Report of the High Powered Expert Committee on Making Mumbai an International Financial Centre
Report of the High Powered Expert Committee on Making Mumbai an International Financial Centre
Ministry of Finance Government of India New Delhi Report of the High Powered Expert Committee on Making Mumbai an International Financial Centre Ministry of Finance, Government of India, New Delhi
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The TEX packages used for typesetting this book have been released under General Public Licence for free usage, modification and redistribution and are available at http://sarovar.org/projects/goi-book. The High Powered Expert Committee (HPEC) on Making Mumbai an International Financial Centre
The Hon. P. Chidambaram th February Minister of Finance, Ministry of Finance Government of India, North Block New Delhi
Dear Honourable Minister:
We submit herewith the ’s Report on Making Mumbai an International Financial Centre. Our choice of the term ‘International’ instead of ‘Regional’ has been explained in our report.
Yours sincerely,
M. Balachandran O. P. Bhatt
C. B. Bhave Bharat Doshi
K. V. Kamath Nimesh Kampani
K. P. Krishnan (Convenor) Subodh Kumar
Ravi Narain Ms. Usha Narayanan
P. J. Nayak Aditya Puri
N. Mohan Raj T. T. Srinivasaraghavan
Acknowledgements
HPEC would like to place on record its grateful thanks to Ajay Shah, Kshama Fernandes, Saugata Bhattacharya, Ritu Anand, and S. Ravindranath who constituted the Research Team that supported the Committee. The also wishes to express its appreciation to Mr. M. Balachandran who put the facilities of the Bank of India at the disposal of the Committee. The and the Government of India would like to acknowledge their appreciation to the Bank of India for meeting the administrative expenditure for the production of this report.
Contents
Executive Summary xiii . International Financial Services () and Centres (s) in Perspective, xiii.—. Implications for India and Mumbai, xiv.—. The difference between and , xv.—. What are International Financial Centres (s) and Services ()?, xvi.—. Growth and globalisation drive India’s demand for , xviii.—. India’s competitive advantages in creating an , xix.—. Financial regime governance: policy and regulation, xx.—. Reorienting the financial system towards provision: A temporal roadmap for reform, xxiv.—. Urban infrastructure and governance in Mumbai, xxviii.—. The choice, xxx.
. The Emergence of IFCs: A brief history . Meeting cross-border trade, investment and other needs, .—. Evolution of international financial services () and centres (s), .—. The first round of globalisation: circa –, .—. An interregnum, the second round of globalisation (–), and beyond, .—. The ‘take-off’ of second round globalisation after , .—. Classification of s, .—. Why did Tokyo and Frankfurt not emerge as credible s?, .—. The Race to establish more s around the world, .—. Implications for India and need for Mumbai to emerge as an , .
. st Century IFS provided by IFCs . Fund Raising in s: What is involved? Who does it and how?, .—. Asset management and global portfolio diversification, .—. Personal wealth management, .—. Global transfer pricing, .—. Global tax management and cross-border tax optimization, .—. Global/regional corporate treasury management, .—. Global and regional risk management and insurance/re- insurance operations, .—. Global/Regional exchange trading of securities, commodities and derivatives in financial instruments and indices in commodities, .—. Financial engineering and architecture for large complex projects, .—. Cross-border mergers and acquisitions (M&A), .—. Financing for public-private partnerships (), .
. Case studies: London, New York, Singapore, Dubai . Summary overview, .—. A closer look at the City of London, .—. New York/Chicago as the GFC for the Americas and the World, .—. Singapore as the /Asian GFC, .—. Dubai as a RFC for the Middle East and South Asia, .
. Domestic and Offshore demand for International Financial Services (IFS) in India . Implications of a large, rapidly growing home market for IFS, .—. India’s growing integration with the world, .—. The impact of globalisation on demand and on s, .—. Estimates for consumption by India, .—. Projections for consumption by India, .—. Implications for India’s aspirations to create an in Mumbai, .—. customers outside India as a market for an in Mumbai, .—. International comparisons, .
. Augmenting IFS provision via BPO . How does an produce ?, .—. An outsourcing approach to provision and IFC development: Possibilities, opportunities and pitfalls, .—.A opportunity: Asset management in Mumbai based on algorithmic trading, .—. IFS subcomponents amenable to outsourcing, .—. Making progress along two paths: Evolution and , .—. Conclusion, .
. Market deficiencies in Mumbai that inhibit the provision of IFS . The context in which Mumbai must develop and evolve as an , .—. Inadequate currency and bond markets ( Nexus), .—. Missing currency & derivatives markets: An illustration, .—. The market weakness of institutional investors, .—. A cross-country comparison, . x R M I F C
. The macroeconomic fallout of an IFC . Introduction, .—. Implications for fiscal policy & deficit reduction, .—. Financing public debt differently, .—. The mutuality of interests in modernising debt management and having an , .—. Implications for monetary policy, .—. Outlook for the current account deficit, .—. Macro-stability for an , .—. The incompatibility of capital controls in a st century , .—. Full capital convertibility and an in Mumbai, .
. Financial Regime Governance: Its role in an IFC and a comparative perspective . The intrinsic value of regulation for production, .—. Three levels of international competition on regulation and law, .—. Where does India stand? An illustrative bird’s eye view, .—. The overall legal regime governing finance, .—. Summary of cross-country comparisons, .
. What are the limitations of financial regime governance? . Where do we stand? An – Market × Players matrix, .—. A pragmatic view of key areas for progress, .—. Lessons from applying competition policy in the real economy, .—. Artificial segmentation of the financial services industry, .—. Barriers to financial innovation, .
. Why does financial regime governance have these limitations? . Why is the pace of financial innovation slow?, .—. Proximate underlying reasons that are not as transparent, .—. Deeper sources of dysfunction, .—. What impedes Mumbai from becoming an ? A summary, .
. Reforming financial regime governance . A shift toward principles-based regulation, .—. Reducing the artificial segmentation of financial firms, products, services and markets, .—. Creating an environment conducive to exit, .—. Retail vs. wholesale markets, .—. The role of exchange-traded vs. OTC derivatives in the BCD nexus, .—. Regulatory impact assessments, .—. Strengthening the legal system supporting an , .
. Tax policy for an IFC in Mumbai . Does India need an IFC or a Tax Haven?, .—. Tax policy for Mumbai as an : and, by implication, for India, .—. A modern income tax, .—. Taxation of financial transactions, .—. A Goods and Services Tax (GST) in Finance, .—. Mumbai as an IFC: Tax Implications for Maharashtra and Mumbai, .—. Interfacing tax policy and administration with the financial industry, .—. Stability of tax policy, .—. Where India Stands on taxes: An international comparison, .
. A perspective on Mumbai’s strengths . Human capital needs for , .—. Democracy, Rule-of-Law and the Legal System, .
. Urban infrastructure and governance . The importance of high quality urban infrastructure for an IFC, .—. Problems of cost, .—. Cross-country comparison, .—. Difficulties in Mumbai from an perspective, .—. Improving urban governance in Mumbai, .
. The HPEC’s recommendations . The general macroeconomic environment, .—. Further Financial System Liberalisation and Reform, .—. The challenge of urban infrastructure and governance in Mumbai, .
Selected Bibliography
A. The Committee
B. Comparing existing IFCs against Mumbai Contents xi
C. Comparing emerging IFCs against Mumbai
D. Chronology of events associated with the effort by Benchmark Asset Management Company (BAMC) to start an Exchange Traded Fund (ETF) on Gold
E. Activities of various financial firms in the areas of operation at an IFC: Wall chart . Fund raising, .—. Asset management, .—. Personal wealth management, .—. Global tax management, .—. Risk management, .—. Financial markets, .—. Securities markets, .—. Mergers and aquisitions, .—. Leasing and Structured finance, .—. Project financing, .—. Financing, .—. Insurance and reinsurance, .
F. Abbreviations
Executive Summary
1. International Financial across borders: i.e. they are international Services (IFS) and Centres financial services (). A cross-border market for has existed over millennia. (IFCs) in Perspective But it has been transformed in the th and Historically, finance has always been th centuries and grown quite differently ‘international’ in character; capital has rarely and more dramatically since . It has also been immobile. Money has moved freely become extremely competitive, with buyers across borders for all of civilisation with gold and sellers around the world now having a and silver (in various weights and measures) choice of procuring from competing being global currencies for millennia. But, international financial centres (s). the freedom of capital was dramatically A concrete example of procuring curtailed during the ‘Bretton Woods’ regime, from an would be the raising of created in , when capital controls were debt. If Mumbai became an , a imposed on war-ravaged, capital-starved South African railway project could issue economies. With post-war recovery, that a bond there in the primary market. It regime broke down in . World finance would wish to do so because of Mumbai’s has since been reverting to its natural state sophisticated securities markets, along with with the removal of capital controls and the a number of asset managers in Mumbai gradual re-integration of national capital running global portfolios. If the bond and banking markets; but this time on a market was developed, the South African global scale. bond issue could be denominated. countries opened their capital Global investors would buy these bonds accounts between and . A number and trade them on the secondary market of emerging markets did so in the s in Mumbai. Each of these three steps – – often at the ’s urging. In , primary market bond issuance by the South the contemplated making an open African entity, primary bond purchases by capital account a condition of membership. global and Indian investors, and secondary But the idea was shelved when the Asian bond market trading by global players – financial crisis erupted in . That was would generate revenues from the export of precisely when India first contemplated re- financial services from Mumbai. Creating opening its capital account. A series of an in India requires that Mumbai must similar mini-crises occurred elsewhere in be viewed as competitive in the eyes of the engulfing Russia and Latin America. By South African railway and in the eyes of global bond investors, when compared with all these crises were contained. Capital alternatives like Singapore or London. account opening resumed but with reduced The global market in the st momentum as the and others began century is one in which competition is driven to reconsider its benefits and costs. The by rapid innovation in financial products, question of capital account convertibility services, instruments, structures, and now weighs heavily on China and India, arrangements to accommodate and manage where financial systems with structural myriad requirements, risks, and a ceaseless weaknesses, legacy constraints and varying quest for cost reduction. Competitive degrees of State domination now confront advantage in provision depends on the irresistible forces of globalisation. seven key factors: Even with an open capital account, some financial services (e.g. deposit . An extensive national, regional, global banking) remain local and non-tradable. network of corporate and government But most financial services are now tradable (supranational, sovereign, sub-sovereign xiv R M I F C
and local) client connections possessed involving complex judgment and intellectu- by financial firms participating in an alisation continue to be clustered at a few international financial centre (). physical locations, where key individuals . High level human capital specialised in meet face-to-face. This is characteristic of finance, particularly quantitative finance, R&D in computer technology – clustered in supported by a numerate labour force Silicon Valley and the Cambridge Corridor providing lower level paraprofessional – despite extensive use of email, voice tele- accounting, book-keeping, compliance phony and video conferencing. India has and other skills. achieved a minor miracle with the explo- sion of export revenues from services; . World-class telecommunications infras- tructure with connectivity around the yet, these revenues are a fraction of Silicon clock, and around the world. Valley’s. Similarly, routine production of financial services takes place everywhere. . State-of-the-art systems, capability But, the most important and high value to help develop, maintain and manage decision-making functions are concentrated the highly sophisticated and expensive in a handful of s that have effectively infrastructure of global financial (and consequently) become global cities firms, trading platforms and regulators; At present, London, New York and systems that are evolving continuously Singapore are the only global financial to help firms retain their competitive centres (s). Many emerging s edge. around the world are aspiring to play a global . A well-developed, sophisticated, open role in the years to come: e.g. Shanghai financial system characterised by: (i) and Dubai. Other s in Europe and a complete array of proficient, liquid Asia, like Paris, Frankfurt or Tokyo, connect markets in all segments, i.e. equities, their financial systems to the world. But bonds, commodities, currencies and they have lost market share and importance derivatives; (ii) extensive participation in competing for global for reasons by financial firms from around the explained in the report. The world market world, (iii) full integration of market for is represented mainly by the , segments, i.e. an absence of artificially and Asia which together account for over compartmentalised, isolated financial % of global . Correspondingly the markets that are barred from having global market is concentrated in the operational linkages with one another; three s located in each of these regions. and (iv) absence of protectionist barriers and discriminatory policies favouring 2. Implications for India and domestic over foreign financial firms in providing financial services. Mumbai . A system of financial regime governance Given that an in Mumbai must be (i.e. embracing legislation, policies, rooted in (and serve) India’s financial system, rules, regulations, regulatory agencies rather than be an artificial offshore appendix, etc.) that is amenable to operating on the call for creating an in Mumbai at global ‘best-practice’ lines and standards; this time is implicitly a metaphor for (and and finally synonymous with) deregulating, liberalizing . A ‘hinterland advantage’ in terms of and globalising, all parts of the Indian either a national or regional economy financial system at a much faster rate than (preferably both) whose growth is is presently the case. Raising the issue of generating rapid growth in demand for an in Mumbai now suggests that the . pressing need for a new, more intensive phase of deregulation and liberalization of Advances in information and commu- the financial system has been anticipated nications technologies () have eased by India’s policy-makers and regulators interactions over a distance and reduced their cost dramatically. However, activities To understand what such a city is see Sassen (). Executive Summary xv
and that the is a device to accelerate gap in capabilities that now exists between movement in that direction. An will Mumbai and established s. not be created quickly in Mumbai, nor will it succeed, if action on further deregulation 3. The difference between BPO and liberalisation is not taken in real time. and IFS In sustaining its trajectory as an emerging, globally significant, continental The production of financial services economy, the believes that India has worldwide is now fragmented into a series no choice but to: (a) become a producer of interrelated sub-processes undertaken and exporter of ; and (b) capture an separately. Business process outsourcing increasing share of the rapidly growing () of individual processes occurs at global market. To achieve these a considerable distance from the point two goals, its financial centre in Mumbai of customer contact where their eventual must compete to become a successful resynthesis occurs. India is now a highly . Incremental growth in the global successful venue for the global financial market is now being driven by the services industry. In the last five years, it has growing demands of China, India and gone beyond simple towards complex A. With its strengths in human capital, knowledge process outsourcing or . This a globally powerful services industry, and is a positive development for India to realise its own hinterland, India has many natural its ambitions of creating an in Mumbai. advantages for competing successfully in this Finance-related / builds up skills market. In evolving as an , Mumbai will in India and increases the ‘mind-share’ of probably grow in two distinct phases: India amongst global finance professionals. However, there is a substantial differ- . In the first phase (–) Mumbai ence between / and providing must connect India’s financial system via an . Financial processes that get out- with the world’s financial markets sourced under involve low-value, low- through . That is what s like skill tasks. They are codified in a manual that Frankfurt, Paris, Sydney, Tokyo and a indicates how tasks are to be performed, con- host of smaller s do now in respect trols quality/integrity, and measures whether of their national economies. they are being done correctly. Once the pro- . In its second phase (–) Mumbai tocols are in place, the task is performed must develop the capacity to compete repetitively. But some outsourced activities with the three established s for in finance, involving research and analy- global business that goes beyond sis, are moving up the value chain. meeting India’s needs. After , For example, company financial analysis, would hope that Mumbai would hold its credit research, and stock market research own in competing with the other s functions are now also being outsourced. and acquire increasing global market Still, the real value in financial services share. provision remains concentrated in a small number of jobs performed by qualified, India’s financial services industry will super-numerate, imaginative people with not become export-orientated, nor derive the specialised expertise, experience, domain significant export-revenues, if Mumbai knowledge and skill-sets to be innovative fails to become an . That will in designing financial instruments and compromise not just export earnings from structures. Such people have extensive cross- , but the quality, efficiency and range of border networks of clients and colleagues. domestic financial services offered in India Their work involves fine judgment in as well. For Mumbai to become an , making decisions covering a vast array of India’s policy-makers and financial operators circumstances. It cannot be scripted in need to understand fully the nature of and a manual codifying its mechanics. Such opportunities in: the global market; judgments rely on intensive interaction, the activities undertaken in s; and the inter-personal information flows, and xvi R M I F C
complex negotiations among a number We categorise s in this report in four of highly qualified professionals including ways; i.e. as: financial experts, specialised corporate Global (GFCs ) These are centres that gen- lawyers, accountants, tax experts, etc. Such uinely serve clients from all over the interaction takes place at an . world in the provision of the widest From an Indian perspective, further possible array of ; progress with expanding the / chain in financial services (horizontally and Regional (RFCs) They serve their regional vertically) is inevitable and positive. But that rather than their national economies should not be confused with what is required (see below) – examples of such s would be Dubai or Hong Kong; to provide the full array of via an . Intuitively, moving up from / to a Non-global and non-regional, ordinary inter- fully fledged is analogous to moving up national IFCs These are centres like from low-end programming to replicating Paris, Frankfurt, Tokyo and Sydney Silicon Valley. Incremental progress in the that provide a wide range of but Indian industry will not bring Silicon cater mainly to the needs of their na- Valley to India; that requires a quantum tional economies rather than their leap. Similarly, doing more / regions or the world – one might be for the global financial services industry tempted to call them national s al- will not, as a matter of course, result in though that term is an awkward one because its two defining adjectives are India automatically graduating to providing contradictory; and through natural evolution. / will be done by specialised sub-contractors Offshore (OFCs) These are centres that are with different skill sets and competencies. primarily tax havens for wealth man- can only be provided by qualified agement and global tax management and internationally known financial firms; rather than providing the fully array which is what Indian financial firms must of . quickly strive to become. India’s growth in The products and services that / is about doing more through s provide include the following eleven services firms (like Infosys, Satyam, Wipro activities. s provide all of them. Other or ). India’s growth in is about s provide some combination of them. exporting through established and new financial intermediaries. a. Fund Raising: for individuals, corpo- rations and governments (sovereign 4. What are International and sub-sovereign). This includes debt and quasi-debt across maturity/currency Financial Centres (IFCs) and Services (IFS)? Singapore and London are also regional in the sense that they serve Asean and the while New York Financial centres that cater to customers serves North and Latin America. But because these outside their own jurisdiction are referred to three centres serve the global economy, well beyond meeting the needs of their respective regions, we as international (s) or regional (s) classify them as global rather than regional. In that or offshore (s). These three different sense, the sees limited potential for Mumbai adjectives are often (but wrongly) used to be a regional financial centre for South Asia given current geopolitical realities. South Asia is more likely synonymously in the literature. Yet these to be served by Singapore and Dubai for the time being. three types of s are difficult to define We see Mumbai being an that serves India in the in a clear-cut, mutually exclusive fashion; first stage and leapfrogs to serving the global economy in its next stage of evolution. Ironically, Mumbai as an although they are quite distinct. All these is likely to serve its region after it serves the world, centres are ‘international’ in the sense that rather than before. For that reason, although the they deal with the flow of finance and was asked to look into Mumbai becoming a regional financial products/services across borders. financial centre we dispensed with that characterisation early on in the knowledge that it would be misleading. But that description does not differentiate Throughout this report therefore we refer to Mumbai them sufficiently in terms of their scope. becoming an international rather than a regional FC. Executive Summary xvii
spectra; equity and quasi-equity for pri- will become increasingly important to vate, public and public-private corpora- Indian firms as they evolve into s. tions; as well as risk-management appen- f. Global/Regional Corporate Treasury dices attached to primary fund-raising Management Operations: involves transactions to ensure that the risk expo- fund raising, liquidity investment and sure of the primary borrower or fund- management, asset-liability and dura- raising entity (to currency, interest rate, tion matching, and risk-management credit, market, operational and political through insurance and traded deriva- risks) does not exceed tolerable limits. tive products for currency, interest-rate, b. Asset Management and Global Port- credit and political risk exposure. folio Diversification: undertaken by a g. Global/Regional Risk Management Op- variety of national, regional and global erations and Insurance/Re-insurance: asset managers including, inter alia pen- which involves highly developed ex- sion funds, insurance companies, in- change traded and tailored derivatives vestment and mutual funds of various (futures, options, swaps, swaptions, caps types characterised by nature of instru- and collars) as well as world class deriva- ment (i.e. debt, equity or convertibles), tives exchanges that trade a variety of geography, or sector of activity. global contracts. c. Personal Wealth Management (PWM): h. Global/Regional Exchange Trading of for high-net worth individuals (s). Financial Securities, Commodities and This activity is estimated to involve the Derivatives Contracts in Financial In- management of personal assets of $– struments/Indices and in Commodi- trillion worldwide. Overseas Indians ties: There is an increasing tendency to- are estimated to hold financial wealth ward multiple listings of financial securi- (i.e. apart from real estate, gold, art, ties (equities and debt), and of derivative etc.) of over $ billion and total and commodity contracts, on different wealth of over $ trillion. PWM takes exchanges with emerging investor de- place in established s, but is more mand for x x trading of all listed skewed towards specialised -s securities across all exchanges. Demand in the Channel Islands, Switzerland, is highest for the securities of index- Luxembourg, Monaco and Lichtenstein corporations in each major capital mar- for the and Africa; Caribbean ket. It will gradually cascade downwards offshore centres for the and Latin to cover global trading of all listed se- America; Bahrain and Dubai for the curities in all markets – developed and Middle East; Singapore, Hong Kong and emerging. Mumbai is better placed than some Pacific Island offshore centres for most s to meet this demand, because East/North Asia. of its human capital and capability, d. Global Transfer Pricing: This is an as well as its world-class exchanges and activity that o, like most governments, improving exchange regulation. looks askance at, but needs to realise i. Financial Engineering and Architec- and accept the reality of, in a global ture for Large Complex Projects: This economy dominated by transnational primarily involves energy and infras- corporations. This will become tructure projects requiring funds from increasingly important to Indian firms a variety of global sources (public and as they evolve into multinationals. private) with attached risk-management. e. Global Tax Management and Cross- Again, Indian financial institutions and border Tax Liability Optimisation: former FIs have well-honed skills in this which provides a business opportunity particular arena. for financial intermediaries as well as j. Global/Regional Mergers and Acquisi- accountants and law firms until national tions Activity: This will become increas- tax regimes begin to converge toward ingly important in India and for which a global low tax norm. This activity a considerable amount of back-office xviii R M I F C
/ and due diligence research limits set by RBI. The ability of Indian work is already being outsourced to In- households to move resources across the dia. border has increased with India’s increasing k. Financing for Global/Regional Public- openness. The proliferation of Indian s Private Partnerships: This relatively operating around the world – and transfer new activity has emerged on scene with pricing with their subsidiaries abroad – considerable force since the development has led to demand for fund-raising, of the London Underground PPP. It has corporate treasury management and global particular and immediate relevance for tax management. With rapidly increasing the financing and rapid development of annual flows, the stock of assets outside the Indian infrastructure without recourse country controlled by Indian households to the treasury. and firms is rising rapidly. These assets require for wealth, asset and global 5. Growth and globalisation tax management. All these phenomena imply inevitable increases in purchases drive India’s demand for IFS associated with the growing size of cross- Since , India has grown rapidly and its border flows. Calculations in this report economy has globalised. As India grows, suggest that on average, the revenue it globalises faster. That happens through stream works out to % of the gross flows the increased share of trade and foreign across the boundary. investment in economic activity. Evidence of This translates to about $ billion of that lies in two-way cross-border flows. Such IFS purchases by Indian clients in . flows, on the current and capital accounts Looking ahead, India’s engagement with combined, rose from $ billion in the world will intensify in three ways: (a) (<% of ) to $ billion in reduction in barriers such as customs duties (>% of ). The forces that resulted in and capital controls; (b) improvements in this six-fold increase are intensifying and will infrastructure; and (c) greater participation further accelerate growth of cross-border by s (Indian and foreign) in the Indian flows. The next decade is likely to see cross- economy. These developments will induce border flows growing as fast. deeper globalisation of the Indian economy Current and capital account flows in- in the coming decade, inducing an upsurge variably necessitate purchases of . For of purchases. example, current account transactions in- Our estimates suggest that IFS pur- volve payment services, credit enhancement, chases by Indian households and firms will currency risk management, etc. Capital ac- rise to $ billion by on the basis of count flows involve purchase of investment conservative assumptions in a ‘base-case’ banking, legal, accounting, risk manage- scenario. Under more propitious circum- ment, research and other similar services. stances (e.g. if GDP growth is sustained at When / enters or exits India, fees %) that figure could be over US$ billion. are paid to various providers (e.g. com- By that amount could exceed US$ mercial and investment banks, securities billion in nominal terms. brokerages, exchanges, insurance compa- These estimates warrant a different way nies, asset managers, etc.). As India engages of thinking about exports and about more with the world, the stock of assets held an in Mumbai. Traditional conceptu- in India by foreigners rises. Similarly, the alising by Indian exporters about market stock of foreign assets held by Indian house- opportunities typically assumes tapping into holds and firms also rises. Purchases of risk a quasi-infinite world market. Financial ser- management services grow in proportion to these stocks which are far larger than the This was the approach taken by the Indian software capital flows of any one year. industry which now has domestic sales of a mere $ It is estimated that Indian households million while its exports are a -fold multiple of roughly $ billion a year. The search for growth on have accumulated considerable wealth the part of firms like , Infosys or Wipro has been outside the country; well beyond the present primarily about finding international customers. The Executive Summary xix
vices are like software services in that they are exists for Indian financial genius to achieve labour, skill, /communications intensive. similar export success in world markets; But, in terms of market opportunity, there is but with one key difference. India’s own a fundamental difference between finance growth and globalisation, and consequent and software. It lies in India’s hinterland domestic demand for , generates natural advantage. Rapid growth, even more rapid opportunities for producers in India integration with the rest of the world, and (local and foreign) to acquire skills and the high consequent growth rate of two-way exploit economies of scale. Indian software cross-border financial flows now being seen, exports required an enabling framework all serve to make India a large and growing from the State in the form of telecom customer for . Unlike service exports, reforms. Indian exports will require India provides a platform for nurturing a similar enabling framework from the capabilities that can ‘go global’ instantly. State. Deeper and wider reforms and Against that growing demand for , a improvements are needed in: (a) India’s failure to respond on the supply-side, (i.e. financial system and the way it is governed by creating a successful in Mumbai) and regulated; as well as (b) Mumbai’s urban will simply oblige Indian customers to infrastructure and political/administrative do increasing business abroad. That governance on a scale not yet envisaged. will fuel the growth of Singapore, Dubai, London and other s while depriving 6. India’s competitive Mumbai of capturing opportunities for high advantages in creating an value-added exports. For example, IFC the Tata Steel-Corus deal generated revenues in Singapore and London. Some Hinterland Advantage: As argued above elements of such transactions do not appear the growth of the Indian economy in Indian BOP accounts. Financial firms and and more rapid growth of cross- policy makers in the three s and border financial flows have created are highly attuned to the opportunities substantial local demand for . This for selling into India. They have ‘driver’ supports the development of embarked on strategies that exploit the skills, and generates economies of current infirmities of the Indian financial scale on the part of financial firms system. The most capable Indian financial operating in Mumbai. China has the firms are likely to move to these centres in same hinterland advantage. New York order to acquire the flexibility to provide has the North American economy as their extant client base with the they its hinterland. London has the even need, rather than risk losing their clients to larger economy, as well as its own global financial firms. national economy, to serve. Singapore Rapidly growing demand for in has a limited national economy. But it is the financial epicentre of an India provides an opportunity for its A regional economy that is financial services industry that its software almost as large as China and larger industry never had. Indian software exports than India. Dubai does not have were generated by ingenious Indian human that kind of national or regional capital exploiting foreign markets and economy. But it is located in a region requiring nothing from the State other that is generating enormous financial than telecom reforms. Indian genius surpluses for investment abroad. conquered world markets between and Human Capital: India has four strengths in a way that was not imagined in even by way of human capital endowments the most optimistic forecasts of . In that give it a competitive edge over the case of , an identical opportunity Shanghai, Singapore and Dubai: • The extensive use of English, domestic market does not loom large to the s of these firms, and played no role in their graduating into which is the lingua franca of export-oriented MNCs. international finance xx R M I F C
• Generations of experience with upholding liberal values, protecting entrepreneurship, speculation, property rights and maintaining trading in securities and deriva- political stability. It fares well tives, risk taking, and accounting. compared with China, Singapore or Indeed the ability to provide Dubai but does not match London or seems to be genetically coded into New York. Indian finance professionals Mindshare: High growth, the • Strong skills in information tech- / phenomenon, and the nology and quantitative thinking success of Indians in global finance all over the world, ensure that India • Individuals of Indian origin play has significant ‘mindshare’ at policy- a prominent role in the top making levels in global financial firms. global financial firms. They are India has an edge over Singapore and well-positioned to intermediate Dubai, and perhaps even over China, between the business strategies of in this respect. these vital firms and the genuine strengths and weaknesses of India Strong securities markets and advanced trad- as an . ing platforms: India has the foun- dations for providing global by Location: Mumbai is well located in being virtue of its dynamic, technologically able to interact with all of Asia capable securities trading platforms and Europe through the trading day. in the and . These are the Apart from the Americas, transactions rd and th biggest exchanges in the with most of world can occur world measured by number of trans- in daylight. Given the remarkable actions. India has an edge over China and growing role of London in and Dubai, but not over Singapore, in providing global today, India has this respect. the advantage of having a – hour overlap with London time. There is Taking these formidable advantages into no operating within an hour’s account, the initial conditions supporting variation of the Indian Standard Time India’s entry into the global market for zone. India has an edge over Shanghai, are promising; especially when compared but not over Dubai, in this respect. with the early days of software exports Democracy and Rule-of-Law: Properly from India. In the latter case, there was functioning financial markets require no hinterland advantage, location did not a constitutional basis and machinery matter, democracy did not matter, and there for system governance that is stable, was no beach-head. The six comparative reliable, resilient and flexible; i.e. and competitive advantages that India has, one that reduces future political suggest that there is a genuine opportunity risks and uncertainty. Globally for India to create a viable able to credible financial systems need to compete with the best in providing to be rooted in legislative, judicial, and the Indian and global markets in a short span regulatory frameworks that adhere of time. But, it confronts some daunting to rule-of-law and respect/protect challenges. Our report highlights these in property rights; in principle and detail. They include: (a) financial regime in practice. can be provided governance in India; (b) missing markets credibly only from environments that and institutions and (c) urban facilities and permit open and honest expression governance in Mumbai. of independent views by portfolio managers, analysts, commentators, 7. Financial regime governance: researchers, etc. even when such views policy and regulation contradict those of governments and powerful personalities with a vested A sound basic framework for develop- interest. India has proven strengths in ing/applying law and regulation are intrinsic Executive Summary xxi
to . The quality and credibility of traded volumes – in all areas other than provided from India is inextricably linked to equities. A normative rule-of-thumb the soundness and global acceptability of the would suggest that the traded volume regulatory/legal system that governs finance of an exchange-traded futures contract in India. Global competition in is, to in India should be at least one-tenth the an extent, a function of global competition turnover of a corresponding product in (in terms of reputation, capability, efficiency the . By this yardstick, the turnover and effectiveness) among regulatory regimes of Nifty futures is about that size. But and the institutions that apply those regimes. that is not the case for almost all of the The market share of an is determined as top underlying contracts in the . much by the quality and reputation of its • An inadequate universe of institutional regulatory/legal regime as by the abilities of investors: The second deficiency in its financial firms. A cross-country assess- India is a universe of institutional ment suggests that India is weak on many investors that have the size, visibility aspects of the legal and regulatory frame- and capability of those in established work governing its financial system which s. The progress made so far the report discusses in detail. The report with liberalisation has been based also identifies two key strategic institutional largely on speculative price discovery (or structural) weaknesses in Indian finance by non-institutional investors in equity that impede production: markets. Other segments are dominated by state-owned entities which are • ‘Missing’ Debt, Currency, and Deriva- bound by restrictive rules. Banks and tives Markets: The most critical finan- insurance companies are restrained, if cial market components missing in In- not banned, from undertaking risk- dia are: a properly functioning bond hedging activities and other kinds of market, a currency market and a deriva- sophisticated business due to regulatory tives market for currencies and inter- restrictions. Consequently their assets est rates. These three interlinked mar- are growing too slowly. kets are termed collectively as the bond- Indian financial firms tend to operate currency-derivatives (BCD) nexus in in one key business segment at a this report. Six specific deficiencies time. Their portfolios are narrowly in this respect include the absence of: confined and concentrated; so is their (a) a liquid and efficient sovereign risk exposure. That has stunted their bond market with an arbitrage-free growth, imagination and ability to yield curve, (b) a wide range of handle risk. Indian financial firms now essential derivatives on interest need to evolve into full fledged large, rates, (c) a liquid spot market for - complex financial institutions (s in denominated corporate bonds, (d) credit Basel parlance). They need to operate in derivatives on credit spreads or credit all financial market segments of finance events, (e) a liquid currency market and to come up with credible offerings (f) a full range of currency derivatives. and ‘packages’ for the export market. Under a functional nexus, all India lacks domestic commercial and six elements are based on vibrant investment banks capable of taking on speculative price discovery, and are global counterparts without higher levels tightly knitted by arbitrage. They of capitalisation, global market access, interact to result in market efficiency. operational expertise, and high- There is no successful that lacks such level human capital. India also lacks a nexus. Its conspicuous absence large securities brokerages capable of in India handicaps the country’s ability competing with global counterparts. to provide . Another shortcoming India’s brokerage industry reflects the is the inadequacy of India’s spot and infirmities of its retail sector as a derivatives markets – in terms of the whole. It is characterised by too variety of contracts traded and their many small, undercapitalised, limited- xxii R M I F C
capability firms (brokers and sub- regulation. There is no that has so brokers) that are mostly still single compartmentalised an approach to the proprietorships in corporate form. structuring, management and regula- Structural reforms are required urgently tion of its financial markets. Reversing to create Indian financial firms that are counterproductive segmentation of fi- equivalent in size and capabilities to nancial markets in India, and removing global counterparts. Looking ahead, barriers to entry, would result in greater: if India is to create an , there is no economies of scale/scope, competition, escape from inviting the participation and global market-reach. of domestic and foreign institutional • Inhibiting Financial Innovation: investors of adequate size, who would Whether an should be created for deploy the economies of scale, global India to catch up with the world, or to ex- market-reach and efficiency-enhancing ploit comparative advantage in a global behaviour that is evident at other s. market, a considerably faster pace Why does India have these weaknesses? of financial innovation in India is essen- Close scrutiny of the regulatory regime tial. But, financial regime governance in examines the origins of these infirmities India can only cope with change slowly. through a matrix that identifies and analyses The regulatory approach to any change restraints on the activities of different in the structure or functioning of the financial firms in providing various . financial system is conservative, cautious Such a matrix has been prepared as a and inconducive to innovation. As a ‘wallchart’ for this report. It outlines result India falls behind international activities that take place at s and practice by the day in every market seg- the kinds of financial firms that typically ment. The default signal emitted by undertake them. A careful analysis of this Indian regulators when faced with any wallchart reveals that, at present, most of new idea seems to be set at ‘amber’ if not the activities that take place at s ‘red’. Innovative instruments, contracts are banned or severely proscribed in India. and new ways of doing business are acted The red ink across the wallchart – signifying upon in days in the three s. Such activities banned in India – portrays the a pace of rapid progress is not found license-permit-control raj that still operates in India. Basic contracts like interest in Indian finance. It retards development rate futures and options have failed to and sophistication of the financial sector materialise in this climate. and inhibits exports. A pragmatic view of these constraints highlights three urgent, Deregulation and liberalisation through cross-cutting priorities for reform: the s have largely unshackled India’s manufacturing sector, and much of its • Competition Policy: India’s experience real economy. Competition, innovation with liberalisation in the real economy, and scale economies in these sectors are suggests that the most powerful tool for no longer blocked by the State. Yet, having efficient and well-functioning somewhat dissonantly, a much higher degree firms is competition. Application of of control continues to operate in key sound competition policy in all market parts of the financial sector; despite the segments of India’s financial sector is many regulatory reforms of the s. This now a matter of urgency. financial governance regime now needs to • Compartmentalisation of the Finan- be overhauled to create a more modern cial System: Global competitiveness re- governance regime. It does not need quires exploiting fully the economies traditional fine-tuning with the extant of scale and scope. India’s hinterland regime remaining largely intact. advantage represents an opportunity Regulatory reform has had a positive to exploit such economies. However impact on the functioning of India’s capital Indian finance has been artificially frag- markets and the insurance sector. In the mented by financial sector policy and capital markets, India has achieved global Executive Summary xxiii
standards in some aspects. Other financial in Mumbai. The goal of public markets lag behind in not yet having been policy is to foster high economic growth reformed as widely or deeply. Despite the and enhance welfare in India; it is not presence of a large number of different types to cater to the interests of Indian firms of banks, and despite incremental measures or their shareholders. But, in saying aimed at ‘opening-up’, the banking market this, the is mindful of the reality in India has yet to improve substantially that developments during the last decade in competition, innovation and efficiency. have resulted in a debilitating anomaly The improvements achieved at the margins for Indian financial firms versus their have not yet permeated the banking system foreign competitors. In manufacturing, as a whole. They are unlikely to, without the removal of barriers to imports was a major reformative push and diminished accompanied by a simultaneous unshackling public presence. of Indian firms. Indian firms were exposed For that reason, a dramatic change to greater competition from imports and in the governance regime for all financial the entry of foreign s in domestic markets in India is now imperative. Without market space. But they were, simultaneously, it India will not be able to create an given a transitional period and considerable innovation-orientated financial system freedom in terms of formulating business that can evolve and compete at a pace strategies and innovating. commensurate with changes in the Indian The evolution of Indian finance, economy and global finance. Such a in contrast, has resulted in growing system would have the following activities dissonance between external competition undertaken on a par with global norms: and a repressive license-permit raj. India’s (a) continual innovation and improvement long and tortuous evolution towards de facto in the design of financial products and convertibility (which in some respects is customer services as well as in their delivery; not dissimilar to tariff reductions in the (b) the rapid reintegration of segregated real economy) has not been accompanied financial markets into more liquid and more by Indian financial firms being given the integrated markets; and (c) the rapid growth same opportunity and room for manoeuvre and market-induced consolidation of Indian to develop their competitive capabilities. financial firms in a manner that enables They are at a disadvantage in coping with them to achieve economies of scale. competition (for their clients’ business) For this to be achieved, Indian financial from global providers operating in India system regulation needs to be brought up and from abroad for two reasons: to world standards. Regulatory attitudes, • First, key financial markets (i.e. the policies, practices as well as institutional nexus and risk management) have arrangements need to undergo a sea- been prevented from developing in India change. They need to become more because of regulatory restraints. That attuned to, and supportive of, the dynamism, has resulted in Indian financial firms not growth and global competitiveness of the having the opportunity or the time/space Indian financial services industry. Policy to develop domain knowledge and skill- and regulation must adjust and adapt to sets in crucial areas e.g. global fund- the needs of Indian and global financial raising or developing sophisticated risk markets. Financial markets should not management products/services tailored be artificially fragmented, segmented, to client needs. compartmentalised. • Second, the same regulatory restraints This report does not advocate using have deprived Indian financial firms of the hinterland argument as a reason the freedom they need to develop and for protectionism. Nor is the the necessary flexibility in formulating making an argument for ‘self-sufficiency’. global business strategies. They have not Instead the believes that India and had the scope for innovating for and Indian financial firms should be globally thus developing the skills required to competitive in providing through an compete with global providers. xxiv R M I F C
The is clear that, in providing debt of centre and states, including on- from India, there is no case whatsoever and-off-balance-sheet liabilities (such for protectionism. The interests of Indian as pensions) and endorses a lower customers, and that of economic efficiency, level (than the present %) for the are best served by enabling them to choose total consolidated public debt-to-GDP from the best providers in the world. ratio. A public debt ceiling should be But, the asymmetry in policy that has placed bolstered by flexible triggers for actions Indian financial firms at a disadvantage, to be taken by the Ministry of Finance underlines the case for phasing reforms (e.g. accelerated sales of public assets aimed at creating capabilities in a whose proceeds are used to liquidate manner that enables Indian financial firms outstanding public debt if that is deemed to be similarly unshackled in competing to appropriate) when the adopted debt provide . ratio ceiling is breached. While the did not wish to recommend a 8. Reorienting the financial particular debt ceiling ratio without looking more deeply into the matter, system towards IFS global experience suggests that ratios in provision: A temporal the range of –% are widely applied roadmap for reform as prudent. Such a debt ratio should be added to existing measures for The strategy proposed in this report for deficit and debt reduction. creating an comprises in essence a ten- For an Indian to be credible, in point agenda: keeping with ‘best-practice’ worldwide, . Macroeconomic (i.e. Fiscal and Mone- India’s central bank should be indepen- tary) Management. dent and separate from government. It As a new competitor in global must be independent and separate from financial markets, the credibility of government; i.e. in the same way that India’s macro-economic policies, and the Federal Reserve in the , the the quality of its macroeconomic and in Europe, the various national central financial system management, will be banks of Europe and Japan, and the Bank judged more stringently than in the case of England, are independent of and sepa- of established s. This asymmetric rate from their governments. The central reality highlights the importance of bank must employ global best-practices redoubling efforts in reforming policies, in the conduct of monetary policy, in legal and institutional arrangements to order to suffuse international investors achieve and sustain a high growth rate and issuers with growing confidence in (–%) for the economy in general and the as an acceptable global currency the financial sector in particular. for transactions. The level of con- Creating a vibrant, competitive fidence engendered should permit the in Mumbai will require, as an integral to become one of the world’s major backdrop, success in meeting the reserve currencies by or at the legal commitments entered into by latest. the Government of India, and the The gold standard for a stabilising governments of individual states, to monetary policy is a transparent, reduce the consolidated fiscal deficit on independent, inflation-targeting central the timeline announced. In addition, it bank. With such an arrangement the will require (a) reducing the total public Indian State would be: (a) underlining debt/ ratio to more acceptable its commitment to delivering low and levels; and (b) pursuing sound fiscal predictable inflation; and (b) inducing and monetary policies thereafter. greater confidence in the in the eyes HPEC therefore recommends that of domestic and global investors. The further action should be taken to recommends that the Ministry reduce more rapidly the consolidated of Finance consider: (a) reforming Executive Summary xxv
monetary institutions in the light There is considerable unmet global of recent developments in monetary demand for bonds on the part economics; and (b) doing so in a way of long-term institutional investors that bolsters the case for a credible such as foreign pension funds. A in Mumbai. rapidly emerging bond market also recommends a fresh look would trigger currency trading in India at applying key principles in guiding and foster the use of currency reform of the tax system on the revenue and interest rate derivatives. That side, to ensure that India remains would facilitate the evolution of the globally competitive, and avoids price as a global currency, used as distorting subsidies on the expenditure a numeraire by bond investors and side. This has particular implications for issuers from India and around the ensuring that inflation-targeting is not world. Internationalisation of the distorted or rendered ineffective because (a prerequisite for a successful in subsidies (e.g. for key energy prices) Mumbai) would expand transaction emit the wrong inflation signals. volumes in India’s bond, currency . Strategy for Public Debt Financing. and derivatives markets, as well as Traditionally, India has eschewed its equity and commodity markets, bond issuance outside the country, fear- coterminously. It would expand the ing the currency risk that arises with range of financing options open to, issuing forex bonds while having and seignorage revenues derived by, the revenues. This risk of ‘original sin’ does Government of India and its central not arise if denominated bonds bank. are sold to meet foreign demand for . Creation of the BCD Market Nexus. such debt. The HPEC therefore advo- The most important missing piece cates opening up fully to foreign invest- in Indian finance is the nexus ex- ment in INR denominated sovereign plained earlier: i.e. the set of interlinked bonds issued by GoI . It further recom- bond-currency-derivatives markets for mends that no limits should apply to spot and derivative instruments on in- purchases by foreign clients of INR de- terest rates, currencies and credit risk. In nominated corporate bonds or bonds order to ignite these markets, HPEC rec- issued by sub-sovereign entities (states ommends the immediate creation of a and metropolitan administrations). In currency spot market, with a minimum addition, the HPEC believes that the transaction size of Rs. million, acces- function of a public debt management sible to all financial firms. In addition, office should be placed in the Ministry an INR-settled exchange-traded cur- of Finance rather than in a regulatory rency derivatives market should be cre- institution to avoid any perceptions of ated, with trading in futures, options conflicts-of-interest. and swaps on currencies, accessible to This would achieve two goals. First, it all. would open up a new financing channel These two initiatives, along with for o (and state and municipal developing more rapidly the spot governments as well) thus enabling market for bonds, need to be merged it to abandon repressive policies that into the existing securities exchange pre-empt domestic savings with an ecosystem so as to trade alongside array of undesirable and unintended the spot and derivatives markets for consequences (e.g. crowding out and equity. The policy problems that undue pressure on the interest have held back interest rate futures rate). Second, the internationalisation need to be rapidly resolved. The of bonds (issued by the sovereign, responsibility for regulation of these sub-sovereigns and corporates) would markets – spot or derivatives; exchange accelerate the emergence of an Indian or ; government bonds, corporate on the world stage. bonds, and currencies – needs to be xxvi R M I F C
moved to without further ado . Create wholesale asset management and unified with the regulation of businesses with freedom for outsourc- all organised financial trading. The ing by existing financial firms such as goal should be to create and launch a banks or insurance companies. This significant nexus, in conformity would separate the legal and contrac- with world standards, within months. tual structures through which assets . Financial Market Integration and are sourced and securities are created Convergence vs. Market Segmentation – across multiple front-ends across the country – from the ‘factories’ in Indian finance suffers from a frag- which assets are managed. It would mented approach whereby the overall also achieve economies of scale in financial industry has been cut up into asset management. pieces reflecting legislation that is out- dated by years or more. exports . Shift away from regulation by entity will not take place as long as the com- to regulation by domain. As an petencies of Indian financial firms are example, IRDA would regulate only artificially stunted. India now needs its the insurance business, not all the own s present in all lines of busi- activities of insurance companies. ness, and able to achieve economies of . Principles-based Regulation scope and scale. A series of measures Over the decades India has built are needed to achieve market integra- up a license-permit raj in finance. tion and convergence, and thus enable It over-emphasises compliance at the economies of scale, economies of scope, expense of competence, competition greater competition and enhanced IFS and innovation in financial services. export capability, i.e.: A similar raj dominated the real economy since independence. But . Redraft the legal foundations for it was dismantled during the s organised financial trading, so as to the immense benefit of the Indian to unify all organised financial economy and particularly Indian global trading under regulation. This competitiveness. To achieve the same would include currencies, equities, objectives, that raj in finance now needs sovereign and corporate bonds, and to be dismantled if India is to develop commodity derivatives. It would provision and export capabilities immediately diminish some of the and if an is to emerge in Mumbai. fragmentation which has taken place At present financial regulation in In- amongst financial firms. dia is fragmented and rules-based. It is . Remove barriers to a holding over-prescriptive and restrictive of man- company structure through which agerial discretion. In every market seg- virtual financial firms can be created, ment, regulators attempt to codify every with an array of subsidiaries that fit detail of a business in which the shape of Indian regulatory constraints but the future can neither be anticipated nor with corporate headquarters and predicted. Anything not explicitly per- top management able to operate mitted is banned. Any proposed change a unified financial firm. The in the way of doing business requires holding company would be regulated clearance from the regulator. Supervi- only by the Companies Act. It sors apply checklists in verifying that would typically be listed and able to every rule is met while not quite un- leverage itself; while its subsidiaries derstanding all the dimensions of the might be unlisted. All barriers to business possibilities of the regulated M&A in finance need to be identified entity and how it might evolve. This and removed, so as to achieve approach is inflexible and unamenable a market-induced consolidation to swift adaptation of a kind that the process which would permit Indian world of global finance demands. This s to emerge. is counterproductive for the purposes Executive Summary xxvii
of fostering provision capabilities convertibility in any case. Myriad other and inappropriate for an . countries have perfected the combina- HPEC therefore recommends that tion of autonomous monetary policy rules-based regulation in India be and convertibility. India needs to em- replaced by principles-based regula- ulate the dozens of successes, and avoid tion. That will require redrafting In- the mistakes made by the few failures. dia’s securities and banking laws as Having considered the recommen- well as re-skilling of all regulatory staff. dations of the Tarapore- Committee HPEC also recommends that a new Report very carefully, the HPEC nev- unified Financial Services Modernisa- ertheless recommends that full capi- tion Act (FSMA) be drafted to bring tal convertibility should be achieved together, under a single omnibus leg- within a time-bound period of the next islative umbrella, all aspects of finan- - months and by no later that the cial services: i.e. securities trading, end of calendar . banking, derivatives, insurance and This recommendation needs to commodity-finance. Such omnibus leg- be dovetailed with an - month islation should reflect the holistic nature timetable for acting on ’s other of the financial services industry while recommendations. That would kill two creating the foundations for regulation birds with one stone. It would accom- to be modernised and, possibly, uni- modate the accepted international con- fied in the fullness of time. This new sensus that a country moving to con- law should draw on the models of the vertibility must have liquid and efficient ’s and the ’ , and be financial markets and strong institutions. aligned with the shift away from rules- Also, India’s opportunity to export based regulation that is now being wit- will really open up after convertibility. nessed around the world. The new om- So, between now and then, a window nibus law should embed an appeals pro- of opportunity exists to tackle issues of cedure – under an International Finan- public debt management, and missing cial Services Apellate Tribunal () markets/institutions, with forceful reme- – that allows for: (a) appeal against any dial measures. action of any financial regulator in India; . Taxation of IFS and Financial Trans- (b) broadening the scope of appeal; and actions (c) judges having specialised domain recommends a rational and knowledge in finance. fair tax system for which is com- . Capital Account Convertibility petitive by international standards. The The convertibility question is critically is against creating a tax haven in linked to the possibility of a currency cri- an Indian . sis, which India has successfully avoided A key HPEC recommendation en- over –. This discussion needs dorses the Kelkar Committee Report’s to be illuminated by three key points. proposals for including financial ser- First, the present Indian policy config- vices under the Goods and Services Tax uration is not a ‘consistent’ one, given (GST) regime with the simultaneous a pegged exchange rate and attempts at removal of all central and state trans- having an autonomous monetary policy action taxes including the Securities while having significant capital account Transaction Tax (STT), stamp duties, openness. This has, in the past, led to etc. These recommendations should be potentially destabilising one-way bets implemented as swiftly as possible. for foreign capital. Second, it is clear . Inducing greater competition and in- that if export is the goal, this is in- novation in the Indian financial system compatible with capital controls. Third, has made a series of specific the growing integration of India into recommendations in Chapter . All of the world on the current account and them aim at inducing greater competi- the capital account is giving de facto tion and innovation in the Indian finan- xxviii R M I F C
cial system and in the provision/export recommendation is made so that In- of . Apart from what has already dia can catch up quickly with the rest been said about reversing the excessive of the world in becoming a competi- segmentation and compartmentalisa- tive provider of through an in tion of financial markets, these measures Mumbai. It will not do so if it is left to include, inter alia: existing domestic law, accounting and • Removing existing barriers to en- tax advisory firms to develop domain try of private domestic corporate knowledge and skill-sets organically – in players in some segments of the fi- coping with the demands for related nancial services industry; legal, accounting, tax and business advi- • Removing barriers to the entry of sory services –without being confronted foreign financial firms in the pro- with the pressures of competition and vision of IFS on the grounds that innovation in their market. unilateral liberalisation is in India’s Swift implementation of this ten- own interests; point programme, would orientate Indian • Restricting demands for recipro- financial firms towards achieving export cal market access only to domestic competitiveness. It has ramifications for financial services; macro-economic policy that have already been spelt out. It is consistent with the • Reducing the extent of public own- pursuit of sound practices in fiscal, monetary ership progressively in Indian fi- and exchange rate management. These nancial institutions; recommendations constitute a dovetailed • Removing existing barriers to agenda that would be wise for India to follow friendly or hostile mergers, acqui- in any event regardless of the arguments for sitions and takeovers in the finan- or against an . cial services industry within/across market segments; and • Encouraging the emergence of In- 9. Urban infrastructure and dian LCFIs through market-driven governance in Mumbai initiatives. The lure of the burgeoning Indian market . Improving the performance of the legal has already attracted a large number of system for finance/ IFS foreign financial firms to Mumbai. They HPEC believes that significant im- have, in turn, located an increasing number provements need to be made in the In- of high-level expatriate staff in the city, dian legal system in resolving disputes, creating intense competition and driving adjudicating settlements and enforc- up prices quite dramatically for limited ing financial contracts in real time. If accommodation and lifestyle facilities that that does not happen the prospects for are not yet world class. A Mumbai- Mumbai emerging as an , or aspiring that provides only to the Indian market to become a , will be irreparably will not face the same pressures from damaged. foreign firms and expatriates to remedy the . Opening up space for IFS support ser- privations that they presently have to suffer: vices infrastructure i.e. inadequate infrastructure, massive Related to improvements in the le- congestion, rampant pollution, along with gal system as they apply to finance and poor standards of urban governance and law , the HPEC recommends opening enforcement. In ’s view the present up domestic space to permit the en- state of play can be tolerated reluctantly even try of well-known international law as Mumbai grows as an in its first phase, firms that operate in other IFCs and connecting India to the rest of the world. GFCs as well as international account- But that can only last for the next five years ing firms and tax advisory firms as well or so. as specialist management consulting In its second phase of growth, if firms focusing on the IFS industry. This Mumbai is to be a successful that Executive Summary xxix
exports to global markets competitively, it and exchanges – even external and global will have no choice but to match London, regulatory agency representatives – from New York and Singapore in terms of over a hundred different countries. To attracting the requisite high-level human attract such internationally mobile high- talent to the city. If it fails to do so it will level human capital to an in Mumbai, not succeed as a . To match these global special efforts will be required on four fronts: cities in the span of the next - years for i.e. their world class quality of infrastructure and their global standards of governance, • First, elementary, glaring deficiencies Mumbai needs to make a start now. in Mumbai’s urban infrastructure will The individuals that Mumbai must need to be addressed and rectified on a attract (and who matter most) to be globally war footing. These deficiencies have, competitive in providing – whether over the last decade or more, been Indian or not and whether working for discussed in central, state and municipal Indian or foreign firms – are affluent, mobile, government circles, the media, the and multi-culturally inclined in terms of corporate world, and by the public their habits, tastes and preferences. They at large. Progress in addressing these demand world class facilities to live, work deficits is now being made. The and play, as well as world standards of was assured by the of infrastructure and urban governance. They Maharashtra that the pace of progress have ample choice in terms of where they was about to accelerate. Mumbai’s (and their families) choose to be located, deficiencies include: crumbling housing and how their time is allocated. Whether in dilapidated buildings pervading the they choose to locate in Mumbai will be city; poor road/rail mass transit as well influenced by the attractions of Mumbai as a as the absence of water-borne transport global city in which they can live, work and in what is essentially an island-city; play in a manner similar to what they can absent arterial high-speed roads/urban expressways; poor quality of airports, do in other s. This reality may involve airlines and air-linked connections the creation of facilities to support lifestyles domestically and internationally; poor that could result in increasing social tension provision of power, water, sewerage, in the city; that risk will need to be managed waste disposal, as well as a paucity of sensitively and adroitly. high-quality residential, commercial, For Mumbai to become an that can shopping and recreational space that operate on a par with the three established meets global standards of construction, s, it will eventually need to attract a finish and maintenance. large population of individuals who are an integral part of the globally mobile • Second, Mumbai will need to be (globile) finance workforce that already exists. seen as a cosmopolitan metropolis Perhaps –% of them will be of Indian that welcomes and embraces migrants origin. The remainder will be expatriates from everywhere – from India and from around the world representing every abroad. That will mean providing country that has significant trade and more user-friendly visa/resident permit investment links with India (and Asia). mechanisms, making all arms of Most of them will be working for foreign government expatriate-friendly, and financial firms that will include, inter exhibiting a gentle, tolerant, open and alia: commercial and investment banks, welcoming culture. asset management companies, insurance • Third, lifestyle facilities that concern companies, securities and commodities human welfare will need to be brought brokerages, bills discounting houses, private up to world standards and run on equity firms, venture capitalists, hedge funds, world-class lines in terms of their as well as the financial media and financial management and growth. These include: reporting agencies (such as Bloomberg, hospitals and the health system (public Reuters, major global financial publications) and private); educational facilities xxx R M I F C
such as primary/secondary schools, waste of resources on purchasing services colleges, and universities; recreational that India could provide more competitively facilities such as sports stadiums (for for itself. Moreover, an inability to meet a wide variety of sports and not its own needs – and those of its trading just cricket), gymnasiums, cinemas, and investment partners – for will theatres, parks, clubs, hotels, bars, compromise India’s growth. restaurants, racecourses, casinos and Oddly enough, India does not need to other entertainment avenues; as well as rely on foreign providers for . Quite cultural institutions such as libraries, art the contrary: India has several significant galleries, museums and the like, catering strengths that give it an edge in providing to global tastes. not just to itself but to the rest of the • Fourth, the quality of municipal and world on a competitive basis. Indeed, there state governance, the provision of per- is no city in the world that can become an sonal security and of law enforcement, on the scale of London or New York, will need to improve dramatically from within a -year horizon, in the way that third-world to first-world standards to Mumbai can. This reflects India’s unique accommodate an . That is likely to strengths of: democracy, open-mindedness, prove the greatest challenge of all. cultural comfort with foreigners living and Of course, Mumbai needs to tackle these working in Mumbai, use of English, a well infrastructure deficits for reasons other than placed time zone, high quality labour force, becoming an . The is too small a year tradition of speculation and risk a tail with which to wag the much larger taking, and a hinterland advantage. urban development dog. But the case for an But such a future for Mumbai is far would be immeasurably enhanced if it from guaranteed. At present, India is succeeds in doing so. For that reason, absent from the global space, owing recommends a fresh attack on the legal issues to weaknesses in financial sector policy, of urban governance, in a cohesive effort, financial market structure, financial regime undertaken on a war-footing, between the governance, legal system infirmities, as Centre, Maharashtra and Mumbai. The well as in the urban infrastructure and aim must be to create a city government governance of Mumbai. The situation with the necessary autonomy, accountability is worse than initial conditions were for and power to provide local public goods in manufacturing and software exports in . Mumbai in a reasonably unfettered fashion. India does not have a low market share in Mumbai’s needs must be met irrespective of the global market: it has a zero market rural versus urban considerations. The city’s share. administration must have an earmarked Looking ahead, the growth of funding stream through tax sharing, in demand in India is inevitable, given the addition to user charges and property taxes sheer growth of cross-border flows. The that it can levy independently, to finance the pressure of demand that will flow from creation of a ‘global city’ in Mumbai. cross-border transactions of $– trillion per year will inevitably trigger the emergence of rudimentary capabilities in one way 10. The choice or another. The question that India faces is India has already become a large purchaser whether incremental evolution towards a of from the rest of the world; much limited range of capabilities is adequate, larger than is realised in policy-making or or whether there is a more promising future commercial circles, leave alone by the public for India in exporting . at large. As its economy grows, its demand If decision-makers fail to tackle the for will increase in a non-linear fashion. policy issues outlined in this report, Indian India can, of course, choose to continue demand will fuel the growth of Wall buying from abroad indefinitely. But Street, Singapore, and the City the amounts it will need to spend for that of London; often through the aegis of purpose are staggering. They represent a Indian financial firms that will graduate Executive Summary xxxi
into multinationals and relocate their path, are much greater than the operations outside the country. direct revenues that would accrue from The maturity of Indian finance in , sale of to local and foreign customers. in terms of coping with competition and India’s experience with manufacturing has globalisation, is comparable to where Indian demonstrated that outward orientation and manufacturing stood in . The export export competitiveness are the best tools of financial services from India in for producing world class quality for the sounds about as unlikely today as the export domestic market. An Indian financial sector of automobile components or software that can export will do a better task of sounded in . The outlook for export of financial intermediation for India. That is automobile components or software in likely to generate an acceleration of was nothing but bleak. Yet India managed growth as growing investment resources to find the energy to unleash revolutionary (now exceeding % of ) are more changes in policy. efficiently allocated. Such radical changes now need to be These benefits need to be weighed replicated in finance, if export competitive- carefully by India’s leadership against the ness in the provision of financial services political capital that needs to be expended (domestic and international) is desired and in overcoming the technical and realpolitik to be achieved. Visionary thinking needs to constraints of: (a) changing the financial be applied to issues of financial architecture, system in India with a second, more the role of the central bank, and regulatory intensive set of reforms; and (b) urban philosophy. governance in Mumbai. In parallel, Mumbai needs to become a This report has tried to bring objectivity first-world city that can attract the brightest and professional competence to sketching minds of the world by being an attractive the trajectory, should India’s leadership place to live, work and play. decide to take the path. It strives to If India is able to meet these twin deliver a nuanced appreciation of the likely challenges, then exports could outstrip costs and benefits of the path to an , service exports by . The benefits based on understanding of which policy- to the Indian economy, from taking the makers can make a reasoned choice. xxxii R M I F C > PBR 50% Year FSMA FSMA All < 2011 PSFFS Regular Unified? SEBI 0 by 2015 All 4 SEBI Bill Bill BR Separate Regulator - 3 to global levels s PBR FSMA FSMA PSB –Others OTC 2 Extend to all of finance s in All states RIA Maintain at 10% or more Continue training/updating Implementation Completed Apply Table Table supervised by Reduce to 60% Reduce to 26% Implementation Eliminate Totally PPP Weak 2010 by Quarter Single Regulator? Legal System at Global Standard Phase-4 Complete 1 below 5% BSE / NSE 4 s denominated paper for any buyer 33% Public Debt Managed Independently IRDA - < 3 PSB INR PBR Capital and Current Accounts Fully Open All Global legal firms permitted to operate No further compartmentalisation of finance Phase 3 Phase-3 All financial market trading supervised by 2 All Transactions Taxes, Stamp Duties eliminated s in 15 states Final Draft Final Draft -Cap Markets Pilot Phase All Global Accounting firms permitted to operate Strong All bond trading to be done on market exchanges Wholesale and Retail Markets regulated differently Train All Staff Apply Reduce to 65% Reduce by 75% PPP Widen and deepen sovereign/corporate bond markets Increase to 10% RIA 2009 by Quarter Implement 100% Reduce to Extend to Banking 1 Implementation of Changeover Consolidation to 2? and algorithmic trading to be regulated reasonably DMA 4 s PDMO SD 49% SEBI Currency Market operates on PSFFS - Execute < 3 No further restrictions on PBR Launch range of multi-currency futures, options, swaps for trading Remove all restrictions/bans other than usual prudential regulations for Banks No bans on Continually expand range of products traded on Phase 2 Phase-2 2 s in 10 states RIA Independent Shift Platform Consultations Consultations Apply Open up Entry Open up Entry Shift Platforms Policy Decisions Non-bank Reduce to 70% Reduce by 50% Include banking Eliminate all PPP Execute Transfer Implement 70% 2008 by Quarter Increase to 9.5% Separate Markets Reduce to Preparation Phase Train 65% of staff Consolidation to 4 Insurance/Pensions 1 Reduce to 6%by y.e. Prepare 4 STT Open shift Launch trading 3 Projects Widen Range of Contracts to cover currencies, interest rates, credit default and trade them OTC PPP Phase 1 2 Eliminate Start Phase-1 De facto Open up fully Prelim Drafting Prelim Drafting Increase to 9% Technical Study Technical Study Except Banking Reduce to 75% Prepare Ground Prepare Ground Prepare Ground Prepare Ground Reduce by 25% Implement 40% Build Consensus Pilot 2007 by Quarter Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Train 30% of staff Rules Widen 1 Reduce to 7%by y.e. Prepare s s s s PSB PPP . GFC GFC ) s/ s/ 10 million SEBI IFC ) PBR IFC . INR BSE s). GDP FII and NSE ) giving banks more flexibility ) covering all of finance. s). BRA to 4–5% of SD IFSAT + ) to Principles-Based ( to significantly less. RBR GDP ) from 8 GCFD ) and Stamp Duties ( Report on making Mumbai an International Financial Centre: Timelines for Recommended Actions STT Recommended Actions ratio from 80% of Nexus in Indian Capital Markets: HPEC and algorithmic trading GDP BCD trading of exotic and tailor-made derivatives. denominated debt instruments issued by GoI to All Buyers DMA OTC INR Task Force Report of 2004. FRBM cash settled currency derivatives on exchanges open to all ( to the financial services industry. INR GST should incorporate redrafted Banking Regulation Act ( FSMA Reduce Case Backlog of cases involving financial contract disputes Improve knowledge-skills and training of judges and arbitrators A. Bond Market B. Establish Currency trading exchange withC. a Derivatives minimum Market: transaction Shift size trading of inD. vanilla Retain products and (futures, Expand options, swaps)E. to MoF exchanges to review/remove constraints onF. Create any financial firm operating in derivatives 1. Achieving and maintaining an average2. growth Reduce rate the of gross 9% consolidated to fiscal3. 10% deficit Reduce ( total public debt to 4. Implement the 5. Eliminate Securities Transaction Tax ( 6. Apply 7. Open up purchase of 8. Restructure budgets/‘balance-sheets’ of states and9. metropolitan Shift municipal burden corporations of future infrastructure financing from public to private sector through 10. Set up independent public debt management office (or as second-best11. locateFocus it Monetary in Authority MoF) exclusively on12. singleFull task CAC of to managing be key achieved short-term in ‘base a rate’ time-bound manner within13. theImprove next functioning 18–24 of months Legal System insofar as it affects financial services. 14. Create International Financial Services Appellate15. TribunalPermit ( unrestricted entry of well-known16. globalPermit legal unrestricted firms entry operating of in well-known17. other globalDismantle accounting barriers firms between operating different in financial18. market GoI segments to prepare ‘exit strategy’19. for GoI its to withdrawal reduce from equity the stake20. ownership graduallyShift of in Financial financial all Regulatory firms types Regime of from21. public Rules-Based Conduct sector ( Periodic financial Regulatory firms; Impact esp. Assessments22. of Examine the Carefully financial the regulatory Need regime. for23. changingTrading platform extant for Regulatory sovereign Architecture bonds24. toDraft be new moved Financial to Services exchanges Modernisation ( Act embracing ‘Principles Based Regulation’ 25. Transfer all regulation/supervision of any26. typeDistinguish of between organised wholesale financial and trading retail27. to marketsOpen and up use immediately appropriate to regulation for each 28. Create rapidly the Missing 13B. A. Actions on Fiscal Deficit, Tax and Public Debt Financing/Management Fronts: B. Actions on Monetary Policies and Monetary Management based on Inflation Targeting C. Actions on Financial Regime Governance and Financial System Regulation 13A. 24A. D. Actions on Filling the Gaps in ‘Missing Markets’ Executive Summary xxxiii > Year 2011 -based regulation by Construction PBR 4 Construction s 3 AIV 2 2010 by Quarter 1 Contracts Facility Construction and Operations 4 T&D Line Construction and Operations Power Plant Construction and Operations Contracts Underway and Operating 3 PPP Dispense with all controls except urban planning Indian financial sector open to foreign competition Contracts Let market drivethrough consolidation financial system and segment integration 2 Place City on mainly independent financial footing Implement Rationalisation/Streamlining Programme 2009 by Quarter SEBI Encourage rapid expansion of WAM with Indian financial system fullyto prudential open regulation to and fitness global tests participation subject 1 Place City Administration under full control of City Manager 4 s Tenders Tenders Preparation Contracts Contracts Contracts WAM Launch Encourage M&A 3 Full outsourcing of asset managementin activities India by any financial firm operating All restrictions on branch opening by foreign banks to be removed 2 Remove all restrictions on entry of hedge funds and to increase bandwidth rapidly; introduce greater foreign competition Transition Contracts 2008 by Quarter Normalise rentals 1 Plans and Projects underway to increase and improve water quality FLAG to expand landlines in keeping with demand growth; increase competition , Tenders Tenders Tenders Phased development and expansion of Mumbai’s road transport capacity Remove Restrictions FramingRules of Remove Restrictions 4 Accelerated liberalisation Programme in place Appoint/Elect Agree Fund Sources Set up MSc in Finance and a range of specialised technical training programmes VSNL MTNL All restrictions on branch opening by domestic banks to be removed immediately Restrictions limiting private corporate ownership of banks to 10% to be removed Plans and Projects underway to increase and improve sewerage capacity/treatment Plans and Projects already underway to increase and improve storm/flood drainage s Plans and Projects underway to increase and improve water supply quantity/availability RCA TRAI to hold cellular operators to service quality commitments to upgrade continuously / PPP 3 Actions already taken for Santa Cruz and Sahar. New plans for Navi Mumbai airport and runways ULCRA Capacity building by Indian firms 2 Develop Studies Studies Technical Feasibility Studies Technical Feasibility Studies Feasibility Drop 2007 by Quarter Technical Studies Technical Study Technical Study Technical Studies Prepare Groundwork Prepare Groundwork Organisation Study 1 Study Options Agree- WTO (minimum account Rs.10 crores) SEBI s ] PPP 365) × ] ] 7 PPP ] × PPP PPP Report on making Mumbai an International Financial Centre: Timelines for Recommended Actions s ] (24 s ] s to emerge, through M&A and takeovers. PPP PPP LCFI Recommended Actions HPEC s, hedge funds, etc. FII s for Power Infrastructure: PPP ment on Trade in Financial Services. A. Intra-city roads and arterial routesB. [ Coastal Highways and Expressways [ C. Suburban Railways and new MetroD. System Water-borne [ Transport – Ferries/Hydrofoils/Jetfoils [ E. Increase/upgrade airport and runway capacities A. Increase in Power Generation Capacity B. Increase in Transmission/Distribution Capacity A. Increase in Storage Capacity andB. Pipelines Increase [ in Filtration and WaterC. Quality Upgrading/Expansion [ of Sewerage Capacity D. Upgrading of Storm and Flood Drainage A. Substantial Expansion of Cellular Network B. Expansion of Landlines and Broadband C. Expansion of International Bandwidth mutual funds, pension funds, E. Actions to Strengthen Institutions operating in29. IndianGoI Financial to Markets support emergence of Indian 30. GoI to permit Wholesale Asset Management regulated31. by Remove all impediments to outsourcing of asset32. GoI management to by bring forward banks, liberalisation insurance of financial companies, sector in33. keeping Interim with adjustment commitments period to of two34. yearsOpening for of Indian branches institutions by to domestic35. adapt banks Opening to to of global be branches competition. decontrolled by immediately. foreign36. banksRemove to immediately be all decontrolled restrictions after limiting37. one corporateOpen year ownership up of Indian banks capital to markets38. 10% to Set entry up range of of hedge programmes funds forF. development and Actions of alternative to specialised Improve investment human capital Infrastructure vehicles for in the39. Mumbai financialTransport industry Infrastructure: 40. 41. Water Supply, Sewerage& Drainage: 42. Increase Waste Disposal Capacity: For43. solidTelecommunications Infrastructure: and liquid waste with environmental protection 44. Accommodation: Residential, Office and Commercial G. Actions to Improve Urban Governance45. in GoM Mumbai and BMC to appoint or46. arrange Bring to the elect existing a city City governance Manager machinery accountable47. under for Establish the Mumbai independent full financial control base of for48. the the Rationalise City city and Manager that streamline is to under organisation the structure control and of lines the of City responsibility Manager in city management
The Emergence of IFCs: A brief history
1. Meeting cross-border trade, providing trade financing services to specific investment and other needs regions. In this chapter we take a synoptic look The growth of international finance has at the evolution of s around the world, c h a p t e r been shaped by history. It is a chronicle of consider how they might classified in terms episodic needs for capital across geographies of what they do and whom they serve, look outgrowing the domestic resources available. at recent trends in the formation and spread Financial services, institutions and markets of s and, finally, we examine at the case have evolved in response to requirements for Mumbai to emerge as an as India 1 for capital. As colonial empire-building takes its place in the world. and industrial development took off – in Europe, the Orient and elsewhere – large 2. Evolution of international financing needs arose that triggered the need for large cross-border financial firms financial services (IFS) and and markets to emerge. Such needs were centres (IFCs) compounded by new technologies that The provision of has a longer enabled the geographical separation of chronology than commonly recognized. production from consumption (of goods The world had a global currency (based and services) around the world. They fuelled on gold and silver) for several centuries. exponential growth in cross-border trade –in the most basic conceivable forms – and investment. These economic forces were, were provided by merchant traders-cum- and are, the main drivers of international financiers for at least two millennia; if not financial services (). before. Pre-modern flourished across At first, merchants who became bankers Europe, the Middle East, and coastal Africa, worked alone to raise or put together funds under the umbrella of the Roman Empire for large investments. They gradually – which also traded with Persia and the diversified their sources of funds to Orient. Its trajectory was nearly extinguished royalty, church, landed aristocracy, and between the th and th centuries but wealthy professionals. Modern-day financial revived to finance the Crusades in the infrastructure did not exist. Central banking th and th centuries. and financial regulation were nascent and The antecedents of modern are primitive. Securities exchanges/markets traceable to the Renaissance when the city- were few and far between. Credit-rating states of Venice, Florence, Naples and Genoa facilities were nonexistent. Resort to law became mercantile centres that dominated for the settlement of financial disputes was trade between Europe and the Orient from virtually unknown. In this raw environment, the th to th centuries. In the th and vendors in each centre of finance acted th centuries these Mediterranean centres alone or collaborated with partners in were superseded by the rise of Amsterdam, other locations with extreme caution. That Lisbon, London, Madrid, and Paris as s, resulted in delays and inefficiencies. Yet with the discovery of the New World, the these early impulses saw incipient clusters of Antipodes, and the establishment of colonial financial expertise emerge that evolved into empires across the Americas, Africa and Asia s. Over time, many city-states specialised by European powers; viz. Britain, France, in arranging complex financing deals and Holland, Spain and Portugal. 2 R M I F C
The nature of mercantile was . In , the Suez Canal was built transformed with the first round of halving sailing time between London globalisation that occurred from the mid- and Mumbai. th to the early th century. It was revolutionised again by the second round By , two large, productive and of globalisation that had its origins in post- politically stable, economic blocs – the nd world war reconstruction and recovery, British Empire (with India as its economic but gathered real steam since the s. centrepiece) and the – had emerged as Since the s globalisation has entered dominant. They straddled the extremities a new and more intensive phase. It has of the globe from west to east with well become the principal force driving and established intra-imperial trade routes reshaping the world economy. In the process, connected by steamships, railways and the it is increasing the tensions caused by an telegraph. But the world economy of the economy that is increasingly global, being th century was not limited to these two inadroitly governed by polities that remain blocs. Other European powers also had national and, as yet, incapable of graduating ‘intercontinental’ empires in the Americas, toward the kind of supranational governance Africa, and Asia. These were similar to, that globalisation demands. but much smaller than, the British Empire. The Russian and Ottoman empires exerted domain over territories in Eastern/Central 3. The first round of Europe, and the Middle East and North globalisation: circa Africa respectively. Japan established its own 1860–1914 empire in Korea and Formosa (now Taiwan). Cross-border trade occurred mainly From around onwards, there was within the geographies of these separate a quickening of the pace of first-round empires, rarely across them. But there globalisation, owing in part to the following was inter-empire trade in Africa, Asia and major developments among others: Latin America across contiguous borders of neighbouring colonies (e.g., between British . In , a ,-mile telegraph system Kenya and German Tanganyika as well as linking Calcutta, Agra, Mumbai, Pe- Italian Ethiopia, between British Nigeria shawar and Madras was completed. It and French Cote d’Ivoire, or British Malaya, was the first high-speed messaging sys- Dutch Indonesia and French Indochina). tem in India. The th century saw a historically . After the Civil War, economic growth unprecedented surge of intra-colonial trade in the took off based on liberal, with accompanying demand for trade and market driven egalitarian economic investment related . Sophisticated relationships, i.e., without relying on trade finance spilled over into long term slave labour. In the s the First investment finance, for plantation farming, Transcontinental Railroad was built, ranching, mining and infrastructure (e.g., with construction from both coasts railroads and steamships) as well as linking up in . the production of agro-industrial and industrial manufactures. Thus trade and . In parallel, railways were being con- investment (for localised production, based structed in India where, by , over on natural and comparative advantage, , kilometres of railway lines had but aimed at empire-wide consumption) been put in place. provided the principal impulses for the . In , telegraph links between Europe development and growth of in enabling and India became operational, so that economic decentralization and geographical a message could get from London to dispersion. They still do that today; but, on Mumbai in less than minutes. In , a much larger scale, with the growth of cross- the first transatlantic telegraph cable was border trade and investment far exceeding completed. the rate of global output growth. . The Emergence of IFCs: A brief history 3
During the first round of globalisation, semiconductors, transistors and silicon chips London was the pre-eminent , with – was made in decades that previously had Amsterdam and Paris playing supporting taken centuries. roles. New York was still in its infancy then. The -year period (–) between It did not come into its own till around the end of the first, and beginning of . This was an age of universal capital the second, rounds of globalisation was convertibility. Citizens of the world were disrupted by two world wars and an unstable free to move their assets across boundaries -year interregnum. The second round without governments or central banks of globalisation had its hesitant origins in impeding them. Enormous pools of capital an era of post war recovery, adjustment were intermediated in Europe for investment and decolonization (-) that again abroad. Savings were mobilised in London changed the economic structure of the world from around the British Empire (including and the trajectory of the global economy. India) for investment in the Americas, as The revival of cross-border trade across the well as the British colonies in Canada, the Atlantic and Pacific, along with massive Caribbean, Africa, the Middle East, Asia investment for post-war reconstruction (West, South and East), the Indian Ocean financed by the , played a major role and the Antipodes. in resurrecting and galvanising it at a In this period, large amounts of capital more frenetic pace than before. During this flowed from rich to poor countries. Funds period (i.e., –) New York replaced for investment in the colonies of continental London as the world’s pre-eminent . European empires were raised in their In both rounds the distinction between domestic and overseas financing for trade and imperial capitals; but augmented by global investment became blurred in determining funds raised in London for large risky the content of . And, in both rounds, ventures: e.g., ranching and mining in Chile the process of financial integration and and Argentina, mining in almost all of globalization was driven by: Southern Africa, and for financing telegraph systems, railroads, sailing and steamship . Financial innovation in instruments, lines, telegraphy, and such monumental services and risk management arrange- projects such as the Erie and Suez Canals. ments that spread instantaneously across borders (when it was permitted to) to 4. An interregnum, the second meet the evolving needs of clients (savers round of globalisation and users of funds) in the real economy. (1945–71), and beyond . Different risk/return and portfolio diversification demands of global savers In the late th century accelerated and investors. dramatically, driven by the industrial, . The injection of information processing transport (steamships) and communications and communication technologies into (telegraph) revolutions, resulting in a massive-scale gathering, dissemination structural transformation of the world and processing of data. Ubiquitous economy. More technologically-driven access to low-cost information tended to change in the world economy occurred in undermine relationship-based banking the course of the th century than in the two and fuel the growth of arms-length previous millennia. It triggered profound securities markets, particularly when geopolitical change, resulting in a series of it came to large issuers of securities. European wars culminating in two world wars. In many countries, imported capital The th century that followed made financed domestic investment and vice- the remarkable th century appear primi- versa, as direct and portfolio investors (in tive by comparison. Progress – in air trans- an increasingly integrated global market) port, information, communications and diversified their investment portfolios to process technologies for manufacturing, in manage/balance country and sector risk. 4 R M I F C
The second round of economic and financial has been dwarfed by private capital flows globalization began with the being throughout the second half of the th the world’s locomotive and sole provider century, except in –. of surplus investment capital for the As happened through the th and early global economy. While driven initially by th centuries, financial products became the reconstruction needs of Europe, the more diversified. Plain vanilla finance ceded , and Japan, global economic recovery to more complex structures following the resulted in dispersing manufacturing introduction of financial derivatives in the capabilities (and consequently enhanced – period. grew horizontally trade in goods) throughout the developed and vertically. Financial firms innovated world. Second round globalization was imaginatively. enabled rapid changes in boosted by new investment needs created by a number of new technologies (e.g., , bio, the decolonization of the developing world nano, eco, to name a few) to be translated after . into equally rapid changes in products, The drove second round globaliza- services and markets served by entirely new tion single-handedly in –. But that companies. The was not invented till role diminished rapidly with the collapse of . Cellular phones came on the scene in Bretton Woods in . The global mone- the s. tary system that prevailed from to – vastly enhanced by – enabled was designed by Harry Dexter White, John these changes to be transmitted globally Maynard Keynes and others. It consisted and instantly with the management of a of pegged exchange rates and closed capital variety of attendant risks. In response, accounts to support large amounts of pub- risk management techniques, instruments, lic spending for reconstruction and social products, services and risk-trading markets welfare without risking capital leakage from evolved rapidly. They became more resource-starved economies. But that histor- sophisticated with the unbundling of risk, ically anomalous and unnatural confinement specialisation in risk-taking, and synthesis of capital lasted for just years. of risk management packages in a variety of The primordial nature of unrestrained different forms. also financed the tides capital flows across borders (that national of geopolitical flux – both the conflicts that governments consider sacred, but ‘capital’ have taken place and the reconstruction that is oblivious to) was restored in the face of has followed in their aftermath. unsustainable global pressures. These arose The changes of the th and th from chronic global imbalances in savings, centuries seem dramatic in retrospect; consumption, investment and trade. They indeed almost unimaginable in the context were driven by the shifting geographies of of progress made over the previous production, the economic revival of Europe millennium. But, the time-span for progress and Japan, and decolonisation. Between in the st century is becoming even more – the Bretton Woods regime was compressed in considering the speed with replaced in all economies by the new which new technologies keep emerging stable regime based on floating exchange and shortening product/market life-cycles. rates and open capital accounts. Technological innovation is occurring on In the developing world, the role played a log rather than linear scale. Financial by the as the principal global creditor- innovation is struggling to keep pace. cum-investor was supported by capital flows Technological changes that took cen- (official and private) from former imperial turies before occurred in decades in the countries: i.e., Britain, France and, to a th and th centuries. But, just one year in lesser extent, Holland. They were catalyzed the st century, is seeing changes that took and augmented by multilateral institutions five years or a decade in the th. Techno- such as the , World Bank and regional economic and ‘financial world’ changes keep banks. Governments and official institutions racing ahead unbridled. But the social, cul- have played a useful role in global finance; tural, political and institutional changes especially in times of crises. But that role needed to accompany them – and cope . The Emergence of IFCs: A brief history 5
with their consequences – are occurring in , is growing at an annual rate of too slowly. In the developed world these $ billion. This astonishing reversal social and political changes are being made of global capital flows now supports the faster than in developing countries like In- as the world’s consumer of last resort. dia, where structures and institutions for That role is unsustainable for much longer; policy-making and governance are adapting especially if the global distortions now at a glacial pace. In the process, governance being exacerbated by chronic imbalances in is becoming dysfunctional in coping with savings, consumption and investment across transformations in consumer expectations the world’s economies, are to be rectified in and behaviour (as well as in goods/services an orderly manner over time: i.e., without markets and industries) that are now occur- worldwide disruption and a damaging loss ring at ‘warp-speed’ in the real and financial of confidence in the value of the as a worlds. reserve currency. As with the first round of globalization, As the tides of global finance change, so the propagation of new technologies (jet do the fortunes of s. Until , London engines, transistors, computers, television was the world’s premier . After the and telecommunications) and relative First World War, New York – as the real wage cost differentials (adjusted for of the only capital-surplus country in the productivity) are playing a significant role world at the time – eclipsed London. It in accelerating globalization in its second remained ahead for nearly nine decades from avatar. In the first round, cross-border –. New York lost its primacy again capital movements were free. The world to London just this year. London began was financially more integrated, albeit recovering its position as an in the late informally, because of the absence of capital s and s when misguided financial controls. But, the early stages of the second regulation in the – i.e., the infamous Regulations K and Q – resulted in the phase of globalization (i.e., –) saw surplus dollars of American s in Europe economies being heavily regulated and (from profits, dividends, and repayments of financially segregated under the Bretton intra-corporate loans by subsidiaries) being Woods regime monitored by the newly retained in Europe for global reinvestment established International Monetary Fund instead of being repatriated to the where (). Global financial integration began to they would have been taxed exorbitantly. catch up in earnest with the breakdown of That resulted in the creation and Bretton Woods and a reversion to freedom growth of the Eurodollar market with its of money and capital flows. centre of gravity in London where the authorities seized the initiative with a 5. The ‘take-off’ of second ‘light touch’ approach to financial market round globalisation after regulation. Financial regulation in the 1980 has been continuously refined ever since to maintain London’s competitive edge. Macro- Since , the nature and direction of economic policy in the , which went global capital flows, and the continued through a distressing period including one geographical dispersion of production, have IMF program and one speculative attack changed significantly; with aligned changes on the GBP, has been put on an even keel in the nature and direction of . From through a mix of fiscal rules and the Bank of being the world’s largest creditor, the England reforms. These factors have been has become the world’s largest debtor in the key to London’s re-emergence as the just two decades. In , the world owed world’s premier in . the almost $ trillion. By , The Eurodollar market exploded the owed the world the same amount. in the s when the first round of By , it owed the world nearly $ cartelised oil price increases resulted in trillion. The ’ debt to external creditors petrodollar surpluses being accumulated (mainly Asia and ), denominated by oil-exporting countries. Their domestic 6 R M I F C
economies were incapable of absorbing such products/services across borders. But that a sudden, large increase in the volume of does not differentiate them sufficiently in resources available. They were recycled terms of their scope. around the world – mainly through London We categorise s in this report as: and New York – by banks with global branch (a) Global (GFCs); i.e., those that genuinely networks and established correspondent serve clients from all over the world in relationships. The Eurodollar market has the provision of the widest possible array since diversified into a multi-currency Euro- of ; (b) Regional (RFCs) that serve market that is global in nature. It establishes their regional rather than simply their the benchmark for interest rates in all national economies (see below) – examples commonly traded currencies. It has been of such s would be Dubai or Hong mimicked in Singapore by the Asian dollar Kong; (c) International non-global and market although that market is yet a pale non-regional IFCs like Paris, Frankfurt, reflection of its Euro-counterpart. Tokyo and Sydney that provide a wide range The second round of globalisation has of but cater mainly to the needs of their entered a new phase in the st century. national economies rather than their regions The world’s centre of economic gravity has or the world – one might be tempted to call shifted to Asia. It is possible, even likely, that them national s although that term is – with greater market-driven integration awkward because its two defining adjectives of Asian economies – the Asian dollar (or are contradictory; and (d) Offshore (OFCs) multicurrency) market may equal or exceed that are primarily tax havens for wealth the present size of Eurocurrency markets management and global tax management within the next two or three decades. That rather than providing the fully array of . depends on whether Asian bond markets develop in the same way, by taking a lead 6.1. Global financial centres from Japan. Global Financial Centres (s) such as For that to happen, wide and deep London, New York, and Singapore are full- markets will need to be created for currency service centres. They offer a complete trading in Asia and for a wide range of range of markets, products and services derivatives (for currencies, interest rates to clients worldwide, along with advanced and commodities) in the more adroitly settlement and payments systems. All regulated Asian s like Singapore and, three support large hinterlands whether hopefully, Mumbai. The growth of an national (i.e., New York) or regional (e.g., Asian multi-currency market will have major London and Singapore). All have deep and implications for the internationalisation liquid national financial markets. Their of the as a world currency and sources and users of funds are global and perhaps even for the emergence of common diverse. Their legal/regulatory frameworks currencies for two or three Asian sub- are robust enough to safeguard the integrity regions. of all principal-agent relationships and supervisory functions. s generally 6. Classification of IFCs borrow short from residents and non- residents and lend long mainly to non- Financial centres that cater to customers residents. In terms of assets and trading outside their own jurisdiction are referred to volumes, London is the premier , as international (s) or regional (s) followed by New York. The key difference or offshore (s). These three adjectives is that the proportion of international are often (but wrongly) used synonymously to domestic business is much greater in in the literature on s. The three types London. s they identify are difficult to define in a The most recent entrant to the clear-cut, mutually exclusive, fashion. But club is, arguably, Singapore. When its they are quite distinct. All these centres financial services sector was confronted by are ‘international’ in the sense that they the deregulation of Tokyo’s markets in the deal with the flow of finance and financial mid-s, and when Hong Kong’s future . The Emergence of IFCs: A brief history 7
was rendered uncertain by the Anglo-Sino Regional centres include s such as Hong accord of , the Singapore government Kong and Dubai. responded by adopting a strategy aimed London and Singapore are s in at creating a niche for Singapore in Asian a way that Frankfurt, Paris and Tokyo and global markets. It imported are not. New York also serves the North the best expertise, enhanced support American and Latin American regions. But services, and adopted globally competitive all three centres go well beyond serving their tax and regulatory regimes. The success of neighbourhoods to serving the world; so we these policies was reflected in global firms classify them as s. Paris and Frankfurt transferring their Asian regional financial serve the needs of the French and operations from Tokyo and Hong Kong to German economies. Paris also serves, to a Singapore through the s. Singapore also limited extent, the Francophone world while looked west and took steps to encourage the Frankfurt is becoming an increasingly useful emergence of a non-deliverable forwards to neighbouring Eastern European market on the . It is now actively gearing economies. But neither are s, nor s, its industry to capture a larger market as yet. share of Indian business. This digression was necessary because HPEC was tasked to look into making 6.2. Regional financial centres Mumbai a ‘regional financial centre’. But The phrase regional financial centre causes the Committee has deliberately chosen to some confusion because it is commonly avoid using that nomenclature because of used in two different senses: (a) when its implications and connotations. a particular actually serves not just Under present circumstances, it is its national economy but its surrounding difficult to see Mumbai becoming a of neighbourhood region – it is genuinely choice for the South Asian region. India’s a – and probably derives more immediate neighbours may, for geopolitical business from its neighbourhood than from reasons, prefer to use Dubai or Singapore its own economy; and (b) while an may instead for their needs. So, while be regional in the sense of being located in Mumbai is located in South Asia, it is a particular region – it may not necessarily unlikely to become a South Asian serve that region but be confined to serving in the foreseeable future. Instead, the its own economy instead. This report tries believes that it is more likely to to avoid that confusion by accepting only the leapfrog from emerging as an that first definition and disregarding the second. serves India, into becoming a that For example, Paris and Frankfurt are serves the world, without serving its South European s. But they do not provide Asian neighbourhood along the way. In for the to the extent London that sense Mumbai’s emergence as a does. In the same way, Tokyo is an Asian may be different from that of London, New . But Singapore and Hong Kong serve York and Singapore which are all s as more Asian economies with a wider range well as s. Whether Mumbai becomes a of except for the global market for depends on whether the preconditions denominated bonds, which Tokyo necessary for it to play that role are met dominates. Paris, Frankfurt and Tokyo by the concerned authorities. The irony is are not, in our definition, s. They are that if South Asia’s geopolitics are eventually more national than regional in orientation. ironed out, and reach an equilibrium that s differ from s in that they have permits meaningful economic interaction, reasonably developed financial markets Mumbai may become an RFC after it has and infrastructure; but they are not as achieved status. sophisticated, wide or deep as s. They intermediate funds in and out of their region, 6.3. Offshore financial centres but they have relatively small domestic s comprise a third category of . economies (compared with their regions) They are smaller, and provide more limited and are not as globally competitive as s. specialist services in the areas of tax, transfer 8 R M I F C
Box 1.1: Examples of Uses of Offshore Financial Centres (s)
Offshore banking licenses: A multinational corporation sets up an offshore an IBC in an offshore centre to engage in a specific activity. bank to handle its foreign exchange operations or to facilitate Issuance of asset-backed securities is the most frequently cited financing an international joint venture. An onshore bank activity of SPVs. The onshore corporation may assign a set of establishes a wholly owned subsidiary in an OFC to provide assets to the offshore SPV (e.g.,, a portfolio of mortgages, loans offshore fund administration services (e.g., integrated global credit card receivables). The SPV then offers a variety of securities custody, fund accounting, fund administration, and transfer agent to investors based on the underlying assets. The SPV, and hence services). The owner of a regulated onshore bank establishes a the onshore parent, benefit from the favourable tax treatment in sister parallel bank in an OFC. The attractions of the OFC may the OFC. include no capital tax, no withholding tax on dividends or interest, Tax planning: Wealthy individuals make use of favourable tax no tax on transfers, no corporation tax, no capital gains tax, no environments in, and tax treaties with, OFCs, often involving exchange controls, light regulation and supervision, less stringent offshore companies, trusts, and foundations. There is a range of reporting requirements, and less stringent trading restrictions. schemes that, while legally defensible, rely on complexity and Offshore corporations or international business corporations (s): are limited ambiguity, often involving types of trusts not available in the liability vehicles registered in an OFC. They may be used to own client’s country of residence. Multinational companies route and operate businesses, issue shares, bonds, or raise capital in activities through low tax OFCs to minimize their total tax bill other ways. They can be used to create complex financial through transfer pricing. structures. In many OFCs, the costs of setting up IBCs are minimal. Tax evasion and money laundering: Individuals and enterprises rely on They are generally exempt from all taxes and, for that reason, are banking secrecy to avoid declaring assets and income to the a popular vehicle for managing investment funds. relevant tax authorities. Those moving money gained from illegal Insurance companies: A commercial corporation establishes a captive transaction also seek maximum secrecy from tax and criminal insurance company in an OFC to manage risk and minimize taxes. investigation. An onshore insurance company establishes a subsidiary in an OFC to reinsure certain risks underwritten by the parent and reduce Asset management and protection: Wealthy individuals and enterprises in overall reserve and capital requirements. An onshore reinsurance countries with weak economies and fragile banking systems keep assets overseas to protect them against the collapse of domestic company incorporates a subsidiary in an OFC to reinsure currencies and banks, and outside the reach of existing or catastrophic risks. The attractions of an OFC in these circumstances include favourable income/withholding/capital tax potential exchange controls. If these individuals seek regime and low or weakly enforced actuarial reserve requirements confidentiality, then an account in an OFC is often the vehicle of and capital standards. choice. Special purpose vehicles: One of the most rapidly growing activities in OFCs is the use of special purpose vehicles (SPV) to avail of a more Source: Financial Stability Forum’s Working Group on Offshore favourable tax environment. An onshore corporation establishes Financial Centres Report (April 2000).
