Indian Capital Markets:

Recent Development and Policy Issues

FEBRUARY 1999

YOON JE CHO

SOGANG UNIVERSITY

This paper has been prepared for the research project of the Asian Development Bank, Study
of Financial Markets in Selected Member Countries (TA-5770 REG). The views expressed herein are
those of the author and should not be attributed to the Asian Development Bank or its affiliated
institutions.

I.

OVERVIEW

Securities markets of India have a long history. The Bombay Stock Exchange
(BSE) began formal trading in 1875, making it one of the oldest stock exchange in Asia.
Currently there are 22 stock exchanges in India. There has been a rapid change in Indian
securities markets, especially in the secondary markets, during the last several years. Stock
exchanges in India have modernized itself through advanced technology and computer on line
based transactions. In terms of the number of companies listed and total market capitalization, the
Indian equity market is quite large relative to the stage of its economic development. The number
of listed companies increased from 5,968 in March 1990 to about 10,000 as of May 1998. The
market capitalization had got multiplied by 10.9 times during the same period.
The debt markets, however, were almost non-existent in India even though the
volume of government bonds traded has been large. The banks and financial institutions held a
substantial part of this for the statutory liquidity requirement. The portfolio restrictions on the
financial institutions (statutory liquidity requirement) are still in place, primary auction market
for government securities have been created and primary dealer system has been introduced since
1995. There are six authorized primary dealers currently. Mutual funds were opened to the private
sector in 1992. Earlier, in 1987, banks were allowed to enter this segment, breaking the monopoly
of Unit Trust of India (UTI), although it continues to hold a dominant position. Currently there
are 31 mutual funds, out of which 21 are in the private sector.
Prior to 1992, many factors obstructed the expansion of equity trading. Fresh
capital issues were controlled through the Capital Issues control Act. Trading practices were not
transparent, and there used to be a large amount of insider trading. Recognizing the importance of
increasing investor protection, a number of measures were enacted to improve the fairness of the

capital market. The Securities and Exchange Board of India (SEBI) was established in 1988.
Despite the framing of rules by SEBI, problems continued to exist, including those relating to
disclosure criteria, lack of broker capital adequacy, poor regulation of merchant bankers and
underwriters.
There have been significant reforms in the regulation over securities market since
1992 in conjunction with overall economic and financial reforms. In 1992 the SEBI Act was
enacted and SEBI was given statutory status as an apex regulatory body. A series of reform
measures have been introduced to improve investor protection, automation of stock trading,
integration of national markets, and efficiency of the market operation.
In the area of the secondary market for equity, India has achieved a tremendous
change. On most counts, Indias equity market is likely to be comparable with the worlds most
advanced secondary markets within a year or two. The key ingredients which underlie market
quality in Indias equity market are: (i) exchanges based on open electronic limit order books; (ii)
nationwide integrated market with a large number of informed traders and fluency of short or
long positions; and (iii) no counterpart risk. The processes of which has already started and soon
to be fully implemented are: (i) the electronic settlement trade; and (ii) exchange-traded
derivatives. Before 1995, the physical organization of markets in India used open outcry, which
consisted of a pit in which traders shouted and hand-signaled in the process of trading. One major
policy initiated by SEBI from 1993 onwards has concerned migration of all exchanges to screen
based trading, motivated primarily by considerations of transparency. The first exchange based
on an open electronic limit order book, which commenced operation, was the National Stock
Exchange (NSE). NSE started trading debt instruments in June 1994 and equity in November
1994. In March 1995, the BSE shifted from open outcry to a limit order book market. Currently
17 out of 22 stock exchanges have adopted open electronic limit order.

Prior to 1994, Indias markets were dominated by the BSE. The financial
industry in other locations in the country was unable to have equal access to markets and
participate in forming prices, as compared with market participants in Mumbai (Bombay). As a
result, markets outside Mumbai had prices that were often quite different from prices in Mumbai.
These pricing errors served as a barrier to increase in order flow to these markets. This situation
has been changed by explicit nation-wide connectivity and implicit movement towards one
national market (Shah and Thomas, 1997). The NSE established satellite communications, which
gives all trading members of NSE equal access to the market. Similarly, the Bombay Stock
Exchange (BSE) and the Delhi Stock Exchange are both in the process of an expansion of trading
terminals located all over the country. The arbitrages are eliminating pricing discrepancies
between markets.
Despite these big improvements in microstructure, Indian capital market has been
subdued during the last three years. The amount of capital issued has declined from the level of
peak year, i.e., 1994-95, and so is the level of equity prices. In 1994/95 Rs. 276 billion was raised
in primary equity market. This figure has reduced to in Rs. 208 billion in 1995/96 and Rs. 142
billion in 1996-97. Price index (Sensex index) peaked at 4,361 in September 1994, and declined
in the following years. This has been caused by the financial irregularities and overvaluation of
equity prices in the earlier years that eroded the public confidence in the corporate shares. It was
also affected by the reduced inflow of foreign investment after Mexican and Asian financial
crises. In a sense, the market is now going through a period of adjustment. Thus, it is a time for
regulatory authorities to put additional efforts to help recovery of investor's confidence and to
further improve the efficiency and transparency of the operation of the market.
Indian capital markets still faces many challenges in order to better serve for
efficient allocation and mobilization of capital in the economy. First, poor market infrastructure

which has interfered with efficient flow of information and effective corporate governance has to
be improved. Accounting standards have to be improved by implementing internationally
accepted accounting practices. Court system and legal mechanism should be improved to better
protect small shareholders right and their capacity to monitor corporate activities. Second,
transparency of the system has to be further improved. Information disclosure and availability is a
crucial public good that goes into market efficiency. In this relation, consolidated balance sheet
may be required to conglomerate affiliated firms. SEBI should more closely monitor the cases of
insider trading also. Third, India may need further integration of national capital market through
consolidation of stock exchanges. The trend all over the world is to consolidate and merge the
existing stock exchanges. All 22 stock exchanges may not warrant themselves for the existence.
There is a pressing need for developing a uniform settlement cycle and a common clearing
system which will bring an end to unnecessary speculation based on arbitrage opportunities.
Fourth, the payment system has to be improved to better link the banking and securities industry.
Indias banking system yet has to come up with good electronic funds transfer (EFT) solutions.
EFT is important for problems like direct payments of dividends through bank account,
eliminating counter party risk, and facilitating foreign institutional investment. Capital markets
cannot thrive alone and they have to get integrated with other segments of the financial system. It
is a global trend that the traditional wall between banks and securities market is getting
eliminated.
It is also needed to emphasize that the development of securities markets has to
be supported by the overall macroeconomic and financial sector environments. A further
liberalization of interest rates, reduced fiscal deficits fully market-based issuing of government
securities, more competitive banking sector will help the development of a sounder and more
efficient capital market in India.

II.

A.

CAPITAL MARKET REFORMS AND ITS DEVELOPMENT

Reforms in Capital Markets

During the last several years, SEBI announced several far-reaching reform

measures to promote capital markets and protect investor interests. Reforms in the secondary
markets have focused on three main areas: reforms of the structure and functioning of stock
exchanges; automation of trading and post trade systems; and the introduction of surveillance and
monitoring systems. The gist of reform measures implemented in Indian securities markets since
1992 are listed in Appendix I. Computerized on line trading of securities, and setting up of
clearing houses or settlement guarantee funds was made compulsory for stock exchanges. Stock
exchanges were permitted to expand their trading to locations outside their jurisdiction through
computer terminal. Responding to this, major stock exchanges in India are in the process of
expanding their activities by locating computer terminals in far-flung areas, while smaller
regional exchanges are planning consolidate their position by having centralized trading under a
federated structure. Computerized on line trading system has been introduced in almost all stock
exchanges. Trading is much more transparent and quicker now than any time in the past.
Until early 1990s, the trading and settlement infrastructure of Indian capital
markets remained poor. Trading on all stock exchanges was through open outcry; settlement
systems were paper based. Market intermediaries were largely unregulated. The regulatory
structure was fragmented and there was no comprehensive registration or apex body of regulation
of the securities market. Stock exchanges run as brokers club and their management was
dominated by brokers. There was no prohibition of insider trading and fraudulent and unfair trade
practices (see Appendix for the state of Indian securities market before 1992).

The reform in the market has been intensified and there has been a quantum jump
in securities market, especially in the secondary markets for equity, since 1992. Computerized on
line trading has been introduced and clearing houses/corporations have been set up by most of
stock exchange. A depository has become operational for scripless trading and the regulatory
structure has been overhauled with most of powers for regulating capital market vested with
SEBI. Indian capital market has been experiencing a process of structural transformation in that
the operations are being conducted on standard equivalent to those in the developed markets. The
market was opened up for investment by the foreign institutional investors (FIIs) in 1992 and the
Indian companies were allowed to raise resources abroad through Global Depository Receipts
(GDRs) and Foreign Currency Convertible Bonds (FCCBs). Both the primary and secondary
segments of the capital market displayed rapid expansion and growth accompanied by greater
institutionalization and larger participation of individual investors. However there still remain
many problems which interfere with the improvement of the efficiency of the Indian capital
market.

B.

Stock Market
1. Primary Market
Since 1991-92, the primary market has grown fast as a result of the removal of

investment restrictions in the overall economy and a repeal of the restrictions imposed by the
Capital Issues Control Act. In 1991-92, total of Rs. 62.15 billion was raised in the primary
market. This figure had gone up to Rs. 276.21 billion in 1994-95. Since 1995-96, however the
funds raised have been lower due to the overall downtrend in the market and tighter entry barriers
introduced by SEBI for investor protection (Table 1).
<Table 1> Issues in the primary market

(Rs. in Billion)
Year

Public

Rights

Total

No.

