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CHAPTER VII

FINDINGS, CONCLUSIONS AND RECOMMENDATIONS

The key focus of any economic readjustment process is long-term sustainable

development. Long-term sustainable development, among other things, requires the

development of a sound and efficient financial system that accommodates the

coordinated development of three forms of finance – budgetary finance, bank finance

and securities finance. They are like three legs of a stool- stable if they complement

each other; and wobbly if they are not (Yuan, 2003).

Though budgetary finance realises government’s fiscal policy objectives, given

the needs and size of our country budgetary policy has real limitations. Bank finance

through the intermediation of banks helps project realisation, with a multiplier effect.

However, it is an indirect form of finance where banks are made to shoulder market

risk. In sharp contrast, securities finance or capital market finance is a direct form of

financing in a market economy; it envisages direct and widespread participation by the

public. In contrast to the developing countries of Asia, developed economies of

Europe and North America feature highly developed financial system and stock

market that performs the resource allocation function much more efficiently than

budgetary finance. It is true that experiences of developed countries need not suit the

special conditions of developing countries. Yet, it is at least essential to acknowledge

the contributions stock market finance and probe into its future prospects. It is in this
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milieu that the findings of the present study are discussed and policy implications

chalked out.

7.1. Findings and Conclusions of the Study

Despite the heightened attention received by stock market, investor base of

Indian stock market is miserably low. Theoretically, stock market investment aims at

risk diversification and direct participation in project financing in a widespread

manner. It, therefore, requires the existence of a relatively large number of investors

with the sophistication, means and ability to shoulder such risks. However,

irrespective of the long array of reform programmes implemented, fraudulent practices

and excessive speculation are still a nightmare to genuine investors in the country.

People do not consider stock market as formal financial institutions like banks. Instead

it is treated as a gambling place for speculators. Serious policy initiatives are required

in this regard so as to make stock market a more relevant institution.

FII flow is the major factor behind the remarkable surge in turn over and

liquidity of Indian stock market since the past ten years. Besides, the movements of

major stock indices are in tandem with trends in FII flows, and they have become the

most crucial single factor influencing stock market behaviour nowadays. However, in

a long term perspective FII inflow is more likely to plateau out when interest rate

differentials disappear eventually as India become more integrated with developed

markets. Taking this in view, it is essential to develop domestic capabilities in terms of

better participation of domestic financial institutions that have large funds to invest

into. In addition to the current reforms implemented by the government allowing

pension funds to invest in the stock market, further steps should be taken to expand the

domestic institutional participation in the stock market. Domestic institutional

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participation in various derivative instruments also should be allowed for the long

term sustainability of the present growth of Indian stock market.

Indian stock market exhibits positive changes with regard to various aspects of

the market. Equity volatility of Indian stock market has come down significantly from

1995 on wards. India exhibits lowest variation in stock returns among emerging

markets. Contrary to the popular belief, stock market volatility in the Indian stock

market has not increased after opening it up to FIIs. Similarly, market concentration,

and transaction costs have come down in major stock exchanges in the post-reform

period. India’s position in this regard is better than many advanced capital markets.

Indian stock market is still a fragmented market. There are twenty three stock

exchanges in the country of which three are national exchanges. Seventeen exchanges

are providing screen-based services. Internationally, the trend is towards consolidation

of existing exchanges. NSE has already provided connectivity to more than hundred

cities and other major exchanges are also extending their trading terminals outside the

area of their operation. In fact the relevance of regional exchanges has decreased with

the advent of nation-wide trading network. In this context having a large number of

stock exchanges to cater to the needs of a not so large number of investors is

questionable.

Presently, the functions and powers of regulators in the Indian securities

market are fragmented. SEBI has been delegated most of the functions and powers

according to the SC(R) A, and shares the rest with the Ministry of Finance. It has also

been delegated some functions under the Companies Act. RBI also has regulatory

involvement in the stock market with respect to foreign exchange liquidity control.
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Though fragmentation of regulatory environment has not been a major obstacle yet, it

would be better to follow the global trend of consolidation of regulatory institutions

for better policy enforcement.

