by Rakesh Mohan
2.5. Domestic Mutual Funds and Foreign Institutional Investors
DOMESTIC MUTUAL FUNDS
SEBI’s regulations for mutual funds were put in place in 1993. Prior to that, the only mutual fund of note was the UTI set up under the UTI Act of 1964. Private mutual funds crept up on UTI in the 1990s and have surpassed UTI in the 2000s. UTI itself was responsible for this decline because of recurrent management failures and malfeasance, culminating in the dismissal of the then UTI chairman in 2001.
Table 11 details the volumes of mutual fund assets under management in several countries. Although the size of this capital-markets segment has increased in India, it is still small by global standards.
Table 12 shows that the volumes of assets under management (AUM) had grown steadily from 2001 till the financial-sector crash in 2008 and are rising again.
Table 12: Indian Mutual Funds—Assets under Management (AUM)
Year
AUM (Percentage of GDP)
2001
3.07
2005
4.84
2007
9.00
2008
4.85
2009
9.74
2010
6.55
2014
6.55
Source: World Bank.
In August 2016, retail investors owned 45.3 per cent of the stock of assets managed by mutual funds while corporates accounted for 47 per cent. The remaining 7.7 per cent is held by institutional investors and banks. About 59 per cent of individual holdings are invested in equity-oriented schemes while others tend to hold their assets in liquid money-market or debt-oriented schemes.
FOREIGN INSTITUTIONAL INVESTORS (FIIS)
FIIs were allowed to register with SEBI starting in 1992. In addition to the net additionality in foreign-capital inflows, the entry of FIIs has improved accounting standards and corporate governance. FIIs are well equipped to do their due diligence on market potential and auditing standards before making investments. FII investments plus American Depository Receipts and Global Depository Receipts improved awareness among international investors about Indian firms and hence their access to international capital markets. However, FIIs are involved with participatory notes (PNs), which hide the identity of foreign investors and to that extent promote round-tripping of funds.
Table 13 shows that the outstanding stock of FII investments in Indian stocks has multiplied by more than four times over the last ten years.
Table 13: Outstanding Stock of FII Investments in Equity and Debt
Equity ($ billion)
Debt ($ billion)
Total ($ billion)
1995
–
–
2
2005
26
0.4
27
2010
67
12
79
2013
103
16
119
Source: SEBI.
From 2011 to 2016, FIIs have almost doubled their investments in Indian stocks. They now hold about 20 per cent of the market capitalization of Indian stocks as compared to 11 per cent in 2011. This increase has possibly been caused by the ultra-low interest rates in developed countries, including the US. Consequently, if and when US interest rates rise, there could be sizeable selling of Indian equities by FIIs.
Section III
1. Market Integrity
The following are illustrative examples of market-integrity violations since 1992. This summary does not provide anywhere near a comprehensive understanding of the multiple instances and varieties of wrongdoing in Indian capital markets.
