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Indian Capital Market

Recent Developments and Policy Issues

Yoon Je Cho

Yoon Je Cho is Professor, Graduate School of International Studies,


Sogang University, Seoul, Korea.
112 A STUDY OF FINANCIAL MARKETS

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



cluding those relating to disclosure criteria, lack of



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



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



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



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



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



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



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



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



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



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



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



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



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



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

period. ingredients that underlie market quality in India’s



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



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

of Government bonds traded. Banks and financial book;



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

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

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



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



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

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

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

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

are in the private sector. Mutual funds were opened


trading process in which traders shouted and hand-



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

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

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

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

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

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

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

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

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

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

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



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

Board of India (SEBI) was established in 1988. De- nated by BSE. In other parts of the country, the fi-

INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 113

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



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



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



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



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



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



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



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



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



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



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



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



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



located all over the country. The arbitrages are elimi- justify their existence. There is a pressing need to de-


nating pricing discrepancies between markets. ○

velop a uniform settlement cycle and common clear-
Despite these big improvements in microstructure, ing system that will bring an end to unnecessary specu-

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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



The Indian capital market still faces many chal-


Capital Market Reforms


lenges if it is to promote more efficient allocation



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



market infrastructure has to be improved as it hin-


Reforms in the Capital Market


ders the efficient flow of information and effective



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

have to adapt to internationally accepted accounting eral far-reaching reforms to promote the capital

114 A STUDY OF FINANCIAL MARKETS

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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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

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

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

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

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

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

Trading on all stock exchanges was through open



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



market intermediaries were largely unregulated. The PRIMARY MARKET



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

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

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

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

agement was largely composed of brokers. There


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



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

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

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

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

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


Table 1: Issues in the Primary Market




Public Rights Total


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

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


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



1996/97 753 115.65 131 27.19 884 142.84


Dec 1997 59 21.99




Source: Reserve Bank of India.



INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 115

Total market capitalization as of 1997/98 was


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


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



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


BSE Sensex P/E Ratio


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



emerging markets in this respect. The market capi- 50


4,000


talization-GDP ratio at end-1995 was 22.4 percent


40


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


30


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


1 20


and 37.1 percent for Mexico. It was higher how-


1,000 10


ever, in Malaysia (281.9 percent), Philippines Sensex


P/E Ratio


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


1991 1992 1993 1994 1995 1996 1997 1998


(152.9 percent).


Data from January 1991 to January 1998.


Source: Bombay Stock Exchange


Table 2: Number of Listed Companies and Market


Capitalization

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

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

1995/96 9,100 5,723


Risk Management System


1996/97 9,890 4,883


1997/98 9,833 5,898


1999a
SEBI has taken several measures to improve the

9,877 5,741

integrity of the secondary market. Legislative and


a As of March.

Source: Reserve Bank of India, Report on Currency and Finance, 1998–1999.


regulatory changes have facilitated the corporatization

of stockbrokers. Capital adequacy norms have been



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



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

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

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

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

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

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

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

50.5 percent. Prices generally rose for extended pe-



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

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

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

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

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

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

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

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

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

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

more sharply than prices (Figure 1). In March 1998, traded. A short-term and speculative investment is

116 A STUDY OF FINANCIAL MARKETS

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



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



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



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



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



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



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



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



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



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



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



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



intraday trading volume. Every broker is subject to



these requirements. CIRCUIT BREAKER



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



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

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

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

ness. system to maintain the orderly trading of shares on



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



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

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

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

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

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

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

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

old limit, the margin is not payable.



This margin is payable by a stockbroker to the


SHORT SALES AND LONG PURCHASES



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

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

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

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

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


Table 3: Bombay Stock Exchange Price Limits



Price Limit (percent)



Category Market Price of Share Daily Weekly


A Group Shares Over Rs20 10 25



B1 & B2 Group Shares Rs10 up to Rs20 25 25



Rs1 up to Rs10 50 No Limit


Up to Rs1 75 No Limit


Source: Endo (1998).



INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 117

Stock Lending management, were often performed by one body,



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



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



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



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



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



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



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



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



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



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



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



in overseeing the functions of the asset management


Introduction of Derivatives Trading

company. Mutual funds are now required to obtain


At present, there are no exchange traded deriva- ○

the consent of investors for any change in the “fun-
tives or over-the-counter derivative markets in the damental attributes” of a scheme, on the basis of

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

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

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

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

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

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

asset management companies and of trustees.


