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Monday, June 30, 2008

The two hot spots in improving governance in India

In India, we often have a broad notion that the performance of government at producing core public goods is bad. In order to make progress, it helps to focus on the hot spots, where things are extremely bad, so that the maximum bang-for-the-buck can be obtained in return for applying scarce resources of money, top management time and political capital.

Today in Mint there is a very interesting set of statistics showing results from a household survey focusing on poor people, done by Transparency International India and Centre for Media Studies, focusing on corruption. See the results and associated interview with Bhaskara Rao who heads the Centre for Media Studies.

The main result of this survey is:

Police 78 52
Land records 69 36
Housing 70 32
Water 42 12
Hospital 46 11
Electricity 44 11
NREG 47 11
Forest 36 11
PDS 54 8
Banking 26 7
Schools 28 5

I would take away one key message from this: the two areas where the maximum focus is now required are the police and land/housing. These are the hot spots with the worst corruption. Making progress on the police is inevitably tightly interlinked with the larger justice system, which includes the judiciary.

The larger discussion on `improving governance in India' would hence benefit from a focus on these two hot spots: making the police and judiciary function properly, and ending the corruption of the land market. If a prime minister or a chief minister or a mayor has to prioritise the use of his resources, these are the two areas which deserve top priority.

Sunday, June 29, 2008

John Gieve's departure

Willem Buiter has written a fascinating blog post on John Gieve's departure as deputy governor of the Bank of England. None of it directly concerns us here in India. But the deeper issues are universal and worth pondering over. And, we need more people with the stature of Willem Buiter who are willing to speak bluntly, and name names, on questions of public policy.

Thursday, June 26, 2008

RBI reforms

Saubhik Chakrabarti has written a call for RBI reforms in Indian Express. He reminds us that this is one area where a series of expert committees have argued in favour of fundamental change and there are no political constraints.

Recent RBI tightening

I wrote an article Useful but ineffectual in Financial Express today, on the recent RBI tightening.

Wednesday, June 25, 2008

Foreign investment in rupee denominated debt

India has long been doing everything wrong on capital controls for debt instruments.

The Mistry and Rajan reports have recommended opening up to rupee-denominated debt (i.e. reversing the existing bias in favour of offshore, dollar-denominated debt) by placing it on par with FII investments in equity. Also see appendix 1 (page 9) of this paper for a larger understanding of rupee denominated bonds held by foreign investors.

The quantitative restrictions on foreign investments in bonds were recently changed an inch in this direction - from $3.2 billion to $5 billion for FII investments in government bonds, and from US $1.5 billion to US $3 billion for FII investments in corporate bonds.

Quantitative restrictions are pretty abominable things: how do you ration out the overall limit between multiple claimants? SEBI chose to give out quotas on a first-come-first-served basis. Financial Express points out that the quota was consumed in seven minutes. See this very interesting SEBI press release.

How do you prevent financial firms from hoarding a quota and not utilising it? You enact more rules! Once a dirigiste policy framework is created, the maze of rules and restrictions tends to proliferate. SEBI has decreed that the winning firms must utilise their quota within 15 days. As a consequence, these financial firms will tend to become buy and hold investors to a greater extent in the bond market, and not contribute to liquidity and market efficiency to the fullest degree.

Friday, June 20, 2008

Copy with care

Quite often, one hears the idea that India should emulate Chinese-style exchange rate policy, on the grounds that this will help India move up from 7.5% trend GDP growth to Chinese-style 11% GDP growth. I wrote an article Copy with care in Financial Express yesterday, where I talk about the role of exchange rate policy in the Chinese growth miracle, about the costs of Chinese exchange rate policy and the long-term sustainability of Chinese exchange rate policy.

On the difficulties of Chinese monetary policy, read: Barry Eichengreen and Martin Wolf.

Thursday, June 19, 2008

Ten things for India to achieve its 2050 potential

Ten things for India to achieve its 2050 potential, by Jim O'Neill and Tushar Poddar of Goldman Sachs does a good job of summarising the economic policy reforms agenda for the next government.

The 10 tasks are big and complex, and each requires a book-length treatment on translation from ideas to action. E.g. in the case of #6, financial sector reforms, such groundwork has been laid in the form of the Mistry and Rajan reports. Similar work is needed on the other nine as well.

On the subject of the macroeconomic policy framework, you might like to see this.

Wednesday, June 18, 2008

Law, finance and politics: The case of India: A symposium

John Armour and Priya Lele have a paper titled Law, Finance, and Politics: The Case of India. In this symposium, we have comments on this paper by Somasekhar Sundaresan, Sanjay Pandey, Kaushik Krishnan, Surabhi Chopra and Bibek Debroy, and a response by John Armour. You can read the full text right here, or use this printer-friendly version.

The paper

John Armour and Priya Lele have a paper titled Law, Finance, and Politics: The Case of India. Their abstract reads:

The process of liberalization of India's economy since 1991 has brought with it considerable development both of its financial markets and the legal institutions which support these. An influential body of recent economic work asserts that a country's 'legal origin' - as a civilian or common law jurisdiction - plays an important part in determining the development of its investor protection regulations, and consequently its financial development. An alternative theory claims that the determinants of investor protection are political, rather than legal. We use the case of India to test these theories. We find little support for the idea that India's legal heritage as a common law country has been influential in speeding the path of regulatory reforms and financial development. There is a complementarity between (i) India's relative success in services and software, (ii) the relative strength of its financial markets for outside equity, as opposed to outside debt, and (iii) the relative success of stock market regulation, as opposed to reforms of creditor rights. We conclude that political explanations have more traction in explaining the case of India than do theories based on 'legal origins'.

This paper falls into the context of the `LLSV' literature on legal origins, on the implications of common law vs. civil law. On the LLSV literature, you might like to see: a few paragraph description, a review and the original paper.

Of particular interest is this relatively recent working paper which looks back at the literature: The Economic Consequences of Legal Origins, by Rafael La Porta, Florencio Lopez-de-Silanes and Andrei Shleifer, November 2007. In this, they say:

In several studies conducted jointly with Simeon Djankov and others, we found that such outcomes as government ownership of banks (La Porta et al. 2002), the burden of entry regulations (Djankov et al. 2002), regulation of labor markets (Botero et al. 2004), incidence of military conscription (Mulligan and Shleifer 2005a,b), and government ownership of the media (Djankov et al. 2003c) vary across legal families. In all these spheres, civil law is associated with a heavier hand of government ownership and regulation than common law.

