Professional Documents
Culture Documents
Indian Capital Market: Recent Developments and Policy Issues
Indian Capital Market: Recent Developments and Policy Issues
Yoon Je Cho
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cluding those relating to disclosure criteria, lack of
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There are 22 stock exchanges in India, the first be- broker capital adequacy, and poor regulation of mer-
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ing the Bombay Stock Exchange (BSE), which be- chant bankers and underwriters.
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gan formal trading in 1875, making it one of the old- There have been significant reforms in the regula-
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est in Asia. Over the last few years, there has been tion of the securities market since 1992 in conjunction
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a rapid change in the Indian securities market, espe- with overall economic and financial reforms. In 1992,
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cially in the secondary market. Advanced technol- the SEBI Act was enacted giving SEBI statutory sta-
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ogy and online-based transactions have modernized tus as an apex regulatory body. And a series of re-
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the stock exchanges. In terms of the number of com- forms was introduced to improve investor protection,
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panies listed and total market capitalization, the In- automation of stock trading, integration of national
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dian equity market is considered large relative to the markets, and efficiency of market operations.
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country’s stage of economic development. The num- India has seen a tremendous change in the sec-
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ber of listed companies increased from 5,968 in March ondary market for equity. Its equity market will most
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1990 to about 10,000 by May 1998 and market capi- likely be comparable with the world’s most advanced
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talization has grown almost 11 times during the same secondary markets within a year or two. The key
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in India even though there has been a large volume • exchanges based on open electronic limit order
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institutions have been holding a substantial part of • nationwide integrated market with a large num-
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these bonds as statutory liquidity requirement. The ber of informed traders and fluency of short or
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auction market for Government securities has been Among the processes that have already started
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created and a primary dealer system was introduced and are soon to be fully implemented are electronic
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in 1995. There are six authorized primary dealers. settlement trade and exchange-traded derivatives.
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Currently, there are 31 mutual funds, out of which 21 Before 1995, markets in India used open outcry, a
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to the private sector in 1992. Earlier, in 1987, banks signaled from within a pit. One major policy initiated
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were allowed to enter this business, breaking the by SEBI from 1993 involved the shift of all exchanges
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monopoly of the Unit Trust of India (UTI), which to screen-based trading, motivated primarily by the
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maintains a dominant position. need for greater transparency. The first exchange to
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Before 1992, many factors obstructed the expan- be based on an open electronic limit order book was
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sion of equity trading. Fresh capital issues were con- the National Stock Exchange (NSE), which started
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trolled through the Capital Issues Control Act. Trad- trading debt instruments in June 1994 and equity in
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ing practices were not transparent, and there was a November 1994. In March 1995, BSE shifted from
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large amount of insider trading. Recognizing the im- open outcry to a limit order book market. Currently,
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portance of increasing investor protection, several 17 of India’s stock exchanges have adopted open
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the capital market. The Securities and Exchange Before 1994, India’s stock markets were domi-
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Board of India (SEBI) was established in 1988. De- nated by BSE. In other parts of the country, the fi-
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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
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kets and was unable to participate in forming prices, should be enhanced to better protect small share-
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compared with market participants in Mumbai holders’ rights and their capacity to monitor corpo-
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(Bombay). As a result, the prices in markets outside rate activities. Second, the trading system has to be
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Mumbai were often different from prices in Mumbai. made more transparent. Market information is a cru-
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These pricing errors limited order flow to these mar- cial public good that should be disclosed or made
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kets. Explicit nationwide connectivity and implicit available to all participants to achieve market effi-
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movement toward one national market has changed ciency. SEBI should also monitor more closely cases
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this situation (Shah and Thomas, 1997). NSE has of insider trading. Third, India may need further inte-
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established satellite communications which give all gration of the national capital market through consoli-
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trading members of NSE equal access to the mar- dation of stock exchanges. The trend all over the world
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ket. Similarly, BSE and the Delhi Stock Exchange is to consolidate and merge existing stock exchanges.
