ASIAN DEVELOPMENT BANK Operations Evaluation Department

PROGRAM PERFORMANCE AUDIT REPORT ON THE CAPITAL MARKET DEVELOPMENT PROGRAM (LOAN 1408-IND) IN INDIA

In this electronic file, the report is followed by the Managements response.

ASIAN DEVELOPMENT BANK

PPA: IND 26468

PROGRAM PERFORMANCE AUDIT REPORT ON THE CAPITAL MARKET DEVELOPMENT PROGRAM (Loan 1408-IND) IN INDIA

July 2004

CURRENCY EQUIVALENTS Currency Unit Indian rupee/s (Re/Rs) At Appraisal (November 1993) $0.0321 Rs31.13 At Program Completion (December 1999) $0.0230 Rs43.4100 ABBREVIATIONS ADB BSE CCI CCIL CDSL EA FIRE G30 IRDA IT MOF MOJ NRI NSDL NSE OEM PCR PPAR PSU RBI RRP SC(R) SEBI SRO TA USAID UTI Asian Development Bank Bombay Stock Exchange Comptroller of Capital Issues Clearing Corporation of India Limited Central Depository Services Limited Executing Agency Financial Institutions Reform and Expansion Group of Thirty Insurance Regulatory Development Authority information technology Ministry of Finance Ministry of Law, Justice, and Company Affairs nonresident Indian National Securities Depository Limited National Stock Exchange Operations Evaluation Mission program completion report program performance audit report public sector undertaking Reserve Bank of India report and recommendation of the President Securities Contracts (Regulation) Securities and Exchange Board of India self-regulatory organization technical assistance United States Agency for International Development Unit Trust of India NOTES (i) (ii) In this report, "$" refers to US dollars. The fiscal year (FY) of the Government ends on 31 March. At Operations Evaluation (February 2004) $0.02208 Rs45.290000

Re1.00 $1.00

= =

Director General, Operations Evaluation Department Director, Operations Evaluation Division 2 Evaluation Team Leader

: : :

Eisuke Suzuki David Edwards Naomi Chakwin

Operations Evaluation Department, PE-645

CONTENTS Page BASIC DATA EXECUTIVE SUMMARY I. BACKGROUND A. Rationale B. Formulation C. Purpose and Outputs D. Cost, Financing, and Executing Arrangements E. Completion and Self-Evaluation F. Operations Evaluation PLANNING AND IMPLEMENTATION PERFORMANCE A. Formulation and Design B. Achievement of Reform Measures C. Cost and Scheduling D. Organization and Management ACHIEVEMENT OF PROGRAM PURPOSE A. Program Outcomes and Impact B. Sustainability ACHIEVEMENT OF OTHER DEVELOPMENT IMPACTS A. Socioeconomic Impact B. Impact on Institutions and Policy OVERALL ASSESSMENT A. Relevance B. Efficacy C. Efficiency D. Sustainability E. Institutional Development and Other Impacts F. Overall Program Rating G. Assessment of ADB and Borrower Performance ISSUES, LESSONS, AND FOLLOW -UP ACTIONS A. Key Issues for the Future B. Lessons Identified C. Follow-Up Actions iii iv 1 1 2 3 3 4 5 5 5 7 10 11 11 11 16 16 16 16 17 17 18 18 18 18 18 18 19 19 20 20

II.

III.

IV.

V.

VI.

N. Chakwin, Principal Evaluation Specialist (Team Leader), was responsible for the preparation of this report, and conducted document reviews, key informant interviews, and guided the fieldwork undertaken by the consultants, S. Hertel and S. Thomas. R. Lumain, Senior Evaluation Officer, supported the team with research assistance from Manila.

APPENDIXES 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Capital Market Development Program Loan: Status of Reforms Recommendations of Group of ThirtySecurities Clearance and Settlement Study Excerpts of the Securities and Exchange Board of India (Amendment) Act, 2002 Unit Trust of India Joint Parliamentary Commission Elements of Market Design in Indian Securities Market, 1993 and 2004 Growth and Distribution of Turnover on Stock Exchanges New Capital Issues by Nongovernment Public Limited Companies Number of Listed Securities, Market Capitalization, and Turnover at BSE and NSE Yearly Trends in FII Investment in India Transaction Costs in Indias Equity Market 21 43 44 49 51 52 54 55 56 57 58

BASIC DATA Loan 1408-IND: Capital Market Development Program Key Program Data ($ million) Program Cost ADB Loan Amount/Utilization ADB Loan Amount/Cancellation Key Dates Fact-Finding Appraisal Loan Negotiations Board Approval Loan Agreement Loan Effectiveness First Tranche Release Second Tranche Release Loan Closing Program Completion Months (effectiveness to completion) Borrower Executing Agency Government of India Ministry of Finance Number of Missions 1 1 1 3 1 1 Number of Person-Days 84 60 12 22 21 57 As per ADB Loan Documents 250.0 250.0 0.0 Expected Actual 250.0 250.0 0.0 Actual 718 Jun 1993 1631 Aug 1993 811 Nov 1993 28 Nov 1995 29 Nov 1995 8 Dec 1995 22 Dec 1995 22 Dec 1998 31 Mar 1999 31 Mar 1999 40

27 Feb 1996 27 Feb 1996 Dec 1996 30 Jun 1997 30 Jun 1997 16

Mission Data Type of Mission Fact-Finding Appraisal Project Administration Project Specific/Consultation Review Project Completion Operations Evaluation

____________________________ ADB = Asian Development Bank.

EXECUTIVE SUMMARY On 28 November 1995, the Asian Development Bank (ADB) approved a loan of $250 million to India for the Capital Market Development Program (the Program). The loan was funded through ADBs ordinary capital resources. The objectives of the Program were to (i) enhance the country's ability to mobilize internal and external resources to finance economic growth, and (ii) improve the efficiency of resource allocation through a greater reliance on market mechanisms. In doing so, the Program intended to promote stable, long-term economic growth. The Program focused primarily on the implementation of the Governments broad capital market reform agenda. The measures to support this objective were relevant and consistent with the Programs purpose. The lack of clarity on policy actions to strengthen the regulatory powers and authorities of the capital market regulatorthe Securities and Exchange Board of India (SEBI)was the only concern about the design of the Program. The Program is assessed as relevant. The Program was successful in meeting most of the anticipated program outputs. Key accomplishments included (i) establishing an integrated national market system, (ii) modernizing the market trading infrastructure to support growth and expansion, (iii) eliminating legal or regulatory impediments to broader market participation, (iv) improving pricing and efficiency through enhanced competition in the market, and (v) developing a stronger and more independent securities market regulator. The reforms identified in the Program have had a dramatic impact on the efficiency, transparency, and professionalism in the Indian capital market. The Government has demonstrated an awareness of, and a commitment to, pursuing longer-term developments in these areas. Indeed, the Government has supported recent amendments to the SEBI Act and changes in the regulatory structure (including the addition of the new insurance regulator). While SEBI still needs to improve market surveillance and monitoring, these reforms are part of an ongoing process. The Program supported the implementation of reforms that are unlikely to be reversed. Moreover, the Programs contributions to institutional and capital market development are likely to expand as the market develops. Managing fiscal reforms, sustaining the momentum for privatization, and pursuing greater independence for all market regulators will require additional government commitment. However, the scope and objectives of this Program have been largely accomplished. Based on the Operations Evaluation Mission's assessment, the overall rating of the Program is successful. Key lessons from the Program include: (i) The Governments vision for the development of the market can be traced to a small number of fiercely independent civil servants. This vision was needed to sustain the implementation of a reform program of this magnitude. Adequately developing the institutional, administrative, and regulatory framework required a substantial commitment of time and resources. Therefore, the importance of government ownership and dialogue cannot be underestimated. Capital market development also requires a certain depth of human resources or skills in the market. Ensuring sufficient skills and capacity to implement complex

(ii)

v reforms, such as the ones specified in this Program, were critical to the success of the Program. Three factors were essential for this market to develop (a) competition, which forced good market standards for fairness; (b) transparency and efficiency, through an improved clearing, settlement, and depository system, which allowed dematerialized trading and better market regulation; and (c) sufficient supply and demand to foster market depth and liquidity. The derivative market has played a key role in this aspect of market development.

(iii)

Since the Program, ADB has continued to be engaged with India. ADB is supporting the debt and derivative markets, and pension reform. This assessment endorses ADBs approach and efforts in these areas, and encourages more dedicated assistance for the development of bond markets. Support for infrastructure development through the use of debt instruments is needed urgently. Well-structured assistance with concrete deliverables could accelerate development in this area.

Eisuke Suzuki Director General Operations Evaluation Department

I. A. Rationale

BACKGROUND

1. Following an economic crisis in 1991, the Government introduced a broad ranging economic reform program that contained immediate stabilization measures and ambitious structural reforms. Despite some slippage on fiscal consolidation, the stabilization effort restored external confidence and led a buildup of foreign exchange reserves (Figure 1). 1

Figure 1: Official Foreign Exchange Reserves

Approval Completion

80
Approval Completion

10 8 6 4 2 0

60 40 20 0
19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03

Foreign Exchange Reserves

Months of Imports

Source: Operations Evaluation Mission.

2. In the early stages of reform, India emphasized reducing imports temporarily through administrative controls to ease the current account deficit (Figure 2). Subsequent stabilization measures focused on monetary tightening and fiscal consolidation, supported by currency devaluation. Structural reforms, which initially were concentrated in the industrial sector and on trade liberalization, aimed to eliminate most investment and import licensing requirements. The foreign investment regime also was liberalized substantially. The focus then shifted to tax reform, additional trade liberalization, and financial sector reform. As part of its operational strategy for India in much of the 1990s, the Asian Development Bank (ADB) assisted the Government in increasing economic efficiency through support for structural reforms, promotion of competition, and private sector participation. Loan 1208-IND, 2 which included monetary management and banking reforms, kicked off ADBs support of financial sector reform in 1992. At the same time, parallel support for capital market development also was considered.

1 2

The dramatic increase in reserves from 2001 to present might be partly attributable to global events beyond Indias economic reforms. Loan 1208-IND: Financial Sector Program , for $300 million, approved on 15 December 1992.

Months of Imports

100 Billion of Dollars

12

Figure 2: Current Account Balance

Approval Completion

Source: Operations Evaluation Mission.

B.

Formulation

3. Recognizing the need for an efficient banking system and well-functioning capital markets in the aftermath of the economic crisis, the Government introduced a broad economic reform program. After approving the Financial Sector Program loan (footnote 2), ADB sent a reconnaissance mission in March 1993 to continue discussions on the development of the financial sector and possible capital market reforms.3 A fact-finding mission in June 1993 and an appraisal mission in August 1993 led to an understanding with the Government on a number of policy actions for the Capital Market Development Program (the Program). 4. This was ADBs first attempt at capital market reforms in a developing member country, and it coincided with strong momentum for reform within the Government. Program approval was delayed due to concerns about the policy and macroeconomic environment in India. The report and recommendation of the President (RRP) for the Program was circulated to the Board of Directors in November 1993, withdrawn, and re-circulated in November 1995 (using the same RRP as in 1993 with an addendum supplement and corrigendum updating the status of compliance with upfront program actions). 5. When the Program was designed, the country had 23 active stock exchanges, all of which traded the same stocks. The Bombay Stock Exchange (BSE) took the lead in price discovery. (Before the National Stock Exchange [NSE] was established, the BSE accounted for about 80% of the total turnover in the country.) Even exchanges such as Delhi and Calcutta used to trade the same stocks at different prices. Thus, investors in different parts of the country could pay different prices for the same stock at the same time. Furthermore, practices at the exchanges were not transparent. The time was not stamped on transaction documents. Investors could not verify when and at what price their trades had been executed, and complained that stockbrokers sold shares at the lowest price and bought at the highest price.
3

Despite the fact that capital market reforms were pursued as part of an overall financial sector reform strategy within ADB, payment system issues (which links the banking and capital markets) were not discussed.

3 Moreover, prices did not faithfully reflect market conditions, since many trades were unreported. Kerb tradingtrades between brokers outside the floor of the exchange before or after trading hoursstill was practiced despite its prohibition. 6. A number of government-appointed committees formed in response to persistent market manipulation and abuse was the basis for the Governments priority reforms in the capital market. The economic crisis provided the opportunity to undertake powerful reforms in the financial markets. While the Narasimham Committee identified extensive banking sector reforms, a number of other important committees discussed capital market reforms. Based on a comprehensive review of the operations of the exchanges, the Pherwani Committee prepared a set of recommendations in June 1991 on the establishment of a new stock exchange. In June 1992, the Government appointed the Nadkarni Committee to look into the trading of public sector undertaking bonds and mutual fund shares. Former Reserve Bank of India (RBI) Deputy Governor A. Janakiraman led a committee investigating irregularities in securities transactions of banks. The Malhotra Committee was established in 1993 to provide a comprehensive review of the operations of insurance companies. The United States Agency for International Development (USAID) also made a commitment to support government efforts in reforming the capital market. C. Purpose and Outputs

7. Classified as an economic growth activity, the Program included a detailed policy matrix with time-bound policy actions and a development policy letter, but no logical framework. 4 The purpose of the Program was to (i) enhance the country's ability to mobilize internal and external resources to finance economic growth, and (ii) improve the efficiency of resource allocation through a greater reliance on market mechanisms. 8. The policy matrix, containing 44 policy measures under five broad areas, was consistent with this purpose. Anticipated outputs included (i) the establishment of an integrated national market system (3 conditions), (ii) modernization of the market trading infrastructure to support growth and expansion (9 conditions to automate trading and reduce transaction costs), (iii) broader market participation by eliminating impediments (20 conditions), (iv) better pricing and efficiency through enhanced competition in the market (6 conditions to expand market participation), and (v) a strong and independent market regulator (6 conditions to strengthen the role of the security regulator). For the release of the second tranche of the Program, 12 core conditions were identified. No technical assistance (TA) was attached to the Program (para. 10). D. Cost, Financing, and Executing Arrangements

9. On 28 November 1995, ADB approved a program loan to the Government of India for $250 million 5 from its ordinary capital resources. The loan had a maturity of 15 years, including a 3-year grace period, and the interest rate was determined by pool-based variable lending rate system for US dollar loans and included a commitment charge of 0.75% per annum. It was disbursed in two tranches of $125 million. The Ministry of Finance (MOF) was the Executing Agency (EA), and the proceeds of the loan were available for financing eligible imports procured under ADB guidelines, determined by a negative list.

4 5

The logical framework preparation became mandatory for program loans in 1997. Loan proceeds were not tied to specific government budget allocations under the Program. However, there were significant adjustment costs for the trading and clearance and settlement infrastructure.

4 10. USAIDs considerable efforts and resources 6 directed at capital market reforms during this period obviated the need for TA to support the implementation of the Program. USAID approached ADB to formalize this cooperation in 1993, but cooperation remained informal during the program period. From 1994 to 1998, the Financial Institutions Reform and Expansion Project (FIRE), funded by USAID, focused on institution building in the capital markets. Support was provided to (i) modernize the stock exchange; (ii) develop a national depository; (iii) improve clearance and settlements systems; and (iv) create a strong trade association for mutual funds, which has become a model for such organizations and includes a code of conduct and testing for its members. The FIRE project also included a large component that assisted the Securities and Exchange Board of India (SEBI) in strengthening its internal operations and educating management and staff on the responsibilities of a securities regulator. Assistance for designing and developing the National Securities Depository Limited (NSDL) was the most visible and far-reaching outcome of the FIRE project. E. Completion and Self-Evaluation

11. The program loan closed on 31 March 1999. A program completion report (PCR), prepared by ADBs Infrastructure, Energy, and Financial Sectors Department (West), was circulated to the Board of Directors in December 2000. 12. The PCR rated the Program successful under a three-category rating system. (ADB now uses a four-category rating system.7) The PCR stated the Program successfully supported the Government in undertaking much-needed market reforms. The noted reforms included (i) implementing an integrated national market system; (ii) introducing an automated trading, settlement, clearing, and depository system; (iii) introducing competition in capital market sectors; (iv) enhancing private sector participation and reducing government crowding out of private investments; (v) liberalizing mutual funds and stock brokerage industries; (vi) improving the efficiency of primary and secondary markets, and establishing mechanisms to enhance market liquidity; and (vii) enhancing the regulatory and supervisory powers of SEBI as the capital market's sole regulator. The PCR also noted that the reforms resulted in an increase in operational and market efficiency, a reduction of costs and risks, improved market accessibility, and strengthened investor protection, which were necessary for building investor confidence and the sustainable growth of the capital market. 13. The PCR identified four conditions that were not fully met at the time: two conditions on reducing investment restrictions for institutional investors (insurance, pension, and provident funds);8 and two conditions on increasing SEBIs powers as the capital market regulator. 9 While the quality of the PCR was generally high, the Operations Evaluation Mission (OEM) found that the two policy actions on automated trading in debt 10 were reported in the PCR (and in the progress report11) as implemented. However, automated trading in the debt market did not exist as of February 2004. In India, trading debt instruments remains a private placement market, as in most places in the world. Despite the importance attached to one of these conditions for release of the second tranche of the Program, the importance of an automated debt market can be debated. However, increasing the role of institutional investors and strengthening market
6

USAIDs FIRE project, and its successor FIRE-R, were supported by a $44 million grant, planned for 12 years starting in 1993. The program was suspended from 19982000 due to Indias nuclear weapon tests. 7 ADB. 2000. Guidelines for the Preparation of Project Performance Audit Reports. Manila. 8 Appendix 1, conditions 16 and 18. 9 Appendix 1, conditions 40 and 41. 10 Appendix 1, conditions 9 and 20. 11 ADB. 1998. Progress Report on the Capital Market Development Program Loan to India. Manila.