India is a puzzle in this field, for we seem to have got bad outcomes on quite a few of these aspects, despite having common law origins.

This literature also links up to some extent with the discussion of rules-based regulation vs. principles based regulation found in the Percy Mistry and Raghuram Rajan reports.

Comment, by Somasekhar Sundaresan, J. Sagar Associates

There is more to the evolution of investor confidence in India than the legacy of India's legal history. It may be tempting to test India as a case study for the conventional test of whether a common law system furthers a more secure investment environment as opposed to a civil law system. However, indeed, akin to many other features about India, her example will not lend itself easily as a specimen for a debate over the application of reductionist theories of which type of legal system would be more conducive for promoting investments.

It would be useful to examine if the legal system in India as it has evolved, partakes of the character presented by either a common law system or a civil law system. For instance, against the backdrop of capital market regulation, it is important to look at whether features that would otherwise inspire investment into a jurisdiction on account of the jurisdiction having a history of common law, or civil law, are found in India in different institutions.

It is such an analysis that leads the authors to conclude that the development of the legal system has not been driven by conventional understanding of common law and its influence on evolution of law.

The paper presents an excellent context for a debate over the increasing demand for principles-based regulation (``PBR'') in financial services regulation in India. Advocates of the PBR would like the law to only state certain principles and to let the law evolve by interpretation of these principles by courts. On the other hand, votaries of rule-based regulation (``RBR'') fear for the impact PBR could have in practice in real-life situations.

It is pertinent to note that the development of a regulatory framework whereby Parliament has created institutions such as the Securities and Exchange Board of India and the Reserve Bank of India, and has increasingly vested in them powers to proactively regulate the market systems they oversee, has created institutions that play a role similar to the role of the judiciary in the conventional common law system. Indeed, the Supreme Court has remarked (AIR 2004 SC 4236) that the SEBI Act, 1992 runs counter to the conventional doctrine of separation of powers of the legislature, the executive and judiciary. The court expressed concern that such integration of power by vesting legislative, executive and judicial powers in the same body, may raise public law concerns as the principle of control of one body over the other was the central theme underlying the doctrine of separation of powers. Within the overall framework of the SEBI Act, SEBI is free to formulate subordinate legislation, prosecute violations, and also enforce its own regulations, wearing a quasi-judicial hat.

In a conventional understanding of common law, the courts would play the role of a quickly-adapting institution that responds to the needs of society. It is noteworthy that constitutional challenges to the omnibus powers conferred on SEBI under Sections 11 and 11B of the SEBI Act, on the ground that they constitute arbitrary and excessive delegation of powers by Parliament to an arm of the State, have lost repeatedly across various high courts in India. In fact, the generic and sweeping powers vested in SEBI by these provisions, to issue directions and to take measures in the interests of the securities market, have given SEBI the ability to respond creatively without being hamstrung by a strict rule-based system that would otherwise be the hallmark of a civil law system. The Reserve Bank of India (``RBI'') enjoys similar powers in the banking sector -- for instance, powers to supersede bank boards, powers to appoint directors into banks' boards, powers to issue moratoriums on operations etc.

Being a common law system, Indian courts would interpret beneficial, ameliorative and regulatory legislation in a purposive manner, rather than in a strictly technical manner. In other words, if two views are possible in interpreting a provision of the SEBI Act, the courts would look adopt the purposive interpretation i.e. an interpretation that would further the remedy and suppress the mischief. Such an approach arms the judiciary with ensuring that the regulators who enjoy such wide-ranging powers use their powers in furtherance of the objectives of the statute, rather than in a technical and narrow manner.

It is in this perspective that the debate over PBR and RBR has to be considered. The powers vested in regulators are immense, and rightly so : a strong regulator is necessary to instill confidence in the market and the orderly rule of law in the market. However, it is often seen that regulators can be either very technical and procedural (thereby losing sight of the principles and purpose for which they wrote subordinate legislation), or they can be very ambiguous and unclear (inflicting serious regulatory damage). Cases in point abound:

  • UBS AG was directed not to issue participatory notes against underlying Indian securities on the ground of alleged breach of know-your-client requirements. SEBI's view on KYC compliance was that UBS ought to have known the identity of the ultimate beneficial owner of every counterparty to every derivative contract / participatory note to which it was a party. SEBI's position was that the `principle' of `know your client' in plain English was good enough to enable SEBI to expect that UBS ought to have known the ultimate beneficial owner of every counterparty. The SAT had to intervene and set aside the SEBI's action on the basis that its requirements were too unpredictable and vague to result in a breach leading to penal consequences.
  • There is no stated rule about who ought to be the gatekeeper for detecting securities fraud in the primary market system. In principle, the regulator would like every intermediary to be alert to misdeeds around them. Using this reasoning, SEBI went after institutions in the capital market such as the depository and leading depository participants accusing them of contributing to the opening of fictitious securities accounts on account of alleged negligence.
  • In a recent interpretative letter issued by SEBI to a company whose public shareholding had fallen below the minimum level prescribed in the listing agreement due to implementation of a merger exposes how regulators could themselves lose sight of the principles for which they wrote a law. SEBI guidelines provide that to be eligible to make a private placement of equity shares to qualified institutional buyers (``QIBs''), a company ought to be compliant with minimum public float requirements under the listing agreement. The company in question, and the stock exchanges, had agreed that by making a placement with QIBs, the company could increase public shareholding requirements and become compliant. SEBI vetoed the approach and said the company would have to first find some other means of bringing public shareholding to the minimum prescribed level, and only then transact a QIB placement.

These are classic examples of how the authorities that are charged with formulating principles in a PBR regime could lose sight of what the principles are, and instead interpret guidelines as if they were fiscal statute. Even with fiscal statute, which have to be strictly construed, if two views are possible due to an ambiguity, the view favouring the revenue-paying citizen ought to be given precedence to the view that would favour the revenue-collecting authority.

