Jamal Mecklai: Tarapore panel: Medium speed ahead

MARKET MANIAC

The sudden jump in the rupee last week, right after the release of the Tarapore Committee report on Fuller Capital Account Convertibility (complete with two dissent notes), was a pretty loud indicator that the market believes that under a less controlled regime the rupee would be stronger. An India with fewer controls would be more efficient, and, while volatility in financial markets would increase, so would growth. Higher growth would attract greater investment, leading to (among other things) improved infrastructure, which would feed the virtuous cycle. Of course, increasing the speed of the growth cycle would increase risks and there would likely be greater volatility in growth itself.

Unfortunately, the report continued to be educated by the "fear of volatility" that so deeply colours all our policy-making, as a result of which many of the reforms recommended may have difficulty getting appropriately fresh air to breathe. For instance, there was a concern""articulated in one of the dissent notes, of all places""that if a million Indians were to remit $25,000 abroad at the same time""even at today's pathetic limit""it could result in a $25 bn outflow, which would create undue volatility in the market. Huh? Volatility is a reality and something we have to learn to manage rather than fear. Volatility is life, and, to paraphrase India's largest private sector company, life is growth.

Besides, from a purely moral standpoint, why should the Indian government discriminate against Indian residents? Why should I not have the same facility as a non-resident? If the economy starts running aground because of poor policy, I am suffering anyway; why shouldn't I be able to protect my capital by investing overseas? And, if, as a result, the market gets more volatile, so be it.

However, despite these fundamental concerns, I believe the Committee did a reasonably good job in laying out an exhaustive list of "things to do". To my mind, the most important issues raised were the need (i) for the RBI to be independent and singularly focused on monetary policy; (ii) to strengthen banks' capital base and skills at all levels, both of which point to the need for reducing government ownership; (iii) to increase liquidity in the domestic money market; and (iv) to widen participation in the forex market.

The first two areas require considerable political jockeying, and will, because of that, take some time""although some of the work to spin the Office of Debt Management out of the RBI has been already done, and the need to meet the Basel II guidelines is putting more and more pressure on the government to relent on majority ownership of public sector banks. However, the other two areas can be started upon immediately.

The RBI should articulate a maximum percentage (say, 50%) of banks' gilt portfolios to be "held to maturity" and reduce this percentage over time. While this would hit bank's share prices""since the risk-adjusted value of their assets would fall""it would provide a critically necessary jump start to gilts' liquidity, which is a precondition for any further liberalisation.

It is worth noting that our gilts market trades only about Rs 2,500 crore a day, which is about 0.2 per cent of the Rs 12 lakh crore of government securities outstanding; for comparison, US Treasuries trade about $500 bn a day, which is around 2 per cent of outstanding US government debt. This means that our gilts market is just one-tenth of the way to global liquidity, despite having global-quality infrastructure and technology!

In comparison, our domestic forex market, which trades around $15 bn a day, provides a multiplier of 30 on underlying trade; against this, the global forex market trades about 100 times underlying trade, which makes our forex market 25-30 per cent of the global in liquidity terms.

One of the key differences between these two markets is the fact that in the forex market, technology evolved naturally into a strongly broker-driven and, by then, reasonably liquid market about 25 years ago, while in the gilts market, technology was thrust onto a broker-driven but not very liquid market. Technology is amazing at creating transparency and reducing spreads after there is adequate liquidity""witness the success of the NSE. However, imposing technology""and outing brokers""in a thin market results in the kind of turnover we now have in the gilts market. The good news is that the Committee seems to have recognised this and spoken of the need to empower brokerage houses.

To deepen and widen the forex market, the Committee recommended permitting FIIs and FDIs to cancel and rebook forward covers (recognising that this need is driving the growth of the NDF market), which can be immediately implemented. More radical""and wonderful""is the recommendation to delink credit facilities from forex cover limits; this would substantially broaden the market and provide SMEs with an opportunity to much greater efficiency. It would, in parallel, require banks to improve their trading skills or choose not to play this game at all. However, I felt that the Committee's suggestion of creating an electronic price discovery mechanism was a bit clumsy""far better to immediately allow currency futures on one or more of the existing exchanges.

All in all, as I said earlier, I think the report was reasonably good. More importantly, the very fact of the laundry list and the fact that the report is on the table makes me believe that the "like that only" process of jerky liberalisation is about to take a few more steps. Perhaps the rupee's jump is another signal of that.