Instead, I want to frame the issues in a broader context, that of rapid inclusive growth, the UPAs mantra. In an earlier column (October 2006), I reviewed some of the academic evidence for the importance of foreign capital in developing country growth. Academic studies are not sanguine about a positive link between the two, with FDI being a partial exception. This might suggest that CAC is not worth the risks it brings, of increased vulnerability to financial crises. On another front, Martin Wolf, the chief economic commentator at The Financial Times, has dismissed the goal of creating an IFC as being on par with the old dream of every developing nation to have its own flagship airline. Mumbai as an IFC, in this view, would only create an enclave within the economy, benefiting the already well-off.
To assess the competing views, one has to remind oneself of the role of finance in development, which is simply to facilitate the allocation of capital to its most productive uses. One can see why foreign capital might not be particularly productive if it is misappropriated or wasted by a domestic economy that lacks key institutions or complementary inputs. One can also see why an IFC might thrive without benefiting its hinterland if it simply improves the allocation of capital elsewhere in the world. In some ways, therefore, CAC and building an IFC are both carts that must be pulled by the horse of domestic financial development. Sometimes, the argument is made that pursuing these goals will create pressure for improvements in domestic financial institutions, and there is something to that view. Indeed, the development of Indias IT services industry was often decried in the 1990s as creating an enclave of the privileged in the economy. Yet, it has turned out to be very different, with substantial positive spillovers to the rest of the economy.
However, if the two goals of CAC and creation of an IFC are to be politically more palatable, it would be wise to draw out the implications for the domestic economy more explicitly. Of course, many of the recommendations of the Mistry Committee are completely generic in this regardfor example, those with respect to monetary and fiscal policy, and improving urban infrastructure. Others would benefit the domestic financial sector as a whole, such as those on taxation of the sector, or artificial segmentation that restricts competition. Perhaps the thorniest issues pertain to regulation of the sector. The Mistry Committee opts for principles-based regulation, which is particularly light-handed, along the lines of the current British approach. Yet, this may be asking for too much. Regulation in India still needs to move from discretionary, case-by-case decision-making to one with transparent, durable rules. Proper, effective rules-based regulation may be the immediate step that is needed. Many of the needed changes are detailed in the Mistry report, and it is these myriad relaxations and changes (far more than 48 broad recommendations) that need to be highlighted, sequenced and implemented.
The goal should be a regulatory regime that avoids arbitrary and temporary controls and bans, such as were needlessly added to the pure monetary policy instruments in recent attempts to control inflation. The goals of financial sector regulation should be universal, reaching all the way down to smaller firms, state and municipal governments, and even panchayats, and include better and more transparent accounting (the state governments are egregious offenders here), stronger disclosure requirements, reducing transaction costs, and greater competition on a level playing field. Of course, neither the Tarapore nor the Mistry committee was asked to pronounce on overall financial sector reform. And the points above have been made in previous committee reports on that topic. Yet, the Mistry report provides an occasion for revisiting these basic issues. Among all the other economic reforms, financial sector reform has certainly been important in driving and sustaining Indias rapid economic growth. Evidence from developing countries in general bears out the benefits of domestic financial sector development.
Indeed, there may be a case for multiple financial hubs to serve the domestic economy better. That goal would complement the creation of an IFC, support integrated financial sector reform, and gain political traction for implementation of reforms.
Nirvikar Singh is professor of Economics at the University of California, Santa Cruz