Capital Markets Impact Evolution

8/6/2019 Capital Markets Impact Evolution

1/20PNACA922 April 1999

CDIE

Impact

EvaluationUnited States Agency for International Development

Team l eader:James W. Fox

Team members: Joseph M. Lieberson , Frank D. Martin , Ajay Shah,Tush ar Wagmare, and Richard W. Whelden

DEVELOPING THE CAPITAL MARKET IN INDIA

After more than four decades of heav y regulat ion and anemic grow th,Indias government in 1991 dramat ically opened t he economy to

market forces and promot ed moderniz at ion of financial inst itutions.USAIDtechnical assist ance and t raining complemented these policy

and inst it utional changes, helping st rengthen gov ernment ov ersightand increase investor confidence.

SUMMARY

There is broad consensus on how an efficient m odern stock market should operate, and theUnited States is the w orld leader in this area, regarding both market op erations and govern-ment regulation. USAID/ India was able to tap into this expertise and help transfer it to Ind ia.

Reform of capital markets is critical to Indias long-termdevelopment. Past reliance on government investment an dbank lend ing has p rodu ced poor results. These practicesclearly will not provide the amounts of resources neces-sary for rapid future growth, nor allocate them as effi-ciently as a capital marketthe planning office for amarket economycan.

Governm ent oversight is critical to developing an efficientstock market, by requiring disclosure of relevant finan-cial information, limiting transactions costs for securitiestrad ing, and prom oting transparency of market operation.

CONTENTS

A Tale of Two

(or Three ) Cities ...................... 2

The India Country Context ....... 3

USAID Projects

and Their Results..................... 8

Economic Effects of USAIDs

Ca pital Markets

Strategy ................................. 13

Ca pital Ma rkets and Poverty

Reduction in India ................ 16

Conclusions............................. 19


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2Comp anies are reluctant to d isclose finan-cial information, while brokers (who con-trol most stock exchan ges) prefer arran ge-ments tha t make stock transactions non-transparen t and h igh-cost. Disclosure and

transp arency are also imp ortant for avoid-ing the p roblems, such as the recent Asiaflu, caused by excessive dependency onforeign financing through loans.

USAIDs municipal infrastru cture finan cingapp roach w as innova tive and has createdgreat interest. Only time will tell whetherlocal governments can overcome the manyobstacles to general u se of this promisingveh icle. If it succeeds, it could channel bil-

lions of dollars into critically needed ur-ban infrastructure

A TALE OF TWO(OR THREE) CITIES

Several days a week, one can travel to Wash-ington from Mu mbai (formerly Bombay) witha stopover in Amsterdam. Amsterdam and

Mum bai have mu ch in comm on. Each is a col-lection of island s that hu man effortlandfills,swamp drainageconverted into a city. Eachis its coun trys leading port and a bu stling com-mercial center. Each is located in a country thatis among the most densely populated in theworld. At 971 persons a square mile, popula-tion density in the N etherland s is about 25 per-cent higher than in Ind ia. The scale is different,however. India is a vast country, while thepop ulation of the entire Netherland s is about

the same as the city of Mumbai alone.

The two airports do not differ dramaticallyfrom each other. Each has the size and bustleand metal detectors and jetways common totodays interna tional traveler. The latest tech-nology in a ircraft is available to move p eoplefrom one airport to the other. Both are the samedistance (abou t 15 miles) from the center of the

city. It is on leaving the airport for the centercity that the dramatic d ifferences between thetwo cities appear.

From Am sterdams airport, one can take a com-

mu ter train and be at the center of the city in 20minu tes. The ride is quiet and comfortable, andpasses through a mix of residential and indu s-trial areas. Most of the residences are low-riseapartment buildings, but with an abundanceof well-maintained green space and parkland .Some factories can be seen in th e d istance, butthe more common workplaces are high-risebuildings where armies of white-collar work-ers directly p roduce nothing tangible. Like of-fice workers elsewhere, they talk on the tele-

phone, go to meetings, and write words onpaper. The result of these efforts is sufficientfor the average Dutch worker to earn about$50,000 a year. On arrival at the center of thecity, one can stroll along the streets with thesame feeling of quietn ess; of clean, well-main-tained buildings and streets; of a general pleas-antness and uncrowdedness.

The contrast on leaving the Mum bai airport isstark. The taxi ride to d owntown takes an hour

un less traffic is bad . (A new traveler might tryto take a train, but the massive overcrowdingthere would dissuade m ost travelers from d o-ing this a second time.) Most of the trip runsthrough areas that scream poverty. The basicvision that assaults the senses is of massiveovercrowd ing, of taxation of the infrastructureto the breaking point. Too many cars, too manypeople, too much pollution, and too much pov-erty. Some sights strain the imagination, as see-ing wom en d ressed in immaculate saris emerg-

ing from labyrinths of hovels on tidal mu d flats.The bustle of people on their way to w ork is noless than one sees in Amsterdam. The first im-pression is that people work as hard in Mum baias in Amsterdam . Yet the averag e Mum baiworker earn s only $1,000 a year. (This is abou t50 percent more than th e average for Ind ia as awhole.)


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3What explains the difference in the physicalinfrastructure that faces workers in these twocities, and the d ifference in productivity of theworkers? Until recently, any comp arison of thissort between Amsterdam and Mumbai w ould

have seemed un reasonable. After all, the Neth-erlands was probably the most advanced coun-try in the world three centuries ago. The stateof its infrastru cture reflects accretion over longperiods of time. This is true, but the experienceof some other Asian countries suggests thatcenturies may not be n eeded to m ake the trans-formation. One may also f ly easi ly fromMumbai to Singapore, another island citywh ere mu ch has been reclaimed from swam p-land . Until the 1860s, Singapore w as a fishing

village. Even as recently as Indias indepen-dence in 1947, the d ifference in stan dards of liv-ing between Singapore and Mumbai was notstark. Singapore had mu ch of the overcrowd -ing, slums, poor water, sewerage, and mu nici-pal services characteristic of Mum bai tod ay. Yetin two generations, Singapore has mad e stridesthat make it comparable with Amsterdam inmun icipal amen ities. It has a higher per capitaincome than the Netherland s and a longer lifeexpectancy. How did such a rap id transforma-

tion occur? Why has Singapore been able tomake it, and wh y has Mum bai not don e so?

Issues of the am oun t of cap ital that th e societyinvests and more importantthe efficiency ofthe capital investment process seem to lie at thehear t of the answer to these questions. The capi-tal market is the medium through w hich invest-ment is allocated among alternative uses in amarket economy. In such an econom y, the capi-tal market is the investment p lanning office. It

decides how m any resources will be availablefor inves tment by f i rms throughout theeconomy; how mu ch, and at what cost, will beavailable for infrastructure investmen t; whichcompanies will be able to expand and whichwill not. In India, the government sought toplay this role for decades. The USAID capitalmarkets development project sought to help

transfer this function from the government tothe m arketplace.

THE INDIA COUNTRY CONTEXT

Economic Environment

For four decades after independence, India fol-lowed a d evelopm ent strategy based on exten-sive government d irection of the economy. Thisincluded broad p ublic own ership of comm er-cial enterprises, a requirement for governm entapp roval for new investment by large privatecompanies, substantial protection against im-

por ts, restrictions on exports, strict limitationson foreign investment, and a governmentpolicy framework that posed strong obstaclesto the development of capital markets. Mostf inance for investment projects was donethrough banks, heavily administered by thegovernment. Indias private sector was prob-ably the most controlled in the nonsocialistworld.

