Stephen Wells

India's Bond Market - Developments and Challenges Ahead

While India boasts a world-class equity market and increasingly important bank assets, its bond market has not kept up. The government bond market remains illiquid. The corporate bond market, in addition, remains restrictive to participants and largely arbitrage-driven. Securitization, which once had the jump on other Asian markets, has failed to take off. To meet the needs of its firms and investors, the bond market must therefore evolve. This will mean creating new market sectors such as exchange-traded interest rate and foreign exchange derivatives contracts. It will mean relaxing exchange restrictions, easing investment mandates on contractual savings institutions, reforming the stamp duty tax, and revamping disclosure requirements for corporate public offers. This paper reviews the development and outlook of the Indian bond market. It looks at the market participants-including life insurance, pension funds, mutual funds and foreign investors-and it discusses the importance to development of learning from the innovations and experiences of others.

A New Regulatory Framework

In this chapter we put forward a regulatory structure that we believe may be more suited to the environment as it is likely to develop.

Fragmentation and Consolidation

This chapter considers the changing structure of the securities industry. In particular, it analyses the centripetal forces pushing the trading of securities to consolidate on monopoly exchanges, and the centrifugal forces driving securities trading to fragment. ‘The tension between centrality, on the one hand, and competition, on the other, is probably the oldest of all market structure issues’ Arthur Levitt, Chairman of the SEC, Senate Banking Committee (SBC), 1999), and the current market structure reflects the present balance between these two opposite effects. Today’s technology may afford us the opportunity to better achieve these goals [to garner the benefits of centrality without stifling competition] — once thought to be mutually inconsistent’ (Arthur Levitt, 1999).

Preliminary Data Analysis

When comparing the volatility of stocks trading on different markets, it is important to compare stocks that have similar features in terms of market capitalization or size, industry grouping, age and liquidity. AIM stocks have substantially smaller market capitalization than Main Market stocks. Very few Main Market stocks have market capitalization lower than £5m and very few AIM stocks have market capitalization larger than £200m.

Relative Risk Allowing for Size, Age or Liquidity

We then considered size, age and industry effects on volatility. The results suggested that larger stocks are generally less volatile than smaller stocks, and also that small AIM stocks are significantly more volatile than comparable Main Market stocks.

Regression Analyses with Multiple Variables

In the multivariate regression analysis we used the main risk-related variables (size, industry, age and market) to explain differences in volatility. Our results suggested that AIM stocks are significantly more volatile, although the difference is far smaller than that given by the simple ratio analysis. However the strong correlation between age and market on which the stock is listed makes it difficult for a regression to distinguish the impact of the two variables.

Basic Analysis of Relative Volatility

First, we conducted an analysis of comparable stocks that did not switch markets. A simple ratio analysis comparing the annual volatility of AIM and Main Market stocks showed AIM to be substantially more volatile than the Main Market. The volatility of AIM stocks ranged from 1.3 to 2.7 times that of comparable Main Market stocks, and was particularly high in 2005 and 2006.

Market-Switching Stocks

A significant number of stocks (273) have moved between the two markets. These stocks allowed us to study a single event, a market switch, abstracting from other company-specific factors. Again a succession of progressively more complex analyses were applied. After controlling for overall market volatility, the simple switchers analysis using ratios of pre and post-switch volatility to assess the impact of the switch had the following results: (1) When considering stocks switching from AIM to the Main Market, 71? of the switchers have greater volatility on AIM; (2) When considering stocks switching from the Main Market to AIM, 42? of these have greater volatility on AIM; (3) Overall, switching stocks showed marginally higher volatility on AIM. These results are consistent with the notion that AIM is viewed as slightly more risky.

GARCH Analysis of Switchers

A more complex analysis of the switchers was conducted by using high-frequency data to construct GARCH models for the dynamics of volatility. In this analysis 19% of the switchers showed a significant change in volatility with a majority of these showing lower volatility in the AIM period.

Policy Responses to Fragmentation

This chapter examines the regulatory implications of market fragmentation and consolidation. It begins with a brief summary of the arguments advanced at greater length in Chapter 4. This is followed by a longer analysis of regulatory effects, together with a description of suggested responses.