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are both expanding the number of trading terminals Not all of India’s 22 stock exchanges may be able to
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located all over the country. The arbitrages are elimi- justify their existence. There is a pressing need to de-
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nating pricing discrepancies between markets. ○
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velop a uniform settlement cycle and common clear-
Despite these big improvements in microstructure, ing system that will bring an end to unnecessary specu-
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the Indian capital market has been in decline during lation based on arbitrage opportunities. Fourth, the
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the last three years. The amount of capital issued payment system has to be improved to better link the
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has dropped from the level of its peak year,1994/95, banking and securities industries. India’s banking sys-
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and so have equity prices. In 1994/95, Rs276 billion tem has yet to come up with good electronic funds
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was raised in the primary equity market. This figure transfer (EFT) solutions. EFT is important for prob-
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fell to Rs208 billion in 1995/96 and to Rs142 billion in lems such as direct payments of dividends through
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1996/97. The BSE-30 index or Sensex, the sensitive bank accounts, eliminating counterparty risk, and fa-
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index of equity prices, peaked at 4,361 in September cilitating foreign institutional investment. The capital
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1994 and fell during the following years. A leading market cannot thrive alone; it has to be integrated with
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cause was that financial irregularities and over- the other segments of the financial system. The global
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valuations of equity prices in the earlier years had trend is for the elimination of the traditional wall be-
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eroded public confidence in corporate shares. Also, tween banks and the securities market.
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there was a reduced inflow of foreign investment Securities market development has to be supported
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after the Mexican and Asian financial crises. In a by overall macroeconomic and financial sector envi-
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sense, the market is now undergoing a period of ad- ronments. Further liberalization of interest rates, re-
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justment. Thus, it is time for regulatory authorities to duced fiscal deficits, fully market-based issuance of
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make greater efforts to recover investors’ confidence Government securities, and a more competitive bank-
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and to further improve the efficiency and transpar- ing sector will help in the development of a sounder
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corporate governance. Accounting standards will Over the last few years, SEBI has announced sev-
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have to adapt to internationally accepted accounting eral far-reaching reforms to promote the capital
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114 A STUDY OF FINANCIAL MARKETS
market and protect investor interests. Reforms in the Most stock exchanges have introduced online trad-
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secondary market have focused on three main ar- ing and set up clearing houses/corporations. A de-
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eas: structure and functioning of stock exchanges, pository has become operational for scripless trad-
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automation of trading and post trade systems, and ing and the regulatory structure has been overhauled
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the introduction of surveillance and monitoring sys- with most of the powers for regulating the capital
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tems. (See Appendix 1 for a listing of reforms since market vested with SEBI. The Indian capital market
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1992). Computerized online trading of securities, and has experienced a process of structural transforma-
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setting up of clearing houses or settlement guaran- tion with operations conducted to standards equiva-
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tee funds were made compulsory for stock ex- lent to those in the developed markets. It was opened
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changes. Stock exchanges were permitted to expand up for investment by foreign institutional investors
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their trading to locations outside their jurisdiction (FIIs) in 1992 and Indian companies were allowed
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through computer terminals. Thus, major stock ex- to raise resources abroad through Global Depository
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changes in India have started locating computer ter- Receipts (GDRs) and Foreign Currency Convertible
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minals in far-flung areas, while smaller regional ex- Bonds (FCCBs). The primary and secondary seg-
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changes are planning to consolidate by using cen- ments of the capital market expanded rapidly, with
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tralized trading under a federated structure. Online greater institutionalization and wider participation of
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trading systems have been introduced in almost all individual investors accompanying this growth. How-
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stock exchanges. Trading is much more transparent ever, many problems, including lack of confidence in
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and quicker than in the past. stock investments, institutional overlaps, and other
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Until the early 1990s, the trading and settlement governance issues, remain as obstacles to the im-
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infrastructure of the Indian capital market was poor. provement of Indian capital market efficiency.
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regulatory structure was fragmented and there was Since 1991/92, the primary market has grown fast
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neither comprehensive registration nor an apex body as a result of the removal of investment restrictions
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of regulation of the securities market. Stock ex- in the overall economy and a repeal of the restric-
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changes were run as “brokers clubs” as their man- tions imposed by the Capital Issues Control Act. In
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was no prohibition on insider trading, or fraudulent market. This figure rose to Rs276.21 billion in 1994/
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and unfair trade practices (see Appendix 2). 95. Since 1995/1996, however, smaller amounts have
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Since 1992, there has been intensified market re- been raised due to the overall downtrend in the mar-
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form, resulting in a big improvement in securities trad- ket and tighter entry barriers introduced by SEBI for
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ing, especially in the secondary market for equity. investor protection (Table 1).
