India's Financial Sector: An Era of Reforms

India’s Financial Sector

India’s Financial Sector

ii

India’s Financial Sector An Era of Reforms

Vyuptakesh Sharan

Copyright © Vyuptakesh Sharan, 2009 All rights reserved. No part of this book may be reproduced or utilised in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage or retrieval system, without permission in writing from the publisher. First published in 2009 by SAGE Publications India Pvt Ltd B1/I-1 Mohan Cooperative Industrial Area Mathura Road, New Delhi 110 044, India www.sagepub.in SAGE Publications Inc 2455 Teller Road Thousand Oaks, California 91320, USA SAGE Publications Ltd 1 Oliver’s Yard 55 City Road London EC1Y 1SP, United Kingdom SAGE Publications Asia-Pacific Pte Ltd 33 Pekin Street #02-01 Far East Square Singapore 048763 Published by Vivek Mehra for SAGE Publications India Pvt Ltd, typeset in 10.5/12.5 pt Minion by Star Compugraphics Private Limited, Delhi and printed at Chaman Enterprises, New Delhi. Library of Congress Cataloging-in-Publication Data Sharan, Vyuptakesh. India’s financial sector : an era of reforms/Vyuptakesh Sharan. p. cm. Includes bibliographical references and index. 1. Financial institutions—India. 2. Finance—India. I. Title. HG187.I4S535

332.10954—dc22

2009

2009034894

ISBN: 978-81-321-0242-7 (HB) The SAGE Team: Elina Majumdar, Meena Chakravorty and Trinankur Banerjee

To my parents Smt. Kalyani Devi and Shri Hrishikesh Sharan

India’s Financial Sector

vi

Contents

List of Tables List of Figures and Box List of Abbreviations Preface Introduction Part I:

ix xiii xiv xvii xix

Reforms in Financial Intermediaries

1

The Banking Sector

3

2

Non-banking Financial Companies

27

3

Mutual Funds

46

Part II: Financial Markets and Instruments 4

The Primary Market for Securities

69

5

The Secondary Capital Market

85

6

The Market for Government Securities

107

7

The Money Market

124

8

The Foreign Exchange Market

144

Part III: Internationalisation of Indian Financial Market 9 Euro Issues of Indian Firms 10 Foreign Institutional Investment in India

163 178

India’s Financial Sector

Epilogue Postscript Appendix Bibliography Index About the Author

194 203 221 225 232 237

viii

List of Tables

1.1

Capital Adequacy Ratio—Bank Group-wise

8

1.2

Changes in CRR and SLR

9

1.3

NPA Ratios of Commercial Banks

13

1.4

Movements in Deposit and Lending Interest Rates

15

1.5

Banks’ Operating Cost as Percentage of Assets

20

1.6

Operational Efficiency of the Banks in India

22

1.7

Financial Stability Ratios of the Banks in India

24

2.1

Deposits and NOFs among Different Types of NBFCs as on 31 March 1992

31

2.2

Number of NBFCs Registered with the RBI

38

2.3

Deposits held by NBFC-Ds at the end of March 2007 and March 2008

39

2.4

CRAR among NBFCs: March 2001 to March 2008

40

2.5

Interest Rate on Deposits of NBFC-Ds

41

2.6

Gross and Net NPAs in Relation to Assets

42

2.7

Operational Ratios of NBFC-Ds

43

3.1

Resource Mobilisation by Mutual Funds: Gross and Net

56

3.2

Resource Mobilisation by Different Categories of Mutual Funds

57

3.3

Scheme-wise Resource Mobilisation during FY 2007–08

58

3.4

Growth in Net Assets under Management of Mutual Funds

60

Various Segments of Net Assets under Management

61

3.5

India’s Financial Sector

3.6

Mutual Funds’ Investment in Secondary Capital Market in 2000s

63

Resource Mobilisation from the Domestic Primary Capital Market

77

Equity and Debt Funds Raised in the Domestic Primary Market

79

Share of Public and Private Sectors in Funds Raised in the Primary Market

80

4.4

Industry-wise Resource Mobilisation

81

5.1

Turnover and Market Capitalisation at BSE and NSE (Cash Segment)

95

5.2

Stock Market Indices and the Price/Earning Ratio

96

5.3

Turnover in the Equity Derivatives Market

97

5.4

Capitalisation and Turnover in Relation to GDP

99

5.5

Turnover of Debt Securities Traded at NSE

100

5.6

FIIs’ Investment in Indian Secondary Capital Market in 2000s

101

Mutual Funds’ Investment in Secondary Capital Market in the 2000s

102

5.8

Return and Risk in BSE Sensex and NSE Nifty

104

5.9

Inter-country Comparison of Return and Risk during FY 2007–08

104

6.1

T-bills: Gross and Net Amount

115

6.2

Dated Securities: Gross and Net Amount

116

6.3

Central Government Securities and Financing of the Gross Fiscal Deficit

117

Government Security Transactions in the Secondary Market

118

Coefficient of Variation of Monthly Transactions of Government Securities

119

Yield of Government Securities

120

4.1 4.2 4.3

5.7

6.4 6.5 6.6

x

List Introduction of Tables

6.7

Relationship between Yield on Dated Securities and Cost of Funds of Some Financial Institutions in India

121

7.1

Average of Daily Turnover in the CNMM (Double Leg)

128

7.2

Average of Daily Call Money Rates

129

7.3

Average of Daily Turnover in the CBLO Market (Double Leg)

131

Average of Daily Volume of Transaction (All Legs) in the Repo Market (Outside LAF)

132

7.5

Stamp Duty on the Issuance of CP

134

7.6

Issue of CP (Outstanding Amount) during the 2000s

136

7.7

Average of the Maximum and Minimum Discount Rates on CPs

136

Issue of CDs: The Outstanding Amount during the 2000s

139

Average of the Maximum and Minimum Discount Rates on CDs

140

Share of Different Segments in Money Market Transactions

141

Correlation Coefficient among Interest/Discount Rates in Different Segments

143

8.1

Rs./US$ Exchange Rate

145

8.2

RBI’s Purchase and Sale of Foreign Currency during the 2000s

154

8.3

Turnover in the Indian Foreign Exchange Market

155

8.4

Swap Transactions in the Inter-bank Market

156

8.5

CV in Respect of Monthly Turnover in Merchant and Inter-bank Segments

158

9.1

Euro Issues of Indian Companies

169

9.2

The Quarterly Variation in the Size of Issue

170

9.3

Select ADRs’ Trading at the New York Stock Exchange: 10 August 2007

174

7.4

7.8 7.9 7.10 7.11

xi

India’s Financial Sector

9.4 9.5

Issue and Market Prices of GDRs of Indian Firms at LSE on 9 February 2007

175

Correlation between ADRs/GDRs Price and the Respective Rupee Share Prices in the Secondary Market 176

10.1

Size of FIIs’ Net Investment in India

179

10.2

FIIs’ Net Investment in Equity and Debt Securities

181

10.3

Foreign Portfolio Flows and Investment in the Country

189

Annual Volatility in FII Flows Based on Monthly Figures

192

10.5

Turnover at BSE and NSE and Share of the FIIs

192

PS 1

FIIs’ Net Investment in Indian Financial Market

205

PS 2

Secondary Capital Market Indices

207

PS 3

Annualised Volatility in Stock Market Indices during April to December 2008

208

Resource Mobilisation in the Primary Market for Securities

209

Changes in the ADR/GDR Prices vis-à-vis Respective Local Prices of 14 Sensex firms during 10 January to 19 March 2008

212

Exchange Rate: Indian Rupee vis-à-vis US Dollar and Euro during April to December 2008

213

Transactions in Indian Money Market

217

Price of ADRs/GDRs Traded on 29 December 2006, 2 January 2008, 1 April 2008 and 30 June 2008

221

10.4

PS 4 PS 5

PS 6 PS 7 PS A1

xii

List of Figures and Box

Figures I.1

The Contour of the Indian Financial System

xxv

5.1

Turnover in Cash and Derivatives Segment

98

6.1

Ownership Pattern of Government Securities, 1991

122

6.2

Ownership Pattern of Government Securities, 2006

122

7.1

Movement in Repo/Reverse Repo and Call Money Market Rates

142

8.1

Turnover in the Indian Foreign Exchange Market

155

8.2

Monthly Turnover in the Indian Foreign Exchange Market

157

9.1

Funds Raised through Euro Issues

169

9.2

Quarterly Funds Raised from Euro Issues

171

10.1

FIIs’ Annual Net Investment: April 1993 to March 2008

179

10.2

FIIs’ Investment in Debt and Equity

181

10.3

FIIs’ Monthly Net Investment in India: FYs 1999–2008

191

Box 10.1 FII Policy Liberalisation Measures

186

List of Abbreviations

AD ADR AFC AFC-ND-SI AMC ARCIL ARF BIFR BSE CAC CARE CBLO CCI CCIL CD CDSL CMIE CNMM CP CRAR CRISIL CRR CV DFHI DTL DVP ELC FCCBs FDI

Authorised Dealer American Depository Receipt Asset Financing Company Systemically Important AFC Not Accepting Deposits Asset Management Company Asset Reconstruction Company of India Ltd Asset Reconstruction Fund Board for Industrial and Financial Reconstruction Bombay Stock Exchange Capital Account Convertibility Credit Analysis and Research on Equities Collateralised Borrowing and Lending Obligations Controller of Capital Issues Clearing Corporation of India Ltd Certificates of Deposit Central Depository Services Ltd Centre for Monitoring Indian Economy Call/Notice Money Market Commercial Paper Capital to Risk-weighted Assets Ratio Credit Rating Information Services of India Ltd Cash Reserves Ratio Coefficient of Variation Discount and Finance House of India Demand and Time Liabilities Delivery versus Payment Equipment Leasing Company Foreign Currency Convertible Bonds Foreign Direct Investment

List Introduction of Abbreviations

FEMA FIIs FRBMA GAAP GDR GIC HPC ICRA IDBI IFRS IPO LA LAF LIC MCX MIBOR MMMF NABARD NASDAQ NAV NBFC-D NBFC-ND NBFCs NDS NOF NPA NRI NSDL NSE OCTEI PD QIP RBI RBIB RNBC

Foreign Exchange Management Act Foreign Institutional Investors Fiscal Responsibility and Budget Management Act Generally Accepted Accounting Principles Global Depository Receipt General Insurance Corporation Hire Purchase Company Investment Information and Credit Rating Agency of India Ltd Industrial Development Bank of India International Financial Reporting Standards Initial Public Offering Liquid Assets Liquidity Adjustment Facility Life Insurance Corporation of India Multi-commodity Exchange Mumbai Inter-bank Offer Rate Money Market Mutual Fund National Bank for Agriculture and Rural Development National Association of Securities Dealers Automated Quotation Net Asset Value Non-banking Financial Company Accepting Deposits Non-banking Financial Company Not Accepting Deposits Non-banking Financial Companies Negotiated Dealing System Net-owned Funds Non-performing Asset Non-resident Indian National Securities Depository Ltd National Stock Exchange Over-the-counter Exchange of India Primary Dealer Qualified Institutional Placement Reserve Bank of India Reserve Bank of India Bulletin Residuary Non-banking Company xv

India’s Financial Sector

SARFAEST SD SEBI SEO SGL SLR SWIFT T-bills UTI VL WTO

Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Satellite Dealers Securities and Exchange Board of India Subsequent Equity Offering Subsidiary General Ledger Statutory Liquidity Ratio Society for Worldwide Inter-bank Telecommunication Treasury Bills Unit Trust of India Volatile Liabilities World Trade Organization

xvi

Preface

A couple of years back, I had to chair a seminar on financial sector reforms. The young participants presented their views on different aspects of the Indian financial sector. Some of the presentations were really very good. But, I felt the discussion of reforms in this sector from the viewpoint of financial stability and financial inclusion was not stressed upon in a desired way. Moreover, the content of the internationalisation of the Indian financial market was utterly lacking. In fact, this encouraged me to write on the Indian financial sector reforms incorporating especially these viewpoints. The present book presents, in the very beginning, the nature and efficacy of financial sector reforms, draws, in very brief, the broad contour of the Indian financial sector, traces various measures of reform in different segments of this sector and, finally, shows the impact of the reform measures. The impact is analysed from the viewpoint of efficiency that reflects also in profitability. But since profitability has no meaning sans financial stability, the analysis takes well into account the aspect of stability. Again, over more than one-and-a-half decades of the reform era, the financial sector could achieve at least a level of maturity where one was bound to think of financial inclusion. So the present analysis considers this aspect too. The opening of the Indian financial sector to foreign investors has been a part of the reform process. And so the present analysis cannot overlook the foreign investment irrespective of its form. I have tried to incorporate these elements in the analysis. The savers forming one end of financial intermediation are of varied economic, social and educational strata. They need to keep themselves abreast of the developments in the Indian financial sector.

India’s Financial Sector

So the analysis in this book is especially designed for them. It is simple and lucid with no sophisticated econometric tools. I have benefited from the discussion with my colleagues and professionals working in this branch of study. I am thankful to all of them. I also wish to express my sincere thanks to my wife, Roopa Sharan, for the inspiration and encouragement she has provided for preparing this book. Archana and Lokesh should also be thanked for their assistance in compilation of figures and their calculation. I am sure the readers will find this book useful. Vyuptakesh Sharan

xviii

Introduction

For around two-and-a-half decades, a number of developing countries have been practising economic reforms, more precisely known as structural adjustment and macroeconomic reforms, for better allocation of resources and thereby improving economic performance through changes in economic policies. These two terms, macroeconomic stabilisation programme and structural adjustment are interdependent and quite often overlap each other despite a fine distinction between them. The macroeconomic reform involves an immediate change in policies and aims at achieving short-term objectives. Structural adjustment, on the other hand, involves more fundamental changes in the way the economy operates. It modifies the very structure of the economy towards meeting long-term objectives. It takes into account recording of priorities and reconsideration of policy instruments. There may be variations across different countries in adopting economic reforms, but by and large, the policy package encompasses production, saving and investment, sectoral development, monetary and budgetary targets and the external sector (Woodward 1992). Structural adjustment programmes are wide ranging. They tend to reduce the role of the state in matters relating to private sector, to allow prices and income to respond freely to market forces and to open the economy to foreign trade and investment. The rationale is that the private sector is more efficient and the free play of market forces leads to optimal resource allocation. Again, the proceeds of privatisation represent a non-inflationary source of financing for the budgetary deficits. India initiated this process on a full-fledged scale as back as early mid-1991. This was the time when most of the macroeconomic variables in the country were lying on the wrong end of the stick and it

India’s Financial Sector

was very much imperative for the government to remedy those ills and bring the economy back on the rails. The measures of economic reform in India are broad-based covering all the vital sectors of the economy and consequently, the policies—fiscal, financial, monetary, industrial and external—underwent a big change. The reforms in different sectors are interlinked, although the linkage may not be very much direct and proximate. The present study is concerned with the financial sector. The objective is to delineate the major policy changes and, more importantly, to assess the impact of the reform measures. We do agree that some of the policy changes have long-term implications, and the impact will definitely be clearer in the future years, yet the study is based on the experiences during the first oneand-a-half decades of the reforms in the financial sector, say, up to the financial year (FY) 2007–08. The present chapter acquaints the readers with the very concept of financial sector reforms, the contour of the Indian financial system, the strategy of financial sector reforms in India and with the impact of the reform measures.

THE CONCEPT OF FINANCIAL SECTOR REFORM Financial Sector and Economic Growth Why should there be focus of reform on the financial sector? It is simply because the financial sector in an economy is very crucial and so is its orderly development. It is true that, in some quarters, the relationship between financial sector and economic growth is not supposed to be very significant (Chandavarkar 1992; Lucas 1988), but there does exist strong arguments to suggest the role of this sector in stimulating economic growth. Merton and Bodie (1995) feel that an improved financial system reduces the transaction and information costs and thereby helps facilitate a better allocation of resources needed for a high rate of economic growth. Levine (1997) explains this concept at a greater length. He is of the view that an improved financial system possesses financial intermediaries, markets, instruments and also different kinds of services that help: 1. mobilise savings, 2. reduce risk through hedging and diversification, xx

Introduction

3. monitor and exert corporate control and 4. permit better allocation of resources. With a developed financial system, the savers have an easy access to detailed information at a lower cost, and moreover, they can make use of a variety of instruments, with the result that the savings are mobilised on a large scale. The banks and the non-banking financial companies (NBFCs) offer liquid deposit schemes that help savings mobilisation. The quantum of liquidity risk is significantly reduced as the savers are confident that whenever they need their funds back, they can sell their securities. The investment risk too is hedged easily insofar as, first, the hedging schemes are available in the financial market and, second, varieties of instruments are available to help diversify the investment. Normally, it is not possible for the small investors to monitor the corporate functioning. When they try to monitor it, its cost turns very high. But when the investors make the investment through a financial intermediary, the onus of monitoring of corporate functioning lies on the intermediary. The intermediaries can perform this function more efficiently and at a much lesser cost. Again, if the stock market is well developed, one can study the performance of a company based on the share price index (Singh 1997). Furthermore, there are varieties of financial arrangements that help lower the transaction cost that in turn fosters specialisation, which leads to technological innovation. In all, greater saving mobilisation and its optimal allocation along with technological innovation lead to economic growth. The explanation of the linkage between the financial system and the economic growth is supported by a number of empirical findings. Using cross-country regression based on the data from 41 countries during 1976–93, Levine and Zervos (1996) find that the measures of banking and stock market development are robustly correlated with current and future rates of economic growth, capital accumulation and improvements in productivity. Atje and Jovanovic (1993) too find significant correlation between the economic growth and the value of stock market trading relative to gross domestic product (GDP) for 40 countries during 1980–88. Goldsmith (1969) finds, on the basis of the data collected from 35 countries over a period extending xxi

India’s Financial Sector

about a century, a direct relationship between the financial sector development and the economic growth. Berthelemy and Varaoudakis (1996) are of the view that weak financial system has been responsible for creating a ‘poverty trap’ coming in the way of economic growth. The World Bank (1989) and Demirguo-Kunt and Levine (1996) have extended Goldsmith’s work using data from about 50 countries during 1970–93 and have found that there is a positive relationship between the deepening of the financial system, the asset position of the commercial banks and non-banking financial institutions, and the trading and capitalisation of the stock market, on the one hand, and the rising level of income in the country, on the other. Schiantarelli et al. (1994) find greater efficiency in the investment allocation following the financial sector liberalisation in Indonesia.

Nature of Reform in the Financial Sector After it is established that the development of the financial system leads to economic growth, it is worth examining as to what should be the nature of the development/reform in the financial sector. In the context of the reforming of the financial sector, Stiglitz (1994) is of the view that the government intervention makes the financial market function better, that in turn adds to the performance of the economy. To be more specific, he favours government intervention to keep the interest rate below the market equilibrium level, so that it helps improve the average quality of the pool of loan applicants and lowers the cost of capital and direct loans to the sectors with high technological spillover. However, Stiglitz is very cautious of the manipulation of interest rates in this process, so that the real interest rate may not cross below zero. But in some quarters, Stiglitz’s view is not supposed in conformity with the objectives of economic growth. It is because low interest does not necessarily improve the average efficiency of investment, rather it can prompt the funds to move to low-yielding projects. And also, the directed credit in the desired sectors may raise the default rates increasing thereby the risk exposure of the financial agents and squeezing their profits to unmanageable levels. On the contrary, if the interest rate is market determined, low-yielding projects may not remain profitable; the average rate of return on investment will be higher augmenting in turn the saving rate (Fry 1997). xxii

Introduction

McKinnon–Shaw’s views too are in favour of financial market liberalisation (McKinnon 1973; Shaw 1973). They argue that the marketdetermined interest rates can boost up the rate of economic growth in the short and medium periods. In the short run, one can mark inflationary trends, but in the medium run, saving rate will rise, boosting up the rate of economic growth. However, measuring of the impact of financial liberalisation may not be easy insofar as the reform measures in other sectors go side by side. Lanyi and Saracoglu (1983) have found, in their cross-section regression analysis, a significant relationship between the average rate of growth in real GDP and the interest rate dummy variable during 1971–80. Again, the empirical study of Fry (1978) suggests that on an average, a 1 percentage point increase in real deposit rate of interest towards the market equilibrium rate is followed by a rise in economic growth rate of about 1.5 percentage point. Fry (1997) makes another study based on the data collected from 16 countries during 1970–88. While 11 countries of the sample present a controlled financial regime, the rest five experience liberal financial regime in terms of real interest rate structure. The findings reveal that the savings ratio in the five countries with liberal regime averaged 23.8 per cent compared to 16 per cent in 11 countries with regulatory regime. The continuously compounded growth rate in output was 6.2 and 3.9 per cent, respectively. Nevertheless, Fry (1995, 1997) talks about some prerequisites for a successful financial liberalisation programme. They are as follows: 1. adequate prudential regulations and supervision of financial intermediaries along with some accounting and legal infrastructure; 2. reasonable degree of price stability; 3. strict fiscal discipline especially in respect of government borrowing; 4. reasonable degree of competition among financial intermediaries and 5. no tax on financial intermediaries. Fry’s suggestions for liberalising the financial sector are more or less in conformity with the arguments of Caprio et al. (1994). They too are not in favour of a complete laissez-faire policy, rather they recommend for desirable amount of regulation and supervision. In this xxiii

India’s Financial Sector

context, Edwards (1989) is of the view that the liberalisation measures should not be abrupt but they should be adopted in phases. Moreover, they should be tuned with liberalisation measures in other sectors. Otherwise, the entire exercise would be a flop. The Latin American experiences are still fresh where the financial sector reforms manifested in huge bad debt, bank failures and extreme volatility in the financial system (Corbo and deMelo 1985). Thus, emphasis on the financial sector reforms by the Indian government and especially the gradual move towards liberalisation along with the reforms in other sectors has been a well-thought and well-designed plan.

AN OVERVIEW OF THE INDIAN FINANCIAL SECTOR The Indian financial system is a combine of financial intermediaries, financial markets and instruments and financial services. All these three segments are closely interwoven. Financial intermediaries hold and trade financial securities/instruments in the financial market that strengthens the latter. At the same time, the development of the financial market has led to the emergence of complex portfolios that in turn needs the services of the specialised financial intermediaries. Again, with the growing complexity of financial markets and instruments, the role of financial services has turned more significant. They make the functioning of the entire financial system smoother. Let us now brief the different segments of the financial system (see Figure I.1).

Financial Intermediaries Financial intermediaries mobilise savings and put those savings into productive investment. They can be grouped as follows: 1. 2. 3. 4.

Banking institutions Non-banking financial institutions Mutual funds Insurance companies

The banking institutions are the most significant intermediaries in the country. They can be grouped as commercial banks and cooperative banks. The commercial banks are public sector banks, private xxiv

Introduction Figure I.1

The Contour of the Indian Financial System

Indian Financial System

Financial intermediaries, viz. z Banks z NBFCs z Mutual funds z Insurance companies

Financial services, viz. z Custodial & depositories z Credit-rating z Factoring & forfaiting z Merchant banking & portfolio management

Financial markets & instruments z Money market – T-bills, CPs, CDs, Call money market, etc. z Capital market corporate equity and debt, and government dated securities z Primary market – issue of fresh securities by corporate entities and government z Secondary market – trading of listed securities at the stock exchange z Market for derivatives – Futures & options

sector banks, foreign banks operating in the country and regional rural banks. The non-banking financial institutions are no less important as a financial intermediary. While the banking institutions are the creators of credit, non-banking financial institutions are the purveyors of credit. Again, while the liabilities of the banking institutions form a part of the money supply in the country, those of the non-banking financial institutions do not. The non-banking financial institutions are either the NBFCs or the development financial institutions. As per the Reserve Bank of India’s (RBI) notification in December 2006, the NBFCs are grouped as follows: xxv

India’s Financial Sector

1. Asset-financing companies (a) Those accepting deposits (b) Those not accepting deposits 2. Investment companies 3. Loan companies The development financial institutions are normally the term financial institutions. Industrial Development Bank of India, Industrial Finance Corporation of India and many others are functioning in the country both at the centre level and at the state level. The mutual funds mobilise savings for making investment in diversified portfolio of securities. The return, after deducting the necessary expenses, is shared by the funds’ investors. They are thus, to a great extent, similar to portfolio management companies. The only major difference is that while mutual funds target small investors, the portfolio management companies are concerned with high net worth individuals. For a long time, the mutual fund business was confined in the hands of the Unit Trust of India (UTI) that was established as back as in 1963. But in 1987, the area was broadened to include companies sponsored by a few nationalised banks; and again, in 1993, private sector companies—both domestic and foreign—were allowed to operate in this area. The insurance companies provide compensation against the risk of life and property after charging premium from the general public. The savings of the public in the form of premium are invested in many directions, a very significant of them being corporate securities. Beginning from 1956 when the life insurance companies were nationalised and from 1972 when the general insurance companies were nationalised, the insurance business was a public sector show. It was only after the Malhotra Committee recommendations in 1994 that the Indian government thought to allow the private sector companies in the insurance business. In 2000, the insurance business marked the entry of the private players.

Financial Markets and Instruments The financial markets can be grouped either as capital market or as money market. While money market is a market for short-term funds, capital market involves medium- and long-term funds. xxvi

Introduction

The money market encompasses the following: 1. Call/notice money market (CNMM), where money is borrowed or lent for 1–14 days without involving any collateral security. Originally, there were many participants, but now it is primarily an inter-bank market where banks being long of funds deposit the excess funds with other banks and those being short of funds borrow funds from other banks. The deposit, borrowing and lending help in the proper allocation of liquidity in the inter-bank market. 2. Commercial paper (CP) market, where CPs are issued by corporates, primary dealers and all-India financial institutions as an unsecured short-term promissory note mainly to commercial banks and also to individuals and registered Indian corporate bodies. 3. Certificate of deposit (CD) market, where CDs, being unsecured, negotiable short-term instrument, are issued by commercial banks and development financial institutions at a relatively high interest rate in order to mobilise funds during the period of tight liquidity. 4. Treasury-bill (T-bill) market, where the RBI issues T-bills on behalf of the government for a minimum amount of Rs. 25,000 or a multiple thereof to meet the temporary/seasonal gap between the latter’s receipt—both capital and revenue and the expenditure. T-bills are normally issued at discount and are repaid at par on the maturity. The discount serves the purpose of interest. Presently, they are of varying duration, such as 91, 182 and 364 days. 5. Collateralised Borrowing and Lending Obligations market, where the Clearing Corporation of India Limited has introduced a new instrument for the benefit of those entities that have been phased out from making use of CNMM or those who have restricted participation in the CNMM. 6. Term money market transacting funds for less than 1 year. Despite the fact that the term money market has not made great strides during the period of reforms, it does exist and forms a part of the money market.

xxvii

India’s Financial Sector

Capital market is, on the other hand, involved with long-term securities, such as equity shares and debt securities. Debt securities may take the form of private corporate debentures, public sector unit bonds and government’s dated securities. Again, the financial market is divided into primary and secondary markets. The primary market is concerned with the raising of funds through the issue of new securities. The companies issue shares and debentures. When firms go public for the first time, the primary market is known as the initial public offering (IPO) market. The subsequent offerings, on the other hand, form the part of the primary market, known as the subsequent equity offering (SEO) market. The offerings are made either through prospectus or through private placement. Besides companies, the government too issues dated securities to mop-up funds. The public sector units issue bonds through private placement and the private sector companies raise funds selling new shares and debentures either through prospectus or through private placement. The secondary market, on the contrary, involves listing and trading of the already issued shares and debt securities at the stock exchange. The secondary market has not only cash segment but also derivatives segment. In India, the secondary market for derivatives has only a recent origin. One can go for index futures, stock futures, index options and stock options.

Financial Services Financial services tend to give a fillip to the functioning of various financial intermediaries and the financial market. These activities include broadly services of depositories and custodial functions, credit-rating, factoring and forfeiting, merchant banking, and so on. Depository and custodian help in the issue of securities. Credit-rating agencies rate the performance and financial position of a company that helps investors in taking a correct investment decision. Factoring and forfeiting are more concentrated on trade financing. Merchant banking services are related to floatation of new companies, planning and execution of new projects, drafting of prospectus, managing and underwriting of the issue of securities, and so on.

xxviii

Introduction

DESIGNING MEASURES OF REFORM IN INDIA’S FINANCIAL SECTOR The nature of reform in the Indian financial market has not been much different from that in other countries. The basic idea behind designing the measures of reform has been multi-pronged. It is essentially the expanded activities with increasing turnover and greater profitability. But the aspect of profitability is never thought of in isolation from financial stability. In more generic terms, it can be equated with greater return with minimal risk. Moreover, of late, when the fruits of reform could largely be achieved, the measures have come to aim at bestowing the benefits of reform upon different groups of the society, and especially those who have never availed of, or least availed of, such benefits. This new move is known as financial inclusion. All these designs need at least some explanation which can be found hereunder.

Greater Turnover with Increasing Profitability There was a time during the late 1980s and the early 1990s when many of the public sector banks were running into losses. Mutual fund business was limited to only UTI and a few bank-sponsored organisations. Primary market and secondary market transactions were utterly limited and the scenario was similar in the money market. Neither were the foreign investors allowed to operate in the Indian secondary market nor were the Indian companies eligible for making euro issues. The activities in the foreign exchange market were limited in view of the administered exchange rate arrangement. Thus, the financial market and the participants therein were not able to take advantage of the economies of scale. The profitability was the worst victim. Thus, when the measures of reform were designed, the purpose was to broaden the nature of activities, so that more and more participants should come in fray. To mention a few examples, some new private sector banks were allowed to operate. The mutual fund business was extended to private sector companies. In the money market, new instruments were introduced. The foreign institutional investors (FIIs) were allowed to operate at the Indian stock exchanges. The Indian companies were allowed to raise funds in the international financial market through xxix

India’s Financial Sector

the issue of foreign currency convertible bonds and American/global depository receipts. In the foreign exchange market, swaps and options were introduced besides spot and forward transactions. The market for derivatives came to form a part of the secondary market activities. The aftermath was that there was a forward leap in the turnover. The greater the magnitude of turnover, the bigger was the room for enjoying the economies of scale and showing profit margin. Besides achieving greater turnover, the idea behind broadening of participation base was to generate competition that could, in turn, improve efficiency. Improved efficiency could, in turn, raise profitability. But, for wide participation, it was essential to have a liberalised financial sector policy. So rigidity with the system was axed with—in all segments of the financial sector. In fact, the liberalisation of the policy aimed at reducing unnecessary controls and giving a much bigger room for the play of market forces that could lead to optimal allocation of scarce resources. With the optimality of financial intermediation and allocation of funds, it was easy to boost up the profitability. Keeping apart the issue of greater competition and efficiency and the issue of profitability, the liberalisation of the financial sector policy was a compulsion in view of liberal policy in other areas of the economy. The liberal policy in other sectors of the economy, such as liberal industrial policy or liberal external sector policy, could not yield desired results sans liberal financial sector policy.

Financial Stability It has already been mentioned that profitability cannot be stressed upon in isolation of the financial risk involved in the liberalisation process. Financial stability needs to be maintained in order to give way to long-term economic prosperity (Schinasi 2006). We have witnessed many cases of financial instability marring the very process of economic growth. To quote at least one case, the Asian Crisis-hit countries had a record economic growth rate prior to the crisis. The financial sector too was experiencing a big expansion in activities and desired profitability. But it lacked the desired stability with the result that this sector could not sustain the jerks appearing in the real estate and other sectors. The financial crisis could not be avoided. xxx

Introduction

When the structural adjustment or macroeconomic reforms were designed originally during the early 1980s, the aspect of financial stability was not assigned too much of significance. But with varying experience of financial crisis in different areas of the global economy from time to time, this aspect earned greater attention of the economists and policy makers. Many central banks and the international financial institutions started publishing periodic financial stability reports. The Bank for International Settlements set up the Financial Stability Forum for fostering financial stability through the exchange of information. The World Bank and the International Monetary Fund (IMF) introduced the Financial Sector Assessment Programme to identify vulnerability of the financial system in member countries and to highlight the developmental needs of this sector. In India too, a committee on financial sector assessment was constituted under the chairmanship of Rakesh Mohan in September 2006 that submitted its report in February 2008. Financial stability represents financial soundness of the financial transactions in an economy. From a practical viewpoint, it embraces a sound payment and settlement system and accounting practices related to institutions like banks, security firms and institutional investors and markets including capital and money markets, currency markets and the markets for derivatives. If a financial system is stable, it means that it has the ability to resolve imbalances through self-corrective mechanism, ultimately rejecting any crisis to set in. It also means that the financial institutions have the ability to absorb shocks in a way that does not permit any interruption in the financial intermediation process. The financial regulators make the norms, standards and guidelines to be followed by the financial agents. In India, the Ministry of Finance, the RBI and the Securities and Exchange Board of India (SEBI) are the apex-level regulators. Moreover, the Foreign Exchange Management Act is there to protect any foreign exchange laundering. At the same time, different institutions frame rules and regulations at their own level for day-to-day functioning.

Financial Inclusion It is true that in the beginning of the financial sector reform in India, greater stress was given on profitability and then on financial stability. But when the process of reform moved on to achieve to a great xxxi

India’s Financial Sector

extent these objectives and when this sector found itself in a much better shape, it was very much desirable to introduce the element of financial inclusion. Financial inclusion means the delivery of financial services or gains from the financial market at affordable cost to disadvantaged and low-income groups of the society who have so far remained largely excluded from such benefits. It can be done through improving the existing formal credit delivery mechanism and evolving new models for extending outreach. The financially excluded section requires products which are customised to meet their needs. Credit has to be an integral part of this programme aimed at improving productivity and income of such farmers and farmer households. The interventions that require immediate address are strengthening of extension machinery, firming up of quality input supply arrangements, facilitating of marketing of goods, and so on. Thus, the measures of financial sector reforms in India are designed to accommodate all these objectives of growth, profitability, financial stability and financial inclusion.

STRUCTURE OF THE BOOK The discussion in the present book embraces financial sector reforms in India that were initiated more vividly in the early 1990s. Almost in all the cases, the author has tried to present the state of affairs prior to the reform, followed by the measures of reform. At the end of the discussion in different chapters, the impact of the reform measures is analysed in different ways keeping in view the growth along with operating efficiency, financial stability and financial inclusion. The discussion is divided into three parts. The first part deals with the financial intermediaries. The intermediaries include here the commercial banks, NBFCs and the mutual funds. The second part embraces the discussion of the primary and the secondary markets. The market for the government securities is exclusively analysed. This is followed by the discussion of the reforms in the Indian money market. Finally, there is the discussion of the foreign exchange market inasmuch as the financial and foreign exchange market cannot be segregated. The third part focuses on the linkages of the Indian financial market with the international financial market or, in other words, the xxxii

Introduction

internationalisation of the Indian financial market. In fact, the linkages can be explained in terms of foreign direct investment (FDI) in the Indian financial market, but, more importantly, in terms of FIIs operating at the Indian stock exchanges, euro issues of the Indian firms and the raising of funds by the foreign companies in the Indian financial market through the Indian depository receipts (IDR). The IDR is only a recent development. In March 2004, the Indian government permitted only financially strong foreign companies to raise funds from Indian financial market. The SEBI formalised detailed guidelines in April 2006. In the absence of desired response, the norms were liberalised in August 2007. However, it is yet to make a breakthrough. This part of the book, therefore, covers the euro issues of the Indian firms and FIIs’ operation in the Indian secondary market. In the end, the entire discussion is summarised. However, in view of the crisis emerging in the Indian financial sector during 2008, the concluding remarks are followed by a postscript that focuses on the recent trends.

xxxiii

India’s Financial Sector

xxxiv

Part I

Reforms in Financial Intermediaries

India’s Financial Sector

2

1

The Banking Sector

Commercial banking sector constitutes essentially the circulation system which is vital for economic prosperity. Thus, any discussion of the financial sector cannot ignore the role of commercial banks. It is because of this fact that the financial sector reforms started with the reforms in the banking sector. The present chapter, therefore, makes a survey of the major aspects of reform in this area against a brief background of the pre-reform scenario and evaluates the broad achievements.

THE STATE OF BANKING SECTOR DURING THE EARLY 1990s It is true that the government had helped create and develop uniformity in the operational structure of the banks through the enactment of the Banking Regulation Act as back as in 1948. It is also true that the government infused into this sector the ‘socialistic’ content through the nationalisation of major banks in stages since 1969. But too much of the socialistic content manifesting in rigid regulations helped swing the banks far away from the desired yardstick of economic performance and financial soundness. During the early 1990s, the banking sector was in a very bad shape. To be more specific, first, the cash reserves ratio (CRR) being as high as 15 per cent and the statutory liquidity ratio (SLR) being 38.5 per cent of the net demand and time liabilities (DTL) covered barely the cost of the funds and provided only a limited scope for generating profits. Second, around

India’s Financial Sector

two-fifths of the advances stood directed to the priority sectors. A low rate of interest earned from the priority sector lending in many cases entailed definitely upon profitability. Third, too much of political influence on credit market had led to lapses in monitoring of the big borrowers. At the same time, ineffective loan recovery procedures had resulted in making a quarter of the advances of the public sector banks non-performing assets (NPAs). Fourth, high operating cost, especially on account of improper manpower management, existence of uneconomic branches and also lack of competition helped erode profitability. During FY 1990–91, profits of the banks as a percentage of the working funds stood at barely 0.29 which was an extraordinarily low figure by any standard. In case of State Bank of India Group banks and the other nationalised banks, this percentage was still lower at 0.16 and 0.19, respectively (GOI 1993a). To be more precise, 13 out of 28 public sector banks ran into losses aggregating to Rs. 35 billion. Onehalf of the public sector banks had negative net worth (RBI 1993b). All this had caused a huge pressure on the budgetary resources of the government. Besides, the quality of customer service was abjectly poor arresting the banks from emerging as a viable institution. In short, the Indian banking sector was ailing badly needing in turn mega doses of reform.

MEASURES OF REFORM The measures of reform were broad impacting different aspects of the banking sector. For instance, they aimed, among other things, at making the system financially sound, axing reserve requirements so as to reduce the so-called ‘tax’ on the financial intermediation, deregulating interest rate structure so as to allow banks greater flexibility and to encourage competition, fostering supervision so as to improve performance and to help restrict the NPAs within a reasonable limit and at improving the customer services. All of them need a brief discussion here.

Maintaining Capital Adequacy Norms There were two ways to do away with the negative net worth of the banks and to make them financially sound. One was to create an 4

The Banking Sector

Asset Reconstruction Fund (ARF), as suggested by the Narsimham Committee (RBI 1991), and to transfer the NPAs of the banks to this institution. The other was to provide for adequate capital. As far as the first alternative is concerned, the problem was that if those assets had been transferred at discount, the problem of negative net worth would persist. On the contrary, if the assets had been transferred at the book value, it could add to the cost of the newly created institution; and again, the recovery of the loans was difficult as the new institution knew little about the debtors. Thus, in view of the problems associated with ARF, minimum capital adequacy norms were prescribed in conformity with the Basle Accord. The purpose was not only to promote capital adequacy but, more importantly, to bring the banks at par with the international banks. The Indian banks were expected initially to maintain unimpaired minimum capital funds equivalent to 8 per cent of the aggregate of the risk-weighted assets and other off-balance sheet exposures. The capital base was to be a two-tier one: while Tier I capital represented the core capital including paid-up capital, statutory reserves and capital reserves, Tier II capital embraced undisclosed reserves, fully paid-up cumulative preference shares, revaluation reserves, general provisions and loss reserves, and so on. While those banks with branches abroad were to fulfil this norm by March 1994, the others were to abide by it by March 1996. Capital adequacy norms were to be achieved through: (a) the budgetary support from the government, (b) the acquisition of equity funds and debt from the domestic capital market and (c) the financial sector development loan of the World Bank. There were a few cases of oversize equity base coming in the way of approaching the capital market. But, in such cases, the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980, was amended to enable banks to reduce their paid-up capital up to 25 per cent at a time. From FY 1995–96, banks were also required to maintain Tier I capital funds to the extent of 5 per cent of their foreign exchange reserves open position limit. Moreover, they were forbidden to include subordinated debt instruments with an initial maturity of less than 5 years or debt instruments with 1 year remaining maturity as part of their Tier II capital. The banks coping with the new capital adequacy norms could rationalise their branch network meaning that they could set up new branches and new controlling offices. 5

India’s Financial Sector

However, the time frame for capital adequacy could not be maintained. By the end of March 1994, only four public sector banks had a capital to risk-weighted assets ratio (CRAR) of 8 per cent and the other four had a CRAR of 6.7 per cent. By March 1995, only 13 public sector banks achieved the set norm and the others had a CRAR of 4 to 8 per cent. So the emphasis to strengthen the capital base of the banks continued. In FY 1995–96, six public sector banks received Rs. 8.5 billion as capital contribution from the government and a capital restructuring loan for $80 million from the World Bank. During FY 1996–97, the government contributed Rs. 15.090 billion to six public sector banks. Three public sector banks entered the capital market to obtain equity capital of Rs. 17.050 billion. The State Bank of India issued GDRs worth Rs. 26.140 billion. Four public sector banks raised subordinated debt amounting to Rs. 3.250 billion through private placement for inclusion under Tier II capital. By March 1997, there were only two public sector banks that could not achieve the prescribed capital adequacy norms (GOI 1998). The issue of capital adequacy did not end there. In view of large exposure faced by the commercial banks, the capital adequacy norms were revised upwardly as suggested by the Narsimham Committee II (RBI 1998). The banks, as mentioned earlier, were to have 9 per cent CRAR by March 2000 and a CRAR of 10 per cent by March 2002. A number of banks approached the capital market in order to adhere to the capital adequacy norms. The response was highly satisfactory. By the end of March 2000, all the 27 public sector banks, except one, had attained the 9 per cent norm. By March 2002, 23 of 27 public sector banks had achieved the 10 per cent norm. Two had more than 9 per cent CRAR and the rest two, namely, Indian Bank and Dena Bank, failed to fulfil even the 9 per cent norm. However, the banks tried to improve their capital base through moving to capital market— domestic and international. The strengthening of capital base meeting the growing exposure of the banks has been a continuing process. The RBI announced a revised capital adequacy norm based on Basle II norms during January 2006 that was to be achieved by March 2007. This specified a three-tier capital base. The different tiers were redefined. Tier I covered shareholders’ equity, perpetual non-cumulative preference share capital, disclosed reserves and innovative capital instruments. 6

The Banking Sector

Tier II embraced undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt. Lastly, Tier III included short-term subordinated debt that could cover the market risk. At this point, it should be made clear that Basle II norms are more comprehensive than the Basle I norms. While Basle I norms considered only credit risk, Basle II norms take account also of the market risk, operational risk and the liquidity risk. Moreover, they recognise a wide range of collaterals, such as central and state government securities, as risk mitigating and provisioning through estimation of expected losses. Yet again, the short-term subordinated debt forming Tier III capital will be more useful. However, in India where around 80 per cent of the transactions take place in the public sector banks, risk does not matter much insofar as the government stands by as a buffer of supplier of capital stock whenever it is necessary. The banks raised funds from the financial market to meet Basle II requirements. By March 2007, capital base was more than the 10 per cent requirements for different groups of the commercial banks— public sector and the private sector—except for three private banks that were lagging behind. To be precise, CRAR of as many as 79 banks was above 10 per cent. Two banks had a CRAR of 9–10 per cent. It was only Sangli Bank whose CRAR was below 4 per cent at the end of March 2007, but that was subsequently amalgamated with another bank. To be precise, by March 2007, the CRAR was 12.4, 12.1, 12 and 12.4 per cent, respectively, for public sector banks, old private sector banks, new private sector banks and foreign banks operating in India (RBI 2007b). These figures met the Basle II requirements that were to be fully operational by March 2009. During FY 2007–08, the capital base turned still stronger. By March 2008, CRAR was 12.5, 14.1, 14.4 and 13.1 per cent for public sector banks, old private sector banks, new private sector banks and foreign banks operating in India (RBI 2008b). Table 1.1 presents a bird’s eye view of the movement of capital adequacy ratio since March 2000 for different groups of banks. It may be noted here that approaching the capital market to achieve capital adequacy norms led to changes in the pattern of shareholding among the banks. There were 11 public sector banks where private shareholdings accounted for as large as 40–49 per cent of the share capital at the end of March 2008. The other three had 30–39 per cent 7

India’s Financial Sector Table 1.1

Capital Adequacy Ratio—Bank Group-wise

(%) Bank group/end of March 2000

2001

2002

2003

2004

2005

2006

2007

2008

11.1

11.4

12.0

12.7

12.9

12.8

12.3

12.3

13.0

10.7

11.2

11.8

12.6

13.2

12.9

12.2

12.4

12.5

12.4

11.9

12.5

12.8

13.7

12.5

11.7

12.1

14.1

13.4

11.5

12.3

11.3

10.2

12.1

12.6

12.0

14.4

11.9

12.6

12.9

15.2

15.0

14.0

13.0

12.4

13.1

Scheduled commercial banks Public sector banks Old private sector banks New private sector banks Foreign banks

Source: RBI (2008b).

private shareholding. In the remaining ones, it was less than 30 per cent (RBI 2008b). Moreover, the foreign financial institutions too came to participate in the share capital of the Indian banks. There were 28 public sector banks where the foreign financial institutions had their presence, of course, limited to 30 per cent of the total share capital. In six of eight new private sector banks and in three out of 15 old private sector banks, the share of such investors went beyond 40 per cent (RBI 2008b).

Axing CRR and SLR Apart from the issue of capital adequacy, the other major aspect of reforms has been manifest in form of axing of the CRR and the SLR. When reform was started, SLR was 38.5 per cent of net demand and time liabilities (DTL). In addition to it, the incremental SLR was 30 per cent. The incremental SLR was abolished and the average of SLR dropped over the years to 25 per cent. Similarly, CRR during the beginning of reform was 15 per cent of the net DTL. In addition, there was 10 per cent incremental CRR. The incremental CRR of 10 per cent of DTL was removed in the very initial phase of reform and the average CRR was brought down in successive instalments from 15 to 5 per cent by June 2002. But thereafter, it was raised marginally to cope up with the changing scenario of the Indian 8

The Banking Sector

economy to 7.5 per cent, but after viewing at the CRR related to nonresident Indians (NRIs) deposits where the CRR is zero, the effective CRR on all kinds of the deposits taken together is lower than 7 per cent. Table 1.2 shows how CRR and SLR were revised in stages. In fact, the SLR/CRR had to be reduced only gradually because the government securities did not enjoy high demand for them in general. Any sudden slash in SLR would have affected the government borrowing. Again, in the absence of adequate demand, the government securities did not prove an effective tool for credit control. The RBI had to depend on CRR for having effective control on credit. Table 1.2

Changes in CRR and SLR

CRR Date of change 1.4.1992 17.4.1993 15.5.1993 27.4.1996 11.5.1996 6.7.1996 23.10.1996 9.11.1996 4.1.1997 18.1.1997 22.11.1997 26.11.1999 20.11.2000 19.5.2001 20.11.2001 15.6.2002 23.12.2006 6.1.2007 14.4.2007 28.4.2007 4.8.2007 10.11.2007

SLR Ratio (%)

Date of change

a

15 14.5 14.0 13.5 13.0 12.5 11.5 11.0 10.5 10.0 9.50 9.00 8.00 7.50 5.50 5.00 5.25 5.50 6.25 6.50 7.00 7.50

1.4.1992 9.1.1993 6.2.1993 6.3.1993 11.10.1993 20.8.1994 17.9.1994 29.10.1994 25.10.1997

Sources: 1. Reserve Bank of India, Annual Report. Mumbai, various issues. 2. Reserve Bank of India, Press Release. Notes: There were a few upward movements in CRR between the dates mentioned here. a In addition, there was incremental CRR of 10%. b In addition, there was incremental SLR of 30%.

9

Ratio (%) 38.5b 38.25 38.0 37.25 34.75 34.25 33.75 31.50 25.00

India’s Financial Sector

Moreover, the cut helped release sizeably the loanable funds of the banks for profitable lending operation which in turn raised profitability. The interest rates on commercial advances could be reduced so as to attract the borrowers. A low CRR was not a new thing. Prior to 1980s, CRR was low. It was only the growing fiscal deficit that necessitated an increase in CRR. Thus, if CRR has to be kept at a low level, the government has to contain any growth in fiscal deficit. Again, beginning from December 2006, CRR was revised upward in instalments to contain inflationary trend in the country. The moment the inflationary trend is contained, it is expected to come down to 5 per cent. Again, with the amended Reserve Bank of India Act, there will be neither ceiling nor floor on the CRR, nor will be the interest payment by the RBI on the CRR balances. Similarly, the floor on the SLR was removed. But in practice, the SLR lies above the floor.

