Emerging Capital Markets

Emerging Capital Markets: A Case Study of Equity Markets in India
Author(s): Farida Khambata and Dara Khambata

Source: The Journal of Developing Areas , Apr., 1989, Vol. 23, No. 3 (Apr., 1989), pp.
425-438
Published by: College of Business, Tennessee State University
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The Journal of Developing Areas 23 (April 1989) 425-438
Emerging Capital Markets:

A Case Study of Equity
Markets in India
FARIDA KHAMBATA and

DARA KHAMBATA
The purpose of this study is to review the growth and development

of the Indian equity markets. The study has been organized in nine parts.
The first part provides a general overview while the next two parts deal
with the legislative and fiscal framework and the role and operations of
the key institutional players. The demand, supply, and ownership struc-
ture of equity is presented in the fourth, fifth, and sixth parts, respec-
tively, and the characteristics of the primary and secondary market for
equities is provided in parts 7 and 8. The major conclusions of the study
are in the final section.
Indian capital markets played a major role in the mobilization of sav-
ings in the 1950s. Nevertheless, their importance diminished consider-
ably during the period from 1960 to 1980. During the same period
domestic savings as a proportion of national income increased substan-
tially from 13.7 percent in 1960-61 to about 22 percent in the mid-
1980s. While funds raised from the capital market amounted to 13
percent of net domestic savings in the 1950s, they amounted to less than
1 percent in the late 1970s, 0. 4 percent in the 1980s, and 4 percent in
1984 and 1985.'
There were two major reasons why capital markets did not play a sig-
nificant role in the financing of the industrial sector: first, commercial
banks and development finance institutions were able to provide priority
sectors of industry with the funds needed at a "below-market" cost; and,
second, equity was attractive to neither investors nor issuers. Through-
out the 1960s and 1970s there was little investor demand for equity as
Farida Khambata is Division Manager, Capital Markets Department, Intemnational Finance

Corporation, The World Bank; and Dara Khambata is Professor of International Finance,
Kogod College of Business Administration, American University, Washington, DC.
The opinions expressed in the paper are those of the authors and do not necessarily reflect
the views or policy of the institutions of which they are members.
? 1989 by Western Illinois University.

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426 Farida Khambata and Dara Khambata
the returns on shares were lower than those on government securities,

even before adjusting for risk. In addition, there was no liquidity in the
market. With respect to the supply of equity, few firms were willing to
be listed because of dilution of control, the tax consequences for wealth
tax and estate duty purposes, and a pricing policy which resulted in equity
being issued at well below market clearing price, especially for well-
managed firms.2
Today, the Indian government is clearly focusing on the importance
of moving toward a more market-oriented economy and developing the
capital market as a means of mobilizing funds for both the private and
public sectors. The market capitalization and number of listings of 21
emerging markets are presented in tables 1 and 2.
The Legislative and Fiscal Framework

The five basic pieces of legislation providing the framework for the
operations of the capital market are the Companies Act 1956, Securities
Contracts (Regulation) Act 1956, Foreign Exchange Regulation Act 1973,
Monopolies and Restrictive Trade Practices Act 1969, and Income-Tax
Act. Each is now summarized.
The Companies Act, 1956.3 The Companies Act sets forth with great
precision virtually every detail of the structure and legal functioning of
a limited liability company, from its inception to its eventual demise (by
merger or through liquidation, voluntary or otherwise).
TABLE 1
MARKET CAPITALIZATION: EMERGINC MARKETS
(US$ Billions)
1980 1981 1982 1983 1984 1985 1986

