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Introduction to present financial market in India • General Overview
As might be expected, the main impact of the global financial turmoil in India has emanated from the significant change experienced in the capital account in 2008-09 so far, relative to the previous year1. Total net capital flows fell from US$17.3 billion in April-June 2007 to US$13.2 billion in April-June 2008. While Foreign Direct Investment (FDI) inflows have continued to exhibit accelerated growth (US$ 16.7 billion during April-August 2008 as compared with US$ 8.5 billion in the corresponding period of 2007), portfolio investments by foreign institutional investors (FIIs) witnessed a net outflow of about US$ 6.4 billion in April-September 2008 as compared with a net inflow of US$ 15.5 billion in the corresponding period last year. Similarly, external commercial borrowings of the corporate sector declined from US$ 7.0 billion in April-June 2007 to US$ 1.6 billion in April-June 2008, partially in response to policy measures in the face of excess flows in 2007-08, but also due to the current turmoil in advanced economies. Whereas the real exchange rate appreciated from an index of 104.9 (base 1993-94=100) (US$1 = Rs. 46.12) in September 2006 to 115.0 (US$ 1 = Rs. 40.34) in September 2007, it has now depreciated to a level of 101.5 (US $ 1 = Rs. 48.74) as on October 8, 2008.
Rakesh Mohan, Deputy Governer – RBI, Global financial crisis and key risks – impact on India
and Asia, 9th Oct. 2008
Primary Market may be defined as a market for new issues. 2 The primary market is the pacesetter for mobilizing resources by corporates.3 The bull-run in the secondary market enabled and emboldened companies to enter the market with big issues and attract investors and traders to invest in public issues to reap high profits following their listing. The companies profitability performance was also good. The market, however, underwent turmoil as soon as an FII-driven crisis developed in the secondary market and the mega crash occurred in January second week Presently, the primary market is in a bearish mood and this can be seen from the way the issues of Wockhardt Hospital and Emaar MGF have gone. There are two factors for this depressing outlook • • Continuing uncertainties; and Further crash of the stock prices and hesitation on the part of investors due to fall in shares of Reliance Power as soon as they were listed. Investors lost nearly Rs 70 per share on listing of Reliance Power. Only 19 companies have entered the capital market in the current financial year so far, mobilizing Rs 1,968 crore, the lowest since 2003-04. Interestingly, of these 19 public offers, only four are trading above the issue prices while 13 are trading at discounts. Two are not yet listed. IPO investors have become cautious as 70 per cent public offers made last financial year are currently trading at a discount. Following this poor show of public offers and a slippery secondary market, several Indian promoters have withdrawn their plans to raise funds through public offers. The Securities and Exchange Board of India (Sebi) data show that 24 promoters, who were planning to raise Rs 21,300 crore, have either put their plans on hold or have
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withdrawn their offer documents after submitting the red-herring prospectus.4 According to Prime Database, four companies, collectively planning to raise Rs 4,517 crore, have withdrawn their offer documents since April 2008. This includes JSW Energy (Rs 4,000 crore), RNS Infrastructure (Rs 300 crore), Cellebrum Technologies (Rs 200 crore) and Elysium Pharmaceuticals (Rs 17 crore). Many real estate and financial services sector companies have postponed or cancelled their IPO plans after stocks from these sectors reported more than 50 per cent erosion in their market value. Promoters of Emaar MGF Land, Wockhardt Hospitals and SVEC Constructions pulled out their IPOs, amounting to Rs 1,317 crore, due to low response from retail investors. There are over 100 companies such as Essar Power, GMR Energy, ICICI Securities, Lodha Builders, Sterlite Energy and SRL Ranbaxy, which had announced their IPO intentions but have now stalled their plans. • Secondary Market
The sensex climbed at a rapid rate, touching record heights in 2007 -2008. The average Indian investor who traditionally has been a very conservative investor became more confident and started investing heavily in the stock market. The stock market grew in leaps and bounds and its growth in the last five years itself has been a phenomenal twenty five per cent. The BSE Sensex increased significantly from a level of 13,072 as at end-March 2007 to its peak of 20,873 on January 8, 2008 in the presence of heavy portfolio flows responding to the high growth performance of the Indian corporate sector. With portfolio flows reversing in 2008, partly because of the international market turmoil, the Sensex has now dropped to a level of 11,328 on October 8, 2008, in line with similar large declines in other major stock markets. Against this backdrop the unthinkable happened, the stock market Of the United states of America or Wall street stock exchange crashed due to a crisis in the housing finance sector of its leading banks, caused due to delinquency and non-repayment of housing loans. This resulted in a panic in the world market including India. The
