GROWTH AND SUSTAINABILITY

OF

INDIAN CAPITAL MARKET

-A MYTH OR REALITY

By

Alok Patro
Pratik. H.Choksi

E-Mail : alokpatro@gmail.com
kitarp87@gmail.com
Address : Gitam - Cms
Rushikonda
Visakapatnam.
EXECUTIVE SUMMARY

India offers high & uncorrelated returns to FIIs against low returns in developed markets.
This coupled with interest rate differentials and positive India sentiment, remains the
Overwhelming cause of inflows in Indian capital markets and the recent rally. Equity
markets have fared well compared to debt on eight systems (market processes)
parameters.

However Indian Capital markets are

• As yet, not a barometer of the performance of the Indian corporate sector
• Currently, they are not the most important source of funds to Indian economy.

There is case for making capital markets more relevant to the overall growth of the
Indian Economy. We examine if capital markets can provide the economy with a growing
mean rate of capital supply without sudden shocks and thus being more integral to the
Indian growth story. To analyze if capital markets stand on verge of explosive growth, we
ask the following questions and attempt to answer them.

Will Liquidity improve in Equity & Debt Markets including Derivatives?

Liquidity can be actively managed in debt and overlying derivatives for market
development by measures suggested. In equities, the small cap universe is bound to grow
in liquidity with overall growth in economy & capital inflow and certain measures will
hasten that growth.

Should firms raise capital abroad (ADR/GDR) or in India? Which would be followed by
the majority in the future?

Foreign investors require a lower rate of return from Indian equities due to low
Correlation, reducing the cost of capital in India. We conclude that there is now no
liquidity premium to be enjoyed in ADR/GDR listing by Indian companies and that such
Issuances actually incur an opportunity cost of not raising capital in India (except for
Bond financing). We infer that in the next 10-15 years, Indian firms will consolidate all
their liquidity in India and will avoid fragmentation of their liquidity, and obtain
the lowest possible cost of capital.

Market Participation

Is FII inflow a reliable source of capital? Is it based on economic fundamentals?

Or is it a short term bargain hunt?

It is concluded that FIIs are currently operating on a more short term volatile strategies
(in equity as well as debt) resulting in potential volatility. In the Two –Dimensional
Reward to Risk framework developed by this author to analyze the nature of FII inflow, it
can be seen that FII inflow will most likely plateau out when interest rate differentials
disappear and the Indian markets become more correlated with developed markets. The
framework also concludes from macro variables (ignoring future externalities) that other
emerging markets (e.g. Mexico) will emerge more attractive as high uncorrelated returns
in India recede.

What is the role (long term) of domestic financial institutions in capital market
development in such a scenario explored in Q1?

After FII investments stabilize, it is the role of domestic institutions to replace the FII
inflow as the engines of capital market development. FII exit would be much easier after
5-10 years due to lower impact and transaction costs in the future. Therefore, domestic
investment capabilities must be developed to lead market development at that time. In
addition to the current reforms launched by the government allowing banks/life/pension
funds to invest in capital markets, further steps could involve them being allowed a wider
range of investment and new derivative instruments to manage risk along with an active
mortgage market. To enable domestic investment across the board (not just blue chip
firms), we need a paradigm shift in handling efficient capital deployment and contract
failure.

How will contract failure (including bankruptcy) be resolved in the industrial &
Financial sector?

There is a need to bring in alternates to judicial systems such as arbitrations in financial

Contracts while punishing underperforming managements in bankruptcy situations. To
Attract retail capital; a four pronged protection system is needed on western lines. A new
Bankruptcy code is needed which enables deployments of assets to realize maximum
value.

Conclusion
• We conclude that at least in equity markets, our systems are robust for market
Development to be built on top of them. Indian capital markets will grow at a high
Rate on account of FII investments for about 5-10 years as long as Indian returns are
Uncorrelated and interest rate differential persist.

• What is important however, that domestic capabilities should be built up to take?

