation. There still remains some scope for raising additional tax revenue in the
country. This can be done if the government decides to show the required political
will to tax agricultural incomes which presently remain outside the taxation net.

I Apart from tax revenue other important aspects of resource mobilisation are
generation of non-tax revenues, restricting of current government expenditure and
raising of surpluses of public sector enterprises.
Additional resource mobilisation measures undertaken in the 1990-91 budget were
expected to yield Rs. 1,790 crore. Out of this Rs. 550 crore were to be raised through

i
direct taxes and Rs. 1240 crore through indirect taxes. The states' share in centre's
additional resource mobilisation after making adjustment for the loss of Rs. 170 crore
on account of concessions in income tax was estimated at Rs. 3 crore.
The Railway Budget for 1990-91 proposed hikes in the rates of goods traffic,
passenger fares, parcel and luggage rates. These proposals are estimated to yield
additional revenue of Rs. 892 crore. ~ e v i s i o h i nthe postal and telecommunication
tariffs were estimated to result in an additional revenue of Rs. 645 crore. The total
additional revenue changes in tax rates, through revisions in railway fares and freights
and through revisions in postal and telecommunication tariffs was thus estimated at
Rs. 3327 crore in 1990-91.

II Net profits (after tax) of central government public enterprises increased substantially
from Rs. 2994 crore in 1988-89 to Rs. 3782 crore in 1989-90. The rate of return, as
I measured by the ratio of net profits to capital employed, rises to 4.5% in 1989-90,
which is the highest achieved in the decade. Howeb~rthe petroleum sector accounted
for the bulk of these profits, i.e. Rs. 2,900 crore out of the total Rs. 3,782 crore in
1989-90. The non-petroleum sector enterprises numbering about 200 contributed a
meagre sum of Rs. 882 crore. While this reflects an improvement over the net profit
of Rs. 430 crore made in 1988-89, the ratio of the net profits to capital employed in
I non-petroleum sector enterprises was only 1.3% in 1989-90. It indicates that there is
a substantial scope for improving the financial performance of non-petroleum central
government public enterprises. The overall working results of Central Government

i public enterprises for the first half of 1990-91showed a net profit of Rs. 481 crore as
against Rs. 1,103 crore during the corresponding period of 1989-90.
The seventh plan envisaged generation of internal resources to the ex'tent of
Rs. 23,013 crore and additional resource mobilisation to the extent of Rs. 11,490
crore at 1984-85 prices for fii~ancingthe plan outlays. Against this during the seventh
plan, the public enterprises have generated gross internal resources of Rs. 37,715
crore at current market prices. About 32% of plan investment in central public
enterprises during the seventh plan was financed by generating net internal resources
- 28% by extra-budgetary resources and 40Yo by the budgetary support.

The outlook on the resource mobilisation front is serious but not unmanageable. The
resource imbalances accumulated over several years cannot be eliminated in a short
period. In the present context soft options have either a limited effect or no effect at
all in the correction of macro-economic imbalances. The measures introduced during
1990-91, which aimed at better revenue collections and containment of public
expenditure have had a limited effect as evidenced by the revised budget deficit which
is estimated to be considerably higher than the budget estimate. It is essential that a
serious effort be made to introduce corrective measures through hard decisions and
difficult choices. Any beginning should aim at strict control over government
expenditure, particularly the revenue and non-plan expenditure, rationalisation of
subsidies so that they are better directed towards the poor and improvement in
revenue collections. Continued effort on the part of the government may provide the
basis for a transition to a sustainable resource regime over the next few years.

Check Your Progress 2

Notes : i) Use the space given below for your answers.
iih Check vour answers with those given at the end of the unit.
UNIT 20 FINANCIAL SECTOR REFORMS
Objectives
The objectives of this unit are to help you:
understand the nature and use of money;
understand the role played by finance in an economy;
examine the Indian financial system; and
analyse the significance and need for financial reforms

Structure
20.1 Introduction
20.2 Basic Functions of Money
20.3 Indian Financial System
20.4 Financial Sector Reforms
20.5 Summary
20.6 Key Words
20.7 Self Assessment Questions
20.8 Further Readings

20.1 INTRODUCTION
India’s financial system has vast geographical and functional reach, capacity to
mobilize savings, institutional diversity, and large trained manpower. However,
over time, the system has developed weaknesses due to state ownership of
bank’s and insurance companies, its rapid expansion, externally induced
constraints on bank profitability, an over-regulated interest rate regime, and
internal organizational deficiencies.

Profitability in the banking sector has been very low and some banks have
become financially weak. The reform of the banking sector has only addressed
these problems partially. It has however sought to develop the money market as
well as a secondary market in long-term government debt. Very high statutory
liquidity requirements through which banks are compelled to invest in
government securities have been reduced. Indian banks must maintain 25% of
their demand and time deposits in government securities. Government paper
now carries market-clearing rates. There is only one ceiling rate on term
deposits prescribed by the RBI. Interest rates on money market instruments
have been freed. With government securities now carrying market rates, the
basic requirement for developing a secondary market in such paper has been
met. Institutions and fora have been created to help develop trade in money
and long-term debt markets. To improve the working of banks, a strong
prudential regime regarding capital adequacy, income recognition, loan-loss
provisions and transparency of accounts has been established. Profitable banks
have been permitted to access the capital market to augment their capital.
Commercial banks are increasingly entering new businesses such as merchant
banking, underwriting, mutual funds and leasing, usually through subsidiaries.
Efforts are on for expediting computerization of bank operations. To enhance
competition, many new private sector banks, including some more foreign banks,
have been allowed entry into the market. RBI’s supervision over commercial
banks and other financial institutions including non-bank financial companies has
been strengthened. One of the critical areas where banking sector reforms
have not progressed relates to government control over public sector banks. 49
Economic Reforms Since Public sector ownership imposes several constraints including limitations in
1991
methods of recruitment and promotion and restrictions on the salaries they can
pay. Public sector banks are also burdened by standards of public
accountability, which may be inconsistent with the degree of flexibility needed
for commercial decision-making. The Committee on Banking Sector Reforms
has recommended that the government’s equity holding should be reduced to 33
percent. However, no action on this recommendation has been taken so far.
Over the last two decades, the capital market has grown phenomenally in
terms of capital raised, listed companies, trading volumes, market capitalization,
and investor base. The number and diversity of market intermediaries -
merchant banks, underwriters, custodians, share registrars and transfer agents,
mutual fund, rating agencies etc. - have grown rapidly. There are 23 stock
exchanges. The Over-the Counter Exchange of India (OTCEI) and the
National Exchange have screen based trading and are developing a nationwide
reach. The capital market has been liberalized. Corporates are now free to
issue capital and price their issues. FIIs (about 280 in number) have been
permitted to invest in the Indian market and about 80 of them are quite active.
Many Indian companies are accessing foreign markets for raising equity and
debt finance. The regulation of the primary and stock markets as well as of
stock exchanges and market intermediaries has been strengthened through the
establishment of the Securities and Exchange Board of India (SEBI). SEBI is
trying to control insider trading, regulate large acquisition of shares, and improve
the trading practices in stock exchanges. It has been able to revamp the
governing boards of stock exchanges, which were predominantly the domain of
the broker community.

Though the primary market has grown dramatically, the stock market
infrastructure, practices and procedures are relatively inadequate and slow.
Many market intermediaries also lack sufficient capacity to handle growing
business and paper work. Share transfers take considerable time. A major
challenge is to expand the market infrastructures, upgrade technology, and
establish institutions and practices for reducing paper work and delays. Apart
from the National Exchange and OTCEI, the Bombay Stock Exchange too has
screen based trading. Measures are also underway to improve clearing and
settlement procedures and to establish a national depository system with a view
to moving towards scrip less trading in due course. This would require several
changes in existing laws. Though it will take considerable time to achieve a
desirable level of reform of the financial sector, some progress has been made.
Based on the recommendations of the Committee on Reform of the Insurance
Sector, the government has opened up the insurance industry to domestic and
foreign companies with a view to introduce competition in insurance industry,
which, for some decades, had been a government monopoly.

The fundamental function of any monetary and financial system, no matter how
simple or complex, is to promote efficiency in the process of exchange or trade
in real goods and services, and thus to contribute to economic welfare. This
statement suggests several related questions. In what ways is the exchange of
real goods and services beneficial? How do money and finance promote
efficiency in trade? What is meant by efficiency in this context?

Let us take the last question first. There are two types of efficiency:
(a) transactions or operational efficiency, and (b) allocational efficiency.

Transactions, or operational efficiency, refers to economizing on the use of

scarce real resources in carrying out the exchange process. The exchange
process is not costless in real terms. It requires the time and energy of
traders themselves, the services of brokers and others, materials and supplies,
50 and the land and equipment to perform the required functions of gathering and
analyzing information concerning trade opportunities, consummating trade Financial Sector
Reforms
transactions and setting trade accounts. Obviously, scarce resources used to
effect transactions are not available to satisfy other wants. Also, high costs
reflecting inefficiencies in transactions usually lead to a sacrifice of some
allocational efficiency. Allocational efficiency is the degree to which potential
gains from trade are exploited. Complete allocational efficiency would mean
that all opportunities for potential gains from trade are exploited; and no
opportunities remain unexploited so that at least one party feels “better off”
without making the other feel “worse off.” In economics, you would recall
(refer to unit 3), this is known as pareto efficiency.

However two important questions still remain : What are the sources of
benefits from trade? In what specific ways do money and finance facilitate
transactions and operational efficiency? In this unit we take up these questions.
Further, we shall briefly examine the Indian financial system, and finally, analyse
the significance and need for financial reforms.

20.2 BASIC FUNCTIONS OF MONEY

“Not even love has made so many fools of men as the pondering
over the nature of money.”
—W.E. Gladstone, (1844)

It was the classical economists who first attempted to provide an explanation

for the holding of cash balances by people, even though such cash balance
yielded no return as contrasted with other forms of assets. The classical
economists claimed that money was demanded by people for their transaction
needs. This is because no economic unit – firm or household- enjoyed a perfect
synchronization between the seasonal pattern of flow of receipts and the flow
of expenditures. It is these discrepancies which give rise to balances that
accumulate temporarily and are used up later when the expenditures catch up.
That is, these discrepancies give rise to the need for balances to meet seasonal
excesses of expenditures over receipts. These balances are hence transaction
balances. This is precisely what the Quantity Theory of Money (QTM) implies

QTM : MV = PT

Where:
M - quantity of money in circulation

V - Velocity of money (number of times a unit of currency

exchanges hands)

P - average price level of all transactions

T - physical volume of transactions

The idea of QTM is that no rational person holds money idle, for it produces
nothing and thereby yields no utility.

It was in 1936-37 that John Maynard Keynes proposed the idea for the first
time that money apart from acting as a unit of account, was also a store of
wealth. This meant that there was an asset demand for money as well.
Keynes attacked the classical theory as a great abstraction from reality.
51
Economic Reforms Since He proposed two principal purposes for holding money:
1991
a) As a unit of account, money facilitates exchange. In this respect it is a
matter of convenience. This give rise to the transactions demand for
money.
b) As a store of wealth, money is held as a speculative balance. In Kenynes’
own words, “this balance is held partly on reasonable and partly on
instinctive grounds. Our desire to hold money as a store of wealth is a
barometer of the degree of distrust of our own calculations and
conventions concerning the future.”

Thus Md = Mt (Y) + MSP (r)

Transactions demand for money, Mt, depends on the level of income, Y. Speculative
demand for money, MSP, depends on the prevailing rate of interest, r.

The relationship between the rate of interest and speculative demand for money
however need not be similar at all levels of interest rate. Below a critical
minimum rate of interest, r c, all investors would prefer to hold cash (since in
this range, the premium is too low to induce the investor to part such a
perfectly liquid asset). This range is called the “liquidity trap”. However at
higher rates, the high premium on assets would tempt the investor to part with
cash. And as the rate of interest rises the incentive to lend would also
increase. This is known as the famous “Theory of Liquidity Preference”, which
is presented graphically in Figure 20.1.

The four broad functions of money may be described briefly as follows:

I. Primary Functions
Money as a Unit of Value: The monetary unit serves as the unit in terms of
which the value of all goods and services is measured and expressed (i.e. as
rupee, or dollar, or mark, or pound sterling, or yen etc). The value of goods
and services can be expressed as a price which implies the number of
monetary units for which it will exchange. The real value of the monetary unit
is subject to fluctuation.

52 Figure 20.1 Theory of Liquidity Preferences

Money as a Medium of Exchange: Money is generally referred to as the Financial Sector
Reforms
generalized purchasing power or as a bearer of options (since there is freedom
of choice in the use of money). This function of money is served by anything
which is generally accepted by people in exchange for goods and services. In
earlier days copper or gold coins served as money. In modern days, however,
paper currency, and cheques against commercial banks, current and savings
deposits function as the major forms of money. In the well developed financial
system credit cards have become a very important form of payment.
II. Derivative Functions
Money as a Standard of Deferred Payments: Modern economic systems
require the existence of a large volume of contracts where payment of
principal and interest on debt as future payments are in terms of monetary
units.

Money as a Store of Value: The holding of money is, in effect, the holding
of generalized purchasing power. The holder of money is aware of its universal
acceptance any time. Also, the value of money remains constant in itself over
time. Money is thereby an ideal store of value with which contingencies as well
as speculative motives may be satisfied.
Kinds of Money

1. Ordinary money M may be narrowly defined as the sum of currency, C,

and demand deposits, DD of banks held by the public.
M = C + DD
Since other deposits of the RBI included in the measure of M are a small
proportion, they can be reasonably neglected.
2. High-powered money H i.e., high-powered money may be defined as
money (small coins and one rupee notes) produced by RBI and the
Government of India and is held by the public and banks. H is called the
‘reserve money’ by the RBI.
H is therefore the sum of
a) currency held by the public, C
b) cash reserves of banks, R
c) other deposits of the RBI, OD

However, since OD is a small proportion, it may be left out for simplicity of

anlysis.

H = C + R

The student should note here that this empirical definition of H is from the
point of view of its users or holders and not its producers (RBI and the
government).

Let us sum up. In this section we have learned that money performs various
functions in the economy. Its basic function is to improve the efficiency of the
transaction in the process of production, consumption, saving and investment.
Money can function as a unit of value, medium of exchange, store of value or
means of deferred payment.

Ultimately, money is a liability of the monetary system. The control of money is

therefore a direct responsibility of the central bank of the economy. In India it
is the Reserve Bank of India (RBI). However, in a modern economy the
53
Economic Reforms Since central bank can directly control only a part of money known as high-powered
1991
money (H). There is however a stable relationship between H and money
supply in the economy.

20.3 INDIAN FINANCIAL SYSTEM

The structure of the Indian financial system may be summarised in the
following schematic representation (Figure 20.2). Broadly the Indian financial
system may be divided into organized and unorganized segments. The
organized market consists of commercial banks, development banks, co-
operative banks, post-office savings bank operations, stock markets etc.
Unorganised financial market operations consist of hundis, money-lending, chit
funds etc. They operate mainly in the rural areas. However in the urban areas
also unorganized money market activities are quite significant. There is no
precise estimate of the size of the unorganized money market. It is generally
expected that the relative size of the unorganized money market transactions
would decline over time.

RESERVE BANK OF INDIA

Organised Sector Unorganised Sector

Non-Banking Banking Money Indigenous

Institutions Institutions Lenders Bankers

LIC GIC UTI Private Development Cooperative Commercial

Finance Banks Banks Banks
Companies

Figure 20.2 : Structure of Indian Financial System

As depicted in figure 20.2 the Indian financial system consists of an impressive

network of banks and financial institutions and a wide range of financial
instruments. The primary role of the RBI is to maintain a monetary equilibrium
and balance in the economy by formulating various policies from time to time
and controlling the financial instruments of the economy. The balance sheet
identity for the RBI is as follows:

Monetary liabilities (ML) + Non-Monetary liabilities (NML)

= Financial assets (FA) + other assets

If net Non-monetary liabilities (NNML) = NML – other assets, then

ML = FA–NML

The monetary liabilities of the RBI are also called Reserve Money. In some
text books on monetary economics it has also been referred to as high–
powered money.

The monetary liabilities of RBI consist of currency in circulation (CUR) and

commercial banks’ deposits with the RBI (RES, also known as bank reserves).
As against these the financial assets of the RBI consist of RBI credit to the
54 government (RBCG), RBI credit to the commercial banks’ borrowings from the
RBI (RBCB), RBI credit to the development banks, such as National Bank for Financial Sector
Reforms
Rural Development (NABARD), National Housing Bank etc., and net foreign
exchange assets of the RBI.

The variations in the reserve money therefore depend essentially on the RBI’s
financial assets and liabilities, which in turn are influenced by the government’s
fiscal policy and various other rules and regulations.
1. Net RBI Credit to the Government
As banker to the government, RBI provides credit to both the central
government and the state governments. This it does by investing in government
securities (including treasury bills of the central government) and through short-
term advances to state governments. Until recently the central government
was empowered to borrow any amount from RBI through treasury bills and
rupee securities. In recent years the government has made some restrictions
on the amount of borrowing from RBI. In the case of state governments,
however RBI had put restrictions on borrowing even earlier.
2. RBI Credit to Commercial Banks
RBI provides credit to commercial banks through loans and advances against
government securities, use of bills or promissory notes as collateral and through
purchase or discounting of internal commercial bills as well as treasury bills.
However the RBI does not regard its purchase or rediscounting of bills for
banks as a part of its credit to banks. Instead it classifies it as RBC to
whatever sector, commercial or government, which issued these bills in the first
instance.
3. RBI Credit to Development Banks
A large number of development banks had been established in the country
through the initiative and help of RBI for the provision of long and medium
term finance to industry and agriculture. RBI provides them credit by investing
in their securities and through loans. Prominent development banks created
through RBI are: Industrial Development Bank of India (IDBI), Industrial
Financial Corporation of India(IFCI) and National Bank for Agriculture and
Rural Development (NABARD).
4. Net Foreign Assets of RBI
These assets constitute foreign currency reserves of RBI and therefore
represent RBC to the foreign sector (because of the financial liabilities of the
foreign governments). Most of these assets held abroad are in the form of
foreign securities and cash balances. The RBI comes to acquire them as the
custodian of the country’s foreign exchange reserves. As the controller of all
foreign exchange transactions, whether on private or government account, it
regularly buys and sells foreign exchange against Indian currency.
5. Net Non-Monetary Liabilities of the RBI
The net RBC to the above four sectors viz, Government, commercial banks,
development banks and foreign sector, is financed by RBI partly by creating its
monetary liabilities and partly by its net non-monetary liabilities (NNML).

FA or net RBC = ML + NNML

NNML basically consists of the owned funds of RBI (capital and reserves and
accumulated contributions to the National Funds) and compulsory deposits of
the public. The larger these non-monetary resources of RBI, the lesser its
dependence upon the creation of new H (high-powered money) to finance its
credit to various sectors. Hence this factor enters with a negative sign in the
equation. 55
Economic Reforms Since The current magnitude of different components of reserve money is shown in
1991
Table 20.1.
Is H an Autonomous Policy – Determined Variable?
In the Indian case, the monetary authority (RBI) is not autonomous of the
government. RBI is obliged to lend whatever amount the Central Government
chooses to borrow from it; even state governments can go on drawing
unauthorized overdrafts. Thus, for all practical purposes, RBI has no control
over the deficit financing of the government. The government shares the
monetary authority directly with RBI. H is not a fully policy-determined
variable, because it is the decision of both the authorities as well as the public
and the banks which lead to the generation or destruction of H. Banks and
development banks can change H within narrow limits by varying their
borrowing from RBI. The net purchases or sales of foreign exchange by the
public also change H. But despite all this, it would not be wrong to say that
because of the vast powers of monetary control enjoyed by RBI and the
government, net variations in the stock of adjusted H (or disposable H) are
directly within the close control of authorities so that the adjusted H can be
claimed to be a policy–controlled variable, though not a direct policy or control
instrument.

Table 20.1: Sources of Changes in Reserve Money

(Rs. in crores)
Indicator 2002-03 2001-02
Reserve Money 25,196 26,608
Broad Money 2,14,249 1,70,536
Currency with the Public 32,932 34,251
Aggregate Deposits 1,81,759 1,37,716
Net Bank Credit to Government 76,214 71,763
Bank credit to Commercial Sector 1,29,803 62,763
Net Foreign Exchange Assets of the
Banking Sector 82,991 51,650

Source: RBI, Report on Currency and Finance, 2001-02.

Reserve Requirements
By the technique of varying the reserve requirements the central bank at its
initiative can change the amount of cash reserves of banks and affect their
credit creating capacity. It may be applied on the aggregate outstanding
deposits or the increments after a base date or even on certain specific
categories of deposits depending mainly on the origin of deposit expansion.
Direct regulation of the liquidity of the banking system is made by the Reserve
Bank by two complementary methods: depositing in cash with Reserve Bank
of an amount equal to the percentage of deposits with each bank as prescribed
from time to time (known as cash reserve ratio or CRR), and maintenance by
the bank of a proportion of its deposit liabilities in the form of specified liquid
assets (known as the statutory liquidity ratio or SLR). As a result of the
application of reserve ratios, the free liquidity at the disposal of banks at any
time for lending would be the difference between the total deposits and the
total of the sums equivalent to the cash reserve ratio and the statutory liquidity
ratios.
Cash Reserve Ratio (CRR)
The RBI has been pursuing its medium-term objective of reducing the CRR to
its statutory minimum level of 3.0 percent by gradually reducing the CRR from
56 11.0 percent in August 1998 to 7.5% in May 2001. In October, 2001 mid-term
review the CRR of scheduled commercial banks excluding RRBs and Local Financial Sector
Reforms
Area banks was reduced by 200 basis points to 5.5 percent of their net
demand and time liabilities (NDTL). All exemptions were withdrawn, except
inter-bank liabilities, for the computation of NDTL (for requirement of CRR)
with effect from the fortnight beginning Nov 3, 2001. In the Annual policy the
CRR was furher reduced to 5% of NDTL. The CRR would continue to be
used in both directions of liquidity management in addition to other instruments.
Liquidity Adjustment Facility (LAF)
In recent years, the thrust of monetary management has shifted towards
development of indirect instruments of monetary policy to enable the Reserve
Bank of India to transmit liquidity and interest rate signals in a flexible manner.
The LAF operated through daily repo and reverse auctions, is assigned the
objective of meeting day to day liquidity mismatches in the system but not the
funding requirements, restricting volatility in short-term money market rates and
steering these rates consistent with monetary policy objectives.
Statutory Liquidity Ratio (SLR)
The effective SLR of the scheduled commercial banks is estimated to have
fallen to 25.0 per cent of their total net demand and time liabilities (NDTL) at
end March 2002. Bank Rate has fallen to 6 percent with effect from April
2003. All these measures have generated sufficient liquidity in the system.
Bench mark rate for the Prime Lending Rates was also worked out by the
Indian Banks Association consequent on which the PLRs of various banks have
come to signal a new approach to lending rate policy of the various players in
the lending system.
Development Banks
As the name suggests, development banks are development oriented.
Development banks are specialized financial institutions which perform the twin
functions of providing medium and long term finance to private entrepreneurs
and of performing various promotional roles conducive to economic
development. They are different from commercial banks in three ways:
i) They do not seek or accept deposits from the public
ii) They specialize in providing medium and long-term finance (commercial
banks specialize in providing short-term finance).
iii) Their functions are confined to providing long-term finance.

The distinguishing role of development banks is the promotion of economic

development by way of providing investment and enterprise in their chosen
spheres (manufacturing, agriculture, etc). The factors which led to the growth
of development banks are the inability of the normal institutional structure to
keep pace with the requirements of funds and entrepreneurship of the growing
industrial sector.

Figure 20.3 gives a detailed structure of development banks in India. As clearly

depicted, the four main categories of development banking in India are:
a) Industrial development banks
b) EXIM (export–import) bank
c) Agricultural development banks (NABARD)
d) Housing Development banks

Except land development banks (LDB) the rest are a post-independence

phenomenon. With a variegated structures, the development banking institutions
as a group have played a significant part in the economic development of India
via the investment market and have emerged as the backbone of the financial
system. 57
Economic Reforms Since Development banks provide financial assistance to industry in the following
1991
forms:
i) term loans and advances
ii) subscription to shares and debentures
iii) underwriting of new issues
iv) guarantees for term loans and deferred payments

The first two forms place funds directly in the hands of companies as
subscription to shares and debentures. The last two forms facilitate the raising
of funds from other sources.
Aggregative Role of Development Financing Institutions
Development Financing Institutions consist of Development Banks like the
IDBI, SIDBI, NABARD and the State Finance Corporations. Three of the
development financing institutions has exited from the market after the RBI
announced its policy of harmonization of the development and banking
functions. They are: ICICI with a reverse merger with its off-spring ICICI
Bank Ltd., impending merger of IFCI with the Punjab National Bank, and the
winding up of the IRBI due to its unsustainable nature. The IDBI is also
slated for conversion to a Bank and the Parliament already gave its approval.
The process is yet to commence.

The role played by development banks is of two broad types.

1. Quantitative Role
This is the part played by development banks as a constituent of the industrial
financing system in India and refers to the magnitude of funds provided by
them jointly to industrial enterprises. The magnitude of industrial financing by
these development banks has been considerable.
A. These banks have emerged as the single most important source of
institutional finance to industry and have come to occupy a pre-eminent
position in the institutional structure of the financial system. The annual
average of sanctioned assistance by all the development banks during the
three year period 1978-79 to 1980-81 touched an all time high of Rs.1808
crores. At present, as much as one-third of the gross fixed capital
formation in private industry is being contributed by development banks.

DEVELOPMENT BANKS

Housing Industrial Exim Agricultural

Development Development Bank Development
Bank Bank Banks
(HDFC) (NABARD)

All-India State Level Local level State Land

(SFCs, SIDC/SIIC) Development
Banks (SLDBs)

For Small-scale For Large Scale Primary Land Development

Industries Industries Banks and Branches of SLDBs
(SIDBI) (IDBI)

Figure 20.3 : Development Banks

58
B. In India, their operations have the effect of improving the allocative Financial Sector
Reforms
efficiency of the financial system. The development banks perform the
function of being a substitute for the capital market. When industrial
enterprises are unable to raise funds from the normal channels,
development banks fill the gap as well as restore or resuscitate the capital
market.
C. As integral part of their lending operations, they thoroughly appraise
projects as regards the priority aspect, financial viability and economic
soundness and so on. The rigorous and exacting scrutiny by development
banks tones up the quality of industrial projects and enables a more
efficient use of available project resources.
D. Appraisal by the development banks is impersonal and objective. This
results in financial assistance to diverse enterprises for a wide variety of
purposes which would not otherwise have been possible. Included in this
category are; new enterprises, small or medium–sized firms, enterprises in
backward regions, and non-traditional industries.
2. Qualitative Role
Development banking in India has an overwhelmingly qualitative dimension too
in terms of the recent orientation towards promotional or innovative functions in
their operations. With the evolution of a meaningful strategy of industrial
development, a more positive role has been assigned to, and it being played by,
development banks in India since 1969-70. The essential elements of these are:
(i) development of backward regions, (ii) encouragement to a new class of
small entrepreneurs and enterprises, and (iii) rehabilitation of sick mills.
Commercial Banks
Commercial banks are the single most important source of institutional credit in
India. Figure 20.4 shows a detailed structure of commercial banks in India.

There are two essential functions which make a financial institution a bank
(i) Acceptance of cheque-able deposits from the public, and (ii) lending.

Acceptance of cheque–able deposits is the most distinctive function or its

unique function. Cheque–able deposits have the following features;
These are deposits of money and non-financial assets
Deposits are accepted from public at large
Deposits are repayable on demand and withdrawable by cheque

The second essential function related to the use of deposits (Lending includes
direct lending to borrowers and indirect lending through investment in open
market securities). Table 20.2 gives some selected indicators about scheduled
commercial banks.

Table 20.2: Branches of Public Sector Banks and other Commercial Banks

Bank Group Branches

(as on 30 th June 2001)

A. State Bank of India & Associates 13416

B. Nationalised Banks 32663
C. Regional Rural Banks 14452
Total of Public Sector Banks (A+B+C) 60531
D. Other Indian Scheduled Commercial Banks 5206
E. Foreign Banks 194
All Scheduled Banks 65931
F. Non-scheduled Banks 0
All Commercial Banks 65931
59
Source: Economic Survey 2001-02.
Economic Reforms Since 1. Indian Banks
1991
The bulk of the banking business in India is done by the commercial banks
owned and operated from India. Some Indian banks also operate in a few
foreign countries. The Indian banks constitute both public and private sector
banks.
Public Sector Banks
They constitute the dominant part of commercial banking in India. The public
sector banks constitute both nationalized commercial banks and regional rural
banks (RRBs). The public sector banks may also have some private by-owned
shares.
i) Nationalised Banks : Nationalisation began in 1955, when the Imperial
Bank of India was converted into SBI. In addition, this bank has seven other
state banks as its subsidiaries. By April 1980, 28 banks were nationalized in the
public sector. Together they control more than 90 per cent of bank deposits.

ii) Regional Rural Banks : Regional Rural Banks are the newest form of
banks that have been set up in the country on the sponsorship of individual
nationalized commercial banks. These were set up with the express objective of
developing the rural economy by providing credit and other facilities for
agriculture and other productive activities of all kinds in rural areas. The paid
up capital of a rural bank is Rs.25 lakhs, 50 per cent of which is contributed
by the central government, 15 per cent by the state government, and the
remaining 35 per cent by the sponsoring commercial public sector bank.

iii) Local Area Banks (LABs) : As a follow up of the Narasimham

Committee Report – I, LABs were to be set up under Private or NGO
initiative. The policy had a proverbial Hamletian “to be – or not to be”
oscillation for more than seven years. It granted three licenses — one in
Karnataka, and two in Andhra Pradesh in 2000. But their functional data is not
available under separate head. It has become part of rural financial data.

2. Foreign Banks
These are banks which have been incorporated and have their head offices
outside India. They occupy a place of importance in the Indian banking
industry, especially in financing foreign trade and in the field of merchant
banking.

COMMERCIAL BANKS

Indian Banks Foreign Banks

Private Sector Public Sector

Banks Banks

Nationalised Banks Regional Rural Banks &

(including SBI and Local Area Banks (LABs)
its 7 Associated Banks)

Figure 20.4: Commercial Banks

60
3. Co-operative Banks Financial Sector
Reforms
Co-operative banks are so called because they have been organized under the
provisions of the co-operative societies law of the states. Under the law, co-
operative societies may be organized for credit or for non-credit purposes. The
co-operative banking system is much smaller than commercial banking. The
major beneficiary of co-operative banking is the agriculture sector in particular
and the rural sector in general. Despite several organizational weakness, village
level primary cooperative credit societies are best suited to the socio-economic
conditions of Indian villages.

Table 20.3: Deposits of Public Sector Banks and other Commercial Banks
(As at end March)
(Rs. in crore)
Bank Group 2002 2003
Public Sector Banks 968623.57 1079393.81
Nationalised Banks 617550.78 688361.12
State Bank Group 351072.79 391032.69
Private Sector Banks 169432.92 207173.57

Source: Report on Trend and Progress of Banking In India 2002-03.

The co-operative credit structure is represented in Figure 20.5. The arrows

denote flow of funds; the downward flow of funds is larger than the upward
flow. The State Cooperative Banks (SCBs) and Central Cooperative Banks
(CCBs) are also called the higher or central financing agencies (for the primary
societies). At the apex are the SCBs. Primary Agricultural Credit Societies
(PACS) lend to their individual borrowing members. An SCB does not lend
directly to primary societies in areas where a CCB exists and the CCB lends
only to primary societies and not to their members or other individuals (except
in a few cases). This is in the interest of functional specialization,
manageability and cost-effectiveness which is the rationale of the three–tier
structure. The basic need for higher financing agencies arises because the
PACS are not able to raise enough resources or funds by way of deposits from
the public. In fact about 60 per cent of their working capital comes as loans
from the CCBs who in turn borrow about from higher financing agencies.

CO-OPERATIVE BANKS

Agricultural Non-Agricultural

Long-term Credit Short and Medium term Credit

(Land Development Banks) State Co-operative Banks (SCB- State Level)

Central Co-operative Banks (CCB- District Level)

Primary Agricultural Credit Societies (PACS- Village Level)

Figure 20.5 : Co-operative Banks

Contrary to popular belief, the government is actually the net debtor to the co-
operative banking system because :
i) A large part of the government’s financial assistance (about 50 per cent) in
the form of its contribution to the share capital of societies is advanced by
NABARD.
61
Economic Reforms Since ii) The cooperative banking system (including LDBs) provides funds to the
1991
government by way of investment in its securities. For SCBs and CCBs
such investment is required by RBI under its SLR requirement. Hence,
there is a net withdrawal of funds by the government from the co-
operative banking system.
Investment Institutions
We now refer to Figure 20.2, which depicts four categories of non-banking
financial institutions or investment institutions in India, viz.
a) UTI (Unit Trust of India)
b) LIC (Life Insurance Corporation of India)
c) GIC (General Insurance Corporation of India)
d) Private Finance Companies.

The Reserve Bank of India (Amendment) Ordinance, 1997 confers wide-

ranging powers on RBI for controlling the functioning of non-banking financial
companies. The ordinance has defined an NBFC as a financial institution,
which is a company, or a non-banking institution, and which has, as its principal
business, the receiving of deposits under any scheme or arrangement or in any
other manner, or lending in any manner. As per the ordinance, no NBFC can
commence or carry on business (a) without obtaining from RBI a certificate of
registration; and b) having net owned funds of Rs.50 lakhs or such other
amount, not exceeding Rs.200 lakhs, as RBI may specify. As the UTI has
now become a part of SEBI mutual fund discipline, its loan sanction and
disbursement functions are being eliminated, as per SEBI guidelines relating to
mutual funds.
Activity 1
Briefly explain the role played by the following institutions.
a) IDBI .......................................................................................................
.......................................................................................................
b) PACSs .......................................................................................................
.......................................................................................................
d) SCBs .......................................................................................................
.......................................................................................................
e) RRBs .......................................................................................................
.......................................................................................................
f) LIC .......................................................................................................
.......................................................................................................
g) UTI .......................................................................................................
.......................................................................................................

20.4 FINANCIAL SECTOR REFORMS

By now you are well aware that the economic reforms launched by the
Government more than a decade ago were designed to accelerate overall
growth and help India realize its full productive potential. The experience of
successful developing countries indicates that rapid growth requires a sustained
effort at mobilizing savings and resources and deploying them in ways, which
encourage efficient production. Financial sector reform thus constitutes an
important component of the programme of stablisation and structural reform.
62
At the outset the Government had recognised that financial sector reform was Financial Sector
Reforms
an integral part of the new economic policy. A high level committee headed
by Mr. M.N. Narasimham was appointed to consider all relevant aspects of the
structure, organisation, functions and procedures of the financial system.
Following the committee’s report in November 1991, the Government embarked
on a far–reaching processes of reform covering both the banking system and
the capital market. The need for a thorough –going reform of the financial
system was further underscored by the now famous securities scam (or
irregularities of the banks) news of which broke out in April 1992.

A large part of the agenda for reform of the financial system relates to the
problems facing the public sector commercial banks, which have dominated
banking in India since nationalization in July 1969. The goal of nationalization
was to extend the reach of banking and financial services to all parts of the
country and to all sections of society. It also aimed at widening the net of
resources mobilization.

While there are significant achievements, they have been accompanied by

serious shortcomings as well. For instance, the quality of customer service has
not kept pace with modern standards and changing expectations. The time
taken for processing and completing banking transactions is too long. The
banks have also not kept pace with the revolutionary changes in computer and
communication technologies. This affected the speed, accuracy and of
efficiency of services and the basic integrity of banking processes such as
internal controls and inter-branch reconciliation of accounts. It also militated
against prompt decision–making and against improved productivity and
profitability. All these were greatly reflected in the poor financial condition of
the banks and the adverse impact it had on the economy.

The Narasimham Committee recognised the fact that the quantitative success
of the public sector banks in India was achieved at the expenses of
deterioration in qualitative factors such as profitability, efficiency and the most
important the quality of the loan portfolio which now needed to take the centre
stage. The elements of the recovery programme reiterated by the committee
are as follows:
Reduce presumption of lending capacity through staged reductions in SLR and
CRR, while moving the yield on government debt to market–related levels.
Stress availability rather than subsidy in provision of credit to the priority
sector, and restrict cross-subsidy only to the smaller borrowers. The goal
should be to establish incentives that induce adequate flows of credit to
priority uses, especially agriculture, without compromising on prudential and
commercial consideration.
Move to objective, internationally recognised accounting standards, with
suitable transitional provisions to give banks time to adjust. These accounting
norms will clarify and strengthen the incentives for bank managements to
exercise greater care in credit assessment and recover.
Make additional capital available from the government and the capital
markets to strengthen banks’ financial position and provide a basis for future
growth. Provision of capital by the government will be conditional on
monitorable improvements in the management and recovery performance of
each bank. Access to the markets will impose the additional discipline of
prospectus registration or assessment by credit rating agencies and
accountability to non-governmental shareholders.

63
Economic Reforms Since Improve prospects for recovery by setting up special recovery tribunals in
1991
major metropolitan areas.
Set up a credit information database for exchange of information on the
credit history of large borrowers subject to confidentiality.
Upgrade the caliber of appointees to board level posts, stressing longevity
and security of tenure.
Enhance managerial accountability and stress performance–related
promotion.
Encourage technological modernization in banks through computerization and
greater labour flexibility.
Encourage greater competition for public sector banks through the
controlled entry of modern, professional private sector banks including
foreign banks.
Create a new board for financial supervision to devote exclusive attention to
issues of compliance and supervision and review the Banking Regulation
Act.
Ensure viable mechanisms for supply of credit to the rural sector, small-
scale industry and weaker sections.

The steadfast pursuit of this agenda promised to transform Indian banking and
the public sector banks in particular (By June 1996 the following targets had to
be attained).
a) all public sector banks achieving 8 percent capital to risk–assets ratio
b) half the public sector banks (weighted by deposits) should be quoted on the
stock market with appropriate representation of shareholders on bank
boards.
c) significant entry of new private sector banks
d) SLR and CRR appreciably reduced
e) interest rates deregulated
f) at least 500 branches of public sector banks would be fully computerized.

Capital Market Reforms

The Securities Exchange Board of India (SEBI) has been issuing guidelines
from time to time for establishing a fair and transparent capital market. Some
of the major measures announced by SEBI are briefly enumerated below:
In October 1993, regulations for underwriters of capital issues and capital
adequacy norms for the stock brokers in the stock exchanges were
announced.
As per modified guidelines, bonus issues can be made out of free reserves
built out of the genuine profits or share premium collected and the interest
of holders of fully or partly convertible debentures will have to be taken into
account while issuing bonus shares.
The stock exchanges have been directed to broad–base their governing
boards and change the composition of their arbitration, default and
disciplinary committees.

64
 SEBI notified regulations for bankers to issues in July 1994. The Financial Sector
Reforms
regulations make registration of bankers to issues with SEBI compulsory.
It stipulates the general obligations and responsibilities of the bankers to
issues and contains a code of conduct. Under the regulations, inspection of
bankers to an issue will be done by the Reserve Bank on request from
SEBI.
RBI has liberalized the investment norms evolved for NRIs by allowing
companies to accept capital contributions and issue shares or debentures to
NRIs or overseas corporate bodies without prior permission.
The government has allowed foreign institutional investors (FIIs) such as
pension funds, mutual funds, investment trusts, asset or portfolio
management companies etc. to invest in the Indian Capital market provided
they register with SEBI.
SEBI has made it compulsory for credit rating of debentures and bonds of
more than 18 months’ maturity.
The maximum debt-equity ratio of banks is 2:1 and the minimum debt
service coverage ratio required is 1:2.

Reductions in Statutory Liquidity Ratio (SLR) and

Cash Reserve Ratio (CRR)
According to the Narasimham Committee, one of the problems facing our
banking system was that the levels of SLR and CRR had been
progressively increased over the past several years. In the case of SLR this
happened because of the desire to mobilize even larger resources through
so-called market borrowing (at below-market rates) in support of the central
and state budgets. In the case of the CRR this happened because of the
need to counter the expansionary impact on money supply of large budget
deficits. Together the SLR and CRR stipulations preempted a large part of
bank resources into low income earning assets thus reducing bank
profitability and pressurising banks to charge high interest on their
commercial advances. The high SLR and CRR were in effect a tax on
financial savings in the banking system and served to encourage flows in
the market where this tax did not apply. The Government therefore decided
to (and has) reduced SLR in stages over a three year period from 38.5 per
cent to 25 per cent and that of CRR over a forty-year period to a level of
10 per cent.

Reforms in Development Banking Sector

The Narasimham Committee recognized that the development financial
institutions’ operation in India was marked by the total absence of competition
in the matter of provision of loans and medium-term finances. The system
had evolved into a segmentation of business between DFIs and the banks, the
latter concentrating on working capital finance and the former on investment
finance. Borrowers as a consequence had no choice in selecting an
institution to finance their projects. The committee suggested delinking of
these institutions from the state governments for better efficiency. The
operations of the DFIs in respect of loan sanctions should be the sole
responsibility of the institutions themselves based on a professional appraisal
of projects. The Government also embarked on a process of disinvestments
in some of the bigger institutions like IDBI etc.

65
Economic Reforms Since Activity 2
1991
Discuss with some people having relevant knowledge/expertise and find out if
the proposed reforms have actually been worked out successfully in the
following sectors. Give examples.
a) Commercial Banks
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

b) Development Financing Institutions

.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

c) Capital Market
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

d) CRR and SLR

.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

20.5 SUMMARY
Let us summarise the main points of the unit.
The fundamental function of any monetary and financial system is to
promote efficiency in the processes of exchange
The four broad functions of money are to act as
- a unit of account
- a medium of exchange
- a standard of deferred payments
66 - a store of wealth
 The Reserve Bank of India is the apex institution of the Indian financial Financial Sector
Reforms
system. It regulates and controls, by means of laws, financial instruments,
etc., the working of a vast network of financial institutions under it, directly
or indirectly.
The monetary liabilities of the RBI are called the Reserve Bank Money
(RBM).
RBM = (1) net RBC to the government
+ (2) RBC to development banks
+ (3) RBC to banks
+ (4) net foreign assets of RBI
+ (5) net non-monetary liabilities of RBI.
High–powered money, H, is the money produced by RBI and the
Government of India (small coins and one rupee notes) and is held by the
public and banks. It is also called reserve money.
‘H’ is not a fully policy-determined variable. However, adjusted H can be
claimed to be a policy–controlled variable.
Development banks are specialized financial institutions, which perform the
twin functions of providing medium and long-term finance to private
entrepreneurs and of performing various promotional roles conducive to
economic development.
Commercial banks are the single largest source of institutional credit in
India.
Public sector banks constitute the dominant part of commercial banking in
India.
Cooperative banks are so called because they have been organized under
the provisions of the cooperative societies laws of the states. Despite
several weaknesses, village level PACs are best suited to the socio-
economic conditions of Indian villages.
The direct regulations of the banking system is done by the Reserve Bank
by two complementary methods:
a) depositing in cash with the Reserve Bank of an amount equal to the
percentage of deposits with each bank as prescribed from time to time
known as CRR. (Cash Reserve Ratio).
b) maintenance by the bank of a proportion of its deposit liabilities in the
form of specified liquid assets known as SLR (Statutory Liquidity
Ratio).
A high-level committee headed by Mr. M.N. Narasimhan was appointed to
consider all relevant aspects of the structuring, organisation, functioning and
procedures of the Indian financial system. The Committee placed its report
before Parliament in December, 1991.
The Committee’s main recommendations were:
a) Reductions in SLR and CRR.
b) Norms for income recognition, provisioning and capital adequacy.
c) Provision of balance-sheet and profit and loss accounts formats for banks.
d) Branch licensing.
e) Permission to set up new private sector banks. 67
Economic Reforms Since Along with banking system reforms, the committee also thought it
1991
necessary for capital market reforms to be undertaken. The main features
of these reforms (as provided for in SEBI guidelines) are:

a) no promoters’ contribution
b) underwriting not mandatory
c) maximum debt-equity ratio 2:1 minimum debt service coverage ratio 1:2
d) credit rating compulsory for debentures and bonds of more than 18
months’ maturity
e) The committee also felt the need for reforms in the operations of
DFIs.

20.6 KEY WORDS

Reserve Money: A component of money supply directly controlled by RBI.

High Power Money: Money produced by RBI and the Government of India
in the form of small coins and one rupee notes which is held by the public and
banks. High power money is also called the reserve money of RBI.

Cash Reserve Ratio (CRR): The ratio of cash required to be maintained

from time to time with the RBI by the banks against their total net demand
and time liabilities (deposits).

Statutory Liquidity Ratio (SLR): The proportion of deposit liabilities to be

maintained by a bank in the form of specified liquid assets.

Investment Institutions: All institutions making investments for commercial or

industrial purposes. This includes commercial banks, development banks (or
institutions) cooperative banks and non-banking institutions including LIC, GIC,
UTI, and private finance companies.

Development Banks: Specified finance institutions performing the twin

functions of providing medium and long term finance and performing various
promotional roles for economic development of the country.

Commercial Banks: Banks accepting deposits from the public and lending
money for short term requirements of industrial and commercial enterprises.

Cooperative Banks: Banks registered under the provisions of Cooperative

Societies Act and providing credit mainly for agricultural purposes.

Public Sector Banks: Commercial banks owned and managed by the

Government (after nationalization), banks not falling in this category are called
private sector banks.

Monetary Policy: Policy of the Government concerned primarily with the

maintenance of stability in domestic prices and exchange rate stability. The
subsidiary objectives may be social justice, growth etc.

68
Economic Reforms Since Annexure-I
1991

PROGRESS OF FINANCIAL SECTOR REFORMS

(till March 2000)

01.Banking Market Banking industry in India in 1990 consisted of just

70 players, 27 of these were in the public sector,
24 in private and 21 are the foreign banks. Ten
years later, banking industry is vastly expanded
with the number of foreign banks nearly doubling
and ten more new banks in the private sector.
Banking industry today is intensively competitive.

02.Banking Products At the time of reforms, most of the products

offered by banks are plain vanilla. Massive
expansion of products and services took place in
the last few years driven by rapid advances in
technology that has dramatic impact on the delivery
systems and ability to service a greater number of
products.

03.Regulation Regulation is much more refined now. While

banks are given greater operational freedom, the
quality of regulation has heightened with stringent
norms prescribed in respect of capital adequacy,
classification of assets, provisioning, valuation of
investments etc. Regulation is evolved broadly on
the emerging international developments which
while promotes deregulation and liberation at the
same time prescribes stringent rules governing
business operations and market developments.

04.Supervision Increase in the quality of on-site and offsite

surveillance and supervision. A new Board for
Supervision came into being which undertakes
comprehensive banking supervision on the lines of
international better practices.

05.Ownership While public sector continues to account for a

major part of the banking, greater inroads are
made by the private sector in the form of new
banks allowed in the private sector, entry of a
large number of foreign banks, partial divestment
of the government equity in the public sector
banks, allowing the public sector banks, allowing
the public sector to dilute government equity upto
33 percent, allowing foreign direct investment in
banking etc.

70 Contd.
Contd. Financial Sector
Reforms
06.Prudential Norms International better practices covering a wide range
of banking operations and practices prescribed in
the post reforms and are being introduced gradually
in a number of areas.

07.Disclosure The balance sheet of banks today is vastly

Standards different from what was in the beginning of
reforms. Every year additional disclosures are
being made in the bank balance sheets providing
greater amount of information to market players
and participants.

08.Governance A code of governance in banking is yet to be

evolved but the implementation of prudential norms
and adoption of banking standards particularly in
respect of transparency and disclosure has
significant impact on the quality of governance in
Indian banking.

09.Market Share There are sizeable shifts in the market share of

domestic banking institutions; but there is no
perceptible increase in the share of foreign banks.
For instance in the total assets, the share of the
public sector banks has declined from 90 percent in
1990-91 to 80 percent in 1999-00, whereas that of
the private sector shot up from 3.62 percent to
12.56 percent during this period. The share of
foreign banks in assets which was 6.05 percent in
1990-91 increased to 8.08 percent in 1992-93 but
later softened to 7.30 percent in 1990-00.

10.Capital The equity of banks made a massive jump from

Rs.3071 crores in 1990-91 to Rs.18448 crores in
1999-00. All the bank segments such as the public
sector, private sector and foreign banks showed
impressive rise in the equity levels. Reserves also
showed rapid rise in the post reform period.

11. Deposits Total Deposits of banks showed a massive jump

from Rs.231975 crores in 1990-91 to Rs.900307
crores in 1999-00.

12.Credit Bank advances shot up from Rs.143961 crores in

1990-91 to Rs.443661 crores in 1999-00.

13.Income Income increased manifold from Rs.27448 crores in

1990-91 to Rs.115855 crores in 1999-00.

Contd. 71
 Contd.
Economic Reforms Since
1991 14.Profit Net Profit of the banking sector showed an impressive
jump from Rs.640 crores in 1990-91 in 1999-00.

15.Profitability Net Profits as a percent of Working Funds showed a

sharp rise from 0.22 in 1990-91 to 0.66 in 1999-00.

16.Productivity Business Per Employee registered a robust growth

from Rs.40.38 lakhs in 1990-91 to Rs.140.93 lakhs
in 1999-00.

17.Non-Interest Non-Interest Income as a percent to total income

Income increased from 9.85 percent in 1990-91 to about
13.70 percent in 1999-00.

18.New Business Post reforms period in Indian banking unleased a

wide range of new products and services. Driven
by technology a number of new generation
products such as electronic fund transfers, debit
cards, smart cards, electronic clearing service, farm
and consumer credit cards etc., are introduced.
Retail banking received greatest thrust in the post
reform period. Deregulation of the insurance
sector is envisaged to lead to further proliferation
of the products.

19.Competition Competition intensified with a larger base of

players and non-banking financial institutions
emerging stronger in a liberalized and deregulated
environment.

20.Consolidation Evidence of consolidation is found in the private

sector with the merger of HDFC Bank and Times
Banks, ICICI Bank and Bank of Madura, UTI
Bank and Global Trust Bank (yet to be finalized)
etc. The only exercise of consolidation of the
public sector banks was at the beginning of the
reforms with merger of New Bank of India with
the Punjab National Bank. The pace of
consolidation is expected to intensify in the process
of second generation reforms.

21.Globalization Indian banking is gearing up for absorbing the

challenges of global finance. Starting with
harmonization of the operational norms and
procedures, endeavours are being made to enhance
the quality and content of the efficiency
parameters, which is essential to withstand the
impact of global competition. The ushering in of
the second-generation reforms is envisaged to
strengthen the role and performance of Indian
72 banking in this regard.
UNIT 5 MONEY MARKETS
Structure
5.0 Objectives
5.1 Introduction
5.2 Functions and Features of Money Markets
5.3 Evolution of Money Market in India since the mid-eighties
5.4 Money Market Instruments
5.5 Factors Influencing Money Markets in India
5.6 Money Market and Monetary Policy in India
5.7 Let Us Sum Up
5.8 Key Words
5.9 Some Useful Books
5.10 Answers/Hints to Check Your Progress Exercises

5.0 OBJECTIVES
After going through this unit, you will be able to:
z discuss the main functions of the money markets;
z describe the principal features of these markets;
z list the basic money market instruments in India;
z examine the factors influencing money markets in India; and
z analyse the impact of monetary policy on money market operations.

5.1 INTRODUCTION
Debt market is generally understood as comprising the money market (short-term
debt, maturity of one year or less) and the capital market (long-term debt). This
distinction is made as the two sectors are driven different market forces and serve
different needs of the market players. This Unit is a discussion about the nature,
functioning and the developments of Money Market.
Banks and Financial Institutions, even though they plan their cash-flows meticulously,
usually find that on any day their actual cash inflows and cash outflows do not match.
They have either a cash short fall or cash excess. By nature these are of short-term
nature. Though this happens in the case of all enterprises, it is manageable for
commercial enterprises as they depend on their banks. However, banks and financial
institutions that have temporary shortages cannot postpone their liabilities and have
to meet these liabilities; default by them would result on a run on the banks. On the
other hand banks and financial institutions which have temporary surpluses are on
the look out for very short term investment opportunities. But, these should be very
safe or risk-less. Any default or even a day’s delay would land the banks and financial
institutions in unnecessary trouble. One has to remember that these “investments”
are not really investments but are by nature deployment of temporary funds in search
of some return. We can say that these are parking of funds for a short time till
1
required. Thus investments in money market are not made using the universal rule of
Financial Markets “trade-off between risk and return”. But, on the other hand, it a market for funds
seeking safe or riskless avenues. Money markets are different from capital markets.
Financial Markets
Capital Market Money Market
z Market for Long Term z Market for Short Terms Funds
z Supply z Assets
– Individual savers – close substitutes of money
– Investment by Banks z Supply
– FI’s – Temporary surpulses of
– Mutual Funds Companies, FI’s Banks
z Demand z Demand
– Companies – Temporary deficit of
– FI’s Companies, FI’s Banks
– Mutual Funds z Guiding Principle
z Guiding Principle – Parking in Riskless Assets
– Risk-Return trade off z Yield not so important
The differences between the two markets can be understood as given below:

5.2 FUNCTIONS AND FEATURES OF MONEY

MARKETS
Money market can be defined as a market for money and close substitutes for
money. In other words market for assets that can be converted into money easily
and without any loss of capital. It can also be seen as a market for short-term funds,
i.e., up to one-year maturity. The money market is generally expected to perform
three broad functions.
1) It should provide an equilibrating mechanism to even out demand for and supply
of short-term funds.
2) It should provide a focal point for central bank intervention for influencing liquidity
and general level of interest rates in the economy.
3) It should provide reasonable access to providers and users of short-term funds
to fulfill their borrowing and investment requirements at an efficient market
clearing price.
Thus Money Market is a market for short-term funds. Money market constitutes an
important segment of the financial market by providing an avenue for equilibrating
the surplus funds of lenders and the requirements of borrowers for short periods
ranging from overnight up to an year. In this process, it also provides a focal point
for central bank’s intervention in influencing the liquidity in the financial system and
thereby transmitting the monetary policy impulses.

