India's Financial Sector: An Era of Reforms

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Vyuptakesh Sharan

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    Dedication

    To my parents

    Smt. Kalyani Devi and Shri Hrishikesh Sharan

    List of Tables

    • 1.1 Capital Adequacy Ratio—Bank Group-wise 8
    • 1.2 Changes in CRR and SLR 9
    • 1.3 NPA Ratios of Commercial Banks 13
    • 1.4 Movements in Deposit and Lending Interest Rates 15
    • 1.5 Banks' Operating Cost as Percentage of Assets 20
    • 1.6 Operational Efficiency of the Banks in India 22
    • 1.7 Financial Stability Ratios of the Banks in India 24
    • 2.1 Deposits and NOFs among Different Types of NBFCs as on 31 March 1992 31
    • 2.2 Number of NBFCs Registered with the RBI 38
    • 2.3 Deposits held by NBFC-Ds at the end of March 2007 and March 2008 39
    • 2.4 CRAR among NBFCs: March 2001 to March 2008 40
    • 2.5 Interest Rate on Deposits of NBFC-Ds 41
    • 2.6 Gross and Net NPAs in Relation to Assets 42
    • 2.7 Operational Ratios of NBFC-Ds 43
    • 3.1 Resource Mobilisation by Mutual Funds: Gross and Net 56
    • 3.2 Resource Mobilisation by Different Categories of Mutual Funds 57
    • 3.3 Scheme-wise Resource Mobilisation during FY 2007–08 58
    • 3.4 Growth in Net Assets under Management of Mutual Funds 60
    • 3.5 Various Segments of Net Assets under Management 61
    • 3.6 Mutual Funds' Investment in Secondary Capital Market in 2000s 63
    • 4.1 Resource Mobilisation from the Domestic Primary Capital Market 77
    • 4.2 Equity and Debt Funds Raised in the Domestic Primary Market 79
    • 4.3 Share of Public and Private Sectors in Funds Raised in the Primary Market 80
    • 4.4 Industry-wise Resource Mobilisation 81
    • 5.1 Turnover and Market Capitalisation at BSE and NSE (Cash Segment) 95
    • 5.2 Stock Market Indices and the Price/Earning Ratio 96
    • 5.3 Turnover in the Equity Derivatives Market 97
    • 5.4 Capitalisation and Turnover in Relation to GDP 99
    • 5.5 Turnover of Debt Securities Traded at NSE 100
    • 5.6 FIIs' Investment in Indian Secondary Capital Market in 2000s 101
    • 5.7 Mutual Funds' Investment in Secondary Capital Market in the 2000s 102
    • 5.8 Return and Risk in BSE Sensex and NSE Nifty 104
    • 5.9 Inter-country Comparison of Return and Risk during FY 2007–08 104
    • 6.1 T-bills: Gross and Net Amount 115
    • 6.2 Dated Securities: Gross and Net Amount 116
    • 6.3 Central Government Securities and Financing of the Gross Fiscal Deficit 117
    • 6.4 Government Security Transactions in the Secondary Market 118
    • 6.5 Coefficient of Variation of Monthly Transactions of Government Securities 119
    • 6.6 Yield of Government Securities 120
    • 6.7 Relationship between Yield on Dated Securities and Cost of Funds of Some Financial Institutions in India 121
    • 7.1 Average of Daily Turnover in the CNMM (Double Leg) 128
    • 7.2 Average of Daily Call Money Rates 129
    • 7.3 Average of Daily Turnover in the CBLO Market (Double Leg) 131
    • 7.4 Average of Daily Volume of Transaction (All Legs) in the Repo Market (Outside LAF) 132
    • 7.5 Stamp Duty on the Issuance of CP 134
    • 7.6 Issue of CP (Outstanding Amount) during the 2000s 136
    • 7.7 Average of the Maximum and Minimum Discount Rates on CPs 136
    • 7.8 Issue of CDs: The Outstanding Amount during the 2000s 139
    • 7.9 Average of the Maximum and Minimum Discount Rates on CDs 140
    • 7.10 Share of Different Segments in Money Market Transactions 141
    • 7.11 Correlation Coefficient among Interest/Discount Rates in Different Segments 143
    • 8.1 Rs./US$ Exchange Rate 145
    • 8.2 RBI's Purchase and Sale of Foreign Currency during the 2000s 154
    • 8.3 Turnover in the Indian Foreign Exchange Market 155
    • 8.4 Swap Transactions in the Inter-bank Market 156
    • 8.5 CV in Respect of Monthly Turnover in Merchant and Inter-bank Segments 158
    • 9.1 Euro Issues of Indian Companies 169
    • 9.2 The Quarterly Variation in the Size of Issue 170
    • 9.3 Select ADRs' Trading at the New York Stock Exchange: 10 August 2007 174
    • 9.4 Issue and Market Prices of GDRs of Indian Firms at LSE on 9 February 2007 175
    • 9.5 Correlation between ADRs/GDRs Price and the Respective Rupee Share Prices in the Secondary Market 176
    • 10.1 Size of FIIs' Net Investment in India 179
    • 10.2 FIIs' Net Investment in Equity and Debt Securities 181
    • 10.3 Foreign Portfolio Flows and Investment in the Country 189
    • 10.4 Annual Volatility in FII Flows Based on Monthly Figures 192
    • 10.5 Turnover at BSE and NSE and Share of the FIIs 192
    • PS 1 FIIs' Net Investment in Indian Financial Market 205
    • PS 2 Secondary Capital Market Indices 207
    • PS 3 Annualised Volatility in Stock Market Indices during April to December 2008 208
    • PS 4 Resource Mobilisation in the Primary Market for Securities 209
    • PS 5 Changes in the ADR/GDR Prices vis-à-vis Respective Local Prices of 14 Sensex firms during 10 January to 19 March 2008 212
    • PS 6 Exchange Rate: Indian Rupee vis-à-vis US Dollar and Euro during April to December 2008 213
    • PS 7 Transactions in Indian Money Market 217
    • PS A1 Price of ADRs/GDRs Traded on 29 December 2006, 2 January 2008, 1 April 2008 and 30 June 2008 221

    List of Figures and Box

    Figures
    • I.1 The Contour of the Indian Financial System xxv
    • 5.1 Turnover in Cash and Derivatives Segment 98
    • 6.1 Ownership Pattern of Government Securities, 1991 122
    • 6.2 Ownership Pattern of Government Securities, 2006 122
    • 7.1 Movement in Repo/Reverse Repo and Call Money Market Rates 142
    • 8.1 Turnover in the Indian Foreign Exchange Market 155
    • 8.2 Monthly Turnover in the Indian Foreign Exchange Market 157
    • 9.1 Funds Raised through Euro Issues 169
    • 9.2 Quarterly Funds Raised from Euro Issues 171
    • 10.1 FIIs' Annual Net Investment: April 1993 to March 2008 179
    • 10.2 FIIs' Investment in Debt and Equity 181
    • 10.3 FIIs' Monthly Net Investment in India: FYs 1999–2008 191
    Box
    • 10.1 FII Policy Liberalisation Measures 186

    List of Abbreviations

    ADAuthorised Dealer
    ADRAmerican Depository Receipt
    AFCAsset Financing Company
    AFC-ND-SISystemically Important AFC Not Accepting Deposits
    AMCAsset Management Company
    ARCILAsset Reconstruction Company of India Ltd
    ARFAsset Reconstruction Fund
    BIFRBoard for Industrial and Financial Reconstruction
    BSEBombay Stock Exchange
    CACCapital Account Convertibility
    CARECredit Analysis and Research on Equities
    CBLOCollateralised Borrowing and Lending Obligations
    CCIController of Capital Issues
    CCILClearing Corporation of India Ltd
    CDCertificates of Deposit
    CDSLCentral Depository Services Ltd
    CMIECentre for Monitoring Indian Economy
    CNMMCall/Notice Money Market
    CPCommercial Paper
    CRARCapital to Risk-weighted Assets Ratio
    CRISILCredit Rating Information Services of India Ltd
    CRRCash Reserves Ratio
    CVCoefficient of Variation
    DFHIDiscount and Finance House of India
    DTLDemand and Time Liabilities
    DVPDelivery versus Payment
    ELCEquipment Leasing Company
    FCCBsForeign Currency Convertible Bonds
    FDIForeign Direct Investment
    FEMAForeign Exchange Management Act
    FIIsForeign Institutional Investors
    FRBMAFiscal Responsibility and Budget Management Act
    GAAPGenerally Accepted Accounting Principles
    GDRGlobal Depository Receipt
    GICGeneral Insurance Corporation
    HPCHire Purchase Company
    ICRAInvestment Information and Credit Rating Agency of India Ltd
    IDBIIndustrial Development Bank of India
    IFRSInternational Financial Reporting Standards
    IPOInitial Public Offering
    LALiquid Assets
    LAFLiquidity Adjustment Facility
    LICLife Insurance Corporation of India
    MCXMulti-commodity Exchange
    MIBORMumbai Inter-bank Offer Rate
    MMMFMoney Market Mutual Fund
    NABARDNational Bank for Agriculture and Rural Development
    NASDAQNational Association of Securities Dealers Automated Quotation
    NAVNet Asset Value
    NBFC-DNon-banking Financial Company Accepting Deposits
    NBFC-NDNon-banking Financial Company Not Accepting Deposits
    NBFCsNon-banking Financial Companies
    NDSNegotiated Dealing System
    NOFNet-owned Funds
    NPANon-performing Asset
    NRINon-resident Indian
    NSDLNational Securities Depository Ltd
    NSENational Stock Exchange
    OCTEIOver-the-counter Exchange of India
    PDPrimary Dealer
    QIPQualified Institutional Placement
    RBIReserve Bank of India
    RBIBReserve Bank of India Bulletin
    RNBCResiduary Non-banking Company
    SARFAESTSecuritisation and Reconstruction of Financial Assets and Enforcement of Security Interest
    SDSatellite Dealers
    SEBISecurities and Exchange Board of India
    SEOSubsequent Equity Offering
    SGLSubsidiary General Ledger
    SLRStatutory Liquidity Ratio
    SWIFTSociety for Worldwide Inter-bank Telecommunication
    T-billsTreasury Bills
    UTIUnit Trust of India
    VLVolatile Liabilities
    WTOWorld Trade Organization

    Preface

    A couple of years back, I had to chair a seminar on financial sector reforms. The young participants presented their views on different aspects of the Indian financial sector. Some of the presentations were really very good. But, I felt the discussion of reforms in this sector from the viewpoint of financial stability and financial inclusion was not stressed upon in a desired way. Moreover, the content of the internationalisation of the Indian financial market was utterly lacking. In fact, this encouraged me to write on the Indian financial sector reforms incorporating especially these viewpoints.