5 regulation are continuing challenges that require additional effort and commitment by the Government. 14. Except for its assessment of the conditions on the development of the debt market, the PCR was comprehensive. Of the four end-of-program policy actions, two were fully complied with before the release of the second tranche. The PCR reported that the National Clearance, Settlement, and Depository System could not fully meet the recommendations of the Group of Thirty (G30) as of December 1999, because the same-day payment system was not in place. While RBI was considering this initiative, the rolling settlement period could not be reduced effectively until all scrip was dematerialized.12 Subsequently, this was accomplished (paras. 24 and 36). The PCR also cited the importance of two legislative acts to further capital market development: the consolidated SEBI bill and the Insurance Regulatory Development Authority (IRDA) Act. The OEM concurred with the PCR on the importance of these pieces of legislation for sustainable development of the capital markets.13 In addition, capacity building for SEBI and IRDA is needed to strengthen the supervision of the capital market. F. Operations Evaluation

15. An OEM was undertaken from 26 January to 12 February 2004. The OEM met with MOF; Department of Economic Affairs; key stakeholders, including SEBI and the two major stock exchanges (the BSE and the NSE); NSDL; the Clearing Corporation of India Limited; and other market institutions and participants. The primary purpose of this evaluation was to identify the strengths and the weakness of the Program to learn lessons for future operations in India, as well as in similar sectors in other countries. The assessment was based on (i) the need for the Program and the effectiveness of its design (relevance), (ii) the achievement of program purpose and production of outputs (efficacy), (iii) efficiency, (iv) the sustainability of outcomes, and (v) the contribution to institutional strengthening and other impacts. The draft program performance audit report (PPAR) was circulated interdepartmentally within ADB and to the Government and other stakeholders. Comments received were considered in finalizing the PPAR. II. A. PLANNING AND IMPLEMENTATION PERFORMANCE

Formulation and Design

16. The Program was formulated at a time of financial and policy crisis within India (paras. 12). A complex system of industrial licensing, protection against imports, and extensive government intervention in financial intermediation contributed to disappointing growth compared to other countries in Asia during the 1980s. Before 1991, capital flows to India consisted mainly of aid flows, commercial borrowing, and nonresident Indian deposits. 17. Three important elements underpinned the formulation and design of the Program: (i) rapid deployment of program proceeds for immediate balance of payments support, (ii) support for the implementation of the Governments reform agenda in the capital markets, and (iii) a reduction in Indias economic vulnerability through the development of the domestic capital market to mobilize internal and external resources to finance economic growth. From the

12

Dematerialization is a process of shifting securities from physical or scrip form to scripless form, with records kept only in the computer and transfers effected by electronic book entry. 13 The IRDA Act was passed in 1999, but a consolidated SEBI bill has not been adopted. Recent amendments (2002) to the SEBI have helped address some of the weaknesses of the previous 1992 Act.

6 Governments point of view, the most important objective of the Programliquidity support was not met due to a 2-year delay in program endorsement by ADB (para. 30). 18. The policy matrix included 44 policy actions (para. 8), of which (i) 16 were to be completed before program approval for the release of first tranche loan proceeds, (ii) 12 were core or second tranche release conditions, and (iii) 16 conditions were to be completed by the end of the Program (Appendix 1). The conditions provided in the policy matrix and the Programs design were appropriate to meet the last two elements (ii) and (iii) identified in para. 17. However, the Government and ADB continued to discuss the best way to create an integrated national market until the final loan negotiations. Concerns over the efficiency and transparency of a proposed second nationwide exchangethe NSEwere expressed. The main issue was the Governments potential influence, given the shareholding structure of the NSE. As a result, ADB maintained policy actions under the Program that called for an electronic network linking Indias regional stock exchanges, but also included conditions for the establishment of the NSE. In many ways, these were parallel efforts to achieve similar objectivesbetter governance and efficiency in the capital market. In light of ADBs views, the Government agreed not to use loan proceeds in the establishment of the NSE. 19. Proceeds from the $250 million loan were used for the adjustment costs of the Program (excluding the NSE). The intent was to compensate the Government for the fiscal costs of a clearing and settlement and depository system that required standardization of practices and procedures to ensure the accuracy, transparency, and timeliness of investor information. This meant changing traditional practices, eliminating privileges, improving inefficient systems, and upgrading the support infrastructure. The changes required capital outlays, estimated in the RRP at about $300 million, to (i) draft new legislation, standards, and regulatory practices; (ii) upgrade skills, and (iii) educate investors. The OEM requested cost estimates for the clearing and settlement and depository system, but no records were available. 20. While the design generally identified major areas of reform well, it was weak in three specific areas: (i) clarifying the conditions for SEBIs independence and enforcement powers, (ii) eliminating impediments to market growth or market liberalization, and (iii) improving the payments system. The actions contained in the policy matrix were necessary but not sufficient to support SEBI as the sole regulator for the capital markets (para. 27). Policy conditions supporting the elimination of impediments to market growth or market liberalization lacked the cohesion of other areas of the Program. A stronger focus on a few select areas (e.g., debt market development or institutional investors)14 might have improved results. Finally, excluding conditions to improve the payments system was a design omission. Electronic funds transfer capability and real time gross settlement continue to be a significant bottleneck for market development, especially for short-term debt market (repos) (para. 24[iii]). 15

14

ADB followed up with TA in debt market development in the next few years. Three TAs were provided to support debt market development: TA 3367-IND: Reform of the Private Pension and Provident Funds System Reform and the Employees Provident Fund Organization, for $1,000,000, approved on 26 December 1999; TA 3460-IND: Policy and Operational Support and Capacity Building for the Insurance Regulatory and Development Authority, for $800,000, approved on 22 June 2000; and TA 3473-IND: Development of Secondary Debt Market, for $600,000, approved on 28 July 2000. Although these were not integrated into the Program, this sequencing may have better reflected the Governments priorities and capacities at the time. 15 The RBI has started to test a real time gross settlement system in a set of banks starting in February 2004.

7 B. Achievement of Reform Measures

21. The RRP identified the key risks, including (i) the Governments ability to p ursue the required policy reforms in a timely manner; (ii) the legislation required to establish a national automated depository system and enhance the power and authorities of the regulatory and supervisory agency; (iii) opposition to the required changes by vested interests, such as stockbrokers and other affected sectors; and (iv) the complicated national coordination envisaged with multisectoral and geographic challenges. Given the nature of the identified risks and ADBs inexperience in capital market reform, the Governments ability to meet the program conditions was a topic of concern at the management review, staff review, and loan and TA coordination committee meetings. 22. The OEM revisited the Governments progress in satisfying the policy actions identified in the matrix, especially the conditions the PCR identified as not having been fully met (para. 13). Appendix 1 contains a table describing the steps taken by the Government, and an evaluation of the Governments status of compliance with 44 policy reform conditions. A summary discussion is in paras. 2327. 1. Establishing a Framework for an Integrated National Market System

23. Three conditions were intended to support an electronic network linking Indias regional stock exchanges. The network was meant to provide investors with a fair, efficient, and continuous market with the required liquidity and depth. 16 All the conditions have been satisfied, primarily due to the success of the NSE. Two of these were key second tranche conditions: (i) Ensure an efficient and competitive interface among the stock exchanges. Standards were introduced that supported uniformity of practices, operating standards, codes of conduct and ethics, reporting requirements, and quicker dissemination of information and prices across all exchanges. These standards were in preparation for the introduction of automated trading in debt and equity securities, and automated settlement of trades on the exchanges. Ensure automated trading facilities for securities of large, medium, and small enterprises. Today, all exchanges trade-listed equities using the electronic limit order book market structure. The same system is used to trade large, medium, or small capital stocks. Such an integrated nationwide market ensures t at all investors can access a single market price. To ensure safe h trading among all participants, nationwide trading on a rolling settlement basis must be backed by a robust clearing and settlement system. Two important aspects to ensure continuous market growth and expansion were (a) anonymous trading, and (b) elimination of market fragmentation across participants. In 1998, for example, all institutional orders had to be exposed to the (transparent) electronic order book (paras. 3435). Thus, while a trade might be negotiated outside the market, it had to be put on the exchange limit order book to avail of the clearance and settlement systems of the clearing corporation and the depositories. By pooling all the orders into one trading platform, liquidity a nd pricing transparency on the exchanges were increased.

(ii)

16

Continuous market means securities can be traded at any time the market is open. The required liquidity means the price difference is minimal from one transaction to the next. Depth means the market can absorb a large volume of trades.

8 2. Modernize the Market Infrastructure

24. The policy matrix included nine conditions to support the implementation of a clearance and settlement and depository framework in accordance with the G30 recommendations on securities clearance and settlement (Appendix 2). All conditions have been satisfied. Drafting and enacting appropriate legislation and investing in the systems were the two key policy measures. Specific actions were: (i) Establish and operate a national automated depository system. This included (a) title transfer and registration, (b) recognition of ownership, (c) voting rights, (d) rights to dividends, (e) the creation of liens, (f) liabilities of the depository, and (g) settlement of disputes. This core condition of the Program was required for the release of the second tranche, and was initially addressed by the Depository Act, 1996. Regulatory guidelines for the establishment and operation of automated depository. The Depositories Act, 1996 (the Act) established the legal framework for a nationwide depository system in India. The Act included amendments to certain areas of the Companies Act, the Securities Contracts (Regulation) (SC[R]) Act, the Income Tax Act, and the Benami Transac tions (Prohibition) Act.17 While the SEBI Act of 1992 gave the securities regulator authority to register and regulate the working of the depositories, the Depositories Act clarified the authority to make regulations, conduct inquiries and inspections, and enforce regulations through directions from SEBI on the activities of depositories. SEBI subsequently issued Depositories and Participants Regulations, 1996 (the Regulations) to address processes within the depository environment. The Regulations extend to automated processing and electronic connectivity requirements. The Act and the Regulations became the basis for the internal rules, policies, and procedures of the depositories (first NSDL; then Central Depository Services Limited [CDSL]). Establish an automated clearance, settlement, and depository system for securities trading. This policy builds on the establishment and operation of national depository systems. The policy requirement to establish systems in one or more exchanges in all major centers of the country has been addressed through terminal access by all system users. This capability has evolved so that the systems of NSDL, CDSL, and National Securities Clearing Corporation Limited (NSCCL) can be accessed via a single terminal. Daily cash settlement and delivery versus payment meet G30 requirements to the extent possible in India (Appendix 1[12]). Risk is mitigated through guarantee funds at NSCCL and BSE and other risk-management methods. However, inter- and intra-bank connectivity need to be improved through an electronic payments system that would simplify cash movements for settlement purposes. (Where funds cannot be transferred easily, cash is collected before entering the trade order.) The OEM was informed of plans to make cash settlement directly through the RBI, refining delivery versus payment. However, this has been planned for a number of years with little action.

(ii)

(iii)

17

A Benami transaction is where a property is bought in the name of one party, but paid for and used by a second party. The simplest form is where a husband purchases property in the name of his wife, pays for it, and benefits from its use.

9 3. Eliminate Constraints that Inhibit Market Growth, Improve Market Access, and Strengthen the Role of Financial Intermediaries in the Capital Market

25. Twenty policy actions have been grouped together under this category. They constitute an assortment of conditions for (i) market participants, (ii) issuers, (iii) institutional investors, and (iv) instruments. All conditions, except those for the investment of pension and provident funds (para. 13), have been satisfied. Some of the key conditions for the development of the derivative markets are: (i) SEBI to review the key issues for developing a market in options and futures to facilitate the development of a strategy for the operation of such a market. In 1996, the NSE approached SEBI with a proposal to start trading in equity futures and options on a trading platform separate from the equity market platform. SEBI set up a 28-person committee (Gupta Committee) to examine this issue. In 1998, the committee report recommended products, prudential regulation norms, and risk management at the clearing corporations that had to be in place before derivatives could start trading. The committees key recommendation was that derivatives trading should be permitted only on exchanges that had strong online monitoring and surveillance systems, and could settle derivatives trades through an independent clearing corporation and/or clearing house. Lift the restrictions and establish a regulatory framework to enable the operation of a trading system in options and futures. This was a core condition for the release of the second tranche of the Program. The Gupta Committee also made recommendations on the governance of an exchange that could trade derivatives. SEBI accepted the recommendations of the committee and issued regulations. The Government amended the securities bill to include derivatives in the definition of securities that could be traded on an exchange. In December 1999, an amended bill was enacted and became the SEBI (Amendment) Act, 2002 (Appendix 3). Enhance Competition and Level the Playing Field

(ii)

4.

26. Six conditions focused on increasing competition in the market, including among the stock exchanges, brokerage firms, and mutual funds. All conditions have been satisfied. Key conditions were: (i) (ii) Permit 51% foreign ownership of corporate stock brokerage firms. Foreign firms have entered the market and can now acquire up to 100% ownership of brokerage firms. SEBI to regulate Unit Trust of India (UTI) mutual funds. Before October 2002, UTI mutual funds were not required to comply with SEBI regulations, although certain funds did so voluntarily. A liquidity crisis in 2 001 created a potential default in the payment of dividends by one of the funds (Unit Scheme 1964) and triggered some of the changes (Appendix 4). The Government repealed the UTI Act in 2002, and UTI was split. UTI-I now comprises funds that are guaranteed by the Government and will be phased out as they mature (predominantly closed-end funds). UTI-II includes funds that have been transferred to a new

10 company that is under the regulatory authority of SEBI (predominantly openended funds). 18 5. Strengthen Market Regulation and Supervision

27. Six conditions were intended to strengthen the regulatory powers of SEBI. While SEBI powers have increased, these conditions have not been fully satisfied. Specific measures included: (i) Transfer through legislation regulatory and supervisory powers more fully to SEBI. This was a core condition triggering release of the second tranche of the Program. In 1997, SEBI established a committee under former Justice D.R. Dhanuka to examine areas of deficiency in the SEBI Act 1992, the Depositories Act 1996, and the SC(R) Act 1956. Based on that review, the Dhanuka Committee concluded that the number of authorities regulating the Indian securities market should be limited. The committee found that the existence of multiple authorities might create confusion and inconsistent results. The Dhanuka Committee recommended that SEBI become the single regulatory authority. However, regulatory responsibility continues to be shared by SEBI, the RBI, and the Department of Company Affairs. The situation might be changing slowly as SEBI gains more credibility. Rationalize all pertinent laws, rules, and regulations in a manner consistent with SEBIs designation as the principal regulator of the capital market. The Dhanuka Committee also made recommendations on consolidating Indian securities laws. The committee recommended that the SC(R) Act and the SEBI Act be consolidated into a single act. As noted in the PCR, the Dhanuka Committee drafted a proposal for a new securities law. However, the laws still have not been rationalized and/or consolidated. Regulation of the securities industry continues to be fragmented among SEBI, the RBI, and the Department of Company Affairs. Regulatory ambiguity creates an environment where confusion as well as duplicate and inconsistent regulations are possible (Appendix 5). In addition, some of the regulatory responsibilities need to be more clearly defined.

