The charges of insurance companies

Gautam Chikermane has a great article in Indian Express yesterday, on the high fees and expenses of products sold by insurance companies. You may want to also see this older blog entry on a related subject. While I'm on this subject, see this Bloomberg column by John Wasik on how the expenses of actively managed funds rack up.

Some critics of the NPS propose going for a pure private sector solution to pensions, where a bunch of pension products are sold by (say) insurance companies. Insurance companies are selling pension products in India today in such an environment, and the results are visible for all to see in terms of massive fees and expenses. As Raju Chitale once said to me, the New Pension System (NPS) is an attempt at utilising public policy to solve the market failures of the natural outcomes with pure private sector pension fund management.

Bringing some clarity and consistency to monetary policy?

Indian monetary policy is beset with problems; the recipes and policy reflexes which used to work in the olden days have become increasingly out of touch with the dynamics of a new India. Right now, the market is confused about what is going on with interest rates, exchange rates and the monetary policy rule. The market is unable to understand how a central bank would follow an inconsistent policy framework.

In this setting, the `credit policy statement' that is coming up on the 31st is unusually important. Many financial market practitioners are anxiously hoping that RBI will come up with plausible answers to the host of questions that are up in the air - questions about capital controls, exchange rate regime and monetary policy. What is monetary policy doing, and what comes next? I'll update this blog entry over the coming ten days, as events unfold.

Pre 31st: The setting

• Not all FII money is hot, an editorial in Economic Times.
• Policy without framework by Ila Patnaik in Indian Express.
• India's victory over inflation may be short-lived by Andy Mukherjee on Bloomberg.
• India's untenable currency policy by Ila Patnaik in Financial Express.
• Ease the peg, an editorial in Financial Express.
• ECBs as villains, an editorial in Financial Express.
• Rating the credit policy, an editorial in Financial Express.
• There is a lot of talk about capital controls against ECBs. Economic Times has a great front page story Curbs go kaput as firms brandish put options by Sugata Ghosh and Rajesh Unnikrishnan about firms doing financial structures which solve the problem of restrictions against debt flows. While on this subject, you might like to see my blog entry titled Synthetic corporate bonds.

31st: What was done

The limit on Rs.3000 crore for reverse repo was removed, and the CRR was bumped up by 50 bps.

Post-31st: Implications

I wrote an article Still in a quandary in Business Standard of 1st. On the same day, the edit in Business Standard titled Predictable but partial says:

However, the most significant development over the last quarter has been the rise in the external value of the rupee. While expectedly not making any commitments on how it proposes to deal with the situation, the RBI has laid out the various pros and cons of the appreciation with respect to its impact on the real economy, and expressed a willingness to use all available instruments to deal with the situation. This seems to indicate that it will eventually return to its pre-April stance of resisting appreciation, with a consequent increase in capital inflows, accumulation of reserves and further pressures on liquidity. This could well become a never-ending battle. If monetary policy is to transit from merely dealing with immediate problems to creating a more enduring framework for high growth and low inflation, this issue must be squarely addressed. The quarterly announcement on Tuesday failed to do that, which is a pity because the problem is not about to go away. Indeed, most forecasts point to a further increase in the rupee’s external value. That’s a headache the RBI will have to deal with, sooner than later.

Financial Express has an edit titled Only halfway there which says:

What might appear to be a judicious mix of policies—some appreciation, some hiking of the CRR, some MSS issues and some interest rate hikes—only takes us deeper and deeper into this problem. What looks perfectly justified in the near term can look profoundly self-defeating in the overall context. Despite the need to confront all these difficult choices with due forthrightness, sadly, the RBI’s credit policy continues to be evasive on the big picture.

Andy Mukherjee notices the inflationary dangers of the present monetary policy framework.

