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«I ndia and China are both large, poor countries that have benefited from greater integration into the world economy; both are still at an early but ...»

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Greater stress is also given to timely identification and monitoring of the behavior of troubled banks. The role of external auditors has been extended to verifying and certifying almost all aspects of balance sheets including financial ratios. Concurrent audits have also been introduced.

With the increasing use of credit cards and electronic banking, supervision has taken on another dimension: integrity of e-money. As of October 2004, different banks had already issued about 37.85 million plastic cards covering a range of credit cards, debit cards, and smart cards (RBI, 2004).

The RBI has constituted several working groups on electronic money, and the recommendations are being implemented.

Suman Bery and Kanhaiya Singh 157 Capital market reforms The Capital Issues (Continuance of Control) Act, 1947,8 was used to control the issue of capital in the Indian market up to 1992. Under this Act, any firm wishing to raise funds from the market had to obtain approval from the government, which also determined the amount, type, and price of the issue. In order to pave the way for market-determined allocation of resources, the 1947 Act was repealed in 1992 and the Securities and Exchange Board of India Act, 1992 was enacted with statutory power granted to SEBI to (a) protect the interest of investors in securities, (b) promote and develop the securities market, and (c) regulate the securities market. In addition to the SEBI Act, 1992, three other acts are applicable to the capital market. These are: the Securities Contract (Regulation) Act, 1956 (SC(R)A); the Companies Act, 1956; and the Depositories Act,

1996. The government has framed rules under all these three acts, and SEBI issues notifications and guidelines that must be complied with by market participants. The Department of Economic Affairs, Department of Company Affairs, the RBI, and the SEBI with clear areas of jurisdiction under different applicable Acts share the responsibility of regulating the securities market.

SC(R)A was amended in 1995 to lift a ban on the writing of options in securities, and was again amended in December 1999 to expand the definition of securities to include derivatives in order to bring these into the general frame of regulations applicable to any other security. In addition, a 30 year old ban on forward trading was withdrawn in order to make trading in derivatives a reality.

Historically, brokers owned, controlled, and managed stock exchanges in India, which often led to extreme volatility in the securities market. In March 2001, in order to corporatize the stock exchanges, the government proposed de-mutualization, whereby ownership, management, and trading membership would be segregated from one another. The government has offered tax incentives to facilitate this transformation.

8Control of Capital Issues was introduced through the Defense of India Rules in 1943

under the Defense of India Act, 1939, to channel resources to support the war effort. The control was retained after the war with some modifications as a means of controlling the raising of capital by companies and to ensure that national resources were channeled to serve the goals and priorities of the government, and to protect the interests of investors. The relevant provisions in the Defense of India Rules were replaced by the Capital Issues (Continuance of Control) Act in April 1947. (See http://www.sebi.gov.in/ chairmanspeech/histspeech.htm1 for more information.)

158 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATION

SEBI (Central Listing Authority) Regulations, 2003, were issued to provide for the constitution of a Central Listing Authority (CLA) by SEBI.

In addition, the regulations provided for mandatory recommendation from CLA before listing in any stock exchange and appeal to SEBI and the Securities Appellate Tribunal in case of refusal of issuance of letter of recommendations from CLA. The CLA was constituted on April 9, 2003.

The National Stock Exchange of India Limited (NSE) was established during the early 1990s as a competing exchange under public ownership with state of the art technology to supplement the business at the Bombay Stock Exchange (BSE), both of which have traded in derivatives of securities since June 2000. The market presently offers index futures and index options on two indices and stock options and stock futures on 31 stocks.

NSE quickly introduced a nationwide, on-line, and fully automated screen based trading system (SBTS). The SBTS electronically matches orders on a strict price/time priority, cutting costs and reducing risk of error.

Rolling settlement on a T+5 basis was introduced for all scripts in December 2001 to reduce the trading cycle (to as little as 1 day, in the case of specified scripts), which earlier used to take 14 days for specified scripts and 30 days in the case of other scripts. T+5 gave way to T+3 in December 2002, T+2 in April 2003, and now it is moving toward T+1. With a view to make the trading system more efficient and less time consuming, effective April 2004, Straight Through Processing became compulsory for all institutional trades.

The Companies (Second Amendment) Act, 2002, was enacted to provide for a new, modern, efficient, and time-bound Insolvency Law to provide for both rehabilitation and winding up of sick companies within a maximum time frame of two years. It envisaged the setting up of a National Company Law Tribunal with several Benches to be notified by the government all over the country.





Public debt The RBI is the regulator of the market for government securities and it also services and manages the public debt for both the central and state governments. Following the scam of 1992, where lack of transparency in the pricing and settlement of government securities created a funding channel for stock market speculation, significant reforms have been made to markets for both bills and dated securities.

Until 1991, the government securities market consisted mainly of predetermined, low-coupon, long-maturity loans. There was no benchmark rate for the market. In 1992, however, the government began borrowing at market interest rates through an auction system, and, by April 1997, it Suman Bery and Kanhaiya Singh 159 abolished the system of automatic monetization via ad-hoc treasury bills.

These actions paved the way for rapid reforms. New instruments such as zero coupon bonds, floating rate bonds, bonds with call-put options, and capital-indexed bonds were introduced across the maturity spectrum. A system of primary dealers (PDs) was introduced with liquidity support and incentives for underwriting. This, along with permission for FIIs to invest in dated securities and treasury bills in the primary and secondary market segments, added depth and liquidity to the market. The transparency was increased by announcements of an auction calendar for treasury bills, online dissemination of information, creation of the Negotiated Dealing System for delivery, and settlement through the Clearing Corporation of India Limited (CCIL). Market participants can now hedge their risks through interest rate swaps and forward rate agreements on the overthe-counter market and through rate futures on exchanges (RBI, 2005b, Chapter VII). While market infrastructure has clearly become much more robust, and has facilitated the move from direct to indirect instruments, provision of adequate liquidity remains a challenge, perhaps aggravated by the RBI’s habitual ambivalence to the role of brokers in the public debt markets. Liquidity is an even larger issue in the fragmented market for corporate debt, even though other elements of market infrastructure, such as independent and well-staffed rating agencies, have existed for a number of years.

