Table 5.3 : Activity in Other Money Market Segments

(Rupees crore)

Month

Average

Transactions in

Commercial

Certificates

Commercial Bills

Forward Rate

Daily

Repo Market

Paper

of Deposit

Rediscounted

Agreements/

Turnover in

(Outside

(Outstanding

(Outstanding

by commercial

Interest Rates

Term Money

Reserve

Amount)

Amount)

banks

Swaps (Notional

Market

Bank)

Amount)

1

2

3

4

5

6

7

April

225

47,020

8,046

1,393

371

88,813

May

123

44,431

8,111

1,360

463

1,03,993

June

135

37,848

8,447

1,359

701

1,17,644

July

108

34,170

8,520

1,303

400

1,24,453

August

1,179

33,281

9,125

1,007

341

1,32,354

September

247

41,768

9,549

1,236

572

1,31,898

October

117

46,595

8,426

1,394

502

1,31,340

November

392

34,503

8,599

1,219

332

1,53,260

December

454

37,651

9,025

1,163

462

1,61,566

January

288

66,599

8,554

1,226

455

1,92,170

February

281

65,413

7,070

1,125

295

2,18,816

March

546

74,236

5,749

908

105

2,44,161

April

604

41,815

5,994

1,485

164

2,49,449

May

455

43,328

6,820

1,996

334

2,84,048

June

610

48,605

7,108

2,183

393

2,93,127

July

573

74,936

7,557

–

364

3,01,062

– Not Available.

A significant feature of financial market behaviour during 2002-03 was a close co-movement of market segments at the short-end, i.e., call money, Treasury Bills, CP and CDs. Rates in these markets frequently joined the call rates in dipping below the repo rate, the informal floor for the financial market spectrum in India, on many occasions during the course of the year. Similar co-movement was evident in turnovers. The consequent narrowing of spreads at the short end of the market spectrum and the strength of this synchronicity has implications for the operational efficiency of markets as well as for the effectiveness of the transmission of monetary policy which typically operates at the short end of the market structure (Chart). Recognition of this interesting development was reflected in the Statement on Monetary and Credit Policy for 2003-04: 'interest rates in money market instruments converged to a narrow band….'.

In the literature, convergence of risk-adjusted returns is regarded as a necessary condition for market integration, though not a sufficient one. In particular, co-movement in rates is suspect since financial market rates show 'random walk' in that they exhibit no tendency to return to trend value once disturbed. Moreover, association in rate movements may indicate contagion rather than integration. Empirical investigation conducted in the Reserve Bank in a vector error correction model (VECM) framework indicated contemporaneous episodes of excess returns in the call, Treasury Bill, CP and forward segment of the foreign exchange market during periods of turbulence in financial markets. Simultaneous presence of excess returns disappeared with the return of stability in market activity. This asymmetric integration constrains the conduct of monetary policy since simultaneous interventions are required in the disturbed segments and monetary policy could be imprisoned in a self-fulfilling vicious circle.

It is important, therefore, to carefully sift through the empirical evidence on market integration for calibrating the reaction of monetary policy to market movements. Correlation may well obscure the differences in maturity, liquidity and risk characteristics. In particular, it is important to closely scrutinise the stylised evidence of market synchronicity in periods of calm as opposed to the earlier exercise which was conducted on episodes of perturbation. Similar efforts have been conducted in the context of mature financial markets. With the introduction of the gilt repo in the UK money market, tighter spreads were observed between the two-week market rate and the official repo rate, resulting in lower money market volatility at the very short end of the money market curve with no sign of volatility transmission up the curve. Stability in the long-run relationship between the policy rate and T-bill rate under shifting monetary policy regimes was observed in an error correction framework capturing both asymmetries and non-linearities in interest rate dynamics in the US. Co-movement in various money market rates is often explained by the market's expectations about the operating rate over the term of the instrument plus a risk premium. A broad conclusion emerging from these country specific studies is that integration in money market segments tends to reduce volatility. This would work towards improving the transmission of monetary policy.

Empirical investigation of the relationship between the money market rates in a co-integration framework in India indicates the presence of a unique and stable long-run co-movement, despite their being unstable (non-stationary) individually. A vector error correction process suggests that the call rate adjusts rapidly to exogenous disturbances and 'herds' other money market rates back to equilibrium. These findings indicate that money market segments are getting integrated even in periods of normalcy, and the call rate could well emerge as the reference rate for the money market.

