Indian Capital Market

Indian Capital MarketRecent Developments and Policy Issues

Yoon Je Cho

Yoon Je Cho is Professor, Graduate School of International Studies,Sogang University, Seoul, Korea.

112 A STUDY OF FINANCIAL MARKETS

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IntroductionThere are 22 stock exchanges in India, the first be-ing the Bombay Stock Exchange (BSE), which be-gan formal trading in 1875, making it one of the old-est in Asia. Over the last few years, there has beena rapid change in the Indian securities market, espe-cially in the secondary market. Advanced technol-ogy and online-based transactions have modernizedthe stock exchanges. In terms of the number of com-panies listed and total market capitalization, the In-dian equity market is considered large relative to thecountry’s stage of economic development. The num-ber of listed companies increased from 5,968 in March1990 to about 10,000 by May 1998 and market capi-talization has grown almost 11 times during the sameperiod.

The debt market, however, is almost nonexistentin India even though there has been a large volumeof Government bonds traded. Banks and financialinstitutions have been holding a substantial part ofthese bonds as statutory liquidity requirement. Theportfolio restrictions on financial institutions’ statu-tory liquidity requirement are still in place. A primaryauction market for Government securities has beencreated and a primary dealer system was introducedin 1995. There are six authorized primary dealers.Currently, there are 31 mutual funds, out of which 21are in the private sector. Mutual funds were openedto the private sector in 1992. Earlier, in 1987, bankswere allowed to enter this business, breaking themonopoly of the Unit Trust of India (UTI), whichmaintains a dominant position.

Before 1992, many factors obstructed the expan-sion of equity trading. Fresh capital issues were con-trolled through the Capital Issues Control Act. Trad-ing practices were not transparent, and there was alarge amount of insider trading. Recognizing the im-portance of increasing investor protection, severalmeasures were enacted to improve the fairness ofthe capital market. The Securities and ExchangeBoard of India (SEBI) was established in 1988. De-

spite the rules it set, problems continued to exist, in-cluding those relating to disclosure criteria, lack ofbroker capital adequacy, and poor regulation of mer-chant bankers and underwriters.

There have been significant reforms in the regula-tion of the securities market since 1992 in conjunctionwith overall economic and financial reforms. In 1992,the SEBI Act was enacted giving SEBI statutory sta-tus as an apex regulatory body. And a series of re-forms was introduced to improve investor protection,automation of stock trading, integration of nationalmarkets, and efficiency of market operations.

India has seen a tremendous change in the sec-ondary market for equity. Its equity market will mostlikely be comparable with the world’s most advancedsecondary markets within a year or two. The keyingredients that underlie market quality in India’sequity market are:

• exchanges based on open electronic limit orderbook;

• nationwide integrated market with a large num-ber of informed traders and fluency of short orlong positions; and

• no counterparty risk.Among the processes that have already started

and are soon to be fully implemented are electronicsettlement trade and exchange-traded derivatives.Before 1995, markets in India used open outcry, atrading process in which traders shouted and hand-signaled from within a pit. One major policy initiatedby SEBI from 1993 involved the shift of all exchangesto screen-based trading, motivated primarily by theneed for greater transparency. The first exchange tobe based on an open electronic limit order book wasthe National Stock Exchange (NSE), which startedtrading debt instruments in June 1994 and equity inNovember 1994. In March 1995, BSE shifted fromopen outcry to a limit order book market. Currently,17 of India’s stock exchanges have adopted openelectronic limit order.

Before 1994, India’s stock markets were domi-nated by BSE. In other parts of the country, the fi-

113INDIAN CAPITAL MARKET: RECENT DEVELOPMENTS AND POLICY ISSUES

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nancial industry did not have equal access to mar-kets and was unable to participate in forming prices,compared with market participants in Mumbai(Bombay). As a result, the prices in markets outsideMumbai were often different from prices in Mumbai.These pricing errors limited order flow to these mar-kets. Explicit nationwide connectivity and implicitmovement toward one national market has changedthis situation (Shah and Thomas, 1997). NSE hasestablished satellite communications which give alltrading members of NSE equal access to the mar-ket. Similarly, BSE and the Delhi Stock Exchangeare both expanding the number of trading terminalslocated all over the country. The arbitrages are elimi-nating pricing discrepancies between markets.

Despite these big improvements in microstructure,the Indian capital market has been in decline duringthe last three years. The amount of capital issuedhas dropped from the level of its peak year,1994/95,and so have equity prices. In 1994/95, Rs276 billionwas raised in the primary equity market. This figurefell to Rs208 billion in 1995/96 and to Rs142 billion in1996/97. The BSE-30 index or Sensex, the sensitiveindex of equity prices, peaked at 4,361 in September1994 and fell during the following years. A leadingcause was that financial irregularities and over-valuations of equity prices in the earlier years haderoded public confidence in corporate shares. Also,there was a reduced inflow of foreign investmentafter the Mexican and Asian financial crises. In asense, the market is now undergoing a period of ad-justment. Thus, it is time for regulatory authorities tomake greater efforts to recover investors’ confidenceand to further improve the efficiency and transpar-ency of market operations.

The Indian capital market still faces many chal-lenges if it is to promote more efficient allocationand mobilization of capital in the economy. First,market infrastructure has to be improved as it hin-ders the efficient flow of information and effectivecorporate governance. Accounting standards willhave to adapt to internationally accepted accounting

practices. The court system and legal mechanismshould be enhanced to better protect small share-holders’ rights and their capacity to monitor corpo-rate activities. Second, the trading system has to bemade more transparent. Market information is a cru-cial public good that should be disclosed or madeavailable to all participants to achieve market effi-ciency. SEBI should also monitor more closely casesof insider trading. Third, India may need further inte-gration of the national capital market through consoli-dation of stock exchanges. The trend all over the worldis to consolidate and merge existing stock exchanges.Not all of India’s 22 stock exchanges may be able tojustify their existence. There is a pressing need to de-velop a uniform settlement cycle and common clear-ing system that will bring an end to unnecessary specu-lation based on arbitrage opportunities. Fourth, thepayment system has to be improved to better link thebanking and securities industries. India’s banking sys-tem has yet to come up with good electronic fundstransfer (EFT) solutions. EFT is important for prob-lems such as direct payments of dividends throughbank accounts, eliminating counterparty risk, and fa-cilitating foreign institutional investment. The capitalmarket cannot thrive alone; it has to be integrated withthe other segments of the financial system. The globaltrend is for the elimination of the traditional wall be-tween banks and the securities market.

Securities market development has to be supportedby overall macroeconomic and financial sector envi-ronments. Further liberalization of interest rates, re-duced fiscal deficits, fully market-based issuance ofGovernment securities, and a more competitive bank-ing sector will help in the development of a sounderand a more efficient capital market in India.

Capital Market Reformsand DevelopmentsReforms in the Capital MarketOver the last few years, SEBI has announced sev-eral far-reaching reforms to promote the capital


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market and protect investor interests. Reforms in thesecondary market have focused on three main ar-eas: structure and functioning of stock exchanges,automation of trading and post trade systems, andthe introduction of surveillance and monitoring sys-tems. (See Appendix 1 for a listing of reforms since1992). Computerized online trading of securities, andsetting up of clearing houses or settlement guaran-tee funds were made compulsory for stock ex-changes. Stock exchanges were permitted to expandtheir trading to locations outside their jurisdictionthrough computer terminals. Thus, major stock ex-changes in India have started locating computer ter-minals in far-flung areas, while smaller regional ex-changes are planning to consolidate by using cen-tralized trading under a federated structure. Onlinetrading systems have been introduced in almost allstock exchanges. Trading is much more transparentand quicker than in the past.

Until the early 1990s, the trading and settlementinfrastructure of the Indian capital market was poor.Trading on all stock exchanges was through openoutcry, settlement systems were paper-based, andmarket intermediaries were largely unregulated. Theregulatory structure was fragmented and there wasneither comprehensive registration nor an apex bodyof regulation of the securities market. Stock ex-changes were run as “brokers clubs” as their man-agement was largely composed of brokers. Therewas no prohibition on insider trading, or fraudulentand unfair trade practices (see Appendix 2).

Since 1992, there has been intensified market re-form, resulting in a big improvement in securities trad-ing, especially in the secondary market for equity.

Most stock exchanges have introduced online trad-ing and set up clearing houses/corporations. A de-pository has become operational for scripless trad-ing and the regulatory structure has been overhauledwith most of the powers for regulating the capitalmarket vested with SEBI. The Indian capital markethas experienced a process of structural transforma-tion with operations conducted to standards equiva-lent to those in the developed markets. It was openedup for investment by foreign institutional investors(FIIs) in 1992 and Indian companies were allowedto raise resources abroad through Global DepositoryReceipts (GDRs) and Foreign Currency ConvertibleBonds (FCCBs). The primary and secondary seg-ments of the capital market expanded rapidly, withgreater institutionalization and wider participation ofindividual investors accompanying this growth. How-ever, many problems, including lack of confidence instock investments, institutional overlaps, and othergovernance issues, remain as obstacles to the im-provement of Indian capital market efficiency.