7.1.1. Stock Market Development and Economic Growth

The size of the stock market, measured as the market capitalisation ratio does

not seem to affect the growth prospects of the country. The nature of relationship is

also not conclusive. However, stock market size shows significant positive

relationship with the level of industrial activity in the country. This finding is

consistent with the earlier studies (Levine, 1993), that suggests that stock market size

is a less significant contributor towards economic growth compared to stock market

liquidity and efficiency.

Stock market liquidity is found to be positively associated with economic

growth and the index of industrial production. But this relationship is statistically

weak. Stock market efficiency shows statistically significant positive association with

economic growth. It shows weak positive association with the index of industrial

production. Theoretically, stock market efficiency enhances financial intermediation

through the reduction of transaction costs and other imperfections associated with

equity finance. This finding indicates that various measures implemented towards

enhancing stock market efficiency will boost economic growth.

Considering the influence of a multitude of factors on economic growth, the

positive association exhibited by stock market development indicators, though it is

weak in some cases, is an indication of the nexus between the services provided by

stock market and long run economic growth. It is also noteworthy that the results do
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not support the view that stock market development is detrimental to long-term

economic growth.

7.1.2. Stock Prices and Macro Economic Variables

There is long-run equilibrium relationship between stock prices and macro

economic variables such as M3, PLR, and IIP. This indicates that stock markets are

not mere centres of speculation, but meaningful institutions that bear a close

connection with the macro economy.

Granger causality tests show that there is unidirectional causality running from

both stock indices to M3 and PLR. Hence it can be concluded that stock market leads

these monetary variables in India, rather than being led by them. This finding is all the

more significant in the backdrop of increasing use of asset prices as signals for the

conduct of monetary policy worldwide. Since there are cointegrating relations between

stock prices and these monetary variables, stock prices can also be used as devices of

monetary transmission mechanism. It is found that there is bidirectional causality

between Nifty and the index of industrial production. This supports the theoretical link

between industrial activities and stock prices.

Another major implication of unidirectional causality from Sensex and Nifty

to M3 and PLR is that both the stock markets (BSE &NSE) are efficient with respect

to these two variables. This finding provides strong evidence for the presence of semi-

strong form efficiency of Indian stock market. Present information regarding PLR and

M3 are being reflected in both the indices perfectly, and past values of these variables

cannot predict the future value of stock indices. In the wake of wide fluctuation in

stock prices, this finding has special significance. Since stock prices adjust to present
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information about PLR and M3 quickly, monetary authorities can use them to create

desirable impacts upon stock market.

7.1.3. Stock Market and Corporate Financing Pattern

There is a remarkable shift in the proportion of internal and external finance of

Indian corporate sector in recent years, especially since 2003. This finding about

capital structure of Indian firms is novel, since studies prior to 2003 concluded that

Indian firms are more reliant on external finance. Singh and Hamid (1992), and

Samuel (1998) argued that the absence of informational asymmetries in the Indian

economy due to its bank-based financial system has been a major reason for the

increased external dependence of Indian firms. This paradigm shift from external to

internal finance has taken place due to the increased use of retained earnings. The

results also show that among various external sources, firms still prefer bank

borrowing to stock market funds.

It is found that companies do not raise a substantial amount of finance from the

stock market in India. On a net basis, the contribution of stock market accounts to 13.3

per cent of total finance. It is found that firms have made use of the two stock market

booms during 1993-94 and 2001-02. However, there is no sustained rise in the

proportion of equity finance during the study period. Over these years the dependence

of Indian corporate sector on stock market has declined from 18.9 per cent in 1992 to

6.1 per cent in 2005. This is in contrast with the general proposition that, as

economies develop, their financial structure changes from bank-based to equity-based

financing.
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Another robust finding of the study is that, small and medium size firms are

considerably more reliant on external finance than large firms, and obtain a greater

share of funds from stock market and a lesser share from banks and other financial

institutions. Similarly, for young firms stock market funds still constitute a major part

of total external finance used. As the firms grow, the share of borrowings increases

and that of equity finance decreases. This contrasts the general view that stock

markets better serve old and established firms, typically with large tangible assets.