Brazil 20.0 12.6 10.3 15.1 28.9 42.9 42.1
Malaysia 12.4 15.3 13.9 22.7 29.2 20.0 15.6
India 6.0 8.4 8.0 8.5 7.9 15.0 19.8
Taiwan 6.1 5.3 5.1 7.6 9.9 10.4 15.4
Korea 3.8 4.2 4.4 4.4 6.1 7.4 13.9
Mexico 13.0 10.1 9.0 3.0 2.8 4.2 6.0
Jordan 1.6 2.5 3.0 2.9 2.2 2.8 2.8
Nigeria 3.1 3.0 1.5 2.9 3.2 2.6 1.1
Chile 10.3 7.1 4.4 3.0 2.1 2.0 4.1
Venezuela 2.7 2.6 2.7 2.7 1.8 2.0 4.6
Thailand 1.2 1.0 1.3 1.5 1.7 1.8 2.9
Argentina 4.0 1.4 0.9 1.4 1.2 1.4 1.6
Pakistan 0.7 0.9 1.1 1.2 1.2 1.4 1.7
Turkey - 0.8 0.9 1.0 0.9
Colombia 1.6 1.4 1.3 1.0 0.8 1.0 0.7
Philippines 2.1 1.7 1.2 1.3 0.6 0.9 2.0
Morocco 0.4 0.4 0.3 0.3 0.3 0.4
Zimbabwe 1.8 0.6 0.4 0.3 0.2 0.4 0.4
Ivory Coast 0.3 0.2 0.2 0.2 0.2 0.3
Kenya 0.5 0.4 0.3 0.2 0.2 0.2
Indonesia 0.1 0.1 0.4 0.3 0.1 0.1
Total emerging
markets 91.7 79.2 70.5 80.5 101.5 118.2 136.7
SOURCES: Morgan Stanley Capital International Perspective, 1986; Federation Interna-
tionale des Bourses de Valuers, 1986 Report; International Finance Corporation, Emerg-
ing Stock Markets Factbook, 1986.

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Emerging Capital Markets: India 427
TABLE 2
NUMBER OF LISTINGS: EMERGING STOCK MARKETS
1980 1981 1982 1983 1984 1985 1986

India 2,265 2,114 3,358 3,118 3,882 5,460
Brazil 614 614 607 593 608 541 592
Turkey 314 373 41
Pakistan - 311 326 328 347 361 361
Korea 352 343 334 328 336 342 355
Malaysia 249 252 261 271 278 222 289
Colombia 202 201 191 222 239 102 99
Argentina 277 262 247 238 236 227 217
Chile 265 242 212 212 220 228 231
Mexico 271 240 215 174 178 188 166
Peru 112 142 153 160 164
Philippines 193 192 200 184 149 138 128
Jordan 65 74 99 109 131 106 103
Nigeria 92 - 92 93 96 99
Thailand 80 93 84 85 89 100 98
Venezuela 73 73 73 73 91 108
Morocco 78 75 71
Zimbabwe 62 62 62 62 56 55 53
Kenya 55 55 55 55 55
Indonesia 6 9 14 18 24
Ivory Coast 25 26 26 -- -
SOURCES: IFC, Energing Stock Markets Factbook, 1986.
The Securities Contracts (Regulation) Act, 1956.4 The Securities Con-

tracts (Regulation) Act governs the regulation of stock exchanges, trading
practices, the buy and sell contracts traded on an exchange, and the
listing of securities. In each of these activities the government has reserved
the right to intervene and in practice does so actively. This results in a
curious blend of government intervention which, in some ways, protects
the existing structures and is inimical to true shareholder protection and
innovation in the system.
The chief provisions of the act are as follows:
1. While a stock exchange may be organized in any form by any num-

ber of members, only those exchanges specifically recognized by
the government are allowed to trade securities. There are presently
14 recognized stock exchanges, of which Bombay is by far the larg-
est and most important.
2. Options of any sort (put, call, or straddle) are prohibited.
3. With a few exceptions, for any issue to be listed at least 40 percent
of the total must be in the hands of the public. Nonresident Indians
and foreigners may not hold more than 50 percent of the equity of
a company, except in those cases where the company is a foreign
subsidiary or a joint-venture with an offshore partner.
The Foreign Exchange Regulation Act (FERA), 1947.5 The original

Foreign Exchange Regulation Act was passed as a temporary act in 1947,
at a time when virtually every economy was recovering from the effects
of World War II and similar legislation was prevalent throughout the
world. Since that time, however, the original act has been made per-
manent and the FERA legislation greatly expanded.
By nature any foreign exchange control legislation must be highly