Stock MarketPRIMARY MARKETSince 1991/92, the primary market has grown fastas a result of the removal of investment restrictionsin the overall economy and a repeal of the restric-tions imposed by the Capital Issues Control Act. In1991/92, Rs62.15 billion was raised in the primarymarket. This figure rose to Rs276.21 billion in 1994/95. Since 1995/1996, however, smaller amounts havebeen raised due to the overall downtrend in the mar-ket and tighter entry barriers introduced by SEBI forinvestor protection (Table 1).

Table 1: Issues in the Primary Market

Source: Reserve Bank of India.

Year Number Amount (Rs billion) Number Amount (Rs billion) Number Amount (Rs billion)

1994/95 1,342 210.44 350 65.88 1,692 276.321995/96 1,426 142.39 299 65.64 1,725 208.031996/97 753 115.65 131 27.19 884 142.84Dec 1997 59 21.99

Public Rights Total


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Total market capitalization as of 1997/98 wasRs5,898 billion (Table 2), equivalent to about half ofIndia’s annual gross domestic product (GDP) for thesame fiscal year. India compares favorably with otheremerging markets in this respect. The market capi-talization-GDP ratio at end-1995 was 22.4 percentfor Brazil; 12.6 percent for Hong Kong, China;40 percent for Indonesia; 41 percent for Korea;and 37.1 percent for Mexico.

1 It was higher how-

ever, in Malaysia (281.9 percent), Philippines(81.3), Singapore (233 percent), and Thailand(152.9 percent).

EQUITY PRICEFor the past 12 years, equity prices have seen twoextended periods of declining prices and two periodsof rising prices. Between April 1986 and March 1988,Sensex decreased from 589 to 398, or by 32 per-cent. Prices also fell between March 1992, whenthe monthly closing level of Sensex was 4,258, andApril 1993, when the level was 2,122, a decline of50.5 percent. Prices generally rose for extended pe-riods from March 1988 to March 1992 and from May1993 to August 1994. The monthly closing level ofSensex climbed from 398 in March 1988 to 4,285 inMarch 1992, an increase of more than 10 times. Inthe second period of extended rising equity prices,Sensex increased 1.16 times. Since 1995, it has fluc-tuated around the 3,000-4,000 mark (see Figure 1).In April 1998, it hovered around 3,000.

In the period of declining prices, from August 1994to March 1998, the price-earnings (P/E) ratio fellmore sharply than prices (Figure 1). In March 1998,

the monthly average Sensex P/E ratio was 15.65while the figure for October 1993 was 38.76.

Risk Management SystemSEBI has taken several measures to improve theintegrity of the secondary market. Legislative andregulatory changes have facilitated the corporatizationof stockbrokers. Capital adequacy norms have beenprescribed and are being enforced. A mark-to-mar-ket margin and intraday trading limit have also beenimposed. Further, the stock exchanges have put inplace circuit breakers, which are applied in times ofexcessive volatility. The disclosure of short sales andlong purchases is now required at the end of the dayto reduce price volatility and further enhance the in-tegrity of the secondary market.

MARK-TO-MARKET MARGIN AND INTRADAY LIMITUnder the current clearing and settlement system, ifan Indian investor buys and subsequently sells thesame number of shares of stock during a settlementperiod, or sells and subsequently buys, it is not nec-essary to take or deliver the shares. The differencebetween the selling and buying prices can be paid orreceived. In other words, the squaring-off of the trad-ing position during the same settlement period re-sults in nondelivery of the shares that the investortraded. A short-term and speculative investment is

Table 2: Number of Listed Companies and MarketCapitalization

a As of March.Source: Reserve Bank of India, Report on Currency and Finance, 1998–1999.

Number Amount ofof Listed Capitalization

Year Companies (Rs billion)

1995/96 9,100 5,7231996/97 9,890 4,8831997/98 9,833 5,8981999a 9,877 5,741

Figure 1: Price and P/E Ratio for the SensitiveIndex of the Stock Exchange

Data from January 1991 to January 1998.Source: Bombay Stock Exchange

5,000

4,000

3,000

2,000

1,000

0

BSE Sensex

1991

P/E Ratio60

50

40

30

20

10

0

SensexP/E Ratio

1992 1993 1994 1995 1996 1997 1998


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thus possible at a relatively low cost. FIIs and do-mestic institutional investors are, however, not per-mitted to trade without delivery, since nondeliverytransactions are limited only to individual investors.

One of SEBI’s primary concerns is the risk ofsettlement chaos that may be caused by an increas-ing number of nondelivery transactions as the stockmarket becomes excessively speculative. Accord-ingly, SEBI has introduced a daily mark-to-marketmargin and intraday trading limit. The daily mark-to-market margin is a margin on a broker’s daily posi-tion. The intraday trading limit is the limit to a broker’sintraday trading volume. Every broker is subject tothese requirements.

Each stock exchange may take any other mea-sures to ensure the safety of the market. BSE andNSE impose on members a more stringent dailymargin, including one based on concentration of busi-ness.

A daily mark-to-market margin is 100 percent ofthe notional loss of the stockbroker for every stock,calculated as the difference between buying or sellingprice and the closing price of that stock at the end ofthat day. However, there is a threshold limit of 25 per-cent of the base minimum capital plus additional capi-tal kept with the stock exchange or Rs1 million, which-ever is lower. Until the notional loss exceeds the thresh-old limit, the margin is not payable.

This margin is payable by a stockbroker to thestock exchange in cash or as a bank guarantee froma scheduled commercial bank, on a net basis. It willbe released on the pay-in day for the settlement pe-riod. The margin money is held by the exchange for6-12 days. This costs the broker about 0.4-1.2 per-

cent of the notional loss, assuming that the broker’sfunding cost is about 24-36 percent (Endo 1998).Thus, speculative trading without the delivery ofshares is no longer cost-free.

Each broker’s trading volume during a day is notallowed to exceed the intraday trading limit. This limitis 33.3 times the base minimum capital deposited withthe exchange on a gross basis, i.e., purchase plussale. In the event of brokers wishing to exceed thislimit, they have to deposit additional capital with theexchange and this cannot be withdrawn for sixmonths.

CIRCUIT BREAKERSEBI has imposed price limits for stocks whose mar-ket prices are above Rs10 up to Rs20, a daily pricechange limit and weekly price change limit of 25 per-cent. BSE imposes price limits as a circuit breakersystem to maintain the orderly trading of shares onthe exchange (Table 3).

BSE’s computerized trading system rejects buyor sell orders of a stock at prices outside the pricelimits. The daily price limit of a stock is measuredfrom the stock’s closing price in the previous tradingsession. The weekly price limit is based on its clos-ing price of the last trading in the previous week,usually its closing price on the previous Friday.

SHORT SALES AND LONG PURCHASESSEBI regulates short selling in the stock market byrequiring all stock exchanges to enforce reportingby members of their net short sale and long pur-chase positions in each stock at the end of eachtrading day.

Table 3: Bombay Stock Exchange Price Limits

Source: Endo (1998).

Category Market Price of Share Daily Weekly

A Group Shares Over Rs20 10 25B1 & B2 Group Shares Rs10 up to Rs20 25 25

Rs1 up to Rs10 50 No LimitUp to Rs1 75 No Limit

Price Limit (percent)


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Stock LendingA scheme for regulating stock lending was intro-duced in February 1997, following changes in taxregulations. Stock lending can take place throughan intermediary registered for this purpose withSEBI, and which has a minimum capital of Rs500million. Lenders and borrowers of securities haveto enter into agreements with the intermediary. Stocklending facilitates the timely settlement of transac-tions on the stock exchanges, especially in an envi-ronment where physical delivery of certificates isrequired for settlement.

Introduction of Derivatives TradingAt present, there are no exchange traded deriva-tives or over-the-counter derivative markets in thecountry. However, a new law has been passed per-mitting the trading of derivatives. This followed rec-ommendations for the establishment of a regulatoryframework for derivatives by a committee chairedby L.C. Gupta. It is expected that derivatives tradingwill soon form part of the Indian securities market.

Institutional InvestorsMUTUAL FUNDSIndian investors have been able to invest throughmutual funds since 1964, when UTI was established.Indian mutual funds have been organized through theIndian Trust Acts, under which they have enjoyedcertain tax benefits. Between 1987 and 1992, publicsector banks and insurance companies set up mutualfunds. Since 1993, private sector mutual funds havebeen allowed, which brought competition to the mu-tual fund industry. This has resulted in the introduc-tion of new products and improvement of services.The notification of the SEBI (Mutual Fund) Regula-tions of 1993, brought about a restructuring of themutual fund industry. An arm’s length relationship isrequired between the fund sponsor, trustees, custo-dian, and asset management company. This is in con-trast to the previous practice where all three func-tions, namely trusteeship, custodianship, and asset

management, were often performed by one body,usually the fund sponsor or its subsidiary. The regu-lations prescribed disclosure and advertisement normsfor mutual funds, and, for the first time, permittedthe entry of private sector mutual funds. FIIs regis-tered with SEBI may invest in domestic mutual funds,whether listed or unlisted.

