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- 1. Report of the High Powered Expert Committee on Making Mumbai an International Financial Centre
- 3. Report of the High Powered Expert Committee on Making Mumbai an International Financial Centre Ministry of Finance Government of India New Delhi
- 4. Report of the High Powered Expert Committee on Making Mumbai an International Financial Centre Ministry of Finance, Government of India, New Delhi This work consists of a printed book and release of its contents in PDF format in the world wide web, and are subject to copyright. All rights are reserved, whether whole or in part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on CDROM or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the Indian Copyright Act in its current version, and permission for use must always be obtained from Ministry of Finance, Government of India, New Delhi. Published by Sage India, B-1/I-1, Mohan Cooperative Industrial Area, Mathura Road, New Delhi 110044, India. Ministry of Finance or Sage India make no warranty of representation, either express or implied with respect to this work, including their quality, merchantability, or fitness for a particular purpose. In no event will Min. of Finance or Sage India be liable for direct, indirect, special, incidental, or conseqential damages arising out of the use or inability to use the work, even if Min. of Finance or Sage India have been advised of the possibility of such damages. The use of general descriptive names, registered names, trademarks, etc., in this publication does not imply, even in the absence of specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. c Ministry of Finance, Government of India, 2007. Printed in India by Typeset using PDFTEX and GNU/Linux operating system by River Valley Technologies, Trivandrum, India, http://www.river-valley.com. The main text font used is Minion and Frutiger for floats and headings. The TEX packages used for typesetting this book have been released under General Public Licence for free usage, modification and redistribution and are available at http://sarovar.org/projects/goi-book.
- 5. The High Powered Expert Committee ( HPEC ) on Making Mumbai an International Financial Centre The Hon. P. Chidambaram th February Minister of Finance, Ministry of Finance Government of India, North Block New Delhi Dear Honourable Minister: We submit herewith the ’s Report on Making Mumbai an International Financial Centre. Our choice of the term ‘International’ instead of ‘Regional’ has been explained in our report. Yours sincerely, M. Balachandran O. P. Bhatt C. B. Bhave Bharat Doshi K. V. Kamath Nimesh Kampani K. P. Krishnan (Convenor) Subodh Kumar Ravi Narain Ms. Usha Narayanan P. J. Nayak Aditya Puri N. Mohan Raj T. T. Srinivasaraghavan
- 7. Acknowledgements HPEC would like to place on record its grateful thanks to Ajay Shah, Kshama Fernandes, Saugata Bhattacharya, Ritu Anand, and S. Ravindranath who constituted the Research Team that supported the Committee. The also wishes to express its appreciation to Mr. M. Balachandran who put the facilities of the Bank of India at the disposal of the Committee. The and the Government of India would like to acknowledge their appreciation to the Bank of India for meeting the administrative expenditure for the production of this report.
- 9. Contents Executive Summary xiii . International Financial Services () and Centres (s) in Perspective, xiii.—. Implications for India and Mumbai, xiv.—. The difference between and , xv.—. What are International Financial Centres (s) and Services ()?, xvi.—. Growth and globalisation drive India’s demand for , xviii.—. India’s competitive advantages in creating an , xix.—. Financial regime governance: policy and regulation, xx.—. Reorienting the financial system towards provision: A temporal roadmap for reform, xxiv.—. Urban infrastructure and governance in Mumbai, xxviii.—. The choice, xxx. . The Emergence of IFCs: A brief history . Meeting cross-border trade, investment and other needs, .—. Evolution of international financial services () and centres (s), .—. The first round of globalisation: circa –, .—. An interregnum, the second round of globalisation (–), and beyond, .—. The ‘take-off ’ of second round globalisation after , .—. Classification of s, .—. Why did Tokyo and Frankfurt not emerge as credible s?, .—. The Race to establish more s around the world, .—. Implications for India and need for Mumbai to emerge as an , . . st Century IFS provided by IFCs . Fund Raising in s: What is involved? Who does it and how?, .—. Asset management and global portfolio diversification, .—. Personal wealth management, .—. Global transfer pricing, .—. Global tax management and cross-border tax optimization, .—. Global/regional corporate treasury management, .—. Global and regional risk management and insurance/re- insurance operations, .—. Global/Regional exchange trading of securities, commodities and derivatives in financial instruments and indices in commodities, .—. Financial engineering and architecture for large complex projects, .—. Cross-border mergers and acquisitions (M&A), .—. Financing for public-private partnerships (), . . Case studies: London, New York, Singapore, Dubai . Summary overview, .—. A closer look at the City of London, .—. New York/Chicago as the GFC for the Americas and the World, .—. Singapore as the /Asian GFC, .—. Dubai as a RFC for the Middle East and South Asia, . . Domestic and Offshore demand for International Financial Services (IFS) in India . Implications of a large, rapidly growing home market for IFS, .—. India’s growing integration with the world, .—. The impact of globalisation on demand and on s, .—. Estimates for consumption by India, .—. Projections for consumption by India, .—. Implications for India’s aspirations to create an in Mumbai, .—. customers outside India as a market for an in Mumbai, .—. International comparisons, . . Augmenting IFS provision via BPO . How does an produce ?, .—. An outsourcing approach to provision and IFC development: Possibilities, opportunities and pitfalls, .—. A opportunity: Asset management in Mumbai based on algorithmic trading, .—. IFS subcomponents amenable to outsourcing, .—. Making progress along two paths: Evolution and , .—. Conclusion, . . Market deficiencies in Mumbai that inhibit the provision of IFS . The context in which Mumbai must develop and evolve as an , .—. Inadequate currency and bond markets ( Nexus), .—. Missing currency & derivatives markets: An illustration, .—. The market weakness of institutional investors, .—. A cross-country comparison, .