The woes of EPFO

Business Standard has a great editorial on the woes of EPFO:

Now that the inappropriately-named Interest Suspense Account (all incomes are deposited here, and it remains in suspense till it is credited in members accounts) has come to the rescue, and the Employees Provident Fund Organisation has managed to find Rs 450 crore extra in this account in order to pay 8.5 per cent interest for 2006-07 to workers whose forced savings have been kept with the EPFO, you can safely assume the governments interest in the EPFO is over for another year. That is unfortunate; each year that critical reforms are postponed, the problems of the EPFO (which comprises the Employees Provident Fund and the Employees Pension Scheme) get more acute. There is also the larger problem that while energies are consumed in getting a better deal for the very small proportion of Indias workforce which has EPF accounts, the government has still not come out with a new pension system with central record-keeping that would allow account holders to choose pension fund managers and access their accounts at the click of a mousearound 15 million of the 40 million EPF accounts are dormant, a large number of individuals have more than one account, and only 7-8 per cent of accounts have balances of over Rs 50,000.

As for the EPF itself, it functions on antiquated software (few other organisations in the world still use Foxbase) and still uses the single-entry book-keeping system, which makes the organisation quite vulnerable to fraud. While the EPFO had planned to modernise nearly 100 of its 115 offices by April and switch to double-entry book-keeping and more modern software with a web interface that would allow account holders to access their balance online and withdraw funds within three days, the project is still stuck at the pilot phasethe latest plan, if all goes well, is that offices which account for 60-65 per cent of accounts will be online by April next year.

Then there is the problem that, while looking for more interest income for members each year, the board refuses to clear a proposal to invest 5 per cent of EPFO funds in the stock market, which, in the long run, offers unmatched risk-adjusted returns. Indeed, with institutions like ICICI Bank and IDBI no long public sector financial institutions, the EPFO is even running out of investment options, but the board has not cleared investments in corporate bonds; nor has it cleared a proposal to allow trading in securities though the EPFO is allowed to trade 10 per cent of its securities while it holds the rest on a hold-to-maturity basis. This attitude ensured, for instance, that when even the car cleaner knew that IFCI was going bust, the EPFO continued to hold on to its IFCI deposits.

The other, and growing, problem for the EPFO, is the EPSwhile the EPF corpus of Rs 100,000 crore is greater than the Rs 75,000 crore under the EPS, the way the latter is growing, it will outpace the EPF in another two years. Thanks to pension fund plans that were designed when interest rates on fixed deposits were over 15 per cent per annum, the EPS has a huge asset-liability mismatch, which was around Rs 22,000 crore in 2003-04there has been no assessment after that! The solution to this is no secret: reduce some of the pension benefits such as early withdrawal and increase the retirement age till which pension contributions are made by two years (this also reduces the number of years of pension by two years). Yet, the board refuses to take a decision on the mattereach year, the hole in the EPS increases by Rs 3,000-4,000 crore. Disaster stares the EPFO in the face. But neither the labour minister nor the trade union members who focus on asking for higher interest payments seem to be concerned.

Not an end of history

In the late 1980s and the early 1990s, the collapse of the USSR made many people hope this was the `end of history'; that `the final curtain would fall and the game of power politics would no longer be played.' It was felt that all countries were moving towards open minds and open economies, so that there was no room for great power politics rooted in ideological differences.

The reality has shaped up quite differently. China continues to be an explicitly autocratic state. Russia is not a democracy and won't be one for the forseeable future. Both countries are great powers who are based on autocratic ideology. In addition, perhaps 100,000 Islamic extremists are assiduously at work worldwide, seeking to derail the world that is based on open minds and open economies.

Robert Kagan has an interesting article End of Dreams, Return of History where he looks at the global situation from the point of view of what United States foreign policy is doing, and what it ought to do. Among other things, he says:

... the United States should pursue policies designed both to promote democracy and to strengthen cooperation among the democracies. It should join with other democracies to erect new international institutions that both reflect and enhance their shared principles and goals. One possibility might be to establish a global concert or league of democratic states, perhaps informally at first but with the aim of holding regular meetings and consultations on the issues of the day. Such an institution could bring together Asian nations such as Japan, Australia, and India with the European nations -- two sets of democracies that have comparatively little to do with each other outside the realms of trade and finance. The institution would complement, not replace, the United Nations, the G-8, and other global forums. But it would at the very least signal a commitment to the democratic idea, and in time it could become a means of pooling the resources of democratic nations to address a number of issues that cannot be addressed at the United Nations. If successful, it could come to be an organization capable of bestowing legitimacy on actions that liberal nations deem necessary but autocratic nations refuse to countenance as NATO conferred legitimacy on the conflict in Kosovo even though Russia was opposed.

