Financial Reforms in India
Background
Liberalization of Capital Markets
Reduction in Statutory Liquidity Ratio (SLR)
Liberalization of Interest Rates
Unified Exchange Rate
Convertibility of Rupee
New Private Sector Banks
Elimination of Government Access to RBI
Strengthening of SEBI
Incorporation of International Accounting Standards
India’s Financial and Banking Reforms (1992-1994)
India’s Capital Market Reforms (1992-1994)
Government bailout of US-64 of UTI
Indian Banking Hybrid
An efficient banking system that is capable of mobilizing and deploying national savings is essential for successful economic restructuring. However, prior to 1991, the banking sector suffered from many deficiencies in the efficiency and quality of operations. Multiple regulated interest rates and the maintenance of huge reserves as a result of the required statutory liquidity ratio, have weaken the financial health of the banking system and forced banks to charge very high interest rates on their commercial advances. The lack of international accounting norms resulted in bank balance sheets, which do not reflect financial position accurately. Thus, unless major reforms are initiated, India cannot expect to achieve accelerated growth and increased competitiveness.
Since Rao’s government took office in June 1991, the momentum of the reforms has been rapid. Interest rates are now freed from administrative controls. The Reserve Bank of India (RBI) has prescribed new norms for income recognition according to national standards and new capital adequacy standards are prescribed by the Basel Committee. In order to introduce competitive elements into the banking sector, which is nationalized to a large extent, guidelines have been issued governing the entry of new private sector banks. The process of partial dis-investment of government equity has begun like the partial foreign ownership of ICICI. The rapid reforms in the 1990s will increase the stability of India’s financial markets, increase efficiency and set the trend for higher average growth rate.
2. Liberalization of Capital Markets
· Pension and Mutual Funds
Indians are keen savers. According to the Reserve Bank of India, the central bank, Indian households save more than 18% of GDP each year and the rate is rising. When it comes to managing this huge pool of household savings, the private sector has not much of a foot hold. This is due to the fact that whenever a big savings institution totters, the government will rush to its rescue. Hence, savers happily stash their money in state banks, which are technically bust or in a government-controlled mutual fund that makes disastrous investments. However, recent events give hope that private-sector mutual funds might be starting to play more than just a marginal role and maybe Indian savers are at last putting their money into better hands.
Foreign Institutional Investors (FIIs) such as pension funds and mutual funds, are permitted to invest in Indian capital markets on registration with the SEBI (Joint Business Council, 1994). Common application forms have been simplified and foreign brokers are also permitted to assist investors. All mutual funds are allowed to apply for firm allocation in public issues. These funds are also exempted from income tax regardless of whether they are in the private or public sectors. Hence, mutual funds are enjoying a windfall and because of UTI’s sullied image due to recent government bailout of US-64 in March 1999, it is the private sector funds that are benefiting the most. Some have seen that the funds they manage grew 5-fold in 1999. According to the Securities and Exchange Board of India, the industry regulator, in the 6 months to the end of September 1999, more than twice as much money went into privately managed as into public ones. Some Indian savers are thus trading safety for higher returns. Hence, the private sector, which is dominated by foreign firms is making a dent in the huge market share of public funds. Bank deposits though still the most popular way of saving is growing more slowly in 1999.
- Transfer of securities
The procedures for the lodgement of securities for transfer were eased considerably for domestic and foreign institutional investors through the introduction of a jumbo transfer deed and consolidated payment of stamp duty. The Securities Contract (Regulations) Rules have been amended to enable widely held stock broking companies to become members of the stock market. This is expected to increase the growth of corporate membership in the stock market so as to induce greater professionalism and to ensure better services to the investing public.
The amount of capital that was raised from India’s opening up to international capital markets was a hefty US$9 billion from foreign countries in 1994. Almost 70% or US$5 million was from 22 global depository receipts (GDRs) out of which, only 6 were actually launched in NASDAQ in the United States, the largest financial centre in the world.
3. Reduction in Statutory Liquidity Ratio (SLR)
Since the 1950s, India’s central bank had imposed a high liquidity requirement on the banking sector. Almost 47% of deposits ended up as reserves with the central bank in the form of bank deposits and government securities. However, Singapore only requires 18% as reserves. Hence, Singapore’s credit multiplier is almost 4 times the total deposits whereas, India’s banking system can generate twice its deposit rate at most.
The Narasimahan Committee’s recommendation to reduce the SLR has since been adopted. The reduction will provide banks with greater flexibility in the deployment of their resources. They will be able to extend credit to agriculture, industry and hence reduce the fiscal deficit. As a result of the reduction, the amount of the SLR required to be maintained by banks would be reduced by about Rs 28 billion. The SLR was targeted to be 25% by the end of 1996.
