Knowledge Paper

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Knowledge Paper

CAPAM 2012
Developing Indian Capital Markets The Way Forward
Knowledge Paper
FICCI
The information and opinions contained in this document have been compiled or arrived at on the basis of the market opinion
and does not necessarily reflect views of FICCI.
FICCI does not accept any liability for loss however arising from any use of this document or its content or otherwise in
connection herewith.
McKinsey & Company
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Foreword
India’s capital markets are characterised by vibrant equity markets and a debt market
that is assuming more significance. The Indian government and regulator have announced
several far-reaching reforms to promote capital markets and protect investors’ interest.
However, certain emerging challenges as well as regulatory reforms are still on the radar
for widening and deepening of markets. Applying the lessons and techniques that have
already succeeded, India must continue to strengthen its markets.
The 9th edition of our flagship Capital Markets Conference (CAPAM) is therefore poised
to discuss the way forward for the Indian capital markets and its various constituents.
It endeavours to learn from international best practices and explore ways to increase
retail participation, create a resilient bond market and lay the foundation for regulatory
reform. The Knowledge paper of the event is a compendium of papers by McKinsey and
members of FICCI’s Capital Markets Committee. The papers aim to analyse and suggest
solutions for key issues pertaining to the primary and secondary markets, the challenges
for insurance companies, asset management companies and private equity companies as
investors, corporate finance and corporate governance matters and measures to enhance
retail participation . FICCI’s endeavour is to build on this further and develop a concrete
road map for the sector’s progress.
FICCI’s Capital Markets Committee, comprising key players of the sector, is chaired by
Mr. Sunil Sanghai, M.D., Head of Global Banking-India, HSBC Ltd. and co-chaired by
Mr. Anup Bagchi, M.D. & CEO, ICICI Securities Ltd. It has had in depth discussions with
the Reserve Bank of India, Securities and Exchange Board of India, Ministry of Finance
and market participants on the direction that the Indian capital markets need to take.
This paper is a culmination of these deliberations. CAPAM is the ideal forum for the
dissemination of these thoughts with a wider audience to gather their views in order
to further enrich our work. But for Mr. Sunil Sanghai’s and Mr. Bagchi’s support, this
task would have been difficult. We thank the entire McKinsey team and FICCI’s Capital
Markets Committee members involved in this work for their timely and whole-hearted
support in making this possible.
We hope you will find this report insightful.
Naina Lal Kidwai
Senior Vice President
FICCI
4
Contents
6
Theme Paper
7
Developing the Indian Capital Market: The Way forward
Developing the Indian capital market
Developing
Capital Markets - The Way Forward
Capital markets are the lifeline of an economy and offer three key benefits. First,
a solidby:
capital
market spurs
economic development and growth in the real sector
Prepared
McKinsey
& Company
by directing capital to creditworthy companies. Second, developed capital markets
conducive
the long-term
development
of akey
more
stableFirst,
financial
Capitalare
markets
are theto
lifeline
of an economy
and offer three
benefits.
a solidsystem.
capital market spurs
Finally,
emerging
with
capitalcapital
markets
will integrate
more Second,
economic
development
andeconomies
growth in the
real developed
sector by directing
to creditworthy
companies.
smoothly
the global
market.to the long-term development of a more stable financial system.
developed
capitalinto
markets
are conducive
Finally, emerging economies with developed capital markets will integrate more smoothly into the global
DEVELOPMENT OF THE GLOBAL AND INDIAN CAPITAL MARKETS
OVER THE LAST DECADE
market.
The value of global
markets
from
USD 71Markets
trillion in 2002
USDlast
Development
of thecapital
Global
anddoubled
Indian
Capital
overto the
155 trillion in 2007. Since then, the value of financial assets have stayed constant
Decade
at USD 150 trillion levels, due to decline in equity assets (Exhibit 1.1). Capital
market assets have grown faster than GDP in the last 10 years; the penetration
then, the
value of assets/GDP)
financial assets
have stayed
constant
at USD
trillion
due
to decline
in equity
(financial
increased
from
175 per
cent 150
in 2002
to levels,
234 per
cent
in
assets (Exhibit
2011. 1.1). Capital market assets have grown faster than GDP in the last 10 years; the penetration
The value of global capital markets doubled from USD 71 trillion in 2002 to USD 155 trillion in 2007. Since
(financial assets/GDP) increased from 175 per cent in 2002 to 234 per cent in 2011.
Exhibit 1.1
EXHIBIT 1.1
Global Capital Markets have doubled during
2002-2007 period, but have been stagnant since
then due to decline in equity assets
154
13
8
71
5 6
20
16
23
2002
110
9
6
28
41
29
24
43
2005
64
2007
Public debt
securities 2
Financial
institutions bonds
Stock market
capitalization 1
Non-Financial
corporation bonds
Size and penetration of Global Capital Market, 2002-2011
Summary of global financial assets3
USD trillions
Securitized loans
Growth, Percent
2002-07 2007-11
151
14
9
156
13
11
9
9
9
0
0
10
44
42
9
1
37
44
12
12
47
46
8
-8
2009
2011
Global financial assets
as a percent of GDP3
275
234
175
2002
2007
2011
1 Outstanding market value of all listed equity securities (allocated by nationality of issuer)
2 Outstanding face value of bank issues by federal, regional and local governments
3 Nominal value of financial assets and GDP; average exchange rate for the year has been used to convert historical local currency data to USD
SOURCE: McKinsey Global Institute, Bank for International Settlements, Global Insight
McKinsey & Company
The United States and United Kingdom have significant share across key capital market products. The
United States is the largest equities market globally, with market share of 30, 50 and 25 per cent in equity
origination, cash equity trading and equity derivatives trading, respectively. Similarly, the United Kingdom
has a large fixed income marketplace which accounts for around 35 per cent of global foreign exchange
trading.
Knowledge Paper CAPAM 2012
1
1
9
The United States and United Kingdom have significant share across key capital
market products. The United States is the largest equities market globally, with
market share of 30, 50 and 25 per cent in equity origination, cash equity trading
and equity derivatives trading, respectively. Similarly, the United Kingdom has a
large fixed income marketplace which accounts for around 35 per cent of global
foreign exchange trading.
The
USD
and Euro
the key
in which to hold
assetsinternational
and trade capitalassets
marketand
prodThe
USD
and are
Euro
are currencies
the key currencies
in international
which to hold
ucts (Exhibit 1.2).
trade capital market products (Exhibit 1.2).
EXHIBIT 1.2
Exhibit 1.2
U.S. and U.K. are the key contributors to global capital market; USD
continues to be the key trading currency, closely followed by the EUR
Size of global markets by trading centers
Size of global markets by currency
Cash equity trading, 2011
Equity derivatives trading1, 2011
FX trading, 20102
100% = USD 82.9 trillion
100% = 13,787 million contracts
100% = USD 1,264 trillion
48.2
3,476
1,073
4.6
3.5
1,404
1.9
243
494
163
153
$
€
£
240
¥
FX trading, 2010
Commodities trading, 2011
International bond outstanding, 2011
100% = USD 1,264 trillion
100% = 2,750 million contracts
100% = USD 27.6 trillion
464
876
11.3
11.7
146
226
27
78
n/a
2.1
34
$
€
£
0.8
¥
1 Includes stock options and futures, and index options and futures; have added Euronext Liffe (pan-EU exchange) turnover data in UK
2 Total of currencies would add-up to 2x of total FX trading due to double counting
SOURCE: World Federation of Exchanges, Bank for International Settlements (BIS), Global Insight
McKinsey & Company | 5
Asian capital markets continue to grow faster than that of any other region – capital market assets of Asia
Asian capital markets continue to grow faster than that of any other region –
capital
market (financial
assets ofassets/GDP)
Asia grew
by 20
per cent
2002-2007
and
perin 2011.
nancial
penetration
of Asia
increased
frombetween
158 per cent
in 2002 to 170
per 3
cent
cent between
2007-2011
period
(Exhibit
1.3). Similarly,
financial
penetration
However,
Asia’s financial
penetration
is still
below Americas
and EMEA financial
penetration
of 300 and 200
(financial
assets/GDP)
of
Asia
increased
from
158
per
cent
in
2002
to
170
per cent
percent respectively.
in 2011. However, Asia’s financial penetration is still below Americas and EMEA
Stronger growth in capital markets assets also benefited the intermediaries that support the origination and
financial penetration of 300 and 200 percent respectively.
grew by 20 per cent between 2002-2007 and 3 per cent between 2007-2011 period (Exhibit 1.3). Similarly, fi-
trading of these instruments – Asia’s share in the global capital market and investment banking (CMIB) revenue
pool increased
per cent
in 2005 toassets
24 per also
cent inbenefited
2011.
Stronger
growthfrom
in 16
capital
markets
the intermediaries that
support the origination and trading of these instruments – Asia’s share in the
global capital market and investment banking (CMIB) revenue pool increased
from 16 per cent in 2005 to 24 per cent in 2011.
2
10
Developing Indian Capital Markets - The Way Forward
Exhibit 1.3
EXHIBIT 1.3
Asia has outperformed other regions- share in financial assets has risen
from 19 percent in 2002 to 24 percent in 2011
Americas
Equity financial assets
USD trillion, Percent of total
Growth, %
2002-07 2007-11
EMEA
Total financial assets
USD trillion, Percent
APAC
Growth, %
2002-07 2007-11
64
23
30
19
51
43
45
33
22
38
34
28
47
46
22
-8
39
42
15
-5
30
29
26
-11
31
29
32
-7
Debt financial assets 1
USD trillion, Percent of total
48
28
19
53
2002
14
5
46
44
12
3
51
30
19
34
36
33
18
4
29
17
18
23
12
12
19
2005
2007
2009
2011
49
103
156
17
0
44
44
13
0
34
32
21
-1
22
24
20
3
2007
2011
71
110
90
68
Growth, %
2002-07 2007-11
154
53
2002
1 Includes financial/non-financial corp bonds, public debt securities and securitized loans
SOURCE: Dealogic, McKinsey Global CMIB revenue pool database, World Federation of Exchanges
McKinsey & Company
The last 10 years have seen global markets evolve and change as well. Some of the key changes in global
The last 10 years have seen global markets evolve and change as well. Some of the
key changes in global markets that have taken place recently include the
Trading
is conducted electronically across asset classes
following:
markets that have taken place recently include the following:
1.
a. Equities trading is largely electronic; the proportion of electronic trading is 30-60 per cent for different
1. Trading is conducted electronically across asset classes
fixed income products
a. Equities trading is largely electronic; the proportion of electronic trading is
b. New trading venues and channels have emerged – about 50 per cent of total volumes are traded at
30-60 per cent for different fixed income products
alternative platforms in Europe (around 15 per cent MTF, around 15 per cent dark pools, and around
b. New trading venues and channels have emerged – about 50 per cent of total
20 per cent OTC)
volumes are traded at alternative platforms in Europe (around 15 per cent
MTF, around 15 per cent dark pools, and around 20 per cent OTC)
c. Algorithmic strategies are now prominent. About 50 per cent of cash equity trading in United States is
driven by high frequency trading (HFT)
c. Algorithmic strategies are now prominent. About 50 per cent of cash equity
2. There have been
rapid
changesStates
in the client
mix by
andhigh
behaviour
trading
in United
is driven
frequency trading
(HFT)
a. Relationships
and appetite/ability
to lend
than
ever
before when Corporates choose a
2. There have
been rapid changes
inare
theimportant
client mix
and
behaviour
primary bank. Pricing and coverage are considered most important while allocating business
a. Relationships and appetite/ability to lend are important than ever before
b. Buying needs
for investors.
Forbank.
equities,
traditional
investors value
whensignificantly
Corporatesvary
choose
a primary
Pricing
and coverage
are corporate access,
research considered
and global coverage.
Hedge funds
distinctbusiness
needs including balance sheet and multimost important
whilehave
allocating
asset trading
b. Buying needs significantly vary for investors. For equities, traditional
c. There is cross-border
flowcorporate
of capital for
both corporates
andglobal
investors.
More than
half of
equity and
investors value
access,
research and
coverage.
Hedge
funds
fixed income
in Asia
originate
from clients
and taking
investment decisions in
haveinvestments
distinct needs
including
balance
sheetresiding
and multi-asset
trading
the western markets
11
3
d. Clearing regulations are forcing many institutional investors to CCP platforms; even non-obligatory
corporate clients are shifting to CCP to avoid counter-party risk
3. Capital market service providers are consolidating, investing in capability building, and
optimising costs
a. There has been the acquisition/integration of investment and corporate banking businesses for both
foreign and local players
b. The largest players are expanding beyond the home market for future growth. The share of Asia CIB
revenue for the top 10 US/EU banks increased from 17 per cent in 2009 to 22 per cent in 2011
c. Global banks are investing large amounts in technology including multi-asset trading capabilities,
next generation of algorithms, and customising their technology platform for emerging markets
d. Measures are being taken to optimise costs – leading global banks reduced manpower by around
10,000 in the last year; levers (productivity, off-shoring, lean) are being pulled to reduce O&T costs but
the pace of change in cost per trade is slowing down, compelling banks to consider radical changes in
operating models
4. Regulations are having an impact on the trading and economics of the capital market business
a. Basel III regulations will have significant impact on the economics of businesses – ROE is expected to
fall from around 20 per cent to around 12 per cent once fully implemented
b. Volcker type regulations that restrict proprietary trading has resulted in a 50 to 90 per cent decline in
the proprietary trading revenue of leading global banks
c. There is uncertainty over the movement/impact of OTC derivatives products to exchanges/CCP clearing. If it happens at scale, it will result in big shifts in trading volume, revenue margins, capabilities,
and competitor landscape
d. Shadow banking is on the rise. Private Equity players are entering investment banking and pension
funds are focusing on the lending business, etc.
Indian capital markets too have grown significantly over the last decade on the back of strong underlying
economic growth and financial market deepening. Value of financial assets (bonds and equity) increased
from USD 290 billion in 2002 to USD 1.9 trillion in 2011, and capital market penetration (financial assets/
GDP) increased from about 60 per cent in 2002 to about 100 per cent in 2011.
Continuing on the current growth path would make India USD 6 trillion to USD 8 trillion capital market
economy by year 2020 (Exhibit 1.4). Supporting 3-4X the size of current financial markets requires significant
changes across products, market infrastructure and microstructure, and legal and regulatory framework.
12
Indian capital markets too have grown significantly over the last decade on the
back of strong underlying economic growth and financial market deepening. Value
of financial assets (bonds and equity) increased from USD 290 billion in 2002 to
USD 1.9 trillion in 2011, and capital market penetration (financial assets/GDP)
increased from about 60 per cent in 2002 to about 100 per cent in 2011.
Continuing on the current growth path would make India USD 6 trillion to USD 8
trillion capital market economy by year 2020 (Exhibit 1.4). Supporting 3-4X the
size of current financial markets requires significant changes across products,
market infrastructure and microstructure, and legal and regulatory framework.
Exhibit 1.4
EXHIBIT 1.4
India is a USD 1.9 trillion capital market economy today. Continuing
on current growth trajectory would make India USD 6-8 trillion
economy by year 2020
Growth of Indian financial assets1
USD billion
Debt
Equity
7.9
6.6
2.3
1.9
1.8
0.3
0.1
0.2
1.8
0.8
2002
4.2
Are we prepared for USD 6
to 8 trillion capital market
economy in terms of
3.5
1.0
1.2
0.6
0.3
0.5
0.6
0.9
2005
2007
2009
2011
3.7
▪
▪
Products
3.1
Base
Optimistic
▪
Legal and regulatory
framework
▪
Financial intermediation
2020
2,4
EQ3
26
66
152
93
53
53
64
Debt3
32
35
42
51
47
47
56
Market infrastructure
and microstructure
1 Includes financial and non-financial corporate bonds, public debt securitized, securitized loans and equity market capitalisation
2 2011 penetration for India has been used for base case, while 1.2x of base case data for optimistic case forecast of financial assets
3 Financial assets as a percent of GDP
4 At 2011 constant exchange rate
SOURCE: MGI, Global Insight, EIU, McKinsey analysis
McKinsey & Company
Some of the significant changes in Indian capital markets over the last decade are
Some of the significant changes in Indian capital markets over the last decade are
1. Traditional1.product
markets
deepened
(Exhibit
1.5)(Exhibit 1.5)
Traditional
product
markets
deepened
a. Capital market
assetsmarket
increased
by increased
about 6 times
from6 0.3
trillion
cent(58
of GDP)
a. Capital
assets
by about
times
from(58
0.3per
trillion
per to 1.9 trillion
cent
of GDP) to 1.9 trillion (100 per cent of GDP)
(100 per cent of
GDP)
b. Cash
equities
trading
2x, while
options
trading by 25x and 225x,
b. Cash equities
trading
increased
by increased
2x, while by
futures
and futures
optionsand
trading
increased
respectively increased by 25x and 225x, respectively
c. of
The
issuance of
syndicated
loans
increased
to INR 3.8 trillion
c. The issuance
syndicated
loans
increased
by 40x
to INRby
3.840x
trillion
d. of
The
issuance
of corporate
increased
to INR 1.6 trillion
Developing
the
Indian Capital
Market:
Thebonds
Way
forward
d. The issuance
corporate
bonds
increased
by
14x
to INRby
1.614x
trillion
Exhibit 1.5
EXHIBIT 1.5
CAGR
Traditional product markets have deepened
Origination and trading of capital market products, FY 2003-FY 2012
INR trillion
ECM issuance
Corporate bond issuance
1.7
146 -21
xx
2003-08
xx
2008-12
29
82
1.6
0.8
0.1
0
2003
06
09
2012
Cash Equity trading
0.4
06
0.1
09
-9
2012
09
2012
74
78
94
243
43
3
06
06
-9
71
24
2003
0.6
Equity Options trading
103
34
9
2003
1.6
Equity Futures trading
34
38
2003
18
3.8
0.8
0.7
5
Syndicated loan issuance
38
09
2012
2003
06
09
2012
SOURCE: Dealogic, SEBI, NSE
1
5
2003
06
40
09
2012
McKinsey & Company
2. New products were introduced (Exhibit 1.6)
a. Qualified
Knowledge Paper CAPAM
2012institutional placement (QIP) was introduced to meet capital needs
b. Exchange trading of FIC (FX, Rates, Credit) products was introduced
13
2. New products were introduced (Exhibit 1.6)
a. Qualified institutional placement (QIP) was introduced to meet capital needs
b. Exchange trading of FIC (FX, Rates, Credit) products was introduced
c. Exchange traded funds (ETF) in gold, equity and fixed income were introduced
d. Credit default swaps (CDS) was introduced to hedge corporate bond exposure
e. Institutional private placement (IPP) and offer for sale (OFS) introduced recently to help corporates
raise funds to meet minimum public shareholding requirements
The market has responded positively to some of these changes from regulator. For example, QIP was
introduced to help companies raise fund onshore in quick time and check the growth of ADR/GDR. After its
launch since 2007, about INR 100,000 crores have been rasied via QIP route in local markets, which is higher
than funds raised via ADR/GDR route during the same period. Similarly, ETFs are now an asset class worth
INR 11,500 crores from virtually nothing 5 years ago.
The regulators will, therefore, need to keep liberalizing and innovating for driving growth in the Indian
capital markets, while at the same time upgrading capabilities to monitor and manage risk.
Exhibit 1.6
EXHIBIT 1.6
New products have been introduced to meet investor and issuer needs
Trading and origination of Capital Market products, FY 2009-FY 2012
Currency futures
QIP origination
INR trillion
INR billion
432
34
33
233
18
2
2009
Many new products have
been introduced recently to
meet originator and investor
requirements
10
2
10
11
2012
Sec lending and borrowing
Traded quantity in lakh
2009
10
11
ETF trading1
INR billion
738
1
7
2009
10
2012
Credit default swaps (CDS)
▪
Offer for sale (OFS) in stock
exchange
▪
Indian depository receipts
(IDR)
Institutional private
placement (IPP)
170
44
111
11
2012
▪
▪
2009
61
10
93
11
2012
1 Includes Gold, Equity and Fixed Income products
SOURCE: Dealogic, SEBI, NSE
McKinsey & Company
3. Investor participation broadened (Exhibit 1.7)
3. Investor participation broadened (Exhibit 1.7)
a. FII investment limit was enhanced in corporate bonds and G-Sec to USD 20 billion each
a. FII investment
enhanced
corporate
bonds and
G-Sec
USD
b. FII registration
was madelimit
easierwas
which
saw a 3xin
increase
in registration
from
500 into2003
to 20
around
billion
1800 now
each
b. FII registration was made easier which saw a 3x increase in registration
14
from 500 in 2003 to around 1800 Developing
now
Indian Capital Markets - The Way Forward
c. Qualified foreign investors (QFIs) were allowed to invest and investment
c. Qualified foreign investors (QFIs) were allowed to invest and investment norms were further eased
recently
d. The e-IPO and minimum share allotment has been introduced to enhance retail participation
e. The investor protection and education fund enhanced awareness
Exhibit 1.7
EXHIBIT 1.7
Investor participation has broadened- FII example
xx
CAGR
Foreign Institutional Investor (FII) participation in Equity and Debt market
FY 2003-FY 2012
# registrations
Investment in Equity
17
INR Billion
Investment in Debt
37
INR Billion
89
500
Sub-account 6,278
4,967
1,635
488
1,767
FII
437
25
882
-73
-477
2003
06
19
2
502
09
20121
2003
06
09
2012
2003
06
09
2012
1 As on December 2011
SOURCE: SEBI handbook
McKinsey & Company
4. Infrastructure and governance were strengthened (Exhibit 1.8)
4. Infrastructure and governance were strengthened (Exhibit 1.8)
a. SME exchanges were set up recently in which three companies have been listed and there are more
a. SME exchanges were set up recently in which three companies have been
than 10 in the pipeline
listed and there are more than 10 in the pipeline
b. DMA, co-location services, and smart order routing were introduced. These contributed around 30 per
DMA,
co-location
centb.
of cash
equity
trading (in services,
June 2012) and
c.
smart order routing were introduced. These
contributed around 30 per cent of cash equity trading (in June 2012)
The number of independent directors on companies boards is increased
c. The number of independent directors on companies boards is increased
15
EXHIBIT 1.8
EXHIBIT 1.8
Exhibit 1.8
Capital market infrastructure has been strengthenedSME Exchanges
have startedhas
andbeen
received
a good response
Capital
market infrastructure
strengthenedSME Exchanges have started and received a good response
Steps taken to promote growth of SME exchange
Steps
taken tohave
promote
of SME exchange
Regulations
been growth
eased/modified
to get
companies to list on SME platform
Regulations have been eased/modified to get
▪ Companies with issuer capital of upto INR 10 crore can
be listed on SME exchange
▪ Companies with issuer capital of upto INR 10 crore can
▪ be
Submit only half-yearly financial results and are exempted
listed on SME exchange
from giving detailed annual report
▪▪ Submit
only half-yearly financial results and are exempted
Criteria of minimum average pre-tax operating profit of
from giving detailed annual report
INR 15 crore for IPO on main exchange will force
▪ Criteria
of minimum
pre-tax operating profit of
companies
to list onaverage
SME platform
INR 15 crore for IPO on main exchange will force
Strong
surveillance
in-place
for
investor protection
▪ Mandatory UW, including 15% on own account
Strong surveillance in-place for investor protection
▪ Market-markers to provide liquidity for a period of
▪ Mandatory
UW, including 15% on own account
atleast 3 years
▪▪ Market-markers
to provide liquidity for a period of
Minimum IPO and trading lot of INR 1 lakh
atleast 3 years
▪ IPO to be graded, and independent research report for
▪ Minimum
IPO and trading lot of INR 1 lakh
the listed company1
▪▪ IPO
to be graded, and independent research report
for
Trading via “call auction”
and “continuous trading”1
the listed company1
▪1 Only
Trading
via “call auction” and “continuous trading”1
applicable for NSE “EMERGE” platform
EXAMPLE
EXAMPLE
Good response so far from market
intermediaries and companies
Good response so far from market
intermediaries
Intermediaries and companies
▪ 2 exchanges have started this yearIntermediaries
BSE has launched “BSE SME
▪ 2exchange”,
exchangesand
have
started
this yearNSE
has launched
BSE
has launched
“Emerge”
platform “BSE SME
exchange”, and NSE has launched
▪ “Emerge”
~30 intermediaries have registered
platform
as market makers
▪ ~30 intermediaries have registered
Companies
as market makers
▪ 2 companies have listed on BSE
Companies
SME platform, and 1 on NSE
▪▪ 2DRHP
companies have listed on BSE
of 10 more companies
SME platform, and 1 on NSE
already cleared by exchanges for
▪ DRHP
IPO of 10 more companies
cleared by exchanges for
▪ already
Both BSE and NSE hopes to list ~10
IPO
companies each on their platform in
▪ Both
BSE and
and ~100
NSE companies
hopes to listover
~10
FY 2013,
companies
each18
onmonths
their platform in
the subsequent
FY 2013, and ~100 companies over
the subsequent 18 months
SEBI,for
BSE,
Press
reports platform
1SOURCE:
Only applicable
NSE
“EMERGE”
McKinsey & Company
SOURCE: SEBI, BSE, Press reports
McKinsey & Company
India continues to integrate with the global economy and market. International
India
continues
to integrate
with the
economy
market. International
revenue
of the top
100 companies
inglobal
India by
market and
capitalisation
rose from 17
companies in India by market capitalisation rose from 17 per cent in 2002 to 29 per cent in 2009. Similarly,
revenue
topto100
companies
in India
by market
capitalisation
rose from 17
per centof
in the
2002
29 per
cent in 2009.
Similarly,
there
has been a significant
there has been a significant increase in cross-border capital market activity (Exhibit 1.9).
per
cent inin2002
to 29 percapital
cent inmarket
2009. activity
Similarly,
there has
increase
cross-border
(Exhibit
1.9).been a significant
increase in cross-border capital market
activity
Exhibit
1.9 (Exhibit 1.9).
India continues to integrate with the global economy and market. International revenue of the top 100
EXHIBIT 1.9
EXHIBIT 1.9
India continues to integrate with global economy and market
XX
No. of deals
India continues to integrate with global economy and market
XX
No. of deals
Contribution of international revenue
to total revenue
Contribution
of international
Top 100 companies
in India byrevenue
market
to
total revenue
capitalization,
Percent
Top 100 companies in India by market
capitalization, Percent
83
83
17
17
2002
2002
M&A advisory
4
4
136
252
129
2
11
194
252
11
129
194
ECM 136
issuance
75
71
ECM issuance
5
29
25
2006
29
2009
2006
2009
SOURCE: McKinsey Asia Centre, Dealogic
11
2
71
25
22
22
75
SOURCE: McKinsey Asia Centre, Dealogic
16
International issuances of Indian companies
USD billion
International issuances of Indian companies
M&Abillion
advisory
USD
11
5
1
63
5
13
16
1
63
13
16
DCM issuance
2
3
1
2005
2
5
2005
2007
3
10
2007
2009
1
2
2009
5
10
2
5
55
DCM issuance
55
6
6
2011
14
2011
14
9
Although there are clear benefits to integrating with the global markets, it is crucial for policy makers to
mitigate a few challenging risks
– Benefits of integration with global markets
○ Access to international debt markets is less volatile than access to international banking markets
○ The cost of capital decreases because of access to a wider, more diverse set of investors
○ There is better diversification of funding sources
○ The domestic market develops faster by leveraging global standards and practices and skills for international intermediaries, for example, additional pressure to increase transparency and adopt tested
international standards
○ The increased competition decreases the cost of intermediation, thereby making capital markets more
attractive
– Risks of international integration
○ Lack of effective hedging mechanisms, inconsistent transparency requirements, and lack of a welldefined global infrastructure can make emerging economy markets more volatile, with a potential
negative impact on the economy
○ Integration in a broader capital market exposes local markets to greater price integration – that is, it
makes the pricing of assets in one geography dependent on pricing changes and potential shocks in
other geographies
○ Currency risks increase
○ Domestic institutions potentially decrease in importance as large international competitors enter the
market
Capital Market Penetration in India and its Role in Supporting
Economic Growth
Though India’s capital markets have grown in the last decade, there is significant room for growth when compared with developed economies (Exhibit 2.1). Most developed markets’ financial depth is over 2.5 times that
of India, with sophisticated capital markets allowing corporations and government to raise more funds for
productive investments. However, the development of capital markets requires a good institutional framework, which allows the free movement of capital both within a country and across borders.
17
requires a good institutional framework, which allows the free movement of
capital both within a country and across borders.
Exhibit 2.1
EXHIBIT 2.1
India’s capital markets have significant room for growth
with financial depth still lagging that of developed markets
Emerging
Developed
2011, end of period
Financial depth1, Value of bonds, and equity as a percentage of GDP
Percent of GDP
500
Hong Kong
Deeper financial markets
450
Ireland
400
US
UK
350
Japan
Spain
Malaysia
Switzerland
France
South Africa
Greece
Canada
Italy
Korea
Singapore
Finland Australia
Thailand Brazil
Mexico
Germany
China
300
250
200
150
Philippines
100
India
50
Indonesia
Argentina
0
1,000
Russia
Israel
10,000
100,000
GDP per capita at purchasing power parity
$ per person, log scale
1 Includes equity market capitalization, corporate/FI bonds, govt securities, and securitized loans
SOURCE: McKinsey Global Institute Financial Stock Database 2012
Equity penetration in India at 80 per cent of GDP (2009-11) is comparable to large markets but is prone to
penetration
in India
at 80
per cent
of GDPhigh,
(2009-11)
is comparable
toislarge
frequent Equity
fluctuations.