With the legislative framework in place and responsive to market changes, the securities market is also becoming increasingly integrated with the international markets. Indian companies have been permitted to raise resources from abroad through issues of American Depository Receipts, GDRs, Foreign Currency Convertible Bonds, and External Commercial Borrowings (ECBs) and are also allowed listing on foreign stock exchanges under certain conditions. The FIIs enjoy full capital account convertibility. They can invest in a company under portfolio investment up to 24 percent of the paid-up capital of the company, which can be increased up to the sectoral cap/statutory ceiling if it is approved by the Indian company’s board of directors and also its general body.

Money market development and innovations In order to bring financial stability and facilitate the movement of the short-term money market rate within a corridor, a full-fledged liquidity adjustment facility (LAF) was established on June 5, 2000, to be operated through repo and reverse repo instruments. The LAF is now fully supported by a real time gross settlement system and a computerized public debt office. Liquidity is injected by the RBI through the Collateralized

160 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATION

Lending Facility to banks, export credit refinance to banks, and liquidity support to PDs in government securities. The absorption of liquidity takes place through fixed-rate reverse repos (rates being announced daily) and open market operations in government-dated securities by the RBI. However, it is important to note that these operations occur within the given framework of the CRR (that directly affects liquidity) and the Bank Rate which signals the central bank’s medium-term view on shortterm rates. The CCIL now handles most overnight transactions in the repo/reverse repo market.

Introduction of the LAF has been one of the most important recent changes in the money market. It gives the RBI the flexibility to affect liquidity and signal interest rates in the short-term money market. In order to provide the RBI with additional tools to cope with the recent surge in capital flows, however, the Government of India signed a memorandum of understanding with the RBI on March 25, 2004, detailing the rationale and operational modalities of a Market Stabilization Scheme (MSS) to be effective from April 2004. Under the MSS, the government would issue treasury bills and/or dated securities in addition to its normal borrowing requirements, so as to facilitate the RBI’s efforts in absorbing liquidity from the system. The treasury bills and dated securities issued for MSS purposes are matched by an equivalent cash balance, which is held by the government in the RBI. The interest payments on treasury bills and/or dated securities outstanding under the MSS will be the only impact on government revenue and fiscal balances.

Thus, effective April 2004, the MSS became an important instrument of liquidity absorption and sterilization. Initially, an annual provision was made of Rs. 600 billion, which was increased to Rs. 800 billion for 2005–06.

In his budget speech in February 2000, the Indian Finance Minister mooted the idea of amending the RBI Act to accord greater operational flexibility to the Reserve Bank in conducting monetary policy and regulation of the financial system. Accordingly, the Reserve Bank of India (Amendment) Bill, 2005, was introduced in India’s lower house of Parliament (the Lok Sabha), which aims at bestowing enabling powers on the RBI to use a larger variety of financial instruments than hitherto, including derivatives, and more flexibility to set the cash reserve ratio. Apart from these legislative changes, there remains a rich agenda of additional reform to improve the liquidity and efficiency of the money market further, both to serve commercial needs and to improve its sensitivity and responsiveness to the RBI’s monetary policy actions. A few examples follow.

Suman Bery and Kanhaiya Singh 161 The repo market is still at an early stage of development. Reforms on the rollover of repos and on documentation are expected to pave the way for a deeper and more liquid repo market. With appropriate regulatory safeguards, guaranteed settlement through notation in the CCIL, trading in dematerialized form, and uniform accounting, valuation, and disclosure norms, it is expected that the market will deepen further (see also, Mohan and Prasad, 2005).

It is also being proposed to remove the provision for payment of interest to banks on the excess CRR maintained by the commercial banks, as this reduces the effectiveness of the CRR as a monetary policy tool.

There is finally the issue of ownership. Several studies including those of the World Bank (2001) and Barth, Caprio, and Levine (2001) indicate that private banks are more efficient. Given the public banks’ large current share in intermediation, it will take time for new entrants to displace growth, although the capital markets provide an increasingly viable alternative for large listed companies. There is currently no credible proposal, however, to dilute public ownership in these banks to passive, minority status.

Assessment Somewhat unexpectedly, financial sector reform can now be counted as one of the relative successes of India’s economic reform program since

1991. Significant liberalization and (as will be discussed further below) significant international financial integration have occurred without, so far, a major financial crash. Yet, as Kletzer (2004) points out, the lack of coordination between fiscal adjustment and financial reform has had significant implications through the loss of revenue associated with financial repression. He further argues that funding of the government’s high debt stock will become harder as the capital account liberalizes.

Positive surprises over the 15-year span have been the growth in assurance and professionalism of both the RBI and SEBI, as well as the beneficial impact of increased competition from some of the newly established domestic private sector banks. By contrast, so far the collective impact of foreign banks has not been significant. Yet, while the stability of the system is no doubt greater now than at the beginning of the process (Table 7.3), the contradictions between a still largely nationalized banking system and the needs of an increasingly sophisticated and rapidly growing economy are growing more serious and glaring. Unfortunately, denationalization is even less discussed than before. The fact that India emerged unscathed from contagion in the Asian crisis of 1997–98, the fact that China has succeeded in growing rapidly despite a largely publicly owned

162 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATION



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