Another noteworthy trait (again in the capital market, which is the space in which the authors have conducted their experiments) both public law (legislation made by Parliament) and private law (contracts written by private parties) have ousted the jurisdiction of courts. The SEBI Act, for instance, expressly bars the jurisdiction of civil courts in considering disputes over violation of the SEBI Act and regulations made under it. Instead, a special tribunal (the Securities Appellate Tribunal -- ``SAT'') is empowered to hear all appeals against every order passed by SEBI (such appeals can be pursued on questions of law and questions of fact) and orders of the SAT can be appealed against directly in the Supreme Court of India, only on questions of law.

Therefore, unlike in the United States, it would not be possible for a civil suit over whether there has occurred a violation of the SEBI Act. This question itself has been a controversial one -- where parties purported to confer jurisdiction (2002(1) Bom CR 419) on the Bombay High Court, in a suit over alleged violation of the takeover regulations, in appeal, the Supreme Court granted leave to appeal on this point alone (the dispute got settled and therefore the controversy never got resolved for posterity). In a subsequent development, a single judge of the Bombay High Court refused to entertain a suit, explaining that when the earlier case had been entertained by the Bombay High Court, the power of rectification of the register of shareholders upon a breach of the takeover regulations were not found in the law administered by SEBI, but that subsequent amendments to enable rectification had ensured that SEBI itself could administer such relief and therefore the ouster of jurisdiction of the civil courts had become absolute (2006 (1) Bom CR 545).

Therefore, since the legislation of the SEBI Act, a breach of securities laws has increasingly become a matter between the regulator and the person accused of the breach. Instead of approaching a common law court, the victim of the offence, would have to approach SEBI, which could choose to formulate its response, using the powers vested in it.

In private contracts, of course, it is rare to find material contracts not incorporating an arbitration clause -- under Indian law, courts are obliged not to sit in judgement over any dispute that is amenable to arbitration. Of course, courts have been vested with powers under the Arbitration and Conciliation Act, 1996, to grant protective orders, if any party to the dispute approaches it before or after instituting arbitration proceedings.

Against this backdrop, it is but natural that courts would have very little to contribute to big-ticket serious legal disputes and issues around securities laws -- both legislation and private contracts, have tended to oust Indian courts due to the endemic delays in justice delivery.

It is noteworthy that every single violation of any single provision of the SEBI Act, or rules and regulations made under the SEBI is also a criminal offence. Against this backdrop, the absence of clear-cut rules that would make compliance with law a predictable affair for the market, could result in a highly undesirable level of uncertainty in the market. A common law court would not be expected to take a stand as unreasonable as either of the two positions referred to above. However, considering that SEBI has been vested with powers of a civil court to issue such directions as it deems fit, the attitude of SEBI would be very important in the success or failure of a move to a purely PBR approach.

Jurisdictions that have adopted PBR as an approach, have a huge body of rules that govern the conduct of subjects, with the principles of interpretation alone being supplied by the so-called PBR approach. Guidance notes, illustrations, advance rulings and no-action letters abound. As developments evolve, the regulators in a PBR regime would change tack, modify their thinking and provide guidance that would further the principle sought to be pursued by them. India is light years behind in this level of maturity.

In a nutshell, this author believes that the Indian securities market currently seems to have deviated to a so-called RBR system. However, in fact, India is still very much a common law system, with the traditional powers of a court, being exercised, in the capital market, by specially empowered regulators. Should India desire to declare itself a PBR system, regulatory attitude would have to undergo a fundamental change, and cannot swing from strict interpretation of the rulebook to sweeping interpretation of seemingly clear principles.

There are some other issues that have to be kept in mind while analyzing the findings of the paper. These are:

  1. India's domestic equity markets may be noisier and may get more attention. However, this is not a function of equity investors' rights enjoying a higher quality of enforcement as compared with the quality of enforcement available to creditors of Indian borrowers.
  2. The absence of as noisy a corporate bonds market is a function of other legal history circumstances -- for instance, the Constitution of India empowers each state to impose stamp duty on debt instruments independently, and every state has its own framework of stamp duty on the same instrument, which in turn, impedes the evolution of smooth inter-state trading in debt securities. In other words, there are circumstances outside the plane of whether a common law or a civil law legacy would be more suited, that play a role.
  3. In the debt market, it is the secondary market for debt securities that is lacking, rather than a lack of credit offtake. Banks too are reluctant to lend in the form of bonds since they would have to mark their investments to market, and the absence of an active secondary market is more likely to hurt the banks' balance sheets when they mark their portfolios to market.
  4. For unsecured debt, whether the debt is from a foreign source or a domestic source, ought to make no difference. However, notwithstanding the lack of depth in the domestic bond market, the external commercial borrowings market for Indian credit is an active one.
  5. The Indian Rupee not being fully convertible on the capital account, exchange controls, which present regulatory tools to the RBI to sterilize foreign exchange inflows, are often pressed into service to suppress the inflow of external credit (restrictions such as those on end-use, source of credit, tenure, borrowing costs, remittance into India, mark India's exchange control policy governing debt, which is perceived as funds that would eventually also have to flow back out).

It would therefore be difficult to conclude that common law principles have not influenced the evolution of investor confidence in India. The institution that plays the role of the common law arbiter has shifted, at least in the capital markets (and increasingly so in several other sectors -- specialized regulators, specialized tribunals and ouster of civil courts, now represent the norm) from the civil courts to regulatory institutions. Indeed regulators are vested by statute with powers of a civil court, and the constitutional validity of such powers have been repeatedly upheld by the judiciary.

Despite the increasing size of prescriptive law in the form of regulatory provisions drafted by special regulators, the scope of interpretation remains purposive in character. Any effort towards shelving rule-making altogether in favour of adopting certain fundamental principles, should guard itself from over-simplification and carry-over of regulatory mindset. Despite Indian law requiring purposive interpretation, regulators have been known to take an uncomfortably technical approach to administration of the law. The teeth in the law (every breach of every provision of securities law, for instance, is a criminal offence) too heightens the stakes for having to deal with excessively simplistic principles.