The relationship between stock market financing and external debt is not

conclusive. It is found that there is a negative relationship between stock market

funds and external borrowings in most of the samples, and it is highly significant in

some cases. This refutes the findings of previous studies that equity and debt finance

are complements. However, the substitution is not perfect, since in some cases the

correlation coefficient is positive.

7.1.4. Stock Market Development and Corporate Capital Structure

Stock market development is found to bear strong negative correlation with

debt-equity ratio of firms. Larger the size of the stock market, lesser the leverage of

firms. This finding indicates that stock market size and borrowings are inversely

related in India. Stock market size is positively and significantly related to the

demand for equity capital by firms. Larger size of stock market encourages greater

use of equity finance.

Cost of equity shows a strong positive association with leverage. Greater cost

of raising equity leads to larger use of borrowed funds. Further, the cost of equity is

found to be negatively and significantly associated to the demand for equity capital,
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even after controlling for the size of stock market. It indicates that even if stock

market is large in size, high cost of raising funds will adversely affect firms’ demand

for equity capital.

Stock market efficiency shows negative, association with debt-equity ratio and

positive association with demand for equity capital. However, the relationship is not

statistically significant in either case. It indicates that stock market efficiency is not a

major factor affecting corporate financing decisions. In contrast, stock market

efficiency produced good results in regression with economic growth, where it is

found to be more significant than other stock market development indicators.

The level of liquidity of the stock market bears strong negative association

with debt-equity ratio. It implies that existence of liquid stock markets helps to reduce

the level of leverage of firms. Stock market liquidity is also found to be positively and

significantly related to firm’s demand for equity capital. It supports the view that

liquid stock markets ease the risk associated with long term commitment of capital and

hence enhance resource mobilisation through stock markets.

The results indicate that large and liquid stock markets are instrumental in

shaping the capital structure of corporate firms in India, even after controlling for

other major determinants of corporate capital structure. Larger and more liquid the

stock markets are, larger will be their demand for equity capital and smaller will be

their dependence on leveraged funds. This finding refutes results of earlier studies that

initial development of stock market in developing countries leads to a higher debt-

equity ratio and thus more business to banks (Demirgüç -Kunt and Maksimovic,

1995). Another interesting point is that this behaviour of debt-equity ratio in India is in
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tune with that of developed countries, where development of stock market leads to a

substitution of equity for debt financing.

7.1.5. Stock Market Development and Retail Investors

Though theoretically primary market and secondary market are equally

important in the mobilisation of savings, the study reveals that 78 per cent of the

investors prefer to get shares from the secondary market rather than from the primary

market in the country. The abolition of Capital Issues Control and replacing it by a

free-pricing system in 1992 is the major factor that led to the erosion of public trust

in the primary market. The lack of proper regulation facilitated the flotation of a large

number of unsound and even fraudulent companies. The widespread bad experiences

led to withdrawal of the investors from the primary market for many years after the

mid-1990s.

Not only small investors, but large public organisations with enormous funds

like the Employees Provident Fund Organization (EPFO), are not allowed to invest in

stock market because of its erratic and risky nature. Hence healthy functioning of

stock markets should be ensured to induce such organisations and small investors to

invest larger proportion of their funds in equities. The present design of the Indian

stock market, however impressive from technological viewpoint, is faulty in an

important respect – it is extremely attractive to speculators and market operators. Its

behaviour is characterised by too much price volatility and manipulation, which are

the biggest worries of ordinary investors. However, the authorities are not worried

until a market crisis emerges. The objective of the regulators should be to build a

stock market system which will benefit the economy as well as the mass of investors

by attracting a growing volume of savings flow and allocating it efficiently to the

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most productive uses from the economy’s viewpoint, rather than fulfilling the animal

spirit of the speculators and traders.

