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Mumbai as International Financial Centre

Is an international financial centre in Mumbai such a big deal that all policymaking should be oriented towards this objective? This is the fundamental question that needs to be addressed in evaluating the report of the high-powered expert committee on Mumbai as an IFC. By that yardstick, the committee fails to provide a convincing argument that an IFC is necessary to sustain an 8-10 per cent growth rate.


Mumbai as International Financial Centre

Finance Tail Wagging the Economy Dog

Is an international financial centre in Mumbai such a big deal that all policymaking should be oriented towards this objective? This is the fundamental question that needs to be addressed in evaluating the report of the high-powered expert committee on Mumbai as an IFC. By that yardstick, the committee fails to provide a convincing argument that an IFC is necessary to sustain an 8-10 per cent growth rate.


he high-powered expert committee (HPEC) on Making Mumbai an International Financial Centre (Sage Publications), constituted by the ministry of finance, presented its report in February 2007. The committee was headed by an ex-World Bank economist, who is at present chairman of the Oxford International Group, Percy Mistry. His name, however, does not figure in the report prepared by the HPEC. It has been reported that close to the completion of the report, he had disassociated himself from the report following differences with his colleagues.

The HPEC included representatives from the public and private institutions in the financial sector, SEBI, the government of India and the government of Maharashtra. As happens all too often with government committees, no academic was present on this one.

The report, which runs into 210 pages and contains 82 recommendations, is staggering as much in its detail as in its scope. There is a fair degree of repetition both in the main body and in the summary of recommendations – a little editing would have made it easier for policymakers to relate to it. For the reader who is willing to make the effort of wading through it, the benefit is a round tour of some of the principal issues in Indian economic policy today.

The terms of reference given by the ministry were themselves modest. Indeed, the ministry seems to have had in mind the development of Mumbai as a regional financial centre (RFC) rather than an international financial centre (IFC). The terms of reference merely ask the committee to lay out the regulatory and mostly sector-specific changes needed to create an RFC in Mumbai.

For reasons spelt out in the report, the committee decided to shoot for the more ambitious IFC. But this leap is not a minor one. The relatively modest policy changes conceived in the terms of reference will not do. What the HPEC proposes is nothing short of a revolution in the economic and legal framework of the country and a huge change in urban governance and infrastructure in Mumbai itself.

The financial sector reforms proposed are themselves sweeping in their scope. As the report puts it, “…the call for creating an IFC in Mumbai is a metaphor for (and synonymous with) deregulating, liberalising and globalising all parts of the Indian financial system at a faster rate than is presently the case.”

The time frame for implementation of the innumerable recommendations in the report is 2007-20. The creation of an IFC is to happen in two phases. In the first phase (2007-12), Mumbai will have an IFC that connects with the world’s leading financial markets. In the second phase (2012-20), it will compete with the top three IFCs of the world. Taken in conjunction with the scope of the recommendations, this means we are looking at the equivalent of two Five-Year Plans.

True, many of the actions proposed are in the realm of policymaking anyway. Some of these are desirable in relation to broader economic objectives. Many will happen in the natural course of things. But the suggestion that the nation’s economic destiny should be viewed through the prism of an IFC in Mumbai does take one’s breath away.

Rationale for an IFC

What is an IFC and what are the services provided therein? The report provides useful information on these. It categorises IFCs as the following:

  • Global financial centres (GFCs): These are centres that serve clients from all over the world. Examples would be New York, London and Singapore.
  • Regional financial centres (RFCs) They serve their regional rather than their national economies – examples of such RFCs would be Dubai or Hong Kong.
  • Non-global and non-regional, ordinary IFCs: These are centres like Paris, Frankfurt, Tokyo and Sydney that provide a wide range of international financial services (IFS) but cater mainly to the needs of their national economies because its two defining adjectives are contradictory; and
  • Offshore financial centres (OFCs): These are centres that are primarily tax havens for wealth management and global tax management rather than providing the full array of IFS.
  • The HPEC rejects the idea of developing Mumbai as an RFC as defined above catering to the south Asia region. It says, “India’s immediate neighbours may, for geopolitical reasons, prefer to use Dubai or Singapore instead for their IFS needs. So, while Mumbai is located in south Asia, it is unlikely to become a south Asian RFC in the foreseeable future. Instead, the HPEC believes that it is more likely to leapfrog from emerging as an IFC that serves India, into becoming a GFC that serves the world, without serving its south Asian neighbourhood along the way.”