Broadbasing of the Negotiated Dealing System and the establishment of CCIL as a central counter party risk manager would foster market integration by reducing uncertainty relating to funds position. The implementation of RTGS would reduce the settlement risks and strengthen the co-movement of money market rates. This would also help in developing a continuous short-term rupee yield curve through efficient price discovery.

1. Borio, Claudio E.V (1997), 'The Implementation of Monetary Policy in Industrial Countries: A Survey', BIS Economic Papers, No.47, July.
2. Sarno Lucio and Daniel L. Thornton (2002), 'The Dynamic Relationship between the Federal Funds Rate and the Treasury Bill Rate: An Empirical Investigation',Working Paper 2000-032C (revised in March 2002), Federal Reserve Bank of St. Louis, USA.
3. Wetherilt, Anne Vila (2002), 'Money Market Operations and Volatility of UK Money Market Rates', Working Papers No. 174, Bank of England.

Table 5.4 : Purchases and Sales of US dollars by Reserve Bank

(US $ million)

Month

Purchases (+)

Sales (-)

Net (+/-)

Cumulative

Outstanding Net

(over end-

Forward Sales (-)/

March)

Purchases (+) at

the end of month

1

2

3

4

5

6

April

2,082

1,606

477

477

(–)400

May

1,233

1,147

86

563

(–)400

June

812

571

241

803

(–)400

July

2,514

685

1,829

2,632

(–)400

August

2,638

1,459

1,179

3,811

(–)200

September

2,922

1,956

965

4,776

(+)475

October

2,594

1,423

1,171

5,947

(+)638

November

3,087

972

2,115

8,062

(+)812

December

3,231

1,552

1,679

9,741

(+)2,260

January

2,831

1,046

1,785

11,525

(+)2,872

February

3,506

1,171

2,335

13,860

(+)2,577

March

3,189

1,339

1,849

15,709

(+)2,420

April

2,943

1,511

1,432

1,432

(+) 3,281

May

3,978

1,636

2,342

3,774

(+) 4,186

June

1,879

982

896

4,670

(+) 3,866

July

6,096

2,950

3,146

7,815

(+) 4,549

Foreign exchange market efficiency is usually examined through evaluation of the co-movement of domestic and foreign interest rates and the exchange rate. Two key parity conditions - 'covered parity' and 'uncovered parity' – provide a measurement of the extent of market integration and efficiency. According to the covered interest parity (CIP) condition, the forward premium/ discount should equal the interest rate differential between domestic and foreign currency assets. On the other hand, the uncovered interest parity (UIP) condition postulates that the expected change in the exchange rate should equal the interest rate differential. Taken together, the CIP and UIP suggest that forward premia/discounts are an unbiased predictor of the future spot exchange rate. The interest parity hypotheses are important from a policy perspective, since deviations from UIP provide scope for central banks to undertake sterilised foreign exchange market intervention as well as interest rate defence of the exchange rate.

Available empirical evidence in regard to advanced economies suggests that CIP generally holds for assets of similar maturity and similar risk profile; profitable arbitrage opportunities appear for longer maturities. As regards empirical evidence for UIP, it is overwhelmingly rejected. Its failure has been attributed, inter alia, to sudden shifts in risk perceptions and expectations that characterise foreign exchange markets while pricing ‘news’ as well as interventions.

An empirical examination of these parity conditions for India covering monthly data was undertaken over the period April 1993 to March 2003. The interest differential, measured as the difference between 3-month Treasury Bill yields for India and the US, is found to be positively related to forward premia but the operation of CIP is not validated on account of imprecision in the estimated coefficients and the presence of correlated errors. turn out to be serially correlated, indicative of market inefficiency.

An alternative test of UIP is based on the notion that there should not be any systematic excess returns in an efficient foreign exchange market, i.e., interest rate differential less capital gains/losses from exchange rate movements should be a 'white noise' process. Over the sample period, the excess return measure is not statistically significant and is also found to be 'stationary'. This indicates no systematic and predictable excess returns in the Indian foreign exchange market. Transient excess returns generated by lack of full market integration dissipate rapidly, i.e., within two months.

Despite the mixed evidence on market efficiency, forward premia and interest differentials tend to move together in the long-run. Deviations from the parity conditions can be attributed to prudential restrictions on banks’ borrowing/ investments abroad. Central bank interventions in the market can also affect market behaviour. Finally, short-run deviations from UIP suggest that sterilised foreign exchange market intervention can be effective in ensuring orderly conditions.

