Policy easing won't lift investment

Financial Express, 24th October 2012

India is facing the prospect of stagflation. Output growth has slowed down sharply, and is below the recent long-run average of around 7% and consumer price inflation seems to be stuck at around 9-10% (see graphs).

What should RBI's stance be in the forthcoming monetary policy meeting? Under the current circumstances, perhaps the best contribution RBI can make to India's long-term growth is not to give in to the pressure for cutting interest rates, and steadfastly hang in there till inflationary expectations come down. This may happen a few quarters after consumer price inflation rates actually come down. If it moves now, this may not happen.

There is an increasing clamour for RBI to cut interest rates. The government has announced a series of reform measures as well as steps to cut the fiscal deficit such as cutting subsidies on diesel and LPG. Additional plans for disinvestment have been announced. With these and better tax administration, the government hopes to reduce the fiscal deficit. RBI has been making the case that the government needs to bring the fiscal deficit under control for inflation to come down. With the present expansionary fiscal policy, RBI would need to keep monetary policy tight to keep inflation under control. The government is now suggesting that it is doing its bit to control the deficit, so RBI must now ease monetary policy to kick-start investment and push up growth.

RBI Governor Subbarao has a difficult call to make. Considering that inflation has remained high and above RBI's target rate of 4-5% for multiple years now, inflationary expectations have remained high. An easing of monetary policy at this stage will convey that a higher inflation rate is acceptable. This will keep inflation rates high as price setting, salary negotiations and contracts for the coming year will build in the higher inflation rate.

The biggest problem with the investment rate today is issues of government policy and implementation. Projects are stalled largely due to environment and forest clearances, availability of ores and minerals, which has become difficult due to mining bans or other processes that are under litigation or investigation, the difficulties of land acquisition, and the availability of power and water. The government is now setting up a National Investment Board that is expected to give clearances to all projects that cost R1,000 crore or more. Only when projects that are currently stalled due to these problems, bank loans that are being restructured due to these delays and investor sentiment that has been dampened due to the inability of investors to complete their projects on time, start moving ahead, will the private sector have the appetite to take any further risks.

While interest cost is obviously a component of any project, even if interest cost were zero, until the risk of putting equity money into projects can be justified by an expected positive return, many investors are not going to invest more money. Since projects do not run fully on loans, and the risks today posed by the governance problems are so serious, cutting rates will do little to ramp up investment.

In most public debates, there is rarely a lobby for raising interest rates. In general, industry lobbies who talk to media persons, investment advisors and equity market analysts almost always argue the case for rate cuts. They stand to gain from rate cuts and the loud clamour created by them ignores the potential negative impact of the policies they are arguing in favour of. In this case, interest rates are the price being paid by some to others. So there are two sides to the story. Those who lend, i.e the savers, are also impacted by rate cuts. The household savings rate has dropped sharply in one year from 25.4% of GDP in 2010-11 to 22.8% of GDP in 2011-12. Such a sharp and sudden fall in household savings should be a matter of concern. Where did this decline come from and why did it happen? What would be the impact of an interest rate cut on household savings?

This decline in household savings of 2.6% of GDP has come mainly from a sudden and sharp decline in household financial savings. In 2010-11, household financial savings stood at 12.9% of GDP, while in the following year they fell by 2.9% to 10% of GDP. Why did this happen?

The year 2011-12 saw a decline in the growth of bank deposits and small savings. Households prefer to save in real estate and gold. Physical savings of households continued to be high, and even rose slightly, from 12.4% of GDP in 2010-11 to 12.8% of GDP in 2011-12. The bulk of the increase in savings seem to have gone to gold. Last year, gold imports rose dramatically. After the hike in the tariff on gold in the budget, official imports of gold have fallen. Stories from travellers suggest that customs officials in Mumbai are actively trying to prevent gold smuggling in recent months.

World commodity prices are expected to remain depressed as the world economy remains sluggish. The rupee appreciation in recent months has helped reduce the costs of tradables. The slowdown in domestic demand will help stabilise domestic prices. When fiscal policy measures actually have an effect and the deficit comes down, the domestic pressure on prices will reduce. RBI should be in no hurry to ease monetary policy as it can do more harm than good.

One head is better than many

Indian Express, 16th Oct 2012

A single financial regulator, rather than sectoral ones, is what India needs

The Union cabinet recently approved two bills expanding the powers of relatively small financial sector regulators. The PFRDA bill and the FCRA Amendment bill, if passed by Parliament, would give statutory powers and greater teeth to the pensions regulator and the commodity futures regulator. Though this may appear to be a reformist move in the current context, it could create difficulties for longer term financial sector regulatory reform.

