Capital market reforms may help ease pain of global crisis

capital market may crash
The capital markets are bracing for a global recession, a price the world may pay for governments’ failure to act decisively to contain inflation.

Rising inflation is an ominous sign for the Indian capital market. The Sensex fell by close to 12% from this year’s peak of 61,475.15 recorded on January 18, and the slide is expected to continue through the year. The year 2022 could see the worst in more than a decade for the market.

Things were coming back to normal since the economy opened up after two pandemic years when Russia invaded Ukraine in February. The Indian economy had recovered to pre-pandemic levels and most global forecasts saw the economy growing at the fastest pace among major economies. But the war has disrupted the nations’ efforts to bring down the inflation caused by the fiscal and monetary measures taken during the pandemic to boost demand.

As the central banks are expected to tighten money supply by raising interest rates, the growth outlook is negative for most economies including India. The world may be facing a recession, a price nations may pay for not acting fast enough to contain inflation. The worst-case scenario is a stagflation marked by low growth and high prices. Indian markets escape the predicament altogether. But India has enacted a series of market reforms that can shield the investors to some extent.

READ I  Timely action on inflation needed to avert hard landing

The development of national economies and capital markets are closely linked. Capital markets play a role in the economy’s long-term development. Indian capital markets have shown substantial efficiency, tradability, stability, resilience, and maturity over the years.

Capital market instruments

Capital markets are differentiated as markets where money is invested for periods longer than one year. It is different from the money market where monetary assets such as commercial paper, certificates of deposits, and treasury bills that mature within a year are traded. The capital market facilitates speedy and sustainable development of a country’s economy.

The capital market work through intermediaries such as stock exchanges (BSE, NSE, MCX, NASDAQ, NYSE) banks, brokers, insurance companies, and other financial institutions. Capital markets mobilise savings for investments through these intermediaries. Capital markets help the intermediaries conduct business and earn income. India’s capital market instruments can be classified into three categories: Pure, Hybrid, and Derivatives.

Pure instruments: Equity shares, preference shares, debentures, and bonds that are issued with the basic characteristics without mixing the features of other instruments are called pure instruments.

Hybrid instruments: Hybrid instruments are created by combining the features of equities, convertible preference shares, debentures with equity warrant, and secured premium notes.

Derivatives: Derivative instruments derive value from the value of some other financial instruments or variables.

The capital market aggregates the wealth of savers and puts it in the hands of productive users such as companies and governments. A capital market can be classified into primary and secondary markets. Even though the secondary market is many times larger than the primary market, they are interdependent in many ways. In primary markets, new stock or bond issues are sold to investors. Existing securities are sold and bought in the secondary markets, usually on an exchange.

READIndian economy: War on runaway inflation will warrant sacrifices

The existence of secondary markets increases investors’ willingness to invest in primary markets as they know that they will be able to cash out their investments if the need arises. Returns in the stock market depend on several macroeconomic factors. Favourable macroeconomic factors help firms earn higher returns, which, in turn, create favourable conditions for the secondary market. This influences the price of stocks. Favourable macroeconomic factors necessitate raising fresh capital to finance new projects as well as expansion and modernisation of existing projects.

Reforms may provide succour

Indian capital market went through some fundamental changes in the last three decades. These reforms may help the Indian markets to weather the turbulence in global economy.

Economic Liberalisation: Economic liberalisation has led to economic deregulation, and privatisation of public sector undertakings in India. Shares of some of the public sector undertakings were made available to the public through the government’s disinvestment programme. The liberalised industrial policy facilitated investment flows into the core sector from individuals, institutions and the private sector. The shares of several public sector undertakings are available to the public now.

Promoting private sector banks: The opening up of private sector banks has resulted in the public investing in the shares of these banks. Recently, the government announced 74% equity participation by foreigners in private sector banks in India. This policy will help new banks and pave the way for the consolidation of the banking system.

READ I  Interest rate hike: Can RBI avert a hard landing

Promotion of mutual funds: Promotion of mutual funds by public and private banks helped the Indian capital market expand. They were helpful to the public by way of tax-saving schemes. SEBI has regulated the working of mutual funds, and the banks have to publish their net asset value every week by furnishing the details in leading newspapers.