pricing, wealth management and private lightly regulated centres that provide services banking. Offshore finance is, at its simplest, to high-net worth individuals and small the provision of financial services by banks companies or trusts. They are almost entirely and other agents to non-residents. These tax driven. They have limited resources to services include borrowing money from non- support financial intermediation. Many of residents and lending to non-residents. This the financial institutions registered in s can take the form of lending to corporates have little or no physical presence beyond and other financial institutions, funded by a nameplate; although that is not the case liabilities to offices of the lending bank for all s. They are mainly providers elsewhere, or to market participants. It of corporate and accounting services for can also take the form of the taking of ‘passively managed’ offshore accounts. deposits from individuals and investing them elsewhere. s are typically found in the island 7. Why did Tokyo and economies of the North Atlantic, Caribbean, Frankfurt not emerge as Indian and Pacific Oceans as well as in credible GFCs? a few exotic European jurisdictions (e.g., Andorra, Monaco, Lichtenstein and of In considering the prospects for Mumbai as course Switzerland). They range from an , and later as a , it is instructive large and well-established private banking to examine why Frankfurt and Tokyo did not centres like Switzerland – that provide become successful s? Tokyo is located specialist and skilled wealth and asset in the world’s second largest economy, management activities, attractive to major measured in nominal . Frankfurt was financial institutions – to smaller, more located in the world’s third largest national . The Emergence of IFCs: A brief history 9
economy (till China overtook it in ). It to competing centres. But its role as a is at the centre of the world’s largest regional was circumscribed even without the economy – the . So why did these crisis. Barriers to competition and lack of two centres not become s despite their openness restricted its potential. Although hinterlands while London and Singapore Japan deregulated its financial system, as did? the and did in the s and One explanation lies in historical s, it left residual controls in place. Its demand from a large hinterland (home regulatory mindset did not change. Japan’s or regional) capital market that is more financial markets and institutions were sophisticated, better regulated and more sharply segmented and segregated. New sensibly taxed, than elsewhere. This allows financial products had to be approved by financial firms to diversify and exploit the MoF, which banned instruments that economies of scale to become globally were commonplace elsewhere, such as competitive while being able to offer services equity options. Banks were not allowed to that are not over-taxed. It explains London’s fail, however weak. and New York’s success as s because Japan’s Big Bang reform program in their financial firms (mainly investment the mid-s to deregulate the financial banks and asset managers) developed by system had a positive effect. A collapse serving the largest, most sophisticated and in domestic prices and the value of the most demanding capital markets in the made Japanese firms and real estate world. attractive targets for foreign investors. More It also explains why Tokyo (with of Japan’s assets and business came under its huge but unsophisticated and tightly international management. However, its regulated domestic market) and Frankfurt reforms did not go far enough. Tokyo (with its heavily taxed home market) still lacks the right combination of human have not succeeded in emulating them. and market resources for producing and Both Frankfurt and Tokyo are centres in exporting sophisticated financial services. economies with more traditional, rigid Tokyo functions as a large financial bank-dominated rather than capital market plantation, producing a commodity – money dominated financial systems; resulting – in huge amounts. But it lets London and in their being relatively uncompetitive. New York process that commodity and add Their banks have not developed the value to it. Thus, while Tokyo has many of same institutional capabilities for inducing the ingredients needed for a , it has not financial innovation as more capital-market unfettered its institutions nor deregulated its institutions in the and have. financial system properly. It has protected its Tokyo’s example is instructive for banks at the expense of its capital markets. Mumbai. Tokyo possessed many of It has not attracted foreign institutions, in a the attributes needed to rise to global way that encourages more competition and prominence. But it was unable to capitalize financial innovation. Equally importantly, on them. Powered by Japan’s economic Tokyo does not use English as its lingua strength and external surpluses, Tokyo franca. It has a mono-cultural environment achieved status in the late s, that inhibits it from becoming a genuinely when the top global investment banks global city. But Japan is reviving again and brokerages headquartered their Asian and may learn from its mistakes. For that operations there. Indeed, the global capital reason it would be premature to dismiss the market could not ignore Japan’s enormous prospect that Tokyo may yet emerge as a surplus assets in public and private savings. although Japan’s outlook would need Nor could the world go anywhere else to to change dramatically for that to happen. issue bonds or raise funds denominated in Frankfurt, for different reasons, also . does not pose a challenge to London and The bursting of the real estate bubble, New York. Initially it was thought that and Japan’s economic decline since , London would be eclipsed by Frankfurt as ended Tokyo’s rise. The city lost business Europe’s because Britain did not adopt 10 R M I F C
Box 1.2: How London lost the German interest rate futures market The German bond market is one of the trading terminals in the US. By October 1997, lost by LIFFE. By late 1998, the 10-year Bund world’s most liquid and diversified capital 10 firms in the US had terminals, and futures contract traded on the Eurex was the markets. Trading on the “Bund futures” began accounted for 18% of Eurex Bund futures third most actively traded derivative in the at London International Financial Futures volume. In August 1997, Eurex extended world, after Treasury bond futures on the CBOT Exchange (LIFFE) in September 1988. It was a trading hours to match those of LIFFE. In and Eurodollar futures on the Chicago futures contract based on notional German September 1997, Eurex announced that until Mercantile Exchange. In 1999, the Eurex Bund Government bond with a 4% coupon and a the end of 1997, fees on Bund futures trading futures contract became the biggest contract maturity between 8.5 and 10.5 years. By 1990, on Eurex would be zero. In January 1998, in the world. the Bund futures contract accounted for Eurex introduced a new pricing structure LIFFE was stung by this loss of a lucrative almost one third of the total volume on LIFFE. which effectively set the marginal cost of contract, and abandoned manual trading. But Trading at LIFFE was then carried out by open trading to zero for medium and large traders. by this time, merely matching the electronic outcry. Bund futures trading was also initiated From January 1998 onwards, LIFFE started system at Eurex was not enough to bring the at Deutsche Terminborse (DTB) at Frankfurt in losing market share. Even though the impact liquidity back to LIFFE. From 1972 onwards, Spring 1990, but this market failed to gain cost on LIFFE was at first superior, the lower the financial community had engaged in a liquidity; LIFFE remained the dominant charges at Eurex were big enough to sway debate about the merits of electronic trading exchange. some of the order flow to shift from LIFFE to as opposed to trading floors or telephone calls. In March 1996, DTB provided screen-based Eurex. The trade processing efficiencies on The Eurex versus LIFFE story on the Bund trading in London, competing against the Eurex were sufficiently large to overcome futures in 1998 marked the end of this debate. open outcry trading at LIFFE. At the time, LIFFE LIFFE’s initial liquidity advantage. Once this The loss of the Bund futures contract set off continued to insist that pre-computer trading started happening, the order flow started substantial soul searching in the UK about the mechanisms were superior. shifting and impact cost on Eurex started failures of LIFFE and of public policy which led improving. In early 1997, the Eurex futures and options to this debacle. The loss of this contract led to exchange was created by a merger of In early 1997, 65% of Bund futures trading a substantial decline in revenues of UK finance. Germany’s DTB and the Swiss Options and took place on LIFFE. By the end of 1997, These events formed the backdrop and helped Financial Futures Exchange. In March 1997, market share was roughly 50–50. Over the provide impetus for the major reforms to the the USCFTC gave Eurex permissions to place next 21 months, market share was decisively Bank of England and the FSA in 1998.
the Euro. The presence of the European Frankfurt. Focused activities at one Central Bank () was a significant centralized location are important for the development for Frankfurt. It bolstered development of a . Businesses that are the city’s international reputation and clustered in a confined geography gain from enhanced its importance as a financial one another by deriving external economies centre. Frankfurt profited from German of scale. By crowding together, they create financial market reforms as well as European large, liquid markets that drive down trading integration; and especially from the costs and reduce risks by allowing large deals accession of contiguous Eastern European to be handled. Frankfurt has not benefited countries formerly in the ambit of the Soviet from a process of national consolidation bloc. In the future it is expected to be a for providing . It could, possibly, head bridgehead to Russia, the rest of Europe a secondary network of smaller European and Turkey. However, Frankfurt lags behind s. London and New York in terms of most criteria – regulation, taxation, asset 8. The Race to establish more management expertise, securities trading, IFCs around the world and banking. Like Tokyo its language is not English. Nor is it a global city on the Since , the resurgence of the European, same scale as the other s. London has a Japanese and East Asian economies and the great edge because of its established global revival of petrodollar surpluses has resulted networks and historical interdependencies in a plethora of s (of some form or with the rest of the world. other) blossoming in other major (but not The ‘decentralization’ of Germany (into all global) cities including the following: lander or states) has also worked to the disadvantage of Frankfurt as an . Not * San Francisco, Los Angeles, Chicago, all German banks are headquartered in Philadelphia, Boston, and Miami in the Frankfurt. Non-German banks in the have a larger presence in London than in * Santiago, Sao Paulo, Buenos Aires, and . The Emergence of IFCs: A brief history 11
Montevideo in Latin America critical mass of importers, traders and * A large number of islands in the light manufacturers. came into Caribbean (e.g., The Bahamas, Caymans, existence in September , offering a Barbados etc..) wide range of services, and generous fiscal incentives and other benefits. It has strong * Amsterdam, Frankfurt, Luxembourg, commercial connections internationally and Paris and Milan in Europe with India, the upcoming giant in Dubai’s * Tokyo, Hong Kong, Shanghai, Labuan, near neighbourhood. Indeed, is likely Jakarta, Bangkok, Seoul, and Taipei in to be a competitor for some to an East Asia in Mumbai. * Sydney in the Antipodes With the Asia-Pacific region registering * Bahrain, Dubai, Kuwait, Riyadh, Doha high rates of economic growth, its and Muscat in the Persian Gulf economies deregulated their financial sectors during the s and attracted substantial * Johannesburg, Gaborone, Mauritius and inflows of foreign capital in search of the Seychelles in sub-Saharan Africa investment opportunities. As a result, The race amongst cities to establish financial markets in many of these countries themselves as s has intensified. Cities expanded rapidly. Apart from well- in emerging economies look upon having established s in the region – Hong Kong, an as a relatively low-opportunity-cost Singapore, and Tokyo – a successful financial initiative worthy of government support. reform programme during the s led to The apparent ease of establishing an the emergence of Sydney as a potential rival. and the promise of high value-addition have The perceived benefits of an prompted many countries to create s to have attracted other Asian countries such increase the contribution of their financial as: Korea, Indonesia, Taiwan, Thailand, services sectors to output, employment and Malaysia, and the People’s Republic of exports. China () to launch new initiatives for In the Middle East, several governments capturing business, at the beginning of have been competing to establish RFCs. At the s. The South Korean government present Bahrain, Abu Dhabi, Dubai, Qatar announced its Northeast Asian Financial and Muscat are all vying for that stature Hub in Seoul and, in July , published a in the Gulf. The earliest entrant, Bahrain, detailed action plan aimed at achieving this went for an because it was faced with goal. stagnation of its offshore-banking business There has also been an explosion in the and felt pressed to introduce a series of number of small enclave tax-haven s reforms to attract more investment. The around the world providing more limited government of Abu Dhabi – anxious to services. But these are not germane in the diversify its economy beyond oil and to context of the kind of that India must create jobs in the private sector – declared develop now. in that it planned to develop an . Incentives were offered, such as 9. Implications for India and a zero company tax, full repatriation of need for Mumbai to emerge all profits and capital, free import of labour, and no forced local partnership as an IFC requirements. Banks were exempt from A retrospective look at the evolution of reserve requirements. from onwards, and particularly Dubai, which has become the region’s from onwards, suggests three major busiest services hub, may yet become differences between the first and second the most successful in the Gulf. rounds of globalisation where international The emirate has successfully transformed finance is concerned: itself from a small-scale oil producer into a regional services hub in just . Global finance has been transformed years. Its free zone has achieved a by the combination of better data, com- 12 R M I F C
puters, communications, and analytical * Given its present role and size in the financial economics; which has resulted world economy India is becoming a in improved financial risk management. major user of . The locus of the These factors have generated a world- world economy is increasingly shifting wide shift away from bank-dominated to Asia, the home of Japan, China, India finance to securities markets. and . Soon, trans-Himalayan . The supposed stability of the gold and trans-Malaccan trade will rival trans- standard that shaped the first round Atlantic and trans-Pacific trade in size of globalization has been absent after and global importance. . The abandonment of that anchor * As that happens, India’s needs (as well was disconcerting at first for central as those of its Asian trading partners, bankers and financial markets. Now the most importantly China) for will world is coming to recognize that having grow exponentially as global trade a gold standard may be anachronistic and investment (and intra-Asian trade if not antediluvian. The modern and investment) account for a larger consensus holds that the right anchor proportion of its economy. for fiat money is the -basket, i.e., * India cannot afford to remain a taker of that monetary policy should be tied from the global market indefinitely down by inflation targeting. After as its needs for such services grow. centuries of exploration, it appears that Like the , the and Japan, India we now know the correct technique must develop its own -provision for creating fiat money. Floating capability as an essential concomitant of exchange rates, open capital accounts, its growing role in the world economy. and inflation targeting monetary policy So must China, although China is which stabilises the local business cycle already able to rely on a world-class are now the reality pervading and financial centre in Hong Kong, and shaping international economics and to a lesser extent by Singapore (which finance in the second globalization. serves the regional economy Every developing country faces the task even more). of mastering the institutional dance that is required to pull off this combination. * India has emerged in the world as a competitive, reliable provider of . production is now dispersed across services. The provision of on a a number of s, s, s and competitive basis to the global economy s spread across the globe. But is highly dependent on capability and it is still concentrated mostly in the an endowment of human capital that developed world. This was unlike the is numerate, adept mathematically and first globalization, where London was entrepreneurially inclined. Given the clearly the dominant . There is critical importance of those ingredients, a striking difference between financial provision is an arena in which India services production, and that of most has natural advantages for competing other goods and services, in that the bulk successfully. It would be making a of global financial services production major error in not developing its policy- takes place at a few s in what have making, operational and regulatory come to be known as global cities. capacities to compete globally in the What can usefully be deduced from arena as quickly as possible. this brief history of s, in the context of * India’s aspiring to enter the market for India rapidly becoming one of the world’s globalised financial services provision is most significant economies post-? How synonymous with India aspiring to have should India cope as a third and more an in Mumbai, that connects the intense phase of globalization emerges with Indian financial system with the global India and China playing key roles? Simply financial system. This is in contrast put, the main deductions are these: with conventional goods and services, . The Emergence of IFCs: A brief history 13
where production is dispersed across a more rapidly – and thus to galvanise very large number of locations across further investment in productive activity the world; financial services production (especially in encouraging the faster and requires clustering. larger exports of goods and services) – than would otherwise be the case. But what precisely is meant by The argument for having s in India developing -provision capability via is based on the claim that it is too difficult an ? An provides individuals, for various levels of government to propose institutions of various types (including and implement the policy changes needed most importantly productive commercial to make that happen on an India-wide basis; corporations) and governments (sovereign because of the diversity of views in its plural and sub-sovereign) with a wide range of and democratic system. financial products and services through Thus the approach is a strategy an array of appropriate institutions and of ‘change management by exception’ rather markets that are regulated in consonance than a strategy of managing change through with recognized international best practices. country-wide inclusion. Opponents of this These financial products and services ‘change management by privileged exception’ include: banking, insurance, short and strategy argue that the downsides of a long-term asset management, private strategy outweigh any benefits for the wealth management, corporate treasury following reasons: management, and, most importantly, a * First, s will worsen rather than well structured and fully developed capital ameliorate the egregious degree of market (with its array of institutional ‘development concentration’ in new appurtenances in terms of brokers, dealers, privately governed urban areas. exchanges and regulators) for debt, equities, * Second, s may create enclaves owned commodities as well as risk management and run by India’s major corporations – through derivatives. To become a player and that are self-governing, autonomous and compete in the space, India will need to exempt from normal rules. Thus s build requisite infrastructure (institutional will create immense scope for regulatory and physical) and harness the skills and and legal arbitrage that may prove quite expertise needed to launch these products difficult to manage. and services. Mumbai’s prominence as the capital of Indian finance, the existence * Third, s will result in the fragmented, of exchange infrastructure, and its supply incoherent and sub-optimal develop- of skilled manpower, makes it a natural ment of infrastructure rather than hav- contender as an . ing it develop it on a more optimal area wide basis for capturing essential 9.1. The SEZ model as an Alternative economies of scale. for an IFC in Mumbai * Fourth, s open up opportunities In discussions on creating an Indian in for malfeasance through property Mumbai, its location in a Special Economic development that has become the new Zone () in Navi Mumbai has been channel for rent-seeking and realising aggressively promoted by enthusiastic speculative capital gains. At the developers as the best, if not the only, same time, such developments will alternative. In the Indian context, a is a create inequities for small landholders sequestered or quarantined geographical compelled to yield land for area operating under a framework of development. economic laws and tax exemptions that * Fifth, s are likely to result in a net are more liberal than the country’s typical loss to the exchequer that the inflow economic laws. The raison d’etre for of incremental investment – and any establishing s is to accelerate the indirect public revenue benefits that may inflow of private investment (domestic accrue therefore – will not offset to any and foreign) into developing infrastructure reasonable degree. 14 R M I F C
s have been established in several and transactions governed by a world- countries, including the People’s Republic class framework of financial sector of China, India, Iran, Jordan, Poland, policy formulation and regulation. Kazakhstan, the Philippines and Russia. It cannot operate in a regulatory North Korea has attempted this to a degree, vacuum. A that is not regulated by but failed. But, these s have generally internationally acceptable regulators will been large in size, limited in scope, and less not be respected by customers of fragmented than the s approved in India. globally and will fail to attract business. Also, they have been mainly restricted to the If an effort has to be made to build world bonded production of goods for export with class financial sector competencies, and the movement of inputs and outputs from regulatory capacity for a , such an boundaries being tightly controlled to effort would better be directed to India prevent leakage and arbitrage opportunities as a whole rather than just to the . vis-a-vis` the local economy. Many s in . A substantial additional inspector raj India meet those stringent tests. But many will inevitably need to be created, do not. surrounding the , to avoid leakages Proponents of the approach to of financial products and services provision argue that the fastest way between the and the ‘Indian to make progress in establishing an mainland’. When a free trade zone is to suspend Indian capital controls and like was created, inspectors repressive financial policy for a zone of were used to ensure that physical goods about - square kilometres. That special did not flow between and financial zone would, for all intents and India. Preventing flows of capital purposes, be cut off from the rest of India and international financial services for the strategy to be compatible with is more difficult. It will require a continued capital controls and financial correspondingly onerous inspector raj repression in the domestic financial system. that will vitiate having an in a The argument is also made that a in the first place. would have world class urban infrastructure and thus bypass the intractable urban In the Committee’s view the disadvan- infrastructure deficit and the enormous tages of having an in Mumbai located governance problems of Mumbai. in a outweigh any conceivable advan- But, the difficulties with this approach tages. Rather than facilitate start-up, a are threefold: based will compromise development of the kind of that India needs – i.e., . A key strength underlying an Indian one that is rooted in its own financial sys- attempt to establish an is the tem. It will create opportunities for arbitrage economies of scale obtained by virtue between dual financial regimes. It will com- of having a trillion-dollar as the plicate the process of financial regulatory home market. If an enclave approach is liberalisation and have a counter-productive used, India’s hinterland advantage is lost. effect in delaying changes in the regulatory The enclave would be required to restrict system. It may involve external regulatory itself to dealing only with non-resident authorities wishing to intervene in regulating clients and transacting in all convertible offered via a , thus compromising currencies but not in the . Indian regulatory sovereignty. It will de- . It is easy to think of a where lay the swifter removal of capital controls capital controls are absent – this throughout the Indian economy. It will re- requires stroke of the pen reforms that sult in an not yielding public revenues remove hindrances faced by firms and from the outset and obtaining fiscal protec- individuals. But it is harder to have tion that it does not need. An -based a where financial repression is would be an artifice that would de- absent. An IFC located in an SEZ tract from global credibility. It may facilitate would still need to have its operations more / in finance; but it will pre- . The Emergence of IFCs: A brief history 15
vent or delay the provision of broad-based progress towards establishing a credible . , then many financial firms (and their A SEZ-based IFC, that sought to employees) might choose, of their own sidestep India’s capital controls and accord, to locate in an with superior financial regulation would, in the opinion facilities. In this sense, a orientated of the HPEC, not be the right path for India towards improving the quality of urban to take in establishing an IFC in Mumbai. infrastructure in the proximity of Mumbai The right way would be to make Mumbai an – without requiring as a precondition that and a global city by making the urgent an must be located within it from the adjustments that are needed to: (a) financial outset – may turn out to complement the policies, structures, institutions, markets goal of creating an in Mumbai. and to financial regulatory and governance Financial firms located in Mumbai for regimes; as well as to (b) Mumbai’s urban the purpose of providing may decide infrastructure and governance. voluntarily to relocate to the simply for Interestingly enough, there may be reasons of convenience in enjoying better some symbiosis between: (a) a narrower quality infrastructure rather than to escape notion of a located near Mumbai; and draconian regulation. That would mean that (b) the initiative to make Mumbai an . the regulatory regime that applied to them If good quality urban infrastructure in Mumbai would apply to them in the develops in a close to Mumbai, and if – as well. quite separately – Mumbai has made some
st Century IFS provided by IFCs
The st century is witnessing the world’s world with a range of financial products transformation into a global village. This and services in this globalised world. The is being caused by: (a) an inexorable sections of this chapter look at some key process of internationalization – that is products/services provided by s. While c h a p t e r linking countries through trade, investment London and New York provide all of them, and cultural exchange; and (b) equally other s around the world provide some inexorable deregulation. Both forces were combination of them. unleashed by regulatory relaxation in the s. Their impact was amplified in the 1. Fund Raising in IFCs: What is 2 s with the rediscovery and acceptance involved? Who does it and of market economics following the collapse of socialism as an alternative. More how? countries are shifting to market economics An provides a platform for entities to from socialist paradigms to drive their raise large amounts of funds on a global development models. Their governments, rather than domestic scale. This includes: firms, and civil societies – which were (a) debt and quasi-debt across all maturity inward-looking and myopic – have revised and currency spectra; (b) equity and quasi- their views about their respective roles. equity for private, public, multilateral They have become long-sighted, outward- and public-private entities; as well as orientated and global in outlook. (c) diverse risk-management appendages Markets – for goods and services, fi- to primary fund-raising transactions. Such nance, factors of production, and knowledge arrangements permit the risk exposure of – are no longer confined to national geogra- the primary fund-raising entity (to currency, phies. Products and services are no longer interest rate, credit, market, operational designed and made for domestic and export and political risks) to be contained within customers separately with different quality tolerable limits. The presence of large standards for each. Resources are no longer investment banks and global securities firms restricted to those available domestically. In- in an facilitates access to a huge pool of vestments are no longer limited to domestic global finance unconstrained by domestic projects. In other words, economic bound- boundaries. aries have become porous. Among other As the example of London illustrates, things, this new world – in which economics this calls for dynamic, transparent and highly and finance are no longer constrained by liquid capital and derivative markets with geography – is making new demands on firm, principles-based yet flexible regulation financial firms, services, systems and mar- that is unintrusive and does not involve kets. New financial products/services are micro-management. being demanded from traditional financial It is often asserted that modern com- firms to meet the needs of clients who have munications technologies have resulted in suddenly emerged as global players. the ‘death of distance’. It is therefore possi- A modern financial system includes ble for geographically dispersed investors banking, insurance, asset management, and issuers to interact without needing a securities dealing, derivatives and risk geographically focused . However, the management. An provides individuals, empirical reality is that – even after large corporations and governments around the changes in technologies of communication – 18 R M I F C
depositors although some investment banks Box 2.1: The Range of Financial Service Providers called Banks do attract high net worth clients by provid- Commercial banks: Take time and savings customers by utilising capital ing personal wealth management services of deposits and make loans to markets a different type and scale. businesses and individuals Merchant banks: Discount trade bills and Savings banks: Attract only term savings supply both debt and equity Whereas commercial banks generally deposits and make loans to capital to business raise resources at the retail (depositor) individuals and families Wholesale banks: Are larger commercial end, investment banks are wholesale Cooperative banks: Help farmers, ranchers, banks serving corporations and groups and consumers acquire governments intermediaries. They help businesses, goods and services Retail banks: Are smaller banks serving governments, and a variety of other Mortgage banks: Provide mortgage loans on primarily households and small agencies to get bulk-financing from investors new or old homes and finance businesses real estate projects Bankers’ banks: Supply financial process in capital markets through a variety of Community banks: Are smaller, locally services (e.g., cheque clearing and instruments and vehicles. By contrast focused commercial and savings security trading) to banks commercial banks help users of funds banks Affiliated banks: Are wholly or partly owned Money Centre banks: Are large commercial by a holding company that is a to obtain financing by lending them banks based in leading financial financial conglomerate money that the banks’ own customers centres Fringe banks: Offer payday and title loans, have deposited in savings, checking, money Investment banks: Wholesale players that cash checks, operate as pawn solve financing problems faced by shops or rent-to-own firms. market and accounts. Investment banks connect users of money with a variety of sources of money on a bulk-basis, whereas commercial banks connect users of funds the most important aspects of fund raising with their own retail and individual sources still take place through face-to-face meetings of deposits, though the vehicle of loans that in London, New York, or other s. People might be syndicated with other commercial still prefer to do primary ‘front-office’ busi- banks to spread risk. ness in their own daylight while outsourcing A commercial bank usually takes the back-office functions to be performed else- full credit risk on the loans it makes. where on a -hour basis. The primacy of Sometimes it lays all or part of that risk s in fund raising is unlikely to change in off through the purchase of market-traded the foreseeable future. credit derivatives. But that is rarely possible Fund-raising for investment in an in bank-dominated financial systems; doing is now invariably done through investment so requires sophisticated capital markets. or universal banks and rarely through An investment bank operating in capital commercial banks. The fund-raising entity markets rarely takes the credit risk of does not have to use an investment bank, but its clients on its own book except for it usually does so because it is less costly than a short period under an underwriting trying to sell securities directly to the public. obligation (see Box .). Thus, despite The most common method of raising funds the word bank in their names, investment is by issuing and selling new securities, such banks are securities issuing/buying firms as stocks or bonds of a wide variety of types. that match users (usually corporates or An investment bank usually helps in this governments) and providers (usually buyers process by providing its expertise and a of equities and bonds) of bulk funds global market base of customers to buy the in capital markets. When they are not securities. operating in an , their activities (i.e., Investment banks are not like commer- connecting users and sources of funds) are cial banks; although large global conglomer- confined to domestic markets. But, in an ates (like Citigroup or ) often house , national borders cease to matter in both activities under the same brand um- determining either the geographical origins brella. Unlike commercial banks, investment of clients or the geographical residence of banks do not generally attempt to attract funds being tapped. small retail depositors through checking or In capital-market dominated financial savings accounts; nor do they make auto, systems, entities that need funds can discuss home or personal loans. Generally, they do a variety of options and possibilities with not deal at all with small individual retail investment bankers. But in bank-dominated . st Century IFS provided by IFCs 19
Table 2.1: Markets for foreign equities (2005) Table 2.2: International Bond Markets (2005)
Turnover % of global No. of Net issues ($bn) % share ($bn) turnover Foreign cos. listed UK 361 19 Spain 211 11 London 2,496 43 554 US 199 11 NYSE 1,234 21 452 Germany 157 8 Switzerland 896 16 116 France 132 7 Nasdaq 591 10 332 Italy 89 5 Germany 165 3 116 Netherlands 84 5 Others 401 7 1,285 Others 989 53
Total 5,783 100 2,635 Total 1,861 100
Source: World Federation of Exchanges, LSE Source: Bank of International Settlements
systems their choice is usually restricted to just from India but elsewhere, loans from commercial banks. . A liquid and efficient bond market with Tables . and . show the amount a traded yield curve in the currency of of equities and bonds issued in global the that enables global corporate capital markets in . The bulk of the and sovereign bond issuance, bond market is in domestic bonds issued . A large and liquid currency trading by companies in their own country and market, currency. But the share of international bond issues in the total bond market . Robust derivatives markets that permit has risen in recent years. The value of laying off a variety of risks i.e., including bonds issued worldwide totalled over $ credit, interest rate, maturity and trillion at end-. Table . shows the duration, currency, and political risk, percentage share by nationality of the bond . Efficient and globally open banking issuer. International bonds, which include markets that minimize or eliminate Eurobonds and foreign bonds, totalling the conflicts-of-interest that arise with $, billion were issued in . issuers state-ownership and domination of the had the largest share in with nearly a banking system; and fifth of the total, followed by Spain and the . Globally efficient insurance and re- . insurance markets open to global players There is a natural synergy between with all the necessary products and global funds seeking investment opportuni- services available. ties (with a wide range of risk/return possi- bilities) and global seekers of funds. Their Global fund-raising is one of the most mutual interests converge in an . Each prominent revenue sources in every IFC, induces network effects that feed off the and a tangible goal that every IFC aspires for. other. It is not possible to conceive of one However, this prominent activity requires without the other. For that reason India does an underlying infrastructure in the form of not have the luxury of prioritizing either these markets. Hence, the development of one or the other of these two elements in public markets for securities, banking and sequencing the emergence of Mumbai as an insurance on an international scale is a sine . Both have to be accommodated simul- qua non for global fund-raising capability. In taneously. Another key facet that needs to be other words, whether generally recognized or emphasised from a sequencing viewpoint is not, the call for creating an IFC in Mumbai that efficient and cost-effective fund-raising is a metaphor for (and synonymous with) in any requires mature, deep and liquid deregulating, liberalising and globalising, financial markets in all segments at all levels; all parts of the Indian financial system i.e., it requires: at a faster rate than is presently the case. . An efficient, liquid, large and globally Raising the issue of creating an IFC in connected, equity market that can Mumbai at this time, suggests that the support equity issuance by issuers not need for more intensive deregulation and 20 R M I F C
Box 2.2: What Investment Banks do in Global Capital Markets Capital markets permit investment bank pegs the price of a new issue by Hence, to the extent that risk-markets bankers to provide users of funds with buying in the open market. Successful support laying-off through exposure greater flexibility (in terms of underwriting is about selecting the right hedging, the lower is the unhedged instrumentation, timing and risk issue, offering it at the right price, and component of the risk, and thus the management appurtenances) in: selling it at the right time. The lower is the cost of capital for the (a) accommodating how much money is investment bank may have to lower the unhedged portion. required and when; (b) what type of price of the new issue to below what it security should be sold and to whom, in paid for it, thereby resulting in a loss. The total flotation costs of bringing order to maximize efficiency and Furthermore, the initial customers who new issues to the capital market also minimize costs of fund-raising; (c) what paid a higher price for the new issue will includes legal, accounting, and other special features such securities might be disappointed that they paid a higher costs borne by the issuer in addition to have depending on the credit rating and price, and the investment bank may lose the underwriting discount. Economies of cash-flow circumstances of the entity these customers in a future offering. scale result in flotation costs for small concerned; (d) at what price it should be issues generally being a larger Investment banking is a very sold and when; and (e) how much the percentage of the total sale of new competitive business in global capital fund raising activity will cost. securities than for larger issues. They are markets and established IFCs. Every deal also greater for equities than for bonds. To reduce its own uncertainty and risk, forms an input for future business The underwriting spread may vary from a user-of-funds may decide to go in for possibilities for the banker both from the about 1% for investment-grade bonds to an underwriting agreement with its issuer and other companies. almost 25% for the stocks of small investment bank. Under this Most agreements for the sale of new unknown companies. As additional arrangement, called the firm compensation, the underwriting firm commitment, the investment bank buys securities get underwritten. But when the issuer is perceived as risky, the may get rights to buy additional the new securities for an agreed price securities at a specified price and resells the securities to the public at investment bank may use a best efforts approach; i.e., it undertakes to do its (pre-negotiated call options), or receive a a mark-up, bearing all of the expenses membership on the board of directors of associated with the sale. Usually, the best to sell all of the new securities, but does not guarantee it. The issuer bears the issuing company. The underwriting investment bank becomes a firm frequently becomes a market maker broker-dealer or market-maker in the the risk that the investment bank may fail to sell all of the new issue, thereby in the new security, keeping an inventory new security sold. Through underwriting, and providing a firm bid and offer price the issuer (user-of-funds) gets the funds reducing the amount of money that the company receives. Underwriters make for the new security to provide a on a guaranteed basis even if the secondary market, so that investors can investment bank does not succeed in money by selling the new securities at a mark-up from what they paid for it, buy or sell the new securities after selling all of the securities issued. Thus, primary sale. This ensures liquidity for the investment bank takes a calculated known as the underwriting discount, or underwriting spread. The underwriting investors and thus increases the value of risk for a short period. But it can also the primary offering, since few investors profit significantly if the issue is greatly discount is set by bidding and negotiation, but is influenced by the size would buy a new security if they couldn’t desired by investors, allowing the sell it at will. investment bank to charge a higher of the new issue, whether it is equities or bonds, and the perceived difficulty of mark-up and book an immediate profit. Sometimes investment banks form selling the new issue. More speculative Under stable market conditions syndicates and enlist the help of other issues require a larger underwriting knowledgeable investment banks are investment banks to sell securities. The spread for the increased risk involved. rarely trapped into having to hold ‘lead’ investment bank selects the underwritten securities for long. But The liquidity risk taken in an members of the syndicate and sometimes market conditions can change underwriting transaction can be ‘laid off’ determines how many shares each will suddenly in response to an unforeseeable in the risk market using derivatives. get and manages the overall process. In shock. Investment banks can then be Investment banks utilize sophisticated addition, each member of the syndicate, caught holding the bag for longer than financial economics in quantifying their including the originating investment they wanted thus tying up capital that exposure. They establish a set of bank may have selling groups, consisting could be used for other (higher-return) exchange-traded and OTC positions in of other investment bankers, dealers, purposes. derivatives markets (for credit, interest and brokers that may also sell to Direct responsibilities in an rate, and currency risks) through which investors. The main advantage of underwriting include registering new the bulk of their risk is transferred to syndication is that it reduces risk by securities with the concerned regulator, buyers of risk in the derivatives market. sharing it among the syndicate members, deciding the offer price, and The residual risk is borne by investment and each syndicate member and their forming/managing a syndicate to market banks against equity capital, and is selling groups have their own customers the new securities. Often the investment required to earn a high rate of return. to whom they can sell the new issues.
liberalization of the financial system has additional device to accelerate movement been anticipated by India’s policy-makers in that direction. An will not be and regulators and that the IFC is an created quickly in Mumbai, nor will it . st Century IFS provided by IFCs 21
succeed, if action on further deregulation and liberalisation is not taken in real time. Box 2.3: Global Asset Management Asset managers of various hues – i.e., the funds being managed (e.g., pensions); 2. Asset management and mutual funds, open or closed ended active marketing of funds to potential investment companies or trusts, public or investors; continuous real-time global global portfolio private pension funds, insurance premium research into individual assets and asset funds, and, increasingly, of highly mobile classes across all sectors and geographies; diversification and flexible hedge and arbitrage funds – in-depth financial analysis; asset selection; look for an array of investment choices at plan implementation; buy-sell Asset management is a large and important home and overseas, including equities, trading/dealing/transacting; and global industry in its own right. All types bonds, property, commodities and cash continuous monitoring of investments to of asset managers are responsible for the diversified in terms of geography, or sector keep pace with domestic and global management of trillions of dollars, euros, of activity. A viable IFC must have the changes in financial and demographic necessary market, institutional and environments and circumstances. pounds and yen invested in a large variety regulatory infrastructure to attract asset Back-office functions (i.e., tracking and of funds and vehicles. Many of the world’s management and global portfolio recording of all buy/sell transactions, and largest financial conglomerates are at least in diversification services undertaken by a minute-to-minute fund valuations, for variety of national, regional and global thousands of different clients per part asset managers. And the bulk of global asset managers. Very often, revenues from institution) usually involve activities such asset management (over %) is transacted asset management are directly linked to as: payment and settlements for billions of through the world’s s. As a approximate market valuations, so in the event of a daily transactions; ensuring increasingly estimate, the stock of globally managed major fall in asset prices, revenues decline complex national and global compliance relative to costs. for a variety of purposes; book-keeping assets (including non-financial assets such Asset management includes a and financial control; trade confirmations; as real-estate) was believed to be about $ combination of front and back office fault correction and dispute resolution; trillion in , or nearly thrice of world functions. Front-office activities include continuous real-time internal auditing; and inter alia: objective setting for targeted the preparation of a variety of internal and . external reports (by day, week, month, At an average cost of asset management returns, risk and capital preservation, based on the future pay-out obligations of quarter, year) for managers and clients. of about % of assets under management, global revenues from asset management are roughly $ trillion per year, which makes it in other forms of conventional investment one of the world’s largest industries given management. The was the largest source that world is just over $ trillion. of funds under management in with Because of a legacy of financial suppression, % of the world total. It was followed by India’s share of global asset management Japan with % and the with .%. The – in terms of , revenues, efficiency Asia-Pacific region has shown the strongest and cost-effectiveness – is infinitesimal growth in recent years. and insignificant for an economy that is emerging as one of the world’s largest, 3. Personal wealth and that is likely to account for a rapidly increasing share in global portfolios. That management situation is clearly unacceptable and needs The large and rapidly growing number of to be rectified urgently. wealthy individuals around the world, with Table . shows the sources of global a net worth of more than $ million financial assets under management in three each, provides substantial opportunities visible categories – pensions, insurance and for a wide range of firms and institutions mutual funds – by end-. Assets of the that deliver professional wealth management global fund management industry increased (private banking) services to this community. for the second year running in to reach High net-worth individuals (s) a record $. trillion. This was up % are globally mobile (globile) with several on the previous year and % on . residences, tax domiciles, as well as revenues Pension assets accounted for $. trillion of and expenditures, accruing in multiple funds in , with a further $. trillion jurisdictions. This activity is estimated invested in mutual funds and $. trillion to involve the management of trillions of in insurance funds. Merrill Lynch estimates dollars worth of personal assets. Some of it the value of private wealth at $. trillion is double-counted in the asset management of which about a third was incorporated figures shown in the previous section. 22 R M I F C
Personal wealth management takes on behalf of all investors totalled $. place in established s but is skewed trillion in . These figures, based on towards specialized s offering special tax surveys of private bankers are probably exemptions or advantages to non-residents understated as they probably do not include in centres in Switzerland, Luxembourg, full disclosure of all private accounts held by: Monaco, Lichtenstein and the Channel (a) politically prominent people (especially Islands for the and Africa; Atlantic from developing countries and regions) who and Caribbean offshore centres for the are reticent to have their holdings reported and Latin America; Bahrain, Dubai and or disclosed; or (b) generated from illicit Mauritius for the Middle East and South income flows in prohibited (but nevertheless Asia, Singapore, Hong Kong and some large) industries involving drugs, arms and Pacific Island offshore centres for East/North human trafficking and illegal gambling. Asia. Merrill Lynch, Cap Gemini, and Table . illustrates in broad indicative terms Ernst and Young’s annual World Wealth the size of the worldwide international Report estimated that the value of funds private client market. managed on behalf of . million high net Overseas Indians (s) are estimated worth individuals with over $ million of to hold financial wealth (i.e., apart from real investable assets was $. trillion in . estate, gold, art, etc.) of over $ billion In its annual report Global Wealth and total wealth of over $ trillion. They , Boston Consulting Group estimated are a natural beachhead as a customer base that the total value of assets managed where an Indian PWM industry can get
Table 2.3: Global assets under management in three visible categories ($bn 2004)
Pension Insurance Mutual Total funds assets funds
US 11,090 4,968 8,107 24,165 Japan 3,108 2,058 400 5,566 UK 1,464 1,797 493 3,754 France 150 984 1,371 2,505 Germany 104 1,055 296 1,455 Netherlands 630 291 90 1,011 Switzerland 426 258 94 778 Others 1,788 3,064 5,301 10,153
Total 18,760 14,476 16,152 49,388
Source: IFSL estimates, City Business Series, April 2006
Box 2.4: Private Banking and Personal Wealth Management Personal wealth managers (or private account needs). . The portfolio is continually reviewed and bankers) customize investment programs to the client kept informed by way of . Setting asset allocation parameters: i.e., meet specific client needs and provide an array in-depth reporting, internet access, and asset allocation guidelines are set by of related investment services including personalized meetings. Investment goals establishing long-term asset class targets securities, real-estate, art, jewellery, are periodically reassessed. based on return/risk relationship for each commodities (i.e., precious metals or in client. Asset allocation ranges are set to commodities such as oil/gas, base metals etc.), In recent decades, the functions of personal establish guidelines around the long-term vintage wines and collections of antiques, wealth management have mutated far beyond targets designed to add incremental return automobiles, stamps, photographs, etc.. a simple notion of managing a liquid financial and control risk. Wealth management involves: securities portfolio to a broad array of tailored . Establishing and managing personalized services for customers. These range from . Developing an investment profile through wealth portfolios: A portfolio is developed management of real estate to arranging exotic in-depth client consultation in order to that focuses on diversification across and travel services. In these aspects, personal establish clear investment goals for income within each asset class to provide the client wealth management is a highly labour generation and further wealth with attractive risk-adjusted returns. The intensive area; one that requires a large accrual/protection. These are based on the portfolio is managed on a continual basis number of man-hours of staff time in order to investment time frame, tolerance for risk, while maintaining the quality standards provide meticulous personalised services to the income needs, and specific account and market diversification necessary to customer. This suggests that it is an area in circumstances (such as multiple currency achieve the set goals. India might be naturally competitive. . st Century IFS provided by IFCs 23
Table 2.4: Number of wealthy individuals and value of their wealth ($ trillion)
Year Number in Value of wealth of high Value of wealth of millions net worth individuals all investors
1997 5.2 19.1 1998 5.9 21.6 1999 7.0 25.5 71.5 2000 7.0 25.5 67.8 2001 7.0 26.0 64.1 2002 7.2 26.7 65.5 2003 7.7 28.8 78.2 2004 8.3 30.8 85.3
Source: Merrill Lynch Cap Gemini and The Boston Consulting Group
started. Their wealth management services of internationally active law firms. are presently sourced almost exclusively Transfer pricing is an activity that the abroad. Government of India (o) looks at askance. Yet it needs to accept that such activity will 4. Global transfer pricing take place in a global economy dominated by: (a) a growing amount of cross- Transfer pricing is a generic term used to border trade and investment undertaken describe all aspects of intra-group pricing increasingly within s; (b) the provision arrangements between related business en- of professional global tax management tities operating across borders; including: services by global firms of accountants, transfers of intellectual property; transfers lawyers and tax advisors present in all of tangible goods; service fees, loans and major s around the world including other financing transactions. Intra-group tax havens; (c) widely divergent national (inter-company) transactions across borders tax regimes dictated by the revenue and are growing rapidly and becoming more cash-flow needs of particular economies complex. Compliance with the differing facing entirely different circumstances; and requirements of multiple overlapping tax ju- (d) a growing number of mobile risdictions is a complicated, time-consuming entrepreneurs and professionals who, like task. National revenue authorities (espe- s, are not wedded to nationality for cially in high-tax jurisdictions with tax purposes. Collectively they form a increased tax avoidance and evasion) are vibrant network that is driving the process becoming increasingly sensitive to the ways of globalisation in a variety of sunrise in which transfer pricing can affect their industries – e.g., in services, financial tax revenues. Governments and revenue services, sports, leisure, hospitality, media authorities are responding by strengthening and entertainment services industries etc. their legislation and their enforcement capa- The as an institutionalized col- bilities, demanding stricter documentation lective is attempting, somewhat ineffectu- of transfer pricing practices, and imposing ally, to discourage such activity by exerting higher penalties for non-compliance. Most pressure on developing countries and off- countries adhere to the arm’s length princi- shore tax-havens. Yet, oddly, transfer pricing ple as defined in the Transfer Pricing and tax arbitrage are actively encouraged Guidelines for multinational enterprises and by a number of individual countries that tax administrations. are members of : (i) several states in London is the world’s major centre the – e.g., Delaware, Nevada, etc.; (ii) a for international legal and tax related number of European s located in capi- services. Globalisation of business and tals such as London, Amsterdam, Paris and finance has strengthened its position in Frankfurt as well as (iii) European havens recent years. The provision of international such as Luxembourg, Lichtenstein, Monaco legal services in London remains the preserve and Switzerland. 24 R M I F C
available in Mumbai, these services are Box 2.5: Transfer Pricing Services being purchased in Delaware, London, Planning transfer pricing strategies, . Complying with local revenue Switzerland, Mauritius, Singapore, Hong optimising tax exposures, and defending a requirements and preparing Kong, Dubai or elsewhere. company’s tax position and transfer documentation for strong first-line pricing practices on a global basis, requires defence against revenue authority Transfer pricing services require large knowledge of a complex web of tax laws, audits. amounts of skilled labour engaged in regulations, rulings, methods and . Preparing and negotiating appropriate providing professional tax, accounting, requirements around the world. responses to revenue authority auditing and consulting services, a high level Optimisation of transfer pricing also challenges, and assessing the risk of requires an understanding of the capital revenue authority challenge. of labour-force numeracy, and support. controls found in some countries. Thus The provision of transfer pricing services is transfer pricing has become a critical . Identifying appropriate strategies and element in global tax planning. Global approaches to advance pricing thus an area that an Indian can excel in. agreements, and assisting in preparing consultants based at IFCs have large teams The HPEC believes that India should of economists, tax practitioners and these agreements. financial analysts who help clients with permit the development of Indian institu- transfer pricing planning worldwide. A An effective global transfer pricing tional capacity (in its accounting, legal and global network of professionals operates strategy embraces all the cross-border business consulting industries) for pro- throughout the world, supported by the transactions of a MNC. It encompasses not relevant local tax practices. Services only the pricing of tangible goods, but viding global transfer-pricing services in a provided include: also transfers of intangible assets Mumbai-based IFC. GoI should adopt the (knowledge, royalties), services, or group same stance as the US and EU governments . Developing and implementing financing. It incorporates transfer pricing commercially viable transfer pricing planning, controversy resolution and whose official and actual positions on this policies. compliance. issue seem somewhat contradictory. India should override external concerns and pressures exerted by that are, Of course, discriminatory dual tax in reality, more self-serving (in preserving regimes, created specifically for non-residents the competitiveness of their own capitals by tax-havens (in order to attract wealth and s by protecting established market management and corporate transfer pricing share in this lucrative and growing business) business) raise a complex set of issues insofar than globally effectual, in addressing the as supposedly ‘harmful’ tax competition is genuine concerns of harmful tax practices, concerned. Countries like India affected tax competition and revenue leakage. by such regimes might legitimately be concerned about them. But the economic structures of many oil-exporting () 5. Global tax management and countries in the Persian Gulf can afford to cross-border tax eschew levying personal income, corporate optimization and excise taxes on nationals and residents. They are sovereign and free to offer the same Related to transfer pricing is the service advantages to non-residents under a non- of global tax management; it deals with discriminatory, open-economy regime. international tax treaties and international No outside country can afford to argue aspects of domestic income tax laws. that a benign low-tax regime for nationals Multinational businesses, and individuals of such a country should not be open to with income sources in multiple countries, non-residents if the jurisdiction concerned are increasingly affected by tax, legislative wishes to extend that privilege. To do and regulatory developments around the so would infringe upon the sovereign world. Understanding the impact of these rights of nations to determine their own developments on business operations and fiscal and macroeconomic policies and thus transactions between countries is vital for a undermine a key pillar of international company’s profitability and survival. s law. Indian s as well as s usually employ a battery of international (especially s) are customers of services tax specialists to minimise worldwide tax. created by legitimate global tax arbitrage International taxation is a specialisation opportunities in countries in the Gulf that among lawyers and accountants; so much so are not tax havens. In an environment that several universities offer post-graduate where adequate support for them is not programmes in that specialisation. . st Century IFS provided by IFCs 25
Box 2.6: Global Tax Management “The world’s six biggest accountancy firms market for accounting and auditing is an keep their clients abreast of new are in the top rank in virtually every country in imperfect one: buyers lack the information to developments in the international arena that the world, except where they are barred by tell a good accountant from a bad one, or find could affect their business and assist by law. Yet auditing and accounting are intensely it costly to find out, which comes to the same providing expertise in: local affairs, requiring detailed knowledge of thing. They also seek the accountant’s brand local rules and regulations. Arthur Anderson or name as a means to convince others about • Tax efficient holding company locations Price Waterhouse ought not, to have an their own worth, especially investors and • Cross-border financing and treasury advantage over domestic competitors except creditors, who are similarly, short of solutions with multinational clients – which, though information.” • Controlled foreign companies tax large, are almost always a minority. Why, then, planning have these firms themselves become such Source: Multinationals, a supplement in The • Income tax treaties, profit repatriation, successful multinationals? One answer may lie Economist, March 27, 1993. loss utilization in their ancillary businesses such as consulting, • Inbound and outbound structuring in which they have special skills; another may Global tax management provides an • Managing intellectual property and lie in their ability to buy and organize opportunity for financial, accounting and law intangible assets information technology. But these are not firms, to assist MNC clients in constructing • Tax efficient supply chain and shared enough to explain such widespread effective cross-border strategies, aimed at services; and dominance. Reputation, the power of the optimizing their global tax liabilities, while • Regional tax issues e.g., EU tax brand name, must play the biggest part. The adhering to all applicable laws. Such firms also harmonization.
London is a leading international centre their incoming cash flows from customers; for the provision of accounting and related and (d) execute transactions electronically global tax management services. Services across a wide array of currencies, bank that include auditing, taxation, corporate account holdings, tradable bills of exchange finance and consultancy and are dominated and letters of credit, as well as temporary by the big four accounting firms. According investments in treasury bills and corporate to Accountancy Age’s league table, fee money market instruments across a number income amongst the Top accounting of national markets. £ £ firms rose from . billion to . billion. Broadly, services include deposi- Table . shows the fee income earned by tory, collection and disbursement, liquidity some of the largest accounting firms in and cash management services and export the . While there are around , and import related financing services. Most accounting firms in the , the bulk of global banks such as Chase, Citicorp, and services provided to larger companies and organizations including cross border and offer all of the above services. They international services are the preserve of have their own cash management systems, a relatively small number of large firms, often suitably modified to take into account particularly the Big Four. a particular corporation’s needs. They use techniques such as netting, exposure man- 6. Global/regional corporate agement and cash pooling to reduce transac- treasury management Table 2.5: Largest accounting firms in the UK s provide the infrastructure necessary for global investment banks to provide Firm Fee income international treasury management services (£million) for s. These banks provide support PwC LLP 1780.0 systems that enable organizations to: Deloitte LLP 1350.0 (a) optimize cash management and working KPMGLLP 1066.0 capital while earning high returns on surplus Ernst and Young LLP 828.0 Grant Thornton UKLLP 254.3 liquidity; (b) streamline their receivables BDO Stoy Hayward LLP 224.0 using sophisticated information technology Baker Tilly 172.9 to monitor and direct daily cash flows; Smith and Williamson LLP 127.5 PKF (UK) LLP 113.7 (c) manage their payables through their supply chain in keeping with the rhythm of Source: Accountancy Age Top 50, June 2005 26 R M I F C
Box 2.7: Corporate Treasury Management services provided by Banks Depository services: These include: company’s office; lockbox imaging to investment confirmations and automated cash vault services to provide protection view, retrieve and store remittance repurchases that ensures that bills are and processing capabilities; electronic documents information; automated paid on time and the excess funds put to cash letters to enable scanning and clearing house to deliver debits and good use. Help is provided to link transmitting cheque images and data for credits on an electronic and automated business checking accounts with money deposit into accounts; pre-encoded basis and wire transfers that offer market mutual funds, allowing firms to deposits that provide faster check same-day availability. minimize idle cash balances in their clearance; returned items solutions to CTM service providers also enable checking accounts and maximize the help manage returned items with disbursement of funds to vendors, return earned on excess funds invested. detailed images; activity reporting to employees, investors, or other payees. Export and import related services: improve efficiency and increase collection They provide account analysis, itemized Exporters are assisted by providing a rates; zero balance sweep accounts that information on accounts and balances, range of related services that help in concentrate funds into one centralized account reconcilement with detailed hastening the delivery of goods in order account to use cash resources checking account information, to expedite receipt of payment, manage productively while retaining a centralized outsourcing the printing and distribution liquidity by ensuring that payment is disbursing authority and remote deposit of payables and payroll checks, controlled received within the agreed time period, solutions to scan checks at the company disbursement accounts that provide ensure that the payment is correct and end and electronically send the images precise dollar totals of checks that will settlement is directed to the bank where for deposit. clear daily so that the business can make a depository account is maintained. Collection and disbursement services: accurate funding and investment Export licenses vary from country to This involves helping setting up systems decisions, disbursement imaging viewing country and stringent conditions usually to collect funds from customers or other to retrieve and manage check images apply to products related to natural sundry debtors (payers). It also includes online, check matching services that resources, national security, safety or flexibility in payment options for protect businesses against check fraud by health. Export services help in adapting international transactions such as cash in matching issued checks with those products for exports to meet such advance, open account, letter of credit, presented for payment on a daily basis. conditions, provide assistance with or payment on a collection basis. Check Liquidity and cash management freight forwarding and insurance against image deposit solutions are designed to services: This includes liquid reserve loss, damage and delay in transit since make check deposits electronically into accounts with flexibility to earn a international shipment coverage is the business deposit accounts, with both competitive return on investing excess significantly different from domestic speed and accuracy directly from the daily cash balances while providing daily coverage.
tions costs, manage risks and make effective 7. Global and regional risk use of available funds. Major money mar- management and kets in London, New York and Zurich offer insurance/re-insurance a wide variety of highly liquid short-term instruments so that firms practically hold operations no idle cash. providers in turn set Historically, a corporate treasury’s involve- up money management systems that allow ment with risk management has focused on client organizations to borrow from their asset-liability management and on identify- open lines of credit and repay commercial ing and hedging financial exposures to cur- lines of credit automatically without manual rency and interest rate risks. The company intervention. treasurer’s classical responsibilities were to: In recent years, banks have created establish policies for financial risk manage- enormously sophisticated Internet-based ment, execute related practices, and track offerings where the services of the bank take over, on an outsourcing basis, many and report on results. functions of handling an upstream or Today, however, risk management downstream vendor network of a firm. is concerned with an increasingly broad This involves a complex blend of payments range of risks, financial and operational. services and Internet technology. Indian Risks such as: liquidity risk, counterparty financial firms could excel in this area, given risk, operational (including employee) India’s strengths in computer technology, risk, and country risk, confront all and the ability to run low cost call centres in corporate contenders in today’s complex India. and volatile global environment. They have . st Century IFS provided by IFCs 27
Table 2.6: Largest insurance markets innovation and growth at national, regional and global levels. Financial markets, Country Total ($bn) % share of world especially equity markets, have grown dramatically in developed and developing US 1,098 34 countries over the last two decades. Japan 492 15 UK 295 9 Sovereign and corporate bond markets of France 195 6 interest to global investors have grown Germany 191 6 rapidly since in the emerging countries Italy 129 4 of Latin America and Europe. But that Canada 79 2 Others 765 24 has not been the case in Asia or Africa. World 3,244 100 Derivatives markets have grown explosively and become extremely deep and liquid in Source: Swiss Re capital markets but remain nascent become important considerations in overall in most emerging markets. corporate risk management. In Europe, capital markets have become Risk management has become so im- increasingly regionalised. Globalisation has portant that individual financial institutions resulted in: substantially increased cross- invest an average of $ million annually in border capital flows, tighter links among risk management technology. Many of the financial markets, and greater commercial largest institutions have invested hundreds presence of foreign financial firms around of millions of dollars. Independent risk man- the world. Indeed, one feature of London, agement consultants collaborate with cor- as perhaps the best-connected in the porations to identify their business-specific world, is the extent of foreign involvement needs and design integrated solutions de- and ownership of financial firms, exchanges livered through a seamless distribution net- and markets (as well as the employment of work to meet marketplace challenges. large numbers of foreigners) in the City. This involves employing highly sophis- Up to the s, British investment and ticated exchange traded and tailored deriva- merchant banks played a prominent role in tives (futures, options, swaps, swaptions, offering to global clients. But in caps and collars) as well as world class deriva- there was no independent British-owned tives exchanges networking together for trad- global investment bank left standing. They ing a wide variety of global contracts. It also had all been taken over by, or had merged involves providing insurance and reinsur- with, other global firms. in the City ance related services. Table . shows the fees earned by the This was due largely to the global trading of Brady bonds (deep discount, low-coupon, and face value largest insurance markets in the world. The protected) issued in – as a means for converting insurance industry is the largest followed the bank debt of highly indebted Latin American and by Japan and the . It consists of groups European countries in crises into market tradable debt. That mechanism enabled country risk to be spread and companies such as Lloyd’s, underwriters, more widely across a global institutional and individual brokers and intermediaries and their clients. investor base; rather than being concentrated in a few The London market is the world’s leading banks, thus endangering the stability of the global market for internationally traded insurance banking system. Brady bonds were credited with not just developing bond markets in these two regions but and reinsurance. with bringing an end to a developing country debt crisis that had been prolonged unnecessarily, and at great expense to debtors and creditors alike, throughout the 8. Global/Regional exchange ‘lost decade’ of the s. Such bond markets were trading of securities, instrumental in dealing more expeditiously with smaller debt crises that occurred in other emerging markets commodities and derivatives through the s. Had such markets existed in Asia in financial instruments and during the Asian debt crisis of –, it is arguable that Asia might have escaped the worst effects without indices in commodities recourse to the IMF, and with much lower overall economic costs being incurred, especially by Indonesia, Capital (and derivatives) markets have a and without the unnecessary spread of contagion into crucial role to play in enabling enterprise, the secure markets of Singapore and Hong Kong. 28 R M I F C
of London are now offered by a plethora investors. Given the network properties of multinational, American, Japanese and of stock exchanges, high liquidity further European investment banks along with a increases the value of additional transactions few from emerging markets. Yet, contrary at exchanges such as New York or London, to popular belief that the success of an leading to even greater concentration of is characterised by the strong presence order flow and increased liquidity at these of indigenous financial firms, London has exchanges. As a natural extension of these thrived and grown as an rather than tendencies the first steps were taken in suffered any loss of influence as a result of to cross-link ownership and management foreign presence. of corporate exchanges in the and This is an important lesson for Indian through take-over bids such as those policy-makers and regulators to imbibe: launched by Nasdaq and the Deutsche i.e., the success of an IFC and the revenues Bourse for the London Stock Exchange. a country derives from IFS exports should In response the LSE has developed closer not be confused with reserving space and partnership arrangements with the Tokyo ensuring gains for indigenous firms alone. stock exchange. An IFC succeeds because it is international Even more recently, in September in every sense of that word. What makes , a group of global investment banks an IFC international is the multinational announced their intention of collaborating origin of players operating in it. An IFC to establish a global corporate exchange in Mumbai dominated by Indian financial that would provide a more efficient, firms, or reserved for them, would not be less expensive global securities trading as successful as an IFC that embraced all platform to compete with established the global players that already operate in exchanges. Those types of developments will the world’s other GFCs and IFCs . undoubtedly spread world-wide with capital A key feature of financial globalisation market exchange platforms being globally has been the migration of stock exchange owned and operating on universal standards activities abroad, particularly in from of accepted best practice to meet the needs European and emerging markets. There of global investors. It is unlikely that Indian is now an increasing tendency toward exchanges will remain exempt from such multiple listings of financial securities, trends for too long. and of derivative/commodity contracts, on Table . shows the growth of the global different exchanges with emerging investor futures and options market, in units of a demand for ×× trading of all listed million contracts that is used internationally. securities across all exchanges. Many India performs well in equity indexes and firms, from the and emerging markets, individual equity derivatives. But India lacks now cross-list their shares on international interest rate or currency contracts; both of exchanges in the form of s and s. which have now become integral features For example, the shares of are listed in the emergence of viable bond markets. and traded in Hong Kong, London and New London is the biggest market in the world for York; they should perhaps be listed and derivatives traded over-the-counter, and the traded in Mumbai and Shanghai as well. By second largest for exchange-traded futures the same token the shares of several Indian and options; both of whose turnover has multinational companies and transnational doubled in recent years. financial firms, public and private, are traded Mumbai is better placed to develop in New York (s) and Luxembourg these particular capacities more quickly than (s). other emergent s owing to the presence Remote access to trading systems is of strong exchange institutions, highly ubiquitous, implying that the services efficient and cost-effective computerized and offered by stock exchanges can now be fully automated trading platforms, rapid accessed from anywhere, including firms real-time gross settlements and delivery. having their stocks traded on international At the same time, the present situation exchanges while still being accessible to local is daunting, with a huge gap between . st Century IFS provided by IFCs 29
Table 2.7: Global futures and options volume by sector (million contracts)
Jan–Jun 2005 Jan–Jun 2006 Percentage change
Equity indices 1780 2252 26.5 Interest rate 1320 1637 24.0 Individual equity 1139 1463 28.5 Agriculture 164 205 25.3 Energy 131 172 31.2 Currency 75 116 55.0 Non-precious metals 24 41 70.9 Precious metals 24 41 70.9
Total 4681 5944 27.0
Source: Futures industry magazine
Box 2.8: Is India’s National Stock Exchange () a globally competitive derivatives trading exchange? When thinking of an NSE-traded USD/GBP same notional value as one S&P e-mini contract. currency futures that competes against other We assume that the ‘unlimited trading services’ exchanges, such as the USD/GBP futures that are provisions do not come into play. In both cases, available at the Chicago Mercantile Exchange on 8 November 2006, the notional value of the (CME), there are two components of the total transaction was Rs.3,77,730 or $69,575. We cost as seen by a customer. The first is the direct measure the total round-trip transactions costs charges paid to the the government, the faced under three cases: (1) Proprietary trading exchange and the broker. The second is the by a securities firm, where there is no brokerage; ‘impact cost’ when placing an order. The latter (2) A retail customer of a brokerage firm depends on the diversity and sophistication of (assumed 4 basis point charge, ad valorem, in the participants who trade on the NSE. The India, but $3 per contract in the US) and (3) A former is directly influenced by policies. In order high-volume customer of a brokerage firm to compare charges other than impact cost, we (assumed 1 basis point, ad valorem, charge in compare NSE against e-CBOT, the CBOT electronic India, but $0.05 per contract in the US). The platform and the CME Globex electronic platform. round-trip charges are reported in rupees. The tariffs at NSE is made up of the following components. There is a 0.2 basis point charge by NSECME NSE; a 0.01 basis point charge for an ‘Investor Protection Fund’, there is a stamp duty of 0.2 Retail customer 3343.52 374.40 basis points, there is a service tax which is High-volume customer 1235.07 108.90 12.24% of the brokerage fee and there is the Proprietary 788.98 31.05 securities transaction tax which is 1.7 basis points on sales only. External levies work out to roughly This table shows a huge gap in 2 basis points while the NSE charge works out to a tenth of this. competitiveness faced in doing IFS in India. The service which can be bought by a high-volume These are enormous numbers when compared customer in Chicago for Rs. 31 is being sold in with the CBOT. The tariff at CBOT is $0.11 to India for Rs. 788.98. It shows that NSE is the $0.16 per contract (summing across the costlier venue by a factor of 9 times, 11 times or exchange fee and the clearing fee). It is a per 25 times, depending on the choice of perspective: contract charge, which does not vary with the a retail customer, a high-volume customer or value of the transaction. CBOT does not suffer proprietary trading by the securities firm. This is a from payments to an ‘Investor Protection Fund’, particularly unusual situation because the charges stamp duty, service tax on brokerage and imposed by NSE itself, or by the brokerage firm securities transaction tax. At CME, the charge for itself, make up a very small part of the overall equity products is $0.35 per contract. In addition, costs paid by the customer. The overwhelming CME has a provision where the payments contribution to the costs as seen by the customer associated with all proprietary transactions is from the external levies – securities transaction originating from one clearing firm are capped at tax, stamp duty, contribution to investor $50 per day for futures plus $200 a day for protection fund and service tax on brokerage. options. Thus, for a proprietary trading firm, a payment of $250 per day gives unlimited trading Source: Calculations made by Nathan Corson services for futures and options. and Raghvendra Kedia at the request of the HPEC. For comparability, the specific transaction that The full spreadsheet with their calculations can we focus is 8.29 Nifty contracts, which have the be accessed on the MIFC web page. 30 R M I F C
Table 2.8: OTC derivatives turnover (average daily turnover 10. Cross-border mergers and in April $bn) acquisitions (M&A) 1998 2001 2004 Global corporate deal-making (whether UK 171 275 643 in the form of voluntary or hostile M&A, US 91 135 355 or divestiture, disinvestment, unbundling, France 46 67 154 privatization etc.) has become an important Germany 34 97 46 activity as organizations expand and Italy 5 24 41 Belgium 42 22 39 diversify across the world. Global M&A Netherlands 6 14 32 advisors provide cross-border support Others 79 130 198 and opportunities for clients who wish to complete acquisitions, company sales, Total 474 764 1,508 buy-outs and buy-ins, fund raising and Source: Bank of international settlements other corporate finance transactions. The objective is to obtain the best combination of Indian prices and world prices (see Box .). price, form of consideration, deal structure, Significant policy reforms will be necessary and compatible purchaser within a targeted in order to translate India’s latent strengths timescale. in this regard into global competitiveness. Comprehensive research, involving cooperation and expertise of relevant 9. Financial engineering and partners is used to generate an agreed list of recommended buyers with most to gain architecture for large from acquiring the business. By creating a complex projects competitive bidding situation and actively managing the sale process through to legal Large projects (over $ billion or more) completion, the advisor delivers the best in energy and infrastructure now require possible deal, structured for maximum blocks of wholesale funding sourced from tax effectiveness, whilst maintaining strict national and global capital markets, export confidentiality throughout. credit agencies and banks. Often these In the global M&A arena, India was funds have to be raised with complex ranked second last in terms of dollar value of risk-management instruments attached. M&A in a recent ranking by Bloomberg. But, Investment banks situated in s are best what is important in the data for regional suited for putting together the funding and breakdowns by target countries is that, with the risk management of such projects in a % volume change, India’s M&A growth place. is blazing enough to take the country to the A decade ago, funding of such projects third slot, next only to France and Hong was mostly done using convertibles, cum- Kong, each of which have achieved more warrant bonds, credit-linked notes and than % growth. Latin America and forex-linked bonds. Today, while these Canada are at distant fourth and fifth places, products still exist, more complex products, with % and % increase, respectively. including a whole range of s (s as Clearly global M&A is an activity that will well as s), exchangeables and reverse become increasingly important in India and convertibles as well as a huge number of for which a considerable amount of back- certificates linked to all kinds of underlyings office / and due diligence research such as indices, baskets, securities, funds and work is already outsourced to India. hedge funds are available. A large proportion of risk management for these projects is done 11. Financing for public-private using global derivatives. A range of PPP innovative products are developed for clients partnerships ( ) and governments around the world. Table This relatively new activity has emerged . shows the average daily turnover of on scene with considerable force since the derivatives. development of the London Underground . st Century IFS provided by IFCs 31
Box 2.9: Services provided by global M&A advisors Takeovers and acquisitions: Global M&A facilities and asset financing. The clients public company is best ensured by taking the advisors collaborate actively to create attractive business is presented in the most favourable company off the stock market into private acquisition opportunities, by carrying out an light to an agreed list of senior hands, the advisors seek out the best financing exclusive search, to a brief agreed with the decision-makers, within relevant financial partner and assist in all aspects of the public to client, for relevant ‘best-fit’ targets in institutions, drawn from the advisors extensive private transaction. designated territories. Through dedicated list of contacts. By obtaining competing offers, MBOs, MBIs, private equity transactions: research and extensive local and international the most attractive terms are sought to be M&A advisors assist companies to raise private contacts, they produce a recommended list of made available. They also assist over-leveraged equity funding on the best available terms for attractive businesses. Once the client agrees companies in working out new financing a management buy-out (MBO) or buy-in (MBI). upon the target companies, the advisors arrangements with their creditors including the MBOs and MBIs are technically complicated, initiate discussions with prospective vendors. raising of new capital and/or the sale of assets. time-consuming and often risky for They also provide assistance in obtaining IPOs, stock market flotations and management teams. These advisors help additional information, value the target and ‘take-privates’: For unlisted companies with an protect management from risk and introduce then recommend the most suitable way to established trading record, a flotation on a them to relevant financial institutions to raise structure a deal. Then, in conjunction with the suitable stock market may be a sensible the finance required. They work with the client, they negotiate terms, draft the letter of strategic step forward. The global mergers and management team to produce a business plan, intent and manage the transaction safely to acquisitions advisors evaluate the suitability of which sells the investment opportunity and legal completion. the business for a stock market flotation or guides them through the minefield of issues Fund raising, venture capital and initial public offering (IPO) and recommend a which they will inevitably face. They also restructuring: For clients wishing to raise programme of preparatory work, before negotiate with financial institutions to achieve development or venture capital, or refinance approaching an agreed short list of potential the best possible equity deal for the or restructure the balance sheet of an existing sponsors or investors directly. They then help management team and negotiate the purchase business, global M&A advisors assist in raising the company to select the most relevant of the business on the most favourable terms and negotiating the necessary mix of funding. brokers, lawyers and other members of the available. Partners of these firms have regular This could cover the areas of equity, advisory team to make the flotation a success. personal contact with the leading private mezzanine, senior debt, working capital In case it is felt that the continued growth of a equity investors and providers of debt finance.
Box 2.10: Why has the been so successful with s? The UK Government took a hard look at its better services for the public. indications on project priorities and problems with public procurement and public A key principle is to allocate the risks in the demonstrate a ‘deal flow’ of projects. service delivery during the 1980s and was not project such that each sector takes To assist confidence levels in both the at all satisfied. Cost and time overruns were responsibility for those risks it is best able to common in major projects with conflict private and public sectors the UK Government manage. The principal driver for the UK between contractors and the public sector recognized the need for a systematic and ‘top Government is to achieve best value for money down’ driven approach to generate sponsor a major cause of poor performance. for the taxpayer. The best value for money momentum in PPP projects. One of the Buildings in the education, health and other normally comes when the private sector contributory factors to the UK success was public service sectors were also poorly manages the risks of financing, design, build maintained, which inevitably affected the setting up of a high level task force in 1997, and delivery of the service facility. There is no comprising experts from both public and quality of services provided. Yet, elsewhere in payment until the facility is delivered and fully the UK, such as in the offshore oil and gas private sectors, to look at critical issues, and operational. Maintaining the facility at focus on driving through projects. It was also sector, examples of what could be done by constant or improved standards over the life of removing the conflict between project sponsor to act as an important repository of the project (normally around 25 years) is also knowledge for the public sector. and contractor were providing some startling the contractor’s responsibility. There are results in the cost, delivery and ongoing agreed service levels and financial penalties if Another key to success has been the full maintenance throughout the life of the project. the contractor fails to deliver these standards. In other words doing things differently at the involvement of Local Authorities through the start could favourably affect the whole life Two important factors became clear at an agency known as the Public Private costs of the project. early stage of this new process. The first was Partnerships Programme (or 4Ps for short). The that putting private sector capital at risk, not agency provides practical support and In both the public and private sector, just its profit, creates a powerful incentive for guidance to all local authorities in England and attitudes had been influenced by a decade of the private sector to build the assets on time, Wales to enable them to improve their expertise developed in the UK’s programme of maintain and deliver high standards procurement capability, particularly for large privatization of large-scale infrastructure such throughout the contract life. The second was projects, through partnership structures. as power, water and transportation. That that if the private sector money was to be Having worked with 200 local authorities to programme demonstrated that bringing attracted and take on the attendant risks, the date, 4Ps is recognized as an unrivalled source together private sector skills with better Government needed to show a strong of best practice and practical guidance on informed public sector procurement delivers commitment to the process of PPP, give clear project procurement.
