Redraft the policy framework

Financial Express, 8 April 2008

Exceedingly well written, the Raghuram Rajan committee's draft report is an excellent effort at thinking about the public policy issues affecting Indian finance. Alongside the Percy Mistry report which focuses on the external dimension, it adds up to a comprehensive picture of where India has to go. The two reports, put together, offer a fully thought out forward looking picture that replaces the financial and monetary thinking rooted in a planned economy framework that presently characterises Indian finance.

When policy makers sought to "plan" the Indian economy, Indian monetary and financial policies consisted of five key elements. Banks were dominated by government ownership, and the resources of all bank, whether PSU or not, were controlled by MOF and RBI. Financial markets were either banned outright, or they were hobbled and rendered incapable. An extensive license-permit raj was put into place, where financial firms had to request permission from the government for every small change in product or process: and these permissions were generally not given. Monetary economics was originally about funding the fiscal deficit, and after the ways and means agreement of 1997, about exchange rate pegging. Integration with the global economy induced stress on this framework, so an integral part of this package deal was capital controls induced by a fear of globalisation.

A series of committee reports created this repressive framework, and it was enthusiastically implemented by politicians and bureaucrats who claimed that this was all being done to help poor people. This world view was propagandised in all official documents, was shared by most economists, and permeated into the instinctive reflexes of the general public including journalists and practitioners.

Starting from the early 1990s, three key events took place which have upset this happy equilibrium. The first lies in the real economy. Indian non-financial firms have plunged into the world of delicensing, competition and globalisation. FDI is welcomed, trade barriers have been removed, the license-permit raj has been substantially broken down. Embracing foreign technology and capital worked very well. This has made it harder to sustain xenophobia. Further, these sophisticated firms who are operating in global competitive markets require good quality raw materials. They buy the best low-cost steel in the world, and it is increasingly infeasible to tell them to not obtain the best low-cost financing and financial services in the world.

The second event was the stock market. With the creation of SEBI and NSE, India got a genuine stock market. This is now a place where the government has no say in prices, where private forecasts about the future performance of firms or industries determine capital allocation. Alongside this, mutual funds and insurance companies came about with a modern regulatory framework.

The third major development which took place was the gradual movement towards easing capital controls. While a messy licensing environment continues to be in place, it is now increasingly useful to think of India as being effectively open in the sense that money will find its way in and out of the country.

These three developments add up to a sea change in the environment of financial and monetary policy. However, a full rethinking of financial and monetary policy was not done. The avenues for progress in finance unleashed in the early 1990s had petered out by the end of the decade. By 2001 when the last major leg of the transformation of the equity market fell into place, finance had settled into a sullen stagnation.

What was needed was a new way of thinking about finance and its role in the economy, and a new monetary policy framework. This framework must be designed for India as a fast-growing and fast-globalising market economy. Put together, the Percy Mistry and the Raghuram Rajan reports supply this full picture. The Percy Mistry report is international finance focused, and emphasises the international dimension. The Raghuram Rajan report is focused on domestic finance: it addresses critical questions like financial inclusion, credit infrastructure, enhancing competition, policy issues in banking, and the two-way linkages between sound macroeconomic policy and sound financial sector policy.

The report features a tremendous combination of world class intellectual firepower, combined with original research, combined with ground reality as seen by the CEOs of financial firms who were members of the committee. It covers a breathtaking range of issues, and as the preface suggests, has drawn on knowledge from a very wide array of top people. It is an unusually well-written report and is likely to have considerable influence. The report is particularly effective in documenting how the ancien regime gives a raw deal to poor people, thus undermining a key claim of the socialist framework. It offers concrete and tangible market-based solutions through which poor people will do better.

Put together, the Percy Mistry and Raghuram Rajan reports constitute a major contribution to Indian thinking about monetary and financial economics. It is no longer possible for a rational person to hang on to the old Indian framework of financial and monetary policy in the face of the logic and evidence that is on the table. The reports have setup the right intellectual environment in which the leadership at SEBI and RBI can now look at policy questions. Both reports emphasise the need for considerable legislative activism. The Finance Minister needs to embark on technical drafting work now, which can lead to a new legal framework.

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