A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 4 - Financial Sector Reforms

Financial Sector Reform - Concluding Observations - growth of Markets

Except for a brief period of instability on account of border tensions in May 2002, the Rupee remained broadly stable during the current financial year (April-February). The Rupee gained strength against the US dollar during July 2002–February 2003 on account of excess supply resulting both from current and capital account transactions. The Reserve Bank made net purchases of US $ 9.7 billion during April-December 2002. A steady supply of dollar in the foreign exchange market kept the Rupee range-bound during the period and in terms of monthly average exchange rate, the Rupee appreciated by 2.2 per cent during the eight-month period from Rs.48.76 per US dollar in July 2002 to Rs.47.73 per US dollar in February 2003.

While the Rupee depreciated against the US dollar and the Pound Sterling by 35.3 per cent and 36.9 per cent, respectively, it depreciated by 26.7 per cent against the Japanese Yen during the 10-year period 1993-94 to 2002-03 (up to February 2003). Against the Euro, the Rupee depreciated by 6.3 per cent between 1999-2000 and 2002-03 (up to February 2003). Depreciation of the Indian Rupee, however, was lower than that of some other emerging market economies. A cross-country analysis involving select Asian and Latin American emerging market economies reveals that the currencies of Korea, Malaysia and Chile depreciated against the US dollar during the 7-year period 1995-2001. The US dollar appreciated by 67 per cent, 60 per cent and 52 per cent against the Korean Won, Chilean Peso and the Malaysian Ringgit, respectively, as compared to a 46 per cent appreciation against the Indian Rupee during the same period.

The coefficient of variation of the Indian Rupee against the US dollar, which is a measure of volatility, moved in a narrow range, except for two occasions in 1995-96 and 1997-98.

Thus, the foreign exchange market witnessed fairly stable conditions during the 1990s. Even during the period when the market came under pressure, effective measures were initiated and orderly conditions in the market were restored quickly.

As a result of various liberalisation measures, the foreign exchange market in India grew rapidly during the 1990s. The total turnover (merchant plus inter-bank) increased more than two-fold to US $ 129 billion in 2002-03 (up to January) from US $ 38 billion in 1990-91. The average monthly merchant turnover increased by around 550 per cent from a meagre US $ 4 billion in 1990-91 to US $ 26 billion in 2002-03 (up to January). The average inter-bank turnover, on the other hand, increased by around 200 per cent from US $ 34 billion in 1990-91 to US $ 103 billion over the same period. Reflecting the same, the inter-bank to merchant turnover ratio declined from 8.5 in 1990-91 to 4.0 in 2002-03 (up to January) . The merchant segment is dominated by spot transactions and the inter-bank segment is dominated by forward transactions.

To sum up, various reforms measures initiated have resulted in significant growth of the foreign exchange market. Also, despite liberalisation of capital account and introduction of market determined exchange rate, the foreign exchange market in India remained stable during the 1990s barring a few episodes of volatility.

India’s current exchange rate policy of managing volatility without fixed target, while allowing the underlying demand and supply conditions to determine the exchange rate, has yielded satisfactory results. Various reforms measures in the foreign exchange market have also led to the widening and deepening of the forex market in India. This is reflected in the substantial increase in the foreign exchange market turnover particularly in the inter-bank segment. A recent Bank for International Settlements survey of the foreign exchange market turnover during April 2001 in which 43 countries including India participated reveals that while foreign exchange market turnover declined the world over considerably as compared to 1998, it increased in India.

Although reforms in the forex market have yielded good results, there are some issues, which need to be addressed to enhance its stability and ensure further growth.

• Although the turnover in the market increased considerably over the years, it still remains small. The Triennial Central Bank Survey of the Bank for International Settlements on Foreign Exchange and Derivatives Market Activity in 2001 revealed that the share of India in total global daily turnover of the foreign exchange market remained insignificant at 0.2 per cent during 2001. Since the market lacks depth, the Reserve Bank has to actively intervene in the market to absorb/ provide liquidity. There is, therefore, need to take steps to further develop the market so that the need for intervention by the Reserve Bank is minimised.

