Stock Market Modern is at Ion

8/8/2019 Stock Market Modern is at Ion

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1. Executive SummaryThe modernization of Indian Stock Markets is perhaps, the biggest change that hit the Indian

economy in the last two decades. The effects of this innovation has been truly far-reaching

and it is deemed by many as arguably the most effective forerunner of liberalization of the

Indian economy a process started by P V Narasimha Rao and Manmohan Singh in 1990.

The modernization of Indias capital markets is also a classic example of an innovation

where Business, Government & Society come together to first create barriers for the change

and later, help in faster implementation through their interactions with each other. It is also

interestingly, a classic case ofSmithian vs. Keynesian models of regulation. Before 1990,

the capital markets in India was a highly regulated sector, with the Indian Government

exercising undue power, thereby exhibiting a perfect Keynesian model! However, this

proved to be highly detrimental to the In dian economy as it started facing serious balance of

payments problems and Indias foreign exchange reserves reduced to the point where the

Govt. could barely finance imports worth 3 weeks. The Narasimha Rao Govt. in 1990,initiated the process of modernization and the first step towards this, was deregulation of

the stock markets. Gradually, the market moved towards a Smithian form of regulation . As

this reached the other extreme, private shareholders started exploiting the system and

there was a series of infamous scams in the Indian stock market. This called for preventive

measures and protective regulation. The Indian stock market finally settled somewhere at

the middle, with a healthy mix of Smithian and Keynesian regulatory measures.

In this report, we first enlist the salient features of this innovation and take a quick look at

its social impact. We look at how the new measures implemented, deregulated the stock

market and encouraged more private participation, opening up the Indian stock market tothe aam aadmi. This is followed by a study the process by which the innovation was

implemented. Here we look at the events that led to the implementation of this measure,

identify the key stakeholders involved and enumerate the three major steps leading to the

implementation of this innovation. Next, we look at the barriers that it faced from all three

quarters (Business, Govt. & Society) and also, explain the steps taken to overcome these

barriers. In this section, we discuss how factors like colonialism, Fabian Socialism,

Protectionism, bureaucracy, Red tapism, insider trading, private monopoly etc. proved to be

stumbling blocks in the path of modernization. Then the outcomes of this measure are

critically analyzed, its effectiveness assessed and what could have been done to make it

further effective, is discussed. Here we introduce the concept of hasty liberalization and

finally, we conclude with a discussion on the key takeaways and inferences from this study.

In short, the study of modernization of Indian stock markets and its effects is a good story

that brings out the effects of interactions among Businesses, Governments and Society with

respect to a rather significant public innovation and more importantly, the role of regulation

in the corporate world.


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2. Major Reforms in the Indian Capital Marketiy Free pricing was introduced which meant that issuers of securities were allowed to

raise capital without requiring any consent from any authority either for making th e

issue or for pricing it. However issuer of capital were required to meet the SEBI

guidelines for Disclosure and Investor Protection which covered the eligibility norms

for making issues of capital at par and premium by various companies.

y With the removal of capital issue control and free pricing there was anunprecedented upsurge of activity in the primary capital market. It exposed the

inadequacies of the regulations. Thus SEBI strengthened the norms for public issues

in A pril, 1996 without curtailing the freedom of issuers to enter the market and

freely price their issues. Aim was to increase transparency for effective investor

protection. Issuers of capital were now required to disclose information on various

aspects like track record of profitability, risk factors, etc.

y There was modernisation of trading infrastructure by replacing the open outcrysystem with on-line screen based electronic trading. 23 stock exchanges with 8000

trading terminals were spread throughout the country which improved the liquidity

of Indian capital market and better price discovery.

y Trading and settlement cycles were shortened from 14 days to 7 days. The efficiencyof secondary market was enhanced by rolling settlement which was enhanced on

T+5 bases. At April 1, 2002 the settlement cycle was shortened to T+3 for all listed

securities, which was further changed to T+2.

y Measures like margining system, intra-day trading limit, exposure limit and settingup of trade/ settlement guarantee fund were undertaken or strengthened to ensure

safety and integrity of market

y Securities which were held in physical form were dematerialised and their transferwas done through electronic book entry.

