Law of One Price: A Chronicle of Dually Listed Indian Stocks 9781032457819, 9781032457826, 9781003378686

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Law of One Price

Law of one price continues to be a central tenet of Financial Economics. This book is devoted towards examining law of one price in the context of dually listed shares of Indian companies. The book delves on the relationship between the prices of domestic shares issued by Indian companies and the prices of foreign shares issued by the same companies. It also examines the evolving uncertainty in relationships between such dually listed shares issued by Indian companies. It draws upon the insights that we garnered over the years while working on technical papers in this area. The book, thus, undertakes concerted efforts to present facts in a manner that sensitise and meaningfully inform readers of the prevalent breadth and depth of dual-listing (cross-listing) landscape globally and more so, locally (India). Vinodh Madhavan, Ahmedabad University, Ahmedabad, India. Partha Ray, National Institute of Bank Management, Pune, India.

Routledge Focus on Management and Society Series Editor: Anindya Sen Pro Vice-Chancellor, School of Social Sciences, Ramaiah University of Applied Sciences, India

The aim of the Focus series is to present the reader with a number of short volumes which deal with important managerial issues in the Indian context. Volumes already published in the series cover topics which are of perennial interest to managers, like strategic change and transformation, and supply chain management, as well as emerging areas of research like neuro-marketing and digital culture. CEOs today also need to be familiar with critical developments in other fields, like auction theory and the contribution of sociology to management thinking. A forthcoming volume examines the law of one price in the context of dually listed shares, that is, shares which are listed in both Indian stock markets and abroad. In other words, the Focus series is designed to introduce management theorists and researchers (as well as the general public) to a diverse set of topics relevant directly or peripherally to management in a short, readable format, without sacrificing basic rigour and set in the Indian context. Books in this series: Digital Cultures Smeeta Mishra Artificial Intelligence, Business, and Civilization Our Fate Made in Machines Andreas Kaplan Law of One Price A Chronicle of Dually Listed Indian Stocks Vinodh Madhavan and Partha Ray For a full list of titles in this series, please visit: www.routledge.com/ Routledge-Focus-on-Management-and-Society/book-series/RFMS

Law of One Price A Chronicle of Dually Listed Indian Stocks

Vinodh Madhavan and Partha Ray

First published 2023 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 605 Third Avenue, New York, NY 10158 Routledge is an imprint of the Taylor & Francis Group, an information business © 2023 Vinodh Madhavan and Partha Ray The right of Vinodh Madhavan and Partha Ray to be identified as authors of this work has been asserted in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. ISBN: 978-1-032-45781-9 (hbk) ISBN: 978-1-032-45782-6 (pbk) ISBN: 978-1-003-37868-6 (ebk) DOI: 10.4324/9781003378686 Typeset in Times New Roman by Apex CoVantage, LLC

Contents

List of Figures List of Tables Preface Acknowledgements

vi vii viii x

1

Introduction

2

Depositary Receipts: Global Trends and the Indian Story

16

Is the World Flat?: Domestic Share Prices vis-à-vis the Prices of Their Depositary Receipts

39

Conclusion

79

References Index

87 91

3 4

1

Figures

2.1 Illustrative structure of a DR 2.2 Tensions of impossible trinity 2.3 Issuance of depositary receipts by Indian firms during 1992–1993 through 2019–2020 (in USD million) 2.4 GDP growth rates of major economies and India: 2001–2019 2.5 Exchange rate of Indian rupee relative to USD: 2000–2020 2.6 Capital issuances through DRs across the world exchanges: 1991 to 2020 2.7 Capital issuances by firms based in select countries: 1991 to 2020 3.1 Prices of Dr. Reddy’s Laboratories ADR and domestic share 3.2 Dr. Reddy’s Laboratories ADR premium 3.3 Luxembourg versus Mumbai: responses of GDR to innovations in underlying scrip 3.4 London versus Mumbai: responses of GDR to innovations in underlying scrip 3.5 New York versus Mumbai: responses of ADR to innovations in underlying scrip 3.6 DCC plots between Luxembourg-listed GDRs and their underlying domestic shares 3.7 DCC plots between London-listed GDRs and their underlying domestic shares 3.8 DCC plots between New York-listed ADRs and their underlying domestic shares

18 26 32 33 34 35 36 41 42 55 59 61 70 73 74

Tables

2.1 India’s balance of payments: 2018–2019 (USD million) 2.2 Amount of active DRs issuances by select countries at major stock exchanges (in USD million, as on 31 December 2020) 2.3 Number of active DR issuances by top five countries at major stock exchanges as on 31 December 2020 2.4 Capital raised by issuers of each country (in USD million as on 31 December 2020) 2.5 Permissible jurisdictions and international exchanges 2.6 DR issuances by Indian firms across different stock exchange (total capital raised as on end April 2019 in USD million) 3.1 Trading hours in select stock exchanges (in terms of Indian standard time) 3.2 DRs issued by select companies: a snapshot 3.3 Correlations between Depositary Receipts (DRs) and their underlying scrips

21 24 24 25 29 31 40 45 54

Preface

We have been working together on the generic theme of dually listed Indian stocks for some time. We have published a few papers in professional journals pursuing the research question: Are the prices of a stock of an Indian corporate listed in BSE/NSE and the prices of their foreign counterparts under the garb of Global Depositary Receipts (GDRs)/American Depositary Receipts (ADRs) related? If so, what is the kind of such a relationship? While working on these issues, we realised that this research question is related to a larger issue of the ‘law of one price’, which essentially affirms the power of competitive forces (in absence of restrictions on the trade of goods and services and low transport cost) over the limits of geography. Since share trading happens in the virtual place of computer terminals, called stock exchange, and the flow of information happens in a nanosecond, one would expect the price of a share of an Indian corporate (in rupees) listed in a domestic stock exchange and the price of its share listed in New York stock (in dollars, but expressed at the current rupee-dollar exchange rate) to be reasonably close. And we thought that the issue may be of general interest. Around that time two specific things happened. First, while discussing the issue with Professor Anindya Sen, he encouraged us to write a book on this particular issue without assuming much prior knowledge/information of the specifics of the stock market on the part of the reader. Second, we hit upon a somewhat old but relatively less cited 2003 article by Owen A. Lamont and Richard H. Thaler in the Journal of Economic Perspectives that specifically talked of the law of one price in the financial markets and even considered the case of American Depositary Receipts as an illustration. The result is this short book of dually listed stocks of India, where we have tried to explain the underlying concepts and stylised facts in terms of first principles. In doing so, we were also guided by Albert Einstein’s

Preface ix famous quip, ‘Everything should be made as simple as possible, but not simpler’. While this short book is born out of our technical research in select areas pertaining to dually listed shares, we do hope that it offers a snapshot of the breadth of the depositary receipts landscape and also adds to the texture of the landscape of dually listed shares in the Indian context. Vinodh Madhavan Ahmedabad Partha Ray Pune

Acknowledgements

In writing the book we were immensely guided by Professor Anindya Sen, who has chased us during the long gestation period of the book, read through the entire manuscript, and offered his valuable comments. We thank Ahmedabad University; its Director of Libraries, Dr. Sanjay Banavar; Professor Devanath Tirupati, Dean, Amrut Mody School of Management and Senior Dean Academic, Ahmedabad University; and Professor Bibek Banerjee, former Senior Dean, Strategic Initiatives and Planning, Ahmedabad University, for the support they rendered at different stages of this exercise. We also thank Mr. Prashant Joshi, Assistant Vice President, Centre for Monitoring Indian Economy Pvt. Ltd., for helping us in our data collation phase.

1

Introduction

1.1 Introduction The law of one price has always attracted the imagination of people. In absence of any restriction, like octroi or an entry tax, the price of a pen in Pune (where Ray lives) and the price of a similar quality pen in Ahmedabad (where Vinodh lives) should be the same once adjusted for transport cost. After all, in a world without any transport costs, if pens in Pune are expensive, people are going to buy these from Ahmedabad and sell them in Pune. Economists often conceptualise the idea in terms of a competitive market, whereby in the presence of preconditions like a large number of buyers and sellers, full information, identical products, no transport cost, no selling costs, the price of a product would be the same across the markets (in a geographical sense). In fact, economist George Stigler, winner of the 1982 Nobel Memorial Prize in Economic Sciences, has commented, ‘Competition entered economics from common discourse, and for long it connoted only the independent rivalry of two or more persons’ (Stigler, 1957, p. 1). Note that both Pune and Ahmedabad are located within the same country (call it a political territory, if you like) named India. What happens to the prices of the same pen between Pune in India and New York in the US? Will the price be the same? The intuitive answer to this question would be definitely YES, with the caveat that presence of the preconditions of a competitive market is somewhat more difficult when one considers distinct political and economic entities, called countries. Of course, the exchange rate between Indian rupee and US dollar can also play a crucial role in this case. Essentially, thus, the concept ‘Law of One Price’ relates to the notion that market arbitrage (i.e. the practice of buying a product in one place and selling them in another in order to profit from the price differential) is not possible under capitalism without any restriction.1 The intellectual history of the concept of law of one price can be traced back to the French economists of late 18th century. Illustratively, the French economist, François DOI: 10.4324/9781003378686-1

2

Introduction

Quesnay, (1694–1774), who was an Adviser to the French King Louis XV (1715–1774), and is widely believed to be the originator of the term laissezfaire, is reported to have advised to deregulate trade and to slash taxes. However, in the context of different countries, the law of one price has one complication. The force through which the law of one price is established across borders is via international trade. But not all goods are tradable. Thus, while price of a pen in Pune and New York could be similar (adjusted for transport cost), the price of a hair-cut would vary. Economists Bela Balassa and Paul Samuelson in 1964 constructed a theoretical model and showed that an increase in the relative productivity of a tradable good via-a-vis a non-tradable good of one country versus foreign countries raises its relative wage; effectively, its relative price of the non-tradable good is increased. Thus, in presence of tradable and non-tradable goods, the law of one price has a distinct meaning. Interestingly, to conceive an identical product across the globe could be difficult. A frivolous but useful illustration in this case has been the Big Mac burger of the MacDonald’s. The Economist Magazine has invented the Big Mac index in 1986 based on the belief that the Big Mac in different countries are identical. Based on the theory of purchasing power parity, it is based on the implicit notion that any deviation in prices of Big Mac in two countries is essentially a reflection of exchange rate misalignment.2 Thus, in real world, establishing the law of one price becomes difficult. However, since globalisation has a key element of movement of financial flows across borders, what happens to the law of one price in financial world? Two Finance Professors, Owen Lamont of Yale University and Nobel Laureate, Richard Thaler from Chicago University have delved into this question. It is worth noting what they have said: Traditionally, economists thought that the Law [of one price] could be applied almost exactly in financial markets because of the workings of arbitrage. Arbitrage, defined as the simultaneous buying and selling of the same security for two different prices, is perhaps the most crucial concept of modern finance. The absence of arbitrage opportunities is the basis of almost all modern financial theory, including option pricing and corporate capital structure. In capital markets, the Law says that identical securities (that is, securities with identical state-specific payoffs) must have identical prices; otherwise, smart investors could make unlimited profits by buying the cheap one and selling the expensive one. It does not require that all investors be rational or sophisticated, only that enough investors (dollar weighted) are able to recognize arbitrage opportunities. According to the standard assumptions, the Law should hold in financial markets because if some investors mistakenly

Introduction 3 think that odd-numbered shares of some stock are better than evennumbered shares, rational arbitrageurs will prevent these investors from driving up the price of odd-numbered shares . . . . . . Moreover, unlike international trade where it may take some time to move gold physically from London to Zurich, one would expect the Law to hold not only in the long run, but almost instantaneously, since one can quickly buy and sell securities. (Lamont and Thaler, 2003, p. 192) In particular, Lamont and Thaler (2003) considered the case of American Depositary Receipts (ADRs) and looked into the case of price discrepancy in the case of some ADRs. Depositary receipts (DRs), as we explain later, is a domestic stock listed on a foreign stock exchange via a bank. Interestingly, as an illustration of the price discrepancy, they referred to Infosys ADRs and noted that as of 7 March 2000, the Infosys ADR was trading at a 136% premium relative to their shares listed in the Stock Exchange, Mumbai. However, this premium was short-lived. Of course, across the emerging market economies, there are various restrictions on financial flows. In fact, a major phenomenon in the financial market is the presence of home bias where a domestic investor tends to prefer/hold a domestic stock/bond more than a foreign stock. Various factors have been held responsible for the existence of home bias, viz., explicit or implicit regulations that restrict investment in foreign assets; transaction costs associated with a foreign investment; lack of full information about foreign assets; and uncertainty of contract enforcement and the associated moral hazard in a foreign country. What has been the behaviour of dually listed stocks of Indian companies? Did they reflect the law of one price? Or, did they differ substantially? What has been the transmission of shocks from the domestic market to the foreign exchange? The present book delves into these questions in the context of prices of domestic shares and the prices of their counterparts of DRs listed on a foreign stock exchange. The rest of this chapter is organised as follows. The concept of DRs, and the global, and Indian experiences are discussed in sections 1.2, 1.3, and 1.4, respectively. Section 1.5 is in the nature of a brief description of the different exchanges in the world where Indian DRs have been listed. Section 1.6 gives an inkling of the focus of the book.

1.2 What Are Depositary Receipts? A larger proportion of a firm’s activities are geared towards offering products and services that are of value to customers and that fall within the realm

4

Introduction

of its core competency. Having said so, a substantial amount of managerial talent and time is also devoted to deciding on the kind of long-term investments that a firm needs to make to grow and the avenues that a firm needs to tap to finance such long-term investments. During its formative years, a firm raises a considerable portion of capital from financial intermediaries such as banks to meet its long-term as well as day-to-day capital requirements. In due course of time, the firm starts tapping the capital markets to raise capital so that it is not solely dependent on bank credit to meet its requirements. Raising capital through the markets calls for the issuance of equity or debt or hybrid security that possesses certain characteristics of debt as well as common equity. To start with, a firm would engage an Investment Bank that would guide the firm at each stage as it approaches the capital markets. Typically, an investment bank possesses unique skillsets and is wellequipped to draw upon its extensive experience to offer valuable counsel to firms that would enable firms to tap capital markets at competitive (attractive) valuations. Generally speaking, firms that are intent on broadening their source of capital through market mechanisms are bound to tap the domestic capital markets initially. Once they establish themselves in the eyes of domestic investors, they then undertake concerted efforts to tap capital in overseas capital markets. Having said so, there have been instances in the past, especially in India, wherein firms that were unlisted in Indian capital markets succeeded in raising overseas capital. At the risk of oversimplification, it may be noted that overseas capital could be raised by one of the following three routes. It could be in the form of foreign currency debt that comes with a cost and attendant contractual obligation. Or, it could be in the form of issuance of hybrid securities such as, but not limited to, foreign currency convertible bonds, that offer an option for bondholders to convert their debt into equity at a predetermined time. Or, it could be in the form of issuance of foreign currency common equity shares with each equity share issued to overseas investors representing a certain number of domestic shares of the firm. Such equity shares that are issued to overseas investors are referred to as Depositary receipts (DRs). Types of DRs DRs that are issued to investors in the US are generally referred to as American Depositary Receipts (ADRs), while DRs issued to investors outside the US are referred to as Global Depositary receipts (GDRs). ADRs could be issued to the broader public or they could be privately placed with Qualified

Introduction 5 Institutional Buyers (QIBs).3 Public ADRs can be of three types namely level I, II, and III. Level I ADRs is those that are listed in the Over-theCounter (OTC) Market in US, while level II and level III ADRs are listed in stock exchanges such as the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotation (Nasdaq). Private placement happens in the Rule144A market. Along similar lines, GDRs can be issued to investors in two or more foreign trading locations in accordance with Rule144A and Regulation S (Reg S) of the United States Securities Act of 1933. So, Reg S GDRs issued to non-US investors trade concurrently with 144A DRs placed in the US market. Rule 144A offers a gateway for the resale of GDRs issued to nonUS investors to QIBs in the US in a restricted manner. GDR programmes that offer GDRs simultaneously in Reg S as well as in 144A forms in two distinct tranches are referred to as bifurcated GDR programmes while those that offer Reg S as well as 144 A forms in the same tranche are referred to as unitary GDR programmes. GDRs are largely traded in Luxembourg Stock Exchange and London Stock Exchange. Second, DRs could be classified as sponsored and unsponsored DR. Sponsored DRs are those that are issued by an exclusive depositary that is appointed by the issuing firm. The issuing firm as well as the exclusive depositary enter into a depositary agreement whereby the depositary agrees to issue DRs and the issuer agrees to cover certain costs of the depositary such as dividend disbursement fees and, in some cases, the administrative fees of the depositary. On the other hand, unsponsored DRs are issued by a depositary based on demand in the marketplace without a formal agreement with the foreign firm.

1.3 ADRs/GDRs – The Global Experience The first ADR in history was an unsponsored ADR that was issued by the then Guaranty Trust Company on Selfridge Provincial Stores Ltd. in 1927. It is speculated that the idea behind the issuance of ADRs may have come from Holland where Dutch trust companies followed a practice of issuing registered bearer receipts for stocks that were traded in the US (Fountain, 1969). Subsequently, in 1928, ADRs of British American Tobacco (U.K.), L’Air Liquide (France), and Creditansalt (Austria) were issued by Guaranty Trust Company. Most notably, the British American Tobacco ADRs were listed in the then New York Curb Exchange. Circa 1930, New York Curb Exchange was the leading international stock market that listed more foreign issues than all domestic issues combined.4 Other notable ADR issuances by Guaranty Trust Company include the North German Lloyd ADRs

6

Introduction

in 1929 and the Electrical and Musical Industries (EMI) sponsored ADR in 1931. Between 1927 and the stock market crash of 1929, the US stock market witnessed issuance of 17 unsponsored DRs, apart from the Selfridge ADR of 1927 (Gande, 1997). The stock market crash of 1929 and the ensuing Great Depression offered the much-needed impetus for the setting up the US Securities and Exchange Commission (SEC) for regulating the securities markets and protecting the interest of the investors. Among many things, SEC came up with a set of stringent requirements that need to be met for foreign firms intending to list in US securities markets. As a result, there was a lull in the DR market until 1955. However, the tide began to turn in the mid-1950s when 80 members of the New York Society of Security Analysts (NSSA) representing bankers, brokerage firms, insurance companies, and investment funds decided to visit London, Paris, Milan, Frankfurt, and Amsterdam to examine principal European stock exchanges and companies. The birth of common European Economic Community (EEC) in 1957 and then the actions by European nations to make their currencies convertible served as an impetus for this trip, for the NSSA members believed that such a trip would help in nudging foreign companies to comply with US rules and in turn would open gateways for trading ADRs of such foreign companies in the future. During the 1960s, 100 Japanese firms evinced interest in issuing ADRs by responding to a survey conducted by the Government of Japan. Ministry of Finance, Government of Japan accorded approval to 16 Japanese companies. These included Sony, Toshiba, Hitachi, and Yawata Steel. Co., Mitsubishi Corp., and Mitsui & Co. Ltd.5 In 1961, Sony was the first Japanese company to issue ADRs.6 The 1990s witnessed a spurt in DR issuance by companies across the globe. This was largely driven by a confluence of events across the globe. For one, the 1990s was the time when large-scale privatisation of government firms took place across the globe. Nations that were philosophically predisposed to socialism and its associated moorings till then finally realised the allocative efficiency of markets and this in turn served as a catalyst for many companies to look outward and tap offshore markets for private capital. In addition, Rule 144A put forth by SEC relaxed the earlier requirement for institutional buyers to hold on to private placements before trading them. Further, London Stock Exchange came about with regulations that enable foreign issuers to issue sterling-denominated GDRs (Kumar, 2006). Having provided a glimpse of the historical circumstances that paved way for ADRs/GDRs in the global arena, we turn to the narrative on ADRs/ GDRs in the context of Indian issuers.

