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 FinanceGovernment of India

New Delhi

Report of the High Powered Expert Committee onMaking Mumbai an International Financial CentreMinistry of Finance, Government of India, New Delhi

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The High Powered Expert Committee (HPEC) on

Making Mumbai an International Financial Centre

The Hon. P. ChidambaramMinister of Finance, Ministry of FinanceGovernment of India, North BlockNew Delhi

th February

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 Teamthat supported the Committee.

The also wishes to express its appreciation to Mr. M. Balachandran who putthe facilities of the Bank of India at the disposal of the Committee. The and theGovernment of India would like to acknowledge their appreciation to the Bank of India formeeting the administrative expenditure for the production of this report.

Contents

Executive Summary xiii. International Financial Services () and Centres (s) in Perspective, xiii.—. Implicationsfor India and Mumbai, xiv.—. The difference between and , xv.—. What areInternational Financial Centres (s) and Services ()?, xvi.—. Growth and globalisationdrive India’s demand for , xviii.—. India’s competitive advantages in creating an , xix.—.Financial regime governance: policy and regulation, xx.—. Reorienting the financial systemtowards provision: A temporal roadmap for reform, xxiv.—. Urban infrastructure andgovernance in Mumbai, xxviii.—. The choice, xxx.

. The Emergence of IFCs: A brief history . Meeting cross-border trade, investment and other needs, .—. Evolution of internationalfinancial 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 didTokyo and Frankfurt not emerge as credible s?, .—. The Race to establish more s aroundthe 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 andglobal portfolio diversification, .—. Personal wealth management, .—. Global transferpricing, .—. Global tax management and cross-border tax optimization, .—. Global/regionalcorporate treasury management, .—. Global and regional risk management and insurance/re-insurance operations, .—. Global/Regional exchange trading of securities, commodities andderivatives in financial instruments and indices in commodities, .—. Financial engineering andarchitecture 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 theGFC for the Americas and the World, .—. Singapore as the /Asian GFC, .—. Dubaias 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 integrationwith 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 outsideIndia as a market for an in Mumbai, .—. International comparisons, .

. Augmenting IFS provision via BPO . How does an produce ?, .—. An outsourcing approach to provision andIFC development: Possibilities, opportunities and pitfalls, .—. A opportunity: Assetmanagement in Mumbai based on algorithmic trading, .—. IFS subcomponents amenableto 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 currencyand 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 publicdebt differently, .—. The mutuality of interests in modernising debt management and havingan , .—. 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 internationalcompetition on regulation and law, .—. Where does India stand? An illustrative bird’s eyeview, .—. The overall legal regime governing finance, .—. Summary of cross-countrycomparisons, .

. What are the limitations of financial regime governance? . Where do we stand? An – Market× Players matrix, .—. A pragmatic view of key areasfor 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 notas transparent, .—. Deeper sources of dysfunction, .—. What impedes Mumbai frombecoming an ? A summary, .

. Reforming financial regime governance . A shift toward principles-based regulation, .—. Reducing the artificial segmentation offinancial firms, products, services and markets, .—. Creating an environment conducive to exit,.—. Retail vs. wholesale markets, .—. The role of exchange-traded vs. OTC derivatives inthe BCD nexus, .—. Regulatory impact assessments, .—. Strengthening the legal systemsupporting an , .

. Tax policy for an IFC in Mumbai . Does India need an IFC or a Tax Haven?, .—. Tax policy for Mumbai as an : and, byimplication, for India, .—. A modern income tax, .—. Taxation of financial transactions,.—. A Goods and Services Tax (GST) in Finance, .—. Mumbai as an IFC: Tax Implicationsfor Maharashtra and Mumbai, .—. Interfacing tax policy and administration with the financialindustry, .—. Stability of tax policy, .—. Where India Stands on taxes: An internationalcomparison, .

. 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 andReform, .—. 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 ManagementCompany (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, .—. Globaltax management, .—. Risk management, .—. Financial markets, .—. Securitiesmarkets, .—. Mergers and aquisitions, .—. Leasing and Structured finance, .—.Project financing, .—. Financing, .—. Insurance and reinsurance, .

F. Abbreviations

Executive Summary

1. International FinancialServices (IFS) and Centres(IFCs) in Perspective

Historically, finance has always been‘international’ in character; capital has rarelybeen immobile. Money has moved freelyacross borders for all of civilisation with goldand silver (in various weights and measures)being global currencies for millennia. But,the freedom of capital was dramaticallycurtailed during the ‘Bretton Woods’ regime,created in , when capital controls wereimposed on war-ravaged, capital-starvedeconomies. With post-war recovery, thatregime broke down in . World financehas since been reverting to its natural statewith the removal of capital controls and thegradual re-integration of national capitaland banking markets; but this time on aglobal scale.

countries opened their capitalaccounts between and . A numberof emerging markets did so in the s– often at the ’s urging. In ,the contemplated making an opencapital account a condition of membership.But the idea was shelved when the Asianfinancial crisis erupted in . That wasprecisely when India first contemplated re-opening its capital account. A series ofsimilar mini-crises occurred elsewhere in engulfing Russia and Latin America. By all these crises were contained. Capitalaccount opening resumed but with reducedmomentum as the and others beganto reconsider its benefits and costs. Thequestion of capital account convertibilitynow weighs heavily on China and India,where financial systems with structuralweaknesses, legacy constraints and varyingdegrees of State domination now confrontthe irresistible forces of globalisation.

Even with an open capital account,some financial services (e.g. depositbanking) remain local and non-tradable.But most financial services are now tradable

across borders: i.e. they are internationalfinancial services (). A cross-bordermarket for has existed over millennia.But it has been transformed in the th andth centuries and grown quite differentlyand more dramatically since . It has alsobecome extremely competitive, with buyersand sellers around the world now having achoice of procuring from competinginternational financial centres (s).

A concrete example of procuring from an would be the raising ofdebt. If Mumbai became an , aSouth African railway project could issuea bond there in the primary market. Itwould wish to do so because of Mumbai’ssophisticated securities markets, along witha number of asset managers in Mumbairunning global portfolios. If the bondmarket was developed, the South Africanbond issue could be denominated.Global investors would buy these bondsand trade them on the secondary marketin Mumbai. Each of these three steps –primary market bond issuance by the SouthAfrican entity, primary bond purchases byglobal and Indian investors, and secondarybond market trading by global players –would generate revenues from the export offinancial services from Mumbai. Creatingan in India requires that Mumbai mustbe viewed as competitive in the eyes of theSouth African railway and in the eyes ofglobal bond investors, when compared withalternatives like Singapore or London.

The global market in the stcentury is one in which competition is drivenby rapid innovation in financial products,services, instruments, structures, andarrangements to accommodate and managemyriad requirements, risks, and a ceaselessquest for cost reduction. Competitiveadvantage in provision depends onseven key factors:

. An extensive national, regional, globalnetwork of corporate and government(supranational, sovereign, sub-sovereign

xiv R M I F C

and local) client connections possessedby financial firms participating in aninternational financial centre ().

. High level human capital specialised infinance, particularly quantitative finance,supported by a numerate labour forceproviding lower level paraprofessionalaccounting, book-keeping, complianceand other skills.

. World-class telecommunications infras-tructure with connectivity around theclock, and around the world.

. State-of-the-art systems, capabilityto help develop, maintain and managethe highly sophisticated and expensive infrastructure of global financialfirms, trading platforms and regulators;systems that are evolving continuouslyto help firms retain their competitiveedge.

. A well-developed, sophisticated, openfinancial system characterised by: (i)a complete array of proficient, liquidmarkets in all segments, i.e. equities,bonds, commodities, currencies andderivatives; (ii) extensive participationby financial firms from around theworld, (iii) full integration of marketsegments, i.e. an absence of artificiallycompartmentalised, isolated financialmarkets that are barred from havingoperational linkages with one another;and (iv) absence of protectionist barriersand discriminatory policies favouringdomestic over foreign financial firms inproviding financial services.

. A system of financial regime governance(i.e. embracing legislation, policies,rules, regulations, regulatory agenciesetc.) that is amenable to operating onglobal ‘best-practice’ lines and standards;and finally

. A ‘hinterland advantage’ in terms ofeither a national or regional economy(preferably both) whose growth isgenerating rapid growth in demand for.

Advances in information and commu-nications technologies () have easedinteractions over a distance and reducedtheir cost dramatically. However, activities

involving complex judgment and intellectu-alisation continue to be clustered at a fewphysical locations, where key individualsmeet face-to-face. This is characteristic ofR&D in computer technology – clustered inSilicon Valley and the Cambridge Corridor– despite extensive use of email, voice tele-phony and video conferencing. India hasachieved a minor miracle with the explo-sion of export revenues from services;yet, these revenues are a fraction of SiliconValley’s. Similarly, routine production offinancial services takes place everywhere.But, the most important and high valuedecision-making functions are concentratedin a handful of s that have effectively(and consequently) become global cities

At present, London, New York andSingapore are the only global financialcentres (s). Many emerging saround the world are aspiring to play a globalrole in the years to come: e.g. Shanghaiand Dubai. Other s in Europe andAsia, like Paris, Frankfurt or Tokyo, connecttheir financial systems to the world. Butthey have lost market share and importancein competing for global for reasonsexplained in the report. The world marketfor is represented mainly by the , and Asia which together account for over% of global . Correspondingly theglobal market is concentrated in thethree s located in each of these regions.

2. Implications for India andMumbai

Given that an in Mumbai must berooted in (and serve) India’s financial system,rather than be an artificial offshore appendix,the call for creating an in Mumbai atthis time is implicitly a metaphor for (andsynonymous with) deregulating, liberalizingand globalising, all parts of the Indianfinancial system at a much faster rate thanis presently the case. Raising the issue ofan in Mumbai now suggests that thepressing need for a new, more intensivephase of deregulation and liberalization ofthe financial system has been anticipatedby India’s policy-makers and regulators

To understand what such a city is see Sassen ().

Executive Summary xv

and that the is a device to acceleratemovement in that direction. An willnot be created quickly in Mumbai, nor willit succeed, if action on further deregulationand liberalisation is not taken in real time.

In sustaining its trajectory as anemerging, globally significant, continentaleconomy, the believes that India hasno choice but to: (a) become a producerand exporter of ; and (b) capture anincreasing share of the rapidly growingglobal market. To achieve thesetwo goals, its financial centre in Mumbaimust compete to become a successful. Incremental growth in the global market is now being driven by thegrowing demands of China, India andA. With its strengths in human capital,a globally powerful services industry, andits own hinterland, India has many naturaladvantages for competing successfully in thismarket. In evolving as an , Mumbai willprobably grow in two distinct phases:

. In the first phase (–) Mumbaimust connect India’s financial systemwith the world’s financial marketsthrough . That is what s likeFrankfurt, Paris, Sydney, Tokyo and ahost of smaller s do now in respectof their national economies.

. In its second phase (–) Mumbaimust develop the capacity to competewith the three established s forglobal business that goes beyondmeeting India’s needs. After , would hope that Mumbai would hold itsown in competing with the other sand acquire increasing global marketshare.

India’s financial services industry willnot become export-orientated, nor derivesignificant export-revenues, if Mumbaifails to become an . That willcompromise not just export earnings from, but the quality, efficiency and range ofdomestic financial services offered in Indiaas well. For Mumbai to become an ,India’s policy-makers and financial operatorsneed to understand fully the nature of andopportunities in: the global market;the activities undertaken in s; and the

gap in capabilities that now exists betweenMumbai and established s.

3. The difference between BPOand IFS

The production of financial servicesworldwide is now fragmented into a seriesof interrelated sub-processes undertakenseparately. Business process outsourcing() of individual processes occurs ata considerable distance from the pointof customer contact where their eventualresynthesis occurs. India is now a highlysuccessful venue for the global financialservices industry. In the last five years, it hasgone beyond simple towards complexknowledge process outsourcing or . Thisis a positive development for India to realiseits ambitions of creating an in Mumbai.Finance-related / builds up skillsin India and increases the ‘mind-share’ ofIndia amongst global finance professionals.

However, there is a substantial differ-ence between / and providing via an . Financial processes that get out-sourced under involve low-value, low-skill tasks. They are codified in a manual thatindicates how tasks are to be performed, con-trols quality/integrity, and measures whetherthey are being done correctly. Once the pro-tocols are in place, the task is performedrepetitively. But some outsourced activitiesin finance, involving research and analy-sis, are moving up the value chain.For example, company financial analysis,credit research, and stock market researchfunctions are now also being outsourced.

Still, the real value in financial servicesprovision remains concentrated in a smallnumber of jobs performed by qualified,super-numerate, imaginative people withthe specialised expertise, experience, domainknowledge and skill-sets to be innovativein designing financial instruments andstructures. Such people have extensive cross-border networks of clients and colleagues.Their work involves fine judgment inmaking decisions covering a vast array ofcircumstances. It cannot be scripted ina manual codifying its mechanics. Suchjudgments rely on intensive interaction,inter-personal information flows, and

xvi R M I F C

complex negotiations among a numberof highly qualified professionals includingfinancial experts, specialised corporatelawyers, accountants, tax experts, etc. Suchinteraction takes place at an .

From an Indian perspective, furtherprogress with expanding the /chain in financial services (horizontally andvertically) is inevitable and positive. But thatshould not be confused with what is requiredto provide the full array of via an .Intuitively, moving up from / to afully fledged is analogous to moving upfrom low-end programming to replicatingSilicon Valley. Incremental progress in theIndian industry will not bring SiliconValley to India; that requires a quantumleap. Similarly, doing more /for the global financial services industrywill not, as a matter of course, result inIndia automatically graduating to providing through natural evolution. /will be done by specialised sub-contractorswith different skill sets and competencies. can only be provided by qualifiedand internationally known financial firms;which is what Indian financial firms mustquickly strive to become. India’s growth in/ is about doing more through services firms (like Infosys, Satyam, Wiproor ). India’s growth in is aboutexporting through established and newfinancial intermediaries.

4. What are InternationalFinancial Centres (IFCs) andServices (IFS)?

Financial centres that cater to customersoutside their own jurisdiction are referred toas international (s) or regional (s)or offshore (s). These three differentadjectives are often (but wrongly) usedsynonymously in the literature. Yet thesethree types of s are difficult to definein a clear-cut, mutually exclusive fashion;although they are quite distinct. All thesecentres are ‘international’ in the sense thatthey deal with the flow of finance andfinancial products/services across borders.But that description does not differentiatethem sufficiently in terms of their scope.

We categorise s in this report in fourways; i.e. as:

Global (GFCs ) These are centres that gen-uinely serve clients from all over theworld in the provision of the widestpossible array of ;

Regional (RFCs) They serve their regionalrather than their national economies(see below) – examples of such swould be Dubai or Hong Kong;

Non-global and non-regional, ordinary inter-national IFCs These are centres likeParis, Frankfurt, Tokyo and Sydneythat provide a wide range of butcater mainly to the needs of their na-tional economies rather than theirregions or the world – one might betempted to call them national s al-though that term is an awkward onebecause its two defining adjectives arecontradictory; and

Offshore (OFCs) These are centres that areprimarily tax havens for wealth man-agement and global tax managementrather than providing the fully arrayof .

The products and services thats provide include the following elevenactivities. s provide all of them. Others provide some combination of them.

a. Fund Raising: for individuals, corpo-rations and governments (sovereignand sub-sovereign). This includes debtand quasi-debt across maturity/currency

Singapore and London are also regional in thesense that they serve Asean and the while New Yorkserves North and Latin America. But because thesethree centres serve the global economy, well beyondmeeting the needs of their respective regions, weclassify them as global rather than regional. In thatsense, the sees limited potential for Mumbaito be a regional financial centre for South Asia givencurrent geopolitical realities. South Asia is more likelyto be served by Singapore and Dubai for the time being.We see Mumbai being an that serves India in thefirst stage and leapfrogs to serving the global economyin its next stage of evolution. Ironically, Mumbai as an is likely to serve its region after it serves the world,rather than before. For that reason, although the was asked to look into Mumbai becoming a regionalfinancial centre we dispensed with that characterisationearly on in the knowledge that it would be misleading.Throughout this report therefore we refer to Mumbaibecoming an international rather than a regional FC.

Executive Summary xvii

spectra; equity and quasi-equity for pri-vate, public and public-private corpora-tions; as well as risk-management appen-dices attached to primary fund-raisingtransactions to ensure that the risk expo-sure of the primary borrower or fund-raising entity (to currency, interest rate,credit, market, operational and politicalrisks) does not exceed tolerable limits.

b. Asset Management and Global Port-folio Diversification: undertaken by avariety of national, regional and globalasset managers including, inter alia pen-sion funds, insurance companies, in-vestment and mutual funds of varioustypes characterised by nature of instru-ment (i.e. debt, equity or convertibles),geography, or sector of activity.

c. Personal Wealth Management (PWM):for high-net worth individuals (s).This activity is estimated to involve themanagement of personal assets of $–

trillion worldwide. Overseas Indiansare estimated to hold financial wealth(i.e. apart from real estate, gold, art,etc.) of over $ billion and totalwealth of over $ trillion. PWM takesplace in established s, but is moreskewed towards specialised -sin the Channel Islands, Switzerland,Luxembourg, Monaco and Lichtensteinfor the and Africa; Caribbeanoffshore centres for the and LatinAmerica; Bahrain and Dubai for theMiddle East; Singapore, Hong Kong andsome Pacific Island offshore centres forEast/North Asia.

d. Global Transfer Pricing: This is anactivity that o, like most governments,looks askance at, but needs to realiseand accept the reality of, in a globaleconomy dominated by transnationalcorporations. This will becomeincreasingly important to Indian firmsas they evolve into multinationals.

e. Global Tax Management and Cross-border Tax Liability Optimisation:which provides a business opportunityfor financial intermediaries as well asaccountants and law firms until nationaltax regimes begin to converge towarda global low tax norm. This activity

will become increasingly important toIndian firms as they evolve into s.

f. Global/Regional Corporate TreasuryManagement Operations: involvesfund raising, liquidity investment andmanagement, asset-liability and dura-tion matching, and risk-managementthrough insurance and traded deriva-tive products for currency, interest-rate,credit and political risk exposure.

g. Global/Regional Risk Management Op-erations and Insurance/Re-insurance:which involves highly developed ex-change traded and tailored derivatives(futures, options, swaps, swaptions, capsand collars) as well as world class deriva-tives exchanges that trade a variety ofglobal contracts.

h. Global/Regional Exchange Trading ofFinancial Securities, Commodities andDerivatives Contracts in Financial In-struments/Indices and in Commodi-ties: There is an increasing tendency to-ward multiple listings of financial securi-ties (equities and debt), and of derivativeand commodity contracts, on differentexchanges with emerging investor de-mand for x x trading of all listedsecurities across all exchanges. Demandis highest for the securities of index-corporations in each major capital mar-ket. It will gradually cascade downwardsto cover global trading of all listed se-curities in all markets – developed andemerging. Mumbai is better placed thanmost s to meet this demand, becauseof its human capital and capability,as well as its world-class exchanges andimproving exchange regulation.

i. Financial Engineering and Architec-ture for Large Complex Projects: Thisprimarily involves energy and infras-tructure projects requiring funds froma variety of global sources (public andprivate) with attached risk-management.Again, Indian financial institutions andformer FIs have well-honed skills in thisparticular arena.

j. Global/Regional Mergers and Acquisi-tions Activity: This will become increas-ingly important in India and for whicha considerable amount of back-office

xviii R M I F C

/ and due diligence researchwork is already being outsourced to In-dia.

k. Financing for Global/Regional Public-Private Partnerships: This relativelynew activity has emerged on scene withconsiderable force since the developmentof the London Underground PPP. It hasparticular and immediate relevance forthe financing and rapid development ofIndian infrastructure without recourseto the treasury.

5. Growth and globalisationdrive India’s demand for IFS

Since , India has grown rapidly and itseconomy has globalised. As India grows,it globalises faster. That happens throughthe increased share of trade and foreigninvestment in economic activity. Evidence ofthat lies in two-way cross-border flows. Suchflows, on the current and capital accountscombined, rose from $ billion in

(<% of ) to $ billion in

(>% of ). The forces that resulted inthis six-fold increase are intensifying and willfurther accelerate growth of cross-borderflows. The next decade is likely to see cross-border flows growing as fast.

Current and capital account flows in-variably necessitate purchases of . Forexample, current account transactions in-volve payment services, credit enhancement,currency risk management, etc. Capital ac-count flows involve purchase of investmentbanking, legal, accounting, risk manage-ment, research and other similar services.When / enters or exits India, feesare paid to various providers (e.g. com-mercial and investment banks, securitiesbrokerages, exchanges, insurance compa-nies, asset managers, etc.). As India engagesmore with the world, the stock of assets heldin India by foreigners rises. Similarly, thestock of foreign assets held by Indian house-holds and firms also rises. Purchases of riskmanagement services grow in proportionto these stocks which are far larger than thecapital flows of any one year.

It is estimated that Indian householdshave accumulated considerable wealthoutside the country; well beyond the present

limits set by RBI. The ability of Indianhouseholds to move resources across theborder has increased with India’s increasingopenness. The proliferation of Indian soperating around the world – and transferpricing with their subsidiaries abroad –has led to demand for fund-raising,corporate treasury management and globaltax management. With rapidly increasingannual flows, the stock of assets outside thecountry controlled by Indian householdsand firms is rising rapidly. These assetsrequire for wealth, asset and globaltax management. All these phenomenaimply inevitable increases in purchasesassociated with the growing size of cross-border flows. Calculations in this reportsuggest that on average, the revenuestream works out to % of the gross flowsacross the boundary.

This translates to about $ billion ofIFS purchases by Indian clients in .

Looking ahead, India’s engagement withthe world will intensify in three ways: (a)reduction in barriers such as customs dutiesand capital controls; (b) improvements ininfrastructure; and (c) greater participationby s (Indian and foreign) in the Indianeconomy. These developments will inducedeeper globalisation of the Indian economyin the coming decade, inducing an upsurgeof purchases.

Our estimates suggest that IFS pur-chases by Indian households and firms willrise to $ billion by on the basis ofconservative assumptions in a ‘base-case’scenario. Under more propitious circum-stances (e.g. if GDP growth is sustained at%) that figure could be over US$ billion.By that amount could exceed US$

billion in nominal terms.These estimates warrant a different way

of thinking about exports and aboutan in Mumbai. Traditional conceptu-alising by Indian exporters about marketopportunities typically assumes tapping intoa quasi-infinite world market. Financial ser-

This was the approach taken by the Indian softwareindustry which now has domestic sales of a mere $

million while its exports are a -fold multiple ofroughly $ billion a year. The search for growth onthe part of firms like , Infosys or Wipro has beenprimarily about finding international customers. The

Executive Summary xix

vices are like software services in that they arelabour, skill, /communications intensive.But, in terms of market opportunity, there isa fundamental difference between financeand software. It lies in India’s hinterlandadvantage. Rapid growth, even more rapidintegration with the rest of the world, andthe high consequent growth rate of two-waycross-border financial flows now being seen,all serve to make India a large and growingcustomer for . Unlike service exports,India provides a platform for nurturing capabilities that can ‘go global’ instantly.

Against that growing demand for , afailure to respond on the supply-side, (i.e.by creating a successful in Mumbai)will simply oblige Indian customers todo increasing business abroad. Thatwill fuel the growth of Singapore, Dubai,London and other s while deprivingMumbai of capturing opportunities for highvalue-added exports. For example,the Tata Steel-Corus deal generated revenues in Singapore and London. Someelements of such transactions do not appearin Indian BOP accounts. Financial firms andpolicy makers in the three s and are highly attuned to the opportunitiesfor selling into India. They haveembarked on strategies that exploit thecurrent infirmities of the Indian financialsystem. The most capable Indian financialfirms are likely to move to these centres inorder to acquire the flexibility to providetheir extant client base with the theyneed, rather than risk losing their clients toglobal financial firms.

Rapidly growing demand for inIndia provides an opportunity for itsfinancial services industry that its softwareindustry never had. Indian software exportswere generated by ingenious Indian humancapital exploiting foreign markets andrequiring nothing from the State otherthan telecom reforms. Indian geniusconquered world markets between and in a way that was not imagined in eventhe most optimistic forecasts of . Inthe case of , an identical opportunity

domestic market does not loom large to the s ofthese firms, and played no role in their graduating intoexport-oriented MNCs.

exists for Indian financial genius to achievesimilar export success in world markets;but with one key difference. India’s owngrowth and globalisation, and consequentdomestic demand for , generates naturalopportunities for producers in India(local and foreign) to acquire skills andexploit economies of scale. Indian softwareexports required an enabling frameworkfrom the State in the form of telecomreforms. Indian exports will requirea similar enabling framework from theState. Deeper and wider reforms andimprovements are needed in: (a) India’sfinancial system and the way it is governedand regulated; as well as (b) Mumbai’s urbaninfrastructure and political/administrativegovernance on a scale not yet envisaged.

6. India’s competitiveadvantages in creating anIFC

Hinterland Advantage: As argued abovethe growth of the Indian economyand more rapid growth of cross-border financial flows have createdsubstantial local demand for . This‘driver’ supports the development ofskills, and generates economies ofscale on the part of financial firmsoperating in Mumbai. China has thesame hinterland advantage. New Yorkhas the North American economy asits hinterland. London has the evenlarger economy, as well as its ownnational economy, to serve. Singaporehas a limited national economy. Butit is the financial epicentre of anA regional economy that isalmost as large as China and largerthan India. Dubai does not havethat kind of national or regionaleconomy. But it is located in a regionthat is generating enormous financialsurpluses for investment abroad.

Human Capital: India has four strengthsby way of human capital endowmentsthat give it a competitive edge overShanghai, Singapore and Dubai:• The extensive use of English,

which is the lingua franca ofinternational finance

xx R M I F C

• Generations of experience withentrepreneurship, speculation,trading in securities and deriva-tives, risk taking, and accounting.Indeed the ability to provide seems to be genetically coded intoIndian finance professionals

• Strong skills in information tech-nology and quantitative thinking

• Individuals of Indian origin playa prominent role in the top

global financial firms. They arewell-positioned to intermediatebetween the business strategies ofthese vital firms and the genuinestrengths and weaknesses of Indiaas an .

Location: Mumbai is well located in beingable to interact with all of Asiaand Europe through the trading day.Apart from the Americas, transactionswith most of world can occurin daylight. Given the remarkableand growing role of London inproviding global today, India hasthe advantage of having a – houroverlap with London time. There isno operating within an hour’svariation of the Indian Standard Timezone. India has an edge over Shanghai,but not over Dubai, in this respect.

Democracy and Rule-of-Law: Properlyfunctioning financial markets requirea constitutional basis and machineryfor system governance that is stable,reliable, resilient and flexible; i.e.one that reduces future politicalrisks and uncertainty. Globallycredible financial systems need tobe rooted in legislative, judicial, andregulatory frameworks that adhereto rule-of-law and respect/protectproperty rights; in principle andin practice. can be providedcredibly only from environments thatpermit open and honest expressionof independent views by portfoliomanagers, analysts, commentators,researchers, etc. even when such viewscontradict those of governments andpowerful personalities with a vestedinterest. India has proven strengths in

upholding liberal values, protectingproperty rights and maintainingpolitical stability. It fares wellcompared with China, Singapore orDubai but does not match London orNew York.

Mindshare: High growth, the/ phenomenon, and thesuccess of Indians in global financeall over the world, ensure that Indiahas significant ‘mindshare’ at policy-making levels in global financial firms.India has an edge over Singapore andDubai, and perhaps even over China,in this respect.

Strong securities markets and advanced trad-ing platforms: India has the foun-dations for providing global byvirtue of its dynamic, technologicallycapable securities trading platformsin the and . These are therd and th biggest exchanges in theworld measured by number of trans-actions. India has an edge over Chinaand Dubai, but not over Singapore, inthis respect.

Taking these formidable advantages intoaccount, the initial conditions supportingIndia’s entry into the global market for are promising; especially when comparedwith the early days of software exportsfrom India. In the latter case, there wasno hinterland advantage, location did notmatter, democracy did not matter, and therewas no beach-head. The six comparativeand competitive advantages that India has,suggest that there is a genuine opportunityfor India to create a viable able tocompete with the best in providing tothe Indian and global markets in a short spanof time. But, it confronts some dauntingchallenges. Our report highlights these indetail. They include: (a) financial regimegovernance in India; (b) missing marketsand institutions and (c) urban facilities andgovernance in Mumbai.

7. Financial regime governance:policy and regulation

A sound basic framework for develop-ing/applying law and regulation are intrinsic

Executive Summary xxi

to . The quality and credibility of provided from India is inextricably linked tothe soundness and global acceptability of theregulatory/legal system that governs financein India. Global competition in is, toan extent, a function of global competition(in terms of reputation, capability, efficiencyand effectiveness) among regulatory regimesand the institutions that apply those regimes.The market share of an is determined asmuch by the quality and reputation of itsregulatory/legal regime as by the abilities ofits financial firms. A cross-country assess-ment suggests that India is weak on manyaspects of the legal and regulatory frame-work governing its financial system whichthe report discusses in detail. The reportalso identifies two key strategic institutional(or structural) weaknesses in Indian financethat impede production:

• ‘Missing’ Debt, Currency, and Deriva-tives Markets: The most critical finan-cial market components missing in In-dia are: a properly functioning bondmarket, a currency market and a deriva-tives market for currencies and inter-est rates. These three interlinked mar-kets are termed collectively as the bond-currency-derivatives (BCD) nexus inthis report. Six specific deficienciesin this respect include the absence of:(a) a liquid and efficient sovereignbond market with an arbitrage-free yield curve, (b) a wide range ofessential derivatives on interestrates, (c) a liquid spot market for -denominated corporate bonds, (d) creditderivatives on credit spreads or creditevents, (e) a liquid currency market and(f) a full range of currency derivatives.

Under a functional nexus, allsix elements are based on vibrantspeculative price discovery, and aretightly knitted by arbitrage. Theyinteract to result in market efficiency.There is no successful that lacks sucha nexus. Its conspicuous absencein India handicaps the country’s abilityto provide . Another shortcomingis the inadequacy of India’s spot andderivatives markets – in terms of thevariety of contracts traded and their

traded volumes – in all areas other thanequities. A normative rule-of-thumbwould suggest that the traded volumeof an exchange-traded futures contractin India should be at least one-tenth theturnover of a corresponding product inthe . By this yardstick, the turnoverof Nifty futures is about that size. Butthat is not the case for almost all of thetop underlying contracts in the .

• An inadequate universe of institutionalinvestors: The second deficiency inIndia is a universe of institutionalinvestors that have the size, visibilityand capability of those in establisheds. The progress made so farwith liberalisation has been basedlargely on speculative price discoveryby non-institutional investors in equitymarkets. Other segments are dominatedby state-owned entities which arebound by restrictive rules. Banks andinsurance companies are restrained, ifnot banned, from undertaking risk-hedging activities and other kinds ofsophisticated business due to regulatoryrestrictions. Consequently their assetsare growing too slowly.

Indian financial firms tend to operatein one key business segment at atime. Their portfolios are narrowlyconfined and concentrated; so is theirrisk exposure. That has stunted theirgrowth, imagination and ability tohandle risk. Indian financial firms nowneed to evolve into full fledged large,complex financial institutions (s inBasel parlance). They need to operate inall financial market segments of financeto come up with credible offeringsand ‘packages’ for the export market.

India lacks domestic commercial andinvestment banks capable of taking onglobal counterparts without higher levelsof capitalisation, global market access, operational expertise, and high-level human capital. India also lackslarge securities brokerages capable ofcompeting with global counterparts.India’s brokerage industry reflects theinfirmities of its retail sector as awhole. It is characterised by toomany small, undercapitalised, limited-

xxii R M I F C

capability firms (brokers and sub-brokers) that are mostly still singleproprietorships in corporate form.Structural reforms are required urgentlyto create Indian financial firms that areequivalent in size and capabilities toglobal counterparts. Looking ahead,if India is to create an , there is noescape from inviting the participationof domestic and foreign institutionalinvestors of adequate size, who woulddeploy the economies of scale, globalmarket-reach and efficiency-enhancingbehaviour that is evident at other s.

Why does India have these weaknesses?Close scrutiny of the regulatory regimeexamines the origins of these infirmitiesthrough a matrix that identifies and analysesrestraints on the activities of differentfinancial firms in providing various .Such a matrix has been prepared as a‘wallchart’ for this report. It outlinesactivities that take place at s andthe kinds of financial firms that typicallyundertake them. A careful analysis of thiswallchart reveals that, at present, most ofthe activities that take place at sare banned or severely proscribed in India.The red ink across the wallchart – signifyingactivities banned in India – portrays thelicense-permit-control raj that still operatesin Indian finance. It retards developmentand sophistication of the financial sectorand inhibits exports. A pragmatic viewof these constraints highlights three urgent,cross-cutting priorities for reform:

• Competition Policy: India’s experiencewith liberalisation in the real economy,suggests that the most powerful tool forhaving efficient and well-functioningfirms is competition. Application ofsound competition policy in all marketsegments of India’s financial sector isnow a matter of urgency.

• Compartmentalisation of the Finan-cial System: Global competitiveness re-quires exploiting fully the economiesof scale and scope. India’s hinterlandadvantage represents an opportunityto exploit such economies. HoweverIndian finance has been artificially frag-mented by financial sector policy and

regulation. There is no that has socompartmentalised an approach to thestructuring, management and regula-tion of its financial markets. Reversingcounterproductive segmentation of fi-nancial markets in India, and removingbarriers to entry, would result in greater:economies of scale/scope, competition,and global market-reach.

• Inhibiting Financial Innovation:Whether an should be created forIndia to catch up with the world, or to ex-ploit comparative advantage in a global market, a considerably faster paceof financial innovation in India is essen-tial. But, financial regime governance inIndia can only cope with change slowly.The regulatory approach to any changein the structure or functioning of thefinancial system is conservative, cautiousand inconducive to innovation. As aresult India falls behind internationalpractice by the day in every market seg-ment. The default signal emitted byIndian regulators when faced with anynew idea seems to be set at ‘amber’ if not‘red’. Innovative instruments, contractsand new ways of doing business are actedupon in days in the three s. Sucha pace of rapid progress is not foundin India. Basic contracts like interestrate futures and options have failed tomaterialise in this climate.

Deregulation and liberalisation throughthe s have largely unshackled India’smanufacturing sector, and much of itsreal economy. Competition, innovationand scale economies in these sectors areno longer blocked by the State. Yet,somewhat dissonantly, a much higher degreeof control continues to operate in keyparts of the financial sector; despite themany regulatory reforms of the s. Thisfinancial governance regime now needs tobe overhauled to create a more moderngovernance regime. It does not needtraditional fine-tuning with the extantregime remaining largely intact.

Regulatory reform has had a positiveimpact on the functioning of India’s capitalmarkets and the insurance sector. In thecapital markets, India has achieved global

Executive Summary xxiii

standards in some aspects. Other financialmarkets lag behind in not yet having beenreformed as widely or deeply. Despite thepresence of a large number of different typesof banks, and despite incremental measuresaimed at ‘opening-up’, the banking marketin India has yet to improve substantiallyin competition, innovation and efficiency.The improvements achieved at the marginshave not yet permeated the banking systemas a whole. They are unlikely to, withouta major reformative push and diminishedpublic presence.

For that reason, a dramatic changein the governance regime for all financialmarkets in India is now imperative. Withoutit India will not be able to create aninnovation-orientated financial systemthat can evolve and compete at a pacecommensurate with changes in the Indianeconomy and global finance. Such asystem would have the following activitiesundertaken on a par with global norms:(a) continual innovation and improvementin the design of financial products andcustomer services as well as in their delivery;(b) the rapid reintegration of segregatedfinancial markets into more liquid and moreintegrated markets; and (c) the rapid growthand market-induced consolidation of Indianfinancial firms in a manner that enablesthem to achieve economies of scale.

For this to be achieved, Indian financialsystem regulation needs to be brought upto world standards. Regulatory attitudes,policies, practices as well as institutionalarrangements need to undergo a sea-change. They need to become moreattuned to, and supportive of, the dynamism,growth and global competitiveness of theIndian financial services industry. Policyand regulation must adjust and adapt tothe needs of Indian and global financialmarkets. Financial markets should notbe artificially fragmented, segmented,compartmentalised.

This report does not advocate usingthe hinterland argument as a reasonfor protectionism. Nor is the making an argument for ‘self-sufficiency’.Instead the believes that India andIndian financial firms should be globallycompetitive in providing through an

in Mumbai. The goal of publicpolicy is to foster high economic growthand enhance welfare in India; it is notto cater to the interests of Indian firmsor their shareholders. But, in sayingthis, the is mindful of the realitythat developments during the last decadehave resulted in a debilitating anomalyfor Indian financial firms versus theirforeign competitors. In manufacturing,the removal of barriers to imports wasaccompanied by a simultaneous unshacklingof Indian firms. Indian firms were exposedto greater competition from imports andthe entry of foreign s in domesticmarket space. But they were, simultaneously,given a transitional period and considerablefreedom in terms of formulating businessstrategies and innovating.

The evolution of Indian finance,in contrast, has resulted in growingdissonance between external competitionand a repressive license-permit raj. India’slong and tortuous evolution towards de factoconvertibility (which in some respects isnot dissimilar to tariff reductions in thereal economy) has not been accompaniedby Indian financial firms being given thesame opportunity and room for manoeuvreto develop their competitive capabilities.They are at a disadvantage in coping withcompetition (for their clients’ business)from global providers operating in Indiaand from abroad for two reasons:• First, key financial markets (i.e. the

nexus and risk management) havebeen prevented from developing in Indiabecause of regulatory restraints. Thathas resulted in Indian financial firms nothaving the opportunity or the time/spaceto develop domain knowledge and skill-sets in crucial areas e.g. global fund-raising or developing sophisticated riskmanagement products/services tailoredto client needs.

• Second, the same regulatory restraintshave deprived Indian financial firms ofthe freedom they need to develop andthe necessary flexibility in formulatingglobal business strategies. They have nothad the scope for innovating for andthus developing the skills required tocompete with global providers.

xxiv R M I F C

The is clear that, in providing from India, there is no case whatsoeverfor protectionism. The interests of Indiancustomers, and that of economic efficiency,are best served by enabling them to choosefrom the best providers in the world.But, the asymmetry in policy that has placedIndian financial firms at a disadvantage,underlines the case for phasing reformsaimed at creating capabilities in amanner that enables Indian financial firmsto be similarly unshackled in competing toprovide .

8. Reorienting the financialsystem towards IFSprovision: A temporalroadmap for reform

The strategy proposed in this report forcreating an comprises in essence a ten-point agenda:

. Macroeconomic (i.e. Fiscal and Mone-tary) Management.

As a new competitor in globalfinancial markets, the credibility ofIndia’s macro-economic policies, andthe quality of its macroeconomic andfinancial system management, will bejudged more stringently than in the caseof established s. This asymmetricreality highlights the importance ofredoubling efforts in reforming policies,legal and institutional arrangements toachieve and sustain a high growth rate(–%) for the economy in general andthe financial sector in particular.

Creating a vibrant, competitive in Mumbai will require, as an integralbackdrop, success in meeting thelegal commitments entered into bythe Government of India, and thegovernments of individual states, toreduce the consolidated fiscal deficit onthe timeline announced. In addition, itwill require (a) reducing the total publicdebt/ ratio to more acceptablelevels; and (b) pursuing sound fiscaland monetary policies thereafter.

HPEC therefore recommends thatfurther action should be taken toreduce more rapidly the consolidated

debt of centre and states, including on-and-off-balance-sheet liabilities (suchas pensions) and endorses a lowerlevel (than the present %) for thetotal consolidated public debt-to-GDPratio. A public debt ceiling should bebolstered by flexible triggers for actionsto be taken by the Ministry of Finance(e.g. accelerated sales of public assetswhose proceeds are used to liquidateoutstanding public debt if that is deemedappropriate) when the adopted debtratio ceiling is breached. While the did not wish to recommend aparticular debt ceiling ratio withoutlooking more deeply into the matter,global experience suggests that ratios inthe range of –% are widely appliedas prudent. Such a debt ratio should beadded to existing measures fordeficit and debt reduction.

For an Indian to be credible, inkeeping with ‘best-practice’ worldwide,India’s central bank should be indepen-dent and separate from government. Itmust be independent and separate fromgovernment; i.e. in the same way thatthe Federal Reserve in the , the in Europe, the various national centralbanks of Europe and Japan, and the Bankof England, are independent of and sepa-rate from their governments. The centralbank must employ global best-practicesin the conduct of monetary policy, inorder to suffuse international investorsand issuers with growing confidence inthe as an acceptable global currencyfor transactions. The level of con-fidence engendered should permit the to become one of the world’s majorreserve currencies by or at thelatest.

The gold standard for a stabilisingmonetary policy is a transparent,independent, inflation-targeting centralbank. With such an arrangement theIndian State would be: (a) underliningits commitment to delivering low andpredictable inflation; and (b) inducinggreater confidence in the in the eyesof domestic and global investors. The recommends that the Ministryof Finance consider: (a) reforming

Executive Summary xxv

monetary institutions in the lightof recent developments in monetaryeconomics; and (b) doing so in a waythat bolsters the case for a credible in Mumbai.

also recommends a fresh lookat applying key principles in guidingreform of the tax system on the revenueside, to ensure that India remainsglobally competitive, and avoids pricedistorting subsidies on the expenditureside. This has particular implications forensuring that inflation-targeting is notdistorted or rendered ineffective becausesubsidies (e.g. for key energy prices)emit the wrong inflation signals.

. Strategy for Public Debt Financing.Traditionally, India has eschewed

bond issuance outside the country, fear-ing the currency risk that arises withissuing forex bonds while having revenues. This risk of ‘original sin’ doesnot arise if denominated bondsare sold to meet foreign demand forsuch debt. The HPEC therefore advo-cates opening up fully to foreign invest-ment in INR denominated sovereignbonds issued by GoI . It further recom-mends that no limits should apply topurchases by foreign clients of INR de-nominated corporate bonds or bondsissued by sub-sovereign entities (statesand metropolitan administrations). Inaddition, the HPEC believes that thefunction of a public debt managementoffice should be placed in the Ministryof Finance rather than in a regulatoryinstitution to avoid any perceptions ofconflicts-of-interest.

This would achieve two goals. First, itwould open up a new financing channelfor o (and state and municipalgovernments as well) thus enablingit to abandon repressive policies thatpre-empt domestic savings with anarray of undesirable and unintendedconsequences (e.g. crowding out andundue pressure on the interestrate). Second, the internationalisationof bonds (issued by the sovereign,sub-sovereigns and corporates) wouldaccelerate the emergence of an Indian on the world stage.

There is considerable unmet globaldemand for bonds on the partof long-term institutional investorssuch as foreign pension funds. Arapidly emerging bond marketwould trigger currency trading in Indiaand foster the use of currencyand interest rate derivatives. Thatwould facilitate the evolution of the as a global currency, used asa numeraire by bond investors andissuers from India and around theworld. Internationalisation of the (a prerequisite for a successful inMumbai) would expand transactionvolumes in India’s bond, currencyand derivatives markets, as well asits equity and commodity markets,coterminously. It would expand therange of financing options open to,and seignorage revenues derived by, theGovernment of India and its centralbank.

. Creation of the BCD Market Nexus.The most important missing piece

in Indian finance is the nexus ex-plained earlier: i.e. the set of interlinkedbond-currency-derivatives markets forspot and derivative instruments on in-terest rates, currencies and credit risk. Inorder to ignite these markets, HPEC rec-ommends the immediate creation of acurrency spot market, with a minimumtransaction size of Rs. million, acces-sible to all financial firms. In addition,an INR-settled exchange-traded cur-rency derivatives market should be cre-ated, with trading in futures, optionsand swaps on currencies, accessible toall.

These two initiatives, along withdeveloping more rapidly the spotmarket for bonds, need to be mergedinto the existing securities exchangeecosystem so as to trade alongsidethe spot and derivatives markets forequity. The policy problems thathave held back interest rate futuresneed to be rapidly resolved. Theresponsibility for regulation of thesemarkets – spot or derivatives; exchangeor ; government bonds, corporatebonds, and currencies – needs to be

xxvi R M I F C

moved to without further adoand unified with the regulation ofall organised financial trading. Thegoal should be to create and launch asignificant nexus, in conformitywith world standards, within months.

. Financial Market Integration andConvergence vs. Market Segmentation

Indian finance suffers from a frag-mented approach whereby the overallfinancial industry has been cut up intopieces reflecting legislation that is out-dated by years or more. exportswill not take place as long as the com-petencies of Indian financial firms areartificially stunted. India now needs itsown s present in all lines of busi-ness, and able to achieve economies ofscope and scale. A series of measuresare needed to achieve market integra-tion and convergence, and thus enableeconomies of scale, economies of scope,greater competition and enhanced IFSexport capability, i.e.:

. Redraft the legal foundations fororganised financial trading, so asto unify all organised financialtrading under regulation. Thiswould include currencies, equities,sovereign and corporate bonds, andcommodity derivatives. It wouldimmediately diminish some of thefragmentation which has taken placeamongst financial firms.

. Remove barriers to a holdingcompany structure through whichvirtual financial firms can be created,with an array of subsidiaries that fitIndian regulatory constraints butwith corporate headquarters andtop management able to operatea unified financial firm. Theholding company would be regulatedonly by the Companies Act. Itwould typically be listed and able toleverage itself; while its subsidiariesmight be unlisted. All barriers toM&A in finance need to be identifiedand removed, so as to achievea market-induced consolidationprocess which would permit Indians to emerge.

. Create wholesale asset managementbusinesses with freedom for outsourc-ing by existing financial firms such asbanks or insurance companies. Thiswould separate the legal and contrac-tual structures through which assetsare sourced and securities are created– across multiple front-ends acrossthe country – from the ‘factories’ inwhich assets are managed. It wouldalso achieve economies of scale inasset management.

. Shift away from regulation by entityto regulation by domain. As anexample, IRDA would regulate onlythe insurance business, not all theactivities of insurance companies.

. Principles-based RegulationOver the decades India has built

up a license-permit raj in finance.It over-emphasises compliance at theexpense of competence, competitionand innovation in financial services.A similar raj dominated the realeconomy since independence. Butit was dismantled during the sto the immense benefit of the Indianeconomy and particularly Indian globalcompetitiveness. To achieve the sameobjectives, that raj in finance now needsto be dismantled if India is to develop provision and export capabilitiesand if an is to emerge in Mumbai.

At present financial regulation in In-dia is fragmented and rules-based. It isover-prescriptive and restrictive of man-agerial discretion. In every market seg-ment, regulators attempt to codify everydetail of a business in which the shape ofthe future can neither be anticipated norpredicted. Anything not explicitly per-mitted is banned. Any proposed changein the way of doing business requiresclearance from the regulator. Supervi-sors apply checklists in verifying thatevery rule is met while not quite un-derstanding all the dimensions of thebusiness possibilities of the regulatedentity and how it might evolve. Thisapproach is inflexible and unamenableto swift adaptation of a kind that theworld of global finance demands. Thisis counterproductive for the purposes

Executive Summary xxvii

of fostering provision capabilitiesand inappropriate for an .

HPEC therefore recommends thatrules-based regulation in India bereplaced by principles-based regula-tion. That will require redrafting In-dia’s securities and banking laws aswell as re-skilling of all regulatory staff.HPEC also recommends that a newunified Financial Services Modernisa-tion Act (FSMA) be drafted to bringtogether, under a single omnibus leg-islative umbrella, all aspects of finan-cial services: i.e. securities trading,banking, derivatives, insurance andcommodity-finance. Such omnibus leg-islation should reflect the holistic natureof the financial services industry whilecreating the foundations for regulationto be modernised and, possibly, uni-fied in the fullness of time. This newlaw should draw on the models of the’s and the ’ , and bealigned with the shift away from rules-based regulation that is now being wit-nessed around the world. The new om-nibus law should embed an appeals pro-cedure – under an International Finan-cial Services Apellate Tribunal ()– that allows for: (a) appeal against anyaction of any financial regulator in India;(b) broadening the scope of appeal; and(c) judges having specialised domainknowledge in finance.

. Capital Account ConvertibilityThe convertibility question is critically

linked to the possibility of a currency cri-sis, which India has successfully avoidedover –. This discussion needsto be illuminated by three key points.First, the present Indian policy config-uration is not a ‘consistent’ one, givena pegged exchange rate and attempts athaving an autonomous monetary policywhile having significant capital accountopenness. This has, in the past, led topotentially destabilising one-way betsfor foreign capital. Second, it is clearthat if export is the goal, this is in-compatible with capital controls. Third,the growing integration of India intothe world on the current account andthe capital account is giving de facto

convertibility in any case. Myriad othercountries have perfected the combina-tion of autonomous monetary policyand convertibility. India needs to em-ulate the dozens of successes, and avoidthe mistakes made by the few failures.

Having considered the recommen-dations of the Tarapore- CommitteeReport very carefully, the HPEC nev-ertheless recommends that full capi-tal convertibility should be achievedwithin a time-bound period of the next- months and by no later that theend of calendar .

This recommendation needs tobe dovetailed with an - monthtimetable for acting on ’s otherrecommendations. That would kill twobirds with one stone. It would accom-modate the accepted international con-sensus that a country moving to con-vertibility must have liquid and efficientfinancial markets and strong institutions.Also, India’s opportunity to export will really open up after convertibility.So, between now and then, a windowof opportunity exists to tackle issues ofpublic debt management, and missingmarkets/institutions, with forceful reme-dial measures.

. Taxation of IFS and Financial Trans-actions

recommends a rational andfair tax system for which is com-petitive by international standards. The is against creating a tax haven inan Indian .

A key HPEC recommendation en-dorses the Kelkar Committee Report’sproposals for including financial ser-vices under the Goods and Services Tax(GST) regime with the simultaneousremoval of all central and state trans-action taxes including the SecuritiesTransaction Tax (STT), stamp duties,etc. These recommendations should beimplemented as swiftly as possible.

. Inducing greater competition and in-novation in the Indian financial system

has made a series of specificrecommendations in Chapter . All ofthem aim at inducing greater competi-tion and innovation in the Indian finan-

xxviii R M I F C

cial system and in the provision/exportof . Apart from what has alreadybeen said about reversing the excessivesegmentation and compartmentalisa-tion of financial markets, these measuresinclude, inter alia:• Removing existing barriers to en-

try of private domestic corporateplayers in some segments of the fi-nancial services industry;

• Removing barriers to the entry offoreign financial firms in the pro-vision of IFS on the grounds thatunilateral liberalisation is in India’sown interests;

• Restricting demands for recipro-cal market access only to domesticfinancial services;

• Reducing the extent of public own-ership progressively in Indian fi-nancial institutions;

• Removing existing barriers tofriendly or hostile mergers, acqui-sitions and takeovers in the finan-cial services industry within/acrossmarket segments; and

• Encouraging the emergence of In-dian LCFIs through market-driveninitiatives.

. Improving the performance of the legalsystem for finance/ IFS

HPEC believes that significant im-provements need to be made in the In-dian legal system in resolving disputes,adjudicating settlements and enforc-ing financial contracts in real time. Ifthat does not happen the prospects forMumbai emerging as an , or aspiringto become a , will be irreparablydamaged.

. Opening up space for IFS support ser-vices infrastructure

Related to improvements in the le-gal system as they apply to finance and, the HPEC recommends openingup domestic space to permit the en-try of well-known international lawfirms that operate in other IFCs andGFCs as well as international account-ing firms and tax advisory firms as wellas specialist management consultingfirms focusing on the IFS industry. This

recommendation is made so that In-dia can catch up quickly with the restof the world in becoming a competi-tive provider of through an inMumbai. It will not do so if it is left toexisting domestic law, accounting andtax advisory firms to develop domainknowledge and skill-sets organically – incoping with the demands for relatedlegal, accounting, tax and business advi-sory services –without being confrontedwith the pressures of competition andinnovation in their market.Swift implementation of this ten-

point programme, would orientate Indianfinancial firms towards achieving exportcompetitiveness. It has ramifications formacro-economic policy that have alreadybeen spelt out. It is consistent with thepursuit of sound practices in fiscal, monetaryand exchange rate management. Theserecommendations constitute a dovetailedagenda that would be wise for India to followin any event regardless of the arguments foror against an .

9. Urban infrastructure andgovernance in Mumbai

The lure of the burgeoning Indian markethas already attracted a large number offoreign financial firms to Mumbai. Theyhave, in turn, located an increasing numberof high-level expatriate staff in the city,creating intense competition and drivingup prices quite dramatically for limitedaccommodation and lifestyle facilities thatare not yet world class. A Mumbai-that provides only to the Indian marketwill not face the same pressures fromforeign firms and expatriates to remedy theprivations that they presently have to suffer:i.e. inadequate infrastructure, massivecongestion, rampant pollution, along withpoor standards of urban governance and lawenforcement. In ’s view the presentstate of play can be tolerated reluctantly evenas Mumbai grows as an in its first phase,connecting India to the rest of the world.But that can only last for the next five yearsor so.

In its second phase of growth, ifMumbai is to be a successful that

Executive Summary xxix

exports to global markets competitively, itwill have no choice but to match London,New York and Singapore in terms ofattracting the requisite high-level humantalent to the city. If it fails to do so it willnot succeed as a . To match these globalcities in the span of the next - years fortheir world class quality of infrastructureand their global standards of governance,Mumbai needs to make a start now.

The individuals that Mumbai mustattract (and who matter most) to be globallycompetitive in providing – whetherIndian or not and whether working forIndian or foreign firms – are affluent, mobile,and multi-culturally inclined in terms oftheir habits, tastes and preferences. Theydemand world class facilities to live, workand play, as well as world standards ofinfrastructure and urban governance. Theyhave ample choice in terms of where they(and their families) choose to be located,and how their time is allocated. Whetherthey choose to locate in Mumbai will beinfluenced by the attractions of Mumbai as aglobal city in which they can live, work andplay in a manner similar to what they cando in other s. This reality may involvethe creation of facilities to support lifestylesthat could result in increasing social tensionin the city; that risk will need to be managedsensitively and adroitly.

For Mumbai to become an that canoperate on a par with the three establisheds, it will eventually need to attract alarge population of individuals who arean integral part of the globally mobile(globile) finance workforce that already exists.Perhaps –% of them will be of Indianorigin. The remainder will be expatriatesfrom around the world representing everycountry that has significant trade andinvestment links with India (and Asia).Most of them will be working for foreignfinancial firms that will include, interalia: commercial and investment banks,asset management companies, insurancecompanies, securities and commoditiesbrokerages, bills discounting houses, privateequity firms, venture capitalists, hedge funds,as well as the financial media and financialreporting agencies (such as Bloomberg,Reuters, major global financial publications)

and exchanges – even external and globalregulatory agency representatives – fromover a hundred different countries. Toattract such internationally mobile high-level human capital to an in Mumbai,special efforts will be required on four fronts:i.e.

• First, elementary, glaring deficienciesin Mumbai’s urban infrastructure willneed to be addressed and rectified on awar footing. These deficiencies have,over the last decade or more, beendiscussed in central, state and municipalgovernment circles, the media, thecorporate world, and by the publicat large. Progress in addressing thesedeficits is now being made. The was assured by the ofMaharashtra that the pace of progresswas about to accelerate. Mumbai’sdeficiencies include: crumbling housingin dilapidated buildings pervading thecity; poor road/rail mass transit as wellas the absence of water-borne transportin what is essentially an island-city;absent arterial high-speed roads/urbanexpressways; poor quality of airports,airlines and air-linked connectionsdomestically and internationally; poorprovision of power, water, sewerage,waste disposal, as well as a paucity ofhigh-quality residential, commercial,shopping and recreational space thatmeets global standards of construction,finish and maintenance.

• Second, Mumbai will need to beseen as a cosmopolitan metropolisthat welcomes and embraces migrantsfrom everywhere – from India andabroad. That will mean providingmore user-friendly visa/resident permitmechanisms, making all arms ofgovernment expatriate-friendly, andexhibiting a gentle, tolerant, open andwelcoming culture.

• Third, lifestyle facilities that concernhuman welfare will need to be broughtup to world standards and run onworld-class lines in terms of theirmanagement and growth. These include:hospitals and the health system (publicand private); educational facilities

xxx R M I F C

such as primary/secondary schools,colleges, and universities; recreationalfacilities such as sports stadiums (fora wide variety of sports and notjust cricket), gymnasiums, cinemas,theatres, parks, clubs, hotels, bars,restaurants, racecourses, casinos andother entertainment avenues; as well ascultural institutions such as libraries, artgalleries, museums and the like, cateringto global tastes.

• Fourth, the quality of municipal andstate governance, the provision of per-sonal security and of law enforcement,will need to improve dramatically fromthird-world to first-world standards toaccommodate an . That is likely toprove the greatest challenge of all.

Of course, Mumbai needs to tackle theseinfrastructure deficits for reasons other thanbecoming an . The is too smalla tail with which to wag the much largerurban development dog. But the case for an would be immeasurably enhanced if itsucceeds in doing so. For that reason, recommends a fresh attack on the legal issuesof urban governance, in a cohesive effort,undertaken on a war-footing, between theCentre, Maharashtra and Mumbai. Theaim must be to create a city governmentwith the necessary autonomy, accountabilityand power to provide local public goods inMumbai in a reasonably unfettered fashion.Mumbai’s needs must be met irrespective ofrural versus urban considerations. The city’sadministration must have an earmarkedfunding stream through tax sharing, inaddition to user charges and property taxesthat it can levy independently, to finance thecreation of a ‘global city’ in Mumbai.

10. The choice

India has already become a large purchaserof from the rest of the world; muchlarger than is realised in policy-making orcommercial circles, leave alone by the publicat large. As its economy grows, its demandfor will increase in a non-linear fashion.India can, of course, choose to continuebuying from abroad indefinitely. Butthe amounts it will need to spend for thatpurpose are staggering. They represent a

waste of resources on purchasing servicesthat India could provide more competitivelyfor itself. Moreover, an inability to meetits own needs – and those of its tradingand investment partners – for willcompromise India’s growth.

Oddly enough, India does not need torely on foreign providers for . Quitethe contrary: India has several significantstrengths that give it an edge in providing not just to itself but to the rest of theworld on a competitive basis. Indeed, thereis no city in the world that can become an on the scale of London or New York,within a -year horizon, in the way thatMumbai can. This reflects India’s uniquestrengths of: democracy, open-mindedness,cultural comfort with foreigners living andworking in Mumbai, use of English, a wellplaced time zone, high quality labour force,a year tradition of speculation and risktaking, and a hinterland advantage.

But such a future for Mumbai is farfrom guaranteed. At present, India isabsent from the global space, owingto weaknesses in financial sector policy,financial market structure, financial regimegovernance, legal system infirmities, aswell as in the urban infrastructure andgovernance of Mumbai. The situationis worse than initial conditions were formanufacturing and software exports in .India does not have a low market share inthe global market: it has a zero marketshare.

Looking ahead, the growth of demand in India is inevitable, given thesheer growth of cross-border flows. Thepressure of demand that will flow fromcross-border transactions of $– trillion peryear will inevitably trigger the emergenceof rudimentary capabilities in one wayor another. The question that India faces iswhether incremental evolution towards alimited range of capabilities is adequate,or whether there is a more promising futurefor India in exporting .

If decision-makers fail to tackle thepolicy issues outlined in this report, Indian demand will fuel the growth of WallStreet, Singapore, and the Cityof London; often through the aegis ofIndian financial firms that will graduate

Executive Summary xxxi

into multinationals and relocate their operations outside the country.

The maturity of Indian finance in ,in terms of coping with competition andglobalisation, is comparable to where Indianmanufacturing stood in . The exportof financial services from India in

sounds about as unlikely today as the exportof automobile components or softwaresounded in . The outlook for export ofautomobile components or software in

was nothing but bleak. Yet India managedto find the energy to unleash revolutionarychanges in policy.

Such radical changes now need to bereplicated in finance, if export competitive-ness in the provision of financial services(domestic and international) is desired andto be achieved. Visionary thinking needs tobe applied to issues of financial architecture,the role of the central bank, and regulatoryphilosophy.

In parallel, Mumbai needs to become afirst-world city that can attract the brightestminds of the world by being an attractiveplace to live, work and play.

If India is able to meet these twinchallenges, then exports could outstrip service exports by . The benefitsto the Indian economy, from taking the

path, are much greater than thedirect revenues that would accrue fromsale of to local and foreign customers.India’s experience with manufacturing hasdemonstrated that outward orientation andexport competitiveness are the best toolsfor producing world class quality for thedomestic market. An Indian financial sectorthat can export will do a better task offinancial intermediation for India. That islikely to generate an acceleration of growth as growing investment resources(now exceeding % of ) are moreefficiently allocated.

These benefits need to be weighedcarefully by India’s leadership against thepolitical capital that needs to be expendedin overcoming the technical and realpolitikconstraints of: (a) changing the financialsystem in India with a second, moreintensive set of reforms; and (b) urbangovernance in Mumbai.

This report has tried to bring objectivityand professional competence to sketchingthe trajectory, should India’s leadershipdecide to take the path. It strives todeliver a nuanced appreciation of the likelycosts and benefits of the path to an ,based on understanding of which policy-makers can make a reasoned choice.

xxxii R M I F C

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Executive Summary xxxiii

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The Emergence of IFCs:A brief history

1c h a p t e r

1. Meeting cross-border trade,investment and other needs

The growth of international finance hasbeen shaped by history. It is a chronicle ofepisodic needs for capital across geographiesoutgrowing the domestic resources available.Financial services, institutions and marketshave evolved in response to requirementsfor capital. As colonial empire-buildingand industrial development took off – inEurope, the Orient and elsewhere – largefinancing needs arose that triggered theneed for large cross-border financial firmsand markets to emerge. Such needs werecompounded by new technologies thatenabled the geographical separation ofproduction from consumption (of goodsand services) around the world. They fuelledexponential growth in cross-border tradeand investment. These economic forces were,and are, the main drivers of internationalfinancial services ().

At first, merchants who became bankersworked alone to raise or put together fundsfor large investments. They graduallydiversified their sources of funds toroyalty, church, landed aristocracy, andwealthy professionals. Modern-day financialinfrastructure did not exist. Central bankingand financial regulation were nascent andprimitive. Securities exchanges/marketswere few and far between. Credit-ratingfacilities were nonexistent. Resort to lawfor the settlement of financial disputes wasvirtually unknown. In this raw environment,vendors in each centre of finance actedalone or collaborated with partners inother locations with extreme caution. Thatresulted in delays and inefficiencies. Yetthese early impulses saw incipient clusters offinancial expertise emerge that evolved intos. Over time, many city-states specialisedin arranging complex financing deals and

providing trade financing services to specificregions.

In this chapter we take a synoptic lookat the evolution of s around the world,consider how they might classified in termsof what they do and whom they serve, lookat recent trends in the formation and spreadof s and, finally, we examine at the casefor Mumbai to emerge as an as Indiatakes its place in the world.

2. Evolution of internationalfinancial services (IFS) andcentres (IFCs)

The provision of has a longerchronology than commonly recognized.The world had a global currency (basedon gold and silver) for several centuries.–in the most basic conceivable forms –were provided by merchant traders-cum-financiers for at least two millennia; if notbefore. Pre-modern flourished acrossEurope, the Middle East, and coastal Africa,under the umbrella of the Roman Empire– which also traded with Persia and theOrient. Its trajectory was nearly extinguishedbetween the th and th centuries but revived to finance the Crusades in theth and th centuries.

The antecedents of modern aretraceable to the Renaissance when the city-states of Venice, Florence, Naples and Genoabecame mercantile centres that dominatedtrade between Europe and the Orient fromthe th to th centuries. In the th andth centuries these Mediterranean centreswere superseded by the rise of Amsterdam,Lisbon, London, Madrid, and Paris as s,with the discovery of the New World, theAntipodes, and the establishment of colonialempires across the Americas, Africa and Asiaby European powers; viz. Britain, France,Holland, Spain and Portugal.

2 R M I F C

The nature of mercantile wastransformed with the first round ofglobalisation that occurred from the mid-th to the early th century. It wasrevolutionised again by the second roundof globalisation that had its origins in post-nd world war reconstruction and recovery,but gathered real steam since the s.Since the s globalisation has entereda new and more intensive phase. It hasbecome the principal force driving andreshaping the world economy. In the process,it is increasing the tensions caused by aneconomy that is increasingly global, beinginadroitly governed by polities that remainnational and, as yet, incapable of graduatingtoward the kind of supranational governancethat globalisation demands.

3. The first round ofglobalisation: circa1860–1914

From around onwards, there wasa quickening of the pace of first-roundglobalisation, owing in part to the followingmajor developments among others:

. In , a ,-mile telegraph systemlinking Calcutta, Agra, Mumbai, Pe-shawar and Madras was completed. Itwas the first high-speed messaging sys-tem in India.

. After the Civil War, economic growthin the took off based on liberal,market driven egalitarian economicrelationships, i.e., without relying onslave labour. In the s the FirstTranscontinental Railroad was built,with construction from both coastslinking up in .

. In parallel, railways were being con-structed in India where, by , over, kilometres of railway lines hadbeen put in place.

. In , telegraph links between Europeand India became operational, so thata message could get from London toMumbai in less than minutes. In ,the first transatlantic telegraph cable wascompleted.

. In , the Suez Canal was builthalving sailing time between Londonand Mumbai.

By , two large, productive andpolitically stable, economic blocs – theBritish Empire (with India as its economiccentrepiece) and the – had emerged asdominant. They straddled the extremitiesof the globe from west to east with wellestablished intra-imperial trade routesconnected by steamships, railways and thetelegraph. But the world economy of theth century was not limited to these twoblocs. Other European powers also had‘intercontinental’ empires in the Americas,Africa, and Asia. These were similar to,but much smaller than, the British Empire.The Russian and Ottoman empires exerteddomain over territories in Eastern/CentralEurope, and the Middle East and NorthAfrica respectively. Japan established its ownempire in Korea and Formosa (now Taiwan).

Cross-border trade occurred mainlywithin the geographies of these separateempires, rarely across them. But therewas inter-empire trade in Africa, Asia andLatin America across contiguous borders ofneighbouring colonies (e.g., between BritishKenya and German Tanganyika as well asItalian Ethiopia, between British Nigeriaand French Cote d’Ivoire, or British Malaya,Dutch Indonesia and French Indochina).

The th century saw a historicallyunprecedented surge of intra-colonial tradewith accompanying demand for trade andinvestment related . Sophisticatedtrade finance spilled over into long terminvestment finance, for plantation farming,ranching, mining and infrastructure (e.g.,railroads and steamships) as well asthe production of agro-industrial andindustrial manufactures. Thus trade andinvestment (for localised production, basedon natural and comparative advantage,but aimed at empire-wide consumption)provided the principal impulses for thedevelopment and growth of in enablingeconomic decentralization and geographicaldispersion. They still do that today; but, ona much larger scale, with the growth of cross-border trade and investment far exceedingthe rate of global output growth.

. The Emergence of IFCs: A brief history 3

During the first round of globalisation,London was the pre-eminent , withAmsterdam and Paris playing supportingroles. New York was still in its infancy then.It did not come into its own till around. This was an age of universal capitalconvertibility. Citizens of the world werefree to move their assets across boundarieswithout governments or central banksimpeding them. Enormous pools of capitalwere intermediated in Europe for investmentabroad. Savings were mobilised in Londonfrom around the British Empire (includingIndia) for investment in the Americas, aswell as the British colonies in Canada, theCaribbean, Africa, the Middle East, Asia(West, South and East), the Indian Oceanand the Antipodes.

In this period, large amounts of capitalflowed from rich to poor countries. Fundsfor investment in the colonies of continentalEuropean empires were raised in theirimperial capitals; but augmented by globalfunds raised in London for large riskyventures: e.g., ranching and mining in Chileand Argentina, mining in almost all ofSouthern Africa, and for financing telegraphsystems, railroads, sailing and steamshiplines, telegraphy, and such monumentalprojects such as the Erie and Suez Canals.

4. An interregnum, the secondround of globalisation(1945–71), and beyond

In the late th century accelerateddramatically, driven by the industrial,transport (steamships) and communications(telegraph) revolutions, resulting in astructural transformation of the worldeconomy. More technologically-drivenchange in the world economy occurred inthe course of the th century than in the twoprevious millennia. It triggered profoundgeopolitical change, resulting in a series ofEuropean wars culminating in two worldwars.

The th century that followed madethe remarkable th century appear primi-tive by comparison. Progress – in air trans-port, information, communications andprocess technologies for manufacturing, in

semiconductors, transistors and silicon chips– was made in decades that previously hadtaken centuries.

The -year period (–) betweenthe end of the first, and beginning ofthe second, rounds of globalisation wasdisrupted by two world wars and an unstable-year interregnum. The second roundof globalisation had its hesitant origins inan era of post war recovery, adjustmentand decolonization (-) that againchanged the economic structure of the worldand the trajectory of the global economy.The revival of cross-border trade across theAtlantic and Pacific, along with massiveinvestment for post-war reconstructionfinanced by the , played a major rolein resurrecting and galvanising it at amore frenetic pace than before. During thisperiod (i.e., –) New York replacedLondon as the world’s pre-eminent .

In both rounds the distinction betweendomestic and overseas financing for trade andinvestment became blurred in determiningthe content of . And, in both rounds,the process of financial integration andglobalization was driven by:

. Financial innovation in instruments,services and risk management arrange-ments that spread instantaneously acrossborders (when it was permitted to) tomeet the evolving needs of clients (saversand users of funds) in the real economy.

. Different risk/return and portfoliodiversification demands of global saversand investors.

. The injection of information processingand communication technologies intomassive-scale gathering, disseminationand processing of data. Ubiquitousaccess to low-cost information tended toundermine relationship-based bankingand fuel the growth of arms-lengthsecurities markets, particularly whenit came to large issuers of securities.

In many countries, imported capitalfinanced domestic investment and vice-versa, as direct and portfolio investors (inan increasingly integrated global market)diversified their investment portfolios tomanage/balance country and sector risk.

4 R M I F C

The second round of economic and financialglobalization began with the beingthe world’s locomotive and sole providerof surplus investment capital for theglobal economy. While driven initially bythe reconstruction needs of Europe, the, and Japan, global economic recoveryresulted in dispersing manufacturingcapabilities (and consequently enhancedtrade in goods) throughout the developedworld. Second round globalization wasboosted by new investment needs created bythe decolonization of the developing worldafter .

The drove second round globaliza-tion single-handedly in –. But thatrole diminished rapidly with the collapse ofBretton Woods in . The global mone-tary system that prevailed from to

was designed by Harry Dexter White, JohnMaynard Keynes and others. It consistedof pegged exchange rates and closed capitalaccounts to support large amounts of pub-lic spending for reconstruction and socialwelfare without risking capital leakage fromresource-starved economies. But that histor-ically anomalous and unnatural confinementof capital lasted for just years.

The primordial nature of unrestrainedcapital flows across borders (that nationalgovernments consider sacred, but ‘capital’is oblivious to) was restored in the face ofunsustainable global pressures. These arosefrom chronic global imbalances in savings,consumption, investment and trade. Theywere driven by the shifting geographies ofproduction, the economic revival of Europeand Japan, and decolonisation. Between– the Bretton Woods regime wasreplaced in all economies by the newstable regime based on floating exchangerates and open capital accounts.

In the developing world, the role playedby the as the principal global creditor-cum-investor was supported by capital flows(official and private) from former imperialcountries: i.e., Britain, France and, to alesser extent, Holland. They were catalyzedand augmented by multilateral institutionssuch as the , World Bank and regionalbanks. Governments and official institutionshave played a useful role in global finance;especially in times of crises. But that role

has been dwarfed by private capital flowsthroughout the second half of the thcentury, except in –.

As happened through the th and earlyth centuries, financial products becamemore diversified. Plain vanilla finance cededto more complex structures following theintroduction of financial derivatives in the– period. grew horizontallyand vertically. Financial firms innovatedimaginatively. enabled rapid changes ina number of new technologies (e.g., , bio,nano, eco, to name a few) to be translatedinto equally rapid changes in products,services and markets served by entirely newcompanies. The was not invented till. Cellular phones came on the scene inthe s.

– vastly enhanced by – enabledthese changes to be transmitted globallyand instantly with the management of avariety of attendant risks. In response,risk management techniques, instruments,products, services and risk-trading marketsevolved rapidly. They became moresophisticated with the unbundling of risk,specialisation in risk-taking, and synthesisof risk management packages in a variety ofdifferent forms. also financed the tidesof geopolitical flux – both the conflicts thathave taken place and the reconstruction thathas followed in their aftermath.

The changes of the th and thcenturies seem dramatic in retrospect;indeed almost unimaginable in the contextof progress made over the previousmillennium. But, the time-span for progressin the st century is becoming even morecompressed in considering the speed withwhich new technologies keep emergingand shortening product/market life-cycles.Technological innovation is occurring ona log rather than linear scale. Financialinnovation is struggling to keep pace.

Technological changes that took cen-turies before occurred in decades in theth and th centuries. But, just one year inthe st century, is seeing changes that tookfive years or a decade in the th. Techno-economic and ‘financial world’ changes keepracing ahead unbridled. But the social, cul-tural, political and institutional changesneeded to accompany them – and cope

. The Emergence of IFCs: A brief history 5

with their consequences – are occurringtoo slowly. In the developed world thesesocial and political changes are being madefaster than in developing countries like In-dia, where structures and institutions forpolicy-making and governance are adaptingat a glacial pace. In the process, governanceis becoming dysfunctional in coping withtransformations in consumer expectationsand behaviour (as well as in goods/servicesmarkets and industries) that are now occur-ring at ‘warp-speed’ in the real and financialworlds.

As with the first round of globalization,the propagation of new technologies (jetengines, transistors, computers, televisionand telecommunications) and relativereal wage cost differentials (adjusted forproductivity) are playing a significant rolein accelerating globalization in its secondavatar. In the first round, cross-bordercapital movements were free. The worldwas financially more integrated, albeitinformally, because of the absence of capitalcontrols. But, the early stages of the secondphase of globalization (i.e., –) saweconomies being heavily regulated andfinancially segregated under the BrettonWoods regime monitored by the newlyestablished International Monetary Fund(). Global financial integration began tocatch up in earnest with the breakdown ofBretton Woods and a reversion to freedomof money and capital flows.

5. The ‘take-off’ of secondround globalisation after1980

Since , the nature and direction ofglobal capital flows, and the continuedgeographical dispersion of production, havechanged significantly; with aligned changesin the nature and direction of . Frombeing the world’s largest creditor, the has become the world’s largest debtor injust two decades. In , the world owedthe almost $ trillion. By ,the owed the world the same amount.By , it owed the world nearly $

trillion. The ’ debt to external creditors(mainly Asia and ), denominated

in , is growing at an annual rate of$ billion. This astonishing reversalof global capital flows now supports the as the world’s consumer of last resort.That role is unsustainable for much longer;especially if the global distortions nowbeing exacerbated by chronic imbalances insavings, consumption and investment acrossthe world’s economies, are to be rectified inan orderly manner over time: i.e., withoutworldwide disruption and a damaging lossof confidence in the value of the as areserve currency.

As the tides of global finance change, sodo the fortunes of s. Until , Londonwas the world’s premier . After theFirst World War, New York – as the of the only capital-surplus country in theworld at the time – eclipsed London. Itremained ahead for nearly nine decades from–. New York lost its primacy againto London just this year. London beganrecovering its position as an in the lates and s when misguided financialregulation in the – i.e., the infamousRegulations K and Q – resulted in thesurplus dollars of American s in Europe(from profits, dividends, and repayments ofintra-corporate loans by subsidiaries) beingretained in Europe for global reinvestmentinstead of being repatriated to the wherethey would have been taxed exorbitantly.

That resulted in the creation andgrowth of the Eurodollar market with itscentre of gravity in London where theauthorities seized the initiative with a‘light touch’ approach to financial marketregulation. Financial regulation in the has been continuously refined ever since tomaintain London’s competitive edge. Macro-economic policy in the , which wentthrough a distressing period including oneIMF program and one speculative attackon the GBP, has been put on an even keelthrough a mix of fiscal rules and the Bank ofEngland reforms. These factors have beenthe key to London’s re-emergence as theworld’s premier in .

The Eurodollar market explodedin the s when the first round ofcartelised oil price increases resulted inpetrodollar surpluses being accumulatedby oil-exporting countries. Their domestic

6 R M I F C

economies were incapable of absorbing sucha sudden, large increase in the volume ofresources available. They were recycledaround the world – mainly through Londonand New York – by banks with global branchnetworks and established correspondentrelationships. The Eurodollar market hassince diversified into a multi-currency Euro-market that is global in nature. It establishesthe benchmark for interest rates in allcommonly traded currencies. It has beenmimicked in Singapore by the Asian dollarmarket although that market is yet a palereflection of its Euro-counterpart.

The second round of globalisation hasentered a new phase in the st century.The world’s centre of economic gravity hasshifted to Asia. It is possible, even likely, that– with greater market-driven integrationof Asian economies – the Asian dollar (ormulticurrency) market may equal or exceedthe present size of Eurocurrency marketswithin the next two or three decades. Thatdepends on whether Asian bond marketsdevelop in the same way, by taking a leadfrom Japan.

For that to happen, wide and deepmarkets will need to be created for currencytrading in Asia and for a wide range ofderivatives (for currencies, interest ratesand commodities) in the more adroitlyregulated Asian s like Singapore and,hopefully, Mumbai. The growth of anAsian multi-currency market will have majorimplications for the internationalisationof the as a world currency andperhaps even for the emergence of commoncurrencies for two or three Asian sub-regions.

6. Classification of IFCs

Financial centres that cater to customersoutside their own jurisdiction are referred toas international (s) or regional (s)or offshore (s). These three adjectivesare often (but wrongly) used synonymouslyin the literature on s. The three typess they identify are difficult to define in aclear-cut, mutually exclusive, fashion. Butthey are quite distinct. All these centresare ‘international’ in the sense that theydeal with the flow of finance and financial

products/services across borders. But thatdoes not differentiate them sufficiently interms of their scope.

We categorise s in this report as:(a) Global (GFCs); i.e., those that genuinelyserve clients from all over the world inthe provision of the widest possible arrayof ; (b) Regional (RFCs) that servetheir regional rather than simply theirnational economies (see below) – examplesof such s would be Dubai or HongKong; (c) International non-global andnon-regional IFCs like Paris, Frankfurt,Tokyo and Sydney that provide a wide rangeof but cater mainly to the needs of theirnational economies rather than their regionsor the world – one might be tempted to callthem national s although that term isawkward because its two defining adjectivesare contradictory; and (d) Offshore (OFCs)that are primarily tax havens for wealthmanagement and global tax managementrather than providing the fully array of .

6.1. Global financial centresGlobal Financial Centres (s) such asLondon, New York, and Singapore are full-service centres. They offer a completerange of markets, products and servicesto clients worldwide, along with advancedsettlement and payments systems. Allthree support large hinterlands whethernational (i.e., New York) or regional (e.g.,London and Singapore). All have deep andliquid national financial markets. Theirsources and users of funds are global anddiverse. Their legal/regulatory frameworksare robust enough to safeguard the integrityof all principal-agent relationships andsupervisory functions. s generallyborrow short from residents and non-residents and lend long mainly to non-residents. In terms of assets and tradingvolumes, London is the premier ,followed by New York. The key differenceis that the proportion of internationalto domestic business is much greater inLondon.

The most recent entrant to the club is, arguably, Singapore. When itsfinancial services sector was confronted bythe deregulation of Tokyo’s markets in themid-s, and when Hong Kong’s future

. The Emergence of IFCs: A brief history 7

was rendered uncertain by the Anglo-Sinoaccord of , the Singapore governmentresponded by adopting a strategy aimedat creating a niche for Singapore in Asianand global markets. It importedthe best expertise, enhanced supportservices, and adopted globally competitivetax and regulatory regimes. The success ofthese policies was reflected in global firmstransferring their Asian regional financialoperations from Tokyo and Hong Kong toSingapore through the s. Singapore alsolooked west and took steps to encourage theemergence of a non-deliverable forwardsmarket on the . It is now actively gearingits industry to capture a larger marketshare of Indian business.

6.2. Regional financial centresThe phrase regional financial centre causessome confusion because it is commonlyused in two different senses: (a) whena particular actually serves not justits national economy but its surroundingneighbourhood region – it is genuinelya – and probably derives more business from its neighbourhood than fromits own economy; and (b) while an maybe regional in the sense of being located ina particular region – it may not necessarilyserve that region but be confined to servingits own economy instead. This report triesto avoid that confusion by accepting only thefirst definition and disregarding the second.

For example, Paris and Frankfurt areEuropean s. But they do not provide for the to the extent Londondoes. In the same way, Tokyo is an Asian. But Singapore and Hong Kong servemore Asian economies with a wider rangeof except for the global market for denominated bonds, which Tokyodominates. Paris, Frankfurt and Tokyoare not, in our definition, s. They aremore national than regional in orientation.s differ from s in that they havereasonably developed financial marketsand infrastructure; but they are not assophisticated, wide or deep as s. Theyintermediate funds in and out of their region,but they have relatively small domesticeconomies (compared with their regions)and are not as globally competitive as s.

Regional centres include s such as HongKong and Dubai.

London and Singapore are s ina way that Frankfurt, Paris and Tokyoare not. New York also serves the NorthAmerican and Latin American regions. Butall three centres go well beyond serving theirneighbourhoods to serving the world; so weclassify them as s. Paris and Frankfurtserve the needs of the French andGerman economies. Paris also serves, to alimited extent, the Francophone world whileFrankfurt is becoming an increasingly useful to neighbouring Eastern Europeaneconomies. But neither are s, nor s,as yet.

This digression was necessary becauseHPEC was tasked to look into makingMumbai a ‘regional financial centre’. Butthe Committee has deliberately chosen toavoid using that nomenclature because ofits implications and connotations.

Under present circumstances, it isdifficult to see Mumbai becoming a ofchoice for the South Asian region. India’simmediate neighbours may, for geopoliticalreasons, prefer to use Dubai or Singaporeinstead for their needs. So, whileMumbai is located in South Asia, it isunlikely to become a South Asian in the foreseeable future. Instead, the believes that it is more likely toleapfrog from emerging as an thatserves India, into becoming a thatserves the world, without serving its SouthAsian neighbourhood along the way. Inthat sense Mumbai’s emergence as a may be different from that of London, NewYork and Singapore which are all s aswell as s. Whether Mumbai becomes a depends on whether the preconditionsnecessary for it to play that role are metby the concerned authorities. The irony isthat if South Asia’s geopolitics are eventuallyironed out, and reach an equilibrium thatpermits meaningful economic interaction,Mumbai may become an RFC after it hasachieved status.

6.3. Offshore financial centress comprise a third category of .They are smaller, and provide more limitedspecialist 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

bank to handle its foreign exchange operations or to facilitatefinancing an international joint venture. An onshore bankestablishes a wholly owned subsidiary in an OFC to provideoffshore fund administration services (e.g., integrated globalcustody, fund accounting, fund administration, and transfer agentservices). The owner of a regulated onshore bank establishes asister parallel bank in an OFC. The attractions of the OFC mayinclude no capital tax, no withholding tax on dividends or interest,no tax on transfers, no corporation tax, no capital gains tax, noexchange controls, light regulation and supervision, less stringentreporting requirements, and less stringent trading restrictions.

Offshore corporations or international business corporations (s): are limitedliability vehicles registered in an OFC. They may be used to ownand operate businesses, issue shares, bonds, or raise capital inother ways. They can be used to create complex financialstructures. In many OFCs, the costs of setting up IBCs are minimal.They are generally exempt from all taxes and, for that reason, area popular vehicle for managing investment funds.

Insurance companies: A commercial corporation establishes a captiveinsurance company in an OFC to manage risk and minimize taxes.An onshore insurance company establishes a subsidiary in an OFC

to reinsure certain risks underwritten by the parent and reduceoverall reserve and capital requirements. An onshore reinsurancecompany incorporates a subsidiary in an OFC to reinsurecatastrophic risks. The attractions of an OFC in thesecircumstances include favourable income/withholding/capital taxregime and low or weakly enforced actuarial reserve requirementsand capital standards.

Special purpose vehicles: One of the most rapidly growing activities in OFCs isthe use of special purpose vehicles (SPV) to avail of a morefavourable tax environment. An onshore corporation establishes

an IBC in an offshore centre to engage in a specific activity.Issuance of asset-backed securities is the most frequently citedactivity of SPVs. The onshore corporation may assign a set ofassets to the offshore SPV (e.g.,, a portfolio of mortgages, loanscredit card receivables). The SPV then offers a variety of securitiesto investors based on the underlying assets. The SPV, and hencethe onshore parent, benefit from the favourable tax treatment inthe OFC.

Tax planning: Wealthy individuals make use of favourable taxenvironments in, and tax treaties with, OFCs, often involvingoffshore companies, trusts, and foundations. There is a range ofschemes that, while legally defensible, rely on complexity andambiguity, often involving types of trusts not available in theclient’s country of residence. Multinational companies routeactivities through low tax OFCs to minimize their total tax billthrough transfer pricing.

Tax evasion and money laundering: Individuals and enterprises rely onbanking secrecy to avoid declaring assets and income to therelevant tax authorities. Those moving money gained from illegaltransaction also seek maximum secrecy from tax and criminalinvestigation.

Asset management and protection: Wealthy individuals and enterprises incountries with weak economies and fragile banking systems keepassets overseas to protect them against the collapse of domesticcurrencies and banks, and outside the reach of existing orpotential exchange controls. If these individuals seekconfidentiality, then an account in an OFC is often the vehicle ofchoice.

Source: Financial Stability Forum’s Working Group on OffshoreFinancial Centres Report (April 2000).

pricing, wealth management and privatebanking. Offshore finance is, at its simplest,the provision of financial services by banksand other agents to non-residents. Theseservices include borrowing money from non-residents and lending to non-residents. Thiscan take the form of lending to corporatesand other financial institutions, funded byliabilities to offices of the lending bankelsewhere, or to market participants. Itcan also take the form of the taking ofdeposits from individuals and investingthem elsewhere.

s are typically found in the islandeconomies of the North Atlantic, Caribbean,Indian and Pacific Oceans as well as ina few exotic European jurisdictions (e.g.,Andorra, Monaco, Lichtenstein and ofcourse Switzerland). They range fromlarge and well-established private bankingcentres like Switzerland – that providespecialist and skilled wealth and assetmanagement activities, attractive to majorfinancial institutions – to smaller, more

lightly regulated centres that provide servicesto high-net worth individuals and smallcompanies or trusts. They are almost entirelytax driven. They have limited resources tosupport financial intermediation. Many ofthe financial institutions registered in shave little or no physical presence beyonda nameplate; although that is not the casefor all s. They are mainly providersof corporate and accounting services for‘passively managed’ offshore accounts.

7. Why did Tokyo andFrankfurt not emerge ascredible GFCs?

In considering the prospects for Mumbai asan , and later as a , it is instructiveto examine why Frankfurt and Tokyo did notbecome successful s? Tokyo is locatedin the world’s second largest economy,measured in nominal . Frankfurt waslocated in the world’s third largest national

. The Emergence of IFCs: A brief history 9

economy (till China overtook it in ). Itis at the centre of the world’s largest regionaleconomy – the . So why did thesetwo centres not become s despite theirhinterlands while London and Singaporedid?

One explanation lies in historical demand from a large hinterland (homeor regional) capital market that is moresophisticated, better regulated and moresensibly taxed, than elsewhere. This allowsfinancial firms to diversify and exploiteconomies of scale to become globallycompetitive while being able to offer servicesthat are not over-taxed. It explains London’sand New York’s success as s becausetheir financial firms (mainly investmentbanks and asset managers) developed byserving the largest, most sophisticated andmost demanding capital markets in theworld.

It also explains why Tokyo (withits huge but unsophisticated and tightlyregulated domestic market) and Frankfurt(with its heavily taxed home market)have not succeeded in emulating them.Both Frankfurt and Tokyo are centres ineconomies with more traditional, rigidbank-dominated rather than capital marketdominated financial systems; resultingin their being relatively uncompetitive.Their banks have not developed thesame institutional capabilities for inducingfinancial innovation as more capital-marketinstitutions in the and have.

Tokyo’s example is instructive forMumbai. Tokyo possessed many ofthe attributes needed to rise to globalprominence. But it was unable to capitalizeon them. Powered by Japan’s economicstrength and external surpluses, Tokyoachieved status in the late s,when the top global investment banksand brokerages headquartered their Asianoperations there. Indeed, the global capitalmarket could not ignore Japan’s enormoussurplus assets in public and private savings.Nor could the world go anywhere else toissue bonds or raise funds denominated in.

The bursting of the real estate bubble,and Japan’s economic decline since ,ended Tokyo’s rise. The city lost business

to competing centres. But its role as a was circumscribed even without thecrisis. Barriers to competition and lack ofopenness restricted its potential. AlthoughJapan deregulated its financial system, asthe and did in the s ands, it left residual controls in place. Itsregulatory mindset did not change. Japan’sfinancial markets and institutions weresharply segmented and segregated. Newfinancial products had to be approved bythe MoF, which banned instruments thatwere commonplace elsewhere, such as equity options. Banks were not allowed tofail, however weak.

Japan’s Big Bang reform program inthe mid-s to deregulate the financialsystem had a positive effect. A collapsein domestic prices and the value of the made Japanese firms and real estateattractive targets for foreign investors. Moreof Japan’s assets and business came underinternational management. However, itsreforms did not go far enough. Tokyostill lacks the right combination of humanand market resources for producing andexporting sophisticated financial services.

Tokyo functions as a large financialplantation, producing a commodity – money– in huge amounts. But it lets London andNew York process that commodity and addvalue to it. Thus, while Tokyo has many ofthe ingredients needed for a , it has notunfettered its institutions nor deregulated itsfinancial system properly. It has protected itsbanks at the expense of its capital markets.It has not attracted foreign institutions, in away that encourages more competition andfinancial innovation. Equally importantly,Tokyo does not use English as its linguafranca. It has a mono-cultural environmentthat inhibits it from becoming a genuinelyglobal city. But Japan is reviving againand may learn from its mistakes. For thatreason it would be premature to dismiss theprospect that Tokyo may yet emerge as a although Japan’s outlook would needto change dramatically for that to happen.

Frankfurt, for different reasons, alsodoes not pose a challenge to London andNew York. Initially it was thought thatLondon would be eclipsed by Frankfurt asEurope’s because Britain did not adopt

10 R M I F C

Box 1.2: How London lost the German interest rate futures marketThe German bond market is one of the

world’s most liquid and diversified capitalmarkets. Trading on the “Bund futures” beganat London International Financial FuturesExchange (LIFFE) in September 1988. It was afutures contract based on notional GermanGovernment bond with a 4% coupon and amaturity between 8.5 and 10.5 years. By 1990,the Bund futures contract accounted foralmost one third of the total volume on LIFFE.Trading at LIFFE was then carried out by openoutcry. Bund futures trading was also initiatedat Deutsche Terminborse (DTB) at Frankfurt inSpring 1990, but this market failed to gainliquidity; LIFFE remained the dominantexchange.

In March 1996, DTB provided screen-basedtrading in London, competing against theopen outcry trading at LIFFE. At the time, LIFFE

continued to insist that pre-computer tradingmechanisms were superior.

In early 1997, the Eurex futures and optionsexchange was created by a merger ofGermany’s DTB and the Swiss Options andFinancial Futures Exchange. In March 1997,the US CFTC gave Eurex permissions to place

trading terminals in the US. By October 1997,10 firms in the US had terminals, andaccounted for 18% of Eurex Bund futuresvolume. In August 1997, Eurex extendedtrading hours to match those of LIFFE. InSeptember 1997, Eurex announced that untilthe end of 1997, fees on Bund futures tradingon Eurex would be zero. In January 1998,Eurex introduced a new pricing structurewhich effectively set the marginal cost oftrading to zero for medium and large traders.

From January 1998 onwards, LIFFE startedlosing market share. Even though the impactcost on LIFFE was at first superior, the lowercharges at Eurex were big enough to swaysome of the order flow to shift from LIFFE toEurex. The trade processing efficiencies onEurex were sufficiently large to overcomeLIFFE’s initial liquidity advantage. Once thisstarted happening, the order flow startedshifting and impact cost on Eurex startedimproving.