- 10. x R M I F C . The macroeconomic fallout of an IFC . Introduction, .—. Implications for fiscal policy & deficit reduction, .—. Financing public debt differently, .—. The mutuality of interests in modernising debt management and having an , .—. Implications for monetary policy, .—. Outlook for the current account deficit, .—. Macro-stability for an , .—. The incompatibility of capital controls in a st century , .—. Full capital convertibility and an in Mumbai, . . Financial Regime Governance: Its role in an IFC and a comparative perspective . The intrinsic value of regulation for production, .—. Three levels of international competition on regulation and law, .—. Where does India stand? An illustrative bird’s eye view, .—. The overall legal regime governing finance, .—. Summary of cross-country comparisons, . . What are the limitations of financial regime governance? . Where do we stand? An – Market × Players matrix, .—. A pragmatic view of key areas for progress, .—. Lessons from applying competition policy in the real economy, .—. Artificial segmentation of the financial services industry, .—. Barriers to financial innovation, . . Why does financial regime governance have these limitations? . Why is the pace of financial innovation slow?, .—. Proximate underlying reasons that are not as transparent, .—. Deeper sources of dysfunction, .—. What impedes Mumbai from becoming an ? A summary, . . Reforming financial regime governance . A shift toward principles-based regulation, .—. Reducing the artificial segmentation of financial firms, products, services and markets, .—. Creating an environment conducive to exit, .—. Retail vs. wholesale markets, .—. The role of exchange-traded vs. OTC derivatives in the BCD nexus, .—. Regulatory impact assessments, .—. Strengthening the legal system supporting an , . . Tax policy for an IFC in Mumbai . Does India need an IFC or a Tax Haven?, .—. Tax policy for Mumbai as an : and, by implication, for India, .—. A modern income tax, .—. Taxation of financial transactions, .—. A Goods and Services Tax (GST) in Finance, .—. Mumbai as an IFC: Tax Implications for Maharashtra and Mumbai, .—. Interfacing tax policy and administration with the financial industry, .—. Stability of tax policy, .—. Where India Stands on taxes: An international comparison, . . A perspective on Mumbai’s strengths . Human capital needs for , .—. Democracy, Rule-of-Law and the Legal System, . . Urban infrastructure and governance . The importance of high quality urban infrastructure for an IFC, .—. Problems of cost, .—. Cross-country comparison, .—. Difficulties in Mumbai from an perspective, .—. Improving urban governance in Mumbai, . . The HPEC’s recommendations . The general macroeconomic environment, .—. Further Financial System Liberalisation and Reform, .—. The challenge of urban infrastructure and governance in Mumbai, . Selected Bibliography A. The Committee B. Comparing existing IFCs against Mumbai
- 11. Contents xi C. Comparing emerging IFCs against Mumbai D. Chronology of events associated with the effort by Benchmark Asset Management Company (BAMC) to start an Exchange Traded Fund (ETF) on Gold E. Activities of various financial firms in the areas of operation at an IFC: Wall chart . Fund raising, .—. Asset management, .—. Personal wealth management, .—. Global tax management, .—. Risk management, .—. Financial markets, .—. Securities markets, .—. Mergers and aquisitions, .—. Leasing and Structured finance, .—. Project financing, .—. Financing, .—. Insurance and reinsurance, . F. Abbreviations
- 13. Executive Summary 1. International Financial across borders: i.e. they are international Services (IFS) and Centres financial services ( ). A cross-border market for has existed over millennia. (IFCs) in Perspective But it has been transformed in the th and Historically, finance has always been th centuries and grown quite differently ‘international’ in character; capital has rarely and more dramatically since . It has also been immobile. Money has moved freely become extremely competitive, with buyers across borders for all of civilisation with gold and sellers around the world now having a and silver (in various weights and measures) choice of procuring from competing being global currencies for millennia. But, international financial centres (s). the freedom of capital was dramatically A concrete example of procuring curtailed during the ‘Bretton Woods’ regime, from an would be the raising of created in , when capital controls were debt. If Mumbai became an , a imposed on war-ravaged, capital-starved South African railway project could issue economies. With post-war recovery, that a bond there in the primary market. It regime broke down in . World finance would wish to do so because of Mumbai’s has since been reverting to its natural state sophisticated securities markets, along with with the removal of capital controls and the a number of asset managers in Mumbai gradual re-integration of national capital running global portfolios. If the bond and banking markets; but this time on a market was developed, the South African global scale. bond issue could be denominated. countries opened their capital Global investors would buy these bonds accounts between and . A number and trade them on the secondary market of emerging markets did so in the s in Mumbai. Each of these three steps – – often at the ’s urging. In , primary market bond issuance by the South the contemplated making an open African entity, primary bond purchases by capital account a condition of membership. global and Indian investors, and secondary But the idea was shelved when the Asian bond market trading by global players – financial crisis erupted in . That was would generate revenues from the export of precisely when India first contemplated re- financial services from Mumbai. Creating opening its capital account. A series of an in India requires that Mumbai must similar mini-crises occurred elsewhere in be viewed as competitive in the eyes of the engulfing Russia and Latin America. By South African railway and in the eyes of global bond investors, when compared with all these crises were contained. Capital alternatives like Singapore or London. account opening resumed but with reduced The global market in the st momentum as the and others began century is one in which competition is driven to reconsider its benefits and costs. The by rapid innovation in financial products, question of capital account convertibility services, instruments, structures, and now weighs heavily on China and India, arrangements to accommodate and manage where financial systems with structural myriad requirements, risks, and a ceaseless weaknesses, legacy constraints and varying quest for cost reduction. Competitive degrees of State domination now confront advantage in provision depends on the irresistible forces of globalisation. seven key factors: Even with an open capital account, some financial services (e.g. deposit . An extensive national, regional, global banking) remain local and non-tradable. network of corporate and government But most financial services are now tradable (supranational, sovereign, sub-sovereign
- 14. xiv R M I F C and local) client connections possessed involving complex judgment and intellectu- by financial firms participating in an alisation continue to be clustered at a few international financial centre (). physical locations, where key individuals . High level human capital specialised in meet face-to-face. This is characteristic of finance, particularly quantitative finance, R&D in computer technology – clustered in supported by a numerate labour force Silicon Valley and the Cambridge Corridor providing lower level paraprofessional – despite extensive use of email, voice tele- accounting, book-keeping, compliance phony and video conferencing. India has and other skills. achieved a minor miracle with the explo- sion of export revenues from services; . World-class telecommunications infras- tructure with connectivity around the yet, these revenues are a fraction of Silicon clock, and around the world. Valley’s. Similarly, routine production of financial services takes place everywhere. . State-of-the-art systems, capability But, the most important and high value to help develop, maintain and manage decision-making functions are concentrated the highly sophisticated and expensive in a handful of s that have effectively infrastructure of global financial (and consequently) become global cities firms, trading platforms and regulators; At present, London, New York and systems that are evolving continuously Singapore are the only global financial to help firms retain their competitive centres ( s). Many emerging s edge. around the world are aspiring to play a global . A well-developed, sophisticated, open role in the years to come: e.g. Shanghai financial system characterised by: (i) and Dubai. Other s in Europe and a complete array of proficient, liquid Asia, like Paris, Frankfurt or Tokyo, connect markets in all segments, i.e. equities, their financial systems to the world. But bonds, commodities, currencies and they have lost market share and importance derivatives; (ii) extensive participation in competing for global for reasons by financial firms from around the explained in the report. The world market world, (iii) full integration of market for is represented mainly by the , segments, i.e. an absence of artificially and Asia which together account for over compartmentalised, isolated financial % of global . Correspondingly the markets that are barred from having global market