    The present book presents, in the very beginning, the nature and efficacy of financial sector reforms, draws, in very brief, the broad contour of the Indian financial sector, traces various measures of reform in different segments of this sector and, finally, shows the impact of the reform measures. The impact is analysed from the viewpoint of efficiency that reflects also in profitability. But since profitability has no meaning sans financial stability, the analysis takes well into account the aspect of stability. Again, over more than one-and-a-half decades of the reform era, the financial sector could achieve at least a level of maturity where one was bound to think of financial inclusion. So the present analysis considers this aspect too.

    The opening of the Indian financial sector to foreign investors has been a part of the reform process. And so the present analysis cannot overlook the foreign investment irrespective of its form. I have tried to incorporate these elements in the analysis.

    The savers forming one end of financial intermediation are of varied economic, social and educational strata. They need to keep themselves abreast of the developments in the Indian financial sector. So the analysis in this book is especially designed for them. It is simple and lucid with no sophisticated econometric tools.

    I have benefited from the discussion with my colleagues and professionals working in this branch of study. I am thankful to all of them. I also wish to express my sincere thanks to my wife, Roopa Sharan, for the inspiration and encouragement she has provided for preparing this book. Archana and Lokesh should also be thanked for their assistance in compilation of figures and their calculation.

    I am sure the readers will find this book useful.

    VyuptakeshSharan

    Introduction

    For around two-and-a-half decades, a number of developing countries have been practising economic reforms, more precisely known as structural adjustment and macroeconomic reforms, for better allocation of resources and thereby improving economic performance through changes in economic policies. These two terms, macroeconomic stabilisation programme and structural adjustment are interdependent and quite often overlap each other despite a fine distinction between them. The macroeconomic reform involves an immediate change in policies and aims at achieving short-term objectives. Structural adjustment, on the other hand, involves more fundamental changes in the way the economy operates. It modifies the very structure of the economy towards meeting long-term objectives. It takes into account recording of priorities and reconsideration of policy instruments. There may be variations across different countries in adopting economic reforms, but by and large, the policy package encompasses production, saving and investment, sectoral development, monetary and budgetary targets and the external sector (Woodward 1992). Structural adjustment programmes are wide ranging. They tend to reduce the role of the state in matters relating to private sector, to allow prices and income to respond freely to market forces and to open the economy to foreign trade and investment. The rationale is that the private sector is more efficient and the free play of market forces leads to optimal resource allocation. Again, the proceeds of privatisation represent a non-inflationary source of financing for the budgetary deficits.

    India initiated this process on a full-fledged scale as back as early mid-1991. This was the time when most of the macroeconomic variables in the country were lying on the wrong end of the stick and it was very much imperative for the government to remedy those ills and bring the economy back on the rails. The measures of economic reform in India are broad-based covering all the vital sectors of the economy and consequently, the policies—fiscal, financial, monetary, industrial and external—underwent a big change. The reforms in different sectors are interlinked, although the linkage may not be very much direct and proximate. The present study is concerned with the financial sector. The objective is to delineate the major policy changes and, more importantly, to assess the impact of the reform measures. We do agree that some of the policy changes have long-term implications, and the impact will definitely be clearer in the future years, yet the study is based on the experiences during the first one-and-a-half decades of the reforms in the financial sector, say, up to the financial year (FY) 2007–08.

    The present chapter acquaints the readers with the very concept of financial sector reforms, the contour of the Indian financial system, the strategy of financial sector reforms in India and with the impact of the reform measures.

    The Concept of Financial Sector Reform
    Financial Sector and Economic Growth

    Why should there be focus of reform on the financial sector? It is simply because the financial sector in an economy is very crucial and so is its orderly development. It is true that, in some quarters, the relationship between financial sector and economic growth is not supposed to be very significant (Chandavarkar 1992; Lucas 1988), but there does exist strong arguments to suggest the role of this sector in stimulating economic growth. Merton and Bodie (1995) feel that an improved financial system reduces the transaction and information costs and thereby helps facilitate a better allocation of resources needed for a high rate of economic growth. Levine (1997) explains this concept at a greater length. He is of the view that an improved financial system possesses financial intermediaries, markets, instruments and also different kinds of services that help:

    • mobilise savings,
    • reduce risk through hedging and diversification,
    • monitor and exert corporate control and
    • permit better allocation of resources.

    With a developed financial system, the savers have an easy access to detailed information at a lower cost, and moreover, they can make use of a variety of instruments, with the result that the savings are mobilised on a large scale. The banks and the non-banking financial companies (NBFCs) offer liquid deposit schemes that help savings mobilisation. The quantum of liquidity risk is significantly reduced as the savers are confident that whenever they need their funds back, they can sell their securities. The investment risk too is hedged easily insofar as, first, the hedging schemes are available in the financial market and, second, varieties of instruments are available to help diversify the investment.

    Normally, it is not possible for the small investors to monitor the corporate functioning. When they try to monitor it, its cost turns very high. But when the investors make the investment through a financial intermediary, the onus of monitoring of corporate functioning lies on the intermediary. The intermediaries can perform this function more efficiently and at a much lesser cost. Again, if the stock market is well developed, one can study the performance of a company based on the share price index (Singh 1997).

    Furthermore, there are varieties of financial arrangements that help lower the transaction cost that in turn fosters specialisation, which leads to technological innovation. In all, greater saving mobilisation and its optimal allocation along with technological innovation lead to economic growth.

    The explanation of the linkage between the financial system and the economic growth is supported by a number of empirical findings. Using cross-country regression based on the data from 41 countries during 1976–93, Levine and Zervos (1996) find that the measures of banking and stock market development are robustly correlated with current and future rates of economic growth, capital accumulation and improvements in productivity. Atje and Jovanovic (1993) too find significant correlation between the economic growth and the value of stock market trading relative to gross domestic product (GDP) for 40 countries during 1980–88. Goldsmith (1969) finds, on the basis of the data collected from 35 countries over a period extending about a century, a direct relationship between the financial sector development and the economic growth. Berthelemy and Varaoudakis (1996) are of the view that weak financial system has been responsible for creating a ‘poverty trap’ coming in the way of economic growth. The World Bank (1989) and Demirguo-Kunt and Levine (1996) have extended Goldsmith's work using data from about 50 countries during 1970–93 and have found that there is a positive relationship between the deepening of the financial system, the asset position of the commercial banks and non-banking financial institutions, and the trading and capitalisation of the stock market, on the one hand, and the rising level of income in the country, on the other. Schiantarelli et al. (1994) find greater efficiency in the investment allocation following the financial sector liberalisation in Indonesia.

    Nature of Reform in the Financial Sector

    After it is established that the development of the financial system leads to economic growth, it is worth examining as to what should be the nature of the development/reform in the financial sector. In the context of the reforming of the financial sector, Stiglitz (1994) is of the view that the government intervention makes the financial market function better, that in turn adds to the performance of the economy. To be more specific, he favours government intervention to keep the interest rate below the market equilibrium level, so that it helps improve the average quality of the pool of loan applicants and lowers the cost of capital and direct loans to the sectors with high technological spillover. However, Stiglitz is very cautious of the manipulation of interest rates in this process, so that the real interest rate may not cross below zero. But in some quarters, Stiglitz's view is not supposed in conformity with the objectives of economic growth. It is because low interest does not necessarily improve the average efficiency of investment, rather it can prompt the funds to move to low-yielding projects. And also, the directed credit in the desired sectors may raise the default rates increasing thereby the risk exposure of the financial agents and squeezing their profits to unmanageable levels. On the contrary, if the interest rate is market determined, low-yielding projects may not remain profitable; the average rate of return on investment will be higher augmenting in turn the saving rate (Fry 1997).

    McKinnon–Shaw's views too are in favour of financial market liberalisation (McKinnon 1973; Shaw 1973). They argue that the market-determined interest rates can boost up the rate of economic growth in the short and medium periods. In the short run, one can mark inflationary trends, but in the medium run, saving rate will rise, boosting up the rate of economic growth. However, measuring of the impact of financial liberalisation may not be easy insofar as the reform measures in other sectors go side by side. Lanyi and Saracoglu (1983) have found, in their cross-section regression analysis, a significant relationship between the average rate of growth in real GDP and the interest rate dummy variable during 1971–80. Again, the empirical study of Fry (1978) suggests that on an average, a 1 percentage point increase in real deposit rate of interest towards the market equilibrium rate is followed by a rise in economic growth rate of about 1.5 percentage point. Fry (1997) makes another study based on the data collected from 16 countries during 1970–88. While 11 countries of the sample present a controlled financial regime, the rest five experience liberal financial regime in terms of real interest rate structure. The findings reveal that the savings ratio in the five countries with liberal regime averaged 23.8 per cent compared to 16 per cent in 11 countries with regulatory regime. The continuously compounded growth rate in output was 6.2 and 3.9 per cent, respectively.

    Nevertheless, Fry (1995, 1997) talks about some prerequisites for a successful financial liberalisation programme. They are as follows:

    • adequate prudential regulations and supervision of financial intermediaries along with some accounting and legal infrastructure;
    • reasonable degree of price stability;
    • strict fiscal discipline especially in respect of government borrowing;
    • reasonable degree of competition among financial intermediaries and
    • no tax on financial intermediaries.