Amount

No.

Amount

No.

Amount

1994-95

1,342

210.44

350

65.88

1,692

276.32

1995-96

1,426

142.39

299

65.64

1,725

208.03

1996-97

753

115.65

131

27.19

884

142.84

59

21.99

1997 Dec.
Source: Reserve Bank of India

Total market capitalization as of March 1998 was Rs. 5,895 billion (Table 2),
equivalent to about half of annual GDP. India compares favorably with other emerging markets in
this respect. The market capitalization to GDP ratio at end-1995 was 12.6 percent for Hong Kong,
40.0 percent for Indonesia, 41.0 percent for South Korea, 37.1 percent for Mexico and 22.4
percent for Brazil.1

It was higher however, in Malaysia (281.9 percent), Singapore (233.0

percent), Thailand (152.9 percent), and Philippines (81.3 percent).

<Table 2> Number of listed securities and market capitalization

(Rs. in billion)
1994-95

1995-96

1996-97

1998 March

No.

Amount

No.

Amount

No.

Amount

No.

Amount

5,527

9,100

5,072

9,890

4,882

N.A.

5,895

Source: SEBI

2. Equity Price
In the past dozen years, equity prices have seen two extended periods of
declining prices and two periods of rising prices. In the two-year period between April 1986 and
March 1988, the Sensex fell from 589 to 398, a decline of 33%. Prices also fell between March

World Equity Guide, Euromoney Publications, 1996.

1992, when the monthly closing level of the Sensex was 4,258 and April 1993, when the monthly
closing level of the Sensex was 2,122, a decline of 50.5%. Periods in which prices generally rose
extended from March 1988 to March 1992 and from May 1993 to August 1994. The monthly
closing level of the Sensex rose from 398 for March 1988 to 4,285 for March 1992, an increase of
over 9.5 times in the four year period. In the second period of extended increases in equity prices
between April 1993 and August 1994, Sensex increased by 1.16 times. Since 1995, Sensex
fluctuated around 3,000-4,000. In April 1998, Sensex stayed around 3,000.(Figure 1)

5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
Jan-91

60
50
40
30
20
10

BSE Sensex P/E ratio

BSE Sensex

<Figure 1>Price and P/E Ratios for the Sensitive index of The Stock Exchange

0
Jan-92

Jan-93

Jan-94

Jan-95

Sensex

Jan-96

Jan-97

Jan-98

P/E

Source : The Bombay Stock Exchange.

In the present period of declining prices, from August 1994 to March of 1998,
P/E ratio have fallen more sharply than prices (Figure 1). For example, in March of 1998, the
monthly average Sensex P/E ratio was 15.65, while the figure for October 1993 (Sensex closing
level 3,294) was 38.76.

C.

Risk Management System

Several measures have been taken by SEBI to improve the integrity of secondary
markets. Legislative and regulatory changes have facilitated the corporatisation of stockbrokers.
Capital adequacy norms have been prescribed and are being enforced. A mark to market margin
and intraday trading limit are also imposed. Further, the stock exchanges have put in place circuit
breakers, which are applied at times of excessive volatility. The stock exchanges have been
recently required to monitor short sales and long purchases. The disclosure of short sales and long
purchases is now required to be made at the end of day to reduce price volatility and further
enhance the integrity of the secondary markets.

Mark-to-Market Margin and Intra-day Limit

Under the current clearing and settling system in India, if an Indian investor buys

and subsequently sells, or sells and subsequently buys, the same number of shares of a stock
during a settlement period, he or she does not need to take or make delivery of the shares and can
pay or receive the difference between the sell and buy prices. In other words, the squaring-off of
the trading position during the same settlement period results in non-delivery of the shares that
the investor traded. A very short-term and speculative investment is thus possible at a relatively
low cost. FIIs and domestic institutional investors are, however, not permitted to trade without
delivery, since non-delivery transactions are limited only to individual investors.
One of SEBIs primary concerns is the risk of settlement chaos that may be
caused by an increasing number of non-delivery transactions as the stock market gets excessively
speculative. Accordingly, SEBI introduced: (i) daily mark to market margin; and (ii) intraday
trading limit. The daily mark-to-market margin is a margin on a brokers daily position.

The

intra-day trading limit is the limit to a brokers intra-day trading volume. Each broker is subject
to the margins and the trading limit.

Each stock exchange may take any other additional measures to ensure the safety
of the market. The BSE and the NSE both impose on its members a more stringent daily margin
now, including margin based on concentration of business.
A Daily mark-to-market margin is 100% of the notional loss of the stockbroker
for every stock. Calculated as the difference between his or her buying or selling price and the
closing price of that stock at the end of that day. However, there is a threshold limit of 25% of
the base minimum capital plus additional capital kept with the stock exchange or Rs. 1 million,
whichever is lower. Until the notional loss exceeds the threshold limit, the margin is not payable.
This margin is payable by a stockbroker to his or her stock exchange in cash or
bank guarantee from a scheduled commercial bank, on a net basis. It will be released on the payin day for the settlement period. The margin money is held by the exchange for 6-12 days. This
costs the broker approximately 0.40-1.20% of the notional loss, assuming that the brokers
funding cost is around at 24-36% (Endo 1998). Thus, speculative trading without the delivery of
shares is no longer cost-free.
Each brokers trading volume during a day is not allowed to exceed the intra-day
trading limit. This limit is 33 1/3 times his or her base minimum capital deposited with the
exchange in a gross basis, i.e., purchase plus sale. In case a broker wishes to exceed this limit, he
or she has to deposit additional capital with the exchange which would not be permitted to be
withdrawn for a period of 6 months.

Circuit Breaker
SEBI has imposed the price limits for stocks whose market prices are above Rs.

20, namely, the daily price limit of 10% and the weekly price limit of 25%. For instance, BSE

10

imposes price limits as a circuit breaker system to maintain the orderly trading of shares on the
exchange as seen in Table 3.

<Table 3 > Daily Price Limits on BSE

Category

Market Price of the Daily Price Limit

Weekly Price Limit

Share
A Group Shares

Over Rs. 20

B1 & B2 Group Shares Rs. 10 up to 20

10%

25%

25%

Rs. 1 up to 10

50%

No limit

Up to Rs. 1

75%

No limit

Source : Endo (1998)

The BSEs computerized trading system rejects buy or sell orders of a stock at
prices outside the price limits, but does not stop trading itself. The daily price limit of a stock is
measured from the stocks closing price in the previous trading session. The weekly price limit is
based on its closing price on the last trading in the previous week, usually its closing price on the
previous Friday.

3. Short Sales and Long Purchases

SEBI regulates short selling in the Indian stock market by requiring all stock
exchanges to enforce the reporting by their members of their net short sale and long purchase
position in each stock at the end of each trading day.

D.

Stock Lending

11

A scheme for facilitating stock lending in a regulated manner has been

introduced in February 1997, following changes to tax regulations. Stock lending can now take
place through an intermediary which is registered for this purpose with SEBI, and which has a
minimum capital of RS. 0.5 billion. Lenders and borrowers of securities have to enter into
agreements with the intermediary. The introduction of stock lending will facilitate the timely
settlement of transactions on the stock exchanges, especially in an environment where physical
delivery of certificates is required for settlement.

E.

Introduction of Derivatives Trading

At present there are no exchange traded or over the counter derivatives markets
in the country. The legislative changes necessary for permitting the trading of derivatives have
been made. A committee recommended under the chairmanship of Dr. L C Gupta, recommended
the regulatory framework and other modalities for the introduction of derivatives trading in the
country. The law was passed for the establishment of the derivative market. It is expected that
derivatives trading will soon be introduced in Indian securities markets.

F.

Institutional Investors

Mutual Funds
Indian investors have been able to invest through mutual funds since 1964, when

Unit Trust of India (UTI) was established. Indian mutual funds have been organized under the
Indian Trusts Acts, under which they have enjoyed certain tax benefit . Between 1987 and 1992,
public sector banks and insurance companies set up mutual funds. Since 1993, private sector
mutual funds have been allowed to be set up, which has introduced competition to the mutual

12

fund industry. This has resulted in the introduction of new products and improved services. The
notification of the SEBI (Mutual Fund) Regulations, 1993, brought about a restructuring of the
mutual fund industry. An arms length relationship is required between the fund sponsor, trustees,
custodian and asset management company. This is in contrast with the situation prevailing earlier
in which all three functions were often performed by one body which was usually the sponsor of
the fund or a subsidiary of the sponsor. The regulations prescribed disclosure and advertisement
norms for mutual funds, and, for the first time, permitted the entry of private sector mutual funds.
As mentioned earlier, FIIs registered with SEBI may invest in schemes of domestic mutual funds,
whether listed or unlisted.
The SEBI (Mutual Funds) Regulations, 1993 have been revised on the basis of
the recommendations of the Mutual Funds 2000 Report prepared by SEBI. The revised
regulations strongly emphasize the governance of mutual funds and increase the responsibility of
the trustees in overseeing the functions of the asset management company. Mutual Funds have
been required to obtain the consent of investors for any change in the fundamental attributes of
a scheme, on the basis of which unit holders have invested. The revised regulations require
disclosures in terms of portfolio composition, transactions by schemes of mutual funds with
sponsors or affiliates of sponsors, with the asset management company and trustees and also in
respect of personal transactions of key personnel of asset management companies and of trustees.

