FICCI Capam 2012 Knowledge Paper

Developing Indian Capital Markets - The Way Forward

Knowledge Paper

CAPAM 2012

FICCIThe information and opinions contained in this document have been compiled or arrived at on the basis of the market opinion and does not necessarily reflect views of FICCI.FICCI does not accept any liability for loss however arising from any use of this document or its content or otherwise in connection herewith.

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India’s capital markets are characterised by vibrant equity markets and a debt market that is assuming more significance. The Indian government and regulator have announced several far-reaching reforms to promote capital markets and protect investors’ interest. However, certain emerging challenges as well as regulatory reforms are still on the radar for widening and deepening of markets. Applying the lessons and techniques that have already succeeded, India must continue to strengthen its markets.

The 9th edition of our flagship Capital Markets Conference (CAPAM) is therefore poised to discuss the way forward for the Indian capital markets and its various constituents. It endeavours to learn from international best practices and explore ways to increase retail participation, create a resilient bond market and lay the foundation for regulatory reform. The Knowledge paper of the event is a compendium of papers by McKinsey and members of FICCI’s Capital Markets Committee. The papers aim to analyse and suggest solutions for key issues pertaining to the primary and secondary markets, the challenges for insurance companies, asset management companies and private equity companies as investors, corporate finance and corporate governance matters and measures to enhance retail participation . FICCI’s endeavour is to build on this further and develop a concrete road map for the sector’s progress.

FICCI’s Capital Markets Committee, comprising key players of the sector, is chaired by Mr. Sunil Sanghai, M.D., Head of Global Banking-India, HSBC Ltd. and co-chaired by Mr. Anup Bagchi, M.D. & CEO, ICICI Securities Ltd. It has had in depth discussions with the Reserve Bank of India, Securities and Exchange Board of India, Ministry of Finance and market participants on the direction that the Indian capital markets need to take. This paper is a culmination of these deliberations. CAPAM is the ideal forum for the dissemination of these thoughts with a wider audience to gather their views in order to further enrich our work. But for Mr. Sunil Sanghai’s and Mr. Bagchi’s support, this task would have been difficult. We thank the entire McKinsey team and FICCI’s Capital Markets Committee members involved in this work for their timely and whole-hearted support in making this possible.

We hope you will find this report insightful.

Naina Lal KidwaiSenior Vice PresidentFICCI

Foreword

Contents

7

Theme Paper

Knowledge Paper CAPAM 2012 9

Developing Capital Markets - The Way Forward Prepared by: McKinsey & Company

Capital markets are the lifeline of an economy and offer three key benefits. First, a solid capital market spurs

economic development and growth in the real sector by directing capital to creditworthy companies. Second,

developed capital markets are conducive to the long-term development of a more stable financial system.

Finally, emerging economies with developed capital markets will integrate more smoothly into the global

market.

Development of the Global and Indian Capital Markets over the last Decade

The value of global capital markets doubled from USD 71 trillion in 2002 to USD 155 trillion in 2007. Since

then, the value of financial assets have stayed constant at USD 150 trillion levels, due to decline in equity

assets (Exhibit 1.1). Capital market assets have grown faster than GDP in the last 10 years; the penetration

(financial assets/GDP) increased from 175 per cent in 2002 to 234 per cent in 2011.

The United States and United Kingdom have significant share across key capital market products. The

United States is the largest equities market globally, with market share of 30, 50 and 25 per cent in equity

origination, cash equity trading and equity derivatives trading, respectively. Similarly, the United Kingdom

has a large fixed income marketplace which accounts for around 35 per cent of global foreign exchange

trading.

Developing the Indian Capital Market: The Way forward

1 1

Developing the Indian capital market Capital markets are the lifeline of an economy and offer three key benefits. First, a solid capital market spurs economic development and growth in the real sector by directing capital to creditworthy companies. Second, developed capital markets are conducive to the long-term development of a more stable financial system. Finally, emerging economies with developed capital markets will integrate more smoothly into the global market.

DEVELOPMENT OF THE GLOBAL AND INDIAN CAPITAL MARKETS OVER THE LAST DECADE

The value of global capital markets doubled from USD 71 trillion in 2002 to USD 155 trillion in 2007. Since then, the value of financial assets have stayed constant at USD 150 trillion levels, due to decline in equity assets (Exhibit 1.1). Capital market assets have grown faster than GDP in the last 10 years; the penetration (financial assets/GDP) increased from 175 per cent in 2002 to 234 per cent in 2011.

EXHIBIT 1.1

McKinsey & Company

Global Capital Markets have doubled during 2002-2007 period, but have been stagnant since then due to decline in equity assets

1 Outstanding market value of all listed equity securities (allocated by nationality of issuer)2 Outstanding face value of bank issues by federal, regional and local governments3 Nominal value of financial assets and GDP; average exchange rate for the year has been used to convert historical local currency data to USD

SOURCE: McKinsey Global Institute, Bank for International Settlements, Global Insight

Global financial assets as a percent of GDP3

Summary of global financial assets3

USD trillionsGrowth, Percent2002-07 2007-11

20

28

41 44 42

131413

2011

156

46

44

11

2009

151

47

37

9

2007

154

64

29

8

2005

110

43

24

6 9

2002

71

2316

5 6

Financial institutions bonds

Securitized loans

Stock market capitalization 1

Public debt securities 2

Non-Financial corporation bonds

234

275

175

201120072002

999

9

12

8

Size and penetration of Global Capital Market, 2002-2011

0010

1

12

-8

Exhibit 1.1

Developing Indian Capital Markets - The Way Forward10

The USD and Euro are the key currencies in which to hold international assets and trade capital market prod-

ucts (Exhibit 1.2).

Asian capital markets continue to grow faster than that of any other region – capital market assets of Asia

grew by 20 per cent between 2002-2007 and 3 per cent between 2007-2011 period (Exhibit 1.3). Similarly, fi-

nancial penetration (financial assets/GDP) of Asia increased from 158 per cent in 2002 to 170 per cent in 2011.

However, Asia’s financial penetration is still below Americas and EMEA financial penetration of 300 and 200

percent respectively.

Stronger growth in capital markets assets also benefited the intermediaries that support the origination and

trading of these instruments – Asia’s share in the global capital market and investment banking (CMIB) rev-

enue pool increased from 16 per cent in 2005 to 24 per cent in 2011.


2

The United States and United Kingdom have significant share across key capital market products. The United States is the largest equities market globally, with market share of 30, 50 and 25 per cent in equity origination, cash equity trading and equity derivatives trading, respectively. Similarly, the United Kingdom has a large fixed income marketplace which accounts for around 35 per cent of global foreign exchange trading.

The USD and Euro are the key currencies in which to hold international assets and trade capital market products (Exhibit 1.2).

EXHIBIT 1.2

McKinsey & Company 5|

U.S. and U.K. are the key contributors to global capital market; USD continues to be the key trading currency, closely followed by the EUR

100% = USD 82.9 trillion

Size of global markets by trading centers Size of global markets by currency

4.6

1.9

3.5

48.2

Cash equity trading, 2011 Equity derivatives trading1, 2011

153

1,404

243

3,476

FX trading, 20102

240163

494

¥£€$

1,073

FX trading, 2010

7827

464

226

Commodities trading, 2011

34

146

876

n/a

International bond outstanding, 2011

0.82.1

11.711.3

¥£€$

100% = 13,787 million contracts 100% = USD 1,264 trillion

100% = USD 1,264 trillion 100% = 2,750 million contracts 100% = USD 27.6 trillion

SOURCE: World Federation of Exchanges, Bank for International Settlements (BIS), Global Insight

1 Includes stock options and futures, and index options and futures; have added Euronext Liffe (pan-EU exchange) turnover data in UK2 Total of currencies would add-up to 2x of total FX trading due to double counting

Asian capital markets continue to grow faster than that of any other region – capital market assets of Asia grew by 20 per cent between 2002-2007 and 3 per cent between 2007-2011 period (Exhibit 1.3). Similarly, financial penetration (financial assets/GDP) of Asia increased from 158 per cent in 2002 to 170 per cent in 2011. However, Asia’s financial penetration is still below Americas and EMEA financial penetration of 300 and 200 percent respectively.

Stronger growth in capital markets assets also benefited the intermediaries that support the origination and trading of these instruments – Asia’s share in the global capital market and investment banking (CMIB) revenue pool increased from 16 per cent in 2005 to 24 per cent in 2011.

Exhibit 1.2


The last 10 years have seen global markets evolve and change as well. Some of the key changes in global

markets that have taken place recently include the following:

1. Trading is conducted electronically across asset classes

a. Equities trading is largely electronic; the proportion of electronic trading is 30-60 per cent for different

fixed income products

b. New trading venues and channels have emerged – about 50 per cent of total volumes are traded at

alternative platforms in Europe (around 15 per cent MTF, around 15 per cent dark pools, and around

20 per cent OTC)

c. Algorithmic strategies are now prominent. About 50 per cent of cash equity trading in United States is

driven by high frequency trading (HFT)

2. There have been rapid changes in the client mix and behaviour

a. Relationships and appetite/ability to lend are important than ever before when Corporates choose a

primary bank. Pricing and coverage are considered most important while allocating business

b. Buying needs significantly vary for investors. For equities, traditional investors value corporate access,

research and global coverage. Hedge funds have distinct needs including balance sheet and multi-

asset trading

c. There is cross-border flow of capital for both corporates and investors. More than half of equity and

fixed income investments in Asia originate from clients residing and taking investment decisions in

the western markets

Exhibit 1.3


3

EXHIBIT 1.3

McKinsey & Company

Asia has outperformed other regions- share in financial assets has risen from 19 percent in 2002 to 24 percent in 2011

46

2929

42

47

3130

39

64

28

34

3843

2233

45

23

1930

51

22

15

26

32

APACEMEAAmericas

Equity financial assets USD trillion, Percent of total

Growth, %2002-07 2007-11

SOURCE: Dealogic, McKinsey Global CMIB revenue pool database, World Federation of Exchanges

1 Includes financial/non-financial corp bonds, public debt securities and securitized loans

30

2011

110

23

33

44

2009

103

18

36

46

2007

90

1734

49

2005

68

19

51

2002

48

1928

53

Debt financial assets 1USD trillion, Percent of total

-8

-5

-11

-7

14

12

18

12

5

3

4

12

Growth, %2002-07 2007-11

156

2011

24

32

44

2007

154

22

34

44

2002

71

19

29

53

Total financial assets USD trillion, Percent

Growth, %2002-07 2007-11

17

13

21

20

0

0

-1

3

The last 10 years have seen global markets evolve and change as well. Some of the key changes in global markets that have taken place recently include the following:

1. Trading is conducted electronically across asset classes

a. Equities trading is largely electronic; the proportion of electronic trading is 30-60 per cent for different fixed income products

b. New trading venues and channels have emerged – about 50 per cent of total volumes are traded at alternative platforms in Europe (around 15 per cent MTF, around 15 per cent dark pools, and around 20 per cent OTC)

c. Algorithmic strategies are now prominent. About 50 per cent of cash equity trading in United States is driven by high frequency trading (HFT)

2. There have been rapid changes in the client mix and behaviour

a. Relationships and appetite/ability to lend are important than ever before when Corporates choose a primary bank. Pricing and coverage are considered most important while allocating business

b. Buying needs significantly vary for investors. For equities, traditional investors value corporate access, research and global coverage. Hedge funds have distinct needs including balance sheet and multi-asset trading


d. Clearing regulations are forcing many institutional investors to CCP platforms; even non-obligatory

corporate clients are shifting to CCP to avoid counter-party risk

3. Capital market service providers are consolidating, investing in capability building, and

optimising costs

a. There has been the acquisition/integration of investment and corporate banking businesses for both

foreign and local players

b. The largest players are expanding beyond the home market for future growth. The share of Asia CIB

revenue for the top 10 US/EU banks increased from 17 per cent in 2009 to 22 per cent in 2011

c. Global banks are investing large amounts in technology including multi-asset trading capabilities,

next generation of algorithms, and customising their technology platform for emerging markets

d. Measures are being taken to optimise costs – leading global banks reduced manpower by around

10,000 in the last year; levers (productivity, off-shoring, lean) are being pulled to reduce O&T costs but

the pace of change in cost per trade is slowing down, compelling banks to consider radical changes in

operating models

4. Regulations are having an impact on the trading and economics of the capital market business

a. Basel III regulations will have significant impact on the economics of businesses – ROE is expected to

fall from around 20 per cent to around 12 per cent once fully implemented

b. Volcker type regulations that restrict proprietary trading has resulted in a 50 to 90 per cent decline in

the proprietary trading revenue of leading global banks

c. There is uncertainty over the movement/impact of OTC derivatives products to exchanges/CCP clear-

ing. If it happens at scale, it will result in big shifts in trading volume, revenue margins, capabilities,

and competitor landscape

d. Shadow banking is on the rise. Private Equity players are entering investment banking and pension

funds are focusing on the lending business, etc.

Indian capital markets too have grown significantly over the last decade on the back of strong underlying

economic growth and financial market deepening. Value of financial assets (bonds and equity) increased

from USD 290 billion in 2002 to USD 1.9 trillion in 2011, and capital market penetration (financial assets/

GDP) increased from about 60 per cent in 2002 to about 100 per cent in 2011.

Continuing on the current growth path would make India USD 6 trillion to USD 8 trillion capital market

economy by year 2020 (Exhibit 1.4). Supporting 3-4X the size of current financial markets requires significant

changes across products, market infrastructure and microstructure, and legal and regulatory framework.



5

Indian capital markets too have grown significantly over the last decade on the back of strong underlying economic growth and financial market deepening. Value of financial assets (bonds and equity) increased from USD 290 billion in 2002 to USD 1.9 trillion in 2011, and capital market penetration (financial assets/GDP) increased from about 60 per cent in 2002 to about 100 per cent in 2011.

Continuing on the current growth path would make India USD 6 trillion to USD 8 trillion capital market economy by year 2020 (Exhibit 1.4). Supporting 3-4X the size of current financial markets requires significant changes across products, market infrastructure and microstructure, and legal and regulatory framework.

EXHIBIT 1.4

McKinsey & Company

India is a USD 1.9 trillion capital market economy today. Continuing on current growth trajectory would make India USD 6-8 trillion economy by year 2020

1 Includes financial and non-financial corporate bonds, public debt securitized, securitized loans and equity market capitalisation2 2011 penetration for India has been used for base case, while 1.2x of base case data for optimistic case forecast of financial assets3 Financial assets as a percent of GDP4 At 2011 constant exchange rate

SOURCE: MGI, Global Insight, EIU, McKinsey analysis

Growth of Indian financial assets1

USD billion

0.6 0.90.6

1.2 1.0

0.50.30.2

1.80.1

2002

0.3

2011

1.9

2009

1.8

2007

2.3

2005

0.8

Are we prepared for USD 6 to 8 trillion capital market economy in terms of

▪ Products

▪ Market infrastructure and microstructure

▪ Legal and regulatory framework

▪ Financial intermediationEQ3

Debt3

6.6

Optimistic

4.2

3.7

7.9

3.5

3.1

Base

Debt Equity

2020 2,4

26 66 152 93 53 53 64

32 35 42 51 47 47 56

Some of the significant changes in Indian capital markets over the last decade are

1. Traditional product markets deepened (Exhibit 1.5)

a. Capital market assets increased by about 6 times from 0.3 trillion (58 per cent of GDP) to 1.9 trillion (100 per cent of GDP)

b. Cash equities trading increased by 2x, while futures and options trading increased by 25x and 225x, respectively

c. The issuance of syndicated loans increased by 40x to INR 3.8 trillion

d. The issuance of corporate bonds increased by 14x to INR 1.6 trillion


6

EXHIBIT 1.5

McKinsey & Company

0.40.1

2012

1.6

09

0.8

062003

3.8

0.60.1

201209

1.6

062003

24

2012

34

09

38

062003

9

2012

78

09

71

06

43

2003

3 51

06 2012

243

09

40

2003

1.7

0.8 0.7

201209062003

0

ECM issuance

Cash Equity trading Equity Futures trading Equity Options trading

Corporate bond issuance Syndicated loan issuance

Traditional product markets have deepenedOrigination and trading of capital market products, FY 2003-FY 2012INR trillion

SOURCE: Dealogic, SEBI, NSE

-21 1829

-9 -9 9434 103 74

146 38 82

xxCAGR

2003-082008-12xx

2. New products were introduced (Exhibit 1.6)

a. Qualified institutional placement (QIP) was introduced to meet capital needs

b. Exchange trading of FIC (FX, Rates, Credit) products was introduced

c. Exchange traded funds (ETF) in gold, equity and fixed income were introduced

d. Credit default swaps (CDS) was introduced to hedge corporate bond exposure

e. Institutional private placement (IPP) and offer for sale (OFS) introduced recently to help corporates raise funds to meet minimum public shareholding requirements

The market has responded positively to some of these changes from regulator. For example, QIP was introduced to help companies raise fund onshore in quick time and check the growth of ADR/GDR. After its launch since 2007, about INR 100,000 crores have been rasied via QIP route in local markets, which is higher than funds raised via ADR/GDR route during the same period. Similarly, ETFs are now an asset class worth INR 11,500 crores from virtually nothing 5 years ago.

The regulators will, therefore, need to keep liberalizing and innovating for driving growth in the Indian capital markets, while at the same time upgrading capabilities to monitor and manage risk.

Exhibit 1.4

Exhibit 1.5

Some of the significant changes in Indian capital markets over the last decade are

1. Traditional product markets deepened (Exhibit 1.5)

a. Capital market assets increased by about 6 times from 0.3 trillion (58 per cent of GDP) to 1.9 trillion (100 per cent of GDP)

b. Cash equities trading increased by 2x, while futures and options trading increased by 25x and 225x, respectively

c. The issuance of syndicated loans increased by 40x to INR 3.8 trillion

d. The issuance of corporate bonds increased by 14x to INR 1.6 trillion


2. New products were introduced (Exhibit 1.6)

a. Qualified institutional placement (QIP) was introduced to meet capital needs

b. Exchange trading of FIC (FX, Rates, Credit) products was introduced

c. Exchange traded funds (ETF) in gold, equity and fixed income were introduced

d. Credit default swaps (CDS) was introduced to hedge corporate bond exposure

e. Institutional private placement (IPP) and offer for sale (OFS) introduced recently to help corporates

raise funds to meet minimum public shareholding requirements

The market has responded positively to some of these changes from regulator. For example, QIP was

introduced to help companies raise fund onshore in quick time and check the growth of ADR/GDR. After its

launch since 2007, about INR 100,000 crores have been rasied via QIP route in local markets, which is higher

than funds raised via ADR/GDR route during the same period. Similarly, ETFs are now an asset class worth

INR 11,500 crores from virtually nothing 5 years ago.

The regulators will, therefore, need to keep liberalizing and innovating for driving growth in the Indian

capital markets, while at the same time upgrading capabilities to monitor and manage risk.Developing the Indian Capital Market: The Way forward

7

EXHIBIT 1.6

McKinsey & Company

10

233

432

201211102009

2

170

936144

11102009 2012

New products have been introduced to meet investor and issuer needsTrading and origination of Capital Market products, FY 2009-FY 2012

SOURCE: Dealogic, SEBI, NSE

Currency futures

Sec lending and borrowing ETF trading1

QIP origination

1 Includes Gold, Equity and Fixed Income products

3433

18

2

201211102009

738

71

201211

111

102009

Many new products have been introduced recently to meet originator and investor requirements

▪ Credit default swaps (CDS)▪ Institutional private

placement (IPP)▪ Offer for sale (OFS) in stock

exchange▪ Indian depository receipts

(IDR)

INR trillion INR billion

Traded quantity in lakh INR billion

3. Investor participation broadened (Exhibit 1.7)

a. FII investment limit was enhanced in corporate bonds and G-Sec to USD 20 billion each

b. FII registration was made easier which saw a 3x increase in registration from 500 in 2003 to around 1800 now

c. Qualified foreign investors (QFIs) were allowed to invest and investment norms were further eased recently

d. The e-IPO and minimum share allotment has been introduced to enhance retail participation

e. The investor protection and education fund enhanced awareness

Exhibit 1.6

3. Investor participation broadened (Exhibit 1.7)

a. FII investment limit was enhanced in corporate bonds and G-Sec to USD 20 billion each

b. FII registration was made easier which saw a 3x increase in registration from 500 in 2003 to around

1800 now



8

EXHIBIT 1.7

McKinsey & Company

Investment in DebtInvestment in Equity

Investor participation has broadened- FII exampleForeign Institutional Investor (FII) participation in Equity and Debt marketFY 2003-FY 2012

437

488

201209

-477

062003

25882

20121

6,278

1,767

09

4,967

1,635

062003

502

17 37

500

2

201209

19

06

-73

2003

89INR Billion INR Billion

Sub-account

FII

# registrations

SOURCE: SEBI handbook

1 As on December 2011

xx CAGR

4. Infrastructure and governance were strengthened (Exhibit 1.8)

a. SME exchanges were set up recently in which three companies have been listed and there are more than 10 in the pipeline

b. DMA, co-location services, and smart order routing were introduced. These contributed around 30 per cent of cash equity trading (in June 2012)

c. The number of independent directors on companies boards is increased

Exhibit 1.7

4. Infrastructure and governance were strengthened (Exhibit 1.8)

a. SME exchanges were set up recently in which three companies have been listed and there are more

than 10 in the pipeline

b. DMA, co-location services, and smart order routing were introduced. These contributed around 30 per

cent of cash equity trading (in June 2012)

c. The number of independent directors on companies boards is increased

c. Qualified foreign investors (QFIs) were allowed to invest and investment norms were further eased

recently

d. The e-IPO and minimum share allotment has been introduced to enhance retail participation

e. The investor protection and education fund enhanced awareness



9

EXHIBIT 1.8

McKinsey & Company

Capital market infrastructure has been strengthened-SME Exchanges have started and received a good response

1 Only applicable for NSE “EMERGE” platform

SOURCE: SEBI, BSE, Press reports

EXAMPLE

Good response so far from market intermediaries and companies

Intermediaries▪ 2 exchanges have started this year-

BSE has launched “BSE SME exchange”, and NSE has launched “Emerge” platform

▪ ~30 intermediaries have registered as market makers

Companies▪ 2 companies have listed on BSE

SME platform, and 1 on NSE▪ DRHP of 10 more companies

already cleared by exchanges for IPO

▪ Both BSE and NSE hopes to list ~10 companies each on their platform in FY 2013, and ~100 companies over the subsequent 18 months

Regulations have been eased/modified to get companies to list on SME platform▪ Companies with issuer capital of upto INR 10 crore can

be listed on SME exchange▪ Submit only half-yearly financial results and are exempted

from giving detailed annual report▪ Criteria of minimum average pre-tax operating profit of

INR 15 crore for IPO on main exchange will force companies to list on SME platform

Strong surveillance in-place for investor protection▪ Mandatory UW, including 15% on own account▪ Market-markers to provide liquidity for a period of

atleast 3 years▪ Minimum IPO and trading lot of INR 1 lakh▪ IPO to be graded, and independent research report for

the listed company1

▪ Trading via “call auction” and “continuous trading”1

Steps taken to promote growth of SME exchange

India continues to integrate with the global economy and market. International revenue of the top 100 companies in India by market capitalisation rose from 17 per cent in 2002 to 29 per cent in 2009. Similarly, there has been a significant increase in cross-border capital market activity (Exhibit 1.9).

EXHIBIT 1.9


India continues to integrate with global economy and market

112

22

4

1725 29

8375 71

200920062002

XX No. of deals

Top 100 companies in India by market capitalization, Percent

M&A advisory

194129252136

15

115

ECM issuance

16136355

3 62

201120091

20072005

DCM issuance

142105

International issuances of Indian companiesUSD billion

Contribution of international revenue to total revenue

SOURCE: McKinsey Asia Centre, Dealogic


9

EXHIBIT 1.8

McKinsey & Company

Capital market infrastructure has been strengthened-SME Exchanges have started and received a good response

1 Only applicable for NSE “EMERGE” platform

SOURCE: SEBI, BSE, Press reports

EXAMPLE

Good response so far from market intermediaries and companies

Intermediaries▪ 2 exchanges have started this year-

BSE has launched “BSE SME exchange”, and NSE has launched “Emerge” platform

▪ ~30 intermediaries have registered as market makers

Companies▪ 2 companies have listed on BSE

SME platform, and 1 on NSE▪ DRHP of 10 more companies

already cleared by exchanges for IPO

▪ Both BSE and NSE hopes to list ~10 companies each on their platform in FY 2013, and ~100 companies over the subsequent 18 months

Regulations have been eased/modified to get companies to list on SME platform▪ Companies with issuer capital of upto INR 10 crore can

be listed on SME exchange▪ Submit only half-yearly financial results and are exempted

from giving detailed annual report▪ Criteria of minimum average pre-tax operating profit of

INR 15 crore for IPO on main exchange will force companies to list on SME platform

Strong surveillance in-place for investor protection▪ Mandatory UW, including 15% on own account▪ Market-markers to provide liquidity for a period of

atleast 3 years▪ Minimum IPO and trading lot of INR 1 lakh▪ IPO to be graded, and independent research report for

the listed company1

▪ Trading via “call auction” and “continuous trading”1

Steps taken to promote growth of SME exchange

India continues to integrate with the global economy and market. International revenue of the top 100 companies in India by market capitalisation rose from 17 per cent in 2002 to 29 per cent in 2009. Similarly, there has been a significant increase in cross-border capital market activity (Exhibit 1.9).

EXHIBIT 1.9


India continues to integrate with global economy and market

112

22

4

1725 29

8375 71

200920062002

XX No. of deals

Top 100 companies in India by market capitalization, Percent

M&A advisory

194129252136

15

115

ECM issuance

16136355

3 62

201120091

20072005

DCM issuance

142105

International issuances of Indian companiesUSD billion

Contribution of international revenue to total revenue

SOURCE: McKinsey Asia Centre, Dealogic

Exhibit 1.8

Exhibit 1.9

India continues to integrate with the global economy and market. International revenue of the top 100

companies in India by market capitalisation rose from 17 per cent in 2002 to 29 per cent in 2009. Similarly,

there has been a significant increase in cross-border capital market activity (Exhibit 1.9).


Although there are clear benefits to integrating with the global markets, it is crucial for policy makers to

mitigate a few challenging risks

– Benefitsofintegrationwithglobalmarkets

○ Access to international debt markets is less volatile than access to international banking markets

○ The cost of capital decreases because of access to a wider, more diverse set of investors

○ There is better diversification of funding sources

○ The domestic market develops faster by leveraging global standards and practices and skills for inter-national intermediaries, for example, additional pressure to increase transparency and adopt tested international standards

○ The increased competition decreases the cost of intermediation, thereby making capital markets more

attractive

– Risks of international integration

○ Lack of effective hedging mechanisms, inconsistent transparency requirements, and lack of a well-defined global infrastructure can make emerging economy markets more volatile, with a potential negative impact on the economy

○ Integration in a broader capital market exposes local markets to greater price integration – that is, it makes the pricing of assets in one geography dependent on pricing changes and potential shocks in other geographies

○ Currency risks increase

○ Domestic institutions potentially decrease in importance as large international competitors enter the

market

Capital Market Penetration in India and its Role in Supporting Economic Growth

Though India’s capital markets have grown in the last decade, there is significant room for growth when com-

pared with developed economies (Exhibit 2.1). Most developed markets’ financial depth is over 2.5 times that

of India, with sophisticated capital markets allowing corporations and government to raise more funds for

productive investments. However, the development of capital markets requires a good institutional frame-

work, which allows the free movement of capital both within a country and across borders.



11

requires a good institutional framework, which allows the free movement of capital both within a country and across borders.

EXHIBIT 2.1


India’s capital markets have significant room for growthwith financial depth still lagging that of developed markets

0

50

100

150

200

250

300

350

400

450

500

1,000 10,000 100,000

Financial depth1, Value of bonds, and equity as a percentage of GDPPercent of GDP

GDP per capita at purchasing power parity$ per person, log scale

USUK

Thailand

SwitzerlandSpain

South Africa

Singapore

Russia

Philippines Mexico

Malaysia

Korea

Japan

Italy

Israel

Ireland

IndonesiaIndia

Hong Kong

Greece

Germany

France

Finland

China

Canada

Brazil Australia

Argentina

2011, end of period

Dee

per f

inan

cial

mar

kets

SOURCE: McKinsey Global Institute Financial Stock Database 2012

Emerging

Developed

1 Includes equity market capitalization, corporate/FI bonds, govt securities, and securitized loans

Equity penetration in India at 80 per cent of GDP (2009-11) is comparable to large markets but is prone to frequent fluctuations. In-addition, cost of trading is relatively high, institutional participation is low, and market liquidity beyond top stocks is low (Exhibit 2.2).

Similarly, India’s G-sec market is fairly large, but lacks liquidity across maturities. However, the largest challenge in India is in the corporate bond market, where both the size and liquidity of the markets is low (Exhibit 2.3).


