indian financial system 2008-09

7/29/2019 Indian Financial System 2008-09

1/54

How is Indias high growth financed?

An overview of the Indian Financial System

Sidharth Sinha

IIM Ahmedabad

July 2009

1


2/54

How is Indias high growth financed?

An overview of the Indian Financial System

India has completed an unprecedented five years of growth (2003-04 to 2007-08) of around

9% per annum. Almost 70% of the growth is accounted for by services whose share in GDPhas increased from 59% in 2003-04 to 63% in 2007-08.1

The relationship between economic growth and financial development has received intenseattention by researches over the last 15 year. Levine (2003)2, after surveying a decade ofresearch on the finance and growth nexus arrives at the following conclusions:

Countries with better-developed financial systems tend to grow faster. Specifically, bothfinancial intermediaries and markets matter for growth. The size of the banking systemand the liquidity of stock markets are each positively linked with economic growth.

Simultaneity bias does not seem to be the cause of this result.

Better-functioning financial systems ease the external financing constraints that impedefirm and industrial expansion. Thus, one channel through which financial developmentmatters for growth is access to external capital, which enables industries and firms toexpand.

Zingales (2003)3in his commentary on Levine (2003) points out that for the relation betweenfinance and growth to be used as a policy tool, there is a need to better understand themechanism through which finance promotes development. This will o help identify theaspects of the financial system which are most important for growth. For example, while moststudies agree that having a more developed banking sector is better than having anunderdeveloped one, there is still uncertainty about whether a developed equity market

provides an additional benefit, even more so if the development of the equity market occurs at

the expense of the development of the banking system. From a policy perspective, this isprobably the most important question. It is of little use to know that a relation betweenfinance and growth exists, if policymakers do not know how to promote financialdevelopment.

The primary purpose of this paper is to document the performance of the Indian financialsystem during the current period of high growth. The basic framework is one of identifyingthe role of institutions and markets in channelizing household savings to investment by the

public and private sectors. At a disaggregated level the financial system can also influence theallocation of savings to alternative investment opportunities.

The following conclusions emerge from the analysis.

The recent period of high growth has been accompanied by significant changes in firmfinancing patterns. Overall there has been an increase in the share of external sources. The

1A glance at the growth record suggests that it is the continuing and consistent acceleration in growth

in services over the decades, that had earlier been ignored, that really accounts for the continuousacceleration in overall GDP growth, once again, except for the 1965-81 interregnum. There is nothing

particularly special about service sector growth over the last decade except that the acceleration overtime has continued. Rakesh Mohan, Finance and Growth: The Growth Record of the Indian Economy,1950-2008: A Story of Sustained Savings and Investment, June 2008

2Ross Levine, More on Finance and Growth: More Finance, More Growth?, Review of Federal

Reserve Bank of Stylus, July August 2003.

3Luigi Zingales, Commentary, The Weak Links, Review of Federal reserve Bank of St.Louis, July

August 2003.

2


3/54

shares of all major sources of external financing have increased with the exception of tradecredit.

However, banks continue to play a dominant role in the Indian financial systems. The role ofbanks is made possible by high deposit growth as well as liquidation of holding ofgovernment securities beyond the minimum required SLR levels. The role of markets issmall. Equity markets have a minor position in both households financial savings andcorporate financing. Equity markets continue to be illiquid and bonds markets are nonexistent. Private placement of debt has emerged as a major financing source . Attempts are

being made to develop a bond market around private placements. The government securitiesmarket is yet to develop sufficiently. Trading is inadequate to provide a proper term structurefor the development of other fixed income markets. Securitization is still in a nascent stage.Currently it is mainly through direct assignments rather than the issue of tradable securities.

In spite of only a small deficit in domestic savings relative to domestic gross capital formationforeign capital flows have increased significantly and played an important role during thehigh growth period. Foreign capital flows have come in the form of debt (external

commercial borrowings) and equity (foreign direct investment). While the former may havemade up for the absence of corporate debt markets the latter may have been especiallyimportant given the reluctance of households to invest in equity. While overall domesticsavings may have been adequate to finance domestic investment, the form of the savings maynot have matched the capital structure requirements of the corporate sector.

This paper is organized as follows:

Section 1 provides an overview of the savings investment balance, and details of theinstruments of household savings. The main component of household savings is bankdeposits.

Section 2 examines the role of banks in channelizing household deposits to private and publicinvestment. This intermediation has been influenced by recent policy reforms and continuesto be affected by policies for priority sector lending and investment in government securities.

Section 3 assesses the development of financial markets for government securities, equity andbonds. The market for financial derivatives is not covered. The inflow and outflow of foreigncapital is also considered in this section.

Section 4 looks at the role of banks and financial markets in Corporate Finance. Theimplication of concentrated ownership of business groups for corporate governance andfinancing is also examined. The World Economic Forum in its first Financial DevelopmentReport released in 2008 ranked Indias financial system development at 31 out of 52

countries. The banking system was ranked at 50 out of 52.

Section 5 concludes.

A set of Tables which form the basis for the paper are provided in the Appendix. The papercan be read without referring to these Tables. The Tables provide more detailed information.

1. Savings and Investment

3


4/54

Gross Domestic Saving (GDS) of the Indian economy constitutes savings of public, privatecorporate and household sectors. At the sectoral level, savings estimates for the public sectorand private corporate sectors are prepared by CSO. The private corporate sector savingsestimates are prepared on the basis of company finance studies of Reserve Bank of India(RBI). The savings of the household sector are estimated separately under financial assets and

physical assets. RBI takes the responsibility for estimating the household savings in financialassets, while CSO estimates the household savings in physical assets.

Household financial savings is estimated using the economy-wide Flow of Funds (FOF). Forthe FOF, the economy is classified into six sectors and nine instruments. The six sectors arecorporate; public; rest of world; banking and other financial institutions; and the residual

being the household sector comprising heterogeneous entities like individuals andunincorporated business enterprises such as sole proprietorships and partnership concerns,and non-profit institutions. The nine instruments are currency, deposits, investments, loansand advances, small savings, life insurance funds, provident funds, trade debt and foreignclaims. Therefore, the households sector as relevant for savings estimation is exactly thesame as for FOF estimation. Household's financial saving is estimated as a sum of flow in the

above instruments as they emerge from the accounts of the organized sectors.

The household sector is treated differently because while the corporate and governmentsectors have their balance sheets and income-expenditure accounts at annual intervals to basetheir annual savings estimates on, the household sector does not have such accounts for all itsconstituents such as pure households, HUF, self employed persons, trusts, proprietorships etc.

The savings of the household sector in physical assets are not estimated independently. CSOestimates the household investment and transfers the same to the account of household savingin physical assets. As a result, the estimates of household savings in physical assets andhousehold investment are the same estimated through Commodity Flow Approach.

Net financial savings of the household represents the gross financial savings less the increasein financial liabilities of the households. This may be misleading as part of the financialliabilities of household finance physical savings but are deducted from household financialsavings, thus lowering the share of financial savings.

Growth in Savings and Capital formation (Table 1)

After having remained almost stagnant during the decade of the 90s, gross domestic savings(GDS) has increased from 23.5% of GDP in 2001-02 to 37.7% in 2007-08. Households arethe dominant provider of savings. However, the share of households in total savings hasdeclined from 94% of GDS in 2001-2002 to 65% in 2007-08. During the same period the

public sector share increased sharply from a negative 8.6% to a positive 12%. The corporate

sector share increased from 14.4% to 23.3%. This is reflected in the fact that of the totalincrease of 14.2% in GDS over the period 2001-02 to 2007-08, the public sector contributed6.5%, the corporate sector 5.4% and the household sector 2.2%. Therefore, the contributionof the household sector to the growth in savings during this period is small relative to theother sectors.

The improvement in the performance of the public sector may be a result of the FRBM(Fiscal Responsibility and Budget Management Act-2003) legislation which puts limit on the

borrowings as well as on revenue expenditure of both the Central and State governments. Thenet Government borrowing (fiscal deficit) of the Centre as well as of all States has to bereduced to 3% of GDP by the year 2008-09 and subsequently to be contained within 3% ofGDP. During the same period, the revenue deficit is required to be completely eliminated.

4


5/54

Gross capital formation (GCF) kept pace with domestic savings with the overall savingsinvestment gap around +1% till 2003-04 and -1% thereafter, rising to -1.4% in 2007-08. As a

percentage of GDP, GCF increased by about 14.5% during the period 2001-02 to 2007-08.The corporate sector accounted for 10.5%; the household sector 1.3%; the public sector 2.2%;and valuables 0.5%. The savings-investment gap of the private corporate sector increasedfrom -2% in 2001-02 to -7% in 2007-08. The public sector savings-investment gap shrunkfrom -8.9% to -4.6%. These were financed by the household sector savings-investmentsurplus in the form of financial savings which increased from 10.9% to 11.7%.

This financial savings (net of increase in financial liabilities) constitutes about 48% of thetotal savings of the household sector in 2007-08, the balance being physical savings. In 2004-05 construction accounted for about two-thirds of physical savings with the balance onethird

being accounted for by machinery and equipment. Since 2001-02 there has been an increasein the share of construction and a decline in the share of machinery and equipment.