Foreign Institutional Investors

Foreign Institutional Investors (FIIs) have been allowed to invest in Indian

securities markets since September 1992 when the Guidelines for Foreign Institutional
Investment were issued by the government. In November 1995, the SEBI (Foreign Institutional
Investors) Regulations, 1995 have come into effect, which are largely based on the earlier

13

Guidelines. The Regulations require FIIs to register with SEBI and to obtain approval from the
Reserve Bank of India (RBI) under the Foreign Exchange Regulation Act to buy and sell
securities, to open foreign currency and rupee bank accounts and to remit and repatriate funds.
Once SEBI registration has been obtained, an FII does not require any further permission to buy
or sell securities or to transfer funds in and out of the country, subject to payment of applicable
tax.
Foreign investors, whether registered as FII or not, may also invest in Indian
securities outside the FII route. Such investment requires case by case approval from the Foreign
Investment Promotion Board (FIPB) in the Ministry of Industry in the central government and the
RBI, or only by the RBI depending the size of investment and the industry in which this
investment is to be made. Investment in Indian securities is also possible through the purchase of
Global Depository Receipts (GDRs). Foreign currency convertible bonds and foreign currency
bonds issued by Indian issuers which are listed, traded and settled overseas are mainly
denominated in US Dollars. Foreign financial service institutions have also been allowed to set
up joint ventures in stock broking, asset management companies, merchant banking and other
financial services firms along with Indian partners.
Foreign portfolio investments in Indian companies are currently limited in the
following two ways: (i) individual foreign ownership at 10% of the total issued capital of any one
company; and (ii) aggregate foreign ownership at 30% of the total issued capital of any one
company.
FIIs net investment was positive till October 1997 and their cumulative
investments have reached U$ 9.1 billion in October 1997. But since October 1997, it turned to
negative due to the Asian financial crisis (Table 4). As of May 1998, 496 FIIs were registered

14

with SEBI and they had cumulative net investment of U$ 9.2 billion in the Indian securities
market.

<Table 4> Investment by foreign Institutional Investors (FIIs) in Secondary and Primary Markets
Year/Month

No. of

Gross Purchase

Gross Sales

Net Investment

Cumulative

Regd.

Net

FIIs

Investment

(Cumulati
ve)
Rs. billion

US $ mn Rs. billion

US $ mn Rs. billion

US $ mn US $ mn

Jan-Mar 1993

18

0.17

5.6

0.04

1.3

0.13

4.3

4.2

1993-94

158

55.92

1782.8

4.66

148.7

51.26

1634.1

1638.3

1994-95

308

76.31

2431.2

28.34

902.9

47.96

1528.3

3166.6

1995-96

367

96.75

2858.6

27.51

822.9

69.42

2035.7

5202.3

1996-97

439

154.57

4364.6

69.73

1957.5

84.84

2407.1

7609.5

1996-97

429

127.01

3595.6

52.15

1467.0

74.86

2128.6

7331.0

476

143.82

3979.4

102.12

2807.4

41.69

1172.0

8781.5

476

527.57

15422.2

232.43

6640.6

295.32

8781.5

8781.5

Oct. 1997

471

16.0

442.0

9.66

267.0

6.33

174.9

9090.3

Nov. 1997

475

10.93

295.4

15.05

406.7

-4.11

-111.3

8979.0

Dec. 1997

476

9.34

251.0

14.60

392.3

-5.26

-141.3

8837.7

Jan. 1998

476

6.52

175.2

8.62

231.5

-2.09

-56.3

8781.4

(Apr-Jan)
1997-98
(Apr-Jan )
Grand Total
(since Jan 93)

Source : SEBI (1998)

*Annual percentage variations are not given for want of comparable data
** Data include debt instruments also.

Since 1993-94, foreign portfolio investments have far exceeded the foreign direct
investments which also increased rapidly (Table 5). Among foreign portfolio investment has been
investment through FIIs the largest item. Annual inflows have been about US$ 1.5 - 2 billion
during the past three years through FIIs while inflows through GDR has declined after it peaked

15

at US$ 1.8 billion in 1994/95. In 1996/97, India received U$ 5.4 billion in foreign investment of
which U$1.9 billion was in the form of FIIs. During 1997/98 FIIs are estimated to have fallen
while the foreign direct investment has risen. Improvement in inflow of foreign investment raised
Indias foreign exchange reserves from U$17 billion at the end of 1994/95 to US$ 29.3 billion at
the end of June 1997. Perhaps this decline was caused by the Mexican crisis.

<Table 5> Foreign Investment Inflows

(US $ million)
1991-92 1992-93

1993-94

1994-95

1995-96

1996-97

150

341

566

1314

2133

2696

a. Govt. (SIA/FIPB)

87

238

280

701

1249

1922

b. RBI

42

89

171

169

135

c. NRI

63

61

217

442

715

639

92

3649

3581

2748

2864

a. GDRs

86

1602

1839

683

918

b. FIIs

1665

1503

2009

1926

c. Offshort funds and

382

239

56

20

158

433

4235

4895

4881

5560

A. Direct Investment

B. Portfolio Investment

others
Total ( A+B)

Source: RBI, Report on Currency and Finance, 1993-94, 1995-96, 1996-97

Note: GDRs: Global Depository Redeipts
FII: foreign Institutional Investors

Following the changes to the SEBI (Foreign Institutional Investors) Regulations

(1995), FIIs are now allowed to set up an investment fund to invest 100% of the fund in Indian
bonds if it registers the fund with SEBI as a new separate FII or its new sub-account. SEBI during
1996, approved 9 debt funds with a cumulative investment exposure of U$1,278 million for
investments in the securities.
FIIs seems to have strong impact on the equity price movement in India. Trend
analysis indicates that the movement by BSE Sensex and the lagged net investment by FIIs are

16

significantly positively correlated. Figure 2 suggests that monthly net investment has been not
only correlated with the market index movement but it has been taking the lead in changing the
market sentiments.

5,000
4,500
4,000
3,500
3,000
2,500

400
300

2,000
1,500

200
100
0

1,000
500
0

N
ov

NFI

Sensex

Source : SEBI Annual Report 1995-96

17

BSE 30 Index

1000
900
800
700
600
500

-9
Fe 2
bM 93
ay
A 93
ug
N 93
ov
-9
Fe 3
bM 94
ay
A 94
ug
N 94
ov
-9
Fe 4
bM 95
ay
-9
A 5
ug
N 95
ov
-9
Fe 5
bM 96
ay
A 96
ug
M 96
ay
A 97
ug
N 97
ov
-9
M 7
ar
-9
8

Monthly Net Investment (US$

million)

<Figure 2> Net FII Investment & BSE-30 Index

III.
A.

POLICY ISSUES

Regulatory Framework
1

Regulation of Intermediaries
According to the law, most participants in the Indian capital markets are supposed to

register with SEBI in order to carry out their businesses. Such participants are:
(1) Stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of
trust deed, registrars to an issue, merchant bankers, under writers, portfolio
managers, investment advisers and other such intermediaries who may be
associated with securities markets in any manner;
(2) Depositories, participants, custodians of securities, foreign institutional investors,
credit rating agencies and other such intermediaries who may be associated with
securities markets in any manner; and ,
(3) Venture capital funds and collective investment schemes including mutual funds.
However, the registration system is far from complete. For some professional
categories such as sub-brokers, the registration system is nominally in place, but the lack of
SEBIs enforcement power permits hundreds of thousands of unregistered sub-brokers to
conduct their securities businesses, while registered sub-brokers are not effectively regulated
(see below). There is no registration system at all for investment advisers.
Currently, the capital adequacy requirements of registered market participants are
surprisingly low. Consequently, entry barriers are also low. This is probably because the vested
interest of existing market participants cannot be totally ignored since the Indian capital market
would stop functioning without the existing market participants. The majority of them are very
thinly capitalized. As a result, SEBI is compelled to register many small participant and to
regulate them. The regulators limited resources are thus spread too thin.

18

(1) Stockbrokers
The Indian law defines a stockbroker simply as a member of a recognized stock
exchange. Therefore, a registered stockbroker holds the membership of at least one of the
recognized Indian stock exchanges. No stockbroker is allowed to buy, sell or deal in securities,
unless he or she holds a certificate granted by SEBI. At the end of March 1997 they numbered
8,867.
Each stockbroker is subject to capital adequacy requirements consisting of two
components: (a) basic minimum capital, and (b) additional or optional capital related to volume
of business.
The amount of basic minimum capital varies from exchange to exchange. A SEBI
regulation requires stockbrokers of the Bombay Stock Exchange or the National Stock
Exchange to maintain an absolute minimum of Rs. 500,000 (approximately US $ 14,000),
which is the largest of all the stock exchanges. However, the BSE require its members to deposit
with it a larger amount, Rs. 1 million. The NSE also requires its members to deposit with it
larger amounts. The additional or optional capital, including the basic minimum capital, has to
be maintained at 8% or more of the gross outstanding business in the exchange. The gross
outstanding business means the cumulative amount of sales and purchases by a stockbroker in
all securities at any point of time during the ongoing settlement period. Sales and purchases
made on behalf of customers may not be netted but on those on the brokers own behalf may be.
There is no mandatory qualification test for stockbrokers and other market participants
in India, unlike in the United States, the United Kingdom, Japan and many other countries.