is concentrated in the operational linkages with one another; three s located in each of these regions. and (iv) absence of protectionist barriers and discriminatory policies favouring domestic over foreign financial firms in 2. Implications for India and providing financial services. Mumbai . A system of financial regime governance Given that an in Mumbai must be (i.e. embracing legislation, policies, rooted in (and serve) India’s financial system, rules, regulations, regulatory agencies rather than be an artificial offshore appendix, etc.) that is amenable to operating on the call for creating an in Mumbai at global ‘best-practice’ lines and standards; this time is implicitly a metaphor for (and and finally synonymous with) deregulating, liberalizing . A ‘hinterland advantage’ in terms of and globalising, all parts of the Indian either a national or regional economy financial system at a much faster rate than (preferably both) whose growth is is presently the case. Raising the issue of generating rapid growth in demand for an in Mumbai now suggests that the . pressing need for a new, more intensive phase of deregulation and liberalization of Advances in information and commu- the financial system has been anticipated nications technologies ( ) have eased by India’s policy-makers and regulators interactions over a distance and reduced their cost dramatically. However, activities To understand what such a city is see Sassen ().
- 15. Executive Summary xv and that the is a device to accelerate gap in capabilities that now exists between movement in that direction. An will Mumbai and established s. not be created quickly in Mumbai, nor will it succeed, if action on further deregulation 3. The difference between BPO and liberalisation is not taken in real time. and IFS In sustaining its trajectory as an emerging, globally significant, continental The production of financial services economy, the believes that India has worldwide is now fragmented into a series no choice but to: (a) become a producer of interrelated sub-processes undertaken and exporter of ; and (b) capture an separately. Business process outsourcing increasing share of the rapidly growing ( ) of individual processes occurs at global market. To achieve these a considerable distance from the point two goals, its financial centre in Mumbai of customer contact where their eventual must compete to become a successful resynthesis occurs. India is now a highly . Incremental growth in the global successful venue for the global financial market is now being driven by the services industry. In the last five years, it has growing demands of China, India and gone beyond simple towards complex A. With its strengths in human capital, knowledge process outsourcing or . This a globally powerful services industry, and is a positive development for India to realise its own hinterland, India has many natural its ambitions of creating an in Mumbai. advantages for competing successfully in this Finance-related / builds up skills market. In evolving as an , Mumbai will in India and increases the ‘mind-share’ of probably grow in two distinct phases: India amongst global finance professionals. However, there is a substantial differ- . In the first phase (–) Mumbai ence between / and providing must connect India’s financial system via an . Financial processes that get out- with the world’s financial markets sourced under involve low-value, low- through . That is what s like skill tasks. They are codified in a manual that Frankfurt, Paris, Sydney, Tokyo and a indicates how tasks are to be performed, con- host of smaller s do now in respect trols quality/integrity, and measures whether of their national economies. they are being done correctly. Once the pro- . In its second phase (–) Mumbai tocols are in place, the task is performed must develop the capacity to compete repetitively. But some outsourced activities with the three established s for in finance, involving research and analy- global business that goes beyond sis, are moving up the value chain. meeting India’s needs. After , For example, company financial analysis, would hope that Mumbai would hold its credit research, and stock market research own in competing with the other s functions are now also being outsourced. and acquire increasing global market Still, the real value in financial services share. provision remains concentrated in a small number of jobs performed by qualified, India’s financial services industry will super-numerate, imaginative people with not become export-orientated, nor derive the specialised expertise, experience, domain significant export-revenues, if Mumbai knowledge and skill-sets to be innovative fails to become an . That will in designing financial instruments and compromise not just export earnings from structures. Such people have extensive cross- , but the quality, efficiency and range of border networks of clients and colleagues. domestic financial services offered in India Their work involves fine judgment in as well. For Mumbai to become an , making decisions covering a vast array of India’s policy-makers and financial operators circumstances. It cannot be scripted in need to understand fully the nature of and a manual codifying its mechanics. Such opportunities in: the global market; judgments rely on intensive interaction, the activities undertaken in s; and the inter-personal information flows, and
- 16. xvi R M I F C complex negotiations among a number We categorise s in this report in four of highly qualified professionals including ways; i.e. as: financial experts, specialised corporate Global (GFCs ) These are centres that gen- lawyers, accountants, tax experts, etc. Such uinely serve clients from all over the interaction takes place at an . world in the provision of the widest From an Indian perspective, further possible array of ; progress with expanding the / chain in financial services (horizontally and Regional (RFCs) They serve their regional vertically) is inevitable and positive. But that rather than their national economies should not be confused with what is required (see below) – examples of such s would be Dubai or Hong Kong ; to provide the full array of via an . Intuitively, moving up from / to a Non-global and non-regional, ordinary inter- fully fledged is analogous to moving up national IFCs These are centres like from low-end programming to replicating Paris, Frankfurt, Tokyo and Sydney Silicon Valley. Incremental progress in the that provide a wide range of but Indian industry will not bring Silicon cater mainly to the needs of their na- Valley to India; that requires a quantum tional economies rather than their leap. Similarly, doing more / regions or the world – one might be for the global financial services industry tempted to call them national s al- will not, as a matter of course, result in though that term is an awkward one because its two defining adjectives are India automatically graduating to providing contradictory; and through natural evolution. / will be done by specialised sub-contractors Offshore (OFCs) These are centres that are with different skill sets and competencies. primarily tax havens for wealth man- can only be provided by qualified agement and global tax management and internationally known financial firms; rather than providing the fully array which is what Indian financial firms must of . quickly strive to become. India’s growth in The products and services that / is about doing more through s provide include the following eleven services firms (like Infosys, Satyam, Wipro activities. s provide all of them. Other or ). India’s growth in is about s provide some combination of them. exporting through established and new financial intermediaries. a. Fund Raising: for individuals, corpo- rations and governments (sovereign and sub-sovereign). This includes debt 4. What are International and quasi-debt across maturity/currency Financial Centres (IFCs) and Singapore and London are also regional in the Services (IFS)? sense that they serve Asean and the while New York Financial centres that cater to customers serves North and Latin America. But because these three centres serve the global economy, well beyond outside their own jurisdiction are referred to meeting the needs of their respective regions, we as international ( s) or regional ( s) classify them as global rather than regional. In that or offshore ( s). These three different sense, the sees limited potential for Mumbai adjectives are often (but wrongly) used to be a regional financial centre for South Asia given current geopolitical realities. South Asia is more likely synonymously in the literature. Yet these to be served by Singapore and Dubai for the time being. three types of s are difficult to define We see Mumbai being an that serves India in the in a clear-cut, mutually exclusive fashion; first stage and leapfrogs to serving the global economy in its next stage of evolution. Ironically, Mumbai as an although they are quite distinct. All these is likely to serve its region after it serves the world, centres are ‘international’ in the sense that rather than before. For that reason, although the they deal with the flow of finance and was asked to look into Mumbai becoming a regional financial centre we dispensed with that characterisation financial products/services across borders. early on in the knowledge that it would be misleading. But that description does not differentiate Throughout this report therefore we refer to Mumbai them sufficiently in terms of their scope. becoming an international rather than a regional FC.