    IFCs typically offer all or most of a whole range of IFS: fund-raising, asset

    Economic and Political Weekly June 9, 2007

    management and global portfolio diversification, personal wealth management, global transfer pricing, global tax management, global/regional treasury management, global/regional risk management, global/regional trading of financial securities, commodities and derivative contracts in financial instruments, financial engineering for large complex projects, mergers and acquisitions, financing for public-private partnerships.

    An IFC could offer these services mainly for the domestic economy and we know that Mumbai provides some of these services to domestic firms. The HPEC would like Mumbai to be transformed into a GFC that provides the entire range of IFS to international firms, not just domestic firms.

    Is an IFC in Mumbai along these lines such a big deal that all policymaking should be oriented towards this objective? This is the fundamental question that needs to be addressed in evaluating the HPEC report. If it is indeed a big deal, then the massive effort proposed by the HPEC might be worth it.

    The HPEC notes that India has several advantages in attempting to build a major IFC at Mumbai: a large domestic market for financial services, high quality human capital, Mumbai’s location with respect to the various time zones, democracy, strong securities markets and the fact that India is the flavour of the day. It contends that India is better placed to offer IFS than it was to offer software at the advent of reforms because the software industry lacked a strong domestic base.

    But, then, software was backed by tax subsidies, did not require significant infrastructure support and is not an industry that is subject to regulation anywhere. The policy changes that enabled software to take off were modest compared to the proposals outlined in the report for IFS to become a success. Most importantly, the software industry did not need to attract international firms or professionals, it was about Indian players and professionals venturing out or using the advantages of the home base.

    Market for Indian IFS

    Let us begin with the question posed above: how big are the payoffs to creating an IFC in Mumbai? The report estimates the demand for IFS is $ 13 bn at present. It arrives at this figure by applying a fee of 2 per cent to total cross-border flows on both the current and capital accounts.

    The 2 per cent fee is a weighted average of: (a) generic charges for corporate transactions (fund raising, asset management, etc), and (b) standard service charges on current account flows.

    The estimate is rather crude. It assumes that the entire volume of cross-border flows requires IFS of one kind or another. Secondly, it applies a flat fee to the entire volume. A better approach would be to estimate demand for each of 11 IFS listed in the report and aggregate these. Thirdly, some of the services are already being provided out of India. What is being lost to outsiders, even if we accept the HPEC estimate, is $ 13 bn minus what is provided locally at the moment.

    Based on projections of cross-border flows, the HPEC estimates the demand for IFS in 2015 at $ 48 bn. Some proportion of these will be met out of Mumbai anyway as firms based there evolve in step with the economy. The contribution from the transformation of Mumbai into a GFC will be the incremental revenue and hence it must be necessarily less than $ 48 bn. It is incorrect on the part of the HPEC to state, therefore, that its estimate is conservative.

    Suppose we accept the estimate of $ 48 bn. Should we be bowled over by the figure? India’s exports (merchandise plus services) would be of the order of $ 150 bn in 2006-07. Assuming a growth rate of 15 per cent, exports would be $ 460 bn in 2015. The HPEC projection for financial services amounts to 10 per cent of the exports of the present basket in 2015. The impact of the proposed IFC in Mumbai on the economy or the BoP hardly warrants the orienting of economic policy towards the creation of such an IFC.

    The fact that only two or three countries have GFCs suggests that having a GFC is not by any means a condition for rapid growth. As the report points out, Tokyo is a rather modest IFC but this has not kept Japan from becoming a leading economic power. Germany and South Korea do not have IFCs comparable to Tokyo but this has not come in the way of their economic development.

    Using the yard-stick employed by the HPEC, China’s demand for IFS must be considerably larger than India’s and it must lose a huge chunk of this to outsiders. But China’s march towards the third place in the world economy has not been impeded by the absence of a GFC (although in Hong Kong it does have an important IFC). The idea that economic policy should be built around the creation of Mumbai as an IFC fails to enthuse.

    Financial Sector Reforms

    But, if the IFC is not all that attractive in terms of what it does for the economy as a whole, maybe it is attractive for what it does to the financial sector. The financial sector is not just about exporting financial services. Its more important role is to foster efficiency in the domestic economy. It is possible to conceive of an IFC, therefore, as an instrument for broad development of the financial sector. This is an aspect to which the HPEC report devotes four out of 15 chapters. Let us visit some of the HPEC’s comments and proposals.

