by Rakesh Mohan
III. Post-1997 Developments
Monetary Sector
With major institutional reforms having been effected by 1997, the main focus after that was on policy. However, there have been two significant institutional changes that need to be noted.
First, the introduction of the Liquidity Adjustment Facility (LAF), besides providing a mechanism for dealing with the short-term surplus or deficit of funds faced by commercial banks, also established the repo rate as a policy rate. This again was possible only because the administered structure of interest had been done away with earlier. Though interest rate (as distinct from money supply) has emerged as the signal of the central bank, it must be emphasized that any decision of the RBI to raise or lower the repo rate must be accompanied by actions which result in reducing or expanding liquidity. In short, the RBI cannot act as King Canute. It cannot simply order interest rates. It must take such actions as are necessary to make the decision stick.
Second is the most recent change to introduce a new monetary policy framework. Under the new framework which has a legal sanction, the RBI is expected to maintain the consumer price index (CPI) inflation at 4 per cent with a margin of (+) or (-) 2 per cent. A monetary policy committee has also been set up with three nominees each from the RBI and the government. The decision of the committee is binding. The governor has a casting vote in case of a tie. Inflation-targeting as the objective of monetary policy has strong adherents as well as detractors. The new framework is however a firm assertion of the maintenance of price stability as the dominant objective of monetary policy.
Banking Sector Reforms
The structural reforms in the banking sector introduced in the initial years were further strengthened. The prudential norms have been tightened and altered in the context of changing circumstances. We have moved from Basel I norms to Basel II and now to Basel III norms. After the financial crisis of 2008, the need to curb excessive risk-taking by banks has become essential. The RBI brings out at periodic intervals Financial Stability Reports assessing the vulnerability of the banking system to various shocks. The problem of non-performing assets has once again reared its head. The prudential norms only make transparent the health of the banks. It is up to individual banks and the regulator to take appropriate action to improve the situation.
After the initial burst of licensing the private-sector banks, there was a lull. However, most recently, a new policy framework with respect to the licensing of banks has come into operation. The issue of new licences is being put on tap. The new policy relates not just to large banks but also envisages the setting up of small banks as well as of payment banks which do not have the power to lend. The concept of small banks is a modification of the earlier idea of Local Area Banks introduced in 1996. Under the new concept, there is, however, no limit on territorial jurisdiction. The payment banks concept is a new one. These banks are allowed to take the savings deposits and offer facilities for the transfer of funds. While they can invest the funds in government paper, they cannot lend. The new scheme is just taking off.
There is a growing emphasis on financial inclusion. The objective is to bring within the ambit of the organized financial system the vulnerable and the poor. The poor and the low-income groups have been encouraged to open bank accounts and an attempt is also being made to link these bank accounts with various poverty-reduction schemes such as the Mahatma Gandhi National Rural Employment Guarantee Scheme. The payments to the beneficiaries are directly made into their bank accounts.
The Non-Banking Financial Companies (NBFCs) were loosely regulated prior to 1996. That is how the law stood at that time. Post-1997, more stringent norms have been specified. Particularly, NBFCs which take public deposits have come under stringent scrutiny.
Exchange-rate Reforms
The development of the foreign-exchange market became a major concern once the exchange rate came to be determined largely by the market. The RBI has taken several actions that are necessary to strengthen the spot and future markets. It also became obvious that the foreign-exchange market and the domestic money market were organically related.
The Indian economy has faced many external shocks since 1997. First was the East Asian crisis. Second was the impact of the Pokhran nuclear explosion. Third was the 2008 financial crisis and the fourth the 2013 taper tantrums. With deft policy changes, all these were handled well. We could do this with our own resources and without having to go to any international organization. In fact, as mentioned earlier, India’s balance-of-payments situation has never remained as strong as it has been since 1992–93.
Capital-account convertibility has proceeded gradually. There is now much greater freedom to transfer funds on the capital account. However, it is well recognized that regulation of capital movements must remain a necessary part of the policy framework. Capital controls may be needed not only in times of crisis but also in situations where a crisis is looming on the horizon.
With the acceptance of current-account convertibility and with greater freedom on capital account, the erstwhile Foreign Exchange Regulation Act had become inconsistent. A new Act was in preparation even before 1997. It became law subsequently and the new Foreign Exchange Management Act was passed in 1999.