In-addition,
cost of
trading
is relatively
institutional
participation
low, and
markets but is prone to frequent fluctuations. In-addition, cost of trading is
relatively high, institutional participation is low, and market liquidity beyond top
Similarly,stocks
India’sisG-sec
market is2.2).
fairly large, but lacks liquidity across maturities. However, the largest
low (Exhibit
market liquidity beyond top stocks is low (Exhibit 2.2).
challenge in India is in the corporate bond market, where both the size and liquidity of the markets is low
Developing
the Indian
Capital
Market:
The Way
Similarly,
India’s
G-sec
market
is forward
fairly
large, but lacks liquidity across maturities.
However, the largest challenge in India is in the corporate bond market, where
Exhibit 2.2
EXHIBIT
both the2.2
size and liquidity of the markets is low (Exhibit 2.3).
(Exhibit 2.3).
India is comparable with large markets w.r.t. Equity penetration, but
scores low on liquidity, cost of trading and institutional participation
Benchmarking the depth of Indian equity market
Mature markets benchmarks
(US, UK and Germany)
China
India
Size of
equity
market
(2009-11)
▪ Average equity market
▪ High penetration of ~80
▪ High penetration ~80 percent,
▪
▪ Average ECM issuances of
Market
liquidity
(2011)
▪ Top-5 percent shares by
Criteria
▪
▪
▪
penetration (m-cap/GDP) of
105 percent
Average ECM issuances
range between USD 30-250
billion per year
turnover have ~80 percent
share in market turnover
Trading velocity of 1.5x
(turnover 1-leg/m-cap)
High free float. Range
between 80-90 percent
percent, but its highly volatile
Average ECM issuance of >
USD 100 billion (including Hshares) per year
USD 17 billion per year
▪ Liquidity penetrated across
▪ In-line with mature markets-
▪
▪
▪
▪
broader market- top 5 percent
shares only have ~30 percent
share in market turnover
Trading velocity of 1.9x
Free float of ~50 percent
top 5 percent shares have 70
percent share in market
turnover
Low velocity of 0.7x
Low free float of ~40 percent
Cost of
trading
(2010)
▪ Lowest globally due to low
▪ Highest in Asia at ~70 bps,
▪ ~44 bps, equally split
Institutional
participation
(2011)
▪ Institutional share range
▪ Institutional share of ~30
taxes- range between 15-20
bps
due to high market impact
cost
percent (all from DII’s)
SOURCE: Elkins McSherry, WFE, Bloomberg, Dealogic, Global Insight, McKinsey Global Institute
18
but its highly volatile
EXHIBIT 2.3
between commission and
fee/market impact
percent; FII share of ~18
percent
11
Indian G-Sec market is fairly large, but lacks liquidity across maturities; in-
Cost of
trading
(2010)
▪ Lowest globally due to low
▪ Highest in Asia at ~70 bps,
▪ ~44 bps, equally split
Institutional
participation
(2011)
▪ Institutional share range
taxes- range between 15-20
bps
due to high market impact
cost
between commission and
fee/market impact
percent (all from DII’s)
percent; FII share of ~18
percent
SOURCE: Elkins McSherry, WFE, Bloomberg, Dealogic, Global Insight, McKinsey Global Institute
Exhibit 2.3
EXHIBIT 2.3
Indian G-Sec market is fairly large, but lacks liquidity across maturities; inaddition, size and liquidity in Corporate bond market is low
Benchmarking the depth of Indian debt market
Criteria
United States
China
India
Benchmark
yield curve
▪ Market determined yield
▪ High liquidity across
▪ Market determined yield
Size of
outstanding
debt marketGsec and
Corp bonds
(2009-11)
▪ High G-Sec penetration of
▪ Low G-Sec penetration of ~26
▪ Low G-Sec penetration of ~37
▪
▪
▪ Underdeveloped Corp bond
Market
liquidity
(2011)
▪ G-Sec trading velocity of 11x, ▪ G-Sec trading velocity of 0.9x,
Corp debt
profile
(2011)
▪ Capital market is the primary
curve across maturities
▪
maturities resulting into a
fairly good yield curve
~90 percent (G-Sec/GDP)
Corp bond penetration is
~110 percent (Corp bond/
GDP)
Average issuance per year
– GSec ~USD 2,200 bn
– Corp bonds ~USD 700 bn
and Corp bond trading
velocity of 0.4x
▪
▪
source of capital- Corp bond
has 39 percent share in total
capital raised by Corp/FI
curve only for longer term
maturity- 8 to 12 years
percent
Fast growing Corp bond
market- penetration of 24
percent
– GSec ~USD 280 bn
percent
▪
▪ G-Sec trading velocity of 1.4x,
velocity of 0.5x
Top-5 securities have 10
percent share in total trading
▪ Bilateral loans are the
primary source of capitalCorp bond has 15% share in
total capital raised
market- penetration of 5
percent
– GSec ~USD 140 bn
▪
velocity of 1.5x
G-Sec trading concentrated- 2
long dated papers have 85
percent share
▪ Bilateral loans are the
primary source of capitalCorp bond has 9% share in
total capital raised
SOURCE: Bank for International Settlements (BIS), McKinsey Global Institute, CCIL, SIFMA, Dealogic, Wind
Going forward, India will require INR 145 trillion over the next 5 years to ensure GDP growth of 7.5 per cent,
achieving
2.5
per cent
inINR
capital
productivity
(Exhibit
2.4).
The
capital
while gradually
lowering
inflation
togrowth
6 per cent
and145
achieving
per
centnext
growth
in capital
productivity
Going
forward,
India
will
require
trillion2.5
over
the
5 years
to ensure
requirement
is also
increase
given Basel
III
norms
and funding
for cent
growth
7.5
perset
cent,
while
lowering
tofunding
6 per
and
(Exhibit GDP
2.4). The
capitalof
requirement
istoalso
set togradually
increase
given
Basel
IIIinflation
norms
and
for infrastructure
infrastructure growth. Primarily, these needs would be met by internal accruals,
bank credit and net foreign borrowings but around INR 26 trillion would be
but around INR 26 trillion would be required from capital markets. The business as usual growth of capital
required from capital markets. The business as usual growth of capital markets
markets would provide around INR 15 trillion but the gap of around INR 11 trillion must be bridged through
would provide around INR 15 trillion but the gap of around INR 11 trillion must
critical reforms
12 be(Exhibit
bridged2.5).
through critical reforms (Exhibit 2.5).
Exhibit 2.4
EXHIBIT 2.4
growth. Primarily, these needs would be met by internal accruals, bank credit and net foreign borrowings
In India, ~Rs. 145 trillion of capital will be required over the next
5 years to ensure 7.5% GDP growth rate from next fiscal onwards
Capital required till FY17 (FY12–17)
INR ‘000 crore
Assumptions
▪
GDP growth
rate: 7.0% for
FY13 and 7.5%
for FY14-17
▪
Inflation: 8.90%
in FY12
decreasing to
6% in FY17
▪
Capital
productivity:
Increasing at
~2.5% annually
Capital requirement
expected to be higher
with Basel III norms and
infrastructure growth
funding
3300-3400
3100-3200
2850-2950
2350-2450
FY 13
SOURCE: RBI; SEBI; NAS; McKinsey analysis
14000-15000
2650-2750
FY 14
FY 15
FY 16
FY 17
Total
capital
requirement
19
Exhibit 2.5
EXHIBIT 2.5
~INR 26 trillion capital will be required from the capital markets
to ensure ~7.5% GDP growth for the next 5 years
Assumptions
▪
▪
▪
▪
▪
GDP growth
rate: 7.0% for
FY13 and 7.5%
for FY14-17
Deposit
growth:
Bank deposit
growth – 1719%
Bank CD ratio:
75-76% NBFC
CD ratio: 85%
Corporate
savings rate:
~8%
Net foreign
borrowing:
~1.2% of GDP
Requirement from capital market
Rs. ‘000 crore
xx Capital that can be
raised w/o reforms
14,500
5,300
5,900
BAU growth in capital
markets will only provide
~INR 14.5 trillion of
capital; ~INR 11 trillion
gap to be bridged by
reforms
750
2,550
~1450
Total capital Internal
requirement accruals
Bank credit Net foreign
borrowings
Gap to be
bridged
by capital
markets1
1 Public and private capital market excluding bank borrowing
SOURCE: RBI; SEBI; NAS; McKinsey analysis
.
Key Reforms to Develop a Vibrant Market
KEY REFORMS TO DEVELOP A VIBRANT MARKET
To meet the additional capital required for growth including Basel III requirements and infrastructure funding
meet key
the policy
additional
capital
growth
including
IIIequity.
requirements
needsTo
in India,
decisions
must required
drive alongfor
three
key themes
across Basel
debt and
and infrastructure funding needs in India, key policy decisions must drive along
three key themes across debt and equity.
2. Strengthen the equities microstructure and market infrastructure
1. Create a diversified investor base
3.1.Drive
changes
and growth investor
in the debtbase
markets
Create
a diversified
2. aStrengthen
equitiesbase
microstructure and market infrastructure
Create
diversifiedthe
investor
A deep
broad
investorand
basegrowth
with a range
investment
styles and objectives is required to provide a
3. and
Drive
changes
in theofdebt
markets
combination of liquidity and long-term stability. Three distinct categories of investors have a complementary
Create
a diversified
investor
base
role in
market development
as they
pursue diverse
market and investment strategies with diverse objectives
and time
horizons
3.1).
A deep
and (Exhibit
broad investor
base with a range of investment styles and objectives is
to provide a combination of liquidity and long-term stability. Three
• required
Buy and hold
of investors have a complementary role in market development
• distinct
Buy andcategories
turn
they pursue
diverse market and investment strategies with diverse objectives
• as
Dynamic
investors
and time horizons (Exhibit 3.1).
Each category defines critical factors of market development including market liquidity, stability and
■ Buy
efficiency,
skilland
poolhold
and infrastructure building (Exhibit 3.2).
■ Buy and turn
■ Dynamic investors
20
Each category defines critical factors of market development including market
Each category defines critical factors of market development including market
liquidity, stability and efficiency, skill pool and infrastructure building (Exhibit
liquidity, stability and efficiency, skill pool and infrastructure building (Exhibit
3.2).
3.2).
Exhibit 3.1
EXHIBIT 3.1
EXHIBIT 3.1
Three distinct categories of investors have a complementary role in
Threedevelopment
distinct categories
investors
havemarket
a complementary
role in
market
as theyofpursue
diverse
and investment
market
development
as
they
pursue
diverse
market
and
investment
strategies with diverse objective and time horizon
strategies with diverse objective and time horizon
Buy & turn
Buy & turn
Herd
behaviour
Herd
behaviour
Market depth and long
term funding
Market
depth and long
term funding
Pension funds defined
Pension funds contribution
defined
contribution
Kill liquidity
Kill liquidity
Banks
Banks
Retail
Retail
investors
investors
Pension funds Pension
funds defined
benefits
defined benefits
Rol
e Rol
e
Insurance
Insurance
companies
companies
Examples
Examples
Risks
associated
Risks
associated
Active traders
andActive
arbitrators/
traders
proprietary
and arbitrators/
proprietary
trading
desks
trading desks
▪ Seek high relative
returns
▪ Seekabove
high relative
benchmark
returns above
benchmark
▪ Seek safe,
predictable,
▪ Seek safe,
Leverage
Leverage
Mutual funds
Mutual funds
average
returns
predictable,
average returns
▪ Match future
liabilities
▪ Matchwith
future
▪ Seek high
absolute
▪ Seek high
returns
absolute
returns
▪ Employ variety of
strategies
▪ Employtovariety of
liabilities
with
investment
income
investment income
strategies
minimize
risks,toand
minimize
generate
highrisks, and
generate high
returns
returns
Investment objectives
Investment objectives
SOURCE: Interviews; McKinsey analysis
SOURCE: Interviews; McKinsey analysis
Alternative
Alternative
Investors
Investors
▪ Specialized
▪ Specialized
funds
▪ Highfunds
net worth
▪ High net worth
individuals
individuals
▪ Investment
▪ Investment
bank
bank
McKinsey & Company
McKinsey & Company
Exhibit 3.2
EXHIBIT
3.23.2
EXHIBIT
High contributor
High contributor
Average
Average
Poor contributor
Poor contributor
Each
investor
category
defines
critical
factors
Each
investor
category
defines
critical
factors
of of
market
development
market
development
Market liquidity
Market liquidity
Market
efficiency
Market
efficiency
Market
stability
Market
stability
SkillSkill
pool
pool
Critical factors of market development
Critical factors of market development
▪ Tightness
– i.e., small bid/ask spreads
▪ Tightness
– i.e., small bid/ask spreads
▪ Depth
– i.e., size of pool
▪ Depth – i.e., size of pool
▪ Resilience
– i.e.,
adjustment speed
▪ Resilience
– i.e., adjustment speed
“Buy
“Buy
“Dynamic
“Buy
“Buy
“Dynamic
and hold”
and turn”
investors”
and hold”
and turn”
investors”
▪ Price
discovery
▪ Price
discovery
▪ Avoid
herd
behavior
▪ Avoid
herd
behavior
▪ Avoid
feedback
tracking
▪ Avoid
feedback
tracking
▪ Investments
skills
▪ Investments
skills
– –Credit
assessment
Credit
assessment
– –Investment
sophistication
Investment
sophistication
▪ Trading
skills
▪ Trading
skills
▪ Arbitrage
skills
▪ Arbitrage
skills
Infrastructure
Infrastructure
building
building
▪ Use
of product
innovation
▪ Use
of product
innovation
▪ Need
for
rating
agencies
▪ Need for rating
agencies
▪ Need
for for
clearing
systems
▪ Need
clearing
systems
▪ Help
building
legal
infrastructure
▪ Help
building
legal
infrastructure
SOURCE:
Interviews;
McKinsey
analysis
SOURCE:
Interviews;
McKinsey
analysis
McKinsey
& Company
McKinsey
& Company
Four key reforms are required across investor categories to enhance their participation in capital markets:
■
■
■
■
Drive household savings to capital market products
Promote growth in mutual fund AUM through improved distribution
1515
Build retirement participation for pension AUM growth with the New Pension scheme (NPS)
Relax capital market investment restrictions on insurance and pension/ provident funds
21
Four key reforms are required across investor categories to enhance their
participation in capital markets:
■ Drive household savings to capital market products
■ Promote growth in mutual fund AUM through improved distribution
■ Build retirement participation for pension AUM growth with the New
Pension scheme (NPS)
■ Relax capital market investment restrictions on insurance and pension/
provident funds
■ Drive household savings to capital market products:
Indian households still pool 50 per cent of their savings in the form of physical assets at over twice the
■ Drive household savings to capital market products:
share seen in developed economies and even developing economies such as Malaysia (Exhibit 3.3).
Indian households still pool 50 per cent of their savings in the form of physical
Even within
theat
household
financial
savings
share,
only 8 economies
per cent areand
invested
in capital markets with
assets
over twice
the share
seen in
developed
even developing
currency and
deposits
forming
the bulk
of the total
savings
3.4).
economies
such
as Malaysia
(Exhibit
3.3).financial
Even within
the (Exhibit
household
financial
savings share, only 8 per cent are invested in capital markets with currency and
deposits forming the bulk of the total financial savings (Exhibit 3.4).
Exhibit 3.3
EXHIBIT 3.3
DRIVE HOUSEHOLD SAVINGS TO CAPITAL MARKET PRODUCTS
Indian household savings invested in physical assets
must be lowered to reach the level of developed economies
Stock of physical savings is much higher
in India than in other geographies…
USD trillion, 2008
India
US
70
33
Physical
… and the share of physical savings has
been consistent over 10 years
INR ‘000 crore
504
725
1,550
49
44
50
51
56
50
FY 02
FY 05
FY 10
30 3
67
Financial
115
Developed
economies
Germany
Developing Malaysia
economy
50
50
34
66
13
1
SOURCE: Central bank websites
McKinsey & Company
Exhibit 3.4
EXHIBIT 3.4
Higher proportion of household savings should be directed towards
capital market products
16
Split of total household financial savings in India
INR ‘000 crore, Percent of total
207
247
313
419
Currency
10
11
14
13
Deposits1
24
28
25
23
2
1
100% =
MF
Equities and
debentures2
Insurance funds
8
4
14
Pension and
Provident funds
26
Claims on Govt3
14
FY00
19
19
21
16
551
36
2
20
15
28
0
FY02
FY04
11
54
6
16
0
761
15
21
11
6
13
-5
FY06
8
24
FY08
17
0
10
FY10
1 Deposits with SCBs constitute >95% of the total depoits
2 Excluding mutual funds for FY00 to FY08 and including mutual funds in FY10
3 Government claims include investment in government securities and investment in small savings
SOURCE: RBI, CSO
22
McKinsey & Company
The following proactive steps will help Developing
drive household
savings
into
capital- The
market
Indian
Capital
Markets
Way Forward
products.
The following proactive steps will help drive household savings into capital market products.
• Replicate risk/returns of physical investments through capital market linked products such as gold
ETFs and gold saving scheme to drive retail participation. Support these by educating customers
through RMs and IFAs to increase their familiarity with the products. Broker sales channels and bank
tie ups with AMCs can also maximise reach to retail investors
• Drive individual product market changes (ETFs, mutual funds). Launch direct investments through
real estate investment schemes (REIS) to address investor needs not fulfilled by present alternatives.
Attune the risk profile to cater to the risk appetite of different segments; for example, low risk segments
can invest in ready properties for assured rental income, while high risk ones can invest in upcoming
properties for capital appreciation
• Deepen reach into tier 2/3 cities coupled with investor education programmes. Currently, the top eight
cities account
for almost
of the
Developing
the Indianthree-fourths
Capital Market: The
Way mutual
forward fund ownership while only holding one-third of
the overall income pool. Expand into tier 2/3 cities through investor education programmes along the
lines of developed economies with deeper financial markets such as Germany (Exhibit 3.5).
Korea witnessed a 50 per cent CAGR in life insurance premium over a
• Korea witnessed
a 50 per
CAGR in life
premium
over
a decade
decade
aftercent
an integrated
set insurance
of awareness
building
moves
fromafter
the an integrated set
of awareness building
moves
the government
and regulator.
Korea’sannounced
Department of Treasury
government
andfrom
regulator.
Korea’s Department
of Treasury
1977
as “Year
the “Year
of Insurance”.
The government
promoted
insurance
announced 1977
as the
of Insurance”.
The government
promoted
insurance
extensively through
extensively through television commercials, short movies and newspaper
advertisements. Insurance was made a priority industry in the national
industry in the national economic growth plan. An insurance modernisation plan was formed to
economic growth plan. An insurance modernisation plan was formed to
better promotebetter
product
development,
channel management
asset management.
promote
product development,
channel and
management
and asset These initiatives
increased the insurance
premium
50 per cent
CAGR between
1977 and
1988. at 50 per
management.
Theseatinitiatives
increased
the insurance
premium
cent CAGR between 1977 and 1988.
television commercials, short movies and newspaper advertisements. Insurance was made a priority
EXHIBIT 3.5
Exhibit 3.5
Investor education program example: Marketing/education campaign by
German fund association- “Investment funds. Only for everybody."
▪ German fund association BVI, in which most
AMs in Germany are represented, launched
educational campaign "Investment funds. Only
for everybody." in October 2010
▪ The website has four main sections
– "How investing money works"
– "These are funds"
– "There you find funds"
– "Successful with funds"
▪ The language used on the website is very
simple and informal, targeted at people
without any knowledge in finance
▪ Paragraphs which explain a subject are held
short, no information overload
▪ Some subjects are explained with little,
interactive comics making a topic very intuitive
▪ A question box allows to ask any question
related to funds without prior registration, a
BVI representative answers publicly in a short
and simple way
▪ Download section with one-page overviews on
different fund related topics, e.g. "10 questions
regarding to investing in a fund"
▪ Working paper for download explaining how
investment funds help the society
▪ Represented in major social networks to
increase awareness
SOURCE: BVI, nur-fuer-alle.de
McKinsey & Company
■ Promote growth in mutual fund AUM through improved distribution
Entry load abolishment in 2009 drastically reduced the incentives for distributors
affecting new business growth (Exhibit 3.6). Lower industry profitability due to
23
■ Promote growth in mutual fund AUM through improved distribution:
Entry load abolishment in 2009 drastically reduced the incentives for distributors affecting new business
growth (Exhibit 3.6). Lower industry profitability due to stable operating costs and declining revenues
is also affecting channel margins available to distributors. To promote growth in mutual funds AUM,
following measures could be taken
• Introduce a variable load regime (entry and exit) to cater to different distribution channels for
growth beyond the top 10 cities.
• Expand distribution channels for last mile reach. Promote tie-ups with operators to access remote
channels and online distribution to improve distributor economics (Exhibit 3.7). Additionally,
– Expand distribution channels for last mile reach. Promote tie-ups with
access through PSU bank branches would also facilitate reach beyond the top 10 cities with minimal
operators to access remote channels and online distribution to improve
economics (Exhibit 3.7). Additionally, access through PSU
bank branches would also facilitate reach beyond the top 10 cities with
minimal investments
Exhibit 3.6
investments
distributor
EXHIBIT 3.6
GROWTH IN MF AUM THROUGH IMPROVEMENT IN DISTRIBUTION
Mutual fund AUM has stagnated over the last 2 years
AUM growth
Key challenges
USD billions; end of period
+38%
-3%
▪
-2%
+47%
-22%
128
124
112
– Entry load
abolishment in 2009
reducing incentives
for distributors
122
– Lower profitability of
87
mutual fund industry
affecting channel
margins available to
distributors
75
▪
Dec’06 Mar’08
Mar’09
Increasingly unfavorable
distribution channel
economics
Mar’10
Mar’11
Mar’12
Low retail participation in
financial assets with
majority of savings in
physical form, majority in
the top 10 cities
1 PMS not included
SOURCE: AMFI; McKinsey analysis
24
McKinsey & Company
Exhibit 3.7
EXHIBIT 3.7
GROWTH IN MF AUM THROUGH IMPROVEMENT IN DISTRIBUTION
Asset managers can consider tie ups with existing
operators for a better presence across remote channels
Airtel provides mChek a commercial Mcommerce tool
Description
▪
▪
Partners
▪
▪
▪
▪
SMS based mobile
payment platform developed in
collaboration with VISA
Transactions secured by 6 digit
'mChekPIN' number
VISA, Master Card
HDFC Bank, ICICI Bank,
Corporation Bank, State Bank
of India, NDB Bank, Citi, Seylan
Bank
Dialog Telekom, You Telecom
Makemytrip.com, Yatra.com,
Futurebazaar.com, Sify Mall,
Indiatimes Shopping,
BookmyShow, Home Shop 18
CASE EXAMPLE
Services
▪
▪
▪
▪
▪
Prepaid recharge; toll recharge
Bill payments
Flight ticket and movie booking
Insurance premium payment
Any valid Indian Visa / MasterCard Credit Card
How mChek works for mutual funds
▪
▪
▪
▪
▪
Register for mChek and select 6-digit pin number
Setup debit instructions by linking debit card
Select mutual fund scheme for purchase – lump
sum investment or SIP – with amount details
Purchase after entering mChekPIN number
Maintenance activities e.g., switching between
schemes, redemption also through mChek
Results so far
▪
▪
▪
More than 1 million users in Jan 2009
1.2% of Airtel’s subscriber base uses mChek
UTI, Birla Sun Life already using mChek
SOURCE: Press, Company Website
McKinsey & Company
■ Build ■retirement
participation
for pension
AUM growth
with New
Pension Scheme
Build retirement
participation
for pension
AUM growth
with New
(NPS) Pension Scheme (NPS)
NPS 2009 has not performed as per expectations since its launch. While recent changes in regulations
NPS 2009 has not performed as per expectations since its launch. While recent
changes in regulations have been in the right direction, further steps are required to
boostcustomer
participation.
• Increase
awareness and financial literacy: Educate customers on the features and benefits
have been in the right direction, further steps are required to boost participation.
of NPS 2009 through creative means. For example, provide a short explanation on the tax breaks and
– Increase customer awareness and financial literacy: Educate customers on
benefits ofthe
investing
in and
NPSbenefits
2009 on income
forms
for thecreative
self-employed
features
of NPStax
2009
through
means.and
Forsmall businesses.
Mandate distribution
channelsa selling
pension plans
AMCs/Insurers
to disclose
example, provide
short explanation
onfrom
the tax
breaks and benefits
of to customers
the features
of NPS 2009
vis-à-vis
plans they
(for for
example,
how the fees on
investing
in NPS
2009 the
on income
taxsell
forms
the self-employed
andfunds in NPS
businesses.retail
Mandate
distribution
channels selling
plans from
are lower small
than comparable
funds).
Leverage partnerships
with pension
existing players
to enhance
AMCs/Insurers
disclose to customers
the features
coverage of
focus segments to
(self-employed,
casual worker)
of NPS 2009 vis-à-vis
the plans they sell (for example, how the fees on funds in NPS are lower
• Ensure better distributor economics: The current incentives for distribution channels selling NPS
than comparable retail funds). Leverage partnerships with existing players
2009 is unattractive. This is especially so when these incentives are compared to what they make
to enhance coverage of focus segments (self-employed, casual worker)
from selling other financial products. PFRDA needs to improve the commission structure to pay for
– Ensure better distributor economics: The current incentives for distribution
distribution
channels selling NPS 2009 is unattractive. This is especially so when these
• Maintain variable
management
fees for
fund managers
to from
manage
investments
professionally: Fees
incentives
are compared
to what
they make
selling
other financial
products.
needs toand
improve
theofcommission
structure
to pay
should vary
by asset PFRDA
classes managed
quantity
funds managed,
and should
befor
benchmarked
to market distribution
competitive institutional fees (EPF/NPS 2004), so that the best professional managers are
available to investments. Also, vary fees based on type of management (for example, active versus
passive management)
Knowledge Paper
CAPAM 2012
20
25
■ Relax capital market investment restrictions on insurance and pension/ provident
funds
Life insurance inflows have remained stagnant over the last 3 years (Exhibit 3.8) – protection levels were
only 55 per cent of GDP in 2009 as compared to around 250 per cent in the US – with limited deepening of
the financial savings pool. Restrictive capital market investment guidelines for (non-ULIP) life insurance
funds prevent investments in capital market products. A minimum of 50 per cent investment in G-Sec
and approved securities, and 15 per cent in infrastructure must be covered by insurance funds. The rest
of the 35 per cent can be invested in other asset classes including equity/bonds, but there are restrictions
on the quality of capital market assets (for example, investment allowed in AA or higher rated corporate
debt). These limitations severely limit the play for insurance funds. Steps must be undertaken to promote
their investments in capital market products:
• Allow higher direct exposure to equity and debt assets, and indirect exposure via mutual funds
(Exhibit 3.9)
• Make gold ETF a separate class of investment for life insurance and pension funds
• Permit insurers to participate in CDS, SLB, and reverse repo/repo trades in government and
corporate debt securities
Exhibit 3.8
EXHIBIT 3.8
RELAXING CAPITAL MARKET INVESTMENT RESTRICTIONS ON INSURANCE AND PENSION FUNDS
Growth in Indian life insurance industry has slowed down post regulatory
changes in 2010
Life insurance AUM
USD billions, end of period
+12% p.a.
+23% p.a.
156
272
297
Capital market investment
guideline
▪ Minimum 50% of
237
investment in G-Sec and
approved securities and
15% in infrastructure; max
35% can be invested in
other asset classes
including equity/ bonds
171
▪ Further, investment allowed
in AA or higher rated
corporate debt only
2008
2009
2010
2011
2012
1 Equity component at market value, debt at book value
SOURCE: Life Insurance council, IRDA, Disclosures, Team Analysis
McKinsey & Company
EXHIBIT 3.9
26
Developing
Indian relaxed
Capital Markets - The Way Forward
Investment in capital market assets should
be gradually
Benchmarking Life Insurance investment guidelines
Chin
Indi
Korea
approved securities and
15% in infrastructure; max
35% can be invested in
other asset classes
including equity/ bonds
171
156
▪ Further, investment allowed
in AA or higher rated
corporate debt only
2008
2009
2010
2011
2012
1 Equity component at market value, debt at book value
SOURCE: Life Insurance council, IRDA, Disclosures, Team Analysis
McKinsey & Company
Exhibit 3.9
EXHIBIT 3.9
Investment in capital market assets should be gradually relaxed
Benchmarking Life Insurance investment guidelines
Chin
a
Indi
a
Unit Linked
Asset class
Traditional
Traditional
Banking
deposit
▪ No Limit
Securities &
Bonds
▪ Corporate bond < 20% ▪ G-Sec: min of 25%
▪ Convertible bond < 20% ▪ G-Sec (including above)
Real estate
▪ No Limit
▪ NA
Infrastructure
Projects
▪ Maximum of 5%
▪ Minimum 15%
Other asset
classes
including
equity
▪ Equity < 10%
▪ Mutual fund < 10%
▪ Other assets: No Limit
▪ No restrictions
on asset
allocation in
equities
and other approved
securities1: Not less
than 50%
including bonds,
debentures, ABS,
equity etc.