(ii)

28. In summary, some of the policy actions included in the program were either delayed or not fully implemented. The investment guidelines for insurance companies and pension funds were relaxed somewhat, though directed investments continue. In addition, the full delegation of powers to SEBI contained in the SC(R) Act and Companies Act is languishing in Parliament. However, the findings of the Joint Parliamentary Commission (Appendix 5), and the subsequent 2002 amendments to the Securities Act (Appendix 3 contains selected amendments), have provided SEBI with some of the necessary powers to regulate the market more effectively. C. Cost and Scheduling

29. The program loan of $250 million became effective on 8 December 1995. The first tranche of $125 million was disbursed on 22 December 1995, consistent with the provision that funds were to be disbursed upon loan effectiveness. However, slow implementation of policy actions, such as the delay in the resumption of the use of repurchase agreements, delayed the
18

Competition also has increased with domestic firms now being permitted to raise resources from abroad through the issuance of American depository receipts and/or global depository receipts.

11 release of the second tranche, scheduled for December 1996.19 An extension of the loan closing date was granted, and the second tranche of $125 million was disbursed on 22 December 1998 upon satisfaction of the second tranche release conditions. As EA, MOF was responsible for the administration and disbursement of the proceeds and the maintenance of records. D. Organization and Management

30. An agreement with the Government was reached initially in November 1993, but program approval was delayed due to concerns regarding the policy environment in India. The RRP for the Program was circulated to the Board of Directors in November 1993, withdrawn, and re-circulated in November 1995 (using the same RRP as in 1993 with an addendum note and supplement 20 updating the status of compliance with program actions). Twelve policy actions were specified for release of the second tranche of the program loan. An additional 16 end-of-program conditions were added. At the time of Board approval of the Program, the supplement to the RRP reported that the Government had implemented all first tranche conditions, 7 of 12 second tranche release conditions (3 of the remaining 5 conditions had been partly met), and 9 of the end-of-program conditions. The timetable for the Program was revised accordingly (para. 29). The delay did not impact significantly the reform agenda, and allowed the Government to demonstrate its commitment and capacity to implement this far-reaching reform program. 31. Program management was satisfactory. Three review missions were fielded in December 1996, October 1997, and March 1998. The second tranche was released on 22 December 1998 (a 1.5-year delay from the revised 1995 schedule) after the required policy actions were met substantially. The loan was closed in March 1999, and the PCR mission was undertaken in October 1999 and completed in December 1999. 32. The OEM noted the contribution of USAID to the outcomes of this Program. The FIRE team was comprised of talented and experienced professionals, who worked well with government counterparts and achieved tangible results in specific areas (para. 10). Although ADB and USAID did not formally coordinate, ADB staff and the FIRE project team frequently consulted with each other. Direct USAID consultations were less frequent. This arrangement appeared to have worked well, although more f rmal arrangements might have resulted in o greater dialogue and information sharing that would have benefited the institutions and the Borrower. III. A. ACHIEVEMENT OF PROGRAM PURPOSE

Program Outcomes and Impact 1. Outcomes

33. The RRP did not specify performance indicators to capture the program impact or monitoring mechanisms. However, the depth and breadth of reform undertaken by the Government and supported by this Program are striking. The capital market has been transformed radically since the Program was designed in 1993 (Appendix 6). The Government transcended the risks identified in the RRP (para. 21), and in some areas exceeded program expectations. New standards for trading, trade comparison and trade resolution, clearance and
19 20

The operation of the automated depository for debt securities was delayed. ADB. 1995. Supplement to the Report and Recommendation of the President to the Board of Directors on a Proposed Loan to India for the Capital Market Development Program . Manila (Addendum 1).

12 settlements, registration and transfer of securities, and trade reporting were adopted. Some of key outcomes of the Program are listed in paras. 2327. 34. The Establishment of the NSE. The NSE, which was backed indirectly by the Government through a number of powerful financial institutions, effectively changed market practices (para. 5). A national market system requires listing nationally traded securities in one market that is accessible to all accredited brokers and members of existing exchanges. By accumulating orders for each traded security on a nationwide basis, trades have been matched more efficiently and the liquidity of each security has improved. This was made possible through the use of more efficient information technology (IT), which was made readily available to exchange members. Automated facilities linked exchange members electronically, providing them with up-to-the-minute displays of bid and offer price quotes as well as match orders, and allowing them to execute market transactions instantly. The use of more advanced IT improved transparency of market transactions by generating market information about volume, prices, and time of transactions. The NSE was created to compete with the small club of stockbrokers who effectively controlled the stock market in India. Nationwide anonymous electronic bookmaking at the NSE established new market standards (para. 23). 35. As more market participants chose to list and transact business through the NSE, the market was revolutionized. The efficiencies of all processes have increased dramatically, while investor confidence in the safety of the markets has grown significantly. The BSE was forced to adopt the new market standards or go out of business. The success of the NSE proved that the Government was correct to create a national market system (para. 18). The two large active exchanges, the NSE and the BSE, essentially have replaced 98% of the trading in the 23 regional exchanges. The NSE accounted for about 86% of the trading volume in 20022003 (Appendix 7). 36. The Clearance, Settlement, and Depository System. The development of a national automated depository system in India was critical to address problems in trade settlement processing. In the early 1990s, the settlement of trades through the movement of physical securities certificates at the stock exchanges had become extremely cumbersome and time consuming. Transfer agent operations were highly inefficient, causing significant delays in transferring the ownership of traded securities. High volumes of paper and inefficiencies in the settlement and transfer processes led to theft, forgery, mutilation of certificates, and other irregularities. An excessive amount of bad deliveries in the market was the result. With the development of the NSDL (and later the CDSL for the BSE), dematerialization of securities, and automated securities settlement through the clearing organizations, these problems and related risks for the individual investor virtually were eliminated. The two depositories (NSDL and CDSL) now interface electronically, with automated links to their respective clearing organizations. 37. In addition to improvements in trade settlements, other benefits have been realized. Securities can be pledged to secure a bank loan through NSDL. This has simplified the process of market participants borrowing cash from banks. Since accounts at the depository are held by individual investors, beneficial ownership information is immediately available from the depositories to issuers or their agents to support payment of entitlements. Changing an address on company books can be done easily through an individual investors account at the depository. Beneficial owners, therefore, are not only assured that they will receive entitlements, but will receive them in a timely manner. All of these benefits, combined with the safe and efficient system for trade settlement, have increased significantly the confidence of individual and institutional investors in the Indian markets.

13 38. Derivatives. When the Program was designed in 1993, the impact of derivatives trading on the market could not have been foreseen. In 1995, equity markets were trading on a 5-day settlement cycle, which effectively meant that traders were taking (up to) 5-day forward positions. This increased the systemic risk of the trading system, resulting in the exchanges demanding higher capital margins and charging higher trading fees. This translated into excessive entry barriers for markets. A safer market structure would be a separate spot and derivatives market. However, for the markets to move toward true spot trading (with rolling settlement), the 1969 prohibition on trading forwards on securities would have to be repealed. 39. In January 1995, an amendment to the Securities Laws lifted the ban by repealing section 20 of the SC(R) Act. Agreement was reached to regulate the derivatives markets at two levels: at the exchange and at SEBI. Of the 23 exchanges in the country, the BSE and the NSE were the only two that satisfied the SEBI requirements for exchange regulation of derivatives. When the IT market crashed in March 2001, volumes were still small and trading was not being done on a rolling settlement basis. As a result, all exchanges were forced to adopt rolling settlement on a trade date plus 5 days (T+5) basis, and trading on index and single stock options commenced in June and July 2001, respectively. In June 2002, the accounting and taxation questions regarding derivative positions held by investors also were clarified. However, it was the move to trading on rolling settlement and the introduction of individual stock derivatives that spurred the growth of the derivatives market. Volumes on the derivatives markets rose from Rs23 billion in 20002001 to more than Rs1 trillion in 20012002. Single stock futures accounted for more than 50% of the volume. This growth has continued into 2002 2003 as well, with volumes of Rs4.4 trillion. Another leap in volumes appears to be occurring in 20032004. In December 2003 alone, volumes reached Rs3 trillion, compared to Rs0.5 trillion in December 2002, making India the second-largest market for stock futures in the world. 2. Impact

40. The purpose of the Program was to (i) enhance the country's ability to mobilize internal and external resources to finance economic growth, and (ii) improve the efficiency of resource allocation through a greater reliance on market mechanisms. The types of indicators normally used to assess the impact of capital market development programs (market capitalization, turnover ratios, new issues, etc.) are not robust. Indeed, they are extremely sensitive to business cycles and other worldwide events that affect international capital flows. When the economy is growing, these indicators tend to be positive; when the economy is not performing well, they are less impressive. In others words, these indicators reflect others factors, such as the economy, more than the health of the capital market. The causality usually goes from the economy to the capital market. Therefore, these indicators can be used only as proxies that reflect the institutional capacity to channel resources as the economy develops. 41. Table 1 provides information on the new capital issues by nongovernment companies. While market-based finance had been gaining greater importance for new companies, it has not replaced bank financing, especially following the debilitating effects of the IT crash that hit global markets (especially emerging markets) in 20002001. Appendix 8 provides a more detailed disaggregation. New private sector capital issues still lag considerably behind what they were in the mid-1990s, possibly due to the slow pace of the Governments divestment activities. This has limited startups in some sectors and constricted the release of new issues on the market (para. 58). As such, encouraging government divestment might have been considered as a parallel reform linked to this Program.

14 Table 1: New Capital Issues by Nongovernment Public Limited Companies

Item Number of Issues a Amount (Rs crore) 1992 1993 1,040 19,803.4 1994 1995 1,678 26,416.7 1998 1999 48 5,013.0 2000 2001 138 6,144.3 2001 2002 33 5,741.9 2002 2003 16 1,022.6 2003 2004 29 2,290.0

Note: Crore = unit of value equal to Rs10 million. a The large values reported in 19921994 can be explained largely by two factors. In 1992, the Comptroller of Capital Issues (CCI) was abolished and SEBI took over the market for initial public offerings (IPOs). This meant that firms started getting their IPO prices determined by the market, rather than set by the CCI. The most firms in recent memory listed on capital markets during the IPO boom in India in 19931995. These two factors led to IPO overpricing in the first few weeks after the issue got listed and started trading. Prices normally stabilized after the first few weeks on the market. Source: Operations Evaluation Mission

42. Other indicators of company resource mobilization provided in Figure 3 (details in Appendix 9) show that the number of listed companies has increased, the market capitalization (value of resources mobilized through the market) has doubled, and turnover (liquidity) on the NSE and BSE has been impressive. Mobilizing external resources also has assumed greater importance in the past few years, as shown in Figure 4 (details in Appendix 10). The participation of foreign institutional investors in the market has exploded from the early 1990s, with cumulative net investment steadily increasing despite the IT bubble. In addition, the reduction in transactions costs has increased market efficiency dramatically, as shown in Figure 5 (details in Appendix 11). In almost all respects, the impact of these reforms has been exceptional in increasing the mobilization of resources through the market.

Figure 3: Number of Listed Securities, Market Capitalization, and Turnover at BSE and NSE
12,000 10,000 Rs billion 8,000 6,000 4,000 2,000 0 199293 199495 199899 200203 12,000 10,000 8,000 6,000 4,000 2,000 0 Number of Companies

Market Capitalization of Companies Listed in BSE and NSE Turnover at BSE and NSE Number of Companies Listed in Indian Stock Exchanges Number of Listed Companies in BSE and NSE BSE = Bombay Stock Exchange, NSE = National Stock Exchange, Rs = rupees. Source: Operations Evaluation Mission.

15

Figure 4: Yearly Trends in Foreign Institutional Investments in India

800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 19 92 /93 19 93 /94 19 94 /95 19 95 /96 19 96 /97 19 97 /98 19 98 /99 19 99 /00 20 00 /01 20 01 /02 20 02 /03
New York Stock Exchange (1997) Settlement-Bad Paper Risk

Rs million

Cumulative Net Investment Rs = rupees. Source: Operations Evaluation Mission.

Gross Purchases

Gross Sales

Figure 5: Transaction Costs in India's Equity Market

6.0 5.0 4.0 Percent 3.0 2.0 1.0 0.0 India 1993 (Before NSE) 1997 (NSE) 2004 (NSE)

Trading-Brokerage

Trading-Market Impact Cost

Settlement-Back Office

NSE = National Stock Exchange. Source: Operations Evaluation Mission.

16 43. While the efficiency of transactions has increased, ascertaining the efficiency of allocation is more difficult. With bank finance, one can look at nonperforming loans, insolvency, and bankruptcy as indicators. In the capital markets, a comparable indicator might be the number of companies delisted. However, companies are rarely delisted in emerging markets. In India, delisting has occurred primarily because (i) the MOF withdrew a provision in April 2003 for mandatory listing of companies in their respective regional stock exchanges, and (ii) foreign companies obtained 100% ownership of their subsidiaries and decided to take their shares off the Indian market. Neither case provides an example of delisting due to economic distress. Therefore, delisting in India is not a good indication of inefficient mobilization of resources. These companies, in fact, are saving significant listing fees. The OEM was not able to assess if the efficiency of resource allocation has improved under the Program. B. Sustainability

44. In many ways, the reforms have succeeded beyond expectations. The key outcomes of the Program (paras. 3439)automated trading and dematerialization of stock shares; the clearance, settlement, and depository framework; and the introduction of derivatives markets can be considered irreversible. They have resulted in cost-effective changes and stronger market institutions. The Indian stock market has been quite volatile in recent months, but the impact of the Program is sustainable mainly due to the institutional development and the Governments ownership and leadership in the reforms. The establishment of the NSE, based on high governance standards and transparent market practices, is the best example. The result has been a changed trading environment and new culture in the financial markets. The systems and the professionalism of market participants are expected to continue to be in line with international markets. IV. A. ACHIEVEMENT OF OTHER DEVELOPMENT IMPACTS

Socioeconomic Impact

45. The Program allowed India to learn by doing, an important side effect. The demonstration effect of these reforms also was important. Strong market institutions have grown with the support of market professionals who created and, in many cases, are still involved in their operation. The support of international professionals (such as the FIRE team) was critical, but the vision and initiative came from a handful of proactive civil servants. The result has been a confidence to continue the evolution of market institutions, and more openness to change and innovation as demonstrated by the continued development of the depositories and increasingly open markets for foreign investors. This innovation and openness will continue to support growth and development in the economy. B. Impact on Institutions and Policy

46. Before the creation of the NSE, the country had 23 stock exchanges, all of which traded the same stocks. The closing price differences were large enough to fuel inter-exchange arbitrage, generating risk-free returns of up to 2.5% a month for a large number of the brokers. These price differences persisted until the NSE became the dominant exchange for price determination in early 1996. Eventually, most of the trading in the country became concentrated in the NSE or the BSE. However, even though the price premia dropped, significant price differentials remained between the NSE and the BSE due to different settlement cycles at the two exchanges. When trading at both exchanges became rolling settlement, those differentials

17 were eliminated (paras. 3839), though intra-day price differences could occur. All investors access one common price for a given stock, a fundamental change in the market. 47. Recent amendments to the SEBI Act addressed some of the limitations in the original 1992 Act, which established the regulator (Appendix 3). These amendments included providing SEBI with the authority to (i) issue cease and desist orders; (ii) significantly increase fines and penalties for violations; and (iii) obtain evidentiary documents from third parties, which was especially helpful in seeking information from banks. The amendments also specifically prohibit market manipulation and insider trading, allowing SEBI to regulate and take appropriate actions. While laws, rules, and regulations might still need to be rationalized (para. 27), SEBI has been granted far-reaching powers as a regulator. Recent amendments to the SEBI Act (Appendix 3) have enhanced that power. In addition, SEBI has continually increased the number of securities that are required to be settled in dematerialized form, so that 99% of all trades now are settled in that form. 48. One unforeseen positive impact was the introduction in 1997 of a second depository for BSE. CDSL was linked to the BSE clearinghouse, BISL, for settlement of trades on BSE. Today, the two depository systems are fully electronically interfaced. Security positions move between NSDL and CDSL every 15 minutes. Securities are then immediately available for redelivery at the receiving depository. This fluid system accommodates the need for members to quickly and safely move security positions to meet settlement obligations at NSCCL or BISL. 49. With all systems operating well and interfaces between systems established, the depositories are taking on new projects. SEBI recently outsourced to NSDL the design, development, and implementation of a registration database using biometrics.21 The plan is to fingerprint everyone involved in the capital market. The fingerprints, in addition to photographs, will become part of an individuals profile in the database. NSDL will manage the database, but it will be owned by SEBI. NSDL is developing another system to collect information on taxpayers and tax obligation information. Initially, the database will carry details as reported by tax withholding agents. CDSL is working with mutual funds to develop a system that will create a consolidated holdings report for owners of mutual funds. CDSL also is looking at facilitating the settlement of commodities through the depository. V. A. Relevance OVERALL ASSESSMENT

50. The Program was consistent with ADBs development strategy in India and in line with the Governments development strategy. The important question regarding the relevance is whether the Government would have proceeded with these reforms without the Program. The answer is yes. Indeed, the Government proceeded with the majority of these reforms for 2 years (19931995) without support of loan proceeds. Most of the second tranche release conditions were met at the time of program approval. However, the Program helped (i) define and shape the scope of the reform program; and (ii) facilitate continuing dialogue with the Government in difficult reform areas, such as SEBI independence, institutional investor involvement, and debt market development. As a result, the Program was relevant.