Household financial savings financed about 50% of public investment and about 44% ofprivate investment in 2007-08. In 2007-08 about 60% of the household sector financial

savings financed private corporate investment as compared to only 19% in 2001-02.Therefore, there has been a significant increase in the flow of household savings for privateinvestment relative to public investment. This of course represents an almost stagnant publicsector investment at 7-9% of GDP as compared to a sharp jump in private sector investmentfrom 5.4% to 15.9% during the same period. Simultaneously, the public sector also movedfrom a negative 2% savings rate to a positive 4.5% over the period.

Composition of gross financial savings (Table 2)

Gross financial savings is before deducting the increase in financial liabilities. After severalyears of increase in Gross financial savings there was a small drop in 2007-08.

There is a sharp increase in the share of deposits in gross household saving from 37% in2004-05 to 55% in 2007-08. However, the sum of deposits and claims on government,including small savings, has remained almost constant at 60% till 2006-07. In 2007-08 whilethe share of deposits remained unchanged at 55% claims on government was a negative 4%.In addition there has been a decrease in the share of Provident and Pension funds from 13% to9%. Therefore, the recent sharp increase in the share of deposits may be partly attributed tothe decline in small savings and investments in government securities with recent declines ininterest rates and changes in the Government Savings Certificate Act in 2005. One importantchange restricts investments in small savings schemes only to individuals. In additionchanges in the Income Tax Act have lead to neutrality of tax concessions across savingsinstruments.

The share of life insurance funds remained steady at around 15% of gross household savingstill 2006-07 but increased to 17% in 2007-08.

Over the four year period 2004-05 to 2007-08 there has been an increase in the proportion ofshares and debentures in total financial savings from about 2% to 11%. By 2007-08 mutualfunds accounted for almost 75% of the investment in shares and debentures by households.The share of mutual funds in financial saving increased from 0.4% to 8%. Debt fundsaccount for more than 50% of the assets under management of mutual funds.There has been a sharp increase in changes in financial liabilities of the household sector.During the period 2003-04 to 2006-07 changes in financial liabilities of the household sectorhas increased from 2.5% to about 6.5% of GDP. As a percentage of gross financial savingschanges in financial liabilities has increased form 18% to 37%. However, in 2007-08 therewas a drop in changes in financial liabilities to 28% of gross financial savings.

5


6/54

2. Bank intermediation of financial savings

As of March 2007, Public Sector banks accounted for 70% of total assets of scheduled

commercial banks. State Bank of India and its subsidiaries alone accounted for 23% of totalassets of scheduled commercial banks. The share of foreign banks was 8%.

Deposits and Credit (Tables 3-6)

Growth in deposits, accompanied by an increase in the credit deposit ratio, resulted in a sharpincrease in bank credit from 24% of GDP in 2000-01 to 30% in 2003-04 and to 50% in 2007-08.

Deposits consistently account for about 80% of total bank liabilities. Aggregate depositsincreased from 46% of GDP in 2000-2001 to 54% in 2004-05 and then to 68% in 2007-08.Over the period 2001-02 to 2007-08 the share of the household sector in bank deposits

decreased from 67% to 59% of total bank deposits. Over the same period there has been acorresponding increase in the share of the government and corporate sectors. There has beena steady increase in the proportion of short term deposits (up to 2 years) from 52% of totaldeposits in March 2000 to 70% in March 2007. There has been a corresponding decrease inthe share of long term deposits (2-5 years) from 49% to 29%.

The credit deposit ratio increased from 0.56 in 2003-04 to 0.74 in 2007-08. The share ofLoans and advances in total assets of banks increased from 44% in 2003-04 to 57% in 2007-08. Simultaneously, the share of Investments in total assets decreased from 41% in 2003-04to 27% in 2007-08.

With the transformation of ICICI and IDBI into banks, lending by banks is no longer limited

to working capital finance but also includes medium and long term finance. The share ofmedium and long term credit to industry in total credit to industry increased from 26% inMarch 2000 to 54% in March 2007. An important part of the increase in medium and longterm loan came from increased credit to the infrastructure sector.

According to the RBI, a distinct feature of banks operations in the last 10 years has beenflexible adjustment of the investment portfolio in line with the changing credit demand. Ascredit demand slowed down in the second half of the 1990s, banks remained invested in SLRsecurities, even when SLR was brought down significantly. However, as credit demand

picked up, banks liquidated SLR investments. Liquidation of holdings and the expansion ofnet demand and time liabilities have brought down the holding of SLR securities very close tothe statutory limit of 25 per cent.

Policy changes4(Tables 7-8)

There have been several policy changes aimed at relaxing constraints faced by banks in theirlending and borrowing decisions.

Lending rates

4 This is based on RBI Report on Currency and Finance 2005-06 Section 4.39 to 4.42

6


7/54

Lending interest rates of commercial banks were deregulated in October 1994 and banks wererequired to announce their prime lending rates (PLRs). The Reserve Bank mooted theconcept of benchmark prime lending rate (BPLR) in 2003 to address the need fortransparency in banks lending rates as also to reduce the complexity involved in pricing ofloans. Banks now are free to prescribe respective BPLRs, as also lend at sub-BPLR rates.Banks are also permitted to offer floating rate loan products linked to a market benchmark ina transparent manner. Various restrictions on term loans by banks were gradually phased out

by 1997.

Cash Reserve Ratio (CRR)

The Cash Reserve Ratio (CRR) was reduced from its peak level of 15 per cent maintainedduring the period 1989 to 1992 to 4.5 per cent of Net Demand and Time Liabilities (NDTL)in June 2003. Although the Reserve Bank continues to pursue its medium-term objective ofreducing the CRR, in recent years, on a review of macroeconomic and monetary conditions,the CRR has been revised upwards in phases. The CRR after reaching a low of 4.5% in June2003 increased only marginally to 5% till October 2006 and then sharply to a peak of 9% by

August 2008. Since then it has decreased to 5.5% in December 2008. Over the same periodthe Reverse Repo Rate was reduced from 6% to 5.5% and the Repo Rate from 9% to 6.5%.

Statutory Liquidity Ratio (SLR)

In response to widening fiscal deficits beginning in the 1970s there were periodic increases inthe statutory liquidity ratio (SLR)5 to finance the rising fiscal gap. The SLR was raised in

phases reaching 34 per cent by the late 1970s. The process continued during the 1980s asfiscal deficits expanded further, and the SLRreached a high of 38.5 per cent of net demandand time liabilities (NDTL) of the banking system in September 1990. As a part of thefinancial sector reforms and in order to reduce financial repression, the required SLR wasreduced to the then statutory minimum of 25 per cent in 1997 and remained at that level since.

This has been reduced to 24% in view of the liquidity crunch in financial markets.

Although the initial reduction in the required SLR was expected to enable banks to expandcredit to the private sector, banks continued to make investments in Government securitiesmuch in excess of the statutory minimum stipulated requirements.

During this period, several factors contributed to the decline in demand for credit by thecorporate sector. The industrial sector witnessed massive expansion in capacity in certainsectors, especially cement and steel, in the initial phase of reforms. However, as thequantitative restrictions were removed and import tariffs reduced, the corporate sector facedintense competition during the latter part of the 1990s. The focus of the corporate sector, thus,shifted from expanding capacity to restructuring and the industrial sector slowed down

significantly. This affected the demand for credit by the corporate sector.

During 1997-02 downward stickiness of nominal interest rates on the one hand, and fallinginflation rate on the other, led to a significant rise in real interest rates. The average reallending rates of banks increased to 12.5 per cent during 1996-97 to 2001-02 as against 6.5 percent during 1990-91 to 1995-96. This also appeared to have contributed to slackness in creditexpansion.

5Under Section 18 of the Banking Regulation Act, 1949, all scheduled banks are required to maintain

SLR, i.e., a certain proportion of their demand and time liabilities (DTL) as on the last Friday of thesecond preceding fortnight as liquid assets (cash, gold valued at a price not exceeding the current

market price or unencumbered approved securities valued at a price as specified by the Reserve Bankfrom time to time). Following the amendment of the Act in January 2007, the floor rate of 25 per centfor SLR was removed.

7


8/54

The introduction of prudential norms relating to income recognition, asset classification andprovisioning in the mid-1990s revealed large gross NPAs with banks. Banks found risk-adjusted returns on government securities more attractive. Hence, despite lowering of SLR,

banks continued to invest in government securities, far in excess of the requirements.

By March 2004 investment in government securities by banks had increased to 44% ofdeposits and 41% of total assets. As already observed credit growth accelerated in 2002-03and increased sharply during 2004-05 to 2006-07.

