CHAPTER II DEVELOPMENTS IN INDIAN CAPITAL MARKET. governance progressed faster than many other emerging markets. The market

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1 CHAPTER II DEVELOPMENTS IN INDIAN CAPITAL MARKET India s capital market has experienced sweeping changes over the last one and a half decade. Its market microstructure has advanced and corporate governance progressed faster than many other emerging markets. The market capitalisation to GDP ratio, a measure of the size and health of the stock markets, increased from 23.2 per cent of GDP in to 85.9 per cent in (SEBI Annual report, 2007). Although, small compared to many developed economies, it is comparable to that of many other emerging economies such as Brazil, Mexico, Thailand and Korea. The higher level of market capitalisation to GDP ratio can be considered as an indication of the investor confidence and the strength of our economy. The capital market activities are now considered as the barometer of the economic development of a country, because they channel savings to investments and make them available for productive use through a range of complex financial products called securities. The trading of securities takes place in two interdependent and inseparable segments of capital market, viz. primary and secondary markets. While primary market is meant for the issue of new securities, secondary market caters to transactions in securities previously issued. Though secondary market activities do not result in capital formation in the economy, prices and yields of the existing securities determined in the secondary market help primary market in deciding prices at which new

2 instruments can be introduced. The secondary market also provides the muchneeded liquidity to instruments issued in the primary market. There are also arguments against the role and performance of capital market in India. No doubt, like any other institutions, capital market also creates some problems to the economy. But it is emphasised that the positive outcomes of capital market are many, particularly during the Reforms period (that is the last one and a half decade). In order to see the exact picture, it is essential to analyse the developments that have taken place in the Indian capital market. 2.1 Pre-Reforms Scenario Any discussion on the Indian capital market is to be divided into two eras, Pre-Reforms period (i.e., till 1990) and Post-Reforms period. Till 1990, Indian securities market had archaic practices in trading, clearing and settlement and hence was ranked at the bottom of the global ranking sheet with reference to standard global indices relating to efficiency, safety and market integrity. Trading was through open outcry and settlements were paper-based. As settlements were done on a bi-weekly basis, traders could carry forward positions upto two weeks. This often created settlement risks arising out of poor delivery. The price discovery mechanism was rather dubious, as a large number of transactions were done outside the exchange. The actual trade prices often diverged from those reported to customers (Thomas, 2006). The absence of a legal regulatory body and inadequacy of disclosure norms were the other hurdles for the healthy growth of capital markets in India. Even with all these obstructions Indian stock markets have grown in terms of the number of stock 24

3 exchanges, number of listed companies and in capital of listed companies during this period. The overall growth pattern of capital markets in India upto 1991 is portrayed in table 2.1. Table 2.1 Growth of Capital Markets in India No. of stock exchanges No. of listed companies 9 Market capitalization (in crore of rupees.) Source: Various issues of the Stock Exchange Official Directory, Bombay Stock Exchange, Bombay. From table 2.1 we can easily note the tremendous growth that has occurred after the year Between 1985 and 1991, the number of stock exchanges has increased by about 56 per cent, number of listed companies has increased by 92 per cent and market capitalisation by 275 per cent. Though Government took a number of steps to rectify the pitfalls of India s financial markets (identified by Chakravarty Committee, 1985 and Vaghul Working Group, 1987), it did not find much progress in the desired direction, as the stock exchange community was not receptive to the suggested reforms. The classic evidence of this is the scam that surfaced in During 9 Market price multiplied by the number of outstanding shares 25

4 this scam, huge amounts of money were siphoned off from the banking system through devious ways to stock market by a group of unscrupulous stockbrokers to manipulate stock prices. Several investors and banks, both small and big, lost huge amounts, of money during this financial catastrophe. It prompted the Central Government to think of the necessity of major Reforms in this sector. The Government of India decided to delegate regulatory powers to SEBI through a special legislation called SEBI Act As the governance of the existing stock exchanges was very poor, the Government also appointed a highpowered study group under the chairmanship of M.J. Pherwani for the feasibility study of a new National Stock Exchange. The committee identified various pitfalls existing in the system and recommended a package of reforms. As per their recommendations, the Government entrusted Industrial Development Bank of India (IDBI) to set up a full-fledged model stock exchange with the best international practices in trading and settlement. As a result, the National Stock Exchange (NSE) with nation-wide electronic network and automated trading system came into existence in Post-Reforms Scenario The enforcement of SEBI Act 1992 and the establishment of NSE with tight disclosure norms and nationwide electronic network were the major initiatives during the Reforms period. Patil (2006) asserts that from the view point of both adoption of sophisticated information technology tools in trading and settlement mechanisms as also the efficiency of capital markets, not only India ranked in the top league but it is also considered to be way ahead of many 26