It is good to let courts interpret principles and lay down the law, but markets that necessitate having to reach out to courts every now and then, can indeed undermine investor confidence. After all, there is some charm in predictable prescription to enable market participants to remain on the right side of the law.

Comment, by Sanjay Pandey, National Law University, Jodhpur

It is unquestionable that 'legal origin' shapes secondary rules of governance, which essentially form the bulk of regulations in any country. Taking the case of India and coming to the conclusion that financial regulations in the country are influenced mostly by political considerations rather than the legal tradition is not incorrect in principle but factually not palatable. Let me explain.

Common law and civil law systems vary mainly on precedent i.e. the binding nature of superior court decisions (Article 141 of the Constitution of India). In common law, a superior court's decisions can not be overridden by inferior or lower courts because law pronounced by them is final till the same is overruled. In civil law, every court has the authority to interpret the law and apply it accordingly to the given facts. In other words, the opinion of courts through interpretation has a limited role because the rule is required to be applied straightaway on the disputed facts. Such system require an abundance of rules and regulation, which in turn are not a mechanism to guide the court but a process to bind the court. This would suggest to any layman that in the second case uncertainty of application of law is wider in comparison to common law where due to the binding nature of a superior court's decision, the application of law remains certain for a longer period of time.

In matters of financial regulation certainty is the sine qua non for development of markets and their success. This fact does not find mention in John Armour's and Priya Lele's paper, however it can be corroborated from Legal Determinants of External Finance (NBER Working Paper No.5879), Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny, wherein the authors have shown strong links between capital market conditions in different countries and the legal traditions followed by those countries. This paper suggests that common law legal traditions help growth of an effective regulatory system, which is inherently pro development.

As far as the case of India is concerned, I believe any analytical review as to legal origins and financial sector growth needs elaboration of regulations under three phases. Firstly, pre independence, secondly post constitutional era but prior to 1991 and thirdly post 1991 era. If we refer to only a political point of view, which guided development and growth of legislations and also the capital markets in India, undoubtedly legislative growth is incremental and without a political motive it does not find a place anywhere. Law making under the Constitution of India is purely political (given the constitutional separation of power) but it does not affect the conditions of legal origin and its aftermath because the constitutional structure itself, is based on a common law legal tradition (we may see that constitutional rules are mostly found in the Government of India Act, 1935, which was essentially common law codified).

In India, on the capital market front two earlier legislations, namely the Capital Issues (Control) Act, 1947 and the Securities Contracts (Regulation) Act, 1956 were found to be not very effective in allowing the development of capital markets but this does not prove that the capital market remained in bad shape due to absence of political motives to legislate or to over legislate the given sector. Furthermore, it does not establish the fact (as contended in Lele's paper) that courts failed to use their common law jurisdictional tradition in evolving or creating principles of law to facilitate growth and development of capital markets in India.

I firmly believe that political demand and considerations are also related to the mandates of legal origin. In fact 'legal origin' affects drafting of legislations, making of rules and regulations, judicial controls etc., which are by and large seen as factors of development and growth of any given sector. One more interesting fact, which builds up this thesis, is the growth of regulatory institutions. It is a proven fact that a regulatory regime helps efficient and transparent growth of a market allowing it to be a fair and non-manipulative place.

In India ever since the growth of tribunals (from 42nd Constitution Amendment, 1976) common law tradition has ruled the roost, no tribunal has been allowed to function without there being a judicial member (faith in discretion and interpretation of law - a common law mandate). Furthermore tribunals have been made amenable to jurisdictions of the High Courts under Article 226 of the Constitution of India. This makes out a case that indeed there has been development in delegated legislation and institutions like RBI and SEBI have made most of rules and regulations but still role of judiciary is not undermined and on important aspects of interpretations, such decisions are followed by both the rule making institutions. I think this coordinate effort of common law institutional heritage has instilled confidence among the investors to believe in market fairness.

This strengthens the viewpoint that law and regulations coupled with its enforcement efficiency are important determinants to keep up investors' confidence in the market and the quality of law, regulation and enforcement efficiency depends heavily on legal origin. Courts in India are not interference oriented however in matters of finance and fiscal proprietary. They insist on having a legislative mandate in order to avoid accrual of any benefit to shareholders (Commissioner of Income Tax, Bangalore v. Infosys Technologies Ltd., 2008 (2) SCC 272 wherein the Supreme Court ruled that in the absence of legislative mandate a potential benefit could not be considered as `income' of the employee(s) chargeable under the head salaries) and in absence of such, legislative framework, benefit must go to shareholders. Such approach of Court is classic common law tradition.

It may be noted that interpretations by the Supreme Court of laws pertaining to capital market regulations in India show a trend that decisions of SAT have rarely been interfered by the Supreme Court, which instils more confidence in the regulatory mechanism. But this should not be interpreted to mean that the Court is relying more on hard rules, minimising discretion and possible interpretations thus deviating from the common law traditions (Reference could be made to AIR 2008 SC 290 in the matter of Ratnabali Capitals Markets Ltd. case, wherein an alternative interpretation could have allowed reversal of decision of SAT ).

An addition to the existing deliberations comes in form of political intervention and the common law mandate based on a `legal origins' theory and its impact on regulations through the TRAI's case. It may be noted that the Telecom Regulatory Authority of India used its authority under law and reported to the Ministry of Communications, as to business of the telecom department as the biggest player in the telecom market in India. It might be perceived that this could have been the main reason for amendment of TRAI Act in 2000, which turned the regulatory authority mainly into an advisory body (instance of direct political interference). This instance might not have direct capital market impact but it weakens the argument of the authors that statutory changes have remained slower in post 1991 phase. The Post 1991 phase has the seen majority of financial legislations, which have followed the common law mandates of legislative control mechanism (for example FEMA mandates rules and regulation under it subject to parliamentary laying process).

It must be emphasised that choice of law is indeed political but character of law remains based on `legal origin'. This is corroborated from historical aspects of study of law (reference could be given of Alexander Von Savigny, the German philosopher who established the relation between law and common will) this is a fact for Indian scenario as well. There is no point in saying that the equity market development in India owes to political reasons only and has no relation with `legal origin' theory because there is no corresponding debt market development. If `legal origin' theory is applied in historical context it mandates that common law protects individual rights more than institutional or corporate rights. Common law has allowed courts to recognise rights and also devise remedies in absence of legislative framework and historicity goes on to support the same. Thus a case is made out in favour of `legal origin' theory in case of financial regulations in India.

