Comparing Indian and Chinese progress on financial sector reforms

There is a broad consensus that India has done better than China at setting up the financial system. Indian banks are less bankrupt; the Indian equity market works better; the financial sector acts as more of a check in India in choosing which firms obtain access to capital, rewarding performance and good corporate governance. While these statements are broadly on track, in recent years, the Chinese have actually made remarkable and far-reaching progress, much more than they are generally given credit for. The Chinese have gone ahead and done things that are considered heresy in India, particularly in the eyes of the communists. In recent weeks Mythili Bhusnurmath and Ila Patnaik have written a pair of excellent articles on this theme.

One feature which plays in China's favour is the liberalisation of finance that was agreed to when China was admitted into the WTO. Even though a five-year window of time governs the full implications, the promises which have been made surely guide and influence public policy which must plan a trajectory which is compatible with the dates and commitments. In India's case, there is no comparable hard budget constraint influencing liberalisation.

Another central bank gets a nose bloodied

All of us remember the famous speech at IGIDR by Y V Reddy on 12 January 2005 where he expressed interest in more capital controls [link to speech, the next day's front page comment by Ila Patnaik]. In India's case, this yearning ended at the speech stage.

A natural experiment in the introduction of such restrictions took place in Thailand last week. A Chilean-style unremunerative reserve requirement [link] was announced by Thailand's central bank on Monday (18th). The government backed away from this on 19th (Tuesday), after stock prices crashed by 15% [link, link].

I wrote an article Adventures of the Baht in Business Standard on this drama, after their announcement of the reserve requirement but before they backed away from it.

I think that the first best world is one with no capital controls. The second best world is one with no capital controls and this unremunerative reserve requirement; it is better than the intricate system of quantitative restrictions (QRs) which we have as a system of capital controls in India. The Thais may have made mistakes in exactly how they went about trying to do it. The bottom line in this episode is one more central bank with a bloodied nose.

Three interesting opinion pieces on finance & monetary economics

Mythili Bhusnurmath complains about RBI surprising the market; a Business Standard editorial on hedge funds; and another responding to recent SEBI proposals. Coincidentally, a great Foreign Affairs article on hedge funds just appeared by Sebastian Mallaby, and he wrote up a small version of this for Washington Post. And, Lars Nyberg, the deputy governer of the Swedish central bank, has a nice speech on hedge funds. I get really impressed by the speechwriters found in OECD countries.

Bureacrats as bankers: European view

In Financial Times, I saw an article by Wolfgang Munchau titled Get the state out of Europe's banking sector where he says:

When I recently asked a well-known Swedish economist about the lessons of Sweden's economic success for the rest of Europe, he answered: `Don't copy our social model. Have a financial crisis instead.' He was referring to the early 1990s, when Sweden experienced severe financial turmoil that precipitated deep structural changes in the banking industry and the economy at large.

...

My own priority for France and Germany would be ... the banking system. Follow the money. A Schumpeterian Swedish-style financial crisis might do the job but it is not going to happen. Back in the real world, reform is the best alternative.

Of course, the problems are not identical across European countries. In both France and Germany, the banking market is dominated by non-private financial institutions. The problem is perhaps most acute in Germany, where in 2005 commercial banks accounted for a mere 26.5 per cent of the assets of the entire banking system, a figure hardly changed since 1990. The biggest force in the German banking system is the public sector and co-operative banks. The result is a pathological co-existence between the public and private sectors, under which the private sector has been driven out of large parts of the retail market.

There are instructive parallels with Italy. A comparative study of the two systems by academics from the Bank of Italy, the Bundesbank and various European universities found that Italy is in some respects a role model. In 1990, Italy had a similar bank structure to Germany's. Between 1990 and 2005, the asset share of the public sector banks declined from 70 per cent to about 9 per cent. The research found that technological progress was the main cause of the increase in total factor productivity in both countries but in Italy, privatisation also contributed to the rise in TFP.

Why has Italy reformed, while Germany has not? The Italians realised they needed a modern banking sector in time for monetary union in the late 1990s. The Germans, by contrast, actually believed in their multi-pillar system. It served them well, especially in the period of postwar reconstruction. Attitudes are changing but only slowly. As a senior German official noted, the prevailing attitude today is more defensive: if it ain't broke, don't fix it.

Last week, the Bundesbank co-sponsored a conference on the future of public sector banking in Germany. The remarkable fact about this event is that it could not have taken place 10 years ago.