Curbing of the NPAs It may be asserted that when the reform process was initiated, the issue of NPAs was looming large as such assets were found squeezing profitability and entailing upon the very health of the banking sector. Let us first explain what NPA is. NPA represents an advance that stands unserviced as a sequel to past dues accumulating for 180 days or more. A distinction is often made between gross NPA and net NPA. The latter is obtained after deducting from gross NPA items like interest due but not recovered, part payment received and kept in suspense account, and so on. And thus the net NPA is a better guide of the financial health of the banks. The size of NPAs is interpreted either in terms of size of advances or in terms of assets. There were many reasons for the existence of large NPAs, such as incomplete appraisal of borrowers, political influence and waiver of loan by the government, diversion and tunnelling of funds by borrowers, adverse changes in the macroeconomic conditions and government policies and wilful default (Sarkar 1999). A sizeable part of lending directed to the priority sector was an added reason, although a recent study shows that it has been the non-priority sector lending too that had caused NPAs to rise (Mukherjee 2003). However, one of the biggest reasons for large NPAs was that a large part of the bank 10

The Banking Sector

credit, constituting 9 per cent of total bank credit and amounting to Rs. 131 billion, was directed to sick units at the end of FY 1992–93. Consequently, the share of gross NPAs in the gross advances of the public sector banks was as large as 26 per cent in FY 1992–93. Long decision time taken by the Board for Industrial and Financial Reconstruction (BIFR) refrained banks to collect dues in time. By September 2002, there were 586 cases pending with the BIFR with a total of bad assets of Rs. 80 billion that accounted for 36 per cent of the high-value defaults with 27 public sector banks (Chandrasekhar 2003). In order to tackle NPAs, first of all, it was thought to give a room for desired provisioning. The banks were to complete provisioning of bad and substandard assets by March 1994. However, this process continued even after FY 1993–94. The amount of provisioning has been accounting for around 1–2 per cent of the working funds. In June 2004, the RBI introduced a graded higher provisioning on secured portion of NPAs at the end of March 2004 ranging from 60 to 100 per cent over a period of 3 years in a phased manner with effect from April 2005. The provisioning requirements would be 100 per cent in case of unsecured portion of NPAs. Moreover, tribunals were set up in 1993–94 to speed up the recovery of loan arrears. By the end of the first quinquennium, five tribunals were working in major cities along with an appellate tribunal at Mumbai. All this resulted in the contraction in the size of the NPAs. The share of gross NPAs in the gross advances of the public sector banks fell to 20 per cent in FY 1994–95 and further to 18 per cent by the end of FY 1996–97. During FY 1996–97, the net NPA/net advances ratio for the public sector banks was, however, lower at around 9 per cent. In case of private sector banks, it was still lower at around 5 per cent and it was very low at around 2 per cent in case of foreign banks in India (GOI 1998). The situation was not completely under control despite improvement. Narsimham Committee II underlined the need to reduce the average level of net NPAs for all banks to 3 per cent of net advances by March 2002. In July 2000, a few more debt recovery tribunals were started. RBI issued revised guidelines for recovery of NPAs, as a result of which the amount of recovery increased. Beginning from 31 March 2001, NPAs were redefined so as to conform to the international standards. They were classified based on substandard assets, doubtful 11

India’s Financial Sector

assets and loss. A substandard asset is one that remains NPA for a period of 18 months or less. A doubtful asset is one that remains NPA for more than 18 months. And a loss asset is that where loss has been identified but not written off. Moreover, a number of measures were taken up. They were mainly rescheduling and restructuring at the bank level, recovery through tribunals, Lok Adalats and court, and compromise settlements. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAEST) Act was passed in 2002 that allowed the banks to recover their loans outside the court. In January 2003, a revised guideline was issued to make the compromise settlement more effective. Since March 2003, the Credit Information Bureau of India has been cooperating in this context through disseminating the credit information of suit-filed defaulters. Last but not least, the Asset Reconstruction Company of India Ltd (ARCIL), set up in 2003, has purchased the NPAs of several banks. In FY 2004–05 alone, the sale of NPAs to ARCIL amounted to Rs. 153.430 billion that rose to over Rs. 211 billion by March 2006. Looking at the recovery of NPAs through different channels, it is evident that out of a total recovery for Rs. 89.640 billion during FY 2005–06, debt recovery tribunals accounted for 52.5 per cent followed by SARFAEST Act that claimed for another 38.2 per cent. One-time settlement or compromise schemes accounted for 6.8 per cent and the share of recovery through Lok Adalats was barely 2.5 per cent (RBI 2007b). It is true that the Narsimham Committee II expectations to bring down net NPAs of all banks to 3 per cent of net advances by March 2002 could not be fulfilled; yet, it can definitely be said that the different ratios showing the magnitude of NPAs have improved during 2000s. As shown in Table 1.3, the net NPA/net advances ratio for all scheduled banks, which was as high as 6.2 per cent during FY 2000–01, dropped to 1 per cent by FY 2007–08. In case of public sector banks, the fall was larger—from 6.7 to 1.1 per cent. In private sector banks, the diminution was recorded from 5.4 to 1 per cent. In foreign banks operating in the country, NPA was not a major problem; nevertheless, there was a squeeze in it from 1.9 to 0.8 per cent, respectively. The ratio of net NPAs to assets too fell between FY 2000–01 and 2007–08— from 2.7 to 0.6 per cent in case of public sector banks, from 2.3 to 0.6 per cent in private sector banks and from 0.8 to 0.3 per cent in foreign banks during the corresponding period. 12

The Banking Sector Table 1.3

Types of bank Public sector banks

Private sector banks

Foreign banks in India

All scheduled banks

NPA Ratios of Commercial Banks

FY

Net NPAs/Net advances (%)

Net NPAs/ assets (%)

2000–01 2003–04 2006–07 2007–08 2000–01 2003–04 2006–07 2007–08 2000–01 2003–04 2006–07 2007–08 2000–01 2003–04 2006–07 2007–08

6.7 3.0 1.1 1.0 5.4 2.8 1.0 1.1 1.9 1.5 0.7 0.8 6.2 2.9 1.0 1.0

2.7 1.3 0.6 0.6 2.3 1.3 0.6 0.6 0.8 0.7 0.3 0.3 2.5 1.2 0.6 0.6

Sources: 1. Government of India, Economic Survey. New Delhi: Ministry of Finance, various issues. 2. RBI, Report on Trend and Progress of Banking in India. Mumbai, various issues.

Rationalisation of Interest Rate Structure The purpose of restructuring interest rates has been to attract deposits as well as to boost up the credit and also to simplify and to make the whole interest rate structure transparent. It is also to assure greater autonomy for the banks to improve their competitive efficiency. For making the structure simple, the number of interest rate slabs was brought down from around 20 during the early 1990s to only 3 by FY 1993–94. The interest rate regime was basically an administered one prior to October 1994. The RBI had prescribed the minimum lending rate and the ceiling rate till the late 1980s; thenceforth, it switched over to a minimum/prime lending rate. Since October 1994, interest rate came to be deregulated, of course, for a lending over Rs. 0.2 million. In other words, it represented a move towards banks’ freedom in respect of interest rate fixation. Moving still further, in FY 2001–02, RBI permitted the banks to lend in specific cases even at a lower interest rate than 13

India’s Financial Sector

the prime lending rate. In FY 2003–04, the banks began enjoying even greater freedom regarding interest rate manoeuvrability when RBI asked them to announce their own prime lending rate after taking into account their actual cost of funds, operating expenses and a minimum margin to cover the regulatory requirements. Almost all banks adhered to it and their prime lending rates were 25–100 basis point (b.p.) lower than that announced earlier by the RBI. To be precise, the average lending rate which was as high as 19 per cent in FY 1991–92 (high to cope with the high rate of inflation) fell in stages to 15 per cent in 1994–95 and further to 11.50 per cent during FY 2001–02 and to 10 in FY 2004–05, although there was an upturn thereafter continuing up to 2007–08 and even beyond that in view of tight monetary policy. Similarly, the process of deregulating deposit rates began in the very initial phases of reform. A ceiling rate was fixed, below which the banks were free to fix their term deposit rates. Since July 1996, the ceiling rate was also abolished. Consequently, the average deposit rates as a whole slipped from 13 per cent in FY 1995–96 to 5 per cent in FY 2004–05, although showing an upturn thereafter. Now a question arises as to whether the decline in nominal interest rates has helped borrowers increase the use of banks’ funds. The studies show that the fall in interest rates was not commensurate with the changes in the inflation rate with the result that the real effective interest rates did not decline to that extent. In some of the years, they rather increased. If this is the case, based on the explanation given by Ducker and Thornton (1994), it is possible that the borrowing firms would have used their internal funds rather than going for the banks’ funds. Again, as per the recent trends, in some of the non-SLR investments, the yield is lower than the incremental cost of deposit. Moreover, such investments, being not eligible for repurchase operation through RBI, are not liquid. As such the banks have no option other than pushing up the lending rates (Business Line 9 June 2006). During April to June 2006, the banks increased the deposit rates across various maturities by about 25–75 b.p. Similarly, the public sector banks raised their prime lending rates by 25–50 b.p. during the same period (RBI 2007b). Table 1.4 shows the movements in deposit/lending interest rates during March 2006 to March 2008. 14

The Banking Sector Table 1.4

Interest rates

Movements in Deposit and Lending Interest Rates

March 2006

March 2007

March 2008

2

3

4

2.25–6.50 5.75–6.75 6.00–7.25

2.75–8.75 7.25–9.50 7.50–9.50

2.75–8.50 8.25–9.25 8.00–9.00

3.50–7.25 5.50–7.75 6.00–7.75

3.00–9.00 6.75–9.75 7.75–9.60

2.50–9.25 7.25–9.25 7.25–9.75

3.00–5.75 4.00–6.50 5.50–6.50

3.00–9.50 3.50–9.50 4.05–9.50

2.25–9.25 3.50–9.75 3.60–9.50

10.25–11.25 11.00–14.00 10.00–14.50

12.25–12.75 12.00–16.50 10.00–15.50

12.25–13.50 13.00–16.50 10.00–15.50

4.00–16.50 3.15–20.50 4.75–26.00

4.00–17.00 3.15–25.50 5.00–26.50

4.00–17.75 4.00–24.00 5.00–28.00

1 Deposit rates Public sector banks a) Up to 1 year b) 1 year to 3 years c) Over 3 years Private sector banks a) Up to 1 year b) 1 year to 3 years c) Over 3 years Foreign banks a) Up to 1 year b) 1 year to 3 years c) Over 3 years BPLR Public sector banks Private sector banks Foreign banks Actual lending rates Public sector banks Private sector banks Foreign banks

Source: Reserve Bank of India (2008b).

Encouraging Competition The entry norms were relaxed. Apart from making the entry of foreign banks far less restrictive, RBI allowed the private sector banks to come in fray and operate, provided they fulfilled the norms prescribed during the process of reform. A total of 10 new banks were given a green signal by RBI to operate in FY 1993. What is important to note is that the new private banks led to competition among other banks as they (new private banks) were operating on a very low intermediation ratio of 1.92 per cent vis-à-vis 2.5 per cent for the old private banks and as high as 2.88 per cent for the public sector banks (GOI 1994). In January 2001, new guidelines were issued for the operation of the new private banks. They were primarily as follows: 15

India’s Financial Sector

1. A minimum paid-up capital of Rs. 2 billion was to move up to Rs. 3 billion during the first 3 years of commencement of business. 2. Promoter’s contribution was to be at least 40 per cent of the paid-up capital and was to be locked at least for 5 years. 3. NRIs’ contribution to capital must not exceed 49 per cent. 4. The capital adequacy norm of 10 per cent, priority sector lending norms and branch expansion norms would apply to them similarly as in case of the public sector banks. Again, in February 2005, the government provided greater autonomy to the public sector banks so as to compete with the private sector banks and foreign banks in India. Now the public sector banks can shift/close their remote rural branches if they are not doing well. The stronger banks with CRAR of over 9 per cent, NPA of less than 4 per cent and a minimum of Rs. 30 million of owned funds have the freedom of linking pay structure to performance, going for mergers and acquisitions and crafting the human resource policies. In view of such freedom, there was a voluntary amalgamation between the Bank of Punjab Ltd and the Centurion Bank Ltd which became effective from October 2005. In October 2006, United Western Bank Ltd amalgamated with Industrial Development Bank of India Ltd. Yet again, the RBI issued guidelines regarding the entry of foreign banks in conformity with the WTO mandate. But at the same time, it has put some conditionalities. First of all, ownership and control must be well diversified meaning that the aggregate foreign direct investment from all sources should not exceed 74 per cent. The aggregate limit for foreign institutional investment would be restricted to 24 per cent but could be raised to 49 per cent subject to approval of the shareholders. Again, the directors and CEO should be ‘fit and proper’ and should observe sound corporate governance principles. Yet again, the banks must maintain the capital adequacy norms. Last but not least, the policy and programmes must be transparent and fair. Whatever the conditionalities relating to the entry of the foreign banks might be, their number was 30 at the end of March 2008. There were eight newly set-up domestic private sector banks along with greater autonomy enjoying 28 public sector and 15 old private sector banks—all ensuring healthy competition in this sector. 16

The Banking Sector

Making Income Recognition Norms and Financial Supervision Transparent The income recognition norms were amended in the very beginning of FY 1992–93 to ensure that interest not actually paid cannot be shown as accrued so as to avoid any exaggeration of bank profits. The banks were asked to follow a new format for preparing the profit and loss account and the balance sheet. The application of new accounting norms helped identify a more rational amount of profitability. The statistics reveal that perhaps because of changing norms of profitability, the picture of profitability among the public sector banks changed. As many as 13 public sector banks had incurred net losses during FY 1993–94, but in FY 1994–95, the number of public sector banks incurring losses fell to eight (GOI 1996). Of late, the RBI has asked banks to set aside a part of treasury income to investment fluctuation reserves so as to meet any loss on account of interest rate changes. Since October 2005, a part of the amount lying in this reserves account may be shifted elsewhere by those banks that have at least 9 per cent of CRAR. In order to have supervision over the functioning of the banks, the Board of Financial Supervision was set up in 1994 along with an advisory council and an audit sub-committee to strengthen the supervisory work. Moreover, an independent department of supervision was created in the RBI set-up. These bodies were laced with intensive computerisation. In order to ensure transparency and effective supervision of banking operations in conformity with the international standards, banks were asked during FY 2000–01 to disclose additional information related to: 1. maturity pattern of loans and advances, investments, deposits and borrowings, 2. foreign currency assets and liabilities, 3. NPAs and 4. sector-wise allocation of lending. The banks were asked to make in-house arrangements for collecting and controlling credit and for monitoring NPAs. The public sector banks were asked to annex the balance sheet of their subsidiaries along 17

India’s Financial Sector

with their own. During FY 2001–02, a system of financial stability review was begun in respect of key financial ratios. RBI appointed, subsequently, a Committee on International Financial Standards and Codes. Its suggestions have been implemented to improve the financial control of the banks. In June 2004, a monitoring framework was created for the financial conglomerates. During FY 2006–07, the criteria for identifying such conglomerates as well as the format for returns were revised in order to make the supervision more effective. In February 2007, RBI issued guidelines on modus operandi for checking fraud. In April 2007, compliance norms by banks were made more transparent. In May 2008, the Reserve Bank modified the prudential norms on asset classification in respect of infrastructure projects under implementation. The revised instructions came into force with effect from 31 March 2008.

Improving Customer Services In order to improve customer services, the Indian government paved the way for computerisation in Indian banking system in FY 1993–94. Individual banks constituted a task force to increase the message traffic through the Society for Worldwide Inter-bank Telecommunication (SWIFT). In early 1997, the Shared Payment Network System was established at Mumbai with 145 ATMs from 38 banks. Now it is a common affair for all the banks. Electronic funds transfer system was introduced from January 2002 among the banks within and across the cities. In April 2005, RBI started electronic clearing service that was broadened subsequently to cover many cities. A new MICR cheque processing centre (CPC) was set up at Cuttack increasing the number of total MICR CPCs to 60. With a view to improving efficiency and safety, the Reserve Bank has encouraged the use of Magnetic Media Based Clearing System (MMBCS) technology in smaller clearing houses. The implementation of MMBCS in the smaller clearing houses has led to the computerisation of their operations and increased the efficiency in the settlement process. The target was to computerise all the clearing houses by the end of 2008. The RBI advised banks in March 2008 that all large value payments of Rs. 10 million and above (revised subsequently as Rs. 1 million) should be mandatorily routed 18

The Banking Sector

through the electronic payment systems with effect from 1 April 2008. All this helped improve the customer services but increased the dependence of the banks on the information technology and thereby led to the risk of system failures and business disruptions. Thus, in order to avoid the business discontinuity, the banks need to submit quarterly report to the RBI showing such failure, if any, and the steps taken to avoid it. Product package was broadened under the retail banking system with a view to meeting the varied need of customers. The package included, among others, personal loan, housing loan, education loan, credit and debit cards and insurance products. Majority of the banks adopted universal banking so as to suit the varied interest of the customers. The broadened functions include functions of investment banking, securities trading and other financial services. Again, Banking Ombudsmen Scheme was launched in June 1995 under which ombudsmen were appointed to hear and redress the grievances of the customers quicker and without cost. The scope of this scheme was broadened in 2002 and again in 2006. Their award is placed before the Customer Service Committee which has been created as a nodal department at the controlling offices of the banks and with whom the RBI liaises. The banks review periodically their grievances redress machinery and take corrective steps. The RBI set up in February 2006 the Banking Codes and Standards Board of India with supervisory powers and, in July 2006, the Customer Service Department to improve the customer service. A question arises whether the improvement in the customer services has led to an increase in the operating cost of the banks. The statistics on this count presented in Table 1.5 reveal that the operating cost as a percentage of total assets (TAs) has normally decreased, although the trend is slightly different among different groups of banks. The operating cost/asset ratio for all scheduled commercial banks dropped from 2.6 per cent in FY 2000–01 to 1.8 per cent in FY 2007–08. The public sector banks presented a drop in this ratio from 2.7 to 1.5 per cent during the same period. The private sector banks did not witness a definite trend but the ratio has shown slightly an upward trend in the recent years. In case of foreign banks operating in India, also, the ratio dropped from 3.1 to 2.8 per cent during FYs 2000–08. Greater efficiency in customer services without increase in the operating cost is a plus point of the reform measures. 19

India’s Financial Sector Table 1.5

Types of banks Public sector banks Private sector banks Foreign banks in India All scheduled banks

Banks’ Operating Cost as Percentage of Assets

2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 2.7

2.3

2.2

2.2

2.1

2.1

1.8

1.5

1.9

1.4

2.0

2.0

2.0

2.1

2.1

2.2

3.1

3.0

2.8

2.8

2.9

2.9

2.8

2.8

2.6

2.2

2.2

2.2

2.1

2.1

1.9

1.8

Sources: 1. Government of India (Annual), Economic Survey. New Delhi: Ministry of Finance, various issues. 2. RBI (2008b).

IMPACT OF THE REFORM MEASURES The entire discussion of the reform measures raises one important question whether the banking sector in India has really been revamped and the banks, especially the public sector ones sharing the biggest cake of the entire operations, have turned financially viable. It is true that the banks do shoulder the desired social responsibility and they are still guided by the rules and regulations in the national interest. But, at the same time, it is also true that the doses of rules and regulations are not unduly restrictive, rather they are quite transparent. It is clear from the preceding section that, over the years, the capital base of the banks has grown and it is now compatible with the Basle II norms. Moreover, with low CRR and SLR, greater funds are available to them for profitable lending. They have done an immense job to restrict NPAs within manageable limits. Their freedom to manoeuvre the interest rates in order to attract large number of customers has conferred upon them competitive strength. The competition has grown further through allowing new banks into the fray. The system of financial analysis and control has turned more transparent. And above all, customer services have remarkably improved. 20

The Banking Sector

Now with these measures, one can expect that the operational efficiency of the banks should improve. However, any improvement in the operational efficiency cannot be analysed in isolation of the financial stability and the financial inclusion. So the impact of the reform measures is analysed here from these viewpoints.

Operational Efficiency The operational efficiency can be examined in terms of various financial ratios. A few studies may be referred to in this context. Angadi and Devraj (1983) and Sarkar and Das (1997) base their evaluation primarily on interest income/working fund ratio, non-interest income/ working fund ratio, operational expenses/operational income ratio, cost of funds ratio and interest spread/working funds ratio. Since the average working funds are equal to assets or liabilities, the assets can substitute the working funds. Again, the RBI (2005b) relies on almost similar ratios. In the light of these studies, we base our assessment on three ratios that relate primarily to profitable operation of the banks as follows: 1. Net interest earned/assets ratio. Interest income is the most important source of income. But since banks have to pay interest on deposits, the net interest income is taken into account. This ratio shows the efficiency of banks’ intermediation process. A lower ratio shows higher efficiency. 2. Operational expenses/(total income minus interest expenditure) ratio. It is also an indicator of banks’ efficiency. A lower ratio means greater efficiency. 3. Return on assets or net profits/assets. If operational efficiency is there, the net profits and thereby the return on assets has to be higher. The ratios are analysed for different groups of banks on a time series basis ranging between the financial year in the beginning of reform and the latest one, 2007–08. To be precise, Table 1.6 shows these ratios for FY 1991–92, a decade later during FY 2001–02 and for FY 2007–08, and wherever possible, compares them with the internationally prevalent range. 21

India’s Financial Sector Table 1.6

Operational Efficiency of the Banks in India

(%) Profitability ratios Net interest earned/assets ratio Operational expenses/net income ratio Return on assets

FY

Public sector banks

Private sector banks

Foreign banks in India

All scheduled banks

1991–92 2001–02 2007–08 1991–92 2001–02 2007–08 1991–92 2001–02 2007–08

3.22 2.73 2.15 58.73 54.93 48.02 0.27 0.72 0.88

4.01 1.58 2.41 63.56 45.37 51.30 0.65 0.66 1.01

3.94 3.22 3.79 31.16 49.16 42.54 1.27 1.32 1.82

3.30 2.85 2.35 55.73 53.02 48.0 0.35 0.90 0.99

Global range

1.2–11.6

46.0–68.0

–1.2–6.2

Sources: 1. RBI, Report on Trend and Progress of Banking in India. Mumbai, various issues. 2. GOI (1994).

As it is evident from Table 1.6, the net interest earned ratios fell for public sector banks and scheduled commercial banks as a whole during the first one-and-a-half decades, despite minor increase in case of private sector banks and foreign banks operating in India during FY 2007–08. The decrease in ratio indicates improved efficiency in the asset management. Judged against the international standards, the ratios lay quite closer to the desired side of the range. As far as operational expenses/net income ratio is concerned, public sector banks along with the entire scheduled commercial banks witnessed increasing efficiency over the years insofar as this ratio diminished in their case. The foreign banks operating in India too were able to improve their efficiency in this respect during 2000s. However, the private banks tended to lag in this respect in FY 2007–08. In this case too, the ratios lay at the right end of stick when compared with international standards. The return on asset ratio presented an upward trend during the period of reform. The public sector banks witnessed the biggest upsurge from 0.27 per cent in FY 1991–92 to 0.88 per cent in FY 2007–08. The private sector banks performed better from the very beginning as this ratio in their case was high at 0.65 per cent in FY 1991–92 and that increased to 1.01 per cent during FY 2007–08. The foreign banks in India were placed better. This ratio in their case moved up from 22

The Banking Sector

1.27 to 1.82 per cent. For the scheduled commercial banks as a whole, this ratio almost trebled—from 0.35 to 0.99 per cent, during one-anda-half decades. In this context, the findings are similar to those of Demirguc-Kunt and Huizings (1998) that foreign banks showed higher profitability than the domestic banks in a sample of 80 developing countries. On comparing this ratio with the international standard mentioned in Table 1.6, it is quite evident that Indian banks have to go a long way to achieve a good level of profitability.

Financial Stability The process of deregulation and greater scope for the functioning of the market forces is good for the banks’ health, but external/internal shocks may lead to financial crisis manifesting in intense asset price volatility, disruption in the payment and settlement system and in bank failures. So it is important to analyse the financial stability ratios along with the financial performance ratios. Financial stability can be expressed in the following ratios: 1. Provisioning/NPAs ratio: Provisioning is done to cover NPAs. So if this ratio is greater, it reflects banks’ ability to withstand losses in asset value and denotes greater financial stability. 2. Capital/asset ratio: It represents capital adequacy to maintain a certain amount of assets. Higher the ratio, greater is the financial stability. 3. Funding volatility ratio: To calculate this ratio, the volatile liabilities (VLs) including demand deposits minus liquid assets (LAs) comprising of cash in hand, with RBI and other banks, money at call and short notice and investment in government and approved securities are divided by TAs minus LAs. A lower ratio shows lower funds volatility. So it is better to have a lower/ negative ratio. Similar to the profitability ratios, these ratios are analysed for different groups of banks on a time series basis. Table 1.7 shows these ratios for FY 1991–92, a decade later during FY 2001–02 and for FY 2007–08, and wherever possible, compares them with the internationally prevalent range. 23

India’s Financial Sector Table 1.7

Financial Stability Ratios of the Banks in India

(%) Financial stability ratios Provisioning/NPA ratio

Capital/asset ratio

Funding volatility ratio

All Private Foreign sector banks in scheduled banks banks India

FY

Public sector banks

1996–97

13.31

25.45

102.62

16.20

2001–02 2007–08 1991–92 2001–02 2007–08 1991–92

23.68 52.17 2.56 4.97 5.79 –13.35

24.31 54.06 2.15 6.05 9.72 –25.75

71.44 51.75 3.65 9.38 13.55 –10.30

34.35 52.59 2.62 5.48 7.29 –13.53

2001–02 2007–08

–26.39 –32.38

–33.73 –29.61

–33.72 –27.47

–28.38 –31.37 –0.71–0.11

Global range

7.8–266.2

2.7–20.2

Sources: 1. RBI, Report on Trend and Progress of Banking in India. Mumbai, various issues. 2. GOI (1994).

Since the detailed figures for NPAs are available only since FY 1996–97, the provisioning/NPA ratios are presented since then. The ratio more than trebled in case of all the scheduled commercial banks taken together over around a decade between FY 1996–97 and 2007–08. On the contrary, in case of foreign banks in India, it dropped during FYs 1996–2008. Among the public sector banks, it quadrupled and among the private sector banks, the cover went up more than twofold. However, this ratio lags far behind the international standards and indicates for a more systematic approach towards financial stability. The capital/asset ratio increased during FYs 1991–2008 among all groups of banks—from 2.56 to 5.79 per cent among public sector banks, from 2.15 to 9.72 per cent among private sector banks and from 3.65 to 13.55 per cent among foreign banks operating in India. On the whole, it was 7.29 per cent during FY 2007–08 which was better than in many countries, namely, Australia, Canada and Japan (RBI 2008b). All this is a good feature showing increasing financial stability. But judged against the international standards, something more is yet to be done in this respect so as to ensure greater financial stability. Last but not least, the funding volatility ratio lies in all cases in the negative zone which is a good feature. In the first decade of the 24

The Banking Sector

reform period, the move towards greater negativity showed greater financial stability. The private sector banks and foreign banks showed less financial stability in FY 2007–08; nevertheless, judged from the international standards, they are well placed.

Financial Inclusion Apart from the improved operational efficiency and generation of financial stability, it is worth noting that the commercial banks in India have shown interest in financial inclusion. In the very annual policy announcement of FY 2006–07, RBI urged the banks to go for financial inclusion. They were asked to allocate at least 1 per cent of their lending to the weaker sections of the society at as low as 4 per cent interest rate. The financial inclusion was to be achieved through the introduction of ‘no-frill’ accounts, promotion of financial literacy and responsible borrowing and encouraging adoption of Information and Communication Technology (ICT) solutions for achieving greater outreach as also reducing transaction costs. The scheduled commercial banks were to meet the entire credit requirements (income generation activities, social needs, such as housing, education and marriage, and debt wapping) of self-help group members. Majority of the banks introduced no-frill accounts or zero-balance accounts for the low-income customers. To quote one example, Punjab National Bank opened 0.3 million no-frill accounts, and by the end of March 2008, the number was expected to go up to 1 million (Business Line 4 January 2008). The banks initiated pilot projects utilising smart cards to increase their outreach. Biometric methods for uniquely identi-fying customers were increasingly adopted. Around 160 districts were identified and 100 per cent financial inclusion was achieved in 28 districts by FY 2007–08 (RBI 2007b). The RBI advised banks in May 2008 to classify overdrafts up to Rs. 25,000 (per account) granted against no-frill accounts in the rural and semi-urban areas as indirect finance to the agriculture sector under the priority sector with immediate effect. However, despite these efforts to achieve the objectives of financial inclusion, the trend is not satisfactory. As per a RBI study covering public sector banks, such loans accounted for less than 1 per cent by the end of FY 2006–07. The percentage varied between 0.22 and 0.42 25

India’s Financial Sector

in three banks, 0.05 and 0.15 in seven banks and less than 0.05 in other banks. There were four banks in case of which this percentage was 0 (Mint 17 June 2008). On the whole, the broad impact of the reform measures is quite positive. There is a definite move towards improved operational efficiency and financial stability and also towards financial inclusion.

26

2

Non-banking Financial Companies

It is true that the banks share a very large segment of financial intermediation in the Indian financial market; nevertheless, the nonbanking financial companies (NBFCs) play a significant role in this respect. The possible reason is that it has been easy to set up NBFCs and, moreover, they, being less subjected to rigid regulations, have been in a position to offer attractive terms to allure the customers. They grew along with the banking companies providing various kinds of financial services over the past few decades. During the 1980s and the early 1990s, the growth was remarkably fast as the number of NBFCs ballooned from 7,063 at the end of March 1981 to 33,520 and 35,832, respectively, at the end of March 1991 and 1992 (RBIB 1996). By early 1990s, the line demarcating between the banks and the NBFCs looked largely blurred. Despite the fact that the NBFCs did not enjoy chequeissue facilities as the banks did have, they enjoyed comparatively comfortable profitability ratios perhaps because they were comparatively less regulated. Thus, when the economic reforms were started in the country in 1991 and when the financial sector reform was one of the top-level agenda, the policy makers could not overlook the NBFCs. However, the reform measures were different from those for banks. While the banks needed deregulation, the NBFCs required greater doses of regulation not only to ensure depositors’ safety but also for a better management of their assets. In view of these facts, the present chapter anatomises in the beginning the different kinds of NBFCs, then discusses the major reform measures in this area and, finally, analyses the broad impact.

India’s Financial Sector

NATURE OF NBFCs The NBFCs are the companies whose financial assets are more than one-half of the total assets and the income from the financial assets is more than one-half of the gross income. These companies are varied in nature in the sense that their financial functions are different in many ways. Their earlier grouping by the RBI depended broadly upon their registration and regulation. Their three broad groups were as follows: 1. Those registered with, and regulated by, the RBI, such as: (a) (b) (c) (d) (e)

Equipment-leasing company Hire purchase finance company Residuary non-banking company (RNBC) Loan company Investment company

2. Those not registered with RBI but getting necessary directives from it, such as: (a) Mutual benefit finance company (notified nidhis) (b) Mutual benefit company (potential nidhis) (c) Chit fund company 3. Those neither registered with nor regulated by the RBI, such as: (a) (b) (c) (d)

Insurance company Merchant banking company Housing finance company Microfinance company

It would be worthwhile to explain the principal business of these different types of NBFCs. An equipment leasing company (ELC) provides finance for equipment-leasing. A hire purchase company (HPC) provides finance for hire purchase. While the primary function of the RNBC is to accept deposits, a loan company (LC) makes loans and advances for any activity other than equipment-leasing, hire purchase and housing finance. An investment company (IC) is engaged in trading of securities. The nidhi companies operate on the concept of mutual benefit. They accept deposits only from the members and lend only to them. They are notified by the central government under 28

Non-banking Financial Companies

Section 620 A of the Indian Companies Act, 1956. The potential nidhis are not so notified. Chit fund companies come into an agreement with the subscribers who subscribe a certain sum of instalments over a period and each one of the subscribers gets the prize amount by lot/auction/tender. In 1997, the NBFCs were grouped as those accepting deposits and those not accepting/holding deposits. Recently, the annual policy statement of the RBI, during 2006–07, put forth the three broad classifications based on the nature of function. The first is known as the asset financing company (AFC) engaged in financing assets of the manufacturing companies. The second is an IC. And finally, the third is an LC. Again, the AFCs may be those accepting deposits, known as NBFCs-D; they may be those not accepting deposits, known as NBFCs-ND. The AFCs not accepting deposits with an asset size of Rs. 1 billion are known as systemically important ones (AFC-ND-SI) (RBI 2007b). The AFC-ND-SIs are subject to least regulations compared to the NBFCs-D that face strict regulations in view of safety of the depositors.

THE STATE OF NBFCs PRECEDING REFORMS The need to regulate NBFCs was felt during 1960s. The amendment of the RBI Act, 1934, was definitely a move in this respect. But the amendment was limited to deposits and to protecting the interest of depositors. A bit greater tinge of regulation was found in the recommendations of the Bhabtosh Datta Study Group in 1971 that compartmentalised NBFCs into those being approved and those being not approved by the RBI. While the former were subject to regulations regarding capital reserves, liquid assets, and so on, the latter were not so regulated. The recommendations of the James Raj Study Group in 1974 aimed at limiting the deposits within reasonable zone and making NBFCs an instrument of the monetary policy. The Chakraverty Committee that submitted its report in 1985 stressed on the licensing of the NBFCs. Thus, all these efforts were limited to the liabilities side of the NBFCs’ balance sheet. The asset side was never stressed upon. Moreover, the recommendations could not be implemented in their full spirit as the power of the RBI was limited.

29

India’s Financial Sector

As mentioned earlier, the number of the NBFCs stood at 35,832 at the end of March 1992, out of which only 6,680 or 18.64 per cent of the total were set up as public limited companies. The rest were operating in the form of private limited companies where the element of transparency was only limited. What is more astonishing is that only 8,923 companies, being a quarter of the total, were submitting their performance report with the RBI. It means that three-quarters of the NBFCs stood unregulated and, obviously, the depositors’ interest was quite unsecured. As per an RBI study, the total deposit of 8,923 companies at the end of March 1992 amounted to Rs. 204.380 billion, out of which Rs. 28.250 billion or 13.82 per cent only were regulated deposits. The rest Rs. 176.130 billion represented the exempted deposits. The regulated deposits being subject to regulatory measures included normally unsecured debentures, deposits received from shareholders in case of public limited company, deposits guaranteed by the directors in personal capacity and fixed deposits received from the public in general. On the contrary, money received from the government—domestic or foreign—borrowing from banks and financial institutions, inter-company borrowings, money received from directors or private limited companies, security deposits, advances received against orders and money received through issue of secured or convertible debentures represented exempted deposits. It is interesting to note that over 83 per cent of the deposits carried interest rate of over 14 per cent which was definitely more attractive than that in case of the banks. Majority of the companies were small companies with low deposit figures. The study shows that there were only 1,801 companies that had deposit for Rs. 2.5 million or more each. But they accounted for a lion’s share, say, 93 per cent, of the total deposits with the NBFCs (RBI 1996). The study shows further that the magnitude of deposits and the size of net owned funds (NOFs) varied widely among different types of the NBFCs. Table 2.1 shows these variations. It is evident that 46.5 per cent of the NBFCs were ICs whose primary objective was trading in securities. Since their operation involved greater risk, they attracted only 11.3 per cent of the total deposits. The next being 26 per cent of the reporting companies were the LCs with primary objective of lending of funds. They accounted for 44.3 per cent of deposits. HPCs accounted for around 10 per cent of the total number of companies and around similar percentage of the deposits. Equipment leasing 30

Non-banking Financial Companies Table 2.1

Deposits and NOFs among Different Types of NBFCs as on 31 March 1992

(Rs. billion)

Type of company

Number of reporting companies

LCs 2,317 (26.0) Equipment-leasing 102 (1.1) companies Investment companies 4,151 (46.5) Hire purchase companies 860 (9.6) Housing finance companies 30 (0.3) Mutual benefit companies 96 (1.1) Miscellaneous companies 1,367 (15.3) Total 8,923 (100.0)

Deposits

NOFs

Deposits as % of NOFs

90.450 (44.3) 37.700 (18.4)

35.290 6.540

256 577

23.050 (11.3) 19.710 (9.6) 18.520 (9.1) 3.620 (1.8) 11.340 (5.5) 204.380 (100.0)

12.450 6.480 6.580 0.060 0.170 67.560

185 304 281 6,466 6,751 303

Source: Reserve Bank of India Bulletin, May 1996. Notes: 1. The study then included also the housing finance companies. 2. Figures in bracket show the share in total number of companies or in total deposits.

companies were just over 1 per cent of the total number of companies, but their share in total deposits was as high as 18.4 per cent. Mutual benefit companies did neither attract the attention of those who were responsible for setting up of the NBFCs nor attract depositors in a big way. Lastly, around 15.3 per cent of the companies were categorised as miscellaneous, but they attracted barely 5.5 per cent of the deposits. Again, there were variations in the deposit/NOF ratio. The NOF represented the sum of paid-up capital and free reserves minus accumulated loss, deferred revenue expenditure and intangible assets, if any. The statistics show that the deposits as percentage of NOF were abnormally high in case of the mutual benefit companies and even higher in the miscellaneous companies. The percentage stood at 6,466 and 6,751, respectively. On the contrary, this percentage was as low as 185 in case of ICs and 256 in case of LCs. In case of HPCs and ELCs, the percentage was a bit higher. The higher the percentage, the greater is the reliance of the companies on the deposits financing their lending and investment activities. But it is very important to note that greater deposit/NOF ratio goes against financial soundness. It is true that the reporting companies did not assure a high degree of financial stability, but a quite bigger number of companies remained outside the purview of the RBI in case of which the size of NOF was 31

India’s Financial Sector

never stressed upon in absence of regulation, nor was there any regulation guiding their asset management. In the sequel, the depositors’ interest remained greatly unsecured and the financial stability of the NBFCs remained doubtful.

MEASURES OF REFORM SINCE 1992 The Narsimham Committee that was set up to suggest measures for revamping the financial sector and that submitted its report in late 1991 did indicate, among other things, to regulate the NBFCs through creating norms relating to capital adequacy, debt equity, credit concentration and accounting practices. In fact, these indications led the RBI to set up a Working Group on Financial Companies under the chairmanship of A.C. Shah. Its report, submitted in September 1992, redefined the regulated deposits, recommended for the registration of the financial companies and presented guidelines on prudential norms so as to regulate the balance sheet of the NBFCs. But the problem was that these recommendations were not mandatory in the absence of any legal backing. It was because of this reason that an ordinance was promulgated in January 1997 effecting comprehensive changes in the provisions of the RBI Act, 1934. The RBI Act was amended two months later. The amended provisions included, among other things, the establishment of a financial company with a minimum of NOF of Rs. 2.5 million, raised subsequently to Rs. 20 million for those incorporated after 20 April 1999; compulsory registration of the companies; maintenance of a minimum amount of liquid assets; creation of reserves and transferring thereto a minimum of 20 per cent of the profits earned each year; compulsory credit-rating, income recognition and asset classification norms and certain other prudential norms. The Company Law Board was empowered to direct a defaulting NBFC to repay any deposit that violated the prescribed norms. The RBI was empowered to impose penalty for violation of any of the above provisions. In January 1998, the RBI redefined the entire gamut of regulation and supervision. As a result, the NBFCs were trifurcated. The first category was represented by those accepting only public deposits. The second category covered those doing financial business but not accepting deposits. Finally, the third category included core investment 32

Non-banking Financial Companies

companies that held 90 per cent of their assets as investment in securities of their own group. The companies of the first category were more intensively regulated in order to protect the interest of the depositors. Effective from April 1998, the LCs and ICs were to maintain greater amount of liquid assets in the form of statutory reserves which was 10 per cent of their deposits. The percentage was even higher at 15 in case of other companies. Again, a three-tier supervisory framework was mooted based on capital adequacy, asset quality, management, earnings, liquidity and systems (CAMELS). An effective on-site and off-site inspection system was introduced by the Department of Nonbanking Supervision of the RBI. Thus, in real sense of the term, the reforms in respect of the NBFCs were manifest from 1997 or 1998 despite the fact that the efforts were evident in this direction since Shah Committee recommendations in 1992. The above measures led to stricter control. Nevertheless, there were complaints from the investors that in turn led to the setting up of a task force which submitted its recommendations in October 1998. The RBI implemented those recommendations. It prohibited NBFCs with less than Rs. 2.5 million of NOF to accept deposits and prescribed a capital to risk-weighted assets ratio (CRAR) of 15 per cent, inclusive of Tier I and Tier II capital, for NBFC seeking public deposits sans credit-rating and for ELCs, HPCs, LCs, and ICs. It also prescribed a ceiling on real estate/capital market investment so as to avoid risk. It asked NBFCs to bring in transparency in advertisements and emphasised on depositors’ awareness. The registration with the RBI within stipulated time period was made compulsory. The ceiling on bank lending to NBFCs was removed in order to have a better coordination with the banks. Annual inspection rules were delineated and specific action was laid down for the defaulting companies. To this end, proper coordination was brought about between the Company Law Board and the RBI. In January 2000, the RBI exempted the NBFCs licensed under Section 25 of the Indian Companies Act, 1956, and also the mutual benefit companies with an NOF of Rs. 1 million from the purview of registration, maintenance of minimum liquid assets and the minimum prescribed retention of earnings. Fresh guidelines were issued in June 2000 as per which an NBFC with NOF of Rs. 20 million could undertake insurance business as agent on fee basis without any risk participation. Those with NOF of Rs. 5 billion and with less than 33

India’s Financial Sector

5 per cent of NPA could, however, undertake risk. Similarly, an NBFC with NOF of Rs. 2 billion, a minimum of triple-A rating, a CRAR of 12 per cent and a track record of compliance with the RBI could take up the banking business. The guidelines permitted NBFCs to accept deposits from the relatives of their directors and rationalised the format of return submitted by them. Again, in view of default on interest payment by NBFCs, the RBI imposed a ceiling on the interest rate offered by them on the deposits. At the end of March 2000, it was 16 per cent that was reduced subsequently to 14 per cent by March 2001, 12.5 per cent by March 2002 and 11 per cent by March 2003 that continued till March 2006. From 24 April 2007, a ceiling of 12.5 per cent was imposed on the interest rate the NBFC-Ds would pay to the depositors. In case of RNBCs, interest rate fell from 4 to 3.5 per cent during the same period. In 2000, the Expert Committee on Nidhis made several suggestions that were subsequently implemented. Nidhis could be set up with a minimum of 500 members and Rs. 1 million capital. The Companies Act that has been governing the nidhis prescribed ceiling interest rates on deposits and loans, NOF/deposit ratio of 1:20, liquid asset requirements of not less than 10 per cent of deposits and dividend not exceeding 25 per cent of profits. It also provided for the appointment of an auditor. The NBFCs and RNBCs with a minimum deposit of Rs. 5 billion were asked to submit quarterly return, although beginning from September 2005, such companies with even Rs. 1 billion deposits are to submit returns not quarterly but monthly. They also have to furnish additional information relating to capital market exposure beginning from July 2006. The NBFCs and RNBCs were permitted to keep their liquid asset securities with a depository participant registered with the Securities and Exchange Board of India (SEBI) subject to prior approval of the RBI. Guidelines were issued in respect of investment in long- and short-term assets and also for the identification of the loss assets. The RNBCs were allowed to invest in mutual funds including Unit Trust of India subject to a ceiling of 10 per cent of the aggregate liability and a sub-limit of 2 per cent for any one mutual fund. In order to ensure depositors’ protection, the RBI participated with the state governments to make necessary enactments and with the 34

Non-banking Financial Companies

electronic media to make the depositors conscious. The NBFCs have to follow the customer identification procedure similarly as the banks do and to categorise the customers based on different risk classes. They have to watch over suspicious transactions and to report frauds to the RBI within a reasonable time period. The auditors are to be rotated every 3-year period for ensuring good governance. Beginning from December 2005, deposits cannot be clubbed for making premature repayment of more than Rs. 10,000. Again, in June 2004, RNBCs were made to invest 80 per cent of the deposit liability in directed investment in order to avoid risk and safeguard the interest of the depositors. The percentage went up to 90 by April 2005 and to 95 and 100, respectively, by April 2006 relating to deposits till December 2005 and the deposits thereafter. The requirements of double A and rating and listing on stock exchange were introduced for bonds/debentures qualifying towards directed investment. Such companies were asked to follow the guidelines relating to the appointment of directors, agents and sub-agents. In November 2005, the government permitted foreign direct investment up to 49 per cent of the equity capital of the securitisation companies and reconstruction companies and also the investment by the foreign institutional investors up to 10 per cent of the issue of security receipt. In May 2006, the RBI issued guidelines that aimed at imparting transparency in the business practices of the NBFCs. They have to make a disclosure of the upfront, annualised interest rate, service charges, prepayment charges and the schedule of disbursements to the borrowers so that they are not harassed. This was done especially in view of the fact that some NBFCs were charging interest rates up to 50 per cent. Based on the recommendations of the Internal Group appointed by the RBI, fresh guidelines were issued in December 2006. Beginning from April 2007, the AFC-ND-SIs were to maintain a minimum CRAR of 10 per cent. They could not lend to, or invest in, a single company group exceeding one-quarter of their owned funds or exceeding 40 per cent of the owned funds in case of lending and investment simultaneously. However, some relaxation was there in case of lending to, or investment in, an infrastructure company.

35

India’s Financial Sector

In December 2006, it was also decided to allow NBFCs selectively to operate as mutual fund agents and to market and distribute their products as also to issue co-branded credit cards with commercial banks at least for two years initially after getting approval from the RBI, both subject to specific conditions, such as fulfilment of a minimum net owned fund of Rs. 1 billion, NPAs not more than 3 per cent of net advances and a CRAR of 10 per cent for NBFCs-ND and 12 per cent for NBFCs-D. In January 2007, the NBFCs accepting public deposits were permitted to create floating charge on statutory liquid assets in favour of their depositors through the mechanism of ‘Trust Deed’, although necessary information was to be provided in this respect to the RBI. The Ministry of Company Affairs took over the entire regulation of notified nidhis and potential nidhis. Two separate guidelines were issued for the deposit-accepting and not-deposit-accepting NBFCs in February 2007. The deposit-accepting NBFCs and RNBCs with total assets of Rs. 1 billion and above were asked to submit a monthly return on capital market exposure. In view of the regulatory gaps between banks and NBFCs, the prudential norms were reviewed and some basic modifications were introduced. One of such modifications was that any NBFC being a subsidiary of a foreign bank would be brought under the ambit of consolidated supervision. Again, bank-sponsored NBFCs not permitted to offer discretionary portfolio management services would be permitted to do so on a case-by-case basis. The banks were not to offer more than 10 per cent share in the paid-up equity share capital of an NBFC-D, except for the housing financing companies. These modifications were introduced from April 2007. In April 2007, the NBFC-Ds were insisted on maintaining transparency in their advertisement related to deposits. They were asked to mention whether they had certificate of registration issued by the RBI. In May 2007, the NBFCs providing loan were asked to lay down appropriate principles and procedures to determine interest rates and to make them fair. It was a move to check excessive interest rate charged by some NBFCs. Since September 2007, the NBFCs are required to report their secondary market transactions in corporate bonds on Fixed Income Money Market and Derivatives Association of India platform. On 15 January 2008, mortgage guarantee companies were 36

Non-banking Financial Companies

notified as NBFC. They were required to get registered with the RBI, to maintain NOF of Rs. 1 billion at the time of the commencement of business and also to adhere to a minimum capital adequacy norm of 10 per cent. Detailed guidelines were issued concerning investment by the mortgage guarantee companies. They were required to frame a policy in line with the investment directions issued by the Reserve Bank. They were to invest only in government securities, securities of corporate bodies/public sector undertakings guaranteed by government, fixed deposit/certificates of deposit/bonds of scheduled commercial banks, listed and rated debentures/bonds of corporates and fully debt-oriented mutual fund units. These companies have to hold not less than 25 per cent of the total investment portfolio in central/state government securities. The investment should be marked to market. In March 2008, deposit regulations in case of NBFC-D were revised to check frauds.

IMPACT OF THE REFORM MEASURES Now it would be worthwhile to discuss the impact of a plethora of regulatory measures taken to reform NBFCs. Since the regulation became effective only after the amendment of the Reserve Bank of India Act in 1997, we like to review the impact from different angles preferably during 2000s. It may be pointed out that while making this type of review, the focus is greatly on the deposit-accepting companies.

Growth in the Number of Companies Let us take up, first of all, the issue of registration that is basic to regulation. With more and more companies getting certificate of registration, the ambit of regulation would be greater. As the figures in Table 2.2 show, 8,451 companies got registration by June 2000, out of which 679 were the deposit-accepting companies. The respective figures moved up to 14,077 and 784 by June 2002. But since a number of them had to face the cancellation of registration for not abiding by the rules and regulations, the respective figures fell gradually to 13,014 and 428 by June 2006, to 12,968 and 401 by June 2007 and to 12,809 and 364 by June 2008. The figures show that every year,

37

India’s Financial Sector Table 2.2

At the end of June 1 2000 2001 2002 2003 2004 2005 2006 2007 2008

Number of NBFCs Registered with the RBI

NBFCs accepting deposit

NBFCs

Col. 3 as % of col. 2

2

3

4

8,451 13,815 14,077 13,849 13,764 13,261 13,014 12,968 12,809

679 776 784 710 604 507 428 401 364

8.03 5.62 5.57 5.13 4.39 3.82 3.29 3.09 2.84

Source: RBI (2008b).

on an average, 639 companies were registered (net of cancellation) with the RBI. However, this figure should have been much higher in view of bringing large number of unregistered companies under regulatory fold. Table 2.2 shows also that the share of the depositaccepting companies got thinner over the years—from 8.03 per cent at the end of 2000 to barely 2.84 per cent at the end of June 2008. The possible reason might be lack of confidence of the depositors in these companies compared to commercial banks. Moreover, the conversion of deposit-accepting companies into those not accepting deposits with a view to weeding out non-viable deposit-accepting companies is the other factor in this respect. Again, Table 2.3 shows the number of different types of the depositaccepting companies and the amount of deposits held by them, respectively, at the end of March 2007 and March 2008. While the number of AFCs and loan providing companies increased, that of the others decreased at the end of 2008. From the viewpoint of deposit too, they performed differently. While the AFCs witnessed a 522.4 per cent rise in deposit at the end of March 2008 over March 2007, loan providing companies faced a 174.3 per cent decline in deposits. In other cases, the drop in deposits varied between 58.1 and 81.8 per cent. On the whole, there was a decline in deposit by 1.9 per cent at the end of March 2008 over the previous year. 38

Non-banking Financial Companies Table 2.3

Deposits held by NBFC-Ds at the End of March 2007 and March 2008

Amount of deposit (Rs. billion)

Number of companies March 2007 1 AFCs ELCs HPCs ICs LCs MNBCs Total

March 2008

March 2007

2

3

4

72 28 240 3 29 1 373

178 14 78 1 62 — 333

1.86 0.43 16.83 0.45 1.17 0.02 20.77

March 2008 5 11.56 0.08 5.33 0.19 3.21 — 20.38

% change in col. 5 over col. 4 6 522.4 –81.8 –68.3 –58.1 –174.3 — –1.9

Source: RBI (2008b).

Capital Adequacy Capital adequacy is a prerequisite for sound financial health of the NBFCs. Capital adequacy is quantified in terms of CRAR that was set for these companies. Now the question is whether the NBFCs have reached the minimum CRAR set by the RBI. Table 2.4 shows the CRAR of NBFC-Ds between March 2001and March 2008. It is evident that by March 2001, 8 per cent of the companies under review had a CRAR of less than 12 per cent. The other 6 per cent had CRAR 12 per cent and above but less than 20 per cent. Around 12 per cent of the companies had CRAR of 20 per cent and above but less than 30 per cent and the rest, over 73 per cent of the companies, had CRAR of 30 per cent and above. It was a satisfactory finding, especially when one looks at it against the norms set by the RBI. The situation improved marginally in the following years. At the end of March 2008, it is found that over 74.4 per cent of the companies had CRAR of 30 per cent or above. Around 8.8 per cent of the companies had a CRAR of 20 per cent and above but less than 30 per cent. The other 3 per cent of the companies had CRAR of 12 per cent and above but less than 20 per cent, and 13.8 per cent of the companies had CRAR of less than 12 per cent. Again, interpreting capital adequacy in terms of NOF, it may be said that the RBI prescribed the minimum required in order to provide financial strength to these companies. The NBFCs did maintain invariably the minimum. But the question is whether the NOF was sufficient keeping in view the size of deposits. The statistics show that the 39

India’s Financial Sector Table 2.4

CRAR among NBFCs: March 2001 to March 2008

(%) CRAR at the end of March Less than 12% 12% to less than 20% 20% to less than 30% 30% or above Number of reporting companies

2001

2002

2003

2004

2005

2006

2007

2008

8.4 6.4

6.6 8.6

6.4 8.3

5.2 5.2

19.8 6.8

5.9 4.0

7.8 4.5

13.8 3.0

11.5

11.5

11.2

10.4

9.9

11.8

8.7

8.8

73.7 73.4 74.1 79.2 63.5 78.3 82.8 74.4 714 654 658 484 324 322 332 320 (100.0) (100.0) (100.0) (100.0) (100.0) (100) (100) (100)

Source: RBI, Report on Trend and Progress of Banking in India. Mumbai, Annual, various issues.

NOF/deposit ratio moved up from 23.3 per cent at the end of March 2002 to 29.7 and 29.2 per cent, respectively, at the end of March 2005 and March 2006 (RBI 2006b). At the end of March 2007, this ratio moved up to 34.87 per cent and at the end of March 2008, it was as large as 50.26 per cent (RBI 2008b). All this is a good trend.

