Capital markets refer to segments of financial system that help enterprises raise long-term capital by way of equity or debt. In turn, they also help savers to invest their money optimally in productive enterprises. Capital markets comprise financial institutions, banks, stock exchanges, mutual funds, insurance companies, financial intermediaries or brokers etc.
A growing economy like India, where more than 15 million youth are added to workforce every year, needs huge investment on a continuous basis for new capacity as well as for expansion, renovation and modernization of existing productive capacity and creation of supporting infrastructure. This investment, technically referred to as â€˜gross capital formationâ€™, is crucial to sustain growth. Economists work out capital output ratio by computing units of capital required to produce a unit of additional incremental output. In the Indian context, the capital output ratio has historically been around 4, i.e. 4 units of capital are required to produce one unit of incremental output. Therefore, to sustain growth of 8% per annum, we need new investments or gross capital formation of 32% per annum. In other words to sustain growth, we need capital to invest. And to raise capital, we need an efficient capital market. Therefore, capital markets are critical for the countryâ€™s overall economic growth. There is broad consensus that macroeconomic policy framework should be conducive for the development and efficient working of the capital markets.
However, the development of capital markets poses its own challenges. If not overseen properly, capital markets can be vulnerable to frauds, volatility, and excessive speculation. Capital markets mobilize savings of naive investors, directly and indirectly. For policy makers, the conundrum is therefore to strike a balance between pace and order, sophistication and transparency, and regulations and simplicity.
Over the past two decades, Indian regulators have taken the path towards tighter regulations. As a result, in relative terms, our capital markets have been less vulnerable to crises or frauds. Quite justifiably, our regulators and government officials are proud about this. We have a robust regulatory structure in place for the capital markets. However, the flip side is that they are not geared to meet the capital requirement to realize the growth potential of the economy. India has tremendous potential to sustain higher economic growth compared with China because of favorable demographics and the enterprising nature of its people. India can sustain double-digit economic growth for at least a couple of decades more, which can lift millions of people out of poverty as has been the case with China, Singapore, and many other countries.
Let us separately look at equities and debt, the two major parts of the capital markets.
Our debt markets are evolving slowly and quite far from being mature, with multi-tier structure to handle risks and enable large capital flows. Several government committees have been appointed to look into this and develop corporate bond markets. However, very little has happened at the ground level. The absence of an efficient debt market has become a major constraint for new investments, especially in infrastructure, where debt component of a project is significantly higher. Given an underdeveloped corporate bond market and regulatory restrictions on deposits by non-banking sectors, a bulk of intermediation in the debt market is per force through the banking channels. The cost of intermediation in our country is perhaps the highest in the world. Typically, a good individual saver earns 4% p.a. whereas a good corporate borrower pays 12% p.a. A fair, market-linked, inflation-proof and risk-free return will go a long way in reducing the diversion of savings to unproductive asset classes such as gold and real estate. In todayâ€™s world, such spreads can exist only with regulatory protections because free markets else
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