It is found that majority of the investors surveyed belong to the urbanised parts

of the respective regions. This indicates that stock market investment is still an urban

phenomenon. There is potential for increasing the investor base by increasing rural

participation in stock market investment.

The study shows that a vast majority of the investors first entered the stock

market after the age of 35 years. Only a minority of 7 per cent first entered before the

age of 35. Generally the first investments by young people take the form of bank

deposits and life insurance policies which need no prior understanding. People often

refrain from investment in shares since some learning is necessary for successful stock

market investing. Such unfamiliarity affects the confidence level of investors in future

also. Hence, suitable educational programmes for investors are essential. Such

programmes should be conducted during the period of their education so as to attract

investors to stock market at an early age.

It is found that a majority of retail investors do not regard mutual fund equity

schemes as a superior investment alternative to direct holding of equities. 62 per cent

of the surveyed investors invest in shares through stock market only. Only 38 per cent

subscribe to shares both directly and through mutual funds. This is so despite the

theoretical advantages claimed by advocates of mutual funds. The AMFI too has

revealed that households are not allocating their savings to to the mutual fund

schemes, particularly equity schemes. Mutual funds being more safe instruments, it is

necessary to attract more investors towards them in order to create a positive impact
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upon their income and savings. Further research towards this direction is needed to

find out the various reasons for the disenchantment of investors with mutual fund

products.

The level of participation of investors in the stock market has increased

significantly during the past ten years. Among the factors contributing to this

increased participation, most important are increased liquidity, followed by increased

access to trading, and efficient intermediation. This indicates that stock market

reforms and resultant development of the stock market have created favourable impact

on the investors. The reduction in the transaction costs, establishment and promotion

of market intermediaries such as NSDL, CDSL, introduction of NSE and screen based

trading has succeeded in increasing the participation of retail investors in the stock

market. However, the factors that got the least rankings- better return from investment

and low risk of fraud point towards the weaknesses of the present system. Majority of

the investors opined that return from equities does not increase over these years.

Unwise investment decisions and wrong timing of buying and selling by investors

may be reasons for this disappointing performance. Educating investors on stock

market behaviour can help improve return from stock market investment.

Despite the various regulations implemented to make stock market more fair

and credible institution, fraudulent practices and excessive price volatility are still the

biggest worries of majority of the retail investors. Similarly, tax benefits, a factor

which is included in the questionnaire but omitted from further analysis because of

negligible rankings received, need serious attention. While many other financial

instruments attract investors with benefits of tax concessions, equities fail to attract

investors who seek tax benefits from investment. Since mobilisation of savings
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through equities helps capital formation and growth, more tax concessions should be

extended to return from equities, which will eventually help to widen the retail

investor base.

The study reveals that stock market development is not instrumental enough to

raise fresh savings from the investors. The increase in the proportion of stock market

investment out of total saving is mostly financed by diversion of funds from other less

profitable investment rather than by increasing savings. This indicates that stock

market development has not played any significant role in enhancing savings. The

increase in the amount raised through stock market mainly constitutes funds diverted

from other means of assets. The fall in the interest rates on bank deposits and

government savings schemes has led to a greater inclination towards equity shares.

Other than such transferred funds, stock market’s contribution to fresh saving

mobilization is not impressive. To mobilise more domestic savings, early entry of

investors should be encouraged through investor education programmes. Similarly,

providing tax concessions to equity investment also will be instrumental to raise more

household savings.

