2014-12-31

                   Resource Mobilization 2: Capital Markets

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Resources can be mobilized either for short term or for long term. Economy consists of huge number of enterprises and individuals, requirements of all of them differ. Some have surplus cash to save, while some other needs cash. Some firms/individuals wants to make good there short term liquidity requirements, some wants money for long term capital investment. So distinction can be made as to period for which one intends to lend or borrow. In this sense financial market is categorized into money market and capital markets. In Money market, period involved (for funds movement) is 1 year or less, while in capital markets period is generally more than 1 year.  Banks basically caters to money market and mobilizes resources from savers to borrowers (this is because distinguishing feature of a bank is to accept deposits and open current accounts). But, it plays significant role in capital markets too, as it lends for capital investment purposes. As economy of the country grows, highly specialized institutions comes up which caters exclusively to capital needs and banks continues its money market business. These institutions are known as Capital Market intermediaries.

These are intermediaries like insurance companies, housing finance companies, pension funds, and investment funds etc. which mobilize savings and fund long term investments.

Now again, person having surplus money for long term may be willing to ‘lend’ or to ‘invest’. This forms distinction between debt and equity. In former, lender will get fixed return and in latter investor will get share of his profit. These are invested through different type of intermediaries as per interest of lender, may be mutual fund, debt fund, stock market etc.

In financial market, financial assets are created such as debenture, shares, bonds etc. Financial Assets represent claim of their holder over certain asset with certain quantity. This claim arises because of a contract between two parties e.g. lender and borrower or buyer and seller. In the first place, these are created when fresh money is raised in the market (either through debt or equity). These instruments, after being issued could be traded like anything else and they have their market. Now there are again distinctions between primary and secondary markets. Markets in which fresh funds are raised are primary and in which financial assets are traded are called Secondary markets.

What are Financial Markets?

Financial market is a market where financial instruments are exchanged or traded and helps in determining the prices of the assets that are traded (also called the price discovery process). These facilitate trade in financial assets by providing platform for coming together of buyers and sellers or Borrowers or Lenders.

Financial markets may be classified on the basis of -

debt and equity markets

money market and capital market

primary market and secondary market

Indian Financial Market consists of the following markets:

Capital Markets

Primary capital market

Whenever a company raises fresh capital or debt, it does so by ‘initial public offer’ (IPO). Already listed company can again raise capital by ‘follow on public offer’ (FPO).

Secondary capital market

Shares which were issued in primary market remains listed on stock exchanges and are traded. Share prices move in accordance with Market Sentiment, Economic and Political stability, and fundamentals of particular company.

Stock Exchanges

Both these activities are facilitated by Stock exchanges. In layman terms stock exchanges are ‘markets’ (or mandis) where prospective buyer and seller meets and item traded is Shares, debentures, bonds etc. In early days, there was physical interface between two parties; there were mediators in stock exchanges, which for a commission used to negotiate the deal. Lot of buyers would come and make bids for purchase and on other hand there would be sellers with financial assets, attempting to sell at highest possible price. When difference between selling and buying bid is eliminated, deal is done. Mediators used to shout bids for their clients. This was known as open outcry system.

The Bombay Stock Exchange (BSE), the oldest and the largest stock exchange in India. Historically, it traded for two hours in a day with an open outcry system. The exchange was managed in the interests of individual members, a majority of whom had inherited their seats. A large proportion of stocks listed on the exchange were not actively traded. There was minimum supervision from the exchanges and speculation (satta) was rampant.

It was in 1992 that in pursuance of LPG reforms that the Stock Exchanges were reformed. These reforms were on the back of Legal provisions and technology.

One landmark legal reform was passage of Securities and Exchange Board of India Act, 1992, which created an apex independent regulator for capital markets. Earlier, everything was under Finance ministry, which resulted in consistent interference. Apart from this, earlier companies have to get their issue price approved by finance ministry. With reforms, this control was also done away with.

Apart from this, Transactions were now settled in a separate ‘Clearing House’ (as Cheque is cleared in banking separately) which earlier was done mutually between members. Perhaps, most effective reform was ’dematerialization of Securities’ which means conversion of securities from physical to electronic form. In those days there were physical proofs such as Share Certificates which has to be transferred in name of purchaser. This involved lot of time, efforts and also, stamp duty. In electronic form, securities (share, debentures etc.) are held by ‘depositories’ on behalf of actual owners. Two depositories in India are NSDL and CDSL. So trade is handled by Stock Exchanges which have designated brokers like Karvx, Parsavnath etc. These brokers have account with depositories and interface with prospective buyers and sellers. A person willing to trade in securities has to open a ‘demat account’ in Depository with help of broker. As soon as he buys any security, it is transferred to this account.