y All listed companies were required to furnish stock exchange and publish quarterlyunaudited financial results for the purpose of continuous disclosure. For enhanci ng

the same SEBI amended the Listing Agreement to incorporate the Segment

Reporting, Accounting for Taxes on Income, Consolidated Financial Results,

Consolidated Financial Statements, Related Party Disclosures and Compliance with

Accounting Standards

y There was increased integration between Indian and International capital market.FIIs such as mutual funds, pension funds and country funds were allowed in the

Indian markets. Indian firms could now raise capital through issues of Global

Depository Receipts (GDRs), American Depository Receipts(ADRs), Euro Convertible

Bonds(ECBs), etc.


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y SEBI removed the influence of brokers in functioning of stock exchange by denyingthem from being officer bearers of an exchange or hold the position of President,

Vice President, Treasure, etc.

y Apart from stock exchanges, various intermediaries, such as mutual funds, stockbrokers and sub-brokers merchant bankers, portfolio managers, registrars to an

issue and share transfer agents, underwriters, debenture trustees, bankers to an

issue, custodian of securities, venture capital funds and issuers have been brought

under the SEBIs regulatory purview.

y Regulations were put in place for governing substantial acquisition of shares andtakeovers of companies. The process was made more transparent to protect the

interest of minority shareholders

y Trading in derivative products such as stock index future stock index options andfutures and options in individual stocks were also introduced

Social Impact

The dematerialisation led to greater participation of public in Indian Stock Markets.

Removal of Barriers provided apt environment for innovative companies like TCS and Infosys

to grow, as they could now easily raise capital from public as well as foreign investors. The

freeing of market led to increased competition as there were more number of private as

well as foreign companies entering the market, and it helped in raising the infamous Hindu

Growth Rate. Investors become more cautious and involved into analysing financial mar ket

because, the added benefits came with the risk of scams by fraudulent companies. In all it

increases the risk appetite of Indian public who traditionally involved in risk averse options

like Fixed Deposits in Bank, saving schemes of post office etc.

Process of Innovationii

In June 1991, India was in the midst of severe fiscal and external imbalances which had

generated Double digit inflation and put the country on the verge of defaulting on its

external debt obligations. Manmohan Singh as a finance minister in PV Narsimha Rao

government pushed forward the idea of Economic liberalisation, the modernisation of

Indian stock exchange was a part of this larger plan. The main reasons that led to reforms in

Indian capital markets are as follows:-

Meeting the goals of liberalisation- Before the liberalisation began, Indian capital markets

were governed by the Capital Issues (Control) Act, 1947. The government controlled the

manner and price at which companies could raise capital . As the government was no longer

going to be a major investor in capital intensive sectors, a need for transparent and efficient

capital markets was felt to enable private companies to generate resources to meet their

financing needs.


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Opportunity costs associated with traditional market design- Indian capital markets were

characterised by excessive structural and micro regulation that inhibited financial innovation

and increased transaction costs. For India to be able to integrate itself with global economy

and attract flow of FIIs, it required modern and efficient securities markets as an operational

mechanism.

Reactions to the crisis of 1992- Over the decade of the 1980s, millions of households

became investors in the equity market. These households were adversely affected by the

crisis of 1992 and worked as a new political constituency in favour of a market design which

served the interests of investors rather than financial intermediaries.

The key stakeholders involved in this transformation were the Government of India, SEBI,

Corporate sector, Institutional investors and retail investors. This ideas for reforms were

accepted by all quarters without much resistance as it involved benefit to all stakeholders,

for companies it meant easier access to capital, for investors it meant greater disclosures

mechanisms and safer investment options, it also provided government with efficient tool

to raise debt to finance its social welfare schemes. The process for modernisation included

following major steps:-

1. SEBI which was set up as a non statutory body in 1988 was given statutory powersthrough enactment of SEBI Act, 1992. The twin objectives were Protection of investors

and orderly growth of capital marketsiii.

2. The Capital Issues (Control) Act 1947 was repealed in May 1992 which allowedcompanies greater freedom in raising capital in markets.

3. Three new stock exchanges were set up NSE (1994), Over the Counter exchange (1992),Inter-connected stock exchange (1999).