1.1. Harshad Mehta
Over the last twenty-five years, there have been several instances of substantive violations of market integrity in Indian capital markets. For example, the Harshad Mehta (HM) stock-market scam was exposed in April 1992. HM used the Ponzi scheme model, which worked as long as stock prices kept going up. Major public and private banks, mutual funds and broking firms were complicit. A joint parliamentary committee deliberated over the causal reasons and corrective steps. However, till now, assets confiscated from HM are still frozen with a ‘custodian’ appointed by the government. It is important to reach closure in such significant cases of wrongdoing.14
1.2. Badla15
Badla transactions were banned after the HM episode. This type of trade allows buyers of stocks to postpone taking delivery by paying a mutually agreed rate of interest on the amounts owed to the sellers. Under this so-called badla methodology, stocks could be traded on payment of margins, and settlement could be deferred.16 The badla system created high counterparty risk since settlements could be deferred indefinitely.17
The government banned badla in 1993 post the HM scam.18 However, due to the lobbying of brokers, the government allowed badla trading again in 1996.19
The Joint Parliamentary Committee on the Stock Market Scam (2002) noted: ‘The payments crisis on the Calcutta Stock Exchange arose because SEBI in consultation with the Ministry of Finance had permitted the resumption of badla without arranging for curbing or regulating rampant off-market internal badla.’20 At the insistent prodding of government, SEBI banned badla trading for good21 in 2001.22 Exchange-traded derivative products such as futures and options were simultaneously introduced for hedging and trading purposes.23
1.3. Ketan Parekh
Stock prices dropped unexpectedly after the 2001 Budget was presented in Parliament. At the Ministry of Finance’s request, SEBI initiated investigations that spotlighted irregularities involving brokers and promoters.24 The obvious asset-liability mismatch of bank-lending against equity as collateral was exposed.25 Disregarding RBI’s guidelines, the Madhavpura Mercantile Cooperative Bank had loaned Rs 1200 crore to share brokers, including Ketan Parekh and his associates.26
1.4. UTI
Asset-liability mismatches were at the core of the UTI crisis of 2001. UTI had mopped up sizeable volumes of funds under assured return schemes and invested in equities. As equity prices went down, the net-asset values of these schemes went below that of underlying liabilities, prompting an investor run on UTI’s flagship scheme called US-64.27, 28, 29 This could have been prevented by prudent asset-liability management.
1.5. Collective Investment Schemes
In the plantation schemes of the late 1990s, investors were duped by companies with the promise of unrealistically high returns. As part of the reforms process, the Collective Investment Schemes’ Regulations were adopted in 1999 to give the required authority to SEBI.30 Purported chit-fund scams and alleged wrongdoing as in the cases of ‘Sahara’31, 32, 33 and ‘Saradha’ have also exposed regulatory shortcomings. The Ministry of Finance is now evaluating an omnibus ‘central legislation’ to prevent ‘illicit deposit taking schemes’.34
1.6. Reliance Infrastructure and Natural Resources
In January 2011, Reliance Infrastructure Ltd and Reliance Natural Resources Ltd (RNRL) were accused of having diverted proceeds of ECBs and FCCBs, in violation of regulatory guidelines, to invest in stocks. These two ADA group of companies paid Rs 50 crore ($7.5 million) to SEBI for an out-of-court settlement.35
1.7. Serious Allegations
In August 2011, an awkward incident, which was not investigated, was a letter written by the then SEBI board member K.M. Abraham directly to the prime minister alleging that North Block was interfering in the working of SEBI ‘with the knowledge of (then) Finance Minister Pranab Mukherjee’. The SEBI chairman denied Abraham’s allegations as baseless.36 Given the high offices involved, such instances raise questions about the ability of SEBI–government to take anticipatory action to protect the interests of investors.
1.8. Current Status
On balance, stock-market integrity has improved over the last ten years. This is principally because the numbers of market participants and institutions have grown and diversified and they are more vigilant. Additionally, corporate-go
vernance norms are better although there is considerable scope for improvement. The surveillance capabilities in market-infrastructure institutions such as stock exchanges are more sophisticated as also the regulatory efficiency of SEBI. However, a number of infirmities persist. For example, stock holdings are still too concentrated in the hands of promoters and institutional investors who collude, hurting the interests of dispersed retail investors. Sponsors of companies and their senior management have been often involved in dubious practices such as asset stripping and sharing of confidential information with favoured investors.
2. Systemic Risk
It was evident post-2008 that one of the causal factors for financial-sector irregularities in developed countries was excessively generous bonuses. Absurdly high levels of compensation insulate financial-sector personnel from the consequences of their actions. In India, the financial sector is still dominated by public-sector institutions. Consequently, although private-sector salaries and bonuses are high by Indian standards, these are not yet large enough to be a source of systemic risk.