- 17. Executive Summary xvii spectra; equity and quasi-equity for pri- will become increasingly important to vate, public and public-private corpora- Indian firms as they evolve into s. tions; as well as risk-management appen- f. Global/Regional Corporate Treasury dices attached to primary fund-raising Management Operations: involves transactions to ensure that the risk expo- fund raising, liquidity investment and sure of the primary borrower or fund- management, asset-liability and dura- raising entity (to currency, interest rate, tion matching, and risk-management credit, market, operational and political through insurance and traded deriva- risks) does not exceed tolerable limits. tive products for currency, interest-rate, b. Asset Management and Global Port- credit and political risk exposure. folio Diversification: undertaken by a g. Global/Regional Risk Management Op- variety of national, regional and global erations and Insurance/Re-insurance: asset managers including, inter alia pen- which involves highly developed ex- sion funds, insurance companies, in- change traded and tailored derivatives vestment and mutual funds of various (futures, options, swaps, swaptions, caps types characterised by nature of instru- and collars) as well as world class deriva- ment (i.e. debt, equity or convertibles), tives exchanges that trade a variety of geography, or sector of activity. global contracts. c. Personal Wealth Management (PWM): h. Global/Regional Exchange Trading of for high-net worth individuals (s). Financial Securities, Commodities and This activity is estimated to involve the Derivatives Contracts in Financial In- management of personal assets of $– struments/Indices and in Commodi- trillion worldwide. Overseas Indians ties: There is an increasing tendency to- are estimated to hold financial wealth ward multiple listings of financial securi- (i.e. apart from real estate, gold, art, ties (equities and debt), and of derivative etc.) of over $ billion and total and commodity contracts, on different wealth of over $ trillion. PWM takes exchanges with emerging investor de- place in established s, but is more mand for x x trading of all listed skewed towards specialised -s securities across all exchanges. Demand in the Channel Islands, Switzerland, is highest for the securities of index- Luxembourg, Monaco and Lichtenstein corporations in each major capital mar- for the and Africa; Caribbean ket. It will gradually cascade downwards offshore centres for the and Latin to cover global trading of all listed se- America; Bahrain and Dubai for the curities in all markets – developed and Middle East; Singapore, Hong Kong and emerging. Mumbai is better placed than some Pacific Island offshore centres for most s to meet this demand, because East/North Asia. of its human capital and capability, d. Global Transfer Pricing: This is an as well as its world-class exchanges and activity that o, like most governments, improving exchange regulation. looks askance at, but needs to realise i. Financial Engineering and Architec- and accept the reality of, in a global ture for Large Complex Projects: This economy dominated by transnational primarily involves energy and infras- corporations. This will become tructure projects requiring funds from increasingly important to Indian firms a variety of global sources (public and as they evolve into multinationals. private) with attached risk-management. e. Global Tax Management and Cross- Again, Indian financial institutions and border Tax Liability Optimisation: former FIs have well-honed skills in this which provides a business opportunity particular arena. for financial intermediaries as well as j. Global/Regional Mergers and Acquisi- accountants and law firms until national tions Activity: This will become increas- tax regimes begin to converge toward ingly important in India and for which a global low tax norm. This activity a considerable amount of back-office
- 18. xviii R M I F C / and due diligence research limits set by RBI. The ability of Indian work is already being outsourced to In- households to move resources across the dia. border has increased with India’s increasing k. Financing for Global/Regional Public- openness. The proliferation of Indian s Private Partnerships: This relatively operating around the world – and transfer new activity has emerged on scene with pricing with their subsidiaries abroad – considerable force since the development has led to demand for fund-raising, of the London Underground PPP. It has corporate treasury management and global particular and immediate relevance for tax management. With rapidly increasing the financing and rapid development of annual flows, the stock of assets outside the Indian infrastructure without recourse country controlled by Indian households to the treasury. and firms is rising rapidly. These assets require for wealth, asset and global 5. Growth and globalisation tax management. All these phenomena imply inevitable increases in purchases drive India’s demand for IFS associated with the growing size of cross- Since , India has grown rapidly and its border flows. Calculations in this report economy has globalised. As India grows, suggest that on average, the revenue it globalises faster. That happens through stream works out to % of the gross flows the increased share of trade and foreign across the boundary. investment in economic activity. Evidence of This translates to about $ billion of that lies in two-way cross-border flows. Such IFS purchases by Indian clients in . flows, on the current and capital accounts Looking ahead, India’s engagement with combined, rose from $ billion in the world will intensify in three ways: (a) (<% of ) to $ billion in reduction in barriers such as customs duties (>% of ). The forces that resulted in and capital controls; (b) improvements in this six-fold increase are intensifying and will infrastructure; and (c) greater participation further accelerate growth of cross-border by s (Indian and foreign) in the Indian flows. The next decade is likely to see cross- economy. These developments will induce border flows growing as fast. deeper globalisation of the Indian economy Current and capital account flows in- in the coming decade, inducing an upsurge variably necessitate purchases of . For of purchases. example, current account transactions in- Our estimates suggest that IFS pur- volve payment services, credit enhancement, chases by Indian households and firms will currency risk management, etc. Capital ac- rise to $ billion by on the basis of count flows involve purchase of investment conservative assumptions in a ‘base-case’ banking, legal, accounting, risk manage- scenario. Under more propitious circum- ment, research and other similar services. stances (e.g. if GDP growth is sustained at When / enters or exits India, fees %) that figure could be over US$ billion. are paid to various providers (e.g. com- By that amount could exceed US$ mercial and investment banks, securities billion in nominal terms. brokerages, exchanges, insurance compa- These estimates warrant a different way nies, asset managers, etc.). As India engages of thinking about exports and about more with the world, the stock of assets held an in Mumbai. Traditional conceptu- in India by foreigners rises. Similarly, the alising by Indian exporters about market stock of foreign assets held by Indian house- opportunities typically assumes tapping into holds and firms also rises. Purchases of risk a quasi-infinite world market. Financial ser- management services grow in proportion to these stocks which are far larger than the This was the approach taken by the Indian software capital flows of any one year. industry which now has domestic sales of a mere $ million while its exports are a -fold multiple of It is estimated that Indian households roughly $ billion a year. The search for growth on have accumulated considerable wealth the part of firms like , Infosys or Wipro has been outside the country; well beyond the present primarily about finding international customers. The