Interest Rate Structure The liabilities side of the management is concerned also with imposing ceiling on the interest rate on deposit so as to avoid any default on account of interest payment. The ceiling interest rate was revised downward with the result that the real burden of interest payment has reduced over the years. Table 2.5 presents the figures of deposits percentage in a particular interest rate slab. It is evident that at the end of March 1998, one-third of the deposits carried interest rate of over 16 per cent. A slightly less than one-half of them carried interest rate of over 14 per cent and up to 16 per cent. One-sixth of the deposits carried interest rate of over 10 per cent and up to 14 per cent. Lower interest up to 10 per cent was a rare phenomenon. Three years later, at the end of March 2001, only one-tenth of the deposits carried interest rate of over 16 per cent and almost a quarter of them carried interest rate of over 14 per cent. Approximately two-thirds of the deposits stood in the range of over 10 and 14 per cent. The overall burden of interest payments shrank significantly. Again, at the end 40

Non-banking Financial Companies Table 2.5

Interest Rate on Deposits of NBFC-Ds

Percentage of deposits at the end of March Interest rate slabs (%)

1998

2001

2006

2007

2008

Up to 10.0 Over 10.0 and up to 14.0 Over 14.0 and up to 16.0 Over 16

1.1 16.9 48.8 33.2

1.8 64.5 23.7 10.0

83.4 13.5 2.1 1.0

89.5 9.6a 0.9b —

73.28 25.44a 1.28b —

Source: RBI, Report on Trend and Progress of Banking in India. Mumbai, Annual, various issues. Notes: aMore than 10% and up to 12% interest rate. b More than 12% interest rate.

of March 2008, the picture was quite different. As large as 73.28 per cent of the deposits carried interest rate of 10 per cent or lower, the figure being barely 1.1 and 1.8 per cent, respectively, at the end of March 1998 and March 2001. On the other extreme, barely 1.28 per cent of the deposits carried interest rate of over 12 per cent at the end of March 2008. Despite reduced interest burden on deposits, the NBFCs enjoyed till FY 2005–06 the privilege of offering higher interest rate on deposits insofar as the ceiling rate in their case is 11 per cent compared to 6.25 per cent in case of public sector banks on 1- to 3-year maturity deposits (RBI 2006b). During FY 2006–07, the difference of interest rate narrowed. But, surprisingly, they have attracted only a very small segment of deposits moving to the scheduled commercial banks and that too has fallen over past few years. The statistics show that the share of the NBFCs’ deposits in the total deposits of the scheduled commercial banks fell from around 1.4 per cent at the end of FY 2001–02 to 1.1 per cent at the end of FY 2005–06, to 0.95 per cent at the end of FY 2006–07 and to 0.73 per cent at the end of FY 2007–08 (RBI 2008b).

Squeeze in NPAs The asset side management led to positive results. Regulation of lending/investment policies and rationalisation of income recognition norms and provisioning norms led to a squeeze in the nonperforming assets (NPAs). The figures in Table 2.6 show that both the gross and net NPAs in relation to assets declined over the years, 41

India’s Financial Sector Table 2.6

Gross and Net NPAs in Relation to Assets

(%) At the end of March

Gross NPA/assets

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

11.4 10.2 9.9 11.5 10.6 8.8 8.2 7.0 2.4 1.9 0.9

Net NPA/assets 7.4 7.0 9.5 5.6 3.9 2.7 2.4 3.4 0.4 0.4 0.3

Source: RBI, Report on Trend and Progress of Banking in India. Mumbai, Annual, various issues.

respectively, from 11.4 and 7.4 per cent at the end of March 1998 to 7 and 3.4 per cent at the end of March 2005 and even faster to 2.4 and 0.4 per cent by the end of March 2006. At the end of FY 2006–07, the respective figures were 1.9 and 0.4 per cent. And at the end of FY 2007–08, they were 0.9 and 0.3 per cent. The cut, which has been drastic, especially during FYs 2005–08, has added substantially to the financial strength of these companies.

Operational Efficiency Last but not least, a very important question is concerning whether the NBFC-Ds’ operation is justified from the viewpoint of profitability. This question is significant in view of the fact that too much of regulations on banks had led to the erosion of profitability during late 1980s and early 1990s. Table 2.7 presents various ratios of the reporting NBFC-Ds in order to evaluate profitability. The first is the total income/asset ratio. The total income includes both fund income and fees. This ratio declined consistently over the years—from 18.9 per cent in FY 1998–99 to 12.2 per cent in FY 2005–06 and to 12 per cent in FY 2006–07, although increased to 14.6 per cent in FY 2007–08. One reason behind the declining ratio might be that there was growing regulatory control 42

(%)

18.9 6.1 3.0 0.3

16.9 6.5 4.0 0.3

14.9 4.9 3.1 –0.9

13.5 4.3 3.1 –0.5

13.5 5.2 4.6 0.9

13.2 5.8 4.6 1.6

13.1 5.9 4.3 1.7

12.2 5.7 2.5 1.5

12.0 5.8 2.6 1.2

14.6 6.7 3.1 2.9

1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Operational Ratios of NBFC-Ds

Source: RBI, Report on Trend and Progress of Banking in India. Mumbai, Annual, various issues.

Total income/asset Financial expenditure/asset Operating expenses/asset Net profit/asset

Ratios/FYs

Table 2.7

India’s Financial Sector

on excessive interest rates charged by these companies. But it was the growing income in FY 2007–08 that raised this ratio to 14.6 per cent. On the other hand, the financial expenditure in relation to assets moved in the neighbourhood of 6 per cent in majority of the financial years. It shows that the NBFCs have been able to arrest the financial expenditure. In fact, the lowering of the ceiling interest rate on deposits has contributed largely to this state of affairs. Again, as far as the operating expenses are concerned, it could not be managed properly till FY 2003–04 as the operating expenses/asset ratio moved up from 3 per cent in FY 1998–99 to 4.6 per cent in FY 2003–04, except for a marginal drop in a couple of years thereafter. In FY 2007–08, it was higher at 3.1 per cent. So there is something to be done. All these movements have an impact on the overall profitability. Barring two financial years—2000–01 and 2001–02—when net loss was witnessed, the net profit/asset ratio of the reporting NBFC-Ds improved from 0.3 per cent in FY 1998–99 to 1.7 per cent in FY 2004–05 but again dropped to 1.5 and 1.2 per cent, respectively, in FYs 2005–06 and 2006–07. In FY 2007–08, it improved significantly to 2.9 per cent. This is also a good trend.

Financial Stability and Financial Inclusion The tightening of the regulatory measures as explained in the preceding section has certainly added to the financial stability. Detailed explanation of these measures will be a repetition. Nevertheless, it can be stressed that the deposit-accepting companies get a greater focus of stringent measures in order that the interest of the depositors is protected. Moreover, narrowing the gap between the activities of the banking sector and the NBFCs would also be a step towards encouraging financial stability. However, as far as financial inclusion is concerned, it has yet to make a beginning in a more concrete way.

SUMMING UP The focus of reforming NBFCs falls greatly on regulating them to ensure financial viability as well as to protect customers’ interest. A variety of guidelines have been issued to this end and a number of 44

Non-banking Financial Companies

measures have been taken up. But still the companies registered with the RBI represent only a microscopic minority. A large number of NBFCs are still to come under the regulatory umbrella of the RBI. The improvement has been marked in terms of capital adequacy. The interest payment burden has reduced significantly. But the profitability ratios are still confined to lower limits as the NBFCs have not been able to axe drastically the operational expenses. Moreover, these companies have not been able to attract large deposits in relation to the total deposits moving to the banking sector. A sense of confidence needs to be generated among the depositors to bring the NBFCs on par with the banking companies. Last but not least, the element of financial inclusion should be a part of the NBFCs regulations in future.

45

3

Mutual Funds

Mutual funds are the other major financial intermediary collecting funds mainly from small investors and investing them in financial market securities. Till 1986, the entire mutual funds activities were vested in the Unit Trust of India (UTI). In 1987, a few public sector banks, Life Insurance Corporation of India and General Insurance Corporation, entered the mutual funds business. Again, it was in 1993 that private sector companies were allowed to operate in this area. Thus, in view of growing mutual funds activities, regulation became imperative and it was Securities and Exchange Board of India (SEBI) that began regulating them. It is not simply the regulation, several policy measures were taken to reform the functioning of this particular intermediary. The present chapter highlights them and analyses their impact. However, in the beginning, the features of the basic schemes along with the pre-1993 scenario will be mentioned in brief in order to form a background for the main discussion.

FEATURES OF MUTUAL FUNDS AND THEIR SCHEMES Mutual funds launch miscellany of schemes under which they sell units to the investors, thereby collect funds and invest those funds in capital and money market securities. The schemes are varied in features. While some schemes are open ended, the others are close ended. Again, while some schemes are income schemes, the others are growth schemes. In the past years, various combinations of these schemes

Mutual Funds

have been launched in order to serve the multiplicity of interest of the investors. The open-ended schemes have perpetual existence. They come to an end only when the number of outstanding units fall below onehalf of the originally issued units. During the life of the scheme, the repurchase and the sale prices based on the net asset value (NAV) are announced and, accordingly, the transactions take place. The sale price is normally kept above the NAV. The repurchase price is fixed below the NAV. The difference from the NAV is known, respectively, as entry load and exit load. On the contrary, the close-ended schemes exist for a specified period, say, normally for 2–5 years, after which the investment is liquidated and distributed among the unit holders. However, the experiences show that normally the money is not returned to the investors. They are given options to switch over to some other schemes. The income schemes assure regular returns to investors, and so the mobilised resources are invested in fixed-income securities, namely, bonds and debentures and fixed deposits. On the other hand, the growth schemes try to confer on the investors the benefit of capital appreciation; to this end, the mobilised resources are invested in equity shares. In case of money market mutual funds (MMMFs) scheme, the funds are invested in short-term avenues, such as treasury bills (T-bills) and certificates of deposit (CD). In mutual fund market, schemes with varieties of combinations have been launched. It would be relevant to mention a few of them. Some growth schemes provide also income tax benefit to investors. Some schemes are sector specific focussing on a particular sector. Some schemes maintain a balance between growth and regular income. In index schemes, corpus is allocated in proportion to the stock exchange market index. Sometimes the scheme is designed to invest the mobilised resources in other mutual funds. Based on the variety of schemes, the mutual funds have tended to specialise in particular types of activities. For example, the equity funds invest a lion’s share of their funds in equity shares. Some of the equity funds focus on capital appreciation and so they invest in the equity shares of those companies that stress on retention of earnings and not on dividend payment. On the contrary, the other equity funds invest preferably in the equity shares of those companies that prefer 47

India’s Financial Sector

regular and stable dividend payment. The sector funds invest in the securities of a particular sector. Their return is subject to the performance of that sector/industry. Global funds make investment in large proportions in international financial market. They do reap the advantage of diversification insofar as the systematic risk varies among countries. But at the same time, their investment carries greater risk on account of exchange rate changes and changes in political and economic environment. MMMFs invest in money market securities. Income funds invest in fixed-income securities in order to assure the investors regular and stable return. Gilt fund prefer government securities. Index funds try to replicate the performance of a particular stock market index which determines the return to the investors. Funds of fund make investment in the units of other mutual funds. The objective is to generate steady and consistent return with minimal exposure to risk. Of late, the gold exchange traded fund has come into being to offer investors a means of participating in the gold bullion market.

THE PRE-1993 SCENARIO The mutual funds activities in India started with the UTI that was established in 1963 and that commenced operation in July 1964. During the first decade of its existence, it launched five open-ended schemes. Again, between 1976 and 1986, it launched one close-ended scheme, three more open-ended schemes and one close-ended equityoriented scheme. During the early 1990s, a few more schemes were launched. In 1987, UTI’s monopoly came to an end. Between 1987 and 1991, as many as seven mutual funds were set up by some nationalised banks and the insurance corporations. They were, for example, SBI Mutual Fund (SBIMF), Canara Bank Mutual Fund, Life Insurance Corporation Mutual Fund (LICMF), Indian Bank Mutual Fund, Bank of India Mutual Fund, Punjab National Bank Mutual Fund and General Insurance Corporation Mutual Fund. During FY 1992–93, there were in all 59 schemes, out of which 18 were growth schemes, 14 were income schemes, nine were income-cum-growth schemes and the rest 18 were tax-saving schemes (Jayadev 1998).

48

Mutual Funds

It is true that UTI took some effort to mobilise resources, but the lack of competition had entailed on its efficiency. It is only with the establishment of mutual funds business by some of the major financial public sector units that the UTI too fared well. Compared to Rs. 17.676 billion during FY 1987–88, UTI mobilised Rs. 110.570 billion during FY 1992–93. In case of other mutual funds, the growth in resource mobilisation was recorded from Rs. 2.503 billion to Rs. 19.608 billion during the same period. Thus, the total resources mobilised by the mutual funds jumped up around six-and-a-half-fold during FYs 1987–93 (RBI 1994). But in view of the reform process initiated in the financial sector, it was essential to initiate measures of reform for the mutual funds too so that they could revamp their role in the financial intermediation in the country. The statistics relating to the investment of the mobilised resources reveal that in FY 1992–93, a very large segment of such resources was invested in equity shares. The figure for the UTI and other public sector mutual funds was, respectively, 59 and 53 per cent. It was still higher, respectively, at 91 and 76 per cent in case of growth schemes. On the other hand, the figures for the investment in fixed-income securities were, respectively, 28 and 36 per cent. The fixed-income securities attracted more of the income scheme funds (Jayadev 1998). In other words, the risk factor did not attract the desired amount of attention. The lack of a balanced approach to risk return concept was never beneficial for a large number of investors in the mutual funds scheme. If the competition generated by the public sector mutual funds had led to growth in resource mobilisation, it was the need of the day to help generate still greater amount of competition through allowing private sector companies for mutual fund business. Again, the mutual funds were not making vital disclosures about their portfolio turnover which was not desirable from the viewpoint of investors. Last but not least, the mutual fund companies had never attached importance to the calculation and disclosure of the NAV which is very relevant for judging the performance of the scheme and also for determining the repurchase price. In the absence of NAV, the investors’ decision to repurchase was never facilitated. All this needed ample doses of reform.

49

India’s Financial Sector

THE MEASURES OF REFORM The reform measures were initiated in 1993 with a triadic objective of protecting the investor so as to generate their confidence necessary for mobilising resources, generating competition so as to improve efficiency and promoting innovations that is also a prerequisite for an orderly growth of the mutual fund business.

SEBI (Mutual Funds) Regulations 1993 Let us first refer to the SEBI regulations that aim not only at protecting investors but also at a systematic development of the mutual funds. The SEBI (Mutual Funds) Regulations 1993 was announced in January 1993. It covered all mutual funds from the very beginning but UTI came under SEBI regulations in July 1994. The provisions of the regulation dealt, first of all, with the organisational structure. As per the regulations, a mutual fund is constituted as a trust subsequently registered with the SEBI. It has a sponsor, trustees, an asset management company (AMC) and a custodian. Trustees of the mutual fund hold its property for the benefit of the unit holders. AMC manages the affairs of the mutual fund and operates the schemes. The custodian holds the securities of the various schemes of the fund in its custody. The existing mutual funds in 1993 had to restructure themselves on similar lines. It was mandatory for the AMC to have a minimum net worth of Rs. 50 million, 40 per cent of which was to be contributed by the sponsor. One-half of the governing body members of the trust and one-half of the directors of the AMC were to be represented by the outsiders so as to check the insiders’ influence. Second, the documents of the schemes to be offered were to be approved by the SEBI. The floor amount was prescribed for closeended schemes and open-ended schemes, respectively, at Rs. 200 million and Rs. 500 million. The entire subscription amount was to be refunded within six months of the closure of the scheme in case the amount collected fell short of the prescribed amount. Third, as regards the investment policy, the ceiling for investment of the mobilised resources in the equity share of a company was set at 5 per cent of the corpus or 5 per cent of a company’s paid-up capital carrying voting rights. Similarly, investment in debt securities by way 50

Mutual Funds

of private placement was not to exceed 10 per cent of the total assets of the scheme in case of growth schemes and 40 per cent in case of income schemes. The concept of lock-in period was introduced in the shares acquired by promoters through preferential allotment. Investment in options products was banned and was also banned the carry forward transactions. Fourth, as far as distribution of surpluses was concerned, it was provided to distribute 90 per cent of the profits as dividend to the unit holders immediately after the announcement of the annual accounts. Fifth, the managerial remuneration was kept limited to 1.25 per cent of the weekly net assets and the initial expenses pertaining to the scheme was made confined to 6 per cent of the corpus amount. Last but not least, the regulations dealt with the disclosure of information and the SEBI’s supervision. In order to check any malpractices, the SEBI undertook regular monitoring of the mutual funds and asked them to maintain transparency and disclose the vital information. The disclosure pertained especially to trust deed detailing the duties and responsibilities of the trustees, offer document or prospectus containing the details of the scheme, the annual report and the detailed portfolio composition. SEBI approved a standard format for prospectus and specified the procedure of calculating the NAV that was to be declared by the mutual funds. It may be mentioned here that: NAV = (Market value of securities held under scheme – liabilities of the scheme)/ number of units outstanding under the scheme.

SEBI (Mutual Funds) Regulations 1996 The 1993 regulations were revised in December 1996 in order to keep them abreast of the changing scenario in the mutual funds activities. The responsibilities of the trustee increased. They had to ensure that the AMC was managing the fund in a proper way. The minimum net worth of the AMC was raised to Rs. 100 million and the minimum requirements of the corpus amount for open-ended and close-ended schemes were withdrawn. The minimum period for listing was extended to 6 months. The reissue of repurchased units in case of close-ended scheme and the conversion of close-ended scheme into an open-ended one were permitted. The mutual funds could 51

India’s Financial Sector

borrow for not more than one-fifth of the net asset of the scheme for a maximum of 6 months to meet their liquidity requirements. The weekly publication of NAV was made mandatory. The repurchase and resale prices could not move beyond ±7.0 per cent of the NAV. The ceiling for managerial expenses was raised. And finally, the investment norms were made liberal to provide greater flexibility in this respect. For example, mutual funds could own up to 10 per cent of the paid-up capital in a company. Besides, the restrictions on privately placed securities and unquoted debt securities were withdrawn. In the beginning of the present decade, it was made mandatory for the mutual funds to invest in dematerialised securities.

Further Regulatory Measures In FY 2000–01, SEBI issued a code of conduct for advertisement banning mutual funds from making assurance or claims based on past performance that might mislead the investors. They were asked to disclose the non-performing assets (NPAs) and illiquid portfolio every 6 months. The area of disclosure norms was extended to large unit holding in the scheme being over a quarter of the NAV and also to securities transactions by the employees of the AMCs and trustee companies so as to check any abuse of power. The mutual funds were asked to disclose also the benchmark indices in case of equity-oriented schemes in order to enable the investor to compare the performance of a scheme with the given benchmark. In FY 2001–02, SEBI asked the AMCs to maintain records of each decision of investment in equity and debt securities and made it mandatory to launch the scheme within 6 months of its approval. It issued guidelines for the valuation of unlisted equity shares in order to bring uniformity in the calculation of NAV of various mutual fund schemes. During FY 2002–03, a uniform method was evolved to calculate the sale and repurchase price of the units. The SEBI (Mutual Funds) Regulations were amended requiring that the trustees should meet at least six times a year and also to include the modalities for payment to, and recovery from, investors in case of discrepancy in calculation of NAV due to non-recording of transactions. A risk management system was evolved to be followed on a mandatory basis in the area 52

Mutual Funds

of fund management, operations, disaster recovery and business continuity, and so on, that was primarily based on existing industry practices. Again, the SEBI (Mutual Funds) Regulations, 1996, was amended in FY 2007–08 to disallow a trustee of mutual fund to act as a trustee of any other mutual fund. The provision of charging initial issue expertise and amortisation of the same was scrapped. Previously, mutual funds were allowed to amortise up to 6 per cent of the resources mobilised in close-ended new fund offering. A proper methodology was announced for the valuation of gold for the purpose of gold exchange traded funds. Necessary guidelines were issued to restrict parking of funds up to 15 per cent of the mutual funds net assets in short-term deposits with commercial banks as a whole. This percentage was to be 10 in case of deposits with a particular bank.

Widening the Area of Mutual Funds Business In the very beginning of 1993, as mentioned earlier, private companies were allowed to perform mutual funds business. A number of private sector companies got registered as mutual funds. By December 1994, the number of registered mutual funds, other than UTI, was 21. The private mutual fund companies raised Rs. 21.47 billion through 16 schemes. The foreign AMCs too entered the mutual fund business through setting up domestic AMCs under joint venture arrangement. In 1995, the RBI permitted private sector institutions to set up MMMFs. They can invest, as mentioned earlier, in treasury bills, call and notice money market (CNMM), commercial paper, commercial bills accepted/co-accepted by banks, CDs and dated government securities having unexpired maturity up to one year. By December 1996, the number of mutual funds excluding UTI rose to 31, out of which 10 were in public sector and 21 were the private sector companies. In the public sector too, one mutual fund represented collaboration with a foreign company. In October 2002, the UTI Act was repealed and UTI was bifurcated in two separate entities. While UTI-I catered to US 64 Scheme and then existing other fixed-income schemes, UTI-II known as UTI Mutual Funds dealt with NAV-based schemes. In all, the competition grew in this business. Reforms in this area made the mutual funds business more attractive with the result that 53

India’s Financial Sector

there was a distinct growth in the number of mutual funds, more especially in the private sector. The number of mutual funds rose to 40 by the end of March 2008 (SEBI Bulletin, April 2008).

Liberalisation of Investment Policy During FY 1998–99, the mutual funds were permitted to invest abroad initially within an overall limit of US$500 million. A Dedicated Gilt Fund was set up to invest in government securities through which small investors accessed the government securities market. In FY 2000–01, mutual funds were permitted to invest in mortgage-backed securities of investment grade. The investment policy was further liberalised to allow open-ended schemes to invest up to 5 per cent of NAV in equity shares/equity-related instruments of the unlisted companies. Investment in such equities was kept unchanged at 10 per cent for close-ended schemes. In case of investment in listed companies, the ceiling was raised from 5 to 10 per cent of NAV in respect of open-ended schemes. For overseas investment, the US$10 million floor was removed. SEBI was to apportion the overall ceiling of US$500 mil-lion among different mutual funds. The ceiling for UTI was kept at US$50 million. In FY 2001–02, SEBI allowed the mutual funds to invest in listed/ unlisted securities/units of venture capital funds within specified ceiling. It clarified that the managerial fee of 5 per cent could be charged to the schemes as an item of general expenditure without imposing additional burden on the unit holders. In the following financial year, the investment limit on foreign securities was raised from 4 to 10 per cent of total assets of each mutual fund but between the existing floor of US$5 million and the ceiling of US$50 million. The mutual funds were allowed to invest in the equity of overseas companies having a share holding of at least 10 per cent of an Indian company listed on the Indian stock exchange. The overall ceiling for all the mutual funds taken together to invest in ADRs/GDRs of an Indian company and foreign equity and debt securities was raised to US$1 billion, subject to individual ceiling of 10 per cent of the assets/US$50 million. In FY 2007–08, the collective limit was further raised to US$5 billion along with a limit of US$300 million per mutual fund.

54

Mutual Funds

In FY 2003–04, the mutual funds were allowed to participate in derivatives market equity-oriented schemes for portfolio balancing. Each mutual fund could have a maximum of net derivatives position of 50 per cent of the portfolio. In January 2006, SEBI amended the Mutual Funds Regulations to permit the mutual funds to introduce Gold Exchange Traded Fund (ETF) Scheme.

Some Other Incentives The 1999–2000 Budget lowered the tax rate on income earned from mutual funds. The RBI permitted the MMMFs to offer cheque writing facility by allowing the unit holders to issue cheques against a savings account maintained with a designated bank. It permitted the mutual funds also to undertake forward rate agreements and interest rate swaps with a bank/primary dealer/financial institution to hedge their balance sheet risk, although marking to market was not allowed. Specific sectors were targeted for mutual funds, such as information technology, pharmaceuticals and fast-growing consumer goods sector. In FY 2005–06, the mutual funds were permitted to share the Unique Client Code of their schemes with their unit holders in order to facilitate them to claim the tax benefit associated with the payment of securities transaction tax. Beginning from 4 January 2008, the entry load fee was waived for the investors making applications directly for any scheme. A committee was appointed for developing infrastructure funds.

BROAD IMPACT OF THE REFORM MEASURES Various forms of regulation combined with organisational restructuring, liberalised investment policy and other incentives accorded to the mutual funds in India beginning from 1993 led to far greater mobilisation of resources and financial strength of the mutual funds, as well as to greater investment of funds in the money and capital markets. Positive trends were apparent also during the1990s, but we analyse these trends during the present decade in view of the fact that there is always a lag between the implementation of the measures and the accrual of the results.

55

India’s Financial Sector

Trend in Resource Mobilisation Let us first discuss about the mobilisation of resources by mutual funds. Table 3.1 shows that there was consistently great stride forward in the amount of funds mobilised from the investors through different schemes. The amount soared up from Rs. 929.57 billion in FY 2000–01 to Rs. 44,643.76 billion during FY 2007–08. Still greater difference is evident if one compares these figures with Rs. 114 billion mobilised during FY 1993–94. However, there is one question as to whether the mutual funds have been able to attract large share of the total investment of the household sector relatively to other schemes. Based on the figures presented by SEBI, it is evident that in the mid2000s, the share of mutual funds is far lower than those of fixed deposit schemes of the banks, Life Insurance Corporation, EPF/PPF (SEBI 2007). Again, there were large redemptions that made the net amount available with the mutual funds much lower. The net amount varied between Rs. 22 billion and Rs. 1538.02 billion during FYs 2000–08. In other words, the net amount was barely 0.26–9.82 per cent of the gross amount of funds mobilised. Looking at the resource mobilisation from the viewpoint of various groups of mutual funds, it is evident from Table 3.2 that the opening up of the mutual funds activities for the private sector companies has proved a boon for this area of the financial sector. The private Table 3.1

Resource Mobilisation by Mutual Funds: Gross and Net

(Rs. billion)

FY 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Gross amount of funds mobilisation 929.57 1,645.23 3,147.06 5,901.90 8,397.08 10,981.49 19,384.93 44,643.76

Redemption

Net amount of funds mobilisation

Net amount as % of gross amount

838.29 1,573.48 3,105.10 5,433.81 8,375.08 10,453.70 18,445.08 43,105.75

91.28 71.75 41.96 468.08 22.00 527.79 939.85 1,538.02

9.82 4.36 1.3 7.93 0.26 4.81 4.85 3.45

Source: http://www.amfiindia.com

56

124.13 7.49 70.62 239.93 466.56 462.20 1,246.07 3,374.98 (7.6)

Gross

Source: http://www.amfiindia.com

2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

FY

UTI

3.22 –72.84 –94.34 25.97 –27.22 34.24 42.26 98.20 (6.4)

Net

Table 3.2

61.92 136.13 286.25 315.48 565.89 1,372.26 2,140.13 3,461.06 (7.8)

Gross 15.21 14.84 18.95 16.67 –26.77 63.79 107.20 106.77 (7.0)

Net

Public sector-sponsored funds 743.52 1,462.67 2,789.86 5,346.49 7,364.63 9,147.03 15,999.72 33,807.53 (84.6)

Gross 92.92 129.47 121.22 425.45 76.00 429.77 791.34 1,333.04 (84.6)

Net

Private sector mutual funds

Resource Mobilisation by Different Categories of Mutual Funds

929.57 1,645.23 3,147.06 5,901.90 8,397.08 10,981.49 19,384.93 44,643.76 (100.0)

Gross

Total 111.35 71.37 45.83 468.09 22.01 527.80 940.80 1,538.02 (100.0)

Net

(Rs. billion)

India’s Financial Sector

sector companies alone have been able to mobilise a lion’s share of the resources during the entire period of the present decade. In FY 2007–08, they accounted for 84.6 per cent of gross/net mobilisation. The UTI Mutual Funds’ share was barely 6–7 per cent and the rest 7–8 per cent of the mobilised funds were shared by other public sector units. Again, the mobilisation of resources varied from one scheme to the other. Looking at the latest data for FY 2007–08 in Table 3.3, one finds that the open-ended schemes have proved a more effective tool to mobilise resources as they accounted for over 97 per cent of the gross mobilisation of funds. Again, the income/debt schemes mattered much in the gross resource mobilisation. Their share was around 97 per cent of the gross resource mobilisation. Even among these schemes, the investors attached greater importance to liquidity and so they preferred the liquid money market schemes. These schemes helped mobilise 77 per cent of the resources during FY 2007–08. The investors did not like gilt schemes and so their share was not even one-tenth of 1 per cent. However, those debt schemes, where the return was not very assured, accounted for around one-fifth of the gross resource mobilisation. Table 3.3

Scheme-wise Resource Mobilisation during FY 2007–08

(Rs. billion) Scheme A. Open-ended B. Close-ended Total A. Income/debt schemes (i) Liquid money market (ii) Gilt (iii) Debt B. Growth/equity schemes (i) ELSS (ii) Others C. Balanced schemes D. Exchange traded fund schemes Gold ETF Other ETF Total

Gross amount

Redemption

Net amount

43,370.42 1,273.35 44,643.77 43,172.63 34,327.37 31.80 8,813.46 1,262.86 64.48 1,198.39 114.88 99.39

42,035.88 1,069.87 43,105.75 42,133.96 34,177.61 27.46 7,928.89 793.53 2.97 790.56 57.20 121.06

1,334.54 203.48 1,538.02 1,038.67 149.76 4.34 884.57 469.33 61.51 407.82 57.68 –30.43

4.33 89.06 44,643.76

1.56 119.50 43,105.75

2.76 –30.43 1,538.02

Source: SEBI Bulletin, June 2008.

58

Mutual Funds

Yet again, the investors showed interest for growth/equity schemes but they were not as keen for buying them as they were in case of income/debt securities. The growth/equity schemes accounted for around 3 per cent of the gross resource mobilisation during FY 2007–08. The equity-linked saving schemes (ELSS) in this group were not favoured by the investors. Nor were favoured the balanced schemes or the exchange traded fund schemes. It may be noted that the net resource mobilisation indicates similar preference of the investors. The income/debt schemes were responsible for over two-thirds of the net resource mobilisation. A lion’s share of the rest was represented by growth/equity schemes. The balanced schemes never figured large.

Growth in Net Assets under Management After analysing the resource mobilisation aspect of the mutual funds, let us move to their investment behaviour. When there is a growth in their resource mobilisation activities, there will be apparently an uptrend in their investment activities or in the net assets under management. The growth in the amount of assets under management is an indicator of their financial strength. Table 3.4 presents the net asset position at the end of the financial year beginning from FY 2000–01 to FY 2007–08 in totality and also in different groups of mutual funds. The figures reveal fast growth in assets under management from Rs. 905.87 billion at the end of March 2001 to Rs. 5,051.52 billion at the end of March 2008 or over 16 per cent of the GDP. If one compares these figures with Rs. 470 billion or those at the end of March 1993, it is really a great stride. Except for FY 2002–03 when there was a drop in the amount of assets, the yearly change varied between 7.16 per cent and as big as 75.60 per cent. Who is responsible for such a big jump forward in the assets? It is primarily the private sector mutual funds that shared more than four-fifths of the total assets under management at the end of FY 2007–08. Thus, the policy of the Indian government to attract the private sector companies in the mutual fund business was definitely a correct step. Even among the private sector mutual funds, it was primarily those mutual funds that were set up as joint ventures but having Indian domination that accounted for over two-fifths of the 59

India’s Financial Sector Table 3.4

Growth in Net Assets under Management of Mutual Funds

(Rs. billion) At the end of FY

UTI

2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

580.17 514.34 135.16 206.17 207.40 295.19 354.88 —

Other public sector Private sector 68.40 82.04 104.26 119.12 113.74 208.29 287.25 895.31

257.30 409.56 555.22 1,070.87 1,174.87 1,815.15 2,671.75 4,156.21

Total

% change over previous year

905.87 1,005.94 794.64 1,396.16 1,496.01 2,318.62 3,263.88 5,051.52a

— 11.4 –21.01 75.60 7.16 54.99 40.77 54.76

Source: http://www.amfiindia.com Note: aFigures do not include UTI.

total assets under management among the private sector companies at the end of FY 2007–08. The rest three-fifths were almost equally shared by purely Indian companies and those joint venture companies where foreign companies are dominant (amfiindia.com). Again, the composition of the assets reveals some interesting features. Table 3.5 presents the composition of assets under management under various segments during the present decade. The figures reveal that up to FY 2002–03, debt securities dominated the scene. Their share was as high as three-fifths of the total asset under management. But then their share began squeezing, reaching in turn around a quarter in FY 2005–06, although in the following financial years, there was some appreciation. At the end of March 2008, it was again 43.7 per cent. The share of equity shares remained less than a quarter till FY 2004–05, but in the following financial year, it was as high as 40.1 per cent. However, by the end of March 2008, it slumped to 31 per cent. Money market instruments were never a cherished destination for the mutual funds during the early years of the present decade. But since FY 2003–04, they have improved their share hovering around a quarter of the total asset under management, although it was only 17.7 per cent at the end of March 2008. As far as the government securities are concerned, they were never significant. Their share remained confined to a meagre of 5 per cent or lower.

60

Mutual Funds Table 3.5

Various Segments of Net Assets under Management

(Rs. billion) Assets under management At the end of FY 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Debt 488.63 (53.9) 557.88 (55.5) 475.64 (59.9) 625.24 (44.8) 476.05 (31.8) 602.78 (26.0) 1,193.22 (36.6) 2,207.62 (43.7)

Equity 134.83 (14.9) 138.52 (13.8) 98.87 (12.4) 236.13 (16.9) 367.57 (24.6) 928.67 (40.1) 1,133.86 (34.7) 1,567.22 (31.0)

Money market Government instruments securities 41.28 (4.6) 80.69 (8.0) 137.34 (17.3) 417.04 (29.9) 540.68 (36.1) 615.00 (26.5) 720.06 (22.1) 894.02 (17.7)

23.17 (2.6) 41.63 (4.1) 39.10 (4.9) 60.26 (4.3) 45.76 (3.1) 31.35 (1.3) 22.57 (0.7) 28.33 (0.6)

Others

Total

217.96 (24.1) 187.22 (18.6) 43.69 (5.5) 57.49 (4.1) 65.94 (4.4) 140.82 (6.1) 193.17 (5.9) 354.33 (7.0)

905.87 (100.0) 1,005.94 (100.0) 794.64 (100.0) 1,396.16 (100.0) 1,496.00 (100.0) 2,318.62 (100.0) 3,262.88 (100.0) 5,051.52 (100.0)

Source: http://www.amfiindia.com

Performance Evaluation from the Viewpoint of Return Statistics relating to rate of return are not available on the basis of a group of mutual fund companies or such companies as a whole. Yet, a few studies have attempted to evaluate the performance on the basis of the rate of return. We like to refer to these studies. First of all, Panwar and Madhumathi (2006) find out the rate of return of selected mutual fund companies during a period of three years beginning from May 2002. They are of the view that the domestic private sector companies were more efficient than the public sector-sponsored companies and the foreign companies inasmuch as the average return in their case was 0.28 per cent compared to 0.07 per cent in case of the public sector-sponsored companies and 0.05 per cent in case of foreign companies. However, the mean return was not significantly different among these three groups. Similarly, Rao (2006) studies the return scenario in the growth plans vis-à-vis the dividend plans among 61

India’s Financial Sector

select open-ended equity mutual funds schemes during FY 2005–06. His findings indicate that 17 out of 21 growth plans generated higher return than that of the dividend plans. On the contrary, three dividend plans showed higher return. In the rest, the return was almost similar. As far as risk is concerned, 13 dividend plans and four growth plans had higher risk in terms of coefficient of variation. In the rest three cases, the coefficient of variation was almost the same. Again, based on the Sharpe ratio, 18 out of 21 growth plans had better risk-adjusted excess return. Again, Sapar and Madava (2006) tried to compute the relative performance index of select open-ended schemes during September 1998 to April 2002. They studied in detail only 58 cases where the return was higher than the risk-free return. Their findings showed that the return in terms of the monthly logarithm was 0.59 per cent, whereas the risk was 7.10 per cent. Most of the schemes gave excess returns than the expected return based on the premium for systematic risk and total risk. When one compares the rate of return of the mutual fund schemes with the return on assets of the commercial banks as a whole as mentioned in Chapter 1, large disparity is not found insofar as in both the cases, it is less than 1 per cent. However, the banks have fared slightly better.

Do Mutual Funds Influence the Stock Market Index? The Indian secondary market has two significant players—one being the foreign institutional investors and the other being the mutual funds. As it is evident from Table 3.6, the mutual funds have transacted both in debt securities and in equity shares. In both the cases, the magnitude of transactions has consistently moved up. In equities, transactions—purchases plus sales—moved up from Rs. 315.19 billion in FY 2000–01 to Rs. 4,188.52 billion in FY 2007–08. The total transactions—purchase plus sales—in debt securities rose from Rs. 220.01 billion in FY 2000–01 to Rs. 5,234.21 billion in FY 2007–08. In other words, the participation of the mutual funds in the secondary market has experienced an ascending trend which is definitely conducive for this market. Again, the figures in Table 3.6 reveal that except for FY 2000–01 which was an abnormal year, the share of the mutual funds in total 62

113.76 120.98 145.21 366.64 450.45 1,003.89 1,359.48 2,175.78

Gross purchase

201.43 158.94 165.88 353.56 445.97 860.81 1,268.86 2,012.74

Gross sale

Source: SEBI Bulletin, various issues.

2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

FY

Equity

Table 3.6

–27.07 –37.96 –20.67 13.08 4.48 143.08 90.62 163.06

Net investment 135.12 335.57 466.64 631.70 621.86 1,095.51 1,537.33 2,986.05

Gross purchase 84.89 225.94 340.59 404.69 451.99 730.66 1,011.90 2,248.16

Gross sale

Debt

50.23 109.63 126.04 227.01 169.87 364.86 525.43 737.90

Net investment

Mutual Funds’ Investment in Secondary Capital Market in 2000s

(Rs. billion)

61.30 3.41 3.34 4.49 5.40 7.81 9.05 8.16

% share of mutual funds in BSE and NSE equity turnover (cash segment)

India’s Financial Sector

equity turnover at the cash segment of Bombay Stock Exchange and National Stock Exchange went on increasing consistently from 3.41 to 9.05 per cent between FYs 2001–02 and 2006–07, although it slipped slightly in FY 2007–08. This percentage is too low to influence sizeably the stock market index. Moreover, to be firm on this issue, we have computed the correlation coefficient between the monthly figures of the net investment of mutual funds in equity shares at the Bombay Stock Exchange (BSE) and the monthly average (closing) of BSE Sensex during FY 2006–07. The correlation coefficient is (–) 0.3726 which shows that there is no influence of mutual funds on the stock market index. However, one cannot negate the possibility of mutual funds influencing the stock market index in a particular sector where their participation is concentrated.

SUMMING UP Reforms in the mutual fund business have been multi-pronged. Healthy regulations designing the organisational structure, resource mobilisation, investment, valuation and disclosure norms and focussing on SEBI’s supervision have been significant. The inclusion of private sector companies, both Indian and foreign, in mutual fund business brought in competition and thereby helped improve efficiency. The mutual funds were given variety of incentives and the area of their operation was widened. All this had a positive impact on their functioning. The magnitude of resource mobilisation soared up fast. However, this was accounted for primarily by the private sector companies. Again, the open-ended schemes proved more attractive to the investors than the close-ended schemes. Similarly, the investors showed preference for income/debt schemes and not so much for growth/equity schemes. The positive impact of reform was evident in fast-growing net assets under management. In this case too, the private sector companies fared far well. Investment in debt and equity formed the largest share, although investment in money market instrument has improved in the recent years. The government securities lagged far behind on this issue. Again, the element of financial stability needs to be encouraged in this area of financial intermediation, despite the fact that the regulations framed from time to time have taken care of this fact. 64

Mutual Funds

Last but not least, the concept of financial inclusion too needs to be implemented. Recently, waiving of the entry load fee for the small investors in January 2008 has proved to be the pioneering step in this respect. But something more should be done.

65

India’s Financial Sector

66

Part II

Financial Markets and Instruments

India’s Financial Sector

68

4

The Primary Market for Securities

As mentioned earlier, the primary market and the secondary market both are the market for securities. While the former is concerned with raising of funds through the issue of new securities, the latter helps generate liquidity and price level for securities. However, both of them are complementary to each other. The primary market is discussed in the present chapter followed by the discussion of the secondary market in the next chapter. The Indian companies are now making use of the international primary capital market for the raising of funds but this aspect will be discussed in the subsequent part of the book dealing with the internationalisation of capital market.

FEATURES OF PRIMARY MARKET In the primary market, the government issues treasury bills and dated securities to mop-up funds. The companies raise funds selling new shares and debt securities. When the firms go public for the first time, the primary market is known as the initial public offering (IPO) market. The subsequent offerings, on the other hand, form the part of the primary market, known as the subsequent equity offering (SEO) market. The offerings are made either through prospectus or through private placement. In case of the issue of securities through prospectus, the general public, at least 50 in number, subscribe to them directly. There are the merchant bankers who publicise the offerings and manage the issue. On the contrary, in case of private placement, the shareissuing company sells the shares to a group of select institutional

India’s Financial Sector

investors without any prospectus. Thus, mobilisation of funds through private placement is less expensive and, at the same time, very quick. Again, rights issues are also offered but they are limited to the existing shareholders. The shareholders subscribe to the new issue, as their pre-emptive right, on a pro rata basis. It is possible that the existing shareholders do not subscribe to the share or, in other words, they may not exercise their right. In the pre-reform period, the primary capital market was highly regulated under the provisions of the Capital Issues (Control) Act, 1947. The companies had to obtain prior approval from the Controller of Capital Issues (CCI) for the issue of new securities and thereby for raising of funds. The decision regarding the quantum of the issue and sale and the pricing of the issue was the domain of CCI. In majority of the cases, the shares were issued at par. The issue of shares at premium was rare. The size of the premium depended on a prescribed formula set by the CCI. Consequently, the primary capital market lacked the desired flexibility. The magnitude of the funds raised remained confined to lower limits. To be precise, it was Rs. 142.190 billion during FY 1991–92: Rs. 43.120 billion through prospectus and Rs. 99.070 billion through private placement, of which Rs. 56.630 billion represented placement of the bonds of the public sector units (RBI 1993a).

THE MEASURES OF REFORM The purpose of the reform in this area of the financial market has been to make the primary capital market vibrant that is possible not through rigid control but through leaving the activities to the free play of market forces, of course, within a regulatory framework so that the interest of the investors is duly protected. To this end, a host of measures were taken up. First of all, the Capital Issues (Control) Act was abolished in 1992 to avoid rigidity in the system. But since some sort of regulation was required to make a systematic development of the market and to protect the interest of the investors, the government empowered the Securities and Exchange Board of India (SEBI) to regulate the primary capital market. The regulation embraced many aspects, important among them being transparent disclosure norms and axing of the transaction cost and the procedural hurdles. Second, pricing of the securities was an important aspect. This process needed 70

The Primary Market for Securities

the induction of market forces so as to make it flexible and so a new process was started which is known as book-building process. Third, the infrastructure was diversified that included the setting up of merchant bankers, investment and consulting agencies, and so on. Last but not least, the companies were allowed to raise funds in the international financial market under the global depository receipt (GDR)/ American depository receipt (ADR) mechanism. These issues, except for raising funds in international financial market, will be discussed at some length here in this chapter.

SEBI’s Regulation After getting empowerment to regulate the primary market, SEBI took measures to ensure orderly development of the market as well as to protect the interest of the investors. With a view to fulfilling these two objectives, it tried to ease the issue procedures but, at the same time, asked the companies to disclose all material facts prior to the issue. Some more important of the initial steps taken during FY 1993–94 were: 1. to prescribe a minimum percentage of shares to be issued to the public; 2. to prescribe a code for advertisement concerning the issue; 3. to revise the allotment procedures in favour of pro rata allotment and 4. to raise the minimum application money. It became mandatory for the entire allotment process to be supervised by a SEBI official. Moreover, the public sector bonds were brought under the purview of the SEBI (SEBI 1994). In the following financial year, SEBI implemented the major recommendations of the Malegam Committee which included inter alia the issue of shares by the financial companies only after two years of successful operation and made underwriting mandatory to the extent of net offer to the public. The prospectus submitted for vetting was to include the cost of the project, profit and loss statement, the expansion plan, if any, shares to be purchased by the promoter group and the management perception of the risk factors (SEBI 1995). 71

India’s Financial Sector

In FY 1997–98, SEBI released further the norms relating to the issue of securities. According to them, the companies were to make their partly paid shares as fully paid-up or to forfeit those partly paid shares prior to the new issue. The unlisted companies were free to price the shares provided they had earned profit during past 3 years and had made adequate disclosures. The promoters’ contribution to the public issue was set at 20 per cent. Subsequently, in the following years, it was made mandatory to make the public issue through the depositories. The minimum number of collection centres was specified, especially, for the issues amounting to Rs. 100 million or above. The companies were free to change the par value of dematerialised shares. In order to enhance the quality of issues, SEBI tightened the entry norms for IPOs. It allowed only those IPOs whose issue size was five times the pre-issue net worth. The lock-in provisions were rationalised as 3 years for promoter’s contribution of 20 per cent and 1 year for the others. The procedures for allotment of shares and refunds were also streamlined. The time for finalising of allotment was reduced from 30 to 15 days in case of book-built issues so as to lessen the risk arising out of volatility (SEBI 1998). The Indian Companies Act was amended in 2000 as per which SEBI was given even more powers concerning the regulation of the primary market. Dematerialisation was made compulsory for listed companies making IPOs. The interest of the small investors making investment in company securities not exceeding Rs. 20,000 in a financial year was especially protected. In FY 2001–02, the infrastructure companies were provided freedom to issue debt security even without listing equity. The SEBI disclosure norms were amended to permit foreign venture capital investors registered with SEBI to participate in the public issues through book-building route. In FY 2006–07, SEBI took a few measures to make the primary market more viable. First of all, restrictions were imposed on pre-issue publicity to ensure that it should be consistent with the past practices and should not contain projections or any information extraneous to the offer document filed with the SEBI. Second, the companies have to mention on the very cover page of the offer document whether they have opted for an IPO grading from rating agencies and then the grading. Third, the listed companies can raise funds through the Qualified 72

The Primary Market for Securities

Institutional Placement (QIP) route to make the issue cost-effective. Fourth, SEBI has provided a more transparent mechanism to graduate to continuous listing requirements for the companies. As a condition for continuous listing, listed companies, except belonging to a specific category, have to maintain a minimum level of public shareholding at 25 per cent of the total shares issued. Finally, it was made mandatory that foreign companies desirous of issuing Indian depository receipts in India must have been listed in their home country, must have a good track record of performance and must not have been barred in their home country for doing so (SEBI 2007). During FY 2007–08, SEBI permitted fast-track issues for the wellestablished listed companies, allowed all categories of companies to apply for an IPO of Indian depository receipts, initiated mandatory grading of IPOs, relaxed minimum dilution requirements and launched an electronic platform in collaboration with the BSE and National Stock Exchange (NSE) for filing and displaying information about the listed companies. The Group on Review of Issue Process (GRIP) was appointed to suggest measures to make the initial offerings at par with the international standards and to make more efficient the price discovery process of public issues. SEBI simplified the primary debt issue process and initiated mandatory listing of private placement of debt.

The Process of Book Building When the Capital Issues (Control) Act was repealed, the companies were free to price their issues. But many of them did not use their freedom in a proper way, especially in the initial years of reform when there were no strict disclosure norms. They put huge premium without supportive fundamentals. According to one estimate, in 1995 alone, the premium component accounted for 90 per cent of the total funds raised from the primary equity market (Shahani 2005). The brunt of these manipulations was borne by the investors who remained shy towards making investment. SEBI took strict measures against such malpractices with the result that in FY 1997–98, there were only 111 companies tapping the IPO market compared to around 1,726 during FY 1995–96 (GOI 1998). In fact, the pricing of the issue should be optimal, based on fundamentals. Then only it will be comparable to the selling price at the 73

India’s Financial Sector

first listing. If it is so, confidence will be generated in the primary market which is basic to the growth of this market. Thus, in order to evolve proper pricing, a globally adopted system evolved in India during 1995 which is known as book building. In the book-building process, the price for the IPO is based on the investors’ demand. The share-issuing company appoints, first, a merchant banker which is known as the ‘book runner’. The book runner prices the shares within a specified range and invites brokers, merchant bankers, mutual fund companies, and so on, for the bid. In order to avoid any takeover bid, it imposes restrictions on the number of shares to be allotted. After these formalities are complete, the prospectus is filed with the Registrar of Companies. The shares are first allocated for private placement and then the public issue begins. This way a sense of confidence regarding share prices is infused among the general investors insofar as the shares are placed with the institutional investors at a specified price. Initially, this process was applicable to the issues amounting to Rs. 1 billion or more, and so the problem of improper pricing could not be avoided. In 1998, to make this process more effective, 100 per cent book building was made mandatory in respect of issues amounting to Rs. 250 million or more. In 1999, the book-building system was modified. The modified guidelines included the following: 1. Compulsory display of demand at the terminals was made optional. 2. The issuer was allowed to disclose the size of the issue. 3. The reservation of 15 per cent of the issue meant for individual investor was allowed to be clubbed with the fixed price offer. 4. The book-built portion was to be allotted in dematerialised form only. However, it was left to the issuer whether it chose either the original version or the modified version. Further in April 2000, 100 per cent one-stage book-building process was introduced. Moreover, it was allowed to permit allotment of 60 per cent of the issue to institutional investors comprising of development financial institutions, banks, mutual funds, foreign institutional investors and venture capital funds registered with SEBI, 15 per cent to non-institutional 74

The Primary Market for Securities

investors, such as overseas corporate bodies, trusts and the rest 25 per cent to small investors on a pro rata basis (RBI 2001). A major development in the primary market during FY 2004–05 was witnessed in the form of the introduction of screen-based book building where securities are auctioned through an anonymous screen-based system and the price at which securities are sold is discovered on the screen. It avoids delay, risk and some other problems associated with the traditional system.

Infrastructural Support The government encouraged the setting up and development of specific agencies to provide support to the functioning of the financial market in general and the primary market in particular. Here, we like to limit our discussion only to merchant banking, venture capital funds and credit-rating agencies. Merchant banking dates back to 1967 when Grindlays Bank set up its merchant banking division. The development financial institutions and some banks took up this job but it remained to be their secondary function. They were overloaded with their primary function with the result that their merchant banking activities failed to provide desired support to the primary market. With the liberal industrial policy since 1991, the services of merchant banking were very much required in order to help float new companies—beginning from the preparation, planning and execution of new projects to management of new issues of securities. To be more specific in the context of the primary market activities, merchant banks provide expert advice to companies what sort of securities should be issued, what should be the quantum of the securities, what should the par value and what should be the timing for the issue. They assist in the preparation and filing of the prospectus. They act as an underwriter of the issue and maintain close links with the underwriters if they themselves are not the underwriter. They also maintain close links with the banker, registrar and broker who are related to the issue and negotiate with the stock exchange for the listing of the securities. Last but not least, they help the companies in raising funds through private placement insofar as they know better these investors. Thus, during the 1990s and the present decade, of course 75

India’s Financial Sector

with the government’s encouragement, many merchant bankers came up giving fillip to primary market activities. Again, the venture capital funds, normally promoted by the development financial institutions and banks, perform many functions, such as meeting seed capital requirements of companies, making buyouts and meeting working capital requirements. In the context of the primary market activities, they help bring out public issues. They make a link between the issuing company and the financial institution for the purpose of private placement. It is true that the venture capital funds are not very successful in India, yet they have grown during liberal financial policy regime, especially since 1996. Yet again the credit-rating agencies make yeoman service to the primary market activities. Their services are imperative in the sense that the companies have to mention the grades provided by these agencies in their prospectus for issuing shares. Moreover, the grades help the investors in making investment decision. In all, they help generate confidence in the primary market for securities. In India, there are three major credit-rating agencies, namely, Credit Rating Information Services of India Ltd (CRISIL) set up in 1987, Investment Information and Credit Rating Agency of India Ltd (ICRA) set up in 1991 and Credit Analysis and Research on Equities (CARE) set up in 1993. Besides them, there are some international agencies that have set up their offices in India. They are, for example, Duff and Phelps Credit Rating Agency, Standard and Poor’s Rating Agency and Moody’s Investor Services. We do not mean that these agencies were set up with the sole purpose of boosting up the primary market, but it is sure that they have developed their activities during the liberal financial policy since the 1990s and have contributed to the primary market activities.