() . Expert consultants, who help in support services to the public and private putting together a deal, provide legal, parties co-operating under s, providing accounting, consulting and other business comprehensive support from the beginning 32 R M I F C
to the end of a transaction. The consultant – Agreements, including conces- advises on the most appropriate way to sions and licenses, between the develop and structure projects and public and private parties drafts all necessary documents to implement • Designing alternative financial/legal the structure, keeping in mind the needs structures of potential financing parties. Typically • Assisting in every aspect of the they provide value to restructurings and operation renegotiation throughout the lifespan of • Financing models and project docu- projects. This would include: ments • Advising governments on best practices Public private partnerships () have for engaging the private sector in been more widely developed in the and traditional government monopoly the than elsewhere. In the , new sectors. facilities for schools, hospitals, prisons and • The creation of regulations for sector- roads financed through s have delivered based or multi sector-based authorities, substantial benefits. In India, which is whose function is to oversee the short of fiscal headroom for financing development of the competition in the urgently needed infrastructure, s offer private sector, the economic policies the obvious vehicle for expanding its physical defined by the public authorities, and and social infrastructure rapidly. However, the security standards and quality of going beyond India, there is a substantial service. -related market worldwide. The • Drafting: skills required in this business are available – Tender notices and invitation in India. Hence, it offers a major business letters by which the private opportunity for Mumbai as an . contractors submit their tenders – Constituent documents for project companies Case studies: London, New York, Singapore, Dubai
As observed in the two preceding chapters, in other large economies such Germany, are being provided to the world by a France, Japan and the were being over- few international financial centres (s) regulated and over-taxed. located in the , and East Asia. In c h a p t e r this chapter, we present four case studies: New York rose to prominence as an London, New York, Singapore and Dubai. with: (a) the growing stature of the We have chosen these four cities to economy between and – similar to look at closely because: (a) the first two what is happening in China and India today; epitomise what a fully-fledged is, and and (b) relentless American innovation in 3 what Mumbai should aspire to become finance – which is not happening in China as it matures; and (b) the latter two or India as yet. Financial innovation in the offer immediate competition in India’s (not just New York but Chicago as well) own neighbourhood of a kind that may has continued ever since. New York became compromise the emergence of Mumbai as the world’s dominant in when war- an . ravaged Europe involuntarily ceded global Indeed, if policy-makers and regulators leadership to America. That baton is now do not take the necessary actions for making passing to Asia as the st century unfolds. Mumbai a credible/viable in the near future, then Indian financial institutions that Singapore’s emerged in the s and are managerially capable, and have freedom s and is now well established if not yet of manoeuvre, are likely to locate in the fully developed. It is still a far cry from two proximate centres within a matter of London and New York. But it is arguably months. From there they can offer their ahead of Tokyo, Paris and Frankfurt. That clients (whose business they do not wish is a remarkable feat for a small entrepot to lose by default) a range of that they economy to have achieved in the space of a cannot offer from India today. Indeed Dubai mere quarter-century. International Financial Centre () is counting on that eventuality materialising. Dubai – or more specifically, the Dubai Such a move would compromise, delay, International Financial Centre ()– and perhaps even prevent, Mumbai from is a newly emergent enclave with the becoming the kind of that an economy resources and infrastructure in place to of India’s growing stature should have. develop very rapidly in providing to markets in the Middle East as well as in West, 1. Summary overview Central and South Asia. Unlike London and New York, the s London has been an important for over in Singapore and Dubai have not evolved three centuries. It was predominant in – as a consequence of their historical and when the British Empire covered much geographical legacies, or natural evolution of the world. After an interregnum in – of their market economies at the crossroads – when it ceded primacy to New York – it of global financial flows for trade and has now recaptured its status as the world’s investment. They have emerged as a result premier . That has been a result of of a powerful push by their respective canny opportunism and adept regulation. It governments to develop s. Singapore exploited the reality that financial markets has the advantage of being at the centre of 34 R M I F C
the large and flourishing regional From what we discern of activity economy. Dubai is located in a more since , it is clear that the emergence volatile neighbourhood. Its political and of competing s does not necessarily administrative governance is not based on displace work at other s. A study on an established democratic structure, nor on career development patterns in the global global norms concerning the rule of law. It industry insightfully suggests that it is is based upon the unusual competence of typical for high-flyers to work in a number two generations of a monarchic autocracy. of s; particularly London, New York and But the next generation of leadership is Singapore. They do so for different global as yet untried and untested. Succession financial firms, and establish their own is unclear. is incipient and has yet to informal working networks, before settling prove itself. Dubai is only at incipient stages down as senior executives in any one of them. of establishing itself as a stable global city Perhaps as a consequence of such human whose future is assured. But if its recent networks, the growth and development of accomplishments in other spheres (in a Singapore as an appears to have created shorter span than Singapore) are indicative, more business for London and New then portents for success are favourable. York rather than less. On that basis the Taken together, these four global cities emergence of Mumbai and Shanghai as s (two old, two new) are natural reference should be welcomed by London and New points for a policy debate in India about York if not by Singapore and Dubai. establishing an and how it might evolve. But, at the same time, anecdotal In a nutshell, Mumbai’s should, over and quantitative evidence suggests that the long term, aspire to emulate the City of Singapore has diverted some business from London. It should operate and be regulated Tokyo and Hong Kong. Tokyo has not in the same flexible way. But it faces been as global or culturally adaptable in its competition from Singapore and Dubai aspirations and outlook as an . It has not whose capabilities/ambitions are clearer. As adopted English as its ’s lingua franca; noted, that may compromise Mumbai’s nor is it as prone to financial innovation, or development as an in the nascent stage to light-touch regulation, that adapts quickly if the ingredients for a successful are to changing national/global circumstances. unavailable or poorly blended. The main Similarly, the primacy of London ap- such ingredients of course are political, pears to have constrained opportunities administrative and regulatory leadership. for other European centres like Amsterdam, They are required at central, state, municipal, Paris and Frankfurt. These centres have not and corporate, levels of governance. adapted governance frameworks for their If past experience is any guide, symbi- financial regimes, nor their regulatory and otic relationships will develop across s tax practices, in tune with rapidly evolving over the years. The task of global global expectations/standards as London provision is already fragmented into sub- has: nor do they use English for commu- components produced at the most efficient nicating with the world. Though home to production location and synthesised at the large immigrant populations they are not point of contact with the client. Manufactur- as open to, or as tolerant of, cultural and ing in almost all industries is now organised lingual heterogeneity on the same scale as on that basis in a seamless global produc- London and New York. And they have oner- tion chain. Similar complex organisation ous tax regimes that deter expatriates in the of production is now technologically industry from locating there. feasible and becoming increasingly desirable Evidence from all four case studies – in terms of cost-effectiveness and efficiency. and contra-evidence from s like Tokyo Given the proximity of time zones, this will and those in continental Europe – suggests generate strong pressures for close working strongly that the use of English is an essential relationships between/among the in- ingredient for the development of a viable dustry in Mumbai with that in Singapore, Dubai, London and New York. These results are from the ‘Loughborough Study’. . Case studies: London, New York, Singapore, Dubai 35
. That is because English is the default equity trading and syndicated insurance. language of global business. This triggered the growth of public traded The following four case studies have securities and of merchant banks to deal been presented in order to help policy- in them. London invented the market- makers and the wider public to understand dominated financial system now known in concrete terms what it takes for an as the Anglo-Saxon model. Individual to be commercially viable, competitive shipping ventures, as well as such enterprises and successful; and to guide debates as the British, Dutch and Danish East about specific policy aspects important India Companies, were financed by equity in the formation of s. They are interests privately distributed among wealthy particularly relevant given the coming aristocrats, government personages or years of cooperation and competition that merchants from sponsoring countries. Early Mumbai will inevitably confront in its mining ventures were routinely funded by dealings as an with Singapore, Dubai the issue and sale of shares or participations. and London. Another need that London met was government financing for countries ranging 2. A closer look at the City of from those of major European countries London to small princely states; often for financing wars. Given the risks and difficulties of London is at present the most successful contract enforcement, wars could not be Global Financial Centre (). It is the financed by equity participation. They were world’s largest net exporter of financial funded by debt arranged by bankers, such services, earning a net surplus of about as the Rothschilds. Indeed, historians have $ billion in from . It leads in noted that England had an advantage in international bank lending, consulting on waging war against France because of its cross-border mergers and acquisitions, and superior expertise in bond financing with trading/issuing international bonds. It is the centuries of financing wars through large- leading global currency trading centre, with scale sovereign bond issues. Such public a % market share of total global currency debt was run down through fiscal surpluses trading. in peacetime. The long history of the London’s origins as an can be shows a remarkable ability to doggedly run traced back to just before the Napoleonic surpluses and run down the debt/ wars. Edward Lloyd’s Coffee House – ratio for decades on end in peacetime, where maritime insurance was arranged which established the credibility required – was established in . The Bank of for borrowing of the order of % of England was formed in . By the at the time of the Napoleanic wars, the First late th and early th century, economic World War and the Second World War. development in north and west Europe Capital flows in the th and th had advanced to a point where surplus centuries involved issuing securities in savings were being generated. New types of Europe to finance development in the financing needs were making themselves felt Americas and the colonies. Infrastructure simultaneously. This was a period in which (e.g., railways) in the and Latin America, European imperial powers were expanding as well as mining, ranching and plantation their colonial domains rapidly. Colonisation ventures in the colonies, were financed required substantial risk financing for through share and bond issues in London. transport (e.g. railway projects), trade, other In real terms, they would seem enormous infrastructure, as well as for productive even by today’s standards. investment in agriculture, mining and Global trade, finance and capital flows primitive manufacturing. were disrupted for three decades between the In financing commercial activity at start of the First () and end of the Second home and abroad, London played a World War (). Between and , significant role in key innovations such as: the exported capital to Europe and Japan the limited liability company, organised to the tune of over % of its for the 36 R M I F C
Marshall and Stimson Plans alone. A further deregulation and liberalisation of the ’s % of was transferred by way of private capital, insurance and currency markets capital flows as major corporations and replaced the gentlemanly atmosphere established manufacturing bases in Europe. in which business was traditionally done But as domestic consumption in America in the City. Professionalism was infused grew during –, and as domestic from abroad, mainly the . London’s production in Europe revived (much of it financial markets were opened to all. That being exported to the to earn surpluses led to the entry of major global institutions that repaid reconstruction loans), the (e.g., and Citigroup) as well as ’ trade balance with Europe shrank financial institutions from every economy dramatically, thus deepening its overall in Europe, Japan and the developing world. balance-of-payments deficits. An unfortunate consequence was that such Faced with a massive expansion opening-up led to the demise (through of public spending under the Kennedy acquisition) of British owned investment and Johnson Administrations, and the banks which were outclassed by their simultaneous financing of a war in Vietnam, better capitalised and more professionally the Treasury realised in the early run foreign rivals. However, many s that capital exports to Europe could owned commercial banks and mortgage not continue. The Treasury had finance institutions continue to flourish begun encouraging European authorities in providing retail financial services to to develop their own capital markets since domestic customers rather than specialising the late s. That initiative resonated in . well in London where the authorities began The capstone for ensuring London’s immediately to revive its role as an . competitive edge in the provision of was In June , the first Eurobond was laid by the Blair Government in . The issued in London by Autostrade, the Italian Bank of England was made constitutionally state highway authority. British merchant independent and responsible solely for the banks (e.g., Morgan Grenfell, Barings, conduct of monetary policy. That was to Cazenoves, Flemings, Jardines, etc.) rapidly be done in a transparent manner with no assumed leadership in Eurobond issues interference by the Treasury. All tasks other for sovereign, corporate, multilateral and than setting the base rate were shifted out parastatal issuers; not just from Europe of the Bank of England. The frameworks but from around the world. That market for accountability and for total transparency expanded rapidly. It became so lucrative, of decision-making were put into place that leading American investment banks for this one task. The Bank of England such as Morgan Stanley, First Boston, does not trade on the currency market to Lehman Brothers, J.P. Morgan and Goldman intervene in stabilising exchange rates, even Sachs also set up operations in London in times of stress. The burden of financial in the late s; propelling its resurgence regulation and supervision was transferred as an . Its role was bolstered by to a Financial Services Authority () that the recycling of petrodollar surpluses via became a unified single regulator for all London throughout the s via syndicated financial services. Regulatory unification bank lending and sovereign bond issues. prevented the fragmentation of finance, American institutions operating out of avoided regulatory turf wars, eliminated the London were joined in the s by financial problem of regulatory issues falling between firms from Holland, Germany, Japan, France, the cracks when multiple regulators regulate Italy, Scandinavia and Canada. That second different institutions, and increased benefits wave was followed by a third through the from economies of scale and scope. s and s from Singapore and the The developed and applied developing world. What cemented London’s a unique framework of principles-based primacy as a in the st century was regulation — a counterpoint to the the Big Bang triggered by the Thatcher and continental European approaches of Government in . It resulted in total rules-based regulation that necessitates . Case studies: London, New York, Singapore, Dubai 37
Table 3.1: London’s share in global foreign exchange and rule-of-law: London has a long trading tradition of a mature democracy with April Global foreign % share of markets freedom of speech, as well as an array 2006 exchange market UKUS Japan of constitutional and popular checks- turnover ($bn) and-balances to curb the excesses of 2001 1,277 31.1 17.7 9.1 government, legislature, and politicians 2004 2,041 31.3 19.1 8.3 at every level of government. These are 2005 2,103 31.5 18.9 8.3 2006 2,901 32.4 18.2 7.6 firmly respected and enforced without discrimination, fear or favour. London Source: IFSL estimates; Bank for International establishes global standards for the rule Settlements of law with a capable and sophisticated legal system for resolving commercial codifying detailed rules and regulations disputes. This attribute dovetails well that define all financial products and with the contractual requirements of markets. The superiority of principles-based international finance. regulation (with its inherent flexibility in permitting financial innovation) over rules- . A multinational, multilingual work- based regulation (which cannot anticipate force: London has embraced a large every future innovation and therefore tends population of immigrants thanks to the to suppress it) has been proven over a legacy of Empire and a tradition of pro- decade. It has further entrenched London’s viding asylum from oppression in Eu- role as a . It has resulted indirectly rope. People of all nationalities and eth- in many global banks (investment and nic origin are to be found in the City of commercial) shifting entire divisions for London at every level for financial firms major corporate financing functions from from all over the world. Ethnic origin New York to London to take advantage of the and nationality do not pose insuperable regulatory flexibility offered in that location. barriers to employment or advancement Table . shows the growth of the in the City. That enables London to net- currency trading market in London while work and communicate with the rest of Table . indicates the share of London in the world – including the most remote overall . developing country – more effectively than any other . Why/How did London become the world’s . Language: With English having become pre-eminent IFC? Eight factors made a the default language of globalisation, major contribution to that outcome. They London (along with New York) has an need to be considered carefully by Indian advantage over other s that operate policy-makers. in different lingual environments. Lack . Location: London has a particularly of English has hindered the emergence convenient time-zone location. In the of Tokyo, continental European centres, morning, London talks with Tokyo, as well as other aspirant s such as Sydney, Singapore, Hong Kong and Shanghai and Seoul. Mumbai. In the evening, London talks . Capital Controls: The has no cap- with New York, Chicago, Miami and ital controls. But, London was an San Francisco. London daytime overlaps even when capital controls were in force with daytime in Tokyo Singapore, South between and . However global Asia, the Middle East, Europe and the circumstances have changed dramati- Americas. These regions account for the cally since then. In –, the cities bulk of world . Longitudes from that London competed against also had Mumbai to New York can be accessed capital controls consistent with the then- through flights of below hours from prevalent Bretton Woods system. It is London. impossible to see London being as suc- . Open, genuine participatory democracy cessful as a if capital controls (of 38 R M I F C
Table 3.2: Market share in IFS (percent)
UKUSA Japan France Germany Others
% share Cross-border lending (Sep 2005) 20 9 8 8 11 44 Foreign equities turnover (2005) 43 31 – – 3 23 Currency spot turnover (Apr 2004) 31 19 8 3 5 34 Derivatives turnover – exchange-traded (2005) 6 34 2 2 12 44 – over-the-counter (Apr 2004) 43 24 3 10 3 17 International bonds – secondary market (2005) 70 Fund management (as a source of funds, 2004) 8 45 12 5 4 26 Hedge fund assets (Dec 2004) 20 69 1 2 – 8
Source: IFSL, BIS, World Federation of Exchanges, LSE
even a limited sort) were now in place. lack the level of commitment to open- Today, the Bank of England, the ness which enables such a level of inter- and the Treasury do not attempt to nationalisation (e.g., most continental even capture data about capital flows European countries and Japan) and are of the kind that the authorities in India thus unable to compete with London in feel is necessary. But the advent of new providing . regulations aimed at preventing money . Policy innovations of the late s: The laundering and the financing of terror- reforms that: (a) gave the Bank ism may change that situation on an of England statutory independence for exceptional basis. the conduct of monetary policy with a single price stability target and without . Openness and lack of protectionism in any interference from the Treasury the IFC: The Big Bang of resulted and (b) created a single unified finan- in complete deregulation, liberalisation cial system regulator (the ) have and opening up of the market in the together set global standards for cutting . Some restrictions remain on direct edge central banking and financial reg- foreign entry into the domestic finan- ulation. The example has, over the cial services market. But those can be last decade, become the ideal model for overcome by acquiring extant financial central banks and financial regulators firms operating in that market. This pol- worldwide. Moreover the ’s pioneer- icy of openness was pursued despite the ing principles-based approach to regu- threat to the survival of venerable British lation is now seen as more innovation merchant banks. That threat eventually friendly and less risky than traditional materialised. But it did not deter the rules-based regulation. authorities from internationalising the . Policy focus on finance: With a City with no preconceived limit on for- of around $ . trillion, the eign presence, nor any insistence on the economy is the world’s fifth largest participation of domestic institutions, in nominal terms. That is more than nor on the employment of nationals three times the size of the Indian in key executive positions. The inter- economy in nominal dollars; although nationalisation of its financial system it is actually slightly smaller in that the has achieved is remarkable terms. But the role of its financial by any standards; particularly by Indian services industry, and of provision standards that favour protectionism over in particular, in generating employment, openness and efficiency. Table . shows output and net export revenue is that of the banks authorised to op- sufficiently large to command the special erate in the , only are owned attention of politicians and government. and controlled. Many other countries Whereas the has lost competitiveness . Case studies: London, New York, Singapore, Dubai 39
Table 3.3: Ownership structure of banks operating in UK That has led to difficulties in co-ordinating multiple regulators across the financial 1995 2005 system. Legislative myopia, and suspicion of Total authorised banks 481 347 the motives of foreigners in compromising Incorporated in UK 224 165 the ’s commercial interests, has resulted UK owned and controlled 142 78 Foreign owned and controlled 82 87 in the passage of legislation such as the Incorporated outside the UK 257 182 Sarbannes-Oxley Act. Sarbox is anathema Total Foreign banks 339 264 to the global business community. It imposes punitive measures on foreign firms and nationals for questionable reasons in manufacturing, and a number of and attempts to exert extra-territoriality service industries as well (other than in extending the remit of law. publishing, media and entertainment) After the tragic events of //, there it has remained competitive in the have been profound changes in the attitudes provision of . This heightened of the authorities in response to prominence of finance has helped to public concern about terrorism on soil. ensure that the City of London attracts Homeland security concerns on the part its best professional talent, as well as the of the have, in turn, led to reciprocal attention of the ’s key administrators, concerns on the part of global financial political leaders and statesmen. It firms about the stability, reliability and inclines them toward reaching consensus consistency of policy-making under on far-reaching reforms in the financial stress. There is now a perception on the services sector in a timely manner part of capital surplus countries that hold (such as the Bank of England and large reserves of a heightened risk of reforms) and continually adjusting/fine- foreign asset seizure; that has happened in tuning the legislative framework and the case of Iran. Consequently, a subtle regulatory environment in keeping with change in attitudes has occurred on the part changes in the global environment to of foreign financial players about the wisdom assure continued competitiveness. If of putting too many eggs in the New York London lost market share in the global basket, simply as a matter of political marketplace, this would affect risk-management. That perception, along election outcomes in the UK through with the ’s better regulation, has driven the large direct and indirect impact of business from New York/Chicago to revenues upon UK GDP. London since . What London has achieved as a In contrast, whereas financial services standard-setting is surprising; espe- in the as a whole account for a cially given some weaknesses that might significant proportion of value-added, net otherwise have seemed insuperable. Lon- exports are small in comparison with don lacks the intellectual depth of academic the size of the economy ($ trillion financial economics in the . American in ) and of gross exports. American minds have dominated the development of administrations and congressional leaders modern quantitative finance from on- – inclined to be insular – lack a similar wards. Yet, although short on theory and dedicated focus on when compared skills in quantitative finance, in practice Lon- to their counterparts. This has posed don is not at a significant disadvantage where greater difficulties for the in reforming theoretical financial innovation is concerned. unhelpful financial policies (such as the Financial innovations in instruments and prolonged separation of banking and capital markets are now diffused very swiftly. markets under Glass-Steagall). London has established its own Regulation is fragmented across the Fed reputation for innovation: e.g., in financial for banking, the for spot securities regulation and in arranging complex trading, the for derivatives, and the financial packages for politically sensitive Office of the Comptroller of the Currency. privatisations and s. In these areas it is 40 R M I F C
well ahead of New York. It lacks as large a Despite these developments in each national economy as other s (e.g., New of these two competing s, the York, Frankfurt, Tokyo, and now Shanghai). overwhelming cerebral power reposed in Yet London has positioned itself to serve the the American academic establishment keeps economy as the premier with other New York ahead of London intellectually continental s playing a subordinate role. as the ‘Silicon Valley’ of finance with a key Thus, London has leveraged its inherent role in continued financial innovation. Box strengths and flexibility to overcome some . shows one example of the fascinating of its apparent handicaps. interplay between the ideas of academic economics and the operations of real world finance. Another famous example of such 3. New York/Chicago as the an interaction is the pair of academic papers GFC for the Americas and (Christie and Schultz, ; Christie et al., the World ) which led to the demise of the erstwhile market design. New York and Chicago are financial centres While New York continues to have that reflect the overwhelming dominance remarkable strengths based on its intellectual community, to extend that metaphor, it of the economy. Chicago has a strong creates the space and the precedent for position in exchange-traded derivatives. Mumbai as an to relate to New New York accounts for virtually all other York/Chicago and London in the same way financial activities in the . But in both that Bangalore (and now many other centres cities, the provision of is secondary to in India) have prospered by relating to serving the needs of the domestic economy Silicon Valley. whereas in London, assumes primacy. The tides of global financial flows New York is home to and have been turning dramatically since . , the two largest stock exchanges A previously closed second world entered in the world measured by the number and the global economy in as a full dollar value of transactions. It is also home participant creating new demands and to the New York Mercantile Exchange, the needs for . After the lost decade of largest global commodity futures exchange. the s, the developing (or third) world Virtually every major financial conglomerate has grown substantially. It has become a and bank in the world, American-owned more significant part of the global economy; or not, has a presence in New York. Indeed despite ructions such as the Mexican debt any financial institution anywhere that deals crisis of , followed by the Asian crisis of directly in dollars in large amounts finds – and the Turkish, Russian, Brazilian it essential to maintain such a presence. New and Argentina debt crises of –. The York has a bewildering array of integrated, has turned from being the world’s largest as well as specialised, financial firms engaged creditor to being its largest debtor in a span in moving money from one place to another, of years. Large fiscal and current account inventing new trading strategies, raising deficits in the are now being financed capital in all markets and using derivatives largely by international investors. Table . to reshape risk. shows purchases and sales of long-term London and other s replicated the securities by foreign investors. Table . human capital and computer technology indicates investor purchases and sales of in their industries to match New long-term foreign securities. But, although York/Chicago in terms of the instruments global financial flows have reversed, the and contracts they could offer global underlying transactions are still being done clientele, and the platforms needed to in New York. trade them. London, on the other hand, The eight factors that contributed to led the way with innovations in financing London’s success as an have also privatisation and s which New York did contributed in large measure to the success not keep pace with. of New York. But, over the last five years, . Case studies: London, New York, Singapore, Dubai 41
Box 3.1: A History of New York’s emergence as an In the 17th century when London had international financial systems. Between conceptualising tradable financial instruments begun operating as an IFC, New York was still 1860–1914 these needs were met as much by for risk management i.e., derivatives. Currency in its infancy. The end of that century saw New London as by New York. The American Civil futures – introduced at the Chicago Mercantile York become a trading city when American War placed great demands on New York in Exchange (CME) in 1972 – were the first wheat entered European markets. Through the funding the war on the side of the Union, and exchange-traded derivatives. In 1973, the first half of the 18th century, New York’s role thereafter, for the reconstruction and revival of Chicago Board Options Exchange (CBOE) was in shipping agricultural exports to Europe was all the ‘united states’, and for supporting formed, and the Black/Scholes formula for enhanced. But it gradually became a gateway continued migration and expansion of large pricing options was developed at MIT and Bell for reverse British and European investment in territories in the West. Labs. American farming, ranching and mining The internationalisation of New York through the late 18th and 19th centuries. Until 1990 the US was the world leader in occurred in the early 20th century when Until the War of Independence in 1776, computer technology and in financial Europe was exhausted after internecine independent finance was nonexistent in economics. It probably remains so today conflict that extinguished a generation. America. That was because local commercial although it now shares the space it once Interrupted temporarily by a global depression banks were prevented from emerging. The dominated totally with a number of other in 1929–32, New York’s role as an IFC grew prevailing mercantile theory in Britain and countries. Given the monetary and psychic relentlessly between the two world wars Europe was that capital invested in colonies income returns involved, many leading (1918–38) as American corporations and should be loaned by imperial countries (to academics from top US universities migrated to financial firms invested abroad, particularly in benefit from annual returns) rather than be Wall Street. They played an important role in the UK, Western Europe and Latin America. generated and retained in the colonies for key global firms, such as Fischer Black, who During World War-II (1939–45), the US was the their own use through reinvestment. was partner at Goldman Sachs, and Merton main production engine for the Allied Forces. and Scholes, who were involved in LTCM After 1776, the first task of New York New York helped Washington to finance that (Dunbar, 2000). The marriage of new financiers was to help the new US government war on a lend-lease basis and arranged war computer technology with new financial fund the huge war debt that had been run up loans for its allies (mainly the UK, Canada, economics resulted in explosive growth in for the war of independence. When that was Australia and New Zealand as well as the USSR). financial sophistication in the 1980s. That accomplished New York faced competition New York’s role as a GFC became more enabled New York to maintain an intellectual from Philadelphia and Boston as a domestic significant when the Second World War ended. lead even as it was ceding ground in IFS financial centre. In 1814, a stock exchange In 1945 the US was the only economy capable trading terms. The substantial presence of was started in New York to compete with of providing the finance needed to reconstruct leading American financial firms in London led exchange-traded equities in Philadelphia. From and revive the world economy. to the rapid transmission and diffusion of such 1817–29, the Erie Canal (linking the Great In the half-century between 1918–70 the US innovation from New York to London and Lakes to the Atlantic) was built. It transformed beyond. America’s commercial geography and proved led the free world and dominated global finance. But, the US economy became immensely profitable. But it required an By the same token, the wave of privatisation overextended in the early 1960s. Europe was enormous amount of debt financing. Most of unleashed in Britain by the Thatcher resurgent with the completion of that was arranged in New York with a government in the 1980s led to London reconstruction and revival of its war-shattered significant proportion being sourced from becoming the leading IFC for conceptualising economies. European and Japanese export Europe. That canal opened up unprecedented the financial engineering to achieve politically engines went into overdrive in the 1960s. trade opportunities. It made the produce of and socially sensitive financial transformations. American encouragement for reviving Europe’s the American mid-west exportable to the As privatisation and denationalisation were capital markets, as well as its own regulatory world. In turn it increased needs for financing propagated around the world by the World shortcomings, led to the creation of the trade and investment in New York. Following Bank and IMF during the era of structural Eurodollar and Eurobond markets which the success of the Erie Canal, Wall Street grew adjustment (1981–97), London played a boosted London’s revival as an IFC. Although from strength to strength, focusing on raising pivotal role in advising on, and arranging, the breakdown of Bretton Woods in 1971 debt and equity for canals, railroads, and most of these transactions in global capital triggered a gradual slide in the relative shipping companies as well as the cotton and markets. In the 1990s, London continued to standing of New York, it still managed to lead wheat trade. Its role expanded as the West play an innovative role in conceptualizing and London in financial innovation from the 1970s and the Pacific Coast were opened up and executing complex financial/legal structuring to the present. settled by successive waves of immigrants of public private partnerships (PPPs) under the from Europe and Asia. New York pioneered the transition from private finance initiative promoted by the Blair By 1850, New York had become the prime plain vanilla to post-modern finance. It did so government, to augment limited public US financial centre. Its growth was related to a by incorporating risk management features resources for investment in physical and social burgeoning domestic economy and its into financial products and services. That infrastructure. That specialised expertise increased trade (similar to where Mumbai is stream of innovation has transformed the provided another string for its versatile bow. now). The emergence of the US as the largest nature of global finance and of IFS. Although So, at the turn of the 21st century, the economy in the world (overtaking the British futures had existed for some time in the intellectual/innovative edge that New York and Empire) at the end of the 19th century, agricultural and mineral commodities Chicago had in creating and trading inevitably made demands on the domestic and businesses, American ingenuity led to derivatives was becoming blunted. global financial firms have begun moving key Traditionally, New York firms had operations from New York to London. operated under a regulatory regime that This is partly attributed to London’s more was, in most respects, more open to benign regulatory environment and partly innovation than those that governed other to post-/ neurosis in the . s, with the exception of London. 42 R M I F C
Box 3.2: Futures on the Value Line Index: A case study in the interplay of ideas and finance The US pioneered the idea of futures bravely with the situation, treating the futures arbitrage strategy of Eytan and Harpaz, 1986). markets being applied to underlying contracts as an ordinary futures product, where the basis Once this arbitrage capital and mechanism other than those for physical commodities. should be positive and should roughly reflect a was in place, the KCBT index futures was This began with currency futures in 1972, the cost of carry applied on the spot price. priced correctly (Thomas, 2002). success of which immediately led to attention on the stock market index as an underlying for In 1986, a pair of economists named This story involves five remarkable elements: derivatives. Operationalising stock index T. H. Eytan and G. Harpaz wrote a paper in futures required a key innovation – cash Journal of Finance titled “The Pricing of . The innovative spirit of the US financial settlement. Cash settlement is now Futures and Options Contracts on the Value industry in pushing on from commodity mainstream in derivatives trading, and many Line Index” where they worked out the new futures to currency futures to stock index commodity futures are now settled in cash. mathematics of how futures prices and futures; But, though obvious and standard now, it was arbitrage worked when the index was a geometric mean of prices (Eytan and Harpaz, an important innovation at the time. In all . The effort at KCBT to get going on such a countries, cash settlement has presented legal 1986). Remarkably enough, their arbitrage product even if it involved an awkward difficulties owing to laws against wagering. procedures implied that the correct basis (i.e. geometric-mean-of-prices index; the gap between the futures price and the Three exchanges – the Chicago Board of spot price) for the KCBT index futures contract . The engineering approximation of traders Trade (CBOT), the Chicago Mercantile should be negative. who tried to make do in trading this index Exchange (CME) and the Kansas City Board of even though the theory was not Trade (KCBT) – engaged in developmental work It is widely believed that Fischer Black, who developed; leading up to stock index futures trading. was at Goldman Sachs at the time, took up . Scholars like Eytan and Harpaz who solved When the legal constraints were resolved, the these ideas and rapidly implemented them as the puzzle of how to arbitrage and price regulator gave the green light first to KCBT an operational trading strategy (Ritter, 1996). the product; and since their application had been filed first – as As a consequence, almost immediately after early as 1977. Trading began in February 1982. the publication of Eytan and Harpaz, 1986, . Scholars like Fischer Black who were able The index used by KCBT was the Value Line the basis on the KCBT flipped from a positive to rapidly turn the idea from the academic Index. It was a geometric mean of prices of basis (which was based on traders wrongly literature into a trading strategy backed by 1,650 shares. The pricing of futures on such thinking that the geometric mean of prices enormous capital at Goldman Sachs, and an index presented a challenge that was not index was like any other index) to a negative thus bring market efficiency to the market. understood at the time. The market coped basis (which correctly flowed from the
Table 3.4: Foreign purchases and sales of long-term US The is now ahead of the in terms securities (in USD mn) of its regulatory approaches, attitudes 2002 2005 and practices. The rules-based regulation of the faces severe competition United Kingdom 186,691 361,822 Rest of Europe 57,064 158,173 from the principles-based regulation of Caribbean Banking centres 76,144 126,289 the . That competition is being Japan 91.412 81,955 worked out in the global marketplace as Rest of Asia 109,314 188.435 country after country opts for the All other countries 26,940 126,272 model. Total 547,565 1,042,946 But whether New York leads London Source: Treasury International Capital Reporting System as an , or vice versa, is less relevant than the growing reality that these two centres are beginning to increasingly operate as a sin- Table 3.5: US investor’s purchases and sales of long-term gle linked entity. The same global financial foreign securities (in USD mn) firms operate in, and dominate, both s. 2002 2005 In a move was made by exchanges in New York to acquire London’s main stock Foreign bonds −28,492 28,603 Foreign stocks 1,493 126,735 exchange. activity in these two centres is being undertaken within the same ten major − Total 26,999 155,338 global intra-group/inter-corporate brand Source: Treasury International Capital Reporting System umbrellas. The booking of any particular transaction by a given firm is depen- dent on which jurisdiction offers the most However, as other nations moved to favourable regulatory and tax environment liberalize their financial markets, while the for that activity. came up with legislation like Sarbox, What is now happening between this advantage has eroded dramatically. London and New York may well extend to . Case studies: London, New York, Singapore, Dubai 43
bringing all significant s within a single rival the two gigantic economic blocs of the linked operating network that constitutes and – , China, India seem an integrated web of global finance. In to be the main contenders to do so in the that sense the specific -industry based st century – they will need equivalent s linkages between/among global city IFCs to represent their financial and economic may supersede the importance of more interests in the world economy in the same general linkages between/among their way and with the same skills and capabilities. national and regional economies. In such an But the most important lesson is that for environment, an Indian needs to blend s in China and India to function as into that unified global financial industry. effectively as those that already exist, they Both London and New York will remain will need to invite and embrace the same at the top of the heap for some time global players – who know no particular to come, probably well into the middle of nationality of ownership as such – that the st century. New York will represent are already operating in London and New the economic weight of the and North York (and in Singapore, Dubai, Hong Kong, America in the world economy and London Sydney, Amsterdam, Paris, Frankfurt and will do the same for the . Singapore and, other s as well). to a lesser extent, Tokyo (as well as other s do not succeed in providing smaller s) already serve East Asia. But effectively and competitively if, by with the growing weight of China and India, policy design or regulatory preference, they new s will emerge, especially in these remain closed and protected to favour only two countries. However, history suggests domestic players. Nor do s succeed if that Singapore and the newer s will the policy-makers attempting to promote take decades to equal or surpass London them focus exclusively on the domestic and New York. While relative changes scene, and remain unconcerned about what in the economic strength of countries is happening in the world outside. Most (such as China and India) may occur quite of all, s are unlikely to succeed or be rapidly, the more fundamental changes in competitive if financial system regulators institutional arrangements for handling and institutional operators do not adapt global trade and investment transactions swiftly and responsively to changing global through s will continue to occur more best practices and norms of regulation, risk slowly, even in the st century. management and corporate governance. Thus, while the economy was larger than the British Empire by , it still took 4. Singapore as the New York another fifty years until to ASEAN/Asian GFC exceed London in importance as an . By the same token, while the relative size In the s and s, many East Asian of the economy in the world economy countries emulated the success of Japan has been steadily diminishing since the mid- in the s and grew very rapidly. They s, and has now been overtaken by the increased employment with labour-intensive enlarged , New York still remains one of manufacturing exports and low barriers the world’s two key s. for imported inputs. Unlike Japan, they While new s will spring up in China relied on . Ironically, much of it was and India – if not by design then by default from Japan. The most successful East Asian – they will take time to establish themselves economies – which provided a model later and reach the same level of size, credibil- for China – were Hong Kong, Taiwan, and ity and competitive ability as the premier Singapore; followed in quick succession league s; even though transformational by South Korea, Malaysia, Thailand and changes (such as in Dubai) are now occur- Indonesia (although it suffered a near-fatal ring in a shorter time span than they did in reversal in ). Singapore transformed earlier centuries. its economy rapidly and sustained a high The lessons that London and New York rate of growth between –. It adopted convey is that as other economies grow to an export-orientated manufacturing hub 44 R M I F C
strategy with state-driven development of Singapore’s strategy to become a a regional transport and communications and a global city has proven successful. services hub based on state-of-the-art When other Asian countries had capital con- infrastructure (airports, ports, container trols and policies inimical to the growth of terminal, airline, and shipping.) their financial systems, Singapore positioned By the late s, Singapore was itself as a venue with no capital controls experiencing the limitations of depending and sophisticated financial regulation. It for growth on transportation and - became a genuine for as well driven manufacturing. In the early s, it as a linking to global markets. realised that to sustain its growth trajectory, Foreign financial firms in Singapore have and become a developed country, it required grown from fewer than in the mid-s, a shift in focus from low-cost manufacturing to almost in . A full range of fi- to high-value services. Singapore spotted nancial products and services are offered, as a key opportunity for services-led including currency trading, derivatives, loan growth in the world market. Its experience syndication, M&A, insurance, wealth and in attracting the regional headquarters of asset management and capital market activ- manufacturing s was applied to global ities. Financial services (mostly ) now s in finance through efforts to establish account for nearly % of . an that were scripted and controlled by When it first embarked on developing the government and implemented by the an , Singapore had weak human capital Monetary Authority of Singapore (). and lacked world class intellectual depth in Singapore’s strategy was in marked its universities. However, the presence of contrast to the laissez faire approach of Hong global financial firms in Singapore attracted Kong whose strengths in providing arose highly skilled foreign workers (e.g. from purely as a side effect of liberal economic India) to migrate to Singapore to work in policies and market driven developments. finance as well as related services such as But, until , Hong Kong had benefited accountancy, law, management consultancy, from being an exclusive gateway for the and information technology. Expatriates world into a closed China. hold most senior management positions in Since , the Singapore government finance and banking, and constitute almost has been making profound financial sector % of the finance workforce. Singapore has reforms, opening new financial markets, taken significant steps towards developing introducing full convertibility, and enacting world-class universities by depending on regulatory and fiscal incentives to attract foreign academics. foreign financial institutions to Singapore. It MAS initiated the establishment of has reduced public ownership of banking , now called Singapore Exchange firms and created a Singapore dollar bond Limited (), which was the first de- market less to serve its own needs than to mutualised and integrated securities and acquire credibility in the global market. derivatives exchange in Asia. One of the main objectives of is to attracts global issuers for listing, and trades supervise the banking, insurance, securities derivatives on global underlying contracts and futures industries, and develop strategies such as the Japanese Nikkei index or in partnership with the private sector to the Indian - index. In , promote Singapore’s role as a . As obtained a landmark contract with mutual in the case of London, internationalisation, offset for the Eurodollar futures traded at rather than a preoccupation with domestic the Chicago Mercantile Exchange (). finance, is at the core of ’ perspective This enabled positions at to be fluidly on its financial services industry. This is in traded at and vice versa. marked contrast to the role of the monetary Singapore is now the world’s fourth authorities in India whose attention most active currency trading centre after (understandably) is on the domestic London, New York and Tokyo. Daily financial system, and whose concerns about trading volume in averaged nearly are, at best, peripheral in nature. $ billion. . Case studies: London, New York, Singapore, Dubai 45
Table 3.6: Financial market growth in Singapore
1996 2005
Domestic banking units’ external asset and liabilities (S$ mn) 60,302.3 117,685.9 Equity market turnover + market capitalisation (S$ mn) 88,855.1 205,164.4 Number of listed companies (SGX) 323 664 Foreign exchange market turnover (S$ mn) 44,974,690 70,734,830 Exchange traded derivatives turnover (number of contracts) 22,568,545 26,026,128
Source: Monetary Authority of Singapore
Singapore benefits from Indian restric- World Bank’s private sector affiliate – the tions on finance by capturing business that International Finance Corporation, in . Indian regulatory and capital controls pre- Singapore has established itself as a vent. An active ‘non-deliverable forwards’ reliable and secure safe haven for private market exists in Singapore and Hong Kong wealth management by wealthy individuals on the - exchange rate, and there in (particularly the wealthy and has been a mushrooming of interest rate influential overseas Chinese community in derivatives on Indian underlying contracts. Asia) resulting in a vibrant private banking Over the years, Singapore’s financial industry. Given the difficulties with political sector has matured from providing basic stability of many neighbouring countries, services, to sophisticated, technology-driven, Singapore has played a role as a safe haven innovative offerings. As a result, which is reminiscent of that played by the financial services sector has developed Switzerland in the th and th centuries in simultaneously with the growth of the Asian unstable Europe. Currency Unit (), the Asian Dollar More than international asset Bond () market and the Singapore management firms are located in Singapore. Dollar Corporate Bond () market. This process has been assisted through Like the Eurodollar market, the Asian a mechanism where asset management dollar market () has played a significant companies domiciled in Singapore are role in Asia’s economic development. more able to obtain contracts from the Through the , financial institutions government portfolios. Total assets channel surplus funds from regional and under management () stood at international financial markets to finance S$ . billion at the end of . development projects in . Since its Many of the world’s leading names in launch in , the has grown times; insurance broking, captive management and it stood at $ billion by end-. risk management are present in Singapore. Table . shows the growth in the equity, In addition to meeting the needs of the foreign exchange and derivatives markets domestic market, numerous re-insurers over a ten year period. and captive insurers use Singapore as a Since , several initiatives have base to write risks in the region. Offshore boosted the growth of the Singapore bond insurance business has become a major market. The issuance of more Singapore component, accounting for more than half Government Securities () was aimed at of the total general insurance business building market depth and liquidity while written. Singapore is the largest domicile for the issuance of new and -year captive insurers in Asia. served to extend the benchmark yield curve. Singapore is a remarkable success story Rules relating to the use of the Singapore about the extent to which the government Dollar by foreign entities were liberalized was able to see the importance of an to enable foreign players to participate in the late s – roughly years more actively in issuing Singapore Dollar before this issue achieved salience in India. bonds. These have resulted in a series of The build-up of modern knowledge in landmark deals including the first Singapore economics and finance at , and the Dollar foreign entity bond issued by the supportive role played by in the 46 R M I F C
development of sophisticated finance, are virtue of having a zero income tax for locals. both accomplishments that bear great The institutional structure at lessons for India. involves a series of specialised agencies with supervisory and regulatory tasks: i.e., 5. Dubai as a RFC for the Financial Services Authority, Courts Middle East and South Asia and the Registry of Companies. These institutions will allow to operate The newest entrant into space is Dubai, independently of federal law while which has long pursued an economic strat- still being under its broad umbrella. egy based on commerce and trade seeking to These institutions are being staffed with reduce dependence upon oil-related activi- world class talent recruited internationally. As ties. The was setup in September with Singapore, this institutional infrastruc- and has been actively encouraging global ture is supportive of global financial firms that financial firms, including Indian institutions, use modern practices, and are fairly effective to set up operations there. at supporting the innovative deployment of Most successful s in the world reflect new kinds of financial products and practices. the organic strengths of a city gained from a In terms of organised financial trading, Dubai legacy of geography and commercial history, International Financial Exchange and Dubai as well as the potential for becoming a Gold and Commodities Exchange were started ‘global city’. Singapore exemplifies how in September and November . an can grow out of a policy effort is a very recent entrant in the at cultivating relevant strengths such as space. It is too early to tell how successful financial regulation and taking advantage of it will be. Bank and Kotak Mahindra its geography in the context of the regional () have set up offices in , where a economy. It has also exploited to total of global firms, including the likes of the full its connections (trade, investment -Amro, Lehman Brothers, Merrill Lynch, and ethnicity) with China and India. Morgan Stanley, JP Morgan Chase, Goldman By contrast, represents an enclave Sachs International, Franklin Templeton approach brought to bear on developing Investment, Citigroup Global Markets, another in the context of an extremely Deutsche Bank and Barclays Bank, have begun small domestic financial sector and no operations. However, as yet, is more of established stature as a regional provider of a location where staff is placed by global firms for the Middle East and Persian Gulf. to book transactions and attract clients, rather That role, until now, has been dominated than undertake the range of activities by Bahrain. Dubai is essentially a township typically found in a fully-fledged . surrounded by . million square miles of Dubai as a city has recorded a desert. ’s aim is to have , people stunning rate of growth and transformation providing a wide array of to its region over the last years. But it has the and to the world. disadvantage of being located in a highly is providing world class infras- unstable and volatile neighbourhood – tructure to global financial firms for their from the viewpoint of security, politics offices, communication and transportation. and economics as well as growing social As with Singapore, a good quality airport, a instability exacerbated by ethnic tensions – world-class airline, and excellent telecom- that is unlikely to be perceived as totally safe munications facilities are already in place. by global investors in the foreseeable future. In the case of both Singapore and Dubai, But, from the perspective of Indian there is full capital convertibility. In addition, corporates, Indian with growing wealth Dubai has set up unique tax privileges, management needs, and most importantly, declaring a zero tax rate on profits with a growing number of increasingly powerful a -year tax holiday. While the and capable private Indian financial has embarked on a synchronised effort at institutions, the is being seen as a preventing countries from helping foreigners convenient and easily accessible alternative evade taxes, Dubai is in a unique position by for meeting their needs in the immediate . Case studies: London, New York, Singapore, Dubai 47
neighbourhood (a mere . hour flight from financial firm that believes its capacity Mumbai). to expand, by providing essential to That opportunity will be evaluated – their large client base, is being artificially along with Singapore – by every Indian restricted in the present Indian environment.
Domestic and Offshore demand for International Financial Services (IFS) in India
1. Implications of a large, remain, these substantially increased two- rapidly growing home way flows reflect an increase in demand- market for IFS supply for related to trade/investment transactions in India. Put another way, there c h a p t e r A little appreciated aspect of India’s has been an increase in consumption by impressive growth from onwards is Indian customers and by global customers that it has resulted in even faster integration in India. Demand for from both has of India with the global economy and been growing exponentially. financial system. There has been a rapid Cumulative two-way flows in – 4 escalation of two-way flows of trade and were a multiple of such flows in –. The investment. Since , India has globalised degree of ‘globalisation-integration’ that has more rapidly than it has grown, with a occurred in the last years, since reforms distinct acceleration in globalisation after began in earnest, is much larger than in the . Capital flows have been shaped by years between independence and India (a) global investors in India (portfolio and embarking on ‘serious’ reforms. We have direct); and (b) Indian firms investing made up for six lost decades of economic abroad (direct). Indian investors – corporate, interaction with the world in a decade and a institutional and individual – have as yet half. Still, what has happened over the last been prevented from making portfolio years is a small harbinger of what is to investments abroad on any significant scale follow over the next twenty: particularly if by the system of capital controls. the current growth rate of % per annum is By the same token, Indian firms have accelerated to –% as is evocatively being borrowed substantially abroad. But foreign suggested, and if India continues to open firms and individuals have yet to borrow from India. Capital controls still preclude private investment abroad, is that such borrowings (by external issuers of reserve obligations) will remain that possibility. Despite the controls that increasingly confined within the ambit of ‘official finance’ rather than being marketised. That will In saying that, however, it has to be recognised that, result in concentration risk in India’s reserve portfolio. over the past decade, the Treasury has effectively It will make India vulnerable to increased currency, ‘borrowed’ over $ billion from India. But, it does interest rate and political risk as reserves keep growing. not appear that way because that ‘borrowing’ is seen as Instead India’s reserves could (unlike China’s) be made an investment of India’s official reserves; i.e., as meeting more manageable by opening the capital account to India’s investment needs, rather than meeting the deficit encourage development of a more efficient, open and financing needs of the . The fact is that they are robust financial system that promoted rapid growth meeting both, because there is no such thing as a one- and global integration simultaneously. In that event way financial transaction. By the same token European Indian assets might not be concentrated only in governments have ‘borrowed’ another $– billion Treasuries or similar Euro obligations. They would be or so in India as well. Such ‘borrowing’ may rise to $ spread across a wider risk-return matrix of securities – billion or more by . One problem created issued by the official and corporate world. That would by not liberalising the domestic financial system, and yield higher returns in an overall economic ‘welfare removing capital controls more rapidly to permit more gain’ sense if not for the central bank. 50 R M I F C
Figure 4.1: Evolution of the trade/GDP ratio customers constitute India’s ‘hinterland advantage’. India’s attempt to establish an 30 in Mumbai will be aided by retaining such customers on the books of Indian 25 financial firms. Dubai and Singapore have 20 to go out of their way to attract them. India’s 16.63% own customer base contributes a critical 15 mass and induces economies of scale in a way that was not available to the Indian Trade/GDP ratio (%) 10 software industry in its nascent phase. The local-customer argument should 1950 1960 1970 1980 1990 2000 not be confused with ‘self-sufficiency’. A self- sufficiency rationale for provision from Mumbai – implying an autarkic mindset up the economy on both trade and capital that has resulted in past failures – would flows. be counter-productive. The Committee This chapter illustrates the impact is not arguing that, because India has a that economic growth in India is having rapidly growing need for , only Indian on two-way financial flows by making financial firms should meet it. What it is them quantitatively explicit. The typical arguing is that India’s demands for discussion about an Indian exporting are large and growing rapidly; it would (especially made by those arguing for be cavalier, therefore, if not negligent, to locating such an in a ) has been forego using that ‘home-market advantage’ analogous to that for software exports: for developing -provision capacity in a i.e., a sterile relationship between Indian competitive . producers and foreign customers of ‘support- Such capacity should involve Indian and services’. However, in the case of , India global financial firms operating in Mumbai is itself a large, fast growing customer of . to serve the world (and the home market) Conservative estimates of consump- as, or more, competitively than extant s tion in India just a few years out, amount are able to. That is not a self-sufficiency to $ billion a year. That is more than the argument. It is an argument for using the output of many Indian industries today. Do- advantage of a large and growing home- mestic customers for are India’s to lose market for to develop an that can through neglect. If India does not make immediately achieve: (a) economies of scale significant financial reforms now, this and scope; (b) global competitiveness; and demand will be continue to be met by (c) substantial revenues from exports. providers in New York, London and Singa- A domestic customer base with rapidly pore. Dubai may command an increasing growing needs will provide an in share of that business in the coming years. Mumbai with a comparative and competitive The believes that such reforms advantage that can be sustained for the are urgent to unshackle the Indian financial foreseeable future. That is what the , system, and make it globally open and and Asean economies provide as hinterlands competitive, in the same way that Indian for New York, London and Singapore. These industry was freed and obliged to become three s have not grown through self- globally competitive a decade ago. In sufficiency: they grew because they were the absence of a credible Indian , the effective, competitive and innovative. That more capable Indian financial firms will is what Mumbai should strive to be. have no option but to establish full-scale operations in s elsewhere, simply to 2. India’s growing integration retain their customer base and not lose it with the world to competing foreign financial firms that can provide their Indian customers with a India’s post-independence retreat into more complete array of . But, these autarky till , followed by hesitant . Domestic and Offshore demand for International Financial Services (IFS) in India 51
reintegration into the world economy since Figure 4.2: Growth of gross flows on the current account , is illustrated in Figure . (Bhagwati, 200 ; Desai, ; Panagariya, ). It measures the size of merchandise trade 100 compared with . At independence, the merchandise trade/ ratio stood at 50 a respectable .%. Almost all of it at the time involved transportation by sea. 20
In the following decades, the trade/ Billion USD per quarter 10 ratio fell sharply - to below % - at a time 1990 1995 2000 2005 when world trade was growing dramatically, assisted by technological improvements in transportation and communications. East Asian countries successfully harnessed globalisation has accelerated in recent world growth in trade to eradicate poverty. years suggest that projections for the But India turned inwards, losing out on future should take into account a faster growth and faster poverty reduction for four pace of change in recent years, when decades. compared with the average pace of The lowest Trade/ ratios in India change that has taken place from to were seen in the late s to the mid s . which was an era of increasing state control of the economy. The timid liberalising India has been particularly successful reforms of the s did not emphasise in exporting services. Services exports globalisation. As a result, the trade/ grew faster after the telecom reforms of ratio actually fell through most of the s. . Hence, the trade/ ratio for What distinguished the reforms from goods understates the extent of India’s previous desultory attempts was the rapid globalisation. This reinforces the sense growth of trade and investment related of a palpable acceleration in the pace of financial flows that resulted from openness. globalisation from onwards. They have gathered steam continuously Figure . shows the gross flows on since. India reverted to its trade/ the current account - summing across ratio (.%) in . China had achieved import and export of both merchandise and that level (of .%) in - i.e. Chinese invisibles - in log scale. Starting from levels trade reforms were roughly years ahead of of roughly $ billion a quarter in the early India. But then India opened up (–) s, gross flows have grown dramatically, Table 4.1: Growth rates for years after China (). and come to exceed $ billion a quarter. transactions volumes in India’s Balance of Payments Three interesting facts emerge from the A casual examination of Figure . suggests that the rates of growth have not CAGR 2004 over 1993 12% graph above: CAGR 2006 over 1993 15% been constant over the - period. CAGR 2006 over 2002 29% • The trade/ ratio in (.%) was Using the econometrics of structural change, CAGR 2006 over 2004 35% . times bigger than the lowest-value of .% reached in the – period. • The most recent trade/ ratio, in –, of .% is almost five times the Figure 4.3: Structural breaks in growth of gross flows on the current account lowest-value. In other words, the Indian 200 trade- ratio dropped by . times with the retreat into socialism, and has 100 recovered by four times thereafter. That 50 suggests a six-fold turnaround from the nadir. 20 • The rate of change of the trade/ ratio has accelerated palpably in recent Billion USD per quarter 10 years. Insights into why India’s 1990 1995 2000 2005 52 R M I F C
Figure 4.4: Year-on-year growth (in percent) of gross flows on the current account: 2002-2007 in the post-crisis recovery after the - reforms. 60 Gross inflow Gross outflow These results encourage a focus on 50 the - period as being different from the overall - experience, and 40 being more pertinent for thinking about the coming decades. Figure . shows 30 year-on-year growth rates of gross flows on the current account. Extremely high 20 growth rates are seen for both the current
Yoy growth (percent) account and the capital account, sometimes 10 exceeding % per year. Expressed in levels, gross flows on the 0 current account for - are shown in Figure . in log scale. These values are in 2002 2003 2004 2005 2006 2007 the units of billion USD per quarter. Both inflows and outflows have grown sharply, breakpoints are identified in the time-series. from the region of $ billion per quarter in This analysis, shown in Figure . yields four to $ billion per quarter in . This phases of growth: constitutes a tripling in five years. An understanding of what drives rapidly . The early part is a continuation of the growing demand for in India needs to difficult conditions of the late s, and take into account two features: actually involves a slighly negative slope. . Then the reforms of the early s • First, demand is driven by increases generated a positive trend, and gross in gross two-way financial flows that flows grew from roughly $ billion to have occurred in transactions with the roughly $ billion by . rest of the world. It is not driven by net flows. Demand for by Indian . This was followed by a period of slow customers – as well as foreign firms growth until roughly . trading with and investing in India – . After , the slope has sharply risen; is driven by imports and exports. India- indeed, the rate of growth seen in the related purchases of are related to post- period exceeds the slope seen inbound and outbound /. • Second, the annual growth of gross flows Figure 4.5: Gross flows (billion USD per quarter) on the current account: 2002-2007 has accelerated dramatically in recent years. As shown in Table ., India’s 60 external linkages have been transformed Gross inflow since –. But that transformation Gross outflow 50 has been more radical since . The Indian economy is now exhibiting signs of a ‘take-off’ both in growth and even 40 more rapidly in its globalisation (or integration with the world economy).
30 Total two-way gross flows on all BoP transactions were $ bn in –. They doubled to $ bn in –. They increased another . times, to $ bn Billion USD per quarter, log scale in –. Doubling took nine years; 20 the near-tripling took only four. What is noteworthy is that total gross transactions on 2002 2003 2004 2005 2006 2007 India’s balance of payments (o) accounts, . Domestic and Offshore demand for International Financial Services (IFS) in India 53
Table 4.2: Trends in India’s Balance of Payments (in US$ billion)
1992–93 2001–02 2003–04 2004–05 2005–06
INR/USD 30.65 47.69 45.95 44.93 44.27 GDP at factor cost 215.09 439.81 553.51 648.30 724.98
Current account (net) −3.53 3.40 14.08 −5.40 −10.61 Merchandise outflows 24.32 56.28 80 118.78 156.33 inflows 18.87 44.7 66.29 82.15 104.78 Invisibles outflows 7.41 21.76 25.71 40.63 50.54 inflows 9.33 36.74 53.51 71.85 91.48 Total inflows 28.20 81.44 119.79 154.00 196.26 Total outflows 31.73 78.04 105.71 159.40 206.87
Gross flows on C Account 59.93 159.48 225.50 313.41 403.13 Gross flows on K Account 44.63 77.97 135.04 172.74 253.92 FDI outflows 0.03 1.50 2.08 2.73 2.79 inflows 0.35 6.23 4.46 5.97 8.52 Portfolio (equity + debt) outflows 0.00 7.31 16.86 31.63 55.63 inflows 0.24 9.26 28.22 40.54 68.12 Loans and Banking Capital outflows 17.31 24.39 37.6 30.04 52.34 inflows 20.67 25.47 38.39 44.26 57.88 Miscellaneous outflows 1.4 1.52 2.62 3.40 3.85 inflows 1.36 2.3 4.31 8.06 4.79 Net flows on K account Total 5.16 8.56 16.76 31.03 24.70 Total external flows 101.29 237.45 360.54 480.04 657.05
Table 4.3: CAGR Growth comparison during selected reference periods (%)
2002/1993 2006/1993 2006/2002
GDP at factor cost 8.27 9.80 13.31 Merchandise outflows 9.77 15.39 29.1 inflows 10.06 14.10 23.74 Invisibles outflows 12.71 15.91 23.45 inflows 16.44 19.19 25.62 Total inflows 12.50 16.09 24.59 Total outflows 10.52 15.79 27.60 Gross flows on Current account 11.49 15.79 26.09 FDI outflows 54.45 41.72 16.78 inflows 37.92 27.97 8.14 Portfolio (equity + debt) outflows 148.81 119.72 66.09 inflows 49.79 54.22 64.69 Loans & Banking Capital outflows 3.88 8.88 21.03 inflows 2.35 8.24 22.78 Miscellaneous outflows 0.92 8.09 26.15 inflows 6.02 10.18 20.13 Gross flows on K account 7.3 14.98 34.33 Total external flows 9.93 15.47 28.98 after having grown at a Compound Annual merchandise trade in the Nineties, reflecting Growth Rate () of % over the India’s success with services exports, but eleven years from – to -, have merchandise trade growth has now caught increased at a CAGR of % between up with the growth rates of services. The and . highest growth rates have been in Table . shows a breakdown of the and Portfolio () flows, reflecting India’s growth of gross flows. Large values engagement with private capital flows. characterise all components. Gross As a proportion of , external flows invisibles had been rising faster than have increased from .% of in – 54 R M I F C
Table 4.4: Trends in BoP components (as % to GDP)
1992–93 2003–04 2004–05 2005–06
Current account (net) −1.64 2.54 −0.83 −1.46 Merchandise outflows 11.31 14.5 18.32 21.56 inflows 8.77 12 12.67 14.45 Invisibles outflows 3.45 4.6 6.27 6.97 inflows 4.34 9.7 11.08 12.62 Total inflows 13.11 21.6 23.76 27.07 Total outflows 14.75 19.1 24.59 28.53 Gross flows on Current account 27.86 40.74 48.34 55.61 FDI outflows 0.01 0.4 0.42 0.38 inflows 0.16 0.8 0.92 1.18 Portfolio (equity + debt) outflows 0.00 3 4.88 7.67 inflows 0.11 5.1 6.25 9.40 Debt outflows 8 6.8 4.63 7.22 inflows 9.6 7 6.83 7.98 Miscellaneous outflows 0.7 0.5 0.52 0.53 inflows 0.63 0.8 1.24 0.66 Gross flows on capital account 19.2 24.40 25.7 35.02 Total external flows 47.1 65.14 74 90.63
accounts, a plethora of are purchased Box 4.1: Hong Kong and China as part-and-parcel of these cross-border Hong Kong evolved as an enclave IFC to the world through Shanghai and Beijing. transactions. The hinterland effect of provide IFS for traders dealing with a Since the 1980s, China has not required a rapidly growing national or regional closed China. In the 1970s and 1980s, its economic partners to deal with it Hong Kong had superior institutions, and exclusively through Hong Kong. With the economy has been a crucial driver of growth provided IFS to North Asia (China, Taiwan gradual rise of Shanghai as an IFC, Hong in s. and Korea) as well as part of ASEAN (the Kong’s role as an IFC serving China is The st century has yet to unfold. But Philippines and Vietnam which are closer diminishing, although it is unlikely to be to Hong Kong than to Singapore). But, as completely eclipsed. At the same time the emergence of China and India as global a colonial artifice, Hong Kong’s role as an ASEAN regional finance has gravitated economic powers is likely (as in the , IFC was compromised, if not damaged, as decisively toward Singapore. and A) to provide the same raison China opened up and connected itself to d’etre for these two economies evolving their own s to interface with those that serve other regions. History suggests that no to .% in –. Indian capital country or regional economy can become controls have resulted in slower growth of globally significant without having an of gross flows on the capital account; their its own. But the emergence of s has not share grew from % of to %. The always been a tale of growth potential and bulk of the growth has taken place on the start-up followed by prolonged competitive current account, where India has reduced success in exporting to global markets. controls to a greater extent. This analysis The trajectories of s can wax and wane illustrates in quantitative terms: (a) the depending on how world events unfold. potential generated by India’s globalisation Growth in Indian demand is driven i.e., the growth of two-way foreign trade and by the progressive, inexorable integration of investment, for providing through an the Indian economy with the world economy. in Mumbai; and (b) the acceleration As such integration deepens it triggers a that has occurred in India’s globalisation variety of needs for . For example: since . • Current account flows involve payments 3. The impact of globalisation services, credit and currency risk management. on IFS demand and on IFCs • Inbound and outbound (as When the economy of a country or region well as like private equity and (e.g., the or A) engages with venture capital) involves a range of the world through its current and capital financial services including investment . Domestic and Offshore demand for International Financial Services (IFS) in India 55
Table 4.5: Gross cross-border financial flows (in USD billion)
Current account Capital account Overall Inflows Outflow Inflow Outflows Inflows Outflows Total flow
1992–93 28 32 23 19 51 51 102 2001–02 81 78 43 35 125 113 238 2003–04 120 106 76 59 196 165 361 2004–05 154 159 99 68 253 227 481 2005-06 196 207 139 115 337 322 657
banking, due diligence by lawyers and financing’. India is now one of the accountants, risk management, etc. world’s biggest customers of aircraft • Issuance of securities outside the country buying roughly % of the world’s involves fees being paid by Indian firms new output of planes in . This to investment bankers in s around requires buying % of the world’s the world. aircraft financing services. • The stock of cross-border exposure • Indian individuals and firms control a (resulting from accumulation of annual growing amount of globally dispersed flows) requires risk management services assets. They require a range of to cover country risk, currency risk, for wealth management and asset etc. This applies in both directions: management. foreign investors require to protect the market value of their exposure in Outbound by Indian firms in India while Indian investors require the joint ventures and subsidiaries abroad same services to protect the market value has increased since – as they have of their exposure outside the country. globalised. Foreign investments by Indian firms began with the establishment of • The shift to import-price-parity (ow- organic presence, and acquisitions of ing to trade reforms) implies that In- companies, in the and in the dian firms that do not import or export -related services sectors. Now they are nevertheless exposed to global com- encompass pharmaceuticals, petroleum, modity price and currency fluctuations. automobile components, tea and steel. And, These firms require risk management geographically, Indian firms are spreading services. well beyond the and by establishing • Many foreign firms are involved in com- a direct presence or acquiring companies in plex infrastructure projects in India. In- China, A, Central Asia, Africa and the dian firms are involved in infrastructure Middle East. projects abroad. These situations in- Such outward investments are funded volve complex . The same applies through: draw-down of foreign currency to structuring and financing privatisa- balances held in India, capitalization of tions (especially those involving equity future export revenue streams, balances sales to foreign investors) and public– held in accounts, and share swaps. private partnerships which are becoming Outward investments are also financed a growing feature in infrastructure de- through funds raised abroad: e.g., s, velopment around the world. s and s/s. Leveraged • The growth of the transport industry buy-outs related to these investments (shipping, roads, rail, aviation, etc) and executed through s abroad are involves financing arrangements for not captured in the overseas investment fixed assets at terminals (ports, etc.) as transactions data. The Tata Steel- well as for mobile capital assets with a Corus transaction, for example, involved long life: i.e., ships, planes, bus and substantial revenues going to financial auto fleets, taxis, etc. That is done firms in Singapore and London. by specialised firms engaged in ‘fleet When two firms across the globe agree 56 R M I F C
Box 4.2: Derivatives on Indian underlyings trading outside the country In the case of equity derivatives, Nifty led to a blossoming of derivatives on the Indian corporations, but these entities lack futures started trading in Singapore at roughly INR/USD exchange rate, and on the INR yield access to a local credit derivatives market. the same time as trading started in India. curve, outside India. As an example, the However, over the years, the market share of onshore interest rate swaps market has the Putting these together, there is perhaps a Singapore as a trading venue has dropped to following features: billion dollars a day of notional value of zero. This reflects the strength of institutional derivatives which are traded outside the mechanisms and liquidity of the onshore • The market comprises a mere 15–18 active country on Indian underlyings. This is an exchange-traded equity derivatives market. dealers and 80–100 participants. This important development that has largely compares adversely with the enormous escaped the attention of policy makers. The There is a significant market for OTC equity scale of participation in the onshore equity growth of these markets underlines two derivatives, on Indian underlyings. That market derivatives market. points. First, India’s movement towards de comprises dealers in Hong Kong, Singapore facto convertibility is now at a level of maturity and London who sell OTC derivatives of two • The average daily dealt volume is about that permits substantial derivatives trading on kinds. Sometimes, derivatives on Indian equity Rs. 2,500 crores of notional value. The Indian underlyings outside the country. underlyings are sold to customers outside India bid-offer spread seems to be 1–2 basis Second, these markets will wax and wane in who are barred from participation in India. At points for OIS and 3–5 basis points for response to the sophistication of Indian other times, OTC derivatives transacted outside MIFOR swaps. While some liquidity is financial regulation. When India runs a tight the country are not available in India. The available all the way out to 10 years, the license-permit raj, there will be a greater shift ‘Participatory Note’ (PN) is the simplest OTC most liquid segments are 1 year and 5 of trading to locations outside the country. equity derivative, sometimes with a simple years for OIS, and 2 years and 5 years for When India runs relatively liberal policies, these linear payoff structure. It is favoured by MIFOR swaps. markets could shift to India – though that customers who lack a license to trade in India, cannot be taken for granted once liquidity has or by customers who find it cost efficient to The currency derivatives market is similarly become well entrenched in markets trading not deal with the regulatory frictions of India. burdened with many problems. Both markets – elsewhere. the currency derivatives market and the As an example, an FII or FDI portfolio could HPEC proposes no policy hostility to these interest rate derivatives market – lack choose to buy a one-year Nifty put option in markets. These offshore derivatives markets speculative price discovery and market order to eliminate downside risk on the are a positive development for the Indian efficiency rooted in arbitrage. As a portfolio. Nifty options of this maturity are not economy. When Indian financial regulation consequence, trading in derivatives on Indian available in India. The maximum options obstructs derivatives, offshore production of interest rates and the INR/USD exchange rate maturity on NSE is only three months. This these products helps end-users to obtain these has inevitably blossomed outside the country. customer would typically access the OTC services and thus undertake better risk The currency derivatives on the INR/USD market in Hong Kong. A dealer in Hong Kong management of their securities portfolios. This exchange rate are typically “non-deliverable would sell the investor this option. The dealer helps the sophistication and growth of the forward” (NDF) contracts. would then go on to lay off this risk by setting Indian economy. On the other hand, these up a hedging strategy utilising the Nifty The ‘other benchmarks’ in the table include offshore derivatives trading situations derivatives that do trade in India. As an MITOR swaps, CP based swaps, 1-year MIFOR represent a loss of IFS markets that could more example, the risk of the put option can be swaps, etc. In addition to the products listed in easily and efficiently be onshore and fuel the hedged by a dynamic trading strategy based the table, a recent development has been the growth of Indian financial firms and markets, if on a large number of transactions on the Nifty rise of credit derivatives (CDS and CLN) on policy impediments were removed. There is a futures, which replicate the payoff of the put Indian credit risk underlyings, outside India. case for reforms of Indian financial sector option. This is linked to the rise of FCCB borrowing by policy so that some of this market shifts to In the case of currencies and interest rates, Indian firms, which generates demand for Indian soil; there is no case for trying to force the onshore market has much weaker hedging against this credit risk. Global hedge foreign banks to cease and desist from these institutional mechanisms and liquidity. This has funds are known to sell credit protection on activities so as to extinguish these markets.
OTC Debt Onshore Offshore Derivatives Market lot Spread Avg. daily Market lot Spread Avg. daily volume volume
OIS swaps 25 cr. 1 bps 2500–3500 cr. $5Mn 1.5–2 bps $50–150 MIFOR swaps 25 cr. 3–5 bps 250–500 cr. $5Mn 10–15 bps $50–100 Forward rate 25 cr. 10 bps 250–500 cr. Not liquid N.A. N.A. agreements 1Y GOI swaps 25 cr. 10 bps 250–500 cr. Not liquid N.A. N.A. Other 25 cr. 15 bps 100–200 cr. Not liquid N.A. N.A. benchmarks
Currency $5Mn 0.5–1 ps $1.5–2.0 Bn $5Mn 0.5–2 ps $500–750 Mn forwards . Domestic and Offshore demand for International Financial Services (IFS) in India 57
to undertake current or capital account management business which rides on trade buy–sell transactions, the associated flows. are usually bought by the firm with better access to high quality, low cost . Consider 4. Estimates for IFS the example of an Indian firm exporting consumption by India complex engineering goods to a firm in Germany. It can contract and invoice As elaborated upon earlier, different types of in: , or . Because India are required for different types of cross- has limited capabilities, and a stunted border trade and investment transactions. currency trading market, the transaction is A wide range of fees are charged. Baseline likely to be contracted in or . But transaction fees on open trade financing the German importer generates revenues in accounts (i.e., normal trade flows without . It has to buy or to pay the L/Cs or guarantees) vary from .% to Indian firm. It may have to use a currency .%(i.e., to basis points). Investment derivative (future, forward or option) to banking transactions typically involve fees of cover the risk of a movement in the exchange % to % of transaction value. Annual rate of the or vs. the between fees for asset management services are placing the order and receiving the goods. typically between –% of the portfolio This would typically be done in London. under management (at the time of valuation However, if India had a proper currency and not the originally committed funds) spot and derivatives market, the Indian with entry fees varying from –%. Private exporter would be able to invoice in . banking and hedge funds involve higher Local demand would be generated by annual loads and charges that can be partly this local firm converting locked-in future performance based and are negotiable on revenues into current revenues at an individual basis; especially for very large a known exchange rate. portfolios. Indian exporters are not as flexible as Basic transaction flows are accompanied they wish to be in their choice of the or by layers of multiple hedging and derivative of global currencies for invoicing (i.e., , transactions to cover risk exposures. For , or ) – or even the choice of instance, an issue might have currencies such as the or for trade secondary transactions hedging currency with A and China. If they were, that risk. Underlying securities might be could influence the effective price received integrated into an asset pool for mitigating by them. When goods are sold by an Indian underlying credit risk, and so on. Trade exporter, and a German importer pays finance involves hedging as well. In the charges in London for converting into case of the capital account, as economic and managing the exchange risk, the agents within and outside the country net price received by the Indian exporter build up larger stocks of cross-border assets, is lower. When the Indian exporter sells the exposure that requires hedging grows. in , and local are purchased for Substantial assets outside the country are conversion of receipts into , the controlled by Indian households. They price received would be higher. induce a flow of revenues for such These differences are invisible in as private banking, money management, standard o data, which do not separate payments services, etc. which are being lost out and recognise charges for being by India. purchased or sold as part and parcel of Using simple but defensible extrapo- contractual structures on the current or lations for this report, it is estimated that the capital account. For this reason, the purchases related to trade/investment standard o data grossly understate the size in India amount to about % of gross flows. and importance of the global market. This average is based on a weighted com- Focusing on the transactional aspects of posite of: (a) generic charges for corporate trade flows would tend to understate transactions (fund raising, asset manage- demand since this tends to ignore the risk ment etc.) and (b) standard service charges 58 R M I F C
on current account flows. These estimates 5. Projections for IFS have been derived after extensive discussions consumption by India with customers and producers of the kinds of enumerated above. 5.1. Outlook for deep globalisation in In –, applying % (base case) India on gross two-way flows of $ billion, the Whether the focus is on trade in goods estimated IFS market was US$ billion or services, or on the capital account, or INR billion. If estimates of % (low what India has done so far (–) case) and % (high case) are used, then to reintegrate into the world economy the associated IFS market size would work represents a small series of hesitant steps. out to a low of $ . billion and a high of The bulk of exports from India so far $ . billion. are sterile: i.e., where an Indian company These estimates are conservative be- produces a good or service and tries to cause they are based on plain vanilla trans- find buyers (importers) outside the country actions. In the real world, financial firms unconnected with the exporting company. put together increasingly sophisticated pack- ‘Deep globalisation’ comes about when a ages of with risk management services production facility in India is woven into layered over a vanilla transaction. Struc- global production chains that are becoming tured products involve significantly higher vertically (and horizontally) integrated. As fees. But, the ’s inclination to be a number of reports from UNCTAD and conservative in making such broad projec- other sources confirm, over % of world tions/estimates, on a relatively simple but trade in goods and services is now ‘intra- understandable basis, has precluded such firm’ trade; i.e., transactions across borders complexities from being considered. that occur within the boundaries of a single Regardless of arguments about how MNC. A further % is ‘inter-firm but intra- these broad estimates of extant and po- industry’ trade: i.e., across firms, but within tential IFS revenues are derived and inter- industries (e.g., the auto industry). preted, what is unarguable is that rapid Those percentages are likely to grow. As globalisation of the Indian economy has that happens deeper globalisation will occur created domestic demand for IFS at a faster with global MNCs in India (domestic and rate than the economy’s growth. The ‘glob- foreign) exporting to subsidiaries and/or alisation over growth multiplier’ is driving affiliates of those same groups and their Indian demand for IFS more rapidly than suppliers/customers worldwide. At this the supply of IFS in India can cope with. point, trade/ ratios that have already India has not yet made the policy, risen impressively since will turn regulatory, structural, institutional, and upward even more dramatically as happened market changes that are needed to in China. Deep globalisation requires: match domestic supply of IFS with . Continued reduction of government- growth in domestic demand. Essential induced barriers to trade, such as supply-side changes include: (a) the customs duties or capital controls, and a removal of capital controls at a more shift over to a modern framework rapid rate that currently envisaged by where imports of goods or services are the CAC- report to permit demand charged the national rate at entry and supply of IFS to equilibrate more and exports are zero-rated. efficiently and responsively in tune with growth and globalisation; and (b) further . Global standards of physical infrastruc- rapid deregulation and liberalisation of ture – i.e., transportation and commu- Indian finance accompanied by structural, nications, ranging from container ter- institutional and market integration of the minals and airports to fibre-optic ca- Indian financial system with the global bles giving broadband connectivity at financial system, through a focused and world prices, with ubiquitous voice-over- intensive programme of financial sector internet protocol () telephony, etc. structural adjustment and reform. . A substantial presence of the world’s . Domestic and Offshore demand for International Financial Services (IFS) in India 59
major s– whether Indian or foreign s. But, on all these fronts, what – being located in India; since the lion’s has really changed in India is a shift from share of trade in the world today takes egregiously high barriers to modest barriers place within boundaries. This that are still much higher than they should requires removing India’s barriers to be. Incremental changes have been made and opening up to participation in lowering tariff and non-tariff barriers. in all sectors of the economy without Tariffs are still too high by global standards as many obstacles, and encouraging and for meeting India’s own growth and more Indian firms to become global development interests. multinationals. The reduction in barriers that has occurred so far, and the consequent India has made significant progress on improvement in competitiveness, while this three-fold agenda. It is worth noting significant, are not sufficient; except in that, post- when swift advances on these a few instances where remarkable results three issues were made, gross flows rose have been achieved. Similarly infrastructure dramatically. Yet, much work on all three has improved; but, insufficiently in terms fronts still remains to be done. of quantity or quality in every sub- India cannot be sanguine about how far sector: whether power, water, irrigation or it has come in the last years; although it transport. Communications infrastructure has much to applaud in that regard. It has has improved dramatically; simply because come a long way. But now India has to focus reforms in that sector were more sweeping. on how far it still lags behind the rest of the It would improve even faster if such reforms world (especially A, China, Korea, were continued and foreign entry was Brazil, South Africa, leave alone Japan, the opened up further. Entry barriers to and ) and what it must do to catch s have been lowered; but a host of up; not in decades, but in months and years. mind-numbing restrictions, differentiated On the issue of tariffs and capital by sector, size and location, still remain. controls, the empirical experience is The biggest economic gains (in terms that substantial reduction of restrictions of growth and diversification) will be compared with earlier years led to small achieved when India takes the next step in economic benefits as long as the level of moving from modest barriers to no barriers. the barriers remained high in absolute When barriers to entry and competition terms. When a tariff for a product is are removed altogether in the real and lowered from % to % this seems like a financial economies, two-way cross-border dramatic improvement. But % is still a financial flows will grow dramatically – not high barrier that fundamentally undermines incrementally – in the next ten years. As imports. It affects adversely the export shown earlier, they doubled in – and competitiveness of industries that utilise nearly tripled in –. If India ‘goes for the protected product as a raw material. broke’ in reducing extant barriers, especially In the same way, in the financial world, in the financial sector, those flows may allowing mutual funds to start schemes for multiply yet again in –. overseas investment (subject to a series of Another perspective that encourages quantitative restrictions on investment per nonlinear thinking is the empirical expe- fund and aggregate investment by all funds) rience of s such as Singapore. When is quite different from decontrolling overseas Singapore became a , the volume and investment by mutual funds altogether and variety of transactions grew exponen- leaving them to get on with it. That is a tially, not incrementally. If India is able to key issue for understanding the outlook for establish an in Mumbai quickly, a point India’s future. of inflection will be reached when growth Since –, it appears as if India has will be non-linear and not incremental. The made considerable progress in: lowering establishment of an is similar, in that tariffs, lowering capital controls, improving sense, to the provision of liquidity in finan- infrastructure, and permitting entry to cial markets where only a binary outcome is 60 R M I F C
Table 4.6: Segment-wise projections of BoP accounts (amounts in $ bn)
GDP Share (%) BoP component flows 2006 2010 2015 2010 2015
1 2 3 4 5 Merchandise outflows 21.6 26 28 305.14 600.05 inflows 14.5 17 23 199.52 492.90 Invisibles outflows 7.0 7.44 8.62 87.32 184.73 inflows 12.6 15 16.7 176.04 357.89 Total inflows 27.1 33 32.62 375.56 850.78 Total outflows 28.5 29.44 32.79 392.46 784.78 Gross flows on C Account 55.6 62.44 66.00 768.02 1,635.56 Gross flows on K Account 35.0 35.20 35.20 412.64 754.35 Official flows outflows 0.0 0.3 0.3 3.52 6.43 inflows 0.0 0.5 0.5 5.87 10.72 FDI outflows 0.4 1 0.6 11.74 12.86 inflows 1.2 2 1.47 23.47 31.50 Portfolio (equity + debt) outflows 7.7 6 8.94 70.42 191.59 inflows 9.4 9.4 11.37 110.32 243.66 Debt outflows 7.2 5 4 58.68 85.72 inflows 8.0 9 6 105.63 128.58 Miscellaneous outflows 0.5 0.46 0.27 5.40 5.79 inflows 0.7 1.5 1.75 17.60 37.50 Total external flows 90.6 98 101 1,181 2,390
feasible: (a) explosive growth or (b) abject be as large as (columns and of the failure. Table). The actual flows are computed by multiplying (in billion) by the 5.2. Baseline projections of external respective shares. The reasoning for these flows shares is as follows: Under reasonable and plausible assumptions, India’s at nominal market rates will • Exports and imports (other than exceed $ trillion in . It will be over petroleum) have been growing at over $ . trillion by and over $. % annually in the last two years. trillion by . India’s share of global merchandise trade remains below %. But its increasing Based on these growth rates, a competitiveness will take it above % crude metric of India’s globalisation is of by . On the current account, provided by the proportion of total gross India’s merchandise trade share will cross-border flows to its . In –, rise, especially after , with India’s this was % of . This ratio is projected, accession to the trade regime. conservatively, to rise to % of by Moreover, providing further impetus –. It is on that basis that the table to Mumbai’s growth as an , India’s below summarises BoP projections of India’s linkages with other growing countries external flows in the years – and – will increase. . The figures in column are actual shares • In recent years, Asian economies have of individual o components in -. been emerging as major trading partners Given deepening globalisation (i.e., share of of India. Trade with these countries o as a share of ) observed in the past, has grown faster than overall trade. and faster growth likely in the future, Emerging Asia accounted for .% of we have assumed that external flows would India’s exports in – (.% in Kelkar (b) offers arguments about why Indian –) and .% of total Indian growth will accelerate into the coming decade. imports (.% in –). In – . Domestic and Offshore demand for International Financial Services (IFS) in India 61
Table 4.7: External BoP flows under different scenarios (US$ billions)
CAGR 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Low 10% 657 723 795 875 962 1058 1164 1280 1408 1549 Medium Low 15% 657 756 869 999 1149 1322 1520 1748 2010 2311 Medium 20% 657 788 946 1135 1362 1635 1962 2354 2825 3390 Medium High 32% 657 867 1145 1511 1995 2633 3476 4588 6056 7994 High 40% 657 920 1288 1803 2524 3534 4947 6926 9697 13575
, China emerged as the second major scenarios presented in Table . above. export market for India after the . It The different growth rates shown above has now become the largest source of indicate the magnitudes of total external imports, surpassing the . Exports flows that would be generated. The choice to China surged by % in – of s corresponds to those observed and imports increased by %. A over various time horizons in India. The similar trend was noticeable vis-a-vis` –% rates are in line with the in the A-. Looking ahead, there India’s BoP over the s and the early is further scope for expansion in trade years of this millennium. The –% rates with these countries. correspond to growth in the last two years. The data available for – indicate that an assumption of a % growth might be 5.3. Alternative scenarios for foreign more justified in projecting two-way flows transactions growth for the next few years. There are already signs of a profound qualitative change in India’s financial 5.4. Projections for the revenue linkages with the world, in its current and potential of Mumbai as an IFC capital accounts. Table . indicates a rough The direct fees that in Mumbai might quantitative measure of the change, in terms generate by and are illustrated of overall transactions levels over various below. Ancillary taxes and other influences periods, starting from – (the first on current account flows, resulting in inflexion point) to the latest year for which surpluses, would be additional. Although data is available, i.e., –. the range of fees varies widely across The following table indicates the financial services, it is reasonable to estimate magnitudes of BoP flows associated with a an aggregate average of these fees across range of s that could be achieved over various services. We have assumed fees the next decade. It starts with o numbers for intermediating external sector flows to for –, to which these different CAGRs be about % of flows. We arrive at this are applied, assuming that the indicated approximation using the weighted average compound growth rate continues apace over of generic charges for corporate transactions, the next ten years. Obviously, this simplifies including fund raising, asset management reality; but it provides a useful illustration and add the service charges on current nonetheless. The resulting projections account flows. of total o shares are consistent with In summary, our median (base case) the conservative ’s of –% in the projections involve IFS demand in India
Table 4.8: Projections of Fees (end-March, US$ billion)
2006 2010 2015
Total external flows 657 1,181 2,390 Total fees @ 1% 6.57 11.81 23.90 Total fees @2% 13.14 23.61 47.80 Total fees @ 3% 19.71 35.42 71.70 62 R M I F C
rising from $ billion in to $ growth in demand for steel. If Indian steel billion in . A low-case assumption producers are unable to keep pace with the would see IFS consumption rising from quality and quantity of steel required in US$ . to nearly US$ billion over the the country, then Indian demand will be same period. A more optimistic (but not met by producers outside. Applying similar implausible) ‘high-case’ assumption would reasoning, if India chooses not to make see it grow from US$ . to nearly US$ the financial and urban governance regime billion. changes required to create a viable IFC in Mumbai, then Indian customers will look 6. Implications for India’s to Singapore, Dubai, London and other aspirations to create an IFC s. Financial firms and policy-makers in Mumbai in these three cities are already attuned to opportunities for selling to India. They The estimates shown and projections made have embarked on strategies to exploit the for the purposes of this chapter require a new infirmities of the Indian financial system, way of thinking about an in Mumbai. which – as discussed earlier – has not evolved The traditional approach for Indian service apace with the (or ) needs of a rising exports has been that of tapping into a India. quasi-infinite world market. This approach was taken in the case of the software 6.2. The opportunity industry. That industry has domestic sales At the same time, Indian demand of $. billion a year and exports of about provides an opportunity for developing the $ billion a year. Indian software firms overall capability of the industry that have grown by expanding their lists of the software industry never had. Indian international customers. The domestic software exports took place by dint of Indian market does not feature as significant in human capital. firms asked nothing from the minds of the s of these firms. It the State other than telecom reforms though certainly played no role in their graduating they were given tax benefits as well. Indian into multinational export-oriented firms. genius was able to conquer world markets are similar to software in that they in – in a way that could not have are labour and skill intensive. They thrive been predicted. on human capital, telecommunications In the case of , there is an identical infrastructure, and sound policies. As opportunity for Indian financial genius has been argued in this chapter, there is a to achieve success in the world market; fundamental difference between finance and but with one key difference. Unlike software: i.e., India’s hinterland advantage exports, the potential for achieving for provision. The sheer size of the exports are increased dramatically by a Indian economy, its growing integration hinterland advantage. India’s growth and with the world, and the high growth rates the consequential domestic demand for of cross-border flows that are likely to generate natural opportunities for materialise in the future, all imply that India producers in India (local and foreign) to is already a large and growing customer gain skills and realise economies of scale. for . It will be one of the three largest But just as Indian software exports required customers in the world for these services an enabling framework from the State by within a short span of time. way of telecom reforms, Indian exports will require an enabling framework from the 6.1. The threat State through: Intuitively, a simple analogy for might be made with (say) the steel industry. • The removal of capital controls as early India’s rapid growth implies that Indian as practicable demand for steel will rise sharply. Steel, • Further reforms in the financial sector like , is a superior good: a % growth – involving deregulation, liberalisation, in is likely to induce an above-% gradual exit from public ownership of . Domestic and Offshore demand for International Financial Services (IFS) in India 63
Table 4.9: The Global IFS market
Market share (%) Size (USD tn) UK US Japan France Germany Others Total
Cross-border bank lending (09/05) 20% 9% 8% 8% 11% 44% 20.3 Foreign equities turnover (2005) 43% 31% – – 3% 23% 5.8 Foreign exchange turnover (04/04) 31% 19% 8% 3% 5% 34% 600 Derivatives turnover - exchange-traded (2004) 7% 31% 2% 4% 12% 44% - over-the-counter (04/04) 43% 24% 3% 10% 3% 17% 368 International bonds - secondary market dealing (2005) 70% ...... 50.6 Fund management (as a source of AUM, end-2004) 8% 45% 12% 5% 4% 26% 45.9 Hedge funds assets (end-2005) 20% 62% 1% 2% – 8% 0.9
Sources: International Financial Services, London; Bank of International Settlements; London Stock Exchange, Bank of England, Systematics International, International Securities Market Association, World Federation of Exchanges, International Securities and Derivatives Association
financial firms, markets and exchanges, Table 4.10: Global financial stock (USD trillions) and open competition without restric- tion, by removing all remaining barriers 2003 2010 to foreign and domestic competitive en- Equity securities 31.9 56.8 try by financial and non-financial firms Corporate debt 30.8 60.7 securities as investors in financial firms Govt debt 20.3 32.4 • A dramatic improvement in the quality securities Bank deposits 34.8 58.8 of urban facilities and governance in Mumbai. Overall 117.8 208.7 To become a viable , Mumbai must aspire to, and actually become, no less than segments will grow dramatically when the a cosmopolitan and metropolitan ‘global , and A currencies become city’ in every sense of that term. globally tradable. Foreign currency trading volumes were conservatively estimated at 7. IFS customers outside India over $ trillion in . The table as a market for an IFC in shows that to be a credible ‘global’ , a country has to cross the threshold of a Mumbai % market share. France and Germany India’s opportunities for providing are (Paris and Frankfurt) are examples of not, however, confined to demand in its own countries/s that are clearly not ‘global’. market. Unlike continental European s They have values of slightly below % in and Tokyo, an in Mumbai need not be some areas and values of slightly above confined to serving only Indian customers; % in other areas. Singapore, which has although that customer base gives it a mounted an impressive effort to become an clear start-up advantage. For the reasons , has % of global currency spot trading discussed earlier, Mumbai has the potential with a daily turnover of $ billion. In as an – if national financial policies comparison, Indian currency spot turnover and state/municipal urban governance are seldom exceeds $ billion per day. radically improved – to go beyond the Funds under management by asset confines of India and serve the world in managers were nearly $ trillion in a manner similar to London, New York . They have increased significantly and Singapore. The following tables should since. Hedge funds now manage over enable policy-makers to appreciate how large US$ . trillion. That figure is growing by that opportunity is. % annually. With both asset and hedge The scale of global transactions is fund management, there is an important mind-boggling. The largest volumes are distinction between s that are primarily in currency and derivatives trading. These sources of assets seeking management, and 64 R M I F C
Table 4.11: The Global IFS market
Component Projected world market 5% market share in 2010 (Trillion USD) (Trillion USD)
Fund management (assets 100 5 under management) Turnover per day Currency spot 4 0.2 Exchange-traded 25 1.25 derivatives International bonds 0.3 0.015
s in which fund managers set up their the phenomenal growth of this particular operations. Looking into the future, the market after . consulting firm McKinseys estimates that It is worth reiterating that the services the stock of global financial assets will almost considered are only a small subset of the total double from $ trillion in to range of financial services that are currently $ trillion by . The breakdown of on offer. these totals is shown in Table .. The fees and profits associated with these magnitudes are enormous. A major 8. International comparisons mental paradigm-shift is required in India to Tables . and . show a rating comprehend these numbers: for market size, comparison of established and emerging and the corresponding fees generated. As s on demand for from their national, an example, most financial policy makers in regional and global clients. When compared India today would perceive a currency spot against established s, Mumbai fares well market with a daily turnover of $ billion, on domestic demand, but poorly on regional or $ trillion per year, as inconceivable. or global clients. When compared with Profits from investment banking ser- emerging s, Mumbai lags the others vices alone, internationally, were estimated on demand from the region or the globe. at $ billion in . If India had a % share But Mumbai stands out – and perhaps is of investment banking revenues, that matched only by Shanghai – on having a alone would have amounted to over $ vibrant domestic market. . billion. This estimate of course ignores
Table 4.12: Comparing Mumbai against emergent IFCs
Attributes, Characteristics and Capabilities of an Mumbai Hong Kong Labuan Seoul Sydney Dubai IFC: (Scale of 0–10 with 0 = worst; 10 = best)
A. Demand Factors for IFS A1. National (Domestic) demand for IFS 10 4 2 7 6 2 A2. Demand for IFS from Regional clients 1 7 5 2 3 9 A3. Demand for IFS from Global clients 0 2 2 2 3 5
Table 4.13: Comparing Mumbai against existing IFCs
Attributes, Characteristics and Capabilities of an London New York Tokyo S’pore F’furt Mumbai IFC: (Scale of 0–10 with 0= worst; 10= best)
A. Demand Factors for IFS A1. National (Domestic) demand for IFS 10 10 10 4 10 10 A2. Demand for IFS from Regional clients 10 10 3 9 7 1 A3. Demand for IFS from Global clients 10 10 3 5 3 0 Augmenting IFS provision via BPO
1. How does an IFC produce the instruments and trading platforms, IFS? doing the deals, and generally innovating for global finance. As argued in preceding chapters, the A lot is made of the ‘death of distance’ c h a p t e r provision of differs from the production (Cairncross, ) resulting from new of conventional goods and services. It technologies. But, that has not yet affected involves strong economies of agglomeration. the primacy of s, or of national financial This is partly because of the network centres within large economies. The externalities that shape liquid markets web of human networks, inter-personal 5 and complex inter-personal and inter-firm relationships, and information flows (about relationships. In addition, financial regime clients, products and markets) that make governance is an intrinsic, inextricable, a national or international financial centre ‘un-detachable’ part of the financial what it is, has eluded functioning over a product/service, leading to provision distance; despite facilities such as e-mail and being focused in a few s whose video-conferencing. For example, despite governance regimes have achieved global the enormous growth of financial trading acceptability. across India with the use of since , Spectacular progress in and in the the fact is that Mumbai remains the financial costs of transportation of goods has helped capital of the country. That is just as true for to disperse the production of goods and London, New York and Singapore as s services around the world – often within the serving the world well beyond the needs of umbrella of a single MNC. Such dispersion their own national or regional economies. has occurred because firms wish to be The addendum to this argument is that nearer to sources of cheaper/better labour, – if the history of s over three centuries large consumer markets, sources of key raw is any guide – all globally significant materials, or inputs such as water, access economies have no option but to turn their to infrastructure, or simply a more tax national financial centres into s, as advantageous location. their integration with the global economy Paradoxically, the concentration of widens and deepens. That process occurs global provided from London and New by design or default. It cannot be avoided. York has increased even as the dispersion That is because every globally significant of production of goods has taken place in economy has to have a central node the last years. Today, the provision of connecting its financial system with the global is more concentrated than (say) global financial system. The question for global automobile production and assembly. such economies (particularly for China and The latter is decentralised around the world India – now the world’s two largest emerging through a production chain that involves economies) is whether the nascent capacities fragmentation of component manufacture of their financial centres (i.e., Mumbai and and synthesis in assembly. The most intense Shanghai) as s will remain limited to concentration of auto production in the serving only their own economies (like Paris, world – in Detroit – is far less important Frankfurt and Tokyo) or whether they will in determining the contours of global car grow into export-oriented s, serving the production when compared with the role needs of their regions and the world, that just three s now play in shaping the and making a handsome living from service contours, setting the standards, providing export revenues by doing so. 66 R M I F C
The bulk of the value of financial accountants, fund managers, speculators, services production (particularly ) lies arbitrageurs, investors, exchange managers, in creative thinking and complex decision regulators, and treasurers from the financial making. It involves a combination of: fine and non-financial worlds. The nuances judgment and client/market knowledge of these conversations, the millimetric shared across networks of professionals raising of eyebrows or pursing of lips, across financial firms. It has close access to and the non-verbal body language so exchanges, regulators (especially at policy- crucial in understanding human reactions making levels), and sophisticated legal, in negotiations, are not yet as amenable accounting, and tax expertise. to subtle interpretation at a distance or on The process of creating and producing a screen. Phone calls, e-mails and video- new financial services involves: (a) a small conferencing are no substitutes for a chat number of hours of high value human over coffee or agreement on a deal structure capital in financial, legal and accounting over a game of golf or at a recreation club. firms as well as in regulatory agencies; The endless stream of conversations supported by (b) a large number of hours at an is fertile raw material for of lower-priced labour, handling the more creative intellectual leaps and imaginative routine tasks of recording, confirming, connections through lateral thought. The booking and correcting the trading involved mind of the successful financial engineer can in two-way financial transactions. These creatively link three apparently unrelated routine tasks need to be performed conversations with clients/colleagues during meticulously in real time. the previous week, into a set of financial The former involves creative thinking transactions that meet the different needs and complex decision making. As in of three counterparties, while leaving a the case of Silicon Valley or Bangalore tidy profit on the table. Spotting such – or Stanford, Harvard, Oxford and deals requires a regular flow of top quality Cambridge – those processes are critically conversations in an environment that dependent on specialised human capital encourages them. with specific domain knowledge interacting But the ingredients of creativity, in a geographic cluster. For such imagination, and ingenuity notwithstanding, clusters are found in Wall Street or the another phenomenon that has been at City of London. Physical proximity in one work in the world of global finance is location enables people to bounce all kinds an ever-increasing flow of high quality of ideas off each other and to develop/refine data about firms and countries from an them into tradable transactions on increasing variety of sources, coupled with an ‘eye-ball to eye-ball’ basis. Finance rapid analysis and global dissemination of involves more than processing data through this data, through the electronic medium. mathematical formulae. It involves human In principle, a speculator or investor knowledge, requiring fine judgment when (holidaying in Albania) could be far removed faced with different shades of grey, or from an (in London) while looking when tailoring or matching client demands at data on a laptop, engaging in analytical and needs (whether clients are users of thinking, deciding to buy, sell or hedge finance or investors) to sets of circumstances a position or security, and placing the that keep changing, and involve different trade order with a broker/agent to execute combinations of risks that are evolving or immediately. When trading is driven mutating continuously. by cold analytical data processing and An is a place where a set of humans remote decision-making, such activity could can converse, compete and trade in the indeed move out of London and New confines of the ‘financial world’, interpreted York to Mumbai, even when the hub of in the broadest sense of that term. Decision- conversations is not in Mumbai. That making and innovation in s takes migration might be driven by nothing place through ceaseless communications other than better service standards, better among financial analysts, tax specialists, execution capability at a better price, better . Augmenting IFS provision via BPO 67
communications, a more convenient time- consuming electronic information and zone, and lower overall costs in servicing requiring analysis that could be done by that customer’s account. human capital in Mumbai, Bangalore, In some ways, quantitatively oriented Hyderabad, Chennai, Pune, etc.? finance companies find it easiest to leave . What is the potential for outsourcing the hub of conversations and move to sub-tasks to Mumbai from other venues with lower-cost labour, since their s? trades are driven by computerised data . What does India need to do to succeed processing and not conversations amongst with an outsourcing strategy involving humans. But even in this field, London Mumbai or any -enabled Indian city and New York have crucial advantages. immediately in global provision? Securities markets are extremely effective at consuming publicly available data and . How can an outsourcing strategy be used rapidly incorporating it into the price of a to lead to full-scale development contract (owing to speculators all over the in a short span of time? Or would an world who take educated risks based on this outsourcing strategy result in deferring data). Obtaining an edge in decision making, emergence of a fully-fledged by requires human judgment in planning the compromising its development because trading strategies which are implemented in of implicit or explicit non-competition computerised analytical and trading systems. arrangements between clients and Such judgment is concentrated in the human service-providers? capital hubs of s. In answering these questions, it has to 2. An outsourcing approach to be noted that India is already providing software systems development/maintenance IFS provision and IFC and management support to global financial development: Possibilities, firms, operating in almost all extant s, opportunities and pitfalls for ‘back-office’ operations. Increasingly, higher value processes are being outsourced An alternative approach to developing to India such as the financial analysis capabilities involves deploying ‘sub- of companies, stock market research, contracting’ or ‘outsourcing’. The success of credit rating research, etc. using the such an approach depends on the potential same standards, models and practices for breaking up the ‘stack’ of into that are used by major global securities different layers, and sifting out those tasks brokerages, related investment banks, as that require discretionary judgment, as well as the world’s principal credit rating opposed to those that can be driven by a agencies. Hard statistics about the scale well-defined process manual. of employment in Mumbai, of jobs Close examination of provision requiring finance domain knowledge, is hard reveals numerous sub-systems for which to come by. Some news stories suggest process manuals can be codified, specific a significant scale of employment that is activities can be outsourced, and the undertaking increasingly complex functions. technical performance of a sub-system can A Bloomberg column by Mark Gilbert be objectively measured. These sub-systems records significant movement up the value can be outsourced – using protocols now chain with more complex tasks being done well established – from any in the world in India. This is being done within the to India (not necessarily just to Mumbai ambit of major Indian service providers but to any city that provides global as well as the captive processing centres support services). Understanding the role owned and operated by major global s that can play in production, then, such as Citibank, Deutsche Bank, , reduces the policy-making conundrum to , some global insurance companies and four questions: many others. . What can be done by way of provi- sion that is based on computer systems See http://tinyurl.com/yzpbqf on the web. 68 R M I F C
The question for Indian policy-makers markets (if they were permitted to) on level and financial firms interested in develop- terms and with a distinct cost advantage. ing -provision linkages through sub- Under those circumstances a continued contracting/outsourcing is not whether the relationship that did not offer the possibility models and systems already in place of complete absorption of the Indian firm (between global financial firms and Indian by its global partner would only result in service providers) can creep up the value continuation of the forced ‘marriage’ being chain. Of course they can; and they will. But of more net benefit to the Indian partner (in will that result in developing full-fledged terms of access to learning and increasing capabilities in Mumbai? Probably not: competitiveness) than to the foreign one. unless Indian financial firms (rather than Those conclusions have an important firms) organise themselves into being implication: i.e., that: (a) established global sub-contractors, service providers or part- financial firms already acknowledge both the ners to global financial firms. That would significance of the Indian market in global need to be done under contractual arrange- terms, and (b) the innate capability of Indian ments that enabled them to graduate into financial firms to compete in it. Indeed the providing services on a fully-fledged faith of these global firms in Indian financial basis seamlessly through natural progression. firms appears to exceed that of India’s policy- It may require an entirely different approach makers and regulators. to outsourcing and different relationships with extant global providers through 3.A BPO opportunity: Asset the three s. management in Mumbai In looking at that possibility, policy- based on algorithmic trading makers and financial leaders in India need to understand why global financial firms An increasing proportion of the trading (. Merrill Lynch, Goldman Sachs, strategies of major global financial firms can J.P. Morgan Chase, Barclays, Natwest, etc.)– be classified as ‘algorithmic trading’. Such that entered India as joint-venture partners trading involves the translation of public with Indian firms (particularly in investment information into mathematical models that banking and securities markets) – are now compute orders that are placed automatically arranging amicable separations from their on the market for execution. There is, of Indian partners, and preferring to ‘go-it- course, a continuum in two dimensions. alone’. These joint-ventures, on the face To what extent does a human get involved of it, offered one possible structure and in decisions? And, to what extent is order venue for the Indian partners eventually to placement automated? In both dimensions, develop their own provision capabilities there are shades of grey. for the Indian market and beyond. What • The decision-making dimension: In the was the crux of the concern that led decision-making dimension, different these global financial firms to abandon trading houses have varying levels of those partnerships and retain their own automation. Some firms build complete brand identities within organisational and systems that analyse information institutional structures that they controlled and make decisions. Some firms build on their own rather than in partnership? sophisticated models that analyse data In the view of , some of whose and interact with humans. But the final members are s of the Indian partners decision is taken by the human. of global firms, these global firms probably • The order-placement dimension: Sim- felt that: (a) the Indian market was too ilarly, there are shades of grey on the large and globally significant for them to extent of automation for order place- share the returns from it in perpetuity with ment. Some firms build systems where partners they were forced to ‘marry’ to enter sophisticated quantitative information India; and (b) their Indian partners had the processing drives the thought process, innate ability to compete with them in global but the actual order placement is done . Augmenting IFS provision via BPO 69
Box 5.1: Algorithmic Trading () and Direct Market Access () From the late 1980s onwards the phenomenon orders give greater liquidity and greater resilience of of algorithmic trading (AT) has become increasingly liquidity. prominent in international financial transactions. At Contrary to popular perception, the computers first such trading was viewed as an exotic side involved in AT do not continuously make rapid show. But it now occupies centre-stage: to a point trades or run amok without any human supervision. where 80% of the NYSE turnover now comes from On the contrary AT systems are intensely monitored AT. In the case of the Chicago Board Options and controlled by humans and exchanges. As an Exchange (CBOE) the proportion of business example, in doing cash-and-carry arbitrage, the role accounted for by algorithmic trading is even higher. of the human is that of choosing which traded AT represents a fusion of human traders and products to monitor, setting the cost-of-carry computers where the role of the human input shifts parameters to be applied when comparing the spot away from executing trades to instructing the and the futures prices, handling special situations computer on how to place buy/sell trades. such as close of market or futures expiration dates, Computers excel at repetitive work; i.e., at the task and applying a manual override when the system of processing vast amounts of information using misbehaves. pre-defined rules. AT consists of providing electronic market exchange feeds and news feeds into a In the options market, “auto-quote” systems are computer simultaneously. The computer is particularly important, given the large number of controlled by a human decision-maker. But it listed option products. As an example, on the NSE, processes all the data it receives in real-time and there are 9,000 different traded options. It is places buy/sell orders on the exchanges it is impossible for humans to monitor all these connected to and receives price information from. products. Computers excel at interacting with a human manager, computing a fair price for every The connection between the AT system to the traded option, and performing market-making exchange is through Direct Market Access (DMA). functions on the options market. The human The sophistication of the algorithms in use is manager with such an auto-quote system infuses limited only by human imagination and by liquidity into a vast array of options, and runs an mathematical modelling capacity. At their simplest, options book. The overall risk of the book is then algorithms can scan the spot market and the laid off using the futures market using futures market simultaneously, looking for delta-hedging or other dynamic trading schemes. violations of the cost-of-carry mathematical model. If a situation is found in which the futures price In India today, the absence of such sophisticated exceeds the fair price, the computer immediately systems is a key factor explaining the poor liquidity swings into action buying the spot and selling the of the options market, since human traders are future. This is an equilibrating response, one that simply unable to produce liquidity in all 9,000 brings the spot price and the futures price back into traded options. alignment. Computers are inherently superior, For the last quarter century, a debate has taken when compared with humans, at relentlessly place world-wide about the relative efficiency of the scanning the prices of a vast range of contracts on exchange as a way of organising financial trading; a large number of futures and spot markets and at as opposed to the over-the-counter (OTC) market. responding to a mispricing within milliseconds. A In some areas, OTC markets have been unusually market with computers watching for mispricing, successful, such as in the currency forwards market. and undertaking the arbitrage transactions needed In recent years, the rise of algorithmic trading has to eliminate it, is much more efficient than a market re-emphasised the importance of the exchange as a where this task is done in a labour-intensive way. venue. OTC trading is extremely labour intensive; it In London and New York, hundreds of the best involves humans talking to one another, which is mathematical minds in the financial industry are expensive and time-consuming. Minutes if not continually at work analysing historical data and the hours are taken by humans to do what computers performance of extant AT systems. They are can do in milliseconds. In addition, humans are constantly improving the models and the thought more error-prone. It is therefore simply impossible process that drives such trading. There is a to obtain the cost efficiency, enhanced liquidity, and continuous process of analysis of past performance, enhanced rationality that comes from plugging an learning, and innovation leading to building better algorithmic trading into an OTC market. This is one and better AT systems all the time. of the reasons for the significant gains in market share of exchange-traded derivatives, and AT systems are not just liquidity consumers – particularly the growth of currency futures, in the placing orders into an existing order book. last five years. Computerised algorithms can also place limit orders. Algorithms are able to patiently place and revise The prospect of fully automated computerised thousands of orders, even when only a few turn trading systems without human intervention raises into trades, in a way that would exhaust human fears on the part of many mathematically traders. Through this, AT systems tend to drive up unsophisticated people, who worry about a the number of orders processed by an exchange per Frankenstein that can run amok and destabilise the trade matched at the exchange. In return, these market. It is often claimed that the October 1987 70 R M I F C
Box 5.1: continued.. crash in the US was caused by such trading it is now possible to handle enormous spikes international finance circles that the systems. The Committee debated these in the order flow and incorporate into AT algorithms are a force in favour of liquidity issues at length and agreed on the following models much greater variations in prices and stability. Their absence causes illiquidity positions: (1) Just as an individual human caused by one-way herd instincts. and instability because the algorithms work trader can make mistakes and lose money, ceaselessly to analyse information, trade and one computerised trading strategy can make In that sense 1987 provided a profound thus supply liquidity, while humans often mistakes and lose money; as with thinking learning experience that was on the whole back away irrationally from placing orders at about human traders, this is not a policy positive for the lessons it taught. Despite the times of market stress when emotions come problem as long as there are a large number fears and spectre of doom that it raised, in into play. Human traders are more likely to of market participants with no one market the aftermath of 1987, AT has only become suffer fear and panic; whereas computerised participant possessing market power more important all over the world. It does AT systems are relatively free of such human (2) Whether human or computerised, all not seem to have induced any new problems failings; they are able to objectively analyse trading strategies are subject to position although AT driven volumes are hundreds of information, and continue on with their limits and margin requirements. (3) Shifting times larger now than they were then. The work of making markets efficient even in from human traders to algorithms changes evocative mental image of one Frankenstein times of market stress. nothing in terms of compliance with the risk computer running amok and destroying the From an Indian policy perspective, the key management system; the computer is only a foundation of global finance is as fictional as argument that the HPEC would emphasise is highly efficient clerk responding to the rules it is inaccurate. The reality is the opposite that AT based on DMA provides a unique programmed into it by humans.. when hundreds of different AT systems, all with different trading preferences, opportunity for India. Whether we like it or The October 1987 crash was indeed parameters and ideas, are competing with not, all IFCs now have prolific AT. It provides related to relatively primitive systems (by each other and trading with each other in an extremely remunerative entree into the today’s standards) at the NYSE being unable the global finance market place. No one global IFS business where India can play an to cope with the sheer number of sell orders trading system is disproportionately important role, even without making coming in over computer networks outside important. The biases of one AT system are progress on local problems of financial or established price parameters incorporated likely to be offset by the counter-biases of urban governance or capital account into the models at the time (Kleidon and others. So even if a few AT systems suffer convertibility. Hence, it is particularly Whaley, 1992). But that was in 1987 – losses, others make gains (as is always the important for India to work on converting almost 20 years ago – when we did not case when there is a buyer and seller Mumbai into an internationally respected know what we know now. Computer whether human or not). Therefore they do centre where the world’s best financial systems have become perhaps 1000 times to not affect the market as a whole. engineers and computer engineers – who 4000 times more powerful between 1987 build and manage AT systems – are to be and 2007. With modern computer systems, Indeed, the argument is now made in found.
by humans. Other firms build systems through , so India might be losing half where the system interfaces directly or more of potential order flow by erecting with exchanges and orders are placed by regulatory barriers to . Such barriers the machine. are costly for India given the unique role of algorithms in improving market efficiency, All this appears exotic in the present and fostering liquidity at moments when Indian context, where algorithmic trading human traders are thrown off balance. using Direct Market Access () is In terms of contractual structures, what banned with the exception of just one is often seen in established s is such (–) trading strategy: one-shot work being housed in a specialised asset futures arbitrage through cash-and-carry management firm. Assets thus managed or reverse cash-and-carry. staff read might flow in from a hedge fund, or from the computer programs of the trading house large institutional investors like pension to verify that this is the only strategy that funds, insurance companies, banks or is being used before permission to trade is mutual funds. But this is not the only given. This policy framework eliminates the possibility. Most large international banks possibility of developing proprietary trading have a quantitative arbitrage group either strategies for algorithmic trading. Such an housed within the bank as an affiliate or as a approach is out of touch with global reality. % captive subsidiary. There is no other country where regulatory From an / provision perspec- staff read the computer programs written by tive, India can host quantitatively orien- algorithmic trading firms. Roughly % of tated firms that analyse vast data feeds with the order flow into the now comes decision-making by computers. This re- . Augmenting IFS provision via BPO 71
quires high quality skilled labour in econo- economics. The second is labour cost of the metrics, quantitative finance, advanced highly sophisticated human capital inputs mathematics, and computer science. Access that account for the bulk of this business. to top-end staff of this nature, at present, is best obtained in a like London or 4. IFS subcomponents New York. However, it would be possible amenable to outsourcing for India to compete in this space based on low-cost but high quality human capital. The essence of an is the web of human There are two possibilities open to relationships and information flows which India for exploiting this opportunity (in lead to the best possible decision making which India could excel) regardless of capital when faced with complex problems where controls: judgment is required. This is the defining feature of s like London and New York. • As long as capital controls remain, such It might be the most difficult characteristic firms would be restricted to managing foreign assets, consuming information for Mumbai to replicate without the acqui- feeds from outside the country and sition of more knowledge and experience. sending orders back into financial That will take time, as well as openness to markets outside the country. Some firms importing sophisticated human capital with have established operations in India, the kind of experience and expertise that with a structure involving tax domicile in India does not, at present, possess. a tax-haven, raising funds in a number of However, computer and communica- s, and undertaking actual operations tions technologies are now making it possi- in India. ble to break down the production process of specific into sub-tasks, which are • When India removes capital controls, then done at locations around the world. this business will be transformed owing Consequently, an increasing number of to: (a) opportunities for obtaining assets sub-tasks are being performed outside es- for management within the country and tablished s. These include customer call (b) opportunities for sending orders centres and direct selling, accounting, back back into Indian financial markets. office processing, software development, sys- This would benefit India in three ways: tems administration, data processing, re- these finance firms would be more search, etc. viable; Indian assets would be managed What makes outsourcing possible is more professionally; and Indian markets codifying the task that has to be performed would obtain global order flow. in a process manual defining how it will be Consuming public information and performed. A global financial firm operating sending orders back into exchanges is a in an has a financial incentive to identify highly competitive business. Every trader tasks that can be outsourced at a lower cost. and every financial firm has the identical Firms in Mumbai are well placed to bid for information set. Yet some firms believe they and win such contracts given the low prices can obtain an edge by faster and superior of labour with adequate skills and finance processing of information. A large number domain knowledge. This process is already of high people, along with a very large underway. Some sub-tasks of are simple mass of capital sourced from banks and and require no domain knowledge. These hedge funds, strive to obtain supernormal can be easily performed at low-cost returns through such strategies. Algorithmic centres like Jodhpur or Chandigarh. Other trading is therefore a highly competitive sub-components of production require field. There are two possible sources of greater domain knowledge in finance. It competitive advantage. The first is original is in performing these tasks that Mumbai ideas in how to process the information has an edge that overcomes the labour cost available and imagine which trades would advantage of Jodhpur or Chandigarh. be profitable: this is shaped by high-end There is a direct relationship between intellectual capacity in modern financial increasing sophistication in Indian finance, 72 R M I F C
Table 5.1: What is happening in Indian finance through BPO?