These two bills were first proposed before the government set up a slew of expert groups to examine financial regulation in India. Almost all these committees suggested that all non-banking financial regulation, at least, be brought under a single regulator. They argued from Indian and international experience that it is becoming increasingly difficult to effectively regulate modern financial firms through a sectoral approach.

It seems unlikely that the cabinet is turning down these expert recommendations, including those from a group chaired by its present chief economic advisor, Raghuram Rajan. It is more likely that in its attempt to fast-track reforms, it has approved all the financial sector and economy bills that had been placed in limbo, without re-examining them carefully in this post-global-crisis world.

The expert groups, including the Mistry, Rajan, Aziz and Sinha committees, have examined the role and function of various regulators and suggested that they be modified to remove the various conflicts of interest, regulatory overlaps and gaps that plague the system today. They also raise questions about economies of scale in the regulation of organised financial trading. At present, regulatory functions on organised financial trading are spread across SEBI, RBI and the Forward Markets Commission (FMC). This separation between multiple regulators has forced an inefficient partitioning within private firms too: for example, a brokerage firm operating on the stock market where it faces SEBI regulation is forced to create a separate subsidiary to trade on commodity futures markets with FMC regulation and a separate subsidiary to be a primary dealer, which involves an engagement with the RBI.

Given the nature of organised financial trading, there could be economies of scale and scope for both government and the private sector through unification of regulation of organised financial trading. This requires pulling together the functions related to the bond and currency market from the RBI, functions related to the stock market from SEBI and functions related to commodity futures markets from the FMC, and merging these into a single agency.

Further, the Indian financial system has changed from one almost entirely dominated by public sector firms to an incipient role for private and foreign firms, which has helped bring a substantial rise in the sophistication of the firms. This has given rise to large, complex financial institutions such as the ICICI and HDFC, which serve households and firms across all aspects of financial services. At the same time, these firms have chosen to organise themselves through a large number of sectoral financial firms, each of which fits the requirements of one financial regulator. But no single sectoral regulator gets a full picture of the risks in such large conglomerates.

The recent cabinet approvals may have consequences similar to the RBI Amendment Act of 2006, which established the RBI as a regulator of the bond market and the currency market. This was a step in the wrong direction, given India's reform agenda on the regulation and supervision of securities markets. In all the OECD countries but one, a single government agency - the securities regulator or the unified financial regulator - deals with all aspects of organised financial trading. In the US, the treatment of organised financial trading is split between the CFTC, which deals with all derivatives, and the SEC, which deals with the spot market. Apart from this, the OECD practice involves a single agency that regulates all organised financial trading, with a unified treatment of equities, commodity futures, interest rate, currencies, corporate bonds and derivatives.

This mistake led to serious consequences for the bond market. In the equity market, the strategy for critical financial infrastructure, exchanges, clearing corporations and depositories, was based on three principles. First, there was a three-way separation between shareholders, the management team and the member financial firms. Second, there was a competitive framework. Third, the regulator, SEBI, did not own critical financial infrastructure.

None of these three principles was applied to the bond market. The critical bond market infrastructure involved a depository (the SGL) and an exchange (NDS) both owned and operated by the RBI. This was a problematic arrangement because the RBI had conflicts of interest by virtue of being an owner and service provider, and at the same time, the regulator (after the enactment of the RBI Amendment Act of 2006). There was a loss of competitive dynamism when the RBI's policy decisions leaned in favour of blocking competition against NDS and SGL. Only financial firms regulated by the RBI, the banks and the primary dealers were allowed to tap into this infrastructure. This framework was thus unable achieve bond market liquidity. On paper, India has an impressive bond market with trading screens, a clearing corporation, etc. But the essence of a market is liquidity, speculative views, and the resilience of liquidity. None of these is found in the Indian bond market.

The Indian discussion on the role and function of government agencies in financial regulation needs to be examined in the context of the difficulties of staffing high quality agencies. Even when an agency starts with a clean slate, without institutional baggage from a pre-reforms India, without conflicts of interest and archiac legal foundations, without expert staff, there is still a substantial risk of failure in institution building.

In India, there are many delays in processing legislations. At every stage, the government should be checking back whether it still want to propose a certain legislation. A little more thought in 2005 would have prevented the RBI Amendment Act of 2006, and a little more thought today will prevent mistakes on FMC and PFRDA. The government already has the benefit of the views and recommendations of various expert committees, which have studied the issue in detail and set the direction of long-term financial sector reform. Government policies policies in the short run should fit with its long term goals.