Comment, by Kaushik Krishnan

The LLSV literature says that the quality of laws in a country affect the ability of firms to access finance. While the correlations are persuasive, I wonder about the directions of cause and effect. Is access to finance an outcome of quality of laws or is quality of laws the outcome of firms that actively access finance? If India did not have firms that were actively doing OTC currency derivatives, this would not trigger off difficulties and thus improvements to the legal framework for OTC currency derivatives.

LLSV argue that the quality of a legal system can be traced to its legal origin. How a legal system evolved will decide how laws are created. This is broken into parts. First, LLSV claim that common law systems are more adaptable, and hence better, than civil law systems. Second, LLSV claim that the political independence of judges has a positive effect on the quality of a legal system. A judiciary that is more politically independent, will do a better job in protecting private property rights from encroachment of the State.

Let me first talk about Judicial Adaptability. In theory, common law works better because a judge has the discretion to interpret rules to come to favorable outcomes. However, judges interpret laws differently. This results in strange outcomes like the Supreme Court having to decide what to do when two different benches of the same High Court render conflicting judgments (Samatha vs. State of A.P.). For common law systems to harness the tremendous adaptability, a strong effort is simultaneously needed to have top quality judges and courts.

Even if were to assume that judicial adaptability of common law is good, it has little to do with India's financial sector. Indian judges don't have the training to understand and handle corporate finance well. For this reason, we have very little case law in these fields.

The limited success in good laws in India is due to delegation of power to hands-on regulators like SEBI and RBI who make more real-time calls that are often unhindered by politics. The downside to this is that there are too many Notification and Regulations. Many of them contradict one another. Rarely are they written by people trained in the law. Many people have been wondering whether SEBI can really be invested with such wide-ranging powers and I feel that a challenge to the Constitutional validity of the SEBI Act is not far away.

Now let me turn to the question of Political Independence of Judges. LLSV claim that Common Law grants greater political independence to their judiciary. This in turn, leads to a better legal system. I see no connection between common law and independent judiciaries. A judiciary is politically independent because of the Constitution of the country, or political decisions that were taken early in its life. India's judiciary has been so proactive, that is has become counterproductive. The Indian judiciary has frequently expanded the basket of rights that a citizen has without thinking of governmental capacity. Enforcement of newly created rights rarely follows judicial heroism. This results in more litigation, resulting in longer delays and backlog.

Having shown that LLSV does not explain India's situation fully, Lele and Armour offer the broader alternative of a political theory. They say that India's corporate finance laws and institutions exist because of strong lobbying by interest groups. They show how interest groups are now involved in the consultation process before laws or regulations are passed. Indeed, today most laws are passed only after interested parties are allowed to provide feedback through Departmentally Related Joint Standing Committees of the Parliament. They give us a synopsis of Indian financial regulation today. Before wrapping up, they also add that India's path dependencies (history) influence its laws.

As Som points out, both LLSV and Lele's papers need to be viewed from the context of the Rules vs Principles Debate. Both have their advantages. Neither is an outcome of legal origin. A decision to switch to both can be made at any time and should be made after weighing the benefits that both offer. Rules based regulation gives certainty, but it imparts rigidity. Because India has so many market participants, it is easier to just write rules for everything than to monitor the market carefully with a view of throwing bad players out. PBR (like common law) depends heavily on good and motivated human capital in regulatory bodies. Without this, PBR will fail. Neither market participants nor regulators in India have developed the sort of maturity that is required across the field to implement PBR. A phased approach to PBR will require the setting of broad goals that regulators need to strive towards and use as a yardstick to evaluate their decisions. In short, a move to PBR requires more than legislative change, it requires overhauling a mindset that people have gotten used to.

Comment, by Bibek Debroy, Centre for Policy Research

I feel very uncomfortable with any cross-country work concerning legal regimes and this is true of the present paper as well. First, in what sense is India a common law country? If it is the sense of the dispute resolution and adjudicatory process, as the comments make it out to be, there is validity in the description. However, if it is in the sense of codification of the law, as the original Armour-Lele paper seems to suggest, I have problems. Barring personal law, including property and inheritance, most law in India has been codified and the common law/civil law dichotomy serves no useful purpose.

Second, cross-country legal work often has an inordinately high focus on statutory law, ignoring the subordinate legislation. For instance, the `heavy hand of government ownership and regulation' surfaces through administrative law, not through statutory law. Cross-country work on labour law is a case in point, where this is ignored. Third, there is another point, which is not that pertinent for the present paper. Statutory law in India isn't only Central, there are State-level variations, thanks to the Seventh Schedule. A priori, I would therefore tend to think that the questions posed in the paper (political versus common law) are misplaced.

The debate on the form of regulation in the financial sector is extremely important, but is probably independent of these questions. If one ignores some reforms in the 1980s, financial sector reforms have been largely driven by Finance Ministry. They haven't been driven by Ministry of Law, Justice and Company Affairs. The content and the trigger have been economic, not legal. Sure, they have run into Constitutional issues and court intervention. But how does one interpret the Constitution in a common law versus civil law sense?

I think a better understanding of court mindsets is in terms of the conflict between the legislature/executive and judiciary in the early 1950s, followed by the post-emergency years and the post-reform conflict between the legislature/executive from the other end of the spectrum. We still haven't figured out the difference between regulation and control. Nor have we figured out the role of an independent regulator (regulatory powers vary across sectors) vis-a-vis the executive and the judiciary, including the appellate system. Nor should one forget the issue of criminal powers for regulators. The paper is important in raising these questions. But not the questions it sets out to raise.

Comment, by Surabhi Chopra, NIPFP

LLSV's `law and finance' analysis makes two claims. The first, relatively less controversial claim, is that laws that afford greater protection to private property, private contracting, shareholders and creditors enhance financial development. The second, far more problematic claim is that legal origin is a dominant determinant of financial growth.