Value chain Business process Technology
Research Equity research Capabilities in building research tools and Credit research portals
Execution Trade allocation Capabilities in delivering global execution platform
Settlement Settlement instructions Experience in different messaging protocols, Cash operations infrastructure and converters Cash management Electronic payments Risk management Risk modelling Creating and supporting information systems and management for risk management
Data management Data setup Experience in data quality and practices, including analysis of market data
Reconciliation Reconciliation Nostro reconciliation. Position reconciliation
Fund processing Manage payables/ Development and maintenance of fund receivables processing applications
Corporate actions Development and maintenance of corporate processing applications
Source: Infosys Technologies
and India’s ability to win outsourcing highly skilled labour with finance domain contracts requiring higher value addition. knowledge. That requires a large number As Indian finance acquires greater sophis- of postgraduates – masters and doctorates tication in risk management and trading – in economics, mathematics, finance and derivatives, it will create a larger pool of computer science. All four are areas in which qualified human capital in these fields. That Indian output of high quality graduates is will result in more risk management tasks woefully inadequate. While India’s labour being outsourced to India. The disadvantage force is internationally acclaimed, there are of outsourcing, from a strategic perspec- important gaps in education that need to be tive, lies in low price realisations. Once an redressed. sub-task has been codified, and the ini- Specifically, formal education in eco- tial cost-saving allure of out-sourcing has nomics and finance is inadequate. At present, subsided, the outsourcing contract will be there is no programme in India offering a Master of Science in Finance or a Master of opened up to competitive bidding. This Science in Computational Finance. These will result in a price close to long-run av- two degrees are of crucial importance in the erage cost. Prices will be cut to the bone labour market for analytical finance jobs. through global competition. India will get On the international landscape, top univer- high billing rates in comparison with Indian sities in the and that have a strong per capita income. But the much larger rev- economics department and a strong math- enues and value-addition generated in an ematics department produce doctoral stu- will remain elusive. dents in quantitative finance who enter the top end of the financial labour force. That 5. Making progress along two has not yet happened in India where there paths: IFC Evolution and is no world-class university that has a good BPO mathematics department and a good eco- nomics department together in the same The key feature of the evolutionary opening place. up for an and the path – , Mumbai, and some whether for outsourcing or quantitative fund of the other free-standing quantitatively, management – is that they both rely on mathematically orientated research institutes . Augmenting IFS provision via BPO 73
around India could be built up into such labour market with relevant skills, and a institutions. But they would need to set of employees able to network with each have: (a) leadership vision; (b) complete other. The development of skills would be independence of operation that is not further facilitated if restrictions on circumscribed by their funding sources; were eliminated to put India on par (c) an adequately funded corpus to attract with other countries. Skills development by and retain the best faculty at globally local firms engaged in quantitative trading competitive wages; (d) incentives to develop would improve the viability of Mumbai cutting edge research programmes in as a venue where such activities could be financial derivatives and develop state-of- located. Electronic trading and are the-art trading strategy algorithms: (e) the easily implemented in the equity spot and right global partnership arrangements derivatives markets, and commodity futures with the best institutions in the area of exchanges. Reforms in the debt and currency quantitative finance from abroad such as markets that lead to successful electronic Wharton, Chicago, Stern, and , for exchange platforms will help augment the example. This turnaround in otherwise scope and knowledge with quantitative moribund institutions could be achieved trading firms. quite easily and swiftly if the political and In sum, there are two things that administrative will needed for the purpose India should do to foster an agenda were exercised. The Indian (and global) of using high-value outsourcing as a financial sector would fund and support means of preparing capabilities on such institutions enthusiastically; if for no a fast-track. First, it should attach other reason than because they would be the great priority to the development of an principal beneficiaries of their human and elite, high-skill labour force with masters research outputs. and doctoral programmes in economics, There is a considerable flow of knowl- mathematics, quantitative finance, and edge across three financial domains: do- computer sciences. Second, it should mestic finance, outsourcing, and quanti- adopt regulatory attitudes and policies that tative fund management. All three draw induce and encourage, rather than inhibit upon a common labour force. The learning- and discourage, sophistication in domestic by-doing that takes place in these areas is finance. That would automatically increase pertinent for all. Hence, increasing the the pool of qualified labour with relevant sophistication of domestic finance would domain knowledge. One specific control improve the quality of the financial labour which particularly needs to be removed, as force. It will engage in learning-by-doing in part of a quest for sophisticated finance, is response to demand for more sophisticated the ban on . skills. For example, despite the profound weaknesses of graduate education in finance, 6. Conclusion India has one of the world’s most respected The expansion of in India is a positive equity derivatives markets. This came about development that can exploited to advantage through learning-by-doing assisted by ’s in strengthening symbiotically the attempt mandatory certification program. to create an in Mumbai. Some kinds of In the quantitative fund management , involving low skills, are irrelevant for arena, which is a specific area of opportunity that purpose. Owing to cost factors, these for India, the goal should be to create are not already performed in Mumbai but in an ecosystem of a hundred operational other low-cost centres across the country. firms applying such an approach, located However, an impressive array of tasks that in Mumbai. This would lead to a fluid requires finance domain knowledge has already come to India. These tasks are Many research articles, such as Lucas (), have performed in Mumbai where specialised emphasised the role of learning by doing in the context domain knowledge exists. A synergistic of a competitive and globalised economy, rather than formal education, as being of decisive importance in feedback loop now results in Indian finance the process of economic development. creating specialised human capital; it attracts 74 R M I F C
to Mumbai and further enhances the While the continued development of quality of human capital. A two-way flow in finance is a positive feature that is of highly skilled people between domestic supportive of the development of an in finance employers, and employers, is Mumbai, winning high-value contracts already taking place. in financial services does not necessarily High-skill work done in Mumbai result in creating an . The real value in enhances its prospects of becoming an production lies in areas where creativity . It gives Mumbai prominence in the and judgment are required. India’s sights minds of senior decision-makers in global need to be set higher than relying on more financial firms. That strengthens India’s revenues. These are infinitesimal ability to attract such firms into other compared to the revenues that could be activities in Mumbai. It enhances derived from creating a successful . That the development of greater skills and requires a policy approach quite different induces a more international outlook on from Mumbai being promoted as a host for the part of Indian staff, whose knowledge of higher value-added . global capital market opportunities would The only sub-component of the overall otherwise be more limited. universe, where distance is not an With telecom reforms there are no insuperable impediment to capturing full impediments to the growth of other value from such services, is algorithmic than rising labour costs and labour skill trading. It is an area in which India could shortages. Through finance-related , participate immediately in the global the skills of the financial labour force in marketplace with a pure model, even Mumbai are being deepened. But further if India makes no progress on regulatory development of hinges on two factors. difficulties of the local market or on capital controls. The universe of algorithmic • First, India needs to create an elite labour traders comprises firms that consume force in quantitative finance. That is vast quantitative data feeds, analyse them lacking in Mumbai at present. London through algorithms, and automatically place and Mumbai have a similar number buy-sell orders on the world’s exchanges. of individuals – roughly one million This activity is the least firmly anchored – engaged in providing financial services. in existing s, since the conduct of But the knowledge of London’s labour such business does not require the human force (augmented by easy immigration interactions that can only be found at an in filling skills that are domestically in . short supply) is vastly superior. Hence, is an area in which • Second, a programme of financial sector India can make early progress in attracting reform, leading to greater sophistication global financial firms to establish operations. of domestic finance, would enhance India’s growth in this area will be assisted further the quality of skills through by operations in existing financial on-the-job learning. India’s success in exchanges that trade in equities and creating an equity derivatives market has commodities. It will facilitate progress in led to a large labour force that can do bringing currency and fixed income trading equity derivatives arbitrage. India’s lack to these exchanges as well. A key goal should of a liquid and efficient bond market for be to have about hundred international sovereign, sub-sovereign, supranational firms operating in Mumbai. That and corporate issues, has led to the lack can commence even with capital controls, of a labour force that can arbitrage the though deriving the full benefits for India yield curve. would require their removal. Market deficiencies in Mumbai that inhibit the provision of IFS
1. The context in which India is not a small entrepot economy Mumbai must develop and like Dubai or even Singapore; although it is a much poorer one in per capita income evolve as an IFC terms than both. It does not need an to c h a p t e r This chapter aims to provide a strategic diversify from dependency on oil income. perspective on some interrelated questions: Nor does it have any other dependency that (a) what kind of should Mumbai limits its diversification alternatives. The strive to become? (b) How should its Indian economy is deep and immensely capabilities relate to those of its diversified in the production of goods and 6 domestic financial system; (c) What market services. India needs an because it is a deficiencies inhibit Mumbai in becoming an growing global powerhouse. It is already one ? (d) Which institutional deficiencies of the four largest economies in the world prevent financial markets in India from in ‘real’ purchasing power parity () functioning as they should? (e) Do these terms. It will achieve the same rank by deficiencies compromise prospects for a in nominal terms. By the middle of successful – rooted in the domestic the st century India will be the world’s financial system – to emerge? second or third largest national economy, First, therefore, this chapter looks competing only with the and China at the obvious gaps in the market and on the world stage, having surpassed the institutional structures of Indian finance; individual economies of Europe (but not viz. seen specifically from the viewpoint of the as a whole) and Japan. By the end of provision and export of globally competitive the century, India may well be the world’s . If the provision and export of largest and most powerful economy in size from Mumbai were to capitalize on the though not in per capita income. inherent capability of the domestic Indian In that context, for Mumbai to become financial system – and, by the same token, the kind of that India needs (as opposed be compromised by its weaknesses – where to the kind of that developers do the most important gaps lie and what has might wish to promote) it must start out to be done to fill them? What are the main and develop properly. It must do so in a way priorities? that does not at any time compromise its By way of a necessary but brief prospects for becoming like, and competing digression, it must be noted that posing this with, newer s like Singapore, or even question precludes an in Mumbai that established s like London and New York, is either initially or eventually an artificial in the provision of to its extant national, annex, affixed opportunistically, to the and its latent regional and global clientele. domestic financial system. In other words These are the benchmarks that Mumbai an in Mumbai should not be an . must aim to target from the outset. It must Nor should it be like the that does not not be seduced to emulate the easier targets relate to the wider economy. Those of Dubai or Mauritius simply because those models of de-linked s are inappropriate models are quicker to kick-start, or conform for India. better to an -based model. 76 R M I F C
To achieve its destiny, there is no option Every customer generates immediate other than for Mumbai’s capabilities to transactions on the currency spot (and be rooted in its domestic financial system possibly derivatives) markets even if he/she – in the same way as New York, London just buys Indian equity shares, bonds, (representing the rather than the ) country index funds, index futures or and Singapore (for the wider A bloc). options. Furthermore, every successful Given that reality, the only sensible is a centre for global currency trading. In choice for Indian policy-makers is to focus the absence of currency trading, a country on deregulating, liberalizing and unleashing cannot have a ‘real’ . Currency trading the domestic financial system in the rest of services, sold by Indian markets to national, this decade, in the same way that India’s regional and global customers, are an manufacturing and trading sectors were essential ingredient in the creation of a liberalized and unleashed in the previous functional Indian in Mumbai. one. A Mumbai-based that is rooted Similar considerations surround the in a large and efficient domestic financial domestic bond market. Before too long, market, and that operates on global lines, the will be one of the six most traded is likely to be more successful and useful currencies (i.e., the , , , , to India and the world, than one that is a and ) in the world. International mere artifice created to indicate movement bond issues, sovereign and corporate, will rather than commitment. In creating an be denominated in these six currencies. In the Indian authorities would make a many cases, global issuers will probably want serious mistake if they were to repeat the to issue and trade debt securities in all of experiment of failed offshore banking units them. For an in Mumbai to succeed (s). it will be essential to attract global issuers In contemplating the emergence of and investors into the Indian bond market. Mumbai as an , one has to envision An appetite will need to be created and movement towards the removal of capital expanded on the part of global investors for controls, on a purely hypothetical basis at denominated bonds issued by domestic the start. But, assume for a moment that and foreign, public and private, entities. capital controls were out of the way: Would This will require a liquid and arbitrage-free strong revenues immediately emanate from yield curve, backed by interest rate and exports of financial services? Or, even with credit default protection derivatives of every the removal of capital controls would there kind. be structural deficiencies and institutional The use of the in global markets gaps in the financial markets that would for bond issuance, portfolio trading, and impede the export of ? The purpose investment necessitates an active market of this chapter is to answer the question: for all bonds issued by every type of If India had to sell services in global issuer, with an even more active market markets today, and capital controls were not for credit derivatives tiered on top. These an issue, what are the other key deficiencies essentials – the yield curve and interest rate of the existing financial system that would derivatives markets and the currency spot prevent this from happening? and derivatives markets – are inextricably bound together by arbitrage. The currency 2. Inadequate currency and forward curve is but a reflection of interest bond markets (BCD Nexus) rate differentials. A plethora of arbitrage and speculative trading strategies fuse the The most important deficiencies that India currency and debt markets. must overcome, in developing its domestic financial market and moving towards an For a treatment of the problems of bond markets , lies in the absence of efficient, liquid, in Asia, see Eichengreen (). currency and bond markets. Transactions Arbitrage is well understood to be the foundation and cornerstone of market efficiency. As Shleifer and on currency spot and derivatives markets Vishny () have famously pointed out, quasi-infinite are, by definition, the lifeblood of an . capital in the hands of arbitrageurs cannot be taken for . Market deficiencies in Mumbai that inhibit the provision of IFS 77
Box 6.1: Indian Experience with Offshore Banking Units (OBUs) In the Exim Policy of 2002–07, the reserve requirements. In India, OBUs are of units in the SEZ. OBUs can get foreign Commerce Minister announced that, for the exempt from CRR requirements; but they are currency deposits of non-residents, including first time in India, OBUs would be permitted to not ordinarily exempt from the SLR non-resident Indians, subject to KYC guidelines. be set up in Special Economic Zones (SEZs). requirements (except ICICI Bank that was given However, deposits of OBUs are not covered by Accordingly, RBI formulated a scheme in special treatment for 3 years). Profits of OBUs deposit insurance. OBUs can invest their funds November 2002 that was implemented with are not taxable for the first 5 years of overseas and they can trade in foreign some modifications in 2003. However, the operations. Although no separate capital is currencies abroad. OBUs are not treated as scheme implemented is not an OBU in the required for OBUs, the parent bank is required foreign branches in all respects. They do not usual sense of the term. In RBI’s scheme OBUs to provide a minimum of US$10 million to its enjoy the benefits that OBUs do in other are ‘SEZ Banks’. They are only permitted to OBU as start-up funds. All prudential norms countries. For example, OBUs in India cannot serve customers in an SEZ or lend to SEZ applicable to overseas branches of Indian lend overseas nor participate in international developers. banks would apply to the OBUs. OBUs in India, syndications or consortia at par with foreign as in some other countries, are intended to offices. They cannot finance overseas The SEZ, aimed at promoting internationally competitive exports, is a duty free enclave, carry out wholesale banking operations acquisitions. They cannot even fund third deemed to be foreign territory for the purpose dealing only in foreign currencies. An OBU can country trade. of trade operations and duties/tariffs. The meet the foreign currency needs of corporates in the domestic tariff area (DTA) but only under OBUs are like foreign branches of banks At present, there are about a dozen SEZs in operating in India but located in India. Any the scheme of external commercial borrowings the country and half a dozen banks have set bank authorized to deal in foreign exchange (ECBs); i.e., only for term loans with a up OBUs. At SEEPZ Mumbai, the banks that minimum maturity of 3 years, and up to a can set up an OBU in a SEZ. Banks with have set up OBUs are SBI, ICICI, PNB, BOB, and overseas branches and experience of running maximum of 25% of its total liabilities. OBUs UBI. At NOIDA, Canara Bank has set up an OBU. are prohibited from undertaking cash OBUs are given preference. This differs While data are not available on the total size transactions. considerably from the notion of an OBU of OBU operations, the scheme has not outside India. OBUs in countries such as Their sources of funding must be entirely induced export of IFS. The OBU experiment, Singapore and Bahrain have lighter regulatory external, other than the initial support from limited to SEZs, is regarded by the banks with obligations for minimum capital, taxation, and the parent bank and foreign currency accounts these licenses and by users as a damp squib.
These relationships are summarised rapidly in order to: attract local and foreign in Figure .. Speculation and arbitrage participation; have vibrant trading in spot (which are essential ingredients for ensuring and derivatives; have vibrant speculation and liquidity) in the three key markets – the arbitrage to guarantee liquidity. In the case bond market, the currency market and the of the yield curve, the defining issue is that derivatives () market – will integrate of attracting foreign issuers and investors tightly the yield curve, Indian credit into the yield curve. quality curves, and foreign yield curves such The absence of these three markets is as those in the , , , and . a key impediment to an emerging in Once these informational relationships Mumbai today and offering the basic range are in place, with three liquid and efficient of . At present, these markets have fun- markets, they will set the stage for five damental problems. Institutional structures flows: i.e., from two types of foreign issuers are weak. Liquidity is poor. There is no (governments and corporates), from two width or depth. Participation is artificially types of foreign fixed income investors (in constrained through a number of eligibility and origin barriers. Speculative price dis- government and corporate bonds), and from covery is lacking because arbitrageurs and global customers of currency trading. For risk-takers – who are essential for providing these reasons, in creating an in Mumbai, liquidity, and binding these markets by en- the Indian authorities need to comprehend suring informational efficiency – are lacking. the challenge of developing the nexus – Their participation is discouraged. i.e., the bond market, the currency market, In that context, it is odd for Indian and the derivatives market (in interest rates regulators to regard risk-hedging through and currencies) – as an integral package selling futures as proper, safe and prudent, whose individual components cannot be while seeing buying futures as speculative de-linked. All three markets need to develop and harmful. How can counter-parties buy a future or option (deemed good granted. This suggests a special role for public policy in identifying and removing regulatory restrictions which and prudent) in a market if there is no inhibit arbitrage transactions. one to sell it, because it is deemed risky 78 R M I F C
Figure 6.1: Integrated markets for interest rates, currencies and credit risk
Foreign governments Global government issuing bonds bond investors
INR Foreign Riskless Currency Curve Curve
Foreign Currency Curve
INR Credit Curve Foreign Currency Curve
Foreign firms Global credit Global traders on issuing bonds risk investors currency markets
and speculative and therefore discouraged? takers will ensure that these two paths will The implicit value judgements made about yield borrowing at the identical all-in cost the desirability or undesirability of certain after currency and interest rate risks are types of activities or players by regulators covered. In an inefficient market, with in this regard need to be revisited and barriers to arbitrage they almost certainly revised. will not; instead they will increase exposure An example of the difficulties with to currency and interest rate risk (while the these markets in India at present lies in borrowing is outstanding) and will distort the most basic arbitrage relationship on the costs of hedging. the currency forward market: i.e., covered In India, the principle is persis- interest parity (). The principle tently violated (Figure .) to a point where requires that two alternatives for borrowing the deviation is utilised as a predictor should have identical returns: (a) borrowing of future currency fluctuations (Shah and in and using funds in India with Patnaik, , Forthcoming). For a com- a locked-in / exchange rate for parison, in mature market economies, the repayment in ; versus (b) borrowing size of the CIP deviation seldom exceeds in over the same maturity. In an basis points. The deviation in India efficient currency market, arbitrage by risk- points to hurdles in the way of arbitrage . Market deficiencies in Mumbai that inhibit the provision of IFS 79
transactions that induce in all mature Figure 6.2: Deviation from covered interest parity on the INR/USD financial markets. 25 Financial integration between the three elements of the bond-currency-derivatives 20 () nexus – i.e., the risk-free yield 15 curve, the currency market and the credit 10 risk market – is supported by other elements Percentage points 5 that go beyond them. The market for corporate bonds is, 0
in turn, tightly linked to the market 1998 2000 2002 2004 2006 for corporate equities. Indeed, modern financial economics sees the corporate bond and the corporate share as being two different derivatives written on the same tive judgments – even if crude and somewhat underlying assets of the firm (Merton, ). imprecise – in order to identify areas where The underlying assets of many firms are India is doing well and areas where it is weak. interlinked with commodity derivatives: The provides a good benchmark e.g., there is a clear relationship between comparison because it is (like India) a large steel futures and the shares/bonds issued domestic economy with primarily domestic- by Tata Steel. Finally, in an age of import focused financial markets where the parity pricing, there are tight relationships component is relatively small. In London between currency fluctuations and Indian the opposite is the case with its financial commodity futures markets. The larger markets being primarily global -focused. picture is thus one where there is full London does not serve as large a national financial integration, where speculative and economy as the although it does serve arbitrage strategies run across all kinds of a regional economy (the ) that is now financial instruments, inducing liquidity larger than the . The size of financial and market efficiency. markets in London is disproportionately In India’s present situation, consider- large in comparison with the size of the able progress has been made with achieving economy, but not against the size of the . organised financial trading for equities, eq- For that reason it does not provide as useful uity derivatives and commodity futures. a comparator for Mumbai. But the development of a concomitant An Illustrative Comparison: In nexus has lagged, though it is a pivotal ele- comparing India with the , two ratios are ment of the global market. Hence, any relevant: attempt to create an in India has to frontally attack the barriers that have held • In the Indian fiscal year –, back the emergence of the nexus. (in nominal dollars) was $. trillion. Indian at that time was $ billion. In other words the 3. Missing currency & economy was . times larger than derivatives markets: An India’s in nominal terms. illustration • On th October , the Russell , ‘Missing markets’ in currencies and deriva- a stock market index of , companies, tives are markets that either do not exist in which covers practically all equities India, or are so small as to be insignificant, listed, had a market capitalisation of when compared with the requirements of $. trillion. On th September , the global market for . In order to un- the -Cospi index of , firms derstand gaps in the range of traded had a market capitalisation of $ products where India has (or lacks) liquidity, billion. In other words total market it is useful to make normative and compara- capitalisation of listed firms was . times the size of Indian listed firms in See Thomas (, ). nominal dollar terms. 80 R M I F C
Table 6.1: Biggest futures contracts in the US by daily trading volume, with an associated illustrative Indian calculation showing one-twentieth this turnover
Rank US exchange Futures contract Turnover 5% of US turnover (USD bn. per day) (INR crores per day)
1 CME Eurodollar 1581.75 357,317 2 CBOT Federal Funds (30 day) 224.61 50,739 3 CBOT Treasury notes (10 year) 95.41 21,553 4 NYBOT Sugar #11 58.21 13,150 5 CBOT Treasury notes (5 year) 52.53 11,867 6 CME S&P 500 (mini contract) 50.10 11,318 7 CBOT Treasury bonds 39.79 8,989 8 CME Currency futures – Euro 21.52 4,861 9 CME S&P 500 (big contract) 18.60 4,202 10 CBOT Treasury notes (2 year) 17.57 3,969 11 NYMEX Crude oil 13.53 3,056 12 CMENASDAQ 100 (small contract) 9.05 2,044 13 CME Russell 2000 (small contract) 7.42 1,676 14 NYMEX Natural gas 6.90 1,559 15 CME Currency (Yen) 5.70 1,288 16 CBOT Dow Jones index 5.26 1,188 17 CME Currency (Pound) 3.98 899 18 NYMEX No.2 heating oil 3.62 818 19 CME Currency (Swiss Franc) 3.14 709 20 NYMEX Gold 2.83 639
These relationships suggest that, as a in Nifty futures. But, this one isolated case rule-of-thumb, by averaging these two broad apart, India lags substantially in every other multiples, financial stocks/flows in India respect: should be just under one-twentieth (or %) of the amount of those in the . It must be • The key interest rate contracts in emphasised that this percentage should not markets – Eurodollar futures, Fed funds be taken literally but illustratively. There will futures, Treasury notes (, and be contract-to-contract variations reflecting years), Treasury bond contracts – are all differences between the two countries. missing in India. However, the intent is not to isolate fine- • India has made a beginning with grained differences but to understand the commodity futures. Some of the dimensions of broad gaps. turnover numbers in India have crossed Table . shows the twenty largest the % threshold. But, as yet, these futures contracts in the . The turnover markets lack the regulatory credibility of each, measured in billions of dollars, required to attract national or global is shown. In addition, % of this turnover, customers. expressed in crores of Indian rupees, is also • India has only one successful stock index shown. This serves as an illustrative number contract – the Nifty. Other contracts which illustrates in broad brush strokes such as the Nifty Junior have yet to where the gaps in India lie. commence trading or obtain liquidity. The two S&P futures contracts on • The trading of currency futures is equities (a big contract and a small contract) banned in India. add up to a trading volume of $. billion per day of turnover; % of this The India/ crude comparative ratio of amount works out to about Rs. , crores : or % cannot, of course, be interpreted (or billion) per day. That is in the as hard and fast. The share of agriculture ball-park when compared with daily trading in Indian is larger than for the ; so Indian agricultural commodity derivative We are grateful to Michael Gorham and Poulomi contracts should have ratios of greater than Kundu of the Illinois Institute of Technology, Chicago, who constructed this information from primary sources %. In any row of the table, interesting at the request of the Committee. differences can be pointed out between the . Market deficiencies in Mumbai that inhibit the provision of IFS 81
and India where the ratio should be day at the . believes that only higher or lower than %. The main point when is at a point of doing such a daily of this table is to show the areas where turnover of $ billion a day will crucial there is a large gap when compared with the exchange-traded derivatives in India have normative ratio of %. liquidity that is competitive when compared Apart from Nifty futures, there are against global exchanges. important gaps in all rows. The premier With a number of critical missing derivatives exchange in the – the markets in bonds, currencies and derivatives, Group, which represents a merger of the Indian finance is operating in a setting where erstwhile and the erstwhile – the equity spot and derivatives markets are has a daily turnover (futures and options) the only financial markets that are liquid, of $. trillion a day: i.e., trading every day efficient and market rather than fiat driven. is valued at roughly one-third of annual This distorts the relative importance of . The premier exchange where the equity market for financial and non- derivatives are traded in India – the – is financial firms and for signalling. The well below % of this amount (which works supporting bond, currency and derivative out to $ billion a day). () markets either do not exist or are If India is to export IFS a normative mutations. In a properly functioning market goal of % of the market size of the US is economy with a responsive financial system, not good enough. Indian is growing when relevant news breaks, adjustments at a trend rate of per cent, while should take place instantaneously at myriad is growing at a trend rate of . per cent. places: i.e., in currencies, interest rates, credit Taking that into account, within years the spreads and stock prices. In India, the brunt multiple of will be replaced by a multiple of adjustment to all news is concentrated of . Or, inversely, from % of contract in equities. That has probably resulted equivalents in nominal terms, Indian values in excessive volatility in that one market will come up to .%. From an / because the other markets needed to share perspective, however, a market size in India the strain do not exist or function as they that is merely % or % that of the should. is not sufficient for entry into a globally Similarly, the differences between competitive market. If India had an a modestly functioning equity market, - futures market that was only % and other dysfunctional and undeveloped the size of the - futures market at financial markets (in particular the bond the Chicago Mercantile Exchange, the market), have led to a situation where equity business that would come to India for this financing (internal and external) dominates contract would be zero. the financing of firms and distorts efficient Purchasing power parity () trans- resource allocation and use. In –, lations are made by economists because the market value of equity for all large nominal exchange rates do not reflect real- firms in India stood at Rs. . trillion. ity. A reasonable rule-of-thumb that India Their total debt stood at only Rs. trillion. should utilise for the desired size of an In- Under normal leveraging that figure should dian financial market, from an IFS export have been closer to Rs. trillion. Thus, perspective, is % of the size of a compa- on a market value basis, the debt-equity rable US market, and not %. That would ratio of corporate India stood at just . reflect economic reality more closely by re- (Thomas, ) or about a fifth of what moving the distortions of an exchange rate it should have been. That represents a that does not reflect the ‘real’ size of the phenomenal degree of inefficient under- Indian economy in comparison with the . leveraging, and a distortion of returns Applying such a adjustment, it would between equity and debt, than would be stand to reason that if the Group does expected in a more efficient market economy $. trillion of derivatives turnover a day, with more balanced debt and equity markets. India should have about $ billion (or This domination of equity financing in Rs. trillion) of derivatives turnover per corporate finance reflects in part the rational 82 R M I F C
choice of minimising leverage on the part of markets in the country lack speculative firms faced with considerable uncertainty price discovery given the constraints of and crowding out by government debt. But it institutional investors and the lack of non- also reflects the differential pace of progress institutional participation. in the development of the equity and debt One strategy for India would be markets. to replicate the features of its equity market in other financial markets: i.e., 4. The market weakness of harnessing non-institutional participants institutional investors to induce liquidity and market efficiency. Non-institutional investors are a powerful The other weak link in Indian finance lies agent for driving market efficiency. Each in the relative incapacity of institutional participant is motivated, deriving the investors in India to be more responsive full profits or losses of his or her own to market-signals, to induce liquidity and actions. There are no principal-agent market efficiency, and to interface between problems that affect decisions made by India and the world. employees of financial firms. The actions of As far as mutual funds are concerned, participants are oriented towards rationality the regulatory framework in India and the and maximisation, and undistorted by behaviour of such funds as institutional regulators. So, this approach would work investors broadly reflects world standards. to some extent. But the imperatives But, at present, mutual funds have assets of creating a viable in Mumbai under management () of about requires going beyond this and building trillion or just % of . This is not large a wider, more diversified, base of ‘normal’ enough to influence overall price formation. institutional investors because they have The universe of other institutional unique advantages in certain respects: investors in India – i.e., banks, insurance companies, and pension funds – is • Institutional investors have the capac- characterised by too large a proportion of ity to build systematic processes of in- public ownership (and therefore prone to vestment analysis and decision-making directed, rather than market-responsive, that can be applied across millions of behaviour). There are barriers to the entry transactions in different market seg- of a wider range of private financial firms as ments. Sophisticated, modern analytical institutional investors, coupled with many methodologies based on quantitative regulatory weaknesses. These constraints financial economics can be embedded coalesce to make a considerable difference into these processes. Institutional par- between the role that market-responsive ticipants can engage in unique market- institutional investors normally play in efficiency-enhancing trades when such mature market economies and the role groundwork drives their decision mak- that (mainly publicly owned) institutional ing. investors play in India. • Institutional investors can marshal pools The achievements of the Indian equity of capital that individuals cannot match. market in building speculative price India is a large economy. Institutional discovery have been driven primarily by investors are the only channel through non-institutional participants, with only a which the large mass of savings of supporting role played by mutual funds the economy can be brought to bear and s. The equity market reflects in financial markets to induce greater a unique situation in India. Financial efficiency and liquidity. Only a tiny repression was absent in that market. The fraction of the country is presently able government did not have much overt to participate directly in markets. The involvement in influencing prices (except assets of most households, and thus the when was the dominant mutual fund opportunity for India to use its huge and responded to government direction) and size in order for Mumbai to succeed as there were no quantitative controls. Other an – will not come into play in the . Market deficiencies in Mumbai that inhibit the provision of IFS 83
Table 6.2: Comparing Mumbai against existing IFCs
Attributes, characteristics and capabilities of an IFC : London New Tokyo S’pore F’furt Mumbai (Scale of 0–10 with 0 = worst 10 = best) York
B. Supply factors for IFS: Markets, products & services B1. Full Array of international banking services for corporates and individuals 9 9 9 10 6 5 B2. Full Array of international capital markets, products and services 10 10 7 8 5 3 B3. Full Array of risk management services 10 10 5 7 6 2 B4. Full Array of insurance and reinsurance services 10 10 7 5 8 1 B5. Full Array of commodities markets, trading and hedging services 9 9 5 5 4 1 B6. Full Array of business support services for IFS (accounting, legal, IT support) 10 10 8 10 8 5
C. Institution/market endowments enabling range of IFS product/service offerings: C1. Range, width, depth of international commercial banks represented in the IFC 10 7 5 8 6 2 C2. Range of global, regional and national investment banks represented in the IFC 10 10 8 9 7 2 C3. Range of global, regional and national insurance companies represented 10 9 8 6 8 2 C4. Existence of wide and deep reinsurance markets 10 9 8 6 9 1 C5. Existence of global, regional, national equity markets (i.e., exchanges & support) 10 10 9 8 6 4 C6. Existence of wide and deep bond markets for government, corporate, other bonds 10 10 9 5 9 1 C7. Existence of wide, deep and liquid derivatives markets for: Equities and indexes 10 10 6 7 6 5 Interest rates 10 10 8 7 7 1 Currencies 10 10 7 8 8 1 Commodities 10 8 7 5 8 3 C8. Innovative Abilities of Institutions and Markets 10 10 5 6 4 5 D. Services offered D1. Fund Raising, Wholesale and Corporate Banking 10 10 8 7 7 5 D2. Asset Management 10 10 8 9 6 4 D3. Private Banking & Wealth Management 10 7 5 7 5 2 D4. Global Tax Optimisation & Management 6 5 3 8 4 1 D5. Corporate Treasury Management 10 10 9 8 8 4 D6. Risk Management 10 10 7 7 6 2 D7. Mergers & Acquisitions: (national, regional, global) 10 10 6 5 5 3 D8. Financial Engineering for Large Complex Project and PPP Financing 10 10 8 7 6 3 D9. Leasing & Structured Financing of Mobile Capital Assets (ships, planes etc.) 10 10 9 9 10 2
financial markets without considerable liquidity is limited to a maturity of one strengthening of institutional investors. month, and at-the-money options. In the derivatives market, liquidity for • Institutional investors – both domestic options lags futures liquidity by too wide a and foreign – are likely to have a margin. While turnover in Nifty derivatives unique edge in intermediating between is impressive, the overall health and structure India and the world. International of this market leaves much to be desired. finance involves greater complexity A good case could be made that many of and new kinds of knowledge than the problems of Nifty derivatives would are reflected in the capabilities of be resolved by having an adequate mass of extant non-institutional participants institutional investors, with sufficient room in India. If institutional investors are for manoeuvre, so that they could perform faced with enough competition, there their proper role as they do elsewhere in the arise the possibility of their building the world. It also indicates that banks should needed quality of human capital and the be more involved players in the derivatives analytical processes required to perform market especially if it offered interest rate such roles. and currency derivatives for hedging their The Nifty derivatives market – justly debt portfolios. portrayed as a success with the creation of a In summary, the most successful parts genuine financial market characterised by of Indian finance at present are those speculative price discovery, and free play of in which non-institutional participants hedging and arbitrage strategies – still has have engaged in rational, undistorted, residual weaknesses. Mispricing persists in speculative price discovery. This large that market (Thomas, ). Significant mass of retail participants in sophisticated 84 R M I F C
Table 6.3: Comparing Mumbai against emerging IFCs
Attributes, characteristics and capabilities of an IFC: Mumbai Hong Kong Labuan Seoul Sydney Dubai (Scale of 0–10 with 0 = worst;10 = best)
B. Supply factors for IFS: Markets, products & services B1. Full Array of international banking services for corporates and individuals 5 7 4 6 7 6 B2. Full Array of international capital markets, products and services 3 6 2 5 7 5 B3. Full Array of risk management services 2 5 2 5 6 5 B4. Full Array of insurance and reinsurance services 1 5 0 3 5 2 B5. Full Array of commodities markets, trading and hedging services 1 6 2 5 6 2 B6. Full Array of business support services for IFS (accounting, legal, IT support) 5 8 5 5 8 6
C. Institution/market endowments enabling range of IFS product/service offerings: C1. Range, width, depth of international commercial banks represented in the IFC 2 7 5 5 7 4 C2. Range of global, regional and national investment banks represented in the IFC 2 6 1 3 6 4 C3. Range of global, regional and national insurance companies represented 2 6 1 5 6 3 C4. Existence of wide and deep reinsurance markets 1 3 0 3 4 1 C5. Existence of global, regional, national equity markets (i.e., exchanges & support) 4 5 2 4 5 2 C6. Existence of wide and deep bond markets for government, corporate, other bonds 1 1 0 4 7 0 C7. Existence of wide, deep and liquid derivatives markets for: Equities and indexes 5 5 1 5 6 2 Interest rates 1 3 0 4 7 1 Currencies 1 7 2 6 8 5 Commodities 3 5 0 4 6 3 C8. Innovative Abilities of Institutions and Markets 5 5 1 4 7 5 D. Services offered D1. Fund Raising, Wholesale and Corporate Banking 5 7 3 7 7 5 D2. Asset Management 4 9 4 6 6 8 D3. Private Banking & Wealth Management 2 9 6 4 5 9 D4. Global Tax Optimisation & Management 1 9 7 4 4 9 D5. Corporate Treasury Management 4 7 2 7 8 7 D6. Risk Management 2 6 1 4 6 3 D7. Mergers & Acquisitions: (national, regional, global) 3 5 0 5 5 4 D8. Financial Engineering for Large Complex Project and PPP Financing 3 5 1 7 6 5 D9. Leasing & Structured Financing of Mobile Capital Assets (ships, planes etc.) 2 9 5 5 5 7
financial markets is a unique edge that India have not yet been reached by these types of has when compared with established or investors. emerging s. But, a world-class cannot be built without private institutional 5. A cross-country comparison investors. Such investors bring special qualities through their participation in As has been done elsewhere in this report, we financial markets by: (a) using sophisticated have attempted an international comparison analytical tools in quantitative trading of Mumbai against established and emerging systems; (b) bringing enormous pools of s on a variety of metrics. A subjective capital into financial markets; and (c) linking classification has been made, where each city Indian finance with the rest of the world. has been scored on a set of measures on a India has established a solid beachhead with scale from to . institutional investors such as mutual funds As Tables . and . suggest, there is a and s. The regulatory strategies applied large gap between Mumbai and established in these two areas need to be deployed into as well as emerging s on a wide variety reaching those parts of Indian finance that of supply factors in the provision of . The macroeconomic fallout of an IFC
1. Introduction for becoming a by . But it also faces great challenges in realising As suggested earlier, two significant benefits that potential – in terms of financial would accrue from having an in liberalisation, urban infrastructure and c h a p t e r Mumbai that is rooted in a strong domestic governance. Mumbai will, at least, financial system: need to first become an like Paris, . Improvements in Domestic Finance: Frankfurt, Sydney and Tokyo – which Finance is the ‘brain’ of any economy. meet the needs of their national In India it mobilises resources for and economies – by . If it does not, India 7 allocates an investment-to- ratio will be buying over $ billion of of over % (roughly $ billion, or from abroad. But, if Mumbai becomes Rs. trillion per year as of ). It an , it can go beyond serving its ensures value-maintenance and risk national market and capture export management of debt and equity stocks revenues. The opening up of such a large (about Rs. – trillion) issued in the export-oriented sector would influence form of tradable financial securities. India’s growth trajectory; exports of Higher growth will result when the from India could be bigger than Indian economy is served by a better exports from India. financial system than the sub-optimal one it has now. The believes it is critical for The transformation in Indian manu- India’s development, to have a world facturing since shows that the best class financial system with -provision way to ensure that the local economy capabilities that can: (a) mobilise and gets top quality goods is to have them allocate private and public resources as pass the test of ‘export quality’. This efficiently as possible; (b) manage the risks logic applies equally to finance. India involved in optimising and protecting the can only produce world-quality financial value of its financial stocks; (c) ensure that services if it competes in and exports to financial stocks yield returns that minimise the global market for . At present, the risks of servicing those stocks; and India’s share of that market is zero, re- (d) export financial services to the global flecting the artificially restrained abilities economy on a competitive basis. of its financial sector. In comparison, In- That said, however, it is important for dia’s share of global merchandise exports the Committee to stress how mindful it is, had never dropped to zero, even in the of the macroeconomic and macro-financial worst policy environment of the s implications for the domestic economy, of and s. Creating an in Mumbai measures it believes need to be implemented is therefore of strategic importance to to create an in Mumbai. India needs India’s growth. to carefully avoid the mistakes of macro . IFS Exports: Like exports of services, policy in Mexico, Thailand, South Korea, exports are labour, skill and and Indonesia, so as to avoid the ingredients intensive. They constitute a natural which led to currency crises and banking global market opportunity for India. crises. Conversely, it is equally mindful of Of all the cities aspiring to become policies that militate against the prospect of s and s in the st century, creating a credible Indian . The policy Mumbai perhaps has the most potential implications that concern the Committee 86 R M I F C
most, impinge inter alia, upon: fiscal policy, The enactment of legislation by monetary policy, exchange rate policy, and the Centre and subsequently, following the capital account controls. These policies need recommendations of the Twelfth Finance to be considered by policy-makers for the Commission, by a majority of state simple reason that there is no economic or governments as well, reflects recognition financial policy or instrument that is not that this situation had to be rectified. double-edged. Progress needed to be made to reduce An advantage gained by some in the the beginning with reducing the pursuit of a particular policy for a particular deficit of the Centre. But, what is being purpose (like setting up an ) invariably achieved through is neither rapid nor results in a disadvantage suffered by others who may not be directly involved in economists) that fiscal deficits of over –% of benefiting from it. On balance, the question in any country are “undesirable, unfinanceable and unsustainable”. But India has managed to finance and is whether the sum total of the advantages sustain deficits larger than these proportions (ranging that accrue to the economy and populace from –% of ) for over two decades. The at large outweigh the sum total of the general view is that it has managed to do so relatively disadvantages or vice versa. successfully; without compromising its growth potential or creating too many distortions in markets that have It would be remiss of the Committee caused serious collateral damage. That, however, is a to omit mentioning, even en passant, what misleading impression. The indirect costs in terms of some of these implications might be when it financial repression and growth depression have been comes to what it believes needs to be done obscured and are unamenable to easy quantification. India has managed to finance its deficits at below- for an to emerge in Mumbai. This market rates through pre-emption. With the reforms of Chapter attempts to meet that obligation. , and a commitment to reducing pre-emption, that situation has been changing; but too slowly. Financing too large, and for too long, a fiscal deficit in this 2. Implications for fiscal policy manner has, among other things: (a) slowed down & deficit reduction and impeded the creation of an effective market for government and corporate bonds that operates along There is a strong connection between fiscal global norms and is open to global investors; (b) created stability and a healthy, efficient financial a bias toward a capital market that leans too heavily toward trading risk-paper (equity) without being system. Many of the problems faced by the balanced by coupon (fixed return) debt, thus preventing financial system in India owe their origins in investors from managing properly their exposure along part to: a risk-return matrix given their investment objectives; (c) crowded out more efficient private investment in the domestic market for decades; (d) put upward pressure * Fiscal policies pursued since the mid- on Indian interest rates; (e) created artificial regulatory s that have: (a) distorted the burdens for that have exacerbated financial functioning of key markets – including repression by impeding migration from a bank- dominated financial system to a market dominated financial markets – by emitting the one in order to protect the government’s interests as wrong price signals; (b) diverted and both the largest borrower in the financial system and dissipated scarce public resources in the largest owner of financial institutions; (f) created low-yield expenditures; and (c) created too many conflicts-of-interest in financial regime governance that have influenced adversely its credibility, too large and inefficient a state-owned quality and content; (g) protected banks from effective institutional superstructure, with high competition in the domestic market by the erection financial resource absorption and low of high barriers to competitive entry thus fostering financial yield, in too many areas of inefficient intermediation with high margins and high costs for all savers/investors; (h) forced a degree economic activity of segmentation across financial markets (banking, * the means resorted to for financing insurance, capital markets, etc.) that is damaging to a healthy financial system and sound capital market and sustaining gross consolidated fiscal development; (j) induced inefficiencies in resource deficits (i.e., – of the centre, states, use; (k) indirectly impeded the emergence of essential s and quasi-fiscal accounts like the derivatives markets and risk management instruments, oil pool account) that have been too particularly for the management of currency and interest rate risks; and (m) indirectly and inadvertently large for too long. created a situation in which the lowest returns on financial savings (adjusting for risk and inflation) are It has often been asserted (by s and renowned accrued by the poorest depositors. . The macroeconomic fallout of an IFC 87
transformational enough. Further, as recent fiscal management in India is a sine qua non differences of opinion at policy-making for: (a) the participation of global financial levels suggest, there is a perceived trade-off firms in an Indian ; (b) its ability to between maintaining the schedule for deficit transact complex financial transactions with reduction targets under , and risking multi-decade time horizons; and (c) the a loss of economic momentum created by ability of the government to shift part of rapid growth. The impact of such a trade-off its public financing burden from domestic could be ameliorated by having a ‘public financial markets and investors (who carry debt reduction target rule’ added to the excessive India risk today) to global markets deficit reduction target rules under . (that desire more India risk in their globally But, whatever rules are applied, the diversified portfolios). aim of fiscal policy over the next – In consonance with the kind of years should be to achieve reduct- macroeconomic backdrop needed for having ions (through adjustments in revenue, a successful in India, the would expenditure and public asset sales) that countenance the pursuit of a fiscal policy bring: (a) the down to –% of that minimises distortions in the proper ; and (b) overall public short and long- functioning of goods and services markets. term debt (central, and states) down Such distortions occur either through: to well below the present % of . (a) direct price suppression or manipulation The scale of reduction in the debt/ (however well intended) as in the case of ratio that is required is bigger than appears the oil pool subsidy account; or (b) through to be the case, as many off-balance-sheet interventionist public mechanisms whose liabilities (e.g., pensions) need to be fully protection – through implicit or explicit recognised in an improved accounting and government capital guarantees that induce disclosure framework, while the present inefficiency, or through the suppression of estimate (%) ignores these liabilities. competition in markets dominated by them Those targets should be achieved within a – also results in compromising the efficient time-frame that is consistent with stable and functioning of financial markets and distorts non-disruptive adjustments in government resource allocation. accounts, and in financial markets, while But there are political economy maintaining growth momentum or even implications of adhering firmly to such increasing it. rules. They might result in the government Both measures are necessary in order being accused of having an ‘anti-poor’ to achieve (and maintain) the kind of fiscal bias if cutting deficits involves reducing stability that, in the Committee’s view, is a expenditure on populist schemes. It fundamental requirement for a successful is difficult to see, however, how deficit and credible to emerge in Mumbai. reduction could be seen as anti-poor per Strict adherence to clear, transparent ‘golden se. The interests of the poor are never served rules’ aimed at achieving such stability is by running high fiscal deficits that distort critical. That is particularly true for a finance, send the wrong price signals to a large, plural, federal, developing country number of key markets, and destabilise the like India attempting to establish an economy. while maintaining a reputation and image of Financial repression imposes a regres- integrity and probity in the world of global sive tax on unsophisticated users of finance. finance. The commercially sophisticated elite avoid Confidence (on the part of domestic financial instruments where artificially low and global financial markets) in the outlook returns are given through state interference – for long-term macroeconomic stability and i.e., the richest households hold very small balances in bank savings accounts. A high For a discussion of debt/GDP rules, see Mistry fiscal deficit usually results in long-term ef- (). fects that are even more anti-poor – as is For a first effort on measuring the implicit pension debt on account of the civil servants pension, see the case when cumulative deficits require Bhardwaj and Dave (). partial monetisation and inflation (the most 88 R M I F C
regressive tax of all). Over time, high fiscal confidence in the government’s ability to deficits result in governments (states and repay debt denominated in foreign currency centre) running out of headroom to finance can erode rapidly. That, in turn, makes it physical and social infrastructure in poor difficult for government to sell bonds to rural areas and urban slums. Similarly there domestic and foreign investors. Bond prices is no headroom – without a substantial and fall, sometimes accompanied by herd exits. politically difficult restructuring of expen- This is particularly dangerous in a country diture priorities at state and central levels – with a history of financial repression where to provide income support for subsistence banks hold too large a part of government consumption targeted at the poor. debt. A drop in the value of bonds can Instead fiscal policy remains orientated trigger a banking crisis and exacerbate the toward: (a) maintaining an edifice of fiscal deficit by requiring the government to government that is overstaffed and under- recapitalise banks. compensated at senior levels, leading o has never defaulted on its debt to distortions and inefficiency; and in the past. It aims to maintain a policy (b) unsustainable market-distorting price stance that encourages the world to be con- subsidies on a number of key goods (oil, fident that it will never do so in the future. diesel, gasoline and kerosene) that result However, even when the possibility of de- in transferring more income to the rich fault on sovereign obligations is low, the and middle classes than to the poor, whose additional costs to the economy – arising consumption of such goods, direct and from rising interest payments due to in- indirect, is much lower. The combined creasing levels of government debt caused effect distorts prices in too many markets. by persistently large deficits – are signif- It disables prices from equilibrating supply icant. Domestic interest rates rise, slow- and demand thus preventing markets from ing down private consumption and invest- performing their role. It compromises ment. That can result in lower profitabil- the use of inflation-targeting as a tool ity for companies with foreign currency of monetary policy. It makes efficient borrowings. Interest rates for such for- resource allocation via the financial system eign borrowings rise when profitability falls more difficult to achieve. Having a low and takes the credit rating of the company fiscal deficit over the long term, and re- down. orienting expenditure priorities toward income support for the poor, will have a 3. Financing public debt greater ‘pro-poor’ effect than extant policies. differently That strategy will result in spreading the benefits of growth more evenly than they are The first priority for Indian fiscal policy is now. the stabilisation of consolidated debt/, Running a large fiscal deficit constrains inclusive of all implicit liabilities such as a country’s ability to open its capital account civil servants’ pensions, at –% of . without running undue risks. Countries This issue has been well understood in that have opened capital accounts and the debate on fiscal policy over the last stabilised or pegged their exchange rates years. Second, public finance thinking in – while running large fiscal deficits financed India has not made progress in considering in foreign currencies – have triggered an more efficient, mechanisms for public economic crisis. That happened in Mexico borrowing. Until banks were required in , Argentina in –, Russia in to hold a large share of their assets as , Ecuador in and Turkey in . government bonds under the Statutory When the debt-to- ratio starts rising, Liquidity Ratio () requirement. They were paid lower than market rates on An extensive literature has pointed to the role of government bonds. After the liberalisation pegged exchange rates in generating currency crises and of , rates on time deposits ceased to speculative attacks. In addition, exchange rate flexibility assists macroeconomic stability by offering a ‘shock be fixed. But banks are still required to absorber’ (Edwards and Yeyati, ). hold an astonishing % of their assets in . The macroeconomic fallout of an IFC 89
government bonds. Demand deposits pay opportunities for public borrowing with negative real interest rates. Similar pre- fewer adverse side-effects and consequences emption is in place with insurance and for the Indian financial system. pensions. The basic imperative of a sound non- The argument is made that improved distortionary mechanism, for financing the liquidity and market efficiency in financial fiscal deficit in a globally credible financial markets will limit the ability of the system, is that sovereign or sub-sovereign government to control all points on the bonds should be bought voluntarily by any yield curve; which (it is argued) is required kind of buyer, without any direction, coercion for reducing the cost of borrowing for the or restriction by the government. It should government. When such arguments are not be considered necessary to distort deployed for repression, the financial system national finance in order to sell bonds to suffers a loss of credibility and confidence. finance public deficits. That would imply Banking regulators are supposed to uphold abandoning the policy framework which sound risk measurement/management to presently governs investment by banking, support their demands for minimum levels pensions and insurance. of risk capital being held by banks. In If nothing else changes, the removal applying their judgements of risk in bank of repression would increase the cost of portfolios, regulators must be technically financing public debt. It is intuitively proficient, unbiased and impartial in obvious that with coercion out of the picture, evaluating the risks of portfolio choices and with markets that are liquid and made by banks. However, their ability efficient, higher interest rates may need to to be unbiased is compromised when be paid in order to attract voluntary buyers portfolio choices are driven by regulators of bonds. However, there are three lines of themselves. thought which address this problem: When regulation imposes rules that support other aims (such as financing . A sophisticated financial system requires deficits) that have no bearing on the safety sovereign bonds as a credit bell-weather and soundness of the banking system, The liberalisation of finance and wider entry what occurs is a loss of credibility in the of pension funds, insurance companies, financial system on a global scale. It mutual funds, etc. into the sovereign raises doubts in the minds of the global bond market will increase demand for financial community about the technical long-term bonds. These investors soundness and supposed lack of bias in need to buy government bonds as part of banking regulation. prudent portfolio management strategies, The global market involves on a voluntary basis, without coercion. competition not just across s and global As India becomes a more mature market financial firms but across different systems economy, the need for and should of financial regulation. As long as India disappear. When that happens there is no continues with its present system of financial likelihood of demand for o bond holdings regulation, it will induce a lack of respect disappearing as well. For prudential and and credibility, for provided from India portfolio balancing reasons, banks and other and will compromise the functioning and investors will still need to have holdings of competitiveness of an Indian . o bonds in their asset portfolios. It is There is a need, and an opportunity, to quite possible that, with investor desire to find more efficient, less counterproductive hold o bonds becoming voluntary rather ways of financing India’s large and rapidly than forced, demand for such paper will rise escalating public debt. A more efficient and and not fall. better developed financial system would The asset choices of the mutual fund create many more options for doing so. industry exemplify this lack of risk of shifting The creation of provision capacity away from financial repression. Formerly, in through an in Mumbai would add to an India that was more repressed than it is those options by increasing the range of now, mutual funds were the monopoly of 90 R M I F C
under a bank-monopolised financial open capital account, bond issuance system. The shift towards a market-driven avoids concerns about incurring currency system has come with the rapid growth of risk on sovereign debt. It also averts the mutual funds. Regulation of mutual funds liquidity risk involved in servicing such is now free of repression. s are not debt, should a sudden balance-of-payments obliged to hold government bonds. Yet, crisis materialise because of an unforeseeable without compulsion, s have invested very exogenous shock. large sums of money in government bonds. When global investors hold o debt Easing up on repressive policies for s has denominated in , they bear the currency not automatically created problems with risk. In a scenario with a sudden crisis of their buying government bonds. confidence and capital flight out of India, At present, the size of the asset the drops and bond prices drop – this portfolios of banks, insurance companies affects global investors holding bonds and pension funds in India are relatively and does not exert balance sheet effects on small by world standards. The total assets the government. These balance sheet effects of these three groups of firms, expressed as are spread over the very large base of assets percent of , are one-half the size that is held by global institutional investors. It is, commensurate with the level of development therefore, safe to permit such investors to of the Indian economy. When financial buy sovereign bonds as they wish with- repression is eased, and a superior system of out limit. The only risk in doing so is that financial governance is put into place, these such investors, uninfluenced by government three sectors are likely to grow dramatically. direction, might dump o bonds on the That will induce new sources of demand open market when the government of the for o bonds. If greater demand is not day pursues unsound macroeconomic poli- matched by increased supply, the prices cies or generates political risk. As a warning of such bonds should rise, implying that for restraint, that would be a useful signal coupon rates could be reduced. for global investors to emit. It is one that any prudent government should respond . Global fixed income investors are to appropriately. interested in INR denominated sovereign bonds, and it is in India’s best interest to quasi-state programs such as the have, for all practical purposes, entailed a sovereign bond program sell these to them. Traditionally, India has denominated in foreign currency. These have flirted been reticent about financing its fiscal deficit with original sin. The present Indian policy on public through the sale of sovereign bonds to global and private borrowings is paradoxically asymmetrical. investors. Many economists trained in the It causes an overall asset-liability currency mismatch when Indian firms are permitted to borrow overseas s and s when derivatives markets in foreign currencies in increasing amounts, while did not exist (and still unfamiliar with or investment in denominated bonds is still distrustful of currency derivatives and how heavily restricted. The policy framework encourages original sin on the part of firms, shifts revenues markets in them work) felt that financing outside the country, and involves an opportunity cost the fiscal deficit through issuance of dollar- for liquidity and market efficiency on the local denominated bonds was dangerous. This denominated corporate bond market while putting reticence has been based on a perception upward pressure on Indian interest rates. Both these strategies serve to increase the macroeconomic risk of ‘original sin’ where dollar-denominated for the Indian economy. A reversal of these policies – liabilities represent a currency mismatch for discouraging original sin and encouraging local bond a state whose revenues are in . That market development – would simultaneously improve issue does not arise when government systemic stability and growth. Of course such risk is already being incurred on bonds are sold to global investors but borrowings from the s and regional banks which denominated in INR . In the context of an are quite large but concessional. Moreover India has more leverage in dealing with such creditors than with The goal of policy makers has long been to impartial bond markets that are much less easy to have policies on capital flows which are ‘prudent’. persuade or manipulate. Yet, the overall policies on debt financing have For a treatment of international developments on decreased financial stability in two respects (see local currency bond markets, see Burger and Warnock http://tinyurl.com/37vq58 on the web). First, (). . The macroeconomic fallout of an IFC 91
There is now a large demand for long- markets. It is thus a key ingredient for having term bonds on the part of global a successful in India. fixed income investors. One reason is portfolio diversification. No large global . Sophisticated financial structures for in- investor can afford to have less than % frastructure projects will help to put many of total fixed-income investment in bonds assets “off balance sheet” thus reducing issued by a country which has over % the public borrowing requirement. The of world GDP and is one of the fastest third bit of innovative thinking in public growing economies of the world. In addition, finance concerns shifting the burden of fi- as a growing economy with sustained nancing infrastructure from government productivity increases, it is likely that budgets to corporate balance sheets. This the will appreciate through Belassa- can be done by improving the policy and Samuelson effects. Thus an international regulatory climate for public private partner- pension fund looking for a -year bond ships (s). As the private sector invests in might prefer an bond to a bond. infrastructure, the pressure to keep issuing Indeed most global portfolio managers public debt for capital investment would (especially pension funds) bemoan the diminish. absence of access to a larger pool of Today a large part of the burden of denominated paper in global bond and borrowing for infrastructure falls on the money markets across the maturity and balance sheet of the government. In a duration spectrum from -days to - framework under the viability gap funding years. If India had a mere –% share model, a private partner bids for a grant in global fixed-income portfolios, this covering the difference between the cost of would represent a quantum of investment the project and the profit expected from significantly larger than the forced-holdings it. The project goes to the lowest bidder. of bonds by domestic banks, insurance Spending by the government is limited to companies and pension funds. In an optimal the grant. The loans that a private company long maturity global fixed income portfolio, takes to finance the project do not appear in the holdings of paper are likely to be the government’s accounts. If the grant given closer to –%. by government is financed by a deficit then In the judgment of the , opening only that element appears in the debt liability denominated sovereign bond purchases of o. Greater resort to s would to global institutional investors, and simul- support the downsizing of government taneously removing all forms of repression expenditure required to achieve stabilisation in the domestic financial system, will result of the public debt/ ratio. The Ministry in a significantly higher probability of low- of Finance has embarked on establishing ering the financing cost for o, than the a viability gap funding mechanism. This low probability of increasing that cost. needs to be scaled up, at the expense of A fiscal deficit financed by o bonds traditional mechanisms for State expenditure issued in global capital markets, but on infrastructure, thus yielding reduced denominated in INR – rather than financed government expenditure and thus deficits. by banks that monopolise domestic bank deposits – would alleviate crowding 4. The mutuality of interests in out effects in the domestic market. It would release more domestic resources for more modernising debt efficient private investment, and alleviate management and having an upward pressure on local interest rates. IFC That would reduce the need for o and to protect the profitability and balance Moving away from financial pre-emption sheets of state-owned banks. It would for financing the fiscal deficit is essential create more room for neutral regulation that Analysis of investment requirements, and potential allowed greater competition, efficiency and for private sector financing, has been offered at great innovation in banking and other financial length in Mohan (). 92 R M I F C
in its own right as the most appropriate . Investors from all over the world parti- step toward more rational development of cipating in the bond market in the Indian financial system in overcoming Mumbai. the distorted legacies of the past. At the same time it would be highly supportive of Each of these three elements bolsters creating an in Mumbai. Reciprocally, the other two. Creating an yield curve an in Mumbai would provide many – a fundamental pre-requisite for an more options for diversifying sources of in Mumbai – and ensuring that it sends public borrowing, globalising the market the right signals, requires macroeconomic for denominated debt, and reducing stability as a critical pre-condition. The its costs. The emergence of an active absence of such stability would result bond market (as part of an integrated in a loss of confidence in the economic package) that attracted full participation of governance of India. If that happened, global portfolio investors – especially long- domestic and foreign investors would shun term, fixed-income investors such as pension bonds, drive up interest rates and funds – would create new opportunities for precipitate a crisis. For that reason, it is the export of and enhance the stature incompatible to consider having an and of an in Mumbai. It would provide continuing to run destabilising deficits. impetus to a currency trading market as well The market for corporate bonds is as to a more diversified derivatives market an integral part of the nexus that that traded contracts in currencies and this report has stressed the importance of. interest rates. Progress in creating an independent debt In recent years, a number of developing management office that auctioned sovereign countries have attempted to attract global bonds and notes across the maturity investors to buy their local currency bonds. spectrum into a liquid yield curve India has, paradoxically, discouraged them from doing so; although that policy posture in Mumbai, with international investors appears to be changing. India is unusually participating in this market has some well placed to attract global investment in interesting downstream implications. In sovereign bonds because voluntary particular, it would create the opportunity demand for them in the global investment for creditworthy sub-sovereign issuers – i.e., community appears to be far larger state governments and municipalities – to than o’s inclination to accommodate access the same pool of investors. It would that demand. Looking ahead a sound create a new sub-market in India that does public borrowing strategy for India would not yet exist; although sub-sovereign and incorporate three elements: municipal bond markets are key features of bond markets in developed financial . An independent Indian ‘debt manage- systems. ment office’ – operating either as an au- tonomous agency or under the Ministry While there has been legitimate of Finance – that regularly auctioned criticism of o for persistent fiscal deficits, a large quantum of denominated it has not been given the credit it deserves bonds in an in Mumbai. The size for the transformation in public finance that of these auctions would be substantial it has painstakingly wrought. Progress has by world standards and would enhance been sufficiently tortuous as to be invisible. Mumbai’s stature as an . Yet it has been profound. Over the last . A liquid yield curve along with a decade, distortionary taxes like customs functional Bond-Currency-Derivatives and excise have been removed with a shift () nexus and vigorous arbitrage towards . High marginal income tax by sophisticated investors with Direct rates have been reduced. Double-taxation Market Access, ensuring that the yield of firms has been partially reformed. The curve is arbitrage free, with an associated incidence of taxation has increased its focus set of interest rate derivatives for risk on consumption. The Act has been management. passed and income tax collection/accounting . The macroeconomic fallout of an IFC 93
has been automated. All these measures . Making targeted commitments under amount to a paradigm shift in fiscal policy the binding. The and practice. Public finance in India today does not specify the strictures that has been transformed quite dramatically follow if the existing deficit targets are from the situation of ; but the size of violated. There is a need to introduce fiscal deficits has been slower to respond strict penalty clauses and bolster fiscal through desirable shrinkage. accountability about what would happen These achievements need to be built if the targets are violated. upon with a commensurate paradigm shift . Extending rules and principles in debt management. The aim should to States: While the was a key be to create a new policy framework for milestone, it addressed only the fiscal public borrowing that mirrors practice in deficit of the central government and mature markets. Resorting to global markets not that of state governments. Current for public borrowing through an in estimates for the consolidated deficit of Mumbai would require some new elements the centre and states amount to some of when compared with current practices. In the most extravagant aggregate deficits the present framework, o bonds are sold in the world. State governments have by . Designated buyers (like banks been given incentives to restrict deficits and pension funds) have no choice but to by the th Finance Commission. But buy them. Under the alternative paradigm, deficit reduction targets have been not with bonds auctioned to voluntary buyers been defined in a state-specific manner. (domestic and global), the government There need to be state specific targets, will need to work harder in providing the agreed to by state governments, which information required by the global fixed the states should then be held to and income investment community to make penalised if they are not met. MoF needs reasoned judgements. This will involve: to translate the full picture, in terms of . Advertising clearly in headline terms the projections for the Centre and for the gross consolidated fiscal deficit of India States, into projected numbers for the rather than obscuring it by referring consolidated deficit of the centre and to the fiscal deficit run by the centre. states, and projected numbers for the o needs to publish regular reports consolidated debt/ ratio. Cogent, of total public debt: i.e., of central comprehensive analytical documents and state governments. That should showing historical statistics, present include: implicit/explicit government stocks and projections for five years guarantees, implicit pension debt and need to come out from the Ministry the total (public sector borrowing of Finance to the global fixed income requirement) including the debt of investment community, where the unit public sector companies that has a of discussion is the consolidated Indian contingent o or state government State, not just the central government. guarantee. Similar reports should be published by state governments with . Lowering the Total Public Debt/ the aim of publishing the consolidated Ratio: The structure of the debt of the centre and all states. These Act places undue emphasis on the reports should be accessible to the public. annual fiscal deficit in terms of financial They should appear on the website of flow and insufficient emphasis on the the Ministry of Finance every quarter. cumulative effect in terms of the debt The consolidation of information, in stock thus created. Economic logic one place, of all liabilities of all arms does not suggest only that fiscal deficits of government is a key milestone for should be low. It also suggests that strengthening public debt management. the debt/ ratio should be low This information needs to be fully and stable. Low fiscal deficits are a shared with the global bond trading and means to an end: i.e., a fiscal policy investment community. framework in which the debt/ 94 R M I F C
ratio falls in all normal years except if Its conduct becomes more complex and there is a war or a comparable national sophisticated with an open capital account calamity. A greater focus needs to which, as discussed below, is a sine qua be put on full measurement of public non for an in the st century. With debt, avoiding new contingent liabilities, inordinately large fiscal deficits, and a large and finding new ways to ensure that stock of public debt, now exceeding % of properly-measured public debt (which , monetary policy has to bear the brunt is presently well in excess of % of of adjustment when fiscal policy proves too ) does not cross a publicly stated sticky. The expansionary effect of large ceiling such as –% of . The fiscal deficits has often to be countered by is reluctant to suggest a rigid monetary policy: i.e., through higher interest ceiling without studying in more depth rates and more pre-emption than would what ceiling would be appropriate for otherwise prevail. India. For that reason it has suggested a The expanded supply of government range that is typically found around the paper has to remain attractive to the domes- world in terms of prudent public debt tic investor in order to be absorbed. That management practice. The also drives up rates, increases the government’s recommends that, in reducing public borrowing costs, further increases the fis- debt, governments at all levels consider cal deficit, and expands the stock of public not only revenue and expenditure debt explosively through compounding. An measures but other measures – in ever escalating spiral resulting in a loss of particular public asset sales at the fiscal control is thus set in motion. It be- appropriate time and at the appropriate comes difficult to break out of that spiral price – to bring about a reduction in except through: (a) gradual or disruptive public debt. The proceeds of such sales fiscal adjustment – usually too little too late should be applied exclusively to public – which incurs political problems; (b) draco- debt reduction and no other purpose. nian monetary adjustment that throws the In summary, quarterly reports tracking economy out of kilter and creates economic the performance of the centre, states, s as well as political problems; or (c) trans- and the consolidated fiscal situation showing ferring the costs of adjustment to foreign the size of the total deficit and the size bondholders through currency depreciation, of outstanding debt (including implicit if the country is an issuer of reserve currency liabilities), need to be made available to and borrows from foreign investors in its the investing public in a timely manner. own currency (e.g., the ). Projections of the deficit, for five years on With large fiscal deficits, an open capital a rolling basis, should be released every account worsens the problem. In open- quarter. The Ministry of Finance should economy macroeconomics, when a rapidly be required to explain deviations from growing economy opens up, stabilisation projections to the public and to Parliament. of the business cycle through fiscal policy This requires making substantial progress becomes ineffective. Achieving the same on the accuracy of fiscal measurement and result through monetary policy is more improving the quality and performance of effective. As the Indian economy has opened public institutions. That problem is aggravated if the government’s borrowing strategy is to finance its deficit exclusively in 5. Implications for monetary the domestic market. It gets worse if the government is policy obliged to borrow abroad in foreign currency rather than its own because it then takes on added currency A key element in managing a macro- risk and o liquidity risk. But if it can borrow abroad economy with large fiscal deficits and rapidly in its own currency the problem gets ameliorated by reducing interest rate pressures in the domestic market; growing public debt is monetary policy. as long as the expected real return is perceived by global investors in bonds to be superior to returns in For a treatment of contemporary thinking on bonds after adjusting for credit, country, political monetary policy, see Mishkin (). and currency risk. . The macroeconomic fallout of an IFC 95
up, gross flows across borders have risen cycle conditions were adverse in order to sharply. They exceed % of today and counter weak or negative capital flows. That are expected to rise further. would exacerbate the downturn. A policy As in other open economies, it will of pegging the exchange rate would thus become increasingly difficult to control the enable the direction of capital flows to exchange rate through interventions induce a destabilising monetary policy, one by the central bank; as has been done in that increases the volatility of GDP growth the past in India by . The larger the instead of reducing it. interventions by the central bank, the more India, with its large and fast growing the cost of a policy of managing the economy, can no longer peg the to exchange rate. The main ‘cost’ of such a the and incur the resultant loss of policy is the loss of monetary autonomy exercising monetary policy autonomy under as predicted by the iron-law or ‘impossible changing domestic market conditions. An trinity’ of open-economy macroeconomics open capital account would require giving (Joshi, ; Patnaik, ; Joshi and Sanyal, up a stable exchange rate and choosing ). Too many central banks around the autonomous monetary policy. But the world have lost too large an amount of their public and private sectors would need to reserves trying to defend pegged exchange have the resilience and risk management rates when global markets moved against capacity, with world class currency futures them. India should not repeat that error. and options instruments and markets, to In an environment of free capital flows, cope with more frequent movements in downward pressures on the would exchange rates. need to be relieved by raising interest The key element of such a monetary rates if exchange rate stability was the policy would need to be inflation targeting. prime goal. If that was done regardless of When the is not the anchor for the , domestic conditions, an externally induced the basket should take its place. Such a contraction in money supply could prove policy has been shown to have many long deleterious to domestic industry. It would term benefits, including fiscal stability and raise its costs of capital and reduce the low output volatility. Today central banks enhanced export competitiveness that a in the , Euro-zone, Japan, , Australia, depreciating would have afforded. The Israel, Chile, etc. all target inflation to keep opposite would occur if pressure on the it low. For all practical purposes, the Fed in were upward. Interest rate movements the targets inflation de facto; although would be governed by fluctuations in capital it is constitutionally required also to be flows instead of fluctuations in local inflation concerned about growth and employment. and government borrowing requirements. In a country like India, which needs A particularly difficult feature of the loss to build global confidence in the , of monetary policy autonomy lies in the pro- an explicit and legally mandated de jure cyclical nature of capital flows (Kaminsky inflation-target regime governing monetary et al., ). In an ideal world, with a policy would be superior to a de facto pegged sophisticated financial system, capital flows exchange rate regime (as is presently should respond to investment opportunities the case) or a de facto inflation targeting in the real economy. In practice, information regime (as is the case in the ). When asymmetries can lead to pro-cyclical capital domestic and foreign investors hold flows. When the business cycle in India assets – originating from any issuer – an is on the upswing, capital flows would tend to flood in. Conversely, when the Chandavarkar (); Mohanty and Klau (); business cycle reversed, capital might flow Khatkhate () discuss monetary policy in India. out. Pegging the exchange rate would lead to Patnaik () demonstrates that in India’s case, as with many other developing countries, there is a higher interest rates in India when business distinction between the de facto currency regime in operation as opposed to the de jure currency regime For a treatment of the issues in moving to a floating which is claimed to exist, and that India has followed a exchange rate, see Duttagupta et al. (, ). de facto INR/USD pegged exchange rate. 96 R M I F C
institutional commitment to predictable effect would be non-transparent and should and low inflation generates predictability be avoided. The use of interest rates as the in the real value of bond repayments. The instrument, with the aim of policy being a danger of capital flight would be reduced targeted rate of inflation keeping the pass- if the value of the was maintained in through effect in mind, provides a more real terms and expectations about its future transparent framework for achieving the value were stable. A monetary policy that targeted inflation rate. But it also poses a targeted inflation de jure would be an ideal greater risk for fiscal management when partner to a policy of public borrowing by deficits and public debt stocks are larger selling bonds in global markets. than they should be. The choice of inflation measure to Monetary transmission is considerably be targeted from available measures of altered in a world with an efficient financial inflation using the Wholesale Price Index, sector. When the nexus works properly, the Consumer Price Index or a measure of arbitrage binds together all points on the core inflation is significant. Theoretically yield curve. The decisions by the central there may be case for using a measure of bank on the short rate, coupled with the core inflation that excluded commodities publicly stated monetary policy rule, induce like food and oil. But in terms of changes in all interest rates and in exchange public perception and the credibility of rates. This indirect strategy has proven the central bank, the consumer price index highly effective in mature markets. In India, (-Industrial Worker) might be a better there is a feeling that moving away from measure to use. It is this measure to which direct control of all points on the yield curve wages and dearness allowances are linked would be risky if not dangerous. However, and which people are familiar with. ceding direct control and relying on the Unlike measures such as core inflation, nexus to work instead is essential in the public would not suspect fudging of having an effective monetary policy and the figures by the authorities to suit their acquiring global credibility with an open purposes. But, using the CPI for inflation capital account. Monetary policy with targeting will require the government to an open capital account is more effective cease subsidising key prices (e.g., energy when there is a proper combination of and fuel) and intervening in commodity sound markets with a properly functioning markets through price measures. Such nexus and a public, transparent, practices distort measures of inflation unambiguous monetary rule. In other and disable a policy of inflation targeting words, a given impulse for expansion or from working as it should. However, the contraction can be managed much better frequency of measuring the indicator should by making a smaller change to the short- be increased and the time lag with which end interest rate, when the yield curve is it is produced decreased, alongside steady arbitrage free and economic agents know progress in improving measurement of the the correct monetary policy rule that is in consumption basket of the typical industrial operation. worker in India. The pass-through effect of the 6. Outlook for the current exchange rate on inflation (from rising account deficit or falling import prices) could incentivise the central bank perversely to manipulate A current account deficit averaging about exchange rates and have greater control over .%, with a fluctuation of ±0.5%, is the pass-through. Intervention through presently perceived to be sustainable for interest rates would influence the exchange India. India has sometimes run a current rate. Its effects on monetary policy would account surplus. But that is not in India’s be transparent. But if, instead of deploying interests at its stage of development. It interest rates, the central bank’s intervention implies a savings ratio higher than the was through purchase/sale of forex (reserve) investment ratio and results in an export assets, coupled with sterilisation, then the of capital to the rest of the world. An . The macroeconomic fallout of an IFC 97
investment ratio higher than the savings * Low risk of changes in tax policy or tax ratio, with net capital inflow of –% of rates; per year, would permit India to raise * Zero probability of more capital controls its investment rate and stabilise it at –% being introduced in the future; of in order to sustain growth of % or * Low and stable inflation; zero probability more. of hyper-inflation; However, even with these levels of net * A respected and tradable arbitrage-free capital flow, an in India will result yield curve going out to years; in outflows and inflows that are much greater. The benefits of an do not * Lower fiscal deficits to bring about a come as much from more ‘net’ investment stable or declining debt/ ratio; as from gross capital flows in and out of * A high investment grade sovereign credit the country. The benefits of capital flows rating; come from more efficient international * Monetary policy that stabilises the allocation of capital, capital deepening and business cycle; international risk-sharing. All these factors * A ‘consistent’ framework of monetary raise growth and reduce consumption policy that recognises the impossible volatility. But recent research shows that trinity; while such direct benefits do accrue, the * Business cycle volatility that is more potential collateral benefits are even larger. like an industrial country and less like a These arise from better financial market developing country. development, better governance and the macroeconomic discipline that comes with In the case of the , an embarrass- financial globalisation (Kose et al., ; ing history of macroeconomic instability Mishkin, ). The resulting growth in through most of the th century – including capital productivity and efficiency, spread an program in and a breakdown of over a much larger volume of investment, the currency regime in – was resolved can have a greater impact than a mere by the reforms of the late s and s. increase in the investment level. These required the central bank to focus exclusively on monetary policy and nothing 7. Macro-stability for an IFC else, created an explicit inflation targeting regime, and introduced fiscal rules which For a credible to be established in eliminate the risk of a growing debt/ Mumbai, global financial markets need to ratio. be persuaded about the enshrined sanctity India and the both experienced of maintaining macroeconomic stability in difficulties with their currency regimes in the India regardless of which government rules. early s. But the came up with a more This involves institutional reforms on three far-reaching response involving institutional fronts: fiscal, monetary and financial system. surgery and new legislation. The resulting So far, India has made more progress on macroeconomic stability, and an enlightened fiscal reforms. The other two elements have approach to financial regulation that is stayed about where they were in the early principles-based, have been key factors in s. Further, deeper reforms are now bolstering the success of London as a required in fiscal and monetary economics, over the last decade. in order to ensure: The has travelled in the opposite direction since . A loss of hard- The well known results of Feldstein and Horioka earned fiscal control, and the imposition () suggest that in the , convertibility was not very effective at decoupling domestic savings of counterproductive regulation, and from domestic investment. These results have been legislation such as Sarbox, has damaged significantly modified by post- data. However, New York’s standing as a . London’s the basic position of is consistent with the idea experience and that of New York are that convertibility accelerates growth through mechanisms other than a large increase in the instructive for India in opposite ways. sustainable current account deficit. In the , only a few years after the 98 R M I F C
breakdown of its currency regime, the loopholes than on designing the right reforms implemented have becalmed the kind of for clients. expectations of financial markets. They have If the s of financial firms restored global confidence in the despite are forced to focus on the policy a tendency toward fiscal profligacy becoming and regulatory constraints faced by increasingly apparent in recent years. In their business plans – rather than on the , by contrast, global credibility and implementing their business plans and confidence in financial probity has been continually refining them by talking steadily eroded since the new millennium to customers – then what is replicated dawned. is a situation like the India of the A mature market economy is one where s in the real economy. In those inflation and growth are stable, while circumstances the most capable Indian exchange rates are more variable. In the manufacturing firms were unable to third world, this is reversed. Emphasis on a achieve international competitiveness stable exchange rate results in more volatile because they spent more time dealing inflation and more volatile growth. with the government than with their India has to put monetary policy on a sound customers in export markets. But footing to avoid this pathology. when that constraint was removed their success went beyond the imaginable. 8. The incompatibility of As an example, despite many years of policy effort, Indian Depository Receipts capital controls in a 21st have a zero market share in the market century IFC for international equity issuance and the In some ways it might appear to be licenses granted earlier were not theoretically feasible for India to make worth the paper they were printed on. some progress towards internationalisation Even a broad opening of capital controls of finance while retaining an elaborate but with quantitative restrictions on structure of capital controls. For example, different types of transactions involves an institutional mechanism for the issuance financial firms being engaged in heavy- of Indian Depository Receipts (s) could duty persuasion in the interpretation of be created: a narrow opening in a system onerous rules. The complexity of such of controls through which one kind of an institutional mechanism runs afoul transaction can be conducted. Or attempts of the need for speed, flexibility and could be made to find a way of providing innovation in the global market. It through that part of the system where encourages rent-seeking (Krueger, ). the capital account is open; while having to * Piecemeal opening-up defeats the pur- persuade regulators at every step that what is pose of capital controls. Capital is being done is in line with what is permissible more agile and mobile than merchandise. on a ‘moving-target’ basis. But the efficacy When India embarked on autarky on the of this obviously sub-optimal approach is trade account, some items – like gold or questionable for two reasons: s – came into India in boats from Dubai. In the case of most things – like * A successful comprises a vibrant, steel – the Indian attempt at autarky was competitive financial market ecosystem. successful but self-harming. Warding If financial firms have to operate under a off free flows of capital is more diffi- complex maze of ambiguous restrictions, cult than monitoring imports/exports of and have to comply with quantitative steel or cement (Patnaik and Vasudevan, restrictions or license/permit require- ). Under draconian capital and cur- ments that achieve very little, then the rent account controls, the hawala market quality of thinking in, and the services flourished. It effectively bypassed those provided by, the are compromised. controls. As has been noted, the pres- More time is spent by financial firms ence of harsh capital controls did not and their key executives on exploring prevent the currency crisis (Vir- . The macroeconomic fallout of an IFC 99
mani, ; Acharya, ). Conversely, they deprive Indian financial firms of an a more open capital account in – opportunity to earn larger export revenues did not trigger a crisis when many than those derived from services. They East Asian countries experienced disas- reinforce protectionism and barriers to com- ter. What India has achieved, in opening petitive entry in the Indian financial system its capital account, implies more con- rendering it less efficient and more costly as vertibility than is commonly appreciated. an intermediation mechanism than it should Every month, the ‘calibrated opening be. They do not permit financial system lib- of the capital account’ further under- eralisation and reform to take place as swiftly mines residual capital controls. Main- and to the extent that it should. taining partial controls, and removing On the whole, the is of the view remaining obstacles over a long drawn that the capital account should be opened at out period of time, contingent on con- a faster rate than is currently being envisaged. comitant conditions being met, impedes It believes that the risks of doing so can incoming cross-border capital flows in be managed given: (a) the proven skills a counterproductive manner. What it and capabilities of the in managing achieves is to inhibit the export of India’s external accounts with extraordinary from India – while having a de facto open competence; (b) the trends that are now capital account for the real economy, but manifest in accelerating two-way financial not for financial services. That creates a flows at a very rapid rate – i.e., at two or three strong bias against exporting ; an ac- times the output growth rate; and (c) the tivity in which India has a much greater problems that will increase as the partially competitive advantage over most other closed regime is maintained, countries – providing the nexus Opening the capital account decisively can be created quickly in Mumbai – than is not a matter of tweaking technical ratios in almost any other domain. and tinkering with the present limits of At the same time it has to be recognised what is allowable and what is not. That that there has been much argument in process adds little of value. But it increases international financial circles about the levels of frustration throughout the Indian advisability of removing all capital controls financial system, and on the part of Indian when faced with the risk of coping with non-financial firms that are ready and able capital surges (especially of short term hot to showcase their world-class competitive money) induced by the herd instincts of abilities more meaningfully on the global bankers and high-risk fund managers. These stage. Neither of these categories of firms is arguments gathered steam after the Asian enthusiastic going through the hoops of a debt crisis of – and a number of capital account regime that is supposedly subsequent crises that occurred around the ‘open’ for them in theory but still involves developing world since. Clearly no member considerable administrative obstruction in of the would like to see India open its practice. Clearly the focus of the would capital account fully only to be confronted then need to shift rapidly to managing by a financial crisis because capital surges monetary policy in an open economy, with could not be controlled. an open capital account, in a way that But, in weighing the balance of risks, supports the growth and globalisation of what is obscured is what India is losing by the real economy, while maximising the keeping the capital account partially closed, prospects for the success of an in and applying the regime in a manner Mumbai. that effectively closes it even more than the Simply put, in the Committee’s view, rules permit. That loss has been discussed India can have an IFC in Mumbai with at length throughout this report. Remain- an open capital account or it can keep ing capital controls – even partial ones – its capital account partially closed, in the pose a high practical (rather than theoret- way it is now, and forego/delay the option ical) barrier to permitting India to compete of creating an IFC until conditions are in the global market for . By doing so, deemed right to open the capital account 100 R M I F C