21

Fingerprint and face recognition for optimal security.

18 B. Efficacy

51. The Program supported the goal of achieving a higher rate of economic growth, meeting the program purpose of (i) increasing the country's ability to mobilize internal and external resources to finance economic growth, and (ii) attaining the outputs of a more efficient and transparent market-based financial system. The Program was efficacious. C. Efficiency

52. This was the only Program in the history of ADB where a negotiated document was circulated to the Board of Directors, withdrawn, and approved 2 years later. Given the history and processing of the Programand the additional delays in meeting tranche release conditionsthe Program was less efficient. D. Sustainability

53. Sufficient demand and resources exist to sustain the services offered by the institutions created under the Program. In addition, the operating and financial performance of these institutions has become the market standard that new entrants must emulate. The sustainability of the Program is likely. E. Institutional Development and Other Impacts

54. Laws, regulations, and procedures continue to be revised and updated to meet the needs of the markets. The market culture and trading environment is virtually unrecognizable from what existed at the start of the Program 10 years ago. The professionalism of market participants also continues to expand. A market-based financial industry has blossomed in the past decade, and institutions, skills, and capacity have grown to meet the demand. The institutional impact of this Program has been substantial. F. 55. G. Overall Program Rating The overall rating of the Program is successful. Assessment of ADB and Borrower Performance

56. ADBs oversight of the Program was satisfactory. Three review missions were fielded. The first review mission was in December 1996, approximately 1 year after loan effectiveness. The second review mission in October 1997 assessed the Governments progress in meeting the Programs conditions for the second tranche release. The mission identified issues with policy actions for repurchase agreements (repos), granting SEBI sufficient regulatory powers, and investment limits of institutional investors. The third review mission in March 1998 assessed the progress in meeting the remaining conditions, and recommended the release of the second tranche of the loan in the progress report circulated in October 1998. The second tranche was released on 22 December 1998. 57. The MOF served adequately as EA for the Program. It oversaw the implementation of capital market reforms, provided guidance and supervision, and administered the loan disbursement and use of counterpart funds. A report was prepared under the provision of Article IV, Section 4.05c, of the Loan Agreement between ADB and the Government. However, the

19 report was not as comprehensive as expected, primarily due to frequent personnel changes in the Government during the program period. VI. A. ISSUES, LESSONS, AND FOLLOW-UP ACTIONS

Key Issues for the Future 1. Fiscal and Structural Reform

58. A significant amount of attention has been given to support fiscal reform in India in areas such as tax collection and fiscal management.22 Even more has been written about the topic, so it will be noted only briefly. Continued success in diversifying and spreading risk in a marketbased financial system will depend upon sustained efforts to reform the economy. Reducing the large budget deficit and reviving structural reform will be the most critical factors over the medium term. The Government has been unable to correct the large budget deficit, which has remained around 6% of gross domestic product since the late 1990s. The need to maintain a pool of low-cost captive funds from institutional investors has resulted in inefficient investment with costs to the economy and to policyholders. Low international interest rates and large private capital inflows have underpinned the exchange rate and provided ample domestic liquidity. However, this is unlikely to be sustained. In addition, limited progress in privatizing state-owned enterprises 23 continues to limit the restructuring of key sectors and opportunities for new investment and growth. 2. Independence of the Financial Market Regulators

59. A lack of genuine independence for the financial market regulators (RBI, SEBI, and other regulators, such as the newly established insurance regulator, IRDA) continues to inhibit the market-based decisions needed for the financial system to function effectively. Keeping market regulators at arms length from monetary and fiscal policy issues and ensuring sufficient autonomy to pursue market misconduct and regulatory abuse would contribute greatly to more efficient and transparent markets. In addition, inconsistencies in regulations governing the financial sector has created gaps and regulatory overlaps. For example, commercial banks fall under the regulatory authority of the RBI, which affects the manner and scope of positions banks can take in any exchange-traded securities or contract. SEBI, however, has regulatory authority over exchange-traded securities. This can be a serious issue in creating exchangetraded derivatives (or spot) instruments in asset classes where banks are the largest natural participants, such as interest rate or foreign exchange derivatives. 60. The concept of self-regulatory organizations (SROs) is another area of regulatory confusion where SEBI and market participants disagree. SEBI has taken the position that monitoring, supervision, and enforcement are the responsibilities solely of the exchanges. The exchanges believe that SEBI should be responsible for oversight and enforcement. The exchanges, however, perform routine monitoring of their members and take actions based on exchange rules. In this situation, SEBI fails to recognize its responsibility as the principal
22

ADB has provided substantial TA for tax reform in India. A TA performance audit report on Selected Technical Assistance for Fiscal Management and Tax Administration in India is to be completed in 2004, identifying many of the recurring issues with tax reform. 23 Recent aggressive sales (FebruaryApril 2004) lifted privatization proceeds to Rs154 billion in FY2004, exceeding the target of Rs132 billion and well above Rs34 billion ($0.8 billion) in 2002/03. Last years result was only the second time that the annual target was exceeded in the 13-year history of privatization. This represents a small fraction of the assets that need to be privatized.

20 regulator. SEBI also would like to see all trade organizations become SROs. This position reflects SEBIs lack of understanding of a proper SRO environment in which SEBI is the ultimate regulator. A clear delineation of duties and responsibilities in the SRO relationship, codified through an agreement, would simplify some of these regulatory issues. 61. If market regulators had been truly independent, they would have been able to detect earlier recent market irregularities involving banks misusing funds to finance multiple stock market operations, which eventually ended in bankruptcy. A Joint Parliamentary Commission (detailed in Appendix 5) was convened to investigate these irregularities. Rather than strengthening the High Level Committee for Capital Market Developmentcomprised of the governor of the RBI, chairman of SEBI, chairman of IRDA, and the finance secretarythe terms of reference have been weakened to eliminate responsibility for anticipatory market regulation. B. 62. Lessons Identified Key lessons from the Program include: (i) The Governments vision for the development of the market can be traced back to a small number of fiercely independent civil servants. This vision was needed to sustain the implementation of a reform program of this magnitude. Adequately developing the institutional, administrative, and regulatory framework required a substantial commitment of time and resources. Therefore, the importance of government ownership and dialogue cannot be underestimated. Capital market development also requires a certain depth of human resources or skills in the market. Ensuring sufficient skills and capacity to implement complex reforms, such as the ones specified in this Program, were critical to the success of the Program. Three factors proved to be essential for this market to develop: (a) competition, which forced good market standards for fairness; (b) transparency and efficiency, through an improved clearing, settlement, and depository system that allowed dematerialized trading; and (c) sufficient supply and demand to foster market depth and liquidity. The derivative market has played a key role in this aspect of market development.

(ii)

(iii)

C.

Follow-Up Actions

63. Since the Program, ADB has maintained a constructive engagement with India. ADB is supporting the debt and derivative markets, and pension reform. This assessment endorses ADBs approach and efforts in these areas, and encourages more dedicated assistance for the development of bond markets. Support for infrastructure development through the use of debt instruments is urgently needed. Well-structured assistance with concrete deliverables could accelerate development in this area.

CAPITAL MARKET DEVELOPMENT PROGRAM LOAN STATUS OF REFORMS

Policy Actions
a

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

A. Establish the framework for an integrated national market system 1. Government, in consultation with Securities and Exchange Board of India (SEBI), to complete a review of trading, clearance, settlement, and depository systems and practices across all exchanges, including National Stock Exchange (NSE) and OTC Exchange of India (OTCEI). (First tranche release condition) 2. Formulate and adopt firm strategies for ensuring an efficient and competitive interface among the different stock exchanges and harmonizing the trading, clearance, settlement, and depository systems to bring about greater uniformity of practices, operating standards, codes of conduct and ethics, reporting requirements, and quicker dissemination of information and prices across all exchanges in preparation for the introduction of automated rating in debt and equity securities and automated settlement of trades on the exchanges (December 1996).
a

Implemented. Action completed before Board consideration (October 1993).

Implemented. As a first step, SEBI carried out for the first time an examination of all Indian stock exchanges. Based on this examination and following international norms, measures were adopted during the program period to harmonize trading, clearance and settlement, and depository systems. These measures were (i) automated trading systems were introduced in all stock exchanges; the systems provide a more transparent, efficient, and faster means for executing trades and disseminating information; all stock exchanges except two today have automated trading facilities; (ii) the cash settlement period was standardized and reduced from 14 days to 7 days for all stock exchanges; for scripless transfers, SEBI introduced a T+5 (trade date + 5 days) rolling settlement cycle; the objective is to further shorten the

The National Securities Depository Limited (NSDL) has successfully implemented the inter-depository transfer securities module, which allows NSDL to transact with other depositories. A group of 15 regional stock exchanges also established the Inter-connected Stock Exchange of India (ICSI). Therefore, all regional stock exchanges participating in ICSI will conform to a uniform trading and settlement cycle and practices. NSE also took over the management of OTCEI, and OTCEI will conform to prevailing NSE standards. The integration of the stock exchanges will help bring about uniformity of

Of the 23 regional exchanges in India, seven are active and interface with the depositories for clearance and settlement purposes. ICSI has been structured as a single broker member at the exchanges. NSDL has links with nine stock exchanges, including NSE and Bombay Stock Exchange (BSE) plus the seven active regional exchanges. BSE has also developed a depository, Central Depository Services Limited (CDSL). It received its Certificate of Commencement of Business on 8 February 1999. Basic services are similar to those at NSDL. Some variations have been developed by CDSL to provide competitive services to those of the other depository.

Appendix 1

21

Second tranche release conditions highlighted in bold, while end-of-program conditions in italics.

Policy Actions

Progress Report Status of Reforms October 1998 settlement cycle and move toward rolling settlement and delivery versus payment as suggested by the Group of Thirty (G30); (iii) to ensure effective clearing of transactions, all stock exchanges were required to set up a clearinghouse or clearing corporation; this has been implemented by the stock exchanges; (iv) uniform good and bad delivery norms were prescribed for all stock exchanges; (v) a time-bound procedure for resolution of bad deliveries was introduced; (vi) all stock exchanges were advised to set up a trade or settlement guarantee fund to reduce counterpart risk by ensuring that adequate funds are available for timely completion of settlements in the event that member brokers are unable to fulfill their obligations; and (vii) studies were undertaken to streamline and standardize share legislation, transfer and allotment, and delisting of securities from the stock exchanges, and to strengthen continuing disclosure standards by listed companies and timely dissemination of pricesensitive information to the public; measures are being undertaken to carry out the recommendations of these studies.

Program Completion Report Status of Reforms October 1999 practices and operating standards.

Status of Reforms February 2004

22

Competition from CDSL may have contributed to significant reductions in fees as charged by NSDL. NSDL and CDSL are fully interfaced, meaning the same securities are eligible at both depositories. The automated system that moves securities positions between the two depositories is updated every 15 minutes throughout the business day. This allows for same-day redelivery of securities as needed by members. The two depositories are linked to their respective clearing organizations, completing the settlement cycle. All of these interfaces have led to a standardization of processes. Regional market participants are linked electronically to the exchanges, clearing organizations, and depositories. Besides transaction processing, these links have resulted in more timely dissemination of price data and other market information. Codes of conduct have been established by exchanges and certain trade associations. Reporting requirements for members have also been established by exchanges. SEBI regulates the reporting requirements for the exchanges. While intermediaries may be registered through their exchange memberships, they still are not properly certified (see 33). The number of securities eligible for dematerialization through the depositories has continually increased. Trades in all securities that are eligible for dematerialization through the

Appendix 1

Policy Actions

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

depositories must now follow the standard rolling settlement process. The rolling settlement cycle has been gradually and successfully reduced to T+2 days. The smooth transition to T+2 was largely due to the dematerialization of securities through the depository. The plan is to reduce this time further once electronic funds transfer is operational. The Indian securities market has achieved the most effective cash settlement process possible in India under current banking norms (see 12). With the increased usage of the depositories, the clearing corporation (NSCCL) and clearing house (BISL) now operate substantially more efficiently. This is a direct result of expanded automation of the clearance and settlement process and dematerialization. Another extremely important impact of settlement through the depositories is that bad deliveries are virtually non-existent. In 1996, the NSE became the first stock exchange in India to provide a nationwide, order-driven, screen-based, anonymous trading system. All exchanges now have implemented screen-based trading systems. As of 1998, the BSE also provides nationwide access to that exchange. In addition to the trading systems of the exchanges, SEBI has allowed use of the Internet for submission of orders to brokers by their clients. To perform Internet-based trading, brokers must be registered with

3. Adopt a firm action plan to ensure the availability of automated trading facilities for securities of large, medium, and small enterprises across the country (December 1996).

Implemented (see 9).

Appendix 1

23

Policy Actions

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

24

SEBI, fulfill minimum regulatory requirements, and receive permission from the stock exchanges where they are members. B. Modernize existing infrastructure to support market growth and expansion 4. Appoint a technical group with broad representation from users, Stock Holding Corporation of India Limited and SEBI, to examine in-depth all relevant issues regarding the NCDS in order to develop a firm strategy and clear approach to the implementation of the NCDS. (First tranche release condition) 5. Complete report by international consultants on the NCDS, considering the regulatory, structural and technological aspects of the NCDS. (First tranche release condition) 6. Based on the recommendations of the Technical Group for establishing a national clearance, settlement, and depository system (NCDS), determine the conceptual framework of the NCDS and prepare a phased program for setting up automated trading, clearance, settlement, and depository systems based on an agreed timetable aiming for an integrated market

Appendix 1

Implemented. Action completed before Board consideration (February 1993).

Implemented. Action completed before Board consideration (May 1993).

Implemented.

See 23 and 10.

Policy Actions

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

system (December 1996). 7. Enable through legislation the establishment and operation of national automated depository systems, taking into account issues related to, inter alia, title transfer and registration, recognition of ownership, voting rights, rights to dividends, the creation of liens, liabilities of the depository, and settlement of disputes (December 1996). 8. Issue regulatory guidelines for the establishment and operation of automated depository systems incorporating the views of the main users of the systems (March 1997). 9. Commence automated trading in debt securities at the NSE (December 1996).

Implemented. A Presidential Ordinance, promulgated on 21 September 1995, defines the legal basis for the establishment and operation of national automated depositories and provides for their b regulation. Parliament passed the Depositories Act, 1996, which received the assent of the President on 10 August 1996.

Implemented. SEBI issued depositories and participants regulations on 16 May 1996.

Implemented. Automated trading on a screen-based system is fully operational.

The Wholesale Debt Market (WDM) commenced its operation in June 1994 with 224 securities worth Rs1.35 trillion. Operations have increased to 852 securities with outstanding value of Rs3.43 trillion in March 1998. The daily trading volume increased from Rs24 million to Rs3.5 billion in the same period.

Screen-based trading in government debt instruments does exist although trades are made primarily through phone calls. The agreed-upon trades are then reported to one of two NSE trade-reporting systems: (i) NSE WDM WDM reporting system for government debt instruments. (ii) NDSNegotiated dealing system for corporate debt. The two trade-reporting systems are linked to the Clearing Corporation of
Appendix 1

25

The Asian Development Bank fielded a staff consultant at the request of the Government to review the draft bill prior to its finalization.