(2) Sub-brokers
Most stockbrokers in India are still relatively small. They cannot afford to directly

19

cover every retail investor in a gigantic country with such a complex society like India. Subbrokers play an indispensable role in intermediating between investors and stock markets.
Stockbrokers of Indian stock exchanges are permitted t transact with sub-brokers.
In applying for a sub-broker certificate, a sub-broker applicant must be affiliated with
a stockbroker of a recognized stock exchange. A sub-broker may take the form of sole
proprietorship, partnership, or corporation. A sub-broker is, however, a controversial issue in the
Indian capital markets. The issue is twofold:
(i)

the majority of sub-brokers are not registered with SEBI; and

(ii)

the function of a sub-broker is not meaningfully defined.

No sub-broker is supposed to buy, sell or deal in securities, unless he or she holds a

certificate granted by the SEBI. Nevertheless, the reality is that there were only about 2,593
sub-brokers registered with SEBI as at the end of June 1997, while the number of stock subbrokers in India was estimated in the range of 50,000 to 200,000. 1
The Indian law defines a sub-broker as any person, not being a member of a stock
exchange, who acts on behalf of a stockbroker as an agent, or otherwise, for assisting the
investors in buying, selling or dealing securities through such stockbrokers. Based on this
definition, the sub-broker is either a stockbrokers agent, or an arranger for the investor. Thus,
legally speaking, the stockbroker as a principal will be responsible to the investor for a subbrokers conduct if a sub-broker acts as his or her agent. However, the market practice is very
different from this legally defined relationship. In reality, the stockbroker in general issues a
contract note of a transaction even to a registered sub-broker, and not just an unregistered subbroker.
The NSE did not officially allow its members to transact with end-investors through
sub-broker. This is probably because the NSE has generous membership criteria; and its

See Endo (1998)

20

computerized trading network can easily provide geographically scattered stockbrokers with a
direct access to the trading on the NSE. Nevertheless, the reality is that many trading members
of the NSE have been using registered and unregistered sub-brokers.
To sort out this confusing situation, SEBI decided to take some measures in March
1997;
(i)

SEBI will initiate criminal actions on complaints received against unregistered subbrokers in suitable cases;

(ii)

The institution of remisier under rules and bye laws of the stock exchanges will
be revived; and

(iii)

No stockbroker shall deal with unregistered sub-brokers or unregistered remisiers

after 1 June 1997 (this deadline was later extended to 1 July 1997).
Despite this SEBIs decision, there has not been much improvement in solving the

confusion with regard to sub-brokers. In technical aspects, the role of the sub-broker should be
redefined; and the relationship between the broker and the sub-broker should be meaningfully
and realistically defined.

(3) Merchant Bankers

There were four categories of registered merchant bankers under the old regulations,
but under the new regulations, there is only one, namely merchant banker. A merchant banker
applicant must satisfy, among other things, the capital adequacy requirement.
The new regulations have drawn a clear-cut line between the merchant banker and the
non-banking finance company(NBFC). Under the old regulations, a merchant banker is allowed
to carry out fund-based activities such as deposit-taking, leasing, bill discounting and hirepurchasing. However, the new regulations on longer allow a merchant banker to engage in these
fund-based activities except for those related exclusively to the capital market such as

21

underwriting. The merchant banker is required to break away such activities in a period of two
years. Correspondingly, an existing NBFC performing merchant banking activities is required to
relinquish such activities after a certain period of time.
The merchant banking industry in India has many problems; (i) there are two many
merchant banks, and (ii) incompetence of many merchant bankers
Only 20 merchant bankers of Category reportedly account for 60-85% of the
merchant banking business, while 148 of them are in business only on paper. In May 1997, a
substantial number of merchant bankers were found to be professionally imprudent or negligent
in their practices (Endo, 1998). SEBI listed 134 merchant bankers of Categories , and
who broke their underwriting commitments for possible disciplinary actions. 95 of Category
merchant bankers were included in the list. More evidence of the problem is the dishonorable
track record of listing delay or rejection of initial public offerings (IPOs).

2. Fragmentation of Regulatory Authorities

The present regulatory framework for the securities markets in India is somewhat
fragmented ( Appendix ). SEBI is the primary body responsible for regulation of the
securities markets. SEBI derives its powers of registration and enforcement primarily from the
SEBI Act. There was an existing regulatory framework for the securities markets, provided by
the SCR Act, administered by the Ministry of Finance, and the Companies Act, administered by
the Department of Company Affairs(DCA) of the Ministry of Law. SEBI has been delegated
most of the functions and powers under the SCR Act, and shares the remaining under the SCR
Act with the Ministry of Finance. SEBI has also been delegated certain powers under the
Companies Act. RBI also has regulatory involvement in the capital market regarding (i) foreign
exchange control; (ii) liquidity support to market participants, and (iii) debt management

22

through primary dealers. It is RBI and not SEBI which regulates primary dealers in the
government securities market. The securities transactions that involve a foreign exchange
transaction needs the permission of RBI.
So far, the fragmentation of the regulatory authorities itself have not been a significant
obstacle to effective regulation of the securities market. Rather, lack of enforcement capacity
by SEBI has been a more significant factor for poor regulation. But, since Indian capital market
is rapidly being integrated, the authorities may consider a consolidation of regulatory authorities
or better coordination among them which also is global trend.

1.

Self Regulatory Body

Self-regulatory organizations (SRO) are a practical and effectual tool for

regulating various kinds of participants in the securities markets, and are commonly used in many
countries. They have by-laws and codes of conduct that bind their members. Through the SEBI
Act 1992, SRO has been conceptually introduced in the Indian capital market. But it has not yet
been established or accepted. A clear regulatory framework has yet to be set up, and relevant
market participants are not necessarily ready to regulate themselves for professional purposes.
Currently, the only securities-related SROs in India whose regulatory framework have been well
established and which have actually been functioning are the recognized stock exchange. So far,
the participants in the Indian capital market seem to have successfully preserved the spirit and
practice of self-regulation or self-governance in the old stock exchanges such as BSE. However,
it is true that the old stock exchanges have been rife with bested interests of member brokers that
are not necessarily friendly to investors.

23

B.

Stock Market

Fragmented Market

Of the 22 stock exchanges in the country, 17 have introduced screen based

trading. With the expansion of trading networks of the Mumbai and other stock exchanges
beyond their original jurisdictions, which has recently been permitted, more and more investors
in different parts of the country are coming within reach of a national market system. This has
increased informational efficiency of the market and facilitated a rapid integration of stock
markets of India.
The NSE, which provides a screen based order driven system, has already
extended its network to over 100 centers in the country, which are connected to its central
computer via its satellite network. The Over the Counter Exchange of India (OTC) also provides
a nationwide electronic system for trading relatively smaller stocks. The BSE has introduced its
own screen based quote driven trading system. However, the market is still fragmented and it
needs further integration.
The international trend is to consolidate and merge the existing stock exchanges
rather than to set up new ones. In the U.K. there were about 20 stock exchanges in the late sixties
which was reduced to about half a dozen in 1972 and further down to one, i.e., London Stock
Exchange in 1986. Since the NSE has already provided connectivity to more than 100 cities and
other major stock exchanges are in the process of extending their trading terminals outside their
places of operation, it is questionable whether India needs as many as 22 stock exchanges even
after discounting factors such as the vast size of the country.

24

Dominated by Speculative Investment

Turnover in the Indian stock exchange is quite high, implying that they are

dominated by speculative investments, which is not unusual in most emerging market. However,
trading volumes in the Indian capital market are fairly large even compared to those in other
emerging markets. While price levels have been depressed, the total turnover on the BSE and
NSE has been increasing. The combined turnover for 1996-97 was almost three times of the level
of 1995-96. Figure 3 below shows the total turnover of stock trading on all 22 stock exchange in
India. The annual growth rate from 1994-95 to 1996-97 was 56% in nominal terms.
<Figure 3> Turnover of Stock Trading in India

8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0

6,825

2,532

1,809

1994- 95

1995- 96

1996- 97

Source : SEBI Annual Reports 1995-96 & 1996-97

Table 6 shows the turnovers in terms of the US dollar and the liquidity ratios on
BSE and NSE as well as stock exchanges in other countries in 1996. The combined turnover on
the BSE and NSE, which are both located in Mumbai exceeded that of some stock markets in
Asian economies. This is because of the remarkably high liquidity ratio on the NSE. Considering
the fact that the majority of about 6,000 stocks listed on the BSE have little liquidity, it can be

25

inferred that a group of the 1,500 most traded stocks on the BSE would also have a considerably
high liquidity ratio (Endo, 1998). The large expansion in turnover may be attributed primarily to
the recent expansion of trading network of NSE. But this also reflects that Indian stock market is
dominated by speculative investments for short-term capital gains, rather than long-term
investment purpose.

