ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

R H PatilSubscribe to R H Patil

Financial Sector Reforms: Realities and Myths

Does India's strategy for financial sector reform need to be reviewed in the light of what happened in the major developed countries during the global financial crisis, hitherto the role models for our reformers? The only mantra on financial sector reforms that we hear from some senior government officials and influential academicians is to dismantle all controls on cross-border capital flows, go in for market-determined exchange rates and interest rates, downsize the powers of the Reserve Bank of India to that of a pure monetary authority, transfer all the market regulation powers to the Securities and Exchange Board of India and opt for free financial markets. In all these reform packages there is often no recognition of the fact that, at the current stage of its economic development, the country needs different sets of solutions. Markets alone are not going to be the solution for all our problems. All those who talk of totally free markets do not recognise that we need broad-based industrialisation and infrastructure development to tackle poverty and that the financial sector should clearly serve as an instrument to achieve these objectives.

Current State of the Indian Capital Market

In the early 1990s, India figured low in the global ranking of the state of capital markets. The adoption of sophisticated IT tools in trading and settlement mechanisms has now placed India in the lead. The National Stock Exchange has played an important role in this transformation. Shorter settlement periods and dematerialisation have been other major developments. But all is not entirely positive. The introduction of individual stock futures poses a major risk; so also the large inflow of funds through participatory notes.

Contrarian Fund

When markets are behaving in a highly irrational manner governments/regulators often try to send appropriate signals to calm down market sentiments. The problem is to intervene in the markets without sending signals that they are over-protective of market players. Such intervention should be reserved mainly for situations that are really serious and highly destabilising in nature. One way to minimise official intervention is to encourage the setting up of a Contrarian Fund which should not impose anysubsidy on the government but would enjoy all the benefits to which a mutual fund is entitled.

Corporate Debt Market

The healthy development of the corporate debt market hinges on a significant level of reforms in regulations governing the primary and secondary markets in corporate debt. The recent initiatives of both Securities Exchange Board of India (SEBI) on the issuance and trading of corporate debt and the RBI's investment guidelines to its regulated entities like banks and primary dealers in this area comprise essentially the first set of reforms. Further initiatives are needed to consciously shape the corporate debt markets, upgrade them and bring them on par with our equity markets in terms of efficiency in trading, price discovery process, transparency, and investor friendliness. In this article an attempt is made to explain the rationale behind the recent measures announced by RBI and SEBI and then draw out the broad contours of the future directions needed to deepen and widen the corporate debt market, both through the stock exchange and banking mechanism.

Interest Rates and Equity Markets

The Budget for 2003-04 expects that the softening of interest rates will continue. However, the analysis here suggests while demand for funds both from a revival of normal economic activities and from the government is likely to rise, the supply of liquidity in the system is likely to be much lower than in the past 12 months. As for the equity markets, it is unrealistic to expect the markets to be pepped up through fiscal incentives or other palliatives without an overall economic policy framework which encourages new investments and a regulatory mechanism capable of sustaining investor confidence.

Exchange Traded Interest Rate Derivatives

The Reserve Bank of India's Working Group on Rupee Derivatives has, inter alia, recommended introduction of exchange traded derivatives to supplement OTC derivatives. But before we introduce exchange traded interest rates futures it is necessary to be fully aware of the ground realities. The basic issue is the healthy development of the market and abolition of the regulations that artificially protect the interests of a set of intermediaries whose role and functions have got significantly reduced with massive induction of IT applications into the capital and financial markets. Regulatory reforms should facilitate continuous reduction in transaction costs and upgradation of transactional efficiency across different segments of the market. A regulatory regime that ends up protecting the role of certain players merely because they played a useful role in the past in the development of some segments of the markets would be doing a disservice.

Demutualisation of Stock Exchanges

The basic objective of demutualisation of stock exchanges should be to do away with the involvement of brokers in the management of the exchanges and to convert the exchanges into business entities so that they are professionally managed. This basic objective can be achieved in the Indian context without getting into all the legal complications of first converting the exchanges into limited liability tax-paying entities and then separating their ownership from the trading rights of brokers. The necessary changes can be effected quickly and without any hassles by exercise of the powers that SEBI already enjoys to reconstitute the governing boards of the stock exchanges.

Reforming Indian Debt Markets

While equity markets in India have got radically transformed since the 1991-92 securities scam, the government securities markets have not changed very much except that the Reserve Bank of India has significantly improved the settlement process. Recognising the need for introducing transparency and to reform the secondary markets in government securities and money market instruments, the RBI will soon operationalise the Negotiated Dealing System (NDS). Simultaneously, the Clearing Corporation of India (CCIL), promoted by major banks, financial institutions and primary dealers, will be a key market infrastructure to significantly improve market efficiency and integrity. Together with the NDS, the CCIL will introduce major reforms in the way the government securities and money markets function today.

Are Institutional Nominee Directors Required?

Given the context of promoter family control of management of companies in India and the relatively poor quality of corporate governance, institutional shareholders would be doing a great disservice to themselves and to the diffused class of small shareholders if they shirk their responsibility of taking interest in the quality of management of the companies in which they have a large shareholding.

Financial Sector: Single vs Multiple Regulators

The possibility of friction, even conflict, as a result of the functioning of multiple regulators overseeing different segments of the financial sector does not make a convincing case for a single all-powerful super-regulator on the lines of the arrangement in the UK. A more satisfactory solution to the problem would be to devise an institutional mechanism for conflict resolution.

Debt Market Reforms

The debt market remains one of the least developed financial markets in the country. As a result, although the average household investor prefers to invest in fixed income securities, she/he has not been attracted to debt instruments. It is to the credit of the finance minister, therefore, that the major focus of this year's budget in regard to capital markets is the development of an active debt market. The budgetary proposals in this regard aim at the setting up of a major institution for ensuring efficient clearing and settlement of large-sized deals in debt instruments as also some fiscal/legislative reforms for widening the range of tradable debt instruments.

Industrial Finance and Capital Market

Given the current state of the financial institutions and banks, it will take many years before they are integrated into the capital market framework thus bridging the artificial gulf that exists today between the two. The basic function of financial institutions and banks and the financial/capital markets is to facilitate the transfer of funds from the surplus to the deficit pockets. The main thrust of policy now should be to create seamless linkages between DFIs/banks and capital markets to facilitate this process of transfer from the ultimate savers to the ultimate users at minimum cost. Such a policy should also ensure a neutral stance towards banks and the capital markets thus making for an environment where there is efficient resource allocation as well as a certain discipline among users of funds.

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