Management of NPAs

There has been significant improvement in the asset quality of the banking sector in India inrecent years. Gross NPAs as percentage of gross advances steadily declined to 7.2 per cent inMarch 2004 from 15.7 per cent in March 1997. The corresponding decrease in Net NPAs wasfrom 8.1 to 2.8%. Gross and Net NPAs further declined to 3.3 and 1.2 percent respectively

by March 2007. The gap between the gross and net NPAs has also narrowed over the years.NPAs of the Indian banking system are now comparable with several advanced economies

and significantly lower than several economies in the Asian region. The decline in NPAs isparticularly significant as income recognition, asset classification and provisioning normswere also tightened over the years

Sectoral distribution of credit (Table 9-11)

In terms of the sectoral distribution of credit there is a steady decline in the share of industry,including SSI, from about 47% of total credit outstanding in 1999-2000 to 38% in 2006-07.The share of small and medium scale industry declined from about 8% to 4% during this

period.

There have been some changes in the share of specific industries in the overall bank credit to

industry. Among the industries with a decline in share the engineering industry experiencedthe largest decline from 10.5% of total outstanding credit to industry in 2001-02 to 6% in2007-08. The other industry to witness a significant decline was chemicals, whose sharedeclined from 11.3% to 7.4%. Infrastructure experienced the largest increase in share from10..6 % to 23.2% of total outstanding credit to industry. Within infrastructure, poweraccounted for about 50% of total bank credit to infrastructure. There were small increases alsoin the case of gems and jewellery (2.7% to 3.4%), construction (1.7% to 3.2%), andautomobiles (2% to 3.3%).

The share of agriculture has increased marginally over this period from 10% to 12%.

A significant development during the current decade has been the rapid expansion of credit to

the household sector in the form of housing and other retail loans. Until the early 1990s, therewere several restrictions for granting of personal loans and housing loans. All theseconditions/restrictions were gradually removed in the early 1990s and banks were givenfreedom to decide the quantum, rate of interest, margin requirement, repayment period andother related conditions.

The share of personal loans in total bank credit outstanding increased to 23% at end-March2008. Total housing loans accounted for about 12% of outstanding bank credit at March end2008. Housing loans meeting certain criteria were added to the priority sector list in 2007.

Priority Sector Lending (Table 12)

Soon after nationalization in 1972, banks were advised to extend credit to certain activities,known as the priority sectors. Major categories of priority sector credit include agriculture

8


9/54

and allied activities and small scale industries. The scope of the priority sector has beenexpanded over the years to include export activity, education, housing, software industry,venture capital, leasing and hire purchase.

Initially there were no specific targets fixed in respect of priority sector lending. In 1974,public sector banks were advised that their priority sector lending should reach a level of notless than one-third of the outstanding credit by March 1979. Subsequently, the target wasenhanced to 40 per cent of aggregate advances. In achieving this overall target, sub-targets forlending to agriculture sector and weaker sections were also stipulated for the banks. At

present banks are required to lend at least 18 per cent and 10 per cent, respectively, of theirNet Bank Credit to the agriculture sector and weaker sections of society, respectively.

The Public Sector Banks (PSBs), as a group, first achieved the priority sector lending target of40 per cent in 2000 and, as a group, continued to meet the target till 2007-08, missing it by0.4 per cent in March 2007. However, individual banks did not achieve the sub targets foragriculture and weaker sections.

At the end March 2008 the amount outstanding of the priority sector lending by public sectorbanks consisted mainly of loans to Agriculture (41%), Small Enterprises (24%) and Housing(24%).

3. Capital Markets

Capital raised through private placement, public issues, and Euro issues increased from 2.8%of GDP in 2003-04 to 6.8% in 2007-08. During this period private placement accounted forthe dominant share of 72% of total capital raised, with public issues of equity and debtaccounting for 21% and euro issues 7%. Equity issues accounted for about 93% of total

public issues. Public issue of debentures appears to have been completely replaced by private

placement of debt. (Table 13)

Private Placement6 (Table 14)

Under Section 81 of the Companies Act, 1956, a private placement is defined as an issue ofshares or of convertible securities by a company to a select group of persons. An offer ofsecurities to more than 50 persons is deemed to be a public issue under the Act. Private

placement involves issue of securities, debt or equity, to selected subscribers, such as banks,FIs, MFs and high net worth individuals. It is arranged through a merchant/ investment

banker, who acts as an agent of the issuer and brings together the issuer and the investors.Since these securities are allotted to a few sophisticated and experienced investors, thestringent public disclosure regulations and registration requirements are relaxed.

Corporates access the private placement market because of certain inherent advantages.Private placement is a cost and time-effective method of raising funds and can be structuredto meet the needs of the entrepreneurs. It does not require detailed compliance of formalitiesas required in public or rights issues.

The private placement market in India, which shot into prominence in the early 1990s, hasgrown sharply in recent years. The private placement market was initially not regulated.Given the high rate of growth of this market, in May 2004 SEBI prescribed that the listing ofall debt securities, irrespective of the mode of issuance, i.e., whether issued on a private

placement basis or through public/rights issue, shall be done through a separate listing

6 Box VII.2, Private Placement Market in India, Report on Currency and Finance

9


10/54

agreement. The Reserve Bank also issued guidelines to the financial intermediaries under itspurview on investments in non-SLR securities including, private placement. Boards of bankswere advised to lay down policy and prudential limits on investments in bonds anddebentures, including cap on unrated issues and on a private placement basis.

The private placement market is dominated by Financial Institutions which account for almosttwo-thirds of total private placement. The share of private non financial companies stands at20%.

Most of the resources from the market are raised by way of debt, with a majority of issuescarrying AAA or AA rating. Though, there were some instances of private placements ofequity shares, there is no comprehensive data coverage of this. The two sources ofinformation regarding private placement market in India are Prime Database and RBI. Theformer data set, however, pertains exclusively to debt issues. RBI data, which is compliedfrom information gathered from arrangers, covers equity private placements also. RBIestimates the share of equity in total private placements as rather insignificant. Some idea,however, can be derived from the equity shares issued by NSE-listed companies on private

placement basis. During 2006-07 a total of 207 companies privately placed equitiesmobilizing around Rs.12,216 crores. .

According to NSE the maturity profile of issues in the private placement market rangedbetween 12 months to 240 months during 2006-07. The largest number of placements was for36 months (94 placements) and 120 months (79 placements). A total of 58 offers had putoption, while 105 offers had call option. Unlike public issues of bonds, it is not mandatoryfor corporates issuing bonds in the private placement market to obtain and disclose creditrating from an approved credit rating agency. Rating is however required for listing.

Equity markets (Table 15, 16, 17)

Stock prices have increased sharply since 2002-03 with the Sensex increasing from about3,000 in 2002-03 to 13,000 in 2006-07. This caused market capitalization to increase from48% of GDP in 2002-03 to 86% in 2006-07. However, turnover, as a % of capitalization,decreased from 150% to about 80% during the same period. During this period the priceearnings ratio of the BSE Sensex increased from 14.5 in 2002-03 to about 17 in 2005-06.Therefore, most of the increase in prices during this period can be attributed to increases inearnings rather than increases in the P-E ratio. However, there was a sharp jump in the P-Eratio in 2006-07 to about 21. Simultaneously, the P-BV ratio increased steadily during this

period from 2.23 in 2002-03 to 4.9 in 2006-07.

The year 2007-08 saw the BSE Sensex increase from about 13,000 in April 2007 to over20,000 in December 2007. However, by the end of the year the Sensex had fallen to 15,000.

There were significant amounts of equity issues coinciding with the boom in the stockmarkets. This peaked in 2007-08 with equity issues crossing Rs.80,000 crores almost equal tothe total amount raised in the previous three years.

As noted in the Economic Survey of 2006-07, stock market trading is dominated by retailinvestors. On the NSE the average trade size since 2001-02 had been in the range of Rs.25,000-30,000 showing the dominance of retail investors.

There has been an improvement in the depth of the stock market over the period 2003-04 to2007-08. In 2002-03 the top 10 securities accounted for about 50-55% of turnover on both themajor stock exchanges. By 2007-08 this proportion had come down to 25-30%. As of end-December, 2006, the market concentration of Indian equity market was comparable to thoseof other Asian countries.

10


11/54

The volatility of the India stock market continues to be on the higher side relative to otherdeveloped and developing country markets.

Mutual funds (Table 18)

There has been a significant increase in the assets under management of mutual funds from5.1% of GDP in 2004 to 10.7%% in 2008.

Income/Debt oriented schemes account for about 60% of total asset under management at theend of March 2008 with equity schemes accounting for the balance 40%. The highest growthhas been in Assets under management (AUM) in debt schemes. In 2008 AUM under debtschemes alone accounted for 43% of total AUM.The share of AUM in equity schemes accounts for about 4% of total market capitalization atthe end of March 2008.

Government securities (Table 19)

The government securities market serves as the backbone of fixed income markets throughthe creation of risk-free benchmarks of a sovereign borrower.

Outstanding securities of the central and state government has varied between 33% to 37% ofGDP during 2002-03 to 2006-07. For the central government the share of market borrowingsin financing the Gross Fiscal Deficit (GFD) increased from 62% in 2000-2001 to 80% in2006-07. The corresponding increase for state governments was from 14% to 17%. In recentyears, the securities issued to the National Small Savings Fund (NSSF) have emerged as thedominant source of financing the GFD of the State Governments. Set up in 1999, the NSSFinvests in special securities of the Central and State Governments. These securities have a

25-year tenor with an initial five-year moratorium on repayment. In 2007-08 there was asignificant decline in the securities issued to the NSSF. As a result market borrowingsfinanced about 60% of the Gross Fiscal deficit.

