Monday, September 28, 2015

Is India a hospitable environment for India-related finance

by Anjali Sharma, Kanwalpreet Singh, Rajat Tayal, Rohini Grover, Susan Thomas.

Competition in finance

There is an assumption in India that financial services and products connected with India can only exist through the aegis of financial firms and markets in India. As a consequence, there tends to be little discussion on international competition for India-related finance.

There are, indeed, elements of finance which are not amenable to international competition. For example, setting up bank branches in Nagpur is something which can only take place in Nagpur. However, for a growing class of situations, Indian customers of finance, or non-resident customers of India-related finance, now have choices:

  • Indian firms can choose between raising equity or debt capital within India or abroad.
  • Non-residents have a choice of buying the equity of Indian companies by coming to Indian exchanges (NSE or BSE), or by sending orders go to overseas venues (e.g. London Stock Exchange or the New York Stock Exchange) when Indian companies list abroad.
  • Derivatives settled in cash can trade anywhere. Outside India, exchanges and the OTC market  trade derivatives on the rupee, on Nifty, on Indian interest rates, on India-related credit risk, etc. This gives non-residents a choice about whether orders go to India or to overseas rivals.

These developments have taken place over the last decade, changing the dynamics of what is possible for domestic and foreign investors. This has brought international competition to confront Indian financial institutions and systems.

This competition is good for the Indian economy. When an Indian firm is able to access debt overseas, it overcomes the limitations of the Indian credit market. This is good for India. Similarly, when an Indian firm is able to obtain equity capital overseas, overcoming the problems of the Indian primary market for equity, access to capital for India goes up. This is good for India.

When non-resident investors take exposure in Indian assets, they face financial risks such as the rupee risk, Nifty and single stock price risk. To the extent that they are able to reduce risk, this is good for India. For example, a non-resident investor who has given a dollar-denominated loan to an Indian firm, or a foreign firm who has FDI in India, should be able to reduce their risk by trading in derivatives. These include sovereign Indian credit default swaps (CDS), single stock CDS, rupee derivatives, Nifty derivatives, Indian interest rate derivatives, etc. Whether these are available in domestic markets or in competing markets off-shore, the presence of these markets encourages higher foreign participation in Indian assets.

Hence, the emergence of greater competition against Indian financial producers, which gives reduced prices and higher quality, is good for India.

Expected and actual outcomes

India has a natural edge in global competition for India-related finance. As an example, consider trading in Nifty derivatives. The information is formed in India. The most liquid market is in India, created by the trading of hundreds of thousands of thinkers, and decision makers in India. Once India is the most liquid market, this would suck in all order flow, which would help further increase the liquidity. The most reasonable outcome is one where India owns one hundred percent of the market share. However, the outcome that has come about over the last decade is starkly different.

Precise estimates of turnover are difficult to obtain. But most estimates suggest that it is reasonable to think that roughly half of the global trading in the rupee and in Nifty is now taking place outside India. In 2008, the share of the overseas market was roughly 0%. Since then, this share has gone up to roughly 50%. There is a possibility that the share of the overseas market could further increase in the days to come.

Implications: Loss of revenues in India

An order that comes to the Indian financial system induces export of financial services. A basket of revenues comes with the basic order. This includes securities broking, legal services, research, accounting and travel. All these revenues are lost when the order goes to an off-shore market such as Dubai or Singapore.

We believe that a conservative estimate of the total services revenues associated with each order is approximately 0.25%. As there is a buyer and a seller for each unit of turnover, this implies a total revenue stream associated with turnover of 0.5%. Given the extent of international competition that Indian finance faces, what is the size of the revenue at stake?

If turnover is \$1 billion per day, or \$250 billion per year, this would imply a revenue stream of \$1.25 billion per year. This is Rs.83.75 billion per year. In other words, each \$1 billion per day of overseas activity is a loss of financial services exports revenue for India of Rs.83.75 billion per year.

But how much turnover is taking place outside India? This is hard to estimate and there is no unambiguous answer. We believe the answer lies between \$10 billion to \$50 billion per day. If all this business came to India, it would yield additional financial services export revenues of between Rs.83.75 billion per year to Rs.4.18 trillion per year.

Implications: Loss of domestic market liquidity

If an order flow of between \$10 billion/day and \$50 billion/day were added to domestic financial markets, this would yield a quantum leap in market liquidity and market efficiency. The reduced capabilities of domestic financial markets is the second consequence of the loss of market share. This may have an adverse impact for India that is even greater than the headline grabbing figure for the loss of export revenues.

Tackling the problem of the loss of market share

In June 2013, in recognition of the importance of the problem as one requiring research analysis and policy responses, the Ministry of Finance setup a `Standing Council of International Competitiveness of the Indian Financial Sector'. The Standing Council is chaired by the Secretary of the Department of Economic Affairs. IGIDR FRG has been the technical team for the Standing Council.

On 7 September 2015, the Standing Council released Volume 1 of its Report. There is likely to be a Volume 2 that follows shortly after. The Standing Council is likely to establish a rhythm of work where it is continuously watching the space of international competitiveness of the Indian financial system, and making recommendations with remedial actions to the Ministry of Finance.

The Standing Council has diagnosed four classes of problems which have generated this loss of market share of the onshore market.

  1. Problems in domestic financial regulation. In many situations, there are flaws in domestic financial regulation which are harming the onshore financial system.

  2. Taxation. The global financial system sends orders to financial centres which have `residence-based taxation', where non-residents are not part of the tax base as seen by the local authorities. Apart from the Mauritius treaty, this is not how India works.

  3. Capital controls. The global financial system sends orders to financial centres where the frictions are minimal. India's capital controls actively introduce friction which deters financial services exports.

  4. Unpredictability of policy changes. In a mature market economy, there is a consistent economic policy philosophy shaping policy pathways. In a mature market economy, rule of law procedures are used when changing laws or regulations. These two features create predictability about changes in policy. India suffers from flaws in both respects. As a consequence, market participants are frequently suprised by unexpected changes in policy. This enhanced political/regulatory risk deters investments in building organisational capital. It is safer for a global financial firm to build an INR derivatives business in a place like Singapore or London, rather than committing resources to build that same organisational capital in Bombay.

Looking forward

The ongoing process adopted by the Standing Council is to render policy advice to the Ministry of Finance, through which these four classes of problems can be addressed. This line of thinking constitutes one more impulse to undertake deeper reform of Indian finance.

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