Although India had Asia’s oldest stock exchange, its market capitalization to GDP level was much lower than that of developed Asian economies: using 2004 data, Hong Kong’s was 5.97, Singapore’s 2.36, and India’s 0.64.44 This stemmed from a number of factors. For much of the country’s history, the government had controlled the financial sector, including the amount of money companies could borrow. To raise money, they would often go public, usually selling the government minimum of 10% at low valuations. This corresponded to low liquidity and scanty trading volumes and thus in a negative spiral, lack of interest among analysts. In 2004 and the first 11 months of 2005, public stock issues in India raised as much money as was raised in the previous 14 years. Average deal size for companies going public had trebled between 2002 and 2005. “In a way,” observed a long-time investor in India, “buying the stock of most public companies in India was akin to buying a private company only worse. You had illiquidity and no control rights.”
Not only did the average Indian not have much money to invest in the stock markets until the early 2000s, but there was a highly liquid, government guaranteed option that paid handsome interest. Until 2000, passbook savings accounts paid rates between 12% and 15%, compared to an historic return of 17% to equities. Starting in 2000, however, interest rates had started to slide into the single digits, and by 2005, they stood near 6%. Said Oswal, “With no return to illiquidity, how could equities compete? Now our challenge is that the public still believes that interest rates are around 15%. As they start to internalize the recent drop, they will turn to equities in greater numbers.”
Indians historically had high household savings rates, in the vicinity of 29% of GDP, and the 300 million people in the middle class were moving into their prime saving years, but most of those funds were in banks. Mutual funds, the common way in which American retail investors participated in the market, only held INR 1.5 trillion ($34 billion) in assets under management at the end of 2004, with 10 times that amount, INR 16.2 trillion ($368 billion), in banks. In the U.S., for instance, mutual funds held nearly three times the assets of bank deposits.47 Figures from 2000 showed that only 8% of Indian households owned equities, and that overall, Indian households had only 4.5% of their wealth in the equity markets, compared to U.S. figures for the same year that showed 27% of households owning equities, and 15% of household wealth in equity markets.
Retail investors had been more active in 2005 and 2006, opening 1 million new depository accounts in the first seven months of 2005, which raised the total to 8 million by mid-year. Portfolio management services (PMS) had gained favor with those Indians holding equities, as capital gains taxes fell and the stock market rose. India’s “higher income population” – households with incomes above INR 200,000—was expected to almost double, to 32.3 million households between 2005 and 2009. These consumers were expected to increase the scope of product they demanded, moving from purely Indian financial products to globally oriented products.
As FIIs recovered from their fright at the crash of 2000, they had joined retail investors in Indian equity markets starting in 2003. In 2004, FIIs’ trading volume rose 105% from the year before, to $70.5 billion. Along with their faith in the vibrancy of India’s economy, FIIs also benefited from reduced capital gains tax rates.
The Indian broking industry was extremely fragmented but consolidating dramatically. The volume of the top five brokers had doubled between 2001 and 2005, but still was only 15% of the market. The top 50 brokers only had a 50% share . Small players were being acquired by larger domestic operators. At the same time, the industry’s efficiency had significantly improved. The number of registered brokers on the NSE, India’s largest exchange, had fallen by 3% between 1997 and 2005, while the number of trades had risen by 1,630% in the same period.
Competition was intense, as all the major foreign investment banks had entered the country, either independently or in joint ventures. By 2005, though, many of the joint ventures were dissolving, as the foreign partners, thought to want complete control of the operation, either bought or sold their stakes in the joint venture,. December 2005 had seen Merrill Lynch buy out its partner DSP for $500 million to increase its 40% stake in DSP Merrill Lynch to 90%. This effectively valued the operation, which focused on institutional broking, investment banking, and asset management, at $1 billion. In March 2006, Goldman Sachs and Kotak Mahindra Bank had severed their 10-year partnership for a nominal valuation. General sentiment held that Goldman had wanted the split to pave the way for setting up a proprietary operation. Even online broker E-Trade was staking a claim in India through a 27% share in brokerage IL&FS Investsmart. E-Trade was thought to be in the process of adding to that stake. Throughout this time, rumors swirled that Morgan Stanley and JM Financial, partners since 1999, would buy out their shares of the joint operation.
Much of this activity stemmed from the wild ride in the Indian markets. Total investment banking revenue had risen to $637 million by the end of 2006, almost 10 times 2002 levels. In addition, the benchmark BSE Sensex had doubled in value since 2003 and proven surprisingly resilient, as it recovered from a 29% drop in May 2006 only to rebound to new highs in October of that year.
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