Banks are the largest investors in government securities. The holding of governmentsecurities by commercial banks has been driven by interest rate changes, apart from the SLRrequirement. As part of the financial reforms, the SLR requirement for banks was graduallyreduced to 25 per cent by October 1997 from the peak of 38.5 per cent in February 1992.Banks, however, maintained an average SLR of 37.3 per cent of net demand and timeliabilities during the period 1998-99 to 2002-03. In recent years, however, banks restrictedincremental investment and liquidated excess investment in government securities on accountof increase in credit demand. Thus, SLR securities held by commercial banks are now very

close to the prescribed limit of 25 per cent.

The second largest category of investors in the government securities market is the insurancecompanies. According to the stipulations of the Insurance Regulation and DevelopmentAuthority of India (IRDA), all companies carrying out the business of life insurance shouldinvest a minimum of 25 per cent of their controlled funds in government securities. Similarly,companies carrying on general insurance business are required to invest 30 per cent of theirtotal assets in government securities and other guaranteed securities, of which not less than 20

per cent should be in Central Government securities. For pension and general annuitybusiness, the IRDA stipulates that 20 per cent of their assets should be invested ingovernment securities.

The non-Government provident funds, superannuation funds and gratuity funds are requiredby the Central Government to invest 40 per cent of their incremental accretions in Central and

11


12/54

State government securities and/or units of gilt funds regulated by the Securities andExchange Board of India (SEBI) and any other negotiable securities fully and unconditionallyguaranteed by the Central/State Governments. The exposure of a trust to any individual giltfund, however, should not exceed five per cent of its total portfolio at any point of time.

Non-banking financial companies (NBFCs) accepting public deposits are required to maintain15 per cent of such outstanding deposits in liquid assets, of which not less than 10 per centshould be maintained in approved securities, including government securities and governmentguaranteed bonds.

The share of banks in outstanding security of central and state government has declined fromabout 60% in 2002 to 47% in 2007. Over the same period the share of LIC has increased from20 to 23%. Government securities consistently account for almost 80% of LIC investments.The share of others in the holding of government securities has increased from 8.6% to17%.7

At present, FIIs registered with SEBI are permitted to invest in Government Securities and

corporate bonds up to USD 3.2 billion and USD 1.5 billion, respectively. These limits haverecently been increased to USD 5 billion and USD 3 billion.

Trading in government securities

According to the Report on Currency and Finance 2006-07 the trading pattern of governmentsecurities indicates that most of the trading activity takes place in Central Governmentsecurities. The share of State Governments securities in annual turnover of the governmentsecurities market was about 3% in 2004-05 while their share in outstanding governmentsecurities was around 16 per cent.

The number of actively traded securities is very low as compared with the total number of

outstanding securities. As at end-December 2006, there were 102 Central Governmentsecurities with an outstanding amount of Rs.10,55,703 crore. Of these, 46 securities withoutstanding issues of Rs.10,000 crore or more accounted for 77 per cent of the totaloutstanding amount. The turnover to total outstanding ratio dipped sharply to 1.1 in 2005-06from more than 3 in 2003-04. On a daily basis, hardly 10-12 securities are traded, of whichthe actively traded securities are 4-5.

The turnover in the secondary market for government securities manifested asymmetricresponse to the interest rate cycle, i.e. the market turned liquid and active during downwardmovement in interest rates but turned inactive when interest rates rise. As a result, theturnover as percentage of GDP which had increased sharply between 2001-02 and 2004-05,when interest rates softened, declined sharply thereafter when interest rates hardened

Without active trades in the markets, the yield curve is kinked, thereby making it difficult toprice securities. This also leads to a situation where securities of similar maturity profilestrade at different yields, with sizeable illiquidity premiums on some occasions.

Corporate Bond markets

The size of the Indian corporate debt market is very small in comparison with not onlydeveloped markets, but also some of the emerging market economies in Asia such asMalaysia, Thailand and China. In view of the dominance of the private placement segment,

7 Others category includes subscription made by the rest of the economy including, viz., All India andsome State level financial institutions/corporations plantation provident funds and refinancing

12


13/54

most of the corporate debt issues in India do not find a way into the secondary market.Liquidity is also constrained on account of small size of issues. For instance, the average sizeof issue of privately placed bonds in 2005-06 worked out to around Rs.90 crore, less than halfof an average size of an equity issue. Out of nearly 1,000 bond issues in the private placementmarket, only around 3 per cent of the issues were of the size of more than Rs.500 crore. Somecompanies entered the market more than 100 times in a single year to raise funds throughsmall tranches. As a result, the secondary market for corporate debt is characterized by poorliquidity and trading is confined largely to the top 5 or 10 bond papers.

Among various reforms needed for promoting the secondary market trading in corporatebonds, perhaps the most important factor is the existence of a reliable and liquid benchmarkgovernment securities yield curve. Even though the government securities market has seen arange of reforms in both the primary and secondary segments and a surge in issuances as welltrading volumes, a stable and smooth sovereign yield curve, especially at the longer end ofmaturity is yet to emerge in India. If the yield curve derived from benchmark issues is to bereflective of an efficient risk free rate of return, there has to be sufficient liquidity in thegovernment securities market.

In general it has been difficult to develop the corporate bond market in most countries.Almost half the world's corporate bond market is in the US, and another 15 per cent in Japan.Among other countries, while the UK has a long standing bond market, the European bondmarket has only began to really develop after European monetary integration and introductionof the Euro. Among developing countries, it is perhaps only South Korea that has areasonably well developed bond market.

US Corporate Bond Markets8

The experience of the US bond market indicates some of the issues involved in thedevelopment of bond markets in other countries. The primary market for U.S. corporate

bonds is large. Outstanding principal in corporate bonds is larger than either U.S. Treasuryobligations or municipal bond obligations, though not quite as large as mortgage related

bonds.

During the early decades of the twentieth century, corporate bonds were predominantly tradedon the New York Stock Exchanges transparent limit order market. However, corporate bondtrading largely migrated away from the New York Stock Exchange to a dealer-oriented over-the-counter market during the 1940s. This migration coincided with the growth in bondtrading on the part of institutional investors.

The dealer market for corporate bonds is dominated by large institutional investors. Whileover-the-counter corporate bond trades tend to be large, they also tend to be infrequent.

Corporate bonds trade infrequently even compared to other bonds. The lower tradingfrequency of corporate bonds may reflect their relatively large trading costs, which in turncould be attributable to greater information asymmetries regarding underlying value forcorporate bonds compared to government bonds. Bonds issued by a given corporation atdifferent points in time are distinct contracts that differ in terms of promised payments andlegal priority in case of default, and are traded separately. Corporate bonds are also a favoredinvestment for insurance companies and pension funds from the asset-liability management

perspective. Correspondingly, most or all of a bond issue is often absorbed into stable buy-and-hold portfolios soon after issue.

In 2001 the Securities and Exchange Commission initiated post-trade transparency in thecorporate bond market when it approved rules requiring the National Association of Security

8 Transparency and the Corporate Bond Market"Journal of Economic Perspectives. (Forthcoming)

13


14/54

Dealers to compile data on all over-the-counter transactions in publicly issued corporatebonds for public dissemination. By 2006, trades in all publicly-issued bonds weredisseminated to the public. In addition, the timeliness with which dealers were required toreport trades was tightened in stages.

Overall, the statistical and anecdotal evidence indicates that the introduction of post-tradetransparency in the corporate bond markets has significantly reduced the costs that investors

pay to dealer firms for executing their trades in corporate bonds. However, the debateregarding optimal transparency of the corporate bond markets continues. Since corporate

bonds trade less frequently and in larger sizes as compared to equities, the optimal degree oftransparency for bond markets may differ from that of the highly transparent equity markets.

Securitization9(Table 20)

The growth of the corporate bond market in several countries, including the US and Korea,was spurred by increased availability of structured financial products such as mortgage andasset-backed securities. In a pure corporate debt market, only large companies can access the

market. The availability of structured products provides an alternative way of addressing afundamental limitation of the corporate bond market, namely the gap between the creditquality of bonds that investors would like to hold and the actual credit quality of potential

borrowers.

Securitization as a means of raising finance or transferring credit risk has existed in Indiasince the early 1990s. Initially, it consisted primarily of quasi-securitizations or DirectAssignments (DA). Portfolios or individual loans simply moved from the balance sheet ofthe originator to the investor, without any type of tradable security being created. Over time,the market has moved to more formal securitization involving special purpose vehicles (SPV).The individual loan(s) are assigned to an SPV (normally a trust) which issues tradablesecurities in the form of Pass-Through Certificates (PTC) to investors.