What is regulation for?

Indian Express, 4th October 2012

The approach paper of the Financial Sector Legislative Reforms Commission (FSLRC) has proposed a new direction for financial regulation in India. While on one hand, half the Indian population still does not have access to finance, on the other, regulations have restricted the growth of financial services. In a country growing at such a rapid pace that the GDP doubles every 8 to 10 years, the needs of people and firms are constantly changing. In recent years, various government committees have pointed to the need for policy change. But it was found that the required changes could not be made under the existing, mostly outdated, financial laws. This prompted a review of the financial legislative framework.

The FSLRC was given the job of reviewing, simplifying and modernising the legislation that affects financial markets in India. It was asked to prepare legislation in tune with the present-day needs of finance. The commission has recently released an approach paper on its website. The paper discusses its strategy and philosophy.

News reports about the commission have focused on the FSLRC recommendations for India’s financial regulatory architecture. But that is only one of the many aspects of Indian finance that the commission was mandated to review. In its proposed recommendations, it has endorsed a transition to a modern regulatory architecture recommended by previous government reports such as the Raghuram Rajan and the Percy Mistry committee reports. These reports had described the problems in the Indian financial sector arising from regulatory cracks and overlaps. The novel element of the FSLRC approach is the emphasis on the modes of independence, accountability and the rule-making process of regulators in India.

The modern approach to financial regulation allows greater innovation. It emphasises the objectives of regulation. Regulation is needed when markets fail. The approach emphasises that the objective of regulation is to protect consumers. This can be achieved by creating a system in which it is difficult to indulge in unfair practices or sell consumers products that are unsuitable for their specific needs. Unlike in goods and services, where there may only be a small lag between payment and delivery, the lags in finance are long and often contingent on a state of nature. A customer keeps paying a premium to buy a promise from an insurance company to pay his family if he dies. The customer does not know if the company is taking on so much risk that when the time to pay comes, it will be bankrupt. It is the job of the regulator to protect him from fraudulent practices and prevent the company from taking on too much risk.

If consumer protection is the objective of the regulator, it must be empowered with instruments to ensure it. It should not be tasked with other objectives or with doing things “in the public interest”. It cannot prevent innovation as long as the financial firm selling the service is not engaged in practices which violate these objectives and if it is not taking on excessive risk. This requires that regulatory objectives are clearly defined, and the regulator’s powers clearly enumerated. Normally, a regulator might have an incentive to kill innovation so that risk is eliminated and no firm fails on its watch. But eliminating risk altogether will not allow finance to reach out to new customers, products and markets. Thus, the powers of the regulator have to be restricted. It has to be made accountable for what he does. If its regulations go beyond the objectives the law tasks it with, it can be questioned, its decisions can be appealed against. This is a mechanism to restrict the arbitrary use of power and lack of reasoned regulations and orders.

The regulator must not prevent the failure of financial firms completely. Firms that are prone to take very high risks or are very weak should fail. However, firm failure must be happen at minimum cost to consumers and none to the taxpayer. The owner should lose money. The FSLRC approach paper discusses the creation of a new resolution agency for handling firm failure through mergers, acquisition or a close-down before the financial firm goes bankrupt.

The approach paper discusses a consumer protection law and a microprudential law which would lay out principles on the basis of which regulators would write regulations. These laws would not contain detailed regulations, which would be only written by the regulator. These laws will be separate from the regulatory agencies that enforce them. A law, such as a consumer protection or microprudential law, can be enforced by a number of agencies, each in their sector. A single financial redressal agency would hear complaints for all sectors.

Regulators in this approach will be given independence under the law. At the same time, they will be accountable. Accountability will be ensured through clearly defined objectives, avoiding conflicting objectives, a well-laid out rule making process and an appeals mechanism (there would be a newly created non-sectoral financial sector appellate tribunal).

As the Indian economy grows bigger, its need for finance increases. Households and firms often do not have access to the formal financial sector. Until now, the approach in the formal regulated financial sector has been to give explicit permissions for some products or markets. The rest of the financial products and markets are banned. This approach has restricted innovation in financial markets as no market or product is allowed unless the regulator prescribes it. The FSLRC approach should bring about a change to the pace of innovation.

We are, today, at the other end of the spectrum from the American model, where too much innovation appears to be a regulatory challenge. The lessons from the global crisis, which FSLRC proposes to build into the new regulatory framework, will help us to maintain a fine balance between too little innovation as in India today, and too much innovation that might pose risks to the financial system.