Over from FIIs, when their rate of capital infusion slows down in next 10-15 years.
This will determine the growth of the economy after this period as the capital
Markets by then would have become a more important source of funds for the
Economy. For this we examined the crucial roles of market liquidity, instrument
Innovation (debt), more companies raising capital in India by policy incentives and a
Paradigm shift in the way Indian industry handles failure (bankruptcy).
INTRODUCTION

Capital Market is the market for Long term funds, just as the money market is the market
for short term funds. Capital market refers to all the facilities and the institutional
arrangement for borrowing and lending medium and long term funds. It is concerned with
the raising of money capital for investment purpose. Private sector manufacturing
industries, agriculture and the government predominantly make demand of long term
money capital for purpose of investment. The central and the state governments require
substantial sums from the capital market and they are investing not only on economic
overheads as transport, irrigation and power developments but also on basic industries
and sometimes even consumer goods industries. Individual servers, corporate savings,
banks, insurance companies, specialized financing agencies and government are
important supplier of funds for the capital market. Among institutions, we may refer to
the following:
- Commercial banks are important investors, but are largely interested in
government securities and to a small extent on investment in debentures of
companies;
- LIC and GIC are of growing importance in the Indian Capital Market though their
major interest is still in government securities;
- Private funds constitute a major medium of savings but their investments too are
mostly in government securities ; and
- Special institutions set up since independence – IFCI, ICICI, IDBI, UTI, etc – all
these aim at providing long term capital to the private sector.
Gilt-Edged Market and the industrial securities market are two prominent constituents of
the Indian Capital Market. The Gilt-Edged Market refers to the market for government
and semi-government securities, backed by the Reserve Bank of India. There are
stabilized value for the securities traded in this market, that are much sought after by
banks and other institutions.
Foreign Institutional Investors

Positive tidings about the Indian economy combined with a fast-growing market have
made India an attractive destination for foreign institutional investors (FIIs).

The foreign Institutional Investors' (FIIs) net investment in the Indian stock markets in
calendar year 2005 crossed US$ 10 billion in the 2005 calendar, the highest ever by the
foreign funds in a single year after FIIs were allowed to make portfolio investments in the
country's stock markets in the early 90s.

As per the Securities Exchange Board of India (SEBI) figures, FIIs made net purchases of
US$ 587.3 million on December 16, 2005, taking the total net investments in the 2005
calendar to US$ 10.11 billion.

India's popularity among investors can be gauged from the fact that the number of FIIs
registered with SEBI has increased from none in 1992-93 to 528 in 2000-01 to 803 in
2005-06. In 2005 alone, 145 new FIIs registered themselves, taking the total registered
FIIs to 803 (as on October 31, 2005) from 685 in 2004-05.

A number of these investors are Japanese and European funds aiming to cash in on the
rising equity markets in India. In addition, there was increased registration by non-
traditional countries like Denmark, Italy, Belgium, Canada and Sweden.

The Japanese have, in fact, been increasing their foothold in India. Mizuho Corporate
Bank's decision to successfully expand base in the country has managed to convince
almost 60-65 major Japanese corporates to set up manufacturing or marketing base in
India.

• This list of corporates includes big names in auto sectors such as Honda, Toyota
and Yamaha, as well as those in home appliances, pharmaceuticals, and
communications.
 • While Nissan has already set up its base in India, other new entrants include
Japanese business conglomerate Mitsui Metal, Sanyo, and pharma major Eisai.
Japanese Telecom major Nippon Telegraph (NTT) is also in the process of
entering the Indian market.
• Sabre Capital and Singapore's Temasek Holding have teamed up to float a fund
that will invest up to US$ 5 billion in Indian equities as well as fixed income
instruments over the next five years.
• Fidelity International, a leading foreign institutional investor, has picked up about
9 per cent in the Multi Commodity Exchange of India Ltd (MCX) for US$ 49
million.

If FIIs have been flocking to India, it is obvious the returns are handsome. According to
Kamal Nath, the Indian Minister for Commerce and Industry, of all the foreign investors
in India, at least 77 per cent make profit and 8 per cent break even.

These facts are corroborated by recent research on the trend. A landmark survey by the
Japan Bank for International Co-operation (JBIC) shows that in the next three years,
India will be the third most favoured investment destination for Japanese investors in a
list, which includes US and Russia.

A Smith Barney (a Citigroup division) study says the estimated market value of FII
investment in the top 200 companies (including ADRs and GDRs) at current market
prices is a whopping US$ 43 billion. This is 18 per cent of the market capitalization of
the BSE 200.