The decades of government cont ro l had

marginalized India from the w orld economy.Its share of world trad e was less than 0.5 per-cent, down from 2 percent in 1950. Governmentrestrictions on inflows of foreign investmentand capital goods d eprived the country of newforeign technology. An overextended publicsector did an inefficient job of allocating nearlyhalf the countrys gross investment, while gov-ernment capital market regulations and con-trols directed much of the private sectors in-vestmen t. The result was severe structural and

financial imbalances, which along with lowproductivity growth (rather than inadequatesavings) translated into w eak economic growthper forman ce. From 1950 through th e 1980s GDPgrowth rates s tayed ahead of populat iongrowth, but on ly barely so, and imp rovementin average living standards was extremely slow.


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4Although the rate of Ind ian economic growthhad picked u p d uring the 1980s from the ane-mic Hindu rate of growth of about 3.5 per-cent of the previous several decades, this hadnot p revented a grow ing belief that Indias self-

reliant approach to development was not work-ing. Other countries in Asia were achievingrates of economic growth and improvementsin the stand ards of living of ordinary p eoplethat w ere dramatically faster than Ind ias.

In June 1991, in the midst of severe fiscal andexternal imbalances, which had generateddou ble-digit inflation and pu t the country onthe verge of defaulting on its external debt ob-ligations, a new government undertook the

major task of stabilizing and liberalizing theeconom y. Since 1991, reform of the investment,exchange-rate, and trade regimes has endedfour d ecades of state planning and set in m o-tion a qu iet economic revolution.

After the initial economic shock of reform infiscal year 1991 (GDP growth of only 1 percent),annual growth accelerated to 5 percent in fis-cal years 199294, 6 percent in FY 1995, and 7percent in FYs 1996 and 1997. Growth, now

driven by exports and private investment, isaccompanied by an increase in domestic sav-ings and a sharp decline in inflation. Exportshave risen significantly, and pr ivate capital in-flows have increased.

Savings and Investment

India has a high savings rate. It averaged 20percent ofGDP in the 1980s and increased to 25

percent dur ing 199397. The share of savingsinvested in financial assets is still relativelysmall but has been increasing rapidlyrisingfrom 3 percent in 1971 to 6 percent in 1981 and10 percent from 1991 through 1996. While theincrease in financial assets is impressive, mostsavings are still held in the form of physicalassets: gold, land , buildings, or commodities.

Market liberalization has been slower in thebanking sector than in most of the rest of theeconomy. Most banks are state owned and facea number of management and organizationalimpediments, including strong and militant

labor un ions. Banks have generally offered sav-ers low interest rates. As a result, the bankingsystem has been receiving a d eclining share ofincremental savings. Households have beenshifting their savings away from banks andother forms of interest-paying assets and intoequity markets. In 1990 (before financial re-form), 75 percent of incremental financial sav-ings went to banks and 25 percent to equitymarkets. In 1996, banks received 47 percent andequity markets 53 percent. The change in share

of assets intermediated by the equity market isdramatic, but so is the absolute magnitude.Total assets interm ediated (by both banks andequity markets) quad rup led. Even correctingfor inflation, the dollar equ ivalent increase intotal assets intermed iated dou bled over the pe-riod 199096.

Indian corporations raised d omestic debt andequ ity totaling $6.4 billion equivalent in 199495, $8.5 billion in 199596, and $9.3 billion in

199697. Indian comp anies have also been rais-ing substantial sums on the international capi-tal markets$4.7 billion in 199495, $2.3 bil-lion in 199596, and $4.7 billion in 199697.There has been a recent and d ram atic shift to-ward increased issuance of debt instrumen ts.The equity/ debt split was 97 percent to 3 per-cent in 199495; by 199697 it was 23 percentto 77 percent.

Capital Markets InstitutionsAnd Their Evolution

The Invest ment Regime

Before 1991, investmen t in the most importantareas of the economy was a public sector mo-nopoly, private investment was carefully di-rected, and foreign investment discouraged.


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5Even in areas that were not a public sectormonopoly, severe licensing restrictions regu-lated the amoun t of investment a private firmcould undertake. Capital markets were con-strained by five particular governmen t policies:

The government own ed and controlled al-most all of the banking system and pre-vented foreign and dom estic institutionsfrom entering it.

The insuran ce and pension fun d ind ustrywas government owned and had to investmost of its assets in low-yielding govern-men t securities.

Nearly all interest rates were set by the gov-ernment, and financial institutions weredirected on how they shou ld allocate someof their investments.

Banks had to meet high reserve require-ments, and th e fun ds w ere used to financethe governments fiscal deficitin effectpreemp ting p rivate investment.

Private capital markets were small and

needed government approval (includinggovernment determination of price andterms) on new cap ital issues.

Since 1991, there has been a substantial andsteady liberalization of the economy to increasethe role for m arket forces. Most interest rateshave been d eregulated. Foreign investment hasbeen permitted to enter both debt and equitymarkets. The private sector has been allowedto set up m utu al funds. Government control of

the pr ices of initial public offerings (IPOs) hasend ed. Finally, better regulation, enforced d is-closure, and investor protection have greatlyimproved the integrity of the private capitalmarket.

Although the chan ges in the last six years havebeen substantial, a large number of problemsremain. The banking system is still predomi-

nantly governm ent owned and inefficient. Gov-ernment crowding out of private investmentcontinues, including through (declining) re-serve requirements. Investment in some sec-tors, mostly agribusiness, is still controlled by

government , and about 800 products arereserved for production by small-scale enter-prises. Num erous regulations and adm inistra-tive burdens affecting capital are far fromtransparent and differ from state to state. Onbalance, however, there are few areas whereprivate investorsdomestic or foreigncan-not invest, and Indias foreign investment re-gime now compares favorably with severalEast Asian countr ies.

Capital Market Inst itutionsAnd Characteristics

The Bombay Stock Exchange, the oldest stockexchan ge in the coun try, was found ed in 1875.It is the leading exchange in the country, anduntil recently accounted for about 80 percentof all stock transactions. Twenty-two otherstock exchanges also operate in India, as thegovernment has restricted the geographicalreach of each of its exchan ges. There are some

7,000 listed stocks, 7,000 brokers who are mem-bers of the 23 exchanges, along with an esti-mated 100,000 subbrokers w ho interface w ithinvestors, a million active traders, and perhaps20 million citizens w ho hold equ ities in someform, usually a mu tual fun d.

Despite its long history and large number oflisted stocks, the equ ity market has had majorproblems. The exchanges operated with highcommissions, a lack of disclosure of actual

transaction prices, serious p aperw ork p rob-lems, and un reliable clearing and settlemen t.

The issue of new stocks was controlled by agovernmen t agency, the Comptroller of Capi-tal Issues. With a m ission to ensu re the qu alityof new IPOs, the CCI reviewed the financialsituation and prospects of the issuing company,and app roved the price at which the new issue


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6could be offered. Because of its conservativeapp roach, new issues frequently w ere sharplyunderpriced. This created great demand fornew issues. A refinery offering by the Birlagroup was oversubscribed 20-fold, and its price

rose quickly from 10 to 65 rupees per share af-ter the IPO. Another offering by the Tata grou pwas 80-fold oversubscribed. A lottery was usedin such cases, with th e lucky bidd ers winningthe right to buy shares that wou ld immed iatelyrise sharply in p rice.

A num ber of chan ges since 1993 have strength-ened the capital markets. One source charac-terizes the changes as moving the Indian eq-uity market from being am ongst the backward

of the w orld [as of mid -1993 or so] to one of themost mod ern in the world.* Four in particularhave been of critical imp ortance:

The Securities and Exchange Board of India.

Established in 1992, SEBI has a dual man dateof regulating capital markets and promotingtheir development . Since its creation , SEBI hassought to imp rove the structure and function-ing of stock exchanges and to ensure d isclosureand investor p rotection. It has grown rapidly

from an initial staff of 10 to a current level of150.