5.3 EVOLUTION OF MONEY MARKET IN INDIA

SINCE THE MID-EIGHTIES
Recognizing the need for reforms in the financial system in India, The Reserve Bank
of India had constituted a committee to Review the Working of the Monetary System
under the Chairmanship of Shri Sukhamoy Chakravarty in 1985. While this committee
2
gave a detailed recommendation for the reforms in the financial system, it commented
that Money Markets are a special segment and need a detailed study and Money Markets
recommended setting up of a special study group to go into this matter. Thus the
RBI set up a Working Group on Money Market under the Chairmanship of
Shri.N.Vaghul, which submitted its Report in 1987. Based on the recommendations,
RBI initiated a number of measures in the ‘eighties to widen and deepen the money
market. The main initiatives were:
1) In order to impart liquidity to money market instruments and help the
development of secondary market in such instruments, the Discount and Finance
House of India (DFHI) was set up as a money market institution jointly by the
Reserve Bank of India, public sector banks and financial institutions in 1988.
RBI has since divested its shareholding and DFHI has been taken over by SBI
and merged with SBI Gilts to form the SBI DFHI Ltd.
2) To increase the range of money market instruments, Commercial Paper,
Certificates of Deposit, and Interbank Participation Certificates were introduced
in 1988-89. There is a wide range of instruments now.
3) To enable price discovery, the interest rate ceiling on call money was freed in
stages from October 1988. As a first step, operations of DFHI in the call/
notice money market were freed from the interest rate ceiling in 1988 and in
May 1989, the interest rate ceiling was completely withdrawn, for all operators
in the call/notice money market and on interbank term money, rediscounting of
commercial bills and Interbank Participation Certificates without risk. Currently,
all the money market interest rates are by and large determined by market
forces.
Subsequently institutions similar to the DFHI were allowed to be set up and named
as many Primary Dealers PD’s. As of now we have about 16 PD’s in India both in
the Public Sector and the Private. These PD’s play a very important role in the
money market, that of market makers. They participate actively in the auctions of
Treasury Bills and Government Bonds. Thus they buy, stock and retail Government
Debt (Primary Securities)
Check Your Progress 1
1) List the main functions of money markets.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2) Mention the significant changes taking place in the money markets of India
since the mid-eighties.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
................................................................................................................... 3
Financial Markets
5.4 MONEY MARKET INSTRUMENTS
As discussed earlier, the institutions having temporary surpluses seek risk-less
investments. Thus special type of instruments are needed in this market. These
instruments are called Money Market Instruments. They are discussed below.
Characteristics of Money Market Transactions
z Short Term in Nature
z Instruments with very low risk are used
z Very low transaction costs
z No transactions hassles
z Very high volumes
z Thus the market efficiency depends on
z Low cost transactions
z Information availability, and
z Large number of participants
The figure below shows the proportion of various instruments in the total money
market as prevailing in India

CD
12%
Call
29%

CP
23%

Market Repo
CBLO 22%
14%

Call Money
Call Money is the over night inter-bank funds market in India. It has the following
characteristics:
z Overnight funds / deposits
z Participants
4
 z Banks Money Markets

z Primary Dealers
z FI (restricted)
z Demand And Supply
z Temporary surpluses / deficits of banks and PD’s
z RBI restrictions
z Totally deregulated and left to market forces. But,
z Only for Banks and Primary Dealers
z Clean Lending, in the form of a deposit
z Interest rates
z Deregulated i.e., rates determined by the market forces
z Volatile : wide fluctuations even during the day
The figure below shows the change in the rates for various money market instruments
in India in the period 2003-2005.

Chart 1 : Money Market Rates : April 2

7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
29-Jul-03

26-Nov-03
30-A pr-03
30-May-03
29-Jun-03

28-A ug-03
27-Sep-03
27-Oct-03

26-Dec-03
25-Jan-04

25-Mar-04
24-Apr-04
24-May-04
24-F eb-04

z Intervention of RBI through LAF, OMO

z High value transactions
Call Money Reverse Repo Rates
z Brokers not allowed
The call/notice money market was predominantly an interbank market until 1990,
except for UTI and LIC, which were allowed to operate as lenders since 1971. The
RBI’s policy relating to entry into the call/notice money market was gradually
liberalised to widen and provide more liquidity. The behaviour among banks in the
call money market is not uniform. There are some banks, mainly foreign banks and
new private sector banks, which are active borrowers and some public sector banks
5
Financial Markets that are major lenders. RBI has been a major player in the call/notice money market
and has been moderating liquidity and volatility in the market through repos and
refinance operations and changes in the procedures for maintenance of cash reserve
ratio.
A reference rate in the overnight call money market called “MIBOR” or the “Mumbai
Interbank Offer Rate” similar to the LIBOR has emerged recently through the National
Stock Exchange and Reuters.
Commercial Paper
CP is a money market instrument, issued in the form of a promissory note, by highly
rated corporates for a fixed maturity in a discounted form. CP was introduced in
India in 1989 to enable highly rated corporate borrowers to diversify their sources
of short-term borrowing and also to provide an additional instrument to investors.
Terms and conditions for issuing CP like eligibility, modes of issue, maturity periods,
denominations and issuance procedure, etc., are stipulated by the Reserve Bank.
There are no interest rate restrictions on CP. With experience, refinements were
made to the instrument by removing/easing number of restrictions on the maturity
and size of CP, requirement of minimum current ratio, restoration of working capital
finance , etc. Corporates, PDs and SDs are eligible for issuing CP for a minimum
period of maturity of 15 days and maximum period of 1 year. It is significant to note
that there is no lock-in period for CP. The issuance of CP has been generally observed
to be related inversely to the money market rates.
Certificates of Deposit
While deposits kept with banks are not ordinarily tradable, when such deposits are
mobilised by a bank by issue of a CD, then such deposits get securitised and,
therefore, become tradable. Thus, CDs represent essentially securitised and tradable
term deposits.
In India, CDs were first introduced in 1989. The terms and conditions for issuing
CDs like eligibility, maturity periods, size, transferability, applicability of reserve
requirements, etc., are stipulated by the Reserve Bank. CDs in general represent
relatively a high cost liability. Hence, banks resort to this source generally when the
deposit growth is sluggish but credit demand is high.
Treasury Bills
Treasury Bills are instruments of short-term borrowing of the government and play a
vital role in cash management of the government. Their characteristics are as follows:
z Short Term Debt of Government of India
z Maturity less than a year
z Issued
– through RBI
– at a discount to face-value and redeemed at F V
– for 91, 182 and 364 days maturity
– by weekly / fortnightly auction
– competitive and non-competitive bids
6 z Anybody can invest
z Minimum investment Rs 25,000 Money Markets

z Good secondary market

z Good instrument for cash management
z Eligible for Reverse Repo transactions with the RBI
Being risk-free, their yields at varied maturities serve as short-term benchmarks and
help pricing varied floating rate products in the market. Treasury Bills market has
been the most preferred by central banks for market interventions to influence liquidity
and short-term interest rates, generally combined with repos/reverse repos. Hence,
development of this market is very crucial for effective open market operations. The
auction procedures have been streamlined to have notified amounts for all auctions
and to accept non-competitive bids outside the notified amounts.
Repurchase Agreements (Repos)/Ready Forward Transactions
Repo refers to a transaction in which a participant acquires immediately funds by
selling securities and simultaneously agreeing for repurchase of the same or similar
securities after specified time at a given price. The following are its characteristics:
z Repurchase agreement/RP’s Buy-Backs/Ready Forward
z Combination of a Ready Transaction and a Forward Deal
z Simultaneous sale of an asset (today)
And an agreement (contract)
To repurchase the same asset on a future date at a price fixed today
z Two legs
– Sale
– Give the asset and receive rupees
– Title passes on ‘day one’
– Re-purchase
– Give rupees and receive back the asset
– Title restored on the date of maturity
The transaction combines, elements of both a securities purchase/sale operation
and also a money market borrowing/lending operation. Typically it signifies lending
on a collateralised basis. The terms of contract is in terms of a “repo rate” representing
the money market borrowing/lending rate. As in the case of other instruments, repos
also help equilibrating between demand and supply of short-term funds. Internationally,
repurchase agreement (Repo) is a versatile and perhaps the most popular money
market instrument.
In our market, two types of repos are currently in operation - interbank repos and
the RBI repos. Interbank repos are permitted under regulated conditions. RBI repos
are used for absorption/injection of liquidity.
Now all Government securities have been made eligible for repo. Further, besides
banks, Primary Dealers are allowed to undertake both repo/reverse repo
transactions. Non-bank participants have also been allowed recently to lend money
through reverse repos to other eligible participants. In terms of instruments, the
repos have also been permitted in PSU bonds and private corporate debt securities 7
Financial Markets provided they are held in dematerialised form in a depository and the transactions
are done in recognised stock exchanges. RBI has removed the restriction of a
minimum period of 3 days for inter bank repo transactions. This enables banks and
other participants in the repo market to adjust their liquidity in a more flexible manner.
RBI has been using its repo instrument effectively for absorbing excess liquidity and
for infusing funds to ease the liquidity. The repo rate set by the Bank has also more
recently become a sort of signaling rate along with Bank Rate. The repo rate currently
in a way serves the purpose of a ceiling and the Reverse Repo Rate as the floor for
the money market to operate within an interest rate corridor.
Collateralized Borrowing and Lending Obligation(CBLOs)
CBLOs are a mechanism to borrow and lend funds against securities through a
platform provided by the Clearing Corporation of India Ltd (CCIL), for the lenders
and borrowers to come together not only for banks but also for primary dealers,
financial institutions, mutual funds, non-banking finance companies and corporates.
It is a type of derivative debt instrument which has short maturities, up to 90 days .
This overcomes the drawbacks plaguing the present Repos market - obligations
can be squared up only on the due date – cannot “pre-pay or “call-back” . The
holder of CBLO can sell, or, an investor can buy it, at anytime during its tenure . The
CBLO’s are in denominations of Rs 50 lakh and are traded through ‘offers’ and
‘bids’, specifying the discount rate and maturity period. The bids/offers will be through
an auction screen called `auction market’. These orders are matched on the basis of
the best quotations, allowing, of course, for negotiations. The net liabilities and
receivables for each participant are settled at the end of the day are settled. CCIL
fixes borrowing limits for each participant on the basis of a valuation of the securities
after a `hair-cut’. This instrument has emerged as a very useful cash management
instrument for both banks and the corporate firms.
Money Market Mutual Funds
Money Market Mutual Funds (MMMFs) were introduced in India in April 1991 to
provide an additional short-term avenue to investors and to bring money market
instruments within the reach of individuals. A Task Force was constituted to examine
the broad framework outlined in April 1991 as also the implications of the Scheme.
Based on the recommendations of Task Force constituted for the purpose, detailed
scheme of MMMFs was announced by the Reserve Bank in April 1992.
The portfolio of MMMFs consists of short-term money market instruments.
Investment in such funds provide an opportunity to investors to obtain a yield close
to short-term money market rates coupled with adequate liquidity. The growth in
MMMFs has, however, been less than expected.
Check Your Progress 2
1) Explain Call money as a money market instrument.
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8
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2) Distinguish between Repurchase agreements and collaterised borrowing and Money Markets
lending operations.
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5.5 FACTORS INFLUENCING MONEY MARKETS

IN INDIA
There are many factors influencing and affecting money markets. RBI is the most
important influencing factor in India money market. By virtue of the implication for
the conduct of monetary policy, money market comes within the direct purview of
RBI regulation. The primary aim of the Reserve Bank of India’s operations in the
money market is to ensure that the liquidity and short-term interest rates are maintained
at levels consistent with the monetary policy objectives of maintaining price stability,
ensuring adequate flow of credit to productive sectors of the economy and bringing
about orderly conditions in the foreign exchange market. The Reserve Bank of India
influences liquidity and interest rates as follows:
z RBI and the Money Market RBI intervention and signaling through the money
market
z RBI Repo
– sells GOI bonds from own holding and repurchase them
– Implications
– Borrows from the market
– Sucks up liquidity
– Influences interest rates- “ floor”
z RBI Reverse repo
– Buys GOI bonds into own holding and sells them back
– Implications
– Lends to banks/PD’s
– Injects liquidity
– Influences interest rates – “ceiling”
Liquidity Adjustment Facility
The Narasimham Committee has observed that the RBI support to the market should
be through a Liquidity Adjustment Facility (LAF) under which the RBI would
periodically, if necessary, daily, reset its repo and reverse repo rates which would in
a sense provide a reasonable corridor for market play. It now operates as follows in
conjunction with the Open Market Operation (OMO) :
9
Financial Markets z LAF
z every day
z Both REPO and Reverse Repo window
z Pre-announced Reverse Repo and Repo Rates
z “Auction” for the amount borrowed or injected
z Very effective fine tuning of money supply/liquidity/interest rates
z OMO sale or purchase of RBI on “own account”
z Influences the money supply/liquidity
z Longer-term effect that LAF
Thus the thrust of LAF is the continuous presence of the Reserve Bank in the
money market through the operation of repos window. While reverse-repos are
used for absorbing excess liquidity at a given rate (floor) and infusing liquidity into
the system through repos at a given rate (cap), the floor and cap rates set by the
repo window provide an effective corridor for the operation of the call money
market. Depending upon the stance of the policy to ease or tighten the liquidity, floor
and cap rates could be adjusted from time to time. While on the floor side of the
market, the Reserve Bank’s repo window has been by and large effectively operating,
supply of liquidity at a cap rate has to take into account several considerations.

5.6 MONEY MARKET AND MONETARY POLICY

IN INDIA
The linkages between the money market and monetary policy in India are very
important.
A central bank seeks to influence monetary conditions through management of liquidity
by operating in varied instruments. In an administered or controlled regime of money
and financial markets, the management of liquidity is essentially through direct
instruments, like varying cash reserve requirements, limits on refinance, administered
interest rates and quantitative and qualitative restrictions on credit. Thus, the cost,
availability, and direction of funds flow come under the direct influence of the central
bank. In a deregulated and liberalized market environment, the position is different,
since the interest rates are largely determined by market forces. In that situation,
there is still a need to influence monetary conditions through management of liquidity,
but, this has to be achieved mainly through market based operating instruments, like
open market operations and refinance/discount/repo windows. The central bank
becomes, in a way, a part of the market, though it is still above the market, by virtue
of its power to influence primary liquidity. The success of market based indirect
instruments, of course, depends upon the existence of a vibrant, liquid and efficient
money market, well integrated with the other segments of financial market, in particular
the government securities and foreign exchange markets. Such an integrated and
efficient market is necessary, for monetary policy impulses, sent through money
market interventions to be reflected in the monetary conditions, through the
transmission channel of the general level of interest rates. In a later unit of the course,
in Block 4, you will have occasion to study monetary policy in greater detail.
10
 UNIT 15 CAPITAL MARKET AND ITS
REGULATION
Structure
15.0 Objectives
15.1 Introduction
15.2 Role, Significance and Functions of Capital Market
15.3 Stock Market Development in India
15.3.1 Motives for Reforms in the Stock Markets
15.3.2 Liberalisation
15.3.3 Monopoly of Association type of Exchange
15.3.4 Open Outcry System
15.3.5 Clearing, Settlement and Risk Management Problems
15.3.6 The Scams in the Decade of 1990s
15.4 Stock Market Reforms Since 1992
15.4.1 Establishment of SEBI
15.4.2 Market Determined Allocation of Resources and Investor Protection
15.4.3 Demutualisation and Establishment of NSE
15.4.4 Screen Based Trading
15.4.5 Risk Containment at the Clearing Corporation
15.4.6 Risk Management
15.4.7 Dematerialisation
15.4.8 Derivatives Trading
15.4.9 Globalisation
15.4.10 Rolling Settlement and Ban on Deferral Products
15.5 Structure and Performance of Indian Stock Market
15.6 Equity Derivatives in India
15.6.1 Exchange-Traded and Over-the-Counter Derivative Instruments
15.7 Foreign Exchange Market Development in India
15.8 Currency Derivative Market in India
15.8.1 Exchange Traded Currency Derivatives in India
15.9 Long Term Government Bond and Corporate Debt Market in India
15.9.1 Outlook for Development of Corporate Debt Market
15.10 Let Us Sum up
15.11 Exercises
15.12 Some Useful Books
15.13 Answers or Hints to Check Your Progress Exercises

15.0 OBJECTIVES
The primary objective of this unit is to develop an understanding of the organisational
structure, role, function and performance of the Indian capital market. After going
through this unit, you will be able to :
 Explain the radical restructuring of the Indian capital market in the wake of
new economic policy in 1991; and
 Explain the role, function and structure of Indian Equity Market, Currency
Market, Derivative Market and Corporate Debt Market.
28
 Capital Market and its
15.1 INTRODUCTION Regulation

The dynamic and efficient financial system plays a very pivotal role for any economy
for efficient allocation of resources from surplus segment to deficit segment. The
financial system consists of financial markets, financial intermediation and financial
products or instruments. A thriving and vibrant economic system requires a well
developed financial structure with multiple intermediaries operating in the market
with different risk profiles. The financial sector in India is characterised by
progressive liberal policies, vibrant equity and debt markets and prudent banking
norms. Further, a financial system helps to increase output by moving the economic
system towards the existing production frontier. This is performed by transforming
a given total amount of wealth into more productive forms. It induces public and
investors to hold fewer saving in the form of precious metals, real estate land,
consumer durables and ideal cash balances and to replace these assets by financial
instruments such as bonds, shares, preference shares, units etc. A financial system
also helps to increase the volume of investments. It becomes possible for the
deficit spending units to undertake more investment because it would enable them
to command more capital. It encourages the investment activity by reducing the
cost of finance and risk. This is done by providing insurance services and hedging
opportunities and by making financial services such as remittances, discounting,
acceptance, and guarantees available. Finally, it not only increases greater investment
but also raises the level of resource allocational efficiency among different investment
channels. The broad picture of the Indian Financial System is presented in the
schematic diagram below as Figure 15.1.

Figure 15.1
29
Monetary and Fiscal Capital market is an integral part of the financial market. The capital market is a
Policies in India
market for financial assets which have a long or indefinite maturity. Capital market
is broadly categorised into two parts such as primary and secondary market. In
the primary market, new stock or bond issues are sold through a mechanism
popularly known as underwriting. In the secondary market, issued shares are
traded through organised exchanges such as stock exchanges, over the counter
etc. The capital market consists of stock or equity market, debt market, derivative
market, foreign exchange market and commodity market. These markets are
providing the facilities for buying and selling of the variety of financial claims and
services. The corporations, financial institutions, individuals and governments trade
in financial products in these markets either directly or through brokers and dealers
on organised exchanges or off exchanges. The capital market participants on the
demand and supply sides of these markets are financial institutions, agents, banks,
brokers, dealers, lenders, savers and others who are interlinked by the laws,
contracts, covenants and communication networks. The primal role of the capital
market is to channelise investments from investors who have surplus funds to the
ones who are running a deficit. Financial regulator such as Security Exchange
Board of India oversees the capital markets in their designated jurisdictions to
ensure that investors are protected against fraud among other duties.
Reforming and liberalising financial markets began in the wake of the country’s
1991 balance of payments crisis. The thrust of these reforms was to promote a
diversified, efficient and competitive financial system, with the ultimate objective of
improving the allocation of resources through operational flexibility, improved
financial viability and institutional strengthening. The pace of reform was, however,
slower than those in product markets, partly because the introduction of stricter
prudential controls on banks revealed significant problems in asset portfolios.
Prior to the reforms, state-owned banks controlled 90 per cent of bank assets –
compared with approximately 10 per cent at end-2005 – and channelled an
extremely high proportion of funds to the government. Interest rates were determined
administratively; credit was allocated on the basis of government policy and approval
from the Reserve Bank of India (RBI) was required for individual loans above a
certain threshold. Capital markets were underdeveloped, with stock markets
fragmented across the country. The major stock market acted mainly in the interest
of its members, not the investing public. Derivative markets did not exist and
comprehensive capital controls meant that companies were unable to bypass
domestic controls by borrowing abroad. Concerns over the 1997/98 Asian financial
crisis and its contagion effects further spurred Indian authorities to strengthen the
domestic financial system. Reforms were, and continue to be, based on several
principles: (i) mitigate risks in the financial system; (ii) efficiently allocate resources
to the real sector; (iii) make the financial system competitive globally; and (iv)
open the external sector. The goal was to promote a diversified, efficient and
competitive financial system which would ultimately improve the efficiency of
resource allocation through operational flexibility, enhanced financial viability and
institutional strengthening.

15.2 ROLE, SIGNIFICANCE AND FUNCTION OF

CAPITAL MARKET
Capital market facilitates the transfer of capital (financial) assets from savers to
investors. It provides the significant amount of liquidity which refers to how easily
an asset can be converted to currency without loss of value. A side benefit of a
30 capital market is that the transaction price provides a measure of the value of the
asset. The major functions of capital market includes disseminate information Capital Market and its
Regulation
efficiently, enable quick valuation of financial instrument, provides insurance against
market risk and price risk, enable wider participation, provide operational efficiency
through simplified transaction procedure, lowering settlement timings and lowering
transactional costs. The capital market also plays a vital role for developing
integration among real and financial sector, equity and debt instruments, long term
and short term funds, private sector and government sector, and domestic funds
and external funds. It also directs the flow of funds into efficient channels through
investment, disinvestment and reinvestment. The various roles of capital market
include mobilisation of savings and acceleration of capital formation, promotion of
industrial growth, raising of long term capital, provision of a variety of services,
and efficient and optimum channelisation of funds. Some selective roles of the
capital market are explained as follows.
1) Mobilisation of Savings: Capital market is an important source for mobilising
idle savings from the economy. It mobilises funds from people for further
investments in the productive channels of an economy. In that sense, it activates
the ideal monetary resources and puts them in proper investments.
2) Acceleration of Capital Formation: Capital market helps in capital formation.
Capital formation is net addition to the existing stock of capital in the economy.
Through mobilisation of idle resources, it generates savings; the mobilised
savings are made available to various segments such as agriculture, industry,
etc. This helps in increasing capital formation.
3) Provision of Investment Avenue: Capital market raises resources for longer
periods of time. Thus, it provides an investment avenue for people who wish
to invest resources for a long period of time. It provides suitable interest rate
returns also to investors. Instruments such as bonds, equities, units of mutual
funds, insurance policies, etc. definitely provides diverse investment avenue
for the public.
4) Speed up Economic Growth and Development: Capital market enhances
production and productivity in the national economy. As it makes funds available
for long period of time, the financial requirements of business houses are met
by the capital market. It helps in research and development. This helps in,
increasing production and productivity in economy by generation of employment
and development of infrastructure.
5) Proper Regulation of Funds: Capital markets not only helps in fund
mobilisation, but it also helps in proper allocation of these resources. It can
have regulation over the resources so that it can direct funds in a qualitative
manner.
6) Service Provision: As an important financial set up, capital market provides
various types of services. It includes long term and medium term loans to
industry, underwriting services, consultancy services, export finance, etc. These
services help the manufacturing sector in a large spectrum.
7) Continuous Availability of Funds: Capital market is a place where the
investment avenue is continuously available for long term investment. This is
a liquid market as it makes fund available on continues basis. Both buyers
and seller can easily buy and sell securities as they are continuously available.
Basically capital market transactions are related to the stock exchanges.
Thus, marketability in the capital market becomes easy. 31
Monetary and Fiscal
Policies in India

Figure 15.2 : Components of Indian Corporate Securities Markets

Check Your Progress 1

1) What are the constituents of financial system?
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2) Name the participants of capital market.
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3) Identify the major functions of capital market.
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32 .....................................................................................................................
 Capital Market and its
15.3 STOCK MARKET DEVELOPMENT IN INDIA Regulation

The role of a stock market in the process of development has been well recognised.
A developed stock market is considered as the major barometer of economic
growth because (a) it provides an additional channel (along with banks and financial
institutions) for encouraging and mobilising domestic savings, (b) ensures
improvements in the productivity of investment through market allocation of capital,
(c) increases managerial discipline through the market for corporate control. In
brief, the various indictors of stock market development are Market Capitalisation
Ratio (MCR)1, which is considered as a measure of stock market size. In terms
of the economic significance, market capitalisation as a proxy for the market size
is positively related to the ability to mobilise capital and diversify risk. The next
major indicator is market liquidity, which is measured by value-traded ratio and
turnover ratio. Value traded ratio equals the total value of traded shares in the
stock market divided by GDP. While, in turn, turnover ratio is the value of total
shares traded divided by market capitalisation. The next important indicator of
stock market development is the volatility parameter, which conceptualises the
asset price movement in a stock market and conveys important signals for its
development.
In the early stage of 1990s, there has been a marked change in the Indian securities
market. A range of reforms such as measures for liberalisation, regulation and the
development of the securities market have been introduced with the objectives of
improving market efficiency, enhancing transparency, preventing unfair trade practices
and bringing the Indian market up to international standards.
At the same time, the decade of the 1990s was marred by a steady procession
of episodes of market misconduct, which regularly hit the front pages of newspapers.
These episodes of market misconduct have been extremely disruptive of the core
functions of the equity market, i.e. (a) pricing efficiency, and (b) intermediation
between households investing in shares and firms financing projects by issuing
shares. Many observers feel that the two major pieces of reform on the equity
market – the creation of NSE in 1993 and the migration to rolling settlement and
derivatives in 2001 – would not have taken place without the pressure of a recent
crisis.

15.3.1 Motives for Reforms in the Stock market:

In brief, we can discuss the motives/problems behind reforms in the securities
markets in the 1990s.

15.3.2 Liberalisation
The first motive of liberalisation through the new economic policy of 1991 has
been giving freedom to the markets. This meant a shift away from administrative
control of credit and government controls on prices of securities such as shares
or government bonds and created a need to introduce an apex self-regulated body
for regulation and development of the markets.

15.3.3 Monopoly of Association Type of Exchange

As of 1992, the Bombay Stock Exchange (BSE), an association of brokers, and
imposed entry barriers, which led to elevated costs of intermediation was a monopoly

1
The MCR is defined as the value of listed shares divided by GDP. 33
Monetary and Fiscal in the stock market. Membership was limited to individuals and limited liability
Policies in India
firms could not become brokerage firms.
Due to Association nature of the Exchange, a lot of manipulative practices abounded,
so that external users of a market often found themselves at the losing end of price
movements as BSE was run by the brokers themselves.
Retail investors and particularly users of the market outside Bombay, accessed
market liquidity through a chain of intermediaries called “sub-brokers”. Each sub-
broker in the chain introduced a mark-up in the price, in the absence of the
unbundling of professional fees from the trade price. It was not uncommon for
investors in small towns to face four intermediaries before their order reached the
BSE floor, and to face mark-ups in excess of 10 per cent as compared with the
actual trade price.
So a need was felt to establish a demutualised body in which the Trading members
or brokers of the Exchange are separate from the management of the Exchange
so that proper decision making as well as trading could be facilitated without the
loss to any external investor.
15.3.4 Open Outcry System
Trading took place through ‘open outcry’ on the trading floor, which was
inaccessible to users as it was being done through the gestures and body signs.
It was routine for brokers to charge the investor a price that was different from
that actually transacted at. Normal market practice was that the brokers were
charging user’s one single consolidated price without giving the full details of the
trades, transactions and brokerage fees. The system was non-transparent and
there was a need to have a transparent system in which the details about each and
every transaction can be available.
15.3.5 Clearing, Settlement and Risk Management Problems
The market used ‘futures-style settlement’ with fortnightly settlement the period of
which was running between 14 to 30 days. This means that trading was supposed
to take place for a fortnight until a predetermined ‘expiration date’. Open positions
on the expiration date only would go into actual settlement, where funds and
securities were exchanged. In practice, there was little discipline on ensuring a
reliable fortnightly settlement cycle. A peculiar market practice called badla allowed
brokers to carry positions across settlement periods. In other words, even open
positions at the end of the fortnight did not always have to be settled. So a need
was felt to have a timely as well as accurate and fast reliable settlement system.
The efficiencies of the exchange clearinghouse only applied for the largest 100
stocks. For other stocks, clearing and settlement were done bilaterally, which
introduced further inefficiencies and costs. The use of futures-style trading for a
fortnight (or more), coupled with badla, is fraught with counterparty risk. Normally,
collateral (margin) requirements are used to ensure capital adequacy, and reduce
the weakness of the clearing system. A critical feature of the modern approach to
clearing is “novation” at a clearing corporation; the existing association type
exchanges had neither a Clearing Corporation nor novation. The clearing houses
of such exchanges were not providing the guard against counter party risk. So, the
concept of separate clearing house or clearing corporation was necessary to avoid
such kind of situations.
The final flaw of the trade was physical settlement, where share certificates were
34 printed on paper and on the settlement day the physical share certificates were
transferred in exchange of the funds. The system of transfer of ownership was Capital Market and its
Regulation
grossly inefficient as every transfer involved physical movement of paper securities
to the issuer for registration, with the change of ownership being evidenced by an
endorsement on the security certificate. In many cases, the process of transfer
took much longer, and a significant proportion of transactions ended up as bad
delivery due to faulty compliance of paper work. This was intrinsically vulnerable
to theft, counterfeiting, inaccurate signature verification, administrative inefficiencies,
and a variety of other malpractices. If stock splits, rights issues, or dividend
payouts took place during this period, it was common for the purchaser to be
away from the genuine benefits. So electronic transfer and dematerialisation of the
securities were found necessary so that such problems of physical delivery of the
stocks can be avoided.
15.3.6 The Scams in the Decade of 1990s
The first “stock market scam” was one, which involved both the GOI bond and
equity markets in India by Harshad Mehta in 1992 involving around Rs. 54 billion,
the biggest scam Indian market has ever faced. The manipulation was based on
the inefficiencies in the settlement systems in GOI bond market transactions.
When anonymous trading and nation-wide settlement became the norm by the end
of 1995, there was an increasing incidence of fraudulent shares being delivered
into the market. It has been estimated that the expected cost of encountering fake
certificates in equity settlement in India at the time was as high as 1 per cent (Shah
& Thomas 1997). This scam gave a look and consideration at the need of
dematerialised form of securities.
Second biggest scam of about Rs. 7 billion in Indian market after Harshad Mehta
was in 1997 by CRB group, which was a conglomerate of finance and non-
finance companies. The finance companies of the group sourced the funds from
external sources, using manipulated performance numbers, which revealed the
failures of supervision on the part of RBI and SEBI.
Another episode of 1992 Harshad Mehta scam came out in 1998. In this episode
of market manipulation, the President, Executive Director and Vice President of
the BSE had to resign as the top management of the BSE was found to tampering
with records in the trading system in trying to avert a payments crisis.
The most discussed scam after Harshad Mehta and CRB group was the scam by
Ketan Parekh who took leveraged positions on a set of 10 stocks called the
“K10 stocks” stimulating the fall in the prices of IT stocks globally. There are
allegations of fraud in this crisis with respect to an illegal badla market at the
Calcutta Stock Exchange and banking fraud. Investigations for this are still under
way.
Due to the procession of crises and scams coming out one after another a big
question mark was there on the credibility of SEBI and its capability to regulate
and develop the securities market. However, SEBI gave an appropriate response
to these crises and scams by more regulated, efficient and transparent environment
though imposition of investor protection guidelines, ban on badla system,
introduction of rolling settlement and other measures.

15.4 STOCK MARKET REFORMS SINCE 1992

In response to the above mentioned motives and problems, the principal reform
measures undertaken in Indian stock market since 1992 in detail can be discussed
as follows: 35
Monetary and Fiscal 15.4.1 Establishment of SEBI
Policies in India
Under the Capital Issues (Control) Act, 1947 any firm wishing to issue securities
had to obtain approval from the Central Government for the decision of the
amount, type and price of the issue. To cope up with the Liberalisation policy of
1991, the said Act was repealed in 1992 for market determined allocation of
resources and another regulator Security Exchange Board of India (SEBI) was
created and assigned with the main responsibilities for:
a) protecting the interests of investors particularly of small investors in securities,
b) promoting the development of the securities market, and
c) regulating the securities market.
Having been assigned the regulatory jurisdiction not only over the corporate in the
issuance of capital and transfer of securities, but also over all intermediaries and
persons associated with securities market, SEBI was given concurrent/delegated
powers under certain provisions of the Companies Act and the SC(R) Act. Many
provisions in the Companies Act having a bearing on securities market are
administered by SEBI.

15.4.2 Market Determined Allocation of Resources and

Investor Protection
Due to repeal of CC (I) A and establishment of SEBI, Government’s control over
issue of capital, pricing of the issues, fixing of premia and rates of interest on
debentures etc. ceased and the allocation of resources for competing uses left to
the market.
In the interest of investors, SEBI issued Disclosure and Investor Protection (DIP)
guidelines containing a substantial body of requirements for issuers/intermediaries.
SEBI specifies the matters to be disclosed and the standards of disclosure required
for the protection of investors in respect of issues and accordingly SEBI has
issued directions to all intermediaries and other persons associated with the securities
market in the interest of investors or of orderly development of the securities
market. Thus, The SEBI guidelines aim to secure fuller disclosure of relevant
information about the issue, issuer and the nature of the securities to be issued so
that investors can take informed decisions.
Department of Economic Affairs (DEA), Department of Company Affairs (DCA),
SEBI have set up investor grievance cells and the Exchanges have for redressal
of investor grievance. The exchanges maintain investor protection funds/consumer
protection funds/trade guarantee funds to take care of investor claims, which may
arise out of non-settlement of obligations by a trading member for trades executed
on the exchange. DCA has also set up an investor education and protection fund
for the promotion of investors’ awareness and protection of interest of investors.

15.4.3 Demutualisation and Establishment of NSE

The idea of NSE was first contemplated seriously in 1993. At that time the
OTCEI was a recent state-sponsored exchange, which had not shown a good
record. And also the fear that NSE would be going up in competition against the
established liquidity of the BSE. However, for the benefit of the investors and
corresponding to the need of setting up of a demutualised Exchange, equity trading
36
at NSE commenced in November 1994. Within one year of the commencement Capital Market and its
Regulation
of equity trading at NSE, it became India’s most liquid stock market. This was a
remarkable outcome. The BSE responded rapidly by moving to similar technology
to the NSE in March 1995. The benefits of demutualised Exchange with the
improvements in the securities market led to regime-shift towards transparency,
anonymity, Competition in the brokerage industry, Operational Efficiency etc.
For better implementation of the concept of demutualisation, the regulators focused
on reducing dominance of members in the management of stock exchanges and
advised them to reconstitute their governing councils to provide for at least 50 per
cent non-broker representation. As the recommendation did not materially alter
the situation, the Government proposed in March 2001 to corporate the stock
exchanges by which ownership, management and trading membership would be
segregated from one another. A few exchanges have already initiated demutualisation
process. Government has offered a variety of tax incentives to facilitate
corporatisation and demutualisation of stock exchanges.

15.4.4 Screen Based Trading

In order to provide efficiency, liquidity and transparency, NSE introduced a nation-
wide on-line fully-automated screen based trading system (SBTS) where a member
can punch into the computer quantities of securities and the prices at which he
likes to transact and the transaction is executed as soon as it finds a matching sale
or buy order from a counter party.
Providing the solution for the problems arising from the open outcry system, in
terms of infrastructure, practices and approach, Indian market has become as
modern as any developed market of the world. All Exchanges in India switched
from floor trading to anonymous electronic trading by 1994.

15.4.5 Risk Containment at the Clearing Corporation

To effectively address the issue of assessing the credit risk of the counter-party
and to guarantee the final settlement of the transaction, NSE introduced the concept
of a novation, and set up the first clearing corporation, viz. National Securities
Clearing Corporation Ltd. (NSCCL), which commenced operations in April 1996.
Counterparty risk is guaranteed through a fine tuned risk management system and
an innovative method of on-line position monitoring and automatic disablement. A
large Settlement Guarantee Fund provides the cushion for any residual risk. In
order to boost the process of corporatisation, capital gains tax payable on the
difference between the cost of the individual’s initial acquisition of membership and
the market value of that membership on the date of transfer to the corporate entity
was waived.

15.4.6 Risk Management

To prevent market failures and protect investors, the regulator/exchanges have
developed a comprehensive risk management system, which is constantly monitored
and upgraded by the Exchanges and the regulators. It encompasses capital
adequacy of members, net-worth criteria, adequate margin requirements (comprising
of initial margin, daily marked to market margin, variation margin), limits on exposure
and turnover, indemnity insurance, on-line position monitoring and automatic
disablement on crossing the limits, etc. They also administer an efficient market
surveillance system to curb excessive volatility, detect and prevent price
37
Monetary and Fiscal manipulations. Exchanges have set up trade/settlement guarantee funds for meeting
Policies in India
shortages arising out of non-fulfilment/partial fulfilment of funds obligations by the
members in a settlement.

15.4.7 Dematerialisation
To obviate the problems related to physical delivery of securities, the Depositories
Act, 1996 was passed to provide for the establishment of depositories (NSDL
and CDSL) in securities with the objective of ensuring free transferability of securities
with speed, accuracy and security by (a) making securities of public limited
companies freely transferable subject to certain exceptions; (b) dematerialising the
securities in the depository mode; and (c) providing for maintenance of ownership
records in a book entry form.
The stamp duty on transfer of demat securities was waived. Today, all actively
traded scrips are held, traded and settled in demat form. Demat settlement accounts
for over 99.9 per cent of turnover settled by delivery.
Before dematerialisation was started, SEBI used to get about fifty thousand
complaints every year for non-transfer of shares. SEBI has an unenviable record
of getting 2.7 million complaints in ten years. Lately of course the number of
complaints came down, particularly after dematerialisation. This has also prevented
cases where company management’s delayed transfer of shares; it is now automatic.
To prevent physical certificates from sneaking into circulation, it has been made
mandatory for all new IPOs to be compulsorily traded in dematerialised form. For
making a public or rights issue or an offer for sale, the admission to a depository
for dematerialisation of securities has been made compulsorily as a pre-requisite.
It has also been made compulsory for public listed companies making IPO of any
security for Rs.10 crore or more to do the same only in dematerialised form.

15.4.8 Derivatives Trading

A three-decade old ban on forward trading, which had lost its relevance and was
hindering introduction of derivatives trading, was withdrawn in 1999 by way of an
amendment in SC(R) Act, 1954. Considering the recommendations of L. C. Gupta
Committee on derivatives trading, derivative trading was started in June 2000 on
two exchanges namely, NSE and BSE. The market presently offers index futures
and index options on two indices and stock options and stock futures on certain
specified stocks. Recently, the interest rate futures have also started on NSE.

15.4.9 Globalisation
Indian companies have been permitted to raise resources from abroad through
issue of American Depository Receipts (ADRs), Global Depository Receipts
(GDRs), Foreign Currency Convertible Bonds (FCCBs) and External Commercial
Borrowings (ECBs). ADRs/GDRs have two-way fungibility. Indian companies are
permitted to list their securities on foreign stock exchanges by sponsoring ADR/
GDR issues against block shareholding. Non Resident Indians (NRIs) and Overseas
Corporate Body (OCBs) are allowed to invest in Indian companies.
FIIs have been permitted to invest in all types of securities, including government
securities. The investments by FIIs enjoy full capital account convertibility. They
can invest in a company under portfolio investment route upto 24 per cent of the
paid up capital of the company. This can be increased up to the sectoral cap/
statutory ceiling, as applicable, provided this has the approval of the Indian
38 company’s board of directors and also its general body.
Indian Stock Exchanges have been permitted to set up trading terminals abroad. Capital Market and its
Regulation
The trading platform of Indian exchanges is now accessed through the Internet
from anywhere in the world. Mutual Funds have been permitted to set up offshore
funds to invest in equities of other countries. They can also invest in ADRs/GDRs
of Indian companies.

15.4.10 Rolling Settlement and Ban on Deferral Products

Due to long trading cycle and the large open positions which was running about
14 to 30 days, the counterparty risk was very high resulting into defaults and risks
in settlement on many occasions. In order to reduce large open positions, the
trading cycle was reduced over a period of time to a week.
The normal practice of trading a variety of deferral products like modified carry
forward system, which was called, as badla system was also prevalent, which
encouraged leveraged trading by enabling postponement of settlement. In 2001,
“Future style settlement” and deferral mechanisms, which implied that the spot
market featured leverage and futures market principles, were banned in favour of
rolling settlement.
In 1998, rolling settlement on T+5 basis was introduced in respect of specified
scrips reducing the trading cycle to one day. The exchanges, however, continued
to have different weekly trading cycles, which enabled shifting of positions from
one exchange to another. It was made mandatory for all exchanges to follow a
uniform weekly trading cycle in respect of scrips not under rolling settlement. All
scrips were moved to rolling settlement from December, 2001. In April 2002,
T+3 rolling settlement were introduced replacing T+5 settlements. Now of course
we have the rolling settlement, where settlements happen the same day.
Corresponding the necessity of the market, problems of irregulation and
manipulation in the market and need of more transparent system in the Indian
Securities Market, the above reforms were introduced in stages. As some deficiency
is noted or some malpractice surfaces in the working of the market, the concerned
authorities initiated further reforms and corrective steps. A number of steps have
been taken to improve efficiency, transparency and confidence of the investors in
the market. However, the process of reform in the securities market is far from
complete.

15.5 STRUCTURE AND PERFORMANCE OF

INDIAN STOCK MARKET
There are 22 stock exchanges in India, the first being the Bombay Stock Exchange
(BSE), which began formal trading in 1875, making it one of the oldest in Asia.
In 2010, the number of stock exchanges in India reduced to 19 as The Magadh,
Mangalore, Hyderabad and Saurashtra Kutch stock exchanges have been
derecognised by the market watch dog Securities Exchange Board of India (SEBI).
Before 1994, India’s stock markets were dominated by BSE. In other parts of the
country, the financial industry did not have equal access to markets and was
unable to participate in forming prices, compared with market participants in
Mumbai (Bombay). As a result, the prices in markets outside Mumbai were often
different from prices in Mumbai. These pricing errors limited order flow to these
markets. Explicit nationwide connectivity and implicit movement toward one national
market has changed this situation (Shah and Thomas, 1997). NSE has established
39
Monetary and Fiscal satellite communications which give all trading members of NSE equal access to
Policies in India
the market. Similarly, BSE and the Delhi Stock Exchange are both expanding the
number of trading terminals located all over the country. The arbitrages are
eliminating pricing discrepancies between markets. Over the last few years, there
has been a rapid change in the Indian securities market, especially in the secondary
market. Advanced technology and online screen based transactions have modernised
the stock exchanges. In terms of the number of companies listed and total market
capitalisation, the Indian equity market is considered large relative to the country’s
stage of economic development. The number of listed companies increased from
5,968 in March 1990 to about 10,000 by May 1998 and market capitalisation
has grown almost 11 times during the same period. In the financial year 1990-
91, the market capitalisation has increased in BSE from Rs. 90,836 crore to
Rs. 61,65,619 crore in 2009-10. Similarly, the market capitalisation in case of
NSE in 1994-95 has increased from Rs. 3,63,350 crore to Rs. 60,09,173 crore
in the year 2009-10. During the same time the annual averages of stock price in
case of BSE Sensex has increased from Rs.1,050 crore to Rs.15,585 crore in
2009-10. However the annual averages of share price in case of S&P CNX Nifty
has increased from Rs. 364 crore to Rs. 4,658 crore. The annual turnover at
Bombay Stock Exchange has increased from Rs.1,57,88,856 crore in 2007-08 to
Rs.11,03,467 crore and at National Stock Exchange; the annual turnover has
increased from Rs. 3551038 crore in 2007-08 to Rs. 35,77,412 crore in
2010-11. Likewise the Net investment in the Indian capital market has increased
to Rs. 62,583.56 crore to Rs.1,10,718.27 crore in the the financial year 2010-
11. The quantity of shares traded in the stock exchanges has increased from
5,04,149 lakh in 2001-02 to 33,42,947 lakh in 2009-10. The value of the shares
delivered of stock exchanges has increased from Rs.1,36,225 to Rs. 12,28,612
crore in 2009-10.
Check Your Progress 2
1) Why does a developed stock market is considered the barometer of economic
growth?
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2) What is market capitalisation Ratio?
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3) State the problems of stock market leading reforms in this sector during
1990s.
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40
4) What is Demutualisation? State the benefits of demutualised Exchange. Capital Market and its
Regulation
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5) Which steps have been taken by the regulations/exchanges to prevent market
failures and protect the interest of investors?
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15.6 EQUITY DERIVATIVES IN INDIA

A derivative security is a financial contract whose value is derived from the value
of something else, such as a stock price, a commodity price, an exchange rate,
an interest rate, or even an index of prices. Derivatives may be traded for a variety
of reasons. A derivative enables a trader to hedge some pre-existing risk by taking
positions in derivatives markets that offset potential losses in the underlying or spot
market. In India, most derivatives users describe themselves as hedgers (Fitch
Ratings, 2004) and Indian laws generally require that derivatives be used for
hedging purposes only. Another motive for derivatives trading is speculation (i.e.
taking positions to profit from anticipated price movements). In practice, it may
be difficult to distinguish whether a particular trade was for hedging or speculation,
and active markets require the participation of both hedgers and speculators. A
third type of trader, called arbitrageurs, profit from discrepancies in the relationship
of spot and derivatives prices, and thereby help to keep markets efficient. Equity
derivatives trading started in India in June 2000, after a regulatory process which
stretched over more than four years. In July 2001, the equity spot market moved
to rolling settlement. India’s experience with the launch of equity derivatives market
has been extremely positive, by world standards. NSE is now one of the prominent
exchanges amongst all emerging markets, in terms of equity derivatives turnover.
There is an increasing sense that the derivatives market is playing a major role in
shaping price discovery.

15.6.1 Exchange-Traded and Over-the-Counter Derivative

Instruments
OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally
negotiated between two parties. The terms of an OTC contract are flexible, and
are often customised to fit the specific requirements of the user. OTC contracts
have substantial credit risk, which is the risk that the counterparty that owes
money defaults on the payment. In India, OTC derivatives are generally prohibited
with some exceptions: those that are specifically allowed by the Reserve Bank of
India (RBI) or, in the case of commodities (which are regulated by the Forward
Markets Commission), those that trade informally in “havala” or forwards markets.
An exchange-traded contract, such as a futures contract, has a standardised format
41
Monetary and Fiscal that specifies the underlying asset to be delivered, the size of the contract, and the
Policies in India
logistics of delivery. They trade on organised exchanges with prices determined by
the interaction of many buyers and sellers. In India, two exchanges offer derivatives
trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange
(NSE). However, NSE now accounts for virtually all exchange-traded derivatives
in India, accounting for more than 99 per cent of volume in 2003-2004. Contract
performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary
of the NSE Margin requirements and daily marking-to-market of futures positions
substantially reduce the credit risk of exchange-traded contracts, relative to OTC
contracts (Asani Sarkar 2006).
In the exchange-traded market, the biggest success story has been derivatives on
equity products. Index futures were introduced in June 2000, followed by index
options in June 2001, and options and futures on individual securities in July 2001
and November 2001, respectively. As of 2005, the NSE trades futures and options
on 118 individual stocks and 3 stock indices. All these derivative contracts are
settled by cash payment and do not involve physical delivery of the underlying
product. Derivatives on stock indexes and individual stocks have grown rapidly
since inception. In particular, single stock futures have become hugely popular,
accounting for about half of NSE’s traded value in October 2005. In fact, NSE
has the highest volume (i.e. number of contracts traded) in the single stock futures
globally, enabling it to rank 16 among world exchanges in the first half of 2005.
Single stock options are less popular than futures. Index futures are increasingly
popular, and accounted for close to 40 per cent of traded value in October 2005.
NSE launched interest rate futures in June 2003 but, in contrast to equity
derivatives, there has been little trading in them. One problem with these instruments
was faulty contract specifications, resulting in the underlying interest rate deviating
erratically from the reference rate used by market participants. Institutional investors
have preferred to trade in the OTC markets, where instruments such as interest
rate swaps and forward rate agreements are thriving. As interest rates in India
have fallen, companies have swapped their fixed rate borrowings into floating rates
to reduce funding costs. However, it may be noted that the detailed discussion of
Equity Derivative instruments is beyond the scope of this unit.
Table 15.1 : Turnover in Indian Equity Derivatives Market.
  Equity Derivatives (‘ Crore)  
Year Index Index Stock Stock
Future Options Futures Options
2008-09 35,81,870 37,31,512 34,79,657 2,29,227
2009-10 39,34,485 80,28,103 51,95,247 5,06,065
2010-11 43,56,909 1,72,69,366 54,95,757 10,30,343
2011-12        
Apr 2,82,313 16,45,980 3,53,162 69,993
May 3,05,746 18,92,896 3,36,689 70,090
June 2,65,191 17,84,570 3,22,695 65,792
Source: RBI, BSE, NSE, CCIL and SEBI.

42
 Capital Market and its
15.7 FOREIGN EXCHANGE MARKET Regulation
DEVELOPMENT IN INDIA
Historically, the rupee was pegged to the pound sterling till late sixties. Under the
Bretton wood system, as a member of IMF, India declared its par value of rupee
in terms of gold. The RBI maintained par value of rupee within the permitted band
of ±1 per cent using Pound Sterling as the intervention currency. India had to
devalue its currency in June 1966. The par value of rupee was fixed at 0.118489
of fix gold per Indian Rupee. The corresponding Rupee sterling rate was fixed
GBP1= Rs 18.
With the collapse of Bretton woods system in August 1971, major currencies
discarded fixed exchange rate regime. Rupee was pegged to US$ and the exchange
rate was fixed at US$1= Rs. 7.50. However, RBI retained with pound sterling as
the intervention currency. The US$ and Rupee pegging was used to arrive at
Rupee Sterling parity. After Smithsonian Agreement in December 1971, the Rupee
was again delinked from US$ and again linked to Pound Sterling. This parity was
maintained within a band of ±2 ¼ per cent. In 1972, Pound Sterling gradually
started floating. As the Rupee was pegged to Sterling, as a result of which Rupee
fluctuated with other currencies as the Sterling fluctuated vis-à-vis other currencies
of the world. Afterwards, Pound Sterling was depreciated by 20 per cent by
September 1975 because of the poor fundamentals of the British economy. Then
Rupee got depreciated automatically against the other currencies of the world. It
led to rise in inflation in India to undesired levels. With effect from September 25,
1975, Rupee was again delinked from Pound Sterling and was linked to basket
of currencies. The currencies included in the basket as well as their relative weights
were kept secret so that speculator could not identify the direction or the movement
of exchange rate of the Rupee. The main advantage of linking Rupee with the
basket of currencies was that it would no longer be dependent on the vagaries of
a single currency. As a result, RBI was free to exercise its discretion to alter the
currency components in the basket without allowing market to speculate on Rupee
exchange rate.
The liquidity crunch in 1990 and 1991 on the forex front underpinned the significance
of managing the exchange rate effectively. Thus on March 1st, 1992, RBI announced
a new exchange rate system known as “Liberalised Exchange Rate Management
System” (LERMS) with the prime objective to make balance of payments sustainable
on ongoing basis by allowing market forces to play a greater role. As per LERMS,
Rupee became convertible for all approved external transactions. The exporters
were allowed to sell 60 per cent of their foreign receipts at market determined
rates and required to surrender 40 per cent of their foreign receipts to RBI
through authorised dealers’ official rate. Thus, this system prevailed during 1992
in which the exchange rate regime in India was characterised by a daily
announcement by the RBI of its buying and selling rates to authorised dealers for
merchant transactions.
The process of liberalisation was continued further and Reserve Bank decided to
make Rupee fully floating on the current account with effect from March 1, 1993.The
new arrangement came to be called Modified Liberalised Exchange Rate
Management System (MLERMS). With the introduction of MLERMS, all foreign
exchange transactions under current account of balance of payments were being
put through Authorised Dealers (Ads) at market determined exchange rates. Foreign
exchange receipts and payments continued to be governed by Exchange Control 43
Monetary and Fiscal Regulations. Thus the introduction of MLERMS helped to bring more flexibility in
Policies in India
the foreign exchange market such as removal of several trade restrictions, relaxation
in exchange control particularly under current account transactions in order to
achieve the full benefits of the integrating the Indian economy with world economic
system etc.
With the continued process of liberalisation, RBI has been guided by the needs of
further development of foreign exchange markets. On November 22, 1994, it has
been decided to set up “The Expert Group on Foreign Exchange Markets in
India” to examine the issues relating to products available for hedging forex risks,
scope for further development of forex market and introducing of new derivative
products in India under the chairmanship of Mr. O P Sodhani. The group studied
the market in detail and the report finally came in June 1995 with 33
recommendations and out of these, 25 called for actions on the part of RBI. Some
of the important recommendations of the committee were (i) the banks should be
accorded significant initiative and freedom to participate in the forex market such
as freedom to fix net overnight position limit and gap limits, although RBI is
formally approving these limits, freedom to initiate trading position in the overseas
markets, freedom to borrow or invest funds in the overseas markets (up to 15 per
cent of Tier 1 capital), freedom to determine the interest rates (subject to a ceiling)
and maturity period of Foreign Currency Non-Resident (FCNR) deposit (not
exceeding three years), freedom to exempt inter-bank borrowings from statutory
pre-emptions and freedom to use derivative products for asset liability management.
(ii) Corporate should be permitted to take hedge upon declaring the existence of
genuine exposure. But this facility has been temporarily suspended after the Asian
crisis. Corporates having Exchange Earners Foreign Currency Accounts (EEFCAs)
should be allowed margin trading by using the balances in their EEFC accounts.
Corporates were given freedom to cancel or rebook forward contracts though
currently due to the Asian crisis effect, freedom to rebook or cancelled contracts
has been suspended while roll over is permissible, (iii) Authorised Dealers may be
permitted to initiate cross currency positions abroad, (iv) market intervention by
RBI should be on selective basis, (v) number of participants in forex markets
should be increased by permitting financial institutions like IDBI, IFCI etc. to
trade in the forex market. So far as the recommendations are concerned, some
of them are also not yet implemented because of some constraints like speculation.
Gradual liberalisation process in the development of forex market needed the
requirement of capital account convertibility in the early stage of 1997. Reserve
bank of India on February 28, 1997 set up a committee on Capital Account
Convertibility, which is popularly known as Tarapore committee.
Tarapore committee quoted the definition of ‘Capital Account Convertibility’ as
‘Capital Account Convertibility refers to the freedom to convert local financial
assets into foreign financial assets and vice versa at market determined rates of
exchange.’ The major recommendations of the committee broadly related to foreign
direct investment, portfolio investment, investment in joint ventures, project exports,
opening of Indian corporate offices abroad, raising of EEFC entitlement to 50 per
cent, allowing FIIs to cover forward in part of their exposures in the debt and
equity market.
Emphasising the exchange rate policy, the committee strongly recommended that
the RBI should have monitoring exchange rate band of ± 15 per cent around the
neutral Real Effective Exchange Rate (REER). The RBI should ordinarily intervene
44 when REER is outside the band. The committee stresses that the credibility of
exchange rate policy should be vital in the context of Capital Account Convertibility Capital Market and its
Regulation
(CAC), which will bring the transparency in the exchange rate policy.
The committee strongly recommended that in view of the growing degree of
integration of the Indian economy, the size of the current account deficit can be
sustained without encountering external constraint. In the context of moving to
capital account convertibility, capital flows would have a more significant effect on
balance of payments. The committee has specified some indicators of foreign
exchange reserves such as reserves should not be less than the six months imports,
reserve should not be less than the three months imports plus 50 per cent of debt
service payments plus one month’s imports and exports etc.
With the above recommendations, a significant progress has been noticed. In the
money market, for improving the risk management, recent guidelines for interest
rate swaps and Forward Rate Agreement (FRAs) have been issued to facilitate
hedging of interest rate risks and orderly development of fixed income derivative
markets. Measures have also been taken to develop Government securities market
and permission has also been given to banks for fulfilling certain criteria to import
gold for domestic sale. This aspect of gold policy is a major step in bringing off-
market forex transactions into forex markets by officialising the import of gold.

