Hollowing out of the Indian financial system

Business as usual, in India, is taking us to a destination where RBI & SEBI & company will preside over a minor and inconsequential financial system. The bulk of India-linked finance will take place overseas, and the overseas market will dominate price formation for India-related financial products.

Why might this happen?

Finance is the business of bits and bytes. Orders being sent to India can be easily switched to other venues. An array of other venues are now springing up:

1. Nifty futures trade in Singapore on the SGX
2. An array of sophisticated derivatives on Nifty trade on the OTC market offshore (also termed `the PN market').
3. Derivatives on the rupee trade overseas on the OTC market (linear contracts are termed `the NDF market').
4. Trading in individual stocks is taking place on the ADR and the GDR market.

Let's focus on Nifty - the most important financial product in India. (The arguments pretty much identically apply to everything else).

The success and survival of the onshore securities markets is fundamentally about NSE. NSE faces an array of problems rooted in domestic policy (example, example, example, example, etc). The overseas market faces no such problems. The CEO of SGX wakes up in the morning and thinks about competing with NSE. The CEO of NSE wakes up in the morning and thinks of an array of weird things.

And then, there is taxation. The fundamental principle worth using in this field is residence based taxation. We, as India, should not tax the activities of non-residents. For a global investor, sending orders to the Nifty futures on SGX is tax-efficient as Singapore follows a residence-based taxation system. Sending orders to India is inefficient today (owing to the STT and the stamp duty) and could get worse tomorrow (if GAAR is used to abrogate the Mauritius treaty).

We think we are comfortable, because India has capital controls, and residents don't have much of a choice on taking their custom elsewhere. Things aren't that simple. First, non-residents can pioneer sending order flow to overseas venues, and make them liquid. The next stage will be about Indian MNCs, who run global treasuries, who can easily patronise the overseas venues. The third stage will be HNI residents, who can take $200,000 per year per person outside India. In addition, the richest 1% of India would systematically shift money out of the country through various means fair and foul [example].

Put these factors together, and suddenly Nifty futures on SGX are a credible option. And this is exactly how things have worked out. Palak Shah in the Business Standard says:

As on date, the SGX Nifty OI is 27 per cent higher than that for Nifty futures on the National Stock Exchange (NSE). The figures are more alarming if one considers the OI in a single month in May as the built-up positions on the SGX are 70 per cent higher than on the NSE. In May, the SGX Nifty OI was worth over Rs 16,200 crore while that on the NSE stood at over Rs 9,250 crore. As far as three-month contracts go, the Nifty futures OI on the NSE is over Rs 12,750 crore.

In 2008, before these troubles had come together, SGX open interest was 59.78% of NSE. By 2012, where all these problems have come together, SGX open interest has come to 101.77% of NSE's. It is astonishing to see that for the biggest Indian product - Nifty - an overseas exchange has got superior open interest.

In the baseline scenario, Indian policy-making will meander on clueless and unconcerned. NSE will continue to lose ground. Why do we care? Is this mere protectionism - what is wrong if the entire India-linked equity index derivatives business takes place overseas?

• A rich and complex ecosystem of finance has developed surrounding the Nifty contracts. Hundreds of thousands of high skill workers are in this industry. A decisive loss of market share for India would endanger their livelihood.
• The tax revenues associated with all these activities, at present, come to the Indian authorities. The Indian tax man earns income tax (on wages and on corporate profit) and VAT (on an array of activities of the firms). All this will go away if the business shifts to Singapore.
• A sophisticated Indian financial system is required if monetary policy is to be effective. The demise of the onshore financial system will damage the onshore monetary policy transmission. It will further take us back towards a world where government is unable to play a role in business cycle stabilisation.
• Prospects of Bombay emerging as an international financial centre will subside. If we can't even hang on to market share for Nifty or the rupee, where is the question of competing against overseas financial firms or markets on things that aren't India-linked?
• Access to finance for firms will tend to split into a two-tier world: the big firms will go abroad to get their corporate finance done. The small firms will face greater constraints since they will not easily access finance abroad (there is a greater information distance between the typical Singapore investor and the typical Rs.1000 crore or Rs.100 crore Indian company), and the local financial system would be weak.