THE IMPACT OF REFORM MEASURES Size of Resource Mobilisation The process of reforming the primary market activities bore fruits. Table 4.1 presents the picture of resource mobilisation in the primary market during FYs 2000–08. It is evident that during FY 2000–01, the total resource mobilised from the domestic sources amounted to 76

Public offerings Rights issues Private placement Total (A + B + C) A as % of D B as % of D C as % of D No. of issues

112.9 5.6 379.9 498.4 22.7 1.0 76.3 624

102.6 11.1 366.3 480.0 21.5 2.3 76.3 469

2001–02 62.8 8.1 348.2 419.0 15.0 1.9 83.1 511

2002–03 208.9 7.8 309.8 526.6 39.7 1.5 58.9 580

2003–04 253.6 38.2 315.0 606.8 41.8 6.3 51.9 870

2004–05 240.3 39.1 502.2 781.5 30.7 5.0 64.3 1,211

2005–06

Resource Mobilisation from the Domestic Primary Capital Market

Sources: 1. CMIE, Capital Market. Mumbai, 2006. 2. CMIE, Monthly Review of the Indian Economy, January 2008. 3. RBI (2008a). Note: The figures relate to the resources mobilised only from the domestic market.

A. B. C. D. E. F. G. H.

2000–01

Table 4.1

292.5 26.2 842.1 1,160.8 25.2 2.3 72.5 1,797

2006–07

680.46 156.61 2,125.68 2,962.75 23.0 5.3 71.7 1,931

2007–08

(Rs. billion)

India’s Financial Sector

Rs. 498 billion compared to only Rs. 45.7 billion during FY 1997–98. The amount varied only within a limited range during the following three financial years. However, beginning from FY 2004–05, the amount began inflating and reached Rs. 781.5 billion in FY 2005–06 and far greater at Rs. 1,160.8 billion in FY 2006–07. In FY 2007–08, it was as big as Rs. 2,962.75 billion. Strong macroeconomic fundamentals, sustained growth of the manufacturing sector, active institutional support led by mutual funds, positive investment climate, sound business outlook, encouraging corporate results and buoyant secondary market induced large number of companies to raise resources from the primary market. Apart from several mega issues, large number of small and medium-sized companies mobilised resources through public and rights issues. There was overwhelming response to most of the public issues reflecting risk appetite of the investors in general and sustained investment activities in particular. Regulatory reforms such as introduction of proportionate allotment and margin requirements for the Qualified Institutional Buyers (QIBs) and special allocation to mutual funds within the QIB category also contributed to brisk activities. Again, the reclassification of the public offerings shows that the IPOs accounted for over 95 per cent of the public offerings during FY 2006–07 compared to only 47 per cent during FY 2005–06 (SEBI Bulletin 2007). This shows that in view of the buoyant performance of the economy, many new firms emerged that raised funds through IPOs. However, in FY 2007–08, this percentage fell to 47.5, although 82 of the 119 issues were IPO (RBI 2008). On the global level too, India’s rank is very high among the emerging market countries. In 2007, it ranked the fifth largest in the global IPO market in terms of the number of issues and the seventh largest in terms of the amount involved therein. Globally, there were 1,830 IPOs involving US$255 billion. India’s share stood at US$8.3 billion comprising of 95 issues. Nevertheless, the size was far smaller than in China and Russia. In China, there were 222 issues involving US$54.4 billion. In Russia, a single issue was of the amount of US$8.0 billion. In India, the largest issue made by DLF was of the order of US$2 billion (Business Line 27 December 2007). The share of the private placement was naturally the largest in view of the regulation in its favour. It ranged between 72 and 83 per cent, 78

The Primary Market for Securities

except for two financial years of 2003–05 when it was less than threefifths. On the contrary, the share of the rights issues was the lowest hovering normally between 1 and 3 per cent except for over 5–6 per cent during FYs 2004–06 and during FY 2007–08. In fact, the rights issues are not a very common phenomenon. The share of public offerings moved normally around one-fourth of the total resource mobilisation figure, except for FYs 2003–05 when it was around twofifths. The number of issues tended to move up every financial year consistently since FY 2001–02. The increase was slightly less than fivefold—from 469 in FY 2001–02 to 1,931 in FY 2007–08.

The Size of Debt and Equity The funds raised in the domestic primary market are related to both debt and equity. Table 4.2 shows that the debt securities dominated the scene. The share of debt moved between 52 and 82 per cent during FYs 2000–08, except for FY 2006–07 when it was 37.5 per cent. In fact, the issue of debt depends on the capital structure norms, a company that it likes to follow in order to lower the cost of capital and also the risk averseness of the investors. These factors too might be working behind greater proportion of the debt issue. Table 4.2 Equity and Debt Funds Raised in the Domestic Primary Market

(Rs. billion) FYs 1 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Equity

Bonds and debentures

Total

Col. 3 as % of col. 4

2

3

4

5

149.3 83.7 75.4 220.0 292.6 315.2 725.1 838.1

349.2 396.3 343.6 306.6 314.2 466.3 435.7 2,124.7

498.4 480.0 419.0 526.6 606.8 781.5 1,160.8 2,962.8

Sources: 1. CMIE, Capital Market. Mumbai, 2006. 2. CMIE, Monthly Review of the Economy. Mumbai, January 2008. 3. RBI (2008a).

79

70.1 75.6 82.1 58.2 51.7 59.6 37.5 71.7

India’s Financial Sector

Participation of Public and Private Sector Companies Again, anatomising the figures of the funds raised in the primary capital market between the public sector and the private sector, one finds that the private sector companies dominated in the case of public offerings through prospectus including rights issues, whereas the public sector units dominated normally in case of private placements. Table 4.3 shows the share of these two sectors in the total funds raised. As far as public offerings are concerned, the share of the private sector companies ranged between 61.6 and 97.5 per cent, except for less than one-half during FYs 2002–04. In absolute terms, private sector garnered from the public offerings Rs. 636.38 billion through 115 issues in FY 2007–08 against Rs. 316.00 billion through 118 issues in FY 2006–07, Rs. 211.54 billion through 131 issues in FY 2005–06 and Rs. 171.62 billion raised through 55 issues in FY 2004–05. Most of the non-government public limited companies accessed the primary market mainly due to congenial investment climate prevailing in the economy, supported by sustained buoyancy in the secondary market. Table 4.3

Share of Public and Private Sectors in Funds Raised in the Primary Market

(%) 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 Prospectus and rights issues of which: Private sector Public sector Private placement of which: Private sector Public sector

100.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

76.9

80.0

38.6

44.6

61.6

78.5

97.5

76.0

23.1

20.0

61.4

55.4

38.4

21.5

2.5

24.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

34.1

43.8

37.5

25.1

42.9

42.8

58.0

60.9

65.9

56.2

62.5

74.9

57.1

57.2

42.0

39.1

Source: Reserve Bank of India, Annual Report, various issues.

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The Primary Market for Securities

The dominance of the private sector in public offerings means low share of the public sector units. During FY 2006–07, there was a lone financial public sector unit that raised Rs. 7.82 billion compared to seven public sector issues mobilising Rs.57.86 billion during FY 2005–06 and five such issues mobilising Rs. 110.94 billion in FY 2004–05. In FY 2007–08, there were four issues in the public sector involving Rs. 200.69 billion. In case of the private placement, the share of private sector units remained moving between 25.1 and 43.8 per cent. It was only in FY 2006–07 and in the following financial year that the private sector units crossed the half-way mark.

Industry-wise Resource Mobilisation There was variation among industries mobilising resources from primary market through prospectus and rights issues. Table 4.4 presents a precise picture during FYs 2006–07 and 2007–08. During FY 2006–07, the variation among four groups, namely, banks/FIs, finance, IT and cement and construction was not very large as individually they claimed for Rs. 20.77 billion to Rs. 27.6 billion or collectively shared less than one-third of the resource mobilisation. The share of textiles was lower and that of power was still lower. On the contrary, during FY 2007–08, the variation was wide. Banks/FIs raised as large as Rs. 309.55 billion. Cement and construction and power were also significant as their shares were, respectively, Rs. 189.05 billion and Table 4.4

Industry-wise Resource Mobilisation

(Rs. billion) Industry

FY 2006–07

Banks/FIs Finance Information technology Cement and construction Textiles Power Total

FY 2007–08

21.90 27.65 20.77 27.47 10.64 0.30 335.08

Source: SEBI Annual Report: 2007–08. Note: The total is different from that in Table 4.1 in view of different source.

81

309.55 17.73 6.91 189.05 4.42 137.09 870.29

India’s Financial Sector

Rs. 137.09 billion. It means that these three groups collectively shared around three-fourths of the resource mobilisation. On the other end, textiles raised only Rs. 4.42 billion and information technology could raise barely Rs. 6.91 billion. Thus, on the whole, FY 2007–08 witnessed greater industry concentration in the mobilisation of resources in the primary market.

DISTRIBUTION OF THE EQUITY HOLDING Apart from the trend and pattern of the resource mobilisation through primary market trading, it is also very significant to know whether the allotment of shares is concentrated or it is widely dispersed over individual shareholders. It is because any concentration in the share allotment either to promoters or to other groups may come in the way of free movement of the share prices in the secondary market based on macroeconomic fundamentals. If the promoters have a greater stake, insiders’ trading will be large and it may inhibit the free functioning of the stock exchanges. In fact, this might be reason that prior to 1993, it was mandatory for the companies to issue at least 60 per cent of the shares to the public in general. However, with a move to financial sector liberalisation, this norm was changed in September 1993 allowing for a minimum public offer for 25 per cent. Again in 1999, there was further relaxation bringing down this percentage to 10 for the information technology companies, but 1 year later, this relaxation was extended to other sectors too. However, the term, ‘public’ needs a clear definition. Sufficient information on the aggregate level is not available, yet the information compiled by Rao (2002) reveals that in 37.97 per cent of a total number of 2,507 companies in the sample, the promoters’ stake varied between 50 and 74 per cent. In other 11.73 per cent of the companies, it was over 746 per cent. On the other hand, the share of general public in 1,761 out of 2,507 companies was less than 40 per cent. In 746 companies, it was less than 25 per cent. Again, Times Business (2008) lists 30 companies, in four of which the share of individuals varied between 21.70 and 25.13 per cent. In the other four, it was between 15.96 and 19.67 per cent. In nine companies, the share of individuals varied between 10.28 and 13.82 per cent. In the rest 13 companies, it was less than 10 per cent. 82

The Primary Market for Securities

The above revelations make it clear that the allotment of shares in the Indian primary market is highly concentrated among big shareholders which is not subservient to the process of financial sector reform. This is why the Ministry of Finance, Government of India, has proposed that the listed firms should offer at least 25 per cent of the shares to the general public and in this case, no discrimination should be made between the government and non-government companies (The Financial Express 2008). If this is accepted, concentration of ownership may be reduced. Small investors would participate more and more in the primary market which, in turn, may lead to price stability and also may be supportive to financial inclusion.

SUMMING UP The objective of reform in the primary market for securities is to avoid rigidities and to make its structure and functioning greatly flexible and oriented to the market forces, of course, under the supervision of the SEBI and with due regard to the protection of the interest of the investors. In this process, the provisions of the Capital Issues (Control) Act were substituted by those of the SEBI. Pricing of the securities was made subject to the market forces. Over and above, the very infrastructure of the market was developed. The result of the measures was that the amount of the resources mobilised in the domestic segment of this market moved up from a meagre of Rs. 142 billion in FY 1991–92 and below Rs. 500 billion during the early 2000s to Rs. 2963 billion during FY 2007–08. Private placement has outweighed the public offerings. And so was the case of debt securities that were normally responsible for greater mobilisation of resources. The share of the private sector companies has been large in case of public offerings, but in private placement, the public sector companies have done well. The discussion reveals that a very large part of the funds raised was accounted by the services sector and especially by the financial services sector. The share of the manufacturing was much lower. In the manufacturing sector, chemicals and machinery-related companies were significant. Last but not least, the securities were allotted mainly to big investors who can influence the market in their own way. However, the move of 83

India’s Financial Sector

the Ministry of Finance towards dispersion of ownership in favour of individual shareholders may prove conducive to price stability and financial inclusion.

84

5

The Secondary Capital Market

The trading of the listed securities at the stock exchanges, often known as the secondary capital market transactions, is nothing new for India. As far back as in 1875, the Native Share and Stock Brokers’ Association, now known as the Bombay Stock Exchange (BSE) was set up, followed by some other stock exchanges in major cities. By the end of 1990, there were 19 stock exchanges in the country with a market capitalisation of over Rs. 70.5 billion. In order to regulate this market, the Indian government had passed the Securities Contracts (Regulation) Act as back as in 1956. But the Indian stock market remained underdeveloped till the early 1990s with the result that the pricing, delivery and settlement systems were much behind the mark. The cost of transactions was high. The stock exchanges were broker owned and managed with the result that many of the deals lacked transparency. The interest of the general investors was hardly protected. The mechanism for the risk management was utterly lacking. Market closures were a recurring phenomenon. The size of turnover was only limited in view of the fact that the mutual fund activities were limited to the Unit Trust of India (UTI) and a few banks and also the foreign participants were not permitted to trade at the Indian stock exchanges. Last but not least, the equity shares dominated the stock exchange transactions. The debt securities either of the companies or of the government never received the desired focus. The government took some measures during the close of the 1980s but it was only the beginning. They did not materialise in the face of opposition from the powerful brokers’ lobby at the BSE (Patil 2006). Thus, when the financial sector reforms were initiated during the early

India’s Financial Sector

1990s, there was sizeable focus on reforming and strengthening of the secondary capital market. The present chapter highlights the measures of reform in this area of the financial sector and examines how far the measures yielded fruit.

REFORMING THE SECONDARY CAPITAL MARKET Secondary capital market reforms focus primarily on a host of aspects. The first is the empowerment of the Securities and Exchange Board of India (SEBI) to regulate the market. The purpose is to induce proper functioning and thereby to help develop the market as well as to protect the interest of the investors. The second is the generation of competition so as to improve efficiency in the market. This has been achieved through setting up of national-level stock exchanges, especially the National Stock Exchange (NSE) as the main competitor of the BSE, allowing private sector companies to take up mutual fund business and to trade at the stock exchange, permitting foreign institutional investors (FIIs) to participate in the trading of securities and allowing foreign direct investment (FDI) in the Indian stock exchanges. The third is to modernise the trading, clearing and settlement system through making them computer based and setting up depositories and clearing corporations. All this helps improve market efficiency and helps axe the transaction cost so as to make the transactions attractive. Last but not least, the fourth aspect is related to the setting up of the market for derivatives. The objective is to induce healthy arbitrage, hedging and speculative practices so as to push the stock market indices closer to equilibrium. All these moves need at least some discussion.

Establishing SEBI as a Statutory Body In order to encourage the secondary market trading of securities, the government repealed the Capital Issues (Control) Act, 1947, and allowed companies to access the secondary market even without the government approval. But for the purpose of creating an environment of healthy regulation that could check price rigging and insiders’ trading 86

The Secondary Capital Market

and, in turn, fostering transparency in trading procedures, it brought about an ordinance and, later on, an act in April 1992 making SEBI a statutory body. The SEBI made the registration of the participants, such as stock brokers, share transfer agents, portfolio managers, underwriters, and so on, mandatory for a better surveillance. At the same time, it prohibited fraudulent and unfair trade practices and also insiders’ trading in securities. Insiders’ trading is now a criminal offence for which penalty is prescribed. The SEBI banned the cross deals where the sellers and buyers of the securities employ the same broker. Based on the recommendations of the Kumarmangalam Birla Committee, it framed codes of conduct for the share-issuing companies as also for the stock exchanges. It began inspecting the stock exchanges, asking mutual funds and merchant banks to abide by the code of conduct framed by it. It became mandatory for the share-issuing companies to make continuing disclosures to the stock exchange under listing agreements and to file quarterly returns so that the traders get acquainted with the performance of the company whose shares they are buying or selling. In 2000, it came out with a detailed disclosure and investor guideline that was improved upon in the following years. In order to limit undesired fluctuation in the securities prices, the SEBI introduced in 1995 a system of price bands, circuit filters and circuit breakers. In case of circuit filter, no order is placed if price falls beyond a specific range. Circuit breaker suspends trading if price changes abnormally in either of the directions. It began monitoring the entire activities at the stock market with a view to protecting and preserving market integrity, and even initiating prosecution proceedings in case of malfunctioning. It brought a detailed regulation on substantial purchase of shares so as to check unhealthy takeovers. One of the major steps to control speculation and thereby the market risk was manifest in the form of banning of ‘badla’ transactions in 1993 that were in vogue especially at the BSE for more than a century. Badla is nothing but a carry forward transaction where payment and delivery are postponed and carried forward to a future settlement date, normally a week or a fortnight later. On the settlement date, transaction is completed either through squaring up or through effecting actual delivery. The buyer carries forward the transaction by paying contango. The short seller—who sells shares without possessing them—carries forward his sales position by adjusting 87

India’s Financial Sector

the difference between the sale price and a fixed carry forward price. Badla was resumed under adequate safeguard in 1996, modified in 1999, and the modified version was substituted by a system, known as Borrowing and Lending Securities Scheme (BLSS) in January 2001. However, in the wake of the Ketan Parekh scam, the revised version of badla and all other deferral products were finally made a goodbye. However, in December 2007, SEBI permitted short selling by institutional investors. The convenience and protection of investors is quite significant. The SEBI tries to educate them through distributing varieties of published material. It encourages formation of investors’ association and has established a comprehensive redressal mechanism under which it takes punitive action against complaints filed by the investors. In August 2004, it formulated uniform set of documents regarding client’s registration form, member–client agreement, and so on, so as to make trading more convenient for the investors. In FY 2007–08, the SEBI incorporated additional corporate governance measures in order to align the interest of the general shareholders with that of the insiders.

Establishing National-level Stock Exchanges The national-level stock exchanges were set up in order to broaden the structure of the secondary capital market in the country and to bring into its fold various types of investors that were not covered by the BSE. The first one set up in 1990 was the Over-the-counter Exchange of India (OCTEI) just on the pattern of National Association of Securities Dealers Automated Quotation (NASDAQ) which began operations from October 1992. The primary objective was to encourage small-size companies to participate in the capital market. It was set up as an electronic exchange with screen-based trading system. Initially, only listed securities were traded but then the securities listed on some other exchanges were also traded. Debt securities came to be traded from May 1993. Initially, counter receipts containing details of the share certificates were issued instead of share certificates, but from March 1999, share certificates in dematerialised form replaced the counter receipts. Over the years, this stock exchange has broadened its network to many cities in the country. 88

The Secondary Capital Market

The government took a bolder step to set up the NSE in 1994 on the basis of the recommendations of the Pherwani Committee. As per this committee, the NSE was primarily meant for creating a debt market as also for creating liquidity in mid-range stocks, but in practice, it set a trend in the secondary market trading in many ways. Most importantly, it was set up as a demutualised exchange representing a divorce between the ownership and management on the one hand and the stock trading rights on the other. This way it was quite different from the BSE which was owned and managed by the brokers. The NSE is owned by premier financial institutions and managed by those who do not trade directly or indirectly on this exchange. The demutualisation of this stock exchange thus provides no room for insiders’ trading or any broker-sponsored scam and sets a healthy trend for the secondary market transactions. It was this reason that the government made demutualisation mandatory for all the stock exchanges after the 2001 crisis. In 2005, demutualisation of all the stock exchanges was approved and notified. Under this process, the BSE turned into a company in August 2005. When the NSE was set up, there emerged stiff competition between BSE and National Stock Exchange (NSE). In this process, the turnover at the regional stock exchanges was badly affected. In order to improve their position, some 15 regional stock exchanges promoted Interconnected Stock Exchange of India (ISEI) that began operation in 1999. The members of the participating stock exchanges only could trade at this exchange. Thus, with the setting up of all these stock exchanges, the activities of the secondary capital market in the country stood well diversified bringing into its fold small as well large companies, varieties of debt securities and also the interest of the regional stock exchanges. In February 2000, the government/SEBI allowed the stock exchanges to set up trading terminal in foreign countries so as to attract the nonresident Indians to the secondary market trading.

Improving Listing, Trading, Clearing and Settlement System The secondary capital market transacts only listed securities. So the reform measures tried to make the listing process easier and uniform among different stock exchanges. In April 2003, the SEBI set up the 89

India’s Financial Sector

Central Listing Authority that deals with the listing of securities. Uniform practices have been developed although the different stock exchanges are free to determine the listing fee. Again, the OCTEI and the NSE introduced screen-based trading system from the very beginning of their inception, but the other stock exchanges adopted the new technology subsequently in order to stand by the NSE. By 1995, the NSE had nationwide trading terminals in place of open outcry system of trading. In open outcry system, buyers and sellers assembled and quoted their prices. The price was finally agreed upon after a lot of bargain. But in the screen-based trading system, bargain has no place. Those who are distantly located can easily trade in securities and even with greater speed. The computer matches mutually compatible orders. The list of unmatched limit orders is displayed on the screen. This system thus enhances the efficiency of the market where larger number of persons can participate, helps participants to have a full view of the entire market and ensures transparency. All this generates confidence among the participants which is vital for the secondary market operations. Furthermore, the NSE helped set up the National Securities Depository Limited (NSDL) in 1996 for keeping ownership records in a dematerialised form and effecting transfer of ownership through electronic book entries that did away with all the problems related with the physical delivery of securities after trading. The depository went live in November 1996. The BSE did not lag behind. It set up Central Depository Services Ltd (CDSL) in 1999 that could cope with its growing dematerialisation business. The disinvestment of the public sector units has been done through CDSL. In FY 1999–2000, the stamp duty on the transfer of debt instruments within the depository mode was abolished. Moreover, since May 2002, these two depositories have switched over from ad valorem fee to a fixed flat structure which is more convenient for the institutional and high networth investors. In January 2005, the SEBI rationalised the charge structure of dematerialisation. With all these developments in the depository system, the trading process has become very smooth. Yet again, in order to enable the buyer to get the securities in time and the seller to get the money without delay, the stock exchanges introduced the computer-based clearing and settlement system, as a result of which when trade is recorded automatically showing the quantity, price and the settlement date, the Clearing Corporation 90

The Secondary Capital Market

receives the online information from the stock exchange about the details of the trade and ensures that the trading members meet their settlement obligations. In this process, the clearing banks and the depository play an important role. The clearing bank opens an account with the Clearing Corporation on behalf of the trading members and receives funds for the pay-in obligation from the trading member before the dead line. The Clearing Corporation sweeps the funds from the account and credits the designated account of the seller with the swept funds. Again, as far as depository is concerned, it transfers the securities in electronic form from the account of the custodian/ trading members as per the schedule set by the Clearing Corporation. The electronic system of clearing and settlement ensures complete transparency. A large number of participants being in different locations can settle the transactions simultaneously with far greater speed. Informational efficiency of the market is now much improved. The settlement period stands drastically reduced. It is because of smooth settlement that the settlement period was reduced from a fortnight to a week from August 1996. In order to make the settlement system more convenient, SEBI introduced the rolling settlement from July 2001in a phased manner. First of all, only 200 scrips enjoyed the new system, but now the entire trade is covered by this new scheme. Again, on behest of the SEBI, various depositories along with the listed companies are now interlinked making the rolling settlement system more effective. Initially, the settlement cycle was on t + 5 basis. But from April 2002, it came to be t + 3 and then to t + 2 beginning from April 2003. Majority of the securities market in the world have t + 2 system and so the Indian secondary market has achieved global comparability as far as the settlement of the transactions is concerned. In May 2005, comprehensive risk management system was introduced in the t + 2 rolling settlement. In June 2006, the stock exchanges were advised to update the applicable value at risk margin at least five times a day. In fact, this was done to align the risk management mechanism across the cash and derivatives segments. Beginning from April 2000, Internet trading is in vogue. In this case, investor gets himself registered with a broker offering online service and opens a bank account and a demat account with the broker and buys and sells securities on line. The use of electronic system either for trading or in the payment system reduces the time consumed as well as the cost of transaction. Domowitz and Steil (2002) have proved the 91

India’s Financial Sector

beneficial effect of such innovations in the equity trading on the transaction cost and the cost of capital. Humphrey et al. (1996) estimated in a cross-country analysis, of course in the banking transactions, that over 1 per cent of GDP could be saved by a move from cheque system to electronic system in the US. Thus, the new system is definitely costeffective.

Allowing Non-traditional Participants at the Stock Exchange The mutual funds business, as mentioned in Chapter 3, was extended to private sector companies—domestic and foreign, in 1993. Moreover, as explained in Chapter 10, the Indian government allowed the FIIs to operate at the Indian stock exchanges in September 1992. On these counts, the policy was liberalised further in the subsequent years to enhance their participation at the stock exchanges.

Permitting FDI in Stock Exchange Of late the Indian government has allowed FDI in stock exchange up to a maximum of 26 per cent of the issued and paid-up capital. The purpose is to improve the functioning of the stock exchange at par with the international standard and to make the Indian stock exchanges a part of the global financial market. This provision has yielded results. In early 2007, the NSE divested 20 per cent of its equity to four foreign investors—5 per cent each to New York Stock Exchange, General Atlantic, Goldman Sachs and Softbank Asian Infrastructure Fund. Similarly, the BSE divested its 5 per cent equity to Deutsch Bourse and the other 5 per cent to Singapore Stock Exchange. Subsequently, Atticus Mauritius Capital held 4 per cent share in the equity and the other 4 per cent was held by Caldwell Asset Management. It will take at least some time to bear fruits of this type of FDI.

Axing the Transaction Cost Reforming of the secondary capital market aimed also at helping reduce the transaction cost and thereby to make this segment of the 92

The Secondary Capital Market

market more attractive. Transaction costs are both explicit and implicit. While the explicit costs are brokerage, commission, stamp duty, and so on, the implicit costs are impact cost, clearing and settlement cost, paper work cost, counterparty risk, bad paper risk, and so on. Based on the different stages of trading, they can be trifurcated. Brokerage and the market impact cost are related to trading; counterparty risk is related to clearing and, finally, paper work cost, bad paper risk and stamp duty are related to settlement. Various estimates have been made to indicate the magnitude of transaction cost. One of the earliest estimates is made by Shah and Thomas (1997) who finds that the total transaction cost in the wake of the reform measures fell from 5 per cent in mid-1993 to 2.5 per cent in 1997. The fall was recorded primarily in the brokerage and to some extent in the impact cost. Another study indicated that the transaction cost dropped from 4.75 per cent in 1994 to barely 0.60 per cent by 1999. It is because the bad paper risk and stamp duty were zero; paper work cost fell from 0.75 to 0.10 per cent; brokerage fell from 2.50 to 0.25 per cent and market impact cost plummeted from 0.75 to 0.25 per cent (NSE website).

Initiating the Market for Derivatives Based on the L. C. Gupta Committee recommendations, the government lifted three-decade-long ban on forward trading and introduced derivatives trading at the NSE and BSE in 2000. First of all, index futures were started in June 2000. Then trading in index options and stock options was introduced, respectively, in June and July 2001. Finally, trading in stock futures was allowed in January 2002. The arbitrageurs, hedgers and speculators—all of them—use derivatives with the result that this segment of the secondary capital market has grown to boost up the turnover, moderate the price fluctuations and help generate liquidity in the market. In December 2002, the SEBI prescribed a broader eligibility criteria for stocks on which stock options and stock futures would be allowed and also modified the risk containment measures in view of the changed criteria. In April 2003, exchange traded interest rate derivative contracts were introduced. It was on a notional government security with a 10-year maturity and on a notional 91-day treasury bill (T-bill). In January 2004, banks were 93

India’s Financial Sector

allowed to trade in interest rate derivatives market. In FY 2007–08, SEBI approved new derivative products relating to mini contracts on equity indices, options with longer tenure, volatility index and futures and options contracts.

IMPACT OF THE REFORM PROCESS After delineating major steps to reform, it is worth evaluating whether they have helped enlarge the size of the stock market and raise capitalisation and turnover therein. In this context, it would also be worth examining whether the process of reform has helped maintain a rate of return (including also the volatility element) to be supportive to greater trading activities in the Indian secondary capital market. Since there is often a lag between the implementation of the measures and the coming up of the actual results, we prefer to analyse the figures obtained during the present decade of 2000s. It may be mentioned in this context that the FY 2000–01 figures are normally not considered inasmuch as it was an unusual year embracing the effects of Ketan Parekh scam that set in FY 1999–2000, culminated in FY 2000–01 and finally led to a market crash in later months of the same financial year. Again, the study covers trading done only on the BSE and the NSE insofar as it accounts for a lion’s share of the secondary market transactions in the country.

Growth in the Equity Market Cash Segment: One of the most visible results is manifest in remarkable growth in equity market where the turnover as well as the size of capitalisation took a fast gait forward. Let us talk first about the cash segment. The turnover in the cash segment at the BSE, as presented in Table 5.1, increased from Rs. 3,072.92 billion in FY 2001–02 to Rs. 8,160.74 billion in FY 2005–06 and to Rs. 15,788.56 billion in FY 2007–08. At the NSE, the size moved up from Rs. 5,131.67 billion to Rs. 15,695.56 billion and to Rs. 35,510.38 billion during the respective periods. Combining the turnover in the two markets, the increase is recorded from Rs. 8,205 billion to Rs. 51,299 billion between FY 2001–02 and FY 2007–08. These figures are much higher when they

94

The Secondary Capital Market Table 5.1

Turnover and Market Capitalisation at BSE and NSE (Cash Segment)

Turnover (Rs. billion) FY 1992–93 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Market capitalisation at the year-end (Rs. billion)

BSE

NSE

Total

456.96 3,072.92 3,140.73 5,030.53 5,187.15 8,160.74 9,561.86 15,788.56

— 5,131.67 6,179.89 10,995.35 11,400.71 15,695.56 19,452.85 35,510.38

456.96 8,204.59 9,320.62 16,025.88 16,587.86 23,856.30 29,014.71 51,298.94

BSE 1,881.46 6,122.24 5,721.97 12,012.96 16,984.28 30,221.90 35,450.41 51,380.15

NSE

Total

— 6,368.61 5,371.33 11,209.76 15,855.85 28,132.01 33,673.50 48,581.22

1,881.46 12,490.85 11,093.30 23,222.72 32,840.13 58,353.91 69,123.91 99,961.37

Sources: 1. RBI, Annual Report, various issues. 2. SEBI Bulletin, June 2008.

are compared with those during the early 1990s. During FY 1992–93, the total turnover at the BSE had amounted barely to Rs. 456.96 billion. Capitalisation determines the size of the stock market and the activity in the stock market. Table 5.1 shows that although capitalisation remained confined to Rs. 6,122 billion at BSE and to Rs. 6,369 billion at NSE during FYs 2001–03, it soared up fast to Rs. 51,380.15 billion and Rs. 48,581.22 billion by FY 2007–08, respectively, at the BSE and the NSE. At the end of FY 2007–08, the combined figure of capitalisation in the two markets stood at Rs. 99,961.37 billion, compared to Rs. 1,882 billion at the end of FY 1992–93. Greater activities in the equity market are indicated also by the growth in the equity market indices inasmuch as the investors are mostly the return chasers. With the index moving up, return on investment rises and this attracts the investors. They make fresh investment. Greater investment leads to higher rate of economic growth. Against this backdrop, it is evident from Table 5.2 that the average of the Sensex at the BSE surged up from 3,332 during FY 2001–02 to 16,569 during FY 2007–08, except for a marginal fall in FY 2002–03 (FY 1978–79 = 100). Compared to the figures during FY 1992–93 when the BSE Sensex was barely 2,281, the indices during 2000s are much higher. The case of Nifty was not different. Except for FY 2002–03 that recorded a marginal slide, the index ascended from 1,077 to 4,897 during the respective periods (3.11.1995 = 100).

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India’s Financial Sector Table 5.2

Stock Market Indices and the Price/Earning Ratio

Stock market indices (average of the year) Year 1992–93 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

BSE Sensex NSE Nifty (1978–79 = 100) (3.11.1995 = 100) 2,281 3,332 3,206 4,492 5,741 8,280 13,072 16,569

— 1,077 1,037 1,428 1,805 2,513 3,822 4,897

Price–earning ratio % at the year-end Based on BSE Sensex

Based on NSE Nifty

n.a 16.60 14.50 18.57 15.61 20.92 20.33 22.65

— 15.70 15.20 20.70 14.60 20.26 18.40 19.12

Source: RBI, Annual Report, various issues.

Quite linked with the capitalisation and the stock market indices is the price–earning (P/E) ratio that reflects, among other things, the investors’ expectations of corporate income growth in future. The figures show that the P/E ratio based on both the BSE Sensex and NSE Nifty, which tended to ebb during FY 2001–03, rose in the following financial year. Again, it was lower during FY 2004–05 but took a fast upward turn during FY 2005–06. In all, this ratio varied in the range of 14.50 and 20.92 per cent. In FY 2006–07, there was again a marginal fall in this ratio, but then in FY 2007–08, it was higher. However, when we compare this ratio with those obtained from major markets in the world, it is quite apparent that the Indian figures are posited higher than those prevailing in large number of countries. SEBI has presented these ratios prevailing during FY 2005–06 in 24 countries. India ranks fifth from the top—only after China SHCOMP, Japan NKY, Indonesia JCI and US NASDAQ Comp (SEBI 2007). Derivatives Segment: Turning to the derivatives market, which we can call a newly born baby, the turnover, as shown in Table 5.3, soared up from a meagre figure of Rs. 1,039 billion during FY 2001–02 to Rs. 133,123 billion during FY 2007–08. In this case, the BSE lagged far behind the NSE. The former accounted for less than 1 per cent of the total derivatives turnover during FYs 2001–08. Again, the futures— stock futures and index futures—performed far well compared to the options. 96

12.76 18.11 65.72 136.00 0.05 554.91 2,164.47

2

Index futures

0.84 0.01 — 22.98 0.03 0.001 0.28

3

Index options

4.52 6.44 51.71 2.13 0.01 35.15 53.75

4

Stock futures

Source: SEBI, Annual Report, various issues.

2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

1

Period

BSE

1.14 0.21 3.31 0.03 Negative 0.002 0

5

Stock options

Table 5.3

19.26 24.78 124.52 161.12 0.09 590.06 2,218.50

6

Total 8

Index options

214.82 37.66 439.51 92.48 5,544.62 528.23 7,721.74 1,219.54 15,137.51 3,384.69 25,395.75 7,919.12 38,206.67 13,621.11

7

Index futures

NSE

515.16 2,865.32 13,055.49 14,840.67 27,917.21 38,309.72 75,485.63

9

Stock futures

Turnover in the Equity Derivatives Market

11

Total

251.63 1,019.25 1,001.34 4,398.65 2,172.12 21,306.49 1,688.58 25,470.53 1,802.70 48,242.50 1,934.11 73,558.70 3,591.37 130,904.78

10

Stock options

1,038.51 4,423.43 21,431.01 25,631.65 48,242.59 74,148.76 133,123.28

12

Col. 6 + col. 11

(Rs. billion)

India’s Financial Sector

The comparison of turnover between the cash segment and the derivatives segment, which is presented in Figure 5.1, shows that the turnover of derivatives transactions, despite being new for the country, remained lower than the turnover in the cash segment only during the first two financial years of 2001–02 and 2002–03, but then onwards, it turned gradually greater than the turnover in the cash segment. It is thus very much obvious that the derivatives market has a promising future. Stock Market Activities in relation to GDP: Since the stock market development has a definite influence on the development of the entire economy, it is better to express the growth in turnover and capitalisation in relation to GDP. The figures in Table 5.4 show that the turnover to GDP ratio in the cash segment moved up from 39.33 to 119.39 per cent and in the derivatives segment from 17.95 to 309.32 per cent during FYs 2002–08. The capitalisation to GDP ratio at BSE during the same period rose from 23.23 to 119.39 per cent. This percentage, shows a study of the Deutsch Bank, was higher than those in many other emerging market economies, such as Argentina, Brazil, China, Indonesia, Mexico and Thailand, but less than those in South Korea and Malaysia (http://www.dbresearch.com).

Figure 5.1

Turnover in Cash and Derivatives Segments

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The Secondary Capital Market Table 5.4

Capitalisation and Turnover in Relation to GDP

(%) FY 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Total turnover to GDP ratio

Capitalisation to GDP ratio at BSE

Cash segment

Derivatives segment

23.23 43.52 54.41 85.58 93.53 119.39

39.33 58.71 53.40 67.68 76.55 119.19

17.95 77.64 82.12 136.61 195.63 309.32

Sources: 1. SEBI, Annual Report: 2005–06. Mumbai. 2. RBI, Annual Report, various issues.

Trading in Debt Securities at the NSE The permission to trade in debt securities in the secondary market, especially at the NSE during the process of reform, has helped improve the liquidity of such securities and also bolster the activities in the Indian secondary capital market. The debt securities are either the corporate bond or the government securities—T-bills and the dated securities. The secondary market has two segments. One is the wholesale segment where banks, primary dealers, mutual funds, and so on, exist. The deals are negotiated on telephones and the transactions are settled through the RBI that acts as a clearing house. The retail segment is represented by non-banking financial companies, provident funds, cooperative banks, and so on. The transactions are settled directly by the counter parties. Again there are two types of transactions. While one is outright transaction, the other is under repo/reverse repo arrangement. Outright transactions were started in January 2003 to ensure wider access and participation. To this end, an anonymous screen-based order-matching trading system was incorporated in the electronic negotiated dealing system (NDS). On the contrary, repo/reverse repo facility is in use since December 1992. Till 28 October 2004, repo indicated absorption of liquidity through the sale of securities, simultaneously agreeing to repurchase them after a specific period and at a specific price. Reverse repo meant injection of liquidity in the system. But since then the two terms interchanged so as to conform to

99

India’s Financial Sector

international usage. Repo is undertaken by RBI, although inter-bank repo is found in a highly regulated way. Beginning from May 2005, listed companies and non-scheduled urban cooperative banks are being allowed to participate in repo. Since April 2004, the RBI has permitted the participants to sell the government securities against a confirmed purchase contract, provided such contract is guaranteed by the Clearing Corporation of India Ltd (CCIL) and approved by the RBI. This system allows switching over to a mode of settlement in which settlement is done on a net basis. Table 5.5 shows that the government securities accounted for around 99 per cent of the turnover in the secondary capital (bond) market during FYs 2001–08 leaving corporate bonds to be confined to hardly around 1 per cent. Thus, the government bond segment accounting for around 35 per cent of GDP is to some extent comparable to that in many other emerging market economies, such as Argentina, China and Thailand. On the contrary, the corporate bond segment lagged far behind those in South Korea and Malaysia at the end of 2005 (http://www.dbresearch.com). As far as the trend is concerned, it was not uniform either in case of government securities or in case of the corporate bonds. The annual turnover in government securities tended to ascend till FY 2002–03 when it was of the order of Rs. 19,416 billion. It then receded to Rs. 4,649 billion during FY 2005–06, but then again moved upwards to Rs. 20,289 billion during FY 2006–07 and to Rs. 56,273.47 billion during FY 2007–08. The annual turnover in corporate bonds tended to increase from Rs. 22 billion in FY 2001–02 to Rs. 175 billion in Table 5.5

Turnover of Debt Securities Traded at NSE

(Rs. billion) FY 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Government securities

Corporate bonds

Total

9,449.99 19,416.22 13,082.80 8,867.73 4,649.08 20,288.47 56,273.47

21.92 58.16 78.16 175.21 106.19 66.40 757.37

9,471.91 19,474.38 13,160.96 8,872.94 4,755.27 20,354.87 57,030.84

Sources: 1. RBI, Annual Report, various issues. 2. RBI Bulletin, March 2007. 3. CMIE, Monthly Review, various issues.

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FY 2004–05, but then squeezed gradually to Rs. 66.40 billion during FY 2006–07. In FY 2007–08, it again scaled up fast to Rs. 757.37 billion. All this means that corporate bonds were never a favoured security in the secondary market transaction. The empirical study of Bose and Coondoo (2003) based on the figures of 38 months from April 1997 reveals that the secondary market for the corporate bonds was shrinking in terms of depth and width. Moreover, the trade in highly rated bonds dwindled in favour of greater liquidity-oriented bonds.

Performance of Major Participants: FIIs and Mutual Funds It has already been stated that the FIIs and the mutual fund companies are the major participants at the stock market. The size of FIIs’ purchase and the sale of the Indian securities and thereby their net investment oscillated over a wide range. During FYs 2001–06, as shown in Table 5.6, the size of FIIs’ net annual investment fluctuated between Rs. 28 billion and Rs. 490 billion. The FY 2006–07 witnessed a fall in the net investment to Rs. 308 billion from the previous year’s figure but the following year witnessed a net investment of over Rs. 771.0 billion. Table 5.6

FIIs’ Investment in Indian Secondary Capital Market in 2000s

(Rs. billion) Equity FY 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Gross purchase 452.54 437.32 1,355.19 2,005.73 3,440.84 — 8,563.46

Debt

Gross sale

Net investment

372.29 413.79 920.87 1,595.83 2,955.97 — 8,047.84

80.00 24.77 434.34 409.91 484.87 252.37 515.63a

Gross purchase

Gross sale

Net investment

47.09 30.41 129.95 139.51 37.67 — 740.10

39.89 28.07 74.61 120.22 111.00 — 484.74

6.63 3.45 55.34 19.29 73.34 56.07 255.36a

Sources: 1. Centre for Monitoring Indian Economy (2006), Capital Markets. Mumbai. 2. SEBI Bulletin, June 2008. 3. RBI, Annual Report, various issues. Note: aThe figures are different from those in Chapter 5 on account of difference in sources.

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Again, the FIIs preferred equity to debt securities. The size of net investment in equity accounted for 66–96 per cent of their total net investment during FYs 2001–08. In FY 2005–06, the entire net investment was represented by equity. On the contrary, the mutual fund companies, as shown in Table 5.7, preferred debt securities where the annual net investment varied between Rs. 110 billion and Rs. 738 billion. The equities showed a net disinvestment during FYs 2001–03. In the following years, the amount of the net investment in equity by mutual funds varied between Rs. 4.48 billion and Rs. 163.06 billion. Thus, the figures show that FIIs and mutual fund companies showed their presence at the stock exchanges that did help create a congenial environment for the other investors.

The Return-cum-risk Scenario The impact of the reform measures can be evaluated also in terms of whether the rate of return from investment at the stock exchanges has been high as well as stable. The basic principle of portfolio investment is to maximise the return with a given level of risk or to minimise the risk with a given level of return. Since the risk is represented by the volatility in returns, any move towards stability in the return helps lower the risk and thereby encourages the investors to invest. It is true that the speculators take advantage of the volatility in the rate of return and so volatility cannot be avoided completely. But, at the same time, Table 5.7

Mutual Funds’ Investment in Secondary Capital Market in the 2000s

(Rs. billion) Equity FY 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Debt

Gross Net purchase Gross sale investment 120.98 145.21 366.64 450.45 1,003.89 1,359.48 2,175.78

158.94 165.88 353.56 445.97 860.81 1,268.86 2,012.74

–37.96 –20.67 13.08 4.48 143.08 90.62 163.06

Source: SEBI Bulletin, various issues.

102

Gross purchase 335.57 466.64 631.70 621.86 1,095.51 1,537.33 2,986.05

Net Gross sale investment 225.94 340.59 404.69 451.99 730.66 1,011.90 2,248.16

109.63 126.04 227.01 169.87 364.86 525.43 737.90

The Secondary Capital Market

the aspect of financial stability cannot be ignored. All this means that volatility should be confined to a manageable limit. If it is excessive on account of imperfections in the trading mechanism or lack of desired information or still by the speculative behaviour of the investors, the very confidence in the stock market will be lost. It is very difficult for the investors to take a rational decision to purchase/sell securities which in turn entails upon the creation of liquidity in the financial market. If spillover effects are large, the real sector functioning is also hampered. Thus, in this context, it is very much relevant to focus on the return and risk aspect of the Indian secondary equity market. To explain the computation of return and risk, it may be mentioned that while return is equal to the logarithmic difference of stock price index of two successive periods, the risk represents the standard deviation of return. Risk has been measured by a number of studies in the Indian context (Broca 1995; Chaudhuri 1991; Goyal 1995; Roy and Karmakar 1995). But they do not reveal the latest situation as the studies were carried out during the 1990s. We base our analysis on the BSE and NSE figures obtained during FYs 2001–08. The annualised value of return is represented by the sum of monthly return during a year, whereas the annualised value of risk is equal to the standard deviation during a month multiplied by the square root of 12. Finally, we find out the return–risk ratio during different years. The figures in Table 5.8 show that the annualised value of return was in the negative zone both at the BSE and at the NSE during FY 2001–03. Then onwards, it turned positive but it was very much volatile during the following four financial years moving up and down between 83.37 and 15.89 per cent at BSE and between 81.18 and 12.31 per cent at the NSE. In FY 2007–08, these figures were 19.68 and 23.87 per cent, respectively, at BSE and NSE. On the other hand, the annualised value of risk varied between 3.50 and 6.69 per cent at the BSE and between 3.43 and 7.00 per cent at the NSE. The return/risk ratio, which was negative during FYs 2001–03, turned positive in the following financial years but fluctuated between 2.64 and 20.65 per cent at the BSE and between 2 and 18.65 per cent at the NSE. The volatility in the Indian stock market, as presented in Table 5.9, was greater than that in many markets of the world during FY 2007–08. 103

India’s Financial Sector Table 5.8

Financial year 1 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Return and Risk in BSE Sensex and NSE Nifty

BSE/NSE

Annualised value of monthly return %

Monthly volatility %

2

3

4

5

6

1.50 1.40 1.01 0.99 1.35 1.43 1.48 1.61 1.03 1.04 1.74 1.78 1.93 2.03

5.20 4.85 3.50 3.43 4.68 4.95 5.13 5.58 3.57 3.60 6.03 6.17 6.69 7.00

–0.72 –0.33 –3.46 –3.91 17.81 16.40 3.14 2.64 20.65 18.65 2.64 2.00 2.94 3.41

BSE NSE BSE NSE BSE NSE BSE NSE BSE NSE BSE NSE BSE NSE

–3.75 –1.62 –12.12 –13.40 83.37 81.18 16.13 14.90 73.73 67.14 15.89 12.31 19.68 23.87

Annualised Return/risk ratio volatility (col. 3/col. 5) %

Source: SEBI Annual Report, various issues. Note: Annualised volatility figures for India differ from those in Table 5.9 on account of difference in technique of computation. Table 5.9

Inter-country Comparison of Return and Risk during FY 2007–08

(%) Stock market index USA Dew Jones UK FTSE 100 Japan NKY Australia AS 30 Hong Kong HIS China SH Comp. Russia CATX South Korea KOPSI Brazil IBOV India BSE Sensex India NSE Nifty

Annualised return –0.7 –9.6 –27.6 –9.5 15.4 9.1 12.5 17.3 33.1 19.7 23.9

Source: SEBI Annual Report: 2007–08.

104

Annualised volatility

Return/risk ratio

17.47 21.71 24.45 22.30 34.73 36.67 27.95 25.45 29.34 30.55 32.09

–0.40 –44.83 –112.88 –42.60 44.34 24.82 44.72 67.98 112.82 64.48 74.48

The Secondary Capital Market

But as far as the return/volatility ratio in BSE Sensex and NSE Nifty is concerned, India’s position during FY 2007–08 was definitely better than those in US, UK, Japan and Australia inasmuch as in all these four countries return–risk ratio was negative. India was posited on a better place also compared to Hong Kong, China, Russia and South Korea, except Brazil. Thus, from the viewpoint of return–risk ratio, India fared well during FY 2007–08. Here, a very pertinent question arises as to whether the high risk in Indian capital market is due to the lack of good governance. As far as the views of Institute of International Finance are concerned, SEBI has shown good governance (IIF 2006). But for the lack of improved legal framework, the World Bank governance index is far lower in India than those in Hong Kong and Singapore (dbresearch.com). The legal framework needs improvement in order to make the governmental steps more effective, to control corruption and to improve the quality of regulations.

Efficiency in the Market Despite sizeable growth in activities at the Indian secondary capital market, one question needs to be answered whether this market has achieved efficiency over one-and-a-half decades of reforms. The concept of market efficiency was developed long back by Fama (1970). An efficient capital market means a market where all important current information is freely available to all participants with the result that the participants are quite rational and they compete with one another to predict future values of an individual security. All this leads to a situation where individual securities present an equilibrium price. Here, the answer is based on the empirical study of Dash (2007) who finds out Karl Pearson’s coefficient of correlation for daily closing values of Sensex prices during individual months falling during 2001–06. In some of the months, namely, February, April, November and December, he finds positive correlation coefficient, but in other months, it is negative. On this basis, he concludes that the Indian secondary capital market is yet only semi-efficient. It has to go a long way to achieve full efficiency.

105

India’s Financial Sector

SUMMING UP The secondary capital market has been an important area of the financial sector reforms. A number of measures were taken up to revamp this segment of the financial sector. First of all, the government empowered SEBI to regulate it with a view to bringing in transparency and fairness in the deals so as to protect the interest of the investors. Second, the NSE and a few other stock exchanges were set up to foster competition in this area and to make it more viable. Third, the procedure of listing, trading, clearing and settlement was made transparent and convenient with the introduction, among others, of electronic devices. Fourth, the FIIs and also the domestic and foreign mutual fund companies were permitted to operate, so that the size and magnitude of secondary market operations could be large and more competitive. Fifth, the market for derivatives was launched to compete with the cash segment of the market. Last but not least, FDI flowed in the BSE and the NSE that is expected to improve the functioning even further. All these measures led to soaring up of the turnover, market capitalisation and the share price index. Of late, the turnover in the derivatives segment outpaced that in the cash segment. Besides, the transactions in debt securities, including government securities and the corporate bonds, too witnessed an upward trend. The rate of returns has also improved over the years, although there is no even trend. However, volatility in the returns needs to be checked. Last but not least, the market is yet to achieve desired efficiency.

106

6

The Market for Government Securities

Government securities market is an important segment of financial market creating a benchmark for the borrowing programme in the private corporate sector and subserving the objectives of both the fiscal policy and the monetary policy (Reddy 2002). The instruments are the treasury bills (T-bills) and the dated securities. While the T-bills are a short-term instrument of the central government involving maturity of less than a year, the dated securities are a medium/long-term instrument, both of them meeting the fiscal deficit of the government. Sometimes T-bills are converted into dated securities in order to allow a rollover of short-term debt on to a long-term period. As far as the monetary policy objectives are concerned, the issue of these securities along with their secondary market transaction influences the supply of loanable funds or, in other words, liquidity in the financial system. This in turn influences, at least to some extent, the rate of interest and thereby the propensity to invest that ultimately helps determine the income and output in the country. Now the question is whether the reform in the government security segment of the Indian financial sector for around one-and-a-half decades has really subserved the fiscal and monetary policy objectives. The present chapter, therefore, discusses, first, the measures of reform in this area of the financial market and then examines the broad impact of reform, especially in the context of meeting the fiscal deficit and also maintaining liquidity in the financial market that influences in turn the rate of interest. At the same time, the improvement in the efficiency of this market is explained in terms of widening the base

India’s Financial Sector

of this market. The impact on the level of investment and output remains outside the scope of the discussion. In the beginning, the features of these securities and the modalities of the borrowing are explained in brief so as to form a backdrop for the main discussion. It may be specified that the discussion of the government securities is limited to the securities of the central government.

