Capital Market Development Program in India (Loan 1408-InD)

7/31/2019 Capital Market Development Program in India (Loan 1408-InD)

1/67

ASIAN DEVELOPMENT BANKOperations Evaluation Department

PROGRAM PERFORMANCE AUDIT REPORT

ON THE

CAPITAL MARKET DEVELOPMENT PROGRAM(LOAN 1408-IND)

IN

INDIA

In this electronic file, the report is followed by the Managements response.


2/67

ASIAN DEVELOPMENT BANK PPA: IND 26468

PROGRAM PERFORMANCE AUDIT REPORT

ON THE

CAPITAL MARKET DEVELOPMENT PROGRAM(Loan 1408-IND)

IN

INDIA

July 2004


3/67

CURRENCY EQUIVALENTS

Currency Unit Indian rupee/s (Re/Rs)

At Appraisal At Program Completion At Operations Evaluation(November 1993) (December 1999) (February 2004)

Re1.00 = $0.0321 $0.0230 $0.02208$1.00 = Rs31.13 Rs43.4100 Rs45.290000

ABBREVIATIONS

ADB Asian Development BankBSE Bombay Stock ExchangeCCI Comptroller of Capital IssuesCCIL Clearing Corporation of India LimitedCDSL Central Depository Services LimitedEA Executing AgencyFIRE Financial Institutions Reform and Expansion

G30 Group of ThirtyIRDA Insurance Regulatory Development AuthorityIT information technologyMOF Ministry of FinanceMOJ Ministry of Law, Justice, and Company AffairsNRI nonresident IndianNSDL National Securities Depository LimitedNSE National Stock ExchangeOEM Operations Evaluation MissionPCR program completion reportPPAR program performance audit reportPSU public sector undertaking

RBI Reserve Bank of IndiaRRP report and recommendation of the PresidentSC(R) Securities Contracts (Regulation)SEBI Securities and Exchange Board of IndiaSRO self-regulatory organizationTA technical assistanceUSAID United States Agency for International DevelopmentUTI Unit Trust of India

NOTES

(i) In this report, "$" refers to US dollars.

(ii) The fiscal year (FY) of the Government ends on 31 March.

Director General, Operations Evaluation Department : Eisuke SuzukiDirector, Operations Evaluation Division 2 : David EdwardsEvaluation Team Leader : Naomi Chakwin

Operations Evaluation Department, PE-645


4/67

CONTENTS

Page

BASIC DATA iii

EXECUTIVE SUMMARY iv

I. BACKGROUND 1A. Rationale 1B. Formulation 2C. Purpose and Outputs 3D. Cost, Financing, and Executing Arrangements 3E. Completion and Self-Evaluation 4F. Operations Evaluation 5

II. PLANNING AND IMPLEMENTATION PERFORMANCE 5A. Formulation and Design 5B. Achievement of Reform Measures 7C. Cost and Scheduling 10

D. Organization and Management 11

III. ACHIEVEMENT OF PROGRAM PURPOSE 11A. Program Outcomes and Impact 11B. Sustainability 16

IV. ACHIEVEMENT OF OTHER DEVELOPMENT IMPACTS 16A. Socioeconomic Impact 16B. Impact on Institutions and Policy 16

V. OVERALL ASSESSMENT 17A. Relevance 17

B. Efficacy 18C. Efficiency 18D. Sustainability 18E. Institutional Development and Other Impacts 18F. Overall Program Rating 18G. Assessment of ADB and Borrower Performance 18

VI. ISSUES, LESSONS, AND FOLLOW-UP ACTIONS 19A. Key Issues for the Future 19B. Lessons Identified 20C. Follow-Up Actions 20

N. Chakwin, Principal Evaluation Specialist (Team Leader), was responsible for the preparationof this report, and conducted document reviews, key informant interviews, and guided thefieldwork undertaken by the consultants, S. Hertel and S. Thomas. R. Lumain, SeniorEvaluation Officer, supported the team with research assistance from Manila.


5/67

APPENDIXES

1. Capital Market Development Program Loan: Status of Reforms 212. Recommendations of Group of ThirtySecurities Clearance and Settlement Study 433. Excerpts of the Securities and Exchange Board of India (Amendment) Act, 2002 444. Unit Trust of India 495. Joint Parliamentary Commission 51

6. Elements of Market Design in Indian Securities Market, 1993 and 2004 527. Growth and Distribution of Turnover on Stock Exchanges 548. New Capital Issues by Nongovernment Public Limited Companies 559. Number of Listed Securities, Market Capitalization, and Turnover at BSE and NSE 5610. Yearly Trends in FII Investment in India 5711. Transaction Costs in Indias Equity Market 58


6/67

BASIC DATA

Loan 1408-IND: Capital Market Development Program

As per ADBKey Program Data ($ million) Loan Documents Actual

Program Cost 250.0 250.0ADB Loan Amount/Utilization 250.0 250.0ADB Loan Amount/Cancellation 0.0 0.0

Key Dates Expected ActualFact-Finding 718 Jun 1993Appraisal 1631 Aug 1993Loan Negotiations 811 Nov 1993Board Approval 28 Nov 1995Loan Agreement 29 Nov 1995Loan Effectiveness 27 Feb 1996 8 Dec 1995First Tranche Release 27 Feb 1996 22 Dec 1995

Second Tranche Release Dec 1996 22 Dec 1998Loan Closing 30 Jun 1997 31 Mar 1999Program Completion 30 Jun 1997 31 Mar 1999Months (effectiveness to completion) 16 40

Borrower Government of India

Executing Agency Ministry of Finance

Mission DataType of Mission Number of Missions Number of Person-Days

Fact-Finding 1 84

Appraisal 1 60Project AdministrationProject Specific/Consultation 1 12Review 3 22Project Completion 1 21

Operations Evaluation 1 57

____________________________

ADB = Asian Development Bank.


7/67

EXECUTIVE SUMMARY

On 28 November 1995, the Asian Development Bank (ADB) approved a loan of$250 million to India for the Capital Market Development Program (the Program). The loan wasfunded through ADBs ordinary capital resources. The objectives of the Program were to(i) enhance the country's ability to mobilize internal and external resources to finance economic

growth, and (ii) improve the efficiency of resource allocation through a greater reliance onmarket mechanisms. In doing so, the Program intended to promote stable, long-term economicgrowth.

The Program focused primarily on the implementation of the Governments broad capitalmarket reform agenda. The measures to support this objective were relevant and consistentwith the Programs purpose. The lack of clarity on policy actions to strengthen the regulatorypowers and authorities of the capital market regulatorthe Securities and Exchange Board ofIndia (SEBI)was the only concern about the design of the Program. The Program is assessedas relevant.

The Program was successful in meeting most of the anticipated program outputs. Key

accomplishments included (i) establishing an integrated national market system, (ii) modernizingthe market trading infrastructure to support growth and expansion, (iii) eliminating legal orregulatory impediments to broader market participation, (iv) improving pricing and efficiencythrough enhanced competition in the market, and (v) developing a stronger and moreindependent securities market regulator.

The reforms identified in the Program have had a dramatic impact on the efficiency,transparency, and professionalism in the Indian capital market. The Government hasdemonstrated an awareness of, and a commitment to, pursuing longer-term developments inthese areas. Indeed, the Government has supported recent amendments to the SEBI Act andchanges in the regulatory structure (including the addition of the new insurance regulator). WhileSEBI still needs to improve market surveillance and monitoring, these reforms are part of an

ongoing process.

The Program supported the implementation of reforms that are unlikely to be reversed.Moreover, the Programs contributions to institutional and capital market development are likelyto expand as the market develops. Managing fiscal reforms, sustaining the momentum forprivatization, and pursuing greater independence for all market regulators will require additionalgovernment commitment. However, the scope and objectives of this Program have been largelyaccomplished. Based on the Operations Evaluation Mission's assessment, the overall rating ofthe Program is successful.

Key lessons from the Program include:

(i) The Governments vision for the development of the market can be traced to asmall number of fiercely independent civil servants. This vision was needed tosustain the implementation of a reform program of this magnitude. Adequatelydeveloping the institutional, administrative, and regulatory framework required asubstantial commitment of time and resources. Therefore, the importance ofgovernment ownership and dialogue cannot be underestimated.

(ii) Capital market development also requires a certain depth of human resources orskills in the market. Ensuring sufficient skills and capacity to implement complex


8/67

v

reforms, such as the ones specified in this Program, were critical to the successof the Program.

(iii) Three factors were essential for this market to develop (a) competition, whichforced good market standards for fairness; (b) transparency and efficiency,through an improved clearing, settlement, and depository system, which alloweddematerialized trading and better market regulation; and (c) sufficient supply and

demand to foster market depth and liquidity. The derivative market has played akey role in this aspect of market development.