4. Barriers to Modernization of Indian StockMarketsThe Pre-Liberalization policies that Indian Governments followed were clearly the biggest

barriers to the modernization of Indian Stock Markets. From 1947 to 1990, the economic

policies of the Indian Government were influenced by the colonial experience pre-1947.

Indian leaders, for obvious reasons, perceived colonial policies as exploitive in nature and

there was an evident fascination forFabian Socialism and its ideals.

The Five Year Plansiv resembled central planning in the Soviet Union and all Government

policies were effectively aimed at closing the Indian economy to the outside world. When

the Left, as expected, stuck to its anti-liberalist ideals, the Rightist parties, before 1990,

implemented policies that were in line with these principles. All eco nomic policies tended

towards the new catchphrase, Protectionism . Protectionism emphasized on

industrialization, a large public sector, excessive business regulation, central planning,

import substitution, state intervention in labour & financial markets and strict licensing.


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Steel, telecommunications, mining, machine tools, water, insurance and electrical plants

among other industries, were for all practical purposes, nationalized in the mid -1950s.

Before 1990, the Indian Stock Market was primarily controlled by private brokers who had

undue control over the activities of the few companies that actually traded in BSE. They did

not want to relinquish control and therefore were opposed to the idea of modernization.Also, the practice of insider trading prevalent in most companies gave them a virtual

monopoly over the Indian Stock market and they were again, opposed to modernization

because the new rules meant greater transparency and regulation.

To add to all this, there was the bane of bureaucracy for both native and foreign investors

to deal with. Elaborate and complicated regulations, mandatory inefficient licensing policies

and of course, the Red Tape accompanying all these measures were required to set up

businesses in India between 1940 and 1990. This trio of licence -related policies came to be

commonly referred to as the Licence Raj.

The fixed exchange rate system also proved to be a stumbling block for stock market

reforms. In this system, the rupee value was pegged to the value of a basket of currencies of

major trading partners. Since 1985, due to all the reasons quoted above, India started facing

balance of payments problems and by 1990, it was in a serious economic crisis. RBI refused

new credit and forex reservesv

reduced to the point where the Govt. could barely finance

imports worth 3 weeks! And to add insult to injury, the assassination of Prime Minister

Indira Gandhi in 1984 and that of Rajiv Gandhi in 1991, absolutely crushed investor

confidence on the Indian economy that was eventually pushed to a tight spot by early 1990s

and modernization and liberalization of Indian Stock Markets looked like an improbable

dream to both foreign and local investors.

Overcoming Barriers

Licence Raj was slightly reduced and telecom and software industries were promoted in the

1980s during the Rajiv Gandhi era. The VP Singh and Chandra Sekhar Governments added

no significant reforms and stagnated the economy.

The barriers to modernization and liberalization of stock markets were primarily tackled by

the Narasimha Rao Government and its finance policies propounded by the then Finance

Minister, Manmohan Singh. The reforms were mainly aimed at opening up foreign

investment, deregulating domestic businesses, reforming capital markets and reforming

the trade regime. They did away with Licence Raj, ended public monopolies, allowing

automatic FDI in many sectors while stabilizing external loans. The Governments immedi ate

A Balance of Payments crisis in 1991 pushed the country to near bankruptcy. In return for an IMF

bailout, gold was transferred to London as collateral, the Rupee devalued and economic reforms

were forced upon India. That low point was the catalyst required to transform the economy through

badly needed reforms to unshackle the economy.- India Report, Astaire Research

Before the process of reform began in 1991, the government attempted to close the Indian economy

to the outside world. The Indian currency, the rupee, was inconvertible andhigh tariffs andimport

licensing prevented foreign goods reaching the market. India also operated a system of central

planning for the economy, in which firms required licenses to invest and develop. The labyrinthine

bureaucracy often led to absurd restrictions. Up to 80 agencies had to be satisfied before a firm could

be granted a licence to produce and the state would decide what was produced, how much, at what

price and what sources of capital were used! The government also prevented firms from laying off

workers or closing factories. The central pillar of the policy was import substitution, the belief that

India needed to rely on internal markets for development, not international tradea belief generated

by a mixture of socialism and the experience of colonial exploitation. Planning and the state, rather

than markets, would determine how much investment was needed in which sectors. - BBC


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measures to initiate stock market modernization included reduction of fiscal deficit,

privatization of the public sector and increasing infrastructure investment. Analysts believe

that these reforms followed the pattern of Chinese external economic ref orms. Some of the

major corrective measures taken werevi:-

5. Post-Liberalisation Effects on Indian StockMarketviiThe market capitalisation ratio (value of listed shares/GDP) is regarded as a measure of sizeof stock market in a country and it increased from about 1:5 in 1991 to almost 2:3 by 1995 .