Introduction 7

1.4 ADRs/GDRs – The Indian Story While Indian economic reforms that were undertaken by the policymakers were largely a journey of gradualism, it was interspersed with notable deeper reforms such as the reforms-by-stealth of the late 1980s (Panagariya, 2004; Ahluwalia, 2002) and the big-bang reforms of July 1991. The financial sector reforms, primarily undertaken during the years 1993 to 1996, were grounded upon India’s late recognition of the superior allocative efficiency of open financial markets characterised by adequate investor protections, strong information disclosure requirements and efficient market microstructures. These financial sector reforms went a long way in lending credibility to the 1991 big bang reforms that marked a philosophical shift in India’s approach to economic reforms. The post-liberalisation reform in financial markets was predisposed towards equity markets. This was reflected in the proclivity of Indian companies pertaining to Information Technology (IT) and Information Technology Enabled Services (ITES) space to raise capital by issuing equity as opposed to debt. Consequently, the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depositary receipt Mechanism) Scheme of 1993 (hereafter referred to as the 1993 Scheme) that enabled Indian companies to raise overseas capital by issuing DRs was biased towards equity investments in Indian companies (Datta, 2015). This inherent bias in the 1993 scheme was also evident in the subsequent amendments to the scheme such as the permission to issue DR-linked Employee Stock Options (ESOPs) for Indian software firms in June 1998 and for Indian pharmaceuticals and biotechnology firms in March 2000. Reliance Industries Ltd. was the first firm to issue DRs through the 1993 scheme. It was followed by firms such as Hindalco Ltd., Bombay Dyeing and Manufacturing Company, Finolex Cables, Arvind Mills, India Hotel, Larsen and Toubro, Videocon International, CESC, Crompton Greaves, and Great Eastern Shipping (Bantwa, 2020). Since then, a large number of Indian firms availed of the 1993 scheme to issue DRs and, in many instances, to raise capital from global investors. Between 1992 and 2015, a total of 330 Indian firms issued DRs across the globe. For instance, Rolta India Ltd. raised capital by issuing GDRs in 2006. Also, Noida Toll Bridge Co. Ltd. raised capital by GDR issuance in the London Stock Exchange and in due course of time, became the first Indian company to go for a follow-on public offer on London Stock Exchange (Chouksey, 2008). While a large proportion of capital raised by Indian firms is in the form of a few ADRs, a vast majority of the outstanding DR issues issued by Indian firms are listed on the Luxembourg Stock Exchange.

8

Introduction

But for matters pertaining to foreign currency convertible bonds, the 1993 Scheme was repealed and replaced by the Depositary Receipts Scheme of 2014. As per the depositary receipts scheme of 2014, firms were given the option to decide whether voting rights could be accorded to DR holders. In due course, relevant regulations such as Securities Contracts (regulation) Rules of 1957 and takeover regulations of 2011 were amended to ensure that shares underlying DRs were accounted for while tabulating a firm’s public shareholding information. Consequently, the DR holders would possess voting rights should they cancel their DRs and in turn take delivery of the underlying domestic shares of Indian firms. Until such time that DRs are active in the hands of the overseas investors, they have the right to offer voting instructions to the Depositary bank and the depositary bank is authorised to exercise voting rights on behalf of the DR holders (Nair and Snehil, 2019).

1.5 Major Stock Exchanges in the World At the risk of stating the obvious, in order to understand the law of one price of anything, it is important to start with a description of the marketplace. Since our interest is the stocks floated in the domestic country vis-à-vis their counterparts floated in a foreign country, we start with a brief description of regulatory and listing requirements of the major stock exchanges of the world, wherein the DRs issued by Indian firms trade.7 London Stock Exchange Presently London Stock Exchange (LSE) is the world’s most international exchange with 40% of its listings pertaining to firms based outside the UK. LSE’s International Order Book (IOB) is the world’s most liquid platform for trading of GDRs (Global Depositary Receipts). Presently Reliance Industries GDR is one of the most widely traded DR on the IOB platform.8 To raise capital in LSE via GDRs, a non-sovereign entity is required to have at least 25% of outstanding shares in public hands. Further, the entity should possess 3 years of operating history and have a minimum market capitalisation of GBP 700,000. The LSE flagship market is called the Main Market wherein firms could take measures to list in the Premium segment or the Standard segment. Premium listing is available only for common equities and close-ended as well as open-ended investment vehicles. Firms that intend to list on the Premium segment of the main markets have to meet the listing requirements that are considered to be more onerous than EU minimum requirements. Standard listing segment of the main market is open to firms intending to issue shares, GDRs, debt and other securitised

Introduction 9 derivatives by complying with the EU minimum requirements. Listing in the main market entails restatement of financial information of non-UK firms as per International Financial Reporting Standards (IFRS).9 Further firms listed in the main market are required to furnish annual financial reports within 4 months of the end of the fiscal year and half-yearly financial statements within 2 months of the end of the period. Equities listed in the Premium, as well as Standard segments, are traded on LSE’s Stock Exchange Electronic Trading Service (SETS) order book while DRs listed in the Standard segment are traded on LSE’s IOB.10 LSE’s Professional Services Market (PSM) is a specialist market that is geared towards enabling companies to raise capital through the issuance of debt securities and/or DRs to professional investors. A listing in PSM does not call for a restatement of a firm’s financial information as per IFRS or GAAP, for financial statements in National GAAP should suffice.11 Issuers in PSM are required to furnish annual reports within 6 months of the end of the fiscal year. Listing in LSE comes with an initial (admission) fee followed by an annual fee.12 The admission fee is based on the market capitalisation of the firm approaching LSE for an issue. When it comes to annual fees, issuers of actively traded DRs are required to pay an annual fee of GBP 60,000. In addition, issuers of securities that avail of Central Counterparty clearing services are required to pay an annual fee of GBP 31,500 while those that do not avail the central counterparty clearing services are required to pay an annual fee of GBP 12,500. Luxembourg Stock Exchange Luxembourg group comprises the Luxembourg Stock Exchange (LuxSE) and Fundsquare, which is a wholly owned subsidiary that offers information services and regulatory services for the fund industry. Issuers may decide to list their securities on Bourse de Luxembourg or in the Euro-MTF Market. Bourse-de-Luxembourg (BdL) is regulated by European Union (EU) while Euro-MTF is an exchange-regulated multi-trading facility.13 The first GDR that was listed in the Luxembourg was issued by Samsung in 1990. Presently, more than 37,000 securities issued by more than 2,000 issuers are listed on LuxSE. Further, 118 sovereign and quasi-sovereign issuers are listed on LuxSE.14 Also, 41.5% of all securities listed in LuxSE are listed on the Euro-MTF platform. An issuer intent on listing in the BdL market would have to get its prospectus reviewed and approved by the Luxembourg Financial Supervisory Authority, which is Commission de Surveillance du Secteur Financier (CSSF). On the other hand, the prospectus for an issue pertaining to the

10

Introduction

Euro-MTF market would be reviewed and approved by the exchange. Issuers listed on BdL market could use the same prospectus to list on other EU markets.15 Issuers in the Euro-MTF market have the flexibility to present their financial information as per IFRS or Local GAAP. Firms aiming to list on the Euro-MTF market should have a market capitalisation of EUR 1 million, a minimum public float of 25%, and their securities should be fungible, freely negotiable, and eligible for clearing and settlement.16 Presently, a first-time DR listing by an issuer entails an approval fee and a listing fee of EUR 2,500 each, while a subsequent DR listing entails an approval fee and a listing fee of EUR 1250 each. The maintenance fee ranges from EUR 2,500 per year to EUR 625 per year based on the quotation line17 and is the same for first-time as well as subsequent DR listings.18 Firms that are yet to publish financial statements for 3 years are classified as recently established firms and the fee structure for such firms are as follows. A first-time DR listing entails an approval fee of EUR 2,500 and a listing fee of EUR 5,000 while subsequent DR listing of a recently established firm entails an approval fee and a subsequent list fee of EUR 1,250 each. Maintenance fee for DR listing of recently established firm ranges from EUR 5,000 per year to EUR 1,250 per year based on the quotation line and is the same for first-time as well as subsequent DR listings. US Stock Exchanges The likely avenues for ADR listing are the New York Stock Exchange (NYSE), Over-the-Counter (OTC) market, OTCQX, and the National Association of Securities Dealers (Nasdaq) system. As of January 2022, 81.29% of all outstanding ADRs issuances pertain to the OTC markets.19 Further, no capital was raised from 87% of all outstanding ADRs that are listed in the aforementioned American Exchanges. In fact, an overwhelming 92% of non-capital raising ADRs are listed on OTC Markets. The OTC Markets are operated by the OTC Market Group OTC Trading in OTC markets can happen at three levels. They are OTC Pink, OTCQB, and OTCQX. Of the three available OTC market levels, OTCQX is the top-tier. Issuers intent on trading on OTCQX are required to meet high financial standards, possess good corporate governance practices, be forthcoming when it comes to information disclosure, be compliant with US securities law at all times and have a third-party sponsor.20 OTCQB is the middle tier wherein early-stage companies that are unable to meet

Introduction 11 financial standards and information disclosure requirements of OCTQX, trade. OTC Pink is a marketplace that is geared for ADRs of all kinds of companies, with no demand whatsoever with regard to financial standards and/or reporting requirements. Issuers in the OTC market are required to file form F-6 to SEC. NYSE For ADR listing on NYSE, Issuers should have a minimum public float of USD 100 million or USD 60 million for an affiliated company. Further firms should have an operating history of 3 years and must meet one of the following financial standards namely Earnings Test, Valuation/Revenue test and Affiliated Company test. Affiliated companies must have an operating history of 12 months prior to applying for listing on NYSE. Also, all firms are required to restate their financial statements that were originally prepared based on National GAAP as per US GAAP. Some firms may seek permission to prepare or restate their financial statements as per IFRS as opposed to US GAAP. Listing on NYSE entails a fee of $0.004 per share, a one-time fee of USD 50,000, and a maximum total fee of USD 295,000 that is inclusive of a one-time fee of USD 50,000. In addition, listing on NYSE entails an annual fee of $0.000105 per share with a minimum fee of USD 59,500. Nasdaq Nasdaq comprises three markets namely the Nasdaq Global Select Market, Nasdaq Global Market, and Nasdaq Capital Market. Of the three markets, the Nasdaq Capital Market is relatively the most accommodative (least stringent) when it comes to the initial requirements, while the Nasdaq Global Market is relatively more stringent than the Nasdaq Capital Market and the Nasdaq Global Select Market is the most stringent of all. ADR listing on Nasdaq Global Select and Global Markets entails an annual fee that ranges from USD 48,000 to USD 186,000, while ADR listing on Nasdaq Capital Market entails an annual fee that ranges from USD 45,000 to USD 54,500. Also, the Entry Fee in Nasdaq Global Select Markets and Nasdaq Global Markets ranges from USD 150,000 to USD 295,000 which includes an application fee of USD 25,000 while the Entry Fee in Nasdaq Capital Market ranges from USD 50,000 to USD 75,000 that includes an application fee of USD 5,000. The entry and annual fee slabs for all three markets are dictated by the total number of shares outstanding of the issuing firm.21

12

Introduction

Indian Stock Exchanges The Stock Exchange, Mumbai (popularly called the Bombay Stock Exchange or BSE) established in 1875, is Asia’s oldest stock exchange. As of February 2021, the market cap of BSE stood at $2.8 trillion. The National Stock Exchange or NSE was established in 1992 so as to provide a decentralised electronic trading platform for investors. As per the latest records, the market cap of NSE was $2.27 trillion. Both BSE and NSE are based out of Mumbai, Maharashtra. Since April 2019, a total of INR 1.77 trillion was raised through Indian stock exchanges and 75% of such funds was raised through BSE.22 As of March 2022, shares of 5250 companies are listed on BSE. In addition, BSE happens to be the leading exchange platform when it comes to Offer of Sale (OFS) and Offer to Buy (OTB) issues.23 Also, BSE was the first Indian exchange to receive approval from SEBI to launch a Small and Medium Enterprises (SME) platform in September 2011. As of March 2022, a total of 232 firms are listed on BSE’s SME platform with a cumulative market capitalisation of INR 171.89 billion. Also, 57% of all privately placed debt issuances pertaining to all the Indian exchanges since July 2016, took place on BSE’s BOND platform. As part of the Indian financial sector reforms in 1992, National Stock Exchange (NSE) of India was set up as a limited liability company wherein the shareholders appointed a board of directors and the management team, and the brokers were the franchisees of the exchange who neither owned the exchange nor represented the board of directors or the management team (Shah and Thomas, 2000). NSE was the first stock exchange in India to adopt electronic trading systems. In 2021, according to the Futures Industries Association, NSE emerged as the world’s largest exchange for derivatives in 2021, for the third straight year. Further, as per World Federation of Exchanges, NSE ranked fourth in the number of trades for cash equities for the year 2021. Services offered by NSE include exchange listings, trading, clearing and settlement services, technology solutions, financial education services, and market data feeds. As of December 2021, a total of 1,920 firms were listed on NSE. The cumulative market capitalisation of these actively traded firms, as of December 2021, was INR 259.83 trillion.

1.6 Our Focus As we have already pointed out, DRs that are trading in different geographical locations are subject to the regulatory requirements of their location of trade. We saw, for instance, that of all the trading locations, DRs that are listed on US stock exchanges and are used to raise capital from American

Introduction 13 Investors are subject to most stringent regulatory requirements and they call for extensive information disclosures by the issuing firm, from time to time, as mandated by the Securities Exchange Commission (SEC) of US. On the other hand, the regulatory requirements in connection with DRs listed in Luxembourg or for that matter in London are relatively lenient as compared to the US. Notwithstanding differences in regulatory environment across trading locations, the time paths of DR prices are to a larger extent bound by the time paths of the domestic shares of the issuing firm. Since the holders of DRs, as well as domestic shares, have the same claim to the underlying cash flow for equity holders of the firm, the prices of DRs and underlying domestic shares are bound to be intertwined and this phenomenon is referred to as the law of one price. Having said so, there could be market impediments that preclude the prevalence of the law of one price at all times even in this day and age of interconnected markets characterised by automated trading systems and sophisticated (informed) investors. Consequently, the central intent behind this book is to examine the prevalence of the law of one price or the lack of it. Such a discussion throws a great deal of light on the interconnectedness of global markets. While this happens to be the key focus of this quest, we have tried to present the world of DRs to readers in a simple and logical way and in a manner where s/he can relate. The rest of the book is organised as follows. While discussing the key features of DRs, Chapter 2 deals with the global and Indian trends of DRs. Chapter 3 is more technical in nature and specifically raises two questions: (a) are the returns of Indian stocks and their DRs related? and (b) Is there any relationship between the variabilities of Indian stocks and their foreign counterparts? Chapter 4 is in the nature of a concluding chapter and way ahead.

Notes 1 It has been noted that the law of one price is an outcome of “the impact of market arbitrage and trade on the prices of identical commodities that are exchanged in two or more markets. In an efficient market there must be, in effect, only one price of such commodities regardless of where they are traded” (https://eh.net/ encyclopedia/the-law-of-one-price/). 2 Illustratively, as of April 2022, a Big Mac costs £3.59 in Great Britain and US$5.81 in the United States. Assuming the prices of the Big Mac is same in UK and the US (i.e. £3.59 = US$5.81), the implied exchange rate works out to be 3.59 / 5.81 = 0.62. As the actual exchange rate is 0.75, it implies that the British pound is overvalued by 17.1 per cent; see The Economist (February 2, 2022) for details. 3 QIBs are sophisticated US investors that do not require the protections that typical retail investors would require. QIBs are institutional investors that own or

14

4

5 6 7

8 9 10 11

12 13

14 15 16 17

Introduction manage at least USD 100 million worth of securities or broker-dealers that possess at least USD 10 million investments in non-affiliated entities. New York Curb Exchange, which came into existence in 1929 owing to rechristening of the then New York Curb Market, was renamed as American Stock Exchange (AMEX) in 1953. In 2008 AMEX became part of the New York Stock Exchange (NYSE) and its equity market was renamed as NYSE MKT in 2012. Presently, NSYE, NYSE MKT and NYSE Amex Options are owned by Intercontinental Exchange. Source: www.sony.com/en/SonyInfo/CorporateInfo/History/SonyHistory/1-12. html#block3 Source: www.nomuraholdings.com/investor/library/ar/2018/pdf/nomura_ report_07_08.pdf In terms of market capitalization, following stock markets are the biggest in the world (with value of market capitalization in brackets) as of April 2020: (1) NYSE ($28.19 trillion); (2) Nasdaq ($12.98 trillion); (3) Japan Exchange Group ($5.37 trillion); (4) Shanghai Stock Exchange ($4.92 trillion); (5) Hong Kong Exchanges ($4.48 trillion); (6) Euronext ($3.85 trillion); (7) Shenzhen Stock Exchange ($3.49 trillion); (8) London Stock Exchange ($3.13 trillion); (9) Saudi Stock Exchange ($2.15 trillion); and (10) TMX Group ($1.97 trillion). Our selection of stock exchanges has been motivated by Indian companies’ propensity to list their DRs. Source: www.londonstockexchange.com/discover/news-and-insights/indianoverseas-listing-policy IFRS is a set of accounting standards that govern the way in which firm activities that have monetary implications are captured in the financial statements. IFRS is promulgated by International Accounting Standards Board (IASB) of London. www.pwc.com/mn/en/capital-markets/assets/mn_successful_listing_in_london_ eng.pdf GAAP stands for Generally Accepted Accounting Principles and it refers to principles, standards and procedures that firms must adhere to when it comes to financial reporting in US. GAAP is promulgated by Financial Accounting Standards Board (FASB) of US. GAAP are rule-based prescriptive accounting standards primarily meant for American companies that face high levels of litigation risk, while IFRS are principle-oriented accounting standards that offer relatively greater leeway to managers when it comes to financial reporting. A firm that partially follows the GAAP with certain exceptions is said to follow National GAAP or Local GAAP. Source:www.citibank.com/mss/sa/flippingbook/2018/The-Role-of-the-Deposi taryBank//files/assets/common/downloads/ The Role of the Depositary Bank. pdf Multi-Trading Facility is a multilateral system that is operated by an investment firm or a market operator that brings together buyers and sellers of financial instruments whereby contracts fructify between counterparties in-accordance with rules prescribed by the EU Markets in Financial Instruments Directive (MIFiD). Source: www.bourse.lu/listing This is referred to as EU Passporting. www.bourse.lu/listing-shares-gdr-euro-mtf A quotation line refers to a single International Securities Identification Number (ISIN) code, which is a 12-digit alphanumeric code that uniquely identifies a

Introduction 15

18 19 20 21 22 23

security. There can be instances wherein a certain security may be split and admitted for trading on more than one ISIN. In such cases, the maintenance fee would be charged by the exchange for each of the ISINs (quotation lines). Source: www.bourse.lu/documents/fees-LISTING-services_2021.pdf This is based on authors’ calculations of the data retrieved from www.adrbnym ellon.com/directory/dr-directory Source: https://finance.yahoo.com/news/otcqx-vs-otcqb-vs-pink-171211773. html Source: https://listingcenter.Nasdaq.com/assets/initialguide.pdf Source: www.bseindia.com/downloads1/BSE_update_Mar_2022.pdf OFS is an exchange provided mechanism by which the promoters of a firm dilute their shareholders in a transparent manner and in the process call for wider participation of the investors, while OTB is an exchange provided window that facilitates buyback, takeover, and delisting of firms.

2

Depositary Receipts Global Trends and the Indian Story

2.1 Prologue As already explained, a depositary receipt (DR) is typically a mechanism through which a corporate in an emerging market economy floats its shares in a developed country stock market. Definitionally, a DR is ‘a type of . . . transferable financial security that is traded on a local stock exchange but represents a security, usually in the form of equity, that is issued by a foreign publicly listed company’ (Investopedia). Put simply, a DR is a counterpart of a domestic share of the home company that is floated and traded in a foreign stock exchange. When listed in a US stock exchange, a DR is called American Depositary Receipts (ADR). Sometimes, definitions vary marginally across countries. Illustratively, the US securities regulator, the Securities and Exchange Commission (SEC), defines ADRs as ‘negotiable certificate that evidences an ownership interest in American Depositary Shares (ADSs) which, in turn, represent an interest in the shares of a non-US company that have been deposited with a US bank’. Note that the expressions American Depositary Shares (ADSs) and American Depositary Receipts (ADRs) are often used interchangeably in popular parlance and refer to the listed share of a domestic company in a foreign stock market. Being essentially conduits for capital flows, DRs have implications for financial globalisation. In fact, globalisation in general and financial globalisation, in particular, have progressed hugely since the 1990s. Against this backdrop, our focus in the present book is primarily on the DRs of an emerging economy like India. What has been the global trends in the DR market? What has been the Indian experience? What are the rationales for floating DRs? What are the benefits of DRs for a country like India? This chapter delves into some of these questions. For expository convenience, the rest of the chapter is organised as follows. While Section 2.2 is devoted to firms’ motivation to float DRs, Section 2.3 discusses the benefits of DRs to an economy. Global and Indian trends of DRs is tracked in Sections 2.4 and 2.5, respectively. Section 2.6 DOI: 10.4324/9781003378686-2

Depositary Receipts 17 is devoted to the twin phenomena of peak and near-demise of DRs in India. Section 2.7 concludes.

2.2 Why Do Companies Float DRs? Issuance of DRs brings about a whole host of advantages for the issuing firm. To start with, Depositary Receipts offer the much-needed gateway to raise capital from international investors. This, in turn, leads to an enhanced shareholder base for issuing companies. Further, DR issuances in global stock markets that possess stringent listing guidelines increase investor protection, not to mention enhanced liquidity for investors. From a corporate finance perspective, such global access to capital coupled with liberal tax environments in international jurisdictions would aid in the reduction of the cost of capital and concurrent enhancement in enterprise valuation and shareholder wealth. All these intuitions are drawn from extensive technical literature on ADR/ GDR. While discussion of such technical literature is beyond the scope of the present book, to sum up, the significant incentives for the firms to float a DR are enumerated as follows: 1 2 3 4 5 6 7

enhanced shareholder base; increased visibility of the company; enhanced ability to raise capital; access to a more liberal tax environment; increased trading liquidity; reduction in the cost of capital; and improvement in investor protection.