<Table 6> Turnovers & Liquidity Ratios of Indian & Foreign Stock Exchanges in 1996
Turnover (in US$ billion) c

Liquidity Ratio d

Bombay Stock Exchange a

26.5

0.22

National Stock Exchange a

69.1

0.65

New York Stock Exchange

3,728.4

0.58

London Stock Exchange

390.1

0.25

885.7

0.28

Stock Exchange of Singapore

51.9

0.27

Hong Kong Stock Exchange

182.6

0.48

Kuala Lumpur Stock Exchange

183.0

0.68

Jakarta Stock Exchange

32.6

0.41

Stock Exchange of Thailand

51.3

0.43

Tokyo Stock Exchange

Source : BSE, NSE & Nikko Research Center

a Stocks listed and permitted to trade
b The first section only. The second section was not included.
c Converted into US$ amounts with the simple averages of the year-end rates in 1995 and
1996;foreign companies and investment funds are excluded.
d Turnover/average market capitalization

Barriers to IPO

In April 1996, SEBI announced a policy initiative which makes access to the
primary market more restrictive. SEBI now requires that a firm that wishes to go public should
have a three-year track record of dividends, or failing that, it should have project appraisal done
by a financial institution, and appraiser must finance the project to the time of at least 5 percent.

26

There has been debate on whether this entry condition is too restrictive or not. But this seems
necessary at this point to help recovery of investment confidence in the corporate firms.
The process of public subscription in Indian market still seems time consuming
and hence fraught with uncertainty. The public subscription process for domestic equity issues
requires compulsory fall back underwriting, the setting up of thirty mandatory collection centers
across the country for collecting subscriptions from investors and price determination at least 45
days prior to the date of issue. Once an issue has been subscribed to, post subscription procedures
are such that 60 days elapse before the security is listed. Investors are forced to remain illiquid in
that period, or must resort to the gray market to meet liquidity needs. The cost of delay is likely to
be incorporated by investors in the price at which they are prepared to subscribe to an issue. This
raises costs to an issuer, besides encouraging clandestine activities such as gray markets.

Transaction Costs in the Secondary Market

Screen based trading introduces a greater degree of transparency and reduces

spreads. Market manipulation becomes more difficult with screen based trading and easier to
investigate on account of the transparent audit trails that are established. According to an estimate
of Shah and Thomas (1997), the total transaction costs in Indias equity market has been reduced
by half, i.e., from 5% to 2.5% after the above changes have been implemented (Table 7). But it is
still higher compared to advanced markets.

<Table 7> Transactions Costs on Indias Equity Market

(%)
India

New York

Component

Mid-1993

Today

Future

Today

Trading:

3.75

0.75

0.40

1.23

27

Brokerage

3.00

0.50

0.25

1.00

Market Impact Cost

0.75

0.25

0.15

0.23

Counter party Risk

Present

In Part

0.00

0.00

Settlement

1.25

1.75

0.10

0.05

Paperwork Cost

0.75

0.75

0.10

0.05

Bad Paper Risk

0.50

1.00

0.00

0.00

Total

5.00

2.50

0.50

1.28

Clearing:

(+ risk)
Source: Ajay Shah and Susan Thomas, Securities Markets Towards Greater Efficiency, India
Development Report, Oxford University Press, 1997

When depository, derivatives and indexation are fully implemented the

transaction cost of Indian equity market could be even lower than those of most advanced
countries.

Clearing, Settlement and Depositories

The stock exchanges that earlier had a 14-day trading cycle have reduced their
account settlement period to 7 days (effectively 5 days because of 2 intervening no-trading days
on Saturday and Sunday). The BSE and NSE both net obligations over a five-day account period
and complete settlement on the 15th day from the commencement of a trading for an account
period. Other stock exchanges are also moving into this cycle. In the case of the NSE, the
National Securities Clearing Corporation Limited, a wholly owned subsidiary of the NSE,
provides a settlement guarantee. In the case of the BSE, the clearing house is operated by Bank
of India Shareholding Limited, jointly owned by the BSE and the Bank of India.
In India, certificates of securities have been registered with the issuer. In the case
of government securities, the record of ownership is kept by the Reserve Bank of India (RBI),
which maintains a Subsidiary General Ledger in its Public Debt Office. Transfer of ownership

28

takes place through book entry transfer in this ledger. In the case of corporate securities, the
issuer maintains a register of members or holders of securities, and the issuer or his register or
transfer agent has to physically receive a security from a transferee accompanied by a transfer
deed signed by the transferor before transfer is affected. There are no bearer securities in India.
The majority of the settlement of transactions in the securities markets continues to be based on
physical movement of certificates. This results in delays, bottlenecks and an increase in
transaction costs besides creating various risks for market participants such as bad delivery, fraud,
theft, etc. Because the clearing and settlement infrastructure in the stock exchanges could not
keep up with the flow of paper, especially as trading expands to different parts of the country, the
exchanges have been unable to shorten settlement cycles or to move to rolling settlement, both of
which are essential for reducing settlement risk.
The enactment of the Depositories Act (1996) allows for dematerialization of
securities in depositories and the transfer of securities through electronic book entry. It is
expected that as the depository network expands and the proportion of securities dematerialized
in depositories increases, these benefits would extend to the vast majority of market participants.
The National Securities Depository Limited (NSDL) has been granted a certificate of
commencement of business by SEBI. As of May 1998, 197 issues (about 50% of total market
capitalization) have signed for depository and about 10% of them have actually come to
dematerialized. This compares to only 3 issues that had signed for depository as of November
1996. If about 300 to 400 issues sign for depository, they will cover about 90% of total trading
volume. As of May 1998, there were 52 depository participants, which includes brokers, banks,
and custodians, which was increased from 22 participants of two years ago. Thus it is expected
that dematerialization of trade will proceed fast although its completion may take substantial
time.

29

C.

Debt Markets

High Statutory Liquidity Requirement

Debt markets have not been well developed in India. Even though the volume of
government bonds outstanding is large, banks and other financial institutions hold a substantial
part of this as liquidity requirement. The statutory liquidity requirement (on top of cash
requirement of 10%) has been reduced recently from 25% to 23%, but this is still very high and
should be further reduced to activate private debt market.

Mark to Market
Banks tend to hold government securities to maturity to avoid a capital loss on

the balance sheet. Till 1996, only 40 percent of the portfolio of government securities had to be
marked to market. This has been raised to 50 percent for existing banks from 1996-97 financial
year, and 100 percent for the new private sector banks.

The pattern of ownership of government securities is shown in Table 8. The

biggest holder of both central and state government securities are commercial banks, holding
more than 2/3 of total government securities. Life insurance companies have also increased the
holdings of government securities. Banks and life insurance companies are the captive market to
the government securities due to the portfolio restrictions imposed on them. Markets for private
companys debentures are not well developed yet.

30

<Table 8> Pattern of ownership of gilt-edged securities

unit : %

1969

1980

1990

1991

1992

1993

1994

1995

1996

37.5

20.3

22.6

24.8

22.3

10.6

3.0

2.5

9.0

20.4

44.9

53.4

55.1

59.9

64.6

71.9

68.0

11.5

11.8

12.9

13.4

16.3

16.9

17.2

17.8

23.3

15.3

1.1

0.8

0.6

0.5

0.6

7.3

7.7

10

6.7

5.2

0.4

3.3

100

100

100

100

100

100

100

100

100

0.3

37.9

56.5

79.5

78.6

79.1

72.7

74.8

73.0

24

19.1

6.9

7.8

11.1

11.8

12.2

3.1

21

2.7

3.4

2.9

2.8

2.8

4.0

34.7

3.4

11.8

15.5

15.5

11.2

12.4

100

100

100

100

100

100

100

100

Central government
Securities
Reserve Bank of India
Commercial banks
LIC
PPF
Others
Total

1.1

State government
Securities
Reserve Bank of India
Commercial banks
LIC
PPF
Others
Total

100

Source: Reserve Bank of India, Bombay, Reports on Currency and Finance, various issues

Primary Dealers

Table 9 shows the market borrowings of the central and state governments.
The total issue of government securities as well as net borrowing of the government have
increased over time.

<Table 9> Market borrowings of the government of India

(Rs billion)
Total issues

Total subs

31

Cash subs

Conv. Subs

Net borrowing

Central government
1970-71
1975-76
1980-81
1985-86
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97

4.00

4.28

2.26

2.02

1.34

6.00

6.61

4.69

1.92

4.53

26.30

28.71

27.34

1.37

26.03

53.25

57.64

55.54

2.10

50.01

89.88

89.89

85.31

4.58

80.01

89.08

89.12

78.40

1.08

75.01

138.85

138.85

137.39

47.91

490.12

490.12

490.12

261.50

381.08

381.08

381.08

200.74

405.09

405.09

405.09

267.91

296.16

296.16

296.16

200.00

1.43

1.64

1.24

0.33

1.00

2.47

2.75

2.75

2.75

3.00

4.00

2.84

0.49

2.01

12.84

14.14

11.89

2.25

9.73

25.65

25.69

25.69

25.69

33.43

33.64

33.64

0.00

33.64

37.99

38.05

37.07

0.98

34.71

41.45

41.45

41.45

36.39

51.23

51.23

51.23

51.23

62.74

62.74

62.74

59.31

65.36

65.36

65.36

65.36

State Government
1970-71
1975-76
1980-81
1985-86
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97

Source : Reserve Bank of India, Bombay, Reports on Currency and Finance, various issues

Primary auction market for government securities have been created and 6
primary dealers have been authorized by RBI. 1 However, the auctions still do not seem to take
place fully on market basis mainly because government securities are not issued in complete
market rates.