    Fry's suggestions for liberalising the financial sector are more or less in conformity with the arguments of Caprio et al. (1994). They too are not in favour of a complete laissez-faire policy, rather they recommend for desirable amount of regulation and supervision. In this context, Edwards (1989) is of the view that the liberalisation measures should not be abrupt but they should be adopted in phases. Moreover, they should be tuned with liberalisation measures in other sectors. Otherwise, the entire exercise would be a flop. The Latin American experiences are still fresh where the financial sector reforms manifested in huge bad debt, bank failures and extreme volatility in the financial system (Corbo and deMelo 1985). Thus, emphasis on the financial sector reforms by the Indian government and especially the gradual move towards liberalisation along with the reforms in other sectors has been a well-thought and well-designed plan.

    An Overview of the Indian Financial Sector

    The Indian financial system is a combine of financial intermediaries, financial markets and instruments and financial services. All these three segments are closely interwoven. Financial intermediaries hold and trade financial securities/instruments in the financial market that strengthens the latter. At the same time, the development of the financial market has led to the emergence of complex portfolios that in turn needs the services of the specialised financial intermediaries. Again, with the growing complexity of financial markets and instruments, the role of financial services has turned more significant. They make the functioning of the entire financial system smoother. Let us now brief the different segments of the financial system (see Figure I.1).

    Figure I.1 The Contour of the Indian Financial System
    Financial Intermediaries

    Financial intermediaries mobilise savings and put those savings into productive investment. They can be grouped as follows:

    • Banking institutions
    • Non-banking financial institutions
    • Mutual funds
    • Insurance companies

    The banking institutions are the most significant intermediaries in the country. They can be grouped as commercial banks and cooperative banks. The commercial banks are public sector banks, private sector banks, foreign banks operating in the country and regional rural banks.

    The non-banking financial institutions are no less important as a financial intermediary. While the banking institutions are the creators of credit, non-banking financial institutions are the purveyors of credit. Again, while the liabilities of the banking institutions form a part of the money supply in the country, those of the non-banking financial institutions do not. The non-banking financial institutions are either the NBFCs or the development financial institutions. As per the Reserve Bank of India's (RBI) notification in December 2006, the NBFCs are grouped as follows:

    • Asset-financing companies
      • Those accepting deposits
      • Those not accepting deposits
    • Investment companies
    • Loan companies

    The development financial institutions are normally the term financial institutions. Industrial Development Bank of India, Industrial Finance Corporation of India and many others are functioning in the country both at the centre level and at the state level.

    The mutual funds mobilise savings for making investment in diversified portfolio of securities. The return, after deducting the necessary expenses, is shared by the funds' investors. They are thus, to a great extent, similar to portfolio management companies. The only major difference is that while mutual funds target small investors, the portfolio management companies are concerned with high net worth individuals. For a long time, the mutual fund business was confined in the hands of the Unit Trust of India (UTI) that was established as back as in 1963. But in 1987, the area was broadened to include companies sponsored by a few nationalised banks; and again, in 1993, private sector companies—both domestic and foreign—were allowed to operate in this area.

    The insurance companies provide compensation against the risk of life and property after charging premium from the general public. The savings of the public in the form of premium are invested in many directions, a very significant of them being corporate securities. Beginning from 1956 when the life insurance companies were nationalised and from 1972 when the general insurance companies were nationalised, the insurance business was a public sector show. It was only after the Malhotra Committee recommendations in 1994 that the Indian government thought to allow the private sector companies in the insurance business. In 2000, the insurance business marked the entry of the private players.

    Financial Markets and Instruments

    The financial markets can be grouped either as capital market or as money market. While money market is a market for short-term funds, capital market involves medium- and long-term funds.

    The money market encompasses the following:

    • Call/notice money market (CNMM), where money is borrowed or lent for 1–14 days without involving any collateral security. Originally, there were many participants, but now it is primarily an inter-bank market where banks being long of funds deposit the excess funds with other banks and those being short of funds borrow funds from other banks. The deposit, borrowing and lending help in the proper allocation of liquidity in the inter-bank market.
    • Commercial paper (CP) market, where CPs are issued by corporates, primary dealers and all-India financial institutions as an unsecured short-term promissory note mainly to commercial banks and also to individuals and registered Indian corporate bodies.
    • Certificate of deposit (CD) market, where CDs, being unsecured, negotiable short-term instrument, are issued by commercial banks and development financial institutions at a relatively high interest rate in order to mobilise funds during the period of tight liquidity.
    • Treasury-bill (T-bill) market, where the RBI issues T-bills on behalf of the government for a minimum amount of Rs. 25,000 or a multiple thereof to meet the temporary/seasonal gap between the latter's receipt—both capital and revenue and the expenditure. T-bills are normally issued at discount and are repaid at par on the maturity. The discount serves the purpose of interest. Presently, they are of varying duration, such as 91, 182 and 364 days.
    • Collateralised Borrowing and Lending Obligations market, where the Clearing Corporation of India Limited has introduced a new instrument for the benefit of those entities that have been phased out from making use of CNMM or those who have restricted participation in the CNMM.
    • Term money market transacting funds for less than 1 year. Despite the fact that the term money market has not made great strides during the period of reforms, it does exist and forms a part of the money market.

    Capital market is, on the other hand, involved with long-term securities, such as equity shares and debt securities. Debt securities may take the form of private corporate debentures, public sector unit bonds and government's dated securities.

    Again, the financial market is divided into primary and secondary markets. The primary market is concerned with the raising of funds through the issue of new securities. The companies issue shares and debentures. When firms go public for the first time, the primary market is known as the initial public offering (IPO) market. The subsequent offerings, on the other hand, form the part of the primary market, known as the subsequent equity offering (SEO) market. The offerings are made either through prospectus or through private placement. Besides companies, the government too issues dated securities to mop-up funds. The public sector units issue bonds through private placement and the private sector companies raise funds selling new shares and debentures either through prospectus or through private placement.

    The secondary market, on the contrary, involves listing and trading of the already issued shares and debt securities at the stock exchange. The secondary market has not only cash segment but also derivatives segment. In India, the secondary market for derivatives has only a recent origin. One can go for index futures, stock futures, index options and stock options.

    Financial Services

    Financial services tend to give a fillip to the functioning of various financial intermediaries and the financial market. These activities include broadly services of depositories and custodial functions, credit-rating, factoring and forfeiting, merchant banking, and so on. Depository and custodian help in the issue of securities. Credit-rating agencies rate the performance and financial position of a company that helps investors in taking a correct investment decision. Factoring and forfeiting are more concentrated on trade financing. Merchant banking services are related to floatation of new companies, planning and execution of new projects, drafting of prospectus, managing and underwriting of the issue of securities, and so on.

    Designing Measures of Reform in India's Financial Sector

    The nature of reform in the Indian financial market has not been much different from that in other countries. The basic idea behind designing the measures of reform has been multi-pronged. It is essentially the expanded activities with increasing turnover and greater profitability. But the aspect of profitability is never thought of in isolation from financial stability. In more generic terms, it can be equated with greater return with minimal risk. Moreover, of late, when the fruits of reform could largely be achieved, the measures have come to aim at bestowing the benefits of reform upon different groups of the society, and especially those who have never availed of, or least availed of, such benefits. This new move is known as financial inclusion. All these designs need at least some explanation which can be found hereunder.

    Greater Turnover with Increasing Profitability

    There was a time during the late 1980s and the early 1990s when many of the public sector banks were running into losses. Mutual fund business was limited to only UTI and a few bank-sponsored organisations. Primary market and secondary market transactions were utterly limited and the scenario was similar in the money market. Neither were the foreign investors allowed to operate in the Indian secondary market nor were the Indian companies eligible for making euro issues. The activities in the foreign exchange market were limited in view of the administered exchange rate arrangement. Thus, the financial market and the participants therein were not able to take advantage of the economies of scale. The profitability was the worst victim. Thus, when the measures of reform were designed, the purpose was to broaden the nature of activities, so that more and more participants should come in fray. To mention a few examples, some new private sector banks were allowed to operate. The mutual fund business was extended to private sector companies. In the money market, new instruments were introduced. The foreign institutional investors (FIIs) were allowed to operate at the Indian stock exchanges. The Indian companies were allowed to raise funds in the international financial market through the issue of foreign currency convertible bonds and American/global depository receipts. In the foreign exchange market, swaps and options were introduced besides spot and forward transactions. The market for derivatives came to form a part of the secondary market activities. The aftermath was that there was a forward leap in the turnover. The greater the magnitude of turnover, the bigger was the room for enjoying the economies of scale and showing profit margin.

    Besides achieving greater turnover, the idea behind broadening of participation base was to generate competition that could, in turn, improve efficiency. Improved efficiency could, in turn, raise profitability. But, for wide participation, it was essential to have a liberalised financial sector policy. So rigidity with the system was axed with—in all segments of the financial sector. In fact, the liberalisation of the policy aimed at reducing unnecessary controls and giving a much bigger room for the play of market forces that could lead to optimal allocation of scarce resources. With the optimality of financial intermediation and allocation of funds, it was easy to boost up the profitability.

    Keeping apart the issue of greater competition and efficiency and the issue of profitability, the liberalisation of the financial sector policy was a compulsion in view of liberal policy in other areas of the economy. The liberal policy in other sectors of the economy, such as liberal industrial policy or liberal external sector policy, could not yield desired results sans liberal financial sector policy.

    Financial Stability

    It has already been mentioned that profitability cannot be stressed upon in isolation of the financial risk involved in the liberalisation process. Financial stability needs to be maintained in order to give way to long-term economic prosperity (Schinasi 2006). We have witnessed many cases of financial instability marring the very process of economic growth. To quote at least one case, the Asian Crisis-hit countries had a record economic growth rate prior to the crisis. The financial sector too was experiencing a big expansion in activities and desired profitability. But it lacked the desired stability with the result that this sector could not sustain the jerks appearing in the real estate and other sectors. The financial crisis could not be avoided.

    When the structural adjustment or macroeconomic reforms were designed originally during the early 1980s, the aspect of financial stability was not assigned too much of significance. But with varying experience of financial crisis in different areas of the global economy from time to time, this aspect earned greater attention of the economists and policy makers. Many central banks and the international financial institutions started publishing periodic financial stability reports. The Bank for International Settlements set up the Financial Stability Forum for fostering financial stability through the exchange of information. The World Bank and the International Monetary Fund (IMF) introduced the Financial Sector Assessment Programme to identify vulnerability of the financial system in member countries and to highlight the developmental needs of this sector. In India too, a committee on financial sector assessment was constituted under the chairmanship of Rakesh Mohan in September 2006 that submitted its report in February 2008.