(On this subject you may like to see India and NATO?).

In India, a broad majority appears to aspire to become a country based on open minds and an open economy. But the evolution of India in these directions is far from assured. Too many people who grew up in the 1960s and 1970s have socialist instincts on economic policy matters. The present ruling coalition involves giving veto power on all legislation to left parties who got 5% of the votes in 2004 elections, who aspire for a future for India based on a closed economy and a foreign policy which is sensitive to Chinese and Russian interests. The Shiv Sena burns books.

There are, hence, two distinct questions that we face in India. First, how can India continue to chip away at making progress towards becoming a modern, liberal society characterised by ever-expanding freedoms for individuals in terms of both society and economy? Second, what would the consequences of this founding `idea of India' be, for the conduct of foreign policy?

INR-USD appreciation should be seen in the light of the weak dollar

Abheek Barua has a sensible article in Business Standard where he talks about the long-term forces and immediate exigencies which have given a decline in the US dollar against numerous other currencies, with a continuing gloomy outlook for the USD in the days to come.

As he correctly points out, the recent INR appreciation should be seen in this light. If the USD is losing ground, pegging to the USD and insisting on an unchanging INR/USD rate involves forcing a depreciation in the INR.

The other implication of the weak outlook on the USD is that India must avoid holding USD, in order to avoid losses on the reserves portfolio. These losses are an additional fiscal cost of the present exchange rate regime.

Glancing at the data shows that the trade weighted US dollar (for major currencies) has dropped from 100 to 77.6 between Jan 2003 and Jul 2007. Similar results are found for the broad index. This was, unfortunately, a period where India was holding a lot of USD (though one can't know how much owing to poor transparency at RBI). We could have built a few thousand kilometres of highway using these losses.

SBI vs. ICICI Bank

Business World has an opinion piece comparing State Bank of India against ICICI. It argues that the unflattering comparison shows the power of privatisation.

The official and the illegal currency market

A Nigerian diplomat was recently found converting Rs.100 million in cash into USD in New Delhi. This hints at the existence of a substantial INR/USD market outside the reach of capital controls.

I think there are two factors shaping this black market. The first is the capital controls - rapidly globalising India is increasing chafing at the bit. The second is the incredibly bad market design of the currency market.

In India, the equity market sets the benchmark for transparency of financial transactions. There is pre-trade transparency (order books are visible in realtime) and post-trade transparency (exact transaction information is put out in realtime). In addition, equity market intermediaries separately reveal (a) the price at which a transaction was executed on the market as opposed to (b) the brokerage fees charged by the intermediary. On the equity market, liquidity resides in the public, nationwide market, and the broker is only a transactional pathway to the market.

In contrast, the Indian currency market fares poorly on all three counts. It is highly non-transparent from the viewpoint of customers, lacking post-trade and pre-trade transparency. This makes it difficult for customers to ensure that they are getting best-price execution. Banks do not unbundle the price on the currency market as opposed to their intermediation fees.

To look back into the history of the equity market, in the early 1990s, all these features were absent. When BSE brokers were first asked to separately show brokerage fees as opposed to the price at which a transaction was executed, they went on strike. In the early 1990s, BSE brokers would routinely lie to customers, claiming that a purchase was executed at a higher price than it really was. Lacking transparency, customers were not able to cross-verify these claims. These very abuses are found on the currency market today: customers are not able to cross-check prices owing to the lack of pre-trade or post-trade transparency, and customers are not told what they are being charged for financial intermediation services as opposed to market prices. The people who work on policy issues of the currency market have not adequately learned from the success story of the equity market.

Owing to the deficiencies of the market design, currency trading is extremely profitable for banks. Customers pay high prices for buying and get low prices when selling. If a bank gets a buy and a sell order which it is able to serve internally, it earns the full spread (that is shown to customers). Only the net imbalance at a bank reaches the interbank market.