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Year Number Amount (Rs billion) Number Amount (Rs billion) Number Amount (Rs billion)
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Figure 1: Price and P/E Ratio for the Sensitive
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Rs5,898 billion (Table 2), equivalent to about half of Index of the Stock Exchange
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India’s annual gross domestic product (GDP) for the
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BSE Sensex P/E Ratio
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same fiscal year. India compares favorably with other 5,000 60
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emerging markets in this respect. The market capi- 50
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4,000
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talization-GDP ratio at end-1995 was 22.4 percent
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40
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3,000
for Brazil; 12.6 percent for Hong Kong, China;
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40 percent for Indonesia; 41 percent for Korea; 2,000
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1 20
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and 37.1 percent for Mexico. It was higher how-
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1,000 10
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ever, in Malaysia (281.9 percent), Philippines Sensex
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P/E Ratio
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(81.3), Singapore (233 percent), and Thailand
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1991 1992 1993 1994 1995 1996 1997 1998
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(152.9 percent).
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Data from January 1991 to January 1998.
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Source: Bombay Stock Exchange
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Table 2: Number of Listed Companies and Market
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Capitalization
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Number Amount of ○
the monthly average Sensex P/E ratio was 15.65
of Listed Capitalization
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Year Companies (Rs billion) while the figure for October 1993 was 38.76.
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1999a
SEBI has taken several measures to improve the
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9,877 5,741
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a As of March.
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For the past 12 years, equity prices have seen two ket margin and intraday trading limit have also been
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extended periods of declining prices and two periods imposed. Further, the stock exchanges have put in
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of rising prices. Between April 1986 and March 1988, place circuit breakers, which are applied in times of
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Sensex decreased from 589 to 398, or by 32 per- excessive volatility. The disclosure of short sales and
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cent. Prices also fell between March 1992, when long purchases is now required at the end of the day
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the monthly closing level of Sensex was 4,258, and to reduce price volatility and further enhance the in-
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April 1993, when the level was 2,122, a decline of tegrity of the secondary market.
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riods from March 1988 to March 1992 and from May MARK-TO-MARKET MARGIN AND INTRADAY LIMIT
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1993 to August 1994. The monthly closing level of Under the current clearing and settlement system, if
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Sensex climbed from 398 in March 1988 to 4,285 in an Indian investor buys and subsequently sells the
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March 1992, an increase of more than 10 times. In same number of shares of stock during a settlement
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the second period of extended rising equity prices, period, or sells and subsequently buys, it is not nec-
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Sensex increased 1.16 times. Since 1995, it has fluc- essary to take or deliver the shares. The difference
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tuated around the 3,000-4,000 mark (see Figure 1). between the selling and buying prices can be paid or
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In April 1998, it hovered around 3,000. received. In other words, the squaring-off of the trad-
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In the period of declining prices, from August 1994 ing position during the same settlement period re-
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to March 1998, the price-earnings (P/E) ratio fell sults in nondelivery of the shares that the investor
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more sharply than prices (Figure 1). In March 1998, traded. A short-term and speculative investment is
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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
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mestic institutional investors are, however, not per- funding cost is about 24-36 percent (Endo 1998).
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mitted to trade without delivery, since nondelivery Thus, speculative trading without the delivery of
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transactions are limited only to individual investors. shares is no longer cost-free.
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One of SEBI’s primary concerns is the risk of Each broker’s trading volume during a day is not
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settlement chaos that may be caused by an increas- allowed to exceed the intraday trading limit. This limit
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ing number of nondelivery transactions as the stock is 33.3 times the base minimum capital deposited with
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market becomes excessively speculative. Accord- the exchange on a gross basis, i.e., purchase plus
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ingly, SEBI has introduced a daily mark-to-market sale. In the event of brokers wishing to exceed this
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margin and intraday trading limit. The daily mark-to- limit, they have to deposit additional capital with the
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market margin is a margin on a broker’s daily posi- exchange and this cannot be withdrawn for six
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tion. The intraday trading limit is the limit to a broker’s months.