In early 1997, 65% of Bund futures tradingtook place on LIFFE. By the end of 1997,market share was roughly 50–50. Over thenext 21 months, market share was decisively

lost by LIFFE. By late 1998, the 10-year Bundfutures contract traded on the Eurex was thethird most actively traded derivative in theworld, after Treasury bond futures on the CBOT

and Eurodollar futures on the ChicagoMercantile Exchange. In 1999, the Eurex Bundfutures contract became the biggest contractin the world.

LIFFE was stung by this loss of a lucrativecontract, and abandoned manual trading. Butby this time, merely matching the electronicsystem at Eurex was not enough to bring theliquidity back to LIFFE. From 1972 onwards,the financial community had engaged in adebate about the merits of electronic tradingas opposed to trading floors or telephone calls.The Eurex versus LIFFE story on the Bundfutures in 1998 marked the end of this debate.

The loss of the Bund futures contract set offsubstantial soul searching in the UK about thefailures of LIFFE and of public policy which ledto this debacle. The loss of this contract led toa substantial decline in revenues of UK finance.These events formed the backdrop and helpedprovide impetus for the major reforms to theBank of England and the FSA in 1998.

the Euro. The presence of the EuropeanCentral Bank () was a significantdevelopment for Frankfurt. It bolsteredthe city’s international reputation andenhanced its importance as a financialcentre. Frankfurt profited from Germanfinancial market reforms as well as Europeanintegration; and especially from theaccession of contiguous Eastern Europeancountries formerly in the ambit of the Sovietbloc. In the future it is expected to be abridgehead to Russia, the rest of Europeand Turkey. However, Frankfurt lags behindLondon and New York in terms of most criteria – regulation, taxation, assetmanagement expertise, securities trading,and banking. Like Tokyo its language isnot English. Nor is it a global city on thesame scale as the other s. London has agreat edge because of its established globalnetworks and historical interdependencieswith the rest of the world.

The ‘decentralization’ of Germany (intolander or states) has also worked to thedisadvantage of Frankfurt as an . Notall German banks are headquartered inFrankfurt. Non-German banks in the have a larger presence in London than in

Frankfurt. Focused activities at onecentralized location are important for thedevelopment of a . Businesses that areclustered in a confined geography gain fromone another by deriving external economiesof scale. By crowding together, they createlarge, liquid markets that drive down tradingcosts and reduce risks by allowing large dealsto be handled. Frankfurt has not benefitedfrom a process of national consolidationfor providing . It could, possibly, heada secondary network of smaller Europeans.

8. The Race to establish moreIFCs around the world

Since , the resurgence of the European,Japanese and East Asian economies and therevival of petrodollar surpluses has resultedin a plethora of s (of some form orother) blossoming in other major (but notall global) cities including the following:

* San Francisco, Los Angeles, Chicago,Philadelphia, Boston, and Miami in the

* Santiago, Sao Paulo, Buenos Aires, and

. The Emergence of IFCs: A brief history 11

Montevideo in Latin America

* A large number of islands in theCaribbean (e.g., The Bahamas, Caymans,Barbados etc..)

* Amsterdam, Frankfurt, Luxembourg,Paris and Milan in Europe

* Tokyo, Hong Kong, Shanghai, Labuan,Jakarta, Bangkok, Seoul, and Taipei inEast Asia

* Sydney in the Antipodes

* Bahrain, Dubai, Kuwait, Riyadh, Dohaand Muscat in the Persian Gulf

* Johannesburg, Gaborone, Mauritius andthe Seychelles in sub-Saharan Africa

The race amongst cities to establishthemselves as s has intensified. Citiesin emerging economies look upon havingan as a relatively low-opportunity-costinitiative worthy of government support.The apparent ease of establishing an and the promise of high value-addition haveprompted many countries to create s toincrease the contribution of their financialservices sectors to output, employment andexports.

In the Middle East, several governmentshave been competing to establish RFCs. Atpresent Bahrain, Abu Dhabi, Dubai, Qatarand Muscat are all vying for that staturein the Gulf. The earliest entrant, Bahrain,went for an because it was faced withstagnation of its offshore-banking businessand felt pressed to introduce a series ofreforms to attract more investment. Thegovernment of Abu Dhabi – anxious todiversify its economy beyond oil and tocreate jobs in the private sector – declaredin that it planned to develop an. Incentives were offered, such asa zero company tax, full repatriation ofall profits and capital, free import oflabour, and no forced local partnershiprequirements. Banks were exempt fromreserve requirements.

Dubai, which has become the region’sbusiest services hub, may yet becomethe most successful in the Gulf.The emirate has successfully transformeditself from a small-scale oil producerinto a regional services hub in just

years. Its free zone has achieved a

critical mass of importers, traders andlight manufacturers. came intoexistence in September , offering awide range of services, and generous fiscalincentives and other benefits. It has strongcommercial connections internationally andwith India, the upcoming giant in Dubai’snear neighbourhood. Indeed, is likelyto be a competitor for some to an in Mumbai.

With the Asia-Pacific region registeringhigh rates of economic growth, itseconomies deregulated their financial sectorsduring the s and attracted substantialinflows of foreign capital in search ofinvestment opportunities. As a result,financial markets in many of these countriesexpanded rapidly. Apart from well-established s in the region – Hong Kong,Singapore, and Tokyo – a successful financialreform programme during the s led tothe emergence of Sydney as a potential rival.

The perceived benefits of an have attracted other Asian countries suchas: Korea, Indonesia, Taiwan, Thailand,Malaysia, and the People’s Republic ofChina () to launch new initiatives forcapturing business, at the beginning ofthe s. The South Korean governmentannounced its Northeast Asian FinancialHub in Seoul and, in July , published adetailed action plan aimed at achieving thisgoal.

There has also been an explosion in thenumber of small enclave tax-haven saround the world providing more limitedservices. But these are not germane in thecontext of the kind of that India mustdevelop now.

9. Implications for India andneed for Mumbai to emergeas an IFC

A retrospective look at the evolution of from onwards, and particularlyfrom onwards, suggests three majordifferences between the first and secondrounds of globalisation where internationalfinance is concerned:

. Global finance has been transformedby the combination of better data, com-

12 R M I F C

puters, communications, and analyticalfinancial economics; which has resultedin improved financial risk management.These factors have generated a world-wide shift away from bank-dominatedfinance to securities markets.

. The supposed stability of the goldstandard that shaped the first roundof globalization has been absent after. The abandonment of that anchorwas disconcerting at first for centralbankers and financial markets. Now theworld is coming to recognize that havinga gold standard may be anachronisticif not antediluvian. The modernconsensus holds that the right anchorfor fiat money is the -basket, i.e.,that monetary policy should be tieddown by inflation targeting. Aftercenturies of exploration, it appears thatwe now know the correct techniquefor creating fiat money. Floatingexchange rates, open capital accounts,and inflation targeting monetary policywhich stabilises the local business cycleare now the reality pervading andshaping international economics andfinance in the second globalization.Every developing country faces the taskof mastering the institutional dance thatis required to pull off this combination.

. production is now dispersed acrossa number of s, s, s ands spread across the globe. Butit is still concentrated mostly in thedeveloped world. This was unlike thefirst globalization, where London wasclearly the dominant . There isa striking difference between financialservices production, and that of mostother goods and services, in that the bulkof global financial services productiontakes place at a few s in what havecome to be known as global cities.

What can usefully be deduced fromthis brief history of s, in the context ofIndia rapidly becoming one of the world’smost significant economies post-? Howshould India cope as a third and moreintense phase of globalization emerges withIndia and China playing key roles? Simplyput, the main deductions are these:

* Given its present role and size in theworld economy India is becoming amajor user of . The locus of theworld economy is increasingly shiftingto Asia, the home of Japan, China, Indiaand . Soon, trans-Himalayanand trans-Malaccan trade will rival trans-Atlantic and trans-Pacific trade in sizeand global importance.

* As that happens, India’s needs (as wellas those of its Asian trading partners,most importantly China) for willgrow exponentially as global tradeand investment (and intra-Asian tradeand investment) account for a largerproportion of its economy.

* India cannot afford to remain a taker of from the global market indefinitelyas its needs for such services grow.Like the , the and Japan, Indiamust develop its own -provisioncapability as an essential concomitant ofits growing role in the world economy.So must China, although China isalready able to rely on a world-classfinancial centre in Hong Kong, andto a lesser extent by Singapore (whichserves the regional economyeven more).

* India has emerged in the world as acompetitive, reliable provider of services. The provision of on acompetitive basis to the global economyis highly dependent on capability andan endowment of human capital thatis numerate, adept mathematically andentrepreneurially inclined. Given thecritical importance of those ingredients, provision is an arena in which Indiahas natural advantages for competingsuccessfully. It would be making amajor error in not developing its policy-making, operational and regulatorycapacities to compete globally in the arena as quickly as possible.

* India’s aspiring to enter the market forglobalised financial services provision issynonymous with India aspiring to havean in Mumbai, that connects theIndian financial system with the globalfinancial system. This is in contrastwith conventional goods and services,

. The Emergence of IFCs: A brief history 13

where production is dispersed across avery large number of locations acrossthe world; financial services productionrequires clustering.

But what precisely is meant bydeveloping -provision capability viaan ? An provides individuals,institutions of various types (includingmost importantly productive commercialcorporations) and governments (sovereignand sub-sovereign) with a wide range offinancial products and services throughan array of appropriate institutions andmarkets that are regulated in consonancewith recognized international best practices.

These financial products and servicesinclude: banking, insurance, short andlong-term asset management, privatewealth management, corporate treasurymanagement, and, most importantly, awell structured and fully developed capitalmarket (with its array of institutionalappurtenances in terms of brokers, dealers,exchanges and regulators) for debt, equities,commodities as well as risk managementthrough derivatives. To become a player andcompete in the space, India will need tobuild requisite infrastructure (institutionaland physical) and harness the skills andexpertise needed to launch these productsand services. Mumbai’s prominence asthe capital of Indian finance, the existenceof exchange infrastructure, and its supplyof skilled manpower, makes it a naturalcontender as an .

9.1. The SEZ model as an Alternativefor an IFC in Mumbai

In discussions on creating an Indian inMumbai, its location in a Special EconomicZone () in Navi Mumbai has beenaggressively promoted by enthusiastic developers as the best, if not the only,alternative. In the Indian context, a is asequestered or quarantined geographicalarea operating under a framework ofeconomic laws and tax exemptions thatare more liberal than the country’s typicaleconomic laws. The raison d’etre forestablishing s is to accelerate theinflow of private investment (domesticand foreign) into developing infrastructure

more rapidly – and thus to galvanisefurther investment in productive activity(especially in encouraging the faster andlarger exports of goods and services) – thanwould otherwise be the case.

The argument for having s in Indiais based on the claim that it is too difficultfor various levels of government to proposeand implement the policy changes neededto make that happen on an India-wide basis;because of the diversity of views in its pluraland democratic system.

Thus the approach is a strategyof ‘change management by exception’ ratherthan a strategy of managing change throughcountry-wide inclusion. Opponents of this‘change management by privileged exception’strategy argue that the downsides of a strategy outweigh any benefits for thefollowing reasons:

* First, s will worsen rather thanameliorate the egregious degree of‘development concentration’ in newprivately governed urban areas.

* Second, s may create enclaves ownedand run by India’s major corporations –that are self-governing, autonomous andexempt from normal rules. Thus swill create immense scope for regulatoryand legal arbitrage that may prove quitedifficult to manage.

* Third, s will result in the fragmented,incoherent and sub-optimal develop-ment of infrastructure rather than hav-ing it develop it on a more optimalarea wide basis for capturing essentialeconomies of scale.

* Fourth, s open up opportunitiesfor malfeasance through propertydevelopment that has become the newchannel for rent-seeking and realisingspeculative capital gains. At thesame time, such developments willcreate inequities for small landholderscompelled to yield land for development.

* Fifth, s are likely to result in a netloss to the exchequer that the inflowof incremental investment – and anyindirect public revenue benefits that mayaccrue therefore – will not offset to anyreasonable degree.

14 R M I F C

s have been established in severalcountries, including the People’s Republicof China, India, Iran, Jordan, Poland,Kazakhstan, the Philippines and Russia.North Korea has attempted this to a degree,but failed. But, these s have generallybeen large in size, limited in scope, and lessfragmented than the s approved in India.Also, they have been mainly restricted to thebonded production of goods for export withthe movement of inputs and outputs from boundaries being tightly controlled toprevent leakage and arbitrage opportunitiesvis-a-vis the local economy. Many s inIndia meet those stringent tests. But manydo not.

Proponents of the approach to provision argue that the fastest wayto make progress in establishing an is to suspend Indian capital controls andrepressive financial policy for a zone ofabout - square kilometres. That specialfinancial zone would, for all intents andpurposes, be cut off from the rest of Indiafor the strategy to be compatible withcontinued capital controls and financialrepression in the domestic financial system.The argument is also made that a would have world class urban infrastructureand thus bypass the intractable urbaninfrastructure deficit and the enormousgovernance problems of Mumbai.

But, the difficulties with this approachare threefold:

. A key strength underlying an Indianattempt to establish an is theeconomies of scale obtained by virtueof having a trillion-dollar as thehome market. If an enclave approach isused, India’s hinterland advantage is lost.The enclave would be required to restrictitself to dealing only with non-residentclients and transacting in all convertiblecurrencies but not in the .

. It is easy to think of a wherecapital controls are absent – thisrequires stroke of the pen reforms thatremove hindrances faced by firms andindividuals. But it is harder to havea where financial repression isabsent. An IFC located in an SEZwould still need to have its operations

and transactions governed by a world-class framework of financial sectorpolicy formulation and regulation.It cannot operate in a regulatoryvacuum. A that is not regulated byinternationally acceptable regulators willnot be respected by customers of globally and will fail to attract business.If an effort has to be made to build worldclass financial sector competencies, andregulatory capacity for a , such aneffort would better be directed to Indiaas a whole rather than just to the .

. A substantial additional inspector rajwill inevitably need to be created,surrounding the , to avoid leakagesof financial products and servicesbetween the and the ‘Indianmainland’. When a free trade zonelike was created, inspectorswere used to ensure that physical goodsdid not flow between andIndia. Preventing flows of capitaland international financial servicesis more difficult. It will require acorrespondingly onerous inspector rajthat will vitiate having an in a in the first place.

In the Committee’s view the disadvan-tages of having an in Mumbai locatedin a outweigh any conceivable advan-tages. Rather than facilitate start-up, a based will compromise developmentof the kind of that India needs – i.e.,one that is rooted in its own financial sys-tem. It will create opportunities for arbitragebetween dual financial regimes. It will com-plicate the process of financial regulatoryliberalisation and have a counter-productiveeffect in delaying changes in the regulatorysystem. It may involve external regulatoryauthorities wishing to intervene in regulating offered via a , thus compromisingIndian regulatory sovereignty. It will de-lay the swifter removal of capital controlsthroughout the Indian economy. It will re-sult in an not yielding public revenuesfrom the outset and obtaining fiscal protec-tion that it does not need. An -based would be an artifice that would de-tract from global credibility. It may facilitatemore / in finance; but it will pre-

. The Emergence of IFCs: A brief history 15

vent or delay the provision of broad-based.

A SEZ-based IFC, that sought tosidestep India’s capital controls andfinancial regulation would, in the opinionof the HPEC, not be the right path for Indiato take in establishing an IFC in Mumbai.The right way would be to make Mumbai an and a global city by making the urgentadjustments that are needed to: (a) financialpolicies, structures, institutions, marketsand to financial regulatory and governanceregimes; as well as to (b) Mumbai’s urbaninfrastructure and governance.

Interestingly enough, there may besome symbiosis between: (a) a narrowernotion of a located near Mumbai; and(b) the initiative to make Mumbai an .

If good quality urban infrastructuredevelops in a close to Mumbai, and if –quite separately – Mumbai has made some

progress towards establishing a credible, then many financial firms (and theiremployees) might choose, of their ownaccord, to locate in an with superiorfacilities. In this sense, a orientatedtowards improving the quality of urbaninfrastructure in the proximity of Mumbai– without requiring as a precondition thatan must be located within it from theoutset – may turn out to complement thegoal of creating an in Mumbai.

Financial firms located in Mumbai forthe purpose of providing may decidevoluntarily to relocate to the simply forreasons of convenience in enjoying betterquality infrastructure rather than to escapedraconian regulation. That would mean thatthe regulatory regime that applied to themin Mumbai would apply to them in the as well.

st Century IFSprovided by IFCs

2c h a p t e r

The st century is witnessing the world’stransformation into a global village. Thisis being caused by: (a) an inexorableprocess of internationalization – that islinking countries through trade, investmentand cultural exchange; and (b) equallyinexorable deregulation. Both forces wereunleashed by regulatory relaxation in thes. Their impact was amplified in thes with the rediscovery and acceptanceof market economics following the collapseof socialism as an alternative. Morecountries are shifting to market economicsfrom socialist paradigms to drive theirdevelopment models. Their governments,firms, and civil societies – which wereinward-looking and myopic – have revisedtheir views about their respective roles.They have become long-sighted, outward-orientated and global in outlook.

Markets – for goods and services, fi-nance, factors of production, and knowledge– are no longer confined to national geogra-phies. Products and services are no longerdesigned and made for domestic and exportcustomers separately with different qualitystandards for each. Resources are no longerrestricted to those available domestically. In-vestments are no longer limited to domesticprojects. In other words, economic bound-aries have become porous. Among otherthings, this new world – in which economicsand finance are no longer constrained bygeography – is making new demands onfinancial firms, services, systems and mar-kets. New financial products/services arebeing demanded from traditional financialfirms to meet the needs of clients who havesuddenly emerged as global players.

A modern financial system includesbanking, insurance, asset management,securities dealing, derivatives and riskmanagement. An provides individuals,corporations and governments around the

world with a range of financial productsand services in this globalised world. Thesections of this chapter look at some key products/services provided by s. WhileLondon and New York provide all of them,other s around the world provide somecombination of them.

1. Fund Raising in IFCs: What isinvolved? Who does it andhow?

An provides a platform for entities toraise large amounts of funds on a globalrather than domestic scale. This includes:(a) debt and quasi-debt across all maturityand currency spectra; (b) equity and quasi-equity for private, public, multilateraland public-private entities; as well as(c) diverse risk-management appendagesto primary fund-raising transactions. Sucharrangements permit the risk exposure ofthe primary fund-raising entity (to currency,interest rate, credit, market, operationaland political risks) to be contained withintolerable limits. The presence of largeinvestment banks and global securities firmsin an facilitates access to a huge pool ofglobal finance unconstrained by domesticboundaries.

As the example of London illustrates,this calls for dynamic, transparent and highlyliquid capital and derivative markets withfirm, principles-based yet flexible regulationthat is unintrusive and does not involvemicro-management.

It is often asserted that modern com-munications technologies have resulted inthe ‘death of distance’. It is therefore possi-ble for geographically dispersed investorsand issuers to interact without needing ageographically focused . However, theempirical reality is that – even after largechanges in technologies of communication –

18 R M I F C

Box 2.1: The Range of Financial Service Providers called BanksCommercial banks: Take time and savings

deposits and make loans tobusinesses and individuals

Savings banks: Attract only term savingsdeposits and make loans toindividuals and families

Cooperative banks: Help farmers, ranchers,groups and consumers acquiregoods and services

Mortgage banks: Provide mortgage loans onnew or old homes and financereal estate projects

Community banks: Are smaller, locallyfocused commercial and savingsbanks

Money Centre banks: Are large commercialbanks based in leading financialcentres

Investment banks: Wholesale players thatsolve financing problems faced by

customers by utilising capitalmarkets

Merchant banks: Discount trade bills andsupply both debt and equitycapital to business

Wholesale banks: Are larger commercialbanks serving corporations andgovernments

Retail banks: Are smaller banks servingprimarily households and smallbusinesses

Bankers’ banks: Supply financial processservices (e.g., cheque clearing andsecurity trading) to banks

Affiliated banks: Are wholly or partly ownedby a holding company that is afinancial conglomerate

Fringe banks: Offer payday and title loans,cash checks, operate as pawnshops or rent-to-own firms.

the most important aspects of fund raisingstill take place through face-to-face meetingsin London, New York, or other s. Peoplestill prefer to do primary ‘front-office’ busi-ness in their own daylight while outsourcingback-office functions to be performed else-where on a -hour basis. The primacy ofs in fund raising is unlikely to change inthe foreseeable future.

Fund-raising for investment in an is now invariably done through investmentor universal banks and rarely throughcommercial banks. The fund-raising entitydoes not have to use an investment bank, butit usually does so because it is less costly thantrying to sell securities directly to the public.The most common method of raising fundsis by issuing and selling new securities, suchas stocks or bonds of a wide variety of types.An investment bank usually helps in thisprocess by providing its expertise and aglobal market base of customers to buy thesecurities.

Investment banks are not like commer-cial banks; although large global conglomer-ates (like Citigroup or ) often houseboth activities under the same brand um-brella. Unlike commercial banks, investmentbanks do not generally attempt to attractsmall retail depositors through checking orsavings accounts; nor do they make auto,home or personal loans. Generally, they donot deal at all with small individual retail

depositors although some investment banksdo attract high net worth clients by provid-ing personal wealth management services ofa different type and scale.

Whereas commercial banks generallyraise resources at the retail (depositor)end, investment banks are wholesaleintermediaries. They help businesses,governments, and a variety of otheragencies to get bulk-financing from investorsin capital markets through a variety ofinstruments and vehicles. By contrastcommercial banks help users of fundsto obtain financing by lending themmoney that the banks’ own customershave deposited in savings, checking, moneymarket and accounts. Investment banksconnect users of money with a variety ofsources of money on a bulk-basis, whereascommercial banks connect users of fundswith their own retail and individual sourcesof deposits, though the vehicle of loans thatmight be syndicated with other commercialbanks to spread risk.

A commercial bank usually takes thefull credit risk on the loans it makes.Sometimes it lays all or part of that riskoff through the purchase of market-tradedcredit derivatives. But that is rarely possiblein bank-dominated financial systems; doingso requires sophisticated capital markets.An investment bank operating in capitalmarkets rarely takes the credit risk ofits clients on its own book except fora short period under an underwritingobligation (see Box .). Thus, despitethe word bank in their names, investmentbanks are securities issuing/buying firmsthat match users (usually corporates orgovernments) and providers (usually buyersof equities and bonds) of bulk fundsin capital markets. When they are notoperating in an , their activities (i.e.,connecting users and sources of funds) areconfined to domestic markets. But, in an, national borders cease to matter indetermining either the geographical originsof clients or the geographical residence offunds being tapped.

In capital-market dominated financialsystems, entities that need funds can discussa variety of options and possibilities withinvestment bankers. But in bank-dominated

. st Century IFS provided by IFCs 19

Table 2.1: Markets for foreign equities (2005)

Turnover % of global No. of($bn) turnover Foreign

cos. listed

London 2,496 43 554NYSE 1,234 21 452Switzerland 896 16 116Nasdaq 591 10 332Germany 165 3 116Others 401 7 1,285

Total 5,783 100 2,635

Source: World Federation of Exchanges, LSE

systems their choice is usually restricted toloans from commercial banks.

Tables . and . show the amountof equities and bonds issued in globalcapital markets in . The bulk of thebond market is in domestic bonds issuedby companies in their own country andcurrency. But the share of internationalbond issues in the total bond markethas risen in recent years. The value ofbonds issued worldwide totalled over $

trillion at end-. Table . shows thepercentage share by nationality of the bondissuer. International bonds, which includeEurobonds and foreign bonds, totalling$, billion were issued in . issuershad the largest share in with nearly afifth of the total, followed by Spain and the.

There is a natural synergy betweenglobal funds seeking investment opportuni-ties (with a wide range of risk/return possi-bilities) and global seekers of funds. Theirmutual interests converge in an . Eachinduces network effects that feed off theother. It is not possible to conceive of onewithout the other. For that reason India doesnot have the luxury of prioritizing eitherone or the other of these two elements insequencing the emergence of Mumbai as an. Both have to be accommodated simul-taneously. Another key facet that needs to beemphasised from a sequencing viewpoint isthat efficient and cost-effective fund-raisingin any requires mature, deep and liquidfinancial markets in all segments at all levels;i.e., it requires:

. An efficient, liquid, large and globallyconnected, equity market that cansupport equity issuance by issuers not

Table 2.2: International Bond Markets (2005)

Net issues ($bn) % share

UK 361 19Spain 211 11US 199 11Germany 157 8France 132 7Italy 89 5Netherlands 84 5Others 989 53

Total 1,861 100

Source: Bank of International Settlements

just from India but elsewhere,

. A liquid and efficient bond market witha traded yield curve in the currency ofthe that enables global corporateand sovereign bond issuance,

. A large and liquid currency tradingmarket,

. Robust derivatives markets that permitlaying off a variety of risks i.e., includingcredit, interest rate, maturity andduration, currency, and political risk,

. Efficient and globally open bankingmarkets that minimize or eliminatethe conflicts-of-interest that arise withstate-ownership and domination of thebanking system; and

. Globally efficient insurance and re-insurance markets open to global playerswith all the necessary products andservices available.

Global fund-raising is one of the mostprominent revenue sources in every IFC,and a tangible goal that every IFC aspires for.However, this prominent activity requiresan underlying infrastructure in the form ofthese markets. Hence, the development ofpublic markets for securities, banking andinsurance on an international scale is a sinequa non for global fund-raising capability. Inother words, whether generally recognized ornot, the call for creating an IFC in Mumbaiis a metaphor for (and synonymous with)deregulating, liberalising and globalising,all parts of the Indian financial systemat a faster rate than is presently the case.Raising the issue of creating an IFC inMumbai at this time, suggests that theneed for more intensive deregulation and

20 R M I F C

Box 2.2: What Investment Banks do in Global Capital MarketsCapital markets permit investment

bankers to provide users of funds withgreater flexibility (in terms ofinstrumentation, timing and riskmanagement appurtenances) in:(a) accommodating how much money isrequired and when; (b) what type ofsecurity should be sold and to whom, inorder to maximize efficiency andminimize costs of fund-raising; (c) whatspecial features such securities mighthave depending on the credit rating andcash-flow circumstances of the entityconcerned; (d) at what price it should besold and when; and (e) how much thefund raising activity will cost.

To reduce its own uncertainty and risk,a user-of-funds may decide to go in foran underwriting agreement with itsinvestment bank. Under thisarrangement, called the firmcommitment, the investment bank buysthe new securities for an agreed priceand resells the securities to the public ata mark-up, bearing all of the expensesassociated with the sale. Usually, theinvestment bank becomes abroker-dealer or market-maker in thenew security sold. Through underwriting,the issuer (user-of-funds) gets the fundson a guaranteed basis even if theinvestment bank does not succeed inselling all of the securities issued. Thus,the investment bank takes a calculatedrisk for a short period. But it can alsoprofit significantly if the issue is greatlydesired by investors, allowing theinvestment bank to charge a highermark-up and book an immediate profit.Under stable market conditionsknowledgeable investment banks arerarely trapped into having to holdunderwritten securities for long. Butsometimes market conditions can changesuddenly in response to an unforeseeableshock. Investment banks can then becaught holding the bag for longer thanthey wanted thus tying up capital thatcould be used for other (higher-return)purposes.

Direct responsibilities in anunderwriting include registering newsecurities with the concerned regulator,deciding the offer price, andforming/managing a syndicate to marketthe new securities. Often the investment

bank pegs the price of a new issue bybuying in the open market. Successfulunderwriting is about selecting the rightissue, offering it at the right price, andselling it at the right time. Theinvestment bank may have to lower theprice of the new issue to below what itpaid for it, thereby resulting in a loss.Furthermore, the initial customers whopaid a higher price for the new issue willbe disappointed that they paid a higherprice, and the investment bank may losethese customers in a future offering.

Investment banking is a verycompetitive business in global capitalmarkets and established IFCs. Every dealforms an input for future businesspossibilities for the banker both from theissuer and other companies.

Most agreements for the sale of newsecurities get underwritten. But whenthe issuer is perceived as risky, theinvestment bank may use a best effortsapproach; i.e., it undertakes to do itsbest to sell all of the new securities, butdoes not guarantee it. The issuer bearsthe risk that the investment bank mayfail to sell all of the new issue, therebyreducing the amount of money that thecompany receives. Underwriters makemoney by selling the new securities at amark-up from what they paid for it,known as the underwriting discount, orunderwriting spread. The underwritingdiscount is set by bidding andnegotiation, but is influenced by the sizeof the new issue, whether it is equities orbonds, and the perceived difficulty ofselling the new issue. More speculativeissues require a larger underwritingspread for the increased risk involved.

The liquidity risk taken in anunderwriting transaction can be ‘laid off’in the risk market using derivatives.Investment banks utilize sophisticatedfinancial economics in quantifying theirexposure. They establish a set ofexchange-traded and OTC positions inderivatives markets (for credit, interestrate, and currency risks) through whichthe bulk of their risk is transferred tobuyers of risk in the derivatives market.The residual risk is borne by investmentbanks against equity capital, and isrequired to earn a high rate of return.

Hence, to the extent that risk-marketssupport laying-off through exposurehedging, the lower is the unhedgedcomponent of the risk, and thus thelower is the cost of capital for theunhedged portion.

The total flotation costs of bringingnew issues to the capital market alsoincludes legal, accounting, and othercosts borne by the issuer in addition tothe underwriting discount. Economies ofscale result in flotation costs for smallissues generally being a largerpercentage of the total sale of newsecurities than for larger issues. They arealso greater for equities than for bonds.The underwriting spread may vary fromabout 1% for investment-grade bonds toalmost 25% for the stocks of smallunknown companies. As additionalcompensation, the underwriting firmmay get rights to buy additionalsecurities at a specified price(pre-negotiated call options), or receive amembership on the board of directors ofthe issuing company. The underwritingfirm frequently becomes a market makerin the new security, keeping an inventoryand providing a firm bid and offer pricefor the new security to provide asecondary market, so that investors canbuy or sell the new securities afterprimary sale. This ensures liquidity forinvestors and thus increases the value ofthe primary offering, since few investorswould buy a new security if they couldn’tsell it at will.

Sometimes investment banks formsyndicates and enlist the help of otherinvestment banks to sell securities. The‘lead’ investment bank selects themembers of the syndicate anddetermines how many shares each willget and manages the overall process. Inaddition, each member of the syndicate,including the originating investmentbank may have selling groups, consistingof other investment bankers, dealers,and brokers that may also sell toinvestors. The main advantage ofsyndication is that it reduces risk bysharing it among the syndicate members,and each syndicate member and theirselling groups have their own customersto whom they can sell the new issues.

liberalization of the financial system hasbeen anticipated by India’s policy-makersand regulators and that the IFC is an

additional device to accelerate movementin that direction. An will not becreated quickly in Mumbai, nor will it

. st Century IFS provided by IFCs 21

succeed, if action on further deregulationand liberalisation is not taken in real time.

2. Asset management andglobal portfoliodiversification

Asset management is a large and importantglobal industry in its own right. All typesof asset managers are responsible for themanagement of trillions of dollars, euros,pounds and yen invested in a large varietyof funds and vehicles. Many of the world’slargest financial conglomerates are at least inpart asset managers. And the bulk of globalasset management (over %) is transactedthrough the world’s s. As a approximateestimate, the stock of globally managedassets (including non-financial assets suchas real-estate) was believed to be about $

trillion in , or nearly thrice of world.

At an average cost of asset managementof about % of assets under management,global revenues from asset management areroughly $ trillion per year, which makes itone of the world’s largest industries giventhat world is just over $ trillion.Because of a legacy of financial suppression,India’s share of global asset management– in terms of , revenues, efficiencyand cost-effectiveness – is infinitesimaland insignificant for an economy that isemerging as one of the world’s largest,and that is likely to account for a rapidlyincreasing share in global portfolios. Thatsituation is clearly unacceptable and needsto be rectified urgently.

Table . shows the sources of globalfinancial assets under management in threevisible categories – pensions, insurance andmutual funds – by end-. Assets of theglobal fund management industry increasedfor the second year running in to reacha record $. trillion. This was up %on the previous year and % on .Pension assets accounted for $. trillion offunds in , with a further $. trillioninvested in mutual funds and $. trillionin insurance funds. Merrill Lynch estimatesthe value of private wealth at $. trillionof which about a third was incorporated

Box 2.3: Global Asset ManagementAsset managers of various hues – i.e.,

mutual funds, open or closed endedinvestment companies or trusts, public orprivate pension funds, insurance premiumfunds, and, increasingly, of highly mobileand flexible hedge and arbitrage funds –look for an array of investment choices athome and overseas, including equities,bonds, property, commodities and cashdiversified in terms of geography, or sectorof activity. A viable IFC must have thenecessary market, institutional andregulatory infrastructure to attract assetmanagement and global portfoliodiversification services undertaken by avariety of national, regional and globalasset managers. Very often, revenues fromasset management are directly linked tomarket valuations, so in the event of amajor fall in asset prices, revenues declinerelative to costs.

Asset management includes acombination of front and back officefunctions. Front-office activities includeinter alia: objective setting for targetedreturns, risk and capital preservation,based on the future pay-out obligations of

the funds being managed (e.g., pensions);active marketing of funds to potentialinvestors; continuous real-time globalresearch into individual assets and assetclasses across all sectors and geographies;in-depth financial analysis; asset selection;plan implementation; buy-selltrading/dealing/transacting; andcontinuous monitoring of investments tokeep pace with domestic and globalchanges in financial and demographicenvironments and circumstances.Back-office functions (i.e., tracking andrecording of all buy/sell transactions, andminute-to-minute fund valuations, forthousands of different clients perinstitution) usually involve activities suchas: payment and settlements for billions ofdaily transactions; ensuring increasinglycomplex national and global compliancefor a variety of purposes; book-keepingand financial control; trade confirmations;fault correction and dispute resolution;continuous real-time internal auditing; andthe preparation of a variety of internal andexternal reports (by day, week, month,quarter, year) for managers and clients.

in other forms of conventional investmentmanagement. The was the largest sourceof funds under management in with% of the world total. It was followed byJapan with % and the with .%. TheAsia-Pacific region has shown the strongestgrowth in recent years.

3. Personal wealthmanagement

The large and rapidly growing number ofwealthy individuals around the world, witha net worth of more than $ millioneach, provides substantial opportunitiesfor a wide range of firms and institutionsthat deliver professional wealth management(private banking) services to this community.High net-worth individuals (s)are globally mobile (globile) with severalresidences, tax domiciles, as well as revenuesand expenditures, accruing in multiplejurisdictions. This activity is estimatedto involve the management of trillions ofdollars worth of personal assets. Some of itis double-counted in the asset managementfigures shown in the previous section.

22 R M I F C

Personal wealth management takesplace in established s but is skewedtowards specialized s offering special taxexemptions or advantages to non-residentsin centres in Switzerland, Luxembourg,Monaco, Lichtenstein and the ChannelIslands for the and Africa; Atlanticand Caribbean offshore centres for the and Latin America; Bahrain, Dubai andMauritius for the Middle East and SouthAsia, Singapore, Hong Kong and somePacific Island offshore centres for East/NorthAsia. Merrill Lynch, Cap Gemini, andErnst and Young’s annual World WealthReport estimated that the value of fundsmanaged on behalf of . million high networth individuals with over $ million ofinvestable assets was $. trillion in .

In its annual report Global Wealth, Boston Consulting Group estimatedthat the total value of assets managed

on behalf of all investors totalled $.trillion in . These figures, based onsurveys of private bankers are probablyunderstated as they probably do not includefull disclosure of all private accounts held by:(a) politically prominent people (especiallyfrom developing countries and regions) whoare reticent to have their holdings reportedor disclosed; or (b) generated from illicitincome flows in prohibited (but neverthelesslarge) industries involving drugs, arms andhuman trafficking and illegal gambling.Table . illustrates in broad indicative termsthe size of the worldwide internationalprivate client market.

Overseas Indians (s) are estimatedto hold financial wealth (i.e., apart from realestate, gold, art, etc.) of over $ billionand total wealth of over $ trillion. Theyare a natural beachhead as a customer basewhere an Indian PWM industry can get

Table 2.3: Global assets under management in three visible categories ($bn 2004)

Pension Insurance Mutual Totalfunds assets funds

US 11,090 4,968 8,107 24,165Japan 3,108 2,058 400 5,566UK 1,464 1,797 493 3,754France 150 984 1,371 2,505Germany 104 1,055 296 1,455Netherlands 630 291 90 1,011Switzerland 426 258 94 778Others 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 ManagementPersonal wealth managers (or private

bankers) customize investment programs tomeet specific client needs and provide an arrayof related investment services includingsecurities, real-estate, art, jewellery,commodities (i.e., precious metals or incommodities such as oil/gas, base metals etc.),vintage wines and collections of antiques,automobiles, stamps, photographs, etc..Wealth management involves:

. Developing an investment profile throughin-depth client consultation in order toestablish clear investment goals for incomegeneration and further wealthaccrual/protection. These are based on theinvestment time frame, tolerance for risk,income needs, and specific accountcircumstances (such as multiple currency

account needs).

. Setting asset allocation parameters: i.e.,asset allocation guidelines are set byestablishing long-term asset class targetsbased on return/risk relationship for eachclient. Asset allocation ranges are set toestablish guidelines around the long-termtargets designed to add incremental returnand control risk.

. Establishing and managing personalizedwealth portfolios: A portfolio is developedthat focuses on diversification across andwithin each asset class to provide the clientwith attractive risk-adjusted returns. Theportfolio is managed on a continual basiswhile maintaining the quality standardsand market diversification necessary toachieve the set goals.

. The portfolio is continually reviewed andthe client kept informed by way ofin-depth reporting, internet access, andpersonalized meetings. Investment goalsare periodically reassessed.

In recent decades, the functions of personalwealth management have mutated far beyonda simple notion of managing a liquid financialsecurities portfolio to a broad array of tailoredservices for customers. These range frommanagement of real estate to arranging exotictravel services. In these aspects, personalwealth management is a highly labourintensive area; one that requires a largenumber of man-hours of staff time in order toprovide meticulous personalised services to thecustomer. This suggests that it is an area inIndia 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 ofmillions net worth individuals all investors

1997 5.2 19.11998 5.9 21.61999 7.0 25.5 71.52000 7.0 25.5 67.82001 7.0 26.0 64.12002 7.2 26.7 65.52003 7.7 28.8 78.22004 8.3 30.8 85.3

Source: Merrill Lynch Cap Gemini and The Boston Consulting Group

started. Their wealth management servicesare presently sourced almost exclusivelyabroad.

4. Global transfer pricing

Transfer pricing is a generic term used todescribe all aspects of intra-group pricingarrangements between related business en-tities operating across borders; including:transfers of intellectual property; transfersof tangible goods; service fees, loans andother financing transactions. Intra-group(inter-company) transactions across bordersare growing rapidly and becoming morecomplex. Compliance with the differingrequirements of multiple overlapping tax ju-risdictions is a complicated, time-consumingtask. National revenue authorities (espe-cially in high-tax jurisdictions withincreased tax avoidance and evasion) arebecoming increasingly sensitive to the waysin which transfer pricing can affect theirtax revenues. Governments and revenueauthorities are responding by strengtheningtheir legislation and their enforcement capa-bilities, demanding stricter documentationof transfer pricing practices, and imposinghigher penalties for non-compliance. Mostcountries adhere to the arm’s length princi-ple as defined in the Transfer PricingGuidelines for multinational enterprises andtax administrations.

London is the world’s major centrefor international legal and tax relatedservices. Globalisation of business andfinance has strengthened its position inrecent years. The provision of internationallegal services in London remains the preserve

of internationally active law firms.Transfer pricing is an activity that the

Government of India (o) looks at askance.Yet it needs to accept that such activity willtake place in a global economy dominatedby: (a) a growing amount of cross-border trade and investment undertakenincreasingly within s; (b) the provisionof professional global tax managementservices by global firms of accountants,lawyers and tax advisors present in allmajor s around the world includingtax havens; (c) widely divergent nationaltax regimes dictated by the revenue andcash-flow needs of particular economiesfacing entirely different circumstances; and(d) a growing number of mobile entrepreneurs and professionals who, likes, are not wedded to nationality fortax purposes. Collectively they form avibrant network that is driving the processof globalisation in a variety of sunriseindustries – e.g., in services, financialservices, sports, leisure, hospitality, mediaand entertainment services industries etc.

The as an institutionalized col-lective is attempting, somewhat ineffectu-ally, to discourage such activity by exertingpressure on developing countries and off-shore tax-havens. Yet, oddly, transfer pricingand tax arbitrage are actively encouragedby a number of individual countries thatare members of : (i) several states inthe – e.g., Delaware, Nevada, etc.; (ii) anumber of European s located in capi-tals such as London, Amsterdam, Paris andFrankfurt as well as (iii) European havenssuch as Luxembourg, Lichtenstein, Monacoand Switzerland.

24 R M I F C

Box 2.5: Transfer Pricing ServicesPlanning transfer pricing strategies,

optimising tax exposures, and defending acompany’s tax position and transferpricing practices on a global basis, requiresknowledge of a complex web of tax laws,regulations, rulings, methods andrequirements around the world.Optimisation of transfer pricing alsorequires an understanding of the capitalcontrols found in some countries. Thustransfer pricing has become a criticalelement in global tax planning. Globalconsultants based at IFCs have large teamsof economists, tax practitioners andfinancial analysts who help clients withtransfer pricing planning worldwide. Aglobal network of professionals operatesthroughout the world, supported by therelevant local tax practices. Servicesprovided include:

. Developing and implementingcommercially viable transfer pricingpolicies.

. Complying with local revenuerequirements and preparingdocumentation for strong first-linedefence against revenue authorityaudits.

. Preparing and negotiating appropriateresponses to revenue authoritychallenges, and assessing the risk ofrevenue authority challenge.

. Identifying appropriate strategies andapproaches to advance pricingagreements, and assisting in preparingthese agreements.

An effective global transfer pricingstrategy embraces all the cross-bordertransactions of a MNC. It encompasses notonly the pricing of tangible goods, butalso transfers of intangible assets(knowledge, royalties), services, or groupfinancing. It incorporates transfer pricingplanning, controversy resolution andcompliance.

Of course, discriminatory dual taxregimes, created specifically for non-residentsby tax-havens (in order to attract wealthmanagement and corporate transfer pricingbusiness) raise a complex set of issues insofaras supposedly ‘harmful’ tax competition isconcerned. Countries like India affectedby such regimes might legitimately beconcerned about them. But the economicstructures of many oil-exporting ()countries in the Persian Gulf can afford toeschew levying personal income, corporateand excise taxes on nationals and residents.They are sovereign and free to offer the sameadvantages to non-residents under a non-discriminatory, open-economy regime.

No outside country can afford to arguethat a benign low-tax regime for nationalsof such a country should not be open tonon-residents if the jurisdiction concernedwishes to extend that privilege. To doso would infringe upon the sovereignrights of nations to determine their ownfiscal and macroeconomic policies and thusundermine a key pillar of internationallaw. Indian s as well as s(especially s) are customers of servicescreated by legitimate global tax arbitrageopportunities in countries in the Gulf thatare not tax havens. In an environmentwhere adequate support for them is not

available in Mumbai, these services arebeing purchased in Delaware, London,Switzerland, Mauritius, Singapore, HongKong, Dubai or elsewhere.

Transfer pricing services require largeamounts of skilled labour engaged inproviding professional tax, accounting,auditing and consulting services, a high levelof labour-force numeracy, and support.The provision of transfer pricing services isthus an area that an Indian can excel in.

The HPEC believes that India shouldpermit the development of Indian institu-tional capacity (in its accounting, legal andbusiness consulting industries) for pro-viding global transfer-pricing services in aMumbai-based IFC. GoI should adopt thesame stance as the US and EU governmentswhose official and actual positions on thisissue seem somewhat contradictory.

India should override external concernsand pressures exerted by that are,in reality, more self-serving (in preservingthe competitiveness of their own capitalsand s by protecting established marketshare in this lucrative and growing business)than globally effectual, in addressing thegenuine concerns of harmful tax practices,tax competition and revenue leakage.

5. Global tax management andcross-border taxoptimization

Related to transfer pricing is the serviceof global tax management; it deals withinternational tax treaties and internationalaspects of domestic income tax laws.Multinational businesses, and individualswith income sources in multiple countries,are increasingly affected by tax, legislativeand regulatory developments around theworld. Understanding the impact of thesedevelopments on business operations andtransactions between countries is vital for acompany’s profitability and survival. susually employ a battery of internationaltax specialists to minimise worldwide tax.International taxation is a specialisationamong lawyers and accountants; so much sothat several universities offer post-graduateprogrammes in that specialisation.

. st Century IFS provided by IFCs 25

Box 2.6: Global Tax Management“The world’s six biggest accountancy firms

are in the top rank in virtually every country inthe world, except where they are barred bylaw. Yet auditing and accounting are intenselylocal affairs, requiring detailed knowledge oflocal rules and regulations. Arthur Anderson orPrice Waterhouse ought not, to have anadvantage over domestic competitors exceptwith multinational clients – which, thoughlarge, are almost always a minority. Why, then,have these firms themselves become suchsuccessful multinationals? One answer may liein their ancillary businesses such as consulting,in which they have special skills; another maylie in their ability to buy and organizeinformation technology. But these are notenough to explain such widespreaddominance. Reputation, the power of thebrand name, must play the biggest part. The

market for accounting and auditing is animperfect one: buyers lack the information totell a good accountant from a bad one, or findit costly to find out, which comes to the samething. They also seek the accountant’s brandname as a means to convince others abouttheir own worth, especially investors andcreditors, who are similarly, short ofinformation.”

Source: Multinationals, a supplement in TheEconomist, March 27, 1993.

Global tax management provides anopportunity for financial, accounting and lawfirms, to assist MNC clients in constructingeffective cross-border strategies, aimed atoptimizing their global tax liabilities, whileadhering to all applicable laws. Such firms also

keep their clients abreast of newdevelopments in the international arena thatcould affect their business and assist byproviding expertise in:

• Tax efficient holding company locations• Cross-border financing and treasury

solutions• Controlled foreign companies tax

planning• Income tax treaties, profit repatriation,

loss utilization• Inbound and outbound structuring• Managing intellectual property and

intangible assets• Tax efficient supply chain and shared

services; and• Regional tax issues e.g., EU tax

harmonization.

London is a leading international centrefor the provision of accounting and relatedglobal tax management services. Servicesthat include auditing, taxation, corporatefinance and consultancy and are dominatedby the big four accounting firms. Accordingto Accountancy Age’s league table, feeincome amongst the Top accountingfirms rose from £. billion to £. billion.Table . shows the fee income earned bysome of the largest accounting firms inthe . While there are around ,

accounting firms in the , the bulk ofservices provided to larger companies andorganizations including cross border andinternational services are the preserve ofa relatively small number of large firms,particularly the Big Four.

6. Global/regional corporatetreasury management

s provide the infrastructure necessaryfor global investment banks to provideinternational treasury management servicesfor s. These banks provide supportsystems that enable organizations to:(a) optimize cash management and workingcapital while earning high returns on surplusliquidity; (b) streamline their receivablesusing sophisticated information technologyto monitor and direct daily cash flows;(c) manage their payables through theirsupply chain in keeping with the rhythm of

their incoming cash flows from customers;and (d) execute transactions electronicallyacross a wide array of currencies, bankaccount holdings, tradable bills of exchangeand letters of credit, as well as temporaryinvestments in treasury bills and corporatemoney market instruments across a numberof national markets.

Broadly, services include deposi-tory, collection and disbursement, liquidityand cash management services and exportand import related financing services. Mostglobal banks such as Chase, Citicorp, and offer all of the above services. Theyhave their own cash management systems,often suitably modified to take into accounta particular corporation’s needs. They usetechniques such as netting, exposure man-agement and cash pooling to reduce transac-

Table 2.5: Largest accounting firms in the UK

Firm Fee income(£million)

PwC LLP 1780.0Deloitte LLP 1350.0KPMG LLP 1066.0Ernst and Young LLP 828.0Grant Thornton UK LLP 254.3BDO Stoy Hayward LLP 224.0Baker Tilly 172.9Smith and Williamson LLP 127.5PKF (UK) LLP 113.7

Source: Accountancy Age Top 50, June 2005

26 R M I F C

Box 2.7: Corporate Treasury Management services provided by BanksDepository services: These include:

cash vault services to provide protectionand processing capabilities; electroniccash letters to enable scanning andtransmitting cheque images and data fordeposit into accounts; pre-encodeddeposits that provide faster checkclearance; returned items solutions tohelp manage returned items withdetailed images; activity reporting toimprove efficiency and increase collectionrates; zero balance sweep accounts thatconcentrate funds into one centralizedaccount to use cash resourcesproductively while retaining a centralizeddisbursing authority and remote depositsolutions to scan checks at the companyend and electronically send the imagesfor deposit.

Collection and disbursement services:This involves helping setting up systemsto collect funds from customers or othersundry debtors (payers). It also includesflexibility in payment options forinternational transactions such as cash inadvance, open account, letter of credit,or payment on a collection basis. Checkimage deposit solutions are designed tomake check deposits electronically intothe business deposit accounts, with bothspeed and accuracy directly from the

company’s office; lockbox imaging toview, retrieve and store remittancedocuments information; automatedclearing house to deliver debits andcredits on an electronic and automatedbasis and wire transfers that offersame-day availability.

CTM service providers also enabledisbursement of funds to vendors,employees, investors, or other payees.They provide account analysis, itemizedinformation on accounts and balances,account reconcilement with detailedchecking account information,outsourcing the printing and distributionof payables and payroll checks, controlleddisbursement accounts that provideprecise dollar totals of checks that willclear daily so that the business can makeaccurate funding and investmentdecisions, disbursement imaging viewingto retrieve and manage check imagesonline, check matching services thatprotect businesses against check fraud bymatching issued checks with thosepresented for payment on a daily basis.

Liquidity and cash managementservices: This includes liquid reserveaccounts with flexibility to earn acompetitive return on investing excessdaily cash balances while providing daily

investment confirmations and automatedrepurchases that ensures that bills arepaid on time and the excess funds put togood use. Help is provided to linkbusiness checking accounts with moneymarket mutual funds, allowing firms tominimize idle cash balances in theirchecking accounts and maximize thereturn earned on excess funds invested.

Export and import related services:Exporters are assisted by providing arange of related services that help inhastening the delivery of goods in orderto expedite receipt of payment, manageliquidity by ensuring that payment isreceived within the agreed time period,ensure that the payment is correct andsettlement is directed to the bank wherea depository account is maintained.Export licenses vary from country tocountry and stringent conditions usuallyapply to products related to naturalresources, national security, safety orhealth. Export services help in adaptingproducts for exports to meet suchconditions, provide assistance withfreight forwarding and insurance againstloss, damage and delay in transit sinceinternational shipment coverage issignificantly different from domesticcoverage.

tions costs, manage risks and make effectiveuse of available funds. Major money mar-kets in London, New York and Zurich offera wide variety of highly liquid short-terminstruments so that firms practically holdno idle cash. providers in turn setup money management systems that allowclient organizations to borrow from theiropen lines of credit and repay commerciallines of credit automatically without manualintervention.

In recent years, banks have createdenormously sophisticated Internet-basedofferings where the services of the banktake over, on an outsourcing basis, manyfunctions of handling an upstream ordownstream vendor network of a firm.This involves a complex blend of paymentsservices and Internet technology. Indianfinancial firms could excel in this area, givenIndia’s strengths in computer technology,and the ability to run low cost call centres inIndia.

7. Global and regional riskmanagement andinsurance/re-insuranceoperations

Historically, a corporate treasury’s involve-ment with risk management has focused onasset-liability management and on identify-ing and hedging financial exposures to cur-rency and interest rate risks. The companytreasurer’s classical responsibilities were to:establish policies for financial risk manage-ment, execute related practices, and trackand report on results.

Today, however, risk managementis concerned with an increasingly broadrange of risks, financial and operational.Risks such as: liquidity risk, counterpartyrisk, operational (including employee)risk, and country risk, confront allcorporate contenders in today’s complexand volatile global environment. They have

. st Century IFS provided by IFCs 27

Table 2.6: Largest insurance markets

Country Total ($bn) % shareof world

US 1,098 34Japan 492 15UK 295 9France 195 6Germany 191 6Italy 129 4Canada 79 2Others 765 24World 3,244 100

Source: Swiss Re

become important considerations in overallcorporate risk management.

Risk management has become so im-portant that individual financial institutionsinvest an average of $ million annually inrisk management technology. Many of thelargest institutions have invested hundredsof millions of dollars. Independent risk man-agement consultants collaborate with cor-porations to identify their business-specificneeds and design integrated solutions de-livered through a seamless distribution net-work to meet marketplace challenges.

This involves employing highly sophis-ticated exchange traded and tailored deriva-tives (futures, options, swaps, swaptions,caps and collars) as well as world class deriva-tives exchanges networking together for trad-ing a wide variety of global contracts. It alsoinvolves providing insurance and reinsur-ance related services.

Table . shows the fees earned by thelargest insurance markets in the world. The insurance industry is the largest followedby Japan and the . It consists of groupsand companies such as Lloyd’s, underwriters,brokers and intermediaries and their clients.The London market is the world’s leadingmarket for internationally traded insuranceand reinsurance.

8. Global/Regional exchangetrading of securities,commodities and derivativesin financial instruments andindices in commodities

Capital (and derivatives) markets have acrucial role to play in enabling enterprise,

innovation and growth at national, regionaland global levels. Financial markets,especially equity markets, have growndramatically in developed and developingcountries over the last two decades.Sovereign and corporate bond markets ofinterest to global investors have grownrapidly since in the emerging countriesof Latin America and Europe. But thathas not been the case in Asia or Africa.Derivatives markets have grown explosivelyand become extremely deep and liquid in capital markets but remain nascentin most emerging markets.

In Europe, capital markets have becomeincreasingly regionalised. Globalisation hasresulted in: substantially increased cross-border capital flows, tighter links amongfinancial markets, and greater commercialpresence of foreign financial firms aroundthe world. Indeed, one feature of London,as perhaps the best-connected in theworld, is the extent of foreign involvementand ownership of financial firms, exchangesand markets (as well as the employment oflarge numbers of foreigners) in the City.Up to the s, British investment andmerchant banks played a prominent role inoffering to global clients. But in

there was no independent British-ownedglobal investment bank left standing. Theyhad all been taken over by, or had mergedwith, other global firms. in the City

This was due largely to the global trading of Bradybonds (deep discount, low-coupon, and face valueprotected) issued in – as a means for convertingthe bank debt of highly indebted Latin American andEuropean countries in crises into market tradable debt.That mechanism enabled country risk to be spreadmore widely across a global institutional and individualinvestor base; rather than being concentrated in a fewbanks, thus endangering the stability of the globalbanking system. Brady bonds were credited with notjust developing bond markets in these two regions butwith bringing an end to a developing country debt crisisthat had been prolonged unnecessarily, and at greatexpense to debtors and creditors alike, throughout the‘lost decade’ of the s. Such bond markets wereinstrumental in dealing more expeditiously with smallerdebt crises that occurred in other emerging marketsthrough the s. Had such markets existed in Asiaduring the Asian debt crisis of –, it is arguablethat Asia might have escaped the worst effects withoutrecourse to the IMF, and with much lower overalleconomic costs being incurred, especially by Indonesia,and without the unnecessary spread of contagion intothe secure markets of Singapore and Hong Kong.

28 R M I F C

of London are now offered by a plethoraof multinational, American, Japanese andEuropean investment banks along with afew from emerging markets. Yet, contraryto popular belief that the success of an is characterised by the strong presenceof indigenous financial firms, London hasthrived and grown as an rather thansuffered any loss of influence as a result offoreign presence.

This is an important lesson for Indianpolicy-makers and regulators to imbibe:i.e., the success of an IFC and the revenuesa country derives from IFS exports shouldnot be confused with reserving space andensuring gains for indigenous firms alone.An IFC succeeds because it is internationalin every sense of that word. What makesan IFC international is the multinationalorigin of players operating in it. An IFCin Mumbai dominated by Indian financialfirms, or reserved for them, would not beas successful as an IFC that embraced allthe global players that already operate inthe world’s other GFCs and IFCs .

A key feature of financial globalisationhas been the migration of stock exchangeactivities abroad, particularly in fromEuropean and emerging markets. Thereis now an increasing tendency towardmultiple listings of financial securities,and of derivative/commodity contracts, ondifferent exchanges with emerging investordemand for ×× trading of all listedsecurities across all exchanges. Manyfirms, from the and emerging markets,now cross-list their shares on internationalexchanges in the form of s and s.For example, the shares of are listedand traded in Hong Kong, London and NewYork; they should perhaps be listed andtraded in Mumbai and Shanghai as well. Bythe same token the shares of several Indianmultinational companies and transnationalfinancial firms, public and private, are tradedin New York (s) and Luxembourg(s).

Remote access to trading systems isubiquitous, implying that the servicesoffered by stock exchanges can now beaccessed from anywhere, including firmshaving their stocks traded on internationalexchanges while still being accessible to local

investors. Given the network propertiesof stock exchanges, high liquidity furtherincreases the value of additional transactionsat exchanges such as New York or London,leading to even greater concentration oforder flow and increased liquidity at theseexchanges. As a natural extension of thesetendencies the first steps were taken in

to cross-link ownership and managementof corporate exchanges in the and through take-over bids such as thoselaunched by Nasdaq and the DeutscheBourse for the London Stock Exchange.In response the LSE has developed closerpartnership arrangements with the Tokyostock exchange.

Even more recently, in September, a group of global investment banksannounced their intention of collaboratingto establish a global corporate exchangethat would provide a more efficient,less expensive global securities tradingplatform to compete with establishedexchanges. Those types of developments willundoubtedly spread world-wide with capitalmarket exchange platforms being globallyowned and operating on universal standardsof accepted best practice to meet the needsof global investors. It is unlikely that Indianexchanges will remain exempt from suchtrends for too long.

Table . shows the growth of the globalfutures and options market, in units of amillion contracts that is used internationally.India performs well in equity indexes andindividual equity derivatives. But India lacksinterest rate or currency contracts; both ofwhich have now become integral featuresin the emergence of viable bond markets.London is the biggest market in the world forderivatives traded over-the-counter, and thesecond largest for exchange-traded futuresand options; both of whose turnover hasdoubled in recent years.

Mumbai is better placed to developthese particular capacities more quickly thanother emergent s owing to the presenceof strong exchange institutions, highlyefficient and cost-effective computerized andfully automated trading platforms, rapidreal-time gross settlements and delivery.At the same time, the present situationis 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 26.5Interest rate 1320 1637 24.0Individual equity 1139 1463 28.5Agriculture 164 205 25.3Energy 131 172 31.2Currency 75 116 55.0Non-precious metals 24 41 70.9Precious 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 competitivederivatives trading exchange?

When thinking of an NSE-traded USD/GBP

currency futures that competes against otherexchanges, such as the USD/GBP futures that areavailable at the Chicago Mercantile Exchange(CME), there are two components of the totalcost as seen by a customer. The first is the directcharges paid to the the government, theexchange and the broker. The second is the‘impact cost’ when placing an order. The latterdepends on the diversity and sophistication ofthe participants who trade on the NSE. Theformer is directly influenced by policies. In orderto compare charges other than impact cost, wecompare NSE against e-CBOT, the CBOT electronicplatform and the CME Globex electronic platform.

The tariffs at NSE is made up of the followingcomponents. There is a 0.2 basis point charge byNSE; a 0.01 basis point charge for an ‘InvestorProtection Fund’, there is a stamp duty of 0.2basis points, there is a service tax which is12.24% of the brokerage fee and there is thesecurities transaction tax which is 1.7 basis pointson sales only. External levies work out to roughly2 basis points while the NSE charge works out toa tenth of this.

These are enormous numbers when comparedwith the CBOT. The tariff at CBOT is $0.11 to$0.16 per contract (summing across theexchange fee and the clearing fee). It is a percontract charge, which does not vary with thevalue of the transaction. CBOT does not sufferfrom payments to an ‘Investor Protection Fund’,stamp duty, service tax on brokerage andsecurities transaction tax. At CME, the charge forequity products is $0.35 per contract. In addition,CME has a provision where the paymentsassociated with all proprietary transactionsoriginating from one clearing firm are capped at$50 per day for futures plus $200 a day foroptions. Thus, for a proprietary trading firm, apayment of $250 per day gives unlimited tradingservices for futures and options.

For comparability, the specific transaction thatwe focus is 8.29 Nifty contracts, which have the

same notional value as one S&P e-mini contract.We assume that the ‘unlimited trading services’provisions do not come into play. In both cases,on 8 November 2006, the notional value of thetransaction was Rs.3,77,730 or $69,575. Wemeasure the total round-trip transactions costsfaced under three cases: (1) Proprietary tradingby a securities firm, where there is no brokerage;(2) A retail customer of a brokerage firm(assumed 4 basis point charge, ad valorem, inIndia, but $3 per contract in the US) and (3) Ahigh-volume customer of a brokerage firm(assumed 1 basis point, ad valorem, charge inIndia, but $0.05 per contract in the US). Theround-trip charges are reported in rupees.

NSE CME

Retail customer 3343.52 374.40High-volume customer 1235.07 108.90Proprietary 788.98 31.05

This table shows a huge gap incompetitiveness faced in doing IFS in India. Theservice which can be bought by a high-volumecustomer in Chicago for Rs. 31 is being sold inIndia for Rs. 788.98. It shows that NSE is thecostlier venue by a factor of 9 times, 11 times or25 times, depending on the choice of perspective:a retail customer, a high-volume customer orproprietary trading by the securities firm. This is aparticularly unusual situation because the chargesimposed by NSE itself, or by the brokerage firmitself, make up a very small part of the overallcosts paid by the customer. The overwhelmingcontribution to the costs as seen by the customeris from the external levies – securities transactiontax, stamp duty, contribution to investorprotection fund and service tax on brokerage.

Source: Calculations made by Nathan Corsonand Raghvendra Kedia at the request of the HPEC.The full spreadsheet with their calculations canbe accessed on the MIFC web page.

30 R M I F C

Table 2.8: OTC derivatives turnover (average daily turnoverin April $bn)

1998 2001 2004

UK 171 275 643US 91 135 355France 46 67 154Germany 34 97 46Italy 5 24 41Belgium 42 22 39Netherlands 6 14 32Others 79 130 198

Total 474 764 1,508

Source: Bank of international settlements

Indian prices and world prices (see Box .).Significant policy reforms will be necessaryin order to translate India’s latent strengthsin this regard into global competitiveness.

9. Financial engineering andarchitecture for largecomplex projects

Large projects (over $ billion or more)in energy and infrastructure now requireblocks of wholesale funding sourced fromnational and global capital markets, exportcredit agencies and banks. Often thesefunds have to be raised with complexrisk-management instruments attached.Investment banks situated in s are bestsuited for putting together the funding andthe risk management of such projects inplace.

A decade ago, funding of such projectswas mostly done using convertibles, cum-warrant bonds, credit-linked notes andforex-linked bonds. Today, while theseproducts still exist, more complex products,including a whole range of s (s aswell as s), exchangeables and reverseconvertibles as well as a huge number ofcertificates linked to all kinds of underlyingssuch as indices, baskets, securities, funds andhedge funds are available. A large proportionof risk management for these projects is doneusing global derivatives. A range ofinnovative products are developed for clientsand governments around the world. Table. shows the average daily turnover of derivatives.

10. Cross-border mergers andacquisitions (M&A)

Global corporate deal-making (whetherin the form of voluntary or hostile M&A,or divestiture, disinvestment, unbundling,privatization etc.) has become an importantactivity as organizations expand anddiversify across the world. Global M&Aadvisors provide cross-border supportand opportunities for clients who wishto complete acquisitions, company sales,buy-outs and buy-ins, fund raising andother corporate finance transactions. Theobjective is to obtain the best combination ofprice, form of consideration, deal structure,and compatible purchaser within a targetedtimescale.

Comprehensive research, involvingcooperation and expertise of relevantpartners is used to generate an agreed listof recommended buyers with most to gainfrom acquiring the business. By creating acompetitive bidding situation and activelymanaging the sale process through to legalcompletion, the advisor delivers the bestpossible deal, structured for maximumtax effectiveness, whilst maintaining strictconfidentiality throughout.

In the global M&A arena, India wasranked second last in terms of dollar value ofM&A in a recent ranking by Bloomberg. But,what is important in the data for regionalbreakdowns by target countries is that, witha % volume change, India’s M&A growthis blazing enough to take the country to thethird slot, next only to France and HongKong, each of which have achieved morethan % growth. Latin America andCanada are at distant fourth and fifth places,with % and % increase, respectively.Clearly global M&A is an activity that willbecome increasingly important in India andfor which a considerable amount of back-office / and due diligence researchwork is already outsourced to India.

11. Financing for public-privatepartnerships (PPP)

This relatively new activity has emergedon scene with considerable force since thedevelopment of the London Underground

. st Century IFS provided by IFCs 31

Box 2.9: Services provided by global M&A advisorsTakeovers and acquisitions: Global M&A

advisors collaborate actively to create attractiveacquisition opportunities, by carrying out anexclusive search, to a brief agreed with theclient, for relevant ‘best-fit’ targets indesignated territories. Through dedicatedresearch and extensive local and internationalcontacts, they produce a recommended list ofattractive businesses. Once the client agreesupon the target companies, the advisorsinitiate discussions with prospective vendors.They also provide assistance in obtainingadditional information, value the target andthen recommend the most suitable way tostructure a deal. Then, in conjunction with theclient, they negotiate terms, draft the letter ofintent and manage the transaction safely tolegal completion.

Fund raising, venture capital andrestructuring: For clients wishing to raisedevelopment or venture capital, or refinanceor restructure the balance sheet of an existingbusiness, global M&A advisors assist in raisingand negotiating the necessary mix of funding.This could cover the areas of equity,mezzanine, senior debt, working capital

facilities and asset financing. The clientsbusiness is presented in the most favourablelight to an agreed list of seniordecision-makers, within relevant financialinstitutions, drawn from the advisors extensivelist of contacts. By obtaining competing offers,the most attractive terms are sought to bemade available. They also assist over-leveragedcompanies in working out new financingarrangements with their creditors including theraising of new capital and/or the sale of assets.

IPOs, stock market flotations and‘take-privates’: For unlisted companies with anestablished trading record, a flotation on asuitable stock market may be a sensiblestrategic step forward. The global mergers andacquisitions advisors evaluate the suitability ofthe business for a stock market flotation orinitial public offering (IPO) and recommend aprogramme of preparatory work, beforeapproaching an agreed short list of potentialsponsors or investors directly. They then helpthe company to select the most relevantbrokers, lawyers and other members of theadvisory team to make the flotation a success.In case it is felt that the continued growth of a

public company is best ensured by taking thecompany off the stock market into privatehands, the advisors seek out the best financingpartner and assist in all aspects of the public toprivate transaction.

MBOs, MBIs, private equity transactions:M&A advisors assist companies to raise privateequity funding on the best available terms fora management buy-out (MBO) or buy-in (MBI).MBOs and MBIs are technically complicated,time-consuming and often risky formanagement teams. These advisors helpprotect management from risk and introducethem to relevant financial institutions to raisethe finance required. They work with themanagement team to produce a business plan,which sells the investment opportunity andguides them through the minefield of issueswhich they will inevitably face. They alsonegotiate with financial institutions to achievethe best possible equity deal for themanagement team and negotiate the purchaseof the business on the most favourable termsavailable. Partners of these firms have regularpersonal contact with the leading privateequity 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

problems with public procurement and publicservice delivery during the 1980s and was notat all satisfied. Cost and time overruns werecommon in major projects with conflictbetween contractors and the public sectorsponsor a major cause of poor performance.Buildings in the education, health and otherpublic service sectors were also poorlymaintained, which inevitably affected thequality of services provided. Yet, elsewhere inthe UK, such as in the offshore oil and gassector, examples of what could be done byremoving the conflict between project sponsorand contractor were providing some startlingresults in the cost, delivery and ongoingmaintenance throughout the life of the project.In other words doing things differently at thestart could favourably affect the whole lifecosts of the project.

In both the public and private sector,attitudes had been influenced by a decade ofexpertise developed in the UK’s programme ofprivatization of large-scale infrastructure suchas power, water and transportation. Thatprogramme demonstrated that bringingtogether private sector skills with betterinformed public sector procurement delivers

better services for the public.

A key principle is to allocate the risks in theproject such that each sector takesresponsibility for those risks it is best able tomanage. The principal driver for the UK

Government is to achieve best value for moneyfor the taxpayer. The best value for moneynormally comes when the private sectormanages the risks of financing, design, buildand delivery of the service facility. There is nopayment until the facility is delivered and fullyoperational. Maintaining the facility atconstant or improved standards over the life ofthe project (normally around 25 years) is alsothe contractor’s responsibility. There areagreed service levels and financial penalties ifthe contractor fails to deliver these standards.

Two important factors became clear at anearly stage of this new process. The first wasthat putting private sector capital at risk, notjust its profit, creates a powerful incentive forthe private sector to build the assets on time,maintain and deliver high standardsthroughout the contract life. The second wasthat if the private sector money was to beattracted and take on the attendant risks, theGovernment needed to show a strongcommitment to the process of PPP, give clear

indications on project priorities anddemonstrate a ‘deal flow’ of projects.

To assist confidence levels in both theprivate and public sectors the UK Governmentrecognized the need for a systematic and ‘topdown’ driven approach to generatemomentum in PPP projects. One of thecontributory factors to the UK success wassetting up of a high level task force in 1997,comprising experts from both public andprivate sectors, to look at critical issues, andfocus on driving through projects. It was alsoto act as an important repository ofknowledge for the public sector.

Another key to success has been the fullinvolvement of Local Authorities through theagency known as the Public PrivatePartnerships Programme (or 4Ps for short). Theagency provides practical support andguidance to all local authorities in England andWales to enable them to improve theirprocurement capability, particularly for largeprojects, through partnership structures.Having worked with 200 local authorities todate, 4Ps is recognized as an unrivalled sourceof best practice and practical guidance onproject procurement.

() . Expert consultants, who help inputting together a deal, provide legal,accounting, consulting and other business

support services to the public and privateparties co-operating under s, providingcomprehensive support from the beginning

32 R M I F C

to the end of a transaction. The consultantadvises on the most appropriate way todevelop and structure projects anddrafts all necessary documents to implementthe structure, keeping in mind the needsof potential financing parties. Typicallythey provide value to restructurings andrenegotiation throughout the lifespan ofprojects. This would include:

• Advising governments on best practicesfor engaging the private sector intraditional government monopolysectors.

• The creation of regulations for sector-based or multi sector-based authorities,whose function is to oversee thedevelopment of the competition in theprivate sector, the economic policiesdefined by the public authorities, andthe security standards and quality ofservice.

• Drafting:

– Tender notices and invitationletters by which the privatecontractors submit their tenders

– Constituent documents for projectcompanies

– Agreements, including conces-sions and licenses, between thepublic and private parties

• Designing alternative financial/legalstructures

• Assisting in every aspect of the operation

• Financing models and project docu-ments

Public private partnerships () havebeen more widely developed in the andthe than elsewhere. In the , newfacilities for schools, hospitals, prisons androads financed through s have deliveredsubstantial benefits. In India, which isshort of fiscal headroom for financingurgently needed infrastructure, s offerthe obvious vehicle for expanding its physicaland social infrastructure rapidly. However,going beyond India, there is a substantial-related market worldwide. Theskills required in this business are availablein India. Hence, it offers a major businessopportunity for Mumbai as an .

Case studies: London, NewYork, Singapore, Dubai

3c h a p t e r

As observed in the two preceding chapters, are being provided to the world by afew international financial centres (s)located in the , and East Asia. Inthis chapter, we present four case studies:London, New York, Singapore and Dubai.

We have chosen these four cities tolook at closely because: (a) the first twoepitomise what a fully-fledged is, andwhat Mumbai should aspire to becomeas it matures; and (b) the latter twooffer immediate competition in India’sown neighbourhood of a kind that maycompromise the emergence of Mumbai asan .

Indeed, if policy-makers and regulatorsdo not take the necessary actions for makingMumbai a credible/viable in the nearfuture, then Indian financial institutions thatare managerially capable, and have freedomof manoeuvre, are likely to locate in thetwo proximate centres within a matter ofmonths. From there they can offer theirclients (whose business they do not wishto lose by default) a range of that theycannot offer from India today. Indeed DubaiInternational Financial Centre () iscounting on that eventuality materialising.Such a move would compromise, delay,and perhaps even prevent, Mumbai frombecoming the kind of that an economyof India’s growing stature should have.

1. Summary overview

London has been an important for overthree centuries. It was predominant in – when the British Empire covered muchof the world. After an interregnum in – – when it ceded primacy to New York – ithas now recaptured its status as the world’spremier . That has been a result ofcanny opportunism and adept regulation. Itexploited the reality that financial markets

in other large economies such Germany,France, Japan and the were being over-regulated and over-taxed.

New York rose to prominence as an with: (a) the growing stature of the economy between and – similar towhat is happening in China and India today;and (b) relentless American innovation infinance – which is not happening in Chinaor India as yet. Financial innovation in the (not just New York but Chicago as well)has continued ever since. New York becamethe world’s dominant in when war-ravaged Europe involuntarily ceded globalleadership to America. That baton is nowpassing to Asia as the st century unfolds.

Singapore’s emerged in the s ands and is now well established if not yetfully developed. It is still a far cry fromLondon and New York. But it is arguablyahead of Tokyo, Paris and Frankfurt. Thatis a remarkable feat for a small entrepoteconomy to have achieved in the space of amere quarter-century.

Dubai – or more specifically, the DubaiInternational Financial Centre () –is a newly emergent enclave with theresources and infrastructure in place todevelop very rapidly in providing tomarkets in the Middle East as well as in West,Central and South Asia.

Unlike London and New York, the sin Singapore and Dubai have not evolvedas a consequence of their historical andgeographical legacies, or natural evolutionof their market economies at the crossroadsof global financial flows for trade andinvestment. They have emerged as a resultof a powerful push by their respectivegovernments to develop s. Singaporehas the advantage of being at the centre of

34 R M I F C

the large and flourishing regionaleconomy. Dubai is located in a morevolatile neighbourhood. Its political andadministrative governance is not based onan established democratic structure, nor onglobal norms concerning the rule of law. Itis based upon the unusual competence oftwo generations of a monarchic autocracy.But the next generation of leadership isas yet untried and untested. Successionis unclear. is incipient and has yet toprove itself. Dubai is only at incipient stagesof establishing itself as a stable global citywhose future is assured. But if its recentaccomplishments in other spheres (in ashorter span than Singapore) are indicative,then portents for success are favourable.

Taken together, these four global cities(two old, two new) are natural referencepoints for a policy debate in India aboutestablishing an and how it might evolve.In a nutshell, Mumbai’s should, overthe long term, aspire to emulate the City ofLondon. It should operate and be regulatedin the same flexible way. But it facescompetition from Singapore and Dubaiwhose capabilities/ambitions are clearer. Asnoted, that may compromise Mumbai’sdevelopment as an in the nascent stageif the ingredients for a successful areunavailable or poorly blended. The mainsuch ingredients of course are political,administrative and regulatory leadership.They are required at central, state, municipal,and corporate, levels of governance.

If past experience is any guide, symbi-otic relationships will develop across sover the years. The task of global provision is already fragmented into sub-components produced at the most efficientproduction location and synthesised at thepoint of contact with the client. Manufactur-ing in almost all industries is now organisedon that basis in a seamless global produc-tion chain. Similar complex organisationof production is now technologicallyfeasible and becoming increasingly desirablein terms of cost-effectiveness and efficiency.Given the proximity of time zones, this willgenerate strong pressures for close workingrelationships between/among the in-dustry in Mumbai with that in Singapore,Dubai, London and New York.

From what we discern of activitysince , it is clear that the emergenceof competing s does not necessarilydisplace work at other s. A study oncareer development patterns in the global industry insightfully suggests that it istypical for high-flyers to work in a numberof s; particularly London, New York andSingapore. They do so for different globalfinancial firms, and establish their owninformal working networks, before settlingdown as senior executives in any one of them.Perhaps as a consequence of such humannetworks, the growth and development ofSingapore as an appears to have createdmore business for London and NewYork rather than less. On that basis theemergence of Mumbai and Shanghai as sshould be welcomed by London and NewYork if not by Singapore and Dubai.

But, at the same time, anecdotaland quantitative evidence suggests thatSingapore has diverted some business fromTokyo and Hong Kong. Tokyo has notbeen as global or culturally adaptable in itsaspirations and outlook as an . It has notadopted English as its ’s lingua franca;nor is it as prone to financial innovation, orto light-touch regulation, that adapts quicklyto changing national/global circumstances.

Similarly, the primacy of London ap-pears to have constrained opportunitiesfor other European centres like Amsterdam,Paris and Frankfurt. These centres have notadapted governance frameworks for theirfinancial regimes, nor their regulatory andtax practices, in tune with rapidly evolvingglobal expectations/standards as Londonhas: nor do they use English for commu-nicating with the world. Though home tolarge immigrant populations they are notas open to, or as tolerant of, cultural andlingual heterogeneity on the same scale asLondon and New York. And they have oner-ous tax regimes that deter expatriates in the industry from locating there.

Evidence from all four case studies –and contra-evidence from s like Tokyoand those in continental Europe – suggestsstrongly that the use of English is an essentialingredient for the development of a viable

These results are from the ‘Loughborough Study’.

. Case studies: London, New York, Singapore, Dubai 35

. That is because English is the defaultlanguage of global business.

The following four case studies havebeen presented in order to help policy-makers and the wider public to understandin concrete terms what it takes for an to be commercially viable, competitiveand successful; and to guide debatesabout specific policy aspects importantin the formation of s. They areparticularly relevant given the comingyears of cooperation and competition thatMumbai will inevitably confront in itsdealings as an with Singapore, Dubaiand London.

2. A closer look at the City ofLondon

London is at present the most successfulGlobal Financial Centre (). It is theworld’s largest net exporter of financialservices, earning a net surplus of about$ billion in from . It leads ininternational bank lending, consulting oncross-border mergers and acquisitions, andtrading/issuing international bonds. It is theleading global currency trading centre, witha % market share of total global currencytrading.

London’s origins as an can betraced back to just before the Napoleonicwars. Edward Lloyd’s Coffee House –where maritime insurance was arranged– was established in . The Bank ofEngland was formed in . By thelate th and early th century, economicdevelopment in north and west Europehad advanced to a point where surplussavings were being generated. New types offinancing needs were making themselves feltsimultaneously. This was a period in whichEuropean imperial powers were expandingtheir colonial domains rapidly. Colonisationrequired substantial risk financing fortransport (e.g. railway projects), trade, otherinfrastructure, as well as for productiveinvestment in agriculture, mining andprimitive manufacturing.

In financing commercial activity athome and abroad, London played asignificant role in key innovations such as:the limited liability company, organised

equity trading and syndicated insurance.This triggered the growth of public tradedsecurities and of merchant banks to dealin them. London invented the market-dominated financial system now knownas the Anglo-Saxon model. Individualshipping ventures, as well as such enterprisesas the British, Dutch and Danish EastIndia Companies, were financed by equityinterests privately distributed among wealthyaristocrats, government personages ormerchants from sponsoring countries. Earlymining ventures were routinely funded bythe issue and sale of shares or participations.

Another need that London met wasgovernment financing for countries rangingfrom those of major European countriesto small princely states; often for financingwars. Given the risks and difficulties ofcontract enforcement, wars could not befinanced by equity participation. They werefunded by debt arranged by bankers, suchas the Rothschilds. Indeed, historians havenoted that England had an advantage inwaging war against France because of itssuperior expertise in bond financing withcenturies of financing wars through large-scale sovereign bond issues. Such publicdebt was run down through fiscal surplusesin peacetime. The long history of the shows a remarkable ability to doggedly runsurpluses and run down the debt/ratio for decades on end in peacetime,which established the credibility requiredfor borrowing of the order of % of at the time of the Napoleanic wars, the FirstWorld War and the Second World War.

Capital flows in the th and thcenturies involved issuing securities inEurope to finance development in theAmericas and the colonies. Infrastructure(e.g., railways) in the and Latin America,as well as mining, ranching and plantationventures in the colonies, were financedthrough share and bond issues in London.In real terms, they would seem enormouseven by today’s standards.

Global trade, finance and capital flowswere disrupted for three decades between thestart of the First () and end of the SecondWorld War (). Between and ,the exported capital to Europe and Japanto the tune of over % of its for the

36 R M I F C

Marshall and Stimson Plans alone. A further% of was transferred by way of privatecapital flows as major corporationsestablished manufacturing bases in Europe.But as domestic consumption in Americagrew during –, and as domesticproduction in Europe revived (much of itbeing exported to the to earn surplusesthat repaid reconstruction loans), the’ trade balance with Europe shrankdramatically, thus deepening its overallbalance-of-payments deficits.

Faced with a massive expansionof public spending under the Kennedyand Johnson Administrations, and thesimultaneous financing of a war in Vietnam,the Treasury realised in the earlys that capital exports to Europe couldnot continue. The Treasury hadbegun encouraging European authoritiesto develop their own capital markets sincethe late s. That initiative resonatedwell in London where the authorities beganimmediately to revive its role as an .

In June , the first Eurobond wasissued in London by Autostrade, the Italianstate highway authority. British merchantbanks (e.g., Morgan Grenfell, Barings,Cazenoves, Flemings, Jardines, etc.) rapidlyassumed leadership in Eurobond issuesfor sovereign, corporate, multilateral andparastatal issuers; not just from Europebut from around the world. That marketexpanded rapidly. It became so lucrative,that leading American investment bankssuch as Morgan Stanley, First Boston,Lehman Brothers, J.P. Morgan and GoldmanSachs also set up operations in Londonin the late s; propelling its resurgenceas an . Its role was bolstered bythe recycling of petrodollar surpluses viaLondon throughout the s via syndicatedbank lending and sovereign bond issues.

American institutions operating out ofLondon were joined in the s by financialfirms from Holland, Germany, Japan, France,Italy, Scandinavia and Canada. That secondwave was followed by a third through thes and s from Singapore and thedeveloping world. What cemented London’sprimacy as a in the st century wasthe Big Bang triggered by the ThatcherGovernment in . It resulted in total

deregulation and liberalisation of the ’scapital, insurance and currency marketsand replaced the gentlemanly atmospherein which business was traditionally donein the City. Professionalism was infusedfrom abroad, mainly the . London’sfinancial markets were opened to all. Thatled to the entry of major global institutions(e.g., and Citigroup) as well asfinancial institutions from every economyin Europe, Japan and the developing world.An unfortunate consequence was that suchopening-up led to the demise (throughacquisition) of British owned investmentbanks which were outclassed by theirbetter capitalised and more professionallyrun foreign rivals. However, many owned commercial banks and mortgagefinance institutions continue to flourishin providing retail financial services todomestic customers rather than specialisingin .

The capstone for ensuring London’scompetitive edge in the provision of waslaid by the Blair Government in . TheBank of England was made constitutionallyindependent and responsible solely for theconduct of monetary policy. That was tobe done in a transparent manner with nointerference by the Treasury. All tasks otherthan setting the base rate were shifted outof the Bank of England. The frameworksfor accountability and for total transparencyof decision-making were put into placefor this one task. The Bank of Englanddoes not trade on the currency market tointervene in stabilising exchange rates, evenin times of stress. The burden of financialregulation and supervision was transferredto a Financial Services Authority () thatbecame a unified single regulator for allfinancial services. Regulatory unificationprevented the fragmentation of finance,avoided regulatory turf wars, eliminated theproblem of regulatory issues falling betweenthe cracks when multiple regulators regulatedifferent institutions, and increased benefitsfrom economies of scale and scope.

The developed and applieda unique framework of principles-basedregulation — a counterpoint to the and continental European approaches ofrules-based regulation that necessitates

. Case studies: London, New York, Singapore, Dubai 37

Table 3.1: London’s share in global foreign exchangetrading

April Global foreign % share of markets2006 exchange market UK US Japan

turnover ($bn)

2001 1,277 31.1 17.7 9.12004 2,041 31.3 19.1 8.32005 2,103 31.5 18.9 8.32006 2,901 32.4 18.2 7.6

Source: IFSL estimates; Bank for InternationalSettlements

codifying detailed rules and regulationsthat define all financial products andmarkets. The superiority of principles-basedregulation (with its inherent flexibility inpermitting financial innovation) over rules-based regulation (which cannot anticipateevery future innovation and therefore tendsto suppress it) has been proven over adecade. It has further entrenched London’srole as a . It has resulted indirectlyin many global banks (investment andcommercial) shifting entire divisions formajor corporate financing functions fromNew York to London to take advantage of theregulatory flexibility offered in that location.

Table . shows the growth of thecurrency trading market in London whileTable . indicates the share of London inoverall .

Why/How did London become the world’spre-eminent IFC? Eight factors made amajor contribution to that outcome. Theyneed to be considered carefully by Indianpolicy-makers.

. Location: London has a particularlyconvenient time-zone location. In themorning, London talks with Tokyo,Sydney, Singapore, Hong Kong andMumbai. In the evening, London talkswith New York, Chicago, Miami andSan Francisco. London daytime overlapswith daytime in Tokyo Singapore, SouthAsia, the Middle East, Europe and theAmericas. These regions account for thebulk of world . Longitudes fromMumbai to New York can be accessedthrough flights of below hours fromLondon.

. Open, genuine participatory democracy

and rule-of-law: London has a longtradition of a mature democracy withfreedom of speech, as well as an arrayof constitutional and popular checks-and-balances to curb the excesses ofgovernment, legislature, and politiciansat every level of government. These arefirmly respected and enforced withoutdiscrimination, fear or favour. Londonestablishes global standards for the ruleof law with a capable and sophisticatedlegal system for resolving commercialdisputes. This attribute dovetails wellwith the contractual requirements ofinternational finance.

. A multinational, multilingual work-force: London has embraced a largepopulation of immigrants thanks to thelegacy of Empire and a tradition of pro-viding asylum from oppression in Eu-rope. People of all nationalities and eth-nic origin are to be found in the City ofLondon at every level for financial firmsfrom all over the world. Ethnic originand nationality do not pose insuperablebarriers to employment or advancementin the City. That enables London to net-work and communicate with the rest ofthe world – including the most remotedeveloping country – more effectivelythan any other .

. Language: With English having becomethe default language of globalisation,London (along with New York) has anadvantage over other s that operatein different lingual environments. Lackof English has hindered the emergenceof Tokyo, continental European centres,as well as other aspirant s such asShanghai and Seoul.

. Capital Controls: The has no cap-ital controls. But, London was an even when capital controls were in forcebetween and . However globalcircumstances have changed dramati-cally since then. In –, the citiesthat London competed against also hadcapital controls consistent with the then-prevalent Bretton Woods system. It isimpossible to see London being as suc-cessful as a if capital controls (of

38 R M I F C

Table 3.2: Market share in IFS (percent)

UK USA Japan France Germany Others

% shareCross-border lending (Sep 2005) 20 9 8 8 11 44Foreign equities turnover (2005) 43 31 – – 3 23Currency spot turnover (Apr 2004) 31 19 8 3 5 34Derivatives 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) 70Fund management (as a source of funds, 2004) 8 45 12 5 4 26Hedge 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.Today, the Bank of England, the and the Treasury do not attempt toeven capture data about capital flowsof the kind that the authorities in Indiafeel is necessary. But the advent of newregulations aimed at preventing moneylaundering and the financing of terror-ism may change that situation on anexceptional basis.

. Openness and lack of protectionism inthe IFC: The Big Bang of resultedin complete deregulation, liberalisationand opening up of the market in the. Some restrictions remain on directforeign entry into the domestic finan-cial services market. But those can beovercome by acquiring extant financialfirms operating in that market. This pol-icy of openness was pursued despite thethreat to the survival of venerable Britishmerchant banks. That threat eventuallymaterialised. But it did not deter theauthorities from internationalising theCity with no preconceived limit on for-eign presence, nor any insistence on theparticipation of domestic institutions,nor on the employment of nationalsin key executive positions. The inter-nationalisation of its financial systemthat the has achieved is remarkableby any standards; particularly by Indianstandards that favour protectionism overopenness and efficiency. Table . showsthat of the banks authorised to op-erate in the , only are ownedand controlled. Many other countries

lack the level of commitment to open-ness which enables such a level of inter-nationalisation (e.g., most continentalEuropean countries and Japan) and arethus unable to compete with London inproviding .

. Policy innovations of the late s: The reforms that: (a) gave the Bankof England statutory independence forthe conduct of monetary policy with asingle price stability target and withoutany interference from the Treasuryand (b) created a single unified finan-cial system regulator (the ) havetogether set global standards for cuttingedge central banking and financial reg-ulation. The example has, over thelast decade, become the ideal model forcentral banks and financial regulatorsworldwide. Moreover the ’s pioneer-ing principles-based approach to regu-lation is now seen as more innovationfriendly and less risky than traditionalrules-based regulation.

. Policy focus on finance: With a

of around $ . trillion, the economy is the world’s fifth largestin nominal terms. That is more thanthree times the size of the Indianeconomy in nominal dollars; althoughit is actually slightly smaller in terms. But the role of its financialservices industry, and of provisionin particular, in generating employment,output and net export revenue issufficiently large to command the specialattention of politicians and government.Whereas the has lost competitiveness

. Case studies: London, New York, Singapore, Dubai 39

Table 3.3: Ownership structure of banks operating in UK

1995 2005

Total authorised banks 481 347Incorporated in UK 224 165UK owned and controlled 142 78Foreign owned and controlled 82 87Incorporated outside the UK 257 182Total Foreign banks 339 264

in manufacturing, and a number ofservice industries as well (other thanpublishing, media and entertainment)it has remained competitive in theprovision of . This heightenedprominence of finance has helped toensure that the City of London attractsits best professional talent, as well as theattention of the ’s key administrators,political leaders and statesmen. Itinclines them toward reaching consensuson far-reaching reforms in the financialservices sector in a timely manner(such as the Bank of England and reforms) and continually adjusting/fine-tuning the legislative framework andregulatory environment in keeping withchanges in the global environment toassure continued competitiveness. IfLondon lost market share in the global marketplace, this would affectelection outcomes in the UK throughthe large direct and indirect impact of revenues upon UK GDP.

In contrast, whereas financial servicesin the as a whole account for asignificant proportion of value-added, net exports are small in comparison withthe size of the economy ($ trillionin ) and of gross exports. Americanadministrations and congressional leaders– inclined to be insular – lack a similardedicated focus on when comparedto their counterparts. This has posedgreater difficulties for the in reformingunhelpful financial policies (such as theprolonged separation of banking and capitalmarkets under Glass-Steagall).

Regulation is fragmented across the Fedfor banking, the for spot securitiestrading, the for derivatives, and theOffice of the Comptroller of the Currency.

That has led to difficulties in co-ordinatingmultiple regulators across the financialsystem. Legislative myopia, and suspicion ofthe motives of foreigners in compromisingthe ’s commercial interests, has resultedin the passage of legislation such as theSarbannes-Oxley Act. Sarbox is anathemato the global business community. Itimposes punitive measures on foreign firmsand nationals for questionable reasonsand attempts to exert extra-territorialityin extending the remit of law.

After the tragic events of //, therehave been profound changes in the attitudesof the authorities in response topublic concern about terrorism on soil.Homeland security concerns on the partof the have, in turn, led to reciprocalconcerns on the part of global financialfirms about the stability, reliability andconsistency of policy-making understress. There is now a perception on thepart of capital surplus countries that holdlarge reserves of a heightened risk offoreign asset seizure; that has happened inthe case of Iran. Consequently, a subtlechange in attitudes has occurred on the partof foreign financial players about the wisdomof putting too many eggs in the New York basket, simply as a matter of politicalrisk-management. That perception, alongwith the ’s better regulation, has driven business from New York/Chicago toLondon since .

What London has achieved as astandard-setting is surprising; espe-cially given some weaknesses that mightotherwise have seemed insuperable. Lon-don lacks the intellectual depth of academicfinancial economics in the . Americanminds have dominated the development ofmodern quantitative finance from on-wards. Yet, although short on theory andskills in quantitative finance, in practice Lon-don is not at a significant disadvantage wheretheoretical financial innovation is concerned.Financial innovations in instruments andmarkets are now diffused very swiftly.