Now there is highly sophisticated electronic and online trading system in plane. There is real time transfer of market, industry and stock specific information across the country which removes information asymmetry and ensure level playing field.

National Stock Exchange (NSE) is only other national Stock exchange apart from BSE and there are numerous other regional exchanges.

In every country, biggest international stock exchange is located in its financial capital. E.g. New York Stock Exchange, London Stock Exchange, Tokyo Stock Exchange, Shanghai Stock Exchange.

Another important point is that in post liberalization period, there enormous interface in global capital markets. India allowed Foreign Institutional Investors to invest in Indian Markets and FII flows now are its back bone. Many Indian companies have raised funds from outside India via. Global/American Depository Receipts

In present times stock markets indicate health of an economy. They are primary means of mobilization of long term savings and investment and fixed capital formation. Further, when volume of trade in markets is significant, it leads to transparent price discovery. As we have read, funds can be raised either as a debt or as equity. Stock Exchanges enable and facilitate businesses to raise funds predominantly through equity. Forces of market (demand and supply) constantly interact and this results in fluctuating prices. There is huge army of stock analysts who keep eye on price movement, fundamentals of company and related industry, and health of national and world economy. This way they try to find out intrinsic value of a share. Normally, Investments flows into shares which are priced lower than their intrinsic value.

Further, Stock Markets, by providing ready secondary market for long term investment shares, gives investors an option for easy exit from the industry. At the same time it provides avenues for entry of new investors. For example, few year back significant shares in Essar telecom was acquired by Hutchison, and then it was sold to Vodafone. Listed shares make it easy for transactions to take place.

To gauge movement in the market is not an easy task. There are thousands of shares listed and they move in different quantum and may be in different directions. So how would we know how overall stock market is performing? For this there are indices which represents broader trend of the market.

Stock Indexes

Sensex is one such index which is weighted average of 30 stocks (listed on BSE), which have highest market capitalization (MC). MC practically means market value of equity of the company (no. of equity share issued multiply by Market price of Share). When we are told that Sensex is up, then it means these 30 shares have gone up together. It’s same concept like determining Inflation rate, or Index of Industrial production.

Similarly there is Nifty-50 for NSE stocks which represent weighted average of best 50 stocks. There are also sector specific indices, such as IT sector Index, Cement, Iron & Steel, Real Estate etc. these indices tells performance of companies in that sector put together.

Confidence of the investors in the market is imperative for the growth and development of the market. For any stock market, the market Indices is the barometer of its performance and reflects the prevailing sentiments of the entire economy. Stock index is created to provide investors with the information regarding the average share price in the stock market. The ups and downs in the index represent the movement of the equity market. These indices need to represent the return obtained by typical portfolios in the country.

Stock market allows trading of diverse ‘Capital Market Instruments’. These instruments are used to lay claim over specified financial asset. Some of the capital market instruments are: Equity, Preference shares, Debenture/ Bonds, ADRs/ GDRs, Derivatives.

What are derivatives?

A derivative is an instrument which derives its value from an underlying asset.

Different people have difference ‘perception’ about movement of prices of financial asset in future. This provides them avenue for speculation and exploit potential created by current price and expected price.

For example a person can buy an ‘option’ to buy a specified asset, on specified future date and at a specified price. Say some share is currently priced at Rs. 25 and Mr. X expects it will touch 30 rights after 1 month. He, based on his perception will buy an option to buy this share at Rs. 25 next month. As the date approaches and actual price of Rs. 25 will move. Any movement will create a value of this contract as (either negative or positive) as he has ‘right but not obligation’ to buy at Rs. 25, whatever may be the rate.

This is example how derivative instrument gets its value and is traded separately on stock exchanges. There are many such instruments like Futures, forward contracts etc.

One may ask that why doesn’t Mr. X buy that share itself to exploit possible profit? Buying share will require him to invest Rs 25, but in case of option he’ll pay small premium while entering into deal and he’ll directly get profit on final date.

It should be noted that these contracts are standardized by exchanges and then sold as products. It’s not like for every individual investor brokers try to chart a separate deal.

