Indian Financial Markets: An Insider's Guide to How the Markets Work

Indian Financial Markets: An Insider's Guide to How the Markets Work

by Ajay Shah, Susan Thomas, Michael Gorham

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The whole world wants to invest in India. But how to do this successfully? Written by two Indian financial experts with a seasoned expert of the Chicago Mercantile Exchange, this book tells you the why and how of investing in India. It explains how India's financial markets work, discusses the amazing growth of the Indian economy, identifies growth drivers, uncovers


The whole world wants to invest in India. But how to do this successfully? Written by two Indian financial experts with a seasoned expert of the Chicago Mercantile Exchange, this book tells you the why and how of investing in India. It explains how India's financial markets work, discusses the amazing growth of the Indian economy, identifies growth drivers, uncovers areas of uncertainty and risk. It describes how each market works: private equity and IPOs, bonds, stocks, derivatives, commodities, real estate, currency. The authors include a discussion of capital controls in each section to address the needs of foreign investors. Learn about the the markets, the instruments, the participants, and the institutions governing trading, clearing, and settlement of transactions, as well as the legal and regulatory framework governing financial securities transactions.

--Written by two life-long insiders who can explain India's financial markets to outsiders
--Clear and comprehensive coverage of this economic powerhouse
--Caters to the needs of foreign investors

Editorial Reviews

From the Publisher
"...tells you the how and why of investing in India and provides essential information on the markets, institutions and instruments that are integral to Indian financial services.... an invaluable guide for practitioners and students alike." – Richard G. DuFour, Executive Vice President, Chicago Board Options Exchange

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Elsevier Science
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Elsevier and IIT Stuart Center for Financial Markets Press
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India's Financial Markets

An Insider's Guide to How the Markets Work
By Ajay Shah Susan Thomas Michael Gorham


Copyright © 2008 Elsevier Inc.
All right reserved.

ISBN: 978-0-08-055994-0

Chapter One

The Economy


There is a new global interest in India's growth acceleration. What is perhaps well known is that from independence in 1947 up to 1979, GDP growth averaged 3.5%, which lagged behind many other economies. This was particularly disappointing given that the population was growing at 2.2% a year in that period. A per capita GDP growth of just 1.3% per year implied that the Indian GDP would double only once every 53 years. That in turn meant that mass poverty would get eliminated at a glacial pace in India.

However, from 1979 onward, GDP growth started accelerating, to a point in 2006 where trend GDP stood at 7%, with the previous few years having seen growth of more than 7%. Table 1.1 summarizes the experience with acceleration of growth over the decades.

This acceleration of GDP growth was accompanied by a deceleration of population growth. At the time of writing, it appeared that India had a trend GDP growth rate of 7.5% with a population growth rate of 1.5%, giving a per capita GDP growth rate of 6% a year, which induces a doubling every 11.5 years. This constitutes a dramatic improvement when compared with the starting point of a doubling every 53 years.

Table 1.2 shows the change in the structure of GDP. The share of agriculture in GDP dropped sharply from 55.1% in 1950–1951 to 18.5% in 2006–2007. Industry has grown modestly from 15% to 26.6% over this same period. Services has grown dramatically from 29.6% to 54.9%; India appears to be "leapfrogging" to the structure of rich countries where services dominates.

Figure 1.1 shows quarterly GDP growth data for the recent five years. When compared with the information in Table 1.1, it is clear that GDP growth has dramatically increased in the period after 2002. On average, GDP growth after 2000 was 7.31%. From 2003 there has been a powerful rise in the growth rate to around 8%. One of the most interesting puzzles about India lies in deciphering this growth acceleration. Will India revert to lower growth rates of the order of 7%? Or have deeper changes taken place so that a growth of 8% and above will be sustained?

In this chapter, we seek to look behind the well-known facts about GDP growth, and obtain a better understanding of the strengths and weaknesses of India at the level of growth and macroeconomics. This forms a vital foundation for thinking about the role of Indian financial products and markets in a global strategy.


The most important element of India's post-independence trajectory is the withdrawal into autarky and socialism, and the gradual recovery from this policy framework. Evolution of the merchandise trade to GDP ratio stood at 16.63%. From that point on, for many decades, economic policies emphasized autarky and government controls. This led to a decline in the trade to GDP ratio. Historically, some of the lowest values of this ratio were found in the 1969–1977 period (see Figure 1.2 and Table 1.3).