According to ICRA estimates, issuance volume in the Indian structured finance market grewat a CAGR of 43% between FY 2004-2008 and by 59% in FY2008. Size

Traditionally Asset Backed Securities (ABS), which covers cars and utility vehicles,commercial vehicles, construction equipment, two-wheelers, and personal loans, has been thedominant product. However, the share of ABS, declined from 64% in FY2007 to 45% inFY2008.

During FY2008, almost two-thirds of the ABS issuances were originated by NBFCs and thebalance by banks. The ABS market continues to be driven by a small number of issuers withthe top five Originators accounting for 90% of the issuances in FY 2008.

Loan Sell-Off (LSO), or securitization of single corporate loans, was the largest product classduring FY2008, accounting for 54% of the total issuance volumes. In a LSO the Originator(most often a private sector or foreign bank or NBFC) securitizes the receivables from asingle corporate loan (typically a loan to a home finance company or NBFC or a mid-sizedcorporate). Often the loan is originated with the specific intention of securitizing it.

Regulatory factors like priority sector lending (PSL) guidelines for banks are importantdrivers of securitization transactions. Towards the fiscal year-end, banks falling short of thetarget for priority sector loan assets seek to acquire qualifying loan portfoliosloans to SmallRoad Transport Operators, various other Small and Medium Enterprises (SMEs), and loans tofarmers being among themfrom other lenders. Such portfolios are normally sourced from

9 Indian Structured Finance MarketFY2008, ICRA

14


15/54

non-banking finance companies (NBFCs) since the PSL guidelines do not apply to thissegment.

These transactions are usually structured as Direct Assignment, as against securitizationinvolving an SPV. The broad structure of such transactionsincluding bankruptcyremoteness, limited recourse to Originator, performance of servicing function by theOriginator, and permissible commingling of pool collections with the Servicers own fundsis similar to that of regular ABS transactions, except for the absence of the issuance of anyinstruments like PTCs. The pool receivables in such cases are assigned directly to theassignee or purchaser. These are accounted for by the purchaser, typically a bank, in itsadvances book (unlike PTCs, which form a part of the banks investments portfolio).

The choice of the route, direct assignment or securitization, depends largely on investorpreference. For instance, mutual funds can invest only in PTCs. However, banks often preferto acquire loan portfolios outright, as PTCsby virtue of being investmentswould need to

be marked to market, and loans and advances do not have such requirement. Also, the RBIguidelines (on securitization) do not extend to such bilateral direct assignments.

The share of Residential Mortgage-Backed Securities (RMBS) declined further to a negligiblelevel of less than 1% in FY2008. While MBS has large potentialgiven the significantexpansion of the underlying housing finance businessthe long tenure of RMBS paper, thelack of secondary market liquidity, tenure uncertainty, and interest rate risk continue to hindergrowth of this segment. Regulatory requirementscertain category of home loans qualify as

priority sector lendingprovide the motive for trading in home loans too.

The Securities Contracts (Regulation) Amendment Bill 2007 passed by the Parliament in May2007 paves the way for the creation of a legal framework for the listing and trading of PassThrough Certificates (PTC). Once made operational, this law will enable secondary marketliquidity for securitized debt instruments. The next step will be finalization of listing

guidelines for the stock exchanges from the Securities & Exchange Board of India (SEBI), themarket regulator. SEBI had put out draft guidelines for comments and is eliciting feedback.

SEBI has suggested to the Government on the need for rationalization of stamp duty with aview to developing the corporate debt and securitization markets in the country. Further, theFinance Minister in his Budget speech of 2008-09 stated that though stock exchanges providenational electronic trading platforms for securities there is no seamless national market forsecurities because of differences among States on the scope and applicability of rates of stampduty and proposed to request the Empowered Committee of State Finance Ministers to workwith the Central Government to create a truly pan Indian market for securities that willexpand the market base and enhance the revenues of the State Governments.

External capital flow and Foreign Exchange markets (Tables 21-23)

Over the period 2003-04 to 2007-08 capital inflows in the form of direct investment, portfolioinvestment and commercial borrowings increased from 13% to 37% of GDP. Thecorresponding capital outflows increased from 10% to 27%. Overall, net capital flow,inclusive of other items, increased from about 3% to 9% of GDP.

Simultaneously, the current account balance turned from a surplus of 2.3% of GDP to adeficit of 1.5%. The modest current account deficit, in spite of an increase in trade deficitfrom 2.3% to 7.7% of GDP, was made possible by an increase in invisibles from 4.6% to6.2% of GDP. The two major components of invisibles are software exports and privateremittances.

15


16/54

The surge in capital flows relative to the modest current account deficit resulted in an excesssupply condition in the foreign exchange market. Large scale purchases of dollars by theReserve Bank in the foreign exchange market absorbed the strong upward pressure on theexchange rate. As a result, foreign exchange reserves more than trebled during the periodfrom US $ 54.1 billion at end-March 2002 to US $ 310 billion at end-March 2008. TheReserve Bank simultaneously resorted to sterilisation operations to absorb liquidity. Facedwith the finite stock of Government of India securities with the Reserve Bank, marketStabilisation scheme (MSS) was introduced in April 2004 wherein the Government of Indiadated securities/Treasury Bills were issued to absorb liquidity.

External Commercial Borrowing Policy

The government maintains restrictions on the overall external commercial borrowings. Aprospective borrower can access ECB under two routes, namely the automatic route and theapproval route. A corporate, other than a financial intermediary, registered under theCompanies Ac, 1956, can access ECB under the automatic route up to US$ 500 million in afinancial year for investment (deployment of resources on import of capital goods, new

projects, modernization / expansion of existing production units) in real sector (industrialsector including small and medium enterprises and infrastructure sector). The ECB, which isnot covered by the automatic route, is considered under the approval route on a case-by-case

basis by RBI. This includes ECB by a financial intermediary, ECB beyond US$ 500 millionin a financial year, and ECB for purposes other than investment in real sector are consideredunder the approval route.

The External Commercial Borrowing (ECB) policy is regularly reviewed by the Governmentin consultation with Reserve Bank of India (RBI) to keep it in tune with the evolvingmacroeconomic situation, changing market conditions, sectoral requirements, the externalsector and lessons of experience.

Overall assessment of markets

The Raghuram Rajan Committee10 provides an assessment of the efficiency of Indian capitalmarkets.

A major prerequisite for market efficiency is liquidity - the ability to trade with lowtransactions costs. It has three dimensions: immediacy, depth and resilience. Immediacy is theability to execute trades of small size immediately without moving prices adversely. Depthrefers to the impact cost of executing large trades. Resilience is the speed with which pricesand liquidity of the market revert back to normal conditions after a large trade has taken

place.

The Table summarises the state of Indian financial markets on the three aspects of financialmarket liquidity. In the view of the Committee, resilience is found in large stocks, their stockfutures and the index futures. All other markets in India lack resilience. Depth is found, inaddition, with on-the-run government bonds and interest rate swaps. Immediacy is found in afew more markets. A well functioning market is one which has all three elements. India hasonly one market where this has been achieved, for roughly the top 200 stocks, theirderivatives and index derivatives.

Liquidity of Indian financial markets: Market Immediacy, Depth and Resilience

10

A Hundred Small Steps : Report of the Committee on Financial Sector Reforms, Government ofIndia, Planning Commission, New Delhi, 2009

16


17/54

Market Immediacy Depth Resilience

Stocks

Large cap stocks/futures and index futures Y Y Y

Other stocks

Bonds and money market

On the run government bonds Y YOther government bonds

Corporate bonds

Commercial paper and other money marketinstruments

Currency Y

Derivatives

Near money options on index and liquid stocks Y

Other stock options

Interest rate swaps Y Y

Metals, energies and select agricultural commodityfutures

Y

Other commodity futures

4. Corporate Finance and Governance

The recent period of high growth has been accompanied by significant changes in firmfinancing patterns. Overall there has been an increase in the share of external sources. Theshares of all major sources of external financing have increased with the exception of tradecredit.

Corporate finance (Table 24-26)

Based on the Sources and Uses of Funds Statement of non-Government non-financial largepublic limited companies (each with paid-up capital of Rs.1 crore and above) the share ofinternal sources continues to have increased steadily during the decade of the nineties andearly 2000s. However, there is an increase in the share of external sources from about 50%in 2003-04 to a peak of 62% in 2006-07 and a small decline in 2007-08, perhaps as a result ofthe financial crisis. The biggest increase is in the share of equity from 4% to 16% over the

period 2003-04 to 2007-08. Borrowing increased from 19% to a peak of 31% in 2006-07mainly because of an increase in the share of Foreign Institutional Agencies from almost 0%to 8.6% in 2006-07 and then declining to 4.4% in 2007-08. The share of banks afterincreasing from 17.5% in 2003-04 to 24.3% in 2005-06 declined to 19.5% in 2007-08. Witheasier access to external capital companies reduced their reliance on trade credit. The share

of trade credit decreased sharply from 26.8% in 2003-04 to 13.6% in 2005-06 and thenincreased to around 18% in 2007-08.

These trends are also noticed in the aggregate data for various sources of financing.Beginning in 2004-05 there is a steady increase in bank financing, private placement,domestic equity issues, external commercial borrowing and foreign direct investment (FDI).The role of external capital appears to be quite important in terms of providing not only

borrowings but also scarce equity. It is likely that the increase in the share of equity wasdriven mainly by the FDI.