FEATURES OF THE CENTRAL GOVERNMENT SECURITIES Treasury Bills Treasury bills (T-bills) are issued by the Reserve Bank of India (RBI) on behalf of the government for a minimum amount of Rs. 25,000 or a multiple thereof to meet the temporary/seasonal gap between the latter’s receipt—both capital and revenue and the expenditure. T-bills are normally issued at discount and are repaid at par on the maturity. The discount serves the purpose of interest. T-bills are nothing new. They were started in India as back as in the 1950s. The ad hoc T-bills were created whenever the Indian government’s cash balance maintained with the RBI fell below the prescribed minimum. The problem of dwindling cash balance was solved but the process led to monetisation of the budgetary deficit of the government. Over the years, their expanded use came in clash with the objective of monetary policy combating unwanted monetisation. Ultimately, they were discontinued after the reform process got momentum in the 1990s. A system of Ways and Means Advances (WMA) was introduced in their place to accommodate the budgetary deficit. Again there were 91-day tap T-bills that were bought from the RBI any time at an interest rate of 4.663 per cent. They too were discontinued from the beginning of FY 1997–98. Yet again, the auction 182-day T-bills introduced in November 1986 were replaced by auction 364-day T-bills in April 1992. And at the same time, auction 91-day T-bills were introduced in January 1993. Last but not least, 182-day T-bills and intermediate 14-day T-bills were introduced in FY 1997–98, but both of them were discontinued from March 2001. However, beginning from FY 2005–06, 182-day T-bills were reintroduced. Thus, presently, only three types of auction 108

The Market for Government Securities

T-bills are in the run—one is 91-day T-bill and the other is 182-day T-bills and still the other is 364-day T-bill. While the former is auctioned every Friday, the latter two are auctioned every alternate Wednesday. The biggest subscriber has been the RBI. The other subscribers are the mutual funds, banks, financial institutions, nonbanking financial companies, domestic and foreign institutional investors (FIIs), and so on. In case of auctions, the bids are both competitive and noncompetitive. In case of competitive bid, the bids are submitted to the RBI. The RBI decides the cut-off price/yield and then makes the allotment to those whose bid meets the cut-off. The non-competitive bid, on the other hand, is accepted normally from the state government and non-government provident fund having no expertise in making a competitive bid. The T-bills are allotted to them at a weighted average price of the successful competitive bids.

Dated Securities The dated securities carry predominantly fixed rate coupon, although floating rate is also found. Interest is paid half-yearly. Occasionally, these securities are divided into specific number of zero-coupon securities that can be traded separately at varying yields. This process, called stripping, helps expand market for these securities. Earlier, the dated securities were sold by the RBI at predetermined coupon rate and maturity: the process is still continuing in case of the outstanding securities. However, since June 1993, the dated securities are auctioned. The RBI announces the quantum, maturity and date of auction. The bidders submit the bid. The RBI decides about the cutoff yield and allots the securities accordingly. Since FY 1999–2000, auctions have come to be price based and not yield based in order to enable consolidation of securities. The bidding is competitive, but a small fraction of the issues is allotted especially to the retail investors on a non-competitive bidding basis. However, when liquidity is tight in the market and when the investors expect a very high yield, the RBI does not go for auction but places the securities with itself in order to fund the government. Subsequently, these securities are sold when the market is ripe. 109

India’s Financial Sector

MEASURES OF REFORM As mentioned earlier, the government securities existed even prior to the 1990s but they were not long-term objective oriented. They did not bridge even one-fifth of the fiscal deficit (RBI 2005a). Thus, when economic reforms were initiated and the development of financial sector received attention, steps were taken to revamp the government securities segment and to make this segment more objective oriented. From the very beginning of FY 1992–93, the purpose of the reform process was to widen and deepen the primary and secondary segments of government securities market with a view to ensuring a proper fiscal monetary coordination. The efforts were manifest, among other things, in the elongation of maturities, consolidation of the new issues in key maturities, enhancement of liquidity and fungibility, promotion of retailing in these securities and enhancement of transparency in the government’s borrowing programme.

Diversifying the Issue New variants of T-bills with different maturities, such as 364-, 91- and 182-day T-bill, were introduced so as to suit the varying time framework of the buyers and also the varying duration of cash needs of the government. Dated securities too were diversified in terms of maturity varying normally from 2 to 10 years and, of late, to 25 years. During August and October 2002, 30-year bonds were issued. In normal cases, the coupon is fixed. But floating rate bonds too are being issued since July 2002 providing additional liquidity to the market participants. The base rate is set equal to the average cut-off yield in the preceding three auctions of 364-day T-bills with annual resetting. During FY 2002–04, the issue of floating rate bonds accounted for around one-sixth of the total bond issuance (RBI 2004).

Introducing Auction From the very beginning of the reform era, T-bills were auctioned. The dated securities too were auctioned from the beginning of FY 1993–94. Auction-generated competition allowed market forces to act. The interest rate turned reflective of the market forces and helped 110

The Market for Government Securities

a better allocation of resources. It turned as an anchor rate for the financial institutions. It may be mentioned here that when the reform process was initiated, the interest rate was administered and as a result, there was a gap between the real and nominal interest rates. So the measures of reform aimed at avoiding this type of distortion and the interest rate came to be determined by the market forces. This was the basic strategy behind going for auction of the government securities.

Enhancing Marketability and Liquidity In order to enhance the marketability of the securities and to maintain adequate liquidity in the system, the government allowed the sale and purchase of securities in the retail and wholesale segments of the secondary market. Again there were two types of transactions in the secondary market—the outright transactions and those under repo/reverse repo arrangement. Outright transactions were started in January 2003 to ensure wider access and participation. To this end, an anonymous screen-based order matching trading system was incorporated in the electronic negotiated dealing system (NDS) which began functioning in August 2005. Initially, it was limited to the dated securities, but beginning from mid-2006, it took up also the T-bills. The membership of this system was also broadened subsequently. Repo facility was started from December 1992. As mentioned in the preceding chapter, traditionally repo meant sale of the securities by the RBI simultaneously agreeing to repurchase them after a specific period and at a specific price. Reverse repo meant just otherwise. But beginning from 29 October 2004, these two terms were interchanged to conform to the international nomenclature. Now repo means purchase of the securities by the RBI injecting, in turn, liquidity in the money market. Reverse repo, meaning sale of securities, absorbs liquidity from the market (Gray and Place 1999). It is true that repo is undertaken by RBI, but inter-bank repo is also found in a highly regulated way. Beginning from May 2005, listed companies and non-scheduled urban cooperative banks are being allowed to participate in repo. Since April 2004, the RBI has permitted the participants to sell the government securities against a confirmed purchase contract, provided such contract is guaranteed by 111

India’s Financial Sector

the Clearing Corporation of India Ltd (CCIL) and approved by the RBI. This system allows switching over to a mode of settlement in which settlement is done on a net basis.

Restructuring Infrastructure Measures were taken to strengthen the infrastructure both in the wholesale and in the retail segments of the securities market. In the wholesale segment, the RBI helps diversify the investor base through the appointment of primary dealers (PDs) and the satellite dealers (SDs) that function as a market maker. At the end of July 2007, there were eight PDs along with 10 banks taking up the business of PDs. The Fiscal Responsibility and Budget Management (FRBM) Act, 2003, goes one step further through prohibiting the RBI from participating in primary issuance of government securities with effect from April 2006, except under very specific circumstances and asking PDs to shoulder responsibility for primary auctions. To this end, short sale in a phased manner and the introduction of ‘when issued’ market were introduced from the beginning of August 2006 involving conditional transactions where settlement is done only after the actual issue of securities. The when issued trading facilitates price discovery, helps improve liquidity and helps bring down the risk of underwriting. The steps included also the proposal for consolidation meaning buying back of small-size securities and reissuing of largesize securities, mandating 100 per cent underwriting commitments by PDs, diversifying the business of the PDs and the operation of NDS order matching system which is an extension of NDS and where CCIL is the central counter party to each trade done on the system. PDs now include also those banks that possess minimum net-owned funds of Rs. 10 billion, minimum CRAR of 9.0 per cent and have nonperforming assets of less than 3 per cent. However, in order to prevent any scam, the PDs have been brought under the purview of the Board of Financial Supervision since 2003 that can ask for financial returns and undertake on-sight inspection. In fact, the purpose behind attaching importance to PDs is to ensure separation between debt management and monetary operations. The RBI has created a new department, known as the Financial Markets Department that looks after the regulation and development of money market instruments and other government securities. 112

The Market for Government Securities

FIIs were allowed to invest in dated securities with a ceiling of 30 per cent investment in debt instruments. They were provided custodial and depository services, subject to specific conditions. Again, to develop the retail segment that was lagging behind during the pre-reform period, the banks were allowed to buy and sell government securities from, and to, the retail investors on an outright basis and at prevailing market prices. An individual can now deal in these securities for a minimum of Rs. 5,000. The minimum for a PD has come to be Rs. 25,000. The interest income is exempted from the provisions of tax deducted at source with effect from June 1997. The RBI encourages setting up of mutual funds exclusively for dealing in government securities. They, often known as gilt funds, get liquidity support to the extent of onefifth of the investment in dated securities. In retail sector, there are some investors, for example, urban cooperative banks, non-banking financial companies and trusts, that do not possess normally expertise for making competitive bid. For them, the RBI has brought about a system of non-competitive bid since December 2001, as per which the retail investors are allotted securities up to 5 per cent of the notified amount at the weighted average of the competitive bids. This scheme was introduced while launching a 15-year dated security in January 2002.

Easing Settlement of Transactions Moreover, an additional impetus is being provided as far as settlement of transactions is concerned. The RBI has authorised National Securities Depository Ltd (NSDL), Stock Holding Corporation of India Ltd and National Securities Clearing Corporation Ltd to open subsidiary general ledger (SGL) accounts with it in order to facilitate settlement of transactions. The allottees of the government securities are allowed to sell them the same day on which they are allotted the securities, with complete formalities of settlement. Introduction of demat accounts and making them compulsory has eased the settlement considerably. A delivery versus payment (DVP) system was introduced in July 1995 that helps synchronise the transfer of securities with cash payment and eases the settlement and also prevents any diversion of funds that would have been possible in case of transactions routed through SGL account. Even in case of SGL-routed transactions, a scheme of special fund facility was introduced in October 2003 that provides intra-day funds to SGL holders for facilitating settlements in case of 113

India’s Financial Sector

any problem arising in this respect. Moreover, the RBI set up in 1999 a computer networking with the NSDL for easing settlement. In FY 2001–02, as mentioned in the preceding chapter, an Electronic NDS and a CCIL were set up for facilitating trading and smooth settlement. Since November 2002, CCIL has been doing clearing operation in respect of government securities reducing sizeably the liquidity risk. The RBI has standardised the settlement system for transaction in government securities on T + 1 basis, in addition to the existing T + 0 basis, since May 2005. It is now similar as in the US and shorter than in Japan where it is T + 3 (ADB 2006).

FINANCING OF THE FISCAL DEFICIT Size of the Issue Now the question is whether the reform measures have led to the growing use of the government securities for bridging the fiscal deficit. Table 6.1 displays the figures of the gross and the net amount of T-bills since FY 1997–98 when the auction method came in the full swing. The size of the issue was obviously greater than that during FY 1991–92, the year preceding the reform but there was no clear move upwards. The amount of the issue receded from Rs. 987 billion in FY 1997–98 consistently to Rs. 353 billion in FY 2000–01, but then surged up reaching Rs. 629 billion in FY 2003–04 and abruptly to Rs. 2,223 billion in FY 2006–07 and Rs. 3,144.960 billion in FY 2007–08. As far as specific-duration T-bills are concerned, 14-day and 182-day T-bills were introduced in FY 1997–98 and were in vogue till FY 2001–02, but they did not shine as the size of their issue got gradually squeezed over years. The 182-day T-bills were reintroduced in FY 2005–06 but their size remained barely around one-sixth of the size of all kinds of T-bills issued during FYs 2005–08. As regards 91-day T-bills, they performed well especially during FYs 2004–08 accounting for well over three-fifths of the gross amount of all kinds of T-bills. The rest was represented by 364-day T-bills. The T-bills, except for the 364-day ones, being very short term in nature were to be repaid on maturity with the result that the repayments were not less significant. Except for FYs 1998–99, 2005–06 and 2007–08, when the repayments exceeded the gross amount, they accounted for 70–90 per cent of the gross amount. 114

692.370 181.500 164.530 104.800 11.000 — — — — — —

1997–98 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

132.000 166.970 81.550 72.550 202.160 264.020 367.890 1,005.920 1,034.240 1,315.770 2,103.650

91-day T-bills

Source: RBI, Annual Report, various issues.

14-day T-bills

Financial year — — 29.000 26.000 3.000 — — — 268.280 369.120 469.260

162.470 102.000 130.000 150.000 195.880 261.260 261.360 471.320 450.180 538.130 572.050

986.840 450.470 405.080 353.350 412.040 525.280 629.250 1,477.240 1,752.700 2,223.020 3,144.960

Total

T-bills: Gross and Net Amount

182-day T-bills 364-day T-bills

Gross amount

Table 6.1

945.440 512.340 362.630 332.500 318.450 413.640 604.300 1,060.740 1,790.870 1,771.610 3,121.950

Repayment

(Rs. billion)

41.400 –61.870 42.450 20.850 93.590 111.640 24.950 416.500 –38.170 451.410 –23.010

4.20 –13.73 9.43 5.90 22.71 21.25 3.96 28.20 –2.18 20.31 –0.73

Net amount as % of gross amount Net amount

India’s Financial Sector

The dated securities (see Table 6.2), on the other hand, were a bigger source of revenue to the central government compared to the T-bills. The yearly issue size of dated securities swelled consistently from Rs. 434 billion in FY 1997–98 to Rs. 1,250 billion during FY 2002–03, but then fell touching Rs. 804 billion during FY 2004–05. However, thereafter, there was a big jump to Rs. 1,310 billion in FY 2005–06, Rs. 1,460 billion in FY 2006–07 and Rs. 1,560 billion in FY 2007–08. Since the dated securities involved medium- and long-term maturity, the repayment was lower in relation to the total volume of the issue. The net amount varied normally between 71 and 82 per cent of the gross amount except for FY 2004–05 when it was as low as 57 per cent. Again, it is not only the absolute size of the government securities that grew over the years but also the outstanding stock of government securities as percentage of GDP that ascended from 11.8 at the end of March 1992 and 21.6 at the end of March 2001 to 28.9 at the end of March 2006 (http://www.rbi.org.in). An inter-country comparison made by Luengnaruemitchai and Ong (2005) shows that this percentage ranged between as low as 3.7 in Russia and as large as 145.1 in Japan, positing India at 35.4 per cent. India’s position was higher than 11 countries among 22 countries surveyed by them. Table 6.2

Dated Securities: Gross and Net Amount

(Rs. billion)

FY 1997–98 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Gross amount 433.900 837.530 866.300 1,001.830 1,142.130 1,250.000 1,215.000 803.500 1,310.000 1,460.000 1,560.000

Repayment 109.030 148.030 163.530 283.960 264.990 274.200 326.930 343.160 356.310 390.840 453.290

Source: RBI, Annual Report, various issues.

116

Net amount 324.870 689.500 702.770 717.870 877.140 975.800 888.160 460.340 953.690 1,069.160 1,106.710

Net amount as % of gross amount 74.87 82.33 81.23 71.66 76.80 78.06 73.10 57.29 72.80 73.23 70.96

The Market for Government Securities

Meeting the Fiscal Deficit The gross fiscal deficit of the central government, as evident from Table 6.3, went on getting inflated from Rs. 732 billion during FY 1997–98 to over Rs. 1,450 billion in FY 2002–03. There was a marginal shrink in the following two years but then again, it climbed up to Rs. 1,462 billion in FY 2005–06 and Rs. 1,523 billion in FY 2006–07. In FY 2007–08, it was lower at Rs. 1,437 billion. Meeting such a large deficit is not easy. But the securities of the central government met the deficit normally to an extent varying between 63 and 75 per cent, except for FY 1997–98 when this percentage was only 50. In FY 2006–07, this percentage was as large as 99.82 which means that almost entire deficit was covered by the amount of government securities. It is also evident from Table 6.3 that a lion’s share of the deficit was met by the dated securities in all the years except for FY 2004–05 when the T-bills were almost equally important. The apparent reason is that the government preferred to rely on dated securities in view of their longer maturities that did provide a longer breathing space. Table 6.3

Central Government Securities and Financing of the Gross Fiscal Deficit

(Rs. billion) Central government securities

FY 1 1997–98 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

T-bills 2 41.400 –61.870 42.450 20.850 93.590 111.640 24.950 416.500 –38.170 451.410 –23.010

Dated securities

Total

3

4

324.870 689.500 702.770 717.870 877.140 975.800 888.160 460.340 953.690 1,069.160 1,106.710

366.270 627.630 745.220 738.720 970.730 1,087.840 913.110 876.840 915.520 1,520.57 1,083.700

Source: RBI, Annual Report, various issues.

117

Gross fiscal deficit of the central government

Col. 4 as % of col. 5

5

6

732.040 895.600 1,047.170 1,119.720 1,409.550 1,450.720 1,232.720 1,392.310 1,461.750 1,523.280 1,436.530

50.03 70.08 71.17 65.97 68.87 74.99 74.07 62.98 62.63 99.82 75.44

India’s Financial Sector

MAINTENANCE OF LIQUIDITY IN THE FINANCIAL MARKET Size of the Secondary Market Transactions It is true that the government securities have contributed largely to meeting of the fiscal deficit. But it is also true that these securities being transacted also in the secondary market make an influence on liquidity in the financial system. The larger the transactions, greater is the influence on liquidity (McCauley and Remolona 2000). Table 6.4 covering four financial years from 2004–08 shows the amount of transactions in the secondary market that were large enough to influence the liquidity. It is evident from the figures that repo transactions were larger than the outright transactions during three financial years, except for 2006–07 when they were lower than the outright transactions. Again, the transaction size of dated securities—both outright and repo—was far greater than those of T-bills during the four financial years taken together. However, the issue is not limited to the generation of liquidity. The more important question is whether these transactions have fostered stability in liquidity infusion. This is the issue with which one should be more concerned. Table 6.4

Government Security Transactions in the Secondary Market

(Rs. billion) T-bills Period 1

Sum of col. 5 and Dated col. 6 securities

91-day

182-day

364-day

Total

2

3

4

5

6

7

— 219 291 332

1,219 1,137 645 780

2,555 1,975 1,300 1,777

8,794 6,646 8,856 14,841

11,349 8,621 10,156 16,618

— 340 627 218

1,656 1,924 2,184 2,107

2,878 2,801 3,796 3,207

12,665 13,712 2,970 35,710

15,543 16,513 6,766 38,917

Outright transactions FY 2004–05 1,336 FY 2005–06 616 FY 2006–07 364 FY 2007–08 665 Repo transactions (single leg) FY 2004–05 1,224 FY 2005–06 646 FY 2006–07 985 FY 2007–08 882

Source: RBI, Annual Report, various issues.

118

The Market for Government Securities

Instability in Liquidity Infusion The impact of secondary market transactions would be stabilising if the amount of transaction varies from one period to the other only within a narrow range. But if it varies widely, it may have a destabilising impact. In order to analyse the impact, Table 6.5 presents instability in terms of coefficient of variation of the monthly transactions of different forms of government securities for four financial years from 2004–05 to 2007–08. The figures confirm increasing instability in both the cases— outright and the repo. In case of outright transactions, the coefficient of variation rose from 0.32 in FY 2004–05 to 1.92 in FY 2007–08. In repo transactions, the increase was recorded from 0.14 to 2.80. On yearly basis, there is no clear-cut evidence. The T-bills were more unstable than the dated securities in some of the years, whereas the reverse was the case in some other years.

Liquidity and the Yield Looking at the other facet of financial sector liquidity, which is also very relevant for the present study, it is the relationship between the liquidity and the yield on the securities. The yield presented in Table 6.5

Coefficient of Variation of Monthly Transactions of Government Securities

T-bills Period 1

Dated Sum of col. securities 5 and col. 6

91-day

182-day

364-day

Total

2

3

4

5

6

7

— 0.36 0.49 1.52

0.42 0.56 0.38 2.09

0.32 0.54 0.30 2.12

0.41 0.35 0.50 1.73

0.32 0.31 0.46 1.92

— 0.55 0.47 1.45

0.31 0.41 0.55 2.05

0.36 0.38 0.61 2.64

0.18 0.23 0.88 3.51

0.14 0.19 0.49 2.80

Outright transactions FY 2004–05 0.17 FY 2005–06 0.78 FY 2006–07 0.33 FY 2007–08 1.36 Repo transactions (single leg) FY 2004–05 0.80 FY 2005–06 0.75 FY 2006–07 0.98 FY 2007–08 1.02

Note: Calculation is made on the basis of the figures sourced from RBI annual report.

119

India’s Financial Sector

Table 6.6 varies from one period to the other. It is because the greater the liquidity, lower is the yield on government securities. The simple reason is that greater the liquidity, the lower is the interest rate and lower is the yield with a given price of the securities (Malkiel 1962). It is true that there are a host of factors leading to changes in the yield but assuming them constant for a moment, it is the varying liquidity that has led the yield to change more frequently. The figures in Table 6.6 reveal that the yield on different types of government securities tended to decline between 2000–01 and 2003–04. The apparent reason was the increase in liquidity in addition to many other factors (RBI 2004). On the contrary, the yield on different types of government securities tended to increase at least to some extent after FY 2004–05 (RBI 2008).

Yield on Dated Securities as an Anchor Rate In the normal course, the interest rate in the financial market should move positively with the movement in the interest rate/yield of the government securities, with a given degree of market risk. The simple reason is that the interest rate/yield of the government securities acts as an anchor rate. If this is so, there must be a positive correlation between the movement in the yield on the government securities and the interest rate on the debt in the market. Table 6.7 examines this contention based on the yield on the central government dated securities and the cost of funds borrowed by some all-India financial Table 6.6

Yield of Government Securities

(%) Year 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

14-day T-bills

91-day T-bills

182-day T-bills

364-day T-bills

Dated securities

8.23 7.13 — — — — — —

8.98 6.88 5.73 4.63 4.89 5.51 6.80 7.11

9.43 8.44 — — — 5.65 6.87 7.38

9.76 7.30 5.93 4.67 5.15 5.87 7.07 7.50

10.95 9.44 7.34 5.74 6.11 7.34 7.89 8.12

Source: RBI, Annual Report, various issues.

120

The Market for Government Securities Table 6.7

Year 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 Correlation coefficient

Relationship between Yield on Dated Securities and Cost of Funds of Some Financial Institutions in India

Yield on dated securities 11.0 9.5 7.3 5.7 6.1 7.3

Cost of funds borrowed by select all-India financial institutions Exim Bank

NABARD

SIDBI

IDFC

NHB

11.1 8.7 8.9 5.9 6.6 7.0 0.9248

9.5 8.0 6.1 5.4 5.5 5.8 0.9810

9.8 7.5 6.6 4.9 5.9 4.5 0.8863

11.3 9.0 7.6 5.6 6.0 7.0 0.9888

10.2 8.7 6.4 5.4 6.3 5.9 0.9643

Source: RBI, Annual Report, various issues.

institutions for a period extending from 2000–01 to 2005–06. It is found that there is a highly positive correlation coefficient between the two variables despite the fact that the interest rate in India is not completely deregulated. The correlation coefficient varies between 0.8863 and 0.9888 confirming the validity of this contention in the Indian context.

TOWARDS A MORE DIVERSIFIED AND EFFICIENT MARKET With the development of the government securities market, deeper and wider, the investors’ base has also come to be diversified. This is a healthy trend insofar as it minimises the impact of the ‘herd mentality’ and fosters stability in the market. Moreover, with diversified ownership, market forces find a bigger room for play. If one looks at the figures, it is evident that over 55 per cent of the government securities in 1991 were held by the commercial banks that moved up to 72 in 1994. In fact, it was the mandatory statutory liquidity ratio requirement that made the commercial banks so important in the government securities market. The RBI held over one-fourth of the total in 1991 followed by the Life Insurance Corporation of India that held the other one-eighth part. This means that these three held over 92 per cent of the securities. Whatever might be the reason, the ownership was highly concentrated. 121

India’s Financial Sector

The reforms in this sector helped diversify the ownership pattern over one-and-a-half decades. The share of commercial banks fell to 44 per cent and that of the RBI shrank to barely 7 per cent at the end of December 2006. It means that the share of these two institutions dropped from over 80 per cent in 1991 to 51 per cent at the end of 2006. The gap was filled by the life insurance companies that came to hold 27 per cent of the securities. Besides, the PDs and the provident funds held 11 per cent. The other owners were mainly the cooperative banks, corporates, mutual funds and financial institutions (RBI 2007a). Figures 6.1 and 6.2 show the pattern of ownership of government securities. Figure 6.1

Ownership Pattern of Government Securities, 1991

Source: RBI (1992), Report on Currency and Finance, 1991–92. Figure 6.2

Ownership Pattern of Government Securities, 2006

Source: RBI (2007), Annual Report, 2006–07.

122

The Market for Government Securities

The move towards efficiency is supported also by growing integration within the government securities market. The growing integration confirmed by highly positive correlation between the yield of 10-year dated securities on the one hand and the 14- and 364-day T-bills, on the other. According to an RBI study, it was, respectively, 0.88 and 0.98 during April 1998 and January 2006 (http://www.rbi.org.in).

SUMMING UP The market for central government securities—T-bills and dated securities—has been reformed with a view to meeting effectively the desired fiscal and monetary objectives. The measures include, among other things, diversification in their structure, introduction of auctions, enhancement of marketability and liquidity, strengthening of the basic infrastructure and easing of the settlement. The result is that these securities have come to play an important role in bridging the fiscal deficit. Moreover, they have come to infuse sizeable liquidity in the financial sector. The only problem is that instability in the liquidity infusion still persists. However, it is quite evident that liquidity has an impact on the yield and the yield has a definite role in anchoring rate of interest in the capital market. Last but not least, there has been diversification in the ownership pattern of the government securities with the result that the financial stability has been generated and the market has grown more efficient. Greater integration within the government securities market is another plus point conferring on the market greater efficiency.

123

7

The Money Market

After the discussion of the capital market, it is now the turn of the Indian money market that involves the movement of short-term funds among the banking and the non-banking entities as well as the government. To be specific, the Indian money market embraces broadly the call/notice money market (CNMM) where the funds are borrowed and lent for less than a fortnight, the term money market where funds are transacted for three months or more stretching up to one year and the repo/reverse repo market where treasury bills (T-bills) are sold and purchased with a specific motive. Besides, there are a couple of instruments, namely, commercial paper (CP) and certificates of deposit (CDs), quite in vogue for more than one-anda-half decades followed by the newly created instrument known as collateralised borrowing and lending obligations (CBLO). The purpose of the present discussion is to delineate the measures of reform along with the performance in some major areas of the Indian money market and to analyse whether the basic objectives behind the money market reforms have been achieved.

THE CALL/NOTICE MONEY MARKET(CNMM) Features While money borrowed or lent for one day is known as call money, money borrowed and lent for more than a day and for a maximum period of 14 days is known as notice money. All these transactions

The Money Market

do not involve collateral security. The participants are primarily the banks. The cash deficit bank borrows from a cash surplus bank in order to maintain a minimum cash balance which is known as the cash reserve ratio (CRR). The Reserve Bank influences liquidity in this market through direct intervention in the form of supplying funds to call money dealers and also conducting repo/reverse repo transactions. As mentioned earlier, that traditionally repo absorbed liquidity from the market and the reverse repo injected liquidity into the money market. But beginning from 29 October 2004, these two terms stand interchanged to conform to the international nomenclature. Now, repo injects liquidity in the money market and reverse repo absorbs liquidity from the market. The interest rate on call loans is known as call rate. It varies many times a day depending upon the supply of, and demand for, loanable funds or liquidity in the market. In practice, there are two call rates. While one is the interest rate charged by the Discount and Finance House of India (DFHI) on call loans, the other is the inter-bank call rate. These rates depend upon the liquidity conditions. When liquidity is at ease, the call rate tends to ebb. But when it is tight, the call rate moves up towards the bank rate. Similarly, if CRR is axed, liquidity improves and call rates plummet. In the reverse case, call rates climb up.

Measures of Reform The measures of reform in the call money market in the initial period concentrated, first, on pushing up the magnitude of turnover that was tiny during the pre-reform period and, second, on checking unwarranted oscillation in the call money rates. When these objectives were achieved to a moderate level, the emphasis lay on making the call money market a purely inter-bank market, integrating call money market with other segments of the money market and thereby on fostering a balanced development in all the segments of the money market. Fostering of transparency in the deals remained an important objective of reform. In the very early years of 1990s, some of the financial institutions, such as DFHI, The National Bank for Agriculture and Rural Development (NABARD), The Industrial Development Bank of India Limited (IDBI), were allowed to participate in the call money market. Money market mutual funds were set up in 1995 that began participating 125

India’s Financial Sector

in call money market. In FY 1996–97, the RBI permitted primary dealers (PDs) to act as a lender on behalf of fund surplus entities, although there was a limit to the size of such lending. With growing number of participants, the need for funds was easily met and the size of the transactions grew to a sustainable level. The average daily turnover soared up from Rs. 45.06 billion in FY 1991–92 to Rs. 194.92 billion during last fortnight of FY 1996–97 and to Rs. 236.13 billion during the last fortnight of FY 1997–98 (RBI 1999). It was as large as Rs. 364.58 billion during May 2001 (RBI 2001). When the size of turnover reached a sustainable level, the policy was designed to axe gradually the role of non-banking participants (except PDs) making ultimately the call money market an inter-bank market. The phasing out began from May 2001 when the non-bank participants were lending up to 85 per cent of average daily call lending. The percentage fell to 75 in June 2003, 45 in June 2004, 10 in June 2005 and 0 per cent by August 2005. The phasing out helped move the lenders and borrowers from the uncollateralised market to a collateralised one and reduce the lending exposure, especially in the non-collateralised CNMM. At the same time, it helped a balanced development between the call money market and the collateralised segments of the money market. In October 2002, the RBI laid prudential norms for the commercial banks’ lending and borrowing to limit their excessive reliance on the call money market. In fact, the purpose was to limit the exposure of financial transactions those banks had to face on account of excessive borrowing and lending. As per the norms, the scheduled commercial banks’ lending, on a fortnightly basis, was not to exceed one-quarter of their paid-up capital and reserves; however, on a daily basis, the percentage was set high at 50. Similarly, their borrowing was not to exceed 100 per cent of their owned funds on a fortnightly basis and 125 per cent of the owned funds on a daily basis. In February 2004, PDs were permitted to borrow up to 200 per cent of the net-owned funds, on an average in the reporting fortnight. Beginning from May 2005, the benchmark for fixing prudential limits on exposures to the CNMM in the case of scheduled commercial banks was linked to the sum of their Tier I and Tier II capital. Again, the other major objective of the reforms was to limit the unwarranted fluctuations in the call rates. Despite multiplicity of participants and growth in the turnover in the call money market, 126

The Money Market

wide fluctuations in the call money rate remained to continue as an obstinate problem. More often, it either slipped lower than the cut-off rates on 91-day auctioned T-bills or turned very high making the cost of the funds unusually big. In both the cases, it was not conducive to the money market as such. To be precise, the rates moved between a high of 86 per cent and a low of 1 per cent in FY 1992–93. The respective figures were 17 and 0.25 per cent for FY 1993–94 and 60 and 0.25 per cent during FY 1994–95 (GOI 1996). In April 1997, the RBI freed the inter-bank liabilities from reserve requirements so that the yield curve should be smoother and the fluctuation in the call rates would be limited. But that was helpful only to a limited extent. Thus, in April 1999, the interim Liquidity Adjustment Facility (LAF), based on the Narsimham Committee II recommendations, was introduced which was converted into a full-fledged LAF by June 2000. This scheme provided a mechanism for liquidity management through a mix of repos and reverse repos and direct intervention of the RBI in the call money market. To explain the phenomenon, when liquidity grows larger in the market, the call money rate tends to decline. Then reverse repo begins to absorb liquidity from the market and checks the call money rate from slipping down. But with the shrinkage in liquidity, call money rates start moving up. If they move beyond the desired level, repo begins to operate creating liquidity in the market and pushing down the call money rates. So the call money rates move up and down within the corridor created by repo and reverse repo. In case repo and reverse repo fail to influence the call money rate in a desired way, the RBI starts its direct intervention. Yet again the RBI tried to bring in transparency in the CNMM dealings. From May 2003, reporting of transactions in CNMM to the negotiated dealing system (NDS) within 15 minutes of the conclusion of transactions was made mandatory. From April 2005, the NDS members too were required to report their term money deals to the NDS platform. A screen-based negotiated quote-driven system for all dealings, developed by the Clearing Corporation of India Ltd (CCIL), was put into practice in September 2006.

Impact of Reform Measures The impact of reform measures can be analysed broadly in two ways. One is the growth in the turnover in CNMM and the other is the comparative stability in call money rates. As far as the turnover is concerned, 127

India’s Financial Sector

Table 7.1 shows the amount of average daily turnover during different months and also the annual average. The figures indicate no specific trend in the quantum of average daily sales on an annual basis. Broadly speaking, the quantum squeezed between Rs. 142 billion and Rs. 217 billion in the recent past over that in early 2000s when it was Rs. 294–351 billion. It denotes, among other things, that there has been an impact of the policy to shift the transactions from non-collateralised CNMM segment to the collateralised segment and thereby to encourage a balanced development among different segments of the money market. Again, an analysis of the monthly figures suggests a gradual stability in the average daily turnover on the monthly basis. It is because the instability expressed in terms of standard deviation of the monthly figures has tended to decline from 62.92 during FY 2002–03 to 26.19 in FY 2005–06, although marginally increased to 32.96 in FY 2006–07 and 42.14 in FY 2007–08. Turning from the quantum of turnover to the call money rates, one has to examine whether the rates have turned comparatively stable. Table 7.2 presents the figures of monthly average of call money rates during 2000s. Table 7.1

Average of Daily Turnover in the CNMM (Double Leg)

(Rs. billion) FY/Month 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 April May June July August September October November December January February March Annual Standard deviation

334.01 303.43 270.89 284.18 218.09 233.34 302.18 321.48 301.59 385.30 334.12 362.17 304.23 48.60

357.85 364.58 386.06 377.93 368.91 361.00 375.39 328.36 326.81 316.93 336.77 316.67 351.44 24.93

416.16 393.26 289.05 323.86 322.69 288.83 304.69 258.21 243.05 240.34 206.82 243.57 294.21 62.92

173.38 187.25 205.44 186.98 195.56 205.84 239.98 151.56 152.76 141.89 98.09 124.22 171.91 39.70

Source: RBI, Annual Report, various issues.

128

129.16 109.87 109.72 86.32 115.62 170.88 166.67 138.20 195.27 165.34 160.41 152.93 141.70 32.10

172.13 152.69 201.35 200.46 161.58 162.92 171.64 226.20 211.49 179.11 134.97 182.90 179.79 26.19

169.09 180.74 174.25 182.54 212.94 236.65 264.29 256.49 241.68 223.60 232.54 232.17 217.25 32.96

296.89 204.76 168.26 165.81 236.03 219.91 185.49 201.46 162.49 275.31 227.06 223.64 213.93 42.14

The Money Market Table 7.2

Average of Daily Call Money Rates

(%) FY/Month 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 April 6.79 7.49 6.88 4.87 4.29 4.77 5.62 8.33 May 7.48 8.03 6.90 4.87 4.30 4.99 5.54 6.96 June 11.08 7.24 6.04 4.91 4.35 5.10 5.73 2.42 July 7.77 7.19 5.75 4.90 4.31 5.02 5.86 0.73 August 13.06 6.94 5.72 4.83 4.41 5.02 6.06 6.31 September 10.32 7.30 5.75 4.50 4.45 5.05 6.33 6.41 October 9.07 7.40 5.73 4.64 4.63 5.12 6.75 6.03 November 9.28 6.97 5.45 4.38 5.62 5.79 6.69 6.98 December 8.76 7.08 5.58 4.40 5.28 6.00 8.63 7.50 January 9.89 6.63 5.66 4.43 4.72 6.83 8.18 6.69 February 8.51 6.73 5.71 4.33 4.76 6.93 7.16 7.06 March 7.78 6.58 5.86 4.37 4.72 6.58 14.07 7.37 Annual 9.15 7.13 5.92 4.62 4.65 5.60 7.22 6.07 Standard 1.749 0.408 0.475 0.240 0.417 0.795 2.370 2.212 deviation Source: RBI, Annual Report, various issues.

It is evident from the figures that the annual average of the monthly call money rates slipped from 9.15 per cent during FY 2000–01 to 4.65 per cent during FY 2004–05, although an upward move was evident during FYs 2005–07. In FY 2007–08, it was, however, 6.07 per cent compared to 7.22 per cent in the previous year. The downward move showed growth in liquidity in CNMM. The LAF showed positive results inasmuch as the oscillation expressed in terms of standard deviation of the average monthly rates reduced from a level of 1.749 during FY 2000–01 to less than 0.5 in the following four financial years. Joshi (2005) finds that it was the effectiveness of regulatory measures that helped improve the efficiency of the market functioning along with the growing participants in the repos market that led to stability in the call money rates. However, during FY 2005–06, it was a bit higher at 0.795. During FY 2006–07, the annual average and standard deviation were unusually high in view of the fact that there was a sudden soaring up of the rates in March 2007 on account of unusual tightening of liquidity on account of advance tax outflows, rise in credit demand and asymmetric distribution of asset holdings (government securities) across the banks. The rates and standard deviation, however, lowered to 6.07 per cent on an average and 2.212 per cent, respectively, during FY 2007–08 in view of eased liquidity mainly on 129

India’s Financial Sector

account of RBI’s intervention in the foreign exchange market buying US dollars.

COLLATERALISED BORROWING AND LENDING OBLIGATIONS Features Collateralised Borrowing and Lending Obligations (CBLOs) is the latest money market instrument developed by the CCIL for the benefit of those entities that have been phased out from making use of CNMM or those who have restricted participation in the CNMM. Introduced in FY 2002–03, it is a discounted instrument available in dematerialised form having a maturity of 1 day to 90 days, extendable to 1 year in very special cases. The instrument permits the borrower to keep the money for a specified period and then to return to the lender. The lender enjoys the privilege to transfer the authority to any other person to receive the lent money. The CCIL holds the collateral that is in form of central government security including also T-bills with a residual maturity of six months. The users of the instrument are banks and non-banking financial companies, financial institutions, insurance companies, PDs, mutual funds, corporates, and so on. The borrowing limit of the members is fixed daily taking into account the securities deposited by them in CSGL account. The securities are subject to mark-to-market valuation along with desirable haircuts. The borrowers indicate their funds requirements, maturity and the cap rate. The cap rate is the ceiling rate based on Mumbai Inter-bank Offer Rate (MIBOR). On the other end, lenders submit their bids. It is the CCIL that initiates the matching. If a borrower does not go to the auction market, it can use the normal market. The settlement of the deal is on T + 0 basis. The establishment of real time connectivity between public debt office of the RBI and the CCIL along with value-free transfer of securities between market participants and CCIL has eased the transactions.

Growth in Turnover Despite being comparatively a new instrument, it is doing well in the money market. As it is evident from Table 7.3, the annual average of 130

The Money Market Table 7.3

Average of Daily Turnover in the CBLO Market (Double Leg)

(Rs. billion) FY/Month April May June July August September October November December January February March Annual Standard deviation

2003–04

2004–05

2005–06

2006–07

2007–08

0.47 0.41 0.37 1.26 0.16 2.34 1.56 2.48 3.63 7.08 16.93 25.06 5.15 7.84

24.96 38.72 40.15 45.08 49.62 61.49 84.66 96.51 99.62 77.01 89.52 96.25 66.97 26.65

103.69 122.33 117.92 152.91 145.44 171.43 217.63 204.96 212.65 256.34 341.62 357.75 200.39 83.48

326.57 342.93 276.18 313.40 311.78 295.42 339.28 331.38 310.24 315.16 381.26 353.24 324.74 27.65

361.72 416.20 414.84 415.36 537.80 580.88 591.58 572.28 601.74 714.22 720.14 748.26 556.26 131.60

Source: http://www.rbi.org.in

daily turnover (double leg) skyrocketed from a bare figure of Rs. 5.15 billion in FY 2003–04 to Rs. 556.26 billion during FY 2007–08. One of the reasons for rapid growth in the turnover is that the rate in this market has been normally lower than that in the CNMM. But there is far greater variation in the monthly average—the standard deviation ranging between 7.84 and 131.60. The apparent reason is that it is a newly born baby. With maturity in the market, stability is expected to set in.

REPO MARKET OUTSIDE THE LAF There is a repo market even outside LAF. It was introduced in June 1995 enabling initially banks and PDs to trade in funds using T-bills as collateral. Subsequently, in March 2003, the non-SGL account holders, such as non-scheduled urban cooperative banks, non-banking financial companies, mutual funds, and the listed companies having gilt account with scheduled commercial banks were also allowed to operate. Besides, in order to enforce transparency in the system, reporting of all transaction on NDS and their settlement through CCIL was made mandatory. The infrastructure was also strengthened in March 2003 through prescribing uniform accounting norms for repo 131

India’s Financial Sector

and reverse repo transactions. Settlement on a net basis provided flexibility to the participants in managing their collateral. An electronic trading platform in addition to the voice-based system improved the transparency and the ease of transactions even further. In fact, it is an alternative to CNMM where money can be lent and borrowed. With the policy of limiting the participants to trade in CNMM, the volume of transactions tended to increase in this segment. From this viewpoint, Table 7.4 shows the volume of transaction in this segment since FY 2003–04. It is evident from the figures that there was consistent growth in transaction in this segment—the annual average of the daily transactions (all the legs) moving up from Rs. 104.35 billion in FY 2003–04 to Rs. 547.36 billion during FY 2007–08. However, in this case too, the monthly figures tended to fluctuate and variations expressed in terms of standard deviation witnessed an upward trend from 22.74 in FY 2004–05 to 141.39 in FY 2007–08. As far as the interest rate in this market is concerned, only annual figures are available. The average of the minimum and maximum rates ascended over the years—from 4.50 per cent during FY 2003–04 to 4.64 and 5.36 per cent, respectively, in two succeeding financial Table 7.4

Average of Daily Volume of Transaction (All Legs) in the Repo Market (Outside LAF)

(Rs. billion) FY/Month

2003–04

2004–05

2005–06

2006–07

2007–08

April May June July August September October November December January February March Annual Standard deviation

55.75 55.91 64.81 96.69 95.28 95.25 115.42 129.10 129.39 154.26 126.60 133.78 104.35 32.63

151.95 159.32 175.17 192.26 135.61 181.78 157.19 185.60 219.22 175.56 175.62 146.88 171.35 22.74

121.74 136.88 171.63 181.03 213.25 188.72 209.80 256.60 255.74 245.96 240.96 319.64 211.83 55.93

219.64 361.07 422.50 386.84 310.56 367.40 388.84 374.96 286.80 263.64 311.76 347.48 336.76 59.20

284.52 358.60 411.80 492.88 667.52 715.04 612.00 509.16 534.16 681.16 707.28 592.00 547.36 141.39

Source: http://www.rbi.org

132

The Money Market

years and 6.34 per cent during FY 2006–07. In FY 2007–08, it was 5.20 per cent.

THE COMMERCIAL PAPER MARKET Features Based on the Vaghul Committee recommendations, commercial paper (CP) was introduced as a money market instrument on the first day of January 1990. It is basically an unsecured promissory note normally issued at discount. It is negotiable and transferable through endorsement. As regards the issuer of the CP, it was initially a high-rated company that could issue CP to diversify its short-term borrowings. But since April 1997, the PDs too issue CP, and since October 2000 all-India financial institutions are also able to borrow through the issue of CP. The eligibility criteria of an issuer were also relaxed. From the very beginning, an issuer has to maintain a specific credit-rating awarded by the Credit Rating Information Services of India Ltd (CRISIL) or any other credit-rating agencies. Initially, credit-rating was stipulated at P1+ of the CRISIL but gradually it was softened to P2 or its equivalent by May 1992. Apart from the credit-rating, the CP-issuing companies were required to possess initially the tangible net worth of not less than Rs. 100 million which was relaxed gradually to Rs. 40 million by October 1993. To make this instrument popular, it was not only that the new issuers were brought into the ambit of CP but the denomination and maturity of CP too were made more flexible. Initially, the denomination of a CP was Rs. 2.5 million, but gradually, it was lowered to a present level of Rs. 0.5 million. Similarly, the initial maturity varied between 3 and 6 months from the date of issue. But from October 1993 onwards, the maturity was elongated to one year and beginning from May 1998, the other end of the maturity was shortened to 15 days and then in October 2004, to 7 days. Initially, the ceiling for the issue was represented by 20 per cent of the fund-based working capital which was stipulated at Rs. 250 million. But over the years, this ceiling was raised. In June 1996, it was raised to 100 per cent of the working capital. By October 2000, even this requirement was waived. The CP came to be issued as ‘standalone’ product. However, the size of the CP was to be approved by the 133

India’s Financial Sector

Board of Directors of the company. The financial institutions could fix up the size of the issue taking into account their overall borrowings from different sources. Turning from the issuer of the CP to an investor in the CP, it is evident that the individuals, banks and non-resident Indians (NRIs) are the investors from the very beginning. Subsequently, the foreign institutional investors were added to the list with specific conditions.

Stimuli to CP Market Besides variety of liberalisation measures enumerated above to encourage the CP market in the country, there were some other incentives too. They aimed at cutting the cost, fostering transparency and thereby generating confidence in the CP. The stamp duty on the issue of CP was reduced for both the banks and the non-banking entities. The rates varied for different maturities. Table 7.5 gives a brief view of the stamp duty structure. The figures show that the stamp duty is discriminatory against the non-banking entities. They have to face a higher rate of duty. It is also higher for longer maturities. In other words, the policy of the monetary authorities favours shorter maturity CPs and those concerning banks. Table 7.5

Stamp Duty on the Issuance of CP

(%) Banks Maturity period

Non-bank entities

Before March 2004

Since March 2004

0.05 0.10

0.012 0.024

0.125 0.25

0.06 0.12

0.15

0.036

0.375

0.18

0.20

0.05

0.5

0.25

0.40

0.10

1.0

0.5

Up to 3 months Above 3 months up to 6 months Above 6 months up to 9 months Above 9 months up to 12 months Above 12 months Source: http://www.rbi.org

134

Before March Since March 2004 2004

The Money Market

Again to make the deals transparent and to reduce the paper work, the investment in CPs beginning from June 2004 must take the dematerialised form. The outstanding investments were to be converted in (demat) form beginning from October 2001. Besides, the provision for guarantee for the non-bank entities has been initiated beginning from April 2003. Now the non-bank entities may provide unconditional and irrevocable guarantee for credit enhancement for the issuance of CP. However, the guarantor must fulfil the eligibility criteria which involve higher credit-rating and an adequate disclosure of the net worth, and so on.

Growth in the CP Market The introduction of CP received a good response. At the end of FY 1992–93, the outstanding amount was as big as Rs. 5.78 billion. The amount inflated further after reform measures were taken up during 1992 and 1993. The outstanding amount touched Rs. 32.64 billion by March 1994. But the momentum could not continue in the following years. The outstanding amount was as low as Rs. 0.76 billion at the end of March 1996. In fact, the issuance of CP depends primarily on the size of liquidity in the financial sector. Higher the liquidity, greater will be the issuance of CPs. So it was the tight liquidity in the market that came in the way of the fast growth in the CP market. In view of stagnated growth in the CP market, further liberalisation as mentioned above was initiated in the late 1990s. Those measures responded well. Table 7.6 presents the growth at greater length. The outstanding amount rose from Rs. 58.47 billion at the end of March 2001 to Rs. 325.92 billion by March 2008, except for a marginal drop during FY 2005–06. However, there were oscillations in the monthly figures on account of the fluctuating size of the issue and repayment. If one measures the oscillations, it is found to be increasing over the years beginning from FY 2001–02. The standard deviation measuring oscillations was as big as 91.21 during FY 2007–08 compared to barely 7.23 during FY 2001–02. Again, as far as the rate of discount is concerned, Table 7.7 presents the average of minimum and maximum of the discount rate during different months as well as their annual average. The figures reveal that the annual average plummeted consistently from 10.85 per cent in 135

India’s Financial Sector Table 7.6

Issue of CP (Outstanding Amount) during the 2000s

(Rs. billion) FY/Month April May June July August September October November December January February March Annual Standard deviation

2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 56.06 72.32 76.27 73.25 56.72 59.31 56.33 73.64 83.43 71.88 72.46 58.47

70.34 73.14 85.66 72.75 69.82 78.05 88.07 85.07 83.84 88.22 84.02 72.24

80.46 81.11 84.47 85.20 91.25 95.49 84.26 85.99 90.25 85.54 70.70 57.49

59.94 68.20 71.08 75.57 76.46 72.58 68.45 79.56 87.62 95.62 93.79 91.31

103.62 110.38 109.50 110.38 110.02 113.71 104.09 107.19 132.72 130.92 131.89 142.35

152.14 171.82 177.97 186.07 195.08 197.25 187.25 180.13 172.34 164.31 158.76 127.18

165.50 170.67 195.50 211.10 232.99 244.44 231.71 242.38 235.36 243.98 211.67 191.02

187.59 220.24 262.56 306.31 317.84 336.14 421.83 413.08 402.43 500.62 406.42 325.92

9.48

7.23

10.05

11.40

13.31

19.86

28.40

91.21

Source: http://www.rbi.org Table 7.7 Average of the Maximum and Minimum Discount Rates on CPs

(% per annum) FY/Month April May June July August September October November December January February March Annual Standard deviation

2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 10.80 10.35 10.33 10.80 11.03 11.40 11.82 11.04 11.38 10.99 10.15 10.13 10.85 0.53

10.55 10.07 9.45 9.26 10.38 8.70 8.65 8.64 9.43 8.58 8.60 8.75 9.26 0.73

9.35 8.82 8.95 8.03 7.24 7.88 7.21 7.10 6.98 6.83 7.72 6.90 8.50 0.87

7.45 7.44 6.50 6.62 5.65 5.65 6.38 5.37 5.70 5.32 6.05 5.60 6.14 0.74

5.50 5.7 5.35 5.91 6.15 5.78 6.10 6.05 6.10 5.73 6.54 6.23 5.95 0.34

6.08 6.02 6.04 6.38 6.48 6.05 6.57 6.27 6.10 5.73 6.54 6.23 6.21 0.25

8.01 7.79 7.85 7.28 7.80 7.83 7.88 8.82 8.75 9.38 10.00 10.43 8.49 0.99

10.52 9.87 8.93 7.05 8.30 8.95 7.65 9.45 9.27 11.83 9.73 10.38 9.20 1.30

Source: http://www.rbi.org

FY 2000–01 to 5.95 per cent in FY 2004–05, but then began moving up gradually to 9.20 per cent in FY 2007–08. Similarly, the monthly average of the discount rates showed wide fluctuations. The standard 136

The Money Market

deviation moved up from 0.53 to 0.87 during FYs 2000–03. However, the fluctuations could be controlled to some extent thereafter as the standard deviation fell gradually to 0.25 during FY 2005–06. But again, it moved rapidly to 0.99 during the following financial year and to 1.30 during FY 2007–08. An abrupt rise in standard deviation during FYs 2006–08 was mainly due to abrupt rise in discount rate during the later months. Apart from the size of the issue and the rate of discount, it is also interesting to know which sector of the economy or which types of companies are the major issuer of CP. It is found that over the years, the manufacturing companies have shown disinterestedness towards CP as their share descended from as high as 82 per cent in April 2001 to an average of 56 per cent during FY 2002–03 and further to 20.2 and 15.6 per cent, respectively, at the end of March 2005 and March 2006, although increased marginally to 17.4 per cent by March 2008. Internal accruals and better cash management among these companies were largely responsible for this trend. Also, the introduction of sub-PLR lending enabled them to raise funds from banks without making additional expenses on stamp duty, and so on. Besides, easy availability of external commercial borrowing often at cheaper rates made them disinterested towards CP. With squeezing share of manufacturing companies, the share of leasing and finance companies increased from a bare of 17 per cent in April 2001 to an average of 29 per cent in FY 2002–03 and as large as 76.5 per cent at the end of March 2008. Again, the financial institutions have improved their share in recent past primarily because of the RBI guidelines exempting CP from the purview of banks’ investment in non-SLR securities. The respective share of the financial institutions rose from around 3 per cent in FY 2001–02 to 25 per cent in FY 2003–04, although slumped to 6.1 per cent at the end of March 2008 (RBI 2008a).