1. Froot, Kenneth A. and Richard H. Thaler (1990), 'Anomalies: Foreign Exchange', Journal of Economic Perspectives, Vol. 4, Number 3.
2. Pattanaik, R.K., Muneesh Kapur and S.C. Dhal (2003), 'Exchange Rate Policy and Management: The Indian Experience', Economic and Political Weekly, Vol. XXXVIII, No. 22, May 31-June 6.

Table 5.5 : Movements in Deposit and Lending Rates

(Per cent)

Interest Rates

July

March

December

June

September

March

2003

2003

2002

2002

2002

2002

1

2

3

4

5

6

7

Public Sector Banks

a) Up to 1 year

3.75-5.75

4.00-6.00

4.25-6.25

4.25-6.75

4.25-6.75

4.25 – 7.50

b) 1 year up to 3 years

5.00-6.25

5.25-6.75

6.00-7.00

7.00-8.00

6.50-7.75

7.25 – 8.50

c) Over 3 years

5.25-6.50

5.50-7.00

6.50-7.25

7.50-8.25

7.00-8.25

8.00 – 8.75

Private Sector Banks

a) Up to 1 year

3.00-7.00

3.50-7.50

3.50-8.00

4.00-8.75

4.00-8.75

5.00 – 9.00

b) 1 year up to 3 years

5.50-7.50

6.00-8.00

6.50-8.25

7.25-9.50

7.25-9.50

8.00 – 9.50

c) Over 3 years

5.75-8.00

6.00-8.00

6.50-8.50

8.00-10.0

7.50-9.50

8.25 – 10.0

Foreign Banks

a) Up to 1 year

3.00-7.75

3.00-7.75

3.25-7.75

4.25-9.75

4.00-9.75

4.25 – 9.75

b) 1 year up to 3 years

3.50-8.00

4.15-8.00

4.50-8.00

6.25-10.0

5.50-10.0

6.25 – 10.0

c) Over 3 years

4.50-8.50

5.00-9.00

4.75-8.50

6.25-10.0

5.50-10.0

6.25 – 10.0

Public Sector Banks

9.00-12.25

9.00-12.25

9.00-12.50

10.00-12.50

10.00-12.50

10.00–12.50

Private Sector Banks

8.00-15.50

7.00-15.50

9.00-15.50

10.00-15.50

9.50-15.50

10.00–15.50

Foreign Banks

5.45-17.50

6.75-17.50

6.50-17.50

7.90-17.50

7.40-17.50

9.00 –17.50

The real interest rate reflects forces of thrift as well as productivity. It is unobservable but can be measured by the nominal interest rate on saving adjusted for the expected rate of inflation. In a frictionless, perfect-information world no difference exists between the real borrowing and lending rates. In reality, however, bank intermediation drives a wedge between them. Since the real lending rate embodies the true cost of funds for investors in an economy, two questions arise. First, is the real lending rate consistent with the growth rate of the economy? Second, given the structural rigidities, is the wedge between the bank deposit rate and bank lending rate reasonable? These issues become crucial for assessing the investment climate and for gauging the efficacy of the monetary policy transmission mechanism.

In the literature, the determinants of the long run real interest rate vary across growth models. In neoclassical growth models with exogenous saving, the marginal productivity of capital determines the real interest rate. On the other hand, in a Ramsay-type model with endogenous saving, the effective rate of time preference determines allocation of saving and investment and therefore, the real interest rate. In the overlapping generation models, lifetime saving could facilitate build up of assets to allow for consumption smoothing, which could explain the inter-temporal path of the real interest rate. The debate, however, is far from settled. In real life, the short-term nominal interest rate is under the direct control of monetary policy authorities. Additional factors such as maturity period, arbitrage opportunities, taxation, special features of the contract such as call options and risk characteristics, and uncertainties on account of information asymmetry determine the long-term interest rates.

Globally, the 1980s was a period of high nominal interest rates which spilled over into the 1990s. Since the second half of the 1990s there has been a generalised decline in interest rates in an environment of low inflation and weakening real sector activity. Developments in India have mirrored international trends. This has generated intense interest into where is the real lending rate and where it is headed. Industry circles typically complain about high real interest rates. Their view of the real interest rate is the bank prime lending rate adjusted for ex post or past inflation. On the other hand savers argue that the real interest rate is too low by adjusting the deposit rate for inflation on the same basis.