Academic research has consistently shown a negative relationship between the prevalence of public sector banking and a country's growth rate. This has been known for some time. Ross Levine, professor of finance at Brown University, argued that public sector banks are even unsuited to serving the goals they were originally set up to pursue: poverty reduction; financial development assistance; giving people access to capital they would otherwise not get; and overcoming the lack of credit history for small companies. The conclusion from the academic literature is that state-owned banks are mostly political banks that serve sectarian interests within society, but not society at large. To put it another way: they are tools of corruption.

A study of state-owned banks in India, for example, has shown that their credit volume is 5-10 per cent higher in an election year. A similar study in Japan concluded that prefectures represented by influential members of the governing Liberal Democratic party received more public-bank loans. The situation is not fundamentally different in Europe. In Germany, the public sector banking system was often used by politicians at all levels of the federal system to prop up companies that would otherwise not exist in a purely competitive environment. While bail-outs are politically popular, their long-term economic effect is negative. They impede structural change. If Germany had a purely commercial banking system, I would not be surprised if the share of manufacturing in the economy were smaller than it is today. The public-sector banking system is geared heavily towards the manufacturing sector.

So what are the chances of reform? A few years ago, after the collapse of the dotcom bubble, it looked for a while as though Germany might suffer a Swedish-style financial shock. But profit margins have since recovered. My prediction is that the combined force of European competition policy and further European financial integration will eventually lead to the long-overdue modernisation of the banking sector across the eurozone. It should be a priority for economic reformers to prepare the ground for change.

The research paper that he talks about is Productivity Change, Consolidation and Privatization in Italian and German Banking Markets, de Vincenzo et al, conference paper, November 2006.

When it comes to the question of public ownership of banks, the international consensus is that this is a bad idea. Giving elected representatives the power to meddle with loan decisions is a distraction from the core business of a State that focuses on public goods. In the best of times, running an opaque and highly leveraged financial firm is hard; things aren't helped by bureacrats being managers. Finance is about subtle forward-looking judgments about alternative firms: the rigid processes of the public sector aren't conducive to risk taking and jugdment. It is hard for banking regulation to have technical soundness when regulated entities are owned by the government.

The Indian discourse on this question is split between two camps. On one hand, there is the Left which thinks nationalisation of many things is a good idea. On the other hand, there are the folk who see that bank nationalisation was a big blunder, but just don't see how the politics will support privatisation.

Financial regulation of a third world country

In the best of times, financial regulation is hard. A lot of the time, in India, we get the financial regulation of a third world country. Business Standard has an editorial linking up three recent developments:

1. FMC banning advisory services by securities firms on the commodity futures markets,
2. New guidelines from RBI on derivatives and
3. SEBI granting BSE a monopoly corporate bond reporting platform.

The editorial says:

In recent days, three distinct announcements have come out, highlighting the low quality of financial sector policy in India. The first element was an announcement from the RBI about financial derivatives. For many years, the RBI has had profound flaws in the treatment of financial derivatives. Unfortunately, the new guidelines make no progress; they are old wine in an old bottle. Derivatives are the foundation of the new approach to risk in a mature market economy. Liquid and efficient derivatives markets change the functioning of every firm in the country, both through direct participation and indirectly through superior financing. Banks are key players in hedging, speculation and arbitrage, which enable the derivatives markets to function. This requires commensurate knowledge in the regulation and supervision of banks. The new RBI guidelines do not put India on the trajectory of becoming a mature market economy.

The second element was an announcement from the Securities and Exchange Board of India (Sebi) about a `corporate bond reporting platform', where a monopoly has been granted to the Bombay Stock Exchange (BSE). This is wrong at two levels. First, the hallmark of a mature market economy is competition, not monopoly. And, if Sebi felt that the right solution was a monopoly, the award of a concession requires a commensurate procurement procedure. Alternatives to the BSE need to be judged transparently based on technical and financial bids.

The third element was an announcement from the Forward Markets Commission (FMC), banning securities firms from offering clients portfolio advisory, portfolio management and other services in the commodity derivative markets. This move is in the wrong direction because the direction for progress consists of building up greater knowledge, greater sophistication and a bigger mass of capital which is able to trade in the commodity futures market and induce market efficiency. In every country, commodity trading has started out as the exclusive preserve of a small group of merchants. The transition to a mature market economy comes about by breaking the stranglehold of this small group of merchants, by broadening participation, by bringing in analytical thinking backed by capital. The FMC is doubtless responding to complaints from traditional merchant communities who find the modern development of commodity futures markets to be a threat. But the FMC has done wrong by giving in to these demands. The FMC announcement is, of course, completely futile because nobody can come in the way of an advisory relationship between person X and person Y. That advice will continue to be given. The only thing that will change is the mechanism through which the advice will be paid for. The FMC has only achieved a greater level of mis-representation in the accounts of both the buyer and the seller of advice. The FMC has lapsed into 1970s-style economic policy, where a ban drives a legitimate activity underground.