Since the Program, ADB has continued to be engaged with India. ADB is supporting thedebt and derivative markets, and pension reform. This assessment endorses ADBs approachand efforts in these areas, and encourages more dedicated assistance for the development ofbond markets. Support for infrastructure development through the use of debt instruments isneeded urgently. Well-structured assistance with concrete deliverables could acceleratedevelopment in this area.

Eisuke SuzukiDirector GeneralOperations Evaluation Department


9/67

I. BACKGROUND

A. Rationale

1. Following an economic crisis in 1991, the Government introduced a broad rangingeconomic reform program that contained immediate stabilization measures and ambitious

structural reforms. Despite some slippage on fiscal consolidation, the stabilization effort restoredexternal confidence and led a buildup of foreign exchange reserves (Figure 1).1

2. In the early stages of reform, India emphasized reducing imports temporarily throughadministrative controls to ease the current account deficit (Figure 2). Subsequent stabilizationmeasures focused on monetary tightening and fiscal consolidation, supported by currencydevaluation. Structural reforms, which initially were concentrated in the industrial sector and ontrade liberalization, aimed to eliminate most investment and import licensing requirements. Theforeign investment regime also was liberalized substantially. The focus then shifted to taxreform, additional trade liberalization, and financial sector reform. As part of its operationalstrategy for India in much of the 1990s, the Asian Development Bank (ADB) assisted theGovernment in increasing economic efficiency through support for structural reforms, promotion

of competition, and private sector participation. Loan 1208-IND,2

which included monetarymanagement and banking reforms, kicked off ADBs support of financial sector reform in 1992.At the same time, parallel support for capital market development also was considered.

1The dramatic increase in reserves from 2001 to present might be partly attributable to global events beyond Indiaseconomic reforms.

2 Loan 1208-IND: Financial Sector Program, for $300 million, approved on 15 December 1992.

Approval Completion

Figure 1: Official Foreign Exchange Reserves

0

20

40

60

80

100

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

BillionofDol

lars

0

2

4

6

8

10

12

MonthsofImport

Foreign Exchange Reserves Months of Imports

Source: Operations Evaluation Mission.

Approval Completion


10/67

2

B. Formulation

3. Recognizing the need for an efficient banking system and well-functioning capitalmarkets in the aftermath of the economic crisis, the Government introduced a broad economicreform program. After approving the Financial Sector Program loan (footnote 2), ADB sent areconnaissance mission in March 1993 to continue discussions on the development of thefinancial sector and possible capital market reforms.3 A fact-finding mission in June 1993 and anappraisal mission in August 1993 led to an understanding with the Government on a number ofpolicy actions for the Capital Market Development Program (the Program).

4. This was ADBs first attempt at capital market reforms in a developing member country,and it coincided with strong momentum for reform within the Government. Program approvalwas delayed due to concerns about the policy and macroeconomic environment in India. Thereport and recommendation of the President (RRP) for the Program was circulated to the Boardof Directors in November 1993, withdrawn, and re-circulated in November 1995 (using the sameRRP as in 1993 with an addendum supplement and corrigendum updating the status ofcompliance with upfront program actions).

5. When the Program was designed, the country had 23 active stock exchanges, all ofwhich traded the same stocks. The Bombay Stock Exchange (BSE) took the lead in pricediscovery. (Before the National Stock Exchange [NSE] was established, the BSE accounted for

about 80% of the total turnover in the country.) Even exchanges such as Delhi and Calcuttaused to trade the same stocks at different prices. Thus, investors in different parts of the countrycould pay different prices for the same stock at the same time. Furthermore, practices at theexchanges were not transparent. The time was not stamped on transaction documents.Investors could not verify when and at what price their trades had been executed, andcomplained that stockbrokers sold shares at the lowest price and bought at the highest price.

3Despite the fact that capital market reforms were pursued as part of an overall financial sector reform strategywithin ADB, payment system issues (which links the banking and capital markets) were not discussed.

Figure 2: Current Account Balance


Approval Completion


11/67

3

Moreover, prices did not faithfully reflect market conditions, since many trades were unreported.Kerb tradingtrades between brokers outside the floor ofthe exchange before or after tradinghoursstill was practiced despite its prohibition.

6. A number of government-appointed committees formed in response to persistent marketmanipulation and abuse was the basis for the Governments priority reforms in the capital

market. The economic crisis provided the opportunity to undertake powerful reforms in thefinancial markets. While the Narasimham Committee identified extensive banking sectorreforms, a number of other important committees discussed capital market reforms. Based on acomprehensive review of the operations of the exchanges, the Pherwani Committee prepared aset of recommendations in June 1991 on the establishment of a new stock exchange. In June1992, the Government appointed the Nadkarni Committee to look into the trading of publicsector undertaking bonds and mutual fund shares. Former Reserve Bank of India (RBI) DeputyGovernor A. Janakiraman led a committee investigating irregularities in securities transactionsof banks. The Malhotra Committee was established in 1993 to provide a comprehensive reviewof the operations of insurance companies. The United States Agency for InternationalDevelopment (USAID) also made a commitment to support government efforts in reforming thecapital market.

C. Purpose and Outputs

7. Classified as an economic growth activity, the Program included a detailed policy matrixwith time-bound policy actions and a development policy letter, but no logical framework. 4 Thepurpose of the Program was to (i) enhance the country's ability to mobilize internal and externalresources to finance economic growth, and (ii) improve the efficiency of resource allocationthrough a greater reliance on market mechanisms.

8. The policy matrix, containing 44 policy measures under five broad areas, was consistentwith this purpose. Anticipated outputs included (i) the establishment of an integrated nationalmarket system (3 conditions), (ii) modernization of the market trading infrastructure to support

growth and expansion (9 conditions to automate trading and reduce transaction costs),(iii) broader market participation by eliminating impediments (20 conditions), (iv) better pricingand efficiency through enhanced competition in the market (6 conditions to expand marketparticipation), and (v) a strong and independent market regulator (6 conditions to strengthen therole of the security regulator). For the release of the second tranche of the Program, 12 coreconditions were identified. No technical assistance (TA) was attached to the Program (para. 10).

D. Cost, Financing, and Executing Arrangements

9. On 28 November 1995, ADB approved a program loan to the Government of India for$250 million5 from its ordinary capital resources. The loan had a maturity of 15 years, includinga 3-year grace period, and the interest rate was determined by pool-based variable lending rate

system for US dollar loans and included a commitment charge of 0.75% per annum. It wasdisbursed in two tranches of $125 million. The Ministry of Finance (MOF) was the ExecutingAgency (EA), and the proceeds of the loan were available for financing eligible imports procuredunder ADB guidelines, determined by a negative list.

4The logical framework preparation became mandatory for program loans in 1997.

5Loan proceeds were not tied to specific government budget allocations under the Program. However, there weresignificant adjustment costs for the trading and clearance and settlement infrastructure.


12/67

4

10. USAIDs considerable efforts and resources6 directed at capital market reforms duringthis period obviated the need for TA to support the implementation of the Program. USAIDapproached ADB to formalize this cooperation in 1993, but cooperation remained informalduring the program period. From 1994 to 1998, the Financial Institutions Reform and ExpansionProject (FIRE), funded by USAID, focused on institution building in the capital markets. Supportwas provided to (i) modernize the stock exchange; (ii) develop a national depository;

(iii) improve clearance and settlements systems; and (iv) create a strong trade association formutual funds, which has become a model for such organizations and includes a code of conductand testing for its members. The FIRE project also included a large component that assisted theSecurities and Exchange Board of India (SEBI) in strengthening its internal operations andeducating management and staff on the responsibilities of a securities regulator. Assistance fordesigning and developing the National Securities Depository Limited (NSDL) was the mostvisible and far-reaching outcome of the FIRE project.

E. Completion and Self-Evaluation

11. The program loan closed on 31 March 1999. A program completion report (PCR),prepared by ADBs Infrastructure, Energy, and Financial Sectors Department (West), was

circulated to the Board of Directors in December 2000.

12. The PCR rated the Program successful under a three-category rating system. (ADB nowuses a four-category rating system.7) The PCR stated the Program successfully supported theGovernment in undertaking much-needed market reforms. The noted reforms included(i) implementing an integrated national market system; (ii) introducing an automated trading,settlement, clearing, and depository system; (iii) introducing competition in capital marketsectors; (iv) enhancing private sector participation and reducing government crowding out ofprivate investments; (v) liberalizing mutual funds and stock brokerage industries; (vi) improvingthe efficiency of primary and secondary markets, and establishing mechanisms to enhancemarket liquidity; and (vii) enhancing the regulatory and supervisory powers of SEBI as thecapital market's sole regulator. The PCR also noted that the reforms resulted in an increase in

operational and market efficiency, a reduction of costs and risks, improved market accessibility,and strengthened investor protection, which were necessary for building investor confidenceand the sustainable growth of the capital market.