While the big bang reforms of 1991 paved the way for the liberalisation of the Indian economy in general, Depositary Receipts played an instrumental role in catapulting Indian companies into the global arena. Indian companies, hitherto less known in global circles, were able to signal their quality in the eyes of the international investors and foreign regulators by listing their depositary receipts in global stock markets with stringent guidelines. Further, these Depositary receipts also offered foreign (international) investors an opportunity to seriously consider Indian companies as part of their global investment basket. Before the arrival of DRs, foreigners intending to invest in the Indian stock market had to do so as Foreign Portfolio Investors. In doing so, FPIs were exposed to changes in the value of their investment portfolio and the returns realised from such portfolios owing to changes in the price of their currency vis-à-vis the Indian Rupee (INR). Also, FPIs were required to follow guidelines

18

Depositary Receipts

issued by the Securities and Exchange Board of India (SEBI) from time to time. In a way, Depositary Receipts mitigated currency risk for international investors. They made it easy for international investors to take cognisance of the Indian growth story in general and Indian corporates in particular. How do DRs work? To understand the role of a DR, apart from the company issuing shares, two banks in two countries (viz., domestic and foreign) play a crucial role. Hence, the following three types of agents may be introduced at the very outset. • • •

First, the issuer is the company that taps the foreign market through the issue of a DR. Second, a Depositary is a foreign bank authorised by the Issuer Company to issue GDRs/ADRs against the issue of shares of Issuer Company. It acts as an overseas agent of the Issuer Company. Third, a Custodian is a domestic bank that acts as a custodian for the shares of the domestic company. While the custodian is appointed by the domestic bank, it operates in sync with the depositary (the foreign bank).

Figure 2.1 illustrates the typical structure of a DR between India and a Foreign Country, wherein a domestic issuer company keeps the underlying domestic shares with a local custodian and overseas investor invests in domestic share through DRs listed on the overseas stock exchange.

India:

underlying shares Issuer Company

Custodian

listed

Overseas:

European or US Stock Exchange

Depositary

dividend

monies

Overseas Investors

Figure 2.1 Illustrative structure of a DR Source: Desai and D’Souza (1998)

clearing house Euroclear / Cedel / Depositary Trust Company

Depositary Receipts 19 Many Indian corporates have followed this route of tapping the global market via global depositary receipts (GDRs) and American depositary receipts (ADRs) since 1993. Issuing of ADRs by companies such as Infosys in NASDAQ or VSNL in the New York Stock Exchange (NYSE) in and around 1999 or 2000 had attracted widespread attention. Of course, not all the DRs were floated in NASDAQ or NYSE. In fact, given the stringent listing requirements in the American stock exchange, in terms of both number and amount issued, the Luxembourg stock exchange emerged as the most preferred destination for DRs issued by Indian corporates. Indian companies tapping the DR market would have to come out with a DR pricing that is based on the recent closing prices of their domestic shares in the Indian stock exchanges. Further, the issuer has to come out with the conversion ratio that indicates the equivalency between DR and the local shares. For instance, Indiabulls Financial Services Ltd. had priced its GDR issuance in February 2005 such that each GDR listed in the Luxembourg stock exchange represented one domestic share of INR 2 each and was priced at USD 2.45 per GDR. This GDR pricing was at a discount of 5% to the average last 3 days closing price of the company’s shares on the National Stock Exchange of India. Upon completion of the issuance of DRs, the issuing Indian company is duty-bound to convene a meeting of the Board of Directors in general and the Finance Committee, in particular, to take stock of the DR issuance and allot a necessary number of fully paid-up shares that rank exactly on par (pari passu) with existing outstanding equity shares of the firm. Consequently, the issuing Indian company is duty-bound to inform the domestic stock exchanges of the above developments by way of corporate announcements. DR issues that are received well by the global markets are bound to be oversubscribed. The success of DR issuances is not just based on the sound firm fundamentals and the firm management’s clear articulation of the rationale and the near-term purpose of going in for DR issuances, but is also based on the critical role played by the intermediaries who provide their expertise based on past experience on these matters. Such intermediaries are the firms that serve as Global DR coordinators, book runners or lead managers.1 As is customary in Initial Public Offerings (IPOs), DR issuances may include a green shoe option that would enable the underwriters to issue additional DRs, if need be, to ensure price stability.2

2.3 Role of Depositary Receipts What is the role of DRs in a country like India? It may be helpful to initiate the discussion of DRs with a country’s external balance of payments (BoP). Put simply, a country’s BoP is a list of various ways in which a country can

20

Depositary Receipts

earn foreign exchange (say, US dollar) and in which a country can spend it. Note that there is an intrinsic difference between the domestic currency (e.g. Indian rupee, INR) and the foreign currency (say, US dollar or USD). While a country’s central bank (Reserve Bank of India or RBI in the case of India) can theoretically print any amount of domestic currency with the backing of the government securities of the domestic economy, it cannot print even one dollar. The list is typically put forward in a double entry bookkeeping where the two sides of the earnings and spending are always balanced. What are the ways in which India can earn/spend USD? Conceptually, these are divided into three groups: (a) goods, (b) services, and (c) assets (primarily financial assets). While (a) and (b) are said to be part of a country’s current account, (c) is referred to as a capital account. Specifically, items under the current account are primarily three: (a) export/import of goods; (b) exports/import of services; (c) inward/outward remittances. The capital account, on the other hand, comprises three major items: (a) investment (further divided into foreign direct investment (FDI), and foreign portfolio investment (FPI)), (b) borrowing (primarily external commercial borrowing); and (c) bank capital (primarily deposits of non-resident Indians). Table 2.1 illustrates India’s BoP for 2018–2019.3 Several features of the Indian economy are noticeable from table 2.4. The following are interesting in particular: 1 2

3

4

The Indian economy has a substantial deficit on merchandise account (or trade account, defined as the difference between goods and services). That is to say, we import much more than we export. This substantial merchandise deficit (USD 180 billion) has turned into a moderate current account deficit of around USD 57.3 billion because of a significant surplus on account of Invisibles. (Invisibles are those inflows/outflows that are not visible in the sense these items do not pass through sea-ports or airports. These include two critical items for India: (a) software; and (b) private transfers or remittances.) The current account deficit has to be financed by capital inflows, which comes on account of four primary sources: (a) foreign direct investment (USD 31 billion); (b) foreign portfolio investment (USD 618 million); (c) loans (USD 15.8 billion); and (d) banking capital (comprising foreign assets and foreign liabilities of commercial banks, including non-resident Indians’ deposits, amounting to USD 7 billion). Depositary receipts (USD 1.8 billion, item no. 9), representing the fresh floatation of stock by Indian corporates in foreign stock exchanges, are important items of capital inflow under foreign portfolio investment.

Depositary Receipts 21 Table 2.1 India’s balance of payments: 2018–2019 (USD million) No. Item 1 2 3 4 5 5 6 7 8 9 11 12 13 14 15 16 17 18

Credit (inflow) Debit (outflow) Net

6,43,719 A) Current account 3,37,237 A1) Merchandise 3,06,483 A2) Invisibles 5,42,482 B) Capital account 3,21,776 B1) Foreign investment 64,846 B1.a) Foreign direct investment B1.b1) Foreign portfolio 2,56,930 investment Foreign portfolio investment 2,53,714 in India i) of which FIIs 2,51,894 ii) of which GDRs/ADRs 1,820 Foreign portfolio investment 3,216 abroad 94,099 B.2) Loans 92,798 B.3) Banking capital 0 B.4) Rupee debt service 33,809 B.5) Other capital 582 C) Errors and omissions 11,86,784 D) Overall balance (A + B + C) E) Foreign exchange 17,502 reserves (increase –/ decrease +)

7,00,976 5,17,519 1,83,457 4,88,080 2,91,682 34,134

−57,256 −1,80,283 1,23,026 54,403 30,094 30,712

2,57,548

−618

2,54,118

−405

2,54,118 0 3,429

−2,225 1,820 −213

78,249 85,365 31 32,751 1,068 11,90,123

15,850 7,433 −31 1,057 −486 −3,339

14,162

3,339

Source: On-line Handbook on Indian Economy, RBI.

Thus, in the overall macro-economy, DRs are a vital source of foreign capital. Admittedly, as we see later, its importance as a source of foreign capital has been varied and exhibited huge year-to-year fluctuation. Illustratively, in 2019–2020, the net amount of inflows on account of DRs has been zero.

2.4 The Global Story of DRs As we noted earlier, Depositary Receipts (DRs) are negotiable instruments that offer an avenue for international investors to garner equity exposure in foreign companies without directly accessing the concerned foreign market. In other words, DRs act as a conduit for foreign companies to approach international capital markets. Such DR issuances are sponsored by a global depositary bank that serves as custodian of overseas shares of a foreign firm and possesses the necessary settlement, clearing, and stock transfer mechanisms for the creation, cancellation, and redemption of DRs.

22

Depositary Receipts

Since Indian corporates cannot directly list their equity shares on the international stock exchanges, they deposit shares to an overseas bank (typically in the US or Europe). These banks, issue receipts to the Indian corporates in return. These Indian corporates raise funds by providing these DR receipts in the overseas stock market. These DRs are listed in the world’s primary stock exchange; these can also be traded over the counter (OTC). Specifically, American Depositary Receipts (ADRs) are negotiable instruments issued by non-US companies in US stock markets that serve as an avenue for international diversification for American investors. The different types of ADRs available in the marketplace are Rule 144A, Level I, Level II, and Level III ADRs. These levels require further deliberation. •

•

•

Rule 144A ADRs are traded only among qualified institutional buyers (QIBs) in the PORTAL system. A QIB is defined as an institution, which owns and invests on a discretionary basis at least USD 100 million (or, in the case of registered broker-dealers, USD 10 million) in securities of an unaffiliated entity. While Level I ADRs are traded in the OTC market, Level II and III ADRs are listed in American stock exchanges such as NYSE, NASDAQ, and AMEX. Firms intent on issuing level II and/or level III ADRs are required to register with the Securities and Exchange Commission (SEC) and meet all reporting requirements. Further, firms that intend to raise capital from American investors in the US stock market would have to issue level III ADRs since level II ADRs cannot be used to raise capital from American investors. Global Depositary Receipts (GDRs) acts as a conduit for foreign companies to raise capital from non-US Investors. Level II/Level III GDRs are listed on foreign exchanges such as London Stock Exchange, Luxembourg Stock Exchange, and Frankfurt Stock Exchange through the Stock Exchange Automated Quotation System – International (SEAQ-I) platform. Interestingly, US Investors are not allowed to invest in such listed GDRs. However, in line with Rule 144A, Rule S enables depositary receipts issued to non-US Investors via private placement to be resold in US markets after a stipulated waiting period under ‘safe harbor’ transactions. Trading in Reg S. securities takes place in Designated Offshore Securities Market (DOSM). These include London International, Amsterdam, Brussels, Frankfurt, Luxembourg, Milan, Paris, Stockholm, Zurich, Johannesburg, Hong Kong, Tokyo, Toronto, Vancouver, Montreal, and Australia. Trade Settlements of DOSMs happen through European Clearing Agencies CEDEL or EUROCLEAR. GDRs are generally denominated in US dollars.

Depositary Receipts 23 In this chapter, the expression DRs refers to the sum total of all types of GDRs and ADRs together. Each depositary receipt denotes ownership of a specific number of foreign shares of an issuing firm. Subject to availability and conducive market conditions, an investor may acquire DRs either by buying DRs available in the marketplace or by converting underlying shares purchased in the issuer’s domestic market to new DRs. New DRs are created after an investor (or broker) deposits shares with the depositary’s local market custodian. The depositary then issues new DRs, which represent the shares on deposit, to the investor or broker. This is referred to as the issuance of DRs. Conversely, an investor may cancel the DRs and sell the underlying ordinary shares in the relevant home market upon delivery of the DRs and cancellation instructions to the depositary, which in turn withdraws the DRs and notifies its custodian to release the underlying shares. The investor or broker may then either safe-keep or sell the ordinary shares in the local market. As stated earlier, not all DRs enable issuing firms to raise capital from International Investors. While the firm-level advantages for issuing DRs are many, and they have been alluded to in Section 2.2, the primary catalyst behind firms’ issuing DRs is to gain access to capital by tapping international investors. Consequently, this section is geared towards offering a bird’s eye view of the scale of capital issuances that have taken place across the globe through DRs. Table 2.2 offers a snapshot of the countries whose firms have raised capital through depositary receipts to the tune of at least 5% of the total capital raised in the world by firms across all countries. Evidently, the firms pertaining to the BRIC economies have raised considerable capital through depositary receipts across the globe. In a way, international investors have played a part in the growth story of the BRIC economies by subscribing to DRs issued by global entrepreneurial firms of these countries. Further, an overwhelming proportion of capital issuances have taken place in the US, wherein the regulatory guidelines are relatively more stringent, and investor protection is paramount. Table 2.3 offers a snapshot of many DR issues for those countries whose firms have issued at least 5% of the total World DR issues across all countries. In doing so, it offers a glimpse of the concentration of DR issues amidst stock markets across the globe. When it comes to India, while the amount of capital issued at Luxembourg by Indian firms is way lesser than the amount raised in New York, outstanding DR issues at Luxembourg outnumber the issues in NASDAQ and NYSE put together. While table 2.2 features those countries whose firms have raised capital through DRs to the tune of at least 5% of the total capital raised globally, table 2.4 offers the distribution of different types of DRs issued by firms

24

Depositary Receipts

Table 2.2 Amount of active DRs issuances by select countries at major stock exchanges (in USD million, as on 31 December 2020) China Alternext Amsterdam London (LSE) Luxembourg NASDAQ New York OTC OTCQX Private Offering, Resales & Trading through automated Linkages (PORTAL) Unclassified Grand total Country total as % of world total

Russia

Taiwan

Brazil

India

Netherlands

2 5,841

31,749

30,326 65,308 2,397

29 103,900 31.03%

1,957 251 429

1,247 7,356 790 8,770 2,093

19,744 152

1,505 1,111 362 11,558 246

6,322

6,083

399

1,537

25 40,734 12.17%

26,339 7.87%

284 20,582 6.15%

1,406 17,725 5.29%

2,332 12,476 1,180 167

16,154 4.82%

Source: Capital Issuances Directory of Citigroup: Downloaded in January 2021; Accessible at https://depositaryreceipts.citi.com/adr/guides/capRaising.aspx?pageId=8&subpageID=4

Table 2.3 Number of active DR issuances by top five countries at major stock exchanges as on 31 December 2020 Stock exchange of London Luxembourg NASDAQ New York OTC OTCQX Private Offering, Resales & Trading through automated Linkages (PORTAL) Unclassified Grand total Active capital issuances as % of world total

China 5 93 92 8

1 199 21.08%

Taiwan

UK

India

Russia

4 38 6 8 5

7 25 1 19 4

43

1 66 7 1

32

1

17

8

93 9.85%

7 83 8.79%

9 82 8.69%

4 1 1

1 58 6.14%

Source: Capital Issuances Directory of Citigroup: Downloaded in January 2021; Accessible at https://depositaryreceipts.citi.com/adr/guides/capRaising.aspx?pageId=8&subpageID=4

Depositary Receipts 25 Table 2.4 Capital raised by issuers of each country (in USD million as on 31 December 2020)

China Russia1 Taiwan2 Brazil3 India4 Netherlands5

ADR

GDR – 144A+

GDR – Reg S++

Grand total

Country total as % of global total

98,030 2,638 11,556 19,897 12,024 14,378

359 8,946 8,199 399 1,496

5,511 29,126 6,115 284 3,423

103,900 40,734 26,339 20,582 17,725 16,154

31.03% 12.17% 7.87% 6.15% 5.29% 4.82%

Notes: Russia additionally issued USD 25 million of Revised ADRs (i.e. when the conversion ratio of one domestic stock to a foreign stock has been revised). 2 Taiwan additionally issued USD 469 million non-private placement GDRs. 3 BTG Pactual of Brazil additional issued USD 2 million of Global Depositary Units (GDUs) on Alternext Amsterdam Exchange. These GDUs comprised Global Depositary Shares of Banco BTG Pactual S.A. (Brazil) and BTG Pactual Participations (Bermuda). 4 India also issued USD 312 million of Unitary GDRs (i.e. GDRs issued in both the US and Europe) and USD 470 million of Revised ADRs (i.e. when conversion ratio of one domestic stock to a foreign stock has been revised). 5 Netherlands additionally issued USD 1776 million New York registry Shares (ADR-NYRS) as local laws in the Netherlands permits share registration to occur outside the Netherlands + Rule 144A GDRs are privately placed DRs that are issued and traded in accordance with Rule 144A, which is geared towards nudging non-US issuers to raise capital in the US. ++ The European component of a GDR is called Regulation S (Reg S), and it can be traded by only non-US persons. A GDR may have an explicit Reg S tranche meant for the European Market and a US Tranche privately placed under Rule 144A. In some instances, the American and European components of GDR are not offered as separate tranches, but instead, they exist in what is termed Unitary GDR. 1

Source: Capital Issuances Directory of Citigroup: Downloaded in January 2021; Accessible at https://depositaryreceipts.citi.com/adr/guides/capRaising.aspx?pageId=8&subpageID=4

pertaining to countries featured in table 2.2. In the case of China, Brazil, and India, an overwhelming proportion of capital issuances has happened through the American Depositary Receipts route. In the case of Russia, an overwhelming proportion of capital issuances have happened via the GDRReg S securities route.

2.5 DRs: The Indian Journey At the very outset, it is important to note that India does not have a fully open capital account. This means that there are restrictions on Indian corporates when accessing the global capital market and foreign entities in connection with an investment in the Indian financial market. While these

26

Depositary Receipts

restrictions were eased from time to time, some forms of restrictions still remain. But why is that so? Note the following. India traditionally tends to have a current account deficit. Should India completely open up its capital account, it would lead to substantial capital inflows during good times. Having said so, capital flows per se are often dictated by the moods of the global financial markets. As a result, a not-so-good year would lead to massive outflows of capital. This would lead to a sharp depreciation of the Indian rupee (INR) (say from USD 1 = Rs. 75 to USD 1 = Rs. 100), which would increase the nation’s oil import bill. Economists refer to this situation as tensions of the impossible trinity (figure 2.2). In simple words, no economy can have the following three things simultaneously: (a) an open capital account; (b) independent monetary policy (i.e. capability to fix domestic interest rate); and (c) fixed exchange rate. At best, a nation can manage (fix) two of these three things. For example, the US has an independent monetary policy and an open capital account, so USD is a freely floating exchange rate (i.e. the US chose a, and b and sacrificed c). The Indian authorities have selected an independent monetary policy and a reasonably flexible exchange rate, limiting capital account restrictions. Thus, capital account management has been an integral part of India’s exchange rate management (even if partially). The situation was, of course, different in 1991 when the Indian capital account was restricted entirely. India’s current and capital accounts were liberalised in a calibrated manner over the years. Allowing Indian corporates to issue stocks in the foreign stock exchange was part of this

Free cash Flow

a

Fixed exchange rate

b

c

Figure 2.2 Tensions of impossible trinity Source: Authors

Sovereign monetary policy

Depositary Receipts 27 liberalisation program. To begin with, Indian corporates were allowed to go global with the issue of GDRs and ADRs from November 1993. Initially, the foreign equity participation directly or indirectly through Euro-issues were restricted to 51% of the issued and subscribed capital of a company. In March 2001, two-way fungibility for Indian GDR/ADRs was introduced whereby converted local shares could be reconverted into GDR/ADR subject to sectoral caps (Hansda and Ray, 2002). Going forward, we discuss the regulatory structure of these DRs and relate the same with their time series behaviour. Regulatory Structure In 2005, the Government of India (Ministry of Finance) disallowed the issuance of GDRs without listing in India. Before such restriction was imposed, companies such as Sify, Satyam Infoway, and Rediff raised substantial funds by listing their GDRs/FCCBs in foreign stock exchanges and continued to remain unlisted in India. The Securities and Exchange Board of India (SEBI) supported this move by GOI in 2005 since it believed that it would help develop domestic capital markets and give it regulatory control over companies issuing GDRs/FCCBs. However, the poor performance of the domestic capital markets in the ensuing years and the consequent impact on the market sentiment made it difficult for companies to raise money from the domestic capital market. In such a situation, Indian groups or their founders started setting up offshore companies that owned assets in India through their Indian subsidiary. These offshore companies were solely dedicated to raising funds abroad, and they were subsequently listed on the back of their Indian subsidiary. In this background, the government decided in 2013 to permit Indian unlisted companies to issue ADRs/GDRs without the requirement to list in the domestic stock exchange, subject to the following conditions. 1 The companies will be permitted to list on exchanges in IOSCO/FATF4 compliant jurisdictions or those jurisdictions with which SEBI has signed bilateral agreements. 2 The companies will have to comply with SEBI’s disclosure requirements and that of the exchange where it is to be listed. 3 A copy of the return filed with the offshore exchange will also have to be filed with SEBI for the purposes of the Prevention of Money Laundering Act, 2002. 4 The raising of capital abroad shall be in accordance with the extant foreign direct investment policy (FDI Policy), including the sectoral caps, entry route, minimum capitalisation norms, and pricing norms.