Three stylised facts stand out in respect of the movement of interest rates in India in recent years. First, the generalised decline in inflation since the second half of the 1990s has been reflected in a downward trend in nominal interest rates. Secondly, the fall in nominal interest rates of banks has been lower than the decline in the rate of inflation so that real interest rates may not have fallen in tandem with nominal rates. Thus, despite the fall in deposit rates, depositors have received positive real interest rates of close to 2 per cent in the second half of the 1990s, which is much higher than the real return on deposits during the first half of the 1990s. Finally, it is estimated that the average lending rate of scheduled commercial banks has declined from a peak of about 17 per cent in 1995-96 to around 14 per cent by March 2002.

An analysis of the costs of bank lending shows that structural rigidities of the system impose several costs on banks over and above the cost of funds and inflation. Non-performing assets impose a cost on the banking sector in that the greater are the non-performing assets of a bank, the higher must be the margins which its performing assets have to earn for the bank to break even. Cash reserve requirements involve an implicit cost as a portion of these assets are not remunerated at all and the rest earn interest at the Bank Rate which is typically lower than the prime lending rate. A preliminary analysis to assess the level of real lending rate was conducted on data for March 2002. For the purpose of this exercise, the inflation expectations was taken to be the projected inflation in the Monetary and Credit Policy Statement for 2002-03 in April 2002, i.e., four per cent. Accordingly, the real lending rate works out to 10 per cent - average lending rate of 14 per cent, adjusted for inflation expectations. The derived real lending rate needs to be adjusted for the wedges in the form of the CRR preemption as well as carrying costs of NPAs, estimated at about one per cent each. Furthermore, implicit in the real lending rate is a risk premium, which can be proxied by the spread of the discount rate on commercial paper over the yields of 91-day Treasury Bills estimated at around two per cent. Thus, the real lending rate adjusted for these 'mark ups' over fund costs is closely aligned with the trend real growth rate of the economy. With lower fund costs, reductions in the CRR, lower NPAs and improvements in risk perceptions during 2002-03, banks have room for undertaking more aggressive reductions in average lending rate so that the real lending rate remains in alignment with the trend GDP growth rate. With the CRR set on a declining trajectory, the key pre-requisites for a durable reduction in the bank lending rates in India are better management of NPAs and reduction in any unreasonable wedge between the costs and returns.

1. Allsopp, Christopher and Andrew Glyn (1999), 'The Assessment: Real Interest Rates', Oxford Review of Economic Policy, Vol. 15, No. 2.
2. Mohan, Rakesh (2002), 'Transforming Indian Banking, In Search of a Better Tomorrow', Bank Economists' Conference, December.

Table 5.6 : Resources Raised by way of Bonds/Debentures* by Select all-India Financial Institutions (Provisional)

(Amount in Rupees crore)

Resources Raised

Total Borrowings

Weighted Average

Weighted average

during

Outstanding at end

Cost of Funds (%)

Maturity (years)

2002-03

2001-02

March 2003

March 2002

2002-03

2001-02

2002-03

2001-02

1

2

3

4

5

6

7

8

9

IDBI

5,009

4,213

45,280

45,464

8.4

10.3

2.8

4.3

IFCI

267

651

20,046

19,789

6.8

11.1

5.1

8.7

IIBI

150

551

1,468

1,807

12.8

12.9

7.0

6.4

Exim Bank

2,505

625

5,424

3,067

8.9

10.8

6.1

6.4

NABARD

2,988

2,549

8,703

6,078

6.1

8.0

3.2

2.6

NHB

1,876

238

4,675

3,003

6.4

8.7

4.0

7.4

SIDBI

961

1,224

2,498

3,020

6.6

7.5

2.3

1.0

TFCI

93

48

632

689

10.1

10.5

8.5

7.0

IDFC

400

250

1,400

1,000

7.6

9.0

5.6

5.0

* Includes only rupee resources and does not include foreign currency borrowings.

Table 5.7 : Mobilisation of Resources from the Primary Market*

(Amount in Rupees crore)

Item

2002-03 P

2001-02

No. of Issues

Amount

No. of Issues

Amount

1

2

3

4

5

(-67.0)

(16.4)

a)

Financial

4

1,236

10

4,091

b)

Non-financial

5

642

9

1,601

(110.5)

(-3.6)

a)

Public Sector Undertakings

–

–

–

–

b)

Government Companies

–

–

1

350

c)

Banks/Financial Institutions

8

2,989

4

1,070

(-31.6)

(11.8)

(-14.1)

(27.1)

a)

Financial

364

10,102

363

16,019

b)

Non-financial

540

14,496

309

12,601

(2.5)

(-20.5)

a)

Financial

149

18,616

167

17,358

b)

Non-financial

94

18,532

119

18,898

(-4.8)

(-4.8)

(-7.5)

(-3.4)

(43.7)

(-43.2)

*

Including both debt and equity.

