Since the beginning of this decade the Indian capital markets have been receiving global attention due to the improving macroeconomic fundamentals. The presence of a great pool of talent, rapid integration with the world economy and liberalization measures taken by the government have increased India’s global competitiveness and have helped the capital markets grow by leaps and bounds. In this issue we take a look at the major turning points and focus on the most recent developments in the markets.

The major revolution in the capital markets started with the establishment of the Securities and Exchange Board of India (SEBI), the regulatory authority for Indian securities market in 1992. It aimed at protecting the investors and improving the infrastructure of capital markets in India. Since then a flurry of improvements have been initiated by the Government of India and the SEBI which has resulted in transition of exchanges to screen-based order matching systems for better transparency, dematerialization of shares, online trading facility and adoption of market oriented economic policies. This led to faster and cheaper transactions, and increased the volumes traded by many folds. This along with the liberalization measures undertaken by government since 1993 has helped deliver India on the global platform. This decade has also seen the rise of the derivatives markets which are now being used by many Indian corporations for hedging their risks. Mobile phone banking being implemented around the country indicates that much of the system is at the Internet age and beyond. However despite these efforts our markets have not been able to reach the levels desired. Even now less than 1 per cent of our population invests directly in the equity market. In terms of depth, participation and geographical spread, Indian capital markets are nowhere close to the developed nations; not even close to their Asian counterparts

A multitude of reasons surface when we probe these shortcomings of the Indian Capital markets. The primary market which used to be the retail investors’ favorite investment avenue and an entry point till a few years ago, has been dwindling of late. This was reflected in the recent IPO’s of some public-sector firms, which have traditionally enjoyed a sound and safe investment image among public investors. Retail Investor participation in the market remains dismal even in the secondary market. To put the picture in perspective, the Indian retail investor saves over $300 billion but allocates less than 5 per cent to financial market instruments other than low return bank deposits. Even in terms of geographical spread, more than 90 per cent of exchange trade is largely confined to 10 cities and 100 companies.

The biggest reason for this lackluster allocation to capital markets remains lack of confidence and limited financial literacy. In the last two decades, India has seen scams and frauds which has left the investor nervous.  The allocation fraud of Yes bank IPO where multitude of retail accounts were opened by a single investor to get maximum allocation  through retail route rather than HNI route is one such example. It represented not only the pervasiveness of the menace but also the inability of our legal and financial control systems in dealing with it. It takes an era to uncover a scam of this magnitude in any country. To punish the perpetrators takes even longer in India! Compensation if any is hard to come by. Several such scams have left the Indian investor suspicious of the capital markets and those with weaker hearts have instead chosen to invest in the low return fixed deposit schemes. Regaining their confidence will require speedy indictments and compensation for which an overhaul of the legal system is required. There has been some good news on that front with the recent disgorgement of undue profits from the IPO scam and compensation to the wronged investors. Whether it will be enough to entice the retail investor, only time will tell.

The Government and SEBI have been doing their part by spreading investor education and using product innovation and technology to bridge the urban-rural divide for a more equitable and inclusive growth. The dwindling interest in the primary markets can also be rejuvenated by allocating higher retail portion in the IPO and simplifying the procedures and cost of opening Demat accounts to encourage people beyond the top 10 centers to invest directly in equities. Currently, the application forms being used for bidding in initial and follow-on public offers are unnecessarily long and enquire redundant data which can be done away with. There are various proposals currently being discussed by SEBI’s Primary Market Advisory Committee to remove these details from the forms and make them more investor friendly.

The SEBI in its role of protector of investors and capital market regulator recently got into a battle with the IRDA over regulation of ULIPs. Earlier last year, SEBI had banned entry loads on Mutual funds which made the product unprofitable for the insurance agents. They focused their attention on the new product called ULIPs which still had entry loads ranging from 15-20%. During the last year, the premium collected from these products was a total 20 billion dollars which is about 60% of the net FII inflows of the previous year. This huge amount of money, most of which is invested in the capital markets, was not under the purview of the SEBI. This prompted SEBI to ban 14 private insurers from selling any new ULIP product without registering with SEBI. Although the verdict has ended with the court siding with the IRDA and ULIPS still remain under its purview, it has helped being the truth about this product in front of investors who would now think twice before investing in them. An overhaul in the nature of these products is being contemplated without which the product may die a natural death due to all the bad publicity it has gathered during this battle. For more information on the battle between SEBI and IRDA do check out the article ‘ULIPS: Whose product is it anyway?’ in the current issue.

