CAPITAL MARKET India has had a history of securities trading stretching back almost two hundred years, making it one of the oldest capital markets in Asia. The American Civil War of 1861–1865 (which led to the emergence of an affluent community of brokers who profited from the ban on the import of American cotton) resulted in the capital market becoming more organized, and in 1874 a group of brokers congregated in Bombay's Dalal Street to begin trading in securities. A year later the Native Share and Stock Brokers' Association was formally inaugurated, a precursor to the establishment in 1895 of the first stock exchange, which in 1899 moved to premises at Dalal Street, a name which ever since has been synonymous with the Indian capital market.
The Early Years
Indian brokers profited from the U.S. Civil War, with over two hundred emerging in Bombay alone, but the war proved disastrous for financial investors. Share prices rose rapidly, and fell with equal ferocity by the end of the war. It has been recorded, for instance, that the price of the Bank of Bombay share fell from its high of 2,850 rupees to 87 rupees during this period. Investors experienced, and not for the last time, the familiar sequence of a share mania, generating the seeds of its own destruction, leading to dramatic price volatility and subsequent erosion of investor wealth.
While the capital market through most of the nineteenth century grew in response to the resource needs of trade and commerce, and of property development, toward the close of that century it began to provide finance to emerging industrial enterprises. Thus, shares traded in the 1830s were largely of banks and cotton presses; four decades later they encompassed trading enterprises in agricultural commodities such as jute in the 1870s and tea in the 1880s; and by then shares were also issued by joint stock companies which were floated to reclaim and develop land from the sea around Bombay. These were uncertain businesses with the possibility of high returns, and share prices of these companies were accordingly volatile. But by the 1880s, India's textile industry had emerged, with cotton mills in Bombay and Ahmedabad and jute mills in Calcutta set up by domestic entrepreneurs, to be followed in the first decade of the twentieth century by the first Jamsetji Tata iron and steel plant at Jamshedpur. Capital demands of this new industrial entrepreneurship, together with the rise in urban prosperity, led to additional stock exchanges being set up, at Ahmedabad in 1894 and Calcutta in 1908. The Indian industrial class had not merely arrived, but grew profitably during World War I, diversifying into paper, sugar, and the processing of other agricultural commodities, all of which provided breadth to the capital market.
From Independence to the Late 1980s
Firms were free of controls in raising capital from securities markets until World War II, when controls were first introduced through the Defence of India Rules. Controls continued thereafter with the enactment in 1947, the year of India's independence, of the Capital Issues (Control) Act. The emergence of an increasingly dominant public sector in the first three decades thereafter—underpinned by barriers to entry in certain sectors for companies not owned by the government, barriers to growth in the form of industrial licensing, and the nationalization of several large and listed companies—led to a subdued primary market for equity. Well-capitalized companies in sectors such as banking, insurance, petroleum, power, transportation, and coal were in the public sector and had no need to access the market for capital. With interest rates administered, the bond market also remained undeveloped, and firms typically raised debt from the predominantly nationalized development banks and commercial banks. The Foreign Exchange Regulation Act (FERA) of 1973, which required firms from overseas to substantially dilute their foreign shareholding to the level of a minority stake, did however funnel shares into the Indian capital market, and the shares of such companies were much sought after, consequently providing much needed trading momentum to the market. Several rapidly growing and privately owned Indian companies also accessed the market for equity: the most publicized in the 1980s was Reliance Industries, then a textiles company, which first successfully popularized the convertible bond in India. The Unit Trust of India, established in 1964, also helped in reaching out to a wide body of investors by intermediating household savings into the capital market, and enjoyed a mutual fund monopoly until other institutions were permitted to enter the sector in 1987.
Reform: Regulation of the Market
By the time liberalization and reform of the Indian economy began in the early 1990s, the capital market thus rated impressively in terms of the many institutions that had grown around it, and yet was seen as poorly regulated. Volumes of share trading were dominated by the Bombay Stock Exchange (BSE), ostensibly a self-regulatory organization that periodically resembled a closed cartel of broker-members who acted purely in their own interest with little concern for other stakeholders in the market. In 1991 the BSE's market capitalization rose by 130 percent within seven months, when it was discovered that funds had been diverted from commercial banks to the stock market by one broker, and the bubble burst. That episode raised crucial questions about the design and enforcement of financial market regulation. The formal regulation of India's capital market can thus be said to have begun in 1992, when a four-year-old regulatory authority, the Securities and Exchange Board of India (SEBI), was empowered by statute to regulate market intermediaries. This included regulating the market for equity issuance, until then directly controlled by the government, which computed the issue price on the basis of an accounting formula rather than what the market might bear, signaling the notion of "fair value" to investors. In practice, however, initial public offerings of equity were severely underpriced in relation to the price upon listing and were accordingly oversubscribed. While the transfer of powers to SEBI led to the removal of price controls when firms sought to raise capital from the market, the early years of pricing autonomy occasionally saw prices swing to the other extreme, with firms overpricing their equity issuance. It took the better part of a decade to correct pricing anomalies, aided by more responsible investment banks and a further reinforcement of SEBI's powers in 1995, transferring to it virtually all capital market regulatory powers formerly vested in the government.
