The Hindu Business Line : Capital market plays a catalytic role

India’s growth story has important implications for the capital market, which has grown sharply with respect to several parameters — amounts raised, number of stock exchanges and other intermediaries, listed stocks, market capitalisation, trading volumes and turnover, market instruments, investor population, issuer and intermediary profiles.

The capital market consists primarily of the debt and equity markets. Historically, it contributed significantly to mobilising funds to meet public and private companies’ financing requirements. The introduction of exchange-traded derivative instruments such as options and futures has enabled investors to better hedge their positions and reduce risks.

India’s debt and equity markets rose from 75 per cent in 1995 to 130 per cent of GDP in 2005. But the growth relative to the US, Malaysia and South Korea remains low and largely skewed, indicating immense latent potential. India’s debt markets comprise government bonds and the corporate bond market (comprising PSUs, corporates, financial institutions and banks).

India compares well with other emerging economies in terms of sophisticated market design of equity spot and derivatives market, widespread retail participation and resilient liquidity.

SEBI’s measures such as submission of quarterly compliance reports, and company valuation on the lines of the Sarbanes-Oxley Act have enhanced corporate governance. But enforcement continues to be a problem because of limited trained staff and companies not being subjected to substantial fines or legal sanctions.

Given the booming economy, large skilled labour force, reliable business community, continued reforms and greater global integration vindicated by the investment-grade ratings of Moody’s and Fitch, the net cumulative portfolio flows from 2003-06 (bonds and equities) amounted to $35 billion.

The number of foreign institutional investors registered with SEBI rose from none in 1992-93 to 528 in 2000-01, to about 1,000 in 2006-07.

India’s stock market rose five-fold since mid-2003 and outperformed world indices with returns far outstripping other emerging markets, such as Mexico (52 per cent), Brazil (43 per cent) or GCC economies such as Kuwait (26 per cent) in FY-06.

In 2006, Indian companies raised more than $6 billion on the BSE, NSE and other regional stock exchanges. Buoyed by internal economic factors and foreign capital flows, Indian markets are globally competitive, even in terms of pricing, efficiency and liquidity.

Problems remain

Mutually-reinforcing processes of India’s flourishing stock markets, fast-growing mutual funds and banks have strengthened the financial sector. But India’s capital markets continue to be shallow. Despite inflation, only 2 per cent of Indian household savings are invested in the capital market as against 20 per cent in developed economies and around 51 per cent in the US.

India’s government bond segment (nearly 40 per cent of GDP) is comparable to many emerging economies. But corporate bonds constitute only 1 per cent stock of financial assets (debt+equity+deposits).

This compares unfavourably with the Philippines (9 per cent), Thailand (10 per cent), Korea (29 per cent) and the US (36 per cent), necessitating the implementation of the R.H. Patil Committee recommendations.

Market Capitalisation

Market capitalisation, which indicates size of the capital market, investor confidence and discounted future earnings of the corporate sector, crossed $1 trillion (BSE stocks, March 28, 2007). Globally, the capital market is the 14th largest in terms of capitalisation. Market capitalisation ratio is expected to rise from less than 30 per cent to over 60 per cent, as in most other emerging markets.

There are diverse players in the Indian market — retail investors, mutual funds and FIIs, including several sub-categories — pension funds, hedge funds and investment companies.

Protecting the interests of investors is difficult because those of the retail Indian investors, mutual funds and foreign investors in the market might not always converge.

Streamlining the market

The capital market has played a catalytic role in the 9 per cent growth rate the country has achieved. Unlike other markets preoccupied with increasing the number of listed companies, India needs to drastically prune the number of listed companies to ensure that only companies with traded stocks, reasonable volumes and better price discovery remain, while providing other platforms for smaller companies. Foreign listings on the NSE and the BSE must also be allowed.

SEBI’s efforts at creating heightened awareness of full disclosure and transparency have succeeded only partially.

This necessitates shifting to National Listing Authority, empowering investors on the lines of US class action, using information technology and public disclosure aggressively to improve surveillance, adopting a more aggressive pro-competitive policy, introducing effective and competitive securities lending system and broad-basing derivative markets.

Fundamental institutional changes have drastically reduced transaction costs and significantly improved efficiency, transparency and safety. Policies and procedures relating to fair, efficient and transparent markets, investor education, investor protection, reduction of systemic risk and exposure norms, cumulative margins and rising corporatisation of brokers have also helped.

However, inadequate development of the debt market hampers accurate pricing of current and future assets, and PFs/pensions are not allowed to invest in equities.

SEBI’s bill clarified the role of the ‘Department of Company Affairs’ and acquired the power to debar directors and trace and attach assets of those companies. SEBI’s guidelines (effective March 2000) started Internet-broking on Indian securities to enhance transparency and reduce infirmities in Indian capital market transactions.

The creation of Investor Protection Fund (October 2001) under Section 205C of the Companies Act ensures the recovery of investments if and when companies default.

The functioning of the stock market in India continues to be fraught with the danger of frauds and scandals triggered by rigging, cornering of shares and manipulation. Hence, the market must be insulated from “crises”. Since such crises cause systemic damage, prevention and detection of frauds must rely heavily on market discipline, swift prosecution and effective punishment.

Road map

With sustained growth, rising exports, increasing corporate earnings, rising investment rates and moderate inflation, the capital market is poised for growth.

Growth requires wide distribution of ownership of equity, both by direct participation in capital market, and indirectly, through financial institutions, such as mutual funds, pension funds and insurance companies to enhance long-term savings and facilitate long-term financing.

This necessitates an efficient and transparent price discovery process with high disclosure and regulatory standards with sound liquidity and risk management.

Establishment of a single clearing corporation for money, debt and foreign exchange and provision of demutualisation will widen and deepen capital markets. A robust insurance sector with higher capital base and more diverse products would generate long-term funds for investment in debt market and release resources for investment, particularly for infrastructure.

Globally, markets are governed by competition, convergence and coordination. But fragmentation exists in India. The convergence with international best practices regarding clearing and settlement, payment systems and funds transfer, governance, disclosure and transparency require removal of insider trading, information asymmetry, and inadequate and delayed information.

Given the extremely uneven application of standards across markets, uniformity and consistency in various markets are needed to facilitate greater integration across the markets.

In the ultimate analysis, a vibrant, well-developed capital market is a function of economic growth and a reflection of the financial system. Growth and sustainability of the market require careful management of volatility risk and risk of contagion to check sudden withdrawal of highly speculative, short-term capital. There are also important issues of adroit management of liquidity risk, clearance and settlement risk, currency risk and disclosure and legal infrastructure.

Leveraging India’s capital market requires improved corporate governance, reduced market concentration, availability of the market capitalisation for trading and enhanced role of mutual funds.

Protection of retail investors, a modernised capital market with transparent operations, a developed corporate debt market, regulatory support and development of Mumbai as an international financial hub would help deepen the stock market and make them efficient and stable.

(The author is chief economist, Canara Bank, Bangalore and can be reached at sharma-m@canbank.co.in)

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