Renewing the Mumbai project

Retrospective and perspective

The High Powered Expert Committee’s (HPEC) report on Mumbai as an International Financial Centre (MIFC) appeared in April 2007. Since then, the global economy has witnessed its worst downturn in 80 years. The ensuing global trauma is ascribed to the failure of finance. But there is still much confusion and conflation about what failed. Thousands of answers have been advanced. But key questions remain. Some of the right questions have not been asked.

Was it a failure of: Anglo-Saxon finance; large, complex financial institutions (LCFIs) too systemically significant to be permitted to fail; hedge funds and arbitrageurs; inter-bank credit markets; credit default swaps; asset-backed securities and collateralised debt obligations; securitisation and risk transfer; key financial supporting sub-systems, such as risk assessment and management systems, credit rating systems and agencies, internal and external accounting, reporting and audit systems and firms; or systems for global financial coordination or of regulatory systems and architecture?

When these questions are examined, what are seen as obvious failures seem neither failures nor obvious and the real failures seem to be deliberately obscured. Banks and bankers are blamed for the disaster that has befallen. The other side of that same coin—banks got into trouble because borrowers (individuals, households, companies and governments) defaulted, whether because of changed circumstances, or because they borrowed under false prospectuses—is not condemned. Can bad lending occur without bad borrowing?

Nevertheless, because of the debacle, much of what the HPEC report recommended in 2007 is seen as misguided. It reflected misplaced faith in Anglo-Saxon finance. Therefore, say its critics, its recommendations need to be scrapped or revised. This seems to be the view of some local commentators and the RBI. Both are wrong. Believing that the failure of finance was the cause of the current debacle misses the forest for the trees; it emphasises the meso and micro over the macro. For that reason, it is otiose to suggest that HPEC report was misguided. Much of what it said remains as valid today as it was before.

The real failure that resulted in the Great Recession of 2008-09 lay not in finance but in macro-financial policy, compounded by faith in over-indebtedness; a belief that you could have it all now and pay for it later. ‘Failure of finance’ was but a symptomatic manifestation of these deeper, more profound failures.

The eternal verity is that the root of financial failure lies always in a fatal trinity: prolonged fiscal, monetary and social policy incontinence; emergence of a culture of borrowing and dependency in governments, companies and households; and inevitable corrections of asset prices, that are at first inflated by easy credit, but later collapse, because they cannot be supported by future cash flows.

The real cause of the Bush-Greenspan-Brown debacle has been failure on the part of the West. It lived beyond its means. It waged unaffordable wars and created unaffordable welfare states through borrowing, thus creating perverse incentives in overpriced labour markets. Doing so has made the West uncompetitive and bankrupt. The West financed these follies as the issuer of reserve currencies, able to sustain bad borrowing from around the world without having to go cap in hand to the IMF or World Bank.

The last two years reflect a recognition of those realities through financial market dislocation. Earlier such follies were portrayed as the West absorbing China’s excess savings. But the reverse was true. China was generating surplus savings because the West was on a consumption binge it could not afford. It was financed by reserve accumulating countries. Financial failure occurred because governments, companies and households in Western countries over-spent and overborrowed, not just because banks were foolish. Western governments and central banks pursued policies

making borrowing excessively cheap and plentiful. The recession of 2008-09 was the inevitable denouement. The consequences of over-borrowing that monetary policy encouraged emerged in US and UK asset markets (housing). As lenders absorbed asset value losses they had to ‘adjust structurally’ to reduced circumstances. The rest of the world had to adjust to a fall in global demand. That sharp, sudden adjustment surfaced as a global recession. Like all such adjustments it will end. New problems will  emerge requiring another set of adjustments, thwarted by other profound policy errors.

These include the resort to unsustainable deficits and money printing by the West and by China’s selfserving refusal to permit its currency to appreciate. China is defending the indefensible. It is asserting a permanent right to export goods to, and import jobs from, the rest of the world. By doing so, it will trigger more protectionism, and will possibly recipitate the unthinkable—obliging the rest of the world to impose collectively a uniform countervailing duty of 25-40
percent on imports from China. Its folly underlines a key message of HPEC report—any economy which is significant to the global economy must have an open capital account with market-driven exchange rate flexibility to permit seamless equilibration of imbalanced current accounts. Using the developing country argument to forestall that indefinitely will not work.

