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Why Do Some Financial Markets Develop and Others Do Not?
Politics of India’s Capital Market Reform
Paper presented to the
Workshop on States, Development, and Global Governance
March 12-13, 2010
Lubar Commons, University of Wisconsin Law School
John Echeverri-Gent
Department of Politics
University of Virginia
Email:
Why Do Some Financial Markets Develop and Others Do Not?
Politics of India’s Capital Market Reform
“A casual observer might infer from India’s
flourishing stock markets, fast-growing
mutual funds, and capable private banks that
the financial system is one of the country’s
strengths. But closer inspection reveals that
while policy makers deserve credit for
liberating these high-performing parts of the
[financial] system, tight government control
over almost every other part is undermining
India’s overall economic performance.”[1]
Economic historian Douglass North has observed, “it is a peculiar fact that the literature on economics … contains so little discussion of the central institution that underlies neoclassical economics – the market.”[2] Until recently, this neglect was particularly true for analysis of how markets change. Though more recently, economic historians like Douglass North, John McMillan, and Avner Grief have documented the changes in markets over time, the analysis of how markets change is still in early phases of development.[3] My paper takes advantage of the uneven nature of capital market reform in India to offer some modest steps towards advancing our thinking. It poses the question: “Why have India’s equity markets experienced such dramatic reform while its market for government securities have lagged behind, and the limited reforms in the market for corporate debt have failed miserably?”
Implicit in this question is a distinctive and somewhat fine-grained definition of “market.” While economists have delivered great insights on the functioning of markets, comparative economics has not always carefully defined the concept of markets. Many analysts talk about market economies as a national unit of analysis. They compare market vs. non-market economies or different varieties of capitalist markets. Other analysts conceptualize markets in sectoral terms, at either the international or national level. They examine energy markets, agricultural markets, financial markets, etc. Still others discuss regional markets. For the purposes of this papers analysis, I define markets in terms of the technologies and rules that regulate the transactions of market participants. I distinguish market along three dimensions: 1) the technologies and rules that structure the transactions of market participants, or what I call market design; 2) the nature of the goods that are exchanged; and 3) the identity of the participants. A single market is the intersection of these three dimensions. If the same market design is used for transactions of two different commodities and for two different sets of participants, there will be at least two markets distinguished by sectoral or spatial dimensions. If the same commodity is traded according to different market designs and/or among different positions, there will be distinctive markets. Similarly, if the same participants engage in transactions of according to different market designs and/or they trade different commodities there will be distinctive markets.
Following from this definition is a conceptualization of how to measure market development. I measure market development along three dimensions. Markets develop as they adopt more efficient market designs. The efficiency of market design has two indicators. A more efficient market will have lower transaction costs. It will also have more efficient price discovery. Secondly, more advanced markets will have more efficient competition. My idea of more efficient competition differs from notions of “perfect competition” in that the number of participants that achieve efficient competition will vary with the nature of the good being traded. Finally, I measure market development in terms of the sophistication of its regulation. The sophistication of regulation is measured in terms of the extent to which the regulation facilitates efficient competition and innovation in terms of market design and goods traded.
My analysis leads me to adopt somewhat distinctive units of analysis. Some scholars speak of India’s financial sector, a concept that includes the money market, credit market, and capital market. Other scholars analyze India’s capital markets conceptualizing them as including the equity market and the debt market which encompasses the market for government securities and corporate debt. There are good reasons for grouping government securities and corporate debt into a single market since they are interdependent. In particular, the yield curves established for government securities are an important benchmark for corporate debt issues. Also, it is important to keep in mind that India’s financial markets, like financial markets around the world, are becoming increasingly interdependent. Nonetheless, I examine the equity, government securities, and corporate debt markets as being distinct in the Indian case because they are characterized by different market designs, traded goods, market participants, and regulatory regimes.
There are three analytical perspectives explaining financial market development. First, is the Legal Origins Perspective.[4] The premise of the legal origins perspective is that founding legal systems on different principles creates systematic variation in legal systems across countries with the basic variation being between Anglo-Saxon common law traditions and continental European civil law traditions. Variation between these legal traditions can be quantified and has a significant impact of economic outcomes. Common law traditions because of its greater judicial independence and pragmatic approach to resolving legal problems provides greater legal protection for minority shareholders, better contract enforcement, and thus support more rapid financial development in times of stability. Civil law is associated with less flexible dispute resolution, greater government intervention and associated corruption and therefore leads to less respect for private property and the development of less efficient financial markets.
Second is the “Constructivist Crisis” perspective.[5] This perspective views crises as critical junctures that provide opportunities for dramatic change. Rather than characterizing crises as exogenous shocks to equilibrated systems or events that dramatically alter balances of power, recent proponents have highlighted how crises disrupt and delegitimize norms and cognitive understandings of circumstances. Consequently, crises provide opportunities for agents construct meanings which in turn structure understandings of interests and the evaluation of policy alternatives. The approach highlights the role of ideas in shaping actors’ perceptions of their interests, and ultimately, the responses to economic crises.
The third perspective is the political power approach. It began with a focus on the role of political institutions in restraining the arbitrary abuse of government authority and bolstering its credible commitment to property rights.[6] More recently advocates have added a focus on institutions that promote political competition such as separation of powers, federalism, and electoral suffrage.[7] Advocates working in the tradition of this perspective have recently endeavored to extend their analysis “beyond formal institutions of competitive elections and political checks and balances.”[8] Keefer, for instance, observes that there is considerable variability in the accountability of political authorities among competitive political systems. Pointing out that secure property rights and efficient markets are public goods, he finds that variables that align politicians incentives to provide public goods – i.e. variables that affect the credibility of their promises to deliver public goods such as the years of continuous competitive elections and voter information about public policies – are in some ways stronger determinants of financial market development than institutional checks and balances.[9] Rajan and Zingales point out that governments can – and historically have – reversed their support for political institutions.[10] The institutional argument is incomplete. Enduring institutional commitments are the culmination, rather than the source, of changes in a balance of power. In their view, “It is more fruitful to think if the devolution of political power and the security of property as intertwined processes in which secure property eventually became the fount of political power.” [11] Drawing on these positions, the political power perspective will investigate how institutional change is shaped by the exercise power.