28

Depositary Receipts

5 The number of underlying equity shares offered for issuance of ADRs/ GDRs to be kept with the local custodian shall be determined upfront, and the ratio of ADRs/GDRs to equity shares shall be decided upfront based on applicable FDI pricing norms of equity shares of the unlisted company. 6 The unlisted Indian company shall comply with the instructions on downstream investment as notified by the Reserve Bank from time to time. 7 The funds raised may be used for paying off overseas debt or for operations abroad, including for the funding of acquisitions. 8 The criteria for eligibility of unlisted companies raising funds through ADR/GDR shall be prescribed by the Government of India. 9 If the money raised in the offshore listing is not utilised overseas as described, it shall be remitted back to India within 15 days for domestic use and parked in Authorised Dealer (AD) category banks.5 10 The listing company shall report to RBI as prescribed under sub-paragraphs (2) and (3) of Paragraph 4 of Schedule 1 to FEMA Notification No. 20. The Ministry of Finance 2013 Amendment Scheme states that an investment made in a company through GDRs/FCCBs shall be treated as FDI and restricted to 51% of the issued and subscribed share capital of the issuing company. Further, the Amendment Scheme has to be read in conjunction with the FDI policy. In effect, even if FDI in a particular sector is permitted above 51%, investment through GDRs/FCCBs shall be restricted to only 51%. Further, the specific requirement to comply with the guidelines on downstream investment would prevent such Indian companies from accessing this route of raising capital wherein the company has downstream investments in sectors prohibited for foreign investment, or such investment is over the sectoral cap applicable to the sector in which the downstream investee company operates. Further, the 2013 Amendment Scheme permits unlisted companies to issue GDRs on a pilot basis for 2 years from the date of notification of the change. However, this led to uncertainty on whether the unlisted firms that have issued GDRs/FCCBs would be forced to list in the domestic stock market after the 2-year waiver. Moreover, as part of the 2014 budget speech, the then Indian Finance Minister announced a liberalised scheme for ADRs and GDRs based on the recommendations of the M.S. Sahoo Committee (Government of India, 2013). The liberalised scheme aimed to give an impetus to corporates to issue DRs backed by a wide range of securities other than equity. Despite the liberalised norms for depositary issuances, DR issuances did not take off as expected. This is because SEBI failed to share the same sense of

Depositary Receipts 29 urgency as GOI when offering the requisite regulatory push. It was concerned that ADRs and GDRs are difficult to monitor and could be used for money laundering and market manipulation. The liberalised DR norms, notified by the Government in June 2014 which came into existence in December 2014, also paved the way for unsponsored DRs, wherein the company or the issuer of the DRs isn’t involved in the issue of securities. SEBI was also concerned with difficulty in tracking the ultimate beneficiary of DRs and the likelihood of certain investors holding DRs of Indian companies gaining access to the underlying securities without their identity being known. In October 2019, SEBI came out with a circular on the framework for the issuance of DRs. Among many things, the circular clearly stated that only companies incorporated in India and listed on a Recognised Stock Exchange in India may issue Permissible Securities or provide an option for their holders to transfer Permissible Securities for the purpose of issuance DRs in Permissible Jurisdictions. Permissible jurisdictions are those jurisdictions identified by the Central Government from time to time as per the Prevention of Money Laundering Rules 2005. In November 2019, Central Government identified these permissible jurisdictions. In turn, SEBI came out with a circular on international exchanges in permissible jurisdictions on which DRs pertaining to Indian companies could be listed. Table 2.5 offers a snapshot of the permissible jurisdictions and international exchanges. Permissible securities meant equity shares and debt instruments of a company that are in dematerialised form and rank on par (side by side) with the domestic securities and are listed on a Recognised Stock Exchange. The permissible holders of such DRs should be those who are not residing in India and those who are not non-Resident Indians (NRIs).6 While NRIs Table 2.5 Permissible jurisdictions and international exchanges S. No.

Permissible jurisdiction

International exchange(s)

1 2 3 4 5 6 7 8

USA Japan South Korea United Kingdom France Germany Canada International Financial Services Centre in India

NASDAQ, NYSE Tokyo Stock Exchange Korea Exchange Inc. London Stock Exchange Euronext Paris Frankfurt Stock Exchange Toronto Stock Exchange India International Exchange, NSE International Exchange

Source: Govt. of India Notification and SEBI circular dated 28 November 2019

30

Depositary Receipts

per se were and continue to be outside the ambit of DR landscape, SEBI came out with a clarificatory circular in December 2020 based on representations received from market participants that permitted the issuance of DRs to NRIs pursuant to (a) share-based employment benefit schemes; (b) bonus issue; or (c) rights issue. But for these exceptions, NRIs are not permitted to acquire DRs or subscribe to new DR issuances. Further, in October 2020, SEBI, in consultation with market participants, issued broad operational guidelines that would enable Indian Depositories to develop a system that can monitor foreign holdings, including those held through DRs, in accordance with the Foreign Exchange Management Act of 1999. In a nutshell, the Indian policymakers’ perspectives on Indian companies’ appetite for the issuance of depositary receipts have evolved over time. Such an evolution in policy circles is reflected in the trajectory of promulgated regulations and the attendant frameworks put in place to address regulators’ concerns for market manipulation and the possible lack of clarity on beneficial owners in these markets. Twenty-five years after the 1991 big bang reforms, for the first time in the history of liberalised Indian Capital Markets, no capital was raised by way of DRs by Indian Corporate in 2016–2017. This dry spell in the DR landscape is attributed to eased domestic Qualified Institutional Placement (QIP) norms. In a QIP or an Offer-For-Sale (OFS), the issuer can raise funds from foreign institutions and Indian mutual funds and insurance companies with deep pockets. With the entry of foreign investors in India in general and the growing number of Private Equity players in particular, the appetite for capital issuances of Indian companies that possess dollar-driven earnings is being met by abundant PEs. Distribution of DR Issuances by Indian Firms What has been the preferred destination of Indian firms in terms of issuing DRs? Table 2.6 reports total capital raised by Indian firms in the form of DRs as of April 2019. New York Stock Exchange is clearly the most preferred destination, accounting for more than 60% of the total capital raised in the DR route by Indian firms. Admittedly, this is in tune with the importance of the New York stock exchange in global equity issuance. Interestingly, the importance of the Luxembourg stock exchange could be due to the less demanding listing requirements. Time Path of DRs What has been the historical pattern of ADR & GDR issuances? The following pattern emerges from figure 2.2:

Depositary Receipts 31 Table 2.6 DR issuances by Indian firms across different stock exchange (total capital raised as on end April 2019 in USD million) Exchange vs DR structure

ADR

GDR – 144A

GDR – Reg S

GDR – RADR Grand Unitary total

London Stock Exchange 0 370 1,135 0 Luxembourg Stock 0 72 1,599 190 Exchange NASDAQ 362 0 0 0 0 0 0 New York Stock Exchange 11,558 0 0 103 75 Over the Counter Exchange 55 1,071 100 0 Private Offering, Resales & Trading through automated Linkages 0 1,393 0 68 Unclassified Grand total 12,024 1,655 4,227 245

0 0

1,505 1,861

0 0 0 440

362 11,558 178 1,666

0 440

1,461 18,591

Source: Citibank Global DR Directory (available at https://depositaryreceipts.citi.com/adr/ guides/uig.aspx?pageId=8&subpageID=34

• • • •

After some steady increase, the amount of DRs touched its peak at about USD 6.6 billion, in 2007–2008, just before the global financial crisis. During the global financial crisis amount of DRs nosedived to around USD 1.1 billion. During 2009–2010, it experienced an increase and thereafter it experienced steady declines. After a lull over 2016–2017 and 2017–2018, it again experienced a spurt during 2018–2019, before reaching zero in 2019–2020.

This, in a nutshell, is the story of the rise and fall of DRs floated by the Indian corporates during 1992–2020. It started to experience some dynamism, reached its peak in 2007–2008 and almost died down by 2016. After experiencing a sharp rise in 2018–2019, it is again back to its lull. We will turn to these three phenomena, viz., its peak in 2007–2008, complete death during 2016–2017 through 2018–2019 and its upturn in 2018–2019, below.

2.6 The Peak and the Near-Demise of DRs by Indian Corporations In continuation, this section is devoted to probing into the twin phenomena of the peak of DR in 2007–2008 and the near-demise since 2016–2017. Peak DRs During 2007–2008 It is important to note that 2007–2008 was the year of exuberance just before the global financial crisis of 2008–2009. In fact, Indian growth of

32

7,000

6,645

Depositary Receipts

6,000

5,000

3,776

4,000

3,328

3,000 2,050

2,049 1,820

2,000

1,597 1,366

1,271

1,162 645

477

600

597

459

373

270 0

2005-06

187 0

2004-05

240

20

0

0

2017-18

683

2016-17

1,000

768 831

0

Figure 2.3 Issuance of depositary receipts by Indian firms during 1992–1993 through 2019–2020 (in USD million) Source: Handbook of Statistics, RBI, various issues.

2019-20

2018-19

2015-16

2014-15

2013-14

2012-13

2011-12

2010-11

2009-10

2008-09

2007-08

2006-07

2003-04

2002-03

2001-02

2000-01

1999-00

1998-99

1997-98

1996-97

1995-96

1994-95

1993-94

1992-93

0

Depositary Receipts 33 nearly 10% was far higher than global growth of 5.6% and 2.7% growth in the advanced economies (figure 2.4). It is, thus, no wonder that Indian firms could access the global capital market. In fact, during 2007–2008, net capital flows to India increased sharply to the US $ 108.0 billion (or 9.2% of GDP), which were 2.4 times higher than the level in 2006–2007; consequently, capital flows far exceeded the current account deficit. RBI Annual Report, 2007–2008 noted: Both debt and non-debt flows were higher during 2007–08. Direct and portfolio investment inflows and outflows increased sharply. . . . During 2007–08, portfolio investment, including FII flows, remained volatile. The gross inflows and gross outflows under portfolio investment, including FIIs, were of the order of US $ 235.6 billion and US $ 206.3 billion, respectively, resulting in a net inflow of US $ 29.3 billion during 2007–08 (US $ 3.2 billion in 2006–07). (RBI, 2008) As already indicated, by 2008, Indian companies were allowed to raise resources through the issue of ADR/GDR, and the eligibility of the issuer company was aligned with the requirements under the FDI policy. Interestingly, in the very next year, the capital market became much more subdued 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 -2.0 -4.0

World

Advanced economies

Emerging market

China

Figure 2.4 GDP growth rates of major economies and India: 2001–2019 Source: World Economic Outlook Database, IMF, April 2020.

2019

2018

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

-6.0

India

34

Depositary Receipts

‘reflecting depressed secondary markets, deceleration in the domestic output growth and associated contraction in investment demand, a sharp drop in FII exposure to Indian capital market and the overall adverse sentiment on account of the global crisis’ (RBI, 2009). What Caused the Demise of DRs in the Case of India? Various factors are held responsible behind this complete lack of interest in DRs in recent periods, for no new issuances of ADR and GDR took place in 2016–2017 and 2017–2018. It is helpful to remind ourselves that during the 1990s and early 2000s, various Indian corporates had taken recourse to ADR/GDR route to get a better valuation for equity and access to global investors. First, the development of the domestic qualified institutional placement (QIP) market seriously damaged the prospects of DRs. At the end of the day, QIPs turned out to be a more convenient and cheaper method for both the issuer and the investor. Illustratively, in 2017–2018, 22 companies mobilised INR 13,871 crore as compared with INR 14,358 crore raised in the previous year.7 Second, the movement of the rupee has been another factor behind the lack of interest in the DRs. There are views that the ADR/GDR route was popular when the rupee was weaker, and investors were more confident of investing in dollar or pound/euro-denominated instruments. Since the rupee has been stable or has been appreciating from 2016 through a large part of 2018, the attractiveness of DRs seems to have waned (figure 2.5).

35.0000 40.0000 45.0000 50.0000 55.0000 60.0000 65.0000 70.0000 75.0000

Figure 2.5 Exchange rate of Indian rupee relative to USD: 2000–2020 Source: Online Handbook on Indian Economy, RBI.

Jan-2020

Jan-2019

Jan-2018

Jan-2017

Jan-2016

Jan-2015

Jan-2014

Jan-2013

Jan-2012

Jan-2011

Jan-2010

Jan-2009

Jan-2008

Jan-2007

Jan-2006

Jan-2005

Jan-2004

Jan-2003

Jan-2002

Jan-2001

Jan-2000

80.0000

Depositary Receipts 35 Finally, it has been pointed out that DRs have become unattractive from a taxation perspective. Enhanced vigilance by taxation authorities and imposition of capital gains taxes (for the unlisted shares) could have caused a lull in the DR market. Spurt in 2018–2019 The year 2018–2019 was a good year for the Indian economy in terms of capital inflows. In fact, among the emerging market economies, India managed to attract the highest foreign portfolio investor (FPI) flows. Despite some lack of clarity on tax treatment on issuance and transfer of equity shares of companies incorporated in India that are listed on foreign exchange, inflows on account of ADR/GDR experienced a spurt and amounted to USD 1.8 billion. Not many corporates joined the race of issuing DRs. The 2018 GDR issues resulted from the corporate restructuring activities of firms like DishTV and Tube Investments (Madhavan and Ray, 2020).8

2.7 The Silent Emergence of China

50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

USD Million

While there has been a lull in DR issuances by Indian companies off and on, DRs continue to serve as a critical gateway for companies to raise capital across the globe. To put things in perspective, 2020 has witnessed a record amount of USD 48.4 billion raised by companies through DRs across world exchanges (see figure 2.6). In terms of countries, of all the capital that has been raised by firms across the globe via DRs from 1991 to 2020, Chinese firms have raised a whopping 31%, while Russian, Taiwanese, Brazilian, and Indian firms have raised

Year

Figure 2.6 Capital issuances through DRs across the world exchanges: 1991 to 2020 Source: Citibank Global DR Directory

36

Depositary Receipts

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Country-wsie DR Capital raised as a % of DR capital raised across globe

12.17%, 7.87%, 6.15% and 5.29%, respectively. Put differently, firms of China, Russia, Taiwan, Brazil, and India (CRTBI) have collectively raised 62.51% of total capital that has been raised by firms via DRs across the globe between 1991 and 2020. Figure 2.7 offers a snapshot of the year-wise capital raised by these select (CRTBI) countries from 1991 to 2020 as a percentage of total capital raised by all firms across the globe for the respective years. A large amount to the tune of USD 36.52 billion was raised by Chinese firms via DRs across the world’s stock exchanges in 2020. As seen in figure 2.7, Chinese firms raised 75% of total capital raised by all firms across the globe in 2020. This signifies the emergence of China as a key global player in the DR landscape. Further, figure 2.7 reflects the disproportionate role of Chinese firms when it comes to tapping the DR market to raise capital. The emergence of Chinese firms needs to be viewed in the context of deeper reforms undertaken by the Chinese authorities to liberalise the Chinese financial markets. Such reforms include easing restrictions on Chinese firms that are intent on issuing debt in exchanges, permitting the trading of stock options and bond futures, examining the feasibility of same-day settlement mechanism in Shanghai Stock Exchange (SSE), revamping the SSE benchmark, opening the financial markets for global investment banks, and pivoting to market-based loan origination and pricing system. While countries across the world were reeling from the debilitating economic effects of COVID-19 in 2020, the Chinese economy in general and Chinese firms, in particular, have proved to be the outliers when it comes to positive economic growth or, for that matter, a record amount of capital issuances across the globe.

China

Russia

Taiwan

Brazil

India

Figure 2.7 Capital issuances by firms based in select countries: 1991 to 2020 Source: Citibank Global DR Directory

Depositary Receipts 37 So while we ponder the decline and near-demise of DR issuances by Indian firms, we need to acknowledge the critical role of DRs amidst broader multi-faceted measures undertaken by the Chinese authorities in the recent past. In other words, the narrative on DRs is, to a more significant extent, country-specific and firms of different countries are bound to exhibit different degrees of involvement in the DR market. Epilogue DRs have been innovative instruments to list a domestic company’s stock in foreign exchange. In India, too, in the initial days of reforms, many corporates have followed this route of tapping the global market via GDRs and ADRs since 1993. Issuing of ADRs by companies such as Infosys in NASDAQ or VSNL in the New York Stock Exchange (NYSE) in and around 1999 or 2000 had attracted widespread attention. Admittedly, the choice of stock exchanges by the Indian corporates have been quite varied – NASDAQ, NYSE, Luxembourg all drew the attention of Indian DRs. While the DRs could have played a definitive role concerning the integration of the Indian financial markets with global counterparts, have they passed their prime? A lot can be attributed to the Indian policy regime. Interestingly, the liberalised DR scheme that came into effect on 15 December 2014, failed to rejuvenate the DR market. Two primary reasons may be cited for this lack of vitality. First, as there was a nagging concern that many GDRs could have resulted from the conversion of unaccounted money returning to India through a legal route, there has been some discomfort among the Indian regulators. In fact, in 2017, SEBI seemed to have barred 19 firms from the securities markets in India for manipulation in issuances of GDR. Second, domestic Qualified Institutional Placements (QIPs) have also emerged as a more convenient and cheaper mechanism to raise capital, eating into the attractiveness of DRs. Thus, while DR issuances by Indian firms offer an avenue for international investors to diversify risk in their investment portfolios, domestic institutional investors in India are left with very few routes (if any) to mitigate home bias. But without speculating about the future, what has been the relationship between the prices of a scrip listed in the domestic exchange vis-à-vis its foreign counterpart? Do they track each other? Are their volatilities related? We are going to delve into these questions in the following chapter.

Notes 1 A book runner is the lead coordinator in connection with a firm’s issuance of securities such as bonds, shares, and other hybrid instruments (Investopedia).

38

Depositary Receipts

2 An underwriter is an institution that undertakes risk associated with a transaction. The transactions could be issuance of depositary receipts, shares, bonds or rights issues. 3 We have taken the year 2018–19 purely as an illustration. The broad trends will be true for most of the recent period. 4 FATF stands for Financial Action Task Force. It is a global money laundering and terrorist financing watchdog. International Organisation of Securities Commissions (IOSCO) is an FATF observer organisation that brings together world’s securities regulators and is recognized as a standards setter in securities sector. 5 Authorised Dealer is a person or an entity that is authorized by Reserve Bank of India, under section 10(1) of Foreign Exchange Management Act of 1999, to deal in foreign exchange or foreign securities. It normally includes banks. 6 Typically, a Non-Resident Indian (NRI) is an Indian Citizen who resides in India for less than 182 days during the preceding financial year, or who has gone out of India or who stays outside India for the purpose of employment/business. 7 The largest QIP was from Yes Bank Ltd, raising Rs 4,907 crore, accounting for 35% of the total QIP amount. 8 In fact, as per data revealed by the Bank of New York Mellon global DR directory, no GDR/ADR has been issued by an Indian company in any of the stock exchanges across the world in 2019. Only three DRs were issued in 2018. These pertained to GDRs issued by DishTV and Tube Investments at the London Stock Exchange.