P : Provisional.

– Nil/Negligible.

+

Estimates based on information gathered from arrangers, FIs and newspaper reports.

The investment climate influences both the demand and supply of funds in the financial markets. A favourable climate for private investment is determined by general economic activity, the soundness of the financial system, asset prices, credit worthiness, business expectations and risk appetite. In the context of globalisation and the emergence of foreign direct investment (FDI) as a dominant element in international capital flows, improving conditions for investment has become the central concern of policy makers among countries competing for capital. Here, the investment climate includes a host of institutional factors and policies which affect the returns that investors expect and the uncertainties associated with these returns. Fiscal, monetary and exchange rate policies, political stability, the country’s regulatory framework, i.e., issues of entry and exit, labour laws, taxation rules, and the quality and quantity of the physical and financial infrastructure are crucial elements in determining the investment climate of a country.

The most crucial aspect of private investment, i.e., investment in fixed assets and equipments for capacity enhancement, has been the subject of considerable theoretical and empirical attention. The determinants of business fixed investment are typically identified as output, sales or profits and the cost of capital. In the Indian context, some empirical estimates indicate that the cost of capital unambiguously affects investment. Availability of bank credit affects smaller unincorporated firms more than bigger and established firms. Assessment of investment climate at an international level has gathered interest from the point of view of comparative assessment of countries and competitive performance. Several agencies compile country rankings and benchmarks on the basis of indicators that determine investment climate. Some of the available indicators are country credit ratings, country risk rankings, business environment survey, governance indicators and indices of competitiveness, globalisation, FDI confidence, human development, market access and economic freedom.

In India, the pace of private investment has lost momentum since the second half of the 1990s on account of several factors including lack of adequate reforms and public investment in infrastructure as well as uncertainties in the domestic investment climate. The dampening of the investment climate is also reflected in a drastic fall in the number of companies accessing the primary capital market, and a continuous decline in sanctions and disbursements by financial institutions (Appendix Table V.9). The investment climate in India is also being increasingly influenced by global developments such as the global downturn in investment demand and the large declines in equity markets. Efforts to brighten the investment climate will involve a strategic approach to investment and competitiveness.

1. Athukorala, P. and K. Sen. (2000), Saving, Investment, and Growth in India, New Delhi, Oxford University Press.
2. Reserve Bank of India (2003), Report on Currency and Finance, 2001-02, Mumbai, March.
3. World Bank (2002), Improving the Investment Climate in India

Table 5.8 : Net Resource Mobilisation by Mutual Funds

(Amount in Rupees crore)

Item

2002-03

2001-02

No. of

Amount

No. of

Amount

Schemes

Schemes

1

2

3

4

5

1. Unit Trust of India

59

-9,434

72

-7,284

2. Public Sector Mutual Funds

74

1,988

69

1,474

3. Private Sector Mutual Funds

337

12,026

266

12,947

1. Data are provisional.

2. For UTI, the figures are net sales (with premium), including re- Investment sales, and for other mutual funds, figures represent net sales under all schemes.

3. Data exclude amounts mobilised by off-shore funds and through roll-over schemes.

Table 5.9 : Scheme-wise Resource Mobilisation by Mutual Funds

(Rupees crore)

Year

Equity-

Debt-

Balanced

Total

Oriented

Oriented

1

2

3

4

5

2001-02

-534

13,064

-5,354

7,175

2002-03

43

5,781

-1,628

4,196

In contrast to the generally sluggish conditions characterising the stock markets in India, bank scrips have shown a sharp upward movement in prices. On a point-to-point basis, the S&P CNX Bank Index registered an increase of 18.1 per cent during 2002-03, while the BSE Sensex and S&P CNX Nifty declined by 12.1 per cent and 13.4 per cent, respectively. In the current financial year up to August 12, 2003, the S&P CNX Bank Index increased by 46.5 per cent, while S&P CNX Nifty and BSE Sensex registered gains of 26.2 per cent and 27.6 per cent, respectively.