The 1993 Regulations have been revised on thebasis of the recommendations of the Mutual Funds2000 Report prepared by SEBI. The revised regula-tions strongly emphasize the governance of mutualfunds and increase the responsibility of the trusteesin overseeing the functions of the asset managementcompany. Mutual funds are now required to obtainthe consent of investors for any change in the “fun-damental attributes” of a scheme, on the basis ofwhich unit holders have invested. The revised regu-lations require disclosures in terms of portfolio com-position, transactions by schemes of mutual fundswith sponsors or affiliates of sponsors, with the as-set management company and trustees, and also withrespect to personal transactions of key personnel ofasset management companies and of trustees.

FOREIGN INSTITUTIONAL INVESTORSFIIs have been allowed to invest in the Indian secu-rities market since September 1992 when the Guide-lines for Foreign Institutional Investment were issuedby the Government. The SEBI (Foreign InstitutionalInvestors) Regulations were enforced in November1995, largely based on these Guidelines. The regula-tions require FIIs to register with SEBI and to obtainapproval from the Reserve Bank of India (RBI) un-der the Foreign Exchange Regulation Act to buy andsell securities, open foreign currency and rupee bankaccounts, and to remit and repatriate funds. OnceSEBI registration has been obtained, an FII does notrequire any further permission to buy or sell securi-ties or to transfer funds in and out of the country,subject to payment of applicable tax.

Foreign investors, whether registered as FIIs ornot, may also invest in Indian securities outside the


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FII process. Such investment requires case-by-caseapproval from the Foreign Investment PromotionBoard (FIPB) in the Ministry of Industry and RBI,or only from RBI depending on the size of invest-ment and the industry in which the investment is tobe made. Investment in Indian securities is also pos-sible through the purchase of GDRs. Foreign cur-rency convertible bonds and foreign currency bondsissued by Indians that are listed, traded, and settledoverseas are mainly denominated in dollars. Foreignfinancial service institutions have also been allowedto set up joint ventures in stockbroking, asset man-agement companies, merchant banking, and otherfinancial services firms along with Indian partners.

Foreign portfolio investments in Indian companiesare limited to individual foreign ownership at 10 per-cent of the total issued capital of any one companyand to aggregate foreign ownership at 30 percent ofthe total issued capital of any one company.

FIIs’ net investment was positive until October1997 and their cumulative investments reached $9.1billion in the same month. But since then, it has turnednegative due to the Asian financial crisis (Table 4).As of May 1998, 496 FIIs were registered with SEBI,with a cumulative net investment of $9.2 billion inthe Indian securities market.

Since 1993/94, foreign portfolio investment has sofar exceeded foreign direct investment, which has alsoincreased rapidly (Table 5). Investment through FIIsconstituted the bulk of portfolio investment. Annualinflows have been about $1.5 billion-$2 billion from1993/94 to 1996/97 through FIIs, while inflows throughGDRs have declined after peaking at $1.8 billion in1994/95. In 1996/97, India received $5.6 billion in for-eign investment of which $1.9 billion was through FIIs.During 1997/98, FIIs’ investment fell while foreigndirect investment rose. Improvement in inflow of for-eign investment raised India’s foreign exchange re-serves from $17 billion at the end of 1994/95 to $29.3billion at the end of June 1997.

Following the changes to the 1995 SEBI (ForeignInstitutional Investors) Regulations, an FII is allowedto set up an investment fund to invest in Indian bondsif it registers the fund with SEBI as a new separateFII or its new subaccount. In 1996, SEBI approvednine debt funds with a cumulative investment expo-sure of $1.278 billion for investment in securities.

FIIs seem to have a strong impact on equity pricemovements in India. Trend analysis has shown a sig-nificantly positive relationship between BSE Sensexand the lagged net investment by FIIs. Figure 2 sug-gests that monthly net investment has been taking

Table 4: Investment by FIIs in Primary and Secondary Marketsa

FII = foreign institutional investor.( ) = negative values are enclosed in parentheses.a Data include debt instruments.Source: Securities and Exchange Board of India.

No. of CumulativeRegistered Net

FIIs Gross Purchase Gross Sales Net Investment InvestmentYear/Month (cumulative) Rs billion $ million Rs billion $ million Rs billion $ million ($ million)

Jan–Mar 1993 18 0.17 5.6 0.04 1.3 0.13 4.3 4.21993/94 158 55.92 1,782.8 4.66 1,48.7 51.26 1,634.1 1,638.31994/95 308 76.31 2,431.2 28.34 9,02.9 47.96 1,528.3 3,166.61995/96 367 96.75 2,858.6 27.51 8,22.9 69.42 2,035.7 5,202.31996/97 439 154.57 4,364.6 69.73 1,957.5 84.84 2,407.1 7,609.51996/97 (Apr-Jan) 429 127.01 3,595.6 52.15 1,467.0 74.86 2,128.6 7,331.01997/98 (Apr-Jan ) 476 143.82 3,979.4 102.12 2,807.4 41.69 1,172.0 8,781.5Total (since Jan 1993) 476 527.57 15,422.2 232.43 6,640.6 295.32 8,781.5 8,781.5

Oct 1997 471 16.0 442.0 9.66 267.0 6.33 174.9 9,090.3Nov 1997 475 10.93 295.4 15.05 406.7 (4.11) (111.3) 8,979.0Dec 1997 476 9.34 251.0 14.60 392.3 (5.26) (141.3) 8,837.7Jan 1998 476 6.52 175.2 8.62 231.5 (2.09) (56.3) 8,781.4


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• depositories, participants, custodians of securi-ties, FIIs, credit rating agencies, and other suchintermediaries who may be associated with thesecurities market in any manner; and

• venture capital funds and collective investmentschemes, including mutual funds.

However, the registration system is far from com-plete. For some professional categories such as sub-brokers, the registration system is in place, but limi-tations to SEBI’s enforcement power permits hun-dreds of thousands of unregistered subbrokers toconduct their securities businesses, while registeredsubbrokers are not effectively regulated. There is noregistration system at all for investment advisors.

The capital adequacy requirements for registeredmarket participants are surprisingly low. Conse-quently, entry barriers are also low. This is probablybecause the vested interest of existing market par-ticipants cannot be totally ignored since the Indiancapital market would stop functioning without them.The majority are thinly capitalized. As a result, SEBI’slimited resources are spread too thinly to registermany small participants and regulate them.

StockbrokersThe Indian law defines a stockbroker simply as

a member of a recognized stock exchange. There-fore, a registered stockbroker is a member of atleast one of the recognized Indian stock exchanges.

Table 5: Foreign Investment Inflows ($ million)

FII = foreign institutional investor, FIPB = Foreign Investment Promotion Board, GDR = global depository receipt, NRI = nonresident Indian, RBI = Reserve Bank of India,SIA = Secretariat for Industrial Assistance.Source: Reserve Bank of India, Report on Currency and Finance, various issues.

Item 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97

Direct investment 150 341 566 1314 2,133 2,696Government (SIA/FIPB) 87 238 280 701 1,249 1,922RBI 42 89 171 169 135NRI 63 61 217 442 715 639

Portfolio investment 8 92 3,649 3,581 2,748 2,864GDRs 86 1,602 1,839 683 918FIIs 1 1,665 1,503 2,009 1,926Offshore funds and others 8 5 382 239 56 20

Total 158 433 4,215 4,895 4,881 5,560

Figure 2: Monthly Net FII Investment and BSE-30 Index

BSE = Bombay Stock Exchange, FII = foreign institutional investor.Source: Securities and Exchange Board of India, Annual Report, 1995/96.

1,000

800

600

400

200

0

US$ million BSE-30 Index5,000

4,000

3,000

2,000

1,000

0

Net FII investmentSensex

the lead in changing market sentiments as reflectedin the market index movements.

Policy IssuesRegulatory FrameworkREGULATION OF INTERMEDIARIESParticipants in the Indian capital market are requiredto register with SEBI to carry out their businesses.These include:

• stockbrokers, subbrokers, share transfer agents,bankers to an issue, trustees of a trust deed, reg-istrars to an issue, merchant bankers, underwrit-ers, portfolio managers, investment advisers, andother such intermediaries who may be associ-ated with the securities market in any manner;


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Stockbrokers are not allowed to buy, sell, or deal insecurities, unless they hold a certificate granted bySEBI. At the end of March 1997, they numbered 8,867.

Each stockbroker is subject to capital adequacyrequirements consisting of two components: basicminimum capital and additional or optional capitalrelated to volume of business.

The basic minimum capital requirement variesfrom one exchange to another. A SEBI regulationrequires stockbrokers of BSE or NSE to maintain aminimum of Rs500,000 (about $14,000), which is thelargest requirement among the stock exchanges.However, BSE and NSE require their respectivemembers to deposit with them larger amounts. Theadditional or optional capital and the basic minimumcapital combined have to be maintained at 8 percentor more of the gross outstanding business in the ex-change (the gross outstanding business means thecumulative amount of sales and purchases by a stock-broker in all securities at any point during the settle-ment period). Sales and purchases on behalf of cus-tomers may not be netted but may be included tothose of the broker.