The reform of stock exchanges has proved more contentious. The regulatory thrust has been to initially induce, and ultimately coerce, stock exchanges to reform their trading, clearing, and settlement practices. Success in the reform of stock exchange practices in India has been strongly facilitated by changes in market microstructure, best typified by the National Stock Exchange (NSE), an exchange set up in 1994 that created a new microstructure for equities trading. Over four thousand companies now provide for the electronic dematerialization of their shares, encompassing over 90 percent of the market capitalization of listed companies, and trades of such dematerialized shares account for over 99 percent of trades settled by delivery. Problems no longer arise of "bad deliveries" associated with the earlier trading of paper shares. Further, with rolling settlements, trades are now settled on day T +2, where T is the date of trading
Overall, the first decade after capital market reforms began in the early 1990s appears to have greatly improved the efficacy of regulation. For brokers, SEBI has signaled firmer regulatory intolerance of insider trading and front-running, and faster detection of circular trades on illiquid shares that result in price manipulation. For mutual funds, disclosures compare well with the best international practices, and an elaborately crafted regulatory straitjacket defines the bounds within which fund managers must discharge their obligations to investors. Finally, investment bankers are also required to display adequate due diligence in the manner in which capital raising and merger deals are structured.
Uncertainties in Raising Capital
Despite the transformation of the market, companies continue to face uncertainties in their ability to raise capital from the market at valuations that they consider fair, except when liquidity surges in the market occur. Very long-term financial savings are also not being intermediated through the market, leading to a paucity of private domestic equity and debt for infrastructure investment, in the absence of pension fund reform. Consequently, commercial banks continue to finance very long-term debt, at some risk to the matching of their assets and liabilities, while private equity funds, typically from overseas, have begun taking an increasing stake in well-managed companies to facilitate their growth. A significant proportion of fresh equity and debt is placed privately, rather than being offered publicly, reflecting the higher transaction costs of public offerings.
Companies similarly face constraints in raising acquisition finance. As competitive pressures have increased consequent to the liberalization of trade and investment in the early 1990s, companies have sought to restructure themselves in ways that have included ramping production capacities and divesting noncore businesses. This has been fertile territory for mergers and amalgamations, and banks have been restrained by regulation from providing such finance, though that restraint has been eased in financing the privatization of government companies.
Globalization of the Market
Economic reforms of the 1990s also liberalized access to overseas capital by Indian firms, the greatest impact being on the structure and depth of the Indian capital market. Portfolio investments were permitted by SEBI-registered Foreign Institutional Investors which discretionarily manage funds of common pools of money. Soon, however, such funds began issuing synthetic instruments overseas to attract wider pools of money to be invested in the Indian market. In addition, Indian companies have been permitted to access capital overseas, initially through the issuance of global depository receipts, and subsequently in the U.S. market (where stronger disclosure standards are mandated) through American depository receipts. So while it is still not legally possible for every investor overseas to hold shares in an Indian company willing to issue its shares, in practice surrogate markets facilitating such investments have arisen.
Another offshoot of financial integration with overseas capital markets has been the rapid change in the capitalization and practices of domestic market intermediaries. There have been several collaborations and strategic alliances since 1993 between domestic financial services companies and investment banks abroad. Overseas brokerage houses, through Indian affiliates, have become members of the larger stock exchanges and thereby entered the domestic broking industry. The financial services industry grew rapidly through the 1990s and is better capitalized than it was at the start of capital market reform.
While the Indian rupee is still not fully convertible on the capital account, portfolio investment from overseas has become large enough to significantly impact the capital market, be it in trading volume, share valuation, or the structure of trading liquidity across stocks. Although India was well insulated from the currency and capital market turmoil that affected East Asia in 1997, periods during which surges have occurred in overseas inflows into the capital markets in the last decade have seen prices of frontline and liquid stocks depart significantly from their fundamental valuations computed on the basis of discounted cash flows. Reversals in these surges have led inevitably to steep erosion in investor wealth. Opportunities for hedging against such a fall in prices, hitherto restricted, are expected to improve as markets for derivatives on stock indexes and select individual stocks become increasingly liquid.
The resident investor is still not permitted to invest overseas, though a limited window has been opened for mutual funds to do so. If India moves closer to full capital account convertibility, overseas funds can also be expected to become a source of investors in the country. It is at this stage that financial product innovation, market liquidity and stock market clearing and settlement efficiencies will need to be internationally competitive if markets are not to move overseas. The compulsions will be strong for regulators and market participants alike to be sensitive to the importance of market microstructure.
Linkages with Other Financial Markets
Further liquidity and depth in the capital markets require the development of a more diversified fund industry. While the liberalization of the insurance sector in the early twenty-first century will provide an impetus to such diversification as new, privately owned insurance companies grow in size, it is the reform of the pension sector that will be more critical. The government has recently initiated a shift in policy for pensions payable to a segment of its own employees with the acceptance of two instrumentalities. The first is the notion of "contracting out," allowing pension monies to be managed by other asset managers, and to permit employees to switch between asset managers at very low cost. The second is to permit diversification across asset classes (which for the first time are to include equities), so as to enhance returns in the longer term. While the transformation of the pension fund sector is not customarily viewed as an integral part of capital market development, even a modest proportion of retirement savings being invested in the equity markets would significantly impact liquidity in the latter, thereby also reducing the undervaluation of several stocks. This is in addition to other benefits that a diversified pension industry could provide: enhancing earnings at retirement, and so mitigating old-age financial distress; providing long-term funds for the development of infrastructure; and thereby increasing the domestic savings rate. A well-structured reform of the pension fund market provides the opportunity to reach out simultaneously for growth and distributional equity in the next stage of India's capital market development.
P. Jayendra Nayak
Nayak, P. Jayendra. "Regulation and Market Microstructure." In India: A Financial Sector for the Twenty-first Century, edited by James A. Hanson and Sanjay Kathuria. New Delhi: Oxford University Press, 1999.
Parekh, H. T. Indian Capital Market: Past, Present, andFuture. Bombay: A. D. Shroff Memorial Trust, 1975.