London has established its ownreputation for innovation: e.g., in financialregulation and in arranging complexfinancial packages for politically sensitiveprivatisations and s. In these areas it is

40 R M I F C

well ahead of New York. It lacks as large anational economy as other s (e.g., NewYork, Frankfurt, Tokyo, and now Shanghai).Yet London has positioned itself to serve the economy as the premier with othercontinental s playing a subordinate role.Thus, London has leveraged its inherentstrengths and flexibility to overcome someof its apparent handicaps.

3. New York/Chicago as theGFC for the Americas andthe World

New York and Chicago are financial centresthat reflect the overwhelming dominanceof the economy. Chicago has a strongposition in exchange-traded derivatives.New York accounts for virtually all otherfinancial activities in the . But in bothcities, the provision of is secondary toserving the needs of the domestic economywhereas in London, assumes primacy.

New York is home to and, the two largest stock exchangesin the world measured by the number anddollar value of transactions. It is also hometo the New York Mercantile Exchange, thelargest global commodity futures exchange.Virtually every major financial conglomerateand bank in the world, American-ownedor not, has a presence in New York. Indeedany financial institution anywhere that dealsdirectly in dollars in large amounts findsit essential to maintain such a presence. NewYork has a bewildering array of integrated,as well as specialised, financial firms engagedin moving money from one place to another,inventing new trading strategies, raisingcapital in all markets and using derivativesto reshape risk.

London and other s replicated thehuman capital and computer technologyin their industries to match NewYork/Chicago in terms of the instrumentsand contracts they could offer globalclientele, and the platforms needed totrade them. London, on the other hand,led the way with innovations in financingprivatisation and s which New York didnot keep pace with.

Despite these developments in eachof these two competing s, theoverwhelming cerebral power reposed inthe American academic establishment keepsNew York ahead of London intellectuallyas the ‘Silicon Valley’ of finance with a keyrole in continued financial innovation. Box. shows one example of the fascinatinginterplay between the ideas of academiceconomics and the operations of real worldfinance. Another famous example of suchan interaction is the pair of academic papers(Christie and Schultz, ; Christie et al.,) which led to the demise of the erstwhile market design.

While New York continues to haveremarkable strengths based on its intellectualcommunity, to extend that metaphor, itcreates the space and the precedent forMumbai as an to relate to NewYork/Chicago and London in the same waythat Bangalore (and now many other centresin India) have prospered by relating toSilicon Valley.

The tides of global financial flowshave been turning dramatically since .A previously closed second world enteredthe global economy in as a fullparticipant creating new demands andneeds for . After the lost decade ofthe s, the developing (or third) worldhas grown substantially. It has become amore significant part of the global economy;despite ructions such as the Mexican debtcrisis of , followed by the Asian crisis of– and the Turkish, Russian, Brazilianand Argentina debt crises of –. The has turned from being the world’s largestcreditor to being its largest debtor in a spanof years. Large fiscal and current accountdeficits in the are now being financedlargely by international investors. Table .shows purchases and sales of long-term securities by foreign investors. Table .indicates investor purchases and sales oflong-term foreign securities. But, althoughglobal financial flows have reversed, theunderlying transactions are still being donein New York.

The eight factors that contributed toLondon’s success as an have alsocontributed in large measure to the successof 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

begun operating as an IFC, New York was stillin its infancy. The end of that century saw NewYork become a trading city when Americanwheat entered European markets. Through thefirst half of the 18th century, New York’s rolein shipping agricultural exports to Europe wasenhanced. But it gradually became a gatewayfor reverse British and European investment inAmerican farming, ranching and miningthrough the late 18th and 19th centuries.Until the War of Independence in 1776,independent finance was nonexistent inAmerica. That was because local commercialbanks were prevented from emerging. Theprevailing mercantile theory in Britain andEurope was that capital invested in coloniesshould be loaned by imperial countries (tobenefit from annual returns) rather than begenerated and retained in the colonies fortheir own use through reinvestment.

After 1776, the first task of New Yorkfinanciers was to help the new US governmentfund the huge war debt that had been run upfor the war of independence. When that wasaccomplished New York faced competitionfrom Philadelphia and Boston as a domesticfinancial centre. In 1814, a stock exchangewas started in New York to compete withexchange-traded equities in Philadelphia. From1817–29, the Erie Canal (linking the GreatLakes to the Atlantic) was built. It transformedAmerica’s commercial geography and provedimmensely profitable. But it required anenormous amount of debt financing. Most ofthat was arranged in New York with asignificant proportion being sourced fromEurope. That canal opened up unprecedentedtrade opportunities. It made the produce ofthe American mid-west exportable to theworld. In turn it increased needs for financingtrade and investment in New York. Followingthe success of the Erie Canal, Wall Street grewfrom strength to strength, focusing on raisingdebt and equity for canals, railroads, andshipping companies as well as the cotton andwheat trade. Its role expanded as the Westand the Pacific Coast were opened up andsettled by successive waves of immigrantsfrom Europe and Asia.

By 1850, New York had become the primeUS financial centre. Its growth was related to aburgeoning domestic economy and itsincreased trade (similar to where Mumbai isnow). The emergence of the US as the largesteconomy in the world (overtaking the BritishEmpire) at the end of the 19th century,inevitably made demands on the domestic and

international financial systems. Between1860–1914 these needs were met as much byLondon as by New York. The American CivilWar placed great demands on New York infunding the war on the side of the Union, andthereafter, for the reconstruction and revival ofall the ‘united states’, and for supportingcontinued migration and expansion of largeterritories in the West.

The internationalisation of New Yorkoccurred in the early 20th century whenEurope was exhausted after internecineconflict that extinguished a generation.Interrupted temporarily by a global depressionin 1929–32, New York’s role as an IFC grewrelentlessly between the two world wars(1918–38) as American corporations andfinancial firms invested abroad, particularly inthe UK, Western Europe and Latin America.During World War-II (1939–45), the US was themain production engine for the Allied Forces.New York helped Washington to finance thatwar on a lend-lease basis and arranged warloans for its allies (mainly the UK, Canada,Australia and New Zealand as well as the USSR).New York’s role as a GFC became moresignificant when the Second World War ended.In 1945 the US was the only economy capableof providing the finance needed to reconstructand revive the world economy.

In the half-century between 1918–70 the US

led the free world and dominated globalfinance. But, the US economy becameoverextended in the early 1960s. Europe wasresurgent with the completion ofreconstruction and revival of its war-shatteredeconomies. European and Japanese exportengines went into overdrive in the 1960s.American encouragement for reviving Europe’scapital markets, as well as its own regulatoryshortcomings, led to the creation of theEurodollar and Eurobond markets whichboosted London’s revival as an IFC. Althoughthe breakdown of Bretton Woods in 1971triggered a gradual slide in the relativestanding of New York, it still managed to leadLondon in financial innovation from the 1970sto the present.

New York pioneered the transition fromplain vanilla to post-modern finance. It did soby incorporating risk management featuresinto financial products and services. Thatstream of innovation has transformed thenature of global finance and of IFS. Althoughfutures had existed for some time in theagricultural and mineral commoditiesbusinesses, American ingenuity led to

conceptualising tradable financial instrumentsfor risk management i.e., derivatives. Currencyfutures – introduced at the Chicago MercantileExchange (CME) in 1972 – were the firstexchange-traded derivatives. In 1973, theChicago Board Options Exchange (CBOE) wasformed, and the Black/Scholes formula forpricing options was developed at MIT and BellLabs.

Until 1990 the US was the world leader incomputer technology and in financialeconomics. It probably remains so todayalthough it now shares the space it oncedominated totally with a number of othercountries. Given the monetary and psychicincome returns involved, many leadingacademics from top US universities migrated toWall Street. They played an important role inkey global firms, such as Fischer Black, whowas partner at Goldman Sachs, and Mertonand Scholes, who were involved in LTCM

(Dunbar, 2000). The marriage of newcomputer technology with new financialeconomics resulted in explosive growth infinancial sophistication in the 1980s. Thatenabled New York to maintain an intellectuallead even as it was ceding ground in IFS

trading terms. The substantial presence ofleading American financial firms in London ledto the rapid transmission and diffusion of suchinnovation from New York to London andbeyond.

By the same token, the wave of privatisationunleashed in Britain by the Thatchergovernment in the 1980s led to Londonbecoming the leading IFC for conceptualisingthe financial engineering to achieve politicallyand socially sensitive financial transformations.As privatisation and denationalisation werepropagated around the world by the WorldBank and IMF during the era of structuraladjustment (1981–97), London played apivotal role in advising on, and arranging,most of these transactions in global capitalmarkets. In the 1990s, London continued toplay an innovative role in conceptualizing andexecuting complex financial/legal structuringof public private partnerships (PPPs) under theprivate finance initiative promoted by the Blairgovernment, to augment limited publicresources for investment in physical and socialinfrastructure. That specialised expertiseprovided another string for its versatile bow.So, at the turn of the 21st century, theintellectual/innovative edge that New York andChicago had in creating and tradingderivatives was becoming blunted.

global financial firms have begun moving key operations from New York to London.This is partly attributed to London’s morebenign regulatory environment and partlyto post-/ neurosis in the .

Traditionally, New York firms hadoperated under a regulatory regime thatwas, in most respects, more open toinnovation than those that governed others, 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 financeThe US pioneered the idea of futures

markets being applied to underlying contractsother than those for physical commodities.This began with currency futures in 1972, thesuccess of which immediately led to attentionon the stock market index as an underlying forderivatives. Operationalising stock indexfutures required a key innovation – cashsettlement. Cash settlement is nowmainstream in derivatives trading, and manycommodity futures are now settled in cash.But, though obvious and standard now, it wasan important innovation at the time. In allcountries, cash settlement has presented legaldifficulties owing to laws against wagering.

Three exchanges – the Chicago Board ofTrade (CBOT), the Chicago MercantileExchange (CME) and the Kansas City Board ofTrade (KCBT) – engaged in developmental workleading up to stock index futures trading.When the legal constraints were resolved, theregulator gave the green light first to KCBT

since their application had been filed first – asearly as 1977. Trading began in February 1982.The index used by KCBT was the Value LineIndex. It was a geometric mean of prices of1,650 shares. The pricing of futures on suchan index presented a challenge that was notunderstood at the time. The market coped

bravely with the situation, treating the futuresas an ordinary futures product, where the basisshould be positive and should roughly reflect acost of carry applied on the spot price.

In 1986, a pair of economists namedT. H. Eytan and G. Harpaz wrote a paper inJournal of Finance titled “The Pricing ofFutures and Options Contracts on the ValueLine Index” where they worked out the newmathematics of how futures prices andarbitrage worked when the index was ageometric mean of prices (Eytan and Harpaz,1986). Remarkably enough, their arbitrageprocedures implied that the correct basis (i.e.the gap between the futures price and thespot price) for the KCBT index futures contractshould be negative.

It is widely believed that Fischer Black, whowas at Goldman Sachs at the time, took upthese ideas and rapidly implemented them asan operational trading strategy (Ritter, 1996).As a consequence, almost immediately afterthe publication of Eytan and Harpaz, 1986,the basis on the KCBT flipped from a positivebasis (which was based on traders wronglythinking that the geometric mean of pricesindex was like any other index) to a negativebasis (which correctly flowed from the

arbitrage strategy of Eytan and Harpaz, 1986).Once this arbitrage capital and mechanismwas in place, the KCBT index futures waspriced correctly (Thomas, 2002).

This story involves five remarkable elements:

. The innovative spirit of the US financialindustry in pushing on from commodityfutures to currency futures to stock indexfutures;

. The effort at KCBT to get going on such aproduct even if it involved an awkwardgeometric-mean-of-prices index;

. The engineering approximation of traderswho tried to make do in trading this indexeven though the theory was notdeveloped;

. Scholars like Eytan and Harpaz who solvedthe puzzle of how to arbitrage and pricethe product; and

. Scholars like Fischer Black who were ableto rapidly turn the idea from the academicliterature into a trading strategy backed byenormous capital at Goldman Sachs, andthus bring market efficiency to the market.

Table 3.4: Foreign purchases and sales of long-term US

securities (in USD mn)

2002 2005

United Kingdom 186,691 361,822Rest of Europe 57,064 158,173Caribbean Banking centres 76,144 126,289Japan 91.412 81,955Rest of Asia 109,314 188.435All other countries 26,940 126,272

Total 547,565 1,042,946

Source: Treasury International Capital Reporting System

Table 3.5: US investor’s purchases and sales of long-termforeign securities (in USD mn)

2002 2005

Foreign bonds −28,492 28,603Foreign stocks 1,493 126,735

Total −26,999 155,338

Source: Treasury International Capital Reporting System

However, as other nations moved toliberalize their financial markets, while the came up with legislation like Sarbox,this advantage has eroded dramatically.

The is now ahead of the in termsof its regulatory approaches, attitudesand practices. The rules-based regulationof the faces severe competitionfrom the principles-based regulation ofthe . That competition is beingworked out in the global marketplace ascountry after country opts for the model.

But whether New York leads Londonas an , or vice versa, is less relevant thanthe growing reality that these two centres arebeginning to increasingly operate as a sin-gle linked entity. The same global financialfirms operate in, and dominate, both s.In a move was made by exchanges inNew York to acquire London’s main stockexchange. activity in these two centres isbeing undertaken within the same ten majorglobal intra-group/inter-corporate brandumbrellas. The booking of any particular transaction by a given firm is depen-dent on which jurisdiction offers the mostfavourable regulatory and tax environmentfor that activity.

What is now happening betweenLondon and New York may well extend to

. Case studies: London, New York, Singapore, Dubai 43

bringing all significant s within a singlelinked operating network that constitutesan integrated web of global finance. Inthat sense the specific -industry basedlinkages between/among global city IFCsmay supersede the importance of moregeneral linkages between/among theirnational and regional economies. In such anenvironment, an Indian needs to blendinto that unified global financial industry.

Both London and New York will remainat the top of the heap for some timeto come, probably well into the middle ofthe st century. New York will representthe economic weight of the and NorthAmerica in the world economy and Londonwill do the same for the . Singapore and,to a lesser extent, Tokyo (as well as othersmaller s) already serve East Asia. Butwith the growing weight of China and India,new s will emerge, especially in thesetwo countries. However, history suggeststhat Singapore and the newer s willtake decades to equal or surpass Londonand New York. While relative changesin the economic strength of countries(such as China and India) may occur quiterapidly, the more fundamental changes ininstitutional arrangements for handlingglobal trade and investment transactionsthrough s will continue to occur moreslowly, even in the st century.

Thus, while the economy was largerthan the British Empire by , it still tookNew York another fifty years until toexceed London in importance as an .By the same token, while the relative sizeof the economy in the world economyhas been steadily diminishing since the mid-s, and has now been overtaken by theenlarged , New York still remains one ofthe world’s two key s.

While new s will spring up in Chinaand India – if not by design then by default– they will take time to establish themselvesand reach the same level of size, credibil-ity and competitive ability as the premierleague s; even though transformationalchanges (such as in Dubai) are now occur-ring in a shorter time span than they did inearlier centuries.

The lessons that London and New Yorkconvey is that as other economies grow to

rival the two gigantic economic blocs of the and – , China, India seemto be the main contenders to do so in thest century – they will need equivalent sto represent their financial and economicinterests in the world economy in the sameway and with the same skills and capabilities.But the most important lesson is that fors in China and India to function aseffectively as those that already exist, theywill need to invite and embrace the sameglobal players – who know no particularnationality of ownership as such – thatare already operating in London and NewYork (and in Singapore, Dubai, Hong Kong,Sydney, Amsterdam, Paris, Frankfurt andother s as well).

s do not succeed in providing effectively and competitively if, bypolicy design or regulatory preference, theyremain closed and protected to favour onlydomestic players. Nor do s succeed ifthe policy-makers attempting to promotethem focus exclusively on the domesticscene, and remain unconcerned about whatis happening in the world outside. Mostof all, s are unlikely to succeed or becompetitive if financial system regulatorsand institutional operators do not adaptswiftly and responsively to changing globalbest practices and norms of regulation, riskmanagement and corporate governance.

4. Singapore as theASEAN/Asian GFC

In the s and s, many East Asiancountries emulated the success of Japanin the s and grew very rapidly. Theyincreased employment with labour-intensivemanufacturing exports and low barriersfor imported inputs. Unlike Japan, theyrelied on . Ironically, much of it wasfrom Japan. The most successful East Asianeconomies – which provided a model laterfor China – were Hong Kong, Taiwan, andSingapore; followed in quick successionby South Korea, Malaysia, Thailand andIndonesia (although it suffered a near-fatalreversal in ). Singapore transformedits economy rapidly and sustained a highrate of growth between –. It adoptedan export-orientated manufacturing hub

44 R M I F C

strategy with state-driven development ofa regional transport and communicationsservices hub based on state-of-the-artinfrastructure (airports, ports, containerterminal, airline, and shipping.)

By the late s, Singapore wasexperiencing the limitations of dependingfor growth on transportation and -driven manufacturing. In the early s, itrealised that to sustain its growth trajectory,and become a developed country, it requireda shift in focus from low-cost manufacturingto high-value services. Singapore spotted as a key opportunity for services-ledgrowth in the world market. Its experiencein attracting the regional headquarters ofmanufacturing s was applied to globals in finance through efforts to establishan that were scripted and controlled bythe government and implemented by theMonetary Authority of Singapore ().

Singapore’s strategy was in markedcontrast to the laissez faire approach of HongKong whose strengths in providing arosepurely as a side effect of liberal economicpolicies and market driven developments.But, until , Hong Kong had benefitedfrom being an exclusive gateway for theworld into a closed China.

Since , the Singapore governmenthas been making profound financial sectorreforms, opening new financial markets,introducing full convertibility, and enactingregulatory and fiscal incentives to attractforeign financial institutions to Singapore. Ithas reduced public ownership of bankingfirms and created a Singapore dollar bondmarket less to serve its own needs than toacquire credibility in the global market.

One of the main objectives of is tosupervise the banking, insurance, securitiesand futures industries, and develop strategiesin partnership with the private sector topromote Singapore’s role as a . Asin the case of London, internationalisation,rather than a preoccupation with domesticfinance, is at the core of ’ perspectiveon its financial services industry. This is inmarked contrast to the role of the monetaryauthorities in India whose attention(understandably) is on the domesticfinancial system, and whose concerns about are, at best, peripheral in nature.

Singapore’s strategy to become a and a global city has proven successful.When other Asian countries had capital con-trols and policies inimical to the growth oftheir financial systems, Singapore positioneditself as a venue with no capital controlsand sophisticated financial regulation. Itbecame a genuine for as wellas a linking to global markets.Foreign financial firms in Singapore havegrown from fewer than in the mid-s,to almost in . A full range of fi-nancial products and services are offered,including currency trading, derivatives, loansyndication, M&A, insurance, wealth andasset management and capital market activ-ities. Financial services (mostly ) nowaccount for nearly % of .

When it first embarked on developingan , Singapore had weak human capitaland lacked world class intellectual depth inits universities. However, the presence ofglobal financial firms in Singapore attractedhighly skilled foreign workers (e.g. fromIndia) to migrate to Singapore to work infinance as well as related services such asaccountancy, law, management consultancy,and information technology. Expatriateshold most senior management positions infinance and banking, and constitute almost% of the finance workforce. Singapore hastaken significant steps towards developingworld-class universities by depending onforeign academics.

MAS initiated the establishment of, now called Singapore ExchangeLimited (), which was the first de-mutualised and integrated securities andderivatives exchange in Asia. attracts global issuers for listing, and tradesderivatives on global underlying contractssuch as the Japanese Nikkei index orthe Indian - index. In , obtained a landmark contract with mutualoffset for the Eurodollar futures traded atthe Chicago Mercantile Exchange ().This enabled positions at to be fluidlytraded at and vice versa.

Singapore is now the world’s fourthmost active currency trading centre afterLondon, New York and Tokyo. Dailytrading volume in averaged nearly$ 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) 60,302.3 117,685.9Equity market turnover + market capitalisation (S$ mn) 88,855.1 205,164.4Number of listed companies (SGX) 323 664Foreign exchange market turnover (S$ mn) 44,974,690 70,734,830Exchange traded derivatives turnover (number of contracts) 22,568,545 26,026,128

Source: Monetary Authority of Singapore

Singapore benefits from Indian restric-tions on finance by capturing business thatIndian regulatory and capital controls pre-vent. An active ‘non-deliverable forwards’market exists in Singapore and Hong Kongon the - exchange rate, and therehas been a mushrooming of interest ratederivatives on Indian underlying contracts.

Over the years, Singapore’s financialsector has matured from providing basicservices, to sophisticated, technology-driven,innovative offerings. As a result,the financial services sector has developedsimultaneously with the growth of the AsianCurrency Unit (), the Asian DollarBond () market and the SingaporeDollar Corporate Bond () market.

Like the Eurodollar market, the Asiandollar market () has played a significantrole in Asia’s economic development.Through the , financial institutionschannel surplus funds from regional andinternational financial markets to financedevelopment projects in . Since itslaunch in , the has grown times;it stood at $ billion by end-.Table . shows the growth in the equity,foreign exchange and derivatives marketsover a ten year period.

Since , several initiatives haveboosted the growth of the Singapore bondmarket. The issuance of more SingaporeGovernment Securities () was aimed atbuilding market depth and liquidity whilethe issuance of new and -year served to extend the benchmark yield curve.Rules relating to the use of the SingaporeDollar by foreign entities were liberalizedto enable foreign players to participatemore actively in issuing Singapore Dollarbonds. These have resulted in a series oflandmark deals including the first SingaporeDollar foreign entity bond issued by the

World Bank’s private sector affiliate – theInternational Finance Corporation, in .

Singapore has established itself as areliable and secure safe haven for privatewealth management by wealthy individualsin (particularly the wealthy andinfluential overseas Chinese community inAsia) resulting in a vibrant private bankingindustry. Given the difficulties with politicalstability of many neighbouring countries,Singapore has played a role as a safe havenwhich is reminiscent of that played bySwitzerland in the th and th centuries inunstable Europe.

More than international assetmanagement firms are located in Singapore.This process has been assisted througha mechanism where asset managementcompanies domiciled in Singapore aremore able to obtain contracts from thegovernment portfolios. Total assetsunder management () stood atS$ . billion at the end of .

Many of the world’s leading names ininsurance broking, captive management andrisk management are present in Singapore.In addition to meeting the needs of thedomestic market, numerous re-insurersand captive insurers use Singapore as abase to write risks in the region. Offshoreinsurance business has become a majorcomponent, accounting for more than halfof the total general insurance businesswritten. Singapore is the largest domicile forcaptive insurers in Asia.

Singapore is a remarkable success storyabout the extent to which the governmentwas able to see the importance of an in the late s – roughly yearsbefore this issue achieved salience in India.The build-up of modern knowledge ineconomics and finance at , and thesupportive role played by in the

46 R M I F C

development of sophisticated finance, areboth accomplishments that bear greatlessons for India.

5. Dubai as a RFC for theMiddle East and South Asia

The newest entrant into space is Dubai,which has long pursued an economic strat-egy based on commerce and trade seeking toreduce dependence upon oil-related activi-ties. The was setup in September

and has been actively encouraging globalfinancial firms, including Indian institutions,to set up operations there.

Most successful s in the world reflectthe organic strengths of a city gained from alegacy of geography and commercial history,as well as the potential for becoming a‘global city’. Singapore exemplifies howan can grow out of a policy effortat cultivating relevant strengths such asfinancial regulation and taking advantage ofits geography in the context of the regional economy. It has also exploited tothe full its connections (trade, investmentand ethnicity) with China and India.

By contrast, represents an enclaveapproach brought to bear on developinganother in the context of an extremelysmall domestic financial sector and noestablished stature as a regional provider of for the Middle East and Persian Gulf.That role, until now, has been dominatedby Bahrain. Dubai is essentially a townshipsurrounded by . million square miles ofdesert. ’s aim is to have , peopleproviding a wide array of to its regionand to the world.

is providing world class infras-tructure to global financial firms for theiroffices, communication and transportation.As with Singapore, a good quality airport, aworld-class airline, and excellent telecom-munications facilities are already in place.

In the case of both Singapore and Dubai,there is full capital convertibility. In addition,Dubai has set up unique tax privileges,declaring a zero tax rate on profits witha -year tax holiday. While the has embarked on a synchronised effort atpreventing countries from helping foreignersevade taxes, Dubai is in a unique position by

virtue of having a zero income tax for locals.The institutional structure at

involves a series of specialised agencies withsupervisory and regulatory tasks: i.e., Financial Services Authority, Courtsand the Registry of Companies. Theseinstitutions will allow to operateindependently of federal law whilestill being under its broad umbrella.

These institutions are being staffed withworld class talent recruited internationally. Aswith Singapore, this institutional infrastruc-ture is supportive of global financial firms thatuse modern practices, and are fairly effectiveat supporting the innovative deployment ofnew kinds of financial products and practices.In terms of organised financial trading, DubaiInternational Financial Exchange and DubaiGold and Commodities Exchange were startedin September and November .

is a very recent entrant in the space. It is too early to tell how successfulit will be. Bank and Kotak Mahindra() have set up offices in , where atotal of global firms, including the likes of-Amro, Lehman Brothers, Merrill Lynch,Morgan Stanley, JP Morgan Chase, GoldmanSachs International, Franklin TempletonInvestment, Citigroup Global Markets,Deutsche Bank and Barclays Bank, have begunoperations. However, as yet, is more ofa location where staff is placed by global firmsto book transactions and attract clients, ratherthan undertake the range of activitiestypically found in a fully-fledged .

Dubai as a city has recorded astunning rate of growth and transformationover the last years. But it has thedisadvantage of being located in a highlyunstable and volatile neighbourhood –from the viewpoint of security, politicsand economics as well as growing socialinstability exacerbated by ethnic tensions –that is unlikely to be perceived as totally safeby global investors in the foreseeable future.

But, from the perspective of Indiancorporates, Indian with growing wealthmanagement needs, and most importantly,a growing number of increasingly powerfuland capable private Indian financialinstitutions, the is being seen as aconvenient and easily accessible alternativefor meeting their needs in the immediate

. Case studies: London, New York, Singapore, Dubai 47

neighbourhood (a mere . hour flight fromMumbai).

That opportunity will be evaluated –along with Singapore – by every Indian

financial firm that believes its capacityto expand, by providing essential totheir large client base, is being artificiallyrestricted in the present Indian environment.

Domestic and Offshoredemand for International

Financial Services (IFS)in India

4c h a p t e r

1. Implications of a large,rapidly growing homemarket for IFS

A little appreciated aspect of India’simpressive growth from onwards isthat it has resulted in even faster integrationof India with the global economy andfinancial system. There has been a rapidescalation of two-way flows of trade andinvestment. Since , India has globalisedmore rapidly than it has grown, with adistinct acceleration in globalisation after. Capital flows have been shaped by(a) global investors in India (portfolio anddirect); and (b) Indian firms investingabroad (direct). Indian investors – corporate,institutional and individual – have as yetbeen prevented from making portfolioinvestments abroad on any significant scaleby the system of capital controls.

By the same token, Indian firms haveborrowed substantially abroad. But foreignfirms and individuals have yet to borrowfrom India. Capital controls still precludethat possibility. Despite the controls that

In saying that, however, it has to be recognised that,over the past decade, the Treasury has effectively‘borrowed’ over $ billion from India. But, it doesnot appear that way because that ‘borrowing’ is seen asan investment of India’s official reserves; i.e., as meetingIndia’s investment needs, rather than meeting the deficitfinancing needs of the . The fact is that they aremeeting both, because there is no such thing as a one-way financial transaction. By the same token Europeangovernments have ‘borrowed’ another $– billionor so in India as well. Such ‘borrowing’ may rise to $– billion or more by . One problem createdby not liberalising the domestic financial system, andremoving capital controls more rapidly to permit more

remain, these substantially increased two-way flows reflect an increase in demand-supply for related to trade/investmenttransactions in India. Put another way, therehas been an increase in consumption byIndian customers and by global customersin India. Demand for from both hasbeen growing exponentially.

Cumulative two-way flows in –

were a multiple of such flows in –. Thedegree of ‘globalisation-integration’ that hasoccurred in the last years, since reformsbegan in earnest, is much larger than in the years between independence and Indiaembarking on ‘serious’ reforms. We havemade up for six lost decades of economicinteraction with the world in a decade and ahalf. Still, what has happened over the last years is a small harbinger of what is tofollow over the next twenty: particularly ifthe current growth rate of % per annum isaccelerated to –% as is evocatively beingsuggested, and if India continues to open

private investment abroad, is that such borrowings (byexternal issuers of reserve obligations) will remainincreasingly confined within the ambit of ‘officialfinance’ rather than being marketised. That willresult in concentration risk in India’s reserve portfolio.It will make India vulnerable to increased currency,interest rate and political risk as reserves keep growing.Instead India’s reserves could (unlike China’s) be mademore manageable by opening the capital account toencourage development of a more efficient, open androbust financial system that promoted rapid growthand global integration simultaneously. In that eventIndian assets might not be concentrated only in Treasuries or similar Euro obligations. They would bespread across a wider risk-return matrix of securitiesissued by the official and corporate world. That wouldyield higher returns in an overall economic ‘welfaregain’ sense if not for the central bank.

50 R M I F C

Figure 4.1: Evolution of the trade/GDP ratio

1950 1960 1970 1980 1990 2000

Trad

e/GD

P ra

tio (%

)

16.63%

10

15

20

25

30

up the economy on both trade and capitalflows.

This chapter illustrates the impactthat economic growth in India is havingon two-way financial flows by makingthem quantitatively explicit. The typicaldiscussion about an Indian exporting (especially made by those arguing forlocating such an in a ) has beenanalogous to that for software exports:i.e., a sterile relationship between Indianproducers and foreign customers of ‘support-services’. However, in the case of , Indiais itself a large, fast growing customer of .

Conservative estimates of consump-tion in India just a few years out, amountto $ billion a year. That is more than theoutput of many Indian industries today. Do-mestic customers for are India’s to losethrough neglect. If India does not makesignificant financial reforms now, this demand will be continue to be met by providers in New York, London and Singa-pore. Dubai may command an increasingshare of that business in the coming years.

The believes that such reformsare urgent to unshackle the Indian financialsystem, and make it globally open andcompetitive, in the same way that Indianindustry was freed and obliged to becomeglobally competitive a decade ago. Inthe absence of a credible Indian , themore capable Indian financial firms willhave no option but to establish full-scaleoperations in s elsewhere, simply toretain their customer base and not lose itto competing foreign financial firms thatcan provide their Indian customers with amore complete array of . But, these

customers constitute India’s ‘hinterlandadvantage’. India’s attempt to establish an in Mumbai will be aided by retainingsuch customers on the books of Indianfinancial firms. Dubai and Singapore haveto go out of their way to attract them. India’sown customer base contributes a criticalmass and induces economies of scale in away that was not available to the Indiansoftware industry in its nascent phase.

The local-customer argument shouldnot be confused with ‘self-sufficiency’. A self-sufficiency rationale for provision fromMumbai – implying an autarkic mindsetthat has resulted in past failures – wouldbe counter-productive. The Committeeis not arguing that, because India has arapidly growing need for , only Indianfinancial firms should meet it. What it isarguing is that India’s demands for are large and growing rapidly; it wouldbe cavalier, therefore, if not negligent, toforego using that ‘home-market advantage’for developing -provision capacity in acompetitive .

Such capacity should involve Indian andglobal financial firms operating in Mumbaito serve the world (and the home market)as, or more, competitively than extant sare able to. That is not a self-sufficiencyargument. It is an argument for using theadvantage of a large and growing home-market for to develop an that canimmediately achieve: (a) economies of scaleand scope; (b) global competitiveness; and(c) substantial revenues from exports.

A domestic customer base with rapidlygrowing needs will provide an inMumbai with a comparative and competitiveadvantage that can be sustained for theforeseeable future. That is what the , and Asean economies provide as hinterlandsfor New York, London and Singapore. Thesethree s have not grown through self-sufficiency: they grew because they wereeffective, competitive and innovative. Thatis what Mumbai should strive to be.

2. India’s growing integrationwith the world

India’s post-independence retreat intoautarky till , followed by hesitant

. Domestic and Offshore demand for International Financial Services (IFS) in India 51

reintegration into the world economy since, is illustrated in Figure . (Bhagwati,; Desai, ; Panagariya, ). Itmeasures the size of merchandise tradecompared with . At independence,the merchandise trade/ ratio stood ata respectable .%. Almost all of it atthe time involved transportation by sea.In the following decades, the trade/ratio fell sharply - to below % - at a timewhen world trade was growing dramatically,assisted by technological improvementsin transportation and communications.East Asian countries successfully harnessedworld growth in trade to eradicate poverty.But India turned inwards, losing out ongrowth and faster poverty reduction for fourdecades.

The lowest Trade/ ratios in Indiawere seen in the late s to the mid swhich was an era of increasing state controlof the economy. The timid liberalisingreforms of the s did not emphasiseglobalisation. As a result, the trade/ratio actually fell through most of the s.What distinguished the reforms fromprevious desultory attempts was the rapidgrowth of trade and investment relatedfinancial flows that resulted from openness.They have gathered steam continuouslysince. India reverted to its trade/ratio (.%) in . China had achievedthat level (of .%) in - i.e. Chinesetrade reforms were roughly years ahead ofIndia. But then India opened up (–) years after China ().

Three interesting facts emerge from thegraph above:

• The trade/ ratio in (.%) was. times bigger than the lowest-value of.% reached in the – period.

• The most recent trade/ ratio, in–, of .% is almost five times thelowest-value. In other words, the Indiantrade- ratio dropped by . timeswith the retreat into socialism, and hasrecovered by four times thereafter. Thatsuggests a six-fold turnaround from thenadir.

• The rate of change of the trade/ratio has accelerated palpably in recentyears. Insights into why India’s

Figure 4.2: Growth of gross flows on the current account

Billi

on U

SD p

er q

uarte

r1990 1995 2000 2005

10

20

50

100

200

globalisation has accelerated in recentyears suggest that projections for thefuture should take into account a fasterpace of change in recent years, whencompared with the average pace ofchange that has taken place from to.

India has been particularly successfulin exporting services. Services exportsgrew faster after the telecom reforms of. Hence, the trade/ ratio forgoods understates the extent of India’sglobalisation. This reinforces the senseof a palpable acceleration in the pace ofglobalisation from onwards.

Figure . shows the gross flows onthe current account - summing acrossimport and export of both merchandise andinvisibles - in log scale. Starting from levelsof roughly $ billion a quarter in the earlys, gross flows have grown dramatically,and come to exceed $ billion a quarter.

Table 4.1: Growth rates fortransactions volumes in India’sBalance of Payments

CAGR 2004 over 1993 12%CAGR 2006 over 1993 15%CAGR 2006 over 2002 29%CAGR 2006 over 2004 35%

A casual examination of Figure .suggests that the rates of growth have notbeen constant over the - period.Using the econometrics of structural change,

Figure 4.3: Structural breaks in growth of gross flows on the current account

Billi

on U

SD p

er q

uarte

r

1990 1995 2000 200510

20

50

100

200

52 R M I F C

Figure 4.4: Year-on-year growth (in percent) of gross flows on the current account: 2002-2007

Yoy

grow

th (p

erce

nt)

2002 2003 2004 2005 2006 2007

Gross inflowGross outflow

0

10

20

30

40

50

60

breakpoints are identified in the time-series.This analysis, shown in Figure . yields fourphases of growth:

. The early part is a continuation of thedifficult conditions of the late s, andactually involves a slighly negative slope.

. Then the reforms of the early sgenerated a positive trend, and grossflows grew from roughly $ billion toroughly $ billion by .

. This was followed by a period of slowgrowth until roughly .

. After , the slope has sharply risen;indeed, the rate of growth seen in thepost- period exceeds the slope seen

Figure 4.5: Gross flows (billion USD per quarter) on the current account: 2002-2007

Billi

on U

SD p

er q

uarte

r, lo

g sc

ale

2002 2003 2004 2005 2006 2007

Gross inflowGross outflow

20

30

40

50

60

in the post-crisis recovery after the - reforms.

These results encourage a focus onthe - period as being differentfrom the overall - experience, andbeing more pertinent for thinking aboutthe coming decades. Figure . showsyear-on-year growth rates of gross flowson the current account. Extremely highgrowth rates are seen for both the currentaccount and the capital account, sometimesexceeding % per year.

Expressed in levels, gross flows on thecurrent account for - are shown inFigure . in log scale. These values are inthe units of billion USD per quarter. Bothinflows and outflows have grown sharply,from the region of $ billion per quarter in to $ billion per quarter in . Thisconstitutes a tripling in five years.

An understanding of what drives rapidlygrowing demand for in India needs totake into account two features:

• First, demand is driven by increasesin gross two-way financial flows thathave occurred in transactions with therest of the world. It is not driven bynet flows. Demand for by Indiancustomers – as well as foreign firmstrading with and investing in India –is driven by imports and exports. India-related purchases of are related toinbound and outbound /.

• Second, the annual growth of gross flowshas accelerated dramatically in recentyears. As shown in Table ., India’sexternal linkages have been transformedsince –. But that transformationhas been more radical since . TheIndian economy is now exhibiting signsof a ‘take-off ’ both in growth and evenmore rapidly in its globalisation (orintegration with the world economy).

Total two-way gross flows on all BoPtransactions were $ bn in –. Theydoubled to $ bn in –. Theyincreased another . times, to $ bnin –. Doubling took nine years;the near-tripling took only four. What isnoteworthy is that total gross transactions onIndia’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 44.27GDP at factor cost 215.09 439.81 553.51 648.30 724.98

Current account (net) −3.53 3.40 14.08 −5.40 −10.61Merchandise 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 50.54inflows 9.33 36.74 53.51 71.85 91.48

Total inflows 28.20 81.44 119.79 154.00 196.26Total outflows 31.73 78.04 105.71 159.40 206.87

Gross flows on C Account 59.93 159.48 225.50 313.41 403.13Gross flows on K Account 44.63 77.97 135.04 172.74 253.92

FDI outflows 0.03 1.50 2.08 2.73 2.79inflows 0.35 6.23 4.46 5.97 8.52

Portfolio (equity + debt) outflows 0.00 7.31 16.86 31.63 55.63inflows 0.24 9.26 28.22 40.54 68.12

Loans and Banking Capital outflows 17.31 24.39 37.6 30.04 52.34inflows 20.67 25.47 38.39 44.26 57.88

Miscellaneous outflows 1.4 1.52 2.62 3.40 3.85inflows 1.36 2.3 4.31 8.06 4.79

Net flows on K account Total 5.16 8.56 16.76 31.03 24.70Total 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 13.31Merchandise outflows 9.77 15.39 29.1

inflows 10.06 14.10 23.74Invisibles outflows 12.71 15.91 23.45

inflows 16.44 19.19 25.62Total inflows 12.50 16.09 24.59Total outflows 10.52 15.79 27.60Gross flows on Current account 11.49 15.79 26.09FDI outflows 54.45 41.72 16.78

inflows 37.92 27.97 8.14Portfolio (equity + debt) outflows 148.81 119.72 66.09

inflows 49.79 54.22 64.69Loans & Banking Capital outflows 3.88 8.88 21.03

inflows 2.35 8.24 22.78Miscellaneous outflows 0.92 8.09 26.15

inflows 6.02 10.18 20.13Gross flows on K account 7.3 14.98 34.33Total external flows 9.93 15.47 28.98

after having grown at a Compound AnnualGrowth Rate () of % over theeleven years from – to -, haveincreased at a CAGR of % between

and .Table . shows a breakdown of the

growth of gross flows. Large valuescharacterise all components. Grossinvisibles had been rising faster than

merchandise trade in the Nineties, reflectingIndia’s success with services exports, butmerchandise trade growth has now caughtup with the growth rates of services. Thehighest growth rates have been in and Portfolio () flows, reflecting India’sengagement with private capital flows.

As a proportion of , external flowshave 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 −1.46Merchandise outflows 11.31 14.5 18.32 21.56

inflows 8.77 12 12.67 14.45Invisibles outflows 3.45 4.6 6.27 6.97

inflows 4.34 9.7 11.08 12.62Total inflows 13.11 21.6 23.76 27.07Total outflows 14.75 19.1 24.59 28.53Gross flows on Current account 27.86 40.74 48.34 55.61FDI outflows 0.01 0.4 0.42 0.38

inflows 0.16 0.8 0.92 1.18Portfolio (equity + debt) outflows 0.00 3 4.88 7.67

inflows 0.11 5.1 6.25 9.40Debt outflows 8 6.8 4.63 7.22

inflows 9.6 7 6.83 7.98Miscellaneous outflows 0.7 0.5 0.52 0.53

inflows 0.63 0.8 1.24 0.66Gross flows on capital account 19.2 24.40 25.7 35.02Total external flows 47.1 65.14 74 90.63

Box 4.1: Hong Kong and ChinaHong Kong evolved as an enclave IFC to

provide IFS for traders dealing with aclosed China. In the 1970s and 1980s,Hong Kong had superior institutions, andprovided IFS to North Asia (China, Taiwanand Korea) as well as part of ASEAN (thePhilippines and Vietnam which are closerto Hong Kong than to Singapore). But, asa colonial artifice, Hong Kong’s role as anIFC was compromised, if not damaged, asChina opened up and connected itself to

the world through Shanghai and Beijing.Since the 1980s, China has not requiredits economic partners to deal with itexclusively through Hong Kong. With thegradual rise of Shanghai as an IFC, HongKong’s role as an IFC serving China isdiminishing, although it is unlikely to becompletely eclipsed. At the same timeASEAN regional finance has gravitateddecisively toward Singapore.

to .% in –. Indian capitalcontrols have resulted in slower growth ofgross flows on the capital account; theirshare grew from % of to %. Thebulk of the growth has taken place on thecurrent account, where India has reducedcontrols to a greater extent. This analysisillustrates in quantitative terms: (a) thepotential generated by India’s globalisationi.e., the growth of two-way foreign trade andinvestment, for providing through an in Mumbai; and (b) the accelerationthat has occurred in India’s globalisationsince .

3. The impact of globalisationon IFS demand and on IFCs

When the economy of a country or region(e.g., the or A) engages withthe world through its current and capital

accounts, a plethora of are purchasedas part-and-parcel of these cross-bordertransactions. The hinterland effect ofa rapidly growing national or regionaleconomy has been a crucial driver of growthin s.

The st century has yet to unfold. Butthe emergence of China and India as globaleconomic powers is likely (as in the , and A) to provide the same raisond’etre for these two economies evolvingtheir own s to interface with those thatserve other regions. History suggests that nocountry or regional economy can becomeglobally significant without having an ofits own. But the emergence of s has notalways been a tale of growth potential andstart-up followed by prolonged competitivesuccess in exporting to global markets.The trajectories of s can wax and wanedepending on how world events unfold.

Growth in Indian demand is drivenby the progressive, inexorable integration ofthe Indian economy with the world economy.As such integration deepens it triggers avariety of needs for . For example:

• Current account flows involve paymentsservices, credit and currency riskmanagement.

• Inbound and outbound (aswell as like private equity andventure capital) involves a range offinancial 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 OverallInflows Outflow Inflow Outflows Inflows Outflows Total flow

1992–93 28 32 23 19 51 51 1022001–02 81 78 43 35 125 113 2382003–04 120 106 76 59 196 165 3612004–05 154 159 99 68 253 227 4812005-06 196 207 139 115 337 322 657

banking, due diligence by lawyers andaccountants, risk management, etc.

• Issuance of securities outside the countryinvolves fees being paid by Indian firmsto investment bankers in s aroundthe world.

• The stock of cross-border exposure(resulting from accumulation of annualflows) requires risk management servicesto cover country risk, currency risk,etc. This applies in both directions:foreign investors require to protectthe market value of their exposure inIndia while Indian investors require thesame services to protect the market valueof their exposure outside the country.

• The shift to import-price-parity (ow-ing to trade reforms) implies that In-dian firms that do not import or exportare nevertheless exposed to global com-modity price and currency fluctuations.These firms require risk managementservices.

• Many foreign firms are involved in com-plex infrastructure projects in India. In-dian firms are involved in infrastructureprojects abroad. These situations in-volve complex . The same appliesto structuring and financing privatisa-tions (especially those involving equitysales to foreign investors) and public–private partnerships which are becominga growing feature in infrastructure de-velopment around the world.

• The growth of the transport industry(shipping, roads, rail, aviation, etc)involves financing arrangements forfixed assets at terminals (ports, etc.) aswell as for mobile capital assets with along life: i.e., ships, planes, bus andauto fleets, taxis, etc. That is doneby specialised firms engaged in ‘fleet

financing’. India is now one of theworld’s biggest customers of aircraftbuying roughly % of the world’snew output of planes in . Thisrequires buying % of the world’saircraft financing services.

• Indian individuals and firms control agrowing amount of globally dispersedassets. They require a range of for wealth management and assetmanagement.

Outbound by Indian firms injoint ventures and subsidiaries abroadhas increased since – as they haveglobalised. Foreign investments by Indianfirms began with the establishment oforganic presence, and acquisitions ofcompanies, in the and in the-related services sectors. Now theyencompass pharmaceuticals, petroleum,automobile components, tea and steel. And,geographically, Indian firms are spreadingwell beyond the and by establishinga direct presence or acquiring companies inChina, A, Central Asia, Africa and theMiddle East.

Such outward investments are fundedthrough: draw-down of foreign currencybalances held in India, capitalization offuture export revenue streams, balancesheld in accounts, and share swaps.Outward investments are also financedthrough funds raised abroad: e.g., s,s and s/s. Leveragedbuy-outs related to these investmentsand executed through s abroad arenot captured in the overseas investmenttransactions data. The Tata Steel-Corus transaction, for example, involvedsubstantial revenues going to financialfirms in Singapore and London.

When two firms across the globe agree

56 R M I F C

Box 4.2: Derivatives on Indian underlyings trading outside the countryIn the case of equity derivatives, Nifty

futures started trading in Singapore at roughlythe same time as trading started in India.However, over the years, the market share ofSingapore as a trading venue has dropped tozero. This reflects the strength of institutionalmechanisms and liquidity of the onshoreexchange-traded equity derivatives market.

There is a significant market for OTC equityderivatives, on Indian underlyings. That marketcomprises dealers in Hong Kong, Singaporeand London who sell OTC derivatives of twokinds. Sometimes, derivatives on Indian equityunderlyings are sold to customers outside Indiawho are barred from participation in India. Atother times, OTC derivatives transacted outsidethe country are not available in India. The‘Participatory Note’ (PN) is the simplest OTC

equity derivative, sometimes with a simplelinear payoff structure. It is favoured bycustomers who lack a license to trade in India,or by customers who find it cost efficient tonot deal with the regulatory frictions of India.

As an example, an FII or FDI portfolio couldchoose to buy a one-year Nifty put option inorder to eliminate downside risk on theportfolio. Nifty options of this maturity are notavailable in India. The maximum optionsmaturity on NSE is only three months. Thiscustomer would typically access the OTC

market in Hong Kong. A dealer in Hong Kongwould sell the investor this option. The dealerwould then go on to lay off this risk by settingup a hedging strategy utilising the Niftyderivatives that do trade in India. As anexample, the risk of the put option can behedged by a dynamic trading strategy basedon a large number of transactions on the Niftyfutures, which replicate the payoff of the putoption.

In the case of currencies and interest rates,the onshore market has much weakerinstitutional mechanisms and liquidity. This has

led to a blossoming of derivatives on theINR/USD exchange rate, and on the INR yieldcurve, outside India. As an example, theonshore interest rate swaps market has thefollowing features:

• The market comprises a mere 15–18 activedealers and 80–100 participants. Thiscompares adversely with the enormousscale of participation in the onshore equityderivatives market.

• The average daily dealt volume is aboutRs. 2,500 crores of notional value. Thebid-offer spread seems to be 1–2 basispoints for OIS and 3–5 basis points forMIFOR swaps. While some liquidity isavailable all the way out to 10 years, themost liquid segments are 1 year and 5years for OIS, and 2 years and 5 years forMIFOR swaps.

The currency derivatives market is similarlyburdened with many problems. Both markets –the currency derivatives market and theinterest rate derivatives market – lackspeculative price discovery and marketefficiency rooted in arbitrage. As aconsequence, trading in derivatives on Indianinterest rates and the INR/USD exchange ratehas inevitably blossomed outside the country.The currency derivatives on the INR/USD

exchange rate are typically “non-deliverableforward” (NDF) contracts.

The ‘other benchmarks’ in the table includeMITOR swaps, CP based swaps, 1-year MIFOR

swaps, etc. In addition to the products listed inthe table, a recent development has been therise of credit derivatives (CDS and CLN) onIndian credit risk underlyings, outside India.This is linked to the rise of FCCB borrowing byIndian firms, which generates demand forhedging against this credit risk. Global hedgefunds are known to sell credit protection on

Indian corporations, but these entities lackaccess to a local credit derivatives market.

Putting these together, there is perhaps abillion dollars a day of notional value ofderivatives which are traded outside thecountry on Indian underlyings. This is animportant development that has largelyescaped the attention of policy makers. Thegrowth of these markets underlines twopoints. First, India’s movement towards defacto convertibility is now at a level of maturitythat permits substantial derivatives trading onIndian underlyings outside the country.Second, these markets will wax and wane inresponse to the sophistication of Indianfinancial regulation. When India runs a tightlicense-permit raj, there will be a greater shiftof trading to locations outside the country.When India runs relatively liberal policies, thesemarkets could shift to India – though thatcannot be taken for granted once liquidity hasbecome well entrenched in markets tradingelsewhere.

HPEC proposes no policy hostility to thesemarkets. These offshore derivatives marketsare a positive development for the Indianeconomy. When Indian financial regulationobstructs derivatives, offshore production ofthese products helps end-users to obtain theseservices and thus undertake better riskmanagement of their securities portfolios. Thishelps the sophistication and growth of theIndian economy. On the other hand, theseoffshore derivatives trading situationsrepresent a loss of IFS markets that could moreeasily and efficiently be onshore and fuel thegrowth of Indian financial firms and markets, ifpolicy impediments were removed. There is acase for reforms of Indian financial sectorpolicy so that some of this market shifts toIndian soil; there is no case for trying to forceforeign banks to cease and desist from theseactivities so as to extinguish these markets.

OTC DebtDerivatives

Onshore Offshore

Market lot Spread Avg. dailyvolume

Market lot Spread Avg. dailyvolume

OIS swaps 25 cr. 1 bps 2500–3500 cr. $5Mn 1.5–2 bps $50–150MIFOR swaps 25 cr. 3–5 bps 250–500 cr. $5Mn 10–15 bps $50–100Forward rateagreements

25 cr. 10 bps 250–500 cr. Not liquid N.A. N.A.

1Y GOI swaps 25 cr. 10 bps 250–500 cr. Not liquid N.A. N.A.Otherbenchmarks

25 cr. 15 bps 100–200 cr. Not liquid N.A. N.A.

Currencyforwards

$5Mn 0.5–1 ps $1.5–2.0 Bn $5Mn 0.5–2 ps $500–750 Mn

. Domestic and Offshore demand for International Financial Services (IFS) in India 57

to undertake current or capital accountbuy–sell transactions, the associated are usually bought by the firm with betteraccess to high quality, low cost . Considerthe example of an Indian firm exportingcomplex engineering goods to a firm inGermany. It can contract and invoicein: , or . Because Indiahas limited capabilities, and a stuntedcurrency trading market, the transaction islikely to be contracted in or . Butthe German importer generates revenues in. It has to buy or to pay theIndian firm. It may have to use a currencyderivative (future, forward or option) tocover the risk of a movement in the exchangerate of the or vs. the betweenplacing the order and receiving the goods.This would typically be done in London.

However, if India had a proper currencyspot and derivatives market, the Indianexporter would be able to invoice in .Local demand would be generated bythis local firm converting locked-in future revenues into current revenues ata known exchange rate.

Indian exporters are not as flexible asthey wish to be in their choice of the orof global currencies for invoicing (i.e., ,, or ) – or even the choice ofcurrencies such as the or for tradewith A and China. If they were, thatcould influence the effective price receivedby them. When goods are sold by an Indianexporter, and a German importer pays charges in London for converting into and managing the exchange risk, thenet price received by the Indian exporteris lower. When the Indian exporter sellsin , and local are purchased forconversion of receipts into , theprice received would be higher.

These differences are invisible instandard o data, which do not separateout and recognise charges for beingpurchased or sold as part and parcel ofcontractual structures on the current orthe capital account. For this reason, thestandard o data grossly understate the sizeand importance of the global market.Focusing on the transactional aspects oftrade flows would tend to understate demand since this tends to ignore the risk

management business which rides on tradeflows.

4. Estimates for IFSconsumption by India

As elaborated upon earlier, different types of are required for different types of cross-border trade and investment transactions.A wide range of fees are charged. Baselinetransaction fees on open trade financingaccounts (i.e., normal trade flows withoutL/Cs or guarantees) vary from .% to.% (i.e., to basis points). Investmentbanking transactions typically involve fees of% to % of transaction value. Annualfees for asset management services aretypically between –% of the portfoliounder management (at the time of valuationand not the originally committed funds)with entry fees varying from –%. Privatebanking and hedge funds involve higherannual loads and charges that can be partlyperformance based and are negotiable onan individual basis; especially for very largeportfolios.

Basic transaction flows are accompaniedby layers of multiple hedging and derivativetransactions to cover risk exposures. Forinstance, an issue might havesecondary transactions hedging currencyrisk. Underlying securities might beintegrated into an asset pool for mitigatingunderlying credit risk, and so on. Tradefinance involves hedging as well. In thecase of the capital account, as economicagents within and outside the countrybuild up larger stocks of cross-border assets,the exposure that requires hedging grows.Substantial assets outside the country arecontrolled by Indian households. Theyinduce a flow of revenues for suchas private banking, money management,payments services, etc. which are being lostby India.

Using simple but defensible extrapo-lations for this report, it is estimated that purchases related to trade/investmentin India amount to about % of gross flows.This average is based on a weighted com-posite of: (a) generic charges for corporatetransactions (fund raising, asset manage-ment etc.) and (b) standard service charges

58 R M I F C

on current account flows. These estimateshave been derived after extensive discussionswith customers and producers of the kindsof enumerated above.

In –, applying % (base case)on gross two-way flows of $ billion, theestimated IFS market was US$ billionor INR billion. If estimates of % (lowcase) and % (high case) are used, thenthe associated IFS market size would workout to a low of $ . billion and a high of$ . billion.

These estimates are conservative be-cause they are based on plain vanilla trans-actions. In the real world, financial firmsput together increasingly sophisticated pack-ages of with risk management serviceslayered over a vanilla transaction. Struc-tured products involve significantly higherfees. But, the ’s inclination to beconservative in making such broad projec-tions/estimates, on a relatively simple butunderstandable basis, has precluded suchcomplexities from being considered.

Regardless of arguments about howthese broad estimates of extant and po-tential IFS revenues are derived and inter-preted, what is unarguable is that rapidglobalisation of the Indian economy hascreated domestic demand for IFS at a fasterrate than the economy’s growth. The ‘glob-alisation over growth multiplier’ is drivingIndian demand for IFS more rapidly thanthe supply of IFS in India can cope with.

India has not yet made the policy,regulatory, structural, institutional, andmarket changes that are needed tomatch domestic supply of IFS withgrowth in domestic demand. Essentialsupply-side changes include: (a) theremoval of capital controls at a morerapid rate that currently envisaged bythe CAC- report to permit demandand supply of IFS to equilibrate moreefficiently and responsively in tune withgrowth and globalisation; and (b) furtherrapid deregulation and liberalisation ofIndian finance accompanied by structural,institutional and market integration of theIndian financial system with the globalfinancial system, through a focused andintensive programme of financial sectorstructural adjustment and reform.

5. Projections for IFSconsumption by India

5.1. Outlook for deep globalisation inIndia

Whether the focus is on trade in goodsor services, or on the capital account,what India has done so far (–)to reintegrate into the world economyrepresents a small series of hesitant steps.The bulk of exports from India so farare sterile: i.e., where an Indian companyproduces a good or service and tries tofind buyers (importers) outside the countryunconnected with the exporting company.‘Deep globalisation’ comes about when aproduction facility in India is woven intoglobal production chains that are becomingvertically (and horizontally) integrated. Asa number of reports from UNCTAD andother sources confirm, over % of worldtrade in goods and services is now ‘intra-firm’ trade; i.e., transactions across bordersthat occur within the boundaries of a singleMNC. A further % is ‘inter-firm but intra-industry’ trade: i.e., across firms, but withinindustries (e.g., the auto industry).

Those percentages are likely to grow. Asthat happens deeper globalisation will occurwith global MNCs in India (domestic andforeign) exporting to subsidiaries and/oraffiliates of those same groups and theirsuppliers/customers worldwide. At thispoint, trade/ ratios that have alreadyrisen impressively since will turnupward even more dramatically as happenedin China. Deep globalisation requires:

. Continued reduction of government-induced barriers to trade, such ascustoms duties or capital controls, and ashift over to a modern frameworkwhere imports of goods or services arecharged the national rate at entryand exports are zero-rated.

. Global standards of physical infrastruc-ture – i.e., transportation and commu-nications, ranging from container ter-minals and airports to fibre-optic ca-bles giving broadband connectivity atworld prices, with ubiquitous voice-over-internet protocol () telephony, etc.

. 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– being located in India; since the lion’sshare of trade in the world today takesplace within boundaries. Thisrequires removing India’s barriers to and opening up to participationin all sectors of the economy withoutas many obstacles, and encouragingmore Indian firms to become globalmultinationals.

India has made significant progress onthis three-fold agenda. It is worth notingthat, post- when swift advances on thesethree issues were made, gross flows rosedramatically. Yet, much work on all threefronts still remains to be done.

India cannot be sanguine about how farit has come in the last years; although ithas much to applaud in that regard. It hascome a long way. But now India has to focuson how far it still lags behind the rest of theworld (especially A, China, Korea,Brazil, South Africa, leave alone Japan, the and ) and what it must do to catchup; not in decades, but in months and years.

On the issue of tariffs and capitalcontrols, the empirical experience isthat substantial reduction of restrictionscompared with earlier years led to smalleconomic benefits as long as the level ofthe barriers remained high in absoluteterms. When a tariff for a product islowered from % to % this seems like adramatic improvement. But % is still ahigh barrier that fundamentally underminesimports. It affects adversely the exportcompetitiveness of industries that utilisethe protected product as a raw material.

In the same way, in the financial world,allowing mutual funds to start schemes foroverseas investment (subject to a series ofquantitative restrictions on investment perfund and aggregate investment by all funds)is quite different from decontrolling overseasinvestment by mutual funds altogether andleaving them to get on with it. That is akey issue for understanding the outlook forIndia’s future.

Since –, it appears as if India hasmade considerable progress in: loweringtariffs, lowering capital controls, improvinginfrastructure, and permitting entry to

s. But, on all these fronts, whathas really changed in India is a shift fromegregiously high barriers to modest barriersthat are still much higher than they shouldbe. Incremental changes have been madein lowering tariff and non-tariff barriers.Tariffs are still too high by global standardsand for meeting India’s own growth anddevelopment interests.

The reduction in barriers that hasoccurred so far, and the consequentimprovement in competitiveness, whilesignificant, are not sufficient; except ina few instances where remarkable resultshave been achieved. Similarly infrastructurehas improved; but, insufficiently in termsof quantity or quality in every sub-sector: whether power, water, irrigation ortransport. Communications infrastructurehas improved dramatically; simply becausereforms in that sector were more sweeping.It would improve even faster if such reformswere continued and foreign entry wasopened up further. Entry barriers tos have been lowered; but a host ofmind-numbing restrictions, differentiatedby sector, size and location, still remain.

The biggest economic gains (in termsof growth and diversification) will beachieved when India takes the next step inmoving from modest barriers to no barriers.When barriers to entry and competitionare removed altogether in the real andfinancial economies, two-way cross-borderfinancial flows will grow dramatically – notincrementally – in the next ten years. Asshown earlier, they doubled in – andnearly tripled in –. If India ‘goes forbroke’ in reducing extant barriers, especiallyin the financial sector, those flows maymultiply yet again in –.

Another perspective that encouragesnonlinear thinking is the empirical expe-rience of s such as Singapore. WhenSingapore became a , the volume andvariety of transactions grew exponen-tially, not incrementally. If India is able toestablish an in Mumbai quickly, a pointof inflection will be reached when growthwill be non-linear and not incremental. Theestablishment of an is similar, in thatsense, to the provision of liquidity in finan-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 flows2006 2010 2015 2010 2015

1 2 3 4 5

Merchandise outflows 21.6 26 28 305.14 600.05inflows 14.5 17 23 199.52 492.90

Invisibles outflows 7.0 7.44 8.62 87.32 184.73inflows 12.6 15 16.7 176.04 357.89

Total inflows 27.1 33 32.62 375.56 850.78Total outflows 28.5 29.44 32.79 392.46 784.78Gross flows on C Account 55.6 62.44 66.00 768.02 1,635.56Gross flows on K Account 35.0 35.20 35.20 412.64 754.35Official flows outflows 0.0 0.3 0.3 3.52 6.43

inflows 0.0 0.5 0.5 5.87 10.72FDI outflows 0.4 1 0.6 11.74 12.86

inflows 1.2 2 1.47 23.47 31.50Portfolio (equity + debt) outflows 7.7 6 8.94 70.42 191.59

inflows 9.4 9.4 11.37 110.32 243.66Debt outflows 7.2 5 4 58.68 85.72

inflows 8.0 9 6 105.63 128.58Miscellaneous outflows 0.5 0.46 0.27 5.40 5.79

inflows 0.7 1.5 1.75 17.60 37.50Total external flows 90.6 98 101 1,181 2,390

feasible: (a) explosive growth or (b) abjectfailure.

5.2. Baseline projections of externalflows

Under reasonable and plausible assumptions,India’s at nominal market rates willexceed $ trillion in . It will be over$ . trillion by and over $.

trillion by .

Based on these growth rates, acrude metric of India’s globalisation isprovided by the proportion of total grosscross-border flows to its . In –,this was % of . This ratio is projected,conservatively, to rise to % of by–. It is on that basis that the tablebelow summarises BoP projections of India’sexternal flows in the years – and –. The figures in column are actual sharesof individual o components in -.Given deepening globalisation (i.e., share ofo as a share of ) observed in the past,and faster growth likely in the future,we have assumed that external flows would

Kelkar (b) offers arguments about why Indian growth will accelerate into the coming decade.

be as large as (columns and of theTable). The actual flows are computed bymultiplying (in billion) by therespective shares. The reasoning for theseshares is as follows:

• Exports and imports (other thanpetroleum) have been growing at over% annually in the last two years.India’s share of global merchandise traderemains below %. But its increasingcompetitiveness will take it above %of by . On the current account,India’s merchandise trade share willrise, especially after , with India’saccession to the trade regime.Moreover, providing further impetusto Mumbai’s growth as an , India’slinkages with other growing countrieswill increase.

• In recent years, Asian economies havebeen emerging as major trading partnersof India. Trade with these countrieshas grown faster than overall trade.Emerging Asia accounted for .% ofIndia’s exports in – (.% in–) and .% of total Indianimports (.% 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 majorexport market for India after the . Ithas now become the largest source ofimports, surpassing the . Exportsto China surged by % in –

and imports increased by %. Asimilar trend was noticeable vis-a-visthe A-. Looking ahead, thereis further scope for expansion in tradewith these countries.

5.3. Alternative scenarios for foreigntransactions growth

There are already signs of a profoundqualitative change in India’s financiallinkages with the world, in its current andcapital accounts. Table . indicates a roughquantitative measure of the change, in termsof overall transactions levels over variousperiods, starting from – (the firstinflexion point) to the latest year for whichdata is available, i.e., –.

The following table indicates themagnitudes of BoP flows associated with arange of s that could be achieved overthe next decade. It starts with o numbersfor –, to which these different CAGRsare applied, assuming that the indicatedcompound growth rate continues apace overthe next ten years. Obviously, this simplifiesreality; but it provides a useful illustrationnonetheless. The resulting projectionsof total o shares are consistent withthe conservative ’s of –% in the

scenarios presented in Table . above.The different growth rates shown above

indicate the magnitudes of total externalflows that would be generated. The choiceof s corresponds to those observedover various time horizons in India. The–% rates are in line with the inIndia’s BoP over the s and the earlyyears of this millennium. The –% ratescorrespond to growth in the last two years.The data available for – indicate thatan assumption of a % growth might bemore justified in projecting two-way flowsfor the next few years.

5.4. Projections for the revenuepotential of Mumbai as an IFC

The direct fees that in Mumbai mightgenerate by and are illustratedbelow. Ancillary taxes and other influenceson current account flows, resulting insurpluses, would be additional. Althoughthe range of fees varies widely acrossfinancial services, it is reasonable to estimatean aggregate average of these fees acrossvarious services. We have assumed feesfor intermediating external sector flows tobe about % of flows. We arrive at thisapproximation using the weighted averageof generic charges for corporate transactions,including fund raising, asset managementand add the service charges on currentaccount flows.

In summary, our median (base case)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 2,390Total fees @ 1% 6.57 11.81 23.90Total fees @2% 13.14 23.61 47.80Total fees @ 3% 19.71 35.42 71.70

62 R M I F C

rising from $ billion in to $

billion in . A low-case assumptionwould see IFS consumption rising fromUS$ . to nearly US$ billion over thesame period. A more optimistic (but notimplausible) ‘high-case’ assumption wouldsee it grow from US$ . to nearly US$

billion.

6. Implications for India’saspirations to create an IFCin Mumbai

The estimates shown and projections madefor the purposes of this chapter require a newway of thinking about an in Mumbai.The traditional approach for Indian serviceexports has been that of tapping into aquasi-infinite world market. This approachwas taken in the case of the softwareindustry. That industry has domestic salesof $. billion a year and exports of about$ billion a year. Indian software firmshave grown by expanding their lists ofinternational customers. The domesticmarket does not feature as significant inthe minds of the s of these firms. Itcertainly played no role in their graduatinginto multinational export-oriented firms.

are similar to software in that theyare labour and skill intensive. They thriveon human capital, telecommunicationsinfrastructure, and sound policies. Ashas been argued in this chapter, there is afundamental difference between finance andsoftware: i.e., India’s hinterland advantagefor provision. The sheer size of theIndian economy, its growing integrationwith the world, and the high growth ratesof cross-border flows that are likely tomaterialise in the future, all imply that Indiais already a large and growing customerfor . It will be one of the three largestcustomers in the world for these serviceswithin a short span of time.

6.1. The threatIntuitively, a simple analogy for mightbe made with (say) the steel industry.India’s rapid growth implies that Indiandemand for steel will rise sharply. Steel,like , is a superior good: a % growthin is likely to induce an above-%

growth in demand for steel. If Indian steelproducers are unable to keep pace with thequality and quantity of steel required inthe country, then Indian demand will bemet by producers outside. Applying similarreasoning, if India chooses not to makethe financial and urban governance regimechanges required to create a viable IFC inMumbai, then Indian customers will lookto Singapore, Dubai, London and others. Financial firms and policy-makersin these three cities are already attuned toopportunities for selling to India. Theyhave embarked on strategies to exploit theinfirmities of the Indian financial system,which – as discussed earlier – has not evolvedapace with the (or ) needs of a risingIndia.

6.2. The opportunityAt the same time, Indian demandprovides an opportunity for developing theoverall capability of the industry thatthe software industry never had. Indiansoftware exports took place by dint of Indianhuman capital. firms asked nothing fromthe State other than telecom reforms thoughthey were given tax benefits as well. Indian genius was able to conquer world marketsin – in a way that could not havebeen predicted.

In the case of , there is an identicalopportunity for Indian financial geniusto achieve success in the world market;but with one key difference. Unlike exports, the potential for achieving exports are increased dramatically by ahinterland advantage. India’s growth andthe consequential domestic demand for generate natural opportunities for producers in India (local and foreign) togain skills and realise economies of scale.But just as Indian software exports requiredan enabling framework from the State byway of telecom reforms, Indian exportswill require an enabling framework from theState through:

• The removal of capital controls as earlyas practicable

• Further reforms in the financial sector– involving deregulation, liberalisation,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% 20.3Foreign equities turnover (2005) 43% 31% – – 3% 23% 5.8Foreign 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% ... ... ... ... ... 50.6Fund management (as a source of AUM, end-2004) 8% 45% 12% 5% 4% 26% 45.9Hedge 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,and open competition without restric-tion, by removing all remaining barriersto foreign and domestic competitive en-try by financial and non-financial firmsas investors in financial firms

• A dramatic improvement in the qualityof urban facilities and governance inMumbai.

To become a viable , Mumbai mustaspire to, and actually become, no less thana cosmopolitan and metropolitan ‘globalcity’ in every sense of that term.

7. IFS customers outside Indiaas a market for an IFC inMumbai

India’s opportunities for providing arenot, however, confined to demand in its ownmarket. Unlike continental European sand Tokyo, an in Mumbai need not beconfined to serving only Indian customers;although that customer base gives it aclear start-up advantage. For the reasonsdiscussed earlier, Mumbai has the potentialas an – if national financial policiesand state/municipal urban governance areradically improved – to go beyond theconfines of India and serve the world ina manner similar to London, New Yorkand Singapore. The following tables shouldenable policy-makers to appreciate how largethat opportunity is.

The scale of global transactions ismind-boggling. The largest volumes arein currency and derivatives trading. These

Table 4.10: Global financial stock (USD trillions)

2003 2010

Equity securities 31.9 56.8Corporate debtsecurities

30.8 60.7

Govt debtsecurities

20.3 32.4

Bank deposits 34.8 58.8

Overall 117.8 208.7

segments will grow dramatically when the, and A currencies becomeglobally tradable. Foreign currency tradingvolumes were conservatively estimated atover $ trillion in . The tableshows that to be a credible ‘global’ ,a country has to cross the threshold of a% market share. France and Germany(Paris and Frankfurt) are examples ofcountries/s that are clearly not ‘global’.They have values of slightly below % insome areas and values of slightly above% in other areas. Singapore, which hasmounted an impressive effort to become an, has % of global currency spot tradingwith a daily turnover of $ billion. Incomparison, Indian currency spot turnoverseldom exceeds $ billion per day.

Funds under management by assetmanagers were nearly $ trillion in. They have increased significantlysince. Hedge funds now manage overUS$ . trillion. That figure is growing by% annually. With both asset and hedgefund management, there is an importantdistinction between s that are primarilysources of assets seeking management, and

64 R M I F C

Table 4.11: The Global IFS market

Component Projected world market 5% market sharein 2010 (Trillion USD) (Trillion USD)

Fund management (assetsunder management)

100 5

Turnover per dayCurrency spot 4 0.2Exchange-traded

derivatives25 1.25

International bonds 0.3 0.015

s in which fund managers set up theiroperations. Looking into the future, theconsulting firm McKinseys estimates thatthe stock of global financial assets will almostdouble from $ trillion in to$ trillion by . The breakdown ofthese totals is shown in Table ..

The fees and profits associated withthese magnitudes are enormous. A majormental paradigm-shift is required in India tocomprehend these numbers: for market size,and the corresponding fees generated. Asan example, most financial policy makers inIndia today would perceive a currency spotmarket with a daily turnover of $ billion,or $ trillion per year, as inconceivable.

Profits from investment banking ser-vices alone, internationally, were estimatedat $ billion in . If India had a % shareof investment banking revenues, thatalone would have amounted to over $. billion. This estimate of course ignores

the phenomenal growth of this particular market after .

It is worth reiterating that the servicesconsidered are only a small subset of the totalrange of financial services that are currentlyon offer.

8. International comparisons

Tables . and . show a ratingcomparison of established and emergings on demand for from their national,regional and global clients. When comparedagainst established s, Mumbai fares wellon domestic demand, but poorly on regionalor global clients. When compared withemerging s, Mumbai lags the otherson demand from the region or the globe.But Mumbai stands out – and perhaps ismatched only by Shanghai – on having avibrant domestic market.

Table 4.12: Comparing Mumbai against emergent IFCs

Attributes, Characteristics and Capabilities of an Mumbai Hong Kong Labuan Seoul Sydney DubaiIFC: (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 2A2. Demand for IFS from Regional clients 1 7 5 2 3 9A3. 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 MumbaiIFC: (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 10A2. Demand for IFS from Regional clients 10 10 3 9 7 1A3. Demand for IFS from Global clients 10 10 3 5 3 0

Augmenting IFS provisionvia BPO

5c h a p t e r

1. How does an IFC produceIFS?

As argued in preceding chapters, theprovision of differs from the productionof conventional goods and services. Itinvolves strong economies of agglomeration.This is partly because of the networkexternalities that shape liquid marketsand complex inter-personal and inter-firmrelationships. In addition, financial regimegovernance is an intrinsic, inextricable,‘un-detachable’ part of the financialproduct/service, leading to provisionbeing focused in a few s whosegovernance regimes have achieved globalacceptability.

Spectacular progress in and in thecosts of transportation of goods has helpedto disperse the production of goods andservices around the world – often within theumbrella of a single MNC. Such dispersionhas occurred because firms wish to benearer to sources of cheaper/better labour,large consumer markets, sources of key rawmaterials, or inputs such as water, accessto infrastructure, or simply a more taxadvantageous location.

Paradoxically, the concentration ofglobal provided from London and NewYork has increased even as the dispersionof production of goods has taken place inthe last years. Today, the provision ofglobal is more concentrated than (say)global automobile production and assembly.The latter is decentralised around the worldthrough a production chain that involvesfragmentation of component manufactureand synthesis in assembly. The most intenseconcentration of auto production in theworld – in Detroit – is far less importantin determining the contours of global carproduction when compared with the rolethat just three s now play in shaping thecontours, setting the standards, providing

the instruments and trading platforms,doing the deals, and generally innovating forglobal finance.

A lot is made of the ‘death of distance’(Cairncross, ) resulting from newtechnologies. But, that has not yet affectedthe primacy of s, or of national financialcentres within large economies. Theweb of human networks, inter-personalrelationships, and information flows (aboutclients, products and markets) that makea national or international financial centrewhat it is, has eluded functioning over adistance; despite facilities such as e-mail andvideo-conferencing. For example, despitethe enormous growth of financial tradingacross India with the use of since ,the fact is that Mumbai remains the financialcapital of the country. That is just as true forLondon, New York and Singapore as sserving the world well beyond the needs oftheir own national or regional economies.

The addendum to this argument is that– if the history of s over three centuriesis any guide – all globally significanteconomies have no option but to turn theirnational financial centres into s, astheir integration with the global economywidens and deepens. That process occursby design or default. It cannot be avoided.That is because every globally significanteconomy has to have a central nodeconnecting its financial system with theglobal financial system. The question forsuch economies (particularly for China andIndia – now the world’s two largest emergingeconomies) is whether the nascent capacitiesof their financial centres (i.e., Mumbai andShanghai) as s will remain limited toserving only their own economies (like Paris,Frankfurt and Tokyo) or whether they willgrow into export-oriented s, serving the needs of their regions and the world,and making a handsome living from serviceexport revenues by doing so.

66 R M I F C

The bulk of the value of financialservices production (particularly ) liesin creative thinking and complex decisionmaking. It involves a combination of: finejudgment and client/market knowledgeshared across networks of professionalsacross financial firms. It has close access toexchanges, regulators (especially at policy-making levels), and sophisticated legal,accounting, and tax expertise.

The process of creating and producingnew financial services involves: (a) a smallnumber of hours of high value humancapital in financial, legal and accountingfirms as well as in regulatory agencies;supported by (b) a large number of hoursof lower-priced labour, handling the moreroutine tasks of recording, confirming,booking and correcting the trading involvedin two-way financial transactions. Theseroutine tasks need to be performedmeticulously in real time.

The former involves creative thinkingand complex decision making. As inthe case of Silicon Valley or Bangalore– or Stanford, Harvard, Oxford andCambridge – those processes are criticallydependent on specialised human capitalwith specific domain knowledge interactingin a geographic cluster. For suchclusters are found in Wall Street or theCity of London. Physical proximity in onelocation enables people to bounce all kindsof ideas off each other and to develop/refinethem into tradable transactions onan ‘eye-ball to eye-ball’ basis. Financeinvolves more than processing data throughmathematical formulae. It involves humanknowledge, requiring fine judgment whenfaced with different shades of grey, orwhen tailoring or matching client demandsand needs (whether clients are users offinance or investors) to sets of circumstancesthat keep changing, and involve differentcombinations of risks that are evolving ormutating continuously.

An is a place where a set of humanscan converse, compete and trade in theconfines of the ‘financial world’, interpretedin the broadest sense of that term. Decision-making and innovation in s takesplace through ceaseless communicationsamong financial analysts, tax specialists,

accountants, fund managers, speculators,arbitrageurs, investors, exchange managers,regulators, and treasurers from the financialand non-financial worlds. The nuancesof these conversations, the millimetricraising of eyebrows or pursing of lips,and the non-verbal body language socrucial in understanding human reactionsin negotiations, are not yet as amenableto subtle interpretation at a distance or ona screen. Phone calls, e-mails and video-conferencing are no substitutes for a chatover coffee or agreement on a deal structureover a game of golf or at a recreation club.

The endless stream of conversationsat an is fertile raw material forcreative intellectual leaps and imaginativeconnections through lateral thought. Themind of the successful financial engineer cancreatively link three apparently unrelatedconversations with clients/colleagues duringthe previous week, into a set of financialtransactions that meet the different needsof three counterparties, while leaving atidy profit on the table. Spotting suchdeals requires a regular flow of top qualityconversations in an environment thatencourages them.

But the ingredients of creativity,imagination, and ingenuity notwithstanding,another phenomenon that has been atwork in the world of global finance isan ever-increasing flow of high qualitydata about firms and countries from anincreasing variety of sources, coupled withrapid analysis and global dissemination ofthis data, through the electronic medium.In principle, a speculator or investor(holidaying in Albania) could be far removedfrom an (in London) while lookingat data on a laptop, engaging in analyticalthinking, deciding to buy, sell or hedgea position or security, and placing thetrade order with a broker/agent to executeimmediately. When trading is drivenby cold analytical data processing andremote decision-making, such activity couldindeed move out of London and NewYork to Mumbai, even when the hub ofconversations is not in Mumbai. Thatmigration might be driven by nothingother than better service standards, betterexecution capability at a better price, better

. Augmenting IFS provision via BPO 67

communications, a more convenient time-zone, and lower overall costs in servicingthat customer’s account.

In some ways, quantitatively orientedfinance companies find it easiest to leavethe hub of conversations and move tovenues with lower-cost labour, since theirtrades are driven by computerised dataprocessing and not conversations amongsthumans. But even in this field, Londonand New York have crucial advantages.Securities markets are extremely effectiveat consuming publicly available data andrapidly incorporating it into the price of acontract (owing to speculators all over theworld who take educated risks based on thisdata). Obtaining an edge in decision making,requires human judgment in planning thetrading strategies which are implemented incomputerised analytical and trading systems.Such judgment is concentrated in the humancapital hubs of s.

2. An outsourcing approach toIFS provision and IFCdevelopment: Possibilities,opportunities and pitfalls

An alternative approach to developing capabilities involves deploying ‘sub-contracting’ or ‘outsourcing’. The success ofsuch an approach depends on the potentialfor breaking up the ‘stack’ of intodifferent layers, and sifting out those tasksthat require discretionary judgment, asopposed to those that can be driven by awell-defined process manual.

Close examination of provisionreveals numerous sub-systems for whichprocess manuals can be codified, specificactivities can be outsourced, and thetechnical performance of a sub-system canbe objectively measured. These sub-systemscan be outsourced – using protocols nowwell established – from any in the worldto India (not necessarily just to Mumbaibut to any city that provides global support services). Understanding the rolethat can play in production, then,reduces the policy-making conundrum tofour questions:

. What can be done by way of provi-sion that is based on computer systems

consuming electronic information andrequiring analysis that could be done byhuman capital in Mumbai, Bangalore,Hyderabad, Chennai, Pune, etc.?

. What is the potential for outsourcing sub-tasks to Mumbai from others?

. What does India need to do to succeedwith an outsourcing strategy involvingMumbai or any -enabled Indian cityimmediately in global provision?

. How can an outsourcing strategy be usedto lead to full-scale developmentin a short span of time? Or would anoutsourcing strategy result in deferringemergence of a fully-fledged bycompromising its development becauseof implicit or explicit non-competitionarrangements between clients andservice-providers?

In answering these questions, it has tobe noted that India is already providing software systems development/maintenanceand management support to global financialfirms, operating in almost all extant s,for ‘back-office’ operations. Increasingly,higher value processes are being outsourcedto India such as the financial analysisof companies, stock market research,credit rating research, etc. using thesame standards, models and practicesthat are used by major global securitiesbrokerages, related investment banks, aswell as the world’s principal credit ratingagencies. Hard statistics about the scaleof employment in Mumbai, of jobsrequiring finance domain knowledge, is hardto come by. Some news stories suggesta significant scale of employment that isundertaking increasingly complex functions.A Bloomberg column by Mark Gilbertrecords significant movement up the valuechain with more complex tasks being donein India. This is being done within theambit of major Indian service providersas well as the captive processing centresowned and operated by major global ssuch as Citibank, Deutsche Bank, ,, some global insurance companies andmany others.

See http://tinyurl.com/yzpbqf on the web.

68 R M I F C

The question for Indian policy-makersand financial firms interested in develop-ing -provision linkages through sub-contracting/outsourcing is not whether the models and systems already in place(between global financial firms and Indian service providers) can creep up the valuechain. Of course they can; and they will. Butwill that result in developing full-fledged capabilities in Mumbai? Probably not:unless Indian financial firms (rather than firms) organise themselves into beingsub-contractors, service providers or part-ners to global financial firms. That wouldneed to be done under contractual arrange-ments that enabled them to graduate intoproviding services on a fully-fledgedbasis seamlessly through natural progression.It may require an entirely different approachto outsourcing and different relationshipswith extant global providers throughthe three s.

In looking at that possibility, policy-makers and financial leaders in India needto understand why global financial firms(. Merrill Lynch, Goldman Sachs,J.P. Morgan Chase, Barclays, Natwest, etc.) –that entered India as joint-venture partnerswith Indian firms (particularly in investmentbanking and securities markets) – are nowarranging amicable separations from theirIndian partners, and preferring to ‘go-it-alone’. These joint-ventures, on the faceof it, offered one possible structure andvenue for the Indian partners eventually todevelop their own provision capabilitiesfor the Indian market and beyond. Whatwas the crux of the concern that ledthese global financial firms to abandonthose partnerships and retain their ownbrand identities within organisational andinstitutional structures that they controlledon their own rather than in partnership?

In the view of , some of whosemembers are s of the Indian partnersof global firms, these global firms probablyfelt that: (a) the Indian market was toolarge and globally significant for them toshare the returns from it in perpetuity withpartners they were forced to ‘marry’ to enterIndia; and (b) their Indian partners had theinnate ability to compete with them in global

markets (if they were permitted to) on levelterms and with a distinct cost advantage.

Under those circumstances a continuedrelationship that did not offer the possibilityof complete absorption of the Indian firmby its global partner would only result incontinuation of the forced ‘marriage’ beingof more net benefit to the Indian partner (interms of access to learning and increasingcompetitiveness) than to the foreign one.Those conclusions have an importantimplication: i.e., that: (a) established globalfinancial firms already acknowledge both thesignificance of the Indian market in globalterms, and (b) the innate capability of Indianfinancial firms to compete in it. Indeed thefaith of these global firms in Indian financialfirms appears to exceed that of India’s policy-makers and regulators.

3. A BPO opportunity: Assetmanagement in Mumbaibased on algorithmic trading

An increasing proportion of the tradingstrategies of major global financial firms canbe classified as ‘algorithmic trading’. Suchtrading involves the translation of publicinformation into mathematical models thatcompute orders that are placed automaticallyon the market for execution. There is, ofcourse, a continuum in two dimensions.To what extent does a human get involvedin decisions? And, to what extent is orderplacement automated? In both dimensions,there are shades of grey.

• The decision-making dimension: In thedecision-making dimension, differenttrading houses have varying levels ofautomation. Some firms build complete systems that analyse informationand make decisions. Some firms buildsophisticated models that analyse dataand interact with humans. But the finaldecision is taken by the human.

• The order-placement dimension: Sim-ilarly, there are shades of grey on theextent of automation for order place-ment. Some firms build systems wheresophisticated quantitative informationprocessing drives the thought process,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

of algorithmic trading (AT) has become increasinglyprominent in international financial transactions. Atfirst such trading was viewed as an exotic sideshow. But it now occupies centre-stage: to a pointwhere 80% of the NYSE turnover now comes fromAT. In the case of the Chicago Board OptionsExchange (CBOE) the proportion of businessaccounted for by algorithmic trading is even higher.

AT represents a fusion of human traders andcomputers where the role of the human input shiftsaway from executing trades to instructing thecomputer on how to place buy/sell trades.Computers excel at repetitive work; i.e., at the taskof processing vast amounts of information usingpre-defined rules. AT consists of providing electronicmarket exchange feeds and news feeds into acomputer simultaneously. The computer iscontrolled by a human decision-maker. But itprocesses all the data it receives in real-time andplaces buy/sell orders on the exchanges it isconnected to and receives price information from.The connection between the AT system to theexchange is through Direct Market Access (DMA).

The sophistication of the algorithms in use islimited only by human imagination and bymathematical modelling capacity. At their simplest,algorithms can scan the spot market and thefutures market simultaneously, looking forviolations of the cost-of-carry mathematical model.If a situation is found in which the futures priceexceeds the fair price, the computer immediatelyswings into action buying the spot and selling thefuture. This is an equilibrating response, one thatbrings the spot price and the futures price back intoalignment. Computers are inherently superior,when compared with humans, at relentlesslyscanning the prices of a vast range of contracts ona large number of futures and spot markets and atresponding to a mispricing within milliseconds. Amarket with computers watching for mispricing,and undertaking the arbitrage transactions neededto eliminate it, is much more efficient than a marketwhere this task is done in a labour-intensive way.

In London and New York, hundreds of the bestmathematical minds in the financial industry arecontinually at work analysing historical data and theperformance of extant AT systems. They areconstantly improving the models and the thoughtprocess that drives such trading. There is acontinuous process of analysis of past performance,learning, and innovation leading to building betterand better AT systems all the time.

AT systems are not just liquidity consumers –placing orders into an existing order book.Computerised algorithms can also place limit orders.Algorithms are able to patiently place and revisethousands of orders, even when only a few turninto trades, in a way that would exhaust humantraders. Through this, AT systems tend to drive upthe number of orders processed by an exchange pertrade matched at the exchange. In return, these

orders give greater liquidity and greater resilience ofliquidity.

Contrary to popular perception, the computersinvolved in AT do not continuously make rapidtrades or run amok without any human supervision.On the contrary AT systems are intensely monitoredand controlled by humans and exchanges. As anexample, in doing cash-and-carry arbitrage, the roleof the human is that of choosing which tradedproducts to monitor, setting the cost-of-carryparameters to be applied when comparing the spotand the futures prices, handling special situationssuch as close of market or futures expiration dates,and applying a manual override when the systemmisbehaves.

In the options market, “auto-quote” systems areparticularly important, given the large number oflisted option products. As an example, on the NSE,there are 9,000 different traded options. It isimpossible for humans to monitor all theseproducts. Computers excel at interacting with ahuman manager, computing a fair price for everytraded option, and performing market-makingfunctions on the options market. The humanmanager with such an auto-quote system infusesliquidity into a vast array of options, and runs anoptions book. The overall risk of the book is thenlaid off using the futures market usingdelta-hedging or other dynamic trading schemes.

In India today, the absence of such sophisticatedsystems is a key factor explaining the poor liquidityof the options market, since human traders aresimply unable to produce liquidity in all 9,000traded options.

For the last quarter century, a debate has takenplace world-wide about the relative efficiency of theexchange as a way of organising financial trading;as opposed to the over-the-counter (OTC) market.In some areas, OTC markets have been unusuallysuccessful, such as in the currency forwards market.In recent years, the rise of algorithmic trading hasre-emphasised the importance of the exchange as avenue. OTC trading is extremely labour intensive; itinvolves humans talking to one another, which isexpensive and time-consuming. Minutes if nothours are taken by humans to do what computerscan do in milliseconds. In addition, humans aremore error-prone. It is therefore simply impossibleto obtain the cost efficiency, enhanced liquidity, andenhanced rationality that comes from plugging analgorithmic trading into an OTC market. This is oneof the reasons for the significant gains in marketshare of exchange-traded derivatives, andparticularly the growth of currency futures, in thelast five years.

The prospect of fully automated computerisedtrading systems without human intervention raisesfears on the part of many mathematicallyunsophisticated people, who worry about aFrankenstein that can run amok and destabilise themarket. 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 tradingsystems. The Committee debated theseissues at length and agreed on the followingpositions: (1) Just as an individual humantrader can make mistakes and lose money,one computerised trading strategy can makemistakes and lose money; as with thinkingabout human traders, this is not a policyproblem as long as there are a large numberof market participants with no one marketparticipant possessing market power(2) Whether human or computerised, alltrading strategies are subject to positionlimits and margin requirements. (3) Shiftingfrom human traders to algorithms changesnothing in terms of compliance with the riskmanagement system; the computer is only ahighly efficient clerk responding to the rulesprogrammed into it by humans..

The October 1987 crash was indeedrelated to relatively primitive systems (bytoday’s standards) at the NYSE being unableto cope with the sheer number of sell orderscoming in over computer networks outsideestablished price parameters incorporatedinto the models at the time (Kleidon andWhaley, 1992). But that was in 1987 –almost 20 years ago – when we did notknow what we know now. Computersystems have become perhaps 1000 times to4000 times more powerful between 1987and 2007. With modern computer systems,

it is now possible to handle enormous spikesin the order flow and incorporate into AT

models much greater variations in pricescaused by one-way herd instincts.

In that sense 1987 provided a profoundlearning experience that was on the wholepositive for the lessons it taught. Despite thefears and spectre of doom that it raised, inthe aftermath of 1987, AT has only becomemore important all over the world. It doesnot seem to have induced any new problemsalthough AT driven volumes are hundreds oftimes larger now than they were then. Theevocative mental image of one Frankensteincomputer running amok and destroying thefoundation of global finance is as fictional asit is inaccurate. The reality is the oppositewhen hundreds of different AT systems, allwith different trading preferences,parameters and ideas, are competing witheach other and trading with each other inthe global finance market place. No onetrading system is disproportionatelyimportant. The biases of one AT system arelikely to be offset by the counter-biases ofothers. So even if a few AT systems sufferlosses, others make gains (as is always thecase when there is a buyer and sellerwhether human or not). Therefore they donot affect the market as a whole.

Indeed, the argument is now made in

international finance circles that thealgorithms are a force in favour of liquidityand stability. Their absence causes illiquidityand instability because the algorithms workceaselessly to analyse information, trade andthus supply liquidity, while humans oftenback away irrationally from placing orders attimes of market stress when emotions comeinto play. Human traders are more likely tosuffer fear and panic; whereas computerisedAT systems are relatively free of such humanfailings; they are able to objectively analyseinformation, and continue on with theirwork of making markets efficient even intimes of market stress.

From an Indian policy perspective, the keyargument that the HPEC would emphasise isthat AT based on DMA provides a uniqueopportunity for India. Whether we like it ornot, all IFCs now have prolific AT. It providesan extremely remunerative entree into theglobal IFS business where India can play animportant role, even without makingprogress on local problems of financial orurban governance or capital accountconvertibility. Hence, it is particularlyimportant for India to work on convertingMumbai into an internationally respectedcentre where the world’s best financialengineers and computer engineers – whobuild and manage AT systems – are to befound.

by humans. Other firms build systemswhere the system interfaces directlywith exchanges and orders are placed bythe machine.

All this appears exotic in the presentIndian context, where algorithmic tradingusing Direct Market Access () isbanned with the exception of just one(–) trading strategy: one-shotfutures arbitrage through cash-and-carryor reverse cash-and-carry. staff readthe computer programs of the trading houseto verify that this is the only strategy thatis being used before permission to trade isgiven. This policy framework eliminates thepossibility of developing proprietary tradingstrategies for algorithmic trading. Such anapproach is out of touch with global reality.There is no other country where regulatorystaff read the computer programs written byalgorithmic trading firms. Roughly % ofthe order flow into the now comes

through , so India might be losing halfor more of potential order flow by erectingregulatory barriers to . Such barriersare costly for India given the unique role ofalgorithms in improving market efficiency,and fostering liquidity at moments whenhuman traders are thrown off balance.