3

Is the World Flat? Domestic Share Prices vis-à-vis the Prices of Their Depositary Receipts

3.1 Introduction As we have already mentioned, depositary receipts (DRs) issued by an Indian firm and its domestic shares trading in India represent claims to the residual cash flows of the issuing firm. For instance, investors who hold ADRs of Dr. Reddy’s Laboratories Ltd. (DRL) and investors who have exposure to domestic shares of DRL possess similar claims to the free cash flows of the DRL. Since the free cash flows of a firm are based on firm fundamentals, current realities, and future prospects, the price of depositary receipt and the domestic share should move in tandem. The precise question that we ask in this chapter is: what is the relationship between the domestic price of the share issued by an Indian firm and the price of its DR? There could be three sources for which the law of one price may not prevail in this case, viz. (a) the exchange rate of the different countries; (b) timing difference between the two countries; and (c) restrictions on trading on the investors of the different countries. Of these, we neglect the issue of exchange rate all together from our story and express both these prices in their respective currencies – ADR in US dollar and domestic share in terms of Indian rupee. The other two issues are important. Since there are time zone differences between place of listing of domestic shares (India) and the place of listing of DRs (Luxembourg/London/ USA), synchronicity in trading of DRs and underlying domestic shares is bound to be minimal (as in the case of GDRs) or non-existent (as in the case of ADRs). As a result, the price of DRs is bound to be impacted by the prevailing market sentiments in the jurisdiction in which the DR trades. Further, the domestic share price of the issuing firm, the domestic stock market, and the relevant exchange rate also have an impact of DR pricing. Notwithstanding these facts, it may be noted that there cannot be persistent inconsistency between DR prices and domestic share prices of an issuing firm. Wild mispricing of DRs vis-à-vis the underlying shares is bound to be DOI: 10.4324/9781003378686-3

40

Is the World Flat?

short-lived for such instances would be exploited by arbitrageurs who are constantly on the look-out for mispriced securities across different jurisdictions. However, arbitrage restrictions, if any, and transaction costs may pave way for mild mispricing of cross-listed shares. On the issue of time difference, the following trading hours (all expressed in terms of India Standard Time (IST)) in five major exchanges may be noted (table 3.1): • • •

New York Stock Exchange and NASDAQ: Trading on these exchanges take place from 20:00 today to 02:30 tomorrow IST. London and Luxembourg: Trading in these exchanges take places from 13:30 to 22:00 IST Mumbai: Trading in the Bombay Stock Exchange (BSE) opens at 09:15 and closes at 15:30 IST

Thus, while there is some overlap between India and Europe and between Europe and the US, trading hours between India and the US are completely non-overlapping. This chapter is devoted towards examining the relationship between the prices of DRs issued by Indian firms that trade in foreign jurisdictions such as Luxembourg, London and USA (call it PF) and the underlying domestic shares that trade in India (call it PD). At this juncture a digression of the statistical relationship between any two series is in order. While visually the relationship between any two data series may be gauged by plotting each of these two data series against time (or equivalently, one data series against another data series), definitive inference about their underlying relationship may be problematic. Thus, at a generalised level, the relation between any two data series may be captured using four underlying properties of a time series, viz., (a) mean (average); (b) variability; (c) skewness (tilt of the data distribution); and (d) kurtosis (height Table 3.1 Trading hours in select stock exchanges (in terms of Indian standard time) Date t (today)

Date t + 1 (tomorrow)

9.15 . . . . . . 13.30 . . . 15.30 . . . 20.00 . . . 22.00

2.30

Mumbai London Luxembourg New York/ NASDAQ Source: Derived from https://trading.info/trading-hours-stock-exchanges/

Is the World Flat?

41

of the distribution). Most of the discussion on the relationship between any two variables are in terms of means and variability. We initially examine the relationship between prices of DRs and the underlying share prices. Subsequently, we examine the relationship between the volatility of DRs and their underlying domestic shares.

3.2 Co-Movements of Cross-Listed Shares For the sake of illustration, let us consider the American Depositary Receipts (ADRs) issued by Dr. Reddy’s Laboratories and its underlying domestic shares trading in NSE, Mumbai. Figure 3.1 offers a line plot of the share prices of DRL’s ADR and its domestic share. It can be seen that the prices of dually-listed shares move in tandem for most of the time – so much so that most of the time, we are unable to distinguish one from the other.1 Further, figure 3.2 offers a line plot of daily premium or discount (in percentage) at which DRL’s ADR trades vis-à-vis its domestic share from January 2011 to December 2020. As stated earlier, the perfect arbitrage in the case of dually listed shares is elusive owing to arbitrage restrictions and transactions costs. Hence the ADRs trade at a premium or discount to the domestic shares. In this instance, the DRL ADRs trade at a premium as high as 7.08% or at a discount as high as 9.2% during this time period. A prominent strand of the technical literature on DRs deal with the relationship of DRs and their underlying shares and the role of one another

6000

Domestic Share (DRREDDY)

ADR (RDY)

5000

Price in INR

4000

3000

2000

1000

Date

Figure 3.1 Prices of Dr. Reddy’s Laboratories ADR and domestic share

8/11/2020

4/11/2019

12/11/2019

8/11/2018

4/11/2017

12/11/2017

8/11/2016

4/11/2015

12/11/2015

8/11/2014

4/11/2013

12/11/2013

8/11/2012

4/11/2011

12/11/2011

8/11/2010

4/11/2009

12/11/2009

8/11/2008

4/11/2007

12/11/2007

8/11/2006

4/11/2005

12/11/2005

8/11/2004

4/11/2003

12/11/2003

8/11/2002

4/11/2001

12/11/2001

0

42

Is the World Flat?

8.00% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% -10.00% 1/3/2020

1/3/2019

1/3/2018

1/3/2017

1/3/2016

1/3/2015

1/3/2014

1/3/2013

1/3/2012

1/3/2011

-12.00%

Figure 3.2 Dr. Reddy’s Laboratories ADR premium

when it comes to information creation, information transmission and price discovery (Lau and Diltz, 1994; Hauser et al., 1998; Bae et al., 1999; Lieberman et al., 1999). The sensitivity of DRs to the market sentiments prevailing in their jurisdiction is referred to as ‘location of trade’ effect in technical parlance. The literature landscape on DRs is punctuated with studies that examine the implications of location of trade effect when it comes to DR pricing behaviour as well as transmission of shocks between foreign stock market in which the DR trades and the domestic stock market (Poshakwale and Aquino, 2008; Jaiswal-Dale and Jithendranathan, 2009; Chen et al., 2009). Prominent works on Indian DRs have uncovered the segmentation of markets wherein DRs issued by Indian companies are impacted by factors that are global as well as domestic in nature, while Indian domestic shares are impacted only by domestic factors (Jithendranathan et al., 2000). There have been some notable works on Indian DRs. The following deserve special mention. In one of the initial papers on the subject, Hansda and Ray (2003) studied short-term relationship between DRs and domestic shares.2 The strong correlation between the prices of dually listed stocks is corroborated by the finding of a bidirectional causality between them. Furthermore, the impulse responses pattern tended to indicate that a positive shock in the domestic (international) price of a scrip got transmitted in terms of a strong positive movement in the international (domestic) price the very next day.

Is the World Flat? 43 In studying the impact of DR returns on domestic share returns, Kadapakkam and Misra (2003) found that DR returns are sensitive to returns observed earlier in India. Interestingly, this sensitivity is more pronounced for more liquid GDRs. Although arbitrage is not feasible for GDRs that sell at a premium, these GDRs are, nevertheless, sensitive to Indian returns. Kadapakkam et al. (2003) studied long-run relationship between DRs and domestic shares issued by Indian companies and the increasing contribution of GDRs towards price discovery. They found that the London and the Mumbai prices exhibited long-run relationship despite arbitrage restrictions imposed by Indian government regulations.3 Their overall results suggested that offshore trading in emerging market stocks play a beneficial role by aiding domestic price discovery. Majumdar (2007) looked at the location of trade effect of Indian DRs and found that legislative changes in India, like two-way fungibility,4 had an impact on decisions of Indian companies to go in for international listings. However, domestic stocks showed an increase in trading volumes (liquidity gains) after their international listings. In this backdrop, to begin with, we try to examine the price linkages between DRs issued by Indian firms and their domestic shares. In doing so, we offer readers a juxtaposition of how similar or dissimilar are these price linkages for DRs trading in different jurisdictions. Put simply, we examine the price linkages between the following pair of variables: a b c

GDRs issued by Indian firms that trade in Luxembourg Stock Exchange and the domestic shares. GDRs issued by Indian firms that trade in London Stock Exchange and the domestic shares. ADRs issued by Indian firms that trade in New York Stock Exchange and the domestic shares.

3.3 Firms and Their DR Issues In order to understand the relationship between the two prices we have considered DRs issued by the following firms. •

•

Ambuja Cements, Indiabulls Financial Services, IndusInd Bank, Kotak Mahindra Bank, Sterling International Enterprises, Tata Motors, Tata Power, and United Spirits that are listed on Luxembourg Stock Exchange (LuxSE). Larsen & Toubro, State Bank of India, Axis Bank, and Tata Steel that are listed on London Stock Exchange (LSE).

44

Is the World Flat?

•

Dr. Reddy’s Laboratories, ICICI Bank, Infosys, and Tata Motors that are listed on New York Stock Exchange (NYSE).

A snapshot of the different DRs considered is given in table 3.2. To set the context, at this juncture, delving into the story of the DRs and the issuing firms is perhaps in order. Ambuja Cements Ambuja Cements is a leading cement manufacturing company that ranks fourth in the Cement Industry. In the calendar year 2020, 92.3% of firm’s revenues were from manufacturing and selling cements, while 2.36% were from traded goods, 3.15% were from financial services and 0.43% was from sale of scrap. As of December 2020, the firm had ten active subsidiaries and had low leverage with a debt-equity ratio of 0.018. Ambuja Cements Ltd. is listed on Bombay Stock Exchange (BSE), India since 16 January 1984 and on National Stock Exchange (NSE), India since 3 November 1994. Between September 1992 and December 2002, the firm had raised capital through issuance of fixed rate unsecured non-convertible debentures5 on eight different occasions to the tune of INR 7.665 billion. On 25 November 1993, the firm had issued foreign unsecured fully convertible bonds to the tune of INR 2.509 billion. This paved way to the conversion of certain fully convertible bonds to GDRs. These US dollar denominated Reg-S GDRs were listed on EURO MTF Platform of Luxembourg Stock Exchange since May 1994. Each DR represents one domestic share. GDR holders constitute 0.25% of prevailing shareholder base as on 31 December 2020. Indiabulls Financial Services Indiabulls Housing Finance Ltd. is in the business of providing housing financial services and ranks third in the housing financial services industry. The firm per se is highly leveraged with a debt equity ratio of 4.074 and has 15 active subsidiaries as of March 2021. The firm is listed on NSE and BSE since 23 July 2013. As of March 2012, Indiabulls Housing Finance Ltd. (IBHFL) was one of the 13 active subsidiaries of the erstwhile Indiabulls Financial Services Ltd. (IBFSL). Pursuant to the relevant provisions of the then-Companies Act, IBFSL was amalgamated with IBHFL and all undertakings and businesses of IBFSL was transferred to IBHFL as a going concern. IBFSL had issued GDRs in February 2005, August 2005, and May 2007 to the tune of INR 2.62 billion, INR 6.486 billion and INR 12.260 billion,

Is the World Flat? 45 Table 3.2 DRs issued by select companies: a snapshot No. GDR issue 1

Capital Stock issuance exchange

Industry

DR: shares ratio

No

Luxembourg

1:1

Yes

Luxembourg

Construction and Materials Financial Services

Yes

Luxembourg – Bank 1:1 Euro MTF 1:1 Luxembourg – Bank Euro MTF Luxembourg – Technology Hardware 1:4 Euro MTF and Equipment

6

Ambuja Cements – Reg. S Indiabulls Financial Services – Reg. S IndusInd Bank – Reg. S Kotak Mahindra Bank – Reg. S Sterling International Enterprises – Reg. S Tata Motors – Reg. S

7

Tata Power – Reg. S Yes

8

United Spirits – Reg. S Larsen & Toubro – Reg. S State Bank of India – Reg. S Axis Bank – Reg. S Tata Steel – Reg. S

2 3 4 5

Yes Yes

1:10

Yes

Industrial Engineering Luxembourg – Electricity Euro MTF Luxembourg Beverages

Yes

London

1:1

No

London

Yes Yes

London London

Yes

New York

14 15

Dr. Reddy’s Laboratories ICICI Bank Infosys

Yes Yes

New York New York

16

Tata Motors

No

New York

9 10 11 12 13

Yes

Luxembourg

1:1

Construction and Materials Bank Bank Industrial Metals and Mining Pharmaceuticals and Biotechnology Bank Software and Computer Services Industrial Engineering

1:1

2:1

1:2 1:1 1:1 1:1 1:2 1:1 1:5

Notes: The time period under consideration for all other GDRs as well as ADRs was from 1/2/2008 to 12/31/2012, excepting the GDRs issued by Sterling International Enterprises, Tata Motors, Tata Power, and Tata Steel. 2 For GDRs issued by Sterling International Enterprises, Tata Motors, Tata Power, and Tata Steel, the beginning date of consideration was 16 December 2009, 16 October 2009, 28 July 2009, and 22 July 2009, respectively. Time period under consideration lasted until 31 December 2012 for these GDRs as well. 3 ‘Reg S’, referring to Regulation S, is a series of rules of the Securities and Exchange Commission (SEC) of the US under which securities offered and sold outside the US do not need to be registered with the SEC. 4 MTF is a multilateral trading facility (MTF) and exchange-regulated market 1

Source: Compiled by Authors

46

Is the World Flat?

respectively. IBFSL GDRs were listed on Luxembourg Stock Exchange and as of 31 March 2012, the GDR holders of IBFSL constituted 1.04% of the entire shareholder base. As on the record date of amalgamation of IBFSL with IBHFL – 20 March 2013 – IBFSL had outstanding GDRs that represented 5.6 million domestic IBFSL shares. In accordance with the scheme of arrangement, IBHFL issued one IBHFL GDR for each IBFSL GDR that was outstanding on the record date. The IBHFL GDRs were then listed on EURO MTF market of Luxembourg Stock Exchange in September 2013. As of 31 March 2021, the number of IBHFL GDRs outstanding is 0.61 million and it constitutes only 0.13% of IBHFL’s entire shareholder base. Each IBHFL GDR represents one domestic equity share of INR 2 face value. IndusInd Bank IndusInd Bank is a private sector bank that was established by Srichand P Hinduja in 1994. It offers retail banking services, wholesale banking services, treasury and other banking operations services. At the end of fiscal year 2021, IndusInd Bank ranked 11th in banking services on the sales revenue front and had low leverage with a debt-equity ratio of 1.192. IndusInd Bank had come out with a global offering of 29.49 million GDRs with each GDR representing one domestic share in March 2007. These GDRs were listed on Luxembourg Euro MTF market. Subsequently, the firm went for an enhanced global offering of up to 35.19 million GDRs with each GDR representing one domestic equity share of INR 10 par value. As of March 31 2021, the firm has 63.48 million GDRs that effectively constitute 8.21% of its equity capital. Kotak Mahindra Bank In 1985, the then Kotak Mahindra Finance Ltd. (KMFL) dealt in bill discounting business. In due course of time, the firm entered lease and hire purchase business in 1987, auto financing business in 1990, and investment banking operations in 1991. Most notably, KMFL became India’s first nonbanking finance company (NBFC) to be converted into a commercial bank and this paved way to Kotak Mahindra Bank (KMB). KMB’s operating areas include retail banking, wholesale banking, balance sheet management unit and corporate centre, vehicle financing, asset management, insurance, broking, advisory and transactional services. KMB’s stock is listed on NSE since 3 November 1994 and on BSE since 13 April 1992. As of the end of FY 2020–2021, KMB is ranked 12th in the banking services industry based on revenues for FY 2020–2021 and it has a debt equity ratio of 0.382. As of March 2021, the firm has 19 active subsidiaries.

Is the World Flat? 47 In April 2006, Kotak Mahindra Bank undertook a global offering of 15 million Global Depositary Shares (GDS) within USA by way of Rule 144A and outside USA by virtue of Reg. S, with each GDS representing one domestic share. As of March 31 2007, the firm had 3.7 million GDS that constituted 1.14% of its entire shareholder base. These depositary receipts were listed on Euro MTF platform of Luxembourg Stock Exchange. As of 31 March 2015, there were about 0.9 million GDS outstanding in the marketplace, which constituted 0.13% of Kotak Mahindra Bank’s shareholder base. Pursuant to issue of notice of termination of the GDS program by the firm, the Depositary Agreement between the bank and the depositary was terminated with effect from 4 September 2015. Sterling International Enterprises Sterling International Enterprises was incorporated in August 1984 and its shares started trading on BSE in January 1985. The firm ranked 181st in the industrial construction industry based on sales for the year FY 2017–2018. The firm had issued 18.4 million GDRs in December 2009 through the regular offer route and 2.76 million GDRs through the overallotment option. In all, the firm had raised USD 201.25 million (INR 9.3 billion) through GDRs. Each GDR represented four domestic shares of Re. 1 par value each. The GDRs were listed on the Euro MTF platform of Luxembourg Stock Exchange. As of 1 July 2015, shares held by custodians towards GDRs constituted 29.98% of the firm’s entire shareholder base. However, upon conversion of all GDRs into underlying shares by the GDR holders, the company had no outstanding GDRs as of 31 March 2016. Also, the GDRs were delisted from Luxembourg Stock Exchange on 16 June 2015 owing to termination of Deposit Agreement. Sterling International Enterprises Ltd. was part of the Sandesaras group, whose promoters were charged in 2017 by Enforcement Directorate, Government of India with defrauding local Indian banks of over USD 700 million. In 2018, Srei Infrastructure Finance Ltd. had filed an insolvency petition against Sterling International Enterprises and Sterling SEZ before Mumbai bench of National Company Law Tribunal (NCLT). In November 2021, NCLT gave approval for liquidation of Sterling International Enterprises Ltd. Tata Power Tata Power was incorporated on 18 September 1919 and the company derives a predominant proportion of its revenues from Thermal Electricity. Based on its sales for FY 2019–2020, the firm ranks 13th in conventional electrical industry. Also, the firm earned 59.06% of its total revenue for FY

48

Is the World Flat?

2019–2020 from generation of power, while it earned 14.15% and 12.63% from project management services and dividends respectively. As of March 2021, Tata Power had 58 active subsidiaries and had a debt-equity ratio of 1.139. The firm’s shares are trading on BSE since 6 June 1986 and on NSE since 3 November 1994. In March 1994, Tata Power had issued Global Depositary Shares (GDS) jointly with the erstwhile The Tata Hydro-Electric Power Supply Company Limited & The Andhra Valley Power Supply Company Limited and in turn raised INR 52.8 million. These DRs are listed on Luxembourg Stock Exchange and are also designated for trading on the PORTAL system of National Association of Securities Dealers. Each of these DRs represented 90 domestic shares of nominal value of INR 10 each. In July 2009, pursuant to the Deposit Agreement with Bank of New York Mellon, the company had raised USD 335 million (INR 16.170 billion) by issuing 14.8 million GDRs. These GDRs are available for trading on the Euro MTF platform of Luxembourg Stock exchange and on the International Order Board of London Stock Exchange. As of 31 March 2021, GDRs constitute 0.01% of the firm’s entire shareholder base. Tata Motors Tata Motors was incorporated on 1 September 1945 and earns an overwhelming proportion of its revenues from Heavy Commercial Vehicles. Based on revenues of FY 2020–2021, Tata Motors is the leader in the commercial vehicles industry. As of March 2021, Tata Motors has 102 active subsidiaries and possesses low leverage with a debt-equity ratio of 1.196. For the FY 2020–2021, Tata Motors earned 69.49% of its revenues from heavy and medium commercial vehicles, while it earned 7.93% of its revenues from spare parts. In July 1994, the then Tata Engineering and Locomotive Company (TELCO) had issued 3.6 million Global Depositary Shares and 3.6 million warrants and in turn allotted 8.2 million domestic shares of INR 10 par value each against the GDRs. TELCO raised around USD 115 million (INR 3.6 billion) through this first GDR issue. Subsequently, in August 1996, TELCO raised USD 200 million (INR 7.132 billion) by allotting 14.03 domestic shares of INR 10 par value each against GDRs. During 1990s, Government of India (GOI) prohibited two-way fungibility of DRs. Consequently, the DR cancellations that happen owing to overseas investors’ sale of DRs to depositary bank for conversion to underlying domestic shares could not be replenished. In other words, DR cancellations would mean a decline in outstanding DRs of Indian firms. However, in 2002, GOI enabled reverse fungibility of DRs wherein the DRs that were initially cancelled

Is the World Flat? 49 and sold in the domestic market could be reconverted back to DRs. Such reconversion of domestic shares to DRs is lucrative for overseas investors if the DRs trade at a premium vis-à-vis the domestic share. Consequently, in 2002, TELCO entered into an agreement with the Depositary for two-way fungibility of GDRs with domestic shares and as a result, 250,000 domestic shares of TELCO were reconverted to GDRs. In July 2003, TELCO was renamed as Tata Motors Ltd. (TML). In September 2004, TML went for conversion of Global Depositary Shares to American Depositary Shares and in turn was listed on New York Stock Exchange (NYSE). At the time of listing on NYSE, 23.1 million ADS of TML were outstanding. In October 2009, TML raised USD 375 million by issuance of 29.9 million Global Depositary Shares and 375 USD by issuance of 4% coupon convertible notes due 2014. The proceeds from this transaction were utilised towards debt repayment of Jaguar Land Rover (JLR) Acquisition. These Global Depositary Shares were listed on the Euro MTF platform of the Luxembourg Stock Exchange and were also admitted for trading in the International Order Book (IOB) Platform of London Stock Exchange in October 2009. In addition, in a bid to reduce the debt on its balance sheet, TML had invited holders of zero-coupon convertible notes6 that were due in March 2011 and April 2011 for an auction in March 2010 that was geared towards early conversion of these notes to stocks or American Depositary Shares or Global Depositary Shares. On 14 September 2011, the ratio of depositary receipt to domestic shares was changed from 1:1 to 1:5 owing to stock split of TML domestic shares. As of end of March 2013, only 9962 GDS of TML were outstanding and since there was no trading, the company deregistered GDS from IOB platform with effect from 23 May 2013. As of 31 March 2021, the firm has 70.7 million ADRs listed on NYSE with each ADR representing five underlying Ordinary Shares of INR 2 par value each. United Spirits United Spirits is a leader in Beer and Alcohol industry and its shares are traded on NSE as well as on BSE since 27 September 2001. The firm derives a large proportion of its revenues from ethyl alcohol (potable alcohol). As of March 2021, the firm has 14 active subsidiaries and has a debt-equity ratio of 0.173 Pursuant to merger of United Spirits with McDowell & Company Ltd. in July 2009, McDowell and Co. Ltd. came out with a global offering of 17.5 million Global Depositary Shares in March 2006 representing 8.7 million domestic equity shares that had a par value of INR 10 each. As of 31 March 2016, 745,588 GDS of United Spirits were outstanding. During the

50

Is the World Flat?

