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Should we go slow on financial sector reforms?
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September 24, 2008

R Ravimohan
MD and Region Head, South & South East Asia, Standard & Poor's

More financial reforms will make our growth more inclusive. The US lesson is the regulatory system has to be robust and fully aware of the overall risks.

The current state of financial sector in the US is a reflection of excesses in risk taking behaviour and unpreparedness of the regulators for such an unprecedented market outturn. But this was not due to the liberalisation of the financial sector in the US.

Indeed, prior to the exuberances and excesses of the past few years, the US economy and people benefited considerably from the reforms in its financial sector and the innovation that it fostered. It enabled an inclusive growth that allowed funds to flow smoothly to all sectors of the economy, including the weaker sections of the society. It set the US dollar and US treasury security as the world's benchmark currency and risk benchmarks.

To an extent, it is the very openness and efficiency of its financial markets that has caused this current crisis. Free markets became free-for-all markets. Excess funds flowing into its coffers forced invention of newer asset classes. The efficiency of the markets allowed risk takers to take and off-load risks quickly. This obviated the need for getting to know the risks sufficiently well enough.

It also focused the risk calculations on the short term rather than the long term, and hence they resorted to extreme short-term funding. These factors aggregated the risks in the system as a whole. When the system began to understand that the risks had reached unacceptable proportions, the liquidity supporting these vulnerable assets was withdrawn, which precipitated the crisis.

These events, as unfortunate as they are, offer valuable lessons. The key to a system that grows stably and is accommodative of innovation and inclusive of all segments of players is information availability, especially in a centralised and aggregated manner.

Regulators perform two roles. One is to regulate, control and discipline the markets to follow a rule-based and orderly conduct. But the other role, which often gets shadowed in the former role, is to be the repository of aggregate information about the entire system that can be used to assess and control the overall risk in the system.

The current crisis has highlighted the need for this, especially as vast amounts of risks accumulating in the private markets and the indirect exposure to the regulated entities were not sought and available to the regulators.

India lags in its financial system development. It leaves vast segments of the population under-served, especially those in the weaker income group. As India grows at the current robust pace, this gap will only exacerbate. There are large gaps in its market structure, with many missing markets and players. Perhaps regulatory bandwidth restricts expansion of the system and certainly curtails innovation.

The High Powered Committee headed by Raghuram Rajan, and of which I was privileged to be a member, documents urgent further reforms needed for the Indian financial system to prepare for the future challenges. The lessons of the present crisis should give us confidence and help us down the path of necessary reforms to make our financial system more robust, inclusive and efficient. These reforms should foster innovation and efficiency, yet place greater responsibility on the players and supported by adequate regulatory oversight.

India will be well served with an inclusive, efficient, strong and stable financial system that can be developed with more reforms and superior regulations.

A V Rajwade
Chairman, A V Rajwade & Co Pvt Ltd

One, India and China have grown without such reforms. Second, given the huge bailout, how do we say western markets are either mature or competent?

Should events in the US influence our policy of gradual liberalisation of financial markets? The issue is topical also given the recommendations in the Percy Mistry and Raghuram Rajan Committees. It is worth keeping in mind that over the last several years, India has recorded excellent growth (Indeed, only China has done better). Given this, surely, one should not be considering any radical changes in policies, unless there are very strong reasons; the bias should be in favour of continuing the good work rather than making radical changes.

One question is whether the central bank should intervene 'in currency markets only to limit excessive volatility' as recommended by the RRC. A reductio ad absurdum corollary is that if the dollar depreciates 5 paisa every day, taking the exchange rate to Rs 32.50 in a year, no action should be taken as there is no volatility!

It has also been argued that 'an exchange rate that reflects fundamentals tends not to move sharply' (RRC). This is a myth: In the last six years the dollar: euro rate has moved almost 100 per cent (82 cents to $ 1.60) with little change in relative fundamentals. This apart, to expect the real economy to adjust to the exchange rate produced by a hundred traders is perverse, particularly when the economy primarily produces undifferentiated goods.

RRC has also argued that sterilised currency intervention 'is rarely effective beyond the short term.' Our central bank has been doing so for 15 years and the rapid growth and globalisation of the economy during this period speaks for itself. Or, is 15 years 'short term?' Overall, I remain a votary of managed exchange rates to keep domestic costs and prices reasonably competitive in the world.

As for the capital account, one supports fully opening the rupee bond market to foreign institutional investors: We need such investments for the development of a long-term corporate bond market, both primary and secondary. As for other measures, one remains an agnostic:

  • There is little empirical evidence suggesting that a liberal capital account leads to faster growth;
  • The corporate sector has enough freedom to invest abroad as the spate of foreign takeovers, investments and joint ventures suggests.
  • As for individuals, they are hardly using the even the existing facilities (except the super-rich buying apartments in Dubai and Mayfair). In fact, portfolio investment will either keep coming in or remain here (when returns are good) or go out in the opposite scenario. Clearly, this increases risks of financial instability, with little gain to compensate for it.

    As for the domestic sector, a central bank having a single objective, that of low inflation, is not very realistic. The Fed implements monetary policy keeping in view the impact on growth and employment, and so does the Bank of England. Even the supra-national European Central Bank, which formally has a single point agenda, has refrained from tightening money when inflation is currently ruling 100 per cent above the target.

    There is however clearly a case for greater autonomy for the public sector banks, encouragement of the use of technology for bringing banking to a much bigger segment at a reasonable cost and similar incremental steps. One caution: After the trillion dollar bailout of the financial services industry in the US, the Mecca of market fundamentalism, it is high time we stop considering the western markets as mature or even competent! 

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