15.8 CURRENCY DERIVATIVE MARKET IN INDIA

Currency derivative is a contract between the seller and buyer, whose value is to
be derived from the underlying asset, the currency amount. A derivative based on
currency exchange rates is a future contract which stipulates the rate at which a
given currency can be exchanged for another currency as at a future date.
Foreign exchange derivatives are less active than interest rate derivatives in India,
even though they have been around for longer period. OTC instruments in currency
forwards and swaps are the most popular. Importers, exporters and banks use the
rupee forward market to hedge their foreign currency exposure. Turnover and
liquidity in this market has been increasing, although trading is mainly in shorter
maturity contracts of one year or less. In a currency swap, banks and corporations
may swap its rupee denominated debt into another currency (typically the US
dollar or Japanese yen), or vice versa. Trading in OTC currency options is still
muted. There are no exchange-traded currency derivatives in India.

15.8.1 Exchange Traded Currency Derivatives in India

The currency futures market in India remained active during 2010-11. The average
daily turnover in currency futures on the three active exchanges (NSE, MCX-SX
and USE) stood at US $ 8.0 billion in March 2011 as against US $ 7.1 billion
in March 2010. Increased globalisation of the economy increases the foreign
exchange exposure of Indian firms and individuals with exchange rate risk arising
from domestic and global financial market developments. This has necessitated
introduction of various instruments by the Reserve Bank to hedge the exchange
exposure by the residents. Currently, residents in India are permitted to trade in
futures contracts in four currency pairs on recognised stock exchanges. In order
to expand the menu of tools for hedging currency risk, recognised stock exchanges
were permitted to introduce plain vanilla currency options on spot US Dollar/
Rupee exchange rate for residents. The exchange traded currency options market
is functioning subject to the guidelines issued by the Reserve Bank and the Securities
and Exchange Board of India (SEBI) from time to time. In view of the large 45
Monetary and Fiscal positions held by the FIIs and considering the increased depth of the Indian forex
Policies in India
market to absorb the impact on the exchange rate, FIIs have now been permitted
to cancel and rebook up to 10 per cent of the market value of the portfolio as
at the beginning of the financial year as against 2 per cent that was permitted
earlier. The summary report of the Indian Currency Derivative market is presented
as follows:
Table 15.2: Turnover in Indian Currency Derivatives Market.
  Currency Derivatives (in Rs. ‘ Crore)
Exchange Traded
Year Forward Swap Currency Options
and Futures
2008-09 25,54,994 40,65,695 3,11,389
2009-10 20,35,879 31,45,402 37,27,262
2010-11 28,90,222 41,12,539 84,06,307
2011-12      
Apr 2,06,047 3,67,137 7,22,275
May 2,17,188 4,74,893 10,00,498
June 2,40,047 4,95,622 10,39,010
Source: BSE,NSE, CCIL and SEBI.

15.9 LONG TERM GOVERNMENT BOND AND

CORPORATE DEBT MARKET IN INDIA
The corporate bond and long term Government Securities market is the vital
segment of the capital market. The corporate bond market is at the budding phase
in India. The corporate bond market remains restricted in regards to participants,
largely arbitrage driven and also highly illiquid. The lack of development is
anomalous for two reasons: First, India has developed world-class markets for
equities and for equity derivatives supported by high-quality infrastructure. And
second, the infrastructure for the bond market, particularly the government bond
market, is similarly of high quality. Until 2007, information on Indian corporate
bond market turnover was incomplete and largely anecdotal. In 2007, however,
the Securities and Exchange Board of India (SEBI) launched initiatives to ensure
more comprehensive reporting of the over-the-counter (OTC) bond market. Current
volumes are running at low levels — around 140 transactions amounting to about
USD80 million per day. But corporate bond markets worldwide are typically
illiquid, so it may be overly optimistic to expect India to develop a uniquely liquid
corporate bond market. Nonetheless, a more liquid market should eventually
contribute to lower costs of capital for issuers. India’s corporate turnover ratio is
quite high at 70 per cent in 2007, comparing favourably with most other emerging
East Asian corporate bond markets. However, the small total of outstanding
corporate bonds in India means that the secondary market is small and relatively
illiquid, irrespective of the turnover ratio. (ADB Working Paper Series No.22).
A significant momentum of functioning debt (G-sec) market in India was really
46 initiated in the wake of New Economic Policy in 1991. Prescription of indirect
instruments of monetary control such as ‘Statutory Liquidity Ratio’(SLR) i.e. the Capital Market and its
Regulation
ratio at which banks are required to invest in approved securities, though originally
devised as a prudential measure, was used as the main instrument of pre-emption
of bank resources in the pre reform period. The high SLR requirement created a
captive market for government securities, which were issued at low administered
interest rates. After the initiation of the reforms this ratio has been reduced in
phases to the statutory minimum level of 25 per cent. Over the past few years
numerous steps have been taken to broaden and deepen the government securities
market and to raise the level of transparency. Government’s deficit has been
phased out and the market borrowings of the central government are presently
undertaken through a system of auctions at market related rates. The various
selective reforms in government securities market in India are as follows:
 Administered interest rates on government securities were replaced by an
auction system for price discovery.
 Automatic monetisation of fiscal deficit through the issue of ad hoc Treasury
Bills was phased out.
 Primary Dealers (PD) were introduced as market makers in the government
securities market.
 For ensuring transparency in the trading of government securities, delivery
versus Pay (DvP) settlement system was introduced.
 Repurchase agreements (repo) were introduced as a tool of short-term liquidity
adjustment. Subsequently, the Liquidity Adjustment Facility (LAF) was
introduced. LAF operates through repo and reverse auctions to set up a
corridor for short-term interest rate. LAF has emerged as the tool for both
liquidity management and also signalling device for interest rates in the overnight
market.
 Market Stabilisation Scheme (MSS) has been introduced, which has expanded
the instruments available to the Reserve Bank for managing the surplus liquidity
in the system.
 91-day Treasury bill was introduced for managing liquidity and benchmarking.
Zero Coupon Bonds, Floating Rate Bonds, Capital Indexed Bonds were
issued and exchange traded interest rate futures were introduced. OTC interest
rate derivatives like Interest Rate Swap, Forward Rate Agreements were
introduced.
The Indian Primary market in Corporate Debt is basically a private placement
market with most of the corporate bond issues being privately placed among the
wholesale investors i.e. the Banks, Financial Institutions, Mutual Funds, Large
Corporate and other large investors. The proportion of public issues in the total
quantum of debt capital issued annually has decreased in the last few years.
Around 92 per cent of the total funds mobilised through corporate debt securities
in the Financial Year 2002 were through the private placement route.
The Secondary Market for Corporate Debt can be accessed through the electronic
order-matching platform offered by the Exchanges. BSE offers trading in Corporate
Debt Securities through the automatic BOLT system of the Exchange. The Debt
Instruments issued by Development Financial Institutions, Public Sector Units and
the debentures and other debt securities issued by public limited companies are
listed in the ‘F Group’ at BSE. The various types of corporate debt securities in 47
Monetary and Fiscal India issued consists of Non Convertible Debentures, Partly-Convertible
Policies in India
Debentures/Fully-Convertible Debentures (convertible in to Equity Shares), Secured
Premium Notes, Debentures with Warrants, Deep Discount Bonds, PSU Bonds/
Tax-Free Bonds.

15.9.1 Outlook for Development of Corporate Debt Market

The development of a corporate bond market in India has lagged behind in
comparison with other financial market segments owing to many structural factors.
While primary issuances have been significant, most of these were accounted for
by public sector financial institutions and were issued on a private placement basis
to institutional investors. The secondary market, therefore, has not developed
commensurately and market liquidity has been an issue.
The Government had constituted a High Level Committee on Corporate Bonds
and Securitisation (Patil Committee) to identify the factors inhibiting the development
of an active corporate debt market in India and recommend necessary policy
actions. The Committee made a number of recommendations relating to rationalising
the primary issuance procedure, facilitating exchange trading, increasing the
disclosure and transparency standards and strengthening the clearing and settlement
mechanism in secondary market. The recommendations have been accepted in
principle by the Government, RBI and SEBI and are under various stages of
implementation.
The two stock exchanges, namely, the Bombay Stock Exchange (BSE) and the
National Stock exchange (NSE), as well as the industry body Fixed Income,
Money Market and Derivatives Association of India (FIMMDA) have since
operationalised respective trade reporting platforms. While all the exchange trades
in corporate bonds get captured by concerned exchange’s reporting platform,
OTC transactions can be reported on any of these platforms. The aggregated
trade information across the platforms is being disseminated by FIMMDA on its
website.  BSE and NSE have also started order driven trading platforms in July
2007. In practice, however, trading still continues to be largely OTC. SEBI has
also implemented measures to streamline the activity in corporate bond markets
by reducing the shut period in line with that of G-sec, reducing the size of standard
lots to Rs. one lakh and standardising the day count convention. Further, to
streamline the process of interest and redemption payments, Electronic Clearing
Services (ECS), Real time Gross Settlements (RTGS) or National Electronic Funds
Transfer (NEFT) are required to be used by the issuers.
Further progress is anticipated in regard to rationalising the primary issuance
procedures, which is a critical step for moving away from the pre-dominance of
private placements. To reduce the settlement risk and enhance efficiency, the Patil
Committee has also proposed setting up of a robust clearing mechanism. The
settlement was proposed to be initially on DvP I basis (i.e. trade by trade basis)
to address the counterparty settlement risk and gradually migrate to DvP III (net
settlement of funds as well as securities) to impart enhanced settlement efficiency.
(The delivery versus payment (DVP) modules can be broadly classified into three
broad categories viz. DVP I, DVP II and DVP III. Under DVP I, the funds leg
as well as the securities leg are settled simultaneously on a contract-by-contract
basis. Under DVP 2, while the securities leg is settled on a contract-by-contract
basis, the funds leg is settled for the net amount). Under DVP III, both the funds
and the securities legs are settled for the net amounts.)
48
Patil Committee has recommended two important measures to be initiated by the Capital Market and its
Regulation
Government, namely rationalisation of stamp-duty, and abolition of tax deduction
at source, as in the case of government securities. As the corporate debt markets
develop and RBI is assured of availability of efficient price discovery through
significant increases in public issues as well as secondary market trading, and an
efficient and safe settlement system, based on DvP III and STP is in place, RBI
is committed to permitting market repos in corporate bonds. In the medium term,
considering the overall macro-economic situation, the ceiling for foreign investment
in both government securities and corporate debt will continue to be calibrated as
an instrument of capital account management. In particular, a more liberalised
access to foreign investment would be appropriate when, among other things, an
efficient and safe settlement system is well entrenched, aggregate consolidated
public debt to GDP ratio reaches a reasonable level, say less than 50 per cent,
and the corporate debt market acquires depth and liquidity with significant role for
insurance and pension funds in India. In the past, the government securities
dominated the debt market in India, partly on account of the fiscal dominance and
the absence of contractual savings. In the absence of contractual savings only
banks tended to deploy their funds in the corporate bond market, mainly through
private placement. RBI is hopeful that the recent slow but steady development of
insurance sector, mutual funds etc. coupled with the existence of a reliable
government securities market and the availability of robust reporting, trading and
settlement mechanisms would lead to a rapid development of a vibrant corporate
debt market. A framework for the development is already available through the
recommendations of the Patil Committee, the implementation of which has already
been taken up by the various agencies.
Check Your Progress 3
1) State the reasons for trading the derivatives.
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2) Which instruments are traded in the exchange traded markets?
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3) What is capital account convertibility?
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49
UNIT 7 CURRENCY RISK MANAGEMENT'
Structure
Objectives
Introduction
Meaning of Currency Risk and Exposure
Types of Currency Risks
7.3.1 Translation Risk
7.3.2 Transaction Risk
7.3.3 Economic Risk
7.3.4 Political Risk
7.3.5 Interest Rate Risk
Why manage Currency Risk?
Managing Currency Risk with Derivatives
Derivative Instruments
7.6.1 Forward Contracts and Forward Rate Agreements
7.6.2 Future Contracts
7.6.3 Currency Options
7.6.4 Currency Swaps
7.6.5 Interest Rate Swaps
Derivatives Market in India
Let Us Sum Up
Key Words
Terminal Questions/Exercises

7.0 OBJECTIVES

After studying this unit you should be able to:

explain the meaning of currency risk and exposure
highlight need for currency risk management
discuss methods of currency risk management
describe and illustrate instruments of currency risk management, namely,
forwards, futures, options and swaps
discuss derivatives market in India.

7.1 INTRODUCTION

In unit 6, you noted that exchange rates change, and change frequently. And you were
also explained the reasons for the fluctuations in exchange rates and the methods of
exchange rate forecasting . In this unit you will study the nature of various products
available to the risk manager for management of risk arising out of exchange
fluctuations. However, it is necessary for such a manager to take a view on the
direction in which the exchange rates are likely to move at the time of paymentlreceipt
of foreign currency. For this he requires to know reasons for exchange rate movements,
which were discussed in unit 6. In this unit you will learn about the meaning of
currency risk and exposure and types of currency risks faced by business. You will also
learn about how is currency risk managed with derivatives, different types of derivative
instruments and derivatives market in India.

7.2 MEANING
- OF CURRENCY RISK AND EXPOSURE
Risk , in common parlance, is the other naine of possibility of loss. This in finance
literature is called downside risk. In finance, risk means the variability from the most
likely happening. Statistically, standard deviation is taken as the measure of risk. You
 Currency Risk Management
kr~owthat standard deviation is nothing but dispersion or variability, both, upside and
downside from mean; and mean is the most representative or most likely observation.
Standard deviation is thus a measure of total risk, including upside and downside risk.

In practice, a busines's will find that at the time of payments, or receipts in cross border
dteals viz imports, exports, borrowing, lending, investments, the exchange rates are not
necessarily as predicted, despite the use of the best andlor all of the methods for
fixecasting of exchange rates. Businesses therefore, always have an uncertainty, arising
out of exchange rate fluctuations, as to the quantum of cash inflows and outflows in a
given period. Ibis uncertainty is called the currency risk. Another risk to which cross
t~orderdeals (i.e. foreign trade) are exposed is country/political risk. This arises out of
the possible imposition of restriction on the movement of currencies by the government
. of the.country in which the counterpart is located or even that of the business's own
country. This can result in the payment or receipt of funds being affected, as well as,
at a later date, if restrictions on them are removed. Therefore, business or even a
(country may wish to fix the quantum of inflow or outflow of funds in order to increase
its chances of a gain or in other words restrict its chances of a loss for overall
profitability. Besides currency and political risks there are other more common risks
such as the interest rate risk that is the bane of any business enterprise. Interest rate
risk is embedded in any foreign currency borrowjng, lending and investment
transactions. It may be noted that country and interest rate risks are broader terms than
used in the context of currency risk; nevertheless they do belong to currency risk.

In the context of foreign currency dealings, risk arises out of exchange rate fluctuations
i.e, unanticipated 6hanges in the value of the currency itself (e.g. in January 1998 the
exchange rate was 1 USD = 42.50 INR and in June 1998 1 USD = 43.10 INR). The
anticipated changes get reflected in the exchange rate as in the case of the forward
rates, which are ant~cipatedspot rates of the future. As against currency risk which is
system wide or say that would affect all the businesses in an industqr / country,
currency exposure means the degree of variability of profits or cash flow, arising out
of exchange rate fluctuations, faced by an individual firm. As you can imagine, the
currency exposure of a firm will depend on specific revenue and / or cash flow
characteristics of individual firm ; and would differ from each other. So while the
currency risk is broad and common to all, currency exposure is specific to an individual
firm. In conimon parlance, the terms 'currency risk' and 'currency exposure' are
interchangeably used. We will , in this block, use these terms interchangeably; though
the difference should be well recognised from the real world point of view.

7.3 TYPES OF CURRENCY RISKS

Management of currency risks involves dealing with diverse risks, namely, translation
risk, transaction risk, economic risk, political risk, interest rate risk. Mgasurement and
management of transaction, translation and economic risks will be discussed at length in
Units 8 and 9. We may briefly introduce them here.

7.3.1 Translation Risk

Translation risk arises when the functional currency used in various transactions, e.g. US
Dollar (USD) or Great Britain Pound (GBP) or Japanese Yen (JPY), is different from
the reporting currency, which in the Indian context is the Indian rupee (INR). Each
currency may move in different directions vis-a-vis the reporting currency (the one in
which the company's balance sheet is pyepared). The former may appreciate or
depreciate against the reporting currency. Thus, the reported profit or loss and statement
of assets and liabilities may be affected by cgrrency movements.

7.3.2 Transaction Risk

The other aspect of currency risk IS the transaction risk. The associated risk-depends
on the nature of the transaction e.g. whether the company is primarily an importer or an
exporter or both. If the transaction currency is an appreciating one as against the
reporting currency, an importer will find his input costs rising. On the other hand an
Foreign Exchaagc Risk exporter would receive a higher income without having to raise prices.
Mamagenrent Such exposure also affects a company's financial results by virtue of its effect on its
foreign currency investment and borrowing transactions.
I
7.3.3 Economic Risk
Another aspect of currency risk is the impact of exchange rates on future cash flows of
the company. It is based on the extent to which the value of the firm as measured by
the present value of its expected future cash flow willl change when exchange rates .
fluctuate unexpectedly. Such risk is said to arise out of the company's business
transactions vis-a-vis competitors. In an open economy, competitors would include both
domestic and international competitors.

7.3.4 Political Risk

Besides transaction, translation and economic risks as described above, companies also
face political risk, also referred to as country risk. A company transacting in a foreign
country may find its assets in that country frozen or even confiscated or it may find
that the country has prohibited its currency from being convertible. Such an eventuality
will prohibit the asset from being taken out of that country. Similarly a country could
increase the taxes that businesses are required to pay, thereby reducing the amount
repatriable to home country. Another aspect of country risk is the legal iurisdiction to
which business transactions are subjected.

7.3.5 Interest Rate Risk

Although interest rate risk affects all businesses, including dealing solely in the home
currency, foreign currency borrowers and lenders are exposed to the effects of changes
in interest rates on foreign currencies which in turn add to currency risk as the amount
of interest payable / receivable in foreign currency fluctuates with currency movements.

7.4 WHY MANAGE CURRENCY RISK?

Any uncertainty, especially one where the likelihood of an adverse outcome looms high
1
is generally required to be controlled and managed to reduce or altogether nullify its
impact. At times the impact may threaten the very viability of a company. A return - .
on investment is only meaningful if one knows the probability of achieving it. Risk
requires to be managed for reducing the fear of an adverse price, for locking in costs
and revenues and also to be able to forecast cash flows better.

Businesses adopt various systems and procedures to minimise risk. The market offers
various products and services to reduce losses likely to arise out of currency and
interest rate risks. Although risk may be due to reasons other than monetary viz risk
of fire, generally its management translates into financial compensation packages e.g.
possibility of lossfdamage to goods is addressed by the purchase of an insurance policy
that provides monetary compensation as against replacement of goods. There are
therefore, whole systems and organization that are in the business of trading in risk.
Whenever a risk is perceived there is always a financial entrepreneur who will work out
a product such that both the financial entrepreneur and those who are affected adversely,
by the risk stand to gain. They have on offer various products, priced differently.
Purchase of these products entails a cost as opposed to a financial loss. Steps taken to
purchase such products is called hedging and the product i.e. the contract itself
constitutes a hedging instrument and -it has the features of a contract. The consideration,
analysis and endeavor to reduce risk constitute risk management..

The favourable outcome of managing risk can be (1) reduced cost of borrowing, (2)
planning of a better business strategy, (3) better forecast of cash flows and reduction in
its volatility.
 - Currency Risk Management
7.5 MANAGING CURRENCY RISK WITH
DERIVATIVES
Currency risk is managed by the use of financial derivatives. Derivative is a general
telm and is nothing but the derivation of one variable from another. The term
orrginates from mathematics. Derivatives are used to manage systemic or market risk.
Financial derivatives are financial instruments whose prices are derived from the prices
of other financial instruments. They are traded in almost any market where trading takes
place. Derivative trading is linked to the underlying cash or spot market. In this unit
we shall confine ourselves to the currency markets.

Tlne action of managing risk is called hedging. Hedging is the technique by which an
exposure to risk is covered or dealt with in a manner so as to remove and reduce
uncertainties or even to look upon the uncertainty as an opportunity for gain as opposed
tct the occurrence of a possible loss.
d
It is like being in the state of defence preparedness in the event of an enemy attack or
an insurance against future loss or limiting future loss.

Here it is important to observe the distinction between hedging and speculation. The
average person looks upon speculation as a distasteful activity. Yet without speculators
there can only be limited scope for hedging and hedgers. Some persons and companies
a.re in the business of taking risks and making money, for which they use their own
ciapita1 or those of their clients.,. Speculation involves the acceptance of certain risks in
order to receive high returns and does not involve the existence of an underlying
transaction. Whereas in hedging there is an underlying transaction with a certain risk
attached which is being covered through hedging.

Major instruments of currency risk management are forward contracts and forward rate '
irgreements, currency futures, currency options and currency swaps and interest rate
,swaps. Lets explain them in the following.

Check Your Progress A

1. Distinguish with example currency risk and exposure.

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2. Why are derivatives called derivatives?

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3. What is country risk?
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7.6 DERIVATIVE INSTRUMENTS
7.6.1 Forward Contracts and Forward Rate Agreements
The forward contract .is an instrument wherein the price of the forward currency is the
future spot rate for that maturity as expected by the market. Forward contract may be
an outright contract. An outright forwardcontract is an agreement to eychange
currencies at a future date at an agreed price.
 Foreign Exchange Risk
Management
The forward exchange market is an unregulated market and contract specifications-
largely depend on convention and may be changed by mutual consent of the parties to
the contract. Although theoretically it is possible to enter into a forward contract for
any maturity of 3 days and beyond, in practice it is diflicult for maturities of over one
year. In India it is dificult to obtain it for maturities beyond 6 months although the
market is now developing for longer maturities.

A forward rate agreement (FRA) is a contract in which an amount of currency is

borrowed notionally at a certain fixed rate of interest as against a floating rate of
interest or vice versa over a specific, single period of time. It is an over-the counter
transaction in which financial institutions, such as banks act as intermediaries. So
whereas a forward contract is a hedge against exchange rate fluctuations, the FRA is a
hedge against interest rate fluctuations. I

I
The underlying transaction for a FRA would be an investment or debt involving receipt
or payment of interest. However, in the FRA, which is a separate transaction, there is
no exchange of any principal amount. The rate of interest considered is generally the
LIBOR (London Inter bank offered Rate). There is no payment of fee, other than
transaction costs. The payer of the fixed rate is the buyer of the hedge. The receiver
of the fixed rate is the seller of the hedge and the bank or financial institution that
arranges the transaction is the intermediary.

To take an example, assume that the buyer of the hedge, a company, has decided on
day 'A' to borrow a certain sum 'X' at LIBOR for a one-month period beginning from
future date 'B'. The one-month LlBOR on day 'B' is an unknown quantity today i.e.
'A'; giving rise to buy an FRA at a fixed rate for settlement on day 'B'.

As per the mechanics of a FRA, on day 'B' the company has to notionally pay the
fixed rate of interest on sum 'X' for one-month to the intermediary. So also the
intermediary has to pay the company one-month LIBOR on the same sum 'X' on day
'B' when the one-month LIBOR becomes known. In effect, neither the sum 'X'
exchanges hands nor the interest amount due on the sum; but the net of the two interest
amounts is payable by the party, which has to pay the higher of the two interest rates,
to the party which has to pay the lower of the two interest rates ,e.g. if the fixed rate is
5% and the one-month LlBOR on day 'B' is 4%, the company will pay 1% to the
intermediary. On the other hand if the fixed rate is agreed as 6% the intermediary will
pay 1% to the company. The transactions can be represented as below:

LIBOR (4%) 1%
Lender 4 Company Intermediary

LIBOR (6%) 1%
Lender t Company 4 lntennedi!!ry

The cash flows will be such that on Day 'B' the company receives LlBOR and pays it
to lender on Day C i.e. the datk of maturity. Thus the company in effect has paid the
net fixed rate of interest on the sum 'X'. In this manner it converts its floating interest
rate exposure to a fixed rate.

The intermediary on the other hand converts its LlBOR exposure on Day 'B' to a fixed
rate one by selling an FRA to another company, which wishes to buy an FRA to hedge
against its own fixed rate exposure. Such a company will pay, on Day 'B', the
applicable LlBOR to the intermediary and receive a fixed rate interest.

7.6.2 Future Contracts

Most derivatives are futures or options. Some have both features.

Futures are contracts conveying

a) an agreement, b) to buy or sell, c) a specific amount, d) of a financial instrument, e)

 ~ l t h o u ~futures
h are similar to forward contracts they differ in respect of the following: Currency NIsk Management

a futures contract whereas a forward contract

- Standardises the quantity of the
underlying asset to be delivered
per contract.
- has an underlying financial
instrument or index
- is regulated by exchange concerned
- has the minimum price
movement for the contract
- has the period of the contract
- is an exchange traded instrument
- transaction is not directly between
wunter parties but through the
~ntermediationof the exchange
- does not consider
creditworthiness of the opposite
party very relevant.
has a designated quantity of the
underlying asset to be delivered
per contract.
has an underlying financial exposure
is self regulating
has a mutually agreed upon price
for the contract.
has a designated future date for
delivery
is not an exchange traded instrument
is a transaction directly between
counter parties
must consider creditworthiness
of the counter party.

, From the above it is clear that a currency &re is a contract that trades in a futures
exchange where long positions (orders to buy) are matched with short positions (orders
to sell) by brokers and members. The exchange guarantees both sides of the contract.
Currency futures were first traded in 1972 in the International Money Market of the
Chicago Mercantile Exchange. One of the biggest futures exchanges is the London
International Financial Futures Exchange (LIFFE).

Futures prices are generally quoted in USD equivalents of one unit of another currency;
however in the case of Japanese Yen (JPY) the price are quoted as USD equivalent of
JPY100. Contract sizes for some currencies are JPY 12.5 million, GBP 62,500; SFr

Members are required to maintain a margin with the exchange. The margin requirement
would generally be directly proportionate to the volatility of the market. When margin
requirement is low, cost of capital required for trading is reduced. But low margins
increase default risk of the exchange-clearing house. Exchanges generally permit
trading over an eight-hour period. Although this is a restrictive practice, exchanges
enter into mutual offset agreements which permit opening of positions on one exchange
and closing on the other. They may also permit expanded trading hours.

7.6.3 Currency Options

Options are different from forwards and futures contracts which gives one the option to
deliver or not, on the designated date. In the forward contract both parties are obliged
to deliver the designated currencies regardless of the actual exchange rate on the date of
delivery. In the options contract one may compare the actual exchange rate on the
designated date with the contracted rate and opt to deliver or otherwise the designated
currency. As the seller of the option , also called a writer of the option such as a
bank, is exposed to the unlimited risk of non-delivery, the seller is entitled to receive
compensation at the time of the sale or contract upfront. This compensation is called

Depending on whether the option buyer has contracted to buy the asset or sell it, the
option is called 'call' or 'put' respectively. A currency option is the right to exchange
two currencies, which means it is a simultaneous right to buy and sell a certain
currency. The price at which it is agreed to purchase or sell the asset is called the
31
Foreign Exchange Risk In an European option, the option can be exercised only on the date of expiry whereas
Management in an American option it can be exercised any day prior to or on the date of expiry.
Options are traded at the exchange as also over-the-counter.

A 3-month USD lmillion call/INR put European option contract having a strike price
44.25 and premium 2.5% will be executed by the payment of 2.5% by the option .
purchaser to the seller on the date of the contract. At the end of the 3- month period
the buyer will see the spot rate on that day and decide whether to utilise the option or
not. If the spot rate is higher than INR. 44.25 the option buyer will exercise the option
and take delivery of the option contract at INR 44.25 two days after the expiry date.
In this situation, the option is said to be in the money. If the spot rate on the date of
expiry is lower than the strike price the option is said to be out-of-the money and the
buyer will not utilise the contract, as it would be cheaper for the buyer to buy spot in
the market. The buyer of any currency is considered to have assumed a long position
in that currency and the seller to assume a short position.

The simple call or put option as described above is referred to as plain vanilla or
standard derivative. The non- standard option is said to be 'exotic'. Actually it would
be a mix of options with other contracts , for example with swaps, called swaption.

7.6.4 Currency Swaps

A swap is an agreement to buy and sell a currency at agreed rates of exchange and
where the buy and sell trayactions are at different times. A swap is therefore really a
combination of the outright contracts, one of which is a spot transaction and the other
an opposite and forward transaction. However, both legs of the swap can be forward in
which case it is known as a forward-forward swap. When both legs of the swap are
separated by one day, it is known as a rollover swap.

A swap-in INR is a spot purchase of INR against another currency with a forward sale
of INR against the same currency. On the other hand, a swap-out INR is a spot sale
of INR against a certain currency with a forward purchase of INR against the same
currency.

A currency swap is undertaken when a party has a liability into another currency, in
order to take advantage of favorable interest rate or interest rate movement, whereas a
counter party has a liability in the latter currency, which it wishes to convert into
liability in the former currency. The party and counter party can be in two different
countries and need not know each other. A bank or financial institution can act as

currency for a principal and fixed rate interest payment on an equivalent loan in another
'
currency. For example, assume company 'A' may have to pay USD at 5 % whereas
Company 'B' may be in a position to borrow GBP at 8.0%. Similarly, Company 'A'
may be in a position to borrow GBP at 9 % whereas Company B may be able to do so
in USD at 6 %. To make a swap, at the beginning the principal amounts are exchanged
notionally in the original currencies. Thereafter each year the two companies pay
interest on the currencies received by them to the intermediary and the intermediary in
turn pays them interest on their original currencies. In the process all there entities
gain. Let us take an example:

Company 'A' can borrow USD at 5 %

Company B can borrow GBP at 8 %

Intermediary receives 5.5 % from B,and pays 5 % to A in USD and gains .5 %; also
it receives 8.5% from A and pays 8 % to B in GBP and gains .5 % , making a net
gain of 1 %.

-
Thus, Company 'A' has a net gain of 0.5% [ 9 % 8.5%], Company B has a gain of
-
0.5% [ 6% 5.5% ] and the intermediary makes a gain of 1%.

32
 - -

At the end of the swap the two companies would notionally return the currency Currency Risk nIanagement
received at the beginning of the swap and notionally receive their original principal
amounts.

7.6.5 Interest Rate Swaps

An interest rate swap on the other hand is useful to parties, which have interest
liabilities. Consider for example a situation in which Company 'A' has a fixed rate
liability e.g. a three-year bond issue at 8% p.a., which it wants to convert into a
floating rate liability, based on LIBOR, which it expects will go down in the near
future. Assume, this company is able to borrow at LIBOR+O.S%. On the. other hand
Company 'B' may have borrowed the same amount of currency as the bond issue size
of Company 'A' and for the same period at a floating interest rate of LIBOR +1%
payable every six months. Company 'B' may wish to lock into a fixed interest rate of
say 9% p.a. as its treasurer finds it is a nightmare managing the net of interest cash
flows of the Company.

Companies 'A' and 'B' can enter into an interest rate swap through the intermediation
of a financial institution in the following manner.

Company 'A' is required to pay LIBOR + 0.5% to company B at the end of six month.
LIBOR prevailing at the beginning of the 6-month period in question is taken into
account. Company 'B' will pay 9% to Company 'A' at the end of the same 6-month
period. Company 'A' then pays 8% to its bondholders and Company 'B' pays LIBOR
+I% to its lenders. Company 'A' at the end of 6 months thus receives 9% and pays

a +05%. Company 'B' at the end of 6 months receives LIBOR + 0.5% and pays (LIBOR
+I%) + 9% i.e. has a net position (LIBOR +0.5%) - (9% - (LIBOR +I%)} = 9.5%.

Here again neither the principal amount nor the interest are exchanged but the net
mount of the interest is exchanged through the intermediary, which earns a profit by
adding its margin to the interest rates payable by both companies. The intermediary
enters into separate contracts with both companies who may not know each other.

7,7 DERIVATIVES MARKET IN INDIA

Currency markets, spot and forward, are very active markets in India. The forward and
spot currency markets are relatively well developed in India as opposed to the futures
and options markets.

The Reserve Bank of India is nudging banks to deal with derivatives but unless
currency markets are fully developed with large volumes (the minimum units for
-
currency futures in international markets are Deutsche Marks (DEM) and Swiss Francs
(SFr): 125,000; for GBP: 62,500 and for JPY: 12,500,000) and unless for hedging in
international futures markets, rupee becomes fully convertible, the fbtures markets will
not be available to Indian corporates to cover all types of risks.

The disoussion in this unit has therefore limitations in that examples.provided are of
overseas futures markets, which may not appear altogether realistic in Indian conditions.

In the US and European countries, banks act as intermediaries and advice corporate
-about futures and options and undertake the hedginglfutures transactions to cover the
currency risks. In India, unless Indian banks are themselves able to obtain cover for
' futures, Indian banks may not negotiate to undertake the business.

In India, the futures and options currency markets are yet to catch on. The Reserve
Bank of India has permitted it in a limited way at a time when neither bankers nor
customers fully understand the usefulness and mechanism of the instruments. In this
state of general ignorance, news of the losses of Proctor and Gamble Inc. and Orage
County in the U.S.A. only compounds the fear and the parties hesitate to tread into this
area. Nevertheless, it is hoped to pick up very fast with opening up of the economy.
33
 UNIT 6 DETERMINATION AND FORECASTING
OF EXCHANGE RATES
&

Structure

Objectives
Introduction
Equilibrium Approach to Exchange Rates
Purchasing Power Parity
Interest Rate Parity
6.4.I The F~sherEffect
6.4.2 The International Fisher Effect
Inflation and its Impact on Financial Markets
Central Bank Intervention
Exchange Rate Forecasting
Let Us Sum Up
Key Words
Terminal Questions/Exercises

6.0 OBJECTIVES

;I ' ~ f t e rstudying this unit you should be able to :

describe how exchange rates are determined under freely floating exchange rate
regime
examine consequences of central bank intervention in foreign exchange markets.
explain how exchange rates are forecast.

6.1 INTRODUCTION

In unit 5 you learnt about foreign exchange market and its various operational aspects.
In this unit you will first learn about how exchange rates are determined in the free
market environment and then you will learn about forms and consequences of central
bank intervention in the foreign exchange market. You will also study methods of
i exchange rate forecasting.

6.2 EQUILIBRIUM APPROACH TO EXCHANGE RATES

We learnt in unit 5 that exchange rate is relative price of currencies in the foreign
exchange market. How is this price determined? There are various theories offered for
the same. Purchasing Power Parity Theory, Interest Parity Theory are quite popular. But
before we go into these theories, lets examine equilibrium approach or free market
approach to exchange rates.

Equilibrium approach to exchange rate determination essentially states that exchange rate
between any two currencies will be determined by demand and supply of the relevant *
currencies. Thus the exchange rates are influenced by various factors influencing
demand and supply for various currencies. Cross border transactions viz trade, services
and capital account, as explained in Bleck 1, Unit 4 on Balance of Payment , create
.
demand- supply forces in the market and in a free market, exchange rates are the
demand supply clearing prices.

The exchange rates in this environment are determined as part of the general real and
monetary equilibrium of the world economic system; there is no sense in which one
may assert that the exchange rate is an exclusively monetary phenomenon. Indeed an
equilibrium exchange rate can change without any accompanying change in money
SU~DIV or the real rnnnpTr+wand Such wnrrld for example, be the case if there were 1 7
Foreign Exchange Risk
M a r agement
a change in the compos~iionof production between home goods and traded goods or
improvements in domestic supply condition of a critical raw material or discovery of a
new source of energy. Besides, 'expectations' about future demand supply of a
currency play a critical role in determining exchange rates. Needless to say, the
exchange rate will be highly volatile in free market

Changes in exchange rates, as you can well imagine, would have radical impact on -
patterns of international trade and capital flows, and can profoundly influence the
economy of countries. The domestic economy of a country will be directly and
indirectly affected by foreign exchange developments. The immediate impact of
fluctuations in rates is felt at first by those who are directly involved in international !
trade or international finance. What complicates the problems of those affected is the
unpredictability of the markets. While trends can be forecast, timing is a sensitive issue.
The events of recent years have thrown up painful lessons .for institutions which deal in
and with foreign currencies. The advent of tloating rates has given rise to movements
which has made things extremely difficult. The importers who have to pay for their
purchases in foreign currency, investors who have purchased a foreign asset, or the
corporation which floats a foreign debt, are all facing foreign exchange risk. The
exporters are similarly placed. Every one would like to minimise his risks by trying to
quantify it to determine maximum exposure. It is some what easier to identify the
foreign exchange risk in a fixed rate environment - although the danger of parity
changes still exists - than in a floating rate environment. In the latter case, one can only
hope that profit taking or central bank intervention would stop complete panic when
markets are highly illiquid.

Devaluation and revaluation cover large fluctuations but have generally been in the
range of 20 per cent. The measures can give indication of short term foreign exchange
risk. Longer term' risk is greater and much more difficult to evaluate. Currencies can
undergo sharp fluctuations over a few years or even a few months. The South East
Asian crisis towards the end of the last century is a case in point, where currencies lost
70-80 per cent in short span of time. It may thus seem logical to establish parities
under equilibrium, but unfortunately nobody has ever been able to establish them and
nobody even knows all the factors that weigh at a given point of time on the behaviour
of currencies. We are reminded of a quote from a reputed foreign exchange consultant
when at the end of his lecture during a seminar one of the delegates asked him : Sir,
can you tell us what will be the exchange rate of Rupee tomorrow? He replied: Well,
my dear, it will depend on which side of my bed 1 get up tomorrow morning! Well, so
much-for the exchhge forecasts. But the world can not run its mill unless we find
some anchor in this highly unpredictable foreign exchange market. Purchasing power
parity and interest parity have been the two main anchors in this context. Let us
---
discuss them one by one in th&f:lllowing.

6.3 PURCHASING POWER PARITY

Purchasing Power Parity was firs: started in a rigorous manner by Swedish Economist
Gustar Cassel in 1918. It was suggested by him that this could be used for new set of
off~cialexchange rates at the end of World War I that would allow the resumption of
normal trade relations. Since then this has been widely used by central banks as a
, means to establish new par values for their currencies when they find the older rates
were' in disequilibrium.

Purchasing power parity in simple words means that the exchange rate between the two
currencies will be determined by the relative purchasing power of the two currencies.
To take an example, if a ' standard' pizza costs one dollar in US and p s 40 in India,
the dollar1 rupee exchange rate should be I$= Rs. 40. Thus, in absolute terms,
purchasing power parity means that exchange aajusted price levels should be the same
- all over the world. The assumption is that free trade between the countries should
equalise the prices of goods in all the countries expressed in local currencies. Suppose,
for a moment that the exchange rate 1$ = Rs 45. It will provide opportunity for
international arbitrage. How? As you can readily imagine, in this situation, an Indian ,
exporter would buy pizza in India for Rs. 40 and export it to US to sell for 1% and
 convert the sale prlce of I$ into Indian rupees at the rate of Rs. 45 for each dollar. , Detern~inationand
Forecasting of Exchange
Assuming the transportation costs to be zero, the lndian exporter can make neat profit Rates
of Rs. 5 for every pizza he sells in US. Because of this profit potential, forces are set
in motion to change the exchange rate and/or the prices of pizza. In our example,
pizzas will start moving from lndia to US. The reduced supply of pizzas in lndia will
raise the prices of pizzas in India and the increased supply of pizzas in US will lower
the prices of pizzas in US. In addition to moving pizzas around, the pizza exporters
would be busily converting dollars into Indian ruppes to buy more pizzas. This activity
increases the supply of dollar and simultaneously increases the demand for Indian rupee.
This means INR is getting more valuable, so it will take more dollars to buy INR.
Since the rate is quoted in INR, it will take lesser INR to buy dollar. The exchange
rate of INR will go up from Rs 45 towards Rs. 40. Thus, ~ntemationalarbitrage works
to keep exchange rates in line with purchasing power parity . This is the absolute
purchasing power parity theory. The absolute purchasing power parity does not take into
account the differences in prices that will arise due to transportation costs, tariffs, quotas
and other restrictions and product differentiation.

The relative version of purchasing power parity which is more commonly used states .
that the exchange rates between home currency and any foreign currency will adjust to
reflect chiinges in the price levels of the two countries. For example, if inflation is 5%
in the United States and 7 % in India, then in order to equalise dollar price of goods in
the two countries, the dollar value of lndian rupee must fall by about 2%.

If ih and if are the periodic price level increases (rate of inflation) for the home'
currency and foreign currency respectively, eo is the home currency value of one unit
of foreign currency at the beginning of the period and et is the spot exchange rate in
period t then :
et - (l+ih)'
eo (Itif)'

Take an example, if the United States and India are running annual inflation rates of '
5% and 7%, respectively, and the initial exchange rate was 1$ = Rs 40; then according
I to relative purchasing power parity, the value of the dollar in three years should be :

Purchasing power parity bears an important message. Just as the price of goods in one
year cannot be meaningfully compared to the price of goods in another year without
adjusting to interim inflation, so exchange rate change may indicate nothing more than
the reality that countries have different inflation rates. In fact, according to purchasing
power parity, exchange rate movements should cancel out changes in foreign price level
relative to the domestic price level. The offsetting movements should have no effects
on the relative competitive positions of domestic firm and foreign competitors. Thus
'
changes in the nominal exchange rate may be of little significance in determining the
true effects of currency changes on a firm and nation. In terms of currency changes
affecting relative competitiveness, therefore, the focus must be not on nominal exchange
rate changes but instead on changes in real purchasing power of one currency related to
another. That is the exchange rate change during a period should equal the inflation
differential for the same time period. In one word, purchasing power parity says that
currencies with high rates of inflation should devalue relating to currencies with lower
rates of inflation.

6.4 INTEREST RATE PARITY

Besides purchasing power parity theory, another theory which is quite popular is the
interest rate parity theory. According to interest rate panty theory, the currency of one
country with a lower interest rate should be at forward premium in terms of the
I currency of a country with a higher rate. More specifically in an efficient market with
no transaction costs, the interest differential should be equal to the forward differential. ,
When this condition is met, the forward rate is said t c ~be at interest parity and
equilibrium prevails in the money market. This theory is based on interest rate
Foreign Exchange Risk behaviour, commonly known as Fisher Effect and International Fisher Effect. Lets us
Management discuss these in the following.

6.4.1 The Fisher Effect

The financial news papers generally give interest rates for currencies which are mostly
nominal. That is, they are expressed as the rate of exchange between current and future
rupees. For example, a nominal interest rate of 8% p.a. on one year loan means that
Rs.1.08 must be repaid in one year for Rs.1 .OO loaned today. But what really matters to
both parties to a loan agreement is the real interest rate, the rate at which current goods
are being converted into future goods.

In a sense, the real rate of interest is the net increase in wealth that people expect to
achieve when they save and invest current income. Alternatively, it can be viewed as
the added future consumption promised by a corporate borrower to a lender in return
for the latter's deferring current consumption. From the company's standpoint, this
exchange is worth while as long as it can find suitably productive investments.
However, because virtually all financial rates are stated in nominal terms, the nominal
interest rate must be adjusted to reflect expected inflation. The Fisher Effect states that
the nominal interest rate is made of two components (I) a real required rate of return,
a, and (2) an inflation premium equal to the exvected amount of inflation, i. Formally
the Fisher Effect is :

1 + nominal rate = (I + real rate) (I+expected inflation rate)

l+r = (l+a) (1+ i ) or r = a + i + ai

The Fisher equation says that if the required real return is 4% and expected inflation is
lo%, then the nominal interest rate will be 14.4% = I+ r = (1 + .04) ( 1+ .lo).

6.4.2 The International Fisher Effect

The key to understanding the impact of relative changes in nominal interest rates among
I
countries on the foreign exchange value of a nation's currency is to recall the
implications of purchasing power parity (PPP) and the generalised Fisher effect.
Purchasing power parity implies that exchange rates will move to offset changes in
inflation rate differentials. Thus a rise in lndian inflation rates relative to those of other
countries will be associated with a fall in the rupees' value. It will also be associated
with a rise in lndian interest rate relative to foreign interest rates. Combine these two
conditions and the result is the International Fisher Effect.

(1 + rh It - =t
- - 1.1
(1 + rf eo

Where et is the expected exchange rate in period t. The single period analogue to
equation 1.1 is
1 + rh
- -
- - 1
1.2
1 + rf eo
Note the relation here to interest rate parity. If the forward rate is an unbiased predictor
of the future spot rate - that is fl = el then equation 1.2 becomes interest parity
condition
- -- -
+ '-11 f,
1.3
I + rf eo
b
According,to both equations 1.2 and 1.3 the expected return from investing at home,

I
4 + rh should equal 'the expected return in home currency from investing abroad,
(1+ r f ) el/eo or (I + rf ) fifeo . However despite the intuitive appeal of equal expected
retum, domestic and foreign expected returns might not equilibrate if the element of
currency risk restrained the process of international arbitrage.
 Using the International Fisher Effect as discussed above, let us forecast US dollar and Determination and
Forecasting of Elrehaage
Swiss Franc rates. In January, the onesyear interest rate is 4% on Swiss francs and 7 % Ra tts
on US dollars.

3) If the current exchange rate is SF1 = $ 63, what is the expected future exchange
rate in one year? ,

According to International Fisher Effect, the spot exchange rate expected in one year
equals 0.63 x 1,0711.04 = $0.6482.

In this case, international arbitrage works to keep exchange rates in line with interest
dZfferentials.Suppose, for a moment, that one year forward rate equals $ 0. 65 instead
of $ 0.6482. Does this offer an arbitrage opportunity? The answer is yes! Do you see
how? In this situation, an American resident has two options. He can either invest his
1 dollar for one year at the rate of 7% per annum and obtain 1.07 dollar at the end of
one year . Or, alternatively he may convert 1 dollar into SF at the spot rate of $0.63,
I
invest that money in the Swiss market at the rate of 4% per annum and simultaneously
execute a forward contract to convert SF back into dollar at the end of one year. The
necessary steps will be as follows:

1) Convert 1 dollar into 1.5873 SF at the spot rate of 1SF = $0.63

2) Invest 1.5873 SF at 4% to obtain SF L6508 = SF 1.5873 x I+ .04
a 3) Convert SF 1.6508 into dollar 1SF = $0.65, as per forward contract executed, to
get $ 1.0730
Do you notice, under the second alternative, the US resident will get $ 1.0730 instead
of $ 1.07 under the first option. Clearly, it is an opportunity to make neat profit of
.003%. This opportunity will move market forces to convert US $ into SF and make
neat profit which will soon get corrected as we had seen under the case of international
arbitrage under absolute PPP above. Only difference is that instead of Indian pizzas,
now more dollars will like to flow to Swiss, increasing demand for dollars and thereby
strengthening dollar; with exchange rate moving from 1SF = $0.65 towards $0. 6482.

b) If a change in expectations regarding future inflation rate causes the expected

future spot rate rise to $0.68 what would happen to U.S. Interest rate?
If r US is the unknown US interest rate and Swiss interest rate stayed at 4%
then according to the lnternational Fisher Effect
0.6810.63 = (1 + r US) / 1.04
={(0.68 1 0.63) ( 1.04) ) - 1 = r US
= 12.25%.

The International Fisher Effect is also known as Interest parity as foreign exchange
rates tend to adjust for interest differential between two countries. You must have
noticed the role of inflation both under purchasing power parity and interest parity
theories. Lets elaborate on the role of inflation in financial markets in the following.

6.5 INFLATION AND ITS IMPACT ON FINANCIAL

MARKETS
Exchange rate movements have become the single most important factor affecting the
value of investments particularly on an international level. They are crucial to business
sales and profits forecasts and to investment plans and their outcome. They can turn
what was in one year a thriving industry into a loss making industry in two years time
- whether the products were intended for the export or the home market. The much
favoured "discounted cash flow" approach to investment analysis is useless without
taking into account exchange rate assumptions. With the growth of investments across
international boundaries and a shrinking world in tenns of communications, the domestic
cost of food, fuel, clothes or travel are now substantially influenced by international
markets and subject to the exchange rate movements.

In the present day floating exchange rate system, the currency of any individual country
is only wonh what you can buy with it, or what you can exchange it for at any
particular time.
Foreign Exchange Risk A country whose rate of inflation is consistently higher than that of its competitors will
Management experience faster increase in its production costs and its exports will become more
expensive than those of its lower inflation competitors. This invariably leads to a
reduction in level of exports, a rising level of imports and a growing trade and current
account deficit. This will ultimately result in weakening of/the value of its currency
against its competitors.

Over a long term an historic record of high inflation is often thought of as an indicator
of weak currency. A country's inflation rate is determined mainly by a combination of
government economic policies and the political climate in the country. Like in India,
with state 'populism', rate of inflation has invariably been on the rise. Coinsequence!
rupee consistently depreciating against all major currencies. The financial markets are
seriously affected by the inflationary pressures. The U.S. economy has protected itself
from violent exchange rate fluctuations of dollar because of a regime of low inflation
and interest rates over a number of years.

Thus, from the long term perspective, factors which determine the competitiveness of a
particular economy and, in turn, strength and weakness of its currency are relative
inflation rates which further, in turn, are impacted by money supply growth , budget
deficits, economic growth rates, employment rate, etc.

6.6 CENTRAL BANK INTERVENTION

Central banks do participate in foreign exchange markets in their role as agents to their
governments or banker of the banks. Thus they always maintain some form of presence
in the markets. Their most publicised form of involvement however is when they enter
the markets on their own or under orders from their governments to stabilise exchange
rates. Such operations are often termed as central bank intervention.

The primary purpose of intervention is to alter the liquidity of the markets by providing
either supply or demand for home currency in the foreign exchange market. The reasons
could be deep seated or temporary; in any case they will seldom be stated publicly. If
we want to know the success of intervention compared to goals, such goals would not
normally be defined precisely.

When central bank authorities state publicly that a certain level is "unrealistic" and that
they are trying to modify it, they have in fact committed to a support level, and the
user of the market can act accordingly. If they fail to maintain that level, they lose
face. It is then that we witness the cat and mouse game between central bank and the
markets, which former seldom wins. However, over the years central banks have
developed their understanding of markets and developed better intervention methods and
therefore they intervene in the market by using minimum funds with maximum impact.

The most obvious form of intervention takes place in spot markets. A central bank can
intervene openly or under cover. Public intervention consists in calling one or several
banks in the market and either asking for prices and dealing, or making prices. Under
cover intervention consists in giving an order to one bank or a limited number of
banks, like RBI using State Bank of India as agent. The choice and size of such
intervention is determined by the goal that the central bank wishes to achieve.

The intervention of the central bank is not limi!ed to its own market and it can request
other central banks to act as its intervening agent in their markets. Such intei-dentions
/ are however, resorted to under exceptional circumstances and run in large figures.

Spot interventions result in the acquisition of foreign currency, if the central bank is
selling its own currency in the markets, or in acquisition of domestic currency, if the
central bank is a buyer. In the first case the central bank is increasing its reserves of
foreign currency and in the process creates extra domestic money to accommodate
markets. In the second case it is depleting its foreign currency reserves and is
ti&tening the money supply by taking its own currency.
 If a central bafik no longer has foreign currency reserves, it may borrow them from Detc:rmlnrHon and
other central banks or get accommodation from world financing agencies like IMF, Forccrsti~tgof Exchange
Rates
World Bank. Excessive foreign currency reserves may be lent in the markets. What this
means is that spot interventions always lead to other money market operations with
clear interest rate implications. Therefore, central banks, in order to intervene effectively
in spot markets undertake forward swap transactions in sizeable amounts in their
domestic market. However, there are very clear cut lessons which the central banks
have learnt :

I 1)
2)
It is difficult to fight a market trend unless the trend is about to shift;
Acting in a manner that the market is anticipating is futile and self defeating;

3) It is only by keeping the markets guessing that some degree of success can be
achieved;

4) You can put on others the blame for loss of confidence in your currency.

The intervention by a central bank is important because the government considers that
their currency in the international market is vital to their economic and financial well
being. High economic growth with low inflation is the common agenda of all
governments and their central banks. Central bank intervention in foreign exchange
markets is therefore common. In the process, said or unsaid, free floating exchange rate
regime turns into managed exchange rate regime. Intervention by central banks ,
particularly because of the lesson number (3) above, have further added to array of
factors which determine exchange rates. Forecasting is nothing but projecting
explanatory factors into the future. By now you must have realised why that foreign
exchange consultant, quoted above, said that the tomorrow's exchange rate will depend
on which side of the bed he gets up next morning. Foreign exchange rate forecasting is
thus quite challenging.

