7.1 DEBT MARKETS

The debt market in India is characterised by poor trading volumes despite high stock of debt issued leading to poor price discovery. Compared to a total outstanding debt of about Rs. 500,000 cr. (33% of GDP), the average annual trading volume is only about Rs. 100,000 cr. or 20% of market capitalisation, which is low as compared to over 40% prevailing in other countries. Over 90% of the trading volume is in government securities where banks are the main players. The reasons for this lack of depth and width of the markets can be classified into 4 main categories as given below:

7.1.1 Market micro infrastructure

The debt market is largely a telephone market dominated by banks and FIs and suffers from inadequate infrastructure outside metros. There exist a limited number of well-capitalised players, mainly banks, resulting in homogeneous view on market movements at any point in time. Although Insurance and Pension funds manage large corpus to be invested in securities issued by Government of India and PSUs they have only a limited participation in the secondary markets

7.1.2 Trading and post market trading

The tendency to "buy and hold" by large institutions due to their risk averse nature and lack of expertise in active funds management (as they are not required to mark to market their investments, there is a strong tendency to avoid booking losses) constrains the development of vibrant secondary market. The market lacks a efficient clearing and settlement system and cost of accessing the trading infrastructure is high. The absence of long term stable yield curve/market benchmarks, lack of hedging instruments (such as interest rate swaps, forward deals, bond futures) and differential tax and regulatory norms among different classes of players/instruments results in Mispricing.

7.1.3 Information

The market is characterised by lack of standardisation in valuation procedures and inadequacy of disclosure norms on terms of contracts settled.

7.1.4 Regulatory

The high cost of stamp duty and differential stamp duty structure across States constrains trading in the secondary market. Although Insurance and pension funds are the major players in the debt market, administrative hurdles and stringent investment guidelines (while Pension/ Provident Funds are required to invest upto 85% of their corpus in scheduled investments, about 45% of GIC’s funds and 75% of LIC’s funds are in Government securities) inhibits active fund management by insurance and pension/provident funds.

7.2 EQUITY MARKETS

7.2.1 Interest in the Primary Market

The number of issues in the primary market via public and rights issues have dwindled in the last two years as shown in the table below, primarily due to inefficient pricing by merchant bankers. (Annex 7.1).

7.2.2 Market Structure

Over the last three years there has been a marked shift in the structure of the markets. In the year 1995-96, the top 50 companies with the highest turnover accounted for about 60% of the total turnover on the BSE while in 1997-98 they accounted for about 92% which indicates that trading activity is now restricted mainly to the top end of the market. (Annex. 7.2)

7.2.3 Liquidity in the secondary market

The turnover in the markets have increased over 7 times in the last three years but the increase has only been at the top end. This has resulted in lack of trading in most of the B1 and B2 stocks. The ban on renewals and introduction of shorter settlement cycles in non-specified group has seen tremendous changes in trading pattern. (Annex. 7.3)

7.2.4 Cash market and efficient pricing

India’s cash market for equity uses "futures style settlement" where trading takes place with netting through the settlement period. At the end of the settlement period, open positions turn into delivery and payment. Trading in futures style settlement resembles the functioning of a futures market. Despite the government’s commitment on derivatives trading, the SCRA has yet to be amended and there is a lack of hedging opportunities due to absence of derivatives trading

7.2.5 Liquidity in dematerialised stocks

The Indian capital markets for long have been plagued by the use of physical certificates resulting in various costs such as back office, handling, transportation storing etc. Further these have been vulnerable to theft, counterfeiting, and inconsistent signatures. Even with the setting up of NSDL the depository segment has not caught on. Both electronic and physical systems co-exist. Also, a person can convert from physical to demat and then also has the option to convert that into physical that could be self defeating

7.2.6 Information and disclosure

The investor’s access to information is limited and this has acted as a disincentive for a retail investor. Most retail investors have a problem of getting basic information from the companies like the annual reports. Also, the quality and quantity of information in the annual reports still needs to be substantially improved.

7.3 MUTUAL FUNDS

In India approximately 20 million investors, representing about 2% of the population invest in mutual funds as compared to 35 % in a developed market like USA. (Annex 7.4)

The resources mobilised by the mutual fund industry reached a seven-year low in 1995- 96; mobilisations continued to be low in 1996-97 and 97-98. Incremental funds mobilised in 1997-98 was only Rs 11406 crores. (Annex. 7.5).

7.3.1 Guaranteed Return Schemes

Assured return schemes garner about 30% of the funds mobilised and public sector funds have faced immense difficulty in honouring commitments and sponsoring banks have had to come to their rescue to honour the promised return; in a few cases there has been a failure to honour commitments

7.3.2 Investor confidence

The incorrect positioning of mutual fund products (with lack of investor understanding) coupled with poor performance has led to a significant erosion of investor confidence in the industry. The close-ended funds have been quoting at substantial discounts to their Net Asset Value. This has been further aggravated by insufficient disclosure of portfolio management policies and inadequate explanations of poor performance. Absence of liquidity planning by funds to handle redemption requests promptly and the consequent rollover of funds has also created apprehension.

7.3.3 Credit quality

The absence of standardised valuation guidelines vitiates comparisons on performance of funds and the absence of guidelines for provisioning for the non -performing assets compounds the difficulty of assessing the true worth of a fund for investors. The above have led to issues in calculating NAVs and hence has made it difficult to compare performance across mutual funds. Along with the poor performance of the industry, this has led to an erosion of investor confidence.

7.3.4 Product offerings

A cycle of low investor interest leading to lack of product innovation by the funds has resulted in inadequate product range to match investor risk -return profiles

7.3.5 Role and responsibilities of Trustees

The present structure permits setting up of Board of Trustees or Trustee companies; this has led to a lack of clarity on the individual/collective responsibility and accountability of the trustees

7.3.6 Investment guidelines

Investment in unlisted group companies and associate companies, huge transactions with broking houses connected with the sponsor has resulted in the poor performance/collapse of some mutual funds

7.4 PENSION AND PROVIDEND FUNDS

The corpus of the Indian pension and provident funds is currently estimated at about Rs. 200,000cr (about 15% of GDP). As at end March 1996 the cumulative investment in special deposits was high at over 85% of the provident fund corpus.

Pension Funds do not offer withdrawal facilities, are taxable when received by subscribers and are permitted to invest in private equity and debentures upto a certain amount. On the contrary, providend funds permit withdrawals, are tax exempt and are not permitted to invest in private equity and debentures. (Annex. 7.6)

The yields on Provident Funds declared annually in the case of non-exempt funds is tax-free. The exempted funds must declare returns not lower than that on non-exempt funds. But if the returns earned are higher than that earned by the non-exempt funds, the difference is treated as income, and liable for income tax.

While the contribution rate in India is high at over 21%, the real rate of return of the pension/provident funds has on an average over the past 10-12 years been low, at about 2.5%, compared to about 12% in a highly successful "pension fund reformed" countries like Chile.

There is a significant preemption of resources by the Government and the investment pattern stipulated leaves very little room for discretionary management (and hence prevents maximisation of returns) and encourages a highly risk averse approach to fund management. The administrative hurdles in fund management activity impede active fund management and maximisation of returns. For example, withdrawals made from Special Deposit Schemes must be supported by a Trustee Resolution providing the justification.

7.5 SUMMARY

To sum up capital markets in India are shallow and need to be supported to enable capture of their immense potential to intermediate between savers and users. Areas of concern revolve around their morbidity, poor liquidity, poor disclosure standards, rigidity of legislative environment and, above all, poor investor confidence.

Primary market issues