5 developed country capital markets. A brief description of the developments of Indian capital market since 1990, mainly based on the official publications of NSE, SEBI and certain research papers is provided in the following sections Regulatory Framework Before reformation, stock exchanges were functioning as self-regulating organisations, typically as an association of brokers. There was no formal regulatory body to monitor and supervise these exchanges. All aspects of security trading were under the direct control of Central Government mainly through Capital Issues (Control) Act, 1947 and Securities Contracts (Regulation) Act, As the first step of modernisation Capital Issues (Control) Act, 1947 was repealed. With this, the Government s control over price, premium and rates of interests of shares and debenture issues ceased and the market is allowed to allocate resources on the basis of the prevailing market conditions. In 1992 SEBI was assigned the responsibility to safeguard and regulate the security market. As per the existing rules and regulations the responsibility for regulating security market is shared by Department of Economic Affairs (DEA), Department of Company Affairs (DCA), Reserve Bank of India (RBI) and SEBI. A High Level Committee on capital markets coordinates the activities of all these agencies. The orders of SEBI under the securities laws can be appealed against before the Securities Appellate Tribunal (SAT). Besides these, the Self Regulatory Organizations (SRO) like the stock exchanges have also laid down their rules and regulations for the market participants to abide by. 27

6 The Disclosure and Investor Protection (DIP) guidelines issued by SEBI aim at ensuring that all the entities concerned observe high standards of integrity and fair dealing. The guidelines allow issuers, complying with the eligibility criteria, to issue securities at market determined rates. They direct issuers to provide full disclosure of relevant information about the issuer and the nature of securities including the risk factors involved, justification for pricing so that investors can take informed decision. Thus the market moved from merit-based to disclosure-based regulation System of Trading and Settlement The open outcry system that prevailed in Indian stock exchanges till 1994 did not allow immediate matching and recording of trades and at the same time imposed geographical limits on trading. When NSE started its operations in 1994, it introduced a nationwide on-line fully automated Screen Based Trading System (SBTS). In this system, a trading member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching sale or buy order from a counter party. It allows faster incorporation of price sensitive information into prevailing prices, thus increasing the informational efficiency of markets. It enables market participants to see the full market on real-time, making the market transparent. Further it allows a large number of participants, irrespective of their geographical locations, to trade with one another simultaneously, improving the depth and liquidity of the market. Given the efficiency and cost effectiveness delivered by the NSE's trading system, it became the leading stock 28

7 exchange in the country. This forced other stock exchanges to adopt SBTS. The SBTS technology shifted the trading platform from the trading hall of an exchange to brokers premises and the introduction of Internet trading further carried the trading platform to the PCs in the residences of investors. As per the trading system that existed in India, the trading cycle varied from 14 days for specific scrips to 30 days for others and settlement took another fortnight. The trades accumulated over a trade cycle were clubbed together at the end of the cycle so as to netting out the positions and subsequently clearing the settlements. Often this cycle was not adhered to and on several occasions led to defaults and risks in settlement. In order to reduce large open positions, NSE initially reduced the trading cycle to one week. The settlement of the trades used to be done by physical movement of printed certificates, which are registered with the issuer. Transfer of ownership took place through book entry transfer in this ledger. The issuers or their registrars or transfer agents had to physically receive the securities from a transferee accompanied by a transfer deed signed by the transferor for this, before a transfer was effected. This paper-based system resulted in delays, bottlenecks, and an increase in transaction costs, besides creating various risks for market participants, such as bad delivery, fraud, and theft. To alleviate this problem, two depositories, National Securities Depository Limited (NSDL) and Central Depository Services (India) Limited (CDSL) were established. This helped to ensure free transferability of securities with speed, accuracy and 29

8 security by (a) making securities of public limited companies freely transferable, subject to certain exceptions; (b) dematerialising the securities in the depository mode; and (c) providing for maintenance of ownership records in a book entry form. In order to streamline both the stages of settlement process, the transfer of ownership of securities is done electronically by book entry without making the securities move from person to person. At present Indian depository is the only depository in the world to have full data on investor holdings, which gets updated continuously. With this new system, SEBI introduced rolling settlement on T+5 basis in respect of specified scrips reducing the trade cycle to one day. It was then made mandatory for all exchanges to follow uniform weekly trading cycle in respect of scrips that are not under rolling settlement. All scrips moved to rolling settlement from December T+5 gave way to T+3 from April 2002 and T+2 since April Currently T+2 day settlement cycle is being followed. In order to promote dematerialisation 10, SEBI has been promoting settlement in demat form in a phased manner. At the end of March 2007, the number of companies connected to NSDL and CDSL was 6483 and 5589 respectively. The number of dematerialised shares with NSDL went up by 16 per cent to billion in , and from billion in With CDSL the number of dematerialised shares rose by 14.8 per cent to billion in , and from billion in (SEBI Hand Book of 10 The process of making securities in electronic form 30