In parallel, from 1960 onward, evidence started appearing about how superior growth resulted in other economies when they started using outward-oriented and market-oriented growth strategies. A particularly outstanding example is South Korea, which started out behind India in 1960. There was an increasing awareness among intellectuals and policymakers in India by the late 1970s that mistakes in economic policy strategy had been made, particularly the accentuation of government control of the economy that came about under Prime Minister Indira Gandhi from 1966 to 1977. Scholars such as Jagdish Bhagwati, T. N. Srinivasan and Anne Krueger played a significant role in deciphering the difficulties of the prevailing policy framework, and arguing that a fundamental change of course was required.

GDP growth started accelerating from 1979 onward, reflecting the economic reforms introduced by the Janata Party which won the general elections in 1977. These reforms were greatly broadened in the 1980s by Prime Ministers Indira Gandhi and Rajiv Gandhi, assisted by an IMF program in 1981. The reforms of the late 1970s and 1980s were very important in terms of easing entry barriers in the domestic market, and in reducing price controls. These elements of liberalization helped accelerate growth, which gave confidence in market-oriented policies and paved the way for further progress in economic policy thinking. However, the reforms of this period did not emphasize globalization: the trade to GDP ratio actually fell for much of the 1980s.

From the viewpoint of an acceleration in the trend of GDP growth, 1979 is the break date: the trend in GDP growth averaged 3.5% prior to 1979 and steadily accelerated thereafter. However, on the critical issue of when economic globalization started in India, the break date is 1991, when far-reaching reforms took place in the aftermath of a currency crisis and an IMF program (Bhagwati, 1993). The distinguishing feature of the 1991 reforms, and the stance of economic policy after that, has been integration into world economy. India got back to its 1952 levels of the trade to GDP ratio (16.63%) in 1993. China had that level of trade to GDP ratio (16.63%) by 1980, which suggests that the Indian reform effort lagged the Chinese effort by 13 years. It is ironic that, in many respects, communist China was able to break free of autarkic and socialist policies earlier and more effectively than democratic India.

Two key facts about the trade to GDP time-series are: (1) The lowest value of trade to GDP was 7.5%, and (2) in 1952, the ratio was more than twice as high at 16.63%. The most recent value was four times bigger at 30.41%. Thus, the trade to GDP ratio plunged by a factor of 2.2 times in the period of socialism. But it has recovered by a factor of 4 times thereafter.

The economy rapidly responded to the reforms of the early 1990s, with sharp growth in manufacturing exports and an impressive investment boom with the construction of factories. For the first time, growth above 7% was observed for three consecutive years.

The National Democratic Alliance (NDA) coalition, which ruled from 1999–2004, made important progress on economic policy. The NDA started out in a very difficult period, with the recession of 1998–2001. However, after that, the economy responded well to these reforms by bouncing back to the highest-ever rates of growth. There was an emphasis on privatization, creation of infrastructure, equity market reforms, considerable reduction of trade barriers (Panagariya, 2005), a steady pace of easing capital controls, and long-term structural reform on issues such as the fiscal system and the replacement of the civil service pension by the New Pension System. The clarity and pace of reforms slowed down with the UPA which came to power in 2004. Despite weak progress on reforms, the energies unleashed by economic reforms have so far remained effective at delivering excellent growth rates.


As is well known in growth economics, changes in GDP respond to changes in labor, changes in capital and changes in productivity. On all three counts, India has fared well in the post–1980 period. Private final consumption was above 90% of GDP until 1970, and the savings rate only started creeping up to impressive numbers after 1980. The fraction of the working population (ages 15–60) also started improving from the late 1970s onward. Finally, from 1977 onward, economic policy has been shifting away from socialist positions, which has helped in increasing productivity. All three factors combine in explaining the acceleration of growth from the late 1970s onward.


This section discusses the few most important factors that will drive growth in the coming decade. The major factors at work can be classified into "pre-existing strengths" as opposed to "new factors."