Institutional Investors


MUTUAL FUNDS FOREIGN INSTITUTIONAL INVESTORS



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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

tions, namely trusteeship, custodianship, and asset not, may also invest in Indian securities outside the

118 A STUDY OF FINANCIAL MARKETS

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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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

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

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

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

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

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

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

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

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

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

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



Table 4: Investment by FIIs in Primary and Secondary Marketsa




No. of Cumulative

Registered Net
Gross Purchase Gross Sales Net Investment

FIIs Investment

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



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


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


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



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


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



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

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

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

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

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

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

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


FII = foreign institutional investor.


( ) = negative values are enclosed in parentheses.


a Data include debt instruments.


Source: Securities and Exchange Board of India.



INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 119


Table 5: Foreign Investment Inflows ($ million)




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


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



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


RBI 42 89 171 169 135



NRI 63 61 217 442 715 639


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



GDRs 86 1,602 1,839 683 918


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



Offshore funds and others 8 5 382 239 56 20


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




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


SIA = Secretariat for Industrial Assistance.


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





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

US$ million BSE-30 Index




ties, FIIs, credit rating agencies, and other such
1,000 5,000
Net FII investment intermediaries who may be associated with the

Sensex

800 4,000 securities market in any manner; and



• venture capital funds and collective investment


600 3,000

schemes, including mutual funds.



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

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



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


0 0

tations to SEBI’s enforcement power permits hun-



dreds of thousands of unregistered subbrokers to


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


Source: Securities and Exchange Board of India, Annual Report, 1995/96.


conduct their securities businesses, while registered

subbrokers are not effectively regulated. There is no



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

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

market participants are surprisingly low. Conse-


Policy Issues

quently, entry barriers are also low. This is probably



because the vested interest of existing market par-


Regulatory Framework

ticipants cannot be totally ignored since the Indian



REGULATION OF INTERMEDIARIES capital market would stop functioning without them.



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

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

These include: many small participants and regulate them.



• stockbrokers, subbrokers, share transfer agents,



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



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

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

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

ated with the securities market in any manner; least one of the recognized Indian stock exchanges.

120 A STUDY OF FINANCIAL MARKETS

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



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



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



Each stockbroker is subject to capital adequacy fined.



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



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



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



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



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



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



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



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



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



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



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



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

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

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

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

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

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

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

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



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

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

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

United States. stockbroker’s privity with the investor.



NSE does not officially allow its members to trans-




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



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

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

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

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

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

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

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

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



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

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

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



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

in the Indian capital market: and bylaws of the stock exchanges; and

INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 121

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



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



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



tended to 1 July 1997). be relatively incompetent.



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



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



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



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



brokers. to be professionally imprudent or negligent (Endo



1998). SEBI listed 134 merchant bankers of Cat-



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



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



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



ent minimum net worth requirements (Table 6). Un- have been records of listing delay or rejection of ini-


der the new regulations, the categories were abol- ○

tial public offerings (IPOs) in the recent past.
ished. Among other provisions, a merchant banker

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



Rs50 million. AUTHORITIES



The present functions and powers of regulatory agen-


Table 6: Capital Adequacy Requirement for


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

SEBI is the primary body responsible for regulation


Minimum Amount of

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

I 50 tration and enforcement primarily from the SEBI Act.


II 5

There was an existing regulatory framework for the


III 2

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



tract Regulation (SCR) Act and the Companies Act,


.. = nil

Source: Endo (1998).


administered by the Ministry of Finance and the

Department of Company Affairs (DCA) of the Min-



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

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

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

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

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

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

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

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

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

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

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

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

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

period of time. has not been a major obstacle to effective regulation



122 A STUDY OF FINANCIAL MARKETS

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



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



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



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



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



latory authorities or better coordination among them. gration.



The international trend is to consolidate and merge



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



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



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



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



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



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



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



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



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

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

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

tory frameworks have been well established and



which are actually functioning are the recognized SPECULATIVE INVESTMENT



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

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

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

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

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

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

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

ing. The combined turnover for 1996/97 was almost



Stock Market

three times the level of the previous year. Figure 3



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



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

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

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



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

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

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

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

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

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

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

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

its central computer via its satellite network. The ferred that a group of the 1,500 most traded stocks

INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 123

stitution of at least 5 percent of the total project


Figure 3: Turnover of Stock Trading in India


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



Rs billion
try condition is too restrictive. But the measure


8,000


seems necessary to help recover investor confidence



6,000 in the corporate sector.