In terms of contractual structures, whatis often seen in established s is suchwork being housed in a specialised assetmanagement firm. Assets thus managedmight flow in from a hedge fund, or fromlarge institutional investors like pensionfunds, insurance companies, banks ormutual funds. But this is not the onlypossibility. Most large international bankshave a quantitative arbitrage group eitherhoused within the bank as an affiliate or as a% captive subsidiary.

From an / provision perspec-tive, India can host quantitatively orien-tated firms that analyse vast data feeds withdecision-making by computers. This re-

. Augmenting IFS provision via BPO 71

quires high quality skilled labour in econo-metrics, quantitative finance, advancedmathematics, and computer science. Accessto top-end staff of this nature, at present,is best obtained in a like London orNew York. However, it would be possiblefor India to compete in this space based onlow-cost but high quality human capital.

There are two possibilities open toIndia for exploiting this opportunity (inwhich India could excel) regardless of capitalcontrols:

• As long as capital controls remain, suchfirms would be restricted to managingforeign assets, consuming informationfeeds from outside the country andsending orders back into financialmarkets outside the country. Some firmshave established operations in India,with a structure involving tax domicile ina tax-haven, raising funds in a number ofs, and undertaking actual operationsin India.

• When India removes capital controls,this business will be transformed owingto: (a) opportunities for obtaining assetsfor management within the country and(b) opportunities for sending ordersback into Indian financial markets.This would benefit India in three ways:these finance firms would be moreviable; Indian assets would be managedmore professionally; and Indian marketswould obtain global order flow.

Consuming public information andsending orders back into exchanges is ahighly competitive business. Every traderand every financial firm has the identicalinformation set. Yet some firms believe theycan obtain an edge by faster and superiorprocessing of information. A large numberof high people, along with a very largemass of capital sourced from banks andhedge funds, strive to obtain supernormalreturns through such strategies. Algorithmictrading is therefore a highly competitivefield. There are two possible sources ofcompetitive advantage. The first is originalideas in how to process the informationavailable and imagine which trades wouldbe profitable: this is shaped by high-endintellectual capacity in modern financial

economics. The second is labour cost of thehighly sophisticated human capital inputsthat account for the bulk of this business.

4. IFS subcomponentsamenable to outsourcing

The essence of an is the web of humanrelationships and information flows whichlead to the best possible decision makingwhen faced with complex problems wherejudgment is required. This is the definingfeature of s like London and New York.It might be the most difficult characteristicfor Mumbai to replicate without the acqui-sition of more knowledge and experience.That will take time, as well as openness toimporting sophisticated human capital withthe kind of experience and expertise thatIndia does not, at present, possess.

However, computer and communica-tions technologies are now making it possi-ble to break down the production processof specific into sub-tasks, which arethen done at locations around the world.Consequently, an increasing number of sub-tasks are being performed outside es-tablished s. These include customer callcentres and direct selling, accounting, backoffice processing, software development, sys-tems administration, data processing, re-search, etc.

What makes outsourcing possible iscodifying the task that has to be performedin a process manual defining how it will beperformed. A global financial firm operatingin an has a financial incentive to identifytasks that can be outsourced at a lower cost.Firms in Mumbai are well placed to bid forand win such contracts given the low pricesof labour with adequate skills and financedomain knowledge. This process is alreadyunderway. Some sub-tasks of are simpleand require no domain knowledge. Thesecan be easily performed at low-cost centres like Jodhpur or Chandigarh. Othersub-components of production requiregreater domain knowledge in finance. Itis in performing these tasks that Mumbaihas an edge that overcomes the labour costadvantage of Jodhpur or Chandigarh.

There is a direct relationship betweenincreasing sophistication in Indian finance,

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Table 5.1: What is happening in Indian finance through BPO?

Value chain Business process Technology

Research Equity researchCredit research

Capabilities in building research tools andportals

Execution Trade allocation Capabilities in delivering global executionplatform

Settlement Settlement instructionsCash operationsCash managementElectronic payments

Experience in different messaging protocols,infrastructure and converters

Risk management Risk modellingand management

Creating and supporting information systemsfor 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/receivables

Development and maintenance of fundprocessing applications

Corporate actions Development and maintenance of corporateprocessing applications

Source: Infosys Technologies

and India’s ability to win outsourcingcontracts requiring higher value addition.As Indian finance acquires greater sophis-tication in risk management and tradingderivatives, it will create a larger pool ofqualified human capital in these fields. Thatwill result in more risk management tasksbeing outsourced to India. The disadvantageof outsourcing, from a strategic perspec-tive, lies in low price realisations. Once an sub-task has been codified, and the ini-tial cost-saving allure of out-sourcing hassubsided, the outsourcing contract will beopened up to competitive bidding. Thiswill result in a price close to long-run av-erage cost. Prices will be cut to the bonethrough global competition. India will gethigh billing rates in comparison with Indianper capita income. But the much larger rev-enues and value-addition generated in an will remain elusive.

5. Making progress along twopaths: IFC Evolution andBPO

The key feature of the evolutionary openingup for an and the path –whether for outsourcing or quantitative fundmanagement – is that they both rely on

highly skilled labour with finance domainknowledge. That requires a large numberof postgraduates – masters and doctorates– in economics, mathematics, finance andcomputer science. All four are areas in whichIndian output of high quality graduates iswoefully inadequate. While India’s labourforce is internationally acclaimed, there areimportant gaps in education that need to beredressed.

Specifically, formal education in eco-nomics and finance is inadequate. At present,there is no programme in India offering aMaster of Science in Finance or a Master ofScience in Computational Finance. Thesetwo degrees are of crucial importance in thelabour market for analytical finance jobs.On the international landscape, top univer-sities in the and that have a strongeconomics department and a strong math-ematics department produce doctoral stu-dents in quantitative finance who enter thetop end of the financial labour force. Thathas not yet happened in India where thereis no world-class university that has a goodmathematics department and a good eco-nomics department together in the sameplace.

, Mumbai, and someof the other free-standing quantitatively,mathematically orientated research institutes

. Augmenting IFS provision via BPO 73

around India could be built up into suchinstitutions. But they would need tohave: (a) leadership vision; (b) completeindependence of operation that is notcircumscribed by their funding sources;(c) an adequately funded corpus to attractand retain the best faculty at globallycompetitive wages; (d) incentives to developcutting edge research programmes infinancial derivatives and develop state-of-the-art trading strategy algorithms: (e) theright global partnership arrangementswith the best institutions in the area ofquantitative finance from abroad such asWharton, Chicago, Stern, and , forexample. This turnaround in otherwisemoribund institutions could be achievedquite easily and swiftly if the political andadministrative will needed for the purposewere exercised. The Indian (and global)financial sector would fund and supportsuch institutions enthusiastically; if for noother reason than because they would be theprincipal beneficiaries of their human andresearch outputs.

There is a considerable flow of knowl-edge across three financial domains: do-mestic finance, outsourcing, and quanti-tative fund management. All three drawupon a common labour force. The learning-by-doing that takes place in these areas ispertinent for all. Hence, increasing thesophistication of domestic finance wouldimprove the quality of the financial labourforce. It will engage in learning-by-doing inresponse to demand for more sophisticatedskills. For example, despite the profoundweaknesses of graduate education in finance,India has one of the world’s most respectedequity derivatives markets. This came aboutthrough learning-by-doing assisted by ’smandatory certification program.

In the quantitative fund managementarena, which is a specific area of opportunityfor India, the goal should be to createan ecosystem of a hundred operationalfirms applying such an approach, locatedin Mumbai. This would lead to a fluid

Many research articles, such as Lucas (), haveemphasised the role of learning by doing in the contextof a competitive and globalised economy, rather thanformal education, as being of decisive importance inthe process of economic development.

labour market with relevant skills, and aset of employees able to network with eachother. The development of skills would befurther facilitated if restrictions on were eliminated to put India on parwith other countries. Skills development bylocal firms engaged in quantitative tradingwould improve the viability of Mumbaias a venue where such activities could belocated. Electronic trading and areeasily implemented in the equity spot andderivatives markets, and commodity futuresexchanges. Reforms in the debt and currencymarkets that lead to successful electronicexchange platforms will help augment thescope and knowledge with quantitativetrading firms.

In sum, there are two things thatIndia should do to foster an agendaof using high-value outsourcing as ameans of preparing capabilities ona fast-track. First, it should attachgreat priority to the development of anelite, high-skill labour force with mastersand doctoral programmes in economics,mathematics, quantitative finance, andcomputer sciences. Second, it shouldadopt regulatory attitudes and policies thatinduce and encourage, rather than inhibitand discourage, sophistication in domesticfinance. That would automatically increasethe pool of qualified labour with relevantdomain knowledge. One specific controlwhich particularly needs to be removed, aspart of a quest for sophisticated finance, isthe ban on .

6. ConclusionThe expansion of in India is a positivedevelopment that can exploited to advantagein strengthening symbiotically the attemptto create an in Mumbai. Some kinds of, involving low skills, are irrelevant forthat purpose. Owing to cost factors, theseare not already performed in Mumbai but inother low-cost centres across the country.However, an impressive array of tasks thatrequires finance domain knowledge hasalready come to India. These tasks areperformed in Mumbai where specialiseddomain knowledge exists. A synergisticfeedback loop now results in Indian financecreating specialised human capital; it attracts

74 R M I F C

to Mumbai and further enhances thequality of human capital. A two-way flowof highly skilled people between domesticfinance employers, and employers, isalready taking place.

High-skill work done in Mumbaienhances its prospects of becoming an. It gives Mumbai prominence in theminds of senior decision-makers in globalfinancial firms. That strengthens India’sability to attract such firms into other activities in Mumbai. It enhancesthe development of greater skills andinduces a more international outlook onthe part of Indian staff, whose knowledge ofglobal capital market opportunities wouldotherwise be more limited.

With telecom reforms there are noimpediments to the growth of otherthan rising labour costs and labour skillshortages. Through finance-related ,the skills of the financial labour force inMumbai are being deepened. But furtherdevelopment of hinges on two factors.

• First, India needs to create an elite labourforce in quantitative finance. That islacking in Mumbai at present. Londonand Mumbai have a similar numberof individuals – roughly one million– engaged in providing financial services.But the knowledge of London’s labourforce (augmented by easy immigrationin filling skills that are domestically inshort supply) is vastly superior.

• Second, a programme of financial sectorreform, leading to greater sophisticationof domestic finance, would enhancefurther the quality of skills throughon-the-job learning. India’s success increating an equity derivatives market hasled to a large labour force that can doequity derivatives arbitrage. India’s lackof a liquid and efficient bond market forsovereign, sub-sovereign, supranationaland corporate issues, has led to the lackof a labour force that can arbitrage theyield curve.

While the continued development of in finance is a positive feature that issupportive of the development of an inMumbai, winning high-value contractsin financial services does not necessarilyresult in creating an . The real value in production lies in areas where creativityand judgment are required. India’s sightsneed to be set higher than relying on more revenues. These are infinitesimalcompared to the revenues that could bederived from creating a successful . Thatrequires a policy approach quite differentfrom Mumbai being promoted as a host forhigher value-added .

The only sub-component of the overall universe, where distance is not aninsuperable impediment to capturing fullvalue from such services, is algorithmictrading. It is an area in which India couldparticipate immediately in the global marketplace with a pure model, evenif India makes no progress on regulatorydifficulties of the local market or on capitalcontrols. The universe of algorithmictraders comprises firms that consumevast quantitative data feeds, analyse themthrough algorithms, and automatically placebuy-sell orders on the world’s exchanges.This activity is the least firmly anchoredin existing s, since the conduct ofsuch business does not require the humaninteractions that can only be found at an.

Hence, is an area in whichIndia can make early progress in attractingglobal financial firms to establish operations.India’s growth in this area will be assistedby operations in existing financialexchanges that trade in equities andcommodities. It will facilitate progress inbringing currency and fixed income tradingto these exchanges as well. A key goal shouldbe to have about hundred international firms operating in Mumbai. Thatcan commence even with capital controls,though deriving the full benefits for Indiawould require their removal.

Market deficiencies inMumbai that inhibit the

provision of IFS

6c h a p t e r

1. The context in whichMumbai must develop andevolve as an IFC

This chapter aims to provide a strategicperspective on some interrelated questions:(a) what kind of should Mumbaistrive to become? (b) How should its capabilities relate to those of itsdomestic financial system; (c) What marketdeficiencies inhibit Mumbai in becoming an? (d) Which institutional deficienciesprevent financial markets in India fromfunctioning as they should? (e) Do thesedeficiencies compromise prospects for asuccessful – rooted in the domesticfinancial system – to emerge?

First, therefore, this chapter looksat the obvious gaps in the market andinstitutional structures of Indian finance;viz. seen specifically from the viewpoint ofprovision and export of globally competitive. If the provision and export of from Mumbai were to capitalize on theinherent capability of the domestic Indianfinancial system – and, by the same token,be compromised by its weaknesses – wheredo the most important gaps lie and what hasto be done to fill them? What are the mainpriorities?

By way of a necessary but briefdigression, it must be noted that posing thisquestion precludes an in Mumbai thatis either initially or eventually an artificialannex, affixed opportunistically, to thedomestic financial system. In other wordsan in Mumbai should not be an .Nor should it be like the that does notrelate to the wider economy. Thosemodels of de-linked s are inappropriatefor India.

India is not a small entrepot economylike Dubai or even Singapore; although itis a much poorer one in per capita incometerms than both. It does not need an todiversify from dependency on oil income.Nor does it have any other dependency thatlimits its diversification alternatives. TheIndian economy is deep and immenselydiversified in the production of goods andservices. India needs an because it is agrowing global powerhouse. It is already oneof the four largest economies in the worldin ‘real’ purchasing power parity ()terms. It will achieve the same rank by in nominal terms. By the middle ofthe st century India will be the world’ssecond or third largest national economy,competing only with the and Chinaon the world stage, having surpassed theindividual economies of Europe (but notthe as a whole) and Japan. By the end ofthe century, India may well be the world’slargest and most powerful economy in sizethough not in per capita income.

In that context, for Mumbai to becomethe kind of that India needs (as opposedto the kind of that developersmight wish to promote) it must start outand develop properly. It must do so in a waythat does not at any time compromise itsprospects for becoming like, and competingwith, newer s like Singapore, or evenestablished s like London and New York,in the provision of to its extant national,and its latent regional and global clientele.

These are the benchmarks that Mumbaimust aim to target from the outset. It mustnot be seduced to emulate the easier targetsof Dubai or Mauritius simply because thosemodels are quicker to kick-start, or conformbetter to an -based model.

76 R M I F C

To achieve its destiny, there is no optionother than for Mumbai’s capabilities tobe rooted in its domestic financial system– in the same way as New York, London(representing the rather than the )and Singapore (for the wider A bloc).

Given that reality, the only sensiblechoice for Indian policy-makers is to focuson deregulating, liberalizing and unleashingthe domestic financial system in the rest ofthis decade, in the same way that India’smanufacturing and trading sectors wereliberalized and unleashed in the previousone. A Mumbai-based that is rootedin a large and efficient domestic financialmarket, and that operates on global lines,is likely to be more successful and usefulto India and the world, than one that is amere artifice created to indicate movementrather than commitment. In creating an the Indian authorities would make aserious mistake if they were to repeat theexperiment of failed offshore banking units(s).

In contemplating the emergence ofMumbai as an , one has to envisionmovement towards the removal of capitalcontrols, on a purely hypothetical basis atthe start. But, assume for a moment thatcapital controls were out of the way: Wouldstrong revenues immediately emanate fromexports of financial services? Or, even withthe removal of capital controls would therebe structural deficiencies and institutionalgaps in the financial markets that wouldimpede the export of ? The purposeof this chapter is to answer the question:If India had to sell services in global markets today, and capital controls were notan issue, what are the other key deficienciesof the existing financial system that wouldprevent this from happening?

2. Inadequate currency andbond markets (BCD Nexus)

The most important deficiencies that Indiamust overcome, in developing its domesticfinancial market and moving towards an, lies in the absence of efficient, liquid,currency and bond markets. Transactionson currency spot and derivatives marketsare, by definition, the lifeblood of an .

Every customer generates immediatetransactions on the currency spot (andpossibly derivatives) markets even if he/shejust buys Indian equity shares, bonds,country index funds, index futures oroptions. Furthermore, every successful is a centre for global currency trading. Inthe absence of currency trading, a countrycannot have a ‘real’ . Currency tradingservices, sold by Indian markets to national,regional and global customers, are anessential ingredient in the creation of afunctional Indian in Mumbai.

Similar considerations surround thedomestic bond market. Before too long,the will be one of the six most tradedcurrencies (i.e., the , , , , and ) in the world. Internationalbond issues, sovereign and corporate, willbe denominated in these six currencies. Inmany cases, global issuers will probably wantto issue and trade debt securities in all ofthem. For an in Mumbai to succeedit will be essential to attract global issuersand investors into the Indian bond market.An appetite will need to be created andexpanded on the part of global investors for denominated bonds issued by domesticand foreign, public and private, entities.This will require a liquid and arbitrage-free yield curve, backed by interest rate andcredit default protection derivatives of everykind.

The use of the in global marketsfor bond issuance, portfolio trading, andinvestment necessitates an active marketfor all bonds issued by every type ofissuer, with an even more active marketfor credit derivatives tiered on top. Theseessentials – the yield curve and interest ratederivatives markets and the currency spotand derivatives markets – are inextricablybound together by arbitrage. The currencyforward curve is but a reflection of interestrate differentials. A plethora of arbitrageand speculative trading strategies fuse thecurrency and debt markets.

For a treatment of the problems of bond marketsin Asia, see Eichengreen ().

Arbitrage is well understood to be the foundationand cornerstone of market efficiency. As Shleifer andVishny () have famously pointed out, quasi-infinitecapital 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

Commerce Minister announced that, for thefirst time in India, OBUs would be permitted tobe set up in Special Economic Zones (SEZs).Accordingly, RBI formulated a scheme inNovember 2002 that was implemented withsome modifications in 2003. However, thescheme implemented is not an OBU in theusual sense of the term. In RBI’s scheme OBUsare ‘SEZ Banks’. They are only permitted toserve customers in an SEZ or lend to SEZ

developers.

The SEZ, aimed at promoting internationallycompetitive exports, is a duty free enclave,deemed to be foreign territory for the purposeof trade operations and duties/tariffs. TheOBUs are like foreign branches of banksoperating in India but located in India. Anybank authorized to deal in foreign exchangecan set up an OBU in a SEZ. Banks withoverseas branches and experience of runningOBUs are given preference. This differsconsiderably from the notion of an OBU

outside India. OBUs in countries such asSingapore and Bahrain have lighter regulatoryobligations for minimum capital, taxation, and

reserve requirements. In India, OBUs areexempt from CRR requirements; but they arenot ordinarily exempt from the SLR

requirements (except ICICI Bank that was givenspecial treatment for 3 years). Profits of OBUsare not taxable for the first 5 years ofoperations. Although no separate capital isrequired for OBUs, the parent bank is requiredto provide a minimum of US$10 million to itsOBU as start-up funds. All prudential normsapplicable to overseas branches of Indianbanks would apply to the OBUs. OBUs in India,as in some other countries, are intended tocarry out wholesale banking operationsdealing only in foreign currencies. An OBU canmeet the foreign currency needs of corporatesin the domestic tariff area (DTA) but only underthe scheme of external commercial borrowings(ECBs); i.e., only for term loans with aminimum maturity of 3 years, and up to amaximum of 25% of its total liabilities. OBUsare prohibited from undertaking cashtransactions.

Their sources of funding must be entirelyexternal, other than the initial support fromthe parent bank and foreign currency accounts

of units in the SEZ. OBUs can get foreigncurrency deposits of non-residents, includingnon-resident Indians, subject to KYC guidelines.However, deposits of OBUs are not covered bydeposit insurance. OBUs can invest their fundsoverseas and they can trade in foreigncurrencies abroad. OBUs are not treated asforeign branches in all respects. They do notenjoy the benefits that OBUs do in othercountries. For example, OBUs in India cannotlend overseas nor participate in internationalsyndications or consortia at par with foreignoffices. They cannot finance overseasacquisitions. They cannot even fund thirdcountry trade.

At present, there are about a dozen SEZs inthe country and half a dozen banks have setup OBUs. At SEEPZ Mumbai, the banks thathave set up OBUs are SBI, ICICI, PNB, BOB, andUBI. At NOIDA, Canara Bank has set up an OBU.While data are not available on the total sizeof OBU operations, the scheme has notinduced export of IFS. The OBU experiment,limited to SEZs, is regarded by the banks withthese licenses and by users as a damp squib.

These relationships are summarisedin Figure .. Speculation and arbitrage(which are essential ingredients for ensuringliquidity) in the three key markets – the bond market, the currency market and thederivatives () market – will integratetightly the yield curve, Indian creditquality curves, and foreign yield curves suchas those in the , , , and .

Once these informational relationshipsare in place, with three liquid and efficientmarkets, they will set the stage for five flows: i.e., from two types of foreign issuers(governments and corporates), from twotypes of foreign fixed income investors (ingovernment and corporate bonds), and fromglobal customers of currency trading. Forthese reasons, in creating an in Mumbai,the Indian authorities need to comprehendthe challenge of developing the nexus –i.e., the bond market, the currency market,and the derivatives market (in interest ratesand currencies) – as an integral packagewhose individual components cannot bede-linked. All three markets need to develop

granted. This suggests a special role for public policy inidentifying and removing regulatory restrictions whichinhibit arbitrage transactions.

rapidly in order to: attract local and foreignparticipation; have vibrant trading in spotand derivatives; have vibrant speculation andarbitrage to guarantee liquidity. In the caseof the yield curve, the defining issue is thatof attracting foreign issuers and investorsinto the yield curve.

The absence of these three markets isa key impediment to an emerging inMumbai today and offering the basic rangeof . At present, these markets have fun-damental problems. Institutional structuresare weak. Liquidity is poor. There is nowidth or depth. Participation is artificiallyconstrained through a number of eligibilityand origin barriers. Speculative price dis-covery is lacking because arbitrageurs andrisk-takers – who are essential for providingliquidity, and binding these markets by en-suring informational efficiency – are lacking.Their participation is discouraged.

In that context, it is odd for Indianregulators to regard risk-hedging throughselling futures as proper, safe and prudent,while seeing buying futures as speculativeand harmful. How can counter-partiesbuy a future or option (deemed goodand prudent) in a market if there is noone 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

ForeignCurrencyCurve

ForeignCurrencyCurve

ForeignCurrencyCurve

INRRisklessCurve

INRCreditCurve

Global governmentbond investors

Foreign governmentsissuing bonds

Foreign firmsissuing bonds

Global creditrisk investors

Global traders on currency markets

and speculative and therefore discouraged?The implicit value judgements made aboutthe desirability or undesirability of certaintypes of activities or players by regulatorsin this regard need to be revisited andrevised.

An example of the difficulties withthese markets in India at present lies inthe most basic arbitrage relationship onthe currency forward market: i.e., coveredinterest parity (). The principlerequires that two alternatives for borrowingshould have identical returns: (a) borrowingin and using funds in India witha locked-in / exchange rate forrepayment in ; versus (b) borrowingin over the same maturity. In anefficient currency market, arbitrage by risk-

takers will ensure that these two paths willyield borrowing at the identical all-in costafter currency and interest rate risks arecovered. In an inefficient market, withbarriers to arbitrage they almost certainlywill not; instead they will increase exposureto currency and interest rate risk (while theborrowing is outstanding) and will distortthe costs of hedging.

In India, the principle is persis-tently violated (Figure .) to a point wherethe deviation is utilised as a predictorof future currency fluctuations (Shah andPatnaik, , Forthcoming). For a com-parison, in mature market economies, thesize of the CIP deviation seldom exceeds

basis points. The deviation in Indiapoints to hurdles in the way of arbitrage

. Market deficiencies in Mumbai that inhibit the provision of IFS 79

transactions that induce in all maturefinancial markets.

Financial integration between the threeelements of the bond-currency-derivatives() nexus – i.e., the risk-free yieldcurve, the currency market and the creditrisk market – is supported by other elementsthat go beyond them.

The market for corporate bonds is,in turn, tightly linked to the marketfor corporate equities. Indeed, modernfinancial economics sees the corporatebond and the corporate share as being twodifferent derivatives written on the sameunderlying assets of the firm (Merton, ).The underlying assets of many firms areinterlinked with commodity derivatives:e.g., there is a clear relationship betweensteel futures and the shares/bonds issuedby Tata Steel. Finally, in an age of importparity pricing, there are tight relationshipsbetween currency fluctuations and Indiancommodity futures markets. The largerpicture is thus one where there is fullfinancial integration, where speculative andarbitrage strategies run across all kinds offinancial instruments, inducing liquidityand market efficiency.

In India’s present situation, consider-able progress has been made with achievingorganised financial trading for equities, eq-uity derivatives and commodity futures.

But the development of a concomitant nexus has lagged, though it is a pivotal ele-ment of the global market. Hence, anyattempt to create an in India has tofrontally attack the barriers that have heldback the emergence of the nexus.

3. Missing currency &derivatives markets: Anillustration

‘Missing markets’ in currencies and deriva-tives are markets that either do not exist inIndia, or are so small as to be insignificant,when compared with the requirements ofthe global market for . In order to un-derstand gaps in the range of traded products where India has (or lacks) liquidity,it is useful to make normative and compara-

See Thomas (, ).

Figure 6.2: Deviation from covered interest parity on the INR/USD

Perc

enta

ge p

oint

s1998 2000 2002 2004 2006

0

5

10

15

20

25

tive judgments – even if crude and somewhatimprecise – in order to identify areas whereIndia is doing well and areas where it is weak.

The provides a good benchmarkcomparison because it is (like India) a largedomestic economy with primarily domestic-focused financial markets where the component is relatively small. In Londonthe opposite is the case with its financialmarkets being primarily global -focused.London does not serve as large a nationaleconomy as the although it does servea regional economy (the ) that is nowlarger than the . The size of financialmarkets in London is disproportionatelylarge in comparison with the size of the economy, but not against the size of the .For that reason it does not provide as usefula comparator for Mumbai.

An Illustrative Comparison: Incomparing India with the , two ratios arerelevant:

• In the Indian fiscal year –, (in nominal dollars) was $.

trillion. Indian at that time was$ billion. In other words the economy was . times larger thanIndia’s in nominal terms.

• On th October , the Russell ,a stock market index of , companies,which covers practically all equitieslisted, had a market capitalisation of$. trillion. On th September ,the -Cospi index of , firmshad a market capitalisation of $

billion. In other words total marketcapitalisation of listed firms was .times the size of Indian listed firms innominal 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 calculationshowing 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 1581.75 357,3172 CBOT Federal Funds (30 day) 224.61 50,7393 CBOT Treasury notes (10 year) 95.41 21,5534 NYBOT Sugar #11 58.21 13,1505 CBOT Treasury notes (5 year) 52.53 11,8676 CME S&P 500 (mini contract) 50.10 11,3187 CBOT Treasury bonds 39.79 8,9898 CME Currency futures – Euro 21.52 4,8619 CME S&P 500 (big contract) 18.60 4,202

10 CBOT Treasury notes (2 year) 17.57 3,96911 NYMEX Crude oil 13.53 3,05612 CME NASDAQ 100 (small contract) 9.05 2,04413 CME Russell 2000 (small contract) 7.42 1,67614 NYMEX Natural gas 6.90 1,55915 CME Currency (Yen) 5.70 1,28816 CBOT Dow Jones index 5.26 1,18817 CME Currency (Pound) 3.98 89918 NYMEX No.2 heating oil 3.62 81819 CME Currency (Swiss Franc) 3.14 70920 NYMEX Gold 2.83 639

These relationships suggest that, as arule-of-thumb, by averaging these two broadmultiples, financial stocks/flows in Indiashould be just under one-twentieth (or %)of the amount of those in the . It must beemphasised that this percentage should notbe taken literally but illustratively. There willbe contract-to-contract variations reflectingdifferences between the two countries.However, the intent is not to isolate fine-grained differences but to understand thedimensions of broad gaps.

Table . shows the twenty largestfutures contracts in the . The turnoverof each, measured in billions of dollars,is shown. In addition, % of this turnover,expressed in crores of Indian rupees, is alsoshown. This serves as an illustrative numberwhich illustrates in broad brush strokeswhere the gaps in India lie.

The two S&P futures contracts onequities (a big contract and a small contract)add up to a trading volume of $.billion per day of turnover; % of thisamount works out to about Rs. , crores(or billion) per day. That is in theball-park when compared with daily trading

We are grateful to Michael Gorham and PoulomiKundu of the Illinois Institute of Technology, Chicago,who constructed this information from primary sourcesat the request of the Committee.

in Nifty futures. But, this one isolated caseapart, India lags substantially in every otherrespect:

• The key interest rate contracts in markets – Eurodollar futures, Fed fundsfutures, Treasury notes (, and

years), Treasury bond contracts – are allmissing in India.

• India has made a beginning withcommodity futures. Some of theturnover numbers in India have crossedthe % threshold. But, as yet, thesemarkets lack the regulatory credibilityrequired to attract national or global customers.

• India has only one successful stock indexcontract – the Nifty. Other contractssuch as the Nifty Junior have yet tocommence trading or obtain liquidity.

• The trading of currency futures isbanned in India.

The India/ crude comparative ratio of: or % cannot, of course, be interpretedas hard and fast. The share of agriculturein Indian is larger than for the ; soIndian agricultural commodity derivativecontracts should have ratios of greater than%. In any row of the table, interestingdifferences can be pointed out between the

. Market deficiencies in Mumbai that inhibit the provision of IFS 81

and India where the ratio should behigher or lower than %. The main pointof this table is to show the areas wherethere is a large gap when compared with thenormative ratio of %.

Apart from Nifty futures, there areimportant gaps in all rows. The premierderivatives exchange in the – the Group, which represents a merger of theerstwhile and the erstwhile –has a daily turnover (futures and options)of $. trillion a day: i.e., trading every dayis valued at roughly one-third of annual . The premier exchange wherederivatives are traded in India – the – iswell below % of this amount (which worksout to $ billion a day).

If India is to export IFS a normativegoal of % of the market size of the US isnot good enough. Indian is growingat a trend rate of per cent, while is growing at a trend rate of . per cent.Taking that into account, within years themultiple of will be replaced by a multipleof . Or, inversely, from % of contractequivalents in nominal terms, Indian valueswill come up to .%. From an /perspective, however, a market size in Indiathat is merely % or % that of the is not sufficient for entry into a globallycompetitive market. If India had an- futures market that was only %the size of the - futures market atthe Chicago Mercantile Exchange, the business that would come to India for thiscontract would be zero.

Purchasing power parity () trans-lations are made by economists becausenominal exchange rates do not reflect real-ity. A reasonable rule-of-thumb that Indiashould utilise for the desired size of an In-dian financial market, from an IFS exportperspective, is % of the size of a compa-rable US market, and not %. That wouldreflect economic reality more closely by re-moving the distortions of an exchange ratethat does not reflect the ‘real’ size of theIndian economy in comparison with the .Applying such a adjustment, it wouldstand to reason that if the Group does$. trillion of derivatives turnover a day,India should have about $ billion (orRs. trillion) of derivatives turnover per

day at the . believes that onlywhen is at a point of doing such a dailyturnover of $ billion a day will crucialexchange-traded derivatives in India haveliquidity that is competitive when comparedagainst global exchanges.

With a number of critical missingmarkets in bonds, currencies and derivatives,Indian finance is operating in a setting wherethe equity spot and derivatives markets arethe only financial markets that are liquid,efficient and market rather than fiat driven.This distorts the relative importance ofthe equity market for financial and non-financial firms and for signalling. Thesupporting bond, currency and derivative() markets either do not exist or aremutations. In a properly functioning marketeconomy with a responsive financial system,when relevant news breaks, adjustmentsshould take place instantaneously at myriadplaces: i.e., in currencies, interest rates, creditspreads and stock prices. In India, the bruntof adjustment to all news is concentratedin equities. That has probably resultedin excessive volatility in that one marketbecause the other markets needed to sharethe strain do not exist or function as theyshould.

Similarly, the differences betweena modestly functioning equity market,and other dysfunctional and undevelopedfinancial markets (in particular the bondmarket), have led to a situation where equityfinancing (internal and external) dominatesthe financing of firms and distorts efficientresource allocation and use. In –,the market value of equity for all largefirms in India stood at Rs. . trillion.Their total debt stood at only Rs. trillion.Under normal leveraging that figure shouldhave been closer to Rs. trillion. Thus,on a market value basis, the debt-equityratio of corporate India stood at just .

(Thomas, ) or about a fifth of whatit should have been. That represents aphenomenal degree of inefficient under-leveraging, and a distortion of returnsbetween equity and debt, than would beexpected in a more efficient market economywith more balanced debt and equity markets.

This domination of equity financing incorporate finance reflects in part the rational

82 R M I F C

choice of minimising leverage on the part offirms faced with considerable uncertaintyand crowding out by government debt. But italso reflects the differential pace of progressin the development of the equity and debtmarkets.

4. The market weakness ofinstitutional investors

The other weak link in Indian finance liesin the relative incapacity of institutionalinvestors in India to be more responsiveto market-signals, to induce liquidity andmarket efficiency, and to interface betweenIndia and the world.

As far as mutual funds are concerned,the regulatory framework in India and thebehaviour of such funds as institutionalinvestors broadly reflects world standards.But, at present, mutual funds have assetsunder management () of about

trillion or just % of . This is not largeenough to influence overall price formation.

The universe of other institutionalinvestors in India – i.e., banks, insurancecompanies, and pension funds – ischaracterised by too large a proportion ofpublic ownership (and therefore prone todirected, rather than market-responsive,behaviour). There are barriers to the entryof a wider range of private financial firms asinstitutional investors, coupled with manyregulatory weaknesses. These constraintscoalesce to make a considerable differencebetween the role that market-responsiveinstitutional investors normally play inmature market economies and the rolethat (mainly publicly owned) institutionalinvestors play in India.

The achievements of the Indian equitymarket in building speculative pricediscovery have been driven primarily bynon-institutional participants, with only asupporting role played by mutual fundsand s. The equity market reflectsa unique situation in India. Financialrepression was absent in that market. Thegovernment did not have much overtinvolvement in influencing prices (exceptwhen was the dominant mutual fundand responded to government direction) andthere were no quantitative controls. Other

markets in the country lack speculativeprice discovery given the constraints ofinstitutional investors and the lack of non-institutional participation.

One strategy for India would beto replicate the features of its equitymarket in other financial markets: i.e.,harnessing non-institutional participantsto induce liquidity and market efficiency.Non-institutional investors are a powerfulagent for driving market efficiency. Eachparticipant is motivated, deriving thefull profits or losses of his or her ownactions. There are no principal-agentproblems that affect decisions made byemployees of financial firms. The actions ofparticipants are oriented towards rationalityand maximisation, and undistorted byregulators. So, this approach would workto some extent. But the imperativesof creating a viable in Mumbairequires going beyond this and buildinga wider, more diversified, base of ‘normal’institutional investors because they haveunique advantages in certain respects:

• Institutional investors have the capac-ity to build systematic processes of in-vestment analysis and decision-makingthat can be applied across millions oftransactions in different market seg-ments. Sophisticated, modern analyticalmethodologies based on quantitativefinancial economics can be embeddedinto these processes. Institutional par-ticipants can engage in unique market-efficiency-enhancing trades when suchgroundwork drives their decision mak-ing.

• Institutional investors can marshal poolsof capital that individuals cannot match.India is a large economy. Institutionalinvestors are the only channel throughwhich the large mass of savings ofthe economy can be brought to bearin financial markets to induce greaterefficiency and liquidity. Only a tinyfraction of the country is presently ableto participate directly in markets. Theassets of most households, and thus theopportunity for India to use its hugesize in order for Mumbai to succeed asan – 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 & servicesB1. Full Array of international banking services for corporates and individuals 9 9 9 10 6 5B2. Full Array of international capital markets, products and services 10 10 7 8 5 3B3. Full Array of risk management services 10 10 5 7 6 2B4. Full Array of insurance and reinsurance services 10 10 7 5 8 1B5. Full Array of commodities markets, trading and hedging services 9 9 5 5 4 1B6. 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 2C2. Range of global, regional and national investment banks represented in the IFC 10 10 8 9 7 2C3. Range of global, regional and national insurance companies represented 10 9 8 6 8 2C4. Existence of wide and deep reinsurance markets 10 9 8 6 9 1C5. Existence of global, regional, national equity markets (i.e., exchanges & support) 10 10 9 8 6 4C6. Existence of wide and deep bond markets for government, corporate, other bonds 10 10 9 5 9 1C7. Existence of wide, deep and liquid derivatives markets for: Equities and indexes 10 10 6 7 6 5Interest rates 10 10 8 7 7 1Currencies 10 10 7 8 8 1Commodities 10 8 7 5 8 3C8. Innovative Abilities of Institutions and Markets 10 10 5 6 4 5

D. Services offeredD1. Fund Raising, Wholesale and Corporate Banking 10 10 8 7 7 5D2. Asset Management 10 10 8 9 6 4D3. Private Banking & Wealth Management 10 7 5 7 5 2D4. Global Tax Optimisation & Management 6 5 3 8 4 1D5. Corporate Treasury Management 10 10 9 8 8 4D6. Risk Management 10 10 7 7 6 2D7. Mergers & Acquisitions: (national, regional, global) 10 10 6 5 5 3D8. Financial Engineering for Large Complex Project and PPP Financing 10 10 8 7 6 3D9. Leasing & Structured Financing of Mobile Capital Assets (ships, planes etc.) 10 10 9 9 10 2

financial markets without considerablestrengthening of institutional investors.

• Institutional investors – both domesticand foreign – are likely to have aunique edge in intermediating betweenIndia and the world. Internationalfinance involves greater complexityand new kinds of knowledge thanare reflected in the capabilities ofextant non-institutional participantsin India. If institutional investors arefaced with enough competition, therearise the possibility of their building theneeded quality of human capital and theanalytical processes required to performsuch roles.

The Nifty derivatives market – justlyportrayed as a success with the creation of agenuine financial market characterised byspeculative price discovery, and free play ofhedging and arbitrage strategies – still hasresidual weaknesses. Mispricing persists inthat market (Thomas, ). Significant

liquidity is limited to a maturity of onemonth, and at-the-money options. Inthe derivatives market, liquidity foroptions lags futures liquidity by too wide amargin. While turnover in Nifty derivativesis impressive, the overall health and structureof this market leaves much to be desired.A good case could be made that many ofthe problems of Nifty derivatives wouldbe resolved by having an adequate mass ofinstitutional investors, with sufficient roomfor manoeuvre, so that they could performtheir proper role as they do elsewhere in theworld. It also indicates that banks shouldbe more involved players in the derivativesmarket especially if it offered interest rateand currency derivatives for hedging theirdebt portfolios.

In summary, the most successful partsof Indian finance at present are thosein which non-institutional participantshave engaged in rational, undistorted,speculative price discovery. This largemass 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 & servicesB1. Full Array of international banking services for corporates and individuals 5 7 4 6 7 6B2. Full Array of international capital markets, products and services 3 6 2 5 7 5B3. Full Array of risk management services 2 5 2 5 6 5B4. Full Array of insurance and reinsurance services 1 5 0 3 5 2B5. Full Array of commodities markets, trading and hedging services 1 6 2 5 6 2B6. 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 4C2. Range of global, regional and national investment banks represented in the IFC 2 6 1 3 6 4C3. Range of global, regional and national insurance companies represented 2 6 1 5 6 3C4. Existence of wide and deep reinsurance markets 1 3 0 3 4 1C5. Existence of global, regional, national equity markets (i.e., exchanges & support) 4 5 2 4 5 2C6. Existence of wide and deep bond markets for government, corporate, other bonds 1 1 0 4 7 0C7. Existence of wide, deep and liquid derivatives markets for: Equities and indexes 5 5 1 5 6 2Interest rates 1 3 0 4 7 1Currencies 1 7 2 6 8 5Commodities 3 5 0 4 6 3C8. Innovative Abilities of Institutions and Markets 5 5 1 4 7 5

D. Services offeredD1. Fund Raising, Wholesale and Corporate Banking 5 7 3 7 7 5D2. Asset Management 4 9 4 6 6 8D3. Private Banking & Wealth Management 2 9 6 4 5 9D4. Global Tax Optimisation & Management 1 9 7 4 4 9D5. Corporate Treasury Management 4 7 2 7 8 7D6. Risk Management 2 6 1 4 6 3D7. Mergers & Acquisitions: (national, regional, global) 3 5 0 5 5 4D8. Financial Engineering for Large Complex Project and PPP Financing 3 5 1 7 6 5D9. Leasing & Structured Financing of Mobile Capital Assets (ships, planes etc.) 2 9 5 5 5 7

financial markets is a unique edge that Indiahas when compared with established oremerging s. But, a world-class cannot be built without private institutionalinvestors. Such investors bring specialqualities through their participation infinancial markets by: (a) using sophisticatedanalytical tools in quantitative tradingsystems; (b) bringing enormous pools ofcapital into financial markets; and (c) linkingIndian finance with the rest of the world.India has established a solid beachhead withinstitutional investors such as mutual fundsand s. The regulatory strategies appliedin these two areas need to be deployed intoreaching those parts of Indian finance that

have not yet been reached by these types ofinvestors.

5. A cross-country comparison

As has been done elsewhere in this report, wehave attempted an international comparisonof Mumbai against established and emergings on a variety of metrics. A subjectiveclassification has been made, where each cityhas been scored on a set of measures on ascale from to .

As Tables . and . suggest, there is alarge gap between Mumbai and establishedas well as emerging s on a wide varietyof supply factors in the provision of .

The macroeconomic falloutof an IFC

7c h a p t e r

1. Introduction

As suggested earlier, two significant benefitswould accrue from having an inMumbai that is rooted in a strong domesticfinancial system:

. Improvements in Domestic Finance:Finance is the ‘brain’ of any economy.In India it mobilises resources for andallocates an investment-to- ratioof over % (roughly $ billion, orRs. trillion per year as of ). Itensures value-maintenance and riskmanagement of debt and equity stocks(about Rs. – trillion) issued in theform of tradable financial securities.Higher growth will result when theIndian economy is served by a betterfinancial system than the sub-optimalone it has now.

The transformation in Indian manu-facturing since shows that the bestway to ensure that the local economygets top quality goods is to have thempass the test of ‘export quality’. Thislogic applies equally to finance. Indiacan only produce world-quality financialservices if it competes in and exports tothe global market for . At present,India’s share of that market is zero, re-flecting the artificially restrained abilitiesof its financial sector. In comparison, In-dia’s share of global merchandise exportshad never dropped to zero, even in theworst policy environment of the sand s. Creating an in Mumbaiis therefore of strategic importance toIndia’s growth.

. IFS Exports: Like exports of services, exports are labour, skill and intensive. They constitute a naturalglobal market opportunity for India.Of all the cities aspiring to becomes and s in the st century,Mumbai perhaps has the most potential

for becoming a by . But italso faces great challenges in realisingthat potential – in terms of financialliberalisation, urban infrastructure andgovernance. Mumbai will, at least,need to first become an like Paris,Frankfurt, Sydney and Tokyo – whichmeet the needs of their nationaleconomies – by . If it does not, Indiawill be buying over $ billion of from abroad. But, if Mumbai becomesan , it can go beyond serving itsnational market and capture exportrevenues. The opening up of such a largeexport-oriented sector would influenceIndia’s growth trajectory; exports of from India could be bigger than exports from India.

The believes it is critical forIndia’s development, to have a worldclass financial system with -provisioncapabilities that can: (a) mobilise andallocate private and public resources asefficiently as possible; (b) manage the risksinvolved in optimising and protecting thevalue of its financial stocks; (c) ensure thatfinancial stocks yield returns that minimisethe risks of servicing those stocks; and(d) export financial services to the globaleconomy on a competitive basis.

That said, however, it is important forthe Committee to stress how mindful it is,of the macroeconomic and macro-financialimplications for the domestic economy, ofmeasures it believes need to be implementedto create an in Mumbai. India needsto carefully avoid the mistakes of macropolicy in Mexico, Thailand, South Korea,and Indonesia, so as to avoid the ingredientswhich led to currency crises and bankingcrises. Conversely, it is equally mindful ofpolicies that militate against the prospect ofcreating a credible Indian . The policyimplications that concern the Committee

86 R M I F C

most, impinge inter alia, upon: fiscal policy,monetary policy, exchange rate policy, andcapital account controls. These policies needto be considered by policy-makers for thesimple reason that there is no economic orfinancial policy or instrument that is notdouble-edged.

An advantage gained by some in thepursuit of a particular policy for a particularpurpose (like setting up an ) invariablyresults in a disadvantage suffered by otherswho may not be directly involved inbenefiting from it. On balance, the questionis whether the sum total of the advantagesthat accrue to the economy and populaceat large outweigh the sum total of thedisadvantages or vice versa.

It would be remiss of the Committeeto omit mentioning, even en passant, whatsome of these implications might be when itcomes to what it believes needs to be donefor an to emerge in Mumbai. ThisChapter attempts to meet that obligation.

2. Implications for fiscal policy& deficit reduction

There is a strong connection between fiscalstability and a healthy, efficient financialsystem. Many of the problems faced by thefinancial system in India owe their origins inpart to:

* Fiscal policies pursued since the mid-s that have: (a) distorted thefunctioning of key markets – includingfinancial markets – by emitting thewrong price signals; (b) diverted anddissipated scarce public resources inlow-yield expenditures; and (c) createdtoo large and inefficient a state-ownedinstitutional superstructure, with highfinancial resource absorption and lowfinancial yield, in too many areas ofeconomic activity

* the means resorted to for financingand sustaining gross consolidated fiscaldeficits (i.e., – of the centre, states,s and quasi-fiscal accounts like theoil pool account) that have been toolarge for too long.

It has often been asserted (by s and renowned

The enactment of legislation bythe Centre and subsequently, following therecommendations of the Twelfth FinanceCommission, by a majority of stategovernments as well, reflects recognitionthat this situation had to be rectified.Progress needed to be made to reducethe beginning with reducing thedeficit of the Centre. But, what is beingachieved through is neither rapid nor

economists) that fiscal deficits of over –% of in any country are “undesirable, unfinanceable andunsustainable”. But India has managed to finance andsustain deficits larger than these proportions (rangingfrom –% of ) for over two decades. Thegeneral view is that it has managed to do so relativelysuccessfully; without compromising its growth potentialor creating too many distortions in markets that havecaused serious collateral damage. That, however, is amisleading impression. The indirect costs in terms offinancial repression and growth depression have beenobscured and are unamenable to easy quantification.India has managed to finance its deficits at below-market rates through pre-emption. With the reforms of, and a commitment to reducing pre-emption, thatsituation has been changing; but too slowly. Financingtoo large, and for too long, a fiscal deficit in thismanner has, among other things: (a) slowed downand impeded the creation of an effective market forgovernment and corporate bonds that operates alongglobal norms and is open to global investors; (b) createda bias toward a capital market that leans too heavilytoward trading risk-paper (equity) without beingbalanced by coupon (fixed return) debt, thus preventinginvestors from managing properly their exposure alonga risk-return matrix given their investment objectives;(c) crowded out more efficient private investment in thedomestic market for decades; (d) put upward pressureon Indian interest rates; (e) created artificial regulatoryburdens for that have exacerbated financialrepression by impeding migration from a bank-dominated financial system to a market dominatedone in order to protect the government’s interests asboth the largest borrower in the financial system andthe largest owner of financial institutions; (f) createdtoo many conflicts-of-interest in financial regimegovernance that have influenced adversely its credibility,quality and content; (g) protected banks from effectivecompetition in the domestic market by the erectionof high barriers to competitive entry thus fosteringinefficient intermediation with high margins andhigh costs for all savers/investors; (h) forced a degreeof segmentation across financial markets (banking,insurance, capital markets, etc.) that is damaging toa healthy financial system and sound capital marketdevelopment; (j) induced inefficiencies in resourceuse; (k) indirectly impeded the emergence of essentialderivatives markets and risk management instruments,particularly for the management of currency andinterest rate risks; and (m) indirectly and inadvertentlycreated a situation in which the lowest returns onfinancial savings (adjusting for risk and inflation) areaccrued by the poorest depositors.

. The macroeconomic fallout of an IFC 87

transformational enough. Further, as recentdifferences of opinion at policy-makinglevels suggest, there is a perceived trade-off

between maintaining the schedule for deficitreduction targets under , and riskinga loss of economic momentum created byrapid growth. The impact of such a trade-off

could be ameliorated by having a ‘publicdebt reduction target rule’ added to thedeficit reduction target rules under .

But, whatever rules are applied, theaim of fiscal policy over the next –

years should be to achieve reduct-ions (through adjustments in revenue,expenditure and public asset sales) thatbring: (a) the down to –% of; and (b) overall public short and long-term debt (central, and states) downto well below the present % of .The scale of reduction in the debt/ratio that is required is bigger than appearsto be the case, as many off-balance-sheetliabilities (e.g., pensions) need to be fullyrecognised in an improved accounting anddisclosure framework, while the presentestimate (%) ignores these liabilities.

Those targets should be achieved within atime-frame that is consistent with stable andnon-disruptive adjustments in governmentaccounts, and in financial markets, whilemaintaining growth momentum or evenincreasing it.

Both measures are necessary in orderto achieve (and maintain) the kind of fiscalstability that, in the Committee’s view, is afundamental requirement for a successfuland credible to emerge in Mumbai.Strict adherence to clear, transparent ‘goldenrules’ aimed at achieving such stability iscritical. That is particularly true for alarge, plural, federal, developing countrylike India attempting to establish an while maintaining a reputation and image ofintegrity and probity in the world of globalfinance.

Confidence (on the part of domesticand global financial markets) in the outlookfor long-term macroeconomic stability and

For a discussion of debt/GDP rules, see Mistry().

For a first effort on measuring the implicit pensiondebt on account of the civil servants pension, seeBhardwaj and Dave ().

fiscal management in India is a sine qua nonfor: (a) the participation of global financialfirms in an Indian ; (b) its ability totransact complex financial transactions withmulti-decade time horizons; and (c) theability of the government to shift part ofits public financing burden from domesticfinancial markets and investors (who carryexcessive India risk today) to global markets(that desire more India risk in their globallydiversified portfolios).

In consonance with the kind ofmacroeconomic backdrop needed for havinga successful in India, the wouldcountenance the pursuit of a fiscal policythat minimises distortions in the properfunctioning of goods and services markets.Such distortions occur either through:(a) direct price suppression or manipulation(however well intended) as in the case ofthe oil pool subsidy account; or (b) throughinterventionist public mechanisms whoseprotection – through implicit or explicitgovernment capital guarantees that induceinefficiency, or through the suppression ofcompetition in markets dominated by them– also results in compromising the efficientfunctioning of financial markets and distortsresource allocation.

But there are political economyimplications of adhering firmly to suchrules. They might result in the governmentbeing accused of having an ‘anti-poor’bias if cutting deficits involves reducingexpenditure on populist schemes. Itis difficult to see, however, how deficitreduction could be seen as anti-poor perse. The interests of the poor are never servedby running high fiscal deficits that distortfinance, send the wrong price signals to anumber of key markets, and destabilise theeconomy.

Financial repression imposes a regres-sive tax on unsophisticated users of finance.The commercially sophisticated elite avoidfinancial instruments where artificially lowreturns are given through state interference –i.e., the richest households hold very smallbalances in bank savings accounts. A highfiscal deficit usually results in long-term ef-fects that are even more anti-poor – as isthe case when cumulative deficits requirepartial monetisation and inflation (the most

88 R M I F C

regressive tax of all). Over time, high fiscaldeficits result in governments (states andcentre) running out of headroom to financephysical and social infrastructure in poorrural areas and urban slums. Similarly thereis no headroom – without a substantial andpolitically difficult restructuring of expen-diture priorities at state and central levels –to provide income support for subsistenceconsumption targeted at the poor.

Instead fiscal policy remains orientatedtoward: (a) maintaining an edifice ofgovernment that is overstaffed and under-compensated at senior levels, leadingto distortions and inefficiency; and(b) unsustainable market-distorting pricesubsidies on a number of key goods (oil,diesel, gasoline and kerosene) that resultin transferring more income to the richand middle classes than to the poor, whoseconsumption of such goods, direct andindirect, is much lower. The combinedeffect distorts prices in too many markets.It disables prices from equilibrating supplyand demand thus preventing markets fromperforming their role. It compromisesthe use of inflation-targeting as a toolof monetary policy. It makes efficientresource allocation via the financial systemmore difficult to achieve. Having a lowfiscal deficit over the long term, and re-orienting expenditure priorities towardincome support for the poor, will have agreater ‘pro-poor’ effect than extant policies.That strategy will result in spreading thebenefits of growth more evenly than they arenow.

Running a large fiscal deficit constrainsa country’s ability to open its capital accountwithout running undue risks. Countriesthat have opened capital accounts andstabilised or pegged their exchange rates– while running large fiscal deficits financedin foreign currencies – have triggered aneconomic crisis. That happened in Mexicoin , Argentina in –, Russia in, Ecuador in and Turkey in .When the debt-to- ratio starts rising,

An extensive literature has pointed to the role ofpegged exchange rates in generating currency crises andspeculative attacks. In addition, exchange rate flexibilityassists macroeconomic stability by offering a ‘shockabsorber’ (Edwards and Yeyati, ).

confidence in the government’s ability torepay debt denominated in foreign currencycan erode rapidly. That, in turn, makes itdifficult for government to sell bonds todomestic and foreign investors. Bond pricesfall, sometimes accompanied by herd exits.This is particularly dangerous in a countrywith a history of financial repression wherebanks hold too large a part of governmentdebt. A drop in the value of bonds cantrigger a banking crisis and exacerbate thefiscal deficit by requiring the government torecapitalise banks.

o has never defaulted on its debtin the past. It aims to maintain a policystance that encourages the world to be con-fident that it will never do so in the future.However, even when the possibility of de-fault on sovereign obligations is low, theadditional costs to the economy – arisingfrom rising interest payments due to in-creasing levels of government debt causedby persistently large deficits – are signif-icant. Domestic interest rates rise, slow-ing down private consumption and invest-ment. That can result in lower profitabil-ity for companies with foreign currencyborrowings. Interest rates for such for-eign borrowings rise when profitability fallsand takes the credit rating of the companydown.

3. Financing public debtdifferently

The first priority for Indian fiscal policy isthe stabilisation of consolidated debt/,inclusive of all implicit liabilities such ascivil servants’ pensions, at –% of .This issue has been well understood inthe debate on fiscal policy over the last

years. Second, public finance thinking inIndia has not made progress in consideringmore efficient, mechanisms for publicborrowing. Until banks were requiredto hold a large share of their assets asgovernment bonds under the StatutoryLiquidity Ratio () requirement. Theywere paid lower than market rates ongovernment bonds. After the liberalisationof , rates on time deposits ceased tobe fixed. But banks are still required tohold an astonishing % of their assets in

. The macroeconomic fallout of an IFC 89

government bonds. Demand deposits paynegative real interest rates. Similar pre-emption is in place with insurance andpensions.

The argument is made that improvedliquidity and market efficiency in financialmarkets will limit the ability of thegovernment to control all points on theyield curve; which (it is argued) is requiredfor reducing the cost of borrowing for thegovernment. When such arguments aredeployed for repression, the financial systemsuffers a loss of credibility and confidence.Banking regulators are supposed to upholdsound risk measurement/management tosupport their demands for minimum levelsof risk capital being held by banks. Inapplying their judgements of risk in bankportfolios, regulators must be technicallyproficient, unbiased and impartial inevaluating the risks of portfolio choicesmade by banks. However, their abilityto be unbiased is compromised whenportfolio choices are driven by regulatorsthemselves.

When regulation imposes rules thatsupport other aims (such as financingdeficits) that have no bearing on the safetyand soundness of the banking system,what occurs is a loss of credibility in thefinancial system on a global scale. Itraises doubts in the minds of the globalfinancial community about the technicalsoundness and supposed lack of bias inbanking regulation.

The global market involvescompetition not just across s and globalfinancial firms but across different systemsof financial regulation. As long as Indiacontinues with its present system of financialregulation, it will induce a lack of respectand credibility, for provided from Indiaand will compromise the functioning andcompetitiveness of an Indian .

There is a need, and an opportunity, tofind more efficient, less counterproductiveways of financing India’s large and rapidlyescalating public debt. A more efficient andbetter developed financial system wouldcreate many more options for doing so.The creation of provision capacitythrough an in Mumbai would add tothose options by increasing the range of

opportunities for public borrowing withfewer adverse side-effects and consequencesfor the Indian financial system.

The basic imperative of a sound non-distortionary mechanism, for financing thefiscal deficit in a globally credible financialsystem, is that sovereign or sub-sovereignbonds should be bought voluntarily by anykind of buyer, without any direction, coercionor restriction by the government. It shouldnot be considered necessary to distortnational finance in order to sell bonds tofinance public deficits. That would implyabandoning the policy framework whichpresently governs investment by banking,pensions and insurance.

If nothing else changes, the removalof repression would increase the cost offinancing public debt. It is intuitivelyobvious that with coercion out of the picture,and with markets that are liquid andefficient, higher interest rates may need tobe paid in order to attract voluntary buyersof bonds. However, there are three lines ofthought which address this problem:

. A sophisticated financial system requiressovereign bonds as a credit bell-weatherThe liberalisation of finance and wider entryof pension funds, insurance companies,mutual funds, etc. into the sovereignbond market will increase demand forlong-term bonds. These investorsneed to buy government bonds as part ofprudent portfolio management strategies,on a voluntary basis, without coercion.As India becomes a more mature marketeconomy, the need for and shoulddisappear. When that happens there is nolikelihood of demand for o bond holdingsdisappearing as well. For prudential andportfolio balancing reasons, banks and otherinvestors will still need to have holdings ofo bonds in their asset portfolios. It isquite possible that, with investor desire tohold o bonds becoming voluntary ratherthan forced, demand for such paper will riseand not fall.

The asset choices of the mutual fundindustry exemplify this lack of risk of shiftingaway from financial repression. Formerly, inan India that was more repressed than it isnow, mutual funds were the monopoly of

90 R M I F C

under a bank-monopolised financialsystem. The shift towards a market-drivensystem has come with the rapid growth ofmutual funds. Regulation of mutual fundsis now free of repression. s are notobliged to hold government bonds. Yet,without compulsion, s have invested verylarge sums of money in government bonds.Easing up on repressive policies for s hasnot automatically created problems withtheir buying government bonds.

At present, the size of the assetportfolios of banks, insurance companiesand pension funds in India are relativelysmall by world standards. The total assetsof these three groups of firms, expressed aspercent of , are one-half the size that iscommensurate with the level of developmentof the Indian economy. When financialrepression is eased, and a superior system offinancial governance is put into place, thesethree sectors are likely to grow dramatically.That will induce new sources of demandfor o bonds. If greater demand is notmatched by increased supply, the pricesof such bonds should rise, implying thatcoupon rates could be reduced.

. Global fixed income investors areinterested in INR denominated sovereignbonds, and it is in India’s best interest tosell these to them. Traditionally, India hasbeen reticent about financing its fiscal deficitthrough the sale of sovereign bonds to globalinvestors. Many economists trained in thes and s when derivatives marketsdid not exist (and still unfamiliar with ordistrustful of currency derivatives and howmarkets in them work) felt that financingthe fiscal deficit through issuance of dollar-denominated bonds was dangerous. Thisreticence has been based on a perceptionof ‘original sin’ where dollar-denominatedliabilities represent a currency mismatch fora state whose revenues are in . Thatissue does not arise when governmentbonds are sold to global investors butdenominated in INR . In the context of an

The goal of policy makers has long been tohave policies on capital flows which are ‘prudent’.Yet, the overall policies on debt financing havedecreased financial stability in two respects (seehttp://tinyurl.com/37vq58 on the web). First,

open capital account, bond issuanceavoids concerns about incurring currencyrisk on sovereign debt. It also averts theliquidity risk involved in servicing suchdebt, should a sudden balance-of-paymentscrisis materialise because of an unforeseeableexogenous shock.

When global investors hold o debtdenominated in , they bear the currencyrisk. In a scenario with a sudden crisis ofconfidence and capital flight out of India,the drops and bond prices drop – thisaffects global investors holding bondsand does not exert balance sheet effects onthe government. These balance sheet effectsare spread over the very large base of assetsheld by global institutional investors. It is,therefore, safe to permit such investors tobuy sovereign bonds as they wish with-out limit. The only risk in doing so is thatsuch investors, uninfluenced by governmentdirection, might dump o bonds on theopen market when the government of theday pursues unsound macroeconomic poli-cies or generates political risk. As a warningfor restraint, that would be a useful signalfor global investors to emit. It is one thatany prudent government should respondto appropriately.

quasi-state programs such as the have, for allpractical purposes, entailed a sovereign bond programdenominated in foreign currency. These have flirtedwith original sin. The present Indian policy on publicand private borrowings is paradoxically asymmetrical.It causes an overall asset-liability currency mismatchwhen Indian firms are permitted to borrow overseasin foreign currencies in increasing amounts, while investment in denominated bonds is stillheavily restricted. The policy framework encouragesoriginal sin on the part of firms, shifts revenuesoutside the country, and involves an opportunity costfor liquidity and market efficiency on the local denominated corporate bond market while puttingupward pressure on Indian interest rates. Both thesestrategies serve to increase the macroeconomic riskfor the Indian economy. A reversal of these policies –discouraging original sin and encouraging local bondmarket development – would simultaneously improvesystemic stability and growth.

Of course such risk is already being incurred onborrowings from the s and regional banks whichare quite large but concessional. Moreover India hasmore leverage in dealing with such creditors than withimpartial bond markets that are much less easy topersuade or manipulate.

For a treatment of international developments onlocal currency bond markets, see Burger and Warnock().

. The macroeconomic fallout of an IFC 91

There is now a large demand for long-term bonds on the part of globalfixed income investors. One reason isportfolio diversification. No large globalinvestor can afford to have less than %of total fixed-income investment in bondsissued by a country which has over %of world GDP and is one of the fastestgrowing economies of the world. In addition,as a growing economy with sustainedproductivity increases, it is likely thatthe will appreciate through Belassa-Samuelson effects. Thus an internationalpension fund looking for a -year bondmight prefer an bond to a bond.Indeed most global portfolio managers(especially pension funds) bemoan theabsence of access to a larger pool of denominated paper in global bond andmoney markets across the maturity andduration spectrum from -days to -years. If India had a mere –% sharein global fixed-income portfolios, thiswould represent a quantum of investmentsignificantly larger than the forced-holdingsof bonds by domestic banks, insurancecompanies and pension funds. In an optimallong maturity global fixed income portfolio,the holdings of paper are likely to becloser to –%.

In the judgment of the , opening denominated sovereign bond purchasesto global institutional investors, and simul-taneously removing all forms of repressionin the domestic financial system, will resultin a significantly higher probability of low-ering the financing cost for o, than thelow probability of increasing that cost.

A fiscal deficit financed by o bondsissued in global capital markets, butdenominated in INR – rather than financedby banks that monopolise domesticbank deposits – would alleviate crowdingout effects in the domestic market. It wouldrelease more domestic resources for moreefficient private investment, and alleviateupward pressure on local interest rates.That would reduce the need for o and to protect the profitability and balancesheets of state-owned banks. It wouldcreate more room for neutral regulation thatallowed greater competition, efficiency andinnovation in banking and other financial

markets. It is thus a key ingredient for havinga successful in India.

. Sophisticated financial structures for in-frastructure projects will help to put manyassets “off balance sheet” thus reducingthe public borrowing requirement. Thethird bit of innovative thinking in publicfinance concerns shifting the burden of fi-nancing infrastructure from governmentbudgets to corporate balance sheets. Thiscan be done by improving the policy andregulatory climate for public private partner-ships (s). As the private sector invests ininfrastructure, the pressure to keep issuingpublic debt for capital investment woulddiminish.

Today a large part of the burden ofborrowing for infrastructure falls on thebalance sheet of the government. In a framework under the viability gap fundingmodel, a private partner bids for a grantcovering the difference between the cost ofthe project and the profit expected fromit. The project goes to the lowest bidder.Spending by the government is limited tothe grant. The loans that a private companytakes to finance the project do not appear inthe government’s accounts. If the grant givenby government is financed by a deficit thenonly that element appears in the debt liabilityof o. Greater resort to s wouldsupport the downsizing of governmentexpenditure required to achieve stabilisationof the public debt/ ratio. The Ministryof Finance has embarked on establishinga viability gap funding mechanism. Thisneeds to be scaled up, at the expense oftraditional mechanisms for State expenditureon infrastructure, thus yielding reducedgovernment expenditure and thus deficits.

4. The mutuality of interests inmodernising debtmanagement and having anIFC

Moving away from financial pre-emptionfor financing the fiscal deficit is essential

Analysis of investment requirements, and potentialfor private sector financing, has been offered at greatlength in Mohan ().

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in its own right as the most appropriatestep toward more rational development ofthe Indian financial system in overcomingthe distorted legacies of the past. At thesame time it would be highly supportive ofcreating an in Mumbai. Reciprocally,an in Mumbai would provide manymore options for diversifying sources ofpublic borrowing, globalising the marketfor denominated debt, and reducingits costs. The emergence of an active bond market (as part of an integrated package) that attracted full participation ofglobal portfolio investors – especially long-term, fixed-income investors such as pensionfunds – would create new opportunities forthe export of and enhance the statureof an in Mumbai. It would provideimpetus to a currency trading market as wellas to a more diversified derivatives marketthat traded contracts in currencies and interest rates.

In recent years, a number of developingcountries have attempted to attract globalinvestors to buy their local currency bonds.India has, paradoxically, discouraged themfrom doing so; although that policy postureappears to be changing. India is unusuallywell placed to attract global investment in sovereign bonds because voluntarydemand for them in the global investmentcommunity appears to be far largerthan o’s inclination to accommodatethat demand. Looking ahead a soundpublic borrowing strategy for India wouldincorporate three elements:

. An independent Indian ‘debt manage-ment office’ – operating either as an au-tonomous agency or under the Ministryof Finance – that regularly auctioneda large quantum of denominatedbonds in an in Mumbai. The sizeof these auctions would be substantialby world standards and would enhanceMumbai’s stature as an .

. A liquid yield curve along with afunctional Bond-Currency-Derivatives() nexus and vigorous arbitrageby sophisticated investors with DirectMarket Access, ensuring that the yieldcurve is arbitrage free, with an associatedset of interest rate derivatives for riskmanagement.

. Investors from all over the world parti-cipating in the bond market inMumbai.

Each of these three elements bolstersthe other two. Creating an yield curve– a fundamental pre-requisite for an in Mumbai – and ensuring that it sendsthe right signals, requires macroeconomicstability as a critical pre-condition. Theabsence of such stability would resultin a loss of confidence in the economicgovernance of India. If that happened,domestic and foreign investors would shun bonds, drive up interest rates andprecipitate a crisis. For that reason, it isincompatible to consider having an andcontinuing to run destabilising deficits.

The market for corporate bonds isan integral part of the nexus thatthis report has stressed the importance of.Progress in creating an independent debtmanagement office that auctioned sovereignbonds and notes across the maturityspectrum into a liquid yield curvein Mumbai, with international investorsparticipating in this market has someinteresting downstream implications. Inparticular, it would create the opportunityfor creditworthy sub-sovereign issuers – i.e.,state governments and municipalities – toaccess the same pool of investors. It wouldcreate a new sub-market in India that doesnot yet exist; although sub-sovereign andmunicipal bond markets are key featuresof bond markets in developed financialsystems.

While there has been legitimatecriticism of o for persistent fiscal deficits,it has not been given the credit it deservesfor the transformation in public finance thatit has painstakingly wrought. Progress hasbeen sufficiently tortuous as to be invisible.Yet it has been profound. Over the lastdecade, distortionary taxes like customsand excise have been removed with a shifttowards . High marginal income taxrates have been reduced. Double-taxationof firms has been partially reformed. Theincidence of taxation has increased its focuson consumption. The Act has beenpassed and income tax collection/accounting

. The macroeconomic fallout of an IFC 93

has been automated. All these measuresamount to a paradigm shift in fiscal policyand practice. Public finance in India todayhas been transformed quite dramaticallyfrom the situation of ; but the size offiscal deficits has been slower to respondthrough desirable shrinkage.

These achievements need to be builtupon with a commensurate paradigm shiftin debt management. The aim shouldbe to create a new policy framework forpublic borrowing that mirrors practice inmature markets. Resorting to global marketsfor public borrowing through an inMumbai would require some new elementswhen compared with current practices. Inthe present framework, o bonds are soldby . Designated buyers (like banksand pension funds) have no choice but tobuy them. Under the alternative paradigm,with bonds auctioned to voluntary buyers(domestic and global), the governmentwill need to work harder in providing theinformation required by the global fixedincome investment community to makereasoned judgements. This will involve:

. Advertising clearly in headline terms thegross consolidated fiscal deficit of Indiarather than obscuring it by referringto the fiscal deficit run by the centre.o needs to publish regular reportsof total public debt: i.e., of centraland state governments. That shouldinclude: implicit/explicit governmentguarantees, implicit pension debt andthe total (public sector borrowingrequirement) including the debt ofpublic sector companies that has acontingent o or state governmentguarantee. Similar reports should bepublished by state governments withthe aim of publishing the consolidateddebt of the centre and all states. Thesereports should be accessible to the public.They should appear on the website ofthe Ministry of Finance every quarter.The consolidation of information, inone place, of all liabilities of all armsof government is a key milestone forstrengthening public debt management.This information needs to be fullyshared with the global bond trading andinvestment community.

. Making targeted commitments underthe binding. The does not specify the strictures thatfollow if the existing deficit targets areviolated. There is a need to introducestrict penalty clauses and bolster fiscalaccountability about what would happenif the targets are violated.

. Extending rules and principlesto States: While the was a keymilestone, it addressed only the fiscaldeficit of the central government andnot that of state governments. Currentestimates for the consolidated deficit ofthe centre and states amount to some ofthe most extravagant aggregate deficitsin the world. State governments havebeen given incentives to restrict deficitsby the th Finance Commission. Butdeficit reduction targets have been notbeen defined in a state-specific manner.There need to be state specific targets,agreed to by state governments, whichthe states should then be held to andpenalised if they are not met. MoF needsto translate the full picture, in terms ofprojections for the Centre and for theStates, into projected numbers for theconsolidated deficit of the centre andstates, and projected numbers for theconsolidated debt/ ratio. Cogent,comprehensive analytical documentsshowing historical statistics, presentstocks and projections for five yearsneed to come out from the Ministryof Finance to the global fixed incomeinvestment community, where the unitof discussion is the consolidated IndianState, not just the central government.

. Lowering the Total Public Debt/Ratio: The structure of the Act places undue emphasis on theannual fiscal deficit in terms of financialflow and insufficient emphasis on thecumulative effect in terms of the debtstock thus created. Economic logicdoes not suggest only that fiscal deficitsshould be low. It also suggests thatthe debt/ ratio should be lowand stable. Low fiscal deficits are ameans to an end: i.e., a fiscal policyframework in which the debt/

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ratio falls in all normal years except ifthere is a war or a comparable nationalcalamity. A greater focus needs tobe put on full measurement of publicdebt, avoiding new contingent liabilities,and finding new ways to ensure thatproperly-measured public debt (whichis presently well in excess of % of) does not cross a publicly statedceiling such as –% of . The is reluctant to suggest a rigidceiling without studying in more depthwhat ceiling would be appropriate forIndia. For that reason it has suggested arange that is typically found around theworld in terms of prudent public debtmanagement practice. The alsorecommends that, in reducing publicdebt, governments at all levels considernot only revenue and expendituremeasures but other measures – inparticular public asset sales at theappropriate time and at the appropriateprice – to bring about a reduction inpublic debt. The proceeds of such salesshould be applied exclusively to publicdebt reduction and no other purpose.

In summary, quarterly reports trackingthe performance of the centre, states, sand the consolidated fiscal situation showingthe size of the total deficit and the sizeof outstanding debt (including implicitliabilities), need to be made available tothe investing public in a timely manner.Projections of the deficit, for five years ona rolling basis, should be released everyquarter. The Ministry of Finance shouldbe required to explain deviations fromprojections to the public and to Parliament.This requires making substantial progresson the accuracy of fiscal measurement andimproving the quality and performance ofpublic institutions.

5. Implications for monetarypolicy

A key element in managing a macro-economy with large fiscal deficits and rapidlygrowing public debt is monetary policy.

For a treatment of contemporary thinking onmonetary policy, see Mishkin ().

Its conduct becomes more complex andsophisticated with an open capital accountwhich, as discussed below, is a sine quanon for an in the st century. Withinordinately large fiscal deficits, and a largestock of public debt, now exceeding % of, monetary policy has to bear the bruntof adjustment when fiscal policy proves toosticky. The expansionary effect of largefiscal deficits has often to be countered bymonetary policy: i.e., through higher interestrates and more pre-emption than wouldotherwise prevail.

The expanded supply of governmentpaper has to remain attractive to the domes-tic investor in order to be absorbed. Thatdrives up rates, increases the government’sborrowing costs, further increases the fis-cal deficit, and expands the stock of publicdebt explosively through compounding. Anever escalating spiral resulting in a loss offiscal control is thus set in motion. It be-comes difficult to break out of that spiralexcept through: (a) gradual or disruptivefiscal adjustment – usually too little too late– which incurs political problems; (b) draco-nian monetary adjustment that throws theeconomy out of kilter and creates economicas well as political problems; or (c) trans-ferring the costs of adjustment to foreignbondholders through currency depreciation,if the country is an issuer of reserve currencyand borrows from foreign investors in itsown currency (e.g., the ).

With large fiscal deficits, an open capitalaccount worsens the problem. In open-economy macroeconomics, when a rapidlygrowing economy opens up, stabilisationof the business cycle through fiscal policybecomes ineffective. Achieving the sameresult through monetary policy is moreeffective. As the Indian economy has opened

That problem is aggravated if the government’sborrowing strategy is to finance its deficit exclusively inthe domestic market. It gets worse if the government isobliged to borrow abroad in foreign currency ratherthan its own because it then takes on added currencyrisk and o liquidity risk. But if it can borrow abroadin its own currency the problem gets ameliorated byreducing interest rate pressures in the domestic market;as long as the expected real return is perceived by globalinvestors in bonds to be superior to returns in bonds after adjusting for credit, country, politicaland currency risk.

. The macroeconomic fallout of an IFC 95

up, gross flows across borders have risensharply. They exceed % of today andare expected to rise further.

As in other open economies, it willbecome increasingly difficult to control the exchange rate through interventionsby the central bank; as has been done inthe past in India by . The larger theinterventions by the central bank, the morethe cost of a policy of managing the exchange rate. The main ‘cost’ of such apolicy is the loss of monetary autonomyas predicted by the iron-law or ‘impossibletrinity’ of open-economy macroeconomics(Joshi, ; Patnaik, ; Joshi and Sanyal,). Too many central banks around theworld have lost too large an amount of theirreserves trying to defend pegged exchangerates when global markets moved againstthem. India should not repeat that error.

In an environment of free capital flows,downward pressures on the wouldneed to be relieved by raising interestrates if exchange rate stability was theprime goal. If that was done regardless ofdomestic conditions, an externally inducedcontraction in money supply could provedeleterious to domestic industry. It wouldraise its costs of capital and reduce theenhanced export competitiveness that adepreciating would have afforded. Theopposite would occur if pressure on the were upward. Interest rate movementswould be governed by fluctuations in capitalflows instead of fluctuations in local inflationand government borrowing requirements.

A particularly difficult feature of the lossof monetary policy autonomy lies in the pro-cyclical nature of capital flows (Kaminskyet al., ). In an ideal world, with asophisticated financial system, capital flowsshould respond to investment opportunitiesin the real economy. In practice, informationasymmetries can lead to pro-cyclical capitalflows. When the business cycle in Indiais on the upswing, capital flows wouldtend to flood in. Conversely, when thebusiness cycle reversed, capital might flowout. Pegging the exchange rate would lead tohigher interest rates in India when business

For a treatment of the issues in moving to a floatingexchange rate, see Duttagupta et al. (, ).

cycle conditions were adverse in order tocounter weak or negative capital flows. Thatwould exacerbate the downturn. A policyof pegging the exchange rate would thusenable the direction of capital flows toinduce a destabilising monetary policy, onethat increases the volatility of GDP growthinstead of reducing it.

India, with its large and fast growingeconomy, can no longer peg the tothe and incur the resultant loss ofexercising monetary policy autonomy underchanging domestic market conditions. Anopen capital account would require givingup a stable exchange rate and choosingautonomous monetary policy. But thepublic and private sectors would need tohave the resilience and risk managementcapacity, with world class currency futuresand options instruments and markets, tocope with more frequent movements in exchange rates.

The key element of such a monetarypolicy would need to be inflation targeting.When the is not the anchor for the ,the basket should take its place. Such apolicy has been shown to have many longterm benefits, including fiscal stability andlow output volatility. Today central banksin the , Euro-zone, Japan, , Australia,Israel, Chile, etc. all target inflation to keepit low. For all practical purposes, the Fed inthe targets inflation de facto; althoughit is constitutionally required also to beconcerned about growth and employment.

In a country like India, which needsto build global confidence in the ,an explicit and legally mandated de jureinflation-target regime governing monetarypolicy would be superior to a de facto peggedexchange rate regime (as is presently

the case) or a de facto inflation targetingregime (as is the case in the ). Whendomestic and foreign investors hold assets – originating from any issuer – an

Chandavarkar (); Mohanty and Klau ();Khatkhate () discuss monetary policy in India.

Patnaik () demonstrates that in India’s case,as with many other developing countries, there is adistinction between the de facto currency regime inoperation as opposed to the de jure currency regimewhich is claimed to exist, and that India has followed ade facto INR/USD pegged exchange rate.

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institutional commitment to predictableand low inflation generates predictabilityin the real value of bond repayments. Thedanger of capital flight would be reducedif the value of the was maintained inreal terms and expectations about its futurevalue were stable. A monetary policy thattargeted inflation de jure would be an idealpartner to a policy of public borrowing byselling bonds in global markets.

The choice of inflation measure tobe targeted from available measures ofinflation using the Wholesale Price Index,the Consumer Price Index or a measure ofcore inflation is significant. Theoreticallythere may be case for using a measure ofcore inflation that excluded commoditieslike food and oil. But in terms ofpublic perception and the credibility ofthe central bank, the consumer price index(-Industrial Worker) might be a bettermeasure to use. It is this measure to whichwages and dearness allowances are linkedand which people are familiar with.

Unlike measures such as core inflation,the public would not suspect fudging ofthe figures by the authorities to suit theirpurposes. But, using the CPI for inflationtargeting will require the government tocease subsidising key prices (e.g., energyand fuel) and intervening in commoditymarkets through price measures. Suchpractices distort measures of inflationand disable a policy of inflation targetingfrom working as it should. However, thefrequency of measuring the indicator shouldbe increased and the time lag with whichit is produced decreased, alongside steadyprogress in improving measurement of theconsumption basket of the typical industrialworker in India.

The pass-through effect of the exchange rate on inflation (from risingor falling import prices) could incentivisethe central bank perversely to manipulateexchange rates and have greater control overthe pass-through. Intervention throughinterest rates would influence the exchangerate. Its effects on monetary policy wouldbe transparent. But if, instead of deployinginterest rates, the central bank’s interventionwas through purchase/sale of forex (reserve)assets, coupled with sterilisation, then the

effect would be non-transparent and shouldbe avoided. The use of interest rates as theinstrument, with the aim of policy being atargeted rate of inflation keeping the pass-through effect in mind, provides a moretransparent framework for achieving thetargeted inflation rate. But it also poses agreater risk for fiscal management whendeficits and public debt stocks are largerthan they should be.

Monetary transmission is considerablyaltered in a world with an efficient financialsector. When the nexus works properly,arbitrage binds together all points on theyield curve. The decisions by the centralbank on the short rate, coupled with thepublicly stated monetary policy rule, inducechanges in all interest rates and in exchangerates. This indirect strategy has provenhighly effective in mature markets. In India,there is a feeling that moving away fromdirect control of all points on the yield curvewould be risky if not dangerous. However,ceding direct control and relying on the nexus to work instead is essential inhaving an effective monetary policy andacquiring global credibility with an opencapital account. Monetary policy withan open capital account is more effectivewhen there is a proper combination ofsound markets with a properly functioning nexus and a public, transparent,unambiguous monetary rule. In otherwords, a given impulse for expansion orcontraction can be managed much betterby making a smaller change to the short-end interest rate, when the yield curve isarbitrage free and economic agents knowthe correct monetary policy rule that is inoperation.

6. Outlook for the currentaccount deficit

A current account deficit averaging about.%, with a fluctuation of ±0.5%, ispresently perceived to be sustainable forIndia. India has sometimes run a currentaccount surplus. But that is not in India’sinterests at its stage of development. Itimplies a savings ratio higher than theinvestment ratio and results in an exportof capital to the rest of the world. An

. The macroeconomic fallout of an IFC 97

investment ratio higher than the savingsratio, with net capital inflow of –% of per year, would permit India to raiseits investment rate and stabilise it at –%of in order to sustain growth of % ormore.

However, even with these levels of netcapital flow, an in India will resultin outflows and inflows that are muchgreater. The benefits of an do notcome as much from more ‘net’ investmentas from gross capital flows in and out ofthe country. The benefits of capital flowscome from more efficient internationalallocation of capital, capital deepening andinternational risk-sharing. All these factorsraise growth and reduce consumptionvolatility. But recent research shows thatwhile such direct benefits do accrue, thepotential collateral benefits are even larger.These arise from better financial marketdevelopment, better governance and themacroeconomic discipline that comes withfinancial globalisation (Kose et al., ;Mishkin, ). The resulting growth incapital productivity and efficiency, spreadover a much larger volume of investment,can have a greater impact than a mereincrease in the investment level.

7. Macro-stability for an IFC

For a credible to be established inMumbai, global financial markets need tobe persuaded about the enshrined sanctityof maintaining macroeconomic stability inIndia regardless of which government rules.This involves institutional reforms on threefronts: fiscal, monetary and financial system.So far, India has made more progress onfiscal reforms. The other two elements havestayed about where they were in the earlys. Further, deeper reforms are nowrequired in fiscal and monetary economics,in order to ensure:

The well known results of Feldstein and Horioka() suggest that in the , convertibility wasnot very effective at decoupling domestic savingsfrom domestic investment. These results have beensignificantly modified by post- data. However,the basic position of is consistent with the ideathat convertibility accelerates growth throughmechanisms other than a large increase in thesustainable current account deficit.

* Low risk of changes in tax policy or taxrates;

* Zero probability of more capital controlsbeing introduced in the future;

* Low and stable inflation; zero probabilityof hyper-inflation;

* A respected and tradable arbitrage-free yield curve going out to years;

* Lower fiscal deficits to bring about astable or declining debt/ ratio;

* A high investment grade sovereign creditrating;

* Monetary policy that stabilises thebusiness cycle;

* A ‘consistent’ framework of monetarypolicy that recognises the impossibletrinity;

* Business cycle volatility that is morelike an industrial country and less like adeveloping country.

In the case of the , an embarrass-ing history of macroeconomic instabilitythrough most of the th century – includingan program in and a breakdown ofthe currency regime in – was resolvedby the reforms of the late s and s.These required the central bank to focusexclusively on monetary policy and nothingelse, created an explicit inflation targetingregime, and introduced fiscal rules whicheliminate the risk of a growing debt/ratio.

India and the both experienceddifficulties with their currency regimes in theearly s. But the came up with a morefar-reaching response involving institutionalsurgery and new legislation. The resultingmacroeconomic stability, and an enlightenedapproach to financial regulation that isprinciples-based, have been key factors inbolstering the success of London as a over the last decade.

The has travelled in the oppositedirection since . A loss of hard-earned fiscal control, and the impositionof counterproductive regulation, andlegislation such as Sarbox, has damagedNew York’s standing as a . London’sexperience and that of New York areinstructive for India in opposite ways.In the , only a few years after the

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breakdown of its currency regime, thereforms implemented have becalmed theexpectations of financial markets. They haverestored global confidence in the despitea tendency toward fiscal profligacy becomingincreasingly apparent in recent years. Inthe , by contrast, global credibility andconfidence in financial probity has beensteadily eroded since the new millenniumdawned.

A mature market economy is one whereinflation and growth are stable, whileexchange rates are more variable. In thethird world, this is reversed. Emphasis on astable exchange rate results in more volatileinflation and more volatile growth.India has to put monetary policy on a soundfooting to avoid this pathology.

8. The incompatibility ofcapital controls in a 21stcentury IFC

In some ways it might appear to betheoretically feasible for India to makesome progress towards internationalisationof finance while retaining an elaboratestructure of capital controls. For example,an institutional mechanism for the issuanceof Indian Depository Receipts (s) couldbe created: a narrow opening in a systemof controls through which one kind oftransaction can be conducted. Or attemptscould be made to find a way of providing through that part of the system wherethe capital account is open; while having topersuade regulators at every step that what isbeing done is in line with what is permissibleon a ‘moving-target’ basis. But the efficacyof this obviously sub-optimal approach isquestionable for two reasons:

* A successful comprises a vibrant,competitive financial market ecosystem.If financial firms have to operate under acomplex maze of ambiguous restrictions,and have to comply with quantitativerestrictions or license/permit require-ments that achieve very little, then thequality of thinking in, and the servicesprovided by, the are compromised.More time is spent by financial firmsand their key executives on exploring

loopholes than on designing the rightkind of for clients.

If the s of financial firmsare forced to focus on the policyand regulatory constraints faced bytheir business plans – rather than onimplementing their business plans andcontinually refining them by talkingto customers – then what is replicatedis a situation like the India of thes in the real economy. In thosecircumstances the most capable Indianmanufacturing firms were unable toachieve international competitivenessbecause they spent more time dealingwith the government than with theircustomers in export markets. Butwhen that constraint was removed theirsuccess went beyond the imaginable.

As an example, despite many years ofpolicy effort, Indian Depository Receiptshave a zero market share in the marketfor international equity issuance and the licenses granted earlier were notworth the paper they were printed on.Even a broad opening of capital controlsbut with quantitative restrictions ondifferent types of transactions involvesfinancial firms being engaged in heavy-duty persuasion in the interpretation ofonerous rules. The complexity of suchan institutional mechanism runs afoulof the need for speed, flexibility andinnovation in the global market. Itencourages rent-seeking (Krueger, ).

* Piecemeal opening-up defeats the pur-pose of capital controls. Capital ismore agile and mobile than merchandise.When India embarked on autarky on thetrade account, some items – like gold ors – came into India in boats fromDubai. In the case of most things – likesteel – the Indian attempt at autarky wassuccessful but self-harming. Wardingoff free flows of capital is more diffi-cult than monitoring imports/exports ofsteel or cement (Patnaik and Vasudevan,). Under draconian capital and cur-rent account controls, the hawala marketflourished. It effectively bypassed thosecontrols. As has been noted, the pres-ence of harsh capital controls did notprevent the currency crisis (Vir-

. The macroeconomic fallout of an IFC 99

mani, ; Acharya, ). Conversely,a more open capital account in – did not trigger a crisis when manyEast Asian countries experienced disas-ter. What India has achieved, in openingits capital account, implies more con-vertibility than is commonly appreciated.Every month, the ‘calibrated openingof the capital account’ further under-mines residual capital controls. Main-taining partial controls, and removingremaining obstacles over a long drawnout period of time, contingent on con-comitant conditions being met, impedesincoming cross-border capital flows ina counterproductive manner. What itachieves is to inhibit the export of from India – while having a de facto opencapital account for the real economy, butnot for financial services. That creates astrong bias against exporting ; an ac-tivity in which India has a much greatercompetitive advantage over most othercountries – providing the nexuscan be created quickly in Mumbai – thanin almost any other domain.

At the same time it has to be recognisedthat there has been much argument ininternational financial circles about theadvisability of removing all capital controlswhen faced with the risk of coping withcapital surges (especially of short term hotmoney) induced by the herd instincts ofbankers and high-risk fund managers. Thesearguments gathered steam after the Asiandebt crisis of – and a number ofsubsequent crises that occurred around thedeveloping world since. Clearly no memberof the would like to see India open itscapital account fully only to be confrontedby a financial crisis because capital surgescould not be controlled.

But, in weighing the balance of risks,what is obscured is what India is losing bykeeping the capital account partially closed,and applying the regime in a mannerthat effectively closes it even more than therules permit. That loss has been discussedat length throughout this report. Remain-ing capital controls – even partial ones –pose a high practical (rather than theoret-ical) barrier to permitting India to competein the global market for . By doing so,

they deprive Indian financial firms of anopportunity to earn larger export revenuesthan those derived from services. Theyreinforce protectionism and barriers to com-petitive entry in the Indian financial systemrendering it less efficient and more costly asan intermediation mechanism than it shouldbe. They do not permit financial system lib-eralisation and reform to take place as swiftlyand to the extent that it should.

On the whole, the is of the viewthat the capital account should be opened ata faster rate than is currently being envisaged.It believes that the risks of doing so canbe managed given: (a) the proven skillsand capabilities of the in managingIndia’s external accounts with extraordinarycompetence; (b) the trends that are nowmanifest in accelerating two-way financialflows at a very rapid rate – i.e., at two or threetimes the output growth rate; and (c) theproblems that will increase as the partiallyclosed regime is maintained,

Opening the capital account decisivelyis not a matter of tweaking technical ratiosand tinkering with the present limits ofwhat is allowable and what is not. Thatprocess adds little of value. But it increaseslevels of frustration throughout the Indianfinancial system, and on the part of Indiannon-financial firms that are ready and ableto showcase their world-class competitiveabilities more meaningfully on the globalstage. Neither of these categories of firms isenthusiastic going through the hoops of acapital account regime that is supposedly‘open’ for them in theory but still involvesconsiderable administrative obstruction inpractice. Clearly the focus of the wouldthen need to shift rapidly to managingmonetary policy in an open economy, withan open capital account, in a way thatsupports the growth and globalisation ofthe real economy, while maximising theprospects for the success of an inMumbai.

Simply put, in the Committee’s view,India can have an IFC in Mumbai withan open capital account or it can keepits capital account partially closed, in theway it is now, and forego/delay the optionof creating an IFC until conditions aredeemed right to open the capital account

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fully. What it cannot have is a credibleIFC in Mumbai with a capital accountthat remains partially closed. To create anIFC in Mumbai under such circumstanceswould be putting the cart before the horse.It would lead to failure of the IFC andcompromise its prospects for many yearsto come. The experience would be similarto the desultory experience with the OBUexperiment. This is a stark choice thatIndian policymakers face. They mustdecide which way to go. The Committeeis an advisory one and has no mandate tomake that choice. But it would be remissin discharging its advisory mandate if itdid not add that delaying the creation ofan IFC in Mumbai has real costs (in termsof foregone opportunities and revenuesas well as payments for IFS that must beacquired from abroad) that should not beobscured.

As long as residual capital controlsare in place, all India will get is more/ in finance and perhaps be ableto offer a very limited range of suchas algorithmic trading with ; butthere will be no . At the same time,the establishment of an , and theassociated onset of full capital accountconvertibility (), has implications forthe evolution of macroeconomic policy. Insome profound ways, having an inMumbai provides an answer to some of themore daunting questions about how fiscalpolicy and monetary policy will work in anenvironment without capital controls. Fromthe viewpoint of managing macro-policy, itmakes more sense to have full convertibilityand creating an , instead of trying toachieve convertibility without attempting tocreate an .

9. Full capital convertibilityand an IFC in Mumbai

Export-orientation in the Indian realeconomy required the removal of tradebarriers. In similar fashion, successful exportof via an in Mumbai requiresthe removal of capital controls. At thesame time, the reasoning presented in thischapter suggests that creating an hasmany synergies with moving more rapidly

towards convertibility. Each complementsand strengthens the other.