As Armour & Lele note, classification by legal origin is a proxy for underlying differences, and because legal origin is typically an exogenous variable, LLSV argue that it indicates that good, i.e. market friendly, law-making drives growth rather than vice versa.

LLSV posit that common law systems perform better than their civil law counterparts on two broad counts: (1) common law systems do a better job of protecting private property rights, enforcing private contracts, and by corollary, of protecting creditors and minority shareholders; (2) common law systems, which combine judge-made law with statutory legislation, are more flexible and adaptable because judges can bridge the gaps between bedrock statutory provisions and regulation of contemporary financial disputes in incremental, efficient ways. Civil legal tradition, by contrast, can be taken as a proxy for excessive formalism, constraints on judicial power and independence, and a longer time lag between nuanced legal decision-making and the regulatory needs of the financial sector.

Perhaps the LLSV papers are best viewed within the larger context of a literature that examines the effect of institutions, institutional norms and the rules of the policy making game on economic growth, and argues, broadly speaking, that good institutions foster economic growth. However, it can also be argued that economic prosperity fosters sound institutions. To empirically establish the effect of institutions on economic growth, and circumvent the issue of reverse causality, theorists have often deployed a third variable that can explain the contours of the institution and serve as a proxy for it.

Capturing institutional soundness and its causal connections to financial development is slippery. Legal systems, particularly legal systems received through colonial rule or conscious adoption, serve as a handy form of variation through which LLSV have sought to establish the effect of law-making on growth. To my mind, the main question that the LLSV literature raises is whether legal origin is a good proxy for establishing that a market friendly legal framework is a significant determinant of growth. Is it an allowable simplification, which helps us, at a country or regional level, to gain conceptual purchase on roadblocks to financial growth and translate that understanding into policy prescriptions? Or does it mischaracterize legal systems and misdiagnose their effects on financial development?

Can countries usefully be characterized by legal origin? Even if they can be thus characterized, does legal origin play a fundamental role in fostering growth? Armour & Lele seem, persuasively, to answer both questions in the negative, although they address the second question more explicitly. They argue that political choices have been far more influential than `legal origin', i.e. India's common law legal system, in determining India's financial development and growth. In doing so, they chart with great clarity the trajectory of financial and legal reform in India.

Armour & Lele highlight that legislation can be a fraught process in a country governed by large, motley coalitions. Financial regulatory laws passed in previous decades have, in general, fostered over-regulation of the financial sector. Armour & Lele also highlight that, while the Indian judiciary is independent, powerful and has wide powers of judicial review (thereby meeting the LLSV characterization of a `common law' judiciary), these factors have not translated into flexible, efficient judicial law making in the way LLSV suggest they should. As Armour & Lele point out, litigation in India is sclerotic, characterized by a `stay and adjournment' culture, in which cases drag on for years. Institutions such as SEBI and the SAT that deliver more flexible decision-making have been carved out as the result of political decision-making; they are a departure from rather than an organic part of mainstream common law jurisprudence. In showing that India's common-law characteristics have not yielded market and growth friendly frameworks, Armour & Lele show that the LLSV equation of a common law heritage with higher growth is too simplistic. Regardless of pedigree, legal systems will perform based upon the capacity and incentives of those within them.

Armour & Lele's analysis of the Indian experience resonates strongly with Rajan & Zingales' (2003) argument that political decision making and trade-offs determine whether legislation and policies foster competition and financial growth (Rajan, R & Zingales, L., 2003. The Great Reversals: The Politics of Financial Development in the 20th century, Journal of Financial Economics 69 2003.). A relatively static factor such as legal origin might correlate to certain market-friendly norms and regulations, but cannot convincingly explain varying levels of financial development across countries over time.

Beck & Levine (2003, p.17) have discussed a range of research that queries whether the `common law' or `civil law' labels are useful when discussing financial and corporate law within a country (Beck, T & Levine, R. 2003. Legal Institutions and Financial Development. WB Policy Research Working Paper 3136.). Zweigert & Kortz (1998, p.468 at B&L, p.17) for example, have pointed out that English law had very strict privity of contract, until recent statutory reform through the Contracts (Rights of Third Parties) Act 1999. Franks et al (2003, discussed in Beck & Levine 2003, p.28) highlight that England initiated robust minority shareholder protection only in 1980, by statute, and until 1948, the Foss v. Harbottle common law rule held that no individual shareholder could sustain legal action against a company. Nicholas Thompson discusses Mark West's research, on similar lines, which argues that the LLSV characterization of Japan as a civil law country is an oversimplification, particularly with regard to Japanese corporate law (Thompson, N. Common Denominator. Legal Affairs). These efforts unpack the `common law' and `civil law' labels and show that these tags might mischaracterize the nature of legal regulation in a country. While Armour & Lele do not take strong issue with the manner in which LLSV deploy the common law and civil law labels, their analysis of the Indian system highlights the problem with coding countries in this way.

At one point, Lele & Armour suggest that the pattern of India's economic development and the quality of Indian financial laws has been strongly influenced by the legacy of colonial rule and central planning policies adopted after independence. It would be interesting to see them tease out in more detail the effect of colonial legacies on financial laws and economic development.

Acemoglu, Johnson and Robinson (2001) have argued that natural endowments, how habitable a particular place was, influenced the nature of colonial rule (Acemoglu D, Johnson S, & Robinson J, The Colonial Origins of Comparative Development: An Empirical Investigation, American Economic Review, 91 (2001): 1369-1401). Where colonizers settled and built lives, such as the US and Australia, they invested energy and resources in building institutions that protected, inter alia, property rights. Where colonizers were unable to settle, such as the Congo, they developed institutions that allowed them to extract natural resources rather than regulate lives and property. `Settler' institutional legacies were, not surprisingly, more conducive to sound post-colonial institution building than `extractive' institutional legacies.

The colonial experience in South Asia might be categorized as closer to the settler end of the spectrum, but was also significantly extractive. Colonial law making across a range of areas was aimed at controlling subjects, rather than respecting and protecting citizens. It is strongly arguable that the supposed hallmarks of a common system such as judicial independence, strong judicial review, protection of the rights to property and privacy, were attenuated within a colonial context. In East Africa, for example, property rights operated primarily to protect the landholdings of white settlers. One aspect of a `common law' colonial legacy might be systemic comfort with centralized control and curtailing freedoms, mediated, of course, by post-colonial political choices and pressures.