    India’s financial sector, according to the HPEC, suffers from several weaknesses. The report is on strong ground in addressing one of these, the absence of what it calls the BCD nexus (bond-currencyderivative markets). The case for broader development of these markets is well argued and indeed, for the bond markets, we already have a basis for moving forward in the R H Patil Committee report. Whether all securities trading markets (including those for sovereign debt) need to be brought under the purview of SEBI can be debated.

    The report highlights other weaknesses in the Indian financial sector. It lacks competition. It is too heavily regulated. It does not have an environment that promotes innovation. These complaints are all valid – up to a point. The report, however, tends to be too sweeping in its judgments on these counts and not all the arguments it makes are rigorously thought through.

    Perhaps we could begin by examining issues relating to competition in the financial sector. The report dwells at length on the opening up of product markets in the1990s and how this has “ignited” exports of manufacturing. The key was removal of barriers of various kinds – on imports, on entry of domestic firms, and on entry of foreign firms. In particular, the report has a table that shows the progressive lowering of customs duties on imports in various years and the corresponding level of exports.

    But this very table shows that in some of the pre-reform years, when import duties were higher than in the immediate postreform years, exports were higher than in the later years! Moreover, export growth was relatively low in the period 1992-93 to 2000-01 when duties fell from 37.5 per cent to 20.8 per cent. Exports took off

    Economic and Political Weekly June 9, 2007 in a big way in the period 2001-02 to 2005-06 when duties declined from 20.8 per cent to 10.2 per cent. The initial big decline in import duties did not contribute as much as the smaller decline later on. Further, in the initial years, declines in import duties were offset by a sharp depreciation in the rupee. One has to look at the effective rate of protection over the years in order to draw meaningful conclusions.

    A plausible inference could be that the sharp depreciation in the initial years helped cushion the impact of falling duties on Indian industry and gave it time to adjust to import competition. In other words, the story of the opening up of product markets is very likely a story of carefully calibrated increases in competition – quite the opposite of the case being made in the report for a dramatic opening up of the financial sector.

    Besides, it is not as if there has been no increase in competition in the financial sector. In asset management, insurance, investment banking and brokerage, the market has been opened up in a big way to both domestic and foreign players. It is only in banking that progress has been relatively slow but here too private players have waded in and one of them, ICICI Bank, today occupies the number two position.

    The share of public sector banks in assets, deposits and profits has been declining; so has the share of the top five banks. In other words, the trend towards increasing competition is clear enough even in banking; one could argue that the pace might have been quicker. The report talks about creating an environment conducive to the exit of firms as crucial to achieving a globally competitive sector. There are segments in the financial sector – brokerage, investment banking, asset management – where exits have happened and major domestic firms have fallen by the wayside. It is only in banking that exits are rare but that is because banking is a different animal altogether: there are large externalities to bank failure.

    Restrictions on foreign banks’ entry into banking remain. But these too are poised to ease in 2009. With foreign bank entry, there are two major issues. One is reciprocity in access – this is part of the trade negotiations under the WTO. The HPEC urges unilateral liberalisation. This could apply to other sectors as well and not just the financial sector but this is clearly a matter of larger national policy and that policy is today not in favour of unilateral liberalisation. The second issue is one of regulatory capacity, the ability to monitor branches or subsidiaries of foreign banks. This is not a problem that will go away even if we were to accept the HPEC’s recommendation to make a quick transition from rule-based to principleregulation.

    What do we make of the view that there is excessive regulation in the financial sector? The HPEC ascribes part of this to an overweening anxiety to prevent scams. The stock market scams that we have seen, which also involved banks, had a big socio-political impact and their impact on the financial sector itself was not inconsequential. It is impossible for the

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    Economic and Political Weekly June 9, 2007

    political authority or the regulator to treat the scams as par for the course!

    The committee argues that principlesbased regulation might be more effective in tackling malfeasance and it cites the UK experience to buttress its point. But this too presumes a certain regulatory capacity and a certain level of evolution among financial players. It is worth knowing at what point in the evolution of the UK financial system was the switch made to principles-based regulation.