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detailed, and FERA is no exception. The act enumerates controls on the

import and export of foreign currencies, gold and silver bullion, coins,
and jewelry; on the granting of import and export licenses; and on the
payment and/or receipt of dividends, interest, pensions, royalties, guar-
antees, legal fees, and life insurance policies into or out of the country.
As with all foreign exchange controls, the various types of bank accounts
permitted are listed-for residents and nonresidents, Indians and non-
Indians, corporations and individuals-as well as permissible and pro-
hibited transactions for each combination of these categories.
The Monopolies and Restrictive Trade Practices Act (MRTP), 1969.6 This
act was legislated with the stated purpose of regulating the mergers and
acquisition of companies in order to prevent situations of corporate
monopoly and restraint of trade. In many ways it is to domestic Indian
companies what FERA is to nonresident companies. MRTP has used a
licensing system (quotas on capacity and production) to control the growth
and expansion of companies falling within its purview.
The Income-Tax Act.7 As tax laws have a direct impact on investment
decisions, no discussion of the capital market is complete without ref-
erence to the fiscal environment. India's income-tax code is clearly and
succinctly stated and is no more pervasive than those of most other
countries.
All companies and individuals are assessed, without exception, for a
fiscal year beginning April 1. In determining total taxable income, no
distinction is made between earned and unearned income (i.e., wages/
salaries and interest/dividends/royalties/etc.), although agricultural income
is treated separately. Net short-term capital gains (holding period less
than three years) are considered income; net long-term capital gains are
treated separately, with gains being subject to deductions of 50 percent
for movable assets, and 60 percent for immovable assets before being
integrated into total current income.
While marginal tax rates were lowered in 1986 from over 70 percent
to 50 percent, they quickly reach a rather steep and exceedingly high
plateau of 50 percent for an annual income of US$8,000 (equivalent). As
for corporate income, the net profits of most companies are taxed at 50
percent. Net profits are calculated after deduction of depreciation at var-
ious rates corresponding to the nature of the asset.
It is axiomatic that high corporate taxation inhibits dividend distribu-
tion, which in turn discourages the investment of savings in the stock
market. In addition, since dividends are subject to double taxation,
wealthier shareholders subject to high marginal rates will prefer reten-
tion of profits by companies to the benefit of their own effective tax rate.
The accretion of reserves should lead to an appreciation of the value of
the share, allowing for potential capital gains taxable at a lower rate.
Institutional Framework
The Indian financial scene is dominated by government-owned finan-
cial institutions such as commercial banks and development finance insti-
tutions. The Controller of Capital Issues (COCI) in India plays a major
role in the pricing of new equity issues while the Unit Trust of India
has had, until recently, a monopoly in the establishment and operation

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of domestic mutual funds. Merchant banking is a relatively recent phe-

nomenon and comprises the packaging of securities and financial services.
The Capital Issues (Control) Act, 1947.8 Control of capital issues was
first introduced in 1942 to prevent the establishment or expansion of
those industries which did not assist in the production of war material
or necessary consumer goods. This control measure was not discontinued
after the war and has, with modifications, continued to this date. Capital
issues controls apply to capital publicly raised in excess of a specified
minimum. From 1945 to 1959, a firm required prior permission of the
controller only if it raised capital in any one year in excess of Rs500,000
(Rs13 = $1 in 1986). In 1985, this limit was raised from Rs5 million, set
in 1969, to RslO million where it currently stands.9
Merchant Banks. India does not possess a history of merchant or
investment banking similar to that of most Western economies and an
increasing number of developing countries with significant securities
markets (e.g., Brazil, Korea, Philippines, and Thailand). However, it has
been the growth in the equity markets during the past five to ten years
that has resulted in a need for merchant banks as packagers of securities
and financial services. Merchant banks have begun to proliferate-either
as distinct entities, or as part of the brokerage houses. Today, merchant
banking activities fall into three broad categories-those handled by (1)
merchant bank divisions of the commercial banks, both Indian and for-
eign (Grindlays, Chase Manhatten, State Bank of India); (2) large finan-
cial institutions (Industrial Development Bank of India, Industrial Finance
Corporation of India, Industrial Credit and Investment Corporation of
India, and the Unit Trust of India); and (3) stockbrokers or other
independents.
Merchant banking in highly developed capital markets includes much
more than issue management. While underwriting fees remain a major
source of income, increasingly a host of ancillary services are performed
on a fee basis. These services include feasibility studies, company for-
mation, syndication of project financings, working capital management,
tax consultancy, mergers and acquisitions, leveraged buy-outs, and ven-
ture capital.'0 At present, a key function of merchant banking in India
is issue management along with certain basic financial services such as
advice and follow-up.
The Unit Trust of India (UTI) 1963.11 The UTI dominates the Indian
capital market as a result of its monopoly status and its overwhelming
size compared to other private investors. The UTI was established by
special legislation in 1963 to act as the sole financial intermediary for the
sale and management of unit trusts (mutual funds) in India. UTI's initial
shareholders were the Reserve Bank of India (50 percent), the Life
Insurance Corporation of India (15 percent), the State Bank of India (15
percent), and assorted other public financial institutions (20 percent).
UTI is the only unit trust company in India, and it is assured of its
monopoly position by the terms of its enabling legislation. No other entity
may even use the words "unit trust as part of its name. At the end of
June 1985, UTI had a total of RS33.8 billion under management, of which
Rs9.26 billion was in equities or about 9 percent of market capitaliza-
tion.'2 UTI has established a total of 14 different funds ("schemes"), one