fully. What it cannot have is a credible towards convertibility. Each complements IFC in Mumbai with a capital account and strengthens the other. that remains partially closed. To create an IFC in Mumbai under such circumstances 9.1. Impact on the conduct of fiscal would be putting the cart before the horse. policy and debt financing It would lead to failure of the IFC and The first task of Indian public finance is compromise its prospects for many years to reduce the gross fiscal deficit in order to come. The experience would be similar to reduce and stabilise the debt/ ratio to the desultory experience with the OBU at a lower level (–%) than it is now experiment. This is a stark choice that (%). Once this is achieved, the task of Indian policymakers face. They must public debt management is to finance extant decide which way to go. The Committee debt as cheaply as possible. As has been is an advisory one and has no mandate to argued in this chapter, an in Mumbai make that choice. But it would be remiss would attract an array of global institutional in discharging its advisory mandate if it investors and issuers into the yield did not add that delaying the creation of curve. A properly functioning nexus an IFC in Mumbai has real costs (in terms – pivoting on a more liquid and efficient of foregone opportunities and revenues bond market – with well-traded, arbitrage- as well as payments for IFS that must be free and liquid yield curve would acquired from abroad) that should not be provide the best foundation possible for obscured. bond issuance by the o. Growth of Indian As long as residual capital controls institutional investors along with an existing are in place, all India will get is more universe of global investors anxious to buy / in finance and perhaps be able denominated paper would generate to offer a very limited range of such natural customers for Indian government as algorithmic trading with ; but bonds tradable in global markets. Once the there will be no . At the same time, is accepted in the portfolios of global the establishment of an , and the fixed income investors, the size of bond associated onset of full capital account investments available to the Government will convertibility (), has implications for greatly exceed the amounts placed through the evolution of macroeconomic policy. In financial repression today. some profound ways, having an in Mumbai provides an answer to some of the 9.2. Impact on the conduct of more daunting questions about how fiscal monetary policy policy and monetary policy will work in an An in Mumbai would strengthen the environment without capital controls. From information set on which monetary policy is the viewpoint of managing macro-policy, it decided and increase its efficacy. Around the makes more sense to have full convertibility world, monetary authorities make extensive and creating an , instead of trying to use of information from global financial achieve convertibility without attempting to markets in the formulation of monetary create an . policy. This information includes implicit and explicit market estimates of expected 9. Full capital convertibility inflation, currency volatility, interest rate and an IFC in Mumbai volatility, etc. Such vital raw data for the sound conduct of monetary policy is, at Export-orientation in the Indian real present, absent in India owing to the stifling economy required the removal of trade of financial markets. An would enable barriers. In similar fashion, successful export and empower such markets, and thus feed of via an in Mumbai requires better information back into the formulation the removal of capital controls. At the of monetary policy. same time, the reasoning presented in this chapter suggests that creating an has For related arguments, see http://tinyurl. many synergies with moving more rapidly com/yapulp on the web, and Bodie and Merton (). . The macroeconomic fallout of an IFC 101
The second impact of an on build operations all over the world and monetary policy concerns efficacy. Central become multinationals, capital controls lose banks in mature market economies set only efficacy. They simply become discriminatory the short-term interest rate and articulate rather than useful. They discriminate against clear rules about how they will react in firms that do not trade or invest abroad while the future to new domestic and global favouring those that do. developments and data on prices. Once Many countries – e.g., all the small this is done, market arbitrage translates countries of Europe – have local financial adjustments in the short-term rate into systems that are not globally significant changes in long-term interest rates and while having an open capital account. But prices on the corporate bond market across there are powerful synergies between having the maturity/duration spectrum. The a world-class financial system in a large, efficacy of monetary policy comes about globally significant economy and having an through this plethora of changes, which open capital account. An in Mumbai flow through arbitrage in the fixed income dovetails with an open capital account in market. In India, since the fixed income India. On the one hand, an will not market has neither liquidity nor arbitrage, take root without the removal of capital this channel for the exercise of effective controls. But equally, the establishment of monetary policy is made defunct. An an , and an accompanying program of in Mumbai of the kind the envisages financial sector reforms, provides the ideal would result in the creation of a liquid supporting infrastructure for dismantling and arbitrage-free yield curve and a capital controls and coping with the corporate bond market. consequences more smoothly. Worldwide India is headed towards convertibility experience with opening the capital account sooner or later. That is partly due to emphasises the importance of having strong the vision and foresight of policy makers financial markets and institutions to cope but, more importantly, to increasing with the consequences of that transition. The globalisation and the consequent ease with creation of an in Mumbai is an integral which capital controls can be evaded. In and indispensable element in making that practice, when a country has an open transition. current account, and when local firms
Financial Regime Governance: Its role in an IFC and a comparative perspective
1. The intrinsic value of practices. A side-effect has been that export- regulation for IFS production orientation has improved the productivity and efficiency of production, as well as The fundamental difference between the pre- the quality/quantity of goods and services c h a p t e r and post- approaches to development available, for the domestic market. In strategy in India – i.e. the themes addition, competing in global markets has of outward orientation and openness to proved to be useful in sidestepping problems enhance technology, efficiency, productivity, of domestic competition policy, reducing quality and competitiveness throughout rent-seeking impulses in local political 8 the economy – apply with equal force economy, and thus accelerating growth. when it comes to providing . An However, it is important to take note of inward-looking policy aimed at protecting a fundamental difference between the export the domestic market for financial services of financial services and the export of goods (e.g. protecting financial firms from the and non-financial services. force of competition from other domestic IFS exports are intrinsically differ- and foreign competitors) exacerbates and ent from ordinary exports. When a car prolongs: intermediation inefficiency, is exported from India, its quality/value is over-staffing, cost-ineffectiveness, higher measured without regard to the difficul- intermediation margins, poor management, ties encountered in its manufacture. Deal- poor service quality, sub-optimal technology, ers/customers who sell/use the car – any- and inability to capture fully a number of where in the world – evaluate/verify its qual- economies of size and scale. ity and relative value by applying objective In establishing an appropriate context tests. An Indian car is accepted by the world for the discussion on Indian financial market if it passes these tests; it is rejected if regulation that follows, it is essential it does not. to underline that, since , India has Production of the car in India might made a belated but fundamental shift take place in a difficult institutional and from an import-substituting development operating environment characterised by model to an outward oriented strategy a number of weaknesses such as: poor emphasising greater openness and trade infrastructure, restrictive labour laws, high (particularly exports). In the process, real costs of capital, inefficient taxation, a India has discovered that achieving export- weak legal system, difficult trade unions, competitiveness requires a combination poor public governance, poor standards of of: (a) cost-effective human capital inputs; regulation (e.g. health and safety standards, (b) good management and corporate factory hygiene, conformity with local governance; (c) the use of cutting-edge planning rules, etc.). technology that is continuously updated; These difficulties induce additional and (d) the application of best global ‘coping costs’ for firms manufacturing cars 104 R M I F C
in India. For example, an industrial process For example, a simple deposit at a bank that consumes tap water in an involves the performance of an action or country might require a special purification fulfilment of an obligation by the bank to plant in an India; or the unreliability of the customer at a future date: i.e. when one power supply may require investment in a buys or invests in a CD for Rs. , at an captive power plant; or a car manufacturer interest of % for months, one expects may need to have special infrastructure for the bank to return Rs. , at the end of effluent discharge and sewage. However, that period with even thinking about it. The once the car is made, these problems thought process of the customer involves do not affect either the reality or user the financial regime governance at two perceptions of its quality. An objective levels. First, is the bank well regulated and technical assessment of the finished car is supervised, so as to induce a low probability ‘ahistorical’; it has no links to the policy, of failure? And, if the bank goes bankrupt, is regulatory or physical environment under there an effective bankruptcy procedure with which it was produced. This applies for a a high and predictable recovery rate, on a wide range of ordinary goods and services highly predictable time horizon? If Mumbai – ranging from motorcycles to steel to is to become an , and attract global computer programmes. For this reason, customers who place deposits in banks India has made considerable progress in in Mumbai, then an intrinsic part of the exporting a variety of goods and services, product offering would be to have answers even though the underlying institutional to these questions that instil confidence in environment continues to be deficient in the global customer that in these and other many respects. High coping costs induce respects an in Mumbai operates with lower wages, yielding globally competitive world-class standards. prices for finished goods in most industries. When an Austrian customer buys But this separation between final an Indian car, he is concerned with product and the institutional/policy and its quality, performance, reliability and regulatory environment in which it was functionality. He is blithely unaware of produced (i.e. the regime that governed the Indian policy framework for auto its production) does not hold for . manufacturing, the legal regime, the Finance is about the fulfilment of contingent infirmities of physical infrastructure, or the contracts that specify performance of stated capability and competence of the regulatory actions by stated parties at future dates. institutions that governed its production. The quality, performance, and value of Once the car is produced and used, those a financial product or service depends connections cease to matter. In contrast, critically on confidence in the mind of the when an Austrian customer places an order customer, and trust on his/her part, that on an Indian - futures market, stated actions/obligations at future dates will or buys an Indian bond or share, he is be performed/fulfilled as promised. Given inextricably and inexorably affected by their very nature, the implicit obligations Indian law and regulation. Indian law that underlie all financial contracts, and and regulation are an intrinsic part of the the regulatory regime that governs their financial product/service purchased. They fulfilment, become an intrinsic part of such cannot be stripped out. contracts – represented operationally as For that reason, one of the key elements financial products and services. in judging the technical merits and relative Financial Regime Governance: i.e. the safety of a - futures position on framework of laws, rules and regulations an Indian exchange, in the eyes of a foreign governing financial products/services (and customer, are the strengths and weaknesses the way in which authorised regulatory of Indian law and regulation; as well as the institutions specify, apply and enforce them) credibility and capability of its regulatory is therefore intrinsic to the value of financial institutions and exchanges. Hence, achieving services in a way that governance is not success in the export of such as intrinsic to the value of a car or a ball bearing. currency futures trading, or involving . Financial Regime Governance: Its role in an IFC and a comparative perspective 105
global investor participation in Indian 2. Three levels of international bond, equity, derivatives or commodity competition on regulation markets, is not just about having good and law issuers, attractive products that are liquid and tradable, or globally competitive entities International competition on issues of in the private sector, such as exchanges or financial regulation and law, which shapes brokerage firms. It is equally about having competition in provision, occurs at three foundations, institutions and practices of levels: law and regulation or, more holistically, of financial regime governance that is also . Banning products or markets; banning globally competitive in meeting the best export: At the simplest level, one standards of regulatory practice applied can lose out to others because it is around the world. In this sense, Mumbai’s blocked from competing with them seeking to become a globally competitive in the provision of particular financial requires Indian law, regulation and products/services or of a wide range overall financial regime governance to be as of them. At present, most products good as the best ‘state-of-the-art’ equivalents and services in the global space at other s. are not exported from India because their production (even for the domestic Financial regulation is thus an intrin- financial system), or sale to foreigners, is sic, inseparable component of any finan- prohibited. cial service/product; whether it is sold do- . Rules limiting the success of products or mestically or internationally. But, when markets when they are permitted: Even sold internationally, the regulatory com- when provision of a certain kind of ponent of that financial service/product is permitted, restrictive regulation can must conform to the best international limit the success of an in providing norms/practices for it to be acceptable to . Limitations on participation by global markets and the financial firms and certain types of firms in certain markets players operating in them. This is a key (e.g. banks being prohibited from premise that must be appreciated at policy- operating in derivatives markets or making levels. foreign banks being prohibited from When a financial product is sold or a doing government business) or on service is provided across borders, issues of proscribing certain kinds of trading confidence and trust in the fulfilment of strategies (e.g. algorithmic trading obligations by counterparties become more and ), can decisively influence the acute. This has two implications for an success of a product or a market by in Mumbai. First, India as a newcomer in circumscribing its use to the point where the global space must aspire to higher the market becomes too small, fractured standards than those in London and New and illiquid with virtually no market- York, in order to attract global business. making. What are ostensibly ‘prudential’ The same infirmities embedded in London requirements can limit product/service and New York for historical reasons may not success when there is overstretch beyond be acceptable to global customers operating a technically sound notion of prudence. in a new Indian . Second, India will . Intangible issues of trust and level not be able to make rapid inroads into the playing field: Finally, the export of is global customer base without provision influenced by intangible concerns about in Mumbai by global financial firms that legal/regulatory impartiality, fairness are recognised brand-names to global and trust as seen by private players customers. For Mumbai to develop as a (whether domestic or foreign) and global credible it will not be sufficient for customers. Global customers have a to be provided only or mainly by Indian choice of placing orders in competing financial firms that are not as yet globally s for their transactions. That recognised brand-names. choice is influenced by perceptions about 106 R M I F C
the soundness, stability and fairness of global competitiveness in production, the legal/regulatory environment which are scored. The first measure is that of an has; i.e. the extent to which it is ensuring systemic stability (E), the task felt by customers that a particular of avoiding crises that engulf the financial has fair processes of enforcement, and system and the macro-economy at large. treats non-residents fairly. One part of this concerns the protection of the integrity and soundness of financial institutions (E). But equally, recognising 3. Where does India stand? An that firm failure is an inherent feature illustrative bird’s eye view and a learning mechanism in any market To obtain a bird’s eye view on issues economy, a sound regulatory regime has concerning regulation and the legal system, effective coping mechanisms when market as they influence global competition on , and institutional failures do take place (E) this report examines them in comparison so that failures are handled in a manner against existing and emerging s through that does not induce panic. A sound a scoring scheme from (worst) to regulatory regime is one where good quality (best) on a list of crude but useful risk management occurs at the level of illustrative indicators. This is applied to firms, markets and the system at large groups of existing and of emerging s. (E). Failures to achieve this can arise The indicators, and the numerical values from faulty rules, in a rules-based regulatory for scoring shown below, are admittedly environment, or from moral hazard with subjective. There is an inevitable cross- finance firms which believe they will be over where different indicators pertain to bailed out in distress. overlapping, and yet distinct, issues. Much A key test of a sound regulatory regime time has been spent debating the choice is whether it assures consumer protection of indicators, and the numerical values for (E). What matters is the degree of genuine each city and each indicator to obtain a protection that consumers get as opposed more objective picture. But we should to a regime that is strong on rhetoric about stress that there is no objective methodology the importance of consumers while failing underlying these numerical values. to uphold the interests of the consumer in These tables should be cautiously reality. As an example, financial repression utilised as an illustrative input for insights is inimical to the interests of all households. and for policy analysis, rather than as precise It is inconsistent with consumer protection, numerical values that should be argued regardless of rhetorical claims made by ad infinitum. Also it has to be recognised policy makers about the importance of the that in most of the comparator cities scores consumer. Another aspect of consumer are based on subjective judgements about protection is the distinction between notions regulatory regimes for and s that of what consumer protection actually is, are already in place. In most s there as opposed to making it synonymous is some overlap between regulation of the with adherence with an intricate system overall financial system per se, and regulation of rules specified by regulators. As is of provided through an . In now understood from global experience, the case of Mumbai there is no specific financial firms often have clever compliance regime for or an in place yet. Its departments to ensure adherence with scores therefore reflect judgements about complex rules, while violating the spirit its current governance regime for financial and reality of consumer protection in the services as a whole, including those for conduct of business. a limited range of involving foreign One of the strongest tools for consumer institutional investors s and the protection is competition policy (E). A activities of foreign banks. sound regulatory regime is one in which Thirteen aspects of the quality and there is full and effective competition impact of the regulatory regime for the and where every market is genuinely financial sector, from the viewpoint of contestable. This applies in two ways: . Financial Regime Governance: Its role in an IFC and a comparative perspective 107
Box 8.1: Case Study - The Nikkei futures The newspaper Nihon Keizai Shimbun has computed the Nikkei 225 It looked like Japan had successfully captured the Asian day and the index, a price-weighted stock market index of large Japanese firms since Western night business for its Nikkei 225 futures contract. While the 7th September 1950 (Azarmi, 2002). Western day business was done in Chicago, Singapore was pushed aside The first index futures contract was the S&P 500 index futures, which to doing only marginal side business. SIMEX tried hard to attract more started trading at the Chicago Mercantile Exchange (CME) in 1982. It was business. It offered an award to the brokerage firm that did the most only a matter of time before a Japanese index futures contract started business through it. trading. In the summer of 1992, the Japanese regulators gave Singapore a big ‘omiage’ (gift). The Japanese regulators had misdiagnosed the difficulties CME was interested in this market, as was the Singapore International that had led to the October 1987 stock market crash in the US and had Monetary Exchange (SIMEX). SIMEX was established in 1984, as a part of Singapore’s plan to become a centre for international finance. It offered decided that programme trading was to blame. an open outcry trading system for investors across the Asia Pacific and Osaka imposed stringent rules on the options and futures deals in that European regions and to interested parties in the US through the mutual market. In order to stymie programme trading, Japanese regulators offset system. The time difference between Singapore and Tokyo made it imposed restraints on index futures trading in the Osaka Futures convenient for Japanese traders to trade on SIMEX. Three factors affected Exchange. In addition, the price was allowed to move only within tight the evolution of this market: limits. Osaka let the Nikkei contract move to about 3.3% of current market levels while SIMEX permitted a 10% fluctuation. Because of this the Osaka market was often suspended for most of the day, especially . Japan had wagering restrictions that hindered cash-settled index when markets were volatile, leaving traders with no domestic benchmark futures contracts. An effort was made to launch a physically settled against which to buy and sell. Traders had to keep high margins with the contract which quickly failed. This legal hurdle needed to be resolved exchange. Margins were raised four times in 1991 and in 1992, after in order to enable index futures trading. which margin stood at 30% of the value of the contract, of which 13% . Nihon Keisai Shimbun Inc. had to choose how it would license the was a non-interest bearing cash deposit. In addition, dealers’ commissions index. were required meet a minimum rate that the exchange had specified. This enabled SIMEX dealers to gain a competitive advantage by offering . Japanese regulators had to setup a regulatory regime for the product. discount commission rates that could not be matched at Osaka. Within a few weeks of implementing these rules, trading began to Nihon Keisai Shimbun chose to license the index to three exchanges: move from Osaka to SIMEX. Trading in SIMEX rose from 4,000 to over CME (May 1985), Simex and Osaka. CME and SIMEX had the option of 20,000 contracts per day. The success with the Nikkei 225 futures put linking their Nikkei 225 contracts. These exchanges were already linked SIMEX and Singapore on the global map. This was bad for Japan’s through a mutual offset arrangement in a number of futures contracts financial industry, which lost fees for brokerage, transactions, research, offered at both markets, such as the Eurodollar futures. Positions taken in advisory, etc. However, it was good for users in Japan, who were not these contracts at CME could be transferred to or liquidated at SIMEX and locked into using their inferior domestic market: they were able to use vice versa. the offshore market even when policy makers disrupted the local market. With a fungible contract, the risk that one market would grow at the The Nikkei 225 futures now trade in Chicago, Osaka and Singapore. other’s expense was low. However, the rewards of offering a successful Japan’s regulators have since removed many of their restrictions, but an Nikkei contract exclusively were high. SIMEX chose independently to offer important Nikkei 225 futures market remains in Singapore. This is partly a non-fungible Nikkei 225 futures contract in September 1986 – thus it because liquidity is hard to dislodge once it comes about. In addition, decided to compete and not cooperate with CME on this product. Japan appears to have problems with competition policy, and treatment of Osaka Securities Exchange started trading Nikkei 225 futures in 1988 foreign firms, which translates to elevated transaction and brokerage fees. followed by CME in 1990. From the onset, trading in Nikkei 225 futures at Osaka was very successful. Chicago has a 14 hour time difference with Table: Nikkei 225 futures: an example of three levels of international Tokyo. That ensured Japanese traders could not access CME during competition on regulation and law business hours in Japan. However despite the Osaka market, there was much Japanese interest in trading the Nikkei Futures in Chicago. At the Aspect Example: Nikkei 225 futures time, some traders seemed to prefer the open outcry trading mechanism I. Banning of products and markets Nikkei 225 futures of CME to the computerised trading at Osaka. were banned Now three different exchanges were trading the same product. Since II. Rules limiting the success of Restrictions on all three markets were, to a large degree, targeting the same clients, there permitted products and markets participation, and was a chance that one or more of these markets would not attract high margins, in enough clients and suffer a liquidity problem. During these initial years, Nikkei 225 futures trading at SIMEX was not very active. traded in Japan. In the late 1980’s, Japanese regulators allowed banks and securities III. Intangible issues Trust in Japanese houses in Japan to do brokerage business in futures markets for their regulatory mechanisms customers. The biggest benefits of this decision were realised by the as seen by outsiders. Osaka market. The trading hours, the economy of the host country, and the access to the local market by both foreign and domestic traders were This case study illustrates all three levels of competition in export of IFS. all important to the success of Nikkei futures on each exchange. Most of At first, in the period after 1982, even though it was obvious from the these factors were in favour of Chicago and Osaka. success of the S&P 500 futures in the US that there was a market for the Consequently, by the early 1990’s, the Chicago and Osaka markets Nikkei 225 futures in Japan, the Nikkei 225 futures could not be launched were thriving. SIMEX was not. Since the Chicago and Osaka markets did in Japan owing to legal difficulties with cash settlement. Japan then not trade simultaneously, there were no arbitrage opportunities between squandered a head start owing to poor policy analysis in the aftermath of the Chicago and SIMEX markets or the Chicago and Osaka markets. October 1987, which led to restrictions against program trading, high However, for most of the trading day, the Osaka and SIMEX trading times margins and regulated brokerage fees. Finally, SIMEX and CME were more overlapped. So a trader could arbitrage between these two markets. attractive for global order flow in terms of the intangible issues of trust. 108 R M I F C
competition among firms, and competition conflicts-of-interest from arising on a day- across different financial ‘technologies’. to-day basis? Can it do so when the Competition among firms is impeded by government that is its apex authority, is entry barriers in any kind of business. also the country’s largest owner of banks, Competition across technologies is best owns other financial firms and is its largest illustrated by an example: Money market borrower? mutual funds and checking accounts are In the globally competitive game of , alternative technologies through which innovation is the main source of competitive certain kinds of services can be obtained advantage. The impact of the regulatory by customers. Sound competition policy regime on financial innovation (E) directly requires that both these sub-industries affects success in establishing an . This compete with each other in the marketplace. issue is also related to the extent of regulatory Any regime that blocks the growth of intrusiveness and micro-management of checking accounts in order to favour mutual markets and institutions (E). It is inimical funds, or blocks the growth of money to succeeding in the global competition market mutual funds in order to favour bank for . The ideal framework is one deposits, limits competition and damages that is principles-based, open, market- consumer interests. friendly and competition inducing (E). The next question is that of a level s with rules-based regulation, entry playing field (E). It is related to competition barriers, low competition and opposed to the policy. It seeks identical regulatory treatment open internationalisation of their financial of all firms. A key feature of an is the systems would score poorly on E. treatment of foreign firms. One indicator Finally, the overall value of a regulatory is the extent of protectionism embedded in regime for finance is the extent to which it the regulatory system (E). This seeks to is conducive to efficient/effective resource measure the treatment of foreign firms in mobilisation and allocation (E). As a broad sense. It is like a level playing field emphasised above, the choice of these question where a domestic firm is compared thirteen indicators, and the numerical scores against a foreign firm. of each city, are necessarily subjective. Yet, A key indicator affecting the perfor- these tables yield useful comparative insights. mance of the regulatory system is the prob- First, they permit an understanding of the lem of conflicts-of-interest. Financial reg- strengths and weaknesses of established and ulators tasked with various functions in fi- emerging s on these dimensions. But nancial regulation need to have clear goals equally important, for the present purpose, that do not conflict with each other (E). they put the spotlight on the weakest links For example, around the world, an increas- that will inhibit Mumbai from emerging ing number of monetary authorities are as an when compared with its global tasked with achieving the single goal of price competitors. stability. Separate institutions undertake An examination of the values in these regulation and supervision of the financial two tables is revealing. As far as the overall system. score for the quality and impact of finan- But, in India, in addition to the core cial system regulatory regime is concerned, goals of monetary policy, the central bank Mumbai lags behind both established and as a regulator has other subsidiary roles. emerging s. London, with a score of , is These include: protecting banks, enabling the benchmark that every seeks to em- the provision of subsidised credit in some ulate. New York and Singapore both score sectors, running a bond exchange and a an overall along with Sydney and Dubai. depository, and financing the public deficit Hong Kong fares better at . Seoul and at lower than real market cost. Can a Labuan follow up with and respectively. central bank that: is not constitutionally Mumbai lags at . Regulation is clearly an independent of government, has multiple area where much needs to be done if Mum- roles, and is asked to achieve multiple non- bai’s aspirations to become an are to monetary goals, possibly avoid multiple be realised. . Financial Regime Governance: Its role in an IFC and a comparative perspective 109
Table 8.1: Comparing Mumbai against established IFCs on the quality and impact of the financial system regulatory regime
London New York Tokyo Singapore Frankfurt Mumbai
Quality and Impact of Financial System Regulatory Regime 9 7 6 7 5 3 E1: Ensuring Systemic Stability 10 8 8 8 8 7 E2: Protecting Integrity and Soundness of financial institutions 9 8 9 9 8 6 E3: Capacity to Cope with Market and Institutional failures 10 8 8 8 7 7 E4: Sound risk management at all levels: systemic, market, institutional 10 10 8 8 8 5 E5: Effective consumer protection 8 7 7 8 9 5 E6: Encouraging full and effective competition across firms/segments 10 6 5 7 5 2 E7: Ensuring level playing field for all players in all market segments 9 7 5 7 6 2 E8: Extent of Protectionism embedded in regulatory system 9 6 5 5 4 1 E9: Avoidance of conflicts-of-interest 8 7 5 6 5 1 E10: Impact on Financial Innovation 10 10 5 5 4 1 E11: Intrusiveness and micro-management of markets/institutions 10 7 7 6 5 1 E12: Principles-based, open, market- friendly and competition inducing 10 7 7 6 6 1 E13: Conducive to efficient resource Mobilisation and allocation 8 7 6 7 6 2
Table 8.2: Comparing Mumbai against emerging IFCs on the quality and impact of the financial system regulatory regime
Mumbai Hong Kong Labuan Seoul Sydney DIFC
Quality and Impact of Financial System Regulatory Regime 3 8 4 6 7 7 E1: Ensuring Systemic Stability 7 7 3 7 8 5 E2: Protecting Integrity and Soundness of financial instituions 6 7 5 7 8 6 E3: Capacity to Cope with Market and Institutional failures 7 9 3 7 8 6 E4: Sound risk management at all levels: systemic, market, institutional 6 7 5 7 8 5 E5: Effective consumer protection 5 6 4 7 8 5 E6: Encouraging full and effective competition across firms/segments 2 8 5 7 8 9 E7: Ensuring level playing field for all players in all market segments 2 8 4 5 6 8 E8: Extent of Protectionism embedded in regulatory system 1 7 5 5 7 8 E9: Avoidance of conflicts-of-interest 1 6 4 5 8 4 E10: Impact on Financial Innovation 1 7 2 5 7 5 E11: Intrusiveness and micro-management of markets/institutions 1 8 5 5 7 5 E12: Principles-based, open, market- friendly and competition inducing 1 7 2 5 6 8 E13: Conducive to efficient resource allocation 2 7 3 6 6 5
A closer look at the numerical scores on one indicator (coping with market and shows that Mumbai has better scores – such institutional failures) with a score of . as , and – for indicators E through Mumbai may have a slight edge over E. Mumbai appears to match Frankfurt on these measures, though this partly reflects 110 R M I F C
the relative age of ; there is little doubt to the legal system; and (d) the integrity that Dubai will strengthen these features as and competence of the legal system as a time passes and experience is gained with whole and all its components for resolving episodes of failure. civil conflicts and disputes and assuring the enforcement of contracts through recourse Where Mumbai fares badly is on indica- in real time. tors E through E concerning competition, invariably involve multiple instru- level playing field, protectionism, conflicts ments (underlying contracts accompanied of interest, innovation, regulatory intrusive- by a variety of risk management instru- ness, micro-management, and rules-based ments) bundled under a single financial regulation. Mumbai has to make progress structure (such as a syndicated loan or a on E through E, where it lags emerging sovereign bond with features and conditions s by a small extent. But fundamental attached). also involves complex finan- rethinking is required on factors E through cial structures such as those involved with E where both established and other emerg- privatisations involving the participation of ing s out-perform the Indian financial global investors and lenders, or arrange- regime governance. ments involving municipal, state and central On balance, these constraints hamper governments acting in concert with private the ability of the financial system to perform contractors, domestic and foreign, but with its core task: that of supporting efficient distinct performance obligations (and penal- resource mobilisation and allocation (E). ties in the event of default or breach) for Here Mumbai fares poorly when compared each. These complex contractual structures with both established and emerging s. require commensurately sophisticated con- An interesting feature of indicators E to E tract enforcement mechanisms. is that these are the areas in which London An illustrative approach, using indica- appears to fare better than New York. A tors and scores in the same way as above, deeper understanding of the task facing the is brought to bear on understanding the Indian authorities in making Mumbai is quality, efficiency, effectiveness and support- an is illuminated by the international iveness of the legal system insofar as it affects debate about the approach to financial finance in general and in particular. The regulation as opposed to the approach. quality, efficiency and effectiveness of legal Concerns in the that New York is falling recourse for redressing non-performance behind London in these respects are reflected under contracts, is a fundamental ingredi- in recent speeches made by the Treasury ent in the globally competitive provision of Secretary and by the Committee on Capital . In attempting that task, eight indicators Market Regulation that has been set up to are relied upon. The first (F) concerns the see what can be done. knowledge base (‘know-how’) that exists in a particular ; i.e. in terms of having 4. The overall legal regime law firms, specialist lawyers and judges who governing finance understand and are experienced in the in- tricacies of dealing with complex financial Underlying the key, but specific, question contracts. of financial regulation are a broader set of Most established s are characterised issues concerning the extent to which an by the presence of global accounting, law and jurisdiction adheres in principle to globally tax advisory firms employing professional accepted standards for the ‘rule-of-law’ as staff at all levels who have worked in well as how such notions are applied in several s over many years. These practice. Specifically, where the provision of institutions are familiar with not just the is concerned, global financial firms and laws and regulations of the jurisdictions investors place considerable emphasis on: (a) concerned but of other s and the source respect for property rights; (b) enforcement countries of global investors. of creditor and shareholder rights; (c) the Though it does not yet have an efficiency, cost and ‘fairness’ of recourse in Mumbai, India’s legal system is . Financial Regime Governance: Its role in an IFC and a comparative perspective 111
widely perceived as adhering in principle believe in eternal life has never litigated in to the rule of law, underpinned by a an Indian courtroom”. The Indian civil time-tested constitution and a durable, legal system in every city at every level resilient legislative democracy that has been seems beset by frequent interruptions and time-tested for six decades. At its apex, delays in the way cases proceed. There India is perceived as having a paradoxical is a phenomenal backlog of cases (several combination of: (a) world-class knowledge, million) in the pipeline. It can take up to competence and sagacity about global two decades for civil cases to be resolved; finance, reposed in a few accomplished often after the demise of the original litigants individuals with technocratic backgrounds and their immediate descendants. Such and relevant practical experience; coupled absence of time-consciousness would be with (b) a lack of similar knowledge, and a significant deterrent to global investors ideological opposition, at other levels as from using an in Mumbai. Under to how the global economy and financial such circumstances, even if property or system function. creditor rights are respected in principle, The legal system – in terms of its ability they cannot be applied or enforced in to understand and deal with issues of inter- practice, simply because of the perception national finance – is perceived as capable that as many Indian eminent jurists have at the apex level, but weaker at intermedi- repeated: “justice delayed is justice denied”. ate and lower levels. The legal system in Distinct from the time taken to resolve India/Mumbai is perceived by practitioners contractual disputes through legal recourse, abroad as adequate by international stan- an indicator (F) of some concern to dards but not as knowledgeable about global global firms operating in s, and to finance simply because it has not had the global investors, is the issue of probity opportunity to acquire such expertise. The and effectiveness of the legal systems in an absence of recognised global legal firms in , especially when it comes to enforcing India, with specific expertise and experience judgements, and applying the rule of law in dealing with , provides some cause for in practice, as opposed to adhering to concern. That deficit represents a serious in- it in principle. Again, on this measure, stitutional handicap if Mumbai is to become India (Mumbai) would fare poorly when an . compared with s in countries. The second indicator (F) concerns the The next indicator (F) deals with issues efficiency of the ’s legal system. It conveys of integrity and probity across the legal a composite assessment of factors like: the system. It is an illustrative measure that legal requirements and processes involved in indicates the degree to which attributes getting conflicts/disputes resolved through such as fairness, impartiality, and credibility the legal system; interruptions and delays characterise the legal system in an , along in the progress of cases through the system; with the relative presence or absence of the backlog of cases in the civil system; corruption. Global publicity attracted by the quality of decisions and incidence of perceived miscarriages can affect the image successive appeals; the overall time taken of a legal system adversely. for dispute resolution; and the cost involved. The fifth indicator (F) focuses on the The World Bank’s ‘Doing Business’ database quality (in purely technical terms i.e. by way has come out with numerical measures for of professional competence) and the human the number of days that it takes to settle and institutional capacity of the legal system disputes in various countries. This is related to indicator F. On this indicator Mumbai No comparative scores have been provided for Mumbai in these two tables. The felt that as would not fare well relative to other s. there was no in Mumbai, the basis for comparison Most global investors seem aware that might be misleading and controversial if numerical the concept of ‘real time’ appears to be scoring was attempted to convey a spurious sense of elusive in Indian legal practice. That was accuracy. However it also felt in qualitative terms that Mumbai was quite far behind other s in these areas substantiated by the late Nani Palkhiwala and much needed to be done to catch up with best who said that: “Anyone who does not global practices. 112 R M I F C
Table 8.3: Comparing IFCs on the quality, efficiency and effectiveness of the legal system
London New York Tokyo Singapore Frankfurt
Quality, efficiency, effectiveness of legal system F1. Know-how in dealing with complex Financial instruments/arrangements 8 9 6 6 5 F2. Efficiency of legal system (i.e. time for dispute resolution) 7 8 7 9 6 F3. Effectiveness of legal systems - enforcement and rule of law 7 8 7 8 6 F4. Fairness, Credibility, lack of Corruption in civil legal system 7 7 9 10 8 F5. Human and Institutional Capacity and Quality of the Legal System 7 8 7 8 7 F6. Adherence to global benchmarks and standards of best practice 8 8 6 7 6 F7. Use of national law in national, regional and global contracts 8 9 3 5 4 F8. Overall Assessment of Legal System Functioning 8 9 6 8 6
insofar as its capability for dealing with, and (, , or ) when they are supporting, is concerned. While this available; and (b) which foreign jurisdictions indicator may involve a judgemental overlap are chosen by most s as centres for with the first indicator of ‘know-how’ (F) it adjudication and settlement of disputes. is different in the sense that it attempts to Again, on these two indicators, Mumbai capture dimensions that go beyond simply would fare poorly but then so do most the ‘know-how’ aspect. F tries to capture other s other than the three s and a sense of the quality standards of legal those that use and law for their training and expertise in dealing with issues contracts as a matter of course. An attempt that the provision of raises, the degree to make Mumbai an will require a of professionalism, quality of jurisprudence, substantial improvement in the functioning depth and width of human capital, and the of its legal system for this purpose. professional capabilities of legal firms and Under the present circumstances it advocates in comparison with their global would be unrealistic to assume – if an peers. Again a comparison across established were to emerge in Mumbai – that Indian and aspirant s would reveal Mumbai as law covering contracts, or Mumbai as a comparatively weak as far as the capacity jurisdiction for adjudication concerning , of the extant legal system for supporting would be immediately acceptable to global the provision of by financial firms in participants. It is more likely that, as in most Mumbai is concerned. But that weakness s at present, or law would be could be corrected quite swiftly if the will chosen to cover contracts. Over time was exerted to accomplish that. – with experience, expertise and credibility In a similar vein, the sixth indicator being gained, along with improvements in (F) attempts to convey a sense of how well the operating and quality standards of the extant s adhere to global benchmarks Indian legal system – it is more than likely and standards of best practice in matters of that Indian law could gradually be applied law and legal support where the provision of to operations in Mumbai and become is concerned. The seventh indicator (F) acceptable globally. assesses the extent to which: (a) ‘national Finally, the eighth (F) indicator at- law’ prevailing in an jurisdiction tempts to encapsulate information con- governs the provision of in/from tained by all the previous seven indicators that jurisdiction or whether contracts into a composite judgement. Unsurprisingly are governed by the use of foreign law it reflects what has already been alluded to (invariably or ) or international codes above. . Financial Regime Governance: Its role in an IFC and a comparative perspective 113
The two tables on the ability of the The second interesting comparison is extant legal system to support the provision Hong Kong. Here, the traditional argument of reveal a discouraging picture because made in Indian circles is that the Chinese in our subjective judgement Mumbai lags financial and legal systems lag far behind in all aspects. The four tables comparing those of India. That is undoubtedly true as different s on financial regulation and far as Mumbai competing with Shanghai the legal system are particularly illuminating as an is concerned. But China has an in terms of two comparisons: against enormous asset in the form of Hong Kong, a Shanghai and . While Mumbai might thriving well-established that has been be competitive with Shanghai in these shaped by over a half-century of liberal law aspects, that is not the case with , and regulation based on the model. whose legal governance and regulation Hong Kong scores better than Mumbai on is de-linked from the ’s legal and financial regulation and its legal system. This regulatory regime for financial services. It is affects India in two ways. purpose-built for alone. has First, in the global competition for a stated policy of hiring the best available production, China may have a stronger practitioners from abroad to ensure that position than appears to be the case, if regulation and dispute settlement at the institutional attributes of Hong Kong are of the highest world class standards; are taken into account. The caveat lies in i.e. similar to those prevailing in the three whether China will rely more on Hong Kong s. That could give an edge to than on Shanghai as its premier . as a competitor to Mumbai (as an ) in Second, if resource allocation in China attracting regional and global customers for is influenced by the way in which Hong . has a head start over Mumbai in Kong’s financial markets operate, that will the process of complex institution building certainly improve the quality of capital required for financial regulation and the productivity. This facet of having Hong legal system governing its . It is willing Kong contradicts the stereotype that Indian to be flexible, adopt the best global practices, finance and law are far superior to Chinese and has the resources as well as the political finance and law as far as provision is will to employ the best people available in the concerned. A considerable deployment of world, as regulators and for administering Chinese savings, and fundraising by Chinese the special legal framework that has been firms, especially for the southern special established for governing the operations of economic zones and the economic region . surrounding Guangdong, is being done in
Table 8.4: Comparing emerging IFCs on the quality, efficiency and effectiveness of the legal system
Hong Kong Labuan Seoul Sydney DIFC
Quality, efficiency, effectiveness of legal system F1. Know-how in dealing with complex Financial instruments/arrangements 8 4 5 7 6 F2. Efficiency of legal system (i.e.time for dispute resolution) 8 5 6 7 10 F3. Effectiveness of legal systems - enforcement and rule of law 7 5 6 8 5 F4. Fairness, Credibility, lack of Corruption in civil legal system 7 5 6 9 5 F5. Human and Institutional Capacity and Quality of the Legal System 6 5 6 8 5 F6. Adherence to global benchmarks and standards of best practice 8 6 7 8 7 F7. Use of national law in national, regional and global contracts 6 6 5 6 9 F8. Overall Assessment of Legal System Functioning 7 5 6 8 6 114 R M I F C
Hong Kong which outperforms Mumbai by other s are issues of financial regulation a considerable margin as a financial centre. (E to E) and the overall weakness of its legal system. These are the areas on which 5. Summary of cross-country this report places great emphasis as needing comparisons immediate strengthening if a viable is to emerge in Mumbai. In summary, it appears that the weakest links in an Indian effort to compete with What are the limitations of financial regime governance?
1. Where do we stand? describe what takes place at an . Each An IFS – Market × Players cell lists specific activities and accompanying matrix restrictions. This can serve as a useful visual aide for Indian policy-makers to focus on the c h a p t e r Apart from comparing financial regime constraints that hold back production governance in India with other global in India at present. The wallchart can be markets as done in the previous chapter, downloaded from the M website. an illuminating approach to understanding There is an inchoate sense of discomfort impediments to production in India in the Indian financial community that 9 is to look forensically into what constitutes regulation, more than any other variable, provision. That requires opening the prohibits many mainstream activities from ‘black box’ to describe precisely what takes being undertaken by Indian financial firms place when different financial firms provide in space. The wallchart translates various kinds of . This is done through such vague discomfort into operationally a classification of into the various understandable specifics. In other words, for activities/markets discussed at some length each kind of , for each kind of financial in Chapter of this report along with a firm, the wallchart shows what each financial classification of financial firms into ten firm does (or could do) in connection with broad categories as follows: each kind of at an , and the state of the play in the Indian regulatory regime. BANKS This report attempts to describe and • Commercial Banks document, as comprehensively as possible, • Private (not in the Indian vernac- what s do in clear detail and illustrate ular sense but in the Swiss) how much needs to be done in specific terms for Mumbai to become a credible . The • Investment Banks and Universal wallchart conveys the present situation in Banks Mumbai by colour coding: green to identify ASSETMANAGERS permitted activities; blue for restricted activities; and red for banned activities. For • Mutual funds India to become a player in the global • Insurance companies space, the colouring in a large number of • Pension funds cells will need to turn from blue/red to green, • Hedge funds as is the case with other s. The most remarkable feature of the wall FINANCIAL EXCHANGES chart is the extent to which it is coloured red. COMMODITIES EXCHANGES Most of the activities that global financial SECURITIESFIRMS firms undertake at s as a matter of course Combining the activities with the are prohibited in India. This is only partly financial firm classifications, a 19 × 10 due to capital controls. Careful examination matrix has been constructed as a wallchart shows that many activities in India are (see Appendix ). The rows indicate various not banned because of convertibility types of and the columns represent Bhattacharya and Patel () have an insightful various firms. For each kind of firm, in discussion about the difficulties of regulatory each activity, the cells in the matrix institutions in India. 116 R M I F C
constraints. There are regulatory restrictions firms into ten categories or compartments as well, probably reflecting caution and that are mutually exclusive. But it is conservatism on the part of regulatory important to emphasise that in an authorities. That, unfortunately, stifles these are not watertight compartments. financial competition and innovation. An does not specify that there The detailed wallchart, colour coded should be only ten different types of line by line, indicates prohibitions, permis- financial firms in broad terms. Financial sions, and lack of restrictions with some firms self-select the categories they place specificity for each activity in each cell. It themselves in. Large complex financial shows colour variations within cells of pre- institutions (s in Basel parlance) that scribed and proscribed activities. A con- operate on a global scale, like densed chart colours each cell – rather than and Citigroup, may embrace all ten each line – in red, blue or green. The colour categories under one brand, under a white denotes ‘not applicable’. holding company structure. But different This simpler rendition, dominated by and distinct intra-group corporations red, shows the imbalance between what is may undertake different activities like allowed and disallowed when it comes to commercial banking, investment banking, providing from India. It illustrates how securities brokerage, insurance, and asset significant are the restrictions: (a) bans on management to conform to regulatory and the provision of financial products and ser- market requirements. vices that are quite commonplace worldwide; Or, alternatively, a single firm – and (b) excessive compartmentalisation of fi- like Goldman Sachs – might undertake nancial sub-markets in India by prohibiting any or all of these activities; sometimes certain financial activities from being under- with multiple activities being undertaken taken by different kinds of financial firms. by one firm, or through dedicated Restrictions on financial market oper- subsidiaries for each separate activity. It ations, instruments and services have not may choose different routes in different been sufficiently debated either academi- s depending on their particular rules. cally or by the authorities concerned. This Competitive pressure is continually applied lack of debate is counterproductive for the by the market contestability of each of kind of India that is emerging, and for the the ten categories. But the financial kind of financial system that a new India authorities in any jurisdiction play no role needs. in constructing walls between different In summary, the wallchart serves two kinds of financial firms to prevent them purposes. First, it documents the kinds from competing with each other in of activities that are typically performed undertaking whatever combination of these at an . Second, it shows where India activities they wish in any way they stands in terms of regulatory barriers wish. impeding or obstructing the types of Contrarily, in India, a ‘primary dealer’ typically provided at an . The wallchart or a ‘mutual fund’ for example is seen thus provides a finer-grained sense of the as a self-contained firm that is highly impediments we face in competing in the circumscribed in the business it is licensed global market. It provides a useful to do. A ‘primary dealer’ in India can checklist for the task facing policy-makers be a primary dealer in government bonds, and regulators in reforming and aligning and has numerous regulatory restrictions financial regulation and policy to aim at on what other activities it can perform. enabling an to emerge in Mumbai. By contrast, in a typical setting, a primary dealership is merely one activity 1.1. A caveat about what the term undertaken by sophisticated financial firms. “financial firm” implies in the These financial firms do a myriad other matrix things – based on business strategy and not The columns in the wall chart attempt regulatory restrictions – apart from having a to classify different kinds of financial primary dealership. . What are the limitations of financial regime governance? 117
Matrix of Regulatory Issues Influencing the Emergence of Mumbai as an International Financial Centre (IFC)
Banks Asset Managers and Funds Securities markets
Commercial Private Investment Mutual Insurance Pensions Hedge Fin. Exch. Comm. Exch. Brokers/SFs 1 2 3 4 5 6 7 8 9 10 Fund Raising
Equity
Debt
Composite
Asset Management
Discretionary (assets managed purely by the manager; client has no involvement other than broad views about risk expo- sure).
Non-discretionary (assets man- aged with partial or full in- structions from client).
Personal Wealth Mgt.
Global Tax Management
Risk Management
Financial Markets
Currency Trading
Equity Trading
Bond Trading
Derivatives Trading
Commodities Trading
Mergers & Acquisitions
Leasing/Structured Finance
Project Financing
PPP Financing
Insurance & Reinsurance 118 R M I F C
2. A pragmatic view of key of financial firms to create new areas for progress products/services and to export them. The wallchart helps to illuminate for policy- All three issues are tightly related to each makers those key impediments that restrain other and need to be seen in an integrated provision in Mumbai. Policy makers context. Segmentation adversely influences can focus on specific cells in the wallchart competition; poor competition adversely matrix with the aim of converting all the influences innovation. believes that ‘blue’ and ‘red’ cells into ‘green’. That can these three issues constitute the essence in be done by alleviating the regulatory and understanding the regulatory constraints legal constraints that prevent financial firms that inhibit India’s ability to engage in in Mumbai from providing to their export-oriented production. domestic clients and exporting them as well. However, such an attempt on an item- 3. Lessons from applying by-item, rule-by-rule basis is unproductive. A more effective approach would be to competition policy in the look categorically (rather than individually) real economy into the more fundamental sources of the A generic issue that cuts across Indian detailed prohibitions on and deal with finance, but remains as yet unresolved, them at their roots; instead of focusing concerns the use of competition as a tool on trimming single branches and leaves, to drive financial system development and the detail of which would divert attention innovation. from the core problems that afflict Indian In a large, complex economy like finance. The case-by-case and rule-by-rule India’s – that is gradually but inexorably approach to problem identification and shifting away from an autarkic model of resolution is precisely what has prevented development to a more market-driven Indian finance from being transformed in model, and globalising rapidly as a result – the same way that the real economy was the most profound insight gained from post- transformed in the mid-s; through experience for modern policy-making blanket reductions in tariff and non-tariff is the importance of competition. There barriers rather than product-by-product, was a time not so long ago (until the late rule-by-rule, and industry-by-industry. s) when the centrality of competition A careful analysis of the wallchart, and in Indian economic policy was treated as the comparison with other s, suggests unproven conjecture. However, in the last three areas of policy that need to be focused fifteen years, India has seen the impact of upon in a fundamental way: greater competition in the real economy with tradable goods and services. Competition is • Competition policy: Examine the entry now understood as being the most powerful barriers that hinder competition across tool for encouraging firms to innovate, adopt financial firms and market segments and new ideas, abandon counterproductive remove them. beliefs and traditions, cut costs, and increase • Segmentation of the financial services exports. industry: Examine the inefficiencies that That view was resisted powerfully by arise from subdividing financial activ- the cr`eme de la cr`eme of Indian industry ities artificially and unnecessarily – to during the early phases of trade and tariff make regulation easier or make certain reforms. The universal belief on the part activities fall within the purview of one of the country’s public as well as its most regulator rather than another – into sub- prominent businessmen and intellectuals industries with excessive constraints on was that foreign goods were ‘naturally’ interactions and competition. better. Goods produced domestically under • Financial Innovation: Examine the sub-optimal conditions would always be causes of an innovation-unfriendly worse. The Mumbai Club claimed in – environment that limits the ability that, if exposed to global competition, . What are the limitations of financial regime governance? 119
Indian manufacturing would die. But the real sector: i.e., lowering/removing: such resistance proved ill-founded as events . Barriers to entry in the domestic market unfolded. India proved to be more resilient, by new Indian firms flexible, adaptable and competitive than commonly believed. Indian corporations . Barriers inhibiting entry by foreign firms proved to have better management teams into the Indian market which were able to cope with global realities. . Barriers against the sale of foreign goods The same industrialists who opposed such in the domestic market. reforms at the time at the time are now their These developments directly influenced most ardent advocates. the ability of Indian firms to compete in Indian firms are now growing from selling overseas in the following three ways: strength to strength, and becoming major s in their own right competing around • Modified factor markets: The removal the world with companies from the , of entry barriers led to heightened , China, Japan, Korea and A. competition resulting in the exit of weak Indian consumers have benefited from firms, thus freeing up the labour and goods of much better quality being available capital controlled by these firms. This immediately at much lower prices. Inflation influenced the price at which healthy in tradable goods has been kept down firms could obtain labour and capital. through import parity pricing. • Modified product markets: Ease of Table . shows that Indian customs importing made imported raw materials revenues dropped from .% of imports cheaper. It ensured internationally in –, to .% in –. Over this competitive sourcing of local raw same period, Indian manufacturing exports materials priced at import parity. rose from $. billion to $. billion. This • Modified technology: The entry of for- data understates Indian export revenue eign firms brought technical knowledge. growth since service exports are excluded. That set the stage for export from India The sharpest gains – a nearly three-fold of goods and services of international growth of exports – were concentrated in quality. In a world where % of interna- the recent period, from – onwards, tional trade is intra-firm trade within where the customs collection rate dropped multinational corporations, the reduc- from .% to .%. This suggests that tion of barriers to into India was a the gains obtained when going from very key element that enabled exporting from high protection to high protection are India. Foreign firms induced competi- smaller than the gains obtained in going tive pressure on Indian firms. That gen- from high protection to moderate or low erated incentives for Indian firms to ac- protection. India’s emergence as an export quire the knowledge (technology, design, powerhouse selling goods and services quality and market research) needed to into the global market began only after become globally competitive. Individu- a significant, though as yet incomplete, als who gained this knowledge working reforms initiative. at foreign firms went on to work at In- Policy reforms undertaken from to dian firms and carried knowledge with ignited manufacturing exports growth them. Export of software from India by by injecting three kinds of competition into IBM and Sun Microsystems is as much a part of the great Indian software story as For an early treatment of s emerging from the third world, see Lall (). export by Infosys and . The measure of protectionism – customs tariffs divided by imports – is a poor one, since it masks areas Through these three channels, India where high tariffs generate zero imports. There can came to understand the intimate linkages be situations where a reduction in protectionism is between the three pillars of competition associated with a rise in this measure. For the purpose policy, and the ability of firms located in of this table, “manufacturing” exports are defined as merchandise exports while excluding agricultural and India (whether local or foreign) to compete natural resource based exports. successfully in selling to global markets. 120 R M I F C
Table 9.1: Customs duties and manufacturing exports
Year Customs duties Manufacturing exports (% of Imports) (Billion USD)
1987–88 61.6 12.1 1988–89 56.0 14.0 1989–90 51.0 16.6 1990–91 49.0 18.2 1991–92 46.5 13.8 1992–93 37.5 13.8 1993–94 30.3 17.3 1994–95 29.8 21.1 1995–96 29.2 24.6 1996–97 30.8 25.5 1997–98 26.1 27.4 1998–99 22.8 26.3 1999–00 22.5 30.2 2000–01 20.8 37.0 2001–02 16.4 36.8 2002–03 15.1 44.1 2003–04 13.5 54.0 2004–05 11.5 70.0 2005–06 10.2 86.3
With competition in any industry, economy. Thus they drive up prices paid Schumpeterian creative destruction steadily by healthy firms for these inputs. When an reshapes the landscape of firms. It ensures intervention is made to protect a firm from that labour and capital gravitate toward bankruptcy, damage is imposed upon the efficient firms. Weak firms die. Strong economy through these three channels. firms gain market share. The process of Table . below provides empirical creative destruction is not neat or tidy. evidence about the competitive dynamism It involves social disruptions caused by achieved in less than years by the major fluctuations in market share, death of firms, non-financial firms in India by comparing and entry by new firms. However, there is a the biggest firms of – against those fundamental distinction between a tidy and in –. The metric of size used is apparently stable industry – that is usually value added. This overstates the relative inefficient by world standards – as opposed importance of natural resource extraction to a competitive and efficient one. firms: a firm like , which pumps When public policy seeks to prevent crude oil out of the ground and sells it at untidy events such as firms being kept alive import parity pricing, appears to generate a artificially, this gives rise to firms that are lot of value added. unviable in competitive markets, but still The most interesting feature of this table kept alive on artificial ventilation by the is the new firms in the – ranking: state. Three kinds of effects come into play (), Infosys (), Wipro (), Rashtriya when barriers to exit are erected. The first Ispat Nigam (), Bharti Airtel (), Satyam is moral hazard. Managers of such firms (), Hindalco (), and Nuclear Power make decisions knowing that they might Corporation (). Eight out of the top be protected in a future eventuality. The firms in – were not on the list in – second is the competitive pressure exerted by such firms on the market. Healthy firms . Many ranks have changed. The role of are unable to make profits and invest, when firms has been diminished. Apart from prices on the market are artificially driven (which gained a rank) and down by artificially-subsidised firms. Finally, (which stayed on top), all s experienced such firms distort factor markets. They is a new firm in –, but it is the make claims on labour and capital that they corporatised arm of which was present and large could not make in a truly competitive market in – also. . What are the limitations of financial regime governance? 121
Table 9.2: Changing ranks of Indian firms (non-finance) by value added (Rs. crore): 1991–92 versus 2004–05
1991–92 2004–05 Rank Firm Value added Rank Firm Value added
1 ONGC 3,944 1 ONGC 32,710 2 SAIL 2,781 2 BSNL 24,941 3 NTPC 2,059 3 Reliance 14,366 4 Indian Oil 2,011 4 SAIL 14,115 5 MSEB 1,605 5 Indian Oil 10,618 6 MTNL 1,136 6 NTPC 9,780 7 Tata Steel 1,107 7 Tata Steel 7,311 8 Air India 940 8 TCS 6,540 9 BHEL 874 9 Infosys 5,703 10 Reliance 705 10 Wipro 5,005 11 Tata Motors 700 11 GAIL 4,199 12 Shipping Corpn. Of India 660 12 Rashtriya Ispat Nigam 3,671 13 IPCL 594 13 Bharti Airtel 3,624 14 BPCL 522 14 I T C 3,571 15 Western Coalfields 495 15 MTNL 3,506 16 Indian Airlines 477 16 BHEL 3,433 17 L & T 466 17 Tata Motors 3,351 18 NALCO 463 18 HPCL 3,150 19 HPCL 457 19 Satyam 3,031 20 I T C 440 20 Air India 2,991 21 I T I 440 21 Western Coalfields 2,864 22 Neyveli Lignite 424 22 BPCL 2,841 23 A C C 411 23 Hindalco 2,792 24 Century Textiles 400 24 NALCO 2,717 25 GAIL 391 25 Nuclear Power Corpn. 2,661
Source: CMIE Prowess. a decline in rank. The scale of creative finance. Indian finance now needs to destruction amongst Indian non-financial benefit from similar modifications in firms would show up more sharply if firms its factor markets, product markets and engaged in natural resource extraction were technology as were made in the Indian excluded and only manufacturing firms were real economy. The analogy is obvious compared. when it comes to: (a) Indian exports of IFS The remarkable growth of Indian to the world market; and (b) productive exports of goods and services in the s restructuring of the Indian financial system is intimately related to improvements in through creative destruction induced by competition policy. Most non-financial competition. firms now have zero possibility of a India has enormous potential as a government rescue. That removes moral cost-efficient, competitive producer of hazard and focuses the minds of managers. . But there is a gap between the Firms buy raw materials from competitive present capabilities of Indian financial firms industries, at import parity prices. That and the requirements of the world ensures the cheapest-possible sourcing of market. The same situation characterised raw materials. The steady decline in customs Indian manufacturing industry prior to tariffs has brought input prices in India . It was overcome by the visionary close to those found internationally. and imports have led to a flow of new There is much synergy between an export- oriented real economy and an export-oriented finance knowledge into the Indian economy. The industry. The real economy consumes a large quantum ecosystem of the Indian real economy has of financial services. It would be more globally been transformed by competition making competitive if it was able to buy world-class financial the remarkable growth of Indian non- services at lower than world prices. Conversely, financial firms require purchase of non-finance inputs finance exports possible. such as computer hardware/software. The global These lessons apply equally to Indian competitiveness of Indian financial firms would be 122 R M I F C
policies of a succession of governments rules that disfavour foreign participants; from onwards. Through creative such as those preventing foreign banks destruction, Indian financial firms must from doing government business. The reinvent themselves just as non-financial import of financial services is restricted firms had to a decade earlier. They must largely, though not entirely, via capital do so in order to: (a) compete in the global controls. market and (b) improve the quality/range There is widespread recognition that of their services in the domestic market to some segments of Indian finance has, as yet, the same level. Some may die in the process failed to achieve the level of competition of doing so; and they should be permitted now visible in the real economy. The to. There is no room for inefficient Indian National Common Minimum Program financial firms to exist any longer for any (NCMP) of the UPA recognised this reason. The operating environment of the problem, and promised: “Competition in new India provides no room for tolerating the financial sector will be expanded”. That that. Inefficient and uncompetitive financial has not happened as yet. firms, of any hue or ownership, do not just Table . compares the ten largest banks diminish themselves. They compromise in the country in – and in – the market and environment in which . The largest banks in both columns more efficient firms operate and compete are remarkably alike. The new names of for resources and customers. The market – are shown in boldface. Of these, process takes care of such firms through was always a big bank. But it was not friendly or hostile acquisitions, mergers, on the list for – because it was not and takeovers or, at the extreme, through classified as a bank then but as a ‘financial bankruptcy. That process must now be institution’. Apart from that, there are only allowed to work in Indian finance. If it two new names in –. When this is not unleashed, India’s ability to compete table is compared against the previous table in the global market will be seriously for non-financial firms it is immediately compromised and dependent entirely on apparent that competitive dynamism in foreign firms. banking has lagged far behind industry and The key instrument for achieving the the country. transformation of Indian financial firms – to There is an intimate link between the provide world-class at lower than world implementation of competition policy and prices – is competition. The same forces the mechanics of exit. As argued above, that induced competition for non-financial sound competition policy requires that no firms will be just as effective for financial agency be permitted to keep inefficient firms. To repeat, they are the removal of: financial firms alive through: infusions (a) entry barriers to domestic firms and of capital from the exchequer; distorted corporates; (b) barriers to the entry of regulation aimed at supporting weak firms; foreign financial firms; and (c) restrictions entry barriers; or a combination of all three. against import of . The creation of such In extremis, in India the principal owner of a policy framework will generate incentives financial firms has on occasion pursued anti- for financial firms operating in India to competitive policies to help weak financial provide world quality financial services firms accumulate retained earnings, and competitively. recapitalise themselves in a non-transparent In the Indian financial setting, domestic way at the expense of customers. These entry barriers relate to the license-permit maladies are typical in developing countries controls governing entry into a given where exit processes for financial firms are business area by existing or new local weak, competition is poor, and financial firms. Entry barriers against foreign systems are anaemic. firms include barriers to , and For a treatment of the difficulties of domestic boosted by being able to buy world-class inputs at world banking policy, see Hanson (); Mor and prices. Chandrasekar (). . What are the limitations of financial regime governance? 123
Table 9.3: Biggest 10 Indian banks: 1991–92 versus 2004–05 (Assets in Bln Rupees)
1991–92 2004–05 Rank Bank Total assets Rank Bank Total assets
1 State Bank of India 947 1 State Bank of India 4600 2 Bank of India 232 2 ICICI Bank Ltd. 1684 3 Bank of Baroda 213 3 Punjab National Bank 1264 4 Punjab National Bank 192 4 Canara Bank 1103 5 Canara Bank 164 5 Bank of India 950 6 Uco Bank 117 6 Bank of Baroda 946 7 Indian Bank 110 7 Union Bank of India 724 8 Indian Overseas Bank 93 8 Central Bank of India 688 9 Union Bank of India 87 9 Uco Bank 545 10 Syndicate Bank 84 10 Oriental Bank of Commerce 540
Source: Thomas (2006) India now confronts entirely different financial firms; but those do not pervade or global prospects and challenges. It may dominate the system. still be a poor developing country in In a tidy and stable scenario financial terms of per capita averages. But it firms are not permitted to expire. The can no longer afford to think or act like established players remain the same, with one, when it is the world’s fourth largest little incentive to compete or innovate. This economy in real terms, and an emerging needs to be replaced with a preference for global power in geopolitical terms. It has a vibrant, efficient, competitive, world- reached an inflexion point of rapid growth beating financial services industry, where through domestic consumption and export entry and exit is taking place ceaselessly competition. That is likely to be maintained through a process of Schumpeterian creative for some decades to come. There is no room destruction. Financial sector policy should for complacency, sanguinity or maintaining be judged for the pace of entry and exit. an unacceptable status quo in Indian finance. Policy mindsets, expectations and attitudes 4. Artificial segmentation of now need to change as dramatically in the financial services political, administrative, legal and regulatory industry circles as they have in the corporate world. At present, Indian finance is subdivided The public sector needs to catch up with the into sets of firms operating in tightly sealed private sector and the world. sub-industry compartments. There are India therefore needs to apply market competition policy as forcefully in finance two sources of segmentation: (a) rules that as was done in the Indian real economy to prohibit emergence of s (i.e., financial create efficient firms capable of exporting conglomerates), and (b) boundaries between IFS. Financial authorities need to remove the domains of multiple regulators. As an the domestic entry barriers that presently example of the rules that prohibit complex exist. They need to encourage rapid entry firms, consider a ‘primary dealer’. In an by foreign firms, and remove barriers to international setting, the term ‘primary the open import of financial products and dealer’ pertains to one activity of a complex services. That effectively means removing securities-oriented financial firm. However, capital controls as quickly as possible and in India, the term ‘primary dealer’ is not on an ambiguous, opaque timescale interpreted to mean ‘a specialised financial that can be stretched with infinite elasticity. firm that performs only the task of primary Correcting competition policy in finance dealership’. The regulatory framework requires abandoning a preference for a tidy, governing a primary dealer in India prohibits stable and complacent financial services the firm from doing many other highly industry still dominated by state-owned related activities on the securities markets, firms, many of which are uncompetitive and such as equity index arbitrage or commodity uninnovative. So are many small private futures market making. 124 R M I F C
As an example of the boundaries be- provision involves correlated products tween the multiple regulators in finance, the serving the same customers. When separation between and the Forward a firm engages in providing multiple Markets Commission () has induced correlated products, knowledge of one a separation between financial exchanges area spills over into another. Cross- and commodity futures exchanges. In an selling to common customers takes international setting, an exchange is a place place. Risk is reduced by participating in where all manner of spot and derivative diverse areas. These economies are lost products are traded in a unified fashion. through segmentation. Much financial However, in India, the term ‘commodity services provision involves increasing futures exchange’ pertains to ‘a specialised returns to scale. Corporate strategy exchange that performs only the one task overhead, core processing work using of trading derivatives based on commodity systems, brand building and advertising underlyings’. The regulatory framework pro- all involve increasing returns to scale. hibits ordinary exchanges from trading in As an example, the ‘glass house’ with commodity futures, and commodity futures computer systems at an exchange can exchanges from trading in non-commodity process ten times the number of trades underlyings. From an perspective, such at three times the cost. The same ‘glass segmentation damages India in three ways: house’ at a bank can handle both bank accounts and depository participant . It reduces competition. The essence accounts. These economies of scale are of competition is unpredictable entry. lost through artificial segmentation. No software company could have For example, the Indian notion of a anticipated the entry of Wipro, a maker primary dealer is a firm that does low- of edible oil, into the software industry. risk trading strategies on the government However, this entry did take place. bond market. However, these skills are Wipro is now one of the biggest easily redeployed into market making services firms in the country as a and arbitrage on currency derivatives, consequence. equity derivatives and commodity If Telco (now Tata Motors) had derivatives. It would be cost efficient been prevented from producing cars, for the Indian-style primary dealer to this would have been a tidy world of run a % larger organisation which segmentation where truck companies does % more business, by harnessing made trucks and car companies made economies of scope across these areas. cars. But it would have been a world In the commodity futures setting, In- with inferior competition. dia has taken the unique path of having In a financial setting, a policy separate sets of: commodity futures ex- framework that hinders mutual funds changes and financial exchanges. Mem- from competing with bank deposits ber firms are also forced to be separate. through retail sale of money market Each financial firm is forced to create a mutual funds, or prevents and separate subsidiary in order to trade on from trading commodity futures, the commodity futures market. This sub- reduces competition. division induces inefficiency and holds As argued above, the most important back India’s export competitiveness. It ingredient of public policy to enable is analogous to a policy framework that export of from India is competition forced Telco to have separate companies policy, comprising three elements – for making cars and making trucks. domestic entry barriers, barriers against . It leads to a corrosive political economy foreign firms and barriers against imports. Segmentation is a key domestic For a treatment of economies of scale in the entry barrier. securities markets, see Shah and Thomas (). Claessens and Klingebiel (); Claessens () . It results in the loss of economies of offer a discussion of economies of scale and scope scope and scale. A great deal of in developing country financial policy. . What are the limitations of financial regime governance? 125
in which sub-industries engage in circumscribed by a license-permit-control persuading governments to help to raj. increase their profits leading to pressures When a vanaspati firm is compelled to operating to modify or interpret a sell nothing but vanaspati, it makes the soft- particular rule in a particular way. ware industry less competitive. The essence Millimetric calibration of rules can of market competition is based on open en- influence the profitability of a primary try by unexpected firms that produce in an dealer or the market share of banks unexpected way thus inducing sharp changes in the depository participant business. in the profits and market shares of existing As with Indian experience in the real players. It is this continual churning that economy, this induces a corrosive induces efficiency, innovation and techno- political economy. When any such logical change. In finance, that is what makes agency has such powers over an industry, exporting possible and profitable and it is difficult for its functionaries to enables one to compete with another. stay focused on the public goods of In providing , the most globally regulation while being blind to the competitive financial firms are engaged competitive market process and the in all manner of activities. A firm like profits of alternative regulated firms. Goldman Sachs is involved in every element of : it is therefore able to harness Every large finance firm in India is economies of scale and scope. In recent forced to create multiple legal personalities decades, the breakdown of rules that induced for participating in separate regulatory segmentation, such as the Glass-Steagall ponds. At a de facto level, these are unified Act in the , has unleashed extraordinary finance companies with all the complexities competitive energies. Global securities of conglomerate regulation. At the same firms are now competing in areas that time, forced separation into multiple firms were once considered ‘banking’ and global induces higher costs, the loss of economies banks are competing in areas that were once of scale and scope, and the consequent loss considered ‘securities’. of export competitiveness. There remains a ‘legacy affinity’ in 5. Barriers to financial India – left over from the pre- era – innovation toward maintaining the tidy arrangement of firms and sub-industries in a planned Global competitiveness in the world of economy context. For many decades, the is dependent almost entirely on financial services industry was carved up innovation and much less so on fractionally into neat little pieces, each of which was advantageous cost-efficiency. Indian firms tightly compartmentalised. Each piece was can compete on entry in providing prohibited from competing with the other. on the basis of cost-efficiency. But that The authorities viewed their role as that of edge will disappear quickly unless they are tending to the interests of each sub-industry, able to innovate rapidly and continually. If in an attempt to be ‘fair’ to everyone. In they cannot do so, they will not be able to such an environment, each segment had compete on a global scale over a sustained minimal competition. A firm with a license period of time. to operate in any segment had a safe sinecure, What may happen then is innovative with sustained profits, and a low-to-zero ability (located in and financial probability of extinction through its own default. The authorities could claim that a This apparently paradoxical link between the vanaspati industry and the software industry alludes to stable financial sector had been built. But Wipro – one of the top software companies in India. such an approach misses the essence of a Wipro previously produced vanaspati, a hydrogenated market economy; which relies on the process cooking oil. If the Indian State had barred firms that of ceaseless, unpredictable and subversive produced vanaspati from competing in the software industry, and thus blocked production of software by competition. A functional market economy Wipro, it would have hurt competition and India’s is the polar opposite of a planned economy success in the software industry. 126 R M I F C
Box 9.1: Case Study – The Clearing Corporation of India Ltd () India embarked on an important innovation, by world standards, when market participation and currency market participation has remained the idea of novation at the clearing corporation was applied to trades on restricted to the small club of financial firms that existed before CCIL. The the OTC market. Traditionally, there was a divide around the world key economic benefit of building a clearing corporation – lowered entry between exchange ecosystems – that had transparent trading coupled barriers – has not been obtained. with risk management at the clearing corporation – as opposed to the 2. Competitive conditions for critical securities industry OTC market. which had neither. infrastructure In India, it was felt that even if the problems of transparency in trading CCIL has monopoly status in performing clearing services for fixed could not be addressed, it was possible to make progress by introducing income and currency markets. It is the only clearing corporation with risk management at the clearing corporation. The clearing corporation access to clearing in central bank funds and connectivity into RBI would interpose itself into transactions, becoming the legal counterparty settlement systems. The other clearing corporation in India – the National to both sides of the trade, and thus eliminate counterparty credit risk. Securities Clearing Corporation Ltd (NSSCL) – is prohibited from As argued above, a key feature of a sound financial sector is having a performing these functions. This reflects the segmentation of the Indian framework supportive of exit by firms. A clearing corporation is the securities industry into three parts, regulated by RBI, FMC and SEBI. Such institutional mechanism through which the externalities of firm failure are segmentation, and the consequent loss of competition, is suboptimal. controlled. Even if a firm fails, counterparties on the OTC market are not Particularly when dealing with the OTC market, it is easy to have affected by that failure because the clearing corporation is the competition between the two clearing corporation. counterparty. The introduction of a clearing corporation into the system In a competitive policy framework, every player on the OTC market for makes it possible to lower entry barriers, by bringing in firms into the OTC currencies or fixed income would be free to choose between multiple market that have weak credit. It also makes it possible to have financial clearing corporations based on price and services. Using cross-margining sector policy framework where more firm failure and exit of weak firms arrangements between clearing corporations, it would be possible to takes place in a smooth manner. obtain seamless functioning when the two counterparties to a trade are These ideas led to the creation of the Clearing Corporation of India Ltd. customers of two different clearing corporations. Such a competitive (CCIL). CCIL has undoubtedly been a valuable institution which has given a framework would drive both NSCCL and CCIL to higher levels of cost more modern, more stable financial system. However, the policy efficiency, quality of service and customer responsiveness, which would framework in which CCIL has operated has flaws on competition policy at improve India’s ability to export financial services. two levels: The CCIL case is thus an ironic blend of intellectual success and 1. Competitive conditions on the bond market and currency opportunity lost. On one hand, India’s ability to conceive of an institution market like CCIL, and swiftly translate the broad idea into a smoothly functioning The raison d’etre of a clearing corporation is to lower entry barriers. institution, has been the envy of the world. But at the same time, the Once the clearing corporation handles firm failure, there are no difficulties larger policy problems of segmentation and faulty competition policy have in opening up entry to a large number of firms that might otherwise be induced a lost opportunity, whereby India has benefited less from the considered weak credits. However, even though CCIL was created, bond creation of CCIL than could have been the case.
firms) may seek marriages with cost- for India but not for the world. efficiency (located in Indian firms) through • New world-class innovation: One of the acquisitions and mergers on terms more hallmarks of a first-class financial system advantageous to the innovators. Conversely, is its ability to steadily create innovative if an innovation-friendly environment is new financial contracts and instruments setup, then Indian financial firms (that to satisfy different risk appetites and are more than intellectually capable of needs. New institutions and methods of innovation) are likely to flourish. They transacting are continually generated will turn into financial s in their own by a dynamic financial system. The right and may even turn into predators best Indian example is the deployment (rather than be predated upon) and generate of an idea from financial exchanges substantial export-revenues. – the clearing corporation – into Innovation in finance is the creation the markets for currencies and of new products, new trading mechanisms, fixed income, in the form of the new contracting arrangements, and new Clearing Corporation of India (). kinds of finance companies. Innovation in This was a genuinely new idea by Indian finance can be classified into two world standards, and translated into a classes of ‘newness’: successful implementation in India. • Catching up with the world: As an example, cash-settled currency futures 5.1. The economics of financial are a familiar and well-proven idea on a innovation global scale. They do not exist in India. Indian finance currently exhibits a very low The launch of currency futures trading rate of innovation when compared with the in India would constitute an innovation world. To explain this anomaly, superficial . What are the limitations of financial regime governance? 127
explanations are often invoked. It is claimed that provides the return on investment in for example that because Indians naturally innovation. If the policy environment places defer to authority, or to elders, they are high costs upon the innovator, and slows it ‘culturally’ unable to innovate. However, as down to a point where first-mover advan- experience in industry and software services tage is lost to competitors, then firms lose has shown, Indian firms and individuals the incentive to innovate. can excel at innovation when faced with The public advocacy and policy work difficult global competition. What they have required to get innovations across induces lacked is the incentive to do so. Hence, focused costs on one or a few innovators. understanding the problems of innovation The benefits then become public, because in Indian finance requires understanding the all firms – whether pioneers or not – economic incentives that shape innovation, derive benefits from the policy and rule rather than invoking irrelevant superficial changes. Under this environment, a single explanations. private firm does not have the incentive Innovations usually trigger regulatory to persevere and push proposals through and policy concerns (Rajan and Shah, ): hurdles in its way. It requires a special • Who is the target? Is the target public policy effort to create an innovation- sophisticated enough to understand a friendly environment and for government to new financial instrument and benefit push through contractual and institutional from it? Should the new instrument innovations. be restricted only to a smaller set of The process in the case of many recent sophisticated buyers? attempts at financial innovation in India • What risks does it pose to the system? appears to be too convoluted and time- Does the instrument/institution create consuming. This is illustrated by a series of uncontrollable or unmeasurable risks? examples. Who will regulate its use (if that needs Example: stock index futures. Box . to be done)? How will the costs of shows a chronology of how trading in the regulation be paid for? simplest possible equity derivative, cash- settled index futures, came about in India. • What are the tax implications? How This process took from th December will the instrument be taxed? Is it an to th June , a delay of . years. A instrument merely to evade taxes? further three years lapsed in dealing with first • What new legislation does it entail? Is order difficulties of regulation and taxation. the act covering financial instruments In this case, the innovator () could have broad enough to allow for the instru- had a five-year head start. Instead, trading ment? If not, does new legislation have on actually started a few days before to be brought in? How can it be framed and trading on started a few days broadly enough to allow the maximum later. captured no temporary advantage contractual freedom? by invested in innovation. Policy makers and regulators governing the financial regime inevitably and under- standably take time to consider and resolve Box 9.2: Case study – Stock index futures these issues. Firms proposing a new instru- Table: Chronology of stock index futures
ment or product have to invest considerable 14 Dec. 1995 NSE asked SEBI for permission to trade index futures. resources in awareness building, research, 18 Nov. 1996 SEBI setup L. C. Gupta Committee to draft a policy framework for and persuasion to achieve the required pol- index futures. icy and/or rule-changes. A firm embark- 11 May 1998 L. C. Gupta Committee submitted report (Gupta, 1998). 24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index. ing upon innovation must weigh the costs 25 May 2000 SEBI permitted NSE and BSE to trade index futures. and benefits from investing in new devel- 09 June 2000 Trading of BSE Sensex futures commenced at BSE. opmental work. In a Schumpeterian world, 12 June 2000 Trading of Nifty futures commenced at NSE. the innovating firm secures a temporary 25 Sep. 2000 Nifty futures trading commenced at SGX. monopoly owing to a first-mover advantage 128 R M I F C
Box 9.3: Case Study – Collateralised Debt Obligations () The difficulties and delays faced in financial In 1998 or so, it was understood that the three-tier seniority structure. innovation are also illustrated by the first mutual fund was the only structure in India securitisation of corporate debt; a process that met all but the first requirement. The launch of this product faced four worth describing in some detail. As of 1997 or Elsewhere in the world, trusts are used for the impediments: so, there were four impediments which made purpose, but Indian law does not support this. it difficult to undertake transactions involving • RBI regulations did not respect the securitisation of corporate debt: • In 1999, an RBI committee endorsed the bankruptcy – remoteness of the mutual use of mutual funds as the vehicle for fund. This would force banks to view • When an asset-backed loan is sold, the undertaking these securitisation these securities as credit risk of the existing laws erroneously require a stamp transactions. private bank. That distorted their pricing duty to be charged on the ‘transfer’ of • In 2000, the ‘Rajasthan route’ was and acceptance. collateral from one lender to the next. designed, because local laws in Rajasthan • IFC intended to purchase the middle tier • In a securitisation transaction, it is difficult do not require charging stamp duty on of the three-tier seniority structure. RBI to handle the withholding of tax, since it the transfer of collateral when an intended to forward this foreign is not possible to decompose tax asset-backed loan is sold. Using this investment application to the FIPB for deduction at source (TDS) certificates bypass loans are now converted into ’pass approval. amongst multiple investors. through certificates’ (PTCs) which can be • The existing SEBI regulations limited • The special purpose vehicle (SPV) that traded. mutual funds from investing more than would be the centrepiece of securitisation • In October 2000, a private bank 5% of their corpus in other mutual funds. is not immune to income tax. attempted one securitisation transaction This impeded purchases by mutual funds • The SPV needs to be made bankruptcy – using the mutual fund vehicle and the in this securitisation transaction (which remote from the sponsor, in two senses. Rajasthan route. Investors did not buy this was packaged as a mutual fund scheme). If the sponsor goes bankrupt, then the product. • NSE’s rules did not see PTCs as securities, creditors of the sponsor should not have • In March 2002, this bank attempted an and impeded listing of PTCs. a claim on the assets of the SPV. improved design for a product that Conversely, financial profits or losses to securitised roughly Rs. 500 crores of a the SPV should not impact on the sponsor. bond portfolio and broke it up into a
Example: Collateralised debt obligations products that have to deal with: (a) an (s). Box . shows a case study of outdated legal/tax environment and the Collateralised Debt Obligations (s). need for creative solutions to tax/legal Unlike the case with and exchange- impediments; and (b) multiple regulators traded derivatives, where there was just one to come up with regulations adapted to problem (obtaining approval for trading bringing new products to the market. index futures) this example illustrates the On an international scale, the difficulties of creating complex financial is a perfectly mainstream and ordinary
Box 9.4: Case study – Exchange-Traded Fund () for Gold An important new class of ‘mutual fund’ the underlying asset portfolio will be. emanated from India. For gold ETFs to come instruments that has emerged globally is the An ETF on gold is a natural and small about, mutual funds need to be permitted to Exchange Traded Fund (ETF). The ETF is like a innovation on top of the basic idea of the ETF. invest in paper issued by banks under the traded depository receipt. The fund holds a Under this structure, the mutual fund would Gold Deposit Scheme, 1999. Their approvals pre-defined portfolio. Units issued by the purchase the gold linked paper issued by process involves both SEBI and RBI, and is as fund are traded on the secondary market. For banks under the Gold Deposit Scheme, 1999, yet underway despite one budget example, an ETF implementation of an index or to ‘dematerialised’ gold warehouse announcement about this issue. In the fund consists of the fund holding the market receipts. The mutual fund would issue interim, Gold ETFs were launched at NYSE index portfolio, and issuing depository depository receipts (units) equivalent to 1 and the Australian Stock Exchange, and have receipts on the underlying portfolio, which gram of gold that would be traded on the been modestly successful. are traded on the secondary market. secondary market. This would allow transparent trading of gold, in a unit size The delay in this approval process has ETFs may appear to be like closed-end that is amenable to retail participation. These turned India from being an innovator to funds, but they differ in two respects: (a) units could be a convenient avenue for becoming a follower. In this case, the Closed-end funds are not depository receipts; investment in gold by individuals, instead of innovator (Benchmark) lost all the resources investors cannot present their units to the dealing with physical gold. invested in innovation. When the problems fund and exchange them for the underlying In India, Benchmark Mutual Fund are resolved, it is likely that two or three assets, and (b) Closed-end funds retain proposed a Gold ETF in May 2002. It would mutual funds will launch gold ETFs on discretionary power of portfolio have been the world’s first Gold ETF, and a roughly the same date as the launch date of management, while ETFs pre-specify what rare instance where financial innovation Benchmark. . What are the limitations of financial regime governance? 129
Box 9.5: The introduction of interest rate futures in the – a case study in innovation In 1975, the Chicago Mercantile Exchange the direction of interest rates, isn’t that right, hesitation Stein quipped, “I don’t oppose (CME) obtained permissions to do the first Beryl?” anything between two consenting adults”. trading of interest rate futures in the world. Beryl Sprinkel hesitated and looked to me I next turned to the CFTC. Commissioner The then CEO of CME, Leo Melamed, tells this for guidance. I didn’t know the answer, so I Gary Seevers quickly understood the potential story on page 235 of this book Escape to the looked up at the ceiling and watched the Futures. The following text is a verbatim value of these new interest rate products and billows of smoke that had gathered there. became a valuable ally. But now it was up to extract from this book. Mark Powers, Mark Powers too remained silent. After an mentioned in the story, was Chief Economist Bill Bagley, the CFTC chairman. I tried to embarassing pause, Beryl thought of a impress Bagley with the fact that many federal of CME at the time. noncommital response, “Well, Mr. Chairman, officials were already aboard. But Bagley did Unlike our listing of currency futures four it will probably be as good as the Federal not have any financial background and was years earlier, which required no federal Reserve’s own econometric model.” afraid to take the responsibility for such a approval, this time around, new contracts “That,” said the chairman of the Fed with a revolutionary decision. required approval by our newly established laugh, “isn’t worth a shit.” It was a refreshing “Leo,” he implored, “I love you like my federal regulator, the CFTC. That approval bit of honesty. wouldn’t come about without some fancy brother and want to do it, but I need someone footwork on our part. That meeting with Dr. Burns evolved into a higher up to give me an okay.” friendship after I discovered that he and his It was deja vu. First, I recruited Beryl wife were Yiddishistin like my parents. At their “How high up?” I inquired, thinking maybe Sprinkel, now an IMM director, to set up a request, I found for them the works of I. L. he was looking for divine intervention. meeting with his former professor Arthur Peretz in Yiddish which Dr. Burns took with Burns, chairman of the Federal Reserve. That “Well,” Bagley responded, “aren’t T-bills the him when he became U.S. Ambassador to property of the U.S. Treasury? Maybe we need was pivotal to the approval. The meeting that Germany. Having survived this hurdle, I next followed in the boardroom of the Fed, which approval, in writing, from someone like the sought and gained the support of Alan Secretary of Treasury, William Simon.” (Note: also included Mark Powers, is forever Greenspan, who at the time was chairman of ingrained in my memory and could make an The US Secretary of Treasury is equivalent to the Council of Economic Advisors ( CEA). The the Indian Minster of Finance). interesting and funny story. Both Burns and meeting with him was a shot in the arm. Sprinkel were heavy pipe smokers and I, of Before I could fully explain our plans for a A tall order. Simon was a fairly new name in course, was still a chain smoker. Between the futures contract in T-Bills, Greenspan Washington D.C. And E. B. Harris’ connections three of us, the smoke was so thick we could interrupted. provided me with no go-between. To go hardly see each other. without proper protection seemed wrong. So I “What a great idea,” said Greenspan, who began to call around to some of the senior “What a clever idea,” said the chairman of was destined to become one of this nation’s the Fed after we explained what we had in officials of our clearing members to see if most admired Federal Reserve Board chiefs. He anyone knew Bill Simon. Sure enough, I hit mind. “Such a futures contract would be used then proceeded to rattle off a dozen uses for by government securities dealers, investment paydirt. Sanford Weil, the chief of Shearson & such a market, some of which we hadn’t even Co., was a friend of the Secretary of Treasury. bankers, all sorts of commercial interests as considered. In short, this meeting made him a well as speculators, isn’t that right?” Weil was also a shrewd market analyst and friend, which he has remained throughout the sensed the great potential of our T-bill “Yes,” Sprinkel and I agreed. “Its years. Our friendship was of particular contract. He agreed to help. I then took one participants would include every segment of importance at the time of the 1987 stock additional precaution. I called on Milton the commercial and speculative world.” We market crash. Friedman and asked him to again weave his talked further about the value of this contract, As I was leaving his office, I got a bonus by magic. Friedman obliged by calling Simon and, until the Fed chairman fell into his thoughts. bumping into Herbert Stein, Greenspan’s by the time Sandy Weil and I appeared before Suddenly, he had a bright idea. predecessor at the CEA. Like any good him at the Treasury in the winter of 1975, it “In such case,” Dr. Burns said, “this futures evangelist, I immediately expounded on why was a done deal. He quickly agreed and contract would become a terrific predictor of we were there and asked his opinion. Without signed the prepared approval letter to Bagley. product. But in this case, the innovator date of this Report (January ), the (a private bank) wasted resources invested in Gold had not yet been launched in innovation, because, in the end, the India. In parallel, important international failed to overcome regulatory constraints. developments have taken place. The lack of the remains a critical weak talked with World Gold Council () link in the modernisation of the Indian in June , who agreed to market the credit market. Gold for . waited for the Example: Gold ETF – an Indian Indian product launch till the end of . innovation that might have been. The In , initiated a process which Gold case, described in Box ., is resulted in the Gold being launched particularly interesting from the viewpoint in Sydney at the end of . then of examining the phenomenal bottlenecks took the new idea to London and faced by financial innovation in India. in . The Gold now has $ For this reason, a detailed chronology of billion in assets, thus making it a successful events is offered in Appendix . As of the product. 130 R M I F C
On th September , the London 5.2. An innovation-unfriendly Stock Exchange launched a new market environment segment for ‘exchange traded commodities’ These experiences highlight the hostile that would trade s on commodities environment faced by innovation in Indian including cattle, coffee, corn, lean pigs, sugar, finance. If continued, such an environment wheat and baskets of commodities such as would compromise the prospects of Mumbai livestock and energy. If India had created ever emerging as a competitive and viable a more innovation-friendly environment, . The present financial regime then by end-, India could have been a governance hinders innovation. It sends world leader with s on commodities. out strong incentives to individuals and Instead, events in India resulted in this idea firms to avoid business plans that involve taking root in New York, London and Sydney, innovation. It biases the labour market to while India is content to lag behind. favour staff focused on routine operations as For an international comparison, opposed to developmental and innovative Box . recounts the story of the first work. Contrast this with the environment in introduction of interest derivatives in the which interest rate futures were developed world. It shows a remarkable intellectual in the as illustrated in Box .. capacity in the US government and in the industry to understand innovation and to allow progress to take place. Why does financial regime governance have these limitations?
