Project on Indian Financial Market - Module: 3
Financial Market Integration
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Preface & Introduction

Integration is a process by which markets become open and unified so that participants in one market have an unimpeded access to other markets. Integrated financial markets would imply that, in the absence of administrative and informational barriers, risk-adjusted returns on assets of the same tenor in each segment of the market should be comparable to one another. Return differentials across markets could cause arbitraged shifts in portfolios of investors, ultimately bringing about an overall equality of returns across markets. When this argument is applied to cross-border unrestricted movement of capital, risk-adjusted returns on financial instruments of different countries should be equal when the returns are expressed in any single currency. Administrative restrictions on cross-market and cross-border transactions are often viewed as the key factor contributing to market segmentation. While such restrictions exist in regulated state controlled regimes, growing market orientation of the economy warrants greater integration of markets for enhancing the effectiveness of policies and for facilitating better functioning of markets.

The Indian financial system, till the early 'nineties, was characterised by an administered structure of interest rates, restrictions on various market participants - including banks, financial institutions and corporates - in terms of the nature and volume of transactions they could undertake in the money, forex and capital markets and administrative limits on the transactions between the residents and the non-residents. As a result, the markets remained segmented. The process of economic reform that started in the early 'nineties has created the enabling conditions for better integration of the markets. Quick implementation of wide-ranging reforms, the 'big bang' approach, could help to eliminate market segmentation, though faulty timing, speed and sequencing of reforms could expose the economy to several vulnerabilities. The gradual approach to reforms in India, therefore, strives to attain a balance between the goals of "financial stability" and "integrated and efficient markets".

In a market oriented economy, segmented markets could not only obscure the transmission of public policies but also give rise to sub-optimal allocation of resources. Financial markets in India which remained segmented for long are getting increasingly integrated both domestically and internationally following initiation of financial sector reforms in the 1990s. The module on "Financial Market Integration" analyses, in detail, various aspects of the integration of financial markets in India. Integration of domestic financial markets is analysed in terms of the linkages across the term structure of interest rates and between interest rates and other asset prices, particularly stock prices. Cross-border integration is studied through various indicators of openness to trade and finance as also the standard international parity conditions.

Since the mid-1991, the Reserve Bank has taken several steps to develop various segments of the financial markets, strengthen their integration and enhance their efficiency. These steps essentially covered the money market, the government securities market and the foreign exchange market. Steps were also undertaken by other regulators to develop other markets, specially the equity and the debt segments of the capital market. Policy initiatives in these areas related to introduction of new instruments, institutions and practices. Efforts have been made to widen the participant base, improve information base for all participants, create greater transparency and encourage good market practices, introduce efficient settlement mechanisms, rationalise tax structures, create better infrastructure to facilitate faster transactions and lower their costs.

Reforms in the money market included permission for entry of additional participants in the inter-bank call money market, and steps to develop a term-money market - particularly exemption of inter-bank liabilities from Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) stipulations and introduction of new instruments. The Reserve Bank started repos, both on auction and fixed interest rate basis for liquidity management. Since June 5, 2000, the newly introduced Liquidity Adjustment Facility (LAF) has been effectively used to influence short-term rates by modulating day-to-day liquidity conditions. The transition to LAF was facilitated by the experiment with the Interim Liquidity Adjustment Facility (ILAF) from April 1999 that provided a mechanism for liquidity management through a combination of repos, export credit refinance and collaterised lending facilities. In the long-run, the call money market is being seen to be emerging as purely an inter-bank market. In an environment where banks are undertaking non-bank activities and DFIs are planning to undertake banking functions, a more homogenous set of players is expected to emerge in the call money market. This is expected to facilitate introduction of longer and variable term repos. A well developed repo market is also essential to make the call money market purely inter-bank.

With the abolition of the system of automatic monetisation of deficits and the switchover to market related interest rates for market borrowings, it became possible to develop a genuine market for government securities. Introduction of new instruments, such as, zero coupon bonds, floating rate bonds and capital index bonds, establishment of Securities Trading Corporation, the system of Primary Dealers and Satellite Dealers, and the Delivery versus Payments (DvP) system constituted the other areas of reforms in the government securities market. The Reserve Bank is exploring the possibility of an early establishment of Electronic Dealing System which would facilitate both electronic bidding in auctions and dealing in Government securities and money market instruments. It will facilitate a shift from largely telephone-based trading to a completely screen-based on-line trading. Such electronic trading is expected to reduce information asymmetry in the markets and prevent the possibility of collusive trading that provides excess returns to some investors. To facilitate settlement in Government securities transactions, the dealing system will be linked to securities settlement system in Public Debt Office (PDO). A core group has been set up to prepare the project report indicating a road map and modalities for setting up a Clearing Corporation for debt securities. The setting up of Real Time Gross Settlement System (RTGS) is also expected to lower transaction costs by speedier settlement. In order to deepen and widen the Government securities market, it was essential to diversify the investor base. In this context, retailing of Government securities becomes critical. By establishing a system of Primary Dealers (PDs) and Satellite Dealers (SDs) with provision for liquidity support from the Reserve Bank, it is expected that the dealers will take on a larger role in the primary as well as secondary markets in Government securities. The liquidity support arrangements -based on bidding commitments and performance in both primary and secondary markets - would help the dealers to make markets and to minimise volatility in security prices. Dedicated gilt funds have also been provided liquidity support from the Reserve Bank. Banks have been allowed to freely buy and sell Government securities on an outright basis and retail Government securities to non-bank clients without any restriction on the period between the sale and purchase. With a view to enabling dematerialisation of securities of retail holders, National Securities Depository Ltd. (NSDL), Stock Holding Corporation of India Ltd. (SHCIL) and National Securities Clearing Corporation Ltd. (NSCCL) have been allowed to open SGL accounts with the Reserve Bank.