Thompson quotes Shleifer as saying "Lawyers don't do empirical work, they just argue with each other." While it is entirely true that lawyers quibble for a living, it is also the case that they are generally veer towards too much rather than too little empiricism. Armour & Lele carefully assess the facts and evidence on deregulation and growth in India, and in doing so they demonstrate that while LLSV's research throws up provocative correlations between common law systems and growth, this research has yet to convincingly bridge the gap between showing correlation and proving causation.

Response, by John Armour, University of Cambridge

We would like to thank everyone who has contributed very helpful and thought-provoking comments on our paper. We are delighted to see that it has provoked so much interest and debate, and are most grateful to all of your for taking the time to write responses. We are in the process of preparing the next draft and will take these comments into account when we do so. In the meantime we would like to make the following immediate comments/responses.

Somasekhar Sundaresan suggests that we do not make enough of the role played by SEBI's structure: powers to make and enforce rules, which are insulated from challenge under the civil law and subject to appeal in a specialist tribunal. This is clearly key to the effective development of securities market regulation in India. Development via the generalist courts would simply not occur. This is not however a hallmark of `common law' legal origin. Such a regulatory institution could equally well be set up in a civil law country. The point is that the regulatory rule-maker and enforcer is a new institution, and does not depend on the pre-existing legal system, but replaces it.

Moreover, he argues that we overestimate the significance in differences of legal investor protection as a cause of differences in equity and bond market capitalisation. We do not say that these are caused by differences in legal protection, but rather that they are complementary. Our methodology does not allow us to test for direction of causation. It may well be that the relatively underdeveloped market for corporate bonds is a cause of the relative lack of development of bondholder rights, rather than the other way around. To see this, consider the developments that have taken place in relation to creditor rights tend to be specifically enhancing enforcement for banks and financial institutions. Most debt raised by Indian companies is supplied by banks and FIs: enhanced enforcement for these creditors thus complements the pattern of financing. Professor Coffee and others have argued that this was the way in which financial market regulation developed in the US and UK as well -- first came the markets, then came the regulation.

Sanjay Pandey: We agree that it is necessary to separate out the different stages of historical development, and we do this. We suggest that during the period prior to liberalisation, the relative independence of India's judiciary likely assisted in preserving certainty for investors against the possibility of redistributive legalisation altering their entitlements. However the developments post-1991 have been very rapid, and have largely been driven by regulatory, rather than judicial development (via SEBI and the RBI). We do not see that these institutions are characteristically `common law' -- similar institutions exist in many civil law countries.

Sanjay Pandey also suggests that LLSV's findings support the importance of a difference between countries dependent on their legal origins. Our paper suggests that India's undoubted success in developing her capital markets is not a necessary consequence of her legal system's status as `common law'. Moreover, we think that there are grounds for treating LLSV's findings with suspicion. LLSV have of course reported systematic differences in investor protection depending on common law or civil law origins. However their results depend on the meaningfulness of the variables they have selected for coding the `quality' of the law, and the accuracy with which the coding has been done. A recent study by Holger Spamann at Harvard University has shown that much of the coding of the original anti-director rights index is inaccurate: see Spamann (2006). Spamann further reports that when the coding of scores is done accurately and consistently, the results reported by LLSV no longer hold.

Bibek Debroy says `I feel very uncomfortable with any cross-country work concerning legal regimes and this is true of the present paper as well.' We would like to emphasise that our paper is not an example of `cross-country work concerning legal regimes' . Rather it is a single country case study which offers a critique of such work. We show that if one thinks India's `common law' heritage is an explanation for the success of her financial markets, then it is hard to see how this has operated through the channel by which this is commonly said to operate, namely judicial adaptation of rules.

Responding to Surabhi Chopra and Kaushik Krishnan, the implication of our paper is that `common law' vs. `civil law' is unlikely to be a helpful classification, because it is too broad. Rather we should look for particular aspects of regulatory institution which are successful: (i) ability to write new rules quickly; (ii) high quality independent decision makers who are well informed; (iii) certainty; (iv) speed of decision; (v) effective enforcement. Such characteristics might be present in either civil or common law countries and so the binary classification is too narrow to be helpful.

Monday, June 09, 2008

An Indian economics bookshelf

My suggestions.

India needs a better financial system

With a Indian GDP of over a trillion dollars and a savings rate of over 30%, the Indian financial system is involved in intermediating massive flows of money. Writing in Financial Express, Kalpana Kochhar and Charles Kramer remind us that this underlines the need for a good financial system. That Kalpana and Charlie are bang on the money, with a timely and much-needed article, is partly a comment on the quality of the Indian economic policy discourse. Also see this article by Aadisht Khanna in Pragati, and an article by Kalpana Kochhar on the need for financial sector reforms in order to do infrastructure finance.

Kalpana, Charlie and Aadhisht point to the Patil, Mistry and Rajan reports as being the essence of what needs to get done. So far, there is little progress on doing these things. I see three possible scenarios:

  1. In one scenario, we get our act together and set about implementing these reports. That'd be just great.
  2. In a second scenario, a bigger and bigger slice of India-related financial intermediation would get done outside the country, as the private sector tries to escape the brunt of the domestic license-permit raj. This has started happening in many interesting ways. It is critically linked to the extent to which capital controls bind. While such movement is bad for domestic financial firms, there is no role for protectionism. While this is a good solution for the country in some ways, I think it is inefficient and suboptimal because it is costlier for financial intermediation done outside the country to obtain good information and analysis about alternative investments in India. And, as Percy Mistry's report has emphasised, going down this route involves wasting a natural opportunity for India to be a player in international financial services on a global scale.
  3. In a third scenario, capital controls bind and the private sector is a captive customer of the domestic financial system. In this case, an unreconstructed financial system would involve capital going into the wrong places; it would map a given savings rate into a lower GDP growth rate than is possible with financial sector reforms. As an example, the comparable surge in savings in China was associated with a lot of NPAs being created by the unreconstructed financial system.

