Economic future lies in financial markets

Over-dependence on foreign capital can create volatility

Indians are great savers but not so good investors. Their investment pattern is probably dictated by generations-old biases. India was constantly invaded by foreigners,hence savings were invested in movable asset like gold. Our modern financial system is about two centuries old, with most of the regulatory set-up about two decades old. This created bias towards touch and feel instruments like real estate. Before the advent of the Securities and Exchange Board of India (Sebi) many companies disappeared with investors’ hard-earned money in both debt and equity capital. This created preference for safer instruments like government-guaranteed products. This bias for capital protection has resulted in misallocation of savings, leading to lower growth, fewer jobs, higher market volatility and dependency on foreign capital.

Since the mid-1990s regulators have done a great job in creating financial market architecture on a par with the developed world. Two decades back, in the stock market, bad delivery, company circle buying, settlement cancellation, payment crisis, jobbing difference etc were household words. Sebi has worked hard to create a regulatory environment where such words are not part of the lexicon any more. Banks are besieged with non-performing assets (NPA). While some of them are due to the business cycle many of them are related to mis-governance. The capital market has significantly better record in dealing with corporate mis-governance. Most NPA-laden companies before they became so were finding it hard to raise money from capital markets.

The efforts by the government, regulators and market participants in the last two decades have created a solid foundation for India to create better savings allocation, leading to appropriate investment, which is needed to accelerate growth and create jobs. 

A financial market develops on trust. The rule of law is a prerequisite for a deep financial market. Our judicial system is burdened with pending litigations. Complexity of economic crimes requires specialisation. The security scam of the early 1990s still awaits resolution. Cheque bouncing remains a crime on paper, with little real punishment despite a stringent law. Indian shareholders of Satyam haven’t got any compensation even though the US Securities and Exchange Commission fined Satyam and its auditor way back in 2011. Lenders at the National Spot Exchange have a long wait to recover their money. The judicial system must get its act together for establishing rule of law in financial markets. In the financial markets, justice delayed is justice denied. Our regulations are drafted assuming the lowest integrity leading to micromanagement and a tick-the-box approach. It would be far better to give exemplary and swift punishment for breaching the spirit of fairness to create a more compliant market. 

Transparency is another prerequisite for financial markets. Our tax rules are subject to several interpretations. On one hand, tax dodging like bonus stripping, dividend stripping, capital gains through illiquid shares is not curtailed, but foreign institutional investors are sent notices at regular intervals from tax treaties jurisdiction only to be taken back. Securatisation got pushed back with large tax demands due to different interpretation at odds with past methodology. While a clarification was given after repeated industry representations, the momentum was lost. Litigation still continues for that period despite new clarifications. It is the stated and repeated intent of the government to develop India as a regional financial hub like Singapore or Hong Kong. Despite making changes in taxation rules relating to permanent establishment, not many are sure about the current status of the law. Our tax ambiguity has ensured that more equity indices are traded offshore and a substantially large volume of rupee is traded in the non-deliverable forward market offshore than in India. Tax laws should be transparent and without subjective interpretation. Any change should be with prospective effect to reassure investors. 

The regulator should create a level playing field among various industries as well as members of the same industry. Statutory bodies can invest with banks but not mutual funds even though they offer higher risk-adjusted return. Insurance can be sold at a different commission structure vis-a-vis mutual funds. Recognition of NPAs and valuation of securities varies across market participants. Not having a level playing field creates distortions. In mutual funds, such a situation is created as some fund house has more funds than others due to historical approvals, less restrictive asset allocations helping generate out-performance and privileged access to a certain set of client money than others. In the National Pension Scheme, a few players have privileged access to client money over others, creating size advantage. Know-your-customer (KYC) criteria are different across regulators. It is not interchangeable in different regulatory regimes as well as within the same regulatory regime. A lot of unnecessary paperwork acts as deference to financial market entry. There is a need to ensure that there is a common KYC across the financial market and portable across different members. There is an urgent need to create a level playing field to remove market distortions. Let the best person survive under competitive pressure rather than through statutory patronage.

Financial market regulations are far tougher compared to competing peers. There is no KYC required for buying gold. There is no restriction on commission payout in the real estate industry. The governance mechanism varies significantly between financial market players and players in the real estate and gold markets. It is important to upgrade governance standards of non-financial market participants to the financial market level. Let there be a similar client-first approach across all players.

Financial markets thrive on innovation. We must encourage innovation through open interactions with market participants. Interest rate futures needed to be modified several times to make it work in the Indian context as views of market participants were ignored. Gold exchange-traded fund despite being conceived in India was launched elsewhere as approvals took time. We don’t have the luxury of time if we want to become a regional financial hub. 

There are multiple micro-things, which need to be done to deepen and broaden the financial market. The same can be achieved through open dialogue between regulators and market participants, with the common vision of developing India as a regional financial hub.

This is a journey like the one the British government undertook in the mid 1980s through big-bang financial reforms to make London the nerve centre of financial markets. This journey is necessary as India needs trillions of dollars for building infrastructure and manufacturing capacities. India also needs to pull millions of people out of poverty. Over-dependence on foreign capital can create sharp volatility. Inadequate investment will not allow accelerated growth or poverty alleviation. Our economic future to a great extent lies on how we shape the financial markets in the days ahead.

The author is managing director, Kotak Mahindra Asset Management Company