13. The PCR identified four conditions that were not fully met at the time: two conditions onreducing investment restrictions for institutional investors (insurance, pension, and providentfunds);8 and two conditions on increasing SEBIs powers as the capital market regulator. 9 Whilethe quality of the PCR was generally high, the Operations Evaluation Mission (OEM) found thatthe two policy actions on automated trading in debt10 were reported in the PCR (and in theprogress report11) as implemented. However, automated trading in the debt market did not existas of February 2004. In India, trading debt instruments remains a private placement market, asin most places in the world. Despite the importance attached to one of these conditions for

release of the second tranche of the Program, the importance of an automated debt market canbe debated. However, increasing the role of institutional investors and strengthening market

6USAIDs FIRE project, and its successor FIRE-R, were supported by a $44 million grant, planned for 12 yearsstarting in 1993. The program was suspended from 19982000 due to Indias nuclear weapon tests.

7 ADB. 2000. Guidelines for the Preparation of Project Performance Audit Reports. Manila.8

Appendix 1, conditions 16 and 18.9

Appendix 1, conditions 40 and 41.10

Appendix 1, conditions 9 and 20.11 ADB. 1998. Progress Report on the Capital Market Development Program Loan to India. Manila.


13/67

5

regulation are continuing challenges that require additional effort and commitment by theGovernment.

14. Except for its assessment of the conditions on the development of the debt market, thePCR was comprehensive. Of the four end-of-program policy actions, two were fully complied withbefore the release of the second tranche. The PCR reported that the National Clearance,

Settlement, and Depository System could not fully meet the recommendations of the Group ofThirty (G30) as of December 1999, because the same-day payment system was not in place.While RBI was considering this initiative, the rolling settlement period could not be reducedeffectively until all scrip was dematerialized.12 Subsequently, this was accomplished (paras. 24and 36). The PCR also cited the importance of two legislative acts to further capital marketdevelopment: the consolidated SEBI bill and the Insurance Regulatory Development Authority(IRDA) Act. The OEM concurred with the PCR on the importance of these pieces of legislationfor sustainable development of the capital markets.13 In addition, capacity building for SEBI andIRDA is needed to strengthen the supervision of the capital market.

F. Operations Evaluation

15. An OEM was undertaken from 26 January to 12 February 2004. The OEM met withMOF; Department of Economic Affairs; key stakeholders, including SEBI and the two majorstock exchanges (the BSE and the NSE); NSDL; the Clearing Corporation of India Limited; andother market institutions and participants. The primary purpose of this evaluation was to identifythe strengths and the weakness of the Program to learn lessons for future operations in India,as well as in similar sectors in other countries. The assessment was based on (i) the need forthe Program and the effectiveness of its design (relevance), (ii) the achievement of programpurpose and production of outputs (efficacy), (iii) efficiency, (iv) the sustainability of outcomes,and (v) the contribution to institutional strengthening and other impacts. The draft programperformance audit report (PPAR) was circulated interdepartmentally within ADB and to theGovernment and other stakeholders. Comments received were considered in finalizing thePPAR.

II. PLANNING AND IMPLEMENTATION PERFORMANCE

A. Formulation and Design

16. The Program was formulated at a time of financial and policy crisis within India (paras.12). A complex system of industrial licensing, protection against imports, and extensivegovernment intervention in financial intermediation contributed to disappointing growthcompared to other countries in Asia during the 1980s. Before 1991, capital flows to Indiaconsisted mainly of aid flows, commercial borrowing, and nonresident Indian deposits.

17. Three important elements underpinned the formulation and design of the Program:(i) rapid deployment of program proceeds for immediate balance of payments support,(ii) support for the implementation of the Governments reform agenda in the capital markets,and (iii) a reduction in Indias economic vulnerability through the development of the domesticcapital market to mobilize internal and external resources to finance economic growth. From the

12Dematerialization is a process of shifting securities from physical or scrip form to scripless form, with records keptonly in the computer and transfers effected by electronic book entry.

13The IRDA Act was passed in 1999, but a consolidated SEBI bill has not been adopted. Recent amendments (2002)to the SEBI have helped address some of the weaknesses of the previous 1992 Act.


14/67

6

Governments point of view, the most important objective of the Programliquidity supportwas not met due to a 2-year delay in program endorsement by ADB (para. 30).

18. The policy matrix included 44 policy actions (para. 8), of which (i) 16 were to becompleted before program approval for the release of first tranche loan proceeds, (ii) 12 werecore or second tranche release conditions, and (iii) 16 conditions were to be completed by the

end of the Program (Appendix 1). The conditions provided in the policy matrix and thePrograms design were appropriate to meet the last two elements (ii) and (iii) identified in para.17. However, the Government and ADB continued to discuss the best way to create anintegrated national market until the final loan negotiations. Concerns over the efficiency andtransparency of a proposed second nationwide exchangethe NSEwere expressed. Themain issue was the Governments potential influence, given the shareholding structure of theNSE. As a result, ADB maintained policy actions under the Program that called for an electronicnetwork linking Indias regional stock exchanges, but also included conditions for theestablishment of the NSE. In many ways, these were parallel efforts to achieve similarobjectivesbetter governance and efficiency in the capital market. In light of ADBs views, theGovernment agreed not to use loan proceeds in the establishment of the NSE.

19. Proceeds from the $250 million loan were used for the adjustment costs of the Program(excluding the NSE). The intent was to compensate the Government for the fiscal costs of aclearing and settlement and depository system that required standardization of practices andprocedures to ensure the accuracy, transparency, and timeliness of investor information. Thismeant changing traditional practices, eliminating privileges, improving inefficient systems, andupgrading the support infrastructure. The changes required capital outlays, estimated in theRRP at about $300 million, to (i) draft new legislation, standards, and regulatory practices;(ii) upgrade skills, and (iii) educate investors. The OEM requested cost estimates for theclearing and settlement and depository system, but no records were available.

20. While the design generally identified major areas of reform well, it was weak in threespecific areas: (i) clarifying the conditions for SEBIs independence and enforcement powers,

(ii) eliminating impediments to market growth or market liberalization, and (iii) improving thepayments system. The actions contained in the policy matrix were necessary but not sufficientto support SEBI as the sole regulator for the capital markets (para. 27). Policy conditionssupporting the elimination of impediments to market growth or market liberalization lacked thecohesion of other areas of the Program. A stronger focus on a few select areas (e.g., debtmarket development or institutional investors)14 might have improved results. Finally, excludingconditions to improve the payments system was a design omission. Electronic funds transfercapability and real time gross settlement continue to be a significant bottleneck for marketdevelopment, especially for short-term debt market (repos) (para. 24[iii]).15

14ADB followed up with TA in debt market development in the next few years. Three TAs were provided to supportdebt market development: TA 3367-IND: Reform of the Private Pension and Provident Funds System Reform andthe Employees Provident Fund Organization, for $1,000,000, approved on 26 December 1999; TA 3460-IND:Policy and Operational Support and Capacity Building for the Insurance Regulatory and Development Authority, for$800,000, approved on 22 June 2000; and TA 3473-IND: Development of Secondary Debt Market, for $600,000,approved on 28 July 2000. Although these were not integrated into the Program, this sequencing may have betterreflected the Governments priorities and capacities at the time.

15 The RBI has started to test a real time gross settlement system in a set of banks starting in February 2004.


15/67

7

B. Achievement of Reform Measures

21. The RRP identified the key risks, including (i) the Governments ability to pursue therequired policy reforms in a timely manner; (ii) the legislation required to establish a nationalautomated depository system and enhance the power and authorities of the regulatory andsupervisory agency; (iii) opposition to the required changes by vested interests, such as

stockbrokers and other affected sectors; and (iv) the complicated national coordinationenvisaged with multisectoral and geographic challenges. Given the nature of the identified risksand ADBs inexperience in capital market reform, the Governments ability to meet the programconditions was a topic of concern at the management review, staff review, and loan and TAcoordination committee meetings.

22. The OEM revisited the Governments progress in satisfying the policy actions identifiedin the matrix, especially the conditions the PCR identified as not having been fully met (para.13). Appendix 1 contains a table describing the steps taken by the Government, and anevaluation of the Governments status of compliance with 44 policy reform conditions. Asummary discussion is in paras. 2327.