9 Statistics ). At present all actively traded scrips are held, traded and settled in demat form. Demat settlement accounts for over 99.9 per cent of turn over settled by delivery. This has almost eliminated the bad deliveries and associated problems. Now it is mandatory that all new securities issued should be compulsorily traded in dematerialised form and admission to a depository for dematerialisation of securities is a prerequisite for making a public or right issue or an offer of sale. It is also compulsory for public limited companies making Initial Public Offer (IPO) of any security for ten crore rupees or more only in dematerialised form. The measures adopted during the Post-Reforms period do not end up with the regulatory measures and the system of trading and settlement. Owing to the realisation that the risk associated with investments cannot be easily reduced with the above measures, certain additional measures and instruments were also introduced for the risk containment. The ensuing section touches upon those measures. 2.3 Risk Management and Investor Protection Efficient risk management and strict enforcement of investor protection rules are essential for the smooth functioning and healthy development of security markets. The major systemic risk associated with capital market is the settlement risk arising out of non-fulfilment or partial fulfilment of obligations of the traders due to their speculative activities. The concept of settlement guarantee was almost unknown in India until the formation of National 31

10 Securities Clearing Corporation Ltd. (NSCCL) as a wholly owned subsidiary of NSE. As a part of reformation, SEBI with the support of exchanges introduced a number of measures to avoid any kind of market failures. This includes a comprehensive risk management system through the strict enforcement of capital adequacy norms; margin requirements, and limits on exposure and turnover. The market regulators are keen on real time monitoring of the track record and performance of members and their net worth; collection of margin from the members and automatic disabling of trades of members if limits are breached. Further exchanges also have put circuit breakers which are applied in times of excessive volatility. The robustness of risk management system has been amply proved by the timely and default free settlement even on extreme volatile days Counter Party Credit Risk Management In the traditional archaic trading system that existed in India as there was no guarantee for settlement of trades executing in exchanges and hence counter party credit risk management involved knowing the respective counter parties and restricting trades to a subset of reliable counter parties. This induced a lot of inefficiency in the process of price discovery as order flows fragmented across counter parties with different risk levels. When large and old firms enjoyed considerable reputational advantage, comparatively small and new firms suffered. The electronic trading mechanism of NSE provides full anonymity of counter parties involved in a trade. For the counter party risk management NSE 32

11 introduced the concept of settlement guarantee through an independent clearing corporation NSCCL. In April 1996, NSCCL became the common counter party to each transaction in NSE and ensured that funds and security obligations will be met. For this, NSCCL has established a Settlement Guarantee Fund (SGF), which provides a cushion for any residual risk. It operates like a self-insurance mechanism wherein members contribute to the fund. In the event of failure of a trading member to meet his obligations, the fund is utilised to the extent required for successful completion of settlement. Other stock exchanges are also maintain settlement guarantee fund for meeting shortages arising out of non-fulfilment / partial fulfilment of funds obligations by members in a settlement before declaring the member concerned a defaulter. This has eliminated counter party risk of trading on an exchange. Thus the market has full confidence that settlement will take place in time and will be completed irrespective of default by isolated trading members Margin Requirements and Intra Day Limit Under the current trading and settlement system, if an Indian investor buys and subsequently sells the same number of shares of a stock on the same day itself or sells and subsequently buys, it is not necessary to take the delivery of shares. The difference between the selling and buying prices can be paid or received. In other words, the squaring-off of trading position during the same day results in non-delivery of the shares that the investor traded. This type of non-delivery speculative transactions can incur settlement risk; accordingly 33