FY 2016–2017, the firm terminated its agreement with its Depositary and as a result, the outstanding GDRs were cancelled and the receipts held by the GDR holders were converted to underlying shares. Larsen and Toubro Larsen and Toubro was incorporated on 7 February 1946 and is listed on NSE since 3 November 1994 as well as on BSE since 2 January 1981. The firm earns most of its revenues from construction of other industrial plants. For the financial year 2020–2021, the firm earned 75.49% of its revenues from construction, projects and property development while it earned 2.92% from selling switch gear items. As of March 2021, the firm has 116 active subsidiaries and a debt-equity ratio of 0.399. In November 1994, L&T offered 8.08 million GDRs representing 16.16 million domestic shares of the company. The GDR issuance in 1994 was fully subscribed and was listed on Luxembourg Stock Exchange on 5 December 1994. Subsequently, L&T issued GDRs in March 1996 and November 2007. In all 20.87 million GDRs were issued by L&T in 1994, 1996 and 2007 put-together. Each GDR represents one domestic share of INR 2 par value. During the year 2006–2007, Foreign Currency Convertible Bonds (FCCBs) to the tune of USD 21.73 million were converted to 1.13 million GDRs/shares. Further, in the FY 2007–2008, FCCBs to the tune of JPY 11.57 billion were converted to 3.55 million GDRs/shares. As of 31 March 2021, shares underlying L&T GDRs are 20.2 million and they constitute 1.23% of the firm’s entire shareholder base. GDRs are listed on Luxembourg Stock Exchange and are admitted for trading on London Stock Exchange. State Bank of India State Bank of India is an Indian public sector bank that was incorporated on 1 July 1955. It ranks first in the banking services industry based on its revenues for FY 2020–2021. Its shares are trading on NSE since 3 November 1994 and on BSE since 2 January 1981. As of March 2021, the firm has 29 active subsidiaries and has a debt equity ratio of 1.812. In October 1996, SBI came out with a USD 370 million GDR issue whereby SBI issued 26.14 million GDRs that represented 52.29 million domestic shares. At the time of this issuance, two-way fungibility was not permitted by GOI. Later, when GOI permitted two-way fungibility, SBI provided the facility to overseas investors. As of March 31 2021, 10.97 million GDRs of SBI were outstanding and they represented 109.72 million domestic shares of the firm. SBI GDRs are listed on London Stock Exchange.

Is the World Flat? 51 Axis Bank Axis Bank is an Indian private sector bank whose major revenue segments are retail banking, corporate banking, treasury operations, and other banking operations. The firm’s shares are listed on NSE since 3 December 1988 and on BSE since 27 November 1988. As of March 2021, the firm has ten active subsidiaries and has debt-equity ratio of 1.406. In an effort to reach out to international investors, Axis Bank had issued GDRs in March 2005, April 2005, July 2007, and September 2009. These GDRs are listed on London Stock Exchange. As of 31 March 2021, the outstanding GDRs of Axis Bank represent 75.73 million domestic shares of the firm. Put differently, the outstanding GDRs of Axis Bank represent 2.47% of the total paid up capital of the firm. Tata Steel Tata Steel was incorporated on 26 August 1907 and derives maximum revenues from manufacture and sale of finished steel (Non-Alloy Steel). The firm’s share is traded on NSE since 3 November 1994 as well as on BSE since 2 January 1981. Based on revenues for FY 2020–2021, the firm ranks third in steel industry and derived 86.74% of its annual sales from saleable steel. As of March 2021, the firm has 31 active subsidiaries and has a debtequity ratio of 0.312. In 1994, the then Tata Iron and Steel Company Ltd. (TISCO) offered 2.25% convertible bonds of USD 100 million aggregate value that were due in 1999. Bondholders had the option to convert the bonds into GDRs representing domestic shares of the firm at a conversion price of INR 291 per GDR from 1 April 1994 to 2 March 1999. Pursuant to investors exercising the conversion option, the firm issued GDRs, which in turn were listed at Luxembourg Stock Exchange. In July 2009, Tata Steel raised USD 500 million (INR 24.215 billion) by offering 65 million GDRs in London Stock Exchange (LSE) and in turn was listed on the Professional Securities Market (PSM) of LSE. As of 31 March 2021, 10.014 million GDRs of Tata Steel were outstanding with each GDR representing one fully paid-up domestic share of INR 10 face value. Dr. Reddy’s Laboratories Dr. Reddy’s Laboratories belongs to the Drugs and Pharmaceuticals industry and earns a major portion of its revenues by way of drug formulations. The firm ranks fourth in the Indian drugs and pharmaceuticals industry based on revenues for FY 2020–2021 and it earned 93.35% of its annual sales for FY 2020–2021 from drug formulations. As of March 2021, the

52

Is the World Flat?

firm has 50 active subsidiaries and has a debt-equity ratio of 0.072. The firm’s shares are listed on NSE since 3 November 1994 as well as on BSE since 1 September 1986. In July 1994, DRL had issued 4.301 million Global Depositary Receipts (GDRs) with each GDR representing one domestic share of INR 10 par value. These GDRs were issued at a premium of INR 340 and the firm raised USD 48 million (INR 1.505 billion) through this exercise. On April 11 and April 24 2001, the firm issued 13.225 million American Depositary Receipts (ADRs) via a US Initial Public Offering. These ADRs collectively represented 6.612 million domestic shares of INR 10 face value each. The net proceeds from the issuance of ADRs were utilised by DRL to liquidate high-cost liabilities. In addition, during the FY 2002, the outstanding GDRs of the firm were converted to ADRs. In October 2001, each domestic share of INR 10 face value was subdivided into two equity shares of INR 5 face value. In November 2006, DRL came out with an INR 10.03 billion ADR issue whereby new domestic shares to the tune of 12.5 million and 1.98 million were issued against ADRs pertaining to regular and green shoe option respectively. As of 31 March 2001, ADRs represent 12.21% of the firm’s shareholder base. ICICI Bank ICICI Bank is a prominent Indian private sector bank that ranks third in the Indian banking services industry in terms of revenues of the financial year 2020–2021. Its shares are listed on NSE and BSE since 24 September 1997. For the financial year, 2020–2021, it earned 80.38 % of its earnings from interest and 10.84% from commission, exchange and brokerage. As of March 2021, the firm has 16 active subsidiaries and has a debt-equity ratio of 0.635. Notably, ICICI Bank issued American Depositary Receipts in March 2000, March 2005, December 2005, and June 2007. Total capital that was raised from these ADR issuances was around USD 3.576 billion. As of 31 March 2021, outstanding American Depositary shares of ICICI Bank Ltd. represent 1.476 billion domestic shares, which constitute 21.35% of the total shareholder base of the bank. Each ADS represents two domestic shares. Infosys Infosys Ltd. was incorporated on 2 July 1981 and is engaged in the business of providing software services. The firm is ranked second in the computer software industry based on its FY 2020–2021 revenues. As of March 2021, the firm has 73 active subsidiaries and has a debt-equity ratio of 0.054. The

Is the World Flat? 53 firm derived an overwhelming proportion (98.90%) of its FY 2020–2021 revenues from software development services. In March 1999, Infosys issued 2.07 million American Depositary Shares representing 1.035 million domestic shares of the firm at USD 35 per ADS. These were subsequently listed on NASDAQ. In an effort to enable investors to convert a portion of their domestic stockholding to ADRs, Infosys issued secondary-sponsored ADRs of USD 294 million, USD 1.1 billion and USD 1.6 billion in July 2003, June 2005, and November 2006, respectively. In fiscal year 2013, the company delisted its ADS from NASDAQ and in turn listed them at NYSE, Euronext London, and Euronext Paris. Owing to lack of trading activity, the firm voluntarily delisted its shares from Euronext Paris and Euronext London in fiscal year 2019. As of 31 March 2021, 732.49 million ADRs of Infosys are outstanding and it represents 17.19% of the total shareholder base of the firm. Each ADR represent one domestic share. With this backdrop let us now turn to the relationship between the domestic price of the share of a firm and the price of its ADR, two series that are referred to as PD and PF, respectively.

3.4 Relationship Between the Domestic and the Foreign Price of a Scrip 3.4.1 Correlation Analysis The easiest way to look at the co-movement between two variables is simple correlation coefficient (owing its origin to British Mathematician Karl Pearson – 1857–1936).7 If the underlying relationship between the series is linear, the correlation coefficient is a good measure of the degree of association or co-movement. As we have already seen in figure 3.1 for Dr Reddy’s Laboratories, there is very high correlation between domestic prices of a share and the price of its DR. And this result is uniform across all the stock exchanges in London, New York or Luxembourg (table 3.3).8 3.4.2 The Dog and the Tail: Domestic and the Foreign Price of a Scrip9 A key trouble with any correlation analysis is its inability to decipher any chain of causation. A high correlation between any two variables (in this case, the domestic price of a share and its counterpart DR, or, PD and PF) simply means that these two variables move together. In order to get rid of such a problem, traditionally, econometricians (i.e. economists using statistical technics to decipher regularities in the data) used to resort to regression, where a

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Is the World Flat?

Table 3.3 Correlations between Depositary Receipts (DRs) and their underlying scrips No.

Company

Place of listing of DR in stock exchange of

Place of listing of underlying scrip in India

Correlation

1 2

Ambuja Cements Indiabulls Financial Services IndusInd Bank Kotak Mahindra Bank United Spirits Sterling International Enterprises Tata Motors Tata Power Larsen & Toubro State Bank of India Axis Bank Tata Steel Dr. Reddy’s Laboratories ICICI Bank Infosys Tata Motors

Luxembourg Luxembourg

NSE NSE

0.993 0.985

Luxembourg Luxembourg Luxembourg Luxembourg

NSE NSE NSE BSE

0.995 0.942 0.995 0.999

Luxembourg Luxembourg London London London London New York

NSE NSE NSE NSE NSE NSE BSE

0.997 0.998 0.996 0.996 0.996 0.997 0.996

New York New York New York

BSE BSE NSE

0.996 0.997 0.993

3 4 5 6 7 8 9 10 11 12 13 14 15 16

dependent variable (call it the foreign price of a DR) is regressed on an independent variable (call it domestic price of a share) in terms of an equation like, Pt F = a + b Pt D .

(1)

As long as the equation satisfies certain statistical properties and appears as dependable, then looking at the sign and magnitude of b (i.e. the coefficient of PD in equation 1), the researcher/analyst can understand the impact of PD on PF. But later on, there was a huge debate in Economics and Finance regarding how one can choose the status of the variables, PD and PF, i.e. how can one decide which is the independent variable (i.e. the cause) and which is the dependent variable (i.e. the effect). Mechanically, how can we choose which variable to place on the right-hand side and which one to be placed at the lefthand side? Various practices emerged during the 1950s and 1960s. Economic theory or stylised facts were used to understand the nature of causality between the variables and the 1950s through mid-1970s witnessed a proliferation of large-scale econometric models. Such models were criticised on the ground that they imposed ‘incredible identifying restrictions’. Frustrated with such a critique, economist Christopher Sims of Yale University (Later recipient of Nobel Memorial Prize in Economics in 2011) published a paper in 1980 that

Is the World Flat? 55 changed the face of empirical economics. Sims gave rise to a class of models called Vector Autoregression (VAR) which in some sense banished the idea of a priori assigning a cause and effect variable. Put simply, in VAR models proposed by Sims (1980), each variable in a system is regressed over its own past values as well as the past values of all other relevant variables in the system. Once these equations are estimated, artificially a shock is given to a variable to understand its impact/impulse on all other variables in a system. We have adopted this procedure to understand the relationship between the domestic stock price and its DR counterpart in a foreign stock market.10 How does a change in depositary receipt price of a company influence its domestic share price or the other way? Towards finding answers to such questions, the Impulse Response Functions (IRF) of the VARs are generated – these relate to, eight Indian companies whose scrips are trading in Luxembourg, four Indian companies whose scrips are trading in London, and four Indian companies whose scrips are trading in New York. The impulse response functions enable us to capture the response of depositary receipt listed on Luxembourg or London or New York to shocks in the domestic share trading in India. These IRFs are generated with standard error bands that are indicative of the reliability of the impulse responses. The impulse responses in-connection with all these DRs listed on Luxembourg, London and New York are reported in figures 3.3, 3.4, and 3.5, respectively. These IRFs show almost instantaneous (a) Ambuja Cements

Figure 3.3 Luxembourg versus Mumbai: responses of GDR to innovations in underlying scrip

56

Is the World Flat? (b) Indiabulls Financial Services

(c)

Figure 3.3 (Continued)

IndusInd Bank

Is the World Flat? 57 (d) Kotak Mahindra Bank

(e) Sterling International Enterprises

Figure 3.3 (Continued)

58

Is the World Flat? (f)

United Spirits

(g) Tata Motors

Figure 3.3 (Continued)

Is the World Flat? 59 (h) Tata Power

Figure 3.3 (Continued) (a)

Larsen & Toubro

Figure 3.4 London versus Mumbai: responses of GDR to innovations in underlying scrip

60

Is the World Flat? (b) State Bank of India

(c) Axis Bank

Figure 3.4 (Continued)

Is the World Flat? 61 (d) Tata Steel

Figure 3.4 (Continued) (a) Dr. Reddy’s Laboratories

Figure 3.5 New York versus Mumbai: responses of ADR to innovations in underlying scrip

62

Is the World Flat? (b)

ICICI Bank

(c)

Figure 3.5 (Continued)

Infosys

Is the World Flat? 63 (d) Tata Motors

Figure 3.5 (Continued)

sharp reaction on the first day, which could be indicative of smooth informational flows between Indian and foreign stock exchanges. Notwithstanding the lack of synchronicity in trading between Indian capital markets and the foreign markets in which the depositary receipts trade, a sharp reaction of price of depositary receipts subsequent to a unit change (shock) in the domestic stock price, offers a visual illustration of the integration of a firm’s domestic share with its foreign counterpart. The following are some of the takeaways from the Impulse Response Functions. First, but for Luxembourg-listed Tata Power GDR and LSE-listed Tata Steel GDR, all other GDRs and all ADRs that were considered for this exercise exhibit a sharp reaction on day one in response to a unit change (shock) in the domestic share price on day zero. Second, a shock in the underlying domestic share is estimated to have a miniscule but non-zero impact on the depositary share prices for the next 30 days. Each step in the x-axis of an Impulse Response Function denotes a day. For instance, a non-zero value for day (step) 28 in the impulse response function graph visually captures the nonzero impact that a unit change

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Is the World Flat?

(shock) in domestic stock price on day zero has on the price of the depositary receipt 28 days later. Third, as expected, the confidence bands for impulse response function grows larger as the farther one moves from the origin (day zero) – the day on which the domestic stock price experiences a shock. In other words, the precision of the estimates pertaining to the time path of depositary receipt prices owing to unit change in domestic stock price is bound to deteriorate as the horizon grows. Fourth, although the time path of the impulse response function hovers around zero in absolute terms, the initial reaction of DR Price on day one in response to a unit change in the domestic share price on day zero does not die down (decay) completely during the reminder of the time horizon.11 This persistence in impulse response functions could be partially attributed to the fact that these impulse response functions were generated based on prices that are best characterised by random walk processes12 as opposed to being generated based on returns or logarithmic returns that have a strong tendency to revert to the mean. Finally, London-listed Tata Steel GDR exhibits a gradual reaction over 12 days in response to a unit change (shock) in the domestic share on day zero, while Luxembourg-listed Tata Power GDR exhibits gradual decay (as opposed to reaction) in response to a unit change (shock) in the domestic share price on day zero. 3.4.3 Takeaway on Price Linkages How do we see the price linkages between DRs listed on foreign stock exchanges and the underlying domestic shares listed on NSE/BSE? At the risk of broad generalisation, various takeaways may be inferred. At the outset, we found high correlation between the eight Luxembourglisted Indian GDRs considered for this study and their respective underlying stocks being traded in Mumbai. Further, level VAR test outcomes in general and Impulse Response Functions in particular capture close similarity between price of Luxembourg-listed DRs issued by Indian companies and their respective domestic share price. Such similarity in prices of dually listed shares issued by Indian firms was further corroborated by the variance decompositions of domestic share prices that were to a sizable extent explained by their respective Luxembourg-listed GDR prices.13 Subsequent efforts aimed at examining price linkages between London-listed Indian GDRs (New York-listed Indian ADRs) and their underlying domestic shares trading in Mumbai yielded results that are qualitatively similar to the ones obtained in the case of Luxembourg-listed Indian GDRs. While Luxembourg, London and New York differ on the degree of investor disclosure,

Is the World Flat? 65 the price linkages between DRs and the underlying domestic shares are invariant to the foreign jurisdiction in which the DRs trade. Between the three foreign jurisdictions that form part of this exercise, New York calls for stringent investor disclosures. In this day and age of globalisation and integrated financial markets, such synonymous findings on price linkages between DRs and domestic shares across different foreign exchanges is not surprising for stringent regulatory disclosures by a firm in one part of the world percolates to all trading locations. This, in turn, accentuates integration of financial markets and limits investors’ avenues for arbitrage trades that are aimed at exploiting market inefficiencies. This calls for sophisticated arbitragers with technologically advanced automated trading systems that are geared towards unearthing and exploiting transient inefficiencies.

3.5 Are the Volatilities Related? But price linkages reveal half the story. An interesting exercise in this context will be to look at the linkage between the volatility of (a) the domestic stock price and (b) the price of its counterpart DR listed in a foreign country. We do this in two stages. • •

In the first stage we delve into the notion of volatility and measure it for the prices of Indian scrips and their DR counterparts; In the second stage we try to measure the relationship between these two measures of derived volatilities.