9.1. Impact on the conduct of fiscalpolicy and debt financing

The first task of Indian public finance isto reduce the gross fiscal deficit in orderto reduce and stabilise the debt/ ratioat a lower level (–%) than it is now(%). Once this is achieved, the task ofpublic debt management is to finance extantdebt as cheaply as possible. As has beenargued in this chapter, an in Mumbaiwould attract an array of global institutionalinvestors and issuers into the yieldcurve. A properly functioning nexus– pivoting on a more liquid and efficientbond market – with well-traded, arbitrage-free and liquid yield curve wouldprovide the best foundation possible forbond issuance by the o. Growth of Indianinstitutional investors along with an existinguniverse of global investors anxious to buy denominated paper would generatenatural customers for Indian governmentbonds tradable in global markets. Once the is accepted in the portfolios of globalfixed income investors, the size of bondinvestments available to the Government willgreatly exceed the amounts placed throughfinancial repression today.

9.2. Impact on the conduct ofmonetary policy

An in Mumbai would strengthen theinformation set on which monetary policy isdecided and increase its efficacy. Around theworld, monetary authorities make extensiveuse of information from global financialmarkets in the formulation of monetarypolicy. This information includes implicitand explicit market estimates of expectedinflation, currency volatility, interest ratevolatility, etc. Such vital raw data for thesound conduct of monetary policy is, atpresent, absent in India owing to the stiflingof financial markets. An would enableand empower such markets, and thus feedbetter information back into the formulationof monetary policy.

For related arguments, see http://tinyurl.

com/yapulp on the web, and Bodie and Merton ().

. The macroeconomic fallout of an IFC 101

The second impact of an onmonetary policy concerns efficacy. Centralbanks in mature market economies set onlythe short-term interest rate and articulateclear rules about how they will react inthe future to new domestic and globaldevelopments and data on prices. Oncethis is done, market arbitrage translatesadjustments in the short-term rate intochanges in long-term interest rates andprices on the corporate bond market acrossthe maturity/duration spectrum. Theefficacy of monetary policy comes aboutthrough this plethora of changes, whichflow through arbitrage in the fixed incomemarket. In India, since the fixed incomemarket has neither liquidity nor arbitrage,this channel for the exercise of effectivemonetary policy is made defunct. An in Mumbai of the kind the envisageswould result in the creation of a liquidand arbitrage-free yield curve and acorporate bond market.

India is headed towards convertibilitysooner or later. That is partly due tothe vision and foresight of policy makersbut, more importantly, to increasingglobalisation and the consequent ease withwhich capital controls can be evaded. Inpractice, when a country has an opencurrent account, and when local firms

build operations all over the world andbecome multinationals, capital controls loseefficacy. They simply become discriminatoryrather than useful. They discriminate againstfirms that do not trade or invest abroad whilefavouring those that do.

Many countries – e.g., all the smallcountries of Europe – have local financialsystems that are not globally significantwhile having an open capital account. Butthere are powerful synergies between havinga world-class financial system in a large,globally significant economy and having anopen capital account. An in Mumbaidovetails with an open capital account inIndia. On the one hand, an will nottake root without the removal of capitalcontrols. But equally, the establishment ofan , and an accompanying program offinancial sector reforms, provides the idealsupporting infrastructure for dismantlingcapital controls and coping with theconsequences more smoothly. Worldwideexperience with opening the capital accountemphasises the importance of having strongfinancial markets and institutions to copewith the consequences of that transition. Thecreation of an in Mumbai is an integraland indispensable element in making thattransition.

Financial RegimeGovernance: Its role in an

IFC and a comparativeperspective

8c h a p t e r

1. The intrinsic value ofregulation for IFS production

The fundamental difference between the pre-and post- approaches to developmentstrategy in India – i.e. the themesof outward orientation and openness toenhance technology, efficiency, productivity,quality and competitiveness throughoutthe economy – apply with equal forcewhen it comes to providing . Aninward-looking policy aimed at protectingthe domestic market for financial services(e.g. protecting financial firms from theforce of competition from other domesticand foreign competitors) exacerbates andprolongs: intermediation inefficiency,over-staffing, cost-ineffectiveness, higherintermediation margins, poor management,poor service quality, sub-optimal technology,and inability to capture fully a number ofeconomies of size and scale.

In establishing an appropriate contextfor the discussion on Indian financialregulation that follows, it is essentialto underline that, since , India hasmade a belated but fundamental shiftfrom an import-substituting developmentmodel to an outward oriented strategyemphasising greater openness and trade(particularly exports). In the process,India has discovered that achieving export-competitiveness requires a combinationof: (a) cost-effective human capital inputs;(b) good management and corporategovernance; (c) the use of cutting-edgetechnology that is continuously updated;and (d) the application of best global

practices. A side-effect has been that export-orientation has improved the productivityand efficiency of production, as well asthe quality/quantity of goods and servicesavailable, for the domestic market. Inaddition, competing in global markets hasproved to be useful in sidestepping problemsof domestic competition policy, reducingrent-seeking impulses in local politicaleconomy, and thus accelerating growth.

However, it is important to take note ofa fundamental difference between the exportof financial services and the export of goodsand non-financial services.

IFS exports are intrinsically differ-ent from ordinary exports. When a caris exported from India, its quality/value ismeasured without regard to the difficul-ties encountered in its manufacture. Deal-ers/customers who sell/use the car – any-where in the world – evaluate/verify its qual-ity and relative value by applying objectivetests. An Indian car is accepted by the worldmarket if it passes these tests; it is rejected ifit does not.

Production of the car in India mighttake place in a difficult institutional andoperating environment characterised bya number of weaknesses such as: poorinfrastructure, restrictive labour laws, highreal costs of capital, inefficient taxation, aweak legal system, difficult trade unions,poor public governance, poor standards ofregulation (e.g. health and safety standards,factory hygiene, conformity with localplanning rules, etc.).

These difficulties induce additional‘coping costs’ for firms manufacturing cars

104 R M I F C

in India. For example, an industrial processthat consumes tap water in an country might require a special purificationplant in an India; or the unreliability ofpower supply may require investment in acaptive power plant; or a car manufacturermay need to have special infrastructure foreffluent discharge and sewage. However,once the car is made, these problemsdo not affect either the reality or userperceptions of its quality. An objectivetechnical assessment of the finished car is‘ahistorical’; it has no links to the policy,regulatory or physical environment underwhich it was produced. This applies for awide range of ordinary goods and services– ranging from motorcycles to steel tocomputer programmes. For this reason,India has made considerable progress inexporting a variety of goods and services,even though the underlying institutionalenvironment continues to be deficient inmany respects. High coping costs inducelower wages, yielding globally competitiveprices for finished goods in most industries.

But this separation between finalproduct and the institutional/policy andregulatory environment in which it wasproduced (i.e. the regime that governedits production) does not hold for .Finance is about the fulfilment of contingentcontracts that specify performance of statedactions by stated parties at future dates.The quality, performance, and value ofa financial product or service dependscritically on confidence in the mind of thecustomer, and trust on his/her part, thatstated actions/obligations at future dates willbe performed/fulfilled as promised. Giventheir very nature, the implicit obligationsthat underlie all financial contracts, andthe regulatory regime that governs theirfulfilment, become an intrinsic part of suchcontracts – represented operationally asfinancial products and services.

Financial Regime Governance: i.e. theframework of laws, rules and regulationsgoverning financial products/services (andthe way in which authorised regulatoryinstitutions specify, apply and enforce them)is therefore intrinsic to the value of financialservices in a way that governance is notintrinsic to the value of a car or a ball bearing.

For example, a simple deposit at a bankinvolves the performance of an action orfulfilment of an obligation by the bank tothe customer at a future date: i.e. when onebuys or invests in a CD for Rs. , at aninterest of % for months, one expectsthe bank to return Rs. , at the end ofthat period with even thinking about it. Thethought process of the customer involvesthe financial regime governance at twolevels. First, is the bank well regulated andsupervised, so as to induce a low probabilityof failure? And, if the bank goes bankrupt, isthere an effective bankruptcy procedure witha high and predictable recovery rate, on ahighly predictable time horizon? If Mumbaiis to become an , and attract globalcustomers who place deposits in banksin Mumbai, then an intrinsic part of theproduct offering would be to have answersto these questions that instil confidence inthe global customer that in these and otherrespects an in Mumbai operates withworld-class standards.

When an Austrian customer buysan Indian car, he is concerned withits quality, performance, reliability andfunctionality. He is blithely unaware ofthe Indian policy framework for automanufacturing, the legal regime, theinfirmities of physical infrastructure, or thecapability and competence of the regulatoryinstitutions that governed its production.Once the car is produced and used, thoseconnections cease to matter. In contrast,when an Austrian customer places an orderon an Indian - futures market,or buys an Indian bond or share, he isinextricably and inexorably affected byIndian law and regulation. Indian lawand regulation are an intrinsic part of thefinancial product/service purchased. Theycannot be stripped out.

For that reason, one of the key elementsin judging the technical merits and relativesafety of a - futures position onan Indian exchange, in the eyes of a foreigncustomer, are the strengths and weaknessesof Indian law and regulation; as well as thecredibility and capability of its regulatoryinstitutions and exchanges. Hence, achievingsuccess in the export of such ascurrency futures trading, or involving

. Financial Regime Governance: Its role in an IFC and a comparative perspective 105

global investor participation in Indianbond, equity, derivatives or commoditymarkets, is not just about having goodissuers, attractive products that are liquidand tradable, or globally competitive entitiesin the private sector, such as exchanges orbrokerage firms. It is equally about havingfoundations, institutions and practices oflaw and regulation or, more holistically, offinancial regime governance that is alsoglobally competitive in meeting the beststandards of regulatory practice appliedaround the world. In this sense, Mumbai’sseeking to become a globally competitive requires Indian law, regulation andoverall financial regime governance to be asgood as the best ‘state-of-the-art’ equivalentsat other s.

Financial regulation is thus an intrin-sic, inseparable component of any finan-cial service/product; whether it is sold do-mestically or internationally. But, whensold internationally, the regulatory com-ponent of that financial service/productmust conform to the best internationalnorms/practices for it to be acceptable toglobal markets and the financial firms andplayers operating in them. This is a keypremise that must be appreciated at policy-making levels.

When a financial product is sold or aservice is provided across borders, issues ofconfidence and trust in the fulfilment ofobligations by counterparties become moreacute. This has two implications for an in Mumbai. First, India as a newcomer inthe global space must aspire to higherstandards than those in London and NewYork, in order to attract global business.The same infirmities embedded in Londonand New York for historical reasons may notbe acceptable to global customers operatingin a new Indian . Second, India willnot be able to make rapid inroads into theglobal customer base without provisionin Mumbai by global financial firms thatare recognised brand-names to global customers. For Mumbai to develop as acredible it will not be sufficient for to be provided only or mainly by Indianfinancial firms that are not as yet globallyrecognised brand-names.

2. Three levels of internationalcompetition on regulationand law

International competition on issues offinancial regulation and law, which shapescompetition in provision, occurs at threelevels:

. Banning products or markets; banningexport: At the simplest level, one can lose out to others because it isblocked from competing with themin the provision of particular financialproducts/services or of a wide rangeof them. At present, most productsand services in the global spaceare not exported from India becausetheir production (even for the domesticfinancial system), or sale to foreigners, isprohibited.

. Rules limiting the success of products ormarkets when they are permitted: Evenwhen provision of a certain kind of is permitted, restrictive regulation canlimit the success of an in providing. Limitations on participation bycertain types of firms in certain markets(e.g. banks being prohibited fromoperating in derivatives markets orforeign banks being prohibited fromdoing government business) or onproscribing certain kinds of tradingstrategies (e.g. algorithmic tradingand ), can decisively influence thesuccess of a product or a market bycircumscribing its use to the point wherethe market becomes too small, fracturedand illiquid with virtually no market-making. What are ostensibly ‘prudential’requirements can limit product/servicesuccess when there is overstretch beyonda technically sound notion of prudence.

. Intangible issues of trust and levelplaying field: Finally, the export of isinfluenced by intangible concerns aboutlegal/regulatory impartiality, fairnessand trust as seen by private players(whether domestic or foreign) and globalcustomers. Global customers have achoice of placing orders in competings for their transactions. Thatchoice is influenced by perceptions about

106 R M I F C

the soundness, stability and fairness ofthe legal/regulatory environment whichan has; i.e. the extent to which it isfelt by customers that a particular has fair processes of enforcement, andtreats non-residents fairly.

3. Where does India stand? Anillustrative bird’s eye view

To obtain a bird’s eye view on issuesconcerning regulation and the legal system,as they influence global competition on ,this report examines them in comparisonagainst existing and emerging s througha scoring scheme from (worst) to (best) on a list of crude but usefulillustrative indicators. This is applied togroups of existing and of emerging s.The indicators, and the numerical valuesfor scoring shown below, are admittedlysubjective. There is an inevitable cross-over where different indicators pertain tooverlapping, and yet distinct, issues. Muchtime has been spent debating the choiceof indicators, and the numerical values foreach city and each indicator to obtain amore objective picture. But we shouldstress that there is no objective methodologyunderlying these numerical values.

These tables should be cautiouslyutilised as an illustrative input for insightsand for policy analysis, rather than as precisenumerical values that should be arguedad infinitum. Also it has to be recognisedthat in most of the comparator cities scoresare based on subjective judgements aboutregulatory regimes for and s thatare already in place. In most s thereis some overlap between regulation of theoverall financial system per se, and regulationof provided through an . Inthe case of Mumbai there is no specificregime for or an in place yet. Itsscores therefore reflect judgements aboutits current governance regime for financialservices as a whole, including those fora limited range of involving foreigninstitutional investors s and the activities of foreign banks.

Thirteen aspects of the quality andimpact of the regulatory regime for thefinancial sector, from the viewpoint of

global competitiveness in production,are scored. The first measure is that ofensuring systemic stability (E), the taskof avoiding crises that engulf the financialsystem and the macro-economy at large.One part of this concerns the protectionof the integrity and soundness of financialinstitutions (E). But equally, recognisingthat firm failure is an inherent featureand a learning mechanism in any marketeconomy, a sound regulatory regime haseffective coping mechanisms when marketand institutional failures do take place (E)so that failures are handled in a mannerthat does not induce panic. A soundregulatory regime is one where good qualityrisk management occurs at the level offirms, markets and the system at large(E). Failures to achieve this can arisefrom faulty rules, in a rules-based regulatoryenvironment, or from moral hazard withfinance firms which believe they will bebailed out in distress.

A key test of a sound regulatory regimeis whether it assures consumer protection(E). What matters is the degree of genuineprotection that consumers get as opposedto a regime that is strong on rhetoric aboutthe importance of consumers while failingto uphold the interests of the consumer inreality. As an example, financial repressionis inimical to the interests of all households.It is inconsistent with consumer protection,regardless of rhetorical claims made bypolicy makers about the importance of theconsumer. Another aspect of consumerprotection is the distinction between notionsof what consumer protection actually is,as opposed to making it synonymouswith adherence with an intricate systemof rules specified by regulators. As isnow understood from global experience,financial firms often have clever compliancedepartments to ensure adherence withcomplex rules, while violating the spiritand reality of consumer protection in theconduct of business.

One of the strongest tools for consumerprotection is competition policy (E). Asound regulatory regime is one in whichthere is full and effective competitionand where every market is genuinelycontestable. 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 futuresThe newspaper Nihon Keizai Shimbun has computed the Nikkei 225

index, a price-weighted stock market index of large Japanese firms since7th September 1950 (Azarmi, 2002).

The first index futures contract was the S&P 500 index futures, whichstarted trading at the Chicago Mercantile Exchange (CME) in 1982. It wasonly a matter of time before a Japanese index futures contract startedtrading.

CME was interested in this market, as was the Singapore InternationalMonetary Exchange (SIMEX). SIMEX was established in 1984, as a part ofSingapore’s plan to become a centre for international finance. It offeredan open outcry trading system for investors across the Asia Pacific andEuropean regions and to interested parties in the US through the mutualoffset system. The time difference between Singapore and Tokyo made itconvenient for Japanese traders to trade on SIMEX. Three factors affectedthe evolution of this market:

. Japan had wagering restrictions that hindered cash-settled indexfutures contracts. An effort was made to launch a physically settledcontract which quickly failed. This legal hurdle needed to be resolvedin order to enable index futures trading.

. Nihon Keisai Shimbun Inc. had to choose how it would license theindex.

. Japanese regulators had to setup a regulatory regime for the product.

Nihon Keisai Shimbun chose to license the index to three exchanges:CME (May 1985), Simex and Osaka. CME and SIMEX had the option oflinking their Nikkei 225 contracts. These exchanges were already linkedthrough a mutual offset arrangement in a number of futures contractsoffered at both markets, such as the Eurodollar futures. Positions taken inthese contracts at CME could be transferred to or liquidated at SIMEX andvice versa.

With a fungible contract, the risk that one market would grow at theother’s expense was low. However, the rewards of offering a successfulNikkei contract exclusively were high. SIMEX chose independently to offera non-fungible Nikkei 225 futures contract in September 1986 – thus itdecided to compete and not cooperate with CME on this product.

Osaka Securities Exchange started trading Nikkei 225 futures in 1988followed by CME in 1990. From the onset, trading in Nikkei 225 futures atOsaka was very successful. Chicago has a 14 hour time difference withTokyo. That ensured Japanese traders could not access CME duringbusiness hours in Japan. However despite the Osaka market, there wasmuch Japanese interest in trading the Nikkei Futures in Chicago. At thetime, some traders seemed to prefer the open outcry trading mechanismof CME to the computerised trading at Osaka.

Now three different exchanges were trading the same product. Sinceall three markets were, to a large degree, targeting the same clients, therewas a chance that one or more of these markets would not attractenough clients and suffer a liquidity problem. During these initial years,trading at SIMEX was not very active.

In the late 1980’s, Japanese regulators allowed banks and securitieshouses in Japan to do brokerage business in futures markets for theircustomers. The biggest benefits of this decision were realised by theOsaka market. The trading hours, the economy of the host country, andthe access to the local market by both foreign and domestic traders wereall important to the success of Nikkei futures on each exchange. Most ofthese factors were in favour of Chicago and Osaka.

Consequently, by the early 1990’s, the Chicago and Osaka marketswere thriving. SIMEX was not. Since the Chicago and Osaka markets didnot trade simultaneously, there were no arbitrage opportunities betweenthe Chicago and SIMEX markets or the Chicago and Osaka markets.However, for most of the trading day, the Osaka and SIMEX trading timesoverlapped. So a trader could arbitrage between these two markets.

It looked like Japan had successfully captured the Asian day and theWestern night business for its Nikkei 225 futures contract. While theWestern day business was done in Chicago, Singapore was pushed asideto doing only marginal side business. SIMEX tried hard to attract morebusiness. It offered an award to the brokerage firm that did the mostbusiness through it.

In the summer of 1992, the Japanese regulators gave Singapore a big‘omiage’ (gift). The Japanese regulators had misdiagnosed the difficultiesthat had led to the October 1987 stock market crash in the US and haddecided that programme trading was to blame.

Osaka imposed stringent rules on the options and futures deals in thatmarket. In order to stymie programme trading, Japanese regulatorsimposed restraints on index futures trading in the Osaka FuturesExchange. In addition, the price was allowed to move only within tightlimits. Osaka let the Nikkei contract move to about 3.3% of currentmarket levels while SIMEX permitted a 10% fluctuation. Because of thisthe Osaka market was often suspended for most of the day, especiallywhen markets were volatile, leaving traders with no domestic benchmarkagainst which to buy and sell. Traders had to keep high margins with theexchange. Margins were raised four times in 1991 and in 1992, afterwhich margin stood at 30% of the value of the contract, of which 13%was a non-interest bearing cash deposit. In addition, dealers’ commissionswere required meet a minimum rate that the exchange had specified. Thisenabled SIMEX dealers to gain a competitive advantage by offeringdiscount commission rates that could not be matched at Osaka.

Within a few weeks of implementing these rules, trading began tomove from Osaka to SIMEX. Trading in SIMEX rose from 4,000 to over20,000 contracts per day. The success with the Nikkei 225 futures putSIMEX and Singapore on the global map. This was bad for Japan’sfinancial industry, which lost fees for brokerage, transactions, research,advisory, etc. However, it was good for users in Japan, who were notlocked into using their inferior domestic market: they were able to usethe offshore market even when policy makers disrupted the local market.

The Nikkei 225 futures now trade in Chicago, Osaka and Singapore.Japan’s regulators have since removed many of their restrictions, but animportant Nikkei 225 futures market remains in Singapore. This is partlybecause liquidity is hard to dislodge once it comes about. In addition,Japan appears to have problems with competition policy, and treatment offoreign firms, which translates to elevated transaction and brokerage fees.

Table: Nikkei 225 futures: an example of three levels of internationalcompetition on regulation and law

Aspect Example: Nikkei 225 futures

I. Banning of products and markets Nikkei 225 futureswere banned

II. Rules limiting the success of Restrictions onpermitted products and markets participation, and

high margins, inNikkei 225 futurestraded in Japan.

III. Intangible issues Trust in Japaneseregulatory mechanismsas seen by outsiders.

This case study illustrates all three levels of competition in export of IFS.At first, in the period after 1982, even though it was obvious from thesuccess of the S&P 500 futures in the US that there was a market for theNikkei 225 futures in Japan, the Nikkei 225 futures could not be launchedin Japan owing to legal difficulties with cash settlement. Japan thensquandered a head start owing to poor policy analysis in the aftermath ofOctober 1987, which led to restrictions against program trading, highmargins and regulated brokerage fees. Finally, SIMEX and CME were moreattractive for global order flow in terms of the intangible issues of trust.

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competition among firms, and competitionacross different financial ‘technologies’.Competition among firms is impeded byentry barriers in any kind of business.Competition across technologies is bestillustrated by an example: Money marketmutual funds and checking accounts arealternative technologies through whichcertain kinds of services can be obtainedby customers. Sound competition policyrequires that both these sub-industriescompete with each other in the marketplace.Any regime that blocks the growth ofchecking accounts in order to favour mutualfunds, or blocks the growth of moneymarket mutual funds in order to favour bankdeposits, limits competition and damagesconsumer interests.

The next question is that of a levelplaying field (E). It is related to competitionpolicy. It seeks identical regulatory treatmentof all firms. A key feature of an is thetreatment of foreign firms. One indicatoris the extent of protectionism embedded inthe regulatory system (E). This seeks tomeasure the treatment of foreign firms ina broad sense. It is like a level playing fieldquestion where a domestic firm is comparedagainst a foreign firm.

A key indicator affecting the perfor-mance of the regulatory system is the prob-lem of conflicts-of-interest. Financial reg-ulators tasked with various functions in fi-nancial regulation need to have clear goalsthat do not conflict with each other (E).For example, around the world, an increas-ing number of monetary authorities aretasked with achieving the single goal of pricestability. Separate institutions undertakeregulation and supervision of the financialsystem.

But, in India, in addition to the coregoals of monetary policy, the central bankas a regulator has other subsidiary roles.These include: protecting banks, enablingthe provision of subsidised credit in somesectors, running a bond exchange and adepository, and financing the public deficitat lower than real market cost. Can acentral bank that: is not constitutionallyindependent of government, has multipleroles, and is asked to achieve multiple non-monetary goals, possibly avoid multiple

conflicts-of-interest from arising on a day-to-day basis? Can it do so when thegovernment that is its apex authority, isalso the country’s largest owner of banks,owns other financial firms and is its largestborrower?

In the globally competitive game of ,innovation is the main source of competitiveadvantage. The impact of the regulatoryregime on financial innovation (E) directlyaffects success in establishing an . Thisissue is also related to the extent of regulatoryintrusiveness and micro-management ofmarkets and institutions (E). It is inimicalto succeeding in the global competitionfor . The ideal framework is onethat is principles-based, open, market-friendly and competition inducing (E).s with rules-based regulation, entrybarriers, low competition and opposed to theopen internationalisation of their financialsystems would score poorly on E.

Finally, the overall value of a regulatoryregime for finance is the extent to which itis conducive to efficient/effective resourcemobilisation and allocation (E). Asemphasised above, the choice of thesethirteen indicators, and the numerical scoresof each city, are necessarily subjective. Yet,these tables yield useful comparative insights.First, they permit an understanding of thestrengths and weaknesses of established andemerging s on these dimensions. Butequally important, for the present purpose,they put the spotlight on the weakest linksthat will inhibit Mumbai from emergingas an when compared with its globalcompetitors.

An examination of the values in thesetwo tables is revealing. As far as the overallscore for the quality and impact of finan-cial system regulatory regime is concerned,Mumbai lags behind both established andemerging s. London, with a score of , isthe benchmark that every seeks to em-ulate. New York and Singapore both scorean overall along with Sydney and Dubai.Hong Kong fares better at . Seoul andLabuan follow up with and respectively.Mumbai lags at . Regulation is clearly anarea where much needs to be done if Mum-bai’s aspirations to become an are tobe 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 FinancialSystem Regulatory Regime 9 7 6 7 5 3

E1: Ensuring Systemic Stability 10 8 8 8 8 7E2: Protecting Integrity and

Soundness of financial institutions 9 8 9 9 8 6E3: Capacity to Cope with Market and

Institutional failures 10 8 8 8 7 7E4: Sound risk management at all levels:

systemic, market, institutional 10 10 8 8 8 5E5: Effective consumer protection 8 7 7 8 9 5E6: Encouraging full and effective

competition across firms/segments 10 6 5 7 5 2E7: Ensuring level playing field for

all players in all market segments 9 7 5 7 6 2E8: Extent of Protectionism embedded

in regulatory system 9 6 5 5 4 1E9: Avoidance of conflicts-of-interest 8 7 5 6 5 1E10: Impact on Financial Innovation 10 10 5 5 4 1E11: Intrusiveness and micro-management

of markets/institutions 10 7 7 6 5 1E12: Principles-based, open, market-

friendly and competition inducing 10 7 7 6 6 1E13: 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 FinancialSystem Regulatory Regime 3 8 4 6 7 7

E1: Ensuring Systemic Stability 7 7 3 7 8 5E2: Protecting Integrity and

Soundness of financial instituions 6 7 5 7 8 6E3: Capacity to Cope with Market and

Institutional failures 7 9 3 7 8 6E4: Sound risk management at all levels:

systemic, market, institutional 6 7 5 7 8 5E5: Effective consumer protection 5 6 4 7 8 5E6: Encouraging full and effective

competition across firms/segments 2 8 5 7 8 9E7: Ensuring level playing field for

all players in all market segments 2 8 4 5 6 8E8: Extent of Protectionism embedded

in regulatory system 1 7 5 5 7 8E9: Avoidance of conflicts-of-interest 1 6 4 5 8 4E10: Impact on Financial Innovation 1 7 2 5 7 5E11: Intrusiveness and micro-management

of markets/institutions 1 8 5 5 7 5E12: Principles-based, open, market-

friendly and competition inducing 1 7 2 5 6 8E13: Conducive to efficient

resource allocation 2 7 3 6 6 5

A closer look at the numerical scoresshows that Mumbai has better scores – suchas , and – for indicators E throughE. Mumbai appears to match Frankfurt

on one indicator (coping with market andinstitutional failures) with a score of .Mumbai may have a slight edge over on these measures, though this partly reflects

110 R M I F C

the relative age of ; there is little doubtthat Dubai will strengthen these features astime passes and experience is gained withepisodes of failure.

Where Mumbai fares badly is on indica-tors E through E concerning competition,level playing field, protectionism, conflictsof interest, innovation, regulatory intrusive-ness, micro-management, and rules-basedregulation. Mumbai has to make progresson E through E, where it lags emergings by a small extent. But fundamentalrethinking is required on factors E throughE where both established and other emerg-ing s out-perform the Indian financialregime governance.

On balance, these constraints hamperthe ability of the financial system to performits core task: that of supporting efficientresource mobilisation and allocation (E).Here Mumbai fares poorly when comparedwith both established and emerging s.An interesting feature of indicators E to E

is that these are the areas in which Londonappears to fare better than New York. Adeeper understanding of the task facing theIndian authorities in making Mumbai isan is illuminated by the internationaldebate about the approach to financialregulation as opposed to the approach.Concerns in the that New York is fallingbehind London in these respects are reflectedin recent speeches made by the TreasurySecretary and by the Committee on CapitalMarket Regulation that has been set up tosee what can be done.

4. The overall legal regimegoverning finance

Underlying the key, but specific, questionof financial regulation are a broader set ofissues concerning the extent to which an jurisdiction adheres in principle to globallyaccepted standards for the ‘rule-of-law’ aswell as how such notions are applied inpractice. Specifically, where the provision of is concerned, global financial firms andinvestors place considerable emphasis on: (a)respect for property rights; (b) enforcementof creditor and shareholder rights; (c) theefficiency, cost and ‘fairness’ of recourse

to the legal system; and (d) the integrityand competence of the legal system as awhole and all its components for resolvingcivil conflicts and disputes and assuring theenforcement of contracts through recoursein real time.

invariably involve multiple instru-ments (underlying contracts accompaniedby a variety of risk management instru-ments) bundled under a single financialstructure (such as a syndicated loan or asovereign bond with features and conditionsattached). also involves complex finan-cial structures such as those involved withprivatisations involving the participation ofglobal investors and lenders, or arrange-ments involving municipal, state and centralgovernments acting in concert with privatecontractors, domestic and foreign, but withdistinct performance obligations (and penal-ties in the event of default or breach) foreach. These complex contractual structuresrequire commensurately sophisticated con-tract enforcement mechanisms.

An illustrative approach, using indica-tors and scores in the same way as above,is brought to bear on understanding thequality, efficiency, effectiveness and support-iveness of the legal system insofar as it affectsfinance in general and in particular. Thequality, efficiency and effectiveness of legalrecourse for redressing non-performanceunder contracts, is a fundamental ingredi-ent in the globally competitive provision of. In attempting that task, eight indicatorsare relied upon. The first (F) concerns theknowledge base (‘know-how’) that existsin a particular ; i.e. in terms of havinglaw firms, specialist lawyers and judges whounderstand and are experienced in the in-tricacies of dealing with complex financialcontracts.

Most established s are characterisedby the presence of global accounting, law andtax advisory firms employing professionalstaff at all levels who have worked inseveral s over many years. Theseinstitutions are familiar with not just thelaws and regulations of the jurisdictionsconcerned but of other s and the sourcecountries of global investors.

Though it does not yet have an 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 principleto the rule of law, underpinned by atime-tested constitution and a durable,resilient legislative democracy that has beentime-tested for six decades. At its apex,India is perceived as having a paradoxicalcombination of: (a) world-class knowledge,competence and sagacity about globalfinance, reposed in a few accomplishedindividuals with technocratic backgroundsand relevant practical experience; coupledwith (b) a lack of similar knowledge, andideological opposition, at other levels asto how the global economy and financialsystem function.

The legal system – in terms of its abilityto understand and deal with issues of inter-national finance – is perceived as capableat the apex level, but weaker at intermedi-ate and lower levels. The legal system inIndia/Mumbai is perceived by practitionersabroad as adequate by international stan-dards but not as knowledgeable about globalfinance simply because it has not had theopportunity to acquire such expertise. Theabsence of recognised global legal firms inIndia, with specific expertise and experiencein dealing with , provides some cause forconcern. That deficit represents a serious in-stitutional handicap if Mumbai is to becomean .

The second indicator (F) concerns theefficiency of the ’s legal system. It conveysa composite assessment of factors like: thelegal requirements and processes involved ingetting conflicts/disputes resolved throughthe legal system; interruptions and delaysin the progress of cases through the system;the backlog of cases in the civil system;the quality of decisions and incidence ofsuccessive appeals; the overall time takenfor dispute resolution; and the cost involved.The World Bank’s ‘Doing Business’ databasehas come out with numerical measures forthe number of days that it takes to settledisputes in various countries. This is relatedto indicator F. On this indicator Mumbaiwould not fare well relative to other s.

Most global investors seem aware thatthe concept of ‘real time’ appears to beelusive in Indian legal practice. That wassubstantiated by the late Nani Palkhiwalawho said that: “Anyone who does not

believe in eternal life has never litigated inan Indian courtroom”. The Indian civillegal system in every city at every levelseems beset by frequent interruptions anddelays in the way cases proceed. Thereis a phenomenal backlog of cases (severalmillion) in the pipeline. It can take up totwo decades for civil cases to be resolved;often after the demise of the original litigantsand their immediate descendants. Suchabsence of time-consciousness would bea significant deterrent to global investorsfrom using an in Mumbai. Undersuch circumstances, even if property orcreditor rights are respected in principle,they cannot be applied or enforced inpractice, simply because of the perceptionthat as many Indian eminent jurists haverepeated: “justice delayed is justice denied”.

Distinct from the time taken to resolvecontractual disputes through legal recourse,an indicator (F) of some concern toglobal firms operating in s, and toglobal investors, is the issue of probityand effectiveness of the legal systems in an, especially when it comes to enforcingjudgements, and applying the rule of lawin practice, as opposed to adhering toit in principle. Again, on this measure,India (Mumbai) would fare poorly whencompared with s in countries.

The next indicator (F) deals with issuesof integrity and probity across the legalsystem. It is an illustrative measure thatindicates the degree to which attributessuch as fairness, impartiality, and credibilitycharacterise the legal system in an , alongwith the relative presence or absence ofcorruption. Global publicity attracted byperceived miscarriages can affect the imageof a legal system adversely.

The fifth indicator (F) focuses on thequality (in purely technical terms i.e. by wayof professional competence) and the humanand institutional capacity of the legal system

No comparative scores have been provided forMumbai in these two tables. The felt that asthere was no in Mumbai, the basis for comparisonmight be misleading and controversial if numericalscoring was attempted to convey a spurious sense ofaccuracy. However it also felt in qualitative terms thatMumbai was quite far behind other s in these areasand much needed to be done to catch up with bestglobal 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 complexFinancial 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 legalsystems - enforcement and rule of law 7 8 7 8 6

F4. Fairness, Credibility, lack ofCorruption in civil legal system 7 7 9 10 8

F5. Human and Institutional Capacity andQuality of the Legal System 7 8 7 8 7

F6. Adherence to global benchmarks andstandards 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 LegalSystem Functioning 8 9 6 8 6

insofar as its capability for dealing with, andsupporting, is concerned. While thisindicator may involve a judgemental overlapwith the first indicator of ‘know-how’ (F) itis different in the sense that it attempts tocapture dimensions that go beyond simplythe ‘know-how’ aspect. F tries to capturea sense of the quality standards of legaltraining and expertise in dealing with issuesthat the provision of raises, the degreeof professionalism, quality of jurisprudence,depth and width of human capital, and theprofessional capabilities of legal firms andadvocates in comparison with their globalpeers. Again a comparison across establishedand aspirant s would reveal Mumbai ascomparatively weak as far as the capacityof the extant legal system for supportingthe provision of by financial firms inMumbai is concerned. But that weaknesscould be corrected quite swiftly if the willwas exerted to accomplish that.

In a similar vein, the sixth indicator(F) attempts to convey a sense of how wellextant s adhere to global benchmarksand standards of best practice in matters oflaw and legal support where the provision of is concerned. The seventh indicator (F)assesses the extent to which: (a) ‘nationallaw’ prevailing in an jurisdictiongoverns the provision of in/fromthat jurisdiction or whether contractsare governed by the use of foreign law(invariably or ) or international codes

(, , or ) when they areavailable; and (b) which foreign jurisdictionsare chosen by most s as centres foradjudication and settlement of disputes.Again, on these two indicators, Mumbaiwould fare poorly but then so do mostother s other than the three s andthose that use and law for their contracts as a matter of course. An attemptto make Mumbai an will require asubstantial improvement in the functioningof its legal system for this purpose.

Under the present circumstances itwould be unrealistic to assume – if an were to emerge in Mumbai – that Indianlaw covering contracts, or Mumbai as ajurisdiction for adjudication concerning ,would be immediately acceptable to globalparticipants. It is more likely that, as in mosts at present, or law would bechosen to cover contracts. Over time– with experience, expertise and credibilitybeing gained, along with improvements inthe operating and quality standards of theIndian legal system – it is more than likelythat Indian law could gradually be appliedto operations in Mumbai and becomeacceptable globally.

Finally, the eighth (F) indicator at-tempts to encapsulate information con-tained by all the previous seven indicatorsinto a composite judgement. Unsurprisinglyit reflects what has already been alluded toabove.

. Financial Regime Governance: Its role in an IFC and a comparative perspective 113

The two tables on the ability of theextant legal system to support the provisionof reveal a discouraging picture becausein our subjective judgement Mumbai lagsin all aspects. The four tables comparingdifferent s on financial regulation andthe legal system are particularly illuminatingin terms of two comparisons: againstShanghai and . While Mumbai mightbe competitive with Shanghai in theseaspects, that is not the case with ,whose legal governance and regulationis de-linked from the ’s legal andregulatory regime for financial services. It ispurpose-built for alone. hasa stated policy of hiring the best availablepractitioners from abroad to ensure thatregulation and dispute settlement at are of the highest world class standards;i.e. similar to those prevailing in the threes. That could give an edge to as a competitor to Mumbai (as an ) inattracting regional and global customers for. has a head start over Mumbai inthe process of complex institution buildingrequired for financial regulation and thelegal system governing its . It is willingto be flexible, adopt the best global practices,and has the resources as well as the politicalwill to employ the best people available in theworld, as regulators and for administeringthe special legal framework that has beenestablished for governing the operations of.

The second interesting comparison isHong Kong. Here, the traditional argumentmade in Indian circles is that the Chinesefinancial and legal systems lag far behindthose of India. That is undoubtedly true asfar as Mumbai competing with Shanghaias an is concerned. But China has anenormous asset in the form of Hong Kong, athriving well-established that has beenshaped by over a half-century of liberal lawand regulation based on the model.Hong Kong scores better than Mumbai onfinancial regulation and its legal system. Thisaffects India in two ways.

First, in the global competition for production, China may have a strongerposition than appears to be the case, ifthe institutional attributes of Hong Kongare taken into account. The caveat lies inwhether China will rely more on Hong Kongthan on Shanghai as its premier .

Second, if resource allocation in Chinais influenced by the way in which HongKong’s financial markets operate, that willcertainly improve the quality of capitalproductivity. This facet of having HongKong contradicts the stereotype that Indianfinance and law are far superior to Chinesefinance and law as far as provision isconcerned. A considerable deployment ofChinese savings, and fundraising by Chinesefirms, especially for the southern specialeconomic zones and the economic regionsurrounding 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 complexFinancial 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 legalsystems - enforcement and rule of law 7 5 6 8 5

F4. Fairness, Credibility, lack ofCorruption in civil legal system 7 5 6 9 5

F5. Human and Institutional Capacity andQuality of the Legal System 6 5 6 8 5

F6. Adherence to global benchmarks andstandards 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 LegalSystem Functioning 7 5 6 8 6

114 R M I F C

Hong Kong which outperforms Mumbai bya considerable margin as a financial centre.

5. Summary of cross-countrycomparisons

In summary, it appears that the weakestlinks in an Indian effort to compete with

other s are issues of financial regulation(E to E) and the overall weakness of itslegal system. These are the areas on whichthis report places great emphasis as needingimmediate strengthening if a viable isto emerge in Mumbai.

What are the limitations offinancial regime governance?

9c h a p t e r

1. Where do we stand?An IFS – Market × Playersmatrix

Apart from comparing financial regimegovernance in India with other globalmarkets as done in the previous chapter,an illuminating approach to understandingimpediments to production in Indiais to look forensically into what constitutes provision. That requires opening the‘black box’ to describe precisely what takesplace when different financial firms providevarious kinds of . This is done througha classification of into the variousactivities/markets discussed at some lengthin Chapter of this report along with aclassification of financial firms into tenbroad categories as follows:

BANKS

• Commercial Banks

• Private (not in the Indian vernac-ular sense but in the Swiss)

• Investment Banks and UniversalBanks

ASSET MANAGERS

• Mutual funds

• Insurance companies

• Pension funds

• Hedge funds

FINANCIAL EXCHANGES

COMMODITIES EXCHANGES

SECURITIES FIRMS

Combining the activities with the financial firm classifications, a 19× 10matrix has been constructed as a wallchart(see Appendix ). The rows indicate varioustypes of and the columns representvarious firms. For each kind of firm, ineach activity, the cells in the matrix

describe what takes place at an . Eachcell lists specific activities and accompanyingrestrictions. This can serve as a useful visualaide for Indian policy-makers to focus on theconstraints that hold back productionin India at present. The wallchart can bedownloaded from the M website.

There is an inchoate sense of discomfortin the Indian financial community thatregulation, more than any other variable,prohibits many mainstream activities frombeing undertaken by Indian financial firmsin space. The wallchart translatessuch vague discomfort into operationallyunderstandable specifics. In other words, foreach kind of , for each kind of financialfirm, the wallchart shows what each financialfirm does (or could do) in connection witheach kind of at an , and the state ofthe play in the Indian regulatory regime.

This report attempts to describe anddocument, as comprehensively as possible,what s do in clear detail and illustratehow much needs to be done in specific termsfor Mumbai to become a credible . Thewallchart conveys the present situation inMumbai by colour coding: green to identifypermitted activities; blue for restrictedactivities; and red for banned activities. ForIndia to become a player in the global space, the colouring in a large number ofcells will need to turn from blue/red to green,as is the case with other s.

The most remarkable feature of the wallchart is the extent to which it is coloured red.Most of the activities that global financialfirms undertake at s as a matter of courseare prohibited in India. This is only partlydue to capital controls. Careful examinationshows that many activities in India arenot banned because of convertibility

Bhattacharya and Patel () have an insightfuldiscussion about the difficulties of regulatoryinstitutions in India.

116 R M I F C

constraints. There are regulatory restrictionsas well, probably reflecting caution andconservatism on the part of regulatoryauthorities. That, unfortunately, stiflesfinancial competition and innovation.

The detailed wallchart, colour codedline by line, indicates prohibitions, permis-sions, and lack of restrictions with somespecificity for each activity in each cell. Itshows colour variations within cells of pre-scribed and proscribed activities. A con-densed chart colours each cell – rather thaneach line – in red, blue or green. The colourwhite denotes ‘not applicable’.

This simpler rendition, dominated byred, shows the imbalance between what isallowed and disallowed when it comes toproviding from India. It illustrates howsignificant are the restrictions: (a) bans onthe provision of financial products and ser-vices that are quite commonplace worldwide;and (b) excessive compartmentalisation of fi-nancial sub-markets in India by prohibitingcertain financial activities from being under-taken by different kinds of financial firms.

Restrictions on financial market oper-ations, instruments and services have notbeen sufficiently debated either academi-cally or by the authorities concerned. Thislack of debate is counterproductive for thekind of India that is emerging, and for thekind of financial system that a new Indianeeds.

In summary, the wallchart serves twopurposes. First, it documents the kindsof activities that are typically performedat an . Second, it shows where Indiastands in terms of regulatory barriersimpeding or obstructing the types of typically provided at an . The wallchartthus provides a finer-grained sense of theimpediments we face in competing in theglobal market. It provides a usefulchecklist for the task facing policy-makersand regulators in reforming and aligningfinancial regulation and policy to aim atenabling an to emerge in Mumbai.

1.1. A caveat about what the term“financial firm” implies in thematrix

The columns in the wall chart attemptto classify different kinds of financial

firms into ten categories or compartmentsthat are mutually exclusive. But it isimportant to emphasise that in an these are not watertight compartments.An does not specify that thereshould be only ten different types offinancial firms in broad terms. Financialfirms self-select the categories they placethemselves in. Large complex financialinstitutions (s in Basel parlance) thatoperate on a global scale, like and Citigroup, may embrace all tencategories under one brand, under aholding company structure. But differentand distinct intra-group corporationsmay undertake different activities likecommercial banking, investment banking,securities brokerage, insurance, and assetmanagement to conform to regulatory andmarket requirements.

Or, alternatively, a single firm –like Goldman Sachs – might undertakeany or all of these activities; sometimeswith multiple activities being undertakenby one firm, or through dedicatedsubsidiaries for each separate activity. Itmay choose different routes in differents depending on their particular rules.Competitive pressure is continually appliedby the market contestability of each ofthe ten categories. But the financialauthorities in any jurisdiction play no rolein constructing walls between differentkinds of financial firms to prevent themfrom competing with each other inundertaking whatever combination of theseactivities they wish in any way theywish.

Contrarily, in India, a ‘primary dealer’or a ‘mutual fund’ for example is seenas a self-contained firm that is highlycircumscribed in the business it is licensedto do. A ‘primary dealer’ in India canbe a primary dealer in government bonds,and has numerous regulatory restrictionson what other activities it can perform.By contrast, in a typical setting, aprimary dealership is merely one activityundertaken by sophisticated financial firms.These financial firms do a myriad otherthings – based on business strategy and notregulatory restrictions – apart from having aprimary 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

Comm

ercial

Priva

te

Inves

tmen

t

Mut

ual

Insur

ance

Pens

ions

Hedge

Fin. Ex

ch.

Comm

. Exch

.

Brok

ers/S

Fs

1 2 3 4 5 6 7 8 9 10Fund Raising

Equity

Debt

Composite

Asset Management

Discretionary (assets managedpurely by the manager; clienthas no involvement other thanbroad 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 keyareas for progress

The wallchart helps to illuminate for policy-makers those key impediments that restrain provision in Mumbai. Policy makerscan focus on specific cells in the wallchartmatrix with the aim of converting all the‘blue’ and ‘red’ cells into ‘green’. That canbe done by alleviating the regulatory andlegal constraints that prevent financial firmsin Mumbai from providing to theirdomestic clients and exporting them as well.

However, such an attempt on an item-by-item, rule-by-rule basis is unproductive.A more effective approach would be tolook categorically (rather than individually)into the more fundamental sources of thedetailed prohibitions on and deal withthem at their roots; instead of focusingon trimming single branches and leaves,the detail of which would divert attentionfrom the core problems that afflict Indianfinance. The case-by-case and rule-by-ruleapproach to problem identification andresolution is precisely what has preventedIndian finance from being transformed inthe same way that the real economy wastransformed in the mid-s; throughblanket reductions in tariff and non-tariffbarriers rather than product-by-product,rule-by-rule, and industry-by-industry.

A careful analysis of the wallchart, andthe comparison with other s, suggeststhree areas of policy that need to be focusedupon in a fundamental way:

• Competition policy: Examine the entrybarriers that hinder competition acrossfinancial firms and market segments andremove them.

• Segmentation of the financial servicesindustry: Examine the inefficiencies thatarise from subdividing financial activ-ities artificially and unnecessarily – tomake regulation easier or make certainactivities fall within the purview of oneregulator rather than another – into sub-industries with excessive constraints oninteractions and competition.

• Financial Innovation: Examine thecauses of an innovation-unfriendlyenvironment that limits the ability

of financial firms to create new products/services and to export them.

All three issues are tightly related to eachother and need to be seen in an integratedcontext. Segmentation adversely influencescompetition; poor competition adverselyinfluences innovation. believes thatthese three issues constitute the essence inunderstanding the regulatory constraintsthat inhibit India’s ability to engage inexport-oriented production.

3. Lessons from applyingcompetition policy in thereal economy

A generic issue that cuts across Indianfinance, but remains as yet unresolved,concerns the use of competition as a toolto drive financial system development andinnovation.

In a large, complex economy likeIndia’s – that is gradually but inexorablyshifting away from an autarkic model ofdevelopment to a more market-drivenmodel, and globalising rapidly as a result –the most profound insight gained from post- experience for modern policy-makingis the importance of competition. Therewas a time not so long ago (until the lates) when the centrality of competitionin Indian economic policy was treated asunproven conjecture. However, in the lastfifteen years, India has seen the impact ofgreater competition in the real economy withtradable goods and services. Competition isnow understood as being the most powerfultool for encouraging firms to innovate, adoptnew ideas, abandon counterproductivebeliefs and traditions, cut costs, and increaseexports.

That view was resisted powerfully bythe creme de la creme of Indian industryduring the early phases of trade and tariffreforms. The universal belief on the partof the country’s public as well as its mostprominent businessmen and intellectualswas that foreign goods were ‘naturally’better. Goods produced domestically undersub-optimal conditions would always beworse. The Mumbai Club claimed in – that, if exposed to global competition,

. What are the limitations of financial regime governance? 119

Indian manufacturing would die. Butsuch resistance proved ill-founded as eventsunfolded. India proved to be more resilient,flexible, adaptable and competitive thancommonly believed. Indian corporationsproved to have better management teamswhich were able to cope with global realities.The same industrialists who opposed suchreforms at the time at the time are now theirmost ardent advocates.

Indian firms are now growing fromstrength to strength, and becoming majors in their own right competing aroundthe world with companies from the ,, China, Japan, Korea and A.

Indian consumers have benefited fromgoods of much better quality being availableimmediately at much lower prices. Inflationin tradable goods has been kept downthrough import parity pricing.

Table . shows that Indian customsrevenues dropped from .% of importsin –, to .% in –. Over thissame period, Indian manufacturing exportsrose from $. billion to $. billion. Thisdata understates Indian export revenuegrowth since service exports are excluded.

The sharpest gains – a nearly three-foldgrowth of exports – were concentrated inthe recent period, from – onwards,where the customs collection rate droppedfrom .% to .%. This suggests thatthe gains obtained when going from veryhigh protection to high protection aresmaller than the gains obtained in goingfrom high protection to moderate or lowprotection. India’s emergence as an exportpowerhouse selling goods and servicesinto the global market began only aftera significant, though as yet incomplete,reforms initiative.

Policy reforms undertaken from to ignited manufacturing exports growthby injecting three kinds of competition into

For an early treatment of s emerging fromthe third world, see Lall ().

The measure of protectionism – customs tariffsdivided by imports – is a poor one, since it masks areaswhere high tariffs generate zero imports. There canbe situations where a reduction in protectionism isassociated with a rise in this measure. For the purposeof this table, “manufacturing” exports are defined asmerchandise exports while excluding agricultural andnatural resource based exports.

the real sector: i.e., lowering/removing:

. Barriers to entry in the domestic marketby new Indian firms

. Barriers inhibiting entry by foreign firmsinto the Indian market

. Barriers against the sale of foreign goodsin the domestic market.

These developments directly influencedthe ability of Indian firms to compete inselling overseas in the following three ways:

• Modified factor markets: The removalof entry barriers led to heightenedcompetition resulting in the exit of weakfirms, thus freeing up the labour andcapital controlled by these firms. Thisinfluenced the price at which healthyfirms could obtain labour and capital.

• Modified product markets: Ease ofimporting made imported raw materialscheaper. It ensured internationallycompetitive sourcing of local rawmaterials priced at import parity.

• Modified technology: The entry of for-eign firms brought technical knowledge.That set the stage for export from Indiaof goods and services of internationalquality. In a world where % of interna-tional trade is intra-firm trade withinmultinational corporations, the reduc-tion of barriers to into India was akey element that enabled exporting fromIndia. Foreign firms induced competi-tive pressure on Indian firms. That gen-erated incentives for Indian firms to ac-quire the knowledge (technology, design,quality and market research) needed tobecome globally competitive. Individu-als who gained this knowledge workingat foreign firms went on to work at In-dian firms and carried knowledge withthem. Export of software from India byIBM and Sun Microsystems is as much apart of the great Indian software story asexport by Infosys and .

Through these three channels, Indiacame to understand the intimate linkagesbetween the three pillars of competitionpolicy, and the ability of firms located inIndia (whether local or foreign) to competesuccessfully 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 12.11988–89 56.0 14.01989–90 51.0 16.61990–91 49.0 18.21991–92 46.5 13.81992–93 37.5 13.81993–94 30.3 17.31994–95 29.8 21.11995–96 29.2 24.61996–97 30.8 25.51997–98 26.1 27.41998–99 22.8 26.31999–00 22.5 30.22000–01 20.8 37.02001–02 16.4 36.82002–03 15.1 44.12003–04 13.5 54.02004–05 11.5 70.02005–06 10.2 86.3

With competition in any industry,Schumpeterian creative destruction steadilyreshapes the landscape of firms. It ensuresthat labour and capital gravitate towardefficient firms. Weak firms die. Strongfirms gain market share. The process ofcreative destruction is not neat or tidy.It involves social disruptions caused byfluctuations in market share, death of firms,and entry by new firms. However, there is afundamental distinction between a tidy andapparently stable industry – that is usuallyinefficient by world standards – as opposedto a competitive and efficient one.

When public policy seeks to preventuntidy events such as firms being kept aliveartificially, this gives rise to firms that areunviable in competitive markets, but stillkept alive on artificial ventilation by thestate. Three kinds of effects come into playwhen barriers to exit are erected. The firstis moral hazard. Managers of such firmsmake decisions knowing that they mightbe protected in a future eventuality. Thesecond is the competitive pressure exertedby such firms on the market. Healthy firmsare unable to make profits and invest, whenprices on the market are artificially drivendown by artificially-subsidised firms. Finally,such firms distort factor markets. Theymake claims on labour and capital that theycould not make in a truly competitive market

economy. Thus they drive up prices paidby healthy firms for these inputs. When anintervention is made to protect a firm frombankruptcy, damage is imposed upon theeconomy through these three channels.

Table . below provides empiricalevidence about the competitive dynamismachieved in less than years by the majornon-financial firms in India by comparingthe biggest firms of – against thosein –. The metric of size used isvalue added. This overstates the relativeimportance of natural resource extractionfirms: a firm like , which pumpscrude oil out of the ground and sells it atimport parity pricing, appears to generate alot of value added.

The most interesting feature of this tableis the new firms in the – ranking: (), Infosys (), Wipro (), RashtriyaIspat Nigam (), Bharti Airtel (), Satyam(), Hindalco (), and Nuclear PowerCorporation (). Eight out of the top

firms in – were not on the list in –. Many ranks have changed. The role of firms has been diminished. Apart from (which gained a rank) and (which stayed on top), all s experienced

is a new firm in –, but it is thecorporatised arm of which was present and largein – 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 32,7102 SAIL 2,781 2 BSNL 24,9413 NTPC 2,059 3 Reliance 14,3664 Indian Oil 2,011 4 SAIL 14,1155 MSEB 1,605 5 Indian Oil 10,6186 MTNL 1,136 6 NTPC 9,7807 Tata Steel 1,107 7 Tata Steel 7,3118 Air India 940 8 TCS 6,5409 BHEL 874 9 Infosys 5,703

10 Reliance 705 10 Wipro 5,00511 Tata Motors 700 11 GAIL 4,19912 Shipping Corpn. Of India 660 12 Rashtriya Ispat Nigam 3,67113 IPCL 594 13 Bharti Airtel 3,62414 BPCL 522 14 I T C 3,57115 Western Coalfields 495 15 MTNL 3,50616 Indian Airlines 477 16 BHEL 3,43317 L & T 466 17 Tata Motors 3,35118 NALCO 463 18 HPCL 3,15019 HPCL 457 19 Satyam 3,03120 I T C 440 20 Air India 2,99121 I T I 440 21 Western Coalfields 2,86422 Neyveli Lignite 424 22 BPCL 2,84123 A C C 411 23 Hindalco 2,79224 Century Textiles 400 24 NALCO 2,71725 GAIL 391 25 Nuclear Power Corpn. 2,661

Source: CMIE Prowess.

a decline in rank. The scale of creativedestruction amongst Indian non-financialfirms would show up more sharply if firmsengaged in natural resource extraction wereexcluded and only manufacturing firms werecompared.

The remarkable growth of Indianexports of goods and services in the sis intimately related to improvements incompetition policy. Most non-financialfirms now have zero possibility of agovernment rescue. That removes moralhazard and focuses the minds of managers.Firms buy raw materials from competitiveindustries, at import parity prices. Thatensures the cheapest-possible sourcing ofraw materials. The steady decline in customstariffs has brought input prices in Indiaclose to those found internationally. and imports have led to a flow of newknowledge into the Indian economy. Theecosystem of the Indian real economy hasbeen transformed by competition makingthe remarkable growth of Indian non-finance exports possible.

These lessons apply equally to Indian

finance. Indian finance now needs tobenefit from similar modifications inits factor markets, product markets andtechnology as were made in the Indianreal economy. The analogy is obviouswhen it comes to: (a) Indian exports of IFSto the world market; and (b) productiverestructuring of the Indian financial systemthrough creative destruction induced bycompetition.

India has enormous potential as acost-efficient, competitive producer of. But there is a gap between thepresent capabilities of Indian financial firmsand the requirements of the world market. The same situation characterisedIndian manufacturing industry prior to. It was overcome by the visionary

There is much synergy between an export-oriented real economy and an export-oriented financeindustry. The real economy consumes a large quantumof financial services. It would be more globallycompetitive if it was able to buy world-class financialservices at lower than world prices. Conversely,financial firms require purchase of non-finance inputssuch as computer hardware/software. The globalcompetitiveness of Indian financial firms would be

122 R M I F C

policies of a succession of governmentsfrom onwards. Through creativedestruction, Indian financial firms mustreinvent themselves just as non-financialfirms had to a decade earlier. They mustdo so in order to: (a) compete in the globalmarket and (b) improve the quality/rangeof their services in the domestic market tothe same level. Some may die in the processof doing so; and they should be permittedto. There is no room for inefficient Indianfinancial firms to exist any longer for anyreason. The operating environment of thenew India provides no room for toleratingthat. Inefficient and uncompetitive financialfirms, of any hue or ownership, do not justdiminish themselves. They compromisethe market and environment in whichmore efficient firms operate and competefor resources and customers. The marketprocess takes care of such firms throughfriendly or hostile acquisitions, mergers,and takeovers or, at the extreme, throughbankruptcy. That process must now beallowed to work in Indian finance. If itis not unleashed, India’s ability to competein the global market will be seriouslycompromised and dependent entirely onforeign firms.

The key instrument for achieving thetransformation of Indian financial firms – toprovide world-class at lower than worldprices – is competition. The same forcesthat induced competition for non-financialfirms will be just as effective for financialfirms. To repeat, they are the removal of:(a) entry barriers to domestic firms andcorporates; (b) barriers to the entry offoreign financial firms; and (c) restrictionsagainst import of . The creation of sucha policy framework will generate incentivesfor financial firms operating in India toprovide world quality financial servicescompetitively.

In the Indian financial setting, domesticentry barriers relate to the license-permitcontrols governing entry into a givenbusiness area by existing or new localfirms. Entry barriers against foreignfirms include barriers to , and

boosted by being able to buy world-class inputs at worldprices.

rules that disfavour foreign participants;such as those preventing foreign banksfrom doing government business. Theimport of financial services is restrictedlargely, though not entirely, via capitalcontrols.

There is widespread recognition thatsome segments of Indian finance has, as yet,failed to achieve the level of competitionnow visible in the real economy. TheNational Common Minimum Program(NCMP) of the UPA recognised thisproblem, and promised: “Competition inthe financial sector will be expanded”. Thathas not happened as yet.

Table . compares the ten largest banksin the country in – and in –. The largest banks in both columnsare remarkably alike. The new names of– are shown in boldface. Of these, was always a big bank. But it was noton the list for – because it was notclassified as a bank then but as a ‘financialinstitution’. Apart from that, there are onlytwo new names in –. When thistable is compared against the previous tablefor non-financial firms it is immediatelyapparent that competitive dynamism inbanking has lagged far behind industry andthe country.

There is an intimate link between theimplementation of competition policy andthe mechanics of exit. As argued above,sound competition policy requires that noagency be permitted to keep inefficientfinancial firms alive through: infusionsof capital from the exchequer; distortedregulation aimed at supporting weak firms;entry barriers; or a combination of all three.In extremis, in India the principal owner offinancial firms has on occasion pursued anti-competitive policies to help weak financialfirms accumulate retained earnings, andrecapitalise themselves in a non-transparentway at the expense of customers. Thesemaladies are typical in developing countrieswhere exit processes for financial firms areweak, competition is poor, and financialsystems are anaemic.

For a treatment of the difficulties of domesticbanking policy, see Hanson (); Mor andChandrasekar ().

. 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 46002 Bank of India 232 2 ICICI Bank Ltd. 16843 Bank of Baroda 213 3 Punjab National Bank 12644 Punjab National Bank 192 4 Canara Bank 11035 Canara Bank 164 5 Bank of India 9506 Uco Bank 117 6 Bank of Baroda 9467 Indian Bank 110 7 Union Bank of India 7248 Indian Overseas Bank 93 8 Central Bank of India 6889 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 differentglobal prospects and challenges. It maystill be a poor developing country interms of per capita averages. But itcan no longer afford to think or act likeone, when it is the world’s fourth largesteconomy in real terms, and an emergingglobal power in geopolitical terms. It hasreached an inflexion point of rapid growththrough domestic consumption and exportcompetition. That is likely to be maintainedfor some decades to come. There is no roomfor complacency, sanguinity or maintainingan unacceptable status quo in Indian finance.Policy mindsets, expectations and attitudesnow need to change as dramatically inpolitical, administrative, legal and regulatorycircles as they have in the corporate world.The public sector needs to catch up with theprivate sector and the world.

India therefore needs to apply marketcompetition policy as forcefully in financeas was done in the Indian real economy tocreate efficient firms capable of exportingIFS. Financial authorities need to removethe domestic entry barriers that presentlyexist. They need to encourage rapid entryby foreign firms, and remove barriers tothe open import of financial products andservices. That effectively means removingcapital controls as quickly as possible andnot on an ambiguous, opaque timescalethat can be stretched with infinite elasticity.Correcting competition policy in financerequires abandoning a preference for a tidy,stable and complacent financial servicesindustry still dominated by state-ownedfirms, many of which are uncompetitive anduninnovative. So are many small private

financial firms; but those do not pervade ordominate the system.

In a tidy and stable scenario financialfirms are not permitted to expire. Theestablished players remain the same, withlittle incentive to compete or innovate. Thisneeds to be replaced with a preference fora vibrant, efficient, competitive, world-beating financial services industry, whereentry and exit is taking place ceaselesslythrough a process of Schumpeterian creativedestruction. Financial sector policy shouldbe judged for the pace of entry and exit.

4. Artificial segmentation ofthe financial servicesindustry

At present, Indian finance is subdividedinto sets of firms operating in tightly sealedsub-industry compartments. There aretwo sources of segmentation: (a) rules thatprohibit emergence of s (i.e., financialconglomerates), and (b) boundaries betweenthe domains of multiple regulators. As anexample of the rules that prohibit complexfirms, consider a ‘primary dealer’. In aninternational setting, the term ‘primarydealer’ pertains to one activity of a complexsecurities-oriented financial firm. However,in India, the term ‘primary dealer’ isinterpreted to mean ‘a specialised financialfirm that performs only the task of primarydealership’. The regulatory frameworkgoverning a primary dealer in India prohibitsthe firm from doing many other highlyrelated activities on the securities markets,such as equity index arbitrage or commodityfutures market making.

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As an example of the boundaries be-tween the multiple regulators in finance, theseparation between and the ForwardMarkets Commission () has induceda separation between financial exchangesand commodity futures exchanges. In aninternational setting, an exchange is a placewhere all manner of spot and derivativeproducts are traded in a unified fashion.However, in India, the term ‘commodityfutures exchange’ pertains to ‘a specialisedexchange that performs only the one taskof trading derivatives based on commodityunderlyings’. The regulatory framework pro-hibits ordinary exchanges from trading incommodity futures, and commodity futuresexchanges from trading in non-commodityunderlyings. From an perspective, suchsegmentation damages India in three ways:

. It reduces competition. The essenceof competition is unpredictable entry.No software company could haveanticipated the entry of Wipro, a makerof edible oil, into the software industry.However, this entry did take place.Wipro is now one of the biggest services firms in the country as aconsequence.

If Telco (now Tata Motors) hadbeen prevented from producing cars,this would have been a tidy world ofsegmentation where truck companiesmade trucks and car companies madecars. But it would have been a worldwith inferior competition.

In a financial setting, a policyframework that hinders mutual fundsfrom competing with bank depositsthrough retail sale of money marketmutual funds, or prevents and from trading commodity futures,reduces competition.

As argued above, the most importantingredient of public policy to enableexport of from India is competitionpolicy, comprising three elements –domestic entry barriers, barriers againstforeign firms and barriers againstimports. Segmentation is a key domesticentry barrier.

. It results in the loss of economies ofscope and scale. A great deal of

provision involves correlated productsserving the same customers. Whena firm engages in providing multiplecorrelated products, knowledge of onearea spills over into another. Cross-selling to common customers takesplace. Risk is reduced by participating indiverse areas. These economies are lostthrough segmentation. Much financialservices provision involves increasingreturns to scale. Corporate strategyoverhead, core processing work using systems, brand building and advertisingall involve increasing returns to scale.

As an example, the ‘glass house’ withcomputer systems at an exchange canprocess ten times the number of tradesat three times the cost. The same ‘glasshouse’ at a bank can handle both bankaccounts and depository participantaccounts. These economies of scale arelost through artificial segmentation.

For example, the Indian notion of aprimary dealer is a firm that does low-risk trading strategies on the governmentbond market. However, these skills areeasily redeployed into market makingand arbitrage on currency derivatives,equity derivatives and commodityderivatives. It would be cost efficientfor the Indian-style primary dealer torun a % larger organisation whichdoes % more business, by harnessingeconomies of scope across these areas.

In the commodity futures setting, In-dia has taken the unique path of havingseparate sets of: commodity futures ex-changes and financial exchanges. Mem-ber firms are also forced to be separate.Each financial firm is forced to create aseparate subsidiary in order to trade onthe commodity futures market. This sub-division induces inefficiency and holdsback India’s export competitiveness. Itis analogous to a policy framework thatforced Telco to have separate companiesfor making cars and making trucks.

. It leads to a corrosive political economy

For a treatment of economies of scale in thesecurities markets, see Shah and Thomas ().Claessens and Klingebiel (); Claessens ()offer a discussion of economies of scale and scopein developing country financial policy.

. What are the limitations of financial regime governance? 125

in which sub-industries engage inpersuading governments to help toincrease their profits leading to pressuresoperating to modify or interpret aparticular rule in a particular way.Millimetric calibration of rules caninfluence the profitability of a primarydealer or the market share of banksin the depository participant business.As with Indian experience in the realeconomy, this induces a corrosivepolitical economy. When any suchagency has such powers over an industry,it is difficult for its functionaries tostay focused on the public goods ofregulation while being blind to thecompetitive market process and theprofits of alternative regulated firms.

Every large finance firm in India isforced to create multiple legal personalitiesfor participating in separate regulatoryponds. At a de facto level, these are unifiedfinance companies with all the complexitiesof conglomerate regulation. At the sametime, forced separation into multiple firmsinduces higher costs, the loss of economiesof scale and scope, and the consequent lossof export competitiveness.

There remains a ‘legacy affinity’ inIndia – left over from the pre- era –toward maintaining the tidy arrangementof firms and sub-industries in a plannedeconomy context. For many decades, thefinancial services industry was carved upinto neat little pieces, each of which wastightly compartmentalised. Each piece wasprohibited from competing with the other.The authorities viewed their role as that oftending to the interests of each sub-industry,in an attempt to be ‘fair’ to everyone. Insuch an environment, each segment hadminimal competition. A firm with a licenseto operate in any segment had a safe sinecure,with sustained profits, and a low-to-zeroprobability of extinction through its owndefault. The authorities could claim that astable financial sector had been built. Butsuch an approach misses the essence of amarket economy; which relies on the processof ceaseless, unpredictable and subversivecompetition. A functional market economyis the polar opposite of a planned economy

circumscribed by a license-permit-controlraj.

When a vanaspati firm is compelled tosell nothing but vanaspati, it makes the soft-ware industry less competitive. The essenceof market competition is based on open en-try by unexpected firms that produce in anunexpected way thus inducing sharp changesin the profits and market shares of existingplayers. It is this continual churning thatinduces efficiency, innovation and techno-logical change. In finance, that is what makesexporting possible and profitable andenables one to compete with another.

In providing , the most globallycompetitive financial firms are engagedin all manner of activities. A firm likeGoldman Sachs is involved in every elementof : it is therefore able to harnesseconomies of scale and scope. In recentdecades, the breakdown of rules that inducedsegmentation, such as the Glass-SteagallAct in the , has unleashed extraordinarycompetitive energies. Global securitiesfirms are now competing in areas thatwere once considered ‘banking’ and globalbanks are competing in areas that were onceconsidered ‘securities’.

5. Barriers to financialinnovation

Global competitiveness in the world of is dependent almost entirely oninnovation and much less so on fractionallyadvantageous cost-efficiency. Indian firmscan compete on entry in providing on the basis of cost-efficiency. But thatedge will disappear quickly unless they areable to innovate rapidly and continually. Ifthey cannot do so, they will not be able tocompete on a global scale over a sustainedperiod of time.

What may happen then is innovativeability (located in and financial

This apparently paradoxical link between thevanaspati industry and the software industry alludes toWipro – one of the top software companies in India.Wipro previously produced vanaspati, a hydrogenatedcooking oil. If the Indian State had barred firms thatproduced vanaspati from competing in the softwareindustry, and thus blocked production of software byWipro, it would have hurt competition and India’ssuccess in the software industry.

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Box 9.1: Case Study – The Clearing Corporation of India Ltd ()India embarked on an important innovation, by world standards, when

the idea of novation at the clearing corporation was applied to trades onthe OTC market. Traditionally, there was a divide around the worldbetween exchange ecosystems – that had transparent trading coupledwith risk management at the clearing corporation – as opposed to theOTC market. which had neither.

In India, it was felt that even if the problems of transparency in tradingcould not be addressed, it was possible to make progress by introducingrisk management at the clearing corporation. The clearing corporationwould interpose itself into transactions, becoming the legal counterpartyto both sides of the trade, and thus eliminate counterparty credit risk.

As argued above, a key feature of a sound financial sector is having aframework supportive of exit by firms. A clearing corporation is theinstitutional mechanism through which the externalities of firm failure arecontrolled. Even if a firm fails, counterparties on the OTC market are notaffected by that failure because the clearing corporation is thecounterparty. The introduction of a clearing corporation into the systemmakes it possible to lower entry barriers, by bringing in firms into the OTC

market that have weak credit. It also makes it possible to have financialsector policy framework where more firm failure and exit of weak firmstakes place in a smooth manner.

These ideas led to the creation of the Clearing Corporation of India Ltd.(CCIL). CCIL has undoubtedly been a valuable institution which has given amore modern, more stable financial system. However, the policyframework in which CCIL has operated has flaws on competition policy attwo levels:

1. Competitive conditions on the bond market and currencymarket

The raison d’etre of a clearing corporation is to lower entry barriers.Once the clearing corporation handles firm failure, there are no difficultiesin opening up entry to a large number of firms that might otherwise beconsidered weak credits. However, even though CCIL was created, bond

market participation and currency market participation has remainedrestricted to the small club of financial firms that existed before CCIL. Thekey economic benefit of building a clearing corporation – lowered entrybarriers – has not been obtained.

2. Competitive conditions for critical securities industryinfrastructure

CCIL has monopoly status in performing clearing services for fixedincome and currency markets. It is the only clearing corporation withaccess to clearing in central bank funds and connectivity into RBI

settlement systems. The other clearing corporation in India – the NationalSecurities Clearing Corporation Ltd (NSSCL) – is prohibited fromperforming these functions. This reflects the segmentation of the Indiansecurities industry into three parts, regulated by RBI, FMC and SEBI. Suchsegmentation, and the consequent loss of competition, is suboptimal.Particularly when dealing with the OTC market, it is easy to havecompetition between the two clearing corporation.

In a competitive policy framework, every player on the OTC market forcurrencies or fixed income would be free to choose between multipleclearing corporations based on price and services. Using cross-marginingarrangements between clearing corporations, it would be possible toobtain seamless functioning when the two counterparties to a trade arecustomers of two different clearing corporations. Such a competitiveframework would drive both NSCCL and CCIL to higher levels of costefficiency, quality of service and customer responsiveness, which wouldimprove India’s ability to export financial services.

The CCIL case is thus an ironic blend of intellectual success andopportunity lost. On one hand, India’s ability to conceive of an institutionlike CCIL, and swiftly translate the broad idea into a smoothly functioninginstitution, has been the envy of the world. But at the same time, thelarger policy problems of segmentation and faulty competition policy haveinduced a lost opportunity, whereby India has benefited less from thecreation of CCIL than could have been the case.

firms) may seek marriages with cost-efficiency (located in Indian firms) throughacquisitions and mergers on terms moreadvantageous to the innovators. Conversely,if an innovation-friendly environment issetup, then Indian financial firms (thatare more than intellectually capable ofinnovation) are likely to flourish. Theywill turn into financial s in their ownright and may even turn into predators(rather than be predated upon) and generatesubstantial export-revenues.

Innovation in finance is the creationof new products, new trading mechanisms,new contracting arrangements, and newkinds of finance companies. Innovation inIndian finance can be classified into twoclasses of ‘newness’:

• Catching up with the world: As anexample, cash-settled currency futuresare a familiar and well-proven idea on aglobal scale. They do not exist in India.The launch of currency futures tradingin India would constitute an innovation

for India but not for the world.

• New world-class innovation: One of thehallmarks of a first-class financial systemis its ability to steadily create innovativenew financial contracts and instrumentsto satisfy different risk appetites andneeds. New institutions and methods oftransacting are continually generatedby a dynamic financial system. Thebest Indian example is the deploymentof an idea from financial exchanges– the clearing corporation – intothe markets for currencies andfixed income, in the form of theClearing Corporation of India ().This was a genuinely new idea byworld standards, and translated into asuccessful implementation in India.

5.1. The economics of financialinnovation

Indian finance currently exhibits a very lowrate of innovation when compared with theworld. To explain this anomaly, superficial

. What are the limitations of financial regime governance? 127

explanations are often invoked. It is claimedfor example that because Indians naturallydefer to authority, or to elders, they are‘culturally’ unable to innovate. However, asexperience in industry and software serviceshas shown, Indian firms and individualscan excel at innovation when faced withdifficult global competition. What they havelacked is the incentive to do so. Hence,understanding the problems of innovationin Indian finance requires understanding theeconomic incentives that shape innovation,rather than invoking irrelevant superficialexplanations.

Innovations usually trigger regulatoryand policy concerns (Rajan and Shah, ):

• Who is the target? Is the targetsophisticated enough to understand anew financial instrument and benefitfrom it? Should the new instrumentbe restricted only to a smaller set ofsophisticated buyers?

• What risks does it pose to the system?Does the instrument/institution createuncontrollable or unmeasurable risks?Who will regulate its use (if that needsto be done)? How will the costs ofregulation be paid for?

• What are the tax implications? Howwill the instrument be taxed? Is it aninstrument merely to evade taxes?

• What new legislation does it entail? Isthe act covering financial instrumentsbroad enough to allow for the instru-ment? If not, does new legislation haveto be brought in? How can it be framedbroadly enough to allow the maximumcontractual freedom?

Policy makers and regulators governingthe financial regime inevitably and under-standably take time to consider and resolvethese issues. Firms proposing a new instru-ment or product have to invest considerableresources in awareness building, research,and persuasion to achieve the required pol-icy and/or rule-changes. A firm embark-ing upon innovation must weigh the costsand benefits from investing in new devel-opmental work. In a Schumpeterian world,the innovating firm secures a temporarymonopoly owing to a first-mover advantage

that provides the return on investment ininnovation. If the policy environment placeshigh costs upon the innovator, and slows itdown to a point where first-mover advan-tage is lost to competitors, then firms losethe incentive to innovate.

The public advocacy and policy workrequired to get innovations across inducesfocused costs on one or a few innovators.The benefits then become public, becauseall firms – whether pioneers or not –derive benefits from the policy and rulechanges. Under this environment, a singleprivate firm does not have the incentiveto persevere and push proposals throughhurdles in its way. It requires a specialpublic policy effort to create an innovation-friendly environment and for government topush through contractual and institutionalinnovations.

The process in the case of many recentattempts at financial innovation in Indiaappears to be too convoluted and time-consuming. This is illustrated by a series ofexamples.

Example: stock index futures. Box .shows a chronology of how trading in thesimplest possible equity derivative, cash-settled index futures, came about in India.This process took from th December

to th June , a delay of . years. Afurther three years lapsed in dealing with firstorder difficulties of regulation and taxation.In this case, the innovator () could havehad a five-year head start. Instead, tradingon actually started a few days before and trading on started a few dayslater. captured no temporary advantageby invested in innovation.

Box 9.2: Case study – Stock index futuresTable: Chronology of stock index futures

14 Dec. 1995 NSE asked SEBI for permission to trade index futures.18 Nov. 1996 SEBI setup L. C. Gupta Committee to draft a policy framework for

index futures.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.25 May 2000 SEBI permitted NSE and BSE to trade index futures.09 June 2000 Trading of BSE Sensex futures commenced at BSE.12 June 2000 Trading of Nifty futures commenced at NSE.25 Sep. 2000 Nifty futures trading commenced at SGX.

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Box 9.3: Case Study – Collateralised Debt Obligations ()The difficulties and delays faced in financial

innovation are also illustrated by the firstsecuritisation of corporate debt; a processworth describing in some detail. As of 1997 orso, there were four impediments which madeit difficult to undertake transactions involvingsecuritisation of corporate debt:

• When an asset-backed loan is sold, theexisting laws erroneously require a stampduty to be charged on the ‘transfer’ ofcollateral from one lender to the next.

• In a securitisation transaction, it is difficultto handle the withholding of tax, since itis not possible to decompose taxdeduction at source (TDS) certificatesamongst multiple investors.

• The special purpose vehicle (SPV) thatwould be the centrepiece of securitisationis not immune to income tax.

• The SPV needs to be made bankruptcy –remote from the sponsor, in two senses.If the sponsor goes bankrupt, then thecreditors of the sponsor should not havea claim on the assets of the SPV.Conversely, financial profits or losses tothe SPV should not impact on the sponsor.

In 1998 or so, it was understood that themutual fund was the only structure in Indiathat met all but the first requirement.Elsewhere in the world, trusts are used for thepurpose, but Indian law does not support this.

• In 1999, an RBI committee endorsed theuse of mutual funds as the vehicle forundertaking these securitisationtransactions.

• In 2000, the ‘Rajasthan route’ wasdesigned, because local laws in Rajasthando not require charging stamp duty onthe transfer of collateral when anasset-backed loan is sold. Using thisbypass loans are now converted into ’passthrough certificates’ (PTCs) which can betraded.

• In October 2000, a private bankattempted one securitisation transactionusing the mutual fund vehicle and theRajasthan route. Investors did not buy thisproduct.

• In March 2002, this bank attempted animproved design for a product thatsecuritised roughly Rs. 500 crores of abond portfolio and broke it up into a

three-tier seniority structure.

The launch of this product faced fourimpediments:

• RBI regulations did not respect thebankruptcy – remoteness of the mutualfund. This would force banks to viewthese securities as credit risk of theprivate bank. That distorted their pricingand acceptance.

• IFC intended to purchase the middle tierof the three-tier seniority structure. RBI

intended to forward this foreigninvestment application to the FIPB forapproval.

• The existing SEBI regulations limitedmutual funds from investing more than5% of their corpus in other mutual funds.This impeded purchases by mutual fundsin this securitisation transaction (whichwas packaged as a mutual fund scheme).

• NSE’s rules did not see PTCs as securities,and impeded listing of PTCs.

Example: Collateralised debt obligations(s). Box . shows a case study ofCollateralised Debt Obligations (s).Unlike the case with and exchange-traded derivatives, where there was just oneproblem (obtaining approval for tradingindex futures) this example illustrates thedifficulties of creating complex financial

products that have to deal with: (a) anoutdated legal/tax environment and theneed for creative solutions to tax/legalimpediments; and (b) multiple regulatorsto come up with regulations adapted tobringing new products to the market.

On an international scale, the is a perfectly mainstream and ordinary

Box 9.4: Case study – Exchange-Traded Fund () for GoldAn important new class of ‘mutual fund’

instruments that has emerged globally is theExchange Traded Fund (ETF). The ETF is like atraded depository receipt. The fund holds apre-defined portfolio. Units issued by thefund are traded on the secondary market. Forexample, an ETF implementation of an indexfund consists of the fund holding the marketindex portfolio, and issuing depositoryreceipts on the underlying portfolio, whichare traded on the secondary market.

ETFs may appear to be like closed-endfunds, but they differ in two respects: (a)Closed-end funds are not depository receipts;investors cannot present their units to thefund and exchange them for the underlyingassets, and (b) Closed-end funds retaindiscretionary power of portfoliomanagement, while ETFs pre-specify what

the underlying asset portfolio will be.An ETF on gold is a natural and small

innovation on top of the basic idea of the ETF.Under this structure, the mutual fund wouldpurchase the gold linked paper issued bybanks under the Gold Deposit Scheme, 1999,or to ‘dematerialised’ gold warehousereceipts. The mutual fund would issuedepository receipts (units) equivalent to 1gram of gold that would be traded on thesecondary market. This would allowtransparent trading of gold, in a unit sizethat is amenable to retail participation. Theseunits could be a convenient avenue forinvestment in gold by individuals, instead ofdealing with physical gold.

In India, Benchmark Mutual Fundproposed a Gold ETF in May 2002. It wouldhave been the world’s first Gold ETF, and arare instance where financial innovation

emanated from India. For gold ETFs to comeabout, mutual funds need to be permitted toinvest in paper issued by banks under theGold Deposit Scheme, 1999. Their approvalsprocess involves both SEBI and RBI, and is asyet underway despite one budgetannouncement about this issue. In theinterim, Gold ETFs were launched at NYSE

and the Australian Stock Exchange, and havebeen modestly successful.

The delay in this approval process hasturned India from being an innovator tobecoming a follower. In this case, theinnovator (Benchmark) lost all the resourcesinvested in innovation. When the problemsare resolved, it is likely that two or threemutual funds will launch gold ETFs onroughly the same date as the launch date ofBenchmark.

. What are the limitations of financial regime governance? 129

Box 9.5: The introduction of interest rate futures in the – a case study in innovationIn 1975, the Chicago Mercantile Exchange

(CME) obtained permissions to do the firsttrading of interest rate futures in the world.The then CEO of CME, Leo Melamed, tells thisstory on page 235 of this book Escape to theFutures. The following text is a verbatimextract from this book. Mark Powers,mentioned in the story, was Chief Economistof CME at the time.

Unlike our listing of currency futures fouryears earlier, which required no federalapproval, this time around, new contractsrequired approval by our newly establishedfederal regulator, the CFTC. That approvalwouldn’t come about without some fancyfootwork on our part.

It was deja vu. First, I recruited BerylSprinkel, now an IMM director, to set up ameeting with his former professor ArthurBurns, chairman of the Federal Reserve. Thatwas pivotal to the approval. The meeting thatfollowed in the boardroom of the Fed, whichalso included Mark Powers, is foreveringrained in my memory and could make aninteresting and funny story. Both Burns andSprinkel were heavy pipe smokers and I, ofcourse, was still a chain smoker. Between thethree of us, the smoke was so thick we couldhardly see each other.

“What a clever idea,” said the chairman ofthe Fed after we explained what we had inmind. “Such a futures contract would be usedby government securities dealers, investmentbankers, all sorts of commercial interests aswell as speculators, isn’t that right?”

“Yes,” Sprinkel and I agreed. “Itsparticipants would include every segment ofthe commercial and speculative world.” Wetalked further about the value of this contract,until the Fed chairman fell into his thoughts.Suddenly, he had a bright idea.

“In such case,” Dr. Burns said, “this futurescontract would become a terrific predictor of

the direction of interest rates, isn’t that right,Beryl?”

Beryl Sprinkel hesitated and looked to mefor guidance. I didn’t know the answer, so Ilooked up at the ceiling and watched thebillows of smoke that had gathered there.Mark Powers too remained silent. After anembarassing pause, Beryl thought of anoncommital response, “Well, Mr. Chairman,it will probably be as good as the FederalReserve’s own econometric model.”

“That,” said the chairman of the Fed with alaugh, “isn’t worth a shit.” It was a refreshingbit of honesty.

That meeting with Dr. Burns evolved into afriendship after I discovered that he and hiswife were Yiddishistin like my parents. At theirrequest, I found for them the works of I. L.Peretz in Yiddish which Dr. Burns took withhim when he became U.S. Ambassador toGermany. Having survived this hurdle, I nextsought and gained the support of AlanGreenspan, who at the time was chairman ofthe Council of Economic Advisors ( CEA). Themeeting with him was a shot in the arm.Before I could fully explain our plans for afutures contract in T-Bills, Greenspaninterrupted.

“What a great idea,” said Greenspan, whowas destined to become one of this nation’smost admired Federal Reserve Board chiefs. Hethen proceeded to rattle off a dozen uses forsuch a market, some of which we hadn’t evenconsidered. In short, this meeting made him afriend, which he has remained throughout theyears. Our friendship was of particularimportance at the time of the 1987 stockmarket crash.

As I was leaving his office, I got a bonus bybumping into Herbert Stein, Greenspan’spredecessor at the CEA. Like any goodevangelist, I immediately expounded on whywe were there and asked his opinion. Without

hesitation Stein quipped, “I don’t opposeanything between two consenting adults”.

I next turned to the CFTC. CommissionerGary Seevers quickly understood the potentialvalue of these new interest rate products andbecame a valuable ally. But now it was up toBill Bagley, the CFTC chairman. I tried toimpress Bagley with the fact that many federalofficials were already aboard. But Bagley didnot have any financial background and wasafraid to take the responsibility for such arevolutionary decision.

“Leo,” he implored, “I love you like mybrother and want to do it, but I need someonehigher up to give me an okay.”

“How high up?” I inquired, thinking maybehe was looking for divine intervention.

“Well,” Bagley responded, “aren’t T-bills theproperty of the U.S. Treasury? Maybe we needapproval, in writing, from someone like theSecretary of Treasury, William Simon.” (Note:The US Secretary of Treasury is equivalent tothe Indian Minster of Finance).

A tall order. Simon was a fairly new name inWashington D.C. And E. B. Harris’ connectionsprovided me with no go-between. To gowithout proper protection seemed wrong. So Ibegan to call around to some of the seniorofficials of our clearing members to see ifanyone knew Bill Simon. Sure enough, I hitpaydirt. Sanford Weil, the chief of Shearson &Co., was a friend of the Secretary of Treasury.Weil was also a shrewd market analyst andsensed the great potential of our T-billcontract. He agreed to help. I then took oneadditional precaution. I called on MiltonFriedman and asked him to again weave hismagic. Friedman obliged by calling Simon and,by the time Sandy Weil and I appeared beforehim at the Treasury in the winter of 1975, itwas a done deal. He quickly agreed andsigned the prepared approval letter to Bagley.

product. But in this case, the innovator(a private bank) wasted resources invested ininnovation, because, in the end, the failed to overcome regulatory constraints.The lack of the remains a critical weaklink in the modernisation of the Indiancredit market.

Example: Gold ETF – an Indianinnovation that might have been. TheGold case, described in Box ., isparticularly interesting from the viewpointof examining the phenomenal bottlenecksfaced by financial innovation in India.For this reason, a detailed chronology ofevents is offered in Appendix . As of the

date of this Report (January ), theGold had not yet been launched inIndia. In parallel, important internationaldevelopments have taken place. talked with World Gold Council ()in June , who agreed to market theGold for . waited for theIndian product launch till the end of .In , initiated a process whichresulted in the Gold being launchedin Sydney at the end of . thentook the new idea to London and in . The Gold now has $

billion in assets, thus making it a successfulproduct.

130 R M I F C

On th September , the LondonStock Exchange launched a new marketsegment for ‘exchange traded commodities’that would trade s on commoditiesincluding cattle, coffee, corn, lean pigs, sugar,wheat and baskets of commodities such aslivestock and energy. If India had createda more innovation-friendly environment,then by end-, India could have been aworld leader with s on commodities.Instead, events in India resulted in this ideataking root in New York, London and Sydney,while India is content to lag behind.

For an international comparison,Box . recounts the story of the firstintroduction of interest derivatives in theworld. It shows a remarkable intellectualcapacity in the US government and in theindustry to understand innovation and toallow progress to take place.

5.2. An innovation-unfriendlyenvironment

These experiences highlight the hostileenvironment faced by innovation in Indianfinance. If continued, such an environmentwould compromise the prospects of Mumbaiever emerging as a competitive and viable. The present financial regimegovernance hinders innovation. It sendsout strong incentives to individuals andfirms to avoid business plans that involveinnovation. It biases the labour market tofavour staff focused on routine operations asopposed to developmental and innovativework. Contrast this with the environment inwhich interest rate futures were developedin the as illustrated in Box ..

Why does financial regimegovernance have these

limitations?

10c h a p t e r

1. Why is the pace of financialinnovation slow?

The design of a reforms process aimedat improving financial regime governanceneeds to flow from a diagnosis of the sourcesof difficulties. There are a number of obviousoperational reasons as well as proximatereasons and deeper sources of dysfunction.

1.1. Regulators are preoccupied withaverting scams

In an ideal world, regulators evaluating theirimpact on financial system developmentneed to weigh in a balanced fashion three im-portant factors: (a) encouraging progressiveimprovement in the capability of the domes-tic financial system; (b) improvements in itsglobal competitiveness; and (c) the risk offinancial regime reputation loss in the eventof firm/market failure or default. However,the incentive structure faced by regulators inIndia attaches low priority to improving thequality of domestic resource allocation byfinancial markets, or on achieving greaterinternational competitiveness. Indian regu-lation appears disproportionately focusedon averting financial scams. This generatesa regulatory bias of blocking innovation inorder to be safe, and an industry bias ofavoiding untested ideas since they exposefirms to indirect risk when the next failureoccurs.

A more nuanced but realistic regulatoryperspective might be to recognise thataccidents will happen even with the bestregulation. But they will be fewer andless fatal. The only way to avoid accidentsaltogether is to choke traffic with toomany roadblocks, or stop it from flowingaltogether. Air-crashes occur; but that doesnot imply airlines should be regulated out

of flying or, because road crashes occur,that no traffic should be allowed to flow.In India financial regulation has put somany roadblocks in place that financialinnovation can only occur at a snail’s pace.Worse, the road to financial innovation inthe st century cannot be travelled at anyspeed by regulation that results in India’sfinancial firms remaining the equivalentsof antediluvian Ambassadors and Fiats inIndia’s financial services industry when therest of the world is using s and Ferraris.Every year, the gap between Mumbai andLondon is growing, not narrowing.

A more appropriate regulatory viewmight be to accept that even the best-regulated financial system will have somesmall problems (of less than say Rs.

crores or Rs. billion). That is one basispoint compared to total financial assetsof over Rs. lakh crores (Rs. trillion).The efficient safety level is not %. Eachpercentage of point of safety beyond %has a disproportionately higher cost; onethat increases in logarithmic rather thanlinear fashion – and one that is not worthexpending.

In that context it should be notedthat the evidence accumulated over thelast decade in the (when comparedto the ) suggests that principles-basedregulation might be more effective thanrules-based regulation, in averting damagingfinancial malfeasance. That is because itrequires financial firms to conform not justwith the letter of the law (rules/regulations)but with its spirit as well. It co-opts thefinancial firm into becoming an integralplayer, along with the regulator, in acascading and co-operative (rather thanadversarial) process of self-regulation at the

132 R M I F C

level of the individual, firm and market.Principles-based regulation avoids the riskof turning financial firms (as well as theirlawyers, accountants and tax advisors) intoguerilla game-players that ceaselessly focuson beating or side-stepping the rules in orderto gain a competitive edge in the financialmarketplace.

A rational cost-benefit analysis inthe form of regular ‘regulatory impactassessments or s’ (standard practicein most countries) therefore needsto be undertaken to compare the costof inefficient resource allocation (e.g.,through financial preemption) against thecost of tolerating the occasional smallscandal by loosening regulation to permitmore financial flexibility and innovation.Such an analysis might suggest that:achieving allocation efficiency throughbetter functioning of the financial systemwith an investment ratio of % of (i.e.,Rs. trillion) per year, and the avoidance offinancial preemption, might be importantenough to pay for a scandal costing around.% of (roughly Rs. billion) onceevery few years.

1.2. A de facto shift towardsover-prescriptive regulation inIndia

Given its legal heritage, India started outwith a more open basis of law based not onexclusive reference to a codified constitution,but on equal respect for the evolution ofprecedent based on trial-and-error. Butover time it has moved relentlessly towarda style of regulation under which everyminute detail is either written into the basiclegislation or into detailed subordinatedrules and regulations. Under such asystem if something is not specified, it isproscribed; or conversely, if something isproscribed then non-proscribed activitiesremain contentious as to whether they arepermissible or not.