6.7 EXCHANGE RATE FORECASTING

Forecasting of exchange rate can be classified as being short term (e.g., upto one year)
medium term (between one to three years) or long term (three to five years). The
assessment of currency or interest rate in the future cannot be an exact science.
Fundamental analysis can, however, provide a reliabb guide to likely changes in major
trends for individual currencies, although the timings and extent of such changes are
difficult to anticipate precisely. For timing, technical analysis may help. All technical
analysts use historical data as a basis for their conclusions. The patterns of
behaviour that emerge through the study of this data are the basis .for projeak?uture ,

trends. Although technical analysis has become prevalent and accepted, many banks
have also developed their own systems. But technical analysis has considerable
limitations , chief among which is that it does not concern itself with factors such as
upcoming news which can change the market.

The methodology used in forecasting is sometimes guessing, but with a more systematic
and methodical approach. Further , forecasts are again to be seen from the point of
view of the user. Spot dealer could not care less what the currency will be doing in a
year's time. However, corporates who have to develop long-term strategies are interested
in long-term c~rrenc~linte~est
rate forecasts.

short-tbrm Factors

News expected, or unexpectkd may have an impact on the markets. The unpredictability
of political developments in the modern world and the speed with which they are
reported always adds elements of instability. What further aggravates the problem is that
the full impact of a particular development is not always clear. The developments that
affect the markets cuts across all geographical boundaries. There is a great difference
between'the theoretical, "should be", response of the markets to certain developments, to
what "'actually" takes place.
Foreign Exchange Risk The other factor which affect ,the market on a day-to-day basis is reaction to liquidity.
Management Liquidity is the relationship between supply and demand from all market participants.
Liquidity of the markets is initially the result of existing positions.in the interbank
market combined with arising supply and demand.

Let us take an hypothetical situation where the interbank market is highly short in
dollars. If during the day further demand for non-dollar currencies arises, the banks can
easily accommodate this demand by reducing their short positions. This does not
necessarily mean that dollar will stabilise because the banks may wish to re-establish
their original positions. However, if a sudden need for dollars arises, we may have a
situation where banks already over-extended may have to buy large quantities of dollars
that nobody has for sale. This would create a sharp if temporary - dis-equilibrium.

Under the same situation where the market is short in dollars let us assume two news
items appear within a space of one hour. 'The first is very bearish to dollar. Market
participants who wish to sell more dollars, will find buyers - perhaps not easily if
nobody wants to hold them; but at a price somebody will be willing to take them. The
second news item is very bullish. This can suddenly create a demand for dollars that
nobody has. The result can easily be guessed. This rather simple example illustrates
what can happen in a one-sided market when demand shifts abruptly.

The gross liquidity of the market -the total supply and demand - is commonly
referred to as the depth of the market. The greater the depth, the more efficient the
markets are, especially when supply and demand come close to being matched.

The main characteristic of the market depth is the smooth large deals. When a sizeable
deal does not move the market by more than 0.2 or 0.3 per cent or when any move is
only temporary the markets can be said to have depth. On the other hand, if a relatively
small deal, such as a $20 million transaction moves the market by 0.5 per cent or
more, creates a temporary trend, the markets lack depth.

Another important aspect of depth is stability. In the first example above, a purchase
of $200 million instead of $ 20 million in a market heavily selling dollars may not
have a great influence on the trend but $25 million sale may create a further drop. In
this case the market shows reserves only on one side. A truly efficient market will be
one where transactions, no matter how large, are more or less matched - an infrequent
occurrence in foreign exchange markets. Thus, in one word, in the short term, market
liquidity and demand-supply pressure are to be foreseen for exchange rate forecasting.

Long-term Strategies

Long-term strategies focus more on what are perceived as underlying trends. This type
of strategy tends to be more of a manger's prerogative. Such basic positions are
usually taken with a certain goal in mind; perhaps the view that certain parities will
change drastically within a time span, or devaluation or revaluation will occur.
Usually the parameters of such positions are established in advance and dealers are
given specific instructions on how to handle the positions. The one added element on
long-term strategies as opposed to short-term strategies is the financing of basic
positions. Short-term positions are in or out and are settled within a day or two, The
financing is minimal. In the management of long-term positions the financing is
extremely important.

The basic 'qbestidns to.consider when mapping out long-term strategy are : what is the
goal? what is.the time span for achieving that goal? is the financing costly, or does it
create added profit potential? is it better to stay in spot, or should it be changed into a
forward ?

The exchange rate forecasting may be undertaken in-house or bought out. Banks and
large players normally have in- house forecasting team. Forecasting service is to provide
an added tool of analysis for the purpose of predicting market trends. No serious
service can ever claim to be always right. Even if it did, nobody would believe it.
Dealers have therefore, mixed feelings about this as they feel those who forecast have '

no stake as they do not operate in the market.

I 6.8 LET US SUM UP
Delermination and
Forecasti~mgof Exchange
Rater

In the absence of government intervention, exchange rate respond to the forces of

supply and demand that in turn are dependent on inflation rate, interest rates and GNP
growth rates. In a healthier economy, the currency is likely to be strong. Exchange rates
are affected to a large extent by expectations of future exchange rates changes, which
depend on forecasts of future economic and political conditions. .

In order to achieve certain economic and political objectives, governments often

intervene in the currency markets to affect exchange rate. Although the mechanics of
such intervention vary, the general purpose of each variant is basically the same, to
affect market liquidity.

Where people are unsure of what to expect, any new piece of information can alter
their beliefs. Thus if the underlying domestic policies are unstable, exchange rates will
be volatile as traders react to new information.

-6.9 KEY WORDS

Equilibrium Exchange Rate : The rate at which demand and supply of a currency
become equal.
Monetary Equilibrium : Equilibrium between demand and supply of a currency
achieved through monetary forces.
Real Equilibrium : It refers to equilibrium in the commodity market.
Purchasing power parity : It states prices of a similar products of two different
countries should be equal when measured in common currency.
Interest Rate Parity : The forward discount or premium is approximately equal to the
interest differential between' currencies.
Arbitrage : Purchase of securities or commodities on one market for immediate resale

'1 on another to earn profit from price discrepency.

6.10 TERMINAL QCTESTIONSIEXERCISES

I. Suppose prices start rising in the United States relative to prices in India. What
would you expect happen to the dollar - rupee rate? Explain.
2. If a foreigner purchases Indian short term security, what happens to the supply
and demand for rupees?
3. Under each of the following scenario , whether the value of rupees relative to
Japanese yen will appreciate, depreciate or remain the same? Assume that
exchange rates are free to vary and that other factors remain constant.

a) Growth rate of external income is higher in lndia than in Japan.

b) Inflation is higher in lndia than in Japan.

c) Prices in Japan and India are rising at the same rate.

d) Real interest rates are higher in lndia than in Japan.

e) India imposes new restrictions on the ability to buy lndian companies and
real estate,
 UNIT 5 FOREIGN EXCHANGE MARKETS

5.0 Objectives
5.1 Introduction
5.2 Meaning
5.3 Functions
5.3.1 Playm
5.3.2 Cumncies Commonly Treded
5.3.3 Trading Hours
5.4 Foreign Exchange Rates
5.5 Foreign Exchanges Quotations
* 5.6 Types o f Foreign Exchange Transactions
5.6.1 Tlade Transactions
5.6.2 Interbank Transactions
c 5.6.3 Spot Transactions
5.6.4 Forward Transactions
5.7 Indian Foreign Exchange Market
5.8 Let Us Sum Up
5.9 Key Words
5.10 Answers to Check Your Progress
5. II Terminal QuestionsIExercises

OBJECTIVES
ARer studying this unit you should be able to :

explain meaning o f fonign exchange market

discuss various types o f exchange transactim quotations md rates prevailing in
f m i g n exchange markets
describe the functions o f the foreign exchange m a & %and the role o f its
perticipnnts
discuss the operations o f Indian foreign exchange market.

5.1 INTRODUCTION
International trade and investment cnate need for buying, selling borrowing and lending
e
f m i g n cumnciea Let us take an example, an expotter in Japan sells goods to a
customer in the U.K. The sale will be priced in Yen, Sterling or perhaps a third
currency such as U.S. dollar.

a) If the sak is priced in Yen, the U.K. customer will purchase Yen with Sterling
in order to m l e payment.

b) If the sale price is in Sterling, the Japanese supplier will nonnally wish to
convat the receipts into domestic currency yen^ to meet operating expenses in
Japan, and will sell Sterling in exchange for Yen.

c) If the sale price is in a third currency, such as US dollars, the customer will buy
dollars in exchange for Sterling to. make the payment and supplier will then sell
the dollars in exchange for Yen.
Sometimes, international trade transactions do not result in the sale or purchase o f
foreign currency because companies setsff foreign currency receipts against foreign
exchange payments. However. buying and selling, borrowing and lending foreign
currencies an common activities which support international trade and investment. These
activities an undertaken in the financial markets called foreign exchange markets. As
student o f International Business Operations, it is thus important for you to know the
terminology. operations and mechanisms o f foreign exchange markets. In this unit, you
5
Foreign 'Exchange Risk
Management
will learn about the meaning of foreign exchange market and its functions, types of
transactions made and the rates used in this market. You will also learn about the
operations and dynamics of Indian foreign exchange market. !
1

5.2 MEANING
1
Foreign exchange in short form is called Forex. The foreign exchange market or forex
market is the market where one currency is exchanged or traded for another currency.
Forex markets are also called foreign currency or just currency markets. There are
domestic and international foreign currency markets. Domestic foreign currency markets
serve the foreign currency buying, selling, borrowing and lending needs of residents
whereas international markets serve non-residents also. Much of the foreign currency
lending and borrowing take place in the Euromarkets.

Currencies are also traded in other forms as "derivative contracts" such as currency
swaps, options and futures. These are more sophisticated instruments for trading in
foreign currencies. You will study about them in the following units in this block.

5.3 FUNCTIONS

As you know in the past most of the financial markets had a physical centre or say
trading floor, where dealers met to transact their trade by "out cry" method. But things
have changed for many of the markets in many countries. Floor trading has been
replaced by screen trading, meaning trades are made through the network of teIephone
and computers from dealers' dealing rooms. Foreign exchange markets have led this
trend.

Despite its lack of a physical centre, the forex market is still a market, in the sense.that
it is a system for bringing buyers and sellers together and for supplying informations
about prices and trading activity to participants. 'The dealers responsible for setting
prices at which their banks will exchange currencies must have access to the latest
prices in the market. This information is provided constantly by computer networks and
brokers. Thus, forex market performs very useful functions.

The global foreign exchange market has established three principle (major) dealing
centres, each operating with a specific time zone : London, New York and Tokyo.
London is the main forex market centre.

5.3.1 Players
There are various participants in the foreign exchange market. The major participants
are commercial banks which act as a clearing house between users and earners of
foreign exchange. The banks also deal with foreign exchange brokers. These brokers act
as a middleman for a fee between banks. The investors, exporters, importers and tourists
also participate in the market. They are users and suppliers of foreign currencies.

Nation's central bank acts as the lender or buyer of last resort when the nation's total
foreign exchange earnings are not equal to expenditures. In that case the central bank
either draws down its foreign exchange reserves or adds to them.

Most foreign exchange trading is conducted between banks. Non-financial companies

wishing to make foreign currency transactions will either deal with a bank or within the
same group in case companies have internal procedures for inter-company currency

I
trading.

Major international banks trade in many currencies from offices in several countries.
Other banks specialise in certain currencies. A bank will want to be a major dealer in a
 Foreign Exchaege Markets
responsibility for fixing the exchange rates (price) at which the bank will buy or sell
the currency at any time. Trading profits represent the difference between selling (offer
.or ask) and buying (bid) prices. We will discuss more about bid-offer prices a little
later. Exchange rate movements occur because dealers must continuously adjust their
prices to match buying and selling pressures.

5.3.2 Currencies Commonly Traded

The US dollar is the most heavily traded currency in the international forex markets. It .
indicates : a) The role of the dollar as the favoured currency of major energy and
agricultural commodities b) The power of the US economy and its central role in the
. world economy and c) The dollar's status on the traditional reserve' currency and a safe

P heaven for investors in the times of world crises.

In recent years, world wide trading in Yen and Deutsche Mark has increased in volume
and these currencies have begun to challenge the supremacy of the dollar. Euro, the
currency of European Union or Euroland, is aimed to challenge the supremacy of US
dollar, though the experience till now does not bear any such sign. Every currency is
quoted against dollar and most currency transactions included the dollars as one of the
two constituent currencies.

Most non-dollars transactions are called 'cross currency' deals and involve two
transactions, a purchase and a sale transaction in exchange for dollars. An 1NWFrench
Franc exchange, for example, would be a cross-currency deal, involving the bank in two
transactions INWDollar and Dollar/French Franc.

Cross-Currency Deal

Sell Currency A
Buy Currency B

Effected by Sell Currency A Sell. US Dollars

Buy US Dollars Buy Currency B

If a bank wants to purchase of a large quantity of French francs in exchange for

Sterling, it would sell Sterling and purchase French francs for US dollars in two
separate transactions.

5.3.3 Trading Hours

The trading hours of the three major foreign exchange markets virtually span 24 hours,
expressed in local time, are

London 8.00 - 16.30

New York . 8.30 - 16.30
Tokyo 8.00 - 17.30

Allowing for the five-hours time lag between London and New York and nine hours
between Tokyo and London, the effective opening hours in UK time (GMT) are
virtually round the clock. As one major forex market closes for the day, trading will
switch to another centre,.For banks and other organisations, with heavy involvement in
the forex markets, buying and selling currencies can be done virtually round the clock.

5.4 FOREIGN EXCHANGE RATES

Foreign Exchange Risk currency against other major currencies. The exchange rate mechanism (ERM) of the
Management
European monetary system (EMS), intervention by central banks of different countries
from time-to-time, and the keenness with which board meetings of Federal Reserve (US
central bank) or Deutsche Bank (German central bank) and central banks of other G-7
'
countries are watched by forex market players highlight the importance and role of
regulation in the forex markets.

To a large extent, however, the main forex markets are now fairly free from controls
and exchange rates between the major currencies, most notably the US dollar, the Yen,
and the Deutsche mark, fluctuate fieely according to demand and supply. How exchange
rates are determined and forecasted, you will read more abopt it in unit 6.
- - - - - - - -

5.5 FOREIGN EXCHANGE QUOTATIONS

*
The foreign exchange quotations, meaning the way relative prices or rates are quoted
for trade between players in the foreign exchange markets, can be direct, indirect or
cross. w

Direct Quotation is the price of one unit of a foreign currency quoted in terms of the
home country's currency. In other words, it is the home currency that would cost you to
purchase one unit of the foreign currency. For instance, a quotation of Rs. 43.50 per
dollar in New Delhi is a direct quotation for rupee. This is also known as a quotation
in European terms.
- .
Indirect Quotation is just the reverse. It is the price of one unit of the home country's
currency quoted in terms of foreign currency. In other words, it is the amount of
foreign currency that you can buy using one unit of your own currency. For example, a
quotation of S.0435 per rupee is an indirect quotation for rupee. You will notice here
that the direct and indirect quotations are reciprocals of each other. In other words, the
direct quotation is equal to one divided by the indirect quotation. This is also known as
quotation in American terms.

Cross Rates

Although banks deal with non-bank customers in any convertible currency, for a French
franclltalian lira, Sterling/Spanish pesta, Swiss franc1French francs and so on, the inter
bank market normally quotes currencies against the US dollars. This avoids the trouble
of having to quote many individual rates between currencies. The exchange rate for any
non-dollar currencies is then calculated from their respective dollar exchange rates, to
derive a cross rate. For example, the Swiss FranctFrench franc exchange rate can be
derived from Swiss francldollar and dollar1French franc rates. Cross rates are are the
rates between two currencies where neither one is the US dollar. C

5.6 TYPES OF FOREIGN EXCHANGE TRANSACTIONS

A foreign exchange transaction is a contract to buy or sell a quantity of one currency in

exchange for another at a specified time for delivery and settlement and at a specified
price (exchange rate). These transactions take place ip foreign exchange markets. In
terms of counter parties and settlement dates, the forex transactions may be classified as
follows:

5.6.1 Trade Transactions

Trade transaction is a transaction between a bank and a non-bank customer, where the
customer wishes to buy or sell a quantity of currency to complete a business transaction
or (occasionally) specalates for profit by anticipating future changes in the exchange
rate.

8
 I
Foreign Exchange Markets
5.6.2 Interbank Transactions
Interbank transactions are where two banks trade currencies between themselves. Banks
buy and sell huge quantities of foreign currencies. They also accept currency deposits
and lend in foreign currency.

5.6.3 Spot Transactions

A spot transaction is a contract to buy or sell a quantity of a foreign currency for
immediate settlement. Immediate settlement as per convention of forex market means
two working days from the date of contract. The settlement date is also known as 'value
date'. The exchange rate for a spot transaction is known as the 'spot rate' and the
market where spot 'transactions are conducted is called spot market.

Value Date and Dealing Date for Spot Transactions

As noted above, spot transactions traditionally require two banking day's for settlement.
The date on which the spot transaction (agreement) is made is called 'dealing date' and
the exchange of currencies will occur two working days after the dealing date.
Settlement date is known as 'spot value date', this is the day when the exchanged
currencies are delivered with good value into the (bank) accounts of the counter-parties
to the transaction. This allows time for necessary paper work and cash transfers to be
, arranged. These arrangements consist of the verification of the transaction, through an
exchange of confirmation, between the counter parties detailing the terms of the deal,
the issue of settlement instructions by each counter party to its bank to pay the amount
on the appointed date and satisfying exchange control requirements, if any.

When one counter party is a bank, payment may be made by its own branches or by
another bank acting as an agent. The actual transfers of funds will be carried out on the
value date.

Working days do not include Saturdays, Sundays or bank holidays in either of the
r countries of the two currencies involved.
2
t
To take an example, a spot deal transacted on a Tuesday will be settled on the
Thursday of the same week and a deal agreed on a Friday will be settled on the
following Tuesday. But there are some exceptions. For example :

A transaction for US dollar against Canadian dollars is often for delivery on the next
working day. Forex market in the Middle East are closed on Fridays but open on
Saturdays. A transaction involving the exchange of US dollars and Saudi riyals could
t
1
therefore have a split settlement date, with US dollar delivered on the Friday and the
E riyals delivered on the Saturday.

There are over night (Om) contracts also available in forex markets.

Interbank Spot Rates

Interbank spot rates are the current selling and buying prices for spot transactions in a
currency. These are the benchmark rates for trade transactions. They are used for
foreign currency transactions above a certain size. They also provide the basis for an
exchange rate for transactions of smaller size.

For example, if a company wishes to buy US$ 5 million spot, its bank will quote the
current interbank spot rate for the transaction. However, if the company wished to buy
a smaller quantity of dollars; say $ 50,000, the bank would quote a rate less favourable
to the customer (although based on interbank rate) in order to obtain a reasonable profit
from a relatively small transaction.
F-. Exchange RI& Spot rates are quoted as one unit of base currency against a number of units of variable
Mmnagement currency. Quoted rates are therefore, the rates at which a bank will buy or sell the base
currency : e.g. Poudd E 1 = $1.4705 or $1 = Y 1.66.5 10. The spot rates are published in
daily newspapers. There are two spot rates isr a currency, namely, Bid Rate and Offer
(or Ask) Rate.

Bid and Offer Rates

As the bank and the customer are counter parties, they are on opposite sides of the
transaction. If a UK company is converting ~e proceeds of its sales in Japan by selling
Yen for Sterling, the bank is then buying Yen for Sterling.

There is a bid rate at which a bank will buy and the counter party sell the base
currency; and an offer rate at which the bank will sell and the counter party buy the .
base currency.

The terms 'bid' and 'offer' can be confusing and it is easy to mix them up. They
originate from interbank transactions which are normally against US dollars. The bid
rate is the rate at which the bank is willing to pay to buy dollars (and sell the non-
dollar currency) and offer rate is the rate at which the bank will offer to sell dollars
(buy non-dollar currency).

In quotes, the offer rate follows the bid rate. So in a quotation, Sterling / US $ 1.4957
- 1.4962; 1.4953 is bid rate and 1.4962 is the offer rate or ask rate. What it means that
the quoting bank is prepared to buy a sterling for 1.4957 US dollars and is prepared to
sell,a sterling for 1.4962 US dollars. Implicitly, a counterparly can buy a sterling from
this bank for US $ 1.4962 and sell sterling to it for US $ 1.4957. You notice that offer
rate is higher than the bid rate. That is the trading margin of this bank.

Remember as a ready to use rule that the bank will always buy and sell currency at the
more favourable of these two rates.' The difference between the two rates is known as
the spread (sometimes called the bid-offer spread in the UK and the bid-ask spread in
the US). .

5.6.4 Forward Transactions

Currency can be traded spot or forward. In a spot transaction, the purchase or sale of
currencies takes place for settlement two working days later. With a forward transaction,
the purchase or sale is agreed now but will take place at sometime in the future, there
by fixing the rate now for a future exchange of currencies. Forward transactions are --
forward exchange contracts ( or forward contract). The rate at which forward
transactions contracted in the present for future delivery of foreign currency is the
forward rate. The market where purchase and sales of currencies are contracted in the
present for receipt and delivery in future is called forward market.

Forward Quotation

As you know, the forward rate is the rate quoted by foreign-exchange traders for the
purchase or sale of foreign exchange in the future. There is a difference between the
spot rate and the forward rate known as the 'spread' or swap rate in the forward
market. In order to understand how spot and forward rates are determined, let us now
understand how to calculate the spread between the spot and forward rates. In the
example given below, we compute the points, or the difference between the spot and
forward rates, for a 3 months contract for the Canadian dollar and the Japanese ym
quoted in US terms.
&* ~
Canadian dollars Japanese yen

Spot. $0.8590 $0.00760

3 months forward 0.85 10 0.00762
Points
 The spread in Canadian dollars is 80 points; because the forward rate is less than 'the Foreign Exchange Markets
spot rate, the Canadian dollar is at a discount in the 3 months forward market. The
spread in Japanese yen is only 2 points, and since the forward rate is more than the
spot rate, the yen is at a premium in the forward market. Thus, we can say that a
foreign currency is at a forward discount if the forward rate is below the spot rate
whereas it is at forward premium if the forward rate is above the spot rate.

The premium or discount can also be quoted in terms of annualized per cent. The
following fonnula can be used to determine the annualized percentage.

Premium (discount) =
Fl - S, x
12
- x 100,
S, N
Where F, is the forward rate on the day the contract is entered into, S, is the spot rate
on that day, N is the number of months forward, and 100 is used to convert the
decimal to per cent amounts (e.g., 0.05 x 100 = 5%).

0.8510 - 0.8590 12
. . . Discount = x -x 100 = 3.725%
0.8590 3
I

i which means that the Canadian dollar is selling at a discount of 3.725 per cent under
the spot rate. Lets work out forward premium rate for yen, in our example :

Premium =
0.00760 - 0.00762
x-
12
x 100 = 1.05%
t 0.00760 3

Cheek Your Progress A

1. Assume that the following spot rates apply to each question.

Spot Rate Against Sterling

US Dollars 1.4957 - 1.4962

Deutsche Mark ' 2.6197 - 2.6221
Yen 167.728 - 167.859

a) UK Company has to make a payment of S 400,000 to a supplier. What price would

bank quote in Sterling for the dollars?

.....................................................................................................................................................
1

b) The UK company wishes to convert the DM 600,000 'it has just received from a
German Customer into Sterling. How much would the bank be willing to offer?

*
C) A UK importer of electronic goods from Japan must pay W5 million to a supplier.
At what price would the bank fix the foreign exchange transaction with this customer?
........................................ ................

2. Explain the following terms:

a) Bid and Offer Rate
................................................................................................................................
................................................................................................................................
Foreign Exchange Risk c) Forward rate
Management

d) Spread
................................................................................................................................

3. If $ : DM exchange rate is DM 1 = $0.36 and the DM : FF exchange rate is

FFI = DM 0.32. Find out the FF : $ exchange rate.

5.7 INDIAN FORIGN EXCHANGE MARKET

Indian forex market is still in the developmental stage. In Indian forex market not all
the currencies are bought or sold. The banks use London, New York or Singapore
market. for the currencies which are not frequently traded in Indian forex market. From
these rates, the cross rates are calculated.

The structure of forex market in lndia is three tier. The first part consists of
transactions between the Reserve Bank of lndia and the authorised dealers. These
dealers are usually the commercial banks. The second is the interbank market in which
the banks transact among themselves. The third is the retail part in which the authorised
dealer deal with their corporate clients and other retail customers. In the retail part
money changers also operate. These are licensed dealers in the currency market to cater
to the needs of retail customers. In the interbank market the quotes %ppear in swap
points. There are currency brokers also who match the buyers and sellers and they work
on commission basis.

The authorised dealers face two main types of transactions : (i) Clean instruments .
(known telegraphic transfers (TT), and (ii) Payment against collection (bill for
collection) of documents. The authorised dealers (ADS) have to provide more semices.
for the second category of transactions therefore the two rates are different. While fixing
the exchange rate for a transaction ADS must consider (a) is the transaction clean or
documentary? (b) is the bill under consideration a sjght or time draft or a usance bill?
(c) does the ADS have to fork out funds in rupees or in foreign exchange or the
reimbursement would be more or less immediate or after some time? After considering
these things, ADS quote the rates for the following types of instruments : (a) TT Clean
Buying Rate (b) TT Documentary Buying Rate (c) On Demand (OD) Bills Buying Rate
(d) Long Rates (e) Tel Quel Rate (f) DIA Bill Buying Rate

Let us now understand about them one by one:

TT clean buying rate is quoted for transaction of which the reimbursement is more or
1
less immediate. This rate also applies to remittances by mail transfers and bank drafts
provided the required conditions are met. It is the best rate a customer can get. TT
documentary buying rate will be lower than TT clean, because in this case certain
documents are to be collected, therefore handling charges are involved. On demand bill
buying rate is used for sight draft or demand bills that are negotiated or purchased by
authorised dealers. For discounting usance bills, long exchange rates are required. Since
different usance bills have different usance periods; therefore, various long terms
exchange rates are required. Thus there are several long terms rates. These quotations
are used for usance bills that are discounted by ADS. The applicable rate depends on
the usance period. In all the cases, the usance period will have run for some time
before the bill is presented to an authorised dealer for discounting. In such'cases, the
Tel Quel rates are quoted. These rates cover the unbroken period of usance. DIA stands
for documents against acceptance and all the DIA rates are long rates. Tel Quel rates
12
 and the D/A rates depend on the transit time involved. The time between the payment Foreign Exeha~~ge
Markets
made to the document holder and the reimbursement of the document from the issuing
agency is called the transit time. A traveller cheque is paid at sight, but it takes time to
realise these cheques from the issuing bank. Exports bills also involve transit time.
Foreign exchange dealers association of lndia (FEDAI) has prescribed transit periods
and interest factors. The e are taken into account and loaded onto the exchange rates.
!l
The main loading facto are : (a) handling charges, (b) expenses on postage, (c)
administrative charges, (d) stamp duties, (e) commission to the exchange brokers or to
correspondent banks, (g) exchange rate fluctuations, and (g) profit margins.

In Indian forex market besides spot contract, an over night (OM) and tomorrow night
(TM) foreign exchange contract can also be done which means the delivery next
business day or on second business day. Before August 2, 1993, the quotes were
indirect. The quotations were made in the form of foreign currency hundred rupees.
But now-a-days, in the interbank market, the rates are quoted per unit or per hundred
units of foreign currency. Only authorised dealers trade in interbank market. The rates
quoted by ADS are merchant rates at which trading can take place. There are four types
of rates being quoted in the newspapers. These are TT-Bill Rate, Bill Rate, Currency
Notes and the Traveller Cheque Rate.

IT-Bill Rate for immediate payment : TT Bill Rate is a sight draft i.e. a draft to be
paid on seeing or a bill to be paid immediately. The buying and selling rates for such
payments are fixed as follows:

IT-Buying Rate = Base Rate - Exchange Margin

3 TT-Selling Rate = Base Rate + Exchange Margin

.3 The base rate is the interbank rate.

Example : Assume the interbank rate between rupees and dollars is Rs. 43.50 and the
exchange margin is 0.12% then TT Buying Rate is : = 43.50-43.50 x 0.12%
or = 43.50 (1 -0.0012) = 43.46
TT Selling = 43.50 + 43.50 x 0.12%
or = 43.50 (1+0.0012) = 43.55
t
Bill rate when the Bill is to be sent for collection : If some delay is involved in
Payments such as in the case of time draft (the draft to be paid after specified time) or
bill for collection another margin for lag in payment to the bank is added in the form
! of interest payment. This charge is called transit time charges.

Foreign Exchange Dealers Association of lndia fixes the exchange margins, transit time
and rules for charging interest. These involve discounting for immediate payment. If
some service is required the service charges are also to be added or subtracted to the
base rate, for example, banker's drafts issued by other banks or personal cheques then in
that case the clearance is involved, i.e, the bills are to be sent for collection overseas;
so in this case the bill buying and selling rates are fixed as follows:

Bill Buying Rate = Base rate ( 2 ) forward premium (discount) for transit time period
plus usance period rounded off to the higher (lower) month minus
exchange margin.

, Bill Selling Rate = Since it is the issuing of the bill to the importer only, therefore it
only involves a service, i.e., issuing and service the collection of
bills therefore its rate is formed as per TT-Selling Rate plus a
margin for the service rendered.

I Bill Selling Rate = TT Selling Rate + Service Margin

Foreign Exchange Rirk Forward buying rate = Spot rate ( 2 ) Forward Premium (Discount) for transit time
Yanugcmrnt period plus usance period plus forward period rounded off to
the higher (lower) rnonth minus Exchange Margin.

Spot rate is the spot bill buying rate. I

Forward Selling Rate = Interbank spot selling rate (9
Forward premium (discount) for forward period
+ Exchange Margin

Bill Selling Rate = Forward TT selling rate

+ Exchange Margin for Selling a Bill

In the case o f forward buying, the forward period, usance period and the transit period
are to be added together. Thus for 60 days bill bought 2 months forward, with transit s
period of I 5 days, the total comes to 60 + 60 + 15 = 135 days. If the currency is at a
discount the bank will charge the discount for IS0 days and if the currency i s at a
premium the bank will pay premium for four months.

In India national newspaper contains quotes on major currencies traded in India. They
provide exchange rates on major currencies and buying and selling rate for some
currencies. The TT rates given in the figure are the rates for telegraphic transfer. Apart
from the TT rates, the rates on travellers cheque and currency notes are also quoted in
the financial newspapers. All major banks provide currency buying and selling rates for
major trading currencies.

In case of forward rates the premiums and discounts on dollar contracts till six month
forward are quoted. However, one year forward transactions can be contracted. Month-
wise premium and discounts as well as annualised premium/discounts are quoted. These
quotes usually are tentative and are subject to change at the time of contract.

Some of the financial newspapers also provide expected exchange rate matrix (cross
currency matrix) for other forex markets. These are calculated on the basis o f inverse
and cross rate calculations.

The official rate is detennined by the RBI on the basis o f the multi-currency basket.
The official buying and selling rates are announced. The Foreign Exchange Dealers
Association announces indicative free market rate on every business day. The RBI has
the discretion to enter the market to stabilise the exchange rate. Every authorised dealer
has to maintain, at the close of the day a square or near square position in each foreign
currency, except for the limits o f open positions prescribed for each currency or total
currency value. Now a days the authorised dealers have much wider powers or
realising. foreign exchange for business travel abroad, medical treatment, the remittance
o f agency commissions and legal expenses. The banks payment, in those countries
where the bank does not have their branch, are done through a correspondent bank
account called nostro account. It literally means our account with you and& opposite
is called vostro account.

5.8 LET U$ SUM UP

-
The market where one currency is traded for anbther is called forex market. Its primary
function i s to facilitate international trade and investment. The market consists of the
interbank market in which major banks deal with each other and the retail market, in
which banks deal with their commercial customers. Foreign exchange market has two
segments; (a) spot market; and (b) forward market. In spot market, currencies are tradedf
for settlement two business days after. In the forward market contracts are made to buy
or sell currencies for future cyjvery. The foreign exchange quotation cc\? be in direct,
indirect or cross. They can also be expressed in European terms or American tenns.
The participants in the foreign ,exchange markets are commercial banks, brokers,
customers, MNCs and central banks. Indian forex market is in a developing stage. All
the currencies are not traded in the markets.
UNIT 17 EXCHANGE RATES
Structure
17.0 Objectives
17.1 Introduction
17.2 Foreign Exchange Markets
17.3 Fixed Versus Floating Exchange Rates
17.4 Determination of Exchange Rates
17.5 An Illustration: The Exchange Rate System of India
17.6 Let Us Sum Up
17.7 Key Words
17.8 Some Useful Books
17.9 Answers/Hints to Check Your Progress Exercises

17.0 OBJECTIVES
After going through the Unit, you should be able to:
• define exchange rates;
• explain the workings of foreign exchange markets;
• assess the comparative merits of fixed and flexible exchange rate systems;
• discuss the factors influencing the determination of exchange rates; and
• describe the working of the Indian exchange rate regime as it has evolved over
time.

17.1 INTRODUCTION
In this unit we discuss the financial dealings in international markets. You have read
about balance of payments and exchange rates in block 3 of Course MEC 007 on
international trade and finance. The current unit focuses on exchange rates and is a
more in-depth study of foreign exchange markets from the perspective of financial
economics.
You have been acquainted with balance of trade and balance of payments and various
approaches to balance of payments. In the present unit, we get behind these theories
and focus on trading of various currencies for each other. We look at foreign exchange
markets as markets for financial assets and see who the actors in these markets are,
what the mechanisms and devices for trade in these assets are, and how the prices
of these currencies are determined.
In the subsequent section we begin with a description and analysis of the workings
of foreign exchange markets. We will see that it is the biggest market for assets and
round-the-clock trading takes place. In Section 17.3 we explain the workings of
different exchange rate regimes, particularly, fixed and flexible, but also their variants. 1
The foreign exchange markets function under flexible exchange rate regime. We see
International Financial the relative merits of the two systems and explore why many countries gave up the
Markets
fixed exchange rate regime in 1973. Having explained different exchange rate regimes,
we return in section 17.4 to the functioning of foreign exchange markets and explore
how exactly exchange rates (price of one currency for another) are determined in a
situation of exchange rate risk, and briefly explore some strategies to deal with these
risks. Finally, we look in detail at the functioning of the exchange rate system of
India: how it functions, how it has changed over the years, how exchange controls
were carried out, whether total convertibility of currency is a good idea, and so on.

17.2 FOREIGN EXCHANGE MARKETS

A foreign exchange market (sometimes informally called the forex market, or denoted
FEM) is a market in which different currencies are bought and sold. Foreign exchange
markets arise because various countries have different monetary systems and require
different currencies to buy goods, services and financial assets. So people demand
different currencies since they have demand for goods, services and financial assets
of other countries. Naturally, there is a supply element to this as well. To carry out
these transactions between individuals and firms of different countries, there arises a
demand and supply of various currencies. So related but independent markets arise,
big organised markets, where currencies themselves are all the time being traded
for each other. The markets for foreign exchange facilitate foreign trade. The
forex market is not a market say, where Germans give dollars to import jeans from
America. Or the American exporter of jeans says, “fine, you can pay me in Marks
and I will get the marks changed to dollars in my country.” The forex market is a
cash inter-bank or inter-dealer market. To understand how foreign exchange markets
work, we need to understand the concept of exchange rates.
The exchange rate represents the number of units of one currency that exchanges
for a unit of another. There are two ways to express an exchange rate between two
currencies (e.g. the $ and rupee). One can either write $/Rs. or Rs./$ . These are
reciprocals of each other. Thus if E is the $/Rs. exchange rate and V is the Rs./$
exchange rate then E = 1/V. It is important to note that the value of a currency is
always given in terms of another currency. Thus the value of a US dollar in terms of
Indian rupees is the Rs/$ exchange rate. The value of the Japanese yen in terms of
dollar is the $/¥ exchange rate.
We always express the value of all items in terms of something else. Thus, the value
of a litre of milk is given in rupees, not in milk units. The value of car is also given in
rupee terms, not in terms of cars. Similarly, the value of a rupee is given in terms of
something else, usually another currency. Hence the rupee/dollar exchange rate gives
us the value of the dollar in terms of rupees.
Exchange rate quotes by participants in the forex market may be direct or indirect.
A direct quote is the number of units of a local currency exchangeable for one unit of
a foreign currency. An indirect quote is the number of units of a foreign currency
exchangeable for one unit of a local currency. Thus indirect quote is the reciprocal of
a direct quote. We know that a currency appreciates with respect to another
when its value rises in terms of the other. The Rupee appreciates with respect to
the yen if the ¥/Re exchange rate rises. On the other hand, a currency depreciates
with respect to another when its value falls in terms of the other. The Rupee
depreciates with respect to the yen if the ¥/Re exchange rate falls. Note that if the ¥/
Re rate rises, then its reciprocal, the Re/¥ rate falls. Since the Re/¥ rate represents
2 the value of the yen in terms of rupees, this means that when the rupee appreciates
with respect to the yen, the yen must depreciate with respect to the rupee. The rate Exchange Rates
of appreciation (or depreciation) is the percentage change in the value of a currency
over some period of time. Thus, an appreciation means a decline in the direct
quotation.
The foreign exchange market operates worldwide, that is, the reach of the foreign
exchange market is global. The foreign exchange is by far the largest market in the
world, in terms of cash value traded, and includes trading between large banks,
central banks, currency speculators, multinational corporations, governments, and
other financial markets and institutions. The trade happening in the forex markets
across the globe currently exceeds $1.9 trillion/day (on average). The FEM is not
a physical place; rather, it is an electronically linked network of big banks, dealers
and foreign exchange brokers who are all the time bringing buyers and sellers together.
It is spread throughout the big and small financial centres in the world. The biggest
FEM centre is London. The dealing in foreign exchange in these centres goes on
round-the-clock through computers, telephones, telex, fax etc., there is a satellite-
based communications network called Society of Worldwide International Financial
Telecommunications (SWIFT). The FEM operates on a very narrow spreads
between buying and selling prices. But since the volumes traded are very large,
dealers in foreign exchange markets stand to make huge profits or losses.
The foreign exchange market has two parts: wholesale and retail. The retail market
deals with exchange of bank notes, bank drafts, currency, and travellers’ cheques
between private customers, tourists and banks. The wholesale FEM includes the
central bank, but is mainly composed of an inter-bank market in which major banks
trade in currencies held in different currency-denominated bank accounts, that is,
they transfer bank deposits from sellers’ to buyers’ accounts. A physical transfer of
currency is not involved; rather, there is a bookkeeping entry among banks. The
inter-bank market has two parts: direct and indirect. In the direct market, banks
deal directly with each other. Banks quote buying and selling prices directly to each
other and all participating banks are market makers. It is a decentralised market,
characterised by double-auctions and open bids. The indirect part of the wholesale
markets, banks put orders with brokers who try to match purchases and sales of
different currencies. The brokers charge commission to both buyers and sellers of
these currencies.
The currencies are traded on different types of markets and on different basis. There
is the “spot” or cash market, where there is immediate exchange (it actually takes
two days) and forward basis. Let us now understand some of the used terms, and
the basis of these trades.
Arbitrage: Arbitrage, generally means buying a product when its price is low and
then reselling it after its price rises in order to make a profit. Currency arbitrage
means buying a currency in one market (say New York) at a low price and reselling,
moments later, in another market at a higher price.
Spot Exchange Rate: The spot exchange rate refers to the exchange rate that
prevails on the spot, that is, for trades to take place immediately. In reality, however,
even payment for transactions under spot exchange rates take about two days to
take place.
Forward Exchange Rate: The forward exchange rate refers to the rate which
appears on a contract to exchange currencies either 30, 60, 90,180 or sometimes
even more, days in the future. 3
International Financial For example a corporation might sign a contract with a bank to buy DMs for dollars
Markets
60 days from now at a predetermined exchange rate (ER). The predetermined rate
is called the 60-day forward rate. Forward contracts can be used to reduce exchange
rate risk.
When the forward ER is such that a forward trade costs more than a spot trade
today costs, there is said to be a forward premium. If the reverse were true, such
that the forward trade were cheaper than a spot trade then there is a forward
discount.
Hedging: A currency trader is hedging if he or she enters into a forward contract to
protect oneself from a downside loss. However, by hedging the trader also forfeits
the potential for an upside gain.
Check Your Progress 1
1) Briefly mention the structure of foreign exchange markets.
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2) Explain the difference between spot and forward exchange rates. What is foreign
exchange premium?
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3) Explain the retail and the wholesale parts of the foreign exchange market.
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17.3 FIXED VERSUS FLOATING EXCHANGE

RATES
To begin with, we will briefly review the balance of payments (BOP) table of a
nation that you studied in the course on international economics as that will give us
an idea of how exactly exchange rate regimes work. A country’s BOP accounts
summarises its dealings with the rest of the world. The BOP table has two main
4
parts: (a) the current account and (b) the capital account.
The current account includes exports and imports of merchandise; exports and imports Exchange Rates
of services; inflows and outflows of investment income; and grants, remittances and
transfers. The current account shows all flows that directly affect the national income
accounts. Every transaction in the current account is an income-related flow.
The capital account includes direct investment by foreigners into the domestic economy
and direct investment by citizens in foreign countries; portfolio investment, which
includes net purchases of Indian securities and net lending to Indian residents; net
purchases by Indian residents of foreign securities and net lending to foreigners; and
changes in cash balances. The capital account shows all flows that directly affect the
national balance sheet. Every transaction in the capital account is an asset-related
flow.
There are two basic systems that can be used to determine the exchange rate between
one country’s currency and another’s: a floating exchange rates (also called a
flexible exchange rates) system and a fixed exchange rates system. Under a
floating exchange rate system, the value of a country’s currency is determined by the
supply and demand for that currency in exchange for another in a private market
operated by major international banks. In contrast, in a fixed exchange rate system
a country’s government announces, or decrees, what its currency will be worth in
terms of “something else” and also sets up the “rules of exchange.” The “something
else” to which a currency value is set and the “rules of exchange” determines the
type of fixed exchange rate system, of which there are many. For example, if the
government sets its currency value in terms of a fixed weight of gold then we have a
gold standard. If the currency value is set to a fixed amount of another country’s
currency, then it is a reserve currency standard.
When a country has a regime of flexible exchange rates, it will allow the demand and
supply of foreign currency in the exchange rate market to determine the equilibrium
value of the exchange rate. So the exchange rate is market determined and its value
changes at every moment in time depending on the demand and supply of currency
in the market.
Some countries (for e.g. China, Mexico and many others), instead, do not allow the
market to determine the value of their currency. Instead they “peg” the value of the
foreign exchange rate to a fixed parity, a certain amount of rupees per dollar. In this
case, we say that a country has a regime of fixed exchange rates. In order to
maintain a fixed exchange rate, a country cannot just announce a fixed parity: it must
also commit to defend that parity by being willing to buy (or sell) foreign reserves
whenever the market demand for foreign currency is greater (or smaller) than the
supply of foreign currency.
We have seen that banks are big players in the foreign exchange markets. Changes
in flexible exchange rates are brought about by banks’ attempts to regulate their
inventories. However, these inventory changes reflect more basic underlying forces
of demand and supply that come from the attempts of households, firms and financial
institutions to buy and sell goods, services and assets across nations. Changes in
exchange rates, in turn, modify the behaviour by households, firms and financial
institutions. Under a fixed.
The forex market that we studied in Section 17.2 was hugely expanded in 1971,
when the fixed exchange rate system of the Bretton Woods began to be abandoned
and floating exchange rates began to appear. Under the fixed exchange rate system
there was no inter-bank markets for national currencies, no dealers carrying out 5
International Financial huge transactions. The Bretton Woods agreement prevented speculation in currencies.
Markets
The Bretton Woods Agreement was set up in 1945 with the aim of stabilizing
international currencies and preventing money fleeing across nations. This agreement
fixed all national currencies against the dollar and set the dollar at a rate of $35 per
ounce of gold.
If we consider capital flows, then under a flexible exchange rate, capital movements
affect the domestic economy, by having expenditure-switching effects income, output
and employment, and they can also change domestic prices. Under a fixed exchange
rate, capital movements do not affect the domestic economy directly, but may affect
it indirectly by altering the money supply, interest rates, and so on. In fact, with high
capital mobility, the central bank is unable to control the money supply and thus
loses control of the domestic interest rates.
Let us now look at the relative merits of fixed and flexible exchange rates and see
when it is better to have a flexible rate regime. What is the case for and against
flexible exchange rates? Basically, a flexible exchange rate regime, the case for which
was always quite popular among many economists and became attractive to
policymakers of many countries in the wake of currency crises in the late 1960s in
Western countries, is a system where the central bank does not intervene in the
foreign exchange markets to fix rates, is supposed to automatically ensure exchange
rate flexibility. Moreover, this system is supposed to confer other benefits as well.
Let us look at these putative benefits now.
First, under flexible rates, there is monetary policy autonomy. If central banks were
no longer required and obliged to intervene in currency markets to fix exchange
rates, governments would be able to use monetary policy to reach internal and
external balance. No country would be able, moreover, to export inflation or
unemployment to other nations. Secondly, under a system of flexible exchange rates,
the underlying asymmetries of power prevalent under fixed exchange rate system,
like that of the US under the Bretton Woods arrangement, would vanish, and powerful
countries like the US will not be able to set world monetary conditions all by
themselves. Finally, and this is related to the first point above, under a flexible exchange
rate regime, the exchange rates would act as automatic stabilisers. Even in the absence
of an active monetary policy, the quick adjustment of market determined exchange
rates would help countries maintain internal and external balance in the presence of
fluctuating aggregate demand.
What is the case against floating exchange rates? The experience with floating
exchange rates has not been uniformly nice, so that some scepticism about floating
exchange rates have arisen. The following points are put forward as reasons for lack
of faith in flexible exchange rates. First, since central banks are freed from the obligation
to fix exchange rates, it is feared that some indiscipline may creep in, and they may
embark on an inflationary policy. The discipline imposed on them would be lost.
Secondly, flexible exchange rates allow speculators to step in, and speculation on
changes in exchange rates, it is feared, could lead to instability in foreign exchange
markets, and this instability, in turn, might have negative effects on countries’ external
and internal balance. Moreover, floating exchange rates could cause more disruptions
to a country’s home money markets than fixed exchange rates. Third, floating exchange
markets can make relative international prices more predictable and hence damage
international trade and investment.

6
A floating exchange rate regime indicates that coordination on adjustment is less
than under fixed exchange rate regime, which had an architecture like the Bretton
Woods system. Under flexible exchange rates, countries might follow a policy without Exchange Rates
thinking of possible beggar-thy-neighbour effects. The poor countries might be hurt
by competitive currency practices. This is the fourth point against floating exchange
rates. Finally, proponents of flexible exchange rates claim that a flexible exchange
rate regime provides greater autonomy to policymaking by countries. Sceptics of
floating exchange rate regimes claim that such autonomy is largely illusory. Fluctuations
in exchange rates would have such large and wide-ranging macroeconomic effects
that central banks would be forced to intervene in foreign exchange markets, even
though they may not have a formal commitment to peg. Floating exchange rates
would thus increase the uncertainty without giving macroeconomic policy greater
liberty.
How does the central bank intervene in the foreign exchange market under fixed
exchange rates? In technical terms, the central bank intervenes in the foreign exchange
rate market by selling foreign currency. Therefore, a country can defend a fixed
exchange rate parity that differs from the equilibrium exchange rate (that would hold
under flexible rates) only as long as it has a sufficient amount of foreign exchange
reserves to satisfy the market excess demand for the foreign currency. If the country
runs out of foreign exchange reserves, the fixed parity becomes unsustainable and
the central bank will be forced to give up the defence of the currency: the exchange
rate will depreciate to its flexible rate value or it will lead to developing of the black
market for buying and selling of foreign exchange (as has been the case in many
countries as well as in India, before 1993).
Note also that foreign exchange rate intervention affects the money supply of the
country under consideration. In fact, when the central bank intervenes to defend its
parity, it is selling foreign exchange currency in the market; in exchange of its sale of
foreign currency the central bank receives domestic currency that is therefore taken
out of circulation: investors pay with domestic currency their purchase of foreign
currency from the central bank. In this sense, foreign exchange intervention taking
the form of a sale of foreign reserves has an effect on the money supply that is
identical to an open market sale of government securities; in both cases, the money
supply is reduced. Therefore, foreign exchange rate intervention taking the form of a
sale of foreign reserves leads to a reduction in the money supply. Conversely, foreign
exchange rate intervention taking the form of a purchase of foreign reserves leads to
an increase in the money supply.
We discussed in Unit 13, in the Section on the money market equilibrium how
monetary policy affects the money supply and the interest rate of an economy. Open
market operations are the standard instrument way in which a central bank controls
the money supply and interest rates. We should consider now the effects of such
open market operations when the economy is open. Open market operations have
very different effects under flexible and fixed exchange rate regimes.
Consider first the effect of an open market purchase of government bonds under
flexible exchange rates. Under flexible rates, the central bank does not intervene to
defend its currency when market pressures lead to its weakening. Therefore, an
open market purchase of domestic bonds will lead to an increase of the money
supply. In turn, this increase in the money supply will cause a reduction of the domestic
interest rate (please refer to Unit 13). What will be the effect of this monetary expansion
on the exchange rate? The exchange rate will depreciate: in fact, as interest rate at
home are now lower than before, investors will want to reduce their holding of
domestic bonds and increase their holding of foreign bonds that are now relatively 7
International Financial more attractive in terms of their return. Therefore, investors will try to sell domestic
Markets
bonds, buy foreign currency and buy foreign bonds. The attempt to sell domestic
currency in order to buy foreign bonds will, in turn, cause a depreciation of the
domestic currency.
The effects of the open market purchase of bonds on the money supply under flexible
exchange rate will be identical to the one obtained in a closed economy: the money
supply will increase and interest rates will fall. The increase in the money supply and
reduction in the interest rate will lead to a depreciation of the domestic currency but
since the central bank does not defend the current parity under flexible exchange
rates, no foreign reserve intervention will occur and foreign reserves will remain the
same as before: then, the exchange rate will depreciate.
One key advantage of fixed exchange rates is the elimination of exchange rate risk,
which can greatly enhance international trade and investment. A second key advantage
is the discipline a fixed exchange rate system imposes on a country’s monetary
authority, likely to result in a much lower inflation rate.
Some have argued that it is impossible to have simultaneously a combination of: full
capital account convertibility, domestic monetary policy interdependence and a stable
currency. Suppose a country wants capital account convertibility. Then it has to give
up the latter two. Let us briefly mention some of the exchange rate arrangements
that obtain in practice, that are not fully flexible but some variants of flexible exchange
rates. These are called intermediate exchange rate systems. There are the systems
of “crawling peg”, mixed flexible and fixed rates”, “target zone”, and “managed or
pegged or dirty float”. When the range of deviations is allowed to be wider, say 2.5
or 3 per cent, it is known as the wider band system. It is also known as a target zone
system. In practice, most countries opt for fixed pegs or crawling pegs, or managed
floats. No country at present seems to favour fixed exchange rates. However, an
entirely freely floating exchange rate system also appears to be rare.
Check Your Progress 2
1) Explain how floating exchange rates work.
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2) How does the Central Bank of a country intervene to control the money supply
in the presence of fixed exchange rates?
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8
3) Briefly state the basic structure and components of a balance-of payments Exchange Rates
accounts table.
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17.4 DETERMINATION OF EXCHANGE RATES

When we study the determinants of exchange rates, we must distinguish between
long run determinants and short run because the determinants in the two situations
are different and exchange rates are more volatile.
In the long run, the exchange rates are determined by the movement of the important
variables, called the fundamentals, like price and real incomes in different countries.
The long run exchange rates between two currencies are determined by supply and
demand. There are other factors that affect the exchange rates by shifting the demand
and supply curves. An important such factor is real income in an economy, which
reflects the productivity of the country’s resources. Change in real income at home
relative to that abroad will shift the demand and supply curves in the foreign exchange
market. In the long run the equilibrium exchange rate is determined by the intersection
of supply and demand curves. Shifts in the supply curve or demand curves are
brought about by variables such as real income and price levels. Another important
long-run determinant of exchange rates is the domestic price level compared to that
abroad. A basic result is that all things remaining equal, an increase in a country’s
price level will lead to long-run depreciation of the country’s currency. The third
factor influencing exchange rates are tariffs, trade barriers and preferences. These
affect the ability of domestic residents to purchase foreign goods and hence affect
demand for foreign currencies. This altered demand changes the exchange rate. Of
course, the same kind of effect works for foreign consumers to buy domestic goods
and services. Finally, it is suggested that interest rates prevailing in the domestic
financial markets as well as in foreign markets influence long run exchange rates.
However, if interest rate parity holds, interest rates affect exchange rates mainly in
the short run. If interest rates in country A are higher relative to those in country B,
holders of deposits in country B’s currency in B’s domestic economy find it
worthwhile to convert the currency of B into currency of A. this raises the demand
for A’s currency. Thus a rise in interest rate in A leads to a decrease in the currency
of A in the domestic market.
We have put forward several determinants of exchange in the long run. There is a
simpler theory, called purchasing power parity (PPP) that asserts that in the long
run the exchange rate between two currencies is determined only by differences in
the price level in the two countries. The idea of PPP derives from the law of one
price, which states that two identical goods within a same market must sell at the
same price. Violations of the law will be corrected by consumers buying only the
cheaper one. Applied to international economics, the law of one price assets that an
identical good must sell at the same price expressed in the same currency. The law
of one price applies to identical goods, but has extended to purchasing power parity,
9
which is a relationship not between prices of identical goods but between price
International Financial levels in different countries. Purchasing power parity states that the price level in the
Markets
domestic economy times the exchange rate (expressed as foreign currency per unit
of domestic currency) equals the price level in a foreign country:

Pd × e = Pf

where Pd is price level in the domestic economy, Pf is price level in a foreign country,
and e is the exchange rate.
When PPP holds, the domestic currency has the same purchasing power at home
and in any other country. PPP also implies that a foreign currency will depreciate if
the country’s price level rises relative to the foreign price level and appreciate if the
foreign price level rises relative to the country’s own price level. The question is,
does the PPP hold in reality. The empirical evidence seems to suggest that it does
not always hold particularly in the short run. The reason is that there are substantial
transaction costs. Moreover, goods are really not identical across markets and
countries. There are also substantial amount of non-traded goods. But the PPP
does a good job of explaining the direction of change in the exchange rate.
Now let us try to look at the determinants of exchange rates in the short run. In the
short run, there is tremendous volatility and fluctuations in exchange rates. The
determinants of exchange rates in the long run do not explain the fluctuations in
exchange rates in the short run. Since in modern times foreign exchange markets
are linked with computers, banks and other dealers can very quickly convert domestic
currency into foreign currency, they can very quickly buy at a lower price in one
market and try to sell in the same or other market very soon. Thus in the short run,
exchange rates are largely determined by expectations of future exchange rates.
Banks and other traders of currency are continually seeking out profit opportunities.
To them foreign bank deposits are close substitutes for deposits in foreign currency
because these can be easily converted from one currency to another via the foreign
exchange market. So these dealers are constantly monitoring movements of interest
rates and exchange rates to determine the most profitable kind of deposits to hold.
If Eet+1 denotes the trader’s expectations of the future exchange rate, and et the
current exchange rate, then the expected rate of return of holding foreign deposits is:

( Eet +1 − et )
Rf = if −
et

If id is domestic interest rates, traders are continually comparing id with Rf. if the
latter is greater, then the traders will like to hold deposits abroad. They switch
continually across countries to maximise their expected returns, and this goes on
until in equilibrium

( Eet +1 − et )
R f = id = i f −
et

This relation is called interest rate parity, because it depicts the equality of interest
rate on domestic deposits and expected return on foreign deposits. When interest
rate parity holds, traders cannot profit by switching currency holdings, and this
effectively determines the short run current exchange rate et.

