Percy Mistry: The urgency of a new round of financial reforms

MUMBAI-IFC REPORT-II

If everyone is cruising at 120 kmph, insisting on driving at 20 kmph is neither safe nor prudent.

Mumbai's becoming an International Financial Centre is a metaphor for proceeding urgently with the next stage of deep and wide financial sector reforms that have been too long delayed. Vijay Kelkar has astutely observed that the real value of this report may lie not in the emergence of an IFC in Mumbai but in the efficiencies that further financial reform would unleash in resource allocation. By lowering India's capital-output ratio (resulting in more output and exports with less investment of financial capital) and improving capital productivity, India's growth rate of 8.5 per cent could be increased to 10 per cent without much further ado.

But the MIFC Report is not a pioneer in advocating further financial reform. It is a second-stage booster. A comprehensive agenda for financial reform was outlined much earlier in the two Narasimham reports. The first gained traction in 1992-95. Its recommendations were implemented in the immediate aftermath of the 1991 crisis. But the second did not gain as much momentum. Along with the first Tarapore report on capital account convertibility, it came at an inauspicious moment, when the world and India were bent on learning all the wrong lessons from the 1997 Asian crisis. That unfortunate (and avoidable) regional debacle became an excuse for India's financial authorities to move too slowly on reform in general and on capital account convertibility in particular.

The MIFC Report revisits that strategic error. It shows that India's domestic financial system is becoming, inexorably, a part of the global financial system. The boundary between the two is blurring too rapidly for regulatory comfort. But that kind of integration should be a matter of delight to the producers of financial products and services, and to their Indian consumers, alike. The efforts of the regulatory authorities (determined to retain command) appear to be aimed at retarding the evolution of the Indian financial system by deferring action on a multifaceted agenda, such as:

Proceeding decisively with full convertibility;

Inducing the emergence of as strong a corporate bond market as the increasingly robust G-Sec market;

Encouraging the emergence of a complete derivatives market offering interest-rate, currency, credit-default and political risk derivatives;

Breaking down the boundaries between, and strengthening, all types of financial institutions and markets to suit market dynamics; rather than

Compartmentalising financial market segments too tightly to suit regulatory turf divisions and regulatory domain convenience;

Not pressing hard for the overdue privatisation of state-owned banks but instead attempting to prolong their regime of protection; by

Slowing down foreign entry by posing absurd macro and micro barriers;

Indulging in excessively intrusive regulation and supervision, to the point of regulatory micro-management.

The Report deals with all these issues in depth. They require wider public discussion and resonance; regardless of how uncomfortable that might make the regulatory authorities. In justifying their 'go-slow-for-safety's-sake' approach, the authorities are deploying arguments that are only partly valid (if that) in the short-run, and probably damaging in the long-run, to Indian finance. India's growing share in world trade (especially in services) and cross-border investment (direct and portfolio) is making hitherto unprecedented domestic demands for international financial services. But financial policy adaptation and regulation is not keeping pace with that unfolding reality. Instead, and inexplicably, India's financial regulators are adopting a reflexive Canute-like posture, attempting to hold back an unstoppable global tide.

Whether India's authorities wish it or not, its financial system has, of its own accord, entered the slip-road leading on to the global financial expressway. India no longer has a choice of letting its domestic financial system evolve cautiously at bullock-cart speed. India's new annual growth of 8-9 per cent appears to have taken firm hold.

Competing on the global frontier in finance, or trade in real goods and services, is like being on a high-speed motorway, rather than the parallel unpaved rural road that Indian financial policy-makers and regulators are travelling along. If everyone else is cruising along at 120 kmph, then insisting on driving at 20 kmph is neither safe nor prudent, however loudly that instinctive preference may be asserted. In those conditions, the slow-moving Indian financial system becomes a menace to itself, and a danger to others travelling on that same global financial expressway. Yet, the argument being offered axiomatically and ex cathedra by the authorities is that going slow with financial reform and convertibility is essential for its own sake. Going faster runs the risk of destabilising the financial system and the economy. That argument, of course, ignores the fact that going much slower than evolving circumstances demand (simply because the financial authorities do not appear to be sufficiently equipped in terms of their knowledge and grasp of modern quantitative finance, or of principles-based regulation, to cope with the complex new challenges they confront) may run an even greater risk of destabilising the Indian economy and its financial system. This is what the present confusion over monetary and exchange rate policies seems to suggest.

We are experiencing unnecessary difficulty in managing the contradictions of: (1) maintaining a low inflation rate with a competitive exchange rate, in the face of rapid capital inflows; but (2) artificially impeding capital outflows that are not permitted to respond to the same global market signals to the same extent. And we are making life unnecessarily difficult for the Indian corporation and individual by retarding the development of essential markets (such as those for currency, credit and interest rate derivatives) and institutional capabilities that would enable them to better manage their day-to-day risks (for example, of unhedged exposure to exchange and interest rate movements) in properly functioning, liquid derivatives markets, rather than stalling on these markets because our relatively inefficient state-owned banks (or SOBs as they are referred to throughout this series "" an acronym more accurate than the sobriquet 'PSU banks' or zombies, that caused such an unnecessary disturbance when used for explanatory purposes that were clearly misunderstood) cannot be trusted to use them, without incurring the risk of their own financial destruction.

The contours of the world economy that India is competing in, and the complexity of the new policy-making matrix that confronts our financial authorities, requires reform and opening up to go much faster, in order to adjust to the realities of constantly changing global forces. The 'go-slow-at-any-cost' strategy has had the unintended consequence of India's financial system now lagging too far behind the real economy. It is not meeting India's needs for efficient, cost-effective domestic or global financial intermediation. That is why corporate India and high-net-worth individuals look abroad for their financial needs. That will eventually become an ingrained habit, with India and Indian finance losing out permanently.

The author was the chairman of the committee that wrote the MIFC report. This is the second in a six-part weekly series