When India started trying to build a mature market economy in 1991, at first, it felt like a sophisticated financial system would emerge, which would both serve India and start competing for the global market. From 1993 to 2001, India achieved a remarkable revolution in the equity market. This increased optimism in the ability of India to understand problems, to achieve change, and to maintain high ethical standards.

It now seems that those hopes were premature. The more likely scenario is one where India-linked finance will happen offshore, while RBI/SEBI/CBDT/CCI/FMC/IRDA squabble over a minor and inconsequential onshore financial system that is riddled with ethics problems. In the short term, onshore Indian finance will suffer from one setback after another.

We are likely to go back to the conflicted arrangements that gave us the Harshad Mehta scandals of the early 1990s and the Ketan Parekh scandals one decade later. I used to think we were finished with those problems. But we are about to restart on that entire story; there is little institutional memory about how those things came about and how dangerous our present path is. Each future scandal, of this nature, will be greeted with joy by overseas financial providers, who will scoop up market share every time India falls into turmoil.

Many years from now, we may one day get to fundamentally superior governance arrangements in finance, and achieve high ethical standards in public life and securities infrastructure. If this happens, we would be able to come back to these questions. As an example, Japan lost the Nikkei 225 contract to Singapore in the mid-1980s and got back into this to a significant extent 15 years later. In the years or decades that will go by until domestic financial governance structures are corrected, a great deal of organisational capital in the onshore financial system will have been lost.

The revolution in the stock market used to be one of the best success stories of economic reforms in India [link, link]. It may well fall apart in coming months and years.

Doing better in our neighbourhood

A key intuition of modern thinking in international trade and international finance is that distance matters much more than we think.

We may like to believe that the world is becoming more flat. We may like to believe that for weightless things like services and financial flows, distance is irrelevant. But the research evidence is unambiguous: there is a `gravity model' in the affairs of men. The interactions between two countries tend to go up in proportion to the product of their GDP, and vary inversely with the squared distance between them.

Traditional trade theory would encourage us to think that India and Sri Lanka (say) have similar factor endowments, so the gains from trade might not be so great. But this is not borne out by the evidence: some of the most intense trade relationships are found between countries in Europe and between the US and Canada: between countries with very similar endowments.

In this region, we need to be much more mindful of the importance of intra-regional finance and trade activities. For India, this means a strong emphasis upon East Africa, the Middle East, Pakistan, Central Asia (by plane today, but someday we should get to road connectivity from the Indian ocean), the land route to China through Tibet, Nepal, Bangladesh, Burma, Singapore and Sri Lanka. India stands out, in international comparisons, for having unusually low economic engagement with its neighbours. This implies that there are opportunities for very large gains. In recent years, some Indian firms have emphasised these countries in their internationalisation strategy (both trade & investment), reflecting a greater role for natural conditions dictated by geography.

Some of these places are hobbled by political problems and abysmally low GDP. The product of the two GDPs matters, and bad political systems like to interfere with globalisation. The wise thing for us to do is to have a consistent and welcoming engagement strategy, waiting for the time that the country finds its feet in terms of establishing a healthy political system, waiting for the country to engage. A good example of India doing something right is the positive approach towards MFN status for Pakistan. We have to wait for Pakistan to understand that this is in their self-interest - and I do believe that in time, they will - but there is no reason for us to get stuck on reciprocity.

Of particular interest in recent months is Burma. Hamish McDonald has a beautiful piece titled Tractors may have replaced horses, but country is still decades behind.  If Burma comes out of its deep freeze, then the opportunities for trade and financial links with India are huge. We would go closer to the arrangements which were prevalent in the early 20th century, which reflect the natural opportunities.

With increased trade & financial linkages will come greater macroeconomic correlations a.k.a. shared interests. I saw a fascinating new IMF working paper by Ding Ding and Iyabo Masha titled India's growth spillovers to South Asia. This finds that after 1995, Indian growth has a significant impact in the region. If this is a robust finding, it is new; the idea that Indian business cycle fluctuations reach out and influence the region is not part of our intuition, particularly given the onerous trade barriers in place. Perhaps there is a lot more trade going on than meets the eye.