MARKET FOR CERTIFICATES OF DEPOSIT Features Certficates of Deposit (CD) is a negotiable instrument. Beginning from June 2002, it is issued in a dematerialised form to evidence a deposit that is returned to the investor along with interest within a specified 137

India’s Financial Sector

maturity. By October 2002, all then existing CDs were converted into demat form. If the investors wish to get CD in physical form, they can ask the issuer to do so. It is issued by scheduled commercial banks and select financial institutions to raise short-term resources. Banks with no large branch networks and no large deposit base use this instrument to raise funds. The investors or the subscribers to the CD are individuals, corporations, banks, companies, trusts, funds, associations and the NRIs. It is issued to the NRIs on a non-repatriable basis and cannot be endorsed to another NRI in the secondary market. There is no lock-in period for endorsement in other cases. In order to make the CD market attractive, the denomination was lowered to Rs. 0.1 million in June 2002. The banks have the freedom to issue CD up to any amount in the multiple of Rs. 0.1 million depend-ing upon the financial need. However, there is a ceiling in case of the financial institutions. Their total borrowing from the money market including CD must not exceed 100 per cent of their netowned funds. The maturity varies between 7 days and 1 year from the date of issue, but in majority of the cases it is 90 days. The financial institutions can issue CD for a period ranging between one year and three years. This instrument is highly secure. From the point of risk, it is only next to T-bills. A CD is issued at a discount to the face value, the discount rate being negotiated between the issuer and the investor. Beginning from FY 2002–03, banks and FIs can also issue floating rate CD. But in that case, interest rate is to be periodically reset based on a predetermined formula that indicates the spread over a transparent benchmark. Banks have to maintain the appropriate reserve requirements, such as CRR and SLR. The issuers can neither grant loans against CDs nor buy back their own CDs before maturity. In order to make CDs even more attractive, stamp duties were reduced in March 2004. Moreover, premature closure of CDs vis-à-vis other competing instruments was disallowed. This was in the interest of, especially, the mutual funds that used to invest in this instrument in a large measure. Some of the banks started rating of CDs even if it was not mandatory. It raised further the quality of this instrument.

Trend in the CD Market With various stimuli provided to the CD market, there has been a definite uptrend in the size of the CD issues. As evident from Table 7.8, 138

The Money Market Table 7.8

Issue of CDs: The Outstanding Amount during the 2000s

(Rs. billion) FY/ Month April May June July August September October November December January February March Standard deviation

2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 12.73 9.45 10.41 12.11 11.49 11.53 16.95 16.26 11.35 11.97 11.87 7.71 2.55

9.05 9.35 9.21 7.51 7.57 7.36 7.86 8.76 8.39 10.08 12.92 15.76 2.49

13.93 13.60 13.59 13.03 10.07 12.36 13.94 12.19 11.63 12.26 11.25 9.08 1.54

14.85 47.25 19.96 48.60 21.83 54.38 24.66 54.78 29.61 44.80 30.98 51.12 33.21 47.85 36.66 61.18 38.30 61.03 44.19 42.36 46.56 92.14 44.61 120.78 10.38 23.05

166.02 176.89 192.70 207.68 235.68 276.41 291.93 274.57 328.06 345.21 344.87 435.68 81.48

440.59 502.28 563.90 591.67 656.21 652.74 657.64 689.11 686.19 701.49 727.95 924.68 121.96

959.80 997.15 983.37 1,053.17 1,092.24 1,184.81 1,242.32 1,271.43 1,234.66 1,291.24 1,391.60 1,477.92 166.65

Source: http://www.rbi.org

from a bare figure of Rs. 7.71 billion at the end of March 2001, the outstanding amount surged up to Rs. 1,477.92 billion by March 2008. However, there were wide variations in the monthly figures. It is not only that the net size of the CD issue did fluctuate, also that there were variations in the discount rate. The annual average of the discount rates, shows Table 7.9, tended to ebb from 9.71 per cent in FY 2000–01 to 5.01 per cent in FY 2004–05 but then moved up to 7.79 per cent in FY 2006–07 and to 8.94 in FY 2007–08. The monthly figures were more volatile. The standard deviation measuring volatility varied between 0.38 and 1.36. The reason is the changing status of liquidity in the market.

OVERALL TREND IN THE INDIAN MONEY MARKET After delineating the process of reform as well as performance in the major components of the Indian money market, it would be worth examining whether the primary objectives of the money market reforms have been achieved. The primary objectives as stated in the very beginning of the reform era are: 139

India’s Financial Sector Table 7.9

Average of the Maximum and Minimum Discount Rates on CDs

(% per annum) FY/Month 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 April May June July August September October November December January February March Annual Standard deviation

10.25 10.41 11.85 9.75 11.30 10.75 9.53 9.89 9.38 7.80 8.05 7.52 9.71 1.36

8.75 8.25 7.75 7.75 8.25 8.00 7.87 7.90 7.25 7.80 8.05 7.53 7.93 0.38

7.94 7.64 7.70 7.50 6.75 6.87 6.60 6.59 6.60 5.67 6.12 6.18 6.58 0.71

6.33 5.62 5.50 6.33 5.16 5.13 5.38 5.38 5.00 4.89 4.86 4.37 5.33 0.57

4.87 2.91 5.35 5.38 5.52 4.92 4.62 5.45 5.47 5.08 5.29 5.28 5.01 0.72

5.35 5.52 6.49 5.62 5.83 6.07 6.21 6.38 6.30 6.08 6.26 6.65 6.06 0.40

7.45 7.58 6.83 7.40 7.61 6.55 6.63 6.63 7.45 8.77 9.62 10.90 7.79 1.33

10.55 9.87 9.37 7.86 8.67 8.57 7.91 8.48 8.81 8.82 9.94 10.00 8.94 0.87

Source: http://www.rbi.org

1. Strengthening of the very infrastructure by encouraging the use of the existing instruments and by creating new instruments. 2. Facilitating balanced development among different segments and thereby reducing exposure in the uncollateralised CNMM. 3. Fostering stability through checking unwarranted fluctuations in the interest/discount rates in different segments. 4. Fostering integration among different segments. Let us take up these objectives one by one. As far as the strengthening of the infrastructure is concerned, the CP and the CDs were restructured and the discount rates in respect of them were made more responsive to the market forces so as to make these instruments attractive. The introduction of another instrument, known as CBLO during FY 2002–03, contributed still more to the liquidity needs of the borrowers. The payment/settlement infrastructure was strengthened with the formation of the NDS in February 2002 and the CCIL in April 2002. The real time gross settlement system was implemented in April 2004. All these made a positive impact on the volume of transactions in the money market. As already mentioned, the outstanding amount of CP moved up from Rs. 58.47 billion at the end of March 2001 to 140

The Money Market

Rs. 325.92 billion at the end of March 2008. The respective figures for CDs were Rs. 7.71 billion and Rs. 1,477.92 billion. Again, the average daily transactions including both legs in the CBLO segment galloped up from Rs. 5.15 billion during FY 2003–04 to Rs. 556.26 billion during FY 2007–08. The respective figures in the repo market outside the LAF (all legs) were Rs. 104.35 billion and Rs. 547.36 billion. Thus, it would not be wrong to say that strengthening of the money market infrastructure met to a large extent the growing liquidity needs of the short-term borrowers. However, the large-scale oscillations in the monthly figures of transactions failed to promise desired stability. Second, with a view to reducing exposure in the non-collateralised CNMM, the reform measures stressed shifting of participants from the CNMM to the collateralised segment. This shift led also to a balanced growth of the different segments of the money market. Table 7.10 presents the volume of transactions in four compartments of the money market, namely, CNMM, CBLOM, term money market and the repo market outside the LAF. It may be noted that the term money market has not been discussed earlier at greater length in view of tiny volume of transactions in it. The figures show that the share of the CNMM in the transactions in all the four segments taken together reduced consistently from 57.9 per cent in FY 2003–04 to 20.4 per cent during FY 2007–08. The shift of transactions from CNMM was more pronounced in favour of the CBLO market where this percentage rose from 3.5 to 52.9 during the same period. The term money market did not attract the transactions insofar as the companies preferred cash credit to ‘loan’ credit; moreover, any smooth rupee yield curve was absent to provide an anchor Table 7.10

Share of Different Segments in Money Market Transactions

(Rs. billion) Average volume of daily transaction (single leg) Call money market 2003–04 2004–05 2005–06 2006–07 2007–08

CBLO market

Term money market

Repo market (outside LAF)

Amount % share

Amount % share Amount % share Amount % share

85.96 70.85 89.90 108.63 106.97

5.15 33.49 100.20 161.95 278.13

57.9 47.3 36.4 30.2 20.4

3.5 22.4 40.5 45.0 52.9

Source: http://www.rbi.org.in

141

5.19 2.63 4.17 5.06 3.52

3.5 1.8 1.7 1.4 0.7

52.18 42.84 52.96 84.19 136.84

35.1 28.6 21.4 23.4 26.0

India’s Financial Sector

for expectations for long tenor. The share of the repo market too did not fare well. Nevertheless, the collateralised segments accounted for 80 per cent of the transaction during FY 2007–08 compared to around 42 per cent during FY 2003–04, thereby reducing significantly the size of exposure in the CNMM. Third, with a view to curbing of the fluctuations in the interest rate, especially in the CNMM and thereby transfusing stability in the market, the reform measures, as stated above, were aimed at making necessary adjustments in the liquidity status. In this context, repo and reverse repo under LAF have played a crucial role. Figure 7.1 shows as to how the two processes were able to confine the call money rates normally within the tunnel provided by them. It is true that the daily call money rates present a slightly different picture, yet the monthly average of call money rates remained comparatively stable except for unusual and all-of-a-sudden fluctuation during March, June and July 2007. To anatomise it further, in all, out of 36 months between April 2005 and March 2008, there were only 6 months when the call money rates were lower than the reverse repo rates and in other 6 months, they had crossed over the repo rates. In the rest 24 months, they were moving in between the reverse repo and repo rates. Reforms have thus ensured stability on this count in a considerable measure. Figure 7.1 Movement in Repo/Reverse Repo and Call Money Market Rates

142

The Money Market

Last but not least, the reform measures have helped bring the different segments closer to one another. This sort of integration is significant for the strength of the Indian money market as a whole. As far as the integration is concerned, the study of Bhoi and Dhal (1998) covering the period up to 1997 revealed that there existed a fair degree of convergence of interest rates among the short-term money markets, credit and gilt markets. Similarly, the study of Jena et al. (2004) unravelled that there was a high degree of co-movement in the call money rates as well CD rates and 3-month forward premium. There was also co-integration between credit market rates and various money market rates. The incorporation of the latest data up to FY 2007–08 does not change the above findings. Using a very simple tool of correlation, there is found strong positive correlation between the interest rates/discount rates prevailing in the different segments over the years. Table 7.11 presents these correlations based on monthly figures, mentioned in earlier sections, during FYs 2000–01, 2006–07 and 2007–08. The figures indicate a strong positive correlation coefficient that has turned stronger over the years meaning greater integration during different segments. In case of CNMM/CP market, the correlation coefficient moved up from 0.257 in FY 2000–01 to 0.788 in FY 2006–07. Similarly, in case of CNMM/CD market, it went up even more from 0.064 to 0.775 during the respective period. Again, in case of CP market/CD market, it improved, if not so much, from 0.677 to 0.838 during the above period. A comparative figure is not available for integration between the CNMM rates and the repo market rates. Nevertheless, a high degree of correlation coefficient at 0.995 is indicative of a really very sound money market. In FY 2007–08, there was witnessed a slightly lower correlation coefficient. Nevertheless, it was high enough to show high degree of integration. In all, the reform measures in the Indian money market have made a positive contribution. Table 7.11

Correlation Coefficient among Interest/Discount Rates in Different Segments

Market segments CNMM/CP CNMM/CD CP/CD CNMM/repo marketa

FY 2000–01

FY 2006–07

FY 2007–08

0.257 0.064 0.677 0.995

0.788 0.775 0.838 0.9683

0.6262 0.4848 0.6480

Note: aCalculation on the basis of annual average between FYs 2003–04 and 2006–07.

143

8

The Foreign Exchange Market

Any discussion of reforms in the Indian financial market cannot be complete without a reference to the foreign exchange market insofar as the activities in the two markets are quite interdependent. The present chapter, therefore, makes a survey of the reform measures and analyses their possible impact, more particularly in terms of growing turnover and the generation of stability in the foreign exchange market.

THE PROCESS OF REFORM The adoption of floating exchange rate system in 1993 and the resultant exchange rate risk needed a variety of hedging activities. Again, after convertibility on merchandise trade transactions since March 1993 followed by full current account convertibility by August 1994, the government appointed the Expert Group on Foreign Exchange Markets in India, commonly known as the Sodhani Expert Group, which submitted its recommendations in 1995. Many of the recommendations were implemented, such as integration of the domestic foreign exchange market with the external foreign exchange markets, greater operational freedom for the dealing banks and widening and deepening of the market with variety of the activities and also broadening of the infrastructure. In all, there were 25 major recommendations, out of which 20 were implemented. Yet again, beginning from FY 1997–98, with a gradual move to free capital account transactions from the exchange control provisions, the government took up ample measures to reform the foreign exchange market. After around a decade, the Internal Technical Group

The Foreign Exchange Market

on Foreign Exchange Market was constituted to review the situation and to recommend steps needed for further reform. All this needs to be discussed at some length.

Introduction of Managed Floating Exchange Rate Regime Keeping in mind perhaps the concept of ‘Impossible Trinity’ (Mundell 1961) that the fixed exchange rate regime was not in a position to cope up with the fast changing scenario in the country’s external sector environment, the High Level Committee on Balance of Payments, commonly known as the Rangarajan Committee (1992), suggested a dual exchange rate system or a mix of official and market rates at least for a year before finally stepping into a managed floating exchange rate system in March 1993. The managed float involved essentially RBI’s intervention in the foreign exchange market either directly through the purchase and sale of US dollars or indirectly through making changes in the repo rate and the resultant size of liquidity in the monetary and financial system. It is true that the new system of exchange rate along with reforms in trade and investment policies helped boost up trade and investment (Sharan and Mukherji 2001), but the oscillations in exchange rate at times was not completely ruled out. As regards the movements in the exchange rate, Table 8.1 shows that the annual average value of rupee vis-à-vis US dollar tended to depreciate all along from 31.37 in FY 1993–94 to 48.40 in FY 2002–03, although then appreciated moving in the range of 44.26 and 45.95 during FYs 2003–07. In FY 2007–08, rupee appreciated at a rapid pace making an average of 40.24 a dollar. Table 8.1

FY 1993–94 1994–95 1995–96 1996–97 1997–98

Rs./US$ Exchange Rate

Rs./US$ (average)

FY

Rs./US$ (average)

FY

Rs./US$ (average)

31.37 31.40 33.45 35.50 37.17

1998–99 1999–2000 2000–01 2001–02 2002–03

42.07 43.33 45.68 47.69 48.40

2003–04 2004–05 2005–06 2006–07 2007–08

45.95 44.93 44.26 45.25 40.24

Sources: 1. RBI, Annual Report, various issues. 2. RBI, Reserve Bank of India Bulletin, various issues.

145

India’s Financial Sector

Probing still deeper, it is found that the standard deviation of daily spot rate remained confined to a level of 0.04 to 0.1 till FY 2001–02. In fact, the exchange rate oscillations to such a low degree led some of the experts to analogise the managed floating regime in India with a fixed exchange rate regime for all practical purposes (Baig 2001; Patnaik 2003). Rakesh Mohan (rbi.org) has also presented the coefficient of variation (CV) of daily spot rate beginning from March 1995 to March 2007 and is of the view that instability in the daily spot rate was confined between 0.1 and 0.3 except for March 1995, March 1996 and March 2004 when it was 2.5, 1.8 and 1.1, respectively. Managed float, by its very nature, could not avoid exchange rate risk and the resultant forward trading to hedge the risk. Forward rates are expected rates in the future. The literature on the issue whether, or not, the forward rate is an unbiased indicator of future spot rate is vast (Edwards 1982; Hansen and Hodrick 1983; Kohlhagen 1975). Again, there are many studies to show that widening/narrowing of interest rate differential has influenced the forward exchange rate of Indian rupee (Chakrabarti 2006; Patnaik et al. 2003; Sharma and Mitra 2006). Their discussion lies outside the scope of this book. Nevertheless, it can be said that the average discount on forward rate of rupee—both 3 and 6 months—was about 4 per cent per annum between late 1997 and mid-2004. To be more precise, it was 3.7 per cent for 3-month forward and 3.8 per cent for 6-month forward (Chakrabarti 2006). From June 2004 onwards, forward premium was evident that was as high as 3 per cent by August 2004 but then it tended to decline to less than 2 per cent by June 2005 and further to less than 1 per cent by October 2005. At the close of FY 2005–06, it ascended again to over 3 per cent but then shrank to less than 1 per cent by July 2006 (RBI 2006a). During FY 2006–07, the forward premia increased reflecting growing interest rate differential in view of increased domestic interest rates. In March 2007, 1-, 3and 6-month premia were, respectively, 7.30, 5.14 and 4.40 per cent. In fact, it was because of the changes in the macroeconomic variables that the spot rates and the forward rates tended to oscillate. In FY 2007–08, because of continuous off-loading of forward position by the exporters, 1-, 3- and 6-month forward premia tended to decline and reached, respectively, 3.45, 2.75 and 2.50 per cent. 146

The Foreign Exchange Market

Structural Reform Besides rationalising the exchange rate structure, there was a move to strengthen the very structure of the foreign exchange market. The responsibility and authority of foreign exchange transaction, as we all know, is vested with the RBI. But for its own convenience, the RBI has delegated its responsibility of foreign exchange transaction function to three types of authorised dealers (ADs): scheduled commercial banks as AD Grade I, regional rural banks and authorised money changers as AD Grade II and specific financial institutions as AD Grade III. ADs have formed the Foreign Exchange Dealers’ Association of India which frames rules regarding the conduct of business and coordinates with the RBI in the proper administration of the rules and regulations. Prior to the introduction of the Liberalised Exchange Rate Management System in March 1992, ADs had to sell foreign currency acquired by them from the primary market to the RBI at the rate administered by the latter. The RBI too sold British pound and US dollar, spot and forward, to ADs to cover their primary market requirements. But from the beginning of March 1993, the ADs could square their position easily through transactions with other banks. Moreover, the RBI started intervening in the market selling and purchasing US dollar to stabilise the exchange rate. In 2002, in the sequel of the coming up of euro in the European Economic and Monetary Union countries, the Indian government gave option to the RBI to use euro as an intervention currency in addition to US dollar. Besides, the inter-bank market where ADs transact business among themselves and also with overseas banks to cover their own position—long and short—emerged as the most vital organ of the foreign exchange market. Looking back to 1978, when the government had allowed banks to undertake intra-day inter-bank trading in foreign exchange and the stipulation of maintaining square or nearsquare position was to be complied at the close of the business hours everyday, one could notice a sea change now. The inter-bank tier of the market is responsible for over threefourths of the total foreign exchange transactions. Within the country different currencies are transacted, but for the lack of depth in many currencies in the market, only British pound and US dollar are used for overseas transactions. Following the recommendations of the Sodhani Expert Group, efforts were made to standardise the 147

India’s Financial Sector

transactions in this segment of the market. Internationally accepted documentation standards were prescribed, comprehensive risk management guidelines for banks were issued and Basle Committee norms for computing foreign exchange position were adopted. Beginning from FY 2005–06, ADs were allowed to open foreign currency account for the project offices abroad and for intermittent remittances by the project offices. Foreign banks operating in India were allowed to hedge their Tier I capital in Indian books without any restriction on timing of the hedge transactions. The ADs transact also with the ultimate customers. The very existence of this tier is the outcome of the legal provision that all foreign exchange transactions of the Indian residents must take place through ADs. In order to ease the access of the ultimate customers to the foreign exchange transactions, additional entities were allowed in FY 2005–06 to handle non-trade-related current account transactions. These entities are full-fledged money changers, urban cooperative banks and regional rural banks that remit/release foreign exchange for the transactions like private visits, business travel and the travel for international events and medical treatment. Detailed guidelines were issued to make spot and forward market transactions easier for these ultimate participants in the market. In FY 2000–01, the RBI installed ‘Helpline’ at some of its offices with exclusive electronic media arrangements to provide necessary clarification to the public on enquiries relating to foreign exchange transactions. Customer service meetings began to be held every quarter at the RBI’s regional offices. The banks were asked to provide immediate facilities for encashment of foreign currency at many locations, especially related to non-trade current account transactions. Steps were taken to facilitate integration between money market and the foreign exchange market. One of such major steps was that the interest rate implied in the foreign exchange market began to be used as a benchmark for forward rate agreements and interest rate swaps. For the clearing and settlement of inter-bank dollar–rupee transactions, the Clearing Corporation of India Limited (CCIL) was set up that offers multilateral netting mechanism. As central counterparty guaranteeing trade settlement, it interposes as a buyer in a defined trade though a process called novation, thereby giving rise to two contracts from the single original contract between the two parties. Live operations began in this respect from November 2002. While the 148

The Foreign Exchange Market

US dollar leg of transaction is settled through CCIL’s account with its settlement agent in the US, the rupee leg is settled through the member bank’s account maintained with the RBI. This way banks get substantial cost and time benefit concerning clearing and settlement of rupee–dollar transactions. CCIL has also launched its foreign exchange trading platform (FX CLEAR) to settle the foreign exchange transactions even more smoothly. As per the recommendations of the Technical Group on the Foreign Exchange Market, the timing for inter-bank transactions was extended by one hour to 5 p.m. effective from 16 May 2005, to cope up with large amount of the transactions.

Introducing Multiplicity of Activities Foreign exchange transactions in India began with the spot transactions that take place nowadays at different platforms. The transactions for US$1 million and above take place at D 2 Platform and Reuters Market Data System. The IBX has also launched a platform known as FX Direct. However, majority of the transactions are carried out at the FX CLEAR set up by the CCIL in 2003. Forward transactions carried out either over the counter or through market brokers were made more effective. They cannot normally exceed 6 months. However, in case of deferred-term payments where the maturity exceeds 6 months, the period can be extended with the RBI’s approval. Banks face no restrictions on squaring their position, although forward dealing with the overseas banks/branches must cover only genuine transactions. Cancellation of the forward contract is now allowed up to a specific limit, although such cases need to be referred to the RBI. The cancellation involves entering into a reverse transaction at the going rate. The RBI has allowed ADs to re-book cancelled forward contracts falling due within 1 year. The re-booking of forward contracts earlier was possible only in case of export transactions. But from April 2002, re-booking of forward contracts has been extended to all types of transactions. In FY 2001–02, the exporters/importers were allowed to book forward contract subject to a ceiling of US$50.0 million or equivalent. But since November 2004, the ceiling is based on their past 3-year turnover. Companies with genuine exposure are allowed to approach the RBI for booking of forward contracts 149

India’s Financial Sector

even beyond the cap. Contracts booked in excess of three-quarters of the eligible limit have to be on a deliverable basis. Since FY 2007–08, forward contracts are booked also for hedging currency risk on account of overseas direct investment. Such contracts are now available also to small and medium enterprises and resident individuals under specific conditions. Apart from the forward contracts, the currency options contracts were also allowed. Beginning from FY 1993–94, the banks could write cross-currency options for their customers by resorting to arrangements with their overseas branches/other banks abroad. Since July 2003, the banks with a minimum risk-adjusted asset ratio of 9 per cent can go for foreign currency-rupee options on a back-to-back basis for long-term exposure in foreign currency. They are allowed to run an options book after obtaining one-time approval from the RBI. Since April 2007, the cross-currency options are available also to Indian exporters and importers with crystallised foreign currency exposure. Despite these facts, options are not used widely. The reason is that the banks do not prefer it. The options market is liquid only to a limited extent as the offer bid spread in this case is quite wide. The ADs are allowed, since FY 2002–03, to undertake foreign currency–rupee swaps with residents with unlimited hedging of exchange rate/interest rate risk. But limits have continued to exist for swap transactions which allow customers to assume a long-term foreign exchange liability. The banks swap foreign currency nonresident deposits or deposits with exchange earners’ foreign currency account to raise rupee resources. The cross-currency swaps are available to hedge currency/interest rate risk in the context of external commercial borrowings. However, the ADs have been advised against offering of swaps involving leveraged structures. Beginning from FY 2005–06, ADs do not require approval of the RBI for issuing store value cards/charge cards/smart cards to the residents travelling abroad within a prescribed limit.

Permitting Reasonable Doses of Capital Account Convertibility Although full convertibility on current account was introduced and the policies relating to foreign direct investment in India and India’s 150

The Foreign Exchange Market

investment abroad were made much more liberal, there was need to introduce capital account convertibility (CAC) to provide stimuli to the foreign exchange market activities. Fortunately, the Tarapore Committee (1997) came out with a comprehensive blueprint for CAC that was to be attained in a phased manner within 3 financial years beginning from FY 1997–98. The committee suggested for controlfree movement of capital in specified cases at the level of an individual, a company and banks depending upon the fulfilment of some macroeconomic preconditions related to fiscal, monetary, financial and external sector disciplines. The government implemented most of its recommendations. As early as in October 1997, the government liberalised gold import, project exports and also the norms relating to the exchange earners’ foreign currency account and funds flow in, and out of, money and capital market. The process slowed in the wake of the Asian Crisis; nevertheless, the move towards CAC continued to exist in the following years. Every year in the continuum, the capital account transactions turned more and more liberal. To mention a few examples, foreign branches were allowed to remit profits. The ADs in the foreign exchange market were provided a bigger room to play. The Indian companies were allowed to make use of commercial paper (CP) for borrowing from abroad and also to acquire foreign companies. The country’s investment abroad as well as the foreign institutional investors’ (FIIs’) investment was further liberalised. The Indian banks were allowed to invest in money markets abroad. The multilateral institutions, such as the International Finance Corporation or the Asian Development Bank, were allowed to float rupee bonds in India and to buy dated securities. The conversion of the external commercial borrowing into equity and the transfer of shares from a resident Indian to a non-resident one were permitted. In fact, these are some of the examples. Many more such steps were taken to move on to CAC that helped multiply the need for foreign exchange transactions. More recently, in July 2006, the Committee on Fuller Capital Account Convertibility suggested for still a bigger move—to achieve CAC in three stages by 2011. Reviewing then existing macroeconomic fundamentals, the committee detailed a broad 5-year time framework for movement towards fuller convertibility in three phases ranging from FY 2006–07 to FY 2010–11, subject to meeting of specific targets. The targets are related primarily to fiscal reform and budget management. To be specific: 151

India’s Financial Sector

1. It is the management of public sector borrowing requirements, the responsibility of which should lie in the hands of the Office of the Public Debt. 2. It requires banking sector reforms, especially reducing government stake in the public sector banks. 3. There should be greater autonomy and transparency in the conduct of the monetary policy. 4. The current account deficit/gross domestic product (GDP) ratio should be maintained under 3 per cent. 5. Foreign exchange reserves should be adequate from the viewpoint of not only import but also the liquidity risk related to the capital flows. The committee recommended for: 1. Raising of ceiling, and abolishing of restrictions on the enduse, of external commercial borrowings including those under automatic approval scheme; 2. Monitoring of import-linked short-term loans; 3. Raising of the ceiling on corporate overseas investment in phases from 200 to 400 per cent of the net worth; 4. Allowing EEFC account holders to access foreign currency accounts with cheque facility; 5. Prohibiting FIIs from investing funds raised through participatory notes; 6. Allowing non-resident corporates to invest in stock markets and 7. Raising the annual limit for remittances abroad in phases from US$2.0 billion to US$5.0 billion (RBI 2006b). The Indian government accepted most of the suggestions and implemented many of them. As a result, there was a sizeable, stable growth in ECBs. The current account deficit/GDP ratio was well maintained. However, the turmoil in the financial sector following the US sub-prime crisis may prove a hurdle on moving faster towards CAC.

Ensuring Stability in the Market Along with strengthening of the very structure of the foreign exchange market and introducing variety of activities therein, steps were taken 152

The Foreign Exchange Market

for ensuring stability in the foreign exchange turnover. In fact, the issue of financial stability attained significance in the late 1990s in view of keeping at bay the spillover effects of the turbulence in the South-east Asian financial markets and also the deepening of the financial crisis in Russia. The RBI announced a set of policy measures in June 1998. These measures emphasised on the RBI’s role of meeting mismatches between the demand and supply of foreign currency through market intervention, allowing the FIIs to manage their exchange rate exposure through undertaking foreign exchange cover on their incremental investment, advising traders and banks to monitor their foreign currency position and allowing domestic financial institutions to buy back their debt from international financial market. Foreign Exchange Management Act (FEMA) replacing the Foreign Exchange Regulation Act came into force from 1 June 2000. It aimed at promoting an orderly development and maintenance of the foreign exchange market in India. The Act provided for transparent norms relating to the RBI’s approval for acquiring and holding of foreign exchange and the limits to which foreign exchange could be made admissible to current/capital account transactions from the viewpoint of full current account convertibility and growing convertibility on capital account. In fact, it is the very macroeconomic policy, especially the monetary measures and the administrative measures that have helped ensure stability in the foreign exchange market through influencing the supply of, and demand for, the foreign currency. For example, when normal capital inflows faltered, the State Bank of India raised US$4.2 billion through the issue of Resurgent India Bonds during August 1998 and another US$5.5 billion through the issue of India Millennium Deposits during October to November 2000. However, the RBI’s role in form of market intervention has been the most significant one. It has already been mentioned how RBI intervenes in the foreign exchange market but it needs some more details about the extent of intervention. Looking at the figures in the recent past in Table 8.2, it is evident that the amount of the purchase of foreign currency ranged between US$15,239 million and US$55,418 million annually during FYs 2000–06. Similarly, the sale of foreign currency varied between US$7,096 million and US$24,940 million during this period. The FY 2006–07 was singular in the sense that the RBI bought US dollars and never sold them. The quantum of purchase was US$26.824 billion 153

India’s Financial Sector Table 8.2

RBI’s Purchase and Sale of Foreign Currency during the 2000s

(US$ million)

Year

Purchase

Sale

Net (purchase–sale)

RBI intervention as % of turnover in foreign exchange market

2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

28,202 22,822 30,639 55,418 31,398 15,239 26,824 79,696

25,846 15,668 14,927 24,940 10,551 7,096 — 1,493

2,356 7,154 15,712 30,478 20,847 8,143 26,824 78,203

3.9 2.7 2.9 3.8 1.4 0.5 0.4 0.7

Sources: 1. RBI, Annual Report, various issues. 2. RBI Bulletin, various issues.

that helped check at least to some extent the rupee from appreciating. In FY 2007–08, the quantum of the purchase of US dollars was for larger than in the preceding financial year. It amounted to US$79.696 billion. However, it was followed by a small amount of sale of US dollar that had stood at US$1.493 billion. As a ratio of turnover in the foreign exchange market, the size of intervention varied between 3.9 and 0.4 per cent during FYs 2000–08. All this shows that the RBI has taken pains to avoid mismatches between demand and supply of foreign currency in the market and thereby to bring in stability in the exchange rate. Unnikrishnan and Mohan (2003) probe deeper into this issue and find that beginning from January 1996 to March 2002, the RBI adopted a ‘leaning against the wind’ approach which is evident from a negative correlation between the exchange rate and net dollar purchases. It thereby stressed more on checking volatility in the foreign exchange market rather than simply checking appreciation/ depreciation of the currency.

THE IMPACT OF THE REFORM MEASURES Increasing Turnover of the Transactions Let us first look at the size of turnover. Table 8.3 and Figure 8.1 present the magnitude of transactions in both the merchant segment and the inter-bank segment during 2000s. The turnover of the 154

The Foreign Exchange Market Table 8.3

Turnover in the Indian Foreign Exchange Market

(US$ billion) Turnover Financial year 1 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Merchant segment

Inter-bank segment

Total

% change over previous year

2

3

4

5

269.442 256.836 324.560 485.324 704.533 1,220.451 1,787.000 3,647.306

1,117.716 1,165.296 1,235.609 1,610.397 2,187.582 3,192.256 4,727.000 8,669.061

1,387.158 1,422.132 1,560.169 2,095.721 2,892.115 4,412.207 6,514.000 12,316.367

— 2.52 9.70 34.3 37.98 52.56 47.64 89.08

Source: http://www.rbi.org Figure 8.1

Turnover in the Indian Foreign Exchange Market

merchant transactions rose from US$269 billion in FY 2000–01 to US$3,647 billion in FY 2007–08. The corresponding figures for the inter-bank segment were US$1,118 billion and US$8,669 billion. This means that the turnover in both the segments taken together hiked from US$1,387 billion in FY 2000–01 to US$12,316 billion during FY 2007–08, compared to a bare figure of US$600 billion in FY 1993–94. The increase is progressive in the sense that the annual growth moved up continuously from 2.52 per cent in FY 2001–2002 to as big as 52.56 155

India’s Financial Sector

per cent in FY 2005–06, 47.64 per cent in FY 2006–07 and as big as 89.08 per cent in FY 2007–08. The turnover grew not only in absolute terms but also in relative terms. The share of the Indian foreign exchange market transactions in the global turnover moved up from 0.1 per cent in 1998 to 0.2 per cent in 2001 and to 0.3 per cent in 2004 (RBI 2005). Again, on comparing the transactions between the inter-bank sector and the merchant sector, it is evident that the inter-bank transactions accounted for 72.31–81.94 per cent of the total value of transactions during the 8 financial years, FYs 2000–08. The simple reason is that the inter-bank market is much larger.

Swaps in the Inter-bank Segment A variety of transactions were made in the foreign exchange market ranging from the simple spot and forward transactions to options deals and also the swaps. Despite the fact that options have not fared well, the currency swaps have played a significant role in the interbank segment. These transactions are either foreign currency/rupee swaps or the cross-currency swaps. The figures in Table 8.4 based on swapping during April every year between 2001 and 2008 reveal a couple of facts. First, the swaps accounted for between around twofifths and two-thirds of the total turnover in the inter-bank market. Second, the foreign currency-rupee swaps are common as the Table 8.4

Swap Transactions in the Inter-bank Market

(US$ million) Swap transactions Month/year

Foreign currency/rupee

Crosscurrency

April 2001 April 2002 April 2003 April 2004 April 2005 April 2006 April 2007 April 2008

44,554 79,568 41,597 83,502 57,571 115,197 207,802 225,544

3,367 4,717 7,066 12,134 8,510 23,414 53,439 74,614

Total

Crosscurrency as % of total

Swap as % of total turnover

47,921 84,285 48,663 95,636 66,081 138,611 261,241 300,158

7.03 5.60 14.52 12.69 12.88 16.89 20.46 24.86

59.76 67.82 54.46 48.86 39.24 39.44 44.22 43.03

Source: Reserve Bank of India Bulletin, various issues.

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cross-currency transactions are limited to only around one-fourth or much lower of the total swap transactions. Third, the monthly figures are fluctuating over the years; but on the whole, it can be said that the significance of swap in the inter-bank market has definitely improved during recent years insofar as the volume has recorded over six-fold increase between April 2001 and April 2008.

Instability in the Volume of Turnover The volume of transactions depends upon many variables, notable among them being the amount of payment for imports, the quantum of export receipts, the receipts/payments on account of invisibles, the various receipts and payments on the capital account. Since these payments and receipts vary widely from one month to the other, the purchase and sale of the foreign currency are bound to vary during different months. The wider variation, however, leads to greater uncertainty regarding the supply of and the demand for foreign currency and thereby to greater speculation in the foreign exchange market. But this is checked at least to some extent through the RBI’s intervention in the market. When one looks at the monthly volume of transactions as shown in Figure 8.2, a good deal of volatility is found. The volatility is greater in the inter-bank segment. Figure 8.2

Monthly Turnover in the Indian Foreign Exchange Market

Source: RBI, Annual Report, various issues.

157

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However, to be more precise, we have calculated the volatility in terms of the CV based on the monthly figures in the total turnover in merchant and inter-bank segments. Table 8.5 shows that in the merchant segment, the instability moved up from 7.19 per cent in FY 2001–02 to 22.23 per cent in FY 2003–04 but then it tended to recede reaching 11.16 per cent in FY 2006–07. In FY 2007–08, it was again high at 19.18 per cent. In the inter-bank segment, instability moved to and fro, but the CV during FY 2006–07 was lower at 11.34 per cent— being almost equal to that in the merchant segment. In FY 2007–08, it turned higher at 14.31 per cent. All this shows that instability could not be controlled completely.

Growing Efficiency in the Foreign Exchange Market Fama’s ‘efficient capital market’ hypothesis (1970) can easily be extended to the foreign exchange market in order to ascertain whether the exchange rate reflects all available information so that no trader is able to earn excess profit in a systematic manner. Against this backdrop, one may ask whether the Indian foreign exchange market has moved towards efficiency in the sequel of reforms. The efficiency can be judged from various angles. First of all, it depends on the bid-ask spread. Lower and more stable the spread, smaller is the transaction and operating cost along with the risk involved in holding of the foreign exchange and resultantly more efficient is the foreign exchange market. Looking at the statistics, this spread in the Indian case has declined significantly over time and is Table 8.5

CV in Respect of Monthly Turnover in Merchant and Inter-bank Segments

CV (%) Financial year 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Merchant segment

Inter-bank segment

7.29 7.19 13.26 22.22 21.72 20.34 11.16 19.18

15.67 9.36 10.80 15.19 18.09 25.07 11.34 14.31

Source: Reserve Bank of India, Annual Report, various issues.

158

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one of the lowest at the present juncture, say, a quarter of a paisa to 1.0 paisa—far lower than during the mid-1990s (rbi.org). Second, the foreign exchange market should be called efficient if forward premia respond to the interest rate differential. The greater the response, the more efficient is the foreign exchange market. Here, we like to refer to the study of Sharma and Mitra (2006) where it is revealed that the forward premium/discount of US dollar vis-à-vis Indian rupee has largely responded to the interest rate differential between India and the US. This means a move to greater efficiency. Third, market efficiency is found when forward rates are the unbiased predictor of the future spot rate. In the Indian case, the RBI study covering a period from January 1995 to December 2006 shows the growing efficiency on this count (rbi.org). Last but not least, the size of RBI’s intervention in relation to the turnover in the foreign exchange market as shown in Table 8.2 has turned lower from 3.9 per cent in FY 2000–01 to 0.4 per cent in FY 2006–07 and 0.7 per cent in FY 2007–08 which means that the exchange rate stability is maintained greatly by the market forces. The larger the role of market forces, the greater is the efficiency. Thus, in all, the Indian foreign exchange market has definitely moved towards greater efficiency. Nevertheless, oscillations in foreign exchange transaction should be checked in order to transfuse still greater stability in the Indian foreign exchange market.

SUMMING UP The reforms in foreign exchange market in India have witnessed adoption of floating rate exchange rate system, restructuring of the very infrastructure, introduction of a variety of activities and also a gradual move towards capital account convertibility(CAC). Besides, the monetary authorities have helped ensure financial stability in the foreign exchange market. The turnover in the market, both in the merchant and in the interbank segments, has increased. In this context, swap transactions have played a very significant role in the inter-bank segment. Again, it is true that the volume of transactions has fluctuated largely during different months bringing in, at least to some extent, instability in the market. This is natural in view of unstable trade and 159

India’s Financial Sector

capital flows during different months. Nevertheless, the RBI has been conscious of this fact and has tried to intervene in the market, whenever necessary. Last but not least, the foreign exchange market in India can be said moving towards greater efficiency in view of, first, reduced bid-ask spread; second, forward premia, being to a great extent, in line with the interest rate differentials and being, to a great deal, a predictor of future spot rate; and third, a lower degree of the RBI’s intervention giving way to the free play of market forces. Nevertheless, oscillations in foreign exchange transaction should be checked in order to transfuse greater stability in the Indian foreign exchange market.

160

Part III

Internationalisation of Indian Financial Market

India’s Financial Sector

162

9

Euro Issues of Indian Firms

An important aspect of financial market reforms not covered so far at a desired length is the internationalisation of Indian financial market. To be more precise, as mentioned in the Introduction, the Indian government allowed the Indian companies, in the very initial years of economic reform, to raise funds from international financial market through the issue of foreign currency convertible bonds (FCCBs) and also the issue of the shares under ADR/GDR arrangement and permitted the foreign institutional investors (FIIs) to participate in the secondary market in India buying and selling shares and debentures. And, of late, the Indian government allowed the foreign companies to raise funds in the Indian primary market through selling securities under Indian depository receipt (IDR) mechanism. The present chapter, therefore, discusses the first aspect dealing with the issue of shares and bonds in the international financial market. The other one dealing with the FIIs will form the subject matter of the following chapter.

THE BASICS OF EURO ISSUES Features of Euro Issues FCCB is a foreign currency denominated bond issued by an Indian company. The principal and interest accruing thereon is payable in foreign currency. It is issued normally by high promoter shareholding companies which do not perceive any risk of losing management control even after the exercise of the conversion option. Such bonds

India’s Financial Sector

are known by varying nomenclature in different countries, for example, Yankee bonds in the US, Bull-dog bonds in the UK and Samurai bonds in Japan. However, if these bonds are denominated in currency other than the currency of the country where they are issued, they are known as euro bonds. In such cases, there are multicountry investors. As the very term denotes, FCCB is convertible into equity shares depending on the choice of the investors. It means that if the investor likes to hold the bond till maturity, it can do it and earn interest. The redemption may take place at par, at discount or at premium depending on the market value of the bond. For example, 1 per cent of the FCCBs issued by Tata Motors Ltd was redeemed by July 2008 at 116.824 per cent of the principal. On the contrary, if it likes to convert the bond into equity shares, it can do at a predetermined strike rate. The investor normally gains from the conversion if the conversion price is higher. The FCCB can be secured. However, in the Indian context, it is often unsecured. Normally, it is subordinated to the existing debt. The holder of the FCCB can sell a part or the whole of the holding or can convert it into American depository shares. It is often listed on the stock exchanges that help improve its liquidity. There are many cases of listing of Indian companies’ FCCBs at the Singapore Stock Exchange and Luxembourg Stock Exchange. Besides FCCBs, the Indian companies raise funds through the issue of ordinary shares. The shares are issued to the foreign investors in form of global depository receipts (GDRs) or American depository receipts (ADRs). GDR means a security issued by a bank or depository located outside India against underlying equity shares denominated in rupee of a company incorporated in India. If the bank/depository is located in the US, the receipt issued by it in lieu of the Indian rupee shares is known as ADR. ADR/GDR does not involve exchange rate risk for the issuer insofar as it is denominated in US dollars/any other foreign currency with the equity shares denominated in rupees. The process of the ADR/GDR issue is that the Indian company deposits the rupee shares with a custodian bank in India. The custodian bank comes in agreement with a foreign depository for the issue of depository receipts in lieu of these shares. The ratio between the Indian shares and the depository receipts, the value of depository receipts, and so on, are agreed upon between the custodian bank in 164

Euro Issues of Indian Firms

India and the foreign depository before the issue of the depository receipts.

Statutory Guidelines The euro issues are guided initially by the Scheme for Issue of Foreign Currency Convertible Bond (FCCBs) and Ordinary Shares (through Depository Receipt Mechanism) 1993 (GOI 1993b) along with the guidelines issued from time to time by the Ministry of Finance, SEBI and RBI. They have also to abide by the provisions of the Foreign Exchange Management Act. The Government of India treats euro issues as a part of foreign direct investment (FDI) for the purpose of sector-wise caps and some other purposes. The companies going for euro issues must have a consistent track record for good performance for a minimum period of 3 years, although relaxations can be made in case of infrastructural projects. Again, as per the SEBI regulations, companies not eligible for accessing to domestic securities market cannot go for the euro issues. The company must be a listed one. If not listed, simultaneous listing must be made along with the euro issue. Similarly, those overseas corporate bodies not eligible for investing in India through the portfolio route cannot participate in such issues. The issues are made either under automatic route or after the approval of the RBI. If they are related to the infrastructure sector or if they involve an amount up to US$500 million, they come under the automatic route. In other cases, RBI’s approval is mandatory. As regards maturity of the FCCBs, the minimum average should be three years if the issue amount is up to US$20 million. Beyond this amount, the maturity must be at least 5 years. There is no maximum limit for the maturity. Prepayment of FCCBs is permitted up to US$200 million subject to the compliance of the minimum average maturity period. The euro issues are priced at not less than the higher of the two averages—one being the average of the high and low weekly prices of the related shares at the stock exchange during the past 6 months and the other being the average of high and low prices during the past fortnight. Although the companies going for simultaneous issue for the domestic and foreign markets or going for the foreign issue within 30 days of the domestic issue may not abide by the price guidelines, they have simply to get approval of the market regulator. 165

India’s Financial Sector

The raised funds can be parked abroad till the actual use does not emerge. They can be used for the implementation of new projects, the modernisation/expansion of the existing projects or refinancing of an existing FCCB issue. But the proceeds cannot be used for investment in the capital market, real estate and working capital or for repayment of a rupee loan. The guidelines have allowed for two-way fungibility since 2002. Prior to this provision, once a company issued ADR/GDR and if the ADR/GDR was converted back into underlying equity shares of the Indian company, it was not possible to reconvert the equity shares into ADR/GDR. But now the reconversion is possible. The stock brokers in India are authorised to purchase shares of the Indian companies for reconversion. The reconversion is permitted to the extent the ADRs/GDRs are redeemed and the underlying shares are sold in the domestic market. The policy is liberal in the sense that no permission of the RBI is required for reconversion. The significant benefit of the two-way fungibility is that it leads to improvement in liquidity; over and above, the scope for arbitrage is eliminated on account of similar price of the security in domestic and international markets.

SIGNIFICANCE OF THE EURO ISSUES The Primary Market Gains After the delineation of the features and guidelines related to the euro issues, a very important question arises as to whether these issues are supportive to the financial sector reform in particular and the development of the economy in general. The answer is certainly affirmative in many ways. First of all, the liberal industrial sector policy requires huge funds for investment, especially foreign exchange that were not available domestically in the desired quantum in the initial years of the economic reform era. Thus, initiating euro issues was a right step because these issues helped bring in foreign exchange. Second, the funds from the international financial market are available at lower cost. More specifically, in case of bonds to be issued in the international market, the rate of interest has normally been lower there than in India. The reason is that in a matured economy where market forces have a greater scope for a free play, interest rates tend to be lower. 166

Euro Issues of Indian Firms

Third, the opening up of a route to international financial market helps diversification of the sources of funds and in turn lowers the risk factor. It may be mentioned that the systematic risk can be reduced only internationally as the macroeconomic variables tend to vary internationally. Thus, the international issue of securities serves both the ends—lowering of the cost as well as lowering of the risk. Fourth, the ADRs/GDRs are priced by the depositories at the average price of the related shares during past six months or a fortnight and so it is a source of gain when the share market is bullish. Fifth, it is not simply the advantage on account of pricing but also it has the convenience aspect. Since the international financial markets do not normally maintain stringent disclosure norms, it is more convenient to raise funds there. Last but not least, in many cases, it has been found that the company’s presence in the international financial market helps elevate its image. It enjoys higher rating. Choi and Stonehill (1982) confirm this view in case of some Japanese and Korean firms. The Indian case is no exception.

The Secondary Market Gains The significance of the euro issues is not limited to the primary market abroad. After the ADRs/GDRs of Indian firms are issued, they are also listed on the international stock exchanges and subsequently traded there. The trading brings in ample gains to the Indian company. The argument is that the international trading of shares reduces market segmentation and thereby reduces or eliminates risk premium and helps increase the share prices (Errunza and Losq 1985). It may be noted here that capital market segmentation appears when the shares are traded simply in one market on account of restrictions imposed on international investment. The segmentation gets milder with growing liberalisation of the foreign investment policy. So if the Indian government has liberalised the foreign investment policy and allows the Indian companies to go for euro issue listing and trading, it will have a positive impact on the risk–return aspect of these issues. Kumar (2006) finds in case of 68 Indian firms going for listing their securities abroad in form of depository receipts that the volatility of the underlying stocks reduced significantly. The investors at the international stock exchange too prefer to invest in the shares of the 167

India’s Financial Sector

emerging market economies in view of growing stock market in these economies (Moel 2000). The British investment in GDR of 20 Indian firms more than doubled in 2007 with a total turnover of US$11.9 billion (The Financial Times 7 January 2008). Again, it is also believed that the foreign listing of the securities enhances liquidity of a company’s stock on account of informational linkages between domestic country and the foreign country where the shares are traded (Mittoo 1992). Majumdar (2007) confirms that listing in the overseas markets raises the volume of trading in the respective securities at home and thereby boosts up the liquidity. Similar views were expressed by Hargis and Ramanlal (1998). Liquidity in the financial market gives, in turn, a boost to market credibility. It provides accurate price signal to investors and to the companies which is essential for efficient risk-sharing strategies. Moreover, liquidity influences the cost of capital and makes the investment decision more effective. Harris (1993) and Hamilton (1979) are of the opinion that multimarket trading stimulates competition between different markets which in turn forces market makers to provide the best possible bidask spread which in turn retains the existing traders and attracts the new investors. Some of these views were empirically tested. Mittoo (1992) and Fanto and Karmel (1997) find an increase in liquidity as a result of multi-market trading of the shares of some Canadian firms. Pagano and Roell (1990) find that French shares listed and marketed in London financial market had a lower bid-ask spread. In short, the gains from euro issues are sizeable. Hansda and Ray (2003) are of the opinion that given the volatility in the FIIs’ investment in the secondary market, euro issues are a better way of approaching the international financial market.

TREND OF THE EURO ISSUE The Annual Size The policy facilitating euro issues has paid rich dividend. Over the years, the number of such issues has gone up and the amount involved therein has swelled. Table 9.1 and Figure 9.1 show the annual figures of the euro issues. Since the policy was announced in the second half 168

Euro Issues of Indian Firms Table 9.1

FYs

Euro Issues of Indian Companies

Amount (Rs. billion)

1992–93 1993–94 1994–95 1995–96 1996–97 1997–98 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

7.023 78.978 67.432 12.966 55.94.3 40.095 11.478 34.872 41.971 23.848 34.264 30.975 33.532 113.575 170.051 366.260

No. of issues 2 27 31 5 16 7 3 6 13 5 11 18 15 49 40 26

Average size of issue (Rs. billion) 3.512 2.925 2.175 2.593 3.496 5.728 3.826 5.812 3.229 4.770 3.115 1.721 2.235 2.318 4.251 14.087

Source: http://www.rbi.org.in Figure 9.1

Funds Raised through Euro Issues

of FY 1992–93, the amount of the issue was barely Rs. 7.023 billion during that financial year. The scheme was welcomed by the Indian companies with the result that in the following financial year, it was as large as Rs. 78.978 billion. But subsequently, the tempo could not be maintained. The annual figure moved in the range of Rs. 11.478 billion at the minimum and Rs. 67.432 billion at the maximum till FY 2004–05. However, with the growth rate of the Indian economy moving up in recent years and with procedural relaxations in international 169

India’s Financial Sector

financial market, the figures of the euro issues too moved from Rs. 113.575 billion in FY 2005–06 to Rs. 170.051 billion in FY 2006–07 and to Rs. 366.26 billion in FY 2007–08. Again, looking at the issue from the viewpoint of the number, it varied widely between 2 in FY 1992–93 and 3 in FY 1998–99 to 40 and 49, respectively, in FYs 2006–07 and 2005–06, although 26 in FY 2007–08. The result is that the amount per issue was not very large. In 6 out of 15 financial years, the average size of issue was less than Rs. 3 billion. In other 5 financial years, it was over Rs. 3 billion but less than Rs. 4 billion. In only 2 financial years, it was over Rs. 4 billion. In 1 financial year, it was over Rs. 5 billion and in another, it was over Rs. 14 billion. There is no definite trend either descending or ascending in this respect.