The excessive intermediation charges imposed by banks on the currency market reach all the way to retail transactions. A traveller who seeks to buy or sell on the rupee-dollar market faces a bid/offer spread of roughly Rs.1.50 (3.67%). As a consequence, an extensive black market has sprung up all over the country. This involves a network of dealers who do run a book on the rupee-dollar. Your friendly neighbourhood paanwala is often a currency trader. They offer a bid/offer spread of roughly Rs.0.15 (0.37%). This black market helps undercut the intermediation charges of the banks, and on avoiding the constraints which prevent competing trading systems from emerging.

The equity market is able to deliver a spread of Rs.0.1 on a base of Rs.4500 for the Nifty futures - this is like a spread of Rs.0.001 for a base of Rs.45 (roughly the INR/USD rate). Like the Nifty futures, currencies are also "macro" underlyings with little asymmetric information. Currency vol is lower than Nifty vol. Hence, if the market design is done right, currency spreads ought to be lower than the Nifty spread - in other words the spread should be lower than Rs.0.001. Such a tight spread directly saves money for market participants who trade - for the spread is the round-trip transactions cost faced by the customer. In addition, fine spreads improve market efficiency by reducing the overheads faced by speculators.

In short:

1. There is much more convertibility than meets the eye;
2. The currency spot market is one of the most important commanding heights of the economy, and it's a real shame that it has a 19th century market design, aimed at perpetuating entry barriers, profits for banks, non-transparency and high transactions costs for customers;
3. If policy makers want more of the currency market to come above the ground, then an exchange-traded currency spot market is required, where brokers clearly unbundle their brokerage charge from the price seen on the public limit order book.

As an aside, with commodity futures also, there is a substantial `number 2 market', which competes with the official regulated markets. These parallel currency and commodity futures markets reflect an exit from the mainstream regulated markets by some players. If wise policy making is able to unify all liquidity into the public markets - as has pretty much happened with the equity market - we will be able to reap substantially more liquidity than is presently the case.

Moving towards de facto convertibility

One of the most important phenomena which has been taking place in India in recent years is rapid integration into the world economy. In the case of merchandise trade, trade integration is commonly measured by summing exports and imports, and expressing these as percent of GDP. In similar fashion, I find it useful to focus on the sum of money coming in and going out, on the current account and capital account taken together, as a measure of globalisation. The data shows these gross flows have risen sharply:

Year	Trillion rupees	Percent to GDP
1999-00	9.16	51.28
2006-07	41.18	110.01

For such a structural parameter, going from 51.28% in 1999-00 to 110.01% in 2006-07 is a substantial change. When 110% of GDP is moving across the boundary, capital controls become increasingly ineffective.

Swaminathan S Anklesaria Aiyar has an article in Economic Times where he talks about big discrepancies in the BOP data. In my opinion, these discrepancies reflect the increasing use of the current account to effect capital flows. If a software company sends out a C program to a customer by email, and gets paid $1 million for it, what RBI inspector can verify what was the current account transaction that took place?

On a related note, Economic Times has an article on the growing internationalisation of the Indian rupee. The MIFC report has written about policy directions that India needs to embark upon, in order to make the INR one of the six key currencies of the world, a currency that would be used for bond issuance and complex financial transactions by issuers and investors all over the world.

On the scale of a trillion dollar GDP, with such large cross-border flows, the present discussions about bringing back capital controls on one small element (ECB) are missing a sense of scale about India's globalisation. Banning ECBs would have probably made a significant difference circa 1997. But not anymore. Instead of looking for ways to bring in more controls, it would make more sense to look forward to the time when India will be a $2 trillion GDP with $4 trillion in cross-border flows, and gear up for that world with the commensurate institutional maturity.

Harnessing solar energy

The New York Times has a set of three great articles on solar energy:

• Using the sun's heat, not light is about solar thermal energy. It mentions a facility which uses 400 acres of land to produce 64 Megawatts at a price of Rs.5.6 per KiloWattHour. That might make sense in many parts of India.
• Storing sunshine is about the problem of storing energy. A neat idea that I saw there was that of using off-peak low-priced electricity to construct a 2000 kg block of ice in the basement of a building, in order to reduce the purchase of peak-time expensive electricity for air conditioning in the daytime. The benefits from the system depend on how extreme the day vs. night temperature change is. It struck me that in a lot of India, there is a huge difference between the day and night temperatures. Such a system is, of course, only viable when there is a sensible time of day pricing scheme, one which also correctly penalises the capital cost induced by the peak load.
• Solar power wins enthusiasts but not money talks about the politics of government expenditures on alternative energy technologies.