Reporting Date Debt/Equity Gross Purchases Gross Sales Net investment

(Rs.Crores) (Rs.Crores)
15-SEP-2006 Equity 1604.90 1113.30 491.50
Debt 162.80 0.00 162.80
The total market capitalization on BSE on 7th October, 2005 was Rs 2,245,005 Crore.
The recent stock market rally saw FII investment reach 8.65 billion $ in 2005 till date
compared to 8.51 billion $ in whole of 2004. In addition, India’s GDP growth rate is
expected to be around 6.5-7% in the next two years. The most important requirement is to
make the capital markets more integral to the Indian growth story. To sustain, match and
accelerate this growth, the Indian economy needs a growing mean rate of capital supply
without sudden shocks.

Hence there is a need to attract and spread low volatility reliable capital from FIIs across
sectors while developing domestic institutional investment capabilities to take over.

American Depository Receipts / Global Depository Receipts

Currently, Indian equity risk is significantly uncorrelated with global portfolios, so

foreign investors require a lower rate of return from Indian equities. Thus, foreign
ownership of Indian equity reduces the cost of capital in India. FIIs have traditionally
faced two problems:
• Transaction Costs - Indian equity market imposed extremely large transactions Costs
(highly illiquid market). Indian firms used (ADR/GDR) as a way to bypass Indian
markets. These instruments commanded a higher price owing to liquidity Premium.

• Ownership Restrictions - Only FIIs can buy shares in India, while anyone can buy
GDRs or ADRs. FIIs face restrictions on the fraction of a firm that can be purchased. This
imposes ceilings on foreign ownership. In contrast, participation in the GDR or ADR
market is unencumbered, and hence they enjoyed a premium.

However with improvements in Indian capital markets from 1996 onwards, there has
been no liquidity premium argument which favors offshore listing. The liquidity of the
stock market is ultimately driven by retail investors and speculators in the home country.
Hence, no foreign market can ever harness the liquidity which is found in India. Indeed, a
firm which issues ADR/GDRs now suffers an opportunity cost by listing abroad.

Future Development seems better for a firm to issue shares in India, and obtain good
liquidity by building up market capitalization and retail investors in India and FIIs (who
are paying higher prices for uncorrelated returns in India). The companies with the largest
fraction of foreign ownership would obtain the highest P/Es and the lowest cost of
capital. GDR/ADRs are extremely illiquid (even after two-way fungibility) and there is
no real argument in favor of their issuance for an Indian firm which can get capital in
domestic market by FIIs or domestic investors. The only case for such a route would be
justified in case of long term bond financing as those are not very easily placed in India.

The definition of "FII" should be steadily broadened, so as to improve the investor base
that all Indian companies can access. This would eliminate the incentive that Indian firms
are given, to suffer poor liquidity in offshore markets, in order to obtain a wider foreign
investor base. Indian firms will consolidate all their liquidity in India and will avoid
fragmentation of their liquidity, and obtain the lowest possible cost of capital.
The Indian companies were allowed to raise funds from abroad, through American
/Global Depository Receipts and external commercial borrowings (ECBs). The RBI
allowed two way fungibility of ADRs/GDRs in 2002.

EXPORT PERFORMANCE

India’s exports at record high – growth at 40% in June and over 30% cumulatively in first
quarter of this fiscal. With sustained record growth, export to hit USD 126 billion this
year, double the 2003-04 figure. In a continuing surge, India’s merchandise exports
during June 2006 have shown an unprecedented growth of 40.17%, having increased to
USD 9967.08 million (USD 9.9 billion) from the level of USD 7110.96 million (USD 7.1
billion) during June 2005, according to provisional data available for the first quarter
April-June of the current financial year 2006-07. Exports during April-June 2006 are
valued at USD 27671.93 million (USD 27.6 billion) which is 32.40% higher than the
level of USD 20900.31 million (USD 20.9 billion) during April-June 2005.