Marking-to-market is an important component of managing systemic risk. However, significant parts of our debt markets, as distinct from equity, are not adequately liquid to provide market prices. At different points on the sovereign-rupee yield curve, liquidity is not adequate to arrive at robust market-driven prices. Consequently, there are information asymmetries. Existing penalties are inadequate and should be higher if market participants push low-liquidity products without adequate disclosure about the risks involved. Additionally, legal remedies against malfeasance or regulator high-handedness need to be processed faster.
3. Auditing and Accounting Oversight
Adequate attention has not been paid to auditing and accounting integrity even though there are many examples of periodic and systematic wrongdoings. For example, BIFR has commented adversely on connivance between auditors and promoters. Rating agencies too have noted that Indian companies at times overstate/understate their profits to manipulate stock prices, particularly prior to issuance of equity. Specifically, there was no value left in Satyam stocks after its share price plummeted overnight post the announcement of its fraudulent accounting statements. PwC India was fined $6 million by SEC for not following auditing standards in the Satyam case. More recently, there were question marks about the auditing and valuations of the United Breweries group of companies by PwC, Grant Thornton and Deloitte LLP.
4. Double Taxation Avoidance Treaties
In the early 1990s, double taxation avoidance agreements (DTAAs) with Mauritius and other low-tax jurisdictions were extended to portfolio investments. In substance, this was an extension of the provisions instituted in 1983 to promote FDI from NRIs. Portfolio investments were and are important in lowering current-account deficits, given India’s perennially large deficits in goods trade. However, it is likely that a sizeable proportion of these portfolio investments is round-tripping of Indian funds.
In February 2016, the government announced that over the next three years, tax rates on capital gains for foreign investments via Mauritius would be the same as for domestic investments.37 On 13 May 2016, the government announced that derivatives and debentures would not be covered by the amendments in the DTAA with Mauritius. Markets in ‘call and put’ options in listed Indian stocks are adequately liquid, such that these exchange-traded derivatives can be used to duplicate the payoff from underlying shares.
For instance, the basic ‘put-call’ parity identity can be used to replicate future price movements of listed stocks. ‘Put-call’ parity holds for ‘European’ options. The parity equation is:
S = C + PV (X) – P
S: spot stock price; C: call option premium; PV (X): present value of strike price X discounted from date of maturity of option at risk-free rate; P: put option premium.
If an investor were to buy a call option, lend the present value of the strike price at the risk-free rate and sell a ‘put’ option at the same strike price, the resulting exposure is exactly the same as if the investor had bought one share at price S at time t = 0. That is, investors could continue to use the Mauritius route to avoid capital gains taxes even after 1 April 2017, by using derivatives instead of investing directly in shares. It is also not clear why debentures have been excluded from this amended DTAA with Mauritius. Convertible (to equity) debentures could be issued in Mauritius to avoid taxes in India post-April 2017.
4.1. Coordination across Regulators
REGULATORY GAPS AND FINANCIAL STABILITY DEVELOPMENT COUNCIL (FSDC)
Financial-sector regulators have differences of opinion on issues that fall across or between regulators. This was evident in the case of unit-linked insurance schemes, which have insurance and equity characteristics. IRDA and SEBI could not agree on jurisdiction. The government has set up FSDC headed by the finance minister with the heads of RBI, SEBI and the insurance and pension regulatory bodies as members. In various quarters, concerns have been raised that a FSDC headed by the finance minister would be akin to a super regulator and the autonomy of financial-sector regulators would be compromised.
Earlier, before FSDC was constituted, the RBI governor used to head a High-Level Financial Markets Committee. The other members of this committee, set up for purposes of coordination, were the heads of SEBI, other regulatory bodies and finance ministry officials. RBI is naturally primus inter pares compared to the other financial-sector regulators. However, occasionally, RBI was not able to achieve a consensus in the meetings of this committee since RBI has its own preoccupations about turf. For example, around 2001, when it was felt that FX dealers were trying to manipulate currency markets, RBI decided to impose restrictions on spot FX transactions. RBI insisted that this had no impact on currency-swap markets since it did not realize that all currency-swap transactions are accompanied at the outset by spot FX conversions. The FSDC headed by the finance minister would be able to resolve differences of opinion between regulators on technical or turf issues.