They are the Discount and Finance House of India Ltd. (DFHI), the Securities Trading
Corporation of India (STCI), SBI, Gilts Ltd, PNB Gilts Ltd, ICICI Securities and Gilt Securities Trading
Corporation.
32

There seems some other factors that inhibit market clearing mechanism in
primary auction market also. First, there is yet no preannounced notified amount in 364-day and
14-day auctions. This procedure enables the RBI to determine either the cut-off price or the
amounts to be accepted in a flexible manner. Notifying amounts in auctions will bring more
transparency in the auction procedure by removing the uncertainty about volumes in auctions.
Second, currently non-competitive bids are allowed in 91-day and 14-day treasury bills auctions.
Since State Governments are major non-competitive bidders in India their participation in
treasury bills auction make it very uncertain.

Private Placement

Private placements have been on the rising trend in recent years. The amount
of private placement has been of large order during four years starting with 1993-94. It is
estimated that about 40% of total resources mobilized by public and private companies in Indian
capital markets was through private placement in 1995-96, which was increased to 50% in 199697. (Table 10). In terms of available details, the share of public sector in total private placement
was about 70 percent in 1995-96 which moved up to 83 percent in 1996-97. There are several
advantages for tapping the private placement instead of going to public issues. However, certain
vital issues need to be considered for a well-directed and efficient functioning of the market. At
present, there is no transparency in this market and virtually little information. In developed
markets, the regulatory authorities indicate the framework within which the private placement has
to function like arrangement with only qualified investors and regulations to access certain
qualified investors.

33

<Table 10> Private Placement Market

(Rs. in billion)
Year

Private Placement

Total

Percentage of private

Resources

placements

Mobilized
Private Sector

Public Sector

Total

1995-96 P

40.71

92.90

133.61

339.98

39.3

1996-97 P

24.93

125.73

150.66

306.74

49.1

Source : Submaranian (1998)

P: Provisional

Development of Secondary Market

While there has been increased activity in primary debt issues, the secondary
market for debt is yet to become active. The entry of FIIs into the debt market, the launching of
fixed income schemes and money market schemes by the mutual funds is expected to activate the
debt market. A number of technical impediments that prevented more active secondary market
trading in government securities have been removed during the past several years. But still there
are significant barriers to the active development of the secondary markets for fixed income
assets.

D.

Investors
1.

Mutual Funds

34

The performance of mutual funds has not been encouraging during the last
several years. Investor confidence in mutual funds, which ideally should be the most preferred
investment vehicles for the lay investor has been low and the lukewarm response to their schemes
seen in 1995-96, continued in 1996-97 (Table 11). This could be attributed partly to market
conditions that consequently have affected the perception of investors. The notification of revised
SEBI (Mutual Fund) Regulations, 1996, mutual funds have been given greater flexibility to
operate schemes.

It is expected that as a result of this liberalization, mutual funds would

introduce innovative products that would attract investors. The revised regulations also introduce
greater transparency and accountability, which is expected to lead to, increased investor
confidence. Table 12 below gives details of total resources mobilized so far by all domestic
mutual funds.

<Table 11> Resources mobilized by domestic mutual funds (Rs.billion)

1994-95

1995-96

1996-97 till Jan 97

Public Sector Mutual Funds

21.43

2.96

1.51

Private Sector Mutual Funds

20.84

3.12

3.46

Unit Trust of India

95.00

59.00

42.80

Total

137.27

65.08

47.77

Source : Submaranian (1998)

<Table 12> Resources mobilized by domestic mutual funds (Rs.billion)

Period

Resources Mobilized

1964-1987

45.63

1987-1992

329.77

1992-97 (till Jan)

458.45

Total

833.85

Source : submaranian(1998)

35

Foreign Institutional Investors

Currently the total cumulated net FIIs is less than 7% of total market

capitalization of Indian capital market and less than 10% of outstanding external debt of India.
Indias external debt position too showed a considerable improvement in the recent past. The debt
to GDP ratio fell from 41 percent in March 1992 to 25.9 percent in March 1997. And its shortterm debt, although the volatility of FIIs may well affect the performance of stock markets in
India, it would not yet pose significant threat to the foreign exchange crisis. However, increase in
NRI deposits and short-term debt in recent years together with FIIs may pose a potential threat of
currency crisis if India fails to manage macroeconomic environment carefully.

<Table 13> Indias External Debt

(US $ billions)
1985

1990

1991

1992

1994

1995

1996

1997

1. External Assistance

19.31 32.15 34.28

38.10

43.71

48.81

47.29 46.28

2. IMF

3.93

1.50

3.45

5.04

4.30

2.37

3. External Commercial

5.56

13.74 14.78

16.08

17.57

19.62

18.27 18.85

B. NRI Deposits

3.08

10.36 10.58

7.85

12.67

12.38

11.01

11.13

C. Short Term

NA

NA

3.19

3.63

4.27

5.03

6.73

A. Medium and Long term

2.62

1.31

Borrowing
4.80

Source : RBI, Report in Currency and Finance, various issues

36

IV.

POLICY RECOMMENDATIONS

During the last several years, there have been substantial reforms in the Indian
capital markets. As a result, the Indian stock markets have experienced a big structural
transformation. In terms of operational efficiency and transparency of transactions, the Indian
stock exchanges soon will be comparable to the most advanced ones in the world. But, there are
still many issues remain to be addressed to make the Indian capital markets become more
efficient in mobilizing and allocating capital.
Investor's confidence in stock investment is very low currently. Thus, in order to
encourage capital mobilization through primary market issues, recovery of investor's confidence
is essential. For that, further strengthening of the investor protection, improvements in
transparency, corporate governance and monitoring will be necessary. The capital market
infrastructure such as accounting standards and legal mechanisms should also be improved to this
end. In supply side, to encourage corporate firms to rely more on stock markets as their source of
financing, the issuing costs in terms of length of time required and administrative burden should
be streamlined.
To activate debt markets, especially for primary issue market for corporate
debentures and secondary markets, interest rates have to be further deregulated and credibility of
credit rating agencies has to be further enhanced. A suitable solution to stamp duty also has to be
sought. Enhancing the institutionalization of investments, such as investing through mutual funds,
will help to reduce the asymmetric problem in the market.
To improve the corporate governance, it needs to be considered: (i) to give the
institutional investors voting power; (ii) to allow hostile mergers and acquisitions; and (iii) to
adopt consolidated balance sheet requirements for conglomerate affiliated firms.

37

The Policy recommendation can be summarized as is shown in Table 14.

<Table 14 > Matrix of Policy Recommendation

Issues
A. Market Infrastructure
1. Accounting Principles

2. Legal Mechanism

B. Corporate Governance

C. Cost of Capital Issue

D. Debt markets
1. Diversification of Investors

2. Stamp Duty

3. Private Placement

E. Integration of Stock Exchange and Consolidation of

Intermediaries

F. Risk Management

G.Integration of Capital markets with Banking Sector

Policy Recommendation
Improvements in accounting principles making them consistent with
international practice
Stricter enforcement of punitive measures for inaccurate accounting
practice
Establishment of prompt and effective settlements of dispute to protect
small investors interests
Granting institutional investors voting power
Allowing hostile take-over
Requiring consolidated balance sheet for conglomerates affiliated
firms to better monitor cross subsidization and internal
transaction between affiliated firms
Streamline the procedure for public scription of securities to reduce
transaction costs in terms of time lag and uncertainty
Complete market-based interest rates for the issuing of government
securities
Further reduction of statutory liquidity requirements
Further enhancement of the credibility of credit rating agencies
At least a suitable amendment to stamp duty regime by the
Government of Maharashtra, where Mumbai is located, in the
form of one time levy or consolidated fee payable by NSDL
could resolve the issue to a significant degree
The regulatory authorities may indicate the framework within which
the private placement has to function to protect investors
from risk associated with subscriptions in the private
placement market
Provide favorable environment, or some incentives to settling up of a
central trading system through inter-connectivity
Encourage the corporatization and merger of brokers and merchant
bankers through tax incentives
SEBI should more closely monitor and inspect the intermediaries and
stock exchange and, if necessary, punitive measures should be
strengthened.
Banking system needs to establish good EFT solution to enable direct
payments of dividend to bank account eliminate counter party
risk and facilitating FIIs
Encouraging sound competitions between banking sector and capital
markets by further liberalization in banking sector

A.

Improvements in the Market Infrastructure

38

Accounting Principles

Currently, the financial statements of an issuing company in its disclosure

documents are prepared in accordance with Indias generally accepted accounting principles
(GAAP). The increasing exposure of Indian listed firms to international investment communities
has compelled them to adopt more internationally acceptable accounting principles. Institutes of
Chartered Accountants of India issued a note to introduce new accounting standards starting in
the fiscal year 1995-96. Yet, Indian GAAP is considerably different from that of internationally
accepted principles.1 In order to increase the credibility of corporate financial statement and
transparency, further improvements in accounting principles making them consistent with
international practice will be necessary. In relation with this, the credibility of accounting
professions should also be enhanced with stricter enforcement of punitive measures for inaccurate
accounting practice.

Legal Mechanism

The problems of court system and legal mechanism to settle disputes in India
have been frequently raised. After floating shares in the market, it is important for investors to be
able to monitor the corporate performance closely and to protect their interests. For this, prompt
and effective settlements of disputes are also critical. According to a recent survey by Gupta
(1998), 65% of those who brought their complaints to the court answered that the cases have not
been resolved. Even though the minority shareholders can now bring their complaints to the
court, they cannot take advantage of the system since the legal mechanism is so slow. Thus
measures need to be taken to expedite the court decisions to protect small investors interests.
1

See Endo (1998) for comparison of Indian GAAP and that of US and UK.
39

B.

