The global financial crisis has brought a fresh focus on the debate about Indian financial and monetary policy reform. There?s rough consensus, however, that the Percy Mistry and Raghuram Rajan committees? reports represent the most interesting ideas on such reform. There are seven key ideas in these reports. So, a good way to enter the reform debate would be to test how these seven ideas stand up in the light of the global financial crisis? First idea: Correct mistakes in the regulation of institutional investors. Institutional investors in India suffer from three problems: over-prescriptive and irrational rules, resource pre-emption by the government and high entry barriers. The crisis has not changed this analysis. Where there is legitimate criticism about (say) the conduct and regulation of US banks giving out home loans, the solution lies in better regulation, not a license-permit raj. Second idea: Change the flawed regulatory architecture. India has an alphabet soup of regulators. Most elements of the regulatory architecture were in place many decades ago (e.g. laws of 1934 or 1952), before knowledge of finance existed. This issue has been greatly amplified by the crisis, which was enabled by the alphabet soup of regulators in the US, which was inherited from decades ago. The US is now likely to go towards a cleaner regulatory arrangement?e.g. the unificiation of regulation of all organised financial trading into a single agency. This same reform proposal is now pending in India.
Third idea: Improve the legal framework. While India has a common law history, all too often, laws in India embed excessive detail. A new regulatory architecture will undoubtedly require new legislation (for RBI, DMO, PFRDA and Sebi). This new legislation needs to embody a more common law, ?principles based? approach where the law focuses on timeless principles. Firms should be held accountable for adhering to principles, which is a more demanding system of regulation as compared with check-box compliance of detailed regulatory checklists. The importance of this issue is amplified by the crisis, where financial firms (particularly in the US) exploited loopholes in the rules-based regulatory framework. It is interesting to note that the UK principles-based approach worked on one core issue: even a failed bank like Northern Rock had not given out bad home loans. Fourth idea: Make financial firms big. Financial firms in India are inadequate midgets, either by international standards or when compared with the needs of the new India. This is largely a consequence of the three difficulties described above. The way forward lies in multi-product conglomerates, such as ICICI or HDFC, which derive size and sophistication from operating in all areas of finance. This requires breaking the ?silo system? of Indian finance, where each regulator has a feudal notion of the companies that it ?controls?. This issue is unaffected by the crisis. India is the only silo system in global finance, and nobody internationally is planning to put finance into silos.
The IT example
Fifth idea: Remove tax distortions. Needless to say this is not affected by the global crisis. Sixth idea: Remove capital controls. Capital controls are to finance what tariffs or quantitative restrictions are to physical goods. Sophisticated and competitive corporations came about in India only when tariffs and QRs were largely removed. In similar fashion, the removal of capital controls is of critical importance to placing Indian financial firms under competitive pressure, which would then produce competence and dynamism. This issue is unaffected by the crisis. As an example, India?s IT companies were adversely affected by the global IT downturn of 2000-2002, but that does not imply that Indian IT companies should be walled off from the world. Seventh idea: Financial firms should be outwardly oriented. In the real economy, trade barriers have been removed, barriers to FDI have been removed, and Indian firms are now turning into multinationals. Such dynamism is the best way of ensuring that India achieves high growth, that Indian consumers are able to buy world class motorcycles or telephones. Indian financial firms must face competition (by removing capital controls and by removing barriers to FDI) and the best Indian financial firms should start turning into multinationals by expanding overseas. Only then can we know that India?s needs for financial services are being well served. This issue is again unaffected by the crisis.
For many observers, the crisis has ?demonstrated? that the erstwhile RBI approach to running a license-permit raj, to banning most parts of finance, was a good one. This sloganeering fails to carefully analyse the sources of the crisis, or the reforms proposals at hand in India. When a plane crashes, we carefully analyse why the plane crashed, identify the components to blame, and redesign. We do not discard the edifice of aeronautical engineering. In similar fashion, there is no question that mistakes were made that led to the crisis. These mistakes need to be understood and solved in the US and the UK. The crisis does not imply that the homegrown decade-long effort of understanding the problems of Indian finance, and solving them, must now be discarded.