The pre-existing strengths include political stability, quality and quantity of labor, a common law tradition, strong institutions such as the judiciary and the election commission, and strong domestic consumption. These strengths were always present, but a deficient policy environment led to a poor translation of these strengths into growth. The new factors at work are a less restrictive State, a high quality and quantity of capital, strong private corporations, improvements in infrastructure, and globalization.


It is conventional to focus on citizens between ages 15 and 64 as "the working population," and to define the proportion of the population in this age range as a workforce ratio. As Figure 1.3 shows, India will be the last large country in the world to experience the demographic transition. Within a few years, the Chinese workforce ratio will peak, and from there on, the process of ageing will act against Chinese GDP growth. In India's case, the outlook for a few decades involves a rising workforce ratio and thus accelerating GDP growth. A related story is visible in the median age (see Figure 1.4).

The second change taking place in the labor force is equally significant for economic growth. This concerns the quality of the labor force. Every year, the human capital of the stock of labor goes up, through gains in education and (more important) gains in experience. Every year, a cohort at age 60 leaves the labor force, while everyone at younger ages adds one year of experience. The loss of human capital of the retiring cohort is smaller given the relative obsolescence of their knowledge.

While the formal educational system suffers from numerous weaknesses, there is an active process of learning by doing in the context of a globalized and competitive economy. As an example, IT is a highly skill-intensive area where Indian universities are very weak. Yet, India has become an IT superpower with over 1.5 million IT professionals. This has been achieved through a combination of private sector education companies, such as NIIT or Aptech, and on-the-job learning. This is likely to be the mechanism through which human capital is created in the future also.

While the formal education system is weak, significant progress on certain basics is taking place. High school examinations are difficult by world standards. There is an increasing shift toward private schools, where market forces exert pressure on schools for performance.

A self-reported knowledge of English serves as an interesting measure. English is spreading through improvements in schools, and through the world of work. An analysis of a household survey database named IRES, released by the Ministry of Finance and ADB, shows that nearly 40% of the young earners—in the age group 20 to 30—have at least a rudimentary ability to read English.

Incremental workers, incremental education and incremental experience of the existing stock of workers: these add up to a powerful fundamental driver for high economic growth.

Alongside these remarkable features of the labor force, there is a parallel phenomenon of slow growth of organized sector employment, which roughly corresponds to employment in large firms. In the period from 1994 to 2001, even though output by large firms rose dramatically, employment actually dropped slightly. This appears to be partly a response to restrictive labor laws, which gives firms a strong incentive to stay small, and thus avoid the strictures of labor law. Production is often organized in complex ways where a large firm contracts out parts of production to numerous small firms, each of which is efficient in labor contracting by avoiding labor laws. This tends to exert an upward bias on the size of the "informal sector."


The evidence points to a continually positive growth in both the quantity as well as the quality of capital available in the domestic economy.


Excerpted from India's Financial Markets by Ajay Shah Susan Thomas Michael Gorham Copyright © 2008 by Elsevier Inc.. Excerpted by permission of ELSEVIER. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Meet the Author

Ajay Shah studied at IIT, Bombay and USC, Los Angeles. He has held positions at the Centre for Monitoring Indian Economy (Bombay), Indira Gandhi Institute for Development Research (Bombay) and the Ministry of Finance. He is currently a Senior Fellow at the National Institute of Public Finance and Policy (NIPFP) in India. His research interests include policy issues on Indian economic growth, open economy macroeconomics, public finance, financial economics and pensions. In the past decade, he was extensively involved in the policy process in the reforms of the equity market and the New Pension System. His work can be accessed on the web at

Susan Thomas is faculty at the Indira Gandhi Institute for Development Research in Bombay. Her research has been in financial econometrics, specifically on models of the volatility of financial prices, and aspects of market microstructure in Indian financial markets. She has also worked on models for the Indian zero coupon yield curve, govt. bond index construction and probability of default for Indian firms. Her work can be accessed on the web at

Michael Gorham is Industry Professor and Director of the IIT Stuart Center for Financial Markets at the Stuart School of Business in the Illinois Institute of Technology. He serves on the board of directors for two exchanges - the CBOE Futures Exchange and the National Commodity and Derivatives Exchange of India. He also serves on the Business Conduct Committees of the Chicago Mercantile Exchange and the National Futures Association and the editorial boards of the GARP Risk Review and of Futures Industry magazine.

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