This paper argues that though law plays a crucial role in the development of financial markets, the legal origins perspective is not well suited to explain the variation of market reform and development in India’s equity, government securities, and debt market. It contends that while interpretation of economic crises played an important role in shaping the development of India’s capital markets, their impact was structured by the configuration of political power – in particular the power and authority of state agencies like the Reserve Bank of India and the Ministry of Finance – and the structure of institutional capabilities that comprised the context of the reforms.
India’s Capital Markets Before the Reforms
Though India had one of the most regulated non-communist economies of the world until the 1990s, few sectors were as dominated by the state as finance.[12] Two objectives motivated the Indian state’s control over its capital markets: funding the government’s fiscal deficits in a non-inflationary manner and directing capital to sectors and firms that state planners designated as priorities. Though India had long-standing financial institutions, it suffered from severe financial repression and underdeveloped markets at the onset of the reform era in the early 1990s.
Equity Markets
Indian equity markets were stunted by heavy handed state regulation and a monopoly of stock brokers. All companies wishing to raise capital from the primary market needed to get the approval of the Controller of Capital Issues (CCI). The CCI was created under the Capital Issues Controller Act (1947) which itself was influenced by the controls over the issues of capital instituted by the British during World War II. The CCI was not only the gatekeeper to the primary market, but it determined the number and price of shares or debentures that could be issued. The formula that it used to determine the prices of new issues consistently assigned sub-market prices and led to oversubscription to new issues by investors strategies by promoters and brokers to take advantage of the investor’s frenzy.
Though the Ministry of Finance exercised legal authority over India’s secondary equity markets under the Securities Contracts (Regulation) Act 1956, it delegated most of the regulation of the secondary market to the stock exchanges as self-regulatory organizations. Due to poor communications infrastructure and a legal provision that companies must list on at least two exchanges, India had twenty regional stock exchanges at the end of the 1980’s. However, the largest and most prestigious, the Bombay Stock Exchange (BSE) dominated the system. Virtually all of India’s large corporations listed on it, and it had by far the largest capitalization and trading volume. Access to trading on the BSE was controlled by the 554 broker-members of the BSE. [13] The broker-members controlled the exchange management through annual elections to the governing board of the exchange. The governing board’s regulation of the exchange was broker-friendly to an extreme degree, often at the expense of investors. The exchange management often delayed settlements when brokers were having difficulty meeting their financial obligations, and it allowed brokers to mix their trade accounts with the accounts of their clients. With the advent of computerized trading the exchanges’ market design – based on an open-outcry system with jobbers – market makers to infuse liquidity – grew increasingly outdated. It also suffered a fundamental design flaw in the form of badla, a carry forward system of finance that served as a means of hedging by enabling traders to manage their risk by postponing payment from one settlement to the next. However, unlike derivatives, which are traded on a separate exchange, badla trading is mixed with the cash market and therefore distorts price discovery. The capacity to distort prices on the cash market made badla attractive to speculators wishing to profit by creating false market signals. The public sector Unit Trust of India (UTI) had a monopoly over the mutual fund sector until 1986. It was widely believed that the state issued instructions to the UTI – arguably largest and most influential trader on the secondary market– to influence prices.[14]
The Market for Government Securities
“The genius of the Indian economy,” remarked Larry Summers, “is its ability to run high fiscal deficits as much as 10 % of GDP while keeping the rate of inflation low.”[15] The Indian state – through the Finance Ministry – was able to accomplish this feat through forceful repression of the market for government securities. The Reserve Bank of India (RBI), the country’s central bank, lacked autonomy from the government in exercising its role as banker to the state and monetary policy authority.[16] Through the 1990’s the RBI automatically monetized the fiscal deficit at the government’s behest. After the government nationalized 14 of the largest commercial banks in July 1969 -- which together with the already publicly owned State Bank of India accounted for 86 percent of deposits, it forced the banks to serve as a “captive market” for low cost finance for the fiscal deficit.[17] There was no real market – primary or secondary – for government securities. When the government issued treasury bills at administratively determined interest rates to pay for its fiscal deficit, the RBI either absorbed them itself, or it telephoned a bank and requested that they purchase them. The government ensured that the banks would purchase its securities by raising their Statutory Liquidity Ratio (SLR) – the share of net demand and time deposits that banks have to maintain in cash, gold and approved securities – from 25 percent in 1964 to as high as 38.5 percent in 1990. It also increased the Cash Reserve Ratio – for which banks were required to hold cash, gold and securities – from 3 percent to 15 percent of their net demand and time deposits.[18]
The secondary market for the low interest government securities was limited. There was no exchange, rather trading took place through bilateral negotiations over the telephone between banks and other financial institutions often-times facilitated by brokers. The public was excluded, and given the poor condition of India’s telephone infrastructure up to the 1990s, virtually all trading took place within the South Mumbai financial center.[19] The RBI’s Public Debt Office served as a depository for government securities. It recorded transactions by physically entering them a subsidiary general ledger (SGL) on the request from the sellers. Record keeping was notoriously inefficient, often falling weeks behind, and it was not uncommon for a financial institution’s payments to bounce because the record-keeping was behind.[20] These inefficiencies prompted traders to begin trading IOU’s called “bankers receipts” that played a role in the 1992 scandal.