During 2008-09, so far, flow of resources to the commercial sector declined reflectingsubdued conditions in the domestic capital markets as well as deceleration of funds flow from

external sources. Among the domestic sources, barring private placement and credit byhousing companies, flow of resources from other sources have declined. Among the foreign

17


18/54

sources, barring foreign direct investment, flow of resources from all other sources hasdeclined.

Ownership concentration and financing of industry (Tables 27)

The share of Indian promoters in the total shareholding pattern remained unchanged at 45-50%. The share of foreign promoters increased only marginally from 5.6% in December 2002to 7% in March 2008. However, the share of FIIs more than doubled from 4.6% to 11%. Theshare of non institutional Indian investors declined marginally from 17% to 13%.

There is an intense ongoing discussion on the implications of concentrated ownership onfinancial development in general and financial markets in particular. Concentratedownership, and the associated control of management, creates the potential for agency

problems between the controlling shareholder and minority shareholders. Minorityshareholders face the risk of expropriation by the controlling shareholders, especially in theabsence of well enforced legal protection. This prevents the development of equity marketsand possibly bond markets as sources of external financing.

According to a study by LLSV (1999)11 concentrated ownership is the norm in countries otherthan the UK and USA. LLSV examine the ownership structures of the 20 largest publiclytraded firms in each of the 27 generally richest economies using data for 1995. The firms areclassified into those that are widely heldand those with ultimate owners. A corporation has acontrolling shareholder (ultimate owner) if this shareholders direct and indirect voting rightsin the firm exceed 20 percent. They identify 5 categories of ultimate owners: (1) a family oran individual, (2) the State, (3) a widely held financial institution such as a bank or aninsurance company, (4) a widely held corporation, or (5) miscellaneous, such as acooperative, a voting trust, or a group with no single controlling investor.

They find that 36 percent of the firms in the world are widely held, 30 percent are family-

controlled, 18 percent are State-controlled, and the remaining 15 percent are divided betweenthe residual categories. In an average country, the ultimate family owners control, on average,25 percent of the value of the top 20 firms. For the universe as a whole at least 69 percent ofthe time, families that control firms also participate in management. Overall, the controllingshareholder does not have another large shareholder in the same firm in 75 percent of thecases, and this number is 71 percent for family controlling shareholders.

The potential for agency problems between ultimate owners and minority shareholders willdepend upon the extent to which the cash flow ownership rights of the controllingshareholders are substantially below their voting rights. Ultimate owners can reduce theirownership below their control rights by using shares with superior voting rights; byorganizing the ownership structure of the firm in a pyramid; or through cross-shareholdings.

According to the study, relative to shares with differential voting rights and cross-holdings,pyramidal ownership appears to be a more important mechanism used by controllingshareholders to separate their cash flow ownership in sample firms from their control rights.26 percent of firms that have ultimate owners are controlled through pyramids.

Similar observations have been made for East Asia by Claessens (2002) 12 on the basis of astudy of 1,301 publicly traded corporations from eight East Asian economies: Hong Kong,Indonesia, South Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand. Onlyfour percent of corporations do not have a single controlling shareholder at the 10 percent

11Corporate Ownership Around the World, Rafael La Porta, Florencio Lopez-De-Silanes, Andrei

Shleifer, The Journal of Finance 1999 54:2 471

12Disentangling the Incentive and Entrenchment Effects of Large Shareholdings, Stijn Claessens,

Simeon Djankov, Joseph P. H Fan, Larry H. P Lang, The Journal of Finance 2002 57:6 2741

18


19/54

cutoff level of control rights. At the 20 percent cutoff level, 18 percent of corporations arewidely held. Families are the largest shareholders, covering more than two-thirds ofcorporations at the 10 percent cutoff level and three-fifths at the 20 percent level.

Indian business groups13(Tables 28)

Moodys and ICRA have examined corporate governance in 32 companies in 16 prominentfamily-controlled Indian business groups. These companies cover a broad cross-section ofIndian industry, and include 13 Sensex companies accounting for about 40% of the totalSensex market capitalization. Banks are excluded from the survey. Unlike in some othercountries, and following the nationalization of the Indian banking sector in 1969, the bankingsector is generally not family-controlled. Few private sector banks are linked to industrialgroups; and the Reserve Bank of India applies strict controls to the sector, including loans torelated parties.

According to the survey, many families exert control with less than 50% shareholding,whereas others own more than 74%. Promoter shareholdings in the study ranged between 26-

90%, with a median of 50%. This situation may reflect each familys assessment of the levelof shareholding it requires to maintain control - taking into account factors such as the overallgroup shareholding pattern, and rules regarding foreign investment in that sector. Althoughthe Indian business environment does not support hostile M&A, a number of families haverecently increased their shareholdings, possibly as a pre-emptive defense against possiblefuture hostile action.

Many Indian family-controlled groups have complex corporate structures. In such cases, anddespite regulatory requirements to disclose promoter shareholding, it can be difficult to assessownership and control on the basis of public information. Pyramid structures where controlof substantial operating companies can be achieved through ownership of 51% of a chain ofholding companies are not commonly observed in India. In addition, companies have

generally not issued different classes of shares with differential voting rights. The lack ofpyramid structures and different classes of shares in India may be more reflective of the factthat families can maintain control without having to resort to such measures. This is possiblydue to Indias business culture which lacks activist shareholders and does not permit hostileM&A activity, plus the blocking rights available to a 26% shareholder.

SEBI requires listed companies to provide consolidated group accounts. However, this oftendoes not result in consolidation of entities which are controlled. Also, the holding companiesthrough which families exercise control are generally not listed, and it may be difficult toobtain material public information on these entities. The Securities and Exchange Board ofIndia (SEBI), has introduced regulations set out in Clause 49 - for listed companies,covering board composition and functions of the audit committee. Although there are a

number of reports of incomplete compliance, these have generally had a positive impact.0

Clause 49 requires that all related-party transactions must be considered by the companysaudit committee, and should also be disclosed in the annual report. However, the adequacy ofdisclosure on such transactions, particularly for family businesses, is an important governanceconcern in India. It can be difficult to truly know the level of promoter/family control, partlydue to the complex group structures. This makes the extent of related-party transactionsdifficult to evaluate. A material difference between IFRS and Indian GAAP is the non-inclusion as a related party of entities in which either key management personnel or

promoters exercise significant control or voting power.

13Corporate Governance and Related Credit Issues for Indian Family-Controlled Companies, October

2007, Special Comment, Moodys-ICRA Corporate Finance

19


20/54

Tunneling by Indian business groups

There are two studies which investigate the occurrence of tunneling in Indian businessgroups. In a business group, a single shareholder (or a family) completely controls severalindependently traded firms and yet has significant cash flow rights in only a few of them.This discrepancy in cash flow rights between the different firms under control creates strongincentives to expropriate. The controlling shareholder will want to transfer, or tunnel,profitsacross firms, moving them from firms with low cash flow rights to firms with high cash flowrights.

Bertrand, Mehta and Mullainathan (BMM 2002)14 devise a test to measure the changes inprofits of group firms (the response) relative to changes in the profitability of other firms inthe same industry (the industry shock). They find that the profitability of group firms onaverage underresponds and this is larger in low cash-flow-right firms. When this analysis isconducted separately for operating and non operating profits they find that it is theunderresponse to non operating profits that drives the results. Group firms operating profitsare, in fact, more sensitive to their own industry shock. From this they conclude that profits

are tunneled from low cash flow rights firms by manipulating the non operating profitcomponent of total profits. A related implication is that transfer pricing, which would affectoperating profits, is not an important source of tunneling in India.

Gopalan, Nanda and Seru (2007)15carry out a more direct test of tunneling by examining thecharacteristics of intra-group loans, often cited as a mechanism for tunneling. In their samplethey find that group loan inflows are large and, on average, constitute 59% of operating

profits in the year a firm receives loans. The main providers of group loans are firms that arelarger, more profitable, and have more tangible assets. External borrowing is the dominantsource of financing for intra-group loans.

Their evidence indicates that groups extend loans to financially weaker firms and

significantly increase the extent of loans when member firms are hit with a negative earningsshock. There is little evidence for group loans being a means of financing investmentopportunities. In fact, recipients of group loans significantly under-perform, in terms of bothstock returns and operating performance, after receiving group loans. There is little evidencein favor of tunneling either. There is, for instance, no increase in group loan outflows fromlow insider ownership firms that experience a positive earnings shock, which would beexpected to occur if group loans were being used to tunnel cash.

The loans are also made on terms more favorable than those of comparable market loans,consistent with the loans being used to provide subsidized support. On average, firms receivegroup loans at 10% below the corresponding market borrowing rate. Further, a large

proportion of loans (>80%) have no stipulated interest payment at all.

They hypothesize that groups may provide support if they are concerned about revealingnegative information about the group, especially to external capital providers. Such negativeinformation may make it difficult for other firms in the group to raise subsequent externalcapital, further damaging the group's investment prospects and the solvency of the remainingfirms.