At a disaggregated level, the price gains in respect of many bank scrips some of which are not included in the S&P CNX Bank Index have been way ahead of the market average and have outperformed several blue chips. The major price gainers during 2002-03 were Bank of Baroda (80.1 per cent), Indian Overseas Bank (78.0 per cent), Vijaya Bank (76.9 per cent), Dena Bank (76.1 per cent) and Oriental Bank of Commerce (62.5 per cent). The market preference for banking sector scrips is also reflected in the sharp rise in trading volumes. In terms of average daily turnover, the most active scrips during 2002-03 were State Bank of India, Syndicate Bank, ICICI Bank, Bank of Baroda and Bank of India.

The progress of banking sector reforms has been a major factor in enhancing the attractiveness of banking sector stocks. A significant factor leading to heightened activity in bank scrips was the relaxation in the foreign direct investment (FDI) norms for private sector banks in May 2001. This made the old private sector banks particularly attractive because of their undervalued price levels. Improved financial performance drawing from huge trading profits was another contributing factor. Some banks attracted buying interest in anticipation of a takeover or merger in future. The market expectations regarding disinvestments of public sector banks also fuelled some speculative activity.

The prices of the banking sector stocks could be influenced by bank-specific factors and/or general factors. The 'beta' (which measures the riskiness of a stock relative to the market) and synchronicity tests (which indicate the fraction of stocks that move in the same direction) suggest that risk-return perception for banks are determined to a large extent by the industry-wide factors rather than by bank-specific factors. The beta values were found to be varying widely among the individual bank scrips and close to unity only in case of a few bank scrips. On an average, the beta of bank scrips was around 0.7 as reflected in the beta of S&P CNX Bank Index. The synchronicity tests based on daily returns data for the 25 bank stocks showed that, on an average, about 70 per cent of bank scrips move in the same direction.

Table 5.10 : The Indian Equity Markets – Key Indicators

Indicator

BSE

NSE

2002-03

2001-02

2002-03

2001-02

1

2

3

4

5

1.

BSE Sensex/S&P CNX Nifty

(i) Average

3206

3332

1037

1077

(ii) End of the year

3049

3469

978

1130

2.

Co-efficient of Variation (%)

4.9

7.2

5.2

6.8

3.

Price -Earning Ratio@

14.5

16.6

15.2

15.7

4.

Price-Book Value Ratio@

2.2

2.4

2.6

2.6

5.

Yield @ (per cent per annum)

2.2

2.0

2.1

1.2

6.

Listed Companies #

5,650

5,782

673

793

7.

Turnover (Rupees crore)

3,14,073

3,07,292

6,17,989

5,13,167

8.

Market Capitalisation # (Rupees crore)

5,72,197

6,12,224

5,37,133

6,36,861

9.

Turnover Ratio

0.5

0.5

1.2

0.8

@

Based on scrips included in the BSE Sensex and the S&P CNX Nifty and are averages for the year.

#

As at end-March.

The globalisation of the world economy during the 1990s resulted in a substantial increase in portfolio flows from industrialised countries to emerging market economies. Private portfolio flows to emerging markets rose steadily from US $ 56.1 billion during 1992 to US $ 94.6 billion during 1996 but thereafter fell to US $ 1.7 billion during 1998, driven by outflows from the five crisis-affected Asian countries of Indonesia, Korea, Malaysia, Philippines and Thailand. Portfolio flows recovered to around US $ 41.4 billion in 1999. While there is little disagreement about the benefits of portfolio flows as a source of funds, their 'hot money' character has often escalated the possibilities of contagion. This has sparked off a considerable interest in the determinants of capital flows.

Portfolio flows are, by and large, determined by the performance of stock markets of the host economy relative to that of the home economy. There is empirical evidence to suggest that equity flows would be 'pulled' towards an economy with relatively higher returns. When the recipient economy is small, equity inflows could also be 'pushed' in once stock returns in the rest of the world rise sufficiently to allow investors to take such risks. Official policies, especially in terms of capital controls, influence the scale of portfolio flows. The degree of cross-country portfolio diversification which the investors in the developed economy are willing to accept often depends on the 'home bias' which is, however, gradually eroding with the increase in global financial integration and the degree of risk spreading enabled by such investments. For example, emerging equity markets were reported to be offering higher returns at more or less unchanged or reduced portfolio risks during 1988-94. During 1995-98, they yielded lower returns, without reducing portfolio risk. Other factors explaining portfolio flows include interest rate differentials, volatility in the stock markets, exchange rate fluctuations and measures of country risk. There are also feedback-trading effects in that gains (losses) in an economy tend to reinforce the next round of investment (disinvestment). Portfolio inflows are often persistent and besides, such flows to different countries in a particular region often tend to be highly correlated. Stylised evidence suggests that the advantages of informed trading explains about three-fourth of the total persistence. Finally, portfolio flows to emerging market economies in the late 1990s were also driven by sector-specific factors such as the availability of technology scrips during the technology boom of the late 1990s. The evidence on determinants of portfolio flows continues to be mixed depending on model specifications. One set of results suggests that FII flows are, by and large, driven by stock market returns while other variables such as US and world returns and country risk returns are not very significant in explaining capital flows. Other findings indicate that portfolio flows are affected by a combination of domestic, regional and global variables including global interest rates, lagged returns in emerging markets, nominal depreciation expectations of the exchange rate and credit rating downgrades.

