Tuesday, 26 March 2013

Turf war in the offing

Financial Express, 26th March 2013

FSLRC recommendations would be challenged by the financial regulators

Two of the most important committees on financial sector reform in India in recent years-the Raghuram Rajan Committee and the Percy Mistry Committee-have recommended a change in the regulatory architecture. The problems of regulatory gaps, overlaps, turf wars, and tension with the government have only increased since these committees submitted their reports. While the Percy Mistry report recommended a single unified regulator, Raghuram Rajan recommended a more conservative approach-a banking and non-banking regulator, keeping RBI as the banking regulator. The Financial Sector Legislative Reforms Commission (FSLRC) has taken the more conservative approach of two reports, keeping banking with RBI while proposing a merger of other regulatory bodies into one regulator.

In almost every country where regulators have been unified as the financial system has become more complex and as regulatory walls have become hurdles to better regulation, existing regulators have fought back. The past and present staff of various regulatory bodies are amongst the biggest opponents of regulatory institutional change. No doubt, in India too, turf war will take place. The commission, in recommending a non-sectoral law, will no doubt make regulators and many regulated entities, happy in the present set up, quite unhappy. The debate on the draft law in public discourse will need to go beyond who will administer the law and beyond the unhappiness of regulators who find their turf encroached upon to the contents of the law. In many ways, who administers the law is the least important part of the recommendations of the commission.

Financial sector reform in India has been a slow process of responding to the needs of a growing economy. Other than the initiatives in the equity market, most changes in the framework of financial regulation in India have been made in response to the need of the hour. This has meant piecemeal changes to the various laws that give powers to regulators to regulate finance. In addition to the many amendments to the laws, there have been many committees looking into the difficulties of finance. A slow consensus has grown which recommends changes in the regulatory framework. However, many of these changes were not possible since the basic structure of the law did not allow it. The FSLRC was set up to review, rethink and redraft the basic laws so that Indian finance can be reformed to prepare India as a growing modern economy, without having to constantly amend existing laws to incorporate changes in technology or other innovation.

This commission, which submitted its report to the finance minister on March 22, 2013, was not a quick and dirty response to political pressure in a crisis situation. It was a serious, consultative, well-researched effort at rethinking the objectives of regulation, of regulatory governance, and of the independence and accountability of regulators in India. The job of the commission, which began two years ago, was not to simply tweak and fix the things that were not working, but to question the fundamental arrangements between regulators, the government, the regulated and the consumer for whose protection regulation is ultimately being done. The commission involved more than a 100 people doing research, learning lessons from the global crisis and consulting regulators, market participants and various stakeholders.

What is the most important element of the new draft law-the Indian Financial Code. This law puts consumer protection at the centre of all regulation. Whether we have to reduce the risk of failure of banks or an insurance company, so that depositors and policy holders are protected, whether we have to find ways of rescuing failing entities with minimum cost to the taxpayer, whether we have to find ways to ensure that a household is not sold unsuitable products, or whether we wish to prevent a disruption of financial services on the scale of the system as a whole, the objective of the regulation is to protect the consumer without putting the burden on the taxpayer.

The need for regulation arises because of the asymmetric power and information that customers of financial services have, in contrast to the providers, and they must be protected from unfair practices, or from the provider taking very high risks to earn high returns. In this framework, the objective of micro-prudential regulation, i.e. regulation of entities in the financial sector, is to protect customers. If regulation entails a higher burden on owners and shareholders, in proportion to the risks they take and the commitments they make, in order to protect customers, the burden may be justified. After the global financial crisis, whose origins lay first in the sale of unsuitable financial products to consumers, and then in the lax regulation of financial firms that were holding those assets, the commission has focused on the extremely important role that good regulation can play in making the financial system resilient.

A major theme of many of the recommendations of previous committee reports in India has been the opposite problem of those that led to the global financial crisis. Instead of suffering from too much innovation as the US is supposed to have witnessed in the run up to the financial crisis, Indian regulators have often been found to do excessive regulation and strangle of innovation. This issue can be addressed by giving regulators clear objectives, through enumerated powers. If the regulator simply wishes to ban something so that he does not have to witness any risk on his clock, the law will not give him the power to do so. He needs to demonstrate that the regulation is required to meet the objectives assigned to him, and is within his powers to do so, and that a cost benefit analysis of the regulation shows that the additional cost, monetary or otherwise, of complying to this regulation is going to bring clear benefits to the economy. The regulator would be hopefully restricted by the proposed accountability mechanisms not to prevent all innovation. Further, even if he does go ahead and issues regulations that do not meet the objectives that are given to him, the regulation can be challenged in a newly set up Financial Sector Appellate Tribunal.