This retrospective digression is material to revisiting the HPEC report. It highlights the continued misalignment of macro-financial policies in India that run all the risks that have materialised elsewhere. India’s macro-financial policies display some of the characteristics of the United States and the European Union. The risks they were running were signalled in the year 2000 but no one paid attention. However, unlike the US and EU, India has lower consumption. It

has higher savings and investment, supported by capital inflows which RBI is trying to thwart in inexplicable, unpredictable ways. Those differences make India’s policy sins more affordable and forgivable, but not forever. A less primitive financial system, of the kind advocated by the HPEC report, would highlight the future dangers of pursuing such policies. Also, the space vacated in providing global financial services is now being filled—by default—by Chinese and other Asian financial services providers and not by Indian firms. That represents a wasted opportunity for India which opened the global market for services.

Revisiting the Mistry report

In 2007 the HPEC report made over 50 specific recommendations with timelines for each. These have all expired. It would be useful to focus on its agenda for action in the post-2010 context.

Sound macroeconomic and financial policies: Reviewing this 10-point agenda now, there is no argument about the need to pursue sensible macro-policies. Actions though, speak louder than words. In India actions have been opposite to what was recommended. To an extent that was a response to the crisis. But India has not experienced a recession or depression. It has had a growth-recession. Even if the fiscal and monetary stimulus has been vindicated by outcomes so far, it has to be asked how much longer the stimulus can be sustained before the cure becomes worse
than the disease.

An independent Debt Management Office: On debt management there has been glacial movement on the creation of an independent DMO and the RBI has fought hard to prevent it from materialising. It has marshalled old hands to argue, without logic or substance, that, even if it is the right thing to do, it is not the right time to do it. Meanwhile, although the merits of issuing rupee-denominated Indian public debt in global debt markets seem obvious there has been reluctance to go down that road. This has had deleterious consequences for domestic debt markets and for the pursuit of a more sensible monetary policy.

Strengthening the bond-currency-derivative nexus: There has been glacial progress in strengthening the BCD nexus in India. The RBI continues to prevent things from happening, slowing them down, or allowing them to happen with restrictions that ensure that what was intended is thwarted. That has certainly been the case with introducing interest rate and currency derivatives in India. The introduction of credit derivatives will probably be opposed even more obtusely.

Integrated financial markets: The issue of integrating financial markets and moving toward unified regulation was always contentious. There is much dissent across the globe signifying confusion and a lack of consensus within and across countries about the right way to go. There are now several camps advocating different things. The RBI uses any argument from any camp that suits its purpose at any time. Some in the UK would like to abandon the UK-originated model of financial regulation which has spread around much of the world and worked well. Equally, there are those in the US who would like to do the opposite with the Federal Reserve. They wish to introduce UK-style central banking (limited to monetary policy) and regulation via a single regulator instead. Others would re-introduce the former separation of commercial from investment banking in order to: downsize firms that are “too big and too systemically important to fail”; limit future bailouts; and separate the utility functions of finance from casino functions. Still others would like to limit balance sheet size but permit multiple functions.

The arguments made by different camps are based on false understandings of where failures have occurred and what caused them. Some of the remedies proposed could have more disastrous consequences than the diseases diagnosed. The result is that not much has changed in the global financial world. Changes there will be. But they will be marginal rather than the radical changes that the critics of finance would like to see.

However, the HPEC recommendations on regulation remain valid. The crisis provides no incontestable reasons to change them. India would be better served by an RBI that is independent; whose role is limited to sound monetary policy and ensuring systemic stability. As the report suggested, regulation and supervision of all financial services should be delegated to a single regulator that would consolidate the present supervision departments of RBI, all of SEBI, IRDA, and the Forward Market Commission.

Principles-based regulation: On the issue of principles vs rules based regulation, the head of the UK’s Financial Services Authority asked: “how can one apply principles based regulation to people with no principles?” But that lament does not shed light on why rules-based regulation failed in the United States in the simplest and most mature market of all—the mortgage market. Principles-based regulation is the right way to go in India. It is superior to rules-based regulation which results in boxticking superseding the application of thought. Even so, principles-based regulation needs to be bolstered with better human capital in regulatory agencies and with draconian penalties to deter financial institutions from indulging in regulatory capture. That was the case not just with national regulators but even with international regulators like the Bank of International Settlements (BIS) who were taken in by large global banks on Basel-2 rules that such banks (LCFIs) advocated in their own selfserving interest, but that failed spectacularly to prevent the 2008-09 collapse of bank balance-sheets.