A derivative picks a risk or volatility in a financial asset, transaction, market rate, or contingency, and creates a product the value of which will change as per changes in the underlying risk or volatility.

Derivatives can be derived from Shares, Commodities, Foreign Exchange, and Interest rate Differentials. Practically it also can be done from cricket/football matches or even from uncertainties of climates

For commodity derivatives there is National Commodity and Derivative Exchange (NCDEX), Multi Commodity Exchange (MCX) and National Multi Commodity Exchange (NMCE). Read about Its role in Agriculture here

For Regulation of commodity derivative market Forward Market Commission acts as apex regulator.

Securities and Exchange Board of India (SEBI)

SEBI was enacted in 1992 in accordance with the provisions of the Securities and Exchange Board of India Act, 1992 to ‘protect the interests of investors’ in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto. It is quasi legislative, quasi-judicial, quasi administrative body.

Time and again there have been Scams in stock exchanges like Harshad Mehta Scam, Ketan Parekh Scam ore more recent one Satyam Scam. In all these scams lakhs of genuine investors lost their hard earned money. With every such failure SEBI has emerged stronger with plugging up the loop holes. But even today, participation and trust of common man in markets is wavering. It is general perception that only upper few blue chip companies are governed genuinely observing all disclosure requirements and other regulations. In other lesser known companies, manipulation of the stock prices by insiders (promoters, directors and auditors) is rampant. In fact, Satyam before revelation of scam was one of the best performing blue chip stock. But all this was happening on the basis of falsely cooked up books and auditors were party to this manipulation. Indian laws don’t provide stringent punishment for frauds committed in the markets. It is ironical that Raju Ramalingam’s revelation about Satyam fraud and subsequent collapse in share prices, claimed lives of few people who committed suicide and Raju is out on bail. In contrast, US laws are very stringent in this case. It was observed in case of Rajat Gupta and Raj Rajanatnam, who were American citizens are sentenced for life terms longer than 20 years. This is just because they were accused of indulging into ‘insider trading’; in this case effect on market doesn’t matter. Insiders are people who are supposed to have access to ‘price sensitive unpublished information’ of a company. These people are Directors, Promoters, Auditors, Secretaries etc. If they trade (buy or sell) in shares on basis of such information, that will be called insider trading.

When a company is listed, its shares are open for trading for anyone. So sovereignty of promoter, directors etc. is substantially curbed. Practically, owner of the company can be anyone, and these owners (shareholders) gather at annual general meet of the company to appoint new directors by voting. One share carries one vote. Promotors, like Ambanis for Reliance hold majority shares in their companies, so in effect will of Ambanis prevails and they end up keeping top position for themselves. Now every decision, they have to make shall be in interest of these investors at large and company. Stock prices fluctuates due to three reasons I.e. Macro-Economic events , Industry specific events and Company specific events. Information about former two generates outside premises of the company, but in last case it’s the company which generates the Information. Any price Sensitive information may trigger the selloff, if its bad news or reverse may happen in case of good news. So insiders being in position to influence, retain, block such information may cause harm to investors at large for their personal gain.

SEBI strives to provide level playing field for insiders and outsiders and hence insider trading is prohibited. Sometimes promoter creates artificial demand by overinvesting in their own shares, seeing good performance of those shares public at large starts investing and then insiders pull the plug by selling their investments at high prices.

Despite of SEBI’s relentless efforts such things are not uncommon in Indian Markets. SEBI apart from making general rules for whole market maintains a strict vigil of individual companies based on information received by it through complaints and disclosure.

SEBI’s basic functions –

Regulates Stock Exchanges.

Registering and regulating the working of intermediaries like stock brokers, sub-brokers, share transfer agents, bankers to Issues and other such persons involved in share market.

Registering and regulating Collective investment schemes, mutual funds, venture capital funds etc.

Prohibiting fraudulent and unfair trade practices relating to securities markets

Prohibiting insider trading in securities

Promoting investors’ education and training of intermediaries of securities markets.

Controls and regulates FIIs

Ensure Corporate Governance

Every company willing to get listed has to enter into a ‘listing agreement’ with SEBI, in which company agrees certain terms and conditions in Interest of investors. Clause 49 of ‘Listing agreement’ is specifically directed towards ‘Corporate Governance’ for it requires companies to appoint certain independent directors.