Equity capital of BSE listed companies almost trebled to 93 percent by 1995-96 which

indicates a relatively important place attained by Indian stock market. The number of

companies listed at BSE more than doubled between 1991 -92 and 1995-96. The number of

issues increases from 455 in 1991-92 to nearly 1700 each in 1995 -96, however the issues

steeply declined and reached 156 which is about one-third of 1991-92 level. The main

reason was the stock scam during which the BSE Sensex more than doubled from about

2000-4000. This gave public idea of windfall gains and created a herd mentality. Optimism

generated from entrepreneurs by the virtual demolition of industrial licensing system andentry of small companies with the aim of quick money through price manipulations were

other reasons for the unprecedented rise. The period saw a good number of non -

manufacturing companies and also the purpose of issue varied from project finance to

working capital. A number of public issues were made without proper scrutiny. This led SEBI

to strengthen its criteria of public issue, now issuing companies should have paid divi dend

for 3 years out of preceding 5 years and a manufacturing company without the three year

y In the industrial sector, industrial licensing was cut, leaving only 18 industries subjectto licensing. Industrial regulation was rationalized.

y Abolition of Controller of Capital Issues in 1992 which decided the prices and numberof shares that firms could issue

y Introducing the SEBI Act of 1992 and the Security Laws (Amendment) which gave SEBIthe legal authority to register and regulate all security market intermediaries.

y Inception of National Stock Exchange as a computer-based trading system whichserved as an instrument to leverage reforms of India's other stock exchanges.

y Reducing tariffs from an average of 85 percent to 25 percent, and rolling backquantitative controls. (The rupee was made convertible on trade account.)

y Encouraging FDI by increasing the max limit on share of foreign capital in jointventures from 40 to 51% with 100% foreign equity permitted in priority sectors

.

y Streamlining procedures for FDI approvals, and in at least 35 industries, automatically

approving projects within the limits for foreign participation

y Opening up of India's equity markets to FII and permitting Indian firms to raise capitalon international markets by issuing Global Depository Receipts (GDRs).

y Marginal tax rates were reduced.y Privatization of large, inefficient & loss-inducing Govt. corporations was initiated.


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track record of dividend payment can access the securities market if its project has

been appraised by a public financial institution or a schedu led commercial bank and

the appraising agency participates in the project by way of loan or equity to the extent of

minimum 10 per cent of the project. The aggregate market turnover increased significantly

during the post-liberalisation period, the increase has been more substantial after 1995-96.

Fall in turnover due to scam in 1992-93 following the exposure of scam was more than

recovered in 1993-94. Another problem was that out of 6000 companies listed on the BSE,

about 30 percent were not traded at all during 1998. Heavy concentration in turnover has

been another important characteristic of the Indian Stock Market. Out of the turnover of

2400 companies listed on BSE in 1989-90, the share of top 50 was nearly 82 percent and it

stood nearly at 86 percent in 1996.

Hasty Liberalisation vii,viii

The decision to liberalise stock market was sudden as a part of the shock therapy without

adequate preparation or understanding of the behaviour of the financial sector and of the

major players intermediaries, promoters, investors and regulators in a country like India,

and even ignoring the experience of the 1980s when initially the stock market was given a

major push. The regulatory framework was slow to evolve. The Capital Issues Control Act

was repealed even though there were securities scams. It was like that government was

following a pre-set timetable. The process of liberalisation should have been more gradual.