3.5.1 Stage 1: Defining Volatility The underlying foundation of finance happens to be risk and early contributions in finance associate risk with variance in the value of a portfolio (Markowitz, 1952; Tobin, 1958). Contributions that were grounded on assumptions such as, homogenous expectations and information symmetry, led to the emergence of Capital Asset Pricing Model that offered a natural relation between risk and reward (Sharpe, 1964). Subsequently, risk, as measured by variance of expected returns, was employed to derive the theoretical price of derivative securities such as options (Black and Scholes, 1972). A simple measure of volatility is the standard deviation, which is obtained by taking square root of the variance of asset returns.14 Standard deviation per se is highly dependent on the sample data under consideration. As a result, asset returns pertaining to different time periods would yield different estimations of standard deviation. Further, should the time period under consideration be very long, standard deviation would not be realistic. On the other hand, should the time period under consideration be short, standard

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Is the World Flat?

deviation would largely reflect noise. In addition, there is no theoretical basis to arrive at the optimum amount of time period to be considered, while estimating standard deviation of asset returns. Rolling standard deviation was an answer to some of the above-stated problems pertaining to volatility estimation. Rolling standard deviation, as the name indicates, would entail iterative estimations of standard deviation based on a fixed-length moving window comprising of historical asset returns. The first observation pertaining to the recent estimation is dropped and the observation immediately following the last observation of the recent estimation is considered, for all ensuing iterations. While rolling standard deviation per se helps in overcoming some of the limitations of standard deviation, it must be acknowledged that rolling standard deviation is, in essence an equally-weighted, overlapping, moving estimation of a fixed length. Put differently, a rolling standard deviation measure based on daily historical returns of the last 60 trading days (let’s say), would bestow equal weights to each of the past 60 days. This is unrealistic, since one would expect the most recent squared residuals to have higher weights than the older ones. Further, a rolling standard deviation measure based on last 60 days of historical returns bestows zero weightage to returns pertaining to days prior to estimation window. In short, old returns that fall outside the estimation window do not form part of the estimation process. Introducing Time Varying Volatility (ARCH/GARCH Models) A key feature of stock market return is clustering of volatility; that is to say, large volatility is often followed by wide fluctuation and narrow volatility is often followed small fluctuations in stock market prices. In the light of such clustering effects, standard measures of variations like standard deviations or rolling standard deviation fail to capture the true extent of variability. It is here that notion of time-varying volatility becomes important. The important contribution in this regard has been introduced by economist Robert Engle of New York University while he was in a sabbatical at London School of Economics in 1979. Engle introduced a class of models called autoregressive conditional heteroskedasticity (ARCH) models. In his path-breaking 1982 paper, Engle showed that ARCH models tended to overcome some of the limitations of rolling standard deviation measure (Engle, 1982).15 The intuition behind ARCH models is as follows. One of the underlying assumptions of any regression equation (via classical least squares estimation) is homoskedasticity, meaning that the variance of error terms is constant. However, this is not the case in reality. Put differently, the variance of error term is unequal and is larger for some points of data than for the

Is the World Flat? 67 others. In short, real-world data is heteroskedastic in nature. As opposed to viewing heteroskedasticity as an obstacle to be rectified, ARCH models aid in modelling the variance of the error term as part of the broader estimation procedure. Further, ARCH models offer an econometric route to capture certain stylised facts of financial markets namely unpredictability of returns; surprisingly a large number of extreme returns (fat tails); and clustering of extreme and quiet periods (volatility clustering). Engle’s search for a model that would aid in testing the validity of Milton Friedman’s conjecture that, it is not the inflation per se, but the uncertainty of future inflation, that causes business cycles, led to the birth of ARCH models. As opposed to an equally-weighted static standard deviation measure, or an equally weighted rolling standard deviation measure, the ARCH models take an unequal weighted-average of past squared error terms, whereby the weights render more influence to recent information vis-à-vis old information. Although the true volatility pertaining to an asset is unobservable, Engle’s ARCH model utilises the historical returns to estimate the weights. The most widely used conditional heteroskedastic model is the Generalised Autoregressive Conditional Heteroskedasticity (GARCH) model proposed by a Danish economist (currently a Professor at Duke University, US) Tim Bollerslev (Bollerslev, 1986). As per GARCH(1,1) model, the best predictor of variance in the next time period is the long-run variance, the variance forecast pertaining to this period, and the new information pertaining to this period as reflected by the most recent squared error term. In short, Bollerslev’s GARCH model is a succinct weighted average moving average model of past squared error terms, wherein the declining weights never reach zero.16 While ARCH/GARCH models aid in overcoming the limitations of rudimentary volatility measures such as standard deviation, they fail to account for the asymmetric nature of asset returns. Put simply, negative returns have a far greater impact on volatility as opposed to similar positive returns. Attempts to accommodate for asymmetric nature of asset returns while estimating time-varying volatility led to the emergence of more complex models.17 SIGNIFICANCE OF ARCH/GARCH MODELS AND THEIR MULTIVARIATE EXTENSIONS

In the light of the ability of the ARCH/GARCH models to account for unpredictability in asset returns, fat tails, and volatility clustering, ARCH/ GARCH and many of its variants have had a consequential impact on the trajectory of literature on volatility. Further, owing to chronic association of risk with uncertainty in returns, conditional volatility forecasts based on

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Is the World Flat?

ARCH/GARCH models have had a phenomenal impact on areas such as derivative pricing, dynamic hedging strategies, portfolio diversification, and enterprise risk management. For instance, banks and other financial institutions employ value-at-risk (VaR) measure to assess the daily risk of their existing portfolio. A 1% 1-day VaR of USD 30,000 would imply that there is only a one-in-hundred likelihood that the actual losses in a day for the bank are higher than USD 30,000. In other words, only one percent of outcomes are likely to be worse than the VaR measure. A 1% VaR estimate that is grounded on the assumption of normal distribution of asset returns is 2.33 times the estimated standard deviation. Having said so, real-world returns are non-normal in nature. As a result, a VaR measure arrived at based on conditional volatility estimates obtained using ARCH/GARCH models that do not limit themselves to assumptions of normality, are far superior, conservative, and realistic in nature. The above example is just one of the many areas in which ARCH/GARCH models have had a defining impact. The central reason for such wide-spread adoption of conditional volatility estimates is as follows. Financial asset prices are a function of expected future cash flows pertaining to the asset. Because of the inherent risk with regard to expected future cash flows, the distribution of expected future cash flows pertaining to an asset is likely to change as and when new information arrives. Consequently, the price of the financial asset evolves based on new information arrivals. In essence, volatility clustering per se is the result of clustered information arrivals. And ARCH/GARCH models offer an ideal gateway to econometrically capture volatility clustering in a manner that could be utilised to (a) the enhance the forecasting ability of econometric models; (b) to examine the causes of volatility; and (c) to examine the effects of volatility on other variables in a system. While univariate ARCH/GARCH offer volatility estimates of time series under consideration, they do not capture the inter-dependency between two or more time series. In such instances, it is advisable to estimate conditional volatility of two or more time series simultaneously. After all, shocks to two or more time series may be correlated with one another. Further, shock in the volatility of one time series variable might in turn impact the volatility of another time series. Similarly, when it comes to a portfolio, volatility pertaining to an asset on hand is, to a larger extent, dependent on the relationship of return of a particular asset with the other assets in a portfolio. It is in this context that multivariate GARCH models are truly invaluable, for they accommodate for inter-dependency between multiple time series under consideration. The first multivariate GARCH

Is the World Flat? 69 model (MGARCH) is a straight-forward generalisation of the univariate GARCH models (Bollerslev et al., 1988). While it captures interdependency between two or more time series under consideration, it calls for estimation of a large number of parameters – a phenomenon known as ‘over-parametrisation’.18 3.5.2 Stage 2: Relating Volatility Linkages – Dynamic Conditional Correlation (DCC) Owing to the process of calibrated financial liberalisation and the associated calibrated progressive removal of impediments by Indian policymakers, one would a priori expect that the correlations between domestic market of an Indian scrip and its DR counterpart is bound to change over time (Longin and Solnik, 1995). Hence, we examine the volatility linkages between Indian DRs and their underlying shares trading in Mumbai, in a multivariate framework comprising, (a) DRs, (b) underlying domestic shares trading in NSE or BSE, (c) the National Stock Index (Nifty/Sensex), (d) the foreign stock market index (pertaining to Luxembourg or London or New York), and (e) the relevant exchange rate (Indian rupee vis-à-vis euro/US dollar/ Pound Sterling) using MGARCH(1,1) model. Formally, as mentioned earlier, this is done in two steps. As a first step, we estimate an MGARCH(1,1) model on logarithmic returns of dually-listed Indian shares and arrive at the five univariate GARCH(1,1) estimations for each of the five-time series under consideration. The second step involves understanding the relationship between the variability of the domestic share price of a particular stock and the price of its DR counterpart. This is done through the estimation of dynamic conditional correlation (DCC) between the variables under consideration by subjecting the standardised residuals (error terms) obtained from the first step, to a smoothing function that is characterised by two parametric estimates.19 As we are dealing with five variables in our multivariate framework, this second step would yield ten unique conditional covariance terms based on two parametric estimates. In fact, the number of parametric estimates that form part of the smoothing equation (two) is independent of the number of time series.20 Put simply, the one-period dynamic conditional correlation is based on information known the previous period, and multi-period forecasts of the correlation can be defined in the same way (Engle, 2002).21 Based on MGARCH(1,1)-DCC test results, the dynamic conditional correlation (DCC) between Indian DR trading in a foreign stock exchange and its underlying stock trading in Mumbai were derived. These are reported in figures 3.6, 3.7 and 3.8.

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Is the World Flat?

3.5.3 Take Away on Volatility Linkages A common theme that emerges from DCC plots (figures 3.6 to 3.8) is that all Indian DRs considered for this study exhibit, by and large, high dynamic conditional correlation with its underlying stock trading in Mumbai. Notwithstanding the difference in degree of information disclosure called for at Luxembourg, London, and the US, such qualitatively similar findings, when it comes to volatility linkages, are not surprising in nature as stringent regulatory disclosures by a firm in one part of the world percolates to all trading locations. To sum up, the foreign stock exchange per se, wherein the Indian DRs are listed, has no differential impact on the price and volatility linkages between Indian DRs and their underlying domestic shares. (a) Ambuja Cements

(b) Indiabulls Financial Services

Figure 3.6 DCC plots between Luxembourg-listed GDRs and their underlying domestic shares

Is the World Flat? 71 (c)

IndusInd Bank

(d) Kotak Mahindra Bank

(e) Sterling International Enterprises

Figure 3.6 (Continued)

72

Is the World Flat? (f)

United Spirits

(g) Tata Motors

(h) Tata Power

Figure 3.6 (Continued)

Is the World Flat? 73 (a)

Larsen & Toubro

(b) State Bank of India

(c) Axis Bank

Figure 3.7 DCC plots between London-listed GDRs and their underlying domestic shares

74

Is the World Flat? (d) Tata Steel

Figure 3.7 (Continued) (a) Dr. Reddy’s Laboratories

(b)

ICICI Bank

Figure 3.8 DCC plots between New York-listed ADRs and their underlying domestic shares

Is the World Flat? 75 (c)

Infosys

(d) Tata Motors

Figure 3.8 (Continued)

3.6 Concluding Observations Despite the claim that the world is flat, political boundaries exist – so do differences in regulation across countries. But global finance is an amazing entity. It can create unifying forces across borders. This volume studies an illustration of a particular instrument, viz., DRs floated by Indian companies in foreign stock exchanges. Using robust econometric techniques we have been able to establish close relationship between prices of Indian stocks in domestic stock exchanges and those of their DR counterparts in foreign stock exchanges. This close relationship exists both in terms of intertemporal behaviour of these two distinct stock prices and in terms of their variability. This is perhaps indicative of lower arbitrage opportunities and the unifying force of law of one price across borders.

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Is the World Flat?

Notes 1 Dr Reddy’s Laboratories ADR (Ticker: RDY) price in USD and its domestic stock (Ticker: DRREDDY) price in INR was downloaded from finance.yahoo. com. The daily ADR prices in USD were converted into equivalent INR by multiplying ADR prices in USD with “Rupees per US dollar: RBI reference exchange rate: Average” that was downloaded from CMIE Economic Outlook database. Missing values for INR-USD exchange rate were imputed using linear interpolation. 2 They had taken the stocks of the following companies, viz., Infosys, Satyam Infoway, DSP Merill Lynch, Rediff.com India, ICICI, ICICI Bank, Silverline, VSNL, Wipro, Dr Reddy’s, Satyam Computers, HDFC Bank, and MTNL. 3 Should two or more time series exhibit long-run relationship, they are termed to be cointegrated, in econometric parlance. 4 Fungibility paves way for exchanging one asset with another identical asset. When it comes to dually-listed shares, two-way fungibility enables conversion of DRs to underlying domestic shares and vice-versa. 5 Unsecured debentures are financial instruments that do not possess an underlying collateral. Because they do not possess underlying collateral, unsecured instruments are riskier vis-à-vis secured instruments and hence investors demand a relatively higher return for unsecured instruments. Specifically, Unsecured non-convertible debentures are loan agreements between two counterparties that is devoid of underlying collateral and does not offer a mechanism for conversion of such debentures to equity shares of the firm. On the other hand, convertible debentures offer a mechanism for conversion of debt to equity based on terms and conditions of the contract. Pursuant to such a conversion, the erstwhile debenture-holders would become the shareholders of the firm. 6 Zero coupon bonds, otherwise referred to as zeros, are debt instruments that do not pay interim cash flows – coupons – during the life of the security. An investor in zero coupon bond realizes returns only by way of capital appreciation or depreciation. Zero-coupon convertible notes are loan agreements between counterparties that offer a mechanism for conversion of debt to equity based on terms and conditions of the contract. Pursuant to such a conversion, the erstwhile debenture-holders would become the shareholders of the firm. In bond parlance, Interest paid by a bond is referred to as coupons and zero-coupon notes, as the name indicates, do not pay any interest. 7 The correlation coefficient between PD and PF is given by the following ratio (r):

(

Cov P D , P F

)

( ) Sd ( P )

Sd P

D

F

, where sd refers to standard deviation and Cov refers to

covariance between PD and PF. It is well known that r lies between (−) 1 to (+) 1, with (−)1 referring to completely opposing movement between the variables and (+) 1 completely synchronous movements between the variables. 8 Statistically, one should test for values of correlation coefficient different from zero. Since all the values are exceeding 0.9, we can safely infer about the high correlation between PD and PF. 9 The results reported in this section draws on Madhavan and Ray (2019).

Is the World Flat? 77 10 Assuming lag of one, VAR models involve estimating multiple equations with price of the domestic stock (PD) and price of the stock floated in the foreign stock exchange (PF), in terms of equations (2a) and (2b): Pt D = a + a P D + a P F 01 11 t -1 11 t -1

(2a)

F Pt F = a02 + a21Pt D -1 + a22 Pt -1

(2b)

In reality, however, the lag could be of higher order, determined through certain statistical criteria. For details on various kinds of VAR models, see Prabu and Ray (2019). 11 Impulse Response Function plots in figures 3.3 to 3.5 offer the time path of the depositary receipt prices up to 30 days after the onset of a shock (unit change) in the domestic stock price. 12 Random walk processes are those that wander away from the place where they started. The best predictor for the value of a random walk process is its current value. Since future values of such processes cannot be predicted, they do not revert back to their mean and possess unbounded variance. 13 These variance decompositions are not made available here. Please refer to Madhavan and Ray (2019) in this regard. 14 Formally, it is measured by,

15 16

17

18

1 N

∑ t =1( pti − p ) N

2

, where N is the total number

ber of periods, i is an index for domestic (D) share or its foreign (F) DR counterpart, and is the corresponding mean p. In ARCH models, the different weights pertaining to historical asset returns that form part of the estimation window are estimated as part of the procedure. The first order ARCH process for a return (r), is defined in the following three equation structure: (a) rt = σ t et ; (b) et is a white noise with mean zero and variance 1; and (c) σ t2 = ω + α rt2−1. The generalized ARCH or GARCH is a generalized version of an ARCH model, with (c) being augmented as σ t2 = ω + α rt2−1 + β σ t2−1. These include models such as Exponential GARCH (E-GARCH), Threshold ARCH and GJR-GARCH (Nelson, 1991; Zakoian, 1994; Glosten et al., 1993). By now, there exists a wide array of ARCH/GARCH extensions that try to capture aspects such as, long memory, nonlinearity, asymmetry, and non-normal parametric/nonparametric distributions; as part of the time-varying volatility estimation procedure. For an extensive survey of the different ARCH/GARCH extensions please see Bollerslev et al. (1992, 1994), Engle (2002), and Engle and Ishida (2002). Technically, there is no analytical solution to the maximization problem in the case of ARCH/GARCH models and hence it entails usage of numerical methods to find the parametric values that maximize the likelihood of any realization. Prior attempts to overcome the problems associated with MGARCH-VECH model led to notable MGARCH variants such as the Diagonal VECH model (Bollerslev et al., 1994), Baba-Engle-Kroner-Kraft (BEKK) model (Engle and Kroner, 1995), constant conditional correlation (CCC) model (Bollerslev, 1990) and MGARCH-DCC model (Engle, 2002).

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19 Error terms, also referred to as a residuals in econometric parlance, are standardized by dividing the conditional error terms by square root of their conditional variance. 20 Details on the mathematical underpinnings behind MGARCH-DCC models is beyond the scope of the present book; see Madhavan and Ray (2019) for details. 21 The conditional correlation between two random variables r1 and r2 that each have mean zero, is defined to be, p12,t =

Et -1 ( r1,t r2,t )

( ) ( )

2 Et -1 r1,t2 Et -1 r2,t

time subscript and E is the expectations operator.

, where t is the

4

Conclusion

4.1 The Story Told so Far In our quest towards understanding the law of one price, we have told the story of relationship between the price of Indian stocks and their counterparts (DRs) listed abroad. What we found is significant. First, notwithstanding some restriction, there is complete convergence between the prices of Indian stocks and their counterparts listed overseas. Second, not only is there convergence in levels of stock prices, their variability is related as well. How do we explain these regularities? At some level of abstraction, it indicates two basic things: (a) the seamless flow of information across the stock markets of the world and (b) primacy of the advanced country stock markets. This has been seen time and again. Illustratively, after the US Federal Reserve Bank announced the monetary stimulus in the mid-2020 for handling the adverse effects of the pandemic, stock markets across the world started moving up. However, in view of the distinct/partially overlapping trading hours across different stock markets, in case of a particular stock, there could be a chicken and egg problem between the domestic and foreign prices. Who moves whom? Does Monday’s domestic price of an Infosys stock at 4 pm (India time) move its Monday ADR price at 4 pm in US time (corresponding India time is 1:30 am of Tuesday)? Or, does Tuesday’s ADR price at 1:30 am (India time) influence its domestic price at 4 pm (India time)? In the absence of any controlled experiment, it is difficult to answer such questions. Of course, if the same set of investors own the domestic stocks as well as the DRs, then we have a natural explanation of this phenomenon of close relationship between these prices. An added explanation of this phenomenon could be the state of governance in the market of DRs. More bluntly, is this phenomenon of close relationship an outcome of some manipulation of the market participants? In the absence of formal evidence, this chapter looks into these two issues next.

DOI: 10.4324/9781003378686-4

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Conclusion

Rest of this chapter is organised as follows. Sections 4.2 and 4.3 delve into these two issues of possible ownership structure of DRs and stories of some irregularities in this market, respectively. Section 4.3 delves into some of the limitations of our coverage.

4.2 Who Owns the Depositary Receipts? There is some haziness about the ownership structure of DRs. However, there are some sporadic evidences. We turn to these. Using the data culled out from Form 13F filings that were made by institutional investors to SEC, a 2011 study by Citi examined the DR positions and equity assets of institutional investors from 2008 to 2010.1 Between December 2008 and December 2010, the institutional investors increased their exposure to DR market. Such increase in exposure could be through two mechanisms, namely discretionary investment decisions and non-discretionary investment decisions. Increase in institutional investors’ exposure to DRs through non-discretionary investment decisions would be through receipt of stock dividends, stock splits or change in DR: shares ratios. On the other hand, discretionary investments decisions that enhanced institutional investors’ exposure to DR markets are subscriptions to Initial Public Offerings (IPOs), Follow-on Public Offerings (FPOs), Rights-Offerings of DRs and DR purchase via the secondary market. Discretionary investment decisions are those decisions taken by a manager using his/her powers to determine which securities are to be bought or sold for accounts of the firm.2 Institutional investors that had exposure to DRs include Pension Funds and Foundations, Insurance Companies, Insurance Management Division, Hedge Funds, Mutual Funds, Investment Advisors, Brokers, Investment Banks, and more recently, Sovereign Wealth Funds. The 2011 Citi study found Investment advisors and Mutual Funds held about 75% of the market value of all outstanding DRs. The institutional investors listed earlier constitute the bulk of ADR holders and they are required to declare their holdings, on a quarterly basis, to SEC as per rule 13f of the 1934 Securities Act.3 Some ADR holders could be Objecting Beneficial Owners (OBOs) that instruct financial intermediaries not to share their personal details with the issuing firm. On the other hand, non-Objecting Beneficial Owners (NOBOs) are those that instruct the financial intermediary to share their personal details with the issuing firm.4 GDR holders that trade their DRs in the Eurozone via the Euroclear and Clearstream securities clearing houses have the option to withhold their identity as per the laws of Brussels and Luxembourg. As a result, issuing companies are not in a position to reveal the identity of their GDR holders

Conclusion

81

pertaining to DRs trading in Eurozone that were issued as per the erstwhile 1993 Indian Depositary Receipts Scheme. In 2019, Ministry of Corporate Affairs (MCA), GOI laid out the rules for determining the significant beneficial owners (SBOs) that in-turn placed the onus on companies to identify SBOs for GDRs issued by Indian firms in general and more so, for GDR issuances by Indian firms in FATF-compliant jurisdictions.5 SBOs are those individuals or entities that possess, individually or in concert (together) with other entities through multiple layered structure of corporate holdings in a group holding structure, indirect holdings or indirect-cum-direct holdings, to the extent of at least 10% of an issuing firm’s shares and as a consequence are entitled to voting rights, receipt of dividend distribution, and the right to exercise significant control. Firms would have to submit their SBOs to the Registrar of Companies (ROCs) by filing form BEN-2. Failure to file form BEN-2 with the ROCs will attract an initial penalty ranging from INR 1 million to INR 5 million on the issuing firm and every officer of the issuing firm coupled with additional penalty of INR 1000 per day for continued non-compliance.6 These rules do not apply for (a) entity constituted by GOI for administration of Investment Education and Protection Fund (IEPF), (b) entities controlled by central and state governments, (c) investment funds such as Alternative Investment Funds (AIFs), Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) that are registered with SEBI, and (d) investment vehicles that are regulated by Reserve Bank of India (RBI), Insurance Regulatory and Development Authority (IRDA), or Pension Fund Regulatory and Development Authority (PFRDA).7 More clarity on what qualifies as significant control as well as on the harmonisation of definitions of significant beneficiary ownership across multiple Indian corporate laws is expected in the days to come. Such clarifications will go a long way in ensuring seamless compliance of the issuing firms when it comes to SBO filings, which in turn would enhance the transparency of the ultimate beneficiaries of the DRs issued by Indian firms.8

4.3 Is the World of Indian GDRs Grey? Some Indian firms have a history of manipulating the securities market in connivance with financial intermediaries through structured GDR transactions. For instance SEBI banned Pan Asia Advisors – a financial intermediary – and Arun Panchariya in 2011 for facilitating GDR issuances of certain Indian firms to few foreign entities who in turn sold these GDRs to FII sub-accounts. The FIIs subsequently undertook substantial conversion of these GDRs to the underlying shares, which were then sold to domestic stock exchange counterparties, who in turn sold the underlying shares to retail investors.