The process of public subscription in the Indian



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



domestic equity issues, the process requires compul-


2,000


sory fallback underwriting, setting up of 30 manda-



0 tory collection centers across the country for col-


1994/95 1995/96 1996/97


lecting subscriptions from investors, and price deter-



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



Once an issue has been subscribed, postsubscription



on BSE would also have a considerably high liquidity procedures require 60 days to elapse before the se-


ratio (Endo 1998). The substantial increase in turn- ○

curities are listed. Investors are forced to remain il-
over may be attributed primarily to the recent ex- liquid during that period, or resort to the gray market

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

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

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

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

activities such as gray markets.



BARRIERS TO INITIAL PUBLIC OFFERINGS


Transaction Costs in the


In April 1996, SEBI announced a policy initiative


Secondary Market

that makes access to the primary market more re-



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

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

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

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


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

Item Turnover ($ billion)a Liquidity Ratiob



Indian Stock Exchanges


Bombayc 26.5 0.22


Nationalc 69.1 0.65



Foreign Stock Exchanges


Hong Kong, China 182.6 0.48



Jakarta 32.6 0.41


Kuala Lumpur 183.0 0.68


London 390.1 0.25



New York 3,728.4 0.58


Singapore 51.9 0.27


Thailand 51.3 0.43


Tokyod

885.7 0.28

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

bTurnover/average market capitalization.


cStocks listed and permitted to trade.


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

Source: Bombay Stock Exchange, National Stock Exchange, and Nikko Research Center.

124 A STUDY OF FINANCIAL MARKETS

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



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



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



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



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



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



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



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



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



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



ment of transactions in the securities market con-



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



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



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



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



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

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

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

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

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

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

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

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

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

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

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

India. of dematerialized securities in depositories increases,



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

with the issuer. For Government securities, the


jority of market participants. The National Securities



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


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


India New York


Component Mid-1993 Todaya Future Scenario Todaya



Trading 3.75 0.75 0.40 1.23


Brokerage 3.00 0.50 0.25 1.00



Market impact cost 0.75 0.25 0.15 0.23


Clearing

Counterparty risk Present In part 0.00 0.00



Settlement 1.25 1.75 0.10 0.05


Paperwork cost 0.75 0.75 0.10 0.05



Bad paper risk 0.50 1.00 0.00 0.00


Total 5.00 (+ risk) 2.50 0.50 1.28



a 1996-1997

Source: Shah and Thomas (1997).



INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 125

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



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



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



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



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



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



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



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



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



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



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



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



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



creased their holdings of Government securities.

Debt Market ○


Banks and life insurance companies are captive
HIGH STATUTORY LIQUIDITY REQUIREMENT markets for Government securities due to the port-

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

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

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

hold a substantial part of these bonds as liquidity



requirement. The statutory liquidity requirement (on PRIMARY DEALERS



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

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

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

vate debt market. ment have increased.





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



Item 1969 1980 1990 1991 1992 1993 1994 1995 1996

Central Government

Securities

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

Commercial banks 20.4 44.9 53.4 55.1 59.9 64.6 71.9 68.0 na

LIC 11.5 11.8 12.9 13.4 na 16.3 16.9 17.2 17.8


PPF 23.3 15.3 1.1 0.0 1.1 0.8 0.6 0.5 0.6

Others 7.3 7.7 10.0 6.7 na 5.2 0.4 3.3 na


Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

State Government

Securities

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

Commercial banks 37.9 56.5 79.5 78.6 79.1 72.7 74.8 73.0 na

LIC 24.0 19.1 6.0 6.9 7.8 9 11.1 11.8 12.2



PPF 3.1 21.0 2.7 0.0 3.4 2.9 2.8 2.8 4.0

Others 34.7 3.4 11.8 15.5 na 15.5 11.2 12.4 na


Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0



na = not available.