12

EXHIBIT 2.2


India is comparable with large markets w.r.t. Equity penetration, but scores low on liquidity, cost of trading and institutional participationBenchmarking the depth of Indian equity market

SOURCE: Elkins McSherry, WFE, Bloomberg, Dealogic, Global Insight, McKinsey Global Institute

Mature markets benchmarks(US, UK and Germany)

▪ Institutional share range between 70-90 percent

Institutional participation(2011)

▪ Lowest globally due to low taxes- range between 15-20 bps

Cost of trading(2010)

▪ Top-5 percent shares by turnover have ~80 percent share in market turnover

▪ Trading velocity of 1.5x (turnover 1-leg/m-cap)

▪ High free float. Range between 80-90 percent

Market liquidity(2011)

▪ Average equity market penetration (m-cap/GDP) of 105 percent

▪ Average ECM issuances range between USD 30-250 billion per year

Size of equity market (2009-11)

Criteria China

▪ Institutional share of ~30 percent (all from DII’s)

▪ Highest in Asia at ~70 bps, due to high market impact cost

▪ Liquidity penetrated across broader market- top 5 percent shares only have ~30 percent share in market turnover

▪ Trading velocity of 1.9x▪ Free float of ~50 percent

▪ High penetration of ~80 percent, but its highly volatile

▪ Average ECM issuance of > USD 100 billion (including H-shares) per year

India

▪ Institutional share of ~25 percent; FII share of ~18 percent

▪ ~44 bps, equally split between commission and fee/market impact

▪ In-line with mature markets-top 5 percent shares have 70 percent share in market turnover

▪ Low velocity of 0.7x▪ Low free float of ~40 percent

▪ High penetration ~80 percent, but its highly volatile

▪ Average ECM issuances of USD 17 billion per year

EXHIBIT 2.3


Indian G-Sec market is fairly large, but lacks liquidity across maturities; in-addition, size and liquidity in Corporate bond market is lowBenchmarking the depth of Indian debt market

SOURCE: Bank for International Settlements (BIS), McKinsey Global Institute, CCIL, SIFMA, Dealogic, Wind

United States

▪ Capital market is the primary source of capital- Corp bond has 39 percent share in total capital raised by Corp/FI

Corp debt profile(2011)


Size of outstanding debt market-Gsec and Corp bonds(2009-11)

Benchmark yield curve

Criteria China

▪ Bilateral loans are the primary source of capital-Corp bond has 15% share in total capital raised

India


▪ High G-Sec penetration of ~90 percent (G-Sec/GDP)

▪ Corp bond penetration is ~110 percent (Corp bond/ GDP)

▪ Average issuance per year– GSec ~USD 2,200 bn– Corp bonds ~USD 700 bn

▪ Low G-Sec penetration of ~26 percent

▪ Fast growing Corp bond market- penetration of 24 percent

▪ Average issuance per year– GSec ~USD 280 bn– Corp bonds ~USD 200 bn


▪ Underdeveloped Corp bond market- penetration of 5 percent


▪ G-Sec trading velocity of 11x, and Corp bond trading velocity of 0.4x

▪ G-Sec trading velocity of 0.9x, and Corp bond trading velocity of 0.5x

▪ Top-5 securities have 10 percent share in total trading


▪ G-Sec trading concentrated- 2 long dated papers have 85 percent share

▪ Market determined yield curve across maturities

▪ High liquidity across maturities resulting into a fairly good yield curve

▪ Market determined yield curve only for longer term maturity- 8 to 12 years

Going forward, India will require INR 145 trillion over the next 5 years to ensure GDP growth of 7.5 per cent, while gradually lowering inflation to 6 per cent and

Exhibit 2.1

Exhibit 2.2

Equity penetration in India at 80 per cent of GDP (2009-11) is comparable to large markets but is prone to

frequent fluctuations. In-addition, cost of trading is relatively high, institutional participation is low, and

market liquidity beyond top stocks is low (Exhibit 2.2).

Similarly, India’s G-sec market is fairly large, but lacks liquidity across maturities. However, the largest

challenge in India is in the corporate bond market, where both the size and liquidity of the markets is low

(Exhibit 2.3).


Exhibit 2.3


13

achieving 2.5 per cent growth in capital productivity (Exhibit 2.4). The capital requirement is also set to increase given Basel III norms and funding for infrastructure growth. Primarily, these needs would be met by internal accruals, bank credit and net foreign borrowings but around INR 26 trillion would be required from capital markets. The business as usual growth of capital markets would provide around INR 15 trillion but the gap of around INR 11 trillion must be bridged through critical reforms (Exhibit 2.5).

EXHIBIT 2.4


FY 17

14000-15000

FY 16

3100-3200

FY 15

2850-2950

FY 14

2650-2750

FY 13

2350-2450

Total capital requirement

3300-3400

In India, ~Rs. 145 trillion of capital will be required over the next 5 years to ensure 7.5% GDP growth rate from next fiscal onwards

SOURCE: RBI; SEBI; NAS; McKinsey analysis

▪ GDP growth rate: 7.0% for FY13 and 7.5% for FY14-17

▪ Inflation: 8.90% in FY12decreasing to 6% in FY17

▪ Capital productivity:Increasing at ~2.5% annually

Assumptions

Capital required till FY17 (FY12–17)

INR ‘000 crore

Capital requirement expected to be higher with Basel III norms and infrastructure growth funding

Exhibit 2.4

Going forward, India will require INR 145 trillion over the next 5 years to ensure GDP growth of 7.5 per cent,

while gradually lowering inflation to 6 per cent and achieving 2.5 per cent growth in capital productivity

(Exhibit 2.4). The capital requirement is also set to increase given Basel III norms and funding for infrastructure

growth. Primarily, these needs would be met by internal accruals, bank credit and net foreign borrowings

but around INR 26 trillion would be required from capital markets. The business as usual growth of capital

markets would provide around INR 15 trillion but the gap of around INR 11 trillion must be bridged through

critical reforms (Exhibit 2.5).


12

EXHIBIT 2.2


India is comparable with large markets w.r.t. Equity penetration, but scores low on liquidity, cost of trading and institutional participationBenchmarking the depth of Indian equity market

SOURCE: Elkins McSherry, WFE, Bloomberg, Dealogic, Global Insight, McKinsey Global Institute

Mature markets benchmarks(US, UK and Germany)

▪ Institutional share range between 70-90 percent

Institutional participation(2011)

▪ Lowest globally due to low taxes- range between 15-20 bps


▪ Top-5 percent shares by turnover have ~80 percent share in market turnover

▪ Trading velocity of 1.5x (turnover 1-leg/m-cap)

▪ High free float. Range between 80-90 percent


▪ Average equity market penetration (m-cap/GDP) of 105 percent

▪ Average ECM issuances range between USD 30-250 billion per year

Size of equity market (2009-11)

Criteria China

▪ Institutional share of ~30 percent (all from DII’s)

▪ Highest in Asia at ~70 bps, due to high market impact cost

▪ Liquidity penetrated across broader market- top 5 percent shares only have ~30 percent share in market turnover

▪ Trading velocity of 1.9x▪ Free float of ~50 percent

▪ High penetration of ~80 percent, but its highly volatile

▪ Average ECM issuance of > USD 100 billion (including H-shares) per year

India

▪ Institutional share of ~25 percent; FII share of ~18 percent

▪ ~44 bps, equally split between commission and fee/market impact

▪ In-line with mature markets-top 5 percent shares have 70 percent share in market turnover

▪ Low velocity of 0.7x▪ Low free float of ~40 percent

▪ High penetration ~80 percent, but its highly volatile

▪ Average ECM issuances of USD 17 billion per year

EXHIBIT 2.3


Indian G-Sec market is fairly large, but lacks liquidity across maturities; in-addition, size and liquidity in Corporate bond market is lowBenchmarking the depth of Indian debt market

SOURCE: Bank for International Settlements (BIS), McKinsey Global Institute, CCIL, SIFMA, Dealogic, Wind

United States

▪ Capital market is the primary source of capital- Corp bond has 39 percent share in total capital raised by Corp/FI

Corp debt profile(2011)


Size of outstanding debt market-Gsec and Corp bonds(2009-11)

Benchmark yield curve

Criteria China


India


▪ High G-Sec penetration of ~90 percent (G-Sec/GDP)

▪ Corp bond penetration is ~110 percent (Corp bond/ GDP)

▪ Average issuance per year– GSec ~USD 2,200 bn– Corp bonds ~USD 700 bn


▪ Fast growing Corp bond market- penetration of 24 percent



▪ Underdeveloped Corp bond market- penetration of 5 percent


▪ G-Sec trading velocity of 11x, and Corp bond trading velocity of 0.4x


▪ Top-5 securities have 10 percent share in total trading


▪ G-Sec trading concentrated- 2 long dated papers have 85 percent share

▪ Market determined yield curve across maturities

▪ High liquidity across maturities resulting into a fairly good yield curve

▪ Market determined yield curve only for longer term maturity- 8 to 12 years

Going forward, India will require INR 145 trillion over the next 5 years to ensure GDP growth of 7.5 per cent, while gradually lowering inflation to 6 per cent and



14

EXHIBIT 2.5


5,300

5,900

2,550

14,500

Gap to be bridged by capital markets1

Net foreign borrowings

750

Bank creditInternal accruals

Total capital requirement

~1450

~INR 26 trillion capital will be required from the capital marketsto ensure ~7.5% GDP growth for the next 5 years

SOURCE: RBI; SEBI; NAS; McKinsey analysis

1 Public and private capital market excluding bank borrowing

Capital that can be raised w/o reforms

xx▪ GDP growth rate: 7.0% for FY13 and 7.5% for FY14-17

▪ Deposit growth: Bank deposit growth – 17-19%

▪ Bank CD ratio:75-76% NBFCCD ratio: 85%

▪ Corporate savings rate:~8%

▪ Net foreign borrowing:~1.2% of GDP

Assumptions Requirement from capital market

Rs. ‘000 crore

BAU growth in capital markets will only provide ~INR 14.5 trillion of capital; ~INR 11 trillion gap to be bridged by reforms

.

KEY REFORMS TO DEVELOP A VIBRANT MARKET

To meet the additional capital required for growth including Basel III requirements and infrastructure funding needs in India, key policy decisions must drive along three key themes across debt and equity.

1. Create a diversified investor base

2. Strengthen the equities microstructure and market infrastructure

3. Drive changes and growth in the debt markets

Create a diversified investor base A deep and broad investor base with a range of investment styles and objectives is required to provide a combination of liquidity and long-term stability. Three distinct categories of investors have a complementary role in market development as they pursue diverse market and investment strategies with diverse objectives and time horizons (Exhibit 3.1).

■ Buy and hold

■ Buy and turn

■ Dynamic investors

Exhibit 2.5

Key Reforms to Develop a Vibrant Market

To meet the additional capital required for growth including Basel III requirements and infrastructure funding

needs in India, key policy decisions must drive along three key themes across debt and equity.

1. Create a diversified investor base

2. Strengthen the equities microstructure and market infrastructure

3. Drive changes and growth in the debt markets

CreateadiversifiedinvestorbaseA deep and broad investor base with a range of investment styles and objectives is required to provide a

combination of liquidity and long-term stability. Three distinct categories of investors have a complementary

role in market development as they pursue diverse market and investment strategies with diverse objectives

and time horizons (Exhibit 3.1).

Buy and hold•

Buy and turn•

Dynamic investors•

Each category defines critical factors of market development including market liquidity, stability and

efficiency, skill pool and infrastructure building (Exhibit 3.2).



15

Each category defines critical factors of market development including market liquidity, stability and efficiency, skill pool and infrastructure building (Exhibit 3.2).

EXHIBIT 3.1

McKinsey & Company

Three distinct categories of investors have a complementary role in market development as they pursue diverse market and investment strategies with diverse objective and time horizon

Buy & turn

Pension funds -defined benefits

Insurance companies

Mutual funds

Retail investors

Pension funds -defined contribution

Banks Active traders and arbitrators/ proprietary trading desks

Alternative Investors▪ Specialized

funds▪ High net worth

individuals▪ Investment

bankExamplesRol

e

Market depth and long term funding

Herd behaviour

Kill liquidity

Leverage

Investment objectives

▪ Seek high relative returns above benchmark

▪ Seek high absolute returns

▪ Employ variety of strategies to minimize risks, and generate high returns

▪ Seek safe, predictable, average returns

▪ Match future liabilities with investment income

Risks associated

SOURCE: Interviews; McKinsey analysis

EXHIBIT 3.2

McKinsey & Company

Each investor category defines critical factorsof market development


Market efficiency ▪ Price discovery

“Buy and hold”

“Buy and turn”Critical factors of market development

“Dynamicinvestors”

Market liquidity ▪ Tightness – i.e., small bid/ask spreads

▪ Depth – i.e., size of pool

▪ Resilience – i.e., adjustment speed

Market stability ▪ Avoid herd behavior

▪ Avoid feedback tracking

Skill pool ▪ Investments skills– Credit assessment

– Investment sophistication

▪ Trading skills

▪ Use of product innovation

▪ Arbitrage skills

Infrastructurebuilding

▪ Need for rating agencies

▪ Need for clearing systems

▪ Help building legal infrastructure

High contributorAveragePoor contributor


15

Each category defines critical factors of market development including market liquidity, stability and efficiency, skill pool and infrastructure building (Exhibit 3.2).

EXHIBIT 3.1

McKinsey & Company

Three distinct categories of investors have a complementary role in market development as they pursue diverse market and investment strategies with diverse objective and time horizon

Buy & turn

Pension funds -defined benefits

Insurance companies

Mutual funds

Retail investors

Pension funds -defined contribution

Banks Active traders and arbitrators/ proprietary trading desks

Alternative Investors▪ Specialized

funds▪ High net worth

individuals▪ Investment

bankExamplesRol

e

Market depth and long term funding

Herd behaviour

Kill liquidity

Leverage

Investment objectives

▪ Seek high relative returns above benchmark

▪ Seek high absolute returns

▪ Employ variety of strategies to minimize risks, and generate high returns

▪ Seek safe, predictable, average returns

▪ Match future liabilities with investment income

Risks associated


EXHIBIT 3.2

McKinsey & Company

Each investor category defines critical factorsof market development


Market efficiency ▪ Price discovery

“Buy and hold”

“Buy and turn”Critical factors of market development

“Dynamicinvestors”

Market liquidity ▪ Tightness – i.e., small bid/ask spreads

▪ Depth – i.e., size of pool

▪ Resilience – i.e., adjustment speed

Market stability ▪ Avoid herd behavior

▪ Avoid feedback tracking

Skill pool ▪ Investments skills– Credit assessment

– Investment sophistication

▪ Trading skills

▪ Use of product innovation

▪ Arbitrage skills

Infrastructurebuilding

▪ Need for rating agencies

▪ Need for clearing systems

▪ Help building legal infrastructure

High contributorAveragePoor contributor

Exhibit 3.1

Exhibit 3.2

Four key reforms are required across investor categories to enhance their participation in capital markets:

■ Drive household savings to capital market products

■ Promote growth in mutual fund AUM through improved distribution

■ Build retirement participation for pension AUM growth with the New Pension scheme (NPS)

■ Relax capital market investment restrictions on insurance and pension/ provident funds


■ Drive household savings to capital market products:Indian households still pool 50 per cent of their savings in the form of physical assets at over twice the

share seen in developed economies and even developing economies such as Malaysia (Exhibit 3.3).

Even within the household financial savings share, only 8 per cent are invested in capital markets with

currency and deposits forming the bulk of the total financial savings (Exhibit 3.4).


16

Four key reforms are required across investor categories to enhance their participation in capital markets:

■ Drive household savings to capital market products


■ Build retirement participation for pension AUM growth with the New Pension scheme (NPS)

■ Relax capital market investment restrictions on insurance and pension/ provident funds

■ Drive household savings to capital market products:

Indian households still pool 50 per cent of their savings in the form of physical assets at over twice the share seen in developed economies and even developing economies such as Malaysia (Exhibit 3.3). Even within the household financial savings share, only 8 per cent are invested in capital markets with currency and deposits forming the bulk of the total financial savings (Exhibit 3.4).

EXHIBIT 3.3

McKinsey & CompanySOURCE: Central bank websites

Financial

Physical

… and the share of physical savings has been consistent over 10 yearsINR ‘000 crore

Stock of physical savings is much higher in India than in other geographies…USD trillion, 2008

Developed economies

Developing economy

Germany 1350 50

US 11533 67

India 370 30

Malaysia 134 66

51 56 50

49 44 50

FY 10

1,550

FY 05

725

FY 02

504

Indian household savings invested in physical assetsmust be lowered to reach the level of developed economies

DRIVE HOUSEHOLD SAVINGS TO CAPITAL MARKET PRODUCTS


17

EXHIBIT 3.4

McKinsey & Company

1 Deposits with SCBs constitute >95% of the total depoits2 Excluding mutual funds for FY00 to FY08 and including mutual funds in FY103 Government claims include investment in government securities and investment in small savings

SOURCE: RBI, CSO

26

2128

15

13

14

1916

20

2417

24 28 25 23 36

54

10 11 14 1315 11

2114 10

1619Insurance funds

Equities and debentures2

MF

Deposits1

Currency

FY10

761

0

11

FY06

419

26

FY04

313100% =

0

FY02

247

2

0

FY00

207

48

8

FY08

551

-5

Claims on Govt3

Pension and Provident funds

6

1

Higher proportion of household savings should be directed towards capital market products

INR ‘000 crore, Percent of total

Split of total household financial savings in India


The following proactive steps will help drive household savings into capital market products.

– Replicate risk/returns of physical investments through capital market linked products such as gold ETFs and gold saving scheme to drive retail participation. Support these by educating customers through RMs and IFAs to increase their familiarity with the products. Broker sales channels and bank tie ups with AMCs can also maximise reach to retail investors

– Drive individual product market changes (ETFs, mutual funds). Launch direct investments through real estate investment schemes (REIS) to address investor needs not fulfilled by present alternatives. Attune the risk profile to cater to the risk appetite of different segments; for example, low risk segments can invest in ready properties for assured rental income, while high risk ones can invest in upcoming properties for capital appreciation

– Deepen reach into tier 2/3 cities coupled with investor education programmes. Currently, the top eight cities account for almost three-fourths of the mutual fund ownership while only holding one-third of the overall income pool. Expand into tier 2/3 cities through investor education programmes along the lines of developed economies with deeper financial markets such as Germany (Exhibit 3.5).

Exhibit 3.3

Exhibit 3.4



18

Korea witnessed a 50 per cent CAGR in life insurance premium over a decade after an integrated set of awareness building moves from the government and regulator. Korea’s Department of Treasury announced 1977 as the “Year of Insurance”. The government promoted insurance extensively through television commercials, short movies and newspaper advertisements. Insurance was made a priority industry in the national economic growth plan. An insurance modernisation plan was formed to better promote product development, channel management and asset management. These initiatives increased the insurance premium at 50 per cent CAGR between 1977 and 1988.

EXHIBIT 3.5

McKinsey & CompanySOURCE: BVI, nur-fuer-alle.de

Investor education program example: Marketing/education campaign by German fund association- “Investment funds. Only for everybody."

▪ German fund association BVI, in which most AMs in Germany are represented, launched educational campaign "Investment funds. Only for everybody." in October 2010

▪ The website has four main sections

– "How investing money works"

– "These are funds"

– "There you find funds"

– "Successful with funds"

▪ The language used on the website is very simple and informal, targeted at people without any knowledge in finance

▪ Paragraphs which explain a subject are held short, no information overload

▪ Some subjects are explained with little, interactive comics making a topic very intuitive

▪ A question box allows to ask any question related to funds without prior registration, a BVI representative answers publicly in a short and simple way

▪ Download section with one-page overviews on different fund related topics, e.g. "10 questions regarding to investing in a fund"

▪ Working paper for download explaining how investment funds help the society

▪ Represented in major social networks to increase awareness



Entry load abolishment in 2009 drastically reduced the incentives for distributors affecting new business growth (Exhibit 3.6). Lower industry profitability due to stable operating costs and declining revenues is also affecting channel margins available to distributors. To promote growth in mutual funds AUM, following measures could be taken

– Introduce a variable load regime (entry and exit) to cater to different distribution channels for growth beyond the top 10 cities.

Exhibit 3.5

The following proactive steps will help drive household savings into capital market products.

Replicate risk/returns of physical investments through capital market linked products such as gold •

ETFs and gold saving scheme to drive retail participation. Support these by educating customers

through RMs and IFAs to increase their familiarity with the products. Broker sales channels and bank

tie ups with AMCs can also maximise reach to retail investors

Drive individual product market changes (ETFs, mutual funds). Launch direct investments through •

real estate investment schemes (REIS) to address investor needs not fulfilled by present alternatives.

Attune the risk profile to cater to the risk appetite of different segments; for example, low risk segments

can invest in ready properties for assured rental income, while high risk ones can invest in upcoming

properties for capital appreciation

Deepen reach into tier 2/3 cities coupled with investor education programmes. Currently, the top eight •

cities account for almost three-fourths of the mutual fund ownership while only holding one-third of

the overall income pool. Expand into tier 2/3 cities through investor education programmes along the

lines of developed economies with deeper financial markets such as Germany (Exhibit 3.5).

Korea witnessed a 50 per cent CAGR in life insurance premium over a decade after an integrated set •

of awareness building moves from the government and regulator. Korea’s Department of Treasury

announced 1977 as the “Year of Insurance”. The government promoted insurance extensively through

television commercials, short movies and newspaper advertisements. Insurance was made a priority

industry in the national economic growth plan. An insurance modernisation plan was formed to

better promote product development, channel management and asset management. These initiatives

increased the insurance premium at 50 per cent CAGR between 1977 and 1988.


■ Promote growth in mutual fund AUM through improved distribution:Entry load abolishment in 2009 drastically reduced the incentives for distributors affecting new business

growth (Exhibit 3.6). Lower industry profitability due to stable operating costs and declining revenues

is also affecting channel margins available to distributors. To promote growth in mutual funds AUM,

following measures could be taken

Introduce a variable load regime (entry and exit) to cater to different distribution channels for •

growth beyond the top 10 cities.

Expand distribution channels for last mile reach. Promote tie-ups with operators to access remote •

channels and online distribution to improve distributor economics (Exhibit 3.7). Additionally,

access through PSU bank branches would also facilitate reach beyond the top 10 cities with minimal

investments


19

– Expand distribution channels for last mile reach. Promote tie-ups with operators to access remote channels and online distribution to improve distributor economics (Exhibit 3.7). Additionally, access through PSU bank branches would also facilitate reach beyond the top 10 cities with minimal investments

EXHIBIT 3.6

McKinsey & Company

AUM growth

Mutual fund AUM has stagnated over the last 2 years

SOURCE: AMFI; McKinsey analysis

1 PMS not included

-2%-3%

+47%-22%

+38%

Mar’12

122

Mar’11

124

Mar’10

128

Mar’09

87

Mar’08

112

Dec’06

75

Key challenges

USD billions; end of period ▪ Increasingly unfavorable distribution channel economics

– Entry load abolishment in 2009 reducing incentives for distributors

– Lower profitability of mutual fund industry affecting channel margins available to distributors

▪ Low retail participation in financial assets with majority of savings in physical form, majority in the top 10 cities

GROWTH IN MF AUM THROUGH IMPROVEMENT IN DISTRIBUTION

Exhibit 3.6



20

EXHIBIT 3.7

McKinsey & Company

Asset managers can consider tie ups with existingoperators for a better presence across remote channels

SOURCE: Press, Company Website

Airtel provides mChek a commercial M-commerce tool

How mChek works for mutual funds

▪ SMS based mobile payment platform developed in collaboration with VISA

▪ Transactions secured by 6 digit 'mChekPIN' number

Description ▪ Prepaid recharge; toll recharge▪ Bill payments▪ Flight ticket and movie booking▪ Insurance premium payment▪ Any valid Indian Visa / MasterCard Credit Card

Partners ▪ VISA, Master Card▪ HDFC Bank, ICICI Bank,

Corporation Bank, State Bank of India, NDB Bank, Citi, Seylan Bank

▪ Dialog Telekom, You Telecom▪ Makemytrip.com, Yatra.com,

Futurebazaar.com, Sify Mall, Indiatimes Shopping, BookmyShow, Home Shop 18

Results so far

▪ More than 1 million users in Jan 2009▪ 1.2% of Airtel’s subscriber base uses mChek▪ UTI, Birla Sun Life already using mChek

▪ Register for mChek and select 6-digit pin number▪ Setup debit instructions by linking debit card▪ Select mutual fund scheme for purchase – lump

sum investment or SIP – with amount details▪ Purchase after entering mChekPIN number ▪ Maintenance activities e.g., switching between

schemes, redemption also through mChek

Services

CASE EXAMPLE

GROWTH IN MF AUM THROUGH IMPROVEMENT IN DISTRIBUTION

■ Build retirement participation for pension AUM growth with New Pension Scheme (NPS)

NPS 2009 has not performed as per expectations since its launch. While recent changes in regulations have been in the right direction, further steps are required to boost participation.

– Increase customer awareness and financial literacy: Educate customers on the features and benefits of NPS 2009 through creative means. For example, provide a short explanation on the tax breaks and benefits of investing in NPS 2009 on income tax forms for the self-employed and small businesses. Mandate distribution channels selling pension plans from AMCs/Insurers to disclose to customers the features of NPS 2009 vis-à-vis the plans they sell (for example, how the fees on funds in NPS are lower than comparable retail funds). Leverage partnerships with existing players to enhance coverage of focus segments (self-employed, casual worker)

– Ensure better distributor economics: The current incentives for distribution channels selling NPS 2009 is unattractive. This is especially so when these incentives are compared to what they make from selling other financial products. PFRDA needs to improve the commission structure to pay for distribution

Exhibit 3.7

■ Build retirement participation for pension AUM growth with New Pension Scheme (NPS)NPS 2009 has not performed as per expectations since its launch. While recent changes in regulations

have been in the right direction, further steps are required to boost participation.

Increase customer awareness and financial literacy: Educate customers on the features and benefits •

of NPS 2009 through creative means. For example, provide a short explanation on the tax breaks and

benefits of investing in NPS 2009 on income tax forms for the self-employed and small businesses.

Mandate distribution channels selling pension plans from AMCs/Insurers to disclose to customers

the features of NPS 2009 vis-à-vis the plans they sell (for example, how the fees on funds in NPS

are lower than comparable retail funds). Leverage partnerships with existing players to enhance

coverage of focus segments (self-employed, casual worker)

Ensure better distributor economics: The current incentives for distribution channels selling NPS •

2009 is unattractive. This is especially so when these incentives are compared to what they make

from selling other financial products. PFRDA needs to improve the commission structure to pay for

distribution

Maintain variable management fees for fund managers to manage investments professionally: Fees •

should vary by asset classes managed and quantity of funds managed, and should be benchmarked

to market competitive institutional fees (EPF/NPS 2004), so that the best professional managers are

available to investments. Also, vary fees based on type of management (for example, active versus

passive management)


■ Relax capital market investment restrictions on insurance and pension/ provident funds Life insurance inflows have remained stagnant over the last 3 years (Exhibit 3.8) – protection levels were

only 55 per cent of GDP in 2009 as compared to around 250 per cent in the US – with limited deepening of

the financial savings pool. Restrictive capital market investment guidelines for (non-ULIP) life insurance

funds prevent investments in capital market products. A minimum of 50 per cent investment in G-Sec

and approved securities, and 15 per cent in infrastructure must be covered by insurance funds. The rest

of the 35 per cent can be invested in other asset classes including equity/bonds, but there are restrictions

on the quality of capital market assets (for example, investment allowed in AA or higher rated corporate

debt). These limitations severely limit the play for insurance funds. Steps must be undertaken to promote

their investments in capital market products:

Allow higher direct exposure to equity and debt assets, and indirect exposure via mutual funds •

(Exhibit 3.9)

Make gold ETF a separate class of investment for life insurance and pension funds•

Permit insurers to participate in CDS, SLB, and reverse repo/repo trades in government and •

corporate debt securities


22

EXHIBIT 3.8

McKinsey & Company

Life insurance AUM

Growth in Indian life insurance industry has slowed down post regulatory changes in 2010

2008

156

2012

+23% p.a.

+12% p.a.297

2011

272

2010

237

2009

171

Capital market investment guideline

▪ Minimum 50% of investment in G-Sec and approved securities and 15% in infrastructure; max 35% can be invested in other asset classes including equity/ bonds

▪ Further, investment allowed in AA or higher rated corporate debt only

1 Equity component at market value, debt at book value

SOURCE: Life Insurance council, IRDA, Disclosures, Team Analysis

USD billions, end of period

RELAXING CAPITAL MARKET INVESTMENT RESTRICTIONS ON INSURANCE AND PENSION FUNDS

EXHIBIT 3.9

McKinsey & Company

Investment in capital market assets should be gradually relaxed

▪ No restrictions on asset allocation in equities

China

India

Korea

SOURCE: FSS, IRDA, Regulatory websites

Asset class Traditional Unit Linked

Banking deposit

▪ No Limit

Securities & Bonds

▪ Corporate bond < 20%▪ Convertible bond < 20%

▪ G-Sec: min of 25%▪ G-Sec (including above)

and other approved securities1: Not less than 50%

Other asset classes including equity

▪ Equity < 10%▪ Mutual fund < 10%▪ Other assets: No Limit

(including stakes in medical agencies, PE/VC, unlisted commercial banks, ABS/MBS

Real estate ▪ No Limit ▪ NA

Infrastruct-ureProjects

▪ Maximum of 5% ▪ Minimum 15%including bonds, debentures, ABS, equity etc.