Improvement of Corporate Governance Environment

In conjunction with enhancing market infrastructure, such as accounting

principles and legal mechanism, additional measures may be necessary to improve the corporate
governance. The authorities may consider giving institutional investors voting power which is
prohibited now. Another measure that needs to be considered is allowing the hostile take-over
which is not in fact possible in India. Furthermore, authorities may enforce the consolidated
accounting principle for conglomerates affiliated firms in order to better monitor cross
subsidization and internal transactions between affiliated firms. These measures will greatly
improve the capital market environments for corporate governance.

C.

Reduction of Cost of Capital Issue

Currently the transaction costs involved in public issue of securities seem very
high due to the length of time required for it. The time consuming process of public issue also
increases the uncertainty to the issuers and tend to push them to private placement as was
mentioned above. Thus, it will be necessary to streamline the procedure for the public scription of
securities so that it reduces the administrative burdens and transaction costs in term of time and
uncertainty to the firms.

D.

Activation of Debt Markets

Several policy measures have been taken to activate the debt markets, including
competitive pricing of government securities, initiation of open market operation including repo

40

operation, larger percentage of mark to market valuation, etc. These policy measures have had
some beneficial impacts on the system such as greater market absorption of government
securities with lower absorption by RBI and increased attention by investors to interest rate risk
management. For instance, RBIs absorption of primary issues was 13.3% and 16.6 percent in
1996-97 and 1997-981 respectively, as against 32.6% in 1995-96 and 45.6% in 1992-93.
However, further measures will have to be implemented to encourage the development of debt
markets, including reduction of statutory liquidity requirement ratio and 100% mark to market
valuation for all banks.

Diversification of investor base

In order to increase the liquidity in government securities, the diversification of

investor base to the non-traditional investor groups like individuals, firms, trusts and corporate
entities will be necessary. The diversification is also important for the reason that only under such
circumstances can there be an active market with investors need to buy and sell not being in the
same direction at various points in time. Currently, the government securities are predominantly
held by banks, financial institutions and provident funds. In order to encourage diversification of
investors: It may be encouraged for the mutual funds to establish gilt-funds to invest in the
government securities through some tax incentives, and for primary dealers to diversify the
investor base. A complete market-based interest rates for the issuing of government securities are
also necessary. The credibility of credit rating companies should be further established. The
addition, the statutory liquidity requirement which currently is 23% should be further reduced.

Up to August 1997

41

Stamp duty

With the establishment of NSDL, it was expected that a sizable stock of private
debt instruments and Public Sector Units bonds would be dematerialized and covered by a
secured payments and settlements system. At present, NSDL is able to dematerialize only those
scrips which are exempted from stamp duty and those which are transferable by endorsement and
delivery. As most bonds and other corporate debt instruments are not exempted from stamp duty
on transfer of bonds, NSDL has expressed difficulties in dematerializing them. In the automated
environment of the depository, it is not possible for them to keep a track of them. Therefore,
unless the issue of the waiver of stamps duty on transfer of debt is settled with the state
governments, NSDL would not be able to extend its services to bonds and other private debt
instruments. At least a suitable amendment to stamp duty regime by the Government of
Maharashtra, where Mumbai is located, in the form of one time levy or consolidated fee payable
by NSDL could resolve the issue to a significant degree.

Private placements
As was mentioned above, the proportion of total resources mobilized by the

government and non-government companies through private placements has been increasing. In
private placements, bonds have emerged as the most preferred instrument. The popularity of
private placement method could be attributed to lower issuing cost and saving on issue
management time lag, apart from the fact that private placement has not been coming under the
strict regulatory provisions applicable to public issues. At present, there is no transparency in this
market and virtually little information. In developed markets, the regulatory authorities indicate
the framework within which the private placement has to function, like number of persons per

42

placement, arrangements with only qualified investors and strict regulations to access certain
qualified investors. The adequacy of extending regulatory framework to protect the interest of
investors from risks associated with subscriptions in the private placement market needs to be
addressed. With a proper regulatory framework and more transparency, the private placement
market can develop further as an integral and important constituent of the primary market for
raising of resources by the corporate.
Furthermore, extending favorable tax treatment to institutional investors may be
considered to encourage individual investments in private market through professional fund
managers, which can reduce asymmetric information and thereby provide better investor
protections.

Secondary Debt Market Development

In order to activate the secondary markets of debt instruments, the following

measures need to be taken.

Further deregulation of domestic interest rates, the greater reliance on borrowing
at market rates by the government and other quasi state issuers, the greater use of open market
operations as a tool for monetary policy, and improved procedures for the trading, clearing and
settlement will facilitate the secondary market development, Investor groups should be further
diversified in order to provide better liquidity statutory liquidity requirement should be reduced,
A suitable solution to stamp duty in relation with dematerialization of non-government securities
is also necessary. In the case of government securities, RBI provides depository and the coverage
of book-entry holding is enlarging. In respect of PSU bonds and corporate debentures, which are
held mostly in scrip form, a proper settlement system is yet to be put in place. NSDL is expected
to dematerialize a sizable stock of non-government debt. But at present, NSDL has been able to

43

dematerialize only those securities which are exempt from stamp duty. Therefore suitable
amendments to stamp duty regime is necessary to reduce transaction costs in the secondary
markets for private securities. This will also encourage the development of repos market in nongovernment securities.

E.

Integration of Stock Exchanges and Consolidation of Intermediaries

One recent movement in India is that of forming the Federation of Indian Stock
Exchanges (FISE) by 12 regional stock exchanges and setting up of a central trading system
through inter-connectivity by forming Indian Stock Exchanges Services Corporation (ISESC). If
this become successful, there will be three entities with a national stature, i.e., NSE, BSE, and
ISESC. The government may provide favorable environment, and if necessary some incentives,
to facilitate such a movement.

Another related aspect is consolidation of intermediaries. There has been a

mushrooming of the number of intermediaries in Indian capital market during the last ten years.
As a result, the per member turnover is quite low and transaction cost is high in most stock
exchanges. Corporatization of broking business, entry of foreign brokers, drying up of retail
investments and increasing overheads have created survival problems, particularly for the
individual and small brokers. The one time exemption on capital gains tax provided in the Union
Budget 1997-98 would be of help to the brokers for corporatizing their business. Similarly the
number of merchant banks over one thousand seems to be very large given the size of Indian
capital market. The government may give some favorable tax treatment for those brokers and
merchant bankers for merger and take-over.

44

F.

Risk Management

The rules that have been introduced during the last several years to contain the
risk of the market seem to have operated reasonably well. The strict enforcement of these rules is
perhaps at least as important as the rules as such to effectively manage the risk of the market. In
that regards, SEBI should more closely inspect the intermediaries and stock exchange, and if
necessary, the punitive measures should be strengthened.

G.

Integration of Capital Markets with Banking Sector

Capital markets cannot thrive alone and they have to get integrated with other
segments of the financial system. Effective and efficient capital market requires a stable and
strong infrastructure of payments, settlement and clearing system. In this connection, Indias
banking system yet has to come up with good electronic funds transfer solutions. EFT is
important for problems like direct payments of dividend to bank account, eliminating counter
party risk and facilitating FIIs.
It is a global trend that borderlines between different market segments are
becoming blurred in recent years. The traditional wall between banks and securities market is
getting eliminated, with banks being allowed greater flexibility so far as their investment
activities are concerned. Banks are increasingly providing long-term loans and entering capital
market to raise resources though equity capital and subordinated debts. This is also happening in
India and expected to increase the competitiveness of capital markets. But, in India, this should
be pursued in conjunction with a further efforts in liberalization of the banking system and in
enhancing their asset quality in order to encourage sound competitions between banking sector
and capital markets.

45

Appendix : REFORMS IN INDIAN SECURITIES MARKETS SINCE 1992

The development in Indian securities markets since 1992 can be summarized as follows:
Capital Issues (Control) Act, 1947 repealed and the office of Controller of Capital Issues
abolished; control over price and premium of shares removed. Companies are now free to
raise funds from securities markets after filing prospectus with SEBI.
The power to regulate stock exchanges was delegated to SEBI by the government.
SEBI introduces regulations for primary and other secondary market intermediaries, bringing
them within the regulatory framework.

New reforms by SEBI in the primary market include improved disclosure standards,
introduction of prudential norms and simplification of issue procedures.

Companies

required disclosing all material facts and specific risk factors associated with their projects
while making public issues.
Listing agreements of stock exchanges amended to require listed companies to furnish annual
statement to the stock exchanges showing variations between financial projections and
projected utilization of funds in the offer document and actual. This will enable shareholders
to make comparisons between performance and promises.
SEBI introduces a code of advertisement for public issues for ensuring fair and truthful
disclosures.
Disclosure norms further strengthened by introducing cash flow statements.
New issue procedures introduced book building for institutional investors aimed at
reducing costs of issue
SEBI introduces regulations governing substantial acquisition of shares and takeovers and
lays down the conditions under which disclosures and mandatory public offers are to be
made to the shareholders. Regulations further revised and strengthened in 1996

 SEBI reconstitutes the governing boards of the stock exchanges, introduces capital adequacy
norms for broker accounts
Private mutual funds permitted and several such funds have already been set up. All mutual
funds allowed applying for firm allotment in public issues also aimed at reducing issue
costs
Regulations for mutual funds revised in 1996, giving more flexibility to fund managers while
increasing transparency, disclosure and accountability.
Over the Counter Exchange of India (OTCEI) set up

National Stock Exchange of India (NSE) set up as a stock exchange with nationwide
electronic trading

The Stock Exchange, Mumbai (BSE) introduces screen based trading; 15 stock exchanges
now have screened based trading. BSE granted permission to expand its trading network to
other centers
Capital adequacy requirement for brokers enforced
System of marka to market margins introduced on the stock exchanges
Stock lending scheme introduced
Transparency brought out in short selling
National Securities Clearing Corporation Limited set up by the NSE
BSE in the process of implementing a trade guarantee scheme
SEBI strengthens surveillance mechanisms in SEBI and directs all stock exchanges to have
separate surveillance departments

SEBI strengthens enforcement of its regulations.