82

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As a result of such convoluted schemes, Indian retail investors were the ultimate financiers of a large proportion of such structured GDR issuances. Also, the issuing firms’ net worth surged and the lead manager’s commissions increased. The sub-accounts bought the GDRs at a discounted price in the foreign markets and connived with domestic market players that were the market makers for domestic shares pertaining to large-scale GDR conversions, so as to wilfully mislead and attract domestic investors. Apart from banning Pan Asia Advisors, SEBI, in 2011, had also banned 19 firms such as, but not limited to, Avon Corporation, Asahi Infrastructure & Projects, IKF Technologies, K Sera, CAT Technologies, Maars Software International and Cals Refineries, from issuing equity shares or convertible debt instruments or for that matter, from taking actions, that are geared towards altering the capital structure of these firms.9 SEBI’s ban of Pan Asia Advisors was quashed by a three-member bench of Securities Appellate Tribunal (SAT) in 2013 by citing SEBI’s lack of extra-territorial jurisdiction when it comes to GDRs that are traded outside Indian soil. Such a pronouncement by SAT was premised on the view that SEBI’s jurisdiction commences only when the GDRs are converted into underlying domestic shares. SEBI, in turn, challenged SAT’s quash order in the Honourable Supreme Court of India claiming that, while GDRs, per se, are foreign securities, they are based on underlying domestic shares and consequently they fall within the regulatory ambit of SEBI, whose existential purpose is to protect the interests of Indian investors. Based on the facts of the case, the intent behind the gamut of activities that took place in connection with the GDRs under question, and combined reading of sections 11 and 12 of the SEBI Act along with regulations 2, 3, 4, and 5 of the SEBI – Prohibition of Fraudulent and Unfair Trade Practices (PFUTP) relating to security markets regulations of 2003, the Supreme Court set aside SAT’s quash order and sent the case back to SAT (Jayakar, 2015). SC’s actions in this regard vindicated SEBI’s claims of extra-territorial jurisdiction for GDRs that are referenced to underlying domestic shares and in-turn have repercussions for the domestic Indian securities market. Circa 2016, SEBI was investigating 59 GDR issuances of 51 Indian firms that happened between 2002 and 2014.10 A common theme that emerged from SEBI’s investigations is that very few foreign entities subscribed to GDR issuance of the Indian firm and they did so by obtaining a loan from a European-based Bank such as Banco Efisa, S.F.E. S.A. But for this loan, the GDR issuance would have failed. The loan, in many cases, was issued by the Lisbon-based Banco Efisa bank based on pledging of GDR proceeds by the issuing firm. Upon repayment of the loan by the subscribing foreign entity, the proceeds from GDR issuance are then credited to the accounts of the Indian issuing firm. In many instances, SEBI uncovered account charge

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agreements that were signed by the Indian issuing firm and a European bank that formed an integral part of the creditor agreement between the subscribing foreign entity (entities) and the European bank. Notably, SEBI issued show cause notices to Indian issuers that failed to inform the stock exchange of the account charge agreement that they had signed and/or that undertook concerted efforts to mislead Indian investors about the success of the GDR issuance when in fact the entire GDR issuance was subscribed by less than a handful of foreign entities.11 There have been instances when SEBI had come out with ex-parte orders barring one or more promoters of Indian firms whose GDR issuances came under SEBI lens for a variety of reasons.12 In some such instances, the aggrieved promoter in-turn approached the SAT, which pronounced that SEBI’s entire proceedings stand vitiated in the absence of service of show cause notice to the appellant and in-turn instructed the appellant to appear before the concerned whole-time member of SEBI for him/her to be served a show case notice by SEBI and for the proceedings to continue in-accordance with the law.13 While an extensive examination of the development of case law inconnection with SEBI’s enforcement actions pertaining to alleged GDR manipulations by issuing firms is beyond the scope of this book, it needs to be acknowledged that enforcement actions by SEBI are not time bound in nature. Put differently, there have been many an instance when enforcement actions in connection with GDR manipulation cases were taken after an inordinate delay. Such inordinate delay in enforcement actions provides opportunity for prejudice and in some cases, may even preclude the appellant to present matters in an efficacious manner, as pointed out by the SAT order reserved on 12 March 2021 in the matter of Morepen Laboratories Ltd. versus SEBI.14 While SEBI’s contention that there are no statute of limitations that preclude initiation of proceedings in connection with GDR issuances beyond a certain time frame is legally valid, inordinate delay in issuing show-cause notices or for that matter in initiating enforcement proceedings pave way for lost opportunities for financial sector in general and the firms in particular to course – correct in the near-future. While such delayed legal proceedings and attendant outcomes and settlements would very well be in the letter of the law, we are left to ponder if such delayed actions are in-consonance with the spirit of law.

4.4 Missing Characters In this book, we have attempted to access the broad stylised facts of the DR market that came out from our formal econometric research over the last 10 years or so. Nevertheless, as with any story, there are missing characters in our chronicle as well. Three deserve special mention.

84

Conclusion

First, the innovative instrument of Indian Depositary Receipts (IDRs) has not been covered by us. Its mechanism is in reverse of a DR in the sense explained in this book. IDR is essentially a rupee-denominated security listed in a domestic stock exchange and issued against an overseas stock. Formally, ‘An IDR is an instrument denominated in Indian Rupees in the form of a depositary receipt created by a Domestic Depositary (custodian of securities registered with the Securities and Exchange Board of India) against the underlying equity of issuing company to enable foreign companies to raise funds from the Indian securities Markets’ (NSE website).15 These are done by typically by foreign companies with Indian subsidiaries. Standard Chartered Plc is the first company to come out with an IDR issue in 2010 but chose to delist it June 2020. IDR market did not really pick up in India. Second, the issue of dually listed stocks is all the more interesting in view of the restrictions on capital account of India’s balance of payments (BoP) – a phenomenon, known as, limited capital account convertibility whereby there are some restrictions of foreign investment to India. Of course, over the years, such restrictions became less and less as India adopted a process towards ‘fuller capital account convertibility’. It is in this context, that the establishment of the International Financial Services Centres Authority (IFSCA) on 27 April 2020 under the International Financial Services Centres Authority Act, 2019, headquartered at GIFT (Gujarat International Finance-Tec) City, Gandhinagar in Gujarat, deserves special mention.16 Of course, at present, the GIFT IFSC is the maiden international financial services centre in India and it consists of a special economic zone (SEZ) that has been notified as India’s maiden international financial service centre, and an exclusive domestic tariff area (DRT). Located between Ahmedabad and Gandhinagar of Gujarat, the Gift city is going to enjoy various tax benefit, such as, 100% corporate tax exemption for 10 out of 15 years, and no payment of capital gains tax, stamp duty, or GST. As per the Act, all transactions of financial services in IFSCs will be in such foreign currency as specified by the Authority, in consultation with the central government. While its full operationalisation is under way, in the days to come the establishment of an international financial centre in the GIFT city could have profound implication for the law of one price for stocks floated even within India. Third, direct overseas listings is another possible move that could have implications for our research question. While in September 2020, the government took the first step towards allow direct overseas listing when it amended the Companies Act, 2013, tangible actions were awaited. In fact, in August 2021, a few of India’s best known startup founders and investors have reportedly written to the Prime Minister’s Office (PMO) urging the Centre to allow startups to list overseas.17 However, there are

Conclusion

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recent reports that such plans have been temporarily shelved by the Central Government.18 All these three initiatives could have serious implications for the law of one price being valid in Indian stock market.

4.5 Epilogue When the exponents of globalisation start thinking in terms of a euphoria that the world is flat, they tend to miss various restrictions of economic activities. Labour is not mobile because of the restrictions imposed from the concerns of a nation state. Technology is not free to move via patentrelated and political-economy-related restrictions. Notwithstanding capital controls of various degree, financial capital, by its very nature is perhaps most mobile. In this book we have just looked into a specific form of such finance capital, viz., domestically traded stocks in India and their foreign counterparts, viz., DRs. The chronicle presented in the book bears testimony to the fact that there is reasonable convergence in the levels as well as variability of such stock prices. There is an old joke that the secret to getting rich is to buy at a low price and sell at a high price. The story presented in the book perhaps indicates that such actions may be possible at different points of time but such possibilities tend to disappear in a globalising world of finance.

Notes 1 2 3 4 5

6 7 8 9 10

Source: https://depositaryreceipts.citi.com/adr/common/file.aspx?idf=2441 Source: www.sec.gov/divisions/investment/13ffaq.htm Source: www.adr.db.com/drwebrebrand/resources/faqs#11 Source:www.sifma.org/resources/news/non-objecting-beneficial-owners-objectingbeneficial-owners-explained/ FATF stands for Financial Action Task Force. It is a global watchdog for money laundering and terror financing. FATF-compliant jurisdictions are those that are committed to implementing the FATF standards that form part of a global coordinated response aimed at preventing organized crime, corruption, and terrorism. Source: www.thehindubusinessline.com/news/ministry-rolls-out-new-form-forcorporate-disclosure-of-significant-beneficial-owners/article28274876.ece Source: www.dsavocats.com/wp-content/uploads/2020/11/India-%E2%80%93Significant-Beneficial-Owners-%E2%80%93-amended-rules.pdf www.thehindubusinessline.com/economy/policy/beneficial-ownership-pefunds-pitch-for-clarity-in-fdi-policy/article32293418.ece Source: www.thehindubusinessline.com/markets/stock-markets/SEBI-bars-19entities-for-GDR-manipulation/article20338914.ece Source: www.financialexpress.com/industry/sc-seeks-response-from-morepenlabs-in-2003-case/2302760/

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11 In the case of GDR issuance by firms such as, but not limited to, Himachal Futuristic Communications Ltd. (HFCL) in 2002 and KEI Industries Ltd. in 2005, all GDRs were subscribed by just one entity namely Roker Securities in the case of HFCL and Fusion Investments Ltd. in the case of KEI industries Ltd. 12 Ex-parte orders refer to orders that are issued when one of the parties is not present or not represented. One way to issue ex-parte orders is by not issuing a show-cause notice in the first place. 13 See Vipin Sharma vs. SEBI Miscellaneous Application Number (No.) 50 off 2020 and Appeal No. 58 of 2020 that is accessible at http://sat.gov.in/english/ pdf/E2020_JO202058.PDF 14 See Miscellaneous (Misc.) Application No. 12 of 2021 and Misc. Application No. 66 of 2020 and Appeal No. 62 of 2020 that is accessible at http://sat.gov.in/ english/pdf/E2021_JO202062_23.PDF. SEBI has now appealed against SAT’s order setting aside SEBI’s order in-connection with GDR issuance by Morepen Laboratories in the honourable Supreme Court of India. 15 https://www1.nseindia.com/corporates/content/ind_dep_rec.htm#:~:text=An% 20IDR%20is%20an%20instrument,raise%20funds%20from%20the%20Indian 16 The IFSCA will “regulate financial products (such as securities, deposits or contracts of insurance), financial services, and financial institutions which have been previously approved by any appropriate regulator (such as RBI or SEBI), in an IFSC” (https://prsindia.org/billtrack/the-international-financialservices-centres-authority-bill-2019-1005). 17 It is reported, “CEOs of Swiggy, Urban Company, Cred, Infra.Market, Byju’s and Unacademy along with partners from Sequoia Capital, Accel, Lightspeed and Tiger Global, among others, said that enabling overseas listing will be “the single most significant, big bang reform for the startup ecosystem and will instantly pave the way for Indian companies to be on the global map” (www. moneycontrol.com/news/business/markets/top-startup-founders-vcs-write-topm-asking-for-overseas-listing-7285861.html) 18 A story in the Mint of March 23, 2022 reports, “India has frozen plans to allow local firms to list overseas as it seeks to bolster its own capital markets, government officials and industry sources said, in a blow to foreign funds and stock exchanges seeking to tap into the country’s tech boom” (www.livemint.com/ market/stock-market-news/india-freezes-plans-to-allow-local-companies-tolist-overseas-report-11648042753968.html)

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Index

ADR: American Depository Receipt 3, 5, 6, 10, 11, 16, 17, 24, 25, 27, 28, 30, 31, 33, 34, 35, 38, 39, 41, 42, 49, 52, 53, 61, 76, 79, 80, 85, 88 Ahluwalia 7, 87 Alternative Investment Funds 81 Ambuja Cements 43, 44, 45, 54, 55, 70 AMEX 14, 22 arbitrage 1, 2, 13, 40, 41, 43, 65, 75, 88 ARCH 66, 67, 68, 69, 77, 87 Arvind Mills 7 Axis Bank 43, 45, 51, 54, 60, 63, 73 Balassa: Bela Balassa 2 Bantwa 7, 87 Bollerslev 67, 69, 77, 87 Bombay Dyeing 7 BoP 19, 20, 84 British American Tobacco 5 BSE: Bombay Stock Exchange 12, 15, 40, 44, 46, 47, 48, 49, 50, 51, 52, 54, 64, 69, 88 capital account 20, 21, 25, 26, 84 CESC 7 Chouksey 7, 87 Companies Act 44, 84 correlation analysis 53 correlation coefficient 53, 76 COVID-19 36 creditansalt 5 Crompton Greaves 7 CRTBI 36 current account deficit 20, 26, 33

depositary receipt mechanism 7 depository receipt 3, 16, 18, 19, 20, 87, 88, 89 DishTV 35, 38 domestic depository 84 domestic tariff area 84 DR: depositary receipt 3, 4, 7, 8, 17, 21, 22, 23, 25, 30, 38, 39, 41, 47, 49, 52, 54, 55, 63, 64, 77, 80, 81, 84, 88, 89 Dr Reddy’s Laboratories 39, 41, 42, 44, 45, 51, 53, 54, 61, 74, 76 EEC: European Economic Community 6 Employee Stock Options 7 Enforcement Directorate 47 Engle 66, 67, 69, 77, 87, 88 EU 8, 9, 10, 14 Euro 69 Euroclear 18, 22, 80 Euro-MTF 9, 10, 14, 44, 45, 46, 47, 48, 49 Euronext 14, 29, 53 Eurozone 80, 81 FATF 27, 38, 81, 85 FDI 20, 27, 28, 33, 85 FII 21, 33, 34, 81 Financial Services Centres Authority 84 Finolex Cables 7 Foreign Currency Convertible Bonds 4, 7, 8, 50 FPI 17, 20, 35 Futures Industries Association 12

92

Index

GAAP 9, 10, 11, 14 Gandhinagar 84 GARCH 66, 67, 68, 69, 77, 88 GBP 8, 9 GDP 33 GDR 4, 5, 6, 7, 8, 9, 14, 17, 18, 19, 21, 22, 23, 25, 27, 28, 29, 30, 31, 33, 34, 35, 37, 38, 39, 43, 44, 45, 46, 47, 48, 49, 50, 51, 52, 55, 59, 63, 64, 70, 73, 80, 81, 82, 83, 85, 86, 88, 89 GDRs/FCCBs 27, 28, 50, 88 GDS: Global Depositary Shares 25, 47, 48, 49 globalisation 2, 16, 65, 85, 88 Great Depression 6 Great Eastern Shipping 7 GST 84 Gujarat International Finance-Tec 84 Hansda 27, 42, 88 HDFC 76 Hindalco Ltd 7 Hitachi 6 IBFSL 44, 46 IBHFL 44, 46 ICICI Bank 44, 45, 52, 54, 62, 74, 76 IDR: Indian Depositary Receipts 84, 86 Indiabulls Financial Services 19, 43, 44, 45, 54, 56, 70 India Hotel 7 Indian Capital Markets 4, 30, 63 Indian GDRs 27, 64, 81, 88, 89 IndusInd Bank 43, 45, 46, 54, 56, 71 Information Technology 7, 88 Information Technology Enabled Services 7 Infosys 3, 19, 37, 44, 45, 52, 53, 54, 62, 75, 76, 79 INR: Indian rupee 12, 17, 19, 20, 26, 34, 44, 46, 47, 48, 49, 50, 51, 52, 76, 81 International Accounting Standards Board 14 International Financial Reporting Standards 9 International Financial Services Centre 29, 84 Investment Education and Protection Fund 81

IOSCO: International Organisation of Securities Commissions 27, 38 IRDA 81 IRF: Impulse Response Functions 55, 63 Jayakar 82, 88 Jithendranathan 42, 88 Kadapakkam 43, 88 Kotak Mahindra Bank 43, 45, 46, 47, 54, 57, 71 Kotak Mahindra Finance Ltd 46 L’Air Liquide 5 laissez faire 2 Lamont: wen Lamont 2, 3, 89 Larsen & Toubro 7, 43, 45, 50, 54, 59 Lau 42, 89 liberalisation 7, 17, 27, 69 Lieberman 42, 89 LSE: London Stock Exchange 5, 6, 7, 8, 9, 14, 22, 24, 29, 31, 38, 43, 48, 49, 50, 51, 63 Luxembourg Stock Exchange 5, 7, 9, 19, 22, 30, 43, 44, 46, 47, 48, 49, 50, 51 MacDonald’s: Big Mac index 2 Madhavan 35, 76, 77, 78, 89 Majumdar 89 Markowitz 65, 89 McDowell & Company Ltd 49 MGARCH 69, 77, 78 Ministry of Corporate Affairs 81 Ministry of Finance 6, 27, 28 Mitsubishi Corp 6 Mitsui & Co. Ltd 6 Morepen Laboratories Ltd 83, 86 MTF 9, 10, 14, 44, 45, 46, 47, 48, 49 Mujumdar 78 Nasdaq/NASDAQ 5, 10, 11, 14, 15, 19, 22, 23, 24, 29, 31, 37, 40, 53, 88 National Company Law Tribunal 47 National Stock Index 69 NBFC 46 New York Curb Exchange 5, 14 Nifty/Sensex 69

Index

93

Objecting Beneficial Owners 80, 85 octroi 1 OTC: Over-the-Counter 5, 10, 11, 22, 24 OTCQB 10, 15 OTCQX 10, 15, 24

Sahoo Committee 28, 88 Samuelson: Paul Samuelson 2 SBI: State Bank of India 43, 45, 50, 54, 60, 73 Scholes 65, 87 SEBI 12, 18, 27, 28, 29, 30, 37, 81, 82, 83, 85, 86, 88 SEC: S Securities and Exchange Commission 6 Securities Appellate Tribunal 82 Securities Contracts 8 Shanghai Stock Exchange 14, 36 significant beneficial owners 81 Sony 6, 14 Sovereign Wealth Funds 80 Sterling International Enterprises 43, 45, 47, 54, 57, 71 Stock Exchange Electronic Trading Service 9

Panagariya 7, 89 pari passu 19 permissible jurisdictions 29 permissible securities 29 PFRDA 81 PFUTP: Prohibition of Fraudulent and Unfair Trade Practices 82 Prevention of Money Laundering Rules 29 Professional Services Market 9

Tata Motors 43, 44, 45, 48, 49, 54, 58, 63, 72, 75 Tata Power 43, 45, 47, 48, 54, 59, 63, 64, 72 Tata Steel 43, 45, 51, 54, 61, 63, 64, 74 TELCO 48, 49 Thaler: Richard Thaler 2, 3, 89 The Economist 2, 13 Toshiba 6 Tube Investments 35, 38

QIP: Qualified Institutional Placement 30, 34, 37, 38 Quesnay: François Quesnay 1

United Spirits 43, 45, 49, 54, 58, 72 USD 11, 14, 19, 20, 21, 22, 24, 25, 26, 31, 32, 34, 35, 36, 47, 48, 49, 50, 51, 52, 53, 68, 76 US Federal Reserve 79

non-Objecting Beneficial Owners 80, 85 North German Lloyd 5 NRI 29, 30, 38 NSE: National Stock Exchange 12, 19, 22, 29, 41, 44, 46, 48, 49, 50, 51, 52, 54, 64, 69, 84 NSSA: New York Society of Security Analysts 6 NYSE: New York Stock Exchange 5, 10, 11, 14, 19, 22, 23, 29, 37, 44, 49, 53

RBI 20, 21, 28, 32, 33, 34, 76 Real Estate Investment Trusts 81 Recognised Stock Exchange 29 Registrar of Companies 81 Reliance Industries Ltd 7, 8 rolling standard deviation 66, 67 Rule 144A 5, 6, 22, 25, 47

VAR 55, 64, 68, 77 Videocon International 7 VSNL 19, 37, 76 Yawata Steel 6