Setting up of depositories, clearing corporations/houses on the stock exchanges, etc., and introduction of on-line trading in all stock exchanges have helped improve the efficiency of the capital market. Delisting norms have been tightened following the recommendations of the Chandratre Committee that were accepted by SEBI. All publicly issued debt instruments, regardless of the period of maturity, are presently required to be rated by credit rating agencies. All listed companies are also required to publish unaudited financial results on a quarterly basis. With a view to enhancing transparency in corporate affairs, SEBI accepted the recommendations of the Committee on Corporate Governance (Chairman: Shri K.M. Birla) and the listing norms have been modified to reflect a code of corporate governance. With a view to detecting market manipulations, SEBI regularly monitors market movements and oversees the activities of the stock exchanges. These measures in the capital market have helped in improving information flows and in reducing the transaction costs in the stock markets.

Measures to integrate Indian markets with those abroad were largely guided by the recommendations of the Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan) and the Report of the Expert Group on Foreign Exchange Markets in India (Chairman: Shri O.P. Sodhani). The former report recommended, inter alia, liberalisation of current account transactions, compositional shifts in capital flows - away from debt in favour of non-debt, strict regulation of external commercial borrowings (ECBs) - particularly of shorter maturities, and measures to discourage volatile elements in the inflows from NRIs. Against the background of the gradual liberalisation of current transactions, a transition to the market determined exchange rate on March 1, 1993 was achieved through a successful experimentation with a dual exchange rate system under the Liberalised Exchange Rate Management System (LERMS) for one year beginning with March 1992. In October 1993, banks were permitted to rediscount export bills abroad at rates linked to international rates. Introduction of "Post Shipment Export Credit in Foreign Currency (PCFC)" in November 1993 enabled Indian merchants to access funds at internationally competitive rates. In October 1996, ADs were permitted to use FCNR (B) funds to lend to their resident constituents for meeting their foreign exchange as well as rupee needs. Based on the recommendations of the Sodhani Committee, several measures were instituted to deepen and widen the forex market. ADs were permitted in April 1997 to borrow from their overseas offices/correspondents as well as to invest funds in overseas money market instruments up to US $ 10 million. In October 1997, this limit was raised to 15 per cent of Tier I capital of the banks. The uniform limit of Rs. 15 crore on the overnight positions of the ADs was removed with effect from January 4, 1996 and banks were allowed to operate on the limits fixed by their management and vetted by the Reserve Bank. The Aggregate Gap Limit (AGL), which was previously not to exceed US $ 100 million or six times the net owned funds of a bank, was left to be fixed by the individual banks since April 1996, depending upon their foreign exchange operations, risk taking capacity, balance sheet size and other relevant parameters subject to approval by the Reserve Bank.

Liberalisation of capital account should be viewed as a process and not as a single event. In the approach to capital account convertibility (CAC), the initial reform measures were directed at current account convertibility leading to the acceptance of Article VIII of the Articles of Agreement of the IMF in August 1994. For operationalising CAC in India, a clear distinction is made between inflows and outflows with asymmetrical treatment between inflows (less restricted), outflows associated with inflows (free) and other outflows (more restricted). Differential restrictions are also applied to residents versus non-residents and to individuals versus corporate entities and financial institutions. A combination of direct and market based instruments of control is used for meeting the requirements of a prudent approach to the management of the capital account. The policy of ensuring a well diversified capital account with rising share of non-debt liabilities and low percentage of short-term debt in total debt liabilities is reflected in India's policies of foreign direct investment, portfolio investment and external commercial borrowings. Quantitative annual ceilings on ECB along with maturity and end-use restrictions broadly shape the ECB policy. FDI is encouraged through a liberal but dual route - a progressively expanding automatic route and a case-by-case route. Portfolio investments are restricted to select players, particularly approved institutional investors and the NRIs. Short-term capital gains are taxed at a higher rate than longer term capital gains. Indian companies are also permitted to access international markets through GDRs/ADRs, subject to the prescribed guidelines. Foreign investment in the form of Indian joint ventures abroad is also permitted through both automatic and case-by-case routes.

The Committee on Capital Account Convertibility (Chairman: Shri. S.S. Tarapore) which submitted its Report in 1997 highlighted the benefits of a more open capital account but at the same time cautioned that CAC could pose tremendous pressures on the financial system. To ensure a more stable transition to CAC, the Report recommended certain signposts and preconditions of which the three crucial ones relate to fiscal consolidation, mandated inflation rate and strengthened financial system. Keeping in view the recommendations of the Report, India has over the years liberalised certain transactions in its capital account. Vastly altered and liberal policy environment for the external sector is reflected in the Foreign Exchange Management Act, 1999 (FEMA), which replaced the earlier Foreign Exchange Regulation Act, 1973 (FERA). The new Act sets out its objective as "facilitating external trade and payment" and "promoting the orderly development and maintenance of foreign exchange market in India".

The above referred important measures in each of the critical segments of the Indian financial market have enhanced the information sensitivity of the markets and fostered competitive efficiency. Notwithstanding the restrictions that still exist on specific cross-market transactions and the general policy of discouraging destabilishing speculation, markets have shown signs of increasing integration with market participants often recognising the expected return differentials in different markets and triggering cross-market transactions to reduce the return differentials across the markets. Absence of complete integration, stemming to some extent from the lack of complete freedom of individual agents in choosing their preferred portfolios as well as the restrictions on destabilising speculation, are in the interest of developing orderly, and resilient financial markets in India.