Regulation of NRI investments: The Foreign Exchange Regulation Act (FERA) was replaced by the Foreign Exchange Management Act (FEMA) to encourage non-resident investors. The percentage of NRI investment in Indian companies has increased from 5% to 24%. The lock-in period of NRIs investment in the equity shares of Indian companies has been reduced from three years to one year. Any profit earned while diluting the shares will attract a 20% tax on capital gains.

Online trading in capital market: Some of the leading stock markets in India have introduced computer systems for trading activities. The brokers can trade online. The computer terminals of exchanges will enable the public and the brokers to know the price prevailing in the market. This will prevent speculation.

Transparency through online trading: Online trading has brought transparency in market transactions. People can know the prices prevailing in the market at any time, and the brokers cannot deprive their clients of profits. The manipulation of the opening and closing prices of shares in the market is no longer possible.

Circuit-breakers in capital market: Wild fluctuations in the stock market are a thing of the past. Every precaution has been taken to prevent ‘stock scams like the one engineered by Harshad Mehta. For this purpose, the BSE has introduced a cut-off switch called a circuit breaker. Whenever the market index goes up by more than 10%, the circuit breaker will go off, bringing the trading on such shares to a standstill for 30 minutes, after which the market will resume. This will bring down the share price.

Demat shares: The introduction of demat shares has resulted in improving transactions further. Demating is a system under which the physical delivery of shares is no more adopted. The stock holding company holds the shares of individual investors, and a passbook is given to investors. Any sale or purchase of shares will result in entries made in the passbook. The companies are also informed about making due alterations in the share register.

This has prevented blank transfer and speculation. Every transaction in the market is not only recorded, but it brings revenue to the government in the form of registration and stamp charges. Blank transfers will not be possible, and short-term speculation in shares cannot be done. Every share purchased or sold will have to go for registration, and hence bogus or benami share transfer is not possible.

Market makers: The share price of companies will be decided by the supply-demand mechanism. There are market makers who ensure the supply and reasonable price of stocks. With the introduction of these market makers, manipulation of share prices by the brokers is impossible.

Rise of fintech: The distributed ledger technology (DLT) can bring significant efficiency to post-trade processes and can potentially shorten the settlement cycle.

Non-banking finance companies: The role of NBFCs has also been controlled. RBI has introduced new conditions, restricting their activities. New norms concerning the capital of non-banking financial companies have been introduced. A separate Act has been passed for chit funds, and it limits the maximum bidding to 40%.

One nation, one market: Introduction of GST is the most comprehensive tax reform ever to take place in India. The primary aim was to streamline indirect taxation and remove the barriers hindering the smooth passage of trade.

Educating the public: The media has contributed a lot to popularise the stock market, highlighting the prices of securities every day. The mutual funds and merchant banks have been asked to set apart a portion of their funds towards educating the public on the capital market.

Public-holding in listed companies: SEBI has increased mandatory public holding in listed companies to 35% from 25%.

Penalty for insider trading: In 2002, the SEBI Act was amended to make insider trading a punishable offense. The penalty rate has been enhanced to Rs 1 lakh per day, and the maximum can go up to Rs 25 crore.

Based on Goldman’s estimates, 150 private firms could potentially list on the stock market over the next 36 months and are expected to add $400 billion the market size. It is estimated that India’s aggregate stock market value will increase from $3.5 trillion to over $5 trillion by 2024. It will make the country the fifth largest in the world by market capitalisation, surpassing the UK. Indian equity indices could see a larger representation of the new economy sectors over the next 2-3 years as large digital IPOs will get included in the index.

Goldman analysts estimate that segments like e-commerce, internet retail, and media have more weight on the indexes through the consumer discretionary and communication services sectors. Other sectors such as commodity and software services would likely see weightage shrink. The year 2020 has been among the worst years for the global economy in more than 70 years. The current year could see rising exposure to 5G, fintech, health tech, and green tech. We expect 2022 to be the year of restoration.