12 SEBI has introduced a daily margin requirement and intra day trading limit for the trading members. As per SEBI directions, each stock exchange may take any other measures to ensure the safety of the market. BSE and NSE impose on members a more stringent daily margin including mark to market, extreme loss and value at risk 11 margins. Each broker s trading volume during a day is not allowed to exceed the intra day limit fixed in relation to the base minimum capital of a member, which is the amount of funds and securities that the member keeps with the exchange. In the case of NSCCL gross intra-day turnover (Buy + Sell) of a member shall not exceed one third of the capital available with NSCCL. Similarly, gross exposure (aggregate of cumulative net outstanding positions in each security at any point of time) of a member shall not exceed 8.5 times of free base capital upto one crore rupees. If a member has free capital in excess of one crore rupees, his exposure shall not exceed Rs.8.5 crore plus ten times of the capital in excess of Rupees one crore. Members exceeding these limits are automatically and instantaneously disabled by the automated trading screen. A penalty of five thousand rupees is levied for each violation of gross exposure limit and intra-day turnover limit Index-based Market-wide Circuit Breakers The index-based circuit breaker system applies at three stages of index movement, either way, viz. at ten per cent, fifteen per cent and twenty per cent. 11 Security wise margin based on the volatility, which different stocks are subject to. 34

13 These circuit breakers when triggered bring about a coordinated trading halt in all equity and equity derivative markets nationwide. The market-wide circuit breakers are set to trigger movement of either the BSE Sensex or the NSE Nifty, whichever is breached earlier. In case of a ten per cent movement of either of these indices, there will be a one-hour market halt if the movement takes place before 1:00 p.m. In case the movement takes place at or after 1:00 p.m., but before 2:30 p.m., there will be a trading halt for half an hour. In case movement takes place at or after 2:30 p.m., there will be no trading halt at the ten per cent level and market shall continue trading. In case of a fifteen per cent movement of either index, there shall be a twohour halt, if the movement takes place before 1 p.m. If the fifteen per cent trigger is reached at or after 1:00 p.m., but before 2:00 p. m., there shall be a one-hour halt. If the fifteen per cent trigger is reached at or after 2:00 p.m. the trading shall halt for the remainder of the day. In case of a twenty per cent movement of the index, trading shall be halted for the remainder of the day Grievance Redressal and Investor Education DEA, DCA, SEBI and the stock exchanges have set-up investor grievance cells for redress of investor grievances. All these agencies and investor associations are regularly organise investor education and awareness 35

14 programs. NSE has also taken special measures for educating investors, conduct of seminars, workshops and come out with advertisement both in print and electronic media for enlightening the investors. Apart from the above-mentioned measures, SEBI and others have taken the initiative to offer a number of instruments for a diversified portfolio so as to reduce risk. They are discussed in the following section. 2.4 Innovative Instruments for Risk Containment One of the major concerns about investments in financial market is the risk inherent in it, because of the extreme volatile nature of securities. Sharpe (1963) in his famous Market Model classified the inherent risk in security trading into two, as unique risk and systematic risk. The distinction between the two can be explained as follows: Price of a stock at any point of time reflects the influence of two factors. The first set of factors relates essentially to the performance of the company itself: profitability of the company, relative locational advantage / disadvantage of the production facility, type of production technology, quality of its management, etc. The other set of factors that influences the share price of that company will depend on the state of capital market. Even if there is no change in the factors that influence the working of the particular company, prices of its share will go up or down depending on the bullish or bearish condition of the market. The risk arising from the first set of factors is termed as unique risk, which is unique to the particular company and the risk arising from the second set of factors is termed as systematic risk 36

15 which is common to the whole market. Sharpe proved theoretically that the unique risk could be minimized thorough holding a well-diversified portfolio. Mutual Funds and Derivatives are financial instruments which can be effectively used for risk containment through diversification, hedging, arbitrage and speculation. While mutual funds provide opportunity for retail investors to invest in broad based portfolios with different risk levels, derivative instruments such as Futures and Options are designed to provide a mechanism to manage risk arising from unanticipated broad market movements through hedging, speculation and arbitrage. Through the use of derivative products, it is possible to transfer market risks partially or fully by locking-in asset prices Mutual Funds Mutual Fund (MF) is an important product innovation in the field of finance as an instrument for raising capital from public for corporate enterprise s growth and as a tool for diversification of financial investments. The origin of mutual fund industry in India was through the Parliament Act 52 of 1963 with the objective of creating an instrument for channelling investments. Under this legislation an Asset Management Company (AMC) called the Unit Trust of India (UTI) was created and it introduced its first mutual fund named Unit Scheme 1964 (popularly known as US64) in the same year. Though it enjoyed complete monopoly of the MF business upto 1987 the growth of the industry was very slow, because the concept of collective investment was new among Indian investors. Also in the context of political and economic uncertainty that 37