Traditional Traditional

Upper limit of investment (by investment class -▪ Credits to the same individual or

the same corporation : 3%▪ Bonds or shares issued by the

same corporation : 7%▪ Credits extended to the same

borrower or the bonds and shares issued by the same borrowers: 12%

▪ Credits extended to the same individual or the same corporation or dominant shareholder that surpass % of total asset : 20%

▪ Credit to subsidiary company : 2%▪ Bonds or shared issued by

subsidiary company: 3%▪ Credit to the same subsidiary

company : 10%▪ Real Estate : 15%▪ Unlisted Stock : 10%▪ Foreign Currency or overseas real

estate : 30%▪ Derivatives: 5%▪ Margin for domestic or overseas

future transaction : 3%

▪ Other approved investments e.g. corp. bonds, equity, CP etc. subject to exposure and prudential norms: Max 35%– Other than approved

Investments (not meeting above criterion) : max 15%

Includes Corp bonds, equity, debentures, CBLO, MM instruments, CP, and FD’sOnly allowed to invest in very high-rated paper, e.g., AA and above for Corp bonds

Benchmarking Life Insurance investment guidelines

1 Securities which have a guaranteed principal and interest payment from the Central and State government


Several capital market investment restrictions also exist for pension funds – investments are restricted to government securities and securities issues by public

Exhibit 3.8



22

EXHIBIT 3.8

McKinsey & Company

Life insurance AUM

Growth in Indian life insurance industry has slowed down post regulatory changes in 2010

2008

156

2012

+23% p.a.

+12% p.a.297

2011

272

2010

237

2009

171

Capital market investment guideline

▪ Minimum 50% of investment in G-Sec and approved securities and 15% in infrastructure; max 35% can be invested in other asset classes including equity/ bonds

▪ Further, investment allowed in AA or higher rated corporate debt only

1 Equity component at market value, debt at book value

SOURCE: Life Insurance council, IRDA, Disclosures, Team Analysis

USD billions, end of period


EXHIBIT 3.9

McKinsey & Company

Investment in capital market assets should be gradually relaxed

▪ No restrictions on asset allocation in equities

China

India

Korea

SOURCE: FSS, IRDA, Regulatory websites

Asset class Traditional Unit Linked

Banking deposit

▪ No Limit

Securities & Bonds

▪ Corporate bond < 20%▪ Convertible bond < 20%

▪ G-Sec: min of 25%▪ G-Sec (including above)

and other approved securities1: Not less than 50%

Other asset classes including equity

▪ Equity < 10%▪ Mutual fund < 10%▪ Other assets: No Limit

(including stakes in medical agencies, PE/VC, unlisted commercial banks, ABS/MBS

Real estate ▪ No Limit ▪ NA

Infrastruct-ureProjects

▪ Maximum of 5% ▪ Minimum 15%including bonds, debentures, ABS, equity etc.

Traditional Traditional

Upper limit of investment (by investment class -▪ Credits to the same individual or

the same corporation : 3%▪ Bonds or shares issued by the

same corporation : 7%▪ Credits extended to the same

borrower or the bonds and shares issued by the same borrowers: 12%

▪ Credits extended to the same individual or the same corporation or dominant shareholder that surpass % of total asset : 20%

▪ Credit to subsidiary company : 2%▪ Bonds or shared issued by

subsidiary company: 3%▪ Credit to the same subsidiary

company : 10%▪ Real Estate : 15%▪ Unlisted Stock : 10%▪ Foreign Currency or overseas real

estate : 30%▪ Derivatives: 5%▪ Margin for domestic or overseas

future transaction : 3%

▪ Other approved investments e.g. corp. bonds, equity, CP etc. subject to exposure and prudential norms: Max 35%– Other than approved

Investments (not meeting above criterion) : max 15%

Includes Corp bonds, equity, debentures, CBLO, MM instruments, CP, and FD’sOnly allowed to invest in very high-rated paper, e.g., AA and above for Corp bonds

Benchmarking Life Insurance investment guidelines

1 Securities which have a guaranteed principal and interest payment from the Central and State government


Several capital market investment restrictions also exist for pension funds – investments are restricted to government securities and securities issues by public


23

financial institutions, with only a small component (about 10 per cent) available for investment in private sector bonds and securities (Exhibit 3.11). Pension fund managers demonstrate a conservative investment philosophy to secure guaranteed returns, further limiting participation. Investment guidelines must be relaxed to promote participation from pension funds.

EXHIBIT 3.10

McKinsey & CompanySOURCE: EPFO; PFRDA; Controller of Accounts; AMFI; IRDA interviews; press articles; McKinsey analysis

1 Excludes individuals working for business enterprises with <=20 employees2 Represents individuals who do not have steady jobs and their earnings are barely enough to meet their day-to-day living expenses3 Public Provident Fund and Pension plans offered by AMCs and Life insurance firms. Participation is voluntary

▪ Nearly 70% of retirement savings in India are in Pillar 2 schemes

▪ Self-employed and Casual workers who constitute ~85% of workforce do not have access to Pillar 2 schemes

▪ Pillar 3 schemes are utilized by affluent individuals with high disposable income as a result participation and coverage is rather low (~1% compared to 100% in Pillar 2 schemes that are mandatory)

Size and structure of Pensions assets in India- large asset base of ~USD 150 billion, largely coming from mandatory employer scheme

Govt. sector

Private sector1

Self-employed / SMEs

Casual Workers2

Workforce by employer type

PILLAR 2: Employer-sponsored retirement schemes (mandatory)

Size of scheme

Total = 457 million

• DB plan

▪ New Pension Scheme (NPS) 2004

Non-funded liability

$0.4 billion

▪ Employees Provident Fund (EPF)

▪ Private pension, gratuity & owned PF trusts

$62.1 billion

$38.9 billion

PILLAR 3: Individual retirement savings3

465K crores

Public Provident Fund:▪ 3 million subscribers▪ $28.2 billionRetail pension plans by AMCs & Insurers:▪ 3 million plans in

force▪ $15.8 billion

133K crore

None)

None

4.0%

10.0%

51.0%

-

-34.0%

NPS 2009 is a Pillar 3 scheme trying to substitute for Pillar 2 for unorganized workforce


Exhibit 3.9

Exhibit 3.10

Several capital market investment restrictions also exist for pension funds – investments are restricted to

government securities and securities issues by public financial institutions, with only a small component

(about 10 per cent) available for investment in private sector bonds and securities (Exhibit 3.11). Pension fund

managers demonstrate a conservative investment philosophy to secure guaranteed returns, further limiting

participation. Investment guidelines must be relaxed to promote participation from pension funds.



24

EXHIBIT 3.11

McKinsey & CompanySOURCE: EPFO annual report 2011, Interviews, McKinsey analysis

Restrictive investment guidelines for pension and provident funds which limit participation in capital market should be gradually relaxedInvestment guidelines of EPFO schemes and suggested changes

Investment guidelinesCategory Amount to be invested

▪ Central Government securities

▪ 25 percent▪ Central Government Securities and /or units of such Mutual Funds which have been set up as dedicated Funds for investment in Government securities (and approved by SEBI)

▪ (State) Government securities

▪ 15 percent▪ State Government securities and/ or units of such Mutual Funds which have been set up as dedicated Funds for investment in Government securities (and approved by SEBI);

▪ Securities the principal whereof and interest whereon is fully and unconditionally guaranteed by the Central/State govt

▪ Securities issued by public financial institutions

▪ 30 percent▪ Bonds/ Securities of Public Financial Institutions including public sector banks; and /or short duration (less than a year ) Term Deposit Receipts (TDR) issued by public sector banks

▪ Combination of above securities

▪ 30 percent▪ To be invested in any of the above three categories as decided by their Trustees

▪ The Trusts, may invest up to 1/3rd of 30 percent in private sector bonds/ securities, which have an investment grade rating from at least two credit rating agencies.

1

2

3

4

▪ EPFO and the exempted provident fund schemes to be allowed to invest in corporate bonds of private sector borrowers in line with MoF guidelines. This can initially be restricted to bonds with a credit rating of AAA

▪ Change current investment guidelines for pension and other retirement benefit from ownership based criteria (public sector, private sector) to end use (infrastructure) and ratings based criteria


Strengthen the equities microstructure and market infrastructure Strong market infrastructure and microstructure will lead to efficient price discovery, lower trading costs, efficient clearing and settlement of trades, support varying trading strategies, and ensure high transparency of market information.

Comparing India with other developed markets suggests that India has strong risk management practices/systems, high order processing speed (for the leading exchange), and norms to report information by exchanges/market regulator (Exhibit 3.12, 3.13).

However, there is scope to improve the trading latency, order processing speed, control mechanisms to check bulk volumes, and cost of trading (Exhibit 3.12, 3.13, 3.14, 3.15).


25

EXHIBIT 3.12

McKinsey & Company

Benchmarking India market infrastructure and microstructure with other markets

SOURCE: Elkins McSherry, Aite, Celent, press and web search, McKinsey

Trading latency

Mature markets(US, UK, and Germany)Criteria

Asia financial centers and developed markets India

▪ Significant investments to build low latency trading technologies – LSE - 0.1 ms – Nasdaq - 0.25 ms – Chi-X – 0.4 ms

▪ Recent efforts reducing trade latency inline with developed markets – SGX – 0.1 ms – ASX – 0.3 ms

▪ Relatively high trading latency– NSE - 2.5 ms– BSE - ~10 ms

Processing capability

▪ Strong IT capabilities to support high speed trading orders – NASDAQ – 250,000 orders/sec

▪ Additional measures (like circuit filters, throttling etc) to control order flow and ensure stability in the market

▪ At par with developed markets with considerable processing facilities – SGX – 1 mn orders/sec– ASX – 100,000 orders/sec– HKeX – 30,000 orders/sec

▪ Recent efforts to build processing capacity but inadequate control measures still leave the market with high risk of failure due to bulk volumes (like “flash crash” etc) – NSE – 200,000 orders/sec– BSE – 20,000 orders/sec

Competitive efficiency (due to alternative trading platforms)

▪ High competitive efficiency due to considerable number of ATS sharing over 50% trading volumes – ECN/MTF – BATS, CHI-X– Broker crossing networks –

Sigma X, Instinet

▪ Increasing competition with growing presence of ATS (market share of ~5%) – CHI-X, Liquidnet with minor

presence in Singapore, Australia & HK

▪ Limited competition and dominance by leading player (NSE)– No alternative platforms due to

regulatory prohibition


▪ Low cost of trading – UK – 15 bps– US – 16 Bps – Germany – 19 bps

▪ Comparable to mature markets – Singapore – 24 bps– Australia – 20 bps – HK – 28 bps

▪ High cost of trading: ~44 bps, due to high taxes

India has strong risk management systems and high transparency, trading latency and cost of equity trading requires improvement (1/2)

EQUITY MARKET INFRASTRUCTURE AND MICROSTRUCTURE

EXHIBIT 3.13

McKinsey & Company

Benchmarking market infrastructure in Indian equity market

SOURCE: McKinsey analysis, expert interviews



Market transparency

▪ Extensive reporting requirements for all market participants – Exchanges – Daily requirements

to report price/volume details– Brokers – Mandatory to submit

position details across scrip's, products, clients etc

▪ Closely moving towards developed market practices – ASIC (Australia) pressing for

transparency by refining norms in niche products (SLB, short selling)

▪ Efforts to improve transparency but still far behind developed markets – Exchanges - Adequate norms for

daily reporting – Brokers – Ineffective standards

still allowing brokers to manipulate trades to avoid tax liabilities, significant size of grey market operations in IPO etc

Risk management system

▪ Robust risk management system across entire trading value chain – Pre trading – Stringent licensing

requirements and entry norms for all market participants

– Trading and post trading – Real time surveillance and margining facilities

– Violations – Additional systems to handle default situations and prevent market failure

▪ Continuously adopting best practices from developed markets – ASX established “Audit and

Risk” committee and policies in line LSE

▪ At par with mature markets with adequate risk management practices – Real time risk monitoring

system – Advanced CCP (NSCCL) with

extensive post trading facilities and margining system

– Additional safety mechanism (like Investor protection funds) to handle extreme situations

Market education

▪ Significant efforts towards building investor awareness about capital market products– Deutsche Bourse established

“Capital Markets Academy”

▪ Investing in investor education to improve retail participation in the market

▪ Considerable efforts towards market education (but long way to go to cover huge investor base) – NSE introduced “Certifications

in Financial Markets”



Exhibit 3.11

Exhibit 3.12

Strengthen the equities microstructure and market infrastructure Strong market infrastructure and microstructure will lead to efficient price discovery, lower trading costs,

efficient clearing and settlement of trades, support varying trading strategies, and ensure high transparency

of market information.

Comparing India with other developed markets suggests that India has strong risk management practices/

systems, high order processing speed (for the leading exchange), and norms to report information by

exchanges/market regulator (Exhibit 3.12, 3.13).

However, there is scope to improve the trading latency, order processing speed, control mechanisms to check

bulk volumes, and cost of trading (Exhibit 3.12, 3.13, 3.14, 3.15).



25

EXHIBIT 3.12

McKinsey & Company

Benchmarking India market infrastructure and microstructure with other markets

SOURCE: Elkins McSherry, Aite, Celent, press and web search, McKinsey

Trading latency



▪ Significant investments to build low latency trading technologies – LSE - 0.1 ms – Nasdaq - 0.25 ms – Chi-X – 0.4 ms

▪ Recent efforts reducing trade latency inline with developed markets – SGX – 0.1 ms – ASX – 0.3 ms

▪ Relatively high trading latency– NSE - 2.5 ms– BSE - ~10 ms

Processing capability

▪ Strong IT capabilities to support high speed trading orders – NASDAQ – 250,000 orders/sec

▪ Additional measures (like circuit filters, throttling etc) to control order flow and ensure stability in the market

▪ At par with developed markets with considerable processing facilities – SGX – 1 mn orders/sec– ASX – 100,000 orders/sec– HKeX – 30,000 orders/sec

▪ Recent efforts to build processing capacity but inadequate control measures still leave the market with high risk of failure due to bulk volumes (like “flash crash” etc) – NSE – 200,000 orders/sec– BSE – 20,000 orders/sec

Competitive efficiency (due to alternative trading platforms)

▪ High competitive efficiency due to considerable number of ATS sharing over 50% trading volumes – ECN/MTF – BATS, CHI-X– Broker crossing networks –

Sigma X, Instinet

▪ Increasing competition with growing presence of ATS (market share of ~5%) – CHI-X, Liquidnet with minor

presence in Singapore, Australia & HK

▪ Limited competition and dominance by leading player (NSE)– No alternative platforms due to

regulatory prohibition


▪ Low cost of trading – UK – 15 bps– US – 16 Bps – Germany – 19 bps

▪ Comparable to mature markets – Singapore – 24 bps– Australia – 20 bps – HK – 28 bps

▪ High cost of trading: ~44 bps, due to high taxes



EXHIBIT 3.13

McKinsey & Company

Benchmarking market infrastructure in Indian equity market

SOURCE: McKinsey analysis, expert interviews



Market transparency

▪ Extensive reporting requirements for all market participants – Exchanges – Daily requirements

to report price/volume details– Brokers – Mandatory to submit

position details across scrip's, products, clients etc

▪ Closely moving towards developed market practices – ASIC (Australia) pressing for

transparency by refining norms in niche products (SLB, short selling)

▪ Efforts to improve transparency but still far behind developed markets – Exchanges - Adequate norms for

daily reporting – Brokers – Ineffective standards

still allowing brokers to manipulate trades to avoid tax liabilities, significant size of grey market operations in IPO etc

Risk management system

▪ Robust risk management system across entire trading value chain – Pre trading – Stringent licensing

requirements and entry norms for all market participants

– Trading and post trading – Real time surveillance and margining facilities

– Violations – Additional systems to handle default situations and prevent market failure

▪ Continuously adopting best practices from developed markets – ASX established “Audit and

Risk” committee and policies in line LSE

▪ At par with mature markets with adequate risk management practices – Real time risk monitoring

system – Advanced CCP (NSCCL) with

extensive post trading facilities and margining system

– Additional safety mechanism (like Investor protection funds) to handle extreme situations

Market education

▪ Significant efforts towards building investor awareness about capital market products– Deutsche Bourse established

“Capital Markets Academy”

▪ Investing in investor education to improve retail participation in the market

▪ Considerable efforts towards market education (but long way to go to cover huge investor base) – NSE introduced “Certifications

in Financial Markets”




26

EXHIBIT 3.14

McKinsey & CompanySOURCE: Press and Web Search, Aite, Celent

10.0

9.0

5.0

5.0

2.5

0.9

0.4

0.3

0.3

0.1

0.1

BSE

HKeX

OSE

TSE

NSE

NYSE Arca

Chi-X

ASX

Nasdaq OMX

SGX

LSE Turquoise

Launched new trading platform “Genium INET” in 2010 reducing latency by over 60% to <0.25 ms and doubling processing capacity to over 250,000 orders/sec

Adopted new trading technology “ASX trade” in Dec 2010 reducing trade latency to 0.3 ms and increasing processing capacity to over 100,000 orders/sec

Introduction of new platform “SGX Reach” (cost $250 mn) in Aug 2011 to reduce trade latency to <0.1 ms and build processing capability to 1 mn orders/sec

Average latency1 (round trip)Milliseconds, 2011

Leading players are investing to reduce trading latency

Launched US$ 140 million trading system “Arrowhead” in Jan 2011 enhancing processing speed to 5 milliseconds and exec ute 4.7 mn orders/day

Indian exchanges need to minimize trading latency like developed markets to remain attractive to new age investors

1 Time is takes to get an order confirmation from exchange (may or may not result into order execution)


EXHIBIT 3.15

McKinsey & CompanySOURCE: Press and Web Search, Elkins McSherry (survey with institutional investors)

Cash equities cost of trading1

Bps, 2010

India 43.5

HK 28.7

Singapore 24.1

Australia 20.8

Germany 19.3

US 16.3

UK 16.0

Japan 13.1

DerivativesTransaction cost of NIFTY Futures, 2011

1 Includes broker commission and charges 2 Include like taxes and local fee’s 3 Refers to the difference between the price at which a stock trade is executed and the average of that stock’s high, low, opening and closing prices during the day 4 Rupees per lakh of turnover

Cost head SGX4

Stamp duty 2.0 NIL

Service Tax 2.1 0.5

Regulatory Fee 0.2 NIL

Exchange Fee 1.7 5.1

Total 23.0 5.7

For a round trip transaction 29.1 11.2

NSE4

Securities Transaction Tax NIL17.0

Commission1

Fees2

Market Impact3

Cost of equity trading in line with developed markets is critical to attract foreign flows and keep markets onshore

High cost of trading has resulted into some trading moving offshore - ~50%5 of total NIFTY Futures is traded on SGX (based on OI)


Exhibit 3.13

Exhibit 3.14



26

EXHIBIT 3.14

McKinsey & CompanySOURCE: Press and Web Search, Aite, Celent

10.0

9.0

5.0

5.0

2.5

0.9

0.4

0.3

0.3

0.1

0.1

BSE

HKeX

OSE

TSE

NSE

NYSE Arca

Chi-X

ASX

Nasdaq OMX

SGX

LSE Turquoise

Launched new trading platform “Genium INET” in 2010 reducing latency by over 60% to <0.25 ms and doubling processing capacity to over 250,000 orders/sec

Adopted new trading technology “ASX trade” in Dec 2010 reducing trade latency to 0.3 ms and increasing processing capacity to over 100,000 orders/sec

Introduction of new platform “SGX Reach” (cost $250 mn) in Aug 2011 to reduce trade latency to <0.1 ms and build processing capability to 1 mn orders/sec

Average latency1 (round trip)Milliseconds, 2011

Leading players are investing to reduce trading latency

Launched US$ 140 million trading system “Arrowhead” in Jan 2011 enhancing processing speed to 5 milliseconds and exec ute 4.7 mn orders/day

Indian exchanges need to minimize trading latency like developed markets to remain attractive to new age investors

1 Time is takes to get an order confirmation from exchange (may or may not result into order execution)


EXHIBIT 3.15

McKinsey & CompanySOURCE: Press and Web Search, Elkins McSherry (survey with institutional investors)

Cash equities cost of trading1

Bps, 2010

India 43.5

HK 28.7

Singapore 24.1

Australia 20.8

Germany 19.3

US 16.3

UK 16.0

Japan 13.1

DerivativesTransaction cost of NIFTY Futures, 2011

1 Includes broker commission and charges 2 Include like taxes and local fee’s 3 Refers to the difference between the price at which a stock trade is executed and the average of that stock’s high, low, opening and closing prices during the day 4 Rupees per lakh of turnover

Cost head SGX4

Stamp duty 2.0 NIL

Service Tax 2.1 0.5

Regulatory Fee 0.2 NIL

Exchange Fee 1.7 5.1

Total 23.0 5.7

For a round trip transaction 29.1 11.2

NSE4

Securities Transaction Tax NIL17.0

Commission1

Fees2

Market Impact3

Cost of equity trading in line with developed markets is critical to attract foreign flows and keep markets onshore

High cost of trading has resulted into some trading moving offshore - ~50%5 of total NIFTY Futures is traded on SGX (based on OI)



27

High frequency trading (HFT) is one of the biggest innovations in global equity trading. It has seen strong growth in all developed markets and it accounts for more than 50 per cent of trading volume in the United States (Exhibit 3.16).

While the jury is still out on whether HFT is required for the market to function efficiently, the trading strategy continues to grow at a fast pace and has now started penetrating developing markets like India. It is important for us to learn from other developed markets, put in place guidelines to govern HFT, and simultaneously invest in market infrastructure to support the growth of HFT (Exhibit 3.17).

EXHIBIT 3.16

McKinsey & Company

HFT user composition% of total HFT volumes in US, 2009

SOURCE: Celent, TABB Group, LSE, ESMA, Mckinsey experts

6

4648

Independentprop firms

Broker-dealerprop desks

Hedge funds

HFTs have gained significant foothold in developed markets …

Adoption of HFT in US% of total equities trading volume

5442

312715

2010090807

+12% p.a.

2006

▪ Increase in liquidity : High frequency market makers (including HFs, prop, trading firms etc) contribute significant liquidity in market (over 50% of total equities trading volume in US) leading to high certainty of execution

▪ Tighter spreads : Drives market efficiency and reduces spread via high speed market making

▪ Reduces cost of trading and lowers trading latency : Drives competition among trading platforms to reduce latency and trading fee’s

Benefits (offered by HFTs)

… bringing several benefits along with various risks

▪ Systemic failure : High frequency order volumes may lead to system failure and market crash (eg. flash crash on NYSE in May, 20101)

▪ Higher volatility : With higher volumes, HFT leads to short term volatility and price fluctuations in the market

▪ Unfair advantage over other market participants : Better access (in terms of time) to market information and prices provides unjust benefit over other investors (especially retail investors)

▪ Market abuse : Misuse of IT capabilities for fake orders to create false sense in market over price/volume of a stock

Risks (associated with HFTs)

1 HFT and algo trading was the underlying cause of the crash, when Dow Jones Industrial Average plunged about 1000 points or about nine percent the biggest one-day point decline in the history

High-frequency trading (HFT) is an established phenomena in developed markets with several pros and cons


Exhibit 3.15

Exhibit 3.16

High frequency trading (HFT) is one of the biggest innovations in global equity trading. It has seen strong

growth in all developed markets and it accounts for more than 50 per cent of trading volume in the United

States (Exhibit 3.16).

While the jury is still out on whether HFT is required for the market to function efficiently, the trading

strategy continues to grow at a fast pace and has now started penetrating developing markets like India.

It is important for us to learn from other developed markets, put in place guidelines to govern HFT, and

simultaneously invest in market infrastructure to support the growth of HFT (Exhibit 3.17).



28

EXHIBIT 3.17

McKinsey & CompanySOURCE: Press; regulators websites

▪ Current infrastructures leaves market exposed to risk and requires further upgradation (e.g., further increasing # order processing capability, IT systems to ensure market stability)

▪ Governance of high frequency traders

Key learning's for India

Case example of Europe

▪ Extensive guidelines for trading platforms and market intermediariesto improve IT and organizational capabilities – Circuit filters and throttling

techniques to prevent erroneous order booking

– Build strong algo testing and surveillance system

– Develop internal IT to monitor HFT trades and trace faulty trading strategies to origination

ESMA building rigorous rules applicable across all EU members

India is witnessing strong growth from HFT; strong market infrastructure and appropriate regulations are needed to avert any negative consequences


Drive changes and growth in the debt markets

Two broad changes are needed to develop a strong debt market

■ Developing market infrastructure and microstructure

■ Developing a benchmark yield curve for price discovery


Like equity markets, strong market infrastructure and microstructure is critical for debt markets to develop and function efficiently. We recommend three priority measures to enhance the Indian debt market infrastructure and microstructure

– Encourage adoption of CDS as a credit enhancement tool

□ Encourage banks, insurance companies, mutual funds and other market participants to rapidly put in place a CDS policy

□ Educate and create awareness about this product amongst key participants – for example, form a sub-committee comprising treasury/investment officers from PSU banks, insurance companies and pension funds to jointly come up with structures to launch bonds backed by CDS

Exhibit 3.17

Drive changes and growth in the debt marketsTwo broad changes are needed to develop a strong debt market



■ Developing market infrastructure and microstructure Like equity markets, strong market infrastructure and microstructure is critical for debt markets to

develop and function efficiently. We recommend three priority measures to enhance the Indian debt

market infrastructure and microstructure

- Encourage adoption of CDS as a credit enhancement tool○ Encourage banks, insurance companies, mutual funds and other market participants to rapidly put in

place a CDS policy

○ Educate and create awareness about this product amongst key participants – for example, form a sub-committee comprising treasury/investment officers from PSU banks, insurance companies and pen-sion funds to jointly come up with structures to launch bonds backed by CDS

○ Consider a move to a centralised clearing CCIL for CDS to limit participants’ need to form a collateral management system


– Transform credit rating agencies (CRA) and the credit rating process to provide greater transparency

○ Ensure that entities which offer credit rating as a service are registered as a rating agency

○ Ensure that entities not registered as a CRA are not be allowed to “rate organisations” in a manner that is not calibrated to CRA’s rating process

○ Disallow CRA’s from carrying out businesses like consulting on instrument design, etc., even by an independent arm

○ Transform corporate governance norms for CRA’s, for example, the functions responsible to assign initial credit rating and subsequently monitor it should be separate

○ Establish that all credit ratings, once obtained, must be published by the enterprise who is the issuer

and have purchased the service

– Revamp the corporate bond trading infrastructure and settlement system ○ Establish an integrated trading and settlement system for corporate bonds (like NDS-OMS for G-Sec)

○ Take steps to boost liquidity in corporate bond repos. Exempt them from CRR/SLR, encourage MF to participate, and explore the need to create a CBLO type of market

○ Move from DVP-I to DVP-III system

In-addition, several changes are required to deepen corporate bond market (Exhibit 3.18)


30

EXHIBIT 3.18

McKinsey & CompanySOURCE: Interviews, McKinsey analysis

Key initiatives for development of Corporate bond market1

1. Exempt corporate bond repo borrowings from CRR/SLR

2. Implement MoF guidelines on investments for pension funds

3. Change investment guidelines for pension and other retirement products from ownership based criteria to end use industry criteria in line with insurance

4. Ensure MF are allowed to participate in corporate bond repos

5. Clarify securitisation guidelines and capital requirement on second loss piece

1. Encourage market making and participation in corporate bonds across participants

2. Permit repo in Corporate bonds <1 year residual maturity

3. Review impact of CDS guidelines and explore other credit enhancement mechanisms

4. Establish a uniform definition of infrastructure

5. Uniform stamp duty across states

6. Allow seamless settlement of secondary market trades between entities registered with either NSCCL or ICCL

7. Encourage reissuance of corporate bonds under the same ISIN, in order to ensure large floating stock

Stage-1: Attract investors to participate in the market (0-6 months)

Step-2: Deepen market and establish systems (6-12 months)

Step-3: Institutionalize systems and move towards fundamental reforms (12+ months)

1. Accept interest earned by FIIs on their corporate bond holdings from withholding tax

2. Allow PD’s to invest up to 50 per cent of net owned funds in single name bonds

3. Wave tax on capital gains and interest income (upto Rs. 20,000 p.a.) for retail clients

4. Remove cap on yield for infrastructure bonds

5. Review progress of infrastructure debt funds and suggest changes

6. Establish an integrated trading and settlement system (like NDS OMS for G-Sec)

7. Move from DVP I to DVP III system for Corporate bonds

1 Some of the points are already covered earlier

Several changes are required to deepen Corporate bond marketDEBT MARKET INFRASTRUCTURE AND MICROSTRUCTURE


A benchmark security helps price other assets, provides hedging mechanisms against interest risks, and creates a core financial market for participants. A liquid government debt market is the best way to create a benchmark asset because it is the only credible risk-free asset.

India has large G-Sec market whose role as an effective benchmark for the debt market can be enhanced (Exhibit 3.19). Today, the trading in G-Sec is confined to a few securities. Just two securities, “8.79 per cent GS 2021” and “9.15 per cent GS 2024” account for 50 per cent and 37 per cent of the total traded volume respectively.

Exhibit 3.18



31

EXHIBIT 3.19

McKinsey & CompanySOURCE: BIS, Asian Bonds Online, MoF – Public Debt Management Report Jan – March 2012, CCIL report

While India G-Sec outstanding is spread across maturities, trading is concentrated within the 8 – 12 year maturityIndia has a fast growing G-Sec market

Tradingvelocity2

G-Sec O/SDec 2011USD Bn

GrowthCAGR %2002-11

512 1.4 14

1509 0.9 24

151 3.4 18

12788 3.9 12

498 4.7 13

12863 11 12

G-Sec O/SAs on Mar 2012, % of totalYears to maturity

Trading concentration1

(Jan-Mar 2012)% of total

0-2 14% 1%

2-4 12% 1%

4-8 25% 8%

8-12 20% 87%

12-20 14% 2%

> 20 10% 1%

Of this ‘8.79% GS 2021’ and ‘9.15% GS 2024’ are the top 2 traded securities accounting for 50% and 37% of the total traded volume respectively

1 Analysis of top 10 traded securities which account for 87% of the total traded volume2 Only one leg of trading is considered to calculated trading velocity

320 3.0 14

India has a large G-Sec market, but its role as an effective benchmark for the debt market can be enhanced

BENCHMARK YIELD CURVE FOR PRICE DISCOVERY

Five reforms are required to broaden and deepen the G-Sec market in India.