India opened its stock market to FIIs in September 1992. As at end-March 2002, about four-fifth of FII investment emanated from the USA, UK and Western Europe. FII flows were consistently positive for the first few years reflective of buoyant stock market conditions but turned negative in September 1997 for the first time at the time of the Asian crisis (Chart). Although there have been a few periods of net outflows during brief episodes of foreign exchange market volatility, they were quickly reversed once stability returned to the financial markets.

An analysis of the data reveals that FII flows and stock market performance in India are strongly correlated. Daily data for the period October 1999-January 2002 show that there is a bi-directional causality between FIIs' equity investments and changes in the BSE Sensex. This implies that portfolio decisions made by FIIs influence and, in turn, are influenced by the market performance.

1. Chakravarty, Rajesh, 'FII Flows to India: Nature and Causes', mimeo, Georgia Institute of Technology.
2. Gordon, James and Poonam Gupta (2002), 'Portfolio Flows into India: Do Domestic Fundamentals Matter?', Presentation at NCAER.

Table 5.11 : Net Investments by Institutional Investors

(Rupees crore)

FIIs

Mutual Funds

Year

Equity

Debt

Equity

Debt

1

2

3

4

5

2000-01

10,124

-46

-2,767

5,023

2001-02

8,067

685

-3,796

10,959

2002-03

2,528

162

-2,067

12,604

A proper risk management system for the stock exchanges is a necessary precondition for the integrity and safety of the market. The main elements of risk management in stock exchanges in India comprise capital adequacy, exposure limits, margin requirements, counter-party guarantee in the form of trade guarantee funds, price bands and a surveillance system. Capital adequacy refers to the requirement on the part of the trading members of stock exchanges to provide base capital in specified assets in a prescribed proportion. Exposure norms, either in the form of scrip-specific trading limits or a ceiling on the cumulative outstanding position, are linked to capital. Furthermore, scrip-specific and broker-specific margins are collected from the members in order to reduce the risk associated with market fluctuations. While the margin system has limited the members' ability to take highly leveraged positions, the system of circuit filters (price bands) in which the trading in a scrip is halted once it crosses a band, acts as a direct measure to curb volatility. Circuit filters were first introduced in the US in the wake of a sharp fall in share prices. Counter-party guarantees in the form of a trade/settlement guarantee fund to honour the pay-in liabilities by a member act as a risk insurance system in the case of default. Besides, a surveillance system has been instituted in major stock exchanges to ensure efficient functioning of the market.

Minimum capital requirements have been stipulated at broker and sub-broker level. At present, gross exposure limits, stipulated at 15 times the base minimum capital and additional capital, and intra-day trading limits at 33¹/₃ times the base minimum capital and additional capital, are applicable. There are mainly three types of margins in operation, viz., a daily margin, mark-to-market margin and volatility margin in order to curb excess volatility and deter the build up of excessive outstanding positions. Members are required to pay the excess of the mark-to-market margin over the daily margin only if the former exceeds the latter. Price bands were revised from time to time to provide exit and flexibility in trading. There is a price band of 20 per cent (either side) for scrips which are neither included in the BSE Sensex or S&P CNX Nifty, nor included in the list on which derivative products are allowed. To bring about a co-ordinated trading halt in all equity and equity derivative markets nationwide, the SEBI prescribed with effect from July 2, 2001, an index-based market-wide circuit breaker system, at three stages of the index movement either way at 10 per cent, 15 per cent and 20 per cent. All the scrips attract a 99 per cent Value-at-Risk (VaR)-based margin. Stock exchanges have Settlement Guarantee Funds/ Trade Guarantee Funds to face any exigencies that may arise. Major stock exchanges monitor the exposure and intra-day trading limits on a real time basis. A system of pre-set alerts has been introduced as part of the surveillance system. These risk containment measures have been able to enhance the safety of the market in times of extreme volatility, manage credit risk and ensure that settlements take place smoothly.