Begins the process of prosecuting

companies for mis-statements, issues show cause notices to merchant bankers, ensures
refunds of application money in several issues on account of mis-statements in the
prospectus

ii

 Indian companies permitted to access international capital markets through Euro issues
Foreign Direct Investment allowed in stock broking, asset management companies, merchant
banking and other non-bank finance companies.

Foreign Institutional Investors (FIIs) allowed accessing to Indian capital markets on

registration with SEBI.

FIIs have also been Permitted to invest in unlisted securities and corporate and government
debt.
The Depositories Act enacted to facilitate the electronic book entry transfer of securities
through depositories. The National Securities Depository Limited set up.
Guidelines for Offshore Venture Capital Funds announced. SEBI regulations for venture
capital funds become effective.

iii

Appendix: Indian Securities Market before 1992

While the issue of capital used to be regulated by the office of Controller of Capital
Issues, companies, both private and public were governed by the Companies Act, 1956 which
was and continues to be administered by the Department of Company Affairs under the Ministry
of Law, Justice and Company Affairs in the central government.

Besides, governing the

incorporation and management of companies, the Companies Act also specifies certain aspects
concerning the issue of capital and trading in securities. In particular, issue of prospectus for
public offers, contents of prospectus, completion of allotment, issue and trading of securities,
transfer and registration of securities are also governed by this Act. The Act governs the merger
and amalgamation of companies and their winding up.

There are various provisions for

penalties and for violations under the Act.

Indian securities markets before 1990-91 can be characterized as follows:
Fragmented regulation; multiplicity of administration.
Primary markets were not into the mainstream of financial system.
Poor disclosure in prospectus. Prospectus, balance sheet not made available to investors.
Investors faced problems of refund delays, transfer delays, etc.
Stock exchanges regulated through Securities Contracts (Regulations) Act. No inspection of
the stock exchanges undertaken.
Stock Exchanges run as brokers clubs; management dominated by brokers.
Merchant bankers and other intermediaries unregulated.
No concept of capital adequacy
Mutual funds-virtually unregulated with potential for conflicts of interest in structure.
Poor disclosures by mutual funds, NAV not published; no valuation norms.
Private sector mutual funds not permitted.

 Takeovers regulated only through Listing Agreement between the stock exchange and the
company.
No prohibition of insider trading and fraudulent and unfair trade practices.

ii

Appendix : Regulatory Framework

(1) SEBI

SEBI had been set up as an administrative arrangement in 1988. In 1992, the

SEBI Act was enacted, which gave statutory status to SEBI. The SEBI Act mandates SEBI to
perform a dual function that of investor protection through regulation of securities markets and of
fostering the development of securities markets. SEBI has been delegated most of the functions
and powers under the Securities Contract Regulation(SCR) Act which brought stock exchanges,
their members, as well as contracts in securities which could be traded under the regulation of the
Ministry of Finance (see Appendix II for the present regulatory structure for securities market of
India). SEBI has also been delegated certain powers under the Companies Act. In addition to
registering and regulating intermediaries, service providers, mutual funds, collective investment
schemes, venture capital funds, takeover, SEBI is also vested with power to issue directions to
any person or persons related to securities markets or to companies in the matter of issue of
capital, transfer of securities and disclosures. SEBI also has powers to inspect books and records,
to suspend registered entities and to cancel registration.

(2) Reserve Bank of India (RBI)

RBI has also regulatory involvement in the capital market, but it has so far been
limited and is primarily three fold: (i) debt management through primary dealers; (ii) foreign
exchange control; and (iii) liquidity support to market participants. It is the RBI and not SEBI
which regulates primary dealers in the government securities market. RBI instituted the primary
dealership of government securities in March 1998. The securities transactions that involve a
foreign exchange transaction needs the permission of RBI.

(3) Department of Company Affairs (DCA)

In 1956, the SCR Act was enacted which brought stock exchanges, their
members, as well as contracts in securities which could be traded under the regulation of the
central government, through the Ministry of Finance. In 1947, the Capital Issues (Control) Act
was enacted, which formalized and continued initial controls on the issue of securities that were
introduced during the Second World War. This Act was administered by the office of the
Controller of Capital Issues (CCI) which was a part of the Ministry of Finance. This act was
repealed in 1992 as a part of the economic reforms to give freedom to issues and to make price of
issues freely. While the issue of capital used to be regulated by the office of CCI, both private and
public were governed by the Companies Act (1956) which was and continues to be administered
by the Department of Company Affairs (DCA) under the Ministry of Law, Justice and Company
Affairs. Besides governing the incorporation and management of companies, the Companies Act
also specifies certain aspects concerning the issue of capital and trading in securities. In
particular, issue of prospectus for public offers, contents of prospectus, completion of allotment,
issue and trading of securities, transfer and registration of securities are also governed by this Act

(4) Stock Exchanges

SEBI issued directives which require that half the members of the governing
boards of the stock exchanges to be non-broker public representatives and include a SEBI
nominee. To avoid conflicts of interest, stock brokers are a minority on committees of stock
exchanges set up to handle matters of discipline, default and investor-broker disputes. The
exchanges are required to appoint a professional, non-member executive director who is

ii

accountable to SEBI for implementation of the directions of SEBI on the regulation of the stock
exchanges. SEBI has introduced a mechanism within SEBI for redress of investor grievances
against brokers.

(5) Disclosure

As is the case with companies in capital markets of the other countries, a

company offering securities in the Indian capital markets is required to make a public disclosure
of all relevant information through its offer documents. The offer documents for an issue of
securities in India are:

(i)

the prospectus, and

(ii)

the application form and the abridged prospectus in case of an issue to the
public, or

(iii)

the letter of offer in the case of a rights issue to existing shareholders or

debenture holders of a company with or without the right to renounce in favor
of other persons.

After a security issued to the public and subsequently listed on a stock exchange,
the stock exchange requires the issuing company to make continuing disclosures under the listing
agreement. The issuing company is required to continue to disclose in a timely manner to the
exchange, to the holders of the listed securities (the shareholders or the bondholders), and to the
public through the exchange or the media, any information necessary to enable the holders of the
listed securities to appraise its position and to avoid the establishment of a false market in such
listed securities. Such information includes:

iii

(i)

the date of the meeting of the board of directors for corporate actions;

(ii)

the audited financial results on an annual basis and the unaudited ones on a
semi-annual basis;

(iii)

any proposed change in the general character or nature of the companys

business;

(iv)

any alterations of the companys capital;

(v)

any change of the companys directorate including managing directors and

auditors, etc.

iv

Regulatory Framework of India Securities Markets

PARLIAMENT

MINISTRY OF FINANCE

MINISTRY OF LAW

SEBI

DCA

Powers under SEBI Act to

Powers under Companies Act to

Regulate Business in the Stock Exchanges

Specify form and content of prospectus

Regulate Market Intermediaries

Grant incorporation of companies

Regulate Depositories, Custodians and Credit

Specify requirements of financial statements to

Rating

be filed with

Agencies

the Registrar of Companies

Regulate Mutual Funds, Collective Investment

Regulate companies on corporate governance

Schemes,

issues such

Flls and Venture Capital Funds

as conduct of shareholder meetings, proxies,

Regulate Substantial Acquisitions of Shares and

Takeovers

accountants and

Regulate disclosure in the prospectus

chartered

company secretaries

Prohibit Fraudulent and Unfair Trade Practices

Inspect companies affairs

Prohibit Insider Trading

Prohibit Insider Trading
Regulate the Issue of Capital
Powers under SCR Act to

Grant and renew recognition of stock exchanges

Consider appeals against listing refusals

Supervise

Issue directives to stock exchanges and to

oversee their bylaws, listing agreements and administration

Powers under Companies Act to

Act against issuers for violations related to issue

of capital

Act against issuers for delays in registration,

dividend
payment

Act against fraudulent inducement to invest in

securities

vi

accountants,

cost

Reference
Endo, Tadashi., The Inidan Securities Market A Guide for Foreign & Domestic Investors,
Vision books, 1998.
Misra, B. M. Fifty Years of the Indian Capital Market: 1947-97, Banking & Financial
Sector Reforms in India, Vol. 6
Rangarajan, C. Activating Debt Markets in India, Banking & Financial Sector
Reforms in India, Vol. 6
Reddy, Y. V. The Future of Indias Debt Market, RBI Bulletin, November 1997
Reserve Bank of India, Bombay, Reports on Currency and Finance, various issues
SEBI Annual Report 1995-96
Shah, Ajay and Thomas, Susan, Securities Markets-Towards Greater Efficiency,
India Development Report , Oxford University Press,1997
Tarapore, S. S. The Government Securities Market: The Next Stage of Reform, Banking &
Financial Sector Reforms in India, Vol. 4.
World Equity Guide, Euromoney Publications, 1996