10 The interest rate parity relation shows that Rf depends not only on et and If but also
on traders’ expectations about future exchange rates Eet+1. traders are continually Exchange Rates
updating this expectation based on all the relevant current information. Hence, short
run exchange rates are hard to predict and arise mainly due to traders’ minute-to-
minute changes in expectations that take place as new information becomes available.

17.5 AN ILLUSTRATION: THE EXCHANGE RATE

SYSTEM OF INDIA
It is interesting to look at a case study of a country like India for several reasons: first
it is a small country in terms of imports and exports as a proportion of world imports
and exports. Secondly, it is a developing nation that had an experience of being
colonised. Thirdly, the government intervened heavily in the foreign exchange market,
and over the lat 15 years or so, there has been liberalisation, whereby the government
has liberalised the exchange rate policy. Finally, and related to the above point is the
fact that India has changed its exchange rate regime from an earlier fixed one to a
new one. Also the exchange control system has changed. Let us now study the
exchange rate mechanism and system operative in India and explore how it has
undergone changes over the years.
Before the IMF came into being, the rupee was linked to the pound sterling. In
India, there was a sterling exchange standard till 1947. When India became a member
of the IMF, the rupee-pound sterling link was severed, and the rupee’s par value
came to be expressed in gold. Since in the Bretton Woods system, gold was linked
to the US dollar, the dollar in effect became the intervention currency. But the
exchange value of the rupee in terms of the pound sterling was not disturbed. When
the pound was devalued in 1949, the rupee was devalued to an identical extent.
However, the devaluation of the rupee in 1949 and later in 1966 led to the reduction
of the par value of the rupee in terms of gold.
In 1971, after the USA left the fixed exchange regime, the rupee-pound rate was
allowed to fluctuate with reference to the par value of the rupee in terms of the US
dollar, even though the gold parity as well as the US dollar parity of the rupee as
fixed in June 1966 remained unchanged. This arrangement lasted only from August
to December 1971. In December 1971, the pegging of the exchange rate of the
rupee to the dollar was given up and a central rate of the rupee as an average of the
buying and selling rates of the RBI for the pound came to be adopted. This
arrangement continued till September 24, 1975 when the rupee was de-linked from
the pound sterling. The rupee was pegged to gold and sterling till 1966, to gold and
dollar from 1966 to 1971, and again to sterling from 1971 to 1975.
From September 25, 1975, the exchange value of the rupee was determined with
reference to the daily exchange rate movements of a selected number of currencies
of countries that were major trading partners of India. The selection of the currency
units and the weights to be assigned to them was left to the discretion of the RBI,
subject to the approval of the government. Thus, the rupee came to be linked to an
undisclosed basket of currencies. It was undisclosed in order to discourage
speculation in the foreign exchange market. Even when the rupee was pegged to the
basket of currencies, the pound sterling continued to be the currency of intervention.
Under this arrangement, the value of the domestic currency (rupee) with respect to
the intervention currency (pound) was changed in line with the movements in the
weighted average of the value of the trading partners’ currencies vis- a-vis the
intervention currency.
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International Financial India chose basket peg over single-currency peg to give stability to the exchange
Markets
rate. Pegging to a single currency injects greater volatility to the exchange rate
emanating from the fluctuations in the currency to which the pegging has been done.
However, in reality, this stability seems to have been absent as the rupee was adjusted
vis a vis the pound 3 times in 1975, 13 times in 1979, 71 times in 1981, 154 times
in 1985, 200 times in 1988, and 252 times in 1998-90. Over the entire period that
the basket-peg system was in operation, the RBI gave daily announcements of its
buying and selling rates to authorised dealers for transactions.
The basket-peg was given up when India liberalised her economy in 1991. The
basket-peg arrangement was replaced by the system of “Liberalised Exchange Rate
Management” (LERM) or the Dual Exchange Rate System in March 1992. The
dollar replaced the pound sterling as the intervention currency. The LERM was a
tentative shift towards a flexible exchange rate regime. Under LERM, or the Dual
Exchange Rates, there were two exchange rates, one officially determined and one
market determined. Authorised dealers had to surrender 40 per cent of all current
account receipts to the RBI at the official rate, while the remaining 60 per cent could
be traded at the market rate. In February 1993, India moved to a floating exchange
rate regime, with the introduction of the “Unified Exchange Rate System “ (UERS).
As part of the UERS, trade account convertibility of the rupee was introduced on
March 2, 1993. Since then convertibility has been extended in scope and from
August 20, 1994, convertibility of many current account transactions was introduced.
However, there is still some scepticism in official circles over full capital account
convertibility. Thus India now has a floating exchange rate system with intervention
by the authorities to moderate changes in the exchange rate and to avoid undue
speculation. RBI occasionally purchases and sells currencies to ensure that market
operations and exchange rate operations are smooth and not speculative in nature.
India thus had a basket peg system from September 1975 to March 1992, a dual
exchange rate system from March 1992 to February 1993, and a floating exchange
rate system thereafter. The pound was the intervention currency from 1966 to 1992
and subsequently the dollar became the intervention currency. Some subsequent
developments may be mentioned. In August 1993, the direct quotation system was
abolished. In October 1995, the RBI discontinued quoting its buying and selling
rates. In April 1997, the RBI permitted banks to borrow and invest in foreign markets.
There has also occurred a liberalisation of gold policy. This has had a significant
impact on the Indian forex market. This policy has created new channels of gold
import, which led to shrinking of difference in the domestic and international prices
of gold. Consequently, the unofficial market in foreign exchange all but disappeared.
To end this section, let us now look at the process of Central Bank intervention, and
the exchange control system that has been in operation in India. The RBI has the
authority to enter into foreign exchange dealings both on its own accord an on behalf
of the government. Foreign exchange intervention in India is the joint responsibility
of the RBI and the Ministry of Finance. The RBI, however does not deal in foreign
exchange directly with the public. Rather, it does so through authorised dealers
(ADs). The public has to carry out transactions in foreign exchange through authorised
dealers, of whom at present there are about 85. These authorised dealers have
formed an organisation called the Foreign Exchange Dealers’Association of India
(FEDAI) since 1958, which determines the rules for the fixation of commission and
other charges. Before this till 1958, the RBI exercised control over foreign exchange
dealings through the Exchange Banks’Association.
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The RBI determines the exchange rate regime and monitors and supervises the Exchange Rates
foreign exchange market. Previously, the RBI used to establish the day’s buying and
selling rate of the rupee in terms of pound sterling at the beginning of the day. During
the fixed exchange rate regime, in order to maintain the prevailing exchange value of
the rupee, the RBI was obliged to buy and sell foreign exchange against rupee on
demand without limit at fixed rates. Since 1947, after Independence, the RBI was
to buy and sell any currency; before 1947, it was only pound sterling. But even after
1947, in actual practice, the RBI did not buy and sell any currency other than the
pound for a long time, because the pound was the intervention currency till 1971.
Dollar purchases were started on October 9, 1972, and dollar sales from February
2, 1987. Deutsche mark and yen purchases were started in 1974.
Till February 1992, the RBI used to buy US dollars, pound sterling, deutsche mark,
and yen spot and forward for varying maturities up to 12 months, but sold only
dollar and sterling on spot basis. From March 1992, the dollar replaced the pound
sterling as the intervention currency.
There has been in operation an exchange control system that arose in the late 1930s
when India was not only a colonised economy but was in the midst of World War II
and controls were imposed in many areas of the economy. Exchange control was
first imposed under the Defence of India Act, 1939. Later, a statutory basis was
given to it by the Foreign Exchange regulation Act, 1947. This Act was replaced by
a more comprehensive, forceful and expanded legislation, the Foreign Exchange
Regulation Act, 1973, which came into force on January1, 1974. This was replaced
later by the Foreign Exchange Management Act. The exchange control was related
to and complemented by the trade controls imposed by the Chief Controller of
Imports and Exports in terms of Imports and exports (Control) Act, 1947. Exchange
control was relaxed in the 1990s after liberalisation.
Check Your Progress 3
1) What are the main determinants of exchange rates in the short run?
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2) Write a brief note on the exchange rate arrangement in India.
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3) What do you understand by currency convertibility? Do you think India should
have full capital account convertibility?
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 Regulatory Framework
UNIT 5 REGULATORY FRAMEWORK
Objectives
The main objectives of this unit are to:
• provide a general framework of the regulations governing the financial services
industry;

• explain different types of regulation; and

• explain regulations that are in force for the banking, insurance and other
financial services.

Structure
5.1 Introduction
5.2 Types of Regulations
5.3 Regulations on Banking and Financing Services
5.4 Regulations on Insurance Services
5.5 Regulations on Investment Services
5.6 Regulations on Merchant Banking and other Intermediaries
5.7 Summary
5.8 Key Words
5.9 Self Assessment Questions
5.10 Further Readings

5.1 INTRODUCTION
At the centre of any economy, it is the process of financial intermediation and
disintermediation that helps the economy to grow and function smoothly. For
instance, the credit creation function of banking institutions allows the economy to
expand more than what it could do without banking institutions. Financial services
industry not only channels savings into productive investments, it also helps the
economic activities to take place without much difficulties. For example, the cheque
facility and clearing service provided by the banks help several million people to
perform economic activities. Similarly, stock brokers help investors to sell and buy
shares which is critical for development of financial services and financial markets.
Insurance companies give protection against the risk of many unknown events like
fire, flood etc., that affect the business and allow the firms to perform their activities
with confidence. The financial services have thus become indispensable in running
the economy. Such an important system faces two problems – cheating and
instability. During the stock market scams, many investors were cheated. Recently,
internet bubble attracted several investors, who lost their wealth. While such losses
are partially on account of investors overvaluing the securities, it is also on account of
many firms providing misleading information. Financial markets are also highly volatile
and show instability in that process. In view of its importance in the economy, this
sector is governed by strict regulations. Though regulations per se may not remove
cheating and reduce volatility, it would certainly help to reduce its occurrence and
minimise the length of volatile period. 79
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Financial System, A financial service cannot generally be tested at the time of purchase since there is a
Markets and Services time-lag between the purchase of service and its actual effect. For example, when
you buy a share through a member of stock exchange, the service completes only at
the time of physical delivery of shares. Similarly, when you buy units of mutual fund
and take its expert service of investment, the results of this service is known only in
the future. In case of dealings in cheques, the service concludes only when the
cheque amount is credited or debited in your account but the time-lag is short. The
need for regulation stems from the problems of failure of the firms which provide
financial services in the meantime and thus causing hardship to the purchaser. Since
financial system is closely integrated and inter-linked, failure of one firm often affects
other firms and thus the entire financial system is affected. Further, in a competitive
market for borrowing and lending where the spread is thin, financial services firms
often take high risk to maximize the return and thus are more susceptible to default.
There are several other events that can imperil the interest of investors and others
who avail the services. The list includes fraud, misfeasance and collapse of an
institution due to mismanagement. Regulations are thus in place to safeguard the
interests of the participants of the system and prevent economic instability. The
second aspect assumes more relevance recently after several East-Asian economies
have suffered due to the failure of the financial system.

5.2 TYPES OF REGULATIONS

The regulatory framework relating to financial services can be broadly classified into
three main types. One set of regulations determine the types of activities that
different forms of institution are permitted to engage in. These regulations can be
called as structural regulations. For example, the Securities and Exchange Board
of India (SEBI) insists that merchant bankers and stock broking institutions, to
separate all their fund-based activities. Similarly, the Reserve Bank of India (RBI)
has prescribed the activities that commercial banks can provide to the investors.
Structural regulation thus involves demarcation lines between the activities of
financial institutions but many of them have in fact been eroding in recent years.
Banks are now providing various services like leasing, term loan, credit cards, etc., in
addition to their traditional service of working capital lending. The rationale behind
expanding the activities that can be provided by the financial service companies is the
desire of regulatory authorities to create greater competition.
There are regulations that cover the internal management of financial institutions
and other financial service organisations in relation to capital adequacy, liquidity and
solvency. The SEBI for instance has prescribed minimum net worth requirement for
various financial service firms that come under its jurisdiction. The objective of these
regulation is to restrict the firms without adequate resources from entering into this
field. Recently, the RBI has regulated the non-banking finance companies in raising
public deposits. These regulations are known as prudential regulations as they aim
to evolve certain prudential norms for the operation of the industry.
There are number of investor protection regulations. All regulatory agencies in the
financial sector claim that the primary objective of the agency is to protect the
interest of investors. It is generally perceived that investors are the weakest
participants of the financial markets and hence need protection from malpractice,
fraud and collapse. The information asymmetry between the investors and financial
intermediary or institution affects the investors and thus regulatory agencies step-in to
protect the interest of the investors. Thus, investor protection regulations are often in
the nature of demanding larger disclosure of information.

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The regulations can also be classified on their scope. There are regulation which deal Regulatory Framework
with the macro aspects of the system. For example, legislation enacted in the
parliament like Banking Regulation Act, Securities Contracts Regulation Act, etc.,
deal with the macro aspects of respective institutions. The regulatory authorities
under the legislation evolve rules, guidelines and regulations that govern the micro
aspects and operational issues. In addition to the regulations passed under formal
statue and regulators, there are self-regulations from the industry association. For
example, the foreign exchange dealers have their own self-regulation in addition to
several other statues and guidelines that govern their activities. Similarly, the
merchant bankers association is developing self-regulation that will govern their
members in addition to SEBI regulation. In the US and other developed markets,
there are associations for financial analysts which admit the members after they pass
examination and evolve code of conducts when they desire to practice as financial
analyst.
The regulations in general aim to ensure the soundness and safety of financial
institutions, maintain the integrity of the transmission mechanism and protection of the
consumers of financial services. The regulations also ensure freedom of operation
to improve the efficiency and provide adequate scope for innovation that benefit the
investors and other participants. The success of the regulation thus not only depends
on its ability to ensure investors protection but is also determined by the level of
advancement and sophistication the system has achieved. In other words, regulation
should not block the development of financial service industry.
Exhibit 5.1 : Different Levels of Regulation on Financial Services

Level I Government of India

Appellate Authority and Regulator in certain cases

Level II Legislation passed in the Parliament

Banking Regulation Act, SCRA, Insurance Act
Indian Trust Act, etc.

Level III Institutions under an Act of Parliament

UTI Act, LIC Act, GIC Act, etc.
Level IV Regulators
RBI, SEBI, IRA, Forward Market Commission

Level V Regulations given by the Regulators

RBI Directions to Commercial Banks,
NBFCs Directions issued by the RBI,
SEBI Regulations, Guidelines, Notification, etc.

Level VI Self-Regulation
By-laws, Rules and Regulations and Code of Conduct
issued by the various Financial Service Industry
Associations.
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Financial System, Activity 1
Markets and Services
a) State the broad objectives of regulation relating to financial services.
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b) Give a few examples of prudential regulations relating to stock broking service.
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c) Why do we need regulators when there are comprehensive legislation covering
different financial services?
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5.3 REGULATIONS ON BANKING AND

FINANCING SERVICES
Financial intermediaries mobilise savings and allocate (lend) capital to different users.
Savings and capital allocation are two important activities of the economy and they
together determine the growth of the economy. Often, these two are used to change
the direction of the economy to achieve desired results. The Governments all over
the world frame the polices relating to savings and capital allocation but entrust the
responsibility of monitoring them to the central bank. In India, the Reserve Bank of
India, as the central bank of the country, is the nerve centre of the Indian financial
system. It regulates all institutions that are connected with savings and capital
allocation. By regulation, it does not mean that RBI determines the savings rate or
the capital allocation ratios to different sectors or firms in the economy. While in a
closed economy, these are determined by the government whereas in a free-market
economy to which India is slowly moving, these are by and large determined by the
market forces. The role of RBI is to frame regulations that help the orderly
functioning of the institutions that raise and lend the capital. Commercial banks and
non-banking financial institutions are two major set of institutions that come under the
regulation of RBI.

a) Banking Institutions
In order to develop a sound banking system in the country, the RBI regulates the
commercial banking institutions in the following ways:
a) It is the licensing authority to sanction the establishment of new bank or new
branch;
b) It prescribes the minimum capital, reserves and use of profits and reserves,
distribution of dividends, maintenance of minimum cash reserves and other liquid
assets;
c) It has the authority to inspect or conduct investigation on the working of the
banks; and
d) It has the power to control the appointment of Chairman and Chief Executive
Officer of the private banks and nominate members in the Board of Directors.
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The central bank also effectively regulates the credit flows through monetary policy. Regulatory Framework
It controls the amount available for credit by prescribing cash reserve ratio and
statutory liquidity ratio. It also takes away cash through treasury operations by
periodically issuing bonds and REPOS. It also intervenes the credit flows by
prescribing limits of credit availability to different sectors and industries or increase
the bank rate to make credit unattractive. The list of techniques used to control the
credit flows are (a) Open Market Operations, (b) Bank Rate, (c) Discretionary
control of Refinance and Rediscounting, (d) Direct Regulation of Interest Rate on
Commercial Banks Deposits and Loans (the RBI has recently allowed the banks to
determine the rates on their own), (e) Cash Reserve Ratio, (f) Statutory Liquidity
Ratio, (g) Direct Credit Allocation and Credit Rationing, (h) Selective Credit Controls
and (i) Moral Suasion.
The RBI also regulates factoring, bill discounting and credit card services offered by
the commercial banks and other institutions.
The Banking Regulation Act, 1949 also regulates the activities of commercial banks.
The Act was passed in 1949 to consolidate and amend the laws relating to banking
companies. The Act, as amended up-to-date, is a comprehensive piece of legislation
aimed at the development of sound and balanced growth of banking business in the
country. It has extensively enlarged the control of RBI over the entire industry.
Right from the definition of the word banking, its licensing, functioning, capital and
reserve requirements, banking operations and management structure, liquidity
provisions and profit distribution and bank inspection down to the take-overs and
amalgamation of the banks and their liquidation have all been extensively covered
under the Act.

b) Non-banking Financial Companies

The non-banking financial companies (NBFC) has recorded marked growth in recent
years. The Khanna committee had estimated the total deposits of NBFCs at the end
of March 94 at Rs. 56,559 crore and constituted 17.4 per cent of the total deposits
held by the banks. There are different types of NBFCs. The list includes loan
companies, investment companies, hire-purchase finance companies, equipment
leasing companies, mutual benefit finance companies and housing finance companies.
The mushroom growth of these institutions has also caused many unhealthy
developments in this segment of the financial system. Realising the importance of
these institutions, the government instead of curbing the growth of the institutions has
brought regulations to ensure some discipline while discharging their functions. The
Banking Laws (Miscellaneous Provisions) Act, 1963 was introduced to regulate the
NBFCs. The RBI which derives powers under the Act regulates the NBFCs as
follows:
a) It requires the NBFCs of certain categories to register with it and provide
periodical statements on their working;
b) It prescribes the types of companies which are eligible to raise funds from public
and its members;
c) It also prescribes the extent to which the funds could be raised and the terms
and condition thereof;
d) NBFCs are also required to invest certain percentage of the deposits in the
approved securities and maintain reserve fund.
e) It also has the powers to determine policy and give directions relating to
deployment of funds and capital adequacy norms, accounting standards,
provision for bad and doubtful debts, etc.
f) It also collects periodic reports and has the powers to collect information on any
aspects relating to the functioning of the NBFCs, conduct inspection of the 83
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Financial System, books of NBFCs and investigate on any aspects relating to the activities of the
Markets and Services NBFCs.
g) Finally, it has the powers to punish the erring NBFCs either imposing penalties
or suspending or cancelling the license or registration and initiate appropriate
actions against the management of NBFCs.
The RBI has issued three major directions to regulate different forms of non-banking
financial companies and other financial institutions. They are:
a) Non-banking Finance Companies Directions, 1977;
b) Miscellaneous Non-Banking Finance Companies Directions, 1977; and
c) Residuary Non-Banking Companies Directions, 1987.
The mushroom growth of non-banking financial companies causes hardship in
regulating these companies in an effective manner since the infrastructure
requirement is so high that RBI is presently lacking. In order to overcome the
difficulties in implementing the regulation, RBI has recently taken a number of
measures especially after the failure of many such companies in meeting the deposit-
holders liabilities. The compulsory registration, capital adequacy norm and mandatory
credit rating are some of the recent measures aimed to restrict the growth of such
companies which raise funds from the public.
In addition to the regulation prescribed by the RBI, there are several Acts and
regulations that govern different types of non-banking financial companies. For
example, leasing companies have to take into account the provisions of Indian
Contract Act, Motor Vehicles Act, Indian Stamp Act, etc. Similarly, hire-purchase
transactions are governed by the Indian Contract Act, Sale of Goods Act and Hire-
Purchase Act. Though the Hire-Purchase Act is yet to be enforced, in the absence
of any specific law on hire-purchase transactions, the provisions of the Act can be
followed as guideline particularly, where no provisions exist in the general laws. The
National Housing Bank (NHB) is empowered under the provisions of the NHB Act,
1987 to regulate the housing finance companies. The SEBI also regulates all these
companies whenever they approach the market to raise capital.

5.4 REGULATIONS ON INSURANCE SERVICES

Though the government was able to dismantle the restrictions in several financial
services, the insurance services are yet to see any reform despite international
pressures. In the Union Budget 1997-98, the Government has made a small
beginning to allow private participation in the health insurance. This sector is
however expected to see major changes in the next few years and consequently, the
regulatory structure will also undergo major changes.
Before the nationalisation of life and general insurance and the setting up of LIC in
1956 and GIC in 1973 as monolithic institutions, insurers were regulated under the
provisions of the Insurance Act, 1938 which was administered by the Controller of
Insurance. The application of the Act was greatly modified by the nationalisation of
the insurance companies and most of the regulatory functions were taken away from
the Controller of Insurance and vested with LIC and GIC.
In order to improve the efficiency of insurance services in India, the Government of
India had appointed a committee headed by R.N. Malhotra, the former Governor of
Reserve Bank of India in April 1993. The Malhotra Committee has submitted its
report in January, 1994 suggesting a comprehensive framework covering the entire
gamut of life and general insurance. The Committee had recommended that private
and foreign companies be allowed to enter into insurance sector. It also
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recommended to reduce the government holding in the LIC and GIC to 50% and Regulatory Framework
mandated investments from 75% to 50% for LIC and 70% to 35% for GIC and its
subsidiaries. It also required the government to appoint a strong and effective
Insurance Regulatory Authority in the form of statutory autonomous board on the
lines of SEBI and the Tariff Advisory Committee be delinked from the GIC and
function as a separate authority under the regulator.
With an objective of reforming the insurance sector and allowing private entrants, the
Government of India had set up an interim Insurance Regulatory Authority (IRA) in
January, 1996 and introduced the Insurance Regulatory Authority Bill 1996, in
December 1996 to give statutory status. The duties, powers and functions of the
IRA as per the Bill are:
i) to regulate, promote and ensure orderly growth of the insurance business;
ii) to exercise all powers and perform all functions of the Controller of Insurance
under the Insurance Act, 1938; LIC Act, 1956; and the General Insurance
Business (Nationalisation) Act, 1972, or any other law relating to insurance for
the time being in force;
iii) to protect the interest of the policyholders in matters concerning assigning of
policy, nomination by policyholders, insurable interest, settlement of insurance
claims, surrender value of the policy and other terms and conditions of contract
insurance;
iv) to promote efficiency in the conduct of insurance business;
v) to promote and regulate professional organisations connected with the insurance
business;
vi) to call for information from, undertake inspection and conduct enquires and
investigation including audit of the insurers, insurance intermediaries and other
organisations connected with the insurance business;
vii) to control and regulate the rates, advantages, terms and conditions that may be
offered by the insurer;
viii) to prescribe the form and manner in which books of accounts will be maintained
and statements of accounts will be rendered by insurers and other insurance
intermediaries;
ix) to regulate investment of funds by insurance companies;
x) to regulate maintenance of margin of solvency;
xi) to adjudicate disputes between insurers and intermediaries.

5.5 REGULATIONS ON INVESTMENT SERVICES

Investment services are primarily fund based activities. The mutual funds and
venture capital funds directly fall under the investment services. Though portfolio
management service is advisory in nature, the regulation on portfolio management
services could be discussed under the heading of investment services as this service
is closely linked with the investment services. Similarly, stock exchanges and stock
broking institutions have close link with the investment activities and thus regulation
on them could be conveniently discussed along with other direct investment activities.
The regulatory set up consists of Securities Contracts (Regulation) Act (SCRA),
1956, SEBI Regulations and Reserve Bank of India. Before discussing the regulatory
framework under each of the investment and investment related services, it is
appropriate to know Securities and Exchange Board of India which is emerging as a
powerful regulator of various financial services.
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Financial System, a) The Securities and Exchange Board of India (SEBI)
Markets and Services
The complex nature of financial markets and high level of integration of different
segments of the market, the National Securities Exchange Commissions have been
set up to monitor the activities of financial markets and the service providers in order
to ensure healthy development of the market and safeguards the interest of investors.
On the suggestion of the high powered Committee on the Stock Exchange Reforms
headed by G.S.Patel, the Government of India has set up the Securities and
Exchange Board of India on 12th April, 1988. The Board initially functioned as
advisory agency but in 1992, the SEBI has been given the legal status by the
Securities and Exchange Board of India Ordinance 1992 which has been
subsequently passed in the Parliament to become an Act. The SEBI Act, 1992
entrusts the responsibility of protecting the interest of investors in securities and to
promote the development of, and to regulate securities market by such measure it
thinks fit. The Act also listed a few activities that SEBI could perform to achieve
the above objectives. They are:
a) regulating the business of stock exchanges and any other securities markets;
b) registering and regulating the working of stock brokers, sub-brokers, share
transfer agent, merchant bankers and other intermediaries who may be
associated with securities market in any manner;
c) registering and regulating the working of collective investment schemes including
mutual funds;
d) promoting and regulating self-regulatory organisations;
e) prohibiting fraudulent and unfair trade practices relating to securities markets;
f) promoting investors education and training of intermediaries of securities
markets;
g) prohibiting insider trading in securities;
h) regulating substantial acquisition of shares and take-over of companies;
i) calling for information from, undertaking inspection, conducting enquires and
audits of the stock exchanges, intermediaries and self-regulatory organisations in
the securities markets;
j) performing such functions and exercising such powers under the SCRA, 1952 as
may be delegated to it by the Central Government;
k) levying fees or other charges for carrying out these activities;
l) conducting research for the above purpose; and
m) performing such other functions as may be required.
The SEBI has, during the period of five years of its existence since it received legal
status, brought out a number of regulations and guidelines to bring an orderly
functioning of the securities markets. It has also created special wings for Primary
Market, Secondary Market, Mutual Funds, Surveillance, Research, etc. These
regulations and guidelines serve the basic structure of regulatory framework for
several financial services. The SEBI Act also provides that parties aggrieved by its
order can appeal to the Central Government within a prescribed time limit. The
regulations relating to different financial services connected with investment activities
are discussed below:

b) Mutual Funds
The mutual funds in India could be broadly classified into three groups for the purpose
of regulations governing the mutual funds. They are: Unit Trust of India, Public
Sector and Private Sector Mutual Funds, and Money Market and Off-Shore Mutual
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Funds. The Unit Trust of India (UTI) was established by the Government of India Regulatory Framework
as a Trust under UTI Act, 1963. Since inception, the UTI has offered several
schemes and it is governed by the UTI Act, 1963.
In 1986, the government has allowed the public sector banks to enter into mutual fund
service and within a short period of time several public sector banks have
commenced their mutual fund service. In these public sector banks mutual funds
were governed by the Reserve Bank of India. In February, 1992, the Ministry of
Finance issued a notification to the effect that all mutual funds be regulated by the
SEBI and allowed the private sector entry into mutual funds service. In 1993, the
SEBI brought the first mutual funds regulation which prescribed the structure of the
mutual funds and other requirements. The public sector and private sector mutual
funds are now governed by this regulation which is periodically revised. The SEBI
(Mutual Funds) Regulations, 1993 require compulsory registration of all public and
private sector mutual funds companies and approval of individual schemes offered by
the mutual funds. It also requires separation of mutual funds service from investment
activities which has to be entrusted with a separate company known as Asset
Management Company (AMC). It has also prescribed a detailed disclosure norms to
ensure transparency in the operation of mutual funds schemes. The SEBI has issued
a fresh set of regulations governing the mutual funds in 1996. Since Mutual Funds
are established as a Trust, they are also regulated by the Indian Trust Act, 1882.
The Money Market Mutual Funds (MMMF) and Off-shore Mutual Funds (OMC) are
regulated by the Reserve Bank of India. The RBI has appointed a Task Force under
the Chairmanship of Shri. D. Basu to study the feasibility of allowing MMMF to
function in India in 1991 and the Task Force submitted its report in January, 1992.
The RBI issued Guidelines for MMMF in April 1992. The SEBI has also issued
guidelines for the money market transactions of mutual funds under its regulation.

c) Venture Capital Financing

Venture Capital institutions participate in the equity of companies which are not in a
position to raise equity capital directly from the market due to new technology or
small size of the venture in the initial stage. The venture capital institutions sell the
equity in the market once the company established its standing in the market and
normally, such public offers are accompanied with a similar public offering from the
company. The venture capital industry in India is of relatively recent origin. It was
originally in the form of special schemes of Development Finance Institutions (DFI).
In the Union Budget 1988-89, the then Finance Minister announced the formulation of
scheme under which Venture Capital Funds (VCF)/Venture Capital Companies
(VCC) would be enabled to invest in new enterprises and be eligible for favourable
treatment of capital gains and dividend. The Controller of Capital Issues (CCI)
initially brought out a detailed guideline that govern venture capital funds. However,
the SEBI was empowered in 1995 by the government to regulate the VCF/VCC and
consequently the earlier regulation issued by the CCI was repealed on July 25, 1995.
The SEBI has brought out a detailed regulation known as SEBI Venture Capital
Funds Regulation, 1996. The SEBI regulation on VCF prescribes compulsory
registration of VCF, investment conditions, management of the company and
maintenance of records. It also has an authority to inspect the books and investigate
the charges and also take penal action against the erring VCF. In addition to SEBI
regulation, the VCFs are also governed by the Income Tax Act. The VCFs are
required to apply to the Director of Income Tax (Exemptions) to avail favourable
treatment on dividend income and capital gains. The VCFs have to fulfil certain
condition laid down under the Act to get such benefits. The Government of India has

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Financial System, allowed the overseas venture capital companies to operate in India in 1995 and they
Markets and Services require the approval of Foreign Investment Approval Board (FIPB).

d) Portfolio Management Services

The portfolio manager is one who in pursuant to a contract or arrangement with a
client advises or directs or undertakes on behalf of the client (whether as a
discretionary portfolio manager or otherwise) the management or administration of a
portfolio of securities or the funds of the client. The SEBI has issued a detailed
guideline in 1993 (SEBI (Portfolio Managers) Regulations, 1993) to regulate this
advisory service. The regulation requires compulsory registration of portfolio
managers before starting their service, terms and conditions of the schemes that
could be offered, managerial requirement, disclosure norms and periodical reporting to
SEBI.
The commercial banks are also offering portfolio management service to their
customers. These services are regulated by the RBI which issued a detailed guideline
to regulate this service in 1991.

e) Stock Broking
The stock brokers who are the members of recognised stock exchanges enable the
investors to buy and sell securities in the secondary market. They also act as a
broker to the companies which want to raise capital in the primary market. The stock
broking service is regulated by the Securities Contracts (Regulation) Act, (SCRA)
1956 and its Rules, 1957, SEBI (Brokers and Sub-brokers) Regulation, 1992 and the
by-laws of Stock Exchange where the broker is a member.
While the SCRA regulates the stock exchanges, the Securities Contracts (Regulation)
Rules, 1957 prescribes the qualification for membership of a recognised stock
exchange, books of accounts to be maintained by the members and the minimum
number of years the documents and books are to be maintained. The SEBI
regulation requires compulsory registration of members of stock exchange and
prescribed net- worth requirement and capital adequacy norms, books and records to
be maintained and code of conducts to be adopted by the members. The SEBI also
has the powers to inspect books and records and investigate the investors and other
brokers complaints against the stock broker. The sub-brokers are also governed by
the same regulation and SEBI requires them to be registered through a member of
stock exchange under whom the sub-broker will transact business. The by-laws of
the stock exchange is in the nature of self-regulation and varies from exchange to
exchange. It generally prescribes how the members have to conduct the business
and deal with other members of the exchange. It also prescribes how disputes
between the members and members and investors are to be settled.
In addition to the above three regulations, the members of stock exchange need to
have a working knowledge on the Negotiable Instruments Act, 1881, Indian Stamp
Act, 1889 as in force in their respective states, and provisions relating to Service Tax
introduced in the Finance Act, 1994.

Activity 2
a) Explain the role of RBI, IRA and SEBI as regulators.
......................................................................................................................
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b) How do you explain the RBI’s recent move on removing interest rate ceiling and Regulatory Framework
amount to be raised from the market for the NBFC on the one hand and
restricting the NBFCs in raising deposits from the market?
......................................................................................................................
......................................................................................................................
......................................................................................................................
c) Draw a structure of Mutual Fund Service as provided by the SEBI
......................................................................................................................
......................................................................................................................
......................................................................................................................

5.6 REGULATIONS ON MERCHANT BANKING AND

OTHER INTERMEDIARIES
There are several intermediaries associated with management of public and rights
issue of capital. While the Merchant Banker is the main intermediary, others
associated with the issue management are Underwriter, Brokers, Market makers,
Registrar, Advisors, Collection Bankers, Advertisement Consultants, Debenture
Trustees and Credit Rating Agencies. The SEBI has issued a detailed guideline/
regulation on many of these intermediaries. They are:
a) SEBI (Merchant Banker) Regulation, 1992;
b) SEBI Rules for Underwriters;
Exhibit 5.2 : A bird’s-eye view of Regulation on Financial Services

Financial Services

Banking and Non-banking Insurance Services Investment and

Finance Companies Fee-based Services

Banking Regulation Insurance Act, 1938 Securities Contracts

Act, 1949 (Regulation) Act, 1956
Companies Act, 1956
Indian Trust Act, 1882

Reserve Bank of India Insurance Regulatory Securities and

Authority Exchange Board of India

Notifications, Rules, Regulations, Guidelines,

Directions, etc. Clarifications, etc.

a) SEBI (Brokers and Sub-brokers) Regulation, 1992;

b) SEBI Rules for Registrar to an Issue and Share Transfer Agents, 1993;
c) SEBI (Bankers to an Issue) Regulations, 1994;
d) SEBI (Debenture Trustees) Regulations, 1993;
e) Code of Advertisement to Capital Offerings
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Financial System, The intermediaries are required to register themselves with the SEBI under the
Markets and Services relevant regulations before commencing the business. These regulations have also
prescribed the eligibility norms for registration, net worth and capital adequacy norm
wherever relevant and code of conduct. As observed in other regulations, these
regulations also empower the SEBI to inspect the books and record and conduct
investigation on the affairs of the intermediaries and take appropriate action against
them wherever required.
The SEBI relies on the merchant bankers most, when it comes to supervising the
equity and debt offerings of companies. The Merchant Banker who acts as a lead
manager to an issue is expected to examine whether all the provisions relating to
SEBI by the company as well as other intermediaries are duly complied with and
issue a due-diligence certificate to that effect. SEBI Guidelines for Disclosure and
Investor Protection, 1992 which frames the rules relating to issue of capital is also
relevant to the merchant bankers. If a Merchant Banker offers its service to an
acquirer, the SEBI (Substantial Acquisition of Shares and Take-overs) Regulations,
1994 provides the procedure to be followed by the acquirer and the merchant banker
for such acquisition of shares.

Activity 3
a) How are the merchant bankers used to enforce regulations relating to capital
offerings and other intermediaries?
......................................................................................................................
......................................................................................................................
......................................................................................................................
b) How does SEBI protect the interest of investors?
......................................................................................................................
......................................................................................................................
......................................................................................................................
c) What are the regulations to be studied in order to offer Mergers and Acquisition
services?
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......................................................................................................................

5.7 SUMMARY
Financial services industry plays an important role in the economic development of
the country. If there is any collapse in the financial services industry, it adversely
affect the economy. The recent developments in the East-Asian countries where the
failure of banks and other financial services firms have thrown out millions of people
from their jobs. The securities scam of 1992 and Primary market scam of 1994 in
India have affected the industries to raise capital from the public and reduced the
level of investments in the economy. In order to ensure that there is no adverse effect
on the economy, the financial services industry is the most regulated segment of the
economy all over the world. The objective of the regulation is not to control the
growth of the industry and on the contrary allows growth as well as freedom to
operate subject to fulfilment of certain conditions. Despite strict regulations, the
industry has recorded high level of growth all over the world and efficiency and
innovation are the key to the success of the industry. Thus the objectives of the
regulations are to ensure orderly growth of the industry, protecting the investors and
other participants of the markets and using the industry for the development of the
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The regulations can be broadly classified into structural regulations, prudential Regulatory Framework
regulations and investor protection regulations. While the structural regulations cover
the main types of activities that different forms of institutions are permitted to engage
in, the prudential regulations aim to ensure capital adequacy, liquidity and solvency of
the institutions. The investor protection regulations are designed to protect the
investors from the frauds, malpractice and collapse. There are three forms of
regulations that govern the financial industry. At the macro level, the legislation
passed by the Parliament gives a general regulatory framework and stipulate the
government agency which is in charge for administrating the provisions of the Act.
The regulatory agencies set up by the government like SEBI frame several
regulations at micro level and these regulations, guidelines and notifications constitute
the second form of regulation. The third form of regulation is in the nature of self-
regulation where the industry association frame the operating system of the industry,
code of conduct to their members and procedure for settling the dispute between the
members.
The Banking Regulation Act, 1949, Insurance Act, 1938 and Securities Contracts
(Regulation) Act, 1956 provides macro level regulation on banking, insurance and
securities markets transactions. The Reserve Bank of India, Insurance Regulatory
Authority and Securities and Exchange Board of India are the major regulators of the
industry. They have issued a number of regulations, guidelines, notifications,
clarifications, etc., that govern the activities of the financial service providers. The
stock exchanges, Merchant Banking Association, Foreign Exchange Dealers
Association, Equipment Leasing Companies Association, etc., have formed separate
by-laws and regulations that govern their members. All these regulations play a vital
role for the development of the financial service industry.

5.8 KEY WORDS

Structural Regulation determines the type of activities that different forms of
institutions are permitted to engage in.
Prudential Regulation covers the internal management of financial service
providers in relation to capital adequacy, liquidity and solvency.
Investors’ Protection Regulation determine the nature and level of disclosure to
be made by the financial service providers to the investors.
Banking Regulations consisting of Banking Regulation Act, 1949 and Directions
from the Reserve Bank of India, govern the activities of the banking companies.
NBFC Regulations are those directions given by the RBI to regulate different
forms of Non-banking financial companies.
Insurance Regulatory Authority (interim) was set up in 1996 based on the
recommendations of the Malhotra Committee primarily to regulate, promote and
ensure orderly growth of the insurance business in a free market economy.
SEBI is a statutory body that regulate the securities markets and their participants
with a main objective of protecting the interest of investors.
SEBI Regulations are set of regulations and guidelines issued by the SEBI on
various investment institutions and market intermediaries.
Self Regulations are those framed by various industry association that govern its
members activities, code of conduct and settlement of disputes between them.

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UNIT 6 STOCK EXC GES :FUNCTIONS

Objectives
The dojectives of this unit are to:
0 distinguish between primary market and secondary market;
0 highlight various types of traded securities, market players and trading
arrangements which exist in India; and
0 to discuss organisation and functioning of primary and secondary markets for
various types of securities in India.

Structure
6.1 Introduction
6.2 Primary Markets
6.2.1 Principal Steps of a Public Issue
6.2.2 Eligibility for an IPO
6.2.3 Rights Issue
6.2.4 Private Placement
6.2.5 SEBI Guidelines for IPOs
6.3 Secondary Markets
6.4 Stock Exchanges in India
6.4.1 Origin and Growth
6.4.2 Role and Functions
6.4.3 Membership, Organisation and Management
6.4.4 Trading System
6.4.5 Stock Muket Information Systein
6.46 Principal Weak nesses
6.4.7 Directions of Reform
6.5 Summary
6.6 Self Assessment Questions/Exercises
6.7 Further Readings

6.1 INTRODUCTION
Market is a place where buyers and sellers meet and exchange products.
This definition is universal and applies to all markets. In this unit, we will discuss
about the market called capital market. It is a place, where capital of different types
is exchanged. Often individuals like you are lenders or suppliers of capital.
Companies and various other institutions are borrowers or receivers of capital.
The market is organized or divided in two different ways. At a very broad level, the
market is divided into: (a) Short-term Capital Market (money market), and (b)
Long-term capital market (also, called stock market). Another way of classifying
the market is: (a) I~tstitutionalMarket, and (b)Direct Market. As an investor you
can deal with the market in different ways. Let us understand the market from
individual's perspective.

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Financial Market: If the surplus money you have can be spared only for a short period, you have to look
Operations and Services for savings of short-duration. Since the amount available is fairly small in such cases,
you have lo look for some institutional support for such savings. In olher words,
individuals don't directly deal with the money market, which specialize in short-term
capital. Often, individuals approach an institution for this purpose. You can save your
short-term surplus in a bank deposit or a mutual fund, which offer money market
schemes.
If the sui-plus money you have can be spared for a long-term, you have to look for
investments of longer duration. Again, you can go to an institution, which offers long-
term products or you can directly participate in the market. That is, you can deposit
your money in a long-term fixed deposit or invest in a mutual funds scheme or directly
buy securities in the market. Whei~you intend to deal with the market on your own,
you can deal with the market in two ways. The markets are accordilzgly classified
into priniary and secortdary ~lrurket.Primary ntarket is one in which the company
approaches investors to raise capital. They can al~proachfor debt capital or equity
capital or combination of both. Dealing in primary market is fairly simple today. Like
fixed deposit opening, you have to take up an application form of the issue and deposit
the amount after filling up the form. Brokers and sub-brokers will normally help you
to get forms and guide you to fill up the forms. What is important is you have to make
sure that investments fit with your objective. Here too, financial dailies and magazines
publish analytical report on prima~ymarket issues for the help of sniall investors.
After your submission of appl~cationforms, if the company accepts the same, you will
get a certificate or credit in your deposito~yAccount. In the event of too many people
applying for the offel; the company may reject some applications. In such cases, you
will get refund of the money that you have paid initially with the application.
Since the price is fixed in primary market, there will be competition for good issues.
The uncertainty of getting allotment forces Inany investors, who are directly willing to
deal with the market, to turn into secondary market. It is a place where an investor
sells to another investor. Since there are large number of sellers and buyers, the
market is dynamic. Securities prices change depending on he demand and supply of
the securities. Secondary market exists for different types of securities like debt,
equity and others. Investmen1 in secondary market has also become easy, [hanks to
developments in information and computing technologies. You have to open an
account with the members of any stock exchanges of your choice. The procedure to
open an account is fairly simple and it is somewhat si~niIarto opening a Savings Bank
Account with a bank. You can place your buying and seIling orders o$er phone and
often you get immediate confirmation of your purchase or sale. Today, it is also
possible for you to buy and sell securities through internet. In this Unit, we will
discuss more on how the stock market is organised and how investors can transact in
buying and selling of securities in the market.

6.2 PRIMARY MARKETS

P ~ - i ~ n a11iarket
ly is the seglnerzt in ~ihiclz~ z e wiss~lesare made whereas secondary
rliarket is the segrnent ill wlzich outstnndir~gissues are traded It is for this reason
that the Priniary Murket i,r also called New Issues Market and tlze Seco~dary
Market is called Stock Market. In the primary market, new issues may be made in
three ways nameIy, public issue, rights issue and private placement. Public Issues
involves sale of securities to members of public, Rights issue involves sale of
securities to the existing shareholdersldebenture holders. Private placement involves
selling securities privately to a selected group of investors. In the primary market,
equity shares, fully convertible debentures (FCD), partially convertible debentures
(PCD), a?d non-convertible debentures (NCD) are the securities commonly issued by

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non-government public limited companies. Government companies issue equity Stock Excllnages:
Functions and
shares and bonds. Primary market has become very active in India after the abolition Organisation
of Controller of Capital Issue.
In tlie primary market, issues are made either 'at par' or 'at premium'. Pricing the
new issues is regulated under guidelines on Capital issues or what are also known as
guidelines for disclosure and investors protection issued by the Securities and
Exchange Board of India (SEBI). The SEBI guideline on Disclosure and Investor
Protection is now available in the SEBI website, www.sebi.com. I r ~ i is s a detailed
guideline covering all issues relating to capital offerings. Prior to the promulgation of
the ordinance no.9 of 1992 by which the Capital Issues (Control) Act has been
repealed, the pricillg of the new issues was regulated under the Controllers of Capital
Issues' (CCI) pricing formula.
All issues by a new company has to be made at par and for existing companies tlie
issue price should be justified, as per Malegam Committee recommendations, by
The Earnings Per Share (EPS) for the last three years and comparison of
pre-issue Price to Earnings (PIE) ratio to the P/E ratio of the Indust~y.
e Latest Net Asset Value,
Minimum return on increased networth to maintain pre-issue EPS. A company
may also raise finance from the international markets by issuing GDR's and
ADR' s.

6.2.1 Principal Steps of a Public Issue

The process of a public issue starts with the preparation of a draft prospectus which
gives out details of the company, promoters background, management, terms of the
issue, project details, modes of finalicing, past financial performance, projected
profitability and others. Additionally a Venture Capital Film has to file the details of
the terms subject to which funds are to be raised in the proposed issue in a document
called tlie 'placement memoranduni.'
a) Appoiiltment of Underwriters: Tlle underwriters are appointed who co~iimit
to shoulder the liability and subscribe to the shortfall in-case the issue is under-
subscribed. For this commitment tliey are entitled to a maxi~iiumcommission of
2.5 % on the amount underwritten.
b) Appointment of Bankers: Bankers along with their branch network act as the
collecting agencies and process the funds procured during the public issue. The
Banks provide temporary loans for the period between the issue date and the
date the issue proceeds becomes available after allotment, which is referred to
as a bridge loan.
c) Appointment of Registrars: Registrars process the application forms, tabulate
the amounts collected during the Issue and initiate the allotment procedures.
d) Appointment of the Brokers to the Issue: Recognised members of the
Stock exchanges are appointed as brokers to the issue for marketing the issue.
They are eligible for a maximum brokerage of 1.5%.
e) Filing of Prospectus with the Registrar of Companies: 'The draft
prospectus along with the copies of the agreements entered into with the Lead
Manager, Underwriters, Bankers, Registrars and Brokers to the issue is filed
with the Registrar of Coinpanies of the State where the registered office of the
company is located.
f) Printing and Dispatch of Application forms: The prospectus and application
forms are printed and dispatched to ail the merchant bankers, underwriters,
brokers to the issue.

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Financial Market: g) Filing of the Initial Listing Application: A letter is sent to the Stock
Operations and Services exchanges where the issue is proposed to be listed giving the details and stating
the intent of getting the shares listed on the Exchange.
h) Statutory Announcement: An abridged version of the PI-ospectusand the
Issue start and close dates are published in major English dailies and vernacular
newspapers.
i) Processing of Applications: After the close of the Public Issue all the
application fonns are scrutinized, tabulated and then shares are allotted against
these applications.
j) Establishing the Liability of the Underwriter: I11 case the Issue is not F~illy
subscribed to, then the liability for the subscription falls 011 the uirderwriters who
have to subscribe to the shortfall, i n case they have not procured the amount
coininitted by them as per the Underwriting agreement.
k) Allotment of Shares: after the issue is subscribed to the minimum level, the
allotn~entprocedure as prescribed by SEBI is initiated.
I) Listing of the Issue: The shares, after having been allotted, have to be listed
coinpulsorily in the regional stock exchange and optionally at the other stock
exchanges.

6.2.2 Eligibility for an IPO

A11 Indian Company is allowed to make an IPO if:
I) The company has a track record of dividend paying capability for 3 out of the
immediately preceding 5 years;
2) A public financial institution or scheduled comrnel-cia1banks has appraised the
project to be financed through the proposed offer and the appraising agency
participates in the financing of the project to the extent of at least 10% of the
Project cost. Typically a new company has to compulsorily issue shares at par,
while for companies with a track record the shares can be issued at a premium.

6.2.3 Rights Issue

The rights issue involves selling of securities to the existing shareholders in proportion
to their current holding. When a company issues additional equity capital, it has to be
offered in the first instance to the existing shal-eholders on a pro-rata basis as per
Section 81 of tlie Companies Act, 1956. The shareholders may by a special resolutioi~
forfeit this right, partially or fully by aspecial resolution to enable the company to
issue additional:capital to the public or alternatively by passing a simple resolution and
taking the permission of the Central Government. There is no restriction on pricing of
rights issues.

6.2.4 Private PIacement

A private placement results froin the sale of securities by the company to one or few
investors. The issuers are normally the listed public limited companies or closely held
public or private limited companies wliich cannot access the primary market. The
securities are placed normally with the Institutional investors, Mutual funds or other
Financial Institutions. In a number of cases, Indian companies have also offered
shares to promoters under this route. SEBI has issued a separate guideIine for
pricing of such preferential offers.

6.2.5 SEBI Guidelinesfor IPO's

For complete details of SEBI guidelines 011 IPO, you have to visit www.sebi.com,
where you can download the complete guidelines on Disclosure and Investor
Protection Guidelines 2000. The salient features of the guideline are given below:

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 P~.omotersshould contribute a minimum of 20% of the total issued capital, if the Stock Exchnages:
Functions and
company is an unlisted one with a three year track record of consistent Organisation
profitability else in all cases the following slab rate apply :
Size of Capital issued (Including Premium) Contribution %
Less than Rs. 100 crores 50%
> 100 crores upto 300 crores 40%
> 300 crores upto 600 crores 30%
> 600 crores 15%
Promoter's contribution is subject to a lock-in period of 3 years.
Net Offer to the ~ e n e ' r a Public
l has to be at least 25% of the Total Issue Size
for listing on a Stock exchange.
Minimum of 50% of the Net offer to the Public has to be reserved for Investors
applying for less than 1000 shares.
In an Issue'of more than Rs. I00 crores the issuer is allowed to place the whole
issue by book-building.
There should be at-least 5 investors for every 1 lakh of equity offered.
Allotment has to be made within 30 days of the closure of the Public Issue and
42 days in case of a Rights issue.
All the listing formalities for a public Issue has to be completed within 70 days
from the date of closure of the subscription list.
Indian development financial institutions and Mutual Fund can be allotted
securities upto 75% of the Issue Amount.
Allotment to categories of FII's and NIII's/OCB's is upto a maximum of
24% which can be further extended to 30% by an application to the RBI
supported by a resolution passed in the General Meeting.
10% individual ceiling for each category: a) Permanent employees,
b) Shareholding of the promoting companies,
Securities issued to the promoter, his group companies by way of firm allotment
and reservation have a lock-in period of 3 years. However shares allotted to
FII's and certain Indian and Multilateral Development Financial Institutions and
Indian Mutual Funds are not subject to Lock-in periods.
The minimum period for which a public issue has to be kept open is 3 working
days and the maximum for which it can be kept open is 10 working days. The
minimum period for a rights issue is 15 working days and the maximum is
60 working days.
A public issue is effected if the issue is able to procure 90% of the Total issue
size within 60 days from the date of earliest closure of the Public Issue. In case
of over-subscription the company may have the right to retain the excess
application money and allot shares more than the proposed issue which is
referred to as the 'green-slzoe' option.
A rights issue has to procure 90% subscription in 60 days of the opening of the
issue.