Foreign Investment also came down heavily due to a liquidity crunch in the major companies. The banks stopped lending to the bankers and in effect the market came to a sudden stop. The Indian investor panicked again and started selling like crazy. Major companies started making announcements like job layoffs to minimize their losses.5 • Money Markets
Money markets are the markets for short-term, highly liquid debt securities. Examples of these include banker’s acceptances, repos, negotiable certificates of deposit, and Treasury Bills with maturity of one year or less and often 30 days or less. Money market securities are generally very safe investments, which return relatively, low interest rate that is most appropriate for temporary cash storage or short term time needs. Whereas capital markets are the markets for intermediate, long-term debt and corporate stocks. The National Stock Exchange, where the stocks of the largest Indian. Corporations are traded, is a prime example of a capital primary market. Regarding timing, there is no hard and fast rule on this, but when describing debt markets, short term generally means less than one year, intermediate term means one to five years, and long term means more than five years.
o Impact on money market
Money Market is actually an inter-bank market where banks borrow and lend money among them to meet short-term need for funds. Banks usually never hold the exact amount of cash that they need to disburse as credit. The ‘inter-bank’ market performs this critical role of bringing cash-surplus and cash-deficit banks together and lubricates the process of credit delivery to companies (for working capital and capacity creation) and consumers (for buying cars, white goods etc). As the housing loan crisis intensified, banks grew increasingly suspicious about each other’s solvency and ability to honor commitments. The inter-bank market shrank as a result and this began to hurt the flow of funds to the ‘real’ economy. Panic begets panic and as the loan market went into a tailspin, it sucked other markets into its centrifuge.
The Indian Sensex Fall and its Impact - Bombay Stock Exchange BSE October 17, 2008
The liquidity crunch in the banks has resulted in a tight situation where it has become extremely difficult even for top companies to take loans for their needs. A sense of disbelief and extreme precaution is prevailing in the banking sectors. The global investment community has become extremely risk-averse. They are pulling out of assets that are even remotely considered risky and buying things traditionally considered safe-gold, government bonds and bank deposits (in banks that are still considered solvent). As such this financial crisis is the culmination of the above-mentioned problems in the global banking system. Inter-bank markets across the world have frozen over. The meltdown in stock markets across the world is a victim of this contagion. Governments and central banks (like Fed in US) are trying every trick in the book to stabilize the markets. They have pumped hundreds of billions of dollars into their money markets to try and unfreeze their inter-bank and credit markets. Large financial entities have been nationalized. The US government has set aside $700 billion to buy the ‘toxic’ assets like CDOs that sparked off the crisis. Central banks have got together to co-ordinate cuts in interest rates. None of this has stabilized the global markets so far. However, it is hoped that proper monitoring and controlling of the money market will eventually control the situation. 2. Reasons for this turmoil The turmoil in the international financial markets of advanced economies that started around mid-2007 has exacerbated substantially since August 2008. The financial market crisis has led to the collapse of major financial institutions and is now beginning to impact the real economy in the advanced economies. As this crisis is unfolding, credit markets appear to be drying up in the developed world. Why did this huge fall happen? Many factors. The global crisis can be said to be a fault of the Federal Bank of USA. One, there is a change in the global investment climate. One of the primary triggers is the huge fear of the United States' economy going into a recession with foreign institutional investors trying to reallocate their funds from risky emerging markets to
stable developed markets. Analysts are now expecting a cut in US interest rates. • Bad lending policies