– Consolidate instruments

□ Issue securities across maturities

□ Buy back or switch operations to retire/extinguish G-Sec with small outstanding amounts

– Widen investor base

□ Simplify access for investors like trusts, corporates, etc.

□ Encourage long-term gilt funds through appropriate incentives (like tax breaks, liquidity support, etc.)

□ Introduce a web-based system of access to NDS-OM

□ Attract more retail participation. Some initiatives to achieve this could be using banks and post offices as distribution channels

□ Ensure seamless movement of securities from the present SGL form to demat form

□ Keep uniform charges to open/maintain gilt accounts; waive off settlement charges for retail

– Develop market makers

Exhibit 3.19

■ Developing a benchmark yield curve for price discoveryA benchmark security helps price other assets, provides hedging mechanisms against interest risks,

and creates a core financial market for participants. A liquid government debt market is the best way to

create a benchmark asset because it is the only credible risk-free asset.

India has large G-Sec market whose role as an effective benchmark for the debt market can be enhanced

(Exhibit 3.19). Today, the trading in G-Sec is confined to a few securities. Just two securities, “8.79 per

cent GS 2021” and “9.15 per cent GS 2024” account for 50 per cent and 37 per cent of the total traded

volume respectively.

Five reforms are required to broaden and deepen the G-Sec market in India.

– Consolidate instruments○ Issue securities across maturities

○ Buy back or switch operations to retire/extinguish G-Sec with small outstanding amounts

– Widen investor base○ Simplify access for investors like trusts, corporates, etc. ○ Encourage long-term gilt funds through appropriate incentives (like tax breaks, liquidity support,

etc.)○ Introduce a web-based system of access to NDS-OM○ Attract more retail participation. Some initiatives to achieve this could be using banks and post offices

as distribution channels


○ Ensure seamless movement of securities from the present SGL form to demat form

○ Keep uniform charges to open/maintain gilt accounts; waive off settlement charges for retail

– Develop market makers○ Allocate specific securities to each PD for market making and, if required, rotate the stock of securities

among the PDs at periodic intervals

○ Evolve a suitable framework to assess the performance of PDs vis-à-vis market making and provide

incentives like refinance/IDL based on these performance measures

– Re-examine the HTM and repo market guidelines

○ Bring down the upper limit on the HTM portfolio from the present 25 per cent of total investments.

This will help release more G-Sec into the market, thus increasing liquidity

○ Enable the use of securities bought in the repo market for short selling

– Reform Foreign Institutional Investor (FII) rules○ Increase investment limit for FIIs in G-Sec from current USD 20 bn

○ Review withholding tax guideline for FIIs

○ Review SEBI guidelines that require FIIs to surrender their limits in debt securities (including G-Sec)

when these are sold when they mature

○ Amend guidelines prescribing transactions of FIIs in G-Sec only through exchange brokers

□□□

Despite the current uncertainty and fluctuations in the Indian capital markets and the economy, we believe

that the Indian capital markets are set to grow in line with the economy, taking India to a 6-8 trillion USD

capital market economy by 2020. In order to be prepared for and facilitate the 3-4X growth in Indian capital

markets, key reforms are needed to overcome challenges and set the foundation for the robust growth of the

Indian capital markets. We hope the ideas outlined in this report act as a starting point for addressing these

challenges and setting the foundation for the next phase of growth in India’s capital markets

35

Primary and Secondary Markets


Current Status of the Indian Primary Market & Key Learnings from other Developing Markets Mr Sanjay Sharma, M.D., Head- Equity Capital Markets, India, Deutsche Equities India Pvt. Ltd.

The equity markets in India saw a tipping point in 2004 when over US$10bn of equity was raised for Indian

issuers and Sensex closed at 6,600 levels. What followed was an extended bull run with the peak in 2007 when

over US$35 bn was raised and Sensex closed above 20,000 mark. The subprime crisis of 2008 deeply impacted

the global and Indian market sentiment as equity raising in India fell dramatically to US$14.2 bn and India’s

market cap dropped to a third from US$1.8 tn to US$0.6tn. While the markets consolidated in 2009 and

recovered in 2010 as Sensex went up from 9,647 in 2008 to 17,465 in 2009 and 20,509 in 2010, the equity raising

again saw return as US$22.6 bn and US$31.6 bn was raised in 2009 and 2010 respectively. However, the

current European sovereign crisis has made a huge impact on Indian capital markets. Continued volatility

has driven the investors away from the markets and even the issuers are reluctant to issue equity at valuations

lower than historical average. While the 2008 crisis was considered as external and acute; the current global

crisis is seen as chronic and elongated and that is coupled with problems in domestic economy. The past

two years (CY2011 and 2012) have not even seen the total issuance cross US$10bn mark in India in each of

the years.

Initial public offerings (‘IPOs’) are considered as the benchmark for new capex in the economy as newer

companies float issuances to finance their growth cycle. For the first bull cycle since 2005, IPO market saw

its high in 2006 and 2007 when US$9.5bn and US$9.9bn of equity was raised respectively. Following the lull

of 2008 and 2009, IPOs made a comeback in 2010 when over US$11.5bn was raised including the blockbuster

‘Coal India’ IPO. The current calendar year has seen a miniscule amount of less than US$300 mn of funds

being raised through IPOs.

Convertible bonds which were very popular in 2006 and 2007 during the bull cycle have not seen their return

as investors have been reluctant to participate. A lot of mid-cap issuers who issued the bonds in 2007 are

facing difficulty as their equity prices never touched the heights of 2007 to convert and the rising dollar has

made refinancing of those bonds very expensive.

Amongst the different methods used for follow-on offering, further public offerings (FPOs) were very popular

in 2006 to 2008, especially for the government disinvestment programme. But issuers have started to use

quicker means of equity raising as volatile markets have considerably shortened the equity raising windows.

Recognizing this, even the Department of Disinvestment (‘DoD’) has preferred taking up shorter routes like

Offer For Sale (‘OFS’) over FPOs.


Equity raising (US$bn) Sensex India VIX India Mcap (US$b)

Year CB FO IPO Total Average Year End Average Year End Average Year End

2004 2.3 4.9 2.9 10.1 5,563 6,603 n.a. n.a. 277 386

2005 3.6 10.1 2.4 16.1 7,393 9,398 n.a. n.a. 438 546

2006 5.4 7.1 9.5 22.0 11,440 13,787 n.a. n.a. 663 816

2007 8.2 16.9 9.9 35.1 15,564 20,287 31.4 25.4 1,122 1,815

2008 0.6 8.3 5.3 14.2 14,493 9,647 39.4 43.1 1,100 637

2009 3.7 14.6 4.2 22.6 13,701 17,465 37.3 23.4 932 1,301

2010 1.6 18.5 11.5 31.6 18,207 20,509 21.8 16.6 1,430 1,629

2011 0.8 7.7 1.4 9.8 17,778 15,455 23.8 27.1 1,375 1,005

2012 0.4 7.4 0.3 8.0 17,117 18,000 21.5 15.0 1,147 1,127

Total 26.5 95.5 47.3 169.4

Source: Bloomberg, BSE

Recent challenges / issues for the capital markets

The current macro-economic environment in India is extremely challenging. Macro headwinds are strong

while policy momentum is slow; political uncertainties are mounting; and risks of disorderly adjustment in

the real and financial sectors are now not insignificant.

Slowing growth: The current GDP growth rate of 5.3% is the slowest in nine years. Now India is • expected to grow at 6.0-6.5% annually vs. assumption of 9% a year ago.

Persistent high inflation: WPI has been hovering in the 8-12% range for over two years now. Despite the • hawkish stance adopted by RBI, inflation has not been tamed. Slowing output and uncertain monsoon have further tied down RBI’s options to combat slower growth with easing monetary policy.

Higher fiscal deficit: In the first four months of the fiscal year, the government has touched 51.5% of the • annual target due to rising fuel subsidies. Despite the recent fuel hike, government is expected to have consolidated deficit of 8.0% of GDP.

Impending credit rating downgrade: Ballooning subsidies, weak revenues and fiscal deficit • if left unchanged, would push India’s sovereign rating to a sure path of downgrade.

Falling Rupee: The macro concerns have led to the slide of Indian Rupee as it is down 19% since • beginning of 2011 and 14% in the last twelve months. US$ traded at an all time high of INR57.16 on 22nd June.


As seen in the past, these issues can be tackled by determined policy making and appropriate monetary

impetus. Recently, Government has shown its commitment to India’s growth by taking affirmative action but

there is a need to pass long pending structural legislations like DTC and GST and provide stability for policy

framework in future.

The current regime has been accused to be embroiled with policy indecisiveness and political unwillingness

which has worried the investors. In addition, lack of timely clarity on the policies like GAAR from a weakened

government entangled in scams like 2G, ‘Coal-gate’, etc has further spooked the investor sentiment. To be

truly impressed, investors would like to see return of the capex cycle which is stuck due to slow decision

making by the government as companies building the infrastructure are facing multiple headwinds like

unavailability of raw materials and financing.

The back-to-back announcements on fuel price rationalization and opening up FDI (for multi-brand retail,

aviation, power exchanges and broadcasting services) against a backdrop of near unanimous scepticism over

government’s ability to meander through the volatile minefield of coalition politics is a huge signal, symbolic

of the government’s reform commitment and an endorsement of its recognition of the urgency to put the

economy above politics, for now.

Recent regulatory changes for the capital markets

In wake of falling capital raising by Indian issuers and low participation by the domestic investors, SEBI

has been proactive and is making the necessary tweaks to the regulatory framework to shore up investor

sentiment and kick start the fund raising process.

1. Enhancing retail participation in the capital markets:

Widening the reach for applying in IPOs via over 1,000 location in electronic form (eIPO)•

Extending the reach of ASBA by asking banks to expand to all their banks in a phased manner•

Ensuring that all investors get at least a minimum lot and increasing the minimum application size to •

Rs. 10,000-15,000 instead of Rs. 5,000-7,000

2. Facilitating capital raising by issuers

Fast-track issuances can be done by companies with average free float market cap of Rs. 3,000 crore • instead of Rs. 5,000 crore earlier.

SEBI registered Alternative Investment Funds such as SME Funds, Infrastructure Funds, PE funds, • VCFs, etc. can participate (up to 10%) in the promoter’s contribution to encourage professionals and technically qualified entrepreneurs who are unable to meet the requisite 20% contribution by themselves to also raise funds via IPOs.


To facilitate companies to reach minimum public float as per SCRR, additional routes like IPP, OFS, • Rights and Bonus issues are allowed in addition to any other method based on pre-approval on case to case basis

More flexibility to change up to 20% in amount proposed to be raised in the objects of the issue in RHP • without re-filing instead of existing 10%

Allow raising funds via QIPs at up to 5% discount to the SEBI floor price•

More comprehensive annual disclosure similar to a 20F filing updated by the prospectus•

3. Enhancingmarketintegrityandinvestorconfidence

Eligibility criteria for issuers coming through “profitability route” now needs a minimum pretax • operating profit of Rs. 15 crore

Other issuers need to raise funds via SME platform or compulsory book building route (albeit with • higher QIB participation of 75% instead of 50%)

Additional mechanisms to monitor issue proceeds•

No withdrawal or lowering of size of bids permitted for non-retail investors to avoid misleading • signals to investors

Price band along with financial information now to be published at least 5 working days prior to • opening of the issue instead of existing 2 working days so that markets can analyse the issue

To bring transparency in capital raising, ‘General Corporate Purposes’ as an object cannot exceed 25% • of issue size

Employee benefit schemes can now be made only as per SEBI (ESOS and ESPS) guidelines, 1999. • Existing schemes not in conformity with the same would be given time to align them. These schemes are prohibited from acquiring shares from secondary markets

Further changes which can streamline the IPO and delisting processes

1. Speeding up the IPO process

In India, we have one of the most efficient secondary markets as settlement process takes only T+2 in

line with global markets. The IPO process on the other hand is considerably deficient as it still takes

T+12 days for a company to list after issue closes. Even though the allotment process is speeded up since

the advent of demat accounts, the dependency on the physical forms and cheque system for the retail

investors has resulted in significant delays as well as errors in the system. If SEBI, decides to mandatorily

have ASBA / e-IPO for all type of investors, IPOs can be settled in the T+2 process similar to the leading

financial markets globally. This can increase the attractiveness of global investors to invest in Indian

IPOs who are generally reluctant to lock-in funds for such a long period.

2. Streamlining the delisting process

The current delisting process unduly favours the arbitrageurs as reverse book building can throw up any

price (promoter only has option to accept or reject this price). Also there is a requirement to garner over


50% of public shareholding through this process even if promoter owns more than 90% which (given

the geographically distributed retail holding) reduces the chances of success and hence dependence on

arbitrageurs to ensure success. Currently companies are faced with the precarious position of either

accepting unrealistically higher price to delist or offer a huge discount to dilute down to minimum

public float in such companies. If the promoters are allowed to purchase the shares at a pre-determined

(with public shareholders having the option to accept or reject the price) and allow delisting if they own

more than 90%, there would be more execution certainty.

Depth of the secondary markets

Indian secondary markets have undergone systemic change since 2004. Cash volumes have started falling

(both in US$ terms and relative to market cap) and F&O has replaced the mind share of the trader community.

Average cash volumes which went up from US$1.5 bn in 2004 to US$4.4 bn in 2007 have now tapered off

to US$2.6 bn. Even in relative terms, we see cash volumes as percentage of average market cap has seen a

consistent slide from 0.5% in 2004 to 0.2% in 2012. F&O volumes on the other hand have seen record jump

as it went up from US$2.3 bn in 2004 to around US$28 bn in 2011. Even in relative terms, they have gone up

from 0.8% to 2.0% in the same time period.

Retail participation which was very active pre-crisis (as seen by high cash to F&O) has gone down quite a

bit since then, as investors who lost money in the bear markets of 2008 and 2011 have now decidedly stayed

away from stock market and moved their portfolio to other assets like real estate and gold. Institutional as

well as high frequency programme trading have been very active during the recent times as seen by record

F&O turnover.

Table 1

Year Average India Mcap (US$bn)

Average CashTurnover (US$bn)

Average F&OTurnover (US$bn)

Cash turnover/ Mcap (%)

F&O turnover /Mcap (%)

Cash /F&O (%)

2004 277 1.5 2.3 0.5 0.8 66.4

2005 438 1.9 3.5 0.4 0.8 53.5

2006 663 2.6 6.3 0.4 0.9 41.0

2007 1,122 4.4 11.7 0.4 1.0 37.8

2008 1,100 4.3 11.0 0.4 1.0 39.1

2009 932 4.4 13.3 0.5 1.4 32.7

2010 1,430 4.2 22.0 0.3 1.5 19.3

2011 1,375 3.0 28.0 0.2 2.0 10.8

2012 1,147 2.6 22.7 0.2 2.0 11.3

Source: Bloomberg, BSE, NSE


Another measure of the depth of the equity capital markets can be seen by market cap to GDP ratio. As can

be seen in Table 2 below, countries like USA have market capitalization which is greater than their GDP,

whereas India has market cap which is almost half of the GDP, even lower than the world average.

Table 2

Market Cap (US$tn) GDP (US$tn) Mcap / GDP (%)

India 1.0 1.8 54.9

China 3.4 7.3 46.4

USA 15.6 15.1 103.6

Japan 3.5 5.9 60.3

UK 1.2 2.4 49.4

World 45.1 70.0 64.4

Source: World Bank

Coverage of the investing populationA commonly accepted metric for measuring the investing population is seen as the total number of demat

accounts in the country as the major stock exchanges, commodities now see most of their trading taking

place via demat accounts. The demat accounts in India has seen tremendous growth as the accounts have

grown from 6.7 mn accounts in 2004 to 20.3 mn accounts today. This represents that 4,842 accounts have been

opened each day since 2004 at the CAGR of 15.5%. However, a number of these accounts (30-35%) have been

‘dormant’ i.e. no securities or no activity in the last one year. The majority of the new demat accounts opened

recently are for investors who wish to buy bullion in electronic form.

Table 3

(# of demat accounts in millions)

NSDL CDSL Total

Current 12.3 8.0 20.3

2011 11.8 7.8 19.6

2010 11.2 7.3 18.5

2009 10.3 6.3 16.5

2008 9.6 5.4 15.0

2007 0.8 3.5 4.3

2006 7.8 2.1 9.9

2005 7.2 1.2 8.4

2004 5.9 0.9 6.7

Source: NSDL and CSDL


Table 4 below shows the potential of investing population. We have defined the investing population as older

adults (25years +) who have a bank account and have saved money in the past year,as seen by the results of

the World Bank study conducted in April 2012. We can see that only 13.3% of the investing population have

opened demat accounts and that there is a huge potential for expanding the reach of the secondary market.

Table 4

Population (millions)

Total population 1,224.6

Older adults (25+) 612.3

Having bank account 232.8

Saved money in the past year 152.2

Number of demat accounts 20.3

Coverage 13.3%

Source: World Bank, NSDL and CSDL

SEBI is considering opening up of the ‘no-frills’ demat account similar to RBI’s initiative to increase financial

inclusion by opening up of ‘no-frills’ savings account. This should be accompanied with dedicated effort

to increase the reach of demat accounts to the rural areas via using ‘investment correspondent’ similar to

‘business correspondent’ used by banks to target the rural population.

Role of secondary markets in channelling the savings to capital markets

Rajiv Gandhi Equity Savings Scheme

The government launched the Rajiv Gandhi Equity Scheme which provides tax benefits for directly investing

in equities with the twin goals of channelizing savings to capital markets as well as increase the retail

participation in stock market by getting ‘first-time’ investors (with annual income less than Rs.1 mn) and

build the equity culture in India.

India has an estimated 15 mn individuals out of the 25 mn tax payers whose annual income is less than

INR1 mn. If all of these individuals were to invest the full Rs. 50,000 limit in the equity markets, Indian stock

markets can receive just shy of US$23 bn in investments (equivalent to more than two years of FII flows.)

The current scheme only allows a one-time investment opportunity, if the government encouraged by positive

response decides to extend the scheme, we can see a regular flow of investment in the equity market via this

scheme. Also since these investments would have a ‘lock-in’ period of three years, we would see sticky flows

in the markets with long term investment.

To prevent the investment into riskier smaller stocks, Government has decided to curtail the investments to

BSE100, CNX100 and Navratna PSUs in addition to diversified instruments like MFs and ETFs.


PSU ETF Fund

The Department of Disinvestment, Ministry of Finanace, as a part of its divestment plan is proposing to

issue an ETF fund to sell down its equity and at the same time encourage investments in a more diversified

PSU exposure with reduced risk. This is based on the very successful Tracker Fund of Hong Kong (‘TraHK’)

which helped the Hong Kong Government exit its investments in Hong Kong Stock Exchange in a US$4.3

bn IPO in 1999. The Department of Disinvestment is planning to create a pool of shares of the PSUs it wants

to divest and create an ETF, which is an investment fund traded on stock exchanges just like stocks and

would have an underlying benchmark which could be an index on the stock exchange. This could help the

Department to meet the twin objectives of complying with the minimum public float requirement and raise

the finances for the Government. Since ETFs are more commonly invested by retail, they also offer a chance

for retail investors to invest in the PSU companies without the unsystematic risk of each company.

Key learnings from other developing primary and secondary markets

Certain procedures in other developing primary and secondary markets, if implemented in India, could

simplify and boost the Indian primary and secondary markets.

1. Reducing settlement period in public offerings:

Settlement period is a T+12 days process for public offerings in India. The dependency on the physical

forms and cheque system for the retail investors has resulted in significant delays as well as errors in

the system. An e-IPO for all type of investors can result in a shorter time frame for settlement. This can

increase the attractiveness of global investors to invest in Indian public offerings as it reduces the risk of

funds locked up for longer periods. This would also ensure sustainable economics for both primary and

secondary market players.

2. Claw-back mechanism for IPOs:

In the claw-back mechanism, initially, only a small percentage of the shares are offered for public

subscription. However, the claw-back mechanism helps by increasing the size of the public tranche

depending upon the over-subscription levels of the public tranche. Such a mechanism not only ensures

comfort of the deal being executed initially due to the high reservation to the institutional investors but

also ensures greater shares for the public investors in case of oversubscription. In India, due to fixed

proportion to retail investors, these investors receive less shares in an oversubscribed IPO and more

shares in case the offering barely manages to subscribe.

3. Consolidation of disclosures:

Listed companies in India are required to release multiple disclosures annually, semi-anually and

quarterly. These are available publicly at various locations – stock exchanges websites, SEBI website,


company website, other public databases etc. A document that encloses all relevant disclosures of the

listed company during the year would ensure that investors find it easy to obtain all relevant company

information from one location instead of hunting for information at various locations.

Transforming retail participation in Indian capital markets

India is a country with a strong equity culture and with a stock exchange which is more than a century old.

Till a few years back, retail investors used to dominate in secondary markets and were a very important

source of demand for the primary markets. However, retail investors in India are also short term investors. In

IPOs, retail investors are merely followers of the QIB and HNI demand and invest in IPOs based upon QIB/

HNI subscription levels. Typically, majority of the retail investors sell their holding allocated to them in IPOs

on listing date. Also on secondary markets, retail investors do not do enough research but rely on tips from

stock brokers, friends and family. Due to the above, retail investors have an undue bias towards mid-caps

and small-caps, where they look to make quick gains.

The last few years have seen markets to be extremely volatile with spurts of high and low liquidity. The

retail investors have been caught unguarded in such times. Retail investors who have been chasing the ‘IPO

pop’ and investing merely on tips / rumours rather than research, have not only lost money but also faith in

the markets, when many of the IPOs saw share prices drop on first day of listing. The higher than average

interest rates, rising prices of bullion / real estate and active commodities have opened up other attractive

venues for the retail investors to invest and protect their capital.

A unique feature of Indian markets is that retail investors take up direct exposure to equities. As the portfolio

for retail investors is small, there is no scope for diversification. In India, pension funds are not allowed to

invest in equities. Insurance companies invest a disproportionately large asset base in government securities

due to regulations. Equity investments can give positive returns when held for longer time frame. Getting

retail investors to have indirect equity exposure through professional fund managers is as important as

getting them to invest directly. This helps the retail investors hold equity for longer time periods and thereby

reduces chances of losses.

Adopting some of the below methods could attract retail investors back into the primary / secondary

markets:

Focus on proper investor education•

Transparent corporate governance•

Simple and easy to understand IPO document (detailed disclosures)•

Higher discount to retail investors in public offerings•


Attracting FII investments in India

Indian markets attract FIIs due to the long term growth potential and favourable demographics. However,

India also is a country with inherent risks due to unstable policy regime due to political compulsions. The

lower than anticipated growth, higher than expected inflation, burgeoning fiscal deficit and a government

rocked with scams have lowered the attractiveness of Indian markets. The Indian Rupee has also played the

spoil-sport as investor returns are measured in dollar terms. Finally, being an emerging market, FIIs have

looked away from the Indian market due to the general risk-averseness currently built in.

From previous equity offerings, it is seen that FIIs contribute 60-80% of all equity offerings in India. They play

an important role in India primary / secondary markets and own over US$184 bn in BSE500 companies. Some

of the FII flows will see return to India automatically as the macro factors return in favour of India and the

markets start to absorb more risks. However, government stability and further policy making are required

for improving investor sentiment and hence foreign institutional flows into the country. As recently seen, the

positive announcements from Europe and the US central bankers and recent government reforms in India

(fuel hike and allowing foreign investments in the retail and aviation sectors) have lead to an uptick in equity

markets and will also see increased flow of foreign funds into Indian equities.


Note on Delisting Regulations Mr Sunil Sanghai, Chair, FICCI’s Capital Markets Committee and M.D., Head of Global Banking-India, HSBC Ltd.

Background - The process of delisting of equity shares entails removal of the equity shares from the stock exchanges on which

they trade.

Various sources indicate that significant number of the companies, currently listed on various Indian stock

exchanges, is being not actively traded. With limited trading, investors are faced with illiquid investments.

Typically, investors would look to release funds tied up in such companies and invest in relatively active

scripts – voluntary delisting by the majority shareholder is one such mechanism.

Delisting of less active and thinly traded stocks provides option to investors to invest in more active counters

where long term value creation opportunity is higher and decision to enter and exit is not restricted. Such recy-

cling of capital is critical for vibrant and efficient Indian equity capital markets.

The capital markets regulator, SEBI, in 1998, first directed stock exchanges to amend the listing agreement and

other bye laws to provide for delisting procedure including pricing for delisting offers.

Pricing considerations in the 1998 circular took into consideration trading history of the securities over the past

six months. Should such security not be classified as a frequently traded one, pricing for delisting was to be

determined by the statutory auditors of the company as the fair price for delisting i.e. shareholders had no say

on pricing. This arrangement came in for criticism from public shareholders and various investor forums as the

price was solely determined by the statutory auditors of the company. Independence and role of the statutory

auditors and potential influence of the controlling shareholders in determining the price for delisting were also

questioned.

Current Situation - To address these concerns, in 2003, SEBI introduced a price discovery mechanism in the form of reverse book

building for the delisting of equity shares. Price for delisting was based on the price at which maximum

number of shares was tendered by the minority/public shareholders. Revised rules provided flexibility to the

controlling shareholder to accept or reject the price determined by the reverse book building process.

In June 2009, SEBI outlined further changes to the earlier guidelines and introduced new regulations for

delisting of equity shares. Key changes included were the new thresholds for delisting proposals - (a) approval

of delisting proposal by the minority shareholders and (b) determining success or failure of the proposal

under reverse book building. These regulations remain in force at present.


The regulations require that votes cast by the minority shareholders in favour should be at least two times

the number of votes cast against the resolution for a voluntary delisting by a majority shareholder. Also, for

a delisting offer to be successful, the controlling shareholder has to reach either ninety (90) per cent of the

voting capital or fifty (50) per cent of the voting capital held by minority shareholders plus the aggregate

percentage of the pre-offer promoter shareholding, whichever is higher. These changes were in addition to

the price discovery mechanism envisaged through reverse book building.

SEBI should be complimented for a progressive approach towards delisting - in particular, for recognising

the minority shareholders as a separate class of shareholders, an international best practice, thereby

requiring them to approve the delisting offer by two thirds majority.

Reality Check - However, a combination of increased threshold and reverse book building has led to significant powers in the

hands of minority shareholders. A closer scrutiny of how the current delisting rules have worked, particularly

the reverse book building process, indicates a disconnect between the intent of the regulations and the actual

implementation.

Recent experiences provide evidence that the reverse book building process, which was to facilitate an inves-

tor friendly mechanism of price discovery and to aid determination of a fair exit value for the minority/public

shareholders, is not fully achieving the objective. The mechanism is not necessarily translating into genuine

discovery of price.

Shareholders holding significant stake amongst the minority shareholder exercise disproportionate pow-1.

ers while a delisting proposal is being considered for benefit of larger set of minority shareholders. This is

contrary to fundamental corporate law principle that all shareholders should be treated equally.

Odd bids are submitted by arbitragers and other market participants who have neither invested in the 2.

company nor are looking to be a long term shareholder in the company. Such bids destablise the delisting

process for minority shareholders who have undertaken risk of investing over a longer horizon and are

denied a fair exit.

Mutually agreed by a few market participants in the price discovery process which may work adversely for 3.

the other minority shareholders intending to participate in delisting process.

A historical analysis of the premium paid in the delisting process in the past couple of years indicates that com-

panies indicating to delist have paid premium in excess of 70% of the floor price.

Need of the hour - Reverse book building mechanism is not observed in most of the developed markets and a consistent practice

is to enable the majority shareholder to indicate a price for delisting and the same being approved by the mi-

nority shareholders. A review of the delisting regulations in other jurisdictions with healthy capital markets


(the UK, Hong Kong, Singapore) suggest that minority shareholders approve, via a shareholders’ resolution, a

delisting offer as well as the price offered by the majority/ controlling shareholder. This enables an equitable

say to all shareholders. The reverse book building process currently only serves to cater to the interests of the

more sophisticated investors and difficult for retail shareholders to comprehend. Retail and small investors are

more comfortable with a fixed price tendering mechanism. Most developed markets also specify a fixed price

mechanism for delisting.

There is a need for modifications of the existing delisting regulations, in particular the pricing mechanism, for

efficient functioning of the capital markets.

The reverse book building process could include price determination parameters like introduction of a price

band along the lines of the price discovery process for new equity issuance to avoid frivolous bids. The floor

price for the price band can be determined as per the current regulations which assess the floor price on the

basis of factors like trading history, fair value by independent agency, historical deals done etc.

The higher end of price band can be determined by the majority shareholder. To protect the interest of minority

shareholders, a committee of independent directors in consultation with the merchant bankers would provide

a recommendation on the price band. The independent directors and the merchant banker would consider

market scenario, company performance, willingness of controlling/promoter shareholders to delist, quantum

of funds required etc.

The delisting offer price should be the price point, within the pricing band, at which such number of shares

have been tendered for delisting which enables the majority shareholder to meet the relevant threshold. This

price shall be binding on the controlling/promoter shareholders and shall be paid uniformly to all minority

shareholders. Currently there is no provision for investors to bid at the cut-off price similar to an IPO process.

Retail investors should be allowed to bid their shares at a “cut off” price ensuring that shares get tendered from

significant portion of the retail investors and at a price which will be determined through the reverse book

building process. Further, the delisting provisions should allow for a downward revision of the bidding price

in the reverse book building process to ensure public investors can bid at lower prices in case they see the book

building at a price lower than their bid. These steps would ensure better participation in the process.