1. Why is the pace of financial of flying or, because road crashes occur, innovation slow? that no traffic should be allowed to flow. In India financial regulation has put so The design of a reforms process aimed many roadblocks in place that financial c h a p t e r at improving financial regime governance innovation can only occur at a snail’s pace. needs to flow from a diagnosis of the sources Worse, the road to financial innovation in of difficulties. There are a number of obvious the st century cannot be travelled at any operational reasons as well as proximate speed by regulation that results in India’s reasons and deeper sources of dysfunction. financial firms remaining the equivalents 10 of antediluvian Ambassadors and Fiats in 1.1. Regulators are preoccupied with India’s financial services industry when the averting scams rest of the world is using s and Ferraris. In an ideal world, regulators evaluating their Every year, the gap between Mumbai and impact on financial system development London is growing, not narrowing. need to weigh in a balanced fashion three im- A more appropriate regulatory view portant factors: (a) encouraging progressive might be to accept that even the best- improvement in the capability of the domes- regulated financial system will have some tic financial system; (b) improvements in its small problems (of less than say Rs. global competitiveness; and (c) the risk of financial regime reputation loss in the event crores or Rs. billion). That is one basis of firm/market failure or default. However, point compared to total financial assets the incentive structure faced by regulators in of over Rs. lakh crores (Rs. trillion). India attaches low priority to improving the The efficient safety level is not %. Each quality of domestic resource allocation by percentage of point of safety beyond % financial markets, or on achieving greater has a disproportionately higher cost; one international competitiveness. Indian regu- that increases in logarithmic rather than lation appears disproportionately focused linear fashion – and one that is not worth on averting financial scams. This generates expending. a regulatory bias of blocking innovation in In that context it should be noted order to be safe, and an industry bias of that the evidence accumulated over the avoiding untested ideas since they expose last decade in the (when compared firms to indirect risk when the next failure to the ) suggests that principles-based occurs. regulation might be more effective than A more nuanced but realistic regulatory rules-based regulation, in averting damaging perspective might be to recognise that financial malfeasance. That is because it accidents will happen even with the best requires financial firms to conform not just regulation. But they will be fewer and with the letter of the law (rules/regulations) less fatal. The only way to avoid accidents but with its spirit as well. It co-opts the altogether is to choke traffic with too financial firm into becoming an integral many roadblocks, or stop it from flowing player, along with the regulator, in a altogether. Air-crashes occur; but that does cascading and co-operative (rather than not imply airlines should be regulated out adversarial) process of self-regulation at the 132 R M I F C
level of the individual, firm and market. mechanism is written down in meticulous Principles-based regulation avoids the risk detail either in the law or in subordinated of turning financial firms (as well as their legislation. The consequence of this ap- lawyers, accountants and tax advisors) into proach is that every financial innovation guerilla game-players that ceaselessly focus requires interminable changes to be made on beating or side-stepping the rules in order to either governing laws, subordinated reg- to gain a competitive edge in the financial ulations or both. This raises the cost of marketplace. innovation considerably. It deters financial A rational cost-benefit analysis in firms from innovating because the returns the form of regular ‘regulatory impact from investment in innovation are rendered assessments or s’ (standard practice uncertain. in most countries) therefore needs By contrast in the the approach to to be undertaken to compare the cost regulation permits financial innovations to of inefficient resource allocation (e.g., be tried and tested almost instantaneously through financial preemption) against the by financial firms in markets with large cost of tolerating the occasional small sophisticated customers at their own risk scandal by loosening regulation to permit and with full customer awareness. If the more financial flexibility and innovation. innovation works, the regulators step in to Such an analysis might suggest that: see how the risk involved (to customers, achieving allocation efficiency through firms and markets) can be diminished and better functioning of the financial system managed better until the product becomes with an investment ratio of % of (i.e., accepted as standard. This more innovation- Rs. trillion) per year, and the avoidance of friendly approach perhaps explains why financial preemption, might be important London is so successful as an while enough to pay for a scandal costing around financial frauds of Enron, Worldcom, Tyco .% of (roughly Rs. billion) once and Arthur Andersen dimensions continue every few years. to occur in the despite the best rules- based regulation in the world. 1.2.A de facto shift towards over-prescriptive regulation in 1.3. Regulatory architecture India A major source of delay is fragmentation Given its legal heritage, India started out among regulators and uncertainty about with a more open basis of law based not on which one will regulate new instruments exclusive reference to a codified constitution, and markets. Modest innovations like but on equal respect for the evolution of the Gold , interest rate futures or precedent based on trial-and-error. But currency futures – which would not be over time it has moved relentlessly toward called innovations outside the country a style of regulation under which every given their extreme degree of obviousness minute detail is either written into the basic – run afoul of inconsistencies and turf legislation or into detailed subordinated battles across the multiple regulatory rules and regulations. Under such a agencies. The problem is particularly acute system if something is not specified, it is with organised financial market trading, proscribed; or conversely, if something is regulatory responsibilities for which are proscribed then non-proscribed activities spread between three regulators: commodity remain contentious as to whether they are derivatives are regulated by the Forward permissible or not. Markets Commission (); equity spot For example, a Committee on and derivatives and corporate bonds are Gold s did the kind of preparatory regulated by ; government bonds and groundwork that a financial firm, and not currency trading are regulated by . a regulator, should do – i.e., it designed an alternative product structure. In the 1.4. Lack of competition prevailing financial governance regime, ev- The: (a) lack of sufficient competition in the ery detail of financial product and market financial services industry: (b) pervasiveness . Why does financial regime governance have these limitations? 133
of public ownership; and (c) over- deleterious consequences of these aspects compartmentalisation of sub-sectors; result for India’s ability to build export-oriented in easy profits being made through sub- , progress should be relatively easy to optimal performance by existing players. make. However, far-reaching progress – Clearly the situation has improved since which is of essence in achieving the goal of . But much remains to be done to making Mumbai an – will not be made introduce greater competition in Indian until the ‘proximate reasons’ and ‘deeper finance; especially in banking services. sources’ of these problems are addressed. That competition needs to be across A strategic understanding of the reform larger, more capable players rather than effort that is required for making Mumbai among a plethora of small weak, under- an requires an understanding of these capitalised players that cannot capture proximate reasons and deeper sources. economies of scale or make the kinds of investments in people, training, technology 2.1. Financial preemption and research into product development that In a mature market economy, finance must supports innovation. The Indian financial interact productively with the decision- sector needs a wave of consolidation – making of private economic agents and through acquisitions and mergers, among shape the resource allocation emerging out private and publicly owned institutions – of these decisions as efficiently as possible. for its financial firms to be strong enough But Indian finance has a history of financial to compete as aggressively with each other, preemption. Formerly, the task of finance and with foreign firms, in Indian and global was seen as mobilising resources for the markets as they should. A license to operate implementation of socialism at two levels: in a certain area of Indian finance is, all first, to fund fiscal deficits on below-market too often, a safe sinecure with stable profits terms and second, to direct the supply of resources into socially important areas under and a near-zero probability of death. There the guidance of planners rather than the is therefore little incentive to innovate to rules of the market. remain competitive. This is not unlike firms Most policy-making in finance in past in the real economy before . decades, has been shaped by financial For a shift into a high-innovation repression: i.e., forcing finance to allocate regime, both carrot and stick are required. resources based not on economic efficiency The stick would be the introduction of but to channel it in ways sought by the competition: entry barriers in domestic state. Strong elements of financial repression finance and protectionism need to be continue to be in place: e.g., the lack removed. The carrot would be the of a properly functioning bond market; significantly reduced cost of innovation that forced government bond investments by would result from a different regulatory banks, insurance companies and pension attitude and approach. In addition, a shift funds; directed credit; specialised financial from a domestic-focused financial sector institutions catering to the goals of policy to an -focused financial sector would makers. All these dimensions derive from induce the associated carrot of enormously financial repression. Epiphenomena such as larger market size. flaws in competition policy, segmentation and barriers to innovation, are rooted in this 2. Proximate underlying deeper system of appropriation by the State reasons that are not as of financial resources. transparent 2.2. Capital controls To some extent, these constraints to Flaws of competition policy, segmentation innovation are a hangover of the system and barriers to innovation have been enabled of controls that pervaded the Indian and perpetuated by capital controls. As has economy in preceding decades. Once been seen in India’s real economy, if foreign policy makers become aware of the financial service providers were able to bring 134 R M I F C
genuine competition to bear against local Table 10.1: The role of the largest firms in global currency firms through unrestricted entry, this would trading, May 2005 rapidly change the behaviour of local firms Firm Share in total and of policy makers. volume (%)
1. Deutsche Bank 17.0 2.3. Autarky 2. UBS 12.5 Flaws in competition policy, segmentation 3. Citigroup 7.5 and barriers to innovation have been enabled 4. HSBC 6.4 5. Barclays 5.9 and perpetuated by an autarkic mindset that 6. Merrill Lynch 5.7 favours Indian firms at the expense of foreign 7. JP Morgan Chase 5.3 firms in a manner considered so routine and 8. Goldman Sachs 4.4 ‘natural’ that the counterview is deemed 9. ABN Amro 4.2 10. Morgan Stanley 3.9 unpatriotic. All other firms put together 27.2 The provision of from an is uncompromisingly international. The Total 100 players, the regulator and the legal Source: IFSL, http://tinyurl.com/yzg4mj framework have to be designed for global participation and competition, avoiding firms. Realistically, no Indian firm is going the traditional instincts of falling back into to break into this top- ranking in the next autarky. Indeed, in s, an autarkic decade. But in the following decade it is mindset would be opposed by national entirely possible that an Indian financial financial firms. Box . shows a fascinating firm may be able to buy or merge with example of the thought process at the one or more of the global big ten. The on the relationship between trading bulk of jobs created by an in Mumbai in the and trading in the . will almost certainly be created by foreign India’s experiment with autarky from financial firms. Hence, for Mumbai to to , where the trade/ ratio become an , it is absolutely essential that fell from % to % is well known to be a key global financial firms consider Mumbai failure. From onwards India has been as a location to shift their business to. reintegrating into the world. At first, the For Mumbai to become an that can trade/ ratio rose slowly, returning to eventually compete with s, the policy the % level only in . In recent years, goal has to shift away from championing the the growth of trade has been more frenetic. immediate short-term interests of Indian The trade/ ratio has risen from % in firms and shareholders to championing the to % in . This growth of trade interests of Indian employees. Too often, the in goods has been exceeded by growth of discourse between the Indian governance trade in services. India has made significant regime and global financial firms has been progress on reintegrating into the world one where India has tried to prevent global economy since . Yet, policy-making in financial firms from participating in India. too many areas remains dominated by an For Mumbai to become an , that legacy autarkic ethos. This is clearly manifest in the will need to be reversed. All the arms degree of protectionism in finance. While of the Indian state should seek to attract far-reaching trade reforms have taken place, participation by global financial firms in and India is now perhaps two to three years India for the export of . That may away from -quality trade barriers, require opening up its market for domestic foreign firms continue to be barred from financial services. While Indian financial operating freely in numerous parts of Indian firms may resent that competition, as in finance. the real economy, they will be better off As Table . above shows, global in confronting it and so will the Indian is dominated by a small number of consumer. important global firms. Nearly % of global This change would be similar to that currency trading is accounted for by just which has taken place in manufacturing firms. India has many good financial – where India once tried to block foreign . Why does financial regime governance have these limitations? 135
Box 10.1: Internationalisation of financial regulation: an example As electronic trading platforms and cash ICE Futures in London, WTI volumes in ICE The CFTC will thus continue to rely on the settlement allow derivative contracts on Futures have grown to about half of the quality of the regulation of ICE Futures by the anything to be traded anywhere in the world, NYMEX volumes. The result is a fascinating UK Financial Services Authority (FSA) as well as the principle of ‘local regulation of local situation where there is: the information sharing arrangements that it markets’ has become difficult to apply. Where has with FSA. This thinking by the CFTC is a financial market located when it operates . A liquid contract on a US commodity underlines a mature and internationalised in the ether? Is it the jurisdiction in which the . It is predominantly traded by US perspective on financial regulation, exchange chooses to locate its computers? Or participants uncontaminated by nationalist pressures or do we have to consider the nationality of the . It uses terminals in the US resentment about ‘regulatory arbitrage’. owners of the exchange or the nationality of . It is traded on an exchange that is owned those who trade on the exchange or the If Indian regulators accept the principles by a US entity location of the principal cash market for the followed by the CFTC, foreign exchanges underlying contract? . But it is located and regulated in the UK for would be able to offer their contracts directly reasons of regulatory arbitrage. A recent example highlighting the in India through electronic trading platforms. importance of these questions is the ability of This would not require full capital account the US based Intercontinental Exchange (ICE) to After the collapse of Amaranth, a large US convertibility since the RBI now allows Indian offer US energy contracts to US investors hedge fund that had huge positions in energy citizens to remit up to $50,000 a year outside through its own terminals without attracting futures both in ICE and in NYMEX, the US India for investment purposes. Indian citizens US regulatory jurisdiction – thus benefiting Commodities and Futures Trading Commission can use this facility to pay for the contracts from the principles-based regulation of the UK. (CFTC) reviewed and reaffirmed its existing that they buy on foreign exchanges. Foreign ICE Futures in London (formerly the policy exempting the ICE futures contract from exchanges would also be able to offer trading International Petroleum Exchange or IPE) which US regulation on the ground that it is a in India on ADRs and GDRs of Indian companies is owned by ICE, launched futures on the WTI contract on a foreign exchange. The CFTC provided the Indian investor pays for them in crude oil that is consumed in the US, as stated that: dollars. This would produce better price opposed to the Brent crude futures that is discovery in the ADR market and reduce the . The trading volume originating in the US normally traded in London. These are cash price gap between the Indian and offshore did not determine a US location settled off the WTI price in the US (at NYMEX). markets. After ICE was permitted to use its trading . The fact that the contract is based on a US terminals in the United States to allow US produced or economically important Source: Blog entries by Jayanth Varma, investors to trade the WTI crude oil futures on commodity did not probate location http://tinyurl.com/yz6b7
firms but now engages enthusiastically in 2.4. Legacy institutional architecture promoting inward for export-oriented The problems of competition policy, manufacturing firms that can also supply segmentation and barriers to innovation the domestic market. India has replaced its that inhibit Mumbai’s emergence as an legacy of autarky with an open economy are partly the consequence of a financial when it comes to trade in goods and most regime governance whose foundations were services except financial services. Teams designed at a time when the world of finance, of Indian workers are tightly integrated the functions of regulation, the contours of into the world economy when it comes to financial activity, and global competition in which has yielded $ billion of export , were different. While the superstructure of this revenues. Such phenomena are starting governance regime has been modified in to take place in manufacturing also. A bits and pieces from time to time to comparable philosophical change is now yield a shape of multiple regulators that required in the finance industry, if India is to is distinctly ungainly in design and, perhaps achieve $– billion of export revenues in dysfunctional, the conceptual foundations of finance and, alternatively to prevent the the basic regime have remained untouched. drain of $– billion in payments for The Act was first drafted in . acquired abroad. A serious effort to Although it has been amended several times create an will involve road-shows all since it has not been fundamentally changed over the world where presentations are made at its roots. The () Act was drafted to global financial firms requesting them in and the () Act in . The to consider India as a destination for separation between and is rooted in finance. Export-orientation in finance in the () Act of . The strategic requires attracting exactly like export- thinking governing these three Acts would orientation in manufacturing does. be addressed very differently if they were to 136 R M I F C
be drafted using contemporary knowledge. time – is now being exercised in a manner Many of the problems of competition that continues to protect the contours of policy, segmentation and barriers to financial regime governance from an era of innovation that India’s financial system autarky that has now passed and become confronts, and that impinge heavily on dysfunctional. the issue of making Mumbai an , flow In doing so, it is implicitly influencing from the conflicts of interest inherent in the future development of the Indian the multiple objectives and activities of the financial system (inadvertently or otherwise) , ultimately derived from the original in ways that may not necessarily be Act. In addressing the problems of consonant with Mumbai becoming an IFC competition policy, segmentation and the or with Indian firms competing effectively barriers to innovation in finance, the roles, for providing in the global arena. With functions, attitudes, ethos and objectives the inhibitions and restrictions leading to of financial regulatory agencies in India financial repression (or inadvertent implicit requires a new look; particularly in light of suppression of innovation) having their what has been happening in the world as well roots in deeper historical realities that as the different realities of st century India. have not yet adapted to the agenda for reform, it is necessary to be clearer about 3. Deeper sources of what these realities actually are, and what dysfunction needs to be done to alter them, to enable India’s evolution as one of the world’s most It would be misleading to suggest or significant economies to occur as smoothly conclude from the foregoing discussion that and painlessly as possible. the several complex issues raised by financial regulation in India, are issues purely of 3.1. The ‘ownership’ problem and the regulation per se. They often have more to conflicts-of-interest it causes do with the legacy context in which financial As in China, government ownership regulation has evolved to accommodate an continues to be a major feature of India’s array of multiple objectives – both regulatory financial system. It poses the same difficult and strategic. These often conflict; implicitly challenges for both these countries as they if not visibly. In that connection, it should be attempt to export and globalise their noted that a considerable burden has been financial systems. There is now universal placed upon the for taking the brunt of agreement, in global academic and financial dealing with continuing difficult structural circles, that public ownership of financial adjustment since . The weight of firms creates an intractable number of adjustment has fallen disproportionately on avoidable difficulties in influencing the adjusting monetary and exchange rate policy development and regulation of sound simply because fiscal policy has proven financial systems. Most importantly (in stickier, and insufficiently elastic/flexible, the context of the emerging Basel-II regime), in adjusting commensurately, for reasons a number of conflicts-of-interest arise of political economy. In performing this between the roles of government as the task, has also had to protect: (a) the ultimate apex regulator of the financial soundness of the Indian financial system, services industry (which it remains in the as well as (b) the government’s interests as absence of constitutional independence and India’ single largest shareholder in financial legal/juridical separation from government firms. of the , , , and other The adroit manner in which that dual regulators) while also being: responsibility has been acquitted is not as (a) The largest owner of financial firms fully realised or appreciated as it should be. being regulated: i.e., commercial banks – Many astute observers of the financial scene and their capital markets subsidiaries – as believe that such a doctrine – which derives well as in other parts of the financial services from the authority of a reputation earned industry such as: specialised long-term and acknowledged over a long period of financial institutions, insurance companies, . Why does financial regime governance have these limitations? 137
asset management firms, pension funds, and the survival and profitability of public sector firms/agencies involved in commodities. financial firms through artificial means. By In the mutual funds industry (and, so doing, it generates perverse incentives to a lesser extent, insurance), India has for government to diminish competition, made some progress with permitting entry enforce artificial and counterproductive of private and foreign players, as well segmentation, and throw up greater barriers as creating a more level playing field in to innovation. regulating that industry. The point has now In evaluating the characteristics of been reached where, although is still established or emerging s worldwide, the dominant mutual fund, it no longer it is significant that none of these cities commands an overwhelming market share. (other than Shanghai, which is further For Mumbai to become a viable and behind than Mumbai in having a financial competitive IFC within the next few years, services industry that can become globally this successful experiment in the asset competitive quickly) have any significant management segment of financial services, public ownership of financial firms in needs to be replicated in all other segments, any segment of financial markets. The most particularly banking and insurance. most vibrant parts of Indian finance – It needs to be accompanied by eliminating the securities markets – where export restrictions on: (i) the formation of competitiveness is perhaps most visible financial conglomerates or LCFIs that can in the attraction of voluminous foreign compete with their counterparts in the rest portfolio investment, are the parts where of the world; and (ii) the entry of hedge public ownership is the smallest. That funds and the entire range of other funds is no mere coincidence. It signals such as exchange traded funds across the clearly what the government needs to do spectrum. in withdrawing gradually but resolutely (b) The single largest borrower from from the ownership of all financial firms the Indian financial system, with an inherent within the political economy constraints it vested interest in keeping the cost of confronts (but not using those as a reason its borrowing suppressed to the extent to defer taking action indefinitely). That possible; even when that might have larger is indispensable to create the institutional implications in managing monetary policy and competitiveness conditions that are and sending signals through interest rates necessary and fundamental for Mumbai that affect every big price in the economy. to become a viable . In the absence of constitutionally guaranteed regulatory independence – i.e., 3.2. Strategic issues of public debt with regulators being independent public financing and management agencies accountable to the legislature (as An in-built propensity toward financial re- they are in many countries) rather than to pression has become chronic and endemic government – the government’s ultimate in India. It has its origins in historical con- responsibility for sound, impartial and ceptual notions among post-independence objective regulation, collides unavoidably policy-makers, seduced by the supposed with its ownership and borrowing interests. development success of the in – Not only does that create a conflict of interest , about how public (sovereign and sub- in a fundamental sense (i.e., the non sequitur sovereign) debt should be financed and man- that arises from an entity regulating itself), aged. Lacking belief in the efficacy, desirabil- it also incurs the risk of compromising ity (and feasibility) of India’s having efficient fairness of treatment on a uniform basis capital markets in the s, the option of for all financial firms. creating a wide, deep and open bond market Apart from the invidious and corrosive (for sovereigns, sub-sovereigns, municipals nature of these conflicts of interest, studies and corporates) – of the kind that now char- of government ownership of financial firms acterises almost all mature economies – was around the world suggest that it leads to a eschewed in the nascent stages of India’s eco- normal propensity to protect, at any cost, nomic and financial system development. 138 R M I F C
Figure 10.1: Market capitalisation of COSPI firms against non-food credit (trillion rupees) the MoF view on what the level of interest rates should be. The lack of independence Mkt. cap. of liquid set of the central bank hinders acceptance by Non−food credit of banks 30 global investors who prefer to operate in an that adopts global norms concerning separation of powers between monetary and 20 fiscal authorities, and permits independence 15 on the part of both to pursue the most appropriate and optimal policy options. A key part of this strategic thinking 10 Grew at 27.3% p.a. on debt management is the role of foreign
Rs. trillion, log scale investors. A liquid yield curve that can be traded in an efficient bond and bill market by foreign investors is likely to attract enormous investment flows into 5 (The blue line ignores illiquid,unlisted equity and corporate bonds.) Indian sovereign debt from long-term 2002 2003 2004 2005 2006 2007 global fixed income portfolios like pension funds. This would result from (a) pressures In the st century there is a need for for diversification in global fixed income fresh thinking on the part of policy-makers portfolios, especially favouring investment about strategic issues of debt financing, in developing economies that can sustain a issuance and management. Financial superior growth rate over several decades liberalisation does not inevitably imply that as India can, providing its real economy is it will result in a shortage of voluntary and managed as well as it is now and its financial enthusiastic buyers for government bonds. system reflects global standards; and (b) the Quite the contrary; whereas resident Indian positive outlook for India and the over investors with few portfolio diversification the next – years. The participation opportunities might be sated with Indian of these investors requires a modern bond sovereign obligations, either directly or market. That feeds back into establishing indirectly, global investors have an enormous a liquid yield curve. Access to such appetite for digesting Indian paper that has financing would constitute a far-reaching not been addressed, leave alone satiated. transformation of Indian public finance. Through financial sector reforms, a liquid yield curve can easily be 3.3. Lack of strategy on the transition attained, with a market populated by a from a bank-dominated system very large number of participants. This toward a market-dominated is likely to deliver superior, and far financial system more flexible, financing options along the Finally, there has been an absence of maturity/duration and coupon spectrum. sufficiently clear strategic thinking on the It would also widen geographical scope evolution of finance, both domestically for financing the fiscal deficit; especially and internationally, away from banking in the global marketplace (even for paper towards securities (Litan, ). In India, denominated in ) when compared with an examination of the liabilities of firms on the present regime. a market value basis shows the dominance Resorting to the global marketplace, of equity financing. As shown in Figure and meeting global demand for Indian ., the market capitalisation of the top sovereign paper, would ease crowding out , firms of the equity market stands at pressures and pre-emption in the domestic roughly twice the size of non-food credit of market. That would have the benefit of the banking system (which comprises loans easing demand-supply induced pressures on delivered to big companies, small companies Indian interest rates. It would create more and individuals). room for manoeuvre on the part of in A commensurate transformation of the executing monetary policy; independent of policy framework has not taken place. In . Why does financial regime governance have these limitations? 139
many respects, Indian finance continues acting on them. China has the opposite to be rooted in the past, with a banking- reputation of acting too swiftly, without dominated financial system that should, thinking through all the implications. by now, have become much more capital- So far China has made more progress market oriented especially in the market for than India. Perhaps there is a lesson in debt in the form of traded securities rather there somewhere, although the optimal than bank loans. solution would be to blend both these opposite tendencies in a happy medium. 4. What impedes Mumbai from Neither country can afford, however, to delay its entry into the burgeoning global becoming an IFC?A market for providing – driven in summary large measure by their own needs as they This group of three chapters has dealt become more significant players in the global with some of the critical hurdles that economy. The Indian financial industry presently impede the emergence of Mumbai and policy-makers need to focus on, and as an . Clearly, making the profound engage with, these problems at many levels changes that are necessary in financial simultaneously, in order to address these regime governance (i.e., adapting legislation difficulties. to meet modern realities, policy-making, Portraying the world of in regulation, enforcement, and changes in the a somewhat simplistic but nevertheless functioning of the legal system that provides powerfully illustrative matrix, the wallchart recourse for contractual dispute settlement) constructed for this purpose offers specific, is a complex undertaking. Swift progress tangible views on what holds back a specific will be difficult to make. from being provided in India and what India has a reputation for taking far needs to be done to make India a significant too much time to contemplate and discuss player in markets on the world stage. changes ad infinitum without necessarily
See http://tinyurl.com/yu4zk7 on the web on this theme.
Reforming financial regime governance
The previous three chapters offered a diag- codified rules cannot look beyond the nosis of challenges in financial governance letter of the law to its spirit. In recent regime that inhibit Indian firms from export- years, many large financial firms in New ing . This chapter offers an alternative York engaged in activities which were c h a p t e r path for progress to be made on this frontier. unfair to customers and did not meet It dwells on the normative economics of minimum ethical standards. However, financial sector policy at the level of ideas. most of these firms were still able to Based on these, specific recommendations argue that no laws had been violated and that need to be implemented for an are supervisors could not disagree though 11 made in Chapter . both knew that the spirit and intent of the law had not been honoured. 1. A shift toward . From the viewpoint of detection of fraud, principles-based regulation or of impending firm failure, supervisors need to have an overall understanding India’s strategy for financial regulation of the business of the firm. They need deploys rules based regulation – the same to understand its business plan and its strategy used in continental Europe and, sources of profit to form a judgment to a significant extent, in the . It about the incidence of malpractice or consists of building up a large repository probability of default. Rules-based of subordinate law through codification of regulation requires supervisors to focus detailed rules and regulations by specialised on minutiae. It obscures the woods regulators. These define the permissible from the trees. This leads to reduced features of financial products and services awareness and inferior perceptions and the functioning of financial markets in about financial firms in the minds of detail. Such a prescriptive approach avoids supervisors. legal ambiguity through precise codification. . Rules-based regulation inhibits inno- Rules-based regulation has two strengths. vation. Every new idea on products, First, it provides greater legal certainty to services, markets or even new ways of market players, who are able to abide by clear doing business requires going to the reg- rules governing all aspects of their business. ulator requesting a modification of rules. Second, it enables financial regulators and This tends to eliminate the temporary supervisors to operate in a non-discretionary profits obtained by innovative firms who manner. As the manual of rules defines all obtain an edge over their competitors permissible activities, the act of supervision by coming up with new ideas, which (in reduces to ticking off a long checklist, and turn) tends to reduce investments into objectively verifying whether specific rules research and development. have been complied with or not. However, . Rules-based regulation induces corrosive over the decades, important weaknesses of political economy, where firms seek to rules-based regulation have become visible: influence the evolution of rules into pathways which favour themselves. . Sophisticated compliance officers of finance companies are frequently able High quality regulation and supervision to find ways of pushing the edge of is a sine qua non for . It determines the envelope while not violating the the competitiveness of an . If an letter of the law. Supervisors focused on lags in innovation, through slow governance 142 R M I F C
processes, and through weak incentives for firm’s: sources of profit; core businesses firms to invest in innovation, then that processes; corporate adherence to ‘principles’ will lose competitiveness and global market based on its management commitment, share. If regulators and supervisors at an its corporate culture and the corporate are unable to block fraudulent or unfair sanctions applied to rule-breakers; as well behaviour by firms, and are ineffective in as the strength and depth of its compliance setting up a sound risk management system processes. Principles-based supervisors for markets and firms, then the will lose engage in broader and deeper continuous reputation as well as global market share by interaction with the financial firms being becoming a pariah. regulated to understand their businesses The alternative to rules-based regula- and to anticipate how they are evolving as tion – i.e.,‘principles-based regulation’ or markets change. They are often consulted by – was first introduced in the in . the firms they supervise about new products It involves less detailed prescription of what and ideas informally but do not have the is allowed and what is not in every activity or powers to block those ideas from being tried market, less codification, less rigidity of rule- out. Their influence is through relationship book interpretation, and a greater reliance and persuasion rather than through policing. on practice and precedent. The prime expo- The main strength of is that it nents of this approach are the , Ireland fosters innovation. It encourages greater and Australia. However, the ideas underly- competition among financial firms that are ing this new regulatory approach are being able to introduce new ideas into markets applied all over the world, including in es- rapidly. The malpractices that occur when tablished s like Singapore. The same supervisors focus on checklist compliance ideas have been adopted in Japan. But they are avoided. However, imposes have been less effectively implemented there. onerous demands on, and requires adequate Japan has had difficulty erasing the legacy protection for, the staff of supervisory of -style rules-based regulation with the agencies. They are required to understand meticulous application to detail that Japan’s each regulated firm, and make discretionary supervisors appear loath to relinquish. That judgments about whether its business plan stance has inhibited Tokyo’s role as an . and modus operandi are consistent with the It serves as a lesson for Mumbai as well. principles established by the regulator. This The bedrock of is that the regulator requires an elaborate system of transparency articulates broad principles and avoids and checks-and-balances, in order to prevent codifying details of allowable products, abuse. No approach is perfect. Rules-based markets or business plans. Under , the regulation poses no such risk for supervisory top management of financial firms is held staff apart from the risk of performance accountable for ensuring that the business failure. , on the other hand, places plan of the firm, and all its activities, are greater burdens of knowledge, responsibility consistent with the principles defined by the and accountability on supervisory staff. regulator – i.e., not just with the broad letter runs the risk that: (a) supervisory staff of the law but with its intent and spirit. It might misuse their discretion; and (b) they removes incentives for financial firms to play may need to be shielded sufficiently to be an adversarial game (induced by rules-based confident about exercising discretion and regulation) of ‘beat-the-regulator’ to become not become convenient political scapegoats competitive. Under unsavoury business when things go wrong. plans for financial market operations cannot Applying a historical perspective, the be rendered palatable by clever compliance use of at the is not that unique. officers. By its very nature ensures As Jayanth Varma has pointed out, it is that such game-playing does not take only in modern times that regulation by place. With , supervisors are inevitably the - has turned into de facto over- called upon not to think of supervision in prescription. In its early years, the - terms of checklist compliance. They are had enormous flexibility and competence, required instead to understand a financial with a more flexible, accommodating . Reforming financial regime governance 143
philosophy much like . The radically changed the approach of the , was a product of the civil law era in away from a rules-based system towards a administration (the New Deal). But principles-based system. The CFMA defines Chairman Douglas made the the most ‘designation criteria’ and ‘core principles’. successful and least prescriptively oriented Under the CFMA, a futures exchange only of all the New Deal agencies. The - has to certify to the regulator that it is in its heyday – the Douglas and Landis eras – starting a new product or rule, with a notice stands out as an exemplar of the flexible of at least one day in advance. If the exchange approach. This period probably laid the wants to request an approval, the agency has foundations of the enormously successful days to give it. financial system. It would probably not In contrast, stock exchanges in the have emerged as such if the existing cannot change products or rules approach of over-prescription and harmfully without a notoriously slow approval process intrusive legislation had been applied in the at the . In a speech in June formative years. , Commissioner Walt L. Lukken said The European Commission has also the gave exchanges the flexibility become an outpost of excessively prescriptive required to foster innovation, saying: approaches to financial regulation. It stands “While the monitors out in sharp contrast with the . The shift whether a core principle is at the and on the continent towards ultimately met, the exchanges over-prescriptive rules-based regulation has with their hands-on experience helped London to achieve success as the are given discretion to tailor world’s premier . their rules to their special requires a regulator to make in- circumstances”. formed judgements based on an understand- ing of firms, their customers, and the mar- kets in which they operate. In making judge- 2. Reducing the artificial ments about outcomes, and about what con- segmentation of financial stitutes minimum standards, requires a firms, products, services and broad degree of consistency in terms of the markets quality of outcomes that firms deliver; rather than consistency in detailed requirements How can the problem of segmentation in about processes. Firms are expected to adopt Indian finance be addressed? In four ways. approaches to delivering outcomes that meet high regulatory objectives. 2.1. The holding company approach There has been some movement In an international setting, financial firms towards principles-based regulation in the exploit economies of scope and scale by also. For example, in the operating in all sub-segments of financial Congress created the Commodity Futures product/services markets. Global s Trading Commission () for oversight have reaped competitive advantage in the of derivatives exchanges. This resulted global market as a consequence. In some in regulatory bifurcation in the , with jurisdictions, such as the , the integration spot markets being regulated by the of all financial regulation under a single and futures markets being regulated by regulator has facilitated the integration of the . A key milestone for the a range of financial activities in unified was the Commodity Futures Modernisation financial firms. But many countries have Act () of December . This law fragmented regulatory architecture, as in India. In such instances corporate structures Across the Irish Sea is an even more remarkable need to be contrived to support the creation financial regulator in Ireland (). It has a of a virtual unified financial firm that reputation exceeding that of the in terms of is able to operate in any or all areas of applying the rule of common sense alongside common law. It is increasingly seen as one of the smartest and the financial services business. The most most flexible securities regulators in the world. expedient of these is the “holding company 144 R M I F C
Box 11.1: Principles-based Regulation in the The way in which the FSA operates in The mandate of the FSA is designed to avoid gaze of the CEO away from the government regulating the City of London is important in the loss of efficiency from the conservative towards the market. PBR consists of applying understanding regulatory issues surrounding instinct of setting up a license-permit raj, or that approach to finance. The FSA places a IFS provision owing to innovations in the periodic heavy handed complex burden upon the financial firm and regulatory strategy. PBR was pioneered in the front-page-headlines crackdown on finance upon its own staff: that of understanding UK. But it appears to have taken root in several which happens with populist regulators. broad principles and adhering to them in spirit. OECD countries. It is now a well respected The integration of all financial system In return, detailed rules governing every regulatory doctrine around the world. The US regulation at FSA makes it easier to transmit minute detail of every activity in finance have is also likely to apply it before too long if the knowledge on success from one part of the been eliminated. CEOs of financial firms in initiatives now in train come to fruition. FSA (say banking) to another (insurance). London innovate on an everyday basis without needing to continually approach the regulator In May 1997, fundamental financial reforms Internationally, most banking regulators view for permission associated with every change in were announced in the UK. The Bank of securities markets with suspicion or hostility. the business plan. England was made an independent central However, the global economy is shifting away bank with the sole objective of setting the from banks to securities-market dominated Large complex firms (LCFIs) are linked to short-term (base) interest rate with financial systems. The merger of banking and specialised relationship-management teams in accountability for hitting a publicly stated securities into the FSA has ensured that the FSA which provide a single point of contact. inflation target (of keeping inflation under 2%) FSA-regulated banks are not hindered from The team at FSA that deals with the large firm through an open and transparent process. All deep integration with securities markets. is given three tasks: (i) understanding the functions other than setting the short rate Instead of discouraging integrated LCFIs, the sources of profit of the firm; (ii) understanding were removed from the Bank of England. FSA is perfectly happy to see them bloom. that the business plan and processes are All financial regulation that was previously ‘Principles-based’ or ‘light-touch’ regulation consistent with the principles of the FSA; and undertaken by nine separate agencies was was originally conceived at the Bank of (iii) verifying that the processes of the firm unified under a new single England prior to the 1997 reforms. The main perform satisfactorily and that risk is being regulatory/supervisory agency called the insight it applied is that it is neither feasible managed properly in the broadest and Financial Services Authority (FSA). It was nor desirable to write down detailed rules narrowest senses. The FSA team makes regular seeded with the 500 people from the Bank of governing every market and every product. presentations to the board of the regulated England who used to do banking supervision Under this philosophy, it is simply not possible, company about their understanding of the from there, and the staff of all other existing nor even necessary, for regulators to try to areas of concern. This improves the pressure financial regulators. anticipate every change or innovation that on the FSA team to have a sound might occur in financial markets; especially understanding of the regulated firm. By 2006, it is increasingly clear that the FSA given the sheer size of the number of This approach makes two kinds of demands approach has worked in the UK. The FSA has participants, the changing needs of an even upon the staff of the FSA. They are required to managed to steer clear of three kinds of greater number of sovereign, corporate and understand the regulated firm in a manner problems: the populist regulator who likes to individual users of financial services, and the akin to a strategic management consultant, a play to the gallery by currying favour with inexorable global integration of national responsibility not replicated or attempted at a ordinary citizens; the conservative regulator financial systems. Attempting to do so simply conventional regulator in India. Further, FSA where the default answer to all questions inhibits innovation and detracts from staff are empowered to act based on their concerning innovation is ‘no’; and the US-style competition. Instead it is important to focus own discretionary judgment. approach of introducing enormous on broader strategic issues and let firms worry legal-overheads on the production of financial about regulating themselves on points of There is an interesting contrast between a services. Whereas the UK was afflicted by detail – but under the continuous watchful eye principles-based approach and a rules-based recurring failures and crises concerning foreign of friendly and co-operative FSA supervisors, approach. In a rules-based approach, as is banks in the financial system in the 1970s and should things go pear-shaped. practiced in India or in the US, it is all too easy 1980s, these have been conspicuous by their to have rigid checklists that RBI or SEBI staff absence since 1997. Debate about ‘light-touch’ vs. traditional regulation is essentially an argument about the must verify by ticking boxes on long laundry The first innovation of the FSA is its mandate. relative costs and benefits of over-prescription lists when they interact with a firm. This gives The law asks FSA to attain four equally vs. flexibility. The contrasting US approach on supervisory staff plausible deniability when important objectives: (1) Maintaining market the part of all regulators, except those for anything goes wrong. This, of course, does confidence (2) Promoting public understanding derivatives markets where most financial not uncover or solve underlying problems. of the financial system (3) Securing an innovation takes place, attempts to codify a The FSA approach emphasises the need for appropriate degree of protection for full set of rules covering every product and intelligence and judgment on the part of consumers; and (4) Combating financial crime. market mechanism in fine detail. The regulatory staff, not just a mechanical checklist The law codifies little about markets and alternative strategy, adopted by the FSA, is one of rules. The FSA approach requires top quality products. It focuses on broad principles. It is of articulating broad principles, and leaving professional staff, that have considerable interesting to see that that the objective of the market players to continually innovate on the operating experience in financial firms, and are FSA is one of securing appropriate consumer details through which these broad principles capable and senior enough to apply their own protection, not infinite consumer protection at will be achieved. judgement independently without fear or any cost. A conceptual goal of the FSA is that the top favour. In order to help achieve this, FSA The FSA is tasked with making markets work management of a financial firm must primarily wages are decoupled from civil service wages, to deliver benefits to firms and consumers. It look at markets and innovate, without and linked to median wages in the private accepts that some failures neither can, nor worrying about the regulator. This is strikingly sector. More than half of FSA’s staff comes should, be avoided. Failures are part and reminiscent of India’s experience with from the financial industry, through a parcel of what makes markets work and dismantling the control raj in manufacturing, continuous two-way flow between the FSA provide an important source of future learning. where the reforms were about turning the and the industry. . Reforming financial regime governance 145
Box 11.1: continued ... With the concentration of monopoly constitutes an effective feedback loop financial firms can think about innovation and regulatory power at the FSA, there is enormous between export orientation and high quality not undertake regular pilgrimages to the concern about accountability and checks on provision of the ‘public good’ of regulation. Treasury, the Bank of England, the FSA, and the power of FSA and about the possibility of One practical example of the debate other offices of government agencies to regulatory capture. This has been between a rules-based approach and a further their firm’s business interests is accommodated through numerous principles-based approach concerns the enormously attractive. checks-and-balances. The first is that of having operations of hedge funds. The FSA approach staff that understand fully real world finance, At the same time, the UK approach is emphasises the enormous positive daunting on many fronts. The principles based and hence avoid automatically falling back on contribution that hedge funds to market saying ‘no’ as the default option when faced approach can reduce the legal certainty on liquidity and market efficiency. The FSA has with any complex idea. A statutory which firms operate. It places discretionary emphasised supervising hedge funds through power in the hands of regulators and ‘practitioner panel’ watches the FSA and writes prime brokers. Prime brokers are typically arms a reports about areas where things are going supervisors all the way down the line. It of (regulated) investment banks, and provide requires these officials to have high quality wrong. There is a tribunal for appeal on hedge funds with a range of services, enforcement matters, much like the Indian understanding, judgment and probity. And, it including securities lending, leveraged-trade requires that they be shielded from a Securities Appellate Tribunal (SAT). Finally, transactions, and cash management. They are when there are policy disputes between the witch-hunt when discretion is exercised and close to the market, so they can keep things go wrong. industry and the FSA, the UK Treasury (its regulators informed; and, because their money Ministry of Finance) plays the role of a tribunal. is at risk, have an interest in keeping abreast of The most important testimony about the UK The UK finance industry accounts for 8% of what hedge funds are doing. approach is the fact that in the last decade, its GDP. If FSA stifles the innovation or London has emerged as the world premier This approach relies on the self-interest of, competitiveness of this industry, it impacts financial centre, once again overtaking New and intelligence from, prime brokers, instead directly upon GDP growth. Apart from that, York after a 50-year hiatus. That process has, of trying to write down rules and send out the City of London is extremely influential of course, been assisted by other factors such government employees to visit hedge funds politically and government takes its interests as terrorism in New York, Sarbanes-Oxley, and and comprehend what each of the 8,000 very seriously. This generates incentives for top the civil law approach of the EU. However, hedge funds of the world is doing. policy makers and politicians running for there is little doubt that the far-reaching election to take interest in sound financial The FSA approach is both instantly appealing decisions of 1997 in reforming the Bank of regulation, and ensures the global and attractive, yet extremely challenging in England and the FSA transformed the position competitiveness of London as an IFC. It also implementation. The idea that CEOs of of London on the global financial stage. aIn the classification scheme of Pritchett and Woolcock (), the hardest problems of governance are those where there are many interactions between civil servants and private citizens, and there is discretion in the hands of the civil servant.
structure”. If the structure of regulation subsidiary would then be roughly equivalent prohibits commercial banks from fund to the chief of each major operating business management, then the solution involves division of the virtual unified firm. a mother corporation that has two wholly In order to achieve these goals, the owned-subsidiaries, one a commercial bank holding company must be required to and the other a fund manager. The virtual comply only with the Companies Act and financial firm would then be engaged in with exchange listing requirements; in both businesses while satisfying the separate the event that it is listed. It should be regulators covering each area of business. subject to no financial regulation from any In the most refined case, the holding regulator. The fact that a subsidiary of the company would be a listed company, with holding company may be a bank should a corporate engaging in pursuing the give the banking regulator no power over business strategy of a unified financial the owner of the bank, i.e., the holding conglomerate. From the viewpoint of the company. Further, regulations governing shareholder and the , the firm is a banks, insurance companies, etc. need to unified multi-product financial firm, with a accept % ownership in the hands of series of wholly-owned subsidiaries present holding companies that can have dispersed in areas as required by regulatory rules. The shareholding and public listing requirements and the board of the holding company along the lines applied to any other company would make decisions about allocating in any other line of business. Apart from capital and forming business strategy for the regulatory constraints, the other constraints virtual firm. The strategy would be executed faced with a holding company structure in by multiple subsidiaries. The of each the Indian environment are: 146 R M I F C
Box 11.2: Case Study – Principles-based regulation in the for treating customers fairly As an example of how PBR works, consider finance firms – and not just their compliance removing a significant volume of detailed rules consumer protection, or what the FSA calls departments – to embed these objectives on consumer protection. Detailed rules on “Treating Customers Fairly” (TFC)a. The FSA has within the business strategy, culture and money laundering, and on training and defined six desired outcomes from its work in behaviour of their firms. The FSA holds the top competence for wholesale business have been the TFC area: management of each firm accountable for removed. The Authorisation Manual is being meeting these six desired outcomes, and not dismantled. It intends to further implement a . Consumers can be confident that they are seek to micro-manage firms on how these radical simplification of investment Conduct of dealing with firms where the fair treatment outcomes are achieved. Business rules, rules on financial promotions of customers is central to corporate culture This principles-based approach provides and rules on complaints handling. . Products and services marketed and sold in financial firms with more flexibility to decide When firms ask FSA to define minimum the retail market are designed to meet the how best to run their businesses, while standards, in the quest for legal certainty and needs of identified consumer groups and meeting FSA regulatory objectives. Firms are predictability, the FSA response is that the are targeted accordingly better placed to judge the detail of how best Principles and other high level rules are . Consumers are provided with clear to deliver those outcomes in the marketplace, themselves minimum standards, and that FSA information and are kept appropriately and thus deliver fair treatment to their sees these minimum standards primarily in informed before, during and after the customers in a way that is consistent with their terms of outcomes, not of prescribing detailed point of sale commercial objectives. FSA argues that inputs and processes. . When consumers receive financial advice, providing flexibility rather than prescribing Predictability is enhanced by statements of the advice must be suitable and tailored to detailed processes enables firms to compete good and poor practice and through case take explicit account of their circumstances and innovate more effectively in product studies illustrating ways in which firms have design, in the quality of customer service, and successfully met requirements. Such . Consumers are provided with products in achieving economic efficiency. statements of good and poor practice help that perform as firms have led them to FSA works on improving financial capability senior managements of firms to think for expect, and the associated service is both and awareness of consumers, and the themselves about how best to meet high level of an acceptable standard and also as they provision of clear information by firms and by requirements within the specific circumstances have been led to expect the FSA to consumers, to help consumers to of their own activities and business models. By . Consumers do not face unreasonable pursue their own best interests by playing an publishing examples of good and poor practice post-sale barriers imposed by firms to active and informed role in the markets for on either side of an acceptable standard, FSA change product, switch provider, submit a financial products and services. Enforcement indicates to firms both where the minimum claim or make a complaint. actions are taken against firms and their senior standards lie, and that there are alternative management when they fail to achieve high ways of delivering them. In doing this, FSA These six principles define what the FSA level outcomes. respects the confidentiality of ‘proprietary’ requires the financial industry to do for As part of the move to a more good practice that firms have developed to consumer protection. FSA emphasises the principles-based approach, FSA is working on give themselves a competitive advantage. responsibility of the senior management of aSee http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2006/0724_cb.shtml
A. Tax consolidation of accounts. Under compliance costs. Flexible rules need to be Indian , a listed holding company has specified governing intra-group transactions to present stand-alone and consolidated and corporate reorganizations. The regime accounts. However, for income-tax can prescribe conditions, such as minimum purposes, such a consolidation of accounts holding periods and condition for qualifying is not presently permitted. At a conceptual for group level consolidation, consistency of level, it would be desirable to tax a financial years, entry and exit issues etc. group on the basis of its overall financial performance incorporating the performance B. Dividend tax credit. When a subsidiary of all subsidiaries put together. Worldwide company pays dividend to its holding there are a number of jurisdictions, such as company, it pays a dividend tax of .% the , and others that tax a corporate in India. A dividend payout by the holding group as a single unit. Although the company to shareholders incurs a second scope and approach may vary from one dividend tax of .%. This vitiates the jurisdiction to another, tax grouping allows viability of the holding company structure. offset of profits and losses within the group, with a few countries extending the concept C. Leverage by the holding company. Sec- to cover foreign subsidiaries. Hence, there is tion of the Companies Act, , speci- a case for introducing a group tax regime, fies that, without consent of shareholders, that is simple to administer, and involves low a company cannot borrow more than the . Reforming financial regime governance 147
Box 11.3: Principles Based vs. Rules Based Regulations ( vs. ) . Principles Based Regulation (PBR) is . In an environment accustomed to RBR, players in the industry conform to rules outcome oriented regulators see PBR as posing high that protect the reputation and integrity . It differs from Rule Based Regulation regulatory risks of that industry; and ensuring that the (RBR) which is process driven. . They fear that the operating flexibility best global standards of corporate ethics and governance are applied by all . PBR is based on the idea that the that PBR permits could be misused in regulator is not always best placed, or environments with insufficiently high players. better placed than market participants, standards of internal corporate ethics, compliance and governance. . PBR is particularly well suited to the to judge what is best, or what is right regulation of securities markets, which and what is wrong in terms of products, . With RBR, market participants leave it to regulators that are RBR driven (such as in instruments, services, practices or regulators to specify what those the US) have now explicitly recognized. market functioning. standards should be through detailed . PBR is based on the premise that rules. . PBR does not mean lax regulation and competition and innovation in rapidly . But experience suggests that RBR does supervision. Compliance under PBR evolving markets driven by technology not necessarily or automatically instill or depends as much on the spirit as the should not be inhibited by encourage high standards of ethics or letter of the law. For that reason, over-prescriptive regulation. governance to be applied in any compliance with PBR is different and . PBR allows for greater flexibility in particular environment. more demanding than the “checkbox” devising internal corporate business and . What RBR appears to encourage is the compliance under RBR. compliance processes to cope with development of capabilities aimed at . Violation of rigid but specific rules is changes in rapidly evolving markets evading rules through technicalities and much easier to establish than broader . RBR invariably prescribes permissible loopholes. This weakens incentives for principles that are more open to business processes in micro-detail and better self-regulation within the subjective interpretation. changes too slowly in response to regulated industry and induces a tendency for market competition to be market changes. . PBR requires greater knowledge on the . The overall effectiveness of PBR is driven by a propensity for cleverly part of regulators, an obligation to critically dependent on the ethical and evading rules faster than the competitor. remain up to date with changes in governance standards that prevail in the . The key to determining the regulatory rapidly evolving markets, as well as financial and corporate worlds in any tone in a particular environment, and more accountability and responsibility to country. deciding whether PBR is more suitable be exercised by supervisors in exercising . The higher such standards are in a given than RBR in a particular country judgments than RBR which focuses too operating environment, the better is circumstance, depends on the standards much on the use of detailed checklists compliance with PBR and the better its applied by the regulated industry in: for compliance assessment. overall outcome. monitoring itself, ensuring that all total amount of its share capital and free approval of the central government is re- reserves. This restriction is archaic. It needs quired prior to availing such services. This to be removed, particularly for listed com- requirement needs to be reconsidered in a panies where mature corporate governance modern corporate governance environment. processes are in place. At the minimum, this restriction needs to be rephrased to make a 2.2. Reforms in financial system link to the share capital and free reserves of regulatory architecture the consolidated balance sheet. One important source of segmentation in Indian finance is the turf separation D. Restrictions on intra-group transac- created by having multiple regulators. tions. The ultimate goal of a holding com- Reforms to regulatory architecture could pany structure is to support listing and run- be undertaken to mitigate these problems. ning a corporate headquarters for a set of India needs to choose between two paths. finance companies, each of which complies One is to consolidate down to four with the requirement of a separate regulator. regulators covering finance with one each The ultimate objective is to create a virtual for: (a) banking with a regulator separate financial firm that spans the financial ser- from the monetary authority; (b) capital vices universe. However, Section of the markets, with a merger of securities markets Companies Act constrains the utilisation functions on the fixed income, currency of the services of any group company by and commodity markets into a single another group company. When group com- securities and derivatives market regulator; panies have a common directorship, prior (c) pensions with the consolidation of 148 R M I F C
Box 11.4: The politics of regulatory architecture In the US, regulation of all derivatives – the agency was created, futures trading was derivatives exchanges. The Chicago exchanges financial or commodities – is placed under one synonymous with agricultural commodity in general, and the Chicago Mercantile agency (the CFTC). Regulation of financial spot futures trading. That world is, of course, long Exchange in particular, are top donors. In the markets is under another (the SEC). This gone; US derivatives exchanges trade every 2006 election cycle in the US, four exchanges separation is derived from history and manner of derivatives imaginable including appear on the list of the top 20 securities sustained by political economy. currencies, interest rates, energy, weather, etc. industry donors. All but one of the four are futures exchanges. The CME has been on the The CFTC is overseen by the House and The members of the House and Senate Senate Agricultural Committees, owing to the Agricultural Committees tend to obtain top 20 list for the last three election cycles. historical origins of the CFTC. In 1974, when significant political funding from the
Box 11.5: Costs of compartmentalisation, and benefits of unification, in the ‘exchange ecosystem’
Segmented model Unified model Equity Fixed Currency Commodities income
Exchange NSE, BSE NDS, Clearcorp Clearcorp Dealing NCDEX, MCX, All 8–10 exchanges would compete in trading all products. Dealing Systems Systems, Reuters, IBS NMCE etc. (This assumes NDS will be put out as one more exchange). Clearing NSCC, BSE CCIL CCIL None All three clearing corporations would compete in offering corporation Clearing House clearing services for all products Depository NSDL, CDSL SGL n.a. NSDL All three depositories would compete for all demat services. (This assumes that SGL will be put out as one more depository). Problems: Lack of competition, lack of economies of scale, lack of Benefits: More competition, economies of scope and economies of scope. Conflicts of interest owing to functions held scale for both exchange institutions and member firms. within the State at NDS and SGL. Heightened costs for financial firms. Improved functioning of NDS, SGL and the State, owing to elimination of conflicts of interest.
pension regulation into a single pensions 2.3. Shift away from “entity-based regulator; and (d) the insurance regulator. regulation” towards domain Such a quartet might reduce the extant based regulation degree of segmentation and regulatory turf Until an -style agency comes about, protection in Indian finance; but it would care needs to be taken in identifying rules not eliminate them. that induce segmentation in Indian finance Alternatively, India could choose to and removing them. For India to succeed integrate all financial regulation into a in provision, it has to be understood single -style agency. The experience of that the end goal is for India to have London suggests that that provision is efficient, globally competitive financial firms encouraged by the unification of all financial which are able to do what is needed to regulation into the . The principle of the compete effectively in all markets. The is that it is able to take a complete view goal is not to make regulatory life less of all activities of all finance companies and complicated by maintaining the tidy status a holistic view of trends in financial market quo of segmented financial firms that fall development. At the same time, there are neatly within current regulatory domains, problems of accountability and governance and are easy to control, supervise and as well as regulatory monopoly associated regulate. This requires, for example, treating with creating an -style agency. a ‘primary dealership’ as one of the many business activities of a financial firm, and not While the is not yet a statutory regulator, requiring that standalone firms be created the present direction of policy thinking in the field of pensions envisages such a role for it (Shah and Patel, which do nothing but primary dealership. ). The strategy for regulation needs to be one . Reforming financial regime governance 149
where the banking regulator regulates the Rs. crores or $ . million equivalent) business of banking, but does not regulate all for management. A small set of professional the activities of a financial firm that chooses trustee companies – perhaps three to five – to call itself a “bank”. should supply supervisory functions over an industry composed of perhaps – 2.4. Organisation of the asset s. management industry Once this industry is in place, it should The very nature of the asset management be possible for banks, insurance companies, industry enables large economies of scale to mutual funds, hedge funds, s, pension be captured. The costs of managing a bond funds, , etc. to outsource their portfolio of Rs. trillion are not a thousand asset management to one or more of these times larger than those of managing a bond companies. What is envisaged, of course, is portfolio of Rs. billion. They may not even a market-driven process. There should be be ten times larger. Hence, when a firm no compulsion that an insurance company manages a larger quantum of assets, it is must outsource fund management to an able to quote lower prices when expressed . However, any regulatory barriers that as basis points of assets under management impede outsourcing should be removed, (). As an example, in the world market, so that the in-house versus outsourcing the price for index fund management for $ decision is made by every financial firm billion of assets is roughly basis point or in India on the grounds of pure economic .%. At present in India, there is no index efficiency. fund with a size of $ billion, and hence It is important to maintain a distinction index funds in India cost much more than between the regulatory structure that applies basis point. to an insurance company and the regulatory Asset management functions are per- structure that applies for the wholesale formed in almost every sub-segment of fi- . The insurance regulator has a nance: banking, insurance, pensions, mutual legitimate focus on the risk profile of funds, hedge funds, etc. The fragmentation the portfolio of the insurance company. of finance owing to regulatory architecture However, the relationship between the induces huge diseconomies of scale in asset and the insurance company has no link to management. That will hamper the compet- the complex obligations of the insurance itiveness of Indian firms in an international company. setting. As an example, an insurance company Considerable progress can be made on might place Rs. billion with an this problem by separating out the ‘front for managing an equity index fund. The end’ through which assets are sourced for regulatory focus on the would then be management, from the back-end ‘factory’ restricted to verifying that the index fund is where assets are managed. The front ends being correctly managed. As an example, in embed specific contractual structures, and a mutual fund setting, the costs associated regulations, such as insurance companies with retail investor protection should be as opposed to mutual funds. However, the concentrated into the mutual fund. When task of fund management that takes place the MF outsources to an , this contract in each of these firms is done in the same should be struck at the low prices seen in kind of factory. The difference between a wholesale fund management, and the burden mutual fund and a pension fund lies in the of regulation associated with retail investor front-end, not in actual asset management. protection should not fall upon the . This suggests the creation of a new With such a structure, wholesale s industry of Asset Management Companies could achieve significant economies of (s) that are wholesale fund managers. scale by tapping into assets from many This industry should be regulated by . institutional funding sources. In such an The customers of s might be restricted environment, when an insurance company to wholesale customers who put up a evaluates the decision of managing assets minimum of (say) Rs. million (or internally, as opposed to outsourcing that 150 R M I F C
activity, it is likely to find that the charges sound pricing of the insurance and of the wholesale are much lower than administration in a way that avoids the costs of internal asset management. This moral hazard – is of the essence. This would encourage the outsourcing of assets needs to be coupled with a prompt for management from a large number of corrective action () framework, financial firms to save their own costs and where strictures are placed upon weak achieve economies of scale in the firms well before failure; such as a industry. Such a move would immediately prohibition on accepting new business make asset management in India globally when underlying risk capital is too competitive. Asset management companies low. Listing is a powerful tool through in India with over $ billion in assets which stock market speculators monitor under management would be cost-efficient firms, and produce daily estimates of by the standards of the global money their failure probabilities. A policy of management industry. But, for that to requiring listing, and the establishment happen, appropriate institutional structures of procedures within regulators of for wholesale s would need to be monitoring stock prices, would help created and economies of scale captured generate early warnings about distress in the domestic market before such services based on which can be taken. could be globalised. . In the securities markets, clearing corpo- rations which manage counterparty risk 3. Creating an environment are a powerful tool for preventing firm conducive to exit failure from having systemic repercus- sions. India has made excellent progress As argued above, the foundation of through the establishment of the Na- competition policy is a ceaseless process of tional Securities Clearing Corporation creative destruction, where every year, some () and the Clearing Corporation financial firms fail and exit from the business, of India (). The scope of these in- while new financial firms enter into the stitutions, and the competitive market business every year. This ceaseless churning structure of the clearing corporation appears messy since newspaper headlines business, need to be steadily extended. dwell on firm failure. However, it is the . A host of sophisticated finance activities only way to achieve a globally competitive can be encouraged under firms organ- financial sector. ised like hedge funds, where customers This requires a corresponding paradigm are restricted to sophisticated investors. shift on the attitude towards both entry and Once this is done, the death of such firms exit. Financial regulators in India today imposes no political problems upon the are often fearful of exit. The death of a government. financial firm is seen as a failure of the financial governance regime. This attitude needs to shift towards an approach where 4. Retail vs. wholesale markets the death of financial firms is seen as proof Financial regulators around the world are that a properly competitive environment is concerned about investor protection of actually in place. “small households”. Ordinary households There is ample international experience lack the specialised financial knowledge or on how a sound approach towards exit can incentive to understand complex financial be constructed. It comprises the following products that might be mis-sold or embed key elements: dubious practices encoded in fine print. If the regulator does not protect the interests . Regulatory concerns about the failure of ordinary households, then the flow of of financial firms are focused only savings from millions of households into on banking, insurance and defined modern finance will not take place. This benefit pensions. In these areas, a legitimate concern induces regulators to framework of deposit insurance – with be particularly cautious before permitting . Reforming financial regime governance 151
products to be sold to retail investors. This, investors will shift to hedge funds. The in turn, induces a bias toward caution and economy would then benefit from a low cost conservatism and slows down innovation. organisation of money management and This problem has traditionally been from increased competition. seen as a difficult trade-off faced by Hedge funds are appealing when it the regulator. On one hand, financial comes to exit in the event of failure. innovation produces superior products for If a money manager such as a mutual end-consumers. Yet, along the way, new fund has a large number of small retail products need to be screened carefully by customers, then the government inevitably the authorities to avoid episodes where gets involved in the resolution of failure. households are defrauded and bolster In contrast, hedge funds will have only public confidence in modern finance. a small number of wealthy customers. One way of dealing with this issue, and That makes it politically feasible for the fostering innovation without sacrificing the government to watch impassively when a protection of small investors, is to cultivate hedge fund fails. The hedge fund manager a separate policy stance for sophisticated goes out of business and a few rich customers ‘wholesale’ players in the financial markets get hurt. Government is not obliged to who do not have the same knowledge deficits intervene on their behalf and no issue of as retail investors and do not need the same public interest policy arises. Under such degree of protection. In India, a threshold a framework – that distinguishes between of Rs. crore (or Rs. million) might the capabilities and interests of wholesale be appropriate in defining a ‘wholesale’ vs. retail investors – the principle of transaction. Once this is done, in a broad caveat emptor applies to the former and range of settings, the stance of regulators strong regulatory safeguards protect the should be to permit a free flow of innovation. latter permitting financial markets to be The best example of this approach is the regulated in a manner that encourages hedge fund. Mutual funds are specifically aggressive competition, with free entry and designed for retail investors and they are exit of different kinds of financial firms regulated and supervised intensively. This while protecting those that need protection. level of scrutiny imposes costs of compliance Another well-known recent example where and opportunity cost of trading strategies ‘wholesale-retail’ differentiation has been which are prohibited by the government. successfully applied is in the exchange The hedge fund is the unregulated alternative industry in the . There the to the mutual fund. But it can be restricted has eased the entry criteria and softened to deal only with customers who put considerably the regulatory regime for up more than Rs. million of assets for exchanges in which only large financial money management. The argument is firms, and not small individual investors that any customer who has more than or ordinary households, are permitted Rs. million of assets under management to participate. This two-track approach with a hedge fund has the knowledge and makes entry possible for a range of internet- capability to understand what the hedge oriented start-ups which compete against fund manager is doing before investing in it. the established exchanges, without needing The government does not need to protect to incur all the costs and particularly the such a customer. Once such a separation is regulatory burdens associated with the created between mutual funds and hedge established exchanges. funds, there will be healthy competition A fast-paced, globally competitive in the capital market. Large investors will financial sector, in which rapid innovation have a choice between mutual funds and occurs, can be a useful laboratory where hedge funds. If the benefits of regulation new products and services can be quickly outweigh the costs, then large investors will tested in wholesale markets restricted to continue to patronise mutual funds. If the transaction sizes of at least Rs. million. costs of regulation of mutual funds are larger Successful ideas from such tests can later than the consequent benefits, then large be approved for the retail market by the 152 R M I F C
regulator. From an perspective, almost trading. With interest-rate derivatives, while all transactions are likely to be bigger exchange-traded interest rate derivatives are than Rs. million. Hence, a rapid pace of enormous worldwide, they continue to be innovation in wholesale markets is quite smaller than their OTC counterparts. consistent with a focus on export of . But Despite these international empirical this approach has an important downside, regularities, the following seven factors in the context of organised arms-length suggest a greater role for exchange-traded financial markets, where secondary market derivatives in an Indian IFC: liquidity is formed by pooling millions of . The present OTC market in India orders, small and large. The fragmentation largely trades plain vanilla products. of liquidity between segregated retail and For trading plain vanilla products, the wholesale markets would reduce liquidity. exchange traded environment induces India’s key strength – i.e., its vast transparency and liquidity at no cost retail market – will not be able to play in flexibility. Indian currency forward in areas where retail participation is trading is already halfway to the prevented. Hence, while this wholesale exchange-traded framework, with the versus retail approach has merit in some Clearing Corporation of India Ltd areas such as money management, there () performing the services of a is a need of caution when it comes to the central counterparty. The only further securities markets, where unification of step required in shifting from a forward all orders into a single order book yields market to a futures market is the maximum liquidity and thus international introduction of transparent trading at competitiveness. an exchange venue. . Even though the global currency futures 5. The role of exchange-traded market is small when compared with vs. OTC derivatives in the the global currency forward market, BCD nexus recent research has shown that it plays a disproportionate role in price discovery. Derivatives can be traded on an exchange Rosenberg and Traub () find that or bilaterally negotiated on the ‘over the the currency futures market might counter’ (OTC) market. Trading on contribute as much as % of the price exchange requires standardised ‘plain vanilla’ discovery. This reflects the role of products, is anonymous, utilises a clearing transparency in price formation. Traders corporation to eliminate credit risk, and is who might place orders on the opaque fully transparent. The trading computer OTC market find it advantageous to ensures that each buy order is matched constantly watch the transparent futures with the lowest priced sell order. OTC market. A transparent trading venue trading permits unlimited flexibility in the seems to matter disproportionately for contract, lacks anonymity, generally involves overall price discovery, even if the counterparty credit risk, and is generally turnover at this public marketplace is non-transparent. There is never a certainty relatively small. that one privately negotiated purchase was Similar evidence for the role of contracted at the best price available on the exchange-traded futures on the interest non-transparent market. rate market is found in Mizrach and Currency futures were the first situation Neely () who estimate that over % where the idea of the exchange-traded of the price discovery on the US long futures market was applied to a financial bond market takes place in the exchange- underlying. For many years, currency traded product in the period after . futures were not particularly successful . Exchange-traded derivatives have be- when compared with OTC currency come particularly important in the new forwards which dovetailed well with the world of algorithmic trading and in- primarily inter-bank character of currency ternet trading, both of which dovetail . Reforming financial regime governance 153
better with electronic exchange-traded As an example, it appears more feasible products. The new order flow that is cre- to attract users of currency futures and ated owing to these two channels tends currency forwards trading all over the to be concentrated on exchange-traded world to send orders electronically into products. an order-matching system operating in . In an environment where India’s Mumbai, rather than seeking to obtain regulatory and supervisory capacity in market share in the global OTC market. the derivatives market is still nascent but . Exchange-traded derivatives fit well evolving, exchange-traded markets pose with non-institutional customers, who a simpler problem with full transparency, are not able to access the telephone with standardised contracts being traded, networks through which OTC trading and where credit risk is removed by the takes place. This issue is not unique clearing corporation. In comparison, to India: e.g. in Japan, individuals sound regulation and supervision of have come to play a substantial role in more opaque OTC markets makes currency trading in recent years, through greater demands upon regulation and the currency futures market. Given governance. the importance of non-institutional In particular, public sector financial players in Indian finance, an emphasis firms are vulnerable to questions on exchange-traded derivatives will help about lowest-price procurement when in harnessing their participation and a transaction takes place on an thus liquidity. OTC market. In contrast, when a computer does order-matching, lowest- . Finally, exchange-traded derivatives price execution is guaranteed. As long trading plays to India’s strengths in as public sector financial firms are running exchange institutions. NSE, important in India, an emphasis on BSE, NSCC, CCIL are a strong set exchange-traded derivatives will elicit of institutions, and can compete in greater participation. the global market for exchange-traded . Apart from filling a major gap in derivatives. the structure of its financial system, Some of these seven issues are unique another key reason for building a BCD to India. However, some of these issues nexus in India is to enter the export are presently at work in reshaping the market for IFS: i.e. attract global order international derivatives market. As flow into: (a) the INR yield curve; a consequence, currency futures have (b) trades in contracts of the INR vs. experienced considerable growth. BIS data other global currencies; and (c) credit shows currency futures turnover has grown risk management products trading in from $. trillion in Q to $ trillion in India. The clubby world of the global Q . forward market – where counterparties India needs both exchange-traded know each other, face credit risk from derivatives and OTC derivatives. However, each other, and have conversations on these arguments suggest that particularly telephone – will be more difficult for in the early years, a special focus should be India to break into, given that these placed on obtaining world-class liquidity on human relationships are well established the exchange platform. This is where India’s at the three established GFCs and other IFS export opportunity lies, and this is the IFCs like Tokyo, Frankfurt and Paris. It is more feasible for India to compete ‘raw material’ using which OTC derivatives in the world market for order flow are made. The right sequencing is to first into exchange-traded derivatives. This have a liquid electronic trading screen, after is a more meritocratic market, where which an OTC market can spring up based transaction charges and impact cost On the subject of individuals in the Japanese are all that matters; being plugged into currency futures market, see http://tinyurl.com/ certain human networks matters less. ycgbm2 on the web. 154 R M I F C
on utilisation of the prices and liquidity regulator. The difficulties confronted by the produced on this screen. Indian legal system in tackling sophisticated are well known. The system lacks 6. Regulatory impact specialised domain knowledge. Legal assessments processes are drawn out over excessively elongated periods of time. Recent reports In the foreseeable future, India could indicate that over million cases are be headed for a four-way separation of currently pending resolution in India. financial regulation, with separate agencies From an perspective, the most performing regulatory and supervisory useful strategy may be the creation of functions for Banking, Securities, Insurance, specialised courts that combine (a) highly and Pensions. The merits of a larger all- experienced arbitrators equipped with inclusive unification – such as emulating specific domain knowledge, and the - – can be debated ad nauseam (b) streamlined workflow leading to minimal in the Indian context. The would delays. Extending the scope of the present prefer not to trigger or indulge in that debate Securities Appellate Tribunal () might as it diverts from its main concern – i.e., be a useful way of addressing these concerns. that of establishing a successful in already has judicial capacity with Mumbai as swiftly as possible. Regardless of specialised domain knowledge in securities whether -style unification is attempted markets. It processes cases with obvious or another form of regulatory architecture is applied, an in Mumbai will still efficiency at an impressive pace. Going require world-class financial regulation and beyond , there is a possibility of supervision (in terms of policy, approach, utilising for processing appeals against attitude and practice) in either case. and also. One tool for improving the quality of Applying the same logic, ’s scope regulatory agencies is a periodic process and remit could be extended to covering of “Regulatory Impact Assessments” (). as well with adding an These are now commonplace in Appeals Tribunal () to its extant countries. Each is essentially a cost- role. could have its remit expanded benefit analysis carried out independently to deal with appeals not just for capital every – years to review regulatory markets transactions but cover banking, architecture and implementation. The term securities, insurance and pensions as well. ‘architecture’ describes the boundaries of A larger role for arbitration would help the agency, its legal foundations, and its strengthen the legal system. Arbitration mandate, while the term ‘implementation’ is a key mechanism through which faster refers to how the agency translates these and superior contract enforcement can be goals and conceptual framework into achieved between private agents who have successful, globally competitive regulation disputes about private contracts. and supervision. Each needs From the viewpoint of a global periodically to compare Mumbai against participant utilising Indian financial services, peer s, and examine how architecture legal risk induces a risk premium; it reduces and implementation can be evolved so as to the competitiveness of India as a venue improve India’s ability to produce for for production. Effective arbitration the global market. procedures give private agents a way to bypass the constraints of the courts. The 7. Strengthening the legal Indian Arbitration and Conciliation Act was system supporting an IFC passed in , with the intent of enabling The legal system comprises legislature, laws, The ideas and facts here greatly draws upon courts and judges. In a finance setting “What next for Indian arbitration?” by A. Ray and D. Sabharwal, of the International Arbitration Practice with independent regulators, an appeals Group at White & Case, London, which appeared in mechanism is required for all actions of the Economic Times, August . . Reforming financial regime governance 155
and strengthening this channel. However, stantial question of law”. Although this new two decisions of the Supreme Court have ground for challenge is narrower in defini- dealt severe blows to the Act: () the tion than the Saw Pipes ruling, it still affords Oil & Natural Gas Corporation v Saw Pipes losing parties an opportunity to approach () [] and () & Co. v the courts in an attempt to second-guess Patel Engineering () . arbitral tribunals. This could lead to a po- As a response to these problems, the sition not dissimilar to that under the Arbitration and Conciliation (Amendment) Act and complete a full circle for Indian arbi- Bill, , currently pending before Parlia- tration. The problems of Patel Engineering ment, proposes to introduce a new section case prima facie, do not appear to have been that would allow an award to be set aside addressed in this Bill. “where there is an error apparent on the face The last (but not least) component of the arbitration award giving rise to a sub- of the legal system is lawyers. At present, there are some significant weaknesses in the The Act was designed primarily to implement development of legal skills by the present the Model Law on International Commercial Arbitration and create a pro-arbitration Indian education system, particularly when legal regime in India. Prior to its enactment, there it comes to the legal aspects of sophisticated was widespread discontent over the excessive judicial finance. The internationalisation of Indian intervention allowed by its predecessor, the finance will induce new kinds of pressures Act. The Act attempted to rectify this problem by narrowing the basis on which awards could be upon the legal fraternity. On one hand, legal challenged, thereby minimising the supervisory role skills will be demanded in global finance that of courts, ensuring finality of arbitral awards and go well beyond the skills developed in dealing expediting the arbitration process. with Indian financial law. In addition, many Saw Pipes addressed a challenge to an Indian arbitral award on the ground that it was “in conflict global financial firms might feel comfortable with the public policy of India”. Despite precedents utilising the services of the same global law suggesting that “public policy” be interpreted in a firms they use in other s when doing restrictive manner and that a breach of “public policy” certain transactions out of India. This is involves something more than a mere violation of Indian law, the Court interpreted public policy in perhaps analogous to FIIs favouring foreign the broadest terms possible. The Court held that brokerage firms when operating in India. any arbitral award which violates Indian statutory This suggests that India needs to open provisions is “patently illegal” and contrary to “public up on the issue of foreign law firms policy”. By equating “patent illegality” to an “error of law”,the Court effectively paved the way for losing operating in India. Such measures will help parties in the arbitral process to have their day in Indian simultaneously in three directions. It will courts on the basis of any alleged contraventions of improve the legal knowledge available in Indian law, thereby resurrecting the potentially limitless judicial review which the Act was designed to the country, particularly on the interfaces eliminate. between finance and law. It will help In Patel Engineering, the Supreme Court global financial firms feel comfortable with subsequently sanctioned further court intervention operating in Mumbai, since they would find in the arbitral process. The case concerned the appointment of an arbitrator by the Chief Justice in familiar global legal firms. It would have circumstances where the parties’ chosen method for the same impact on improving the skills, constituting the tribunal had failed. The Court held technology and competitiveness of the Indian that the Chief Justice , while discharging this function, legal services industry that permitting is entitled to adjudicate on contentious preliminary issues such as the existence of a valid arbitration in manufacturing had on Indian industrial agreement and is entitled to call for evidence to resolve firms. jurisdictional issues. Significantly, the Court ruled that Developments along these lines are the Chief Justice’s findings on these preliminary issues already taking place. On th October, , would be final and binding on the arbitral tribunal, making a mockery of the well-established principle the Minister for Commerce and Industry said of Kompetenz-Kompetenz – the power of an arbitral that a panel of lawyers had been constituted tribunal to determine its own jurisdiction – enshrined under the -India Joint Economic and in section of the Act. This encourages parties Trade Committee ( ) to work with to sabotage the appointment process of arbitrators, make spurious arguments about preliminary issues a similar group in the to deliberate on and use evidentiary hearings in courts to delay arbitral opening up the legal services sector. proceedings.
Tax policy for an IFC in Mumbai
1. Does India need an IFC or a Moreover, the current global climate Tax Haven? (especially in countries but also in countries like India) is opposed to Creating an in Mumbai – that offers ‘tax competition’ or, more euphemistically, c h a p t e r as competitively and efficiently as other ‘harmful tax practices’. In particular, established s– will induce lobbying the disfavours ‘dual tax regimes’ pressure on the authorities, from service offered by small countries to create tax- providers as well as global investors, to arbitrage to the detriment of its member provide zero or near-zero taxation of the 12 IFS offered. Such pressures are based on countries. They object to a non- three arguments: (a) the desirability of country applying a ‘normal’ tax regime to creating a tax haven explicitly in order to its own citizens/residents, while offering attract a greater proportion of global IFS non-residents a low-tax or no-tax-regime flows for servicing through India; (b) the o should recognise, however, that this is a ‘obvious’ need for providing temporary fiscal self-serving characterisation, contrived to permit subsidies aimed at kick-starting a desirable governments of rich (but uncompetitive) export services industry using infant countries to maintain egregiously high tax regimes that industry arguments; or, more legitimately, support wasteful public expenditure. Such tax-spend policies enable too large an intermediation role to be (c) achieving greater competitiveness with played by these governments (particularly in Europe) other established and emergent/aspirant in transferring – opaquely and unaccountably – real s. income from one part of the middle-class (e.g. the healthy, young working adults, or the childless) to In that connection, proponents for another (families with children, those on the dole, those total tax-exemption of an to encourage who smoke/drink excessively, retirees who have not exports – or for exemption of at least saved enough) – in so-called ‘public service’ domains some products and services – often that are more efficiently served by private markets. Public revenues (and expenditures) in many north point to the success of the Indian European countries now pre-empt over –% of export services industry since . They . They finance unsustainable, failing public health, argue that explosive growth in export education and welfare systems. These nations are becoming uncompetitive and losing jobs – indeed services occurred at least in part because of entire industries – to poorer (therefore lower-cost, more (a) benign Government neglect, resulting in competitive) countries like China (in manufacturing) few opportunities for interference and petty and India (in services and manufacturing as well). rent seeking; and (b) initially favourable Under domestic political pressure, governments (particularly in Europe) are now engaging in a cartelised tax treatment – which, of course, the IT form of ‘protectionism’ to insulate themselves from industry (along with others) is attempting competition by developing countries that have lower to perpetuate through devices like s. public revenues and expenditures of the region of % In the view of the – which is in of in order to encourage savings, investment, growth, markets and competitiveness. Yet the new favour of global competitiveness – these accession countries to the EU have been introducing low pressures have no legitimacy in an effort to flat tax regimes that are proving simpler, more attractive create an in Mumbai. They should be and more efficient. Poorer countries must eventually attain levels of per capita income and standards of resisted at municipal, state and central levels. living now enjoyed in the world. In an efficient, A country like India does not need a tax equitable, open global economy, average per-capita haven. As has been argued before, India is incomes should converge gradually. If it takes tax not a small enclave or island economy, with competition to achieve that happy state, then that is how it should be. o should not accept the anti- limited options for economic diversification tax-competition argument as having any intellectual and growth. legitimacy. 158 R M I F C
at the same time. But the cannot attracting international financial business oppose or punish (via sanctions or black- (i.e., transfer pricing, tax management, and listing) an emirate like Dubai offering the avoidance of high tax in countries same uniform ‘low-tax’ or ‘no-tax’ regime by their residents). There are over to residents and non-residents alike. Doing such centres around the world (see Box so would violate a key tenet of international .) in landlocked principalities and micro- law: i.e., the sovereign right of countries countries such as Andorra, Botswana, to determine their own fiscal policies, as Monaco, Luxembourg, Lichtenstein, etc. long as they do not create discriminatory as well as in island economies in: the dual regimes aimed solely at tax-arbitrage, north Atlantic vicinity (the Channel Islands, or apply their tax policies in a way that Bermuda, Isle of Man); in the Caribbean affects adversely the fiscal rights of other (where there are over fifteen s, the countries. Besides, apart from issues created largest being The Bahamas, The Cayman by artificial tax-arbitrage, an emirate in the Islands, Barbados and the Netherlands Gulf may not need to levy any personal Antilles); as well as in the Indian Ocean income or corporate taxes, because of a (Seychelles, and Mauritius) and Pacific (e.g., surplus of public income derived from Vanuatu). sources such as oil/gas revenues or the sale s derive revenues from the legal, tax of land, or whatever. and accounting services offered to firms that In such a climate, creating a tax haven seek to tax-domicile, or book transactions, would be detrimental for an in Mumbai. in these jurisdictions to avail of near-zero Besides as an observer (and potential new tax rates. In the relative context of their member) of the Financial Action Task Force economies (e.g. Mauritius has a of (), the Indian government can hardly $ . billion or less than the sales of the countenance the creation of yet another Reliance Group) such limited revenues tax-haven . Doing so would trivialise can be quite large (>% of GNI). But such the two main arguments for having an a strategy is inappropriate for India. An in the first place – i.e., (i) to meet India’s in Mumbai should aim to achieve not (and Asia’s) legitimate and rapidly growing just the booking of transactions but IFS needs as one of the world’s largest the actual provision of the product/service emerging trading and investing economies; underlying them. India’s strength lies and (ii) to derive significant service export in its human and technological capacity revenues from , in which India has to provide tradable financial services and natural comparative/competitive advantages capture the value added on a significant for capturing significant global market scale by world standards; not just to the share. A tax haven would compromise the small extent of routine legal, tax, audit or functioning and credibility of an Indian accounting services offered in a tax haven. in the eyes of the world. That is another As an , Mumbai should therefore aspire reason why the Committee would advise to become like London or New York; a against locating an in Mumbai (or venue where large-scale production anywhere else in India) in a SEZ. and exports takes place for the global Also, experience suggests that infant market rather than being content as a mere industry arguments in India are dangerous. transactions-booking centre and artificial Prior to , over-susceptibility to that company registry. argument resulted in India nurturing - Many financial transactions in a success- year old infants in all its industries other ful , such as bond issues, securitisation than IT. products and derivatives contracts, involve Many offshore financial centres in small embarking on a contractual structure with landlocked and island countries chose to consequent cash-flows taking place as per become tax havens – for multinational contract for the coming or even years. corporations as well as wealthy private In order to give the private sector confi- individuals and trusts – to create a tax dence in undertaking such transactions, In- arbitrage advantage for themselves in dia needs to establish a sound tax framework . Tax policy for an IFC in Mumbai 159
Box 12.1: Countries, Territories, and Jurisdictions with Offshore Financial Centres
Africa Asia and Pacific Europe Middle East Western Hemisphere
Djibouti Cook Islands (FSF) Andorra (FSF) Bahrain (J)(OG)(FSF) Anguilla (FSF) Liberia (J) Guam Campione Israel Antigua (FSF) Mauritius (OG)(FSF) Hong Kong, SAR (J)(OG)(FSF) Cyprus (OG)(FSF) Lebanon (J)(OG)(FSF) Aruba (J)(OG)(FSF) 1 Seychelles (FSF) Japan Dublin, Ireland (FSF) Bahamas (J)(OG)(FSF) Tangier Labuan, Malaysia (FSF) Gibraltar (OG)(FSF) Barbados (J)(OG)(FSF) Macao, SAR (FSF) Guernsey (OG)(FSF) Belize (FSF) Marianas Isle of Man (OG)(FSF) Bermuda (J)(OG)(FSF) Marshall Islands (FSF) Jersey (OG)(FSF) British Virgin Islands (FSF) Micronesia Liechtenstein (FSF) Cayman Islands (J)(OG)(FSF) Nauru (FSF) London, UK Costa Rica (FSF) Niue (FSF) Luxembourg (FSF) Dominica Philippines Madeira Grenada 2 Singapore (J)(OG)(FSF) Malta (OG)(FSF) Montserrat Tahiti Monaco (FSF) Netherlands Antilles (J)(OG)(FSF) 3 Thailand Netherlands Panama (J)(OG)(FSF) Vanuatu (J)(OG)(FSF) Switzerland (FSF) Puerto Rico Western Samoa (FSF) St. Kitts and Nevis (FSF) St. Lucia (FSF) St. Vincent and Grenadines (FSF) Turks and Caicos Islands (FSF) United States4 Uruguay 5 West Indies (UK)(J)
Source: Based on Errico and Musalem (1999), IMF Working Paper WP/99/5 (unless otherwise indicated).
Legenda: (J) = Joint BIS-IMF-OECD-World Bank Statistics on External Debt. (OG) = Offshore Group of Banking Supervisors. (FSF) = Financial Stability Forum’s Working Group on Offshore Financial Centers (Press Release of May 26, 2000). 1 Japanese Offshore Market (JOM). 2 Asian Currency Units (ACUs). 3 Bangkok International Banking Facilities (BIBFs). 4 US International Banking Facilities (IBFs). 5Includes Virgin Islands, Anguilla, and Monserrat.
which will be sustained in the long term. An same quality, but provided at lower cost, artificial ‘infant industry’ argument based with greater efficiency, and better customer on tax breaks is not credible in the eyes of service) even if they might prefer – for the private sector, for it is clear that once the global tax management reasons – to book takes hold, the tax code will be changed. transactions in tax havens around the world. This very uncertainty about future tax treat- There are deeper problems with an ment will serve to deter transactions from ‘industrial policy’ of government supporting taking place in Mumbai. the financial industry or IFS via tax Through the proliferation of incentives. If the government ‘encourages’ technologies, it is now increasingly feasible financial firms through lower tax rates, this to decouple the booking of an IFS would implicitly constitute a subsidy from transaction from where it is produced. the general taxpayer to shareholders and Tax domiciles can be far removed from workers in financial firms. Such a fiscal locations where real value is added. subsidy for an is neither necessary nor To the extent that this takes place, India justifiable. More importantly, if financial will not be disadvantaged by having a firms in a Mumbai-based were provided rational taxation regime governing its . with a tax advantage over firms undertaking Global customers will still buy genuine other types of activity, that would encourage from India (providing those are of the less competitive firms (i.e., smaller, weaker 160 R M I F C
and insufficiently capitalised) to provide from different sources (e.g., whether trading, . It would also provide an incentive for dividends, interest, rent, wages, partnership other types of services firms to camouflage profits, or salaries). themselves as financial firms. An ecosystem with financial firms propped up by tax 2. Tax policy for Mumbai as an incentives and exemptions is not one that IFC: and, by implication, for would be populated by the most capable, India efficient and innovative financial firms nor would it necessarily attract global financial By and large, the endorses fully, firms to locate in such a . and urges swift implementation of all But, it should be emphasised that the recommendations contained in the the argument against tax exemptions, or Kelkar Committee Report (i.e., Report of any form of preferential tax treatment the Task Force on Implementation of the Fiscal in an , is not the same as making Responsibility and Budget Management Act, an argument for having a regime of ) that was issued in June . The kind generally high, complex and harmful taxes of tax regime suggested by the Kelkar Report – that provide disincentives for effort, should be applicable to the financial system transparency, volunteerism and honesty in (domestic and ) as a whole – one that provides incentives for increased output, tax payments – being applied to the high value-addition, and efficiency rather either. What would be best for an Indian than for tax breaks. – as well as for the rest of industrial, It would also be the desired strategy commercial and financial India – is a to apply to an while keeping in mind general regime of uniformly low marginal the need for flexibility to make adjustments tax rates, applied universally across the for certain types of in keeping with board in every sector of economic activity international norms. Such flexibility would without any exception (including agriculture be desirable to ensure that an in and agricultural finance) with as few tax Mumbai remained competitive with s incentives, exceptions and exemptions as elsewhere. With clearer tax policies, a possible. The tax regime should be simpler tax regime, and consensus that such simple, and structured so as to be as non- a regime would the most appropriate for the discriminatory and non-distortionary as financial sector and for exports, three possible; i.e., across different activities, and key principles come to the fore: in the tax-treatment of income derived . The need for applying a modern, low but In that connection it needs to be observed that universally applicable income tax regime inadequate prior analysis, and confused policy support across all sectors and activities, and a (lacking full public consensus), has resulted in far too modern low to avoid the prospect many disparate, variably-sized s being approved by central and state governments, in too many fragmented of smuggling and cash transactions locations. That has compromised the tax principle compromising collections. being enunciated here at the outset. It has also created opportunities for distortions to arise in piecemeal, . Confining taxation to resident income imbalanced investment in infrastructure around the and consumption while exempting non- country. That reduces the prospect of economies residents from all direct taxes (regardless of scale from being exploited; e.g. by fragmenting of whether or not India has s power generation across s rather than having generation being determined by the needs of a particular with their home countries). This contiguous area or geographic region. Moreover, it does not mean exempting non-residents appears that many approved s now incorporate from indirect taxes on consumption sub-projects for speculative real estate development of goods/services in the country. It for residential and commercial purposes (as opposed to dedicated manufacturing or service industry use). does mean creating a special tax These entirely unnecessary add-ons could compromise regime specifically for non-residents the financial portfolios of major financial firms lending under which they could arbitrage tax to s and to firms locating in them. That harm liabilities against their own tax regimes. should not be exacerbated by extending similar tax benefits to an . . Removal of all bad taxes: i.e., those that . Tax policy for an IFC in Mumbai 161
lead to incentives for evasion, those that government at several levels should not be cost more to collect than yield, those that a reason to create and sustain (through in- are discriminatory and distortionary, ertia) a plethora of cascading and distort- and those that create friction in the ing taxes (such as stamp duties and octroi, production of goods and services (i.e., which are a barrier to intra-country trade eliminate all transaction taxes such and movement of goods) with negative ef- as stamp duties and transfer taxes on fects on output, efficiency and intra-country capital assets, particularly in financial as well as international trade in goods and transactions). As proposed in the Kelkar services. Task Force report, this needs In sum: the first issue to be emphasised to be done as part of the reform. in the context of a fiscal regime that would The simultaneous removal of all bad support India having an – but one taxes plus the introduction of the that has wider resonance and applicability is fiscally neutral while enhancing both – is that the most immediate objective and tax buoyancy. in tax policy has to be to move rapidly For an in India to be credible, tax- towards a modern income tax and a modern wise, to residents and non-residents alike, it for universal applicability in India is essential that the features, structures, rates (and applied uniformly above practical and quantum of taxation in India should be thresholds). The second principle governing consistent with: desired tax strategy is that no government should attempt to ‘export taxes’ or try to (a) Optimising (not maximising) public rev- achieve extra-territoriality in the imposition enue in line with the minimal financing of its tax regime. The incidence of a of essential public goods/services – using should fall on domestic consumption only. a minimalist approach to defining what With a well-designed , imports are these should be and who should benefit charged , and exports are zero-rated, from them so that foreign customers of Indian goods (b) Emphasising rapid output and high and services do not pay to the Indian value-added growth over any other government. The third principle is that bad objective over the next years taxes (no matter how politically attractive) (c) Avoiding tax distortions, tax discrimi- lead to a weak, dysfunctional economy. nation, tax exemptions and preferences They compromise fairness, growth and altogether and adhering to the notion of equity. universality Once a framework of sound and low (d) Incentivising tax-payment ‘volunteerism’ income taxes and is created, the maze rather than inducing tax avoidance of distortionary taxes and exemptions that and/or evasion by making it less India has inherited from previous decades expensive for taxpayers to comply needs to be removed. In particular, turnover instead of avoiding compliance; and taxes matter greatly for export of ; their (e) Cost-effectiveness: i.e., taxes should not removal is directly material to the effort of be levied that are more expensive to India emerging as an . collect at the margin than the amount of revenue they yield regardless of equity 3. A modern income tax or social engineering concerns. At the level of broad principle, India In achieving these objectives the ques- should seek to roughly match the income tion should be asked whether India’s multi- tax treatment of a modern such as layered political/administrative structures, Singapore, while avoiding the zero-tax at multiple levels of governance, and its tra- approach of a city like Dubai. It should ditional political/administrative practices, avoid attempting to have a dual tax regime do not result in too many taxes being levied for residents and non-residents specifically by too many different authorities at higher to attract business. than necessary rates. The need to finance 162 R M I F C
3.1. What should the capital gains tax Kelkar Report. These concern () tax be? treatment of savings, () taxation of An important debate now taking place asset management, () definitions and in India that has considerable relevance tax treatment of ‘speculative’ transactions for finance and concerns the capital and () the tax treatment of zero coupon gains tax. Modern macroeconomic and bonds. The basic approach of the public finance theories shed much light Implementation Task Force on these issues on the optimal conduct of monetary and is entirely consistent with the goal of making fiscal policies. A robust result of the Mumbai an Indian . research literature suggests the need for From an perspective, the primary low taxes on capital income (Chari and priority is to bring about a liquid and Kehoe, ; McCaffery, ). One of the efficient bond market with an arbitrage-free foundation blocks of economic reasoning yield curve. Administered interest rates, suggests that the goal of a sound fiscal system and tax exemption provisions for particular (especially in a developing country) should financial products, militate against this rely on taxing consumption not savings. goal. exports are unlikely to materialise This can be achieved by taxation with from India in the absence of its asset/fund large permissible annual savings per person. management industry operating in the same Under such a scheme, individuals should be way and being governed by the same policy encouraged to save, with income and capital regime as its global counterparts in other gains being exempt from taxation, until they mature financial markets. That requires chose to consume. achieving ‘neutrality’ as an essential feature Thus, the path to a sound consumption between ‘in-sourcing’ and ‘outsourcing’ of tax lies in low or zero tax rates applied to asset/fund management where three cases capital income. Such an approach dovetails can be distinguished: well with the export of . Low or zero . A firm or a person manages funds/assets tax rates applied to capital gains would put . Funds are given to an AMC for asset India on par with many other countries that management on an agency basis have taken such a path. But, this approach needs to be applied symmetrically to both . A global further subcontracts to domestic and foreign investors without other national/sectoral s. creating officially sanctioned loopholes of Tax considerations should not encour- the kind that exist in Indian tax treaties age or discourage the way in which the asset allowing special tax treatment for investors management business is organised in terms in Mauritius, Cyprus and Singapore. Many of the extent of outsourcing that takes place. of these treaties will lose their potency in As an example, corporations should have diverting tax revenues almost automatically no tax-induced motivation to outsource with the removal of residual capital controls. treasury functions to mutual funds in an It may be better to take that approach in attempt to reduce their effective tax rates. dealing with the problems they appear to Furthermore, tax considerations should not create than to attempt renegotiating them generate artificial differences in the rela- clause-by-clause. This overall approach to tive attractiveness of alternative financial the taxation of finance would be consistent products, in the eyes of either providers with Indian exports of being rooted or consumers of those products. As an ex- in the Indian financial system, and not ample, an insurance company should not separated into an enclave. have to (or be allowed to) embellish an asset management product with a small actuarial 3.2. Mature issues in the Indian tax component, in order to obtain superior tax debate concerning finance and treatment when compared with the same IFS product being sold by a mutual fund or a There are four specific areas of tax policy private bank. Concessional tax treatment of that influence where the policy debate certain savings instruments is particularly in India is mature and articulated in the important insofar as it distorts price discov- . Tax policy for an IFC in Mumbai 163
ery for the yield curve. The adoption that are applicable to financial transactions: of a rational tax policy in these respects is • The securities transaction tax () inextricably bound to having an emerge applies to some kinds of securities: e.g., in India that is viable. equity spot and derivative transactions. • Registration duties/fees need to be 3.3. LLPs as tax-efficient paid for specific services provided by pass-throughs government in recording contract and In creating sophisticated financial products deeds. The government maintains or structures the need keeps recurring a registry of deeds in return for a for a ‘corporate or partnership’ structure fee. Government agents (called ‘sub- that supports tax-efficient transmission of registrars’) do not verify the legal validity cash-flows coupled with specific types of of documents; they focus only on the financial contracts. Internationally, such a payment of the correct fee. The payment structure is provided by the Limited Liability of the registration fee does not entitle Partnership (). Examples include: the payee to a guaranteed legal title. • A securitisation special purpose vehicle • Stamp duty is a tax on the value of in- () can be in the form of an . It struments used in various transactions. would be the placeholder for a certain contractual set of obligations through All three of these are cascading taxes; they which cash-flows would come into are comparable with excise taxes in the case the . These cash-flows would be of manufactured and traded goods. transmitted to the holders of securities issued by the . The itself 4.1. Taxation of transactions distorts would need to be a tax pass-through, the conduct of business while the cash-flows reach their eventual In the real economy, it is now a well accepted beneficial owners and get taxed in their principle that turnover is an inappropriate tax-domiciles. If double-taxation takes base for taxation. When transactions are place – if the cash-flow gets taxed once taxed, this leads to a cascading impact. The at the and again in the tax domicile incidence of such taxes falls to a greater of the owner of the security – then extent upon processes that involve several securitisation cannot take place. stages of production. Transaction taxes encourage vertical integration i.e., they • ‘Hedge funds’ are invariably structured encourage transactions to occur within the as . The lack of an structure firm (rather than between independent in India hinders the development of firms) so as to incur lower taxes. This runs hedge funds as an institutional investing contrary to a key feature of a mature market mechanism although these funds are economy, where firms are specialised to now the mainstays of other s. In dis- focus on core competencies, and where allowing them, India is doing enormous transactions take place between firms. damage to itself. Transaction taxes give firms a bias in favour Some development work towards getting of some production mechanisms over others: structures legitimised in India has been these biases distort the organisation of taking place, but it is more focused on the production and firms. needs of professional services firms such as The identical issues apply in the lawyers or accountants. Such development taxation of financial transactions. A financial needs to take into account the needs of the firm can be thought of as buying raw as a key building block of sophisticated materials (securities or money on its assets financial structures. side) in order to produce finished goods (securities on its liabilities side). The 4. Taxation of financial activities of a typical financial firm consist transactions of a set of transactions that transform risk At present, there are three main kinds of and return in a variety of ways to meet the transactions (i.e., turnover) taxes in India needs of different customers. In finance, 164 R M I F C
the trading strategy is analogous to process 4.2. Taxing transactions in a world of technology. Different technologies can be IFS utilised to produce the identical product. Thus, in a purely domestic economy, the In other words, a given set of risk/return taxation of turnover is inappropriate because characteristics can be produced through it violates every principle of sensible public different trading strategies. As an example, finance. But the problems it creates escalate if the goal is to produce a riskless asset with and multiply in the context of competing a maturity of days, the different ways in in global markets for . Taxes on which this can be done include: transactions force business to leave venues . Buy a zero-coupon government bond with effective high taxation (as well as high with a -day maturity tax rates) and migrate to venues with low . Buy a zero-coupon government bond taxation (and low rates). with an ‘n’-day maturity and rollover In the manufacturing world, the every ‘n’ days. principle that you cannot export taxes is now well-understood. This has led to the entire . Enter into cash-and-carry arbitrage on sophisticated framework of , where one of many futures products. exports are zero-rated, and imports are . Enter into put-call parity arbitrage charged . Under this framework, the positions using one of many options incidence of falls only on domestic products. consumption. The price of all goods ‘in . Run an options book, and lay off risk, transit’ is free of charged by any using delta-neutral hedging, dynamically country. All mature market economies modifying the hedge continuously so as have eliminated all turnover taxes on goods. to achieve zero risk. But, identical issues apply when it comes These are only five examples of to the global market for . It is not alternative technologies through which a possible for India to impose taxes upon riskless position with a -day maturity foreign customers of produced in India: can be obtained. Numerous other the attempt to do so will simply shift ‘technologies’ for achieving this outcome transactions away from India. This clearly can be designed, all of which combine implies arguing for the removal of all taxes underlying financial ‘raw materials’ through on transactions. different trading strategies. Under normal circumstances, traders would decide among 4.3. Removal of turnover taxes in these different routes on the basis of India commercial considerations. But, when The removal of the Securities Transaction turnover is taxed, the incidence of taxation Tax () will influence efficiency and falls disproportionately on ‘technologies’ export-competitiveness for in a way that require more trading; even though similar to the removal of cascading taxes they may be better options for investors in manufacturing. There will be an initial to exercise. As an example, there might be a loss of revenue; but this is inevitable with large degree of mispricing on the options the removal of bad taxes. As an example, market; but ‘delta-neutral hedging’ might be India steadily eliminated customs duties, unattractive because it involves perhaps which did hurt tax revenues. There was no times the trading volume when compared attempt at introducing any compensating with buying a treasury bill. If transactions changes in the tax code, one-for-one, which taxes applied, they would automatically tilt compensated for the removal of the bad tax. the investment decision toward sub-optimal Sometimes, it is felt that a trade-off purchase of a T-bill. A core principle of can be created between the taxation of public finance is that tax policy must not capital gains and the taxation of financial modify the choice of technology by a private market turnover. However, the unique economic agent. Transaction taxes distort historical features of India’s evolution on the choice of technology by financial firms. both questions should not obscure the need Therefore they are ‘bad taxes’. for rational tax policy on both questions. . Tax policy for an IFC in Mumbai 165
Box 12.2: Case Study on Swedish experience with transaction taxes, – The research literature suggests that with those involving equity options being seen over 30% of all trading volume in Swedish transaction taxes can have negative effects on as the least useful. Continuing pressure from equities. By 1990, that share increased to price discovery, volatility, liquidity, and lead to the Left compelled Parliament to double rates around 50%. Only 27% of the trading volume a reduction in the informational efficiency of in July 1986, and broaden its coverage in in Ericsson, the most actively traded Swedish markets (Habermeier and Kirilenko, 2003). 1987. Furthermore, following large losses in stock, took place in Stockholm in 1988. One fascinating experiment with the interest rate futures and options (most notably In the Swedish experience, revenues from introduction, and then the repeal, of a by the City of Stockholm, which lost SEK 450 the STT were poor for two reasons: shift in securities transaction tax took place from million), the tax was extended to transactions turnover to venues free of STT, and the decline October 1983 to December 1991 in Sweden in fixed-income securities, including in share prices associated with the tax and its (Umlauf, 1993; Campbell and Froot, 1995). government debt and the corresponding impact upon market liquidity. derivatives in 1989. The maximum tax rate for Left-wing political parties in Sweden Broadening the tax to fixed-income fixed-income instruments was set at 0.15% of believed that trading on financial markets was instruments resulted in a sharp drop in trading the underlying notional or cash amount. In an undesirable activity. It was argued that “the volume in Swedish government bills and bonds salaries earned by young finance professionals addition, the tax was designed to be and in fixed-income derivatives contracts. were unjustifiable in a society giving high yield-neutral, with longer maturity instruments During the first week of the tax, bond trading priority to income equality, especially given the being taxed at progressively higher rates. volume dropped by about 85% from its seemingly unproductive tasks that they The empirical experience with revenues average during the summer of 1987 and performed”. Despite the objections of the from STT was poor. When rates were doubled trading in fixed-income derivatives essentially Swedish Finance Ministry and the financial in July 1986, tax collections only went up by disappeared. This significantly undermined the industry, popular support led to the adoption 22%. Customers were avoiding the tax by ability of the Bank of Sweden to conduct of the STT by Parliament in October 1983, with shifting their order flow to London or New monetary policy, made government borrowing effect from January 1, 1984. The STT was York. The first thing which dried up was the more expensive, and eroded both popular and levied on domestic stock and derivative order flow from foreign investors. Domestic political support for the tax. Taxes on transactions. Purchases and sales of domestic investors avoided the STT by first establishing fixed-income instruments were abolished in equities were taxed at 0.5% each, resulting in offshore accounts (and paying the tax equal to April 1990. Taxes on other instruments were a 1% tax per round trip. Round-trip three times the round-trip tax on equity for cut in half in January 1991 and abolished transactions in stock options were taxed at funds moved offshore) and then using foreign altogether in December 1991. 2%. In addition, exercise of an option was brokers. The scale of avoidance was Following the abolition of the tax, some treated as a transaction in the underlying stock manifested by a massive migration of stock trading volume came back to Sweden. By and, thus, was subject to an additional one trading volume from Stockholm to other 1992, roughly 56% of trading in Swedish percent round-trip charge. financial centres. Following the doubling of equities took place in Sweden. Once lost to The tax coverage and rates were based on the tax, 60% of the traded volume of the 11 other centres such trading volume becomes populist notions about the usefulness of most actively traded Swedish stocks migrated extremely difficult for countries to bring back transactions in different financial instruments, to London. The migrated volume represented home.