Policy Actions

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

26

India Ltd. (CCIL) for settlement purposes. 10.Establish an automated clearance, settlement, and depository system for securities trading in one or more exchanges in all major centers in the country. Implemented. Pursuant to SEBI (Depositories and Participants) Regulations, 1996, SEBI, granted a certificate of registration as depository to the NSDL on 7 June 1996. The NSDL became operational from 8 November 1996, providing depository services for equity shares. Today, NSDL has 65 depository participants, providing service at 400 locations around the country. Listed securities registered at the NSDL number 251, of which 238 are in scripless form. The National Securities Clearing Corporation Ltd. (NSCCL), which handles the clearing and settlement functions of the NSE, interfaces with the NSDL and the clearing banks to provide delivery versus payment settlement for trades within the depository. The NSCCL started operating in April 1996 and set up a settlement guarantee fund contributed by the clearing members of the corporation. The clearing banks are attached to the NSCCL and electronic transfer of funds is made for pay-in and pay-out. The NSCCL has implemented a nationwide clearing and settlement system since September 1996. It also has in place an online monitoring and surveillance system. The NSCCL proposes to provide a securities lending and borrowing facility to its clearing members, and clear and settle all trades once trading in options and futures are introduced at the NSE. All stock exchanges have their own clearinghouses. The Stock Exchange, Mumbai (BSE), also has set up a The CDSL, a depository established by BSE and a few other commercial banks, started operating in 1999. The transaction cost of Indias equity markets dropped dramatically from 5% in 1993 to 2.2% in 1997. As of May 1999, NSDL participants had increased to 88. These participants provided services at 831 locations in 178 cities around the country. The number of investors accounts increased from 11,000 in March 1998 to 435,000 and 557,000 in March and May 1999, respectively. The number of corporate securities available for dematerialization at NSDL increased to 375. Of 7,000 stocks, SEBI required 104 securities to be traded only in a dematerialized form. This covers around 80% of market capitalization and 50% of the settlement volume. The value of dematerialized securities increased from Rs225 billion in March 1998 to Rs1,110 billion in March 1999. The settlement volume in dematerialized form increased from around 100 million shares in May1998 to 400 million shares in March 1999. The number of monthly settlements in NSCCL increased from 2 million trades in the second half of 1996 to Continued progress (see 2). SEBI has continually expanded mandatory settlement in dematerialized form. Today, more than 99% of 4.6 securities delivered against trades is through the depositories. NSDL has 214 depository participants (DPs). At the client level, 6.2 million accounts are open and 4.6 million are active. These accounts represent individual investors nationwide. CDSL has 196 DPs and more than 500,000 accounts, linking members nationwide through computer terminals. The CDSL system differs slightly from NSDL in that individual investors are allowed to give instructions directly to the depository rather than going through a DP. The depositories are interfaced to facilitate electronic movement of positions between them. They are also linked to their respective clearing organizations to facilitate settlement (see 2).

Appendix 1

Policy Actions

Progress Report Status of Reforms October 1998 settlement guarantee fund and proposes to set up its own depository.

Program Completion Report Status of Reforms October 1999 around 3.5 million trades in the first half of 1998. Bad deliveries are less than 0.3%, compared with the market standard of 10%. The settlement guarantee funds of NSCCL stood at Rs7.6 billion as of August 1999. NSE expanded its links to 283 cities and 2,238 VSATs (terminal) as of August 1999. Some local stock exchanges have set up subsidiaries to link trading with NSE.

Status of Reforms February 2004

11.Commence automated trading in debt and equity securities in all major centers in the country.

Implemented. The NSE is linked to 206 cities throughout India, which include the major centers of Ahmedabad, Chennai, Kolkata, Mumbai, and New Delhi, and 141 cities with no stock exchanges. The OTCEI operates out of 42 offices outside Mumbai. Following a SEBI directive requiring stock exchanges to initiate online trading by 30 June 1996, all but two stock exchanges started online trading. In a recent directive, SEBI also granted permission to BSE to offer its online trading facility called the BSE On-Line Trading System (BOLT) to investors outside Mumbai via satellite links with other stock exchanges or with brokers where no exchanges exist. BOLT is linked to 189 centers in various states of India. Continual progress. The implementation of automated national depositories in India and the standards enforced will determine how close to international norms present systems can get and the extent and nature of links possible with global financial markets. Five of the nine recommendations of the G30 have been introduced. They relate to the depository system, trade netting, use of delivery versus payment, securities lending, and adoption of International Organization for Standardization (ISO) standards 7775 and 6166. Compliance with the remaining

Debt in India is not yet traded through an exchange. Trades are still made through telephone calls. Agreed-upon trades are reported to one of two NSE systems that feed the clearing corporation for settlement purposes (see 9). The infrastructure of Indias debt market has been enhanced with the development of The (CCIL) (see 20).

12. Move toward compliance with the G30 recommendations on securities clearance and settlement.

Continual progress. The implementation of national depositories according to G30 recommendations has progressed since the last review. Trade comparison is done after each trade between brokers. However, it is not extended to other market participants. The settlement has moved to a voluntary T+5 rolling settlement or weekly netting settlement, and 10 dematerialized securities will follow a compulsory T+5 rolling settlement in December 1999.

Continual progress. The Indian equities market has achieved the most effective cash settlement process possible in India under current banking norms. Cash settlement is effected by the NSCCL (NSEs clearing house) and BISL (BSEs clearing corporation). As prescribed by G30 and the International Organization of Securities Commission (IOSCO), this includes the final transfer of securities only upon receipt of the related cash payments, cash payments in same day funds, and finality of payment. Risk management practices are

Appendix 1

27

Policy Actions

Progress Report Status of Reforms October 1998 conditions will depend on how soon all securities are in scripless form and how son facilities for electronic transfer of funds are in place.

Program Completion Report Status of Reforms October 1999 The same day funds payment system and T+3 rolling settlement system are not in place yet. The former depends on RBI initiatives. Remarks: Many countries in Asia still do not comply with G30 recommendations, especially on same day funds and the T+3 rolling settlement. However, better and cheaper information technology will induce countries in the region to shorten the period of payment and settlement.

Status of Reforms February 2004

28
used by the exchanges, depositories, and clearing entities to offset any remaining risks (including guarantee funds). Market participants and their regulator want DVP to be perfected through the exchange of cash and securities at precisely the same moment. Part of the objective is to use the RBI to effect money transfers for trade settlement. Liquidity to support cash settlement has been enhanced through NSDLs pledge loan program. Depository participants pledge securities to lending banks through the depository. Only the lending bank can release the securities back to the borrower once the loan is paid. Mark-to-market (market price) on pledged securities is performed by the lender. India has moved to a T+2 rolling settlement cycle for all securities eligible for dematerialization through the depositories. (Virtually, 100% of deliveries are now in dematerialized form.) Banking constraints are currently being overcome through the collection of funds by brokers from their clients prior to the entry of trade orders (generally, T-2). Improved banking systems are needed before India can move to T+1. In addition to the original G30 recommendations, India also has implemented most of the recommendations under International Securities Services Association 2000 and Bank for International Settlements (BIS)-IOSCO. They continue to work on areas of governance, messaging standards, and risk management.
Appendix 1

Policy Actions

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

C. Eliminate constraints that inhibit market growth, improve market access, and strengthen the role of financial intermediaries in the capital market 13.SEBI to commence approval of registration of foreign institutional investors (FIIs) to invest in all securities traded in the capital market based on guidelines issued by the Government. (First tranche release condition) 14.Government to create a committee (the Malhotra Committee) to examine the workings of the insurance sector and scope of reforms. 15.Review Malhotra Committee recommendations regarding the reduction in directed investments of insurance companies (June 1994) 16.Reduce directed investments of insurance companies from 70% for General Insurance Corporation (GIC) and 75% for Life Insurance Corporation (LIC) based on the review of the Malhotra Committee recommendations (December 1996).

Implemented. Action completed before Board consideration (December 1992).

Implemented. Action completed before Board consideration. (July 1993)

Implemented.

Substantially implemented. The proportion of investible funds of the GIC and its subsidiaries devoted to directed investments has been reduced from 70% to 45%. GIC and its subsidiaries are now allowed to invest 55% of funds in the open market. The Malhotra Committee recommended a target level of aggregate directed investments out of total investments of 35%. The Government has enlarged the scope of investments under the socially oriented sector to include private sector infrastructure projects. Thus, in the case of LIC, directed investments have been reduced from 75% to 50% of its annual

Although investment restrictions have been relaxed, LIC has not effectively reduced the portion of directed investment to total assets due to two main factors: (i) the lack of capability and financial skills to invest in private sector projects, and (ii) slow progress in developing infrastructure projects resulting from the economic slowdown. Parliament passed the IRDA bill on 7 December 1999. The bill seeks to provide statutory status to IRDA and to privatize the sector by

The status of reforms has not changed substantially since 1998. The limits on the amount of investment in Government securities remain at 50% of funds. Only 5% of these bonds can be traded; the rest are kept as permanent portfolio. The insurance companies are allowed to invest up to 25% in infrastructure projects. LIC has been able to invest about 10% of its portfolio in these projects due to the limited number of viable projects coming to market. The Government retains the ownership and management of most of the infrastructure in the country. Small

Appendix 1

29

Policy Actions

Progress Report Status of Reforms October 1998 investible funds, and 25% of the annual increase in funds has to be invested in the infrastructure sector either in public or private sector companies. The scope of infrastructure projects also has been widened to include projects in ports, roads and highways, railways, and airports. Additionally, LIC will be allowed to form joint ventures for managing pension funds that could be invested in the capital market. On insurance reforms, the Malhotra Committee has recommended that the level of directed investments of LIC be reduced to no more than 50% of total investments. Beyond the liberalization of investments, the Government announced its policy of opening up the insurance industry to private sector and foreign participation to promote competition. Accordingly, the Government established a new regulatory authority for the insurance industry, which was approved by the Cabinet in September 1995, in preparation for the liberalization of entry into the domestic insurance business. The new Insurance Regulatory Development Authority (IRDA) is to be given statutory powers. The IRDA bill was introduced in Parliament in December 1996, but was not passed in August 1997. The IRDA bill, with modifications, will be reintroduced by the Government in the coming winter session of Parliament. Implemented. Provident and pension funds were covered in the Malhotra Committee Report.

Program Completion Report Status of Reforms October 1999 amending the exclusive privilege granted to GIC and LIC, and to allow the establishment of domestic private insurance companies and foreign participation of up to 26%.

Status of Reforms February 2004

30
public offerings in state-owned enterprises started last year and are planned for this year. LIC will take stakes in these offerings as they become available. LIC also keeps about 10% of its funds in equity distributed among approximately 300 top stocks listed on the exchanges. Lack of investment partners and viable infrastructure projects coming to market constrain the efficient use of institutional funds.
Appendix 1

17.Government to review restrictions on provident and pension funds to invest other than in bank deposits and government securities (December 1996).

The Asian Development Bank (ADB) provided TA 3367-IND: Reform of the Private Pension and Provident Funds System Reform and the Employees Provident Fund for $1 million, approved on 26 December 1999 to examine issues related to the Employees Provident Fund Organization (EPFO)

Policy Actions

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004 and the development of private pension funds, including investment guidelines. This TA is part of a technical assistance performance audit report (TPAR) focused on the pension sector (www.adb.org/evaluations). The TA to India was viewed as partly successful. Overall, the TA was relevant, but it was implemented too early for India. Had the TA been implemented even a year later, its impact would likely have been more substantial. The guidelines that govern the asset allocation of the EPFO have evolved over time. Currently, the guidelines require that almost all the EPFO assets be invested in government bonds (central or state government bonds, or public sector firms). A maximum of 10% of the assets can be invested in corporate bonds, although actual investments in this asset class are negligible. Therefore, more than 90% of the funds of the EPFO are invested in government securities. Only a small fraction of these funds are available for the private sector in the country. Historically, the government has set returns paid on EPFO funds annually. The rate of return paid on government bonds over the past decade has been about 12% This rate was largely independent of market rates. Since the provident funds finance a significant portion of the Governments budget deficits such an administratively determined rate was a convenient way for the government to obtain low-cost financing in an environment of high market interest rates. Since July 2000

18. Based on the review of investment restrictions on provident and pension funds, Government to adopt a more liberal policy for allowing investments to be made out of provident and pension funds (December 1996).

Partly Implemented. Based on the review of investment restrictions on provident and pension funds, the Controller of Insurance issued instructions that the Controlled Fund of the LIC will exclude non-linked pension business comprising group superannuation and group and individual annuities. Up to 60% of these funds may be invested in approved investments other than central government and state securities. For FY1997, these funds totaled RS 59.09 billion. Funds of group schemes other than group superannuations (lump-sum benefit and death benefit schemes) totaled Rs52 billion. The management of investible funds of the EPFO, which is the largest fund, was also entrusted to the State Bank of India by the central bank, RBI. The investment pattern for EPFO has been relaxed slightly, The most recent guidelines issued in March 1997 allow for 25% of provident funds investments to be made in government securities, 15% in central government and state government securities, 40% in the bonds of public sector units and public sector financial institutions, and the balance of 20% to be

Although the provident funds were allowed to invest in private sector bonds, the risk-averse investment committee declined to invest in such securities. Discussions have been held with the Government and the EPFO on technical assistance for the reform of the private pension and provident funds system and the modernization of EPFO.

Appendix 1

31

Policy Actions

Progress Report Status of Reforms October 1998 deployed freely in any of the above three categories. In the Union Budget for FY1999, provident funds have been allowed to invest up to 10% of their incremental accretions in private sector bonds and securities as part of the 20% balance. requested ADB assistance in reforming the EPFO system and for capacity building, particularly in the Malhotra Committee recommended allowing investments of these provident and pension funds of up to 60% of their investible funds in other than government, state government, and governmentguaranteed securities. The EPFO has undertaking investments and overseeing the functions of fund managers.

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

32
the government has been lowering the interest payable to EPFO contributions, and the rates now are around 9.5%. Recent moves to lower this further have met with political opposition. However, the real issue is that the rates have little to do with the prevailing market rates of return on funds. If the universe of asset classes is expanded to include domestic equities, the cost in terms of lost revenue is quite high. The equity market index shows returns of around 1820% for a period of more than 2 decades. This implies an equity premium of around 10% (assuming a real rate of return of around 10% for the same period). Even if a small amount of funds were invested in equity funds, contributors would have gained significantly.
Appendix 1

19. Adopt accreditation guidelines for market makers in equity securities and provide adequate access to bank credit and financing by fixing appropriate margin requirements. (December 1996). (First tranche release condition) 20. Begin trading operations in debt securities in at least one exchange with a view to developing a sound and active market in debt securities. (First tranche release condition)

Implemented. Action completed before Board consideration. (July 1993)

Implemented. Action completed before Board consideration. (May 1993)

An exchange-based trading system for debt does not exist yet. Trades are typically negotiated via phone call. When agreement is met, trades are reported to one of two systems at NSE (NSEWDM for governments; Reserve Bank of Indias Negotiated Dealing System [NDS] for corporate debt) (see 9).

Policy Actions

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004 CCIL has been established to address the need for an integrated clearing and settlement system for government debt and foreign exchange transactions. CCIL clears and settles trades of its members transacted on NDS and NSEWDM. The settlement of these trades is guaranteed by CCIL through novation, whereby CCIL becomes central counter party for each trade. CCIL also clears and settles inter-bank foreign exchange trades in India. CCIL guarantees settlement of trades of its members concluded in the debt and foreign exchange market. Foreign exchange trades carried out by the dealers on their respective trading systems are reported to CCIL for settlement. The use of repos will remain limited until the payment system moves to electronic funds transfer.

21. Establish prudential guidelines for resumption of the use of repurchase agreements (repos) for ready forward deals in order to enhance liquidity in the secondary market for public undertaking bonds and government securities (December 1996). 22. Establish prudential guidelines for extending the use of repos to cover private debt securities (December 1996).

Implemented. The use of repos for government securities was resumed for banks and accredited primary dealers following RBIs strengthening of the subsidiary general ledger (SGL) system to track transactions more effectively.

Satellite dealers have been permitted to enter the repo market since March 1998. Since July 1999, the Government has permitted 35 nonbank entities to undertake repos in treasury bills of all maturities and approved dated securities.

Implemented. RBI further relaxed its monetary policy, announced in October 1997, to permit repo deals in public sector undertaking bonds and private corporate debt securities, provided these securities are in scripless form and transactions are completed in recognized stock exchanges. These repos initially are to be permitted for those entities undertaking repos in government securities.