Recently, by Securities Laws (amendment) bill, powers of SEBI over collective investment schemes were increased. It was given authority to attach properties of non-complaint companies. This was related Saradha Scam.

In Sahara case, it came out that SEBI has power to regulate any company which issues and security. Prior position was that it only had powers over listed companies.

Corporate Governance

What is corporate governance?

CG concept holds that company should not ignore interest of its any stakeholder. Main stakeholders are investors, employees, government and society at large.

Investor’s interest: Better Returns, Transparency & accountability in business, secure future of company.

Employees Interest: Regular salaries, good working conditions, Career progress potential and social status.

interest: Regular payment of taxes, Compliance with laws & rules, Non indulgence in anti-national activities.

Society’s Interest: generation of employment, less pollution, efficient utilization of scarce resources, Healthy & affordable products etc.

SEBI’s role in safeguarding interest of investors and curbing malpractices is significant from point of view of Corporate Governance.

Apart from this Companies act, 2013 too gives sound stress on CG – It provides for appointment of Independent directors, Regulates remuneration of directors, Internal Audit Committee, increases responsibility and penalties of auditors and provides that atleast 1 director should be woman.

New companies act also introduced mandatory Corporate Social Responsibility clause. Every company having net worth of rupees five hundred crore or more, or turnover of rupees one thousand crore or more or a net profit of rupees five crore or more during any financial year shall constitute a Corporate Social Responsibility Committee of the Board consisting of three or more directors, out of which at least one director shall be an independent director.

They also need to formulate a CSR policy which should be continuously monitored. Company should spend for CSR, minimum, 2% of its average net profit during previous three years.

Two main committees for corporate governance in past were – Kumar Manglam Birla Committee in 1999 and N.R. Narayan Murthy Committee in 2002. Read here and here

Mutual Funds

Different shares in the market carry different kind and degree of risks. So an investors instead of putting all eggs in one basket, diversifies its portfolio. He attempts to minimize his risk and maximize return by investing in both debt and equity and further within equity, he picks up various sectors – infra, textile, IT, Cement, Housing, banking etc.

A normal investor often faces information constraints and fails to get an adequate portfolio. For this purpose there are ‘Asset Management Companies’ which forms a fund by issuing units to the public. These units are just like any other instrument – shares or debentures. Public purchases these units and money reaches AMC. Now this AMC is manned with financial market experts and they will invest this money in different sectors so as to maximize returns and minimize risk. As profit from different investment flows value of units of mutual fund increases. These units are also traded on stock exchanges.

The mutual fund industry in India was started in 1963 with the formation of Unit Trust of India (UTI), at the initiative of the government of India and Reserve Bank. The history of mutual funds in India can be broadly divided into different phases. In the first phase UTI has enjoyed the status of monopoly in the mutual fund industry. In the second phase some public sector mutual funds set up by the public sector banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC) were launched besides the UTI. In the third phase, which started in 1993, the government allowed private players to offer mutual fund schemes giving the Indian investors a wider choice of fund families.

Corporate Debt/bond Market in India

As we have read, resource for investment can be either mobilized in form of either Equity or Debt. Foregone discussion was for equity. Any business prefers to get financed first from internal sources like profit from its own operation, or capital infused by its owners. Second comes the debt and equity is preferred only if debt is unavailable. This is because equity gets ‘share of profit’ in return, while debt is entitled only to fixed interest. Normally, former is significantly higher than latter. So all over the world cooperate bond markets are well developed. In this corporates raise equity, not by issuing shares, but by debentures or bonds, on which investors/lenders will get fixed rate of interest. In India government bond market is well developed and it has been financing its fiscal deficit by such bonds, but corporate bond market is quite laggard.

In India, the Government bond market has experienced a steady growth over the years due to the need to finance the fiscal deficit. The Government bond market, which is around 39.5 per cent of GDP in end-2010 in India compares favourably to most other Asian countries. The corporate bond market on the other hand is just 1.6 per cent of GDP in end-2010 and small in relation to the economy’s size. From 2008 to 2010 corporate bond market in India in value terms grew from $7.85 billion to $24.99 billion. In comparison to other countries such as South Korea ($380.62 billion) and China ($ 522.09 billion), the Indian corporate bond market appears to be under-developed. The under development of the corporate bond market in India is not incidental and is mainly attributable to the structure of the Indian financial system and regulatory structure.