    Financial stability represents financial soundness of the financial transactions in an economy. From a practical viewpoint, it embraces a sound payment and settlement system and accounting practices related to institutions like banks, security firms and institutional investors and markets including capital and money markets, currency markets and the markets for derivatives. If a financial system is stable, it means that it has the ability to resolve imbalances through self-corrective mechanism, ultimately rejecting any crisis to set in. It also means that the financial institutions have the ability to absorb shocks in a way that does not permit any interruption in the financial intermediation process. The financial regulators make the norms, standards and guidelines to be followed by the financial agents. In India, the Ministry of Finance, the RBI and the Securities and Exchange Board of India (SEBI) are the apex-level regulators. Moreover, the Foreign Exchange Management Act is there to protect any foreign exchange laundering. At the same time, different institutions frame rules and regulations at their own level for day-to-day functioning.

    Financial Inclusion

    It is true that in the beginning of the financial sector reform in India, greater stress was given on profitability and then on financial stability. But when the process of reform moved on to achieve to a great extent these objectives and when this sector found itself in a much better shape, it was very much desirable to introduce the element of financial inclusion. Financial inclusion means the delivery of financial services or gains from the financial market at affordable cost to disadvantaged and low-income groups of the society who have so far remained largely excluded from such benefits. It can be done through improving the existing formal credit delivery mechanism and evolving new models for extending outreach. The financially excluded section requires products which are customised to meet their needs. Credit has to be an integral part of this programme aimed at improving productivity and income of such farmers and farmer households. The interventions that require immediate address are strengthening of extension machinery, firming up of quality input supply arrangements, facilitating of marketing of goods, and so on.

    Thus, the measures of financial sector reforms in India are designed to accommodate all these objectives of growth, profitability, financial stability and financial inclusion.

    Structure of the Book

    The discussion in the present book embraces financial sector reforms in India that were initiated more vividly in the early 1990s. Almost in all the cases, the author has tried to present the state of affairs prior to the reform, followed by the measures of reform. At the end of the discussion in different chapters, the impact of the reform measures is analysed in different ways keeping in view the growth along with operating efficiency, financial stability and financial inclusion.

    The discussion is divided into three parts. The first part deals with the financial intermediaries. The intermediaries include here the commercial banks, NBFCs and the mutual funds.

    The second part embraces the discussion of the primary and the secondary markets. The market for the government securities is exclusively analysed. This is followed by the discussion of the reforms in the Indian money market. Finally, there is the discussion of the foreign exchange market inasmuch as the financial and foreign exchange market cannot be segregated.

    The third part focuses on the linkages of the Indian financial market with the international financial market or, in other words, the internationalisation of the Indian financial market. In fact, the linkages can be explained in terms of foreign direct investment (FDI) in the Indian financial market, but, more importantly, in terms of FIIs operating at the Indian stock exchanges, euro issues of the Indian firms and the raising of funds by the foreign companies in the Indian financial market through the Indian depository receipts (IDR). The IDR is only a recent development. In March 2004, the Indian government permitted only financially strong foreign companies to raise funds from Indian financial market. The SEBI formalised detailed guidelines in April 2006. In the absence of desired response, the norms were liberalised in August 2007. However, it is yet to make a breakthrough. This part of the book, therefore, covers the euro issues of the Indian firms and FIIs' operation in the Indian secondary market.

    In the end, the entire discussion is summarised. However, in view of the crisis emerging in the Indian financial sector during 2008, the concluding remarks are followed by a postscript that focuses on the recent trends.

  • Epilogue

    The significance of a liberal financial sector for economic growth stands proved. A number of studies confirm that any move infusing liberalisation into the financial sector leads to, first, bigger mobilisation of resources with less risk involved, second, desired corporate control and, third, better allocation of resources. The preceding discussion in the book focuses on the reform measures related to the key financial intermediaries and the financial market and instruments till the end of FY 2007–08 and analyses the broad impact primarily in terms of growth in activities, profitability, financial stability and also, to some extent, financial inclusion. It also deals with the international linkages of the Indian financial market focussing on the euro issues of the Indian firms and the FIIs' investment in the Indian secondary market. The recent trends emerging during FY 2008–09 will, of course, be shown as a postscript.

    Financial Intermediaries
    Commercial Banks

    Let us begin with the banking sector reform. The objective has been to make banks a profit-making unit along with desired financial strength and financial stability and ultimately to benefit those who were not so far the beneficiary of the banking facilities. To this end, capital adequacy norms were prescribed at par with the Basle norms that the banks were able to achieve. The CRR and SLR requirements were axed, so that the banks could have larger funds at their disposal for profitable lending. Interest rate structure was deregulated in order to do away with the artificial barrier and to allow the market forces to work. Non-performing Assets (NPAs) were brought to a manageable limit through greater provisioning and better loan recovery methods. Income recognition norms were made more transparent and financial supervision was made more workable. Competition among banks was encouraged through liberalising entry norms so as to help improve efficiency. Last but not least, customer service was taken care of.

    With all these moves, the banks' efficiency and thereby profitability increased over one-and-a-half decades of reform period. There were, of course, variations among different groups of banks—public sector, private sector and the foreign banks operating in the country. However, the scheduled commercial banks as a whole improved their efficiency. The net interest earned/asset ratio and the operational expenses/net income ratio squeezed, respectively, from 3.30 to 2.35 per cent and from 55.73 to 48 per cent between FY 1991–92 and FY 2007–08. With increasing efficiency, profitability did increase. It moved up from 0.35 to 0.99 per cent during the same period. What is important is that the profitability ratio was quite in tandem with the international standards.

    As far as financial stability is concerned, different ratios indicated improvement in this context over the period of reform. The banks' ability to cover NPAs through provisioning improved substantially. The provisioning/NPA ratio moved up from 16.20 to 52.59 per cent during FYs 1991–2008. The capital adequacy of the banks too improved as the capital/assets ratio surged up from 2.62 to 7.29 per cent. The fund volatility ratio, on the other hand, dropped from (–) 13.53 to (–) 31.37 per cent during the above period showing greater financial stability. These ratios too were comparable to international standards.

    Finally, the efforts towards financial inclusion are only a recent one. Although steps were taken to reach the weaker sections of the society through no-frill accounts, yet, according to an RBI study, the progress has not been very satisfactory.

    Non-Banking Financial Companies

    Again, as far as the Non-banking Financial Companies (NBFCs) are concerned, the focus of reform fell greatly on regulating them to ensure financial viability as well as to protect customers' interest. But still, the companies registered with the RBI are only a few meaning that a large number of NBFCs are yet to come under the RBI's regulatory umbrella. As regards capital adequacy, the situation improved over the years. At the end of March 2008, around 83 per cent of companies, especially the deposit-accepting ones had a CRAR of 20 per cent or above.

    The NPAs' position improved significantly as the net NPA/asset ratio fell drastically from 7.4 per cent at the end of March 1998 to 0.3 per cent at the end of March 2008. However, these companies have not been able to attract large deposits in relation to the total deposits moving to the banking sector. Their deposits were barely 0.73 per cent of the deposits moving to the scheduled commercial banks at the end of March 2008. A sense of confidence needs to be generated among the depositors so as to bring the NBFCs at par with the banking companies.

    Again, in view of various support measures, the efficiency of these companies improved. Although the financial expenses as well as operating expenses, both in relation to assets, remained moving, respectively, around 6 and 3 per cent between FY 1998–99 and FY 2007–08, the profitability ratio manifesting in net profit/asset ratio increased from 0.3 per cent in FY 1998–99 to 2.9 per cent in FY 2007–08. It could have been higher, had the NBFCs axed sizeably the operational and financial expenses.

    Last but not least, the element of financial inclusion is still not very apparent. It should be a part of the NBFCs regulations in future.

    Mutual Funds

    The mutual fund business expanded since 1987 when a few organisations sponsored by banks and insurance corporations joined hands with the UTI to perform such business. Again, with the initiation of financial sector reforms, this business was further extended in 1993 to private sector companies, both domestic and foreign. Regulatory measures along with big doses of liberalisation were implemented on various fronts, such as maintenance of net worth, creation of new schemes, investment policy, profit distribution, so as to encourage the mutual fund companies to play an active role and, at the same time, to protect the interest of the small investors. All this had a positive impact on the size of resource mobilisation as the amount of gross resource mobilisation surged up from Rs. 930 billion in FY 2000–01 to Rs. 44,644 billion in FY 2007–08. The size of net assets under management too inflated from Rs. 906 billion to Rs. 5,052 billion during this period. The largest share, say, over four-fifths was accounted for by the private sector companies. The open-ended schemes and income/debt schemes proved more attractive. On the contrary, investment in money market instrument and in the government securities lagged far behind.

    On the whole, the performance of the mutual funds got great impetus from the reform measures. Yet the investment by mutual funds in the secondary market did not influence vividly the stock market index. Again, as far as financial stability is concerned, this aspect needs greater attention of the policy makers.

    Financial Markets
    Primary Market for Securities

    First of all, in the primary market for securities, SEBI came to regulate the entire functioning with a view to making its structure and functioning greatly flexible and market oriented and protecting the interest of the investors. The development of infrastructure, such as merchant banking, venture capital funds and credit-rating agencies, and basing the pricing process on the market forces, known as book-building process, were the focus of reform. All this bore fruit. The amount of the resources mobilised in the domestic segment surged up from a meagre of Rs. 142 billion in FY 1991–92 and below Rs. 500 billion during the early 2000s to Rs. 2,963 billion during FY 2007–08. Private placement outweighed the public offerings. The share of the private sector companies was large in case of public offerings, but in private placement, the public sector companies fared well. The discussion reveals that a very large part of the funds raised was accounted by the services sector and especially by those services that were financial in nature. In the manufacturing sector, chemicals and machinery-related companies were significant.