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of which has since matured and been liquidated. These funds are widely
distributed throughout every part of the country by some 12,500 com-
missioned salesmen (in addition to UTI's 660 full-time employees), each
fund seeking to meet the specific needs of a particular group of savers.
Demand for Securities

Probably the main reason for the sluggishness of the stock market in
the 1970s was the low return on equity. A study undertaken by Raol"
for the period from 1970-71 to 1978-79 shows that the total return (yield
plus capital gain) on equity was greater than 25 percent in only two
years, because capital gains were high in those periods. In all other years
the total return on equity was 10 percent or less, with the average annual
gross dividend yield in the 1970s being 6 percent. At that time the return
on alternative investments was about 8 percent for three-to-five-year bank
deposits and 10 percent for deposits over five years. The return on com-
pany deposits was 9 to 13 percent for one year, and 10 to 15 percent
for three years. Under these circumstances, equity was clearly not a pre-
ferred asset category.
The dividend performance of shares in the 1980-85 period, based on
a study of 417 companies undertaken by Industrial Credit and Invest-
ment Corporation of India (ICICI), is shown in table 3. From table 3 it
can be observed that the number of companies omitting dividends
increased by 38 percent between 1980 and 1985, while the number pay-
ing dividends between 10 and 20 percent also decreased. Interestingly,
companies paying dividends in excess of 25 percent have remained
remarkably constant throughout the period.
A 1980-85 study'4 based on 3,000 listed companies shows that the total
pretax return from equity to the investor averaged only 13 percent per
year while debentures provided a guaranteed return of 15 percent per
year. Only about 100 of the 3,000 listed companies registered an appre-
ciation of over 15 percent per year. In the 1980s, as in the previous
decade, the overall return on equity was lower than that on short-term
fixed income instruments even before adjusting for risk. In both periods
TAB LE 3
FREQUENCY DISTRIBUTION OF COMPANIES ACCORDINC TO ORDINARtY DIVIDENDS
AS A PERCENTAGE OF ORDINARY PAID-IN CAPrrAL
(1980-81 to 1984-85)
RANGE OF DIVIDENDS NUMBER OF COMPANIES

(In Percentages) 1980-81 1981-82 1982-83 1983-84 1984-85
No dividend 86 76 99 112 119
0.1-5.0 7 5 8 4 8
5.1-10.0 38 49 49 61 46
10.1-15.0 131 118 103 100 102
15. 1-20.0 117 132 114 90 100
20.1-25.0 30 29 36 39 34
25.1 and above 8 8 8 11 8
Total 417 417 417 417 417

SOURCE: The Industrial Credit and Investment Corporation of India Limited (ICICI),
Financial Performance of Companies, ICICI Portfolio, 1984-85 (Bombay, India: ICICI,
May 1986).