Looking back at late 2008

by Ajay Shah.

P. Vaidyanathan Iyer has a great first draft of history, in the new Sunday magazine that goes with the Indian Express, telling the story of what happened in India in late 2008. This was a difficult period with 6 shocks hitting us in a short time period:

1. The Lehman failure,
   
2. The crisis on the money market,
   
3. Difficulties at some banks,
   
4. Difficulties in some mutual fund schemes,
   
5. The Bombay attacks, and finally
   
6. The Satyam crisis.

Things could have turned out much worse. The individuals at MoF, SEBI, and RBI really came together and delivered. As India becomes a more complex economy, it becomes more and more important to bring top quality skills into policy making. The Indian success of crisis management in late 2008 is tightly linked to India's success on the great conflicts over appointments in 2008. Reading Vaidy's article made me go back into September and October 2008 on this blog to see what I was thinking and writing at the time:

• On 25 September, I did a lunch talk on the crisis at DEA.
  
• On 29th September evening, murmurs about difficulties at ICICI Bank erupted after the Indian market closing time. I remember how, late in the night of the 29th, I watched the ICICI ADR trade in the US, saw nothing big happening, did some Merton model calculations, and thought we were okay. The next morning, I wrote this blog post on ICICI Bank.
  
• This was the first day of the 3rd Research Meeting of the NIPFP DEA Research Program. Those present will remember how the crisis made for a dramatic backdrop for the inaugural session and indeed the entire conference.
  
• On 6 October I started seeing the liquidity crisis coming together.
  
• On 10 October, I wrote about the remarkable collapse in the money market which had come about. From 13 October onwards, I started doing a series of Crisis Watch posts.
  
• On 10 October, Jahangir Aziz, Ila Patnaik and I started writing a paper on what was going wrong and what should be done. Our paper was emailed out on 14th, we did a meeting at NIPFP to discuss it on 18th, and finalised it on 20th.
  
• On 26th October, I wrote about the short selling question.
• We watched the Satyam crisis unfold with horror [Anticipation, Maytas, Worsens].
• Here is the 7 December 2008 picture of macro policy.

When I look back, I feel that (of all people) the NIPFP Macro/Finance Group should have quickly and clearly understood the linkages between multinationals and the money market, and how the collapse of the money market in London in late September would surely matter greatly to India. We had the building blocks: We truly get India's high de facto integration into global finance, and we truly get the rise of Indian multinationals as a game changer. But we weren't cool enough to connect these pieces and make the consequent inferences to a surprising conclusion. We only woke up when it was obvious that the Indian money market had collapsed. When I look back, the really hard thing at that time was the `fog of war' which envelops economic policy thinking. In the best of times, the Indian statistical system is weak, and at a time like that, the data was hopelessly out of date. We're being penny wise + pound foolish in ignoring the informational foundations of the economy, without which policy makers are forced to fly blind. We do this by tolerating an awful statistical system, and by preventing the financial markets which produce vital information.

There was a lot of drama and loud opinions, but it was very hard to figure out what was actually going on. I was quite concerned about Indian CEOs crying wolf in order to get money from the government, given the long history of Indian CEOs not standing on their own feet. So I was biased in favour of ignoring the cries at first.

How the global financial crisis affects India, and what we can do about it

See this paper by Jahangir Aziz, Ila Patnaik and myself.

The pitfalls of an Indian Sovereign Wealth Fund

For the people manning the existing monetary policy regime, a Sovereign Wealth Fund is attractive because it alleviates one criticism: the cost of holding gigantic reserves. It helps RBI to delay RBI reform; to perpetuate the monetary policy regime of a pegged exchange rate for a wee bit longer. While this perspective is convenient for RBI, it ignores the difficulties of actually running a Sovereign Wealth Fund in India.

