The Hindu Business Line : Capital market ecosystem

The overwhelming response of retail investors to the offer for sale made for the Government equity in Maruti provides the opportunity for the simplification and renewal of the capital market ecosystem. These are best accomplished at a time when the enthusiasm for corporate securities has increased significantly in the ecosystem, say G. Ramachandran and Ramachandra.

The Sensex board at Churchgate station in Mumbai... Stock exchanges serve shareholders admirably by enabling trading of capital. But they have not really helped India Inc. and the economy to steam ahead. — Paul Noronha

"Everybody will now watch what you do with the company. It is a test case. Please remember, our honour is at stake, in your hands, because the process of disinvestment will be judged by the continued success of Maruti Udyog Limited and the returns investors get." — Disinvestment Minister, Mr Arun Shourie, at the Mumbai roadshow on May 30.

INDIA'S capital market ecosystem is ready for simplification and renewal that favour shareholders, debt-holders and companies in a balanced manner. The overwhelming response of retail investors to the offer for sale made by the Government of India of its equity in Maruti Udyog Limited (Maruti) provides the opportunity for the simplification and renewal. These could be accomplished at a time when the enthusiasm for corporate securities has increased significantly in the ecosystem.

The renewal should be aimed at deriving the most from the (1) corporate structure of organisation, (2) diversification of investment risk, (3) information and risk dynamics that result from listing of corporate securities and (4) reduction of corporate agency costs. The powerful economic benefits of these should reach as many shareholders, debt-holders and companies as possible.

These benefits are currently made available or availed of in a restricted manner. The restrictions constrain the growth of the corporate economy and, therefore, the growth of the total economy. Towards reaping the four sets of benefits, four recommendations are made.

First, heterogeneous and corporate-friendly capital market regulations may be put in place so that (1) the smallest and the riskiest company that issues `junk equity' and (2) the biggest and safest company that issues `AAA+ equity' can market equity to investors of their choice in India's vast capitalistic ecosystem. There may be at least as many implicit `equity risk classes' as there are explicit `debt risk classes'.

Second, for-profit exchanges may be allowed to unleash the power of demutualisation. These exchanges may specialise in one or more `equity risk classes' of their choice and then find suitable markets for such equities. For-profit exchanges will then become mutualistic and reliable partners of India Inc. in promoting economic growth.

Third, for-profit exchanges may be allowed to evolve innovative corporate disclosure protocols that serve companies and investors. For example, companies that issue `junk equity' may be encouraged to present audited financial statements every month or more frequently. The innovative corporate disclosure and interactive information protocols could focus on discouraging corporate agency costs.

Fourth, for-profit exchanges may be allowed to compete with one another so that companies can choose the `right ecosystem' for listing and liquidity. Companies would get an opportunity to graduate to more appropriate ecosystems through their life cycles just as many families begin with the Maruti 800 and then upgrade to roomier and more powerful cars.

One size does not fit all

The four recommendations are aimed at empowering India Inc. and at releasing it from elitist regulations that were evolved in economies that are different in the context of property rights, bankruptcy and limited liability, social safety nets and technology. But India faces different needs, opportunities and incentives. Property rights, laws related to bankruptcy and limited liability, and social safety nets are different. India's needs, opportunities and incentives require India Inc. to upset tradition. New regulations are required so that India Inc. can build a mutualistic relationship with a large mosaic of investors.

Empirical evidence since 1991 shows that investors know how to respond to opportunities and threats, and how to take care of their economic interests. Moreover, investors know how to operate in exchange-traded markets with advanced trading, clearing and settlement technologies.

The rewards to India Inc. from upsetting tradition can be considerable because market participants understand the information and risk dynamics pertinent to corporate performance, earnings and cash flows.

They possess the vital capability to assess the `absolute price of risk', the `relative price of risk vis-à-vis the broad market' and the payoffs from bearing absolute and relative risk. India Inc. should seek mutualistic relationships in a new ecosystem.

Present ecosystem

Capital market regulations are based on the assumption that (1) India Inc. and (2) its shareholders and debt-holders are involved in adversarial relationships. Regulations are aimed at suppressing agency costs that corporate managers impose when they act principally in their self-interest. Agency costs undermine the welfare of investors.