    Again, the securities were allotted mainly to big investors who could influence the market in their own way. However, the move of the Ministry of Finance towards dispersion of ownership in favour of individual shareholders may prove conducive to price stability and financial inclusion. Of late, the SEBI Advisory Committee has suggested to carry out the entire process of IPO through Internet and to lower the time lag between the issue and the listing of securities (Financial Express 10 March 2008). All this may boost further the primary market activities.

    Secondary Capital Market

    In the secondary capital market too, SEBI is the regulator. The NSE and a few other stock exchanges were set up as well as the FIIs and also the domestic and foreign mutual fund companies were permitted to operate in the market so as to foster competition in this area. The procedure of listing, trading, clearing and settlement was made transparent and convenient with the introduction, among others, of electronic devices. The market for derivatives was launched to compete with the cash segment of the market. The transaction cost was also axed, so as to make the market still more attractive. Last but not least, FDI was allowed in the BSE and the NSE that is expected to improve the functioning even further.

    All these measures led to an upward move in the turnover, market capitalisation and the share price index. The turnover at BSE and NSE taken together swelled from Rs. 8,205 billion in FY 2001–02 to Rs. 51,299 billion during FY 2007–08. The total capitalisation during this period sped up from Rs. 12,491 billion to Rs. 99,961 billion. The annual average of BSE Sensex rose from 3,372 to 16,569 (FY 1978–79 = 100) and NSE Nifty recorded an increase from 1,077 to 4,897 (3.11.1995 = 100) during the same period. The derivatives segment is quite a new one but it showed faster growth in the turnover during the same period from Rs. 1,039 billion to Rs. 133,123 billion. Besides the trade in equity shares, the debt securities were also traded. Their turnover increased manifold from Rs. 9,472 billion in FY 2001–02 to Rs. 57,031 billion during FY 2007–08. However, a lion's share was accounted for by the government securities. The trade in corporate debt remained confined to a lower limit.

    The rate of returns too improved over the years but volatility in the returns remained a major cause of concern, especially when we compare it with that among major international stock markets. In other words, financial stability is yet to be achieved. Last but not least, the market has moved towards greater efficiency but yet it has to go a long way to achieve the desired efficiency.

    Market for Government Securities

    Apart from the primary and secondary market, the ray of reform fell also on the market for government securities—treasury bills and dated securities—so as to meet effectively the desired fiscal and monetary objectives. The reform measures were manifest especially in the diversified structure of this market, introduction of auctions, enhancement of marketability and liquidity, strengthening of the basic infrastructure and easing of the settlement procedure.

    The central government securities, to which the present study is confined, played an important role in bridging the fiscal deficit. While they covered only around one-half of the central government's fiscal deficit during FY 1997–98, the percentage was almost 100 during FY 2006–07, although it was lower at 75 during FY 2007–08.

    As far as the infusion of liquidity is concerned, the government securities played a significant role. They were transacted in the secondary market both outright and under repo arrangement. There was a big growth in the quantum of these transactions in past years. In FY 2007–08, those being outright amounted to Rs. 16,618 billion and those under repo arrangement were as large as Rs. 38,917 billion. The share of treasury bills was low compared to the dated securities. The only problem is that instability in the liquidity infusion still persists. However, it is quite evident from the study that liquidity has an impact on the yield and the yield has a definite role in anchoring rate of interest in the capital market. Last but not least, there has been diversification in the ownership pattern of the government securities with the result that the financial stability has been generated and market has grown more efficient. Greater integration within the government securities market is another plus point conferring greater efficiency on the market.

    Indian Money Market

    When one talks about reforms in the Indian financial market, the money market segment is no less significant. The Indian money market has different segments and variety of instruments. The objective of reform has been to encourage the turnover through infusing greater doses of transparency, to bolster a balanced development in different segments of this market and to foster stability through checking volatility in the interest rates primarily through repo and reverse repo measures. The CNMM was made a purely inter-bank market. Those participants who were barred from entering the inter-bank market can now use a newly created instrument, known as CBLO. The ceiling rate in case of CBLO is based on MIBOR and this instrument enjoys the provisions of marking to market and desirable haircuts. As a result, the turnover increased in this case. The average daily turnover (double leg) moved up from Rs. 5.15 billion in FY 2003–04 to Rs. 556.26 during 2007–08. Again, it is because of checking fluctuations in the call money rates that the turnover in the repo market outside the LAF too increased. The increase in terms of average of daily transactions (all legs) was recorded from Rs.104.35 billion in FY 2003–04 to Rs. 547.36 billion in FY 2007–08.

    Besides, the Vaghul Committee twins—CPs and CDs were made more attractive through making changes in their structure, cutting the transaction cost and providing incentives. The turnover in their case did show an upward trend. The outstanding amount of CPs rose from Rs. 58.47 billion at the end of March 2001 to Rs. 325.92 billion by March 2008, except for a marginal drop during FY 2005–06. Similarly, in case of CDs, the outstanding amount rose from a bare figure of Rs. 7.71 billion at the end of March 2001 to Rs. 1,477.92 billion by March 2008.

    The objective behind reforming money market was largely achieved. Besides increase in turnover in the money market as a whole, the share of call money market in the total turnover of the money market reduced and the reduction was in favour of CBLO. It shows a definite move towards creating the CNMM a purely inter-bank market and also the success of the CBLO. The call money rates could be stabilised to some extent insofar as, in the majority of the months under study, they moved within the tunnel provided by the repo and reverse repo rates. Last but not least, the correlation in the interest rates/discount rates between different segments of the money market turned greatly positive meaning that the different segments got highly integrated. Greater integration is the most valuable fruit of the reform measures.

    Foreign Exchange Market

    Finally, the study is not limited to the capital and money market. It discusses also the reforms in Indian foreign exchange market. The move towards reform was manifest in the adoption of managed floating exchange rate system, restructuring of the very infrastructure of the market, introduction of a variety of activities, such as swaps and options and also a gradual move towards capital account convertibility. Besides, the intervention by the monetary authorities, say, RBI helped correct imbalances in supply and demand forces and infused stability in the foreign exchange market.

    The turnover in the market increased from Rs. 1,387 billion in FY 2000–01 to Rs. 12,316 billion during FY 2007–08, although the size of the turnover was much lower in the merchant segment than in the inter-bank market. Again, instability in the monthly turnover was very much apparent that needs to be controlled. Nevertheless, the market attained greater efficiency in view of reduced bid-ask spread, greater alignment between forward premia and interest rate differentials and lower degree of the RBI's intervention giving way to the free play of market forces.

    Internationalisation of Indian Financial Market

    The transactions in the Indian financial market are now not limited to the boundary of the country. The securities of the Indian firms are traded in the primary and secondary segments of the international financial market. And also the FIIs are allowed to transact securities at the Indian stock exchanges.

    Euro Issues

    A number of Indian firms have issued FCCBs and also shares under the ADE/GDR arrangement to get foreign exchange and to reap the primary and secondary market gains abroad. The Indian government initiated the policy in 1992 and liberalised it from time to time with the result that annual figure of such issues increased over the years and it was as large as Rs. 366 billion during FY 2007–08. The shares of a number of firms were listed on major international stock exchanges. In past years, the volume of turnover of the ADRs/GDRs of Indian companies at the international stock exchanges swelled fast. While in many cases, ADRs/GDRs were traded at premium, trading at discount was not very uncommon. Nevertheless, one aspect is very significant to note. It is a very close integration between the Indian secondary market and the international secondary market in view of a highly positive correlation between the movement of price index of ADRs/GDRs and that of those shares in the domestic market.

    FIIs' Investment

    As far as the FIIs' investment in the Indian secondary market is concerned, the amount of the net investment was quite substantial. In this case too, the policy was initiated in 1992 and was liberalised from time to time. The amount of FIIs' net investment in the Indian secondary market varied widely over different months and also over different years. The apparent reason was that the FIIs being a fair weather friend were greatly influenced by the international economic scenario as well as the economic scenario in India. However, their net investment was over US$16 billion during FY 2007–08.

    These investors showed preference for equity in view of reaping gains from price fluctuations, although they invested in debt instruments too. The reasons for their investment in the Indian market as per the present study were mainly the interest rate differential and the liberalisation of the governmental policy on this count. It is true that the net investment of the FIIs accounted for a very small share in the total domestic investment; yet, their influence on the stock market activities was profound.

    Postscript

    Crisis in Indian Financial Market

    The preceding discussion makes it evident that there was an overall upward trend in the Indian financial market till FY 2007–08. But the trend, as it is being witnessed now, took a reverse gear in FY 2008–09. In fact, the reversal was apparent as back as in the last quarter of FY 2007–08. In the following quarters, it turned stark. Here, we present some more significant trends that the Indian financial sector has witnessed.

    Factors behind the Crisis

    The reversal is the aftermath of the factors prevailing both in the international economy and in the domestic economy. There is a view based on the ‘decoupling’ concept that the economic scenario prevailing in a country does not necessarily influence the economic variables in other countries. Akin and Kose (2007) found in their study that the emerging market economies had stood decoupled from performance of the developed countries for past couple of decades. But the recent crisis in the Indian financial market following the financial crisis in the US has put the decoupling concept in a wrong box.

    The financial crisis in the US was primarily the sub-prime crisis that was quite enormous. A continued escalation in the real estate prices for a decade or so and then a sudden and drastic drop in those prices during 2007 made the collateral of the home loans sub-prime. There were large defaults that in turn led to huge bank losses and put abnormal pressure on the functioning of the banks. The losses on this account were estimated to be over US$400 billion, over one-half of which was to be borne by banks and other highly leveraged financial institutions. For each dollar of loss, these institutions had to shrink their balance sheet by US$10 to US$25 with the result that their lending was greatly affected. As per an estimate, there should be a squeeze over US$2 trillion in their lending activities (http://www.livemint.com). All this had a spillover effect in form of dwindling currency, an economic recession and subdued activities in the financial market of the US.