Legal clarity and rule of law vs. capital controls

While India has made substantial progress towards de facto convertibility, the de jure situation has not commensurately changed. Capital account decontrol is riddled with quantitative restrictions and piecemeal measures. Fundamental foundations of the old approach have not been questioned; tinkering at the margins has been done in trying to open up.

One casualty of this piecemeal approach is legal clarity and the deeper concept of rule of law. Writing in Business Standard today, Somasekhar Sundaresan writes about the legal mess in FDI policy. This should be read alongside his piece on portfolio investment on 26 May. A short while ago, I had touched on the problem of rule of law in RBI's administration of ECB policy.

Saturday, June 07, 2008

We have seen this movie before

In the 1970s, the oil shock kicked up inflation all over the world. At the time, monetary policy was poorly structured the world over, and governments did all kinds of silly things in combating inflation. This messy combination of policies helped trigger of the painful period of `stagflation'. For economists, though, it was a great period in that it triggered off new thinking about what monetary policy should do. These new ideas have reshaped monetary policy in all high-income countries. New ideas of monetary policy have helped usher in the `great moderation' where recessions are shallower and shorter. I have an article We have seen this movie before in Financial Express today where I interpret India's problems with monetary policy and inflation from this point of view.

Critical appointments watch

Chairman, Finance Commission November 2007 Vijay Kelkar, 14 November 2007
Comptroller and Auditor-General January 2008 Vinod Rai, 17 December 2007.
Secretary, Dept. Financial Services, MOF January 2008 Arun Ramanathan, 8 January 2008.
Chairman, SEBI. link, Video on 24 January February 2008 C. B. Bhave, but do see this, 14 February 2008.
Two members of SEBI
Chairman, IRDA. link, link May 2008
Governor, RBI. link link September 2008
Chairman and members of Competition Commission. link, link, link

Also see:

Thursday, June 05, 2008

India needs an `inflation report'

All countries experience shocks to inflation. The countries with badly structured monetary policy regimes are those where these shocks get embedded into the structure of expectations, where inflation is more persistent, where the economic cost of wringing inflation out of the system is higher. Ila Patnaik had an article in Indian Express about care in thinking about fluctuations of inflation, and the urgent need for an `inflation report'.

Here are examples of some well written inflation reports - UK, Turkey. A good inflation report is one that is intellectually sound: it is rooted in a conceptually correct understanding of the macroeconomy. The people writing the report have to be clear-headed thinkers, grounded in modern macroeconomics, who understand what is actually going on in the country. The authors of the inflation report should have no conflicts of interest other than honestly talking about inflation: there should not be an effort at covering up for mistakes or upholding a broken monetary policy framework. And, it must be written in plain English, not mumbo jumbo, so as to influence the thinking of millions of individuals in the economy.

What shapes our outlook for inflation? The INR/USD has depreciated in recent weeks, which will fuel inflation in coming months. The small rise in WPI Fuel will also worsen inflation in coming months. These factors need to be properly understood by the authors of an inflation report. On the subject of exchange rate pass through, while one can do a little work, even elementary eyeballing of a graph is quite revealing.

Comment on inflation targeting for India

Tony Cavoli and Ramkishen Rajan have a interesting comment on the question of inflation targeting for India. Towards the end, they have a particularly interesting paragraph:

This leads us to a broader issue as to whether an inflation targeting arrangement errs on the side of policy rigidity and discipline or discretion and flexibility? While the exact balance between flexibility and rigidity will no doubt vary between countries (and possibly over time within a country), broad rules of thumb suggest: (a) the less credible the central bank (i.e. poorer its inflation-fighting track record); (b) the less its technical ability; and (c) the lower its political independence, the more advisable it is to pre-commit to a strict or hard inflation target (i.e. preference of a rule over discretion).

Tuesday, June 03, 2008

FRBM: A post mortem

I wrote an article in Business Standard titled FRBM: A Post Mortem.

Monetary policy must respond to changes in future inflation

Writing in Mint today, Vivek Moorthy argues that there is a conflict between inflation targeting and pre-emptive attacks on inflation.

Because monetary policy impacts upon aggregate demand and hence inflation with a lag, monetary policy formulation must necessarily be concerned with forecasts of inflation. Inflation targeting inherently means : watching future inflation and modifying the short rate so as to influence future inflation.

If Vivek is saying: It's silly to target last month's inflation, I could not agree more. The job of monetary policy is to anticipate future shocks to inflation and respond to them well ahead of time. Last month's inflation is an input into forecasting future inflation, and is only one input into this task. A smart inflation targeting central bank must forecast inflation, and act on what it sees in the forecasts.

As an example, when RBI setup an INR/USD depreciation of 9.7%, from 39.12 on 1 Feb to 42.93 on 22 May, it was easy to forecast that this was going to exacerbate inflation over a horizon of roughly 4 months. We know that a shock to the currency of 1% induces a shock of between 0.2 and 0.3 to WPI over a horizon of roughly four months. In other words, a shock to WPI of 2 to 3 percentage points is in the offing for WPI data from June to September, purely owing to the movement of the currency. Such empirical strategies can yield a lot of insight into future inflation.

I think a key strength of an inflation targeting central bank is that it is not in a fog of conflicting goals. There is only one goal. The entire organisation is focused on one thing. This generates better work on forecasting inflation and acting on these forecasts.

While on this subject, do read this piece about the `Taylor principle'. This is a necessary condition for a sensible monetary policy, and it's entirely phrased in terms of shocks to inflation that is expected at future dates.

Sunday, June 01, 2008

Radical Islam is evolving

Lawrence Wright has an article in The New Yorker titled The Rebellion Within about a key Islamic thinker moving away from violence. Then, see The Unraveling by Peter Bergen and Paul Cruickshank, in The New Republic. These threads are put together by Stephen Fidler in Financial Times. And, James Traub has an article in The New York Times about a pioneering liberal effort in Pakistan: The Lawyers' Crusade.

Steve Jobs and others have worried that `people don't read anymore'. The Internet has, indeed, changed reading habits; it does seem like there is more consumption of article-length pieces rather than book-length pieces. But the Lawrence Wright article linked to above is all of 13,866 words (!) or roughly a fifth of a good sized book. I know of no outlet in India that would carry pieces of this length.