The regulations assume that `big' issuers impose `minimum' agency costs and that `small' issuers of capital impose `maximum' agency costs. Therefore, big issuers are preferred to small issuers. Regulations have raised the bar high in the context of corporate access to the capital market. They do not necessarily serve the interests of India Inc. as a whole.

Stock exchanges operate with similar assumptions. They serve shareholders and debt-holders admirably well by enabling the trading of capital. But they play a passive role in connecting savings with the capital requirements of India Inc. Their business models are not oriented to serving the needs of India Inc. They have few incentives to promote the interests of India Inc.

Cost of exclusion

The Securities and Exchange Board of India (SEBI) applies a `uniform set of conditions' to all companies accessing the capital market. A high `threshold level' has been set for accessing savings. A high `continuation level' has been set so that companies that fulfil the two preceding criteria can remain listed on the exchanges. The uniform and high barriers have hurt the interests of India Inc.

Smaller companies have been shut out from the capital market. The barriers have also resulted in the drying up of the supply of corporate securities to savers. A wide and deep chasm separates savings and corporate capital. But Enron, WorldCom and Xerox show that high entry barriers do not necessarily result in the elimination of agency costs. Corporate managers may yet play high-stake games after qualifying for bigger initial public offerings.

Counterproductive exclusion

The regulatory thrust of the capital market and the business models of the exchanges provide no opportunity to India Inc. to play a constructive role in connecting savings with capital. But savers depend on India Inc. to work on financial savings and then convert savings into financial flows through socially and economically relevant activities.

Investors, SEBI, the Stock Exchange, the National Stock Exchange and the regional stock exchanges depend on the cycle of savings and financial flows for their revenues, but it is India Inc. that energises the flows. Everyone depends on the energy and economic context provided by India Inc. The exhortation by the Union Minister for Disinvestment, Mr Arun Shourie, to the managers of Maruti at a roadshow underscores the indispensability of corporate managerial effort.

But India Inc. has been excluded from the ecosystem. Has the adversariness gone too far? Do the creative energies of some important sections of India Inc. remain untapped because of the capital market's business models and the regulatory thrust?

The exclusion of India Inc. from the formulation of the regulatory matrix and from the constructive strategy of the stock exchanges is patently counterproductive.

India Inc. should be empowered to address agency costs and thereby promote the interests of investors. The Associated Chambers of Commerce and Industry of India, the Confederation of Indian Industry, the Federation of Indian Chambers of Commerce and Industry, and the National Association of Software and Service Companies have chosen to energetically promote India's economic growth.

Their views on transforming India into a world-class developed economy are sought keenly. But it is sad and ironical that they have no role to play in connecting savings with capital, in addressing agency costs, and in making India's capital market ecosystem work towards promoting economic growth. Why has the adversariness gone this far?

A2-P3-C2-G3

Corporate organisations possess important economic and social properties that make incorporation and diffuse funding an apt choice in many circumstances. Incorporation and property rights spawn a `vital and viable nexus' of effort, reward, penalty and mutualistic relationships.

The nexus facilitates the effective management of complex and risky businesses. The nexus spreads risk, and enables the funding of complex and risky businesses. Capital markets and stock exchanges promote A2-P3-C2-G3. First, they require two As: `Assessment' and `announcement' of risk.

Second, they permit three Ps: `Participation', `pooling' and `parcelling' out of risk.

Third, they enable two Cs: `Control' over corporate resources and `contests' aimed at shifting control to capable managers.

Fourth, they enable three Gs: `Gauging' of performance, transparent `governance' and, thereby, `guiding' additional resources to fund growth.

A2-P3-C2-G3 promotes managerial efficiency and the prudent utilisation of capital. Quite clearly, a company that fails to cross the hurdle set by SEBI will forfeit these benefits. One company with an investment of Rs 100 crore may get the benefits while 100 companies that each make an investment of Rs 1 crore may not get the benefits.

But companies that fall below the high threshold collectively make very large investments in India. Some part of India Inc. and a major part of the Indian economy cannot derive the benefits from the powerful properties of A2-P3-C2-G3. Why has India Inc. been deprived of a catalyst for robust and rapid growth?

(G. Ramachandran is a financial analyst. Ramachandra is a principal consultant with Tata Consultancy Services. The views expressed are personal. Feedback may be sent to markets@prosyslab.com or indiagrow@sify.com)

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