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a small group of shares did phenomenally well. In the 1970s they com-
prised multinationals and companies belonging to the large industrial
houses (Tata, Birla); in the 1980s the best performing shares were the
specified shares or those where delivery could be carried forward to sub-
sequent settlement periods. It was this small group of shares that were
very heavily traded and were responsible for the stock market boom of
1980-81 and 1984-86. Apart from a short period of total stock market
euphoria in late 1985, when anything sold, investor interest concentrated
on only a very small number of shares, around 3 to 5 percent of the
market, and resulted in highly volatile stock market movements.
Supply of Securities
The supply of corporate securities comprises newly issued and existing
securities. The former results in additional resource mobilization through
the securities market,'5 while the latter represents a transfer of resources
among the shareholding public. In the Indian context, resource mobili-
zation takes place primarily through rights issues for existing companies
and new listings for companies entering the market for the first time.
Bonus shares, resulting from retained earnings or revaluation of fixed
assets, and secondary offerings of shares (for ownership restructuring or
other purposes) do not involve additional resource mobilization from a
strictly economic point of view but do affect the mobility of capital and
the supply of corporate securities.
As of December 1986, 5,460 companies were listed on the Indian stock
exchanges as against 1,203 companies in 1961."' This is a higher number
than in any other emerging market (Brazil is next with 608 companies)
and compares favorably with most mature markets.
Despite the limited availability of equity of established well-run com-
panies and the considerable demand for it, closely held companies have
been unwilling to go public for a variety of reasons. First, the effective
cost of equity is significantly higher than it is for debt, and dividends
are paid out of posttax profits while interest on loans is tax deductible.
In addition, loans by development finance institutions (DFIs) to priority
sectors have been at subsidized rates. Earlier, the DFIs required a 1:1
debt-equity ratio for industrial corporations, which was subsequently raised
to 2:1 for most companies. Most companies could meet their funding
requirements from long-term borrowing from DFIs. In addition, most
companies found corporate deposits from the public a more attractive
way of mobilizing funds since they carried no restrictive provisions. The
public found such deposits to be an attractive investment owing to the
high interest rate offered and the short-term maturity. The corporate
deposit market is estimated at RslO billion, with the typical interest rate
paid on a three-to-six month deposit being 16-17 percent per year.'7
Second, for family-controlled operations there has been an unwillingness
to enlarge the capital base by going public for fear that dilution of share-
holding would result in a loss of control and on account of tax implica-
tions. For a listed company the market valuation of equity is taken for
wealth tax and estate duty assessments, while for nonlisted companies a
break-up or net asset value is taken. For well-managed companies, the
net asset valuation is normally much lower than the market valuation.

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Third, the terms and conditions set by the Controller of Capital Issues
(particularly regarding the pricing of issues) act as a damper on going
public. Fourth, in addition to pricing procedures other government pol-
icies have also been unintentionally responsible for the paucity of suit-
able stock. Since banking, insurance, utilities, and local authorities are
entirely in the public sector as is a large portion of industry, these stocks
are not quoted on the market. In addition, MRTP legislation has, until
recently, prevented existing well-established companies from expanding
or diversifying. Finally, the supply of corporate securities might be sub-
ject to a crowding-out effect resulting from the issue of public sector
debt securities with special features with which the private sector could
compete.
Ownership Pattern for Securities

The guidelines for public issues stipulate as wide a distribution of secu-
rities as possible. The general public also participates indirectly through
UTI and the insurance companies. Furthermore, there are nearly 8 mil-
lion individual shareholders-largely but not exclusively in the cities-
which is the largest number of any developing country. Still, only 13
percent of all shares in the survey were held in holdings of Rs5,000 or
less. In actual fact, it is estimated that institutional investors own close
to 50 percent of private sector companies, leaving only 40 percent for
both major individual shareholders ("controlling interests") and the gen-
eral public.18
An analysis of the broad ownership pattern of corporate equity is indi-
cated in table 4. It shows that individuals are the major shareholders in
the equity of private sector (with 39 percent) and joint stock companies
while the financial institutions own approximately 28 percent of each.
The New Issues Market

Volume of Funds Mobilized. For the 35 years ending in 1985, capital
issues by the private corporate sector totaled Rs7.2 billion.'9 While his-
torically capital markets have played a relatively minor role in the mobi-
lization of capital for the private sector, a dramatic change occurred in
1980-81 and then again in 1984-85, as indicated in table 5. The total
volume of resources mobilized through the capital market over the 5
TABLE 4
OWNERSHIP PATTERN OF EQUITY IN COMPANIES
(In Percentages)
All Private Joint Public