A subgroup of the Technical Advisory Committee on the Government Securities Market submitted a report on repos in April 1999. The Group proposed several changes to the repo market including (i) introduction of exchange-traded and over-thecounter repos, (ii) allowing rollover of repos, and (iii) expansion

Appendix 1

33

Policy Actions

Progress Report Status of Reforms October 1998 However, implementation remained difficult because of the stamp duty attached to the transfers of debt securities. This issue had been examined closely, and the Solicitor General of India and the Ministry of Justice had rendered their opinion that under the Depositories Act, 1996, such stamp duty does not apply to transfers made within the depository. Implemented. RBI issued the Guidelines for Primary Dealers in Government Securities on 29 March 1995, and accredited six primary dealers in government securities: Discount and Finance House of India, Ltd., Securities Trading Corporation of India Ltd., SBI Gilts Ltd., PNB Gilts Ltd., Gilt Securities Trading Corporation Ltd., and ICICI Securities and Finance Company Ltd. The first two became operational on 3 January 1996 and the four others on 1 June 1996. RBI also decided to create a second tier of satellite dealers that can provide support to primary dealers as well as diversify and expand the investor base. RBI has granted permission to nine firms to serve as satellite dealers. Implemented. A SEBI directive to this effect was issued on 13 December 1993. A revised carry forward system with safety features became operational in January 1996. This was modified in October 1997. On 6 February 1997, the Securities Lending Scheme, 1996, as approved by SEBI, became operational. The scheme provides for lending of securities by an approved intermediary to a borrower under an agreement for a specified period, with the condition that the borrower would return the equivalent securities of the same class or

Program Completion Report Status of Reforms October 1999 of the repos market in users and instruments. Under the Union Budget for 1999 2000, the Government abolished the stamp duty on transfer of debt instruments within the depository mode.

Status of Reforms February 2004

34
Appendix 1

23. Adopt accreditation guidelines for market makers in debt securities (December 1996)

The number of primary dealers has increased from the original 6 to 14, while the number of satellite dealers is 9.

24. Discontinue the badla system (December 1996)

Effective 1 July 2001, badla has been banned in the Indian markets. This ban resulted from the potential risk through possible abuse of the badla system. The settlement of trades could be extended indefinitely, delaying delivery to the individual investor. Settlement failures were possible. After the ban, brokers complained about liquidity problems. However, most have adjusted. Activity in securities lending in India is relatively low. FIIs are permitted to loan securities, but cannot borrow. NSDL has developed a stock lending model.

Policy Actions

Progress Report Status of Reforms October 1998 type at the end of the specified period along with the corporate benefits on the securities borrowed.

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

However, it is not used. All lending is done over the counter. Lending against securities faces another fundamental limitation because the RBI prohibits banks from having more than 5% exposure to securities in their portfolio. This includes exposure to either equity or debt.

25. SEBI to complete a review of issues on developing a market in options and futures in order a strategy for operation of such a market (December 1996). 26. Lift the restrictions and establish a regulatory framework to enable a trading system in options and futures to operate (December 1996).

Implemented. SEBI organized an international seminar on options and futures to consider the key issues in the operation of a derivatives market.

Implemented. The prohibition on options was lifted on 25 January 1995. However, a provision in an old Indian law, the Indian Contracts Act, which prohibits wagers (and options have been considered a form of wager) had prevented the introduction of options and futures. This provision has since been clarified. On 17 March 1998, the Gupta Committee finalized its study and submitted its report on the introduction of derivative products in India and on a regulatory framework for options and futures. On 4 July 1998, the Government introduced a bill in Parliament seeking to amend the Securities Contracts (Regulation) Act, 1956. The bill will redefine securities to include all types of derivative instruments and derivatives trading will be formally introduced. As far back as December 1996, the NSE filed with SEBI an application to introduce futures contracts based on its NSE-50 index.

The SCR (Amendment) bill was passed by the Parliament on 1 December 1999. This will allow the trading of derivatives to start.

Derivatives trading has become one of the most active areas in the market, approaching Rs3 trillion in December 2003.

Appendix 1

35

Policy Actions

Progress Report Status of Reforms October 1998 Implemented. The SEBI (Merchant Bankers) Rules and Regulations, 1992 does not include a fixed lead management fee. However, Section 76 of the Companies Act, 1956 does establish a fixed ceiling on the underwriting commission. SEBI has removed the requirement for the mandatory underwriting of issues, and the modified Companies Bill, 1997 was introduced in Parliament. Implemented. The total underwriting obligations of an underwriter will not exceed 20 times its net worth. The minimum capital requirement for a lead manager to an issue is currently Rs50 million.

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

36

27. Permit market-driven and risk -related lead management and underwriting fees to be charged (June 1996).

Appendix 1

28. Define the responsibilities of lead managers and underwriters of securities with respect to the extent of permissible commitment relative to a minimum capital base (December 1996). 29. Allow pricing for public offerings to be fixed at a date closer to the actual offering period by the lead manager(s) to reduce the price risk and ensure such price is relayed to all distribution channels and ultimately to investors, allowing for at least the normal stipulated time within which investors may reasonably respond (December 1996).

Implemented. To reduce the risk to underwriters, SEBI permitted the use of a price band of 20% instead of a single fixed price in the document to be submitted to it for vetting. The actual price is to be set only at the time of filing of the offer document with the Registrar of Companies and/or stock exchange, which should be within the indicated price band. Filing is normally 21 days before the opening of the public issue. An option to use socalled bought-out deals has also allowed issues to be priced close to the issue date. Under a bought-out deal, an issuer arranges with a lead manager, who organizes an underwriting syndicate, to buy a large portion of the issue or the entire issue outright. The underwriters would proceed to sell the issue to other investors at prices that will clear the market. With automated trading, pricing of an issue can be moved even closer to the offering date to reduce, if not eliminate,

Policy Actions

Progress Report Status of Reforms October 1998 the price risk to the underwriters. SEBI also has allowed the book-building method for public issues, which enables issuers to fix a price based on a survey of investors. Today, however, listing on a stock exchange has been made mandatory for public issues. A price risk thus arises between the time subscription is made and the time an investor is able to sell the subscribed issue, which is during allotment of the issue and listing with the stock exchange. SEBI has been able to reduce the time period from about 7085 days to 3035 days, and further improvements are contemplated. In addition, with the introduction of hedging instruments, investors will be in a position to cover their risk exposures. Implemented. Action completed before Board consideration. (October 1993)

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

30. Allow allocation of shares in the case of oversubscription to be made on a pro-rata basis to avoid multiplicity of applications. (First tranche release condition) 31. Increase minimum application size for equity issues offered to investors. (First tranche release condition) 32. Streamline the public issue process by reducing the number of nationwide centers where issues must be offered. (First tranche release condition) D. Enhance competition and level the playing field 33. Allow expanded membership through clear qualification criteria. (First tranche release condition)

Implemented. Action completed before Board consideration. (October 1993)

Implemented. Action completed before Board consideration. (October 1993)

Appendix 1

Implemented. Action completed before Board consideration. (October 1993)

Progress has been limited in this area. NSE and BSE have broker member requirements. These include some training and testing of applicants.

37

Policy Actions

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

38
Primarily, these are at the operational level to ensure that members and staff know how to use the exchange systems. SEBI recently outsourced to NSDL the design, development, implementation, and management of a registration database of market participants. The database will be owned and accessed only by SEBI, and is expected to ultimately contain information down to the individual investor level. This does not address, however, the need for proper certification and licensing of intermediaries by the regulator. Testing related to certification ensures that intermediaries have a minimum standard of knowledge about products they are selling, related regulations, and markets. Licensing is tied to testing levels. With testing and certification, intermediaries become more professional and are better able to assist customers in selecting appropriate investments. Individual investors have a higher level of trust with proper testing, certification and licensing. For the protection of individual investors, such a program is needed in India to fully identify and subject all intermediaries to the regulatory system, including ultimate oversight by SEBI.
Appendix 1

34. Remove legal impediments to permit 51% foreign ownership of corporate stock brokerage firms by reputable foreign institutions upon SEBI registration so that these firms can acquire membership in the stock exchanges (December 1996).

Implemented. Impediments have been removed. Eleven stock brokerage firms and 17 asset management companies with substantial foreign stakes now operate in India. Meanwhile, 22 foreign brokers registered with SEBI are allowed to service investments made in India by foreign institutional investors (FIIs).

Policy Actions

Progress Report Status of Reforms October 1998 Implemented. Action completed before Board consideration (October 1993).

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

35. With regard to NSE, ensure that future ownership is independently determined and that management remains autonomous. (First tranche release condition) 36. Approve the operation of private sector mutual funds. (First tranche release condition) 37. Subject to regulation by SEBI the closed-end mutual fund operations of the Unit Trust of India (UTI) as they related to closed-end schemes and opened-end schemes regulation. (December 1996)

Implemented. Action completed before Board consideration (February 1993). Implemented. UTI has been brought under the regulatory ambit of SEBI. Accordingly, new schemes of UTI were required to be submitted to SEBI for approval. Since UTI has evolved as a distinct and hybrid financial institution, it received certain special dispensations under the UTI Act in keeping with its special character. Certain operations have, therefore, remained within the scope of the UTI Act. SEBI has vetted around 20 UTI schemes. UTI has been subjected to SEBI examination for the first time under the provisions of Regulation 60(1) of the SEBI (Mutual Funds) Regulations, 1993, in a directive issued 7 June 1995. SEBI supervises 84 UTI schemes, but 20 schemes still are not covered by SEBI: 10 will be transferred to SEBI in November 1999, 4 will be closed, and 5 will be reviewed and transferred by July 2000. UTIs share of cumulative assets of mutual funds decreased from 86% to 78%, while other public sector and private sector mutual funds asset increased their share from 10% and 4% to 12 and 10%, respectively. According to the Union Budget for 19992000, the tax on UTI schemes and that on other mutual funds were equalized. The US-64 Scheme and all open-ended equity schemes of UTI and other mutual funds were exempted from dividend tax for 3 years. Income from holding UTI and other mutual funds also was exempted from income tax. In 2001, UTI funds came under scrutiny when problems arose with one of the funds, US-64. The price at which it was being traded far exceeded the value. It became apparent that the fund did not have enough money to cover guaranteed dividends. Subsequent actions by the government led to the repeal of the UTI Act in 2002, and the bifurcation of the UTI funds. UTI-I comprises those UTI funds that are guaranteed by the government. UTI-II (as deemed by the market) includes those funds that have been transferred to a new company. As such, the new company is under the regulatory authority of SEBI. Previously, compliance with SEBI regulations and oversight was voluntary for these UTI funds. The Union Budget 20032004 provides that, under the restructuring of the funds, UTI-I will be exempt from the dividend distribution tax. However, as a company, the UTI-II funds will be subject to the standard 12.5% distribution tax. Dividends are tax free to the shareholders.

Appendix 1

39

38. Introduce in a phased manner parity in the dividend tax

Implemented. Action completed before Board consideration. (May 1993)

Policy Actions

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

40

between UTI and other mutual funds. (First tranche release condition) E. Strengthen market regulation and supervision 39. Transfer through legislation regulatory and supervisory powers more fully to SEBI (December 1996).

Appendix 1

40. By notification in the Official Gazette, delegate to SEBI, more fully, powers of regulation and enforcement relating to the capital market currently contained in (i) the Securities Contracts (Regulation) Act, 1956, and (ii) the Companies Act, 1956 (December 1996).

Implemented. SEBI was given the power to regulate issuers or companies with respect to the issuance and transfer of securities, to exact compliance with respect to the conditions of the listing agreement by a company with any stock exchange; and to register and regulate depositories, securities custodians, FIIs, and credit rating agencies, including venture capital funds. SEBI was also empowered to levy monetary penalties for various forms of offenses, to issue summonses, to subpoena any person, and to call for submission of documents relating to an inquiry. Securities Appellate Tribunals were created by the Central Government to expedite the resolution of cases involving securities. A Presidential Ordinance to this effect was issued. Substantially implemented. Except for the powers vested in the Central Government under Sections 118(2), and 133(2) of the Companies Act, 1956, all powers vested in the Central Government contemplated to be delegated to SEBI under the Program of policy actions and reforms under the Capital Market Development Program Loan (CMDPL) have been delegated. Powers that have yet to be delegated relate to (i) failure by a company to furnish a copy of the trust deed within the time specified for a debenture issue, and (ii) willful omission by a company of the endorsement of the certificate of registration of any debenture issue where payment is secured by the charge registered. However, Sections 118(2) and 133(2) were incorporated in the

See below.

See 40.

While certain powers have been delegated to SEBI over the years, the securities regulator continues to be inhibited through lack of authority in a number of areas. This was significantly improved in October, 2002 when SEBI was given additional powers, such as the authority to issue cease and desist orders, significantly increase fines and penalties, and obtain evidentiary documents from third parties (helpful with banks). The amendment also specifically prohibits market manipulation and insider trading, allowing SEBI to regulate and take appropriate actions (see 41 and 42).

Policy Actions

Progress Report Status of Reforms October 1998 Companies Bill, 1997, which had already been introduced in Parliament. Under the proposed Companies Bill, 1997, SEBI is to be entrusted with the administration and supervision (including powers to prosecute) of matters relating to the issue of securities and listing of public companies to avoid overlapping of functions. Clause 47 of the proposed Companies Bill provides that the provision of Part IV of the Companies Bill relating to prospectus, allotment, listing, and other matters concerning the issue of securities of listed public companies and companies proposed to be listed be administered by SEBI. Partly implemented. SEBI formed a committee in February 1997 chaired by former Justice D.R. Dhanuka to review the Securities Contracts (Regulation) Act, 1956; the SEBI Act, 1992; and Depositories Act, 1996, to enable SEBI to more fully regulate and develop the securities market. The Dhanuka Committee also examined the provisions of the Companies Act, 1956, to enable SEBI to improve market regulations concerning, in particular, the issue of capital, listing of securities, transfer of securities, and investor protection. The Dhanuka Committee recommended that the Securities Contracts (Regulation) Act, 1956, and SEBI Act, 1992, be consolidated into a composite securities legislation, making SEBI the sole regulatory agency as envisaged under the CMDPL. The report is being reviewed by the Ministry of Finance (MOF) before seeking the approval of Parliament. Implemented. Action completed before Board consideration. (November 1992 October 1993)

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

41. Rationalize all pertinent laws, rules, and regulations in a manner consistent with SEBIs designation as the principal regulator of the capital market

The unified SEBI and SCR bill is expected to be introduced to the Parliament.

SEBI still shares regulatory authority with the RBI and Department of Company Affairs. This continues to create confusion periodically in the marketplace, where regulations and/or directives are not consistent among regulators. While laws, rules, and regulations may still need to be rationalized, SEBI has had farreaching powers as a regulator, further enhanced by the recent amendments to the SEBI Act (see 40). However, in some cases, SEBI has not effectively applied those powers. A Joint Parliamentary Committee (JPC) investigation that resulted from the identification of severe market irregularities recently highlighted weaknesses in regulation and oversight at SEBI. These weaknesses are directly related to SEBIs position on SRO responsibilities. The amendment to the SEBI Act in October 2002 (see 40) strengthens SEBIs powers through the addition of a

Appendix 1

42. Make rules and regulations under the SEBI Act covering insider trading, merchant

41

Policy Actions

Progress Report Status of Reforms October 1998

Program Completion Report Status of Reforms October 1999

Status of Reforms February 2004

42

bankers, portfolio manager, mutual funds, appeals against SEBI rulings, registrars to the issues and securities transfer agents, and underwriters. (First tranche release condition)

new section titled Prohibition of Manipulative and Deceptive Devices, Insider Trading and Substantial Acquisition of Securities or Control. This section of the amendments defines market manipulation and insider trading, increases penalties to be levied by SEBI, strengthens the Securities Appellate Tribunal (SAT) that hears such cases, and provides for appeals. Implemented. Pertinent regulations have been issued.

Appendix 1

43. Make rules and/or regulations under the SEBI Act covering corporate takeovers; bankers to an issue, and debenture trustees (December 1996) 44. Establish high-level interagency committee composed of representatives from MOF, RBI, and SEBI to coordinate policy at the Government level. (First tranche release condition)

Implemented. Action completed before Board consideration. (October 1993)

The High Level Committee for Capital Market Development (HLCC), formed following the JPC (A ppendix 5), was an attempt to coordinate regulation over the entire capital market environment. The committee members are the governor of the RBI, the chairman of SEBI, the chairman of IRDA and the finance secretary from MOF. The joint secretary in charge of capital markets at MOF is the member secretary of the HLCC.

Sources: ADB. 1999. Program Completion Report on the Capital Market Development Program Loan to India. Manila; and Operations Evaluation Mission.