There is no mandatory qualification test for stock-brokers and other market participants in India, unlikeother countries such as Japan, United Kingdom, andUnited States.

SubbrokersMost stockbrokers in India are still relatively small.

They cannot afford to directly cover every retail in-vestor in a geographically vast country and in such acomplex society. Thus, they are permitted to trans-act with subbrokers as the latter play an indispens-able role in intermediating between investors and thestock market.

An applicant for a subbroker certificate must beaffiliated with a stockbroker of a recognized stockexchange. A subbroker application may take the formof sole proprietorship, partnership, or corporation.

There are two major issues concerning subbrokersin the Indian capital market:

• majority of subbrokers are not registered withSEBI; and

• the function of the subbroker is not clearly de-fined.

No subbroker is supposed to buy, sell, or deal insecurities, without a certificate granted by SEBI.Nevertheless, there were only about 2,593 sub-brokers registered with SEBI as of end-June 1997,while the number of stock subbrokers in India wasestimated in the range of 50,000 to 200,000 (Endo,1998).

The Indian law defines a subbroker as any per-son, not being a member of a stock exchange, whoacts on behalf of a stockbroker as an agent, or oth-erwise, to assist the investors in buying, selling, ordealing securities through such a stockbroker. Basedon this definition, the subbroker is either a stock-broker’s agent or an arranger for the investor. Thus,legally speaking, the stockbroker as a principal willbe responsible to the investor for a subbroker’s con-duct if a subbroker acts as his or her agent. How-ever, the market practice is different from this le-gally defined relationship. In reality, the stockbroker,in general, issues a contract note of a transactioneven to a registered subbroker, thus treating the lat-ter as a counterparty. This implicitly denies thestockbroker’s privity with the investor.

NSE does not officially allow its members to trans-act with end-investors through a subbroker. This isprobably because NSE has liberal membership cri-teria and its computerized trading network can eas-ily provide geographically scattered stockbrokers withdirect access to trading on NSE. Nevertheless, manytrading members of NSE have been using registeredand unregistered subbrokers.

To sort out this confusion, SEBI enforced the fol-lowing measures in March 1997:

• initiation of criminal actions on complaints re-ceived against unregistered sub-brokers in suit-able cases;

• revival of the institution of “remisier” under rulesand bylaws of the stock exchanges; and


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• prohibition of stockbrokers in dealing with un-registered subbrokers or unregistered remisiersafter 1 June 1997 (this deadline was later ex-tended to 1 July 1997).

In spite of these actions, the confusion has re-mained. There is a need to address the basic is-sue of clarifying the role of the subbroker and tooperationally define its relationship with the stock-brokers.

Merchant BankersUnder the old regulations, there were four cat-

egories of registered merchant bankers with differ-ent minimum net worth requirements (Table 6). Un-der the new regulations, the categories were abol-ished. Among other provisions, a merchant bankerapplicant is required to have a minimum net worth ofRs50 million.

The new regulations have drawn a clear-cut linebetween the merchant banker and the nonbankingfinance company (NBFC). Under the old regulations,a merchant banker is permitted to carry out fund-based activities such as deposit-taking, leasing, billdiscounting and hire-purchasing. The new regulationsno longer allow a merchant banker to engage in thesefund-based activities except for those related exclu-sively to the capital market such as underwriting.The merchant banker is required to cease such ac-tivities within two years. Correspondingly, an exist-ing NBFC performing merchant banking activities isrequired to relinquish such activities after a certainperiod of time.

The merchant banking industry in India has manyproblems, the main ones being that there are too manymerchant bankers, and that they are considered tobe relatively incompetent.

Only 20 merchant bankers account for 60-85 per-cent of the merchant banking business, while 148 ofthem are in business only on paper. In May 1997, asubstantial number of merchant bankers were foundto be professionally imprudent or negligent (Endo1998). SEBI listed 134 merchant bankers of Cat-egories I, II, and III who broke their underwritingcommitments for possible disciplinary actions. Of thisnumber, 95 were in Category I. Furthermore, therehave been records of listing delay or rejection of ini-tial public offerings (IPOs) in the recent past.

FRAGMENTATION OF REGULATORYAUTHORITIESThe present functions and powers of regulatory agen-cies for the securities market seem to be fragmented.SEBI is the primary body responsible for regulationof the securities market, deriving its powers of regis-tration and enforcement primarily from the SEBI Act.There was an existing regulatory framework for thesecurities market, provided by the Securities Con-tract Regulation (SCR) Act and the Companies Act,administered by the Ministry of Finance and theDepartment of Company Affairs (DCA) of the Min-istry of Law, respectively. SEBI has been delegatedmost of the functions and powers under the SCRAct, and shares the rest with the Ministry of Finance.It has also been delegated certain powers under theCompanies Act. RBI also has regulatory involve-ment in the capital market regarding foreign exchangecontrol liquidity support to market participants anddebt management through primary dealers. It is RBIand not SEBI that regulates primary dealers in theGovernment securities market. However, securitiestransactions that involve a foreign exchange trans-action need the permission of RBI.

So far, fragmentation of the regulatory authoritieshas not been a major obstacle to effective regulation

Table 6: Capital Adequacy Requirement forMerchant Banker Applicant (old regulations)

.. = nilSource: Endo (1998).

Minimum Amount ofCategory Net Worth (Rs million)

I 50II 5III 2IV ..


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of the securities market. Rather, lack of enforce-ment capacity by SEBI has been a more significantcause of poor regulation. But since the Indian stockmarkets are rapidly being integrated, the authoritiesmay follow the global trend of consolidation of regu-latory authorities or better coordination among them.

SELF-REGULATORY BODYSelf-regulatory organizations (SROs) have beenadopted in many countries to regulate various par-ticipants in the securities market. Members are boundby the SRO’s bylaws and codes of conduct. Throughthe SEBI Act of 1992, SROs were introduced in theIndian capital market, but they are not yet opera-tional. A clear regulatory framework has yet to beset up, and relevant market participants are not readyto regulate themselves for professional purposes. Theonly securities-related SROs in India whose regula-tory frameworks have been well established andwhich are actually functioning are the recognizedstock exchanges. Participants in the Indian capitalmarket seem to have successfully preserved the spiritand practice of self-regulation or self-governance inthe old stock exchanges such as BSE. However, it istrue that the old stock exchanges have been rife withvested interests of member brokers who are not fullyfriendly to investors.

Stock MarketFRAGMENTED MARKETOf the 22 stock exchanges in the country, 17 haveintroduced screen-based trading. With the expan-sion of trading networks of BSE and other stockexchanges beyond their original jurisdictions, an in-creasing number of investors in different parts ofthe country are within the reach of a national mar-ket system. This has raised informational efficiencyand helped rapid market integration.

NSE, which provides a screen-based order drivensystem, has already extended its network to morethan 100 centers in the country that are connected toits central computer via its satellite network. The

Over-the-Counter Exchange of India (OTCEI) alsoprovides a nationwide electronic system for tradingrelatively smaller stocks. BSE has introduced its ownscreen-based quote-driven trading system. However,the market is still fragmented and needs further inte-gration.

The international trend is to consolidate and mergeexisting stock exchanges rather than to set up newones. In the UK, there were about 20 stock ex-changes in the late 1960s, which were reduced toabout half a dozen in 1972 and further down to one,i.e., the London Stock Exchange, in 1986. NSE hasalready provided connectivity to more than 100 cit-ies, and other major stock exchanges are in the pro-cess of extending their trading terminals outside theirplaces of operation. Thus, it is questionable whetherIndia needs as many as 22 stock exchanges, eventaking into account the vastness of the country.

SPECULATIVE INVESTMENTTurnover in the Indian stock exchanges is high, im-plying that they are dominated by speculative invest-ments, which is not unusual in emerging markets.However, trading volumes in the Indian capital mar-ket are fairly large compared to those in other emerg-ing markets. While price levels have been depressed,the total turnover on BSE and NSE has been increas-ing. The combined turnover for 1996/97 was almostthree times the level of the previous year. Figure 3shows the total turnover of stock trading on all 22stock exchanges in India. The annual average growthrate from 1994/95 to 1996/97 was 56 percent in nomi-nal terms.

Table 7 compares the dollar turnovers and liquid-ity ratios on BSE and NSE with stock exchanges inother economies in 1996. The combined turnover onBSE and NSE, which are both located in Mumbai,exceeded that of some other stock markets in Asia.This is because of the remarkably high liquidity ratioon NSE. Considering that the majority of about 6,000stocks listed on BSE have low liquidity, it can be in-ferred that a group of the 1,500 most traded stocks


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on BSE would also have a considerably high liquidityratio (Endo 1998). The substantial increase in turn-over may be attributed primarily to the recent ex-pansion of the NSE’s trading network. But this alsoreflects the fact that the Indian stock market is domi-nated by speculative investments for short-term capi-tal gains, rather than long-term investment.

BARRIERS TO INITIAL PUBLIC OFFERINGSIn April 1996, SEBI announced a policy initiativethat makes access to the primary market more re-strictive. SEBI requires that a firm that wishes togo public should have a three-year track record ofdividends. If this is not satisfied, it should at leasthave a project with investment from a financial in-

stitution of at least 5 percent of the total projectcost. There has been a debate on whether this en-try condition is too restrictive. But the measureseems necessary to help recover investor confidencein the corporate sector.