In certain aspects of the reforms process, the ruling United Progressive Alliance faces constraints owing to its inability to be tough with the Left parties. Such reasons explain the failure of the UPA government to pass the pension reform Bill. But no such reasons hold back the government when it comes to solving key bottlenecks in the financial sector. These policies of the RBI, Sebi and the FMC are not designed to help India move into the world of developed markets.

At present in India, too much power has been placed in the hands of these agencies without adequate mechanisms for transparency and accountability. When these agencies go wrong in this fashion (or in other ways), the system does not have an adequate homeostatic response.

What to do with $170 billion of reserves

Jaimini Bhagwati has a great article in today's Business Standard about the poor returns on India's foreign exchange reserves portfolio. In it, he says:

According to the Reserve Bank of India?s Annual Report for 2005-06, the nominal rupee (INR) denominated rates of return on India's foreign currency assets (FCA) for 2005-06 and 2004-05 were 3.9% and 3.1%, respectively. Foreign currency assets include foreign exchange reserves less gold holdings, special drawing rights and India's reserve position in the IMF. Inflation in India in the last one year has been about 5%. Therefore, the real rate of return on India's FCA for 2005-06 was around minus 1.1% (3.9-5).

The Reserve Bank of India (RBI) is currently responsible for managing the country's foreign exchange (FX) reserves. Since central banks hold gold as a last measure of protection against a balance of payments crisis, the discussion in this article is confined to FCA management. The real INR rate of return on India's FCA has been negligible to negative in the last two years. These low returns on India's FCA could be attributed to the RBI's cautious policies in which the guiding principles are to maintain mark-to-market value and liquidity by taking minimal credit and market risk. Effectively, the rate of return is a secondary concern and the RBI's options are accordingly limited to investing in short-dated triple-A rated government debt securities.

How should we measure the performance of the Indian FCA portfolio? For instance, should the numeraire currency be the dollar or INR? The currency in which the rate of return is measured should not matter in economic terms. It is the currency composition of the benchmark portfolio, against which the FCA portfolio's performance is measured, which needs to be calibrated carefully. Given the potential for disorderly US$ depreciation the benchmark portfolio may need to be tweaked frequently to take into account the exposure of the Indian current account to exchange rate risk.

A traditional yardstick to assess the sustainability of a sovereign's external borrowings is to compare the average cost of such borrowings with the GDP growth rate. By extension, India's FCA earnings should be comparable with the GDP growth rate. In the last one year, real growth has been 8% plus, making the GDP growth rate 9% [8 - (-1.1)] more than FCA earnings. Another construct, suggested by Dani Rodrik, is to compare FCA earnings with the cost of short-term external commercial borrowings (ECBs). At the margin, Indian FCA earnings would be about the same as the yield on 3-month US Treasury bills, currently about three-month LIBOR - 0.40%. The average cost of short-term ECBs for Indian firms is about 3-month LIBOR + 2.5%. That is, the opportunity cost of holding "excess" FCA would be at least about 3%.

Of the Asian countries which have accumulated significant volumes of FX reserves, Singapore has allocated the responsibility of managing reserves to maintain the stability of the Singapore dollar to the Monetary Authority of Singapore (MAS) and excess reserves have been assigned to the Government of Singapore Investment Corporation (GIC), which manages higher risk-return investment portfolios. More recently, South Korea has followed the same model and set up the Korean Investment Corporation.

Some questions about Indian FCA management need answers. Could the returns be increased significantly without undue risk to the country's ability to service its external debt and sustain current account deficits required for investment purposes? Is the allocation of Indian FCA management to the RBI conducive to a satisfactory rate of return? Further, if the mandate for FCA management is altered would that necessarily result in a higher rate of return?

Obviously, there are no definitive answers to these questions. In the context of adequacy of FX reserves, Guidotti-Greenspan have suggested that these should be at least equal to external debt maturing in the next one year. As of end March 2006, India's short-term external debt plus long-term debt maturing in a year was about $15 billion. On the same date, non-resident Indian (NRI) deposits amounted to approximately $35 billion and external commercial borrowings (ECBs) totalled about $26 billion. The market value of foreign institutional investors' (FII) portfolio investments in Indian equity markets is around $110 billion. That is, total external debt maturing in a year plus 50% of NRI deposits and ECBs and 25% of FII portfolio investments add up to about $70 billion.

