Indian Financial Markets

CHAPTER 11

Policy Issues

This chapter reviews the strengths and weaknesses of Indian finance and

sketches the directions for reform.

11.1 THE STATE OF INDIAN FINANCE

The outstanding success story of Indian finance is the equity market, which has

achieved a full ecosystem with high levels of liquidity and market efficiency.

It has:

• Private equity investors;

• The IPO market;

• A fairly liquid secondary market, with electronic trading, competing

exchanges, nationwide anonymous electronic trading, risk management

at the clearing corporation;

• Derivatives trading;

• Mutual funds;

• Stock market indexes, index funds and index derivatives;

• Barring barriers faced by pension funds, few domestic participants are

blocked from market access;

• Participation from overseas players through the FII framework, accentu-

ated using participatory notes.

All these features have been described in various chapters of this book. While

the government is involved in regulation and supervision of the equity market,

it has no role in determining prices of equity securities.

1

In contrast, with the

three other elements of finance, namely currencies, commodities and bonds,

1

For a treatment of the policy debates and evolution of the equity market, see Shah and Thomas

(2000) and Echeverri-Gent (2007).

191

192 India’s Financial Markets

speculative price discovery does not take place in India. The government is

deeply involved in determining prices.

Figure 11.1, drawn from Mistry (2007), shows the Bond-Currency-

Derivatives Nexus as it operates in a mature market economy. In an Indian

setting, the BCD Nexus would involve the rupee riskless yield curve, with

issuance and investment from all over the world of riskless rupee denominated

government bonds. There would be rupee credit curves, also with issuance and

investors from all over the world. The fixed-income markets would interface

with global yield curves through the currency spot and derivatives markets.

Alongside this would be the credit derivatives market, which would (in turn)

be linked with the equity market through arbitrage.

Currency spot & derivatives

Foreign firms

issuin

g

bonds

Global traders

on currenc

y

markets

Global government

bond investors

Global credit

risk investors

Rupee

Riskless

Curve

USD

Yield

Curve

Euro

Yield

Curve

Yen

Yield

Curve

Credit spot

& derivatives

Rupee

Credit

Curves

Interest rate spot & derivatives

Foreign governments

issuing bonds

FIGURE 11.1 The Bond-Currency-Derivatives Nexus