India’s exports of engineering goods have put up a record growth of about 35.6% in
dollar terms in April-2006 over April-2005. EEPC estimates based on the provisional data
obtained from DGCI&S suggest that exports of engineering goods from India in April-
2006 touched USD 1.99 billion. In rupee terms India’s export of engineering goods are
valued at Rs 8977.39crores during April-06 which is 39.36% higher than the value of
export Rs 6441.78crores during April-05. In comparison to March 2006 the engineering
exports have shown the same trend of negative growth of -18.40% in April-2006 as we
see the growth of -11.00%, -32.26% and -27.20% for the months April-03, April-04 and
April-05 respectively, in comparison to the corresponding previous months for the same
fiscals.
MUTUAL FUNDS

Trends in Transactions on Stock Exchanges by Mutual Funds (since January 2000)

Equity Debt (Rs

(Rs in in
Crores) Crores)
Net Net
Gross Gross Purchase/ Gross Gross Purchase/
Purchase Sales Sales Purchase Sales Sales
Jan 2000-March 2000. 11070.54 11492.19 -421.65 2764.72 1864.29 900.43
April 2000 -March 2001. 17375.78 20142.76 -2766.98 13512.17 8488.68 5023.49
April 2001-March 2002. 12098.11 15893.99 -3795.88 33583.64 22624.42 10959.22
April 2002-March 2003 14520.89 16587.59 -2066.70 46663.83 34059.41 12604.42
April 2003-March 2004 36663.58 35355.67 1307.91 63169.93 40469.18 22700.75
April 2004-March 2005 45045.25 44597.23 448.02 62186.46 45199.17 16987.29
April 2005-March 2006 100435.90 86133.70 14302.20 109804.91 73003.67 36801.24
April 2006. 12752.47 9631.91 3120.56 11227.96 6800.08 4427.88
May 2006. 18345.43 10452.07 7893.36 15386.47 7774.06 7612.41
June 2006. 7843.52 9820.47 -1976.95 14235.54 8906.90 5328.64
July 2006. 7552.18 7633.89 -81.71 15982.62 8266.41 7716.21
August 2006. 8851.58 8425.14 426.44 16169.28 11853.22 4316.06
September 2006 (as on 14th) 4429.67 3928.87 500.80 4990.79 3545.83 1444.96
Total (April - August '06) 59774.85 49892.35 9882.50 77992.66 47146.50 30846.16

As we see in the above table there is a significant increase in the mutual fund
market, mainly because of three reasons:
• Liquidity
• Profitability
• Safety
FOREIGN DIRECT INVESTMENT

FDI INFLOWS DURING CURRENT YEAR 2006:

FINANCIAL YEAR-WISE FDI INFLOWS:

50000
40000
30000
20000
10000
0
-10000
1992- 1994- 1996- 1998- 2000- 2002- 2004-
93 95 97 99 01 03 05
Gilt-Edged Market
The Gilt-Edged Market is also known for the securities guaranteed by the government
apart from government securities. The government securities are risk free because the
government can’t default on its payment obligations and are hence known as Gilt-Edged
(which means “of the best quality”).

NATIONAL STOCK EXCHANGE (NSE)

The National Stock Exchange (NSE), located in Bombay, is India's first debt market. It
was set up in 1993 to encourage stock exchange reform through system modernization
and competition. It opened for trading in mid-1994. It was recently accorded recognition
as a stock exchange by the Department of Company Affairs. The instruments traded are,
treasury bills, government security and bonds issued by public sector companies.

The number of members trading on the exchange has been on a steady increase, helping
integrate the national market and providing a modern system with a complete audit trail
of all transactions.

Membership

• 1026 trading members on the Capital Market segment, of which around 86%
account for corporates and the remaining individuals and firms.
• 113 trading members on the Wholesale Debt Market segment, all of which
account for corporates. (Out of these 113 trading members, 106 are members of
the Capital Market segment also and are included in the 1026 members indicated
above).

Geographic Distribution

• Over 2600 trading terminals

• Over 1500 VSAT’s across the country with a 24 hour Network monitoring system
in over 160 cities as of December 31st, 1997.
Number of Companies

• On the Capital Market segment, 600 securities are listed and 762 securities are
permitted to trade as of December 31st, 1997.
• On the Wholesale Debt Market segment, 470 securities are listed and 369
securities are permitted to trade as of December 31st, 1997. Of the 470 securities
listed, 267 are Government Securities, T-Bills and the balance account for other
securities.