Sectors Sector Sector Sector
Individuals 31.0 38.7 35.5 10.3
Financial institutions 24.7 27.3 28.5 16.1
Governmental and
semigovernmental bodies 20.4 1.0 19.5 64.7
Joint stock companies 22.2 30.9 14.5 8.4
Trusts and charitable
institutions 0.3 0.4 0.1 0.1
Other 1.4 1.7 1.9 0.5
SOURCE: The Industrial Development Bank of India (IDBI), Ownership Pattern of Shares
and Debentures of Assisted Companies (Bombay, India, 1985).

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TABLE 5
CAPITAL RAISED THROUGH SECURITIES MARKET
(Rs Millions)
1980 1981 1982 1983 1984 1985

Equity 600 2,050 2,380 2,420 3,520 6,440
Debenture 695 2,088 4,004 5,911 9,639 12,450
Total 1,295 4,138 6,384 8,331 13,159 18,890

SOURCE: Government of India, Ministry of Finance, Controller of Capital Issues, Quar-
terly Statisticis (Delhi: Government of India, 1980 to 1986.
years from 1980 to 1985, increased 14-fold and more than doubled over
the 2-year period, 1983-85. While the volume of equity mobilized through
the market showed a steady increase over the period from 1980 to 1985,
there were two periods of particularly rapid growth: between 1980-81,
when the volume of equity mobilized increased by 242 percent; and
between 1984-85, when it rose by 83 percent. The debenture market
also underwent two periods of particularly rapid growth: between 1980-81,
when the debenture market grew by 200 percent; and between 1983-84,
when this market grew by 63 percent.
Characteristics of New and Existing Capital Issues. Table 6 shows the
allocation of equity between new and existing issues. While in 1979-80
over half the equity mobilized in the capital market use for existing firms,
by 1984-85 newly established firms (new issues) accounted for about 70
percent of the funds mobilized, a very high figure in comparison with
most industrialized and emerging markets. The increase in new issues
reflects the generally buoyant secondary markets during the period 1982-85.
Other factors encouraging firms to come to the market have been the
modification in both the listing requirements and the issue of bonus shares.
Pricing of Public Issues. The pricing of public issues is determined by
the COCI. It currently employs three formulas, as follows:20
1. All issues of new companies are priced at par;
2. Shares of widely held listed companies are priced by means of for-
mula which considers par value, net asset value, and market value;
and
3. Closely held companies going public for the first time are valued
by considering the book value net of revaluation of assets, and cap-
italizing the last three years' after-tax profit assuming an effective
tax rate of 50 percent irrespective of the actual rate paid.
TABLE 6
ALLOCATION OF EQUITY BETWEEN NEW AND EXISTING ISSUES
(In Percentages)
1979-80 1980-81 1981-82 1982-83 1983-84 1984-85

New issues 41.1 45.1 60.5 63.0 60.1 69.8
Existing issues 58.9 54.9 39.5 37.0 39.9 30.2
Total 100.0 100.0 100.0 100.0 100.0 100.0

SOURCE: D. R. Mehta, "Recent Capital Market Developments in India" (Paper delivered
at the Regional Symposium on Capital Market Developments in Asia Pacific Region, Asian
Development Bank, Manila, Philippines, 14-16 January 1986).

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In each case, the requisite formula is applied to historical data with

no account being taken of factors such as future earnings potential, type
of industry, or management capabilities.
Cost of Public Issues.2" The cost of public issues is extremely high in
India and has ranged between 5 and 10 percent over the period
1978-84 for new companies and between 10 and 17 percent for existing
companies.
The Secondary Market