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intraday trading volume. Every broker is subject to
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these requirements. CIRCUIT BREAKER
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Each stock exchange may take any other mea- SEBI has imposed price limits for stocks whose mar-
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sures to ensure the safety of the market. BSE and ket prices are above Rs10 up to Rs20, a daily price
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NSE impose on members a more stringent daily change limit and weekly price change limit of 25 per-
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margin, including one based on concentration of busi- cent. BSE imposes price limits as a circuit breaker
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the notional loss of the stockbroker for every stock, BSE’s computerized trading system rejects buy
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calculated as the difference between buying or selling or sell orders of a stock at prices outside the price
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price and the closing price of that stock at the end of limits. The daily price limit of a stock is measured
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that day. However, there is a threshold limit of 25 per- from the stock’s closing price in the previous trading
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cent of the base minimum capital plus additional capi- session. The weekly price limit is based on its clos-
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tal kept with the stock exchange or Rs1 million, which- ing price of the last trading in the previous week,
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ever is lower. Until the notional loss exceeds the thresh- usually its closing price on the previous Friday.
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stock exchange in cash or as a bank guarantee from SEBI regulates short selling in the stock market by
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a scheduled commercial bank, on a net basis. It will requiring all stock exchanges to enforce reporting
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be released on the pay-in day for the settlement pe- by members of their net short sale and long pur-
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riod. The margin money is held by the exchange for chase positions in each stock at the end of each
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6-12 days. This costs the broker about 0.4-1.2 per- trading day.
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Up to Rs1 75 No Limit
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A scheme for regulating stock lending was intro- usually the fund sponsor or its subsidiary. The regu-
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duced in February 1997, following changes in tax lations prescribed disclosure and advertisement norms
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regulations. Stock lending can take place through for mutual funds, and, for the first time, permitted
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an intermediary registered for this purpose with the entry of private sector mutual funds. FIIs regis-
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SEBI, and which has a minimum capital of Rs500 tered with SEBI may invest in domestic mutual funds,
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million. Lenders and borrowers of securities have whether listed or unlisted.
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to enter into agreements with the intermediary. Stock The 1993 Regulations have been revised on the
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lending facilitates the timely settlement of transac- basis of the recommendations of the Mutual Funds
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tions on the stock exchanges, especially in an envi- 2000 Report prepared by SEBI. The revised regula-
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ronment where physical delivery of certificates is tions strongly emphasize the governance of mutual
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required for settlement. funds and increase the responsibility of the trustees
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in overseeing the functions of the asset management
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Introduction of Derivatives Trading
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company. Mutual funds are now required to obtain
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At present, there are no exchange traded deriva- ○
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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
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country. However, a new law has been passed per- which unit holders have invested. The revised regu-
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mitting the trading of derivatives. This followed rec- lations require disclosures in terms of portfolio com-
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ommendations for the establishment of a regulatory position, transactions by schemes of mutual funds
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framework for derivatives by a committee chaired with sponsors or affiliates of sponsors, with the as-
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by L.C. Gupta. It is expected that derivatives trading set management company and trustees, and also with
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will soon form part of the Indian securities market. respect to personal transactions of key personnel of
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Institutional Investors
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Indian investors have been able to invest through FIIs have been allowed to invest in the Indian secu-
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mutual funds since 1964, when UTI was established. rities market since September 1992 when the Guide-
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Indian mutual funds have been organized through the lines for Foreign Institutional Investment were issued
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Indian Trust Acts, under which they have enjoyed by the Government. The SEBI (Foreign Institutional
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certain tax benefits. Between 1987 and 1992, public Investors) Regulations were enforced in November
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sector banks and insurance companies set up mutual 1995, largely based on these Guidelines. The regula-
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funds. Since 1993, private sector mutual funds have tions require FIIs to register with SEBI and to obtain
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been allowed, which brought competition to the mu- approval from the Reserve Bank of India (RBI) un-
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tual fund industry. This has resulted in the introduc- der the Foreign Exchange Regulation Act to buy and
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tion of new products and improvement of services. sell securities, open foreign currency and rupee bank
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The notification of the SEBI (Mutual Fund) Regula- accounts, and to remit and repatriate funds. Once
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tions of 1993, brought about a restructuring of the SEBI registration has been obtained, an FII does not
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mutual fund industry. An arm’s length relationship is require any further permission to buy or sell securi-
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required between the fund sponsor, trustees, custo- ties or to transfer funds in and out of the country,
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dian, and asset management company. This is in con- subject to payment of applicable tax.
