Central banking, not central planning

Financial Express, 30 October 2009

The recent speech by the RBI governor has some useful ingredients in financial reform. These small steps represent progress when compared with RBI's stance of recent years of blocking all progress in finance. For a comparison, in the one year of Governor Subbarao's tenure, there has been just one achievement in financial reforms: the delicensing of ATM installation by banks. Compared with that, this is progress.

However, there are two problems. First, these tinkering changes will not yield results. Second, the conceptual framework which underpins this tinkering continues to be one of a license-permit raj, of central planning.

Unlikely to yield results

Issues such as STRIPs fall in the former case. Deep and fundamental problems bedevil the Indian bond market. Minor moves, whether unbanning STRIPs trading or unbanning repos on corporate bonds, are merely tinkering at the margin.

Speeches by RBI staff in coming weeks will proudly show a great deal of effort on setting up a bond market. But what matters is results, and not effort. The RBI way on the bond market has been tried and failed for 15 years. There is no reason to think that more of the same will now get results.

The deeper diagnoses of why India does not have a sensible Bond-Currency-Derivatives Nexus has been done by top experts in the R. H. Patil, Percy Mistry and Raghuram Rajan reports. The key action points of these reports continue to languish. Minor things that will not threaten the status quo are finding their way into announcements. But the essence of what is required is changing the status quo.

The ethos of central planning

The deeper problem is the ethos of central planning, of a license permit raj. RBI has set itself up as the super CEO of a set of financial firms. All the product launches of these financial firms are controlled by RBI. Whether we discuss trading in STRIPs or CDS or currency futures or the time-of-day at which trading should start and stop: all these decisions are made by the central planner.

This approach has been tried before in India, in the real economy. It failed dismally, and was abandoned. For central planning and a license-permit raj to work, an omniscient central planner who is maximising the interests of the people is required. Both these conditions are not satisfied in India or anywhere. Growth in India only got started when the central planner started getting out of the way.

Example: Currency derivatives

To take a specific example, consider currency derivatives. At present, a full array of currency derivatives are traded `OTC', which means that the players talk to each other on the telephone and strike up deals. The phone market is a bad way to organise financial trading. It features non-transparency, unfairness to customers, and counterparty credit risk.

The right position for policy makers is to frown on the phone market, and allow exchange-traded derivatives to come about. On exchanges, there is full transparency. Counterparty credit risk is eliminated through the clearing corporation. Thousands of financial firms from all across India are able to participate: their diversity of views yields greater liquidity and market efficiency when compared with the monoculture of banks in South Bombay on the phone market, all of whom think alike.

Prior to the global financial crisis, the international picture was one where governments were neutral about OTC versus exchange. That has changed after the crisis: now governments are encouraging exchanges. In India -- before and after the crisis -- RBI has steadfastly favoured the phone market. This is partly an analytical failure at RBI. Here, the central planner was less than omniscient. In addition, RBI is keen to foster the phone market (where it is the regulator) and not keen on exchanges (since SEBI is their regulator). Here, the central planner is placing its own interests first.

All exchange-traded currency derivatives are banned in India, unless specifically permitted by RBI. Now RBI will permit rupee-dollar and rupee-euro futures, but it continues to ban dollar-euro futures. This third product would close the "currency triplet", where the three contracts -- rupee to dollar, dollar to euro and euro to dollar -- would be linked up and strengthen each other. With one of the three legs missing, all three will suffer from inferior price discovery.

In similar fashion, RBI continues to ban options trading on the rupee-dollar on exchanges, while permitting it through the phone market. FIIs and NRIs continue to be banned from the exchange-traded market but permitted on the phone market.


In the Indian discourse, we request RBI to see one issue at a time (e.g. "please unban trading in rupee-euro futures"). However, the entire apparatus of central planning needs to be questioned and dismantled. The phrase "RBI has launched rupee-euro futures trading" is a throwback to the age of central planning. Economic reforms in India were not about a government that permitted Tata Motors to launch the Nano in blue and white: they were about a government that got out of licensing.

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