One of the steps the government has undertaken is the liberalization of the restrictive monetary policy. The SLR was 38% in 1994 and it was slated to be reduced to 33% by the end of 1995. (Government of India, 1994). Plans were made to further reduce this ratio to a comfortable 25% which is almost ½ of the 1950s level. With these steps installed, there has been a steady flow of funds into India. The cumulative total has been increasing since then. It was US$3.6 billion in 1990 and reached US$5 billion by 1993.
On the other hand, this fulcrum of increasing liquidity spells trouble for the fund-starved nationalized companies. These companies have traditionally been acquiring cheap funds out of the central bank’s reserves derived from SLR deposits. When the SLR was reduced, the availability of the cheap funds reduced exponentially and companies were forced to approach the capital market for liquidity. In fact, many companies have appealed to overseas sources for global depository receipts (GDRs) over the last few years.
4. Liberalization of Interest Rates
The difference between the deposit rate and the minimum lending rate in India is 2.88% in 1995 which is very low compared to Singapore’s 4.4%. The lower spread would make India banks less profitable and hence, less able to modernize quickly.
Today, the minimum lending rate for loans above Rs 200,000 has been abolished. Banks are now able to set their own prime lending rates. The banks’ prime lending rates will have to be declared and be uniformly applicable at all branches. After freeing the lending rates for amounts above Rs 200,000, many banks may decide to reduce the minimum rates to 14%. The lifting of the restriction on interest rates would result in a new realignment among banks now that efficiency becomes the criterion for survival. More mergers and takeovers are likely to be seen in India’s banking sector.
With the banking reform in 1994, the regulated interest rate structure is being rationalized and simplified. Bank deposit rates have been deregulated subjecting to a ceiling rate. The number of lending rates has been reduced from about 20 before the reforms, to 3 rates today, 2 concessional and 1 floor for all advances above Rs 200,000.
A unified market determined exchange rate of the rupee was introduced in March 1993. Foreign exchange rates have been eased significantly and market forces now determine the exchange rate of the rupee. The rupee has shown remarkable stability since it was floated and has tended to appreciate.
At the same time, the premium on foreign exchange in the illegal or “hawala” market has dropped to about 8% as compared to 25% in the past. The new system provides a powerful incentive for exports including services, exports and remittances. It has also greatly reduced the incentive for forward remittances flowing to the illegal “hawala” market.
The rupee has been made fully convertible on the current account. This will assure foreign investors that there will be impediment in the repatriation of their earnings and other service charges in the coming years. Finally, the government opted for full convertibility of the rupee on the capital account in the 1995-1996 budget to complete the process of foreign exchange liberalization.
More: Exchange Rate Developments
· After reasonable stability lasting for a period of about eighteen months, the exchange rate of the Rupee against the U.S. dollar came under downward pressure intermittently since the last week of August 1997. However, since September 1998, the Rupee has shown slight appreciation against the U.S. dollar. The downward pressure on the exchange rate of the Rupee since late August 1997 may, largely be attributable to the East Asian financial crisis and uncertainties related to domestic developments. At the end of January 1999, the exchange rate vis-à-vis the U.S. dollar was Rs.42.50, recording a cumulative depreciation of about 7.1 per cent from the end-March 1998 level of Rs.39.50.
· The movements in the exchange rate during the first half of 1998-99 corrected for the appreciation of Rupee in real effective exchange rate terms, which had occurred over the previous one year or so because of the inflation differential between India and her major trading partners. The market driven correction in the exchange rate offset some of the competitive disadvantages arising from the sharp depreciation of currencies of our competitors in East Asia and neighboring countries and helped restrain import growth and strengthen our efforts at cost effective import substitution.
· Exchange rate management by the RBI continues to focus on moderating excessive volatility in the exchange rate and maintaining orderly market conditions to ensure that the exchange rate remains consistent with economic fundamentals. Since July 1997, there has been an unusual degree of uncertainty prevailing in the international arena. The RBI, as and when necessary, has intervened in the foreign exchange markets and deployed suitable monetary and other measures to counter speculative pressures on the Rupee and to ensure orderly foreign exchange market conditions. These measures have helped to maintain reasonable stability in the external value of the Rupee during periods of external pressures and to maintain the level of exchange rate consistent with the preservation and improvement of India’s external competitiveness.