Once the draft code becomes law, regulators would be required to write regulations in line with the powers and role given to them by the new law. The process may take time, but the framework provided by the FSLRC would lay the foundations of a well regulated modern financial system in India.

Wednesday, 20 March 2013

Caps unlock

Indian Express, 20th March 2013

Finance Minister P. Chidambaram is reported to be considering removing FDI caps in various sectors. The imperative for the removal of caps in sectors where they are below 100 is to attract capital flows to India in a situation where the current account is expected to be 5 per cent of the GDP. While FDI in multi-brand retail, pensions and insurance have become political issues, in other sectors such as credit information, asset reconstruction or private security agencies, where the issue is not political, it may be possible to remove restrictions more easily.

Even though it makes good economic sense to ease unnecessary capital controls at times when the country needs inflows, opponents often whip up fears of what might happen when controls are reduced. Instead, we need to determine what the objectives of controls are, the kind of controls that the country would like to keep, and which ones are detrimental and should be removed.

Capital controls, or controls on the cross-border flow of money for sale and purchase of assets, are imposed for three broad reasons. In largely open economies, concerns about terrorism or money laundering require that information be provided before money can be transferred across borders. When a country becomes a member of the Financial Action Task Force (FATF), it is required to pass laws that require it to prevent money flows from being used for such activities. These require financial firms to fulfil various know-your-customer (KYC) obligations. When India became a member of the FATF, it introduced these laws. The regulations in India that flow from these laws are, it has often been felt, far more stringent than in other FATF member countries, involving proof of residence and paper documents beyond proof of identity. While the excesses would need to be sorted, controls arising from FATF obligations will have to remain.

A second reason for capital controls is national security. Again, almost all countries in the world, including the most advanced ones, have laws that prevent foreign ownership of, say, ports, airports or other infrastructure facilities where the government feels that the security of the country may be compromised. For example, the government may choose to prevent FDI in a port by a foreign government or an entity owned by it, especially by a government it does not trust. Such capital controls are in place in India as well as in advanced open economies and it is unlikely that such restrictions will go away as long as national security remains an issue.

In addition to the above, capital controls have been seen, primarily in emerging economies, as tools for macro-economic policy. When emerging economies witness pressure on their currencies, they loosen or tighten capital controls. These controls are of many kinds. They include price-based measures or quantitative restrictions. Controls may be on various kinds of asset classes such as debt, equity, derivatives, bank capital, mutual funds or direct investment. Controls may differ according to whether residents or non-residents are investing. They may differ depending on whether they concern inflows or outflows.

Emerging economies often have many of the above kinds of restrictions. When the domestic economy is doing well, foreign inflows come in search of higher returns. This may lead to an upward pressure on the currency. In such situations, a country may impose controls on capital coming in. Similarly, when domestic business cycle conditions are bad, money may flow out, putting pressure on the currency to depreciate. The country may respond by imposing controls on outflows.

Whether such controls are able to reduce the pressure on the currency is still not settled. There is a large empirical literature examining whether controls achieve their objective at least for a short time and whether that is useful, considering the costs they impose. However, one thing appears to be clear - almost all emerging economies have slowly removed controls that permanently impede cross-border capital flows. The two exceptions are India and China. Countries such as Brazil have opened up their capital account, but have kept in place transparent price-based controls that can be imposed by the government.

In India, we have tied ourselves up in knots. Even at a time when the country needs capital inflows, it is not easy for the government to move at the required speed. The U.K. Sinha committee on capital controls documented the complex maze of capital controls that has taken the power of switching controls on and off, depending on the need of the hour, away from the government and into the hands of a number of financial regulators. Various financial sector laws and regulations treat foreign investors differently from Indian investors, with a bias against foreign investors. This has created a situation in which, even when macroeconomic stability requires that at a time when the flow of capital is weak, when the current account deficit is strong, when the government wishes to reduce capital controls, it is unable to do so.

Today, even when the FM does roadshows abroad, when he sends out the message that India wants to attract foreign capital, the experience of foreigners with the Indian financial regulatory system, the legal complexity and the tax uncertainty are such that capital does not flow in easily. As the experience after last year's Union budget showed, we cannot take foreign capital flows for granted. Considering how vulnerable a large trade account makes the country, it is not surprising that other emerging economies have got rid of the complex capital controls and moved to simple, transparent frameworks.

Hopefully, the finance minister will be able to attract more foreign capital as he proposes to. But it is equally important that the system of controls now be re-examined and rationalised keeping in mind the objectives they serve.