For example, a Committee onGold s did the kind of preparatorygroundwork that a financial firm, and nota regulator, should do – i.e., it designedan alternative product structure. In theprevailing financial governance regime, ev-ery detail of financial product and market

mechanism is written down in meticulousdetail either in the law or in subordinatedlegislation. The consequence of this ap-proach is that every financial innovationrequires interminable changes to be madeto either governing laws, subordinated reg-ulations or both. This raises the cost ofinnovation considerably. It deters financialfirms from innovating because the returnsfrom investment in innovation are rendereduncertain.

By contrast in the the approach toregulation permits financial innovations tobe tried and tested almost instantaneouslyby financial firms in markets with largesophisticated customers at their own riskand with full customer awareness. If theinnovation works, the regulators step in tosee how the risk involved (to customers,firms and markets) can be diminished andmanaged better until the product becomesaccepted as standard. This more innovation-friendly approach perhaps explains whyLondon is so successful as an whilefinancial frauds of Enron, Worldcom, Tycoand Arthur Andersen dimensions continueto occur in the despite the best rules-based regulation in the world.

1.3. Regulatory architectureA major source of delay is fragmentationamong regulators and uncertainty aboutwhich one will regulate new instrumentsand markets. Modest innovations likethe Gold , interest rate futures orcurrency futures – which would not becalled innovations outside the countrygiven their extreme degree of obviousness– run afoul of inconsistencies and turfbattles across the multiple regulatoryagencies. The problem is particularly acutewith organised financial market trading,regulatory responsibilities for which arespread between three regulators: commodityderivatives are regulated by the ForwardMarkets Commission (); equity spotand derivatives and corporate bonds areregulated by ; government bonds andcurrency trading are regulated by .

1.4. Lack of competitionThe: (a) lack of sufficient competition in thefinancial services industry: (b) pervasiveness

. Why does financial regime governance have these limitations? 133

of public ownership; and (c) over-compartmentalisation of sub-sectors; resultin easy profits being made through sub-optimal performance by existing players.Clearly the situation has improved since. But much remains to be done tointroduce greater competition in Indianfinance; especially in banking services.

That competition needs to be acrosslarger, more capable players rather thanamong a plethora of small weak, under-capitalised players that cannot captureeconomies of scale or make the kinds ofinvestments in people, training, technologyand research into product development thatsupports innovation. The Indian financialsector needs a wave of consolidation –through acquisitions and mergers, amongprivate and publicly owned institutions –for its financial firms to be strong enoughto compete as aggressively with each other,and with foreign firms, in Indian and globalmarkets as they should. A license to operatein a certain area of Indian finance is, alltoo often, a safe sinecure with stable profitsand a near-zero probability of death. Thereis therefore little incentive to innovate toremain competitive. This is not unlike firmsin the real economy before .

For a shift into a high-innovationregime, both carrot and stick are required.The stick would be the introduction ofcompetition: entry barriers in domesticfinance and protectionism need to beremoved. The carrot would be thesignificantly reduced cost of innovation thatwould result from a different regulatoryattitude and approach. In addition, a shiftfrom a domestic-focused financial sectorto an -focused financial sector wouldinduce the associated carrot of enormouslylarger market size.

2. Proximate underlyingreasons that are not astransparent

To some extent, these constraints toinnovation are a hangover of the systemof controls that pervaded the Indianeconomy in preceding decades. Oncepolicy makers become aware of the

deleterious consequences of these aspectsfor India’s ability to build export-oriented, progress should be relatively easy tomake. However, far-reaching progress –which is of essence in achieving the goal ofmaking Mumbai an – will not be madeuntil the ‘proximate reasons’ and ‘deepersources’ of these problems are addressed.A strategic understanding of the reformeffort that is required for making Mumbaian requires an understanding of theseproximate reasons and deeper sources.

2.1. Financial preemptionIn a mature market economy, finance mustinteract productively with the decision-making of private economic agents andshape the resource allocation emerging outof these decisions as efficiently as possible.But Indian finance has a history of financialpreemption. Formerly, the task of financewas seen as mobilising resources for theimplementation of socialism at two levels:first, to fund fiscal deficits on below-marketterms and second, to direct the supply ofresources into socially important areas underthe guidance of planners rather than therules of the market.

Most policy-making in finance in pastdecades, has been shaped by financialrepression: i.e., forcing finance to allocateresources based not on economic efficiencybut to channel it in ways sought by thestate. Strong elements of financial repressioncontinue to be in place: e.g., the lackof a properly functioning bond market;forced government bond investments bybanks, insurance companies and pensionfunds; directed credit; specialised financialinstitutions catering to the goals of policymakers. All these dimensions derive fromfinancial repression. Epiphenomena such asflaws in competition policy, segmentationand barriers to innovation, are rooted in thisdeeper system of appropriation by the Stateof financial resources.

2.2. Capital controlsFlaws of competition policy, segmentationand barriers to innovation have been enabledand perpetuated by capital controls. As hasbeen seen in India’s real economy, if foreignfinancial service providers were able to bring

134 R M I F C

genuine competition to bear against localfirms through unrestricted entry, this wouldrapidly change the behaviour of local firmsand of policy makers.

2.3. AutarkyFlaws in competition policy, segmentationand barriers to innovation have been enabledand perpetuated by an autarkic mindset thatfavours Indian firms at the expense of foreignfirms in a manner considered so routine and‘natural’ that the counterview is deemedunpatriotic.

The provision of from an is uncompromisingly international. Theplayers, the regulator and the legalframework have to be designed for globalparticipation and competition, avoidingthe traditional instincts of falling back intoautarky. Indeed, in s, an autarkicmindset would be opposed by nationalfinancial firms. Box . shows a fascinatingexample of the thought process at the on the relationship between tradingin the and trading in the .

India’s experiment with autarky from to , where the trade/ ratiofell from % to % is well known to be afailure. From onwards India has beenreintegrating into the world. At first, thetrade/ ratio rose slowly, returning tothe % level only in . In recent years,the growth of trade has been more frenetic.The trade/ ratio has risen from % in to % in . This growth of tradein goods has been exceeded by growth oftrade in services. India has made significantprogress on reintegrating into the worldeconomy since . Yet, policy-making intoo many areas remains dominated by anautarkic ethos. This is clearly manifest in thedegree of protectionism in finance. Whilefar-reaching trade reforms have taken place,and India is now perhaps two to three yearsaway from -quality trade barriers,foreign firms continue to be barred fromoperating freely in numerous parts of Indianfinance.

As Table . above shows, global is dominated by a small number ofimportant global firms. Nearly % of globalcurrency trading is accounted for by just firms. India has many good financial

Table 10.1: The role of the largest firms in global currencytrading, May 2005

Firm Share in totalvolume (%)

1. Deutsche Bank 17.02. UBS 12.53. Citigroup 7.54. HSBC 6.45. Barclays 5.96. Merrill Lynch 5.77. JP Morgan Chase 5.38. Goldman Sachs 4.49. ABN Amro 4.2

10. Morgan Stanley 3.9All other firms put together 27.2

Total 100

Source: IFSL, http://tinyurl.com/yzg4mj

firms. Realistically, no Indian firm is goingto break into this top- ranking in the nextdecade. But in the following decade it isentirely possible that an Indian financialfirm may be able to buy or merge withone or more of the global big ten. Thebulk of jobs created by an in Mumbaiwill almost certainly be created by foreignfinancial firms. Hence, for Mumbai tobecome an , it is absolutely essential thatkey global financial firms consider Mumbaias a location to shift their business to.

For Mumbai to become an that caneventually compete with s, the policygoal has to shift away from championing theimmediate short-term interests of Indianfirms and shareholders to championing theinterests of Indian employees. Too often, thediscourse between the Indian governanceregime and global financial firms has beenone where India has tried to prevent globalfinancial firms from participating in India.For Mumbai to become an , that legacywill need to be reversed. All the armsof the Indian state should seek to attractparticipation by global financial firms inIndia for the export of . That mayrequire opening up its market for domesticfinancial services. While Indian financialfirms may resent that competition, as inthe real economy, they will be better off

in confronting it and so will the Indianconsumer.

This change would be similar to thatwhich has taken place in manufacturing– where India once tried to block foreign

. Why does financial regime governance have these limitations? 135

Box 10.1: Internationalisation of financial regulation: an exampleAs electronic trading platforms and cash

settlement allow derivative contracts onanything to be traded anywhere in the world,the principle of ‘local regulation of localmarkets’ has become difficult to apply. Whereis a financial market located when it operatesin the ether? Is it the jurisdiction in which theexchange chooses to locate its computers? Ordo we have to consider the nationality of theowners of the exchange or the nationality ofthose who trade on the exchange or thelocation of the principal cash market for theunderlying contract?

A recent example highlighting theimportance of these questions is the ability ofthe US based Intercontinental Exchange (ICE) tooffer US energy contracts to US investorsthrough its own terminals without attractingUS regulatory jurisdiction – thus benefitingfrom the principles-based regulation of the UK.ICE Futures in London (formerly theInternational Petroleum Exchange or IPE) whichis owned by ICE, launched futures on the WTI

crude oil that is consumed in the US, asopposed to the Brent crude futures that isnormally traded in London. These are cashsettled off the WTI price in the US (at NYMEX).After ICE was permitted to use its tradingterminals in the United States to allow US

investors to trade the WTI crude oil futures on

ICE Futures in London, WTI volumes in ICE

Futures have grown to about half of theNYMEX volumes. The result is a fascinatingsituation where there is:

. A liquid contract on a US commodity

. It is predominantly traded by US

participants

. It uses terminals in the US

. It is traded on an exchange that is ownedby a US entity

. But it is located and regulated in the UK forreasons of regulatory arbitrage.

After the collapse of Amaranth, a large US

hedge fund that had huge positions in energyfutures both in ICE and in NYMEX, the US

Commodities and Futures Trading Commission(CFTC) reviewed and reaffirmed its existingpolicy exempting the ICE futures contract fromUS regulation on the ground that it is acontract on a foreign exchange. The CFTC

stated that:

. The trading volume originating in the US

did not determine a US location

. The fact that the contract is based on a US

produced or economically importantcommodity did not probate location

The CFTC will thus continue to rely on thequality of the regulation of ICE Futures by theUK Financial Services Authority (FSA) as well asthe information sharing arrangements that ithas with FSA. This thinking by the CFTC

underlines a mature and internationalisedperspective on financial regulation,uncontaminated by nationalist pressures orresentment about ‘regulatory arbitrage’.

If Indian regulators accept the principlesfollowed by the CFTC, foreign exchangeswould be able to offer their contracts directlyin India through electronic trading platforms.This would not require full capital accountconvertibility since the RBI now allows Indiancitizens to remit up to $50,000 a year outsideIndia for investment purposes. Indian citizenscan use this facility to pay for the contractsthat they buy on foreign exchanges. Foreignexchanges would also be able to offer tradingin India on ADRs and GDRs of Indian companiesprovided the Indian investor pays for them indollars. This would produce better pricediscovery in the ADR market and reduce theprice gap between the Indian and offshoremarkets.

Source: Blog entries by Jayanth Varma,http://tinyurl.com/yz6b7

firms but now engages enthusiastically inpromoting inward for export-orientedmanufacturing firms that can also supplythe domestic market. India has replaced itslegacy of autarky with an open economywhen it comes to trade in goods and mostservices except financial services. Teamsof Indian workers are tightly integratedinto the world economy when it comes to which has yielded $ billion of exportrevenues. Such phenomena are startingto take place in manufacturing also. Acomparable philosophical change is nowrequired in the finance industry, if India is toachieve $– billion of export revenues infinance and, alternatively to prevent thedrain of $– billion in payments for acquired abroad. A serious effort tocreate an will involve road-shows allover the world where presentations are madeto global financial firms requesting themto consider India as a destination for in finance. Export-orientation in financerequires attracting exactly like export-orientation in manufacturing does.

2.4. Legacy institutional architectureThe problems of competition policy,segmentation and barriers to innovationthat inhibit Mumbai’s emergence as an are partly the consequence of a financialregime governance whose foundations weredesigned at a time when the world of finance,the functions of regulation, the contours offinancial activity, and global competition in, were different.

While the superstructure of thisgovernance regime has been modified inbits and pieces from time to time toyield a shape of multiple regulators thatis distinctly ungainly in design and, perhapsdysfunctional, the conceptual foundations ofthe basic regime have remained untouched.The Act was first drafted in .Although it has been amended several timessince it has not been fundamentally changedat its roots. The () Act was draftedin and the () Act in . Theseparation between and is rootedin the () Act of . The strategicthinking governing these three Acts wouldbe addressed very differently if they were to

136 R M I F C

be drafted using contemporary knowledge.Many of the problems of competition

policy, segmentation and barriers toinnovation that India’s financial systemconfronts, and that impinge heavily onthe issue of making Mumbai an , flowfrom the conflicts of interest inherent inthe multiple objectives and activities of the, ultimately derived from the original Act. In addressing the problems ofcompetition policy, segmentation and thebarriers to innovation in finance, the roles,functions, attitudes, ethos and objectivesof financial regulatory agencies in Indiarequires a new look; particularly in light ofwhat has been happening in the world as wellas the different realities of st century India.

3. Deeper sources ofdysfunction

It would be misleading to suggest orconclude from the foregoing discussion thatthe several complex issues raised by financialregulation in India, are issues purely ofregulation per se. They often have more todo with the legacy context in which financialregulation has evolved to accommodate anarray of multiple objectives – both regulatoryand strategic. These often conflict; implicitlyif not visibly. In that connection, it should benoted that a considerable burden has beenplaced upon the for taking the brunt ofdealing with continuing difficult structuraladjustment since . The weight ofadjustment has fallen disproportionately onadjusting monetary and exchange rate policysimply because fiscal policy has provenstickier, and insufficiently elastic/flexible,in adjusting commensurately, for reasonsof political economy. In performing thistask, has also had to protect: (a) thesoundness of the Indian financial system,as well as (b) the government’s interests asIndia’ single largest shareholder in financialfirms.

The adroit manner in which that dualresponsibility has been acquitted is not asfully realised or appreciated as it should be.Many astute observers of the financial scenebelieve that such a doctrine – which derivesfrom the authority of a reputation earnedand acknowledged over a long period of

time – is now being exercised in a mannerthat continues to protect the contours offinancial regime governance from an era ofautarky that has now passed and becomedysfunctional.

In doing so, it is implicitly influencingthe future development of the Indianfinancial system (inadvertently or otherwise)in ways that may not necessarily beconsonant with Mumbai becoming an IFCor with Indian firms competing effectivelyfor providing in the global arena. Withthe inhibitions and restrictions leading tofinancial repression (or inadvertent implicitsuppression of innovation) having theirroots in deeper historical realities thathave not yet adapted to the agenda forreform, it is necessary to be clearer aboutwhat these realities actually are, and whatneeds to be done to alter them, to enableIndia’s evolution as one of the world’s mostsignificant economies to occur as smoothlyand painlessly as possible.

3.1. The ‘ownership’ problem and theconflicts-of-interest it causes

As in China, government ownershipcontinues to be a major feature of India’sfinancial system. It poses the same difficultchallenges for both these countries as theyattempt to export and globalise theirfinancial systems. There is now universalagreement, in global academic and financialcircles, that public ownership of financialfirms creates an intractable number ofavoidable difficulties in influencing thedevelopment and regulation of soundfinancial systems. Most importantly (inthe context of the emerging Basel-II regime),a number of conflicts-of-interest arisebetween the roles of government as theultimate apex regulator of the financialservices industry (which it remains in theabsence of constitutional independence andlegal/juridical separation from governmentof the , , , and otherregulators) while also being:

(a) The largest owner of financial firmsbeing regulated: i.e., commercial banks –and their capital markets subsidiaries – aswell as in other parts of the financial servicesindustry such as: specialised long-termfinancial institutions, insurance companies,

. Why does financial regime governance have these limitations? 137

asset management firms, pension funds, andfirms/agencies involved in commodities.

In the mutual funds industry (and,to a lesser extent, insurance), India hasmade some progress with permitting entryof private and foreign players, as wellas creating a more level playing field inregulating that industry. The point has nowbeen reached where, although is stillthe dominant mutual fund, it no longercommands an overwhelming market share.

For Mumbai to become a viable andcompetitive IFC within the next few years,this successful experiment in the assetmanagement segment of financial services,needs to be replicated in all other segments,most particularly banking and insurance.It needs to be accompanied by eliminatingrestrictions on: (i) the formation offinancial conglomerates or LCFIs that cancompete with their counterparts in the restof the world; and (ii) the entry of hedgefunds and the entire range of other fundssuch as exchange traded funds across thespectrum.

(b) The single largest borrower fromthe Indian financial system, with an inherentvested interest in keeping the cost ofits borrowing suppressed to the extentpossible; even when that might have largerimplications in managing monetary policyand sending signals through interest ratesthat affect every big price in the economy.

In the absence of constitutionallyguaranteed regulatory independence – i.e.,with regulators being independent publicagencies accountable to the legislature (asthey are in many countries) rather than togovernment – the government’s ultimateresponsibility for sound, impartial andobjective regulation, collides unavoidablywith its ownership and borrowing interests.Not only does that create a conflict of interestin a fundamental sense (i.e., the non sequiturthat arises from an entity regulating itself),it also incurs the risk of compromisingfairness of treatment on a uniform basisfor all financial firms.

Apart from the invidious and corrosivenature of these conflicts of interest, studiesof government ownership of financial firmsaround the world suggest that it leads to anormal propensity to protect, at any cost,

the survival and profitability of public sectorfinancial firms through artificial means. Byso doing, it generates perverse incentivesfor government to diminish competition,enforce artificial and counterproductivesegmentation, and throw up greater barriersto innovation.

In evaluating the characteristics ofestablished or emerging s worldwide,it is significant that none of these cities(other than Shanghai, which is furtherbehind than Mumbai in having a financialservices industry that can become globallycompetitive quickly) have any significantpublic ownership of financial firms inany segment of financial markets. Themost vibrant parts of Indian finance –the securities markets – where exportcompetitiveness is perhaps most visiblein the attraction of voluminous foreignportfolio investment, are the parts wherepublic ownership is the smallest. Thatis no mere coincidence. It signalsclearly what the government needs to doin withdrawing gradually but resolutelyfrom the ownership of all financial firmswithin the political economy constraints itconfronts (but not using those as a reasonto defer taking action indefinitely). Thatis indispensable to create the institutionaland competitiveness conditions that arenecessary and fundamental for Mumbaito become a viable .

3.2. Strategic issues of public debtfinancing and management

An in-built propensity toward financial re-pression has become chronic and endemicin India. It has its origins in historical con-ceptual notions among post-independencepolicy-makers, seduced by the supposeddevelopment success of the in –, about how public (sovereign and sub-sovereign) debt should be financed and man-aged. Lacking belief in the efficacy, desirabil-ity (and feasibility) of India’s having efficientcapital markets in the s, the option ofcreating a wide, deep and open bond market(for sovereigns, sub-sovereigns, municipalsand corporates) – of the kind that now char-acterises almost all mature economies – waseschewed in the nascent stages of India’s eco-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)

Rs. t

rillio

n, lo

g sc

ale

2002 2003 2004 2005 2006 2007

Mkt. cap. of liquid setNon−food credit of banks

Grew at 27.3% p.a.

(The blue line ignores illiquid,unlisted equity and corporate bonds.)5

10

15

20

30

In the st century there is a need forfresh thinking on the part of policy-makersabout strategic issues of debt financing,issuance and management. Financialliberalisation does not inevitably imply thatit will result in a shortage of voluntary andenthusiastic buyers for government bonds.Quite the contrary; whereas resident Indianinvestors with few portfolio diversificationopportunities might be sated with Indiansovereign obligations, either directly orindirectly, global investors have an enormousappetite for digesting Indian paper that hasnot been addressed, leave alone satiated.

Through financial sector reforms, aliquid yield curve can easily beattained, with a market populated by avery large number of participants. Thisis likely to deliver superior, and farmore flexible, financing options along thematurity/duration and coupon spectrum.It would also widen geographical scopefor financing the fiscal deficit; especiallyin the global marketplace (even for paperdenominated in ) when compared withthe present regime.

Resorting to the global marketplace,and meeting global demand for Indiansovereign paper, would ease crowding outpressures and pre-emption in the domesticmarket. That would have the benefit ofeasing demand-supply induced pressures onIndian interest rates. It would create moreroom for manoeuvre on the part of inexecuting monetary policy; independent of

the MoF view on what the level of interestrates should be. The lack of independenceof the central bank hinders acceptance byglobal investors who prefer to operate in an that adopts global norms concerningseparation of powers between monetary andfiscal authorities, and permits independenceon the part of both to pursue the mostappropriate and optimal policy options.

A key part of this strategic thinkingon debt management is the role of foreigninvestors. A liquid yield curve thatcan be traded in an efficient bond andbill market by foreign investors is likelyto attract enormous investment flows intoIndian sovereign debt from long-termglobal fixed income portfolios like pensionfunds. This would result from (a) pressuresfor diversification in global fixed incomeportfolios, especially favouring investmentin developing economies that can sustain asuperior growth rate over several decadesas India can, providing its real economy ismanaged as well as it is now and its financialsystem reflects global standards; and (b) thepositive outlook for India and the overthe next – years. The participationof these investors requires a modern bondmarket. That feeds back into establishinga liquid yield curve. Access to suchfinancing would constitute a far-reachingtransformation of Indian public finance.

3.3. Lack of strategy on the transitionfrom a bank-dominated systemtoward a market-dominatedfinancial system

Finally, there has been an absence ofsufficiently clear strategic thinking on theevolution of finance, both domesticallyand internationally, away from bankingtowards securities (Litan, ). In India,an examination of the liabilities of firms ona market value basis shows the dominanceof equity financing. As shown in Figure., the market capitalisation of the top, firms of the equity market stands atroughly twice the size of non-food credit ofthe banking system (which comprises loansdelivered to big companies, small companiesand individuals).

A commensurate transformation of thepolicy framework has not taken place. In

. Why does financial regime governance have these limitations? 139

many respects, Indian finance continuesto be rooted in the past, with a banking-dominated financial system that should,by now, have become much more capital-market oriented especially in the market fordebt in the form of traded securities ratherthan bank loans.

4. What impedes Mumbai frombecoming an IFC? Asummary

This group of three chapters has dealtwith some of the critical hurdles thatpresently impede the emergence of Mumbaias an . Clearly, making the profoundchanges that are necessary in financialregime governance (i.e., adapting legislationto meet modern realities, policy-making,regulation, enforcement, and changes in thefunctioning of the legal system that providesrecourse for contractual dispute settlement)is a complex undertaking. Swift progresswill be difficult to make.

India has a reputation for taking fartoo much time to contemplate and discusschanges ad infinitum without necessarily

acting on them. China has the oppositereputation of acting too swiftly, withoutthinking through all the implications.

So far China has made more progressthan India. Perhaps there is a lesson inthere somewhere, although the optimalsolution would be to blend both theseopposite tendencies in a happy medium.Neither country can afford, however, todelay its entry into the burgeoning globalmarket for providing – driven inlarge measure by their own needs as theybecome more significant players in the globaleconomy. The Indian financial industryand policy-makers need to focus on, andengage with, these problems at many levelssimultaneously, in order to address thesedifficulties.

Portraying the world of ina somewhat simplistic but neverthelesspowerfully illustrative matrix, the wallchartconstructed for this purpose offers specific,tangible views on what holds back a specific from being provided in India and whatneeds to be done to make India a significantplayer in markets on the world stage.

See http://tinyurl.com/yu4zk7 on the webon this theme.

Reforming financial regimegovernance

11c h a p t e r

The previous three chapters offered a diag-nosis of challenges in financial governanceregime that inhibit Indian firms from export-ing . This chapter offers an alternativepath for progress to be made on this frontier.It dwells on the normative economics offinancial sector policy at the level of ideas.Based on these, specific recommendationsthat need to be implemented for an aremade in Chapter .

1. A shift towardprinciples-based regulation

India’s strategy for financial regulationdeploys rules based regulation – the samestrategy used in continental Europe and,to a significant extent, in the . Itconsists of building up a large repositoryof subordinate law through codification ofdetailed rules and regulations by specialisedregulators. These define the permissiblefeatures of financial products and servicesand the functioning of financial markets indetail. Such a prescriptive approach avoidslegal ambiguity through precise codification.Rules-based regulation has two strengths.First, it provides greater legal certainty tomarket players, who are able to abide by clearrules governing all aspects of their business.Second, it enables financial regulators andsupervisors to operate in a non-discretionarymanner. As the manual of rules defines allpermissible activities, the act of supervisionreduces to ticking off a long checklist, andobjectively verifying whether specific ruleshave been complied with or not. However,over the decades, important weaknesses ofrules-based regulation have become visible:

. Sophisticated compliance officers offinance companies are frequently ableto find ways of pushing the edge ofthe envelope while not violating theletter of the law. Supervisors focused on

codified rules cannot look beyond theletter of the law to its spirit. In recentyears, many large financial firms in NewYork engaged in activities which wereunfair to customers and did not meetminimum ethical standards. However,most of these firms were still able toargue that no laws had been violated andsupervisors could not disagree thoughboth knew that the spirit and intent ofthe law had not been honoured.

. From the viewpoint of detection of fraud,or of impending firm failure, supervisorsneed to have an overall understandingof the business of the firm. They needto understand its business plan and itssources of profit to form a judgmentabout the incidence of malpractice orprobability of default. Rules-basedregulation requires supervisors to focuson minutiae. It obscures the woodsfrom the trees. This leads to reducedawareness and inferior perceptionsabout financial firms in the minds ofsupervisors.

. Rules-based regulation inhibits inno-vation. Every new idea on products,services, markets or even new ways ofdoing business requires going to the reg-ulator requesting a modification of rules.This tends to eliminate the temporaryprofits obtained by innovative firms whoobtain an edge over their competitorsby coming up with new ideas, which (inturn) tends to reduce investments intoresearch and development.

. Rules-based regulation induces corrosivepolitical economy, where firms seek toinfluence the evolution of rules intopathways which favour themselves.

High quality regulation and supervisionis a sine qua non for . It determinesthe competitiveness of an . If an lags in innovation, through slow governance

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processes, and through weak incentives forfirms to invest in innovation, then that will lose competitiveness and global marketshare. If regulators and supervisors at an are unable to block fraudulent or unfairbehaviour by firms, and are ineffective insetting up a sound risk management systemfor markets and firms, then the will losereputation as well as global market share bybecoming a pariah.

The alternative to rules-based regula-tion – i.e., ‘principles-based regulation’ or – was first introduced in the in .It involves less detailed prescription of whatis allowed and what is not in every activity ormarket, less codification, less rigidity of rule-book interpretation, and a greater relianceon practice and precedent. The prime expo-nents of this approach are the , Irelandand Australia. However, the ideas underly-ing this new regulatory approach are beingapplied all over the world, including in es-tablished s like Singapore. The sameideas have been adopted in Japan. But theyhave been less effectively implemented there.Japan has had difficulty erasing the legacyof -style rules-based regulation with themeticulous application to detail that Japan’ssupervisors appear loath to relinquish. Thatstance has inhibited Tokyo’s role as an .It serves as a lesson for Mumbai as well.

The bedrock of is that the regulatorarticulates broad principles and avoidscodifying details of allowable products,markets or business plans. Under , thetop management of financial firms is heldaccountable for ensuring that the businessplan of the firm, and all its activities, areconsistent with the principles defined by theregulator – i.e., not just with the broad letterof the law but with its intent and spirit. Itremoves incentives for financial firms to playan adversarial game (induced by rules-basedregulation) of ‘beat-the-regulator’ to becomecompetitive. Under unsavoury businessplans for financial market operations cannotbe rendered palatable by clever complianceofficers. By its very nature ensuresthat such game-playing does not takeplace. With , supervisors are inevitablycalled upon not to think of supervision interms of checklist compliance. They arerequired instead to understand a financial

firm’s: sources of profit; core businessesprocesses; corporate adherence to ‘principles’based on its management commitment,its corporate culture and the corporatesanctions applied to rule-breakers; as wellas the strength and depth of its complianceprocesses. Principles-based supervisorsengage in broader and deeper continuousinteraction with the financial firms beingregulated to understand their businessesand to anticipate how they are evolving asmarkets change. They are often consulted bythe firms they supervise about new productsand ideas informally but do not have thepowers to block those ideas from being triedout. Their influence is through relationshipand persuasion rather than through policing.

The main strength of is that itfosters innovation. It encourages greatercompetition among financial firms that areable to introduce new ideas into marketsrapidly. The malpractices that occur whensupervisors focus on checklist complianceare avoided. However, imposesonerous demands on, and requires adequateprotection for, the staff of supervisoryagencies. They are required to understandeach regulated firm, and make discretionaryjudgments about whether its business planand modus operandi are consistent with theprinciples established by the regulator. Thisrequires an elaborate system of transparencyand checks-and-balances, in order to preventabuse. No approach is perfect. Rules-basedregulation poses no such risk for supervisorystaff apart from the risk of performancefailure. , on the other hand, placesgreater burdens of knowledge, responsibilityand accountability on supervisory staff. runs the risk that: (a) supervisory staff

might misuse their discretion; and (b) theymay need to be shielded sufficiently to beconfident about exercising discretion andnot become convenient political scapegoatswhen things go wrong.

Applying a historical perspective, theuse of at the is not that unique.As Jayanth Varma has pointed out, it isonly in modern times that regulation bythe - has turned into de facto over-prescription. In its early years, the -had enormous flexibility and competence,with a more flexible, accommodating

. Reforming financial regime governance 143

philosophy much like . The was a product of the civil law era in administration (the New Deal). ButChairman Douglas made the the mostsuccessful and least prescriptively orientedof all the New Deal agencies. The -in its heyday – the Douglas and Landis eras –stands out as an exemplar of the flexible approach. This period probably laid thefoundations of the enormously successful financial system. It would probably nothave emerged as such if the existing approach of over-prescription and harmfullyintrusive legislation had been applied in theformative years.

The European Commission has alsobecome an outpost of excessively prescriptiveapproaches to financial regulation. It standsout in sharp contrast with the . The shiftat the and on the continent towardsover-prescriptive rules-based regulation hashelped London to achieve success as theworld’s premier .

requires a regulator to make in-formed judgements based on an understand-ing of firms, their customers, and the mar-kets in which they operate. In making judge-ments about outcomes, and about what con-stitutes minimum standards, requires abroad degree of consistency in terms of thequality of outcomes that firms deliver; ratherthan consistency in detailed requirementsabout processes. Firms are expected to adoptapproaches to delivering outcomes that meethigh regulatory objectives.

There has been some movementtowards principles-based regulation in the also. For example, in the Congress created the Commodity FuturesTrading Commission () for oversightof derivatives exchanges. This resultedin regulatory bifurcation in the , withspot markets being regulated by the and futures markets being regulated bythe . A key milestone for the was the Commodity Futures ModernisationAct () of December . This law

Across the Irish Sea is an even more remarkablefinancial regulator in Ireland (). It has areputation exceeding that of the in terms ofapplying the rule of common sense alongside commonlaw. It is increasingly seen as one of the smartest andmost flexible securities regulators in the world.

radically changed the approach of the ,away from a rules-based system towards aprinciples-based system. The CFMA defines ‘designation criteria’ and ‘core principles’.Under the CFMA, a futures exchange onlyhas to certify to the regulator that it isstarting a new product or rule, with a noticeof at least one day in advance. If the exchangewants to request an approval, the agency has days to give it.

In contrast, stock exchanges in the cannot change products or ruleswithout a notoriously slow approval processat the . In a speech in June, Commissioner Walt L. Lukken saidthe gave exchanges the flexibilityrequired to foster innovation, saying:

“While the monitorswhether a core principle isultimately met, the exchangeswith their hands-on experienceare given discretion to tailortheir rules to their specialcircumstances”.

2. Reducing the artificialsegmentation of financialfirms, products, services andmarkets

How can the problem of segmentation inIndian finance be addressed? In four ways.

2.1. The holding company approachIn an international setting, financial firmsexploit economies of scope and scale byoperating in all sub-segments of financialproduct/services markets. Global shave reaped competitive advantage in theglobal market as a consequence. In somejurisdictions, such as the , the integrationof all financial regulation under a singleregulator has facilitated the integration ofa range of financial activities in unifiedfinancial firms. But many countries havefragmented regulatory architecture, as inIndia. In such instances corporate structuresneed to be contrived to support the creationof a virtual unified financial firm thatis able to operate in any or all areas ofthe financial services business. The mostexpedient of these is the “holding company

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Box 11.1: Principles-based Regulation in the The way in which the FSA operates in

regulating the City of London is important inunderstanding regulatory issues surroundingIFS provision owing to innovations inregulatory strategy. PBR was pioneered in theUK. But it appears to have taken root in severalOECD countries. It is now a well respectedregulatory doctrine around the world. The US

is also likely to apply it before too long if theinitiatives now in train come to fruition.

In May 1997, fundamental financial reformswere announced in the UK. The Bank ofEngland was made an independent centralbank with the sole objective of setting theshort-term (base) interest rate withaccountability for hitting a publicly statedinflation target (of keeping inflation under 2%)through an open and transparent process. Allfunctions other than setting the short ratewere removed from the Bank of England.

All financial regulation that was previouslyundertaken by nine separate agencies wasunified under a new singleregulatory/supervisory agency called theFinancial Services Authority (FSA). It wasseeded with the 500 people from the Bank ofEngland who used to do banking supervisionfrom there, and the staff of all other existingfinancial regulators.

By 2006, it is increasingly clear that the FSA

approach has worked in the UK. The FSA hasmanaged to steer clear of three kinds ofproblems: the populist regulator who likes toplay to the gallery by currying favour withordinary citizens; the conservative regulatorwhere the default answer to all questionsconcerning innovation is ‘no’; and the US-styleapproach of introducing enormouslegal-overheads on the production of financialservices. Whereas the UK was afflicted byrecurring failures and crises concerning foreignbanks in the financial system in the 1970s and1980s, these have been conspicuous by theirabsence since 1997.

The first innovation of the FSA is its mandate.The law asks FSA to attain four equallyimportant objectives: (1) Maintaining marketconfidence (2) Promoting public understandingof the financial system (3) Securing anappropriate degree of protection forconsumers; and (4) Combating financial crime.The law codifies little about markets andproducts. It focuses on broad principles. It isinteresting to see that that the objective of theFSA is one of securing appropriate consumerprotection, not infinite consumer protection atany cost.

The FSA is tasked with making markets workto deliver benefits to firms and consumers. Itaccepts that some failures neither can, norshould, be avoided. Failures are part andparcel of what makes markets work andprovide an important source of future learning.

The mandate of the FSA is designed to avoidthe loss of efficiency from the conservativeinstinct of setting up a license-permit raj, orthe periodic heavy handedfront-page-headlines crackdown on financewhich happens with populist regulators.

The integration of all financial systemregulation at FSA makes it easier to transmitknowledge on success from one part of theFSA (say banking) to another (insurance).Internationally, most banking regulators viewsecurities markets with suspicion or hostility.However, the global economy is shifting awayfrom banks to securities-market dominatedfinancial systems. The merger of banking andsecurities into the FSA has ensured thatFSA-regulated banks are not hindered fromdeep integration with securities markets.Instead of discouraging integrated LCFIs, theFSA is perfectly happy to see them bloom.

‘Principles-based’ or ‘light-touch’ regulationwas originally conceived at the Bank ofEngland prior to the 1997 reforms. The maininsight it applied is that it is neither feasiblenor desirable to write down detailed rulesgoverning every market and every product.Under this philosophy, it is simply not possible,nor even necessary, for regulators to try toanticipate every change or innovation thatmight occur in financial markets; especiallygiven the sheer size of the number ofparticipants, the changing needs of an evengreater number of sovereign, corporate andindividual users of financial services, and theinexorable global integration of nationalfinancial systems. Attempting to do so simplyinhibits innovation and detracts fromcompetition. Instead it is important to focuson broader strategic issues and let firms worryabout regulating themselves on points ofdetail – but under the continuous watchful eyeof friendly and co-operative FSA supervisors,should things go pear-shaped.

Debate about ‘light-touch’ vs. traditionalregulation is essentially an argument about therelative costs and benefits of over-prescriptionvs. flexibility. The contrasting US approach onthe part of all regulators, except those forderivatives markets where most financialinnovation takes place, attempts to codify afull set of rules covering every product andmarket mechanism in fine detail. Thealternative strategy, adopted by the FSA, is oneof articulating broad principles, and leavingmarket players to continually innovate on thedetails through which these broad principleswill be achieved.

A conceptual goal of the FSA is that the topmanagement of a financial firm must primarilylook at markets and innovate, withoutworrying about the regulator. This is strikinglyreminiscent of India’s experience withdismantling the control raj in manufacturing,where the reforms were about turning the

gaze of the CEO away from the governmenttowards the market. PBR consists of applyingthat approach to finance. The FSA places acomplex burden upon the financial firm andupon its own staff: that of understandingbroad principles and adhering to them in spirit.In return, detailed rules governing everyminute detail of every activity in finance havebeen eliminated. CEOs of financial firms inLondon innovate on an everyday basis withoutneeding to continually approach the regulatorfor permission associated with every change inthe business plan.

Large complex firms (LCFIs) are linked tospecialised relationship-management teams inthe FSA which provide a single point of contact.The team at FSA that deals with the large firmis given three tasks: (i) understanding thesources of profit of the firm; (ii) understandingthat the business plan and processes areconsistent with the principles of the FSA; and(iii) verifying that the processes of the firmperform satisfactorily and that risk is beingmanaged properly in the broadest andnarrowest senses. The FSA team makes regularpresentations to the board of the regulatedcompany about their understanding of theareas of concern. This improves the pressureon the FSA team to have a soundunderstanding of the regulated firm.

This approach makes two kinds of demandsupon the staff of the FSA. They are required tounderstand the regulated firm in a mannerakin to a strategic management consultant, aresponsibility not replicated or attempted at aconventional regulator in India. Further, FSA

staff are empowered to act based on theirown discretionary judgment.

There is an interesting contrast between aprinciples-based approach and a rules-basedapproach. In a rules-based approach, as ispracticed in India or in the US, it is all too easyto have rigid checklists that RBI or SEBI staffmust verify by ticking boxes on long laundrylists when they interact with a firm. This givessupervisory staff plausible deniability whenanything goes wrong. This, of course, doesnot uncover or solve underlying problems.

The FSA approach emphasises the need forintelligence and judgment on the part ofregulatory staff, not just a mechanical checklistof rules. The FSA approach requires top qualityprofessional staff, that have considerableoperating experience in financial firms, and arecapable and senior enough to apply their ownjudgement independently without fear orfavour. In order to help achieve this, FSA

wages are decoupled from civil service wages,and linked to median wages in the privatesector. More than half of FSA’s staff comesfrom the financial industry, through acontinuous two-way flow between the FSA

and the industry.

. Reforming financial regime governance 145

Box 11.1: continued . . .With the concentration of monopoly

regulatory power at the FSA, there is enormousconcern about accountability and checks onthe power of FSA and about the possibility ofregulatory capture. This has beenaccommodated through numerouschecks-and-balances. The first is that of havingstaff that understand fully real world finance,and hence avoid automatically falling back onsaying ‘no’ as the default option when facedwith any complex idea. A statutory‘practitioner panel’ watches the FSA and writesreports about areas where things are goingwrong. There is a tribunal for appeal onenforcement matters, much like the IndianSecurities Appellate Tribunal (SAT). Finally,when there are policy disputes between theindustry and the FSA, the UK Treasury (itsMinistry of Finance) plays the role of a tribunal.

The UK finance industry accounts for 8% ofits GDP. If FSA stifles the innovation orcompetitiveness of this industry, it impactsdirectly upon GDP growth. Apart from that,the City of London is extremely influentialpolitically and government takes its interestsvery seriously. This generates incentives for toppolicy makers and politicians running forelection to take interest in sound financialregulation, and ensures the globalcompetitiveness of London as an IFC. It also

constitutes an effective feedback loopbetween export orientation and high qualityprovision of the ‘public good’ of regulation.

One practical example of the debatebetween a rules-based approach and aprinciples-based approach concerns theoperations of hedge funds. The FSA approachemphasises the enormous positivecontribution that hedge funds to marketliquidity and market efficiency. The FSA hasemphasised supervising hedge funds throughprime brokers. Prime brokers are typically armsof (regulated) investment banks, and providehedge funds with a range of services,including securities lending, leveraged-tradetransactions, and cash management. They areclose to the market, so they can keepregulators informed; and, because their moneyis at risk, have an interest in keeping abreast ofwhat hedge funds are doing.

This approach relies on the self-interest of,and intelligence from, prime brokers, insteadof trying to write down rules and send outgovernment employees to visit hedge fundsand comprehend what each of the 8,000hedge funds of the world is doing.

The FSA approach is both instantly appealingand attractive, yet extremely challenging inimplementation. The idea that CEOs of

financial firms can think about innovation andnot undertake regular pilgrimages to theTreasury, the Bank of England, the FSA, andother offices of government agencies tofurther their firm’s business interests isenormously attractive.

At the same time, the UK approach isdaunting on many fronts. The principles basedapproach can reduce the legal certainty onwhich firms operate. It places discretionarypower in the hands of regulators andsupervisors all the way down the line.a Itrequires these officials to have high qualityunderstanding, judgment and probity. And, itrequires that they be shielded from awitch-hunt when discretion is exercised andthings go wrong.

The most important testimony about the UK

approach is the fact that in the last decade,London has emerged as the world premierfinancial centre, once again overtaking NewYork after a 50-year hiatus. That process has,of course, been assisted by other factors suchas terrorism in New York, Sarbanes-Oxley, andthe civil law approach of the EU. However,there is little doubt that the far-reachingdecisions of 1997 in reforming the Bank ofEngland and the FSA transformed the positionof 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 betweencivil servants and private citizens, and there is discretion in the hands of the civil servant.

structure”. If the structure of regulationprohibits commercial banks from fundmanagement, then the solution involvesa mother corporation that has two whollyowned-subsidiaries, one a commercial bankand the other a fund manager. The virtualfinancial firm would then be engaged inboth businesses while satisfying the separateregulators covering each area of business.

In the most refined case, the holdingcompany would be a listed company, witha corporate engaging in pursuing thebusiness strategy of a unified financialconglomerate. From the viewpoint of theshareholder and the , the firm is aunified multi-product financial firm, with aseries of wholly-owned subsidiaries presentin areas as required by regulatory rules. The and the board of the holding companywould make decisions about allocatingcapital and forming business strategy for thevirtual firm. The strategy would be executedby multiple subsidiaries. The of each

subsidiary would then be roughly equivalentto the chief of each major operating businessdivision of the virtual unified firm.

In order to achieve these goals, theholding company must be required tocomply only with the Companies Act andwith exchange listing requirements; inthe event that it is listed. It should besubject to no financial regulation from anyregulator. The fact that a subsidiary of theholding company may be a bank shouldgive the banking regulator no power overthe owner of the bank, i.e., the holdingcompany. Further, regulations governingbanks, insurance companies, etc. need toaccept % ownership in the hands ofholding companies that can have dispersedshareholding and public listing requirementsalong the lines applied to any other companyin any other line of business. Apart fromregulatory constraints, the other constraintsfaced with a holding company structure inthe Indian environment are:

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Box 11.2: Case Study – Principles-based regulation in the for treating customers fairlyAs an example of how PBR works, consider

consumer protection, or what the FSA calls“Treating Customers Fairly” (TFC)a. The FSA hasdefined six desired outcomes from its work inthe TFC area:

. Consumers can be confident that they aredealing with firms where the fair treatmentof customers is central to corporate culture

. Products and services marketed and sold inthe retail market are designed to meet theneeds of identified consumer groups andare targeted accordingly

. Consumers are provided with clearinformation and are kept appropriatelyinformed before, during and after thepoint of sale

. When consumers receive financial advice,the advice must be suitable and tailored totake explicit account of their circumstances

. Consumers are provided with productsthat perform as firms have led them toexpect, and the associated service is bothof an acceptable standard and also as theyhave been led to expect

. Consumers do not face unreasonablepost-sale barriers imposed by firms tochange product, switch provider, submit aclaim or make a complaint.

These six principles define what the FSA

requires the financial industry to do forconsumer protection. FSA emphasises theresponsibility of the senior management of

finance firms – and not just their compliancedepartments – to embed these objectiveswithin the business strategy, culture andbehaviour of their firms. The FSA holds the topmanagement of each firm accountable formeeting these six desired outcomes, and notseek to micro-manage firms on how theseoutcomes are achieved.

This principles-based approach providesfinancial firms with more flexibility to decidehow best to run their businesses, whilemeeting FSA regulatory objectives. Firms arebetter placed to judge the detail of how bestto deliver those outcomes in the marketplace,and thus deliver fair treatment to theircustomers in a way that is consistent with theircommercial objectives. FSA argues thatproviding flexibility rather than prescribingdetailed processes enables firms to competeand innovate more effectively in productdesign, in the quality of customer service, andin achieving economic efficiency.

FSA works on improving financial capabilityand awareness of consumers, and theprovision of clear information by firms and bythe FSA to consumers, to help consumers topursue their own best interests by playing anactive and informed role in the markets forfinancial products and services. Enforcementactions are taken against firms and their seniormanagement when they fail to achieve highlevel outcomes.

As part of the move to a moreprinciples-based approach, FSA is working on

removing a significant volume of detailed ruleson consumer protection. Detailed rules onmoney laundering, and on training andcompetence for wholesale business have beenremoved. The Authorisation Manual is beingdismantled. It intends to further implement aradical simplification of investment Conduct ofBusiness rules, rules on financial promotionsand rules on complaints handling.

When firms ask FSA to define minimumstandards, in the quest for legal certainty andpredictability, the FSA response is that thePrinciples and other high level rules arethemselves minimum standards, and that FSA

sees these minimum standards primarily interms of outcomes, not of prescribing detailedinputs and processes.

Predictability is enhanced by statements ofgood and poor practice and through casestudies illustrating ways in which firms havesuccessfully met requirements. Suchstatements of good and poor practice helpsenior managements of firms to think forthemselves about how best to meet high levelrequirements within the specific circumstancesof their own activities and business models. Bypublishing examples of good and poor practiceon either side of an acceptable standard, FSA

indicates to firms both where the minimumstandards lie, and that there are alternativeways of delivering them. In doing this, FSA

respects the confidentiality of ‘proprietary’good practice that firms have developed togive themselves a competitive advantage.

aSee http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2006/0724_cb.shtml

A. Tax consolidation of accounts. UnderIndian , a listed holding company hasto present stand-alone and consolidatedaccounts. However, for income-taxpurposes, such a consolidation of accountsis not presently permitted. At a conceptuallevel, it would be desirable to tax agroup on the basis of its overall financialperformance incorporating the performanceof all subsidiaries put together. Worldwidethere are a number of jurisdictions, such asthe , and others that tax a corporategroup as a single unit. Although thescope and approach may vary from onejurisdiction to another, tax grouping allowsoffset of profits and losses within the group,with a few countries extending the conceptto cover foreign subsidiaries. Hence, there isa case for introducing a group tax regime,that is simple to administer, and involves low

compliance costs. Flexible rules need to bespecified governing intra-group transactionsand corporate reorganizations. The regimecan prescribe conditions, such as minimumholding periods and condition for qualifyingfor group level consolidation, consistency offinancial years, entry and exit issues etc.

B. Dividend tax credit. When a subsidiarycompany pays dividend to its holdingcompany, it pays a dividend tax of .%in India. A dividend payout by the holdingcompany to shareholders incurs a seconddividend tax of .%. This vitiates theviability of the holding company structure.

C. Leverage by the holding company. Sec-tion of the Companies Act, , speci-fies that, without consent of shareholders,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

outcome oriented. It differs from Rule Based Regulation

(RBR) which is process driven.. PBR is based on the idea that the

regulator is not always best placed, orbetter placed than market participants,to judge what is best, or what is rightand what is wrong in terms of products,instruments, services, practices ormarket functioning.

. PBR is based on the premise thatcompetition and innovation in rapidlyevolving markets driven by technologyshould not be inhibited byover-prescriptive regulation.

. PBR allows for greater flexibility indevising internal corporate business andcompliance processes to cope withchanges in rapidly evolving markets

. RBR invariably prescribes permissiblebusiness processes in micro-detail andchanges too slowly in response tomarket changes.

. The overall effectiveness of PBR iscritically dependent on the ethical andgovernance standards that prevail in thefinancial and corporate worlds in anycountry.

. The higher such standards are in a givenoperating environment, the better iscompliance with PBR and the better itsoverall outcome.

. In an environment accustomed to RBR,regulators see PBR as posing highregulatory risks

. They fear that the operating flexibilitythat PBR permits could be misused inenvironments with insufficiently highstandards of internal corporate ethics,compliance and governance.

. With RBR, market participants leave it toregulators to specify what thosestandards should be through detailedrules.

. But experience suggests that RBR doesnot necessarily or automatically instill orencourage high standards of ethics orgovernance to be applied in anyparticular environment.

. What RBR appears to encourage is thedevelopment of capabilities aimed atevading rules through technicalities andloopholes. This weakens incentives forbetter self-regulation within theregulated industry and induces atendency for market competition to bedriven by a propensity for cleverlyevading rules faster than the competitor.

. The key to determining the regulatorytone in a particular environment, anddeciding whether PBR is more suitablethan RBR in a particular countrycircumstance, depends on the standardsapplied by the regulated industry in:monitoring itself, ensuring that all

players in the industry conform to rulesthat protect the reputation and integrityof that industry; and ensuring that thebest global standards of corporateethics and governance are applied by allplayers.

. PBR is particularly well suited to theregulation of securities markets, whichregulators that are RBR driven (such as inthe US) have now explicitly recognized.

. PBR does not mean lax regulation andsupervision. Compliance under PBRdepends as much on the spirit as theletter of the law. For that reason,compliance with PBR is different andmore demanding than the “checkbox”compliance under RBR.

. Violation of rigid but specific rules ismuch easier to establish than broaderprinciples that are more open tosubjective interpretation.

. PBR requires greater knowledge on thepart of regulators, an obligation toremain up to date with changes inrapidly evolving markets, as well asmore accountability and responsibility tobe exercised by supervisors in exercisingjudgments than RBR which focuses toomuch on the use of detailed checklistsfor compliance assessment.

total amount of its share capital and freereserves. This restriction is archaic. It needsto be removed, particularly for listed com-panies where mature corporate governanceprocesses are in place. At the minimum, thisrestriction needs to be rephrased to make alink to the share capital and free reserves ofthe consolidated balance sheet.

D. Restrictions on intra-group transac-tions. The ultimate goal of a holding com-pany structure is to support listing and run-ning a corporate headquarters for a set offinance companies, each of which complieswith the requirement of a separate regulator.The ultimate objective is to create a virtualfinancial firm that spans the financial ser-vices universe. However, Section of theCompanies Act constrains the utilisationof the services of any group company byanother group company. When group com-panies have a common directorship, prior

approval of the central government is re-quired prior to availing such services. Thisrequirement needs to be reconsidered in amodern corporate governance environment.

2.2. Reforms in financial systemregulatory architecture

One important source of segmentationin Indian finance is the turf separationcreated by having multiple regulators.Reforms to regulatory architecture couldbe undertaken to mitigate these problems.India needs to choose between two paths.One is to consolidate down to fourregulators covering finance with one eachfor: (a) banking with a regulator separatefrom the monetary authority; (b) capitalmarkets, with a merger of securities marketsfunctions on the fixed income, currencyand commodity markets into a singlesecurities and derivatives market regulator;(c) pensions with the consolidation of

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Box 11.4: The politics of regulatory architectureIn the US, regulation of all derivatives –

financial or commodities – is placed under oneagency (the CFTC). Regulation of financial spotmarkets is under another (the SEC). Thisseparation is derived from history andsustained by political economy.

The CFTC is overseen by the House andSenate Agricultural Committees, owing to thehistorical origins of the CFTC. In 1974, when

the agency was created, futures trading wassynonymous with agricultural commodityfutures trading. That world is, of course, longgone; US derivatives exchanges trade everymanner of derivatives imaginable includingcurrencies, interest rates, energy, weather, etc.

The members of the House and SenateAgricultural Committees tend to obtainsignificant political funding from the

derivatives exchanges. The Chicago exchangesin general, and the Chicago MercantileExchange in particular, are top donors. In the2006 election cycle in the US, four exchangesappear on the list of the top 20 securitiesindustry donors. All but one of the four arefutures exchanges. The CME has been on thetop 20 list for the last three election cycles.

Box 11.5: Costs of compartmentalisation, and benefits of unification, in the ‘exchange ecosystem’

Segmented model Unified modelEquity Fixed

incomeCurrency Commodities

Exchange NSE, BSE NDS, ClearcorpDealing Systems

Clearcorp DealingSystems, Reuters, IBS

NCDEX, MCX,NMCE etc.

All 8–10 exchanges would compete in trading all products.(This assumes NDS will be put out as one more exchange).

Clearingcorporation

NSCC, BSEClearing House

CCIL CCIL None All three clearing corporations would compete in offeringclearing 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 moredepository).

Problems: Lack of competition, lack of economies of scale, lack ofeconomies of scope. Conflicts of interest owing to functions heldwithin the State at NDS and SGL. Heightened costs for financial firms.

Benefits: More competition, economies of scope andscale for both exchange institutions and member firms.Improved functioning of NDS, SGL and the State, owing toelimination of conflicts of interest.

pension regulation into a single pensionsregulator; and (d) the insurance regulator.

Such a quartet might reduce the extantdegree of segmentation and regulatory turfprotection in Indian finance; but it wouldnot eliminate them.

Alternatively, India could choose tointegrate all financial regulation into asingle -style agency. The experience ofLondon suggests that that provision isencouraged by the unification of all financialregulation into the . The principle of the is that it is able to take a complete viewof all activities of all finance companies anda holistic view of trends in financial marketdevelopment. At the same time, there areproblems of accountability and governanceas well as regulatory monopoly associatedwith creating an -style agency.

While the is not yet a statutory regulator,the present direction of policy thinking in the field ofpensions envisages such a role for it (Shah and Patel,).

2.3. Shift away from “entity-basedregulation” towards domainbased regulation

Until an -style agency comes about,care needs to be taken in identifying rulesthat induce segmentation in Indian financeand removing them. For India to succeedin provision, it has to be understoodthat the end goal is for India to haveefficient, globally competitive financial firmswhich are able to do what is needed tocompete effectively in all markets. Thegoal is not to make regulatory life lesscomplicated by maintaining the tidy statusquo of segmented financial firms that fallneatly within current regulatory domains,and are easy to control, supervise andregulate. This requires, for example, treatinga ‘primary dealership’ as one of the manybusiness activities of a financial firm, and notrequiring that standalone firms be createdwhich do nothing but primary dealership.The strategy for regulation needs to be one

. Reforming financial regime governance 149

where the banking regulator regulates thebusiness of banking, but does not regulate allthe activities of a financial firm that choosesto call itself a “bank”.

2.4. Organisation of the assetmanagement industry

The very nature of the asset managementindustry enables large economies of scale tobe captured. The costs of managing a bondportfolio of Rs. trillion are not a thousandtimes larger than those of managing a bondportfolio of Rs. billion. They may not evenbe ten times larger. Hence, when a firmmanages a larger quantum of assets, it isable to quote lower prices when expressedas basis points of assets under management(). As an example, in the world market,the price for index fund management for $

billion of assets is roughly basis point or.%. At present in India, there is no indexfund with a size of $ billion, and henceindex funds in India cost much more than

basis point.Asset management functions are per-

formed in almost every sub-segment of fi-nance: banking, insurance, pensions, mutualfunds, hedge funds, etc. The fragmentationof finance owing to regulatory architectureinduces huge diseconomies of scale in assetmanagement. That will hamper the compet-itiveness of Indian firms in an internationalsetting.

Considerable progress can be made onthis problem by separating out the ‘frontend’ through which assets are sourced formanagement, from the back-end ‘factory’where assets are managed. The front endsembed specific contractual structures, andregulations, such as insurance companiesas opposed to mutual funds. However, thetask of fund management that takes placein each of these firms is done in the samekind of factory. The difference between amutual fund and a pension fund lies in thefront-end, not in actual asset management.

This suggests the creation of a newindustry of Asset Management Companies(s) that are wholesale fund managers.This industry should be regulated by .The customers of s might be restrictedto wholesale customers who put up aminimum of (say) Rs. million (or

Rs. crores or $ . million equivalent)for management. A small set of professionaltrustee companies – perhaps three to five –should supply supervisory functions overan industry composed of perhaps –

s.Once this industry is in place, it should

be possible for banks, insurance companies,mutual funds, hedge funds, s, pensionfunds, , etc. to outsource theirasset management to one or more of thesecompanies. What is envisaged, of course, isa market-driven process. There should beno compulsion that an insurance companymust outsource fund management to an. However, any regulatory barriers thatimpede outsourcing should be removed,so that the in-house versus outsourcingdecision is made by every financial firmin India on the grounds of pure economicefficiency.

It is important to maintain a distinctionbetween the regulatory structure that appliesto an insurance company and the regulatorystructure that applies for the wholesale. The insurance regulator has alegitimate focus on the risk profile ofthe portfolio of the insurance company.However, the relationship between the and the insurance company has no link tothe complex obligations of the insurancecompany.

As an example, an insurance companymight place Rs. billion with an for managing an equity index fund. Theregulatory focus on the would then berestricted to verifying that the index fund isbeing correctly managed. As an example, ina mutual fund setting, the costs associatedwith retail investor protection should beconcentrated into the mutual fund. Whenthe MF outsources to an , this contractshould be struck at the low prices seen inwholesale fund management, and the burdenof regulation associated with retail investorprotection should not fall upon the .

With such a structure, wholesale scould achieve significant economies ofscale by tapping into assets from manyinstitutional funding sources. In such anenvironment, when an insurance companyevaluates the decision of managing assetsinternally, as opposed to outsourcing that

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activity, it is likely to find that the chargesof the wholesale are much lower thanthe costs of internal asset management. Thiswould encourage the outsourcing of assetsfor management from a large number offinancial firms to save their own costs andachieve economies of scale in the industry. Such a move would immediatelymake asset management in India globallycompetitive. Asset management companiesin India with over $ billion in assetsunder management would be cost-efficientby the standards of the global moneymanagement industry. But, for that tohappen, appropriate institutional structuresfor wholesale s would need to becreated and economies of scale capturedin the domestic market before such servicescould be globalised.

3. Creating an environmentconducive to exit

As argued above, the foundation ofcompetition policy is a ceaseless process ofcreative destruction, where every year, somefinancial firms fail and exit from the business,while new financial firms enter into thebusiness every year. This ceaseless churningappears messy since newspaper headlinesdwell on firm failure. However, it is theonly way to achieve a globally competitivefinancial sector.

This requires a corresponding paradigmshift on the attitude towards both entry andexit. Financial regulators in India todayare often fearful of exit. The death of afinancial firm is seen as a failure of thefinancial governance regime. This attitudeneeds to shift towards an approach wherethe death of financial firms is seen as proofthat a properly competitive environment isactually in place.

There is ample international experienceon how a sound approach towards exit canbe constructed. It comprises the followingkey elements:

. Regulatory concerns about the failureof financial firms are focused onlyon banking, insurance and definedbenefit pensions. In these areas, aframework of deposit insurance – with

sound pricing of the insurance andadministration in a way that avoidsmoral hazard – is of the essence. Thisneeds to be coupled with a promptcorrective action () framework,where strictures are placed upon weakfirms well before failure; such as aprohibition on accepting new businesswhen underlying risk capital is toolow. Listing is a powerful tool throughwhich stock market speculators monitorfirms, and produce daily estimates oftheir failure probabilities. A policy ofrequiring listing, and the establishmentof procedures within regulators ofmonitoring stock prices, would helpgenerate early warnings about distressbased on which can be taken.

. In the securities markets, clearing corpo-rations which manage counterparty riskare a powerful tool for preventing firmfailure from having systemic repercus-sions. India has made excellent progressthrough the establishment of the Na-tional Securities Clearing Corporation() and the Clearing Corporationof India (). The scope of these in-stitutions, and the competitive marketstructure of the clearing corporationbusiness, need to be steadily extended.

. A host of sophisticated finance activitiescan be encouraged under firms organ-ised like hedge funds, where customersare restricted to sophisticated investors.Once this is done, the death of such firmsimposes no political problems upon thegovernment.

4. Retail vs. wholesale markets

Financial regulators around the world areconcerned about investor protection of“small households”. Ordinary householdslack the specialised financial knowledge orincentive to understand complex financialproducts that might be mis-sold or embeddubious practices encoded in fine print. Ifthe regulator does not protect the interestsof ordinary households, then the flow ofsavings from millions of households intomodern finance will not take place. Thislegitimate concern induces regulators tobe particularly cautious before permitting

. Reforming financial regime governance 151

products to be sold to retail investors. This,in turn, induces a bias toward caution andconservatism and slows down innovation.

This problem has traditionally beenseen as a difficult trade-off faced bythe regulator. On one hand, financialinnovation produces superior products forend-consumers. Yet, along the way, newproducts need to be screened carefully bythe authorities to avoid episodes wherehouseholds are defrauded and bolsterpublic confidence in modern finance.One way of dealing with this issue, andfostering innovation without sacrificing theprotection of small investors, is to cultivatea separate policy stance for sophisticated‘wholesale’ players in the financial marketswho do not have the same knowledge deficitsas retail investors and do not need the samedegree of protection. In India, a thresholdof Rs. crore (or Rs. million) mightbe appropriate in defining a ‘wholesale’transaction. Once this is done, in a broadrange of settings, the stance of regulatorsshould be to permit a free flow of innovation.

The best example of this approach is thehedge fund. Mutual funds are specificallydesigned for retail investors and they areregulated and supervised intensively. Thislevel of scrutiny imposes costs of complianceand opportunity cost of trading strategieswhich are prohibited by the government.The hedge fund is the unregulated alternativeto the mutual fund. But it can be restrictedto deal only with customers who putup more than Rs. million of assets formoney management. The argument isthat any customer who has more thanRs. million of assets under managementwith a hedge fund has the knowledge andcapability to understand what the hedgefund manager is doing before investing in it.The government does not need to protectsuch a customer. Once such a separation iscreated between mutual funds and hedgefunds, there will be healthy competitionin the capital market. Large investors willhave a choice between mutual funds andhedge funds. If the benefits of regulationoutweigh the costs, then large investors willcontinue to patronise mutual funds. If thecosts of regulation of mutual funds are largerthan the consequent benefits, then large

investors will shift to hedge funds. Theeconomy would then benefit from a low costorganisation of money management andfrom increased competition.

Hedge funds are appealing when itcomes to exit in the event of failure.If a money manager such as a mutualfund has a large number of small retailcustomers, then the government inevitablygets involved in the resolution of failure.In contrast, hedge funds will have onlya small number of wealthy customers.That makes it politically feasible for thegovernment to watch impassively when ahedge fund fails. The hedge fund managergoes out of business and a few rich customersget hurt. Government is not obliged tointervene on their behalf and no issue ofpublic interest policy arises. Under sucha framework – that distinguishes betweenthe capabilities and interests of wholesalevs. retail investors – the principle ofcaveat emptor applies to the former andstrong regulatory safeguards protect thelatter permitting financial markets to beregulated in a manner that encouragesaggressive competition, with free entry andexit of different kinds of financial firmswhile protecting those that need protection.Another well-known recent example where‘wholesale-retail’ differentiation has beensuccessfully applied is in the exchangeindustry in the . There the has eased the entry criteria and softenedconsiderably the regulatory regime forexchanges in which only large financialfirms, and not small individual investorsor ordinary households, are permittedto participate. This two-track approachmakes entry possible for a range of internet-oriented start-ups which compete againstthe established exchanges, without needingto incur all the costs and particularly theregulatory burdens associated with theestablished exchanges.

A fast-paced, globally competitivefinancial sector, in which rapid innovationoccurs, can be a useful laboratory wherenew products and services can be quicklytested in wholesale markets restricted totransaction sizes of at least Rs. million.Successful ideas from such tests can laterbe approved for the retail market by the

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regulator. From an perspective, almostall transactions are likely to be biggerthan Rs. million. Hence, a rapid pace ofinnovation in wholesale markets is quiteconsistent with a focus on export of . Butthis approach has an important downside,in the context of organised arms-lengthfinancial markets, where secondary marketliquidity is formed by pooling millions oforders, small and large. The fragmentationof liquidity between segregated retail andwholesale markets would reduce liquidity.

India’s key strength – i.e., its vastretail market – will not be able to playin areas where retail participation isprevented. Hence, while this wholesaleversus retail approach has merit in someareas such as money management, thereis a need of caution when it comes to thesecurities markets, where unification ofall orders into a single order book yieldsmaximum liquidity and thus internationalcompetitiveness.

5. The role of exchange-tradedvs. OTC derivatives in theBCD nexus

Derivatives can be traded on an exchangeor bilaterally negotiated on the ‘over thecounter’ (OTC) market. Trading onexchange requires standardised ‘plain vanilla’products, is anonymous, utilises a clearingcorporation to eliminate credit risk, and isfully transparent. The trading computerensures that each buy order is matchedwith the lowest priced sell order. OTCtrading permits unlimited flexibility in thecontract, lacks anonymity, generally involvescounterparty credit risk, and is generallynon-transparent. There is never a certaintythat one privately negotiated purchase wascontracted at the best price available on thenon-transparent market.

Currency futures were the first situationwhere the idea of the exchange-tradedfutures market was applied to a financialunderlying. For many years, currencyfutures were not particularly successfulwhen compared with OTC currencyforwards which dovetailed well with theprimarily inter-bank character of currency

trading. With interest-rate derivatives, whileexchange-traded interest rate derivatives areenormous worldwide, they continue to besmaller than their OTC counterparts.

Despite these international empiricalregularities, the following seven factorssuggest a greater role for exchange-tradedderivatives in an Indian IFC:

. The present OTC market in Indialargely trades plain vanilla products.For trading plain vanilla products, theexchange traded environment inducestransparency and liquidity at no costin flexibility. Indian currency forwardtrading is already halfway to theexchange-traded framework, with theClearing Corporation of India Ltd() performing the services of acentral counterparty. The only furtherstep required in shifting from a forwardmarket to a futures market is theintroduction of transparent trading atan exchange venue.

. Even though the global currency futuresmarket is small when compared withthe global currency forward market,recent research has shown that it plays adisproportionate role in price discovery.Rosenberg and Traub () find thatthe currency futures market mightcontribute as much as % of the pricediscovery. This reflects the role oftransparency in price formation. Traderswho might place orders on the opaqueOTC market find it advantageous toconstantly watch the transparent futuresmarket. A transparent trading venueseems to matter disproportionately foroverall price discovery, even if theturnover at this public marketplace isrelatively small.

Similar evidence for the role ofexchange-traded futures on the interestrate market is found in Mizrach andNeely () who estimate that over %of the price discovery on the US longbond market takes place in the exchange-traded product in the period after .

. Exchange-traded derivatives have be-come particularly important in the newworld of algorithmic trading and in-ternet trading, both of which dovetail

. Reforming financial regime governance 153

better with electronic exchange-tradedproducts. The new order flow that is cre-ated owing to these two channels tendsto be concentrated on exchange-tradedproducts.

. In an environment where India’sregulatory and supervisory capacity inthe derivatives market is still nascent butevolving, exchange-traded markets posea simpler problem with full transparency,with standardised contracts being traded,and where credit risk is removed by theclearing corporation. In comparison,sound regulation and supervision ofmore opaque OTC markets makesgreater demands upon regulation andgovernance.

In particular, public sector financialfirms are vulnerable to questionsabout lowest-price procurement whena transaction takes place on anOTC market. In contrast, when acomputer does order-matching, lowest-price execution is guaranteed. As longas public sector financial firms areimportant in India, an emphasis onexchange-traded derivatives will elicitgreater participation.

. Apart from filling a major gap inthe structure of its financial system,another key reason for building a BCDnexus in India is to enter the exportmarket for IFS: i.e. attract global orderflow into: (a) the INR yield curve;(b) trades in contracts of the INR vs.other global currencies; and (c) creditrisk management products trading inIndia. The clubby world of the globalforward market – where counterpartiesknow each other, face credit risk fromeach other, and have conversations ontelephone – will be more difficult forIndia to break into, given that thesehuman relationships are well establishedat the three established GFCs and otherIFCs like Tokyo, Frankfurt and Paris.

It is more feasible for India to competein the world market for order flowinto exchange-traded derivatives. Thisis a more meritocratic market, wheretransaction charges and impact costare all that matters; being plugged intocertain human networks matters less.

As an example, it appears more feasibleto attract users of currency futures andcurrency forwards trading all over theworld to send orders electronically intoan order-matching system operating inMumbai, rather than seeking to obtainmarket share in the global OTC market.

. Exchange-traded derivatives fit wellwith non-institutional customers, whoare not able to access the telephonenetworks through which OTC tradingtakes place. This issue is not uniqueto India: e.g. in Japan, individualshave come to play a substantial role incurrency trading in recent years, throughthe currency futures market. Giventhe importance of non-institutionalplayers in Indian finance, an emphasison exchange-traded derivatives will helpin harnessing their participation andthus liquidity.

. Finally, exchange-traded derivativestrading plays to India’s strengths inrunning exchange institutions. NSE,BSE, NSCC, CCIL are a strong setof institutions, and can compete inthe global market for exchange-tradedderivatives.

Some of these seven issues are uniqueto India. However, some of these issuesare presently at work in reshaping theinternational derivatives market. Asa consequence, currency futures haveexperienced considerable growth. BIS datashows currency futures turnover has grownfrom $. trillion in Q to $ trillion inQ .

India needs both exchange-tradedderivatives and OTC derivatives. However,these arguments suggest that particularlyin the early years, a special focus should beplaced on obtaining world-class liquidity onthe exchange platform. This is where India’sIFS export opportunity lies, and this is the‘raw material’ using which OTC derivativesare made. The right sequencing is to firsthave a liquid electronic trading screen, afterwhich an OTC market can spring up based

On the subject of individuals in the Japanesecurrency futures market, see http://tinyurl.com/ycgbm2 on the web.

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on utilisation of the prices and liquidityproduced on this screen.

6. Regulatory impactassessments

In the foreseeable future, India couldbe headed for a four-way separation offinancial regulation, with separate agenciesperforming regulatory and supervisoryfunctions for Banking, Securities, Insurance,and Pensions. The merits of a larger all-inclusive unification – such as emulatingthe - – can be debated ad nauseamin the Indian context. The wouldprefer not to trigger or indulge in that debateas it diverts from its main concern – i.e.,that of establishing a successful inMumbai as swiftly as possible. Regardless ofwhether -style unification is attemptedor another form of regulatory architectureis applied, an in Mumbai will stillrequire world-class financial regulation andsupervision (in terms of policy, approach,attitude and practice) in either case.

One tool for improving the quality ofregulatory agencies is a periodic processof “Regulatory Impact Assessments” ().These are now commonplace in countries. Each is essentially a cost-benefit analysis carried out independentlyevery – years to review regulatoryarchitecture and implementation. The term‘architecture’ describes the boundaries ofthe agency, its legal foundations, and itsmandate, while the term ‘implementation’refers to how the agency translates thesegoals and conceptual framework intosuccessful, globally competitive regulationand supervision. Each needsperiodically to compare Mumbai againstpeer s, and examine how architectureand implementation can be evolved so as toimprove India’s ability to produce forthe global market.

7. Strengthening the legalsystem supporting an IFC

The legal system comprises legislature, laws,courts and judges. In a finance settingwith independent regulators, an appealsmechanism is required for all actions of the

regulator. The difficulties confronted by theIndian legal system in tackling sophisticated are well known. The system lacksspecialised domain knowledge. Legalprocesses are drawn out over excessivelyelongated periods of time. Recent reportsindicate that over million cases arecurrently pending resolution in India.

From an perspective, the mostuseful strategy may be the creation ofspecialised courts that combine (a) highlyexperienced arbitrators equipped withspecific domain knowledge, and(b) streamlined workflow leading to minimaldelays. Extending the scope of the presentSecurities Appellate Tribunal () mightbe a useful way of addressing these concerns. already has judicial capacity withspecialised domain knowledge in securitiesmarkets. It processes cases with obviousefficiency at an impressive pace. Goingbeyond , there is a possibility ofutilising for processing appeals against and also.

Applying the same logic, ’s scopeand remit could be extended to covering as well with adding an Appeals Tribunal () to its extantrole. could have its remit expandedto deal with appeals not just for capitalmarkets transactions but cover banking,securities, insurance and pensions as well.A larger role for arbitration would helpstrengthen the legal system. Arbitrationis a key mechanism through which fasterand superior contract enforcement can beachieved between private agents who havedisputes about private contracts.

From the viewpoint of a globalparticipant utilising Indian financial services,legal risk induces a risk premium; it reducesthe competitiveness of India as a venuefor production. Effective arbitrationprocedures give private agents a way tobypass the constraints of the courts. TheIndian Arbitration and Conciliation Act waspassed in , with the intent of enabling

The ideas and facts here greatly draws upon“What next for Indian arbitration?” by A. Ray andD. Sabharwal, of the International Arbitration PracticeGroup at White & Case, London, which appeared inEconomic Times, August .

. Reforming financial regime governance 155

and strengthening this channel. However,two decisions of the Supreme Court havedealt severe blows to the Act: () theOil & Natural Gas Corporation v Saw Pipes() [] and () & Co. vPatel Engineering () .

As a response to these problems, theArbitration and Conciliation (Amendment)Bill, , currently pending before Parlia-ment, proposes to introduce a new sectionthat would allow an award to be set aside“where there is an error apparent on the faceof the arbitration award giving rise to a sub-

The Act was designed primarily to implementthe Model Law on InternationalCommercial Arbitration and create a pro-arbitrationlegal regime in India. Prior to its enactment, therewas widespread discontent over the excessive judicialintervention allowed by its predecessor, the

Act. The Act attempted to rectify this problemby narrowing the basis on which awards could bechallenged, thereby minimising the supervisory roleof courts, ensuring finality of arbitral awards andexpediting the arbitration process.

Saw Pipes addressed a challenge to an Indianarbitral award on the ground that it was “in conflictwith the public policy of India”. Despite precedentssuggesting that “public policy” be interpreted in arestrictive manner and that a breach of “public policy”involves something more than a mere violation ofIndian law, the Court interpreted public policy inthe broadest terms possible. The Court held thatany arbitral award which violates Indian statutoryprovisions is “patently illegal” and contrary to “publicpolicy”. By equating “patent illegality” to an “errorof law”, the Court effectively paved the way for losingparties in the arbitral process to have their day in Indiancourts on the basis of any alleged contraventions ofIndian law, thereby resurrecting the potentially limitlessjudicial review which the Act was designed toeliminate.

In Patel Engineering, the Supreme Courtsubsequently sanctioned further court interventionin the arbitral process. The case concerned theappointment of an arbitrator by the Chief Justice incircumstances where the parties’ chosen method forconstituting the tribunal had failed. The Court heldthat the Chief Justice , while discharging this function,is entitled to adjudicate on contentious preliminaryissues such as the existence of a valid arbitrationagreement and is entitled to call for evidence to resolvejurisdictional issues. Significantly, the Court ruled thatthe Chief Justice’s findings on these preliminary issueswould be final and binding on the arbitral tribunal,making a mockery of the well-established principleof Kompetenz-Kompetenz – the power of an arbitraltribunal to determine its own jurisdiction – enshrinedin section of the Act. This encourages partiesto sabotage the appointment process of arbitrators,make spurious arguments about preliminary issuesand use evidentiary hearings in courts to delay arbitralproceedings.

stantial question of law”. Although this newground for challenge is narrower in defini-tion than the Saw Pipes ruling, it still affordslosing parties an opportunity to approachthe courts in an attempt to second-guessarbitral tribunals. This could lead to a po-sition not dissimilar to that under the

Act and complete a full circle for Indian arbi-tration. The problems of Patel Engineeringcase prima facie, do not appear to have beenaddressed in this Bill.

The last (but not least) componentof the legal system is lawyers. At present,there are some significant weaknesses in thedevelopment of legal skills by the presentIndian education system, particularly whenit comes to the legal aspects of sophisticatedfinance. The internationalisation of Indianfinance will induce new kinds of pressuresupon the legal fraternity. On one hand, legalskills will be demanded in global finance thatgo well beyond the skills developed in dealingwith Indian financial law. In addition, manyglobal financial firms might feel comfortableutilising the services of the same global lawfirms they use in other s when doingcertain transactions out of India. This isperhaps analogous to FIIs favouring foreignbrokerage firms when operating in India.

This suggests that India needs to openup on the issue of foreign law firmsoperating in India. Such measures will helpsimultaneously in three directions. It willimprove the legal knowledge available inthe country, particularly on the interfacesbetween finance and law. It will helpglobal financial firms feel comfortable withoperating in Mumbai, since they would findfamiliar global legal firms. It would havethe same impact on improving the skills,technology and competitiveness of the Indianlegal services industry that permitting in manufacturing had on Indian industrialfirms.

Developments along these lines arealready taking place. On th October, ,the Minister for Commerce and Industry saidthat a panel of lawyers had been constitutedunder the -India Joint Economic andTrade Committee () to work witha similar group in the to deliberate onopening up the legal services sector.

Tax policy for an IFC inMumbai

12c h a p t e r

1. Does India need an IFC or aTax Haven?

Creating an in Mumbai – that offers as competitively and efficiently as otherestablished s– will induce lobbyingpressure on the authorities, from serviceproviders as well as global investors, toprovide zero or near-zero taxation of theIFS offered. Such pressures are based onthree arguments: (a) the desirability ofcreating a tax haven explicitly in order toattract a greater proportion of global IFSflows for servicing through India; (b) the‘obvious’ need for providing temporary fiscalsubsidies aimed at kick-starting a desirableexport services industry using infantindustry arguments; or, more legitimately,(c) achieving greater competitiveness withother established and emergent/aspirants.

In that connection, proponents fortotal tax-exemption of an to encourage exports – or for exemption of at leastsome products and services – oftenpoint to the success of the Indian export services industry since . Theyargue that explosive growth in exportservices occurred at least in part because of(a) benign Government neglect, resulting infew opportunities for interference and pettyrent seeking; and (b) initially favourabletax treatment – which, of course, the ITindustry (along with others) is attemptingto perpetuate through devices like s.

In the view of the – which is infavour of global competitiveness – thesepressures have no legitimacy in an effort tocreate an in Mumbai. They should beresisted at municipal, state and central levels.A country like India does not need a taxhaven. As has been argued before, India isnot a small enclave or island economy, withlimited options for economic diversificationand growth.

Moreover, the current global climate(especially in countries but alsoin countries like India) is opposed to‘tax competition’ or, more euphemistically,‘harmful tax practices’. In particular,the disfavours ‘dual tax regimes’offered by small countries to create tax-arbitrage to the detriment of its membercountries. They object to a non-country applying a ‘normal’ tax regime toits own citizens/residents, while offeringnon-residents a low-tax or no-tax-regime

o should recognise, however, that this is aself-serving characterisation, contrived to permitgovernments of rich (but uncompetitive) countries to maintain egregiously high tax regimes thatsupport wasteful public expenditure. Such tax-spendpolicies enable too large an intermediation role to beplayed by these governments (particularly in Europe)in transferring – opaquely and unaccountably – realincome from one part of the middle-class (e.g. thehealthy, young working adults, or the childless) toanother (families with children, those on the dole, thosewho smoke/drink excessively, retirees who have notsaved enough) – in so-called ‘public service’ domainsthat are more efficiently served by private markets.Public revenues (and expenditures) in many northEuropean countries now pre-empt over –% of. They finance unsustainable, failing public health,education and welfare systems. These nations arebecoming uncompetitive and losing jobs – indeedentire industries – to poorer (therefore lower-cost, morecompetitive) countries like China (in manufacturing)and India (in services and manufacturing as well).Under domestic political pressure, governments(particularly in Europe) are now engaging in a cartelisedform of ‘protectionism’ to insulate themselves fromcompetition by developing countries that have lowerpublic revenues and expenditures of the region of %of in order to encourage savings, investment,growth, markets and competitiveness. Yet the newaccession countries to the EU have been introducing lowflat tax regimes that are proving simpler, more attractiveand more efficient. Poorer countries must eventuallyattain levels of per capita income and standards ofliving now enjoyed in the world. In an efficient,equitable, open global economy, average per-capitaincomes should converge gradually. If it takes taxcompetition to achieve that happy state, then that ishow it should be. o should not accept the anti-tax-competition argument as having any intellectuallegitimacy.

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at the same time. But the cannotoppose or punish (via sanctions or black-listing) an emirate like Dubai offering thesame uniform ‘low-tax’ or ‘no-tax’ regimeto residents and non-residents alike. Doingso would violate a key tenet of internationallaw: i.e., the sovereign right of countriesto determine their own fiscal policies, aslong as they do not create discriminatorydual regimes aimed solely at tax-arbitrage,or apply their tax policies in a way thataffects adversely the fiscal rights of othercountries. Besides, apart from issues createdby artificial tax-arbitrage, an emirate in theGulf may not need to levy any personalincome or corporate taxes, because of asurplus of public income derived fromsources such as oil/gas revenues or the saleof land, or whatever.

In such a climate, creating a tax havenwould be detrimental for an in Mumbai.Besides as an observer (and potential newmember) of the Financial Action Task Force(), the Indian government can hardlycountenance the creation of yet anothertax-haven . Doing so would trivialisethe two main arguments for having an in the first place – i.e., (i) to meet India’s(and Asia’s) legitimate and rapidly growingIFS needs as one of the world’s largestemerging trading and investing economies;and (ii) to derive significant service exportrevenues from , in which India hasnatural comparative/competitive advantagesfor capturing significant global marketshare. A tax haven would compromise thefunctioning and credibility of an Indian in the eyes of the world. That is anotherreason why the Committee would adviseagainst locating an in Mumbai (oranywhere else in India) in a SEZ.

Also, experience suggests that infantindustry arguments in India are dangerous.Prior to , over-susceptibility to thatargument resulted in India nurturing -year old infants in all its industries otherthan IT.

Many offshore financial centres in smalllandlocked and island countries chose tobecome tax havens – for multinationalcorporations as well as wealthy privateindividuals and trusts – to create a taxarbitrage advantage for themselves in

attracting international financial business(i.e., transfer pricing, tax management, andavoidance of high tax in countriesby their residents). There are over

such centres around the world (see Box.) in landlocked principalities and micro-countries such as Andorra, Botswana,Monaco, Luxembourg, Lichtenstein, etc.as well as in island economies in: thenorth Atlantic vicinity (the Channel Islands,Bermuda, Isle of Man); in the Caribbean(where there are over fifteen s, thelargest being The Bahamas, The CaymanIslands, Barbados and the NetherlandsAntilles); as well as in the Indian Ocean(Seychelles, and Mauritius) and Pacific (e.g.,Vanuatu).

s derive revenues from the legal, taxand accounting services offered to firms thatseek to tax-domicile, or book transactions,in these jurisdictions to avail of near-zerotax rates. In the relative context of theireconomies (e.g. Mauritius has a of$ . billion or less than the sales of theReliance Group) such limited revenuescan be quite large (>% of GNI). But sucha strategy is inappropriate for India. An in Mumbai should aim to achieve notjust the booking of transactions butthe actual provision of the product/serviceunderlying them. India’s strength liesin its human and technological capacityto provide tradable financial services andcapture the value added on a significantscale by world standards; not just to thesmall extent of routine legal, tax, audit oraccounting services offered in a tax haven.As an , Mumbai should therefore aspireto become like London or New York; avenue where large-scale productionand exports takes place for the globalmarket rather than being content as a meretransactions-booking centre and artificialcompany registry.

Many financial transactions in a success-ful , such as bond issues, securitisationproducts and derivatives contracts, involveembarking on a contractual structure withconsequent cash-flows taking place as percontract for the coming or even years.In order to give the private sector confi-dence in undertaking such transactions, 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)Seychelles (FSF) Japan1 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) DominicaPhilippines Madeira GrenadaSingapore2(J) (OG) (FSF) Malta (OG) (FSF) MontserratTahiti Monaco (FSF) Netherlands Antilles (J) (OG) (FSF)Thailand3 Netherlands Panama (J) (OG) (FSF)Vanuatu (J) (OG) (FSF) Switzerland (FSF) Puerto RicoWestern Samoa (FSF) St. Kitts and Nevis (FSF)

St. Lucia (FSF)St. Vincent and Grenadines (FSF)Turks and Caicos Islands (FSF)United States4

UruguayWest Indies (UK) (J)5

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).1Japanese Offshore Market (JOM).2Asian Currency Units (ACUs).3Bangkok International Banking Facilities (BIBFs).4US International Banking Facilities (IBFs).5 Includes Virgin Islands, Anguilla, and Monserrat.

which will be sustained in the long term. Anartificial ‘infant industry’ argument basedon tax breaks is not credible in the eyes ofthe private sector, for it is clear that once the takes hold, the tax code will be changed.This very uncertainty about future tax treat-ment will serve to deter transactions fromtaking place in Mumbai.

Through the proliferation of technologies, it is now increasingly feasibleto decouple the booking of an IFStransaction from where it is produced.Tax domiciles can be far removed fromlocations where real value is added.To the extent that this takes place, Indiawill not be disadvantaged by having arational taxation regime governing its .Global customers will still buy genuine from India (providing those are of the

same quality, but provided at lower cost,with greater efficiency, and better customerservice) even if they might prefer – forglobal tax management reasons – to booktransactions in tax havens around the world.

There are deeper problems with an‘industrial policy’ of government supportingthe financial industry or IFS via taxincentives. If the government ‘encourages’financial firms through lower tax rates, thiswould implicitly constitute a subsidy fromthe general taxpayer to shareholders andworkers in financial firms. Such a fiscalsubsidy for an is neither necessary norjustifiable. More importantly, if financialfirms in a Mumbai-based were providedwith a tax advantage over firms undertakingother types of activity, that would encourageless competitive firms (i.e., smaller, weaker

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and insufficiently capitalised) to provide. It would also provide an incentive forother types of services firms to camouflagethemselves as financial firms. An ecosystemwith financial firms propped up by taxincentives and exemptions is not one thatwould be populated by the most capable,efficient and innovative financial firms norwould it necessarily attract global financialfirms to locate in such a .

But, it should be emphasised thatthe argument against tax exemptions, orany form of preferential tax treatmentin an , is not the same as makingan argument for having a regime ofgenerally high, complex and harmful taxes– that provide disincentives for effort,transparency, volunteerism and honesty intax payments – being applied to the either. What would be best for an Indian– as well as for the rest of industrial,commercial and financial India – is ageneral regime of uniformly low marginaltax rates, applied universally across theboard in every sector of economic activitywithout any exception (including agricultureand agricultural finance) with as few taxincentives, exceptions and exemptions aspossible. The tax regime should besimple, and structured so as to be as non-discriminatory and non-distortionary aspossible; i.e., across different activities, andin the tax-treatment of income derived

In that connection it needs to be observed thatinadequate prior analysis, and confused policy support(lacking full public consensus), has resulted in far toomany disparate, variably-sized s being approved bycentral and state governments, in too many fragmentedlocations. That has compromised the tax principlebeing enunciated here at the outset. It has also createdopportunities for distortions to arise in piecemeal,imbalanced investment in infrastructure around thecountry. That reduces the prospect of economiesof scale from being exploited; e.g. by fragmentingpower generation across s rather than havinggeneration being determined by the needs of a particularcontiguous area or geographic region. Moreover, itappears that many approved s now incorporatesub-projects for speculative real estate developmentfor residential and commercial purposes (as opposedto dedicated manufacturing or service industry use).These entirely unnecessary add-ons could compromisethe financial portfolios of major financial firms lendingto s and to firms locating in them. That harmshould not be exacerbated by extending similar taxbenefits to an .

from different sources (e.g., whether trading,dividends, interest, rent, wages, partnershipprofits, or salaries).

2. Tax policy for Mumbai as anIFC: and, by implication, forIndia

By and large, the endorses fully,and urges swift implementation of allthe recommendations contained in theKelkar Committee Report (i.e., Report ofthe Task Force on Implementation of the FiscalResponsibility and Budget Management Act,) that was issued in June . The kindof tax regime suggested by the Kelkar Reportshould be applicable to the financial system(domestic and ) as a whole – one thatprovides incentives for increased output,high value-addition, and efficiency ratherthan for tax breaks.

It would also be the desired strategyto apply to an while keeping in mindthe need for flexibility to make adjustmentsfor certain types of in keeping withinternational norms. Such flexibility wouldbe desirable to ensure that an inMumbai remained competitive with selsewhere. With clearer tax policies, asimpler tax regime, and consensus that sucha regime would the most appropriate for thefinancial sector and for exports, threekey principles come to the fore:

. The need for applying a modern, low butuniversally applicable income tax regimeacross all sectors and activities, and amodern low to avoid the prospectof smuggling and cash transactionscompromising collections.

. Confining taxation to resident incomeand consumption while exempting non-residents from all direct taxes (regardlessof whether or not India has swith their home countries). Thisdoes not mean exempting non-residentsfrom indirect taxes on consumptionof goods/services in the country. Itdoes mean creating a special taxregime specifically for non-residentsunder which they could arbitrage taxliabilities against their own tax regimes.

. Removal of all bad taxes: i.e., those that

. Tax policy for an IFC in Mumbai 161

lead to incentives for evasion, those thatcost more to collect than yield, those thatare discriminatory and distortionary,and those that create friction in theproduction of goods and services (i.e.,eliminate all transaction taxes suchas stamp duties and transfer taxes oncapital assets, particularly in financialtransactions). As proposed in the Kelkar Task Force report, this needsto be done as part of the reform.The simultaneous removal of all badtaxes plus the introduction of the is fiscally neutral while enhancing both and tax buoyancy.

For an in India to be credible, tax-wise, to residents and non-residents alike, itis essential that the features, structures, ratesand quantum of taxation in India should beconsistent with:

(a) Optimising (not maximising) public rev-enue in line with the minimal financingof essential public goods/services – usinga minimalist approach to defining whatthese should be and who should benefitfrom them

(b) Emphasising rapid output and highvalue-added growth over any otherobjective over the next years

(c) Avoiding tax distortions, tax discrimi-nation, tax exemptions and preferencesaltogether and adhering to the notion ofuniversality

(d) Incentivising tax-payment ‘volunteerism’rather than inducing tax avoidanceand/or evasion by making it lessexpensive for taxpayers to complyinstead of avoiding compliance; and

(e) Cost-effectiveness: i.e., taxes should notbe levied that are more expensive tocollect at the margin than the amount ofrevenue they yield regardless of equityor social engineering concerns.

In achieving these objectives the ques-tion should be asked whether India’s multi-layered political/administrative structures,at multiple levels of governance, and its tra-ditional political/administrative practices,do not result in too many taxes being leviedby too many different authorities at higherthan necessary rates. The need to finance

government at several levels should not bea reason to create and sustain (through in-ertia) a plethora of cascading and distort-ing taxes (such as stamp duties and octroi,which are a barrier to intra-country tradeand movement of goods) with negative ef-fects on output, efficiency and intra-countryas well as international trade in goods andservices.

In sum: the first issue to be emphasisedin the context of a fiscal regime that wouldsupport India having an – but onethat has wider resonance and applicability– is that the most immediate objectivein tax policy has to be to move rapidlytowards a modern income tax and a modern for universal applicability in India(and applied uniformly above practicalthresholds). The second principle governingdesired tax strategy is that no governmentshould attempt to ‘export taxes’ or try toachieve extra-territoriality in the impositionof its tax regime. The incidence of a should fall on domestic consumption only.With a well-designed , imports arecharged , and exports are zero-rated,so that foreign customers of Indian goodsand services do not pay to the Indiangovernment. The third principle is that badtaxes (no matter how politically attractive)lead to a weak, dysfunctional economy.They compromise fairness, growth andequity.

Once a framework of sound and lowincome taxes and is created, the mazeof distortionary taxes and exemptions thatIndia has inherited from previous decadesneeds to be removed. In particular, turnovertaxes matter greatly for export of ; theirremoval is directly material to the effort ofIndia emerging as an .