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trast to the previous practice where all three func- Foreign investors, whether registered as FIIs or
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tions, namely trusteeship, custodianship, and asset not, may also invest in Indian securities outside the
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118 A STUDY OF FINANCIAL MARKETS
FII process. Such investment requires case-by-case Since 1993/94, foreign portfolio investment has so
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approval from the Foreign Investment Promotion far exceeded foreign direct investment, which has also
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Board (FIPB) in the Ministry of Industry and RBI, increased rapidly (Table 5). Investment through FIIs
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or only from RBI depending on the size of invest- constituted the bulk of portfolio investment. Annual
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ment and the industry in which the investment is to inflows have been about $1.5 billion-$2 billion from
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be made. Investment in Indian securities is also pos- 1993/94 to 1996/97 through FIIs, while inflows through
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sible through the purchase of GDRs. Foreign cur- GDRs have declined after peaking at $1.8 billion in
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rency convertible bonds and foreign currency bonds 1994/95. In 1996/97, India received $5.6 billion in for-
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issued by Indians that are listed, traded, and settled eign investment of which $1.9 billion was through FIIs.
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overseas are mainly denominated in dollars. Foreign During 1997/98, FIIs’ investment fell while foreign
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financial service institutions have also been allowed direct investment rose. Improvement in inflow of for-
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to set up joint ventures in stockbroking, asset man- eign investment raised India’s foreign exchange re-
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agement companies, merchant banking, and other serves from $17 billion at the end of 1994/95 to $29.3
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financial services firms along with Indian partners. billion at the end of June 1997.
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Foreign portfolio investments in Indian companies Following the changes to the 1995 SEBI (Foreign
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are limited to individual foreign ownership at 10 per- Institutional Investors) Regulations, an FII is allowed
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cent of the total issued capital of any one company to set up an investment fund to invest in Indian bonds
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and to aggregate foreign ownership at 30 percent of if it registers the fund with SEBI as a new separate
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the total issued capital of any one company. FII or its new subaccount. In 1996, SEBI approved
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FIIs’ net investment was positive until October nine debt funds with a cumulative investment expo-
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1997 and their cumulative investments reached $9.1 sure of $1.278 billion for investment in securities.
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billion in the same month. But since then, it has turned FIIs seem to have a strong impact on equity price
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negative due to the Asian financial crisis (Table 4). movements in India. Trend analysis has shown a sig-
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As of May 1998, 496 FIIs were registered with SEBI, nificantly positive relationship between BSE Sensex
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with a cumulative net investment of $9.2 billion in and the lagged net investment by FIIs. Figure 2 sug-
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the Indian securities market. gests that monthly net investment has been taking
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No. of Cumulative
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Registered Net
Gross Purchase Gross Sales Net Investment
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FIIs Investment
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1996/97 (Apr-Jan) 429 127.01 3,595.6 52.15 1,467.0 74.86 2,128.6 7,331.0
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1997/98 (Apr-Jan ) 476 143.82 3,979.4 102.12 2,807.4 41.69 1,172.0 8,781.5
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Total (since Jan 1993) 476 527.57 15,422.2 232.43 6,640.6 295.32 8,781.5 8,781.5
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Oct 1997 471 16.0 442.0 9.66 267.0 6.33 174.9 9,090.3
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Nov 1997 475 10.93 295.4 15.05 406.7 (4.11) (111.3) 8,979.0
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Dec 1997 476 9.34 251.0 14.60 392.3 (5.26) (141.3) 8,837.7
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Jan 1998 476 6.52 175.2 8.62 231.5 (2.09) (56.3) 8,781.4
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Table 5: Foreign Investment Inflows ($ million)
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Item 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97
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Direct investment 150 341 566 1314 2,133 2,696
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Government (SIA/FIPB) 87 238 280 701 1,249 1,922
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RBI 42 89 171 169 135
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NRI 63 61 217 442 715 639
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Portfolio investment 8 92 3,649 3,581 2,748 2,864
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GDRs 86 1,602 1,839 683 918
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FIIs 1 1,665 1,503 2,009 1,926
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Offshore funds and others 8 5 382 239 56 20
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Total 158 433 4,215 4,895 4,881 5,560
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FII = foreign institutional investor, FIPB = Foreign Investment Promotion Board, GDR = global depository receipt, NRI = nonresident Indian, RBI = Reserve Bank of India,
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SIA = Secretariat for Industrial Assistance.