While on this subject, see this fascinating article by R. K. Pachauri and Leena Srivastava in Indian Express on the energy efficiency implications of having two time zones in India. In that case, we'd have a GMT+5 west coast and a GMT+6 east coast instead of an awkward GMT+530 for the full country. And, there's a great article by Kevin Hassett on Bloomberg about the possibility of the government supplying put options on the price of alternative energy, to investors taking risks on alternative energy.

Comparing the Indian and Chinese governments

I wrote an article in today's Business Standard titled Comparing the Indian and Chinese governments.

Just in case you thought things were going well, Business Standard has an edit which is bang on:

One minister approves a massive order for new telecom equipment, placed by the country’s erstwhile telecom monopoly, but his successor comes along, raises a series of questions and the board of the company concerned dutifully does a re-think. Oil prices go through the roof, and the state-owned oil companies lose Rs 190 crore a day, but the petroleum minister will not reverse the product price cuts that he announced in February this year and November last year. The food minister cancels one wheat purchase contract, then approves another at a higher price. The minister for chemicals and fertiliser and steel and mines (yes, ministers do multi-task) announces arbitrary price controls for pharmaceuticals and won’t pay the fertiliser companies the subsidies that are their due. The finance minister summons the chiefs of state-owned banks every now and then and speaks his mind—don’t raise interest rates, lend more to agriculture, reduce interest rates for exporters… In each case, the gentleman concerned must think that he is doing national service (the food minister even declares in a rare rhetorical flourish that price is not a consideration when it comes to feeding the people—as though the alternative to defective import decisions is mass starvation).

Taken together, these and other examples point to a fundamental problem with economic management: the continuing dominance of the public sector, and in turn its continuing subjugation to ministerial whim. This is not just when it comes to board-level appointments, where it turns out that the most appropriate and best-qualified people who can be made non-executive directors just happen to be faithful members of the Congress party. After 16 years of economic reform, the hard fact is that more than half of India’s industrial sector is still government-owned (including the bulk of the banking, insurance, power, rail transport, oil and gas, and coal industries, and good chunks of aviation, telecommunications, shipping, steel…). In most of those sectors, ministerial whim prevails, irrespective of the presence of supposedly independent regulators armed with statutory powers. And large parts of private enterprise are subject to the same policy whims—if in doubt, ask Mukesh Ambani why he is being denied an oil subsidy that his public sector counterparts get.

If it were collective decision-making through a cabinet system, that would act as a brake on individual ministerial whim. But with an unassertive Prime Minister, and Cabinet ministers who owe their positions to their party bosses rather than to the Prime Minister (Mr Raja’s appointment as telecom minister was made, not by the President’s office in Rashtrapati Bhavan but in Chennai by the DMK chief, Mr Karunanidhi, who had also decided earlier on Mr Maran’s resignation), everyone feels free to pull in his or her own direction. In an effort to curb ministerial freelancing, the Prime Minister has set up dozens of “groups of ministers” and charged them to take a view on individual ministerial initiatives; but this not only slows down decision-making, it also overloads the two or three senior ministers who can be trusted to chair the GoMs and guide their deliberations so that aberrant policy does not result.

But only policy matters go to GoMs. What about all the executive decisions where ministers intervene, and where they can run amok without a “by your leave”? Privatisation of all non-vital state-owned enterprises would be a solution, but the UPA government and its Left allies will not hear of it, and even the previous NDA government was enthusiastic about it for only a brief while. A variety of stratagems have been worked out to try and give state-owned companies operational independence (formal agreements on performance benchmarks, “navratna” status, and so on), but nothing can stop a minister determined to wade into a purchase order.

Fixing the IPO process

Dinesh Narayanan has an excellent article in Business World on solving the problems of the IPO process.

