THE CAPITAL MARKET: THEN AND NOW

by

NITIN DESAI

The financial sector has been transformed but the financing outcomes are not as different as they need to be

The abolition of industrial licensing and a shift in trade and exchange rate policy thirty years ago was a radical change in the relationship between the Union Government and the private sector. This about turn required changes in other policies and institutions, of which the deepest is in the operations of the capital market and the financial sector.

The foundation of the change in the financial system is the large shift in investment funding from the budget to the capital market with the sharp increase in the share of the private corporate sector in gross fixed capital formation (GFCF), from an average of 18.9 percent in the eighties (and much below that in earlier decades) to 36.7 percent in the decade ending in 2019-20.  In comparison the share of the public sector in GFCF has fallen from 50 percent in the eighties to 23.5 percent in the decade ending in 2019-20.  Within the public sector, PSUs which account for nearly half the investment are also now more dependent on market-based funding than on budgetary support.

The other factor in the rise in private corporate share in GFCF is the growing involvement of the private sector in infrastructure investments which, in the pre-liberalisation days, were largely budget funded public sector projects.  Now the private sector owns practically all the renewable energy power capacity, nearly 40 percent of the thermal capacity and is involved in the about 1000 Public-Private-Partnership (PPP) projects, mainly for roads and ports.

The rise in the share of private companies in GFCF should mean more resource mobilisation through the capital market. In the pre-liberalisation days this required the approval of the Controller of Capital Issues for the size of the issue and the issue price. That changed completely with liberalisation which abolished the post of the Controller and shifted the responsibility for investor protection to an independent regulatory authority, SEBI.

The easing of the issue of shares by private companies was matched by changes that made share-trading much easier. The establishment of the National Stock Exchange that introduced screen-based trading and the dematerialisation of shares removed the tedious pre-liberalisation process of signing many share-trade forms and supplying share certificates. Liberalisation also opened the mutual fund market to private asset management companies in 1993 and the assets under management of mutual funds rose from 4.5 percent of GDP at the end of 1990-91 to nearly 16 percent of GDP now.

But perhaps the most important change in the liberalisation era came from the opening of financial intermediation to private entities. In 1993 the banking sector was opened to new private sector banks and their share in total bank deposits has gone up from 4 percent in 1990-91 to 30 percent in 2020-21. Along with this, non-banking financial institutions (including housing finance companies) have become a significant force in the capital market and account for 16 percent of the flow of commercial finance. Yet another source of finance for the private sector emerged with the liberalisation of rules for foreign direct and portfolio investment. In the current decade the financial system has also been heavily influenced by the spread of telecommunications and the internet and the spread of internet banking and digital payment systems.

This expansion of the finance system is reflected in the gross value added in financial services of ₹10.5 trillion in 2019-20 which came from the charges paid by savers and investors to financial intermediaries. It amounts to about 4 percent of the stock of financial assets or 25 percent of gross financial savings. This lucrative return is what lies behind the fact that today financial companies are 5 out of the top 10 companies in terms of market capitalisation.

The financial sector has clearly been transformed. But the reform agenda is not over and done.  The main issue, pending for decades now, is the health of public sector banks. They are in the grip of unacceptably large non-performing assets, some of it due to their involvement in PPP projects and other long-term funding, which is very different from the usual lending operations of banks. We also need a firewall between the finance ministry and the public sector banks to allow them to function as market entities rather than as de facto departmental enterprises.

The capital market has been freed from many onerous regulations. Yet the figures on the sources of commercial finance^[1] provide a sobering corrective. Taking an average of the three years ending 2019-20, only 2 percent of the flow of commercial finance came from public issues.  As a percentage of GFCF by the private corporate sector, public issues also amount to just 2 percent and private placements to 9 percent. The major source remains bank credit which accounted for 49 percent of the flows. Pre-liberalisation financial institutions like LIC, NABARD and EXIM account for 7 percent and 16 percent from foreign direct investment.

The rather low dependence on public issues is probably a product of a proprietary family dominated corporate management structure, and the reluctance to dilute control, a feature which will have to change if India is to make a transition to a proper market-based economy. In the more mature market economies this happened when corporate ownership widened with indirect share purchases by retail investors through mutual funds and pension funds who exercised substantial voting power to protect the interests of their clients. In India foreign investor institutions have already started doing this but the Indian institutions are more circumspect.

Public issues in capital markets are the route for corporate finance.  However, one also needs organised arrangements for non-corporate enterprises and households.  According to a 2018 study^[2], out of the total debt of ₹69.3 trillion incurred by the MSMEs only ₹10.9 trillion came from banks and other formal sources. The MSMEs have also been hit harder by the COVID pandemic and the ill-considered lockdowns. The formal financial arrangements for them must be increased by an order of magnitude.

We also need domestic venture funds, possibly connected with large corporations, to fund MSME vendors and technology or business-model driven start-ups in manufacturing and in socially desirable activities like education, health, and environmental management. We should not be distracted from this by the proliferation of IT based unicorns that attract millions of dollars of funding from foreign investors who hope to make a killing by reselling their holding to new speculators.

The broad conclusion one comes to is that, though the financial system and capital markets are substantially different from the pre-liberalisation days, the outcomes in terms of breadth and depth are not yet as different from the past as they need to be.