Indian Financial Markets

P.V. Viswanath

FIN 680A/ FIN 360A/ INB 670C/ ECO 395

Fall 2009

Learning Objectives

Foreign Exchange Markets in IndiaCurrency Convertibility and its RelevanceDebt Markets in India, current situation and problems.Equity Markets in India

Foreign Exchange Market

Size of current marketFutures, Forwards and SpotImportance of Forex MarketReforms under way

Spot Currency MarketsThree approved spot trading systems:– Reuters. Offers dealers a system to communicate and negotiate with each

other ($7b/day in 2007) and a computerized order matching system ($1b/day in 2007).

– FX-Clear (run by the Clearing Corporation of India - CCIL), $300m/day through order-matching.

– IBS-Forex (small)

Trades in all three systems are cleared through CCIL, allowing for netting and elimination of credit risk.End customers access this market through banks.Market is not very transparent and banks have a lot of market power. Hence, there is a black market at the retail level. Bid-ask spreads for retail customers are 10% of those with banks.

Forward Markets

A bilaterally negotiated over-the-counter market.Trading for near maturities, as well as for maturities above 1 year, with the 180-365 days segment accounting for about 40% in May 2009.Contracts are standardized in that they expire on the last business day of the month.Settlement through CCIL.Trading in non-deliverable forwards (through settlement in cash) in HK, Dubai, Singapore and London.Existence primarily due to non-access of non-residents to domestic forex markets; increases the overall efficiency of the forex markets. MNCs and international banks are key players.Such markets also exist for other RMB, Indonesian rupiah, Korean won and Philippine peso.

Exchange-Traded Currency Derivatives

There is now a currency futures market at the NSE (launched on Aug 29, 2008), but only in the US$/Rupee contract.However, participation by FIIs and NRIs is banned.Still, the market is very liquid and the impact costs may be lower than in the OTC forward market. (http://ajayshahblog.blogspot.com/2009/09/currency-futures-liquidity-ahead-of.html)

Volume on the NSE surged and outpaced the MCX Stock Exchange (the OTC forward market). However, more recently, volumes on the MCX-SX reached an industry high on Oct. 7, 2009, crossing Rs10,798 crores ($2.2b) and overtaking National Stock Exchange of India Ltd (NSE) (Rs9,857 crores ($2b)).

Currency Convertibility

RelevanceArguments forArguments againstWhere we are

What is convertibility?

Currency convertibility refers to the freedom to convert the domestic currency into other internationally accepted currencies and vice versa.Current account convertibility refers to freedom in respect of ‘payments and transfers for current international transactions.’Capital account convertibility (CAC) would mean freedom of currency conversion in relation to capital transactions in terms of inflows and outflows.

Relevance of convertibility

Attracting foreign capital inflows and thus reducing cost of capitalto improve the efficiency of the financial sector through greater competition, thereby minimizing intermediation coststo provide opportunities for diversification of investments by residents

Risks of free convertibilityOne cannot simultaneously control the interest rate and exchange rate and have full currency convertibility. Complete freedom in any one of these restricts freedom of action on the others.Rapid inflows and outflows of funds into and out of the country leading to sharp movements in exchange rates and destabilization of the financial markets, such as happened during the Asian crisis. These may be unrelated to events within the country. The Asian crisis was at least partially precipitated by events occurring in Russia.These events are exacerbated by – Overvalued exchange rates– large unsustainable levels of external and domestic debt– Weak and badly-run financial institutions, such as banks

Current Status of convertibility

For foreign corporates, and foreign institutions, there is a reasonable amount of convertibility; For non-resident Indians (NRIs) there is approximately an equal amount of convertibility, but one accompanied by severe procedural and regulatory impediments. For non-resident individuals, other than NRIs, there is near-zero convertibility.Indian companies are allowed to borrow abroad in foreign currencies.Indian residents face restrictions on investing abroad.

Steps needed prior to full convertibility

Better regulation of commercial banks.Control of central government deficits and consequent pressure on the exchange rate through government borrowing.Inflation caused particularly because of government deficits.Financial markets – debt and equity need to be well developed and integrated so that shocks to one or more market segments get transmitted to other segments efficiently so that the entire financial system is able to absorb the shocks with minimal damage.