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Source: Reserve Bank of India, Report on Currency and Finance, various issues.
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Figure 2: Monthly Net FII Investment and BSE-30 Index • depositories, participants, custodians of securi-
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Sensex
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600 3,000
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400 2,000
However, the registration system is far from com-
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0 0
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the lead in changing market sentiments as reflected registration system at all for investment advisors.
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in the market index movements. The capital adequacy requirements for registered
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Policy Issues
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Regulatory Framework
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Participants in the Indian capital market are required The majority are thinly capitalized. As a result, SEBI’s
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to register with SEBI to carry out their businesses. limited resources are spread too thinly to register
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istrars to an issue, merchant bankers, underwrit- The Indian law defines a stockbroker simply as
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○
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-
○
○
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
○
○
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-
○
○
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-
○
○
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
○
○
Merchant Banker Applicant (old regulations) cies for the securities market seem to be fragmented.
○
○
Minimum Amount of
○
Category Net Worth (Rs million) of the securities market, deriving its powers of regis-
○
○
II 5
○
III 2
○
.. = nil
○
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
○
○
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.
○
○
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-
○
○
Stock Market
○
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-
○
○
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
○
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
○
○
Secondary Market
○
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
○
○
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.
○
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
○
○
In India, certificates of securities are registered the benefits are expected to extend to the vast ma-
○
○
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)
○
○
○
Clearing
○
a 1996-1997
○
○
○
○
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.
○
○
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-
○
○
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
○
PPF 23.3 15.3 1.1 0.0 1.1 0.8 0.6 0.5 0.6
○
○
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
○
PPF 3.1 21.0 2.7 0.0 3.4 2.9 2.8 2.8 4.0
○
Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
○
○
○
○
na = not available.
○
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
○
1994/95
○
Source: Reserve Bank of India, Report on Currency and Finance, various issues.
○
○
○
○
○
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
○
○
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
○
○
○
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
○
○
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
○
○
Investors
○
MUTUAL FUNDS
○
○
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-
○
○
○
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-
○
○
A. Market infrastructure
○
1. Accounting • Improve accounting principles, make them consistent with international practice.
○
• Establish prompt and effective settlement of disputes to protect small investors’ interests.
○
2. Legal mechanism
○
• Require consolidated balance sheets for conglomerates-affiliated firms to better monitor cross-
○
C. Cost of capital issue • Streamline the procedure for public subscription of securities to reduce transaction costs in
○
D. Debt market
○
1. Diversification of • Apply fully market-based interest rates for issuing Government securities.
○
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
○
E. Integration of stock • Provide favorable environment or some incentives for establishing central trading system through
○
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
○
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.
○
○
curate accounting practices. Several policy measures have been taken to acti-
○
○
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
○
○
Improvement of Corporate
○
○
Governance Environment
○
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-
○
○
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
○
○
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
○
○
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
○
○
○
○
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
○
○
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
○
○
• Listing agreements of stock exchanges amended • Capital adequacy requirement for brokers en-
○
○
tual figures. This is to enable shareholders to • Transparency brought out in short selling.
○
○
make comparisons between performance and • National Securities Clearing Corporation, Ltd.
○
○
• SEBI introduces a code of advertisement for • BSE in the process of implementing a trade guar-
○
○
• Disclosure norms further strengthened by intro- directs all stock exchanges to have separate sur-
○
○
• 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
○
○
• 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.
○
○
• Primary markets not in the mainstream of the (NAV) not published; no valuation norms.
○
○
• 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-
○
○
• Stock exchanges regulated through the Securi- and unfair trade practices.
○
○
○
○
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.
○
○
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.
○
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
○
○
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.
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
○
○
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.
References
○
velopment Bank.
○
○
○
Endo, Tadashi. 1998. The Indian Securities Market—A Tarapore, S. S. “The Government Securities Market: The
○
Books. India.
○
○
Gupta, L.C. 1998. “What Ails the Indian Capital Market?” Euromoney. 1996. World Equity Guide. UK: Euromoney
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