IV. An Assessment
The reforms in the monetary sector have been in the right direction. The two big changes—phasing out the system of ad hoc treasury bills and the new monetary policy framework—have made the monetary authority more autonomous and accountable. Monetary policy has emerged as an independent tool of economic policy. If growth is to be achieved with stability, much depends on how monetary policy is operated. The institutional freedom is now available. Results depend on the sagacity and wisdom of policymakers. Regarding the new monetary policy framework, one misgiving needs to be dispelled. Inflation-targeting, it is argued, precludes monetary authorities from paying attention to other objectives. This is a wrong interpretation. So long as inflation remains within the comfort zone, the monetary authority must and can take care of other objectives. It is only when inflation goes above the limit and it is feared that this will persist that the exclusive concern of the authority becomes inflation control. Some critics point out that inflation-targeting has not prevented the financial crisis of 2008. Hence, again one saw a wrong application of the concept. Even if inflation is within the acceptable range and if for other reasons interest rate should be increased, it should be done. It is here that the monetary authorities in the West failed.
As far as financial-sector reforms are concerned, two questions arise. One is whether the reforms have been taken to the logical end and what is the unfinished agenda. The second relates to the efficiency-impact of the reforms. Financial-sector reforms have been gradual but substantial. They have been done in a way that they did not disrupt the system. Banking-sector reforms have gone hand in hand with capital-market reforms. In terms of reforms, two issues remain to be resolved. The first concerns public-sector banks. State-owned banks still dominate the banking scene, even though their share is coming down. The amendment to the Nationalization Act has allowed private-sector participation up to 49 per cent. Do we need all these state-owned banks or can we reduce the number and let, at least in the case of some banks, private-sector participation go beyond 50 per cent? These are not strictly economic issues. Given the fact that public-sector banks will continue to dominate the banking sector, what are the reforms that are needed to make them independent of political influence and at the same time accountable? Very little progress has been made in this area despite several committees reporting on it.
The second issue relating to financial-sector reforms is whether a common legislation for the entire financial sector, as recommended by the Financial Sector Legislative Reforms Commission, is needed. There is no doubt that all regulators, whether of banks or capital markets or insurance companies, must follow certain common standards. It is accepted that customer protection is a key requirement. However, there is a difference of opinion o
n whether there should be a single omnibus legislation or whether there can be separate legislations for different regulators accompanied by one legislation laying down certain common principles, including judicial review of the regulators’ action. The latter approach seems easier to achieve.
On the efficiency-impact of reforms, it has to be noted that the primary purpose of banking-sector reforms was to make the banking system sound and safe while serving as an instrument of growth by providing credit. The discipline of prudential norms had a highly beneficial impact. As noted earlier, the ratio of non-performing loans steadily came down. However, there has been a sharp rise in the last three years. The slowdown in growth is an important factor. The optimistic assumptions made during the phase of high growth have been belied. The exposure to sectors which are vulnerable to the macro environment has been high. Even as attempts are made to clean up the balance sheets of banks, there has to be a rethink on our prudential regulations, particularly macro prudential norms and our regulatory apparatus.
In conclusion, one broader issue involving the relationship between innovation and regulation needs to be kept in mind. Banking development has taken big strides in the last two decades. A question that is being asked increasingly is whether the financial sector today is inherently more volatile and vulnerable than before. The very factors that have contributed to the growth of the financial sector may well have contributed to increased fragility. Close interdependence among markets and market participants has increased the potential of adverse events to spread quickly. It has significantly increased the scope and speed of contagion. Some question whether the new financial products serve any socially useful purpose. It has been argued that much of the recent innovation in the financial system has sought to increase the short-term profitability of the financial sector rather than increase the ability of financial markets to better perform their essential functions of managing risks and allocating capital. It would be inappropriate to classify all or even most of the financial innovations introduced in the last few decades as socially useless. Many of the financial products satisfy a felt need. There is no argument that the regulatory regime needs to be structured to make the banking system sound. Excessive risk-taking and leveraging by banks need to be discouraged with appropriate regulatory measures or controls. In developing economies like India, the structure of the economy is undergoing a rapid change. The financial system must be able to meet the diversified needs of a growing economy. In this context, we must actually encourage financial innovations. Too little regulation may lead to financial instability but too much of it can impede financial innovations which are badly needed. The policymakers must strike an appropriate balance between the need for financial innovations to promote growth and the need for regulation to ensure stability.
22
Liberalizing Indian Capital Markets: Highly Successful Reforms and an Unfinished Agenda
Jaimini Bhagwati1
Wonders if adequate attention has been paid to auditing and accounting integrity, despite several examples of periodic and systematic wrongdoings. In retrospect, a calibrated approach to liberalizing capital markets was appropriate in the early 1990s since it takes time to build regulatory expertise. SEBI needs to continually improve its surveillance capabilities in even closer coordination with the other financial-sector regulators.