The N ational Stock Exchange. NSE was estab-lished in 1994 as a competitor to the BombayStock Exchange (BSE). NSE was backed bymajor financial institutions, led by the Indus-trial Developm ent Bank of Ind ia. The exchangeintroduced nationwide screen-based tradingwith a dish-to-satellite data transmission sys-tem that provides instant trad ing access to bro-

kers anyw here in India. It spent m ore than $100million developing its system, wh ich n ow hasinstantan eous access through m ore than 1,500

locations throu ghou t the country. NSE forcedBSE and other exchanges to adapt by u pgrad -ing to computerized systems and by reform-ing trading rules and procedures, which in-cluded increased surveillance over the capital

adequacy of brokers. BSE shifted from an openoutcry trading system to a screen-based sys-tem, making major investments in equ ipment,and revised its own procedures to providetransp arency for investors. As a result of thesereforms, total transactions costs on Ind ias eq-uity markets dropped from 5 percent in mid-1993 to rou ghly 2.5 percent in 1997. This is stillapp roximately double transactions costs on theNew York Stock Exchan ge, but p rocedu ralchanges in p rocess, such as the u se of a deposi-

tory where securities are held in dematerial-ized form, are expected to red uce transactionscosts further in the next several years.

Clearance, settlement, and the National Se-

curities Depository. In mid-1996 NSE beganguaranteeing execution of trades through a newclearing corporation. This removed a m ajor riskthat had always been present in the past andforced BSE to respond w ith improved clearanceprocedures. In late 1996, the N ational Secur i-

t ies Depository Limited was inaugurated.NSDL is gradually providing a m eans by whichsecurities trading will take place using elec-tronic means. An earlier prop osal for a d eposi-tory that wou ld hold p hysical shares had beenun der d evelopm ent for several years, but theIndian securities indu stry decided to forgo thecosts of storing physical shares and created adepository for dematerialized shares. Trad-ing takes place in both ph ysical and d emateri-alized shares, but SEBI now requires institu-

tions to trade on ly in the latter form.

Foreign institutional investors. Since 1993, for-eign institutional investors have begun to takean active interest in the Ind ian capital market.There are a total of 467 registered foreign insti-tutional investors, but most are small. About20 large foreign investors are present in the mar-ket today, including such firms as Merrill

*Ajay Shah and Susan Thom as. 1997. Securities Markets:

Tow ard s Grea ter Efficiency. InIndia Development Report

1997. New Delhi: Oxford University Press, 172. This

source is also responsible for many insights on the role

of capital markets expressed elsewhere in this paper.


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7Lynch, Jard ine Fleming, Pion eer, CS First Bos-ton, the Alliance Group , Lehm an Brothers, andHongkong Shanghai Bank. The number hasgrown grad ually, as the experience of the p io-neers convinced others that the Ind ian market

provided an opportunity for placing capitalwith prospects for profitable investment. Theforeign investors have demanded changes inpractices by companies and both stock ex-changes, in the direction of greater transpar-ency and disclosure of the financial situationof companies.

The process of open ing the Indian capital mar-ket has been un even. Abolition of the Com p-troller of Capital Issues in 1991 (with residual

responsibility for oversight of new issues givento the Securities and Exchange Board) led tolarge numbers of initial public offerings in199294. The nu mber of public companies rosedramatically from 1,000 in the late 1980s to6,000 by 1994. The h istorical exper ience of in-vestors, whereby an IPO was an almost au to-matic winner, created an acceptance in th e mar-ketp lace for any new issue. The liberalizationof the economy led to revaluation of stockprices, and investor enthusiasm produced a

speculative bu bble during 199294. Stock pr iceswere bid up, and prices of many new issuesrose to levels simp ly un justified by future earn -ings prospects. Some highly questionable, oroutright fraudulent, financial deals were soldto an unsuspecting public. Compounding thoseproblems was a s tock market system thatlacked an ad equate trading, processing, settle-ment, paymen t, and registration infrastructure.The result was a m ajor stock market crash thatthoroughly spooked retail investors. At the end

of 1997, stock m arket indices were still substan-tially below the peak of September 1994. Of the6,000 listed companies, only about 1,000 hadsufficient trad ing to justify the claim that a liq-uid market existed. Five hundred companiesprovided abou t two thirds of total market capi-talization of $170 billion.

Remaining Problems

In sum, major changes have been institutedsince 1993: Surveillance and monitoring sys-tems have been introduced at major stock ex-

changes. Capital adequacy rules for brokershave been strengthened and enforced. A na-tional securities depository has been set up.Trad e settlemen t and clearance has greatly im-proved . And the establishm ent of a true com-petitor to the Bombay Stock Exchange hassharply reduced transactions costs and im-proved the efficiency of the trad ing p rocess.

While the capital market reforms are impres-sive, there are still areas that present major

problems. The market has still not recoveredfrom its skittishness abou t IPOs. The debt m ar-ket presents the biggest problems. While thereis an active debt market, the longest matu ritiesare less than seven years. Consequ ently, manylarge Ind ian companies look to foreign capitalmarkets for longer term debt and equity. Onthe d omestic debt side the lack of a debt yieldcurve, and a stamp tax on debt transactions,have p revented a second ary-debt market fromdeveloping. Finally, the fact that pension fund s

and banks cannot invest freely in private sec-tor debt or equity eliminates major demandfrom the m arket.

Indian capital market institutions are still notcomp letely u p to world stand ards. Settlementof stock transactions takes p lace five d ays afteragreement, while the international stand ard isfor settlement by the third day. The use of asecur i t ies deposi tory has not been ful lyadop ted. The regulators have also held back the

creation of specialized p rodu cts, such as indexfutu res and other d erivatives, that can add li-quidity to the market.


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8USAID PROJECTSAND THEIR RESULTS

USAID/ Ind ia has implemented three projects inthe last dozen years relating to capital markets.

The third of these is still under way, and wasthe subject of most of the Evaluation Teamswork. This section d escribes that project, alongwith the two previous projects and the avail-able information on th eir direct results.

The PACT Project

The Program for Acceleration of CommercialTechnology, or PACT, was develop ed in 1985.*

USAID

made a $10 million grant for commer-cialization of technology by business firms. Theproject was m anaged by the largest Indian in-vestment bank, the Industrial Credit Invest-ment Corp oration of Ind ia (ICICI).

PACT promoted two ideas: external fun ding forR&D by ventu re capitalists or others, and jointdevelopment between Indian and U.S. comp a-nies. Though the project had n o direct relation-ship w ith ven ture capital, it was used as an ar-

gument for liberalizing government policy toperm it development of a venture capital ind us-try.

The project mad e cond itional grants to fun d u pto half the cost (to a maximum of $500,000 aproject) of R&D projects that were jointly car-ried out by U.S. and Indian companies. Thefunding would remain as a grant if no com-mercial prod uct resulted, but u p to 200 percent(later raised to 250 percent) of the cost wou ld

be repaid as royalties from sales of the com-mercial prod uct that resulted.

Though PACT was only a small part of ICICIsoperations (the institution had borrowed morethan $1 billion from the World Bank), the p rojectwas strongly p romoted by ICICIs chairman . Italso acqu ired substantial visibility in the Indian

government, being seen as a manifestation ofU.S. support for thenPrime Minister RajivGand his push for developmen t of Indian tech-nology. A separate PACT unit was establishedin ICICI to implement the p roject.