Quarterly Variation in the Issue Size The annual size of the euro issue over around one-and-a-half decades has been volatile. But when one looks at the monthly figures, they are still more volatile. We present here in Table 9.2 and Figure 9.2 the quarterly figures and their volatility measured in terms of standard deviation. Table 9.2

The Quarterly Variation in the Size of Issue

(Rs. million) FY 1994–95 1995–96 1996–97 1997–98 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Q1 11,270 2,817 7,906 22,279 0 73 1,850 14,803 993 2,244 7,698 18,443 57,862 209,410

Q2

Q3

20,501 0 15,575 402 631 13,733 11,753 9,045 0 15,946 5,968 19,941 20,303 51,520

31,253 0 25,216 16,140 0 5,057 800 0 30,685 10,139 10,033 49,961 9,239 86,840

Source: http://www.rbi.org.in

170

Q4 4,408 10,150 7,245 1,273 10,847 16,009 10,917 0 2,584 2,646 9,833 2,533 816,477 18,491

SD 1164.35 479.31 838.74 1090.52 532.65 744.88 729.91 727.46 1478.44 656.38 192.59 1466.28 3350.23 83.4215

Euro Issues of Indian Firms Figure 9.2

Quarterly Funds Raised from Euro Issues

The quarterly figures are available from FY 1994–95. They vary within a wide range with the result that the standard deviation too are volatile. While the standard deviation was as low as 83.42 during FY 2007–08, it was as high as 1466.28 in FY 2005–06 and 3350.23 in FY 2006–07. In many cases, if not all, larger annual size of issue was accompanied by greater volatility. For example, the recent upsurge too in the size of the issue was fraught with far greater instability.

Varying Sizes of ADRs/GDRs When the domestic custodian bank comes in agreement with the foreign depository for the issue of depository receipts, the ratio between the number of shares and the number of depository receipts is agreed upon. In a sample of 71 issues, 39 cases had 1.0 share per GDR. In two cases, the ratio was 0.5. In four cases, it was 3.0 and in nine cases it was 2.0. In one case, it was 4.0 and in the other, it was 6.0. In eight cases, this figure was 5.0 and still in four cases, it was 10.0. Two cases presented a ratio of 15.0 shares per GDR. There was one case in which one GDR was issued for 100 Indian shares (http://www.indiamart. com). In fact, the determination of the ratio is subject to a host of factors, such as rating of the company, the domestic market price, the exchange rate and the demand position in the international financial market. Apart from the ratio between the number of shares and the number of ADRs/GDRs, the size of GDR issue too varies. Out of 71 cases 171

India’s Financial Sector

in the sample, there were four cases where the size of GDR exceeded US$300. In case of Videsh Sanchar Nigam Limited (VSNL), it was as large as US$527. There were two cases where the value was US$200 and above but less than US$300. In 19 cases, it was US$100 and above but less than US$200. But in majority of the cases, the size of the GDR issue was less than US$100. In 26 cases, it was US$50 or above but less than US$100. In the rest 20 cases, it was less than US$50 (http://www.indiamart.com). Again, in another sample, except in case of Tata Electric issue where the value per GDR was US$710 and in case of Century Textiles where it was US$254, the unit price was well below US$25. Out of the rest 69 cases in the sample, 25 cases had unit value for US$10 or less. In 24 cases, it was above US$10 but less than US$15. Yet in 14 cases, it was above US$15 but less than US$20. In the remaining cases, it was higher than US$20 (http://www.indiamart.com).

SECONDARY MARKET TRADING OF ADRs/GDRs Some Features of ADRs/GDRs Trading Similarly as in India where shares issued in the primary market are listed on the stock exchanges and traded in the domestic secondary market, the GDRs issued in lieu of the rupee shares are listed on the America-, London-, Luxembourg-, Dubai- and Singapore-based stock exchanges and are traded there. The beginning was made in FY 1997–98 when the Mahanagar Telephone Nigam Limited (MTNL) securities got a room in the GDR secondary market. The process of global financial integration got another boost when the ADRs of Infosys Technologies were listed on NASDAQ in March 1999 followed by Satyam Infoway in October 1999. Since 1999–2000, the Ministry of Finance continued to liberalise the procedures and environment that had a positive impact on the listing trend. The financial year, 2001–02 saw a dip in GDR issues, which was due to global slowdown in developed markets. But, within a couple of years, the trend reversed and the overseas market began to look up. ADR/GDR issues by Indian companies began to rise. By FY 2004–05, there were eight Indian firms making presence on the NYSE. There are, of course, a few barriers to listing formalities. On the basis of interview of the senior executives of some Indian firms, Kumar (http://www.ssm.com) finds that in case of listing of the ADRs at the US stock exchanges, there were 172

Euro Issues of Indian Firms

long legal formalities coming in the way. One of such formalities was that the Indian firm had to make its financial books compatible with the US Generally Accepted Accounting Principles (GAAP) and then only its ADRs could be listed. This procedure took months and some times years. In case of GDRs, it was often the absolute size of the GDR that came in the way. It was difficult to list a small-size GDR. Accounting formalities were also there for getting GDRs listed at the London Stock Exchange (LSE), such as the listing firm had to comply with the International Financial Reporting Standards (IFRS). But this condition was waived for the Indian firms in November 2005. This might be the reason that the GDRs of many Indian companies were listed at the LSE only thereafter. Besides liberalisation of the norms at the international financial markets, the Indian government permitted in FY 2005–06 the unlisted companies to go for ADR/GDR issue. The boom in the Indian financial market was an additive factor. All this brought about a boom in the ADRs/GDRs trading at the international secondary markets. A New Delhi daily, Business Standard began reporting the market price of ADRs/GDRs that covered more than 100 Indian firms at the end of December 2006 (Business Standard 2 January 2007). The turnover at the LSE increased from US$5.4 billion in 2005 and US$5.2 billion in 2006 to as large as US$11.9 billion in 2007 (Financial Express 20 January 2008). The Indian firms began showing their presence in Dubai and Singapore stock markets. Table 9.3 presents some of the trading features of the ADRs of the Indian companies, such as the issue price, market price, quantum and the market capitalisation. In all, there are 11 companies in Table 9.3. In two out of 11 cases, the market price on 10 August 2007 was lower than the issue price; in other words, the depository receipts were selling at discount. The extent of discount was only marginal in case of MTNL, but in case of WIPRO, it was substantial. On the other hand, in nine out of 11 cases, the depository receipts were selling at premium. In case of HDFC Bank, the market price was over six-fold of the issue price. In ICICI Bank, it was almost four-fold. But normally, the market price was less than two-fold of the issue price. The existence of premium in the market showed at least a couple of facts. The first is that these companies maintained a high rating in the international financial market which is also very significant for their rating in the domestic financial market. The high rating of the 173

India’s Financial Sector Table 9.3

Company 1 Dr. Reddy’s Laboratories HDFC Bank ICICI Bank Infosys Technologies MTNL Patni Comp. Satyam Com. Satyam Info Tata Motors VSNL WIPRO

Select ADRs’ Trading at the New York Stock Exchange: 10 August 2007

Col. 5 as % ADR market of domestic Market market price (US$) capitalisation (10.8.2007) (US$ million) capitalisation

No. of ADRs (million)

Issue price (US$)

2

3

4

5

6

76.5

10.0

15.8

1,208.2

45.77

94.5 368.4 270.6

13.8 11.0 17.0

83.9 42.4 49.0

7,929.6 15,616.5 13,258.0

89.71 81.32 47.68

315.0 68.9 157.3 141.5 353.0 142.5 703.6

7.5 20.3 9.7 4.5 10.0 17.9 41.2

6.9 21.0 26.5 8.0 16.8 20.8 13.7

21,86.1 1,446.2 4,160.6 1,126.5 5,916.3 2,968.3 9,646.0

99.50 99.67 51.02 NM 92.35 101.29 55.41

Source: http://www.indiamart.com. Note: NM: Not mentioned.

companies also helps stimulate investment flow at the macro level. Second, the foreign market capitalisation as percentage of domestic market capitalisation was quite high. In one case, namely, VSNL, it was even higher than the domestic market capitalisation. In other four cases, it was 90 per cent or above of the domestic market capitalisation. In other four cases, it was around one-half of the domestic market capitalisation. There was a lone case where the depository receipts were yet to be traded. Similarly, Table 9.4 shows the issue price and the market price of GDRs of 12 Indian firms traded at the LSE on 9 February 2007. The figures show wide disparity in the issue prices. They also show that in majority of the cases, they were traded at discount as there were only three out of 12 cases representing trading at premium. The study of Kadapakkam et al. (2003) shows that both the Indian stock market and the London stock market influenced each other despite restrictions on arbitrage imposed by the Indian government prior to 2002. According to the study, the factors contributing to the price discovery of the GDRs were the extent of foreign ownership of the Indian firms and the GDR size. There were also volatility spillovers from one market to the other. 174

Euro Issues of Indian Firms Table 9.4

Issue and Market Prices of GDRs of Indian Firms at LSE on 9 February 2007

Firm Bajaj Auto Grasim Inds. G. Abuja Hindalco Inds. Hind. Cons. ITC Ltd L&T M&M Ranbaxy Lab. Reliance Energ. Reliance Inds. State Bank of India

Issue price (US$)

Market price: premium/ discount (%)

69 64.50 3.14 3.97 3.20 3.98 39.20 21.20 9.66 38.00 62.90 69.80

30 –60 –34 –8 –25 2 –30 –50 –3 –75 –10 95

Source: The India Report Astaire Research. London, 9 February 2007.

Integration between Indian and International Financial markets Kadapakkam et al. (2003) have already indicated about the integration between the Indian financial market and the foreign financial markets. The present study makes a deeper probe to show that the degree of integration is quite large meaning that efforts at the internationalisation of the Indian financial market have been successful. It deals with the price behaviour of nine ADRs and 12 GDRs at the international stock exchanges and that of the respective rupee shares at the Bombay Stock Exchange (BSE). The period covered is 1 month from 15 February to 14 March 2008 that has 20 working days. A correlation is found out between the price at which ADRs/GDRs were traded and the respective rupee shares were traded on a particular day. The correlation presented in Table 9.5 is positive in all the cases and highly significant over 0.8 in many cases. Such a significant positive correlation confirms integration of the Indian financial market with the international financial market. The above finding is different from those of Chakrabarti (2003) and Hansda and Ray (2003). But the difference is not astonishing in view of the fact that the period covered in these two studies was related, respectively, to March 1999 to January 2003 and February 2002 that did not consider the effects of two-way fungibility that was permitted by the Indian government only in November 2002. 175

India’s Financial Sector Table 9.5

Correlation between ADRs/GDRs Price and the Respective Rupee Share Prices in the Secondary Market

ADRs Firm Dr. Reddy’s Laboratories HDFC Bank ICICI Bank Infosys Tech. MTNL Satyam Comp. Sterlite Inds. Tata Motors WIPRO

GDRs Correlation

Firm

Correlation

0.4453

Axis Bank

0.5916

0.9261 0.9441 0.9324 0.9313 0.8155 0.8742 0.9204 0.7411

Bajaj Auto GAI (I) Ltd Grasim Inds. Hindalco Inds. ITC Ltd M&M Ranbaxy Lab. Reliance Energ. Reliance Inds. State Bank of India

0.8099 0.3148 0.2986 0.9221 0.8237 0.3051 0.9072 0.8096 0.8702 0.9452

Source: Based on the figures presented in: Mint, New Delhi, various issues.

The two-way fungibility leads to arbitrage that helps equalise the prices in different markets in due course of time. A study of Instanex Capital Consultants Ltd shows that 41 of 162 dual-listed stocks covered under the study offered an average arbitrage profit of 6 per cent. It further states that in 29 firms whose depository receipts were cheaper than the local shares, investors could earn 1.9 per cent if they bought depository receipts and sold the respective shares in India. Turning to a few individual cases, Bajaj Hindustan Ltd offered a big advantage. Its GDR at Luxembourg Stock Exchange was cheaper than the shares at the BSE. The difference in price leading to arbitrage yielded 5.43 per cent gain. Similarly, Tata Communications’ ADRs trading at 4.9 per cent discount compared to the local price at BSE led to arbitrage activities. On the contrary, Infosys Technologies’ ADRs selling at a premium of 5.8 per cent compared to the BSE prices helped arbitrageurs to gain (http://www.instanexcapital).

SUMMING UP It was 1992 when the Indian government allowed domestic firms to raise funds through the issue of securities in the overseas capital market. The process helped ease the availability of foreign exchange at 176

Euro Issues of Indian Firms

lower cost and with lower risk and less disclosure norms. In view of the gains, the government liberalised the issue guidelines permitting, in the sequel, automatic route for the issue and two-way fungibility along with embracing even the unlisted companies for this purpose. The volume of the funds raised this way varied widely from year to year and from one quarter to the other. The size of the ADRs and GDRs and the ratio between the value of rupee shares and the ADRs/ GDRs too lacked uniformity. Beginning from the late 1990s, the ADRs/GDRs are traded at the select international stock exchanges. The process leaves a positive impact on the risk–return scenario and helps infuse liquidity in the market. Again, with greater integration of the Indian financial market with major international financial markets, there is found a significantly positive correlation between the price of domestic shares and that of the respective ADRs/GDRs.

177

10

Foreign Institutional Investment in India

The other aspect of the internationalisation of Indian financial market, besides the euro issues, is the operation of the foreign institutional investors (FIIs) at the Indian stock exchanges. The FIIs, such as pension funds, mutual funds, asset management companies, etc., buy and sell the securities of the Indian firms. Their net purchases mean their net portfolio investment into the Indian economy. It is only after one year of initiating economic reforms in the country that the Indian government opened its financial market to foreign portfolio investors, especially the FIIs in September 1992. Subsequently, positive regulatory measures were taken up to attract them with the result that the number of FIIs registered with the SEBI rose from 9 at the end of 1993 to 506 by March 2000, 996 by March 2007 and further to 1,319 by March 2008. The cumulative amount of such investment soared up to US$11.237 billion by March 2000 and further to US$68.007 billion by March 2008 (SEBI website). Thus, in view of the huge inflow, it would be worth examining the factors that have motivated FIIs to invest in this country and also focusing on the growth orientation aspect of such investments. However, in the beginning, the size and trend of the investment flow is presented in order to provide a background for the main discussion.

SIZE AND TREND OF FIIs’ NET INVESTMENT Table 10.1 and Figure 10.1 presents the annual figures for FIIs’ net investment in India beginning from FY 1993–94 to FY 2007–08. The net

Foreign Institutional Investment in India Table 10.1

Size of FIIs’ Net Investment in India

(US$ million) FYs 1993–94 1994–95 1995–96 1996–97 1997–98 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Net investment

Annual average

1,665 1,503 2,009 1,926 979 –390 2,135 1,847 1,505 377 10,918 8,686 9,926 6,708 20,328

1,776

295 1,466

11,313

Sources: 1. Reserve Bank of India Bulletin, various issues. 2. SEBI Bulletin, various issues. Figure 10.1

FIIs’ Annual Net Investment: April 1993 to March 2008

Source: Based on the figures presented in Table 10.1.

investment means the value of FIIs’ purchase of securities minus the sale value. Greater value of purchase than that of the sale means net 179

India’s Financial Sector

inflow of investment. The reverse means net disinvestment. The FY 1992–93 does not figure in the table because the policy permitting FIIs’ investment was announced by the time the financial year was already half the way and the actual implementation of the policy as also the response from the foreign investors took some time. Consequently, the size of such investments was then simply US$1 million. For the purpose of our study, we divide the entire period into four phases despite the fact that the partitioning line among the phases cannot be a precise one. The first phase spanning over FYs 1993–94 to 1996–97 can be termed as the initial phase when the very infrastructure for such investments was just in the making. This phase witnessed a good response from the FIIs, despite some ups and downs in the quantum of the net inflow. The annual net investment varied between US$1,503 million and US$2,009 million with an average of US$1,776 million. The second phase representing 2 fiscal years from 1997–98 was the Asian Crisis phase. Although India was not directly engulfed in the crisis, the financial market in the country could not remain isolated from its demonstration effect. Moreover, it was the ‘regional effect’ explaining a high degree of positive correlation in the portfolio investment in the different countries of a particular region (Froot et al. 2001) that was mainly responsible for a scanty net inflow for US$979 million during FY 1997–98 followed by a net disinvestment of US$390 million in the subsequent financial year. Obviously, the annual average was barely US$295 million during the second phase. The third phase was the phase of revival that set in FY 1999–2000 but it was followed by a bearish tinge till FY 2002–03. The FY 1999–2000 witnessed a net investment of US$2,135 million, but the upward movement could not last long. The size of the net investment gradually dropped and touched US$377 million by FY 2002–03. In fact, the depressive scenario in the Indian equity market along with many Asian equity markets was responsible for this drop. Moreover, the Indian economy was rated low by some international credit-rating agencies (GOI 2003). However, the annual average was US$1,466 million—far greater than that in the second phase but lower than the first phase. The fourth phase beginning from FY 2003–04 can be termed as a maturing phase that presents a well-built financial infrastructure and massive response from the FIIs. Their investment was unusually big during FY 2007–08 making the annual average of the size of net 180

Foreign Institutional Investment in India

investment during FYs 2003–08 as large as US$11,313 million—much bigger than in any of the preceding periods. As far as the choice between debt and equity is concerned, the net investment in equity, as shown in Table 10.2 and Figure 10.2, dominated the scene. In two financial years, namely, 2000–01 and 2005–06, due to net disinvestment in case of debt securities, the entire net investment was accounted for by equities. In other financial years, the share of equity in total net investment varied between 81 and 96 per cent. Table 10.2

Financial year

FIIs’ Net Investment in Equity and Debt Securities

Equity (INR billion)

Debt (INR billion)

Total of equity and debt (INR billion)

% share of equity in net investment

101.42 80.00 24.77 434.34 441.20 488.00 252.40 534.03

–6.41 6.63 3.45 55.34 17.60 –73.30 56.10 127.76

95.01 86.63 28.22 489.68 458.80 414.70 308.50 661.79

Entirely equity 92.35 87.77 88.70 96.29 Entirely equity 81.82 80.66

2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 Source: SEBI website.

Figure 10.2

FIIs’ Investment in Debt and Equity

Source: Based on the figures presented in Table 10.2.

181

India’s Financial Sector

Whatever may be the details, the FIIs have been able to increase their stake in the shareholdings of the Indian companies in recent years. As per a report, their share in top 500 companies listed at the Bombay Stock Exchange (BSE) moved up from 10.1 per cent in March 2003 to 16.3 per cent in March 2006 and further to 16.7 per cent in September 2006 (Business World 2006). It is because of growing interest of the FIIs in the Indian market that the portfolio flows were recorded bigger than the foreign direct investment in 2007 contrasting the situation in the other BRIC nations, namely, Brazil, Russia and China. The inflow of foreign direct investment and foreign portfolio investment was, respectively, US$84 billion and US$35 billion in China, US$52.5 billion and US$14.8 billion in Russia and US$34.6 billion and US$26.2 billion in Brazil contrary to US$21 billion and US$34 billion in India (The World Bank 2008).

FACTORS BEHIND FIIs’ INVESTMENT IN INDIA Despite ‘home bias’ among the international investors (Cooper and Kaplanis 1994), international portfolio investments, especially those of the FIIs have boomed up during past couple of decades. The emerging market economies play as a cherished host and India is not an exception. A few studies have analysed the factors behind FIIs’ investment at the international level as well as with respect to India. First of all, at the international level, it is the diversification benefit that the FIIs reap. They reduce the risk through investing abroad inasmuch as the inter-country correlation in the equity market returns is much lower than the intra-country correlations (Hunter and Coggin 1990). Based on the Korean experience, Choe et al. (1990) feel that it is the higher return in the host country that attracts FIIs. Garibaldi et al. (2002), based on the experiences of some transition economies, stress on the financial market infrastructure and intellectual property rights indicators that explain FIIs’ investment in a host country. Again, Claessens et al. (2002), based on the data from 77 countries, feel that the shareholders’ protection, especially, regarding buying of shares and listing them on the stock exchange are the important motivations behind FIIs’ involvement in a host country. Similarly, in the Indian context, Mukherjee et al. (2002) find in their study that the external factors, such as the US and the world stock price 182

Foreign Institutional Investment in India

movements, volatility in return in different markets and the internal factors like domestic financial variables had only minor impact on the FIIs’ investment. On the contrary, Gordon and Gupta (2003) find that it was the combination of domestic, regional and global variables including, especially, the interest rates and the lagged domestic market returns that were significant to explain such flows. But Laxmi Sharma (http://www.nseindia.com) puts greater weight to the bottom-up approach explaining that it was the impact cost differential that explained FIIs’ flow into the Indian economy. Impact cost, she explains, is the cost of executing a transaction in a given stock for a specified predefined order at a point of time. Again, Chakrabarti (2001) is of the view that the FII flows were correlated with contemporaneous returns in the Indian market. The returns were the sole driving force behind such flows during the post-Asian Crisis period which means that the FIIs were the return chasers. The greater return the Indian market experienced, the bigger were the FII flows into the Indian financial market. He reveals further that the other variables at the domestic and international levels were not very important nor were the changes in country risk rating for India. Last but not least, Bose and Coondoo (2004) held policy liberalisation for greater FII flows in India. They considered 10 policy interventions made at different points of time during January 1999 to January 2004 and found that the liberal policy had led to the broadening of FII categories, enhancement in the sectoral and individual caps, opening of derivatives market and to procedural simplification that in turn boosted up the FII flows into the Indian capital market. Thus, the different studies are not unanimous on a particular factor that has motivated the FIIs to invest in India. The reason is that the period of the studies differs. A particular factor being more significant during a particular period may not be so significant during the other periods depending upon the changes in the financial market environment. Moreover, the way the figures are compiled differs from one case to the other. For example, Chakrabarti (2001) bases his analysis on the monthly figures for correlating the market returns and the investment flow. But it may not be justified in view of the fact that the investors react immediately and take any investment decision immediately after changes in the return scenario. Thus, it is the daily figures that should be relied upon. In order to examine the above 183

India’s Financial Sector

factors, we like to base our analysis on the latest figures available inasmuch as they only can reveal the present scenario. For the present analysis, we like to take up here three factors to show whether they explain the changes in the FII flow into India. First, we discuss the return chasing behaviour of the FIIs that is the most important factor in Chakrabarti’s study (2001) and then we take up the interest rate differential issue figuring in the study of Gordon and Gupta (2003). Finally, we analyse the policy liberalisation issue that is the focal point in the study of Bose and Coondoo (2002).

Return Chasing Behaviour of the FIIs In order to examine whether the returns in the Indian equity market have motivated FIIs to go for investment, we base our study on the daily figures obtained during July to December 2006. This is the period when both the outflows and the inflows on account of FIIs’ trading in securities were very large. Moreover, the daily figures are closer to reality showing investors’ reaction to changes in the returns from the equity market. The return from the equity market on a particular day is equal to the difference between the logarithm of the closing BSE Sensex on that day and that on the previous day. Having a lag for one day, the return on a particular day motivates the investor to make investment on the next day. On this assumption, we compute the correlation between the return on a particular day and the investment on the next day based on the SEBI figures during the entire period of July to December 2006. The correlation coefficient arrived at is 0.011705 which presents a very weak correlation meaning that this factor is not important.

The Interest Rate Differential The simple argument explaining the relationship between the interest rate differential and the motivation to invest in debt securities is that when the rate of interest is higher in the Indian economy, the FIIs make investment in lure of higher interest gain. In order to examine this hypothesis, we again base our analysis on the figures obtained during 2006. During 2006, in India, the interest rate relating to 1-year T-bills moved up from 6.25 to 7.25 per cent and that in respect 184

Foreign Institutional Investment in India

of corporate bonds scaled up from 8 to 9.5 per cent compared, respectively, to 4.73–5.24 and 7.4 per cent in the US. This increasing differential coincided with a net inflow of FIIs’ investment in the Indian debt market amounting to US$881.30 million during this year (Business Line 6 January 2007). Again, a cut in the Federal Bank’s rate to the extent of 0.25 per cent in September 2007 led to a huge FIIs’ investment in India aggregating to US$7 billion during the following 6 weeks (Hindustan Times 13 December 2007). It means that the higher rate of interest in India is an important factor behind FIIs’ investment in the Indian debt securities.

Policy Liberalisation It is the liberal economic policy of the Indian government in general and towards the FIIs in particular that has helped boost up the flow. As far as the impact of the policy towards FIIs is concerned, we support the study of Bose and Coondoo (2004) that the impact is definitely positive but like to differ from their views that relate the immediate impact of the policy intervention at different points of time to FII flow. It is because any step towards policy liberalisation has a lasting effect and if it is the sole factor, the flow should not have squeezed subsequently. In our view, policy liberalisation is an additive factor and not the sole factor that can be statistically related to the quantum of the flow. The policy liberalisation measures along with some positive regulatory measures, put in Box 10.1, are related to: 1. Mandatory registration of the FIIs with the SEBI and the easing of the norms for registration. 2. Broadening of the list of types of funds that could be registered as FII in India and the entities on behalf of whom that could invest. 3. Expanding the list of the instruments in which FIIs could invest. 4. Raising of the caps for investment in different sectors and companies. 5. Easing of procedural formalities, reduction of fees, and so on. 6. Introduction of transparent disclosure norms, and so on.

185

India’s Financial Sector Box 10.1

FY 1992–93

1995–96

1996–97 1997–98 1998–99

1999–2000

2000–01

2001–02 2002–03

FII Policy Liberalisation Measures

Permission to FIIs including institutions such as pension funds, mutual funds, investment trusts, asset management companies, nominee companies and Incorporated/ Institutional Portfolio Managers or their power-of-attorney holders (providing discretionary and non-discretionary portfolio management services) to make investment in all the securities traded on the Primary and Secondary markets, including the equity and other securities/instruments of companies which were listed/to be listed on the stock exchanges in India including the OTC Exchange of India. Institutionalisation of the FII regulation by SEBI allowing the above-mentioned FIIs to buy and sell securities listed on the stock exchange. Embracing of university funds, endowments, charitable trusts and proprietary funds under the definition of FIIs. FIIs having securities for Rs. 100 million or more were asked to settle their transactions only through dematerialised account. FIIs were allowed for trading in government securities, namely, T-bills and dated securities, and in derivatives, such as indexed futures, for stock lending, and for investing in unlisted securities via debt route. The procedure for approval of subaccounts of registered FIIs was eased. They began to avail of the forward cover by the authorised dealers in the foreign exchange market under specific conditions. FIIs were allowed to participate in open offers in the secondary market. The conditions regarding forward cover in respect of foreign exchange were made more favourable. The domestic portfolio managers were permitted to manage the subaccounts of FIIs under specific conditions. The FIIs were allowed to make an appeal to the Securities Appellate Tribunal in case of any functional problem. Again, it was specified that an individual FII could invest in a company’s securities only up to 5 per cent of the latter’s issued capital within the aggregate limit of 24 per cent of the company in which such investment was made. The aggregate limit of 24 per cent was raised first to 30 per cent and then to 40 per cent. It was raised again to 49 per cent subject to the approval of the shareholders at the General Body Meeting. FIIs were allowed to transact in all forms of derivatives. The sectoral limits for their investment were waived. The registration fee for the FIIs was halved from Rs. 10,000 to Rs. 5,000. (Box 10.1 Continued)

186

Foreign Institutional Investment in India (Box 10.1 Continued) 2003–04

2004–05

2005–06

2006–07

2007–08

A Code of Conduct was imposed on the FIIs. A position limit was specified for them for trading in interest rate derivatives contracts. In order to monitor their investment and to make it more transparent, the SEBI revised the reporting format. The Indian government raised the cumulative investment ceiling for FIIs in debt funds from US$1 billion to US$1.75 billion. Against this background, the SEBI raised the overall investment limit in case of government securities (under 70:30 route) from US$100 million to US$200 million. For the corporate bonds, the cumulative ceiling was raised to US$500 million. FIIs’ position limits for investment in stock-based derivatives were revised upwardly. The Budget for 2006–07 proposed to increase their investment limit in government securities to US$2 billion from US$1.75 billion and in corporate debt to US$1 billion from US$0.5 billion. FIIs also embraced insurance companies, investment managers, foreign central banks and international organisations. The Indian government raised the cumulative investment ceiling for FIIs in debt funds to US$2.0 billion. In case of corporate bonds, it was raised to US$1.5 billion. Foreign investment in the stock exchanges was permitted up to 49 per cent of the shares, out of which foreign direct investment could go up to 26 per cent and the remaining 23 per cent was meant for the FIIs. Commodity exchanges were permitted to have FIIs’ investment up to 23 per cent along with FDI up to 26 per cent, subject to specific terms and conditions. The limit of FIIs’ cumulative investment in government securities was raised to US$3.2 billion. The FIIs and their sub-accounts were allowed to short sell, lend and borrow equity shares of Indian companies, subject to specific conditions.

Sources: 1. RBI, Annual Report, various issues. 2. Government of India, Economic Survey. New Delhi: Ministry of Finance, various issues.

The other aspect of the policy liberalisation is related to the financial market reforms in general. The reforms in banking sector, non-banking financial companies, mutual funds, money and capital market and in financial services have led to greater economic activity in the financial sector and also in other sectors. At the same time, with orderly development of the financial sector, the risk factor has naturally been brought under control. Thus, with growing activities 187

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and lessening of risk in the Indian financial market, the investors in general and the FIIs in particular found a congenial environment for investment. Moreover, the gradual move towards capital account convertibility relaxing control on funds movement was yet another significant aspect of the financial sector reform attracting the FIIs. Thus, in short, there is a mix of factors, and definitely not a single one, that have motivated the FIIs to make investments in Indian capital market.

THE GROWTH ORIENTATION CONTENT IN FIIs’ INVESTMENT Bridging of the Resource Gap Any discussion on FIIs’ investment in India is not complete without examining whether such flows have given stimulus to the processes of economic growth in the country. This issue can be discussed from different angles, a few being more important need to be explained here. First of all, the ‘dual gap’ approach justifies the inflow of foreign capital on the ground that it bridges the saving investment and foreign exchange gaps, thereby permits the warranted rate of investment and generates economic growth. Since the two gaps are assumed ex post equal, we better show the relationship between the rate of investment and the FIIs’ net investment in the country. The figures in Table 10.3 show that while the investment as percentage of gross domestic product (GDP) varied between 23.09 and 33.80 between FYs 1993–94 and 2007–08 (figures for FY 2007–08 being not available), the FIIs’ investment as percentage of GDP varied between –0.01 and 2.12. In majority of the financial years, the percentage was less than 1. If this is the case, the contribution of the FII flow to domestic investment is only marginal. However, the support of FII flow to the investments in the country is evident from the movement in the FII net investment figures largely in tandem with the movement in the figures of investment. The correlation coefficient between the two is positive at 0.5530.

Instability in the Investment Inflow Apart from the contribution of FIIs’ investment to the bridging of the resource gap, there is the aspect of instability in the volume of net 188

Foreign Institutional Investment in India Table 10.3

Foreign Portfolio Flows and Investment in the Country

(% GDP) FY 1993–94 1994–95 1995–96 1996–97 1997–98 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Investment

FIIs’ investment

23.09 26.00 26.90 24.48 24.60 22.57 26.29 24.36 22.95 25.19 27.25 31.50 33.40 33.80 n.a.

1.30 1.19 0.77 0.86 0.44 –0.01 0.68 0.60 0.42 0.19 1.89 1.29 1.28 0.74 2.12

Sources: 1. RBI, Handbook of Statistics on the Indian Economy, various issues. 2. Government of India, Economic Survey, various issues.

investment that cannot be overlooked. If the inflow of foreign capital is fluctuating, the policy makers cannot frame a sound investment plan; the investment plan becomes a stop-and-go one; the output and employment fluctuate. All this thwarts the very impulses for economic growth. This is not all. Since the FIIs have been dominating at the stock exchanges in India, the volatility in their investment makes the share prices volatile leading to greater amount of speculation in the financial market. Participants in the financial market transactions avoid any long-term financial commitment with the result that the economic activities get badly distorted. If the financial vulnerability turns large, the country can land in a currency/payments crisis. Now the question is how far volatile are the FII inflows in India. The volatility can be probed both on the cross-country basis and on the time series basis. In a cross-country framework, Gordon and Gupta (2003) find that during January 1998 to April 2000, the coefficient of variation (CV) in the Indian case was simply 1.56 per cent compared to 1.79 per cent in the Philippines, 2.89 per cent in Indonesia, 1.82 per cent in Korea and as large as 25.07 per cent in Thailand. It shows that even if there is volatility, it is less in India than that in many other Asian countries. 189

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Again, a bird’s eye view of the volatility during different time periods can be had from Figure 10.3. It shows monthly volatility and covers the post-Asian Crisis years—beginning from April 1999 to March 2008. However, to be very precise, we have calculated the standard deviation for different years based on the monthly figures. The outcome is presented in Table 10.4. The figures reveal that the standard deviation has increased over the years, except for two financial years, namely, 2001–02 and 2005–06 when it was lower than that in the previous year. It was as low as 130.65 during FY 2001–02 and as high as 3299.335 during FY 2007–08. However, taking into account the varying size of investment during different years, the CV has been computed. It moved usually in the range of 0.57–2.04, except for 4.73 in FY 2002–03. Even this much of volatility in the inflow is a serious matter, especially when we look at the FII flows from the viewpoint of stability in the Indian financial market and also the economic growth in the country.

FIIs and Increased Activities at the Indian Stock Market The impact of FIIs’ investment on the Indian economy can be analysed also through its impact on the turnover, market capitalisation and the share price index. It is contended that if the FIIs trade in the shares in large volume, there is an increase in the turnover and the market capitalisation leading to greater liquidity in the stock market. Again, greater demand for the shares helps raise the stock market index that in turn raises the investment. All this may lead to current and future rates of economic growth (Levine 1996). Table 10.5 presents the size of total turnover at the two major stock exchanges, namely, the BSE and the National Stock Exchange (NSE) during past few years and that in case of the FIIs. It is true that the correlation based on the daily figures between FIIs’ involvement in the stock market trading on one hand and the turnover, market capitalisation and the share price index on the other is not very positive to confirm their role in greater liquidity and greater investment in the Indian stock market, but their increasing large share in the total cash segment trading at the stock market cannot be denied. To be precise, between 23.4 and 35.7 per cent of the combined turnover in the cash 190

Source: RBI Bulletin, different issues.

Figure 10.3

FIIs’ Monthly Net Investment in India: FYs 1999–2008

India’s Financial Sector Table 10.4

FY

Annual Volatility in FII Flows Based on Monthly Figures

Mean of the monthly flow

1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

177.91 153.92 125.42 31.42 909.83 690.00 827.25 553.50 1877

Standard deviation 209.34 277.46 130.65 148.72 518.96 1,081.72 922.76 1,127.13 3,299.335

CV 1.18 1.80 1.04 4.73 0.57 1.57 1.12 2.04 1.76

Source: Based on the figures obtained from RBI Bulletin, different issues. Note: Calculation is based on the figures published in Reserve Bank of India Bulletin and SEBI Bulletin. Table 10.5

Turnover at BSE and NSE and Share of the FIIs

Total turnover (Rs. billion) FYs 1 2004–05 2005–06 2006–07 2007–08

BSE

NSE

Total

2

3

4

5,187 8,161 9,562 15,789

11,401 15,696 19,453 35,510

16,588 23,856 29,015 51,299

Turnover in case of FIIs Col. 5 as % (Rs. billion) of col. 4 5 3,880 6,525 10,102 18,299

6 23.4 27.4 34.8 35.7

Source: SEBI Bulletin, March 2007.

segment at BSE and NSE taken together was accounted for by the FIIs during FYs 2004–08. If they are so dominant in the trading activities at the stock market, an increase in the turnover, market capitalisation and the share price index can surely be attributed largely to them. The figures show that while the combined turnover of the BSE and the NSE moved up from Rs. 16.6 trillion to Rs. 51 trillion between FYs 2004–05 and 2007–08, the respective figures for the FIIs surged up from Rs. 3.9 trillion to Rs. 18.3 trillion. All this highlights a positive role of the FIIs in providing stimuli to stock market activities and thereby in accelerating economic growth in India. In order to substantiate this view, one can refer to the empirical study of Narsimhan and Ubaidullah (2007) who have used data available from NSE in three different time periods covering a total of 2 years 26 days from 17 May 2004 and have found that: 192

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1. Nifty moved up by one point in the first segment for every Rs. 720 million of FIIs’ investment. 2. Nifty moved up by one point in the second segment for every Rs. 300 million of FIIs’ investment. 3. Nifty suffered a loss of one point during the third segment for every Rs. 90 million selling by FIIs.

SUMMING UP The opening of the Indian financial market to the FIIs in September 1992 led to a huge flow of their portfolio investment in the country, although the annual/monthly ups and downs in their net investment were very much evident. There were a host of factors to attract the FIIs to the Indian capital market from time to time. But presently, as our study shows, the interest rate differential and the policy of the Indian government towards the financial market in general and the FIIs in particular were very much significant. The return chasing behaviour of the FIIs was not important. As far as the growth orientation of such flows is concerned, such investment, despite being only marginal in the economy’s annual investment outlay, moved in tandem with the movement in the investment rate. However, from the viewpoint of the surplus balance of payments scenario and buoyant foreign exchange reserves position, the role of FII flow in bridging of the foreign exchange gap did not attract our attention. Again, the volatility in the net monthly investment is quite large which may create instability in the financial market and also may not support the government’s move to go for a sound and stable investment plan. Yet again, FIIs’ role in transfusing liquidity in the capital market was expected to be large insofar as they had accounted for a very big share in the securities turnover at the stock exchange. It is because of this fact that they were responsible, at least to some extent, for a general bullish trend in the stock market index.

193

Epilogue

The significance of a liberal financial sector for economic growth stands proved. A number of studies confirm that any move infusing liberalisation into the financial sector leads to, first, bigger mobilisation of resources with less risk involved, second, desired corporate control and, third, better allocation of resources. The preceding discussion in the book focuses on the reform measures related to the key financial intermediaries and the financial market and instruments till the end of FY 2007–08 and analyses the broad impact primarily in terms of growth in activities, profitability, financial stability and also, to some extent, financial inclusion. It also deals with the international linkages of the Indian financial market focussing on the euro issues of the Indian firms and the FIIs’ investment in the Indian secondary market. The recent trends emerging during FY 2008–09 will, of course, be shown as a postscript.

FINANCIAL INTERMEDIARIES Commercial Banks Let us begin with the banking sector reform. The objective has been to make banks a profit-making unit along with desired financial strength and financial stability and ultimately to benefit those who were not so far the beneficiary of the banking facilities. To this end, capital adequacy norms were prescribed at par with the Basle norms that the banks were able to achieve. The CRR and SLR requirements were axed, so that the banks could have larger funds at their disposal for profitable lending. Interest rate structure was deregulated in order to do away with the artificial barrier and to allow the market forces

Epilogue

to work. Non-performing Assets (NPAs) were brought to a manageable limit through greater provisioning and better loan recovery methods. Income recognition norms were made more transparent and financial supervision was made more workable. Competition among banks was encouraged through liberalising entry norms so as to help improve efficiency. Last but not least, customer service was taken care of. With all these moves, the banks’ efficiency and thereby profitability increased over one-and-a-half decades of reform period. There were, of course, variations among different groups of banks—public sector, private sector and the foreign banks operating in the country. However, the scheduled commercial banks as a whole improved their efficiency. The net interest earned/asset ratio and the operational expenses/net income ratio squeezed, respectively, from 3.30 to 2.35 per cent and from 55.73 to 48 per cent between FY 1991–92 and FY 2007–08. With increasing efficiency, profitability did increase. It moved up from 0.35 to 0.99 per cent during the same period. What is important is that the profitability ratio was quite in tandem with the international standards. As far as financial stability is concerned, different ratios indicated improvement in this context over the period of reform. The banks’ ability to cover NPAs through provisioning improved substantially. The provisioning/NPA ratio moved up from 16.20 to 52.59 per cent during FYs 1991–2008. The capital adequacy of the banks too improved as the capital/assets ratio surged up from 2.62 to 7.29 per cent. The fund volatility ratio, on the other hand, dropped from (–) 13.53 to (–) 31.37 per cent during the above period showing greater financial stability. These ratios too were comparable to international standards. Finally, the efforts towards financial inclusion are only a recent one. Although steps were taken to reach the weaker sections of the society through no-frill accounts, yet, according to an RBI study, the progress has not been very satisfactory.

Non-banking Financial Companies Again, as far as the Non-banking Financial Companies (NBFCs) are concerned, the focus of reform fell greatly on regulating them to ensure financial viability as well as to protect customers’ interest. But still, 195

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the companies registered with the RBI are only a few meaning that a large number of NBFCs are yet to come under the RBI’s regulatory umbrella. As regards capital adequacy, the situation improved over the years. At the end of March 2008, around 83 per cent of companies, especially the deposit-accepting ones had a CRAR of 20 per cent or above. The NPAs’ position improved significantly as the net NPA/asset ratio fell drastically from 7.4 per cent at the end of March 1998 to 0.3 per cent at the end of March 2008. However, these companies have not been able to attract large deposits in relation to the total deposits moving to the banking sector. Their deposits were barely 0.73 per cent of the deposits moving to the scheduled commercial banks at the end of March 2008. A sense of confidence needs to be generated among the depositors so as to bring the NBFCs at par with the banking companies. Again, in view of various support measures, the efficiency of these companies improved. Although the financial expenses as well as operating expenses, both in relation to assets, remained moving, respectively, around 6 and 3 per cent between FY 1998–99 and FY 2007–08, the profitability ratio manifesting in net profit/asset ratio increased from 0.3 per cent in FY 1998–99 to 2.9 per cent in FY 2007–08. It could have been higher, had the NBFCs axed sizeably the operational and financial expenses. Last but not least, the element of financial inclusion is still not very apparent. It should be a part of the NBFCs regulations in future.

Mutual Funds The mutual fund business expanded since 1987 when a few organisations sponsored by banks and insurance corporations joined hands with the UTI to perform such business. Again, with the initiation of financial sector reforms, this business was further extended in 1993 to private sector companies, both domestic and foreign. Regulatory measures along with big doses of liberalisation were implemented on various fronts, such as maintenance of net worth, creation of new schemes, investment policy, profit distribution, so as to encourage the mutual fund companies to play an active role and, at the same time, to protect the interest of the small investors. All this had a positive impact on the size of resource mobilisation as the amount of gross 196

Epilogue

resource mobilisation surged up from Rs. 930 billion in FY 2000–01 to Rs. 44,644 billion in FY 2007–08. The size of net assets under management too inflated from Rs. 906 billion to Rs. 5,052 billion during this period. The largest share, say, over four-fifths was accounted for by the private sector companies. The open-ended schemes and income/ debt schemes proved more attractive. On the contrary, investment in money market instrument and in the government securities lagged far behind. On the whole, the performance of the mutual funds got great impetus from the reform measures. Yet the investment by mutual funds in the secondary market did not influence vividly the stock market index. Again, as far as financial stability is concerned, this aspect needs greater attention of the policy makers.

FINANCIAL MARKETS Primary Market for Securities First of all, in the primary market for securities, SEBI came to regulate the entire functioning with a view to making its structure and functioning greatly flexible and market oriented and protecting the interest of the investors. The development of infrastructure, such as merchant banking, venture capital funds and credit-rating agencies, and basing the pricing process on the market forces, known as bookbuilding process, were the focus of reform. All this bore fruit. The amount of the resources mobilised in the domestic segment surged up from a meagre of Rs. 142 billion in FY 1991–92 and below Rs. 500 billion during the early 2000s to Rs. 2,963 billion during FY 2007–08. Private placement outweighed the public offerings. The share of the private sector companies was large in case of public offerings, but in private placement, the public sector companies fared well. The discussion reveals that a very large part of the funds raised was accounted by the services sector and especially by those services that were financial in nature. In the manufacturing sector, chemicals and machinery-related companies were significant. Again, the securities were allotted mainly to big investors who could influence the market in their own way. However, the move of the Ministry of Finance towards dispersion of ownership in favour 197

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of individual shareholders may prove conducive to price stability and financial inclusion. Of late, the SEBI Advisory Committee has suggested to carry out the entire process of IPO through Internet and to lower the time lag between the issue and the listing of securities (Financial Express 10 March 2008). All this may boost further the primary market activities.

Secondary Capital Market In the secondary capital market too, SEBI is the regulator. The NSE and a few other stock exchanges were set up as well as the FIIs and also the domestic and foreign mutual fund companies were permitted to operate in the market so as to foster competition in this area. The procedure of listing, trading, clearing and settlement was made transparent and convenient with the introduction, among others, of electronic devices. The market for derivatives was launched to compete with the cash segment of the market. The transaction cost was also axed, so as to make the market still more attractive. Last but not least, FDI was allowed in the BSE and the NSE that is expected to improve the functioning even further. All these measures led to an upward move in the turnover, market capitalisation and the share price index. The turnover at BSE and NSE taken together swelled from Rs. 8,205 billion in FY 2001–02 to Rs. 51,299 billion during FY 2007–08. The total capitalisation during this period sped up from Rs. 12,491 billion to Rs. 99,961 billion. The annual average of BSE Sensex rose from 3,372 to 16,569 (FY 1978–79 = 100) and NSE Nifty recorded an increase from 1,077 to 4,897 (3.11.1995 = 100) during the same period. The derivatives segment is quite a new one but it showed faster growth in the turnover during the same period from Rs. 1,039 billion to Rs. 133,123 billion. Besides the trade in equity shares, the debt securities were also traded. Their turnover increased manifold from Rs. 9,472 billion in FY 2001–02 to Rs. 57,031 billion during FY 2007–08. However, a lion’s share was accounted for by the government securities. The trade in corporate debt remained confined to a lower limit. The rate of returns too improved over the years but volatility in the returns remained a major cause of concern, especially when we compare it with that among major international stock markets. 198

Epilogue

In other words, financial stability is yet to be achieved. Last but not least, the market has moved towards greater efficiency but yet it has to go a long way to achieve the desired efficiency.

Market for Government Securities Apart from the primary and secondary market, the ray of reform fell also on the market for government securities—treasury bills and dated securities—so as to meet effectively the desired fiscal and monetary objectives. The reform measures were manifest especially in the diversified structure of this market, introduction of auctions, enhancement of marketability and liquidity, strengthening of the basic infrastructure and easing of the settlement procedure. The central government securities, to which the present study is confined, played an important role in bridging the fiscal deficit. While they covered only around one-half of the central government’s fiscal deficit during FY 1997–98, the percentage was almost 100 during FY 2006–07, although it was lower at 75 during FY 2007–08. As far as the infusion of liquidity is concerned, the government securities played a significant role. They were transacted in the secondary market both outright and under repo arrangement. There was a big growth in the quantum of these transactions in past years. In FY 2007–08, those being outright amounted to Rs. 16,618 billion and those under repo arrangement were as large as Rs. 38,917 billion. The share of treasury bills was low compared to the dated securities. The only problem is that instability in the liquidity infusion still persists. However, it is quite evident from the study that liquidity has an impact on the yield and the yield has a definite role in anchoring rate of interest in the capital market. Last but not least, there has been diversification in the ownership pattern of the government securities with the result that the financial stability has been generated and market has grown more efficient. Greater integration within the government securities market is another plus point conferring greater efficiency on the market.

Indian Money Market When one talks about reforms in the Indian financial market, the money market segment is no less significant. The Indian money market has 199

India’s Financial Sector

different segments and variety of instruments. The objective of reform has been to encourage the turnover through infusing greater doses of transparency, to bolster a balanced development in different segments of this market and to foster stability through checking volatility in the interest rates primarily through repo and reverse repo measures. The CNMM was made a purely inter-bank market. Those participants who were barred from entering the inter-bank market can now use a newly created instrument, known as CBLO. The ceiling rate in case of CBLO is based on MIBOR and this instrument enjoys the provisions of marking to market and desirable haircuts. As a result, the turnover increased in this case. The average daily turnover (double leg) moved up from Rs. 5.15 billion in FY 2003–04 to Rs. 556.26 during 2007–08. Again, it is because of checking fluctuations in the call money rates that the turnover in the repo market outside the LAF too increased. The increase in terms of average of daily transactions (all legs) was recorded from Rs.104.35 billion in FY 2003–04 to Rs. 547.36 billion in FY 2007–08. Besides, the Vaghul Committee twins—CPs and CDs were made more attractive through making changes in their structure, cutting the transaction cost and providing incentives. The turnover in their case did show an upward trend. The outstanding amount of CPs rose from Rs. 58.47 billion at the end of March 2001 to Rs. 325.92 billion by March 2008, except for a marginal drop during FY 2005–06. Similarly, in case of CDs, the outstanding amount rose from a bare figure of Rs. 7.71 billion at the end of March 2001 to Rs. 1,477.92 billion by March 2008. The objective behind reforming money market was largely achieved. Besides increase in turnover in the money market as a whole, the share of call money market in the total turnover of the money market reduced and the reduction was in favour of CBLO. It shows a definite move towards creating the CNMM a purely inter-bank market and also the success of the CBLO. The call money rates could be stabilised to some extent insofar as, in the majority of the months under study, they moved within the tunnel provided by the repo and reverse repo rates. Last but not least, the correlation in the interest rates/discount rates between different segments of the money market turned greatly positive meaning that the different segments got highly integrated. Greater integration is the most valuable fruit of the reform measures. 200

Epilogue

Foreign Exchange Market Finally, the study is not limited to the capital and money market. It discusses also the reforms in Indian foreign exchange market. The move towards reform was manifest in the adoption of managed floating exchange rate system, restructuring of the very infrastructure of the market, introduction of a variety of activities, such as swaps and options and also a gradual move towards capital account convertibility. Besides, the intervention by the monetary authorities, say, RBI helped correct imbalances in supply and demand forces and infused stability in the foreign exchange market. The turnover in the market increased from Rs. 1,387 billion in FY 2000–01 to Rs. 12,316 billion during FY 2007–08, although the size of the turnover was much lower in the merchant segment than in the inter-bank market. Again, instability in the monthly turnover was very much apparent that needs to be controlled. Nevertheless, the market attained greater efficiency in view of reduced bid-ask spread, greater alignment between forward premia and interest rate differentials and lower degree of the RBI’s intervention giving way to the free play of market forces.

INTERNATIONALISATION OF INDIAN FINANCIAL MARKET The transactions in the Indian financial market are now not limited to the boundary of the country. The securities of the Indian firms are traded in the primary and secondary segments of the international financial market. And also the FIIs are allowed to transact securities at the Indian stock exchanges.