In 2005-07 the property markets were on a high growth path. The property prices kept increasing. A sense of complacency had set in the real estate markets. It was assumed that the residential property prices would keep increasing forever. Mortgage lenders relaxed lending standards. Billions of dollars of sub-prime loans were to given borrowers with the sketchiest credit histories on recommendations of mortgage brokers who were more interested in their commission. Loans were structured very innovatively. Some gave borrowers the ability to skip repayments and some had interest rates that rose over the life of the loan. Lenders were not worried about repayments as defaults if any, on loans, could be recouped from the property itself. Contrary to this assumption, the property bubble burst leading to sharp depreciation in property prices. As loans were given to people who could not repay it in the best of time, mortgage repayments defaults kept increasing, triggering off a chain of events that led to the bankruptcies of the hallowed institutions of Wall Street. The rise in default rates in the sub-prime market is essentially due to two things. Most borrowers got into adjustable rate mortgages where the interest rates were reset periodically. Second, as the US Fed relentlessly hiked policy rates (17 times between 2004 and 2006), mortgage rates rose as much as 40 per cent. Sub-prime borrowers, characterized by low and often volatile incomes, found that they could not service their loans any longer. The result is the large default across the board, which plagues the markets. Therefore, the Fed has to shoulder at least part of the blame for the current mess. Perhaps the US central bank could have been a little more prescient and figured out that the series of rate hikes had the potential to trigger a crisis of this kind. The existence of the large quantum of sub-prime assets and the impact of mortgage rate resets should have figured more actively in their monetary policy discussions much
earlier. Finally, if the Fed had felt that the excess liquidity was whipping up too much froth in the housing market, it should have excised the problem much earlier than allowing festering. As growth slows in the U.S. and Europe, emerging economies' exports to them will slow. In the past, a 1 percent decline in U.S. growth has led to a decline in growth in emerging economies by 0.5 to 1 percent, depending on trade and financial links with the United States. The present crisis is the result of a perfect storm: a macroeconomic environment with a prolonged period of low interest rates, high liquidity and low volatility, which led financial institutions to underestimate risks, a breakdown of credit and risk management practices in many financial institutions, and shortcomings in financial regulation and supervision.6 • • This environment both fueled a U.S. housing boom and encouraged banks and other institutions to take on excessive leverage to generate high returns. Financial institutions weakened their lending standards and took on excessive risk. The most obvious example is the US sub-prime mortgage market, but the holders of these risks were not only in the United States, and problems may also surface in other kinds of lending—for example leveraged loans and consumer credit—or other countries. Nor is the problem confined to industrial countries. For example loose credit in some emerging economies may lead to problems down the road.7 • A bleaker economic outlook would in turn make it more difficult to get out of the financial crisis, because it worsens the prospects of businesses and individuals. This is one reason that equity markets have fallen as the risks of a U.S. recession and a global downturn have grown
3. Are Foreign Investors Responsible for this crisis
FII (Foreign Institutional Investors) is used to denote an investor, it is mostly of the form of a institution or entity which invests money in the financial markets of a country. The term FII is most commonly used in India to refer to companies that are established or incorporated outside India, and is investing in the financial markets of India. These investors must register with the Securities & Exchange Board of India (SEBI) to take part in the market. • Influence of FIIs on Indian Stock Market
The current investments of FIIs is Rs. 2,55,464.40 Crores. This is almost 9% of the total market capitalization.8 • • • They increased depth and breadth of the market. They played major role in expanding securities business. Their policy on focusing on fundamentals of the shares had caused efficient pricing of shares. These impacts made the Indian stock market more attractive to FIIs and also domestic investors, which involve the other major player MF (Mutual Funds). The impact of FIIs is so high that whenever FIIs tend to withdraw the money from market, the domestic investors become fearful and they also withdraw from market.
Major Collapses in BSE Sensex
Just to show the impact, we analyze below the 10 biggest falls of stock market:9 Day (Points Loss in Gross Sensex) 21/01/2008 (1408) 22/01/2008 (875) 18/05/2006 (856) 17/12/2007 (826) 18/10/2007 (717) 18/01/2008 (687) 21/11/2007 (678) 16/08/2007 (643) 02/08/2007 (617) 01/08/2007 (615) Purchases Gross Sales (Rs. Net Investments (Rs. Crores) 1060.30 1618.20 527.40 869.00 1372.50 1348.40 791.80 750.30 542.00 956.90 Crores) 2001.80 1195.10 234.40 -199.00 -265.50 -271.20 -151.10 239.20 -7.50 -147.50
(Rs. Crores) 3062.00 2813.30 761.80 670.00 1107.00 1077.20 640.70 989.50 534.50 809.40
From this table, we can see that the major falls are accompanied by the withdrawal of investments by FIIs. Take the case on January 18, 2008, the Sensex lost almost 687 points. Here, the net sales by FIIs was Rs. 1348.40 Crores. This is a major contributor to the fall on that day. But contrary to that day, take the case on January 21, 2008, the Sensex lost 1408 points and the gross sales was Rs. 1060.30 Crores and the purchases were Rs. 3062.00 Crores. So this can be concluded that after the fall of market, FIIs had invested again into the market. From this, we can see the effect of FIIs.