At a p olicy level, the ICICI chairman used theenthusiasm surrounding PACT to argue thatcommercialization of new technologies re-quired the establishment of a domestic ventu recapital ind ustry. Ventu re capitalists sometimes

finan ce high-technology comp anies during theearly stages of their growth, usually in ex-change for a share of the companys equityownership. Ventu re capital had in effect beenprohibited in India by a requirement that salesof equity in businesses be preceded by govern-ment ap proval of public trading an d establish-men t of the p rice of the initial pu blic offering.

The PACT project financed a total of 50 jointR&D projects. Of these, 35 led to a commercial

use of a new technologymostly products in-trodu ced into the U.S. market. The project sup -ported expansion of a nu mber of high-technol-ogy comp anies, some of them great successes.For example, a new m ushroom-growing tech-nology generated substantial new exports,wh ich h ave risen from zero to $6 million a year.

Despite its prom otion of new technology, PACTwas not a commercial success. It did not recoverits costs through royalty paym ents. Contribu t-

ing to this were a variety of problems, includ -ing difficulty in defining the specific producton which royalties were to be paid. More im-portant, the prohibition on the use ofUSAIDfund s to acquire equity preven ted PACT frombenefiting from success. One company, ERASoftware, had offered stock for its PACT gran tthat would have yielded a $20 million profithad PACT been able to accept it.

*This project is described m ore fully in a p revious CDIE

study: James W. Fox.Export Promotion and Investment in

India. 1993. Technical Report N o. 16. Washington : USAID.


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9Nevertheless, some capital markets p rofession-als (includ ing the then-chairm an of ICICI) heldthat the p rograms main contribution lay in theimpetus i t gave the Indian government tomodify its policies on ventu re capital. In 1988

the Indian government altered regulations topermit the establishment of venture capitalfirms that could acquire equity stock in com-pan ies without the need for prior governmen tapproval and price setting. This led to the es-tablishm ent of at least a dozen ventu re capitalfirms. By the end of 1993, ventu re fund s estab-lished u nd er the 1988 regulations had investedmore than $120 million in financing for 428compan ies, most of them startup operations.

Housing Guaranty Programs

USAID has supported four housing guarantyloans in Ind ia. The first three were intended topromote the provision of hou sing loan finan ceto lower income hou seholds. The fourth, to p ro-mote finan cing of municipal infrastructure, ispart of the Financial Institutions Reform andExpansion (FIRE) project, and is discussedseparately later.

Under the Housing Guaranty Program, USAIDguarantees repaymen t to U.S. savings and loaninstitutions of long-term (usually 30-year) loansmade for qualifying purposes. The U.S. gov-ernmen t gu arantee thu s allows comm ercial fi-nancing at lower interest rates and for longermatu rities than wou ld otherw ise be possible.The Agency initially promoted constru ction ofmoderate-income housing through the Hous-ing Guaranty Program, but it has gradually

widened its scope to include policy reform andinstitution building. In Ind ia, the emp hasis hasbeen on institution bu ilding, p roviding long-term financing to new Ind ian institutions in thehou sing finance business.

The first Hou sing Gu aranty Program began in1982, providing long-term m oney th rough theHousing Development Finance Corporation.

HDFC was then a fledgling mortgage lenderestablished by th e Indu strial Developm entBank of India, the International Finance Cor-poration, and the Aga Khan Foundation. Itoperated as a private company. However, as

with the Indu strial Development Bank and theIndustrial Credit Investment Corporation, itsultimate owner was the Ind ian governmen t. In-clud ing a second Hou sing Guaran ty Program,USAIDsupport to HDFC totaled $125 millionin loan guaran tees.

The third Hou sing Guaran ty Program m ovedbeyond HDFC to another new institution, theNa tional Hou sing Bank. Created in 1987, NHBacts as both a secondary-mortgage bank and

as a regulator. It does this by on-lending tohousing finance compan ies that comp ly withbank guidelines.

For both inst i tut ionsthe HDFC and theNH B sup ported by USAID, the assistance wasprovided early on to a new institution. Bothsubsequently became imp ortant features of thehousing finance landscape in Ind ia.

HDFC holds one half of all hom e mortgages in

India. The USAIDhousing guaranty was the firstexternal financing received by HDFC, and thefirst head of HDFC credits the USAIDHousingGuaranty Program as an important catalyst thathelped the finance corporation get started.

Through the N ational Hou sing Bank, the Hou s-ing Guaranty Program supported on-lendingto 23 organizations involved in hou sing creditoperations, suppor ting a total of $142 millionin credits to lower-income h ouseholds d uring

the p eriod 199295. Altogether, the n umber ofhousing finance comp anies has grown to m orethan 200, providing over $100 million each yearin mortgage loans to Indian families. Despitethese results, the N ational Housing Bank itselfhas not prosp ered. It suffered major losses in afinancial scandal in 1992, and its future hasbecome questionable.


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10Both institutions provided steps toward the cre-ation of a long-term m ortgage market. Never-theless, both operated under the constraintspresented by the Indian policy environment a tthe time the Housing Guaranty Programs w ere

undertaken. The institutions supported werein the public sector. The interest rates offeredby the institutions were controlled by govern-ment regulation, and a variety of proceduraland legal impediments to the creation of a realsecondary-mortgage market existed, and con-tinue to exist. Limitations on the ability to fore-close on mortgages still restrict the value ofmortgage finan cing. The HDFC seems to havead apted better to the liberalization of financialmarkets that has taken place over the past five

years.

The FIRE Project

Indias 1992 reform program included a com-mitment to liberalize its financial markets, toend the domination by public sector institu-tions, and to end government control of finan-cial variables such as interest ra tes. The USAIDFinancial Institutions Reform and Expansion

(FIRE) project w as d esigned in 1994 to sup por tthis liberalization by prov iding technical assis-tance and training. The stated strategic objec-tive of the p roject is to reform the finan cial sec-tor in order to increase the mobilization of capi-tal.

Implementation of the program has been di-vided into two p arts, each w ith a separate con-tractor managing activities: FIRE/ R, for regu-latory, which covers government regulation and

the stock market; and FIRE/ D, for debt, wh ichcovers the d ebt market.

The FIRE/Regulatory Component

This component sought to improve securitiesmarket transparency, modernize systems topromote th e efficiency of the capital markets,

reduce the existing high levels of risk arisingfrom system inadequ acies, improve the p rotec-tion of investors, and increase the liquidity inthe equity and d ebt markets.

FIRE/ R has been managed under contract byPrice Waterh ouse since February 1995. The con-tractor prepares annu al work p lans for specificactivities to be u nd ertaken, in conjun ction w iththe Indian governm ent regulatory body, the Se-curities and Exchange Board. USAID reviewsand app roves the annual work plan. The projecthas a resident chief of party in Mumbai. Indi-vidual consultants and specialists are broughtto India as needed for specific pu rposes pu r-suant to task orders. To date, there have been

more than 30 task orders.

Price Waterhouse began by examining the gen-eral level of sophistication of the market par-ticipants through a survey of 127 peop le work-ing in Indian financial institu tionsSEBI, bro-kerages, other market intermediaries, the stockexchanges, financial training institutions, a pro-posed securities depository, and the CreditRating Information Services of Ind ia. With thestated strategic objective of reforming the finan-

cial sector in order to increase the m obilizationof capital, the Price Waterhouse component hasaddressed financial market efficiency by con-centrating on seven areas: 1)

reducing invest-

ment risk by shortening clearing and settlementtime for secondary trades in both stocks andbond s; 2) transforming the stock exchan ges andassociations of various securities markets in-termediaries into self-regulatory organizations;3) developing a functioning secondary-debtmarket in Ind ia; 4) improving the effectiveness

of the regu lation of Indias securities markets,with the long-term objective of reaching inter-national standards; 5)

developing risk m anage-

ment and increasing liquidity; 6) helping thedevelopment of Indias mutu al fun d ind ustryin order to broad en Ind ias retail investor baseand mobilize additional resources through thestock and bond markets; and 7) institutionaliz-ing capital market training and research.