▪ Other approved
(including stakes in
medical agencies,
PE/VC, unlisted
commercial banks,
ABS/MBS
investments e.g. corp.
bonds, equity, CP etc.
subject to exposure and
prudential norms: Max
35%
– Other than approved
Investments (not
meeting above
criterion) : max 15%
Includes Corp
bonds, equity,
debentures,
CBLO, MM
instruments,
CP, and FD’s
Only allowed to
invest in very
high-rated
paper, e.g., AA
and above for
Corp bonds
Korea
Traditional
Upper limit of investment (by
investment class ▪ Credits to the same individual or
the same corporation : 3%
▪ Bonds or shares issued by the
same corporation : 7%
▪ Credits extended to the same
borrower or the bonds and shares
issued by the same borrowers:
12%
▪ Credits extended to the same
individual or the same corporation
or dominant shareholder that
surpass % of total asset : 20%
▪ Credit to subsidiary company : 2%
▪ Bonds or shared issued by
subsidiary company: 3%
▪ Credit to the same subsidiary
company : 10%
▪ Real Estate : 15%
▪ Unlisted Stock : 10%
▪ Foreign Currency or overseas real
estate : 30%
▪ Derivatives: 5%
▪ Margin for domestic or overseas
future transaction : 3%
1 Securities which have a guaranteed principal and interest payment from the Central and State government
SOURCE: FSS, IRDA, Regulatory websites
McKinsey & Company
Several capitalDeveloping
market capital
investment
restrictions
also
exist for also
pension
– investments
the
Indianmarket
Capital
Market:
The Way
forward
Several
investment
restrictions
existfunds
for pension
funds – are restricted to
investments
restricted
to government
securitiesinstitutions,
and securities
issues
government securities
and are
securities
issues
by public financial
with
onlyby
a public
small component
financial
institutions,
with only
small sector
component
10 per cent)
available
(about 10 per cent)
available
for investment
in aprivate
bonds(about
and securities
(Exhibit
3.11). Pension fund
for investment in private sector bonds and securities (Exhibit 3.11). Pension fund
managers demonstrate a conservative investment philosophy to secure guaranteed
participation. Investment guidelines must be relaxed to promote participation from pension funds.
returns,
further limiting participation. Investment guidelines must be relaxed to
22
promote participation from pension funds.
managers demonstrate a conservative investment philosophy to secure guaranteed returns, further limiting
Exhibit 3.10
EXHIBIT 3.10
Size and structure of Pensions assets in India- large asset base of ~USD
150 billion, largely coming from mandatory employer scheme
Workforce by
employer type
Govt. sector
4.0%
PILLAR 2: Employer-sponsored Size of
retirement schemes (mandatory) scheme

• DB plan
▪ New Pension Scheme

Non-funded
liability

▪ Employees Provident
$62.1 billion
▪ Private pension, gratuity

$38.9 billion
 None)
-
 None
NPS 2009 is a Pillar 3
scheme trying to
substitute for Pillar 2 for
- unorganized workforce
(NPS) 2004
Private
sector1
10.0%
Fund (EPF)
& owned PF trusts
Self-employed /
SMEs
$0.4 billion
51.0%
Casual Workers2
34.0%
Total = 457 million
PILLAR 3: Individual
retirement savings3
465K crores
Public Provident Fund:
▪ 3 million subscribers
▪ $28.2 billion
Retail pension plans by
AMCs & Insurers:
▪ 3 million plans in
force
▪ $15.8 billion
▪
Nearly 70% of
retirement savings in
India are in Pillar 2
schemes
▪
Self-employed and
Casual workers who
constitute ~85% of
workforce do not have
access to Pillar 2
schemes
▪
Pillar 3 schemes are
utilized by affluent
individuals with high
disposable income as
a result participation
and coverage is rather
low (~1% compared to
100% in Pillar 2
schemes that are
mandatory)
133K crore
1 Excludes individuals working for business enterprises with <=20 employees
2 Represents individuals who do not have steady jobs and their earnings are barely enough to meet their day-to-day living expenses
3 Public Provident Fund and Pension plans offered by AMCs and Life insurance firms. Participation is voluntary
SOURCE: EPFO; PFRDA; Controller of Accounts; AMFI; IRDA interviews; press articles; McKinsey analysis
McKinsey & Company
27
Exhibit 3.11
EXHIBIT 3.11
Restrictive investment guidelines for pension and provident funds which
limit participation in capital market should be gradually relaxed
Investment guidelines of EPFO schemes and suggested changes
Category
Investment guidelines
Amount to be invested
1▪ Central
Government
securities
▪
Central Government Securities and /or units of such Mutual
Funds which have been set up as dedicated Funds for
investment in Government securities (and approved by SEBI)
▪
25 percent
2▪ (State) Government
securities
▪
State Government securities and/ or units of such Mutual
Funds which have been set up as dedicated Funds for
investment in Government securities (and approved by SEBI);
Securities the principal whereof and interest whereon is fully
and unconditionally guaranteed by the Central/State govt
▪
15 percent
▪
3▪ Securities issued
by public financial
institutions
▪
Bonds/ Securities of Public Financial Institutions including
public sector banks; and /or short duration (less than a year )
Term Deposit Receipts (TDR) issued by public sector banks
▪
30 percent
4▪ Combination of
above securities
▪
To be invested in any of the above three categories as
decided by their Trustees
The Trusts, may invest up to 1/3rd of 30 percent in private
sector bonds/ securities, which have an investment grade
rating from at least two credit rating agencies.
▪
30 percent
▪
▪
▪
EPFO and the exempted provident fund schemes to be allowed to invest in corporate bonds of private sector
borrowers in line with MoF guidelines. This can initially be restricted to bonds with a credit rating of AAA
Change current investment guidelines for pension and other retirement benefit from ownership based criteria
(public sector, private sector) to end use (infrastructure) and ratings based criteria
SOURCE: EPFO annual report 2011, Interviews, McKinsey analysis
McKinsey & Company
Strengthen the equities microstructure and market infrastructure
Strengthen the equities microstructure and market
infrastructure
Strong market infrastructure and microstructure will lead to efficient price discovery, lower trading costs,
efficient clearing and settlement of trades, support varying trading strategies, and ensure high transparency
Strong market infrastructure and microstructure will lead to efficient price
discovery, lower trading costs, efficient clearing and settlement of trades, support
varying
trading
strategies,markets
and ensure
high transparency
marketrisk
information.
Comparing India
with other
developed
suggests
that India hasofstrong
management practices/
of market information.
systems, high order
processing
speed
(fordeveloped
the leading
exchange),
to strong
report risk
information by
Comparing
India with
other
markets
suggestsand
thatnorms
India has
exchanges/market
regulator practices/systems,
(Exhibit 3.12, 3.13).high order processing speed (for the leading
management
exchange), and norms to report information by exchanges/market regulator
(Exhibit 3.12, 3.13).
However, there is scope to improve the trading latency, order processing speed, control mechanisms to check
Developing
thetrading
Indian Capital
Market:3.12,
The Way
forward
bulk volumes, and
cost of
(Exhibit
3.13,
3.14, 3.15).
However, there is scope to improve the trading latency, order processing speed,
Exhibit 3.12
EXHIBIT
3.12
control mechanisms
to check bulk volumes, and cost of trading (Exhibit 3.12,
EQUITY MARKET INFRASTRUCTURE AND MICROSTRUCTURE
3.13, 3.14,
3.15).
India has strong risk management systems and high transparency, trading
latency and cost of equity trading requires improvement (1/2)
Benchmarking India market infrastructure and microstructure with other markets
Mature markets
(US, UK, and Germany)
Asia financial centers and
developed markets
Trading
latency
▪ Significant investments to build low
▪ Recent efforts reducing trade
Processing
capability
▪ Strong IT capabilities to support high
▪ At par with developed markets with ▪ Recent efforts to build processing
Criteria
latency trading technologies
– LSE - 0.1 ms
– Nasdaq - 0.25 ms
– Chi-X – 0.4 ms
▪
24
speed trading orders
– NASDAQ – 250,000 orders/sec
Additional measures (like circuit
filters, throttling etc) to control order
flow and ensure stability in the market
latency inline with developed
markets
– SGX – 0.1 ms
– ASX – 0.3 ms
considerable processing facilities
– SGX – 1 mn orders/sec
– ASX – 100,000 orders/sec
– HKeX – 30,000 orders/sec
▪ Relatively high trading latency
– NSE - 2.5 ms
– BSE - ~10 ms
capacity but inadequate control
measures still leave the market
with high risk of failure due to bulk
volumes (like “flash crash” etc)
– NSE – 200,000 orders/sec
– BSE – 20,000 orders/sec
Competitive
efficiency (due
to alternative
trading
platforms)
▪ High competitive efficiency due to
▪ Increasing competition with
▪ Limited competition and dominance
Cost of
trading
(2010)
▪ Low cost of trading
– UK – 15 bps
– US – 16 Bps
– Germany – 19 bps
▪ Comparable to mature markets
– Singapore – 24 bps
– Australia – 20 bps
– HK – 28 bps
▪ High cost of trading: ~44 bps, due
considerable number of ATS sharing
over 50% trading volumes
– ECN/MTF – BATS, CHI-X
– Broker crossing networks –
Sigma X, Instinet
growing presence of ATS (market
share of ~5%)
– CHI-X, Liquidnet with minor
presence in Singapore,
Australia & HK
SOURCE: Elkins McSherry, Aite, Celent, press and web search, McKinsey
28
India
EXHIBIT 3.13
by leading player (NSE)
– No alternative platforms due to
regulatory prohibition
to high taxes
McKinsey & Company
efficiency (due
to alternative
trading
platforms)
Cost of
trading
(2010)
considerable number of ATS sharing
over 50% trading volumes
– ECN/MTF – BATS, CHI-X
– Broker crossing networks –
Sigma X, Instinet
growing presence of ATS (market
share of ~5%)
– CHI-X, Liquidnet with minor
presence in Singapore,
Australia & HK
▪ Low cost of trading
– UK – 15 bps
– US – 16 Bps
– Germany – 19 bps
▪ Comparable to mature markets
– Singapore – 24 bps
– Australia – 20 bps
– HK – 28 bps
by leading player (NSE)
– No alternative platforms due to
regulatory prohibition
▪ High cost of trading: ~44 bps, due
to high taxes
SOURCE: Elkins McSherry, Aite, Celent, press and web search, McKinsey
McKinsey & Company
Exhibit 3.13
EXHIBIT 3.13
Benchmarking market infrastructure in Indian equity market
Mature markets
(US, UK, and Germany)
Asia financial centers and
developed markets
Market
transparency
▪ Extensive reporting requirements for
▪ Closely moving towards developed ▪ Efforts to improve transparency but
Risk
management
system
▪ Robust risk management system
▪ Continuously adopting best
▪ At par with mature markets with
Market
education
▪ Significant efforts towards building
▪ Investing in investor education to
▪ Considerable efforts towards
Criteria
all market participants
– Exchanges – Daily requirements
to report price/volume details
– Brokers – Mandatory to submit
position details across scrip's,
products, clients etc
India
market practices
– ASIC (Australia) pressing for
transparency by refining norms
in niche products (SLB, short
selling)
across entire trading value chain
– Pre trading – Stringent licensing
requirements and entry norms for
all market participants
– Trading and post trading – Real
time surveillance and margining
facilities
– Violations – Additional systems
to handle default situations and
prevent market failure
practices from developed markets
– ASX established “Audit and
Risk” committee and policies
in line LSE
investor awareness about capital
market products
– Deutsche Bourse established
“Capital Markets Academy”
improve retail participation in the
market
SOURCE: McKinsey analysis, expert interviews
still far behind developed markets
– Exchanges - Adequate norms for
daily reporting
– Brokers – Ineffective standards
still allowing brokers to
manipulate trades to avoid tax
liabilities, significant size of grey
market operations in IPO etc
adequate risk management
practices
– Real time risk monitoring
system
– Advanced CCP (NSCCL) with
extensive post trading facilities
and margining system
– Additional safety mechanism
(like Investor protection funds)
to handle extreme situations
market education (but long way to
go to cover huge investor base)
– NSE introduced “Certifications
in Financial Markets”
McKinsey & Company
Exhibit 3.14
EXHIBIT 3.14
Indian exchanges need to minimize trading latency like developed markets
to remain attractive to new age investors
Average latency1 (round trip)
Milliseconds, 2011
LSE Turquoise
0.1
SGX
0.1
Nasdaq OMX
0.3
ASX
0.3
Chi-X
0.4
NYSE Arca
NSE
Leading players are investing to reduce trading
latency
25
Introduction of new platform “SGX
Reach” (cost $250 mn) in Aug 2011
to reduce trade latency to <0.1 ms
and build processing capability to 1
mn orders/sec
Launched US$ 140 million trading
system “Arrowhead” in Jan 2011
enhancing processing speed to 5
milliseconds and exec ute 4.7 mn
orders/day
0.9
Adopted new trading technology
“ASX trade” in Dec 2010 reducing
trade latency to 0.3 ms and
increasing processing capacity to
over 100,000 orders/sec
2.5
TSE
5.0
OSE
5.0
HKeX
BSE
Launched new trading platform
“Genium INET” in 2010 reducing
latency by over 60% to <0.25 ms and
doubling processing capacity to over
250,000 orders/sec
9.0
10.0
1 Time is takes to get an order confirmation from exchange (may or may not result into order execution)
SOURCE: Press and Web Search, Aite, Celent
McKinsey & Company
EXHIBIT 3.15
of equity
Knowledge Paper Cost
CAPAM
2012 trading in line with developed markets is critical to attract
foreign flows and keep markets onshore
Cash equities cost of trading1
Derivatives
29
enhancing processing speed to 5
milliseconds and exec ute 4.7 mn
orders/day
0.4
Chi-X
0.9
NYSE Arca
Adopted new trading technology
“ASX trade” in Dec 2010 reducing
trade latency to 0.3 ms and
increasing processing capacity to
over 100,000 orders/sec
2.5
NSE
TSE
5.0
OSE
5.0
Launched new trading platform
“Genium INET” in 2010 reducing
latency by over 60% to <0.25 ms and
doubling processing capacity to over
250,000 orders/sec
9.0
HKeX
10.0
BSE
1 Time is takes to get an order confirmation from exchange (may or may not result into order execution)
SOURCE: Press and Web Search, Aite, Celent
McKinsey & Company
Exhibit 3.15
EXHIBIT 3.15
Cost of equity trading in line with developed markets is critical to attract
foreign flows and keep markets onshore
Cash equities cost of trading1
Bps, 2010
Japan
Derivatives
Transaction cost of NIFTY Futures, 2011
13.1
UK
16.0
US
16.3
Germany
Commission1
Cost head
NSE4
SGX4
Fees2
Securities Transaction Tax
17.0
NIL
Stamp duty
2.0
NIL
Service Tax
2.1
0.5
Regulatory Fee
0.2
NIL
Exchange Fee
1.7
5.1
Total
23.0
5.7
For a round trip transaction
29.1
11.2
Market Impact3
19.3
Australia
20.8
Singapore
24.1
HK
28.7
India
43.5
High cost of trading has resulted into some
trading moving offshore - ~50%5 of total
NIFTY Futures is traded on SGX (based on OI)
1 Includes broker commission and charges 2 Include like taxes and local fee’s 3 Refers to the difference between the price at which a stock trade is
executed and the average of that stock’s high, low, opening and closing prices during the day 4 Rupees per lakh of turnover
SOURCE: Press and Web Search, Elkins McSherry (survey with institutional investors)
McKinsey & Company
High frequency trading (HFT) is one of the biggest innovations in global equity trading. It has seen strong
High frequency trading (HFT) is one of the biggest innovations in global equity
trading. It has seen strong growth in all developed markets and it accounts for
States (Exhibit 3.16).
more than 50 per cent of trading volume in the United States (Exhibit 3.16).
growth in all developed markets and it accounts for more than 50 per cent of trading volume in the United
While the jury is still out on whether HFT is required for the market to function efficiently, the trading
While the jury is still out on whether HFT is required for the market to function
strategy continues
at trading
a fast pace
andcontinues
has now to
started
penetrating
efficiently,
strategy
grow at
a fast pacedeveloping
and has nowmarkets like India.
26 to growthe
It is important started
for us to
learn from
other developed
markets,
place guidelines
to govern HFT, and
penetrating
developing
markets like
India.put
It isinimportant
for us to learn
developed
markets, put
place guidelines
HFT, and
simultaneously from
investother
in market
infrastructure
to in
support
the growthtoofgovern
HFT (Exhibit
3.17).
simultaneously invest in market infrastructure to support the growth of HFT
(Exhibit 3.17).
Exhibit 3.16
EXHIBIT 3.16
High-frequency trading (HFT) is an established phenomena in developed
markets with several pros and cons
HFTs have gained significant foothold
in developed markets …
… bringing several benefits along with various risks
Adoption of HFT in US
% of total equities trading volume
Benefits (offered by HFTs)
Risks (associated with HFTs)
▪
▪
Systemic failure : High frequency
order volumes may lead to system
failure and market crash (eg. flash
crash on NYSE in May, 20101)
▪
Higher volatility : With higher
volumes, HFT leads to short term
volatility and price fluctuations in
the market
▪
Unfair advantage over other
market participants : Better
access (in terms of time) to market
information and prices provides
unjust benefit over other investors
(especially retail investors)
▪
Market abuse : Misuse of IT
capabilities for fake orders to
create false sense in market over
price/volume of a stock
+12% p.a.
15
2006
27
31
07
08
54
42
09
2010
▪
HFT user composition
% of total HFT volumes in US, 2009
▪
Hedge funds
6
46
Broker-dealer
prop desks
48
Independent
prop firms
Increase in liquidity : High
frequency market makers
(including HFs, prop, trading firms
etc) contribute significant liquidity
in market (over 50% of total
equities trading volume in US)
leading to high certainty of
execution
Tighter spreads : Drives market
efficiency and reduces spread via
high speed market making
Reduces cost of trading and
lowers trading latency : Drives
competition among trading
platforms to reduce latency and
trading fee’s
1 HFT and algo trading was the underlying cause of the crash, when Dow Jones Industrial Average plunged about 1000 points or about nine percent the
biggest one-day point decline in the history
McKinsey & Company
SOURCE: Celent, TABB Group, LSE, ESMA, Mckinsey experts
30
Exhibit 3.17
EXHIBIT 3.17
India is witnessing strong growth from HFT; strong market infrastructure
and appropriate regulations are needed to avert any negative
consequences
Case example of Europe
ESMA building rigorous rules
applicable across all EU members
▪
Extensive guidelines for trading
platforms and market intermediaries
to improve IT and organizational
capabilities
– Circuit filters and throttling
techniques to prevent erroneous
order booking
– Build strong algo testing and
surveillance system
– Develop internal IT to monitor
HFT trades and trace faulty trading
strategies to origination
Key learning's for India
▪
▪
Current infrastructures leaves market
exposed to risk and requires further
upgradation (e.g., further increasing #
order processing capability, IT systems
to ensure market stability)
Governance of high frequency traders
SOURCE: Press; regulators websites
McKinsey & Company
Drive changes
and growth
in themarkets
debt markets
Drive changes
and growth
in the debt
Two broad
are needed
develop
strong debt
market
Two changes
broad changes
are to
needed
to adevelop
a strong
debt
market
■ Developing
marketmarket
infrastructure
and microstructure
■ Developing
infrastructure
and microstructure
■ Developing
a benchmark
yield curve
forcurve
price discovery
■ Developing
a benchmark
yield
for price discovery
■ Developing market infrastructure and microstructure
Like equity
markets, strong
market
infrastructure
and
microstructure is critical for debt markets to
■ Developing
market
infrastructure
and
microstructure
develop and function efficiently. We recommend three priority measures to enhance the Indian debt
Like equity markets, strong market infrastructure and microstructure is critical for
efficiently. We recommend three priority
measures
to
enhance
the
Indian
debt
market
infrastructuretool
and microstructure
- Encourage adoption of CDS as a credit enhancement
marketdebt
infrastructure
microstructure
markets toand
develop
and function
○ Encourage
banks, insurance
companies,
fundsenhancement
and other market
– Encourage
adoption
of CDSmutual
as a credit
toolparticipants to rapidly put in
place a CDS policy
□
Encourage banks, insurance companies, mutual funds and other market
○ Educate and create awareness about this product amongst key participants – for example, form a subparticipants to rapidly put in place a CDS policy
committee comprising treasury/investment officers from PSU banks, insurance companies and penandup
create
about
thisbonds
product
amongst
key
sion funds□to Educate
jointly come
withawareness
structures to
launch
backed
by CDS
participants
– for example,
formfor
a sub-committee
comprising
○ Consider a move
to a centralised
clearing CCIL
CDS to limit participants’
need to form a collateral
treasury/investment
officers
from
PSU
banks,
insurance
companies
and
management system
pension funds to jointly come up with structures to launch bonds backed
by CDS
28
31
– Transform credit rating agencies (CRA) and the credit rating process to provide
greater transparency
○ Ensure that entities which offer credit rating as a service are registered as a rating agency
○ Ensure that entities not registered as a CRA are not be allowed to “rate organisations” in a manner that
is not calibrated to CRA’s rating process
○ Disallow CRA’s from carrying out businesses like consulting on instrument design, etc., even by an
independent arm
○ Transform corporate governance norms for CRA’s, for example, the functions responsible to assign
initial credit rating and subsequently monitor it should be separate
○ Establish that all credit ratings, once obtained, must be published by the enterprise who is the issuer
and have purchased the service
– Revamp the corporate bond trading infrastructure and settlement system
○ Establish an integrated trading and settlement system for corporate bonds (like NDS-OMS for G-Sec)
○ Take steps to boost liquidity in corporate bond repos. Exempt them from CRR/SLR, encourage MF to
participate, and explore the need to create a CBLO type of market
○ Move from DVP-I to DVP-III system
In-addition, several changes are required to deepen corporate bond market (Exhibit 3.18)
Exhibit 3.18
EXHIBIT 3.18
DEBT MARKET INFRASTRUCTURE AND MICROSTRUCTURE
Several changes are required to deepen Corporate bond market
Key initiatives for development of Corporate bond market1
Stage-1: Attract investors to
participate in the market (0-6
months)
1.
2.
3.
4.
5.
Exempt corporate bond repo
borrowings from CRR/SLR
Implement MoF guidelines on
investments for pension funds
Change investment guidelines
for pension and other
retirement products from
ownership based criteria to end
use industry criteria in line with
insurance
Ensure MF are allowed to
participate in corporate bond
repos
Clarify securitisation guidelines
and capital requirement on
second loss piece
Step-2: Deepen market and
establish systems (6-12
months)
1.
2.
3.
4.
5.
6.
7.
1 Some of the points are already covered earlier
SOURCE: Interviews, McKinsey analysis
32
Encourage market making and
participation in corporate bonds
across participants
Permit repo in Corporate bonds
<1 year residual maturity
Review impact of CDS
guidelines and explore other
credit enhancement
mechanisms
Establish a uniform definition of
infrastructure
Uniform stamp duty across
states
Allow seamless settlement of
secondary market trades
between entities registered with
either NSCCL or ICCL
Encourage reissuance of
corporate bonds under the same
ISIN, in order to ensure large
floating stock
Step-3: Institutionalize systems
and move towards fundamental
reforms (12+ months)
1.
2.
3.
4.
5.
6.
7.
Accept interest earned by FIIs
on their corporate bond holdings
from withholding tax
Allow PD’s to invest up to 50 per
cent of net owned funds in
single name bonds
Wave tax on capital gains and
interest income (upto Rs. 20,000
p.a.) for retail clients
Remove cap on yield for
infrastructure bonds
Review progress of
infrastructure debt funds and
suggest changes
Establish an integrated trading
and settlement system (like
NDS OMS for G-Sec)
Move from DVP I to DVP III
system for Corporate bonds
McKinsey & Company
■ Developing a benchmark yield curve for price discovery
A benchmark security helps price other assets, provides hedging mechanisms
■ Developing a benchmark yield curve for price discovery
A benchmark security helps price other assets, provides hedging mechanisms against interest risks,
and creates a core financial market for participants. A liquid government debt market is the best way to
create a benchmark asset because it is the only credible risk-free asset.
India has large G-Sec market whose role as an effective benchmark for the debt market can be enhanced
(Exhibit 3.19). Today, the trading in G-Sec is confined to a few securities. Just two securities, “8.79 per
cent GS 2021” and “9.15 per cent GS 2024” account for 50 per cent and 37 per cent of the total traded
volume respectively.
Exhibit 3.19
EXHIBIT 3.19
BENCHMARK YIELD CURVE FOR PRICE DISCOVERY
India has a large G-Sec market, but its role as an effective benchmark for
the debt market can be enhanced
India has a fast growing G-Sec market
G-Sec O/S
Dec 2011 Trading
USD Bn
velocity2
Growth
CAGR %
2002-11
While India G-Sec outstanding is spread across maturities,
trading is concentrated within the 8 – 12 year maturity
Years to maturity
G-Sec O/S
As on Mar 2012,
% of total
Trading concentration1
(Jan-Mar 2012)
% of total
512
1.4
14
0-2
14%
1%
1509
0.9
24
2-4
12%
1%
151
3.4
18
4-8
25%
8%
498
4.7
13
8-12
20%
87%
320
3.0
14
12-20
14%
2%
12788
3.9
12
10%
1%
12863
11
12
> 20
Of this ‘8.79% GS 2021’ and ‘9.15% GS 2024’ are
the top 2 traded securities accounting for 50% and
37% of the total traded volume respectively
1 Analysis of top 10 traded securities which account for 87% of the total traded volume
2 Only one leg of trading is considered to calculated trading velocity
SOURCE: BIS, Asian Bonds Online, MoF – Public Debt Management Report Jan – March 2012, CCIL report
McKinsey & Company
Five reforms are required to broaden and deepen the G-Sec market in India.
Five reforms
are required to broaden and deepen the G-Sec market in India.
– Consolidate
instruments
– Consolidate
instruments
○ Issue securities
across maturities
○ Buy back or □switch
retire/extinguish
Issueoperations
securitiestoacross
maturities G-Sec with small outstanding amounts
□ Buybase
back or switch operations to retire/extinguish G-Sec with small
– Widen investor
outstanding
amounts
○ Simplify access for investors like trusts, corporates, etc.
○ Encourage
gilt funds
– long-term
Widen investor
basethrough appropriate incentives (like tax breaks, liquidity support,
etc.)
□ Simplify access for investors like trusts, corporates, etc.
○ Introduce a web-based system of access to NDS-OM
Encourage
long-term
funds through
appropriate
(likeand
taxpost offices
○ Attract more□retail
participation.
Somegilt
initiatives
to achieve
this could incentives
be using banks
as distribution breaks,
channelsliquidity support, etc.)
□
Introduce a web-based system of access to NDS-OM
Attract more retail participation. Some initiatives to achieve this could
Knowledge Paper CAPAM
2012banks and post offices as distribution channels
be using
□
□
Ensure seamless movement of securities from the present SGL form to
33
○ Ensure seamless movement of securities from the present SGL form to demat form
○ Keep uniform charges to open/maintain gilt accounts; waive off settlement charges for retail
– Develop market makers
○ Allocate specific securities to each PD for market making and, if required, rotate the stock of securities
among the PDs at periodic intervals
○ Evolve a suitable framework to assess the performance of PDs vis-à-vis market making and provide
incentives like refinance/IDL based on these performance measures
– Re-examine the HTM and repo market guidelines
○ Bring down the upper limit on the HTM portfolio from the present 25 per cent of total investments.
This will help release more G-Sec into the market, thus increasing liquidity
○ Enable the use of securities bought in the repo market for short selling
– Reform Foreign Institutional Investor (FII) rules
○ Increase investment limit for FIIs in G-Sec from current USD 20 bn
○ Review withholding tax guideline for FIIs
○ Review SEBI guidelines that require FIIs to surrender their limits in debt securities (including G-Sec)
when these are sold when they mature
○ Amend guidelines prescribing transactions of FIIs in G-Sec only through exchange brokers
□□□
Despite the current uncertainty and fluctuations in the Indian capital markets and the economy, we believe
that the Indian capital markets are set to grow in line with the economy, taking India to a 6-8 trillion USD
capital market economy by 2020. In order to be prepared for and facilitate the 3-4X growth in Indian capital
markets, key reforms are needed to overcome challenges and set the foundation for the robust growth of the
Indian capital markets. We hope the ideas outlined in this report act as a starting point for addressing these
challenges and setting the foundation for the next phase of growth in India’s capital markets
34
Primary and Secondary
Markets
35
36
Current Status of the Indian Primary Market & Key
Learnings from other Developing Markets
Mr Sanjay Sharma, M.D., Head- Equity Capital Markets, India, Deutsche Equities India Pvt. Ltd.