This mechanism would address the balance between controlling/ promoter and minority shareholder. This

also provides an independent oversight over pricing to ensure that minority shareholders receive a fair exit.

Such a process will be a key enabler for minority/public shareholders to release capital invested in such com-

panies and recycle capital and contribute to efficient functioning of the Indian equity capital markets. The

multiple levels of approval, first approval to the shareholder resolution and a subsequent successful tendering

by atleast 50% of minority shareholders, tend to confuse the shareholders and is also time consuming. The re-

quirement of the shareholder approval should not be waived which would significantly shorten the timeline.

The approval of the shareholders would in any case be evident through their participation in the reverse book

building process.


Developing Indian Capital Markets - the Way ForwardMr. Shachindra Nath, Group CEO, Religare Enterprises Limited

The current macro-economic environment in India is that of turbulence partly due to global uncertainties and

partly due to domestic ambiguity on a path forward for the short term, but the long term India growth story

remains intact. India’s linkage with the rest of the world’s financial markets has been on an upward trajectory

since the country began economic reforms in 1991. This trend is going to continue in the foreseeable future as

we become more closely integrated with the global economy. The capital markets in India have grown manifold

in the last two decades and several structural changes have brought us at par with international standards on

many counts. However, there is still a long way to go. One of the biggest challenges facing our markets is the

lack of penetration and low retail participation. Penetration in products such as currency is limited with equity

and commodities accounting for a large share of trading volumes. Retail investor penetration in India is very

low compared to many developed or developing markets. Now is the right time to expand access and instill

confidence to get the population rolling once more and this time in larger groups.

Challenges faced by the Indian Capital MarketsCapital markets are facing challenges with some being structurally related and some being regulatory related.

While the policy makers have taken steps to address some of the regulatory challenges, such initiatives have

not significantly affected the structural challenges. In addition, changes are required in regulations to provide

an impetus to further the development of capital markets.

Low depth in equity markets1. - Indian markets have a lower trading velocity as compared to other markets

such as China, Japan, United States, Germany and UK. Indian exchanges are also somewhat undiversified

with equities and commodities accounting for 90% of the trading volumes.

Low retail equity ownership2. - Indian households have the highest savings rate in the world; the household

savings rate has increased from around 11 per cent in 1980 to over 35 per cent today. However, less than

1% of India’s population invests in equities and less than 2% of total household savings makes it to direct

equities and debentures. Moreover, 50% of the total household savings continue to be invested in physical

assets, in particular gold and real estate.

Dominance of top tier cities in trading volumes3. - The top eight cities in India by population account for 73

per cent of mutual funds and 87 per cent of cash trading volumes, while they account for only 30 per cent

of the income. Considering the minuscule contribution of the other top-350 urban centers, there is a huge

opportunity to deepen the retail investor base in India.

Higher costs per trade 4. - Costs per trade (brokerage commission, taxes (exchange and regulatory) and

market impact on price) are significantly higher in India than in developed markets.


Underdeveloped debt market5. - Although the Indian corporate bond market has expanded from USD 19

billion in 2007 to USD 40 billion in 2012, bond market penetration in India continues to be low. Corporate

bond penetration in India is only about 8 per cent of GDP, compared to 28 per cent in China. Institutions

such as insurance companies and pension funds are restricted to invest in corporate bonds beyond a certain

limit, which affects the liquidity compared to the government securities market.

The Way ForwardIncreasing market participation

Moving household savings to the capital markets is an imperative. There is a need to create capital market

products that replicate the risks and returns of physical assets to capture the proportion of physical savings

held for investment purposes.

Grow gold-backed capital market products, Gold Savings Schemes (GSS) - GSS is a new product offered •

only by two players in India (Kotak and Reliance Mutual Fund). However, given the potential of

these products to replicate the returns from gold, players should focus on three areas to deepen retail

participation in this space.

Launch Real Estate Investment Trusts (REITs) to address investor needs not fulfilled by products like Real •

Estate PMS. Till now in India, only venture funds have been offering real estate funds available largely

to high net worth individuals and institutional and global investors due to the minimum investment

size restriction. REITs can take the form of pooled investments in both upcoming and existing income

generating properties to cater to different classes of investors. REITs act as a tax efficient tool as income

is distributed at regular intervals with no tax implications for the holder.

Improve mutual fund penetration across asset classes and introduce newer products like Debt •

Infrastructure funds which is likely to create long term investment opportunity for retail investors.

Enhance investor awareness in tier II urban and semi-urban centres through investor camps in key centres, •

nation-wide programmes with a focus on ethical selling practices by financial services companies.

Regulatory reforms to encourage retail participationThere are three critical regulatory challenges which should be addressed to encourage greater retail participation

in the Indian equity markets:

Rationalizing the Securities Transaction Tax - The tax regime in India, with the introduction of Securities 1.

transaction tax (STT) in the year 2004 has made the cost of transaction skewed against cash trading (both

delivery and intra-day). The STT for cash delivery transactions today stands at about 730 times than the

equivalent turnover in options. This difference stands at 73 times between intra-day cash trading and

options. This has led to a large skew in turnover in the Futures & Options (F&O) segment. The ratio of F&O

to cash turnover in the Indian exchanges stand currently at 11: 1 against a global ratio of 2-2.5:1.


Uniformity in stamp duty charged by different states on equity transactions - The government of 2.

Maharashtra, which accounts for 40 per cent equity volumes on the country’s two biggest exchanges,

doubled the stamp duty on equity transactions, in their annual budget for 2011. A uniform duty of 0.005

per cent on all equity transactions was mandated in comparison for the average of 0.0024 per cent in the

cash segment and 0.002 per cent in the derivative segment.

Increasing domestic institutional investor participation by allowing higher investments by pension funds 3.

in equities - Current regulations allow only about 10 percent of the pension fund corpus of Rs. 6.4 trillion

to be invested in the equities market directly or through mutual funds. In contrast, internationally, up

to 50 percent of pension funds is invested in equities. Moving the Indian pension fund market closer to

international levels could potentially create equity inflows of up to Rs 2,500 billion at current levels, giving

a much needed boost to domestic institutional investor participation.

Deepen product markets1. Deepen the Corporate Debt Market - Liquidity in the corporate bond market in India is constrained. There

are few changes which are likely to drive liquidity in the corporate bond market:

Exempt corporate bond repos from the cash reserve ratio/statutory liquidity ratio requirement to •

deepen the corporate bond repo market. The deepening of the corporate bond repo market will likely

drive significant activity in the bond markets.

Over time, create an integrated trading and settlement system for corporate bonds (like the Negotiated •

Dealing System-Order Matching for government bonds) and move to a clearing house guaranteed

settlement system. Additionally, encourage investors with larger bond holdings (insurance companies,

pension funds) to trade in bonds rather than letting them mature in order to create liquidity in the

corporate bonds space.

2. Deepen the interest-rate futures market - Interest-rate derivatives are needed to hedge rate risks, the largest

macro-economic risk. Globally, interest rate derivatives constitute the largest part of derivatives turnover

on both exchange-traded as well as over the counter products.

Streamlining securities lending and borrowing to increase turnover Securities lending and borrowing (SLB) facilitates short-selling, increasing liquidity, improving pricing

and facilitating arbitrage between derivatives and cash markets. Due to current regulations in India, SLB

turnover remains abysmally low, while in markets like Hong Kong and Australia the turnover is more than

USD 80 bn.

Creation of a Sovereign Wealth FundSetting up a Sovereign Wealth Fund (SWF) for India could be an important channel to invest in the local market

to bring financial stability. As on date, India doesn’t have a SWF unlike most of the emerging economies. SWFs


are only one of the many channels through which governments deploy their financial assets. The funding

of SWFs comes from various sources, which vary from current account surpluses from export of oil and

other commodities or manufactured goods, fiscal surpluses, public savings, privatization receipts or pension

reserves. Around 45% of SWFs come from oil rich countries in the Middle East while Asia followed with a

third of the total with most funds there originating from excess of official foreign exchange reserves. In India,

the government can create an SWF in partnership with the private sector at large (ownership to be 50% each)

that provides a minimum guarantee return. Such a structure will encourage wider participation and will

provide a safety net of the government.

ConclusionThe capital markets in India have evolved considerably over the last two decades to create a strong foundation

for future growth. As the inter-linkages between global financial markets increase, the capital market in India

will need to hasten the process of transformation to a globally competitive capital market. The way forward for

the Indian capital markets is continuous regulatory reforms to adapt to the changing dynamics of the industry,

increasing the use of technology for easing the access to market, innovative products to increase choice as well

as participation and financial awareness for wider retail engagement. Focus on these areas will strengthen the

foundation that has been already created since economic reforms.

55

Domestic and Global Investors’ Perspective of the

Indian Capital Markets


Paper on Investors Perspective SessionMr. Anup Bagchi, Co-Chair, FICCI’s Capital Markets Committee and M.D. & CEO, ICICI Securities

Inclusive Policy: Getting the basic rights

Investment management companies such as mutual funds, insurance companies, private equity companies,

etc and enablers of these services such as distributors are facing muted inflows amid an evolving regulatory

framework and sagging domestic & global economy. Notwithstanding these challenges, a lot of effort and

steps have already been taken across the value chain ensuring better investment proposition to investors,

which will go a long way in improving the investor’s interest and the overall growth of the industry. These

recent measures are steps in the right direction and will go a long way in enhancing the mobilisation and

channelising of savings into efficient financial products once the overall domestic and global economic sce-

nario improves.

Mutual funds and life insurance companies have remained major domestic institutional investors in Indian

equity markets for the last five to seven years. Inflows in both MF equity and insurance are shrinking largely

contributed by a 500 bps knock in savings rate to 31.8% from its peak in FY08 due to local and global growth

issues. Financial savings have declined from 15.3% of GDP in FY10 to 10.9% of GDP in FY12. Within financial

savings, 52.8% is still with bank deposits, 23% for life insurance and 15.6% in provident and pension funds.

In FY12, shares and debentures saw a negative outflow of -0.7% as a proportion of financial savings, down

from 4.5% in FY10.

Mutual funds – lot more scope to increase

As on March 2012, the MF industry had an equity AUM of Rs 192465 crore (equity + ELSS + 65% of balance

funds) and witnessed an annual inflow of Rs 370 crore (equity + ELSS + 65% of balance funds), much lower

than the entry load regime. This is far lower than any global yardstick given the higher saving rates.

Exhibit1:MutualfundAUM&fundflow ( Rs crore)

MF NetInflows(FY12) ALM-Mar’12 FY13(YTD) AUM-AUG’12

IncomeEquityBalancedLiquidGltELSSGold ETFOther ETFFoF (Overseas)

-18528264382

-7104-20

-1423646-623102

29084415843216261803543659

23644986616072530

50239-3035-165

108159-496-681-35-51

-153

34931115301515761

1934663282

230651070115482399

Total -22023 587197 153782 752548

Source : AMFI, Insurance Company presentations, IRDA, Media articles, ICICI direct.com Research*Equity+ELSS+65% of balanced funds AUM as per AMFI


Insurance - significantly underpenetrated

The Indian insurance industry is the fifth largest among emerging economies and has grown at 25% CAGR after

the markets were opened up for private players in 2000. The life insurance industry has seen 20% growth in

annual premium income in FY10. However, in the current slowdown, the growth has declined with gross an-

nual premium collection of Rs 283315 crore in FY12. The penetration (annual premium/GDP), which was 1.77%

in FY00 increased to 4.4% in FY10 in India. The industry has huge investment corpus with an AUM size of Rs

1618544 crore as on March 2012 rising from Rs 934030 crore on March 2009. Equity investments of industry also

more than doubled to Rs 473000 crore.

Exhibit 2 : Life insurance industry growth over years (Rs crore)

FY09 FY10 FY11 FY12

Total AUMGrowthEquity AUMPremiumsPrivate LifeLICTotalGrowth

93403010%

199966

64600157100221700

128894638%

446881

79200186100265300

20%)

148254915%

507434

86900203500290400

9%

16185449%

473000

80600202700283300

-2%

Source : IRDA, Life Insurance Council, ICICIdirect.com Research

The industry generated gross annual premium of Rs 283000 crore in FY12. At 20% deployment ratio, Rs 56000

crore is estimated to be annually invested in Indian equities via insurance companies, which is substantial in

the current context and is bound to increase with higher penetration.

Exhibit3:IndustryAUMoflifeinsuranceandMFandannualinflows(FY12)(Rscrore)

Industry Level AUM Annual Premium

Private LifeLICTotalEquity assumption

-2.5 lakh crore-13 -14 lakh crore

1618544-5 lakh crore

31%

80600202700283300

56660@20%

Source : Insurance Company presentations, IRDA, Media articles, ICICI direct.com Research

Private equity – Past investments under stress

The Indian PE industry started with a small size of $20 million in 1996, which has now gone up to an esti-

mated $68 billion in the past 10 years. Of this, ~ 50% of the PE inflow in the last four or five years likely went

into capital-intensive sectors like real estate and infrastructure, which are under stress, thereby providing

less profitable exits. Deals are likely to perk up if the overall economy improves, going forward.


Key drivers: Getting the basics right

The single biggest drivers of any financial product besides the financial environment are brands, trust and

decision simplicity. The ease with which consumers are able to gather trustworthy information, evaluate

merits of the products according to their financial needs and are rightly navigated towards purchase decision

are the basic building blocks for growing financial products.

Regulations in India and like in many markets play a pivotal role in building trust and confidence and also

ensure that the interest of all stakeholders’ viz. companies, distributors and consumers is taken care of. It

would be too much to expect that investment companies, distributors and consumers always do the right

thing all the time given past instances of mis-selling of financial products. Regulators play a dominant role

in financial product purchase journey and ensure that the interest of all stakeholders is protected given the

conflicting interest between them.

Financial regulation in our country has undergone a vast change of late and rightly so compared to an earlier

practice of it being product based and housed under separate regulators. For example, MFs are regulated by

SEBI while IRDA performs the same duty for insurance companies.

Various Indian regulators like SEBI, IRDA and PFRDA have worked relentlessly towards bridging the trust

deficit in the minds of consumers. A slew of investor friendly measures have been taken to ensure that the

needs of customer are understood and are catered to in a reliable and cost efficient manner.

Regulations in India are anchored around product innovation and decision simplicity i.e. making it easy for

customers in terms of process to comprehend, choose and execute products in line with their risk return trade

off through the right medium.

Product innovation

Financial products and its innovation go a long way in not only meeting the appropriate suitability of cus-

tomers but also facilitate resource mobilisation, asset creation and development of financial markets.

Exhibit 4 : PE deals & investment in India

98 73 98 94 112 90 136 159 157 113 130 78 65 48 66 102 88 79 113 94 111 126 118 122 101 97

1336 18

02

1437 17

91

2575

1563

3979 47

04

3593

2334

2429

1008

500 77

1

850 15

00 1978

1830 22

99

1666

3611

2477

2212

1164

1935

1616

0500

100015002000250030003500400045005000

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

FY06 FY07 FY08 FY09 FY10 FY11 FY12

1838587898118138158178

Deals (RHS) Deal value Mn$

Source: PWC Money Tree India Report

Exhibit 4 : PE deals & investment in India

Source: PWC Money Tree India Report


Although the industry is moving towards capturing investors requirement through innovative products like

gold ETFs for meeting investor’s appetite for physical gold investment, exchange traded products like eq-

uity ETFs/Debt ETFs/FMPs, NCDs and tax free bonds. New pension schemes, Rajiv Gandhi Equity Savings

Scheme, real estate funds, infrastructure debt funds, PMS, structured products like Nifty linked debentures,

etc have also recently introduced unique measures. In addition, SEBI has recently allowed alternative invest-

ment funds (AIF) to offer private equity funds, real estate funds and hedge funds products to investors.

Further, more innovative products are required like capital protected products/hedged products to cater to

specific individual/corporate investor requirements, investment in mutual funds through the SIP route, real

estate investment trust, inflation linked bonds, long term index/stock futures, delivery based equity deriva-

tives, etc.

Process

Good regulation involves supervision, regulation and enforcement. It also involves informed and broad par-

ticipation of customers and other stakeholders. Investors sometimes get harmed by lack of transparency,

information and actions that concealed or misled them. Improving processes to keep pace with regulatory

changes makes it easier for all stakeholders to do business without compromising on risk, reduce the cost

of operations and mutually share the benefits in terms of better market growth. The recent regulations to

include mis-selling as a ‘fraudulent and unfair trade practice’ and regulating investment advisory are steps

in the right direction. Some of the other recently introduced measures include:

Understanding the product: Investor risk profiling, classification of products, investor friendly disclosures

and limiting number of similar products to suit investor’s risk profiling would ensure proper understanding

of the product and simplify decision making.

Investing in the product: Measures like a common KYC norm, segregation between online investing, di-

rected investing, consolidation of mutual funds folio, etc are welcome measures. In addition, introduction of

e-IPOS is expected to simplify the application process and extend its reach. In order to provide a boost to the

primary market, SEBI has increased the minimum investment by a retail investor by increasing the lot size to

Rs 10,000 – 15,000 now from Rs 5000-7000 earlier.

Monitoring the investment: Consolidated investment statements for MF investments are good initiatives for

better monitoring and can be replicated for other financial products like insurance & alternative investments.

Regular and investor friendly disclosures of portfolio and valuation especially in PMS and private equity

would ensure effective monitoring.

Other measures by SEBI such as mandating all depository participants that they should not levy any main-

tenance charges for securities of value up to Rs 50,000, Rs 100 to be charged for Rs 50,000 – 2 lakh and normal

demat account maintenance charges for value above 2 lakh.


Distribution

Distributors of financial products are agents of both the product provider and customer. It has been found

that it had inherent imbalances due to differential product commissions. This has worked against the best

interests of customers leading to increased instances of mis-selling of products motivated by higher commis-

sion structure. Going ahead, distribution tailored to reach each kind of customers with products and capabil-

ity suited for that profile of customers.

Product neutral commission: The regulatory, compliance and commission structures vary across segments

within the financial services sector like mutual funds, insurance, pension funds, PMS, private equity, etc.

and each of them are governed by an independent regulatory framework and compete for the same share of

the customer’s wallet. This anomaly needs to be addressed to ensure products are commission neutral and

providing a level playing field to all financial products.

Adequate compensation is the most important aspect that encourages any distributor to sell a product. To

avoid aggressive churning and mis-selling, incentivising the distributor via higher trail commission may be

considered. This will align the interest of the investor as well as the distributor.

Investors-distributor interest alignment: Alignment of interest between investor and distributor is one of

the most important aspects in growing the financial industry. Measures like investor awareness, low cost

higher lock in period funds, advisory based distribution model, product neutral transaction charge model

with low fund management expense ratio and profit sharing model with low set up cost in products like

PMS, structured products, etc should help.

Investment Option: Different investment options should be available to investors so that it is the investor

who decides the mode of investment. Like in mutual funds, after the recent regulation, the investor has the

choice to go directly to the AMC or he needs distributor advice and, accordingly, has to pay a commensurate

charge on the investment. Similarly, in PMS, an investor is given a choice to choose between fixed charge and

profit sharing model. Similarly, in insurance, online option is available. There is a need to create awareness

of all investment options available across financial products. Awareness also needs to be created regarding

value created through proper and effective advice.

A distributor selling various financial products often doubles up as an advisor as well. SEBI has now drawn

a line by segregated fee based advisor and commission based distributors for better alignment of investor

interest. Also, MF schemes need to offer separate direct investment options with lower expenses. Similarly,

online insurance in insurance are welcome measures.

Wehavemadeagoodbeginninginthelongroadtowardsestablishingacrediblefinancialmarketbyway

of right regulations, product innovation, improving processes for aiding navigation, building trust and

making iteasierandcosteffective for customers toconfidentlyandefficientlyweigh their investment

decision.


Potential of Indian Capital Market: The Road AheadMr. Sundeep Sikka, President & CEO, reliance Capital Asset Management Limited

Capital Markets – A Key to strong economic growthCapital markets act as a catalyst to the socioeconomic growth story of any country due to their indispensable

role in financial intermediation & capital formation process. A vibrant capital market makes the entire financial

market efficient by enhancing liquidity, transparency and aiding price discovery.

Importance of capital markets cannot be particularly under-mined in India which requires ~ $ 500 billion of

capital for infrastructure development. India is a fairly large economy of ~$1.6 trillion with savings rate of

~33.7%. In next few years, it is expected to grow at an average rate of ~8% which will lead to additional savings

of ~$5 trillion. US economy is ~$15.23 trillion. Assuming a savings rate of 5%, it may be realism that Indian

households’ savings exceeds that of US in the next 10 – 15 years.

However, Indians prefer risk-averse investment avenues. Out of a huge population in excess of 1.2 billion, only

less than 1% are active participants, with a mere ~ 10% of their investments in equities & fixed income market.

As a result, retail equity ownership amounts to ~ 10 % of total equity ownership due to which trading volumes

are relatively lower than other countries. The corporate debt market is even less developed. The lack of a de-

veloped capital market system could be resulting in higher (and therefore ineffective) borrowing cost for the

companies and the vicious cycle of financial inefficiency.

It is pertinent for us to channel the huge household savings into capital markets through the development of

financial intermediaries in order to effectively fund our long-term sustainable growth story. Although a lot of

initiatives were taken in the recent past by the Regulator to develop a robust system and the market itself,

we believe lot many such developments need to be undertaken on a priority basis.

Heading For Growth: Transformation & Current DevelopmentsRevolutionary change in India’s capital market started in early 1990s with SEBI acting as a forerunner for

investor’s protection & development of market infrastructure & technology. Also, establishment of NSE

resulted in increased healthy competition & integration with global markets leading to a momentum in volume

& advent of new financial instruments.

Ononehand,financialstability&resilienceassumedimportance&morereformswererequiredtoestab-

lish a robust regulatory framework. On the other hand, investor awareness & penetration of retail markets

became the need of the hour for the optimum growth of the capital market.

The Market Regulator had taken up a lot of initiatives towards developing the market, some of which are:

“Basic Service Demat Account”:• Considering that there are only 2 crs Demat accounts which is ~2% of

population and ~40% are active accounts, SEBI proposed to open Demat accounts at a subsidized cost.


50 % of the Demat accounts holders would not have to pay any charge & 10 % would have to pay a small

charge. New Demat accounts would cover 60 % of total investor base.

Rajiv Gandhi Equity Savings Scheme:• Offers tax sops to first time retail investors. There are ~ 1.5 Cr

PAN Holders with an income < Rs.10 lakh who do not hold Demat accounts. Even if 20% avail the ben-

efit, Rs.15,000 Crs equity investment will be garnered in 2012-13 itself.

Increase SME Participation:• Realizing that SMEs face a road block in raising capital due to high in-

terest costs, SEBI had proposed dedicated exchanges for SMEs which could prove to be a remarkable

development for our capital markets.

Introduction of QFI regime to provide impetus to capital market:• In order to expand the markets, the

Regulator issued guidelines allowing Qualified Foreign Investors (QFI) to invest into capital markets.

Direct investments in equity market as well as mutual funds are allowed with an overall investment limit

of $ 10 Billion for equity schemes & $ 3 Billion for IDFs. A separate sub limit of $ 1 Billion has also been

created for QFIs investment in corporate bonds & MF Debt Schemes. The Regulator is also considering

to relax margin norms for FIIs.

Encouraging passive investing:• ETFs comprise 2% of total MF assets. In comparison, ETFs comprise

9% of US MF industry. To support development, Department of Disinvestment proposes to launch

“Disinvestment ETF” which will enable the Government to raise Rs.4,000 Crs .The move will help to

bridge national deficits, help PSUs to reduce promoter holding and enable retail participation.

Development of Corporate Bond Market:• India’s Corporate Bond Market is only 3.3% of GDP and is

under-penetrated compared to other economies. Share of corporate bonds to GDP is 10.6% in China &

41.7% in Japan. In order to develop the market, the Market Regulator has taken up initiatives to enable

MFs to participate in repos in corporate debt securities, enhancing the existing limit for FII investment

in government securities by $5 billion and allowing a large investor set consisting of Sovereign Wealth

Funds, multi-lateral agencies, insurance funds, and pension funds etc, registered with SEBI to invest the

entire limit of $ 20 billion in G-Secs.

Development of Commodity Markets: • Commodity markets have an important role to play in developing

agricultural sector and related eco-systems of any country. In India, importance of the same is evident from

number of commodity exchanges set-up.

Currency Derivatives Segment:• Currency derivatives segment on NSE & MCX has been consistently

growing both in traded value & open interest. MCX-SX is world’s largest currency futures exchange and

is ranked as the world’s most liquid among 20 exchanges across America, Europe & Asia. It has developed

a superior technology for process efficiency & new techniques to make prices more accessible.

Investor Education Programs:• SEBI has launched various programs in partnership with NISM to increase

financial literacy. Asset Management Companies also are mandated to conduct such investor awareness

programs across the country.


The Road Ahead: To reinstate, we believe focal approach towards financial awareness through integration of technology with

business, developing innovative yet simple financial solutions and creating a favorable environment both for

retail & institutional investors, including FIIs to access different asset classes will augment the growth path in

the foresight.

Increasing Retail Participation:• Around 90% of liquidity comes from around 10 cities and 100 listed

companies. Capital markets have huge potential to drive financial inclusion by providing investors

with the opportunity for wealth creation. Customized products and services will be required to suit the

investors’ risk-return profile for which financial literacy, apt customer segmentation, low-cost distribution

channel and integration of regional exchanges with national exchanges will assume greater importance.

Effective use of Technology platform:• India has ~80 million internet users and 5.2 million broadband

internet connections. However, internet penetration is only 7% as compared to 31% in China and 77%

in the US, implying a huge scope for internet trading. Also, Mobile trading can revolutionize financial

inclusion, given the base of more than 800 million mobile subscribers.

Unlocking Value of the Bond Market: • Retail segment has shown little interest in government securities,

due to small savings instruments and accessibility challenges. To encourage small investors, we believe

the bond market should align itself with the equity market model. As markets develop the investor

becomes aware about new products available in the developed markets, demand for these instruments

will increase. Thus, instruments like interest rate derivatives, credit default swap, “Dim-Sum Bond Funds”

(to raise Renminbi funds to facilitate companies that engage in trade with China), Islamic Bonds & other

Shariah compliant products, etc. are yet to take off in India but certainly have immense potential.

Developing the Pension Market:• Indian Pension Fund Market is ~ Rs.7, 50,000 Crs. Retirement benefits

was available to 11 % of working population in form of EPF, PPF, NPS, insurance products and 2 MF

Schemes. EPF in India is ~Rs.3 Lakh Crores. Even if a small proportion is allowed to be invested in

mutual funds, then it would not be far away for our asset management industry to boast for a ‘401k’.

Developing Passive Investing –• The following untapped segments present huge potential: Fixed Income

ETFs on Credit Oriented/High Yield/Investment Grade Bond, Currency & Real Estate ETF, Quasi active

ETF that tracks indices created for that particular ETF, Theme Based ETF – Dividend ETF, Inverse ETF &

Hybrid ETF, ETF Wrapper that minimizes exposure risk to narrow strategy ETF.

Commodity markets:• Institutional investors should be allowed to invest so as to negate the inherent volatility.

Also, the flat to negative returns of equity markets have made investors looking for alternate investments.

Globally, there are different ways in which mutual funds invest in commodity markets. Domestically, gold

is the only commodity where retail investors can participate. As the market evolves, an alteration in product

mix is on the cards. A huge opportunity lies in developing those commodity based products (silver, copper,

crude oil, etc), which can enable increase in wallet share.


Volatility - The New Investment ParadigmMr. Nimesh Shah, M.D. & CEO, ICICI Prudential Mutual Fund

The Indian equity market direction is being driven by a number of global and domestic factors, albeit in a

range. Global factors like the pending Euro zone debt crisis and domestic concerns like rupee depreciation,

high fiscal and current account deficit, inflation etc. have been key triggers for volatility. The markets

presently are at a juncture where valuations are at fair value and fundamentals have improved due to recent

reform action like the fuel price hike, disinvestment announcements etc,. Markets will therefore continue to

be volatile as they get impacted by global news flow like Qe3, FII flows and oil prices, or domestic triggers

such as execution on the initiated reforms etc. This multiplicity of variables, not withholding market direction

is contributing to an increased volatility. Volatility has become the new normal. Kenneth Rogoff and Carmen

Reinhart in their book “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises” have

indicated that the period after a financial crisis is usually marked by long periods of volatility. The current

equity markets are a clear endorsement of this trend.

The why and the how? The current cyclical growth downturn and volatility in Indian markets was triggered due to a lack of

structural reforms, lack of policy reforms and corruption scandals that have hurt confidence and adversely

impacted markets. The slowdown however can be reversed by constructive policy action by government.

The first and foremost in this direction has already been taken by the government towards reducing fiscal

deficit by adopting progressive energy reforms and other initiatives like allowing FDI in select sectors. While

one part of setting the wheel of progress in motion has been initiated, the other key focus has to be towards

addressing supply side issues by driving capacity creation. The sustained growth in India over the last few

years was the outcome of capacities created across sectors like telecom, financial services etc between 2001

-2005. There is therefore a need for a similar conducive growth environment through increased investment

into infrastructure to sustain growth. With the monsoons that were a cause of worry improving significantly,

if the government is able continue with its developmental policies and demonstrate affirmative execution on

the initiated reforms, support capacity creation etc, there is potential for an interest rate cut which will turn

out to be very positive for the Indian equity market.

While there are challenges abound, positive cues continue to provide optimism. Most importantly, India is

a structural growth story with favorable demographics, strong domestic consumption and strong balance

sheets across banks/ corporates. Therefore, India will continue to grow in the long term. For investors, the

cyclical growth slowdown in India marked by volatility presents an opportunity to enter Indian equities at

attractive valuations with better upside potential.

