Why list offshore?
From 1992 onwards, offshore listing has been an important vehicle through which firms in India have raised capital. Initially, the focus was on "global depository receipts" (GDRs), which trade in many European countries and particularly in London. In recent years, there has been sharp interest in "American depository receipts" (ADRs), which trade in the US.
In this article, we think through the rationale for offshore listing and ask questions about the appropriate role for ADRs/GDRs in India's financial system.
Let us start with the question about foreign ownership of Indian equity. We have preponderant evidence, and conceptual arguments, in favour of large-scale ownership of local firms by foreign shareholders. For example, it makes great sense for Indian investors to buy shares of foreign companies: doing so would yield improved diversification and hence low risk for Indian investors. By the same coin, Indian equity risk is uncorrelated with global portfolios, so foreign investors require a lower rate of return from Indian equities. Thus, foreign ownership of Indian equity reduces the cost of capital in India, and makes more investment projects viable.
How can foreign investment into Indian equities be implemented? Broadly, there are two strategies: either foreign investors can buy Indian shares in India, or Indian firms can list their shares abroad in order to make these shares available to foreigners.
Foreign investors buying shares in India has traditionally been limited by two problems:
- The first problem faced is poor market design on the Indian equity market. When foreign investors first appeared in India, in the early 1990s, they were horrified at the equity markets that they saw. The Indian equity market imposed extremely large transactions costs upon investors (i.e., it was highly illiquid). This was an obvious motivation for GDRs and ADRs: Indian firms saw these as a way to bypass the incompetent Indian equity market mechanisms and instead jump to the well-functioning equity markets found abroad. When Indian firms issued shares on the GDR or ADR markets, their shares commanded a higher price owing to a liquidity premium.
- The second problem faced is restrictions on equity ownership by foreigners. Only "foreign institutional investors" can buy shares in India, while anyone can buy GDRs or ADRs. FIIs face restrictions on the fraction of a firm that can be purchased. This imposes ceilings on foreign ownership. In contrast, participation in the GDR or ADR market is unencumbered, and hence GDRs or ADRs generally enjoy a premium.
From 1994 onwards, with the rise of electronic trading, clearing corporation and depository, the first order mistakes in market design in India have been addressed. The Indian equity market has obtained a quantum leap in liquidity. We are still inferior to international standards in a few respects, such as the rolling settlement, the presence of leveraged trading on the spot market, and the limited access to derivatives. However, the picture on liquidity has turned around completely. It is easy to examine the `market by price' on NSE, and compare it with the bid/offer spreads seen for GDRs or ADRs: we see sharply higher liquidity on NSE. From 1996 onwards, there has been no liquidity premium argument which favours offshore listing.
This superiority of liquidity in India is not accidental. The liquidity of the stock market is ultimately driven by retail investors and speculators, who are found in the home country, in Indian standard time. Hence, no foreign market can ever harness the liquidity which is found in India. Indeed, a firm which issues ADRs or GDRs actually suffers an opportunity cost by listing abroad: if it had (instead) issued shares domestically, it would have improved local liquidity and obtained a liquidity premium. Instead, issuance abroad fragments the order flow and yields no improvement to local liquidity.
In this conceptual framework, what is the optimal policy for a firm which operates under existing Indian regulations and laws, and seeks to obtain the highest possible valuation? We can propose a few ingredients:
- As far as possible, it is better for a firm to issue shares in India, and obtain good liquidity by building up market capitalisation and retail investors in India.
- Foreign investors would always be willing to pay higher prices for Indian shares, so it is important to woo FIIs. The companies with the largest fraction of foreign ownership would obtain the highest P/Es and the lowest cost of capital. Towards this goal, the company should pass the special resolution which raises the limit upon FII shareholding from 24% to 40%.
- When the company hits the limit of 40% FII shareholding, it makes sense to use ADRs or GDRs as a way of further improving foreign shareholding. The benefits here (of greater foreign ownership giving an improved valuation) are diminished to the extent that GDRs and ADRs are extremely illiquid. The two--way fungibility, announced in the budget speech, will help improve the liquidity of ADRs or GDRs, but there is no possibility of an ADR or GDR being as liquid as NSE.
- Conversely, there is no real argument in favour of GDR or ADR issuance for an Indian firm which has not yet hit the 40% limit.
The above receipe is appropriate for a firm in India which faces existing economic policies. Suppose we could change these economic policies, and try to find the economic policy strategy which would yield the lowest possible cost of capital for the firms of India. What would we undertake?
- Foreign investment brings capital into India, and reduces the cost of capital for a firm. From the perspective of economic freedom, the shareholders of a firm should be free to choose whom they sell shares to. The sale of a share is a private action between one investor and another. This budget has made a step in the right direction by allowing shareholders to increase the limit on FII shareholding from 30% to 40%. However, this limit should be raised to 100%. A firm should be free to sell shares to anyone it wants; the Government of India should not have a say in this matter.
- The definition of "FII" should be steadily broadened, so as to improve the investor base that all Indian companies can access. This would eliminate the incentive that Indian firms are given, to suffer poor liquidity in offshore markets, in order to obtain a wider foreign investor base.
If our policies are amended in these two directions, there will be no case for ADRs or GDRs by Indian firms. Instead, Indian firms will consolidate all their liquidity in India. Indian firms will then avoid fragmentation of their liquidity, and obtain the lowest possible cost of capital.
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