The process of public subscription in the Indianmarket is lengthy and fraught with uncertainty. Fordomestic equity issues, the process requires compul-sory fallback underwriting, setting up of 30 manda-tory collection centers across the country for col-lecting subscriptions from investors, and price deter-mination of at least 45 days before the date of issue.Once an issue has been subscribed, postsubscriptionprocedures require 60 days to elapse before the se-curities are listed. Investors are forced to remain il-liquid during that period, or resort to the gray marketto meet liquidity needs. The cost of delay is likely tobe incorporated by investors in the price at whichthey are prepared to subscribe to an issue. This raisescosts to an issuer, besides encouraging clandestineactivities such as gray markets.

Transaction Costs in theSecondary MarketScreen-based trading introduces a greater degreeof transparency and reduces spreads. Market ma-nipulation becomes more difficult with screen-basedtrading and easier to investigate on account of the

Figure 3: Turnover of Stock Trading in India

Source: Securities and Exchange Board of India, Annual Report, 1995/96 and 1996/97.

1994/95 1995/96 1996/970

2,000

4,000

6,000

8,000Rs billion

Table 7: Turnovers and Liquidity Ratios of Indian and Foreign Stock Exchanges, 1996

a Converted into dollar amounts, using the simple averages of the year-end rates in 1995 and 1996; foreign companies and investment funds are excluded.b Turnover/average market capitalization.c Stocks listed and permitted to trade.d The first section only. The second section was not included.Source: Bombay Stock Exchange, National Stock Exchange, and Nikko Research Center.

Item Turnover ($ billion)a Liquidity Ratiob

Indian Stock ExchangesBombayc 26.5 0.22Nationalc 69.1 0.65

Foreign Stock ExchangesHong Kong, China 182.6 0.48Jakarta 32.6 0.41Kuala Lumpur 183.0 0.68London 390.1 0.25New York 3,728.4 0.58Singapore 51.9 0.27Thailand 51.3 0.43Tokyod 885.7 0.28


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transparent audit trails that are established. As esti-mated by Shah and Thomas (1997), the total trans-action costs in India’s equity market have been re-duced by half, i.e., from 5 to 2.5 percent since theintroduction of screen-based trading (Table 8). Butthis is still high compared to advanced markets.

When depository, derivatives, and indexation arefully in place, the transaction costs of the Indian eq-uity market could be even lower than those of mostadvanced countries.

CLEARING, SETTLEMENT, AND DEPOSITORIESAccount settlement period of stock exchanges thatearlier had a 14-day trading cycle has been short-ened to seven days (effectively five days because oftwo intervening no trading days on Saturday andSunday). Both BSE and NSE process net obliga-tions over a five-day account period and completethe settlement on the 15th day from the commence-ment of trading for an account period. Other stockexchanges are also moving into this cycle. In thecase of NSE, the National Securities Clearing Cor-poration, Ltd., its wholly owned subsidiary, providesa settlement guarantee. In the case of BSE, the clear-ing house is operated by Bank of India ShareholdingLtd., which is jointly owned by BSE and the Bank ofIndia.

In India, certificates of securities are registeredwith the issuer. For Government securities, therecord of ownership is kept by RBI, which main-

tains a Subsidiary General Ledger in its Public DebtOffice. Transfer of ownership takes place throughbook entry transfer in this ledger. In the case ofcorporate securities, the issuer maintains a registerof members or holders of securities, and the issu-ers or their register or transfer agents have to physi-cally receive the securities from a transferee ac-companied by a transfer deed signed by the transf-eror before a transfer is effected. There are nobearer securities in India. The majority of the settle-ment of transactions in the securities market con-tinues to be based on physical movement of certifi-cates. This results in delays, bottlenecks, and anincrease in transaction costs besides creating vari-ous risks for market participants such as bad deliv-ery, fraud, and theft. Because the clearing andsettlement infrastructure in the stock exchangescannot keep up with the flow of paper, especiallyas trading expands to different parts of the country,the exchanges have been unable to shorten settle-ment cycles or move to rolling settlement, whichare essential to reduce settlement risk.

The Depositories Act of 1996 allows for demate-rialization of securities in depositories and the trans-fer of securities through electronic book entry. Asthe depository network expands and the proportionof dematerialized securities in depositories increases,the benefits are expected to extend to the vast ma-jority of market participants. The National SecuritiesDepository, Ltd. (NSDL) has been granted a certifi-

Table 8: Comparison of Transaction Costs Between Indian and New York Equity Markets (percent)

a 1996-1997Source: Shah and Thomas (1997).

India New YorkComponent Mid-1993 Todaya Future Scenario Todaya

Trading 3.75 0.75 0.40 1.23Brokerage 3.00 0.50 0.25 1.00Market impact cost 0.75 0.25 0.15 0.23

ClearingCounterparty risk Present In part 0.00 0.00

Settlement 1.25 1.75 0.10 0.05Paperwork cost 0.75 0.75 0.10 0.05Bad paper risk 0.50 1.00 0.00 0.00

Total 5.00 (+ risk) 2.50 0.50 1.28


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cate of commencement of business by SEBI. As ofMay 1998, 197 issues (about 50 percent of marketcapitalization) have applied for dematerialization andabout 10 percent of them have been dematerialized.In contrast, only three issues had signed for the sameas of November 1996. If about 300 to 400 issuesapply for dematerialization, they will cover about 90percent of trading volume. As of May 1998, therewere 52 depository participants, which include bro-kers, banks, and custodians—an increase from 22participants in 1996. Thus, it is expected that dema-terialization of trade will proceed quickly although itscompletion may still take some time.

Debt MarketHIGH STATUTORY LIQUIDITY REQUIREMENTThe debt market is not well developed in India. Eventhough the volume of Government bonds outstand-ing is large, banks and other financial institutionshold a substantial part of these bonds as liquidityrequirement. The statutory liquidity requirement (ontop of cash requirement of 10 percent) has beenreduced from 25 to 23 percent. But this is still highand should be further decreased to activate the pri-vate debt market.

MARK-TO-MARKETBanks tend to hold Government securities to matu-rity to avoid a capital loss on the balance sheet. Until1996, only 40 percent of the portfolio of Governmentsecurities had to be marked-to-market. Starting fis-cal year 1996/97, the requirement has been raised to50 percent for existing banks and 100 percent forthe new private sector banks.

The pattern of ownership of Government secu-rities is shown in Table 9. The biggest holders ofboth central and state Government securities arecommercial banks, with more than two thirds ofthe total. Life insurance companies have also in-creased their holdings of Government securities.Banks and life insurance companies are captivemarkets for Government securities due to the port-folio restrictions imposed on them. Meanwhile, themarket for private companies’ debentures is notyet well developed.

PRIMARY DEALERSTable 10 shows the market borrowings of the cen-tral and state Governments. The total issue of Gov-ernment securities and net borrowing of the Govern-ment have increased.

Table 9: Pattern of Ownership of Gilt-edged Securities (percent)

na = not available.LIC = Life Insurance Corporation of India, PPF = Public Provident Funds.Source: Reserve Bank of India, Report on Currency and Finance, various issues.

Item

Central GovernmentSecurities

Reserve Bank of IndiaCommercial banksLICPPFOthers

TotalState GovernmentSecurities

Reserve Bank of IndiaCommercial banks

LICPPFOthers

Total

1996

9.0na

17.80.6na

100.0

0.0na

12.24.0na

100.0

1995

2.568.017.2

0.53.3

100.0

0.073.011.82.8

12.4100.0

1994

3.071.916.90.60.4

100.0

0.074.811.12.8

11.2100.0

1993

10.664.616.3

0.85.2

100.0

0.072.7

92.9

15.5100.0

1992

22.359.9

na1.1na

100.0

0.079.17.83.4na

100.0

1991

24.855.113.4

0.06.7

100.0

0.078.6

6.90.0

15.5100.0

1990

22.653.412.9

1.110.0

100.0

0.079.5

6.02.7

11.8100.0

1980

20.344.911.815.37.7

100.0

0.056.519.121.03.4

100.0

1969

37.520.411.523.3

7.3100.0

0.337.924.0

3.134.7

100.0


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A primary auction market for Government secu-rities has been created and six primary dealers havebeen authorized by RBI.

2 However, the auctions still

do not seem to take place fully on a market basis,mainly because Government securities are not is-sued at completely market rates.

Other factors seem to be inhibiting the marketclearing mechanism in the primary auction market.First, there is yet no preannounced notification amountin 364-day and 14-day auctions. This procedure en-ables RBI to determine in a flexible manner eitherthe cutoff price or the amounts to be accepted. Re-moving uncertainty by notifying auction volumes willbring about more transparency in the auction proce-dure. Second, noncompetitive bids are allowed in 91-day and 14-day Treasury bill auctions. Since stateGovernments are major noncompetitive bidders inIndia, their participation in Treasury bill auctionscauses further uncertainty in auction volumes.

