Capital account liberalization and stability of capital markets in India

Table of Contents

Introduction

Research Problem and Relevance

Preliminary Trends

Estimation Procedure and Results

Conclusion and Policy Implications

Appendices

References

1. Introduction

With the wave of financial globalization in the developing countries, most developing countries have started removing the restrictions on capital account transactions. Theoretically, capital account liberalization will result in a lower cost of funds due to diversification ,an increase in the supply of capital, an expansion in the size of the market, improved liquidity, improved market depth and increased efficiency in allocation of investments (Bekaert and Harvey, 2000; Bekaert et al. 2001).As an open economy allows for cross-border capital flow, capital account liberalization provides an additional mechanism through which shocks to the economy are offset, thus leading to lower income stream and asset price variability (Wu, 2006).However, in an economy where information is asymmetric, markets do not behave as predicted by standard competitive models, and liberalization could lead to episodes of capital flight, and asset market volatility (Stiglitz, 2000). Thus theoretically the implications of capital account liberalization on the stability of capital markets1 is not clear.

Empirical studies and country experiences in this regard give mixed evidence and show that the results depend on country specific characteristics (Bekaert and Harvey 1997, Levine and Zervos, 1998; Aggarwal et al. 1999; Kim and Singal 2000, Bekaert et al. 2001, Kaminsky and Schmuckler 2003, Edwards at al. 2003, Claessens et al, 2006; Dhir, 2007etc).

2. Research Problem and Relevance

In India, there has been a change in the policy framework regarding capital account from an inward looking one, with great reliance on official flows and debt creating flows to a more convertible regime with an environment conducive for non debt creating private capital flows like Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). Capital account liberalization in India was a response to the Balance of Payments (B.O.P) crisis in 1991, as a part of a comprehensive, integrated process that involves reforms in the domestic financial system and macroeconomic policies. The state of capital controls today in India can be considered as the most liberalized one it has ever been in its history since the late 1950s (RBI, 2006).

In India, the financial markets were opened to foreign portfolio capital, which followed within a year of liberalization of FDI rules .India opened its stock market to Foreign Institutional Investors (FII) in September 1992 subject to a one percent ceiling on individual acquisition and prudential limits. Associated outflows, namely repatriation of investments and income/interest thereon, were made optional. Ceilings on FII Investments have been progressively relaxed. In the sequencing pattern followed by most economies undergoing the process of liberalization, liberalization of portfolio flows takes place at a much later stage, after the development of domestic financial markets. This exception to the general pattern of financial liberalization is attributable to the existence of a well developed equity market in India compared to most developing countries (Kohli, 2005).

The main objectives of FPI opening in India were (1) to inject global liquidity into the markets (2) to reduce cost of capital, which in turn leads to improved economic growth (3) to raise the equity flows to help the corporate sector shift from their dependence on internal resources and funds from public sector banks to the capital markets (4) providing a channel for portfolio diversification to the residents and thereby reducing market volatility and (5)achieving improved access to international financial markets(RBI,2000) .

In the Indian context, empirical studies ( Pethe and Karnik ,2000; Bhattacharya and Mukherjee ,2002; Pratnik and Vina,2004etc) have been done on the relative influence of macroeconomic variables like domestic output, inflation, exchange rate and FII on stock prices .However ,none of the above mentioned studies have exclusively focused on the implications of capital account liberalization on the liquidity of stock markets in India. Further there is no systematic empirical study focusing on the implications of capital account liberalization, particularly foreign portfolio investment liberalization on stock market volatility in India.

This paper empirically examines the implications of capital account liberalization particularly, FPI liberalization on the stability of capital markets in India using monthly data for the period 1993-94 to 2007-08. Such a study seems particularly relevant for the following reasons.

(1) Lack of empirical studies on the capital account of B.O.P, in the post liberalization era and (2) the choice of an approach towards full capital account convertibility is in question in India in the aftermath of Southeast Asian crisis.

This paper is organized as follows. Section 3 tracks the movements in net capital flows and stock market indicators following liberalization, section 4 describes the estimation procedure and results and section 5concludes.

3. Preliminary trends

Table I shows that FPI flows have exceeded the FDI flows in many years following liberalization. Further, it is seen that net foreign investment inflows constitute the major share of total flows whereas the official flows have only a minute share. One of the major aims of these reforms was to enhance liquidity in financial markets and reduce the volatility of financial markets, particularly capital markets (RBI, 1997).