The restrictions on the formation of new banks in the private sector have finally been removed. They are allowed provided that they conform to RBI guidelines for them. By October 1994, RBI had issued licences to 6 new private banks. Existing private banks are also allowed to expand without the fear of nationalization. These banks can raise capital contributions from foreign institutional investors up to 20%, and up to 40% from non-resident Indians (NRIs). They are also permitted to close non-viable branches other than in the rural areas which a change away from India’s tight labour laws which used to prohibit the sacking of workers or the closing down of any registered company.
The introduction of a private sector will inject competition into the financial market. Further cuts in the prime lending rates of banks, private or public, are expected as well. Competition from the entry of new private banks, including joint ventures with foreign banks, in turn, will result in innovative public services.
The approval process for the establishment of private banks has also been greatly simplified. An example reported by the media in April 1994, indicated that an approval for the establishment of a banking institution by foreign investors was obtainable within 69 days.
8. Elimination of Government Access to RBI
The government’s automatic access to RBI to fund its budget deficit has been eliminated so that nay increases in the future will have to be made from market borrowings. Government deficits will not be automatically monetized and, as a result, it will be easier to control the growth of the money supply as well as inflation.
The Office of the Controller of Capital Issues (CCI) has been abolished and the control over share prices and premiums was removed in May 1992. Companies are free to approach the capital markets after clearance by the Securities and Exchange Board of India (SEBI). The SEBI is armed with the necessary authority and power for the regulation and reform of the capital market. Rules and regulations governing various aspects of the stock market and intermediaries operating therein, have been introduced with the aim to improve trading practices, disclosure and investor protection.
The SEBI has introduced a number of measures for streamlining the secondary market such as the reconstitution of the governing board of the stick exchange, capital adequacy norms for brokers and transparency in client/broker relationships. T provide a stimulus to India’s financial market growth, the slow and inefficient out-cry system will gradually be abolished and replaced with screen-based trading. Hence, this explains the emergence of both the National Stock Exchange of India and the over-the-counter market which both practise the more efficient screen-based trading. All these activities signify the seriousness of the government about much publicized reforms. Furthermore, companies are now at liberty to price their securities unlike previously when there was tight control of security issues by the government.
As a result of the deregulations, there has been a massive increase in India’s market capitalization. The amount of capital raised in India in 1992 was 270 billion rupees as compared to less than 1 billion rupees during 1990. The number of investors increased from 2 million to 16 million in 1994, which represents an 8-fold increase. In fact, India has one of the largest capital markets in Asia. These activities lead to a multiplication of merchant banks, underwriters and custodians who were almost invisible prior to the pre-1988 era. The Security Exchange Board of India (SEBI) was subsequently set up to regulate this growth sector.
However, foreign institutional investors may find the 7-year equity policy as somewhat restrictive because of the volatility of the Indian market. Am institution is not allowed to transfer dividends out of the country when the quantum is less than its revenue in foreign currencies for the first 7 years of operations. This will force foreign investors to plough their earnings back into the country even though the yields are low.
10. Incorporation of International Accounting Standards
New accounting standards relating to income recognition, provisions for bad debts and capital adequacy, in harmony with generally accepted international standards, were implemented in 1992-1993. This ensures that the banks’ balance sheets reflect an accurate financial position, which is a prerequisite for effective monitoring and improving performance. Banks are also required to make provisions for doubtful and substandard assets by the end of March 1994. Companies are also required to disclose all material facts and specific risk factors associated with their projects while marketing public issues.
15 accounting standards, which include the consolidation of accounts and funds flow statement requirements, were set up in accordance with generally accepted international accounting standards. Listed firms now required by legislation to publish financial statements every 6 months. Plans are also underway to make the listing requirements more stringent by encouraging quarterly reports. This would improve the transparency of the capital markets, thus protecting investors. With the increased transparency, greater market efficiency should follow.
In 25 December 1997, India’s investment rating was raised to that of the lowest investment grade rating level, Baa3 by Moody’s.
India’s Financial and Banking Reforms (1992-1994)
(Adapted from “Economic Reforms in India – Highlights and Updates”, October 1994)
1. Statutory Liquidity Ratio (SLR) on incremental net demand and time liabilities (DTL) is reduced from 38.5% to 25% SLR and on the whole total DTL, reduced from 38.5% to 34.75%. It is set to fall to 33% by the end of 1995.
2. Incremental Cash Reserves Ratio (ICRR) of 10% is removed. 1/3 of the impounded cash balances under the incremental CRR was released, implying a reduction in CRR by 0.6%. CRR on the net total DTL is reduced from 15% to 14%.
3. Number of interest rate slabs on bank advances is reduced from about 20 in 1989-1990 to 3 currently. Controlled floor interest rate on bank advances and ceiling interest rates on term deposits reduced by 4% and 3% respectively.