Investors ….. “Is this the right time to invest in equity?” Globally, economies are going through a debt de leveraging cycle. In such a scenario, equities seldom provide


unidirectional multi bagger returns. One pertinent question in the mind of every investor in such times

therefore continues to be “Is this the right time to invest in equity?” The answer is a resounding yes. The

fact is that irrespective of a range bound market, opportunity for returns exists in volatility and the trend of

polarized markets. Investors worry about volatility, while the fact of the matter is that, volatility translates

to opportunity. The chart below clearly shows that while over a 3 year period the market has remained

range bound and has generated some 15% returns, volatility has provided over a dozen unique and distinct

opportunities to generate over 8 percent returns. In the current context, the view remains that investors need

to provide for greater volatility and value investing in their equity investment strategy.

Chart A

In this new paradigm, volatility has emerged as the new asset class. While the opportunity of investing

in volatility was a fact, how to invest?... was the bigger concern. Investors today have the platform and

opportunity to capitalize in this trend of expected volatility by investing in relevant funds? Today, there are

products like flexi cap dynamic fund that are structured to tide volatility through adopting strategies like 1).

An active cash strategy that helps mitigate downside risks when markets get overvalued. This would mean

holding more cash as the market valuation gets steeper and vice versa i.e. Maximum possible cash holding

in Nov 2010 when markets (Nifty) were over 6000 and minimum possible cash in Dec 2011 when markets

(Nifty) were around 4500. 2). Capturing upside opportunities across market caps. This translates to actively

moving across market caps based on relative valuation attractiveness 3.) Investing across sectors based on

valuation attractiveness and growth potential.

Finally, investors today have a multitude of choices and strategies that they can adopt. Important is to adopt

the right strategy, seek advice of financial advisor and be systematic.


Capital Market – Need for Active Retail ParticipationMr. Sanjay Doshi, Director, KPMG India Private Limited Mr. Manish Loyalka, Manager, KPMG India Private Limited

IntroductionA vibrant, dynamic and well functioning capital market leads to host of improved economic outcomes

through various channels such as mobilization of savings, allocation of resources to productive uses, easy

facilitation of transactions among others. Active participation of various participants (e.g seeker of funds and

provider of funds) is essential for smooth functioning and required depth in the financial market.

Over the last decade, the Indian Capital market has been receiving global attention. Currently, all key

providers of funds such as international and domestic investors, institutional investors and retail investors

are allowed to participate and are active in the Indian market.

The current market volumes are contributed relatively more by international and institutional investors. The

share of retail investors in the capital market is relatively low. As a result, the performance and activity in the

capital market gets impacted by inflow from FIIs. In order to improve the ‘market depth’, it is important that

retail investors also play a more important role in the market.

A quick global comparison indicated that in 2011, the retail investor participation (as a percentage of the total

population) in India, was just 1.3%, whereas in the US and China it was 27.7% and 10.5% respectively1.

It may be noted that the Indian economy has a healthy saving rate (above 30 % of the GDP)2. However, bank

deposits garner a large share of these savings whereas capital market is able to attract only a small portion

of the same.

Low retail participation – Structural cum psychological issueWhile there are multiple reasons for low retail participation, some of these are psychological whereas others

may be more structural in nature. Some key factors behind low participation appear to be:

• Risk averse nature – Indians typically are risk averse in financial matters. Capital protection takes priority

over ‘high to moderate risk and return’ investments. Consequently, majority of them choose to invest their

money in fixed deposits and postal savings. Adjusted for inflation, these deposits may not be providing any

real return, however capital protection makes them preferred over other asset classes.

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1 Source: http://www.moneylife.in/article/increasing-retail-investor-base-sebi-has-a-tough-job-ahead/16977.html2 Source: RBI


___________________________________________________________________________

3 Economic Times dated 6th November, 20114 http://www.angelcommodities.com/partner_us/financial-industry.aspx

• Crisis of confidence – Current low level retail participation is also attributable to losses incurred by retail

investors during market meltdown in 2008. In India, retail investors typically like to take a direct exposure

in the market instead of mutual fund route. Many a times these investment decisions are not backed by

sound research but are based on market inputs, informal tips, advice from the broker etc. Losses incurred

during 2008 impacted investors confidence thereby leading to lower inflows in capital market.

• Subdued IPO market – An active IPO market also acts as a catalyst for higher retail participation in the

secondary market. On the other hand, higher retail participation is also one of the key determining factor

for launch of an IPO by fund seekers. The same makes it a vicious circle. Given current low level of IPO

activity in the primary market, secondary market volume has also remain subdued.

• Delivery channel – While various intermediaries such as stock brokers, sub brokers, stock exchanges,

depository participants, custodians etc. are present in the Indian market, their reach and penetration in tier

3 and tier 4 cities needs to deepen. Majority of these intermediaries are concentrated in two Indian states

namely Maharastra and Gujarat. However, some of these intermediaries especially broking houses are

trying to ensure pan-India coverage (a plan which has been partially hit by subdued markets).

• Limited product offering - Equities and commodities comprise 90 percent of trading volume whereas

other developed markets have a diversified mix such as interest rate futures, foreign exchange futures and

corporate bonds accounting for a sizeable share. Level of retail participation in government and corporate

debt market in India is very low even as compared to some other emerging economies.

Sufficient tailwinds exist for capital market growth in medium termSustained increase in retail participation over the long term period would require a combination of

psychological change (which can be achieved by higher investor education) and policy changes. However

there appear to be sufficient tail winds which if used effectively could support market growth in the medium

term. Key existing enablers could be:

• Growing base of demat account – Despite the subdued capital market activity, the number of demat

accounts have been constantly increasing. As of November, 2011, number of demat accounts stood at 1.9

Crores which is ~1.6% of the total population of the country3. Demat accounts have been growing at the rate

of 20% CAGR over the last few years4. Further, recent regulatory changes capping the fee on demat account

is expected to further increase demat penetration. Historical evidence suggest that dematerialized trading

lead to faster and cheaper transactions and have positive impact on trading volumes.

• Diversification of product portfolio – Over the last few years, while volumes in equities market have been

sub-dued, setting up of the dedicated commodities exchanges have provided investors an alternative asset


class. Commodities turnover (lead by bullions) have witnessed significant increase in volumes; a healthy

trend for growth of capital market.

• Online trading facility – Online trading facilities help in executing transactions in an effective, speedy,

transparent and cost effective manner. With improving internet penetration and brokerage houses offering

online trading platform, the share of online trading facility has been increasing steadily.

• Common KYC – In India, there are multiple KYC required for opening bank accounts, trading account, demat

account, mutual fund investment. Same act as a deterrent for retail investors. Recently, market regulator

has taken steps for common KYC which if implemented, will reduce operational and administrative

challenges.

Changes which could have positive impact on retail participation• Investor education – One of the ways to increase retail participation is to educate the investors. Investor

education should focus on highlighting the need for having equity as an asset class in their portfolio,

importance of long term investment strategy, investment should be based on sound research (done by

independent competent research analyst) instead of market tips and other traditional approach currently

being followed by the investor. Also, regulating research and advisors may contribute to improving

investor confidence.

• Better surveillance system – Existing surveillance system may be further geared up to prevent volatile price

fluctuation (which is not supported by any underlying change in the business of the Company); especially

in relation to illiquid securities.

• Increase in free float – One of the aspects which may need to be assessed is the float available in the market

as compared to the market capitalization and trading volumes. Measures around improving the float

available and trading volumes may reduce the volatility of share price and thereby increase investor

confidence.

• Technology – Last but not the least, technology could help a lot in increasing retail participation. We need

to find out ways to use technology to achieve higher financial penetration and participation in the retail

market. Some of the technological support we may try to leverage on for increasing the number of demant

accounts, faster and efficient clearing of funds and securities, increasing online trading penetration.

Higher retail participation in capital market would result in reducing the intermediation cost, would enable

fund seekers to raise funds (debt or equity) at a competitive cost and act as a natural hedge against volatilities

of fund flow from developed markets.


Proposal for Pricing of Preferential Placements to Institutional Investors Prepared by: FICCI’s Capital Markets Committee Subgroup on Private Equity chaired by Mr. Rohit Sipahimalani, Co-Chief Investment Officer & Head-India, Temasek International Pte. Ltd. and co-chaired by Mr. Niten Malhan, Managing Director & Co-Country Head, Warburg Pincus

According to SEBI’s guidelines, the price for preferential allotment cannot be less than the average of the week-

ly high and low of the closing prices of the related shares quoted on the stock exchange during the six months

preceding the relevant date. So, at times when capital markets are depressed, the minimum price at which

allotment could be made is at a substantial premium to the market price. It therefore acts as an obstacle for

companies wanting to raise capital. It is suggested to have a market determined pricing mechanism subject to

safeguards (instead of this artificial 6-month high and low average of the closing prices, as the floor price).

SEBI in its move to aid companies to raise capital through QIPs had revised the pricing guidelines for QIP

placement to include floor price based on the average of high and low prices over period of two weeks. This

helped companies reduce the impact of volatility experienced over a longer period of 6 months at the time of

pricing the placement to QIBs. Further, SEBI in the past introduced new concepts like volume weighted average

prices to help arrive at an average price matching the movements in volume and prices over a trading period.

Further in a recent proposal in August 2012 SEBI has proposed a flexibility to provide a discount of upto 5% to

floor price for investors participating in the QIP placement.

Key ConsiderationsA. During volatile global conditions like we face currently, companies are often shut off from access to any

form of financing in the equity markets (through QIP, GDR, etc) and increasingly even debt capital & bank

loans. This makes it difficult for them to execute their growth plans. At such times, investors who come

in through the preferential route play a key role in providing growth capital. Given that global volatility

seems likely to persist, economic and valuation outlooks are likely to change rapidly and a 6 month based

pricing formula may not be reflective of the inherent value of a company.

B. While the investor community focused on investing through the preferential route is inherently focused

on the long term, the present pricing formula can make deals commercially unviable for investors. It also

does not serve the needs of promoters or existing minority shareholders as lack of ability to raise capital at

the right time can seriously impair future growth, which could further depress the share price. This could

particularly impact sectors like power, infrastructure where the country needs significant investment but

the companies in the sector today face a large funding gap.


C. We understand that the original intention of the regulations was to prevent promoters from increasing

stakes in companies at very low prices to the detriment of minority shareholders. The current regulatory

process where a special resolution at an EGM is needed for a preferential allotment ensures the protection

of minority shareholders, when the allotment is to an external investor. The existing pricing formula can be

retained in case of allotments to promoters or other investors not registered with SEBI.

RecommendationsA. We would recommend modifying the pricing guidelines and have highlighted some feasible options.

B. The formula for computation of the floor price for preferential issuances may be based on the volume

weighted average price of the two weeks preceding the “relevant date” (30 days prior to the date of the

shareholders resolution), instead of the six-month average of just closing prices (which currently does not

even have regard to the number of shares that changed hands at the closing price). A discount on similar

lines as proposed in QIP placement should be provided to the floor price for placement to all non-promoter

investor entities participating in the preferential placement. Any allotment to investors on preferential ba-

sis is subject to 1 year lock in provisions.

C. The prevailing market price can be considered the result of an “efficient price discovery process” and as

discussed in the previous section, is the true reflection of the current economic/market scenario.

D. To ensure minority shareholder protection, this would only apply to all non-promoter entities making

investments into listed Indian shares including foreign direct investors and offshore funds (subject to com-

pliance with exchange controls), insurance companies, mutual funds (MFs), domestic financial institutions

(DFIs) and other investors.

E. For allotment to promoters, the existing pricing guidelines can continue to apply. Alternatively, the pricing

guidelines can be relaxed for promoter allotments as well, provided promoters abstain from voting on the

special resolution at EGM which approves such allotment.

73

Corporate Finance


India and the Changing Dynamics in Global Business FinancingDr. V Shunmugam, Chief Economist, MCX Stock Exchange Mr. Arbind Kumar, AVP-Research & Product Development Team, MCX Stock Exchange

Global Financial Markets:Global financial markets have experienced significant growth especially during the last few decades in terms

of their volumes, liquidity and depth in line with the growth in the real economies across the nations and

the level of development of their financial sector. Simultaneously it resulted in a greater demand for capital

needs for various activities of the businesses. Depending on the level of their development, capital markets

and banks shared the responsibility of capital allocation in the respective underlying economies. The global

financial intermediation industry, comprising of markets, funds and banks, has been witnessing shifting roles

of suppliers and users of capital especially, post the recent financial crisis. Such shifts have impacted those

looking to raise funds as well as institutional investors as suppliers of funds and thus the cost of intermediation

as well as the cost of funds.

PE as major source of Funds in recent timesPrivate Equity (PE) has become a major

source of funds in the recent past for many

businesses wishing to raise funds irrespec-

tive of their sizes. PE being an investment

in the risk capital of a company whose eq-

uity does not trade publicly, it requires a

long-term approach on their part. It had

not only shifted the job of PEs towards

their inflow and outflows but also to re-

ward their long-term investors suitably,

compared with short-term investors whose

numbers are increasing given the outcome

of the current financial crisis. Internation-

ally, Institutional investors such as pension

funds and endowments remain the major

source of long-term funds in private eq-

uity financing. In India, such relationship

between such long-term sources of funds


and capital needs of PE firms is evolv-

ing though initiatives have been taken

up to strengthen collection of long-term

funds through various pension schemes.

Private equity investors play a critical

role in firms in terms of nurturing the

management and governance of the busi-

nesses they invest in but also in grooming

them up for the market. In the absence

of long-term domestic funds match-

ing the capital needs of Indian businesses, PEs in India predominantly relied upon foreign funds. In-

ward foreign fund flows depended largely on cost effective exit that markets could provide them with.

While some exits could successfully happen through markets, some of the exits are awaiting policy changes

such as allowing firms to raise IPOs in foreign markets before their Indian listing. PE-backed IPOs declined

in the recent period in India due to the overall decline in the number of IPOs. There were only 8 IPOs by PE

during 2011 compared with 27 during 2010. The amount raised through IPOs during the same period also

declined from US$4.3 billion to US$1.2 billion — a 71% decline (E&Y, Global Private Equity Watch - 2012).

Rise of PEs in Asian MarketsIn line with the Asia growth story, there has been a significant rise in recent times in the amount of private equity

investment flowing into China, Singapore, South Korea, and India. Private equity continues to be a major source

of risk capital for companies around the world. As evidenced from the above figure, during 2000-2010, nearly 50

percent of the private equity investment in the business got refinanced by strategic sales to the corporates, while

35 percent was refinanced by another PE financing and the remaining 15 percent through IPOs. It indicates the

declining role of Capital Markets in PE exits and the increasing role of strategic sales and PE refinancing. PE

backed IPO deals and the average size of the deal had witnessed a steady increase in the global markets during

the recent times (Table 1). It emphasizes the importance of strengthening the PE ecosystem to bring about

vibrancy in the Indian entrepreneurship story by bringing them on par with their global arms/counterparts in

terms of sources of funds, access to domestic/foreign institutional funds, operations, fiscal treatment, etc.

Table 1: PE Exits Through IPOs in Global Markets

Details 2008 2009 2010

Number of deals 769 577 1393

Capital raised (US$ Billion) $95.8 $112.6 $284.6

Average deal size (US$ Million) $124.6 $195.1 $204.8

PE-backed IPOs 52 deals, $10.8b 53 deals, $16.2b 155 deals, $35.0b

Source: DEALOGIC/E&Y

In addition to the traditional role played by public capital markets, recent years have seen the emergence of

private equity and sovereign wealth funds as major players in financial markets.


Sovereign wealth fundsSovereign wealth funds (SWFs) have also recently emerged as another source of business financing in developed

as well as developing countries. SWFs are government investment funds that invest in foreign companies in

order to earn profits and increase the wealth of the state of the origin. These funds have existed for a long time,

but the increase in their scope and magnitude has recently made them a major financial player due to increased

transparency in their operations and the emerging confidence of various developed market regulators. According

to IMF, the assets under control by SWFs in early 2008 which was estimated at US$3 trillion and is expected to rise

to $10 trillion by 2012, making them an inevitable source of alternative in financing businesses in both developed

and developing markets. Keeping in mind the sensitivity of the industry sectors, SWF participation could be

allowed subject to same terms and conditions as applicable to other foreign investors in sensitive sectors.

Role of Stock Exchange in Capital raisingStock exchanges play a critical role in the capital-raising process (Table 2). During the last five years, funds

raised through private placement of debt capital continued to dominate the scenario as opposed to capital

raised through the primary markets. Exchanges across the world have gone through major structural changes

in the last few years in line with the changing business environment and their financing requirements in their

effort to meet participant expectations. Starting with the demutualization of the Stockholm Stock Exchange

in 1993, the number of financial exchanges that have adopted a “for-profit”, publicly listed organizational

form has grown steadily. This has facilitated a number of innovations during the last decade enabled by their

“for-profit” structure which has also allowed exchanges to raise capital and invest in technology. It resulted

in exchange businesses complementing other businesses in the economy in tapping finance through various

venues including the route of listing on the exchanges.

Table 2: Access to Finance for Companies through Indian Capital Market

Private Placement of Corporate Debt (in Rs Crore)

Capital Raised from the Primary Markets (in Rs Crore)

2008-09 1,73,281 16,220

2009-10 2,12,635 57,555

2010-11 2,18,785 67,609

2011-12 2,61,282 48,468

April 2012 23,515 200

May 2012 23,993 246

June 2012 26,250 63

Source: SEBI

Though the total market capitalization of all publicly traded companies across globe experienced wide swing

from a high of US$ 57.5 trillion in May 2008 to drop below US$ 28.7 trillion in February 2009, the exchanges

across the globe have helped companies raise $ 95.8 billion in 2008, $ 112.6 billion in 2009 and $ 284.6 billion

in 2010. As evidenced from Table 3, capital raised in June 2012 indicates the significance of stock exchanges in

enabling companies to raise capital through bonds as well equity route.


Table 3: Investment Flows – New Capital raised by Shares and Bonds in the Major Exchanges (US$ Million in June 2012)

Equities Bonds TotalBM&FBOVESPA (Brazil) 1150.42 253.7 1404.13Deutsche Borse (Germany) - 37,274.11 37,274.11Hong Kong Exchanges 1,376.15 4,003.62 5,379.77Korea Exchange 124.65 42,282.48 42,407.13London SE Group 775.38 58,593.91 59,369.29NASDAQ OMX Nordic - 5,490.61 5,490.61Shenzhen SE 4,008.97 1,207.09 5,216.07Singapore Exchange 536.67 8,631.99 9,168.65Tel Aviv SE 33.78 2,965.29 2,999.08Wiener Borse (Austria) 19.24 3,532.61 3,551.85

Source: WFE

Emerging Sources of fund raising in an integrated worldThe recent capital flow dynamics emphasizes the need for global coordination in an environment where capital has no national boundary. This development has made it easier for companies worldwide to raise large sums of capital through public offerings and while making it cheaper for market participants to conduct transactions in deep liquid markets, domestically and across the borders. In addition to increase in ways of raising public capital, there has been a tremendous increase in the use of private capital such as commercial borrowings, foreign currency convertible bonds, etc., used by various Indian corporates to fund their growth aspirations.

Another innovative source is “Stand by Equity” which is a flexible and cost-effective alternative to a traditional equity private placement or secondary offering. It provides the Company with the right, but not the obligation, to issue shares and raise capital at a time of their choice. Fairly common in Australia, under this facility, the company receives a firm commitment by the “Stand by Equity” provider to purchase new company shares up to an agreed maximum value. The facility is normally available for up to 3 years and renewable thereafter. The

programme is entirely controlled by the company.

ConclusionIn the recent times, with the dire need for boosting economic growth across nations, fund raising plays a critical role for both government and private entities. Development of financial sector infrastructure in line with the growth in the real economies is essential to effective channelization of wealth and resources. In the current context of fund flow dynamics, both the market and off-market channels of fund raising play a critical role in connecting capital with the growth needs of nations. An analysis of various sources of funds reveal that alternative channels of fund raising have increasingly become predominant source of funds for various entrepreneurial activities. However, it is essential that the investors in these alternative sources of funds are provided access to transparent and efficient market infrastructure providing freedom to the companies to raise funds essential for their various business activities through market as well as providing individuals/investors to participate in growth opportunities. While the complimentary existence of market and off market sources of fund raising nurtures entrepreneurial activities in the economy, it also establishes a synchronous balance in wealth generation, employment creation and wealth distribution as both the markets converge.


Time to Complete Unfinished Reform of Takeover Law Mr. Somasekhar Sundaresan, Partner, J Sagar Associates

It has been a year since the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011

(“Takeover Regulations”) were brought into force. The Takeover Regulations replaced the old regulations

of 1997, which represented an excellent base on which the architecture of takeover law for the next several

decades was sought to be built. The experience with the new law has been mixed, particularly since the

package envisaged by the Takeover Regulations Advisory Committee (“TRAC”), which wrote the draft of

the new law, has not been fully implemented.

Deviation from Expert Recommendation:

The Securities and Exchange Board of India (“SEBI”) made fundamental deviations from the recommenda-

tions of the TRAC. The core aspect of the reform was the obligation of an acquirer to make an open offer to

acquire all the shares held by all other shareholders. The old law required an acquirer to acquire only 20% of

the voting capital, and the new law now requires 26% to be so acquired. Neither is justified by any rationale

or logic if providing an exit opportunity to all shareholders is at the heart of the obligation to make an open

offer when a listed company is taken over.

When the Bhagwati Committee wrote the takeover regulations of 1997, Nimesh Kampani of the JM Financial

Group, a reputed merchant banker of standing and wide experience wrote a dissent note against the con-

cept of making an open offer for just 20%. He was told he was too ahead of his time. Fifteen years later, the

Achuthan Committee unanimously recommended that the open offer should be for all the shares of the listed

company being acquired – popularly termed in the media as the “100% offer size”. The entire committee was

told that it was ahead of its time. SEBI publicly stated that a full offer is the right thing to do, but it would be

the goal that would be eventually reached, and that India was not ready for it.

The ostensible reason for the disagreement with the recommendation of a full-sized offer was that in India

bank funds are not available for financing M&A activity while they are available abroad, and that thereby,

such a law would place foreign acquirers at an advantage over Indian acquirers. A regulatory hurdle from a

fellow financial regulator is a matter to be addressed by working on removing the hurdle rather than creating

a set of new hurdles.

Regulatory Framework Skewed:

However, this has resulted in the regulatory framework getting substantially skewed. Along with the recom-

mendation of obliging an acquirer to offer to buy all shares of the company, the TRAC also recommended that

an acquirer should be given the option of staying compliant with listing requirements – that of maintaining a

public shareholding of 25%. To stay at a maximum of 75%, it had been proposed that the acquirer be given an


option to prune what he acquires from the exiting substantial shareholder and from the public in proportion.

Another option sought to be given to the acquirer was to delist the company if the response to the open offer

took his holding to a stake of more than 90%. Therefore, an acquirer who would end up at above 75% but less

than 90% would have consciously done so despite having the option to stay compliant with minimum public

shareholding requirements. If he were not to prune his acquisition to 75% and also does not get a 90% response,

the acquirer would have to become compliant with the minimum public shareholding requirement before at-

tempting to delist the company.

However, SEBI rejected the entire framework of the recommendations on the size of the open offer. Yet, a

prohibition on delisting without first ensuring compliance with minimum public shareholding has been re-

tained, although in a completely new form, making the acquisition of a listed company in India, one of the most

complicated considerations in the M&A space. Under the new law, the acquirer has to make an open offer to

acquire at least 26% of the remaining shares – an increase from the old offer size of 20%. The acquirer cannot

delist the company even if he were to cross 90%. The acquirer is given no option to stay compliant with the

rules governing minimum public shareholding.

Yet, if he were to end up at above 75%, he would have to wait for twelve months before attempting a delist-

ing transaction. Under the Securities Contracts Regulation Rules, 1957 (“SCRR”), whenever the shareholding

crosses 75%, the group holding such shares has to bring their collective stake to 75% or below within a period of

twelve months of crossing the limit. In a nutshell, in any transaction where one acquires more than 49% stake

in a listed company, the acquirer may cross a 75% stake since the response to his open offer could be for 26%.

Yet, the very law that forces him to cross 75% (without giving him an option to prune what he buys, to stay at

75%) would also force him not to attempt delisting unless he prunes his stake to 75% or below.

Yo-Yo of Securities Offerings:

For example, if an acquirer were to acquire 60% from an outgoing substantial shareholder, he would have to

make an open offer of 26%, which would potentially take his post-transaction stake to 86%. Now that would

mean public shareholding would be only 14%, well below the minimum 25% mandated under other securi-

ties laws. In this example, the acquirer would have no choice but to end up at 86%. Under the rules govern-

ing minimum public shareholding, such an acquirer is required to bring his stake down to 75% within twelve

months. However, during these twelve months, the Takeover Regulations would deny him a statutory right to

attempt delisting, otherwise available under the SEBI (Delisting of Equity Shares) Regulations, 2009 (“Delisting

Regulations”).

In other words, the capital markets would be presented with a yo-yo of securities offerings. First, an offer to ac-

quire shares under the Takeover Regulations, second, an offer to sell shares to achieve minimum public share-

holding requirements; and third, yet another offer to acquire shares, this time under the Delisting Regulations.

This is bad policy. In fact, the very spirit and reason for which SEBI has imposed a statutory “lock-in” under the

regulations governing offerings of securities – the SEBI (Issue of Capital and Disclosure Requirements) Regu-


lations, 2009 (“ICDR Regulations”) was to ensure that there is no supply of securities right after an offering

since investors who respond to an offering should have stability in demand and supply of the securities. Such

a yo-yo conflicts with that spirit.

Insider Trading Regulations:

If this were not complicated enough, there is also the sword of the SEBI (Prohibition of Insider Trading) Regu-

lations, 1992 (“PIT Regulations”) that hangs over every acquisition of a listed company. The PIT Regulations

prohibit the communication and counseling of “unpublished price-sensitive information” (essentially, informa-

tion that is unpublished, and which, when published, is likely to materially impact the price of securities), apart

from prohibiting dealing in securities when in possession of such information. Now, it would be quite impos-

sible to acquire even a listed company without conducting any due diligence. It would be Utopian to assume

that the published information available in the public domain about a listed company would alone be adequate

to assess and complete a listed M&A transaction. Therefore, the very commercial path to doing a transaction

that could lead to an open offer under the Takeover Regulations is fraught with the risk of an allegation that the

PIT Regulations have been breached.

The PIT Regulations indeed permit a valid defence of having dealt in securities despite being in possession

of such information provided the acquisition is “as per” the Takeover Regulations. This again, is too vague a

provision. A fair and logical way to construe the phrase “as per” would be to state that acquisitions that would

attract the obligation to make an open offer under the Takeover Regulations alone would be covered by such

valid defence. In the case of smaller acquisitions that do not attract an open offer, the Takeover Regulations

impose only disclosure obligations. The obligation to make an open offer to buy shares from the public share-

holders gets attracted when the acquisitions cross certain serious and material thresholds. To acquire listed

securities of above such material and serious thresholds, it would logically be necessary to conduct some form

of due diligence which would result in information being placed in possession of the acquirer.

In any case, under the Takeover Regulations, a letter of offer is required to be circulated to all shareholders

communicating all information necessary for the public shareholders to make an informed investment decision

in relation to the opportunity to divest their shareholding. Such letter of offer and the obligation to publish all

relevant information would, in substance, necessitate publication of any unpublished price sensitive informa-

tion in the possession of acquirer.

No Articulation of Rationale:Moreover, the absence of any articulated rationale for the regulatory regime in place can be frustrating for

corporate decision-makers. The Supreme Court has repeatedly exhorted regulators to spell out the legislative

intent behind the measures they take when writing regulations so that the world knows exactly what is in the

mind of the regulator and courts too could interpret regulations with a purposive frame of mind. However,

this appeal has always fallen on deaf ears, and no regulator has started articulating the purpose behind the

regulations it writes.


The Takeover Regulations, as currently framed, can in fact become a punishment to the acquirer for having

done a transaction that triggered an open offer under the Takeover Regulations. Statisticians and database

managers can only track deals actually done and build up league tables. By definition, there can be no record of

deals that failed because an acquirer could not handle the regulatory uncertainty and imprecision surrounding

an M&A transaction. Corporate India deserves more predictability and certainty in the conduct of business.

(Disclosure: The author is a partner of JSA, Advocates & Solicitors. The author was a member of the TRAC. The views expressed herein are his own and do not represent the views of his firm or of FICCI.)

[email protected]

83

Debt Capital Market


Knowledge Paper on Corporate Bond Markets-Overview, Issues & Way forwardMr. R. Govindan, Vice President (Corporate Finance & Risk Management), Larsen & Toubro Limited

A well developed capital market consists of both debt and equity. In India, equity markets are more popular

and comparatively more developed than the debt markets.

Corporate bond market is a very good supplement to the banking system of any country. Important les-• son from the financial crisis is that when the financial system collapses, a liquid corporate bond market will support the funding requirements of real economic activity.

Liquid corporate bond market reduces the cost of capital for issuers.•

Banks have constraints around debt issuances and ALM issues where a robust corporate bond market • can help. Today with excessive dependence on the banking system, corporates end up paying more than what they would normally pay if they borrowed in the corporate bond market.

For a country like India, healthy bond market in India can channelize the savings into infrastructure • creation.

Introduction: India Vs. RestWorld GDP is around USD 50 trn, world corporate bond issuances are around USD 3-4 trn, i.e. roughly 6-7%

of GDP.

India issues Corporate bonds worth USD 50 bn (3%) of GDP compared to 8-12% of GDP in countries like • US, Europe, Japan & China.

