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STUDIES ON CAPITAL MARKET IN INDIA

In India, the topic 'Capital Market and Economic Growth' became an issue of interesting debate, thereby, immensely enriching economic literature. Two schools of thought emerged; one advocating capital market reforms and development and the other skeptical of the same. The first group supporting capital market reforms and recognizing their positive effect on corporate and economic growth continued in the tradition of the World Bank's views. Prominent representatives of this group are Shah and Thomas. The other group, which is skeptical of stock market development, raised some serious issues regarding the not so positive, and, at times negative effects, of capital market development on savings, investment and economic growth in the Indian context. The prominent representatives of this group are Nagaraj and Ajit Singh. The works of these two representative groups are examined in some detail. Shah and Thomas (1 996tii are str~ng advocates of stock market reform and development. Studying the stock market reform and the banking sector, they reached the following conclusions: 1. The banking system and the stock market compete in two dimensions: to maximize the quality of their information processing and to minimize the transaction costs that they impose upon households. In the Indian cqntext the stock market is more efficient than the banking system, in both dimensions. The stock market's superiority in the quality of information processing arises out of its freedom relative to the banking sector, which is subject to a number of controls and constraints. Controls like direct government ownership, entry barriers, high reserve ratios and directives on credit allocation adversely affected the banking system's ability to process information. 2. Stock market development plays a key role in strongly assisting reforms in the Banking system. 3. Efficient stock market would contribute to long-term growth in the real economy through efficient allocation of scarce savings and improving utilization of funds. 4. Foreign capital inflows have a positive impact on the real economy via lowering the cost of capital and the assets effect. Regarding the transactions costs, Shah and Thomas conclude that India's banking system has been suffering from high costs due to labour problems, low level of technology and lack of competition. On the other hand, the transaction costs in the stock market have declined considerably due to the introduction of On Line Trading system, dematerialization of securities etc. Ajit Singh (1998)xiv examines the growth and evolution of stock markets in India during the 199Qs, which, according to him is largely due to internal and external liberalization measures and the general liberal economic ethos created by the reforms. Singh argues that even though the corporate sector considerably benefited from the boom in the stock market by raising huge

amounts of capital, including foreign exchange, from the market, the aggregate real economy did not benefit from this. At least in the 1980s, there was no increase in the savings rate in the economy, despite the boom in the stock market. What really happened was a portfolio substitution by households and institutions from bank deposits to financial corporate securities. Singh also argues that it is problematic to attribute variations in corporate investments to variations in resources raised from the stock markets, because, the resources raised from the market essentially replaced the internal resources of the corporations. And Singh does not see any increased productive use of investment resources. Nevertheless, Singh compliments the government for its prudent handling of portfolio capital inflows and ensuring that no loss was suffered on that count to the economy, in spite of large inf1ows. Singh's conclusion is that despite all the extraordinary growth achieved by the stock market, as far as the real economy was concerned, it has just been a sideshow. In conclusion, Singh sounds a note of warning that as the market for corporate control develops with mergers, takeovers, acquisitions and divestments becoming common place, the situation will worsen and the real economy will be harmed by these developments. According to Singh, the market for corporate control IS a 'bridge too far' at the present level of development of the Indian economy. A comprehensive empirical work came from Nagaraj (1996)xv. Nagaraj's study examines the long-term trends in India's capital markets and the structural changes that have taken place in the country's saving pattern. Examining important indicators like the amount of capital raised, share of equity in total capital mobilized, share of financial saving in Gross Domestic Savings, Gross Fixed Capital Formation, corporate GFCF as percentage of GDCF, corporate profitability etc., Nagaraj comes to the following conclusions: i. In India, the growth of the capital market was in fact financial disinter- mediation, which involved portfolio substitution by households and institutions from bank deposits to stock market instruments. There is no correlation between growth rate of capital mobilization and aggregate saving rate, and corporate physical investment and value added. The positive correlation between the annual growth rate of capital raised externally and the corporate fixed capital formation, which existed previously, has become statistically insignificant in the 1980s. There is a long-term decline in the contribution of internal finance to corporate fixed investment, despite a fall in the ratio of corporate tax to gross profit. The growth rate of real value added in the. corporate manufacturing sector in the 1980s was lower than that of registered manufacturing sector as a whole suggesting that the small corporate firms, which did not have access to stock market funds, were able to grow at a faster rate than the larger corporate firms.