In Economic Times today, there is a story:

The government on Thursday wished the country's top mobile operator Bharti Airtel success in its pursuit to acquire South African telecom company MTN, while assuring other private companies of extending a helping hand in overseas buyouts.

Making it clear that there is no need to involve the government when private companies pursue deals among themselves, Minister of State for IT and Telecom Jyotiraditya Scindia said, "If the need arises and the companies ask for help, then the government can consider helping companies".

Scindia was replying to query if the government would back Bharti's move to acquire South African operator MTN, which has operations in 20 countries.

Earlier, the government had provided support to India- born businessmen L N Mittal during his company's takeover of Luxembourg-based steel maker Arcelor. The Indian government had lobbied with French authorities during the takeover.

This made me quite concerned. If an Indian SWF existed, would this mean that the Indian State would support overseas takeover attempts by Indian firms? How would the State pick which firms should be supported and which should not? Is there a possibility that there could be a variety of murky deals that are worked out in smoke filled rooms where politicians ask for a quid pro quo? And, is this all not a huge distraction for the incredibly overstretched Indian State from the core business of delivering public goods? A Sovereign Wealth Fund might be convenient for RBI but it is a bad idea when juxtaposed against the low standards of governance in India.

While on the subject of Sovereign Wealth Funds, see this.

Bharti Airtel proposes purchase of MTN

Bharti Airtel Ltd. is trying to buy MTN, the biggest mobile phone company in Africa. If the transaction works, at $19 billion, it would be the biggest transaction in outbound FDI from India so far. Bharti's market capitalisation on 9th was Rs.1.6 trillion or $40 billion. News of 8th, 9th. In 2006-07, Bharti Airtel had foreign assets which were just 0.07% of total assets. If this transaction comes through, it would be a huge jump into being a multinational firm. As with other large transactions such as the Tata Steel - Corus buyout, a great deal of international financial services are required for such events, and Indian financial firms are prohibited from producing these.

See the story in The Economist. The two papers mentioned in the story were both in the Internationalisation of firms session at the 2nd Research Meeting of the NIPFP-DEA Research Program on Capital Flows and their Consequences.

In the analytical framework employed in Graduating to globalisation by Dilek Demirbas, Ila Patnaik and myself [paper] [slideshow], telecom services are not tradeable and hence the progression from first learning to export (termed "DX") and then learning to do exporting and outbound FDI (termed "DXI") can't come about. (In 2006-07, Bharti Airtel shows exports of Rs.1335 crore. That's the net settlement between Airtel customers calling outside the country vs. foreigners calling Airtel customers. Apart from this, telecom is a non-tradeable: it's not possible for a telecom company in India to offer telecom services in Africa).

If a firm has high productivity, it can jump from being purely domestic (termed "D") to doing outbound FDI (termed "DI"). A firm which is unable to export but jumps to outbound FDI is a high productivity firm that knows how to rearrange labour and capital - in faraway countries - to produce cheaper than local firms there. That sounds like a good description of good Indian telecom companies.

The story that Ashok Jhunjhunwala tells is as follows. Roughly a decade ago, the standard engineering solutions that came from international telecom vendors induced prices for mobile telephony like USD 0.1 per minute. In India, there was a unique bulge of customers who were only available at lower prices. This market reality, coupled with competitive pressure, prompted Indian mobile phone vendors to resort to an array of hardware and software innovations which have induced the lowest cost of mobile telephony in the world.

These skills are transportable: a firm like Bharti Airtel which knows how to produce at very low prices in India can rearrange labour and capital in faraway countries to produce better than local firms there. The biggest telecom firm in Africa - also a place with a bulge of consumers who are very sensitive to prices - sounds like a good place to make such a play.

While Bharti Airtel isn't a particularly internationalised firm in terms of exporting, it has highly internationalised liabilities. The ownership pattern in March 2008 shows 20.57% in the hands of foreign `promoters' (i.e. insiders) and 25% in the hands of FIIs. Thus, 46% of the ownership of the firm is by foreigners. As with the typical large Indian firm, debt financing is not important: total borrowings are just Rs.5,310 crore compared with market capitalisation of Rs.160,000 crore. The internationalisation of liabilities is concentrated in equity financing.