The Organization and Structure of the Stock Exchanges. Stock
Exchanges in India are regulated under the Securities Contracts (Reg-
ulations) Act, 1956. At present there are 14 recognized stock exchanges
in the country. Each stock exchange operates within the framework of
its rules, bylaws, and regulations, which are approved by the govern-
ment prior to granting recognition. The stock exchanges in India are con-
stituted either in the form of a voluntary, non-profit-making association,
or as a public limited company, or as a company limited by guarantee.
Each stock exchange is managed by a governing body, principally com-
prising elected members; the president of the stock exchange is a mem-
ber elected by the governing body. The executive director, appointed
by the governing board, is subject to approval by the Ministry of Finance.22
The Bombay Stock Exchange is the oldest exchange in India and was
the first to be granted permanent recognition under the 1956 Act. It is
the largest, accounting for 60 percent of total Indian market capitalization
(exclusive of double listings), which amounted to US$15 billion at the
end of 1985 and is estimated to have reached US$18 billion by March
1986. There are approximately six million individual shareholders for
companies listed on the Bombay Stock Exchange, with ten companies
each having over 100,000 shareholders. Bombay accounts for over 60
percent of the market value of listed stocks and of secondary market
dealings. In terms of volume, the market is highly concentrated: ten
companies account for 80 percent.23 Although, as permitted by the con-
stitution, the Bombay Stock Exchange has 504 members, there are only
290 active members.
Stock Market Indices. Two indices are commonly used to indicate trends
in the equity market-the Financial Express Index and the Reserve Bank
of India Index.
1. The Financial Express Index, which is published daily, is based on
the price movements of 100 stocks using 1979 as the base year.
Each security is assigned a weight based on its outstanding market
value and the frequency with which it is traded. The index is cal-
culated using the weighted average of the market price to the aver-
age market price for all stocks in the index.
2. The Reserve Bank of India Index, which is published weekly, is
computed on the basis of 356 stocks. The base year is 1970-71 and
the index is calculated on the basis of weights assigned to various
industry groups.
Information on Stock Market Operations. 24 In general, the data

available on stock market operations are limited. Only 3 of the 14

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exchanges collect data on the volume of transactions. The data on the

pricing of trades are limited and often incorrect, which casts doubts on
the credibility of the exchange. Korea faced similar problems prior to
computerization.
Settlement Procedures. While the primary capital market is growing
rapidly, the secondary market has not kept pace with the growth in the
primary market, resulting in poor liquidity for the vast majority of shares.
It is estimated that the daily volume of trading in the secondary market
in the recognized stock exchanges is likely to have gone from an esti-
mated average of Rs1O million in the 1960s and about Rs5O million in
the 1970s to Rs700 million in the mid-1980s.25 Given this sharp increase
in the volume of securities traded, the settlement procedures will have
to be changed if the securities market is to continue operating.
Insider Trading. The Indian stock market is distinctive on account of
the total absence of regulations or sanctions regarding insider trading.
In theory, the executive director, who is an employee of the stock exchange
and is appointed by the governing board and approved by the govern-
ment, is responsible for seeing that members of the stock exchange do
not engage in insider trading. Since insider trading is carried out by
members of the stock exchange board and the stockbrokers themselves,
there is almost no attempt at curbing it. Even if insider trading is found
to be occurring, no legal sanctions can be imposed.26
Summary and Conclusions

On fundamental characteristics such as price earnings ratios and yield
the Indian equity market is on a par with markets like the Netherlands
and Sweden. Given a market capitilization of US$15 billion, it compares
with smaller markets in Europe. Like Japan, Korea, and other countries
before it, India has decided to begin opening its securities markets to
international portfolio investment by means of a phased liberalization
program.
In order to streamline and improve the efficiency of Indian equity
markets, a number of issues need to be resolved. At present the pricing
of public issues is determined by COCI. All issues of new companies
are priced on the basis of a formula using only historical data without
considering future earnings potential. The issue price for well-managed
companies is almost always below the market clearing price, and leads
to a windfall gain for those allotted the new issue.27
Despite the presence in India of international accounting firms, nowhere
have generally accepted accounting principles been fully codified. As a
result, many areas, particularly those of inventory evaluation and depre-
ciation rules, are notably weak or ambiguous. This situation not only
creates outright abuses (as in the depreciation for leasing companies), but
more insidiously serves to confuse both investors and the company's
managers.
The archaic settlement system is incapable of dealing with the sharp
increase in trading volume. A centralized depository system is imperative
for the functioning of the markets. At present, organizationally and
functionally, the numerous stock exchanges are independent of each
other and there is no apex body that integrates their functions. This