How should the RBI maintain an adequate level of reserves for external debt servicing and other requirements while it manages excess FCA separately to maximise returns within acceptable credit and market risk limits? As of mid November 2006, Indian FX reserves amounted to about $170 billion. One option is for the RBI to manage a highly liquid, low-return portfolio of $70 billion as insurance against capital flight caused by unexpected market developments. The remaining $100 billion could also be managed by the RBI in separate portfolios with associated benchmarks which carry greater market risk and hence commensurately higher returns. This proposal for several portfolios with differing risk-return characteristics is not necessarily to take additional credit risk but diversified market risk. For instance, FCA managers could move up the yield curve and take some interest rate risk and invest in highly-rated municipal and asset-backed securities. They could also diversify out of fixed-income instruments into asset categories such as equity and real estate. Singapore and South Korea have set up separate investment corporations to manage their growing reserves because the skills required for managing investments in equities, asset-backed securities, and real estate are qualitatively different from those needed for managing portfolios consisting of short-maturity government-debt securities.

Lawrence Summers, speaking at an LK Jha memorial lecture in Mumbai on March 24, 2006, remarked that India could expect to earn about 6% in real terms on its FCA if these were invested in global capital markets. On balance, it appears that it should be possible to earn an additional 5%, compared to current FCA earnings by investing excess Indian FCA through a dedicated investment platform set up by the RBI/Ministry of Finance. An additional 5% return on $100 billion is $5 billion, which is about 0.6% of GDP. This number would be lower if the investment guidelines for the higher risk-return reserves portfolios were to be restrictive but it is still likely to be a significant figure. All things considered, it is time for the RBI and the Ministry of Finance to set up a separate investment firm or platform with appropriate performance benchmarks and incentives for the staff.

In my understanding, the quasi-fiscal costs of holding reserves in this fashion come in two parts. First, there is the well known opportunity cost of being invested in a low return asset (US government bonds or USD denominated bank accounts). As a country, India is paying higher rates for the equity/debt capital coming into the country, but earning low rates for the USD assets held by RBI - doesn't sound like a very good deal. More narrowly, if you focus on the consolidated government of India, there has been a gap between the high price at which GOI borrows on the bond market versus the low returns obtained on the reserves portfolio - this is a fiscal cost to GOI. This issue has been known in the literature for a while.

The second component, in my opinion, is more important: this is the losses that come about in the reserves portfolio when the currency adjusts. Suppose RBI tries to block an INR appreciation by purchasing USD, at a time when the exchange rate is Rs.46/$. This involves buying $100 for Rs.4600. Suppose you believe that you are in a situation where the central banks can only slow down the inevitable market process but not block it. So, if an appreciation was coming, it would come anyway - RBI is unable to prevent the inevitable, only delay it. In this case, after some period of time, you end up at Rs.43/$. Now the RBI portfolio is valued at Rs.4300. In other words, a loss has taken place from Rs.4600 to Rs.4300.

Some of this difficulty goes away by keeping score in USD. If RBI holds 25% of the reserves portfolio in EUR, and keeps score in USD, then the returns on the reserves portfolio as measured in USD looks great when the USD depreciates. I think this is illusory. I think it's safest to think in INR. In the Indian case, there are two manifestations of the fiscal costs of reserves. First, the `market stabilisation scheme' (MSS) was a very nice thing in converting some of the hidden cost of reserves into a line item in the budget. I think it's wrong to waste money on holding reserves, but if you must do so, I think it's better to be transparent about it. In addition, if you look at the time-series of the dividend paid by RBI to GOI over the years, expressed as percent of GDP, there's been a sharp drop. This drop has come about largely because of the growth of reserves.

Jaimini asks: Can we do better than RBI's management of the reserves portfolio? I'm sure we can. Jaimini is right in saying that the improved performance could amount to as much as 1% of GDP, which is a huge number.

I think it's equally important to ask: Do we need reserves beyond $70 billion? Does it make sense for any bureaucrat to hold a portfolio of 20% of GDP? I think it is preferable to not hold such assets in the public sector in the first place; it is better for the citizens of the country to hold globally diversified portfolios rather than placing these in the hands of a government agency, regardless of whether it's an RBI-style agency which earns low returns or an ADIA-style agency which does better. As an example, consider this Economic Times article titled Indian Temasek Challenger to be Launched (an inaccurate title). I think Indian politics does not mix well with such an entity. We are better off without it; we are better off with a government which just sticks to public goods and stays out of the management of the stock of assets of the citizens of the nation.

