Ajay Shah: New IFCs and their implications

The Indian licence-permit raj in finance is going to face significant stress from the external world. In particular, Dubai and Qatar could prove to be important in catalysing a breakdown in the role of domestic finance.

At present, India runs an elaborate licence-permit raj in finance. While the licence-permit raj has been dismantled in the real economy, it is flourishing in finance. In areas such as banking and pensions, steep entry barriers are in place; it is very difficult to start a new firm. FDI is proscribed. In all parts of finance, launching products requires permission from the government. These permissions are often not given (e.g. currency futures are banned). When permissions are given, they involve substantial delays, thus robbing financial firms of the incentive to innovate. As a consequence, we have a slothful financial sector with stable market shares, much like the cosy existence of Indian non-financial firms prior to the reforms of the 1990s.

This licence-permit raj is failing to meet the needs of domestic non-financial firms, who are increasingly turning into world-class firms. For firms like Infosys, Reliance or Tata Steel, the world is the market, and competition is global. Buying inferior raw materials leads to competitive disadvantage. As a consequence, these firms have evolved towards buying the best products and services "" such as low-cost debt capital or sophisticated financial derivatives "" from the global financial sector.

Through an elaborate system of capital controls, the government is valiantly striving to prevent Indian firms from buying the best financial products and services. However, the pressures of global competition are real. If international steel companies have access to world-class finance, then forcing Tata Steel to buy inferior local raw materials hampers competitiveness. This gives Tata Steel a strong incentive to find ways to get past the wall of capital controls and do business on a global scale as befits a global company. As an example, the bulk of the international financial services (IFS) associated with the Tata Steel-Corus transaction was put together outside the country, at a safe distance from the Indian licence-permit raj.

This puts Indian financial firms in an extremely uncomfortable position. Indian financial firms are unable to compete in selling to their natural customers "" local firms requiring IFS "" because the government comes in the way. Some governments try to be "protectionist" so as to prevent foreign competition from adversely affecting local firms. Through the licence-permit raj that is operating in finance, the Indian government is doing "reverse protectionism": it is preventing local financial firms from adversely affecting foreign firms.

In this situation, important developments are taking place in Dubai and Qatar. Both cities are trying to develop a capability to produce IFS. They are approaching it in two different ways. In Dubai, an enclave approach has been used. The Dubai International Financial Centre (DIFC) is removed from the local economy, which continues to operate under old-fashioned rules. In Qatar, the new effort consists of transformation of the country and not setting up something new in an enclave.

In both countries, a remarkable effort is under way to leapfrog to the frontier in terms of financial regulation. Concepts of financial regulation based on the "principles-based" approach of the UK are being implemented. The senior financial regulatory staff are typically recruited from first world countries. This yields rapid transfer of knowledge, and also inspires international credibility. This senior staff is free of the "fear of finance" that afflicts senior people in Indian financial regulators, who have often imbibed the attitudes to finance found in socialist India of the 1970s or 1980s.

These countries are emphasising the common law framework, where laws define broad principles and courts work out the implications of broad principles for specific institutional detail. The common law framework is intimately linked to the "principles-based" approach to financial regulation. However, operationalising common law requires high-quality judges with skills in understanding intricate details of financial markets and products. In order to achieve this, foreigners are also being brought in to be judges. The willingness to sacrifice holy cows is remarkable: Qatar even has a judge who is Jewish.

Dubai and Qatar are both tuned into the opportunity of rescuing Indian financial firms from the Indian licence-permit raj. In January, Rajat Gupta of McKinsey joined the board of the Qatar Financial Centre Authority. In May, ICICI Bank became the first Indian bank to set up a branch in QFC. Any ambitious CEO of an Indian financial firm needs to consider a strategy of setting up operations in London, Qatar, Dubai or Singapore so as to be immune to the Indian licence-permit raj, and be able to offer IFS to Indian customers from that platform.

These developments suggest two possible scenarios for India. In the gloomy scenario, Indian finance will evolve along Latin American lines. In Latin America, local firms typically get their financial services work done using the US financial system. In this scenario, the local financial system would shrivel into insignificance. Local financial firms which have any ambition of providing IFS would set up operations in Singapore, Dubai, Qatar or London, as a way of escaping the domestic licence-permit raj. Kotak Bank might provide financial services to Tata Steel in this scenario, but it would be done out of a jurisdiction outside India.

The alternative scenario is one where India is able to find the energy and dynamism required to achieve a far-reaching transformation of the financial sector. This requires a second wave of economic reforms, comparable with what was achieved in the non-financial sector from 1991 onwards, where a pernicious licence-permit raj was broken down, barriers to FDI were removed, entry barriers were removed, customs duties were slashed, and government permissions were no longer required for launching new products.

The "Mumbai International Financial Centre" (MIFC) report (https://bsmedia.business-standard.comtinyurl.com/2osms4 ) has given a blueprint of the financial sector policy initiatives required to cope with this challenge. The political leadership now faces a choice on whether this effort needs to be undertaken. While the task appears daunting in terms of rewriting obsolete legislation, reforming legacy agencies, and treading on bureacratic toes, it is not one which requires expending important political capital, because voters do not care about these things. It is much easier to transform the RBI and Sebi than it is to reform labour law.