The equity markets in India saw a tipping point in 2004 when over US$10bn of equity was raised for Indian
issuers and Sensex closed at 6,600 levels. What followed was an extended bull run with the peak in 2007 when
over US$35 bn was raised and Sensex closed above 20,000 mark. The subprime crisis of 2008 deeply impacted
the global and Indian market sentiment as equity raising in India fell dramatically to US$14.2 bn and India’s
market cap dropped to a third from US$1.8 tn to US$0.6tn. While the markets consolidated in 2009 and
recovered in 2010 as Sensex went up from 9,647 in 2008 to 17,465 in 2009 and 20,509 in 2010, the equity raising
again saw return as US$22.6 bn and US$31.6 bn was raised in 2009 and 2010 respectively. However, the
current European sovereign crisis has made a huge impact on Indian capital markets. Continued volatility
has driven the investors away from the markets and even the issuers are reluctant to issue equity at valuations
lower than historical average. While the 2008 crisis was considered as external and acute; the current global
crisis is seen as chronic and elongated and that is coupled with problems in domestic economy. The past
two years (CY2011 and 2012) have not even seen the total issuance cross US$10bn mark in India in each of
the years.
Initial public offerings (‘IPOs’) are considered as the benchmark for new capex in the economy as newer
companies float issuances to finance their growth cycle. For the first bull cycle since 2005, IPO market saw
its high in 2006 and 2007 when US$9.5bn and US$9.9bn of equity was raised respectively. Following the lull
of 2008 and 2009, IPOs made a comeback in 2010 when over US$11.5bn was raised including the blockbuster
‘Coal India’ IPO. The current calendar year has seen a miniscule amount of less than US$300 mn of funds
being raised through IPOs.
Convertible bonds which were very popular in 2006 and 2007 during the bull cycle have not seen their return
as investors have been reluctant to participate. A lot of mid-cap issuers who issued the bonds in 2007 are
facing difficulty as their equity prices never touched the heights of 2007 to convert and the rising dollar has
made refinancing of those bonds very expensive.
Amongst the different methods used for follow-on offering, further public offerings (FPOs) were very popular
in 2006 to 2008, especially for the government disinvestment programme. But issuers have started to use
quicker means of equity raising as volatile markets have considerably shortened the equity raising windows.
Recognizing this, even the Department of Disinvestment (‘DoD’) has preferred taking up shorter routes like
Offer For Sale (‘OFS’) over FPOs.
37
Equity raising (US$bn)
Year
CB
FO
IPO
Sensex
Total
India Mcap
(US$b)
India VIX
Average Year End Average Year End Average
Year End
2004
2.3
4.9
2.9
10.1
5,563
6,603
n.a.
n.a.
277
386
2005
3.6
10.1
2.4
16.1
7,393
9,398
n.a.
n.a.
438
546
2006
5.4
7.1
9.5
22.0
11,440
13,787
n.a.
n.a.
663
816
2007
8.2
16.9
9.9
35.1
15,564
20,287
31.4
25.4
1,122
1,815
2008
0.6
8.3
5.3
14.2
14,493
9,647
39.4
43.1
1,100
637
2009
3.7
14.6
4.2
22.6
13,701
17,465
37.3
23.4
932
1,301
2010
1.6
18.5
11.5
31.6
18,207
20,509
21.8
16.6
1,430
1,629
2011
0.8
7.7
1.4
9.8
17,778
15,455
23.8
27.1
1,375
1,005
2012
0.4
7.4
0.3
8.0
17,117
18,000
21.5
15.0
1,147
1,127
26.5
95.5
47.3
169.4
Total
Source: Bloomberg, BSE
Recent challenges / issues for the capital markets
The current macro-economic environment in India is extremely challenging. Macro headwinds are strong
while policy momentum is slow; political uncertainties are mounting; and risks of disorderly adjustment in
the real and financial sectors are now not insignificant.
• Slowing growth: The current GDP growth rate of 5.3% is the slowest in nine years. Now India is
expected to grow at 6.0-6.5% annually vs. assumption of 9% a year ago.
• Persistent high inflation: WPI has been hovering in the 8-12% range for over two years now. Despite the
hawkish stance adopted by RBI, inflation has not been tamed. Slowing output and uncertain monsoon
have further tied down RBI’s options to combat slower growth with easing monetary policy.
• Higher fiscal deficit: In the first four months of the fiscal year, the government has touched 51.5% of the
annual target due to rising fuel subsidies. Despite the recent fuel hike, government is expected to have
consolidated deficit of 8.0% of GDP.
• Impending credit rating downgrade: Ballooning subsidies, weak revenues and fiscal deficit if left
unchanged, would push India’s sovereign rating to a sure path of downgrade.
• Falling Rupee: The macro concerns have led to the slide of Indian Rupee as it is down 19% since
beginning of 2011 and 14% in the last twelve months. US$ traded at an all time high of INR57.16 on
22nd June.
38
As seen in the past, these issues can be tackled by determined policy making and appropriate monetary
impetus. Recently, Government has shown its commitment to India’s growth by taking affirmative action but
there is a need to pass long pending structural legislations like DTC and GST and provide stability for policy
framework in future.
The current regime has been accused to be embroiled with policy indecisiveness and political unwillingness
which has worried the investors. In addition, lack of timely clarity on the policies like GAAR from a weakened
government entangled in scams like 2G, ‘Coal-gate’, etc has further spooked the investor sentiment. To be
truly impressed, investors would like to see return of the capex cycle which is stuck due to slow decision
making by the government as companies building the infrastructure are facing multiple headwinds like
unavailability of raw materials and financing.
The back-to-back announcements on fuel price rationalization and opening up FDI (for multi-brand retail,
aviation, power exchanges and broadcasting services) against a backdrop of near unanimous scepticism over
government’s ability to meander through the volatile minefield of coalition politics is a huge signal, symbolic
of the government’s reform commitment and an endorsement of its recognition of the urgency to put the
economy above politics, for now.
Recent regulatory changes for the capital markets
In wake of falling capital raising by Indian issuers and low participation by the domestic investors, SEBI
has been proactive and is making the necessary tweaks to the regulatory framework to shore up investor
sentiment and kick start the fund raising process.
1. Enhancing retail participation in the capital markets:
• Widening the reach for applying in IPOs via over 1,000 location in electronic form (eIPO)
• Extending the reach of ASBA by asking banks to expand to all their banks in a phased manner
• Ensuring that all investors get at least a minimum lot and increasing the minimum application size to
Rs. 10,000-15,000 instead of Rs. 5,000-7,000
2. Facilitating capital raising by issuers
• Fast-track issuances can be done by companies with average free float market cap of Rs. 3,000 crore
instead of Rs. 5,000 crore earlier.
• SEBI registered Alternative Investment Funds such as SME Funds, Infrastructure Funds, PE funds,
VCFs, etc. can participate (up to 10%) in the promoter’s contribution to encourage professionals
and technically qualified entrepreneurs who are unable to meet the requisite 20% contribution by
themselves to also raise funds via IPOs.
39
• To facilitate companies to reach minimum public float as per SCRR, additional routes like IPP, OFS,
Rights and Bonus issues are allowed in addition to any other method based on pre-approval on case
to case basis
• More flexibility to change up to 20% in amount proposed to be raised in the objects of the issue in RHP
without re-filing instead of existing 10%
• Allow raising funds via QIPs at up to 5% discount to the SEBI floor price
• More comprehensive annual disclosure similar to a 20F filing updated by the prospectus
3. Enhancing market integrity and investor confidence
• Eligibility criteria for issuers coming through “profitability route” now needs a minimum pretax
operating profit of Rs. 15 crore
• Other issuers need to raise funds via SME platform or compulsory book building route (albeit with
higher QIB participation of 75% instead of 50%)
• Additional mechanisms to monitor issue proceeds
• No withdrawal or lowering of size of bids permitted for non-retail investors to avoid misleading
signals to investors
• Price band along with financial information now to be published at least 5 working days prior to
opening of the issue instead of existing 2 working days so that markets can analyse the issue
• To bring transparency in capital raising, ‘General Corporate Purposes’ as an object cannot exceed 25%
of issue size
• Employee benefit schemes can now be made only as per SEBI (ESOS and ESPS) guidelines, 1999.
Existing schemes not in conformity with the same would be given time to align them. These schemes
are prohibited from acquiring shares from secondary markets
Further changes which can streamline the IPO and delisting processes
1. Speeding up the IPO process
In India, we have one of the most efficient secondary markets as settlement process takes only T+2 in
line with global markets. The IPO process on the other hand is considerably deficient as it still takes
T+12 days for a company to list after issue closes. Even though the allotment process is speeded up since
the advent of demat accounts, the dependency on the physical forms and cheque system for the retail
investors has resulted in significant delays as well as errors in the system. If SEBI, decides to mandatorily
have ASBA / e-IPO for all type of investors, IPOs can be settled in the T+2 process similar to the leading
financial markets globally. This can increase the attractiveness of global investors to invest in Indian
IPOs who are generally reluctant to lock-in funds for such a long period.
2. Streamlining the delisting process
The current delisting process unduly favours the arbitrageurs as reverse book building can throw up any
price (promoter only has option to accept or reject this price). Also there is a requirement to garner over
40
50% of public shareholding through this process even if promoter owns more than 90% which (given
the geographically distributed retail holding) reduces the chances of success and hence dependence on
arbitrageurs to ensure success. Currently companies are faced with the precarious position of either
accepting unrealistically higher price to delist or offer a huge discount to dilute down to minimum
public float in such companies. If the promoters are allowed to purchase the shares at a pre-determined
(with public shareholders having the option to accept or reject the price) and allow delisting if they own
more than 90%, there would be more execution certainty.
Depth of the secondary markets
Indian secondary markets have undergone systemic change since 2004. Cash volumes have started falling
(both in US$ terms and relative to market cap) and F&O has replaced the mind share of the trader community.
Average cash volumes which went up from US$1.5 bn in 2004 to US$4.4 bn in 2007 have now tapered off
to US$2.6 bn. Even in relative terms, we see cash volumes as percentage of average market cap has seen a
consistent slide from 0.5% in 2004 to 0.2% in 2012. F&O volumes on the other hand have seen record jump
as it went up from US$2.3 bn in 2004 to around US$28 bn in 2011. Even in relative terms, they have gone up
from 0.8% to 2.0% in the same time period.
Retail participation which was very active pre-crisis (as seen by high cash to F&O) has gone down quite a
bit since then, as investors who lost money in the bear markets of 2008 and 2011 have now decidedly stayed
away from stock market and moved their portfolio to other assets like real estate and gold. Institutional as
well as high frequency programme trading have been very active during the recent times as seen by record
F&O turnover.
Table 1
Year
Average India
Mcap (US$bn)
Average Cash
Turnover (US$bn)
Average F&O
Turnover (US$bn)
Cash turnover
/ Mcap (%)
F&O turnover /
Mcap (%)
Cash /
F&O (%)
2004
277
1.5
2.3
0.5
0.8
66.4
2005
438
1.9
3.5
0.4
0.8
53.5
2006
663
2.6
6.3
0.4
0.9
41.0
2007
1,122
4.4
11.7
0.4
1.0
37.8
2008
1,100
4.3
11.0
0.4
1.0
39.1
2009
932
4.4
13.3
0.5
1.4
32.7
2010
1,430
4.2
22.0
0.3
1.5
19.3
2011
1,375
3.0
28.0
0.2
2.0
10.8
2012
1,147
2.6
22.7
0.2
2.0
11.3
Source: Bloomberg, BSE, NSE
41
Another measure of the depth of the equity capital markets can be seen by market cap to GDP ratio. As can
be seen in Table 2 below, countries like USA have market capitalization which is greater than their GDP,
whereas India has market cap which is almost half of the GDP, even lower than the world average.
Table 2
Market Cap (US$tn)
GDP (US$tn)
Mcap / GDP (%)
India
1.0
1.8
54.9
China
3.4
7.3
46.4
USA
15.6
15.1
103.6
Japan
3.5
5.9
60.3
UK
1.2
2.4
49.4
45.1
70.0
64.4
World
Source: World Bank
Coverage of the investing population
A commonly accepted metric for measuring the investing population is seen as the total number of demat
accounts in the country as the major stock exchanges, commodities now see most of their trading taking
place via demat accounts. The demat accounts in India has seen tremendous growth as the accounts have
grown from 6.7 mn accounts in 2004 to 20.3 mn accounts today. This represents that 4,842 accounts have been
opened each day since 2004 at the CAGR of 15.5%. However, a number of these accounts (30-35%) have been
‘dormant’ i.e. no securities or no activity in the last one year. The majority of the new demat accounts opened
recently are for investors who wish to buy bullion in electronic form.
Table 3
(# of demat accounts in millions)
NSDL
CDSL
Total
Current
12.3
8.0
20.3
2011
11.8
7.8
19.6
2010
11.2
7.3
18.5
2009
10.3
6.3
16.5
2008
9.6
5.4
15.0
2007
0.8
3.5
4.3
2006
7.8
2.1
9.9
2005
7.2
1.2
8.4
2004
5.9
0.9
6.7
Source: NSDL and CSDL
42
Table 4 below shows the potential of investing population. We have defined the investing population as older
adults (25years +) who have a bank account and have saved money in the past year,as seen by the results of
the World Bank study conducted in April 2012. We can see that only 13.3% of the investing population have
opened demat accounts and that there is a huge potential for expanding the reach of the secondary market.
Table 4
Population (millions)
Total population
1,224.6
Older adults (25+)
612.3
Having bank account
232.8
Saved money in the past year
152.2
Number of demat accounts
20.3
Coverage
13.3%
Source: World Bank, NSDL and CSDL
SEBI is considering opening up of the ‘no-frills’ demat account similar to RBI’s initiative to increase financial
inclusion by opening up of ‘no-frills’ savings account. This should be accompanied with dedicated effort
to increase the reach of demat accounts to the rural areas via using ‘investment correspondent’ similar to
‘business correspondent’ used by banks to target the rural population.
Role of secondary markets in channelling the savings to capital markets
Rajiv Gandhi Equity Savings Scheme
The government launched the Rajiv Gandhi Equity Scheme which provides tax benefits for directly investing
in equities with the twin goals of channelizing savings to capital markets as well as increase the retail
participation in stock market by getting ‘first-time’ investors (with annual income less than Rs.1 mn) and
build the equity culture in India.
India has an estimated 15 mn individuals out of the 25 mn tax payers whose annual income is less than
INR1 mn. If all of these individuals were to invest the full Rs. 50,000 limit in the equity markets, Indian stock
markets can receive just shy of US$23 bn in investments (equivalent to more than two years of FII flows.)
The current scheme only allows a one-time investment opportunity, if the government encouraged by positive
response decides to extend the scheme, we can see a regular flow of investment in the equity market via this
scheme. Also since these investments would have a ‘lock-in’ period of three years, we would see sticky flows
in the markets with long term investment.
To prevent the investment into riskier smaller stocks, Government has decided to curtail the investments to
BSE100, CNX100 and Navratna PSUs in addition to diversified instruments like MFs and ETFs.
43
PSU ETF Fund
The Department of Disinvestment, Ministry of Finanace, as a part of its divestment plan is proposing to
issue an ETF fund to sell down its equity and at the same time encourage investments in a more diversified
PSU exposure with reduced risk. This is based on the very successful Tracker Fund of Hong Kong (‘TraHK’)
which helped the Hong Kong Government exit its investments in Hong Kong Stock Exchange in a US$4.3
bn IPO in 1999. The Department of Disinvestment is planning to create a pool of shares of the PSUs it wants
to divest and create an ETF, which is an investment fund traded on stock exchanges just like stocks and
would have an underlying benchmark which could be an index on the stock exchange. This could help the
Department to meet the twin objectives of complying with the minimum public float requirement and raise
the finances for the Government. Since ETFs are more commonly invested by retail, they also offer a chance
for retail investors to invest in the PSU companies without the unsystematic risk of each company.
Key learnings from other developing primary and secondary markets
Certain procedures in other developing primary and secondary markets, if implemented in India, could
simplify and boost the Indian primary and secondary markets.
1. Reducing settlement period in public offerings:
Settlement period is a T+12 days process for public offerings in India. The dependency on the physical
forms and cheque system for the retail investors has resulted in significant delays as well as errors in
the system. An e-IPO for all type of investors can result in a shorter time frame for settlement. This can
increase the attractiveness of global investors to invest in Indian public offerings as it reduces the risk of
funds locked up for longer periods. This would also ensure sustainable economics for both primary and
secondary market players.
2. Claw-back mechanism for IPOs:
In the claw-back mechanism, initially, only a small percentage of the shares are offered for public
subscription. However, the claw-back mechanism helps by increasing the size of the public tranche
depending upon the over-subscription levels of the public tranche. Such a mechanism not only ensures
comfort of the deal being executed initially due to the high reservation to the institutional investors but
also ensures greater shares for the public investors in case of oversubscription. In India, due to fixed
proportion to retail investors, these investors receive less shares in an oversubscribed IPO and more
shares in case the offering barely manages to subscribe.
3. Consolidation of disclosures:
Listed companies in India are required to release multiple disclosures annually, semi-anually and
quarterly. These are available publicly at various locations – stock exchanges websites, SEBI website,
44
company website, other public databases etc. A document that encloses all relevant disclosures of the
listed company during the year would ensure that investors find it easy to obtain all relevant company
information from one location instead of hunting for information at various locations.
Transforming retail participation in Indian capital markets
India is a country with a strong equity culture and with a stock exchange which is more than a century old.
Till a few years back, retail investors used to dominate in secondary markets and were a very important
source of demand for the primary markets. However, retail investors in India are also short term investors. In
IPOs, retail investors are merely followers of the QIB and HNI demand and invest in IPOs based upon QIB/
HNI subscription levels. Typically, majority of the retail investors sell their holding allocated to them in IPOs
on listing date. Also on secondary markets, retail investors do not do enough research but rely on tips from
stock brokers, friends and family. Due to the above, retail investors have an undue bias towards mid-caps
and small-caps, where they look to make quick gains.
The last few years have seen markets to be extremely volatile with spurts of high and low liquidity. The
retail investors have been caught unguarded in such times. Retail investors who have been chasing the ‘IPO
pop’ and investing merely on tips / rumours rather than research, have not only lost money but also faith in
the markets, when many of the IPOs saw share prices drop on first day of listing. The higher than average
interest rates, rising prices of bullion / real estate and active commodities have opened up other attractive
venues for the retail investors to invest and protect their capital.
A unique feature of Indian markets is that retail investors take up direct exposure to equities. As the portfolio
for retail investors is small, there is no scope for diversification. In India, pension funds are not allowed to
invest in equities. Insurance companies invest a disproportionately large asset base in government securities
due to regulations. Equity investments can give positive returns when held for longer time frame. Getting
retail investors to have indirect equity exposure through professional fund managers is as important as
getting them to invest directly. This helps the retail investors hold equity for longer time periods and thereby
reduces chances of losses.
Adopting some of the below methods could attract retail investors back into the primary / secondary
markets:
• Focus on proper investor education
• Transparent corporate governance
• Simple and easy to understand IPO document (detailed disclosures)
• Higher discount to retail investors in public offerings
45
Attracting FII investments in India
Indian markets attract FIIs due to the long term growth potential and favourable demographics. However,
India also is a country with inherent risks due to unstable policy regime due to political compulsions. The
lower than anticipated growth, higher than expected inflation, burgeoning fiscal deficit and a government
rocked with scams have lowered the attractiveness of Indian markets. The Indian Rupee has also played the
spoil-sport as investor returns are measured in dollar terms. Finally, being an emerging market, FIIs have
looked away from the Indian market due to the general risk-averseness currently built in.
From previous equity offerings, it is seen that FIIs contribute 60-80% of all equity offerings in India. They play
an important role in India primary / secondary markets and own over US$184 bn in BSE500 companies. Some
of the FII flows will see return to India automatically as the macro factors return in favour of India and the
markets start to absorb more risks. However, government stability and further policy making are required
for improving investor sentiment and hence foreign institutional flows into the country. As recently seen, the
positive announcements from Europe and the US central bankers and recent government reforms in India
(fuel hike and allowing foreign investments in the retail and aviation sectors) have lead to an uptick in equity
markets and will also see increased flow of foreign funds into Indian equities.
46
Note on Delisting Regulations
Mr Sunil Sanghai, Chair, FICCI’s Capital Markets Committee and M.D., Head of Global BankingIndia, HSBC Ltd.
Background The process of delisting of equity shares entails removal of the equity shares from the stock exchanges on which
they trade.
Various sources indicate that significant number of the companies, currently listed on various Indian stock
exchanges, is being not actively traded. With limited trading, investors are faced with illiquid investments.
Typically, investors would look to release funds tied up in such companies and invest in relatively active
scripts – voluntary delisting by the majority shareholder is one such mechanism.
Delisting of less active and thinly traded stocks provides option to investors to invest in more active counters
where long term value creation opportunity is higher and decision to enter and exit is not restricted. Such recycling of capital is critical for vibrant and efficient Indian equity capital markets.
The capital markets regulator, SEBI, in 1998, first directed stock exchanges to amend the listing agreement and
other bye laws to provide for delisting procedure including pricing for delisting offers.
Pricing considerations in the 1998 circular took into consideration trading history of the securities over the past
six months. Should such security not be classified as a frequently traded one, pricing for delisting was to be
determined by the statutory auditors of the company as the fair price for delisting i.e. shareholders had no say
on pricing. This arrangement came in for criticism from public shareholders and various investor forums as the
price was solely determined by the statutory auditors of the company. Independence and role of the statutory
auditors and potential influence of the controlling shareholders in determining the price for delisting were also
questioned.
Current Situation To address these concerns, in 2003, SEBI introduced a price discovery mechanism in the form of reverse book
building for the delisting of equity shares. Price for delisting was based on the price at which maximum
number of shares was tendered by the minority/public shareholders. Revised rules provided flexibility to the
controlling shareholder to accept or reject the price determined by the reverse book building process.
In June 2009, SEBI outlined further changes to the earlier guidelines and introduced new regulations for
delisting of equity shares. Key changes included were the new thresholds for delisting proposals - (a) approval
of delisting proposal by the minority shareholders and (b) determining success or failure of the proposal
under reverse book building. These regulations remain in force at present.
47
The regulations require that votes cast by the minority shareholders in favour should be at least two times
the number of votes cast against the resolution for a voluntary delisting by a majority shareholder. Also, for
a delisting offer to be successful, the controlling shareholder has to reach either ninety (90) per cent of the
voting capital or fifty (50) per cent of the voting capital held by minority shareholders plus the aggregate
percentage of the pre-offer promoter shareholding, whichever is higher. These changes were in addition to
the price discovery mechanism envisaged through reverse book building.
SEBI should be complimented for a progressive approach towards delisting - in particular, for recognising
the minority shareholders as a separate class of shareholders, an international best practice, thereby
requiring them to approve the delisting offer by two thirds majority.
Reality Check However, a combination of increased threshold and reverse book building has led to significant powers in the
hands of minority shareholders. A closer scrutiny of how the current delisting rules have worked, particularly
the reverse book building process, indicates a disconnect between the intent of the regulations and the actual
implementation.
Recent experiences provide evidence that the reverse book building process, which was to facilitate an investor friendly mechanism of price discovery and to aid determination of a fair exit value for the minority/public
shareholders, is not fully achieving the objective. The mechanism is not necessarily translating into genuine
discovery of price.
1. Shareholders holding significant stake amongst the minority shareholder exercise disproportionate powers while a delisting proposal is being considered for benefit of larger set of minority shareholders. This is
contrary to fundamental corporate law principle that all shareholders should be treated equally.
2. Odd bids are submitted by arbitragers and other market participants who have neither invested in the
company nor are looking to be a long term shareholder in the company. Such bids destablise the delisting
process for minority shareholders who have undertaken risk of investing over a longer horizon and are
denied a fair exit.
3. Mutually agreed by a few market participants in the price discovery process which may work adversely for
the other minority shareholders intending to participate in delisting process.
A historical analysis of the premium paid in the delisting process in the past couple of years indicates that companies indicating to delist have paid premium in excess of 70% of the floor price.
Need of the hour Reverse book building mechanism is not observed in most of the developed markets and a consistent practice
is to enable the majority shareholder to indicate a price for delisting and the same being approved by the minority shareholders. A review of the delisting regulations in other jurisdictions with healthy capital markets
48
(the UK, Hong Kong, Singapore) suggest that minority shareholders approve, via a shareholders’ resolution, a
delisting offer as well as the price offered by the majority/ controlling shareholder. This enables an equitable
say to all shareholders. The reverse book building process currently only serves to cater to the interests of the
more sophisticated investors and difficult for retail shareholders to comprehend. Retail and small investors are
more comfortable with a fixed price tendering mechanism. Most developed markets also specify a fixed price
mechanism for delisting.
There is a need for modifications of the existing delisting regulations, in particular the pricing mechanism, for
efficient functioning of the capital markets.
The reverse book building process could include price determination parameters like introduction of a price
band along the lines of the price discovery process for new equity issuance to avoid frivolous bids. The floor
price for the price band can be determined as per the current regulations which assess the floor price on the
basis of factors like trading history, fair value by independent agency, historical deals done etc.
The higher end of price band can be determined by the majority shareholder. To protect the interest of minority
shareholders, a committee of independent directors in consultation with the merchant bankers would provide
a recommendation on the price band. The independent directors and the merchant banker would consider
market scenario, company performance, willingness of controlling/promoter shareholders to delist, quantum
of funds required etc.
The delisting offer price should be the price point, within the pricing band, at which such number of shares
have been tendered for delisting which enables the majority shareholder to meet the relevant threshold. This
price shall be binding on the controlling/promoter shareholders and shall be paid uniformly to all minority
shareholders. Currently there is no provision for investors to bid at the cut-off price similar to an IPO process.
Retail investors should be allowed to bid their shares at a “cut off” price ensuring that shares get tendered from
significant portion of the retail investors and at a price which will be determined through the reverse book
building process. Further, the delisting provisions should allow for a downward revision of the bidding price
in the reverse book building process to ensure public investors can bid at lower prices in case they see the book
building at a price lower than their bid. These steps would ensure better participation in the process.
This mechanism would address the balance between controlling/ promoter and minority shareholder. This
also provides an independent oversight over pricing to ensure that minority shareholders receive a fair exit.
Such a process will be a key enabler for minority/public shareholders to release capital invested in such companies and recycle capital and contribute to efficient functioning of the Indian equity capital markets. The
multiple levels of approval, first approval to the shareholder resolution and a subsequent successful tendering
by atleast 50% of minority shareholders, tend to confuse the shareholders and is also time consuming. The requirement of the shareholder approval should not be waived which would significantly shorten the timeline.
The approval of the shareholders would in any case be evident through their participation in the reverse book
building process.
49
Developing Indian Capital Markets - the Way
Forward
Mr. Shachindra Nath, Group CEO, Religare Enterprises Limited
The current macro-economic environment in India is that of turbulence partly due to global uncertainties and
partly due to domestic ambiguity on a path forward for the short term, but the long term India growth story
remains intact. India’s linkage with the rest of the world’s financial markets has been on an upward trajectory
since the country began economic reforms in 1991. This trend is going to continue in the foreseeable future as
we become more closely integrated with the global economy. The capital markets in India have grown manifold
in the last two decades and several structural changes have brought us at par with international standards on
many counts. However, there is still a long way to go. One of the biggest challenges facing our markets is the
lack of penetration and low retail participation. Penetration in products such as currency is limited with equity
and commodities accounting for a large share of trading volumes. Retail investor penetration in India is very
low compared to many developed or developing markets. Now is the right time to expand access and instill
confidence to get the population rolling once more and this time in larger groups.
Challenges faced by the Indian Capital Markets
Capital markets are facing challenges with some being structurally related and some being regulatory related.
While the policy makers have taken steps to address some of the regulatory challenges, such initiatives have
not significantly affected the structural challenges. In addition, changes are required in regulations to provide
an impetus to further the development of capital markets.
1. Low depth in equity markets - Indian markets have a lower trading velocity as compared to other markets
such as China, Japan, United States, Germany and UK. Indian exchanges are also somewhat undiversified
with equities and commodities accounting for 90% of the trading volumes.
2. Low retail equity ownership - Indian households have the highest savings rate in the world; the household
savings rate has increased from around 11 per cent in 1980 to over 35 per cent today. However, less than
1% of India’s population invests in equities and less than 2% of total household savings makes it to direct
equities and debentures. Moreover, 50% of the total household savings continue to be invested in physical
assets, in particular gold and real estate.
3. Dominance of top tier cities in trading volumes - The top eight cities in India by population account for 73
per cent of mutual funds and 87 per cent of cash trading volumes, while they account for only 30 per cent
of the income. Considering the minuscule contribution of the other top-350 urban centers, there is a huge
opportunity to deepen the retail investor base in India.