16 existed during the period, no investor was prepared to risk his money on either business initiatives or financial investments (Thomas, 2006). The monopoly of UTI in mutual fund business came to an end in 1987 when non-uti players such as public sector banks and insurance companies were permitted to enter the industry. State Bank of India, Canara Bank, Life Insurance Corporation of India, Punjab National Bank and General Insurance Corporation of India were the major public sector firms that entered mutual fund industry between 1987 and In 1993 private sector mutual funds were allowed, following which competition entered the mutual fund business. With the entry of private sector funds, a new era started in the Indian mutual fund industry, giving the Indian investors a wider choice of fund families. In 1996 an in-depth review of the mutual fund regulations led to a new set of regulations known as SEBI (Mutual Fund) Regulations, This brought about restructuring of mutual fund industry and laid down norms for the structure of management of mutual funds by defining required relationship between the fund sponsor, trustees, custodian, and AMC. This is in contrast to the previous practice where all the three functions, namely, trusteeship, custodianship, and asset management, were often performed by one body, usually the fund sponsor or its subsidiary. Also, as per this notification Foreign Institutional Investors (FIIs) registered with SEBI were permitted to invest in domestic mutual funds. 38

17 Table 2.2 Resource Mobilization by Mutual Funds Rs. Crore Public Sector Year UTI Others Private Total Sector P P: Provisional Source: RBI Database 39

18 The popularity of mutual funds as an investment avenue is clearly visible from table 2.2 which provides data on net resources mobilised by MFs during and The table shows that during the period , resource mobilization of mutual funds was almost steady, amounting to an average of Rs. 117,00 crore. The next two years witnessed severe outflow from the mutual funds, probably due to the bearish sentiments that existed in the stock market. Following this the industry managed to mobilise modest sums amounting to an average of Rs crore during the next two years. During , the mutual fund industry witnessed a sharp rebound, probably due to the tax sops announced in the union budget and the emergence of bullish trends in the stock market. A critical point to be noted is the significant share of private mutual funds especially after the year Derivatives In India channel for derivative trading opened when Union Government amended the Securities Contract Regulation Act in December 1999 to include derivatives within the ambit of securities. In March 2000, the three-decade old notification prohibiting forward trading in securities was cancelled and in May 2000 SEBI granted the final approval for the commencement of derivative trading in two stock exchanges NSE and BSE. These two exchanges started trading of index futures based on S&P CNX Nifty and SENSEX respectively in June Index options, stock options and single stock futures were introduced in 2001 and interest rate futures based on notional 10-year bond, notional 10-year zero coupon bond and notional 91-day Treasury bill were introduced in 40

19 June The derivative trading has grown exponentially in terms of the number of contracts and turnover since its introduction. (See table 2.3). Table 2.3 Growth of Derivative Segment Year Jun 00 to Mar01 No. of contracts BSE NSE TOTAL Turnover (Rs.crore) No. of contracts Turnover (Rs.crore) No. of contracts Turnover (Rs.crore) Source: SEBI, Annual Report The table provides a clear picture of the growth of derivative trading. In the second year of its introduction ( ) the total turnover has grown by about 326 per cent from the previous year and thereafter at the rate of 384 per cent and 19 per cent respectively in the following years The combined turnover in derivatives in BSE and NSE exceeds combined turnover in cash segment by 41

20 32 per cent and 54 per cent during and respectively. The picture is different if we take stock exchanges individually. The turnover of derivatives at BSE was merely three per cent of its cash market turnover; on the other hand the NSE derivative turnover was 223 per cent of its cash market turnover in (SEBI, Annual Report ) As can be seen from the table 2.3 that NSE dominates the derivative market with its share of more than 99 per cent in the turnover as well as number of transactions. 2.5 Foreign Institutional Investment: A Recent Development In September 1992 the Government issued guidelines for foreign institutional investment which allowed FIIs to enter Indian capital market for the first time. Based on these guidelines, SEBI (Foreign Institutional Investors) Regulations were enforced in November As per the regulations, overseas institutions have to register as FII with SEBI and obtain approval from RBI under Foreign Exchange Regulation Act to trade in Indian stock markets. Once these formalities have been completed, an FII does not require any further permission to buy or sell securities subject to the sector ceiling prescribed and to transfer funds in and out of the country, after paying the applicable tax. Overseas investment in Indian capital market is also possible outside this FII route as Foreign Direct Investment. As per the regulations, Foreign Direct Investment (FDI) has been allowed in almost all sectors of the economy, except a few strategic sectors, such as defence production, public sector banking, etc. However such FDI requires case-by-case approval from the Foreign Investment Protection Board in the Ministry of Industry and from RBI or only from RBI 42