6.3 SECONDARY MARKET

The secondary market is the segment in which outstanding issues are traded and thus
provide liquidity. Investors, who seek both profitability and liquidity, need both primary
ind secondary markets. There is thus a direct and complementary interface between
the primary and secondary markets. Secondary market exists both for short-term

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 Financial Market: (money market) securities and long-telm securities. It exists for debt, equity and a
Operations and Services variety of hybrid securities. While the secondary market activities in money market
securities are conducted over phone or through market makers, the trading is more
organized for long-term securities and conducted through stock exchanges. Buying
and selling securities in secondary market is fairly simple. Investors have to open an
account with a member of stock exchange and then place orders through the
member.
For an orderly functioning of stock market, a set of institutions is required.
The role of these institutions assumes importance in securities marlcet because the
market deals with high value financial.assets. Institutions connected with securities
markets are Stock Exchanges, Members of Stocks Exchanges (popularly called
brokers), Clearing Corporation, Depository www.nsdl.co.in and
www.centraldepository.co~n.Transfer Agents and Securities and Exchange
Board of India (SEBI) www.sebi.gov.in).
Technology has converted stock exchanges into a virtual institution. Earlier, there
was an importance for the physical location of stock exchange because it was a place
where brokers or their assistailts negotiate the prices (outsiders can hear only some
noise but brokers understand the meaning) and enter into transactions on behalf of
their client-investors. Since the telecommunication was very poor in India, one or two
stock exchanges have been opened up in every state to cater the investors of the
region. India is one of the few countries with a large rlulnber of stock exchanges.
Thanks to development in telecommunication and information technology, the physical
constraint was removecl during the last few years. National Stock Exchange today
has its presence everywhere in the country. Bombay Stock Exchange has also
expanded its network. Many other stock exchanges are finding it difficult to
compete with these two principal stock exchanges and trying to come together and
create new business. This new development has improved transparency of
operations and brought down the cost. Today, stockbrokers are operating from
their office through cornputer network and investors can see the price at which the
transactions are settled. Internet based stock broking www.icicidirect.co~nor
www,5paisa.com) allows investors to enter into transactions by themselves
without contacting their brokers directly, Competition has brought down the
brokerage from 2% to around 0.5% and today the brokerage rate in India is
one of the lowest in the world. This transforn~ationhas taken place in a matter
of few months.
Members of stock exchanges, called stock brokers, are intermediaries between
buyers and sellers. Buying and selling securities through members of stock
exchange is beneficial, legally and functionally. Entry of major institutions like ICICI,
Kotak Mahindra, into brokerage services and development in technology
including internet based broking service have irnproved the quality of service.
Many of these brokerage houses offer a number of facilities to the investors at
no extra cost.
Clearing corporation enables the members to settle the transactions entered among
themselves on behalf of their client-investors. It operates something similar to cheque
clearing service offered by RBI for the banks. Earlier when securities were traded in
physical form, a large number of securities have to be exclianged between members
and clearing corporation had a major work on this part. Today, after depository facility
was introduced, the workload of the clearing corporations has come down
significantly. Clearing corporation today facilitates the members lo transfer (or
receive) securities to (or from) depositories and also settle monetary part of the
transactions. It is an institution exclusively serving the brokers.

10

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I
Depository service is another major development in the Indian stock market. It Stock Exchnages:
allows investors to hold securities in electronic form (like you are holding cash in your Functions and
Organisation
bank account) and transfers electronically when they sell the shares. The operation is
fairly simple. Investors have to open a depository account with a member of
depository service provider (we have two depository service providers in India
National Securities Depository Ltd. and Central Depository Services (India) Limited).
Investors can give physical securities that they are holding for cancellation (provided
depository facility is available for the securities/company) and convert them in to
electronic holding. A large number of companies have depository holding facility and
SEBI has made it compulsory to trade certain stocks only under depository mode.
When an investor applies for new shares next time in the primary market, helshe can
ask the issuer to credit the depository account in the event of successful allotment.
Any new purchases in the secondary market can also be credited in the depository
account. Investors will get periodical statement on their holding from the member
with whom the depository account is maintained. Many depository participants allow
the investors to see their account through internet. There was some resistance from
retail investors for this change but today everyone started seeing the benefit of this
service. A significant part of volume traded today is settled through depository mode.
Apart from holding the stocks electronically, there are other benefits from depository
services. There is no need to apply for transfer of shares after the purchase of
shares. If an investor buys securities in physical form and desire to transfer the
shares in herthis name, shethe has to fill-up the transfer deed, affix transfer fee
(0.5% of market value of stock) and then send the same to transfer agent. There is a
cost, time and uncertainty involved in the transfer. Under depository mode, the
shares are transferred within a short period of time without any further action from
your side. For more details about depository, visit one of the web sites (http:1/
www.usdl.co.in or http://www.centraldepository.com) of depository service providers
or the members of depository service providers.
Transfer agents maintains the members register of the companies. On the
instructions of tlie company, they transfer the shares from tlie exisling members to
new member. When an investor buys a share in a physical mode and intend to
transfer the share in herthis name, shelhe has to send the transfer deed along with
share certificate to the Transfer Agent. There are many transfer agents like Karvy
Consultants Ltd (http://www.karvy.com) and MCS Ltd. After initial verification, they
will place the shares received for transfer for the approval of company's Board.
The shares are transferred in the name of investors after the approval of the
Board and investor will receive communication to this effect along with share
certificates from the Transfer Agent. Some companies perform this transfer of
shares internally whereas many leading companies have outsourced this service by
appointing one of these transfer agents. The process of verification and other
formalities connected with transfer has been simplified after the introduction of
depository services.
Securities and Exchange Board of India (SEBT) regulates the institutiolis and
intermediaries connected with the securities to protect the interest of investors,
particularly small investors. It is government sponsored but independent body. SEBI
has prescribed detailed regulations and guidelines for various activilies related to
transactions of securities market (See http://www.sebi.gov.in), Regulations are
primarily intended to protect small investors. Despite strong resistance, SEBI is
pushing several reforms connected with securities market. Some of the major
achievements of SEBI so far are bringing transparency in the securities market
operation, speeding up the tech~iologicalprogress and improving disclosure norms.
SEBI is struggling hard to prevent insider trading and price rigging. Since regulation is
a complex task, it will take time to complete the process.

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Financial Market: Activity 1
Operations and Services
a) Write brief note on a recent public issue of a company. The note may include the
size of the issue, type of security offered, price, justification of premium,
registrar, banker to issue, underwriter, etc.

b) Visit any one or more of the websites and describe your additional learning on
the identified public issue.

6.4 STOCK EXCHANGES IN INDIA

From scattered and small beginnings in the 19th Century, India's stock market has
risen to great heights. By 1990, we had 19 stock exchanges in the country. There
were around 6,000 listed companies and the investors population stood around 15
milliorl. Ygu might be interested in knowing more about the origin and the growth of
stock market in India. What functions does it perform? What is the form of
organizatio~lof stock exchanges in India? How are these administered? We shall
address these and other questions subsequently.

6.4.1 Origin and Growth

Organizatio~~s and institutions, whether they are economic, social or political, are
products of historical events and exigencies. The events continually replace andlor
reform the existing organizations, so as to make them relevant and operational in
contemporary situations. It is, therefore, useful to briefly acquaint ourselves with the
origin and growth of the stock market in India.
Stock exchanges of India in a rudimentary form originated in 1800 and since that time
have developed through six broad stages.
1800-1865 : The East India Coinpany and few conlmercial banks floated shares
sporadically, through a very small group of brokers. According to a newspaper in
1 850, in Bonibay during 1840-1850 there were only half a dozen recognised brokers.
The year 1850 marked a watershed. ,A wave of company flotations took over the
market ; the number of brokers spurted to 60. The backbone of industrial growth and
the resulting boom in share flotation was the legendary personality of the financial
wodd, Premchand Roychand.
In 1960 the stock market created a unique history. The entire market was gripped by
what is known as 'share mania'. The American Civil War created cotton famine.
Indian cotton manufacturers exploited this situation and exported large quantities of
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cotton. The resulting increase in export earnings opened opportunities for share Stock Exchnapes:
investments. New companies started to come up. Excessive speculation and Functions and
Organisation
reckless buying became the order of the day. Th'is mania lasted up 1865. It marks
the end of the first phase in the Indian stock exchange history because with the
cessation of the Civil War, demand for Indian cotton slumped abruptly. The share
became worthless pieces of paper. To be exact, on July 1, 1865 all shares ceased to
exist because all time bargains which had matured could not be fulfilled.
1866-1900 : We find another distinct phase-during 1866-1900. The mania effect
haunted the stock exchange of Bombay during these 25 years. Above everything
else, it led to foundation of a regular market for securities. Since the inarket was
established in Bombay, it soon became and still is the leading and the most organised
stock exchange in India. A number of stock brokers who geared up themselves, set
up a voluntary organisation in 1887, called Native Share and Slockbrokers
Association. The brokers drew up codes of conduct for brokerage business and
mobilized private funds for industrial growth. It also mobilized funds for government
securities (gilt edged securities), especially of the Bombay Port Trust and the Bombay
Municipality. A similar organisation was started at Ahmedabad in 1894.
1901-1913: Political developments gave a big fillip to share investment. The
Swadeshi Movement led by Mahatma Gandhi encouraged the indigeneous trading and
business class to start industrial enterprises. As a result, Calcutta became another
major centre of share trading. The trading was prompted by the coal boom of
1904- 1908. Thus, the third stock exchange was started by Calcutta stock brokers.
During Inter-war years, demand for industrial goods kept increasing due to British
involvement in the World Wars. Existing enterprises in steel and cotton textiles,
woolen textiles, tea and engineering goods expanded and new ventures were floated.
Yet another stock exchange was started at Madras in 1920.
1935-1965: This period can be considered as the period of development of the
existing stock exchanges in India. In this period industrial development planning
played the pivotal role of expanding the industrial and commercial base of the country.
Two more stock exchanges were set up, at Hyderabad in 1943 and at Delhi in 1947.
At the time of Independence seven stock exchanges were functioning located in the
major cities of the country. Between 1946 and 1990, 12 more stock exchanges were
set up trading the shares of 4843 additional listed companies.
There are 24 stock exchanges in the country, 20 of them being regional ones with
L
allocated areas. Three others set up in the reforms era, viz., National Stock Exchange
(NSE) the Over the Counter Exchange of India Limited (OTCEI) and Inter-
connected Stock Exchange of India Limited (ISE) have mandate to nationwide
trading network. The ISE is promoted by 15 regional stock exchanges in the country
and has been set up at Mumbai. The ISE provides a member-broker of any of these
stock exchanges an access into the national market segment, which would be in
addition to the local trading segment available at present. The NSE and OTCEI, ISE
and majority of the regional stock exchanges have adbpted the screen based trading
system (SBTS) to provide automated and modem facilities for trading in a
transparent, fair and open manner with access to inve~torsacross the country. As on
31 March 1999,9,877 companies were listed on the stock exchyges and the market
. capitalization was 5,30,772 crore. The total single sided turnover on all stock
exchanges during 1998-99 was Rs 10,23,381 cr. The following are the names of the
various stock exchanges in India.
1) The Bombay Stock Exchange
2) The Ahmedabad Stock exchange Association
3) Bangalore Stock Exchange
4) The Calcutta Stock Exchange Association
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Financial Market: 5) Cochin Stock Exchange
Operations and Services
6) The Delhi Stock Exchange Association
7) The Guwahati Stock Exchange
8) The Hyderabad Stock Exchange
9) Jaipur Stock Exchange
10) Kanara Stock Exchange
1I) The Ludhiana Stock Exchange Association
12) ~ a d r a stock
s Exchange
13) Madliya Pradesh Stock Exchange
14) The Msrgadh Stock Exchange
15) Mangalore Stock Exchange
16) Pune Stock Exchange
17) Saurashtra Kutch Stock Exchange
18) The Uttar Pradesh Stock Exchange Association
19) Vadodara Stock Exchange
20) Coimbutore Stock Exchange
21) Meerut Stock Exchange
22) Over The Counter (OTC) Exchange of India
23) The National Stock Exchange of India
24) Inter-connected Stock Exchange of 1ndia Limited

6,4.2 Role and Functions

The history of stock exchanges in foreign countries as well as in India shows that the
development of joint stock enterprise would never have reached its present stage but
for the facilities which the stock exchanges provided for dealing in securities. Stock
exchanges have a very important function to fulfil in the country's economy. In
Union of Indiavs. Allied International Products Ltd. (1971) 41 Comp Cas 127 (SC) :
(1970) 3 SCC 59411, the Supreme Court of India has enunciated the role of the stock
exchanged in these words:
'A Stock Exchange fulfils a vital function in the economic development of a nation: its
main function is to qualify' capital by enabling a person who has invested money in,
say a factory or a railway, to convert it into cash by disposing off his shares in the
enterprise to someone else. Investment in joint stock companies is attractive to the
public, because the value of the shares is announced day after day in the stock
exchanges, and shares quoted on the exchanges are capable of almost immediate
conversion into money. In modem days a company stands little chance of inducing
the public to subscribe to its capital, uiiless its shares are quoted in an approved stock
exchange. All public companies are anxious to inform the investing public that the
shares of the company will be quoted on the stock exchange.
The stock exchange is really an essential pillar of the private sector corporate
economy. It discharges three essential functions in the process of capital formation
and in raising resources for the corporate sector.
First, the stock exchartge provides a market place for purchase and sale of
securities viz., shares, bonds, debentures etc. It, therefore, ensures the free
transferability of securities which is the essential basis for the joint stock enterprise
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 Stock Exchnnges:

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Functions and
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system. The private sector economy cannot function without the assurance provided
by the stock exchange to the owners of shares and bonds that they can be sold in the
market at any time. At the same time those who wish to invest their surplus funds in
securities for long-term capital appreciation or for speculative gain can also buy
stocks of their choice in.tlie market.
Secondly, the stock exchange provides the linkage between the savings irt the
household sector and the irtvestmerit in corporate economy. It mobilizes savings,
channelises them as securities into those enterprises which are favoured by the
investors on the basis of such criteria as future growth prospects, good returns and
appreciation of prevalence on the Indian scene of such interventionist factors as
industrial licensing, provision of credit to piivate sector by public sector development
banks, price controls and foreign exchange regulations. The stock exchanges
discharge this function by laying down a number of regulations which have to be
complied with while making public issues e.g. offering at least the prescribed
percentage of capital of the public, keeping the subscription list open for a minimum
period of three days, making provisions for receiving applications at least at the
centres where there are recognised stock exchanges, stock exchanges and allotting
the shares against applications on a fair and unconditional basis with the weightage
being given to the applications in lower categories, particularly those applying for
shares worth Rs.500 or Rs.1,000 etc. Members of stock exchanges also assist in the
flotation of new issues by acting as managing brokers/official broker of new issue.
In that capacity, they, i~zteralia, try to sell these issues to investors spread all over
the country. They also act as under-writers to new issues. In this way, the broker
community provides an organic linkage between the primary and the secondary
markets,
Thirdly, by providing a market quotation of the prices of shares and bonds-a sort
of collective judgement simultaneously reached by many buyers and sellers in the
market-the stock exchanges serve the role of a barometer, not only of the state of
health of individual companies, but also of the nation's economy as a whole. It is 15
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Financial Market: often not realised that changes in share prices are brought about by a complex set of
Operations and Services factors, all operating on the markets simultaneously. Share values as a whole are
subject to secular trends set by the economic progress of the nation, and governed by
factors like general economic situation, financial and monetary policies, tax changes,
political environment, international economic and financial developments, etc. These -
trends are influenced to some extent by periodical cycles of booms and depressions in
the free market economies. As against these long-lerm trends, the day-to-day prices
are influenced by another variety of factors notably, the buying or selling of major
operators, the buying and selling of shares by the investment financial institutions such
as the U.T.I. or L.I.C. which have in recent years emerged as the largest holders of
corporate securities, speeches and pronouncements by ministers and other
government spokesmen, statements by company chairmen at annual general meetings
and reports of bonus issues or good dividends by companies etc. While these factors,
both long-term and short-term, act as macro influences on the corporate sector and
the level of stock prices as a whole, there is also a set of micro influences relating to
prospects of individual companies such as the reputation of the management, the state
1
of industrial relations in the enterprises, the volu~neof retained earnings and the
related prospects of capitalisation of reserves, etc. which have a bearing on [he level
of prices. In the complex interplay of all these forces, which leads to day-to-day
quotation of prices of all listed securities, speculation plays a crucial role. In the
absence of speculative operations, every purchase by an investor has to be matched
by a sale of the same security by an investor-seller, and this may lead to sharp
fluctuation in prices. With speculative sale and purchases taking place continuously,
actual sale and purchase by investors on a large scale are absorbed by the market
with small changes in prices. There are always some professional operators who are
hoping that the prices would rise. There are others predicting that prices will fall.
Both these groups acting on their respective assumptioil buy or sell continuously in the
market. Their operation helps to bring about all orderly adjustment of prices. Without
these speculative operations, a stock exchange can become a very mechanical thing.
However, excessive speculation endangers market equilibrium and must be
discouraged through appropriate safeguards. The regulatory authorities should
always take necessary precautionary measures to prevent and penalize excessive
speculation and to discipline trading.
A fact which needs to be emphasized is that the stock exchanges in India also serve
the joint sector units as also to some extent public sector enterprises. There is
substantial private participation in the share capital of a number of government
companies such as Balmer Lawrie, Andrew Yule, Gujarat State Fertilizers
Corporation, Gujarat Narniada Fertilizers Corporation, State Bank of India, ICICI,
etc. In recent times some of the Central public sector companies have gone in for
public debentures through the stock exchanges. Also, there are some public sector
companies like VSNL which have made their share capital open for public
subscription.
Another important function that the stock exchanges in India discl~argeis of providing
a market for gilt-edged securities i.e. securities issued by the Central Government,
State government, Municipalities, Improvement Trusts and other public bodies. These
securities are automatically listed on the stock exchanges when they are issued and
transactions in these take place regularly on the stock exchanges.
I
6.4.3 Membership, Organisation and Management
By virtue of the century-old tradition, stock exchange is a highly organized and
smooth functioning network h the world. The membership of stock exchanges
initially comprised of individuals and partnership films. Later on companies were also
allowed to become members. A number of financial institutions are now members of
16
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I
Indian stock exchanges. Over the years, stock exchanges have been organized in Stock Exchnages:
Functions and
various forms. For ex;lmple, while the Bombay Stock Excliange (now Mumbai Stock
0rg:misation
Exchange). Ahlnedabad Stock Exchange and M.P. (Indore) Stoclc Exchange were
organised as voluntary lion-profit making association of persons, the Calcutta Stock
Exchange. Delhi Stoclc Exchange, U.P. (Kanpur) Stock Exchange, Ludhiana Stock
Exchange, Cocliin Stock Exchange, Gauhati Stoclc Exchange, Jaipur Stoclc Excliange.
and Kanara (Mangalore) Stoclc Exchange were organised as public limited
companies. Quite a few others have been organised as company lilnited by
guarantee.
Tlie internal governance of every stoclc exchange rests in a governing board
compt-ising members of tlie board and Executive Director/President. Members of the
governing boards include brokers and 11011-brolters. Governing bodies of stock
exclia~igesalso have government nominees. Tlie Executive Director/President is
expecteel to ensure strict compliance by all member:; of tlie excha~igeof rules/by
laws, margin regulations and tracling restriction, etc. Sub.ject to tlie previous approval
of SEBI, under tlie law, governing bodies of stoclc exchanges have wicle powers to
make bye-laws. Govestling bodies can admit, punish, censure and also expel any
member, any partner, any remisier, ant1 authorised clerk and employee. It lias the
power to adjudicate disputes. Above all, it has the power to malce, amencl, suspend
and enforce rules, by-laws, regulations and supervise the entire functioning of a stock
exchange.

6.4.4 Trading System

Trading system differs from exchange to exchange. Tracling system refers to few
things namely: (a) tlie types of trades allowed by the system, (b) order-matching
system, and (c) settlement system. The details of the first two are cliscussed in depth
in Unit 7 (Brolting and Trading in Equity). The scttlelnent system refers to time
recluired to settle tlie transactions. India has cotne tI11.ougha long way in this area.
A decade back, India Sollowed batch processing system (popularly callcd crury-
forward system o r periodic settlement system). Under this batch processilig, trades
of two wceks are clubbed, netted and settled at the encl of another two weeks.
The problem under this system was, speculators can freely buy secul-ities ancl sell
securities or sell securities initially and buy thcm later during the two wcelts period.
A genuine investor lias to wait nearly four weeks to get tlie money for tlie sale
transactions. Tlie trading system was mainly encouraging speculation than
investments. Iliclia moved from this system to Rolling Settlement System and to shrt
with both NSE ancl BSE adopted Tc5. That mciuns speculation is allowed williin a
day but once the day is over, the position at the end of the day has to be settlecl at the
end of trade day plus five days. The rolling settlctnent system was shortened to T+3
and further T+2. India is also moving to T+1 and [nost probably much ahead of other
countries. The rolling settlement brought some discipline in speculation. While it
allows speculation within the clay, it is not possible to carry the spcculation to next
day. Investors get the money on third day frotn the date of sale of securities.

6.4.5 Stock Market Information System

Stock exchange cluotntions and indices published in daily newspapers are the main
source of information on stock exchange trades and turnover. Dailies like Econoniic
Times, Financial Express, Business Standard, Business Line, Times of India and
Hindustan Tiines publish daily cluotations and indices. As for Bombay Stock
Exchange quotations published in Economic Times, information on equity shares,
starting from the first column, is presented in the following order: Co~npany'sname;
previous day's closing price in brackets; all the daily traded prices as published by the
BSE; key financial parameters such as earnings per share (EPS), cash earnings per

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Financial Market: share (CPS), cash PIE (price to earnings ratio), Return on Net Worth (RNW) and
Operations and Services Gross Profit Margin (GPM) etc. on different days; P/E; and the high and low prices
in the preceding 5 2 weeks.
The first traded price is the day's opening price. If only one such price is recorded, it
is also the day's closing price. If there are two prices, then the middle quote is either
the high or low price. If there are four prices, then one of the middle quotes is the
day's high and tlie other, the low. If there are 110 transactions in a company's share
on any day, the previous day's closing price is presented in brackets.
The EPS is the average net profit after tax per equity share and the CPS the average
cash profit (after adding back depreciation) per share. The cash P/E is the ratio of
the day's closing price to the cash earnings per share as distinct from the P/E ratio,
which relates price to the net profit per, share. PE values are not printed when
earnings are either nil or negative.
'The RNW is the net profit as a percentage of the net worth and measures the return
earned on the sharehoIders' fund i.e. equity capital plus reserves. The GPM is the
gross profit margin (before depreciation and tax) as a percentage of gross sales and
measures tlie company's profit maixin which is available to absorb depreciation
charges arising from capital expenditure, tax payments, dividend distribution and profit
ploughback. All the figurers are taken from the latest available results (audited/
unaudited) of the company.
The 52-week high and low prices of each share are worked out every day on the
basis of the highest and lowest points scaled during the immediately preceding 52
weeks. The high and low prices are adjusted for bonus and rights issue of equity
shares. If any of the day's traded price is a yearly high or low, the entire line,
including the name of the company, is shown in bold types, with a 'H' attached to the
high value or 'L'attached to the low value. Whenever there is a significant change in
the day's closing value as compared to the previous closing, it is shown in boId types
with a 'plus' or 'minus' sign as the case may be, after the closing value. For
specified shares, a three per cent change and for non-specified shares a 15 per cent
change is treated as significant. Whenever a share goes ex-divided or ex-bonus or
ex-rights, it is ihdicated by notation XD or XB or XR, as the case may be placed next
to its closing price. Symbol of face values other than Rs. 10, are also indicated along
with the names. Since Indian regulations allow stock splits, a number of firms have
face value other than Rs. 10.
For debentures, the information starting from the first column, is presented in the
following order: the nominal rate of interest on the face value, company name, face
value, previous day's closing-price, the day's opening price, Yield To Maturity (YTM)
and yield (both annualized). The yield is nominal interest expressed in percentage
terms of closing value. The YTM adjusts the nomilla1 retum for the maturity period.
frequency of interest payments, manner of priilcipal repayment, redemption pi-emium,
if any, and thereby enables investors to compare different investment options in
debentures on a uniform scale. If there are no quotations for a company's debenture
on a day, the opening price is shown as nil, and the closing price the same as the
previous day's closing.
Besides these quotations share price indices are also published in different dailies.
Bombay Stock Exchange's 30 share 'Sensex' and 100 share 'National' indices are
quite popular. In addition, NSE-50 (Nifty) has also become popular with institutional
and retail investors in recent times. Besides these, there are other indices also which
include The Economic Times Index of Ordinary Share Price, Busi~iessStandard
Index of Ordinary Shares Price and a few others. Reserve Bank of India also
publishes Share Price Index.

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Activity 3 Stock Exchnslges:
Functions and
I) Take a look at tlie B o ~ i ~ b aStock
y Exchange quotations published in Economic Organisation
Times and write out hereunder price quotations for five Shares and five
Deben tul-es.

2) Tale a loolc at Economic Times or any other financial daily and compare and
contrast 30-share Sensex and 100-share National Index of Bombay Stock
Exchange and also NSE-50 Index.

3) Write out two sources of stock market information other than a newspaper.

6.4.6 Principal Weaknesses

The Indian stock markets have made rapid developments in the last few years. From
the implementation of dernaterialised securities in the year 1998 to a phased
commencement of rolling settlements from the year 2001, Indian Stock Exchanges
have made advances, which can be compared to the best in the world. India is one of
the few countries at this point where tlie complcte trading syslem is computerized/
automated. Most of the restrictions relating Lo Foreign investments have been
removed. Despite such developments, there are few areas of concern, Most
important oL tlie~nis concentration of liquidity. Though India can claim that it has
second largest number of listed companies in tlie World, the liquidity or trading is
restricted to handful of stocks. About 70% of volume is accounted by 3 to 5 stocks.
About 90% trading is accounted by another 20 stocks, This in turn affects the interest
of several small investors who are generally attracted to market during IYO times.
There is no move from any agencies to improve the liquidity of sinall stocks. The
second major concein is FIIs investments. ~ h o u FIIs ~ h bring capital for the country,
they play critical role in the price movements. Their buying and selling behaviour
affect the stock market significan'tly. The market turns highly volatile the moment FIIs
turn net sellers. In other words, stock market is yet to become important medium of
savings to Indian public. FIIs investment being 'hot money' might create havoc to the
stability of India market if there is a large scale outflow. The third important concern
is 011 insider trading. Though insider trading rule was made a decade ago, there are
very few cases actually booked under this rule. Several international surveys rank
India amongst the top few countries 011 insider trading index. Another general
concern about Indian stock market js quality of financial reporting. Though Indian
companies provide information in their annual report, which is more than the
information provided by companies in the developed markets, the quality of
information is a major concern.

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Pinallcia1 Market: 6.4.7 Directions of Reform
Operations and Services
The refolm process is continuing to set right some of the above concerns. SEBI and
stock exchanges are now trying to weed out defrrnct coinpanies by de-listing them.
SEBI has also recenlly initiated a move to connect stock-exchanges in India to
provide additional 1 iquidity of regional stocks. Several steps have been taken to control
risk and improve risk management systems. All members of the stock exchanges are
required to follow strict capital adequacy norms. Until 2001, India has followed
Rolling settlement was introduced in India from July 2,2001 with a Trade Date+ 5
(T+5) system and has since moved to a Ti-2 system from April 1 , 2003. Securities
and Exchange Board of India (SEBI) had formally committed to sliorten the trading
cycle further to T+l .

6.5 SUMMARY
In this unit, we have discussed two segments of Indian securities market namely
primary market or new issues market and secondary market or stoclc market. We
have highlighted recent trends in the primary market and discussed various lypes OF
market players and trading arrangements which exist in the Indian stock market.
Different aspects of the Indian stock market viz., origin and growth, role and
functions, membership, organisation and manage~nent,trading systems, and stock
~narketinformation system have been explained so that you as a student of this
course are able to clearly visualise the environment in which invest~nentand portfolio
management decisions are made. In the next unit we shall focus on the legal frame of
Indian securities market.

6.6 SELF ASSESSMENT QUESTIONS/EXERCISES

1) What are the basic constituents of the securities market?
2) What are the different types of securities markets? What are their role and
functions? I ,

3) What are different categories of players operating in primary and secondary

markets?
1

4) Write a brief note on the hanagement of stock exchanges in India.

5) Briefly discuss recent trends in tlle development of the primary market in India. I
1

6) What is OTCEI and NSE? How are they different from other stock
exchanges ?
7) Critically evaluate stock market indices as indicators of the mood of the market
and health of the economy.

6.7 FURTHER READINGS

I
Bombay Stock Exchange Official Directory, Bombay Stock Exchange, Bombay
Gupta, L.C. 1992, Sfock Exclza~zgeTrading in India-Agenda For Refonl?, Society I
For Capital Market Research and Development, New Del hi. I

SEBI Act and Reg~ifatiorzsoil val-iozts iiztennediaries ~ ~ capital

n d offerirzgs.

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s
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.
UNIT 15 CAPITAL MARKET IN INDIA AND
WORKING OF SEBI
Structure
15.0 Objectives
15.1 Introduction
15.2 Developments since Independence
15.3 Indian Equities Market as of 1992
15.4 Reforms in the Indian Capital Market
15.4.1 Institutional Reforms
15.4.2 Impact of Reforms
15.5 Let Us Sum Up
15.6 Exercises
15.7 Key Words
15.8 Some Useful Books
15.9 Answers or Hints to Check Your Progress Exercises

15.0 OBJECTIVES
The primary objective of this unit is to develop an idea of the securities
market infrastructure and how such market functions in the country. After
going through this unit, you will be able to:
• state the nature of the problems that beset the country’s stock market for
almost a century until the early 1990’s;
• explain the radical reforms that led of world class securities market
infrastructure within a short span of less than a decade; and
• analyse the underlying processes of the functioning of stock markets.

15.1 INTRODUCTION
While the money market is a market for short-term debt (up to one year
maturity at the time of issue), the capital market is a market for long-term debt
as well as equity shares. In this market, debt and equity instruments are issued
to the public as well as placed privately to a select group of investors. The
stock exchanges are also part of this market, where most of these instruments
are traded. Thus, the capital market consists of broadly two segments: primary
market and secondary market. Primary market refers to the market for new
issues of these securities. Once the securities are issued, they are traded in
what is called the secondary market. Both equities and debt are traded in the
secondary market.
There are basically three categories of participants in the capital market – the
issuer of securities, the investors in securities and the intermediaries. The
issuers are the borrowers or deficit savers, who issue securities to raise funds.
The investors, who are surplus savers, deploy their savings by subscribing to
these securities. The intermediaries are the agents who match the needs of
users and suppliers of funds for a commission. There are a large variety of
intermediaries providing various services in the Indian securities market.
The corporate sector as well as the Central Government and State
Governments issue securities in the primary market. While the primary market
helps the corporate sector to raise fresh capital for financing investment in 47
Sectoral Performance-II productive assets, the Government sector issues securities in the primary
market mainly to finance a part of their deficits. The investors in the capital
market include the retail investors (i.e., Indian public), mutual funds, Foreign
Institutional Investors (FIIs), Financial Institutions (like LIC, GIC, IDBI,
IFCI, etc.), banks, etc.
For the investor, the secondary market provides the much needed liquidity and
information on asset prices. Investors supply capital to the users of capital
(corporate and Government sector) in the primary market. In the absence of a
secondary market, many of the investors would probably not agree to supply
capital in the primary market because they would not have an exit route for
their investment. The secondary market provides this exit route. Secondly,
through active trading by millions of investors, prices of securities are
established in the secondary market. This price information is used to judge
the corporate performance (share prices) or performance of the Government
and the economy (through interest rates on Government debt). Price
information provided by the secondary market also guides managerial
decision-making. Secondary market also provides the platform for monitoring
and control – by facilitating value-enhancing control activities (mergers &
acquisitions) and enabling implementation of incentive-based management
contracts (employee stock options).
The Securities and Exchange Board of India (SEBI) is the regulatory authority
that regulates both the primary and secondary markets. The basic role of SEBI
is to protect the interests of the investors in securities and to promote the
development of the securities market.
Stock market in India has a history of over 200 years, although the first
organised stock exchange was established in 1875 in Bombay (now Mumbai).

15.2 DEVELOPMENTS SINCE INDEPENDENCE

The developments in the Indian capital markets since Independence can
broadly be divided into four distinct phases. The first phase (1947-1973) was
characterised by institution-building, the second phase (1973-1980) was
characterised by deep-seated changes triggered by the enactment of the
Foreign Exchange Regulation Act (FERA), the third phase (1980-1992)
witnessed an unprecedented broadening and deepening of the markets and
emergence of a set of new generation institutions and market segments. The
final phase (1992-till date) is characterised by widespread reforms and a
dramatic transformation of the capital markets, along with the introduction of
foreign institutional investors (FIIs), emergence of the National Stock
Exchange (NSE) as the pre-dominant stock exchange and the Securities and
Exchange Board of India (SEBI) as the major regulator. In this unit, the focus
is on the fourth phase. However, first three phases are also described briefly.
After Independence, the country lacked the base of heavy and basic industries
that form the backbone of industrial development. Development of such
industries, which are usually characterised by long gestation period, required
supply of long-term capital. But the banking system provided predominantly
short-term finances (as their deposits were at best of medium-term); the
corporate debt market did not exist at that time. Consequently, the country
lacked a dependable source of long-term capital. To fill this lacuna, a number
of Development Financial Institutions (DFIs) were set up – IFCI (in 1948),
ICICI (1955), IDBI and UTI (1964). The State governments also set up state-
level organisations for promotion and financing of industries during the 1950s
48 and 1960s. Thus, the first phase of capital market development since
Independence that lasted up to 1973 was characterised by institution-building. Capital Market in India
and Working of SEBI
The focus was on building institutions to provide institutional finance. Barring
the establishment of UTI, not a single entity was created by the Government
to foster capital market development during this phase.
However, this period witnessed the development of a solid legal framework
for the capital markets. Legislations like Capital Issues (Control) Act, 1947,
Securities Contracts (Regulation) Act, 1956 and Companies Act, 1956, which
were to shape the capital market development in the following years, were
enacted.
In short, the first phase up to 1973 witnessed the development of institutions
and a legal framework for orderly development of the capital market
consistent with the planned industrial development of the country. The
dependence of the industrial sector on shares and debentures (or public capital
markets) as source of finance during the 1950s and 1960s was insignificant.
One major reason was the availability of cheap (subsidised) credit from the
DFIs (long-term) and banks (short-term). Another reason was the lack of
popular participation to any significant extent.
The enactment of FERA in 1973, that required foreign ownership in Indian
joint venture companies to be brought down to 40 per cent to be regarded as
an Indian company, ushered in a new phase of capital market development.
The well-managed multinational companies had to offer shares to the Indian
public at a very low price in the 1970s because issue price used to be
regulated by stringent formulae laid down by the CCI. This evoked
tremendous response from the public. Drawing a clue from the MNCs, a
number of domestic companies also made successful public issues to raise
equity capital. The secondary market also witnessed sustained rally. All these
led to a large number of individuals being brought into the capital market for
the first time.
The third phase of capital market development (1980-1992) began with the
limited liberalisation of the industrial sector in the early 1980s. Riding on
buoyant industrial performance resulting from liberalisation, the share prices
boomed. This was followed by another boom in the primary market, and
another round of widening of the equity culture among the masses. As can be
seen from Table 15.1, while only two exchanges were set up during 1946-
1980, as many as five stock exchanges were established during the following
five years (1980-85), and another six during the next five years (1986-1991).
Apart from number of stock exchanges, other parameters of stock market
development – the number of companies listed, number of issues of listed
companies and market value of capital – registered a significant growth during
the 1980s. Another point to be noted was that debentures became an important
source of capital for the corporate sector in the late 1980s.
Apart from strong growth in stock markets, the later half of the 1980s
witnessed establishment of a few new institutions. The culture of credit rating
was introduced for the first time in the country through establishment of three
credit rating agencies (CRISIL, ICRA and CARE) during this phase. The
SEBI was also established (1988) during this phase, although the regulator
had to wait for four more years to obtain statutory power. The securities scam
marked the end of this phase and beginning of a new phase. The scam
exposed the weaknesses and loopholes of Indian capital market and called for
widespread reforms. Incidentally, the need for reforming the capital market
was also felt as part of the overall economic reforms programme initiated in
1991.
49
Sectoral Performance-II

Table 15.1: Growth of Indian Stock Market

As on 31st December 1946 1961 1971 1975 1980 1985 1991 1995
1 No. of Stock Exchanges 7 7 8 8 9 14 20 22
2 No. of Listed Cos. 1125 1203 1599 1552 2265 4344 6229 8593
3 No. of Stock Issues of Listed Cos. 1506 2111 2838 3230 3697 6174 8967 11784
4 Capital of Listed Cos. (Cr. Rs.) 270 753 1812 2614 3973 9723 32041 59583
5 Market Value of Capital of Listed 971 1292 2675 3273 6750 25302 110279 478121
Cos. (Cr. Rs.)
6 Capital Per Listed Cos. 24 63 113 168 175 224 514 693
(Lakh Rs.) (4/2)
7 Market Value of Capital Per 86 107 167 211 298 582 1770 5564
Listed Cos. (Lakh Rs.) (5/2)
8 Appreciated Value of Capital Per 358 170 148 126 170 260 344 803
Listed Cos. (Lakh Rs.)
Source: Bombay Stock Exchange Official Directory, Various issues.
The fourth phase (1992 onwards) witnessed a dramatic structural
transformation of the capital markets. All aspects of the Indian capital market
– operations, regulations, intermediation costs, fund mobilisation, technology,
geographical spread, globalisation, public access – changed beyond
recognition. The end result is the creation of a securities market infrastructure
within the span of less than a decade that can be compared with only the very
best among the developed markets.

15.3 INDIAN EQUITIES MARKET AS OF 1992

The problems of the secondary equity market, at the time, may be summarised
as follows:
• Although there were almost 20 regional stock exchanges, trading was
concentrated in Bombay Stock Exchange and it enjoyed a monopoly
within the city of Bombay. Users from outside Bombay found it extremely
difficult to trade in BSE due to poor technology and high cost of
telecommunications. BSE imposed a high entry barrier, so that
competition among brokers was absent. The intermediation services
provided by the brokers were, thus, extremely inefficient and costly.
• The exchange limited the membership to individuals; doors were closed to
the limited liability firms. This led to an extremely inefficient form of
business organisation and low level of technology. Securities markets are
inherently complex and these factors rendered the quality of service
delivery poor.
• Trading was characterised by “open outcry” system, wherein trading used
to take place in trading ring where non-brokers were not allowed in.
Neither was there any mechanism to verify the prices at which trading
actually took place. Consequently, brokers used to charge prices to the
investors (buyers and sellers of securities) that were usually different from
the actual prices and to the disadvantage to the latter (e.g., brokers used to
report higher than actual prices for buy orders and lower than actual prices
for sell orders). If investors (buyers or sellers) demanded a more accurate
price, orders often got cancelled (for example, the broker could simply
claim that such a favourable price was not obtained in the market).
50
• BSE being an association of brokers who ran the affairs of the exchange, Capital Market in India
and Working of SEBI
enforcements of rules and regulations (which meant penalising themselves
against unlawful activities) were conspicuous by their absence. Brokers
habitually resorted to manipulative practices, and went scot-free on every
occasion.
• The settlement system (payment of money and delivery of securities after
trade) followed by BSE was primitive, fraught with high degree of risks,
favoured the brokers and was to the disadvantage of the investors. First,
the settlement was “futures-style” and was on a fortnightly basis. This
means that trading done during a fortnight would be settled at the end of
the fortnight. On that date, only the net position would be settled, rather
than each buy and each sell. Besides, the system of badla enabled the
brokers to carry forward their liability (of money or securities) to next
settlement. Consequently, brokers could postpone settlement almost
indefinitely. This led to a high degree of risks. For example, brokers could
take on position (long ⎯ by buying without paying the money, or short ⎯
selling while not owning the stock), and could postpone settlement if
prices tuned unfavourable to them. This process had to end sooner or later,
when failure to settle (pay the money or deliver the securities) would lead
to a systemic crisis.
• BSE provided in-house clearing facility to only top 100 scrips, and
clearing and settlement for all other scrips were done bilaterally. Even for
the top 100 scrips, the clearing function lacked mandatory element in the
sense that if cash and stocks arose from two sides (buyers and sellers), the
exchange matched them. All these had the consequence of increasing the
counter-party risk (i.e., the risk that one of the two parties in a transaction
may fail to honour their commitment to pay cash [buyer] or stock [seller]
on the scheduled settlement date). Almost every settlement witnessed
problems of partial or delayed payment. Large-scale problems arising out
of failure to make payment or deliver shares, leading to closure of BSE for
days together, used to recur at the rate of almost once every other year.
• Last but not the least was the problem of “bad delivery”. After buying the
shares, and after getting them delivered in his hands, the investor had to
send the shares to the registrar of the company to register the ownership in
his name. At this stage, the problem of bad delivery arose due to a number
of problems most of which were not the creation of the investor. The
primary among these reasons used to be inaccurate signature verification
of the seller of the shares. That is, if the signature of the seller did not
match with the one maintained with the registrar, the shares were sent
back. The seller of the shares, who probably purchased the shares years
back, might unwillingly sign in a different manner. But in many cases,
manipulations by unscrupulous operators were responsible. Examples of
such manipulations included counterfeit shares (wherein any signature
were put by the counterfeiter), and engineering bad deliveries by selling
party’s brokers or by the companies themselves to delay settlement in
order to support price manipulation. The time lag between buying shares
and getting it registered in the name of the buyer used to take anything
between one to three months if everything was alright. The time lag
normally went up to six months on an average in case of bad delivery.
The primary market in the early 1990s had its own set of problems. The major
problem of the primary market was extremely restrictive regulations on the
issuers enforced by the Controller of Capital Issues (CCI). First of all,
51
Sectoral Performance-II stringent criteria of entry allowed very few companies to raise capital by
making public issues. Even those companies who could get an approval from
the CCI were not free to price their issues. Formula suggested by the CCI had
to be adopted in pricing the capital issues, which often resulted in severe
underpricing of issues. Almost every maiden public offer of equity shares
(known as Initial Public Offering or IPO) used to attract subscriptions for
shares many times the number of shares offered. This resulted into a system of
lottery wherein a relatively few lucky investors got allotment and the majority
of the applicants did not get any allotment. Such shares used to get listed at
prices far above the issue price resulting into wealth losses by the issuing
companies because such companies could have issued the shares at a much
higher price (if the CCI allowed).
The country started with overall economic reforms in the real sectors in 1991.
The financial sector could not be far behind. The securities market scam of
1992 acted as a trigger. Wide-ranging reforms were initiated in the Indian
capital markets in late-1993.
Check Your Progress 1
Note: i) Space is given below each question for your answer.
ii) Check your answer(s) with those given at the end of the unit.
1) List the distinct shares of development of capital market in India. What
were the peculiar phases of IIIrd phase?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
2) Point out two major problems of the Indian securities markets in the early
1990s.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
3) State whether following statements are True or False.
i) SEBI was established in 1988. ( )
ii) SEBI was the capital market regulator before May 1992. ( )
iii) NSE displaced BSE as the largest stock exchange in India within one
year of its establishment. ( )
iv) The equity market has achieved a state of substantial importance in the
National Economy since 1980s. ( )
v) The Controller of Capital Issues (CCI) regulated the pricing and issue
of new securities until May 1992. ( )

52
 Capital Market in India
15.4 REFORMS IN THE INDIAN CAPITAL and Working of SEBI
MARKET
The radical changes and the consequent improvement in securities market
infrastructure that the Indian capital markets witnessed during the 1990s have
been made possible by a remarkable success in the institution-building
process.

15.4.1 Institutional Reforms

Creation of four new securities market institutions characterised the process of
institution-building from the late 1993 onwards – the Securities and
Exchanges Board of India (SEBI) (although it was set up in 1988, it was given
statutory status in 1992, and started to function effectively in 1993). The
National Stock Exchange (NSE) with its wide network across the country has
become the premier stock exchange in the country. The National Securities
Clearing Corporation (NSCC) and the National Securities Depository Limited
(NSDL) are other securities market institutions.
The SEBI
The Securities and Exchanges Board of India (SEBI) was formed in 1988.
However, SEBI attained statutory status in May, 1992 only after the repeal of
the Capital Issues (Control) Act, 1947 and the consequent abolishment of the
regulatory organ under this Act, viz., the Controller of Capital Issues. Since
then, SEBI has gradually adopted many important roles in the area of policy
formulation, regulation, enforcement and market development. Although the
stock exchanges were legally under the control of the Ministry of Finance,
they practically functioned like brokers’ clubs in an independent and
unaccountable manner. They were brought under regulation for the first time
under the regulatory purview of SEBI.
Today, SEBI supervises almost every element of the capital markets –
including regulation of intermediaries, curbing malpractices like market
manipulation and insider trading, development of fair practices by the
intermediaries, development of the market, awareness creation among
investors, and so on.
The National Stock Exchange (NSE)
NSE was a new exchange promoted and owned by public sector financial
institutions (like IDBI, UTI, LIC, GIC, IFCI, etc.) and banks. Establishment of
NSE as a professionally-managed (as opposed to the other exchanges that are
managed by brokers or members still today) marked a radical break with the
past. Four key innovations were brought about with the establishment of the
NSE:
First, physical, floor-based, brokers-dominated trading outside the eyes of the
investors was replaced by anonymous, computerised order matching system
where trading is done in front of the investors. The order-matching system is
characterised by strict price-time priority, wherein an order is executed
according to the price parameters set by the investors.
Second, use of satellite communication system to spread the reach of the
exchange to all over the country was attempted successfully, for the first time,
by NSE. This was in stark contrast to the other exchanges which till then had
the reach limited to their cities of operation for over a century.

53
Sectoral Performance-II Third, the traditional exchanges were and still are managed by the member
brokers. This gave rise to many malpractices, a conflict of interest being the
most important one. Since the brokers themselves were in charge of
enforcement of rules and regulations, they never took a decision in favour of
the investors that went against their interest. This gave rise to a conflict of
interest between the members as brokers and members as responsible for
enforcement of rules and regulations. NSE avoided this problem right from
beginning because it was set up as a limited liability company with brokers as
franchisees. This led to a situation where brokers were not held responsible
for enforcement of rules and regulations, and those who were entrusted with
enforcement (professional managers) were not brokers. As a result, NSE’s
staff is free of pressures from brokers and is better able to perform regulatory
and enforcement functions.
Fourth, the traditional practice of fortnightly settlement cycle along with the
system of badla that allowed extension of even this fortnightly cycle was
replaced by a strict weekly settlement cycle without badla.
Equity trading at NSE commenced in November 1994. Within one year of
operation, NSE surpassed the BSE in terms of turnover. It is, thus, not
surprising that BSE rapidly responded to NSE by adopting similar trading
technology (but with the same ownership structure and consequent conflict of
interest) in March 1995. In other words, NSE suddenly introduced a huge dose
of competition in a market habituated to monopoly practices for over a
century. This almost immediately led to drastic improvement in at least five
aspects:
i) Improved Transparency: Investors can see with their own eyes the
prices that are currently being quoted in the market, and choose to trade or
not.
ii) The electronic trading platform makes trading completely anonymous.
Traditionally, lack of anonymity in trading in the floor-based system
gave rise to cartels (of brokers) and made price manipulation easy. NSE
was a break from this tradition as well and removed much of the scope for
price manipulation.
iii) NSE throws open the business of stock broking to all and everyone
(subject to fulfillment of certain criteria). In contrast, BSE restricted new
entry into the brokerage business until NSE came into picture. More than a
thousand brokers entered the market with the NSE leading to steep
increase in competition and the consequent fall in the brokerages by a very
substantial amount. This led to a drastic fall in transaction costs.
iv) Automation of the trading system eliminated all the problems associated
with manual trading (e.g., bad delivery) and allowed NSE to set a high
standard of operational efficiency.
v) Investors from all over the country have got access to an exchange on
same terms and conditions as investors within Mumbai for the first time.
Earlier, Bombay stock exchange was the pre-dominant one in the country,
but investors outside the city found it extremely difficult and costly to do
business in the exchange. Thus, true to its name, NSE turned out to be the
first national stock exchange. This benefited the investors from outside
Mumbai more than perhaps the investors within the city.

54
National Securities Clearing Corporation Limited (NSCCL) Capital Market in India
and Working of SEBI
The NSE promoted National Securities Clearing Corporation Limited
(NSCCL), the first clearing corporaion of the country, in August, 1995 as its
wholly-owned subsidiary. NSCCL started clearing operation from April 1996.
NSCCL introduced the practice of settlement guarantee and settlement
guarantee fund for the first time in India. The concept of “innovation”
introduced by NSCCL revolutionised clearing and settlement in the country
by reducing counter-party risk to almost zero. This is how it works. For every
trade (buy or sell) done on the NSE, NSCCL becomes the counter-party. That
is, the seller sells the securities to the NSCCL, and the buyer buys from the
NSCCL. In reality, NSCCL becomes the legal counter-party to the net
obligations of each brokerage firm. Even if a brokerage firm fails to make
payment (or deliver securities), NSCCL makes the payment (or deliver
securities). This has almost eliminated counter-party risk and contained the
recurrence of payment crises that characterised Indian stock markets for
almost a century.
However, the counter-party risk is now borne entirely by NSCCL. To protect
itself from the counter-party risk, NSCCL has adopted a two-pronged strategy.
First, it has reduced the possibility of default itself through a variety of means.
For example, certain minimum net worth requirement (including a portion of
it maintained as deposit with NSE) has been specified by the brokers; a
sophisticated risk management system has been instituted by the NSE &
NSCCL so that the risk never exceeds a certain pre-specified level (through
application of the concept of Value at Risk). An innovative method of on-line
monitoring of positions of brokers and investors has been devised. All these
have substantially reduced the probability of default and reduced the potential
loss to NSCCL. Second, whatever risk still remains is covered by a settlement
guarantee fund (SGF) whose corpus has slowly been built over the years and
stands at Rs. 1,550.90 crore as on 31st March, 2004.
NSCCL has an uninterrupted track record of implementing every settlement
on time since inception. It marks an important milestone in the institutional
development of India’s financial system.
Competitive pressure from NSE-NSCCL and directives from SEBI forced
other stock exchanges to set up their own clearing corporations and SGF. The
Bombay Stock Exchange set up SGF in 1997 and other exchanges followed
suit later on. By 1999, all the major stock exchanges (11 stock exchanges
apart from NSE) set up their own clearing corporations and SGF.
National Securities Depositories Limited (NSDL)
The trading and settlement using electronic trading was made possible
because of dematerialisation of share holdings of investors. The
dematerialised shares are held in depositories. In November 1996, the
National Securities Depository Ltd. (NSDL), the first depository in India, was
established. With the shares dematerialised with the depository, the potential
for theft and counterfeiting of shares, bad delivery and the likes was
eliminated. SEBI played an active role in gradual shifting from physical
certificates to dematerialised holding by introducing a mandatory element in
the process. Currently almost cent percent trading and settlement are done in a
dematerialised environment.
15.4.2 Impact of Reforms
Indian securities markets were radically transformed owing to deep-routed
institutional reforms and innovations carried during a short period of four 55
Sectoral Performance-II years (1994-1998). All these changes have vastly improved market practices,
sharply lowered transactions costs, and improved market efficiency. In no
other part of India’s financial sector has such a radical reforms agenda been
executed, in such a short time.
The most visible change of all has been the shift from physical, floor-based
non-transparent trading system to a transparent and efficient electronic trading
system. The OTCEI, which was set up in 1992, was the first computerised
exchange in India. This has been made possible by creation of the supporting
infrastructure (depositories) and introduction of innovative practices
(dematerialisation, novation). The NSE started operations in 1994 with
electronic trading, while all other exchanges introduced electronic trading
subsequently. Till 1996-97, 16 exchanges in the country had shifted to
electronic trading and in the year 1997-98 four more exchanges established
these facilities. By March 31, 1999, all the 23 stock exchanges in the country
had computerised on-line screen based trading.
Second, the counter-party risk and possibility of recurrent payment crisis have
almost been eliminated.
Third, the earlier system was characterised by segmented markets fragmented
through geographical distance where it was a telephonic market (for rest of the
country other than Mumbai). The new system achieved a national market with
equal access to everybody, and, hence, was successful in achieving
aggregation and revelation of order flow (i.e., market demand and supply) on
a nation-wide basis.
Fourth, the brokers (the most important intermediary) were fraught with
agency problems, practised oligopolistic pricing and cartelisation. The new
system dispensed with all these ills. Competitive pricing practices emerged,
that led to a substantial fall in transaction costs (by a factor of one-tenth for
investors outside Mumbai).
Fifth, the new system ensured timely settlement, unlike the previous system
where settlement lacked the mandatory element and was irregular.
Sixth, the enforcement of rules and regulations has been strict in the new
system and is in stark contrast with the earlier system.
Seventh, once a world-class securities market infrastructure was set up,
introduction of derivatives (futures on individual stocks and on stock indices
and options on individual stocks and on stock indices) was possible. Starting
from June 2000, derivatives have been introduced in the Indian stock markets.
With the successful introduction of stock market derivatives, Indian stock
markets now compare favourably even with the very best of the developed
financial markets.
Check Your Progress 2
Note: i) Space is given below each question for your answer.
ii) Check your answer(s) with those given at the end of the unit.
1) Point out the various supervisory functions of SEBI.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
56
2) List the novel practices introduced by the NSCCL that removed the Capital Market in India
and Working of SEBI
counter-party risk from Indian stock markets.
………………………………………………………………………………
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………………………………………………………………………………
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3) Summarise the impact of the radical reforms on the functioning of Indian
stock markets.
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4) State whether following statements are True or False:
i) NSE is a de-mutualised stock exchange, but BSE has not yet adopted
such a structure. ( )
ii) Novation helped in automating the stock market trading. ( )
iii) India currently follows a T+2 settlement cycle. ( )
iv) India currently has three depositories. ( )
v) Counter-party risk is absent in NSE. ( )

15.5 LET US SUM UP

Indian securities markets had been suffering from some serious problems for
over a century until the early 1990’s. The organisational structure of the stock
exchanges and restrictive practices adopted by the members (i.e., the brokers),
and lack of application of modern technology were responsible for these
problems. Starting from 1993, wide-ranging reforms have been introduced in
the Indian stock markets. The reforms were primarily concentrated on
institution building and creation of world-class securities market
infrastructure. Some innovative institutional structures and some innovative
practices, with strong backing of the regulator (i.e., the SEBI), were
responsible for success of the efforts at radically changing the Indian stock
markets within a very short time span of less than a decade. Today, Indian
securities markets are comparable with even the best of the markets in the
developed world.

15.6 EXERCISES
1) Distinguish between money market and capital market. Examine the role
and significance of a well-developed capital market in the growth process
of an economy.
2) Trace the development of capital market in India, listing the shortcomings
it suffered from in the recent past and the reforms that have been
undertaken.
57
Sectoral Performance-II 3) Discuss the functions of the SEBI. What has been the impact of the SEBI
on the capital market in India?