4. International norms for income recognition, classification of assets and provisioning for bad debts is introduced. Banks are to complete provisioning for doubtful and substandard assets by the end of March 1994.
5. Introduction of capital adequacy norms requiring 4% to be attained by all banks by 31 March 1993 and 8% by 31 March 1996. Foreign banks operating in India and Indian banks operating abroad, must attain 4% by 31 march 1993 and 8% by March 31 1994, respectively.
6. Budgetary support of Rs 5,700 million for capitalization of banks will be released after the nationalized banks enter into performance agreement with Reserve Bank of India (RBI) for strengthening bank management and ensuring efficiency improvement.
7. State Bank of India Act (SBI) was amended to enable the bank to access the capital market and allow 10% voting rights to shareholders. SBI raised over Rs 1,400 million as equity (including premium) and Rs 1,000 million as bonds through a public issue. The RBI shareholding is now 67% as against 99% earlier.
8. Bill to enable nationalized banks to assess the capital markets for debt and equity has been introduced in the parliament.
9. Banks are given freedom to open new branches and upgrade extension counters on attaining capital adequacy norms and prudential accounting standards. They are also permitted to close non-viable branches other than in rural areas.
10. New Bank of India Merged with Punjab National Bank.
11. “In principle” approval given to 7 proposals for the setting up of new private sector banks. Banks are allowed to raise capital contribution from foreign institutional investors up to 20% and from non-resident Indians (NRIs), up to 40%.
12. A new Board of Financial Supervision is being set up within RBI to strengthen the supervisory system of banks and financial institutions. A new department, Department of Supervision, was established in RBI as an independent unit effective from 22 December 1993 for the supervision of commercial banks.
13. Recovery of debts due to Banks and Financial Institutions Act 1993, passed to set up Special Recovery Tribunals to facilitate quicker recoveries of loan arrears.
14. Bank lending norms liberalized and banks are given freedom to decide levels of holding of individual items of inventories and receivables.
15. Ordinance promulgated amending Banking Regulation Act 1949 to enable a banking company to have a non-executive chairman and up to 3 directors from among the directors of promoting institutions. It is to raise the ceiling for the exercise of voting rights for a shareholder up to 10% and to raise the penalties for contravention of the act.
16. Union agreement in October 1993 paves the way for faster computerization in banks.
17. Scope of mandatory consortium arrangements narrowed to 76 large accounts in place of 934 accounts hitherto; borrowers are allowed to induct new banks into a consortium and banks are permitted to leave consortium after 2 years.
18. Financial institutions’ access to SLR funds is reduced and they are encouraged to approach the capital market for funds.
19. IFIC converted into a company and its IPO raised over Rs 600 million as equity (including premium).
20. Convertibility clause no longer obligatory for assistance sanctioned by the lending institutions.
21. Ceiling on interest rates on debentures and bonds removed excepted that on tax-free PSU bonds.
India’s Capital Market Reforms (1992-1994)
(Adapted from “Economic Reforms in India – Highlights and Updates”, October 1994)
1. The Capital Issues (Control) Act, 1947 repealed and the Office of the Controller of Capital Issues (CCI) is abolished. Control over price and premium of shares is removed. Companies are now free to approach the capital market after clearance by the Securities and Exchange Board of India (SEBI).
2. SEBI armed with necessary authority and powers for regulations and reform of capital market.
3. Indian companies are permitted to access international capital markets through Euro-equity shares.
4. Companies are required to disclose all material facts and specific risk factors associated with their projects while making public issues.
5. Merchant banking statutorily brought under the regulatory framework of SEBI and merchant bankers are required to abide by a code of conduct.
6. Private mutual funds are permitted and a few have already been set up. All mutual funds are allowed to apply for firm allocation in public issues.
7. Investment norms for NRIs liberalized allowing companies to accept capital contribution and issue shares or debentures, to NRIs or overseas corporate bodies without prior permission of RBI.
8. Foreign Institutional Investors (FFIs) are permitted to invest in Indian capital market on registration with SEBI. Common application forms are simplified for them and foreign brokers allowed to assist them.
9. Over-the Counter Exchange of India (OTCEI) commenced operations and a number of shares have been listed on it.
10. SEBI notified several regulations for intermediaries within regularity framework for the first time.
11. SEBI introduced new reforms in the primary market for improving the disclosure standards, introducing prudential norms and simplifying issue procedures.
12. The procedures for lodgement of securities for transfer are considered eased for domestic and foreign institutional investors through the introduction of a jumbo transfer deed and consolidated payment of stamp duty.