Currently corporates and business get majority (almost all) of the lending from banks. Banks are exposed to numerous other risks. If bank’s credit is exposed to a bad company (say kingfisher) than any default by that company (in repayment) can cause harm to depositor, who otherwise wouldn’t have opted to get exposed to this bad company. So Corporate bond market provides investors option to choose their risk and return. It also leaves finance with bank to lend to more socially productive ventures. Last but not least, a company with good reputation can get cheap finance for its expansion as this is directly from public and ‘middleman’ bank is eliminated. By same logic, investor will also get somewhat better deal. For corporate debt market to develop, it is imperative that regulatory mechanism is strengthened at very first place.

Corporate bonds markets too have primary and secondary distinction.

Mobilization of Small Savings in Investment

Foregoing discussion was related mobilization of savings under which central objective of savers is just to invest and increase their wealth. There are other forms of savings under which small denominations of savings gets together to form significant investment figures. These are mainly Insurance, Provident fund and pension Savings (also called contractual savings). These have an important social security angle, but here focus is on resource mobilization through them. These funds have long maturity (repayment) period so they are better placed to cater need of projects with long gestation periods like infrastructure. But in India, the investment patterns of these funds are highly regulated with a bias towards investment in Government securities.  There is need to deregulate these long-term fund sources and formulate prudential norms for such financing. Insurance sector is somewhat contributing to private sector, but pension and provident savings are completely government controlled, so the will be discussed in next article along with government finance.

Savings through these three forms 20-25% of total household savings, so efficient mobilization becomes crucial.

Insurance

Insurance is service in which individual economic risk is spread over large number of people. Any loss that can be quantified in money can be insured. For e.g. Life Insurance provides risk cover on life of a person. Life cannot be quantified in itself, but economic hardships on survivors of a deceased breadwinner can be undoubtedly quantified in money terms, so this way life insurance can be done.

How individual economic risk is spread over large number of people?

In insurance large number of people pay premium and their risk gets covered. In case of any mishappening, under which claim can be invoked as per legal agreement; person will get compensated by Insurance company. Not all covered vehicles will meet an accident, nor all covered persons will die. But everyone certainly has risk of dying or getting trapped into an accident. So premium from all people under risk is used to pay a person who really met accident or relatives of person who died.

Insurance is highly profitable and cash rich business. Premium is collected and claims are to be paid when there is risk materialized. The insurance sector has been an important source of low cost funds of long-term maturities all over the world.  In the Indian context, however, the insurance companies, particularly in life insurance, apart from covering risk are also committed to repayment of the principal with interest although with long maturities and thereby tend to act as investment funds.  One of the reasons that this has happened is that the average premium charged by the insurance companies in India tends to be relatively high due to obsolete and rigid actuarial practices and inefficient operations.

This is the reason Life Insurance Corporation is one of the richest and omnipresent government companies.

(Actuaries are Experts who tries to quantify risk in a particular segment and determine the appropriate premium.)

Insurance industry is generally classified into Life Insurance Business and General Insurance. Former was nationalized in 1950’s and latter in 1970’s. After LPG reforms there have been increasing involvement of privates sector. A watershed moment came in 1999 when Insurance Regulatory and Development Authority act was passed which establish IRDA. This independent authority remains at apex of Insurance business. This was necessary because government was keen on promoting private sector participation, for which independent and efficient regulators are prerequisite.

An ordinance recently has been promulgated to allow FDI upto 49% in insurance sector. This is expected to bring much needed forex, Human Resource and differentiated products in the sector.

Capital markets, as name suggests, mobilize savings towards productive capital assets. High investment in primary market will suggest high fixed capital formation, which in turn will have all around impact on employment creation, tax collection and eventually higher standard of living. However, capital markets at times can squeeze savings from large public to a handful of sectors. This results in income inequalities. As was seen in last decade, that much growth was due to services sector and much of the resources got concentrated into that sector. Government through its policy interventions has to make sure that any growth is inclusive of all sects, regions, classes of the country, it is only then it can be sustainable. Otherwise it will receive a backlash from disadvantaged people, which has strong implications for political and economic stability of the country.

Questions –

What reforms were undertaken in India to revive its Stock Exchanges? Explain how they help in mobilization of resources. (200 words)

What is importance of corporate debt market? (200 words)

Do you think government should facilitate development of a burgeoning Corporate Bond market? Why? (200 words)

How does Insurance helps in mobilization of small savings? Should FDI allowed in Insurance sector at time when domestic industry is nascent? (200 words)

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