1. Establishing a Framework for an Integrated National Market System

23. Three conditions were intended to support an electronic network linking Indias regionalstock exchanges. The network was meant to provide investors with a fair, efficient, andcontinuous market with the required liquidity and depth. 16 All the conditions have been satisfied,primarily due to the success of the NSE. Two of these were key second tranche conditions:

(i) Ensure an efficient and competitive interface among the stock exchanges.Standards were introduced that supported uniformity of practices, operatingstandards, codes of conduct and ethics, reporting requirements, and quickerdissemination of information and prices across all exchanges. These standardswere in preparation for the introduction of automated trading in debt and equity

securities, and automated settlement of trades on the exchanges.(ii) Ensure automated trading facilities for securities of large, medium, andsmall enterprises. Today, all exchanges trade-listed equities using theelectronic limit order book market structure. The same system is used to tradelarge, medium, or small capital stocks. Such an integrated nationwide marketensures that all investors can access a single market price. To ensure safetrading among all participants, nationwide trading on a rolling settlement basismust be backed by a robust clearing and settlement system. Two importantaspects to ensure continuous market growth and expansion were (a) anonymoustrading, and (b) elimination of market fragmentation across participants. In 1998,for example, all institutional orders had to be exposed to the (transparent)electronic order book (paras. 3435). Thus, while a trade might be negotiated

outside the market, it had to be put on the exchange limit order book to avail ofthe clearance and settlement systems of the clearing corporation and thedepositories. By pooling all the orders into one trading platform, liquidity andpricing transparency on the exchanges were increased.

16Continuous market means securities can be traded at any time the market is open. The required liquidity meansthe price difference is minimal from one transaction to the next. Depth means the market can absorb a largevolume of trades.


16/67

8

2. Modernize the Market Infrastructure

24. The policy matrix included nine conditions to support the implementation of a clearanceand settlement and depository framework in accordance with the G30 recommendations onsecurities clearance and settlement (Appendix 2). All conditions have been satisfied. Draftingand enacting appropriate legislation and investing in the systems were the two key policy

measures. Specific actions were:

(i) Establish and operate a national automated depository system. Thisincluded (a) title transfer and registration, (b) recognition of ownership, (c) votingrights, (d) rights to dividends, (e) the creation of liens, (f) liabilities of thedepository, and (g) settlement of disputes. This core condition of the Programwas required for the release of the second tranche, and was initially addressedby the Depository Act, 1996.

(ii) Regulatory guidelines for the establishment and operation of automateddepository. The Depositories Act, 1996 (the Act) established the legalframework for a nationwide depository system in India. The Act includedamendments to certain areas of the Companies Act, the Securities Contracts

(Regulation) (SC[R]) Act, the Income Tax Act, and the Benami Transactions(Prohibition) Act.17 While the SEBI Act of 1992 gave the securities regulatorauthority to register and regulate the working of the depositories, theDepositories Act clarified the authority to make regulations, conduct inquiries andinspections, and enforce regulations through directions from SEBI on theactivities of depositories. SEBI subsequently issued Depositories andParticipants Regulations, 1996 (the Regulations) to address processes within thedepository environment. The Regulations extend to automated processing andelectronic connectivity requirements. The Act and the Regulations became thebasis for the internal rules, policies, and procedures of the depositories (firstNSDL; then Central Depository Services Limited [CDSL]).

(iii) Establish an automated clearance, settlement, and depository system for

securities trading. This policy builds on the establishment and operation ofnational depository systems. The policy requirement to establish systems in oneor more exchanges in all major centers of the country has been addressedthrough terminal access by all system users. This capability has evolved so thatthe systems of NSDL, CDSL, and National Securities Clearing CorporationLimited (NSCCL) can be accessed via a single terminal. Daily cash settlementand delivery versus payment meet G30 requirements to the extent possible inIndia (Appendix 1[12]). Risk is mitigated through guarantee funds at NSCCL andBSE and other risk-management methods. However, inter- and intra-bankconnectivity need to be improved through an electronic payments system thatwould simplify cash movements for settlement purposes. (Where funds cannotbe transferred easily, cash is collected before entering the trade order.) The

OEM was informed of plans to make cash settlement directly through the RBI,refining delivery versus payment. However, this has been planned for a numberof years with little action.

17A Benami transaction is where a property is bought in the name of one party, but paid for and used by a secondparty. The simplest form is where a husband purchases property in the name of his wife, pays for it, and benefitsfrom its use.


17/67

9

3. Eliminate Constraints that Inhibit Market Growth, Improve Market Access,and Strengthen the Role of Financial Intermediaries in the Capital Market

25. Twenty policy actions have been grouped together under this category. They constitutean assortment of conditions for (i) market participants, (ii) issuers, (iii) institutional investors, and(iv) instruments. All conditions, except those for the investment of pension and provident funds

(para. 13), have been satisfied. Some of the key conditions for the development of the derivativemarkets are:

(i) SEBI to review the key issues for developing a market in options andfutures to facilitate the development of a strategy for the operation of sucha market.In 1996, the NSE approached SEBI with a proposal to start trading inequity futures and options on a trading platform separate from the equity marketplatform. SEBI set up a 28-person committee (Gupta Committee) to examine thisissue. In 1998, the committee report recommended products, prudentialregulation norms, and risk management at the clearing corporations that had tobe in place before derivatives could start trading. The committees keyrecommendation was that derivatives trading should be permitted only on

exchanges that had strong online monitoring and surveillance systems, andcould settle derivatives trades through an independent clearing corporationand/or clearing house.

(ii) Lift the restrictions and establish a regulatory framework to enable theoperation of a trading system in options and futures. This was a corecondition for the release of the second tranche of the Program. The GuptaCommittee also made recommendations on the governance of an exchange thatcould trade derivatives. SEBI accepted the recommendations of the committeeand issued regulations. The Government amended the securities bill to includederivatives in the definition of securities that could be traded on an exchange. InDecember 1999, an amended bill was enacted and became the SEBI(Amendment) Act, 2002 (Appendix 3).

4. Enhance Competition and Level the Playing Field

26. Six conditions focused on increasing competition in the market, including among thestock exchanges, brokerage firms, and mutual funds. All conditions have been satisfied. Keyconditions were:

(i) Permit 51% foreign ownership of corporate stock brokerage firms. Foreignfirms have entered the market and can now acquire up to 100% ownership ofbrokerage firms.

(ii) SEBI to regulate Unit Trust of India (UTI) mutual funds. Before October 2002,UTI mutual funds were not required to comply with SEBI regulations, although

certain funds did so voluntarily. A liquidity crisis in 2001 created a potentialdefault in the payment of dividends by one of the funds (Unit Scheme 1964) andtriggered some of the changes (Appendix 4). The Government repealed the UTIAct in 2002, and UTI was split. UTI-I now comprises funds that are guaranteedby the Government and will be phased out as they mature (predominantlyclosed-end funds). UTI-II includes funds that have been transferred to a new


18/67

10

company that is under the regulatory authority of SEBI (predominantly open-ended funds).18

5. Strengthen Market Regulation and Supervision

27. Six conditions were intended to strengthen the regulatory powers of SEBI. While SEBI

powers have increased, these conditions have not been fully satisfied. Specific measuresincluded:

(i) Transfer through legislation regulatory and supervisory powers more fullyto SEBI. This was a core condition triggering release of the second tranche ofthe Program. In 1997, SEBI established a committee under former Justice D.R.Dhanuka to examine areas of deficiency in the SEBI Act 1992, the DepositoriesAct 1996, and the SC(R) Act 1956. Based on that review, the DhanukaCommittee concluded that the number of authorities regulating the Indiansecurities market should be limited. The committee found that the existence ofmultiple authorities might create confusion and inconsistent results. The DhanukaCommittee recommended that SEBI become the single regulatory authority.

However, regulatory responsibility continues to be shared by SEBI, the RBI, andthe Department of Company Affairs. The situation might be changing slowly asSEBI gains more credibility.

(ii) Rationalize all pertinent laws, rules, and regulations in a manner consistentwith SEBIs designation as the principal regulator of the capital market. TheDhanuka Committee also made recommendations on consolidating Indiansecurities laws. The committee recommended that the SC(R) Act and the SEBIAct be consolidated into a single act. As noted in the PCR, the DhanukaCommittee drafted a proposal for a new securities law. However, the laws stillhave not been rationalized and/or consolidated. Regulation of the securitiesindustry continues to be fragmented among SEBI, the RBI, and the Departmentof Company Affairs. Regulatory ambiguity creates an environment where

confusion as well as duplicate and inconsistent regulations are possible(Appendix 5). In addition, some of the regulatory responsibilities need to be moreclearly defined.