Sovereign Wealth Funds and India

Shivnath Thukral hosted a debate on NDTV profit on Sovereign Wealth Funds, which dealt with two points of view. Should India worry about domestic assets being purchased by SWFs? And, should India setup a SWF? The show featured A. V. Rajwade, R. H. Patil, Somasekhar Sundaresan, Jayanth Varma and myself. Here's the video: part 1, part 2, part 3. You might like to also see this.

Separation between market and state

I wrote an article Concerns about sovereign funds in Business Standard today where I worry about placing shares - and thus a say in corporate governance - in the hands of governments, particularly those which lack domestic political accountability. It is related to the problems of civil servants managing large reserves portfolios.

Here's a useful collection of readings on the subject of sovereign wealth funds (SWFs) [wikipedia], organised in chronological fashion. I was dimly aware of the problem for quite a while; Larry Summers, Jeffrey Garten and William Pesek woke me up. The recent fracas about China talking about selling US government bonds is an illuminating episode: it tell us something about what can happen with SWFs in the days to come, and it tells us that the reserves portfolio is not that different from a SWF when it comes to such strategic behaviour. On the issues of both the reserves portfolio and SWFs, I'm reminded about the difficulties of `quasi-nationalisation' that arise in the context of government-controlled pension funds getting invested in equities (see this paper, particularly page 34, for the index fund response to that issue).

• Tracking the Tectonic Shift in Foreign Reserves and SWFs by Stephen Jen of Morgan Stanley, March 16, 2007.
• Asia, Oil Nations Poke Holes in IMF Reserves by Michael R. Sesit, 9 April 2007.
• The world's most expensive club, in The Economist, 24 May 2007.
• How sovereign wealth funds are muscling in on global markets by Tony Tassell and Joanna Chung in FT, 24 May 2007.
• Taming sovereign wealth funds in two easy steps by Willem Buiter, 22 July 2007.
• China should beware of a backlash, in FT, 24 July 2007.
• State Capitalism, an edit in FT, 25 July 2007.
• China takes the bank, in The Economist, 26 July 2007.
• Big spenders stir protectionism by John Willman, FT, 29 July 2007.
• Funds that shake capitalist logic by Larry Summers, 29 July 2007.
• Sovereign Wealth Funds: The Need for Greater Transparency and Accountability by Edwin M. Truman, policy brief from Peterson Institute, 6 August 2007.
• Insight: China prepares for overseas investment by Jing Ulrich, 7 August 2007.
• We need rules for sovereign funds by Jeffrey Garten, in FT, 7 August 2007.
• Thatcherism is out as China vindicates Galbraith by William Pesek, 7 August 2007.
• The balance of financial terror, circa August 9, 2007 by Brad Setser, 9 August 2007.
• China should use reserves to sway the US, by Christina Soon, 9 August 2007.
• China threatens `nuclear option' of dollar sales in The Telegraph (UK), 10 August 2007.
• China, Reserve Accumulation, and (Further) Threats to Financial Stability, blog posting by Menzie Chinn, 12 August 2007.

Easing capital controls on outbound FDI

In recent months, there has been a considerable focus on outbound FDI by Indian firms. Shyamala Gopinath, deputy governor of the RBI, has a speech documenting the evolution of policy on these questions.

I think there is more going on than is portrayed in this speech. The Tata Steel / Corus (would be) transaction is an example. It involves clever fund-raising in Singapore. The scale of resources involved greatly exceeds the flows across the Indian boundary as portrayed in Indian BOP data and as constricted by existing RBI rules.

When Indian firms become multinationals, capital controls bind less for them, for they will be able to transfer-price cash to a tax-efficient location where there is convertibility. Decisions from the headquarters about global FDI will then use the resources controlled at these foreign locations. The overall impact upon Indian de facto capital account openness, of "a gradual opening up" to outbound FDI is much larger than meets the eye.

This point falls within the larger theme of capital controls being porous and essentially un-enforceable in a world of modern trade, finance and MNCs.