What now, UPA?

Financial Express, 24 July 2008

The UPA has a last few months of life in which it can get on with economic reforms, unencumbered by the CPI(M). Financial sector reforms are bound to be high on this agenda. This requires attacking the seven structural flaws of the existing policy framework.

The success story of Indian finance is the equity market, which has achieved a full ecosystem with high levels of liquidity and market efficiency. In contrast, with currencies, commodities and bonds, the markets are deeply flawed. Indian finance is an airplane running on one engine. The critical task is of making these other three markets come to life. This requires work on seven fronts.

  1. Mistakes in regulation of institutional investors. Institutional investors in India suffer from three problems: over-prescriptive and irrational rules, resource pre-emption by the government and high entry barriers. As a consequence, even though India is a big country, financial firms in India are tiny by world standards and have not achieved global competitiveness. Solving these three problems requires modifying laws, modifying the behaviour of regulators and modifying regulations.
  2. Flawed regulatory architecture. India has an alphabet soup of regulators. Most elements of the regulatory architecture were in place many decades ago (e.g. laws of 1934 or 1952), before knowledge of finance existed. The financial industry has distorted itself to fit within the constraints of the regulatory architecture. This needs to be turned upside down: government must adjust to the requirements of a healthy financial sector.
    This requires reforms of the regulatory architecture. RBI needs to become an independent central bank that is held accountable for delivering low and stable inflation. The Budget 2007 announcement about setting up an independent Debt Management Office (DMO) requires commensurate legislation. Banking requires a BRDA. The regulation of all organised financial trading needs to be merged into SEBI. IRDA is already in place; PFRDA requires legal foundations. This would give us a regulatory architecture with one central bank doing monetary policy and four financial regulators.
  3. Flawed legal framework While India has a common law history, all too often, laws in India embed excessive detail. A new regulatory architecture will undoubtedly require new legislation (for RBI, DMO, PFRDA and SEBI). This new legislation needs to embody a more common law, `principles based' approach where the law focuses on timeless principles and does not micro-manage the products and processes of financial firms. Firms should be held accountable for adhering to principles, which is a more demanding system of regulation as compared with check-box compliance of detailed regulatory checklists.
  4. Inadequacies of financial firms Financial firms in India are inadequate midgets, either by international standards or when compared with the needs of the new India. This is largely a consequence of the three difficulties described above. The way forward lies in multi-product conglomerates, such as ICICI or HDFC, which derive size and sophistication from operating in all areas of finance. This requires breaking the `silo system' of Indian finance, where each regulator has a feudal notion of the companies that it `controls'. This silo system needs to give way to a financial holding company framework. ICICI Holding Company should be the corporate headquarters, that is only subject to company law (and listing agreements). It should control a series of subsidiaries in various fields, while retaining a coordinated group-wide product strategy.
  5. Tax distortions There are three big flaws in tax policy. The first is taxation of transactions at various points. This must give way to the VAT principle, as has been done with great success for goods. The second is the lack of pass-through in fund management. This is a core principle of tax policy: whether person X manages his own money or hires person Y to be his fund manager, nothing should change about the tax treatment of X. The third problem is the partial double-taxation of corporations. The logically sound level of dividend taxation is zero.
  6. Capital controls Capital controls are to finance what tariffs or quantitative restrictions are to physical goods. Sophisticated and competitive corporations came about in India only when tariffs and QRs were largely removed. In similar fashion, the removal of capital controls is of critical importance to placing Indian financial firms under competitive pressure, which would then produce competence and dynamism.
  7. Outward orientation of financial firms. In the real economy, trade barriers have been removed, barriers to FDI have been removed, and Indian firms are now turning into multinationals. Such dynamism is the best way of ensuring that India achieves high growth, that Indian consumers are able to buy world class motorcycles or telephones. These three changes are now required in finance. Indian financial firms must face competition (by removing capital controls and by removing barriers to FDI) and the best Indian financial firms should start turning into multinationals by expanding overseas. Mumbai can then turn into an international financial centre. Only then can we know that India's needs for financial services are being well served.

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