Background
The catalytic intermediary role of an efficient financial sector in promoting innovative growth is accepted internationally. The interdependence of the four segments of the financial sector—banking, capital markets, insurance and pensions—is also well acknowledged. Capital markets are the dominant providers of financing in the US, while in Europe, banks are the principal intermediaries of capital. Banks and non-finance banking companies (NBFCs) continue to be the major source of financing in India. Public-sector banks still account for over 70 per cent of deposits in the banking sector. Although there are a number of private insurance companies, the Life Insurance Corporation of India (LIC), which is government-owned, is the largest player in the insurance space. Among pension providers, government and public provident funds are dominant.
In contrast, Indian capital markets are the most penetrated by private-sector market-makers and participants. Due to the reforms initiated in the early 1990s, Indian equity markets—spot and exchange-traded derivatives—are relatively ahead in transparency and pricing efficiency. In the banking, insurance and pension sub-sectors, there is inadequate competition as the majority government-owned institutions are the market leaders.
In the first four decades post-Independence, Indian capital markets consisted essentially of stocks and government debt securities. That is, till the late 1980s, the capital-market segments consisted of: (a) listed equities that were traded principally on just one stock exchange, namely the Bombay Stock Exchange (BSE); (b) central and state government debt securities, issued at administered interest rates rather than through auctions and; (c) mostly private and limited public placements of equity and corporate debt. The Controller of Capital Issues (CCI) in the Ministry of Finance decided on the quantum, pricing and timing of the corporate sector’s issuance of both equity and debt through initial public offerings. The Reserve Bank of India (RBI) managed the issuance of central-government debt and was the fallback purchaser of these securities.
Since the 1990s, government debt has been auctioned and primary dealers bid for these securities to try and arrive at market-determined interest rates. However, small-scale savings and the amounts managed by the Employees’ Provident Fund Organization and other provident funds are still at administered interest rates. Plus, an array of schemes for agriculture and small-scale sectors receive credit at subsidized interest rates.
The mutual fund industry was initiated with the establishment of the UTI mutual fund under the Unit Trust of India Act passed in 1964. The UTI mutual fund continued to be the largest till the 1990s. In 1988, the government set up the capital markets regulator called the Securities Exchange Board of India (SEBI) under an administrative order.
Section I of this review of capital-market reforms in the last twenty-five years details the most significant steps taken by the government and SEBI. This section includes the setting up and strengthening of market-infrastructure institutions such as stock exchanges, depositories and clearing corporations, which led to enhanced competition. Section II explains the development and continuing shortcomings of the sub-segments of Indian capital markets, i.e., equity, debt and derivatives markets and institutional participants such as mutual funds and foreign institutional investors (FIIs). Section III covers overarching issues of market integrity, coordination across regulators, accounting oversight and systemic risk. The last and concluding Section IV lists what has been achieved and what remains to be done.
Section I
1. Game-changing Reforms
1.1. Capital Markets Regulator: SEBI
From 1991–96, significant economic reforms were initiated by the Narasimha Rao government. This was also the period for a wave of improvements in the regulation of capital markets and its infrastructure with the overall objective of minimizing liquidity, solvency and operational risks.
One of the most significant reforms was the passing of the SEBI Act in 1992 to set up a statute-based capital markets regulator. The 1993–94 Budget speech mentioned that the government was ‘vigorously pursuing reforms in the capital markets’. Further, it stated that SEBI ‘which was given statutory status and powers … has been entrusted with bringing about this transition … the office of the CCI in the Ministry of Finance has been abolished and almost all powers under the Securities Contract (Regulation) Act2 have been delegated or transferred to SEBI’.
1.2. Market Infrastructure Institutions (MIIs)
STOCK EXCHANGES
Another game-changing reform was the setting up of the National Stock Exchange (NSE) in 1993. In the early 1990s, the central government was concerned about BSE’s monopoly in stock trading and its resistance
to demutualization.3 Accordingly, the NSE was set up and its principal public-sector shareholders were LIC, State Bank of India (SBI), IFCI and Stock Holding Corporation of India. In April 1993, NSE was recognized as the first demutualized exchange in India under the Securities Contracts (Regulation) Act. Transactions in equities and wholesale debt markets started on NSE in November 1994. Since its inception, NSE’s order booking system was based on electronic matching of buy–sell orders instead of open outcry, which incidentally was the practice at that time in stock exchanges in developed countries. NSE went on to have a significant role in developing equity, debt and derivatives markets.