Appendix 2

43

RECOMMENDATIONS OF GROUP OF THIRTY SECURITIES CLEARANCE AND SETTLEMENT STUDY Recommendation 1: Trade Comparison on T+1 "By 1990, all comparisons of trades between direct market participants (i.e., brokers, broker/dealers and other exchange members) should be accomplished by trade date plus 1." Recommendation 2: Trade Comparison for Indirect Participants "Indirect market participants (such as institutional investors, or any trading counterparties which are not broker/dealers) should, by 1992, be members of a trade comparison system which achieves positive affirmation of trade details." Recommendation 3: Central Depository "Each country should have an effective and fully developed central securities depository, organized and managed to encourage the broadest possible industry participation (directly and indirectly), in place by 1992." Recommendation 4: Netting "Each country should study its market volumes and participation to determine whether a trade netting system would be beneficial in terms of reducing risk and promoting efficiency. If a netting system would be appropriate, it should be implemented by 1992." Recommendation 5: Delivery versus Payment "Delivery versus payment (DvP) should be employed as the method for settling all securities transactions. A DvP system should be in place by 1992." Recommendation 6: Same Day Funds "Payments associated with the settlement of securities transactions and the servicing of securities portfolios should be made consistent across all instruments and markets by adopting the same day funds convention." Recommendation 7: T+3 Rolling Settlement "A 'Rolling Settlement' system should be adopted by all markets. Final settlement should occur on T+3 by 1992. As an interim target, final settlement should occur on T+5 by 1990 at the latest, save only where it hinders the achievement of T+3 by 1992." Recommendation 8: Securities Lending "Securities lending and borrowing should be encouraged as a method of expediting the settlement of securities transactions. Existing regulatory and taxation barriers that inhibit the practice of lending securities should be removed by 1990." Recommendation 9: Use of ISO Standards 7775 and 6166 "Each country should adopt the standard for securities messages developed by the International Organization for Standardization (ISO Standard 7775). In particular, countries should adopt the ISIN numbering system for securities issues as defined in the ISO Standard 6166, at least for cross border transactions. These standards should be universally applied by 1992."

44

Appendix 3

EXCERPTS OF THE SECURITIES AND EXCHANGE BOARD OF INDIA (AMENDMENT) ACT, 2002 A. 1. Amendment of Section 11 In section 11 of the principal Act, (a) Information and record(s) from any bank or any other authority or board or corporation established or constituted by or under any Central, State, or Provincial Act in respect of any transaction in securities which is under investigation or inquiry by the Board; Without prejudice to the provisions contained in sub-section (2), the Board may take measures to undertake inspection of any book, or register, or other document or record of any listed public company or a public company (not being intermediaries referred to in section 12) which intends to get its securities listed on any recognized stock exchange where the Board has reasonable grounds to believe that such company has been indulging in insider trading or fraudulent and unfair trade practices relating to securities market; The Board may, by an order, for reasons to be recorded in writing, in the interests of investors or securities market, take any of the following measures, either pending investigation or inquiry or on completion of such investigation or inquiry, namely: (a) suspend the trading of any security in a recognized stock exchange; (b) restrain persons from accessing the securities market and prohibit any person associated with securities market to buy, sell, or deal in securities; (c) suspend any office-bearer of any stock exchange or self-regulatory organization from holding such position; (d) impound and retain the proceeds or securities in respect of any transaction which is under investigation; (e) attach, after passing of an order on an application made for approval by the Judicial Magistrate of the first class having jurisdiction, for a period not exceeding one month, one or more bank account or accounts of any intermediary or any person associated with the securities market in any manner involved in violation of any of the provisions of this Act, or the rules or the regulations made thereunder:

(b)

(d)

B. 2.

Insertion of New Sections 11C and 11D 11C. (1) Investigation. Where the Board has reasonable ground to believe that (a) the transactions in securities are being dealt with in a manner detrimental to the investors or the securities market; or (b) any intermediary or any person associated with the securities market has violated any of the provisions of this Act or the rules or the regulations made or directions issued by the Board thereunder; it may, at any time by order in writing, direct any person (hereafter in this section referred to as the Investigating Authority) specified in the order to investigate the affairs of such intermediary or persons associated with the securities market and to report thereon to the Board.

Appendix 3

45

(2)

(3)

(4)

(5)

(6)

(8)

Without prejudice to the provisions of sections 235 to 241 of the Companies Act, 1956 (1 of 1956), it shall be the duty of every manager, managing director, officer, and other employee of the company and every intermediary referred to in section 12 or every person associated with the securities market to preserve and to produce to the Investigating Authority or any person authorized by it in this behalf, all the books, registers, other documents, and record of, or relating to, the company or, as the case may be, of or relating to, the intermediary or such person, which are in their custody or power. The Investigating Authority may require any intermediary or any person associated with securities market in any manner to furnish such information to, or produce such books, or registers, or other documents, or record before him or any person authorized by it in this behalf as it may consider necessary if the furnishing of such information or the production of such books, or registers, or other documents, or record is relevant or necessary for the purposes of its investigation. The Investigating Authority may keep in its custody any books, registers, other documents, and record produced under sub-section (2) or sub-section (3) for six months and thereafter shall return the same to any intermediary or any person associated with securities market by whom or on whose behalf the books, registers, other documents, and record are produced: Provided that the Investigating Authority may call for any book, register, other document, and record if they are needed again: Provided further that if the person on whose behalf the books, registers, other documents, and record are produced requires certified copies of the books, registers, other documents, and record produced before the Investigating Authority, it shall give certified copies of such books, registers, other documents, and record to such person or on whose behalf the books, registers, other documents, and record were produced. Any person, directed to make an investigation under sub-section (1), may examine on oath, any manager, managing director, officer, and other employee of any intermediary or any person associated with securities market in any manner, in relation to the affairs of his business and may administer an oath accordingly and for that purpose may require any of those persons to appear before it personally. If any person fails without reasonable cause or refuses (a) to produce to the Investigating Authority or any person authorised by it in this behalf any book, register, other document, and record which is his duty under sub-section (2) or sub-section (3) to produce; or (b) to furnish any information which is his duty under sub-section (3) to furnish; or (c) to appear before the Investigating Authority personally when required to do so under sub-section (5) or to answer any question which is put to him by the Investigating Authority in pursuance of that sub-section; or (d) to sign the notes of any examination referred to in sub-section (7), he shall be punishable with imprisonment for a term which may extend to one year, or with fine, which may extend to one crore rupees, or with both, and also with a further fine which may extend to five lakh rupees for every day after the first during which the failure or refusal continues. Where in the course of investigation, the Investigating Authority has reasonable ground to believe that the books, registers, other documents and record of, or relating to, any intermediary or any person associated with securities market in

46

Appendix 3

(10)

(11)

any manner, may be destroyed, mutilated, altered, falsified or secreted, the Investigating Authority may make an application to the Judicial Magistrate of the first class having jurisdiction for an order for the seizure of such books, registers, other documents, and record. The Investigating Authority shall keep in its custody the books, registers, other documents, and record seized under this section for such period not later than the conclusion of the investigation as it considers necessary and thereafter shall return the same to the company or the other body corporate, or, as the case may be, to the managing director or the manager or any other person, from whose custody or power they were seized and inform the Magistrate of such return: Provided that the Investigating Authority may, before returning such books, registers, other documents, and record as aforesaid, place identification marks on them or any part thereof. Save as otherwise provided in this section, every search or seizure made under this section shall be carried out in accordance with the provisions of the Code Criminal Procedure, 1973 (2 of 1974) relating to searches or seizures made under that Code.

11D.

Cease and desist proceedings.If the Board finds, after causing an inquiry to be made, that any person has violated, or is likely to violate, any provisions of this Act, or any rules or regulations made thereunder, it may pass an order requiring such person to cease and desist from committing or causing such violation: Provided that the Board shall not pass such order in respect of any listed public company or a public company (other than the intermediaries specified under section 12) which intends to get its securities listed on any recognised stock exchange unless the Board has reasonable grounds to believe that such company has indulged insider trading or market manipulation. Chapter VA PROHIBITION OF MANIPULATIVE AND DECEPTIVE DEVICES, INSIDER TRADING AND SUBSTANTIAL ACQUISITION OF SECURITIES OR CONTROL

12A.

Prohibition of manipulative and deceptive devices, insider trading, and substantial acquisition of securities or control.No person shall directly or indirectly (a) use or employ, in connection with the issue, purchase, or sale of any securities listed or proposed to be listed on a recognized stock exchange, any manipulative or deceptive device or contrivance in contravention of the provisions of this Act or the rules or the regulations made thereunder; (b) employ any device, scheme, or artifice to defraud in connection with issue or dealing in securities which are listed or proposed to be listed on a recognized stock exchange; (c) engage in any act, practice, course of business which operates or would operate as fraud or deceit upon any person, in connection with the issue, dealing in securities which are listed or proposed to be listed on a recognized stock exchange, in contravention of the provisions of this Act or the rules or the regulations made thereunder; (d) engage in insider trading; (e) deal in securities while in possession of material or non-public information or communicate such material or non-public information to any other person, in a

Appendix 3

47

(f)

manner which is in contravention of the provisions of this Act or the rules or the regulations made thereunder; acquire control of any company or securities more than the percentage of equity share capital of a company whose securities are listed or proposed to be listed on a recognized stock exchange in contravention of the regulations made under this Act.

C. 3.

Insertion of New Sections 15HA and 15HB After section 15H of the principal Act, the following sections shall be inserted, namely: 15HA. Penalty for fraudulent and unfair trade practices.If any person indulges in fraudulent and unfair trade practices relating to securities, he shall be liable to a penalty of twenty-five crore rupees or three times the amount of profits made out of such practices, whichever is higher. 15HB. Penalty for contravention where no separate penalty has been provided. Whoever fails to comply with any provision of this Act, the rules or the regulations made or directions issued by the Board thereunder for which no separate penalty has been provided, shall be liable to a penalty which may extend to one crore rupees.

D.

Substitution of New Sections for Sections 15L and 15M

4. 15L. Composition of Securities Appellate Tribunal.A Securities Appellate Tribunal shall consist of a Presiding Officer and two other members, to be appointed, by notification, by the Central Government: E. 5. Substitution of New Section for Section 15Z For section 15Z of the principal Act, the following section shall be substituted, namely: 15Z. Appeal to Supreme Court.Any person aggrieved by any decision or order of the Securities Appellate Tribunal may file an appeal to the Supreme Court within sixty days from the date of communication of the decision or order of the Securities Appellate Tribunal to him on any question of law arising out of such order:

F. 6.

Insertion of New Sections 24A and 24B 24B. Power to grant immunity. (1) The Central Government may, on recommendation by the Board, if the Central Government is satisfied, that any person, who is alleged to have violated any of the provisions of this Act or the rules or the regulations made thereunder, has made a full and true disclosure in respect of the alleged violation, grant to such person, subject to such conditions as it may think fit to impose, immunity from prosecution for any offence under this Act, or the rules or the regulations made thereunder or also from the imposition of any penalty under this Act with respect to the alleged violation:

48 G.

Appendix 3

Repeal and Saving

7. (1) The Securities and Exchange Board of India (Amendment) Ordinance, 2002 (Ord. 6 of 2002) is hereby repealed. (2) Notwithstanding the repeal of the Securities and Exchange Board of India (Amendment) Ordinance, 2002 (Ord. 6 of 2002), anything done or any action taken under the principal Act as amended by the said Ordinance, shall be deemed to have been done or taken under the principal Act, as amended by this Act.

Appendix 4

49

UNIT TRUST OF INDIA 1. The government-run Unit Trust of India (UTI) is the largest mutual fund manager in India. Established by an act of Parliament, UTI started operations in 1964 with the twin objectives of (i) mobilizing retail savings, and investing those savings in the capital market; and (ii) enabling small investors to benefit from the acquisition, holding, management, and disposal of securities. 2. As a financial intermediary between investors and stock markets, UTI provides a range of services, including mutual funds. Unit Scheme 1964 (US-64) was the first open-ended mutual funds scheme in India. It was also the first mutual scheme offering of UTI and its flagship scheme with more than 20 million investors.1 As of end June 2001, UT I manages funds of more than Rs58,221 crore with more than 41.8 million investors accounts under 85 schemes. Reserve Bank of India, Life Insurance Corporation of India, State Bank India, and some foreign banks contributed the initial capital of Rs5 crore for US-64 scheme. In 2002, UTI had 54 branch offices, 266 chief representatives, and about 67,000 agents. 3. UTI initially invested in government paper at fixed returns. It took the opportunity created by the rise in stock market values at the start of liberalization in 1991 to shift an increasing part of the portfolio to equities. US-64, a balanced income fund it has run since 1964, invested heavily in equities in the mid-1990s and paid dividends that were kept artificially high for political reasons. Similarly, UTI did not alter the structure of its savings instruments, which offered units at artificially administered prices that did not take into account the changing value of its stocks with long-term security. In 1998, UTIs principal fund was responsible for the bulk of equity investments in the market. 4. UTI deteriorated from a thriving investment establishment and collapsed due to inefficient management, affecting millions of investors who placed their trust in the government body. 2 UTI operations reflected a lack of accountability and professionalism, poor expertise, and fraud. It suffered from a lack of clear investment policies and improper transfers of investments and money across funds. A major weakness of its premiere US-64 was its lack of transparency. UTI did not disclose its net asset value (NAV), a figure that should be made publicly available every working day, even though UTI is reported to have made internal calculations. For years, a shroud of secrecy created by Parliament protected UTI, which did not have a system for public scrutiny of the accounts or a periodic declaration of the assets and the portfolios of UTI. Under the protection afforded by an act of Parliament, UTI was able to do everything from invest in the stock market in collusion with shady speculators to buy large chunks of real estateall of which finally resulted in its failure. In 1998, faced with cash shortages to meet dividend payments that were artificially high for political reasons, UTI secretly sold shares and represented the capital return as income. When the deal was exposed, the market went into another decline. 5. A key problem of UTI was the widening gap between its fixed commitments (on guaranteed income and capital gains schemes) and its real net asset value in the market. UTI proved a poor judge of the equities it purchased, and was caught in the stock market fall in the
1

In addition to equity, debt, and balanced schemes, UTI manages schemes aimed at meeting specific needs, such as low cost insurance cover, regular income and liquidity needs, and building up funds to meet the cost of higher education. It also provides financial services, including underwriting to the corporate sector. UTI set up associate companies in the field of banking, securities, trading, investor servicing, investment advice, and training to meet investors varying needs through a diversified financial conglomerate. In 2001, it was the largest single player in Indias markets with investments totaling Rs600 billion. UTI is a trust without ownership capital and independent board of trustees. The Government of India appoints the chairman of the board of UTI.

50

Appendix 4

late 1990s. As the crisis in the information technology sector and a string of stock market scandals in February 2001 drove down equity prices, UTI ran into liquidity problems and closed down. The Government bailed UTI out, but it faced competition from smaller and bettermanaged mutual funds that had gained market share. By the end of 2001, UTIs share of assets of all mutual funds fell from 65% to 50%. Private mutual funds increased their share from 28% to 42%. 6. US-64 was considered safe and provided high returns to investors, especially in the first half of the 1990s. US-64 encountered difficulties in July 1998 with reports that the value of the scheme had dropped. As a consequence, US-64s reserves showed a negative balance. This shook investor confidence in the scheme, prompting the government bailout of UTI with a grant of Rs300 crores. Despite the earlier problems, UTI continued to choose equities poorly, missed out on the technology boom in the stock markets in 19992000, and fell into a deeper hole. In June 2000, a run on deposits led to the US-64 fund for 6 months. The loss in confidence was fueled by rumors that the value of its real assets was far below the administered price at which its units were sold. 7. The Malegam Committee investigated and found the paper valuation of UTI funds was nearly 50% higher than its real assets.3 In addition to recommending better management of the UTI, the Committee proposed a series of reforms with far-reaching implications for the capital market. It called on the public sector to stay out of the mutual fund business, at least for equity transactions. UTI also needed to find a strategic partner in the private sector and adopt marketbased management principles. Even if the Government retains partial ownership, UTI must operate like any other market trader. Large-scale structural changes (including improved accounting and auditing, more transparency, and a reduction in the risk of non-settlement and a payment crisis) are needed within the UTI. Because of the magnitude of UTIs activities relative to the market and private placements it accepts, increased transparency in its activities would also benefit the capital market. 8. In October 2002, the Union Cabinet repealed the UTI Act of 1963. As part of the structural reform process, the assets and liabilities of the UTI were vested into two entitiesUTI-I and UTI-IIunder the purview of the Securities and Exchange Board of India (SEBI). Losses from both were borne by the Government. UTI-I comprised the US-64 scheme, Assured Return Schemes, SUS 1999, and Development Reserve Fund. A governmentappointed administrator will continue to manage UTI-I until the fund fulfills its commitments to the investors of US-64 and more than 20 assured-return schemes. The healthy net asset value (NAV)-based schemes were transferred to UTI-II. Subsequently, it was registered as UTI Asset Management Company (AMC) Limited, a new asset management company formed by the State Bank of India, Punjab National Bank, Bank of Baroda, and Life Insurance Corporation. 4 The UTI AMC would manage UTI-II and its NAV-based schemes, totaling more than Rs17,000 crore. UTI-II will be a SEBI-compliant mutual fund with a three-tier structure, comprising the board of trustees, sponsors, and an asset management company with an initial paid-up capital of Rs10 crore. A chartered accountant would carry out due diligence on UTI-II, allowing a decision to be need on whether to privatize UTI-II after 35 years.