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STUDIES ON FOREIGN PORTFOLIO/INSTITUTIONAL INVESTMENT


Since Foreign Portfolio Investment IS a recent phenomenon, literature on the same has been scanty till recent times. However with financial globalization and the explosion of FPI since early nineties the topic has attracted lot of scholarly attention. Bekaert and Harvey (2002rix studied the impact of financial liberalization on capital flows and the consequent market volatility. From the analysis of data for 16 emerging markets, they found that capital flows increased substantially after liberalization. It was found that, on an average, capital flows increased tenfold in the five years after liberalization compared to the five years preceding liberalization. Of course, the market volatility increased after the capital flows. But, this should be expected in a market economy. The notable favourable consequence of the capital flows was that in all emerging markets, the cost of capital declined after the capital flows. The decline in cost varied between 5 and 75 basis points. Decline in the cost of capital is investment and growth promoting and therefore eminently desirable for developing countries. However, increasing capital flows has always been associated with increasing concerns regarding volatility and vulnerability. Regarding volatility and the criticisms flowing from that, Bekaert and Harvey (2000)xx feel the criticism rather strange. Developing and emerging economies start with very little capital flows and after liberalization experience sudden increase in capital flows. This is bound to increase volatility. But it has been found that volatility increased immediately after liberalization and later subsided. Of course, it is a fact that portfolio capital flows are far more volatile than FDI. An interesting issue in portfolio capital flows is whether "capital flows are causes or consequences of stock price movements". Scholars have attempted to grapple with this 'chicken to egg issue'. One argument is that foreign investors have a 'cumulative informational disadvantage' vis--vis local investors and therefore returns lead capital flows. However there are evidences to the contrary. Froot, O'Connel and Seasholes (2001)xxi found from their analysis using daily data for 44 countries that capital flows lead price changes. They found that a one basis point change in portfolio flows result in a 40 basis point change in stock prices. Stiglitz (1998rXii has been a prominent critic of hasty financial liberalization. He argues that developing countries are far more vulnerable to volatility in capital flows. Volatility in capital flows wrecked havoc with the financial and real sectors of the economy of the South East Asian countries during the South East Asian currency crisis of 1997-98. The consequences were devastating for these economies. Therefore Stiglitz argues for greater control and regulation of capital flows for developing countries. An insightful probe into the financial and economic imbalances caused by capital flows into emerging markets came from Christoffersen and Errunza (2000)xxiii. The authors examined in detail the causes of financial crisis in recent times, particularly in the nineties. According to the authors, the imbalances in the internal and external accounts, asset bubbles, inappropriate exchange rate policies, imprudent and excessive external borrowing by the public and private sectors, less developed capital markets and banking sector,

crony capitalism, information problems and lack of political reforms contributed to the crisis. External factors that contributed to the crisis were identified as moral hazard from political availability of multilateral financing, expectation of sovereign bailouts, under estimation of credit and foreign exchange risks by domestic and international investors, difficulties in the export sector from loss of competitiveness and currency speculation that exacerbated panic in exchange and asset markets. The authors made several proposals for reform which included: i. ii. iii. iv. v. Timely, accurate and full disclosure of information to assess the economic and financial health of the nation. Reform of the banking system on the basis of the Basle norms. Flexible fiscal, monetary and exchange rate policies. Capital market liberalization with safeguards. A new global financial architecture based on a democratic and open system.