Modern economic reasoning suggests that functions are comparable to those of a there is merit in having both zero taxation depository on the markets. Registration of turnover and low-to-zero taxation of fees can be interpreted as user charges capital income. Discussions about the for performing record keeping functions should not be undertaken as a trade-off with – which justifies small charges such as discussions about capital gains to achieve the per-transaction charge of . But ‘revenue neutrality’. That is a false trade-off. the imposition of indirect taxes through The removal of stamp duty is part of registration and stamp duties constitutes the Grand Bargain proposed by the Kelkar a case of erroneous tax policy. There is a Task Force. In exchange for tax revenues case for a user charge for operating and from all services, states should be willing to maintaining an system that maintains give up distortionary taxes like the stamp ownership records. There is no case for duty. In the case of real estate, the Kelkar transaction taxes. Task Force report proposes integrating the real estate sector into the GST, which further 5. A Goods and Services Tax enhances the case for elimination of stamp (GST) in Finance duty on real estate transactions. In the case of registration fees, there is The Kelkar Task Force report a role for the State in performing essential proposed the creation of a two-part asset registry functions, and enforcing named the Goods and Services Tax (). property rights associated with them. These What it envisages is a pair of taxes – levied by 166 R M I F C
Centre and States – that are harmonised in on transactions would ensure that there terms of tax policy and administration. The would, in all probability, be no trading incidence of falls on consumption in in/from Mumbai at all. Without stamp the domestic economy; foreign consumers duties and other forms of ‘local’ taxation to are not taxed. All parts of the economy – capture, state and city politicians may ask: including the financial sector – would be “What does Mumbai gain from having an covered by . This objective is consistent ?” The answer is that: with both modern economic reasoning • First, the two-part proposed (Auerbach and Gordon, ) and with involves a layer that consists of a the establishment of an in India. In consumption tax enforced at the State the context of debates about treatment of level. This would generate incremental domestic firms versus foreign firms, the revenues in proportion to the substantial comes down very clearly, seeking to have incremental consumption opportunities identical treatment of all firms. created by having an in Mumbai; i.e., From the viewpoint of Indian public as a consequence of having more global finance, the emergence of an in Mumbai financial firms locating in Mumbai to would generate tax revenues through: trade and employing a far greater (a) taxes on the income of individuals number of high-income people from working in the industry; (b) corporate Mumbai and abroad. income taxes applied to the firms operating That would create downstream in the ; and (c) the GST applied to opportunities for providing these value added by the industry when selling incoming high-income firms and people to local customers. Once these three with the usual range of incremental sources of tax revenue are in place, it goods and services (from homes, to cars, should become possible to simultaneously refrigerators, washing machines, food, remove all turnover taxes, including stamp clothing, household linen and durables, duty, registration duty and the securities domestic helpers, chauffeurs, peons, transaction tax (). clerical workers, secretaries, finance Applying the to financial services professionals and paraprofessionals is sound in principle. But the practical such as accountants, book-keepers, difficulties of achieving this outcome need auditors, compliance officers, as well to be better appreciated. The European as restaurants, laundries, bakeries, Union pioneered building an -scale clubs, cinemas, theatres, bookshops, on finance. Its experience has highlighted hairdressers, fuel, gas stations, etc. etc.) But it would also have incremental many areas of complex decision-making in costs: i.e., by generating new needs for tax policy and tax administration. India infrastructure (homes, office space, re- needs to approach the construction of a tail space, water, power, telecommunica- on finance as a multi-year process, to be tions, roads, sewerage, storm drainage, undertaken delicately and thoughtfully. parking, airlines, airports, trains etc.), for law and order, security, and for phys- 6. Mumbai as an IFC: Tax ical/social recreation. Such investment Implications for could be made through PPPs thus saving Maharashtra and Mumbai the state and the city from making the actual investment necessary in creating This chapter underlines the principle that such facilities. there is no role for taxation of transactions The additional demand created for on financial services – whether for or goods and services by an in Mumbai (domestic financial services). Hence, would generate a significant amount of neither Mumbai nor Maharashtra should additional revenue for the city and the expect a new revenue base emerging from state without having to resort either to large trading volumes of in Mumbai. In directly taxing transactions, or the fact turnover taxes (like stamp duties) levied profits of firms providing or trading . Tax policy for an IFC in Mumbai 167
in . To the extent that an in 7. Interfacing tax policy and Mumbai increases general consumption administration with the – of both goods and services – it would financial industry generate substantially increased tax revenues indirectly. The development of an in Mumbai But it would also demand better requires more vibrant interaction between standards of governance to be provided Department of Revenue, the and the (from policing to keeping public , with the financial services industry. lavatories spotless and deodorised) by This will be particularly necessary when both city administration and the State the greater complexity of provision government – governance that meets escalates the complexity of tax policy and tax international standards. That would administration. A better institutionalised pose a greater challenge; one that mechanism for interaction could yield should worry city/state (and central) a greater understanding of the ground government politicians and officials realities of finance. This could influence much more than the incremental tax policy, and practical problems of revenues emanating from an in implementation could get more rapidly Mumbai. sorted out. Hence, there is a case for the Department of Revenue, as the agency • To the extent that there are high responsible for tax policy, and the two productivity firms and individuals in implementation arms (the and Mumbai, this would support higher the ) to establish an Ombudsman property prices and thus a bigger function in Mumbai. Such an office revenue stream from property taxes; would facilitate engagement by the financial especially if the market for owned and services industry on one hand and the rented properties were to clear more efficiently in Mumbai than it presently tax authorities on the other. It would does. The same is true for taxes from enable issues of tax policy and consistency fuel consumption etc. of its administration to be institutionalised. There is also considerable scope for these The benefit for state and municipal agencies doing some hands-on learning exchequers from having an in Mumbai from cities like New York, London and would be the enormous additional impact on Singapore in understanding how they deal prosperity in Mumbai and its surrounding with the same issues without disrupting region. It would not be seen through operations. higher direct tax revenues. If there is any doubt about that then state and local 8. Stability of tax policy politicians/officials should see for themselves first hand, the large incremental indirect From the viewpoint of India’s aspirations to benefits being derived in New York, London have Mumbai become an , it is essential and Singapore by having an located to emphasise the importance of stability and there. If such benefits were ephemeral it is predictability of future tax policy. No firm certain that Dubai would not be pursuing – and financial firms least of all – likes to the establishment of an as aggressively deal with uncertainty in making investment and tenaciously – particular in inviting decisions and deciding where transactions Indian financial firms to operate from there. will be booked and operating cash-flows Mumbai would have to be prepared to registered. Global financial firms will require accommodate migrants not just from all some assurance about the rationality and over India but from the world who would stability of the Indian macro-policy regime be attracted by work opportunities in an (on tax, capital controls, exchange rates, . Slogans and policies perceived to be inflation, and monetary policy) in coming ‘anti foreigner’ or ‘anti expatriate’ would do years, in order to make decisions about immense damage to the prospects of making placing parts of their global operations Mumbai a viable IFC. in Mumbai. 168 R M I F C
Table 12.1: Comparing India against existing IFCs on taxation
Attributes, Characteristics and Capa- London New York Tokyo Singapore Frankfurt Mumbai bilities of an IFC: (Scale of 0–10 with 0 = worst; 10 = best)
N. Taxation Issues as they affect the attractiveness of an IFC N1. Taxation of Resident Individuals 5 4 3 5 2 5 working in the IFC N2. Taxation of Non-resident Individuals 7 5 5 6 3 6 working in an IFC N3. Taxation of Resident Companies 4 4 3 5 2 5 N4. Taxation of Non-resident companies 7 5 5 8 4 5 N5. Withholding Taxes levied on financial 4 3 3 5 3 5 instruments/transactions. N6. Transactions Taxes on Financial 6 7 4 7 4 1 Transactions – Domestic N7. Transactions Taxes on Financial 7 6 6 8 5 ? Transactions – IFS N8. Provisions for IBC or GBC licensing 6 8 2 8 2 0 (e.g., Delaware type) N9. Taxation of IBC/GBC companies 6 6 5 8 2 0 N10. Overall Taxation Environment 5 5 4 7 2 5 N11. Complexity of Tax Laws, Codes, 4 3 4 7 3 1 Rules, Regulations N12. Effectiveness, Efficiency, Fairness and 9 7 8 9 9 3 Corruption in Tax Administration
Table 12.2: Comparing India against emerging IFCs on taxation
Attributes, Characteristics and Capa- Mumbai Hong Kong Labuan Seoul Sydney Dubai bilities of an IFC: (Scale of 0–10 with 0 = worst; 10 = best)
N. Taxation Issues as they affect the attractiveness of an IFC N1. Taxation of Resident Individuals 5 8 5 4 4 10 working in the IFC N2. Taxation of Non-resident Individuals 6 10 10 7 7 10 working in an IFC N3. Taxation of Resident Companies 5 8 6 5 4 10 N4. Taxation of Non-resident companies 5 10 9 8 5 10 N5. Withholding Taxes levied on financial 5 10 9 5 5 10 instruments/transactions. N6. Transactions Taxes on Financial 1 10 5 5 2 10 Transactions – Domestic N7. Transactions Taxes on Financial ? 10 9 8 6 10 Transactions – IFS N8. Provisions for IBC or GBC licensing 0 9 9 5 3 10 (e.g., Delaware type) N9. Taxation of IBC/GBC companies 0 9 8 6 5 10 N10. Overall Taxation Environment 5 8 7 6 5 10 N11. Complexity of Tax Laws, Codes, 1 8 7 5 4 9 Rules, Regulations N12. Effectiveness, Efficiency, Fairness and 3 8 7 6 8 9 Corruption in Tax Administration
As an example, the creation of a as a potential will be enhanced by securitisation may involve cash-flows having both (a) rational tax policy and (b) a for the coming years or years. If framework that guarantees the stability of there is a risk of a major change in tax tax policy. policy in that period then there is a reduced In the last decade, India has seen incentive to setup the under Indian considerable changes in its tax regime, jurisdiction. The credibility of Mumbai reflecting fiscal reforms that have been more . Tax policy for an IFC in Mumbai 169
far-reaching than is generally appreciated. From the viewpoint of creating a viable Most of the changes made by the Centre have , the recommendation of the Committee been in the right direction. Unfortunately, would be that a more specialised committee some of the tax changes made by States, to of tax experts familiar with and the cope with their chronic fiscal incontinence, operations of global s should now be have been in the wrong direction. Few parts created to translate the ideas of this chapter of the Indian economy have experienced into detailed tax policies for specific as much progress as fiscal policy, with products and services, after which private sharp reductions in customs duties, shift agents should be encouraged to expect from turnover taxes to , reduction stability of tax policy for the deep future. of rate dispersion in indirect taxes, and lower income taxes. This paradigm shift in 9. Where India Stands on taxes: policy has been accompanied by far-reaching An international comparison improvements in tax administration through computerisation, particularly with income In a pair of tables, we show a subjective tax and customs. But this progress has comparison, where incumbent and emergent inevitably implied an environment of fast- s are rated on a scale from to changing tax policy. A particularly unhappy on twelve measures of the tax policy and set of events has taken place on the tax administration. When compared against treatment of dividends, where India has established s, the overall score of changed tax policy multiple times and Mumbai () matches that of London or New created sufficient uncertainty about the York. But it fares poorly when compared future as to cause serious concern among with Singapore () and Dubai (). global investors about policy stability.
A perspective on Mumbai’s strengths
In contemplating the creation of an in can take place with transacting coun- India, the metropolis of Mumbai, backed terparties from Tokyo to London i.e., by the human resources of India as a whole, covering all of Asia, the and every- has six manifestly visible strengths: where in between. While the Americas c h a p t e r are beyond daytime conversations with . Hinterland advantage: Mumbai is the Mumbai, the experience of services, financial and commercial capital of / and call centre industries has one of the largest and fastest-growing shown that this handicap can be over- countries in the world. India is already come. The same will be true of the 13 the world’s fourth largest economy in industry. There is no operating in terms after the , China and the Indian time-zone; resulting in a wide Japan. By it will be the fourth largest empty space ( time zones) between the in nominal terms. By it will be the clusters of s in the East (Tokyo, Hong third largest. India’s rapid growth has Kong, Singapore and Sydney) and the resulted in a phenomenal increase in West (London, Paris, Amsterdam, Frank- two-way cross-border financial flows furt and New York). Dubai, for instance, that are related to trade and investment. is using its location, straddling these Those flows are inducing high growth in time zones as a selling point for . demand. Mumbai is to India what But it does not have many of the advan- New York is to the (see Chapter ). tages that Mumbai has (human capital, . Human capital: India has high well-developed exchanges and trading quality, low cost human capital (at platforms, a large hinterland market, all skill/knowledge levels) with English support capability) while having some speaking ability for a world class advantages that Mumbai does not have: industry that can export successfully to i.e., excellent infrastructure, good urban the world. But such human capital is governance, political and administra- being absorbed at a rapid rate across tive drive, the makings of a global city all service industries, and specialised with expatriates from all over the world, knowledge in the frontiers of finance is and an ambition to succeed, with no weak. Much needs to be done by way domestic political economy constraints of education and training to expand holding it back. the human resource base in terms of its . Democracy and Rule-of-Law: Properly width and depth. These constraints are functioning financial markets require discussed later in this chapter. a basis for governance that is stable, . Location: In the -hour trading en- reliable, resilient and flexible; i.e., vironment of what is now an increas- one that reduces future political ingly integrated global financial mar- risks and uncertainty. While these ket (encompassing countries and are important strengths, they are embracing many significant emerging accompanied by equally important markets as well) a well placed location difficulties in governance of Mumbai that permits contact with participants and of India’s financial regime. These in this market during daylight can be a issues are discussed later in this chapter. significant strategic advantage. In work- . Mindshare: High growth, the ing hours, conversations from Mumbai phenomenon, and the remarkable 172 R M I F C
success of Indians in global finance all prominent role in the top global over the world, serve to ensure that India financial firms. They are well-positioned has significant ‘mindshare’ at senior to intermediate between the business decision-making levels of most global strategies of these vital firms and the financial firms. genuine strengths and weaknesses of . Strong securities markets and techno- India as an . logically advanced trading platforms: India has established a beach-head for The international image of India today providing global by virtue of its involves a ‘high-skill with high motivation dynamic, technologically capable securi- and high adaptability’ labour force for almost ties trading platforms in the and all service export industries. The attitude of . These are the rd and th biggest ambition and hard work is epitomised in a exchanges in the world measured by vol- statement of Shri Kamal Nath, the Indian ume of transactions. Minister of Commerce: “In India, a hour Three of these six factors constitute working week is considered part-time”. unambiguous strengths: hinterland Table . applies the same -to- advantage, location and mindshare. scoring scheme, utilised earlier in this report, The remaining three issues represent in making a cross-country comparison of strengths, but a nuanced analysis reveals human skills in various kinds of finance many important flaws. In the case of functions. Mumbai is compared against securities markets and trading platforms, established and emerging s. It shows these issues have been dealt with at that Mumbai has some strengths when length earlier in the report. It was argued compared with established s. But at that the framework of financial sector the same time, the table does not support policy and regulation at present severely simplistic triumphalism of a kind often limits India’s ability to utilise and expressed about the superiority of the Indian fully in order to obtain an edge in labour advantage. While India has a certain international competition. In this presence in the finance labour force, there chapter, we turn to a careful analysis are many areas of weakness. of the two remaining points: human India is weak in not yet being a full capital, and the issue of democracy and beneficiary (because it does not yet have its rule-of-law. own ) of the globally mobile expatriate workforce in finance. To be sure, Indian 1. Human capital needs for IFS expatriates populate almost all the English- speaking s. The three s and India has four strengths by way of human would not be able to function as capital endowments that give it an edge over well as they do without them. But these other emerging s as far as the utility of its expatriates choose to live in these s human capital endowments for competitive and change their nationality rather than provision is concerned: remaining India-centric. By contrast, the . The extensive use of English, which is the financial community of British, American, lingua franca of international finance; Australian, Japanese, Canadian, Singaporean and European nationals is genuinely globally . Generations of experience with en- mobile, shifting continually across s at trepreneurship, speculation, trading in home and abroad, while remaining anchored securities and derivatives, risk taking, to their nationalities and homelands. They and accounting. Indeed the ability to accrue significant benefits for their home provide competitively seems geneti- economies by doing so. Having an cally coded into Indian finance profes- in Mumbai would enable India to sionals; shift from exporting its best financial . Strong skills in information technology talents permanently, to retaining a hold and quantitative thinking; on such talent in the future by providing . Individuals of Indian origin play a greater global mobility, combined with an . A perspective on Mumbai’s strengths 173
Table 13.1: Cross country comparison of human capital support for the IFS Industry
London New York Tokyo Singapore Mumbai Hong Kong Seoul Sydney Dubai
J1. Quality, availability and cost of Finance Industry professionals: : Strategic/Exec 10 10 5 6 3 6 5 7 6 : Management (all functions) 7 8 5 6 4 7 6 7 6 : Trading & Dealing 9 9 6 8 4 7 6 7 5 : Financial Analysis & Research 7 9 5 6 8 7 6 7 6 : Compliance Specialists 8 7 6 9 4 5 6 8 6 : Back-Office Functions/Support 6 7 4 5 9 7 6 4 6 J2. Presence/Quality of Post-Graduate Teach- 6 10 4 3 2 3 3 5 0 ing/Research Institutions in Finance J3. Local Pool/Network of globally experienced 10 8 4 7 2 5 5 7 5 finance professionals J4. Local presence of Global HR Recruit- 10 10 6 8 2 5 5 7 5 ment/Consulting/Training Firms J5. Ease of entry, exit and overall mobility of global 8 7 3 7 2 6 3 6 8 finance professionals at all levels
attachment to the homeland, that will prove is only % of the total university educated mutually beneficial. workforce in India, compared to % in A McKinsey Global Institute Survey Germany and % in China. estimates India’s pool of young university Some evidence from the World Eco- graduates (those with years or less of nomic Forum and from (Switzerland) experience) at million – the largest of comparing India against some other coun- the countries surveyed. This is . times tries on workforce skills is shown in Ta- that of China and almost twice that of the ble .. There are divergent views between . This pool increases by about . million the two sources on the educational system: every year. But, only a fraction of this pool ranks India at th out of (i.e., in has credible, usable skills. managers the top decile) while ranks the educa- surveyed estimate that only –% of tional system at th out of (i.e., in the this pool would be suitable for an bottom third). India scores high on edu- environment. That is half the proportion in cation and staff quality in finance in both Central Europe. The reason for this outcome instances. is ascribed to: (a) extreme variability in the One aspect of labour quality concerns quality of tertiary educational institutions support services – e.g., accounting, legal – India has a handful of the best such services, business consulting and support – that are typically outsourced by financial institutions in the world; but they co-exist firms. These services complete the skill alongside too many of the worst; (b) high sets required by an . The presence, for rates of emigration of graduates from India’s instance, of highly specialised printing firms top quality institutions to countries; with tight internal security arrangements, and (c) the inadequacy of communication has become a complex specialised service in skills in English except for the top tier of the market, given increasingly stringent students from the better institutions who regulatory disclosure and insider-trading come from relatively high income groups prohibitions. Hitherto, a combination of and class backgrounds. In terms of technical legal and commercial skills was a prized and quantitative skills, only . million requirement in financial contracts; this students hold engineering degrees. That combination is now meshed with specialised printing skills. “Ensuring India’s offshoring future”,Diana Farrell, Noushir Kaka and Sacha Sturze, in Fulfilling India’s Broadly speaking, in a cross-country Promise (McKinsey Quarterly Special Edition ). comparison, India fares well in these support 174 R M I F C
Table 13.2: Workforce skills base comparisons
Rankings USAUK Japan India Hong Kong S’pore Australia
Educational System (b) 17 36 40 11 15 3 4 Quality of the Educational System (a) 27 22 31 39 17 2 7 Education in Finance (b) 16 45 54 17 12 5 4 Quality of Management Schools (a) 1 3 37 6 25 16 7 Tertiary Enrolment Rate (a) 4 13 29 79 56 32 9 Availability of Finance Skills (b) 8 33 49 12 7 11 17 Reliance on Professional Management (a) 5 2 12 29 28 18 3 Labour Productivity – GDP (PPP) per person per 7 21 24 60 30 28 17 hour (b)
(a): Global Competitiveness Report 2004/05, World Economic Forum, (104 countries); (b): World Competitiveness Yearbook 2005, Institute for Management Development, Switzerland, (60 countries) services, except in the case of global law Modern post- finance knowledge, firms, where India lags other s. One at present, in India is weak; especially way of developing capacities rapidly in the on the part of senior executives in most support services and financial segments Indian financial firms as well as in the upper mentioned above is to attract dominant echelons of financial regime governance. players in these segments into the . Lacking such knowledge and familiarity London got a major boost when Deutsche with the kinds of operations and risks Bank decided to move its global operations involved in derivatives markets for instance, there. The presence of all the big investment the approach taken in India is to avoid and commercial banks provides a critical these activities altogether or to constrain mass to financial operations in Singapore. them to a point of irrelevance. Mainstream Emerging s like Dubai are pulling out programs have a heterogeneous intake, and do not delve into modern quantitative all the stops to attract global financial talent finance. Staff quality at universities supported by middle management and lower is inadequate when compared with the level labour skills for from India. requirements of teaching modern finance. Although there are still many regulatory As an example, the Heath-Jarrow-Morton restrictions on the entry of foreign banks model is the workhorse of thinking about into its domestic banking market, India fixed income derivatives. There are probably has not been able to attract large capital not more than five individuals working at markets players, even though there are universities in India who understand this fewer restrictions on their entry in that model. sub-segment. That is mainly because the Indian finance professionals have development of major areas of financial a reputation for being quantitatively activity in which such institutions excel (e.g., competent. This is rooted in the high quality mergers and acquisitions, risk management, of high school education in India, where currency trading, interest-rate arbitrage, everyone going through the th Standard corporate-sovereign-sub-sovereign bond learns calculus. Many engineers who turn issuance, hedge funds) are also artificially to finance are skilled in calculus and linear proscribed in India. algebra. But they often do not know as
Table 13.3: Rankings: Quality and Capacity of Business Support Services to sustain an IFC
London New York Tokyo Singapore Mumbai Hong Kong Seoul Sydney Dubai
H1. Quality, reputation and presence of Global 9 9 8 9 6 8 7 9 6 Accounting Firms H2. Quality, reputation and presence of Interna- 9 10 6 7 2 8 5 8 5 tional Law Firms H3. Quality, reputation, presence of Global 10 10 8 9 4 7 6 8 6 Consulting Firms H4. Quality and competitiveness of IT, BPO, KPO 6 6 4 5 9 5 5 5 6 support . A perspective on Mumbai’s strengths 175
Box 13.1: The Master of Science in Finance () In India today, the and developing and testing technology and financial commonest degree obtained by trading strategies. methodologies are applied to individuals seeking a career in analyze complex problems. The . The MSF tends to involve finance is the MBA. coursework stresses the substantial teaching in Internationally, however, there application of contemporary analytical financial has been a strong shift in theories in a global context and economics, going beyond finance professionals, away develops valuable financial the more descriptive finance from the MBA towards a new modelling and analytical skills. coursework as seen in the degree called the Master of The programme contents MBA where the Science in Finance. There are impart students with a mathematical background three main differences between thorough understanding of the of students is inadequate. the MBA and the MSF: nature and operation of international financial markets . Usually about 20–25% of The MSF program prepares and institutions and develop the the coursework in an MBA students for careers in financial analytical skills essential to curriculum is focused on analysis, investment structuring deals and designing finance, while all the management and corporate financial instruments, pricing coursework in an MSF is in finance where they will financial products and valuing finance. confront sophisticated financial companies, designing and . The MSF imparts greater instruments, markets and managing investment portfolios knowledge of mathematics trading strategies. The typical and managing risk for financial and computer science, thus MBA student has a very limited institutions and multinational preparing the student for knowledge of derivatives corporations. the quantitative and arbitrage; the typical MSF India’s best institutions data-intensive modern student knows quite a bit about urgently need to introduce and finance workplace, where it. mathematical models are offer courses aimed at an MSF applied into measuring risk, The MSF is a quantitative degree. pricing financial instruments, program, where current
much about probability theory. Finance School () and the London School of professionals in London do more computer Economics () supported by mathematics programming, while their counterparts in and quantum physics graduates from nearby Mumbai are likely to use a spreadsheet. Oxford and Cambridge which are an hour’s If Mumbai is to emerge as an , drive away. But they do not quite compare substantial skills development will be as yet with the sheer cerebral firepower in required to overcome a potential human quantitative finance that is concentrated at capital supply constraint in financial services: the top institutions. especially in the areas of stochastic calculus Singapore has the National University and analytical financial economics. Middle of Singapore (). In a recent and level executives and senior staff employees remarkable achievement, the ‘Singapore of financial firms, who knew mathematics Management University’ has been created. when they were in their twenties, need to This is a private university, created in go back to learning probability, statistics, using public funding. It operates in the analytical financial economics and computer heart of the city, in order to maximise programming. The flow of young people the two-way flows of knowledge between coming into the finance field needs to have the industry and the university. It pays a much stronger grounding in probability, globally competitive wages in order to statistics, analytical financial economics and attract world class researchers. Singapore computer programming. Management University is very young when New York has the Stern School of compared with the IIMs, and it has only Business at New York University (), and one campus when compared with the the Economics Department at Columbia numerous IIMs. Yet, a google search for University. It is also supported by schools “singapore management university” already in close proximity such as , Wharton yields , hits while a google search and Chicago that excel in quantitative for “indian institute of management” yields finance. London has the London Business ,. This suggests that Singapore 176 R M I F C
Table 13.4: Rankings: governance issues affecting operations/Credibility of an IFC
London New York Tokyo Singapore Hong Kong Seoul Sydney Dubai
G1. Quality and Credibility of National Governance 7 6 7 10 3 6 7 7 G2. Quality and Credibility of State/Provincial Governance 8 9 8 10 5 7 8 7 G3. Quality and Credibility of Local/Municipal Governance 8 8 9 10 6 7 8 9 G4. Influence of Politics in diminishing Governance Quality: National/Federal 6 6 8 10 5 5 8 8 State/Provincial 6 8 8 10 6 5 7 8 Local/Municipal 8 8 8 10 7 7 8 10 G5. Quality, Capacity, Efficiency, Effectiveness of Administra- tion: National 6 7 8 10 5 6 8 8 State 6 8 8 10 6 6 8 8 Municipal 8 9 9 10 7 7 8 8 G6. Role of Checks & Balances (NGO oversight, media 8 9 5 2 4 4 6 0 freedom, civic action etc.)
Management University has been able of openness. Respect for property rights to very rapidly build up a presence and is strong (more in principle than practice). achieve impact. In addition, the Singapore India has, in the past expropriated property government is working with over a dozen and undertaken sweeping nationalisations global universities, attracting them to in finance and industry. That history should establish campuses in Singapore. In theoretically count against it as far as having contrast, India has presented a forbidding an is concerned although London was in environment where foreign universities are a similar situation when the also resorted unable to establish operations in India. to nationalisations that it later reversed. Mumbai has no institutions (except And, in the era of nationalisation in the perhaps ) where a few of the highest- , London’s fortunes as an definitely calibre intellectuals inhabit an ivory tower, suffered. conduct on-going research programmes As Fareed Zakaria has emphasised, the with Indian financial firms at the frontiers heart of a democracy (and its protection of finance, and teach the next generation and safe-keeping) lies in the quality of its of finance professionals. Mumbai lacks judiciary and not only in the legislature or the wealth of conferences, seminars, short- in elections. The infrastructure for law and term continuing education courses, and order, and contract enforcement, are central intellectual life that sustains the top end of to a vibrant democracy. They directly affect the financial services industry. The top ten the credibility/viability of Mumbai as an books on the desks of quantitative financial emerging . professionals in global financial firms are India is a thriving democracy – the available off the shelf at bookshops in New world’s largest, most complex and most York, London and Singapore. But they are vibrant – supported by a legal system that almost impossible to find in Mumbai and is now being strained at the seams with have to be acquired abroad. India lacks not the rapid growth and progress that has just the sophisticated mathematical skills it occurred since the s. The length of needs in its financial services workforce it time taken for cases to progress through the lacks teachers in these disciplines and simply legal system and the consequent enormous does not produce enough of an annual flow backlog of cases that has built up in of them. the lower civil courts, impinges on the question of whether India has a legal system 2. Democracy, Rule-of-Law and environment that is sufficiently supportive of the Legal System the swift resolution of conflicts and disputes arising from the settlement/enforcement of India has a long tradition of free and fair complex international financial contracts. elections, freedom of speech, and a spirit That in turn influences the prospects of . A perspective on Mumbai’s strengths 177
Table 13.5: Protecting Investors & Enforcing Contracts
Strength of Extent of Extent of Ease of investor disclosure director shareholder protection index liability index suits index index Procedures Time (0–10) (0–10) (0–10) (0–10) (number) (days)
Singapore 10 9 9 9.3 23 69 United States 7 9 9 8.3 17 250 Hong Kong, China 10 8 8 8.7 16 211 United Kingdom 10 7 7 8 14 288 Australia 8 2 8 6 11 157 Japan 6 7 7 6.7 16 60 Germany 5 5 6 5.3 26 175 Korea 7 2 5 4.7 29 75 Malaysia 10 9 7 8.7 31 300 France 10 1 5 5.3 21 75 Taiwan, China 8 4 4 5.3 28 210 UAE 4 8 2 4.7 53 614 China 10 1 2 4.3 25 241
Sources: World Bank Group Doing Business 2007 and 2006
providing to the global market from consensus that there was considerable scope Mumbai on an efficient, competitive basis for improving governance at all levels of and of Mumbai becoming a competitive the system –particularly at sub-sovereign in the foreseeable future. levels. It felt that governance standards in Using the same techniques as in earlier India needed to approach world standards chapters, the comparative Table . ranks as rapidly as possible if Mumbai prospects various established and emerging s on a for emerging as an that was credible series of layered governance variables. As in in global financial markets were not to be the case of legal comparators shown in an compromised. earlier chapter, the felt that it was not The most critical role of the State in a position to derive subjective rankings (and the government in power at the time on these variables for Mumbai. Consensus exercising the functions of the State), as far as could not be achieved on quantitative scores its citizens and residents are concerned, is its for Mumbai, given the degree of subjective ability (with the infrastructure and human judgement involved in coming up with capacity it has in place) to uphold the law, such scores. But the did have broad to ensure the maintenance of law and order
Table 13.6: Paying Taxes
Payments Time Total tax payable (number) (hours per year) (% of gross profit)
Singapore 16 30 19.5 United States 9 325 21.5 Hong Kong, China 1 80 14.3 United Kingdom 22 – 52.9 Australia 12 107 37 Japan 26 315 34.6 Germany 32 105 50.3 Korea 26 290 29.6 Malaysia 28 – 11.6 France 29 72 42.8 Taiwan, China 15 296 23.6 United Arab Emirates 15 12 8.9 China 34 584 46.9 India 59 264 43.2
Source: World Bank Group Doing Business 2007 and 2006 178 R M I F C
through enforcement capability (i.e., the areas. On the specific question that exercises effectiveness of its police forces and other the mind of those operating in an – i.e., mechanisms), to prevent crime and provide the problem of enforcing a contract, this security for persons and their property, to takes on average days in India, far longer enforce property and creditor rights fairly than in any other country shown in the table and impartially, and to resolve contractual with the exception of the . disputes through the due processes of law. Finally, an important aspect concerning In all these respects it is no secret that the functioning of the State in a country much progress needs to be made at sovereign intent on establishing an – that auto- and sub-sovereign levels of governance to matically requires extensive participation arrive at global standards. The challenge by international firms and individuals – at a of a third world country attempting to procedural level is the overhead and com- achieve first world standards in these areas is plexity of its tax system. Table . below daunting; but India has made a promising shows that in India, there are distinct tax start with domestic expectations rising as payments made by a firm, a task which takes rapidly as incomes. The believes up man-hours per year. This compares that progress in governance at all levels – in poorly with alternative s like Dubai or the public and private sectors – needs to be Singapore. commensurate with rate of progress in other Urban infrastructure and governance
1. The importance of high in turn need to be supported by high quality urban infrastructure quality electric power supply (with minimal for an IFC voltage and current fluctuations) and with sufficient back-up to minimize (to nearly c h a p t e r While the answer may seem obvious, or it zero probability) the risks of interruption. may be otiose, the question has to be asked: For these reasons, production re- Why do successful s, like London, New quires a venue where physical infrastruc- York or Singapore, need to have such high ture (i.e., residential and commercial space, quality urban infrastructure? For two main power, water, waste disposal, transportation 14 reasons: and communications) has to be of the high- The first concerns productivity: Inter- est quality in order to be globally competi- national finance involves highly compen- tive. Deficiencies in infrastructure increase sated specialists with unusual knowledge- direct and indirect production costs. experience skill sets. They are busy and need They hurt finance directly by confounding to make the most of their time. To them, the the mission-critical processes of the securi- costs of delay, non-performance, or failure ties markets and payments, and by placing on their part are inordinately high. pro- onerous coping costs upon every firm which vision involves intensive national, regional has to plan on failures of public infrastruc- and inter-continental travel and -hour ture and incur additional costs privately in telecommunications connectivity. In that order to compensate for these shortcomings. respect it is unlike , which takes place The indirect cost imposed by poor infras- in an isolated campus with staff-persons tructure is upon the wasted staff time of who mostly sit at their desks all day long. high-skill and high-wage finance profession- In contrast, production involves inten- als, and the opportunity cost suffered when sive intra- and extra-city travel for meeting tasks which could be performed in Mumbai clients, exchanging information and analysis, are directed elsewhere as a response to the negotiating and putting together transac- weaknesses of Mumbai. tions that often involve a consortium of As has been argued elsewhere in cooperating financial firms. this report, an abundance of fibre-optic Moreover production in an cables and video-conferencing have not is highly systems dependent. That is removed the fundamental role of face- true not just for financial firms operating to-face meetings for the most important in an , but for exchanges and trading negotiations and decisions. A day in the platforms, payment and settlement systems, life of a skilled worker in production and regulators who need to exert continuous may involve an early morning breakfast surveillance over transactions in real time. meeting at a club or hotel, a long commute All this requires not just sophisticated to work, moving around several different hardware (and immediately available meeting venues within the city throughout hardware maintenance) but also software the day to meet clients, colleagues in other and software support capacity, along firms, accountants, lawyers, consultants, with stable and reliable systems of high- along with lunch and dinner meetings quality air-conditioning and ventilation to before returning home after a -to--hour maintain constant atmospheric conditions day. That daily routine is interspersed of temperature and humidity. All these during the week and month with air 180 R M I F C
travel around the country and across the origin. All these people have a choice of world. living and working in any city in the world. Mumbai faces a tall hurdle in being Their choice will hinges on the attractiveness hospitable to this kind of individual. More of a city as a place in which to live, work than half of his/her day can be spent stuck and play. All the attributes that a city must in traffic. Mumbai needs to match at least have – as a hospitable, friendly, welcoming, the mundane efficiencies of London, New efficient and pleasant environment – matter York and Singapore in order to be a credible very much in influencing the decisions made venue for production. by this community. There is a paradoxical effect at work Once again, the more skilled a person in having the city and country make is, the more sensitive he/she will be to a transition from to . The the wastage of time, and the disutility more skilled a person, and the higher associated with the very large number of the opportunity cost of time, the less mundane irritations imposed by Mumbai inclined that person will be to spend time on its residents such as poor roads, air in Mumbai’s traffic, or in solving mundane and noise pollution, road and rail traffic problems of power, water or electricity, or congestion, poor health and safety standards law and order. Hence, as long as the urban and frequent city shut-downs. problems of Mumbai are not resolved more These realities make Mumbai an decisively, there will remain a bias in favour unattractive urban environment for housing of keeping the junior staff-persons of global an . They need to be tackled and financial firms in Mumbai to do the low- overcome on a war footing after long years value work required. High-value work of delay and many declarations of intent will migrate to proximate centres that are that remain to be translated into action better endowed with infrastructure and with plans for a new reality. Yet, despite all much higher, more efficient standards of city its shortcomings, Mumbai remains the administration and urban governance i.e., financial and commercial hub of India. Dubai and Singapore. This kind of fracture Those who wish to serve the Indian market will frustrate the goal of Mumbai becoming for will have little choice but to endure an that can capture high value addition its privations and put even further pressure in work. on the city’s limited resources and drive up The second, related issue is that the accommodation and land prices. But those most skilled staff-persons in global finance privations will not be endured by global have choices about where they are located clients of an who have other choices. and where their time is spent. Initially The highest skill individuals specialised Mumbai’s role as an is likely to be in providing are precisely those who limited to serving mainly the Indian market would make a material difference to for – in other words it will be an Mumbai’s aspirations to become an . more like Tokyo and the continental s It has oft been remarked by the cognoscenti rather than like the three s. That who have lived and worked in the three initial phase will probably stretch from s that, more often than not, the around –. It will require additional most innovative ideas in production infrastructure. are exchanged by imaginative, creative But those demands are unlikely to be as financial architects, engineers and artists great as those made when Mumbai enters over cups of coffee. The most fundamental its second phase (from onwards) and ingredient in a vibrant is the intellectual attempts to compete with the three s. and commercial interplay between a large A defining issue for Mumbai’s becoming a number of heterogeneous requirements and credible post- will be the challenge viewpoints. of attracting around , high level people A successful is one that brings a of the kind typically employed by global diverse array of knowledge into financial financial firms in the three s. Only problem solving through lateral thinking, –% of these are likely to be of Indian and constructing creative links across diverse . Urban infrastructure and governance 181
groups of players. This requires a large Hence, the most critical task in a number of conversations and a wide range strategy for making Mumbai an is the of participants in these conversations. challenge of upgrading the city to world If Mumbai is a hospitable and attractive standards in terms of the quality of its city to a globally mobile population of infrastructure and, even more importantly, high-level providers, then a person the quality of its governance. For Mumbai who comes to Mumbai for a meeting on to become a successful , the best minds a Friday is more likely to stay over on in global finance will need to perceive it the weekend for amusement or leisure. as a city that is as attractive as the other The stray conversations of the weekend three established s in terms of locating can ignite further -related business. If their families, educating their children, Mumbai is inhospitable, and the person and as a venue for furthering their own concerned cannot wait for his flight to careers and for enhancing their lives. If depart the same evening, these conversations Mumbai is not perceived in that way by this and informal relationships, and thus the highly mobile community with extremely business they contribute to the , are demanding standards then it will not succeed lost. as a even if it manages to survive The growth and success of the Indian as a more limited serving India’s economy does not automatically overcome needs on a partial rather than total the problem of an inhospitable Mumbai for basis. . In fact, in the short-term, it appears In offering this observation, the to be making that problem much worse Committee realises the challenge it poses as the city is unable – in a meaningful to all levels of government in India, sense other than haphazard building – Maharashtra and Mumbai. It may be that the to cope with the consequences of such human talent needed to manage and run a rapid growth in a deliberate, planned world class city may have to be sourced from way that allows for carefully designed wherever it exists to upgrade dramatically urban regeneration, redevelopment and the quality of local city administration. It expansion. If India is successful, but is by no means easy to create and govern Mumbai continues to be a hostile urban a first world global city in a third world environment, then global financial firms environment. But it is not impossible. intent on expanding their India-related Malaysia has managed to do that with Kuala business will continue to make key Lumpur; although that city does not have decisions connected with India as they are the advantages of the vast Indian market and doing now: i.e., in New York, Singapore, and is obliterated from competition in the London. race by having Singapore on its doorstep Perhaps over time some of the executive with vastly superior capabilities. China functions undertaken in those s for has managed to do that with Hong Kong, India-related business may migrate to Beijing and Shanghai. South Africa has Dubai if the manages to establish managed to do that with Johannesburg. itself in the face of Mumbai’s (and India’s) Brazil has managed to accomplish the same failure to come to grips with the physical with Rio de Janeiro and Sao Paulo. Chile has infrastructure challenges that both city and managed to do that with Santiago and so country face. The creation of is on. The problems faced in Mumbai are predicated partly on anticipating such failure. not new, having been solved by dozens In this scenario, relatively junior staff will of cities, including many in the third be placed in Mumbai to maintain regular world. client contact at managerial (rather than To accomplish that difficult, but by no senior executive) levels and to undertake means impossible task central and state level routine process work. Senior executives policy-makers may have to consider the will travel infrequently to Mumbai to short-term perpetration of an inequity quite handle the more critical functions and deliberately, as an investment in the future decisions. not just of Mumbai but of India. What 182 R M I F C
needs to be done is to recreate Mumbai Table 14.1: Index of fully loaded costs per head within the next – years (i.e., in – (London = 100) ) as a forerunner, at the city level, of London 100 what India should become in the next New York 96 – years – i.e., a developed country. Paris 97 Meeting the challenge of making Mumbai Frankfurt 84 Hong Kong 99 an capable of graduating to status Mumbai 36 relatively quickly is not a secondary issue. It ranks as being equally important to the Source: The Competitive Position of London as a Global Financial Centre, the Corporation of London, November major transformation that is required of the 2005. Based on Z/Yen Limited, 2005 Cost per Trade license-permit raj in Indian finance. Survey (July 2005). In other words whether Mumbai becomes a successful , and graduates quickly to status, depends on whether in distorting reality and compromises the two strategic challenges can be met achievement of the outcome. simultaneously by the authorities in the knowledge that the Indian private sector 2. Problems of cost has the capacity to meet its operating Even though India is a third world country, challenge. The two challenges confronting and labour costs in India are low, the the authorities at central and state/municipal costs of renting office space in Mumbai are levels respectively are: high when all components of establishment cost are taken into account. This will . Having the vision, resolve, and political deter the placement of activities in courage/will to make the fundamental Mumbai. wide and deep reforms needed across As Table . and . show, Mumbai Indian finance to make it operate on has a significant cost advantages over most global lines and integrate more rapidly s in countries; but it fares poorly with the global financial system (a GoI when compared with Shanghai or Singapore, challenge); and two cities which are likely to compete with . Making the equally wide and deep ur- Mumbai in the space. The costs seen ban policy reforms needed to upgrade in Mumbai are out of line with general cost the quality of Mumbai’s infrastructure levels associated with India’s low per capita and governance – so that it can become . As an example, even New Delhi – a global city similar to the other GFCs; which has severe problems of urban policy (a GoM and municipal challenge). itself – has costs that are much lower than The most important aspect of becoming Mumbai’s. an – with enormous beneficial side- 3. Cross-country comparison effects for the Indian economy – lies in In Table ., established and emerging s attracting the people needed from around are ranked for indices K through K, all the world to live and work in Mumbai. of which measure the quality of physical Whether Indian or foreign, all of them can and social infrastructure, and the living live anywhere in the world they choose. environment. Mumbai has two strengths: For Mumbai to become an / this (a) the use of English as the default language community needs to choose to be in for global and financial contracts; and Mumbai. That basic reality needs to be (b) the availability and quality of personal seen for precisely what it is. Going for an and domestic services. In the area of in Mumbai is a policy choice that will telecommunications, Mumbai is increasingly inevitably invoke social reactions in the city closing the gap against other cities. In all and require astute political management. other areas, there is a huge gap between Those reactions may be difficult to cope with. Mumbai and the emergent s. But it would be remiss to obscure this reality for that reason; or attempt to deal with it Occupancy costs are defined as the average total through a rhetorical compromise that results cost of leasing , sq.ft. ( sq.m.) of net usable . Urban infrastructure and governance 183
Table 14.2: Occupancy costs
2005 2004 Total occupancy cost Space utilisation Total per workstation pa standard per worker Occupancy cost (US$) (sf) (US$ psf pa)
Rank Rank Location 2005 2005 2005
3 4 London (City) 15,280 113.0 135.2 5 3 Frankfurt 13,640 236.8 57.6 6 5 Tokyo (Central 5 Wards) 13,400 136.7 98.0 8 6 New York (Midtown) 12,200 225.0 54.2 14 33 Hong Kong 9,320 139.9 66.6 14 19 Seoul 9,320 161.5 57.7 29 17 Sydney 7,790 150.7 51.7
40 40 Mumbai 6,670 129.2 51.6
63 69 New Delhi 5,140 129.2 39.8 90 92 Shanghai (Puxi) 4,150 113.0 36.7 92 87 Singapore 3,970 118.4 33.5
Source: DTZ Research, Global Office Occupancy Costs Survey, January 2005
4. Difficulties in Mumbai from Point/Fort in South Mumbai – intra- an IFC perspective city drive times have become particularly critical. New and innovative strategies The main infrastructure deficiencies in need to be undertaken to dramatically Mumbai are well known: electricity, transform transportation time, utilising water, sewage, flooding, transportation both public transport and high speed and communications. With the city now intra-city expressways. A host of developing a fractured geography with solutions, based on user charges, can be its two financial centres being located in rapidly rolled out in order to alleviate the Bandra Kurla Complex and Nariman infrastructure constraints such as transport, power, water, sewage, drainage, railway office space in a modern, well-specified office building stations, etc. These should be put together by in a prime Central Business District location. They the Indian industry, global players, include rent and outgoings, such as maintenance costs and property tax, but exclude rent-free periods, fitting- and multilateral institutions. out costs and other leasing incentives. The exorbitant cost of real estate in
Table 14.3: Rankings: Quality of physical and social infrastructure and living environment
London NY Tokyo S’pore Mumbai HK Seoul Sydney Dubai
K1. Quality/Availability/Cost of infrastructure: Power 9 9 10 10 4 9 10 10 10 Water 9 9 10 10 4 9 10 10 8 Telecommunications 9 10 10 10 6 10 10 10 10 Transport 5 6 7 8 2 6 8 8 5 Residential Space 7 5 5 7 3 7 8 8 7 Office/Commercial 9 9 10 10 3 9 9 9 10 K2. Leisure, Entertainment, Global Cultural, Recreational 10 10 3 4 2 4 3 7 5 and Food Facilities K3. Use of English as the default international language 10 10 2 9 7 5 3 10 6 at work and at leisure K4. Use of English as the default international language 10 10 5 10 9 10 5 10 10 for financial contracts K5. Availability, Accessibility, Cost of healthcare and 5 5 6 8 3 6 7 8 6 education (global standards) K6. Availability, Accessibility, Cost of personal and 3 3 1 5 9 6 4 2 9 domestic services 184 R M I F C
Mumbai could inhibit its emergence as primarily of residential and commercial an . Mumbai is said to have lost the space, supported by an array of services industry to Bangalore owing to its such as: adequate water supply for drinking astronomical prices of real estate. Mumbai and other uses; drainage sanitation and might end up losing the industry to sewage systems; utilities such as electricity Dubai if this issue is not addressed. This and gas distribution; adequate road, rail and involves repealing the Urban Land Ceiling water-borne urban transport and parking Act, and new thinking on . both public and private; primary as well Becoming an also requires strength- as sophisticated secondary health care ening the spirit of tolerance which has always services that caters to all segments of the been a part of Mumbai’s ethos. A healthy population; primary, secondary and tertiary and hospitable city environment that can educational facilities; and environmental attract expatriates requires good residential regulation. The sound provision of facilities, office space, leisure, and enter- urban infrastructure is intimately linked tainment facilities catering to international to decentralisation of economic and political tastes, smooth enrolment processes at good powers to sub-national tiers of government, schools, hospitals, colleges, universities, and which flows from the th Amendment sports clubs accessible to expatriates. Ex- to the Constitution. There is a need to patriates in an IFC should be able to use create fully empowered city government English in their interfaces with government, to manage the urbanisation process, while state or city officials. having political and financial accountability Fresh thinking is called for revamping for it. the city’s administrative structure. In China, International experience suggests that the four largest cities have been given without reforms in the institutional provincial status; much like Delhi. But the framework for urban infrastructure, central sensitivity of state and local politics need to or state level government funds directed into be taken into account in considering such the urban sector will not have the expected an option for Mumbai; even if, theoretically, economic and social returns. Nor will it might ensure better city governance and they be appropriately directed for priority greater accountability of the city’s policy- use. What Mumbai needs is not simply a makers to the urban electorate. If this few large eye-catching projects that require solution is out of the question, the most massive expenditures. What is needed even critical priority is to transform the city’s more is a transformation of the institutional administrative structure in a way that creates structure that puts the long-run tasks of a fully empowered if not elected ‘manager’ urban governance on a sound administrative for the city, who can be held accountable footing. for everything that goes right or wrong in The key problems are those of indepen- Mumbai (without being able to pass the dence and accountability. Local/municipal buck to the state government), and who is governance functions in Mumbai need to be not required to be concerned about anything concentrated under an urban development else. authority (whether elected or appointed, Finally, ways need to be found to reduce although legitimacy would be enhanced if the city’s vulnerability to city wide bandhs, a that authority was elected) that is directly ac- peculiarly Indian phenomenon. countable to the city’s electorate. At present, decision-making on financial and gover- 5. Improving urban nance matters concerning the city is split in governance in Mumbai a haphazard fashion across the Centre, State and City. This results in diffused responsi- The sheer size and rapid but disorderly bility, lack of coordination and disjointed uncontrolled growth of Mumbai presents planning; as well as a loss of financial inde- an unprecedented challenge in inducing the pendence for the city. evolution of sound institutions for urban Financial allocations for the city made governance. Urban infrastructure consists by central and state governments are . Urban infrastructure and governance 185
disproportionately low in comparison with: project-by-project basis. Increasingly, the (a) the public revenues it generates and sustainability of infrastructure development (b) its legitimate needs for infrastructure and poverty reduction programs will be maintenance as well as planned urban determined by the overall management and growth and development. Unlike Delhi, creditworthiness of urban centres. other metropolitan centres in India are In terms of institutional structures, mu- handicapped – in terms of having an nicipal functions in Mumbai are fragmented independent trajectory for their growth and across many different corporations, agencies, development – by not having their own and local government bodies with conflict- revenue base nor any clear autonomous ing lines of accountability. Existing agencies status within the present three-tiered for municipal service delivery are structured structure of governance. It is a recipe that on functional lines with attendant implica- has brewed the twin paradox of having tions for poor accountability, limited incen- key Indian cities decaying rapidly in the tive for innovation in delivery of services, face of even more rapid population growth. and limited use of private sector capacity to That will eventually change with the rate of manage and finance services. There is no urbanisation that is now taking place across effective interface and almost no account- India. But such change may occur too late to ability connecting the city’s administrative matter in making a difference when it comes systems to its various decentralised com- to Mumbai becoming an within the next munities. In particular, poor communities – years and creating the administrative have almost no voice over city policies except structure it needs for that purpose. through extreme forms of public resistance The Delhi Metro Rail Transit System when their interests have been compromised () was inaugurated on December , beyond their limited abilities to cope. . Early indicators suggest that this may In terms of fiscal problems, there is become a Metro system that can compete persistent under-performance on revenue with that of New York, London or Singapore. collection with unsustainable tariff struc- As yet, a comparable system has yet to be tures and non-transparent subsidy schemes. built in Mumbai. It is particularly important The general property tax system requires to build transportation infrastructure in the complete restructuring and modernisation. form of a Metro to augment the suburban State and municipal governments need to railways, along with intra-city and coastal deal urgently and fairly with the problems expressways that link the island to the created by a legacy of rent control and espe- mainland, so that the mainland becomes a cially the problem of pre- buildings. In viable alternative for residential and business doing so, they have to recognize and respect decision making. This would serve to the ‘acquired rights’ of long-term tenants decongest the city and improve the cost that may exceed those of landlords who have efficiency of production in Mumbai. only recently acquired such properties for When it comes to city financing, the speculative purposes under circumstances foundation principle of urban finance has that would be questionable in law. to be user charges for the occupation and Moreover they have to deal more use of city infrastructure. It is possible for decisively with resolving the outstanding urban institutions to access resources from problems concerning the urban land ceiling capital markets to finance a large portion renewal act. In Mumbai, low income of urban capital expenditure, reflecting households are often to be found at the their future outlook for user charges and regressive end of the fiscal system. At the long term cash flows from property taxes. same time, improvements in tax revenues This approach makes it possible to increase and user charges are likely to be most capital expenditure rapidly on urban acceptable in the context of concurrent infrastructure in Mumbai without requiring improvement in the institutions of service recourse to Central or State finances. delivery. This is perhaps analogous to the However, access to infrastructure and private political acceptance of tolling highways after finance cannot be sustained on a piece-meal, high quality highways came about. 186 R M I F C
At present Mumbai has limited credit- Solving the problems of Mumbai worthiness, with opaque financial and ac- requires a shift away from an immediate counting systems and primitive treasury focus on a few high-profile projects such as management. The relative lack of trans- the second airport project or a metro project, parency on a variety of public works con- and dwell more on building the institutional tracts has emerged largely as a consequence foundations for a healthy city. Although of such lack of controls; coupled with indi- such projects are essential they are not the vidual discretion over budgets of a kind that mainstay. generates perverse incentives inclined to- The central policy focus needs to be on ward malfeasance. These need to be rectified the empowerment of the city government before Mumbai can access capital markets, to take economic and service delivery and make the needed institutional and fiscal decisions, as envisaged originally in the reforms. th Amendment. This will require a new A program of transforming urban in- framework for planning and implementing frastructure in Mumbai therefore has di- urban expenditures that is driven exclusively mensions of institutional, fiscal, financial by the city government. It needs to address and regulatory reform. Sector-focused re- the current fragmentation of authority forms in service delivery – e.g., a programme between state and local levels, support urban which focuses only on water and sanita- government oversight and accountability tion and solid waste – need to incorporate for urban functions, and support control of such institutional, fiscal, financial and reg- service delivery investments, operations and ulatory dimensions to the reform package. financing by the urban government. The HPEC’s recommendations
Throughout the chapters of this report In most cases the focus of other a series of suggestions have been made Committees has not taken into account the either implicitly (i.e., arising from the logic possibility of Mumbai becoming an . of the arguments made) or explicitly in Their recommendations were crafted mainly c h a p t e r the form of a specific change. These in a domestic context. Therefore it should recommendations/suggestions have been not be surprising that in some instances arrived at bearing in mind that the ToR of their findings may (implicitly) militate the outlined a broad remit requiring against the establishment and successful the Committee to raise any issue that, in operation of an . In many instances 15 its view, impinged upon the success of the recommendations may require an in Mumbai. In some areas, the further detailed scrutiny by specialists to recommendations of the concern convert broad ideas and suggestions for formulating an appropriate approach. In change into specific ‘actionables’. With other situations, the Committee has crafted this background in mind, the has specific recommendations. In some attempted to draw an appropriate balance situations, the Committee proposes a re- in making its recommendations in terms of examination of certain issues by the Ministry their width, specificity and depth. These are of Finance, recognising their bearing upon pulled together in coherent form below. the issues of achieving an in Mumbai, In recommending that policy makers but at the same time recognising that their opt for creating an Indian in Mumbai, resolution requires more detailed treatment, for a variety of strategic reasons of national which impinges upon many other issues interest, this chapter explicates what is in economic policy. Putting both together, implicit. It collates and clusters its the believes it has articulated a set recommendations under the following three of immediate and medium term goals in pillars on which an has to be supported: the form of a roadmap to put Mumbai on a . The general macroeconomic environ- trajectory for becoming an . ment in which an operates and The is mindful that it has not the policy framework that affects its op- been tasked specifically with looking into erations and credibility in the global detailed matters concerning macroeconomic financial system. policies (ie fiscal, monetary, exchange rate, convertibility etc..) financial regulation . The agenda for further financial system and regulatory architecture or, for that reform that needs to be carried through matter, the prevailing legal or educational so that an can operate on a viable systems. Nevertheless all these areas exert basis. Such reforms include changes a considerable influence upon whether an that need to be made in: (a) financial can be established in Mumbai and upon regime governance and regulation; its prospects for success. Therefore they have (b) the development of ‘missing’ or weak attracted our attention and comment. Other markets; (c) the development of globally Committees have looked into some of these competitive institutions and financial issues. The has taken their findings firms; and (d) other policies concerning and suggestions fully into account in its the financial system and ensuring that deliberations. That does not necessarily its growing need for qualified human mean that it agrees with what has been capital are met. suggested by others in every instance. . The agenda for urban infrastructure 188 R M I F C
and governance in Mumbai, particularly The persistence and pervasiveness in the context of making it a hospitable of direct rather than indirect forms global city for a large and demanding of public intervention in the financial expatriate population that will be system (from ownership to directed indispensable in the successful operation lending) has compromised the early and of an . smooth development of various financial markets and concomitant institutional structures in different financial sub- segments. It has prolonged the existence of 1. The general macroeconomic too many inefficient, small, undercapitalised environment financial firms (public and private) that are incapable of withstanding the heat of global This report traces the origins of a tendency competition in almost every financial market toward financial repression in India, given its segment. Thus the domestic institutional development trajectory since independence, and market infrastructure that is needed and the policy choices made under for an to operate is deficient in many governing political economy pressures and important respects at the present time in constraints at different points in time. To India. So is the range of financial products a significant degree, the present problems and services that are offered and traded in of Indian finance, and therefore the future Indian financial markets relative to those prospects of an Indian , are rooted in available in global markets. An cannot legacies created by the size of the public function when the domestic-global gap is deficit and how it has been financed over the quite so wide. last three decades. This assertion demands a With the policy choices made in the digressive preamble. past it is no surprise that natural market India has run a high gross consolidated discipline has been prevented from operating fiscal deficit (for the centre, states and as it usually does in the financial system contingent liabilities) – three to four times to induce efficiency and competition – i.e., the size generally regarded as prudent through time-tested processes of adjustment, as a percentage of GDP – for too long; adaptation, acquisition, merger, takeover particularly since the s. That has and bankruptcy. Direct public intervention resulted in expedient strategic and tactical in the financial system (through ownership) options being resorted to for financing has influenced, if not compromised, the such a public deficit. These options, which policy objectives of financial regulation perhaps were necessary at that point in by inclining them toward the goal of time, in turn, have affected the evolution protecting certain types of financial firms of the Indian financial system. They for social or political, rather than economic have bolstered public sector ownership of or commercial, reasons. financial firms through ‘balance sheet and Regulatory objectives aimed at the pri- profit-loss protection’ as well as high barriers mary goals of fostering prudence, soundness to entry and competition and the resultant and stability of the financial system, have be- suppression of financial innovation. A come inextricably intertwined with the sec- distorted yield curve – determined by ondary goals of protecting (implicitly or ex- the government rather than the market – plicitly) the legitimate vested interests of the accompanied by a reliance on captive bank State as the largest single borrower from, as rather than bond market financing, have well as the largest single owner of, financial been seen as pre-requisites for financing firms and markets in India. That multiplicity public debt at low cost. These tendencies of objectives makes any system of financial are, axiomatically, anathema to markets and regulation imbalanced and opaque; if not therefore to the prospects for establishing occasionally confused and contradictory, in an – which by definition requires a attempting to accommodate too many irrec- liquid bond market with undistorted interest oncilable but inherent conflicts-of-interest. rates. Such a cocktail of multiple ingredients be- . The HPEC’s recommendations 189
comes even more potently dangerous when of differentiation and privilege of one the conduct of an independent monetary economic agent over another strikes at the policy is fused with the exercise of regula- roots of what makes a market economy tory responsibility under circumstances in tick – i.e., a level playing field, equality of which the state as the ultimate regulator is opportunity, application of the same rules implicitly protecting its own interests as a to all players across the board regardless of privileged economic agent as much as it is their ownership, no barriers to entry or exit, protecting the wider interests of a market competition, innovation and adaptation financial system. through unfettered freedom. It is important for us to stress at The inescapable result of the accumu- the outset that, in tracing this history lated legacy of pre-emptive and repressive as a matter of fact, the does not policies in Indian finance has resulted in a question the legitimacy or propriety of ‘lowest common denominator’ approach what has happened and why. Nor is influencing the outlook and mindset of fi- it advocating any particular ideological nancial policy and financial regime gover- line. It is simply establishing the links nance. These deficiencies began to be cor- between historical impulses, policy choices rected with the onset of ‘serious’ reforms in and market/institutional outcomes in the –. Those reforms have gone far, wide evolution of Indian finance since . In and deep in the real economy resulting in opting, through a democratic process of a transformation of Indian manufacturing choice, for a command-and-control type and of service industries such as services. of economy between and , the But those reforms have not yet penetrated State had the legitimacy and the right to India’s financial system to the same extent. arrogate unto itself a special privileged Considerable progress has since been made; position as a superior economic agent and especially on public finance, with tax re- driver of development; as well as the prime forms and the passage of the Act. But protector of wider social interests. That key issues and concerns remain that public choice was supported by successive is obliged to illuminate and adumbrate in electoral mandates. the context of establishing an : But in shifting gears and transiting toward a market oriented economy – which 1.1. On Economic Strategy, Fiscal is what the reforms of onwards were all Policy and Deficit Financing about – the legitimacy and ‘appropriateness’ . An in Mumbai would become of that privileged position for the state as credible and successful more quickly an economic agent, over other types of if India’s overall economic strategy was economic agents, has come into question. It aimed at achieving and maintaining causes systemic discomfort and dysfunction an average growth rate of % to when the prerogatives and privileges of % between now and . With the State as an economic agent are % growth, India’s nominal maintained in a market economy which, expressed in dollars is likely to by definition, does not recognise such double every – years. In terms of prerogatives or privileges as legitimate or crude approximations, that would imply functional. Markets – whether financial or India’s nominal dollar increasing real – and market economies do not function from $ billion in to $. trillion as they are intended to when economic in . It would increase again to agents are differentiated in this fashion $. trillion by , and $ trillion and when one type of agent (the State) by . Such growth would create a maintains a privileged position over other favourable environment for an in economic agents in terms of access to natural Mumbai to capture a huge hinterland or financial resources, pre-emption in the advantage. These rates of growth are ownership of productive or institutional achievable. Indeed they may be the assets, or in access to factors that determine only way of generating sufficient public a firm’s competitive abilities. That kind resources to deal with poverty, fiscal 190 R M I F C
deficit, and public debt reduction all at ratio as a ceiling. It has done no detailed the same time. When is $ trillion, work on the range that would be appro- a government that spends % of on priate; that was not its primary mandate. welfare programs puts itself in a position By way of illustration, however, it does to transfer about Rs. , per person suggest that ratios of –% have been per month to the poorest one-sixth of adopted by different countries as being the country’s population. Clearly, a % indicative of prudence. India needs to real rate of growth cannot be achieved establish its own ratio for a debt/ unless extant, binding infrastructure ceiling after careful study, as a natural and governance constraints are relieved. accompaniment to the deficit Those key objectives would be facilitated reduction targets. That ceiling should by India having its own in Mumbai. suggest to global markets India’s com- mitment to fiscal prudence at all levels . Despite the Act and a number of of government. Total public debt in this other measures that have been taken, context would mean the outstanding insufficient progress has been made long and short term debt of central and toward reducing the gross consolidated state governments, as well as the debt of fiscal deficit (GCFD) to –% of s guaranteed (directly or indirectly) GDP. More progress needs to be by o, and all contingent liabilities of made to underline an unshakeable central and state governments incurred o commitment to establish the fiscal through off-balance sheet financing or foundations for a rapidly growing – but quasi-fiscal accounts. When these ad- still ‘developing’ – economy in which a justments are made, the true debt/ ‘newcomer’ must operate credibly. ratio of India is well in excess of %. ff No IFC has taken o or thrived in any Public debt reduction depends, to a large economy where such sizeable deficits degree, on fiscal deficit reduction. But it have been incurred for so long. Global can be accelerated through programmes markets are deterred from participating of public asset sales at all levels of gov- in s whose home economies are ernment. Such sales would galvanise fiscally incontinent because of a chronic capital markets, spur growth and result inability to align public expenditure with in more foreign investment (portfolio public revenue. Large deficits (and the and direct) to achieve a higher growth build-up of an overhang of public debt) rate. pose a latent threat to systemic stability . In restructuring tax revenues to achieve in the event of endogenous or exogenous deficit reduction, particularly in the shocks. Confidence in the is context of an and the effects that diminished in such an environment. For taxes have on influencing financial that reason, if having an is a strategic system evolution, the HPEC would objective to be achieved by India (and recommend, broadly, that tax policy for other obvious reasons as well), then should implement the key principles governments at all levels (central, state determined by a series of expert and local) need to exert greater political committees starting from the mid will over the next five years and beyond s, and leading up to the FRBM Task to reduce their respective fiscal deficits. Force Report of . This involves a . Related to the deficit reduction target simple tax code, with administrative (and contributing to its achievement) efficiency, low tax rates, removal of the HPEC would recommend progres- exemptions, and a tax system which sive reduction of the total public debt places the main burden of taxation to GDP ratio from the current level of on consumption rather than income % of GDP to significantly less. That or saving. From an perspective, reduction has already begun. It must be the HPEC recommends eliminating sustained. The HPEC did not reach a transactions taxes in the form of the consensus on any particular debt/GDP Securities Transaction Tax (STT) and . The HPEC’s recommendations 191
stamp duties. The former requires (a) exposing sub-sovereign governments actions by the Ministry of Finance, to the discipline of the market; (b) creat- while phasing out the latter needs to ing new financial markets in these seg- be synchronised with the shift to the two ments thus adding to the width/depth of part Goods and Services Tax () and a bond market in India that is, at present, integration of the real estate sector into lacking in both; (c) expanding the array the . HPEC does not see the need of that could be provided by an for a tax haven, or even temporary tax in Mumbai. breaks, as concomitants to having an . Shift the burden of future infrastruc- IFC in Mumbai. But it does recommend ture investment from the public to the applying GST to the financial services private sector through PPPs : i.e., pub- industry. This will require appointment lic private partnerships involving private of a technical committee to work out finance – from the domestic and global the mechanics of how this should be markets – to provide public goods and achieved. services on an appropriately structured . In financing the fiscal deficit, over- basis that avoids the risk of ‘privatising dependence on the domestic financial profits while socialising costs’. Greater market needs to be reduced. o should resort to PPPs would: (a) resolve the fi- continue reducing reliance on pre- nancing constraint facing infrastructure emption or quasi-pre-emption through investment in India which requires stag- the financial system. Public debt should gering amounts of funding; and (b) also be financed in domestic and global bond provide an opportunity to hone a special markets. Such markets are willing to competitive edge in the provision finance the public deficit by buying INR capabilities of an in Mumbai. denominated o notes and bonds. The purchase of INR denominated 1.2. On Monetary Policy and its instruments issued by GoI should be Implementation/Execution open to anyone across the maturity . The creation of an in the st spectrum from -days to -years. century inevitably requires an open capital account if the is to: This opening-up should be done in (a) function with a modicum of two steps, so as to postpone foreign efficiency; (b) provide the full array investment into short-dated bonds. This of IFS; and (c) be viable/successful would automatically reduce pressures and globally competitive with other on the domestic financial system and s/ s within a conscionable time- on: (a) crowding out private investment; span. But, with large fiscal deficits being (b) interest rates; (c) the balance sheets run, the task of managing monetary of banks and other financial firms; policy – with an open capital account in (d) continued public sector ownership a rapidly growing, developing economy of financial firms; and (e) keeping the like India – becomes more complicated capital account partially closed thus that it presently is. When faced with thwarting or delaying full convertibility such a situation, the implication for the of the . monetary authority may well be that – . The budgets and ‘balance-sheets’ of in keeping with regimes that characterise state governments and major metropoli- economies with successful s– it tan municipal corporations (and other needs to consider focusing exclusively local authorities as well) need to be on the single task of managing a key restructured. That would permit sub- short-term ‘base rate’ to maintain sovereign governments to become ‘sol- price stability (e.g., inflation being kept vent’ and resort to market financing within a range of –%), consistent rather than depending on o support with supporting a high growth rate and direct/indirect financial guarantees. (–%). As global experience with Doing so would have the triple effects of: managing monetary regimes in the 192 R M I F C
more successful economies suggests, carefully whether such a focus makes achieving that prime objective is critical. sense in an economy that is still subject It may be so crucial in the Indian to price manipulation of some ‘big ‘high-growth requirement’ context that prices’ (e.g., energy price) that feed all other subsidiary functions now through the economy and have an performed by the extant monetary- impact on all other prices as well; and cum-regulatory authority may need to (f) the gradual evolution of the be divested to agencies that specialise into becoming a global reserve currency in undertaking them. In particular, by . These issues, which have the monetary authority should not be also been examined tangentially by the placed is a position where: (a) it is Tarapore- Committee on CAC, need to obliged to manage multiple conflicts- be looked into further by a specialised of-interest; and (b) runs the risk expert technical committee. that managing such conflicts might . The debate on convertibility is primarily lead to sub-optimal decisions on about avoiding the currency crisis and adjusting the base rate as evolving banking crises which came about in internal and external circumstances countries such as Mexico, Thailand, impinging on the economy might South Korea and Indonesia in the last demand. Confidence in an Indian decade. These failures are understood will be enhanced if the monetary to have been caused primarily by flawed authority is seen to be free of these currency policies, and these pitfalls need conflicts of interest. As part of this to be carefully avoided. Taking into framework, the HPEC believes that the account the balance of risks evaluated by function of a public debt management many previous committees and experts, office should be either completely the HPEC is of the view that the capital independent – in the form of an account needs to be liberalised more autonomous agency – or placed in the rapidly and in a time bound fashion Ministry of Finance rather than in than is presently envisaged. CAC needs a regulatory institution to avoid any to be achieved within the next – perceptions of conflicts-of-interest in months – i.e., by the end of calendar the eyes of regulated financial firms. at the latest – preferably sooner. . Managing monetary policy under That is required partly to ensure than changed circumstances will require any established in Mumbai has fundamental reconsideration of core a fighting chance of succeeding. At issues such as: (a) the viability of the same time, this policy is what the maintaining a ‘stable’ exchange rate for Indian economy and financial system the ; (b) whether that rate should need at this critical juncture. The capital be managed around a notional central controls that are now in place: (a) pose peg or a different trade/investment a high (if not insuperable) barrier weighted currency basket; (c) whether in practice, to Indian financial firms official intervention in currency markets offering IFS in the global market and to ‘stabilise’ the should occur, hobble them in competing against global except in extreme (market failure) firms in the context of increasing de facto circumstances; (d) ceding a ‘stable convertibility; (b) deprive these firms exchange rate policy’ in favour of from earning significantly higher export monetary autonomy, thus putting the revenues; (c) delay the development burden of adjusting to a more variable and acquisition of core -provision exchange rate on private actors and competencies; (d) reinforce protectionist the government, while creating more barriers to entry in the Indian financial risk management possibilities (through system thus rendering it inefficient, currency derivatives) that make such uncompetitive and more costly in terms adjustment easier; (e) a focus on of basic financial intermediation; and ‘inflation targeting’ and examining (e) inhibit essential financial system . The HPEC’s recommendations 193
liberalisation from occurring as swiftly the Indian economy, in attempting to and to the extent that it should. achieve higher growth rates (–%) than it has proven capable of over the last four years (%) needs a financial system that mobilises resources more 2. Further Financial System efficiently, and does not waste or divert Liberalisation and Reform scarce financial resources through sub- optimal allocation. The ’s recommendations and sugges- . Financial regime governance needs to tions under this heading fall into four broad change fundamentally across the board categories: (a) financial regime governance if an is to be allowed to emerge in and regulation; (b) the development of ‘miss- Mumbai for two reasons: ing’ or weak markets; (c) the development of * The quality, flexibility, adaptability globally competitive institutions and finan- and ‘lightness-of-touch’ of financial cial firms; and (d) other policies concerning regime governance, is an integral the financial system and ensuring that its feature of a country’s ability to growing need for qualified human capital provide and export successfully are met. and to establish a successful for doing so. The importance 2.1. On Financial Regime Governance of that assertion is brought home and Regulation with particular force when even a . Financial regime governance in India well regulated (by world standards) must now be transformed in the jurisdiction like New York is faced same way that governance of the ‘real’ with becoming less competitive by economy was transformed through the the day in the face of regulatory s to make Indian manufacturing competition from a better, more firms more efficient and globally responsively regulated regime in competitive. Indian financial firms London. By the same token, s and the financial system need to be like Paris, Frankfurt and Tokyo that exposed to the same discipline, in are perceived by global markets as order to adjust in the same way, to over- or unpredictably-regulated, do achieve the same goals. There is not make the frame when it comes an immediate need for the Indian to competing globally. Financial financial system to become more open regulation is not, therefore, a feature and outward-orientated to enhance that can be treated independently its technology, efficiency, productivity, and ‘left alone’ when it comes to competitiveness and quality. Without considering what a new needs such transformation the emergence of a in order to compete effectively in the credible in Mumbai could not be global arena. contemplated. * A financial regulatory regime is . Such a transformation is essential not counterproductive for an , or just to enable the export of from for encouraging the emergence of an in Mumbai. It is essential to a dynamic domestic financial sys- make the entire financial system more tem, if it: (a) is too risk averse; (b) is efficient so that it can provide world- prepared to erect severe roadblocks class financial services to the domestic to ‘financial traffic’ or even stop it market and intermediate financial in order to avoid any probability resources more efficiently for use in of an ‘accident’ occurring; (c) re- the real economy as well. At present the acts negatively to financial innova- Indian consumer of financial services is tion or new proposals for products poorly treated, and served at a higher or services; (d) tends to ban finan- price than his counterpart in more cial products, services, players or developed financial systems. Similarly markets; (e) issues rules that limit 194 R M I F C
the success of products/services even short-comings with suitable reform when they are not banned; (f) dis- of the legal system. If that cannot criminates in its treatment of firms be done relatively quickly then, in the based on their ownership or origin; interim, consideration should be given (g) is protectionist in its rules and by policy-makers to establishing a special regulations and in the manner of system of fast-track ‘financial’ courts their application in practice: i.e., ef- and special arbitration mechanisms fectively or implicitly favouring cer- to deal with the legal and regulatory tain firms while disfavouring others; complexities that an and the (h) discourages – through a policy of provision of will create. This intervention, intrusion and regula- could mean creating an International tory micro-management – voluntary, Financial Services Appellate Tribunal self-induced risk-management, and (IFSAT), covering all parts of finance. corporate governance of high stan- IFSAT should offer a comprehensive dards, on the part of the financial appeals procedure against all actions of firms being regulated; (j) discourages all financial regulators, where judges vibrant competition and financial have specialised financial domain innovation from occurring in the knowledge. The specific measures financial marketplace; and (k) artifi- needed to effect improvements in this cially compartmentalises different area will require scrutiny by other segments of financial markets while experts and specialists before this broad forcing them to remain apart – for recommendation can be translated into regulatory convenience rather than a series of specific actions and remedial market efficiency – thus reducing measures. liquidity and trading opportunity in . To improve the knowledge-base and pro- each segment as well as diminishing fessional competencies that an in arbitrage and risk-transformation Mumbai will need to function and com- opportunities than enable financial pete effectively, the HPEC recommends markets to innovate. that domestic space be opened up with- . But financial system regulation in India out any restrictions (such as insistence (which is of a high technical quality if on domestic partnerships or joint ven- more contentious in terms of its overall tures) to permit immediate entry into orientation, policy and approach) is Mumbai of: (a) well-known global legal not the only issue. Other aspects of firms (corporate or partnerships) that financial regime governance – especially operate in other IFCs and especially the functioning of the legal system – the three GFCs; as well as (b) all global leave much to be desired. They must accounting firms, tax advisory, infor- be improved to increase the prospect mation technology, business consulting of establishing an IFC in Mumbai. and education firms that support the If they are left unattended, some IFS industry. glaring deficiencies in the capacities, . From the ‘wall-chart’ that has been de- knowledge-base, and the administrative rived for this report, to depict illustra- functioning of these critical systems tively the barriers and impediments that for dispute settlement and conflict- operate on Indian financial firms of vari- resolution (especially given the way in ous types, effectively preventing them which civil cases proceed through the from providing to a global clientele, legal system with interminable delays) three sets of issues emerge regarding the will prevent an in India from ever financial sector in India. They include: emerging or competing effectively in the (a) implications for competition pol- global marketplace. icy that governs activity in the financial . HPEC therefore recommends that system; (b) artificially tight compart- urgent action be taken to remedy these mentalisation of financial markets with . The HPEC’s recommendations 195
little ‘crossover’ being permitted across it more dynamic, globally competitive, boundaries; and (c) the impact that both and to let financial firms emerge that these influences have on suppressing are of the right size and scale to take on financial innovation in India. global competition. That is precisely . In each of these areas the HPEC what was done in the industrial sector recommends that policy-makers revisit during the last decade when over one carefully the nature of the financial thousand firms disappeared but were re- regime governance so as to make it placed by fewer but larger, more efficient more competitive, less fragmented, and more competitive industrial firms. and more innovative. Operating . But that also means having the together, these three factors prevent Government prepare an ‘exit strategy’ Indian financial firms from realising the through reduction in its ownership of economies of size, scale and scope they financial firms. As a shareholder it is need to exploit to compete globally. perfectly rational for the government . The HPEC further recommends that to act in this manner to protect its this regime be opened up to permit a shareholding interest and the value of greater degree of competition (domestic its equity stake. But from the viewpoint and foreign) and induce a more rapid of the welfare of the Indian market rate of innovation that will permit economy, and to a lesser extent of Indian finance to catch up with the rest having a credible , that policy is of the world within the next years and counterproductive and myopic. It results operate along global lines thereafter. By in the inefficient use of public resources the same token it recommends that the at a time when greater efficiency is excessive compartmentalisation that demanded to attain and sustain a high has occurred across different financial growth rate. The logic of the argument market segments be reversed. suggests that the state should withdraw gradually, at a pace dictated by realpolitik, . In the view of , the artificial from being a shareholder in any financial barriers that have been erected between firm. different segments of the financial market – i.e., banking, insurance, . By doing so it would avoid the serious capital markets, asset management conflicts of interest. In terms of a activities, and derivative markets – so possible timeline, the HPEC would that they can be regulated separately suggest that the legislature contemplate by different regulators should be a general policy of reducing the state’s dismantled. Whether regulators are present shareholding in all types of separated or not, the financial sector financial firms to below % by end- needs to operate as a seamless whole , below % by end-, and in order to achieve global standards toward a full exit by . If this of market efficiency, competition and trajectory of withdrawal is not put innovation. This may be inconvenient in place the prospects for an for regulators. But, in the view of the in Mumbai emerging as a credible HPEC, regulatory arrangements and and competitive centre in the eyes of architecture should be rearranged to the global financial market will be meet the market’s needs; rather than compromised. having the market rearranged in order . Over the next – years the HPEC to meet the demands of regulatory recommends that the Indian financial convenience. regulatory regime makes a much . In the view of HPEC, artificial obstruc- needed and overdue transition from: tion to greater competition in the fi- (a) a rigid, inflexible and overly- nancial sector now needs to cease.A A few members disagreed with this recommenda- process of ‘creative destruction’ needs to tion. However, this was the majority view and is hence be unleashed in Indian finance to make retained as the position. 196 R M I F C
prescriptive ‘rules-based’ regime under . Finally, in keeping with the recommen- which the regulator and regulated dations made above for improving regu- adopt adversarial and antagonistic latory approaches and practices, there postures vis-a-vis` one another; to may be a corresponding need for an (b) the more flexible and state-of-the- accompanying change in regulatory ar- art ‘principles-based’ regime or PBR chitecture and arrangements governing pioneered in the by the Bank of the financial system as a whole and, less England and embraced and applied importantly, to permit a credible enthusiastically by its supervisory to emerge. Such a change, if made only successor, the . is becoming to satisfy the needs of an , would be more popular around the world. A akin to “a very small tail wagging a very decade’s experience with it in the large dog”. The change has to be made and elsewhere suggests that it is more for the sake of the financial system as effective. The regime is more whole and not just for the sake of hav- open, flexible and user-friendly. It ing an . But, in suggesting this, the does not expect regulators to perceive observes that the interests of the ‘non-compliance’ as the natural default financial system as a whole, and those of setting of regulated firms. It is non- an , happily coincide. adversarial and more co-operative. It . When it comes to reconsidering regula- expects regulated firms not only to obey tory architecture – whose foundations and comply with the letter-of-the-law were set as early as with the original (i.e., what is codified) but also with Act, although many amendments its spirit (i.e., compliance with what have been made since – India has three may be uncodified because it was not options, i.e.,: anticipated, but was intended in any a. Keeping the extant architecture event). For financial firms, is much in place but with improved co- more demanding, since they are required ordination and co-operation to to adhere to the spirit of the law, and reduce regulatory conflict, turf- not just the letter. Such a transition protection, and achieve coherent, will require a major mental adjustment consistent regulation across the on the part of both Indian regulators entire financial system and financial firms for many of which b. Partial consolidation of extant reg- ‘beating-the-rules-of-the-regulator’ has ulators into a tightly knit quartet become an essential game in order to covering: (a) banking; (b) insur- secure marginal competitive advantage ance; (c) pensions; and (d) capital, over rival firms. derivatives and commodities mar- kets. Any area of activity that did not . Adopting practice that is now normal fall neatly or obviously into these in almost all countries, the four categories would be regulated HPEC would recommend that GoI automatically by the capital mar- conducts – using independent, impartial kets regulator. In other words ac- interlocutors, including regulators from tivities such as asset management other s– a periodic (– yearly) and mutual funds would fall under Regulatory Impact Assessment of the the purview of the capital markets financial regulatory regime. The regulator, as would regulation of the would aim to evaluate, using sovereign and corporate bond mar- enhanced cost-benefit methodology, ket. Under such an arrangement, how efficient and cost-effective extant regulators of specific types of institu- regulation (policy, practice, application, tions (e.g., banks or insurance com- and institutional arrangements) is in panies) would not have the right meeting the main regulatory objectives, to regulate other domains/market and to understand what modifications segments (e.g., capital markets) in are needed to improve it. which banks or insurance companies . The HPEC’s recommendations 197
(and/or their subsidiaries/affiliates) the regulatory system’s absorptive might operate. Domain regulation capacity for such change. Such a would be the responsibility of the move may trigger legitimate concerns functional domain regulator regard- about technical and other problems that less of the institution that wanted may be caused by changes in the long- to operate in that domain; whether established operating domains of extant directly or through another corpo- regulatory agencies. But, after careful rate arrangement. The regulatory consideration of all the pros and cons, quartet would be presided over by a policy-makers may still conclude that regulatory co-ordination commit- rapidly changing circumstances – of tee chaired by the regulatory agency the kind that are impelling the next that regulates the largest part of the phase of financial system development financial system. and calling for the creation of an c. Evolve rapidly toward unified regu- in Mumbai – require swift changes in lation with a single regulator for all regulatory architecture. They may wish financial services to avoid problems to expend the political capital needed to of co-ordination or of matters falling move toward more unified regulation between regulatory cracks when reg- now rather than later. In that event, the ulation is more fragmented. would concur with movement toward more rapid reform. But, . The HPEC is mindful that in large whatever is decided by policy-makers federal countries like India and the on reforming regulatory architecture, with a legacy of multiple regulators the would recommend an early, policy-makers must consider the pros if not immediate, migration from and cons of these different options ‘rules-based regulation’ to ‘principles and tread carefully. The evidence based regulation’ even under the extant being generated from the twenty odd architecture. countries that have adopted style unified regulation on a ‘principles-based . As far as financial system regulation platform’ is that it works well. But is concerned two key priorities need many regulators more firmly wedded to to be addressed and enshrined in new tradition argue that one decade is not a legislation: (a) the regulatory approach sufficient period to be conclusive about and mindset adopted; and (b) regulatory its unquestioned superiority. The quality architecture. The present series of of a regulatory system can only be tested disparate legislation governing the when it comes under severe strain. The Indian financial regime needs to be counter-argument is that the model revamped and redrafted into a new actually works toward minimising the Financial Services Modernisation Act risk of such strains appearing in the that embraces a ‘Principles Based first place. Moreover, in an imperfect Regulation’ approach, as articulated world, there may be as many problems in Chapter . with having a regulatory monopoly (the . A key task in reforming regulatory lack of regulatory competition may also architecture is to place all regulatory impede innovative thinking) as with a and supervisory functions connected regulatory oligopoly differentiated by with all organised financial trading activity or market segment. (currencies, bonds, equities, corpo- . For that reason, while conceptually rate bonds, commodity derivatives; attracted to the unified, principles-based whether exchange-traded or OTC) into regulatory approach as the model for the SEBI . This requires collecting together future – i.e., the ideal that India should elements of law that are presently dis- strive for in the long run – the HPEC’s persed across many other acts, including view is that movement in that direction the Act, the (R)A, the Compa- should proceed at a pace that reflects nies Act, etc.. The objectives of , 198 R M I F C
under the new law, should replicate the are ‘missing’ in India’s financial system: objectives and approach of the -. i.e., (i) a properly functioning, liquid This requires closely studying the corporate and sovereign bond market; and the , the and (ii) a spot currency trading market; the regulatory and legal foundations and (iii) a broad derivatives markets used in Ireland. The new law governing that includes exchange traded as well as financial system regulation should ar- tailored derivatives for the management ticulate broad principles, and provide of currency, interest rate, and credit sufficient flexibility for more rapid fi- default risk. nancial innovation. It should embed . These three markets, termed the bond- the distinction between wholesale mar- currency-derivatives (BCD) nexus in kets and retail markets, where a much this report, are inter-woven by currency lighter regulatory touch is applied to and interest rate arbitrage. In an wholesale markets. efficient market, the currency forward . The proposed new Act should also is only a reflection of current and embed a redrafting of the Banking expected interest rate differentials across Regulation Act (BRA), shifting towards currencies. A number of sophisticated principles-based regulation, and giving trading strategies employed by global banks greater flexibility in operations financial firms (using sophisticated and management than is presently the quantitative finance models to drive case. There is considerable merit in algorithmic trading) bind together all merging the new securities law and traded products of the nexus. No the new banking law into a unified can function (or even become an financial sector law (the Financial ) in the absence of any of these Services Modernisation Act), even if markets. If India is to have an the two regulatory agencies continue in Mumbai, the HPEC would place to be distinct. This would underline emphasis on having these ‘missing’ the unity of finance, and increase the BCD markets develop rapidly. extent of coherence found in different . A domestic bond market, in which parts of finance. As an example, the global investors can participate on the creation of the proposed International same basis as in other s, cannot Financial Services Appellate Tribunal operate without having an established () which would provide an INR yield curve that is arbitrage free, appeals procedure covering all aspects of liquid and well-traded along maturities finance is best done within an Act which ranging from the very short (-days) to covers both banking and securities. the very long ( or years). A bond . Finally, when it comes to financial market operating along global lines is regime governance, the believes propelled by the monetary authority that India should immediately open setting the short (base) interest rate up to Direct Market Access (DMA) at which banks can borrow from it. on Indian exchanges to match the The market arbitrage process in a free situation with foreign exchanges in and liquid bond market translates such other IFCs that provide a hospitable base rate changes into changes in long environment for algorithmic trading. rates over different maturities; based That would enable India to compete as on expectations about policy stability, an venue for global firms in this the market view about the monetary important market segment. policy rules in operation, expectations of the future direction of domestic interest 2.2. On ‘Missing Markets’ rates, inflation and external conditions. . As has been elaborated upon at some . In India, the bond market is limited length in the report, an Indian is and stunted. It is a market in which the handicapped by three key markets that monopoly trading platform for bonds is . The HPEC’s recommendations 199