Capital Market Operations

• NSE is working to increase the capacity of the trading system from the present
4,00,000 trades per day to more than 10,00,000 trades per day.
• The average daily numbers of trades have gone up from over 893 trades in
November-94 to over 1,48,783 trades in November 97. On August 7, ’97 the
number of trades reached a record high of 2,36,411 which makes NSE one of the
largest stock exchanges in the world.
• Average daily traded value has increased from Rs.7 crores in November-94 to
more than Rs. 1480 crores in December-97 with a high of Rs.3,080.61 crores
recorded on 26th June-97.
• Number of shares traded has increased from 76.10 lakhs in November-94 to
11,148.21 lakhs in December-97.
• Net traded value has increased from Rs.125 crores in November -94 to Rs. 32,549
crores in December-97.
• Delivered value (settlement wise) has increased from Rs.60 crores in November
-94 to Rs.5,008 crores in December -97.
• Number of shares traded (depository segment) has increased from 200 shares in
December -96 to 1,19,102 shares in December-97.
• Net traded value (depository segment) has increased from Rs.0.43 lakhs in
December -96 to Rs.185.44 lakhs in December-97.
 • Market share of cities other than five metros (Mumbai, Delhi, Calcutta, Chennai
& Ahmedabad) which was about 16% in first quarter of 1996 grew to as high as
24% during the last quarter of 1997.
• The ratio of contribution to turnover from Non Stock Exchange centres to Stock
Exchange centres has risen from 0.36% in first quarter (Jan to Mar) of 1996 to
over 10% in fourth quarter of 1997.
• The market capitalization of companies has increased from Rs. 292637 crores in
November'94 to Rs. 4571663 crores in February'98.

Clearing & Settlement

• Completed 170 settlements successfully without any delay or postponement as on

February 28, 1998.
• Value of shares handled by the Clearing house per week has increased from Rs.
30 crores in November-94 to over Rs.1042 crores per week in December-97. The
highest value of shares handled during the period was more than Rs. 2251.40
crores.
• Inter-Region Clearing: NSCCL has Regional Clearing Centres at Delhi, Calcutta,
Chennai and a Central Clearing Centre at Mumbai. Members have the option of
delivering/receiving the securities at a clearing centre chosen by them.

Wholesale Debt Market Operations

• The WDM segment commenced operations on June 30, 1994 with 224 securities
carrying an outstanding debt value of Rs. 1,35,000 crores (US$ 34 billion). This
has now increased to 839 securities with a market capitalizations of Rs. 3,50,565
crores (US$ 88 billion). More than half of the securities available for trading are
listed and the balance are permitted to trade.
• Currently, the Exchange has 78 registered participants on the WDM segment
which includes 24 Public sector banks, 18 Foreign banks, 15 Private sector banks,
6 Primary dealers, 5 Financial institutions, the others being corporate bodies,
mutual funds and foreign debt fund.
 • Average daily value in the WDM segment increased from Rs. 2.4 crores in June-
94 to Rs. 298.17 crores in December -97 with a high of Rs. 1831.27 crores
recorded on 12-Aug-97.
• Net traded value in the WDM segment increased from Rs. 1096.25 crores in July
-94 to Rs. 7,752.52 crores in December-97 with a high of Rs. 15,545.40 crores
recorded in July '97.
• There has been a consistent increase in NSE’s share of the total volume of activity
in the market (gilt securities) over the period. Government securities along with
Treasury bills together account for over 80% of the total market activity.
• The share of the Exchange of the total market activity in Government Securities
and T-Bills has increased from a mere 22% in 1996 to 53% in 1997.

EDIFAR

EDIFAR is the Electronic Data Information Filing and Retrieval system. This is an
automated system for filing, retrieval and dissemination of time sensitive corporate
information which till now were being filed physically by the listed companies with the
stock exchanges in India. By centralising the information through on-line filing,
EDIFAR’s primary objective is to centralise the information and accelerate its
dissemination and by doing so enhance the transparency and efficiency for the benefit of
all the stakeholders in the securities market.

Conclusion
• Indian capital markets will grow at a high rate on account of FII investments for
about 5-10 years as long as Indian returns are uncorrelated and interest rate
differential persist.
• What is important however, that domestic capabilities should be built up to take
over from FIIs when their rate of capital infusion slows down in 10-15 years.
This will determine the growth of the economy after this period as the capital
markets by then would have become a more important source of funds for the
economy.