In 2003 and 2004, when India was building up reserves at a huge pace, Ila Patnaik wrote an excellent group of articles in Business Standard warning about these kinds of issues. In particular, see The USD quagmire, Dining with the devil and Feeding an elephant. This sequence of articles ended in March 2004 when India got off that tightly-pegged exchange rate. On the subject of `how much reserves is adequate', see her India's policy stance on reserves and the currency.

The only saving grace about the Indian story is that things are better here when compared with East Asia. The reserves managers in East Asia must feel terrible, holding gigantic USD assets that they dare not sell, while week after week they endure the agony of watching the USD drop.

It's been the best deal imaginable for the US: buy cheap Chinese goods through a distorted exchange rate, pay for them using IOUs, and then have those IOUs depreciate in value so they don't even have to be paid back in full. The Chinese get hurt twice: first when selling cheap goods, and second when suffering losses on the USD portfolio. The same double-whammy hurt India also, but on a much smaller scale.

Dubai: an international financial centre?

There is an article in The Economist about the effort at Dubai in becoming an international financial centre. On one hand, this is a success story of the speed and effectiveness of a dictatorship-doing-the-right-things. But as their next piece on the same subject says:

...

Yet it takes more than a dream and government largesse to succeed as a financial hub. Dubai and its imitators need to remember that the market is built not just on subsidies that attract foreigners, but markets that attract locals.

Dubai has done a lot right. Despite a tarnished past as a centre for money laundering, it has burnished its image so as to attract big investment banks and other financiers in the past year. Just a few weeks ago Carlyle, a large private-equity firm, announced that it would open shop there. Building on its transport links and a pleasant quality of life, Dubai has created a sparkling new financial centre that offers international-quality regulations enforced by imported regulators, a Western legal code, oodles of subsidies and refreshingly little red tape.

Yet in spite of this and the sea of petrodollars sloshing around the Middle East, Dubai is only halfway towards its ambition (see article). Its new stock exchange is struggling, with thin trading and few listings. The banks that blew in with the tide of global capital are impatiently muttering about embarking for the next port. Something is still missing.

To win a place in the top club of financial centres, Dubai must attract not just providers of capital but users, too. The bankers need companies that want to sell their shares and bonds in the region; fund managers want local companies to invest in; and private-equity partners need a pipeline of enticing ventures and the prospect of listing their companies after a few years. Dubai has sought to profit from the unprecedented mobility of markets, but without local demand for capital, that same mobility will start to count against it.

The trouble is that few local companies are ready for Dubai's capital markets. The Arab world includes plenty of sophisticated large investors but few modern companies. Long ago, the region's failure to develop joint-stock companies was one reason why it fell behind the West. Even today, financial transparency is weak and accounting is erratic. Most enterprises are family owned and, since they operate in protected markets, have no great need to raise capital, especially if it means exposing themselves to greater scrutiny.

This is not unique to the Gulf: the developing world is full of companies that are shielded from competitive marketsll that oil wealth, which means there is plenty of traditional bank credit for all sorts of Middle Eastern businesses. To make matters worse, local stockmarkets are still shaky after a crash earlier this year.

My reading, based on conversations with many people who have looked closely at DIFC, is that DIFC is creeping up into the ranks of a credible venue for placing certain mid-range financial functions. For the low-end BPO, India wins. For the high-end knowledge work, it's still London. There is a certain middle where Dubai is attractive. But as yet, it isn't a `financial ecosystem', where people meet and talk and do transactions on each other, where secondary market liquidity pulls in economic agents. A `big push' by a State, that tries to create an exchange or three by fiat, does not generate this liquidity. E.g. as of yet DGCX is doing perhaps 2,500 contracts per day... the case has yet to be made for trading at an exchange in Dubai when capital controls do not force business away from the great exchanges of the world. Perhaps you cannot will an international financial centre in a desert.

I like to apply a `bookshop test' in judging an international financial centre. I judge the quality of a financial centre by wandering the bookshops, which gives me a hint of the kinds of books the local financial elite is buying. Here London and New York clearly stand alone: their elite buys books on implementing finite difference schemes for Heath/Jarrow/Morton. Singapore is very, very impressive, with plenty of effort on learning stochastic calculus. Bombay is mediocre - with a big focus on get-rich-quick trader books. I haven't seen a bookshop inhabited by finance folk in Dubai - what is it like?