Net Investments of FII from 2003-0810 Year 2003 2004 2005 2006 Net Investment 30458.7 38965.1 47181.2 36539.7
2007 2008 (10/08/08)
From this, we can see that there is an increase in net investments till 2005 and there was small decrease in investments in the year 2006. But there was a steep increase in the year 2007-08. This was the best period in Indian stock market where stock prices were increased and the market was in good mood. When we take the investments in 2008, the net investments are negative. And we know the market is volatile in this year. So we find that there is direct relation between net investments and movement of stock market. From all the above discussions and data analysis, we conclude that FII has a major impact in Indian stock market. Particularly, the fall on October 17, 2007, in which just a peculation about governments plan to control P-Notes had caused the biggest fall in Indian stock market, even market had to be closed for one hour without trade. The impact is that even the domestic players and MFs also follow a close look on FIIs. So if FIIs are confident in Indian markets, there is a general perception that market is on a song. Furthermore, Depreciation in rupee value has added to the worries of FIIs. Depreciation in currency leads to losses (in dollar terms) for the FIIs, as they have to periodically represent to market value of their investments overseas. Many analysts fear the rupee may depreciate even more against the dollar. If that happens, FIIs will have to report huge losses on the currency account, and hence are pulling out from the domestic markets. Also, Analysts are projecting a slowdown in the economic growth here due to macroeconomic issues. The RBI has also downgraded the growth projections to below eight percent this year, based on the interim data released last month. Although inflation is looking flattened out at around 12 percent, the depreciation in the rupee value will again give an upward push to it. The softening crude oil prices has provided a bit of relief, but the rupee value
depreciation is a very big issue as it is countering a large portion of savings resulting from lower crude oil prices. It has also been found that the major (almost 50%) of FIIs' investments are from PNotes. So it implies that major forces behind the FII investments are anonymous. This has a negative impact on stock market. Because money launders and even terrorists use this facility to pump money to Indian market and their sudden withdrawal causes volatility in markets. 4. Policy followed by government for investors In early 2008, the government liberalised its policy towards foreign investment in the following key economic sectors by increasing the maximum permitted foreign investment to:
• • •
49 per cent for commodity exchanges 49 per cent for credit information companies 74 per cent for non-scheduled airlines (however, foreign airlines are not allowed to invest in a scheduled airline company in India), and 100 per cent in titanium mining with prior Indian Government approval.
In October last year, the markets regulator had put a 40 per cent cap on FIIs’ total asset holding via participatory notes or overseas derivatives instruments and stopped them from issuing fresh P-notes or renewal of old ones with an 18-month deadline ending in March 2009 to do the needful. The moved was aimed to keep track of foreign flows into the country. SEBI has now decided to do away with the conditions limiting FIIs’ allocation of funds between debt and equity to provide greater flexibility and investment options to overseas investors. SEBI had done away with the existing limit on distribution of FII investment a day after the government doubled the cap on their investment in corporate debt to $6 billion. The decision came in the wake of FIIs pulling out of the Indian equity market and pumping money in the debt market. FIIs have taken out US$11.56 billion from
equity market and bought net debt worth US$1.8 billion since January. However, another regulation that FIIs investing up to 100 per cent in the debt market will have to form a 100 per cent fund for this purpose and get it registered with Sebi remains, the central bank said.11 • Security Receipts
So far as security receipts issued by the Asset Reconstruction Companies (ARCs) are concerned, the total holding of a single FII in each tranche of scheme must not exceed 10 per cent of the issue. Besides, the total holding of all FIIs put together must not exceed 49 per cent of the paid up value of each tranche of scheme of security receipts issued by ARCs. The relaxation, according to Sebi, is aimed at according “greater flexibility to the FIIs to allocate investments across equity and debt.” “It will have a two-way positive impact. This will enable FIIs to invest without any obligation and will also enable Indian companies to get more funds for their expansion plans,” observed Nexgen Capital Equity Head Jagannadham Thunuguntla.12
The move comes a day after government doubled the limit of FII investment in corporate debts to US$6 billion. Finance Minister P Chidambaram, on Friday, said “Sebi had informed me that it would address any request for relaxation in the proportion of investment in equity and debt required to be maintained by an FII under current regulations.”