21 depending on the size of investment and the industry in which investment is made. Global Deposit Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs) and Foreign Currency Bonds issued by Indian companies that are listed, traded, and settled overseas. Further foreign financial service institutions are now allowed to setup joint ventures in stock broking, asset management, merchant banking and other financial services firms along with Indian partners and Indian stock exchanges have been permitted to setup trading terminals abroad. The various policy initiatives encouraging foreign capital investments coupled with other positive factors produced a surge in FII inflows during the Post-Reforms period. As in March 2006, a total of 882 FIIs were registered with SEBI. The intensity of capital flows through FII route is clearly visible from Diagram 2.1, which gives net FII investment in India for the period from to It has been observed that FII investments have a strong impact on equity price movements in India, since they were allowed to invest in Indian securities market. Diagram 2.2 based on monthly data on SENSEX and cumulative FII investments provides supportive evidence for a high degree of positive correlation between cumulative FII investments and level of SENSEX. 43

22 Diagram 2.1 Net FII Investments (US $ mn.) Source: SEBI Annual Report ; 44

23 45 Diagram 2.2 Movement of Monthly data on SENSEX and Cumulative FII investments Cumulative FII investments (US $ mn.) SENSEX Jan- 02 Apr- 02 Jul- 02 Oct- 02 Jan- 03 Apr- 03 Jul- 03 Oct- 03 Jan- 04 Apr- 04 Jul- 04 Oct- 04 Jan- 05 Apr- 05 Jul- 05 Oct- 05 Jan- 06 Apr- 06 Jul- 06 Oct- 06 Jan Source: Hand Book of Statistics 2006, SEBI; http// and www. sebi.gov.in

24 2.6 Impact of Reforms on Indian Capital Market The Reforms that had taken place during the last decade in the finance sector have greatly improved Indian securities market in terms both qualitative and quantitative parameters. The market has witnessed fundamental institutional changes resulting in drastic reduction in transaction costs, and significant improvements in informational efficiency, transparency and safety. Shah and Thomas (1997) estimate that transaction cost in India s equity market has been reduced by half, i.e. from 5 per cent to 2.5 per cent in The SEBI-NCAER survey 2001, reveals that the average trading cost of Indian stock markets is further reduced to 0.6 per cent in 1999 (note that the global best is 0.45 per cent). As more and more financial institutions offer online trading facilities, the trading cost is still decreasing due to the existing competition in the business. The major impacts of these Reforms on the size and performance of Indian capital market are discussed in the ensuing sections Size of the Market Consequent on the ongoing financial Reforms both primary and secondary segments of Indian securities market have grown significantly as measured in terms of the amount raised from primary market, number of listed companies, market capitalization, trading volume and turnover in stock exchanges. A clear picture of this growth is portrayed in table 2.4 and diagram

25 47 Table 2.4 Growth of Market Selected Indicators Amount in Rs. Million Primary Market Resource Secondary Market Selected Indicators Mobilization 47 Year Corporate Securities Government Securities Total No. Of Listed Companies Market Capitalization Market Capitalization Ratio (%) Turnover Turnover Ratio (%) Source: Indian Securities Market: A Review, Vol.9, 2006

26 Diagram 2.3 Movement of SENSEX Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 The resource mobilisation from the primary market shows consistent growth since reformation. In fact, it has grown about 279 per cent between and The secondary market also witnessed a radical transformation during the period. The market capitalization ratio (defined as the value of the listed stocks divided by GDP) has increased sharply to per cent in This measure of stock market size is of great economic significance since the market is positively correlated with the ability of the economy to mobilise capital and diversify risk. The average turnover ratio which reflects the volume of trading in relation to market capitalization stood at 48

27 79 per cent in this period. However, this was at its peak at per cent in Then it decreased to 79 per cent in The returns from the market improved significantly during this period. This is clearly visible in Chart 2.3, which shows the movement of the most popular India stock market index BSE SENSEX. Except in a short bearish period of , the aggregate index consistently improved breaking all barriers Performance of the Market The performance of Indian stock markets in comparison with other major developed and developing markets is provided in table 2.5 and table 2.6. India s turnover ratio at the end of December 2004 is at per cent just behind the corresponding figures of developed markets such as the UK, the US and Germany. Though the market capitalisation ratio of India is only 68 per cent, which is far below the UK and, the US, but it is above the corresponding figures of Germany and China. S&P Global Fact Book ranks India 18 th in terms of market capitalization, 18 th in terms of turnover and 15 th in terms of turnover ratio as in December Though these data seem to be impressive they do not reflect Indian market, as S&P Global Stock Markets Fact Book does not cover the whole market. The stock markets worldwide have grown in size as well as in depth over the last one and a half decade. A picture of this growth and the growth of Indian stock markets in comparison with markets worldwide can be read from table 2.6. The growth of Indian stock markets in terms of market capitalization and turnover is far above the aggregate values of world total, developed total and 49