From the lessons learnt, if the HPEC report were to be rewritten now, it should include the need for creating in India: first, central bank liquidity intervention capability in key markets to assure bank liquidity at all times such as the domestic and global interbank and money markets; second, a central clearing house to act as a universal counter-party for the trading of credit default swaps (CDS); third, derivative contracts to be exchange-traded to the extent possible or, when tailored, to be convertible into tradable instruments; and fourth, explicit resolution rules governing the failure of systemically important financial institutions that posed either a balance-sheet risk or a network risk to the system as a whole.

Opening the capital account: On HPEC’s proposals for opening the Indian capital account, and making the rupee convertible, no apology is offered for pressing even harder for that now. The partial, residual Indian capital controls that are in place do not achieve anything. They discriminate against resident small and medium enterprises and individuals. But they allow other economic agents to do what they want, though only after incurring the frictional, time and transaction costs of seeking RBI’s prior approval. The RBI has been asked to demonstrate why these controls are necessary and to clarify what they achieve. So far it has not provided any answers. Present capital controls do not prevent destabilising inward and outward surges of foreign direct or portfolio capital. India has experienced surges in both directions since 2006. If preventing them is the issue then controls have failed.Besides, India is a capital deficient country that needs to import large amounts of external capital to finance its infrastructure and development. The capital controls that RBI seems to favour are counterproductive.

Concerns about outward migration of resident capital if residual controls were removed seem odd. The annual allowance of US$200,000 for Indian residents to invest abroad has hardly been used. When India offers the highest returns on portfolio capital invested, why would residents invest abroad? Only the most sophisticated and wealthiest Indians would use that window for portfolio, political risk and currency diversification purposes. But such Indians with a liquid net worth of over US$2 million already have assets abroad in deposits, property and securities. These assets have been accumulated through diasporic connections when capital controls were draconian.

The RBI forgets that the largest outward migration of resident capital occurred when controls were tightest. The removal of controls would result in a sustained inflow of capital for some time. There is a risk that flows of hot money at particular periods could prove problematic. But that could be accommodated. Migration of resident capital would be a concern only if India pursued the policies of Robert Mugabe’s Zimbabwe.

For all these reasons, maintaining residual capital controls seems otiose. If there is concern about the monetary (and fiscal) implications of destabilising surges of external capital, surely it is not beyond the RBI to create ‘tidal basin’ arrangements with the IMF. These could be expanded through swap facilities with other central banks. Such arrangements would dampen the effects of external capital surges with minimal spill-over. The fact that RBI has not explored such avenues but remained intransigent in its opposition to further capital account liberalisation reflects a disconcerting preference for authority over intellect.

Tax, legal reform and opening  professional services to foreign entrants: Similarly, progress on rationalising taxation of financial services and transactions is occurring at a slow pace although breakthroughs seem to be in the offing. Movement on opening up the legal, accounting and other business-support professionals to unrestricted foreign entry is much too slow for a country of the size and significance of India in the global economy. Nor is enough progress being made on improving the functioning of the judiciary and legal system.

Mumbai’s urban infrastructure: But, most depressing of all is what is happening to Mumbai as a city. This compromises any prospect of it becoming a credible IFC in the foreseeable future. The city’s governance, infrastructure—despite the new sea-link between Bandra and Worli—and cosmopolitan character, are regressing. Instead of becoming more cosmopolitan and global in character Mumbai is becoming parochial, narrowminded, uncivil and uninhabitable. Municipal governance is appalling. It is at odds with the state government and legislature. The latter, in turn, are dominated by the rural constituencies of the state. Mumbai is a cow being milked by the Maharashtra state to advance rural interests. Little of the revenues it generates is reinvested in the city. By contrast Delhi, the only Indian megalopolis that is a state in its own right, is making rapid progress. Unless Mumbai competes with Delhi on equal terms as a state, or as a Union Territory, its prospects of becoming an IFC are receding rapidly. For this, the HPEC report can only mourn.