For safe and quick transfer of shares, all actively traded shares have been shifted to the dematerialised form, substantially reducing transaction costs and risks of bad delivery. Two depositories, viz., the National Securities Depositories Ltd. and the Central Depository Services Ltd. have established inter-connectivity between themselves and 10 stock exchanges accounting for 99 per cent of the turnover have established connectivity with either of the two depositories.

Stock exchanges were set up the world over as non-profit organisations owned by their member brokers. In the recent years, however, there has been an increasing trend towards alternative structures from the traditional cooperative or mutual models to corporate service provider models. Demutualisation involves separation of trading rights from ownership and management control. In most cases, this involves the conversion of an existing not-for profit organisation into a for-profit organisation.

The basic rationale for demutualised stock exchanges is that exchanges owned by members often tend to work towards the interest of members alone, which could at times be detrimental to the rights of other stakeholders. The division of ownership between members and outsiders can lead to a balanced approach, remove conflicts of interest and create greater management accountability, transparency and market discipline. The exchanges increasingly need to invest in technology upgradation to face the competition from newly created technology-oriented market entities. Demutualised exchanges could be better equipped to face this challenge by raising the capital from the market. Furthermore, the forces of competition and globalisation have also created the need for strategic alliances and cross-holdings. The experience the world over shows that the broker-managed stock exchanges are relatively slow and reluctant to respond to changes.

In recent years, many stock exchanges such as Frankfurt, Stockholm, Amsterdam and Australia have demutualised. The Amsterdam and the Australia stock exchanges have additionally become publicly listed companies and the Deutsche Bourse in Frankfurt is considering this step. In Asia, the Stock Exchange of Singapore and Singapore Monetary Exchange (Simex) have been merged.

Demutualisation, however, raises some concerns. One of the major concerns is about the compatibility of the demutualised structure with the role of stock markets as self-regulators. In particular, it is argued that the conversion into for-profit organisation could adversely affect the support of funding for regulation. It is also argued that even demutualised exchanges may be reluctant to bring enforcement actions against holders of trading rights if they are also major stakeholders. It is often argued, therefore, that after demutualisation, the stock exchange should merely be a transaction clearing entity and not a self-regulatory organisation. The stock exchange as a company should not have special powers over other companies whose shares are also listed and traded. Hence, in some countries, regulators are considering the possibility of taking away listing powers from such exchanges as a matter of fair play.

In India, stock exchanges have historically been set up as not-for-profit organisations, though the need for a demutualised structure of stock exchanges has also been recognised. The National Stock Exchange (NSE) and the Over-the-Counter Exchange of India (OTCEI) followed demutualised models from the beginning. The Union Finance Minister, in his Budget Speech for 2002-03, emphasised the need to separate trading, ownership and management in stock exchanges. A Group constituted by the SEBI under the chairmanship of Justice M.H. Kania examined the legal, financial and fiscal issues involved to corporatise and demutualise the stock exchanges. It recommended that the three stakeholders, viz., shareholders, brokers and the investing public through the regulatory body should be equally represented on the governing board of the demutualised stock exchange, with a ceiling of 5 per cent of the voting rights which can be exercised by a single entity or groups of related entities, irrespective of the size of ownership of the shares held. The Chairman of the board should not be a practicing broker. The Group suggested that the trading card system be replaced by the deposit system wherein the money deposited by a member to obtain trading rights only be considered as deposit with the stock exchange for trading purposes. Since the transfer of stock exchange assets and membership cards from the present legal structure into the new company (exchange) would attract one-time capital gains and other taxes, the Group suggested a one-time exemption from taxes for the newly demutualised stock exchanges. The Union Budget, 2003-04 announced exemption from payment of capital gains tax for exchanges on corporatisation. The Government has proposed necessary amendments to the Securities Contract (Regulation) Act, 1956 which are necessary to separate the ownership of these stock exchanges from their management in order to enhance investor confidence.

1. Patil R. H. (2000), 'The Capital Market in the 21st Century', Economic and Political Weekly, November 18.
2. Securities and Exchange Board of India (2002), Report of the Group on Corporatisation and Demutualisation of Stock Exchanges (Chairman: Justice M. H. Kania).