28 emerging total figures. A point of worry is, despite the large number of companies listed in stock exchanges, India accounted for a meagre one per cent and 0.96 per cent of the world total in market capitalization and turnover respectively. But it is interesting to note that while the U.S. share decreased (from per cent to per cent in market capitalization and from 67.2 per cent to per cent in turnover) Indian share, even though very small, increased during the same period (from 0.56 per cent to one per cent in market capitalization and from 0.52 per cent to 0.96 per cent in turnover) Table 2.5 International Comparison as on December 2004 USA UK Japan Germany Singapore Hongkong China India No. of Listed Companies Market Capitalisation ($ Bn) 4 Market Capitalisation Ratio (%) 2 6 Turnover ($ Bn) 5 Turnover Ratio (%) Source: S&P Global Stock Markets Fact book,

29 Country/ Region Developed Markets Table 2.6 Market Capitalization and Turnover for Major markets Market Capitalization Turnover US $ Million (62.42%) Australia (104.94) Japan (73.01) UK (51.05) USA Emerging Markets (47.09) (95.55) China (38.15) India (196.04) Indonesia (144.24) Korea World Total (71.71) (65.84) (0.15%) (74.52) (118.04) (94.12) (-23.71) (60.91) (124.46) (92.31) (111.32) (-19.35) (4.12) US as % of World India as % of World Source: S&P Global Stock Markets Fact book, 2005 Figures in the bracket is the per cent of increase 51

30 2.7 Household Investments Every reform can be said to have achieved its final goal only if the resulting progress reaches all sections of the society. From this point of view the Indian story cannot be considered as impressive. Though returns from stock markets have reached new heights, foreign portfolio investors stormed into market the participation of Indian household sector in this rally is very dismal. The SEBI-NCAER surveys (1999,2001) on Indian investors provide a clear picture of the attitude of Indian households towards financial investments. The latest survey conducted in was based on a sample of 288,081 geographically dispersed rural and urban areas, covering 17.7 crore households. The major findings of the survey in connection with the investments in securities are discussed below: The survey estimates that only 7.41 per cent of the Indian households directly invest in securities. Among the security investors, per cent are from urban area and only the remaining per cent are from the rural area. When 15.2 per cent of the total urban population invest in securities only 4.22 per cent of the rural population invest in securities. Between and , the proportion of security investors has decreased by 0.16 per cent. This decrease was due to the decrease of security investors in the urban segment. During this period, the proportion of urban security investors decreased from per cent to 15.2 per cent, while the 52

31 proportion of rural security investors increased to 4.22 per cent from 3.28 per cent. The distribution of investments among equities and bonds also changed during this period. In , 94.5 per cent of the investments were in equities and the remaining 5.5 per cent in bonds and debentures. In this proportion changed to 50.4 per cent and 49.6 per cent respectively, showing a significant shift towards bonds and debentures. Diagram 2.4 Distribution of Security Investors (%) All India Urban Rural Investors Non-Investors 53

32 Diagram 2.5 Urban-Rural Classifications of Investors (%) Urban Rural Diagram 2.6 Equity- Bond Classification (%) Equity Bonds 54

33 Table 2.7 Distribution of Household Investments in Financial Assets Figures in per cent Securities Market Year Currency Fixed Income Corporate Mutual Govt. Securities Funds Securities Total Source: RBI Annual Reports Table 2.7 based on RBI data provides the distribution of financial investments of the household sector among various assets. Like anywhere else, investors in India allocate funds in their portfolio of investments on the basis of risk-return valuations. In the case of financial assets, the basic choice is between less risky fixed income investments (like deposits with financial institutions and companies, bond funds, insurance, small savings, etc.) and risky securities 55