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11The FIRE project has made a significant anddemonstrable impact on the development ofIndias finan cial markets. In a ll but one of theareas for action identified earlier, substantialimprovemen t has taken place in th e financial

market. The d ebt market is the one area whereFIRE did not achieve the intended results. Gov-ernment policy and the legal regime st i l lpresent a major obstacle to the d evelopm ent ofa second ary market that p rovides both liquid -ity and price discovery. In each other area,Agency assistance was intimately involvedwith the p rocess. It is not possible to separateout the contribution of the USAIDproject. Themost important steps in the improvement inthe capital marketscreation of the Securities

and Exchange Board and the National StockExchangewere done prior to the USAIDproject. Nevertheless, the p roject did p lay a keyrole in strengthen ing SEBI. It provided analyti-cal studies for the N ational Stock Exchange andplayed an important p art in the creation of thedepository. FIRE has also helped other ex-changes think through their evolution in therapidly changing environment.

Evidence of the FIRE projects effectiveness in-

cludes the following:

Following substantial training and techni-cal assistance in d rafting regulations, SEBIhas been established as an effective, cred-ible regulatory agency.

Specific institutions are in place and do-ing what is expected of them. They are p ro-ducing the desired results in the marketand for the economy through clearing an d

settlement, depository, better stock ex-changes, better supervised market partici-pants.

The concept of self-regulation has begunto take root in Ind iaa major cultural shift.

Government agencies and private institu-tions have looked to the FIRE project ford isinterested assistance. Both sectors h avegiven great weight to the ad vice providedby th e FIRE project director an d consult-

ants. Daily newspapers report develop-ments in the capital markets that are di-rectly related to the FIRE project.

There is evidence that the equity markets arebecoming a more significant element of Ind iasfinancial system. In 1996, 55 percent of the fi-nancial systems assets were intermediatedthrough the capital markets and 45 percentthrou gh banks. In contrast, in 1990, the valueof bank-intermediated assets was three times

that intermediated through equity markets.This is not to suggest that the FIRE project iscausally responsible for th is developm ent. Butit does suggest that the FIRE project was atimely activity, und ertaken w hen it could sup-port and reinforce other activities und er w ayto strengthen Ind ias equity markets.

The FIRE/Debt Component

The projects debt comp onent seeks to dem on-strate the comm ercial viability of selected ur-ban infrastructure projects. The FIRE/ D com-ponent will develop a mechanism to channelpr ivate capital into the finan cing of mu nicipalinfrastru cture projects. Further, the p roject willwork w ith local governm ents to ensure that themunicipal infrastructure investments servehouseholds below the med ian income level.

The government of India estimates its infra-

structure financing requ irements at $300 billionover the next decade. Traditional financingsources, tax revenues, and borrowings frominternational d evelopm ent ban ks w ill be ableto raise only a fraction of that.


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12Traditionally, Indian cities have relied on cen-tral government gran ts and expertise to fun dand design municipal infrastructure projects.Infrastructure investments did not have to passa m arket test. Private capital, by contrast, will

not flow into the financing of infrastructureunless the projects are commercially viablethat is, unless the p rojects generate a cash flowsufficient to repay the borrowed funds and theaccrued interest. The approach taken for theproject assumes that commercially viableprojects can attract fun ding via the issuance ofmu nicipal bond s.

The ability of the p roject to introdu ce these twoinnovationscommercially viable municipal

projects and the issuance of mu nicipal bond sinto India will determine the success of theproject. Of the two, the former has been thepreoccupation of the project implementers todate. Six cities have been selected as pilot sitesin which the p roject attemp ts to systematize theproject cycle: planning, cost and budgetinganalysis, environmental assessment, monitor-ing. By insisting th at projects be comm erciallyviable, the project encourages city officials tothink about cost recovery, service levels, and

operating efficiency. Before issu ing a bond , themunicipalities are examined by credit ratingagencies. (The project provided technical ad-visers to an Indian credit rating agency.) Theprospect of a low grade or a subsequent d own-grade in its rating is expected to p ut ad ditionalpressure on city officials to manage revenuesand assets wisely.

This componen t is a capital market d evelop-ment project by the fact that it adds a new fi-

nancial instrument (municipal bonds) to thedebt market. The project is not attempting toalter the regulatory framew ork or the structureof the debt market. It is perh aps accurate to sayFIRE/ D is a mun icipal water and sewageproject with an innovative finan cing tacticthemu nicipal bond s. Success in dem onstrating theviability of this approach might encourage ad-ditional municipalities to seek this type of fi-

nancing, catalyze changes in the regulatoryframew ork, and add new d ebt vehicles.

It will be several years before the value of thisact ivi ty can be judged. The f i r s t ci ty,

Ahmedabad , issued a bond sup ported by theproject in December 1997, and USAIDis work-ing w ith six other localities to develop d emon -stration bon d issues. A project in anoth er city,Tirup pu r, has a strong local private-sector par-ticipation elemen t.

The reaction of relevant Indian organizationsis encouraging. The Infrastructure Leasing andFinancial Services Corporat ion, a project coun-terpart, has set up an engineering unit to pu r-

sue opportunities in infrastructure designwork, including the type of investments fi-nan ced u nd er FIRE. Two organ izations are ex-pand ing to offer adv isory services in p roject fi-nan cing. All three credit rating agen cies are in-terested in mu nicipal work.

Indian cities are taking n ote of bond issues as apoten tial source of investmen t finan cing. Thefirst step toward debt finance of municipalprojects is to have a credit rating, which may

be a leading ind icator of anticipated urban in-frastructure projects. Ahmedabad MunicipalCorporation last year received its ratingthefirst municipa lity in Asia so credited . Since then25 other Ind ian cities have been rated . One cansay that, at a minimum, the idea of bond-fi-nanced municipal investment has attracted agreat deal of interest in Ind ia.

Whether the p roject will induce substantial ac-tivity will depend up on the extent to which it

leads to changes in the structure of the Ind iandebt market. This will require major policychanges in several areas. First, the p roblem ofgovernmen t crowd ing-out in the bond marketmust be addressed and market-based pricingfor debt perm itted to emerge. Second, the ma-jor legal obstacles to protection of investors inthe case of defau lt by mu nicipa lities need to beaddressed. Third , tariff structures for munici-


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13pal services such as water and sewerage thatpermit servicing of debt through fees need tobe established and institutionalized. These aremajor tasks.

ECONOMIC EFFECTS OFUSAIDSCAPITAL MARKETSSTRATEGY

There are two channel sthrough which USAID assis-tance could have affected sav-ings and investment in India.

I t could have af fected thequantity of savings or invest-men t , t he r eby p r oduc i ngoverall effects on the amou ntof resources flowing throughfinan cial markets into invest-ment by the society. Second , itcould affect the quality of ei-ther savings or investment,thereby changing the impactthat results from given levels

of savings and investment.These issues are d iscussed inturn.

Quantitative Aspects

Developm ent of capital markets can lead to in-creased national savings. Because there areeasier ways to save, or higher returns to sav-ings, individuals may choose to save more.

This, however, ignores the basic behavioralconsideration that savings is not an end in it-self, but rather a m eans to finan cial security. Ahigher return on savings may eventually en-able peop le to achieve their security goals withlower levels of new savings. Greater securityof savings similarly may reduce the need forhigh am oun ts to be put aside. Economic stud -

ies shed little light on th is question, and thereis nothing in the Indian context that suggestsexperience there is unusual. In sum, there is noreason to expect that better financial marketswill increase the level of national savings.