Another major finding is that 70 per cent of the investors make investment

and risk hedging decisions on the basis of own experience. This point towards the

need to impart better investor education so as to reduce loss due to unwise decisions

and resultant withdrawal of investors from the market. A large number of investors

lose money by investing in shares by investing at the wrong time, or by making

unwise stock selection. Many of them lack a historical understanding of the stock

market’s behaviour and inherent volatility.

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From the open ended question about the measures to improve stock market

condition, 38 per cent suggested better regulations so as to prevent fraudulent practices

and excessive volatility. Such unruly market behaviour has the effect of discouraging

or even driving away the genuine investors from the market. Since the study reveals

that 81 per cent of the respondents are first generation investors, it is essential that the

trust of investors in the stock market should be maintained in order to widen the

investor base of the stock market, and to ensure sustained flow of funds to the stock

market

7.2. Recommendations and Policy Implications

1. Domestic capabilities in the stock market should be enlarged by allowing

institutions like provident funds to invest into the stock market. The current level of

participation of pension funds also should be enhanced by allowing them to invest

in various derivative instruments.

2. Suitable investor educational programmes are essential to attract potential investors

to stock investing. Necessary steps should be taken to enhance participation of rural

investors in the stock market. For this, investment management should be included

in the curriculum during the years of schooling itself. Similarly for undergraduate

course in Economics, a comprehensive study of stock market should be included.

3. Training programmes for existing investors should be conducted on a regular basis

to make them aware of the behaviour of stock market and management of risk

through scientific analysis.

4. The study has found that small and medium size firms and young firms are more

dependent on stock market than large and established firms. Hence steps should be

taken to develop SME specific trading platforms like BSE Indonext, so as to enable
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capital formation by SME companies from the stock market and help develop

entrepreneurial backbone of the country.

5. Further reforms in stock market should aim at enhancing the efficiency of the

market, since it is found to be more robustly related to long run economic growth of

the country.

6. To control the concentration of turnover and price volatility, benchmark indices like

BSE Sensex and CNX Nifty should be made broader based.

7. More fiscal incentives should be given to stock market investment to attract

investors with high income.

8. For better enforcement of reforms and to avoid institutional overlap, regulatory

framework of the stock market should be unified.

9. Integration of stock exchanges should be encouraged by giving incentives for

establishing central trading system through interconnectivity.

10. Primary market should be made more dynamic by making pricing of shares more

credible, IPO rules less cumbersome, and disclosure norms more alert.

11. Investors should be attracted towards mutual fund investments by giving more

incentives.

12. Stock markets should be made more formal financial institutions by cubing

excessive speculation and other fraudulent practices. For this better disclosure

norm, quality intermediation services, legal and accounting practices should be

introduced. Listing of government securities in stock exchanges can help in this

regard.

7.3. Areas for Further Research

The relationship between stock market and real economy is a comparatively less

researched area in India. Even in the international level, interest in this subject evoked
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only in the 1990s following a wide effort by World Bank to explore the link between

finance and development. As a result cross-country, country-wise, industry-wise and

firm-level case studies were made in many parts of the world exploring the functional

link between stock market and the economy. However, the applicability of the findings of

these studies differs among countries depending on the level of development achieved

and the pattern of economic policies adopted. Separate studies taking into account the

economic condition of each country is essential to frame suitable policies in this regard.

The study identifies the following areas of future endeavour for researchers interested in

this field.

There is little evidence for the link between stock market development and

domestic savings, financial intermediation, capital accumulation, income distribution,

corporate growth, and legal framework in the Indian context. Event studies that examine

the impact of various fiscal and monetary events are also at infancy in the country.

Similarly, very few attempts are made to study the impact of stock prices on the real

sector, and the use of stock market dynamics in the conduct of monetary and fiscal

policies. Another area with extensive research possibility is the impact of foreign

portfolio investment on various aspects of national stock market and economy.

Considering the history and present development of the stock market in the country, the

volume of research done is so inadequate and there is ample scope of further research.