13. SEBI introduced a number of measures for streamlining the functioning of the secondary market such as the reconstitution of the governing boards of the stock exchange, capital adequacy norms for brokers and for providing transparency in client/broker relationships.
14. National Stock Exchange of India with nationwide stock trading facilities, electronic displays, clearing and settlement facilities being set up by financial institutions and banks.
15. The nationalized banks have been allowed to raise 49% of their equity from the market.
16. SEBI introduced a code of advertisement for public issues for ensuring fair and truthful disclosures.
Government bailout of US-64 of UTI
In the wake of the opprobrium that followed the nuclear tests in May 1999, the Bombay bourse dived, knocking off almost 20% off the value of the US-64, the flagship fund of the government-controlled Unit Trust of India. Investors began to take their money and run. That led to the announcement in early October 1999 that the US-64 will have to unload shared in order to finance the withdrawals. The Bombay market dropped another 7.2%. Finance Minister Yashwant Sinha characteristically blamed the troubles on a “foreign cartel”.
US-64 is a curious hybrid, behaving like both a unit trust and a savings scheme. However, unlike unit trusts, it refuses to reveal its net asset value. Unlike most fixed-income funds, it has the major part of it portfolio in equities, which are unpredictable. Moreover, unlike any other financial product, it refuses to acknowledge that markets fall as well as rise.
US-64 has US$ 5.2 billion under management, about 3% of India’s total stock market capitalization. The problem is that while the fund has increased the risk in the portfolio with about 2/3 is now invested in equities, compared with 30% in 1990s, it has refused to pass that risk onto its 20 million investors. These middle-class small-timers have come to see their hefty dividends as something close to an entitlement. Even when the market slump reduced the value of US-64 equity holdings by US$850 million, the fund still pays the usual 20% dividend, taking a Rs 258 million charge against reserves. P.S. Subramayam, the chairman of UTI, is expected to keep dividends high for year 2000 as well.
The Indian government has many reasons to make funds available to keep the dividends coming. Privately, officials say that they will continue to prop up US-64 even at the risk of pushing India’s fiscal deficit beyond the 5.6% target. That might give Subramayam time to restructure the fund, either by changing the ratio between debt and equity or aligning the fund with world norms. However, there seemed to be little urgency about it and private sector analysts are dubious. Foreign institutional investors are dismayed at the apparent willingness of Indian officials to muddle through.
Indian Banking Hybrid
Steeped in the socialist legacy of state patronage to industry, Indian’ development banks have in recent years lost their empires due to the economic reforms of recent years. ICICI, the second largest with assets of more than US$15 billion, is seeking a new life. On 22 September 1999, it sold off US$315 million worth of American depository receipts (ADRs) representing its shares, making it the first Indian company to list on the New York Stock Exchange. Foreign investors now own 44% of ICICI, a bigger proportion than any other Indian bank.
The Indian government has approved the New York flotation some weeks before but only on the condition that foreign ownership will not exceed 49%. ICICI is something like a hybrid. It is registered as a private company but because the government guarantees some of its borrowings, it is also deemed as a public financial institution. Foreigners had already owned 35% of ICICI, so a planned issue of US$500 million in ADRs was ruled out. Instead, ICICI privately sold shares to 2 government-owned insurance companies and a government-controlled mutual fund. This will keep their holding at around 29% after the ADR issue. It has also made a small public offer to Indian investors.
Foreigners who bought ICICI’s chares are counting on Vanam Kamath, its chief executive and his determination to recast it as a universal bank so as to prevent ICICI from sinking under the huge long term loans to inefficient Indian companies. Mr Kamath has added new diverse assets at a furious pace. The balance sheet has doubled in size since 1997. After aggressive efforts to clean up bad loans, the drain on profits has been stemmed. ICICI now owns a commercial bank, an investment bank, a retail finance company and 45% of a fund management company. It has even spun off an IT subsidiary and even picked up a stake in a delivery company.
However, it may be difficult to replace loss-making assets with new profitable ones fast enough. Over 1/10of ICIC’s loans are non-performing and over 80% are to new projects. Its managers are are getting tough with borrowers but faced a lonely battle. Other Indian lenders, which are more firmly in the government’s grasp tend to act as lenders of the last resort to troubled clients.
Despite the difficulties and uncertainty of the success of ICICI, the market has rewarded its efforts by valuing its share over twice as highly as those of a larger rival, the Industrial Development Bank of India. ¼ of its profits has been shaved off with the use of American accounting practices and it has to raise its loan-loss provision The new capital thus can help to absorb some of this differentials.