PRIVATE PLACEMENTThe number of private placements has risen in re-cent years. It is estimated that about 40 percentof total resources mobilized by public and privatecompanies in the Indian capital market in 1995/96was through private placement, and this increasedfurther to close to 50 percent in 1996/97 (Table11). The share of the public sector in total privateplacements was about 70 percent in 1995/96, whichrose to about 84 percent in 1996/1997. There areseveral advantages to tapping private placementsinstead of resorting to public issues. However, cer-tain problems need to be addressed for the well-directed and efficient functioning of the market.At present, there is no transparency in this marketand virtually little information. In developed mar-kets, the regulatory authorities indicate the frame-work within which private placements have tofunction.

Table 10: Market Borrowings of the Government of India (Rs billion)

Source: Reserve Bank of India, Report on Currency and Finance, various issues.

Year

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

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

TotalIssues

4.06.0

26.353.389.989.1

138.9490.1381.1405.1296.2

1.42.53.0

12.825.633.438.041.451.262.765.4

Total

4.36.6

28.757.689.989.1

138.9490.1381.1405.1296.2

1.62.73.3

14.125.733.638.141.451.262.765.4

Cash

2.34.7

27.355.585.378.4

137.4490.1381.1405.1296.2

1.22.72.8

11.925.733.637.141.451.262.765.4

Conversion

2.01.91.42.14.6

10.71.5

0.3

0.52.3

1.0

NetBorrowing

1.34.5

26.050.080.075.047.9

261.5200.7267.9200.0

1.02.72.09.7

25.733.634.736.451.259.365.4

Subscription

Central Government

State Government


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DEVELOPMENT OF SECONDARY MARKETWhile there has been increased activity in primarydebt issues, the secondary market for debt is yet tobecome active. The entry of FIIs into the debt mar-ket and the launching of fixed income schemes andmoney market schemes by mutual funds are expectedto activate the debt market. Several technical im-pediments that prevented more active secondarymarket trading in Government securities have beenremoved over the past few years. But still there aresignificant barriers to the active development of thesecondary market for fixed income assets.

InvestorsMUTUAL FUNDSTable 12 shows increasing resource mobilization bymutual funds. However, over the last few years, theperformance of mutual funds has not been encour-aging. Investor confidence in mutual funds, whichideally should be the most preferred investment ve-hicles for the lay investor, has been low and the luke-warm response seen in 1995/96 continued in 1996/97 (Table 13). This could be attributed partly to mar-ket conditions, which have affected the perceptionof investors. With the revised SEBI (Mutual Fund)Regulations of 1996, mutual funds have been givengreater flexibility to operate schemes. It is expectedthat as a result of this liberalization, mutual funds willintroduce innovative products to attract investors. Therevised regulations have also introduced greater trans-parency and accountability, which is anticipated toboost investor confidence.

Table 13: Resource Mobilization, by Type of MutualFunds (Rs billion)

a As of January 1997.Source: Submaranian (1998).

Item 1994/95 1995/96 1996/97a

Public sector mutual funds 21.43 2.96 1.51Private sector mutual funds 20.84 3.12 3.46United Trust of India 95.00 59.00 42.80Total 137.27 65.08 47.77

Table 12: Resources Mobilized by Domestic MutualFunds (Rs billion)

a Until January 1997.Source: Submaranian (1998).

Period Resources Mobilized

1964-1987 45.631987-1992 329.771992-1997a 458.45Total 833.85

FOREIGN INSTITUTIONAL INVESTORSAccumulated net investment of FIIs contribute lessthan 7 percent of total market capitalization of theIndian capital market and less than 10 percent ofthe outstanding external debt of the country. India’sexternal debt position has shown considerable im-provement in the recent past. The debt-GDP ratiofell from 41 percent in March 1992 to 25.9 per-cent in March 1997. Short-term debt and the vola-tility of FIIs may well affect the performance ofIndia’s stock markets, but would not yet pose asignificant threat to cause a foreign exchange cri-sis. However, if these were coupled with an in-crease in nonresident Indian (NRI) deposits, there

Table 11: Private Placement in the Capital Market

a Provisional. Source: Submaranian (1998).

Total Resources PercentagePrivate Placement Mobilizeda of PrivateYear Private sector Public sector Total (Rs billion) Placements

Amount (Rs billion)a

1995/96 40.71 92.90 133.61 339.98 39.31996/97 24.93 125.73 150.66 306.74 49.1

Share (%)1995/96 30.50 69.50 100.001996/97 16.50 83.50 100.00


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may well be the potential for a currency crisis ifIndia fails to carefully manage its macroeconomicenvironment.

Policy RecommendationsOver the last few years, there have been substantialreforms in the Indian capital market. But there arestill many issues to be addressed to make it moreefficient in mobilizing and allocating capital.

Investor confidence in stock investment is low.This must be regained in order to encourage capital

Table 14: India’s External Debt ($ billion)

Source: Reserve Bank of India, Report in Currency and Finance, various issues.

Item 1985 1990 1991 1992 1994 1995 1996 1997

Medium- and long-termExternal assistance 19.31 32.15 34.28 38.10 43.71 48.81 47.29 46.28International Monetary Fund 3.93 1.50 2.62 3.45 5.04 4.30 2.37 1.31External commercial borrowing 5.56 13.74 14.78 16.08 17.57 19.62 18.27 18.85

Nonresident Indian deposits 3.08 10.36 10.58 7.85 12.67 12.38 11.01 11.13Short-term na na 4.80 3.19 3.63 4.27 5.03 6.73

mobilization through primary market issues. Furtherstrengthening of investor protection, and improve-ments in transparency, corporate governance, andmonitoring will be necessary. The capital market in-frastructure, such as accounting standards and legalmechanisms, should also be improved to this end.On the supply side, to encourage corporate firms torely more on stock markets for their source of fi-nancing, the issuing costs in terms of length of timerequired and administrative burden should be stream-lined (Table 15).

Table 15: Matrix of Policy Recommendations

Issues

A. Market infrastructure1. Accounting

principles2. Legal mechanism

B. Corporategovernance

C. Cost of capital issue

D. Debt market1. Diversification of

investors

2. Stamp duty

3. Private placement

E. Integration of stockexchanges andconsolidation ofintermediaries

F. Risk management

G. Integration of thecapital market withthe banking sector

Policy Recommendation

• Improve accounting principles, make them consistent with international practice.• Strictly enforce punitive measures for inaccurate accounting practice.• Establish prompt and effective settlement of disputes to protect small investors’ interests.• Grant institutional investors voting power.• Allow hostile takeovers.• Require consolidated balance sheets for conglomerates-affiliated firms to better monitor cross-

subsidization and internal transactions between affiliated firms.• Streamline the procedure for public subscription of securities to reduce transaction costs in

terms of time lag and uncertainty.

• Apply fully market-based interest rates for issuing Government securities.• Further reduce statutory liquidity requirements.• Further enhance the credibility of credit rating agencies.• Amend stamp duty regime by the Government of Maharashtra, where Mumbai is located, in the

form of one time levy or consolidated fee payable by National Securities Depository, Ltd (NSDL).• 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 for establishing central trading system through

interconnectivity.• Encourage the corporatization and merger of brokers and merchant bankers through tax

incentives.• Securities and Exchange Board of India to more closely monitor and inspect the intermediaries

and stock exchanges and, if necessary, strengthen punitive measures.• Banking system to establish a good electronic funds transfer (EFT) solution to enable direct

payments of dividends to bank accounts, eliminate counterparty risk, and facilitate FIIs.• Encourage sound competition between the banking sector and the capital market through more

banking liberalization.


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Market Infrastructure ImprovementACCOUNTING PRINCIPLESThe financial statements of an issuing company in itsdisclosure documents are prepared in accordancewith India’s generally accepted accounting principles(GAAP). The increasing exposure of Indian listedfirms to international investors has compelled themto adopt more internationally acceptable accountingprinciples. The Institute of Chartered Accountantsof India has issued a note to introduce new account-ing standards starting fiscal year 1995/96. Yet, In-dian GAAP is considerably different from that ofinternationally accepted principles.

3 To raise the cred-

ibility of corporate financial statements and trans-parency, accounting principles should be improvedfurther to make them consistent with internationalpractice. In relation to this, the credibility of the ac-counting profession should also be enhanced throughstricter enforcement of punitive measures for inac-curate accounting practices.

LEGAL MECHANISMThe problems of the court system and legal mecha-nism to settle disputes in India have been frequentlyraised. After floating shares in the market, investorsshould be able to monitor corporate performanceclosely to protect their interests. Prompt and effec-tive settlement of disputes is also critical. Accordingto a recent survey by Gupta (1998), 65 percent ofthose who brought complaints to court indicated thatthe cases have not been resolved. Even though mi-nority shareholders can now bring their complaintsto the court, they are discouraged from doing so be-cause the legal mechanism is very slow. Measuresare therefore needed to expedite court decisions andprotect small investors’ interests.