4. Higher costs per trade - Costs per trade (brokerage commission, taxes (exchange and regulatory) and
market impact on price) are significantly higher in India than in developed markets.
50
5. Underdeveloped debt market - Although the Indian corporate bond market has expanded from USD 19
billion in 2007 to USD 40 billion in 2012, bond market penetration in India continues to be low. Corporate
bond penetration in India is only about 8 per cent of GDP, compared to 28 per cent in China. Institutions
such as insurance companies and pension funds are restricted to invest in corporate bonds beyond a certain
limit, which affects the liquidity compared to the government securities market.
The Way Forward
Increasing market participation
Moving household savings to the capital markets is an imperative. There is a need to create capital market
products that replicate the risks and returns of physical assets to capture the proportion of physical savings
held for investment purposes.
• Grow gold-backed capital market products, Gold Savings Schemes (GSS) - GSS is a new product offered
only by two players in India (Kotak and Reliance Mutual Fund). However, given the potential of
these products to replicate the returns from gold, players should focus on three areas to deepen retail
participation in this space.
• Launch Real Estate Investment Trusts (REITs) to address investor needs not fulfilled by products like Real
Estate PMS. Till now in India, only venture funds have been offering real estate funds available largely
to high net worth individuals and institutional and global investors due to the minimum investment
size restriction. REITs can take the form of pooled investments in both upcoming and existing income
generating properties to cater to different classes of investors. REITs act as a tax efficient tool as income
is distributed at regular intervals with no tax implications for the holder.
• Improve mutual fund penetration across asset classes and introduce newer products like Debt
Infrastructure funds which is likely to create long term investment opportunity for retail investors.
• Enhance investor awareness in tier II urban and semi-urban centres through investor camps in key centres,
nation-wide programmes with a focus on ethical selling practices by financial services companies.
Regulatory reforms to encourage retail participation
There are three critical regulatory challenges which should be addressed to encourage greater retail participation
in the Indian equity markets:
1. Rationalizing the Securities Transaction Tax - The tax regime in India, with the introduction of Securities
transaction tax (STT) in the year 2004 has made the cost of transaction skewed against cash trading (both
delivery and intra-day). The STT for cash delivery transactions today stands at about 730 times than the
equivalent turnover in options. This difference stands at 73 times between intra-day cash trading and
options. This has led to a large skew in turnover in the Futures & Options (F&O) segment. The ratio of F&O
to cash turnover in the Indian exchanges stand currently at 11: 1 against a global ratio of 2-2.5:1.
51
2. Uniformity in stamp duty charged by different states on equity transactions - The government of
Maharashtra, which accounts for 40 per cent equity volumes on the country’s two biggest exchanges,
doubled the stamp duty on equity transactions, in their annual budget for 2011. A uniform duty of 0.005
per cent on all equity transactions was mandated in comparison for the average of 0.0024 per cent in the
cash segment and 0.002 per cent in the derivative segment.
3. Increasing domestic institutional investor participation by allowing higher investments by pension funds
in equities - Current regulations allow only about 10 percent of the pension fund corpus of Rs. 6.4 trillion
to be invested in the equities market directly or through mutual funds. In contrast, internationally, up
to 50 percent of pension funds is invested in equities. Moving the Indian pension fund market closer to
international levels could potentially create equity inflows of up to Rs 2,500 billion at current levels, giving
a much needed boost to domestic institutional investor participation.
Deepen product markets
1. Deepen the Corporate Debt Market - Liquidity in the corporate bond market in India is constrained. There
are few changes which are likely to drive liquidity in the corporate bond market:
• Exempt corporate bond repos from the cash reserve ratio/statutory liquidity ratio requirement to
deepen the corporate bond repo market. The deepening of the corporate bond repo market will likely
drive significant activity in the bond markets.
• Over time, create an integrated trading and settlement system for corporate bonds (like the Negotiated
Dealing System-Order Matching for government bonds) and move to a clearing house guaranteed
settlement system. Additionally, encourage investors with larger bond holdings (insurance companies,
pension funds) to trade in bonds rather than letting them mature in order to create liquidity in the
corporate bonds space.
2. Deepen the interest-rate futures market - Interest-rate derivatives are needed to hedge rate risks, the largest
macro-economic risk. Globally, interest rate derivatives constitute the largest part of derivatives turnover
on both exchange-traded as well as over the counter products.
Streamlining securities lending and borrowing to increase turnover
Securities lending and borrowing (SLB) facilitates short-selling, increasing liquidity, improving pricing
and facilitating arbitrage between derivatives and cash markets. Due to current regulations in India, SLB
turnover remains abysmally low, while in markets like Hong Kong and Australia the turnover is more than
USD 80 bn.
Creation of a Sovereign Wealth Fund
Setting up a Sovereign Wealth Fund (SWF) for India could be an important channel to invest in the local market
to bring financial stability. As on date, India doesn’t have a SWF unlike most of the emerging economies. SWFs
52
are only one of the many channels through which governments deploy their financial assets. The funding
of SWFs comes from various sources, which vary from current account surpluses from export of oil and
other commodities or manufactured goods, fiscal surpluses, public savings, privatization receipts or pension
reserves. Around 45% of SWFs come from oil rich countries in the Middle East while Asia followed with a
third of the total with most funds there originating from excess of official foreign exchange reserves. In India,
the government can create an SWF in partnership with the private sector at large (ownership to be 50% each)
that provides a minimum guarantee return. Such a structure will encourage wider participation and will
provide a safety net of the government.
Conclusion
The capital markets in India have evolved considerably over the last two decades to create a strong foundation
for future growth. As the inter-linkages between global financial markets increase, the capital market in India
will need to hasten the process of transformation to a globally competitive capital market. The way forward for
the Indian capital markets is continuous regulatory reforms to adapt to the changing dynamics of the industry,
increasing the use of technology for easing the access to market, innovative products to increase choice as well
as participation and financial awareness for wider retail engagement. Focus on these areas will strengthen the
foundation that has been already created since economic reforms.
53
54
Domestic and Global
Investors’ Perspective of the
Indian Capital Markets
55
56
Paper on Investors Perspective Session
Mr. Anup Bagchi, Co-Chair, FICCI’s Capital Markets Committee and M.D. & CEO, ICICI Securities
Inclusive Policy: Getting the basic rights
Investment management companies such as mutual funds, insurance companies, private equity companies,
etc and enablers of these services such as distributors are facing muted inflows amid an evolving regulatory
framework and sagging domestic & global economy. Notwithstanding these challenges, a lot of effort and
steps have already been taken across the value chain ensuring better investment proposition to investors,
which will go a long way in improving the investor’s interest and the overall growth of the industry. These
recent measures are steps in the right direction and will go a long way in enhancing the mobilisation and
channelising of savings into efficient financial products once the overall domestic and global economic scenario improves.
Mutual funds and life insurance companies have remained major domestic institutional investors in Indian
equity markets for the last five to seven years. Inflows in both MF equity and insurance are shrinking largely
contributed by a 500 bps knock in savings rate to 31.8% from its peak in FY08 due to local and global growth
issues. Financial savings have declined from 15.3% of GDP in FY10 to 10.9% of GDP in FY12. Within financial
savings, 52.8% is still with bank deposits, 23% for life insurance and 15.6% in provident and pension funds.
In FY12, shares and debentures saw a negative outflow of -0.7% as a proportion of financial savings, down
from 4.5% in FY10.
Mutual funds – lot more scope to increase
As on March 2012, the MF industry had an equity AUM of Rs 192465 crore (equity + ELSS + 65% of balance
funds) and witnessed an annual inflow of Rs 370 crore (equity + ELSS + 65% of balance funds), much lower
than the entry load regime. This is far lower than any global yardstick given the higher saving rates.
Exhibit 1 : Mutual fund AUM & fund flow ( Rs crore)
MF
Net Inflows (FY12)
ALM-Mar’12
FY13(YTD)
AUM-AUG’12
-18528
290844
50239
349311
264
158432
-3035
153015
382
16261
-165
15761
-7104
80354
108159
193466
Income
Equity
Balanced
Liquid
Glt
-20
3659
-496
3282
ELSS
-142
23644
-681
23065
Gold ETF
3646
9866
-35
10701
Other ETF
-623
1607
-51
1548
102
2530
-153
2399
-22023
587197
153782
752548
FoF (Overseas)
Total
Source : AMFI, Insurance Company presentations, IRDA, Media articles, ICICI direct.com Research
*Equity+ELSS+65% of balanced funds AUM as per AMFI
57
Insurance - significantly underpenetrated
The Indian insurance industry is the fifth largest among emerging economies and has grown at 25% CAGR after
the markets were opened up for private players in 2000. The life insurance industry has seen 20% growth in
annual premium income in FY10. However, in the current slowdown, the growth has declined with gross annual premium collection of Rs 283315 crore in FY12. The penetration (annual premium/GDP), which was 1.77%
in FY00 increased to 4.4% in FY10 in India. The industry has huge investment corpus with an AUM size of Rs
1618544 crore as on March 2012 rising from Rs 934030 crore on March 2009. Equity investments of industry also
more than doubled to Rs 473000 crore.
Exhibit 2 : Life insurance industry growth over years (Rs crore)
Total AUM
Growth
FY09
FY10
FY11
FY12
934030
1288946
1482549
1618544
10%
38%
15%
9%
199966
446881
507434
473000
64600
79200
86900
80600
LIC
157100
186100
203500
202700
Total
221700
265300
290400
283300
20%)
9%
-2%
Equity AUM
Premiums
Private Life
Growth
Source : IRDA, Life Insurance Council, ICICIdirect.com Research
The industry generated gross annual premium of Rs 283000 crore in FY12. At 20% deployment ratio, Rs 56000
crore is estimated to be annually invested in Indian equities via insurance companies, which is substantial in
the current context and is bound to increase with higher penetration.
Exhibit 3: Industry AUM of life insurance and MF and annual inflows (FY12) (Rs crore)
Industry Level
Private Life
LIC
Total
Equity assumption
AUM
Annual Premium
-2.5 lakh crore
80600
-13 -14 lakh crore
202700
1618544
283300
-5 lakh crore
56660
31%
@20%
Source : Insurance Company presentations, IRDA, Media articles, ICICI direct.com Research
Private equity – Past investments under stress
The Indian PE industry started with a small size of $20 million in 1996, which has now gone up to an estimated $68 billion in the past 10 years. Of this, ~ 50% of the PE inflow in the last four or five years likely went
into capital-intensive sectors like real estate and infrastructure, which are under stress, thereby providing
less profitable exits. Deals are likely to perk up if the overall economy improves, going forward.
58
Exhibit 4 : PE deals & investment in India
1616
1935
1164
2477
2212
3611
2299
1666
1978
1830
1500
850
771
500
1008
2429
3593
2334
4704
2575
1563
1791
1802
1437
1336
5000
4500
4000
3500
3000
2500
2000
1500
1000
500
0
3979
Exhibit 4 : PE deals & investment in India
98 73 98 94 112 90 136 159 157 113 130 78 65 48 66 102 88 79 113 94 111 126 118 122 101 97
178
158
138
118
98
78
58
38
18
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2
FY06
FY07
FY08
Deals (RHS)
FY09
FY10
FY11
FY12
Deal value Mn$
Source:PWC
PWC Money
Tree India
Source:
Money
TreeReport
India Report
Key drivers: Getting the basics right
The single biggest drivers of any financial product besides the financial environment are brands, trust and
decision simplicity. The ease with which consumers are able to gather trustworthy information, evaluate
merits of the products according to their financial needs and are rightly navigated towards purchase decision
are the basic building blocks for growing financial products.
Regulations in India and like in many markets play a pivotal role in building trust and confidence and also
ensure that the interest of all stakeholders’ viz. companies, distributors and consumers is taken care of. It
would be too much to expect that investment companies, distributors and consumers always do the right
thing all the time given past instances of mis-selling of financial products. Regulators play a dominant role
in financial product purchase journey and ensure that the interest of all stakeholders is protected given the
conflicting interest between them.
Financial regulation in our country has undergone a vast change of late and rightly so compared to an earlier
practice of it being product based and housed under separate regulators. For example, MFs are regulated by
SEBI while IRDA performs the same duty for insurance companies.
Various Indian regulators like SEBI, IRDA and PFRDA have worked relentlessly towards bridging the trust
deficit in the minds of consumers. A slew of investor friendly measures have been taken to ensure that the
needs of customer are understood and are catered to in a reliable and cost efficient manner.
Regulations in India are anchored around product innovation and decision simplicity i.e. making it easy for
customers in terms of process to comprehend, choose and execute products in line with their risk return trade
off through the right medium.
Product innovation
Financial products and its innovation go a long way in not only meeting the appropriate suitability of customers but also facilitate resource mobilisation, asset creation and development of financial markets.
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Although the industry is moving towards capturing investors requirement through innovative products like
gold ETFs for meeting investor’s appetite for physical gold investment, exchange traded products like equity ETFs/Debt ETFs/FMPs, NCDs and tax free bonds. New pension schemes, Rajiv Gandhi Equity Savings
Scheme, real estate funds, infrastructure debt funds, PMS, structured products like Nifty linked debentures,
etc have also recently introduced unique measures. In addition, Sebi has recently allowed alternative investment funds (AIF) to offer private equity funds, real estate funds and hedge funds products to investors.
Further, more innovative products are required like capital protected products/hedged products to cater to
specific individual/corporate investor requirements, investment in mutual funds through the SIP route, real
estate investment trust, inflation linked bonds, long term index/stock futures, delivery based equity derivatives, etc.
Process
Good regulation involves supervision, regulation and enforcement. It also involves informed and broad participation of customers and other stakeholders. Investors sometimes get harmed by lack of transparency,
information and actions that concealed or misled them. Improving processes to keep pace with regulatory
changes makes it easier for all stakeholders to do business without compromising on risk, reduce the cost
of operations and mutually share the benefits in terms of better market growth. The recent regulations to
include mis-selling as a ‘fraudulent and unfair trade practice’ and regulating investment advisory are steps
in the right direction. Some of the other recently introduced measures include:
Understanding the product: Investor risk profiling, classification of products, investor friendly disclosures
and limiting number of similar products to suit investor’s risk profiling would ensure proper understanding
of the product and simplify decision making.
Investing in the product: Measures like a common KYC norm, segregation between online investing, directed investing, consolidation of mutual funds folio, etc are welcome measures. In addition, introduction of
e-IPOS is expected to simplify the application process and extend its reach. In order to provide a boost to the
primary market, Sebi has increased the minimum investment by a retail investor by increasing the lot size to
Rs 10,000 – 15,000 now from Rs 5000-7000 earlier.
Monitoring the investment: Consolidated investment statements for MF investments are good initiatives for
better monitoring and can be replicated for other financial products like insurance & alternative investments.
Regular and investor friendly disclosures of portfolio and valuation especially in PMS and private equity
would ensure effective monitoring.
Other measures by Sebi such as mandating all depository participants that they should not levy any maintenance charges for securities of value up to Rs 50,000, Rs 100 to be charged for Rs 50,000 – 2 lakh and normal
demat account maintenance charges for value above 2 lakh.
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Distribution
Distributors of financial products are agents of both the product provider and customer. It has been found
that it had inherent imbalances due to differential product commissions. This has worked against the best
interests of customers leading to increased instances of mis-selling of products motivated by higher commission structure. Going ahead, distribution tailored to reach each kind of customers with products and capability suited for that profile of customers.
Product neutral commission: The regulatory, compliance and commission structures vary across segments
within the financial services sector like mutual funds, insurance, pension funds, PMS, private equity, etc.
and each of them are governed by an independent regulatory framework and compete for the same share of
the customer’s wallet. This anomaly needs to be addressed to ensure products are commission neutral and
providing a level playing field to all financial products.
Adequate compensation is the most important aspect that encourages any distributor to sell a product. To
avoid aggressive churning and mis-selling, incentivising the distributor via higher trail commission may be
considered. This will align the interest of the investor as well as the distributor.
Investors-distributor interest alignment: Alignment of interest between investor and distributor is one of
the most important aspects in growing the financial industry. Measures like investor awareness, low cost
higher lock in period funds, advisory based distribution model, product neutral transaction charge model
with low fund management expense ratio and profit sharing model with low set up cost in products like
PMS, structured products, etc should help.
Investment Option: Different investment options should be available to investors so that it is the investor
who decides the mode of investment. Like in mutual funds, after the recent regulation, the investor has the
choice to go directly to the AMC or he needs distributor advice and, accordingly, has to pay a commensurate
charge on the investment. Similarly, in PMS, an investor is given a choice to choose between fixed charge and
profit sharing model. Similarly, in insurance, online option is available. There is a need to create awareness
of all investment options available across financial products. Awareness also needs to be created regarding
value created through proper and effective advice.
A distributor selling various financial products often doubles up as an advisor as well. Sebi has now drawn
a line by segregated fee based advisor and commission based distributors for better alignment of investor
interest. Also, MF schemes need to offer separate direct investment options with lower expenses. Similarly,
online insurance in insurance are welcome measures.
We have made a good beginning in the long road towards establishing a credible financial market by way
of right regulations, product innovation, improving processes for aiding navigation, building trust and
making it easier and cost effective for customers to confidently and efficiently weigh their investment
decision.
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Potential of Indian Capital Market:
The Road Ahead
Mr. Sundeep Sikka, President & CEO, reliance Capital Asset Management Limited
Capital Markets – A Key to strong economic growth
Capital markets act as a catalyst to the socioeconomic growth story of any country due to their indispensable
role in financial intermediation & capital formation process. A vibrant capital market makes the entire financial
market efficient by enhancing liquidity, transparency and aiding price discovery.
Importance of capital markets cannot be particularly under-mined in India which requires ~ $ 500 billion of
capital for infrastructure development. India is a fairly large economy of ~$1.6 trillion with savings rate of
~33.7%. In next few years, it is expected to grow at an average rate of ~8% which will lead to additional savings
of ~$5 trillion. US economy is ~$15.23 trillion. Assuming a savings rate of 5%, it may be realism that Indian
households’ savings exceeds that of US in the next 10 – 15 years.
However, Indians prefer risk-averse investment avenues. Out of a huge population in excess of 1.2 billion, only
less than 1% are active participants, with a mere ~ 10% of their investments in equities & fixed income market.
As a result, retail equity ownership amounts to ~ 10 % of total equity ownership due to which trading volumes
are relatively lower than other countries. The corporate debt market is even less developed. The lack of a developed capital market system could be resulting in higher (and therefore ineffective) borrowing cost for the
companies and the vicious cycle of financial inefficiency.
It is pertinent for us to channel the huge household savings into capital markets through the development of
financial intermediaries in order to effectively fund our long-term sustainable growth story. Although a lot of
initiatives were taken in the recent past by the Regulator to develop a robust system and the market itself,
we believe lot many such developments need to be undertaken on a priority basis.
Heading For Growth: Transformation & Current Developments
Revolutionary change in India’s capital market started in early 1990s with SEBI acting as a forerunner for
investor’s protection & development of market infrastructure & technology. Also, establishment of NSE
resulted in increased healthy competition & integration with global markets leading to a momentum in volume
& advent of new financial instruments.
On one hand, financial stability & resilience assumed importance & more reforms were required to establish a robust regulatory framework. On the other hand, investor awareness & penetration of retail markets
became the need of the hour for the optimum growth of the capital market.
The Market Regulator had taken up a lot of initiatives towards developing the market, some of which are:
• “Basic Service Demat Account”: Considering that there are only 2 crs Demat accounts which is ~2% of
population and ~40% are active accounts, SEBI proposed to open Demat accounts at a subsidized cost.
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50 % of the Demat accounts holders would not have to pay any charge & 10 % would have to pay a small
charge. New Demat accounts would cover 60 % of total investor base.
• Rajiv Gandhi Equity Savings Scheme: Offers tax sops to first time retail investors. There are ~ 1.5 Cr
PAN Holders with an income < Rs.10 lakh who do not hold Demat accounts. Even if 20% avail the benefit, Rs.15,000 Crs equity investment will be garnered in 2012-13 itself.
• Increase SME Participation: Realizing that SMEs face a road block in raising capital due to high interest costs, SEBI had proposed dedicated exchanges for SMEs which could prove to be a remarkable
development for our capital markets.
• Introduction of QFI regime to provide impetus to capital market: In order to expand the markets, the
Regulator issued guidelines allowing Qualified Foreign Investors (QFI) to invest into capital markets.
Direct investments in equity market as well as mutual funds are allowed with an overall investment limit
of $ 10 Billion for equity schemes & $ 3 Billion for IDFs. A separate sub limit of $ 1 Billion has also been
created for QFIs investment in corporate bonds & MF Debt Schemes. The Regulator is also considering
to relax margin norms for FIIs.
• Encouraging passive investing: ETFs comprise 2% of total MF assets. In comparison, ETFs comprise
9% of US MF industry. To support development, Department of Disinvestment proposes to launch
“Disinvestment ETF” which will enable the Government to raise Rs.4,000 Crs .The move will help to
bridge national deficits, help PSUs to reduce promoter holding and enable retail participation.
• Development of Corporate Bond Market: India’s Corporate Bond Market is only 3.3% of GDP and is
under-penetrated compared to other economies. Share of corporate bonds to GDP is 10.6% in China &
41.7% in Japan. In order to develop the market, the Market Regulator has taken up initiatives to enable
MFs to participate in repos in corporate debt securities, enhancing the existing limit for FII investment
in government securities by $5 billion and allowing a large investor set consisting of Sovereign Wealth
Funds, multi-lateral agencies, insurance funds, and pension funds etc, registered with SEBI to invest the
entire limit of $ 20 billion in G-Secs.
• Development of Commodity Markets: Commodity markets have an important role to play in developing
agricultural sector and related eco-systems of any country. In India, importance of the same is evident from
number of commodity exchanges set-up.
• Currency Derivatives Segment: Currency derivatives segment on NSE & MCX has been consistently
growing both in traded value & open interest. MCX-SX is world’s largest currency futures exchange and
is ranked as the world’s most liquid among 20 exchanges across America, Europe & Asia. It has developed
a superior technology for process efficiency & new techniques to make prices more accessible.
• Investor Education Programs: SEBI has launched various programs in partnership with NISM to increase
financial literacy. Asset Management Companies also are mandated to conduct such investor awareness
programs across the country.
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The Road Ahead:
To reinstate, we believe focal approach towards financial awareness through integration of technology with
business, developing innovative yet simple financial solutions and creating a favorable environment both for
retail & institutional investors, including FIIs to access different asset classes will augment the growth path in
the foresight.
• Increasing Retail Participation: Around 90% of liquidity comes from around 10 cities and 100 listed
companies. Capital markets have huge potential to drive financial inclusion by providing investors
with the opportunity for wealth creation. Customized products and services will be required to suit the
investors’ risk-return profile for which financial literacy, apt customer segmentation, low-cost distribution
channel and integration of regional exchanges with national exchanges will assume greater importance.
• Effective use of Technology platform: India has ~80 million internet users and 5.2 million broadband
internet connections. However, internet penetration is only 7% as compared to 31% in China and 77%
in the US, implying a huge scope for internet trading. Also, Mobile trading can revolutionize financial
inclusion, given the base of more than 800 million mobile subscribers.
• Unlocking Value of the Bond Market: Retail segment has shown little interest in government securities,
due to small savings instruments and accessibility challenges. To encourage small investors, we believe
the bond market should align itself with the equity market model. As markets develop the investor
becomes aware about new products available in the developed markets, demand for these instruments
will increase. Thus, instruments like interest rate derivatives, credit default swap, “Dim-Sum Bond Funds”
(to raise Renminbi funds to facilitate companies that engage in trade with China), Islamic Bonds & other
Shariah compliant products, etc. are yet to take off in India but certainly have immense potential.
• Developing the Pension Market: Indian Pension Fund Market is ~ Rs.7, 50,000 Crs. Retirement benefits
was available to 11 % of working population in form of EPF, PPF, NPS, insurance products and 2 MF
Schemes. EPF in India is ~Rs.3 Lakh Crores. Even if a small proportion is allowed to be invested in
mutual funds, then it would not be far away for our asset management industry to boast for a ‘401k’.
• Developing Passive Investing – The following untapped segments present huge potential: Fixed Income
ETFs on Credit Oriented/High Yield/Investment Grade Bond, Currency & Real Estate ETF, Quasi active
ETF that tracks indices created for that particular ETF, Theme Based ETF – Dividend ETF, Inverse ETF &
Hybrid ETF, ETF Wrapper that minimizes exposure risk to narrow strategy ETF.
• Commodity markets: Institutional investors should be allowed to invest so as to negate the inherent volatility.
Also, the flat to negative returns of equity markets have made investors looking for alternate investments.
Globally, there are different ways in which mutual funds invest in commodity markets. Domestically, gold
is the only commodity where retail investors can participate. As the market evolves, an alteration in product
mix is on the cards. A huge opportunity lies in developing those commodity based products (silver, copper,
crude oil, etc), which can enable increase in wallet share.
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Volatility - The New Investment Paradigm
Mr. Nimesh Shah, M.D. & CEO, ICICI Prudential Mutual Fund
The Indian equity market direction is being driven by a number of global and domestic factors, albeit in a
range. Global factors like the pending Euro zone debt crisis and domestic concerns like rupee depreciation,
high fiscal and current account deficit, inflation etc. have been key triggers for volatility. The markets
presently are at a juncture where valuations are at fair value and fundamentals have improved due to recent
reform action like the fuel price hike, disinvestment announcements etc,. Markets will therefore continue to
be volatile as they get impacted by global news flow like Qe3, FII flows and oil prices, or domestic triggers
such as execution on the initiated reforms etc. This multiplicity of variables, not withholding market direction
is contributing to an increased volatility. Volatility has become the new normal. Kenneth Rogoff and Carmen
Reinhart in their book “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises” have
indicated that the period after a financial crisis is usually marked by long periods of volatility. The current
equity markets are a clear endorsement of this trend.
The why and the how?
The current cyclical growth downturn and volatility in Indian markets was triggered due to a lack of
structural reforms, lack of policy reforms and corruption scandals that have hurt confidence and adversely
impacted markets. The slowdown however can be reversed by constructive policy action by government.
The first and foremost in this direction has already been taken by the government towards reducing fiscal
deficit by adopting progressive energy reforms and other initiatives like allowing FDI in select sectors. While
one part of setting the wheel of progress in motion has been initiated, the other key focus has to be towards
addressing supply side issues by driving capacity creation. The sustained growth in India over the last few
years was the outcome of capacities created across sectors like telecom, financial services etc between 2001
-2005. There is therefore a need for a similar conducive growth environment through increased investment
into infrastructure to sustain growth. With the monsoons that were a cause of worry improving significantly,
if the government is able continue with its developmental policies and demonstrate affirmative execution on
the initiated reforms, support capacity creation etc, there is potential for an interest rate cut which will turn
out to be very positive for the Indian equity market.
While there are challenges abound, positive cues continue to provide optimism. Most importantly, India is
a structural growth story with favorable demographics, strong domestic consumption and strong balance
sheets across banks/ corporates. Therefore, India will continue to grow in the long term. For investors, the
cyclical growth slowdown in India marked by volatility presents an opportunity to enter Indian equities at
attractive valuations with better upside potential.
Investors ….. “Is this the right time to invest in equity?”
Globally, economies are going through a debt de leveraging cycle. In such a scenario, equities seldom provide
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unidirectional multi bagger returns. One pertinent question in the mind of every investor in such times
therefore continues to be “Is this the right time to invest in equity?” The answer is a resounding yes. The
fact is that irrespective of a range bound market, opportunity for returns exists in volatility and the trend of
polarized markets. Investors worry about volatility, while the fact of the matter is that, volatility translates
to opportunity. The chart below clearly shows that while over a 3 year period the market has remained
range bound and has generated some 15% returns, volatility has provided over a dozen unique and distinct
opportunities to generate over 8 percent returns. In the current context, the view remains that investors need
to provide for greater volatility and value investing in their equity investment strategy.
Chart A
In this new paradigm, volatility has emerged as the new asset class. While the opportunity of investing
in volatility was a fact, how to invest?... was the bigger concern. Investors today have the platform and
opportunity to capitalize in this trend of expected volatility by investing in relevant funds? Today, there are
products like flexi cap dynamic fund that are structured to tide volatility through adopting strategies like 1).
An active cash strategy that helps mitigate downside risks when markets get overvalued. This would mean
holding more cash as the market valuation gets steeper and vice versa i.e. Maximum possible cash holding
in Nov 2010 when markets (Nifty) were over 6000 and minimum possible cash in Dec 2011 when markets
(Nifty) were around 4500. 2). Capturing upside opportunities across market caps. This translates to actively
moving across market caps based on relative valuation attractiveness 3.) Investing across sectors based on
valuation attractiveness and growth potential.
Finally, investors today have a multitude of choices and strategies that they can adopt. Important is to adopt
the right strategy, seek advice of financial advisor and be systematic.