managed and governed by the monetary markets (including those for sovereign authority rather than by a securities debt) under the regulatory purview of exchange. This is a sharp departure the regulator responsible for securities from global practice. The framework trading, ie SEBI; and (b) to ensure that of existing regulations permits neither the platforms for trading all such debt liquidity nor arbitrage. Nor does it have instruments are transferred to the NSE bond issues reflecting a wide spectrum and BSE. of credit risks through the inclusion of . Short selling of bonds is of funda- corporate issuers. The bond market is mental importance for obtaining an dominated by sovereign issues that have arbitrage-free yield curve. This re- no credit risk given the government’s quires the ability to borrow bonds. right to print money in . Moreover, A borrowing mechanism needs to be the market’s institutional structures setup by exchanges, to enable short are weak, participation is artificially selling in government bonds, corpo- constrained by a number of eligibility rate bonds and equities. This needs and origin barriers, speculative price- to be done in an integrated way, for all discovery is lacking because of the three kinds of securities, so as to harness absence of arbitrageurs, option-writers economies of scope and scale. and speculative risk-takers who are barred from operating in this market. . At present bond purchases by FIIs are constrained by quantitative . But a bond market in an Indian restrictions whereas equity purchases are needs to also issue and trade bonds in not. An essential step for increasing the currencies other than the . Indian presence of INR denominated bonds and foreign corporate borrowers may (and the INR yield curve) in global wish to choose, in an Indian (as investment portfolios (e.g., of globally they could in any other ), to issue managed pension funds) is to remove bonds in a wide range of globally traded the existing quantitative restrictions or even exotic currencies to optimise so as to put INR bond purchases by their borrowing costs using derivatives FIIs and other foreign buyers wishing to cover future currency and interest to purchase INR denominated bonds rate risk. They may want to issue a in global markets on a par with their long-term bond in and immediately equity purchases. swap it into another currency with built- . At present, there is a small currency in provisions for a reverse swap when derivatives market and a small interest repayment is due on maturity. At present rate derivatives market where trading of they can do none of these things. primarily vanilla products takes place . The R.H. Patil Committee Report on over-the-counter (). However, domestic debt markets made a number there is a considerable advantage in of far-reaching policy, operational, transparent trading of vanilla products and technical recommendations. In on the exchange platform, particularly the view of , these should be given the dramatic progress of electronic implemented as soon as possible to exchanges and algorithmic trading. make domestic bond markets function Electronic trading and transparency more efficiently and to perform the assist liquidity, and it is easier for important economic role that such India to compete in the global IFS markets play. To the Patil Committee’s market by emphasising order flow many recommendations, and from into electronic exchanges – where the viewpoint of internationalising the objective characteristics of liquidity Indian debt market as a key building matter more than human relationships block for creating a viable in and counterparty risk. Hence, there is a Mumbai, the HPEC would add the need to shift trading in vanilla products need to: (a) bring all securities trading (futures, options, swaps) to exchanges 200 R M I F C
while retaining and expanding the OTC . This wholesale currency spot market trading of transactions for exotic and needs to be accompanied by an tailor-made products. INR cash settled currency derivatives market, offering products such as . Vibrant trading, on exchanges, of inter- currency futures, currency options est rate derivatives is a fundamental part and currency swaps, traded on India’s of the nexus. India’s experience established exchanges. The currency with interest rate futures has been an derivatives market should be open unfortunate one, with banks being pro- to all (including FIIs). It must hibited from participating in the market aspire to replace the trading that except as short sellers of interest rate presently takes place on the - futures. The Ministry of Finance needs market. Regulatory responsibility of the rapidly to take stock of the constraints suggested currency market – spot and that hold back exchange-traded inter- derivatives, exchange and – needs est rate derivatives, including futures, to be shifted to . options and swaps, and obtain the req- uisite modifications of regulations of . Contracts involving the four major insurance companies, banks, mutual globally traded currencies (ie , , funds and FIIs so as to get this critical and ) are well established and component of the BCD nexus off the account for the bulk of global trading ground immediately. in spot and derivatives markets. A number of smaller countries in . By the same token, markets for trading with open capital accounts offer traded global currencies (spot and derivatives) contracts in their own currencies against are the lifeblood of an . Every these four global currencies. The customer buying generates a trading market could be networked series of immediate transactions on into and piggy-back off trades in these the currency spot market and covers markets. An market could quickly exchange risk with currency derivatives. dominate trading in vs. the four That is true whether a global investor global currency contracts. But it should operating in a Mumbai-based seek to also establish a first-mover wants to buy Indian equities, bonds, advantage in trading new contracts index funds, or index derivatives. As involving: (a) the vs. other India’s growth continues over the next tradable but exotic currencies such as decade the will join the global the Australian, Canadian, Hong Kong, club of major currencies. By New Zealand and Singapore dollars, the these will comprise the , , various Scandinavian kroners, and Swiss , , and : the reserve franc; as well as (b) emerging market currencies of the world. That requires currencies (under special arrangements establishing immediately a currency with their central banks) of countries trading exchange in Mumbai, with a with which India is likely to have growing minimum transaction size of INR trade and investment links such as the million (or roughly $ , at Malaysian dollar, the Thai baht, South present exchange rates). Initially, this African rand, the Russian new rouble market should be open to domestic and and the Brazilian real. It could develop foreign financial firms including FIIs; pass-through contracts between the opening to individual traders should and currencies that are loosely be deferred until the INR becomes fully or firmly pegged to the USD (e.g., the convertible. Establishing a wholesale and as well as a range of but fully-fledged currency market will Gulf currencies) but lacking in formal require removing those capital controls arrangements to protect the peg. The that presently disallow financial firms possibilities are limitless and must be from holding multicurrency deposits left to the ingenuity of indigenous and with banks. global market operators and arbitrageurs . The HPEC’s recommendations 201
to develop and exploit. Some contracts when the relative difference in the size will fail to attract trading volumes of their respective home economies is and die a natural death. Others (like smaller, deprives Indian financial firms the / contract) may trade in of the ability to realise greater economies volumes that, in a decade, could rival of scale and competitiveness within their the volumes of traded contracts across internal structures. It reflects the in-built the four global currencies. advantage that foreign financial firms have established in operating globally 2.3. On Weak Institutions in an unfettered manner for several . Side-by-side with weak or missing decades when Indian financial firms markets, the Indian financial system has have been constrained from doing so. a number of weaknesses in the make- International financial firms have a up, diversity, skill sets, competitiveness presence in all aspects of finance, while and size of its financial firms. India’s Indian financial firms are hemmed into equity and limited derivatives markets slots defined by over-compartmentalised are dominated by trading done by financial system architecture. This private firms and s although public increases the risks of Indian financial institutions in the insurance and mutual firms. They have less diversified sources funds industries are also large players in of profit. It results in Indian financial these markets. That bias in institutional firms requiring intermediation spreads structure, in all financial markets other to cover costs that are higher than than the equity market, gives Indian international norms. It disables them financial firms an excessive ‘home bias’ from operating successfully in a global in their operational orientation and marketplace where substantial resources handicaps them from developing global have to be expended to establish a reach beyond the community. globally accepted brand identity, and to invest capital in globally sized operations . That feature also disables Indian for: commercial banking, investment financial firms from competing on banking, securities broking, derivatives level terms with foreign counterparts in trading or insurance. global markets. It will constrain the development of an in Mumbai. For . The same is true of Indian investment example, the ten largest global financial banks. At present, they are anaemic conglomerates (comprising, under a replicas of their global counterparts, single brand umbrella like Citigroup despite their considerable reserves or , subsidiaries or affiliates of human capital and their core that are commercial banks, investment competencies. Earlier a number of banks, insurance companies, securities joint-ventures were created (largely to brokerages, global fund managers, hedge accommodate Indian entry barriers funds and derivatives operations) all at the time) between established and have a balance sheet size exceeding reputable Indian financial houses and $ trillion. The top four or nearly all the major global investment five now have a balance sheet size banks. These joint ventures are now approaching or exceeding $ trillion. coming apart. That raises questions of In India, the largest financial group how the Indian partner ‘divorcees’ from () has a balance sheet size of around these ‘arranged marriages’ will evolve $ billion; or less than a fifth that of in the future. While they may have the its ‘smaller’ foreign counterparts when human capital, they certainly do not yet India is the fourth largest economy in have the size of financial capital they the world in PPP terms and the seventh need. largest in nominal terms. . What is said about commercial and . Such a large relative difference in the investment banks above applies even size of Indian vs. global financial firms, more to the indigenous securities 202 R M I F C
brokerage industry. It is a far cry from dation of Indian firms in the financial achieving the size, efficiency, capability sector to permit – through the uncon- or capital of its foreign equivalents. The strained operation of natural market Indian brokerage industry exhibits many processes – sizeable Indian financial of the same symptoms and malaise as conglomerates to emerge, through ac- India’s retail sector in general. It is quisitions, mergers and (hostile as well dominated by a landscape of ‘mom-and- as amenable) takeovers. The aim should pop’ shops and single proprietorships be to create a few (at least five or six) masquerading as companies. They Indian s– led by the most capable do not have the capital or knowledge and dynamic financial groups in India – required to service their investor-clients the size of whose consolidated balance on a basis that remotely approaches sheets exceeds US$ billion. No fi- global brokerage service standards; nancial firm should be exempt from this although they do provide a limited array consolidation process, regardless of own- of brokerage services at a fraction of ership. Furthermore the consolidation global costs for a securities account. of Indian financial conglomerates should . None of these institutional categories are be facilitated by foreign equity participa- inherently or congenitally weak. Their tion on the part of private equity firms, weakness is derived from a legacy of strategic direct investors, and institu- financial policies and strategies that tional portfolio investors to augment the are proving, in retrospect, to have limitations of Indian capital resources. discouraged emergence of the kind The implementation of this strategy does of institutional base of financial firms not require government or regulatory that India needs to compete in global direction concerning which firm should financial markets. acquire which other firm. It requires re- moving the barriers to reintegration, and . The legacy problem inherited by Indian impediments to market-driven M&A, financial firms, and exacerbated by that are present today. the domination of financial firms in the Indian financial universe, . The end goal should be to have Indian needs to be tackled boldly on two s that span the entire financial simultaneous tracks: (a) first, India spectrum. Until India achieves needs to moderate, and eventually style integration of all finance under dispense with, its legacy of state one regulator, a key tool for achieving ownership in the financial universe; this goal might be the ‘financial holding (b) second, Indian policy-makers and company’ as described in Chapter . regulators need to shift away from the sees the holding company as artificial over-compartmentalisation of the logical organisational structure for sub-markets. Those two propensities Indian financial firms that seek to have inhibited the proper development become global players in the period of these markets. They have also where India uses the proposed four-pillar prevented larger, more capable financial regulatory architecture. A set of policy conglomerates – operating across measures need to be taken to enable this different market segments – from institutional structure to emerge. emerging and competing globally. With . In the specific field of asset management, reintegration across the extant sub- a major organisational innovation to har- sectors of finance, and with barriers to ness scale economies is recommended. expanding into new lines of business At present, banks, insurance companies, being removed, large, sophisticated and mutual funds, pension funds, s, etc. competitive Indian financial firms will all undertake uneconomic asset manage- emerge. ment operations. Each of these opera- . The HPEC believes that the Indian au- tions is small, lacks economies of scale, thorities should support the consoli- and is unable to compete in the global . The HPEC’s recommendations 203
market for asset management. In this sit- India’s progress on this score should uation, the government needs to permit be measured by comparing the Indian the emergence of Wholesale Asset Man- wholesale price for running an index agement businesses, regulated by SEBI, fund for $ billion of the S&P against where the minimum size of customer the wholesale price seen in New York or funds is at least Rs. crores. London. . This initiative should get the benefit of . In addition, Indian authorities should light-touch regulation, given that the bring forward their liberalisation plans protection of retail investors does not for the financial sector (e.g., opening arise as an issue under this arrangement. up to branch banking by foreign banks) All impediments to outsourcing of ahead of the commitments to the asset management by financial firms Agreement on Trade in financial services. in India – banks, insurance companies, In this instance, the believes that mutual funds, pension funds, FIIs, more open foreign entry will be in India’s hedge funds, etc.. – should be identified own self-interest in the short, medium and removed. Once these artificial and long term. barriers to outsourcing are removed, . The protectionist arguments that have each entity – such as a mutual fund – will become so familiar in other sectors – to make a commercial decision on whether give Indian financial firms more time the task of asset management should be to adjust to new global realities – need in-sourced or outsourced to one of the to be re-examined carefully. Indian Wholesale Asset Management firms. financial firms have seen the writing . Given the immense economies of scale on the wall since . It is true that that can be captured by large asset they have not had the freedom and management factories, differentiated flexibility as yet to grow organically and front-end entities – such as mutual diversify as they might have wished. funds, insurance companies, pension envisages convertibility within funds, investment banks – may choose – months. This gives all Indian to outsource their asset management financial firms a window of – functions to such Wholesale Asset months for gearing up to cope with the Managers. This would separate the opportunities and competition that flow front-end interface with a customer – from convertibility. Giving firms more such as a mutual fund, bank, insurance time than that will prolong inefficiency company or pension fund – from the rather than enhance competitiveness. back-end factory undertaking the actual . The Indian financial sector now needs activity of asset management. The front- to open its doors to face the full end financial firms would continue to force of international competition and be regulated by their domain regulator adjust accordingly. As with their while the factory would be regulated counterparts in manufacturing industry by using . Undertaken on some Indian financial firms will perish. a wholesale basis, that is blind to the Others will strengthen to take their sourcing of assets being managed, such place in the world in the same way that asset management factories can achieve the more robust, competitive Indian much lower costs and much larger manufacturing firms are now doing. The economies of scale than the present HPEC sees no convincing argument plethora of fragmented, small asset in favour of delaying this move any management units of disparate financial further. It will enable India to rectify its firms. By pooling assets from all institutional weaknesses and deficiencies parts of the Indian financial system, faster than it otherwise would. There Wholesale Asset Managers could achieve is little point in being cautious simply pricing efficiencies that would make for the sake of caution if, given the them competitive by global standards. balance of probabilities, such caution 204 R M I F C
only ends up in damaging India’s ability % ownership of the same types of to compete effectively in the global institutions. While this will increase the market for by having a less efficient workload and complexity of banking financial system. regulation and supervision, the benefits through increased competition will be . The control of branch licensing for considerable. banks is an anachronism, at a time when India has moved away from the license- . Banking regulation requires strong fea- permit raj in most respects. There tures of market discipline to accompany is no other industry in India, today, the kinds of competition policies de- where firms have to take permission scribed above. This requires that all from the government in order to open banks in India should now raise equity branch offices. Simply because they in the capital market and raise a mini- take deposits does not make bank mum proportion of their liabilities by branches any different from other issuing bonds with no safety net of de- market enterprises. Banks should decide posit insurance. In the context of the where and when they want to open need for additional equity capital on the branches and not the regulator. As part of Indian banks to meet Basel-II part of improving competition policy, requirements, regulators appear to have the opening of branches by domestic been tempted to accommodate high asset banks should now be immediately growth with diluted equity requirements. decontrolled. No domestic bank should This temptation needs to be checked, have to ask the banking regulator for in the interests of controlling the lever- permission for each ATM or branch. age of Indian banks and simultaneously After one year (ie by the beginning of exposing banks to market discipline. ) this policy should be extended to . Finally, the Indian financial market all banks. This will give local banks a should be made fully open to the one-year head start over foreign rivals entry of globally established alternative on opening branches. investment vehicles with a track record as well as to exchange traded funds, ffl . Indian banking is a icted by a weak arbitrage funds and any financial entity pace of entry and exit, reflecting poor of any sort provided it meets the competition. Entry into domestic requisite performance, track record banking has been hampered by over- and ‘fit-and-proper’ tests for entry. prescriptive and asymmetrical rules These tests should not be manipulated about the ownership of banks. Banning to bar or delay entry in practice when banks with ownership patterns that have it has been opened up in principle. close relationships with the owners of Alternative investment vehicles should non-finance companies eases the task of also be enabled on the domestic market. regulators and supervisors. The time has come to remove these restrictions and . In Chapter , Box . showed a permit unrestricted entry by Indian comparison of the charges for trading corporates into banking and all other index futures in Mumbai versus Chicago. financial services. As the Tarapore- Indian exchanges have charges that Committee has pointed out, and the are higher by a multiple of or HPEC concurs, the discriminatory % depending upon the size of the ceiling on investments by corporates customer. The reforms proposed in this in banks is unjustifiable and should report rectify this egregious anomaly be removed immediately. As a through the following measures: member of the observed, in . Eliminating all transactions taxes a market economy there can be no like the and stamp duties; justification for such a restriction when . Subsuming into the on finance another economic agent – i.e., the all service taxes on brokerage and state – can have any level up to refunding the applied to foreign . The HPEC’s recommendations 205
customer transactions (because need to be made simultaneously exports are zero-rated); including inter alia: . Adoption of a approach by • Creating a specialised postgraduate that is likely to reform the programme (M.Sc. in Finance) ad-valorem charge going into the that combines the teaching of ‘Investor Protection Fund’; high-level quantitative economics, . Permitting algorithmic trading, finance, advanced mathematics and and greater global participa- complex modelling, and computer tion by sophisticated traders such science. Such a programme should as alternative investment vehicles to be pioneered in an academic centre increase the number of transactions of excellence close to Mumbai and in India, thus reducing the average should result in a steady stream of charge per transaction; graduates to populate the and . Unifying equity, commodities, cur- replenish its human capital base rencies and interest rates into a sin- regularly. gle exchange industry to open the • For this initiative to have a material possibility for Indian exchanges to impact upon the human capital in trade additional contracts and ob- Mumbai, the size of the program tain economies of scope and scale, should be set at students thus lowering average charge per graduating every year. Once a transaction; major program is established, it is . Global benchmarking: i.e., at likely that other graduate schools present the management teams of of business in India will mimic its Indian exchanges do not compare structure thus further augmenting themselves against the Chicago tariff the supply of numerate staff-persons structure. The situation is like into the emergent . that of Indian steel companies in • Increasing the output of s ma- which thought that the price joring in Finance and Quantitative of Indian steel was distinct from Finance from India’s best postgrad- the world price of steel. If the uate teaching institutions, with a reforms suggested in this report are particular focus on strengthening implemented, global competition the quality of academic staff and the would greater pressure on Indian linkages between their research pro- exchanges in favour of efficiency and gram and the emergent . lower charges, as happened with • Increasing the output of qualified Indian steel companies. professionals and paraprofessionals for the supporting accounting, 2.4. Other Policies and Issues auditing, business-consulting, and affecting the Financial System legal professions to ensure that an and an IFC adequate supply of properly trained . The Indian services industry was and qualified human capital is always based on India’s exploitation of its available in these areas. advantage in ‘purpose-suited’ human capital. That will be equally true of . In the final analysis, it would be a grave India’s entry into the export of IFS error to take an ‘industrial policy’ or through a Mumbai based . But planning approach to the emergence India’s human capital resources and of an IFC in Mumbai. It is tempting their qualifications for this purpose for policy-makers to have a laundry should not be taken for granted. There check-list to guide what specific actions are intense competitive pressures across need to be taken to make an work, all industries to attract these human or to try and ‘pick winners’ in terms resources. Major investments therefore of firms or areas of business to be 206 R M I F C
encouraged by government. Clearly, itiveness in is comparable to the as this report elucidates, a number of task faced in reforms of Indian trade critical issues do need to be resolved and industry in . At the time, key as far as financial regime governance reform initiatives did not consist of in India and urban infrastructure and thinking through all steps from governance in Mumbai are concerned. to . They consisted of introducing But, beyond that, the authorities should new elements of competition into the not attempt to be over-prescriptive. system, after which a continual process . The role of government should be to of learning and policy evolution took set up an enabling framework, and place. rely on two principles: (a) ensuring . In similar fashion, the set of recommen- that the market for IFS provision dations of this report do not claim to in Mumbai works as efficiently as be a fully thought out program of fi- possible; and (b) adopting a policy of nancial sector reform for a multi-year total ‘openness’ in terms of entry into time horizon. However, what is likely to that market by every kind of player be achieved by implementing this pro- that wants to provide any kind of gram of reforms is of unleashing new IFS without being bound by capital forces of competition and outward ori- controls, artificial entry barriers and entation into Indian finance. That pro- restrictive rules. cess would (in turn) have far-reaching . The IFC in Mumbai should evolve consequences; comparable to the re- on its own, based on the drive, moval of industrial licensing and scal- entrepreneurship and innovation of ing back of trade barriers in the early domestic and foreign financial firms s. participating in the export of IFS. . Once these recommendations are im- Clearly such players need to meet plemented, a dynamic of competition the basic ‘fit-and-proper-person’ tests and innovation would come about, of probity, integrity and competence. which would trigger off new learning They need to have an established track and new forces of political economy, record which inspires confidence in their which would then influence the fu- ability to enhance the reputation of ture evolution of financial sector pol- the . In short, the IFC’s destiny icy. However, the immediate prior- should be left to market forces and ity is to implement the recommenda- not be determined by government tions of this report. They constitute a fiat. minimum set of reforms which break . The reason for relying on these free from the present stasis, and un- principles is that it is impossible to leash competition and outward orien- predict how the industry will evolve tation. India has dismantled an au- or what products and services will tarkic license-permit raj in industry appear five or ten years from now, or and trade, and can do it again in fi- who the players will be. Certainly nance. it would have taken an extraordinary insightful if not clairvoyant observer 3. The challenge of urban to predict ten years ago what the infrastructure and industry would be doing today. Government should not attempt to governance in Mumbai go too far beyond that other than . As indicated earlier, the prospects of doing what is needed and what establishing an in Mumbai and en- has already been elaborated upon suring its commercial viability, global earlier. credibility, and operating success, de- . Intuitively, the task of bringing Indian pends as much on financial regime trans- finance up to a level of global compet- formation in India as on how well Mum- . The HPEC’s recommendations 207
bai covers its debilitating infrastructure international agencies) in the recent past. and urban governance deficits. The . In ’s considered view (with many HPEC has more concerns about how members of the Committee having and whether these large urban gover- resided in Mumbai for most of their nance challenges in Mumbai will be lives) the progress that has been made met than it does about achieving the so far has been more rhetorical than necessary transformations in Indian real. The state and civic administrations financial policies and practices to ac- have made numerous statements of commodate an IFC. intent in the past but little progress was made until recently. But the scene . For a Mumbai based to be globally appears to be changing with new vision competitive, on a par with other and drive on the part of the State’s s and the three major s, it Chief Minister to go on a war footing has to have world class infrastructure to improve the urban environment of that meets global standards in the Mumbai. Excellent staff appointments quality of construction, finish and have been made in Mantralaya to drive ongoing maintenance. That applies to: the development of infrastructure in the (a) residential and commercial space; city. The change in the air is palpable. (b) shopping and recreational facilities; While India was progressing rapidly (c) uninterrupted, high quality electric by way of economic growth, Mumbai power supply with minimal fluctuations seemed until last year, paradoxically, to in voltage and current; (d) water be decaying and crumbling at almost supply with minimal fluctuations of the same pace. That obviously could pressure and quality; (e) sewerage not continue. The Chief Minister and and waste disposal as well as storm his dynamic team have done much to drainage and flood control during the change that state of affairs. monsoon season; (f) local gas and utility . If Mumbai is to host an then its distribution; (g) global standards in infrastructure deficiencies need to be all modes of private and public urban resolved quickly – and not through commuter transport – road, rail and arabesques such as the Navi Mumbai water-borne – as well as rapid transport . The HPEC suggests that the links that connect the Mumbai with impressive and laudable combined the rest of India (ie air links involving efforts now being made by central, state airports and airlines as well as high- and civic authorities – along with the speed rail and world class motorways) active support of the private corporate and the rest of the world (mainly air- sector – should be enhanced and linkages); and (h) global standards of supported by multilateral financing telecommunications (landline, cellular institutions and PPP arrangements and broadband) that connect the in every sub-sector of infrastructure. Mumbai around the clock to the The authorities should invite the open world. Apart from coming close on the participation of foreign construction last of these requirements, Mumbai does and development firms alongside their not hit the board on all the others. Indian counterparts to ensure that . All these infrastructural requirements Mumbai’s infrastructure deficit is have been explicated in several forums covered in the next years. If that before with elaborate plans being drawn is not done then the pursuit of an up to meet these challenges by a variety in Mumbai will remain a pipe dream of public and private bodies aiming to that will be impossible to convert into put ‘Mumbai First’. For that reason reality. Locating it in a is not a the has desisted from going too viable option. far down a path trodden too often . In that connection the believes by too many others (a slew of local that state and civic administrations need city committees as well as national to move swiftly but fairly in resolving 208 R M I F C
the outstanding issues posed by the to its citizens and residents. The city and the Rent Control Act needs an administrative apparatus for that are blocking access to pipeline governance that is under the direct funds available from the Centre and control of such a City Manager – with multilateral financing institutions. the support of the state and centre . Apart from the present state of its – and that has its own revenue base physical infrastructure – that makes and financial independence to match. Mumbai remote from being world Mumbai has been a ‘milch cow’ for both class – the city also confronts a serious the Centre and State for some time. It ‘governance deficit’. The reasons for that has got very little back for its own urban are well-known and have been discussed development. That asymmetry needs to ad nauseam in academic circles, the be reversed. media, and in policy-making circles at . Mumbai needs to be seen across India central and state levels of government. and around the world as a welcoming, Given this backdrop, believes cosmopolitan and cultured metropolis that it is time for the talking to stop capable of accommodating a large and the action to start. Mumbai needs number of expatriates. It is only with a City Manager (whether elected or such an ethos that Mumbai can become appointed) who is directly accountable an . . The HPEC’s recommendations 209 > PBR 50% Year FSMA FSMA All < 2011 PSFFS Regular Unified? SEBI 0 by 2015 All 4 SEBI Bill Bill BR Separate Regulator - 3 to global levels s PBR FSMA FSMA PSB –Others OTC 2 Extend to all of finance s in All states RIA Maintain at 10% or more Continue training/updating Implementation Completed Apply Table Table supervised by Reduce to 60% Reduce to 26% Implementation Eliminate Totally PPP Weak 2010 by Quarter Single Regulator? Legal System at Global Standard Phase-4 Complete 1 below 5% BSE / NSE 4 s denominated paper for any buyer 33% Public Debt Managed Independently IRDA - < 3 PSB INR PBR Capital and Current Accounts Fully Open All Global legal firms permitted to operate No further compartmentalisation of finance Phase 3 Phase-3 All financial market trading supervised by 2 All Transactions Taxes, Stamp Duties eliminated s in 15 states Final Draft Final Draft -Cap Markets Pilot Phase All Global Accounting firms permitted to operate Strong All bond trading to be done on market exchanges Wholesale and Retail Markets regulated differently Train All Staff Apply Reduce to 65% Reduce by 75% PPP Widen and deepen sovereign/corporate bond markets Increase to 10% RIA 2009 by Quarter Implement 100% Reduce to Extend to Banking 1 Implementation of Changeover Consolidation to 2? and algorithmic trading to be regulated reasonably DMA 4 s PDMO SD 49% SEBI Currency Market operates on PSFFS - Execute < 3 No further restrictions on PBR Launch range of multi-currency futures, options, swaps for trading Remove all restrictions/bans other than usual prudential regulations for Banks No bans on Continually expand range of products traded on Phase 2 Phase-2 2 s in 10 states RIA Independent Shift Platform Consultations Consultations Apply Open up Entry Open up Entry Shift Platforms Policy Decisions Non-bank Reduce to 70% Reduce by 50% Include banking Eliminate all PPP Execute Transfer Implement 70% 2008 by Quarter Increase to 9.5% Separate Markets Reduce to Preparation Phase Train 65% of staff Consolidation to 4 Insurance/Pensions 1 Reduce to 6%by y.e. Prepare 4 STT Open shift Launch trading 3 Projects Widen Range of Contracts to cover currencies, interest rates, credit default and trade them OTC PPP Phase 1 2 Eliminate Start Phase-1 De facto Open up fully Prelim Drafting Prelim Drafting Increase to 9% Technical Study Technical Study Except Banking Reduce to 75% Prepare Ground Prepare Ground Prepare Ground Prepare Ground Reduce by 25% Implement 40% Build Consensus Pilot 2007 by Quarter Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Technical Studies Train 30% of staff Rules Widen 1 Reduce to 7%by y.e. Prepare s s s s PSB PPP . GFC GFC ) s/ s/ 10 million SEBI IFC ) PBR IFC . INR BSE s). GDP FII and NSE ) giving banks more flexibility ) covering all of finance. s). BRA to 4–5% of SD IFSAT + ) to Principles-Based ( to significantly less. RBR GDP ) from 8 GCFD ) and Stamp Duties ( Report on making Mumbai an International Financial Centre: Timelines for Recommended Actions STT Recommended Actions ratio from 80% of Nexus in Indian Capital Markets: HPEC and algorithmic trading GDP BCD trading of exotic and tailor-made derivatives. denominated debt instruments issued by GoI to All Buyers DMA OTC INR Task Force Report of 2004. FRBM cash settled currency derivatives on exchanges open to all ( to the financial services industry. INR GST should incorporate redrafted Banking Regulation Act ( FSMA Reduce Case Backlog of cases involving financial contract disputes Improve knowledge-skills and training of judges and arbitrators A. Bond Market B. Establish Currency trading exchange withC. a Derivatives minimum Market: transaction Shift size trading of inD. vanilla Retain products and (futures, Expand options, swaps)E. to MoF exchanges to review/remove constraints onF. Create any financial firm operating in derivatives 1. Achieving and maintaining an average2. growth Reduce rate the of gross 9% consolidated to fiscal3. 10% deficit Reduce ( total public debt to 4. Implement the 5. Eliminate Securities Transaction Tax ( 6. Apply 7. Open up purchase of 8. Restructure budgets/‘balance-sheets’ of states and9. metropolitan Shift municipal burden corporations of future infrastructure financing from public to private sector through 10. Set up independent public debt management office (or as second-best11. locateFocus it Monetary in Authority MoF) exclusively on12. singleFull task CAC of to managing be key achieved short-term in ‘base a rate’ time-bound manner within13. theImprove next functioning 18–24 of months Legal System insofar as it affects financial services. 14. Create International Financial Services Appellate15. TribunalPermit ( unrestricted entry of well-known16. globalPermit legal unrestricted firms entry operating of in well-known17. other globalDismantle accounting barriers firms between operating different in financial18. market GoI segments to prepare ‘exit strategy’19. for GoI its to withdrawal reduce from equity the stake20. ownership graduallyShift of in Financial financial all Regulatory firms types Regime of from21. public Rules-Based Conduct sector ( Periodic financial Regulatory firms; Impact esp. Assessments22. of Examine the Carefully financial the regulatory Need regime. for23. changingTrading platform extant for Regulatory sovereign Architecture bonds24. toDraft be new moved Financial to Services exchanges Modernisation ( Act embracing ‘Principles Based Regulation’ 25. Transfer all regulation/supervision of any26. typeDistinguish of between organised wholesale financial and trading retail27. to marketsOpen and up use immediately appropriate to regulation for each 28. Create rapidly the Missing 13B. A. Actions on Fiscal Deficit, Tax and Public Debt Financing/Management Fronts: B. Actions on Monetary Policies and Monetary Management based on Inflation Targeting C. Actions on Financial Regime Governance and Financial System Regulation 13A. 24A. D. Actions on Filling the Gaps in ‘Missing Markets’ 210 R M I F C > Year 2011 -based regulation by Construction PBR 4 Construction s 3 AIV 2 2010 by Quarter 1 Contracts Facility Construction and Operations 4 T&D Line Construction and Operations Power Plant Construction and Operations Contracts Underway and Operating 3 PPP Dispense with all controls except urban planning Indian financial sector open to foreign competition Contracts Let market drivethrough consolidation financial system and segment integration 2 Place City on mainly independent financial footing Implement Rationalisation/Streamlining Programme 2009 by Quarter SEBI Encourage rapid expansion of WAM with Indian financial system fullyto prudential open regulation to and fitness global tests participation subject 1 Place City Administration under full control of City Manager 4 s Tenders Tenders Preparation Contracts Contracts Contracts WAM Launch Encourage M&A 3 Full outsourcing of asset managementin activities India by any financial firm operating All restrictions on branch opening by foreign banks to be removed 2 Remove all restrictions on entry of hedge funds and to increase bandwidth rapidly; introduce greater foreign competition Transition Contracts 2008 by Quarter Normalise rentals 1 Plans and Projects underway to increase and improve water quality FLAG to expand landlines in keeping with demand growth; increase competition , Tenders Tenders Tenders Phased development and expansion of Mumbai’s road transport capacity Remove Restrictions FramingRules of Remove Restrictions 4 Accelerated liberalisation Programme in place Appoint/Elect Agree Fund Sources Set up MSc in Finance and a range of specialised technical training programmes VSNL MTNL All restrictions on branch opening by domestic banks to be removed immediately Restrictions limiting private corporate ownership of banks to 10% to be removed Plans and Projects underway to increase and improve sewerage capacity/treatment Plans and Projects already underway to increase and improve storm/flood drainage s Plans and Projects underway to increase and improve water supply quantity/availability RCA TRAI to hold cellular operators to service quality commitments to upgrade continuously / PPP 3 Actions already taken for Santa Cruz and Sahar. New plans for Navi Mumbai airport and runways ULCRA Capacity building by Indian firms 2 Develop Studies Studies Technical Feasibility Studies Technical Feasibility Studies Feasibility Drop 2007 by Quarter Technical Studies Technical Study Technical Study Technical Studies Prepare Groundwork Prepare Groundwork Organisation Study 1 Study Options Agree- WTO (minimum account Rs.10 crores) SEBI s ] PPP 365) × ] ] 7 PPP ] × PPP PPP Report on making Mumbai an International Financial Centre: Timelines for Recommended Actions s ] (24 s ] s to emerge, through M&A and takeovers. PPP PPP LCFI Recommended Actions HPEC s, hedge funds, etc. FII s for Power Infrastructure: PPP ment on Trade in Financial Services. A. Intra-city roads and arterial routesB. [ Coastal Highways and Expressways [ C. Suburban Railways and new MetroD. System Water-borne [ Transport – Ferries/Hydrofoils/Jetfoils [ E. Increase/upgrade airport and runway capacities A. Increase in Power Generation Capacity B. Increase in Transmission/Distribution Capacity A. Increase in Storage Capacity andB. Pipelines Increase [ in Filtration and WaterC. Quality Upgrading/Expansion [ of Sewerage Capacity D. Upgrading of Storm and Flood Drainage A. Substantial Expansion of Cellular Network B. Expansion of Landlines and Broadband C. Expansion of International Bandwidth mutual funds, pension funds, E. Actions to Strengthen Institutions operating in29. IndianGoI Financial to Markets support emergence of Indian 30. GoI to permit Wholesale Asset Management regulated31. by Remove all impediments to outsourcing of asset32. GoI management to by bring forward banks, liberalisation insurance of financial companies, sector in33. keeping Interim with adjustment commitments period to of two34. yearsOpening for of Indian branches institutions by to domestic35. adapt banks Opening to to of global be branches competition. decontrolled by immediately. foreign36. banksRemove to immediately be all decontrolled restrictions after limiting37. one corporateOpen year ownership up of Indian banks capital to markets38. 10% to Set entry up range of of hedge programmes funds forF. development and Actions of alternative to specialised Improve investment human capital Infrastructure vehicles for in the39. Mumbai financialTransport industry Infrastructure: 40. 41. Water Supply, Sewerage& Drainage: 42. Increase Waste Disposal Capacity: For43. solidTelecommunications Infrastructure: and liquid waste with environmental protection 44. Accommodation: Residential, Office and Commercial G. Actions to Improve Urban Governance45. in GoM Mumbai and BMC to appoint or46. arrange Bring to the elect existing a city City governance Manager machinery accountable47. under for Establish the Mumbai independent full financial control base of for48. the the Rationalise City city and Manager that streamline is to under organisation the structure control and of lines the of City responsibility Manager in city management Selected Bibliography
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The Committee
The members of the Committee and its This report reflects their personal expertise Terms of Reference are as follows: and judgement about the best strategy for India in modernising finance and achieving an ; it does not reflect the views of the A p p e n d i x Members: organisations they represent. (i) Mr. Percy S. Mistry, Chairman, Oxford International Group, Chairman Terms of Reference of the Commitee (resigned as Chairman of w.e.f. In the recent decade, India has made //) significant strides in the financial sector. A (ii) Mr. M. Balachandran, , Bank of Some of the important developments India are strengthening of banks, de-regulation (iii) Mr. Aditya Puri, , Bank of interest rates and sector competition (iv) Mr. K.V. Kamath, & , in the banking system, development of Bank the government securities market, and infrastructure for trading, particularly on (v) Mr. C.B. Bhave, , the equity market, with the move to (vi) Mr. Ravi Narain, , National Stock electronic trading, novation at the clearing Exchange corporation, T + 2 rolling settlement, (vii) Mr. Bharat Doshi, , Mahindra & dematerialised settlement, demutualisation Mahindra of stock exchanges and derivatives trading. (viii) Dr. P.J. Nayak, , Bank This raises questions about how Mumbai (ix) Shri T.T. Srinivasaraghavan, , Sun- can play a bigger role in the global market daram Finance for financial services. Our current policy on capital account convertibility constrains the (x) Shri Mohan Raj, , Mutual Fund emergence of Mumbai as a financial centre. (xi) Mr. Nimesh Kampani-Chairman, JM There is, however, a need to look ahead and Morgan Stanley prepare for the emergent role of Mumbai (xii) Mr. O. P. Bhatt, Chairman, State Bank of as a regional/international financial centre, India (Mr. A.K. Purwar, Chairman, so that our institutions get integrated with was a member of till // global institutions and economies in terms and Mr. Bhatt, Chairman, from of provision of financial services. // till the submission of the The committee will look into and make report.) recommendations on the following issues: (xiii) Ms. Usha Narayanan, , Securities and (i) Review the functioning of and develop- Exchange Board of India ments related to international/offshore (xiv) Mr. Subodh Kumar, Principal Secretary financial centres and current trends in (Finance), Government of Maharashtra regard to establishment of new centres; (Mr. O.P. Gahrotra, Additional Chief (ii) Identify the characteristics of a regional Secretary (Finance) was a member of financial centre (), and the current till // and Mr. Subodh state of Mumbai as a national financial Kumar, Principal Secretary (Finance) centre; from // till the submission of the report.) (iii) Review the existing legal, regulatory, taxation and accounting framework (xv) Dr. K P Krishnan, Convenor-Joint related to financial services in India, Secretary (Capital Markets), , GoI. identify the extant policy and regulatory (xvi) Representatives of participated in restrictions constraining the emergence some of the meetings as invitees. of Mumbai as an and the changes 220 R M I F C
therein necessary for enabling and (vii) Identify and evaluate the considerations facilitating the function of such a centre; that should govern the development (iv) Identify the measures that would need of the institutional framework for to be adopted for Mumbai to transform such a centre in India in the light of itself from being a national financial international experience, issues in the centre to an in each of the financial management of the capital account sub-sectors e.g., the equity, bond, forex in India and international financial and commodity markets; integration of the Indian economy consistent with the framework; (v) Examine the nature of financial services and that could be permitted to be undertaken in the in Mumbai, the desirable In light of the above, recommend sequencing of permitting such services a phased action plan, including specific and the appropriate regulatory frame- actions required by different agencies work therefore, in each of the financial covering institutions, infrastructure, legal, sub-sectors aforesaid, including the al- taxation issues etc. for the development of location of regulatory responsibilities Mumbai as an . amongst different financial sector regu- lators, consistent with the progress made in achieving full capital account convert- Team of consultants ibility; The committee was supported by a team (vi) Make an assessment of the risks and of consultants comprising Ritu Anand benefits inherent in such a centre and the (), Saugata Bhattacharya ( Bank), safeguards that would need to be built Kshama Fernandes (Goa Institute of Man- into the policy framework, alongwith the agement), S. Ravindranath (Bank of India), scope and structure desirable for such a and Ajay Shah. centre; Comparing existing IFCs A p p e n d i x against Mumbai
Attributes, Characteristics and Capabilities of an IFC :(Scale of London New York Tokyo SingaporeB Frankfurt Mumbai 0–10 with 0 = worst 10 = best)
A. Demand Factors for IFS A1. National (Domestic) demand for IFS 10 10 10 4 10 10 A2. Demand for IFS from Regional clients 10 10 3 9 7 1 A3. Demand for IFS from Global clients 10 10 3 5 3 0
B. Supply Factors for IFS: Markets, Products & Services B1. Full Array of international banking services for corporates and 9 9 9 10 6 5 individuals B2. Full Array of international capital markets, products and services 10 10 7 8 5 3 B3. Full Array of risk management services 10 10 5 7 6 2 B4. Full Array of insurance and reinsurance services 10 10 7 5 8 1 B5. Full Array of commodities markets, trading and hedging services 9 9 5 5 4 1 B6. Full Array of business support services for IFS (accounting, legal, 10 10 8 10 8 5 IT support)
C. Institution/Market Endowments enabling range of IFS product/service offerings: C1. Range, width, depth of international commercial banks 10 7 5 8 6 2 represented in the IFC C2. Range of global, regional and national investment banks 10 10 8 9 7 2 represented in the IFC C3. Range of global, regional and national insurance companies 10 9 8 6 8 2 represented C4. Existence of wide and deep reinsurance markets 10 9 8 6 9 1 C5. Existence of global, regional, national equity markets (i.e. 10 10 9 8 6 4 exchanges & support) C6. Existence of wide and deep bond markets for government, 10 10 9 5 9 1 corporate, other bonds C7. Existence of wide, deep and liquid derivatives markets for: Equities and indexes 10 10 6 7 6 5 Interest rates 10 10 8 7 7 1 Currencies 10 10 7 8 8 1 Commodities 10 8 7 5 8 3 C8. Innovative Abilities of Institutions and Markets 10 10 5 6 4 5
D. Services Offered D1. Fund Raising, Wholesale and Corporate Banking 10 10 8 7 7 5 D2. Asset Management 10 10 8 9 6 4 D3. Private Banking & Wealth Management 10 7 5 7 5 2 D4. Global Tax Optimisation & Management 6 5 3 8 4 1 D5. Corporate Treasury Management 10 10 9 8 8 4 D6. Risk Management 10 10 7 7 6 2 D7. Mergers & Acquisitions: (national, regional, global) 10 10 6 5 5 3 D8. Financial Engineering for Large Complex Project and PPP 10 10 8 7 6 3 Financing D9. Leasing & Structured Financing of Mobile Capital Assets (ships, 10 10 9 9 10 2 planes etc.) 222 R M I F C
Attributes, Characteristics and Capabilities of an IFC :(Scale of London New York Tokyo Singapore Frankfurt Mumbai 0–10 with 0 = worst 10 = best)
E. Quality & Impact of Financial System Regulatory Regime 10 7 6 7 5 3 E1. Ensuring Systemic Stability 10 9 8 8 8 7 E2. Protecting Integrity & Soundness of Financial Institutions 9 9 9 9 8 6 E3. Capacity to Cope with Market & Institutional failures 10 9 8 8 7 7 E4. Sound risk based management at all levels: systemic, market, 10 10 8 8 8 6 institutional E5. Effective (vs. intended but ineffectual) Consumer Protection 8 7 7 8 9 5 E6. Encouraging full and effective competition across institu- 10 6 5 7 5 2 tions/segments E7. Ensuring level playing field for all players in all market segments 9 7 5 7 6 2 E8. Extent of Protectionism embedded in regulatory system 9 6 5 5 4 1 E9. Avoidance of conflicts-of-interest 8 7 5 6 5 1 E10. Impact on Financial Innovation 10 10 5 5 4 1 E11. Extent of Intrusiveness and micro-management of mar- 10 8 7 6 5 1 kets/institutions E12. Principles-based, open, market-friendly and competition inducing 10 7 7 6 6 1 E13. Conducive to efficient and effective resource mobilisation and 8 7 6 7 6 2 allocation
F. Quality, Efficiency, Effectiveness and Supportiveness of Judicial/Legal Systems F1. Knowledge capacity in dealing with complex financial contracts, 8 9 6 6 5 instruments, etc. F2. Efficiency of judicial/legal system (i.e. time for dispute resolution) 7 8 7 9 6 F3. Effectiveness of judicial/legal systems – enforcement and rule of 7 8 7 8 6 law F4. Fairness, Impartiality, Credibility, Lack of Corruption in civil justice 7 7 9 10 8 system F5. Human & Institutional Capacity and Quality of the Judicial/Legal 7 8 7 8 7 System F6. Adherence to global benchmarks and standards of best practice 8 8 6 7 6 F7. Use of national law in national, regional and global contracts 8 9 3 5 4
G. Governance Issues Affecting Operations/Credibility of the IFC G1. Quality and Credibility of National Governance (Legislature & 7 6 7 10 6 3 Government) G2. Quality and Credibility of State/Provincial Governance 8 9 8 10 8 1 G3. Quality and Credibility of Local/Municipal Governance 8 8 9 10 8 0 G4. Influence of Politics in diminishing Governance Quality: National/Federal 6 6 8 10 8 2 State/Provincial 6 8 8 10 7 1 Local/Municipal 8 8 8 10 7 0 G5. Quality, Capacity, Efficiency, Effectiveness of Administration: National 6 7 8 10 7 4 State 6 8 8 10 7 2 Municipal 8 9 9 10 7 1 G6. Role of Checks & Balances (NGO oversight, media freedom, civic 8 9 5 2 7 2 action etc.) B. Comparing existing IFCs against Mumbai 223
Attributes, Characteristics and Capabilities of an IFC :(Scale of London New York Tokyo Singapore Frankfurt Mumbai 0–10 with 0 = worst 10 = best)
H. Quality & Capacity of Business Support Services to Sustain an IFC H1. Quality, reputation and presence of International Account- 9 9 8 9 9 6 ing/Audit Firms H2. Quality, reputation and presence of International Law Firms 9 10 6 7 6 2 H3. Quality, reputation and presence of International Business 10 10 8 9 7 4 Consulting Firms H4. Quality and competitiveness of IT, BPO, KPO support systems 6 6 4 5 4 9
J. Human Capital Support for the IFS Industry J1. Quality, availability and cost of Finance Industry professionals: Strategic/Exec10 10 5 6 4 3 Management (all functions) 7 8 5 6 4 4 Trading & Dealing 9 9 6 8 6 4 Financial Analysis & Research 7 9 5 6 5 8 Compliance Specialists 8 7 6 9 8 4 Back-Office Functions/Support 6 7 4 5 4 9
J2. Presence/Quality of Post-Graduate Teaching/Research Institutions 6 10 4 3 3 2 in Finance J3. Local Pool/Network of globally experienced finance professionals 10 8 4 7 4 2 J4. Local presence of Global HR Recruitment/Consulting/Training 10 10 6 8 5 2 Firms J5. Ease of entry, exit and overall mobility of global finance 8 7 3 7 4 2 professionals at all levels
K. Quality of Physical & Social Infrastructure & Living Environment K1. Quality/Availability/Cost of Basic Core infrastructure: Power 9 9 10 10 10 4 Water 9 9 10 10 10 4 Telecommunications 9 10 10 10 9 6 Transport 5 6 7 8 8 2 Residential Space 7 5 5 7 8 3 Office/Commercial 9 9 10 10 10 3 K2. Leisure, Entertainment, Global Cultural, Recreational and Food 10 10 3 4 6 2 Facilities K3. Use of English as the default international language at work and 10 10 2 9 5 7 at leisure K4. Use of English as the default international language for financial 10 10 5 10 6 9 contracts K5. Availability, Accessibility, Cost of healthcare and education (global 5 5 6 8 8 3 standards) K6. Availability, Accessibility, Cost of personal and domestic services 3 3 1 5 1 9
L. Capital Account Convertibility 10 10 10 10 10 3
M. Overall Score/Rating 9.5 9 6 7.5 5.5 2.5 224 R M I F C
Attributes, Characteristics and Capabilities of an IFC :(Scale of London New York Tokyo Singapore Frankfurt Mumbai 0–10 with 0 = worst 10 = best)
N. Taxation Issues as they affect the attractiveness of an IFC N1. Taxation of Resident Individuals working in the IFC 5 4 3 5 2 5 N2. Taxation of Non-resident Individuals working in an IFC 7 5 5 6 3 6 N3. Taxation of Resident Companies 4 4 3 5 2 5 N4. Taxation of Non-resident companies 7 5 5 8 4 5 N5. Withholding Taxes levied on financial instruments/transactions. 4 3 3 5 3 5 N6. Transactions Taxes on Financial Transactions – Domestic 6 7 4 7 4 1 N7. Transactions Taxes on Financial Transactions – IFS 7 6 6 8 5 ? N8. Provisions for IBC or GBC licensing (e.g., Delaware type) 6 8 2 8 2 0 N9. Taxation of IBC/GBC companies 6 6 5 8 2 0 N10. Overall Taxation Environment 5 5 4 7 2 5 N11. Complexity of Tax Laws, Codes, Rules, Regulations 4 3 4 7 3 1 N12. Effectiveness, Efficiency, Fairness and Corruption in Tax 9 7 8 9 9 3 Administration Comparing emerging IFCs A p p e n d i x against Mumbai C Attributes, Characteristics and Capabilities of an IFC :(Scale of Mumbai Hong Kong Labuan Seoul Sydney Dubai 0–10 with 0 = worst 10 = best)
A. Demand Factors for IFS A1. National (Domestic) demand for IFS 10 4 2 7 6 2 A2. Demand for IFS from Regional clients 1 7 5 2 3 9 A3. Demand for IFS from Global clients 0 2 2 2 3 5
B. Supply Factors for IFS: Markets, Products & Services B1. Full Array of international banking services for corporates and 5 7 4 6 7 6 individuals B2. Full Array of international capital markets, products and services 3 6 2 5 7 5 B3. Full Array of risk management services 2 5 2 5 6 5 B4. Full Array of insurance and reinsurance services 1 5 0 3 5 2 B5. Full Array of commodities markets, trading and hedging services 1 6 2 5 6 2 B6. Full Array of business support services for IFS (accounting, legal, 5 8 5 5 8 6 IT support)
C. Institution/Market Endowments enabling range of IFS product/service offerings: C1. Range, width, depth of international commercial banks 2 7 5 5 7 4 represented in the IFC C2. Range of global, regional and national investment banks 2 6 1 3 6 4 represented in the IFC C3. Range of global, regional and national insurance companies 2 6 1 5 6 3 represented C4. Existence of wide and deep reinsurance markets 1 3 0 3 4 1 C5. Existence of global, regional, national equity markets (i.e., 4 5 2 4 5 2 exchanges & support) C6. Existence of wide and deep bond markets for government, 1 1 0 4 7 0 corporate, other bonds C7. Existence of wide, deep and liquid derivatives markets for: Equities and indexes 5 5 1 5 6 2 Interest rates 1 3 0 4 7 1 Currencies 1 7 2 6 8 5 Commodities 3 5 0 4 6 3 C8. Innovative Abilities of Institutions and Markets 5 5 1 4 7 5
D. Services Offered D1. Fund Raising, Wholesale and Corporate Banking 5 7 3 7 7 5 D2. Asset Management 4 9 4 6 6 8 D3. Private Banking & Wealth Management 2 9 6 4 5 9 D4. Global Tax Optimisation & Management 1 9 7 4 4 9 D5. Corporate Treasury Management 4 7 2 7 8 7 D6. Risk Management 2 6 1 4 6 3 D7. Mergers & Acquisitions: (national, regional, global) 3 5 0 5 5 4 D8. Financial Engineering for Large Complex Project and PPP 3 5 1 7 6 5 Financing D9. Leasing & Structured Financing of Mobile Capital Assets (ships, 2 9 5 5 5 7 planes etc.) 226 R M I F C
Attributes, Characteristics and Capabilities of an IFC :(Scale of Mumbai Hong Kong Labuan Seoul Sydney Dubai 0–10 with 0 = worst 10 = best)
E. Quality & Impact of Financial System Regulatory Regime 3 8 4 6 7 7 E1. Ensuring Systemic Stability 7 7 3 7 8 5 E2. Protecting Integrity & Soundness of Financial Institutions 6 7 5 7 8 6 E3. Capacity to Cope with Market & Institutional failures 7 9 3 7 8 6 E4. Sound risk based management at all levels: systemic, market, 6 7 5 7 8 5 institutional E5. Effective (vs. intended but ineffectual) Consumer Protection 5 6 4 7 8 5 E6. Encouraging full and effective competition across institu- 2 8 5 7 8 9 tions/segments E7. Ensuring level playing field for all players in all market segments 2 8 4 5 6 8 E8. Extent of Protectionism embedded in regulatory system 1 7 5 5 7 8 E9. Avoidance of conflicts-of-interest 1 6 4 5 8 4 E10. Impact on Financial Innovation 1 7 2 5 7 5 E11. Extent of Intrusiveness and micro-management of mar- 1 8 5 5 7 5 kets/institutions E12. Principles-based, open, market-friendly and competition inducing 1 7 2 5 6 8 E13. Conducive to efficient and effective resource mobilisation and 2 7 3 6 6 5 allocation
F. Quality, Efficiency, Effectiveness and Supportiveness of Judicial/Legal Systems F1. Knowledge capacity in dealing with complex financial contracts, 8 4 5 7 6 instruments, etc. F2. Efficiency of judicial/legal system (i.e., time for dispute resolution) 8 5 6 7 10 F3. Effectiveness of judicial/legal systems – enforcement and rule of 7 5 6 8 5 law F4. Fairness, Impartiality, Credibility, Lack of Corruption in civil justice 7 5 6 9 5 system F5. Human & Institutional Capacity and Quality of the Judicial/Legal 6 5 6 8 5 System F6. Adherence to global benchmarks and standards of best practice 8 6 7 8 7 F7. Use of national vs. UK/US law in national, regional and global 6 6 5 6 9 contracts
G. Governance Issues Affecting Operations/Credibility of the IFC G1. Quality and Credibility of National Governance (Legislature & 3 3 6 6 7 7 Government) G2. Quality and Credibility of State/Provincial Governance 1 5 6 7 8 7 G3. Quality and Credibility of Local/Municipal Governance 0 6 6 7 8 9 G4. Influence of Politics in diminishing Governance Quality: National/Federal 2 5 5 5 8 8 State/Provincial 1 6 5 5 7 8 Local/Municipal 0 7 6 7 8 10 G5. Quality, Capacity, Efficiency, Effectiveness of Administration: National 4 5 5 6 8 8 State 2 6 5 6 8 8 Municipal 1 7 6 7 8 8 G6. Role of Checks & Balances (NGO oversight, media freedom, civic 2 4 3 4 6 0 action etc.) C. Comparing emerging IFCs against Mumbai 227
Attributes, Characteristics and Capabilities of an IFC :(Scale of Mumbai Hong Kong Labuan Seoul Sydney Dubai 0–10 with 0 = worst 10 = best)
H. Quality & Capacity of Business Support Services to Sustain an IFC H1. Quality, reputation and presence of International Account- 6 8 5 7 9 6 ing/Audit Firms H2. Quality, reputation and presence of International Law Firms 2 8 5 5 8 5 H3. Quality, reputation and presence of International Business 4 7 4 6 8 6 Consulting Firms H4. Quality and competitiveness of IT, BPO, KPO support systems 9 5 3 5 5 6
J. Human Capital Support for the IFS Industry J1. Quality, availability and cost of Finance Industry professionals: Strategic/Executive/Conceptual 3 6 4 5 7 6 Management (all functions) 4 7 5 6 7 6 Trading & Dealing 4 7 3 6 7 5 Financial Analysis & Research 8 7 3 6 7 6 Compliance Specialists 4 5 3 6 8 6 Back-Office Functions/Support 9 7 6 6 4 6
J2. Presence/Quality of Post-Graduate Teaching/Research Institutions 2 3 0 3 5 0 in Finance J3. Local Pool/Network of globally experienced finance professionals 2 5 2 5 7 5 J4. Local presence of Global HR Recruitment/Consulting/Training 2 5 3 5 7 5 Firms J5. Ease of entry, exit and overall mobility of global finance 2 6 4 3 6 8 professionals at all levels
K. Quality of Physical & Social Infrastructure & Living Environment K1. Quality/Availability/Cost of Basic Core infrastructure: Power 9 9 10 10 10 Water 4 9 9 10 10 8 Telecommunications 6 10 10 10 10 10 Transport 2 6 8 8 8 5 Residential Space 3 7 8 8 8 7 Office/Commercial 3 9 8 9 9 10 K2. Global Leisure, Entertainment, Cultural, Recreational and Food 2 4 3 3 7 5 Facilities K3. Use of English as the default international language at work and 7 5 5 3 10 6 at leisure K4. Use of English as the default international language for financial 9 10 10 5 10 10 contracts K5. Availability, Accessibility, Cost of healthcare and education (global 3 6 7 7 8 6 standards) K6. Availability, Accessibility, Cost of personal and domestic services 9 6 7 4 2 9
L. Capital Account Convertibility 3 10 7 10 10 10
M. Overall Score/Rating 2.5 6.5 3 5 7 6 228 R M I F C
Attributes, Characteristics and Capabilities of an IFC :(Scale of Mumbai Hong Kong Labuan Seoul Sydney Dubai 0–10 with 0 = worst 10 = best)
N. Taxation Issues as they affect the attractiveness of an IFC N1. Taxation of Resident Individuals working in the IFC 5 8 5 4 4 10 N2. Taxation of Non-resident Individuals working in an IFC 6 10 10 7 7 10 N3. Taxation of Resident Companies 5 8 6 5 4 10 N4. Taxation of Non-resident companies 5 10 9 8 5 10 N5. Withholding Taxes levied on financial instruments/transactions. 5 10 9 5 5 10 N6. Transactions Taxes on Financial Transactions – Domestic 1 10 5 5 2 10 N7. Transactions Taxes on Financial Transactions – IFS ? 10 9 8 6 10 N8. Provisions for IBC or GBC licensing (e.g., Delaware type) 0 9 9 5 3 10 N9. Taxation of IBC/GBC companies 0 9 8 6 5 10 N10. Overall Taxation Environment 5 8 7 6 5 10 N11. Complexity of Tax Laws, Codes, Rules, Regulations 1 8 7 5 4 9 N12. Overall Effectiveness, Efficiency, Fairness and Corruption in Tax 2 8 7 6 8 9 Revenue Administration Chronology of events associated with the effort by Benchmark Asset Management Company (BAMC) to start an Exchange Traded Fund (ETF) on Gold
• May Draft offer document of Gold • Sep Presentation made to filed by with . stating that the Scheme would not • May Copy of offer document sent amount to forward trading in gold. to for information. • October again wrote to A p p e n d i x explaining the mechanism and how • May raised first list of the Scheme will help meet objectives of queries, and asked to incorporate Gold Deposit Scheme. the features of Gold Deposit Scheme in the offer document. Meanwhile, • October replied to D informally advised to seek stating that primary gold cannot be specific approval of . deposited by Authorised Participants under Gold deposit scheme. It also • June wrote to seeking advised to satisfy before clarification on Gold Deposit Scheme launching the product. for inclusion in offer document. • October informed • June asked for a detailed that it planned to launch the Scheme mechanism including investment and under existing Gold Deposit Scheme settlement process envisaged under Gold guidelines and that it will accept gold . from s as per existing Gold Deposit • July A detailed note was submitted guidelines. to . • November responded to a • July to September, Several meetings request with information about took place between , and the proposed method for valuation of to sort out issues relating to Gold s issued by banks under Gold Deposit . asked for comments Scheme. from . • November informed • September Fresh offer document and that the Scheme is violative of was filed with incorporating the Forward Contracts (Regulation) Act. observations made by vide its letter • December called a meeting dated May , . However had of bankers interested in Gold . still not replied. Bank and Bank of Nova Scotia 230 R M I F C
attended the meeting in ’s office • st week May forwarded and reaffirmed their commitment to this letter to for their enabling the Gold . comments and action. • nd week December wrote to • th week August Presentation made asking its views on Gold and by to (), Ministry of whether s issued under Gold Deposit Finance. scheme are money market instruments. • th week September Presentation • January obtained a made by to and legal opinion from Dave, Girish & . Co. stating that Gold does not • th week October Presentation made amount to spot trading in gold and by to Member, . the Scheme is not violative of Forward • nd week December Presentation Contract Regulations. forwarded made by to Monetary Policy this opinion to , and . Department of . was to Subsequently, lifted the ban on prepare a note and forward the same to forward trading in gold, so in any case, /. ’s objection became irrelevant. • All of Silence. • st week February wrote to stating that should decide • February Finance Minister whether a Gold was a “money market announced in his budget speech that instrument”, and that the Gold gold s would come about in India. structure had not been envisaged by • March–April constituted a RBI when the Gold Deposit Scheme was committee to write down rules about launched. Gold s. • February modified the • December Board approves Scheme stating that deposit of gold amendment to Act for permitting under Gold Deposit scheme will not launch of gold s. be restricted to s and will be open to • April announced valuation all. Moerever any party would be able to guidelines for gold s. deposit gold in a form acceptable under • May filed fresh offer Gold Deposit Scheme. document with which was • nd week April again wrote consistent with the committee report. to asking whether this modified Scheme is acceptable to . Activities of various financial firms in the areas of
operation at an IFC: A p p e n d i x Wall chart
In Chapter , we looked at the various activities that take place in an . We discussed in E details the products and services that s like London and New York provide. If the goal is to make Mumbai an in the true sense, we would need to put in place the infrastructure, both institutional and regulatory that would enable entities to engage in providing and availing these products and services. In the process of creation of an , the adequacy of regulatory infrastructure needs to be evaluated, to get a sense of what needs to be put in place for progressing towards being a full-fledged . We study the regulatory impediments that exist and prevent banks, asset managers and securities exchanges from offering/availing these products and services in the area of fund raising, asset management, personal wealth management, global tax management, risk management, financial markets, mergers and acquisitions, leasing/structured finance, project finance, and insurance and reinsurance.
1. Fund raising An provides a platform for entities to raise large amounts of funds on a global scale. Funds could be raised via equity, debt or composite structures across various maturity and currency spectra. We look at the impediments on fund raising by various entitites in India.
1.1. Fund raising and commercial banks Commercial banks are permitted to do the following:
. Raise equity in India or abroad for their own capital base. However banks have problems since GOI does not allow their own share to drop below %. Raising equity abroad is a problem because of government restriction on foreign ownership and on the voting rights of foreigners. . Give lending to specialised finance companies involved in the equity market such as investment banks, exchanges, securities firms, asset managers and hedge funds subject to prudent limits. However these banks are not permitted to lend to the above entitities in foreign currency. Nor are they allowed to invest by way of equity into these specialised finance firms.
However they face various regulatory impediments in terms of providing products and services in fund raising:
. Inability to provide equity funding to corporate customers in India or abroad. . Inability to invest or foreign equity to specialised finance companies involved in the equity market such as investment banks, exchanges, securities firms, asset managers and hedge funds. . Inability to trade on domestic and foreign equity markets. . Inability to setup hedge funds or any type of money management firms. . Lack of identical policy/regulatory treatment for “local” versus “foreign” firms. 232 R M I F C
. Lack of identical policy/regulatory treatment for lending through loans versus corporate bonds. . Lack of identical policy/regulatory treatment for a domestic borrower as opposed to a foreign borrower, across currencies of denomination of lending. . Absence of a sound legal framework governing bankruptcy, with a well–developed “bankruptcy code” with adequate supporting institutions. . Absence of a legal framework which makes it possible to exactly codify the seniority associated with a given loan/bond. . Absence of regulations which enable equity capital requirements for credit portfolio to be based on the portfolio risk after all credit derivatives and other derivatives are taken into account. . Lack of access to liquid and risk-manageable and foreign loan and bond markets. . Absence of prudent limits for the and foreign debt financing based on credit risk of both borrower and lender. . Inability to engage in syndication, securitisation, cash-flow stripping, trading in loans, between a full range of finance companies and third parties. . Inability to provide holistic /forex financial structure to corporate clients comprising packages of equity, debt, convertibles, options, swaptions, caps, collars. . Inability to finance convertible instruments in or forex, either up-front or in “workouts”. . Inability to exercise conversion options in or forex (issues of price, period, post- conversion ownership structure, ownership concentration, foreign ownership). . Absence of legal/regulatory framework that permits the handling of workouts that may involve debt conversion into various kinds of equity or quasi-equity.
1.2. Fund raising and investment banks Investment banks in India are greatly disadvantaged due to restrictions and lack of regulatory clarity about fund raising activities. To make investment banks in India globally competitive in terms of debt and equity funding, regulations need to enable them to do the following:
. Raise equity funding for themselves in India or abroad. . Provide equity funding to firms, or forex. . Setup hedge funds. . or forex equity provision for other providers of equity (securities, asset managers, insurance companies, hedge funds). . Trade in and forex equity markets either onshore or offshore. . Raise /forex debt resources for own use, for providing debt, for underwriting corporate bonds, or buying corporate bonds on the primary or secondary market. . Receive identical treatment between banks and s in terms of participation on the government bonds markets onshore and offshore. . Utilise securitisation and derivatives to perform debt transformation services for maturity, duration, coupon, currency exposure, credit enhancement. . Take up opportunities in distressed debt and workout funds. . Receive identical treatment for local and foreign firms in the distressed debt workout/reconstruction market.
In terms of providing composite funding structures, investment banks in India face the same issues as the commercial banks. E. Activities of various financial firms in the areas of operation at an IFC: Wall chart 233
1.3. Fund raising and private banks In order to provide a range of products and services in private banking, the following needs to be put in place in terms of legal/regulatory issues:
. Removal of constraints against banks or specialist “private bankers” offering private banking services. . Enabling commercial banks to setup a private banking division, subsidiary or affiate. . Setting up regulatory infrastructure that lays down guidelines in terms of client solicitation, invitation for services, global assets, global customers including local and customers.
1.4. Fund raising and securities markets In order to permit brokerage/security firms in India to tap the global market and make them competitive in fund raising activities, the regulatory/legal framework must provide and support the following which is currently not permitted:
. Providing equity funding in /forex to customer firms. . Setting up of hedge funds. . /forex resource raising for banks, exchanges, money managers, hedge funds. . Investments in or forex in other providers of equity — i.e., asset managers, insurance companies, hedge funds, mutual funds. . Trading in local and offshore equity markets. . Identical treatment of brokerage firms versus investment banks when it comes to funding equity directly or indirectly in or forex. . Raising /forex debt resources, for loans, underwriting corporate bonds, or purchase of bonds on the primary or secondary market. . Level playing field between banks and securities firms on the government bond market, on collateralised debt financing, and on recovery procedures in the event of default. . Offering transformation services based on interest rate derivatives, credit derivatives or securitisaion. . Level playing field for foreign/local firms, neutral treatment of local assets versus foreign assets. . Raising/providing funding using any debt or equity composite structure.
2. Asset management The bulk of asset management is transacted through the world’s major s. Asset management includes a combination of front and back office functions. We look at two forms of asset management and the legal/regulatory impediments that exist from the point of view of banks, asset managers and brokers/security firms — discretionary asset management (assets are managed purely by the asset manager and the client has no involvement other than a broad view about risk exposure) and non-discretionary asset management (assets are managed with partial or full instructions from client).
2.1. Asset management and banks Commercial banks have very strict restrictions and very little scope to engage in activities as far as asset management is concerned. To enable banks to compete in the space, the following needs to be enabled:
.O ffering discretionary asset management services without restrictions on types of assets being managed ( or foreign) and without restrictions on nationality of customer. 234 R M I F C
. Flexibility in equity, debt and hedge funds. . Creating subsidiaries/affliates offering asset management services. . Smooth handling of / regulations and supervision for fund management by commercial banks. . Absence of government regulation of fees and service fees. . Offering non-discretionary asset management, hold or actively manage assets for individuals, firms and trusts, regardless of nationality of customer. . Investing across all asset classes, to ensure global diversification. . Clarity on the role of / in regulation. . Lending against non-dicretionary portfolio value.
Besides being able to offer all the services provided by commercial banks, private banks need to be permitted to operate freely in the asset management space to do the following:
. Discretionary asset management of high networth individuals’ personal wealth portfolios. . Invest across global assets using equities, debt, securities, private placements, mutual funds, derivatives, hedge funds, commodities, gold, art, wine, etc. . Contract with foreign private banks to have client portfolios managed abroad. . Invest in real estate or real estate funds, and then offer a full set of real-estate related services such as property management. . Do non-discretionary portfolio management across global customers and global assets. . Receive identical treatment for local or foreign customers. . Have their fiduciary obligations protected when they obey client instructions which result in losses. . Have the freedom to decide fees and service charges.
Investment banks need to be permitted to do all of the activities listed above for commercial and private banks, both for discretionary as well as non-discretionary asset management, but in the context of investment banking. The same would hold good for brokerage and securities firms.
2.2. Asset management and fund managers We look at the legal/regulatory environment as it exists for mutual funds, insurance companies, pension funds and hedge funds in India and list the requirements that must be in place to enable these entities to compete in a global market. As far as mutual funds are concerned, most of the regulatory requirements for enabling discretionary asset management are in place. We already have the following:
. Rules on qualification and capitalisation of fund manager which permit a steady pace of entry. . Sound regulation of fees, entry and exit by customers, trading of fund assets, valuation rules, periodicity and communication of and portfolio composition. . Almost a full range of asset classes permissible, except forex. . Almost a full range of products that can be offered, excluding forex based products.
What we do not have in place in terms of mutual fund asset management is neutrality between Indian and foreign mutual funds and Indian and foreign assets. There are restrictions on Indian mutual funds investing abroad and foreign mutual funds investing in India. In terms of discretionary asset management by insurance companies, we do have a fair amount of regulations in place. Insurance companies can: E. Activities of various financial firms in the areas of operation at an IFC: Wall chart 235
. Choose between insourcing and outsourcing of their fund management. . Sell policies which bundle insurance with fund management. . Sell annuities. . Freely decide investment of annuity purchase proceeds. What is yet not in place in terms of regulations concerning insurance asset management is the following: . Neutrality between local and offshore assets. Insurance companies have restrictions in terms of investing abroad. . While permitted to bundle insurance with fund management, there is no tax neutrality with other fund managers. A lot of insurance schemes qualify for tax concessions. . Ability to sell ‘with profit’ endowment funds. . Ability to sell mortgage insurance policies. In terms of non-discretionary asset management, the following is not permitted: . Sale of tailored life insurance policies . Sale of tailored annuities . Sale of tailored ‘with profit’ endowment funds . Sale of tailored disability policies . Sale of tailored risk policies for individuals With respect to the pension fund asset management process, there is a long way to go as far as the regulatory framework is concerned. The following needs to be enabled from the point of view of discretionary pension asset management: . Full range of assets in pension portfolios from government bonds to real estate and hedge funds. The current regulations are highly restrictive in terms of where pension fund money can be invested. . Reduced protectionism in terms of foreign pension fund managers operating in India. . A regulated pension fund management industry which can obtain economies of scale off the local market and then seek foreign customers. . Local strength in fund trusteeship and administration. . Neutrality between local and offshore assets. . Regulatory framework based on prudent management principles giving the fund manager flexibility on asset allocation. . Treatment of defined benifit pensions, in addition to defined contribution pensions, in regulatory framework. As far as non-discretionary pension asset management is concerned, the restrictions on personalised tailored pension funds and guaranteed annuities need to be taken away. On the hedge fund asset management scenario, a beginning has yet to be made. We need regulations which will permit the following: . Establishment of hedge funds . Ability to engage in a full range of activities . Ability to invest in assets across national boundaries . Ability to have customers across national boundaries . Removal of limitations on trading, churning or leverage (including borrowing from banks and other sources of debt) . Settlement of issues concerning disclosure and risk limits 236 R M I F C
3. Personal wealth management Personal wealth managers or private bankers as they are sometimes called, customize investment programs to meet the specific needs of clients and provide a range of asset classes across which the investments can be made on behalf of the client. Mostly offered by banks, the high degree of customization makes personal wealth management a very labor intensive activity. In terms of commercial banks offering services, the same regulatory issues as concerns non-discretionary asset management apply. Besides these, the following needs to be enabled:
. Ability to offer and manage a full range of personal assets such as gold, commodities, art, wine, real estate etc. . Ability to provide the customer with comprehensive services as a one-stop solution. This would include property management services, credit card services, travel, entertainment etc.
In terms of private banks in India offering services, the following needs to be done:
. Removal of contraints against banks or specialist ‘private bankers’ offering private banking services. . Enable commercial banks to setup a private banking division, subsidiary or affiliate. . List out regulatory issues concerning client solicitation, invitation for services, global assets, global customers including local and customers.
Investment banks need to be permitted to do all the activities of personal wealth management listed above, but in the context of investment banking. The same would hold good for brokerage and securities firms.
4. Global tax management Global tax management provides a business opportunity for financial intermediaries, typically banks, to build strategies that optimize a corporation’s global tax liabilities. Regulatory structures need to be put in place to enable the following:
. Serve local customers with global assets and global customers with global assets. . Deal with s, firms or trusts owned by s. . Do full service global tax management for Indian multinationals, which requires substituting the services provided by foreign banks, foreign accountants and foreign lawyers.
5. Risk management Risk management is an important activity at an . Risk management consultants work with clients to identify sources of risk and design integrated solutions. We look at the regulatory framework that would need to be set in place in order to enable banks, asset managers and funds and brokers/security firms to avail risk management services in India.
5.1. Risk management and banks To enable commercial banks to offer/avail risk management services, the following would need to be enabled:
. Operations in derivatives markets for hedging risks of the core commercial banking book and for clients on an agency basis (possibly in the context of a personal wealth management structure). E. Activities of various financial firms in the areas of operation at an IFC: Wall chart 237
. Identical structure for currency, interest rate and credit derivatives markets, regardless of whether or forex. . Ability to combat political risk through derivatives and insurance. . Ability to cover market risk and operational risk.
Investment banks would require a similar enabling framework with respect to investment banking activities. So would private banks for risk management of private portfolios in currencies, equities, bonds and commodities and risk management of discretionary funds.
5.2. Risk management and the asset managers The regulatory framework for risk management activities by mutual funds is partially in place to the following extent:
. Mutual funds are permitted to trade in equity and equity index derivatives. . There has been full integration of derivatives positions into rules about valuation and disclosure.
However a lot of risk management activities essencial for fund management are not permitted in India. So are risk management products. To enable risk management on an scale, regulations would have to be put in place to enable the following:
. Use of derivatives for full range of arbitrage, hedging and speculation . Currency derivatives . Interest rate derivatives . Political risk insurance or derivatives . Other underlyings such as weather or catastrophe risk . Risk management through insurance . Neutrality between local and offshore derivatives markets
From the point of view of insurance companies, regulations will have to enable the offering of financial risk reduction insurance products ranging across currencies, interest rates, credit risk, political risk, catastrophes, weather, and any risk that can be analysed in actuarial terms. From pension funds’ point of view, regulations would have to enable the following:
. Do maturity transformation of pension fund cashflows. . Use of derivatives for producing pension guarantees. . Trade in equity, debt, derivatives, commodity and property markets.
And finally regulations that would permit hedge funds to use derivatives, insurance, proactive trading, short selling and leverage.
5.3. Risk management and securities firms To enable brokerage/security firms to avail/provide risk management, the following would need to be enabled:
. Risk management of private portfolios and discretionary funds, across all manner of derivatives markets (currencies, credit risk, political risk, equities, bonds, commodities) . Proprietary derivatives trading . Neutrality between local and offshore markets, and or exchange markets 238 R M I F C
6. Financial markets Most world class s provide financial institutions which provide trading in various asset classes such as currency, equity, bonds, commodities and derivatives. We look at the legal/regulatory system from the point of view of banks, asset managers and funds, and securities markets in terms of their access to various asset classes in India.
6.1. Financial markets and banks At present, Indian banks have limited access to currency markets. Commercial and private banks need to be enabled to do the following:
. Full fledged participation in speculation, market-making, hedging and arbitrage for all currency pairs out of , , , and futures, options, swaps and exotics. . Participation out of Mumbai in Chicago, New York and London markets. Private banks also need to be enabled to give clients global currency management and currency trading services along with multi-currency checking, savings and deposit accounts. Investment banks should be able to offer clients multi-currency facilities with conversion rights across currencies through swaps and swaptions. They should also be in a position to do and tailored multi-currency facilities. In terms of equity trading, commercial banks need to be enabled to do the following:
. Invest in equities for proprietary in-house trading, with full access to leverage and/or short-selling. . Offer equity trading and portfolio management facilities to individuals, trusts and s. . Finance equity trades through collateralised leverage. . Market making on equity spot and derivatives markets. . Equity derivatives arbitrage. . Accept listed equities as collateral subject to risk-based limits. . Engage in all the above without concern for the location of the exchange.
Private banks should be permitted to do the following:
. Have in-house proprietary trading account. . Create in-house funds for private clients. . Operate in domestic and foreign equity markets, including access to borrowed shares, short selling, and derivatives.
Investment banks should be enabled access to equity trading and be able to do all the above from an investment banking perspective. Commercial and private banks need to be allowed access to the entire spectrum of bond market products enabling them to do the following:
. Take long/short/leveraged/repo positions on government bonds, sub-sovereign, GOI- guaranteed, municipal, corporate ‘bonds’ and other fixed-coupon instruments, junk bonds, workout bonds, ARC bonds. . Do market making for exchange-traded bonds. . Originate and trade stripped/securitised assets based on a full range of underlying cashflows. . Have neutrality between Indian and offshore assets in all the above. . Not be under financial repression that forces purchases of Indian government paper or requires high credit ratings on corporate bonds. E. Activities of various financial firms in the areas of operation at an IFC: Wall chart 239
Investment banks should have access to the bond market and be able to do all the above from an investment banking perspective. Commercial banks should have access to derivatives markets which would enable them to avail/offer a range of products and services as follows:
. Build arbitrage businesses in all kinds of derivatives trading as a robust fixed-income business. . Do market making on derivatives exchanges. . Hedge in-house proprietary trading accounts. . Risk-manage corporate or individual client portfolios. . Risk-manage internal bond portfolio based on risk considerations, without limitations on long or short positions, or a bias against options. . Risk-manage commodity exposure. . Offer full-service contracts to securities firms and hedge funds, involing financing, recordkeeping, information feeds, order routing, sales support etc. . Have neutrality between Indian and offshore exchanges.
Private banks must be enabled to risk-manage client or proprietary portfolios, provide liquidity and have open speculative positions and trade in equity, currency, interest-rate and credit risk. In terms commodities trading, commercial banks should be enabled the following:
. Market making and arbitrage on commodity futures markets. . Take open or hedged positions. . Finance commodity traders on a collateralised basis. . Hedge exposure owing to collateral. . Have neutrality between Indian and offshore exchanges.
Private banks must be enabled to do the following:
. Diversify and enhance private client portfolios. . Participate in a full range of commodities, well beyond bullion. . Provide liquidity to clients against commodity portfolios as collateral.
Besides being able to do all the above in an investment banking context, investment banks must be able to develop innovative new commodity contracts and be able to trade on established // contracts.
6.2. Financial markets and asset managers We look at the regulatory/legal framework as it applies to mutual funds, insurance firms, pension funds and hedge funds in an Indian context. Mutual funds in India are not allowed access to the currency markets. In an setting, mutual funds as well as hedge funds would be allowed to do the following:
. Currency conversions associated with a global portfolio. . Trading in currencies as assets. . Hedging currency exposure of a global portfolio.
In terms of equity trading by mutual funds, we have some regulations in place. For instance the transperancy and disclosure requirements, and customer redemption rules and rules about fund liquidation and distribution of proceeds are fairly clearly laid out. However mutual funds are not permitted the following: 240 R M I F C
. Access to the market for global mutual funds . Investments all over the world . Full range of fund types (sector, risk, geography) . Access to borrowed shares, borrowed money, derivatives trading and short selling On the bond trading aspect, mutual funds can do a lot more. We have rules in place on and mark to market, holding to maturity, trading the yield curve and so on. Regulations provide the following: . Ability to create debt funds (government securities, corporate bonds, etc.) . Access to trading the corporate bond market However mutual funds still face financial repression where rules require purchases of Indian government bonds or require corporate bonds to have high credit ratings. Funds do not have access to trading the government bond market or debt securities all over the world. As far as derivatives trading by mutual funds is concerned, some activity is permitted. Mutual funds are allowed to hold open positions on derivatives on index or single stocks. They are allowed to do arbitrage using derivatives and these arbitrage positions are treated as being a fixed income position. However the following is still not permitted: . Risk-managing the portfolio including specific derivatives positions associated with specific risks (e.g., A yen futures position when there is an investment in a firm which imports raw materials from Japan) . Holding positions on markets across the world, which flow from the core portfolio which is internationally diversified. . Participation in credit derivatives. On the commodities trading front, there isn’t much that mutual funds are permitted to do at the moment. They cannot establish commodity funds, undertake commodity trading in general or take speculative positions on commodities in India or across the world. Much of the issues discussed above that apply to mutual funds are also applicable to hedge funds. Insurance companies have no access to currency trading. To be able to compete in a global market, these companies should be in a position to offer a range of forex denominated insurance products and engage in activities such as: . Produce products with premia or payouts in foreign exchange. . Take asset positions in foreign securities and currency markets. . Manage currency exposure on assets or liabilities. . Provide insurance to companies on their foreign assets or liabilities. While insurance funds are allowed to invest and trade in local equities, investments into offshore equities are not permitted. Also, sound rules need to be formed about extent of asset allocation into equities, matching equity holding to long-term liabilities and reserve requirements on equity assets. In terms of bond trading, insurance companies face financial repression, where rules require purchases of Indian government bonds or require corporate bonds to have high credit ratings. Investment and trading in government bonds and corporate bonds across all rating categories is not permitted. Neither are insurance companies allowed to invest in bonds in all countries. There is a need to have sound rules about matching of bond cashflows and liabilities as well as reserve requirements on bond holdings. In terms of derivatives trading, insurance companies face issues similar to those faced by mutual funds. So also in terms of trading on the commodity markets. Investments in E. Activities of various financial firms in the areas of operation at an IFC: Wall chart 241
commodities such as gold or oil either through direct holdings or indirect paths such as s is not permitted. Neither is trading and taking proprietary positions on commodity markets. Even hedging of commodity positions on derivatives markets is not permitted. Pension funds should be able to take exposures in currency markets and design pension products which cope with foreign contributions or benefits, sell pensions to individuals or firms outside the country, globally diversify their assets and be able to manage currency exposure on foreign assets or liabilities. At the moment none of this is permitted. While pension funds are allowed to invest in equity to a limited extent, they cannot hold equity indexes and individual stocks across countries. There are no clear rules about computation of equity portfolios nor is there clarity about transperency and disclosure requirement. As far as trading in bond funds, derivatives and commodities markets is concerned, the same issues that apply for insurance companies also apply to pension funds.
7. Securities markets We look at the regulatory framework for financial exchanges that do currency trading, trading of equity and debt, derivatives trading and commodity trading. The only market in currency trading that exists in India at the moment is the interbank currency forward market. There is a need for an exchange that would offer spot or derivatives trading facilities on any currency pair. Similarly partnerships with global exchanges on transfer of currency derivatives positions need to be put in place. To enable entities to arbitrage and exploit price differentials across markets, there is need enable direct market access. As far as equity trading is concerned, we have a fair degree of success in terms of the following regulations already in place: . Listing of s including s on closed-end funds, investment trusts, etc. . Disclosure and transperancy rules governing all trades. . Required minimum publicly traded stock that has to be issued. . Rules about proportions that can be owned by certain kinds of institutional investors. . Support for diverse array of market participants. . Flexible framework permitting multiple listing by a given issuer. . Sound rules about circuit breakers. . On-line realtime surveillance by exchange that is world respected. What we are lacking in terms of regulations on the equity markets is the following: . Listing rules that enable listing of a diverse array of international issuers. . Listing of s on commodities. . Neutrality between local and offshore issuers. . Support for borrowed shares and margin trading. . Consistency with global approved - regulations for members, dealers and customers. . Direct Market Access. As concerns the bond markets, we have rules in place for listing of fixed income funds and s. There are no restrictions on multiple listing. However the following still needs to be enabled: . Listing and trading of government bonds, sub-sovereign bonds, corporate bonds, with issuers from across the world. . Sound procedures for disclosure, transparency and surveillance. 242 R M I F C
. Support for borrowed bonds, margin trading and short selling. . Direct Market Access.
On the derivatives trading front, a lot needs to happen. We need regulations in place that will permit the following:
. Ability to innovate and create derivatives contracts on all underlyings in equity, currency, fixed income and commodities. . Global exchanges to trade local underlyings. . Placement of terminals by global exchanges in India and placement of terminals by Indian exchanges abroad. . Margin requirements based on overall portfolio risk, where there is an attempt at incorporating maximal information into the definition of the position, including positions, asset holdings, etc. . International-style position limits. . Direct Market Access.
As far as commodity exchanges are concerned, there is a need for listing of all manner of futures and options on all types of commodities and providing fungibility of local contracts against those prevalent globally. All issues of market design and operations as seen with securities exchanges need to be implemented on the commodity exchanges. As far are brokerage/securities firms are concerned, all issues that apply to banks in terms of trading on the various markets discussed above also apply to these firms.
8. Mergers and aquisitions As organisations expand and diversify, global corporate deal-making has become an important activity. India has been an important player in this market. Regulations that permit banks to engage in M&A activity are well in place. Investment banks as well as commercial banks can engage in the following:
. Arrange M&A among clients on a solicited/requested basis. . Arrange M&A among clients unsolicited, at investment bankers initiative. . Arrange M&A solicited/unsolicited among non-clients. . Promote M&A services in the corporate world in general. . Weave M&A into asset reconstruction or workout. . Do cross-border M&A involving Indian and non-Indian firms. . Play a role in M&A research and due diligence for the global market.
9. Leasing and Structured finance Large scale projects often require funding from global sources, often by way of leasing or complex structured finance products. Regulations would have to enable both commercial and investment banks to do the following by way of financing alternatives:
. Undertake structured leasing activities, under and international-style tax regime, for a full range of client-specific assets including aircraft, ships, containers, locomotives, wagons, cars, buses, trucks, computer equipment, etc. . Deal with assets abroad and assets subject to cross-border movement. . Be subject to sound provisioning requirements for leased assets. E. Activities of various financial firms in the areas of operation at an IFC: Wall chart 243
From the securities markets point of view, we need regulations in place that would enable exchanges to offer spot and derivatives trading on securitised paper. So also enable them to offer a full range of complex derivatives required for putting together complex financing structures.
10. Project financing To enable commercial and investment banks to do project financing, regulations must enable banks to do the following: . Structure and finance long gestation projects without restrictions on term lending (maturity, coupon, currency, collateral) and project bonds. . Issue long maturity corporate bonds, and use interest rate derivatives, in order to do duration matching. . Provide equity financing, convertible and subordinated debt, guarantees for export credits and suppliers’ credit, financing import credits, etc. . Risk management of exposure through the project life (currencies, coupon, maturity transformation, performance bonds, contractor guarantees, etc.) . Construction financing. . Finance projects secured by a sequestered receivables cashflow (e.g., Tolls). Financial exchanges should be allowed to offer a full range of complex derivatives required for complex financing structures.
11. PPP Financing is probably the most obvious vehicle for putting together a physical and social infrastructure for a country like India. Much of the PPP activity in the world is done by investment banks. To make this happen in India, investment and commercial banks should be enabled to do the following: . Finance public obligations under s (service provision financing, poor consumer financing, take-or-pay arrangements, maintenance cost subsidy, etc.). . Finance private sector obligations through performance bond guarantees. . Structure s (legal, financial, accounting arrangements). . Access internationally credible PPP dispute resolution mechanisms.
12. Insurance and reinsurance Risk management using insurance and reinsurance has become an important activity at an . To enable banks and insurance companies to be able to offer products and services in this area, regulations need to enable the following: . Permit banks, both commercial and investment banks, to own insurance and reinsurance subsidiaries. . Have reasonable firewalls between banking and insurance operations. . Provisioning and investment for insurance risk without spilling into banking risk. . Creation of joint ventures with domestic or foreign insurance companies. . Selling insurance products through bank branches. . Use of tailored insurance products in the bank risk management process. . Being able to engage in derivatives transactions (e.g., credit risk or interest rate risk) against insurance companies, either or on exchange. 244 R M I F C
. Selling insurance services either in India or abroad, either to an Indian client or to a foreign client. Private bank client need to be able to participate in local or global insurance/re-insurance syndicates, such as Lloyds. As far as insurance companies are concerned, regulations need to permit them to do the following: . Sell insurance products across the world insuring against global risks. . Participate in trading on the global reinsurance market. . Hold global portfolios in the management of assets. . Be subject to sound pruential regulations which do not discriminate against equity. . Participate in local and offshort, exchange traded and derivatives. To promote competitiveness in a global context, it is essential that entities operating in the insurance and reinsurance business are free from financial repression and are not forced to purchase Indian government bonds or restricted by requirements for corporate bonds to have high ratings. Abbreviations
ADB Asian Development Bank FEMA Foreign Exchange Management Act ADR American Depository Receipt FII Foreign Institutional Investor AMC Asset Management Company FIPB Foreign Investment Promotion Board A p p e n d i x AT Algorithmic Trading FMC Forward Markets Commission AUM Assets under Management FRBM Fiscal Responsibility and Budgetary BAMC Benchmark Asset Management Management Act Company (a mutual fund) FSI Floor Space Index FSMA F BCD Bond-Currency-Derivatives Nexus Financial Services Modernisation Act BHEL Bharat Heavy Electricals Ltd. (an GAIL Gas Authority of India Ltd. (an SOE SOE electrical equipment maker) in the natural gas business) BOB Bank of Baroda (an SOE bank) GFC Global Financial Centre BPCL Bharat Petroleum Corporation Ltd. GST Goods and Services Tax (an SOE petroleum company) GoI Government of India BPO Business Process Outsourcing HDFC Housing Finance Development Cor- BSE Bombay Stock Exchange poration (a financial firm working in home loans) BSNL Bharat Sanchar Nigam Ltd. (an SOE telecom company) HNI High Net Worth Individuals BoP Balance of Payments HNW High Net Worth CAC Capital Account Convertibility HNWI High Net Worth Individuals CAGR Compound Average Growth Rate HPCL Hindustan Petroleum Corporation Ltd. (an SOE petroleum company) CBDT Central Board of Direct Taxes (the agency which implements central HPEC High Powered Expert Committee direct taxes) IAS Indian Administrative Service CBEC Central Board of Excise and Customs IDRs Indian Depository Receipts (the agency which implements central IFS International Financial Service indirect taxes) IFSAT International Financial Services CCI Controller of Capital Issues Appellate Tribunal CCIL Clearing Corporation of India Ltd. IGIDR Indira Gandhi Institute for Develop- CDO Collateralised Debt Obligation ment Research CFMA Commodity Futures Modernisation IIT Indian Institute of Technology Act KPO Knowledge Process Outsourcing CMIE Centre for Monitoring Indian Econ- KYC Know Your Customer omy LCFI Large Complex Financial Institution CRR Cash Reserve Ratio LIC Life Insurance Corporation (an SOE DEA Department of Economic Affairs insurance company) DMA Direct Market Access LLP Limited Liability Partnership DOT Department of Telecommunications MAS Monetary Authority of Singapore EET Exempt-Exempt-Tax MOF Ministry of Finance EPFO Employee Provident Fund Organisa- NBER National Bureau of Economic Re- tion search ETF Exchange Traded Fund NBFC Non Banking Finance Company 246 R M I F C
NCDEX National Commodity Derivatives PWM Personal Wealth Management Exchange QIB Qualified Institutional Buyer NCMP National Common Minimum Pro- RBI Reserve Bank of India gram RBR Rules Based Regulation (the opposite NDF Non Deliverable Forward of PBR) NGO Non Government Organisation RFC Regional Financial Centre NRI Non Resident Indian RIA Regulatory Impact Assessment NSCC National Securities Clearing Corpo- SAT Securities Appellate Tribunal ration SBI State Bank of India (the largest bank of NSDL National Securities Depository Ltd. India, an SOE) NTPC National Thermal Power Company SEBI Securities and Exchanges Board of (an SOE in electricity generation) India NUS National University of Singapore SEZ Special Economic Zone OTC Over The Counter SLR Statutory Liquidity Ratio PBR Principles Based Regulation SOB State Owned Bank PFRDA Pension Fund Regulation and SPV Special Purpose Vehicle Development Authority STT Securities Transaction Tax PN Participatory Note TDS Tax Deducted at Source PSU Public Sector Unit (Indian term for VOIP Voice over IP SOE) PTCs Pass Through Certificates