Subir Gokarn: Icing on the cake

Many of the individual recommendations of the Percy Mistry report are in alignment with the current trajectory of the economy.

An invitation to speak at a seminar on the report on Mumbai as an International Financial Centre, recently submitted by the High-Powered Expert Committee, gave me an opportunity to think about this issue a little systematically. When the recommendations of the report were first published, my reactions, like those of many others, swung between awe at the sweep and scale of the recommendations and disbelief about the possibility of anybody in government taking them seriously.

However, regardless of what one might think of the grand plan, the several recommendations made by the Committee deserve consideration on their individual merits, both with respect to their perspective on the financial sector and their view on the future of urban governance. These are some thoughts, mainly on the former.

First, on the fundamental issue of agglomeration, which the Committee believes is critical to the emergence of an IFC, the historical precedents of London and New York appear to have a heavy influence on its thinking. The need to get a critical mass of capabilities and activities together in one location drives many of the recommendations. However, the recent evolution of global financial services suggests a strong tendency towards "de-glomeration", with various components of the value chain that support the final transaction between service provider and client being spread over several locations, based on relative costs.

India is clearly a huge beneficiary of this de-glomeration and, just as clearly these benefits are not concentrated in Mumbai, Bangalore, Chennai, Gurgaon, Pune, Hyderabad, Kolkata and Jaipur are all mature or growing locations for several links in the financial value chain. Yes, these links may currently be at the lower end of the chain, but their location in India has undoubtedly helped London and New York maintain their competitive advantage with respect to higher-value transactions.

Even when this erodes, enabling other locations to take their place, it is quite unlikely that agglomeration will drive that process in the same way that it did in the past. Mumbai itself would have to leverage lower-cost resources, not just in India but in other countries as well, to sustain its competitiveness in the upper end of the value chain.

From this perspective, the exclusive focus on Mumbai may be too narrow. The city may emerge as the next big thing in global finance, but it will be at the apex of a pyramid whose lower levels may be anywhere. As desirable as it may be to see Mumbai governed and invested in more effectively, the emergence of an IFC in India may need to be seen through a somewhat wider geographic lens.

Nevertheless, there is little question that the country will, sooner rather than later, reach a point at which the demand for financial services will justify an IFC. Sustained growth will not only keep the current momentum on capital inflows going, it will intensify it as funds flow into infrastructure (without which, the growth is unlikely to sustain!). More finicky investors, such as pension funds, will strengthen the demand for services related to governance, compliance, certification and so on. Outward investment by Indian companies and individuals will also seek the most efficient services, whether they are produced in India or elsewhere. It is already clear that the big outward investments by Indian firms hardly use any services provided by the domestic financial sector.

Under the circumstances, expanding and strengthening the availability of financial services within the country through a more liberal entry and foreign investment regime is important. Of course, the regulatory framework "" more importantly, regulatory capacity "" would have to be beefed up. This process would also put priority on the development of a full spectrum of financial markets "" the bond, currency and derivative markets that the Committee emphasises.

Two other recommendations are also consistent with the emerging balance of payments scenario. Persistently high capital inflows warrant both an accelerated movement towards full convertibility and a transition to a flexible exchange rate regime. An undervalued currency can continue to boost competitiveness, but, as a policy, it both heightens risks of a crisis in response to external shocks and, by encouraging people to avoid hedging their foreign exchange exposures, it makes them more vulnerable to these shocks. Together, the development of markets, the timeframe for convertibility and the transition to a flexible rate regime constitute a high-priority agenda for financial sector reform independent of the ultimate goal of an IFC.

None of these, however, is dependent on the shift to inflation targeting as the principle of monetary policy, as the Committee suggests. With full convertibility, the domestic financial sector is fully plugged into the transmission of global shocks, wherever they might originate. Just as a pegged exchange rate reduces the degrees of freedom that the central bank has to deal with shocks, so does a commitment to an inflation target. Flexibility is critical to dealing with turbulence. A credible commitment to balancing growth and inflation in a stable and sustainable way is the most appropriate position for monetary policy in this environment.

A final point, on the dilemma that articulating the need and approach to reforms. One way is to point to a lofty objective as a motivating and energising force and risk the non-acceptance that comes from disbelief. The other is to structure the change agenda as a series of small and non-disruptive steps, which are more palatable but take way too long to have any meaningful impact. Regardless of whether the ultimate objective of the recommendations is accepted or not, many of the individual recommendations are in alignment with the current trajectory of the economy and action will have to be taken on them.

One would hope that the association between a set of sensible recommendations, which need to be looked at on their own merits, and the setting up of an IFC, which is quite likely to be the subject of prolonged debate, does not result in the abandonment of those recommendations. In other words, I would like to see financial markets deepen, full convertibility happens and the exchange rate being determined largely by market forces. I would also like to see Mumbai become a better governed city, even perhaps a model for urban reform in the rest of the country. An IFC, though, would just be the icing on the cake.

The writer is Chief Economist, Standard & Poor's Asia-Pacific. The views are personal. This article is based on remarks made at a seminar organised by the Ministry of Finance, the National Council of Applied Economic Research, and Mastercard International on August 21, 2007