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


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

126 A STUDY OF FINANCIAL MARKETS


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



Total Subscription Net


Year Issues Cash Conversion Total Borrowing



Central Government



1970/71 4.0 2.3 2.0 4.3 1.3


1975/76 6.0 4.7 1.9 6.6 4.5


26.3 27.3 1.4 28.7 26.0


1980/81


1985/86 53.3 55.5 2.1 57.6 50.0


1990/91 89.9 85.3 4.6 89.9 80.0


89.1 78.4 10.7 89.1 75.0


1991/92


1992/93 138.9 137.4 1.5 138.9 47.9


1993/94 490.1 490.1 490.1 261.5


381.1 381.1 381.1 200.7


1994/95


1995/96 405.1 405.1 405.1 267.9


1996/97 296.2 296.2 296.2 200.0


State Government



1970/71 1.4 1.2 0.3 1.6 1.0


1975/76 2.5 2.7 2.7 2.7


3.0 2.8 0.5 3.3 2.0


1980/81


1985/86 12.8 11.9 2.3 14.1 9.7


1990/91 25.6 25.7 25.7 25.7


33.4 33.6 33.6 33.6

1991/92

1992/93 38.0 37.1


1.0 38.1 34.7


1993/94 41.4 41.4 41.4 36.4

51.2 51.2 51.2 51.2


1994/95

1995/96 62.7 62.7 62.7 59.3


1996/97 65.4 65.4 65.4 65.4





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




A primary auction market for Government secu- PRIVATE PLACEMENT



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

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

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

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

sued at completely market rates.


was through private placement, and this increased



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

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

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

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

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

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

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

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

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

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

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

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

causes further uncertainty in auction volumes. function.



INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 127


Table 11: Private Placement in the Capital Market



Total Resources Percentage
Private Placement
Mobilizeda


of Private


Year Private sector Public sector Total (Rs billion) Placements


Amount (Rs billion)a



1995/96 40.71 92.90 133.61 339.98 39.3


1996/97 24.93 125.73 150.66 306.74 49.1


Share (%)



1995/96 30.50 69.50 100.00


1996/97 16.50 83.50 100.00



a Provisional.


Source: Submaranian (1998).





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



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



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



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


1987-1992 329.77

ket and the launching of fixed income schemes and ○

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

to activate the debt market. Several technical im-


a Until January 1997.


Source: Submaranian (1998).


pediments that prevented more active secondary

market trading in Government securities have been


Table 13: Resource Mobilization, by Type of Mutual


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

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

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

Private sector mutual funds 20.84 3.12 3.46


Investors

United Trust of India 95.00 59.00 42.80


Total 137.27 65.08 47.77


MUTUAL FUNDS

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


Source: Submaranian (1998).


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



performance of mutual funds has not been encour-



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



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

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

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

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

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

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

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

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

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

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

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

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

boost investor confidence. crease in nonresident Indian (NRI) deposits, there



128 A STUDY OF FINANCIAL MARKETS


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




Item 1985 1990 1991 1992 1994 1995 1996 1997



Medium- and long-term


External assistance 19.31 32.15 34.28 38.10 43.71 48.81 47.29 46.28


International Monetary Fund 3.93 1.50 2.62 3.45 5.04 4.30 2.37 1.31



External commercial borrowing 5.56 13.74 14.78 16.08 17.57 19.62 18.27 18.85



Nonresident Indian deposits 3.08 10.36 10.58 7.85 12.67 12.38 11.01 11.13


Short-term na na 4.80 3.19 3.63 4.27 5.03 6.73



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





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



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



environment. ments in transparency, corporate governance, and



monitoring will be necessary. The capital market in-


Policy Recommendations


frastructure, such as accounting standards and legal



Over the last few years, there have been substantial mechanisms, should also be improved to this end.


reforms in the Indian capital market. But there are ○

On the supply side, to encourage corporate firms to
still many issues to be addressed to make it more rely more on stock markets for their source of fi-

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

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

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





Table 15: Matrix of Policy Recommendations




Issues Policy Recommendation



A. Market infrastructure

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

principles • Strictly enforce punitive measures for inaccurate accounting practice.


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

2. Legal mechanism

B. Corporate • Grant institutional investors voting power.


governance • Allow hostile takeovers.


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

subsidization and internal transactions between affiliated firms.



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

terms of time lag and uncertainty.


D. Debt market

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

investors • Further reduce statutory liquidity requirements.



• Further enhance the credibility of credit rating agencies.


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

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

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

from risk associated with subscriptions in the private placement market.



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

exchanges and interconnectivity.


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

intermediaries incentives.

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

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


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

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

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

banking liberalization.



INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 129

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



ACCOUNTING PRINCIPLES authorities may enforce a consolidated accounting



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



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



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



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



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



to adopt more internationally acceptable accounting


Reduction of Cost of Capital Issue


principles. The Institute of Chartered Accountants



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



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



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


3


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



ibility of corporate financial statements and trans- placements. Streamlining the procedure for public


parency, accounting principles should be improved ○

subscription of securities is necessary not only to re-
further to make them consistent with international duce administrative burdens and transaction costs,

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

counting profession should also be enhanced through


Activation of the Debt Market


stricter enforcement of punitive measures for inac-



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

vate the debt market, such as competitive pricing



LEGAL MECHANISM of Government securities, initiation of open market



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

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

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

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

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

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

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

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

4

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

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

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

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

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

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

valuation for all banks.