15.7 KEY WORDS

Depository: A Depository is an organisation where the securities of an
investor are held in electronic form. A Depository can be compared to a bank.
In a bank, one has to open an account to deposit money and withdraw money
already deposited. Similarly, an investor has to open an account, called demat
account, with a depository (through a depository participant) to deposit his/her
holding of securities in electronic form. A Depository Participant (DP) is an
agent appointed by the Depository and is authorised to offer depository
services to all investors. Like a bank statement, the DP provides the statement
of transaction and holding for their demat account to the clients. Thus, the DP
is basically the interface between the investor and the Depository.
All trading in shares is currently done on electronic trading platform where
every transaction is recorded electronically. The ownership records of
investors are maintained by the depositories. After an investor buys shares, the
shares are deposited in the demat account, and he/she can sell those shares
already held in the demat account.
Shares are actually held by the depositories, which become the legal owner of
the shares held by them and the investors who have purchased the shares are
the beneficiary owners. That is, all the benefits of owning shares accrue to the
investors.
At present, India has only two depositories—National Securities Depository
Ltd. (NSDL), promoted by the NSE, and Central Depository Services Ltd.
(CDSL) promoted by the BSE. NSDL is the first Depository to have started in
India.
Dematerialisation: Dematerialisation is a process in which your physical
certificates get converted to securities in electronic form which is credited into
the demat account (an account of the investor maintained with a depository
participant) of the investor. To convert existing physical certificates, an
investor needs to send the physical certificates along with a request to
dematerialise to the depository through the depository participants.
Dematerialisation offers several benefits:
• Paper-less holding of securities i.e. in electronic form, which enables
buying and selling almost instantaneous.
• Risks associated with physical certificates (bad delivery, loss, mutilation
or theft of share certificates, forgery, etc.) completely eliminated.
• No stamp duty and lower transaction costs for transfer of shares.
• Reduced paper work.
• Fast settlement cycles.
• Automatic receipt of Corporate Actions (such as Initial Public Offer,
dividends, bonus shares, rights shares, etc.)
Rematerialisation is the process of converting back the dematerialised
holdings to the physical certificate form. For rematerialisation, the investor
needs to forward a request to the DP which will be verified for the balances
held by the investor in the demat account and, in turn, will be forwarded to the
Depository. The Depository, in turn, will forward the request to the Registrars
and Transfer agents who will print the certificates and dispatch them to the
58 investor.
De-mutualisation: In India, all stock exchanges (except NSE) were set up as Capital Market in India
and Working of SEBI
non-profit organisations. Among these, BSE, Ahmedabad Stock Exchange
and Madhya Pradesh Stock Exchange were set as association of persons
(AOP). Rest of the stock exchanges are companies. Corporatisation refers to
the process of converting the organisational structure of the stock exchange
from a non-corporate structure to a corporate structure. De-mutualisation, on
the other hand, refers to the process of converting an exchange from a
“mutually-owned” association to a company “owned by shareholders”. In
other words, transforming the legal structure of an exchange from a
mutual form to a business corporation form is referred to as
demutualisation. The above in effect means that after demutualisation, the
ownership, the management and the trading rights at the exchange are
segregated from one another. This is not the case even for stock exchanges
that have a corporate structure, because brokers themselves are owners as well
as managers of these exchanges. Mutual exchange, the three functions of
ownership, management and trading are interwined into a single group. Here,
the broker members of the exchange are both the owners and the traders on
the exchange and they further manage the exchange as well. Demutualised
exchange, on the other hand, has all these three functions clearly segregated,
i.e. the ownership, management and trading are in separate hands. Currently,
the National Stock Exchange (NSE) and Over the Counter Exchange of India
(OTCEI) are not only corporatised but also demutualised with segregation of
ownership and trading rights of members.
SEBI had constituted a Group on Corporatisation and Demutualisation of
Stock Exchanges under the Chairmanship of Justice M H Kania, former Chief
Justice of India, for advising SEBI on corporatisation and demutualisation of
exchanges and to recommend the steps that need to be taken to implement the
same. The Group had submitted its Report to SEBI on August 28, 2002. SEBI
has taken up with Central Government to amend the SC (R) A to affect
Corporatisation and Demutualisation. The amendment is to be introduced in
the House of Parliament.
Market Capitalisation: Market capitalisation (MC) of a listed company is the
product of the market price and the number of shares outstanding. It is taken
as the market value of the listed company. Along with market price, the
market capitalisation changes on a daily basis. The MC of the equity market
of a country is the sum total of the MCs of all individual listed companies in
that country. The equity market capitalisation as proportion of the country’s
GDP, known as market capitalisation ratio, is an indicator of the size of equity
market of the country. Market capitalisation of a company is an extremely
important factor in investment decisions of institutional investors (FIIs,
mutual funds, etc.). Many such investors do not even consider investment in
stocks with market capitalisation below a certain level.
Turnover Ratio: The trading value (or turnover) of a listed company is
defined as the number of shares of the company traded during a period
(usually a year) multiplied by the price. The ratio of trading value to market
capitalisation of the company, known as the turnover ratio, is an indicator of
how active or liquid the company’s stock is. Similarly, the turnover ratio for
the entire market is an indicator of liquidity of equity market in a country. For
example, a turnover ratio of 1 (whether for a company or for a market)
indicates that the entire market value (or market capitalisation) is traded once
in a year. A low turnover ratio indicates lack of liquidity. If an investor
purchases a low liquidity stock, he/she may find it difficult to sell simply
59
Sectoral Performance-II because not enough buyers are available. Thus, most of the institutional
investors avoid stocks with turnover ratio below a certain level.
Rolling Settlement: In a Rolling Settlement, all trades outstanding at end of
the day have to be settled. That is, the buyers have to make payments for
securities purchased and sellers have to deliver the securities sold. In India,
rolling settlement was introduced with a T+5 settlement cycle effective from
December 31 2001, which meant that a trade done on Day 1 had to be settled
on the fifth working day after (excluding) the trading day. This was changed
to the T+3 cycle effective from April 1, 2002, and T+2 cycle with effect from
April 1, 2003, which is the current practice. Rolling settlement is a standard
practice adopted in most developed countries.
Introduction of rolling settlement has stopped the practice of building the
uncovered exposure by the brokers. Introduction of clearing corporation and
novation and settlement guarantee fund have reduced the possibility of a
payment crisis to almost nil. Not a single payment crisis has occurred so far in
the NSE-NSCCL-NSDL system; crisis precipitated by the likes of Ketan
Parikh and others after the mid-1990’s have occurred outside the NSE-
NSCCL-NSDL system.
Short-Selling: Selling securities without owning them.

15.8 SOME USEFUL BOOKS

Patil, R.H. (2000); The Capital Market in 21st Century, Economic and
Political Weekly, November, 2000.
Shah, A. and Thomas, S. (1997); Securities Markets, in K.S. Parikh, ed., India
Development Report 1997, Oxford University Press, Chapter 10, pp. 167-192.
Shah, A. and Thomas, S. (2000); David and Goliath: Displacing a Primary
Market, Journal of Global Financial Markets 1(1), 14-21.
Shah, A. (1999); Institutional Change on India’s Capital Markets, Economic
and Political Weekly.
Waghmare, Tushar (1998); The Future of India’s Stock Markets, 1997, IIEF,
New Delhi, XXXIV (3-4), 183-194.

15.9 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) See Section 15.2
2) See Section 15.3
3) i) True
ii) False
iii) True
iv) True
v) False
vi) True

60
UNIT 5 COMMERCIAL BANKS IN
INDIA
Structure
Objectives
Introduction
Classification of Commercial Banks
5.3.1 Public Sector Banks
5.3.1.1 State Bank of India Group
5.3.1.2 Nationalised Banks
5.3.2 Private Sector Banks
5.3.2.1 Privately Owned Banks
5.3.2.2 Foreign Banks
5.3.3 Scheduled Banks
Resources of Commercial Banks
5.4.1 Paid-up Capital and Reserves
5.4.2 Deposits
5.4.3 Borrowings
Employment of Resources
Reserve Bank's Directives and Norms
5.6.1 Priority Sector Advances
5.6.2 Prudential Norms
5.6.3 Income Recognition
5.6.4 Asset Classificafion and Pravisioning
5.6.5 Capital Adequacy Norms
5.7 Problem of Non-Performing Assets
5.8 Let U s Sum Up
5.9 Key Words
5.10 Some Useful Books
5.1 1 AnswersIHints to Check Your Progress

5.1 OBJECTIVES
After reading this Unit, you will be able to -
Explain the structure of Commercial Banks in India,
Describe the sources of funds for Commercial Banks and
their utilisation,
b i s ~ u s aililportant regulatory directives issued and norms
laid down by Reserve Bank of India, and
Identify the problem of non-performing assets of banks.

INTRODUCTION
Commercial Banks are the oldest and the largest banking
institutions in India. Some of them are more than hundred
years old. Their branches are spread all over the country
and have penetrated in the countryside as well.
Commercial Banking has passed through three distinct
phases in India since Independence. The period 1955-1970
I
B,in%iitst‘ 8ylcitem land witxlessed tkbc get~esisof public sector in lrldian banking
Maneg Market
cornrnencirig with the setting u p of the State Bank of India
in 1955 and ending with the nationalisation 6f 14 major
banks in 1969.
The two decades after nationalisation of banks i.e. the
seventies and eighties witnessed the conversion of class
banking into mass banking. During
U U- - this ~ e r i o dbrunch
U b

expansion took place on a large-scale, followed by recruitment

1 V .
I .
of -large numb& of bank em~lovees.e x ~ a n s i o nin ~rioritv
.-
b 4

sector advances, especially for the poor and neglected sectors.

Loan Melns were <he main feature9 of this period. On the
other hand, the Reserve Bank of India's regulatory control
intensified over various facets of banking operations.
The oost-nationalisation era wins not withaut its resultant
probierns. With poor training, employee efficiency and
productivity went down, problem of non-recovery of loans
cropped up, and pre-ernption of funds in meeting statutory
r.eqm,irerncnts went up, resulting in reduced profitability of
banks.
i c was such a situation in 199 1 when the new economic
policies were launched by the Government. A Committee on
financial sector u n d e r the Chairmanship of Shri M ,
Narashimham was appointed which suggested measures of
far-reaching significance to improve efriciency, productivity
and profitability of banks. These measures have been Ilargelv
u .
I

implemented. in this Unit. you will study the position nf

Commercial Banks in India in the present situation, after
the reform- measures have largely been implemented,

CLASSIFICATION OF CQMMERCIAL
BANKS
On the basis of ownership and control aver management
commercial banks in India are classified into two broad
categories i.e.
z) Public Sector Bankx, and
ii) Muate Sector Banks.
Public Sector banks nceottnt for the major share of the
banking business in India and are sub-classified into two
categories i.e.

a$ State Bank.of India Group, and

b FJationalked Bunks.

6.3.P. 1 8bt9 Baak s f India Group

This group c0rnprise.s State Hank ,of india and its seven
 subsidiaries which is the largest commercial bank in India.
State Bank of In'dia came into existence in 1r355 when the
Government converted the then existing Imperial E3ank of
India into State Bank of India under the State Bank of India
Act, 1955. At that time, about 93% of its shares were held
by the Reserve Bank of India. State Bank of India acts as
the agent of Reserve Bank of India a t places where the latter
i
has no office of its own. In 1959, eight state associated
banks were converted into the subsidiaries of State Bank of
India under the State Bank of India (Subsidiary Banks) Act
1959. Later, one of them was merged with another. Thus,
State Bank Group comprises of eight banks. The objective
. of formation of State Bank Group was to accelerate the
extension of banking facilities in the countryside.
5.3.1.2 NationaUsed Banks

After about a decade, in July 1969, 14 major commercial

banks in India were nationalised by the enactment of
Banking Companies (Acquisition and Transfer of Under-
takings) Act 1970. A decade later in 1980, 6 more commercia%
banks were nationalised with deposits of Rs. 200 crore each.
One of them was subsequently merged with another, thus,
the total number of nationalised bank8 is 19 a t present.
The decision to nationalise the major commercial banks was
taken with the objective of opening a large number of
branches throughout the country, especially in the rural
areas and to mobilise deposits on R massive scale for the
purpose of lending to productive purposes. These were the
projects, which h a d remained neglected so far, i.e.
agriculture, small industries and small businesses, weaker
sections, etc. Initially, cent percent ownership of nationalised
. banks was vested, in the Government of India. Subsequently,
after the amendment in the Act, private ahare holding has
also been permitted with the provision that the share of the
Government shall not fall below 51%. A few banks have
' since issued shares to the public, with the result the
Government shareholding percentage has been reduced,

5.3.2 h i v a t s Geetot Bank

. 5.3.2.1 Privately 'Owned Bank
Private Sector banks fall in two categories. Those private
sector banks which were in existence at the time of
nationalisatioi~ are 23 and are called Old Private Sector
Banks. Till 1993 no new bank coulrd be established in
Tndia. In 19931,Reserve Bank of India formulated guidelines
for the establisshment of new private sector bunks in India.
According to these guidelines, a new bank was required to
have a minimvrrn capital of Rs. 100 crorc and to observe the
capital adequ:ncy norm of 8940 from the very beginning. Nine
Banking System and new banks were set up according to these guidelines. One
Money Market
of them was subsequently, merged with another. After the
merger bf ICICI Ltd., one of the All India Development Banks
in India, with its subsidiary I ~ I C Bank
I Ltd. on March 30,
2002; IClCI Bank Ltd. h a s become the second largest
commercial bank in lndia after the State Bank of India. I t
is obviously the largest bank in the private seetor. In 200 1,
these guidelines were revised with the effect that the amount
of capital has been raised to Rs. 200 crore (to .be further
raised to R s . 300 crore) and capital adequacy norm was
raised to 9%.
1

5.3.2.2 Foreign Banks

At present there are 4 1 foreign banks from 21 countries

operating in India. They are the branches of. banking
companies incorporated outside India. There were 194
branches of foreign banks operating in India as on June 30,
200 1.

5.3+3 Scheduled Banks

Accarding to Section 42.oi the Reserve Bank of lndia Act,
1934, banks-both public sector and private sector banks,
are given the status of a Scheduled Banks, if their names
are included in the Second Schedule to the Reserve Bank
of India Act. For this purpose, the bank must satisfy the
1
following conditions:

i) It must have a paid-up capital and reserves of an aggregate

value of not less than Rs. 5 lakhs,

ii) It must satisfy the Reserve Bank of India that its affairs are
not being conducted in a manner detrimental to the interest
of its depositors, and
iii) It must be a State Co-operative Bank 6r a company or a n
institution notified.by'the Central Government in this behalf,
- or a corporation, or a company incorporated under any law.
Thus, besides Commercial Banks, Regional Rural Banks,
State Co-operative Banks and Urban Co-operative Banks are
also entitled to get the status of a Scheduled Banks.
C -
Check Your Progress 1
1) List various categories of Cominercial Banks in India.

............."...........+....'..............................................................
2) Fill :up in the blanks:
i ) Commercial Banks in lndia have paf;seb throug?
.....................................phases since Indcpendcncr:.
 ii) State Bank group comprises of .;.................................. Cornmerclal Braarks
in India
Banks. { ,

'
iii) The totai number of Nationalised Banks at present Is

iv) ....................................bank is the !argest Bank in the

private sector.

.j Which are the conditions required to be satisfied by a bank

for placing it under the category of Scheduled Bank under
i
Section 42 of RBI Act 19343

5.4 RESOURCES OF COMMERCIAL

Banking business essentially lies in the acceptarlce of

deposits for the purpose of lending a n d investment. .
Acceptance of deposits thus, constitutes the main source of
funds for them. Their own f u n d s constitute a small
percentage of their total resources. A s we shall see later,
efforts are being made during recent years to increase the
owned funds of the banks also.

5.4.1 Paid Up Capital and Reseaves

The authorised capital of nationalised banks is Rs. 1500
crore each. The Central Government has subscribed to the .
100% paid-up capital in case of some banks, while in other
cases, its percentage holding has declined with the issuance
of shares to the public.

Banks transfer 20% (now 25%) of their net profits to a

Statutory Reserrz Fund ever$ year. Besides, they also
maintain other Reserve Funds, e.g. Capital Reserves, Share
Fremium, ~ e v e n u e a"n d other reserves and Investment
Fluctuation Reserve.

5.4.2 Deposits
1

Deposits from the public, institutions, and organizations

constitute the bulk of the resources of commercial banks.
They accept deposits under three types of deposit accounts:

i) Fixed Deposits: the minimum period of such deposits is 15

days

ii) Savings Deposits

iii) Current Deposits t

. ,f
Banking System and No interest is payable on current deposits, while interest on
Money Market
savings bank accounts is prescribed by Reserve Bank of
India. Currently it is payable @ 4% p.a. Interest is calculated
on the minimum balance held in the savings accounts from
ll'h day of the month till the last day of the month.

Interest rates on fixed deposits were prescribed by Reserve

Bank of India till a few years ago. Now, such'interest rates
are ~ompletelyderegulated. Banks are permitted to prescribe
their 'own interest rates for fixed deposits of different
maturities. At the stance of the Reserve Bank of India,
banks pay slightly higher rates on bulk deposits of Rs. 15
lakh and above and on deposits held in the names of senior
citizens (i.e. persons of age 60 years and abdie).

Deposits with Commercial banks, a s well as with Regional

Rural Banks and Co-operative banks ate insured by Deposit
Insurance and Credit Guarantee Corporation of India upto
a n amount of Rs. 1 lakh in each account. These banks pay
the insurance premium @ 5 paise per cent to the corporation
for this insurance.
Scheduled Commercial Banks also solicit large deposits
through certificates of deposits. The outstanding amount of
CDs issued by them stood a t Rs. 1695 crore as on October
20, 2000, but declined to Rs. 8 2 3 crore as on October 5,
' 2001.

Banks augment their resources by borrowings also. Sources

of such borrowings are:

i) Reserve Bank of India

ii) Other Banks
iii) Other Institutions and Agencies.
Reserve Bank of India provides refinance for export credit
and also provides short-term funds under its Liquidity
Adjustment Facility (explained fully in Unit on Money
Market). Moreover, banks get refinance from other Apex
Banks like Exim Bank, IDBI etc.

5.5 EMPLOYMENT OF RESOURCES

A s you have keen, bulk of banks' funds are raised in the
form of deposits, which are repayable on demand or after a
specified period. Banks, therefore, employ these funds
partly in liquid assets like cash balances with themselves
and other banks and money a t call and short notice and the
rest of the amount is either invested in securities or given
in the form of loans and advances.
 Cash and Balances with other Banks Commercial Banke
i) in India

These are the most liquid assets of a bank and are called
the first line of defence, because banks can immediately '
repay the claims of the dePositors with these balances.
Banks keep a reasonable amount of cash, say 10% or so of
,deposits, in such balances.
I

ii) Money at Call and Short Notice

\
The surplus money with the b k k s is lent to other banks
which are in need of funds for a day or a few days. Banks
earn interest on-such amount lent to other banks. The
/ interest rate varies from day to 'day on the basis of demand
1
I
for and supply of funds.

iii) . Cash Reserves with Reserve Bank of India

Under Section 42 of the Reserve Bank of India Act, 1934,

scheduled commercial banks are required to maintain a t
least 3 % of their net demand and time liabilitiescwith the
Reserve Bank of India. This is the statutory minimum limit,
Reserve Pank of India is empowered to raise it'to a higher
\
percentaie of upto 20%.

With effect from J u n e 1, 2002, the Cash Reserve Ratio

ICRR) is required to be maintained @ 5% (reduced from .
5.5%). In recent years, Reserve Bank of India has gradually
reduced this rate. With every reduction in CRR, Commercial'
Banks',balances with Reserve Bank of India are released to
them, thereby increasing their liquidity. Reserve Bank of
India pays interest at bank rate on eligible balances i.e.
balances held in excess of statutory 3% limit.

iv) Investments
P Banks invest substantial portion of their deposit liabilities
7
'

r in investments. Primarily, rbanks are under compulsion to

invest in Government and other approved securities to meet
I the Statutory Liquidity requirement under section 24 'of the
L i d n 1949. ,
Banking ~ e ~ u l ~ t Act,

Besides, R e s e w Bank of India has also permitted the' banks

to invest in corporate securities, i.e. equity shares, convertible
. bonds and debentures within the ceiling of 5% of their total
outstanding advances as on March 31 of the previous year.
Thus, commercial banks do invest in corporate securities,
predominantly, bonds and debentures.

Investments of banks are shown under the following head A

in their Balance Sheets : I

I1
Bealaing System and 1) Government .Securities
Money Market
2) Other approved securities
3) Shares
4) Debentures and Bonds
5) Subsidiaries and Joint Ventures
6 ) Others (Commercial Paper, IndiraVikas Patras, Units of UTI
and Mutual Funds)

Though the Statutory Liquidity Requirement a t present is

25% of net demand and time liabilities, banks do invest
more than this percentage, which is mainly due to their
investments in corporate bonds a n d debentures. The
investment-deposit ratio of Scheduled Commercial banks
(on an outstanding basis) was 38.5% a s on March 23, 2001.

v) wan8 and Advances

Granting loans and advances is the principal business of

commercial banks. There are three forms in which such
loans are granted :

a) Bills purchased and discounted,

b) Cash credits, overdrafts and loans repayable on demand,
and
c) Term loans.

a) Bill of exchange arises out of genuine trade transactions.

When the bills are payable a t sight or presentment, banks
purchase them from customers (i.e. drawersJ of the bills).
In case of time bills or usance bills banks discount them.

b) Cash Credit is a running account wherein a cash credit

limit is prescribed for a customer. He is permitted to
withdraw the amount any time he likes and may return
the money wheneyer he is able to do so. Interest is charged
on the actual amount lent and for the period of loan.

Overdraft is a temporary facility which is granted to account

holders. They are permitted to draw more than their deposits
for some exigency or urgent work. Short-term loans are
granted- to the customers, which are repayable on demand.

c) Term loans are loans for medium to long periods. Such

loans are granted by banks either singly, or jointly with
term lending institutions. These loans are meant for
investment in futed assets or for expansion, modernisation,
etc.
 On the basis of security taken by banks, loans are divided Comziereial Banks
In India
into:

i) Secured by Tangible Assets (includingadvances against book

debts)
ii) Covered by Bank/ Government guarantees
iii) Unsecured

Bulk of loans fall in (i)above, and the least in (iii) above.

vi) Interest Rate Policy

Reserve Bank of India has introduced financial sector reforms

to provide operational flexibility to the banks. Till 1994
interest rates charged by banks on their advances were
regulated by Reserve Bank of India. In October i334,
Reserve Bank introduced the Prime Lending Rate (PRL) EIS
the minimum lending rate ~hargeableby banks to their
borrowers with Credit Limit dbove Rs. 2 lakhs. Thereafter,
banks were given autonomy to fix their own PLR and
maximum spread thereon. At present, banks are permitted
to determine their own PLR. They are also permitted to
offer tenor linked PLRs, i.e. different PLRs for loans with
different maturities, with effect from April 19, 2001.
Commercial banks have been permitted to lend at rates
below PLR to exporters and other credit worthy borrowers
including public enterprises.

vii) Sectoral Deployment of Bank Credit

t

Commercial banks serve the needs of different sectors of the

economy. They not only provide finance to industry and
1 trade, but are also engaged in the business of granting
i consumer credit, retail credit and housing loans, etc. Their
I '
priority sector advances constitute over 40% a6 the bank
credit. The following table shows the sectoral employment
*'
of cc+stand;qe bank credit as on July 27, 2001.

I
Table-5.1
Sectoral Deployment of Bank Credit as on July 27,2001

Sectors Amount
(in Ws. crore)
I
1. Industry [Medium EL, Large)
2. Wholesale Trade (other than
Banking System and
Money Market I (in Rs. crore)
I
4. Priority Sectors :
(i) Agriculture
(ii) Small Industries
(iii) Other Priority Sectors

5 . Other Sectors
(i) Housing
(ii) Consumer Durables
(iii) Non-Banking Finance Companies
(iv) Loans to individuals
(v) Real Estate Loans
(vi) Other Non-Priority Sector
Personal Loan
(vii) Advances against fixed deposits .
(viii)Tourism & Tourism related hostels

Tota1
6, Export Credit 3,227
Total 3,39,477
Source : Report on Trend 86 Progress of Banking in India (2000-01).

Check Your Progress 2

1) Identify the main sources of augmentation of banks'

resources by borrowings.

2 ) What is the maximum limit to which Cash Reserve Ratit

(CRR) can be increased by RBI?

...........................................................................................
3) List the various forms in which loans are granted?.

5-6 RESERVE BANK'S DIRECTIVES AND

NORlVIS
5.6.1. Priority Sector Advances
Indian commercial banks (both in public and private sectors)
ale under a n obligation to provide loans to the priority
sectors a s per the following targets laid down by Reserve
fdmk of India :
Total Priority Sector Advances : 40% of the net bank Commercial Banks
in India
credit
Total Agricultural Advances : 18% of the n e t b a n k
credit
Advances to, Weaker Section : 10% of t h e n e t b a n k
credit
For foreign banks the targets are a s follows:

Total Priority Sector Advances : 32% of the n e t b a n k

credit
Advances to Small Scale : 10% of the net bank
Industries credit
Export Credit : 12% of the n e t b a n k
credit

Priority sectors advances include advances to agriculture

(direct and indirect), small-scale industries, transport
operators, retail trade and small business, professional and
self-employed persons, housing loans to weaker sections,
and others, and investment in specified bonds of HUDCO,
NABARD and National Housing Bank.

5.6.2 Prudential Norms

To bring about reforms in the functioning of commercial
banks, Reserve Bank of India has prescribed prudential
norms for banks a s follows :

1) Non-Performing Assets

An asset shall be treated as non-performing asset in the

following circumstances :

i) Interest and/or instalment of principal remain overdue for

a period of more than 180 days in respect of a term loan.
ii) An account remains out of order for a period of more than
.r
r
.
#jq +~vr '- respect of overdraft and Cash Credit Account.

iii) A bill of exchange remains overdue for a period of more

than 180 days.

iv) Interest and/ or principal of short-term agricultural loan

remains overdue for two harvest seasons.

The above-mentioned period of 180 days shall b e reduced

to 90 days from the year ending March 31, 2004.

5.6.3 Income Recognition .

Banks are required not to take to income account interest

on any non-performing asset. But, interest on advances
 against term deposits, Indira Vikas Patra, Kisan Vikas Patra
and Life Policies may be recognised, providcd adequate
margin is available in the accounts. If government guaranteed
advances become NPA, interest on such advances should
not be taken to income account unless the interest has
been realised.

5.6.4 Asset Classification and ~roviiionin~

All non-performing assets in the advances portfolio are to be
classified into the following three categories :

i) Sub-Standard Asset : If the asset has been an NPA for a

period less than or equal to 18 months.

ii) Doubtful Asset : If it remains NPA for a period exceeding 18

months.
!
iii) Loss Asset : Where loss has been identified by the bank1
internallexternal auditor but the amount has not been
written off wholly..

The above will not apply to :

i) State Government guaranteed advances where guarantee

is not involved, and

Ii) Central Government advances where the Central Govern-

ment has not repudiated the guarantee.

All performing assets will be classified a s standard assets.

Banks are required to make provisions in their books as

follows:

i), Standard Assets: 0.25% on global portfolio basis

ii) Sub-standard ' ~ s s e t s 10%

: of the outstanding balance

iii) Doubtful Assets: 100% on unsecured portion and the

following percent on the secured portion--

20Yo if the doubtful asset is upto 1 year

30% if the doubtful asset isbover,1 year and upto 3 years

50% if the doubtful asset: is ovei- 3 years

. ] Loss rksefs:100%of the outstanding amount

1) Exposure Norms
To nninirnisr: the risks inherent in.lending, Reserve Bank of
I
India has srescribtd Exposure Norms for the Cornrnercial
Uanks. Under these norms, the maximum amount that can Conlrnercial Banks
in India
be granted to a single borrower and/or group of borrowers
by way of fund based and non-fund based facilities a s well
a s in investment in their shares (upto the prescribed ceiling
discussed below) are prescribed as follows with effect from
March 2002.

i) Individupl Borrowers : 15% of capital funds of the bank

(paid up capital and free reserves).

ii) Group Borrowers : 40% of capital funds (it can go up

by additional 10% in case of
financing infrastructure projects
alone). ,

11) Norm for ~ x ~ o s u to

r eCapital Market

Banks invest their funds in corporate securities and lend

against shares to individuals, brokers, etc. Reserve Bank of
India has prescribed the norms for their exposure to capital
market. Such exposure in all forms has been restricted to
5% of total outstanding advances (including commercial
paper) a s on March 31 of the previous year. TheLceilingof
5% thus covers (w.e.f. May 11, ,2001) :

a) Direct investments in equity share and convertible bonds

; and debentures,

b) Advances against shares' to individuals for investment in

equity shares, bonds, debentures, units of equity oriented
mutual funds, and

c) Secured and unsecured advances to stock brokers and

guarantees issued on behalf of stock brokers.

5.6.5. Capital Adequacy Norms

Reserve Bank of India h a s prescribed Capital Adequacy
Norms for Commercial Banks since 1992. All banks are
required to maintain Capital adequacy norm of 9% with
effect from March 31, 2000 (raised from earlier norm of 8%).
The basic objective of prescribing these norms is to compel
the banks to increase their capital funds (as defined below)
with the increase in the risks associated with different types
of assets. For this purpose different assets of the bank are
assigned differczt risk weights-from 0 to 100. The risk-
adjusted values of assets are, thus, arrived at. The capital
funds of the banks should be at least equal to the prescribed
perczztsl~eof risk-adjusted values of the assets. This ratio
is, therefore, called Capital to Risk-Weighted Asset Ratio
(CRAR). Presently this required percentage is 9%.
Banking System and Capital funds include the following:
Money Market
Tier I Capital includes :

i) Paid up capital, statutory reserve arid other- clisclosed free

reserves, if any, and

ii) Capital reserves representing surplus arising out of sale

- proceeds of assets.

The total of (i) and"(ii) above will be reduced by :

a) Equity investments in subsidiaries of the bank,

b) Intangible assets, and

c) Losses in the current period and previous periods.

Tier I1 Capital includes :

i) Undisclosed reserves and cumulative perpetual preference

shares,
t

ii) Revaluation reserves (at a discount of 55%))

iii) General provision and loss reserves (including general
provisions on standard assets not more than 1.25%))

iv) Hybrid debt capital instruments, and

v) Subordinated debt (upto 50% of their I Capital eligible for

this purpose).

Capital to Risk-weighted Assets Ratio (CRAR)

A s at the end of March 2001, 23 out of the 27 F'ublic Sector

banks had capital in excess of 10% risk-weighted assets.
Among the remaining, 2 had the ratio between 9 and 10%)
one between 4% and,90/0 and one had negative CHAR.

Amongst the 23 old private sector banks, 16 had CRAR in

excess of 10%) four between 9 and 10%) one between 4 and
9%) while 2 had negative CRAR. Amongst the new private
sector banks only 1 had CRAR between 9% and 10% while
the other 7 banks had CRAR in excess of 10%1

5.7 THE PROBLEM OF NON-PERFORMING

ASSETS
The Commercial Banks' biggest problem a t present is the
existehce of huge amount of non-performing assets. The
gross non-performing assets of Scheduled Commercial Banks
increased from Rs. 60,408 crore a s a t end March 2000 to
Rs. 63,883 crore a t March end 2001. The net NPAs a t these
 dates were Rs. 30,073 crore and Rs. 32,468 crore respectively. Commercial Banks
in India
All categories of banks-public sector, private sector and
foreign banks face this problem. The Government of India _
and the Reserve Bank of 1hdia have taken various initiatives
to reduce the magnitude of NPAs.

These initiatives include:

i) Establishment of Debts Recovery Tribunals

After the enactment of the Recovery of Debts due to Banks
and Financial 'Institutions Act 1993, twenty-three Debt
Recovery Tribunals have been established a t various places
in India. These Tribunals ensure expeditious adjudication
and recovery of debts due to banks and financial institutions.
Recently, these Tribunals have been granted more powers
for this purpose. These Tribunals deal with claims of banks
exceeding Rs. 10 lakhs each.

ii) Proposed Establishment of Asset Reconstruction

Companies
Government h a s issued a n ordinance in J u n e 2 0 0 2 *
permitting the setting u p of Asset Reconstruction Companies.
These companies will take over the non-performing assets
from banks and financial institutions and will try to realise
hem a s soon a s possible.
-
Check Your Progress 3
1) Fill u p in the blanks: I<

i) RBI has laid down that ...................... per cent of the

net bank credit should be advanced to weaker section.
ii) The foreign banks are obliged to provide ............. per cent
of the net banks credit to priority sector advances.
2) Identify the circumstances in which an asset is treated a s
1 non-performing asset.
...........................................................................................
i

I 5.8 LET US'SUM UP

Major portion of commercial banking in 1ndia is undertaken
in the public sector. Within the public sector, the State
Bank of India and its subsidiaries constitute State Bank
Croup on the basis of their ownership pattern. New private
zector banks incl-~deICICI Bank Ltd; which is the second
biggest bank after State Bank of India. Banks get the status
of Scheduled B a n k s on t h e fulfilment of prescribed
conditions.
Banking System and - The main sources of banks' funds are deposits. Interest
Money Market Rates on deposits are now completely deregulated (except
savings). Borrowings from Reserve Bank a n d other
institutions also augment their funds.
Commercial Banks employ their funds in liquid assets, semi-
liquid assets a n d profit earning a s s e t s like loans and
advances. They are required to maintain a prescribed
percentage of deposits with Reserve Bank of India as CRR
and also to maintain Statutoiy Liquidity Ratio of 25%.
Funds are lent for diversified purposes-priority sector
advances constitute over 40°/i of total advances. They also
lend for housing, consumer durables, rea! s t a t e financing
and other personal purposes also.
Reserve Bank of India h a s prescribed prudential norms to
be followed by the commercial banks. Capital Adequacy
Norm of 9% is to be fulfilled by them.
The biggest problem of Commercial Banks presently is the
existence of huge amount of non-performing assets. Efforts
are being made to solve it through Debt Recovery Tribunals
and otherwise also. Banking Sector Reforms have been
undertaken since 1991, still further reforms are needed to
improve the functioning of commercial banks.

KEY WORDS
Authotised Capital : Authorised Capital of a company
is the maximum amount of capital,
which it is authorised to raise from
shareholders. It is Iixed at the time
the companies incorporated and is
specified in its Memorandum of
Association.
Capital to Risk- : According to Capital Adequacy
weighted Assets Ratio norms, banks have to maintain
capital (as defined in the norms)
a t a certain percentage of the risk-
adjusted values of their assets.
This ratio a t present is gO/O and is
called Capital to Risk-Weighted
Asset Ratio (CRAR).
Hybrid Debt Capital : Those debt instruments which have
Instrument some characteristic of equity also
a r e called Hybrid Debt Capital
Instrument.
Intangible Assets : Certain assets which do not exist
in physical form are called intan-
gible assets, e.g. goodwill, patents, .
rights etc. Other assets are called
, Tangible Assets.
UNIT 6 REGULATORY FRAMEWORK
FOR BANKS AND NON-
BANKING FINANCE
COMPANIES
Structure

Objectives
Introduction
Reserve Bank of India : Its Functions a s a Central Bank
Regulations over Commercial Banks
Regulations over Co-operative Banks
Regulations over Non-Banking Finance Companies
Let U s Sum Up
Key Words
Some Useful Books
Answers/ Hints to Check Your Progress

6.0 OBJECTIVES
After going through this Unit, ydu will be able to -

9 Name the various participants in the money market,

9 Identify the principal regulatory authorities for banks and
non-banking finance companies,

9 Explain the main provisions of the Banking Regulation Act,

1949, which govern the Commercial Banks a n d non-
banking finance companies, and

8 Describe the powers vested with Reserve Bank of India under

Reserve Bank of India Act, 1934 to regulate Commercial
Banks and non-banking finance companies.

6.1 INTRODUCTION
Necessity of regulatory framework for the financial system
has been universally felt, primarily to safeguard the interests
of a large number of savers/depositors and also to ensure
proper and efficient functioning of the institutions that are
part and parcel of the financial system. We have, in India,
two principal regulatory authorities, namely, the Reserve
Bank of India (RBI) and the Securities and Exchange Board
of India (SEBI). They are entrusted with the responsibilities
of development and regulation of the money market and
capital market respectively. These regulators derive their
powen from various legislative enactments and exercise their
discretion as well. The financial system t h u s functions
wlthin the regulatory framework. The objective of this and
the next Units are t o give you a broad account of such
Lng System and regulatory framework. In this Unit,. we shall deal with the
y Market
regulatory environment for the money market and the
participants therein, i.e. the Commercial Banks, the Co-
operative Banks, financial institutions and the non-banking
finance companies.

6.2 RESERVE BANK O F INDIA : ITS

FUNCTIONS A S A CENTRAL BANK
Reserve Bank of India, besides being the Central Bank of 1
the country, is the principal regulatory authority in the
Indian money market. It derives its powers from two principal
enactments, namely the Reserve Bank of India Act, 1934
I- 1
and the Banking Regulations act, 1949. The Reserve Bank 1
of India Act, 1934, apart from providing for the Constitution
management and functions of the RBI, also empowers it to
exercise control and regulations, over the Commercial Banks,
the non-banking finance companies and the financial
institutions. The Banking Regulation Act 1949 contains 1
various provisions'governing the Commercial Banks in India! I
Many of these provisions are also applicable to the Co-
operative Banks. The State Bank of India, its subsidiary
banks and the nationalised banks ,are also governed by the
1
I
!
status under which they have been incorporated. In the
I
subsequent sections of this Unit, we shall deal with the
regulatory framework.

First, we shall discuss the main functions performed by the

i,
Reserve Bank of India. The Reserve Bank of India was
established on April 1, 1935 ,under the Reserve Bank of
India Act, 1934. A s the country's Central Bank, the Reserve
Bank of India performs the following function:

a) Issuer of Currency Notes: Reserve Bank of India is the sole

authority to issue currency notes, except one-rupee note
and coins of smaller henominations. Within the RBI, all
functions relating to the issuance of notes are undertaken
by the 'Issue Department', which is responsible for issue
of notes and t'he maintenance of eligible assets of equivalent
value to back the notes issued.

b) Banker to the Government: RBI acts as banker to the

Central Government under the Reserve Bank of India Act,
and to the State Governments, under agreements with them.
A s the banker to the Government, RBI provides services,
such as acceptance of deposits, withdrawal of funds, receipts
- and payments on behalf of the Government, transfer of

funds and the management of public debt.

c) Banker's Bank: The Reserve Bank of India controls the

volume of resources at the disposal of the Commercial Banks
through the various measures of credit control. This checks
 the ability of banks to create/squeeze credit to the industry, Regul atory Franlework
for Banks and Non-
trade and commerce. Banking Finance
Companies
d) Supervisory Authority: RBI has the powers to supervise
and control Commercial Banks. It issues licenses for
starting new banks and for opening new branches. It has
the power to vary the reserve ratios, to inspect the working -
of banks, and to approve the appointment of Chairman and
Chief Executive Officers of the banks.

e) Exchange Control Authority: The Reserve Bank of India

regulates the demands for foreign exchange in terms of the
Foreign Exchange Management Act, besides maintaining
the external value of Indian rupee.

f) Regulation of Credit: One of the most important functions

of the Reserve Bank of India is to regulate the flow of credit
to industry. This is achieved by measures such a s the Bank
rate, Reserve Requirements, Open Market Operations,
selective credit controls and moral suasion.

R-EGWLATIONS OVER COMMERCIAL

BANKS
Main provisions of the Banking Regulation Act, 1949, which
govern the Commercial Banks, are a s follows:

1 ) Establishment

It is essential for every banking company-Indian or foreign,

to acquire a licence from the Reserve Bank of India, before
it commences its business in India. Reserve Bank of India
issues a licence, if it is satisfied that the company fulfils the
following conditions:

i) the company is/or will be in a position to pay its present or

future depositors in full a s their claims accrue,

ii) the affairs of the company are not being, or are not likely to
be conducted in a manner detrimental to the interest of its
present or future depositors,

iii) the general character of the proposed management of the

company will not be prejudicial to the public interest, or
the interests, of its depositors,

iv) the company has adequate capital structure and earning

prospects,

v) public interest will be served by the grant of a licence to

the company to carry on banking business in India,

vi) the grant of licence would not be prejudicial to the operation

Banking System and and consolidation of the banking system consistent with
Money Market monetary stability and economic growth, and

vii) any other condition to ensure that the carrying on of the

banking business in India by the company will not be
prejudicial to the public interest or the interests of the
depositors.

A foreign bank must, in addition, satisfy the following

conditions:

i) the carrying on of banking business by such company in

India will be in the public interest,

ii) the Government or the law of the country in which it is

incorporated does not discriminate in any way against
banking companies in India, and

iii) the company complies with all the provisions cf the Act
applicable to such companies.

2) bpening of Branches

Every banking company (Indian as well as foreign) is required

to take Reserve Bank's prior permission for opening a new
place of business in India or outside India, or to change the
location of a n existing place of business in India or outside.
Reserve Bank, before granting its permission, takes into
account -

i) the financial condition and history of the company,

ii) the general character of its management,

iii) the adequacy of its capital structure and earning prospects,
and

iv) whether public interest will be served by the opening/

change of location of the place of business.

3) Business Permitted and Prohibited

Section 6 contains a list of businesses which may be

undertaken by a banking company. Under Clause 'O', any
other business may also be specified by the Central
Government as the lawful business of a banking company.

But, a banking company is prohibited from undertaking,

directly or indirectly, trading activities and trading risks
(except for the realisation of the amount lent or in connection
with the realisation of bills for collection/ negotiations).

4) Subsidiary Company

A bill~kingcompany inuy establish a subsidiary company for

undertaking any business permitted under Section 6, or for
. .
carrying on the business of banking exclusively outside Regulatory Framework
for Banks and Non-
India, or for undertaking any other business, which in the Banking Finance
opinion of Reserve Bank, would be conducive to the spread Companies
of banking in India or to be useful in public interest.

5) Paid-up Capital

The Act stipulates the minimum aggregate value of its paid-

up capital and reserves for banks established before 1962.
Minimum amount of capital was raised to Rs. 5 Lakhs for
banks set u p after 1962. The revised guidelines issued by
Reserve Bank for establishing new private sector banks
prescribed minimum paid-up capital for such bank: a t Rs.
200 crore, which shall be increased to Rs. 300 crore in the
next three years, out of which promoter's contribution will
be 25% (or 20% in case paid-up capidal exceeds Rs. 100
crore). Non-Resident .Indians may participate in the equity
of a new bank to the extent of 40%.

The authorised capital of a nationalised bank is Rs. 1580

crore, which may be raised to Rs. 3000 crores. These banks
are allowed to reduce the capital also but nor below Rs.
1500 crore. These banks are permitted to issue shares ta
the public also, but the share of the Central Government is
not allowed to be less than 51% of the paid-up capital. The
paid-up capital may be reduced a t any time so a s to render
it below 25% of the paid-up capital a s on 1995.

6) Maintenance of Liquid Assets

Section 24 required every banking company to maintain in

India in cash, gold or unencumbered approved securities a n
amount which shall not, a t the close of business on any
day, be less than 25% of the total of its net demand and
time liabilities in India. Reserve Bank of India is empowered
to step u p this ratio, called Statutory Liquid Ratio (SLR),
upto 40% of the net demand and time liabilities. When
this ratio is raised, banks are compelled to keep larger
proportion of their deposits in these specified liquid assets.

SLR is to be maintained on a daily basis. The amount of

SLR is calculated on the basis of net demand and time
liabilities a s on the last Friday of the secoi~dpreceding
fortnight. Reserve Bank also possesses the power to decide
the mode of valuation of the securities held by banks, i.e.
valuation may be with reference to cost price, inarlcet price,
book value or face value a s may be decided by Reserve Bank
of India from time to time.

Approved securities mean the securities in which the trustees

may invest trust funds under Section 20 of the Indian
Trusts Act 1882. 'The securities. should be unencumbered
i.e. free of charge in favour of any creditor.
Banking System and The Act also provides for penalties for default in maintaining
Money Market
the liquid assets under Section 24. At present SLR is to be
maintained @ 25% of net demand and time liabilities (which
excludes net inter bank liabilities).

7) Maintenance of Assets in India

'Section 25 requires that the assets of every banking company
in India at the close of business on the last Friday of every
quarter shall not be less than 75% of its demand and time
liabilities.

8) Inspection by Reserve Bank

Under Section 35, the Reserve Bank may, either a t its own
initiative or a t the instance of the Central Government,
cause an inspection to be made by one or more of the
officers, of any banking company and its books and accounts.
If, on the basis of the inspection report submitted by the
Reserve Bank, the Central Government is of the opinion
that the affairs of the banking company are conducted to
detriment the interests of its depositors, it may prohibit the
banking company from receiving fresh deposits or direct the
Reserve Bank to apply for the winding u p of banking
company.

9) Reserve Bank's Power to Issue Directions

Reserve Bank of India is vested with wide powers under
Section 35 A to issue direction to banking companies
generally, or to any banking company, in particular:

i) in the public interest or in the interest or banking policy,

0r

ii) to prevent the affairs of any banking company being

conducted in a manner detrimental to the interests of the
depositors or in a manncr prejudicial to the interests of the
banking company, or

iii) to secure proper management of ally banking company

generally.

The banking company shall be bound to comply with such

directionq.

Section 36 empowers the Reserve Rank to caution or

prohibit banking companies against entering illto any
particular transaction or class of transactions and gei~erally
give advice to the banking company.

Reserve Bank also possesses the powers to ask the banking

company to call a meeting of Board of Directors, to depute
its officers, to watch the proceedings-of the meetings of the
Board, to appoint its officers a s observe~rsand to requirc: the
- -
 banking company to make changes it1 the management 011 r<cgulutory Fratnuwork
For Banks e n d N o ~ i -
suggested lines. Barilting 1"111il1:ce
Companies
10) Management of Banks

'l'he constitution of the Board of Directors of the private

sector commercial banks m u s t be in accordance with the
provisions of the Banking Regulation Act, 1949. Section 10
A lays down the Board of Directors be constituted in such
ri way that not less than 51% of the total number of members
shall consist of persons who satisfy the following two
conditions:

i) they have special knowledge or practical experience in

respect of accountancy, agriculture, rural economy, banking,
co-operation, economics, finance, law, small scale industry,
or any other related matter.

ii) they do not have substantial interest in, or be connected

with any company or firm which carries on any trading,
commercial or industrial concern (this excludes those
connected with small-scale i n d u s t r i e s o r companies
registered under Section 25 of the Companies Act).

Reserve Bank of India h a s conferred the power to direct a

banking company to reconstitute the Board, if it is not
constituted as above. It may remove a Director and appoint
a suitable director also. A person cannot be a Director of two
banking companies or a Director of a banking company, if
he is ;.A Director of companies which are entitled to exercises
voting rights in excess of 25% of the total voting rights of
all shareholders of the banking company.

The Act also requires t h a t the Chairman of a banking

company shall be a person who h a s special k~iowledgeand
practical experience of the working of a bank or financial
~rlstiiution, or t h a t of financial, economic or b u s i n e s s
:~dministrakion. But he shall not be a Director of a company,
1,artner in a firm or have substantial interest in any company
. I firm If, rhe Reserve Bank of India is of the opinion that
w
p person appointed as Chairman is not a fit/proper person
C
i c i hold such office, it may request the bank to elect another
person. If it fails to do so, the Reserve Bank of India is
P
:auihorised to remove the said person and to appoint a
suitable person in his place.

Reserve Bank's approval is also required to appoint, re-appoint,

or terminate the appointment of a Chairman, Director, or
Chief Executive Officer. Reserve Bank has the power to remove
top managerial personnel of the banking companies, if the
Bank feels it necessary in the public interest, or for preventing
the affairs of a banking company being conducted in a manner
detrimental to the interests of the depositors. Reserve Bank
may appoint a suitable person in place of the person so
Banking System and removed. Moreover, Reserve Bank is also empowered to
Money Market
appoint Additional Directors not exceeding five or one third
of the maximum strength of the Board, whichever is less.

The Board of Directors of the nationalised banks, are to be

constituted in accordance with the provisions of Section 9
of the Banking Companies (Acquisition and Transfer of
Undertakings) Act, 1970 or 1980. It provides for appointment
a s Directors or officials of RBI, Central Government, other
financial institutions and from amongst the officers and
workmen of the bank concerned. Moreover, six Directors are
to be nominated by the Central Government, and two to six
directors are to be elected by shareholders other than Central
Government. These Directors are required to be experts in,
or have practical experience in the subjects enumerated
above in case of private banks' Directors. If the Reserve
Bank is of the opinion that any Director elected by the
shareholders (other than Government) does not fulfil the
aforesaid requirement, it can remove such Director, and the
Board of Directors shall co-opt another person in his place.

The nationalised banks are under a n obligation to comply

with the guidance given by the Central Government.
According to Section 8 of the (Nationalisation) Act, "every
nationalised bank shall, in the discharge of its functions, be
guided by such directions in regard to matters of policy,
involving public interest as the Central Government may,
after consultation with the Governor of the Reserve Bank,
give".

11) Control over Advances

Section 21 confers wide powers on the Reserve Bank of

India to issue directive to the banking companies with regard
to the advances to be granted by the banking companies
either generally or by any of them in particular. These
directions may relate to any or all of the following:

a) the purposes for which advances may, or may not be,

granted,

b) the margins to be maintained in respect of secured advances,

c) the maximum amount of advance to any one company, firm,

individual or association of persons,

d) the maximum amount upto which guarantees may be given

by the banking company on behalf of any company or firm,
and

e) the rate of interest and other terms and conditions, on which

advances may be made or guarantees may be given.

The directive issued under this Section is called Selective

 \

Regulatory Framework
Credit Control Directives, if they relate to advances on the for Banks and Non-
security of selected commodities. Banks are bound to comply Banking Finance
with these directives. Companies

12) Restrictions on Loans and Advances

A banking company is prohibited from sanctioning loans

and advances on the security of its own shares. Restrictions
are also imposed under Section 20 on the loans granted by
banks to the persons interested in the management of banks.

13) Maintenance of Cash Reserve with Reserve Bank

Section 42 of the Reserve Bank Act, 1934 requires every

scheduled bank to maintain with the Reserve Bank of India
a n average daily balance, the amount of which shall not be
less than 3% of the net demand and time liabilities of the
bank in India. Reserve Bank of India is empowered to increase
this rate upto 20% of the net demand and time liabilities.
If a bank fails to maintain the cash balance as required by
the Reserve Bank, penalty may be imposed as prescribed in
the Act. This provision applies to all scheduled banks,
commercial banks, state co-operative banks, and Regional
Rural Banks.

With effect from December 29, 2001, commercial banks are

required to maintain Cash Reserve Ratio @ 5.5% of their net
demand and time liabilities of the second preceding fortnight.
It was reduced by 2 percentage points from 7.5% to 5.5%
with effect from that date and further to 5% w.e.f. J u n e 1,
2002. Reserve Bank of India pays interest on eligible cash
reserves as per the Bank Rate (6.5%).

6.4 REGULATIONS OVER COOPERATIVE

BANKS
The c3tegory of co-operative banks comprises of the central
and state co-operative banks and urban co-operative banks.
They are organised co-operative societies, which are registered
and governed by State Governments under the respective
Cooperative Societies Act. T h u s , m a t t e r s relating to
registration, administration, recruitments, liquidation and
amalgamation are controlled by State Governments. A s they
perform the functions of a bank, certain provisions of the
Banking Regulation Act, 1949 also apply to them. Thus,
they are regulated by Reserve Bank of India so far a s matters
relating to banking are concerned.

Reserve Bank's supervision and control over urban co-

operative banks is far weaker. They are subject to dual
control, which remains a problem. Reserve Bank has,
I~owever, prescribed prudential norms relating to income
recognition, asset classification and provisioning. Exposure
Banking System and norms, similar to commercial b a n k s , have also been
Money Market
orescribed for urban co-operative banks.
C
Check Your Progress 1

1) List the factors which are taken into consideration by

Reserve Bank of India while permitting banking company
to open a new place of business.

2) Fill in the blanks:

i) The authorised capital of a nationalised bank is

.....................................
ii) Reserve Bank of India is empowered to raise the
Statutory Liquidity Ratio (SLR) upto the extent of
...................................of net demand and time liabilities.
iii) Section ..............empowers RBI to issue directives to
banking companies.
iv) Cash Reserve Ratio is a n important instrument of
.....................................
3) Which functions are performed by the RBI?

6.5 REGULATIONS OVER NON-BANKING

FINANCE COMPANIES
The Non-Banlting Finance Companies perform very important
financial intermediation function in India. They supplement
the role of the banking institutions, as they cater to the
needs of those borrowers who remain beyond the purview
of the banking institutions and mobilise the savings from
the depositors. Iiire purchase finance and leasing companies,
loans a n d investment companies a n d housing finance
companies are the important categories of such Non-Banking
Finance Companies (NBFCs).

In view of the significant role played by NRFCs, regulatory

framework has been devised, particularly to safeguard the
interests of the depositors. Chapter 111 B of the Rcscrve
Bank of India Act, 1934 provides for s u c h regulatory
framework over NBFCs. Significant amendments to this
Chapter were made in January, 1997, vesting more powers
in the Reserve Bank of India to regulate the activities of
such companies. We shall first d e a l with thc provisions of
Chapter 111 B, following by lhe importai~tprovisions o f the
directives issued by the Reserve Bank o f Irit-lia in this rcgard.
 Regulatory Framework
1) Reserve Bank of India Act, 1834 for Banks and Non-
Banking Finance
The powers vested in the Reserve Bank of India Act under Companies
Chapter I11 B of Reserve Bank of India Act, 1934 are as
follows:

i) To regulate or prohibit issue of prospectus

In the public interest, the Reserve Bank of India may regulate

or prohibit the issue by any non-banking company of any
prospectus or advertisement soliciting deposits of money
from the public. The Bank may also give directions to these
companies as to the particulars to be included in such
advertisements.

j i) To collect information as to deposits and to give direction

The Reserve Bank of India is empowered to direct every
non-banking institution to furqish to it information or
particulars relating to the deposits received by it. The Bank
may also issue directions in the public interest, to such
institutions generally, or to any institution in particular, or
group of such institutions in particular, on any of the matters
connected with the receipt of deposits. If any such institution
fails to comply with any direction, the Bank may prohibit
the acceptance of deposits by such institutions.

iii) To conduct inspection

The Reserve Bank of India may, a t any time, cause a n

inspection to be made of any non-banking institution to
verify the correctness/completeness of the particulars
furnished to the Bank or to obtain any such particulars, if
not submitted.

iv) The Reserve Bank of India (Amendment) Act, 1997, has

conferred explicit powers on the Reserve Bank of India as
follows:

i a) A new NBFC cannot operate unless it is registered with

Reserve Bank of India and has a minimum owned funds of
Rs. 25 lakhs. Reserve Bank has been vested with the power
of enhancing the minimum Net Owned Funds (NOF) of
NBFCs to Rs. 2 crore in case of companies which are
incorporated on or after April 20, 1999, and which seek
I
registration with Reserve Bank of India.

