Go slow on banks

When India opened up to trade, it facilitated greater competition and improved the muscle tone of Indian manufacturing. In similar fashion, opening the capital account will give greater competition in Indian finance. A lean and competitive financial sector will help to speed up Indian GDP growth. Hence, convertibility is a core element in policies for accelerating GDP growth. But capital account convertibility is known to induce grief with badly regulated parts of finance. This is, hence, an appropriate time to take stock of the structural flaws in Indian finance.

A longstanding problem remains that of the debt market. There will be six great currencies in the world in the years to come: the US dollar, the euro, the Japanese yen, the British pound, the Chinese yuan and the Indian rupee. The first four in this list have globalised debt markets. Anyone in the world can buy a yen-denominated bond, and anyone in the world can issue a yen-denominated bond. A key goal for India should be that the rupee yield curve should reflect a fully globalised market. The rupee should be a hard currency that is used for issuance by governments and companies from all over the world. But in order to get there, we need to first get to a well-functioning bond market. For 15 years now, efforts on the debt market have floundered while the equity market has gone from strength to strength. It is time for policy makers to go back to the drawing board, and replicate the market design of the equity market for the bond market.

A key aspect of Indian financial globalisation will be commodity markets such as gold. Mumbai can be a world centre for the gold spot and gold futures markets. But for this to come about, we need to question the wisdom of placing commodity futures regulation with the Forward Markets Commission and the department of consumer affairs. Consumers affairs are about weights and measures; gold futures trading is about securities markets. A sound policy foundation is required for commodity futures trading, that can only be provided by Sebi and the department of economic affairs.

The soft underbelly of Indian finance is banking. Banking regulation and supervision are riddled with problems. Though banks are much better capitalised now than a decade ago, they are still highly leveraged""with a 20:1 debt-equity ratio that would scare any normal businessman. Small mistakes by banks or the regulator can yield a troubled bank. The lion's share of Indian banking is with state-owned banks, so the initiative lies with the government. If the banking system cannot be fixed quickly, the wise strategy for the short run may be to keep banks out of the agenda for liberalisation of the capital account. India can reap enormous gains out of financial globalisation, based on inflows and outflows on the securities markets (comprising equity, debt and commodity futures) and investment (both inbound and outbound). These benefits are without risk if the economy is managed well over-all. Opening up banks to financial globalisation should be put off until basic institutional problems are solved: (a) Upgrading banking regulation, if not creating a new regulator on a par with some of the other new ones in the financial sector, (b) achieving high-quality regulations and supervisory procedures as judged by a team of international peer reviewers, and (c) creating much more space for private banking than is the case today.