For more than a decade, Indian policy makers have aspired for a globally competitive financial sector in India. In 2007, a High Powered Expert Committee headed by Percy Mistry (MIFC) proposed that Mumbai be developed as a full fledged International Financial Center (IFC). At the time, this was `an offensive strategy', in the sense that India was aspiring to export into the world market. In 2013, a Standing Council of Experts on the International Competitiveness of the Indian Financial Sector, was setup to evaluate the cost of doing business in the Indian market, and find ways to improve international competitiveness. This was a `defensive strategy', as there had been a sea change in Indian finance between 2007 and 2013: the collapse of market share in Nifty and the rupee.
A third initiative is now visible: a white paper Policy framework for Finance SEZs (referred to as FSEZs going forward). This was followed by a budget announcement regarding issuance of regulations for GIFT city, a FSEZ, by March, 2015. Finance SEZs are viewed as a tool to expedite the globalisation of Indian finance.
Competing in international finance requires four things: (a) No capital controls; (b) Residence-based taxation; (c) Sound financial law and regulations; (d) Good urban infrastructure. At present, India fails on all four counts. There has been some progress on implementing "c", with the draft Indian Financial Code proposed by the Financial Sector Legislative Reforms Commission (FSLRC) in March 2013. There is little sign of progress on the other three fronts. India's capital controls deter foreign customers of Indian finance, and are not onerous enough to prevent the flight of domestic customers.
The white paper points out to loss of market share in INR and Nifty futures trading. The decline of Indian finance goes beyond just Nifty and the rupee, though these can be visible symbols of the decline of the ecosystem akin to the tiger in the Indian jungle. Indian non-financial firms borrowed Rs.4.5 trillion from foreign shores in 2012-13, almost double their foreign borrowings in 2009-10. Indian firms, and even the Indian government, use offshore rather than domestic commodity derivatives markets to hedge commodity risk. Indian firms are increasingly interested in offshore listings. In India-related CDS, 100% of the market share is overseas.
London, Dubai and Singapore are obtaining a strong share of the increased financial services revenues associated with Indian GDP growth. These cities score over India with stable legal and regulatory frameworks, competitive tax regime and efforts to improve market liquidity and depth. The policy establishment of these countries is free of the reflexive socialism which bedevils economic policy thinking in India.
Are FSEZs the right solution to these problems?
An SEZ follows an enclave approach. Manufacturing units located within the SEZ, are given fiscal, regulatory and trade exemptions so as to enhance exports. The white paper proposes three objectives for an Indian FSEZ: create high value financial sector jobs on Indian soil; create an avenue into financial globalisation (like Hong Kong is to China); and be a laboratory of new ideas for financial policy making for the development of the overall Indian financial system. This is small thinking compared with MIFC, where the aspiration was: to capture a share of the global finance business by delivering a wide variety of services to a wide variety of global participants with minimum friction.
The areas of concern are:
- Financial reform in India has fared poorly. The implementation of MIFC from 2007 onwards, or the implementation of the Indian Financial Code, from 2013 onwards, has been an uphill struggle. These same difficulties will hamper the enclave approach.
- There is a chicken-and-egg problem in market liquidity. Bombay has a certain market. It has a full ecosystem of financial firms and their customers. That market can suck in additional orders, if the mistakes of financial regulation, capital controls and taxation are fixed. A Finance SEZ would start from scratch, with no ecosystem. It is hard to build from scratch. The natural jumping off point for obtaining foreign customers is Bombay, not an SEZ.
- The white paper proposes that a subset of the draft Indian Financial Code will be enacted as the Finance SEZ Act. It will be more complicated than this. The regulatory machinery required in a Finance SEZ differs from that required for India. E.g. there will be no fiat money in a Finance SEZ, hence there will be no requirement for monetary policy. It may make sense to have a single unified regulator in a Finance SEZ. The work required, in going from the Indian Financial Code to the Finance SEZ Act, may be significant.
- After the Finance SEZ Act is passed, new regulatory institutions will need to be created. It will be important to avoid importing the institutional culture, and pessimism, of existing regulatory agencies. Getting away from the `inspector raj' (as described in the MIFC report) will be quite a challenge. Exporting from an Indian platform can only come about when world class regulatory agencies are found there. This may take many years. If enough new age project management is not put into this, the institutional culture of existing financial agencies might recur, in which case the Finance SEZ will fail.
- The removal of capital controls in the FSEZ will have an immediate benefit for foreign clients who might shift order flow away from the mainland. This may adversely impact upon liquidity and market efficiency in the mainland. While the FSEZ is intended to compete with London, Dubai and Singapore, the first victim of its success could be Bombay.