- 19. Executive Summary xix vices are like software services in that they are exists for Indian financial genius to achieve labour, skill, /communications intensive. similar export success in world markets; But, in terms of market opportunity, there is but with one key difference. India’s own a fundamental difference between finance growth and globalisation, and consequent and software. It lies in India’s hinterland domestic demand for , generates natural advantage. Rapid growth, even more rapid opportunities for producers in India integration with the rest of the world, and (local and foreign) to acquire skills and the high consequent growth rate of two-way exploit economies of scale. Indian software cross-border financial flows now being seen, exports required an enabling framework all serve to make India a large and growing from the State in the form of telecom customer for . Unlike service exports, reforms. Indian exports will require India provides a platform for nurturing a similar enabling framework from the capabilities that can ‘go global’ instantly. State. Deeper and wider reforms and Against that growing demand for , a improvements are needed in: (a) India’s failure to respond on the supply-side, (i.e. financial system and the way it is governed by creating a successful in Mumbai) and regulated; as well as (b) Mumbai’s urban will simply oblige Indian customers to infrastructure and political/administrative do increasing business abroad. That governance on a scale not yet envisaged. will fuel the growth of Singapore, Dubai, London and other s while depriving 6. India’s competitive Mumbai of capturing opportunities for high advantages in creating an value-added exports. For example, IFC the Tata Steel-Corus deal generated revenues in Singapore and London. Some Hinterland Advantage: As argued above elements of such transactions do not appear the growth of the Indian economy in Indian BOP accounts. Financial firms and and more rapid growth of cross- policy makers in the three s and border financial flows have created are highly attuned to the opportunities substantial local demand for . This for selling into India. They have ‘driver’ supports the development of embarked on strategies that exploit the skills, and generates economies of current infirmities of the Indian financial scale on the part of financial firms system. The most capable Indian financial operating in Mumbai. China has the firms are likely to move to these centres in same hinterland advantage. New York order to acquire the flexibility to provide has the North American economy as their extant client base with the they its hinterland. London has the even need, rather than risk losing their clients to larger economy, as well as its own global financial firms. national economy, to serve. Singapore Rapidly growing demand for in has a limited national economy. But it is the financial epicentre of an India provides an opportunity for its A regional economy that is financial services industry that its software almost as large as China and larger industry never had. Indian software exports than India. Dubai does not have were generated by ingenious Indian human that kind of national or regional capital exploiting foreign markets and economy. But it is located in a region requiring nothing from the State other that is generating enormous financial than telecom reforms. Indian genius surpluses for investment abroad. conquered world markets between and Human Capital: India has four strengths in a way that was not imagined in even by way of human capital endowments the most optimistic forecasts of . In that give it a competitive edge over the case of , an identical opportunity Shanghai, Singapore and Dubai: • The extensive use of English, domestic market does not loom large to the s of these firms, and played no role in their graduating into which is the lingua franca of export-oriented MNCs. international finance
- 20. xx R M I F C • Generations of experience with upholding liberal values, protecting entrepreneurship, speculation, property rights and maintaining trading in securities and deriva- political stability. It fares well tives, risk taking, and accounting. compared with China, Singapore or Indeed the ability to provide Dubai but does not match London or seems to be genetically coded into New York. Indian finance professionals Mindshare: High growth, the • Strong skills in information tech- / phenomenon, and the nology and quantitative thinking success of Indians in global finance all over the world, ensure that India • Individuals of Indian origin play has significant ‘mindshare’ at policy- a prominent role in the top making levels in global financial firms. global financial firms. They are India has an edge over Singapore and well-positioned to intermediate Dubai, and perhaps even over China, between the business strategies of in this respect. these vital firms and the genuine strengths and weaknesses of India Strong securities markets and advanced trad- as an . ing platforms: India has the foun- dations for providing global by Location: Mumbai is well located in being virtue of its dynamic, technologically able to interact with all of Asia capable securities trading platforms and Europe through the trading day. in the and . These are the Apart from the Americas, transactions rd and th biggest exchanges in the with most of world can occur world measured by number of trans- in daylight. Given the remarkable actions. India has an edge over China and growing role of London in and Dubai, but not over Singapore, in providing global today, India has this respect. the advantage of having a – hour overlap with London time. There is Taking these formidable advantages into no operating within an hour’s account, the initial conditions supporting variation of the Indian Standard Time India’s entry into the global market for zone. India has an edge over Shanghai, are promising; especially when compared but not over Dubai, in this respect. with the early days of software exports Democracy and Rule-of-Law: Properly from India. In the latter case, there was functioning financial markets require no hinterland advantage, location did not a constitutional basis and machinery matter, democracy did not matter, and there for system governance that is stable, was no beach-head. The six comparative reliable, resilient and flexible; i.e. and competitive advantages that India has, one that reduces future political suggest that there is a genuine opportunity risks and uncertainty. Globally for India to create a viable able to credible financial systems need to compete with the best in providing to be rooted in legislative, judicial, and the Indian and global markets in a short span regulatory frameworks that adhere of time. But, it confronts some daunting to rule-of-law and respect/protect challenges. Our report highlights these in property rights; in principle and detail. They include: (a) financial regime in practice. can be provided governance in India; (b) missing markets credibly only from environments that and institutions and (c) urban facilities and permit open and honest expression governance in Mumbai. of independent views by portfolio managers, analysts, commentators, 7. Financial regime governance: researchers, etc. even when such views policy and regulation contradict those of governments and powerful personalities with a vested A sound basic framework for develop- interest. India has proven strengths in ing/applying law and regulation are intrinsic