I b) Every NBFC is required to create a Reserve Fund and

i transfer not less than 20% of its net profit each year to
I such fund before declaring any dividend.
j
c) Reserve Bank of India is given the power to prescribe the
I
minimum level of liquid assets, as a percentage of the
1
t
deposits, to be maintained in unencumbered approved
securities (i.e. government securities/ guaranteed bonds).
I
Banking System and d) The Company Law Board has been empowered to direct
Money Market
NBFCs to repay deposits that have matured, if it finds
that the campany is unable or unwilling to repay the
depositors.

e) Powers have been conferred upon the Reserve Bank of

India to:

give directions to the NBPCs regarding prudential norms,

give directions to the NBFCs and their auditors on matters
relating to balance sheets and cause special audit a s
well a s to impose penalty on erring auditors,
prohibit NBFCs from accepting deposits for violation of
the provisions of the RBI Act and to direct NBFCs not to
alienate their assets,
file winding u p petition against erring NBFCs,
impose penalty directly on the erring NBFCs.

2) NBFCs Acceptance of Public Deposits (Reserve Bank)

Directions

In exercise of the powers vested in it under Chapter 111 B,

the Reserve Bank of India, issued these directions to NBFCs
regarding acceptance of deposits from the public. These
directions were substantially revised in January, 1998 ,to
include prudential norms to be followed by NBFCs. The
salient features of RBI Directions, a s further revised in
December, 1998 are a s follows:

i) For regulatory purposes, NBFCs have been classified into

three categories:

a) those accepting public deposits,

b) those not accepting public deposits, but engaged in
financial business ,
c) core investment companies, with 90% of their total assets
in investments in the securities of their group/holding/
subsidiary companies.
The thrust of RBI regulation is on kompanies accepting
public deposits (category (a) above).

ii) Public deposits have been defined to include fied/recurring

deposits received from public, deposits received from
relatives and friends, deposits from shareholders by a public
limited company and money raised by issue of unsecured
debentures and bonds to shareholders and the public.
Public Deposits exclude money raised by way of issue of
secured debentures and bonds, borrowings from banks and
financial institutions (including by way of unsecured
debentures), deposits from directors, inter-corporate
deposits, deposits from foreign citizens, deposits received
 by private limited companies from their shareholders, Regulatory Framework
for Banks and Non-
t security deposits from employees, advance receipt of lease Banking Finance
and hire purchase instalments. Companier
I
i
I iii) NBFCs with net owned funds (NOF) of less than Rs. 25
1 lakh (with or without credit rating) are not allowed to accept
public deposits.

iv) Ceilings on public deposits for NBFCs, with NOF of Rs. 25

lakh and above, have been prescribed as follows. These
ceiling limits were enforced in December, 1998. Prior to
that, these limits were based on the credit rating (effective
January, 1998). C

A) Equipment Leasing and Hire Purchase Finance

Companies

a) for unrated and under-rated (i.e. rating below the

minimum investment grade) NBFCs-1.5 times of their
NOF or Rs. 10 crore, whichever is less (provided their
CRAR is 15%, or above, as per their last audited balance
sheet).
b) for NBFCs with minimum investment grade credit
rating-4 times of their NOF (provided they have CRAR
of not less than 10% as on 31.3.1998 and not less than
12% a s on 3 1.3.1999). They are required to increase
CRAR to 15% as early a s possible.
B) Loan and Investment Companies

a) unrated and under-rated-not entitled to accept public

deposits (irrespective of their NOF and CRAR).
b) with minimum Investment Grade Credit Rating-1.5
times of NOF (provided they have CRAR of 15% or above).
Further, it has been stipulated that loan and investment
companies which do not have minimum CRAR of 15% as on
date, but other-wise comply with all the prudential norms
and

a) have credit rating of AAA may accept or renew public

deposits upto the level outstanding a s on December 18,
1998 or 1.5 times of the NOF whichever is more, subject
to the condition that they should attain CRAR or 15%
by 31"' March, 2000 and bring down the excess deposits,
if any, by December 3 1, 2000, and
b) have credit rating of AA/A may accept or renew public
deposits a s per the existing provisions of Directions (i.e.
0.5 or 1 time of their NOF), but they should attain the
minimum CRAR of 15% on or before 3 lEtMarch, 2000
a s per their audited balance sheet, failing which they
should regularise their position by repayment or
otherwise by December 3 1, 200 1.
Banking System and The above benefit will not be available to those companies
Money Market
whose CRAR is presently 15% and above but slips down
below the minimum level of 15% subsequently.

v) The maximum permissible interest rate on public deposits

has been fixed a t 16% per annum. NBFCs can pay uniform
maximum brokerageof 2% on deposits for 1 year to 5 years.
!
Brokers may also be reimbursed other expenses not
exceeding 0.5% of the collected deposits. i
II
vi) Only those NBFCs, which are accepting public deposits,
are required to submit to Reserve Bank annual statutory
returns and financial statements. Other NBFCs are
exempted from this requirement.

3) Prudential Norms for NBFCs

Reserve Bank of India issued guidelines prescribing the

prudential norms for NBFCs in June, 1994. Companies acc-
i
epting public deposits
- have to comply with all the guidelines,
?
while leasing, hire purchase finance, loan and investment
companies, not accepting public deposits, are required to
comply with prudential norms other norms on capital
adequacy and creditlinvestment concentration. Similarly,
investment companies holding not less than 90% of their
assets being securities of their group/holding/subsidiary
companies and not accepting public deposits are exempted ]I
from prudential norms, These guidelines are a s follows:
1
1
i) Income Recognition 1
NBFCs are required not to take into books income due but
not received within a period of six months, till it is actually
received.

ii) Classification of Assets

NBlFCs are required to classify their assets a s non-performing

assets if payment of principal/instalment is due but not I

received within six months. For leasing, hire purchase finance

companies such assets are to be treated as NPAs, if lease
rentals and hire purchase ilistalments remain past due lor 1
12 months. Guidelines regarding classification of assets into
4 categories and provisioning issued to commercial banks,
are applicable to NBFCs also.

iii) .Capital Adequacy Norm

In January 1998, the capital adequacy requirement for

NBFCs with net owned funds of Rs. 25 lakhs and above and
having public deposits had been raised from 8% to 10Y0
(effective 3 1.3.1998), and further to 12% (effective 3 1.3.1999).
The composition of capital and risk weights attached to
assets and conversion of off Balance Sheet items are the
samg a s applicable to banks.
iv) Credit/ Investment Concentration Norms Regulatory Framework
for Banks and Non-
Banking Finance
Registered finance companies are required not to lend more Companies
than 15% of their net owned funds to a single borrower and
not more than 25% of their owned fund; to a group of
borrowers. These limits are also applicable to investment in
a single company or a single group of companies. Composite
limits of credit to and investment in a single company or a
single group of companies have been prescribed a t 25% and t
40% respectively of its owned funds. NBFCs are not permitted
to lend on the security of their own shares.

The ceiling on investment in unquoted shares of companies

other than their group/subsidiary companies has been fixed
a t 10% of their owned funds for equipment leasing and hire
purchase finan'ce companies and 20% of the owned funds
for loan and investment companies.
NBFCs are advised not to invest more than 10% of their
owned funds in land and building except for their own use.

NBFCs are requied to dispose off excess of the assets over

the indicated ceilings within three years.

v) Liquid Assets

NBFCs are required to maintain certain percentage of their

deposits in liquid assets to ensure their liquidity and to
safeguard the interests of the depositors. With effect from
January 2, 1998, the ratio of liquid assets is uniform for all
NBFCs accepting public deposits. It has been prescribed a t
12.5% with effect from April 1, 1998 and a t 15% with effect
from April 1, 1999. The liquid assets are to be maintained
with relation to public deposits only.
NBFCs are required to keep Government securities and
Government guaranteed bonds in the custody of a scheduled
bank at the place of its head office. These securities are
permitted to be withdrawn for repayment to depositors or
for replacing them by other securities or in the case of
reduction of deposits.

The above account shows that the Resewe Bank of India has
instituted a comprehensive regulatory framework for NBFCs.
Out .of 8802 applications of NBFCs which were eligible for
registration on the basis of Minimum Net Owned Funds of
Rs. 25 lakh, registration has been granted to 7555 NBFCs.
Out of them only 584 NBFCs have been permitted to accept
public deposits. Applications of 1030 companies have been
rejected. 28676 companies with NOF below Rs. 25 lakh
have been given time upto January 8, 2000 to achieve the
minimum NOF. T h u s , a n e r a of consolidating a n d
strengthening the Non-Banking Financial Companies has
commenced and better results may be expected in future.
Banking System ar Check Your Progress 2
Money Market

1) Identify the powers vested in Rbl under Chapter 3, I11 B of

RBI Act 1934.

2) State whether following statements are true or false:

i) NBFCs with owned fund of less than Rs. 25 lakh are not
allowed to accept public deposits. (T/ F)
ii) For regulatory purpose NBFCs have been classified into
four categories. (TIF)
iii) Unrated a n d under-rated loan a n d investment
companies are not entitled to accept public deposits.
(TIF)
iv) NBFCs are advised not to invest more than 10% of
their owned funds in Land and building except for
their own use. (TIF)

3) Are Non-Banking Finance Companies required to observe

capital adequacy and creditlinvestment concen.tratioc
norms? Why?

6.6 LET US SUM UP

In this Unit we have studied the regulatory framework under
which the banks and non-banking finance companies in
India function. There are two regulatory authorities in this
field, viz. the Reserve Bank of India and the Securities and
Exchange Board of India. They have been entrusted with
the responsibilities of development and regulation of the
money market and capital market respectively.
b

The Reserve Bank of India is the regulatory authority over

the commercial banks, co-operative banks, non-banking
finance companies and the financial institutions. It derives
its powers from the Reserve Bank of India AcL, 1934 and the
Banking Regulation Act, 1949. Exercising its discretionary
powers, the Reserve Bank of India issues directives to these
institutions from time to time. In this Unit, we have studied
institution-wise regulatory framework.

Reserve Bank exercises control over the commercial banks

through the provisions of the Banking Regulation Act, 1949,
relating to licensing of banks, opening of branches,
establishment of subsidiaries, paid-up capital, maintenance
of liquid assets. Reserve Bank of India h a s the power to
inspect the banks, to issue the directives, to exercise control Regul atory Framework
for Banks and Non-
over the top management and advances granted by them. Banking Finance
Cash Reserves are maintained by banks with the Reserve Companies
Bank of India under Section 42 of the Reserve Bank of India
Act, 1934. Reserve Bank of 11;dia has also issued directives
regarding priority sector advanced, capital adequacy ratio,
exposure norms, assets classification, provisioning, etc.

Co-operative Banks are under the dual cchtrol of the State

Government concerned and the Reserve Bank of India.
Reserve Bank of India has been vested with the powers to
regulate the non-banking finance companies and the financial
institutions. Directives have been issued by Reserve Bank
of India to NBFCs regarding acceptance of public deposits
and Prudential Norms have been prescribed for both NBFCS
and financial institutions.

6.7 KEY WORDS

Call/Notice/Term : These are three sub-divisions of the
Money Market money market. When funds are
lent for very short-period of time,
say a day or two, or are repayable
on call by the lender, it is called a
transaction in the call money
market. Banks are generally parti-
cipants in call money market.
When funds lent are repayable
after a short notice or 3 or 7 days,
it constitutes notice money market.
When iunds are lent for a fixed
but short period, say 15 or 30 days,
it is term money market.

Cash Reserve Ratio : Banks are required to maintain a

certain percentage of their net
demand and time liabilities as cash
balance with Reserve Bank of India.
The statutory minimum ratio is 3%,
but Reserve Bank of India can raise
it upto 20%. At present it is 5.0%
(effective from J u n e 1, 2002).

Capital Adequacy : Reserve Bank of India has laid down

Norms this norm for banks and financial
institutions to ensure that they
possess adequate capital funds of
their own, vis-a-vis their assets,
which are adjusted for the risk
involved therein.

Credit Rating : Credit Rating is a symbol assigned

A bv Credit Rating. A~encvto a debt
 i

instrument of a company like bond, !

debentures, fixed deposits a n d i
commercial paper, depicting the I
quality of the instrument in terms
of safety of principal and possi-
bilities of payment of interest etc.

Exposure Norms : These norms are also fixed by

Reserve Bank of India for banks and
financial institutions. These norms
lay down the maximum limit on
advances to be granted by a bank/
non-banking company or financial
institution, together with any other
stake undertaken by them in respect
of one single borrower and/or a
group of borrowers. This norm is
expressed as a percentage of the
net-owned funds of the bank/FI.
Such norm is also laid down by a
bank's exposure in a single industry.
Its purpose is to restrict the banks
from over-lending to a single borro-
wer/group of borrowers.

Liquid Assets : Banks maintain a certain portion

of their deposits in c a s h with
themselves or in current account
with other banks or with Reserve
Bank of India. Besides, they invest
in gilt, edged securities also which
can be converted in cash easily.
Such assets of a bank are called
liquid assets.
Money Market : Money Market is that segment of
t h e financial m a r k e t wherein
transactions in short-term funds
are undertaken, i.e. where funds
are low and borrowing is for short:
periods.

Nationalised Banks : There are 19 Commercial Banks in

India which are nationalised banks.
The ownership of such banks ia
vested in Government of India. A
few of them have in recent years
issued capital to the public also.
,
Priority Sector : Reserve Bank of India has desigl-
1
nated certain sectors of the economy
as priority sectors. Banks have been
asked to provide at least 40% of their
credit tn these s ~ r t n r s These sertnrn
 include small industries, export, latory Framework
1gu1
for Bank8 and Non-
small business and small trans- a

Banking Pinanae
porters and self-employed persons Companies
a n d s o on. These sectors h a d
remained neglected by the banks in
the past.
Prudential Norms : To improve the financial position
of the banks and their efficiency
and productivity, Reserve Bank of
India has prescribed certain norms
(i.e. principles or standards) to be
followed by banks. These norms
are called prudential norms as they
are intended to lead to prudential
practices.
Repo a n d Reverse : Repo means repurchase. A person
Repo Deals or institution may borrow money
for a short period on rep0 basis
also. It means that he sells to the
lender h i s securities with t h e
condition that he may buy back
his securities within a certain
period and repay the amount of
the loan taken/sale proceeds of the
security. In such case, he will pay
interest for the period for which
he has utilised the money. It is
called 'repo rate'.
'Reverse repo' is opposite to 'Repo'.
In this case the lender lends the
money (or purchases the securi-
ties) on the condition that he may
sell the securities back to the same
person, who shall take them back
and pay the 'reverse repo' rate to
the lender.
I Selective Credit : Reserve Bank of India has the
Control power to issue directives to the
banks determining the amounts,
terms and conditions, the rate of
interest etc. on advances granted,
on the security of selected commo-
dities. Such directives are called
selective credit control directives.
;
Statutory Liquid : Reserve Bank of India prescribes a
Ratio (SLR) '
ratio of liquid assets to net demand
and time liabilities of a bank. Such
rstio is called SLR. At present it is
25% (i.e. minimum prescribed by
law).
 UNIT 23 DISINVESTMENT POLICE
A CASE STUDY OF INDIA
Structure
23.0 Learning Outcome
23.1 Introduction
* 23.2 Disinvestment:Central Public Enterprises
23.3 Disinvestments: State-Level Public Enterprises
23.4 Disinvestment Policy: Analysis andRecomnendations
23.5 Conclusion
23.6 Key Concepts
23.7 References and Further Reading
23.8 Activities

After studyingthis Unit, you should be able to:

Understand the policy process of disinvestments in India-i ts change over the years;
e Discuss the disinvestmentsof Central Public Enterprises;
'2
e Explain an overview of disinvestrnentsand restructureof the State-Level Public Enterprises
in various states in India; and
s, e Bring out major recommendations and analysis of the disinvestmentpolicyprocess in India.

This Unit analyses the strategy,economics, and administrativeexercise behind the policy process
-tdisinvestments of public enterprises. It discusses, in brief, the methods of disinvest~nentsand
provides a profile of the nature of enterprises and the financial gains to the government. In addition,
this Unit highlights the progress made so far and what lies ahead on the road to privatisation and
disi nvestments.
Public enterprises are incorpol-atedorganisations,set up under various statutes, wherein government
has equal to or more than 5 1per cent of the sharecapital. There are 236 Central Public Enterprises
(CPEs), having a capital of Rs. 2,02,000 crores and gross profitability of 14.53 percent; and 911
State-Level Public Enterprises (SLPEs) with Rs.2,21,600 crore capital, most of them with negative
contribution. In addition, there are departmental enterprises, which are not incorporated; these I
I
include Railways, Postal Department, and Ordinance Factories. This Unit relates to disinvestments
I
of CPEs and SLPEs only. I
Disinvestment of shareholding in public enterprises by government may be a part of economic
reform of the country or/and is in response to the demands of various financing or donor agencies.
Disinvestment, a form of privatisation, has been resorted to by a number of countries including
India. It refers to the offer of shares or equity to the financial institutions or the public. There are
various methods of disinvestments, which are presented as under:
I
 Public Policy and Analysis

Disinvestment- Methods
* Public Floatation => requires k Developed Capital Market
.4 Profitable P E

+ Mutual Punds/FIIs
Private Placement => by offering .-
shares to + Voucher System

Employee/ MGT Buyout

+ Strategic Sale
Trade Sale + Share Buy-back
k Share Cross-holding

The auction disinvestments process is relatively less cumbersome; it involves less administrative
expenses, and results in higher realisation. Among the disinvestments methods, private sector
companies that involve high publicity, other floatationexpenses, and net proceeds noimally follow
public floatation. Trade investment method is suitable for industries of specidised nature, like
telephone or telecommunication,electricity generation, or airline. Piggyback method increases the ,

size of the issue and is reported to be quicker and less expensive. 3.

This Unit attempts,in the first part, to portray and malyse the disinvestments of CPEs. Further, in
the second part, it: presents the analysis of restructure and disinvestmentmeasures of SLPEs in.
various states.

23.2 DISINVESTMENTS: CENTRAL PUBLIC a

ENTERPRISES
B
Disinvestments of government shareholdings in Central Public Enterprises (CPEs) started in
1991-92 as an integral part of the process of economic reforms. The total realisation from
disinvestments up to2004-05, from about 50 enterprises, had been Rs. 47,645 crores against the
target of Rs. 96,800 crores.
Aprofile of the CPEs in terns of their profitability and seryice or manufacturingactivity is given z
under: I

Table 23.1: Number of Central Public Enterprises

r
Public Enterprises Manufacturing Services Total.
Profit Making 81 51 . 132
U
Loss Making 79 23 102 I

No-profit no-loss 1 1 2 I

i.
Total 161 75 236 '

Throughout, disinvestmentshad been apart of annual budgetary exercise of the government, and
9
year-wrse realisation and target are given in table 23.2
 1 Disim~e.~tinent
Policy: A Case Study of' India 297

I Table 23.2: Disinvestment in Central -P ublic Enterprises (CPEs)

Year Target (Rs. Crore) Achievement (Rs.. Crore)

2,500 3,038
2,50 1,913
3,50 @ clisir?vesti~zentsproceeds
received iiz 1994-05
1994-95 4843
1995-96 168
1996-97 380
1997-98 910
1998-99 5,3,71
1999-2000 1,860
200 1-01 1,871
200 1-02 5,632"
2002-03 3,348
2003-04 15,547
2004-05 2,764
TOTAL 47,645

proceeds of six enterprises were received next year, i .e.1994-05

@Disinvestme~~t
'''Includes amount rertlised by way of control premium, special dividencls and transfer of surplus cash
t reserves prior to disinvestments.
Sources: ' Department of Disinvestment web-site- www.disinvest.gov.in/disinves~Eco~zon~ic
S~irvey,
8 Government of India
~isinvkstmentsof the Central Public Enterprises (CPEs) holdings by the government over the
years could be analysed by gro~lpingthem under four periods, as presented it1the following table.

able 23.3: Disinvestrnents of CPEs

During 1991-92 to 2004-05

Period Targets (Rs. Crore) Actual Receipts (Rs. Crore)

Phase I 29,300 11,251

Phase I1 5,000
1998-99
Phase 111 - 58,500 . , 28,258 @
1999-00 td 2003-04
Phase IV 4,000 2,768
2004-05 onwards
TOTAL 96,800 47,645
 298 Public Policy and Analysis

Characteristics of disinvestmentsfor the four periods are as under:

-
i) Period I 1991-92 to 1997-98
CPEs disinvestments got a-boost from the Industrial Policy of 1991, and as a part of economic
reforms, government holdings in selectedpublicenterprises were to be disinvested up to 20 per cent
of equity in mutual funds, investment institutionsin public sector,including sale or transfer to employees
of these Cnterprises. Disinvestment was pursued in order to raise resources; introduce market
sensitivityto improvethe perfoimanceof the enterprises and; for attracting wide public participation.
Disinvestment process involved auction under which bids were invited for shares having arnini~num
reserve price for each script - except that in the first year, bids were invited for a 'bundle' of
shares, with each bundle comprising of nine 'very good , 'good' and 'average' companies. Bids
7

were initially opened to public sector banks, insurance companies, UTI. Bids were opened to
private agencies during 1992-93 and to approvedForeignInstitutionalInvestors (FlIs) also from
1993-94 onwards. The government had not laid-down any minimum number of shares offered for
sale and there was jlo underwriter as had bcen the practice in the UK.
7

Disinvestment was a part of annual budgetary exercise and the sale process was to be carried out
during the period of validity of the buaget. ADisinvestment Commission was set up in 1996 as an
advisory body to draw up an overall long-teim disinvestmentprogramme for the Public Enterprises
(PEs) referred to it; or to determine the extent of disinvestments and to recommend the preferred
model(s) of disinvestments in the overall interest of shareholders, employees and other stakeholders.
As an advisory body, the Commission identified enterprises for disinvestments;laid down the
extent and mode of disinvestments and issues relating to grant of autonomy.By August 1999, the
Commission made recolmendations on 58 PEs and the recomme~ldationsindicated, as discussed a

later, a shift from public offerings to strategic/tradesales with transfer of management.

Disinvestment during the early period led only to sale of 'fractional equity' of selected enterprises e
without any change of management, controlor ownership.In fact, disinvestmentshad been confined
~nainlyto profitable enterprises and that too about half of the total realisation had been from the
flisinvestments of five enterprises, namely, BPCL, HPCL, SAIL, ONGC, MTNL,Still, such sale
of fractional equity did not result in privatisation of PEs, nor did it bring in positive effects like
managerial autonomy, or introduction of market forces, as there was very little trading for such
securities listed on stock exchanges. @

TO c~uotefrom The Ekonomist (1999, "Partial disinvestmentsof equity jn flie public sector enterprises
fails to address the efficiency problem,it has no impact on ownership, control andmanagement..,.It
has been used more as a fiscal tool in order to raise cash to finance the government deficit, rather
I
than to improve the efficiency af enterprises operations.. ..There is also the danger that such an
approach can be a temptation to privatise badly, and to postpone the more difficult but much
neededlonger tern fiscal reforms".
In short, this period of disinvestments had a 'passive' or 'silent' approach having no visible o r
significant impact on economic reforms.
-
ii) Period I1 Year 1998-99 P

In the budget speech for the year 1998-99, the then Finance Minister also referred to government
decision of bringing down the governmentshareholdings in public enterprises to 26 per ceG other
than enterprises of strategic importance and in the case of enterprises involving strategic
considerations, the government was to continue to retain majority holding.
Duringthe year, there were different alternative proposals of disinvestments which includedSpecial
'
Purpose Vehicle (SPV), sale of shares to financial institutions, buy-backof shares and share cross-
Disirzvestil~.er~t
Policy: A Case Study of lrzdin
299

holdings. Disinvestment during the year was mainly through shares cross-holding among IOC,
ONGC and GAIL.
This strategy of equity swap, first of its kind, which was expected to have synergic effect on the
enterprises' operations, had a dampening effect on the prices of the scripts swapped.
Further, as in the earlier period, the disinvestments had no positive effect on economic reforms.

-
iii) Period111 1999-00 to 2003-04
The expression 'privatisation' was used-for the first time in the budget speech for the year 1999-
2000. The policy towards public sector enterprises was to encompass a judicious mix of
st{-engtheningstrategic units, privatising non-strategic ones through gradual disinvestrnents or a
strategic sale, and devising viable rehabilitation package for weak units. For purposes of
disinvestments, public enterprises (F'Es) were classified as strategic and non-strategic,and following
were reserved as strategic areas:
Arms and a m ~ ~ n i t i oand
n s allied items of defence equipment,defence air crafts and warships;
Atomic energy (except in certain areas); and
e Railway transport.
List of CPEs under the strategic list are given in table 23.4. Thirteen CPEs in the strategic list
include four enterprises, which were earlier(1996) referred to the Disinvestment Commission (but
later wi tl~drawn)m d of which one had been referred to the BIFR. b

Table 23.4: List o f CPES Under the Strategic List

SI.No. 1 Name Industry

"'"Hindustan ~eronauticsktd. Transp. Equip.
Airports Authority of India. Transp. Equip.
'*
*B hniat Electronics Lfd.
d
M & L Engg.
Nuclear Power Corpn. of Jndia Ltd. Power
B harat Dynamics Ltd. M & L Engg.
"Garden Reach Shipbuilders. and Engg. Ltd.
Indian Rare Earth Ltd.
Transp. Equip.
Minerals B Metals
Transp. Equip.
I
*Bharat Earth Movers Ltd.
Mazagon Dock Ltd. Transp. Equip.
Uranium Corporation of India Ltd. . Minerals & Metals
Antrix Corporation Ltd. M & L Engg.
Mishra Dhatu Nigam Ltd. Steel
Konkan Railways Corp. Ltd. Contr. & Constr. Serv.

* Withdnrwn jiroin the First List (September 1996) to Disinvestment Commission.

*"' Withdrawn from the First List (September 1996) to Dkhvesbnent Commission. Referrid to BlFR.
Source: http://www.disinvest.gov.in/disinves~J

All other PEs were to be considered non-strategic and for these reduction of government stake
would not be automatic and the manner and pace of disinvestments would be decided on a case
by case basis, However, decision as regards the percentage of disinvestments, that is, to bring
down government stake to less than 51 per cent or to 26 per cent were to be taken on &e basis of
the fbllowingconsiderations:
 300 Public Policy and Analysis

rr Whether the industrial sector requires the presence of tl~epublicsector as acountervailing

force to prevent concentration of power in private hands?
9 Whether the industrial sector requires a proper regulatory mechmism to protect the consumer
interests before public enterprises are privatised?
F~tr-ther,during 2000-01, it was decided to reduce governmentstake in non-strategic CPEs even
below 26 per cent. However, disinvestments during this period were characterised as 'strategic'
sale, whereby, a substantial stake in an enterprise was sold along with the management conwpl to
a bidder who was expected to complement the existing strength of the enterprise with a view to
impart a long-term viability.
A Department of Disinvestment was established in 1999 under the charge of a Minister to lay
down a systematic policy approach to disinvestmentsand privatisation, and to give an impetus to
the disinvestmentprogranme. After this, there had been a strategic sale of shares, of a number of
PEs, resulting in the transfer of management control and also privatisation of enterprises. These
enterprises included, Modern Food Industries, Hindustan Zinc, IPCL, BALCO, CMC, VSNL,
IBP, PPL, WL. Details of strategic sale of PEs are pesented in Table 23.5.In addition, there are
a number of enterprises, which are on the anvil of disinvestment; these are listed in table 23.6.

Table 23.5: Strategic Sale - Central Public Enterprises

S. Public Enterprise Equity Accru- Buyer Paidup Net Employe-
Na als Capital@ Worth@ es@
Sold % (Rs. (b. (Rs. (Nos.)
Crores) Crores) Crores)
I Lagan Jute Machinery 74 2,53 76.53 . . 5 395
Company Ltd. (LJMC)
2 Modern Food Industries Ltd. (MFIL) ,
100 149 HLL 30 2301
3 Bharat Aluminium Company Ltd. 51 826.5 Sterlite 489 913 7294
@ALco) Inds
4 CMC Ltd. (CMC) ,51 158.07 Tatas 15 46 3025
5 HTLLtd. (JTIL) 74 55 Himachd 15 45 1171
Futuristic
6 IBP Ltd. (IBP) 33.58 1153.7 IOC 22 310 2723
7 Videsh Sanchar Nigam Ltd. (VSNL,) 25 . 3689 Tatas 95 542 2975
8 Indian Tourism Development Corpn. 4441 BhiutltHotels 67 264 7890
(ITDC)19 Hotels & Others
9 Hotel Corp. of IndiaLtd. (£XI)
3 Hotels 242.51 40 57 4066
10 Paradeep Phosphates Limited (PPL) 74 151.7 Zud- 337 337 1O!X
Maroc
11 ' ~ e s s o ~ 72 18.18 RuiaCotex 87 88 3285
12 Hindustan Zinc Limited (HZL) 4492 775.07 SterljteInds 422. 980 11,851
13 lPCL 26 1490.8 RIL 248 3030 13,402
14 Maruti UdyogLimited (MUL) - 1000 Suzuki
15 STC 40*
16 MMTC 60*
1
m J
9
.

' Sources: Department od Disinvestment site- http://www.disinvest.gov.in.disinvest~

Economic Surveys previous years
@ Public Enterprises Survey - Vol I to 111- 1999
qeceipts on account of transfer of cash reserves
Disinvestr~entPolicy: A Case Study of India 301

Table 23.6 : Other CPEs which are on the Anvil for Disinvestment

. SI.No. Name of the Organisation

Air-India Limited (AI)
Engineering Pro-ject(India) Limited (EPIL)
Hindustan Cables Limited (HCL)
Hindustan Copper Limited (HCL)
Hindustan Organic Chemicals Limited (HOCL)
Hindustan Salts Limited (HSL)
Indian Airlines Limited (IA)
Madras Fertilisers Limited.(MFL)
Minerals and Metals Trading Corporation of India Ltd. (MMTC)
National Fertilisers Limited (NEL)
Shipping Corporation ofIndia Limited (SCI)
Sponge Iron India Limited (SIIL)
State Trading Corporation of India Limited (STC)
MECON Limited
National Aluminium Company Limited (NALCO)
Tungabahadra Steel Products Limited (TSPL)
Burn Standard Company Limited
- Braithwaite and Company Limited
BPCL
HPCL
Source: Economic Survey, Government of India

A strategic sale agreement normally contained safety provisio~lslike, 'claw back' provision, or
'post-closure adjustment' or provisions for the use of assets, or terms of employment for the
existi~igemployees of the unit divested.The claw back provision gives aright to the to
share in future profits and specify the period of such sharing. Similarly, the post-closure acljustlnent
clause entitles the successful bidder to claim refund for the losses incurred by the enterprise from
the date of last published financial results till the date when the bids were invited from the bidder.
Estimated refunds on account of post-closure adjustment in respect of I3ALCO and MPIL were
Rs. 8 crores and Rs. 16 crores, respectively, In addition, the government hadcollected special
dividends from certain cash-rich enterprises, like VSNL, MMTC, STC, EIL, and also control
premi~~m for MUL; these arc included in the disinvestme~ltrealisations shown in tables 23.2,23.3
and 23.5. Strategic sale as shown in table 23.5 included three enterprises (namely, PPL, LJMC,
MFIL) 111nning into losses, and it resulted in disinvestment proceeds oERs. 10,257 crores, acco~~nting
for transfer of approximately 40 per cent of total equity of the enterprises.
I11 short, government's policy towards public sector was aenplified in the budget speech of the
Finance Minister for the year 2000-01. It elaborated on disinvestment/privatisation/publicsector
restruchlring as:
e Restructure and revive potentially viable PEs,
e Close down PEs, which cannot be revived.
Bring down government equity in allnon-strategic PEs to 26 per cent or lower, if neeessay.
0 Fully protect the interests of workers.
 302 P ~ ~ b l Policy
ic and Analysis

Government policy towards public sector and disinvestments is well portrayed by the address of
the then President, Shri K.R. Narayanan, to the Joint session of the Parliament in Februaiy, 2002.
Excerpts from the address are: "The public sector has played a laudable role in enabling our
country to achieve the national objective of self-reliance. However, the significantly changed
economic environment that now prevails both in India and globally makes it imperative for both the
pub1ic sector and the private sector to become competitive. Learning from our experience, especially
oves the last decade, it is evident that disinvestments in public sector enterprises is no longer a
matter of choice, but an imperative.The prolonged fiscal haemorrhage from the majority of these
ente~prisescannot be sustained any longer. The disinvestrnents policy and the transparent proced~~res
adopted for disinvestments have now been widely accepted, and the shift in emphasis from
disinvest~nentsof minority shares to strategic sale has yielded excellent results. The Government
has taken two major initiatives to improve the safety net for the workers of PSUs. The first enhanced
VRS benefits in those PSUs where wage revision had not taken place in 1992 or 1997. The
second increased training oppol-tunities for self-employn~ent for workers retiring under VRS."
Similarly, the privatisation policy of the government as summarised in a statement laid before the
Parliament on December 9,2002 states, "... the inain objective of disinvestlnent is to put national
resources and assets to optimal use and in particular to unleash the prod~~ctive
potential interest in
our public sector enterprises".

iv) Period IV- 2004-05 Onwards

During this period, the government stated its policy of commitment towards a strong and effective
public sector, and that profit-making public enterprises, in general, were not to be privatised;
disinvestments was to be made for a fractional equity holdings; and the earlier policy of strategic
sale was shelved. A National Investment Fund (NIF)was constituted into which the realisation
from the sale of minority shareholdings of the government in profitable PEs was to be channelised.
The NIF was to be maintained outside the Consolidated Fund of India and was to be used for
social sectors like education, health care, and employment or for reviva1,of PEs. The disinvestment
proceeds during the period were Rs 2,764 crores against the target of Rs 4,000 crores. The
psoceeds were mainly froin the disinvestments of 5.25 per cent shares of NTPC by adopting the
'piggy back' method.
Thus, disinvestments of CPEs over the years 1991-92to 2004-05 yielded Rs. 47,645 crores
against the target of Rs. '96,800 crores, and a greater part of it was realised in the later years, with
the adoption of the policy of strategic sale of enterprises. The strategic sale resulted in transfer of
management control of the enterprises to the strategic buyer, though this process of disinvesbnents
hid not been without controversies and resistance from employee unions and local government
a~~thorities. The resistance was mainly on politicakgrounds and less on economic considerations.
The Supreme Court observed, in its order dated December 10,2001, with regard to BALCO
disinvestments: "Thus, apart from the fact that the policy of disinvestments cannot be questioned as
such, that the facts herein show that fair, just and equitable, procedure has been followed in cillrying
out this disinvestments". Similarly, dfference within the government,and more specifically between
the Disinvestmentsand Petroleum ministries on the quantum of shares to be off-loaded and mode
of sale, or giving 'strategic' status to certain oil companies, and other details. This highlights the
need for political as well as economic justifications of strategies towards disifivestrnents. .
Political justification of disinvestments warrants that resources are to be owned and managed by
people, commonly known as 'popular capitalism' as in the UK. It goes by the principle that
government should not interfere in the management of business; rather it should concentrate on
'governance' or regulatory function. It raises a question, is there a political consciousness of
I Disinvestment Policy: A Cast. Study of Irzdia ' 303

disinvestrnentsamong the various major political parties in the countty? Or is there political mandate
on disinvestments or controversies on disinvestmentsof BALCO or HPCL or BPCL? Or whether
prior Parliament approval is requiredfor disinvestments of enterprises, which were set up by
Parliainentary enactment? Or was there any resistance by state governments when the project had
been earlier cleared by the Central governmenl? All these issues emphasise the need for political
justification.
Disinvestment can be justified on economic grounds as it lessens the burden on governmentfinances.
It is also expected to lead to faster economic growth by facilitating technology up-gradation through
investment by the private sector in public enterprises whose performance isbelow par. Further, it
encourages greater professionalism in the management of enterprises and frees them from poli tical
interference and bureaucratic shackles. Disinvestment would also enable government to inobilise
funds, which could be used to reduce debt burden or to take up projects of social and community
welfare.

23.3 DISLNVESTMENTS: STATE-LEVEL PUBLIC

ENTERPIUSES
Various state governments initiated steps for privatisatio~~/liquidation/restructure of their public
enterprises. As mentioned earlier, 911 state-level public enterprises (SLPEs) were estimated to
have an investment of Rs. 2,21,653 crores. Table 23.7 presents details of investment and status of
working of PEs in various states. Data from table 23.7 shows that a sizeable number of SLPEs
(about 63% of the total) were non-working or were running on losses, for Haryana, Rajasthan,
and Andhra Pradesh the corresponding percentages were 3 1,38 and 55 respectively. For the
other states (Maharashtra, West Bengal, Orissa, Madhya Pradesh, Punjab, Himuchal Pradesh,
Assam) the proportion of the non-working or loss-making enterprises was around two-thirds of
the total. Aggregate data for all the states reveals that about 37 per cent of the non-working or loss
makingenteqrises were identified for restructure (privatisationldisinvestrnentSAiquidation);the ratio
was on the higher side for states like Andhra Pradesh, Karnataka, Orissa, Madhya Pradesh,
Himachal Pradesh and Haryana. This indicates that alarge number of states were activelyconsidering
restructuring of their PEs and have in fact initiated steps towards PE reforms. It should be noted
that a very small number of enterprises in Rajasthan and Tamil Nadu wererunning on proFits.
Accumulated losses fro~nPEs for all the states put together were approximately 14 per cent of the
total investment.
A number of states had initiatedeconomic reforms or.PE reforms, including their restructure,and
some had appointed disinvestrnents commissions,These states include, Andhra Pradesh, Gujwat,
Haryana, Himachal Pradesh, Jammu and Rashmir, Karnataka, Maharashtra, Manipur, Osissa,
Punjab, Rajasthan, Tamil Nadu, and Uttar Pradesh. Further, states like Andhra Pradesh, Orissa
and Madhya Pradesh have been utilising assistance from multilateral agencies Iike the World Bank,
~ s i a Development
n Bank, and DFID for PE restructure or VRS for employees. Most of the states
have been utilising financial assistance from B.I.F.R. States like Andhra Pradesh Karnataka,
Maharashtra, West Bengal, MadhyaPradesh, Pulljab, Rajasthan and Orissa had initiated measures ,
towards privatisationor disinveitments. Despite the SLPEs being adrastic drain on stateresources,
a number of states had sizeable budgetary outgo on SLPES in terms of grantslsubsidies, guarantees
and waiver of dues and conversion of loans into equity. For six states, these amounts are estimated
at Rs. 7,961 crores for the year 2000-01, the corresponding figures for the years 1998-99 and
1999-2000 were Rs. 4,694 crores and Rs. 4,652 crores, as'shown in table 23.7.
 Public Policy and Analysis

Table 23.7 : Budgetary Outgo: Grants/Subsidies, Guarantees,

Waiver of Dues and e on version of Loans into Equity
(Rs. In Crores)

State 1998-99 1999-2000 2000-01

Assam 155 92 117

Haryalla 694 848 1206
Karnataka 1341 1771 3974
Kerala 371 269 211
Orissa 336 279 98
West Bengal 1797 4647 2355
7

TOTAL 4694 4652 7961

Salient features of restructure of SLPEs in various states are as under:

i) Rajasthan
There were 24 SLPEs having an investment of Rs. 11,576 crores, and only 15 were sl~owing
profits.The Re-organisation, Strengthening and Disinvest~nentsCo~nrnitteestudied 21 LSPEs,
and the government decided to close/privatisesix enterprises.

ii) Uttar Pradesh

The State has 4.1 SLPEs &it11a total investmentof Rs. 17,773crores, of which approximately 30
per cent had been lost; and as a step towards economic reforms, 27 SLPEs wcre identified for a

disinvestments or restructure.

iii) Haryana A.

The State has 41 SLPEs with a total investmentof Rs. 443 crores, of which approximately 87 per
cent was estimated to have been lost. Fourteen enterprises were non-functional or were running
on losses, and 22 enterprises were identifiedfor disinvestments, restruchtl-ingor winding up and a
number of these had been closed after sanctioning VRS benefits to employees.

iv) Himachal Pradesh

There were 21 SLPEs involving an investment of Rs. 3,143 crores and of these 15 enterprises
Nere identifiedfor disinvestments or restructuring, and many enterprises were non-functional or ,
I

were running on losses. L

a
The State has 53 SLPEs with total investmentof Rs. 12,425 crores; of these 25 enterprises were
running on losses and 23 were non-functional.Five enterprises were closed down and leasing out
to private parties through managementcontracts; and privatised a few others.'

vi) Madhya Pradesh

I
There were 26 SLPEs with a total investment of Rs. 7,923 crores, of these 23 were either running
on losses ornon-functional.Fourteen enterprises were identifiedfor disinvestments with assistance
from the ADB for VRS or a social safety net programme.
Disilzvestnzent Policy: A Case Stcldy of India

vii) Orissa
There were 68 SLPEs, with an investment of Rs. 9,796 crores; of these 52 enterprises were either
non-working or were running on losses. The amount of losses was estimated to be 12 per cent of
Lhe investment. Twenty seven enterprises were identified for disinvestments, and a number of
lneasures including reforms in the power sector, had been initiated.

viii) Maharashtra
There was a total investment of Rs. 19,186 crores in 65 SLPEs in the State; of these 60 were non-
working or were running on losses. The S late Government decided on disinvesh~~ent, with reduction
of government holdings to 49 per cent, which was later reduced to 26 per cent. In addition, a
number of entei-prises were identified for restiucturing.

ix) Gujirat
These were 54 SLPEs, having an iilvestmellt of Rs.23,438 crores, and of these 24 enterprises
were identified for restructure or disinvestment. Of the 24 enterprises identifiedfor disinvestment,
six loss-making enterprises were to be closed along with VRS to employees. Full privatisation was
proposed for four enterprises and partial privatisation for four others. 'It was also decided to
provide social safety net through VRS to employees.

x)' Tamil Nadu

Of the 59 entel-prises,with a total investment of Rs. 6,192 crores, only 26 were showing profits.
The government decided to set up DisinvestmentsCommission for disinvestmentsof profit-making
en telprises and privatisation of loss-making ones. As a step towards restructtlring PEs, seven units
of Tamil Nadu Srnall Industries Co~porationwere closed: and 21 State Transport Corporations
were reorganised into seven units.

xi) Andhra Pradesh

There were 128 SLPEs with an investment of Rs. 48,794 crores, of which Rs. 2,919 crores had
been lost. Fifty five per cent of the enterprises wereeither mlning on losses or were non-functional.
Many enteiprises have been disinvested, granting VRS to 16,436 employees.

xii) Kerala
Though a small state Kerala had 109 SLPEs, with a total investment of Rs. 9,805 crores, and of
these 65 were either non-functional or were running on losses.

xiii) Karnataka
Of the 82 SLPEs, having an investment of Rs. 21,209 crores 33 were earning and generating
profits, and the remaining ones were either running on losses or were not functioning. As part of
the exercise in economic refoms the state has identified the SLPEs, which have become arecurring
burden on the state exchequer. Following this, the ariat taka ~overnment has decided to privatise
or close 15 SLPEs in a phased manner, and disinvestment of the equity of a few others.
 306 Public Policy and Analysis

--

NT POLICE ANALYSIS AND

-

Disinvestment as a means to PE reforms, restructure and privatisation started in the early 1990s
with the objective to raise resources, to broad base the equity, improve management, or to provide
market discipline to the performance of the enterprise. In early years, disinvestments was for a
1
'fractional equity' or saIe of only minority shares without any change of ownership or control; the
sale was by inviting bids from mutual funds, public sector banks and FIIs. Later, during 1999 to
2003, there was a shift in emphasis from disinvestmentsof minority share sale to strategic sale by
transferring control to private enterprise with or without change of ownership; again during
2004-05 onwards, disinvestmentpolicy was changed with sale of fractional equity and there was
to be no strategicsale involving transfer of ownership/control.In short, disinvestmentpolicy took
a f ~ ~turn
l l from fractional sale to strategic sale to and back fractional sale.
Over the years, the disinvestment process was institutionalised by setting up the Department of
Disinvestment in 1999 under the independent charge of a minister. The Depa tment adopted the
policy of disinvesting government sharkholdings through strategic sale. The strategic sale of 13
CPSEs (in addition, management control in MUL was transferred to Suzuki for Rs. 2,424 crore)
and fractional sale in 34 others since 1991 resulted in disinvestment proceeds of approximately 22
r
percent of the total of Rs. 47,645 crores; it amounted to transfer of approximately two-fifths of
the equity capital. Realisation under strategic sales was about ten times that of the equity capital
transferred and in about half of the cases equity transfer was more than 50 per cent, including three
enterprises running into losses. However, Hindustan Zinc Ltd (HZL) was the first instance where
the governmentceded management control to Sterlite Company even while it retained approximately
50 per cent stake. Since disinvestment, the performance of the Hindustan Zinc has improved by
increasing production and efficiency through de-bottlenecking and cost cutting. On an operational
basis, between fiscal year 2001-02 and 2005-06, the production has increased by 60 per cent
while earnings per share have in'creased twenty times. A significant growth has been observed in '
capital investment, which went up from Rs 19 crore to Rs 214 croreper year, peaking at Rs 1,036
crore during 2004-05. The goirernment,along with the public shareholders, gained a lot from the
transactionin addition to the money it received at the time of privatisation. The Central Tax proceeds
increased from Rs 210 crore to Rs 1,200 crore over four years. The state exchequer also has seen
similar gains. Even shareholders have gained as the share price has risen from Rs 37 to Rs 585,
after achieving apeak of Rs 750 in early 2006. (Bajjal, 2006)
The successful strategic bidders included Reliance India Ltd. (for IPCL), Tatas (for CMC and
VSNL), Sterlite (Qr HZL and BALCO), Hindustan Levers Ltd. (for MFL), Suzuki (for MUL),
and IOC (for IBP). The IBP sale to IOC was not a case of privatisation, though it could be argued 6

as a case of restructuring. It was certainly a case of unintended nationalisation resulting in

strengthening of IOC, which already accounted for 40 per cent market share of petroleum products
B
(while the remaining share was enjoyed by BPCL and HPCL 40 per cent and 20 per cent
respectively). The IOC bid price was approximately four times that of the reserve price of '

Rs. 455 per share.

In order to ensure that transfer of management control under the strategic sale arrangement, with
or without majority ownership transfer, does not lead to the creation of a monopoly a strong
regulatory mechanism is necessary. One such instance of gaining monopoly was that of Sterlite
Industries, which on acquisition of HZL, became one of the major globalplayersin the non-ferrous
mining and metals business.

-
Disi~zvestrnentPolicy: A Case Study of India 307

As mentioned earlier, a strategic investor as per a special agreement, gives the government a
veto power on critical issues and the strategic.investoris required to consult the government on
matters regarding sale, lease, exchange or disposal of existing assets or taking up a new line of
business.
Similarly, privatisation of PEs or transfer of management control would lead to consideration of
issues, such as, rese~vationsin employmentfor certain categories,or promotion of national language,
or 'nodal agency status' of an enterprise for preference in supply of goods and services to other
departments.
What about continuance of some of the pre-existing facilities in post-disinvestment scenario? For
example, as a nodal agency the ShippingCorporation of India (SCI) has apreference in supply of
services to other departments;one is not sure as to whether on strategic sale of SCI, the successful
bidder would enjoy this preference.
Further, there is need to spell out policy regarding the management of minority gavernment
shareholdings in the post-disinvestment period.
As a matter of accepted policy, disinvestments proceeds have to be used for meeting of expenditure
jn social and infrastmcture sectors, restmct~~ringof PEs and retiring of public debt; accordingly,
'Disinvestment Fund' was set up (during 2002-03) or 'National Investment Fund' was set up
(during 2004-05). But we are not sure as to the extent to which the disinvestments proceeds are
used for financing the purposes intended or diverted for meeting fiscal deficit.
There should be a time-framefor implementation of policies formulated for revival of PEs, or for
improvement of their performance, or for reduction of burden on the national exchequer, Si~nilarly,
in order to activate the economic reform process, there is a need to lay down the policy to bring in
a measure of privatisation of departmental enterpsises like ordinance factories (39 in nuxnber) to
improve their eficiency and productivity. At present,they operate under the purview of Ordinance
Production Board and are entirely dependent on the national exchecluer for funds.
as regards the states, about 63 per cent of the PEs has been non-functional or running
F~~rther,
on losses. One striking feature is that a large number of statcs have initiated measures
towards economic reforms, or restructure of public enterprises, or have set up disinvest~nent
comtnissions.
In order to smoothen and accelerate the privatisation and disinvestment process, there is a need to
build national consensus so that a decision to disinvest or privatise a pal-ticularenterprise sl~ouldbe
a national decision and political considerations should not deter such disinvestments. There is also
need for co-ordination between the Centre and States to disinvest or privatise once the proposal
j s agreed upon.

As a step towards coordination between the Union and State Government for purposes of
disinvestmentsand restiucture of PEs, there should be a system of Mernorandu~nof Understanding
(MOU) similasto that of power sector reforms, identifying their respective commitments and roles
in this regard. The MOU would also spell out the nature and extent of central assistance for
restructuringlrevival or for VRS schemes, etc. Further, there should be a system of time-bound
clearances from the state government concerned so as to attract more bids for a strategic sale.
Such procedures would prevent the mixing of political considerations with economic ones. Public
representatives like MPs or NILAs, isrespective of their party affiliations, should shouIder the
responsibilityfor articulating public opinion on disinvestment/privatisation of 'an enterprisefalling in
their respectiveconstituencies.
308 Public Policy and Analysis

At present, disinvestment is a part of annual budgetary exercise of the government and exerts
pressure to achieve the target before the end of the financial year. Disinvestment programmefor a
longer period, say five years, as recommended by the Disinvestment Commission, will be a desirable
step to improve investor confidence and to avoid crowding on the capital market. It would also be
helpful in terms of costs and time. This wouldentail a separate enactment to enable the government
to acquire or dispose of business or property, perhaps a task not easily possible in the present
I

democratic set-up having governments of diverse political orientations. It may also cause problems
when the five-year stretch overlaps with the tenure of political regimes.
No doubt, strategic sale of enterprises has resulted in change of ownership of PEs, it has also
changed management control and is reported to have improved the operational performance of
enterprises like, HZL, MFL, especially because of efforts to woo workers to VRS.
Lastly,change in the disinvestment policy over the years, as discussed above, raises a few questions,
such as, the following:
What is the overall policy of the union and state governments regarding public enterprises?
To whht extent is disinvestment an economic exercise,and to what extent it is influenced by political
expediency?
Is disinvestmentviewed as revenue-raising exercise or an exercise to improve the working of PEs? .
What are the implications of privatisation?
What are the hurdles in granting greater autonomy to PEs?

23.5 CONCLUSION
In this Unit, we have discussed the policy process with special reference to disinvestment policy in
India. The economic reforms of 1991-92 initiated steps for restructuring/privatisation/saleof equity
,i
of some PEs on various economicgrounds so as to reduce the burden on the government exchequers
since many PEs have not been functioning, or incurring heavy losses.The strategy,economics, and
administrative exercise behind the policy process have been analysed.Disinvestment of the Central
Public Enterprises (CPEs) has been described for each of the four phases.
In the case of State-Level Public Enterprises, the salient features of restructure of some SLPs in
various states have been described. Lastly, the.problemsin the policy process of disinvestments
have been analysed, besides highlighting important problems and major recommendations.

23.6 KEY CONCEPTS

Auction disinvestments
: In this type of disinvestment, selected banks and financial
institutions are invited to bid for tenders as per norms. The
successful bidders, in their turn, offload the shares purchased in
the stock market. This process of disinvestment does not lead
to broad basing the equity holding pattern.ofpublic enterprises
until the shares are listed on a stock exchange, and are made
availableto the public. This process of disinvestmentof shares
is relatively less cumbersome, which involvesless administrative
expensesand results in higher realisation.
 Disinvestment Policy: A Case Study of India

Piggyback method : Under this method, government simultaneously approaches the

stock market along with the public enterprise for apublic issue.
This method has the advantage of higher realisation from the
issue and is reported to be quicker and less expensive.
Public floatation : The method of disinvestment of shares to the public through stock
market iscommonly termed as public iloatation,which is normally
followed by private sector companies and involves high publicity
and other floatation expenses.
Share-cross holding : It refers to the selling of the shares of one public enterprise to
another public entesprisein the disinvestment process.
Shares to employees : Disinvestments can,also be by offering shares to employees or
workers' co-operatives. Various Eastern European count~ieslike
Hungry and Argentina disinvested shares to employees by issuing
them 'vo~~chers', which entitle them for a certain number of shares
against a specific price.
Trade investment : Trade investment or 'buy out deals' are also called strategic sale
under which shares are sold as a process of negotiation to
organisations, domestic or foreign, engaged in similarbusiness.
This method is suitable for industries of specialised nature like
telephone or telecommunication,electricity generation,or airlines.

23.7 REFERENCES AND FURTHlER READING

Baijal, Pradip, "Arnuch quieterprivatisation of Hindustan Zinc",HT2Business &World, July 13,
2006.
-Baijal,Pradip,"Commercial Feature on Karnataka's Fiscal Reforms", BusinessStandard, October
19,2002.
Baijal, Pradip, "Disinvestment;,Why Strategic Sales Worked", Business Stun.durd,December
12, 2002.
Dha~neja,Nand, "Disinvestment of Central and State Enterprises: Analysis and Way Ahead",
Indian Journal of Ptlblic Adi?zirzistration,Vol. XLIX, No. 2, April- June, 2003.
Dha~neja,Nmd, "PSU Disinvestment in India: Process and Policy - Changing Scenario", Vision,
Jan.-March, 2006.
Dhameja, Nand and K.S.Sastry, 1998, Privatization: Theory and Practice, wheeler ~ublication,
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*1

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