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Capital Market – Need for Active Retail
Participation
Mr. Sanjay Doshi, Director, KPMG India Private Limited
Mr. Manish Loyalka, Manager, KPMG India Private Limited
Introduction
A vibrant, dynamic and well functioning capital market leads to host of improved economic outcomes
through various channels such as mobilization of savings, allocation of resources to productive uses, easy
facilitation of transactions among others. Active participation of various participants (e.g seeker of funds and
provider of funds) is essential for smooth functioning and required depth in the financial market.
Over the last decade, the Indian Capital market has been receiving global attention. Currently, all key
providers of funds such as international and domestic investors, institutional investors and retail investors
are allowed to participate and are active in the Indian market.
The current market volumes are contributed relatively more by international and institutional investors. The
share of retail investors in the capital market is relatively low. As a result, the performance and activity in the
capital market gets impacted by inflow from FIIs. In order to improve the ‘market depth’, it is important that
retail investors also play a more important role in the market.
A quick global comparison indicated that in 2011, the retail investor participation (as a percentage of the total
population) in India, was just 1.3%, whereas in the US and China it was 27.7% and 10.5% respectively1.
It may be noted that the Indian economy has a healthy saving rate (above 30 % of the GDP)2. However, bank
deposits garner a large share of these savings whereas capital market is able to attract only a small portion
of the same.
Low retail participation – Structural cum psychological issue
While there are multiple reasons for low retail participation, some of these are psychological whereas others
may be more structural in nature. Some key factors behind low participation appear to be:
• Risk averse nature – Indians typically are risk averse in financial matters. Capital protection takes priority
over ‘high to moderate risk and return’ investments. Consequently, majority of them choose to invest their
money in fixed deposits and postal savings. Adjusted for inflation, these deposits may not be providing any
real return, however capital protection makes them preferred over other asset classes.
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1
2
Source: http://www.moneylife.in/article/increasing-retail-investor-base-sebi-has-a-tough-job-ahead/16977.html
Source: RBI
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• Crisis of confidence – Current low level retail participation is also attributable to losses incurred by retail
investors during market meltdown in 2008. In India, retail investors typically like to take a direct exposure
in the market instead of mutual fund route. Many a times these investment decisions are not backed by
sound research but are based on market inputs, informal tips, advice from the broker etc. Losses incurred
during 2008 impacted investors confidence thereby leading to lower inflows in capital market.
• Subdued IPO market – An active IPO market also acts as a catalyst for higher retail participation in the
secondary market. On the other hand, higher retail participation is also one of the key determining factor
for launch of an IPO by fund seekers. The same makes it a vicious circle. Given current low level of IPO
activity in the primary market, secondary market volume has also remain subdued.
• Delivery channel – While various intermediaries such as stock brokers, sub brokers, stock exchanges,
depository participants, custodians etc. are present in the Indian market, their reach and penetration in tier
3 and tier 4 cities needs to deepen. Majority of these intermediaries are concentrated in two Indian states
namely Maharastra and Gujarat. However, some of these intermediaries especially broking houses are
trying to ensure pan-India coverage (a plan which has been partially hit by subdued markets).
• Limited product offering - Equities and commodities comprise 90 percent of trading volume whereas
other developed markets have a diversified mix such as interest rate futures, foreign exchange futures and
corporate bonds accounting for a sizeable share. Level of retail participation in government and corporate
debt market in India is very low even as compared to some other emerging economies.
Sufficient tailwinds exist for capital market growth in medium term
Sustained increase in retail participation over the long term period would require a combination of
psychological change (which can be achieved by higher investor education) and policy changes. However
there appear to be sufficient tail winds which if used effectively could support market growth in the medium
term. Key existing enablers could be:
• Growing base of demat account – Despite the subdued capital market activity, the number of demat
accounts have been constantly increasing. As of November, 2011, number of demat accounts stood at 1.9
Crores which is ~1.6% of the total population of the country3. Demat accounts have been growing at the rate
of 20% CAGR over the last few years4. Further, recent regulatory changes capping the fee on demat account
is expected to further increase demat penetration. Historical evidence suggest that dematerialized trading
lead to faster and cheaper transactions and have positive impact on trading volumes.
• Diversification of product portfolio – Over the last few years, while volumes in equities market have been
sub-dued, setting up of the dedicated commodities exchanges have provided investors an alternative asset
___________________________________________________________________________
3
4
Economic Times dated 6th November, 2011
http://www.angelcommodities.com/partner_us/financial-industry.aspx
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class. Commodities turnover (lead by bullions) have witnessed significant increase in volumes; a healthy
trend for growth of capital market.
• Online trading facility – Online trading facilities help in executing transactions in an effective, speedy,
transparent and cost effective manner. With improving internet penetration and brokerage houses offering
online trading platform, the share of online trading facility has been increasing steadily.
• Common KYC – In India, there are multiple KYC required for opening bank accounts, trading account, demat
account, mutual fund investment. Same act as a deterrent for retail investors. Recently, market regulator
has taken steps for common KYC which if implemented, will reduce operational and administrative
challenges.
Changes which could have positive impact on retail participation
• Investor education – One of the ways to increase retail participation is to educate the investors. Investor
education should focus on highlighting the need for having equity as an asset class in their portfolio,
importance of long term investment strategy, investment should be based on sound research (done by
independent competent research analyst) instead of market tips and other traditional approach currently
being followed by the investor. Also, regulating research and advisors may contribute to improving
investor confidence.
• Better surveillance system – Existing surveillance system may be further geared up to prevent volatile price
fluctuation (which is not supported by any underlying change in the business of the Company); especially
in relation to illiquid securities.
• Increase in free float – One of the aspects which may need to be assessed is the float available in the market
as compared to the market capitalization and trading volumes. Measures around improving the float
available and trading volumes may reduce the volatility of share price and thereby increase investor
confidence.
• Technology – Last but not the least, technology could help a lot in increasing retail participation. We need
to find out ways to use technology to achieve higher financial penetration and participation in the retail
market. Some of the technological support we may try to leverage on for increasing the number of demant
accounts, faster and efficient clearing of funds and securities, increasing online trading penetration.
Higher retail participation in capital market would result in reducing the intermediation cost, would enable
fund seekers to raise funds (debt or equity) at a competitive cost and act as a natural hedge against volatilities
of fund flow from developed markets.
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Proposal for Pricing of Preferential Placements to
Institutional Investors
Prepared by: FICCI’s Capital Markets Committee Subgroup on Private Equity chaired by
Mr. Rohit Sipahimalani, Co-Chief Investment Officer & Head-India, Temasek International
Pte. Ltd. and co-chaired by Mr. Niten Malhan, Managing Director & Co-Country Head,
Warburg Pincus
According to SEBI’s guidelines, the price for preferential allotment cannot be less than the average of the weekly high and low of the closing prices of the related shares quoted on the stock exchange during the six months
preceding the relevant date. So, at times when capital markets are depressed, the minimum price at which
allotment could be made is at a substantial premium to the market price. It therefore acts as an obstacle for
companies wanting to raise capital. It is suggested to have a market determined pricing mechanism subject to
safeguards (instead of this artificial 6-month high and low average of the closing prices, as the floor price).
SEBI in its move to aid companies to raise capital through QIPs had revised the pricing guidelines for QIP
placement to include floor price based on the average of high and low prices over period of two weeks. This
helped companies reduce the impact of volatility experienced over a longer period of 6 months at the time of
pricing the placement to QIBs. Further, SEBI in the past introduced new concepts like volume weighted average
prices to help arrive at an average price matching the movements in volume and prices over a trading period.
Further in a recent proposal in August 2012 SEBI has proposed a flexibility to provide a discount of upto 5% to
floor price for investors participating in the QIP placement.
Key Considerations
A. During volatile global conditions like we face currently, companies are often shut off from access to any
form of financing in the equity markets (through QIP, GDR, etc) and increasingly even debt capital & bank
loans. This makes it difficult for them to execute their growth plans. At such times, investors who come
in through the preferential route play a key role in providing growth capital. Given that global volatility
seems likely to persist, economic and valuation outlooks are likely to change rapidly and a 6 month based
pricing formula may not be reflective of the inherent value of a company.
B. While the investor community focused on investing through the preferential route is inherently focused
on the long term, the present pricing formula can make deals commercially unviable for investors. It also
does not serve the needs of promoters or existing minority shareholders as lack of ability to raise capital at
the right time can seriously impair future growth, which could further depress the share price. This could
particularly impact sectors like power, infrastructure where the country needs significant investment but
the companies in the sector today face a large funding gap.
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C. We understand that the original intention of the regulations was to prevent promoters from increasing
stakes in companies at very low prices to the detriment of minority shareholders. The current regulatory
process where a special resolution at an EGM is needed for a preferential allotment ensures the protection
of minority shareholders, when the allotment is to an external investor. The existing pricing formula can be
retained in case of allotments to promoters or other investors not registered with SEBI.
Recommendations
A. We would recommend modifying the pricing guidelines and have highlighted some feasible options.
B. The formula for computation of the floor price for preferential issuances may be based on the volume
weighted average price of the two weeks preceding the “relevant date” (30 days prior to the date of the
shareholders resolution), instead of the six-month average of just closing prices (which currently does not
even have regard to the number of shares that changed hands at the closing price). A discount on similar
lines as proposed in QIP placement should be provided to the floor price for placement to all non-promoter
investor entities participating in the preferential placement. Any allotment to investors on preferential basis is subject to 1 year lock in provisions.
C. The prevailing market price can be considered the result of an “efficient price discovery process” and as
discussed in the previous section, is the true reflection of the current economic/market scenario.
D. To ensure minority shareholder protection, this would only apply to all non-promoter entities making
investments into listed Indian shares including foreign direct investors and offshore funds (subject to compliance with exchange controls), insurance companies, mutual funds (MFs), domestic financial institutions
(DFIs) and other investors.
E. For allotment to promoters, the existing pricing guidelines can continue to apply. Alternatively, the pricing
guidelines can be relaxed for promoter allotments as well, provided promoters abstain from voting on the
special resolution at EGM which approves such allotment.
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Corporate Finance
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74
India and the Changing Dynamics in Global
Business Financing
Dr. V Shunmugam, Chief Economist, MCX Stock Exchange
Mr. Arbind Kumar, AVP-Research & Product Development Team, MCX Stock Exchange
Global Financial Markets:
Global financial markets have experienced significant growth especially during the last few decades in terms
of their volumes, liquidity and depth in line with the growth in the real economies across the nations and
the level of development of their financial sector. Simultaneously it resulted in a greater demand for capital
needs for various activities of the businesses. Depending on the level of their development, capital markets
and banks shared the responsibility of capital allocation in the respective underlying economies. The global
financial intermediation industry, comprising of markets, funds and banks, has been witnessing shifting roles
of suppliers and users of capital especially, post the recent financial crisis. Such shifts have impacted those
looking to raise funds as well as institutional investors as suppliers of funds and thus the cost of intermediation
as well as the cost of funds.
PE as major source of Funds in recent times
Private Equity (PE) has become a major
source of funds in the recent past for many
businesses wishing to raise funds irrespective of their sizes. PE being an investment
in the risk capital of a company whose equity does not trade publicly, it requires a
long-term approach on their part. It had
not only shifted the job of PEs towards
their inflow and outflows but also to reward their long-term investors suitably,
compared with short-term investors whose
numbers are increasing given the outcome
of the current financial crisis. Internationally, Institutional investors such as pension
funds and endowments remain the major
source of long-term funds in private equity financing. In India, such relationship
between such long-term sources of funds
75
and capital needs of PE firms is evolving though initiatives have been taken
up to strengthen collection of long-term
funds through various pension schemes.
Private equity investors play a critical
role in firms in terms of nurturing the
management and governance of the businesses they invest in but also in grooming
them up for the market. In the absence
of long-term domestic funds matching the capital needs of Indian businesses, PEs in India predominantly relied upon foreign funds. Inward foreign fund flows depended largely on cost effective exit that markets could provide them with.
While some exits could successfully happen through markets, some of the exits are awaiting policy changes
such as allowing firms to raise IPOs in foreign markets before their Indian listing. PE-backed IPOs declined
in the recent period in India due to the overall decline in the number of IPOs. There were only 8 IPOs by PE
during 2011 compared with 27 during 2010. The amount raised through IPOs during the same period also
declined from US$4.3 billion to US$1.2 billion — a 71% decline (E&Y, Global Private Equity Watch - 2012).
Rise of PEs in Asian Markets
In line with the Asia growth story, there has been a significant rise in recent times in the amount of private equity
investment flowing into China, Singapore, South Korea, and India. Private equity continues to be a major source
of risk capital for companies around the world. As evidenced from the above figure, during 2000-2010, nearly 50
percent of the private equity investment in the business got refinanced by strategic sales to the corporates, while
35 percent was refinanced by another PE financing and the remaining 15 percent through IPOs. It indicates the
declining role of Capital Markets in PE exits and the increasing role of strategic sales and PE refinancing. PE
backed IPO deals and the average size of the deal had witnessed a steady increase in the global markets during
the recent times (Table 1). It emphasizes the importance of strengthening the PE ecosystem to bring about
vibrancy in the Indian entrepreneurship story by bringing them on par with their global arms/counterparts in
terms of sources of funds, access to domestic/foreign institutional funds, operations, fiscal treatment, etc.
Table 1: PE Exits Through IPOs in Global Markets
Details
Number of deals
Capital raised (US$ Billion)
Average deal size (US$ Million)
PE-backed IPOs
2008
2009
2010
769
577
1393
$95.8
$112.6
$284.6
$124.6
$195.1
$204.8
52 deals, $10.8b
53 deals, $16.2b
155 deals, $35.0b
Source: DEALOGIC/E&Y
In addition to the traditional role played by public capital markets, recent years have seen the emergence of
private equity and sovereign wealth funds as major players in financial markets.
76
Sovereign wealth funds
Sovereign wealth funds (SWFs) have also recently emerged as another source of business financing in developed
as well as developing countries. SWFs are government investment funds that invest in foreign companies in
order to earn profits and increase the wealth of the state of the origin. These funds have existed for a long time,
but the increase in their scope and magnitude has recently made them a major financial player due to increased
transparency in their operations and the emerging confidence of various developed market regulators. According
to IMF, the assets under control by SWFs in early 2008 which was estimated at US$3 trillion and is expected to rise
to $10 trillion by 2012, making them an inevitable source of alternative in financing businesses in both developed
and developing markets. Keeping in mind the sensitivity of the industry sectors, SWF participation could be
allowed subject to same terms and conditions as applicable to other foreign investors in sensitive sectors.
Role of Stock Exchange in Capital raising
Stock exchanges play a critical role in the capital-raising process (Table 2). During the last five years, funds
raised through private placement of debt capital continued to dominate the scenario as opposed to capital
raised through the primary markets. Exchanges across the world have gone through major structural changes
in the last few years in line with the changing business environment and their financing requirements in their
effort to meet participant expectations. Starting with the demutualization of the Stockholm Stock Exchange
in 1993, the number of financial exchanges that have adopted a “for-profit”, publicly listed organizational
form has grown steadily. This has facilitated a number of innovations during the last decade enabled by their
“for-profit” structure which has also allowed exchanges to raise capital and invest in technology. It resulted
in exchange businesses complementing other businesses in the economy in tapping finance through various
venues including the route of listing on the exchanges.
Table 2: Access to Finance for Companies through Indian Capital Market
Private Placement of Corporate Debt
(in Rs Crore)
Capital Raised from the Primary Markets
(in Rs Crore)
2008-09
1,73,281
16,220
2009-10
2,12,635
57,555
2010-11
2,18,785
67,609
2011-12
2,61,282
48,468
April 2012
23,515
200
May 2012
23,993
246
June 2012
26,250
63
Source: SEBI
Though the total market capitalization of all publicly traded companies across globe experienced wide swing
from a high of US$ 57.5 trillion in May 2008 to drop below US$ 28.7 trillion in February 2009, the exchanges
across the globe have helped companies raise $ 95.8 billion in 2008, $ 112.6 billion in 2009 and $ 284.6 billion
in 2010. As evidenced from Table 3, capital raised in June 2012 indicates the significance of stock exchanges in
enabling companies to raise capital through bonds as well equity route.
77
Table 3: Investment Flows – New Capital raised by Shares and Bonds in the Major Exchanges (US$
Million in June 2012)
Equities
Bonds
Total
1150.42
253.7
1404.13
-
37,274.11
37,274.11
1,376.15
4,003.62
5,379.77
Korea Exchange
124.65
42,282.48
42,407.13
London SE Group
775.38
58,593.91
59,369.29
-
5,490.61
5,490.61
4,008.97
1,207.09
5,216.07
BM&FBOVESPA (Brazil)
Deutsche Borse (Germany)
Hong Kong Exchanges
NASDAQ OMX Nordic
Shenzhen SE
Singapore Exchange
536.67
8,631.99
9,168.65
Tel Aviv SE
33.78
2,965.29
2,999.08
Wiener Borse (Austria)
19.24
3,532.61
3,551.85
Source: WFE
Emerging Sources of fund raising in an integrated world
The recent capital flow dynamics emphasizes the need for global coordination in an environment where capital
has no national boundary. This development has made it easier for companies worldwide to raise large sums
of capital through public offerings and while making it cheaper for market participants to conduct transactions
in deep liquid markets, domestically and across the borders. In addition to increase in ways of raising public
capital, there has been a tremendous increase in the use of private capital such as commercial borrowings,
foreign currency convertible bonds, etc., used by various Indian corporates to fund their growth aspirations.
Another innovative source is “Stand by Equity” which is a flexible and cost-effective alternative to a traditional
equity private placement or secondary offering. It provides the Company with the right, but not the obligation,
to issue shares and raise capital at a time of their choice. Fairly common in Australia, under this facility, the
company receives a firm commitment by the “Stand by Equity” provider to purchase new company shares up
to an agreed maximum value. The facility is normally available for up to 3 years and renewable thereafter. The
programme is entirely controlled by the company.
Conclusion
In the recent times, with the dire need for boosting economic growth across nations, fund raising plays a
critical role for both government and private entities. Development of financial sector infrastructure in line
with the growth in the real economies is essential to effective channelization of wealth and resources. In the
current context of fund flow dynamics, both the market and off-market channels of fund raising play a critical
role in connecting capital with the growth needs of nations. An analysis of various sources of funds reveal
that alternative channels of fund raising have increasingly become predominant source of funds for various
entrepreneurial activities. However, it is essential that the investors in these alternative sources of funds are
provided access to transparent and efficient market infrastructure providing freedom to the companies to
raise funds essential for their various business activities through market as well as providing individuals/
investors to participate in growth opportunities. While the complimentary existence of market and off market
sources of fund raising nurtures entrepreneurial activities in the economy, it also establishes a synchronous
balance in wealth generation, employment creation and wealth distribution as both the markets converge.
78
Time to Complete Unfinished Reform of
Takeover Law
Mr. Somasekhar Sundaresan, Partner, J Sagar Associates
It has been a year since the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011
(“Takeover Regulations”) were brought into force. The Takeover Regulations replaced the old regulations
of 1997, which represented an excellent base on which the architecture of takeover law for the next several
decades was sought to be built. The experience with the new law has been mixed, particularly since the
package envisaged by the Takeover Regulations Advisory Committee (“TRAC”), which wrote the draft of
the new law, has not been fully implemented.
Deviation from Expert Recommendation:
The Securities and Exchange Board of India (“SEBI”) made fundamental deviations from the recommendations of the TRAC. The core aspect of the reform was the obligation of an acquirer to make an open offer to
acquire all the shares held by all other shareholders. The old law required an acquirer to acquire only 20% of
the voting capital, and the new law now requires 26% to be so acquired. Neither is justified by any rationale
or logic if providing an exit opportunity to all shareholders is at the heart of the obligation to make an open
offer when a listed company is taken over.
When the Bhagwati Committee wrote the takeover regulations of 1997, Nimesh Kampani of the JM Financial
Group, a reputed merchant banker of standing and wide experience wrote a dissent note against the concept of making an open offer for just 20%. He was told he was too ahead of his time. Fifteen years later, the
Achuthan Committee unanimously recommended that the open offer should be for all the shares of the listed
company being acquired – popularly termed in the media as the “100% offer size”. The entire committee was
told that it was ahead of its time. SEBI publicly stated that a full offer is the right thing to do, but it would be
the goal that would be eventually reached, and that India was not ready for it.
The ostensible reason for the disagreement with the recommendation of a full-sized offer was that in India
bank funds are not available for financing M&A activity while they are available abroad, and that thereby,
such a law would place foreign acquirers at an advantage over Indian acquirers. A regulatory hurdle from a
fellow financial regulator is a matter to be addressed by working on removing the hurdle rather than creating
a set of new hurdles.
Regulatory Framework Skewed:
However, this has resulted in the regulatory framework getting substantially skewed. Along with the recommendation of obliging an acquirer to offer to buy all shares of the company, the TRAC also recommended that
an acquirer should be given the option of staying compliant with listing requirements – that of maintaining a
public shareholding of 25%. To stay at a maximum of 75%, it had been proposed that the acquirer be given an
79
option to prune what he acquires from the exiting substantial shareholder and from the public in proportion.
Another option sought to be given to the acquirer was to delist the company if the response to the open offer
took his holding to a stake of more than 90%. Therefore, an acquirer who would end up at above 75% but less
than 90% would have consciously done so despite having the option to stay compliant with minimum public
shareholding requirements. If he were not to prune his acquisition to 75% and also does not get a 90% response,
the acquirer would have to become compliant with the minimum public shareholding requirement before attempting to delist the company.
However, SEBI rejected the entire framework of the recommendations on the size of the open offer. Yet, a
prohibition on delisting without first ensuring compliance with minimum public shareholding has been retained, although in a completely new form, making the acquisition of a listed company in India, one of the most
complicated considerations in the M&A space. Under the new law, the acquirer has to make an open offer to
acquire at least 26% of the remaining shares – an increase from the old offer size of 20%. The acquirer cannot
delist the company even if he were to cross 90%. The acquirer is given no option to stay compliant with the
rules governing minimum public shareholding.
Yet, if he were to end up at above 75%, he would have to wait for twelve months before attempting a delisting transaction. Under the Securities Contracts Regulation Rules, 1957 (“SCRR”), whenever the shareholding
crosses 75%, the group holding such shares has to bring their collective stake to 75% or below within a period of
twelve months of crossing the limit. In a nutshell, in any transaction where one acquires more than 49% stake
in a listed company, the acquirer may cross a 75% stake since the response to his open offer could be for 26%.
Yet, the very law that forces him to cross 75% (without giving him an option to prune what he buys, to stay at
75%) would also force him not to attempt delisting unless he prunes his stake to 75% or below.
Yo-Yo of Securities Offerings:
For example, if an acquirer were to acquire 60% from an outgoing substantial shareholder, he would have to
make an open offer of 26%, which would potentially take his post-transaction stake to 86%. Now that would
mean public shareholding would be only 14%, well below the minimum 25% mandated under other securities laws. In this example, the acquirer would have no choice but to end up at 86%. Under the rules governing minimum public shareholding, such an acquirer is required to bring his stake down to 75% within twelve
months. However, during these twelve months, the Takeover Regulations would deny him a statutory right to
attempt delisting, otherwise available under the SEBI (Delisting of Equity Shares) Regulations, 2009 (“Delisting
Regulations”).
In other words, the capital markets would be presented with a yo-yo of securities offerings. First, an offer to acquire shares under the Takeover Regulations, second, an offer to sell shares to achieve minimum public shareholding requirements; and third, yet another offer to acquire shares, this time under the Delisting Regulations.
This is bad policy. In fact, the very spirit and reason for which SEBI has imposed a statutory “lock-in” under the
regulations governing offerings of securities – the SEBI (Issue of Capital and Disclosure Requirements) Regu-
80
lations, 2009 (“ICDR Regulations”) was to ensure that there is no supply of securities right after an offering
since investors who respond to an offering should have stability in demand and supply of the securities. Such
a yo-yo conflicts with that spirit.
Insider Trading Regulations:
If this were not complicated enough, there is also the sword of the SEBI (Prohibition of Insider Trading) Regulations, 1992 (“PIT Regulations”) that hangs over every acquisition of a listed company. The PIT Regulations
prohibit the communication and counseling of “unpublished price-sensitive information” (essentially, information that is unpublished, and which, when published, is likely to materially impact the price of securities), apart
from prohibiting dealing in securities when in possession of such information. Now, it would be quite impossible to acquire even a listed company without conducting any due diligence. It would be Utopian to assume
that the published information available in the public domain about a listed company would alone be adequate
to assess and complete a listed M&A transaction. Therefore, the very commercial path to doing a transaction
that could lead to an open offer under the Takeover Regulations is fraught with the risk of an allegation that the
PIT Regulations have been breached.
The PIT Regulations indeed permit a valid defence of having dealt in securities despite being in possession
of such information provided the acquisition is “as per” the Takeover Regulations. This again, is too vague a
provision. A fair and logical way to construe the phrase “as per” would be to state that acquisitions that would
attract the obligation to make an open offer under the Takeover Regulations alone would be covered by such
valid defence. In the case of smaller acquisitions that do not attract an open offer, the Takeover Regulations
impose only disclosure obligations. The obligation to make an open offer to buy shares from the public shareholders gets attracted when the acquisitions cross certain serious and material thresholds. To acquire listed
securities of above such material and serious thresholds, it would logically be necessary to conduct some form
of due diligence which would result in information being placed in possession of the acquirer.
In any case, under the Takeover Regulations, a letter of offer is required to be circulated to all shareholders
communicating all information necessary for the public shareholders to make an informed investment decision
in relation to the opportunity to divest their shareholding. Such letter of offer and the obligation to publish all
relevant information would, in substance, necessitate publication of any unpublished price sensitive information in the possession of acquirer.
No Articulation of Rationale:
Moreover, the absence of any articulated rationale for the regulatory regime in place can be frustrating for
corporate decision-makers. The Supreme Court has repeatedly exhorted regulators to spell out the legislative
intent behind the measures they take when writing regulations so that the world knows exactly what is in the
mind of the regulator and courts too could interpret regulations with a purposive frame of mind. However,
this appeal has always fallen on deaf ears, and no regulator has started articulating the purpose behind the
regulations it writes.
81
The Takeover Regulations, as currently framed, can in fact become a punishment to the acquirer for having
done a transaction that triggered an open offer under the Takeover Regulations. Statisticians and database
managers can only track deals actually done and build up league tables. By definition, there can be no record of
deals that failed because an acquirer could not handle the regulatory uncertainty and imprecision surrounding
an M&A transaction. Corporate India deserves more predictability and certainty in the conduct of business.
(Disclosure: The author is a partner of JSA, Advocates & Solicitors. The author was a member of the TRAC.
The views expressed herein are his own and do not represent the views of his firm or of FICCI.)
somasekhar@jsalaw.com
82
Debt Capital Market
83
84
Knowledge Paper on Corporate Bond MarketsOverview, Issues & Way forward
Mr. R. Govindan, Vice President (Corporate Finance & Risk Management), Larsen & Toubro Limited
A well developed capital market consists of both debt and equity. In India, equity markets are more popular
and comparatively more developed than the debt markets.
• Corporate bond market is a very good supplement to the banking system of any country. Important lesson from the financial crisis is that when the financial system collapses, a liquid corporate bond market
will support the funding requirements of real economic activity.
• Liquid corporate bond market reduces the cost of capital for issuers.
• Banks have constraints around debt issuances and ALM issues where a robust corporate bond market
can help. Today with excessive dependence on the banking system, corporates end up paying more than
what they would normally pay if they borrowed in the corporate bond market.
• For a country like India, healthy bond market in India can channelize the savings into infrastructure
creation.
Introduction: India Vs. Rest
World GDP is around USD 50 trn, world corporate bond issuances are around USD 3-4 trn, i.e. roughly 6-7%
of GDP.
• India issues Corporate bonds worth USD 50 bn (3%) of GDP compared to 8-12% of GDP in countries like
US, Europe, Japan & China.
• Outstanding CorporateBonds as % of GDP in India is 9-10% compared to 40-70% of GDP in other developing/developed countries.
• Average daily volumes of Corporate bonds in India are USD 200-350 mn as compared to USD 17 bn daily in
USA.
• Total Debt (government debt, household debt & corporate debt) to GDP ratio in India is 120% as compared
to over 300% of GDP in countries like USA, Europe and Japan, which reflects the overleveraged household
and private sector in those countries.