Steps needed prior to full convertibility

Tax policies need to be harmonized. Else capital will flow in through countries that have liberal tax agreements with India, e.g. Mauritius is the largest source of foreign investment in India, contributing $39 bn in FDI inflows during the period April 00 to May 09, representing 44% share of total flows.This is because of a tax treaty: the gains derived by a resident of Mauritius from the sale of shares of an Indian company are exempt from tax in India. This has led to some misuse by non-Mauritius residents seeking to become temporary Mauritius residents to avail of this tax exemption.

Corporate Implications of Convertibility

Indian firms have been using ECBs to make foreign acquisitiions.With FCAC, they would be able to use money raised in India, as well.This would make the acquisition process much faster.

Impact of Convertibility Restrictions

Capital controls imply a cost of arbitrage or induce riskiness to the arbitrage position. These unseen costs or risks induce a threshold effect where arbitrage will only become profitable (on a risk adjusted basis) outside a given level of Covered Interest Parity deviation.CIP implies a relationship between spot rates, forward rates and interest rates.It is possible to use NDF forward rates to estimate implied Indian interest rates. These can be compared with actual Indian interest rates to estimate deviations from CIP.

Tests show that there have been significant reduction in the barriers to arbitrage from the pre-2003 period to the post-2003 period.

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Indian Capital Control Liberalization: Evidence from NDF Markets – Hutchison, Kendall, Pasricha and Singh, Jan. 2009

Debt Markets

Size of debt marketImportance of debt marketsReforms under way

Worldwide Debt Markets

The size of the outstanding debt in global markets, as of 2008, was about $83 trillion.Domestic bonds accounted for about 71% of this, with 23% being international. International bonds are issued or traded outside the country of their domestic currency.

US Japan Italy France Germ Spain UK Canada Belg Others WorldTotal 24,622 11,077 3,262 2,921 2,593 1,746 1,223 1,035 553 10.634 59,666

Public 7,888 9,113 1,780 1,437 1,364 540 827 670 373 5,795 29,787

Finan 13,819 1,197 1,055 1,160 929 543 378 254 144 3,795 23,274

Corp 2,914 767 427 324 300 663 19 110 36 1,045 6,605

Source: Bank of International Settlements, in bn. $

The Indian Debt Market

Outstanding Govt of India debt, as of Sept. 2007 was Rs.12.195 trillion or about $250bn. (Source: Shah, Thomas and Gorham,p.83)In addition, there is state government debt, debt issued by public sector enterprises, as well as private sector corporate debt (including financial enterprises).In 2006, it was estimated that corporate debt represented 2% of total debt outstanding, while financials represented about 5%. Hence most of the debt is government debt.

The Indian Debt MarketDebt raised in the primary market in 2007-8 was about $64bn. by the government and $29bn. by non-government/corporate issuers (NSE report, 2008).Turnover was about $1.4 trillion for government issues and $5.5billion for non-govt/corporates. Trading is electronic and there is a negotiated dealing system (NDS), which allows for anonymous negotiation and order matching. The quality of this bond market is superior to that of many other Asian countries.The RBI is planning to develop a market for STRIPS. There are primary dealers, who are required to support the secondary market. However, because of restrictions on short-selling, they don’t‘ always meet their obligation in this regard.

Corporate Debt Markets

Corporate debt is minuscule in terms of importance. Although India has long had the regulatory framework for companies to offer debt, the disclosure requirements are so stringent that few bother. In 2007, Indian companies issued bonds equivalent to just 1% of the country's gross domestic product, compared with 112% of GDP in the U.S. and 10% in China. In 2008, this number was estimated at about 3.9% by the Asian Development Bank. The stringency of regulations for exchange issuance of bonds means that most debt is raised through private placement. For example, shelf registration is not allowed and disclosure standards are high.Although corporate bonds can be listed and traded on the NSE and the BSE, most trading is done on an over-the-counter market.In 2008, it was estimated that there were about 140 trades per day, amounting to $80m.