Euro Issues A number of Indian firms have issued FCCBs and also shares under the ADE/GDR arrangement to get foreign exchange and to reap the primary and secondary market gains abroad. The Indian government initiated the policy in 1992 and liberalised it from time to time with the result that annual figure of such issues increased over the years and it was as large as Rs. 366 billion during FY 2007–08. The shares of 201

India’s Financial Sector

a number of firms were listed on major international stock exchanges. In past years, the volume of turnover of the ADRs/GDRs of Indian companies at the international stock exchanges swelled fast. While in many cases, ADRs/GDRs were traded at premium, trading at discount was not very uncommon. Nevertheless, one aspect is very significant to note. It is a very close integration between the Indian secondary market and the international secondary market in view of a highly positive correlation between the movement of price index of ADRs/ GDRs and that of those shares in the domestic market.

FIIs’ Investment As far as the FIIs’ investment in the Indian secondary market is concerned, the amount of the net investment was quite substantial. In this case too, the policy was initiated in 1992 and was liberalised from time to time. The amount of FIIs’ net investment in the Indian secondary market varied widely over different months and also over different years. The apparent reason was that the FIIs being a fair weather friend were greatly influenced by the international economic scenario as well as the economic scenario in India. However, their net investment was over US$16 billion during FY 2007–08. These investors showed preference for equity in view of reaping gains from price fluctuations, although they invested in debt instruments too. The reasons for their investment in the Indian market as per the present study were mainly the interest rate differential and the liberalisation of the governmental policy on this count. It is true that the net investment of the FIIs accounted for a very small share in the total domestic investment; yet, their influence on the stock market activities was profound.

202

Postscript

CRISIS IN INDIAN FINANCIAL MARKET The preceding discussion makes it evident that there was an overall upward trend in the Indian financial market till FY 2007–08. But the trend, as it is being witnessed now, took a reverse gear in FY 2008–09. In fact, the reversal was apparent as back as in the last quarter of FY 2007–08. In the following quarters, it turned stark. Here, we present some more significant trends that the Indian financial sector has witnessed.

Factors behind the Crisis The reversal is the aftermath of the factors prevailing both in the international economy and in the domestic economy. There is a view based on the ‘decoupling’ concept that the economic scenario prevailing in a country does not necessarily influence the economic variables in other countries. Akin and Kose (2007) found in their study that the emerging market economies had stood decoupled from performance of the developed countries for past couple of decades. But the recent crisis in the Indian financial market following the financial crisis in the US has put the decoupling concept in a wrong box. The financial crisis in the US was primarily the sub-prime crisis that was quite enormous. A continued escalation in the real estate prices for a decade or so and then a sudden and drastic drop in those prices during 2007 made the collateral of the home loans subprime. There were large defaults that in turn led to huge bank losses and put abnormal pressure on the functioning of the banks. The losses on this account were estimated to be over US$400 billion, over

India’s Financial Sector

one-half of which was to be borne by banks and other highly leveraged financial institutions. For each dollar of loss, these institutions had to shrink their balance sheet by US$10 to US$25 with the result that their lending was greatly affected. As per an estimate, there should be a squeeze over US$2 trillion in their lending activities (http://www.livemint.com). All this had a spillover effect in form of dwindling currency, an economic recession and subdued activities in the financial market of the US. The factor at the domestic front was the galloping inflation. The rate of inflation in the country, which was barely 4.26 per cent during the week ended on 5 January 2008, rose to 7.75 per cent by the last week of March 2008 and to 11.89 per cent by 28 June 2008. It crossed subsequently the 12-per cent mark and continued to maintain almost the same level during the second quarter of FY 2008–09. The reason behind the fast-growing rate of inflation lies outside the scope of our discussion. However, one must accept that it did put a definite impact on the activities in the Indian financial sector more directly in terms of falling real income from investment. ‘Fisher effect’ clearly explains that higher the rate of inflation, lower is the real interest rate with a given nominal interest rate. It is true that the growth in the rate of inflation began to recede during the closing months of 2008, yet the damage created by it was enormous. These two factors along with many others, first of all, accelerated the disinvestment by the FIIs and thereby put a curb on the secondary and primary capital market activities. The spillover effect permeated over other areas of the financial market and also over the entire economy.

Large Withdrawal of FIIs’ Investment It is true that rising inflation axed considerably the real return of the FIIs from the Indian secondary market that was, in the sequel, responsible for their disinterestedness in investing at the Indian stock exchanges. But the most significant factor responsible for withdrawal of their investment was the US sub-prime crisis. The FIIs pulled back their investment from the Indian market perhaps for the purpose of making up of the losses in the US market. They also pulled back their investment in those securities where price oscillations were greater. 204

Postscript

It is a psychological phenomenon that whenever there is a crisis, the investors try to avoid risk taking and make investment only in less risky channels. The pull-back was quite large and resultantly, their net disinvestment in India was as large as US$8.991 billion and US$1.643 billion, respectively, in February and March 2008 (RBI 2009). The SEBI eased the registration norms for FIIs. The result was positive. There were 68 new registrations during one-and-a-half months of 2008 compared to 226 during the whole of 2007. The Indian government too liberalised the policy and broadened the definition of the FIIs. It brought into the ambit of FIIs also the sovereign wealth funds, NRIs-owned asset management companies, unregulated university funds, endowments and charitable fund, bilateral and multilateral organisations and overseas central banks. The ceiling on FIIs’ cumulative investment in government securities was raised from US$3.2 billion to US$5.0 billion. In corporate securities, it was raised from US$1.5 billion to US$3.0 billion. This was on first-come-firstserve basis with an individual entity limit of US$200 million (Financial Express 18 June 2008). But FIIs’ investment position failed to improve. FIIs recorded a net disinvestment of over US$12.409 billion during the first 9 months of FY 2008–09 compared to a net investment worth US$24.472 billion during the first 9 months of FY 2007–08 (RBI 2009) (see Table PS 1). A further anatomy of figures makes it clear that disinvestment was vivid in case of equity rather than debt securities perhaps in view of Table PS 1

FIIs’ Net Investment in Indian Financial Market

(US$ billion) Month April May June July August September October November December Total

FY 2007–08 1.963 1.847 3.279 4.685 –3.323 7.057 6.833 –0.265 2.396 24.472

Source: RBI Bulletin, March 2009.

205

FY 2008–09 –1.432 –0.734 –3.011 –0.499 0.464 –1.403 –5.250 –0.574 0.030 –12.409

India’s Financial Sector

the fact that investment in equity carried greater risk. During the first 9 months of FY 2008–09, debt securities presented a net investment for Rs. 82.010 billion vis-à-vis equity that showed a net disinvestment for Rs. 415.55 billion (SEBI 2009).

Reversals at the Secondary Capital Market The FIIs’ disinvestment influenced many areas of the Indian financial sector. Its direct and more proximate repercussions fell on the secondary market transactions. Since FIIs dominate the Indian secondary market, their pulling back of investment was manifest in the crash of stock price index at the Indian stock exchanges. In January 2008 alone, the fall was recorded at 16 per cent which was higher than 12.44 per cent for the emerging market as a whole, although lower than 16.12 per cent in Russia, 21.40 per cent in China and 22.70 per cent in Turkey (Financial Express 12 February 2008). In February and March 2008, there was a further drop in the share price index. A comparative analysis shows that the BSE Sensex which was 20,301 on 1 January 2008 plunged to 14,833 on 18 March 2008. The respective figures for NSE Nifty were 6,144 and 4,533. The galloping rate of inflation put fuel to the fire. It caused the real rate of return to shrink. Furthermore, the profitability of the companies relying largely on debt shrank fast. The price of their shares fell fast pulling down in the sequel the stock market index. The explanation is that the RBI increased the interest rate in order to check the inflationary pressure. Higher interest rate helped enlarge the interest payment. The pre-tax profit fell despite large operating profits. As per a study conducted by Mint, there was a dramatic slowdown in the growth of net profit of the Indian companies that constituted the country’s stock market indices—BSE Sensex and NSE Nifty. The situation was even worse if the oil firms were excluded from the sample (Mint 30 June 2008). Another study of the Economic Times (2 July 2008) reveals that 347 listed companies paid 26 per cent lower dividend during the first half of 2008 compared to the corresponding period of 2007. The profitability being the first victim, the BSE Sensex and NSE Nifty sagged further despite minor revival in a few months. The average figures of BSE Sensex and NSE Nifty during the first nine months of FY 2008–09 are presented in Table PS 2. 206

Postscript Table PS 2

Secondary Capital Market Indices

Period (average of the month)

BSE Sensex (1978–79 = 100)

NSE Nifty (3 Nov. 1995 = 100)

April 2009 May 2009 June 2009 July 2009 August 2009 September 2009 October 2009 November 2009 December 2009

16,291 16,946 14,997 13,716 14,722 13,943 10,550 9,454 9,514

4,902 5,029 4,464 4,125 4,417 4,207 3,210 2,835 2,896

Source: RBI Bulletin, March 2009.

It is evident from the figures that the BSE Sensex fell by over 42 per cent during the above period. The NSE Nifty was not in a much better form as it too fell by over 41 per cent during the same period. A study of Mint (1 January 2009) presents the extent of fall in 14 stock market indices covering different countries during the whole of 2008 and finds that the fall in BSE Sensex and NSE Nifty was the largest only to Shanghai SE Composite Index that slipped by 65.39 per cent. The BSE Sensex fell by 52.45 per cent followed by NSE Nifty which plunged by 51.79 per cent compared to a fall between 49 and 33 per cent in 11 other indices. With all these symptoms, it was natural for the market capitalisation to shrink. The market capitalisation at the BSE squeezed from Rs. 57,943 billion to Rs. 31,448 billion between April and December 2008. At the NSE, there was recorded a drop in market capitalisation from Rs. 54,428 billion to Rs. 29,168 billion during the same period. In relation to the gross domestic product, the market capitalisation at the BSE fell from 152.1 per cent at the end of 2007–08 to 59 per cent during December 2008. At the NSE, it was a fall from 138.8 to 55.5 per cent during the same period (http://www.rbi.org). It was not simply an overall downtrend in the stock market index or the market capitalisation. A high degree of volatility was marked in the stock market indices. As Table PS 3 shows, the annualised volatility in BSE Sensex and S&P CNX Nifty during April to December 2008 was, respectively, 45.69 and 43.89 per cent. This figure was much higher than the annualised volatility in many other indices around the world. 207

India’s Financial Sector Table PS 3

Annualised Volatility in Stock Market Indices during April to December 2008

(%) Indices US Dow Jones US NASDAQ Comp. UK FTSE Hong Kong HIS Malaysia KLCI South Korea Kospi

Volatility

Indices

41.44 44.70 39.69 51.33 18.40 42.14

Thailand SET Singapore STI Germany DAX France CAC BSE Sensex S&P CNX Nifty

Volatility 36.60 35.14 39.61 42.73 45.69 43.89

Source: SEBI Bulletin, January 2009.

Downtrend in the Primary Market The secondary market effects permeated to the Indian primary market for securities. It is observed that after the secondary market crash in January 2008, the retail primary market investors failed to respond to the issues. The maiden issue of Wockhardt Hospitals ran into rough water. Similar was the case of Emaar-MGF Land Ltd. In both the cases, price had to be reduced after bleak response. Even then there was no response (Financial Express 6 February 2008). Surya Foods and Agro had to postpone their IPO for Rs. 1,500 million (Financial Express 15 March 2008). In view of making the primary market lucrative and to do away with the grey market, SEBI made changes in the public issue process reducing the gap between opening of the public issue and its listing to less than five days and increasing the application money that the institutional investors had to put up, from 10 to 100 per cent. It also reduced the fees for filing offer documents for public issues and mutual funds from 0.03 to 0.005 per cent and the annual fee for registration of mutual funds to 0.0005 per cent of assets under custody from then existing 0.001 per cent. The registration fee for venture capital funds was halved to Rs. 0.5 million (Financial Express 6 March 2008). SEBI proposed a 25-per cent price band on the issue price on the listing day of an IPO up to a size of Rs. 2.5 billion to arrest the price volume volatility on the day of listing of IPO under this size. It is because when the volatility is not sustained by the general public investors, the band should assist in a more orderly price discovery over a period of time. Again, with the implementation of the recommendations of the SEBI-appointed committee on reforming IPOs, the deposit of qualified institutional buyers was revised as 100 per cent of the bid 208

Postscript

amount instead of 10 per cent earlier; the ceiling on the application of a single investor was doubled to 0.2 million shares, and the allotment of shares was done on a proportionate basis rather than on a discretionary basis. Despite these measures taken by the SEBI, desired positive effect on the primary market trading was not felt. In face of bleak market, the companies raised funds to a great extent through rights issues. The amount of rights issue as shown in Table PS 4 constituted 84 per cent of the total resource mobilisation during the first three quarters of FY 2008–09 compared to barely 18 per cent during the corresponding period of the previous financial year. The total resources mobilised from the primary market amounted barely to Rs. 142.45 billion during April to December 2008—down from Rs. 727.10 billion during the corresponding period of FY 2007–08 as shown in Table PS4. It was a drop of 80.41 per cent. As far as the number of issue is concerned, the drop was recorded from 125 to 43 during the respective periods. Table PS 4

Resource Mobilisation in the Primary Market for Securities

April to December 2007 No. of issues

Amount (Rs. billion) 3

April to December 2008 No. of Amount issues (Rs. billion)

% change in April to December 2008 No. of issues

Amount

1

2

4

5

6

7

Public issues Rights issues QIP Total

74

381.53

20

20.59

–2.97

–94.60

22

134.47

21

119.97

–4.55

–10.78

29 125

211.10 727.10

2 43

1.89 142.45

–93.10 –65.60

–99.11 –80.41

Source: SEBI Bulletin, January 2009.

Shrunken Activities of Mutual Funds The massive withdrawal of investment by the FIIs, the resultant crash in the stock market indices and the downtrend in the primary market influenced also the activities of the mutual funds. They sensed emerging uncertainty in the behaviour of the financial market and turned cautious about their involvement in the secondary market activities. 209

India’s Financial Sector

Their investment in the secondary market amounted to Rs. 371.27 billion during April to December 2008, compared to Rs. 583.72 billion in the corresponding period of the preceding financial year. Moreover, they invested over 78.80 per cent of their funds in debt securities in view of greater risk in equity investment. Again, on account of uncertainties in the market, the mutual funds were not able to get funds from the general investors. The investors started giving cold shoulders to new fund offerings. The maiden fund offering of Mirae Asset Global Investment Management (India) Pvt. Ltd could collect only Rs. 700 million by 10 March 2008. Morgan Stanley’s ACE Fund managed to collect barely Rs. 800 million during the same period. These figures were far lower than Rs. 56.6 billion collected by Reliance Capital Asset Management Company’s Natural Resource Fund in the first week of February 2008 (Mint 15 March 2008). As on 30 June 2008, the NAV of nearly 30 odd equity schemes was at its 52-week low level (The Economic Times 2 July 2008). On the whole, the resource mobilisation was abjectly poor during the first three quarters of FY 2008–09. It was rather negative at Rs. 304.32 billion compared to Rs. 1,239.93 billion during the corresponding period of FY 2007–08. In fact, there was a massive redemption during April to December 2008 especially among the privately owned mutual fund companies. All this had an impact on the size of asset under management of the mutual fund companies that fell from Rs. 5,628 billion at the end of March 2008 to Rs. 4,134 billion at the end of December 2008 (http://www.amfi.com).

Euro Issues The gloom prevailed also in case of the fund mobilisation through the euro issues. During January to June 2008, funds raised through overseas depository receipts and through the issue of FCCBs amounted, respectively, to US$211 million and US$424 million compared to US$4.847 billion and US$4.717 billion, respectively, during the whole of 2007 (Mint 4 July 2008). The situation was not very different during the first three quarters of FY 2008–09. As per the RBI figures, the funds mobilised through euro issues amounted to Rs. 46.85 billion during April to December 2008 compared to Rs. 249.72 billion during the corresponding period of the previous financial year (http://www. rbi.org). 210

Postscript

The impact was seen also on the price of the ADRs/GDRs of the Indian firms at the overseas secondary markets. The Appendix PS A1covers 86 cases and presents a comparative picture of their market price during first two quarters of 2008. In the first quarter, a comparative picture of four cases is not found as they were not traded on 1 April 2008. Out of 82 cases, there was appreciation in the market price of two cases. In the rest 80 cases, the market price plunged. The extent of the drop in prices varied widely. In 15 cases, the price fall was less than 20 per cent. In 34 cases, it was over 20 per cent but less than 40 per cent. In 29 cases, the price ebbed over 40 per cent but less than 60 per cent. There were only two cases where the drop was over 60 per cent. In the second quarter of 2008, there were 11 cases where the prices rose, although the rise was only meagre. In 25 cases, they fell below 20 per cent. In 37 cases, the fall was recorded 20 per cent or more but less than 40 per cent. There were four cases where the fall was steeper at 40 per cent or higher but less than 60 per cent. There was a lone case where the price decline was beyond 60 per cent. The Instanex Skindia Index shows that the GDR/ADR price index at the international stock exchanges decreased from 3639.43 on 1 January 2008 to 1278.89 on 23 December 2008. It was a drop of 64.8 per cent. On comparing the fall in the ADR/GDR prices with those of domestic share prices of the same firms, it is revealed that the plunge in the former was steeper. Mint (25 March 2008) has made a study of 14 such firms and has found that out of 14 Sensex firms, 13 experienced a steep fall in their ADR/GDR prices compared to their local share prices between 10 January and 19 March 2008 (Table PS 5). The comparison shows, first, greater integration between the Indian financial market and the international financial markets and that the impact of sub-prime crisis in Indian secondary market was not as intense as it was in case of international financial markets. Moreover, it is because of lowering price of ADRs and GDRs that the debt burden of the Indian firms was expected to rise abnormally. The explanation is that the Indian firms issue FCCBs that are converted into equity shares after some time at a predetermined rate. If the stock price is greater than the conversion price, the bonds are converted into equity shares and, in the sequel, the burden of interest payment and repayment is over. But, in many cases, when the conversion price was greater in the wake of falling stock prices, it was not 211

India’s Financial Sector Table PS 5

Firm

Changes in the ADR/GDR Prices vis-à-vis Respective Local Prices of 14 Sensex firms during 10 January to 19 March 2008

% change in ADR/GDR prices

ICICI Bank Reliance Comm. L&T SBI HDFC Bank Reliance Inds. Tata Steel WIPRO Hindalco Infosys Tata Motors Satyam Comp. Cipla Ranbaxy Lab.

–51.26 –44.34 –34.86 –32.68 –32.41 –30.31 –27.90 –27.10 –24.91 –22.08 –19.97 –13.09 –1.53 –7.91

% change in local prices –43.51 –36.38 –32.52 –29.47 –26.16 –28.67 –25.38 –22.76 –23.42 –16.25 –13.16 –7.19 –1.90 –13.03

Source: Mint, 25 March 2008.

in the interest of the firm to convert the FCCBs into equity shares. Servicing of bonds remained a major problem. In fact, the Indian firms with FCCBs valued at US$17.7 billion were facing this problem (Mint 13 March 2008). However, many firms managed to lower the conversion price under the provisions of the reset clause where the conversion price might be revised with a fall in the company’s share price below a predetermined level. Pioneer Embroideries Ltd lowered the conversion price by 30 per cent in March 2008. In January 2008, it had already lowered the price by 10 per cent. As a result of the fall in the conversion price, the dilution in the equity turned higher and the firms needed the issue of more shares. The downtrend was observed not only in the ADRs/GDRs prices abroad. The prices of bonds issued overseas by the Indian firms were also on the ebb in the final quarter of FY 2007–08. The yield turned greater than the coupon rate. In such cases, the Indian firms had to start buying back the debt securities. ICICI Bank Ltd bought back US$50 million worth of overseas bonds that were to mature in 2012 (Mint 13 March 2008). Other banks might follow the lead. In other words, issuing overseas bonds did not remain lucrative. In view of this problem, the Indian government permitted the funds raised through FCCBs to be used for the equity of other companies of the group, 212

Postscript

subject to the necessary FDI cap (Financial Express 16 February 2008). How far this provision is workable is not beyond doubt.

The Exchange Rate Scenario The impact of the sub-prime crisis along with the domestic inflation was visible also on the exchange rate. With the outflow of funds on FIIs’ account, falling stock market index and tight position of the inflow of fresh investments on account of liquidity crunch in the overseas market, the rupee depreciated by around 2.5 per cent during the last quarter of FY 2007–08 after gaining 12.3 per cent during the first three quarters of the same financial year. On 17 March 2008, rupee touched a 6-month low of 40.735 a dollar. The depreciation continued to persist in the first three quarters of FY 2008–09. Table PS 6 shows the average exchange rate of rupee in relation to US dollar and euro. It is evident from the figures that the rupee depreciated vis-à-vis US dollar from Rs. 40.65 in April 2008 to Rs. 49.69 during November 2008, although there was a slight appreciation during the following month to Rs. 48.45. Similarly, the trend in Rs./euro was not very different. Barring a few months when there was marginal appreciation, rupee fell from 62.78 to 68.22 vis-à-vis euro during the same period. It may be noted that the depreciation of rupee continued to remain despite huge selling of US dollar by RBI in the foreign exchange Table PS 6

Exchange Rate: Indian Rupee vis-à-vis US Dollar and Euro during April to December 2008

Monthly average

Rupee/US$

Rupee/Euro

April 2008 May 2008 June 2008 July 2008 August 2008 September 2008 October 2008 November 2008 December 2008

40.65 42.79 43.21 42.49 44.37 46.88 49.24 49.69 48.45

62.78 66.71 67.92 66.33 63.41 64.99 62.89 63.46 68.22

Source: SEBI Bulletin, various issues.

213

India’s Financial Sector

market ranging between US$1.477 billion and 20.626 billion a month during May–December 2008 (RBIB, March 2009). There were basically four reasons. First, it was the bounce in US dollars as Fed rate cut seemed to be coming to an end. Second, it was the FIIs’ net disinvestment that was really huge. Third, it was the soaring oil prices, at least for only a few months that led to greater demand for dollars to meet the oil import bill. Fourth, it was the psyche of the general importers who advanced their imports in face of depreciating rupee in order to minimise their exchange rate exposure. These factors led to a rise in demand for dollars, euro and other foreign currencies and, in the sequel, to depreciation of rupee. As far as the nominal and real effective exchange rates are concerned, the six-currency trade weighted NEER and REER of the rupee depreciated, respectively, by 8.5 and 3.7 per cent between March 2008 and September 2008. By December 2008, these rates slid further. To be precise, during December 2008, NEER, based on six-currency weight, was 62.66 compared to an average of 74.17 in FY 2007–08 (1993–94 = 100). The respective figures for REER were 99.89 and 114.09 (RBI 2009).

The Market for Currency Futures Despite the downtrend, the government set up the market for currency futures following the recommendations of the Raghuram Rajan Committee and the Expert Group at the RBI. The three Indian exchanges, namely, BSE, NSE and MCX applied for dealing in currency futures. RBI and SEBI released the guidelines in this respect on 6 August 2008. Finally, NSE started operating on 29 August 2008. MCX and BSE followed the suit. The guidelines allowed only US dollar–rupee contracts with a size of US$1,000 for a maturity not exceeding 12 months. The trading is done on Monday through Friday excluding public holidays between 9.00 a.m. and 5.00 p.m. and settlement is done on the last working day of the month, and not earlier. Thus, the standardised size is smaller than those at the international exchanges. The contracts are quoted and settled in rupee. The membership of the currency futures market would be separate from the membership of derivatives/cash segment. Again, only 214

Postscript

a resident Indian, including banks, can participate in the deal. This means that the FIIs/NRIs are not entitled to participate in the deal. A bank being a member must have reserves worth Rs. 5 billion, 10 per cent CRAR, an NPA of 3 per cent at the maximum and a profit record for at least 3 years. The trading limit for an individual client is US$5 million or 6 per cent of the total open interest, whichever is higher. For a trading member—bank or broker, it is US$25 million or 15 per cent of the total open interest, whichever is higher. The hedger or the client is first registered with the trading member who buys or sells the currency futures contract on behalf of the client. The marking to market is based on the daily settlement price which is arrived at after taking the weighted average of last half an hour’s transactions. The loss or gain arising out of this process is settled on t + 1 basis. At the end of the day, net positions are reset with respect to the current day’s daily settlement price and are carried forward to next day. Finally, on the settlement day, the settlement is done in cash payable in rupee. In the entire process, the clearing member has a crucial role to play. At the NSE, its wholly owned subsidiary, National Securities Clearing Corporation Ltd (NSCCL) carries out the entire clearing and settlement process. It acts as counter party to all transactions and guarantees the final settlement. It carries out also novation which means that it helps replacement of one obligation with another with the mutual consent of both the parties. The clearing banks help NSCCL in carrying out clearing and settlement. The NSCCL monitors the members’ operation online and asks for immediate halt of any transaction if the open position or the margin money requirements are violated. Here, it may be mentioned that the margin requirements are enforced by the NSCCL. It calculates the initial margin money requirements on the client’s level using Standard Portfolio Analysis of Risk methodology and informs the trading members daily about the clients’ margin liability. The trading members submit the compliance report. The extreme loss margin in case of the trading members is 1 per cent of the value of their gross open position. Now the question is whether the currency futures are better than the forwards transacted in India. First of all, while in case of OTC forward contracts, the banks quote different bid-ask rates for different 215

India’s Financial Sector

customers, future rates are shown on the screen of the exchange. Thus, the price discovery is more transparent in case of futures. Second, participants, such as exporters and importers, can go for a forward contract only for their underlying transactions. Their purpose cannot be speculation. But in case of currency futures, no underlying securities are required. As far as trading size is concerned, the value differed widely from one stock exchange to the other. At the NSE, the amount moved up from Rs. 2.620 billion in September 2008 to Rs. 10.876 billion in December 2008. At MCX too, it moved up from Rs. 3.248 billion in October 2008 to Rs. 10.922 billion in December 2008. On the contrary, at the BSE, it plummeted from Rs. 383 million to Rs. 13 million during October to December 2008 (SEBI Bulletin January 2009).

Activities in the Money Market It is true that during the first quarter of FY 2008–09, the daily average call rate continued to remain normally within the tunnel created by reverse repo and repo rates. But during the following quarter, the call rate mostly hovered around the repo rate reflecting perhaps the impact of the increase in the CRR in three stages to 9 per cent and in repo rate to 9 per cent. The average call rate was 9.10 per cent during August 2008 and 10.52 per cent in September 2008. As regards treasury bills, the primary market yields tended to harden as a sequel to high money market interest rates. In the third quarter, the pressure on the Indian money market continued on account of RBI’s intervention in the foreign exchange market, but a cut in CRR checked the call money rate from unwarranted appreciation. During mid-September, the failure of Lehman Brothers led to a panic in the world financial market. However, the Indian money market activities were not so badly affected. During the third quarter, there was some minor improvement in the money market scenario. Table PS 7 shows the trends in different segments of the Indian money market during April to December 2008 compared to those during FY 2007–08. Let us first talk about the average daily volume of transactions (one leg) in the call money market; it showed a marginal increase during April to December 2008 over that during FY 2007–08. The transactions in CBLO and term money market were almost 216

Postscript Table PS 7: Transactions in Indian Money Market

(Rs. billion) Average daily volume of transactions (one leg)

Period FY 2007–08 April to December 2008

CD CP Term outstanding outstanding Call money at the end of at the end of money Repo market outside LAF CBLO market the period the period 106.97 113.71

136.84 124.87

278.13 278.57

3.52 3.54

338.13 380.55

1169.04 1512.14

Source: Reserve Bank of India (2009).

constant during the above period. Repo outside LAF declined but only marginally. The outstanding amount of CP and CD rose during the first nine months of FY 2008–09.

Banks and NBFCs However, a few push-ups in CRR entailed upon the profitability of many banks. The net profit of some of the banks, namely, Canara Bank, Allahabad Bank, Indian Overseas Bank, fell by a good margin. Again, in order to make the NBFC financially stronger to sustain the upheavals in the economy and to bring in greater transparency in their working, RBI issued guidelines on 2 June 2008. The guidelines prescribed, first, to raise CRAR from 10 to 12 per cent immediately and further to 15 per cent from April 2009. Second, they made it mandatory to disclose some additional information in their balance sheet, especially related to CRAR, derivative deals and maturity pattern of assets and liabilities. Moreover, the NBFCs are now to submit halfyearly reports relating to various aspects of liquidity, such as structural liquidity, short-term dynamic liquidity and the interest rate sensitivity. RBI tightened further the deposit-accepting policy of the NBFCs. An NBFC with a minimum investment grade credit-rating and a capital adequacy ratio of 12 per cent can accept deposit only up to 1.5 times of their NOF. Earlier it was four times. In other cases, this multiple is 1. Any excess level of deposit has to be brought down by March 2009. But these measures have hardly improved their financial strength. 217

India’s Financial Sector

To conclude, India’s financial sector continued to remain under strains during the first three quarters of FY 2008–09.

The Way Ahead It is difficult to say how long the financial turmoil shall exist. Nevertheless, if remedial measures are taken, the time span of the crisis will certainly be shorter. The remedial measures need to be taken at different levels. One is the international level. It is the international agencies that can do something. During the Asian Crisis, it was the IMF that had provided a huge financial package to deal with that crisis. It can be done even now. This is why the G-20 Summit recommended for trebling the resources with the IMF—from the present US$250 billion to US$750 billion. But this measure is fraught with a couple of problems. One is that unwarranted liquidity should not be created and allocated among the member countries. The other problem is related to the conditionalities associated with the lending. The issue is whether the IMF’s prescription for greater liberal policies would be befitting at a time when there is a growing consensus on a fine balance between the state and the private sector. It may be recalled that the handsome financial package to remedy the Asian Crisis carried too much of intrusiveness that the Asian countries did not relish. Their unwillingness to abide by the IMF conditionalities was the factor behind their excessive reliance on reserves build-up. Thus, whenever the IMF’s financial package is talked about, these two issues should be taken into account. The second level of the policy prescription is the national level. All the different governments—whether developed or the emerging market economies—should take appropriate steps to enhance liquidity. Since the different economies are interrelated, the fruitful results of the different measures taken up in one country will definitely permeate over to other countries. It may be mentioned in this context that there is unanimity among the G-20 members on an increase in the governmental spending and also on an expansionary monetary policy along with price stability. In many developed countries, the government has provided fiscal packages and has restructured the monetary policy. In emerging market economies too, such measures have been taken, despite the fact that the crisis in a developed country 218

Postscript

spread from the financial sector to the real sector vis-à-vis in an emerging market economy where the crisis moved the other way. As far as India is concerned, the response to the crisis manifested in both the government’s fiscal stimulus and RBI’s monetary policy restructuring. In case of the fiscal response, the Indian government invoked the emergency provisions of the Fiscal Responsibility and Budget Management Act and launched two fiscal packages during December and January of FY 2008–09. The two packages included government-guaranteed funds for infrastructure spending, axing of indirect taxes, enhanced guarantee cover for credit to small enterprises, added support to the exporters, expanded safety net for the rural poor and a farm loan waiver. These steps should help generate demand. But one has to be cautious on the fiscal deficit front. The government’s profligacy has already led to an increase in the fiscal deficit from a level of 2.7 per cent of GDP to a present level of around 6 per cent. The fiscal incentives thus must not make the fiscal deficit unmanageable. The Asian Development Bank has pointed out in its 2009 outlook that India does not have any room for fiscal stimulus. Turning from the fiscal package to the monetary package, it may be noted that the RBI has endeavoured to maintain a comfortable liquidity position in terms of rupee besides maintaining foreign exchange liquidity. At the same time, it has helped harness the credit delivery so as to maintain the growth rate. It is true that during the days of climbing inflation rate, tight monetary policy was adopted. But with an ease in inflation scenario, RBI adopted a liberal monetary policy, especially since mid-September 2008. The liberal monetary policy included a number of measures, such as reduction in interest rates, reduction in the quantum of bank reserves impounded by RBI, liberal refinance facilities for export credit, raising of the ceiling on foreign currency deposits by NRIs, liberal policy in respect of external commercial borrowings and allowing NBFCs to borrow from external sources. RBI eased the policy towards rupee–dollar swaps, so that the banks could manage their short-term funding requirements. With the implementation of the fiscal and monetary measures, the performance in specific industries has improved. Industries like cement and steel are recovering (Vyas 2009). In the financial sector, the liquidity position has definitely improved. A number of banks have lowered their benchmark prime lending rates expanding in turn 219

India’s Financial Sector

the size of credit. A few positive results are evident. For example, the pressures on mutual funds have eased. The net resource mobilisation by them amounted to Rs. 668 billion during January 2009 compared to Rs. 427 billion in January 2008. Their investment in the secondary market too amounted to Rs. 176 billion during January 2009 that compared favourably with that in any of the preceding months of FY 2008–09 (SEBI Bulletin February 2009). The non-food credit, which had declined fast during the first three quarters of FY 2008–09, has started showing fast recovery since February 2009. It is not only at the domestic front. In international financial market too, Indian firms have started doing well. The ADRs of Tata Motors and IT companies, such as Patni Computers, Satyam Computers and Wipro, have started enjoying premium (Financial Express 6 April 2009). It is true that such cases are only a few, but one should be hopeful. Besides policy design at the macroeconomic level, the improvements can be brought about at the micro level. If different enterprises make out a cost reduction plan to raise profit and, at the same time, raise the asset turnover, the return on investment is bound to increase. It is because the return on investment is the product of profit margin and asset turnover. The cost reduction plan may raise the size of sales on the basic assumption that lower the price, higher is the demand. This way the economic strength of the enterprises will be greater and the value of their shares at the stock exchanges will rise. All this may generate confidence in the financial market. Here, it may be stressed that the psyche of the participants in the financial market must be positive if the fiscal and monetary measures have to bear fruits.

220

1 Aftek Ltd Alps Inds. Apollo Hosp. Arvind Mills Bajaj Auto Bajaj Hin. Ballarpur Chem. Bharat Forge Bombay Dyeing BSEL Infrast. Carol Info Centurion

Firm

2 3.43 3.15 9.80 1.17 64.0 4.97 1.91 8.21 17.27 13.84 1.17 10.19

Price on 29.12.2006

3 7.45 3.69 15.04 2.25 65.9 7.36 2.96 9.33 22.02 28.16 2.64 25.91

4 3.21 1.94 12.58 0.94 16.65 4.77 2.04 6.76 15.16 11.13 1.2 15.84

Price on 1.4.2008 5 2.49 1.39 11.37 0.79 10.24 3.92 1.89 5.47 14.09 8.10 0.96 —

Price on 30.6.2008 6 1.172012 0.171429 0.534694 0.923077 0.029688 0.480885 0.549738 0.136419 0.275043 1.034682 1.25641 1.542689

Change in col. 3 over col. 2

7 –0.56913 –0.47425 –0.16356 –0.58222 –0.74734 –0.3519 –0.31081 –0.27546 –0.31153 –0.60476 –0.54545 –0.38865

(£)

8 –0.2243 –0.28351 –0.09618 –0.15957 –0.38498 –0.1782 –0.07353 –0.19083 –0.07058 –0.27224 –0.2

Change in col. 5 over col. 4

(Appendix Continued)

Change in col. 4 over col. 3

Price of ADRs/GDRs Traded on 29 December 2006, 2 January 2008, 1 April 2008 and 30 June 2008

Price on 2.1.2008

Table PS A1

Appendix

Firm Century Text. Cipla Cranes Soft Crest Anim. Crompton Gr. Dow1Ltd Dhampur Sugar Dr. Reddy’s (A) Eid Parry Elder Pharma Emco Ltd Era Const. Eveready Federal Bank Finolex Cab. Gail India Gammon India Garden Silk Gateway Dist. Granules Grasim Indust. Gujrat Ambuja Gujrat Narm. Gv Films

(Appendix Continued)

Price on 29.12.2006 16.69 5.64 2.34 30.54 15.0 1.23 2.11 18.20 3.05 16.61 16.14 10.65 1.45 5.17 — 36.10 9.32 6.31 4.68 2.0 64.0 3.30 11.46 —

Price on 2.1.2008 31.46 5.38 3.96 38.74 33.33 5.25 2.28 18.28 4.43 22.2 38.82 20.61 1.83 8.6 3.04 80.5 16.56 14.86 4.08 3.03 94.8 3.76 28.02 8.55

Price on 1.4.2008 18.14 5.45 3.52 15.42 23 2.31 1.16 15.21 4.34 18.51 — 14.79 0.98 — 1.78 65 9.75 6.6 2.46 1.84 64.3 3.03 16.89 3.62

Price on 30.6.2008 12.56 4.90 2.88 11.92 23.10 1.73 1.02 15.60 4.28 15.84 3.61 12.56 0.81 — 1.27 46.20 5.07 5.58 1.67 1.34 43.58 1.78 13.56 2.00

Change in col. 3 over col. 2 0.884961 –0.0461 0.692308 0.2685 1.222 3.268293 0.080569 0.004396 0.452459 0.336544 1.405204 0.935211 0.262069 0.663443 — 1.229917 0.776824 1.354992 –0.12821 0.515 0.48125 0.139394 1.445026 —

Change in col. 5 over col. 4 –0.30761 –0.10092 –0.18182 –0.22698 0.004348 –0.25108 –0.12069 0.025641 –0.01382 –0.14425 –0.15078 –0.17347 –0.28652 –0.28923 –0.48 –0.15455 –0.32114 –0.27174 –0.32224 –0.41254 –0.19716 –0.44751

Change in col. 4 over col. 3 –0.42339 0.013011 –0.11111 –0.60196 –0.30993 –0.56 –0.49123 –0.16794 –0.02032 –0.16622 –0.28239 –0.46448 –0.41447 –0.19255 –0.41123 –0.55585 –0.39706 –0.39274 –0.32173 –0.19415 –0.39722 –0.57661

HDFC Bank (A) Himatsingka Hindalco Inds. ICICI Bank (A) India Cement Indian Hotel Infosys Tech. Ispat Inds. JCT Ltd Jindal Saw JK Paper Kesoram Inds. Kotak Mahindra L&T LIC Housing Lyka Labs. MTNL (A) M&M Mascon Gl. Meghmani Micro Techno. Nagarjuna Nepc Micon Noida Tollbr. Orchid Chem. Oriental Hot. Patni Comp. (A) Pentamedia

75.48 2.73 4.10 41.74 10.64 — 54.56 2.48 4.05 8.74 0.97 12.41 8.98 33.80 7.28 5.56 6.36 21.75 0.98 — 5.56 4.90 — 3.90 4.40 9.00 20.38 —

127.33 3.13 5.4 62.15 7.94 4 44.43 20.13 4.33 28.67 1.47 15.35 35.26 104.9 19.33 12.29 10.39 21.21 2.70 0.45 9.51 9 0.95 8.25 7.58 9.89 16.78 0.3

104.11 1.52 4.18 41.18 4.6 — 37.43 7.9 1.89 16.01 0.89 9.65 15.22 71.65 14.13 4.97 5.17 16.6 1.33 0.37 5.13 5.18 0.36 6.5 4.12 7.13 12.15 —

71.66 1.04 3.12 28.76 3.19 — 43.46 5.42 1.29 11.7 0.79 5.95 10.89 51.95 12.57 4.17 4.26 10.45 1.37 0.25 5.09 3.09 0.24 6.63 5.18 6.14 10.04 —

0.686937 0.14652 0.317073 0.488979 –0.25376 — –0.18567 7.116935 0.069136 2.28032 0.515464 0.236906 2.926503 2.10355 1.65522 1.210432 0.633648 –0.02483 1.755102 — 0.710432 0.836735 — 1.115385 0.722727 0.098889 –0.17664 —

–0.18236 –0.51438 –0.22593 –0.33741 –0.42065 — –0.15755 –0.60755 –0.56351 –0.44158 –0.39456 –0.37134 –0.56835 –0.31697 –0.26901 –0.59561 –0.50241 –0.21735 –0.50741 –0.17778 –0.46057 –0.42444 –0.62105 –0.21212 –0.45646 –0.27907 –0.27592 (Appendix Continued)

–0.31169 –0.31579 –0.25359 –0.3016 –0.30652 — 0.161101 –0.31392 –0.31746 –0.26921 –0.11236 –0.38342 –0.28449 –0.27495 –0.1104 –0.16097 –0.17602 –0.37048 0.030075 –0.32432 –0.0078 –0.40347 –0.33333 0.02 0.257282 –0.13885 –0.17366

0.02 9.18 18.13 18.40 — 58.20 6.61 24.01 2.51 9.53 2.22 72.50 25.93 8.13 20.43 — 3.56 10.65 64.35 19.20 16.15 7.91

Price on 29.12.2006

0.1 10.27 23.54 10.96 193 146.5 3.92 25.69 3.34 5.19 5.11 126.5 26.67 12.71 19.76 23.78 17.88 17.47 48.71 36.52 14.42 11.08

Price on 2.1.2008 0.04 11.5 14.61 8.72 95 118.75 2.17 18.51 1.82 4.86 3.02 90 24.6 5.88 16.13 16.62 10.26 11.61 14.13 17.34 12.17 6.75

Price on 1.4.2008 — 11.62 9.91 7.77 30.00 94.20 — 24.52 1.30 3.84 2.46 49.10 25.60 3.69 10.05 16.88 8.55 8.32 11.07 10.80 12.18 4.30

Price on 30.6.2008 4 0.118736 0.2984 –0.40435 — 1.517182 –0.40696 0.069971 0.330677 –0.4554 1.301802 0.744828 0.028538 0.563346 –0.03279 — 4.022472 0.640376 –0.24305 0.902083 –0.10712 0.400759

Change in col. 3 over col. 2

Source: Business Standard, New Delhi, 2 January 2007, 4 January 2008, 3 April 2008 and 2 July 2008.

Pentasoft Ranbaxy Lab. Raymonds Rediff.com Reliance Ener. Reliance Inds. Ruchi Soya Satyam Comp. (A) Shreyas Ship Sify (A) Southern Petro SBI Sterling Bio Taneja Aero Tata Motors (A) Tata Steel Usha Martin UTI Bank Vaibhav Gems VSNL (A) Wipro (A) Wockhardt

Firm

(Appendix Continued)

–0.6 0.119766 –0.37935 –0.20438 –0.50777 –0.18942 –0.44643 –0.27949 –0.45509 –0.06358 –0.409 –0.28854 –0.07762 –0.53737 –0.1837 –0.30109 –0.42617 –0.33543 –0.70992 –0.52519 –0.15603 –0.39079

Change in col. 4 over col. 3

0.324689 –0.28571 –0.20988 –0.18543 –0.45444 0.04065 –0.37245 –0.37694 0.015644 –0.16667 –0.28338 –0.21656 –0.37716 0.000822 –0.36296

0.010435 –0.3217 –0.10894 –0.68421 –0.20674

Change in col. 5 over col. 4

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231

Index

American depository receipt (ADR), 71 prices of, 221–24 process of, 164 secondary market trading of, 172–75 variation in size of, 171–72 Asset financing company (AFC), 29 Asset management company (AMC), 50 entry of foreign, into mutual fund business, 53 Asset Reconstruction Fund (ARF), 5 Auctioning dates securities, of, 110 t-bills, of (see T-bills, auctioning of) Badla transaction banning on, 87 modification of, 88 Banking Companies (Acquisition and Transfer of Undertakings) Act (1970), 5 Banking Companies (Acquisition and Transfer of Undertakings) Act (1980), 5 Banking Ombudsmen Scheme, 19 Banking Regulation Act (1948), 3 Banking sector in 1990s, 3–4 maintenance of adequate capital norms, 4–8 measures of reform, 4 impact of, 20–21 Bank(s) customer service methods for improvement, 18–20

functioning establishment of Board of Financial Supervision for, 17 operating cost of, 20 operational efficiency of, 21–23 Bombay Stock Exchange (BSE), 85 turnover and market capitalisation at, 95 book building process definition of, 74 modification in, 74 price of IPO, 74 Borrowing and Lending Securities Scheme (BLSS), 88 Call/notice money market (CNMM) features of, 124–25 reform measures for, 125–27 impact of, 127–30 Capital account convertibility (CAC), 151 Capital adequacy NBFCs, of, 39–40 Capital adequacy, asset quality, management, earnings, liquidity and systems (CAMELS), 33 Capital Issues (Control) Act (1947), 70, 86 Capital to risk-weighted assets ratio (CRAR), 6, 33 Cash reserves ratio (CRR), 3 axing of, 8–10 Central Depository Services Ltd (CDSL), 90

Index Electronic system clearing and settlement, of, 91 Equipment-leasing company (ELC), 28 Equity market growth in, 94–99 Euro issue(s), 210–13 features of, 163–65 guidelines for, 165–66 significance gain in primary market, 166–67 gain in secondary market, 167–68 trend of, 168 Exchange Traded Fund (ETF) Scheme, 55

Central government security(ies) features of dated securities (see Dated securities) treasury bills (T-bills) (see Treasury bills (T-bills)) marketability and liquidity, enhancement of, 111–12 ownership pattern of, 122 Central Listing Authority, 90 Certificates of Deposit (CD) market features of, 137–38 trend in, 138–39 Chakraverty Committee, 29 Clearing Corporation of India Ltd., 91 Collateralised borrowing and lending obligations (CBLOs) features of, 130 turnover in market, 131 Commercial bank(s), 194–95 Commercial paper (CP) market features of, 133–34 growth in, 135–37 incentives in, 134–35 use for borrowing from abroad, 151 Committee on International Financial Standards and Codes, 18 Credit Analysis and Research on Equities (CARE), 76 Credit Rating Information Services of India Ltd (CRISIL), 76 Currency swaps role in inter-bank segment, 156 Current account full convertibility on, 150

Financial market, of India crisis in, 203 reasons for, 203–4 Financial Markets Department, 112 Financial stability banks, of, 23–25 Fiscal deficit, 117 financing of size of issue, 114–16 Fiscal Responsibility and Budget Management (FRBM) Act (2003), 112 Floating exchange rate system adoption of, 144 Floating rate bonds, 110 Foreign currency convertible bonds (FCCBs), 163 Foreign direct investment (FDI), 86 Foreign Exchange Management Act (FEMA), 153 Foreign exchange transaction, 147

Dated securities, 109 Decoupling concept, 203 Delivery versus payment (DVP) system, 113 Demand and time liabilities (DTL), 3 Derivatives trading, 93 Disinvestment public sector units by CDSL, 90

Foreign institutional investors (FIIs), 86, 188–90, 204–6 liberal policy of Indian government towards, 185–88 permission to invest in dated securities, 113 reasons for investment in India, 182–84 size and trend of investment, 178–82 stock market of India, and, 190–93

Efficient capital market, 158 Electronic funds transfer system, 18

233

India’s Financial Sector Malegam Committee, 71 Managed floating exchange rate, 145–46 Money market mutual funds (MMMFs), 47 Mutual fund(s), 196–97, 209–10 evaluation of performance, 61–62 features and schemes of, 46–48 growth in net assets under management of, 59–61 influence in stock market, 62–64 liberalization of investment policy, 54–55 lowering of tax rate, on income from, 55 reform measures for ban on advertisement, 52–53 impact of, 55 SEBI (Mutual Funds) Regulations 1993, 50–51 SEBI (Mutual Funds) Regulations 1996, 51–52 resource mobilisation by, 56–59 scenario before 1993, 48–49 widening of business of, 53–54

Forward contract cancellation of, 149 Fuller capital account convertibility, 151 FX Direct, 149 Global depository receipt (GDR), 71 issuance of shares to foreign investors, 164 prices of, 221–24 process of, 164 secondary market trading of, 172–75 variation in size of, 171–72 Government security market, 107 Gross domestic product (GDP) and activities in stock market, 98–99 Hire-purchase company (HPC), 28 Impossible trinity, concept, 145 Income recognition norms for, 17–18 Indian Companies Act (1956), 29 Initial public offering (IPO), 69 dematerialisation by companies, 72 reclassification of, 78 Inter-bank repo, 111 Inter-connected Stock Exchange of India (ISEI), 89 Interest rate(s) restructuring of, 13–15 Investment company, 28 Investment Information and Credit Rating Agency of India Ltd (ICRA), 76

Narsimham Committee II, 12 National Association of Securities Dealers Automated Quotation (NASDAQ), 88 National-level stock exchange, 88 National Securities Depository Limited (NSDL), 90 National Stock Exchange (NSE), 86 adoption of open outcry system, 90 origin of, 89 trading in debt securities at, 99–101 turnover and market capitalisation at, 95 Negotiated dealing system (NDS), 99, 111 Net asset value (NAV), 47 Non-banking financial companies (NBFCs), 27, 37–39, 195–96 capital adequacy of (see Capital adequacy, of NBFCs) deposits and net owned funds of, 30–31 exemption by RBI, 33 guidelines by RBI for, 35

Kumarmangalam Birla Committee, 87 Liberalised exchange rate management system, 147 liquidity maintenance in financial market, 118 yield and (see Yield and liquidity) Liquidity adjustment facility (LAF), 127 Loan company (LC), 28 Magnetic Media Based Clearing System (MMBCS), 18

234

Index Reverse repo, 111 Restructuring interest rate, of (see Interest rate, restructuring of) Rolling settlement system, 91

interest rates on deposits of, 40–41 mutual funds agents, management of, 36 Narsimham Committee report on regulation of, 32 nature of, 28–29 public deposits, acceptance of, 36 regulation of, 29–32 trifurcation of, 32–33 Non-performing assets (NPAs), 4 curbing of, 10–13 squeeze in, 41–42

Satellite dealers (SDs) appointment by RBI, 112 Screen based training system, 88 Secondary capital market, 198–99 impact of transaction on, 119 reduction in transaction cost, 93 reform measures for, 86 reversal in, 206–8 Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAEST) Act (2002), 12 Securities and Exchange Board of India (SEBI), 34 establishment as statutory body, 86–88 rationalisation of charge structure, 90 Securities Contracts (Regulation) Act (1956), 85 Settlement system, 91 Shared Payment Network System, 18 Society for Worldwide Inter-bank Telecommunication (SWIFT), 18 Statutory liquidity ratio (SLR), 3 axing of, 8–10 Stock exchange non-traditional participants at, 92 permission of foreign direct investment in, 92 Subsequent equity offering (SEO), 69

Open outcry system, 90 Over-the-counter Exchange of India (OCTEI), 88 Primary dealers (PDs) appointment by RBI, 112 Primary market(s), 197–98 downtrend in, 208–9 equity and debt funds raised in, 79 feature of, 69–70 infrastructural support by government, 75–76 measures for reform, 70–71 by SEBI, 72–73 impact of reform measures, 76 mobilisation of resources among industries, 81–82 public and private sector companies, participation of, 80–81 regulation by SEBI, 71–73 Private bank(s) guidelines for operation of, 15–16 Product package broadening under retail banking system, 19

Transaction(s) in capital market easing of settlement, 113 Treasury bills (T-bills), 107 auctioning of, 110–11 issued by RBI, 108 new variants of, 110

Qualified Institutional Buyers (QIBs), 78 Qualified institutional placement (QIP), 72–73 Repo meaning of, 111 Repo market, 131–33

Unique client code for mutual funds, 55

235

India’s Financial Sector Unit Trust of India (UTI) origin of, 48

Yield dated securities, on, 120–21 liquidity and, 119–20

Ways and Means Advances (WMA), 108

236

About the Author

Vyuptakesh Sharan is presently Emeritus Fellow at the South Asian Studies Division, School of International Studies, Jawaharlal Nehru University, New Delhi. Prior to this assignment, he was UGC Visiting Professor at the Department of Commerce, Delhi School of Economics, University of Delhi and also AICTE Visiting Professor, Global Business Operations Post-graduate Programme, Shri Ram College of Commerce, University of Delhi, and former Professor and Dean, Faculty of Commerce and Business, Magadh University. Professor Sharan has delivered special lectures at several universities, including a University at Warsaw. The articles authored by him have been published in several international and Indian journals. His book India’s External Sector Reforms (2001) was widely appreciated by academics.