28. In summary, some of the policy actions included in the program were either delayed or notfully implemented. The investment guidelines for insurance companies and pension funds wererelaxed somewhat, though directed investments continue. In addition, the full delegation of powersto SEBI contained in the SC(R) Act and Companies Act is languishing in Parliament. However,the findings of the Joint Parliamentary Commission (Appendix 5), and the subsequent 2002amendments to the Securities Act (Appendix 3 contains selected amendments), have providedSEBI with some of the necessary powers to regulate the market more effectively.

C. Cost and Scheduling

29. The program loan of $250 million became effective on 8 December 1995. The firsttranche of $125 million was disbursed on 22 December 1995, consistent with the provision thatfunds were to be disbursed upon loan effectiveness. However, slow implementation of policyactions, such as the delay in the resumption of the use of repurchase agreements, delayed the

18Competition also has increased with domestic firms now being permitted to raise resources from abroad throughthe issuance of American depository receipts and/or global depository receipts.


19/67

11

release of the second tranche, scheduled for December 1996.19 An extension of the loan closingdate was granted, and the second tranche of $125 million was disbursed on 22 December 1998upon satisfaction of the second tranche release conditions. As EA, MOF was responsible for theadministration and disbursement of the proceeds and the maintenance of records.

D. Organization and Management

30. An agreement with the Government was reached initially in November 1993, butprogram approval was delayed due to concerns regarding the policy environment in India. TheRRP for the Program was circulated to the Board of Directors in November 1993, withdrawn,and re-circulated in November 1995 (using the same RRP as in 1993 with an addendum noteand supplement20 updating the status of compliance with program actions). Twelve policyactions were specified for release of the second tranche of the program loan. An additional16 end-of-program conditions were added. At the time of Board approval of the Program, thesupplement to the RRP reported that the Government had implemented all first trancheconditions, 7 of 12 second tranche release conditions (3 of the remaining 5 conditions had beenpartly met), and 9 of the end-of-program conditions. The timetable for the Program was revisedaccordingly (para. 29). The delay did not impact significantly the reform agenda, and allowed

the Government to demonstrate its commitment and capacity to implement this far-reachingreform program.

31. Program management was satisfactory. Three review missions were fielded inDecember 1996, October 1997, and March 1998. The second tranche was released on22 December 1998 (a 1.5-year delay from the revised 1995 schedule) after the required policyactions were met substantially. The loan was closed in March 1999, and the PCR mission wasundertaken in October 1999 and completed in December 1999.

32. The OEM noted the contribution of USAID to the outcomes of this Program. The FIREteam was comprised of talented and experienced professionals, who worked well withgovernment counterparts and achieved tangible results in specific areas (para. 10). Although

ADB and USAID did not formally coordinate, ADB staff and the FIRE project team frequentlyconsulted with each other. Direct USAID consultations were less frequent. This arrangementappeared to have worked well, although more formal arrangements might have resulted ingreater dialogue and information sharing that would have benefited the institutions and theBorrower.

III. ACHIEVEMENT OF PROGRAM PURPOSE

A. Program Outcomes and Impact

1. Outcomes

33. The RRP did not specify performance indicators to capture the program impact ormonitoring mechanisms. However, the depth and breadth of reform undertaken by theGovernment and supported by this Program are striking. The capital market has beentransformed radically since the Program was designed in 1993 (Appendix 6). The Governmenttranscended the risks identified in the RRP (para. 21), and in some areas exceeded programexpectations. New standards for trading, trade comparison and trade resolution, clearance and

19The operation of the automated depository for debt securities was delayed.

20ADB. 1995. Supplement to the Report and Recommendation of the President to the Board of Directors on aProposed Loan to India for the Capital Market Development Program. Manila (Addendum 1).


20/67

12

settlements, registration and transfer of securities, and trade reporting were adopted. Some ofkey outcomes of the Program are listed in paras. 2327.

34. The Establishment of the NSE. The NSE, which was backed indirectly by theGovernment through a number of powerful financial institutions, effectively changed marketpractices (para. 5). A national market system requires listing nationally traded securities in one

market that is accessible to all accredited brokers and members of existing exchanges. Byaccumulating orders for each traded security on a nationwide basis, trades have been matchedmore efficiently and the liquidity of each security has improved. This was made possible throughthe use of more efficient information technology (IT), which was made readily available toexchange members. Automated facilities linked exchange members electronically, providingthem with up-to-the-minute displays of bid and offer price quotes as well as match orders, andallowing them to execute market transactions instantly. The use of more advanced IT improvedtransparency of market transactions by generating market information about volume, prices, andtime of transactions. The NSE was created to compete with the small club of stockbrokers whoeffectively controlled the stock market in India. Nationwide anonymous electronic bookmaking atthe NSE established new market standards (para. 23).

35. As more market participants chose to list and transact business through the NSE, themarket was revolutionized. The efficiencies of all processes have increased dramatically, whileinvestor confidence in the safety of the markets has grown significantly. The BSE was forced toadopt the new market standards or go out of business. The success of the NSE proved that theGovernment was correct to create a national market system (para. 18). The two large activeexchanges, the NSE and the BSE, essentially have replaced 98% of the trading in the23 regional exchanges. The NSE accounted for about 86% of the trading volume in 20022003(Appendix 7).

36. The Clearance, Settlement, and Depository System. The development of a nationalautomated depository system in India was critical to address problems in trade settlementprocessing. In the early 1990s, the settlement of trades through the movement of physical

securities certificates at the stock exchanges had become extremely cumbersome and timeconsuming. Transfer agent operations were highly inefficient, causing significant delays intransferring the ownership of traded securities. High volumes of paper and inefficiencies in thesettlement and transfer processes led to theft, forgery, mutilation of certificates, and otherirregularities. An excessive amount of bad deliveries in the market was the result. With thedevelopment of the NSDL (and later the CDSL for the BSE), dematerialization of securities, andautomated securities settlement through the clearing organizations, these problems and relatedrisks for the individual investor virtually were eliminated. The two depositories (NSDL andCDSL) now interface electronically, with automated links to their respective clearingorganizations.

37. In addition to improvements in trade settlements, other benefits have been realized.

Securities can be pledged to secure a bank loan through NSDL. This has simplified the processof market participants borrowing cash from banks. Since accounts at the depository are held byindividual investors, beneficial ownership information is immediately available from thedepositories to issuers or their agents to support payment of entitlements. Changing an addresson company books can be done easily through an individual investors account at thedepository. Beneficial owners, therefore, are not only assured that they will receive entitlements,but will receive them in a timely manner. All of these benefits, combined with the safe andefficient system for trade settlement, have increased significantly the confidence of individualand institutional investors in the Indian markets.


21/67

13

38. Derivatives. When the Program was designed in 1993, the impact of derivatives tradingon the market could not have been foreseen. In 1995, equity markets were trading on a 5-daysettlement cycle, which effectively meant that traders were taking (up to) 5-day forwardpositions. This increased the systemic risk of the trading system, resulting in the exchangesdemanding higher capital margins and charging higher trading fees. This translated intoexcessive entry barriers for markets. A safer market structure would be a separate spot and

derivatives market. However, for the markets to move toward true spot trading (with rollingsettlement), the 1969 prohibition on trading forwards on securities would have to be repealed.

39. In January 1995, an amendment to the Securities Laws lifted the ban by repealingsection 20 of the SC(R) Act. Agreement was reached to regulate the derivatives markets at twolevels: at the exchange and at SEBI. Of the 23 exchanges in the country, the BSE and the NSEwere the only two that satisfied the SEBI requirements for exchange regulation of derivatives.When the IT market crashed in March 2001, volumes were still small and trading was not beingdone on a rolling settlement basis. As a result, all exchanges were forced to adopt rollingsettlement on a trade date plus 5 days (T+5) basis, and trading on index and single stockoptions commenced in June and July 2001, respectively. In June 2002, the accounting andtaxation questions regarding derivative positions held by investors also were clarified. However,

it was the move to trading on rolling settlement and the introduction of individual stockderivatives that spurred the growth of the derivatives market. Volumes on the derivativesmarkets rose from Rs23 billion in 20002001 to more than Rs1 trillion in 20012002. Singlestock futures accounted for more than 50% of the volume. This growth has continued into 20022003 as well, with volumes of Rs4.4 trillion. Another leap in volumes appears to be occurring in20032004. In December 2003 alone, volumes reached Rs3 trillion, compared to Rs0.5 trillionin December 2002, making India the second-largest market for stock futures in the world.

