A High-Powered Expert Committee (HPEC), set up by the Ministry of Finance, submitted its report on making Mumbai an International Financial Centre (IFC) in February 2007. The report and other details are available at http://www.finmin.nic.in/mifc.html. This article discusses some of the principal recommendations in the report.
The HPEC report's recommendations to convert Mumbai into an IFC are embedded in wide-ranging suggestions for financial sector reforms and also improvements in central and state government finances, the legal system, urban infrastructure, and governance.
In this context, the single most important issue highlighted in the HPEC report is the need to enhance competition in the Indian financial sector. Logically, the report suggests that at least the existing licensees in the banking sector (domestic or foreign) could be allowed to decide where they want to open new branches and domestic companies could be allowed entry into this sector.
As the report correctly points out, it is for the regulator to prevent cosy relationships between a private firm's financing needs and its banking activities. The report also advocates that we should move from a rule-based regime in which any financial sector activity which is not explicitly allowed is banned to an environment in which anything which is not explicitly banned should be allowed.
I would expect that such an approach would enhance competition provided our financial sector regulators are sufficiently alert and the legal system responds in a timely manner including simplifying out-of-court settlement procedures.
Many in India insist that public sector ownership of banks and other financial sector firms should not be diluted. In contrast, the HPEC report sounds overconfident about India's ability to move faster on privatisation and suggests lowering the government's stake below 49 per cent by end 2008.
The fact remains that any significant reduction in the public ownership of financial sector firms would require amendment/repeal of existing legislation. Additionally, it can be expected that public financial sector employees would oppose privatisation if it were to be attempted. Consequently, for the next two years, it would be productive to focus on the overriding objective of promoting competition rather than reducing government ownership.
The report suggests that financial sector reforms have lagged too far behind reforms in the real economy. Informed opinion in India is divided about the rate at which financial sector reforms should be pushed since the potential benefits and downside risks are not borne by the same sections of the population. Further, there are important steps that remain to be taken to open up the real economy.
The HPEC report draws attention to another important issue, namely that a country which houses an International Financial Centre (IFC) is likely to allocate capital relatively efficiently. It also points out a crucial missing link in Indian financial markets, i.e. liquid sub-sovereign debt markets.
Although credit and exchange-traded currency/interest rate derivatives have not developed as yet, the report does not highlight the fact that institutions do have access to over-the-counter derivatives such as currency and interest rate swaps.
The cross-country comparisons in the report on volumes of transactions and trading costs are reflective of the reforms that remain to be implemented to catch up with developed markets. As has been perceptively pointed out in the report, a major impediment is that the INR yield curve is not adequately liquid and is not arbitrage free.
The report recommends global issuance of sovereign bonds denominated in INR. I would submit that this could await capital account convertibility since there would be no net additionality of funds to the country in INR. As of now, our foreign exchange reserves would increase unless the hard currency inflows, received from global investors, can be used to fund imports.
Indian interest rates are not yet sufficiently deregulated since the central and state governments have relatively high stocks of outstanding debt. As the HPEC report has recommended, to facilitate the movement towards market determined interest rates, public debt management should be separated from the RBI's functions and made the responsibility of a statutory autonomous body.
The lack of agreement at the June 2007 Potsdam Doha Round trade-related discussions, at which India, the EU, the US and Brazil were represented, was due to differences on manufacturing and agricultural tariffs.
These deep-rooted differences over real economy issues are a clear indication (if it was needed) that "unilateral liberalisation" of the financial sector, as recommended in the HPEC report, is not advisable.
Urban development in India is affected by a host of governance issues and the IT industry has grown despite infrastructure shortcomings in Bangalore and Hyderabad. Even as we develop our urban areas, Indian financial sector firms could aim to capture more of the global market for back-office and middle-office services.
The revenues for these services would be substantial and basing international front-office activities in Mumbai, which often require face to face interaction, could follow over time.
The HPEC report maintains that an IFC cannot be built in Mumbai without capital account convertibility (CAC) and this should be implemented by end 2008. The Reserve Bank of India's Committee on "Fuller Capital Account Convertibility" submitted its report in July 2006.
This RBI Committee advocated a slower three-phase relaxation of controls on movement of capital over the period 2006-2011 with reviews every two years. The HPEC report sounds impatient about ground realities on CAC, financial repression and public sector dominance of the financial sector. My sense is that fuller capital account convertibility should go hand-in-hand with further deregulation in interest rates and an arbitrage-free INR yield curve, whatever time it takes.
To summarise, political considerations are inevitable since reforms have a differential impact across end-users of financial services, market-makers and those who are not covered by financial markets at all. The HPEC report advocates opening up the Indian financial sector rapidly to greater competition from international quarters.
This suggestion would face the usual infant industry argument. We are likely to progress faster if we were to focus on promoting competition by allowing domestic private sector firms to enter the financial sector. Inexplicably, financial inclusion is not addressed in the report in any detail.
Even as the sophistication of products offered out of Mumbai rises, financial services need to reach a larger fraction of our population.
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