Improvement of CorporateGovernance EnvironmentTo boost corporate governance, the authorities mayconsider giving institutional investors voting power,which is prohibited now, and allow hostile takeovers,

a practice not yet done in India. Furthermore, theauthorities may enforce a consolidated accountingprinciple for conglomerate-affiliated firms in orderto better monitor cross-subsidization and internaltransactions between affiliated firms. These mea-sures will greatly improve the capital market envi-ronments for corporate governance.

Reduction of Cost of Capital IssueTransaction costs involved in the public issue of se-curities seem high due to the length of time required.This time-consuming process also increases issuers’uncertainty and tends to push them towards privateplacements. Streamlining the procedure for publicsubscription of securities is necessary not only to re-duce administrative burdens and transaction costs,but also to lessen firms’ uncertainty.

Activation of the Debt MarketSeveral policy measures have been taken to acti-vate the debt market, such as competitive pricingof Government securities, initiation of open marketoperation including repo operation, and a larger per-centage of mark-to-market valuation. These mea-sures have had a beneficial impact on the system,such as greater market absorption of Governmentsecurities, lower absorption by RBI, and increasedattention by investors to interest rate risk manage-ment. For instance, RBI’s absorption of primaryissues was 13.3 and 16.6 percent in 1996/97 and1997/98,

4 respectively, as against 32.6 percent in

1995/96 and 45.6 percent in 1992/93. However, fur-ther measures have to be implemented to encour-age the development of the debt market, includingreduction of the 23 percent statutory liquidity re-quirement ratio and 100 percent mark-to-marketvaluation for all banks.

DIVERSIFICATION OF INVESTOR BASEIn order to increase liquidity of Government securi-ties, diversification of the investor base with nontra-ditional investor groups such as individuals, firms,


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trusts, and corporate entities is necessary. Diversifi-cation is also important to promote an active marketin which investors’ buying and selling needs varyacross time. Banks, financial institutions, and provi-dent funds are the predominant holders of Govern-ment securities. To promote diversification of inves-tors, mutual funds could be encouraged to establishgilt funds to invest in Government securities throughtax incentives, and for primary dealers to diversifythe investor base. Fully market-based interest ratesfor issuing Government securities are also neces-sary. The credibility of credit-rating companies shouldbe further established.

STAMP DUTYWith the establishment of NSDL, a sizable stock ofprivate debt instruments and Public Sector Unit (PSU)bonds was expected to be dematerialized and cov-ered by a secured payment and settlement system. Atpresent, NSDL is able to dematerialize only those scripsthat are exempted from stamp duty and are transfer-able by endorsement and delivery. As most bonds andother corporate debt instruments are not exemptedfrom stamp duty on transfer of bonds, NSDL has en-countered difficulties in dematerializing them. In theautomated environment of the depository, it is not pos-sible for NSDL to keep track of them. Therefore, un-less the issue of the waiver of stamp duty on transferof debt is settled with the state governments, NSDLwould not be able to extend its services to bonds andother private debt instruments. A suitable amendmentto stamp duty regime by the Government ofMaharashtra in the form of a one-time levy or con-solidated fee payable by NSDL could resolve the is-sue to a significant degree.

PRIVATE PLACEMENT MARKETThe proportion of total resources mobilized by gov-ernment and nongovernment companies through pri-vate placements has been increasing. In privateplacements, bonds have emerged as the most pre-ferred instrument. The popularity of private place-

ment could be attributed to lower issuing cost andsavings on issue management time lag, apart fromthe fact that private placement has not been subjectto the strict regulatory provisions applicable to publicissues. At present, there is no transparency in thismarket, with virtually little information issued. In de-veloped markets, the regulatory authorities indicatethe framework within which the private placementhas to function, such as the number of persons perplacement, arrangements with only qualified inves-tors and strict regulations to access certain qualifiedinvestors. The issue of extending the regulatoryframework to protect investors’ interests from risksassociated with subscriptions in the private place-ment market needs to be addressed. With a properregulatory framework and more transparency, theprivate placement market can develop further as anintegral and important constituent of the primarymarket for raising resources by corporates.

Furthermore, favorable tax treatment may be ex-tended to institutional investors to encourage indi-vidual investment in the private placement marketthrough professional fund managers, which can re-duce asymmetric information and provide better in-vestor protection.

SECONDARY DEBT MARKET DEVELOPMENTIn order to activate the secondary market for debtinstruments, several measures need to be undertaken.

Further deregulation of domestic interest rates,greater reliance on borrowing at market rates by theGovernment and other quasi-state issuers, more utili-zation of open market operations as a tool for mon-etary policy, and better procedures for trading, clear-ing, and settlement will facilitate secondary marketdevelopment. Investor groups should be further diver-sified in order to provide better liquidity, and statutoryliquidity requirement should be reduced. A suitablesolution to stamp duty in relation to dematerializationof nongovernment securities is also necessary. In thecase of Government securities, RBI provides deposi-tory, and coverage of book-entry holding is expand-


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ing. With respect to PSU bonds and corporate deben-tures, which are held mostly in scrip form, a propersettlement system is yet to be put in place. As noted,NSDL was expected to dematerialize a sizable stockof nongovernment debt but it has been able to dema-terialize only those securities that are exempt fromstamp duty. Therefore, suitable amendments to thestamp duty regime are necessary to reduce transac-tion costs in the secondary markets for private securi-ties. This will also encourage the development of arepo market in nongovernment securities.

Integration of Stock Exchanges andConsolidation of IntermediariesA recent movement in India is the formation of theFederation of Indian Stock Exchanges (FISE) by 12regional stock exchanges and the setting up of a cen-tral trading system, the Indian Stock Exchanges Ser-vices Corporation (ISESC). If this materializes, therewill be three entities of national stature: NSE, BSE,and ISESC. The Government should make the envi-ronment favorable and, if necessary, provide incen-tives to facilitate this process.

A related aspect is the consolidation of intermedi-aries. The number of intermediaries in the Indiancapital market has mushroomed over the last 10 years.As a result, turnover per member is quite low andtransaction costs are high in most stock exchanges.Corporatization of broking, entry of foreign brokers,drying up of retail investments, and increasing over-head costs have created survival problems, particu-larly for the individual and small brokers.

5 Also, the

number of merchant banks (more than 1,000) seemslarge for the Indian capital market. The Governmentshould consider favorable tax treatment for brokersand merchant bankers who want to engage in merg-ers and takeovers.

Risk ManagementThe rules that have been introduced during the lastfew years to contain market risks seem to have op-erated reasonably well. Strict enforcement of theserules is as important as the rules themselves to ef-fectively manage risk. In this regard, SEBI shouldmore closely inspect intermediaries and the stockexchanges and, if necessary, strengthen punitivemeasures.

Integration of the Capital Marketwith the Banking SectorCapital markets cannot thrive alone—they have tobe integrated with the other segments of the finan-cial system. Effective and efficient capital marketsrequire a stable and strong payment, settlement, andclearing systems. India’s banking system is yet tocome up with good EFT solutions. EFT is importantfor solving problems such as those related to directpayment of dividends to bank accounts, eliminatingcounterparty risk, and facilitating FII investments.

Global trends in recent years have seen a blur-ring of borders between financial market segments.The traditional wall between banks and the securi-ties market is being eliminated, leaving banks withgreater investment flexibility. Banks are also in-creasingly providing long-term loans and enteringthe capital market to raise resources through eq-uity capital and subordinated debt. India is experi-encing the same trends and they are expected toincrease the competitiveness of its capital market.However, the country should pursue further expan-sion of banking activities in conjunction with fur-ther efforts to liberalize the banking system, andenhance asset quality to encourage sound competi-tion between the banking sector and the capitalmarket.


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Appendix 1

Reforms in Indian Securities MarketSince 1992

The development in Indian securities market since1992 can be summarized as follows:

• Capital Issues (Control) Act of 1947 repealedand the office of Controller of Capital Issues abol-ished; control over price and premium of sharesremoved. Companies now free to raise fundsfrom securities markets after filing prospectuswith the Securities and Exchange Board of In-dia (SEBI).

• The power to regulate stock exchanges delegatedto SEBI by the Government.

• SEBI introduces regulations for primary andother secondary market intermediaries, bringingthem within the regulatory framework.

• Reforms by SEBI in the primary market includeimproved disclosure standards, introduction ofprudential norms, and simplification of issue pro-cedures. Companies required to disclose all ma-terial facts and specific risk factors associatedwith their projects while making public issues.

• Listing agreements of stock exchanges amendedto require listed companies to furnish annualstatement to the exchanges showing variationsbetween financial projections and projected uti-lization of funds in the offer document and ac-tual figures. This is to enable shareholders tomake comparisons between performance andpromises.

• SEBI introduces a code of advertisement forpublic issues to ensure fair and truthful disclo-sures.

• Disclosure norms further strengthened by intro-ducing cash flow statements.

• New issue procedures introduced—book build-ing for institutional investors—aimed at reduc-ing costs of issue.

• SEBI introduces regulations governing substan-tial acquisition of shares and takeovers and lays

down conditions under which disclosures andmandatory public offers are to be made to theshareholders. Regulations further revised andstrengthened in 1996.

• SEBI reconstitutes the governing boards of thestock exchanges and introduces capital adequacynorms for broker accounts.