In the US, the Financial Stability Oversight Council (FSOC) was set up under the Dodd–Frank legislation of July 2010. FSOC is headed by the US treasury secretary and the members include chairpersons of the Federal Reserve, SEC and other regulators.
Section IV
Conclusions
Household Investments in Stocks and Debentures Compared to Other Investments
Table 14 shows that despite the significant advances made over more than two and a half decades, Indian households continue to favor bank deposits and investments in insurance or pension plans to stocks. The volume of investments in stocks and debentures dropped from 1.7 per cent of GDP in 1994–95 to 0.46 per cent in 2014–15.
Indian MIIs such as stock exchanges, clearing and settlement corporations follow international best practices. Higher net-worth retail investors do apply for shares at the time of initial public offerings of well-known companies. However, median-income households remain hesitant participants in Indian equity markets. Moreover, average individual investors are still wary of investing in stocks and corporate bonds. This is partly because the free float of shares of well-managed companies is limited since such stocks are held closely by promoters, FIIs, domestic institutional investors and mutual funds. Additionally, the episodic yet steady flow of news about collusion across promoters, managers and others in a variety of scams dampens retail-investor sentiment.
During high-inflation periods, households tend to invest their savings in assets that hold their value against a general rise in prices. It appears that bank deposit and contractual savings rates from 2011–12 to 2014–15 were not considered sufficiently high compared to inflation (CPI was around 9.4 to 10 and then 6.5 per cent over this period). To preserve the purchasing power of their savings, household investments probably shifted towards gold and real estate (gold imports went up from $29 billion in 2009–10 to $56 billion in 2011–12 and $54 billion in 2012–13).
Table 14: Household Savings Invested in Financial Instruments
&nb
sp; (Percentage of GDP)
Bank Deposits*
Contractual Savings@
Shares & Debentures+
1994–95
6.5
3.2
1.7
2004–05
5.40
3.82
0.25
2007–08
7.83
4.84
1.49
2008–09
7.68
4.02
-0.04
2010–11
7.11
4.51
0.02
2011–12
6.07
3.30
0.20
2013–14
7.14
3.03
0.29
2014–15
4.86
3.49
0.46
*Includes bank and non-bank deposits; @Life Insurance, Pension and Provident Funds;
+Includes holdings in the UTI and other Mutual Funds.
Source: Central Statistical Organization as tabulated in RBI Annual Reports.
Clearly, household savers are still not sufficiently knowledgeable or comfortable about the risks involved in investing in stocks.
Liberalization and Indian Capital Market Crises
In the first half of the 1990s, government policymakers acted swiftly to effect game-changing reforms in Indian capital markets. In that era, reforms were well-conceived to set up a statute-based regulator and to enhance the credibility of market-infrastructure institutions such as stock exchanges. By 1994–95, the Narasimha Rao’s government had lost its appetite for reforms, probably because Rao preferred to appease special interests with an eye to getting a second term as prime minister. The short-lived coalition governments of Gujral and Gowda were too preoccupied with remaining in power to focus on effective governance let alone improvements of any sort. Highly significant reforms were implemented by Vajpayee’s government from 1999–2004, e.g. elimination of ‘badla’, introduction of derivatives and demutualization of stock exchanges. Manmohan Singh’s government from 2004–14 took incremental steps, e.g. amendment of the Securities Contract (Regulation) Act in 2007 to allow trading of securitized debt, raised investor protection funds and made PAN numbers mandatory for stock-exchange transactions. However, these ten years were a period of missed opportunities, for instance, in the tightening of market-integrity norms and increasing the depth of corporate-debt markets.