Sebi said the enhanced limit for investment in corporate debts will be allocated among the FIIs on a “first come first served” basis up to a ceiling of US$300 million per entity. • Two views
The Finance Minister P Chidambaram has urged banks to lower interest rates, in the light of the steps taken by RBI both on liquidity and interest rate, and several public sector banks have already announced plans on reducing their prime lending rates. Banks have been asked to increase credit for productive purposes and ensure credit quality. RBI has also suggested to banks to restructure the dues of small and medium enterprises on merits. The Reserve Bank of India had vigorously moved in October to bring down the cash reserve ratio from a peak of 9 per cent to 5.5 per cent, reduce the key policy interest rate from 9 to 7.5 per cent and also the statutory liquidity ratio by one percentage point to 24 per cent of their net demand and time liabilities. As part of measures to minimize the adverse impact of global crisis on domestic economy, the Finance Minister has reduced certain duties to give relief to some of the affected sectors like steel and aviation. On the budgetary side, higher allocations for social sectors and rural employment and other flagship programmes should generate consumption, which contributes to economy’s growth.
5. Suggestions and Lessons Learnt 1. Increase rupee liquidity The demand for base money has increased. In order to hold interest rates at targeted levels, the supply of base money needs to be increased. While there is a concern that a massive injection of liquidity could find its way into runaway credit growth fuelling inflation (which has declined only somewhat to below 12 percent on a year-on-year basis in recent weeks) and sowing the seeds of the next asset price bubble, the central
bank has instruments within its existing framework (including tighter regulatory requirements) to absorb liquidity if a particularly sharp acceleration in credit growth is seen. In a financial crisis, other sources of financing have decreased. Thus a certain robust credit growth is a goal of monetary policy. These are extraordinary circumstances and it is preferable to err on the side of too much liquidity rather than too little. There are several measures that the government and the RBI can implement quickly to help restore liquidity in the system. • • • A reduction of CRR A reduction of SLR. This should release substantial liquidity in the system. As the cost of interbank lending to some banks has risen sharply based on fears that counterparty risk is difficult to gauge in the present circumstances, the MoF/RBI could provide counterparty-risk insurance in interbank transactions. This could be done at a market-discovered price as a percentage of interbank lending, such that it is not seen as a blanket government guarantee. This would help increase participation in the interbank market, and thus increase liquidity in it. Even if the immediate need for this is not visible right now, setting up such a useful mechanism now induces a reduction in the perception of liquidity risk in the money market. • Easing the barriers faced by banks and insurance companies from buying the bonds of NBFCs and real estate companies.
