India Transformed

by Rakesh Mohan

  DEPOSITORIES AND CLEARING CORPORATIONS

  It was widely recognized well before the 1990s that paper-based trading of stocks led to ‘bad’ and delayed deliveries of titles. Consequently, the Depositories Act was passed in May 1996. The National Securities Depository Limited (NSDL) was set up by IDBI, UTI and NSE in November 1996. Securities (shares, bonds and debentures) could then be held in individual or institutional accounts and transferred, and dividends received without hard copies being signed and exchanged. Subsequently, the Central Depository Services Limited was set up by BSE in 1999. Currently, the settlement time and transaction costs in Indian stock exchanges are similar to those in developed countries. Table 1 provides the details of the steady increase in dematerialized volumes since 1996–97.

  The National Securities Clearing Corporation (NSCCL) is a fully owned subsidiary of NSE. NSCCL started operations in April 1996 as India’s first clearing corporation and it introduced settlement and counter-party risk guarantees. RBI has traditionally been circumspect about Indian stock-exchange brokers and does not trust them to transparently manage trading in instruments that have a bearing on rupee interest or exchange rates. This was perhaps the principal motivating factor in RBI’s decision to set up the Clearing Corporation of India (CCIL). CCIL settles trades in government debt securities consisting of outright and repo transactions that are reported in RBI’s Negotiated Dealing System (NDS). CCIL is aimed at settling all trades that deal with interest and exchange rate over-the-counter (OTC) derivatives. Central banks around the world are usually not involved in setting up clearing corporations. RBI, as a financial-sector regulator, should distance itself from CCIL, which is an MII.

  Stock exchanges in several developed countries are listed and this practice is cited as an example for Indian stock exchanges to follow. Stock Exchanges, Depositories and Clearing Corporations were categorized as MIIs in the Bimal Jalan Committee report,4 which stated that it was ‘not in favor of permitting listing of MIIs’. MIIs, including stock exchanges, have surveillance responsibilities. It follows that profit maximization should not be part of the mandate of MIIs, and they should not be listed.

  Section II

  1. Equity Markets

  In the early 1990s, BSE had the overwhelming share of trading turnover. However, NSE quickly overtook BSE and the margin widened over time as is evident from the numbers in Table 2.

  LIC is one of the largest holders of stocks among institutional investors. The timing of LIC’s purchases and sales of key equity index stocks appears to indicate that it usually works with the government to ‘stabilize’ markets. Equity markets need to be weaned off any dependence on LIC, whose principal objective should be to broaden its reach in insurance markets.

  Table 3 details equity-market capitalization and trading turnover in several countries. Stock-market capitalization, as a percentage of GDP, has grown substantially in India since 1991. Capitalization varies with movements in stock prices and growth in GDP. At the height of the financial-sector excesses in 2006–07, prior to the 2008 crash, the value of Indian stocks rose briefly to 147 per cent of GDP.

  In the last few years, fresh investment in India has been inhibited as large borrowers have struggled to service their debts. The companies that are continuing to do well are relatively cash rich and their promoters do not want to dilute their equity holdings. As a result, as seen in Table 4, the volumes of public and rights issues of equity have shrunk since 2010–11.

  Table 4: Corporate-sector Equity Issues

  Public Issues of Equity (Rs 1000 crores)

  Rights Issues of Equity (Rs 1000 crores)

  2000–01

  2.5

  0.7

  2005–06

  24

  4

  2010–11

  49

  9.5

  2014–15

  3

  6.8

  Source: Indian Securities Market Review (several years) NSE.

  As of 2015, 46 per cent of the market value of Indian stocks was held by domestic and another 5 per cent by foreign promoters. Of the remaining free float of 49 per cent, about 20 per cent was held by FIIs, 16 per cent by retail investors, 12 per cent by domestic institutional investors such as insurance companies (mainly LIC) and mutual funds.

  1.1. Private Equity and Venture Capital

  Indian private equity and venture capital (VC) markets have developed substantially in the last fifteen years. Global private-equity flows did slow down after 2008 but have picked up again in the last few years. Private-equity investments in 2014 saw a robust increase over 2013. Deal value, including real estate, infrastructure and VC, increased to $15.2 billion, inching closer to the pre-crisis 2007 peak level of $17.1 billion.5

  2. Debt Markets

  2.1. Central Government Debt

  Indian debt markets are dominated by government-fixed income securities. The outstanding stocks of central-government securities are shown in Table 5. Once government decides on its requirements of funds for the financial year, RBI manages debt issuance across the desired maturity buckets.

  Table 5 also lists central-government borrowings at non-market interest rates through small savings schemes, provident funds and deposits. The stock of managed interest rate borrowings amounted to 10.2 per cent of GDP in 2015–16 as compared to 39 per cent for borrowings based on market-interest rates.

  Over the last two decades, markets for central-government debt securities have increased in liquidity and sophistication. For example, floating-interest rate, zero coupon and inflation-linked bonds have been issued, and repo markets involving government securities are liquid.