- 21. Executive Summary xxi to . The quality and credibility of traded volumes – in all areas other than provided from India is inextricably linked to equities. A normative rule-of-thumb the soundness and global acceptability of the would suggest that the traded volume regulatory/legal system that governs finance of an exchange-traded futures contract in India. Global competition in is, to in India should be at least one-tenth the an extent, a function of global competition turnover of a corresponding product in (in terms of reputation, capability, efficiency the . By this yardstick, the turnover and effectiveness) among regulatory regimes of Nifty futures is about that size. But and the institutions that apply those regimes. that is not the case for almost all of the The market share of an is determined as top underlying contracts in the . much by the quality and reputation of its • An inadequate universe of institutional regulatory/legal regime as by the abilities of investors: The second deficiency in its financial firms. A cross-country assess- India is a universe of institutional ment suggests that India is weak on many investors that have the size, visibility aspects of the legal and regulatory frame- and capability of those in established work governing its financial system which s. The progress made so far the report discusses in detail. The report with liberalisation has been based also identifies two key strategic institutional largely on speculative price discovery (or structural) weaknesses in Indian finance by non-institutional investors in equity that impede production: markets. Other segments are dominated by state-owned entities which are • ‘Missing’ Debt, Currency, and Deriva- bound by restrictive rules. Banks and tives Markets: The most critical finan- insurance companies are restrained, if cial market components missing in In- not banned, from undertaking risk- dia are: a properly functioning bond hedging activities and other kinds of market, a currency market and a deriva- sophisticated business due to regulatory tives market for currencies and inter- restrictions. Consequently their assets est rates. These three interlinked mar- are growing too slowly. kets are termed collectively as the bond- Indian financial firms tend to operate currency-derivatives ( BCD ) nexus in in one key business segment at a this report. Six specific deficiencies time. Their portfolios are narrowly in this respect include the absence of: confined and concentrated; so is their (a) a liquid and efficient sovereign risk exposure. That has stunted their bond market with an arbitrage-free growth, imagination and ability to yield curve, (b) a wide range of handle risk. Indian financial firms now essential derivatives on interest need to evolve into full fledged large, rates, (c) a liquid spot market for - complex financial institutions (s in denominated corporate bonds, (d) credit Basel parlance). They need to operate in derivatives on credit spreads or credit all financial market segments of finance events, (e) a liquid currency market and to come up with credible offerings (f) a full range of currency derivatives. and ‘packages’ for the export market. Under a functional nexus, all India lacks domestic commercial and six elements are based on vibrant investment banks capable of taking on speculative price discovery, and are global counterparts without higher levels tightly knitted by arbitrage. They of capitalisation, global market access, interact to result in market efficiency. operational expertise, and high- There is no successful that lacks such level human capital. India also lacks a nexus. Its conspicuous absence large securities brokerages capable of in India handicaps the country’s ability competing with global counterparts. to provide . Another shortcoming India’s brokerage industry reflects the is the inadequacy of India’s spot and infirmities of its retail sector as a derivatives markets – in terms of the whole. It is characterised by too variety of contracts traded and their many small, undercapitalised, limited-
- 22. xxii R M I F C capability firms (brokers and sub- regulation. There is no that has so brokers) that are mostly still single compartmentalised an approach to the proprietorships in corporate form. structuring, management and regula- Structural reforms are required urgently tion of its financial markets. Reversing to create Indian financial firms that are counterproductive segmentation of fi- equivalent in size and capabilities to nancial markets in India, and removing global counterparts. Looking ahead, barriers to entry, would result in greater: if India is to create an , there is no economies of scale/scope, competition, escape from inviting the participation and global market-reach. of domestic and foreign institutional • Inhibiting Financial Innovation: investors of adequate size, who would Whether an should be created for deploy the economies of scale, global India to catch up with the world, or to ex- market-reach and efficiency-enhancing ploit comparative advantage in a global behaviour that is evident at other s. market, a considerably faster pace Why does India have these weaknesses? of financial innovation in India is essen- Close scrutiny of the regulatory regime tial. But, financial regime governance in examines the origins of these infirmities India can only cope with change slowly. through a matrix that identifies and analyses The regulatory approach to any change restraints on the activities of different in the structure or functioning of the financial firms in providing various . financial system is conservative, cautious Such a matrix has been prepared as a and inconducive to innovation. As a ‘wallchart’ for this report. It outlines result India falls behind international activities that take place at s and practice by the day in every market seg- the kinds of financial firms that typically ment. The default signal emitted by undertake them. A careful analysis of this Indian regulators when faced with any wallchart reveals that, at present, most of new idea seems to be set at ‘amber’ if not the activities that take place at s ‘red’. Innovative instruments, contracts are banned or severely proscribed in India. and new ways of doing business are acted The red ink across the wallchart – signifying upon in days in the three s. Such activities banned in India – portrays the a pace of rapid progress is not found license-permit-control raj that still operates in India. Basic contracts like interest in Indian finance. It retards development rate futures and options have failed to and sophistication of the financial sector materialise in this climate. and inhibits exports. A pragmatic view of these constraints highlights three urgent, Deregulation and liberalisation through cross-cutting priorities for reform: the s have largely unshackled India’s manufacturing sector, and much of its • Competition Policy: India’s experience real economy. Competition, innovation with liberalisation in the real economy, and scale economies in these sectors are suggests that the most powerful tool for no longer blocked by the State. Yet, having efficient and well-functioning somewhat dissonantly, a much higher degree firms is competition. Application of of control continues to operate in key sound competition policy in all market parts of the financial sector; despite the segments of India’s financial sector is many regulatory reforms of the s. This now a matter of urgency. financial governance regime now needs to • Compartmentalisation of the Finan- be overhauled to create a more modern cial System: Global competitiveness re- governance regime. It does not need quires exploiting fully the economies traditional fine-tuning with the extant of scale and scope. India’s hinterland regime remaining largely intact. advantage represents an opportunity Regulatory reform has had a positive to exploit such economies. However impact on the functioning of India’s capital Indian finance has been artificially frag- markets and the insurance sector. In the mented by financial sector policy and capital markets, India has achieved global