Indian debt market

Debt Market plays a very critical role for any growing economy which need to employ a large amount of capital and resources for achieving the desired industrial and financial growth. The Indian debt market is today one of the largest in Asia which includes government securities, public sector undertakings, other government bodies, financial institutions, banks and corporate.

In most of the economies of the world the debt markets have been more popular than the equity markets. However in India the reverse remains true. The debt markets had been plagued by excessive controls and administered rates to pave way for any development.  Before1992, only a handful of institutions participated in the government bond market with no trading activity on any exchange and a system of administered rates. Money was lent according to the plan prepared by the government of India and any fallout of the plan was funded by issuance of more government bonds.

The exponential growth of India’s government bond market during last decade can be attributed mainly to structural changes pioneered by the Government and the Reserve Bank of India to improve transparency in market dealings, method of primary auctions, deepening the market with new market participants like Primary Dealers, borrowings at market determined rates, and creating technology platforms like NDS to recognize the institutional characteristics of the market. In the wake of deregulation of interest rates as part of financial sector reforms, there was a need for introducing hedging instruments to manage interest rate risks. RBI introduced Over the Counter hedging instruments like Interest Rate Swaps (IRS), Forward Rate Agreements(FRA), Interest Rate futures(IRF), zero coupon bonds, convertible bonds, callable (put-able) bonds and step-redemption bonds over the years.

However the same kind of impetus has been lacking in the corporate bond markets in India. As a result this, major source of corporate funding is all but non-existent. The corporate in India still prefer to borrow on loans from financial institutions which they can keep on their books at book value rather than by bonds which need be marked to market. These financial institutions divert the huge domestic savings which never find way into the equities market, for corporate consumption. Even the foreign currency borrowings by way of FCCB’s and ECB’s are favorites among the Indian corporations rather than the domestic corporate bonds. A slew of reasons have been cited for this, most notably, the lengthy issuance procedure for public issues, the information disclosure requirements, higher costs of public issues and inability of the public segment in handling larger issues. However, the most important factor remains that the corporate bond market remains a cheap source of funds only for AAA rated paper. This limits the number of entities which would find it profitable and cheaper to raise money by this route. As a result, the corporate bond segment is dominated only by very credit worthy PSU’s. The biggest investors in this segment of the market, namely LIC, GIC and UTI prefer to hold the instruments to maturity, thereby truncating the supply of paper in the market. If there ever was a need to develop the corporate bond market, its time has quite definitely come.

Indian authorities are targeting an increase in infrastructure spending of some $500 billion during the current five-year plan which cannot be financed through the usual bank loan route. Most of the resources raised by banks are by way of deposits, which are short-term in nature, while infrastructure projects have a long-gestation period creating an asset liability mismatch. This kind of financing can only be arranged by the bond market.

Going forward the emphasis in the debt market shall remain on financial innovation by means of newer products within a sound regulatory and supervisory framework. In 2010, India has proposed to introduce exchange-traded rupee options and interest-rate futures based on a wider range of debt securities and step up efforts to further develop a derivatives market that can help investors guard against financial risk. Bourses will be permitted to introduce dollar-rupee options and futures based on two- and five-year government bonds and 91- day treasury bills. The Reserve Bank of India also plans to finalize regulations for customized foreign-exchange derivatives.

The Reserve bank of India (RBI) has also proposed to introduce credit default swaps, or CDS, in Indian markets to enable firms to hedge against any possible default by a bond issuer. Although such a proposal has been drafted twice before, the introduction of CDS remained stalled in the wake of the financial crisis of 2008. At a time when the entire world is shying away from CDS, its introduction in Indian markets is triggered more by necessity than by anything else, especially for infrastructure bonds to fund India’s growth story. However caution will have to be observed knowing the explosive nature of this product.

If there is anything that we have learnt from the last crisis it’s that maintaining adequate capital, avoiding excessive reliance on short term funding, maintaining proper loan underwriting and following sound risk management policies is a must. Thankfully we have the SEBI and RBI which quite skillfully handled this during the crisis keeping India somewhat protected from the magnitude of turmoil in the west. However there have been criticisms of excessive control which have hampered product innovation. India still has significant opportunities for productive and prudent financial innovation, leaving it in the enviable position of learning from the experience of others. Product innovation in multiple asset classes such as bonds, interest rate futures, equity and SME will surely bring about the much-needed multifold capital formation and a scope for huge employment generation in India.

About the Author:

Smitalee Prusty is a 2nd year PGP student at IIM Calcutta. She holds a masters degree in Mathematics and Computing from Indian Institute of Technology Kharagpur. She can be reached at smitalee@gmail.com

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