Charts - A quick reflection of India Corporate Bond market
Comparison of % breakup of outstanding bonds across countries
Country
Government
Finance
Corporate
India
76
15
9
Japan
85
9
7
UK
81
18
1
Germany
66
21
13
Brazil
62
37
1
China
54
29
17
USA
44
45
11
Source:BIS,RBI,JPM
85
Break up of Debt financed across bank credit & bonds
Comparison of % breakup of outstanding bonds across countries
Country
Bank loans
Corporate bonds
China
85
15
India
84
16
UK
72
28
Japan
71
29
Brazil
66
34
Germany
52
48
Korea
45
55
US
8
92
Source:JPM,BIS,CEIC
Gross issuance of Corporate bonds
in India (INR bn)
Total outstanding Corporate bonds
in India (INR bn)
Year
Amount
Year
Amount
2007
1057
2007
3356
2008
1431
2008
6210
2009
2026
2009
7920
2010
2378
2010
7620
2011
3100
2011
9070
2012(YTD)
1600
2012
10900
Source:SEBI
Source:SEBI
Percentage break up of total outstanding Indian bonds
Year
Government
Financial
Corporate
2008
91
7
2
2009
88
9
3
2010
86
11
4
2011
80
13
7
2012
76
15
9
Source:BIS,RBI,JPM
86
India CP issuances & Outstanding (INR bn)
Year
Issuances
India CD issuances & Outstanding (INR bn)
Outstanding
Year
2007
178
2007
933
2008
326
2008
1478
2009
442
2009
1929
2010
755
2010
3410
2011
803
2011
4247
912
2012
2012
3000
Source:RBI
Issuances
Outstanding
8860
4195
Source:RBI
Breakup of Outstanding CD,CP and
Corporate bonds
Sectoral breakup of outstanding
corporate bonds
Category
% outstanding
Category
Percentage
Corporate bonds
64
PSU
44
CDs
30
Banks
25
CP
6
Corporate
15
NBFC
16
Source:NSDL,SEBI,RBI
Source:NSDLI
Percentage sector wise breakup of issuances in last few years
Year
Banks
Corporates
NBFCs
PSU
2007
37
2
11
50
2008
28
18
14
40
2009
27
20
12
42
2010
13
21
22
44
2011
8
18
27
47
Source:NSDL
Breakup of Assets of under management
of mutual funds
Category
Percentage
Debt
47
Liquid
25
Gilt
0
Equity
26
Others
2
Source:AMFI
Breakup of Bank Assets
Category
Percentage
Credit
60
Cash+Reserves
5
G Secs
30
Mutual Funds
2
Shares
1
Corporate bonds
2
Source:RBI
87
Key initiatives for market development:
Issuer’s perspective:
• Indian primary bond market is primarily dominated by NBFC issuers and a very small proportion of
issuances happen by manufacturing and service related companies.
• NBFCs engaged in infrastructure financing should be given capital relaxations, incentives to facilitate
dollar borrowing from abroad. Specific capital relaxations can be given to assets financed under takeout
mechanism by Infra NBFCs.
• Efforts of SEBI and stock exchanges to bring trading to electronic stock exchange platforms have not
yielded results. Investor awareness of debt markets in India is very poor, there is a need to have awareness
programmes across cities.
• Since cash credit system of banks works like a loan in perpetuity, many corporates prefer it to bond
financing where the amount has to be returned on a specific date.
• Currently bonds are issued in India only on private placement basis (not more than 49 investors) In order
to use the private placement route, corporates continue to do a number of private placements which
results in market fragmentation.
• Public issue of bonds is uncommon in India. Large corporates ignore the fact that lower cost of capital can
more than offset the higher issuance cost in public issuances. It is important to encourage large corporates
with AAA status to issue corporate bonds on regular basis, which finally results in a deeper bond market.
• Indian market lacks multiple bonds (like mortgage backed bonds, variable cash flow bonds, index linked
bonds, municipal bonds etc) and most bonds issued are in the shorter tenor(3-5 years as compared to
international bonds which are in 10-15 year bucket).
• Issuers are generally comfortable disclosing their minor financial details to banks to obtain loans rather
than disclose them in public domain for Corporate bond issuances.
• Credit team in banking system is decentralized whereas the investment team in a bank is centralized.
Various options are available for loan restructuring for a bank which does not become public whereas a
Corporate bond default becomes public. Hence banks are hesitant to invest in Corporate bonds. Banks
should therefore be incentivized by regulator to invest in Corporate bonds.(MTM relaxation, risk capital
relaxations)
• Corporate bond issuer also has problem of parking money in the intervening period till it is used in business, as against bank cash credit lines which he can draw at will.
• Allow banks to credit enhance bonds by way of guarantees. Allowing banks to credit enhance bond
issues by corporates would encourage lower rated corporate to access debt capital markets as there is
healthy demand for lower rated issues. Alternatively, India should create specialized credit enhancement
institutions in the absence of banks doing the job.India can also look at international insurers to facilitate
credit enhancement.Specific domestic institutions like IIFC, PFC with requisite sector expertise can also
assume credit risk.
88
• Issue of local currency corporate bonds-AA and below. The lack of a good credit spread curve impedes
the pricing of lower rated corporate bonds. Issuers of AA and below should be encouraged to issue more
local currency corporate bonds to facilitate a well price credit spread curve.
• Corporates find it difficult to issue bonds because they fear investors sometimes are highly demanding
and raise far more searching questions about the viability of projects for which funds are being raised.
• Market making is completely absent in corporate bonds because of lack of adequate compensation from
issuers. Most of the arrangers are looking to palm off the stock to investors post issue and hold on to only
part of the stock of they have a positive view on the market. It is suggested to start market making with
a few large corporates coming together.
• PFs are banned from selling in the secondary market unless there are 2 rating downgrades.PF should be
allowed and encouraged to sell in the secondary markets.
• Indian mutual funds can play a very proactive role of channelizing the retail savings into bonds, though
they have launched FMPs, their focus is restricted to institutional guys only. Mutual funds should be
encouraged to float long term infrastructure Corporate Bond fund to channelize the retail savings into
infrastructure financing.
Regulator’s perspective:
• The issue of withholding tax on FII investment in debt needs to be resolved. International pension funds
do not sometimes get any set off for the withholding tax that is deducted in India. The matter should be
taken with SEBI/RBI for a resolution.
• Multiplicity of regulators in the Corporate bond market can be reduced from RBI/SEBI/Company law
board to being under single regulator.
• No uniformity in stamp duty across states. The concept of stamp duty is not proper, stamp duties aim
to tax the transaction itself and not the income, which is unfair. The stamp duty for a typical issuance is
0.38% of the total issue size. An appropriate resolution to the problem should be found.
• Robust investor protection mechanism needs to be in place. A FICCI sub group could be set up to study
and suggest action plan.
• Long and expensive issuance process needs to be sorted out.(issuances involve cost of fiduciary agents,
lawyer fees, registration, rating agencies and bank fees)
• Absence of a proper liquid risk free yield curve is an impediment to proper pricing of Corporate bonds.
(data analysis of G Secs shows that only 8 government bonds are traded for more than 200 days in a
year).A FICCI sub group could study the proposal and meet RBI with its recommendations.
• Currently, only SEBI regulates the Corporate bond market with some oversight by RBI. There should be
some concept of Self Regulatory organizations like National Association of Securities dealers as it exists
in USA. FICCI sub group to could study the proposal and meet SEBI/RBI with its recommendations.
89
Market development perspective:
• Consolidation of issuances is required to improving liquidity.
• Current FII investment limit in corporate bonds is USD 46 bn (Infra increased from USD 5 bn to USD 25
bn) and G Secs is USD 20 bn.FIIs are only investing in the 1-2 year bond market to take advantage of the
high short term rates. FII money being at the shorter end is not being used currently for any productive
use. Once FIIs gain comfort in Indian corporate bonds, they will possibly stay invested in bonds when
down cycle in equities happen thereby nullifying the systemic risk posed by sudden outflow of foreign
capital.
• The current utilization status for bonds is as follows:
Percentage sector wise breakup of issuances in last few years
Particulars
Limit
Utilised
G Secs
USD 20bn
USD 14bn
Corporate Debt
USD 46bn
USD 19bn
Corporate Debt without restrictions
USD 20bn
USD 16bn
USD 3bn
Nil
USD 22bn
USD 3bn
USD 1bn
Recently introduced
Infrastructure Debt Fund
Corporate debt long term infra(1 year lock in with 15 month
residual maturity by FIIs
QFIs investing in Corporate bonds and MF debt schemes
○ FIIs are not interested to come to India with lock in restrictions
○ Withholding tax (To be reduced to 5% in line with relaxation of withholding tax on ECB
interest)
○ All infrastructure companies issuing bonds have to be rated. Annuity projects can get a AAA rating
but all other projects will at best get A rating or below. Even domestic insurance and pension companies are not comfortable investing in A rated bonds, therefore FII investments are ruled out.
○ Possibility of pooling investments into one company to get an enhanced rating is not workable because holding companies are not classified as infrastructure companies. Pooling the SPVs into trust is
possible but it will be difficult to attract investors in Trust structure.
• A FICCI sub group could study the proposal on how to increase FII interest in the long tenor Corporate
bonds. Since there is heavy demand at the shorter end, RBI should keep increasing FII limits for G Secs/
Corporate bonds on a regular basis.
• Currently there is no integrated trading and settlement system for corporate bonds(like NDS Order
matching system for G Secs).The establishment of an integrated trading and settlement system would
increase market transparency through better price discovery and is integral to the development of the
Corporate bond market.
90
• A central body should track and maintain a comprehensive database on primary issues and rating
migrations, which is needed for wider dissemination of market information among various market
participants and would help increasing investor confidence in domestic debt markets.
Investors perspective:
• Risk management products like Interest rate futures and Credit default swaps are in place. Currently
very minimal activity is happening in Interest rate futures market as banks are allowed to use it for hedging purposes only. No perceivable activity is noticed in the CDS market. With effect from November
2011, RBI has permitted CDS on unlisted but rated bonds of infrastructure companies and unlisted/unrated bonds issued by the SPVs set up by infrastructure companies. Users are not allowed to buy naked
CDS. In order to restrict the users from holding naked CDS positions, physical delivery is mandated in
case of credit events. Exchange traded CDS market may also be introduced shortly.
• Unlike Government bonds, wherein there are SLR requirements, banks do not have any compulsion to
invest in Corporate bonds. Further banks cannot invest in unrated instruments beyond a small limit(10%
of non SLR instruments) while there is no such restriction in loans. A small mandatory 5% investment in
Corporate bonds by banks will help.
• Regulatory asymmetry in treatment of loans and bonds in books. Corporate bonds require a higher risk
capital as compared to loans advanced by banks as it involves both market risk and credit risk. RBI could
consider reducing this requirement for bonds given that most bonds are subject to mark to market and
can be sold in the secondary market.
• Unlike FDs where exit is possible for a retail investor, there is no such mechanism for Corporate bonds.
Companies issuing securities should look at doing some kind of buyback to facilitate liquidity for retail
investors. For lower rated corporates, banks can provide some guarantee.
• If banks start investing in corporate bonds, it becomes easier for them to sell it off/reshuffle the portfolio
whenever desired, unlike a typical term loan where they are stuck till the loan matures.
• Although banks give loans of varying credit quality but invest in Corporate bonds of investment grade
only.
• Higher administered rate in small saving schemes is also prohibiting the development of vibrant Corporate bond market.
• Although repo in Corporate bonds is permitted, the market has not developed. Currently, AA bonds
and above are permitted for repo operations, repo available for 1 day to 1 year and bonds are subject to
25% haircut. Illiquidity of the underlying asset leads to drying up of the repo market during periods of
crisis.
• Short selling should be permitted in Corporate bonds. Even today the short selling provisions for govt
securities are very stringent. For example in case of Government bonds short selling is allowed in only
0.25% of the total issue, a bank can hold a short position in G Secs for only 90 days and in case of a
delivery failure, bank is barred from short selling for 6 months.
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• Allow FIIs to invest in securitized debt issues. Currently pass through certificates while are classified as
security, are not notified as eligible investment for an FII by RBI. Allowing FIIs to invest in PTCs will help
develop structured debt market in India.
• Credit exposure limit: Banks should be allowed to run trading positions in corporate bonds without hitting credit exposure limits which includes corporate banking exposure. This will enable PSU banks to
participate in the corporate bond market.
• Introduction of HTM in Corporate bonds for banks and primary dealers irrespective of maturity. This
should be done at least for issuances of infrastructure companies.
• Households are a very important constituent, is practically absent because of the lack of an efficient legal
system that is critical to investor confidence and the unhappy experience with the debenture trustees.
• Increased market participation: PF trusts are currently not allowed to churn their portfolios. This may be
revisited as world wide, the returns declared are market linked and not fixed at a particular level.
Debt markets and Infrastructure financing:
• Global imbalances - A savings and investment perspective:
Global savings and investment balances have fallen over the years and the current account imbalances
have widened to unprecedented levels. Savings in Asia which ideally should have been channelized into
investment in Asia have been diverted to the US to finance its current account. Some part of the savings
in Asia have been diverted to the US Asset markets resulting in the asset market bubble.
• Is there a change in perspective?
Data shows that Japan over the years is slowly transforming from savings driven growth model to a more
consumption driven growth model. China, on the other hand, has realized its folly and is now focusing
on a more consumption driven model.US is slowly but steadily reducing its current account deficit.
• India’s growth model:
Delta to India GDP during 2003-08 is contributed mainly by investments. India’s investments account for
36% percent of GDP compared to savings rate of 33% of GDP, the remaining 3% being funded by capital
flows from abroad. Since India is facing structural inflation issues, it is imperative that investments continue to grow over the next decade. For investments to happen in India, two things must happen:
○ Either India should reduce its consumption so that domestic savings finance domestic investment.
○ Or India must consistently get foreign savings year after year.
• India’s investments since independence:
Since independence, India’s growth and investments can be categorized as follows:
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Period
GDP
Investments
Between 1905-1980
3.5%
Below USD 10bn per year
1980-1990
Sub 5%
10 bn a year
1990-2000
5-6%
30 bn a year
USD 100bn per year between 00-03
2000-2012
7+
USD 250bn per year between 03-06
USD 300-350bn per year between 06-12
• Infrastructure investments as % of total investments in India:
India’s infrastructure investments as % of total investments every year: Out of USD 350 bn of investments
every year, India’s infrastructure investments every year is around USD100 bn or about 28%. For the 12th
5 year plan India aims to increase this share to 50%. In other words, out of USD 350 bn of investments
every year, USD 170 bn will be infrastructure investments.
• A study of India’s savings:
The cumulative savings/investment in India as on date is around USD 2.9trillion.The cumulative
break-up of savings and investments is as follows:
Type of Savings
Amount(USD bn)
Deposit sources
USD 1200bn
Non Deposit sources
Household savings
USD 1000bn
Private sector
USD 700bn
Non deposit sources of USD 1.7 trillion represents investments by households and corporates into securities, mutual funds, insurance, pension funds and government securities.
Out of 34% savings currently, household savings are currently 24% and private savings are 10%.On a net
basis, Government sector does not have any savings.
Current pattern of savings of the household sector is as follows:
Cash: 6%
Deposits: 44%
Insurance/Provident/Pension Funds: 22%
Small savings: 12%
Mutual Funds: 3.6%
Government securities: 2.4%
Others: 9%
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A careful look at the above savings will tell us that Government takes a lot of these savings for financing
a major chunk of its revenue expenditure. Once the government gets its house in order, a lot of bank
deposit savings and Insurance/Provident/Pension fund savings will find its way into the infrastructure
space. Alternatively through various incentives, retail savings can directly be channelized into the
infrastructure space.
• Summary of India’s infrastructure investments over the years:
Historically India has always lagged in infrastructure capacity creation:
Plan
Estimate (USD bn)
Actual (USD bn)
Achievement (%)
9th plan(97-02)
130
107
82
10th plan(02-07)
158
117
74
11th plan(07-12)
500
496
99
12th plan(12-17)
1000
800(Exp)
80
India has a history of achieving around 80% of its targeted plan spend, 11th Plan being an exception
where Oil and Gas (USD 86 bn) and telecom (USD 88 bn) helped achieve targets. Both Oil and Gas and
telecom were part of the original plan expenditure of USD 500 bn.
• India’s infrastructure competitiveness Vs Rest of the World:
The Global Competitiveness Index of the World Economic Forum which ranks the infrastructure development in 133 countries across the globe has ranked India at the 86th place in 2010-11.India ranks well
below the BRICs nations-China at 50, Brazil at 62 and Russia at 47.
• Sector wise break up of infrastructure investments India:
The sector wise actual breakup of expenditure for the 11th and 12th Plan is as follows:
Infrastructure
Power
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11th plan
USD bn 12th plan
% growth
118
230
95
Oil & Gas
86
160
86
Roads
71
153
115
Railways
44
105
139
Irrigation
45
74
64
Telecom
88
70
-20
Water supply
26
56
115
Ports
8
23
188
Airports
8
8
0
Warehousing
2
4
100
496
883
• Current funding of India’s infrastructure investments:
While difficult to quantify, a rule of thumb suggests that India’s infrastructure deficit shaves off 2
percentage points of its GDP every year. The 12th Plan envisages investments of $1 trillion in Indian
infrastructure in the next five years. Half of this is expected to be funded by the private sector. The
estimated funding for the 12th plan is as follows:
Funded by
Type of financing
%
Central/State Govt.
335
38
Banks/FIIs/NBFCs/ECB
304
34
Private/PSU cos
244
28
883
If India has to achieve USD 1 trillion target, then at least USD 200 bn of foreign capital may be required.
Various constraints into infrastructure financing can be summarized as under:
Constraints to Equity financing into infrastructure:
○ High gearing(3:1)
○ Operationally complex/risky jobs
○ Non availability of exit options for the private investor
○ Corporate Governance issues
Constraints to Debt financing:
○ Lending institutions prefer lending for short/medium term(5-7 years)
○ Loans from multi lateral agencies perceived to be cumbersome procedure.
○ Lack of proper bond market
○ ECB guidelines limit compensation for lenders who take higher credit risk
Execution and policy issues pose significant challenges to infrastructure investments:
○ Delay in environmental clearances.
○ Land acquisition
○ Lack of clarity over regulators role in determining tariffs.
○ Bottlenecks in fuel availability
○ Poor financial health of State Electricity boards
○ Prevailing high rates of interest.
○ Rising cost of other raw materials like cement, steel & bitumen.
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Major suggestions for improving infrastructure financing in India:
o Government of India to consciously work on reducing fiscal deficit(specific emphasis on increasing
capital expenditure)
o Asset liability mismatch of banks can be improved if banks attract long term deposits from retail
investors (tax breaks can help).
o Enhanced exposure norms/security classification for infrastructure lending(for both banks/
NBFCs)
o Take out financing (Since April 2006, IIFCL has sanctioned loans to the tune of INR 586 bn to 267
projects).Quicker the pace of IIFCL, faster will banks be able to free up their balance sheets and
move on.
o Insurance/pension fund investments into infrastructure space needs to be revisited.
o Developing municipal bond market for financing urban infrastructure.
o Infrastructure debt funds as a concept is there but not many have been set up till date.
o Attract retail savings into infrastructure bonds.
o Forex reserves for infrastructure development.
o Further ECB relaxations for infrastructure development.
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Corporate Bonds in India- A Perspective
Mr. Rajkumar Singhal, Managing Director-Head of South Asia Local Markets and Rates
Trading-Global Markets, Bank of America Merrill Lynch
Indian economy grew at a scorching pace in the last decade and along with growth in GDP, corporate
borrowing also burgeoned rapidly. According to Prime Database, debt private placement has jumped to INR
2.5 trillion in 2011-12 from INR 0.45 trillion in 2001-02. In the current year, April- June quarter saw placement
of INR 0.64 trillion (a 29% YoY growth). However even with this multifold growth, corporate bond market
is still perceived as an opaque market which lacks liquidity and adequate market making, playing second
fiddle to both Government Securities (G-Secs) and Loan market.
Chart 1: Amount mobilized through Debt Private Placement (in INR Trillion)
Source: PRIME Database
Though the absolute size of corporate bond issuance and bond outstanding is gigantic, it pales in comparison
to overall size of the economy. For example, corporate bond issuance globally is about USD 3-4 trillion which
is 6-8% of world GDP. In developed countries like US and Japan, the ratio stands at 11% and 7 % respectively.
In China, the ratio has jumped from 5% in 2005-06 to 17% in 2010-11, however in India, the ratio stands at a
dismal 4%, though it has climbed from 1% in 2005-06 ( according to an article by The Economic Division,
Department of Economic Affairs). Even the total corporate bond outstanding to GDP for India is just 1.6% as
compared to 27% for Malaysia and 37.8% for Korea according to a paper published by International Journal
of Trade, Economics and Finance.
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Chart 2: Corporate Debt Outstanding as % of GDP
Source: BIS
Indian borrowers have not only tapped domestic bond market but also borrowed in Dollar, Yen, Swiss Franc,
Yuan etc in the last few years. Among the currencies, Yuan borrowing has gained attention as after swapping,
Indian corporates can still save 0.5–1% over other currencies. IDBI Bank Ltd. became the first Indian company
to borrow in Yuan, raising RMB 650 million for three years at 4.5% in November 2011, followed by ICICI and
IL&FS raising RMB 210 million at 4.62% in March and RMB 630 million at 5.75% in April 2012 respectively.
Even dollar denominated bonds has seen an uptick with nearly USD 3.6 Billion being raised in July- August
2012 by State Bank of India, ICICI Bank, Axis Bank, Indian Overseas Bank, Union Bank of India and Exim
Bank. Banks typically use the funds for lending to Indian corporates’ overseas operations.
In domestic corporate bonds, there are two distinct segments:
1. Liquid segment dominated by Banks/ PSUs and few AAA and AA+ rated private players
2. Illiquid segment dominated by names starting from AA+ ( those without strong promoters) and going
all the way to un-rated papers
In the liquid segment, there are only 12-15 issuers who issue in large size at frequent interval. Liquidity
can be tricky even in the liquid segment with total trading volume daily across names averaging just USD
200 million (nearly one tenth of G-Secs and USD 14-18 Billion in US corporate bond market, as per SIFMA).
Further, there is no regular or fixed calendar followed by issuers hence we have seen the same issuer issuing
twice/ thrice in the same month and at the other extreme not issuing for months together. Another distinct
feature is every new issuance has a new ISIN ( due to private placement regulations which restricts total
number of issuers) and hence with every fresh issuance, the previously issued bonds becomes illiquid and
98
trades at 1-2 bps discount to the new bond (1 bps is one hundredth of a percent). The illiquid segment
is dominated by hold to maturity investors and with 98% of borrowing in secured form. Further as CDS
and other risk transfer tools haven’t developed, bonds typically have duration of less than 5 years. Specific
financing needs from corporates have led to innovative structure, such as Perpetual Bonds and STRPPS, FII
specific structures in the past.
Investors in the corporate bond market are Pension Funds, Insurance Companies, Banks, Mutual Funds, FIIs,
HNIs with small retail participation. While Pension Funds and Insurance companies focus on the longer
end of the curve for ALM requirements, MFs and FIIs are focused on shorter (1-3 year) segment. Each of
these investor classes has to comply with respective regulators. Specifically in case of FIIs, we have seen the
Ministry of Finance/RBI liberalizing rules to welcome greater inflows. Steps such as expanding available
limits, regularizing limits auction calendar, possible deferment of GAAR have cheered FIIs. However on the
other hand, the current limits are for one time usage, which prevents FIIs from churning their portfolio hence
impeding liquidity.
Chart 3: Investment in India in debt by FIIs (in INR Billion)
Source: SEBI
To make the market broad based, the market also needs strong retail participation, which leads to a virtuous
cycle of liquidity, stronger regulations and in general development of the market. India already boasts of a
vibrant equity market and logical next step will be to develop a strong corporate bond market. This is a winwin proposition as it not only provides corporates another avenue for financing (often with cost benefits),
it also provides retail investors higher returns with relatively reduced risk and volatility. The success of tax
free bonds has already demonstrated the depth of this segment. Public issuance has grown from INR 15
billion in 2008-09 to INR 350 billion in 2011-12 as per the Economic Times, mainly boosted by tax-free bonds.
99
Multiple steps to increase retail participation have been undertaken such as trading on exchange such as
BSE/ NSE , providing pick up in yields ( in some cases upto 90 bps to retail investors), minimum lot size of
INR 1000/ 5000 compared with INR 1,000,000 in regular bonds among others. However, most top corporates
haven’t shown interest in this segment, as they have happily tapped credit lines from banks; as a result public
issuance has been mostly from NBFCs.
There are various proposals in pipeline such as inviting Primary Dealers to make markets, further promoting
and streamlining CDS, introducing screen based trading in addition to specific stimulants for each investor
class for promoting the market. One of the major proposals is to reduce the withholding tax (WHT) for FIIs.
Though the government has recently reduced the WHT on foreign borrowings in the form of loan or infra
bonds, we strongly believe that WHT should be reduced for the FIIs as an investor class as well. This should
be done both for government bonds and corporate bonds. Foreigners’ holding of Indian bonds is dismally
low at 2-3% as compared to 30-40% for other Asian countries like Korea, Malaysia and Indonesia.
As India’s economic growth languishes at sub 6%, with most corporate portraying a bleak outlook, India Inc.
will need all the support to prod them to boost investment. A cheaper and broad based source of financing via
bonds will go a long way in strengthening the balance-sheet for these firms. The 12th Plan envisages investments
of $1 trillion in Indian infrastructure in the next five years. Half of this is expected to be funded by the private
sector. With banks already grappling with huge asset-liability mismatches and NPAs from State Electricity
Boards, it has become quite critical that corporates (especially in infrastructure space) diversify their source of
funding. Further with RBI gradually easing its monetary policies and interest rates poised to drop in coming
months, the stage is set favorably for investors. What is required is a coordinated and objective thrust in
this area!
Source: Reserve bank of India, Prime Database, FICCI, International Journal of Trade, Economics and Finance, The Economic
Division, Department of Economic Affairs, Ministry of Finance.
100
The INR Corporate Bond Market: An Overview
Mr. Vineet Patawari, Associate Director, Institutional Sales, HSBC Global Markets, India
The Indian bond market has historically been dominated by bonds issued by the Government of India (GoI).
Traditionally, bank loans have been the primary source of credit for the domestic corporates. Bond issuances
have been the exception rather than the primary source of funds, due to the lack of a diverse investor base.
Government bonds on the other hand have enjoyed regulatory benefits including imposition of the Statutory
Liquidity Ratio1 which mandates investments by banking institutions, as well as demand from insurance and
pension/ provident funds which are required to invest a certain proportion of their asset base in these.
However, the current decade has seen an increasing issuance volume and appetite for non-sovereign debt
fuelled by strong credit demand from financial institutions and manufacturing as well as the emergence of new
classes of investors such as mutual funds and insurance companies
Certificates of Deposits and Commercial Paper
Along with Treasury Bills (91, 182 and 364 day issues by the Government of India), Commercial Paper and
Certificates of Deposits comprise the sub-one-year tenor portion of Indian Debt Market. The exploding consumer
and commercial credit off-take in the country has led to a burgeoning requirement for short term credit from
banks and financial institutions.
The secondary market for CDs and CPs is primarily a broker-driven market with moderate levels of liquidity.
The yields and liquidity in these instruments are highly influenced by technical factors like short term liquidity
in the financial system. Investors in these instruments are typically mutual funds and financial institutions that
seek to deploy short-term liquidity or capital.
Corporate Bonds
Corporate Bonds can be broadly classified as those issued by:
1. Banking Institutions
2. Non-Banking Financial Institutions (both Central and State)
3. Central and State Public Sector Enterprises
4. Corporates (Manufacturing and Others)
The yield and liquidity of the issues vary across the issue categories. . This market is primarily driven by
private placements and it is estimated that over 90% of debt issues are placed privately. A major constraint
to liquidity in this market has been the absence of a diverse investor and issuer base. The demand is predominantly for highly-rated issues and investors are limited to insurance companies, pension funds and
____________________________________________________________________
SLR is the proportion of Net Deposits and Term Liabilities that banks are required to invest in Government Securities.
1
101
commercial banks. Banks and Insurance companies are limited by restrictions on the amount of investments they are allowed in corporate paper. In spite of these drawbacks, the market has shown significant
growth and the issuance volumes have been trending upwards. (Chart 1)
Chart 1: Corporate Debt Issuance
Corporate Debt Issuance (INR Billion)
3500
3013
3000
2405
2500
2055
2000
1763
917
1000
500
1463
12791354
1500
162
295
602 566 508 531 564 684
460
394
13
12
FY
11
FY
10
FY
09
FY
08
FY
07
FY
06
FY
05
FY
04
FY
03
FY
02
FY
01
FY
00
FY
99
FY
98
FY
97
FY
FY
FY
96
0
Source: Prime Database (Please note that FY13 figures are till Sept end)
Investor Base
The major investors in the rupee debt markets are:
1. Banks and Financial Institutions
2. Insurance Companies
3. Mutual Funds
4. Pension Funds
5. Foreign Institutional Investors (FIIs)
6. Large Corporates
7. High Networth Individuals (HNIs)
Reforms in the Corporate Bond Market
The evolution of Government securities market has an important bearing on the development of the corporate debt market, though the latter is not yet developed, for reasons stated above. The Government securities
102
market had the benefit of unrelenting support from the Government and the RBI for obvious reasons. On the
other hand, the corporate debt market did not enjoy a similar patronage. Some of the reforms in this area are
as follows:
1992: Government abolished the ceiling on the interest rate that erstwhile Controller of Capital Issues used to
stipulate for issuance of corporate debentures
1994: NSE started trading in debt instruments through its WDM segment. However, WDM has been mostly
used as a reporting platform for the deals on the OTC market. The WDM segment of BSE commenced operations in 2001.
2009: Corporate Bond settlement through NSCCL. This has removed much of the counterparty risk from the
system and made the settlement procedure more robust.
