Loosening up

FINANCE & ECONOMICS

Reforming India's equity market

Feb 3rd 2005
From The Economist print edition

India's government takes another step towards financial-market reform

BIT by bit, India's financial system is undergoing overdue reform. Recently, the government relaxed the rules on foreign companies in joint-ventures with Indian partners. Changes in the regulation of bank ownership are in the works—although they seem to have been delayed by a dispute between the reform-minded finance ministry and the cautious central bank. And last week the finance ministry loosened restrictions on India's pension funds, which should in turn help the country's equity market.

The ministry says that from April non-government “provident” funds (in essence, employee pension funds) may invest 5% of their new inflows directly in shares. A further 10% can be put into equity-linked mutual funds. Provident funds manage over 1.5 trillion rupees ($34 billion) in assets—currently, all of it in government-guaranteed securities or in debt instruments issued by government-owned companies and banks. Any money received when earlier investments mature will also be subject to the new rule.

According to one observer in Mumbai, over the next 18 months perhaps a quarter of the provident funds' assets are likely to mature. In all, more than 200 billion rupees are likely to be available for investment in the stockmarket, either directly or through mutual funds. About 100 billion rupees can be invested in the first year of the new system.

This should reduce the reliance of the Indian stockmarket on foreign institutional investors. Less than 1% of Indian household savings are invested in equity markets, and the market tends to swing as foreigners' interest waxes and wanes (see chart). Not surprisingly, the stockmarket welcomed the rule change: the Bombay Stock Exchange's Sensex index jumped 5% in two days after the announcement.

The country's mutual-fund industry should also benefit. At present, it manages just 300 billion rupees in equity assets, or 1.5% of market capitalisation. (By contrast, American funds' share of their country's stockmarket is perhaps 20%.) Many believe that provident funds, which lack fund-management skills, will prefer to place money with mutual funds rather than buy shares directly, at least at first.

However, Gautam Bharadwaj, a consultant to the Indian Ministry of Finance on pension reform, says that the new rule issued by the finance ministry has to be ratified by the labour ministry. A similar reform, allowing up to 10% of pension-fund money to be invested in shares, has been blocked by the labour ministry for the past five years, he said.

The labour ministry cannot halt the new plan altogether, but its rejection would stop the participation of the Employees' Provident Fund Organisation (EPFO), a government body that manages money for 27m of the 35m people covered by the pension schemes. The independent provident funds would then also hesitate.

Possibly to sweeten political opposition to the change, the finance ministry said on February 2nd that the minimum return provident funds must offer will rise from 8.5% to 9.5%. For EPFO-managed funds, this guarantee is the state's responsibility—so the increase may put further strain on the government's already wobbly finances. Privately managed funds have to meet the minimum from their own resources in the event of a shortfall.

This is a step back: a truly market-oriented reform would be to weaken, or even scrap, the guarantee. More reforms are planned. Expert committees have recommended privatising the asset-management function of the EPFO. They would also like to see more privately managed, individually funded defined-contribution schemes. What concessions might be needed to get these through?

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