14 Ferreting Out Tunneling: An Application to Indian Business Groups , Marianne Bertrand, Paras

Mehta, Sendhil Mullainathan, The Quarterly Journal of Economics, Vol. 117, No. 1 (Feb., 2002), pp.121-148

15

Radhakrishnan Gopalan, Vikram Nanda, Amit Seru, Affiliated firms and financial support: Evidencefrom Indian business groups, Journal of Financial Economics volume 86, Issue 3, , December 2007,Pages 759-795.

20
http://www.sciencedirect.com/science?_ob=MathURL&_method=retrieve&_udi=B6VBX-4P5R63J-1&_mathId=mml190&_user=1007252&_cdi=5938&_rdoc=1&_ArticleListID=745120843&_acct=C000050223&_version=1&_userid=1007252&md5=0da6eee968d40cf91c29c50f2af29a2fhttp://www.jstor.org/stable/2696484http://www.jstor.org/stable/2696484http://www.jstor.org/action/showPublication?journalCode=quarjeconhttp://www.jstor.org/action/showPublication?journalCode=quarjeconhttp://www.sciencedirect.com/science?_ob=MathURL&_method=retrieve&_udi=B6VBX-4P5R63J-1&_mathId=mml190&_user=1007252&_cdi=5938&_rdoc=1&_ArticleListID=745120843&_acct=C000050223&_version=1&_userid=1007252&md5=0da6eee968d40cf91c29c50f2af29a2fhttp://www.jstor.org/stable/2696484


21/54

Their evidence, therefore, does not support the tunneling hypothesis. However, it raisesquestions about the efficiency of the internal capital market. Support of group firms indistress may represent an inefficient allocation of capital if distress represents long termunderperformance.

Corporate Governance practices of Indian companies

Two recent surveys by Bain Consulting and KPMG provide some information on thecorporate governance practices of Indian companies. The main conclusion of both thesereports is that while companies appear to be meeting the formal regulatory requirements theactual implementation is far from satisfactory.

Is your board working?, Bain Brief

Bain's Corporate Governance in India in 2009 survey16 was conducted in association withInternational Market Assessment (IMA) India and included more than 100 interviews withdirectors on the boards of 44 prominent Indian companies, across industries. Regulators,

commentators, analysts and company secretaries were also interviewed. The major findingsof the study are outlined below.

Contributions to strategy: Indian board members make only informal contributions tostrategy-most are in fact, never asked to formally take part in developing corporate strategy.Many board members also raised the concern that they were ill-equipped to commenteffectively on strategy: about 45 percent of the respondents felt they did not understand thestrategic issues facing their company.

Succession planningMore than 75 percent of the survey respondents reported that their boarddid not discuss CEO succession planning at all.

Appointment of independent directors In a majority of the boards surveyed, board membersdid not play an active role in bringing the right leadership and talent on the board byappointing independent directors. According to a survey respondent: "It is the promoter(founder) of the company who does the head-hunting for independent directors." Very fewIndian companies use a nominations committee to select new independent directors. Instead,in a few instances there is anecdotal evidence that independent directors were actually friendsor family members; in one case, the lawyer to the family of the promoter was listed as anindependent director.

Evaluation-of the corporate leadership and the board : Indian boards do not focus enough onevaluation-of the corporate leadership's or their own. Board members are involved in CEOevaluation and compensation in just about 20 percent of the companies surveyed, and theinvolvement is lower in promoter-led companies.

Risk management : Indian companies try to maintain high standards, but the stress is oncompliance with rules, rather than a committed approach to unearthing weaknesses.

Financial expertise of audit committee members : This was far from satisfactory. On thebasis of a random sample of audit committees from the survey pool, the average expertisescore was just 2.9 on a scale of 1 (limited expertise) to 5 (expert), and the highest averagescore was just 3.7.

16Is your board working?, Bain Brief 05/07/09, by Vivek Gambhir, Ashish Singh and Karan Singh

21


22/54

Rights of different types of shareholders : Indian boards lacked clarity on the rights ofdifferent types of shareholders and were resistant to wider representation on the board. Onerespondent dismissed private equity investors for "their short-term orientation," another foundfinancial-institution nominees to the board "unproductive and to be tolerated." Manyrespondents rejected the right of minority shareholders being represented on the board.According to one respondent, "There is no such thing as minority shareholder interest, onlyshareholder interest."

Decision making process : In many Indian boards, members contribute to decision makingonly informally. Repeatedly, survey respondents showed a lack of clarity on the role of boardmembers and in most companies there is no well-defined, formal structure for board decision-making. As a consequence, the accountability of Indian board members suffers.

Multiple board membership : Respondents were, on average, on more than four boards each.20 percent of the respondents were on more than eight boards each. Given that, on average,

board members attended seven board meetings a year per company, the survey reflected thepractical limits to which board members can engage in strategic matters.

KPMG The State of Corporate Governance in India: 2008

KPMG India conducted a poll17 between late November 2008 to early January 2009,involving over 90 respondents comprising CEOs, CFOs, independent directors and similarleaders, who were asked about the journey, experience and the outlook for corporategovernance in India. The respondents were predominantly from private equity firms, financialservices and the manufacturing sector. Some important findings of the poll are given below.Penalties for poor corporate governance :In comparison with developed countries that imposestringent penal and criminal consequences for poor corporate governance, penalty levels inIndia are considered to be inadequate to enforce good governance. 71 percent of therespondents considered penalty levels to discipline poor and unethical governance to be low.

Another 22 percent of the respondents were either undecided or did not know if the penaltylevels are low.

Independent directors : Majority of the respondents felt that independent directors do notadequately challenge the executive directors and management in the process of dischargingtheir governance responsibilities.

Minority shareholders : In response to a question, Are concerns of minority shareholdergroups adequately addressed by Indian board groups , 63% answered More often than not;12% answered Sometimes, but in the best personal interests, rather than the best interests ofthe company; and 25% answered, Sometimes, in the best interests of the company ratherthan personal enrichment.

Overall assessment of financial system development (Table 29-30)

The World Economic Forum has undertaken a research initiative aimed at providing businessleaders and policymakers with a common framework to identify and discuss the key factors inthe development of global financial systems and markets. The attempt is to define andmeasure financial system development. The inaugural Financial Development Report 2008

provides an Index and ranking of 52 of the worlds leading financial systems.

In order to understand and measure the degree of financial development, the report considersall of the different factors that together contribute to the degree of depth and efficiency of the

17 The State of Corporate Governance in India: 2008 is an initiative of KPMG in Indias AuditCommittee Institute

22


23/54

provision of financial services. The seven pillars of development, that go into defining theindex of financial development, have been grouped into three broad categories.

1. Factors, policies, and institutions: the inputs that allow the development of financialintermediaries, markets, instruments and services

2. Financial intermediation: the variety, size, depth, and efficiency of the financialintermediaries and markets that provide financial services

3. Capital availability and access: the outputs of financial intermediation as manifested inthe size and depth of the financial sectors and the availability of, and access to, financialservices

The rankings of various countries on the seven pillars and the overall ranking is shown inTable 29. India is ranked 31st out of 52 in terms of its overall ranking. While Indias banksare ranked at the bottom at 50, non banks are ranked 16, and financial markets 22. Theranking on financial depth and access is 28. According to the report

While India delivered solid results in terms of its financial markets (particularly foreign

exchange and derivatives) and its non-bank institutions, its banks appear hamstrung bylack of size, low efficiency and poor information disclosure. Despite this, the bankingsystem is very stable (5th) likely owing in part to sizable capital buffers that help itweather credit cycles. The business environment shows significant room fordevelopment, characterized by an inhospitable tax regime and relatively poor contractenforcement. India receives low marks related to the liberalization of its domesticfinancial sector and capital account. The quality of Indias higher educationinstitutions is apparent as seen in the high score for the quality of management schools(8th), but development areas include brain drain, the ease of hiring foreign talent, andenrollment in tertiary schools.

Indias ranking on each component of the seven pillars is shown in Table 30.

5. Conclusions

The Indian financial system is characterized by the dominance of banks with relativelyunderdeveloped equity markets. Bond markets are non existent but there is a large andgrowing private placement market. In the finance and growth literature underdevelopment ofmarkets is sometimes attributed to the concentration of ownership. Ownership concentration,especially through pyramids and cross-holdings, expose minority shareholders toexpropriation by controlling shareholders. More generally, these structures reducetransparency for arms-length investors. It is also possible that promoters significantshareholding removes a large proportion of shares from the floating stock leading to low

liquidity and high volatility of equity markets in India.