SEBI was inexperienced and in addition government failed to arm it with adequate powe rs

in time. This enabled the private sector to misuse the new freedom and it resulted in a

series of scam of various scale and magnitude. Even large houses and translational

corporations took advantage of policy vacuum and issued shares to themselves at

ridiculously low prices. Scam was unfortunately characterised by long drawn investigations,

procedural delays and a slow acting judiciary which brought a lot of Indian stock market.

Investor could not adjust to the rapid changes as now the public financial institutions, the

industrial licensing systems and the capital issue control mechanisms could no longer be

trusted to assess the feasibility, viability and profitability of investment projects. The

atmosphere was euphoric and investors were ignoring the risk factors revealed in the issue

prospectuses of the so-called vanishing companies. Primary market dried up, investors lost

confidence in stock market and households shifted from investing in shares and debentures.

Companies had to again rely on assistance from banks and financial institutions. Liquiditycrunch meant that investors could not exit company even after realising that the prospects

of capital appreciation or dividend earnings were very poor. Having faced the scams it

meant that investors would be more cautious in future, however this positive outcome was

achieved at a substantial cost and brought the very concept of stock market regulation to

dispute.


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Key Lessons and Takeaways

1) The government is not always the best allocator of resources Before the liberalisationof stock exchanges the funds raised through capital markets were channelled through

the Govt. and the business houses close to centre were the ones which benefitted the

most. This form of crony capitalism was detrimental to the growth of country as a

whole, as the returns from equity due to inefficient allocation were less than what a free

market system could have provided.

2) Market mechanism cannot be allowed free rein in any forms of society- Themechanisms and regulations in place before the liberalisation were stifling the

innovation and growth of economy. The Government brought in a shock therapy by

doing away with most of regulations in one go in the 1990s. This exposed the dark

underbelly of free market mechanism. As there was information asymmetry, many

companies were able to con innocent retail investors through price rigging. The IPOs

that hit the market were priced at huge premiums. Stock markets work on basis of aKeynesian Beauty Contest where you do not judge the choic e you are making on basis

of its merits but on the basis of herd mentality. When the retail investors saw that there

were windfall gains being made in stock markets, they jumped in without any prior

knowledge or analysis and were duped by fly by night companies.

3) Importance of the role of regulator- Though there have been scams that have rockedthe markets time and again, SEBI has been largely successful in increasing investor

confidence and ensuring transparent capital markets. More stringent Disclosure policies

imposed by SEBI resulted in decreasing the information asymmetry; it also took up

initiatives to make investors better informed about their rights. Life was made easier for

companies as well, as the simplification of procedures reduced the transaction costs and

lessened time needed to tap the capital markets.

4) Importance of technology in system- When shares were traded in physical form it was alot of hassle for investors to trade their shares. There only source of income were

dividends from shares and they could not take advantage of increased share price.

Introduction of Demat accounts has done away with problem of physical possession.

5) Promotion of Innovation- Many companies which today form the backbone of theIndian economy benefitted from modernisation of stock exchanges. The likes of Infosys

& TCS tapped capital markets to fund their growth. The most recent innovative company

to raise money has been SKS Microfinance which is working on model of social

entrepreneurship.

In conclusion, this exercise has highlighted that liberalisation does not mean doing away

with all checks and balances but putting in place a mechanism for market forces to function

in a free and fair manner, keeping in view that no group is at a distinct disadvantage,

thereby minimizing risk of systematic failure.


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iIndian Financial System and Capital Market A Note

iiEvolution of the securities markets in India in 1990s :Ajay Shah & Susan Thomas

iiiIndian Financial System : Bharati V. Pathak

ivSam Staley (2006). "The Rise and Fall of Indian Socialism: Why India embraced economic reform".

http://www.reason.com/news/show/36682.html.v

India's Pathway through Financial Crisis. Arunabha Ghosh. Global Economic Governance Programme.

Retrieved on 2 March 2007.vi

Local industrialists against multinationals. Ajay Singh and Arjuna Ranawana. Asiaweek. Retrieved on 2 March

2007.vii

Indian Financial Sector After a Decade of Reforms, Prof. Jayanth R. Varma, Indian Institute of Management

Ahmedabadviii

An Overview of the Indian Stock Market with Emphasis on Ownership Pattern of Listed Companies,

K.S.Chalapati Rao

Stock Market Modern is at Ion

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