    The factor at the domestic front was the galloping inflation. The rate of inflation in the country, which was barely 4.26 per cent during the week ended on 5 January 2008, rose to 7.75 per cent by the last week of March 2008 and to 11.89 per cent by 28 June 2008. It crossed subsequently the 12-per cent mark and continued to maintain almost the same level during the second quarter of FY 2008–09. The reason behind the fast-growing rate of inflation lies outside the scope of our discussion. However, one must accept that it did put a definite impact on the activities in the Indian financial sector more directly in terms of falling real income from investment. ‘Fisher effect’ clearly explains that higher the rate of inflation, lower is the real interest rate with a given nominal interest rate. It is true that the growth in the rate of inflation began to recede during the closing months of 2008, yet the damage created by it was enormous.

    These two factors along with many others, first of all, accelerated the disinvestment by the FIIs and thereby put a curb on the secondary and primary capital market activities. The spillover effect permeated over other areas of the financial market and also over the entire economy.

    Large Withdrawal of FIIs' Investment

    It is true that rising inflation axed considerably the real return of the FIIs from the Indian secondary market that was, in the sequel, responsible for their disinterestedness in investing at the Indian stock exchanges. But the most significant factor responsible for withdrawal of their investment was the US sub-prime crisis. The FIIs pulled back their investment from the Indian market perhaps for the purpose of making up of the losses in the US market. They also pulled back their investment in those securities where price oscillations were greater. It is a psychological phenomenon that whenever there is a crisis, the investors try to avoid risk taking and make investment only in less risky channels. The pull-back was quite large and resultantly, their net disinvestment in India was as large as US$8.991 billion and US$1.643 billion, respectively, in February and March 2008 (RBI 2009).

    The SEBI eased the registration norms for FIIs. The result was positive. There were 68 new registrations during one-and-a-half months of 2008 compared to 226 during the whole of 2007. The Indian government too liberalised the policy and broadened the definition of the FIIs. It brought into the ambit of FIIs also the sovereign wealth funds, NRIs-owned asset management companies, unregulated university funds, endowments and charitable fund, bilateral and multilateral organisations and overseas central banks. The ceiling on FIIs' cumulative investment in government securities was raised from US$3.2 billion to US$5.0 billion. In corporate securities, it was raised from US$1.5 billion to US$3.0 billion. This was on first-come-first-serve basis with an individual entity limit of US$200 million (Financial Express 18 June 2008). But FIIs' investment position failed to improve. FIIs recorded a net disinvestment of over US$12.409 billion during the first 9 months of FY 2008–09 compared to a net investment worth US$24.472 billion during the first 9 months of FY 2007–08 (RBI 2009) (see Table PS 1).

    Table PS 1 FIIs' Net Investment in Indian Financial Market
    (US$ billion)
    MonthFY 2007–08FY 2008–09
    April1.963−1.432
    May1.847−0.734
    June3.279−3.011
    July4.685−0.499
    August−3.3230.464
    September7.057−1.403
    October6.833−5.250
    November−0.265−0.574
    December2.3960.030
    Total24.472−12.409
    Source: RBI Bulletin, March 2009.

    A further anatomy of figures makes it clear that disinvestment was vivid in case of equity rather than debt securities perhaps in view of the fact that investment in equity carried greater risk. During the first 9 months of FY 2008–09, debt securities presented a net investment for Rs. 82.010 billion vis-à-vis equity that showed a net disinvestment for Rs. 415.55 billion (SEBI 2009).

    Reversals at the Secondary Capital Market

    The FIIs' disinvestment influenced many areas of the Indian financial sector. Its direct and more proximate repercussions fell on the secondary market transactions. Since FIIs dominate the Indian secondary market, their pulling back of investment was manifest in the crash of stock price index at the Indian stock exchanges. In January 2008 alone, the fall was recorded at 16 per cent which was higher than 12.44 per cent for the emerging market as a whole, although lower than 16.12 per cent in Russia, 21.40 per cent in China and 22.70 per cent in Turkey (Financial Express 12 February 2008). In February and March 2008, there was a further drop in the share price index. A comparative analysis shows that the BSE Sensex which was 20,301 on 1 January 2008 plunged to 14,833 on 18 March 2008. The respective figures for NSE Nifty were 6,144 and 4,533.

    The galloping rate of inflation put fuel to the fire. It caused the real rate of return to shrink. Furthermore, the profitability of the companies relying largely on debt shrank fast. The price of their shares fell fast pulling down in the sequel the stock market index. The explanation is that the RBI increased the interest rate in order to check the inflationary pressure. Higher interest rate helped enlarge the interest payment. The pre-tax profit fell despite large operating profits. As per a study conducted by Mint, there was a dramatic slowdown in the growth of net profit of the Indian companies that constituted the country's stock market indices—BSE Sensex and NSE Nifty. The situation was even worse if the oil firms were excluded from the sample (Mint 30 June 2008). Another study of the Economic Times (2 July 2008) reveals that 347 listed companies paid 26 per cent lower dividend during the first half of 2008 compared to the corresponding period of 2007. The profitability being the first victim, the BSE Sensex and NSE Nifty sagged further despite minor revival in a few months. The average figures of BSE Sensex and NSE Nifty during the first nine months of FY 2008–09 are presented in Table PS 2.

    Table PS 2 Secondary Capital Market Indices
    Period (average of the month)BSE Sensex (1978–79 = 100)NSE Nifty (3 Nov. 1995 = 100)
    April 200916,2914,902
    May 200916,9465,029
    June 200914,9974,464
    July 200913,7164,125
    August 200914,7224,417
    September 200913,9434,207
    October 200910,5503,210
    November 20099,4542,835
    December 20099,5142,896
    Source: RBI Bulletin, March 2009.

    It is evident from the figures that the BSE Sensex fell by over 42 per cent during the above period. The NSE Nifty was not in a much better form as it too fell by over 41 per cent during the same period. A study of Mint (1 January 2009) presents the extent of fall in 14 stock market indices covering different countries during the whole of 2008 and finds that the fall in BSE Sensex and NSE Nifty was the largest only to Shanghai SE Composite Index that slipped by 65.39 per cent. The BSE Sensex fell by 52.45 per cent followed by NSE Nifty which plunged by 51.79 per cent compared to a fall between 49 and 33 per cent in 11 other indices.

    With all these symptoms, it was natural for the market capitalisation to shrink. The market capitalisation at the BSE squeezed from Rs. 57,943 billion to Rs. 31,448 billion between April and December 2008. At the NSE, there was recorded a drop in market capitalisation from Rs. 54,428 billion to Rs. 29,168 billion during the same period. In relation to the gross domestic product, the market capitalisation at the BSE fell from 152.1 per cent at the end of 2007–08 to 59 per cent during December 2008. At the NSE, it was a fall from 138.8 to 55.5 per cent during the same period (http://www.rbi.org).

    It was not simply an overall downtrend in the stock market index or the market capitalisation. A high degree of volatility was marked in the stock market indices. As Table PS 3 shows, the annualised volatility in BSE Sensex and S&P CNX Nifty during April to December 2008 was, respectively, 45.69 and 43.89 per cent. This figure was much higher than the annualised volatility in many other indices around the world.

    Table PS 3 Annualised Volatility in Stock Market Indices during April to December 2008
    Downtrend in the Primary Market

    The secondary market effects permeated to the Indian primary market for securities. It is observed that after the secondary market crash in January 2008, the retail primary market investors failed to respond to the issues. The maiden issue of Wockhardt Hospitals ran into rough water. Similar was the case of Emaar-MGF Land Ltd. In both the cases, price had to be reduced after bleak response. Even then there was no response (Financial Express 6 February 2008). Surya Foods and Agro had to postpone their IPO for Rs. 1,500 million (Financial Express 15 March 2008).

    In view of making the primary market lucrative and to do away with the grey market, SEBI made changes in the public issue process reducing the gap between opening of the public issue and its listing to less than five days and increasing the application money that the institutional investors had to put up, from 10 to 100 per cent. It also reduced the fees for filing offer documents for public issues and mutual funds from 0.03 to 0.005 per cent and the annual fee for registration of mutual funds to 0.0005 per cent of assets under custody from then existing 0.001 per cent. The registration fee for venture capital funds was halved to Rs. 0.5 million (Financial Express 6 March 2008). SEBI proposed a 25-per cent price band on the issue price on the listing day of an IPO up to a size of Rs. 2.5 billion to arrest the price volume volatility on the day of listing of IPO under this size. It is because when the volatility is not sustained by the general public investors, the band should assist in a more orderly price discovery over a period of time. Again, with the implementation of the recommendations of the SEBI-appointed committee on reforming IPOs, the deposit of qualified institutional buyers was revised as 100 per cent of the bid amount instead of 10 per cent earlier; the ceiling on the application of a single investor was doubled to 0.2 million shares, and the allotment of shares was done on a proportionate basis rather than on a discretionary basis.

    Despite these measures taken by the SEBI, desired positive effect on the primary market trading was not felt. In face of bleak market, the companies raised funds to a great extent through rights issues. The amount of rights issue as shown in Table PS 4 constituted 84 per cent of the total resource mobilisation during the first three quarters of FY 2008–09 compared to barely 18 per cent during the corresponding period of the previous financial year. The total resources mobilised from the primary market amounted barely to Rs. 142.45 billion during April to December 2008—down from Rs. 727.10 billion during the corresponding period of FY 2007–08 as shown in Table PS 4. It was a drop of 80.41 per cent. As far as the number of issue is concerned, the drop was recorded from 125 to 43 during the respective periods.

    Table PS 4 Resource Mobilisation in the Primary Market for Securities
    Shrunken Activities of Mutual Funds

    The massive withdrawal of investment by the FIIs, the resultant crash in the stock market indices and the downtrend in the primary market influenced also the activities of the mutual funds. They sensed emerging uncertainty in the behaviour of the financial market and turned cautious about their involvement in the secondary market activities. Their investment in the secondary market amounted to Rs. 371.27 billion during April to December 2008, compared to Rs. 583.72 billion in the corresponding period of the preceding financial year. Moreover, they invested over 78.80 per cent of their funds in debt securities in view of greater risk in equity investment.