34 (corporate securities, mutual funds and Government securities). From the table, it is very clear that the most preferred route for financial investments of Indian households is less risky fixed income investments. The share of fixed income investments is more than 70 per cent throughout the period, except during In , the share of fixed income investments was only per cent, as investors diverted substantial amount towards securities. Unfortunately, the worst stock market scam in India occurred during this period. A large number of investors incurred heavy losses on account of the scam. As a result, the investors, especially household investors, lost faith in banks, stock markets and mutual funds. They have not yet recovered from that shock. Thereafter, the share of security market decreased considerably (to single digit figure in the period ). Even now the household investors investing in securities are very cautious about their investments. This is clearly visible from the zigzag type pattern of investments in securities after Another pattern change that reflects the attitude of investors occurred in Till , investments in corporate securities (including mutual funds) were considerably higher than investments in Government securities. In , the pattern changed to the opposite direction; investments in corporate securities decreased considerably and investments in Government securities increased. This may be attributed to the depression that occurred in Indian stock market as well as in stock markets throughout Asia during this period. Between BSE SENSEX has declined about 31 per cent (from 5000 in March 2000 to 3470 in March 2002) and turnover in stock exchanges 56

35 declined by nearly 57 per cent. After that the market regained sharply at 6493 as in March 2005; 87 per cent gain from the value as in March 2002, but the shift that occurred in in the pattern of security investments of household segment is still continuing. The above discussion points out the fact that though Indian capital market has improved substantially in terms of both qualitative and quantitative parameters, it failed to bring domestic retail investors to the market activities. The benefits of the qualitative improvement that occurred in Indian capital markets are largely reaped by the institutional investors, especially the FII investors. Accordingly, Indian households do not benefit much form the recent rise in the stock markets valuations. 2.8 Some Issues There is no doubt that the finance sector reforms have greatly improved the quality of Indian stock markets in terms of efficiency, safety and market integrity. By the continued efforts of the regulators, Indian stock markets are now considered one of the safest markets among the capital markets of developing countries. Even with all these safety measures, several episodes of market misconduct also occurred repeatedly, which marred the rosy picture of our capital markets (recall the scam that occurred during 1992, 1998 and 2001). This shows that still there are some issues to be observed and addressed carefully. Three major issues identified are: risk associated with individual stock futures, problems of uncontrolled inflow of foreign capital and the problem of participatory notes. 57

36 2.8.1 Problem of Individual Stock Futures It is observed that in India more than 50 per cent of the turnover in the derivative segment is the contribution of single stock futures (SEBI, Hand Book of Statistics on the Indian Security Market 2006). This cannot be considered a healthy tendency for reasons explained below. The basic purpose which the derivatives are supposed to serve is to provide a mechanism for investors to hedge their risks arising from unanticipated market movements. It is universally accepted that index futures and options serve this objective. If an investor is interested only in specific stocks, he may as well use single stock options for this purpose. In fact stock options are the safest for an individual since his upside risk of buying an option is limited to the extent of the margin money paid. In the case of stock futures the risk can be very high, if the market moves in the opposite direction by a large measure. The stock futures are not favoured throughout the world in view of the risk they pose to investors and also to the markets. Also individual stock futures are considered to be highly risky because they can be easily used for manipulation of stock prices. A group of unscrupulous speculators can come together to manipulate the future prices of an individual stock by acting in a particular fashion. Since a trader in futures needs to shell out only a margin amount and not the full price of the value of the contract, leveraging becomes easy. For this reason, in most of the countries, wherever equity futures are traded, individual stock futures are considered highly risky products. 58

37 2.8.2 Uncontrolled Inflow of Foreign Capital The uncontrolled inflow of foreign capital into Indian capital market is a problem that is to be tackled carefully. Going by data from SEBI, net cumulative FII inflow into India till March 2006 is US $ million. No doubt, FII investments have been an important force driving the market to its unprecedented heights. Aggrawal (1997) and Chakrabarty (2001) show that there is significant positive relation between equity returns and FII flows. It is to be noted that such a massive fund flow induces a high degree of volatility in stock prices. Studies made by experts like Mukherjee, Bose and Coondoo (2002), Gordon and Gupta (2003), Coondoo and Mukherjee (2004) and Bose and Coondoo (2004) sound a caution about the negative impacts of FII investments on the domestic markets. As FIIs have the power to influence stock prices, they can purposely push the market up and choose an appropriate moment to exit. The resulting high levels of volatility may be substantial to a country like India Problem of Participatory Notes Participatory notes (PNs) are offshore instruments sold by FIIs to their clients against underlying Indian securities (both cash and derivatives). This allows offshore investors to enter and exit Indian market while avoiding registration, settlement and other issues. A majority of the FIIs that are registered with SEBI mobilise funds through such PNs, which are supposed to be subscribed by eligible investors. Though FIIs have to give a written affidavit that they have not mobilised funds from non-eligible entities, at present there is 59