2. Increase dollar liquidity • • • Increase the avenues for capital inflows by raising the FII limit on corporate bonds Remove restrictions on capital account transactions for NRI’s. The recent removal of capital controls against PNs was on the right track. However, the PN market has collapsed owing to the heightened risk perception of counterparties such as the large investment banks who were the
main producers of PNs. As a consequence, the unbanning of PNs will have no impact on dollar flows into India. The customers of PNs are now using the Nifty futures in SGX. Now the challenge lies in undertaking deeper reform of the FII framework to make it easier for qualified market participants to directly access the Indian market, and choose to do so instead of going to global venues such as SGX, NYSE, LSE, NASDAQ, etc. 3. Exchange rate policy Almost all economists now agree that when conditions change, the central bank must not stand in the way of adjustment by the exchange rate. Sustained exchange-rate misalignment is extremely damaging for the economy, either in terms of undervaluation or in terms of overvaluation. Adjustment by the currency is a shock absorber. When times are good, an INR appreciation is a stabilizing influence, and when times are bad, INR depreciation is a stabilizing influence. By allowing the exchange rate to fluctuate, we reduce the fluctuations of the economy. Conversely, exchange rate rigidity forces the real economy to adjust since the currency market was prevented from adjusted by the central bank. In the present situation, preventing rupee depreciation would set off a financial crisis at home, for domestic and foreign economic agents would be selling shares, companies, bonds, and real estate, trying to realize US dollars which would be pulled out of the country and placed into US Treasury bills. All this would be driven by the desire to profit from a coming depreciation of the rupee. If, in contrast, when bad news strikes, it immediately generates an exchange rate depreciation after which both appreciation or depreciation are equally likely, then it would not set off the process of selling off assets in India in order to profit from a coming depreciation. There is thus a strong case for RBI avoiding any sort of management of the exchange rate (in the sense of the rupee-dollar rate). 4. Other Suggestions • Focus more on growth by improving public and private investment continue to
take measures for improving liquidity; enhance investor confidence to ensure growth of industry. • All banks should be asked to make a liquidity plan and a solvency plan. RBI should review these plans and insist that each of these plans have quantitative monitorable actions and targets. As an example, the solvency plan should include suspension of payment of dividends; this is the sort of measure which shareholders are unlikely to take on their own without a push from These plans should be triggered when measures of illiquidity or insolvency are hit. Lessons Learnt The advantage of falling behind the curve in terms of financial market development is that, hopefully, we get to learn from others’ mistakes. Indian markets can learn from the current global financial crisis that has stemmed from large default in the American mortgage market. It is important, however, that we learn the right lessons and not allow events around lead us into an obscurantist financial policy regime. Historically, Indian banks have stayed away from lending to segments that have had the faintest whiff of risk. Given a chance, banks would prefer an asset of portfolio consisting of stodgy low-return blue chips than take a chance with the odd promising but risky entrepreneur. There was some change, though, in the last few years. Loan securitization, for one, made some headway. Better credit information is now available on both retail and smaller corporate borrowers. The credit boom in India of the last four years has come not on the back of increased lending to blue-chip companies or individuals with assured high-income streams. It was been driven by banks’ willingness and enhanced ability to take more risk on their books. I would argue that this was a critical ingredient in pushing us on to a new growth trajectory. If we are to remain there, it is imperative to ensure that this process gains momentum. What are the lessons to be learnt then? Clearly there is a message in all this for the credit rating companies. I do not claim to be an expert but from whatever little I understand of it there does not seem to be anything grossly wrong with the methodology of rating these structured products. I certainly do not subscribe to the
now popular conspiracy theory that the rating companies in league with structured product marketers vetted the issue of junk credit as high investment grade instruments. The methodology and safeguards that were used are reasonably transparent. Instead the key problem with the current paradigm of ratings that the crisis puts its finger on is its inability to predict large-scale default adequately ahead. 13 Following the sub-prime crisis in the US over a year ago, the approach of RBI was cautious (non-reformist according to critics) on all fronts — whether in allowing the hedge funds to invest in Indian equities and real estate, greater FDI in the banking sector or allowing excessive capital inflows. These lessons are particularly important for the RBI. If we do stay on the current growth trajectory, there is bound to be much more expansion in credit to increasingly riskier segments. The central bank will have to facilitate this expansion and balance this with the more conventional role of inflation management. It has to make sure that it doesn’t throw the baby out with the bathwater. The present churnings in the global financial sector mainly the investment and banking sector has exposed chinks in the Indian financial sector too in the form of inadequacies within the system to contain losses mainly because of the absence of a healthy and effective risk assessment and management system and to absorb the losses there should be the presence of a strong capital base. In financial market policies, emerging economies can learn from the risk-management and regulatory failures of industrial economies. All emerging markets should build regulatory capacities to safeguard against the risks associated with non-transparent instruments and excesses in lending. The present churnings in the global financial sector mainly the investment and banking sector has exposed chinks in the Indian financial sector too in the form of inadequacies within the system to contain losses mainly because of the absence of a healthy and effective risk assessment and management system and to absorb the
Asian Crisis of 1997
losses there should be the presence of a strong capital base.
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