- 23. Executive Summary xxiii standards in some aspects. Other financial in Mumbai. The goal of public markets lag behind in not yet having been policy is to foster high economic growth reformed as widely or deeply. Despite the and enhance welfare in India; it is not presence of a large number of different types to cater to the interests of Indian firms of banks, and despite incremental measures or their shareholders. But, in saying aimed at ‘opening-up’, the banking market this, the is mindful of the reality in India has yet to improve substantially that developments during the last decade in competition, innovation and efficiency. have resulted in a debilitating anomaly The improvements achieved at the margins for Indian financial firms versus their have not yet permeated the banking system foreign competitors. In manufacturing, as a whole. They are unlikely to, without the removal of barriers to imports was a major reformative push and diminished accompanied by a simultaneous unshackling public presence. of Indian firms. Indian firms were exposed For that reason, a dramatic change to greater competition from imports and in the governance regime for all financial the entry of foreign s in domestic markets in India is now imperative. Without market space. But they were, simultaneously, it India will not be able to create an given a transitional period and considerable innovation-orientated financial system freedom in terms of formulating business that can evolve and compete at a pace strategies and innovating. commensurate with changes in the Indian The evolution of Indian finance, economy and global finance. Such a in contrast, has resulted in growing system would have the following activities dissonance between external competition undertaken on a par with global norms: and a repressive license-permit raj. India’s (a) continual innovation and improvement long and tortuous evolution towards de facto in the design of financial products and convertibility (which in some respects is customer services as well as in their delivery; not dissimilar to tariff reductions in the (b) the rapid reintegration of segregated real economy) has not been accompanied financial markets into more liquid and more by Indian financial firms being given the integrated markets; and (c) the rapid growth same opportunity and room for manoeuvre and market-induced consolidation of Indian to develop their competitive capabilities. financial firms in a manner that enables They are at a disadvantage in coping with them to achieve economies of scale. competition (for their clients’ business) For this to be achieved, Indian financial from global providers operating in India system regulation needs to be brought up and from abroad for two reasons: to world standards. Regulatory attitudes, • First, key financial markets (i.e. the policies, practices as well as institutional nexus and risk management) have arrangements need to undergo a sea- been prevented from developing in India change. They need to become more because of regulatory restraints. That attuned to, and supportive of, the dynamism, has resulted in Indian financial firms not growth and global competitiveness of the having the opportunity or the time/space Indian financial services industry. Policy to develop domain knowledge and skill- and regulation must adjust and adapt to sets in crucial areas e.g. global fund- the needs of Indian and global financial raising or developing sophisticated risk markets. Financial markets should not management products/services tailored be artificially fragmented, segmented, to client needs. compartmentalised. • Second, the same regulatory restraints This report does not advocate using have deprived Indian financial firms of the hinterland argument as a reason the freedom they need to develop and for protectionism. Nor is the the necessary flexibility in formulating making an argument for ‘self-sufficiency’. global business strategies. They have not Instead the believes that India and had the scope for innovating for and Indian financial firms should be globally thus developing the skills required to competitive in providing through an compete with global providers.
- 24. xxiv R M I F C The is clear that, in providing debt of centre and states, including on- from India, there is no case whatsoever and-off-balance-sheet liabilities (such for protectionism. The interests of Indian as pensions) and endorses a lower customers, and that of economic efficiency, level (than the present %) for the are best served by enabling them to choose total consolidated public debt-to-GDP from the best providers in the world. ratio. A public debt ceiling should be But, the asymmetry in policy that has placed bolstered by flexible triggers for actions Indian financial firms at a disadvantage, to be taken by the Ministry of Finance underlines the case for phasing reforms (e.g. accelerated sales of public assets aimed at creating capabilities in a whose proceeds are used to liquidate manner that enables Indian financial firms outstanding public debt if that is deemed to be similarly unshackled in competing to appropriate) when the adopted debt provide . ratio ceiling is breached. While the did not wish to recommend a particular debt ceiling ratio without 8. Reorienting the financial looking more deeply into the matter, system towards IFS global experience suggests that ratios in provision: A temporal the range of –% are widely applied roadmap for reform as prudent. Such a debt ratio should be added to existing measures for The strategy proposed in this report for deficit and debt reduction. creating an comprises in essence a ten- For an Indian to be credible, in point agenda: keeping with ‘best-practice’ worldwide, . Macroeconomic (i.e. Fiscal and Mone- India’s central bank should be indepen- tary) Management. dent and separate from government. It As a new competitor in global must be independent and separate from financial markets, the credibility of government; i.e. in the same way that India’s macro-economic policies, and the Federal Reserve in the , the the quality of its macroeconomic and in Europe, the various national central financial system management, will be banks of Europe and Japan, and the Bank judged more stringently than in the case of England, are independent of and sepa- of established s. This asymmetric rate from their governments. The central reality highlights the importance of bank must employ global best-practices redoubling efforts in reforming policies, in the conduct of monetary policy, in legal and institutional arrangements to order to suffuse international investors achieve and sustain a high growth rate and issuers with growing confidence in (–%) for the economy in general and the as an acceptable global currency the financial sector in particular. for transactions. The level of con- Creating a vibrant, competitive fidence engendered should permit the in Mumbai will require, as an integral to become one of the world’s major backdrop, success in meeting the reserve currencies by or at the legal commitments entered into by latest. the Government of India, and the The gold standard for a stabilising governments of individual states, to monetary policy is a transparent, reduce the consolidated fiscal deficit on independent, inflation-targeting central the timeline announced. In addition, it bank. With such an arrangement the will require (a) reducing the total public Indian State would be: (a) underlining debt/ ratio to more acceptable its commitment to delivering low and levels; and (b) pursuing sound fiscal predictable inflation; and (b) inducing and monetary policies thereafter. greater confidence in the in the eyes HPEC therefore recommends that of domestic and global investors. The further action should be taken to recommends that the Ministry reduce more rapidly the consolidated of Finance consider: (a) reforming