Towards better financial regulation

Financial Express, 2nd October 2012

The Financial Sector Legislative Reforms Commission was set up to review, simplify and rewrite the legislations affecting financial markets in India. It has been asked to make legislations to bring them in tune with the changing financial landscape in India and the world. The commission, headed by former Supreme Court Judge Justice Srikrishna, has been deliberating since April 2011, and consulting with a spectrum of experts and stakeholders in the financial sector and regulators.

The commission has just released an approach paper available on its website. The paper outlines its strategy and the recommendations it is thinking of making in its report to be submitted by end March 2013. The approach emphasises the objectives of regulation, the rule-making process, and discusses a change in India’s financial regulatory architecture.

In the 2000s, through a number of government committee reports such as the Raghuram Rajan and the Percy Mistry reports which highlighted problems in the Indian financial sector, a slow consensus was seen to be developing in support of reforms. As India grows, the needs of the economy for finance increases. Households and firms, especially small firms, do not have access to finance. Until now, the approach in Indian finance has been to give permissions for some products or markets. The rest of the financial products and markets for which no explicit permission is given, are banned. This approach has restricted innovation in financial markets.

The modern approach to financial regulation, in many advanced economies such as Australia and Canada, which have undertaken financial sector reform in recent decades and which were resilient during the crisis, is one which allows greater innovation, and yet addresses issues of market failure in finance, emphasises the objectives of regulation. It emphasises that the objective of regulation is to protect consumers. Protecting consumers can be achieved by creating a system in which it is difficult to cheat them, indulge in unfair practices, or sell them unsuitable products. If this is the objective of the regulator, and he is empowered with instruments to ensure it, he does not prevent innovation as long as the financial firm is not engaged in such practices which violate these objectives. This envisages that the regulator’s objectives are clearly defined, his powers are clearly enumerated and that his decisions are appealable.

With the objective of protecting consumers, the financial regulator must reduce the probability of failure of financial firms. Here, the regulator must not prevent failure completely. Weak firms should fail, so that labour and capital is freed up. However, firm failure must be done with a minimum cost to consumers or to the taxpayer. It should be the shareholder who pays since he took the risks. The FSLRC envisages creation of a new resolution agency for smooth firm resolution, before a firm goes bankrupt. Such agencies, in other countries, try to sell off weak firms before they fail.

With a view to protecting consumers and improving microprudential regulation of financial firms, the FSLRC has discussed a consumer protection law and a microprudential law which would outline the basic principles on the basis of which regulators would write regulations. Laws may be separated from agencies that enforce these laws. A law can be administered by one agency or many agencies. The same law, such as a consumer protection law, can be enforced by a number of agencies, each in its field. The question of regulatory architecture—a separate banking regulator, or one banking and one non-banking regulator, or indeed one consumer protection agency (as in Australia) and one unified non-sectoral regulator—can be decided by a separate regulatory architecture law.

A crucial element of the FSLRC approach is an emphasis on the governance of regulation. Regulators will be given independence under the law through the selection process, and mechanisms that determine the relationship between government and regulators. But they will be accountable. Accountability will be ensured through clear, well-defined objectives, avoiding conflicting objectives, a well-structured rule-making process involving a clear reference to the objective of the regulation being in sync with that of the law and to the appeals mechanism (through a newly created non-sectoral Financial Sector Appellate Tribunal that subsumes the present Securities Appellate Tribunal).

Questions of policy such as public sector ownership are left to politicians. But the law will require regulation to be ownership neutral: public, private, cooperative or foreign financial institutions, once registered and regulated in India, will face the same laws and regulation. The path to capital account convertibility is, of course, not a matter of law. It is policy. But law will ensure that regulations made under the capital controls law are subject to the same rule of law, procedures and appeals as all other financial sector law.

The commission has invited comments on its approach paper. These comments will be inputs into further discussions and decisions that are to be made.

Approach paper released by the Financial Sector Legislative Reforms Commission

The Financial Sector Legislative Reforms Commission (FSLRC) is rethinking the legislative foundations of the Indian financial system. FSLRC was setup by a notification on 24 March 2011 and asked to submit its findings on 24 March 2013. FSLRC constitutes the first time in Indian history that a large-scale re-examination of multiple laws in a sector is being undertaken.

FSLRC has released a compact approach paper showing preliminary findings about the strategy that will be adopted. The release of this report is part of the consultative mechanisms that have been followed within the Commission. The Commission has invited feedback from experts and interested parties on this document.