The future of trading

Roughly speaking, NSE has 50,000 trading screens and BSE has 25,000 trading screens. Over and above this, a growing share of orders have been coming into NSE and BSE over the Internet. Recent data shows that the share of Internet trading went up from 3 per cent in 2003-04 to 16 per cent in 2006-07. Given that the broadband expansion in India started only very recently, the outlook for future growth of Internet trading is very good.

The sources of order flow coming into the market, then, are these 75,000 trading screens coupled with a large number of users sitting on their web browsers. All these people add up to a massive virtual trading floor. Their information gets pooled into the price that is revealed, and their disagreements are played out in the order matching process. Their diversity is a key source of liquidity and liquidity resilience [link].

To a significant extent, the same securities firms are playing the same role with commodity futures trading. So even though there is an FMC vs. SEBI separation, there has been de facto convergence. As you walk around India, you routinely see roadsigns of securities firms offering both NSE/BSE and commodity futures trading.

The big puzzle now lies in bringing the potential of this enormous virtual trading floor to infuse life into the moribund fixed income and currency markets.

Outside India, there have been fascinating developments in going beyond the vanilla Internet trading system. The game lies in enhancing the information set of the user while supporting `dumb' transaction services, and in doing better than the awful discussion boards that have proliferated. See link and link. (I had blogged about Zecco before). These sites rely on network externalities - the larger the number of people using them, the more attractive they become. So there may be a tipping point - perhaps 100,000 users? - beyond which they could just explode.

As seen in those two URLs, in the US, the price of brokerage services with some brokerage firms has dropped to zero. In India, that progression cannot be achieved because of the massive government charges which are layered on top of the basic transaction -- see Box 2.8, page 29 of the MIFC report.

These developments have interesting implications for exchanges also. An article in The Economist discusses some of these changes. It talks in hushed tones about an exchange that will sell transactions at a price of $1.2 per trade. In my mind, that's not a big deal; the technology exists today to do much better. The key thing to latch into is economies of scale - by the time you have a factory pumping out 10 million trades a day, the costs get dramatically lower than those seen with small exchanges. As a consequence, I believe that the pressures in favour of low prices paid by customers which will propagate to low prices charged by exchanges will generate a more oligopolistic situation where a few giant exchanges - like NSE and BSE - will dominate the world's trading.

Indian REITs in Singapore

Andy Mukherjee has a column on Bloomberg about Indian REITs taking shape in Singapore rather than in India.

Feature request for blogspot: block comments from persistent offendors

I am periodically picking up comment spam from registered blogspot users who come in and put a comment on a page advertising (say) stock market tips. I see regulars who are coming in and repeatedly putting in such comment-spam. I can delete these comments and I do. But it'd be great if, in addition to the "Delete Comment" button, there was an additional button which says "Delete this comment and forever block this user from submitting a comment on my blog".

Controls on banks opening branches

Sourav Majumdar has an article on the oddities of branch licensing for banks by RBI in Financial Express of June 29. While on this subject, recommendation #62 (Chapter 15, page 204) of the MIFC report will interest you:

The control of branch licensing for banks is an anachronism, at a time when India has moved away from the license- permit raj in most respects. There is no other industry in India, today, where firms have to take permission from the government in order to open branch offices. Simply because they take deposits does not make bank branches any different from other market enterprises. Banks should decide where and when they want to open branches and not the regulator. As part of improving competition policy, the opening of branches by domestic banks should now be immediately decontrolled. No domestic bank should have to ask the banking regulator for permission for each ATM or branch. After one year this policy should be extended to all banks. This will give local banks a one-year head start over foreign rivals on opening branches.

Article by John Echeverri-Gent on the political economy of financial sector reforms

John Echeverri-Gent has a fascinating article Politics of market microstructure [pdf] about the reforms of the Indian equity market. It is forthcoming in a book: India's Economic Transition: The Politics of Reform, edited by Rahul Mukherji, Oxford, 2007.

One interesting sequel waiting to be written is about the commodity futures market, and another is about the currency and fixed income market. While on this subject, also see this article.