• The market is presently skewed with a few public sector banks accounting for the major share of the merchant transactions. For development of the market on healthy lines, it is necessary to have large number of players participating in the market.

• Derivatives are an important instrument of risk hedging. Although a few derivative products have been introduced, there has not been much activity in some of them such as FRAs. There is a need to further develop a range of derivative products like forex options

The capital market provides an alternative mechanism for allocating resources; it channelises household savings to the corporate sector and allocates funds among firms. In this process, it allows both firms and households to share risk. The capital market enables the valuation of firms on an almost continuous basis and it plays an important role in the governance of the corporate sector. The reforms in the capital market were aimed at enhancing the efficiency, safety, integrity and transparency of the market. The key reform measures for the capital market are provided in Box VI.4. The impact of various reform measures could be seen in the primary as well as secondary segments of the capital market.

Notwithstanding depressed conditions in the capital market in the last few years, significance of the capital market in meeting the financing requirements of the corporates has generally improved. Since the initiation of the reforms, the reliance of the corporate sector on the capital market for funds increased markedly. The resources raised by the private sector companies from the primary equity market rose sharply in the first half of the 1990s to touch a peak of Rs.17,414 crore in 1994-95. The resource mobilisation from the primary market, however, tapered off in the second half of the 1990s due to a variety of reasons such as tightening of disclosure norms and subdued secondary market 6. The ratio of resource mobilisation by the private sector to GDP almost trebled from an average of 0.4 per cent during the period 1970-92 to 1.1 per cent of GDP during 1992-2000

Reflecting the growing importance of market-based financing, the share of capital market-based instruments in total funds raised by non-Government non-financial public limited companies increased to 22.3 per cent during the period 1991-92 to 2000-01 from 17.3 per cent in the period 1985-86 to 1990-91. During the period 1992-93 to 1996-97, the share of capital market instruments in total external financing worked out to 37.3 per cent, with a peak of 51.3 per cent in 1993-94. The share of shares and debentures in financial savings of households rose, on an average basis, to 9.0 per cent during the 1990s from 6.0 per cent during the 1980s, with a peak at 13.5 per cent in 1993-94.

In the secondary market, the move to an electronic trading system has resulted in transparency in trades, better price discovery and lower transaction costs. The efficiency of the market has improved through faster execution of trades. The operational efficiency of the stock market has also been strengthened through improvements in the clearing and settlement practices and the risk management process. Almost the entire delivery of securities now takes place in dematerialised form. During the last four years or so, there has been no instance of postponement or clubbing of settlements at two main stock exchanges (BSE and NSE) despite defaults by brokers. The cases of bad deliveries have become almost nil. The setting up of trade/settlement guarantee funds in most of the exchanges has considerably reduced the settlement risk for investors. The corporate governance practices and disclosure norms have led to transparency in information flows, which, in turn, have improved the price discovery process.

There has been an appreciable increase in liquidity as reflected in the traded value and turnover ratios. The traded value ratio, i.e., the ratio of turnover to GDP, increased from 23.2 per cent in 1993-94 to about 136.9 per cent in 2000-01. At the same time, the turnover ratio, i.e., the ratio of turnover to market capitalisation, increased from 50.9 per cent in 1993-94 to 139.0 per cent in 2001-02.

The transaction cost in the Indian stock markets declined sharply as a result of measures such as automated trading, compression of settlement cycle, and introduction of dematerialisation. The transaction costs7 in terms of the brokerage, regulator’s fees, custody, safekeeping and clearing is estimated at about 0.31 per cent (0.40 per cent for foreign institutional investors), which compares favourably with international standards (Raju, 2000).