3. A modern income tax

At the level of broad principle, Indiashould seek to roughly match the incometax treatment of a modern such asSingapore, while avoiding the zero-taxapproach of a city like Dubai. It shouldavoid attempting to have a dual tax regimefor residents and non-residents specificallyto attract business.

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3.1. What should the capital gains taxbe?

An important debate now taking placein India that has considerable relevancefor finance and concerns the capitalgains tax. Modern macroeconomic andpublic finance theories shed much lighton the optimal conduct of monetary andfiscal policies. A robust result of theresearch literature suggests the need forlow taxes on capital income (Chari andKehoe, ; McCaffery, ). One of thefoundation blocks of economic reasoningsuggests that the goal of a sound fiscal system(especially in a developing country) shouldrely on taxing consumption not savings.This can be achieved by taxation withlarge permissible annual savings per person.Under such a scheme, individuals should beencouraged to save, with income and capitalgains being exempt from taxation, until theychose to consume.

Thus, the path to a sound consumptiontax lies in low or zero tax rates applied tocapital income. Such an approach dovetailswell with the export of . Low or zerotax rates applied to capital gains would putIndia on par with many other countries thathave taken such a path. But, this approachneeds to be applied symmetrically to bothdomestic and foreign investors withoutcreating officially sanctioned loopholes ofthe kind that exist in Indian tax treatiesallowing special tax treatment for investorsin Mauritius, Cyprus and Singapore. Manyof these treaties will lose their potency indiverting tax revenues almost automaticallywith the removal of residual capital controls.It may be better to take that approach indealing with the problems they appear tocreate than to attempt renegotiating themclause-by-clause. This overall approach tothe taxation of finance would be consistentwith Indian exports of being rootedin the Indian financial system, and notseparated into an enclave.

3.2. Mature issues in the Indian taxdebate concerning finance andIFS

There are four specific areas of tax policythat influence where the policy debatein India is mature and articulated in the

Kelkar Report. These concern () taxtreatment of savings, () taxation ofasset management, () definitions andtax treatment of ‘speculative’ transactionsand () the tax treatment of zero couponbonds. The basic approach of the Implementation Task Force on these issuesis entirely consistent with the goal of makingMumbai an Indian .

From an perspective, the primarypriority is to bring about a liquid andefficient bond market with an arbitrage-free yield curve. Administered interest rates,and tax exemption provisions for particularfinancial products, militate against thisgoal. exports are unlikely to materialisefrom India in the absence of its asset/fundmanagement industry operating in the sameway and being governed by the same policyregime as its global counterparts in othermature financial markets. That requiresachieving ‘neutrality’ as an essential featurebetween ‘in-sourcing’ and ‘outsourcing’ ofasset/fund management where three casescan be distinguished:

. A firm or a person manages funds/assets

. Funds are given to an AMC for assetmanagement on an agency basis

. A global further subcontracts toother national/sectoral s.

Tax considerations should not encour-age or discourage the way in which the assetmanagement business is organised in termsof the extent of outsourcing that takes place.As an example, corporations should haveno tax-induced motivation to outsourcetreasury functions to mutual funds in anattempt to reduce their effective tax rates.Furthermore, tax considerations should notgenerate artificial differences in the rela-tive attractiveness of alternative financialproducts, in the eyes of either providersor consumers of those products. As an ex-ample, an insurance company should nothave to (or be allowed to) embellish an assetmanagement product with a small actuarialcomponent, in order to obtain superior taxtreatment when compared with the sameproduct being sold by a mutual fund or aprivate bank. Concessional tax treatment ofcertain savings instruments is particularlyimportant insofar as it distorts price discov-

. Tax policy for an IFC in Mumbai 163

ery for the yield curve. The adoptionof a rational tax policy in these respects isinextricably bound to having an emergein India that is viable.

3.3. LLPs as tax-efficientpass-throughs

In creating sophisticated financial productsor structures the need keeps recurringfor a ‘corporate or partnership’ structurethat supports tax-efficient transmission ofcash-flows coupled with specific types offinancial contracts. Internationally, such astructure is provided by the Limited LiabilityPartnership (). Examples include:

• A securitisation special purpose vehicle() can be in the form of an . Itwould be the placeholder for a certaincontractual set of obligations throughwhich cash-flows would come intothe . These cash-flows would betransmitted to the holders of securitiesissued by the . The itselfwould need to be a tax pass-through,while the cash-flows reach their eventualbeneficial owners and get taxed in theirtax-domiciles. If double-taxation takesplace – if the cash-flow gets taxed onceat the and again in the tax domicileof the owner of the security – thensecuritisation cannot take place.

• ‘Hedge funds’ are invariably structuredas . The lack of an structurein India hinders the development ofhedge funds as an institutional investingmechanism although these funds arenow the mainstays of other s. In dis-allowing them, India is doing enormousdamage to itself.

Some development work towards getting structures legitimised in India has beentaking place, but it is more focused on theneeds of professional services firms such aslawyers or accountants. Such developmentneeds to take into account the needs of the as a key building block of sophisticatedfinancial structures.

4. Taxation of financialtransactions

At present, there are three main kinds oftransactions (i.e., turnover) taxes in India

that are applicable to financial transactions:

• The securities transaction tax ()applies to some kinds of securities: e.g.,equity spot and derivative transactions.

• Registration duties/fees need to bepaid for specific services provided bygovernment in recording contract anddeeds. The government maintainsa registry of deeds in return for afee. Government agents (called ‘sub-registrars’) do not verify the legal validityof documents; they focus only on thepayment of the correct fee. The paymentof the registration fee does not entitlethe payee to a guaranteed legal title.

• Stamp duty is a tax on the value of in-struments used in various transactions.

All three of these are cascading taxes; theyare comparable with excise taxes in the caseof manufactured and traded goods.

4.1. Taxation of transactions distortsthe conduct of business

In the real economy, it is now a well acceptedprinciple that turnover is an inappropriatebase for taxation. When transactions aretaxed, this leads to a cascading impact. Theincidence of such taxes falls to a greaterextent upon processes that involve severalstages of production. Transaction taxesencourage vertical integration i.e., theyencourage transactions to occur within thefirm (rather than between independentfirms) so as to incur lower taxes. This runscontrary to a key feature of a mature marketeconomy, where firms are specialised tofocus on core competencies, and wheretransactions take place between firms.Transaction taxes give firms a bias in favourof some production mechanisms over others:these biases distort the organisation ofproduction and firms.

The identical issues apply in thetaxation of financial transactions. A financialfirm can be thought of as buying rawmaterials (securities or money on its assetsside) in order to produce finished goods(securities on its liabilities side). Theactivities of a typical financial firm consistof a set of transactions that transform riskand return in a variety of ways to meet theneeds of different customers. In finance,

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the trading strategy is analogous to processtechnology. Different technologies can beutilised to produce the identical product.In other words, a given set of risk/returncharacteristics can be produced throughdifferent trading strategies. As an example,if the goal is to produce a riskless asset witha maturity of days, the different ways inwhich this can be done include:

. Buy a zero-coupon government bondwith a -day maturity

. Buy a zero-coupon government bondwith an ‘n’-day maturity and rolloverevery ‘n’ days.

. Enter into cash-and-carry arbitrage onone of many futures products.

. Enter into put-call parity arbitragepositions using one of many optionsproducts.

. Run an options book, and lay off risk,using delta-neutral hedging, dynamicallymodifying the hedge continuously so asto achieve zero risk.

These are only five examples ofalternative technologies through which ariskless position with a -day maturitycan be obtained. Numerous other‘technologies’ for achieving this outcomecan be designed, all of which combineunderlying financial ‘raw materials’ throughdifferent trading strategies. Under normalcircumstances, traders would decide amongthese different routes on the basis ofcommercial considerations. But, whenturnover is taxed, the incidence of taxationfalls disproportionately on ‘technologies’that require more trading; even thoughthey may be better options for investorsto exercise. As an example, there might be alarge degree of mispricing on the optionsmarket; but ‘delta-neutral hedging’ might beunattractive because it involves perhaps

times the trading volume when comparedwith buying a treasury bill. If transactionstaxes applied, they would automatically tiltthe investment decision toward sub-optimalpurchase of a T-bill. A core principle ofpublic finance is that tax policy must notmodify the choice of technology by a privateeconomic agent. Transaction taxes distortthe choice of technology by financial firms.Therefore they are ‘bad taxes’.

4.2. Taxing transactions in a world ofIFS

Thus, in a purely domestic economy, thetaxation of turnover is inappropriate becauseit violates every principle of sensible publicfinance. But the problems it creates escalateand multiply in the context of competingin global markets for . Taxes ontransactions force business to leave venueswith effective high taxation (as well as hightax rates) and migrate to venues with lowtaxation (and low rates).

In the manufacturing world, theprinciple that you cannot export taxes is nowwell-understood. This has led to the entiresophisticated framework of , whereexports are zero-rated, and imports arecharged . Under this framework, theincidence of falls only on domesticconsumption. The price of all goods ‘intransit’ is free of charged by anycountry. All mature market economieshave eliminated all turnover taxes on goods.But, identical issues apply when it comesto the global market for . It is notpossible for India to impose taxes uponforeign customers of produced in India:the attempt to do so will simply shifttransactions away from India. This clearlyimplies arguing for the removal of all taxeson transactions.

4.3. Removal of turnover taxes inIndia

The removal of the Securities TransactionTax () will influence efficiency andexport-competitiveness for in a waysimilar to the removal of cascading taxesin manufacturing. There will be an initialloss of revenue; but this is inevitable withthe removal of bad taxes. As an example,India steadily eliminated customs duties,which did hurt tax revenues. There was noattempt at introducing any compensatingchanges in the tax code, one-for-one, whichcompensated for the removal of the bad tax.

Sometimes, it is felt that a trade-off

can be created between the taxation ofcapital gains and the taxation of financialmarket turnover. However, the uniquehistorical features of India’s evolution onboth questions should not obscure the needfor 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

transaction taxes can have negative effects onprice discovery, volatility, liquidity, and lead toa reduction in the informational efficiency ofmarkets (Habermeier and Kirilenko, 2003).One fascinating experiment with theintroduction, and then the repeal, of asecurities transaction tax took place fromOctober 1983 to December 1991 in Sweden(Umlauf, 1993; Campbell and Froot, 1995).

Left-wing political parties in Swedenbelieved that trading on financial markets wasan undesirable activity. It was argued that “thesalaries earned by young finance professionalswere unjustifiable in a society giving highpriority to income equality, especially given theseemingly unproductive tasks that theyperformed”. Despite the objections of theSwedish Finance Ministry and the financialindustry, popular support led to the adoptionof the STT by Parliament in October 1983, witheffect from January 1, 1984. The STT waslevied on domestic stock and derivativetransactions. Purchases and sales of domesticequities were taxed at 0.5% each, resulting ina 1% tax per round trip. Round-triptransactions in stock options were taxed at2%. In addition, exercise of an option wastreated as a transaction in the underlying stockand, thus, was subject to an additional onepercent round-trip charge.

The tax coverage and rates were based onpopulist notions about the usefulness oftransactions in different financial instruments,

with those involving equity options being seenas the least useful. Continuing pressure fromthe Left compelled Parliament to double ratesin July 1986, and broaden its coverage in1987. Furthermore, following large losses ininterest rate futures and options (most notablyby the City of Stockholm, which lost SEK 450million), the tax was extended to transactionsin fixed-income securities, includinggovernment debt and the correspondingderivatives in 1989. The maximum tax rate forfixed-income instruments was set at 0.15% ofthe underlying notional or cash amount. Inaddition, the tax was designed to beyield-neutral, with longer maturity instrumentsbeing taxed at progressively higher rates.

The empirical experience with revenuesfrom STT was poor. When rates were doubledin July 1986, tax collections only went up by22%. Customers were avoiding the tax byshifting their order flow to London or NewYork. The first thing which dried up was theorder flow from foreign investors. Domesticinvestors avoided the STT by first establishingoffshore accounts (and paying the tax equal tothree times the round-trip tax on equity forfunds moved offshore) and then using foreignbrokers. The scale of avoidance wasmanifested by a massive migration of stocktrading volume from Stockholm to otherfinancial centres. Following the doubling ofthe tax, 60% of the traded volume of the 11most actively traded Swedish stocks migratedto London. The migrated volume represented

over 30% of all trading volume in Swedishequities. By 1990, that share increased toaround 50%. Only 27% of the trading volumein Ericsson, the most actively traded Swedishstock, took place in Stockholm in 1988.

In the Swedish experience, revenues fromthe STT were poor for two reasons: shift inturnover to venues free of STT, and the declinein share prices associated with the tax and itsimpact upon market liquidity.

Broadening the tax to fixed-incomeinstruments resulted in a sharp drop in tradingvolume in Swedish government bills and bondsand in fixed-income derivatives contracts.During the first week of the tax, bond tradingvolume dropped by about 85% from itsaverage during the summer of 1987 andtrading in fixed-income derivatives essentiallydisappeared. This significantly undermined theability of the Bank of Sweden to conductmonetary policy, made government borrowingmore expensive, and eroded both popular andpolitical support for the tax. Taxes onfixed-income instruments were abolished inApril 1990. Taxes on other instruments werecut in half in January 1991 and abolishedaltogether in December 1991.

Following the abolition of the tax, sometrading volume came back to Sweden. By1992, roughly 56% of trading in Swedishequities took place in Sweden. Once lost toother centres such trading volume becomesextremely difficult for countries to bring backhome.

Modern economic reasoning suggests thatthere is merit in having both zero taxationof turnover and low-to-zero taxation ofcapital income. Discussions about the should not be undertaken as a trade-off withdiscussions about capital gains to achieve‘revenue neutrality’. That is a false trade-off.

The removal of stamp duty is part ofthe Grand Bargain proposed by the KelkarTask Force. In exchange for tax revenuesfrom all services, states should be willing togive up distortionary taxes like the stampduty. In the case of real estate, the KelkarTask Force report proposes integrating thereal estate sector into the GST, which furtherenhances the case for elimination of stampduty on real estate transactions.

In the case of registration fees, there isa role for the State in performing essentialasset registry functions, and enforcingproperty rights associated with them. These

functions are comparable to those of adepository on the markets. Registrationfees can be interpreted as user chargesfor performing record keeping functions– which justifies small charges such asthe per-transaction charge of . Butthe imposition of indirect taxes throughregistration and stamp duties constitutesa case of erroneous tax policy. There is acase for a user charge for operating andmaintaining an system that maintainsownership records. There is no case fortransaction taxes.

5. A Goods and Services Tax(GST) in Finance

The Kelkar Task Force reportproposed the creation of a two-part named the Goods and Services Tax ().What it envisages is a pair of taxes – levied by

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Centre and States – that are harmonised interms of tax policy and administration. Theincidence of falls on consumption inthe domestic economy; foreign consumersare not taxed. All parts of the economy –including the financial sector – would becovered by . This objective is consistentwith both modern economic reasoning(Auerbach and Gordon, ) and withthe establishment of an in India. Inthe context of debates about treatment ofdomestic firms versus foreign firms, the comes down very clearly, seeking to haveidentical treatment of all firms.

From the viewpoint of Indian publicfinance, the emergence of an in Mumbaiwould generate tax revenues through:(a) taxes on the income of individualsworking in the industry; (b) corporateincome taxes applied to the firms operatingin the ; and (c) the GST applied tovalue added by the industry when sellingto local customers. Once these threesources of tax revenue are in place, itshould become possible to simultaneouslyremove all turnover taxes, including stampduty, registration duty and the securitiestransaction tax ().

Applying the to financial servicesis sound in principle. But the practicaldifficulties of achieving this outcome needto be better appreciated. The EuropeanUnion pioneered building an -scale on finance. Its experience has highlightedmany areas of complex decision-making intax policy and tax administration. Indianeeds to approach the construction of a on finance as a multi-year process, to beundertaken delicately and thoughtfully.

6. Mumbai as an IFC: TaxImplications forMaharashtra and Mumbai

This chapter underlines the principle thatthere is no role for taxation of transactionson financial services – whether for or (domestic financial services). Hence,neither Mumbai nor Maharashtra shouldexpect a new revenue base emerging fromlarge trading volumes of in Mumbai. Infact turnover taxes (like stamp duties) levied

on transactions would ensure that therewould, in all probability, be no tradingin/from Mumbai at all. Without stampduties and other forms of ‘local’ taxation tocapture, state and city politicians may ask:“What does Mumbai gain from having an?” The answer is that:

• First, the two-part proposedinvolves a layer that consists of aconsumption tax enforced at the Statelevel. This would generate incrementalrevenues in proportion to the substantialincremental consumption opportunitiescreated by having an in Mumbai; i.e.,as a consequence of having more globalfinancial firms locating in Mumbai totrade and employing a far greaternumber of high-income people fromMumbai and abroad.

That would create downstreamopportunities for providing theseincoming high-income firms and peoplewith the usual range of incrementalgoods and services (from homes, to cars,refrigerators, washing machines, food,clothing, household linen and durables,domestic helpers, chauffeurs, peons,clerical workers, secretaries, financeprofessionals and paraprofessionalssuch as accountants, book-keepers,auditors, compliance officers, as wellas restaurants, laundries, bakeries,clubs, cinemas, theatres, bookshops,hairdressers, fuel, gas stations, etc. etc.)

But it would also have incrementalcosts: i.e., by generating new needs forinfrastructure (homes, office space, re-tail space, water, power, telecommunica-tions, roads, sewerage, storm drainage,parking, airlines, airports, trains etc.),for law and order, security, and for phys-ical/social recreation. Such investmentcould be made through PPPs thus savingthe state and the city from making theactual investment necessary in creatingsuch facilities.

The additional demand created forgoods and services by an in Mumbaiwould generate a significant amount ofadditional revenue for the city and thestate without having to resort either todirectly taxing transactions, or theprofits of firms providing or trading

. Tax policy for an IFC in Mumbai 167

in . To the extent that an inMumbai increases general consumption– of both goods and services – it wouldgenerate substantially increased taxrevenues indirectly.

But it would also demand betterstandards of governance to be provided(from policing to keeping publiclavatories spotless and deodorised) byboth city administration and the Stategovernment – governance that meetsinternational standards. That wouldpose a greater challenge; one thatshould worry city/state (and central)government politicians and officialsmuch more than the incrementalrevenues emanating from an inMumbai.

• To the extent that there are highproductivity firms and individuals inMumbai, this would support higherproperty prices and thus a biggerrevenue stream from property taxes;especially if the market for owned andrented properties were to clear moreefficiently in Mumbai than it presentlydoes. The same is true for taxes fromfuel consumption etc.

The benefit for state and municipalexchequers from having an in Mumbaiwould be the enormous additional impact onprosperity in Mumbai and its surroundingregion. It would not be seen throughhigher direct tax revenues. If there isany doubt about that then state and localpoliticians/officials should see for themselvesfirst hand, the large incremental indirectbenefits being derived in New York, Londonand Singapore by having an locatedthere. If such benefits were ephemeral it iscertain that Dubai would not be pursuingthe establishment of an as aggressivelyand tenaciously – particular in invitingIndian financial firms to operate from there.Mumbai would have to be prepared toaccommodate migrants not just from allover India but from the world who wouldbe attracted by work opportunities in an. Slogans and policies perceived to be‘anti foreigner’ or ‘anti expatriate’ would doimmense damage to the prospects of makingMumbai a viable IFC.

7. Interfacing tax policy andadministration with thefinancial industry

The development of an in Mumbairequires more vibrant interaction betweenDepartment of Revenue, the and the, with the financial services industry.This will be particularly necessary whenthe greater complexity of provisionescalates the complexity of tax policy and taxadministration. A better institutionalisedmechanism for interaction could yielda greater understanding of the groundrealities of finance. This could influencetax policy, and practical problems ofimplementation could get more rapidlysorted out. Hence, there is a case forthe Department of Revenue, as the agencyresponsible for tax policy, and the twoimplementation arms (the andthe ) to establish an Ombudsmanfunction in Mumbai. Such an officewould facilitate engagement by the financialservices industry on one hand and thetax authorities on the other. It wouldenable issues of tax policy and consistencyof its administration to be institutionalised.There is also considerable scope for theseagencies doing some hands-on learningfrom cities like New York, London andSingapore in understanding how they dealwith the same issues without disrupting operations.

8. Stability of tax policy

From the viewpoint of India’s aspirations tohave Mumbai become an , it is essentialto emphasise the importance of stability andpredictability of future tax policy. No firm– and financial firms least of all – likes todeal with uncertainty in making investmentdecisions and deciding where transactionswill be booked and operating cash-flowsregistered. Global financial firms will requiresome assurance about the rationality andstability of the Indian macro-policy regime(on tax, capital controls, exchange rates,inflation, and monetary policy) in comingyears, in order to make decisions aboutplacing parts of their global operationsin Mumbai.

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Table 12.1: Comparing India against existing IFCs on taxation

Attributes, Characteristics and Capa-bilities of an IFC: (Scale of 0–10 with0 = worst; 10 = best)

London New York Tokyo Singapore Frankfurt Mumbai

N. Taxation Issues as they affect theattractiveness of an IFC

N1. Taxation of Resident Individualsworking in the IFC

5 4 3 5 2 5

N2. Taxation of Non-resident Individualsworking in an IFC

7 5 5 6 3 6

N3. Taxation of Resident Companies 4 4 3 5 2 5N4. Taxation of Non-resident companies 7 5 5 8 4 5N5. Withholding Taxes levied on financial

instruments/transactions.4 3 3 5 3 5

N6. Transactions Taxes on FinancialTransactions – Domestic

6 7 4 7 4 1

N7. Transactions Taxes on FinancialTransactions – 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 0N10. Overall Taxation Environment 5 5 4 7 2 5N11. Complexity of Tax Laws, Codes,

Rules, Regulations4 3 4 7 3 1

N12. Effectiveness, Efficiency, Fairness andCorruption in Tax Administration

9 7 8 9 9 3

Table 12.2: Comparing India against emerging IFCs on taxation

Attributes, Characteristics and Capa-bilities of an IFC: (Scale of 0–10 with0 = worst; 10 = best)

Mumbai Hong Kong Labuan Seoul Sydney Dubai

N. Taxation Issues as they affect theattractiveness of an IFC

N1. Taxation of Resident Individualsworking in the IFC

5 8 5 4 4 10

N2. Taxation of Non-resident Individualsworking in an IFC

6 10 10 7 7 10

N3. Taxation of Resident Companies 5 8 6 5 4 10N4. Taxation of Non-resident companies 5 10 9 8 5 10N5. Withholding Taxes levied on financial

instruments/transactions.5 10 9 5 5 10

N6. Transactions Taxes on FinancialTransactions – Domestic

1 10 5 5 2 10

N7. Transactions Taxes on FinancialTransactions – 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 10N10. Overall Taxation Environment 5 8 7 6 5 10N11. Complexity of Tax Laws, Codes,

Rules, Regulations1 8 7 5 4 9

N12. Effectiveness, Efficiency, Fairness andCorruption in Tax Administration

3 8 7 6 8 9

As an example, the creation of asecuritisation may involve cash-flowsfor the coming years or years. Ifthere is a risk of a major change in taxpolicy in that period then there is a reducedincentive to setup the under Indianjurisdiction. The credibility of Mumbai

as a potential will be enhanced byhaving both (a) rational tax policy and (b) aframework that guarantees the stability oftax policy.

In the last decade, India has seenconsiderable changes in its tax regime,reflecting fiscal reforms that have been more

. Tax policy for an IFC in Mumbai 169

far-reaching than is generally appreciated.Most of the changes made by the Centre havebeen in the right direction. Unfortunately,some of the tax changes made by States, tocope with their chronic fiscal incontinence,have been in the wrong direction. Few partsof the Indian economy have experiencedas much progress as fiscal policy, withsharp reductions in customs duties, shiftfrom turnover taxes to , reductionof rate dispersion in indirect taxes, andlower income taxes. This paradigm shift inpolicy has been accompanied by far-reachingimprovements in tax administration throughcomputerisation, particularly with incometax and customs. But this progress hasinevitably implied an environment of fast-changing tax policy. A particularly unhappyset of events has taken place on the taxtreatment of dividends, where India haschanged tax policy multiple times andcreated sufficient uncertainty about thefuture as to cause serious concern amongglobal investors about policy stability.

From the viewpoint of creating a viable, the recommendation of the Committeewould be that a more specialised committeeof tax experts familiar with and theoperations of global s should now becreated to translate the ideas of this chapterinto detailed tax policies for specific products and services, after which privateagents should be encouraged to expectstability of tax policy for the deep future.

9. Where India Stands on taxes:An international comparison

In a pair of tables, we show a subjectivecomparison, where incumbent and emergents are rated on a scale from to

on twelve measures of the tax policy andadministration. When compared againstestablished s, the overall score ofMumbai () matches that of London or NewYork. But it fares poorly when comparedwith Singapore () and Dubai ().

A perspective on Mumbai’sstrengths

13c h a p t e r

In contemplating the creation of an inIndia, the metropolis of Mumbai, backedby the human resources of India as a whole,has six manifestly visible strengths:

. Hinterland advantage: Mumbai is thefinancial and commercial capital ofone of the largest and fastest-growingcountries in the world. India is alreadythe world’s fourth largest economy in terms after the , China andJapan. By it will be the fourth largestin nominal terms. By it will be thethird largest. India’s rapid growth hasresulted in a phenomenal increase intwo-way cross-border financial flowsthat are related to trade and investment.Those flows are inducing high growth in demand. Mumbai is to India whatNew York is to the (see Chapter ).

. Human capital: India has highquality, low cost human capital (atall skill/knowledge levels) with Englishspeaking ability for a world class industry that can export successfully tothe world. But such human capital isbeing absorbed at a rapid rate acrossall service industries, and specialisedknowledge in the frontiers of finance isweak. Much needs to be done by wayof education and training to expandthe human resource base in terms of itswidth and depth. These constraints arediscussed later in this chapter.

. Location: In the -hour trading en-vironment of what is now an increas-ingly integrated global financial mar-ket (encompassing countries andembracing many significant emergingmarkets as well) a well placed locationthat permits contact with participantsin this market during daylight can be asignificant strategic advantage. In work-ing hours, conversations from Mumbai

can take place with transacting coun-terparties from Tokyo to London i.e.,covering all of Asia, the and every-where in between. While the Americasare beyond daytime conversations withMumbai, the experience of services,/ and call centre industries hasshown that this handicap can be over-come. The same will be true of the industry. There is no operating inthe Indian time-zone; resulting in a wideempty space ( time zones) between theclusters of s in the East (Tokyo, HongKong, Singapore and Sydney) and theWest (London, Paris, Amsterdam, Frank-furt and New York). Dubai, for instance,is using its location, straddling thesetime zones as a selling point for .But it does not have many of the advan-tages that Mumbai has (human capital,well-developed exchanges and tradingplatforms, a large hinterland market, support capability) while having someadvantages that Mumbai does not have:i.e., excellent infrastructure, good urbangovernance, political and administra-tive drive, the makings of a global citywith expatriates from all over the world,and an ambition to succeed, with nodomestic political economy constraintsholding it back.

. Democracy and Rule-of-Law: Properlyfunctioning financial markets requirea basis for governance that is stable,reliable, resilient and flexible; i.e.,one that reduces future politicalrisks and uncertainty. While theseare important strengths, they areaccompanied by equally importantdifficulties in governance of Mumbaiand of India’s financial regime. Theseissues are discussed later in this chapter.

. Mindshare: High growth, the phenomenon, and the remarkable

172 R M I F C

success of Indians in global finance allover the world, serve to ensure that Indiahas significant ‘mindshare’ at seniordecision-making levels of most globalfinancial firms.

. Strong securities markets and techno-logically advanced trading platforms:India has established a beach-head forproviding global by virtue of itsdynamic, technologically capable securi-ties trading platforms in the and. These are the rd and th biggestexchanges in the world measured by vol-ume of transactions.

Three of these six factors constituteunambiguous strengths: hinterlandadvantage, location and mindshare.The remaining three issues representstrengths, but a nuanced analysis revealsmany important flaws. In the case ofsecurities markets and trading platforms,these issues have been dealt with atlength earlier in the report. It was arguedthat the framework of financial sectorpolicy and regulation at present severelylimits India’s ability to utilise and fully in order to obtain an edge ininternational competition. In thischapter, we turn to a careful analysisof the two remaining points: humancapital, and the issue of democracy andrule-of-law.

1. Human capital needs for IFS

India has four strengths by way of humancapital endowments that give it an edge overother emerging s as far as the utility of itshuman capital endowments for competitive provision is concerned:

. The extensive use of English, which is thelingua franca of international finance;

. Generations of experience with en-trepreneurship, speculation, trading insecurities and derivatives, risk taking,and accounting. Indeed the ability toprovide competitively seems geneti-cally coded into Indian finance profes-sionals;

. Strong skills in information technologyand quantitative thinking;

. Individuals of Indian origin play a

prominent role in the top globalfinancial firms. They are well-positionedto intermediate between the businessstrategies of these vital firms and thegenuine strengths and weaknesses ofIndia as an .

The international image of India todayinvolves a ‘high-skill with high motivationand high adaptability’ labour force for almostall service export industries. The attitude ofambition and hard work is epitomised in astatement of Shri Kamal Nath, the IndianMinister of Commerce: “In India, a hourworking week is considered part-time”.

Table . applies the same -to-

scoring scheme, utilised earlier in this report,in making a cross-country comparison ofhuman skills in various kinds of financefunctions. Mumbai is compared againstestablished and emerging s. It showsthat Mumbai has some strengths whencompared with established s. But atthe same time, the table does not supportsimplistic triumphalism of a kind oftenexpressed about the superiority of the Indianlabour advantage. While India has a certainpresence in the finance labour force, thereare many areas of weakness.

India is weak in not yet being a fullbeneficiary (because it does not yet have itsown ) of the globally mobile expatriateworkforce in finance. To be sure, Indianexpatriates populate almost all the English-speaking s. The three s and would not be able to function aswell as they do without them. But theseexpatriates choose to live in these sand change their nationality rather thanremaining India-centric. By contrast, thefinancial community of British, American,Australian, Japanese, Canadian, Singaporeanand European nationals is genuinely globallymobile, shifting continually across s athome and abroad, while remaining anchoredto their nationalities and homelands. Theyaccrue significant benefits for their homeeconomies by doing so. Having an in Mumbai would enable India toshift from exporting its best financialtalents permanently, to retaining a holdon such talent in the future by providinggreater 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 Industryprofessionals:

: 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-ing/Research Institutions in Finance

6 10 4 3 2 3 3 5 0

J3. Local Pool/Network of globally experiencedfinance professionals

10 8 4 7 2 5 5 7 5

J4. Local presence of Global HR Recruit-ment/Consulting/Training Firms

10 10 6 8 2 5 5 7 5

J5. Ease of entry, exit and overall mobility of globalfinance professionals at all levels

8 7 3 7 2 6 3 6 8

attachment to the homeland, that will provemutually beneficial.

A McKinsey Global Institute Survey

estimates India’s pool of young universitygraduates (those with years or less ofexperience) at million – the largest ofthe countries surveyed. This is . timesthat of China and almost twice that of the. This pool increases by about . millionevery year. But, only a fraction of this poolhas credible, usable skills. managerssurveyed estimate that only –% ofthis pool would be suitable for an environment. That is half the proportion inCentral Europe. The reason for this outcomeis ascribed to: (a) extreme variability in thequality of tertiary educational institutions– India has a handful of the best suchinstitutions in the world; but they co-existalongside too many of the worst; (b) highrates of emigration of graduates from India’stop quality institutions to countries;and (c) the inadequacy of communicationskills in English except for the top tier ofstudents from the better institutions whocome from relatively high income groupsand class backgrounds. In terms of technicaland quantitative skills, only . millionstudents hold engineering degrees. That

“Ensuring India’s offshoring future”, Diana Farrell,Noushir Kaka and Sacha Sturze, in Fulfilling India’sPromise (McKinsey Quarterly Special Edition ).

is only % of the total university educatedworkforce in India, compared to % inGermany and % in China.

Some evidence from the World Eco-nomic Forum and from (Switzerland)comparing India against some other coun-tries on workforce skills is shown in Ta-ble .. There are divergent views betweenthe two sources on the educational system: ranks India at th out of (i.e., inthe top decile) while ranks the educa-tional system at th out of (i.e., in thebottom third). India scores high on edu-cation and staff quality in finance in bothinstances.

One aspect of labour quality concernssupport services – e.g., accounting, legalservices, business consulting and support– that are typically outsourced by financialfirms. These services complete the skillsets required by an . The presence, forinstance, of highly specialised printing firmswith tight internal security arrangements,has become a complex specialised service inthe market, given increasingly stringentregulatory disclosure and insider-tradingprohibitions. Hitherto, a combination oflegal and commercial skills was a prizedrequirement in financial contracts; thiscombination is now meshed with specialisedprinting skills.

Broadly speaking, in a cross-countrycomparison, India fares well in these support

174 R M I F C

Table 13.2: Workforce skills base comparisons

Rankings USA UK Japan India Hong Kong S’pore Australia

Educational System (b) 17 36 40 11 15 3 4Quality of the Educational System (a) 27 22 31 39 17 2 7Education in Finance (b) 16 45 54 17 12 5 4Quality of Management Schools (a) 1 3 37 6 25 16 7Tertiary Enrolment Rate (a) 4 13 29 79 56 32 9Availability of Finance Skills (b) 8 33 49 12 7 11 17Reliance on Professional Management (a) 5 2 12 29 28 18 3Labour Productivity – GDP (PPP) per person perhour (b)

7 21 24 60 30 28 17

(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 lawfirms, where India lags other s. Oneway of developing capacities rapidly in thesupport services and financial segmentsmentioned above is to attract dominantplayers in these segments into the .London got a major boost when DeutscheBank decided to move its global operationsthere. The presence of all the big investmentand commercial banks provides a criticalmass to financial operations in Singapore.Emerging s like Dubai are pulling outall the stops to attract global financial talentsupported by middle management and lowerlevel labour skills for from India.

Although there are still many regulatoryrestrictions on the entry of foreign banksinto its domestic banking market, Indiahas not been able to attract large capitalmarkets players, even though there arefewer restrictions on their entry in thatsub-segment. That is mainly because thedevelopment of major areas of financialactivity in which such institutions excel (e.g.,mergers and acquisitions, risk management,currency trading, interest-rate arbitrage,corporate-sovereign-sub-sovereign bondissuance, hedge funds) are also artificiallyproscribed in India.

Modern post- finance knowledge,at present, in India is weak; especiallyon the part of senior executives in mostIndian financial firms as well as in the upperechelons of financial regime governance.Lacking such knowledge and familiaritywith the kinds of operations and risksinvolved in derivatives markets for instance,the approach taken in India is to avoidthese activities altogether or to constrainthem to a point of irrelevance. Mainstream programs have a heterogeneous intake,and do not delve into modern quantitativefinance. Staff quality at universitiesis inadequate when compared with therequirements of teaching modern finance.As an example, the Heath-Jarrow-Mortonmodel is the workhorse of thinking aboutfixed income derivatives. There are probablynot more than five individuals working atuniversities in India who understand thismodel.

Indian finance professionals havea reputation for being quantitativelycompetent. This is rooted in the high qualityof high school education in India, whereeveryone going through the th Standardlearns calculus. Many engineers who turnto finance are skilled in calculus and linearalgebra. 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 GlobalAccounting Firms

9 9 8 9 6 8 7 9 6

H2. Quality, reputation and presence of Interna-tional Law Firms

9 10 6 7 2 8 5 8 5

H3. Quality, reputation, presence of GlobalConsulting Firms

10 10 8 9 4 7 6 8 6

H4. Quality and competitiveness of IT, BPO, KPO

support6 6 4 5 9 5 5 5 6

. A perspective on Mumbai’s strengths 175

Box 13.1: The Master of Science in Finance ()In India today, the

commonest degree obtained byindividuals seeking a career infinance is the MBA.Internationally, however, therehas been a strong shift infinance professionals, awayfrom the MBA towards a newdegree called the Master ofScience in Finance. There arethree main differences betweenthe MBA and the MSF:

. Usually about 20–25% ofthe coursework in an MBA

curriculum is focused onfinance, while all thecoursework in an MSF is infinance.

. The MSF imparts greaterknowledge of mathematicsand computer science, thuspreparing the student forthe quantitative anddata-intensive modernfinance workplace, wheremathematical models areapplied into measuring risk,pricing financial instruments,

and developing and testingtrading strategies.

. The MSF tends to involvesubstantial teaching inanalytical financialeconomics, going beyondthe more descriptive financecoursework as seen in theMBA where themathematical backgroundof students is inadequate.

The MSF program preparesstudents for careers in financialanalysis, investmentmanagement and corporatefinance where they willconfront sophisticated financialinstruments, markets andtrading strategies. The typicalMBA student has a very limitedknowledge of derivativesarbitrage; the typical MSF

student knows quite a bit aboutit.

The MSF is a quantitativeprogram, where current

technology and financialmethodologies are applied toanalyze complex problems. Thecoursework stresses theapplication of contemporarytheories in a global context anddevelops valuable financialmodelling and analytical skills.The programme contentsimpart students with athorough understanding of thenature and operation ofinternational financial marketsand institutions and develop theanalytical skills essential tostructuring deals and designingfinancial instruments, pricingfinancial products and valuingcompanies, designing andmanaging investment portfoliosand managing risk for financialinstitutions and multinationalcorporations.

India’s best institutionsurgently need to introduce andoffer courses aimed at an MSF

degree.

much about probability theory. Financeprofessionals in London do more computerprogramming, while their counterparts inMumbai are likely to use a spreadsheet.

If Mumbai is to emerge as an ,substantial skills development will berequired to overcome a potential humancapital supply constraint in financial services:especially in the areas of stochastic calculusand analytical financial economics. Middlelevel executives and senior staff employeesof financial firms, who knew mathematicswhen they were in their twenties, need togo back to learning probability, statistics,analytical financial economics and computerprogramming. The flow of young peoplecoming into the finance field needs to havea much stronger grounding in probability,statistics, analytical financial economics andcomputer programming.

New York has the Stern School ofBusiness at New York University (), andthe Economics Department at ColumbiaUniversity. It is also supported by schoolsin close proximity such as , Whartonand Chicago that excel in quantitativefinance. London has the London Business

School () and the London School ofEconomics () supported by mathematicsand quantum physics graduates from nearbyOxford and Cambridge which are an hour’sdrive away. But they do not quite compareas yet with the sheer cerebral firepower inquantitative finance that is concentrated atthe top institutions.

Singapore has the National Universityof Singapore (). In a recent andremarkable achievement, the ‘SingaporeManagement University’ has been created.This is a private university, created in

using public funding. It operates in theheart of the city, in order to maximisethe two-way flows of knowledge betweenthe industry and the university. It paysglobally competitive wages in order toattract world class researchers. SingaporeManagement University is very young whencompared with the IIMs, and it has onlyone campus when compared with thenumerous IIMs. Yet, a google search for“singapore management university” alreadyyields , hits while a google searchfor “indian institute of management” yields,. 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 7G2. Quality and Credibility of State/Provincial Governance 8 9 8 10 5 7 8 7G3. Quality and Credibility of Local/Municipal Governance 8 8 9 10 6 7 8 9G4. Influence of Politics in diminishing Governance Quality:

National/Federal 6 6 8 10 5 5 8 8State/Provincial 6 8 8 10 6 5 7 8Local/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 8State 6 8 8 10 6 6 8 8Municipal 8 9 9 10 7 7 8 8

G6. Role of Checks & Balances (NGO oversight, mediafreedom, civic action etc.)

8 9 5 2 4 4 6 0

Management University has been ableto very rapidly build up a presence andachieve impact. In addition, the Singaporegovernment is working with over a dozenglobal universities, attracting them toestablish campuses in Singapore. Incontrast, India has presented a forbiddingenvironment where foreign universities areunable to establish operations in India.

Mumbai has no institutions (exceptperhaps ) where a few of the highest-calibre intellectuals inhabit an ivory tower,conduct on-going research programmeswith Indian financial firms at the frontiersof finance, and teach the next generationof finance professionals. Mumbai lacksthe wealth of conferences, seminars, short-term continuing education courses, andintellectual life that sustains the top end ofthe financial services industry. The top tenbooks on the desks of quantitative financialprofessionals in global financial firms areavailable off the shelf at bookshops in NewYork, London and Singapore. But they arealmost impossible to find in Mumbai andhave to be acquired abroad. India lacks notjust the sophisticated mathematical skills itneeds in its financial services workforce itlacks teachers in these disciplines and simplydoes not produce enough of an annual flowof them.

2. Democracy, Rule-of-Law andthe Legal System

India has a long tradition of free and fairelections, freedom of speech, and a spirit

of openness. Respect for property rightsis strong (more in principle than practice).India has, in the past expropriated propertyand undertaken sweeping nationalisationsin finance and industry. That history shouldtheoretically count against it as far as havingan is concerned although London was ina similar situation when the also resortedto nationalisations that it later reversed.And, in the era of nationalisation in the, London’s fortunes as an definitelysuffered.

As Fareed Zakaria has emphasised, theheart of a democracy (and its protectionand safe-keeping) lies in the quality of itsjudiciary and not only in the legislature orin elections. The infrastructure for law andorder, and contract enforcement, are centralto a vibrant democracy. They directly affectthe credibility/viability of Mumbai as anemerging .

India is a thriving democracy – theworld’s largest, most complex and mostvibrant – supported by a legal system thatis now being strained at the seams withthe rapid growth and progress that hasoccurred since the s. The length oftime taken for cases to progress through thelegal system and the consequent enormousbacklog of cases that has built up inthe lower civil courts, impinges on thequestion of whether India has a legal systemenvironment that is sufficiently supportive ofthe swift resolution of conflicts and disputesarising from the settlement/enforcement ofcomplex international financial contracts.That in turn influences the prospects of

. A perspective on Mumbai’s strengths 177

Table 13.5: Protecting Investors & Enforcing Contracts

Strength ofExtent of Extent of Ease of investordisclosure 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 69United States 7 9 9 8.3 17 250Hong Kong, China 10 8 8 8.7 16 211United Kingdom 10 7 7 8 14 288Australia 8 2 8 6 11 157Japan 6 7 7 6.7 16 60Germany 5 5 6 5.3 26 175Korea 7 2 5 4.7 29 75Malaysia 10 9 7 8.7 31 300France 10 1 5 5.3 21 75Taiwan, China 8 4 4 5.3 28 210UAE 4 8 2 4.7 53 614China 10 1 2 4.3 25 241

Sources: World Bank Group Doing Business 2007 and 2006

providing to the global market fromMumbai on an efficient, competitive basisand of Mumbai becoming a competitive in the foreseeable future.

Using the same techniques as in earlierchapters, the comparative Table . ranksvarious established and emerging s on aseries of layered governance variables. As inthe case of legal comparators shown in anearlier chapter, the felt that it was notin a position to derive subjective rankingson these variables for Mumbai. Consensuscould not be achieved on quantitative scoresfor Mumbai, given the degree of subjectivejudgement involved in coming up withsuch scores. But the did have broad

consensus that there was considerable scopefor improving governance at all levels ofthe system –particularly at sub-sovereignlevels. It felt that governance standards inIndia needed to approach world standardsas rapidly as possible if Mumbai prospectsfor emerging as an that was crediblein global financial markets were not to becompromised.

The most critical role of the State(and the government in power at the timeexercising the functions of the State), as far asits citizens and residents are concerned, is itsability (with the infrastructure and humancapacity it has in place) to uphold the law,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 19.5United States 9 325 21.5Hong Kong, China 1 80 14.3United Kingdom 22 – 52.9Australia 12 107 37Japan 26 315 34.6Germany 32 105 50.3Korea 26 290 29.6Malaysia 28 – 11.6France 29 72 42.8Taiwan, China 15 296 23.6United Arab Emirates 15 12 8.9China 34 584 46.9India 59 264 43.2

Source: World Bank Group Doing Business 2007 and 2006

178 R M I F C

through enforcement capability (i.e., theeffectiveness of its police forces and othermechanisms), to prevent crime and providesecurity for persons and their property, toenforce property and creditor rights fairlyand impartially, and to resolve contractualdisputes through the due processes of law.

In all these respects it is no secret thatmuch progress needs to be made at sovereignand sub-sovereign levels of governance toarrive at global standards. The challengeof a third world country attempting toachieve first world standards in these areas isdaunting; but India has made a promisingstart with domestic expectations rising asrapidly as incomes. The believesthat progress in governance at all levels – inthe public and private sectors – needs to becommensurate with rate of progress in other

areas. On the specific question that exercisesthe mind of those operating in an – i.e.,the problem of enforcing a contract, thistakes on average days in India, far longerthan in any other country shown in the tablewith the exception of the .

Finally, an important aspect concerningthe functioning of the State in a countryintent on establishing an – that auto-matically requires extensive participationby international firms and individuals – at aprocedural level is the overhead and com-plexity of its tax system. Table . belowshows that in India, there are distinct taxpayments made by a firm, a task which takesup man-hours per year. This comparespoorly with alternative s like Dubai orSingapore.

Urban infrastructure andgovernance

14c h a p t e r

1. The importance of highquality urban infrastructurefor an IFC

While the answer may seem obvious, or itmay be otiose, the question has to be asked:Why do successful s, like London, NewYork or Singapore, need to have such highquality urban infrastructure? For two mainreasons:

The first concerns productivity: Inter-national finance involves highly compen-sated specialists with unusual knowledge-experience skill sets. They are busy and needto make the most of their time. To them, thecosts of delay, non-performance, or failureon their part are inordinately high. pro-vision involves intensive national, regionaland inter-continental travel and -hourtelecommunications connectivity. In thatrespect it is unlike , which takes placein an isolated campus with staff-personswho mostly sit at their desks all day long.In contrast, production involves inten-sive intra- and extra-city travel for meetingclients, exchanging information and analysis,negotiating and putting together transac-tions that often involve a consortium ofcooperating financial firms.

Moreover production in an is highly systems dependent. That istrue not just for financial firms operatingin an , but for exchanges and tradingplatforms, payment and settlement systems,and regulators who need to exert continuoussurveillance over transactions in real time.All this requires not just sophisticated hardware (and immediately availablehardware maintenance) but also softwareand software support capacity, alongwith stable and reliable systems of high-quality air-conditioning and ventilation tomaintain constant atmospheric conditionsof temperature and humidity. All these

in turn need to be supported by highquality electric power supply (with minimalvoltage and current fluctuations) and withsufficient back-up to minimize (to nearlyzero probability) the risks of interruption.

For these reasons, production re-quires a venue where physical infrastruc-ture (i.e., residential and commercial space,power, water, waste disposal, transportationand communications) has to be of the high-est quality in order to be globally competi-tive. Deficiencies in infrastructure increasedirect and indirect production costs.They hurt finance directly by confoundingthe mission-critical processes of the securi-ties markets and payments, and by placingonerous coping costs upon every firm whichhas to plan on failures of public infrastruc-ture and incur additional costs privately inorder to compensate for these shortcomings.The indirect cost imposed by poor infras-tructure is upon the wasted staff time ofhigh-skill and high-wage finance profession-als, and the opportunity cost suffered whentasks which could be performed in Mumbaiare directed elsewhere as a response to theweaknesses of Mumbai.

As has been argued elsewhere inthis report, an abundance of fibre-opticcables and video-conferencing have notremoved the fundamental role of face-to-face meetings for the most importantnegotiations and decisions. A day in thelife of a skilled worker in productionmay involve an early morning breakfastmeeting at a club or hotel, a long commuteto work, moving around several differentmeeting venues within the city throughoutthe day to meet clients, colleagues in otherfirms, accountants, lawyers, consultants,along with lunch and dinner meetingsbefore returning home after a -to--hourday. That daily routine is interspersedduring the week and month with air

180 R M I F C

travel around the country and across theworld.

Mumbai faces a tall hurdle in beinghospitable to this kind of individual. Morethan half of his/her day can be spent stuckin traffic. Mumbai needs to match at leastthe mundane efficiencies of London, NewYork and Singapore in order to be a crediblevenue for production.

There is a paradoxical effect at workin having the city and country makea transition from to . Themore skilled a person, and the higherthe opportunity cost of time, the lessinclined that person will be to spend timein Mumbai’s traffic, or in solving mundaneproblems of power, water or electricity, orlaw and order. Hence, as long as the urbanproblems of Mumbai are not resolved moredecisively, there will remain a bias in favourof keeping the junior staff-persons of globalfinancial firms in Mumbai to do the low-value work required. High-value workwill migrate to proximate centres that arebetter endowed with infrastructure and withmuch higher, more efficient standards of cityadministration and urban governance i.e.,Dubai and Singapore. This kind of fracturewill frustrate the goal of Mumbai becomingan that can capture high value additionin work.

The second, related issue is that themost skilled staff-persons in global financehave choices about where they are locatedand where their time is spent. InitiallyMumbai’s role as an is likely to belimited to serving mainly the Indian marketfor – in other words it will be an more like Tokyo and the continental srather than like the three s. Thatinitial phase will probably stretch fromaround –. It will require additionalinfrastructure.

But those demands are unlikely to be asgreat as those made when Mumbai entersits second phase (from onwards) andattempts to compete with the three s.A defining issue for Mumbai’s becoming acredible post- will be the challengeof attracting around , high level peopleof the kind typically employed by globalfinancial firms in the three s. Only–% of these are likely to be of Indian

origin. All these people have a choice ofliving and working in any city in the world.Their choice will hinges on the attractivenessof a city as a place in which to live, workand play. All the attributes that a city musthave – as a hospitable, friendly, welcoming,efficient and pleasant environment – mattervery much in influencing the decisions madeby this community.

Once again, the more skilled a personis, the more sensitive he/she will be tothe wastage of time, and the disutilityassociated with the very large number ofmundane irritations imposed by Mumbaion its residents such as poor roads, airand noise pollution, road and rail trafficcongestion, poor health and safety standardsand frequent city shut-downs.

These realities make Mumbai anunattractive urban environment for housingan . They need to be tackled andovercome on a war footing after long yearsof delay and many declarations of intentthat remain to be translated into actionplans for a new reality. Yet, despite allits shortcomings, Mumbai remains thefinancial and commercial hub of India.Those who wish to serve the Indian marketfor will have little choice but to endureits privations and put even further pressureon the city’s limited resources and drive upaccommodation and land prices. But thoseprivations will not be endured by globalclients of an who have other choices.

The highest skill individuals specialisedin providing are precisely those whowould make a material difference toMumbai’s aspirations to become an .It has oft been remarked by the cognoscentiwho have lived and worked in the threes that, more often than not, themost innovative ideas in productionare exchanged by imaginative, creativefinancial architects, engineers and artistsover cups of coffee. The most fundamentalingredient in a vibrant is the intellectualand commercial interplay between a largenumber of heterogeneous requirements andviewpoints.

A successful is one that brings adiverse array of knowledge into financialproblem solving through lateral thinking,and constructing creative links across diverse

. Urban infrastructure and governance 181

groups of players. This requires a largenumber of conversations and a wide rangeof participants in these conversations.If Mumbai is a hospitable and attractivecity to a globally mobile population ofhigh-level providers, then a personwho comes to Mumbai for a meeting ona Friday is more likely to stay over onthe weekend for amusement or leisure.The stray conversations of the weekendcan ignite further -related business. IfMumbai is inhospitable, and the personconcerned cannot wait for his flight todepart the same evening, these conversationsand informal relationships, and thus thebusiness they contribute to the , arelost.

The growth and success of the Indianeconomy does not automatically overcomethe problem of an inhospitable Mumbai for. In fact, in the short-term, it appearsto be making that problem much worseas the city is unable – in a meaningfulsense other than haphazard building –to cope with the consequences of suchrapid growth in a deliberate, plannedway that allows for carefully designedurban regeneration, redevelopment andexpansion. If India is successful, butMumbai continues to be a hostile urbanenvironment, then global financial firmsintent on expanding their India-related business will continue to make key decisions connected with India as they aredoing now: i.e., in New York, Singapore, andLondon.

Perhaps over time some of the executivefunctions undertaken in those s forIndia-related business may migrate toDubai if the manages to establishitself in the face of Mumbai’s (and India’s)failure to come to grips with the physicalinfrastructure challenges that both city andcountry face. The creation of ispredicated partly on anticipating such failure.In this scenario, relatively junior staff willbe placed in Mumbai to maintain regularclient contact at managerial (rather thansenior executive) levels and to undertakeroutine process work. Senior executiveswill travel infrequently to Mumbai tohandle the more critical functions anddecisions.

Hence, the most critical task in astrategy for making Mumbai an is thechallenge of upgrading the city to worldstandards in terms of the quality of itsinfrastructure and, even more importantly,the quality of its governance. For Mumbaito become a successful , the best mindsin global finance will need to perceive itas a city that is as attractive as the otherthree established s in terms of locatingtheir families, educating their children,and as a venue for furthering their owncareers and for enhancing their lives. IfMumbai is not perceived in that way by thishighly mobile community with extremelydemanding standards then it will not succeedas a even if it manages to surviveas a more limited serving India’s needs on a partial rather than totalbasis.

In offering this observation, theCommittee realises the challenge it posesto all levels of government in India,Maharashtra and Mumbai. It may be that thehuman talent needed to manage and run aworld class city may have to be sourced fromwherever it exists to upgrade dramaticallythe quality of local city administration. Itis by no means easy to create and governa first world global city in a third worldenvironment. But it is not impossible.Malaysia has managed to do that with KualaLumpur; although that city does not havethe advantages of the vast Indian market andis obliterated from competition in the race by having Singapore on its doorstepwith vastly superior capabilities. Chinahas managed to do that with Hong Kong,Beijing and Shanghai. South Africa hasmanaged to do that with Johannesburg.Brazil has managed to accomplish the samewith Rio de Janeiro and Sao Paulo. Chile hasmanaged to do that with Santiago and soon. The problems faced in Mumbai arenot new, having been solved by dozensof cities, including many in the thirdworld.

To accomplish that difficult, but by nomeans impossible task central and state levelpolicy-makers may have to consider theshort-term perpetration of an inequity quitedeliberately, as an investment in the futurenot just of Mumbai but of India. What

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needs to be done is to recreate Mumbaiwithin the next – years (i.e., in –) as a forerunner, at the city level, ofwhat India should become in the next– years – i.e., a developed country.Meeting the challenge of making Mumbaian capable of graduating to statusrelatively quickly is not a secondary issue.It ranks as being equally important to themajor transformation that is required of thelicense-permit raj in Indian finance.

In other words whether Mumbaibecomes a successful , and graduatesquickly to status, depends on whethertwo strategic challenges can be metsimultaneously by the authorities in theknowledge that the Indian private sectorhas the capacity to meet its operatingchallenge. The two challenges confrontingthe authorities at central and state/municipallevels respectively are:

. Having the vision, resolve, and politicalcourage/will to make the fundamentalwide and deep reforms needed acrossIndian finance to make it operate onglobal lines and integrate more rapidlywith the global financial system (a GoIchallenge); and

. Making the equally wide and deep ur-ban policy reforms needed to upgradethe quality of Mumbai’s infrastructureand governance – so that it can becomea global city similar to the other GFCs;(a GoM and municipal challenge).

The most important aspect of becomingan – with enormous beneficial side-effects for the Indian economy – lies inattracting the people needed from aroundthe world to live and work in Mumbai.Whether Indian or foreign, all of them canlive anywhere in the world they choose.For Mumbai to become an / thiscommunity needs to choose to be inMumbai. That basic reality needs to beseen for precisely what it is. Going for an in Mumbai is a policy choice that willinevitably invoke social reactions in the cityand require astute political management.Those reactions may be difficult to cope with.But it would be remiss to obscure this realityfor that reason; or attempt to deal with itthrough a rhetorical compromise that results

Table 14.1: Index of fully loaded costs per head(London = 100)

London 100New York 96Paris 97Frankfurt 84Hong Kong 99Mumbai 36

Source: The Competitive Position of London as a GlobalFinancial Centre, the Corporation of London, November2005. Based on Z/Yen Limited, 2005 Cost per TradeSurvey (July 2005).

in distorting reality and compromises theachievement of the outcome.

2. Problems of costEven though India is a third world country,and labour costs in India are low, thecosts of renting office space in Mumbai arehigh when all components of establishmentcost are taken into account. This willdeter the placement of activities inMumbai.

As Table . and . show, Mumbaihas a significant cost advantages over mosts in countries; but it fares poorlywhen compared with Shanghai or Singapore,two cities which are likely to compete withMumbai in the space. The costs seenin Mumbai are out of line with general costlevels associated with India’s low per capita. As an example, even New Delhi –which has severe problems of urban policyitself – has costs that are much lower thanMumbai’s.

3. Cross-country comparisonIn Table ., established and emerging sare ranked for indices K through K, allof which measure the quality of physicaland social infrastructure, and the livingenvironment. Mumbai has two strengths:(a) the use of English as the default languagefor global and financial contracts; and(b) the availability and quality of personaland domestic services. In the area oftelecommunications, Mumbai is increasinglyclosing the gap against other cities. In allother areas, there is a huge gap betweenMumbai and the emergent s.

Occupancy costs are defined as the average totalcost 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 Totalper workstation pa standard per worker Occupancy cost

(US$) (sf) (US$ psf pa)

Rank Rank Location 2005 2005 2005

3 4 London (City) 15,280 113.0 135.25 3 Frankfurt 13,640 236.8 57.66 5 Tokyo (Central 5 Wards) 13,400 136.7 98.08 6 New York (Midtown) 12,200 225.0 54.2

14 33 Hong Kong 9,320 139.9 66.614 19 Seoul 9,320 161.5 57.729 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 39.890 92 Shanghai (Puxi) 4,150 113.0 36.792 87 Singapore 3,970 118.4 33.5

Source: DTZ Research, Global Office Occupancy Costs Survey, January 2005

4. Difficulties in Mumbai froman IFC perspective

The main infrastructure deficiencies inMumbai are well known: electricity,water, sewage, flooding, transportationand communications. With the city nowdeveloping a fractured geography withits two financial centres being located inthe Bandra Kurla Complex and Nariman

office space in a modern, well-specified office buildingin a prime Central Business District location. Theyinclude rent and outgoings, such as maintenance costsand property tax, but exclude rent-free periods, fitting-out costs and other leasing incentives.

Point/Fort in South Mumbai – intra-city drive times have become particularlycritical. New and innovative strategiesneed to be undertaken to dramaticallytransform transportation time, utilisingboth public transport and high speedintra-city expressways. A host of solutions, based on user charges, can berapidly rolled out in order to alleviateinfrastructure constraints such as transport,power, water, sewage, drainage, railwaystations, etc. These should be put together bythe Indian industry, global players,and multilateral institutions.

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 10Water 9 9 10 10 4 9 10 10 8Telecommunications 9 10 10 10 6 10 10 10 10Transport 5 6 7 8 2 6 8 8 5Residential Space 7 5 5 7 3 7 8 8 7Office/Commercial 9 9 10 10 3 9 9 9 10

K2. Leisure, Entertainment, Global Cultural, Recreationaland Food Facilities

10 10 3 4 2 4 3 7 5

K3. Use of English as the default international languageat work and at leisure

10 10 2 9 7 5 3 10 6

K4. Use of English as the default international languagefor financial contracts

10 10 5 10 9 10 5 10 10

K5. Availability, Accessibility, Cost of healthcare andeducation (global standards)

5 5 6 8 3 6 7 8 6

K6. Availability, Accessibility, Cost of personal anddomestic services

3 3 1 5 9 6 4 2 9

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Mumbai could inhibit its emergence asan . Mumbai is said to have lost the industry to Bangalore owing to itsastronomical prices of real estate. Mumbaimight end up losing the industry toDubai if this issue is not addressed. Thisinvolves repealing the Urban Land CeilingAct, and new thinking on .

Becoming an also requires strength-ening the spirit of tolerance which has alwaysbeen a part of Mumbai’s ethos. A healthyand hospitable city environment that canattract expatriates requires good residentialfacilities, office space, leisure, and enter-tainment facilities catering to internationaltastes, smooth enrolment processes at goodschools, hospitals, colleges, universities, andsports clubs accessible to expatriates. Ex-patriates in an IFC should be able to useEnglish in their interfaces with government,state or city officials.

Fresh thinking is called for revampingthe city’s administrative structure. In China,the four largest cities have been givenprovincial status; much like Delhi. But thesensitivity of state and local politics need tobe taken into account in considering suchan option for Mumbai; even if, theoretically,it might ensure better city governance andgreater accountability of the city’s policy-makers to the urban electorate. If thissolution is out of the question, the mostcritical priority is to transform the city’sadministrative structure in a way that createsa fully empowered if not elected ‘manager’for the city, who can be held accountablefor everything that goes right or wrong inMumbai (without being able to pass thebuck to the state government), and who isnot required to be concerned about anythingelse.

Finally, ways need to be found to reducethe city’s vulnerability to city wide bandhs, apeculiarly Indian phenomenon.

5. Improving urbangovernance in Mumbai

The sheer size and rapid but disorderlyuncontrolled growth of Mumbai presentsan unprecedented challenge in inducing theevolution of sound institutions for urbangovernance. Urban infrastructure consists

primarily of residential and commercialspace, supported by an array of servicessuch as: adequate water supply for drinkingand other uses; drainage sanitation andsewage systems; utilities such as electricityand gas distribution; adequate road, rail andwater-borne urban transport and parkingboth public and private; primary as wellas sophisticated secondary health careservices that caters to all segments of thepopulation; primary, secondary and tertiaryeducational facilities; and environmentalregulation. The sound provision ofurban infrastructure is intimately linkedto decentralisation of economic and politicalpowers to sub-national tiers of government,which flows from the th Amendmentto the Constitution. There is a need tocreate fully empowered city governmentto manage the urbanisation process, whilehaving political and financial accountabilityfor it.

International experience suggests thatwithout reforms in the institutionalframework for urban infrastructure, centralor state level government funds directed intothe urban sector will not have the expectedeconomic and social returns. Nor willthey be appropriately directed for priorityuse. What Mumbai needs is not simply afew large eye-catching projects that requiremassive expenditures. What is needed evenmore is a transformation of the institutionalstructure that puts the long-run tasks ofurban governance on a sound administrativefooting.

The key problems are those of indepen-dence and accountability. Local/municipalgovernance functions in Mumbai need to beconcentrated under an urban developmentauthority (whether elected or appointed,although legitimacy would be enhanced ifthat authority was elected) that is directly ac-countable to the city’s electorate. At present,decision-making on financial and gover-nance matters concerning the city is split ina haphazard fashion across the Centre, Stateand City. This results in diffused responsi-bility, lack of coordination and disjointedplanning; as well as a loss of financial inde-pendence for the city.

Financial allocations for the city madeby central and state governments are

. Urban infrastructure and governance 185

disproportionately low in comparison with:(a) the public revenues it generates and(b) its legitimate needs for infrastructuremaintenance as well as planned urbangrowth and development. Unlike Delhi,other metropolitan centres in India arehandicapped – in terms of having anindependent trajectory for their growth anddevelopment – by not having their ownrevenue base nor any clear autonomousstatus within the present three-tieredstructure of governance. It is a recipe thathas brewed the twin paradox of havingkey Indian cities decaying rapidly in theface of even more rapid population growth.That will eventually change with the rate ofurbanisation that is now taking place acrossIndia. But such change may occur too late tomatter in making a difference when it comesto Mumbai becoming an within the next– years and creating the administrativestructure it needs for that purpose.

The Delhi Metro Rail Transit System() was inaugurated on December ,. Early indicators suggest that this maybecome a Metro system that can competewith that of New York, London or Singapore.As yet, a comparable system has yet to bebuilt in Mumbai. It is particularly importantto build transportation infrastructure in theform of a Metro to augment the suburbanrailways, along with intra-city and coastalexpressways that link the island to themainland, so that the mainland becomes aviable alternative for residential and businessdecision making. This would serve todecongest the city and improve the costefficiency of production in Mumbai.

When it comes to city financing, thefoundation principle of urban finance hasto be user charges for the occupation anduse of city infrastructure. It is possible forurban institutions to access resources fromcapital markets to finance a large portionof urban capital expenditure, reflectingtheir future outlook for user charges andlong term cash flows from property taxes.This approach makes it possible to increasecapital expenditure rapidly on urbaninfrastructure in Mumbai without requiringrecourse to Central or State finances.However, access to infrastructure and privatefinance cannot be sustained on a piece-meal,

project-by-project basis. Increasingly, thesustainability of infrastructure developmentand poverty reduction programs will bedetermined by the overall management andcreditworthiness of urban centres.

In terms of institutional structures, mu-nicipal functions in Mumbai are fragmentedacross many different corporations, agencies,and local government bodies with conflict-ing lines of accountability. Existing agenciesfor municipal service delivery are structuredon functional lines with attendant implica-tions for poor accountability, limited incen-tive for innovation in delivery of services,and limited use of private sector capacity tomanage and finance services. There is noeffective interface and almost no account-ability connecting the city’s administrativesystems to its various decentralised com-munities. In particular, poor communitieshave almost no voice over city policies exceptthrough extreme forms of public resistancewhen their interests have been compromisedbeyond their limited abilities to cope.

In terms of fiscal problems, there ispersistent under-performance on revenuecollection with unsustainable tariff struc-tures and non-transparent subsidy schemes.The general property tax system requirescomplete restructuring and modernisation.State and municipal governments need todeal urgently and fairly with the problemscreated by a legacy of rent control and espe-cially the problem of pre- buildings. Indoing so, they have to recognize and respectthe ‘acquired rights’ of long-term tenantsthat may exceed those of landlords who haveonly recently acquired such properties forspeculative purposes under circumstancesthat would be questionable in law.

Moreover they have to deal moredecisively with resolving the outstandingproblems concerning the urban land ceilingrenewal act. In Mumbai, low incomehouseholds are often to be found at theregressive end of the fiscal system. At thesame time, improvements in tax revenuesand user charges are likely to be mostacceptable in the context of concurrentimprovement in the institutions of servicedelivery. This is perhaps analogous to thepolitical acceptance of tolling highways afterhigh quality highways came about.

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At present Mumbai has limited credit-worthiness, with opaque financial and ac-counting systems and primitive treasurymanagement. The relative lack of trans-parency on a variety of public works con-tracts has emerged largely as a consequenceof such lack of controls; coupled with indi-vidual discretion over budgets of a kind thatgenerates perverse incentives inclined to-ward malfeasance. These need to be rectifiedbefore Mumbai can access capital markets,and make the needed institutional and fiscalreforms.

A program of transforming urban in-frastructure in Mumbai therefore has di-mensions of institutional, fiscal, financialand regulatory reform. Sector-focused re-forms in service delivery – e.g., a programmewhich focuses only on water and sanita-tion and solid waste – need to incorporatesuch institutional, fiscal, financial and reg-ulatory dimensions to the reform package.

Solving the problems of Mumbairequires a shift away from an immediatefocus on a few high-profile projects such asthe second airport project or a metro project,and dwell more on building the institutionalfoundations for a healthy city. Althoughsuch projects are essential they are not themainstay.

The central policy focus needs to be onthe empowerment of the city governmentto take economic and service deliverydecisions, as envisaged originally in theth Amendment. This will require a newframework for planning and implementingurban expenditures that is driven exclusivelyby the city government. It needs to addressthe current fragmentation of authoritybetween state and local levels, support urbangovernment oversight and accountabilityfor urban functions, and support control ofservice delivery investments, operations andfinancing by the urban government.

The HPEC’srecommendations

15c h a p t e r

Throughout the chapters of this reporta series of suggestions have been madeeither implicitly (i.e., arising from the logicof the arguments made) or explicitly inthe form of a specific change. Theserecommendations/suggestions have beenarrived at bearing in mind that the ToR ofthe outlined a broad remit requiringthe Committee to raise any issue that, inits view, impinged upon the success ofan in Mumbai. In some areas, therecommendations of the concernformulating an appropriate approach. Inother situations, the Committee has craftedspecific recommendations. In somesituations, the Committee proposes a re-examination of certain issues by the Ministryof Finance, recognising their bearing uponthe issues of achieving an in Mumbai,but at the same time recognising that theirresolution requires more detailed treatment,which impinges upon many other issuesin economic policy. Putting both together,the believes it has articulated a setof immediate and medium term goals inthe form of a roadmap to put Mumbai on atrajectory for becoming an .

The is mindful that it has notbeen tasked specifically with looking intodetailed matters concerning macroeconomicpolicies (ie fiscal, monetary, exchange rate,convertibility etc..) financial regulationand regulatory architecture or, for thatmatter, the prevailing legal or educationalsystems. Nevertheless all these areas exerta considerable influence upon whether an can be established in Mumbai and uponits prospects for success. Therefore they haveattracted our attention and comment. OtherCommittees have looked into some of theseissues. The has taken their findingsand suggestions fully into account in itsdeliberations. That does not necessarilymean that it agrees with what has beensuggested by others in every instance.

In most cases the focus of otherCommittees has not taken into account thepossibility of Mumbai becoming an .Their recommendations were crafted mainlyin a domestic context. Therefore it shouldnot be surprising that in some instancestheir findings may (implicitly) militateagainst the establishment and successfuloperation of an . In many instancesthe recommendations may requirefurther detailed scrutiny by specialists toconvert broad ideas and suggestions forchange into specific ‘actionables’. Withthis background in mind, the hasattempted to draw an appropriate balancein making its recommendations in terms oftheir width, specificity and depth. These arepulled together in coherent form below.

In recommending that policy makersopt for creating an Indian in Mumbai,for a variety of strategic reasons of nationalinterest, this chapter explicates what isimplicit. It collates and clusters itsrecommendations under the following threepillars on which an has to be supported:

. The general macroeconomic environ-ment in which an operates andthe policy framework that affects its op-erations and credibility in the globalfinancial system.

. The agenda for further financial systemreform that needs to be carried throughso that an can operate on a viablebasis. Such reforms include changesthat need to be made in: (a) financialregime governance and regulation;(b) the development of ‘missing’ or weakmarkets; (c) the development of globallycompetitive institutions and financialfirms; and (d) other policies concerningthe financial system and ensuring thatits growing need for qualified humancapital are met.

. The agenda for urban infrastructure

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and governance in Mumbai, particularlyin the context of making it a hospitableglobal city for a large and demandingexpatriate population that will beindispensable in the successful operationof an .

1. The general macroeconomicenvironment

This report traces the origins of a tendencytoward financial repression in India, given itsdevelopment trajectory since independence,and the policy choices made undergoverning political economy pressures andconstraints at different points in time. Toa significant degree, the present problemsof Indian finance, and therefore the futureprospects of an Indian , are rooted inlegacies created by the size of the publicdeficit and how it has been financed over thelast three decades. This assertion demands adigressive preamble.

India has run a high gross consolidatedfiscal deficit (for the centre, states andcontingent liabilities) – three to four timesthe size generally regarded as prudentas a percentage of GDP – for too long;particularly since the s. That hasresulted in expedient strategic and tacticaloptions being resorted to for financingsuch a public deficit. These options, whichperhaps were necessary at that point intime, in turn, have affected the evolutionof the Indian financial system. Theyhave bolstered public sector ownership offinancial firms through ‘balance sheet andprofit-loss protection’ as well as high barriersto entry and competition and the resultantsuppression of financial innovation. Adistorted yield curve – determined bythe government rather than the market –accompanied by a reliance on captive bankrather than bond market financing, havebeen seen as pre-requisites for financingpublic debt at low cost. These tendenciesare, axiomatically, anathema to markets andtherefore to the prospects for establishingan – which by definition requires aliquid bond market with undistorted interestrates.

The persistence and pervasivenessof direct rather than indirect formsof public intervention in the financialsystem (from ownership to directedlending) has compromised the early andsmooth development of various financialmarkets and concomitant institutionalstructures in different financial sub-segments. It has prolonged the existence oftoo many inefficient, small, undercapitalisedfinancial firms (public and private) that areincapable of withstanding the heat of globalcompetition in almost every financial marketsegment. Thus the domestic institutionaland market infrastructure that is neededfor an to operate is deficient in manyimportant respects at the present time inIndia. So is the range of financial productsand services that are offered and traded inIndian financial markets relative to thoseavailable in global markets. An cannotfunction when the domestic-global gap isquite so wide.

With the policy choices made in thepast it is no surprise that natural marketdiscipline has been prevented from operatingas it usually does in the financial systemto induce efficiency and competition – i.e.,through time-tested processes of adjustment,adaptation, acquisition, merger, takeoverand bankruptcy. Direct public interventionin the financial system (through ownership)has influenced, if not compromised, thepolicy objectives of financial regulationby inclining them toward the goal ofprotecting certain types of financial firmsfor social or political, rather than economicor commercial, reasons.

Regulatory objectives aimed at the pri-mary goals of fostering prudence, soundnessand stability of the financial system, have be-come inextricably intertwined with the sec-ondary goals of protecting (implicitly or ex-plicitly) the legitimate vested interests of theState as the largest single borrower from, aswell as the largest single owner of, financialfirms and markets in India. That multiplicityof objectives makes any system of financialregulation imbalanced and opaque; if notoccasionally confused and contradictory, inattempting to accommodate too many irrec-oncilable but inherent conflicts-of-interest.Such a cocktail of multiple ingredients be-

. The HPEC’s recommendations 189

comes even more potently dangerous whenthe conduct of an independent monetarypolicy is fused with the exercise of regula-tory responsibility under circumstances inwhich the state as the ultimate regulator isimplicitly protecting its own interests as aprivileged economic agent as much as it isprotecting the wider interests of a marketfinancial system.

It is important for us to stress atthe outset that, in tracing this historyas a matter of fact, the does notquestion the legitimacy or propriety ofwhat has happened and why. Nor isit advocating any particular ideologicalline. It is simply establishing the linksbetween historical impulses, policy choicesand market/institutional outcomes in theevolution of Indian finance since . Inopting, through a democratic process ofchoice, for a command-and-control typeof economy between and , theState had the legitimacy and the right toarrogate unto itself a special privilegedposition as a superior economic agent anddriver of development; as well as the primeprotector of wider social interests. Thatpublic choice was supported by successiveelectoral mandates.

But in shifting gears and transitingtoward a market oriented economy – whichis what the reforms of onwards were allabout – the legitimacy and ‘appropriateness’of that privileged position for the state asan economic agent, over other types ofeconomic agents, has come into question. Itcauses systemic discomfort and dysfunctionwhen the prerogatives and privileges ofthe State as an economic agent aremaintained in a market economy which,by definition, does not recognise suchprerogatives or privileges as legitimate orfunctional. Markets – whether financial orreal – and market economies do not functionas they are intended to when economicagents are differentiated in this fashionand when one type of agent (the State)maintains a privileged position over othereconomic agents in terms of access to naturalor financial resources, pre-emption in theownership of productive or institutionalassets, or in access to factors that determinea firm’s competitive abilities. That kind

of differentiation and privilege of oneeconomic agent over another strikes at theroots of what makes a market economytick – i.e., a level playing field, equality ofopportunity, application of the same rulesto all players across the board regardless oftheir ownership, no barriers to entry or exit,competition, innovation and adaptationthrough unfettered freedom.

The inescapable result of the accumu-lated legacy of pre-emptive and repressivepolicies in Indian finance has resulted in a‘lowest common denominator’ approachinfluencing the outlook and mindset of fi-nancial policy and financial regime gover-nance. These deficiencies began to be cor-rected with the onset of ‘serious’ reforms in–. Those reforms have gone far, wideand deep in the real economy resulting ina transformation of Indian manufacturingand of service industries such as services.But those reforms have not yet penetratedIndia’s financial system to the same extent.Considerable progress has since been made;especially on public finance, with tax re-forms and the passage of the Act. Butkey issues and concerns remain that is obliged to illuminate and adumbrate inthe context of establishing an :

1.1. On Economic Strategy, FiscalPolicy and Deficit Financing

. An in Mumbai would becomecredible and successful more quicklyif India’s overall economic strategy wasaimed at achieving and maintainingan average growth rate of % to% between now and . With% growth, India’s nominal expressed in dollars is likely todouble every – years. In terms ofcrude approximations, that would implyIndia’s nominal dollar increasingfrom $ billion in to $. trillionin . It would increase again to$. trillion by , and $ trillionby . Such growth would create afavourable environment for an inMumbai to capture a huge hinterlandadvantage. These rates of growth areachievable. Indeed they may be theonly way of generating sufficient publicresources to deal with poverty, fiscal

190 R M I F C

deficit, and public debt reduction all atthe same time. When is $ trillion,a government that spends % of onwelfare programs puts itself in a positionto transfer about Rs. , per personper month to the poorest one-sixth ofthe country’s population. Clearly, a %real rate of growth cannot be achievedunless extant, binding infrastructureand governance constraints are relieved.Those key objectives would be facilitatedby India having its own in Mumbai.

. Despite the Act and a number ofother measures that have been taken,insufficient progress has been madetoward reducing the gross consolidatedfiscal deficit (GCFD) to –% ofGDP. More progress needs to bemade to underline an unshakeableo commitment to establish the fiscalfoundations for a rapidly growing – butstill ‘developing’ – economy in which a‘newcomer’ must operate credibly.No IFC has taken off or thrived in anyeconomy where such sizeable deficitshave been incurred for so long. Globalmarkets are deterred from participatingin s whose home economies arefiscally incontinent because of a chronicinability to align public expenditure withpublic revenue. Large deficits (and thebuild-up of an overhang of public debt)pose a latent threat to systemic stabilityin the event of endogenous or exogenousshocks. Confidence in the isdiminished in such an environment. Forthat reason, if having an is a strategicobjective to be achieved by India (andfor other obvious reasons as well), thengovernments at all levels (central, stateand local) need to exert greater politicalwill over the next five years and beyondto reduce their respective fiscal deficits.

. Related to the deficit reduction target(and contributing to its achievement)the HPEC would recommend progres-sive reduction of the total public debtto GDP ratio from the current level of% of GDP to significantly less. Thatreduction has already begun. It must besustained. The HPEC did not reach aconsensus on any particular debt/GDP

ratio as a ceiling. It has done no detailedwork on the range that would be appro-priate; that was not its primary mandate.By way of illustration, however, it doessuggest that ratios of –% have beenadopted by different countries as beingindicative of prudence. India needs toestablish its own ratio for a debt/ceiling after careful study, as a naturalaccompaniment to the deficitreduction targets. That ceiling shouldsuggest to global markets India’s com-mitment to fiscal prudence at all levelsof government. Total public debt in thiscontext would mean the outstandinglong and short term debt of central andstate governments, as well as the debt ofs guaranteed (directly or indirectly)by o, and all contingent liabilities ofcentral and state governments incurredthrough off-balance sheet financing orquasi-fiscal accounts. When these ad-justments are made, the true debt/ratio of India is well in excess of %.Public debt reduction depends, to a largedegree, on fiscal deficit reduction. But itcan be accelerated through programmesof public asset sales at all levels of gov-ernment. Such sales would galvanisecapital markets, spur growth and resultin more foreign investment (portfolioand direct) to achieve a higher growthrate.

. In restructuring tax revenues to achievedeficit reduction, particularly in thecontext of an and the effects thattaxes have on influencing financialsystem evolution, the HPEC wouldrecommend, broadly, that tax policyshould implement the key principlesdetermined by a series of expertcommittees starting from the mids, and leading up to the FRBM TaskForce Report of . This involves asimple tax code, with administrativeefficiency, low tax rates, removal ofexemptions, and a tax system whichplaces the main burden of taxationon consumption rather than incomeor saving. From an perspective,the HPEC recommends eliminatingtransactions taxes in the form of theSecurities Transaction Tax (STT) and

. The HPEC’s recommendations 191

stamp duties. The former requiresactions by the Ministry of Finance,while phasing out the latter needs tobe synchronised with the shift to the twopart Goods and Services Tax () andintegration of the real estate sector intothe . HPEC does not see the needfor a tax haven, or even temporary taxbreaks, as concomitants to having anIFC in Mumbai. But it does recommendapplying GST to the financial servicesindustry. This will require appointmentof a technical committee to work outthe mechanics of how this should beachieved.

. In financing the fiscal deficit, over-dependence on the domestic financialmarket needs to be reduced. o shouldcontinue reducing reliance on pre-emption or quasi-pre-emption throughthe financial system. Public debt shouldbe financed in domestic and global bondmarkets. Such markets are willing tofinance the public deficit by buying INRdenominated o notes and bonds.The purchase of INR denominatedinstruments issued by GoI should beopen to anyone across the maturityspectrum from -days to -years.This opening-up should be done intwo steps, so as to postpone foreigninvestment into short-dated bonds. Thiswould automatically reduce pressureson the domestic financial system andon: (a) crowding out private investment;(b) interest rates; (c) the balance sheetsof banks and other financial firms;(d) continued public sector ownershipof financial firms; and (e) keeping thecapital account partially closed thusthwarting or delaying full convertibilityof the .

. The budgets and ‘balance-sheets’ ofstate governments and major metropoli-tan municipal corporations (and otherlocal authorities as well) need to berestructured. That would permit sub-sovereign governments to become ‘sol-vent’ and resort to market financingrather than depending on o supportand direct/indirect financial guarantees.Doing so would have the triple effects of:

(a) exposing sub-sovereign governmentsto the discipline of the market; (b) creat-ing new financial markets in these seg-ments thus adding to the width/depth ofa bond market in India that is, at present,lacking in both; (c) expanding the arrayof that could be provided by an in Mumbai.

. Shift the burden of future infrastruc-ture investment from the public to theprivate sector through PPPs : i.e., pub-lic private partnerships involving privatefinance – from the domestic and globalmarkets – to provide public goods andservices on an appropriately structuredbasis that avoids the risk of ‘privatisingprofits while socialising costs’. Greaterresort to PPPs would: (a) resolve the fi-nancing constraint facing infrastructureinvestment in India which requires stag-gering amounts of funding; and (b) alsoprovide an opportunity to hone a specialcompetitive edge in the provisioncapabilities of an in Mumbai.

1.2. On Monetary Policy and itsImplementation/Execution

. The creation of an in the stcentury inevitably requires an opencapital account if the is to:(a) function with a modicum ofefficiency; (b) provide the full arrayof IFS; and (c) be viable/successfuland globally competitive with others/s within a conscionable time-span. But, with large fiscal deficits beingrun, the task of managing monetarypolicy – with an open capital account ina rapidly growing, developing economylike India – becomes more complicatedthat it presently is. When faced withsuch a situation, the implication for themonetary authority may well be that –in keeping with regimes that characteriseeconomies with successful s– itneeds to consider focusing exclusivelyon the single task of managing a keyshort-term ‘base rate’ to maintainprice stability (e.g., inflation being keptwithin a range of –%), consistentwith supporting a high growth rate(–%). As global experience withmanaging monetary regimes in the

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more successful economies suggests,achieving that prime objective is critical.It may be so crucial in the Indian‘high-growth requirement’ context thatall other subsidiary functions nowperformed by the extant monetary-cum-regulatory authority may need tobe divested to agencies that specialisein undertaking them. In particular,the monetary authority should not beplaced is a position where: (a) it isobliged to manage multiple conflicts-of-interest; and (b) runs the riskthat managing such conflicts mightlead to sub-optimal decisions onadjusting the base rate as evolvinginternal and external circumstancesimpinging on the economy mightdemand. Confidence in an Indian will be enhanced if the monetaryauthority is seen to be free of theseconflicts of interest. As part of thisframework, the HPEC believes that thefunction of a public debt managementoffice should be either completelyindependent – in the form of anautonomous agency – or placed in theMinistry of Finance rather than ina regulatory institution to avoid anyperceptions of conflicts-of-interest inthe eyes of regulated financial firms.

. Managing monetary policy underchanged circumstances will requirefundamental reconsideration of coreissues such as: (a) the viability ofmaintaining a ‘stable’ exchange rate forthe ; (b) whether that rate shouldbe managed around a notional central peg or a different trade/investmentweighted currency basket; (c) whetherofficial intervention in currency marketsto ‘stabilise’ the should occur,except in extreme (market failure)circumstances; (d) ceding a ‘stableexchange rate policy’ in favour ofmonetary autonomy, thus putting theburden of adjusting to a more variableexchange rate on private actors andthe government, while creating morerisk management possibilities (throughcurrency derivatives) that make suchadjustment easier; (e) a focus on‘inflation targeting’ and examining

carefully whether such a focus makessense in an economy that is still subjectto price manipulation of some ‘bigprices’ (e.g., energy price) that feedthrough the economy and have animpact on all other prices as well; and(f) the gradual evolution of the into becoming a global reserve currencyby . These issues, which havealso been examined tangentially by theTarapore- Committee on CAC, need tobe looked into further by a specialisedexpert technical committee.

. The debate on convertibility is primarilyabout avoiding the currency crisis andbanking crises which came about incountries such as Mexico, Thailand,South Korea and Indonesia in the lastdecade. These failures are understoodto have been caused primarily by flawedcurrency policies, and these pitfalls needto be carefully avoided. Taking intoaccount the balance of risks evaluated bymany previous committees and experts,the HPEC is of the view that the capitalaccount needs to be liberalised morerapidly and in a time bound fashionthan is presently envisaged. CAC needsto be achieved within the next –

months – i.e., by the end of calendar at the latest – preferably sooner.That is required partly to ensure thanany established in Mumbai hasa fighting chance of succeeding. Atthe same time, this policy is what theIndian economy and financial systemneed at this critical juncture. The capitalcontrols that are now in place: (a) posea high (if not insuperable) barrierin practice, to Indian financial firmsoffering IFS in the global market andhobble them in competing against globalfirms in the context of increasing de factoconvertibility; (b) deprive these firmsfrom earning significantly higher exportrevenues; (c) delay the developmentand acquisition of core -provisioncompetencies; (d) reinforce protectionistbarriers to entry in the Indian financialsystem thus rendering it inefficient,uncompetitive and more costly in termsof basic financial intermediation; and(e) inhibit essential financial system

. The HPEC’s recommendations 193

liberalisation from occurring as swiftlyand to the extent that it should.

2. Further Financial SystemLiberalisation and Reform

The ’s recommendations and sugges-tions under this heading fall into four broadcategories: (a) financial regime governanceand regulation; (b) the development of ‘miss-ing’ or weak markets; (c) the development ofglobally competitive institutions and finan-cial firms; and (d) other policies concerningthe financial system and ensuring that itsgrowing need for qualified human capitalare met.

2.1. On Financial Regime Governanceand Regulation

. Financial regime governance in Indiamust now be transformed in thesame way that governance of the ‘real’economy was transformed through thes to make Indian manufacturingfirms more efficient and globallycompetitive. Indian financial firmsand the financial system need to beexposed to the same discipline, inorder to adjust in the same way, toachieve the same goals. There isan immediate need for the Indianfinancial system to become more openand outward-orientated to enhanceits technology, efficiency, productivity,competitiveness and quality. Withoutsuch transformation the emergence of acredible in Mumbai could not becontemplated.

. Such a transformation is essential notjust to enable the export of froman in Mumbai. It is essential tomake the entire financial system moreefficient so that it can provide world-class financial services to the domesticmarket and intermediate financialresources more efficiently for use inthe real economy as well. At present theIndian consumer of financial services ispoorly treated, and served at a higherprice than his counterpart in moredeveloped financial systems. Similarly

the Indian economy, in attempting toachieve higher growth rates (–%)than it has proven capable of over thelast four years (%) needs a financialsystem that mobilises resources moreefficiently, and does not waste or divertscarce financial resources through sub-optimal allocation.

. Financial regime governance needs tochange fundamentally across the boardif an is to be allowed to emerge inMumbai for two reasons:

* The quality, flexibility, adaptabilityand ‘lightness-of-touch’ of financialregime governance, is an integralfeature of a country’s ability toprovide and export successfullyand to establish a successful for doing so. The importanceof that assertion is brought homewith particular force when even awell regulated (by world standards)jurisdiction like New York is facedwith becoming less competitive bythe day in the face of regulatorycompetition from a better, moreresponsively regulated regime inLondon. By the same token, slike Paris, Frankfurt and Tokyo thatare perceived by global markets asover- or unpredictably-regulated, donot make the frame when it comesto competing globally. Financialregulation is not, therefore, a featurethat can be treated independentlyand ‘left alone’ when it comes toconsidering what a new needsin order to compete effectively in theglobal arena.

* A financial regulatory regime iscounterproductive for an , orfor encouraging the emergence ofa dynamic domestic financial sys-tem, if it: (a) is too risk averse; (b) isprepared to erect severe roadblocksto ‘financial traffic’ or even stop itin order to avoid any probabilityof an ‘accident’ occurring; (c) re-acts negatively to financial innova-tion or new proposals for productsor services; (d) tends to ban finan-cial products, services, players ormarkets; (e) issues rules that limit

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the success of products/services evenwhen they are not banned; (f) dis-criminates in its treatment of firmsbased on their ownership or origin;(g) is protectionist in its rules andregulations and in the manner oftheir application in practice: i.e., ef-fectively or implicitly favouring cer-tain firms while disfavouring others;(h) discourages – through a policy ofintervention, intrusion and regula-tory micro-management – voluntary,self-induced risk-management, andcorporate governance of high stan-dards, on the part of the financialfirms being regulated; (j) discouragesvibrant competition and financialinnovation from occurring in thefinancial marketplace; and (k) artifi-cially compartmentalises differentsegments of financial markets whileforcing them to remain apart – forregulatory convenience rather thanmarket efficiency – thus reducingliquidity and trading opportunity ineach segment as well as diminishingarbitrage and risk-transformationopportunities than enable financialmarkets to innovate.

. But financial system regulation in India(which is of a high technical quality ifmore contentious in terms of its overallorientation, policy and approach) isnot the only issue. Other aspects offinancial regime governance – especiallythe functioning of the legal system –leave much to be desired. They mustbe improved to increase the prospectof establishing an IFC in Mumbai.If they are left unattended, someglaring deficiencies in the capacities,knowledge-base, and the administrativefunctioning of these critical systemsfor dispute settlement and conflict-resolution (especially given the way inwhich civil cases proceed through thelegal system with interminable delays)will prevent an in India from everemerging or competing effectively in theglobal marketplace.

. HPEC therefore recommends thaturgent action be taken to remedy these

short-comings with suitable reformof the legal system. If that cannotbe done relatively quickly then, in theinterim, consideration should be givenby policy-makers to establishing a specialsystem of fast-track ‘financial’ courtsand special arbitration mechanismsto deal with the legal and regulatorycomplexities that an and theprovision of will create. Thiscould mean creating an InternationalFinancial Services Appellate Tribunal(IFSAT), covering all parts of finance.IFSAT should offer a comprehensiveappeals procedure against all actions ofall financial regulators, where judgeshave specialised financial domainknowledge. The specific measuresneeded to effect improvements in thisarea will require scrutiny by otherexperts and specialists before this broadrecommendation can be translated intoa series of specific actions and remedialmeasures.

. To improve the knowledge-base and pro-fessional competencies that an inMumbai will need to function and com-pete effectively, the HPEC recommendsthat domestic space be opened up with-out any restrictions (such as insistenceon domestic partnerships or joint ven-tures) to permit immediate entry intoMumbai of: (a) well-known global legalfirms (corporate or partnerships) thatoperate in other IFCs and especiallythe three GFCs; as well as (b) all globalaccounting firms, tax advisory, infor-mation technology, business consultingand education firms that support theIFS industry.

. From the ‘wall-chart’ that has been de-rived for this report, to depict illustra-tively the barriers and impediments thatoperate on Indian financial firms of vari-ous types, effectively preventing themfrom providing to a global clientele,three sets of issues emerge regarding thefinancial sector in India. They include:(a) implications for competition pol-icy that governs activity in the financialsystem; (b) artificially tight compart-mentalisation of financial markets with

. The HPEC’s recommendations 195

little ‘crossover’ being permitted acrossboundaries; and (c) the impact that boththese influences have on suppressingfinancial innovation in India.

. In each of these areas the HPECrecommends that policy-makers revisitcarefully the nature of the financialregime governance so as to make itmore competitive, less fragmented,and more innovative. Operatingtogether, these three factors preventIndian financial firms from realising theeconomies of size, scale and scope theyneed to exploit to compete globally.

. The HPEC further recommends thatthis regime be opened up to permit agreater degree of competition (domesticand foreign) and induce a more rapidrate of innovation that will permitIndian finance to catch up with the restof the world within the next years andoperate along global lines thereafter. Bythe same token it recommends that theexcessive compartmentalisation thathas occurred across different financialmarket segments be reversed.