Tuesday, 5 March 2013

Budget has two faces

Indian Express, 5th March 2013

How a Congress-friendly budget also addresses the markets

Initial reactions to the Union budget, 2013-14, were based on an analysis of numbers as Finance Minister P. Chidambaram chose to represent them in his budget speech. The budget was seen as a tax and spend document - expenditure on the Congress's pet projects was increased, to be financed by higher taxes on the super rich. The budget was mostly in line with the Congress's politics of the last ten years. It was pro-rural poor and anti-rich.

The disappointment that followed was mainly due to expectations from Chidambaram, who was seen as more market-friendly than the rest of his party but had failed to present a budget that pushed investment and helped growth, or to defy the party line. Arguably, the budget was not more market friendly than that which could have been presented by any other Congress minister.

There seem to be two issues here. First, shouldn't it have been expected that the last budget before the elections would be one that represented Congress ideology? In the last ten years, the Congress has not portrayed itself as pro-business or even pro-market. It is only when the economy started slipping into a bottomless hole that the party brought in its most competent and most market-friendly cabinet minister to take charge. Chidambaram's job was to convey to the markets that it was not a complete return to the days of the licence-permit raj. But to expect that the Congress was ready to give up its agenda of welfare programmes, or the pro-poor, anti-rich image it has been trying to build, was perhaps unrealistic.

As a consequence, the budget essentially had to be a tight-rope walk between the instincts of the Congress and the needs of a government rapidly losing the confidence of industry, foreign investors and credit-rating agencies.

The second issue concerns the message of the budget speech. The reaction to the speech was perhaps what the finance minister calculated it would be. The budget would be seen as pro-rural poor and anti-rich. After all, in his speech, the minister chose to interpret his budget numbers as he liked. The speech was more Congress-friendly than market-friendly. But the same budget may have been used to convey a very different message - one of moving towards a smaller government and restricted spending on welfare schemes.

For example, in his Congress-friendly speech in Parliament, Chidambaram said: "I have been able to set the budget estimates of total expenditure at Rs 16,65,297 crore and of plan expenditure at Rs 5,55,322 crore."

A market-friendly version of the same numbers would have read: "I propose to allocate Rs 16,65,297 crore for total expenditure, thus raising expenditure by 11 per cent over last year's budget estimates. Since I expect the GDP to grow by 13.5 per cent in nominal terms, this means reducing the size of the government in the total GDP."

Similarly, Chidambaram said: "Hon'ble Members will be happy to know that plan expenditure in 2013-14 will be 29.4 per cent more than the revised estimate of the current year."

A market friendly version of the budget numbers might have read: "Plan expenditure in 2012-13 was budgeted to be Rs 65,000 crore. Owing to the difficult fiscal situation, I propose to allocate only an additional Rs 3,000 crore, or Rs 68,000 crore for planned expenditure in 2013-14. This will mean that the amount budgeted for plan expenditure will shrink in real terms."

Further, in his Congress friendly speech, the finance minister said: "The ministry of rural development steers a number of flagship programmes. We estimate that they will be able to spend Rs 55,000 crore before the end of the current year, and I propose to allocate Rs 80,194 crore in 2013-14, marking an increase of 46 per cent. MGNREGS will get Rs 33,000 crore."

A market friendly version of the same speech might have read: "Last year the ministry of rural development got a budget allocation of Rs 76,000 crore. This year I propose to allocate Rs 80,194 crore, a contraction in real terms. Expenditure on MGNREGS was budgeted to be Rs 33,000 crore in 2012-13. I do not propose to raise the allocation for MGNREGS in 2013-14. This implies almost a 10 per cent reduction in the allocation for MGNREGS in real terms."

This is not to say that the Congress is actually moving towards a smaller size of government. If there has been a contraction compared to what was proposed last year, there has been little change in the long-run growth path of government spending, at roughly 15 per cent.

Similarly, the tax on the super rich might yield less returns in terms of economics and more in terms of politics. The finance minister clearly ignored the advice of the chief economic advisor, who said, "higher and higher tax rates impinge more and more on incentives to undertake taxable activity, while encouraging tax evasion". Higher taxes on luxury goods, a surcharge on corporate income tax and dividend distribution may raise tax revenue in 2013-14, but it is unlikely to facilitate a good tax policy for the country in the long run. That can only come with a simpler tax code, fewer exemptions, increased compliance through a GST and lower taxes discouraging evasion. The increase in non-tax revenue based on spectrum sale and disinvestment may be able to finance the budgeted expenditure next year while keeping the fiscal deficit down, but it will not lay the ground for sustainable fiscal consolidation. The tight-rope walk of a finance minister trying to marry Congress ideology with the need for growth and investment in the economy cannot be a long-term strategy.