2. Impact

40. The purpose of the Program was to (i) enhance the country's ability to mobilize internaland external resources to finance economic growth, and (ii) improve the efficiency of resource

allocation through a greater reliance on market mechanisms. The types of indicators normallyused to assess the impact of capital market development programs (market capitalization,turnover ratios, new issues, etc.) are not robust. Indeed, they are extremely sensitive tobusiness cycles and other worldwide events that affect international capital flows. When theeconomy is growing, these indicators tend to be positive; when the economy is not performingwell, they are less impressive. In others words, these indicators reflect others factors, such asthe economy, more than the health of the capital market. The causality usually goes from theeconomy to the capital market. Therefore, these indicators can be used only as proxies thatreflect the institutional capacity to channel resources as the economy develops.

41. Table 1 provides information on the new capital issues by nongovernment companies.While market-based finance had been gaining greater importance for new companies, it has not

replaced bank financing, especially following the debilitating effects of the IT crash that hit globalmarkets (especially emerging markets) in 20002001. Appendix 8 provides a more detaileddisaggregation. New private sector capital issues still lag considerably behind what they were inthe mid-1990s, possibly due to the slow pace of the Governments divestment activities. Thishas limited startups in some sectors and constricted the release of new issues on the market(para. 58). As such, encouraging government divestment might have been considered as aparallel reform linked to this Program.


22/67

14

Table 1: New Capital Issues by Nongovernment Public Limited Companies

Item 19921993

19941995

19981999

20002001

20012002

20022003

20032004

Number ofIssues

1,040 1,678 48 138 33 16 29

Amounta

(Rs crore)

19,803.4 26,416.7 5,013.0 6,144.3 5,741.9 1,022.6 2,290.0

Note: Crore = unit of value equal to Rs10 million.a

The large values reported in 19921994 can be explained largely by two factors. In 1992, the Comptroller ofCapital Issues (CCI) was abolished and SEBI took over the market for initial public offerings (IPOs). Thismeant that firms started getting their IPO prices determined by the market, rather than set by the CCI. Themost firms in recent memory listed on capital markets during the IPO boom in India in 19931995. Thesetwo factors led to IPO overpricing in the first few weeks after the issue got listed and started trading. Pricesnormally stabilized after the first few weeks on the market.

Source: Operations Evaluation Mission

42. Other indicators of company resource mobilization provided in Figure 3 (details inAppendix 9) show that the number of listed companies has increased, the market capitalization(value of resources mobilized through the market) has doubled, and turnover (liquidity) on the

NSE and BSE has been impressive. Mobilizing external resources also has assumed greaterimportance in the past few years, as shown in Figure 4 (details in Appendix 10). Theparticipation of foreign institutional investors in the market has exploded from the early 1990s,with cumulative net investment steadily increasing despite the IT bubble. In addition, thereduction in transactions costs has increased market efficiency dramatically, as shown in Figure5 (details in Appendix 11). In almost all respects, the impact of these reforms has beenexceptional in increasing the mobilization of resources through the market.

Figure 3: Number of Listed Securities, Market Capitalization, and

Turnover at BSE and NSE

0

2,000

4,000

6,000

8,000

10,000

12,000

199293 199495 199899 200203

Rsbillion

0

2,000

4,000

6,000

8,000

10,000

12,000

NumberofCompanies

Market Capitalization of Companies Listed in BSE and NSE

Turnover at BSE and NSE

Number of Companies Listed in Indian Stock Exchanges

Number of Listed Companies in BSE and NSE

BSE = Bombay Stock Exchange, NSE = National Stock Exchange, Rs = rupees.



23/67

15

Figure 4: Yearly Trends in Foreign Institutional Investments

in India

-

100,000

200,000

300,000

400,000

500,000

600,000700,000

800,000

1992/93

1993/94

1994/95

1995/96

1996/97

1997/98

1998/99

1999/00

2000/01

2001/02

2002/03

Rsmillion

Cumulative Net Investment Gross Purchases Gross Sales Rs = rupees.Source: Operations Evaluation Mission.

Figure 5: Transaction Costs in India's Equity Market

0.0

1.0

2.0

3.0

4.0

5.0

6.0

India 1993

(Before NSE)

1997 (NSE) 2004 (NSE) New York

Stock

Exchange(1997)

Percent

Trading-Brokerage Trading-Market Impact Cost Settlement-Back Office Settlement-Bad Paper Risk

NSE = National Stock Exchange.



24/67

16

43. While the efficiency of transactions has increased, ascertaining the efficiency ofallocation is more difficult. With bank finance, one can look at nonperforming loans, insolvency,and bankruptcy as indicators. In the capital markets, a comparable indicator might be thenumber of companies delisted. However, companies are rarely delisted in emerging markets. InIndia, delisting has occurred primarily because (i) the MOF withdrew a provision in April 2003 formandatory listing of companies in their respective regional stock exchanges, and (ii) foreign

companies obtained 100% ownership of their subsidiaries and decided to take their shares offthe Indian market. Neither case provides an example of delisting due to economic distress.Therefore, delisting in India is not a good indication of inefficient mobilization of resources.These companies, in fact, are saving significant listing fees. The OEM was not able to assess ifthe efficiency of resource allocation has improved under the Program.

B. Sustainability

44. In many ways, the reforms have succeeded beyond expectations. The key outcomes ofthe Program (paras. 3439)automated trading and dematerialization of stock shares; theclearance, settlement, and depository framework; and the introduction of derivatives marketscan be considered irreversible. They have resulted in cost-effective changes and stronger

market institutions. The Indian stock market has been quite volatile in recent months, but theimpact of the Program is sustainable mainly due to the institutional development and theGovernments ownership and leadership in the reforms. The establishment of the NSE, basedon high governance standards and transparent market practices, is the best example. The resulthas been a changed trading environment and new culture in the financial markets. The systemsand the professionalism of market participants are expected to continue to be in line withinternational markets.

IV. ACHIEVEMENT OF OTHER DEVELOPMENT IMPACTS

A. Socioeconomic Impact

45. The Program allowed India to learn by doing, an important side effect. Thedemonstration effect of these reforms also was important. Strong market institutions have grownwith the support of market professionals who created and, in many cases, are still involved intheir operation. The support of international professionals (such as the FIRE team) was critical,but the vision and initiative came from a handful of proactive civil servants. The result has beena confidence to continue the evolution of market institutions, and more openness to change andinnovation as demonstrated by the continued development of the depositories and increasinglyopen markets for foreign investors. This innovation and openness will continue to supportgrowth and development in the economy.

B. Impact on Institutions and Policy

46. Before the creation of the NSE, the country had 23 stock exchanges, all of which tradedthe same stocks. The closing price differences were large enough to fuel inter-exchangearbitrage, generating risk-free returns of up to 2.5% a month for a large number of the brokers.These price differences persisted until the NSE became the dominant exchange for pricedetermination in early 1996. Eventually, most of the trading in the country became concentratedin the NSE or the BSE. However, even though the price premia dropped, significant pricedifferentials remained between the NSE and the BSE due to different settlement cycles at thetwo exchanges. When trading at both exchanges became rolling settlement, those differentials


25/67

17

were eliminated (paras. 3839), though intra-day price differences could occur. All investorsaccess one common price for a given stock, a fundamental change in the market.

47. Recent amendments to the SEBI Act addressed some of the limitations in the original1992 Act, which established the regulator (Appendix 3). These amendments included providingSEBI with the authority to (i) issue cease and desist orders; (ii) significantly increase fines and

penalties for violations; and (iii) obtain evidentiary documents from third parties, which wasespecially helpful in seeking information from banks. The amendments also specifically prohibitmarket manipulation and insider trading, allowing SEBI to regulate and take appropriate actions.While laws, rules, and regulations might still need to be rationalized (para. 27), SEBI has beengranted far-reaching powers as a regulator. Recent amendments to the SEBI Act (Appendix 3)have enhanced that power. In addition, SEBI has continually increased the number of securitiesthat are required to be settled in dematerialized form, so that 99% of all trades now are settledin that form.

48. One unforeseen positive impact was the introduction in 1997 of a second depository forBSE. CDSL was linked to the BSE clearinghouse, BISL, for settlement of trades on BSE. Today,the two depository systems are fully electronically interfaced. Security positions move between

NSDL and CDSL every 15 minutes. Securities are then immediately available for redelivery atthe receiving depository. This fluid system accommodates the need for members to quickly andsafely move security positions to meet settlement obligations at NSCCL or BISL.

49. With all systems operating well and interfaces between systems established, thedepositories are taking on new projects. SEBI recently outsourced to NSDL the design,development, and implementation of a registration database using biometrics.21 The plan is tofingerprint everyone involved in the capital market. The fingerprints, in addition to photographs,will become part of an individuals profile in the database. NSDL will manage the database, butit will be owned by SEBI. NSDL is developing another system to collect information ontaxpayers and tax obligation information. Initially, the database will carry details as reported bytax withholding agents. CDSL is working with mutual funds to develop a system that will create

a consolidated holdings report for owners of mutual funds. CDSL also is looking at facilitatingthe settlement of commodities through the depository.