Things are different with resp ect to foreign sav-ings. The amount of world savings that will

f low in to India dependsgreatly on conditions in thecountry. If expectations ofr i sk-adjus ted returns arehigher in other countries,savers will bypass Ind ia andplace thei r savings else-where.

The effect of improvementsin Ind ias capital m arketson fore ign savings andthe more sound policy envi-ronment is unambiguouslypositive. Policy changes in1991 and improvements inthe transparency of Indiancapital markets have led toa substantial increase in in-

f lows of pr ivate capi tal .Compared with 1990, wh ensuch f lows were meager,

substantial amou nts of foreign capital haveflowed into India in recent years. Roughly $4billion is flowing into the country each year,equally divided between direct investment andpor tfolio investment.

The USAIDassistance, of course, was not respon-sible for the bu lk of these inflows. They w ould

have h app ened anyw ay. Nevertheless, capitalmarkets professionals interviewed w ere virtu-ally unanimou s in stating that the USAIDprojecthas contributed to improving the climate forforeign capital inflows. Most talked of theproject add ing to their comfort level, and oneattributed a substantial portion of the capitalinflows to the USAIDrole.

Policy changes in1991 and improvementsin the transparency ofIndian capital markets

have led to . . .[r]oughly $4 billion . . .

flowing into the countryeach year, equally

divided between directinvestment and

portfolio investment.


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14The inflow of foreign savings means that do-mestic capital formation w ill be larger, in bothprivate and pu blic sectors. If improvements indebt markets continue (and governm ent policyimproves), foreign finan cing of infrastructure

will likely increase su bstan tially.

These capital inflows are of value to India inincreasing the national investment rate, but theopening of the Ind ian market also benefits sav-ers in the coun tries from which the investmentcomes. That is because, according to currentfinan cial theory, an internationally d iversifiedportfolio will reduce risk.

Qualitative Aspects

The qualitative aspects of improvements in thecapital market are likely to be far larger thanthe qu antitative ones. The reasons for this arediscussed in some detail in the next section.

The primary contribution of capital markets inthis area is in p roviding a continu ous and in-stantan eous assessment of the value of cap italin specific uses. This valu ation role of the capi-

tal marketsits price discovery rolepro-vides a means for signaling what is valuableand wh at is not. It provides a signal to banksand other lenders of the value of each listedfirm th at reflects the available knowledge in themarketplace.

The capital markets are likely to be particularlyimportant in reforming Indias banking system.As the banking sector is liberalized and re-formed, banks will face some serious tests.

Strengthened capital adequacy norms will forcebanks to go to the equity market to recapital-ize themselves. Disclosure requirements areforcing banks to report and to write downnonp erforming loans and to mark other assetsto market value. That will require substantialimprovements in management by the banks,and only those that can meet the test will beable to add capital so they can grow.

What Difference Did USAID Make?

Capital markets are a quintessential privatesector activity. Efficiency in cap ital markets in-volves having capital move to the highest pay-

off activities and having savers receive the high-est (risk-ad justed) returns. There is a mon etaryincentive for efficiency, so what is the role forgovernment?

One answer is that the case for unregulatedmarkets is based on assumptions that all ac-tors have the same information base. In finan-cial markets, this is often not the case. Whateconom ists call information asymm etries arerampant, and either the buyer or seller may

have better information abou t the value of theasset being traded. In developed economies,government regulation h as sought to redu ce oreliminate such problems in two ways. First,companies are required to subject themselvesto external auditing, to provide systematic fi-nancial information about the companys op-erations. Company principals can be held li-able for losses to investors caused by negligenceor fraud in such reporting. Second, trading instock by compan y insiders is prohibited du r-

ing periods w hen imp ortant information aboutthe comp anys prospects has not been d isclosedpublicly.

Such ru les of the game m ay not emerge natu -rally from th e operation of market forces. Theeconomy, and investors generally, may benefitfrom prohibitions on insider trad ing, but thosemost active in financial markets m ay lose. Theself-interest of brokers may suggest that vague-ness about the prices at which equities actu-

ally trade is beneficial to them, although it hasan overa ll negative effect on the developmen tof the capital market.

The expertise provided und er the USAIDprojectis available in the international marketplace.The Ind ian government or private groups couldhave contracted for the techn ical experts made


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15available under the project. The activitiesclearly benefited the Ind ian capital market andthe Indian economy. Why did USAIDneed toget involved? Where was the USAID valueadded?

A strong consensus existed amon g capital mar-kets professionals interviewed in this assess-ment that the USAID contributions w ere timeand disinterestedness. The p resence of the USAIDadvisers in Mumbai, with an extensive inter-national network of contacts and a fundingmechanism, meant that expertise on a varietyof technical, legal, and regulatory issues waseasily accessible.

Any technical or regulatory action in capitalmarkets will not affect all actors in the sameway. Some will be advantaged or disadvan-taged relative to others by any chan ge. Conse-quently, each participan t in the market has anincentive to promote those changes that givehim relative advantage and to oppose thosethat give him relative disadvantage. Thus, ex-perts hired by participants in capital marketsmay not be accepted at face value. The suspi-cions that result lead to resistance to change and

extensive negotiations over the specifics ofchanges. But the USAID-financed experts werewidely viewed as disinterested, providingjud gments on technical issues without consid-ering (or u sually even know ing) how th eir rec-omm endations would affect particular marketparticipan ts. In sum, USAID was able to playthe role of honest broker in the Indian equitiesmarkets. This was widely recognized.

The effect of the project, then, w as threefold: 1)

to speed up the process of applying interna-tional expertise to technical problems in thedevelopment of the Indian capital market, 2)to provide ad vice that was w idely regarded asobjective, and consequ ently 3) to speed up theprocess of identifying and adopting technicalimprovemen ts in the operation of Indian capi-tal markets.

How mu ch is speed worth? Market profession-als concede that the USAIDexperts had no spe-cial know ledge. Without their involvement, thecorrect app roach w ould eventually have beenadopted. Governments do learn, and Indian

leaders were gradually absorbing lessons fromthe rapid growth of East Asian economies.Nevertheless, the essential mechanism thatmakes rapid economic growth possible is fasterinstitutional change. If Ind ia grows at 4 percenta year, it w ill eventu ally reach th e current U.S.per capita income. Ifbecause such chan ge isfaster, allowing more investment nowitgrows at 6 percent a year, it will arrive at theU.S. per capita income generations faster.

The Asian Crisis

And Capital Markets Development

The recent financial crisis in many Asian mar-kets has raised the question of whether encour-aging capital inflows from abroad is a desir-able policy. Recent events suggest that herdbehavior by foreign investors may create sub-stantial instability in financial markets, withstock prices crashing and foreign exchange

rates tumbling as foreign investors try to exitthe country ahead of everyone else.

Although contagion seems to have hap penedto some extentAsian markets without severeproblems still experienced speculative at-tacksthe long-term consequ ences seem likelyto be limited to countries wh ere financial mar-kets had serious u nd isclosed p roblems. In themost seriously affected countries (Indonesia,Korea, Thailand), serious financial problems

that were previously und isclosed have been themajor factor. The two problems of note havebeen financial statements by businesses thatoverstated earnings and hid losses and ban ks

that have such largeamou nts of nonp erformingloans that they undermine their f inancialstrength. In both cases, greater transfer of theregulatory and accounting standard s from the


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16United States would have reduced or mini-mized these problems. Use of internationallyaccepted accoun ting stand ards w ould haveexposed problems of companies before theyfestered. In the banking sector, strengthening

of oversight by the government regulatorsnotably requiring d isclosure of nonperformingassets and requ iring that assets be continuallyrevalued to reflect market prices rather thanhistorical costwould have introd uced the re-alism into financial statements that would haveavoided large-scale unpleasant surprises.