Corporate Debt MarketsAlthough the corporate debt market is small, compulsory reporting of trades has increased trading transparency.All corporate bonds have to be rated before they can be brought to market.There are five rating agencies, of which four are tied to foreign rating firms – S&P (Crisil), Moody’s (ICRA), Fitch and Duff and Phelps.Rates of taxation vary according to the end-user, e.g. insurance cos and mutual funds are exempt, but banks are not – this causes friction in the pricing of corporate bonds.State Governments also levy stamp duty per trade, which increases trading costs.Efforts are under way to improved the situation. In addition, creditors’ rights under bankruptcy have been strengthened for secured credit.

Recent Developments

According to a notification by SEBI in October 2009, non-exchange trades in corporate bonds from Dec. 1 onwards have to be cleared through a clearing corporation -- National Securities Clearing Corporation Limited (NSCCL) or the Indian Clearing Corporation Limited (ICCL).This will increase market efficiency and reduce counter-party risk.Continuing Problems:– The lack of a liquid GOI yield curve along with interest rate derivatives, so as

to be able to layoff interest rate risk when holding a corporate bond portfolio, – The low values for loss-given-default, given the lack of a bankruptcy code and – The ban on credit derivatives.

Regulation and Securities Issuance

Indian companies often sell shares rather than bonds, and some $50 billion in initial public offerings are in the pipeline for the next two years. But this creates another problem: IPOs in India are painfully slow. Regulators want all of the country's 20 million individual investors--many living in remote areas without computers--to have a shot at getting shares. So companies must also accept paper applications for allocations. Anyone who wants to buy must put down 10% of the value of the stock requested. Consequently, when a popular offering is in the works, investors' money is locked up for three weeks while the shares are parceled out--which saps liquidity from the market.

Equity Markets

Size of India’s stock marketsPerspectiveWhat’s happening today

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Equity Markets

No. of listed companies is 4887 (BSE), compared to 5130 for the US and 1530 for China.Index stocks share of total market capitalization is about the same for the US and India (78%).Turnover in China for 2007 ($7800 trillion)was >7 times that in India. Suggests that Chinese market is more liquid.Market Capitalization ratio (ratio of MV equities to GDP) was 109% in 2007-8, 90% in 2006 (compared to 126% for high-income countries).

Shareholding Patterns in India

However, the ratio of the number for India to that of high-income countries has risen from 0.236 in 1990 to 0.6076 in 2005.

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Ratio of India's MktCap/GDP to High-Income Countries'

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Household Participation

Most household investment is in fixed deposits and in insurance/provident funds. Very little in the equity market or even in any other financial securities (8.5% in 2007-8).More than 50% of shares issued (as of June 2008) are held by promoters (insiders); about 10% by foreign institutional investors and 13% directly by individuals.According to data for 2006, individual stock ownership in the US was about 30%, but only about 12% in the UK. However, pension funds and investment funds held 20% and 23% respectively in the US and 16% and 5% in the UK. Since individuals could have exposure to stocks through mutual funds or pension funds, we see that the relative exposure of Indians is small, compared to the US and UK.

Stock Market Efficiency

Stock prices are trending up.There is tremendous volumeHowever, in order for the stock market to work as an efficient mechanism for channeling resources, prices have to reflect true value.One requirement for this to happen is that the market should not be manipulable by a few parties.Shareholder dispersion is an important factor for this to be true.

Shareholder Dispersion: Why?

Helps stock market liquidityWhich, in turn, helps market efficiency and– Information aggregation

Prevents control of government by corporate sector, leading to subversion of political system.From the firm’s point of view, IPOs directed to shareholders at large, rather than financial Institutions will keep the cost of capital lower. This will ensure economic efficiency.

Shareholder Dispersion: Why not?

Agency costs– Leads to divergence between managerial goals and

shareholder goals– Reduced investment in monitoring of managers– Inefficient investment

Need strong market for corporate control and well-regulated securities market to offset this.Empirically, dispersed share-ownership is a characteristic of developed economies.