V. OVERALL ASSESSMENT

A. Relevance

50. The Program was consistent with ADBs development strategy in India and in line withthe Governments development strategy. The important question regarding the relevance iswhether the Government would have proceeded with these reforms without the Program. Theanswer is yes. Indeed, the Government proceeded with the majority of these reforms for 2 years(19931995) without support of loan proceeds. Most of the second tranche release conditions

were met at the time of program approval. However, the Program helped (i) define and shapethe scope of the reform program; and (ii) facilitate continuing dialogue with the Government indifficult reform areas, such as SEBI independence, institutional investor involvement, and debtmarket development. As a result, the Program was relevant.

21Fingerprint and face recognition for optimal security.


26/67

18

B. Efficacy

51. The Program supported the goal of achieving a higher rate of economic growth, meetingthe program purpose of (i) increasing the country's ability to mobilize internal and externalresources to finance economic growth, and (ii) attaining the outputs of a more efficient andtransparent market-based financial system. The Program was efficacious.

C. Efficiency

52. This was the only Program in the history of ADB where a negotiated document wascirculated to the Board of Directors, withdrawn, and approved 2 years later. Given the historyand processing of the Programand the additional delays in meeting tranche releaseconditionsthe Program was less efficient.

D. Sustainability

53. Sufficient demand and resources exist to sustain the services offered by the institutionscreated under the Program. In addition, the operating and financial performance of these

institutions has become the market standard that new entrants must emulate. The sustainabilityof the Program is likely.

E. Institutional Development and Other Impacts

54. Laws, regulations, and procedures continue to be revised and updated to meet theneeds of the markets. The market culture and trading environment is virtually unrecognizablefrom what existed at the start of the Program 10 years ago. The professionalism of marketparticipants also continues to expand. A market-based financial industry has blossomed in thepast decade, and institutions, skills, and capacity have grown to meet the demand. Theinstitutional impact of this Program has been substantial.

F. Overall Program Rating

55. The overall rating of the Program is successful.

G. Assessment of ADB and Borrower Performance

56. ADBs oversight of the Program was satisfactory. Three review missions were fielded.The first review mission was in December 1996, approximately 1 year after loan effectiveness.The second review mission in October 1997 assessed the Governments progress in meetingthe Programs conditions for the second tranche release. The mission identified issues withpolicy actions for repurchase agreements (repos), granting SEBI sufficient regulatory powers,and investment limits of institutional investors. The third review mission in March 1998 assessedthe progress in meeting the remaining conditions, and recommended the release of the second

tranche of the loan in the progress report circulated in October 1998. The second tranche wasreleased on 22 December 1998.

57. The MOF served adequately as EA for the Program. It oversaw the implementation ofcapital market reforms, provided guidance and supervision, and administered the loandisbursement and use of counterpart funds. A report was prepared under the provision of ArticleIV, Section 4.05c, of the Loan Agreement between ADB and the Government. However, the


27/67

19

report was not as comprehensive as expected, primarily due to frequent personnel changes in theGovernment during the program period.

VI. ISSUES, LESSONS, AND FOLLOW-UP ACTIONS

A. Key Issues for the Future

1. Fiscal and Structural Reform

58. A significant amount of attention has been given to support fiscal reform in India in areassuch as tax collection and fiscal management.22 Even more has been written about the topic, soit will be noted only briefly. Continued success in diversifying and spreading risk in a market-based financial system will depend upon sustained efforts to reform the economy. Reducing thelarge budget deficit and reviving structural reform will be the most critical factors over themedium term. The Government has been unable to correct the large budget deficit, which hasremained around 6% of gross domestic product since the late 1990s. The need to maintain apool of low-cost captive funds from institutional investors has resulted in inefficient investmentwith costs to the economy and to policyholders. Low international interest rates and large

private capital inflows have underpinned the exchange rate and provided ample domesticliquidity. However, this is unlikely to be sustained. In addition, limited progress in privatizingstate-owned enterprises23 continues to limit the restructuring of key sectors and opportunities fornew investment and growth.

2. Independence of the Financial Market Regulators

59. A lack of genuine independence for the financial market regulators (RBI, SEBI, and otherregulators, such as the newly established insurance regulator, IRDA) continues to inhibit themarket-based decisions needed for the financial system to function effectively. Keeping marketregulators at arms length from monetary and fiscal policy issues and ensuring sufficientautonomy to pursue market misconduct and regulatory abuse would contribute greatly to more

efficient and transparent markets. In addition, inconsistencies in regulations governing thefinancial sector has created gaps and regulatory overlaps. For example, commercial banks fallunder the regulatory authority of the RBI, which affects the manner and scope of positionsbanks can take in any exchange-traded securities or contract. SEBI, however, has regulatoryauthority over exchange-traded securities. This can be a serious issue in creating exchange-traded derivatives (or spot) instruments in asset classes where banks are the largest naturalparticipants, such as interest rate or foreign exchange derivatives.

60. The concept of self-regulatory organizations (SROs) is another area of regulatoryconfusion where SEBI and market participants disagree. SEBI has taken the position thatmonitoring, supervision, and enforcement are the responsibilities solely of the exchanges. Theexchanges believe that SEBI should be responsible for oversight and enforcement. Theexchanges, however, perform routine monitoring of their members and take actions based onexchange rules. In this situation, SEBI fails to recognize its responsibility as the principal

22ADB has provided substantial TA for tax reform in India. A TA performance audit report on Selected TechnicalAssistance for Fiscal Management and Tax Administration in India is to be completed in 2004, identifying many ofthe recurring issues with tax reform.

23Recent aggressive sales (FebruaryApril 2004) lifted privatization proceeds to Rs154 billion in FY2004, exceedingthe target of Rs132 billion and well above Rs34 billion ($0.8 billion) in 2002/03. Last years result was only thesecond time that the annual target was exceeded in the 13-year history of privatization. This represents a smallfraction of the assets that need to be privatized.


28/67

20

regulator. SEBI also would like to see all trade organizations become SROs. This positionreflects SEBIs lack of understanding of a proper SRO environment in which SEBI is the ultimateregulator. A clear delineation of duties and responsibilities in the SRO relationship, codifiedthrough an agreement, would simplify some of these regulatory issues.

61. If market regulators had been truly independent, they would have been able to detect

earlier recent market irregularities involving banks misusing funds to finance multiple stockmarket operations, which eventually ended in bankruptcy. A Joint Parliamentary Commission(detailed in Appendix 5) was convened to investigate these irregularities. Rather thanstrengthening the High Level Committee for Capital Market Developmentcomprised of thegovernor of the RBI, chairman of SEBI, chairman of IRDA, and the finance secretarythe termsof reference have been weakened to eliminate responsibility for anticipatory market regulation.

B. Lessons Identified

62. Key lessons from the Program include:

(i) The Governments vision for the development of the market can be traced back

to a small number of fiercely independent civil servants. This vision was neededto sustain the implementation of a reform program of this magnitude. Adequatelydeveloping the institutional, administrative, and regulatory framework required asubstantial commitment of time and resources. Therefore, the importance ofgovernment ownership and dialogue cannot be underestimated.

(ii) Capital market development also requires a certain depth of human resources orskills in the market. Ensuring sufficient skills and capacity to implement complexreforms, such as the ones specified in this Program, were critical to the successof the Program.

(iii) Three factors proved to be essential for this market to develop: (a) competition,which forced good market standards for fairness; (b) transparency and efficiency,through an improved clearing, settlement, and depository system that allowed

dematerialized trading; and (c) sufficient supply and demand to foster marketdepth and liquidity. The derivative market has played a key role in this aspect ofmarket development.

C. Follow-Up Actions

63. Since the Program, ADB has maintained a constructive engagement with India. ADB issupporting the debt and derivative markets, and pension reform. This assessment endorsesADBs approach and efforts in these areas, and encourages more dedicated assistance for thedevelopment of bond markets. Support for infrastructure development through the use of debtinstruments is urgently needed. Well-structured assistance with concrete deliverables couldaccelerate development in this area.


29/67

CAPITAL MARKET DEVELOPMENT PROGRAM LOAN

STATUS OF REFORMS

Policy Actionsa

Progress ReportStatus of Reforms

October 1998

Program Completion ReportStatus of Reforms

October 1999

Status of ReformsFebruary 2004

A. Establish the framework for an

integrated national marketsystem1. Government, in consultation

with Securities and ExchangeBoard of India (SEBI), to

complete a review of trading,clearance, settlement, anddepository systems andpractices across allexchanges, including NationalStock Exchange (NSE) andOTC Exchange of India(OTCEI). (First trancherelease condition)

Implemented. Action completed beforeBoard consideration (October 1993).