    Again, on account of uncertainties in the market, the mutual funds were not able to get funds from the general investors. The investors started giving cold shoulders to new fund offerings. The maiden fund offering of Mirae Asset Global Investment Management (India) Pvt. Ltd could collect only Rs. 700 million by 10 March 2008. Morgan Stanley's ACE Fund managed to collect barely Rs. 800 million during the same period. These figures were far lower than Rs. 56.6 billion collected by Reliance Capital Asset Management Company's Natural Resource Fund in the first week of February 2008 (Mint 15 March 2008). As on 30 June 2008, the NAV of nearly 30 odd equity schemes was at its 52-week low level (The Economic Times 2 July 2008). On the whole, the resource mobilisation was abjectly poor during the first three quarters of FY 2008–09. It was rather negative at Rs. 304.32 billion compared to Rs. 1,239.93 billion during the corresponding period of FY 2007–08. In fact, there was a massive redemption during April to December 2008 especially among the privately owned mutual fund companies. All this had an impact on the size of asset under management of the mutual fund companies that fell from Rs. 5,628 billion at the end of March 2008 to Rs. 4,134 billion at the end of December 2008 (http://www.amfi.com).

    Euro Issues

    The gloom prevailed also in case of the fund mobilisation through the euro issues. During January to June 2008, funds raised through overseas depository receipts and through the issue of FCCBs amounted, respectively, to US$211 million and US$424 million compared to US$4.847 billion and US$4.717 billion, respectively, during the whole of 2007 (Mint 4 July 2008). The situation was not very different during the first three quarters of FY 2008–09. As per the RBI figures, the funds mobilised through euro issues amounted to Rs. 46.85 billion during April to December 2008 compared to Rs. 249.72 billion during the corresponding period of the previous financial year (http://www.rbi.org).

    The impact was seen also on the price of the ADRs/GDRs of the Indian firms at the overseas secondary markets. The Appendix PS A1 covers 86 cases and presents a comparative picture of their market price during first two quarters of 2008. In the first quarter, a comparative picture of four cases is not found as they were not traded on 1 April 2008. Out of 82 cases, there was appreciation in the market price of two cases. In the rest 80 cases, the market price plunged. The extent of the drop in prices varied widely. In 15 cases, the price fall was less than 20 per cent. In 34 cases, it was over 20 per cent but less than 40 per cent. In 29 cases, the price ebbed over 40 per cent but less than 60 per cent. There were only two cases where the drop was over 60 per cent. In the second quarter of 2008, there were 11 cases where the prices rose, although the rise was only meagre. In 25 cases, they fell below 20 per cent. In 37 cases, the fall was recorded 20 per cent or more but less than 40 per cent. There were four cases where the fall was steeper at 40 per cent or higher but less than 60 per cent. There was a lone case where the price decline was beyond 60 per cent.

    The Instanex Skindia Index shows that the GDR/ADR price index at the international stock exchanges decreased from 3639.43 on 1 January 2008 to 1278.89 on 23 December 2008. It was a drop of 64.8 per cent.

    On comparing the fall in the ADR/GDR prices with those of domestic share prices of the same firms, it is revealed that the plunge in the former was steeper. Mint (25 March 2008) has made a study of 14 such firms and has found that out of 14 Sensex firms, 13 experienced a steep fall in their ADR/GDR prices compared to their local share prices between 10 January and 19 March 2008 (Table PS 5).

    Table PS 5 Changes in the ADR/GDR Prices vis-à-vis Respective Local Prices of 14 Sensex firms during 10 January to 19 March 2008
    Firm% change in ADR/GDR prices% change in local prices
    ICICI Bank−51.26−43.51
    Reliance Comm.−44.34−36.38
    L&T−34.86−32.52
    SBI−32.68−29.47
    HDFC Bank−32.41−26.16
    Reliance Inds.−30.31−28.67
    Tata Steel−27.90−25.38
    WIPRO−27.10−22.76
    Hindalco−24.91−23.42
    Infosys−22.08−16.25
    Tata Motors−19.97−13.16
    Satyam Comp.−13.09−7.19
    Cipla−1.53−1.90
    Ranbaxy Lab.−7.91−13.03
    Source: Mint, 25 March 2008.

    The comparison shows, first, greater integration between the Indian financial market and the international financial markets and that the impact of sub-prime crisis in Indian secondary market was not as intense as it was in case of international financial markets.

    Moreover, it is because of lowering price of ADRs and GDRs that the debt burden of the Indian firms was expected to rise abnormally. The explanation is that the Indian firms issue FCCBs that are converted into equity shares after some time at a predetermined rate. If the stock price is greater than the conversion price, the bonds are converted into equity shares and, in the sequel, the burden of interest payment and repayment is over. But, in many cases, when the conversion price was greater in the wake of falling stock prices, it was not in the interest of the firm to convert the FCCBs into equity shares. Servicing of bonds remained a major problem. In fact, the Indian firms with FCCBs valued at US$17.7 billion were facing this problem (Mint 13 March 2008). However, many firms managed to lower the conversion price under the provisions of the reset clause where the conversion price might be revised with a fall in the company's share price below a predetermined level. Pioneer Embroideries Ltd lowered the conversion price by 30 per cent in March 2008. In January 2008, it had already lowered the price by 10 per cent. As a result of the fall in the conversion price, the dilution in the equity turned higher and the firms needed the issue of more shares.

    The downtrend was observed not only in the ADRs/GDRs prices abroad. The prices of bonds issued overseas by the Indian firms were also on the ebb in the final quarter of FY 2007–08. The yield turned greater than the coupon rate. In such cases, the Indian firms had to start buying back the debt securities. ICICI Bank Ltd bought back US$50 million worth of overseas bonds that were to mature in 2012 (Mint 13 March 2008). Other banks might follow the lead. In other words, issuing overseas bonds did not remain lucrative. In view of this problem, the Indian government permitted the funds raised through FCCBs to be used for the equity of other companies of the group, subject to the necessary FDI cap (Financial Express 16 February 2008). How far this provision is workable is not beyond doubt.

    The Exchange Rate Scenario

    The impact of the sub-prime crisis along with the domestic inflation was visible also on the exchange rate. With the outflow of funds on FIIs' account, falling stock market index and tight position of the inflow of fresh investments on account of liquidity crunch in the overseas market, the rupee depreciated by around 2.5 per cent during the last quarter of FY 2007–08 after gaining 12.3 per cent during the first three quarters of the same financial year. On 17 March 2008, rupee touched a 6-month low of 40.735 a dollar. The depreciation continued to persist in the first three quarters of FY 2008–09. Table PS 6 shows the average exchange rate of rupee in relation to US dollar and euro.

    Table PS 6 Exchange Rate: Indian Rupee vis-à-vis US Dollar and Euro during April to December 2008
    Monthly averageRupee/US$Rupee/Euro
    April 200840.6562.78
    May 200842.7966.71
    June 200843.2167.92
    July 200842.4966.33
    August 200844.3763.41
    September 200846.8864.99
    October 200849.2462.89
    November 200849.6963.46
    December 200848.4568.22
    Source: SEBI Bulletin, various issues.

    It is evident from the figures that the rupee depreciated vis-à-vis US dollar from Rs. 40.65 in April 2008 to Rs. 49.69 during November 2008, although there was a slight appreciation during the following month to Rs. 48.45. Similarly, the trend in Rs./euro was not very different. Barring a few months when there was marginal appreciation, rupee fell from 62.78 to 68.22 vis-à-vis euro during the same period. It may be noted that the depreciation of rupee continued to remain despite huge selling of US dollar by RBI in the foreign exchange market ranging between US$1.477 billion and 20.626 billion a month during May–December 2008 (RBIB, March 2009).

    There were basically four reasons. First, it was the bounce in US dollars as Fed rate cut seemed to be coming to an end. Second, it was the FIIs' net disinvestment that was really huge. Third, it was the soaring oil prices, at least for only a few months that led to greater demand for dollars to meet the oil import bill. Fourth, it was the psyche of the general importers who advanced their imports in face of depreciating rupee in order to minimise their exchange rate exposure. These factors led to a rise in demand for dollars, euro and other foreign currencies and, in the sequel, to depreciation of rupee.

    As far as the nominal and real effective exchange rates are concerned, the six-currency trade weighted NEER and REER of the rupee depreciated, respectively, by 8.5 and 3.7 per cent between March 2008 and September 2008. By December 2008, these rates slid further. To be precise, during December 2008, NEER, based on six-currency weight, was 62.66 compared to an average of 74.17 in FY 2007–08 (1993–94 = 100). The respective figures for REER were 99.89 and 114.09 (RBI 2009).

    The Market for Currency Futures

    Despite the downtrend, the government set up the market for currency futures following the recommendations of the Raghuram Rajan Committee and the Expert Group at the RBI. The three Indian exchanges, namely, BSE, NSE and MCX applied for dealing in currency futures. RBI and SEBI released the guidelines in this respect on 6 August 2008. Finally, NSE started operating on 29 August 2008. MCX and BSE followed the suit.

    The guidelines allowed only US dollar–rupee contracts with a size of US$1,000 for a maturity not exceeding 12 months. The trading is done on Monday through Friday excluding public holidays between 9.00 a.m. and 5.00 p.m. and settlement is done on the last working day of the month, and not earlier. Thus, the standardised size is smaller than those at the international exchanges. The contracts are quoted and settled in rupee.

    The membership of the currency futures market would be separate from the membership of derivatives/cash segment. Again, only a resident Indian, including banks, can participate in the deal. This means that the FIIs/NRIs are not entitled to participate in the deal. A bank being a member must have reserves worth Rs. 5 billion, 10 per cent CRAR, an NPA of 3 per cent at the maximum and a profit record for at least 3 years. The trading limit for an individual client is US$5 million or 6 per cent of the total open interest, whichever is higher. For a trading member—bank or broker, it is US$25 million or 15 per cent of the total open interest, whichever is higher.

    The hedger or the client is first registered with the trading member who buys or sells the currency futures contract on behalf of the client. The marking to market is based on the daily settlement price which is arrived at after taking the weighted average of last half an hour's transactions. The loss or gain arising out of this process is settled on t + 1 basis. At the end of the day, net positions are reset with respect to the current day's daily settlement price and are carried forward to next day. Finally, on the settlement day, the settlement is done in cash payable in rupee.