- 25. Executive Summary xxv monetary institutions in the light There is considerable unmet global of recent developments in monetary demand for bonds on the part economics; and (b) doing so in a way of long-term institutional investors that bolsters the case for a credible such as foreign pension funds. A in Mumbai. rapidly emerging bond market also recommends a fresh look would trigger currency trading in India at applying key principles in guiding and foster the use of currency reform of the tax system on the revenue and interest rate derivatives. That side, to ensure that India remains would facilitate the evolution of the globally competitive, and avoids price as a global currency, used as distorting subsidies on the expenditure a numeraire by bond investors and side. This has particular implications for issuers from India and around the ensuring that inflation-targeting is not world. Internationalisation of the distorted or rendered ineffective because (a prerequisite for a successful in subsidies (e.g. for key energy prices) Mumbai) would expand transaction emit the wrong inflation signals. volumes in India’s bond, currency . Strategy for Public Debt Financing. and derivatives markets, as well as Traditionally, India has eschewed its equity and commodity markets, bond issuance outside the country, fear- coterminously. It would expand the ing the currency risk that arises with range of financing options open to, issuing forex bonds while having and seignorage revenues derived by, the revenues. This risk of ‘original sin’ does Government of India and its central not arise if denominated bonds bank. are sold to meet foreign demand for . Creation of the BCD Market Nexus. such debt. The HPEC therefore advo- The most important missing piece cates opening up fully to foreign invest- in Indian finance is the nexus ex- ment in INR denominated sovereign plained earlier: i.e. the set of interlinked bonds issued by GoI . It further recom- bond-currency-derivatives markets for mends that no limits should apply to spot and derivative instruments on in- purchases by foreign clients of INR de- terest rates, currencies and credit risk. In nominated corporate bonds or bonds order to ignite these markets, HPEC rec- issued by sub-sovereign entities (states ommends the immediate creation of a and metropolitan administrations). In currency spot market, with a minimum addition, the HPEC believes that the transaction size of Rs. million, acces- function of a public debt management sible to all financial firms. In addition, office should be placed in the Ministry an INR -settled exchange-traded cur- of Finance rather than in a regulatory rency derivatives market should be cre- institution to avoid any perceptions of ated, with trading in futures, options conflicts-of-interest. and swaps on currencies, accessible to This would achieve two goals. First, it all. would open up a new financing channel These two initiatives, along with for o (and state and municipal developing more rapidly the spot governments as well) thus enabling market for bonds, need to be merged it to abandon repressive policies that into the existing securities exchange pre-empt domestic savings with an ecosystem so as to trade alongside array of undesirable and unintended the spot and derivatives markets for consequences (e.g. crowding out and equity. The policy problems that undue pressure on the interest have held back interest rate futures rate). Second, the internationalisation need to be rapidly resolved. The of bonds (issued by the sovereign, responsibility for regulation of these sub-sovereigns and corporates) would markets – spot or derivatives; exchange accelerate the emergence of an Indian or ; government bonds, corporate on the world stage. bonds, and currencies – needs to be
- 26. xxvi R M I F C moved to without further ado . Create wholesale asset management and unified with the regulation of businesses with freedom for outsourc- all organised financial trading. The ing by existing financial firms such as goal should be to create and launch a banks or insurance companies. This significant nexus, in conformity would separate the legal and contrac- with world standards, within months. tual structures through which assets . Financial Market Integration and are sourced and securities are created Convergence vs. Market Segmentation – across multiple front-ends across the country – from the ‘factories’ in Indian finance suffers from a frag- which assets are managed. It would mented approach whereby the overall also achieve economies of scale in financial industry has been cut up into asset management. pieces reflecting legislation that is out- dated by years or more. exports . Shift away from regulation by entity will not take place as long as the com- to regulation by domain. As an petencies of Indian financial firms are example, IRDA would regulate only artificially stunted. India now needs its the insurance business, not all the own s present in all lines of busi- activities of insurance companies. ness, and able to achieve economies of . Principles-based Regulation scope and scale. A series of measures Over the decades India has built are needed to achieve market integra- up a license-permit raj in finance. tion and convergence, and thus enable It over-emphasises compliance at the economies of scale, economies of scope, expense of competence, competition greater competition and enhanced IFS and innovation in financial services. export capability, i.e.: A similar raj dominated the real economy since independence. But . Redraft the legal foundations for it was dismantled during the s organised financial trading, so as to the immense benefit of the Indian to unify all organised financial economy and particularly Indian global trading under regulation. This competitiveness. To achieve the same would include currencies, equities, objectives, that raj in finance now needs sovereign and corporate bonds, and to be dismantled if India is to develop commodity derivatives. It would provision and export capabilities immediately diminish some of the and if an is to emerge in Mumbai. fragmentation which has taken place At present financial regulation in In- amongst financial firms. dia is fragmented and rules-based. It is . Remove barriers to a holding over-prescriptive and restrictive of man- company structure through which agerial discretion. In every market seg- virtual financial firms can be created, ment, regulators attempt to codify every with an array of subsidiaries that fit detail of a business in which the shape of Indian regulatory constraints but the future can neither be anticipated nor with corporate headquarters and predicted. Anything not explicitly per- top management able to operate mitted is banned. Any proposed change a unified financial firm. The in the way of doing business requires holding company would be regulated clearance from the regulator. Supervi- only by the Companies Act. It sors apply checklists in verifying that would typically be listed and able to every rule is met while not quite un- leverage itself; while its subsidiaries derstanding all the dimensions of the might be unlisted. All barriers to business possibilities of the regulated M&A in finance need to be identified entity and how it might evolve. This and removed, so as to achieve approach is inflexible and unamenable a market-induced consolidation to swift adaptation of a kind that the process which would permit Indian world of global finance demands. This s to emerge. is counterproductive for the purposes