The USAID project has promoted greater dis-closure and transparency in the securities in-du stry and an end to insider activities that un -

derm ine investor confidence in the long run .The Asian financial crisis of 199798 demon-strated the risks faced by companies that re-lied h eavily on debt finan ce, and the u tility ofstock market developmen t, both as a m eans ofraising capital and of providing assurance toinvestors by requiring disclosure of financialconditions. These were precisely the kind ofreforms prom oted by USAID.

CAPITAL MARKETSAND POVERTY REDUCTIONIN INDIA

In broad terms, USAIDsought to improve theefficiency of Ind ian cap ital markets, or of thelarger Ind ian finan cial system. Increased effi-ciency in the financial sector in tu rn is expectedto direct financial resources into the sectorswhere their prod uctivity is highest. This in tu rn

is expected to increase the rate of economicgrowth. Faster economic growth is then ex-pected to red uce poverty. The link between in-creases in income and redu ctions in poverty isempirically strongly established over the me-dium an d long term. (For shorter periods, thetwo can move in op posite directions becauseof a variety of factors. But extreme povertytheWorld Bank defines it as $1 a day per person

prevails only in coun tries wh ere average incomesare low.)

Batchelder an d Holt* have drawn u pon the his-torical experience of developing countries on

the relationship betw een economic growth andpoverty to make p rojections for India and oth ercountries of future poverty levels. They pro-vide two scenarios for India. Under the poorpolicy scenario, where government restric-tions prevent free markets from operating incapital markets and foreign trade, growthwould average 1.2 percent per capita a year,while it would average 5 percent per capitaun der market-based policies. The d ifference inpoverty between the two scenarios is stark.

With p oor policies, the num ber of poor (thosewith per capita incomes below $1 a day) in-creases slightly, from 473 million to 476 million,thou gh their share in the pop ulation falls from51 percent to 37 percent. With the faster grow thresulting from market-based policies, the num-ber of poor falls from 473 million to 174 mil-lion, or from 51 percent of the pop ulation to 14percent. (This decline is roughly in line withwhat occurred in Indonesia over the last 25years.)

Batchelder and Holts scenarios overstate thedifference in India. Its policies have moved asubstantial distance over the past five yearstoward free markets for goods and finance, andrecent economic growth rates have reflectedthose better policies. Nevertheless, the basicpoint is shown by experience. Countries withbetter policies have substantially faster rates ofpoverty redu ction. This model, of course, doesnot separate imp rovements in capital markets

from other policy changes. Improvements incapital markets alone would be expected toprovide some fraction of the impetus to growthfound by Batchelder and Holt.

*Alan Batchelder and Tyler Holt. 1997. 2020 Visions:

Creating Tigers, Cutting Poverty, and Increasing Trade,

19952020. USAID Economists Working Paper No. 6.Washington.


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17This empirical link between market-orientedpolicies and growth is important in the p resentcontext because the link between USAIDcapi-tal markets projects and poverty reduction isneither direct nor immediate. At present, the

firms that raise capital because of improve-men ts in the structure of the capital market w illnot m ake major increases in emp loyment as aresult. Nor will the Indian stock market pro-vide a means for the great bulk of small andmed ium enterprises in Ind ia to gain capital forexpansion. Imp rovement in the structure of theequ ity market will directly affect perhap s sev-eral thousand firms, not the millions of smallerenterp rises that constitute the mass of businessenterprises. (Large firms do dom inate output:

in Ind ia, the 3,000 largest firms accoun t for halfof all manu facturing value ad ded .) Small firmswill, as elsewhere, need to rely primarily oninternally generated savings, funds from fam-ily an d associates, and borrowing from banksfor their capital needs. Despite these limita-tions, work in capital markets app ears to be acritical element in the rapid reduction in pov-erty in India in the longer term. The reasonsfor this lie in p ast Ind ian p olicies.

The role of capital markets in Indian develop-ment cannot be un derstood w ithou t a theory.The prevailing view among economists is thatIndia is much p oorer than it should be in v iewof its resources. Ind ias savings r ate has alwaysbeen high, and has grown over the past sev-eral decades. The basic education system isweak, but its coverage has increased over time,and literacy has been increasing. Its higher edu -cation system is good, and the country has asubstantial number of engineers and techni-

cians. (Unfortun ately, Indian expertise is morehighly rewarded abroad than at home, and thecountry has had a continuing brain drain ofskilled people. Major newspapers in India in-clude large nu mbers of advertisements for for-eign jobs.) Thus, the basic challenge in Ind ia isefficiencyto permit more to be produced withavailable resources.

Since independence, the Indian governmenthas given central imp ortance to investment andto capital. With the institution of economicplanning in Ind ia shortly after indep endence,the government took control of allocation of in-

vestment in both the public and private sec-tors. The five-year plans set targets for each,by sector of the economy. The basic idea wasthat capital was the key constraint in the In-dian economy. To move from its present pov-erty to its rightful place as an ind ustrial coun-try, it was essential tha t all cap ital be allocatedcarefu lly to avoid w aste. Allowing the p rivatesector to invest whatever it wanted and inwh atever form it wan ted w as though t likely tolead to waste of investment capital. Without

central planning, firms in some industrieswould be likely to build too much capacity,wh ile firms in others would build too little. Theexcess capacity by the overinvesting firmswou ld slow growth because capital would havebeen usefu lly emp loyed elsewhere. The short-ages in ou tpu t from the latter firms w ould cre-ate bottlenecks in the economy. This wouldprevent firms in other sectors from achievingmaximum output, thus also slowing overallgrowth. The key in th is view w as to have bal-

anced growth, with governm ent setting clearparameters so that firms in all industries knewhow much capacity to add. Since the entireeconomy would move forward in lock step,booms or d epressionsor excess capacity andshortageswou ld all be avoided.

Further, the government believed that econo-mies of scale were essential in heavy ind ustry.

Private sector operation was likely to lead tocompetition among firms that were less than

optimum size. For maximum efficiency forheavy ind ustry, there should be only one firmable to achieve these economies and prod uceat minimum cost. Here again, capital is usedmost efficiently and waste is avoided . Since aprivate monopoly in such an industry wouldgouge consumers, such comman ding heightsof the economy shou ld be government owned.


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18In other sectors, private activity would be al-lowed, but the tendency for business firms tobuild excess capacity and to engage in destru c-tive comp etition w ould be limited by govern-ment controls on new investment. Firms wou ld

not be allowed to expand their factories un lessthey could show that the investment wasneeded to meet demand .

In sum, the Indian planning model was cen-tered on concern abou t using cap ital efficiently.In 1950, the theory had considerable p lausibil-ity. The West had recovered from a lengthy de-pression only through the onset of world war,and the Soviet Union app eared to have mad e agreat leap forward into indus t r ial izat ion

through central planning.

This theory had two central assumptions thatproved fallacious in practice. First, it was as-sumed that efficient prod uction resulted m oreor less au tomatically from modern, technocraticmanagem ent of industrial concerns. Getting themaximum p roduction from a set of machineswas a straightforward engineering problem. Thekey problem for economic growth w as to en-sure that all factories had the p roper amou nt

of capital so that the entire productive struc-ture could move forward together. Second, thetypes of goods to be p rodu ced were conceivedof in simplistic termstons of steel, num bersof automobiles, pairs of shoesimplicitly as-suming that each indu stry produ ced h omog-enous products for which the needs of theeconomy could be measured quan titatively.