    In the entire process, the clearing member has a crucial role to play. At the NSE, its wholly owned subsidiary, National Securities Clearing Corporation Ltd (NSCCL) carries out the entire clearing and settlement process. It acts as counter party to all transactions and guarantees the final settlement. It carries out also novation which means that it helps replacement of one obligation with another with the mutual consent of both the parties. The clearing banks help NSCCL in carrying out clearing and settlement.

    The NSCCL monitors the members' operation online and asks for immediate halt of any transaction if the open position or the margin money requirements are violated. Here, it may be mentioned that the margin requirements are enforced by the NSCCL. It calculates the initial margin money requirements on the client's level using Standard Portfolio Analysis of Risk methodology and informs the trading members daily about the clients' margin liability. The trading members submit the compliance report. The extreme loss margin in case of the trading members is 1 per cent of the value of their gross open position.

    Now the question is whether the currency futures are better than the forwards transacted in India. First of all, while in case of OTC forward contracts, the banks quote different bid-ask rates for different customers, future rates are shown on the screen of the exchange. Thus, the price discovery is more transparent in case of futures.

    Second, participants, such as exporters and importers, can go for a forward contract only for their underlying transactions. Their purpose cannot be speculation. But in case of currency futures, no underlying securities are required.

    As far as trading size is concerned, the value differed widely from one stock exchange to the other. At the NSE, the amount moved up from Rs. 2.620 billion in September 2008 to Rs. 10.876 billion in December 2008. At MCX too, it moved up from Rs. 3.248 billion in October 2008 to Rs. 10.922 billion in December 2008. On the contrary, at the BSE, it plummeted from Rs. 383 million to Rs. 13 million during October to December 2008 (SEBI Bulletin January 2009).

    Activities in the Money Market

    It is true that during the first quarter of FY 2008–09, the daily average call rate continued to remain normally within the tunnel created by reverse repo and repo rates. But during the following quarter, the call rate mostly hovered around the repo rate reflecting perhaps the impact of the increase in the CRR in three stages to 9 per cent and in repo rate to 9 per cent. The average call rate was 9.10 per cent during August 2008 and 10.52 per cent in September 2008. As regards treasury bills, the primary market yields tended to harden as a sequel to high money market interest rates. In the third quarter, the pressure on the Indian money market continued on account of RBI's intervention in the foreign exchange market, but a cut in CRR checked the call money rate from unwarranted appreciation.

    During mid-September, the failure of Lehman Brothers led to a panic in the world financial market. However, the Indian money market activities were not so badly affected. During the third quarter, there was some minor improvement in the money market scenario.

    Table PS 7 shows the trends in different segments of the Indian money market during April to December 2008 compared to those during FY 2007–08. Let us first talk about the average daily volume of transactions (one leg) in the call money market; it showed a marginal increase during April to December 2008 over that during FY 2007–08. The transactions in CBLO and term money market were almost constant during the above period. Repo outside LAF declined but only marginally. The outstanding amount of CP and CD rose during the first nine months of FY 2008–09.

    Table PS 7: Transactions in Indian Money Market
    Banks and NBFCs

    However, a few push-ups in CRR entailed upon the profitability of many banks. The net profit of some of the banks, namely, Canara Bank, Allahabad Bank, Indian Overseas Bank, fell by a good margin.

    Again, in order to make the NBFC financially stronger to sustain the upheavals in the economy and to bring in greater transparency in their working, RBI issued guidelines on 2 June 2008. The guidelines prescribed, first, to raise CRAR from 10 to 12 per cent immediately and further to 15 per cent from April 2009. Second, they made it mandatory to disclose some additional information in their balance sheet, especially related to CRAR, derivative deals and maturity pattern of assets and liabilities. Moreover, the NBFCs are now to submit half-yearly reports relating to various aspects of liquidity, such as structural liquidity, short-term dynamic liquidity and the interest rate sensitivity. RBI tightened further the deposit-accepting policy of the NBFCs. An NBFC with a minimum investment grade credit-rating and a capital adequacy ratio of 12 per cent can accept deposit only up to 1.5 times of their NOF. Earlier it was four times. In other cases, this multiple is 1. Any excess level of deposit has to be brought down by March 2009. But these measures have hardly improved their financial strength.

    To conclude, India's financial sector continued to remain under strains during the first three quarters of FY 2008–09.

    The Way Ahead

    It is difficult to say how long the financial turmoil shall exist. Nevertheless, if remedial measures are taken, the time span of the crisis will certainly be shorter. The remedial measures need to be taken at different levels. One is the international level. It is the international agencies that can do something. During the Asian Crisis, it was the IMF that had provided a huge financial package to deal with that crisis. It can be done even now. This is why the G-20 Summit recommended for trebling the resources with the IMF—from the present US$250 billion to US$750 billion. But this measure is fraught with a couple of problems. One is that unwarranted liquidity should not be created and allocated among the member countries. The other problem is related to the conditionalities associated with the lending. The issue is whether the IMF's prescription for greater liberal policies would be befitting at a time when there is a growing consensus on a fine balance between the state and the private sector. It may be recalled that the handsome financial package to remedy the Asian Crisis carried too much of intrusiveness that the Asian countries did not relish. Their unwillingness to abide by the IMF conditionalities was the factor behind their excessive reliance on reserves build-up. Thus, whenever the IMF's financial package is talked about, these two issues should be taken into account.

    The second level of the policy prescription is the national level. All the different governments—whether developed or the emerging market economies—should take appropriate steps to enhance liquidity. Since the different economies are interrelated, the fruitful results of the different measures taken up in one country will definitely permeate over to other countries. It may be mentioned in this context that there is unanimity among the G-20 members on an increase in the governmental spending and also on an expansionary monetary policy along with price stability. In many developed countries, the government has provided fiscal packages and has restructured the monetary policy. In emerging market economies too, such measures have been taken, despite the fact that the crisis in a developed country spread from the financial sector to the real sector vis-à-vis in an emerging market economy where the crisis moved the other way.

    As far as India is concerned, the response to the crisis manifested in both the government's fiscal stimulus and RBI's monetary policy restructuring. In case of the fiscal response, the Indian government invoked the emergency provisions of the Fiscal Responsibility and Budget Management Act and launched two fiscal packages during December and January of FY 2008–09. The two packages included government-guaranteed funds for infrastructure spending, axing of indirect taxes, enhanced guarantee cover for credit to small enterprises, added support to the exporters, expanded safety net for the rural poor and a farm loan waiver. These steps should help generate demand. But one has to be cautious on the fiscal deficit front. The government's profligacy has already led to an increase in the fiscal deficit from a level of 2.7 per cent of GDP to a present level of around 6 per cent. The fiscal incentives thus must not make the fiscal deficit unmanageable. The Asian Development Bank has pointed out in its 2009 outlook that India does not have any room for fiscal stimulus.

    Turning from the fiscal package to the monetary package, it may be noted that the RBI has endeavoured to maintain a comfortable liquidity position in terms of rupee besides maintaining foreign exchange liquidity. At the same time, it has helped harness the credit delivery so as to maintain the growth rate. It is true that during the days of climbing inflation rate, tight monetary policy was adopted. But with an ease in inflation scenario, RBI adopted a liberal monetary policy, especially since mid-September 2008. The liberal monetary policy included a number of measures, such as reduction in interest rates, reduction in the quantum of bank reserves impounded by RBI, liberal refinance facilities for export credit, raising of the ceiling on foreign currency deposits by NRIs, liberal policy in respect of external commercial borrowings and allowing NBFCs to borrow from external sources. RBI eased the policy towards rupee–dollar swaps, so that the banks could manage their short-term funding requirements.

    With the implementation of the fiscal and monetary measures, the performance in specific industries has improved. Industries like cement and steel are recovering (Vyas 2009). In the financial sector, the liquidity position has definitely improved. A number of banks have lowered their benchmark prime lending rates expanding in turn the size of credit. A few positive results are evident. For example, the pressures on mutual funds have eased. The net resource mobilisation by them amounted to Rs. 668 billion during January 2009 compared to Rs. 427 billion in January 2008. Their investment in the secondary market too amounted to Rs. 176 billion during January 2009 that compared favourably with that in any of the preceding months of FY 2008–09 (SEBI Bulletin February 2009). The non-food credit, which had declined fast during the first three quarters of FY 2008–09, has started showing fast recovery since February 2009.

    It is not only at the domestic front. In international financial market too, Indian firms have started doing well. The ADRs of Tata Motors and IT companies, such as Patni Computers, Satyam Computers and Wipro, have started enjoying premium (Financial Express 6 April 2009). It is true that such cases are only a few, but one should be hopeful.

    Besides policy design at the macroeconomic level, the improvements can be brought about at the micro level. If different enterprises make out a cost reduction plan to raise profit and, at the same time, raise the asset turnover, the return on investment is bound to increase. It is because the return on investment is the product of profit margin and asset turnover. The cost reduction plan may raise the size of sales on the basic assumption that lower the price, higher is the demand. This way the economic strength of the enterprises will be greater and the value of their shares at the stock exchanges will rise. All this may generate confidence in the financial market. Here, it may be stressed that the psyche of the participants in the financial market must be positive if the fiscal and monetary measures have to bear fruits.

    Appendix

    Table PS A1 Price of ADRs/GDRs Traded on 29 December 2006, 2 January 2008, 1 April 2008 and 30 June 2008

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    About the Author

    Vyuptakesh Sharan is presently Emeritus Fellow at the South Asian Studies Division, School of International Studies, Jawaharlal Nehru University, New Delhi. Prior to this assignment, he was UGC Visiting Professor at the Department of Commerce, Delhi School of Economics, University of Delhi and also AICTE Visiting Professor, Global Business Operations Post-graduate Programme, Shri Ram College of Commerce, University of Delhi, and former Professor and Dean, Faculty of Commerce and Business, Magadh University.

    Professor Sharan has delivered special lectures at several universities, including a University at Warsaw. The articles authored by him have been published in several international and Indian journals. His book India's External Sector Reforms (2001) was widely appreciated by academics.


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