- While the white paper envisages that FSEZs should be India's Hong Kong, this requires today's regulatory agencies to respect and value a Hong Kong. At present, this may not be the case; today's regulatory agencies may work systematically to ensure that FSEZs do not become India's Hong Kong. RBI has regulation-making power under FEMA. This could easily yield draconian restrictions that hamper onshore participants, cutting off the FSEZ from the mainland. If FSEZs on Indian soil are cutoff from India, they cannot succeed.
- FSEZs require improved working from the Indian tax bureaucracy as much as they require improved working from the Indian financial regulatory bureaucracy.
- FSEZs will need not just good laws but sound enforcement agencies and sound courts. While important new work is underway in building courts, there is little certainty as yet that this will work out well. Three things are required: a Tribunal to hear appeals against the regulator, a court where disputes between private parties are heard, and an arbitration mechanism. All these are extremely important for the mainland, and have not been done for decades; why will they now be done for FSEZs?
These are onerous challenges. It will take remarkable project management to overcome them, of a kind that we have not seen in Indian finance in the past. Given enormous political capital and implementation capabilities, Finance SEZs in India can work. But would that effort not be better used in combating the low quality of financial law and financial agencies of the mainland?
There is a very scarce resource in Indian economic policy: the time and energy of the persons who actually do reform. Man-hours allocated to Finance SEZs come at the cost of man-hours which could be spent on fixing the mainland. It could get worse. A dangerous scenario that can be envisioned is as follows. Suppose domestic financial reform is stranded in bureaucratic politics. Suppose FSEZs make progress and cannibalise activity away from the mainland. Suppose this creates feedback loops where the intelligent end of the economic policy establishment gets increasingly focused on successful work on FSEZs and despairs of the difficulties of the mainland. It would be very costly for India if, in this fashion, FSEZs damage the future of Indian finance.
How to approach Finance SEZs
As the white paper says, a useful role for Finance SEZs is:
"...to be a laboratory where controlled experiments with new ideas in policy take place, and feedback can then be used by the Ministry of Finance to alter course for the future."
If this vision is emphasised, FSEZ development would complement domestic reform and globalisation, rather than become a substitute. New ideas should be tried out in an FSEZ, and once proven, be immediately implemented in the mainland. Finance in the mainland should not stagnate in the present mode.
If this is done, FSEZs can facilitate the process of achieving the scale of ambition of the MIFC report. There may be useful lessons from China, in the development of the China (Shanghai) Pilot Free, Trade Zone (SPFTZ). The main objective of the SPFTZ is to develop institutional capacity while opening up the Chinese financial system and liberalising capital controls and currency convertibility. For example, the Shanghai-HongKong Stock Connect is an experimental system through which Chinese investors can trade their share holdings with foreign participants in the Hong Kong market.
This initiative involves setting new capital controls for the traded shares, regulations on the trade and settlement of shares, operations of connecting trading, common clearing and settlement across the Hong Kong Stock Exchange and The Shanghai Stock Exchange. The intention is to develop the equity market liquidity for both domestic and global participants. The intention is backed by consistency of implementation: the experiment was tried once before, failed and tried again.
Many markets and products that are not permitted today in the Indian market, due to legal or regulatory constraints, reinforced by low knowledge in financial agencies. Such missing markets and products can be tested and understood in a controlled environment by policy makers and regulators in the FSEZ, before they are introduced into the Indian financial system. Some examples where there is global interest include Indian OTC commodity derivatives, Credit Default Swaps on Indian credit, Rupee denominated foreign currency settled government bonds, and a Eurodollar market for Masala bonds. This will require changing the easy life of existing Indian financial regulators.
While the effort to take back market share on the INR and Nifty futures may yield some results in an FSEZ, these new markets and products have the potential to yield large benefits for India. The FSEZ could also be a testing ground for introducing global standards into market processes such as marginning for financial portfolios spanning equity, commodity, currency and interest assets rather than each one individually as is done in the Indian market today.
In this approach, the stagnation of financial law and agencies on the mainland must be tackled. Policy makers should not make the choice of permitting the mainland to stagnate, while building high quality structures in Finance SEZs.
The way forward
In conclusion, the FSEZ white paper is the latest policy proposal to improve the international competitiveness of India's financial system. It proposes an enclave approach to overcome the failures of implementation which have held India back ever since the MIFC report and the drafting of the Indian Financial Code. However, the enclave approach appears to face as many challenges. Remarkable inputs of State capacity are required to make it work. That human capital, project management and political capital would surely have better uses in fixing Indian finance.
The key insight in salvaging the situation is to not lose sight of the main objective: the mainland. We should build an enclave because it will help us solve the problems of the mainland. Every decision about building the enclave should be made keeping this larger objective in mind.