The experience since 1950 demonstrates thatmodern economies are not like that. For the

needs of steel-using industry, the problem isnot simply the num ber of tons of steel produ cedbut the number of tons of steel of particularspecifications ava ilable in a particular place ata par ticu lar time. Planning processes are pow -erless to deal effectively with the qualitative,locational, and temp oral dimensions. Only theflexibility of a market system, where the pro-ducer is reward ed for meeting these constraints

by the p rospect of profit, and p un ished for fail-ing to do so by the prospect of loss (and bank-ruptcy), has p roven capable of this. The prob-lem of specifications is compoun ded w ith con-sum er goods. If all consum ers preferred size 9

brown penn y loafers, the p roblem of predict-ing and meeting consumer demand for shoeswould be relatively straightforward. But con-sumer preferences vary widely and changeover time.

The second factor, closely related to the first, istechnological advancement. Improvement intechnology in both m anu factur ing processes inthe world and in design of consumer goods hasbeen rap id. Consequen tly, the idea of a know -

able and fixed capacity for prod uction for eachfactory disappears. To remain efficient, man-agers in each factory have to continua lly revisetheir production methods, adding machineryand techniques in line w ith evolving technol-ogy. They need to change the product in linewith changing d esigns and new materials. Insum, they must continually make new deci-sions about what to produ ce and how to p ro-duce it. Once the immensity of these problemsbecomes clear, it becomes evident tha t central

planning is simp ly not capable of meeting theneeds of a modern economy.

To cite a specific example, India began prod uc-ing automobiles under the planning approach,importing the technology and equipm ent nec-essary to bu ild a m odel close to the 1954 Mor-ris Minor. For three decades, production con-tinued of essentially the same vehicle withminimal design and production changes. By the1980s, India was probably producing 1954

Morris Minors rather efficiently. However, rela-tively frozen technology made possible byIndias isolation from the world economy andthe absence of domestic competition m eant thatthe Indian automobile was technologically ob-solescent. No one with access to the alterna-tives available in the world marketplace wou ldwan t one. Other coun tries had found ways toproduce better automobiles at lower cost. As


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19with the Soviet bloc wh en those markets wereopened (where it was d ifficult to find any firmthat was producing goods salable on worldmarkets, even at very low p rices), it has becomeclear that the forces of competition are critical

to the efficiency of industry in the long run .

What Joseph Schumpeter called creative de-struction is at the core of modern marketeconomies. Firms and entire industries that donot m aintain comp etitiveness in the long ru nby adapting new technologies are s implypushed aside. Firms go bankrupt, or are ac-quired by others, in order to reorganize peopleand capital equipm ent into arrangements thatcan produce efficiently what is wanted by so-

ciety.

Looking around Ind ia, it is clear that mu ch capi-tal is wasted or misallocated. Because of theuncertainty of electric power, business firmshave their own generators. Dozens of shipswait in the port of Mumbai for their turn tounload or load . Bun galows for offices and resi-dences of governm ent officials, relics of a qui-eter day, sit in the shad ow of Mumbai skyscrap-ers on some of the most valuable land in India.

More broadly, the am oun t of economic growththat has occurred in India has not been com-mensu rate with the am oun t of capital invest-ment that has been taking place. To achievefaster economic growth, and faster reductionin poverty, capital needs to be used m ore effi-ciently.

This greater efficiency of capital use is the keyto converting Mum bai into an Amsterdam or aSingap ore. To achieve faster econom ic growth ,

the capital market mu st provide continuous re-valuation of the worth of the econom ys capi-tal assets through the prices they comm and inthe marketplace. This continuous revaluationmakes three important contributions to growth.First, it signals to other providers of capital(such as banks) the prospects, and therefore theriskiness, of lend ing to companies. Second, it

provides incentives for new firms to enterprom ising sectors, and for investors to seek outand invest in comp anies of the futu re. Third, itprovides the means, through takeovers of ex-isting companies by more efficient firms, in

order to red eploy th e capital more efficiently.In the longer term, restructuring the capitalbase and the means by which capital can bedrawn to the most efficient use provides themost p romising way for p rodu ctivity of laborto be increased. Increasing labor p roductivityis the only sure means for steadily increasingwage rates and incomesof allowing thosehard-working but unproductive laborers vis-ible everywhere in Mumbai to acquire the in-comes and amenities of their counterparts in

Singapore or Amsterdam .

CONCLUSIONS

1. USAIDs capital markets development

projects have been very successful.The threeprojects reviewed each h ad an identifiable link

to significant improvements in the operationof Ind ias capital markets. Each offered concreteexperimentation w ith p romising activities, and

each pushed the policy environment in a fa-vorable d irection. Each led to establishmen t ofnew or stronger institutions that have grownand evolved to solve real development prob-lems. USAID/ India was able to work construc-tively with appropriate host-country institu-tions and p rovide timely and effective support.

The PACT project helped launch the ven-ture capital indu stry and demonstrated thevalue of close collaboration between In-

dian an d U.S. comp anies at a time w henpolicymakers w ere skeptical.

The HDFC project provided Hou sing Gu ar-anty m oney for hou sing finance. It helpedlaunch this ind ustry, wh ich has since pro-vided billions of dollars of long-term fi-nance for private housing.


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FIRE/ regulatory has increased the trans-pa rency of the securities markets and im-proved oversight by the Securities andExchange Board, making India more at-tractive for foreign and domestic invest-

ment.

FIRE/ debt is helping finance local infra-structure activities and may well catalyzenew approaches to the financing of mu-nicipa l infrastructure in India.

2. Capital markets are critical to Indias de-

velopment. India needs to grow at 8 or 9 per-cent a year in order to eliminate p ervasive pov-erty within a generation. It cannot d o this with-

out better capital markets. Improving capitalmarkets in Ind ia would h ave two important ef-fects.

First, it would increase the quality of invest-men t in the econom y. Ind ias economic growthproblem in the p ast half-century has been d uemore to the quality of national investmen t thanto its quantity. Indian savings rates are suffi-ciently high to supp ort faster economic growth .Better capital markets are particularly impor-

tant to mov ing savings into m ore efficient in-vestments.

Second, efficient and transparent capital mar-kets can attract increased foreign savings toIndia (billions of dollars a year) to finance ad -ditional investment in public infrastructure. In-creased infrastructure investment is essentialfor both faster economic growth and povertyreduction. The faster development of Indiasinfrastructure requires both progress on the

policy environment and innovative approachesto financing long-term investment.

3. In India, capit al markets development is im-

portant to poverty alleviat ion in the long term.

India would have substantially less povertytoday if its government had given more atten-tion to capital markets efficiency and less todirectly intervening in the economy, often inthe nam e of poverty alleviation. USAIDusuallyprefers activities wh ere the links to p overty aretangible. In Indias case, there is simply toomuch to be done for microlevel activities tomake any dent in the problem. Permitting m ar-kets to allocate investment is one of the pre-requisites to large-scale poverty red uction.

4. In capital markets, USAID/India has been able

to achieve substantial impact and visibility

w ith small projects in a large country. This maybe du e to the fact that capital markets activityis concentrated geographically and operateswith a relatively small nu mber of participan ts.

5. USAIDs generalist st aff has been able to man-

age an activity requiring highly specialized

expertise, including excellent technical contrac-

tors. The development of a modern capital mar-ket requires specialized knowledge about is-sues such as clearance and settlemen t systems,depositories, and the desirability of financialinstruments such as derivatives. USAID stafftypically have little knowledge or exper tise onsuch issues. Nevertheless, the Ind ia experiencesuggests that this is no obstacle to prop er con-tracting and oversight of such specialized ex-pertise.

Capital Markets Impact Evolution

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