The volatility in the Indian stock markets has declined in the recent years. The coefficient of variation of the BSE Sensex declined to 14.9 per cent during the 2-year period April 2000 to March 2002 from 25.9 per cent during the 10-year period from April 1991 to March 2000 and 33.6 per cent during the 6-year period from April 1985 to March 1991.

Thus, the various parameters, such as liquidity, volatility and transaction cost, point towards the improvements in the efficiency of the capital market. The impact of various reform measures on two critical aspects of efficiency, viz., the information efficiency (i.e., whether all market information is reflected in the prices) and allocative efficiency (whether resources are being allocated efficiently) of the capital market, has been explored further.

Efficiency test conducted using data up to December 2002 reveals that in terms of informational efficiency the Indian stock markets are not efficient (Box VI.5). However, it is significant to note that many studies conducted in the context of advanced economies also suggest that most markets are not informationally efficient, i.e., markets do not as such follow a random walk especially as they seldom satisfy the stringent criteria of stationary, independent, identical and normally distributed stock returns.

Reforms in the Indian capital market during the 1990s fostered a steady process of financial disintermediation, with corporates increasingly accessing the equity route, while on the supply side, investors earmarked an increasing portion of their savings in risk capital. Although the stock market has gained in importance in terms of channellisation of resource flows, the key macroeconomic issue is whether this has led to an increase in the allocative efficiency of the system. This assumes added significance as the recent literature has emphasised that the contribution of the financial system to economic growth comes as much through the efficiency of investment as the increase in saving and investment (De Gregario and Guidotti, 1995; Levine and Zervos, 1998).

The allocative efficiency of the Indian capital market was tested using two measures 8, viz., synchronicity of equity prices and R2. The results indicate that market-wide factors (as against company-specific factors) play a predominant role in determining the behaviour of stock markets in India. In a select sample of 66 scrips in the BSE-100 list during 1995-96 to 2001-02, about 70 per cent of stocks moved in the same direction. Although this would suggest that the stock markets in India do not allocate resources efficiently, the allocative efficiency of the Indian stock market compares well with several emerging market economies. In many emerging market economies, the synchronicity was much higher, i.e., 80 per cent in China, 82.9 per cent in Poland and 75.4 per cent in Malaysia. The proportion of stocks moving together in the case of Brazil (64.7 per cent) and Indonesia (67.1 per cent) were more comparable with the results for India. Similar results were obtained in respect of the R2 measure.

Thus, reforms in the capital market have had a multi-dimensional impact. Notwithstanding the recent depressed conditions, the significance of the capital market has improved in providing a mechanism for allocation of resources as is reflected in increase in its share in the sources of finance for the corporates. Various indicators such as reduced volatility are pointers in the direction of increase in the safety of the market. The safety of the market has also been considerably enhanced by adoption of risk management practices and the setting up of settlement guarantee funds and investor protection funds. The integrity and transparency of the market has also gone up with the wider availability of information regarding the corporates’ performance. The trading and settlement framework in the Indian stock exchanges now compares favourably with the international best practices. The liquidity in the market has improved considerably.

While reforms in the capital market have had a significant impact, there are some issues which need to be addressed. A major concern has been the depressed state of the primary capital market. Resources raised from the primary capital market have declined sharply in comparison with the first half of the 1990s. The subdued environment in the primary market in the second half of the 1990s stands in sharp contrast to the buoyant first half. Another major area of concern is the primary corporate debt market, which is yet to develop. The secondary market for corporate debt is virtually non-existent. Though some debt securities are listed on the stock exchanges, there is not much trading in these securities. In the secondary market for equity, there is concentration of liquidity among few prominent scrips. Although as a result of electronic trading, investors are able to trade in the securities listed on the premier exchanges from any location in the country, this has reduced the significance of regional stock exchanges, which have witnessed a sharp decline in volumes rendering them financially vulnerable. The truthful compliance of listed companies with the corporate governance standards is another issue, which needs to be addressed.