Improvement of Corporate

Governance Environment

DIVERSIFICATION OF INVESTOR BASE



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

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

which is prohibited now, and allow hostile takeovers, ditional investor groups such as individuals, firms,

130 A STUDY OF FINANCIAL MARKETS

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



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



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



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



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



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



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



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



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



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



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



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



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



associated with subscriptions in the private place-



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



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

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

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

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

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

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

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

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

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

countered difficulties in dematerializing them. In the vestor protection.



automated environment of the depository, it is not pos-



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

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

of debt is settled with the state governments, NSDL


instruments, several measures need to be undertaken.



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

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

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

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

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

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

development. Investor groups should be further diver-



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

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

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

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

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

ferred instrument. The popularity of private place- tory, and coverage of book-entry holding is expand-

INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 131

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



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



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



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



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



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



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



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



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



ties. This will also encourage the development of a


Integration of the Capital Market


repo market in nongovernment securities.


with the Banking Sector



Integration of Stock Exchanges and


Capital markets cannot thrive alone—they have to


Consolidation of Intermediaries

be integrated with the other segments of the finan-


A recent movement in India is the formation of the ○

cial system. Effective and efficient capital markets
Federation of Indian Stock Exchanges (FISE) by 12 require a stable and strong payment, settlement, and

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

5

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

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

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

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

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

ers and takeovers. market.













132 A STUDY OF FINANCIAL MARKETS

Appendix 1 down conditions under which disclosures and



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



Since 1992 shareholders. Regulations further revised and



strengthened in 1996.



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



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



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



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



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



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



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



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



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



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



to SEBI by the Government. ability.



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

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

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

• Reforms by SEBI in the primary market include trading.



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



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

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

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

with their projects while making public issues. centers.



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

to require listed companies to furnish annual forced.



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



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



lization of funds in the offer document and ac-


• Stock lending scheme introduced.



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

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

promises. set up by NSE.



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

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



sures. • SEBI strengthens surveillance mechanisms and



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

ducing cash flow statements. veillance departments.



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

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

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



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

tial acquisition of shares and takeovers and lays statements in the prospectus.

INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 133

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



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



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



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



banking, and other nonbank finance companies. through depositories.



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



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



SEBI. funds become effective.









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



The Indian Securities Market ment dominated by brokers.



Before 1992 • Merchant bankers and other intermediaries un-



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

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



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



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



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

financial system. • Private sector mutual funds not permitted.



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

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

• Investors faced problems of delays (refund, pany.



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



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

ties Contracts (Regulations) Act. No inspection



of stock exchanges undertaken.































134 A STUDY OF FINANCIAL MARKETS

Appendix 3 Department of Company Affairs



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



acted, which formalized and continued initial con-



INSTITUTIONS trols on the issue of securities that were introduced



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



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



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



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



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



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



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



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



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



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



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



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

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

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

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

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

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

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

venture capital funds, and takeovers, SEBI is also



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



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

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

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

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

istration.

stock brokers are a minority in the committees of



stock exchanges set up to handle matters of disci-



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

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

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

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

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

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

regulates primary dealers in the Government securi- brokers.



ties market. RBI instituted the primary dealership of



Government securities in March 1998. Securities DISCLOSURE



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

action need the permission of RBI. tries, a company offering securities in the Indian



INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES 135

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



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



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



• prospectus, appraise its position and to avoid the establishment



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



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



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



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



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



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



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



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



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



tinue to disclose in a timely manner to the exchange, • any change of the company’s directorate, includ-


to the holders of the listed securities (the sharehold- ○


ing managing directors and auditors.

Figure A3: Regulatory Framework of the Indian Securities Market


































DCA = Department of Company Affairs, FII = foreign institutional investor, SCR = Securities Contract Regulation, SEBI =Securities and Exchange Board of India.



















136 A STUDY OF FINANCIAL MARKETS

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



1947-1997.” In Banking and Financial Sector Reforms


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


1Euromoney (1996).



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


2They are the Discount and Finance House of India


Reserve Bank of India Bulletin. October.


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



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


Ltd., Industrial Credit and Investment Corporation of


Reserve Bank of India Bulletin, November.


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



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



various issues.


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



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



1996/97. Annual Report. India: SEBI.


4Up to August 1997.



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


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


kets—Towards Greater Efficiency.” In India Develop-


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

corporatizing their businesses.




sity Press.

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



Market Reforms.” Draft paper submitted to Asian De-


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

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