Chinese monetary policy - no magic bullet

Surjit Bhalla has repeatedly suggested that Rakesh Mohan be sent to a re-education camp in China in order to learn how to do Chinese-style monetary policy. It is felt that China is reaping a free lunch of high exports growth based on a distorted exchange rate. In Business Standard yesterday, Jahangir Aziz and Kalpana Kochhar argue that Chinese monetary policy isn't the role model it's made out to be.

Korea moves towards IFC

Korea is about to make the moves required of policy makers to get going on becoming an international financial centre. As an editorial in the Wall Street Journal says:

...It may be late, but South Korea is finally getting serious about financial market reform. This week the National Assembly is expected to approve a significant overhaul of the country's financial system, with an eye to making it an international hub. That goal is a decade or more away but if they stay on track, the South Koreans may just have a chance.

The reform is sweeping. The biggest change will be a shift to "negative list" regulation from a "positive list" regime. Under a positive list, only financial products that are approved by regulators can be marketed. A negative list system allows any product that's not explicitly banned. In the U.S. and Britain, negative list regulation has allowed financial innovators to market a dizzying array of new products, from weather futures to exotic credit derivatives. In South Korea, the hurdles imposed by positive regulation have, for example, blocked the development of over-the-counter credit derivatives found in many other markets.

South Korea is also tearing down regulatory barriers to consolidation and rationalization within the securities industry. The reform legislation will allow brokers to offer one-stop shopping for a variety of products, from futures to options to asset management services. ...

For just one example of what all this will mean for the average investor, consider banking services. A provision in the reform clears the way for brokerages to access the electronic payments system used by the banks. This will finally allow South Koreans access to the same kind of brokerage deposit accounts Americans have been able to open for years now. ...

The reform effort has been a long time coming. The government of President Roh Moo-hyun developed two separate roadmaps since 2003 for turning South Korea into a financial hub. The first roadmap, released in late 2003, was criticized for being too gradualist, trying to position South Korea first as a niche player in asset management services and only later -- around 2020 -- as a global hub.

In 2005, a much more daring roadmap was released, which has spurred several important reforms, culminating in this week's legislation. Special credit is due to Prime Minister Han Duck-soo, formerly the minister of finance and economy, who has been especially vigorous in pushing for change.

South Korea's measure is being compared to the "big bang" reforms that rejuvenated a drooping City of London two decades ago. But the legislation alone won't do the trick. The U.K.'s big bang resulted from a broad tranche of liberalization of everything from financial markets to telecommunications that touched virtually every aspect of the business climate. South Korea, by contrast, still has a highly restrictive business climate. Lingering red tape associated with cross-border capital flows is just one serious challenge to Seoul's ambitions.

Reinventing a city as a financial market hub isn't a new idea, especially as competition in Asia intensifies. Malaysia enacted its own little big bang in March, easing capital controls and lifting restrictions on foreign ownership of banks. ...

Whether or not the Koreans succeed, the big boys in London, New York and Hong Kong can't afford to be complacent. South Korean policy makers are mustering the political will to overcome past policy mistakes in the name of boosting competitiveness....

This impinges on the discussion of fast versus slow reforms in India. The typical government bureaucracy likes to set itself decade-long timetables for any significant change, thus placing changes deep in the future after the present staff is safely out of the way. But such a strategy inhibits the possibility of achieving an IFC in India in two ways. First, cities like London and Singapore have a certain international finance ecosystem humming today and not ten years in the future. Achieving even a 0.1% market share in international financial services requires making a big move compared with where we are. Further, new players - like South Korea - are doing big bang reforms, which actually sound quite familiar to the reader of the MIFC report. The fact that they do this increases the competitive pressure upon India to move quickly and not slowly.

The Korean movement on moving to negative list regulation is particularly remarkable because Korea comes from a German/continental legal tradition where everything is written down. Compared with that, executing modern financial sector reforms in a supposedly "common law" place like India ought to be easier. While on this subject, see a skeptical piece in The Economist about the difficulties of functioning in South Korea.

A Maginot Line of controls

I wrote a piece in Business Standard today titled A Maginot Line of controls on the distorted perception about capital account convertibility that is found in some policy circles in India.