• Private mutual funds permitted and several suchfunds already set up. All mutual funds allowedto apply for firm allotment in public issues—alsoaimed at reducing issue costs.

• Regulations for mutual funds revised in 1996,giving more flexibility to fund managers whileincreasing transparency, disclosure, and account-ability.

• Over-the-Counter Exchange of India formed.• National Stock Exchange (NSE) establishment

as a stock exchange with nationwide electronictrading.

• Bombay Stock Exchange (BSE) introducesscreen-based trading; 15 stock exchanges nowhave screened-based trading. BSE granted per-mission to expand its trading network to othercenters.

• Capital adequacy requirement for brokers en-forced.

• System of mark-to-market margins introducedin the stock exchanges.

• Stock lending scheme introduced.• Transparency brought out in short selling.• National Securities Clearing Corporation, Ltd.

set up by NSE.• BSE in the process of implementing a trade guar-

antee scheme.• SEBI strengthens surveillance mechanisms and

directs all stock exchanges to have separate sur-veillance departments.

• SEBI strengthens enforcement of its regulations.Begins the process of prosecuting companies formisstatements and ensures refunds of applica-tion money in several issues on account of mis-statements in the prospectus.


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• Indian companies permitted to access interna-tional capital markets through Euro issues.

• Foreign direct investment allowed in stockbrok-ing, asset management companies, merchantbanking, and other nonbank finance companies.

• Foreign institutional investors (FIIs) allowed ac-cess to Indian capital markets on registration withSEBI.

Appendix 2

The Indian Securities MarketBefore 1992

The Indian securities market before 1992 had thefollowing characteristics:

• Fragmented regulation; multiplicity of adminis-tration.

• Primary markets not in the mainstream of thefinancial system.

• Poor disclosure in prospectus. Prospectus andbalance sheet not made available to investors.

• Investors faced problems of delays (refund,transfer, etc.)

• Stock exchanges regulated through the Securi-ties Contracts (Regulations) Act. No inspectionof stock exchanges undertaken.

• FIIs also permitted to invest in unlisted securi-ties and corporate and Government debt.

• The Depositories Act enacted to facilitate theelectronic book entry transfer of securitiesthrough depositories.

• Guidelines for Offshore Venture Capital Fundsannounced. SEBI regulations for venture capitalfunds become effective.

• Stock Exchanges run as brokers clubs; manage-ment dominated by brokers.

• Merchant bankers and other intermediaries un-regulated.

• No concept of capital adequacy.• Mutual funds—virtually unregulated with poten-

tial for conflicts of interest in structure.• Poor disclosures by mutual funds; net asset value

(NAV) not published; no valuation norms.• Private sector mutual funds not permitted.• Takeovers regulated only through listing agree-

ment between the stock exchange and the com-pany.

• No prohibition of insider trading, or fraudulentand unfair trade practices.


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Appendix 3

Regulatory Framework

INSTITUTIONSSecurities and Exchange Board of IndiaSecurities and Exchange Board of India (SEBI)

was set up as an administrative arrangement in 1988.In 1992, the SEBI Act was enacted, which gavestatutory status to SEBI. It mandates SEBI to per-form a dual function: investor protection through regu-lation of the securities market, and fostering the de-velopment of this market. SEBI has been delegatedmost of the functions and powers under the Securi-ties Contract Regulation (SCR) Act, which broughtstock exchanges, their members, as well as contractsin securities which could be traded under the regula-tions of the Ministry of Finance (see Figure A3 forthe present regulatory structure of the Indian securi-ties market). It has also been delegated certain pow-ers under the Companies Act. In addition to regis-tering and regulating intermediaries, service provid-ers, mutual funds, collective investment schemes,venture capital funds, and takeovers, SEBI is alsovested with power to issue directives to any person(s)related to the securities market or to companies inareas of issue of capital, transfer of securities, anddisclosures. It also has powers to inspect books andrecords, suspend registered entities, and cancel reg-istration.

Reserve Bank of IndiaReserve Bank of India (RBI) has regulatory in-

volvement in the capital market, but this has beenlimited to debt management through primary deal-ers, foreign exchange control, and liquidity supportto market participants. It is RBI and not SEBI thatregulates primary dealers in the Government securi-ties market. RBI instituted the primary dealership ofGovernment securities in March 1998. Securitiestransactions that involve a foreign exchange trans-action need the permission of RBI.

Department of Company AffairsIn 1947, the Capital Issues (Control) Act was en-

acted, which formalized and continued initial con-trols on the issue of securities that were introducedduring World War II. This Act was administered bythe office of the Controller of Capital Issues (CCI),which was a part of the Ministry of Finance. In linewith economic reforms, it was repealed in 1992 toliberalize capital issuance and pricing. While capitalissuance used to be regulated by the office of theCCI, both private and public companies were gov-erned by the Companies Act of 1956, which wasand continues to be administered by the Departmentof Company Affairs (DCA) under the Ministry ofLaw, Justice and Company Affairs. Besides gov-erning the incorporation, management, mergers, andwinding up of companies, this Act also specifies cer-tain aspects concerning capital issuance and securi-ties trading, particularly the issue of prospectus forpublic offers, contents of the prospectus, completionof allotment, issue, and trading of securities, andtransfer and registration of securities.

Stock ExchangesSEBI issued directives that require that half the

members of the governing boards of the stock ex-changes be nonbroker public representatives and in-clude a SEBI nominee. To avoid conflicts of interest,stock brokers are a minority in the committees ofstock exchanges set up to handle matters of disci-pline, default, and investor-broker disputes. The ex-changes are required to appoint a professional, non-member executive director who is accountable toSEBI for the implementation of its directives on theregulation of stock exchanges. SEBI has introduceda mechanism to remedy investor grievances againstbrokers.

DISCLOSURESimilar to companies in capital markets in other coun-tries, a company offering securities in the Indian


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capital market is required to make a public disclo-sure of all relevant information through its offer docu-ments. These documents are as follows:

• prospectus,• application form and the abridged prospectus (in

case of an issue to the public), or• letter of offer (in case of a rights issue to exist-

ing shareholders or debenture holders of a com-pany with or without the right to renounce in fa-vor of other persons).

After a security is issued to the public and subse-quently listed on a stock exchange, the issuing com-pany is required under the listing agreement to con-tinue to disclose in a timely manner to the exchange,to the holders of the listed securities (the sharehold-

ers or the bondholders), and to the public (throughthe exchange or the media), any information neces-sary to enable the holders of the listed securities toappraise its position and to avoid the establishmentof a false market in such listed securities. Such in-formation include:

• the date of the meeting of the board of directorsfor corporate actions;

• the audited financial results on an annual basisand the unaudited ones on a semiannual basis;

• any proposed change in the general characteror nature of the company’s business;

• any alterations of the company’s capital; and• any change of the company’s directorate, includ-

ing managing directors and auditors.

Figure A3: Regulatory Framework of the Indian Securities Market

DCA = Department of Company Affairs, FII = foreign institutional investor, SCR = Securities Contract Regulation, SEBI =Securities and Exchange Board of India.


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Notes1Euromoney (1996).

2They are the Discount and Finance House of IndiaLtd. (DFHI), the Securities Trading Corporation of In-dia (STCI), State Bank of India, Gilts Ltd., PNB GiltsLtd., Industrial Credit and Investment Corporation ofIndia (ICICI) Securities, and Gilt Securities Trading Cor-poration.

3See Endo (1998) for comparison of Indian GAAP withthose of the UK and US.

4Up to August 1997.

5The one-time exemption on capital gains tax provided inthe Union Budget 1997/98 should be of help to brokers forcorporatizing their businesses.

ReferencesEndo, Tadashi. 1998. The Indian Securities Market—A

Guide for Foreign and Domestic Investors. VisionBooks. India.

Gupta, L.C. 1998. “What Ails the Indian Capital Market?”Economic and Political Weekly, 23 (29-30).

Misra, B. M. 1997. “Fifty Years of the Indian Capital Market:1947-1997.” In Banking and Financial Sector Reformsin India, Vol. 6, edited by Kapila, Raj and Uma Kapila.

Rangarajan, C. 1997. “Activating Debt Markets in India.”Reserve Bank of India Bulletin. October.

Reddy, Y. V. 1997. “The Future of India’s Debt Market.”Reserve Bank of India Bulletin, November.

Reserve Bank of India. Report on Currency and Finance,various issues.

Securities and Exchange Board of India. 1995/96 and1996/97. Annual Report. India: SEBI.

Shah, Ajay, and Susan Thomas. 1997. “Securities Mar-kets—Towards Greater Efficiency.” In India Develop-ment Report, edited by K. Parikh. UK: Oxford Univer-sity Press.

Subramanian, V. V. 1998. “Impact Assessment of CapitalMarket Reforms.” Draft paper submitted to Asian De-velopment Bank.

Tarapore, S. S. “The Government Securities Market: TheNext Stage of Reform.” Banking and Financial SectorReforms in India, Vol. 4.

Euromoney. 1996. World Equity Guide. UK: EuromoneyPublications.

Documents

Indian Capital Market