23


24/54

Table 1

Ratio of Savings and Investment to GDP (per cent at current market prices)

2001-02 2002-03 2003-04 2004-05 2005-062006-07 PE

2007-08QE

Gross Domestic Saving 23.5% 26.3% 29.8% 31.7% 34.2% 35.7% 37.7%

Household Saving 22.1% 22.9% 24.1% 22.8% 24.1% 24.1% 24.3%

of which :

a) Financial assets 10.9% 10.3% 11.4% 10.1% 11.7% 11.7% 11.7%

b) Physical assets 11.3% 12.6% 12.7% 12.7% 12.4% 12.4% 12.6%

Private Corporate Saving 3.4% 4.0% 4.6% 6.7% 7.7% 8.3% 8.8%

Public Sector Saving (2.0%) (0.6%) 1.1% 2.2% 2.4% 3.3% 4.5%

Net capital inflow (0.6%) (1.2%) (2.2%) 0.4% 1.2% 1.1% 1.4%

Gross Domestic CapitalFormation 22.8% 25.2% 27.6% 32.1% 35.5% 36.9% 39.1%

Gross Capital Formation 24.2% 25.2% 26.8% 31.6% 34.8% 36.4% 38.7%

of which :

a) Public sector 6.9% 6.1% 6.3% 6.9% 7.6% 8.0% 9.1%

b) Private corporate sector 5.4% 5.9% 6.8% 10.8% 13.7% 14.8% 15.9%

c) Household sector 11.3% 12.6% 12.7% 12.7% 12.4% 12.4% 12.6%

d) Valuables 0.6% 0.6% 0.9% 1.3% 1.2% 1.2% 1.1%

Memo

Saving-Investment Balance 0.6% 1.2% 2.2% (0.4%) (1.2%) (1.1%) (1.4%)

Public Sector Balance (8.9%) (6.7%) (5.3%) (4.7%) (5.2%) (4.6%) (4.6%)Private Sector Balance 8.8% 8.4% 9.2% 6.1% 5.7% 5.2% 4.7%

a) Private Corporate Sector (2.1%) (1.9%) (2.2%) (4.0%) (6.0%) (6.5%) (7.0%)

b) Household Sector 10.9% 10.3% 11.4% 10.1% 11.7% 11.7% 11.7%

Sector shares

Gross Domestic Saving 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Household Saving 94.0% 87.1% 80.9% 71.9% 70.5% 67.5% 64.5%

of which :

a) Financial assets 46.4% 39.2% 38.3% 31.9% 34.2% 32.8% 31.0%

b) Physical assets 48.1% 47.9% 42.6% 40.1% 36.3% 34.7% 33.4%

Private Corporate Saving 14.5% 15.2% 15.4% 21.1% 22.5% 23.2% 23.3%

Public Sector Saving (8.5%) (2.3%) 3.7% 6.9% 7.0% 9.2% 11.9%

Source: Macroeconomic and Monetary Developments in 2008-09, RBI, Table 19, Apr 20, 2009,

24


25/54

Table 2

Changes in financial assets / liabilities of the Household Sector

Rs Crores Percentage of Changes in Financial Assets Rs. Crores

Year

Changes in

FinancialAssets

Bank

Deposits#

Life

InsuranceFund*

Providentand

PensionFund

Claimson

Govern-ment +

Sharesand

Debentures ++-

Changes in

FinancialLiabilities

2001-02 296,582 38% 14% 16% 18% 3% 51,727

2002-03 322,583 38% 16% 15% 17% 2% 60,305

2003-04 377,387 38% 14% 13% 23% 2% 69,982

2004-05 434,318 36% 16% 13% 25% 2% 120,566

2005-06 597,867 46% 14% 10% 15% 5% 183,424

2006-07 650,412 48% 18% 11% 3% 9% 176,787

2007-08 715,994 50% 18% 10% -4% 12% 173,135

2008-09 746,864 55% 20% 9% -3% 3% 165,656

P : Provisional. $ : Preliminary Estimates.+ : Includes compulsory deposits.# : Includes deposits with co-operativenon-credit societies.* : Includes State / Central Government and postal insurance funds.

++ : Includes investment in shares and debentures of credit / non-credit societies, public sector bonds andinvestment in mutual funds (other than UTI)

Source: Table 11, Handbook of Statistics on Indian Economy 2008, RBI

25


26/54

Table 3

SCHEDULED COMMERCIAL BANKS RATIOS

(Year end outstanding amounts)

Year

As per cent to Aggregate Deposits As per cent to GDP

CreditTotal

Investments

Investmentsin

GovernmentSecurities Credit

TotalInvestments

Investmentsin

GovernmentSecurities

AggregateDeposits

2000-01 53% 39% 35% 24% 18% 16% 46%

2001-02 53% 40% 37% 26% 19% 18% 48%

2002-03 57% 43% 41% 30% 22% 21% 52%

2003-04 56% 45% 44% 30% 25% 24% 54%

2004-05 65% 44% 42% 35% 24% 23% 54%

2005-06 72% 34% 33% 42% 20% 20% 59%

2006-07 74% 30% 30% 47% 19% 19% 63%

2007-08 74% 30% 30% 50% 21% 20% 68%

2008-09 72% 30% 30% 52% 22% 22% 72%

Source: Table 239 Handbook of Statistics on Indian Economy 2008, RBI

26


27/54

Table 4

CONSOLIDATED BALANCE SHEET OF SCHEDULED COMMERCIAL BANKS

Liabilities

Total

(Rs. Crores) Percentage of Total

Total

Liabilities/

Assets Equity Deposits

Borrowing

s

Other

Liabilities

and

Provisions

2001-02 1,536,424 5% 78% 7% 9%

2002-03 1,699,197 6% 80% 5% 9%

2003-04 1,974,017 6% 80% 5% 9%

2004-05 2,355,509 6% 78% 7% 8%

2005-06 2,785,863 7% 78% 7% 8%

2006-07 3,463,406 6% 78% 7% 9%

Assets

Total

Rs. crores Percentage of Total

Total

Liabilities/

Assets

Cash

and

Balances

with RBI

Moneyat Call

and

Short

Notice Investments

Loans

and

Advances

Fixed

Assets

Other

Assets

1 13 7 8 9 10 11 12

2001-02 1,536,424 6% 8% 38% 42% 1% 5%

2002-03 1,699,197 5% 4% 41% 44% 1% 5%

2003-04 1,974,017 6% 4% 41% 44% 1% 5%

2004-05 2,355,509 5% 4% 37% 49% 1% 4%

2005-06 2,785,863 5% 4% 31% 54% 1% 4%

2006-07 3,463,406 6% 5% 27% 57% 1% 4%


27


28/54

Table 5

SCHEDULED COMMERCIAL BANKS - MATURITY PATTERN of term deposits

Rs.crores Percentage of Total Deposits

Yesr

end

Total

deposits 1 year

1-2

year

2-3

years

3-5

years 5 plus

2000 516,228 29% 23% 16% 22% 11%

2001 601,456 31% 22% 15% 21% 11%

2002 725,216 35% 23% 14% 19% 10%

2003 818,009 35% 23% 18% 15% 9%

2004 935,856 38% 22% 12% 20% 8%

2005 1,064,146 39% 23% 11% 18% 8%

2006 1,246,353 40% 27% 9% 16% 8%

2007 1,596,140 37% 33% 7% 15% 7%


Percentage Share in Total Deposits of Scheduled Commercial Banks: Sector-wise

End-March

GovernmentSector

CorporateSector(Non-financial)

CorporateSector

(Financial)HouseholdSector

ForeignSector

TotalDeposits

2000 10% 4% 8% 68% 11% 100%

2001 10% 5% 7% 67% 11% 100%

2002 11% 6% 7% 67% 10% 100%

2003 12% 5% 7% 65% 11% 100%2004 15% 8% 9% 58% 11% 100%

2005 15% 9% 8% 61% 8% 100%

2006 14% 10% 10% 59% 7% 100%

Note : Foreign sector represents the deposits of non-residents, foreign consulates,embassies, trade missions, information services, etc.and others.

Source: Table 4.13, Handbook of Currency and Finance, 2008, RBI

28


29/54

Table 6

Type of Credit to Industry by Banks(Amount outstanding Rs. crore)

End-March

Short-Term Loans* Medium-Term Loans Long-Term Loans

TotalCreditAmount

Share inTotalCredit(Percent) Amount

Share inTotal

Credit(Percent) Amount

Share inTotalCredit(Percent)

2000 1,52,369 74% 13,928 7% 38,777 19% 2,05,074

2001 1,70,114 75% 16,067 7% 41,341 18% 2,27,522

2002 1,65,828 63% 22,313 8% 74,910 28% 2,63,051

2003 1,79,687 59% 22,366 7% 99,853 33% 3,01,906

2004 1,89,918 58% 32,187 10% 1,06,084 32% 3,28,189

2005 2,29,672 52% 46,535 11% 1,62,296 37% 4,38,503

2006 2,68,138 48% 58,018 10% 2,30,202 41% 5,56,357

2007 3,36,958 46% 71,865 10% 3,22,335 44% 7,31,157

* : Short-term credit includes cash credit, overdraft, demand loans, packing credit,export trade bills purchased and discounted, export trade bills advanced against,advances against export cash incentives and duty drawback claims, inland bills

purchased and discounted (trade and others), advances against import bills,foreign currency cheques, TCs/DDs/TTs/MTs purchased.

Source: Basic Statistical Returns of Scheduled Commercial

indian financial system 2008-09

Documents