Outstanding CorporateBonds as % of GDP in India is 9-10% compared to 40-70% of GDP in other develop-• ing/developed countries.

Average daily volumes of Corporate bonds in India are USD 200-350 mn as compared to USD 17 bn daily in • USA.

Total Debt (government debt, household debt & corporate debt) to GDP ratio in India is 120% as compared • to over 300% of GDP in countries like USA, Europe and Japan, which reflects the overleveraged household and private sector in those countries.

Charts-AquickreflectionofIndiaCorporateBondmarket

Comparison of % breakup of outstanding bonds across countries Country Government Finance Corporate

India 76 15 9

Japan 85 9 7

UK 81 18 1

Germany 66 21 13

Brazil 62 37 1

China 54 29 17

USA 44 45 11

Source:BIS,RBI,JPM


BreakupofDebtfinancedacrossbankcredit&bonds

Comparison of % breakup of outstanding bonds across countries Country Bank loans Corporate bonds

China 85 15

India 84 16

UK 72 28

Japan 71 29

Brazil 66 34

Germany 52 48

Korea 45 55

US 8 92

Source:JPM,BIS,CEIC

Percentage break up of total outstanding Indian bonds

Year Government Financial Corporate

2008 91 7 2

2009 88 9 3

2010 86 11 4

2011 80 13 7

2012 76 15 9

Source:BIS,RBI,JPM

Gross issuance of Corporate bonds in India (INR bn)

Year Amount

2007 1057

2008 1431

2009 2026

2010 2378

2011 3100

2012(YTD) 1600

Source:SEBI

Total outstanding Corporate bonds in India (INR bn)

Year Amount

2007 3356

2008 6210

2009 7920

2010 7620

2011 9070

2012 10900

Source:SEBI


Percentage sector wise breakup of issuances in last few yearsYear Banks Corporates NBFCs PSU

2007 37 2 11 50

2008 28 18 14 40

2009 27 20 12 42

2010 13 21 22 44

2011 8 18 27 47

Source:NSDL

Breakup of Outstanding CD,CP and Corporate bonds

Category % outstanding

Corporate bonds 64

CDs 30

CP 6

Source:NSDL,SEBI,RBI

Breakup of Assets of under management of mutual funds

Category Percentage

Debt 47

Liquid 25

Gilt 0

Equity 26

Others 2

Source:AMFI

India CP issuances & Outstanding (INR bn)Year Issuances Outstanding

2007

178

2008 326

2009 442

2010 755

2011 803

2012 3000 912

Source:RBI

India CD issuances & Outstanding (INR bn)Year Issuances Outstanding

2007

933

2008 1478

2009 1929

2010 3410

2011 4247

2012 8860 4195

Source:RBI

Sectoral breakup of outstanding corporate bonds

Category Percentage

PSU 44

Banks 25

Corporate 15

NBFC 16

Source:NSDLI

Breakup of Bank Assets

Category Percentage

Credit 60

Cash+Reserves 5

G Secs 30

Mutual Funds 2

Shares 1

Corporate bonds 2

Source:RBI


Key initiatives for market development:

Issuer’s perspective:

Indian primary bond market is primarily dominated by NBFC issuers and a very small proportion of •

issuances happen by manufacturing and service related companies.

NBFCs engaged in infrastructure financing should be given capital relaxations, incentives to facilitate •

dollar borrowing from abroad. Specific capital relaxations can be given to assets financed under takeout

mechanism by Infra NBFCs.

Efforts of SEBI and stock exchanges to bring trading to electronic stock exchange platforms have not •

yielded results. Investor awareness of debt markets in India is very poor, there is a need to have awareness

programmes across cities.

Since cash credit system of banks works like a loan in perpetuity, many corporates prefer it to bond •

financing where the amount has to be returned on a specific date.

Currently bonds are issued in India only on private placement basis (not more than 49 investors) In order •

to use the private placement route, corporates continue to do a number of private placements which

results in market fragmentation.

Public issue of bonds is uncommon in India. Large corporates ignore the fact that lower cost of capital can •

more than offset the higher issuance cost in public issuances. It is important to encourage large corporates

with AAA status to issue corporate bonds on regular basis, which finally results in a deeper bond market.

Indian market lacks multiple bonds (like mortgage backed bonds, variable cash flow bonds, index linked •

bonds, municipal bonds etc) and most bonds issued are in the shorter tenor(3-5 years as compared to

international bonds which are in 10-15 year bucket).

Issuers are generally comfortable disclosing their minor financial details to banks to obtain loans rather •

than disclose them in public domain for Corporate bond issuances.

Credit team in banking system is decentralized whereas the investment team in a bank is centralized. •

Various options are available for loan restructuring for a bank which does not become public whereas a

Corporate bond default becomes public. Hence banks are hesitant to invest in Corporate bonds. Banks

should therefore be incentivized by regulator to invest in Corporate bonds.(MTM relaxation, risk capital

relaxations)

Corporate bond issuer also has problem of parking money in the intervening period till it is used in busi-•

ness, as against bank cash credit lines which he can draw at will.

Allow banks to credit enhance bonds by way of guarantees. Allowing banks to credit enhance bond •

issues by corporates would encourage lower rated corporate to access debt capital markets as there is

healthy demand for lower rated issues. Alternatively, India should create specialized credit enhancement

institutions in the absence of banks doing the job.India can also look at international insurers to facilitate

credit enhancement.Specific domestic institutions like IIFC, PFC with requisite sector expertise can also

assume credit risk.


Issue of local currency corporate bonds-AA and below. The lack of a good credit spread curve impedes •

the pricing of lower rated corporate bonds. Issuers of AA and below should be encouraged to issue more

local currency corporate bonds to facilitate a well price credit spread curve.

Corporates find it difficult to issue bonds because they fear investors sometimes are highly demanding •

and raise far more searching questions about the viability of projects for which funds are being raised.

Market making is completely absent in corporate bonds because of lack of adequate compensation from •

issuers. Most of the arrangers are looking to palm off the stock to investors post issue and hold on to only

part of the stock of they have a positive view on the market. It is suggested to start market making with

a few large corporates coming together.

PFs are banned from selling in the secondary market unless there are 2 rating downgrades.PF should be •

allowed and encouraged to sell in the secondary markets.

Indian mutual funds can play a very proactive role of channelizing the retail savings into bonds, though •

they have launched FMPs, their focus is restricted to institutional guys only. Mutual funds should be

encouraged to float long term infrastructure Corporate Bond fund to channelize the retail savings into

infrastructure financing.

Regulator’s perspective:

The issue of withholding tax on FII investment in debt needs to be resolved. International pension funds •

do not sometimes get any set off for the withholding tax that is deducted in India. The matter should be

taken with SEBI/RBI for a resolution.

Multiplicity of regulators in the Corporate bond market can be reduced from RBI/SEBI/Company law •

board to being under single regulator.

No uniformity in stamp duty across states. The concept of stamp duty is not proper, stamp duties aim •

to tax the transaction itself and not the income, which is unfair. The stamp duty for a typical issuance is

0.38% of the total issue size. An appropriate resolution to the problem should be found.

Robust investor protection mechanism needs to be in place. A FICCI sub group could be set up to study •

and suggest action plan.

Long and expensive issuance process needs to be sorted out.(issuances involve cost of fiduciary agents, •

lawyer fees, registration, rating agencies and bank fees)

Absence of a proper liquid risk free yield curve is an impediment to proper pricing of Corporate bonds. •

(data analysis of G Secs shows that only 8 government bonds are traded for more than 200 days in a

year).A FICCI sub group could study the proposal and meet RBI with its recommendations.

Currently, only SEBI regulates the Corporate bond market with some oversight by RBI. There should be •

some concept of Self Regulatory organizations like National Association of Securities dealers as it exists

in USA. FICCI sub group to could study the proposal and meet SEBI/RBI with its recommendations.


Market development perspective:

Consolidation of issuances is required to improving liquidity.•

Current FII investment limit in corporate bonds is USD 46 bn (Infra increased from USD 5 bn to USD 25 •

bn) and G Secs is USD 20 bn.FIIs are only investing in the 1-2 year bond market to take advantage of the

high short term rates. FII money being at the shorter end is not being used currently for any productive

use. Once FIIs gain comfort in Indian corporate bonds, they will possibly stay invested in bonds when

down cycle in equities happen thereby nullifying the systemic risk posed by sudden outflow of foreign

capital.

The current utilization status for bonds is as follows:•

Percentage sector wise breakup of issuances in last few years

Particulars Limit Utilised

G Secs USD 20bn USD 14bn

Corporate Debt USD 46bn USD 19bn

Corporate Debt without restrictions USD 20bn USD 16bn

Infrastructure Debt Fund USD 3bn Nil

Corporate debt long term infra(1 year lock in with 15 month residual maturity by FIIs USD 22bn USD 3bn

QFIs investing in Corporate bonds and MF debt schemes USD 1bn Recently introduced

○ FIIs are not interested to come to India with lock in restrictions

○ Withholding tax (To be reduced to 5% in line with relaxation of withholding tax on ECB

interest)

○ All infrastructure companies issuing bonds have to be rated. Annuity projects can get a AAA rating

but all other projects will at best get A rating or below. Even domestic insurance and pension compa-

nies are not comfortable investing in A rated bonds, therefore FII investments are ruled out.

○ Possibility of pooling investments into one company to get an enhanced rating is not workable be-

cause holding companies are not classified as infrastructure companies. Pooling the SPVs into trust is

possible but it will be difficult to attract investors in Trust structure.

A FICCI sub group could study the proposal on how to increase FII interest in the long tenor Corporate •

bonds. Since there is heavy demand at the shorter end, RBI should keep increasing FII limits for G Secs/

Corporate bonds on a regular basis.

Currently there is no integrated trading and settlement system for corporate bonds(like NDS Order •

matching system for G Secs).The establishment of an integrated trading and settlement system would

increase market transparency through better price discovery and is integral to the development of the

Corporate bond market.


A central body should track and maintain a comprehensive database on primary issues and rating •

migrations, which is needed for wider dissemination of market information among various market

participants and would help increasing investor confidence in domestic debt markets.

Investors perspective:

Risk management products like Interest rate futures and Credit default swaps are in place. Currently •

very minimal activity is happening in Interest rate futures market as banks are allowed to use it for hedg-

ing purposes only. No perceivable activity is noticed in the CDS market. With effect from November

2011, RBI has permitted CDS on unlisted but rated bonds of infrastructure companies and unlisted/un-

rated bonds issued by the SPVs set up by infrastructure companies. Users are not allowed to buy naked

CDS. In order to restrict the users from holding naked CDS positions, physical delivery is mandated in

case of credit events. Exchange traded CDS market may also be introduced shortly.

Unlike Government bonds, wherein there are SLR requirements, banks do not have any compulsion to •

invest in Corporate bonds. Further banks cannot invest in unrated instruments beyond a small limit(10%

of non SLR instruments) while there is no such restriction in loans. A small mandatory 5% investment in

Corporate bonds by banks will help.

Regulatory asymmetry in treatment of loans and bonds in books. Corporate bonds require a higher risk •

capital as compared to loans advanced by banks as it involves both market risk and credit risk. RBI could

consider reducing this requirement for bonds given that most bonds are subject to mark to market and

can be sold in the secondary market.

Unlike FDs where exit is possible for a retail investor, there is no such mechanism for Corporate bonds. •

Companies issuing securities should look at doing some kind of buyback to facilitate liquidity for retail

investors. For lower rated corporates, banks can provide some guarantee.

If banks start investing in corporate bonds, it becomes easier for them to sell it off/reshuffle the portfolio •

whenever desired, unlike a typical term loan where they are stuck till the loan matures.

Although banks give loans of varying credit quality but invest in Corporate bonds of investment grade •

only.

Higher administered rate in small saving schemes is also prohibiting the development of vibrant Corpo-•

rate bond market.

Although repo in Corporate bonds is permitted, the market has not developed. Currently, AA bonds •

and above are permitted for repo operations, repo available for 1 day to 1 year and bonds are subject to

25% haircut. Illiquidity of the underlying asset leads to drying up of the repo market during periods of

crisis.

Short selling should be permitted in Corporate bonds. Even today the short selling provisions for govt •

securities are very stringent. For example in case of Government bonds short selling is allowed in only

0.25% of the total issue, a bank can hold a short position in G Secs for only 90 days and in case of a

delivery failure, bank is barred from short selling for 6 months.


Allow FIIs to invest in securitized debt issues. Currently pass through certificates while are classified as •

security, are not notified as eligible investment for an FII by RBI. Allowing FIIs to invest in PTCs will help

develop structured debt market in India.

Credit exposure limit: Banks should be allowed to run trading positions in corporate bonds without hit-•

ting credit exposure limits which includes corporate banking exposure. This will enable PSU banks to

participate in the corporate bond market.

Introduction of HTM in Corporate bonds for banks and primary dealers irrespective of maturity. This •

should be done at least for issuances of infrastructure companies.

Households are a very important constituent, is practically absent because of the lack of an efficient legal •

system that is critical to investor confidence and the unhappy experience with the debenture trustees.

Increased market participation: PF trusts are currently not allowed to churn their portfolios. This may be •

revisited as world wide, the returns declared are market linked and not fixed at a particular level.

Debt markets and Infrastructure financing:

Global imbalances - A savings and investment perspective: •

Global savings and investment balances have fallen over the years and the current account imbalances

have widened to unprecedented levels. Savings in Asia which ideally should have been channelized into

investment in Asia have been diverted to the US to finance its current account. Some part of the savings

in Asia have been diverted to the US Asset markets resulting in the asset market bubble.

Is there a change in perspective? •

Data shows that Japan over the years is slowly transforming from savings driven growth model to a more

consumption driven growth model. China, on the other hand, has realized its folly and is now focusing

on a more consumption driven model.US is slowly but steadily reducing its current account deficit.

India’s growth model: •

Delta to India GDP during 2003-08 is contributed mainly by investments. India’s investments account for

36% percent of GDP compared to savings rate of 33% of GDP, the remaining 3% being funded by capital

flows from abroad. Since India is facing structural inflation issues, it is imperative that investments con-

tinue to grow over the next decade. For investments to happen in India, two things must happen:

○ Either India should reduce its consumption so that domestic savings finance domestic investment.

○ Or India must consistently get foreign savings year after year.

India’s investments since independence:•

Since independence, India’s growth and investments can be categorized as follows:


Period GDP Investments

Between 1905-1980 3.5% Below USD 10bn per year

1980-1990 Sub 5% 10 bn a year

1990-2000 5-6% 30 bn a year

2000-2012 7+USD 100bn per year between 00-03 USD 250bn per year between 03-06

USD 300-350bn per year between 06-12

Infrastructure investments as % of total investments in India:•

India’s infrastructure investments as % of total investments every year: Out of USD 350 bn of investments

every year, India’s infrastructure investments every year is around USD100 bn or about 28%. For the 12th

5 year plan India aims to increase this share to 50%. In other words, out of USD 350 bn of investments

every year, USD 170 bn will be infrastructure investments.

A study of India’s savings:•

The cumulative savings/investment in India as on date is around USD 2.9trillion.The cumulative

break-up of savings and investments is as follows:

Type of Savings Amount(USD bn)

Deposit sources USD 1200bn

Non Deposit sources

Household savings USD 1000bn

Private sector USD 700bn

Non deposit sources of USD 1.7 trillion represents investments by households and corporates into securi-

ties, mutual funds, insurance, pension funds and government securities.

Out of 34% savings currently, household savings are currently 24% and private savings are 10%.On a net

basis, Government sector does not have any savings.

Current pattern of savings of the household sector is as follows:

Cash: 6%

Deposits: 44%

Insurance/Provident/Pension Funds: 22%

Small savings: 12%

Mutual Funds: 3.6%

Government securities: 2.4%

Others: 9%


A careful look at the above savings will tell us that Government takes a lot of these savings for financing

a major chunk of its revenue expenditure. Once the government gets its house in order, a lot of bank

deposit savings and Insurance/Provident/Pension fund savings will find its way into the infrastructure

space. Alternatively through various incentives, retail savings can directly be channelized into the

infrastructure space.

Summary of India’s infrastructure investments over the years:•

Historically India has always lagged in infrastructure capacity creation:

Plan Estimate (USD bn) Actual (USD bn) Achievement (%)

9th plan(97-02) 130 107 82

10th plan(02-07) 158 117 74

11th plan(07-12) 500 496 99

12th plan(12-17) 1000 800(Exp) 80

India has a history of achieving around 80% of its targeted plan spend, 11th Plan being an exception

where Oil and Gas (USD 86 bn) and telecom (USD 88 bn) helped achieve targets. Both Oil and Gas and

telecom were part of the original plan expenditure of USD 500 bn.

India’s infrastructure competitiveness Vs Rest of the World:•

The Global Competitiveness Index of the World Economic Forum which ranks the infrastructure devel-

opment in 133 countries across the globe has ranked India at the 86th place in 2010-11.India ranks well

below the BRICs nations-China at 50, Brazil at 62 and Russia at 47.

Sector wise break up of infrastructure investments India:•

The sector wise actual breakup of expenditure for the 11th and 12th Plan is as follows:

Infrastructure 11th plan USD bn 12th plan % growth

PowerOil & GasRoadsRailwaysIrrigationTelecomWater supplyPortsAirportsWarehousing

118867144458826882

2301601531057470562384

9586

11513964

-20115188

0100

496 883


Current funding of India’s infrastructure investments:•

While difficult to quantify, a rule of thumb suggests that India’s infrastructure deficit shaves off 2

percentage points of its GDP every year. The 12th Plan envisages investments of $1 trillion in Indian

infrastructure in the next five years. Half of this is expected to be funded by the private sector. The

estimated funding for the 12th plan is as follows:

Funded by Typeoffinancing %

Central/State Govt.Banks/FIIs/NBFCs/ECBPrivate/PSU cos

335304244

383428

883

If India has to achieve USD 1 trillion target, then at least USD 200 bn of foreign capital may be required.

Variousconstraintsintoinfrastructurefinancingcanbesummarizedasunder:

Constraints to Equity financing into infrastructure:

○ High gearing(3:1)

○ Operationally complex/risky jobs

○ Non availability of exit options for the private investor

○ Corporate Governance issues

Constraints to Debt financing:

○ Lending institutions prefer lending for short/medium term(5-7 years)

○ Loans from multi lateral agencies perceived to be cumbersome procedure.

○ Lack of proper bond market

○ ECB guidelines limit compensation for lenders who take higher credit risk

Execution and policy issues pose significant challenges to infrastructure investments:

○ Delay in environmental clearances.

○ Land acquisition

○ Lack of clarity over regulators role in determining tariffs.

○ Bottlenecks in fuel availability

○ Poor financial health of State Electricity boards

○ Prevailing high rates of interest.

○ Rising cost of other raw materials like cement, steel & bitumen.


MajorsuggestionsforimprovinginfrastructurefinancinginIndia:

o Government of India to consciously work on reducing fiscal deficit(specific emphasis on increasing

capital expenditure)

o Asset liability mismatch of banks can be improved if banks attract long term deposits from retail

investors (tax breaks can help).

o Enhanced exposure norms/security classification for infrastructure lending(for both banks/

NBFCs)

o Take out financing (Since April 2006, IIFCL has sanctioned loans to the tune of INR 586 bn to 267

projects).Quicker the pace of IIFCL, faster will banks be able to free up their balance sheets and

move on.

o Insurance/pension fund investments into infrastructure space needs to be revisited.

o Developing municipal bond market for financing urban infrastructure.

o Infrastructure debt funds as a concept is there but not many have been set up till date.

o Attract retail savings into infrastructure bonds.

o Forex reserves for infrastructure development.

o Further ECB relaxations for infrastructure development.


Corporate Bonds in India- A PerspectiveMr. Rajkumar Singhal, Managing Director-Head of South Asia Local Markets and Rates Trading-Global Markets, Bank of America Merrill Lynch

Indian economy grew at a scorching pace in the last decade and along with growth in GDP, corporate

borrowing also burgeoned rapidly. According to Prime Database, debt private placement has jumped to INR

2.5 trillion in 2011-12 from INR 0.45 trillion in 2001-02. In the current year, April- June quarter saw placement

of INR 0.64 trillion (a 29% YoY growth). However even with this multifold growth, corporate bond market

is still perceived as an opaque market which lacks liquidity and adequate market making, playing second

fiddle to both Government Securities (G-Secs) and Loan market.

Though the absolute size of corporate bond issuance and bond outstanding is gigantic, it pales in comparison

to overall size of the economy. For example, corporate bond issuance globally is about USD 3-4 trillion which

is 6-8% of world GDP. In developed countries like US and Japan, the ratio stands at 11% and 7 % respectively.

In China, the ratio has jumped from 5% in 2005-06 to 17% in 2010-11, however in India, the ratio stands at a

dismal 4%, though it has climbed from 1% in 2005-06 ( according to an article by The Economic Division,

Department of Economic Affairs). Even the total corporate bond outstanding to GDP for India is just 1.6% as

compared to 27% for Malaysia and 37.8% for Korea according to a paper published by International Journal

of Trade, Economics and Finance.

Chart1:AmountmobilizedthroughDebtPrivatePlacement(inINRTrillion)

Source: PRIME Database


Chart 2: Corporate Debt Outstanding as % of GDP

Source: BIS

Indian borrowers have not only tapped domestic bond market but also borrowed in Dollar, Yen, Swiss Franc,

Yuan etc in the last few years. Among the currencies, Yuan borrowing has gained attention as after swapping,

Indian corporates can still save 0.5–1% over other currencies. IDBI Bank Ltd. became the first Indian company

to borrow in Yuan, raising RMB 650 million for three years at 4.5% in November 2011, followed by ICICI and

IL&FS raising RMB 210 million at 4.62% in March and RMB 630 million at 5.75% in April 2012 respectively.

Even dollar denominated bonds has seen an uptick with nearly USD 3.6 Billion being raised in July- August

2012 by State Bank of India, ICICI Bank, Axis Bank, Indian Overseas Bank, Union Bank of India and Exim

Bank. Banks typically use the funds for lending to Indian corporates’ overseas operations.

In domestic corporate bonds, there are two distinct segments:

Liquid segment dominated by Banks/ PSUs and few AAA and AA+ rated private players 1.

Illiquid segment dominated by names starting from AA+ ( those without strong promoters) and going 2.

all the way to un-rated papers

In the liquid segment, there are only 12-15 issuers who issue in large size at frequent interval. Liquidity

can be tricky even in the liquid segment with total trading volume daily across names averaging just USD

200 million (nearly one tenth of G-Secs and USD 14-18 Billion in US corporate bond market, as per SIFMA).

Further, there is no regular or fixed calendar followed by issuers hence we have seen the same issuer issuing

twice/ thrice in the same month and at the other extreme not issuing for months together. Another distinct

feature is every new issuance has a new ISIN ( due to private placement regulations which restricts total

number of issuers) and hence with every fresh issuance, the previously issued bonds becomes illiquid and


trades at 1-2 bps discount to the new bond (1 bps is one hundredth of a percent). The illiquid segment

is dominated by hold to maturity investors and with 98% of borrowing in secured form. Further as CDS

and other risk transfer tools haven’t developed, bonds typically have duration of less than 5 years. Specific

financing needs from corporates have led to innovative structure, such as Perpetual Bonds and STRPPS, FII

specific structures in the past.

Investors in the corporate bond market are Pension Funds, Insurance Companies, Banks, Mutual Funds, FIIs,

HNIs with small retail participation. While Pension Funds and Insurance companies focus on the longer

end of the curve for ALM requirements, MFs and FIIs are focused on shorter (1-3 year) segment. Each of

these investor classes has to comply with respective regulators. Specifically in case of FIIs, we have seen the

Ministry of Finance/RBI liberalizing rules to welcome greater inflows. Steps such as expanding available

limits, regularizing limits auction calendar, possible deferment of GAAR have cheered FIIs. However on the

other hand, the current limits are for one time usage, which prevents FIIs from churning their portfolio hence

impeding liquidity.

To make the market broad based, the market also needs strong retail participation, which leads to a virtuous

cycle of liquidity, stronger regulations and in general development of the market. India already boasts of a

vibrant equity market and logical next step will be to develop a strong corporate bond market. This is a win-

win proposition as it not only provides corporates another avenue for financing (often with cost benefits),

it also provides retail investors higher returns with relatively reduced risk and volatility. The success of tax

free bonds has already demonstrated the depth of this segment. Public issuance has grown from INR 15

billion in 2008-09 to INR 350 billion in 2011-12 as per the Economic Times, mainly boosted by tax-free bonds.

Chart 3: Investment in India in debt by FIIs (in INR Billion)

Source: SEBI


Multiple steps to increase retail participation have been undertaken such as trading on exchange such as

BSE/ NSE , providing pick up in yields ( in some cases upto 90 bps to retail investors), minimum lot size of

INR 1000/ 5000 compared with INR 1,000,000 in regular bonds among others. However, most top corporates

haven’t shown interest in this segment, as they have happily tapped credit lines from banks; as a result public

issuance has been mostly from NBFCs.

There are various proposals in pipeline such as inviting Primary Dealers to make markets, further promoting

and streamlining CDS, introducing screen based trading in addition to specific stimulants for each investor

class for promoting the market. One of the major proposals is to reduce the withholding tax (WHT) for FIIs.

Though the government has recently reduced the WHT on foreign borrowings in the form of loan or infra

bonds, we strongly believe that WHT should be reduced for the FIIs as an investor class as well. This should

be done both for government bonds and corporate bonds. Foreigners’ holding of Indian bonds is dismally

low at 2-3% as compared to 30-40% for other Asian countries like Korea, Malaysia and Indonesia.

As India’s economic growth languishes at sub 6%, with most corporate portraying a bleak outlook, India Inc.

will need all the support to prod them to boost investment. A cheaper and broad based source of financing via

bonds will go a long way in strengthening the balance-sheet for these firms. The 12th Plan envisages investments

of $1 trillion in Indian infrastructure in the next five years. Half of this is expected to be funded by the private

sector. With banks already grappling with huge asset-liability mismatches and NPAs from State Electricity

Boards, it has become quite critical that corporates (especially in infrastructure space) diversify their source of

funding. Further with RBI gradually easing its monetary policies and interest rates poised to drop in coming

months, the stage is set favorably for investors. What is required is a coordinated and objective thrust in

this area!

Source: Reserve bank of India, Prime Database, FICCI, International Journal of Trade, Economics and Finance, The Economic

Division, Department of Economic Affairs, Ministry of Finance.


The INR Corporate Bond Market: An OverviewMr. Vineet Patawari, Associate Director, Institutional Sales, HSBC Global Markets, India

The Indian bond market has historically been dominated by bonds issued by the Government of India (GoI).

Traditionally, bank loans have been the primary source of credit for the domestic corporates. Bond issuances

have been the exception rather than the primary source of funds, due to the lack of a diverse investor base.

Government bonds on the other hand have enjoyed regulatory benefits including imposition of the Statutory

Liquidity Ratio1 which mandates investments by banking institutions, as well as demand from insurance and

pension/ provident funds which are required to invest a certain proportion of their asset base in these.

However, the current decade has seen an increasing issuance volume and appetite for non-sovereign debt

fuelled by strong credit demand from financial institutions and manufacturing as well as the emergence of new

classes of investors such as mutual funds and insurance companies

Certificates of Deposits and Commercial Paper

Along with Treasury Bills (91, 182 and 364 day issues by the Government of India), Commercial Paper and

Certificates of Deposits comprise the sub-one-year tenor portion of Indian Debt Market. The exploding consumer

and commercial credit off-take in the country has led to a burgeoning requirement for short term credit from

banks and financial institutions.

The secondary market for CDs and CPs is primarily a broker-driven market with moderate levels of liquidity.

The yields and liquidity in these instruments are highly influenced by technical factors like short term liquidity

in the financial system. Investors in these instruments are typically mutual funds and financial institutions that

seek to deploy short-term liquidity or capital.

Corporate Bonds

Corporate Bonds can be broadly classified as those issued by:

Banking Institutions 1.

Non-Banking Financial Institutions (both Central and State)2.

Central and State Public Sector Enterprises3.

Corporates (Manufacturing and Others)4.

The yield and liquidity of the issues vary across the issue categories. . This market is primarily driven by

private placements and it is estimated that over 90% of debt issues are placed privately. A major constraint

to liquidity in this market has been the absence of a diverse investor and issuer base. The demand is pre-

dominantly for highly-rated issues and investors are limited to insurance companies, pension funds and

____________________________________________________________________

1 SLR is the proportion of Net Deposits and Term Liabilities that banks are required to invest in Government Securities.


commercial banks. Banks and Insurance companies are limited by restrictions on the amount of invest-

ments they are allowed in corporate paper. In spite of these drawbacks, the market has shown significant

growth and the issuance volumes have been trending upwards. (Chart 1)

Investor BaseThe major investors in the rupee debt markets are:

Banks and Financial Institutions1.

Insurance Companies2.

Mutual Funds3.

Pension Funds4.

Foreign Institutional Investors (FIIs)5.

Large Corporates6.

High Networth Individuals (HNIs)7.

Reforms in the Corporate Bond MarketThe evolution of Government securities market has an important bearing on the development of the corpo-

rate debt market, though the latter is not yet developed, for reasons stated above. The Government securities

Chart 1: Corporate Debt Issuance

Corporate Debt Issuance (INR Billion)

162295 394 460

602 566 508 531 564684

917

12791354

1763

2055

2405

3013

1463

0

500

1000

1500

2000

2500

3000

3500

FY96

FY97

FY98

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

Source: Prime Database (Please note that FY13 figures are till Sept end)


market had the benefit of unrelenting support from the Government and the RBI for obvious reasons. On the

other hand, the corporate debt market did not enjoy a similar patronage. Some of the reforms in this area are

as follows:

1992: Government abolished the ceiling on the interest rate that erstwhile Controller of Capital Issues used to

stipulate for issuance of corporate debentures

1994: NSE started trading in debt instruments through its WDM segment. However, WDM has been mostly

used as a reporting platform for the deals on the OTC market. The WDM segment of BSE commenced opera-

tions in 2001.