  The central government has consciously chosen not to borrow in hard currencies through bond offerings. The unstated concern is that this may lead to borrowings in foreign exchange (FX) reaching unsustainable levels. FIIs are allowed to invest in government debt up to a ceiling of $50 billion. The reasoning for this ceiling is that if the volumes of such investments reach high levels, it may become difficult, at times of balance-of-payments stress, to service interest and principal redemption in FX. In August–September 2013, at the time of the ‘taper tantrum’, there were substantial FX outflows mostly due to redemption of FII investments in government debt securities.

  The Indian Constitution does not allow state governments to borrow directly in hard currency. All their borrowings from private or multilateral agencies such as the World Bank have to be routed through the central government.

  2.2. Corporate Bond Market

  Table 6 shows that even if corporate-debt volumes are taken into account, Indian debt markets are smaller and consequently less liquid than comparable markets in the US, Japan and Germany. Developed-country bond markets facilitate raising of funds at competitive interest rates as compared to syndicated bank loans.6 Further, liquid bonds can be used to reduce duration mismatch risk between assets and liabilities.7

  Short-selling of government securities is not allowed. Consequently, the government-yield curve is not arbitrage-free. That is, interest rates across the maturity spectrum are not consistent with each other. It follows that this makes pricing of corporate creditworthiness of the government-yield curve, which is also inadequately liquid at longer maturities, less accurate. A mitigating factor is that CRISIL and ICRA, two major Indian credit-rating agencies, have created a better appreciation of credit risk across corporate-debt issuers.

  Table 6: Domestic Bond* Market

  Country

  2011

  (Per Cent of GDP)

  2014

  (Per Cent of GDP)

  India

  31

  338

  Mexico

  37

  45

  China

  45

  45

  UK

  71

  –

  Germany

  74

  –

  Malaysia

  96

  99

  USA

  174
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br />   –

  Japan

  263

  234

  *India’s private debt data is available till 2011; the total in 2014 consists of only government debt.

  Source: World Bank.

  Large and profitable Indian corporations with a proven track record are able to issue bonds in FX or access funds through external commercial borrowings. The other options for credit-worthy corporates are public offerings or private placements of equity. As a result, there is relatively limited issuance of bonds by higher credit-rated Indian firms.

  Another reason for the underdeveloped state of the Indian corporate bond market is the lack of liquid secondary markets. In this context, long-term institutional investors, particularly pension funds and insurance companies, are restrained by regulator-prescribed guidelines from investing in corporate bonds.

  Historically, Indian courts have sided with debtors against creditors on the grounds that this may lead to workers losing employment. The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act of 2002 and Debt Recovery Tribunals were expected to address this bias against creditors. However, this did not happen due to the interminable delays in the working of the Bureau of Industrial and Financial Reconstruction (BIFR) which was finally abolished on 1 December 2016.9 In July 2016, the Insolvency and Bankruptcy Act was passed by Parliament. Although it will take time for this legislation to be put into effect, this law should make it easier for creditors to stake their claims against debtors.

  In the Budget speech of 2016–2017, the government announced measures to deepen the corporate bond market.10 The report of the H.R. Khan ‘Working Group on Development of the Corporate Bond Market in India’ was issued in August 2016. RBI has been asked to encourage large corporate borrowers to access bond markets rather than banks and also create an electronic platform to facilitate a repo market in corporate bonds. However, lenders will continue to be watchful of the creditworthiness of corporate borrowers and the efficacy of the Insolvency and Bankruptcy Act. LIC has been directed to set up a separate fund to raise the creditworthiness of infrastructure projects. This could become an unwarranted subsidy for corporate borrowers. It is perceived high-credit risk that is the single-most important factor holding back further development of this segment of fixed-income markets in India. Consequently, the legal balance that is lopsided in favor of debtors needs to be corrected.

  MUNICIPAL BONDS

  The Bangalore Municipal Corporation was the first to raise Rs 125 crore in 1997 by issuing bonds with a state government guarantee. In 1998, the Ahmedabad Municipal Corporation issued bonds without a government guarantee. In aggregate, Rs 1353 crore worth of bonds have been issued under tax-free, taxable and pooled municipal bond schemes. There is hardly any secondary market for these bonds.

  Indian municipal bond markets are underdeveloped compared to developed country jurisdictions such as the US where the size of the municipal bond market is estimated at $3 trillion. This is principally because of the lack of qualified personnel in Indian municipalities. Additionally, the perception is that municipal revenues cannot be reliably estimated or escrowed. Potential investors in long maturity municipal bonds have to be reassured by ring-fencing municipal income to address the perceived high-credit risk in investing in such bonds. In September 2016, credit ratings were assigned to twelve India cities (urban local bodies), and this may facilitate municipal bond issuance.

  ASSET-BACKED SECURITIES (ABSS)

  The need for housing finance in India far outstrips supply. In developed countries, providers of housing finance reduce risk on their balance sheets by issuing mortgage-backed securities. Table 7 shows that as of 2015, issuance of ABSs in India was relatively small. If credit ratings are prudent, ABSs help to improve the efficiency with which capital is allocated. In India, the legal framework for ABSs is provided by the SARFAESI Act. The application of this legislation is perceived as inadequately protective of creditor rights.