180.179.211.146 on Tue, 11 Apr 2023 09:36:21 UTC
encourages speculation and prices vary from center to center. Not only
a centralized quotation service, but a credit rating agency is needed to
provide guidance to investors by differentiating between market
participants.
NOTES
'These figures have been computed on the basis of data provided by the Bombay Stock
Exchange.
2S. S. Mehta, and R. M. Honavar, "Some Aspects of the Indian Capital Market"
(Industrial Credit and Investment Corporation of India, 1985).
3U. K. Bhargava, and B. P. Bhargava, eds., The Companies Act, 1956 (Bombay, India:
Taxmann Publishing Co., 1982).
4Government of India, The Securities Contracts (Regulation) Act, 1956 (Bombay, India:
The Stock Exchange, 1985).
5Roy, ed., Foreign Exchange Regulation Act of 1973 (Calcutta, India: Kamal Law House
Publishers).
6Government of India, The Monopolies and Restrictive Trade Practices Act, 1969 (Act
#54 of 1969).
7U. K. Bhargava, and B. P. Bhargava, eds., Income Tax Act (Bombay, India: Taxmann
Publishing Co., 1985).
8K. V. Shanbhogue, and K. Ganesan, Wade Guide to Capital Issues and Listings (Bombay,
India: Wadhwa and Co., 1986).
9D. R. Mehta, "Recent Capital Market Developments in India" (Paper delivered at the
Regional Symposium on Capital Market Developments in Asia Pacific Region, Asian
Development Bank, Manila, Philippines, 14-16 January 1986).
'?"The Money Merchants," Business India, 24 September-7 October 1984, pp. 83-88;
and A. Ganguli, "The Merchant Banker," Fortune India, February 1985, pp. 35-36.
"Government of India, Unit Trust of India Act, 1963, and the General Regulations,
1964.
"2International Finance Corporation (IFC), Energing Stock Markets Factbook, 1986; Unit
Trust of India, 21st Annual Report '84-'85 (Tata Press Limited).
"3D. C. Rao, "Structure of Corporate Finance and Some Related Issues," Reserve Bank
of India, Occasional Papers 1 (December 1980): 131.
'4R. Piperaiya, "Share Prices: A Five-Year Perspective," Fortune India, December 1984.
'5This increase in financial savings may not be the same as savings mobilization, since
a part may come from other forms of savings (e.g., branch deposits, investment in hous-
ing, real estate, etc.). However, a portion is likely to be a substitute for consumption,
capital export, and money floating in the "underground" economy.
'6Data provided by the Bombay Stock Exchange; IFC, Emerging Stock Markets Fact-
book, 1986.
'7Estimate provided by J. M. Financial and Investment Consultancy Services Private

Limited, Bombay, India.
'8The Industrial Development Bank of India (IDBI) undertook a survey of the security
holdings of companies it had assisted. Information was sought from 773 companies; 447
companies responded, forming the sample for the study.
"9Government of India, Ministry of Finance, Controller of Capital Issues, Quarterly

Statistics (Delhi: Government of India, 1980-86).

180.179.211.146 on Tue, 11 Apr 2023 09:36:21 UTC
2ODiscussions with J. M. Financial and Investment Consultancy Services Private Lim-

ited, Bombay, India.
2"Estimates based on discussions with and data provided by the Industrial Credit and
Investment Corporation of India and J. M. Financial and Investment Consultancy Services
Private Limited.
'The Stock Exchange, Bombay, The Stock Exchange Rules, Bye-Laws, and Regulations
(Bombay Stock Exchange, 1957).
23Data provided by Bombay Stock Exchange.

2ADiscussions with M. R. Mayya, Executive Director, Bombay Stock Exchange.
'Data provided by Bombay Stock Exchange.
'Final Report of the High Powered Committee on Stock Exchange Reforms, 1986. The
committee, which was appointed by the Government of India, was headed by Mr. G. S.
Patel.
2'Final Report of the High Powered Committee on Stock Exchange Reforms, 1986.

180.179.211.146 on Tue, 11 Apr 2023 09:36:21 UTC
438 Fanda Khambata and Dara Khambata

180.179.211.146 on Tue, 11 Apr 2023 09:36:21 UTC

Emerging Capital Markets

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Emerging Capital Markets: A Case Study of Equity Markets in India

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