2010: Corporate Bond Repo-RBI has announced the permissibility of Corporate Bond Repo between the
market participants. The facility is now in process of implementation.
2012: Corporate Bond Trade Reporting-All the OTC trades need to be reported online on the platform
developed by FIMMDA and accessible to public through internet. This has resulted in better transparency
and price discovery in the corporate bond market.
Problems with the Development of the Corporate Bond Market
Corporates – Bank financing versus bond financing: Till the early 1990s, the Indian Corporate sector was sourcing its long term funding requirements – from the so-called development financial institutions (DFIs such
as Industrial Development Bank of India (IDBI) and ICICI) and from commercial banks for their short term
requirements, working capital requirements. Development of the capital markets facilitated disintermediation and companies started tapping the bond/debenture markets in the 1990s. However, the disappearance
of development financial institutions, which were the main source of long term finance, caused a vacuum.
While, this should have been a great opportunity for developing a bond market, this surprisingly did not
happen. Corporates resorted to their growing internal resources, raised resources through low cost equity
taking advantage of the equity boom, borrowed abroad taking advantage of low interest rates and wherever
possible, approached the long term debt market through the private placement route. Further, in the absence of hedging avenues, bond financing turned out to be more risky and less flexible in comparison with
bank financing.
Risk Management: The derivatives markets in India are not sufficiently developed to enable both issuers
and investors to efficiently transfer the risks arising out of interest rate movements. Though markets exist
for interest rate swaps and interest rate futures, the number of participants is limited and the market is not
broad and deep. The primary cause for this situation is the lack of a term money benchmark, which restricts
the development of the swap market as well an efficient term money market. Interest Rate options either
exchange traded or OTC are not permitted. This, combined with Mark-To-Market regulations, deters banks
from investing in corporate bonds. Banks therefore show a distinct preference towards traditional lending
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which permits them to change their base rates based on their cost of funds, which includes changes on
account of interest rate movements and therefore their cost of deposits. .
Tax Deducted at Source (T.D.S): In the case of corporate bond TDS is deducted on accrued interest at the end
of every fiscal year as per prevalent tax laws and a TDS certificate is issued to the registered owner. While
insurance companies and mutual funds are exempt from the provisions of TDS, other market participants are
subject to TDS in respect of interest paid on the corporate bonds. Interestingly, TDS was viewed as a major
impediment to the development of the Government securities market and was abolished when the RBI pointed out to the Government how TDS was making Government securities trading inefficient and cumbersome.
Besides efficiency issues, the different treatment meted out to insurance companies/mutual funds on the one
hand and other market participants on the other also makes it difficult to introduce a uniform computerized
trading system.
Stamp Duty: Stamp duty is a significant source of revenue for State governments. The Indian Stamp Act is
an enactment of the central government. States have powers to make amendments to the Act. Section 3 of
the Stamp Act stipulates that stamp duty has to be paid as per Schedule I to the Act. States have by way of
amendment, introduced schedule IA to the act with differential stamp duty payable in different states. Duty
is levied on financial instruments both at the time of issuance or on transfer or on both depending upon the
nature of the instrument, issuer etc. These duties are perceived to be very high and act as a deterrent to the
development of the bond markets. Promissory notes attract much lower duty. In the interest of developing
the corporate bond market, there is a pressing need for rationalization of the stamp duty structure across the
country. Since stamp duty heavily impacts the cost of issue of bonds and debentures, it would be desirable to
reduce stamp duty levels and also introduce a suitable provision which stipulates the maximum amount of
stamp duty that is payable in respect of any single issue. This will not only bring down the cost of issuance
but will also lead to the creation of a single stamp duty rate. As has been mentioned earlier, the stamp duty
is generally levied by each State Government, and they differ across States. Hence, there is a need to take the
State governments into confidence to rationalize the duty structure. Further, the stamp duty applicable for a
security differs on the basis of the class of investor. This discourages corporates from issuing bonds to certain
class of investors like retail investors (either directly or through mutual funds), and to long-term investors
like insurance companies, provident and pension funds.
Fragmentation: Size of individual debt issuances is generally small. There is no cap on the number of issues a
company can make. Corporates, especially the medium and small ones, prefer to raise resources as and when
required on cost considerations. In addition, they take recourse to the private placement route, which leads to
creation of large number of small issues. Corporates thus tend to go for multiple issues primarily to avoid the
hassles involved in going through the pubic issue route as also to limit the issue size to their current requirements. (Under the extant guidelines, if a bond issue is to be sold to 50 or more investors, the issuer has to follow the public issue route which is cumbersome, costly, and time consuming). This results in fragmentation
of issues and is not conducive for the development of a liquid bond market. This however, could be corrected
through regulatory caveats or by making public issuance structure simpler.
104
Information: Information is key to price discovery. While at a broader level, spreads on a corporate bond
ought to be decided on the basis of its credit rating and the sovereign yield curve, this is not necessarily
the case in reality, on account of subtle credit differences, liquidity in the paper and mandated investments
which create preferences for certain issuers. Therefore, bonds with the same rating but issued by different
issuers trade at different prices and in the absence of credit migration matrix, it is difficult to assess the probability of default for a rating class and vice versa, price a bond based on its probability of default.
Furthermore, a centralized information system for historical trade data is required to track the change in
spreads and prices on account of a variety of factors, which is not available to date in India. Such information
would help both issuers and investors in fair pricing.
Trading in corporate bonds, though mandated to be reported to the Stock Exchanges, remains an OTC market.
Price discovery therefore continues to remain inefficient.
Market Practices: Uniform market practices are a prerequisite for efficient markets. This is, however, not the
case in Indian markets. For instance for a trade on stock exchange like the WDM segment of NSE, the minimum
amount of trade is Rs. 1 million. However, OTC market transactions are flexible in terms of the deal size.
Coupon conventions also differ (such as Actual/365, Actual/Actual etc.,) leading to problems in settlements.
Bodies like the Fixed Income Money Market Derivatives Association (FIMMDA) have developed some
standardized practices. However, as FIMMDA is not yet a Self Regulatory Organization (SRO), these practices
are merely recommendations at the best and are not being followed by issuers at large. While the CCIL has
recently been made the central counterparty for all trades settled between market counterparties on a DVP-I
(Delivery Versus Payment) basis, the system is yet to graduate to a true DVP settlement system (DVP-III).
The absence of multilateral netting also reduces the liquidity in the market.
Market Makers: The role of market makers is significant in an incipient market but it is easier said than done.
Since market makers are supposed to add diversity to the market, they assume a lot of risk in such a market
and need to be backed up, both in terms of financial resources and the supply of securities. Currently the Indian
markets do not have a class of such market makers in the corporate debt markets. To create such a class of
market makers, one solution is that the investment banks that help corporates to raise money from the market
can possibly be roped in to market making in the bonds, which they have helped in issuance. However, lack
of adequate compensation from issuers and/or the market is a disincentive for such a system to develop. Most
issuances in the Indian market pay only very negligible fees or in most cases no fees at all. Thus, the “arrangers”
of debt issues in most cases attempt to sell the issued securities on a back-to-back basis to investors or hold these
on the books only in cases where there is a positive interest rate or spread trading view.
This situation, along with the considerable information asymmetry and lack of public information has also led
to the development of a class of “arrangers” who distribute debt paper to smaller, non-whole sale investors
such as small pension funds, upcountry co-operative and rural banks as well as to High Networth Investors
with large margins. This development is not necessarily healthy for the development of an evolved debt
capital market.
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Narrow Investor Base:
(a) In developed markets, provident and pension funds are large investors in corporate bonds. In India,
these funds have been traditionally investing in Government securities on account of the preference for
safety as well as a political preference against private sector debt and equity. The guidelines issued by
the Central Board of Trustees (which is governed by the Ministry of Labour rather than the Finance Ministry belies this preference) to these funds for their investments which are skewed in favor of Government securities, Government guaranteed investments and PSU Bonds. However, transparency in terms
of pricing and credit worthiness of the borrowers would be necessary prior to a larger allocation towards
private sector paper to prevent abuse of the system. In fact, there is a case to consolidate the investment
function of small Pension and Provident Funds to achieve greater efficiency and professional management of these funds. Further, the Pension and Provident Funds are typically “Hold till Maturity (HTM)”
investors and once they buy any bond, they are not mandated to sell unless in exceptional circumstances.
This reduces the liquidity in the market as a significant investor class does not trade in the bond. It would
significantly help to deepen the corporate bond market if this investor class is allowed to trade within
their normal investment activity.
(b) Co-operative banks are permitted to invest up to 10% of their deposits in PSU Bond and only scheduled
co-operative banks are allowed to invest in private sector bonds. Allowing all co-operatives banks to
invest in high quality corporate bonds would assist the development of the debt markets. However, as
in the case of pension funds, there needs to be a more credible price discovery system as a prerequisite
for the opening up of the investment norms for such banks.
(c) Retail investors’ participation in tradable fixed income securities is very negligible. One of the reasons is
higher interest rates offered on the Government’s own small savings scheme, which is being addressed
by bring these rates to align with market rates. However, the minimum trade size, transaction costs and
illiquidity of bond markets hamper the involvement of retail investors in this market. While internationally individual investors participate in the bond markets through Mutual Funds, the pre-occupation of
the mutual fund industry with wholesale investors and their hunt for Asset Under Management (AUM),
have led to the small investor being largely ignored by the industry. Sustainable development of the
Mutual Fund industry itself necessitates a re-orientation of priorities, which the SEBI has been pushing
towards. However, development of appropriate products and innovation cannot take place by regulatory fiat. Last year, the issuance of Tax Free Bonds have seen significant interest from High Networth Individuals (HNIs). These bonds filled up a genuine investment needs for HNIs as they provided attractive
post tax returns. However, the focus on retail investors is slightly misplaced as these bonds are attractive
only for the investors in the top tax brackets. Retail investors are not the natural investors in these bonds
as they would be better off by investing in comparable taxable instruments.
(d) FIIs do not have a large presence in the debt markets. They use the debt markets for parking the funds
temporarily and for portfolio management in a limited way, along with short term arbitrage activities.
The reasons for these are the current tax laws and regulations on hedging their foreign exchange risk.
106
FIIs unlike in the international market, cannot undertake asset swaps to hedge their foreign exchange
risk but can only enter into forward contracts to hedge the principal amount of the paper invested in (or
market value, whichever is higher). However, there is reluctance on the part of the regulators to genuinely address the requirements of FIIs in the debt markets unlike the equity markets, based on the belief
that large debt flows restrict the operation of domestic monetary policy. The increases in debt investment
limits therefore remain a cosmetic measure with no real desire to open up the market.
To summarise, we would suggest that to develop the corporate bond market, we would need further reforms
and some of the reforms include:
1. Development of deep and efficient Term Money Yield curve to enable efficient hedging structures to
be developed
2. Rationalisation of T.D.S. on corporate bond in line with Government Securities
3. Rationalisation of Stamp Duty at the time of issuance of bonds.
4. Development of Uniform market conventions
5. Encourage issuances in Benchmark sizes
6. Development of Market makers in the corporate bond
7. Diversification of the investor base
Given the acknowledged importance of the corporate bond markets as a part of efficient and deep capital
markets in the country, these issues require to be addressed at the earliest. While the Reserve Bank of India
and the Ministry of Finance are seized of the importance of the issue, the pace of reforms and establishment
of an institutional framework for the market has been slow in comparison to what has been achieved for the
Government Securities market. With the size of investments envisaged for the infrastructure sector, the gross
capital formation required to maintain 8%+ GDP growth, efficient channeling of the relatively high domestic
savings would be required. The need therefore to move ahead with the development of this market cannot
be overemphasized.
107
108
Macroeconomic
Framework & Policy
Reforms
109
110
Current State of Indian Economy
Dr. Rajiv Kumar, Secretary General, FICCI
Dr. Soumya Kanti Ghosh, Director, FICCI
Recent developments indicate the global economy grappling amidst a difficult situation. The state of affairs
in the Euro zone remain particularly worrisome, with IMF WEO for July 2012 putting the growth forecast for
the Euro area at (-)0.3% and 0.7% for 2012 and 2013 respectively. The world output is projected to grow by
3.5% and 3.9% in 2012 and 2013 respectively.
While the situation on external front remains difficult, there has been a discernible slowdown in the domestic
economy as well. The latest GDP numbers indicate moderation in growth; the IIP and export data also show
conspicuous signs of deceleration. And to add to that the fiscal situation persists to be one of the major
concerns. Inflation also continues to be stubborn, showing no signs of abating.
Nevertheless, despite this current phase of slowdown, what remains important is to acknowledge the fact
that India over the past few years has witnessed some structural changes and these changes are an important
aspect in strengthening its position as one of the leading investment destinations.
India once again is ready to take the next leap forward and has proved its commitment to the reform process.
The country remains committed in its endeavor to provide an environment conducive for investors.
The recently announced reform measures have set the ball rolling and are expected to infuse some buoyancy
in to the otherwise gloomy scenario that had been prevailing in the economy. The government’s final call
of action on some of the long pending but imperative areas of reforms has certainly been taken in a positive
stride by the investors’ community.
Some of the key announcements which included liberalizing FDI, decontrolling diesel prices and proceeding
more aggressively on the path of disinvestment reflect the erstwhile endeavor of the government to tread
the economy on to a path of higher growth trajectory. The understandable benefits of these announcements
cannot be ignored.
With the opening up of FDI in multi brand retail, we may be standing on the anvil of a retail revolution.
It may be noted that the country’s urban population has increased by nearly 90 million between the years
2001 and 2011 and is expected to increase by 250 million (as per independent forecasts between 2008 & 2030).
Besides rapid urbanization, it is vital to mention here that the expanding rural and semi rural markets also
provide potential opportunities for the retail industry.
111
Also, millions of youth would be trained for the skilled jobs created by the large format retail stores. One
needs to keep in mind the challenge of generating 10 million new jobs in our economy simply to absorb new
entrants in the workforce.
Further, the move of decontrolling diesel is indispensable in wake of 1) our rising subsidies and ballooning
fiscal deficit 2) increasing import bill. It may be noted that India’s rising deficit (trade and current account)
is largely due to rising imports of oil products. Import of these commodities should therefore be managed
through immediate policy action. The average oil import bill (in $) has increased by 22% in the last 5 years,
with the oil import bill rising by 32% in the FY12.
Post these announcements the rupee appreciated by nearly 1.5% with in a week to be at Rs 53.91/USD on
September 21, 2012, it was last seen around this level in May this year. There has also been a visible increase
in the FII inflows. For instance, by looking at the trend of FII inflows in the month of September 2012, it is
clearly noticeable- between 3rd and13th September 2012 the FII inflows amounted to USD 249.95 million,
post the announcements on September 14, 2012 the inflows till date have been USD 4255.37 million.
In addition, the most recent set of announcements that included proposal of raising FDI caps for insurance
and pension sectors and the likely amendments to the Companies Bill and Competition Act are also most
welcome.
With the government finally breaking the long hauled lull in the reform process, the country is finally
cracking the image of going through a policy paralysis. It will be important that this reform process is
carried forward in right earnest. Some action on other pending but very crucial issues like land reforms
and getting environment clearances also need to be taken forward. These would be decisive for allowing the
manufacturing sector to be the next big thing for India.
Also a forward movement on GST, introducing greater competition in the mining sector (particularly
coal), strengthening framework and creating new avenues for infrastructure financing and improving agrimarketing systems are some areas where the government should now focus on.
India is a storehouse of opportunities and the country’s growth story still finds echo in her enjoying a special
status amongst MNCs and fund managers as an attractive investment destination. It is important that we
continue to leverage this status.
112
Cues lie in the eco survey
Dr. Ajit Ranade, Chief Economist, Aditya Birla Group
The Economic Survey is an annual report card on the economy, and a statutory submission to Parliament. In
recent years it has also served as a window to the mind of the government, revealing what the policy makers
are thinking about economic reforms. Whether these reforms get implemented either by executive decisions
or though bills tabled in the House is a different matter. But those ideas do enter the public domain, and
become more robust through debate. The need to allow FDI into multi-brand retail was articulated in this
year’s Survey.
Some other notable ideas are also worth mentioning. To deal with the dilemma of food inflation amidst
record foodgrain stocks, the Survey had advocated selling small quantities throughout the year. This is in
contrast to the present practice of selling through a tender process to large wholesale traders only. This
continuous dribble sale of small quantities puts a bearish pressure on prices. Though the idea is three years
old, it has seen the light of implementation only now. Another reformist idea was the use of smart cards
in the sale of fertilisers, so as to better target beneficiaries, and reduce the ballooning subsidy (the fertiliser
subsidy last year was approaching Rs 1 lakh crore).
Another suggestion was the removal of perishable items like fruits and vegetables from the purview of
the APMC Act. This has only been done piecemeal in some states. Reform ideas in the public distribution
system include the use of cash transfers. The idea is several years old, but only this year, Maharashtra became the first state to start using cash vouchers for sale of kerosene in public distribution system outlets,
on a pilot basis.
The above are only some examples from food management and agriculture. Another idea in the Survey relates to reforming the incentive structure applied to tax collectors. To get the entire list of pending reforms
one has to simply take the extract of the relevant chapters of all the recent Economic Surveys.
The journey from idea to implementation of reforms is arduous and unpredictable. Even when an idea is
well ‘roasted’ by debate, it still may not see the light of day, due to coalition compulsions. This is a generic
diagnosis; sort of like saying coalitions are allergic to reforms.
But the need for reforms is undoubted. Achieving higher economic growth is necessary for large-scale job
creation and for being able to fiscally afford greater social inclusion. Even Amartya Sen, who is not known
as a frontline votary of economic reforms, recently wrote about the importance of achieving high growth
to fund social programmes.
The UPA regime pursued inclusive development by legislating several social rights (like right to education, right to work-NREGA, and now right to food), all of which have fiscal costs. The high growth of 2003
113
to 2007 made us believe that we could pursue and afford inclusive growth. That growth is now at a decadal
low, and is putting great stress on public finances.
The outlook for the world economy is clouded, with slowing China and Europe burdened with unsustainable sovereign debts.
But these clouds have a silver lining in India. During 2011-12, India had some spectacular achievements.
The inbound FDI was the highest ever at $48 billion. The rather ambitious export target set by the commerce minister in April 2011, was not only achieved, but exceeded. The foodgrain production at 252 million
tonnes was a new record. During April to June 2012, oil prices dropped sharply by 37 per cent, much more
than rupee depreciation of about 20 per cent. This was a positive for oil-dependent India. And the rupee
itself, in relative terms is 20 per cent more ‘competitive’ vis-à-vis the Chinese RMB.
Unfortunately, these silver linings were insufficient to prevent an outlook downgrade by the rating agencies. Moreover, all these significant positive sparks occurred in the midst of sharp decline in industrial
investments, high deficit and high inflation.
The Prime Minister is aware that investment spending, especially from the private sector, needs to be
desperately revived. That can happen only with a helping booster dose of economic reforms (which are
already articulated in the government’s own report card, the Economic Survey).
Hence, the decision to open multi-brand retail to foreign investors is to be welcomed. The decision was
taken by the Cabinet in December 2011, but its implementation was withheld to garner a stronger consensus. But with the threat of a possible rating downgrade, the government does not have the luxury of time
for further consensus building. This is to be seen as a pro-farmer reform, and not anti-kirana reform. The
kirana shops will survive well into the future, but they are not expected to invest in cold storage chain or
back-end infrastructure.
Other decisions on raising FDI caps are also to be seen as growth-promoting. As for the decision on disinvestment and raising diesel prices, those address fiscal concerns. The diesel increase, however, could have
been done in smaller doses of successive Re 1 increases over several months. But it was overdue. India is
possibly the only country where rail has lost to road freight consistently. Rail freight share may fall to 15
per cent if there is no investment in railway infrastructure. This is a pity, because it entails loss of efficiency,
burning of fossil fuels and is ultimately very expensive for the economy. Investment in railway (as in China
and now in the US as well) serves multiple goals: creation of a public good, saving of fuel, increase of efficiency and creates more jobs.
Thus the pipeline of pending reforms is long. Some are easy to digest, some are harder, and some have
possible side-effects. Their passage is imperative, and calls for greater articulation and communication to
the voters and taxpayers.
We hope that big bang Friday was just the beginning.
114
Financial Sector Reforms: The Need for Changes
Mr. Himanshu Kaji, Executive Director & Group COO, Edelweiss Financial Services Limited
Though the financial and macroeconomic environment is challenging, India’s fundamental strength means
that, with the right incentives, the economy could see significant growth over the next decade. The financial
services sector, especially its chief components of banking, NBFCs, capital markets and insurance, has the
potential to contribute to this growth.
However, growth cannot come without change. We believe that changes must be made to the regulatory
system to enable financial institutions to compete on a global level, while not compromising the regulators’
ability to oversee and supervise their operations.
The Banking Sector
Reforming the Banking sector is vital to preservation and enhancement of Indian banks’ ability to provide
efficient and high-standard services domestically and compete with their peers on an equal footing
internationally. Passing the Banking Laws (Amendment) Bill is an immediate step that can be taken as a key
component of such reform.
Increasing the voting rights of entities in private banks to 26% and in public banks to 10% is likely to increase
participation in the Banking sector from both Indian and international investors. The possibility of higher
voting rights will encourage greater investment in existing banks. In addition, this measure will support the
establishment of new banks. In the initial years of a new venture, a significant percentage of its shares will be
held by promoters. Passing this Bill will give the promoters commensurate voting rights as well.
The Bill also removes banks’ and NBFCs’ mergers and acquisitions, which already require RBI approval,
from the additional ambit of the Competition Commission. This will prevent the confusion that is likely to
arise from more than one regulator overseeing the same transaction.
Banking in India is underpenetrated, with around 9,000 adults per branch (compared to around 7,200 for
Brazil and 2,800 for the US). To ensure greater penetration, banking licenses should be made more freely
available. Issuing new banking licenses would increase competition, and have the added advantage of forcing
new banks to go to underpenetrated locations to gain market share. This would boost financial inclusion.
It would be ideal to take these steps immediately. At the very least, these measures must be implemented in
the next two to three years to enable Indian banks to achieve and maintain international standards.
Another important measure that must be taken in the near future is the creation of certain specific exceptions
to the RTI Act. While the importance of the RTI Act to transparency is indisputable, banks must be allowed to
115
protect the interests of their depositors and borrowers by maintaining client confidentiality. Individual client
records should be exempt from the provisions of the Act.
The non-implementation of these reforms in the near future will have an adverse effect on innovation in the
Banking sector, since new players will be discouraged from joining the industry and existing banks will find
it difficult to raise fresh funds. This, in turn, will have an adverse impact on their financial inclusion efforts,
and make participation in India’s economic growth challenging for people at the grassroots level. The effect
of this will flow through the economy and dampen domestic savings.
On the other hand, the implementation of these reforms will spark innovation in product offerings and better
customer service across the board. There will be a high degree of financial inclusion, bolstering domestic
savings, especially financial savings of households.
NBFCs
NBFCs are an important component of India’s financial services landscape, providing funds to people who
are unable to obtain funding from banks and providing people new and innovative products in which to
invest their money.
To maintain NBFCs’ ability to innovate and provide services distinct from those provided by banks, it would
be beneficial for them to have a separate regulatory authority. To enable them to obtain the funds, they need
to grow and innovate, systemically important NBFCs, whether or not they take deposits, should be permitted
to raise additional capital by issuing perpetual bonds.
Finally, NBFCs should have the same powers as banks under the SARFAESI Act.
These changes to the regulatory environment of NBFCs should be made as soon as possible – ideally, within
the next twelve months, and certainly in the next two to three years.
If provided with a level playing field, NBFCs will be able to complement banks. They have the potential to
play a useful role in driving the economy by ensuring that lines of credit are open to sectors and companies
that are fundamentally strong but unable to obtain bank loans.
Capital Markets
India’s capital markets face significant difficulties due to regulatory anomalies. Stamp duty, for instance,
is decided at the state level and is therefore not uniform across states. This leads to businesses that operate
out of Maharashtra, for instance, which has high stamp duty, having their registered offices and signing
their contracts in other places in the country that have lower stamp duty. Setting uniform stamp duty rates
applicable through the country would put an end to this inefficiency. At the same time, all other existing
transaction charges, such as STT, should be reviewed and reduced. At the same time, stamp duty on options
should be made applicable on option premium only instead of on strike.
116
These changes will reduce transaction cost and make the capital markets more attractive to both retail and
institutional participants. Failing to make these changes could result in declining trading volumes as high
costs make people drop out of the markets.
Insurance
Insurance is a sector that stands to benefit greatly from international interest as more and more foreign
financial services companies look at India as a growth market. To reap the full benefits of foreign interest,
the limit on FDI should be raised from 26% to 51%, thereby giving insurance companies access to foreign
capital.
Insurers should also be allowed the freedom to structure their distribution and promotion expenses in the
most efficient way, provided they operate within the prescribed limits for the overall expense ratio. Further,
a comprehensive legal framework should be put in place to deal with fraud cases quickly, reducing the time,
effort and money insurance companies have to spend dealing with falsified claims.
If these reforms are not implemented, insurance companies will have difficulties raising capital and may
have to slow down their branch expansion plans. Making these changes will lead to an influx of foreign
capital. This will allow branch expansion and encourage product innovation and a sharp improvement in
service levels. New and innovative products will then be available to more people.
General Reform
The Indian financial services industry is hampered by regulatory anomalies, which lead to operational
inefficiencies. One of the most important medium-term requirements is a comprehensive public policy on
the role of the private sector in financial services. This will bring greater clarity to private sector companies
and enable them to formulate their business plans in an effective and inclusive manner.
In addition, there need to be common KYC norms across the financial services sector. This will increase
efficiency and reduce cost for companies that will no longer need a separate KYC for each individual product
sold to the same customer.
An absence of clarity and uniformity of thought on the role of the private sector in India’s financial services
space will curtail innovation and inhibit improvements in customer service. Encouraging private participation
in financial services will increase competition, leading to a more efficient market, easier access to capital, and
improved domestic savings as a result of retail participation in new and innovative products.
Conclusion
Financial Services is one of India’s highest-growth sectors. It has the potential to be a major driver of India’s
GDP, both directly and indirectly.
117
Reforming banking sector norms will lead to increased participation and new players entering the banking
space. The increased competition will result in better and more efficient products and the entry of new
participants will be an impetus for innovation and greater financial inclusion. NBFCs have the potential,
if appropriate steps are taken, to complement banks and provide credit to sectors and companies that are
ineligible for bank credit, giving a fillip to the economy.
Improved liquidity in the capital markets will mean that companies can raise money more easily. Easing
regulations on foreign participation can be another major source of funding. This increased availability of
capital will lead to expansion in several sectors. The elimination of regulatory anomalies and the establishment
of standardized tax and stamp duty rates and KYC norms will lead to more efficient processes and reduced
costs. The cost reduction will be passed on to customers in the form of greater returns on investments, leading
to increased savings and a boost to the economy.
Insurance companies, if reforms are implemented, will be in a position to offer insurance cover to more
people and will be able to benefit from the experience and expertise of the large international players, leading
to far higher inclusion and efficiency.
Thus, resolving regulatory and structural concerns in a few key areas could lead to significant benefits in
economic growth. It will come both in the form of financial services revenues and investment returns and in
the form of increased productivity and revenues in other sectors.
Bibliography
http://data.worldbank.org/indicator/FB.CBK.BRCH.P5
http://www.business-standard.com/india/news/cabinet-clears-higher-voting-rights-for-bank-shareholders/472751/
http://www.moneycontrol.com/news/cnbc-tv18-comments/cabinet-clears-banking-amendment-bill_697414.html
http://www.prsindia.org/billtrack/the-banking-laws-amendment-bill-2011-1589/
http://www.business-standard.com/india/news/what-issarfaesi-act/439266/
118
About Federation of Indian Chambers of
Commerce and Industry (FICCI)
Established in 1927, FICCI is the largest and oldest apex business organisation in India. Its history is
closely interwoven with India’s struggle for independence, its industrialization, and its emergence as
one of the most rapidly growing global economies. FICCI has contributed to this historical process by
encouraging debate, articulating the private sector’s views and influencing policy.
A non-government, not-for-profit organisation, FICCI is the voice of India’s business and industry.
FICCI draws its membership from the corporate sector, both private and public, including SMEs and
MNCs; FICCI enjoys an indirect membership of over 2,50,000 companies from various regional chambers
of commerce.
Our Vision:
To be the thought leader for industry, its voice for policy change and its guardian for effective
implementation.
Our Mission:
• To carry forward our initiatives in support of rapid, inclusive and sustainable growth that
encompasses health, education, livelihood, governance and skill development.
• To enhance efficiency and global competitiveness of Indian industry and to expand business
opportunities both in domestic and foreign markets through a range of specialized services and
global linkages.
Federation of Indian Chambers of Commerce and Industry (FICCI)
Federation House
1, Tansen Marg, New Delhi 110 001
Please contact us at
Email: nirupama.soundararajan@ficci.com
Tel: +91-11-2335 7391, Fax: +91-11-2332 0714

Knowledge Paper

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