  Table 7: Issuance of ABS in 2015 (Per Cent of GDP)

  ABS Issuance

  ($ billions)

  Percentage of GDP

  India

  2.82

  0.10%

  US

  274.5

  1.48%

  UK

  50.4

  1.83%

  Germany

  50

  1.44%

  Source: Estimates of Securities, Industry and Financial Markets Association, ICRA.

  2.3. Pension and Insurance Sectors

  The sub-sectors of banking, capital markets, pension and insurance feed into each other. The development of capital markets and particularly bond markets depends on the growth of insurance and pension coverage. Tables 8 and 9 show that the insurance and pension markets are still small in India. It follows that further growth of these two sub-sectors would help in the development of Indian capital markets.

  The guidelines of the Pension Fund Regulatory and Development Authority (PFRDA) stipulate that for investments under the National Pension Scheme (NPS), debt securities are favoured over equity. Further, the overriding concern is about creditworthiness of issuers of debt and hence government securities are preferred.11 Similarly, the investment norms prescribed by the Insurance Regulatory and Development Authority (IRDA) state that at least 50 per cent of investments have to be in government or similar securities. Additionally, 75 per cent of investments in debt instruments have to be sovereign bonds, AAA rated or equivalent. Consequently, the norms for pension and insurance funds do not allow investment in most Indian corporate bonds since these are rated below AAA.

  2.4. Derivatives

  OTC AND EXCHANGE-TRADED DERIVATIVES

  Interest rate and currency swap OTC derivatives were introduced by RBI in the late 1990s. Subsequently, in 2001, at the initiative of the Ministry of Finance, the Securities and Contract (Regulation) Act was amended to include derivatives in the definition of securities. This enabled trading in exchange-traded derivatives beginning with stock futures and options, interest-rate futures in 2003, and currency futures in 2008. The underlying ‘security’ on which exchange-traded and OTC derivatives are marketed include stock, commodity and bond prices as also interest and exchange rates. The maturities of OTC derivatives in Indian markets have been lengthening, but are still way short of those in the developed markets. This is principally because the rupee is not convertible on the capital account and, hence, these markets are limited by the width and depth of the Indian financial markets.

  The considerable increase in the outstanding principal volumes of exchange-traded derivatives (also called ‘open interest’) on NSE is evident from the numbers in Table 10. The number of contracts has increased by a factor of thirty and the notional principal has risen by more than twenty times between 2004 and 2015. One of the principal benefits is that it is now difficult, compared to the pre-derivatives era before 2002, to manipulate stock prices. If stock prices are artificially raised, asset-management firms or individuals would spot the opportunity for profits and take short positions in the futures/options markets, thus bringing down stock prices to realistic levels.

  Table 10: Open Interest Volumes of Stock-exchange-traded

  Open interest volumes of Stock-exchange-traded derivatives: NSE

  Number of Contracts

  Rs 1000 Crore

  April 2004

  2,49,845

  8

  April 2010

  37,49,538

  103

  April 2012

  34,59,455

  89

  April 2015

  64,68,279

  164

  Source: SEBI.

  COMMODITY DERIVATIVES

  In India, commodity derivatives12 used to be regulated by the Forward Markets Commission (FMC) and the administrative Ministry for Food and Civil Supplies. The logic was that this ministry was in a better position to oversee derivative markets in the prices of agricultural and other commodities. Given
the suspicion that traders had hoarded ‘dal’ (pulses), rice and wheat, the trading of commodity derivatives in these products was suspended in 2007. Later in 2008, trading in commodity derivatives related to the prices of rubber, potato, chickpeas and soya oil was stopped. There have been instances of fraud in commodity futures as in the 2013 Jignesh Shah-led National Spot Exchange Limited scam. However, gradually there is greater understanding about commodity derivatives in Indian government and regulatory circles. In a widely acclaimed move to reduce regulatory arbitrage, the FMC was folded into SEBI at end of September 2015. Currently, SEBI allows trading of futures contracts on prices of agricultural items, metals and energy products.

  CREDIT DERIVATIVES

  Market makers in credit derivatives segregate credit risk and effectively offer insurance for the risk, e.g. that a bond issuer may default. Credit Default Swaps (CDSs) was the credit-derivative instrument of choice before 2008. Around 2006, according to the International Swaps and Derivatives Association, the notional principal of credit derivatives was about $34 trillion. It should have been evident to regulators in the US that insurance market makers such as AIG were inadequately capitalized for the volumes of credit derivatives that they were underwriting. The Financial Stability Board based in Basel has recommended that credit derivatives be traded on exchanges rather than tailor-made as OTC derivatives. The supporting logic is that margins would have to be posted on a daily basis if CDSs are traded on exchanges. This would reduce credit risk in the event that liquidity or solvency issues arise for market makers or participants.

  Post-2008, there is considerable concern in regulatory circles around the world that CDSs, as these are traded off stock exchanges without margins, result in unacceptably high systemic counter-party risk. RBI’s revised guidelines for CDSs on corporate bonds were issued in January 2013.13 As of now, the markets for CDSs in India are thin because the markets for the underlying security, for example, corporate bonds, are underdeveloped.