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Table I: Composition of Capital flows (percentage)

Source: Calculations using table 143, RBI, 2008

Indian capital market is now increasingly getting integrated with the rest of the world since 1992. Indian companies have been permitted to raise resources from abroad through issues of American Depository Receipts, Global Depository Receipts, Foreign Currency Convertible Bonds and External Commercial Borrowings.Following the implementation of all the reforms, the liquidity indicators in Indian stock market have shown considerable increase since 1992-93.The data from Securities and Exchange Board of India(2008) for the Bombay Stock Exchange(BSE)shows that Market capitalization ratio, which is the amount of new capitalization raised through stock offerings as a percentage of GDP has increased from 25.1 percent in 1992-93 to 109.1 percent in 2007-08 ; value traded ratio, which is the total value of trades on the stock market divided by GDP has increased from 6.1 percent to 33.5 percent and turnover ratio, which is the ratio of market capitalization to turnover has increased from 24.3 percent to 30.7 percent. The first indicator denotes the stock market size whereas the second and third indicators are measures of stock market liquidity.

Further following the reforms, Indian stock markets have stood out in the world ranking also. Table II shows that as of end December 2006, India has a market capitalization ratio of 101.84 and turnover ratio of 93.1 percent which is quite comparable to other developed markets. As per Standard and Poor's Fact Book 2007, India ranked 15th in terms of market capitalization (18th in 2004 and 17th in 2005) , 18th in terms of total value traded in stock exchanges and 21st in terms of turnover ratio as of December 2006.

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Table II: International comparison of stock Markets: end December 2006

Source: NSE, 2007

In addition to the above indicators, the FIIs interest in the Indian Stock Market can be gauged from various indicators like, FII’s Market Capitalization ratio, Turnover ratio and Value Traded ratio. Table III gives the FII stock market indicators for 2006-07 listed by NSE. The most commonly used indicator of stock market development is the size of the market, measured by Market Capitalization ratio. Market Capitalization ratio is the value of listed shares on the country's exchanges divided by GDP of the country. In the year 2006-07, market capitalization ratio of the FIIs (Market capitalization of FII holdings / GDP) on NSE was 13.14 %. The share of FIIs market capitalization to the total market capitalization of NSE as end March 2007 was 16.10 %.The Turnover ratio equals the total value of shares traded on a country's stock exchange divided by stock market capitalization (Turnover of FIIs during the year 2006-07/ market capitalization of FII holdings). It is used as a measure of trading activity or liquidity in the stock markets. Another variable is the value traded ratio which equals the total value of domestic stocks traded on domestic exchanges as a share of GDP. The turnover ratio of FII was 126.60% during the current year 2006-07. The value traded ratio was 16.63 %.All these indicators show the interest of foreign Institutional investors in Indian stock market as a result of liberalization measures implemented.

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Table III: FII Stock Market Indicators 2006-07

Source: NSE, 2007

Table IV gives the estimated daily volatility of select world stock indices including India from 1992. From the preliminary observation, it seems that the daily volatility of BSE index and Nifty may be higher than those of all other indices except Brazil, Mexico and Hong Kong for most of the years. Thus from preliminary observations, though the stock market development indicators have shown considerable increase since 1993, volatility in Indian stock markets might be higher than the other major developed markets .

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Table IV: Daily Volatility: Select World Stock Indices

Note: Volatility is calculated as the standard deviation of daily logarithmic returns Source: SEBI, 2008

Thus this section shows that since 1993-94, the stock market development indicators have increased remarkably in India and Indian stock markets stood out in world ranking also. However, irrespective of that, it seems that the volatility of Indian stock markets still remains high when compared to that of world markets. Thus the implications of capital account liberalization measures on the stability of capital markets need to be analyzed in a well defined framework that controls for other factors also. The next section describes the estimation procedure and results.

4. Estimation Procedure and Results

The period of analysis is 1993-94 to 2007-08. The capital account liberalization measures are captured by constructing monthly policy indices (Figures I,II and III) from 1993-94 to 2007­08 following Quinn(1997) that capture the intensity of restrictions. These policy indices are constructed for FDI, FPI, Commercial borrowings (LOAN Indices) and deposits inflows and outflows separately. The total capital account liberalization index is the sum of all these indices. The methodology for the construction of these indices and data used for construction are given in appendix I.

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Figure I: Inflow, Outflow and total indices

Source: Economic Survey, RBI Annual Reports, various issues

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Figure II: FDI, FPI, Loan and deposit inflow indices

Source: Economic Survey, RBI Annual Reports, various issue

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