2009: Corporate Bond settlement through NSCCL. This has removed much of the counterparty risk from the

system and made the settlement procedure more robust.

2010: Corporate Bond Repo-RBI has announced the permissibility of Corporate Bond Repo between the

market participants. The facility is now in process of implementation.

2012: Corporate Bond Trade Reporting-All the OTC trades need to be reported online on the platform

developed by FIMMDA and accessible to public through internet. This has resulted in better transparency

and price discovery in the corporate bond market.

Problems with the Development of the Corporate Bond MarketCorporates – Bank financing versus bond financing: Till the early 1990s, the Indian Corporate sector was sourc-

ing its long term funding requirements – from the so-called development financial institutions (DFIs such

as Industrial Development Bank of India (IDBI) and ICICI) and from commercial banks for their short term

requirements, working capital requirements. Development of the capital markets facilitated disintermedia-

tion and companies started tapping the bond/debenture markets in the 1990s. However, the disappearance

of development financial institutions, which were the main source of long term finance, caused a vacuum.

While, this should have been a great opportunity for developing a bond market, this surprisingly did not

happen. Corporates resorted to their growing internal resources, raised resources through low cost equity

taking advantage of the equity boom, borrowed abroad taking advantage of low interest rates and wherever

possible, approached the long term debt market through the private placement route. Further, in the ab-

sence of hedging avenues, bond financing turned out to be more risky and less flexible in comparison with

bank financing.

Risk Management: The derivatives markets in India are not sufficiently developed to enable both issuers

and investors to efficiently transfer the risks arising out of interest rate movements. Though markets exist

for interest rate swaps and interest rate futures, the number of participants is limited and the market is not

broad and deep. The primary cause for this situation is the lack of a term money benchmark, which restricts

the development of the swap market as well an efficient term money market. Interest Rate options either

exchange traded or OTC are not permitted. This, combined with Mark-To-Market regulations, deters banks

from investing in corporate bonds. Banks therefore show a distinct preference towards traditional lending


which permits them to change their base rates based on their cost of funds, which includes changes on

account of interest rate movements and therefore their cost of deposits. .

Tax Deducted at Source (T.D.S): In the case of corporate bond TDS is deducted on accrued interest at the end

of every fiscal year as per prevalent tax laws and a TDS certificate is issued to the registered owner. While

insurance companies and mutual funds are exempt from the provisions of TDS, other market participants are

subject to TDS in respect of interest paid on the corporate bonds. Interestingly, TDS was viewed as a major

impediment to the development of the Government securities market and was abolished when the RBI point-

ed out to the Government how TDS was making Government securities trading inefficient and cumbersome.

Besides efficiency issues, the different treatment meted out to insurance companies/mutual funds on the one

hand and other market participants on the other also makes it difficult to introduce a uniform computerized

trading system.

Stamp Duty: Stamp duty is a significant source of revenue for State governments. The Indian Stamp Act is

an enactment of the central government. States have powers to make amendments to the Act. Section 3 of

the Stamp Act stipulates that stamp duty has to be paid as per Schedule I to the Act. States have by way of

amendment, introduced schedule IA to the act with differential stamp duty payable in different states. Duty

is levied on financial instruments both at the time of issuance or on transfer or on both depending upon the

nature of the instrument, issuer etc. These duties are perceived to be very high and act as a deterrent to the

development of the bond markets. Promissory notes attract much lower duty. In the interest of developing

the corporate bond market, there is a pressing need for rationalization of the stamp duty structure across the

country. Since stamp duty heavily impacts the cost of issue of bonds and debentures, it would be desirable to

reduce stamp duty levels and also introduce a suitable provision which stipulates the maximum amount of

stamp duty that is payable in respect of any single issue. This will not only bring down the cost of issuance

but will also lead to the creation of a single stamp duty rate. As has been mentioned earlier, the stamp duty

is generally levied by each State Government, and they differ across States. Hence, there is a need to take the

State governments into confidence to rationalize the duty structure. Further, the stamp duty applicable for a

security differs on the basis of the class of investor. This discourages corporates from issuing bonds to certain

class of investors like retail investors (either directly or through mutual funds), and to long-term investors

like insurance companies, provident and pension funds.

Fragmentation: Size of individual debt issuances is generally small. There is no cap on the number of issues a

company can make. Corporates, especially the medium and small ones, prefer to raise resources as and when

required on cost considerations. In addition, they take recourse to the private placement route, which leads to

creation of large number of small issues. Corporates thus tend to go for multiple issues primarily to avoid the

hassles involved in going through the pubic issue route as also to limit the issue size to their current require-

ments. (Under the extant guidelines, if a bond issue is to be sold to 50 or more investors, the issuer has to fol-

low the public issue route which is cumbersome, costly, and time consuming). This results in fragmentation

of issues and is not conducive for the development of a liquid bond market. This however, could be corrected

through regulatory caveats or by making public issuance structure simpler.


Information: Information is key to price discovery. While at a broader level, spreads on a corporate bond

ought to be decided on the basis of its credit rating and the sovereign yield curve, this is not necessarily

the case in reality, on account of subtle credit differences, liquidity in the paper and mandated investments

which create preferences for certain issuers. Therefore, bonds with the same rating but issued by different

issuers trade at different prices and in the absence of credit migration matrix, it is difficult to assess the prob-

ability of default for a rating class and vice versa, price a bond based on its probability of default.

Furthermore, a centralized information system for historical trade data is required to track the change in

spreads and prices on account of a variety of factors, which is not available to date in India. Such information

would help both issuers and investors in fair pricing.

Trading in corporate bonds, though mandated to be reported to the Stock Exchanges, remains an OTC market.

Price discovery therefore continues to remain inefficient.

Market Practices: Uniform market practices are a prerequisite for efficient markets. This is, however, not the

case in Indian markets. For instance for a trade on stock exchange like the WDM segment of NSE, the minimum

amount of trade is Rs. 1 million. However, OTC market transactions are flexible in terms of the deal size.

Coupon conventions also differ (such as Actual/365, Actual/Actual etc.,) leading to problems in settlements.

Bodies like the Fixed Income Money Market Derivatives Association (FIMMDA) have developed some

standardized practices. However, as FIMMDA is not yet a Self Regulatory Organization (SRO), these practices

are merely recommendations at the best and are not being followed by issuers at large. While the CCIL has

recently been made the central counterparty for all trades settled between market counterparties on a DVP-I

(Delivery Versus Payment) basis, the system is yet to graduate to a true DVP settlement system (DVP-III).

The absence of multilateral netting also reduces the liquidity in the market.

Market Makers: The role of market makers is significant in an incipient market but it is easier said than done.

Since market makers are supposed to add diversity to the market, they assume a lot of risk in such a market

and need to be backed up, both in terms of financial resources and the supply of securities. Currently the Indian

markets do not have a class of such market makers in the corporate debt markets. To create such a class of

market makers, one solution is that the investment banks that help corporates to raise money from the market

can possibly be roped in to market making in the bonds, which they have helped in issuance. However, lack

of adequate compensation from issuers and/or the market is a disincentive for such a system to develop. Most

issuances in the Indian market pay only very negligible fees or in most cases no fees at all. Thus, the “arrangers”

of debt issues in most cases attempt to sell the issued securities on a back-to-back basis to investors or hold these

on the books only in cases where there is a positive interest rate or spread trading view.

This situation, along with the considerable information asymmetry and lack of public information has also led

to the development of a class of “arrangers” who distribute debt paper to smaller, non-whole sale investors

such as small pension funds, upcountry co-operative and rural banks as well as to High Networth Investors

with large margins. This development is not necessarily healthy for the development of an evolved debt

capital market.


Narrow Investor Base: (a) In developed markets, provident and pension funds are large investors in corporate bonds. In India,

these funds have been traditionally investing in Government securities on account of the preference for

safety as well as a political preference against private sector debt and equity. The guidelines issued by

the Central Board of Trustees (which is governed by the Ministry of Labour rather than the Finance Min-

istry belies this preference) to these funds for their investments which are skewed in favor of Govern-

ment securities, Government guaranteed investments and PSU Bonds. However, transparency in terms

of pricing and credit worthiness of the borrowers would be necessary prior to a larger allocation towards

private sector paper to prevent abuse of the system. In fact, there is a case to consolidate the investment

function of small Pension and Provident Funds to achieve greater efficiency and professional manage-

ment of these funds. Further, the Pension and Provident Funds are typically “Hold till Maturity (HTM)”

investors and once they buy any bond, they are not mandated to sell unless in exceptional circumstances.

This reduces the liquidity in the market as a significant investor class does not trade in the bond. It would

significantly help to deepen the corporate bond market if this investor class is allowed to trade within

their normal investment activity.

(b) Co-operative banks are permitted to invest up to 10% of their deposits in PSU Bond and only scheduled

co-operative banks are allowed to invest in private sector bonds. Allowing all co-operatives banks to

invest in high quality corporate bonds would assist the development of the debt markets. However, as

in the case of pension funds, there needs to be a more credible price discovery system as a prerequisite

for the opening up of the investment norms for such banks.

(c) Retail investors’ participation in tradable fixed income securities is very negligible. One of the reasons is

higher interest rates offered on the Government’s own small savings scheme, which is being addressed

by bring these rates to align with market rates. However, the minimum trade size, transaction costs and

illiquidity of bond markets hamper the involvement of retail investors in this market. While internation-

ally individual investors participate in the bond markets through Mutual Funds, the pre-occupation of

the mutual fund industry with wholesale investors and their hunt for Asset Under Management (AUM),

have led to the small investor being largely ignored by the industry. Sustainable development of the

Mutual Fund industry itself necessitates a re-orientation of priorities, which the SEBI has been pushing

towards. However, development of appropriate products and innovation cannot take place by regula-

tory fiat. Last year, the issuance of Tax Free Bonds have seen significant interest from High Networth In-

dividuals (HNIs). These bonds filled up a genuine investment needs for HNIs as they provided attractive

post tax returns. However, the focus on retail investors is slightly misplaced as these bonds are attractive

only for the investors in the top tax brackets. Retail investors are not the natural investors in these bonds

as they would be better off by investing in comparable taxable instruments.

(d) FIIs do not have a large presence in the debt markets. They use the debt markets for parking the funds

temporarily and for portfolio management in a limited way, along with short term arbitrage activities.

The reasons for these are the current tax laws and regulations on hedging their foreign exchange risk.


FIIs unlike in the international market, cannot undertake asset swaps to hedge their foreign exchange

risk but can only enter into forward contracts to hedge the principal amount of the paper invested in (or

market value, whichever is higher). However, there is reluctance on the part of the regulators to genu-

inely address the requirements of FIIs in the debt markets unlike the equity markets, based on the belief

that large debt flows restrict the operation of domestic monetary policy. The increases in debt investment

limits therefore remain a cosmetic measure with no real desire to open up the market.

To summarise, we would suggest that to develop the corporate bond market, we would need further reforms

and some of the reforms include:

Development of deep and efficient Term Money Yield curve to enable efficient hedging structures to 1.

be developed

Rationalisation of T.D.S. on corporate bond in line with Government Securities2.

Rationalisation of Stamp Duty at the time of issuance of bonds.3.

Development of Uniform market conventions4.

Encourage issuances in Benchmark sizes5.

Development of Market makers in the corporate bond6.

Diversification of the investor base7.

Given the acknowledged importance of the corporate bond markets as a part of efficient and deep capital

markets in the country, these issues require to be addressed at the earliest. While the Reserve Bank of India

and the Ministry of Finance are seized of the importance of the issue, the pace of reforms and establishment

of an institutional framework for the market has been slow in comparison to what has been achieved for the

Government Securities market. With the size of investments envisaged for the infrastructure sector, the gross

capital formation required to maintain 8%+ GDP growth, efficient channeling of the relatively high domestic

savings would be required. The need therefore to move ahead with the development of this market cannot

be overemphasized.

109

Macroeconomic Framework & Policy

Reforms


Current State of Indian EconomyDr. Rajiv Kumar, Secretary General, FICCI

Dr. Soumya Kanti Ghosh, Director, FICCI

Recent developments indicate the global economy grappling amidst a difficult situation. The state of affairs

in the Euro zone remain particularly worrisome, with IMF WEO for July 2012 putting the growth forecast for

the Euro area at (-)0.3% and 0.7% for 2012 and 2013 respectively. The world output is projected to grow by

3.5% and 3.9% in 2012 and 2013 respectively.

While the situation on external front remains difficult, there has been a discernible slowdown in the domestic

economy as well. The latest GDP numbers indicate moderation in growth; the IIP and export data also show

conspicuous signs of deceleration. And to add to that the fiscal situation persists to be one of the major

concerns. Inflation also continues to be stubborn, showing no signs of abating.

Nevertheless, despite this current phase of slowdown, what remains important is to acknowledge the fact

that India over the past few years has witnessed some structural changes and these changes are an important

aspect in strengthening its position as one of the leading investment destinations.

India once again is ready to take the next leap forward and has proved its commitment to the reform process.

The country remains committed in its endeavor to provide an environment conducive for investors.

The recently announced reform measures have set the ball rolling and are expected to infuse some buoyancy

in to the otherwise gloomy scenario that had been prevailing in the economy. The government’s final call

of action on some of the long pending but imperative areas of reforms has certainly been taken in a positive

stride by the investors’ community.

Some of the key announcements which included liberalizing FDI, decontrolling diesel prices and proceeding

more aggressively on the path of disinvestment reflect the erstwhile endeavor of the government to tread

the economy on to a path of higher growth trajectory. The understandable benefits of these announcements

cannot be ignored.

With the opening up of FDI in multi brand retail, we may be standing on the anvil of a retail revolution.

It may be noted that the country’s urban population has increased by nearly 90 million between the years

2001 and 2011 and is expected to increase by 250 million (as per independent forecasts between 2008 & 2030).

Besides rapid urbanization, it is vital to mention here that the expanding rural and semi rural markets also

provide potential opportunities for the retail industry.


Also, millions of youth would be trained for the skilled jobs created by the large format retail stores. One

needs to keep in mind the challenge of generating 10 million new jobs in our economy simply to absorb new

entrants in the workforce.

Further, the move of decontrolling diesel is indispensable in wake of 1) our rising subsidies and ballooning

fiscal deficit 2) increasing import bill. It may be noted that India’s rising deficit (trade and current account)

is largely due to rising imports of oil products. Import of these commodities should therefore be managed

through immediate policy action. The average oil import bill (in $) has increased by 22% in the last 5 years,

with the oil import bill rising by 32% in the FY12.

Post these announcements the rupee appreciated by nearly 1.5% with in a week to be at Rs 53.91/USD on

September 21, 2012, it was last seen around this level in May this year. There has also been a visible increase

in the FII inflows. For instance, by looking at the trend of FII inflows in the month of September 2012, it is

clearly noticeable- between 3rd and13th September 2012 the FII inflows amounted to USD 249.95 million,

post the announcements on September 14, 2012 the inflows till date have been USD 4255.37 million.

In addition, the most recent set of announcements that included proposal of raising FDI caps for insurance

and pension sectors and the likely amendments to the Companies Bill and Competition Act are also most

welcome.

With the government finally breaking the long hauled lull in the reform process, the country is finally

cracking the image of going through a policy paralysis. It will be important that this reform process is

carried forward in right earnest. Some action on other pending but very crucial issues like land reforms

and getting environment clearances also need to be taken forward. These would be decisive for allowing the

manufacturing sector to be the next big thing for India.

Also a forward movement on GST, introducing greater competition in the mining sector (particularly

coal), strengthening framework and creating new avenues for infrastructure financing and improving agri-

marketing systems are some areas where the government should now focus on.

India is a storehouse of opportunities and the country’s growth story still finds echo in her enjoying a special

status amongst MNCs and fund managers as an attractive investment destination. It is important that we

continue to leverage this status.


Cues lie in the eco surveyDr. Ajit Ranade, Chief Economist, Aditya Birla Group

The Economic Survey is an annual report card on the economy, and a statutory submission to Parliament. In

recent years it has also served as a window to the mind of the government, revealing what the policy makers

are thinking about economic reforms. Whether these reforms get implemented either by executive decisions

or though bills tabled in the House is a different matter. But those ideas do enter the public domain, and

become more robust through debate. The need to allow FDI into multi-brand retail was articulated in this

year’s Survey.

Some other notable ideas are also worth mentioning. To deal with the dilemma of food inflation amidst

record foodgrain stocks, the Survey had advocated selling small quantities throughout the year. This is in

contrast to the present practice of selling through a tender process to large wholesale traders only. This

continuous dribble sale of small quantities puts a bearish pressure on prices. Though the idea is three years

old, it has seen the light of implementation only now. Another reformist idea was the use of smart cards

in the sale of fertilisers, so as to better target beneficiaries, and reduce the ballooning subsidy (the fertiliser

subsidy last year was approaching Rs 1 lakh crore).

Another suggestion was the removal of perishable items like fruits and vegetables from the purview of

the APMC Act. This has only been done piecemeal in some states. Reform ideas in the public distribution

system include the use of cash transfers. The idea is several years old, but only this year, Maharashtra be-

came the first state to start using cash vouchers for sale of kerosene in public distribution system outlets,

on a pilot basis.

The above are only some examples from food management and agriculture. Another idea in the Survey re-

lates to reforming the incentive structure applied to tax collectors. To get the entire list of pending reforms

one has to simply take the extract of the relevant chapters of all the recent Economic Surveys.

The journey from idea to implementation of reforms is arduous and unpredictable. Even when an idea is

well ‘roasted’ by debate, it still may not see the light of day, due to coalition compulsions. This is a generic

diagnosis; sort of like saying coalitions are allergic to reforms.

But the need for reforms is undoubted. Achieving higher economic growth is necessary for large-scale job

creation and for being able to fiscally afford greater social inclusion. Even Amartya Sen, who is not known

as a frontline votary of economic reforms, recently wrote about the importance of achieving high growth

to fund social programmes.

The UPA regime pursued inclusive development by legislating several social rights (like right to educa-

tion, right to work-NREGA, and now right to food), all of which have fiscal costs. The high growth of 2003


to 2007 made us believe that we could pursue and afford inclusive growth. That growth is now at a decadal

low, and is putting great stress on public finances.

The outlook for the world economy is clouded, with slowing China and Europe burdened with unsustain-

able sovereign debts.

But these clouds have a silver lining in India. During 2011-12, India had some spectacular achievements.

The inbound FDI was the highest ever at $48 billion. The rather ambitious export target set by the com-

merce minister in April 2011, was not only achieved, but exceeded. The foodgrain production at 252 million

tonnes was a new record. During April to June 2012, oil prices dropped sharply by 37 per cent, much more

than rupee depreciation of about 20 per cent. This was a positive for oil-dependent India. And the rupee

itself, in relative terms is 20 per cent more ‘competitive’ vis-à-vis the Chinese RMB.

Unfortunately, these silver linings were insufficient to prevent an outlook downgrade by the rating agen-

cies. Moreover, all these significant positive sparks occurred in the midst of sharp decline in industrial

investments, high deficit and high inflation.

The Prime Minister is aware that investment spending, especially from the private sector, needs to be

desperately revived. That can happen only with a helping booster dose of economic reforms (which are

already articulated in the government’s own report card, the Economic Survey).

Hence, the decision to open multi-brand retail to foreign investors is to be welcomed. The decision was

taken by the Cabinet in December 2011, but its implementation was withheld to garner a stronger consen-

sus. But with the threat of a possible rating downgrade, the government does not have the luxury of time

for further consensus building. This is to be seen as a pro-farmer reform, and not anti-kirana reform. The

kirana shops will survive well into the future, but they are not expected to invest in cold storage chain or

back-end infrastructure.

Other decisions on raising FDI caps are also to be seen as growth-promoting. As for the decision on disin-

vestment and raising diesel prices, those address fiscal concerns. The diesel increase, however, could have

been done in smaller doses of successive Re 1 increases over several months. But it was overdue. India is

possibly the only country where rail has lost to road freight consistently. Rail freight share may fall to 15

per cent if there is no investment in railway infrastructure. This is a pity, because it entails loss of efficiency,

burning of fossil fuels and is ultimately very expensive for the economy. Investment in railway (as in China

and now in the US as well) serves multiple goals: creation of a public good, saving of fuel, increase of ef-

ficiency and creates more jobs.

Thus the pipeline of pending reforms is long. Some are easy to digest, some are harder, and some have

possible side-effects. Their passage is imperative, and calls for greater articulation and communication to

the voters and taxpayers.

We hope that big bang Friday was just the beginning.


Financial Sector Reforms: The Need for ChangesMr. Himanshu Kaji, Executive Director & Group COO, Edelweiss Financial Services Limited

Though the financial and macroeconomic environment is challenging, India’s fundamental strength means

that, with the right incentives, the economy could see significant growth over the next decade. The financial

services sector, especially its chief components of banking, NBFCs, capital markets and insurance, has the

potential to contribute to this growth.

However, growth cannot come without change. We believe that changes must be made to the regulatory

system to enable financial institutions to compete on a global level, while not compromising the regulators’

ability to oversee and supervise their operations.

The Banking Sector

Reforming the Banking sector is vital to preservation and enhancement of Indian banks’ ability to provide

efficient and high-standard services domestically and compete with their peers on an equal footing

internationally. Passing the Banking Laws (Amendment) Bill is an immediate step that can be taken as a key

component of such reform.

Increasing the voting rights of entities in private banks to 26% and in public banks to 10% is likely to increase

participation in the Banking sector from both Indian and international investors. The possibility of higher

voting rights will encourage greater investment in existing banks. In addition, this measure will support the

establishment of new banks. In the initial years of a new venture, a significant percentage of its shares will be

held by promoters. Passing this Bill will give the promoters commensurate voting rights as well.

The Bill also removes banks’ and NBFCs’ mergers and acquisitions, which already require RBI approval,

from the additional ambit of the Competition Commission. This will prevent the confusion that is likely to

arise from more than one regulator overseeing the same transaction.

Banking in India is underpenetrated, with around 9,000 adults per branch (compared to around 7,200 for

Brazil and 2,800 for the US). To ensure greater penetration, banking licenses should be made more freely

available. Issuing new banking licenses would increase competition, and have the added advantage of forcing

new banks to go to underpenetrated locations to gain market share. This would boost financial inclusion.

It would be ideal to take these steps immediately. At the very least, these measures must be implemented in

the next two to three years to enable Indian banks to achieve and maintain international standards.

Another important measure that must be taken in the near future is the creation of certain specific exceptions

to the RTI Act. While the importance of the RTI Act to transparency is indisputable, banks must be allowed to


protect the interests of their depositors and borrowers by maintaining client confidentiality. Individual client

records should be exempt from the provisions of the Act.

The non-implementation of these reforms in the near future will have an adverse effect on innovation in the

Banking sector, since new players will be discouraged from joining the industry and existing banks will find

it difficult to raise fresh funds. This, in turn, will have an adverse impact on their financial inclusion efforts,

and make participation in India’s economic growth challenging for people at the grassroots level. The effect

of this will flow through the economy and dampen domestic savings.

On the other hand, the implementation of these reforms will spark innovation in product offerings and better

customer service across the board. There will be a high degree of financial inclusion, bolstering domestic

savings, especially financial savings of households.

NBFCsNBFCs are an important component of India’s financial services landscape, providing funds to people who

are unable to obtain funding from banks and providing people new and innovative products in which to

invest their money.

To maintain NBFCs’ ability to innovate and provide services distinct from those provided by banks, it would

be beneficial for them to have a separate regulatory authority. To enable them to obtain the funds, they need

to grow and innovate, systemically important NBFCs, whether or not they take deposits, should be permitted

to raise additional capital by issuing perpetual bonds.

Finally, NBFCs should have the same powers as banks under the SARFAESI Act.

These changes to the regulatory environment of NBFCs should be made as soon as possible – ideally, within

the next twelve months, and certainly in the next two to three years.

If provided with a level playing field, NBFCs will be able to complement banks. They have the potential to

play a useful role in driving the economy by ensuring that lines of credit are open to sectors and companies

that are fundamentally strong but unable to obtain bank loans.

Capital MarketsIndia’s capital markets face significant difficulties due to regulatory anomalies. Stamp duty, for instance,

is decided at the state level and is therefore not uniform across states. This leads to businesses that operate

out of Maharashtra, for instance, which has high stamp duty, having their registered offices and signing

their contracts in other places in the country that have lower stamp duty. Setting uniform stamp duty rates

applicable through the country would put an end to this inefficiency. At the same time, all other existing

transaction charges, such as STT, should be reviewed and reduced. At the same time, stamp duty on options

should be made applicable on option premium only instead of on strike.


These changes will reduce transaction cost and make the capital markets more attractive to both retail and

institutional participants. Failing to make these changes could result in declining trading volumes as high

costs make people drop out of the markets.

InsuranceInsurance is a sector that stands to benefit greatly from international interest as more and more foreign

financial services companies look at India as a growth market. To reap the full benefits of foreign interest,

the limit on FDI should be raised from 26% to 51%, thereby giving insurance companies access to foreign

capital.

Insurers should also be allowed the freedom to structure their distribution and promotion expenses in the

most efficient way, provided they operate within the prescribed limits for the overall expense ratio. Further,

a comprehensive legal framework should be put in place to deal with fraud cases quickly, reducing the time,

effort and money insurance companies have to spend dealing with falsified claims.

If these reforms are not implemented, insurance companies will have difficulties raising capital and may

have to slow down their branch expansion plans. Making these changes will lead to an influx of foreign

capital. This will allow branch expansion and encourage product innovation and a sharp improvement in

service levels. New and innovative products will then be available to more people.

General ReformThe Indian financial services industry is hampered by regulatory anomalies, which lead to operational

inefficiencies. One of the most important medium-term requirements is a comprehensive public policy on

the role of the private sector in financial services. This will bring greater clarity to private sector companies

and enable them to formulate their business plans in an effective and inclusive manner.

In addition, there need to be common KYC norms across the financial services sector. This will increase

efficiency and reduce cost for companies that will no longer need a separate KYC for each individual product

sold to the same customer.

An absence of clarity and uniformity of thought on the role of the private sector in India’s financial services

space will curtail innovation and inhibit improvements in customer service. Encouraging private participation

in financial services will increase competition, leading to a more efficient market, easier access to capital, and

improved domestic savings as a result of retail participation in new and innovative products.

ConclusionFinancial Services is one of India’s highest-growth sectors. It has the potential to be a major driver of India’s

GDP, both directly and indirectly.


Reforming banking sector norms will lead to increased participation and new players entering the banking

space. The increased competition will result in better and more efficient products and the entry of new

participants will be an impetus for innovation and greater financial inclusion. NBFCs have the potential,

if appropriate steps are taken, to complement banks and provide credit to sectors and companies that are

ineligible for bank credit, giving a fillip to the economy.

Improved liquidity in the capital markets will mean that companies can raise money more easily. Easing

regulations on foreign participation can be another major source of funding. This increased availability of

capital will lead to expansion in several sectors. The elimination of regulatory anomalies and the establishment

of standardized tax and stamp duty rates and KYC norms will lead to more efficient processes and reduced

costs. The cost reduction will be passed on to customers in the form of greater returns on investments, leading

to increased savings and a boost to the economy.

Insurance companies, if reforms are implemented, will be in a position to offer insurance cover to more

people and will be able to benefit from the experience and expertise of the large international players, leading

to far higher inclusion and efficiency.

Thus, resolving regulatory and structural concerns in a few key areas could lead to significant benefits in

economic growth. It will come both in the form of financial services revenues and investment returns and in

the form of increased productivity and revenues in other sectors.

Bibliographyhttp://data.worldbank.org/indicator/FB.CBK.BRCH.P5

http://www.business-standard.com/india/news/cabinet-clears-higher-voting-rights-for-bank-shareholders/472751/

http://www.moneycontrol.com/news/cnbc-tv18-comments/cabinet-clears-banking-amendment-bill_697414.html

http://www.prsindia.org/billtrack/the-banking-laws-amendment-bill-2011-1589/

http://www.business-standard.com/india/news/what-issarfaesi-act/439266/

About Federation of Indian Chambers of Commerce and Industry (FICCI)Established in 1927, FICCI is the largest and oldest apex business organisation in India. Its history is

closely interwoven with India’s struggle for independence, its industrialization, and its emergence as

one of the most rapidly growing global economies. FICCI has contributed to this historical process by

encouraging debate, articulating the private sector’s views and influencing policy.

A non-government, not-for-profit organisation, FICCI is the voice of India’s business and industry.

FICCI draws its membership from the corporate sector, both private and public, including SMEs and

MNCs; FICCI enjoys an indirect membership of over 2,50,000 companies from various regional chambers

of commerce.

Our Vision:To be the thought leader for industry, its voice for policy change and its guardian for effective

implementation.

Our Mission:To carry forward our initiatives in support of rapid, inclusive and sustainable growth that •

encompasses health, education, livelihood, governance and skill development.

To enhance efficiency and global competitiveness of Indian industry and to expand business •

opportunities both in domestic and foreign markets through a range of specialized services and

global linkages.

Federation of Indian Chambers of Commerce and Industry (FICCI) Federation House

1, Tansen Marg, New Delhi 110 001Please contact us at

Email: [email protected]: +91-11-2335 7391, Fax: +91-11-2332 0714

FICCI Capam 2012 Knowledge Paper

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