Capital markets refer to segments of financial system that help
enterprises raise long-term capital by way of equity or debt. In turn, they
also help savers to invest their money optimally in productive enterprises.
Capital markets comprise financial institutions, banks, stock exchanges, mutual
funds, insurance companies, financial intermediaries or brokers etc.
A growing economy like India, where more than 15 million youth are added
to workforce every year, needs huge investment on a continuous basis for new
capacity as well as for expansion, renovation and modernization of existing
productive capacity and creation of supporting infrastructure. This investment,
technically referred to as ‘gross capital formation’, is crucial to sustain
growth. Economists work out capital output ratio by computing units of capital
required to produce a unit of additional incremental output. In the Indian
context, the capital output ratio has historically been around 4, i.e. 4 units
of capital are required to produce one unit of incremental output. Therefore,
to sustain growth of 8% per annum, we need new investments or gross capital
formation of 32% per annum. In other words to sustain growth, we need capital
to invest. And to raise capital, we need an efficient capital market.
Therefore, capital markets are critical for the country’s overall economic
growth. There is broad consensus that macroeconomic policy framework should be
conducive for the development and efficient working of the capital markets.
However, the development of capital markets poses its own challenges. If
not overseen properly, capital markets can be vulnerable to frauds, volatility,
and excessive speculation. Capital markets mobilize savings of naive investors,
directly and indirectly. For policy makers, the conundrum is therefore to
strike a balance between pace and order, sophistication and transparency, and
regulations and simplicity.
Over the past two decades, Indian regulators have taken the path towards
tighter regulations. As a result, in relative terms, our capital markets have
been less vulnerable to crises or frauds. Quite justifiably, our regulators and
government officials are proud about this. We have a robust regulatory
structure in place for the capital markets. However, the flip side is that they
are not geared to meet the capital requirement to realize the growth potential
of the economy. India has tremendous potential to sustain higher economic
growth compared with China because of favorable demographics and the
enterprising nature of its people. India can sustain double-digit economic
growth for at least a couple of decades more, which can lift millions of people
out of poverty as has been the case with China, Singapore, and many other countries.
Let us separately look at equities and debt, the two major parts of the
capital markets.
Our debt markets are evolving slowly and quite far from being mature,
with multi-tier structure to handle risks and enable large capital flows.
Several government committees have been appointed to look into this and develop
corporate bond markets. However, very little has happened at the ground level.
The absence of an efficient debt market has become a major constraint for new
investments, especially in infrastructure, where debt component of a project is
significantly higher. Given an underdeveloped corporate bond market and
regulatory restrictions on deposits by non-banking sectors, a bulk of
intermediation in the debt market is per force through the banking channels.
The cost of intermediation in our country is perhaps the highest in the world.
Typically, a good individual saver earns 4% p.a. whereas a good corporate
borrower pays 12% p.a. A fair, market-linked, inflation-proof and risk-free
return will go a long way in reducing the diversion of savings to unproductive
asset classes such as gold and real estate. In today’s world, such spreads can
exist only with regulatory protections because free markets elsewhere in the
world have driven it down to a few basis points. Our policy makers would
justify this as a social obligation to the agriculture and SME sectors.
However, relative to their urban counterparts, our farmers have become much
poorer since independence and the Indian SME sector is much worse than its
global counterpart as far as availability of capital is concerned.
The bigger policy conundrum pertains to equities markets. Our policy
makers need to understand and appreciate that:
a) Equities are risky but very crucial to sustain high economic growth.
b) There can be no equities markets without financing and speculation.
Equity investing is perceived as risky and akin to gambling. One should
not forget that the risk capital or equity capital forms the base on which
enterprises can leverage and raise debt capital. Without equities, no project
can even be conceived. Therefore, a healthy equity market forms the foundation
for an efficient capital market. It will also benefit individual investors over
the long term as the equities market can generate 15-18% p.a. tax-free retruns
compared with 7-8% returns p.a. in fixed income assets.
We have the most benign fiscal policy structure for the equities capital
market. Return on Equity by way of dividend and capital gains is either
tax-free or attracts lower tax rate compared with interest income. The same has
not been effective nor will schemes such as Rajeev Gandhi Equity Investment
will yield much results. This is evident from the fact that only 4% of
household savings is directed to equities and retail penetration and
participation continues to be weak. We are overly dependent on investment from
Foreign Institutional Investors (FIIs) of US$20-25bn p.a, even though our
domestic savings are more than US$400bn.
Equity investors are not lured by sops but expectations of above-normal
profit which obviously will entail higher risk as well. We can have a conducive
environment for equities only when our policy makers appreciate that neither
super profit nor super loss (even to a small investor) by itself is a bad word.
My favorite analogy is of a Church priest who becomes a football referee and
does not want players to be violent, wants them to avoid injuries and follow
queue discipline. No doubt, the game of football has to have rules of fair
play. There are fouls and penalties for pushing, tripping, and rough tackling
but normal injuries and aggression are an essential part of the game. In
equities, although excessive speculation or manipulation has to be punishable
but volatility, speculation and losses to investors, small or big, are part of
the game.
It appears that our policy makers perceive all financing, intra-day, and
speculative activities as undesirable or evil elements and want to encourage
only genuine investors. The interesting paradox is that, investors can be
attracted only in a market with financiers and speculators. Typically, equity
shareholders are owners who do not directly manage the company’s affairs. For
them, liquidity or an easy option to exit is important. World over, in the
equities markets, liquidity is provided not by genuine investors but by
traders, speculators, and arbitragers who essentially need financiers. The
rapid growth of the derivative market also corroborates the same characteristic
of the equity capital markets. The genuine investment transactions among
investors are so rare and even a blue chip trades only a few times in a month.
For instance, millions of shares are traded in a stock like Infosys; but the
buyers and sellers are not those who have simultaneously got excited and
unexcited about valuation and long-term potential of the IT sector and on
Infosys as a company.
Although manipulation is not healthy, lack of liquidity will prevent
growth and participation. Our regulators frown on speculation and on financing.
SEBI’s margin funding guidelines are too onerous to secure any meaningful response.
RBI has put several restrictions on bank’ finance to the capital markets and it
discourages capital market financing by NBFCs.
As we look at the
next five years, to get our infrastructure ready to sustain growth, the
magnitude of capital required is staggering. Our policy makers need to have
clarity on the macroeconomic objective, which to my mind can be: we need to
encourage directing savings into equities, particularly from retail investors.
We should reduce our dependence on FII hot money, which causes greater
volitility in the market. We need more competition, more products and easy
regulations in the debt markets and in banks. The fiscal, monetary, and all
other policy framework should recognise this and be conducive.
The above views were expressed in the
December 2012 edition of the Boston Consulting Group – Confederation of Indian
Industry publication on Deepening of Capital Markets: Enabling Faster
Economic Growth
Great excellent points.
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