NEW DELHI, January 25, 2008. Even as the economy and the capital markets exhibit strong fundamentals-led growth and vibrancy, their sustained growth hinges on the ability of the market regulator and the players to cope with five key challenges -- political uncertainties till the general elections are over; pressure on the exchange rate, interest rates and inflation; rising oil prices; subprime crises, US slowdown and other global economic dynamics; and protecting investors’ interests in rapidly changing market dynamics, cautions a FICCI-Ernst & Young (E&Y) Paper on ‘Capital Markets – Sustaining Growth and the Challenges Ahead’.

The paper notes that the India story is clearly liberalisation-led and the reform programmes instituted in the 1990s are paying rich dividends. An analysis of micro and macro parameters post liberalisation indicates that the economy witnessed structural shifts to spur growth, which was driven by services and manufacturing sectors. On one hand, population growth is leading to positive demographics, which will fuel growth. On the other hand, it may lead to unskilled rural population adding to India’s social and employment woes. A consensus amongst the political circles has helped the economy to stay on the growth track. India has managed its monetary and fiscal policies along the way to sustain the growth momentum.

Some of the global challenges that India will need to manage in the near term is the fallout of subprime and its impact on the US economy, which is believed to be inching towards a slowdown. The slowdown may have an impact on the Indian exports as well as it could lead to capital flight due to increased profit booking and portfolio adjustments.

Rising oil prices, the FICCI - (E&Y) paper, points out, continue to remain a concern for India. In order to address this, India needs to be more proactive and opt for energy efficiency, which will also help in reducing global warming. Biofuels are emerging as an effective substitute to oil; however prolonged usage is likely to result in food price inflation and the exploitation of natural resources.

The paper states that the retail investors have seen increased participation directly and through financial assets such as mutual funds and unit linked plans. Institutional investors—both domestic and foreign—have huge funds, which is flowing into the markets. The mutual fund asset under management is at an all time high, insurance companies are growing rapidly led by growth in linked products. Pension reforms will also aid the markets. On the international side, foreign flows both direct and portfolio flows are at their peak. The good news is that India is attracting a number of new investor classes such as hedge funds and private equity. Sovereign funds are also expected to increase their presence as markets continue to provide above average returns.

The investor classes, however, require a strong impetus to expand the flows into the markets. The retail investors are an expanding class as the per capita income is on the rise; however, only a small portion is in the markets. The financial markets will require sustained efforts to improve distribution to expand the financial depth of the markets. There may be pockets that may require personalised attention. Domestic institutions, while inundated with funds, are required to meet stringent asset allocation norms. This results in the funds being channelled into the Government sector.

The FICCI – E&Y paper suggests that in order to improve the financial depth in the market through domestic institutions, the relaxation of asset allocation norms is important and these should be supported by improved risk management capability to manage portfolio risk and provide investor protection.

The domestic capital markets, particularly the equity markets, have shown dependency on the foreign portfolio flows. While the flows are on a rise, they have the potential of increasing volatility in the market. The regulators would need to take steps to improve stability of these flows and discourage speculative flows.

The market infrastructure and regulatory reforms have kept pace with growth. The markets have grown dramatically from an outcry system to one of the most efficient equity markets in the world with T+2 settlement cycle and significant automation of the clearing and settlement process. The improved payment systems are also adding to the efficiency of the market. There has been significant regulatory thrust to improve certain segments of the market and also to introduce new assets. The regulators have been active in the market to ensure proactive monitoring in the market place and instilling investor confidence, which is important to enhance financial depth.

The focus of the equity market now needs to move more towards making the market more efficient and protect the interests of investors particularly the retail investors. The cycle time in the primary market needs to be reviewed and reduced. The section of the market that needs maximum attention currently is the debt market. The regulators need to focus on improving the market infrastructure and providing a regulatory impetus to

improve the markets. The initial focus could be to create the market infrastructure as seen in the equity side of the market and then pushing the market players to increasingly use the market infrastructure. The market players may initially require incentives to come into the market. The reform and regulatory impetus in the debt markets require focus on investors, issuers, markets, and other regulatory norms, alike.

Globally, regulators are taking a cautious approach towards adopting regulatory approaches to the new investor classes. India is no different. It is the stated intent of the regulators that cautious steps will be taken to regulate the new investor classes. The regulatory quality in India in global comparison as indicated by the World Governance Index still needs improvement. A case in point is the UK, where the move towards a single regulator over the last two decades seems to have paid off, is a model that India could consider adopting, says the FICCI – E&Y paper.

The increasing significance of the new investor classes equipped with international dollar flows is changing the dimensions of the market place. They are providing financial depth in the market as they continue to contribute more capital and foster innovation in the market place. They are facilitating price discovery processes in relatively less liquid sections of the market and are asking for better governance. As they facilitate global

integration, there is an outside chance that growing international demand for investing in India may be pushing flows in the already deep sectors of the market.

India, opportunities galore, will require significant investments into the infrastructure sector. Capital markets, one of the providers of the long term capital, stands to gain from the boost required in the infrastructure sector. The economy and the markets, alike, on their way to another year of above average growth, however, may need to overcome some stumbling blocks such as the US slowdown, rising oil prices, impossible trinity, and the next general elections, amongst others.

MEDIA DIVISION