2. Formulate and adopt firmstrategies for ensuring anefficient and competitiveinterface among the different

stock exchanges andharmonizing the trading,clearance, settlement, and

depository systems to bring

about greater uniformity ofpractices, operating

standards, codes of conductand ethics, reportingrequirements, and quicker

dissemination of informationand prices across allexchanges in preparation for

the introduction of automatedrating in debt and equitysecurities and automatedsettlement of trades on the

exchanges (December 1996).

Implemented.As a first step, SEBI carriedout for the first time an examination of allIndian stock exchanges. Based on thisexamination and following internationalnorms, measures were adopted during theprogram period to harmonize trading,clearance and settlement, and depositorysystems. These measures were (i)

automated trading systems wereintroduced in all stock exchanges; thesystems provide a more transparent,efficient, and faster means for executingtrades and disseminating information; allstock exchanges except two today haveautomated trading facilities; (ii) the cashsettlement period was standardized andreduced from 14 days to 7 days for allstock exchanges; for scripless transfers,SEBI introduced a T+5 (trade date + 5days) rolling settlement cycle; theobjective is to further shorten the

The National Securities DepositoryLimited (NSDL) has successfullyimplemented the inter-depositorytransfer securities module, whichallows NSDL to transact with otherdepositories.

A group of 15 regional stock

exchanges also established theInter-connected Stock Exchange ofIndia (ICSI). Therefore, all regionalstock exchanges participating inICSI will conform to a uniformtrading and settlement cycle andpractices.

NSE also took over the managementof OTCEI, and OTCEI will conformto prevailing NSE standards. Theintegration of the stock exchangeswill help bring about uniformity of

Of the 23 regional exchanges in India,seven are active and interface with thedepositories for clearance andsettlement purposes. ICSI has beenstructured as a single broker member atthe exchanges.

NSDL has links with nine stock

exchanges, including NSE and BombayStock Exchange (BSE) plus the sevenactive regional exchanges.

BSE has also developed a depository,Central Depository Services Limited(CDSL). It received its Certificate ofCommencement of Business on 8February 1999. Basic services aresimilar to those at NSDL. Somevariations have been developed byCDSL to provide competitive services tothose of the other depository.

Second tranche release conditions highlighted in bold, while end-of-program conditions in italics.


30/67

Policy Actions Progress Report

Status of ReformsOctober 1998

Program Completion Report


Status of Reforms

February 2004

settlement cycle and move toward rollingsettlement and delivery versus paymentas suggested by the Group of Thirty(G30); (iii) to ensure effective clearing oftransactions, all stock exchanges wererequired to set up a clearinghouse orclearing corporation; this has beenimplemented by the stock exchanges; (iv)

uniform good and bad delivery normswere prescribed for all stock exchanges;(v) a time-bound procedure for resolutionof bad deliveries was introduced; (vi) allstock exchanges were advised to set up atrade or settlement guarantee fund toreduce counterpart risk by ensuring thatadequate funds are available for timelycompletion of settlements in the eventthat member brokers are unable to fulfilltheir obligations; and (vii) studies wereundertaken to streamline and standardizeshare legislation, transfer and allotment,and delisting of securities from the stockexchanges, and to strengthen continuingdisclosure standards by listed companiesand timely dissemination of price-sensitive information to the public;measures are being undertaken to carryout the recommendations of thesestudies.

practices and operating standards. Competition from CDSL may havecontributed to significant reductions infees as charged by NSDL.

NSDL and CDSL are fully interfaced,meaning the same securities are eligibleat both depositories. The automatedsystem that moves securities positions

between the two depositories is updatedevery 15 minutes throughout the businessday. This allows for same-day redeliveryof securities as needed by members.The two depositories are linked to theirrespective clearing organizations,completing the settlement cycle. All ofthese interfaces have led to astandardization of processes.

Regional market participants are linkedelectronically to the exchanges, clearingorganizations, and depositories. Besidetransaction processing, these links haveresulted in more timely dissemination ofprice data and other market informationCodes of conduct have beenestablished by exchanges and certaintrade associations. Reportingrequirements for members have alsobeen established by exchanges. SEBIregulates the reporting requirements forthe exchanges. While intermediariesmay be registered through theirexchange memberships, they still arenot properly certified (see 33).

The number of securities eligible fordematerialization through thedepositories has continually increased.Trades in all securities that are eligiblefor dematerialization through the


31/67





Status of Reforms

February 2004

depositories must now follow thestandard rolling settlement process.

The rolling settlement cycle has beengradually and successfully reduced toT+2 days. The smooth transition to T+2was largely due to the dematerializationof securities through the depository. Theplan is to reduce this time further onceelectronic funds transfer is operational.

The Indian securities market hasachieved the most effective cashsettlement process possible in Indiaunder current banking norms (see 12).

With the increased usage of thedepositories, the clearing corporation(NSCCL) and clearing house (BISL)now operate substantially moreefficiently. This is a direct result ofexpanded automation of the clearanceand settlement process anddematerialization. Another extremelyimportant impact of settlement throughthe depositories is that bad deliveries

are virtually non-existent.3. Adopt a firm action plan to

ensure the availability of

automated trading facilitiesfor securities of large,medium, and small

enterprises across thecountry (December 1996).

Implemented (see 9). In 1996, the NSE became the first stockexchange in India to provide anationwide, order-driven, screen-based,anonymous trading system. Allexchanges now have implementedscreen-based trading systems. As of1998, the BSE also provides nationwideaccess to that exchange. In addition tothe trading systems of the exchanges,SEBI has allowed use of the Internet forsubmission of orders to brokers by theirclients. To perform Internet-basedtrading, brokers must be registered with


32/67





Status of Reforms

February 2004

SEBI, fulfill minimum regulatoryrequirements, and receive permissionfrom the stock exchanges where theyare members.

B. Modernize existing

infrastructure to supportmarket growth and expansion4. Appoint a technical group with

broad representation fromusers, Stock HoldingCorporation of India Limitedand SEBI, to examine in-depthall relevant issues regardingthe NCDS in order to developa firm strategy and clearapproach to theimplementation of the NCDS.(First tranche releasecondition)

Implemented. Action completed before

Board consideration (February 1993).

5. Complete report byinternational consultants onthe NCDS, considering theregulatory, structural andtechnological aspects of theNCDS. (First tranche releasecondition)

Implemented. Action completed beforeBoard consideration (May 1993).

6. Based on therecommendations of theTechnical Group for

establishing a nationalclearance, settlement, anddepository system (NCDS),

determine the conceptualframework of the NCDS andprepare a phased program

for setting up automatedtrading, clearance,settlement, and depository

systems based on anagreed timetable aiming foran integrated market

Implemented. See 23 and 10.


33/67





Status of Reforms

February 2004

system (December 1996). 7. Enable through legislation

the establishment andoperation of nationalautomated depository

systems, taking into accountissues related to, inter alia, titletransfer and registration,

recognition of ownership,voting rights, rights todividends, the creation of

liens, liabilities of thedepository, and settlementof disputes (December 1996).

Implemented. A Presidential Ordinance,promulgated on 21 September 1995,defines the legal basis for the establishmentand operation of national automateddepositories and provides for theirregulation.

bParliament passed the

Depositories Act, 1996, which received

the assent of the President on 10 August1996.

8. Issue regulatory guidelinesfor the establishment andoperation of automated

depository systemsincorporating the views ofthe main users of the

systems (March 1997).

Implemented. SEBI issued depositoriesand participants regulations on 16 May1996.

9. Commence automatedtrading in debt securities at

the NSE (December 1996).

Implemented.Automated trading on ascreen-based system is fully operational.

The Wholesale Debt Market (WDM)commenced its operation in June1994 with 224 securities worthRs1.35 trillion. Operations haveincreased to 852 securities withoutstanding value of Rs3.43 trillionin March 1998. The daily tradingvolume increased from Rs24 millionto Rs3.5 billion in the same period.

Screen-based trading in governmentdebt instruments does exist althoughtrades are made primarily throughphone calls. The agreed-upon tradesare then reported to one of two NSEtrade-reporting systems:

(i) NSE WDMWDM reporting systemfor government debt instruments.

(ii) NDSNegotiated dealing system forcorporate debt.

The two trade-reporting systems arelinked to the Clearing Corporation of

The Asian Development Bank fielded a staff consultant at the request of the Government to review the draft bill prior to its finalization.


34/67





Status of Reforms

February 2004

India Ltd. (CCIL) for settlementpurposes.

10.Establish an automatedclearance, settlement, and

depository system for securitiestrading in one or moreexchanges in all major centers in