. In the view of , the artificialbarriers that have been erected betweendifferent segments of the financialmarket – i.e., banking, insurance,capital markets, asset managementactivities, and derivative markets – sothat they can be regulated separatelyby different regulators should bedismantled. Whether regulators areseparated or not, the financial sectorneeds to operate as a seamless wholein order to achieve global standardsof market efficiency, competition andinnovation. This may be inconvenientfor regulators. But, in the view of theHPEC, regulatory arrangements andarchitecture should be rearranged tomeet the market’s needs; rather thanhaving the market rearranged in orderto meet the demands of regulatoryconvenience.

. In the view of HPEC, artificial obstruc-tion to greater competition in the fi-nancial sector now needs to cease. Aprocess of ‘creative destruction’ needs tobe unleashed in Indian finance to make

it more dynamic, globally competitive,and to let financial firms emerge thatare of the right size and scale to take onglobal competition. That is preciselywhat was done in the industrial sectorduring the last decade when over onethousand firms disappeared but were re-placed by fewer but larger, more efficientand more competitive industrial firms.

. But that also means having theGovernment prepare an ‘exit strategy’through reduction in its ownership offinancial firms. As a shareholder it isperfectly rational for the governmentto act in this manner to protect itsshareholding interest and the value ofits equity stake. But from the viewpointof the welfare of the Indian marketeconomy, and to a lesser extent ofhaving a credible , that policy iscounterproductive and myopic. It resultsin the inefficient use of public resourcesat a time when greater efficiency isdemanded to attain and sustain a highgrowth rate. The logic of the argumentsuggests that the state should withdrawgradually, at a pace dictated by realpolitik,from being a shareholder in any financialfirm.

. By doing so it would avoid the seriousconflicts of interest. In terms of apossible timeline, the HPEC wouldsuggest that the legislature contemplatea general policy of reducing the state’spresent shareholding in all types offinancial firms to below % by end-, below % by end-, andtoward a full exit by . If thistrajectory of withdrawal is not putin place the prospects for an in Mumbai emerging as a credibleand competitive centre in the eyes ofthe global financial market will becompromised.

. Over the next – years the HPECrecommends that the Indian financialregulatory regime makes a muchneeded and overdue transition from:(a) a rigid, inflexible and overly-

A few members disagreed with this recommenda-tion. However, this was the majority view and is henceretained as the position.

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prescriptive ‘rules-based’ regime underwhich the regulator and regulatedadopt adversarial and antagonisticpostures vis-a-vis one another; to(b) the more flexible and state-of-the-art ‘principles-based’ regime or PBRpioneered in the by the Bank ofEngland and embraced and appliedenthusiastically by its supervisorysuccessor, the . is becomingmore popular around the world. Adecade’s experience with it in the and elsewhere suggests that it is moreeffective. The regime is moreopen, flexible and user-friendly. Itdoes not expect regulators to perceive‘non-compliance’ as the natural defaultsetting of regulated firms. It is non-adversarial and more co-operative. Itexpects regulated firms not only to obeyand comply with the letter-of-the-law(i.e., what is codified) but also withits spirit (i.e., compliance with whatmay be uncodified because it was notanticipated, but was intended in anyevent). For financial firms, is muchmore demanding, since they are requiredto adhere to the spirit of the law, andnot just the letter. Such a transitionwill require a major mental adjustmenton the part of both Indian regulatorsand financial firms for many of which‘beating-the-rules-of-the-regulator’ hasbecome an essential game in order tosecure marginal competitive advantageover rival firms.

. Adopting practice that is now normalin almost all countries, theHPEC would recommend that GoIconducts – using independent, impartialinterlocutors, including regulators fromother s– a periodic (– yearly)Regulatory Impact Assessment of thefinancial regulatory regime. The would aim to evaluate, usingenhanced cost-benefit methodology,how efficient and cost-effective extantregulation (policy, practice, application,and institutional arrangements) is inmeeting the main regulatory objectives,and to understand what modificationsare needed to improve it.

. Finally, in keeping with the recommen-dations made above for improving regu-latory approaches and practices, theremay be a corresponding need for anaccompanying change in regulatory ar-chitecture and arrangements governingthe financial system as a whole and, lessimportantly, to permit a credible to emerge. Such a change, if made onlyto satisfy the needs of an , would beakin to “a very small tail wagging a verylarge dog”. The change has to be madefor the sake of the financial system aswhole and not just for the sake of hav-ing an . But, in suggesting this, the observes that the interests of thefinancial system as a whole, and those ofan , happily coincide.

. When it comes to reconsidering regula-tory architecture – whose foundationswere set as early as with the original Act, although many amendmentshave been made since – India has threeoptions, i.e.,:a. Keeping the extant architecture

in place but with improved co-ordination and co-operation toreduce regulatory conflict, turf-protection, and achieve coherent,consistent regulation across theentire financial system

b. Partial consolidation of extant reg-ulators into a tightly knit quartetcovering: (a) banking; (b) insur-ance; (c) pensions; and (d) capital,derivatives and commodities mar-kets. Any area of activity that did notfall neatly or obviously into thesefour categories would be regulatedautomatically by the capital mar-kets regulator. In other words ac-tivities such as asset managementand mutual funds would fall underthe purview of the capital marketsregulator, as would regulation of thesovereign and corporate bond mar-ket. Under such an arrangement,regulators of specific types of institu-tions (e.g., banks or insurance com-panies) would not have the rightto regulate other domains/marketsegments (e.g., capital markets) inwhich banks or insurance companies

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(and/or their subsidiaries/affiliates)might operate. Domain regulationwould be the responsibility of thefunctional domain regulator regard-less of the institution that wantedto operate in that domain; whetherdirectly or through another corpo-rate arrangement. The regulatoryquartet would be presided over by aregulatory co-ordination commit-tee chaired by the regulatory agencythat regulates the largest part of thefinancial system.

c. Evolve rapidly toward unified regu-lation with a single regulator for allfinancial services to avoid problemsof co-ordination or of matters fallingbetween regulatory cracks when reg-ulation is more fragmented.

. The HPEC is mindful that in largefederal countries like India and the with a legacy of multiple regulatorspolicy-makers must consider the prosand cons of these different optionsand tread carefully. The evidencebeing generated from the twenty oddcountries that have adopted styleunified regulation on a ‘principles-basedplatform’ is that it works well. Butmany regulators more firmly wedded totradition argue that one decade is not asufficient period to be conclusive aboutits unquestioned superiority. The qualityof a regulatory system can only be testedwhen it comes under severe strain. Thecounter-argument is that the modelactually works toward minimising therisk of such strains appearing in thefirst place. Moreover, in an imperfectworld, there may be as many problemswith having a regulatory monopoly (thelack of regulatory competition may alsoimpede innovative thinking) as with aregulatory oligopoly differentiated byactivity or market segment.

. For that reason, while conceptuallyattracted to the unified, principles-basedregulatory approach as the model for thefuture – i.e., the ideal that India shouldstrive for in the long run – the HPEC’sview is that movement in that directionshould proceed at a pace that reflects

the regulatory system’s absorptivecapacity for such change. Such amove may trigger legitimate concernsabout technical and other problems thatmay be caused by changes in the long-established operating domains of extantregulatory agencies. But, after carefulconsideration of all the pros and cons,policy-makers may still conclude thatrapidly changing circumstances – ofthe kind that are impelling the nextphase of financial system developmentand calling for the creation of an in Mumbai – require swift changes inregulatory architecture. They may wishto expend the political capital needed tomove toward more unified regulationnow rather than later. In that event, the would concur with movementtoward more rapid reform. But,whatever is decided by policy-makerson reforming regulatory architecture,the would recommend an early,if not immediate, migration from‘rules-based regulation’ to ‘principlesbased regulation’ even under the extantarchitecture.

. As far as financial system regulationis concerned two key priorities needto be addressed and enshrined in newlegislation: (a) the regulatory approachand mindset adopted; and (b) regulatoryarchitecture. The present series ofdisparate legislation governing theIndian financial regime needs to berevamped and redrafted into a newFinancial Services Modernisation Actthat embraces a ‘Principles BasedRegulation’ approach, as articulatedin Chapter .

. A key task in reforming regulatoryarchitecture is to place all regulatoryand supervisory functions connectedwith all organised financial trading(currencies, bonds, equities, corpo-rate bonds, commodity derivatives;whether exchange-traded or OTC) intoSEBI . This requires collecting togetherelements of law that are presently dis-persed across many other acts, includingthe Act, the (R)A, the Compa-nies Act, etc.. The objectives of ,

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under the new law, should replicate theobjectives and approach of the -.This requires closely studying the and the , the andthe regulatory and legal foundationsused in Ireland. The new law governingfinancial system regulation should ar-ticulate broad principles, and providesufficient flexibility for more rapid fi-nancial innovation. It should embedthe distinction between wholesale mar-kets and retail markets, where a muchlighter regulatory touch is applied towholesale markets.

. The proposed new Act should alsoembed a redrafting of the BankingRegulation Act (BRA), shifting towardsprinciples-based regulation, and givingbanks greater flexibility in operationsand management than is presently thecase. There is considerable merit inmerging the new securities law andthe new banking law into a unifiedfinancial sector law (the FinancialServices Modernisation Act), even ifthe two regulatory agencies continueto be distinct. This would underlinethe unity of finance, and increase theextent of coherence found in differentparts of finance. As an example, thecreation of the proposed InternationalFinancial Services Appellate Tribunal() which would provide anappeals procedure covering all aspects offinance is best done within an Act whichcovers both banking and securities.

. Finally, when it comes to financialregime governance, the believesthat India should immediately openup to Direct Market Access (DMA)on Indian exchanges to match thesituation with foreign exchanges inother IFCs that provide a hospitableenvironment for algorithmic trading.That would enable India to compete asan venue for global firms in thisimportant market segment.

2.2. On ‘Missing Markets’. As has been elaborated upon at some

length in the report, an Indian ishandicapped by three key markets that

are ‘missing’ in India’s financial system:i.e., (i) a properly functioning, liquidcorporate and sovereign bond market;(ii) a spot currency trading market;and (iii) a broad derivatives marketsthat includes exchange traded as well astailored derivatives for the managementof currency, interest rate, and creditdefault risk.

. These three markets, termed the bond-currency-derivatives (BCD) nexus inthis report, are inter-woven by currencyand interest rate arbitrage. In anefficient market, the currency forwardis only a reflection of current andexpected interest rate differentials acrosscurrencies. A number of sophisticatedtrading strategies employed by globalfinancial firms (using sophisticatedquantitative finance models to drivealgorithmic trading) bind together alltraded products of the nexus. No can function (or even become an) in the absence of any of these markets. If India is to have an in Mumbai, the HPEC would placeemphasis on having these ‘missing’BCD markets develop rapidly.

. A domestic bond market, in whichglobal investors can participate on thesame basis as in other s, cannotoperate without having an establishedINR yield curve that is arbitrage free,liquid and well-traded along maturitiesranging from the very short (-days) tothe very long ( or years). A bondmarket operating along global lines ispropelled by the monetary authoritysetting the short (base) interest rateat which banks can borrow from it.The market arbitrage process in a freeand liquid bond market translates suchbase rate changes into changes in longrates over different maturities; basedon expectations about policy stability,the market view about the monetarypolicy rules in operation, expectations ofthe future direction of domestic interestrates, inflation and external conditions.

. In India, the bond market is limitedand stunted. It is a market in which themonopoly trading platform for bonds is

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managed and governed by the monetaryauthority rather than by a securitiesexchange. This is a sharp departurefrom global practice. The frameworkof existing regulations permits neitherliquidity nor arbitrage. Nor does it havebond issues reflecting a wide spectrumof credit risks through the inclusion ofcorporate issuers. The bond market isdominated by sovereign issues that haveno credit risk given the government’sright to print money in . Moreover,the market’s institutional structuresare weak, participation is artificiallyconstrained by a number of eligibilityand origin barriers, speculative price-discovery is lacking because of theabsence of arbitrageurs, option-writersand speculative risk-takers who arebarred from operating in this market.

. But a bond market in an Indian needs to also issue and trade bonds incurrencies other than the . Indianand foreign corporate borrowers maywish to choose, in an Indian (asthey could in any other ), to issuebonds in a wide range of globally tradedor even exotic currencies to optimisetheir borrowing costs using derivativesto cover future currency and interestrate risk. They may want to issue along-term bond in and immediatelyswap it into another currency with built-in provisions for a reverse swap whenrepayment is due on maturity. At presentthey can do none of these things.

. The R.H. Patil Committee Report ondomestic debt markets made a numberof far-reaching policy, operational,and technical recommendations. Inthe view of , these should beimplemented as soon as possible tomake domestic bond markets functionmore efficiently and to perform theimportant economic role that suchmarkets play. To the Patil Committee’smany recommendations, and fromthe viewpoint of internationalising theIndian debt market as a key buildingblock for creating a viable inMumbai, the HPEC would add theneed to: (a) bring all securities trading

markets (including those for sovereigndebt) under the regulatory purview ofthe regulator responsible for securitiestrading, ie SEBI; and (b) to ensure thatthe platforms for trading all such debtinstruments are transferred to the NSEand BSE.

. Short selling of bonds is of funda-mental importance for obtaining anarbitrage-free yield curve. This re-quires the ability to borrow bonds.A borrowing mechanism needs to besetup by exchanges, to enable shortselling in government bonds, corpo-rate bonds and equities. This needsto be done in an integrated way, for allthree kinds of securities, so as to harnesseconomies of scope and scale.

. At present bond purchases byFIIs are constrained by quantitativerestrictions whereas equity purchases arenot. An essential step for increasing thepresence of INR denominated bonds(and the INR yield curve) in globalinvestment portfolios (e.g., of globallymanaged pension funds) is to removethe existing quantitative restrictionsso as to put INR bond purchases byFIIs and other foreign buyers wishingto purchase INR denominated bondsin global markets on a par with theirequity purchases.

. At present, there is a small currencyderivatives market and a small interestrate derivatives market where trading ofprimarily vanilla products takes placeover-the-counter (). However,there is a considerable advantage intransparent trading of vanilla productson the exchange platform, particularlygiven the dramatic progress of electronicexchanges and algorithmic trading.Electronic trading and transparencyassist liquidity, and it is easier forIndia to compete in the global IFSmarket by emphasising order flowinto electronic exchanges – whereobjective characteristics of liquiditymatter more than human relationshipsand counterparty risk. Hence, there is aneed to shift trading in vanilla products(futures, options, swaps) to exchanges

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while retaining and expanding the OTCtrading of transactions for exotic andtailor-made products.

. Vibrant trading, on exchanges, of inter-est rate derivatives is a fundamental partof the nexus. India’s experiencewith interest rate futures has been anunfortunate one, with banks being pro-hibited from participating in the marketexcept as short sellers of interest ratefutures. The Ministry of Finance needsrapidly to take stock of the constraintsthat hold back exchange-traded inter-est rate derivatives, including futures,options and swaps, and obtain the req-uisite modifications of regulations ofinsurance companies, banks, mutualfunds and FIIs so as to get this criticalcomponent of the BCD nexus off theground immediately.

. By the same token, markets for tradingglobal currencies (spot and derivatives)are the lifeblood of an . Everycustomer buying generates aseries of immediate transactions onthe currency spot market and coversexchange risk with currency derivatives.That is true whether a global investoroperating in a Mumbai-based wants to buy Indian equities, bonds,index funds, or index derivatives. AsIndia’s growth continues over the nextdecade the will join the globalclub of major currencies. By

these will comprise the , ,, , and : the reservecurrencies of the world. That requiresestablishing immediately a currencytrading exchange in Mumbai, with aminimum transaction size of INR

million (or roughly $ , atpresent exchange rates). Initially, thismarket should be open to domestic andforeign financial firms including FIIs;opening to individual traders shouldbe deferred until the INR becomes fullyconvertible. Establishing a wholesalebut fully-fledged currency market willrequire removing those capital controlsthat presently disallow financial firmsfrom holding multicurrency depositswith banks.

. This wholesale currency spot marketneeds to be accompanied by anINR cash settled currency derivativesmarket, offering products such ascurrency futures, currency optionsand currency swaps, traded on India’sestablished exchanges. The currencyderivatives market should be opento all (including FIIs). It mustaspire to replace the trading thatpresently takes place on the -market. Regulatory responsibility of thesuggested currency market – spot andderivatives, exchange and – needsto be shifted to .

. Contracts involving the four majorglobally traded currencies (ie , , and ) are well established andaccount for the bulk of global tradingin spot and derivatives markets. Anumber of smaller countries in with open capital accounts offer tradedcontracts in their own currencies againstthese four global currencies. The trading market could be networkedinto and piggy-back off trades in thesemarkets. An market could quicklydominate trading in vs. the fourglobal currency contracts. But it shouldseek to also establish a first-moveradvantage in trading new contractsinvolving: (a) the vs. othertradable but exotic currencies such asthe Australian, Canadian, Hong Kong,New Zealand and Singapore dollars, thevarious Scandinavian kroners, and Swissfranc; as well as (b) emerging marketcurrencies (under special arrangementswith their central banks) of countrieswith which India is likely to have growingtrade and investment links such as theMalaysian dollar, the Thai baht, SouthAfrican rand, the Russian new roubleand the Brazilian real. It could developpass-through contracts between the and currencies that are looselyor firmly pegged to the USD (e.g., the and as well as a range ofGulf currencies) but lacking in formalarrangements to protect the peg. Thepossibilities are limitless and must beleft to the ingenuity of indigenous andglobal market operators and arbitrageurs

. The HPEC’s recommendations 201

to develop and exploit. Some contractswill fail to attract trading volumesand die a natural death. Others (likethe / contract) may trade involumes that, in a decade, could rivalthe volumes of traded contracts acrossthe four global currencies.

2.3. On Weak Institutions. Side-by-side with weak or missing

markets, the Indian financial system hasa number of weaknesses in the make-up, diversity, skill sets, competitivenessand size of its financial firms. India’sequity and limited derivatives marketsare dominated by trading done byprivate firms and s although publicinstitutions in the insurance and mutualfunds industries are also large players inthese markets. That bias in institutionalstructure, in all financial markets otherthan the equity market, gives Indianfinancial firms an excessive ‘home bias’in their operational orientation andhandicaps them from developing globalreach beyond the community.

. That feature also disables Indianfinancial firms from competing onlevel terms with foreign counterparts inglobal markets. It will constrain thedevelopment of an in Mumbai. Forexample, the ten largest global financialconglomerates (comprising, under asingle brand umbrella like Citigroupor , subsidiaries or affiliatesthat are commercial banks, investmentbanks, insurance companies, securitiesbrokerages, global fund managers, hedgefunds and derivatives operations) allhave a balance sheet size exceeding$ trillion. The top four orfive now have a balance sheet sizeapproaching or exceeding $ trillion.In India, the largest financial group() has a balance sheet size of around$ billion; or less than a fifth that ofits ‘smaller’ foreign counterparts whenIndia is the fourth largest economy inthe world in PPP terms and the seventhlargest in nominal terms.

. Such a large relative difference in thesize of Indian vs. global financial firms,

when the relative difference in the sizeof their respective home economies issmaller, deprives Indian financial firmsof the ability to realise greater economiesof scale and competitiveness within theirinternal structures. It reflects the in-builtadvantage that foreign financial firmshave established in operating globallyin an unfettered manner for severaldecades when Indian financial firmshave been constrained from doing so.International financial firms have apresence in all aspects of finance, whileIndian financial firms are hemmed intoslots defined by over-compartmentalisedfinancial system architecture. Thisincreases the risks of Indian financialfirms. They have less diversified sourcesof profit. It results in Indian financialfirms requiring intermediation spreadsto cover costs that are higher thaninternational norms. It disables themfrom operating successfully in a globalmarketplace where substantial resourceshave to be expended to establish aglobally accepted brand identity, and toinvest capital in globally sized operationsfor: commercial banking, investmentbanking, securities broking, derivativestrading or insurance.

. The same is true of Indian investmentbanks. At present, they are anaemicreplicas of their global counterparts,despite their considerable reservesof human capital and their corecompetencies. Earlier a number ofjoint-ventures were created (largely toaccommodate Indian entry barriersat the time) between established andreputable Indian financial houses andnearly all the major global investmentbanks. These joint ventures are nowcoming apart. That raises questions ofhow the Indian partner ‘divorcees’ fromthese ‘arranged marriages’ will evolvein the future. While they may have thehuman capital, they certainly do not yethave the size of financial capital theyneed.

. What is said about commercial andinvestment banks above applies evenmore to the indigenous securities

202 R M I F C

brokerage industry. It is a far cry fromachieving the size, efficiency, capabilityor capital of its foreign equivalents. TheIndian brokerage industry exhibits manyof the same symptoms and malaise asIndia’s retail sector in general. It isdominated by a landscape of ‘mom-and-pop’ shops and single proprietorshipsmasquerading as companies. Theydo not have the capital or knowledgerequired to service their investor-clientson a basis that remotely approachesglobal brokerage service standards;although they do provide a limited arrayof brokerage services at a fraction ofglobal costs for a securities account.

. None of these institutional categories areinherently or congenitally weak. Theirweakness is derived from a legacy offinancial policies and strategies thatare proving, in retrospect, to havediscouraged emergence of the kindof institutional base of financial firmsthat India needs to compete in globalfinancial markets.

. The legacy problem inherited by Indianfinancial firms, and exacerbated bythe domination of financialfirms in the Indian financial universe,needs to be tackled boldly on twosimultaneous tracks: (a) first, Indianeeds to moderate, and eventuallydispense with, its legacy of stateownership in the financial universe;(b) second, Indian policy-makers andregulators need to shift away from theartificial over-compartmentalisation ofsub-markets. Those two propensitieshave inhibited the proper developmentof these markets. They have alsoprevented larger, more capable financialconglomerates – operating acrossdifferent market segments – fromemerging and competing globally. Withreintegration across the extant sub-sectors of finance, and with barriers toexpanding into new lines of businessbeing removed, large, sophisticated andcompetitive Indian financial firms willemerge.

. The HPEC believes that the Indian au-thorities should support the consoli-

dation of Indian firms in the financialsector to permit – through the uncon-strained operation of natural marketprocesses – sizeable Indian financialconglomerates to emerge, through ac-quisitions, mergers and (hostile as wellas amenable) takeovers. The aim shouldbe to create a few (at least five or six)Indian s– led by the most capableand dynamic financial groups in India –the size of whose consolidated balancesheets exceeds US$ billion. No fi-nancial firm should be exempt from thisconsolidation process, regardless of own-ership. Furthermore the consolidationof Indian financial conglomerates shouldbe facilitated by foreign equity participa-tion on the part of private equity firms,strategic direct investors, and institu-tional portfolio investors to augment thelimitations of Indian capital resources.The implementation of this strategy doesnot require government or regulatorydirection concerning which firm shouldacquire which other firm. It requires re-moving the barriers to reintegration, andimpediments to market-driven M&A,that are present today.

. The end goal should be to have Indians that span the entire financialspectrum. Until India achieves style integration of all finance underone regulator, a key tool for achievingthis goal might be the ‘financial holdingcompany’ as described in Chapter . sees the holding company asthe logical organisational structure forIndian financial firms that seek tobecome global players in the periodwhere India uses the proposed four-pillarregulatory architecture. A set of policymeasures need to be taken to enable thisinstitutional structure to emerge.

. In the specific field of asset management,a major organisational innovation to har-ness scale economies is recommended.At present, banks, insurance companies,mutual funds, pension funds, s, etc.all undertake uneconomic asset manage-ment operations. Each of these opera-tions is small, lacks economies of scale,and is unable to compete in the global

. The HPEC’s recommendations 203

market for asset management. In this sit-uation, the government needs to permitthe emergence of Wholesale Asset Man-agement businesses, regulated by SEBI,where the minimum size of customerfunds is at least Rs. crores.

. This initiative should get the benefit oflight-touch regulation, given that theprotection of retail investors does notarise as an issue under this arrangement.All impediments to outsourcing ofasset management by financial firmsin India – banks, insurance companies,mutual funds, pension funds, FIIs,hedge funds, etc.. – should be identifiedand removed. Once these artificialbarriers to outsourcing are removed,each entity – such as a mutual fund – willmake a commercial decision on whetherthe task of asset management should bein-sourced or outsourced to one of theWholesale Asset Management firms.

. Given the immense economies of scalethat can be captured by large assetmanagement factories, differentiatedfront-end entities – such as mutualfunds, insurance companies, pensionfunds, investment banks – may chooseto outsource their asset managementfunctions to such Wholesale AssetManagers. This would separate thefront-end interface with a customer –such as a mutual fund, bank, insurancecompany or pension fund – from theback-end factory undertaking the actualactivity of asset management. The front-end financial firms would continue tobe regulated by their domain regulatorwhile the factory would be regulatedby using . Undertaken ona wholesale basis, that is blind to thesourcing of assets being managed, suchasset management factories can achievemuch lower costs and much largereconomies of scale than the presentplethora of fragmented, small assetmanagement units of disparate financialfirms. By pooling assets from allparts of the Indian financial system,Wholesale Asset Managers could achievepricing efficiencies that would makethem competitive by global standards.

India’s progress on this score shouldbe measured by comparing the Indianwholesale price for running an indexfund for $ billion of the S&P againstthe wholesale price seen in New York orLondon.

. In addition, Indian authorities shouldbring forward their liberalisation plansfor the financial sector (e.g., openingup to branch banking by foreign banks)ahead of the commitments to the Agreement on Trade in financial services.In this instance, the believes thatmore open foreign entry will be in India’sown self-interest in the short, mediumand long term.

. The protectionist arguments that havebecome so familiar in other sectors – togive Indian financial firms more timeto adjust to new global realities – needto be re-examined carefully. Indianfinancial firms have seen the writingon the wall since . It is true thatthey have not had the freedom andflexibility as yet to grow organically anddiversify as they might have wished. envisages convertibility within– months. This gives all Indianfinancial firms a window of –

months for gearing up to cope with theopportunities and competition that flowfrom convertibility. Giving firms moretime than that will prolong inefficiencyrather than enhance competitiveness.

. The Indian financial sector now needsto open its doors to face the fullforce of international competition andadjust accordingly. As with theircounterparts in manufacturing industrysome Indian financial firms will perish.Others will strengthen to take theirplace in the world in the same way thatthe more robust, competitive Indianmanufacturing firms are now doing. TheHPEC sees no convincing argumentin favour of delaying this move anyfurther. It will enable India to rectify itsinstitutional weaknesses and deficienciesfaster than it otherwise would. Thereis little point in being cautious simplyfor the sake of caution if, given thebalance of probabilities, such caution

204 R M I F C

only ends up in damaging India’s abilityto compete effectively in the globalmarket for by having a less efficientfinancial system.

. The control of branch licensing forbanks is an anachronism, at a time whenIndia has moved away from the license-permit raj in most respects. Thereis no other industry in India, today,where firms have to take permissionfrom the government in order to openbranch offices. Simply because theytake deposits does not make bankbranches any different from othermarket enterprises. Banks should decidewhere and when they want to openbranches and not the regulator. Aspart of improving competition policy,the opening of branches by domesticbanks should now be immediatelydecontrolled. No domestic bank shouldhave to ask the banking regulator forpermission for each ATM or branch.After one year (ie by the beginning of) this policy should be extended toall banks. This will give local banks aone-year head start over foreign rivalson opening branches.

. Indian banking is afflicted by a weakpace of entry and exit, reflecting poorcompetition. Entry into domesticbanking has been hampered by over-prescriptive and asymmetrical rulesabout the ownership of banks. Banningbanks with ownership patterns that haveclose relationships with the owners ofnon-finance companies eases the task ofregulators and supervisors. The time hascome to remove these restrictions andpermit unrestricted entry by Indiancorporates into banking and all otherfinancial services. As the Tarapore-

Committee has pointed out, and theHPEC concurs, the discriminatory %ceiling on investments by corporatesin banks is unjustifiable and shouldbe removed immediately. As amember of the observed, ina market economy there can be nojustification for such a restriction whenanother economic agent – i.e., thestate – can have any level up to

% ownership of the same types ofinstitutions. While this will increase theworkload and complexity of bankingregulation and supervision, the benefitsthrough increased competition will beconsiderable.

. Banking regulation requires strong fea-tures of market discipline to accompanythe kinds of competition policies de-scribed above. This requires that allbanks in India should now raise equityin the capital market and raise a mini-mum proportion of their liabilities byissuing bonds with no safety net of de-posit insurance. In the context of theneed for additional equity capital on thepart of Indian banks to meet Basel-IIrequirements, regulators appear to havebeen tempted to accommodate high assetgrowth with diluted equity requirements.This temptation needs to be checked,in the interests of controlling the lever-age of Indian banks and simultaneouslyexposing banks to market discipline.

. Finally, the Indian financial marketshould be made fully open to theentry of globally established alternativeinvestment vehicles with a track recordas well as to exchange traded funds,arbitrage funds and any financial entityof any sort provided it meets therequisite performance, track recordand ‘fit-and-proper’ tests for entry.These tests should not be manipulatedto bar or delay entry in practice whenit has been opened up in principle.Alternative investment vehicles shouldalso be enabled on the domestic market.

. In Chapter , Box . showed acomparison of the charges for tradingindex futures in Mumbai versus Chicago.Indian exchanges have charges thatare higher by a multiple of or depending upon the size of thecustomer. The reforms proposed in thisreport rectify this egregious anomalythrough the following measures:

. Eliminating all transactions taxeslike the and stamp duties;

. Subsuming into the on financeall service taxes on brokerage andrefunding the applied to foreign

. The HPEC’s recommendations 205

customer transactions (becauseexports are zero-rated);

. Adoption of a approach by that is likely to reform thead-valorem charge going into the‘Investor Protection Fund’;

. Permitting algorithmic trading, and greater global participa-tion by sophisticated traders suchas alternative investment vehicles toincrease the number of transactionsin India, thus reducing the averagecharge per transaction;

. Unifying equity, commodities, cur-rencies and interest rates into a sin-gle exchange industry to open thepossibility for Indian exchanges totrade additional contracts and ob-tain economies of scope and scale,thus lowering average charge pertransaction;

. Global benchmarking: i.e., atpresent the management teams ofIndian exchanges do not comparethemselves against the Chicago tariffstructure. The situation is likethat of Indian steel companies in which thought that the priceof Indian steel was distinct fromthe world price of steel. If thereforms suggested in this report areimplemented, global competitionwould greater pressure on Indianexchanges in favour of efficiency andlower charges, as happened withIndian steel companies.

2.4. Other Policies and Issuesaffecting the Financial Systemand an IFC

. The Indian services industry wasbased on India’s exploitation of itsadvantage in ‘purpose-suited’ humancapital. That will be equally true ofIndia’s entry into the export of IFSthrough a Mumbai based . ButIndia’s human capital resources andtheir qualifications for this purposeshould not be taken for granted. Thereare intense competitive pressures acrossall industries to attract these humanresources. Major investments therefore

need to be made simultaneouslyincluding inter alia:

• Creating a specialised postgraduateprogramme (M.Sc. in Finance)that combines the teaching ofhigh-level quantitative economics,finance, advanced mathematics andcomplex modelling, and computerscience. Such a programme shouldbe pioneered in an academic centreof excellence close to Mumbai andshould result in a steady stream ofgraduates to populate the andreplenish its human capital baseregularly.

• For this initiative to have a materialimpact upon the human capital inMumbai, the size of the programshould be set at studentsgraduating every year. Once amajor program is established, it islikely that other graduate schoolsof business in India will mimic itsstructure thus further augmentingthe supply of numerate staff-personsinto the emergent .

• Increasing the output of s ma-joring in Finance and QuantitativeFinance from India’s best postgrad-uate teaching institutions, with aparticular focus on strengtheningthe quality of academic staff and thelinkages between their research pro-gram and the emergent .

• Increasing the output of qualifiedprofessionals and paraprofessionalsfor the supporting accounting,auditing, business-consulting, andlegal professions to ensure that anadequate supply of properly trainedand qualified human capital is alwaysavailable in these areas.

. In the final analysis, it would be a graveerror to take an ‘industrial policy’ orplanning approach to the emergenceof an IFC in Mumbai. It is temptingfor policy-makers to have a laundrycheck-list to guide what specific actionsneed to be taken to make an work,or to try and ‘pick winners’ in termsof firms or areas of business to be

206 R M I F C

encouraged by government. Clearly,as this report elucidates, a number ofcritical issues do need to be resolvedas far as financial regime governancein India and urban infrastructure andgovernance in Mumbai are concerned.But, beyond that, the authorities shouldnot attempt to be over-prescriptive.

. The role of government should be toset up an enabling framework, andrely on two principles: (a) ensuringthat the market for IFS provisionin Mumbai works as efficiently aspossible; and (b) adopting a policy oftotal ‘openness’ in terms of entry intothat market by every kind of playerthat wants to provide any kind ofIFS without being bound by capitalcontrols, artificial entry barriers andrestrictive rules.

. The IFC in Mumbai should evolveon its own, based on the drive,entrepreneurship and innovation ofdomestic and foreign financial firmsparticipating in the export of IFS.Clearly such players need to meetthe basic ‘fit-and-proper-person’ testsof probity, integrity and competence.They need to have an established trackrecord which inspires confidence in theirability to enhance the reputation ofthe . In short, the IFC’s destinyshould be left to market forces andnot be determined by governmentfiat.

. The reason for relying on theseprinciples is that it is impossible topredict how the industry will evolveor what products and services willappear five or ten years from now, orwho the players will be. Certainlyit would have taken an extraordinaryinsightful if not clairvoyant observerto predict ten years ago what the industry would be doing today.Government should not attempt togo too far beyond that other thandoing what is needed and whathas already been elaborated uponearlier.

. Intuitively, the task of bringing Indianfinance up to a level of global compet-

itiveness in is comparable to thetask faced in reforms of Indian tradeand industry in . At the time, keyreform initiatives did not consist ofthinking through all steps from

to . They consisted of introducingnew elements of competition into thesystem, after which a continual processof learning and policy evolution tookplace.

. In similar fashion, the set of recommen-dations of this report do not claim tobe a fully thought out program of fi-nancial sector reform for a multi-yeartime horizon. However, what is likely tobe achieved by implementing this pro-gram of reforms is of unleashing newforces of competition and outward ori-entation into Indian finance. That pro-cess would (in turn) have far-reachingconsequences; comparable to the re-moval of industrial licensing and scal-ing back of trade barriers in the earlys.

. Once these recommendations are im-plemented, a dynamic of competitionand innovation would come about,which would trigger off new learningand new forces of political economy,which would then influence the fu-ture evolution of financial sector pol-icy. However, the immediate prior-ity is to implement the recommenda-tions of this report. They constitute aminimum set of reforms which breakfree from the present stasis, and un-leash competition and outward orien-tation. India has dismantled an au-tarkic license-permit raj in industryand trade, and can do it again in fi-nance.

3. The challenge of urbaninfrastructure andgovernance in Mumbai

. As indicated earlier, the prospects ofestablishing an in Mumbai and en-suring its commercial viability, globalcredibility, and operating success, de-pends as much on financial regime trans-formation in India as on how well Mum-

. The HPEC’s recommendations 207

bai covers its debilitating infrastructureand urban governance deficits. TheHPEC has more concerns about howand whether these large urban gover-nance challenges in Mumbai will bemet than it does about achieving thenecessary transformations in Indianfinancial policies and practices to ac-commodate an IFC.

. For a Mumbai based to be globallycompetitive, on a par with others and the three major s, ithas to have world class infrastructurethat meets global standards in thequality of construction, finish andongoing maintenance. That applies to:(a) residential and commercial space;(b) shopping and recreational facilities;(c) uninterrupted, high quality electricpower supply with minimal fluctuationsin voltage and current; (d) watersupply with minimal fluctuations ofpressure and quality; (e) sewerageand waste disposal as well as stormdrainage and flood control during themonsoon season; (f) local gas and utilitydistribution; (g) global standards inall modes of private and public urbancommuter transport – road, rail andwater-borne – as well as rapid transportlinks that connect the Mumbai withthe rest of India (ie air links involvingairports and airlines as well as high-speed rail and world class motorways)and the rest of the world (mainly air-linkages); and (h) global standards oftelecommunications (landline, cellularand broadband) that connect theMumbai around the clock to theworld. Apart from coming close on thelast of these requirements, Mumbai doesnot hit the board on all the others.

. All these infrastructural requirementshave been explicated in several forumsbefore with elaborate plans being drawnup to meet these challenges by a varietyof public and private bodies aiming toput ‘Mumbai First’. For that reasonthe has desisted from going toofar down a path trodden too oftenby too many others (a slew of localcity committees as well as national

international agencies) in the recent past.. In ’s considered view (with many

members of the Committee havingresided in Mumbai for most of theirlives) the progress that has been madeso far has been more rhetorical thanreal. The state and civic administrationshave made numerous statements ofintent in the past but little progresswas made until recently. But the sceneappears to be changing with new visionand drive on the part of the State’sChief Minister to go on a war footingto improve the urban environment ofMumbai. Excellent staff appointmentshave been made in Mantralaya to drivethe development of infrastructure in thecity. The change in the air is palpable.While India was progressing rapidlyby way of economic growth, Mumbaiseemed until last year, paradoxically, tobe decaying and crumbling at almostthe same pace. That obviously couldnot continue. The Chief Minister andhis dynamic team have done much tochange that state of affairs.

. If Mumbai is to host an then itsinfrastructure deficiencies need to beresolved quickly – and not througharabesques such as the Navi Mumbai. The HPEC suggests that theimpressive and laudable combinedefforts now being made by central, stateand civic authorities – along with theactive support of the private corporatesector – should be enhanced andsupported by multilateral financinginstitutions and PPP arrangementsin every sub-sector of infrastructure.The authorities should invite the openparticipation of foreign constructionand development firms alongside theirIndian counterparts to ensure thatMumbai’s infrastructure deficit iscovered in the next years. If thatis not done then the pursuit of an in Mumbai will remain a pipe dreamthat will be impossible to convert intoreality. Locating it in a is not aviable option.

. In that connection the believesthat state and civic administrations needto move swiftly but fairly in resolving

208 R M I F C

the outstanding issues posed by the and the Rent Control Actthat are blocking access to pipelinefunds available from the Centre andmultilateral financing institutions.

. Apart from the present state of itsphysical infrastructure – that makesMumbai remote from being worldclass – the city also confronts a serious‘governance deficit’. The reasons for thatare well-known and have been discussedad nauseam in academic circles, themedia, and in policy-making circles atcentral and state levels of government.Given this backdrop, believesthat it is time for the talking to stopand the action to start. Mumbai needsa City Manager (whether elected orappointed) who is directly accountable

to its citizens and residents. The cityneeds an administrative apparatus forgovernance that is under the directcontrol of such a City Manager – withthe support of the state and centre– and that has its own revenue baseand financial independence to match.Mumbai has been a ‘milch cow’ for boththe Centre and State for some time. Ithas got very little back for its own urbandevelopment. That asymmetry needs tobe reversed.

. Mumbai needs to be seen across Indiaand around the world as a welcoming,cosmopolitan and cultured metropoliscapable of accommodating a largenumber of expatriates. It is only withsuch an ethos that Mumbai can becomean .

. The HPEC’s recommendations 209

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Tech

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ithin

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mpr

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far

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ase

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ase

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eIn

tern

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ella

teTr

ibun

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SAT)

cove

ring

allo

ffin

ance

.Te

chni

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esIn

sura

nce/

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ions

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ndto

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ing

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ndto

allo

ffin

ance

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erm

itun

rest

ricte

den

try

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ngl

obal

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lfirm

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inot

her

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s/G

FCs

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are

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und

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nup

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itted

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erm

itun

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ricte

den

try

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obal

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atin

gin

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und

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nup

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llG

loba

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firm

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rmitt

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ate

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ism

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barr

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betw

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diff

eren

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anci

alm

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furt

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finan

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draw

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me

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ples

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BR)

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nica

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lyPB

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lyPB

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RD

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pply

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RA

llPB

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21.C

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finan

cial

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gim

e.Pr

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ers

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lar

22.E

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ine

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eful

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chan

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lato

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atfo

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vere

ign

bond

sto

bem

oved

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chan

ges

(NSE

and

BSE

)Te

chni

calS

tudi

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iftPl

atfo

rmA

llbo

ndtr

adin

gto

bedo

neon

mar

ket

exch

ange

s

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raft

new

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ncia

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vice

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oder

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embr

acin

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rinci

ples

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gula

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raft

ing

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sulta

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ble

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llFS

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shou

ldin

corp

orat

ere

draf

ted

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latio

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ore

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nalD

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rans

fer

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n/su

perv

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type

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sed

finan

cial

trad

ing

toSE

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Tech

nica

lStu

dies

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ute

Tran

sfer

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finan

cial

mar

ket

trad

ing

supe

rvis

edby

SEB

I

26.D

istin

guis

hbe

twee

nw

hole

sale

and

reta

ilm

arke

tsan

dus

eap

prop

riate

regu

latio

nfo

rea

chTe

chni

calS

tudi

esSe

para

teM

arke

tsW

hole

sale

and

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ilM

arke

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gula

ted

diff

eren

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pen

upim

med

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dal

gorit

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trad

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pen

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bans

onD

MA

and

algo

rithm

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adin

gto

bere

gula

ted

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onab

ly

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ctio

ns

on

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ng

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sin

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sin

gM

arke

ts’

28.C

reat

era

pidl

yth

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issi

ngB

CD

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usin

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anC

apita

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kets

:A

.Bon

dM

arke

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chni

calS

tudi

esSh

iftPl

atfo

rms

Wid

enan

dde

epen

sove

reig

n/co

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ate

bond

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kets

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ish

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renc

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adin

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chan

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itha

min

imum

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sact

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size

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mill

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urre

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ket

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ates

onN

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perv

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ans

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reat

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rivat

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chan

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nica

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unch

rang

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ti-cu

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aps

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trad

ing

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byQ

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12

34

12

34

12

34

12

34

Year

E.A

ctio

ns

toSt

ren

gth

enIn

stit

uti

on

so

per

atin

gin

Ind

ian

Fin

anci

alM

arke

ts

29.G

oIto

supp

ort

emer

genc

eof

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anLC

FIs

toem

erge

,thr

ough

M&

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dta

keov

ers.

Tech

nica

lSt

udie

sRe

mov

eRe

stric

tions

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urag

eM

&A

Let

mar

ket

driv

eco

nsol

idat

ion

and

segm

ent

inte

grat

ion

thro

ugh

finan

cial

syst

em

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oIto

perm

itW

hole

sale

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etM

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emen

tre

gula

ted

bySE

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inim

umac

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.10

cror

es)

Tech

nica

lSt

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Fram

ing

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les

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chW

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cour

age

rapi

dex

pans

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with

PBR-b

ased

regu

latio

nby

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I

31.R

emov

eal

lim

pedi

men

tsto

outs

ourc

ing

ofas

set

man

agem

ent

byba

nks,

insu

ranc

eco

mpa

nies

,m

utua

lfun

ds,p

ensi

onfu

nds,

FIIs

,hed

gefu

nds,

etc.

Tech

nica

lSt

udy

Rem

ove

Rest

rictio

nsFu

llou

tsou

rcin

gof

asse

tm

anag

emen

tac

tiviti

esby

any

finan

cial

firm

oper

atin

gin

Indi

a

32.G

oIto

brin

gfo

rwar

dlib

eral

isat

ion

offin

anci

alse

ctor

inke

epin

gw

ithco

mm

itmen

tsto

WTO

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ee-

men

ton

Trad

ein

Fina

ncia

lSer

vice

s.

Tech

nica

lSt

udie

sA

ccel

erat

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eral

isat

ion

Prog

ram

me

inpl

ace

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anfin

anci

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stem

fully

open

togl

obal

part

icip

atio

nsu

bjec

tto

prud

entia

lreg

ulat

ion

and

fitne

sste

sts

33.I

nter

imad

just

men

tpe

riod

oftw

oye

ars

for

Indi

anin

stitu

tions

toad

apt

togl

obal

com

petit

ion.

Cap

acity

build

ing

byIn

dian

firm

sIn

dian

finan

cial

sect

orop

ento

fore

ign

com

petit

ion

34.O

peni

ngof

bran

ches

bydo

mes

ticba

nks

tobe

deco

ntro

lled

imm

edia

tely.

All

rest

rictio

nson

bran

chop

enin

gby

dom

estic

bank

sto

bere

mov

edim

med

iate

ly

35.O

peni

ngof

bran

ches

byfo

reig

nba

nks

tobe

deco

ntro

lled

afte

ron

eye

arA

llre

stric

tions

onbr

anch

open

ing

byfo

reig

nba

nks

tobe

rem

oved

36.R

emov

eim

med

iate

lyal

lres

tric

tions

limiti

ngco

rpor

ate

owne

rshi

pof

bank

sto

10%

Rest

rictio

nslim

iting

priv

ate

corp

orat

eow

ners

hip

ofba

nks

to10

%to

bere

mov

ed

37.O

pen

upIn

dian

capi

talm

arke

tsto

entr

yof

hedg

efu

nds

and

alte

rnat

ive

inve

stm

ent

vehi

cles

Rem

ove

allr

estr

ictio

nson

entr

yof

hedg

efu

nds

and

AIV

s

38.S

etup

rang

eof

prog

ram

mes

ford

evel

opm

ento

fspe

cial

ised

hum

anca

pita

lfor

the

finan

cial

indu

stry

Set

upM

Scin

Fina

nce

and

ara

nge

ofsp

ecia

lised

tech

nica

ltra

inin

gpr

ogra

mm

es

F.A

ctio

ns

toIm

pro

veIn

fras

tru

ctu

rein

Mu

mb

ai39

.Tra

nspo

rtIn

fras

truc

ture

:A

.Int

ra-c

ityro

ads

and

arte

rialr

oute

s[P

PPs

]Ph

ased

deve

lopm

ent

and

expa

nsio

nof

Mum

bai’s

road

tran

spor

tca

paci

ty

B.C

oast

alH

ighw

ays

and

Expr

essw

ays

[PPP

s]

Tech

nica

lFea

sibi

lity

Stud

ies

Tend

ers

Prep

arat

ion

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trac

tsC

onst

ruct

ion

C.S

ubur

ban

Railw

ays

and

new

Met

roSy

stem

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chni

calF

easi

bilit

ySt

udie

sTe

nder

sC

ontr

acts

Con

stru

ctio

n

D.W

ater

-bor

neTr

ansp

ort

–Fe

rrie

s/H

ydro

foils

/Jet

foils

[PPP

s]

Feas

ibili

tyTe

nder

sC

ontr

acts

Faci

lity

Con

stru

ctio

nan

dO

pera

tions

E.In

crea

se/u

pgra

deai

rpor

tan

dru

nway

capa

citie

sA

ctio

nsal

read

yta

ken

for

Sant

aC

ruz

and

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r.N

ewpl

ans

for

Nav

iMum

baia

irpor

tan

dru

nway

s

40.

PPPs

for

Pow

erIn

fras

truc

ture

:A

.Inc

reas

ein

Pow

erG

ener

atio

nC

apac

ity(2

4×

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365)

Stud

ies

Tend

ers

Con

trac

tsPo

wer

Plan

tC

onst

ruct

ion

and

Ope

ratio

ns

B.In

crea

sein

Tran

smis

sion

/Dis

trib

utio

nC

apac

itySt

udie

sTe

nder

sC

ontr

acts

T&D

Line

Con

stru

ctio

nan

dO

pera

tions

41.W

ater

Supp

ly,Se

wer

age&

Dra

inag

e:A

.Inc

reas

ein

Stor

age

Cap

acity

and

Pipe

lines

[PPP

]Pl

ans

and

Proj

ects

unde

rway

toin

crea

sean

dim

prov

ew

ater

supp

lyqu

antit

y/av

aila

bilit

y

B.In

crea

sein

Filtr

atio

nan

dW

ater

Qua

lity

[PPP

]Pl

ans

and

Proj

ects

unde

rway

toin

crea

sean

dim

prov

ew

ater

qual

ity

C.U

pgra

ding

/Exp

ansi

onof

Sew

erag

eC

apac

ityPl

ans

and

Proj

ects

unde

rway

toin

crea

sean

dim

prov

ese

wer

age

capa

city

/tre

atm

ent

D.U

pgra

ding

ofSt

orm

and

Floo

dD

rain

age

Plan

san

dPr

ojec

tsal

read

yun

derw

ayto

incr

ease

and

impr

ove

stor

m/fl

ood

drai

nage

42.I

ncre

ase

Was

teD

ispo

salC

apac

ity:

For

solid

and

liqui

dw

aste

with

envi

ronm

enta

lpro

tect

ion

Dev

elop

PPPs

Con

trac

tsPP

PC

ontr

acts

Und

erw

ayan

dO

pera

ting

43.T

elec

omm

unic

atio

nsIn

fras

truc

ture

:A

.Sub

stan

tialE

xpan

sion

ofC

ellu

lar

Net

wor

kTR

AIt

oho

ldce

llula

rop

erat

ors

tose

rvic

equ

ality

com

mitm

ents

toup

grad

eco

ntin

uous

ly

B.Ex

pans

ion

ofLa

ndlin

esan

dBr

oadb

and

MTN

Lto

expa

ndla

ndlin

esin

keep

ing

with

dem

and

grow

th;i

ncre

ase

com

petit

ion

C.E

xpan

sion

ofIn

tern

atio

nalB

andw

idth

VSN

L,FL

AG

toin

crea

seba

ndw

idth

rapi

dly;

intr

oduc

egr

eate

rfo

reig

nco

mpe

titio

n

44.A

ccom

mod

atio

n:Re

side

ntia

l,O

ffice

and

Com

mer

cial

Dro

pU

LCR

A/R

CA

Nor

mal

ise

rent

als

Dis

pens

ew

ithal

lcon

trol

sex

cept

urba

npl

anni

ng

G.A

ctio

ns

toIm

pro

veU

rban

Go

vern

ance

inM

um

bai

45.G

oMan

dBM

Cto

appo

int

orar

rang

eto

elec

ta

City

Man

ager

acco

unta

ble

for

Mum

bai

Prep

are

Gro

undw

ork

App

oint

/Ele

ctPl

ace

City

Adm

inis

trat

ion

unde

rfu

llco

ntro

lof

City

Man

ager

46.B

ring

the

exis

ting

city

gove

rnan

cem

achi

nery

unde

rth

efu

llco

ntro

lof

the

City

Man

ager

Prep

are

Gro

undw

ork

47.E

stab

lish

inde

pend

ent

finan

cial

base

for

the

city

that

isun

der

the

cont

rolo

fth

eC

ityM

anag

erSt

udy

Opt

ions

Agr

eeFu

ndSo

urce

sPl

ace

City

onm

ainl

yin

depe

nden

tfin

anci

alfo

otin

g

48.R

atio

nalis

ean

dst

ream

line

toor

gani

satio

nst

ruct

ure

and

lines

ofre

spon

sibi

lity

inci

tym

anag

emen

tO

rgan

isat

ion

Stud

yTr

ansi

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214 R M I F C

University; K. R. Narayanan Memorial Lecture. URL http://rspas.anu.edu.au/papers/narayanan/2004oration.pdf.

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Lall R (). “Third world multinationals: The characteristics of Indian firms investingabroad.” Journal of Development Economics, , –.

Laurenceson J, Kamalakanthan A (). Emerging Financial Centres in Asia: A ComparativeAnalysis of Mumbai and Shanghai. J. Laurenceson, A. Kamalakanthan.

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Luo Ping (). “ Financial regulation in emerging markets: a case study of China, anemerging market and an economy in transition.” Technical report.

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The Committee

AA p p e n d i x

The members of the Committee and itsTerms of Reference are as follows:

Members:

(i) Mr. Percy S. Mistry, Chairman,Oxford International Group, Chairman(resigned as Chairman of w.e.f.//)

(ii) Mr. M. Balachandran, , Bank ofIndia

(iii) Mr. Aditya Puri, , Bank

(iv) Mr. K.V. Kamath, & , Bank

(v) Mr. C.B. Bhave, ,

(vi) Mr. Ravi Narain, , National StockExchange

(vii) Mr. Bharat Doshi, , Mahindra &Mahindra

(viii) Dr. P.J. Nayak, , Bank

(ix) Shri T.T. Srinivasaraghavan, , Sun-daram Finance

(x) Shri Mohan Raj, , Mutual Fund

(xi) Mr. Nimesh Kampani-Chairman, JMMorgan Stanley

(xii) Mr. O. P. Bhatt, Chairman, State Bank ofIndia (Mr. A.K. Purwar, Chairman, was a member of till //

and Mr. Bhatt, Chairman, from// till the submission of thereport.)

(xiii) Ms. Usha Narayanan, , Securities andExchange Board of India

(xiv) Mr. Subodh Kumar, Principal Secretary(Finance), Government of Maharashtra(Mr. O.P. Gahrotra, Additional ChiefSecretary (Finance) was a member of till // and Mr. SubodhKumar, Principal Secretary (Finance)from // till the submission ofthe report.)

(xv) Dr. K P Krishnan, Convenor-JointSecretary (Capital Markets), , GoI.

(xvi) Representatives of participated insome of the meetings as invitees.

This report reflects their personal expertiseand judgement about the best strategy forIndia in modernising finance and achievingan ; it does not reflect the views of theorganisations they represent.

Terms of Reference of the Commitee

In the recent decade, India has madesignificant strides in the financial sector.Some of the important developmentsare strengthening of banks, de-regulationof interest rates and sector competitionin the banking system, development ofthe government securities market, andinfrastructure for trading, particularly onthe equity market, with the move toelectronic trading, novation at the clearingcorporation, T + 2 rolling settlement,dematerialised settlement, demutualisationof stock exchanges and derivatives trading.This raises questions about how Mumbaican play a bigger role in the global marketfor financial services. Our current policy oncapital account convertibility constrains theemergence of Mumbai as a financial centre.There is, however, a need to look ahead andprepare for the emergent role of Mumbaias a regional/international financial centre,so that our institutions get integrated withglobal institutions and economies in termsof provision of financial services.The committee will look into and makerecommendations on the following issues:

(i) Review the functioning of and develop-ments related to international/offshorefinancial centres and current trends inregard to establishment of new centres;

(ii) Identify the characteristics of a regionalfinancial centre (), and the currentstate of Mumbai as a national financialcentre;

(iii) Review the existing legal, regulatory,taxation and accounting frameworkrelated to financial services in India,identify the extant policy and regulatoryrestrictions constraining the emergenceof Mumbai as an and the changes

220 R M I F C

therein necessary for enabling andfacilitating the function of such a centre;

(iv) Identify the measures that would needto be adopted for Mumbai to transformitself from being a national financialcentre to an in each of the financialsub-sectors e.g., the equity, bond, forexand commodity markets;

(v) Examine the nature of financial servicesthat could be permitted to be undertakenin the in Mumbai, the desirablesequencing of permitting such servicesand the appropriate regulatory frame-work therefore, in each of the financialsub-sectors aforesaid, including the al-location of regulatory responsibilitiesamongst different financial sector regu-lators, consistent with the progress madein achieving full capital account convert-ibility;

(vi) Make an assessment of the risks andbenefits inherent in such a centre and thesafeguards that would need to be builtinto the policy framework, alongwith thescope and structure desirable for such acentre;

(vii) Identify and evaluate the considerationsthat should govern the developmentof the institutional framework forsuch a centre in India in the light ofinternational experience, issues in themanagement of the capital accountin India and international financialintegration of the Indian economyconsistent with the framework;and

In light of the above, recommenda phased action plan, including specificactions required by different agenciescovering institutions, infrastructure, legal,taxation issues etc. for the development ofMumbai as an .

Team of consultants

The committee was supported by a teamof consultants comprising Ritu Anand(), Saugata Bhattacharya ( Bank),Kshama Fernandes (Goa Institute of Man-agement), S. Ravindranath (Bank of India),and Ajay Shah.

Comparing existing IFCsagainst Mumbai BA p p e n d i x

Attributes, Characteristics and Capabilities of an IFC : (Scale of0–10 with 0 = worst 10 = best)

London New York Tokyo Singapore Frankfurt Mumbai

A. Demand Factors for IFSA1. National (Domestic) demand for IFS 10 10 10 4 10 10A2. Demand for IFS from Regional clients 10 10 3 9 7 1A3. Demand for IFS from Global clients 10 10 3 5 3 0

B. Supply Factors for IFS: Markets, Products & ServicesB1. Full Array of international banking services for corporates and

individuals9 9 9 10 6 5

B2. Full Array of international capital markets, products and services 10 10 7 8 5 3B3. Full Array of risk management services 10 10 5 7 6 2B4. Full Array of insurance and reinsurance services 10 10 7 5 8 1B5. Full Array of commodities markets, trading and hedging services 9 9 5 5 4 1B6. 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 IFSproduct/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 banksrepresented in the IFC

10 10 8 9 7 2

C3. Range of global, regional and national insurance companiesrepresented

10 9 8 6 8 2

C4. Existence of wide and deep reinsurance markets 10 9 8 6 9 1C5. 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 5Interest rates 10 10 8 7 7 1Currencies 10 10 7 8 8 1Commodities 10 8 7 5 8 3

C8. Innovative Abilities of Institutions and Markets 10 10 5 6 4 5

D. Services OfferedD1. Fund Raising, Wholesale and Corporate Banking 10 10 8 7 7 5D2. Asset Management 10 10 8 9 6 4D3. Private Banking & Wealth Management 10 7 5 7 5 2D4. Global Tax Optimisation & Management 6 5 3 8 4 1D5. Corporate Treasury Management 10 10 9 8 8 4D6. Risk Management 10 10 7 7 6 2D7. Mergers & Acquisitions: (national, regional, global) 10 10 6 5 5 3D8. Financial Engineering for Large Complex Project and PPP

Financing10 10 8 7 6 3

D9. Leasing & Structured Financing of Mobile Capital Assets (ships,planes etc.)

10 10 9 9 10 2

222 R M I F C

Attributes, Characteristics and Capabilities of an IFC : (Scale of0–10 with 0 = worst 10 = best)

London New York Tokyo Singapore Frankfurt Mumbai

E. Quality & Impact of Financial System Regulatory Regime 10 7 6 7 5 3E1. Ensuring Systemic Stability 10 9 8 8 8 7E2. Protecting Integrity & Soundness of Financial Institutions 9 9 9 9 8 6E3. Capacity to Cope with Market & Institutional failures 10 9 8 8 7 7E4. Sound risk based management at all levels: systemic, market,

institutional10 10 8 8 8 6

E5. Effective (vs. intended but ineffectual) Consumer Protection 8 7 7 8 9 5E6. Encouraging full and effective competition across institu-

tions/segments10 6 5 7 5 2

E7. Ensuring level playing field for all players in all market segments 9 7 5 7 6 2E8. Extent of Protectionism embedded in regulatory system 9 6 5 5 4 1E9. Avoidance of conflicts-of-interest 8 7 5 6 5 1E10. Impact on Financial Innovation 10 10 5 5 4 1E11. Extent of Intrusiveness and micro-management of mar-

kets/institutions10 8 7 6 5 1

E12. Principles-based, open, market-friendly and competition inducing 10 7 7 6 6 1E13. Conducive to efficient and effective resource mobilisation and

allocation8 7 6 7 6 2

F. Quality, Efficiency, Effectiveness and Supportiveness ofJudicial/Legal SystemsF1. Knowledge capacity in dealing with complex financial contracts,

instruments, etc.8 9 6 6 5

F2. Efficiency of judicial/legal system (i.e. time for dispute resolution) 7 8 7 9 6F3. Effectiveness of judicial/legal systems – enforcement and rule of

law7 8 7 8 6

F4. Fairness, Impartiality, Credibility, Lack of Corruption in civil justicesystem

7 7 9 10 8

F5. Human & Institutional Capacity and Quality of the Judicial/LegalSystem

7 8 7 8 7

F6. Adherence to global benchmarks and standards of best practice 8 8 6 7 6F7. Use of national law in national, regional and global contracts 8 9 3 5 4

G. Governance Issues Affecting Operations/Credibility of theIFCG1. Quality and Credibility of National Governance (Legislature &

Government)7 6 7 10 6 3

G2. Quality and Credibility of State/Provincial Governance 8 9 8 10 8 1G3. Quality and Credibility of Local/Municipal Governance 8 8 9 10 8 0G4. Influence of Politics in diminishing Governance Quality:

National/Federal 6 6 8 10 8 2State/Provincial 6 8 8 10 7 1Local/Municipal 8 8 8 10 7 0

G5. Quality, Capacity, Efficiency, Effectiveness of Administration:National 6 7 8 10 7 4State 6 8 8 10 7 2Municipal 8 9 9 10 7 1

G6. Role of Checks & Balances (NGO oversight, media freedom, civicaction etc.)

8 9 5 2 7 2

B. Comparing existing IFCs against Mumbai 223

Attributes, Characteristics and Capabilities of an IFC : (Scale of0–10 with 0 = worst 10 = best)

London New York Tokyo Singapore Frankfurt Mumbai

H. Quality & Capacity of Business Support Services to Sustainan IFCH1. Quality, reputation and presence of International Account-

ing/Audit Firms9 9 8 9 9 6

H2. Quality, reputation and presence of International Law Firms 9 10 6 7 6 2H3. Quality, reputation and presence of International Business

Consulting Firms10 10 8 9 7 4

H4. Quality and competitiveness of IT, BPO, KPO support systems 6 6 4 5 4 9

J. Human Capital Support for the IFS IndustryJ1. Quality, availability and cost of Finance Industry professionals:

Strategic/Exec10 10 5 6 4 3Management (all functions) 7 8 5 6 4 4Trading & Dealing 9 9 6 8 6 4Financial Analysis & Research 7 9 5 6 5 8Compliance Specialists 8 7 6 9 8 4Back-Office Functions/Support 6 7 4 5 4 9

J2. Presence/Quality of Post-Graduate Teaching/Research Institutionsin Finance

6 10 4 3 3 2

J3. Local Pool/Network of globally experienced finance professionals 10 8 4 7 4 2J4. Local presence of Global HR Recruitment/Consulting/Training

Firms10 10 6 8 5 2

J5. Ease of entry, exit and overall mobility of global financeprofessionals at all levels

8 7 3 7 4 2

K. Quality of Physical & Social Infrastructure & LivingEnvironmentK1. Quality/Availability/Cost of Basic Core infrastructure:

Power 9 9 10 10 10 4Water 9 9 10 10 10 4Telecommunications 9 10 10 10 9 6Transport 5 6 7 8 8 2Residential Space 7 5 5 7 8 3Office/Commercial 9 9 10 10 10 3

K2. Leisure, Entertainment, Global Cultural, Recreational and FoodFacilities

10 10 3 4 6 2

K3. Use of English as the default international language at work andat leisure

10 10 2 9 5 7

K4. Use of English as the default international language for financialcontracts

10 10 5 10 6 9

K5. Availability, Accessibility, Cost of healthcare and education (globalstandards)

5 5 6 8 8 3

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 of0–10 with 0 = worst 10 = best)

London New York Tokyo Singapore Frankfurt Mumbai

N. Taxation Issues as they affect the attractiveness of an IFCN1. Taxation of Resident Individuals working in the IFC 5 4 3 5 2 5N2. Taxation of Non-resident Individuals working in an IFC 7 5 5 6 3 6N3. Taxation of Resident Companies 4 4 3 5 2 5N4. Taxation of Non-resident companies 7 5 5 8 4 5N5. Withholding Taxes levied on financial instruments/transactions. 4 3 3 5 3 5N6. Transactions Taxes on Financial Transactions – Domestic 6 7 4 7 4 1N7. 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 0N9. Taxation of IBC/GBC companies 6 6 5 8 2 0N10. Overall Taxation Environment 5 5 4 7 2 5N11. Complexity of Tax Laws, Codes, Rules, Regulations 4 3 4 7 3 1N12. Effectiveness, Efficiency, Fairness and Corruption in Tax

Administration9 7 8 9 9 3

Comparing emerging IFCsagainst Mumbai CA p p e n d i x

Attributes, Characteristics and Capabilities of an IFC : (Scale of0–10 with 0 = worst 10 = best)

Mumbai Hong Kong Labuan Seoul Sydney Dubai

A. Demand Factors for IFSA1. National (Domestic) demand for IFS 10 4 2 7 6 2A2. Demand for IFS from Regional clients 1 7 5 2 3 9A3. Demand for IFS from Global clients 0 2 2 2 3 5

B. Supply Factors for IFS: Markets, Products & ServicesB1. Full Array of international banking services for corporates and

individuals5 7 4 6 7 6

B2. Full Array of international capital markets, products and services 3 6 2 5 7 5B3. Full Array of risk management services 2 5 2 5 6 5B4. Full Array of insurance and reinsurance services 1 5 0 3 5 2B5. Full Array of commodities markets, trading and hedging services 1 6 2 5 6 2B6. 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 IFSproduct/service offerings:C1. Range, width, depth of international commercial banks

represented in the IFC2 7 5 5 7 4

C2. Range of global, regional and national investment banksrepresented in the IFC

2 6 1 3 6 4

C3. Range of global, regional and national insurance companiesrepresented

2 6 1 5 6 3

C4. Existence of wide and deep reinsurance markets 1 3 0 3 4 1C5. 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 2Interest rates 1 3 0 4 7 1Currencies 1 7 2 6 8 5Commodities 3 5 0 4 6 3

C8. Innovative Abilities of Institutions and Markets 5 5 1 4 7 5

D. Services OfferedD1. Fund Raising, Wholesale and Corporate Banking 5 7 3 7 7 5D2. Asset Management 4 9 4 6 6 8D3. Private Banking & Wealth Management 2 9 6 4 5 9D4. Global Tax Optimisation & Management 1 9 7 4 4 9D5. Corporate Treasury Management 4 7 2 7 8 7D6. Risk Management 2 6 1 4 6 3D7. Mergers & Acquisitions: (national, regional, global) 3 5 0 5 5 4D8. Financial Engineering for Large Complex Project and PPP

Financing3 5 1 7 6 5

D9. Leasing & Structured Financing of Mobile Capital Assets (ships,planes etc.)

2 9 5 5 5 7

226 R M I F C

Attributes, Characteristics and Capabilities of an IFC : (Scale of0–10 with 0 = worst 10 = best)

Mumbai Hong Kong Labuan Seoul Sydney Dubai

E. Quality & Impact of Financial System Regulatory Regime 3 8 4 6 7 7E1. Ensuring Systemic Stability 7 7 3 7 8 5E2. Protecting Integrity & Soundness of Financial Institutions 6 7 5 7 8 6E3. Capacity to Cope with Market & Institutional failures 7 9 3 7 8 6E4. Sound risk based management at all levels: systemic, market,

institutional6 7 5 7 8 5

E5. Effective (vs. intended but ineffectual) Consumer Protection 5 6 4 7 8 5E6. Encouraging full and effective competition across institu-

tions/segments2 8 5 7 8 9

E7. Ensuring level playing field for all players in all market segments 2 8 4 5 6 8E8. Extent of Protectionism embedded in regulatory system 1 7 5 5 7 8E9. Avoidance of conflicts-of-interest 1 6 4 5 8 4E10. Impact on Financial Innovation 1 7 2 5 7 5E11. Extent of Intrusiveness and micro-management of mar-

kets/institutions1 8 5 5 7 5

E12. Principles-based, open, market-friendly and competition inducing 1 7 2 5 6 8E13. Conducive to efficient and effective resource mobilisation and

allocation2 7 3 6 6 5

F. Quality, Efficiency, Effectiveness and Supportiveness ofJudicial/Legal SystemsF1. Knowledge capacity in dealing with complex financial contracts,

instruments, etc.8 4 5 7 6

F2. Efficiency of judicial/legal system (i.e., time for dispute resolution) 8 5 6 7 10F3. Effectiveness of judicial/legal systems – enforcement and rule of

law7 5 6 8 5

F4. Fairness, Impartiality, Credibility, Lack of Corruption in civil justicesystem

7 5 6 9 5

F5. Human & Institutional Capacity and Quality of the Judicial/LegalSystem

6 5 6 8 5

F6. Adherence to global benchmarks and standards of best practice 8 6 7 8 7F7. Use of national vs. UK/US law in national, regional and global

contracts6 6 5 6 9

G. Governance Issues Affecting Operations/Credibility of theIFCG1. Quality and Credibility of National Governance (Legislature &

Government)3 3 6 6 7 7

G2. Quality and Credibility of State/Provincial Governance 1 5 6 7 8 7G3. Quality and Credibility of Local/Municipal Governance 0 6 6 7 8 9G4. Influence of Politics in diminishing Governance Quality:

National/Federal 2 5 5 5 8 8State/Provincial 1 6 5 5 7 8Local/Municipal 0 7 6 7 8 10

G5. Quality, Capacity, Efficiency, Effectiveness of Administration:National 4 5 5 6 8 8State 2 6 5 6 8 8Municipal 1 7 6 7 8 8

G6. Role of Checks & Balances (NGO oversight, media freedom, civicaction etc.)

2 4 3 4 6 0

C. Comparing emerging IFCs against Mumbai 227

Attributes, Characteristics and Capabilities of an IFC : (Scale of0–10 with 0 = worst 10 = best)

Mumbai Hong Kong Labuan Seoul Sydney Dubai

H. Quality & Capacity of Business Support Services to Sustainan IFCH1. Quality, reputation and presence of International Account-

ing/Audit Firms6 8 5 7 9 6

H2. Quality, reputation and presence of International Law Firms 2 8 5 5 8 5H3. Quality, reputation and presence of International Business

Consulting Firms4 7 4 6 8 6

H4. Quality and competitiveness of IT, BPO, KPO support systems 9 5 3 5 5 6

J. Human Capital Support for the IFS IndustryJ1. Quality, availability and cost of Finance Industry professionals:

Strategic/Executive/Conceptual 3 6 4 5 7 6Management (all functions) 4 7 5 6 7 6Trading & Dealing 4 7 3 6 7 5Financial Analysis & Research 8 7 3 6 7 6Compliance Specialists 4 5 3 6 8 6Back-Office Functions/Support 9 7 6 6 4 6

J2. Presence/Quality of Post-Graduate Teaching/Research Institutionsin Finance

2 3 0 3 5 0

J3. Local Pool/Network of globally experienced finance professionals 2 5 2 5 7 5J4. Local presence of Global HR Recruitment/Consulting/Training

Firms2 5 3 5 7 5

J5. Ease of entry, exit and overall mobility of global financeprofessionals at all levels

2 6 4 3 6 8

K. Quality of Physical & Social Infrastructure & LivingEnvironmentK1. Quality/Availability/Cost of Basic Core infrastructure:

Power 9 9 10 10 10Water 4 9 9 10 10 8Telecommunications 6 10 10 10 10 10Transport 2 6 8 8 8 5Residential Space 3 7 8 8 8 7Office/Commercial 3 9 8 9 9 10

K2. Global Leisure, Entertainment, Cultural, Recreational and FoodFacilities

2 4 3 3 7 5

K3. Use of English as the default international language at work andat leisure

7 5 5 3 10 6

K4. Use of English as the default international language for financialcontracts

9 10 10 5 10 10

K5. Availability, Accessibility, Cost of healthcare and education (globalstandards)

3 6 7 7 8 6

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 of0–10 with 0 = worst 10 = best)

Mumbai Hong Kong Labuan Seoul Sydney Dubai

N. Taxation Issues as they affect the attractiveness of an IFCN1. Taxation of Resident Individuals working in the IFC 5 8 5 4 4 10N2. Taxation of Non-resident Individuals working in an IFC 6 10 10 7 7 10N3. Taxation of Resident Companies 5 8 6 5 4 10N4. Taxation of Non-resident companies 5 10 9 8 5 10N5. Withholding Taxes levied on financial instruments/transactions. 5 10 9 5 5 10N6. Transactions Taxes on Financial Transactions – Domestic 1 10 5 5 2 10N7. Transactions Taxes on Financial Transactions – IFS ? 10 9 8 6 10N8. Provisions for IBC or GBC licensing (e.g., Delaware type) 0 9 9 5 3 10N9. Taxation of IBC/GBC companies 0 9 8 6 5 10N10. Overall Taxation Environment 5 8 7 6 5 10N11. Complexity of Tax Laws, Codes, Rules, Regulations 1 8 7 5 4 9N12. Overall Effectiveness, Efficiency, Fairness and Corruption in Tax

Revenue Administration2 8 7 6 8 9

Chronology of eventsassociated with the effort by

Benchmark AssetManagement Company

(BAMC) to start an ExchangeTraded Fund (ETF) on Gold

DA p p e n d i x

• May Draft offer document of Gold filed by with .

• May Copy of offer document sentto for information.

• May raised first list ofqueries, and asked to incorporatethe features of Gold Deposit Schemein the offer document. Meanwhile, informally advised to seekspecific approval of .

• June wrote to seekingclarification on Gold Deposit Schemefor inclusion in offer document.

• June asked for a detailedmechanism including investment andsettlement process envisaged under Gold.

• July A detailed note was submittedto .

• July to September, Several meetingstook place between , and to sort out issues relating to Gold. asked for commentsfrom .

• September Fresh offer documentwas filed with incorporatingobservations made by vide its letterdated May , . However hadstill not replied.

• Sep Presentation made to stating that the Scheme would notamount to forward trading in gold.

• October again wrote to explaining the mechanism and howthe Scheme will help meet objectives ofGold Deposit Scheme.

• October replied to stating that primary gold cannot bedeposited by Authorised Participantsunder Gold deposit scheme. It alsoadvised to satisfy beforelaunching the product.

• October informed that it planned to launch the Schemeunder existing Gold Deposit Schemeguidelines and that it will accept goldfrom s as per existing Gold Depositguidelines.

• November responded to a request with information aboutthe proposed method for valuation ofs issued by banks under Gold DepositScheme.

• November informed and that the Scheme is violative ofthe Forward Contracts (Regulation) Act.

• December called a meetingof bankers interested in Gold . Bank and Bank of Nova Scotia

230 R M I F C

attended the meeting in ’s officeand reaffirmed their commitment toenabling the Gold .

• nd week December wrote to asking its views on Gold andwhether s issued under Gold Depositscheme are money market instruments.

• January obtained alegal opinion from Dave, Girish &Co. stating that Gold does notamount to spot trading in gold andthe Scheme is not violative of ForwardContract Regulations. forwardedthis opinion to , and .Subsequently, lifted the ban onforward trading in gold, so in any case,’s objection became irrelevant.

• st week February wrote to stating that should decidewhether a Gold was a “money marketinstrument”, and that the Gold structure had not been envisaged byRBI when the Gold Deposit Scheme waslaunched.

• February modified theScheme stating that deposit of goldunder Gold Deposit scheme will notbe restricted to s and will be open toall. Moerever any party would be able todeposit gold in a form acceptable underGold Deposit Scheme.

• nd week April again wroteto asking whether this modifiedScheme is acceptable to .

• st week May forwardedthis letter to for theircomments and action.

• th week August Presentation madeby to (), Ministry ofFinance.

• th week September Presentationmade by to and.

• th week October Presentation madeby to Member, .

• nd week December Presentationmade by to Monetary PolicyDepartment of . was toprepare a note and forward the same to/.

• All of Silence.

• February Finance Ministerannounced in his budget speech thatgold s would come about in India.

• March–April constituted acommittee to write down rules aboutGold s.

• December Board approvesamendment to Act for permittinglaunch of gold s.

• April announced valuationguidelines for gold s.

• May filed fresh offerdocument with which wasconsistent with the committee report.

Activities of various financialfirms in the areas ofoperation at an IFC:

Wall chart EA p p e n d i x

In Chapter , we looked at the various activities that take place in an . We discussed indetails the products and services that s like London and New York provide. If the goal is tomake Mumbai an in the true sense, we would need to put in place the infrastructure, bothinstitutional and regulatory that would enable entities to engage in providing and availingthese products and services.

In the process of creation of an , the adequacy of regulatory infrastructure needs to beevaluated, to get a sense of what needs to be put in place for progressing towards being afull-fledged . We study the regulatory impediments that exist and prevent banks, assetmanagers and securities exchanges from offering/availing these products and services in thearea 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. Fundscould be raised via equity, debt or composite structures across various maturity and currencyspectra. We look at the impediments on fund raising by various entitites in India.

1.1. Fund raising and commercial banksCommercial banks are permitted to do the following:

. Raise equity in India or abroad for their own capital base. However banks haveproblems since GOI does not allow their own share to drop below %. Raising equityabroad is a problem because of government restriction on foreign ownership and on thevoting rights of foreigners.

. Give lending to specialised finance companies involved in the equity market such asinvestment banks, exchanges, securities firms, asset managers and hedge funds subject toprudent limits. However these banks are not permitted to lend to the above entitities inforeign currency. Nor are they allowed to invest by way of equity into these specialisedfinance firms.

However they face various regulatory impediments in terms of providing products andservices 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 theequity market such as investment banks, exchanges, securities firms, asset managers andhedge 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 corporatebonds.

. Lack of identical policy/regulatory treatment for a domestic borrower as opposed to aforeign 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 seniorityassociated with a given loan/bond.

. Absence of regulations which enable equity capital requirements for credit portfolio to bebased on the portfolio risk after all credit derivatives and other derivatives are taken intoaccount.

. 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 ofboth 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 comprisingpackages 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 mayinvolve debt conversion into various kinds of equity or quasi-equity.

1.2. Fund raising and investment banksInvestment banks in India are greatly disadvantaged due to restrictions and lack of regulatoryclarity about fund raising activities. To make investment banks in India globally competitive interms 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 corporatebonds, or buying corporate bonds on the primary or secondary market.

. Receive identical treatment between banks and s in terms of participation on thegovernment 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 debtworkout/reconstruction market.

In terms of providing composite funding structures, investment banks in India face thesame 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 banksIn order to provide a range of products and services in private banking, the following needs tobe put in place in terms of legal/regulatory issues:

. Removal of constraints against banks or specialist “private bankers” offering privatebanking 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 marketsIn order to permit brokerage/security firms in India to tap the global market and make themcompetitive in fund raising activities, the regulatory/legal framework must provide andsupport 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, insurancecompanies, hedge funds, mutual funds.

. Trading in local and offshore equity markets.

. Identical treatment of brokerage firms versus investment banks when it comes to fundingequity directly or indirectly in or forex.

. Raising /forex debt resources, for loans, underwriting corporate bonds, or purchase ofbonds on the primary or secondary market.

. Level playing field between banks and securities firms on the government bond market, oncollateralised debt financing, and on recovery procedures in the event of default.

. Offering transformation services based on interest rate derivatives, credit derivatives orsecuritisaion.

. Level playing field for foreign/local firms, neutral treatment of local assets versus foreignassets.

. 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 managementincludes a combination of front and back office functions. We look at two forms of assetmanagement and the legal/regulatory impediments that exist from the point of view of banks,asset managers and brokers/security firms — discretionary asset management (assets aremanaged purely by the asset manager and the client has no involvement other than a broadview about risk exposure) and non-discretionary asset management (assets are managed withpartial or full instructions from client).

2.1. Asset management and banksCommercial banks have very strict restrictions and very little scope to engage in activities as faras asset management is concerned. To enable banks to compete in the space, the followingneeds to be enabled:

. Offering discretionary asset management services without restrictions on types of assetsbeing 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 bycommercial banks.

. Absence of government regulation of fees and service fees.

. Offering non-discretionary asset management, hold or actively manage assets forindividuals, 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 banksneed 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 relatedservices 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 resultin 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 commercialand private banks, both for discretionary as well as non-discretionary asset management, butin the context of investment banking. The same would hold good for brokerage and securitiesfirms.

2.2. Asset management and fund managersWe 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 toenable these entities to compete in a global market.

As far as mutual funds are concerned, most of the regulatory requirements for enablingdiscretionary asset management are in place. We already have the following:

. Rules on qualification and capitalisation of fund manager which permit a steady pace ofentry.

. Sound regulation of fees, entry and exit by customers, trading of fund assets, valuationrules, 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 neutralitybetween Indian and foreign mutual funds and Indian and foreign assets. There are restrictionson 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 fairamount 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 isthe following:

. Neutrality between local and offshore assets. Insurance companies have restrictions interms of investing abroad.

. While permitted to bundle insurance with fund management, there is no tax neutralitywith 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 asfar as the regulatory framework is concerned. The following needs to be enabled from thepoint of view of discretionary pension asset management:

. Full range of assets in pension portfolios from government bonds to real estate and hedgefunds. The current regulations are highly restrictive in terms of where pension fund moneycan 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 managerflexibility on asset allocation.

. Treatment of defined benifit pensions, in addition to defined contribution pensions, inregulatory framework.

As far as non-discretionary pension asset management is concerned, the restrictions onpersonalised 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 needregulations 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 banksand 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 investmentprograms to meet the specific needs of clients and provide a range of asset classes across whichthe investments can be made on behalf of the client. Mostly offered by banks, the high degreeof customization makes personal wealth management a very labor intensive activity.

In terms of commercial banks offering services, the same regulatory issues asconcerns non-discretionary asset management apply. Besides these, the following needs to beenabled:

. 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. Thiswould include property management services, credit card services, travel, entertainmentetc.

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 bankingservices.

. 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 wealthmanagement listed above, but in the context of investment banking. The same would holdgood for brokerage and securities firms.

4. Global tax management

Global tax management provides a business opportunity for financial intermediaries, typicallybanks, to build strategies that optimize a corporation’s global tax liabilities. Regulatorystructures 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 requiressubstituting the services provided by foreign banks, foreign accountants and foreignlawyers.

5. Risk management

Risk management is an important activity at an . Risk management consultants work withclients to identify sources of risk and design integrated solutions. We look at the regulatoryframework that would need to be set in place in order to enable banks, asset managers andfunds and brokers/security firms to avail risk management services in India.

5.1. Risk management and banksTo enable commercial banks to offer/avail risk management services, the following would needto be enabled:

. Operations in derivatives markets for hedging risks of the core commercial banking bookand for clients on an agency basis (possibly in the context of a personal wealth managementstructure).

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 ofwhether 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 investmentbanking activities. So would private banks for risk management of private portfolios incurrencies, equities, bonds and commodities and risk management of discretionary funds.

5.2. Risk management and the asset managersThe regulatory framework for risk management activities by mutual funds is partially in placeto 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 anddisclosure.

However a lot of risk management activities essencial for fund management are notpermitted 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 theoffering 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 actuarialterms.

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 firmsTo enable brokerage/security firms to avail/provide risk management, the following wouldneed to be enabled:

. Risk management of private portfolios and discretionary funds, across all manner ofderivatives 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 variousasset classes such as currency, equity, bonds, commodities and derivatives. We look at thelegal/regulatory system from the point of view of banks, asset managers and funds, andsecurities markets in terms of their access to various asset classes in India.

6.1. Financial markets and banksAt present, Indian banks have limited access to currency markets. Commercial and privatebanks need to be enabled to do the following:

. Full fledged participation in speculation, market-making, hedging and arbitrage for allcurrency 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 andcurrency trading services along with multi-currency checking, savings and deposit accounts.

Investment banks should be able to offer clients multi-currency facilities with conversionrights 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/orshort-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 theabove from an investment banking perspective.

Commercial and private banks need to be allowed access to the entire spectrum of bondmarket 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, junkbonds, workout bonds, ARC bonds.

. Do market making for exchange-traded bonds.

. Originate and trade stripped/securitised assets based on a full range of underlyingcashflows.

. Have neutrality between Indian and offshore assets in all the above.

. Not be under financial repression that forces purchases of Indian government paper orrequires 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 abovefrom an investment banking perspective.

Commercial banks should have access to derivatives markets which would enable them toavail/offer a range of products and services as follows:

. Build arbitrage businesses in all kinds of derivatives trading as a robust fixed-incomebusiness.

. 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 onlong 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, provideliquidity and have open speculative positions and trade in equity, currency, interest-rate andcredit 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, investmentbanks must be able to develop innovative new commodity contracts and be able to trade onestablished // contracts.

6.2. Financial markets and asset managersWe 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. Forinstance the transperancy and disclosure requirements, and customer redemptionrules and rules about fund liquidation and distribution of proceeds are fairly clearly laid out.However mutual funds are not permitted the following:

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. 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. Regulationsprovide 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 ofIndian government bonds or require corporate bonds to have high credit ratings. Funds do nothave 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. Theyare allowed to do arbitrage using derivatives and these arbitrage positions are treated as being afixed income position.

However the following is still not permitted:

. Risk-managing the portfolio including specific derivatives positions associated with specificrisks (e.g., A yen futures position when there is an investment in a firm which imports rawmaterials from Japan)

. Holding positions on markets across the world, which flow from the core portfolio whichis internationally diversified.

. Participation in credit derivatives.

On the commodities trading front, there isn’t much that mutual funds are permitted to doat the moment. They cannot establish commodity funds, undertake commodity trading ingeneral 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 hedgefunds.

Insurance companies have no access to currency trading. To be able to compete in aglobal market, these companies should be in a position to offer a range of forex denominatedinsurance 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 intooffshore equities are not permitted. Also, sound rules need to be formed about extent ofasset allocation into equities, matching equity holding to long-term liabilities and reserverequirements on equity assets.

In terms of bond trading, insurance companies face financial repression, where rulesrequire purchases of Indian government bonds or require corporate bonds to have high creditratings. Investment and trading in government bonds and corporate bonds across all ratingcategories is not permitted. Neither are insurance companies allowed to invest in bonds in allcountries. There is a need to have sound rules about matching of bond cashflows and liabilitiesas well as reserve requirements on bond holdings.

In terms of derivatives trading, insurance companies face issues similar to those facedby 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 sis 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 pensionproducts which cope with foreign contributions or benefits, sell pensions to individuals orfirms outside the country, globally diversify their assets and be able to manage currencyexposure 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 cannothold equity indexes and individual stocks across countries. There are no clear rules about computation of equity portfolios nor is there clarity about transperency and disclosurerequirement.

As far as trading in bond funds, derivatives and commodities markets is concerned, thesame 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, tradingof equity and debt, derivatives trading and commodity trading. The only market in currencytrading that exists in India at the moment is the interbank currency forward market. There is aneed 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 needto 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 thefollowing 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 andcustomers.

. Direct Market Access.

As concerns the bond markets, we have rules in place for listing of fixed income funds ands. There are no restrictions on multiple listing. However the following still needs to beenabled:

. Listing and trading of government bonds, sub-sovereign bonds, corporate bonds, withissuers from across the world.

. Sound procedures for disclosure, transparency and surveillance.

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. 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 thatwill 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 Indianexchanges abroad.

. Margin requirements based on overall portfolio risk, where there is an attempt atincorporating 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 offutures and options on all types of commodities and providing fungibility of local contractsagainst those prevalent globally. All issues of market design and operations as seen withsecurities exchanges need to be implemented on the commodity exchanges.

As far are brokerage/securities firms are concerned, all issues that apply to banks in termsof 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 importantactivity. India has been an important player in this market. Regulations that permit banks toengage in M&A activity are well in place. Investment banks as well as commercial banks canengage 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 orcomplex structured finance products. Regulations would have to enable both commercial andinvestment banks to do the following by way of financing alternatives:

. Undertake structured leasing activities, under and international-style tax regime, for a fullrange 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 enableexchanges to offer spot and derivatives trading on securitised paper. So also enable them tooffer a full range of complex derivatives required for putting together complex financingstructures.

10. Project financing

To enable commercial and investment banks to do project financing, regulations must enablebanks 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 doduration matching.

. Provide equity financing, convertible and subordinated debt, guarantees for export creditsand suppliers’ credit, financing import credits, etc.

. Risk management of exposure through the project life (currencies, coupon, maturitytransformation, 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 requiredfor complex financing structures.

11. PPP Financing

is probably the most obvious vehicle for putting together a physical and socialinfrastructure for a country like India. Much of the PPP activity in the world is doneby investment banks. To make this happen in India, investment and commercial banks shouldbe enabled to do the following:

. Finance public obligations under s (service provision financing, poor consumerfinancing, 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 thisarea, regulations need to enable the following:

. Permit banks, both commercial and investment banks, to own insurance and reinsurancesubsidiaries.

. 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) againstinsurance companies, either or on exchange.

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. Selling insurance services either in India or abroad, either to an Indian client or to a foreignclient.

Private bank client need to be able to participate in local or global insurance/re-insurancesyndicates, such as Lloyds.

As far as insurance companies are concerned, regulations need to permit them to do thefollowing:

. 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 theinsurance and reinsurance business are free from financial repression and are not forced topurchase Indian government bonds or restricted by requirements for corporate bonds to havehigh ratings.

Abbreviations

FA p p e n d i x

ADB Asian Development Bank

ADR American Depository Receipt

AMC Asset Management Company

AT Algorithmic Trading

AUM Assets under Management

BAMC Benchmark Asset ManagementCompany (a mutual fund)

BCD Bond-Currency-Derivatives Nexus

BHEL Bharat Heavy Electricals Ltd. (anSOE electrical equipment maker)

BOB Bank of Baroda (an SOE bank)

BPCL Bharat Petroleum Corporation Ltd.(an SOE petroleum company)

BPO Business Process Outsourcing

BSE Bombay Stock Exchange

BSNL Bharat Sanchar Nigam Ltd. (an SOEtelecom company)

BoP Balance of Payments

CAC Capital Account Convertibility

CAGR Compound Average Growth Rate

CBDT Central Board of Direct Taxes (theagency which implements centraldirect taxes)

CBEC Central Board of Excise and Customs(the agency which implements centralindirect taxes)

CCI Controller of Capital Issues

CCIL Clearing Corporation of India Ltd.

CDO Collateralised Debt Obligation

CFMA Commodity Futures ModernisationAct

CMIE Centre for Monitoring Indian Econ-omy

CRR Cash Reserve Ratio

DEA Department of Economic Affairs

DMA Direct Market Access

DOT Department of Telecommunications

EET Exempt-Exempt-Tax

EPFO Employee Provident Fund Organisa-tion

ETF Exchange Traded Fund

FEMA Foreign Exchange Management Act

FII Foreign Institutional Investor

FIPB Foreign Investment Promotion Board

FMC Forward Markets Commission

FRBM Fiscal Responsibility and BudgetaryManagement Act

FSI Floor Space Index

FSMA Financial Services Modernisation Act

GAIL Gas Authority of India Ltd. (an SOEin the natural gas business)

GFC Global Financial Centre

GST Goods and Services Tax

GoI Government of India

HDFC Housing Finance Development Cor-poration (a financial firm working inhome loans)

HNI High Net Worth Individuals

HNW High Net Worth

HNWI High Net Worth Individuals

HPCL Hindustan Petroleum CorporationLtd. (an SOE petroleum company)

HPEC High Powered Expert Committee

IAS Indian Administrative Service

IDRs Indian Depository Receipts

IFS International Financial Service

IFSAT International Financial ServicesAppellate Tribunal

IGIDR Indira Gandhi Institute for Develop-ment Research

IIT Indian Institute of Technology

KPO Knowledge Process Outsourcing

KYC Know Your Customer

LCFI Large Complex Financial Institution

LIC Life Insurance Corporation (an SOEinsurance company)

LLP Limited Liability Partnership

MAS Monetary Authority of Singapore

MOF Ministry of Finance

NBER National Bureau of Economic Re-search

NBFC Non Banking Finance Company

246 R M I F C

NCDEX National Commodity DerivativesExchange

NCMP National Common Minimum Pro-gram

NDF Non Deliverable Forward

NGO Non Government Organisation

NRI Non Resident Indian

NSCC National Securities Clearing Corpo-ration

NSDL National Securities Depository Ltd.

NTPC National Thermal Power Company(an SOE in electricity generation)

NUS National University of Singapore

OTC Over The Counter

PBR Principles Based Regulation

PFRDA Pension Fund Regulation andDevelopment Authority

PN Participatory Note

PSU Public Sector Unit (Indian term forSOE)

PTCs Pass Through Certificates

PWM Personal Wealth Management

QIB Qualified Institutional Buyer

RBI Reserve Bank of India

RBR Rules Based Regulation (the oppositeof PBR)

RFC Regional Financial Centre

RIA Regulatory Impact Assessment

SAT Securities Appellate Tribunal

SBI State Bank of India (the largest bank ofIndia, an SOE)

SEBI Securities and Exchanges Board ofIndia

SEZ Special Economic Zone

SLR Statutory Liquidity Ratio

SOB State Owned Bank

SPV Special Purpose Vehicle

STT Securities Transaction Tax

TDS Tax Deducted at Source

VOIP Voice over IP