3 4

A corporate committee was set up to reposition UTI in an emerging financial sector. Under the chairmanship of Shri Y.H. Malegam, the Committee would examine relevant issues and make recommendations. The State Bank of India, Punjab National Bank, Bank of Baroda, and Life Insurance Corporation each will have a 25% stake and invested Rs2.5 crore in the UTI AMC.

Appendix 5

51

JOINT PARLIMENTARY COMMISSION 1. The identification of severe market irregularities in 2001 resulted in a Joint Parliamentary Committee (JPC) investigation in 2002. In its report, the JPC highlighted weaknesses in the areas of regulation and oversight at the Securities and Exchange Board of India (SEBI). These weaknesses can be attributed in part to SEBIs position on the self-regulatory organization (SRO) responsibilities. The concept of SROs is an area of regulatory confusion where SEBI and market participants clearly disagree. Under the SEBI Act, SEBI has the power to license SROs. However, regulations governing the requirements of an organization to obtain SRO status are lacking. In the past, SEBI has expressed the desire that all trade organizations become SROs. Currently, only the National Stock Exchange and Bombay Stock Exchange have been designated as SROs. SEBI has taken the position that these exchanges are solely responsible oversight and enforcement, and would like the trade associations assume the same responsibilities. The exchanges (and others) believe that SEBI should be ultimately responsible for oversight and enforcement. SEBI has not issued a formal memorandum of agreement, understanding, or guidelines to clarify the powers and responsibilities of the regulator versus those of the exchanges. 2. The exchanges, however, perform routine oversight of their members and take actions based on membership rules of the exchange. While India appears to have elected to operate its capital market under the SRO concept, SEBI has not recognized its responsibility as the principal regulator in the past. That has led to a lack of understanding of a proper SRO environment with SEBI as the ultimate regulator. The regulator and the exchanges need to sort out the confusion to avoid further market irregularities falling through the cracks. In addition to the SRO issue, market participants have expressed dissatisfaction with the amount and quality of SEBI circulars. (Circulars may be issued to clarify regulations, provide directives, add to earlier circulars, etc.) Market participants have complained that SEBI issues circulars without understanding an issue completely or thinking through all the ramifications of its directives.

ELEMENTS OF MARKET DESIGN IN INDIAN SECURITIES MARKET, 1993 AND 2004 52

Features Regulator

Corporate Securities
1993 No specific regulator, but central government oversight. 2004 A specialized regulator for securities market (SEBI) vested with powers to protect investors interest and to develop and regulate securities market. SROs strengthened. Specialized intermediaries emerged, which are registered and regulated by SEBI. The intermediaries as well as their employees are required to follow a code of conduct and are subject to a number of compliances. Eligible issuers access the market after complying with the issue requirements.

Government Securities 1993 2004 RBI participates in Unchanged. SROs emerged. and regulates the market.

Appendix 6

Intermediaries

Some of the intermediaries (stock brokers, authorized clerks, and remisiers) regulated by the SROs.

Brokers and/or dealers with agency problems.

Brokers of specified exchanges authorized to trade. Primary dealers offer two-way quotes.

Access to Market

Granted by central government.

Pricing of Securities

Determined by central government.

Determined by market, either by the issuer through fixed price or by the investors through book building.

Authorized by Parliament. Automatic monetization prevalent. Determined by RBI.

Unchanged. Automatic monetization discontinued.

Integration with International Market

No access.

Trading Mechanism

Open outcry. Available at the trading rings of the exchanges. Opaque, auction and negotiated deals. Fragmented market through geographical distance. Order flow unobserved.

Corporates allowed to issue ADRs and GDRs and raise ECBs. ADRs and GDRs have two-way fungibility. FIIs allowed trade in Indian market. MFs also allowed to invest overseas. Screen-based trading system. Orders are matched on price-time priority. Transparent trading platform accessible from all over the country. Order flow observed. The exchanges have open electronic consolidated limit order book OECLOB.

No access except external borrowing by the Government.

Determined by market through a system of auctions (uniform/multiple price/yield). Small proportion available at prices determined by RBI. Unchanged. FIIs permitted to invest in government securities.

Negotiated deals over telephone.

Aggregation Order Flow

Anonymity in Trading

Absent.

Complete.

Fragmented market through geographical distance. Order flow unobserved. Absent.

Negotiations over telephone and on screen. Also screenbased trading system where orders are matched on pricetime priority. Unchanged. Limited use of OECLOB.

Absent except for OECLOB market.

ADR = American depository receipt, ECB = external commercial borrowing, FII = foreign institutional investor, GDR = global depository receipt, MF = mutual fund, OECLOB = open electronic consolidated limit order book, RBI = Reserve Bank of India, SEBI = Securities and Exchange Board of India, SRO = self-regulatory organization.

Features 1993 Settlement System Bilateral.

Corporate Securities
2004 Clearing house of the exchange or the Clearing Corporation is the central counterparty. Rolling settlement on T+2 basis. 1993 Bilateral.

Government Securities 2004 Clearing corporation is counterparty to most of the trades. Bilateral settlement continues. Rolling settlement on T+0 to T+2 basis. Absent for trades settled through clearing corporation Mostly electronic through DvP. Unchanged. However, net in funds for settlement through clearing corporation. Securities are freely transferable. Transfers are recorded electronically in book entry form in SGL. Comprehensive risk management mechanism for transactions settled through clearing corporation.

Settlement Cycle

Counterparty Risk Form of Settlement Basis of Settlement Transfer of Securities

14-day account period settlement, but not adhered to always. Present. Physical. Bilateral netting.

Spot.

Absent. Mostly electronic. Multilateral netting.

Present. Physical. Gross.

Cumbersome. Transfer by endorsement on security and registration by issuer. No focus on risk management.

Securities are freely transferable. Transfers are recorded electronically in book ent ry form by depositories. Comprehensive risk management system encompassing capital adequacy, limits on exposure, and turnover. VaR-based margining, client level gross margining, online position monitoring, etc. Exchange-traded futures and options available on two indices and select securities. Exchange-traded interest rate derivatives on 91-day notional treasury bill and 10-year notional 6% coupon bearing bond as well as zero coupon bonds.

Transfer by endorsement.

Risk Management

No focus on risk management.

Derivatives Trading

Absent.

Absent.

Absent. Repurchase agreement transactions permitted.

DvP = delivery versus payment, SGL = subsidiary general ledger, VaR = value at risk. Source: Operations Evaluation Mission. Appendix 6

53

54

GROWTH AND DISTRIBUTION OF TURNOVER ON STOCK EXCHANGES (Rs million)

No. Stock Exchange 19941995 19951996 19961997 19971998 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. NSE 85,090 Mumbai 677,480 Kolkata 528,720 Delhi 90,827 Ahmedabad 56,508 Uttar Pradesh 78,230 Ludhiana 24,880 Pune 36,720 Bangalore 7,120 Hyderabad 13,752 ICSE Cochin 5,970 OCTEI 3,650 Chennai 30,327 Madhya Pradesh 1,182 Magadh 7,968 Vadodara 16,210 Gauhati 2,853 Bhubaneshwar 1,434 Coimbatore 13,095 Jaipur 8,786 Mangalore 615 SKSE 5,447 Total 1,696,864 800,090 500,640 621,280 100,760 87,860 23,730 48,490 70,710 8,900 12,850 18,030 2,180 2,040 16,290 12,590 6,190 2,260 25,030 10,470 390 5,640 2,376,420 3,367,820 1,242,840 1,056,640 486,310 205,330 160,700 52,740 99,030 43,980 4,800 14,010 2,210 23,150 120 27,550 42,680 4,840 2,310 23,980 15,190 3,730 3,980 6,883,940 4,811,970 2,073,830 1,787,780 678,400 307,710 153,900 83,150 86,240 86,360 18,600 17,830 1,250 12,280 10 3,230 45,760 200 2,020 21,360 4,310 3,080 170 10,199,440 19981999 5,198,520 3,119,990 1,717,804 517,593 297,342 186,267 59,779 74,528 67,790 12,759 7 7,730 1,422 3,696 9 0 17,491 302 770 3,947 648 112 0 11,288,506 19992000 11,432,680 6,850,282 3,571,655 932,889 375,656 240,478 77,405 60,868 111,474 12,365 5,452 0 35,879 2,502 97 80 1,593 0 701 388 21 1 0 23,712,466 20002001 17,704,580 10,016,190 3,550,354 838,711 540,352 247,467 97,322 61,705 60,328 9,778 2,331 1,866 1,259 1,092 24 16 9 0 0 0 0 0 0 33,133,385 20012002 15,622,830 3,093,156 270,747 58,280 148,435 252,373 8,566 11,710 703 413 554 0 38 241 235 0 101 1 0 266 0 0 0 19,468,650 20022003 21,265,445 3,165,516 65,228 111 154,586 147,634 0 0 0 46 531 0 1 756 0 2 26 1 0 0 0 0 0 24,799,883

Appendix 7

= not available, ICSE = Inter-Connected Stock Exchange, NSE = National Stock Exchange, OCTEI = Over-the-Counter Exchange of India, Rs = rupees, SKSE = Saurashtra Kutch Stock Exchange. Note: Turnover means total value of transactions of securities in all market segments of an exchange. Source: Securities and Exchange Board of India.

NEW CAPITAL ISSUES BY NONGOVERNMENT PUBLIC LIMITED COMPANIES (Rs crore)

19921993 Security and Type of Issue No. of Amount Issues 1. Equity Shares a. Prospectus b. Rights 2. Preference Shares a. Prospectus b. Rights 3. Debentures a. Prospectus b. Rights 4. Total (1+2+3) a. Prospectus b. Rights 868 484 384 1 0 1 171 47 124 1,040 531 509 9,952.6 3,889.7 6,062.9 0.5 0.0 0.5 9,850.3 3,187.5 6,662.8 19,803.4 7,077.2 12,726.2 19941995 No. of Amount Issues 1,548 1,275 273 9 5 4 121 48 73 1,678 1,328 350 17,414.4 13,727.3 3,687.1 131.4 81.4 50.0 8,870.9 5,868.1 3,002.8 26,416.7 19,676.8 6,739.9 19981999 No. of Amount Issues 33 15 18 3 0 3 12 9 3 48 24 24 2,562.7 340.4 2,222.3 59.7 0.0 59.7 2,390.6 2,261.3 129.3 5,013.0 2,601.7 2,411.3 20002001 No. of Amount Issues 127 108 19 2 0 2 9 7 2 138 115 23 2,924.7 2,580.6 344.1 142.2 0.0 142.2 3,077.4 2,987.1 90.3 6,144.3 5,567.7 576.6 20012002 No. of Amount Issues 16 6 10 1 0 1 16 10 6 33 16 17 1,150.7 891.4 259.3 46.8 0.0 46.8 4,544.4 3,743.5 800.9 5,741.9 4,634.9 1,107.0 20022003 No. of Amount Issues 15 3 12 0 0 0 1 0 1 16 3 13 1,022.1 206.7 815.4 0.0 0.0 0.0 0.5 0.0 0.5 1,022.6 206.7 815.9 20032004 No. of Amount Issues 26 10 16 0 0 0 3 3 0 29 13 16 1,490.0 759.6 730.4 0.0 0.0 0.0 800.0 800.0 0.0 2,290.0 1,559.6 730.4

Rs = rupees. Notes: 1. Equity shares exclude bonus shares. 2. Figures exclude data on private placement and offer for sale. 3. Preference shares include cumulative convertible preference shares and equi-preference shares. 4. Convertible debentures include partly convertible debentures. 5. Non-convertible debentures include secured premium notes and secured deep discount bonds. 6. Debentures include bonds. 7. Rs1 crore = Rs10 million. Sources: Reserve Bank of India and Operations Evaluation Mission.

Appendix 8

55

56

Appendix 9

NUMBER OF LISTED SECURITIES, MARKET CAPITALIZATION, AND TURNOVER AT BSE AND NSE (Rs billion) Item
Number of Companies Listed in Indian Stock Exchanges BSE Number of Listed Companies Market Capitalization of Companies Listed in BSE Turnover at BSE (per annum) Turnover ratio at BSE (per annum) BSE Sensitive Index Average Year-End NSE Listed Companies Number of Listed Companies Market Capitalization Permitted Equities Number of Equities Permitted Market Capitalization Turnover S&P CNX Nifty Indexa Average Year-End

19921993
6,925

19941995
9,077

19981999
9,877

20022003
9,413

2,781 2,109.5 457.0 21.7%

4,413 4,688.4 677.5 14.5%

5,860 6,195.3 3,120.0 50.4%

5,650 5,722.0 3,140.7 54.9%

2,896.0 2,280.5

3,975.0 3,261.0

3,295.0 3,740.0

3,206.3 3,048.7

135 3,633.5 543 2,901.3 18.1

648 4,911.8 609 1,559.7 4,144.7

818 5,371.3 6,179.9

660.5

1,203.1 990.2

954.4 1,078.1

978.2

= not available, BSE = Bombay Stock Exchange, CNX = Credit Rating Information Services of India Limited (CRISIL) NSE index, NSE = National Stock Exchange, Rs = rupees, S&P = Standard and Poor. Note: Data of NSE for 19941995 is from November 1994 to March 1995. a S&P CNX Nifty is a well diversified 50 stock index accounting for 24 sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index-based derivatives, and index funds. Sources: BSE, NSE, and Securities and Exchange Board of India.

Appendix 10

57

YEARLY TRENDS IN FII INVESTMENT IN INDIA

Gross Purchases (Rs million) Gross Sales (Rs million) Net Investment (Rs million) Cumulative Net Investment (Rs million) Net Investment ($ million) a Cumulative Net Investment ($ million)

Year

19921993 19931994 19941995 19951996 19961997 19971998 19981999 19992000 20002001 20012002 20022003 Total

170 55,920 76,311 96,935 155,539 186,947 161,150 568,555 740,506 499,199 470,601 3,011,833

40 4,660 28,348 27,516 69,794 127,372 176,994 467,335 641,164 411,650 443,710 2,398,583

130 51,260 47,963 69,419 85,745 59,575 (15,844) 101,220 99,342 87,549 26,891 613,250

130 51,390 99,353 168,772 254,517 314,092 298,248 399,468 498,810 586,359 613,250

4 1,634 1,528 2,036 2,432 1,650 (386) 2,339 2,159 1,846 562 15,804

4 1,638 3,167 5,202 7,634 9,284 8,898 11,237 13,396 15,242 15,804

FII = foreign institutional investor, Rs = rupees. Based on monthly exchange rate. Source: Securities and Exchange Board of India.

58

Appendix 11

TRANSACTION COSTS IN INDIA'S EQUITY MARKET

India 1993 (Before NSE) % 3.75 3.00 0.75 New York Stock Exchanges (1997) % 1.23 1.00 0.23

Cost Component

1997 (NSE) % 0.65 0.50 0.15

2004 (NSE) % 0.50 0.40 0.10

Trading Brokerage Market Impact Cost Clearing Counterparty Risk Settlement Back Office Bad Paper Risk Total

Present 1.25 0.75 0.50 5.00

In Part 1.50 0.75 0.75 2.15

0.00 0.03 0.03 0.00 0.53

0.00 0.05 0.05 0.00 1.28

NSE = National Stock Exchange. Sources: Shah, Ajay and Susan Thomas. 1997. Securities Market . India Development Report, edited by K. Parkh, and Operations Evaluation Mission.

MANAGEMENT RESPONSE ON THE PROGRAM PERFORMANCE AUDIT REPORT (PPAR) ON THE CAPITAL MARKET DEVELOPMENT PROGRAM IN INDIA (LOAN 1408-IND)

On 9 August 2004, the Director General, Operations Evaluation Department, received the following response from the Managing Director General on behalf of Management: Management takes note of the lessons identified in the PPAR and will take them into account for the design of relevant future ADB projects.