    The HPEC bemoans the low level of innovation in the Indian financial system. Lack of innovativeness again arises from some of the factors mentioned earlier and others: excessive regulation, lack of competition, government ownership, artificial barriers between different segments of the financial market (banking, asset management, insurance, capital markets).

    Some of these points have been addressed earlier. To take the last point now, the report contends that the barriers between different segments have prevented the emergence of large complex financial institutions with all the advantages of scale and scope. Such an entity may not have emerged in a particular corporate form (the holding company) but institutions such as SBI, ICICI Bank and HDFC do have a presence in different segments of the financial market and they have also been able to achieve synergies amongst these.

    Is government ownership such a big deal today? The HPEC thinks so. It wants government ownership to fall below 49 per cent by 2008, 26 per cent by 2010 followed by a complete exit in 2015. Government ownership remains an important factor only in banking and insurance and in both sectors, government firms have been losing market share. The trend is set to continue. Given this trend, it is not all obvious why the HPEC should attach so much importance to the elimination of government ownership.

    In banking, the requirements of agriculture and, more generally, financial inclusion render a strong public sector presence necessary in the foreseeable future. Surprisingly for a committee that included heads of public sector banks, the expression “financial inclusion” is altogether missing in the report.

    Time was when privatisation was seen as an imperative for faster growth in other sectors as well – we even had pundits who argued that GDP growth would go up by over 1 percentage point if this happened and this was one way the economy could get out of the 6 per cent rut. Privatisation did not happen and the growth rate has accelerated. One lesson is that it is not necessary to privatise; it suffices to give the private sector greater freedom of entry. State ownership then ceases to be a material factor. This is happening in the financial sector as well.

    That apart, any decline in government equity holdings in banking matters only insofar as it helps public sector banks to access capital. It makes no difference whatsoever to the public sector character of these banks. Under the circumstances, for the HPEC to set deadlines for government ownership to fall to particular levels makes little sense in terms of impacting the ownership character of public sector banks.

    One last comment about innovation in the financial sector. Innovation is not necessarily about superior or sophisticated products (stock index futures, collateralised debt obligations, etc), it is also about processes. Retail loans or life insurance are not sophisticated products. But, in a market such as ours, there is scope for innovation in creating distribution to reach these to large numbers of people. Indian firms as well as foreign firms operating in India have been quite successful in doing so. Gains in innovation in distribution, be it noted, can often be far greater than gains in product innovation. The report does leave you with the feeling that the HPEC has a rather narrow view of what constitutes financial innovation.

    Macroeconomic and Other Policies

    As though the menu of financial sector reforms proposed is not dizzying enough, the report also spells out the implications for macroeconomic policy and urban governance. One, the consolidated fiscal deficit of the centre and the states must be brought down to 4-5 per cent of GDP (as against the 6 per cent proposed by the Twelfth Finance Commission). Two, the HPEC also wants the total GDP/debt ratio, including pension liabilities, to come down to 50-60 per cent of GDP. On present trends, both these are conceivable but it is hard to see any government exerting to achieve these targets so that an IFC can become feasible.

    Three, the HPEC wants radical changes in public debt management. SLR requirements must be dispensed with; investment in government securities should be entirely voluntary. Financing of public debt, it says, should not pose problems once mutual funds, insurance companies and pension funds become large enough because all of these will have a natural appetite for debt. Further, investment in rupee denominated debt should be opened up to foreign investors.

    Since, the report does not specify a time frame for these to happen, the recommendations do not present great problems. SLR has indeed been progressively coming down and today we are already in a position where SLR can be driven below 25 per cent thanks to a favourable combination of factors: the fall in the fiscal deficit to GDP ratio, the rise in the savings rate and growing appetite for government debt from non-bank intermediaries. The SLR has not been cut below this level because the RBI is keen to rein in credit growth. This again is an area where a certain natural evolution is taking place and one sees no call to intervene in order to expedite the arrival of an IFC.

    Four, the HPEC argues that a credible IFC is inconsistent with capital controls of any kind, hence full capital account convertibility is a requirement for such an IFC. The report seeks the elimination of all capital controls by calendar year 2008. But the relevant section fails to make out a convincing enough case for full convertibility as a precondition for an IFC.

    We are moving towards a situation in the near future where very substantial liberalisation on the capital account will have taken place and the only serious restriction will be on domestic residents taking out large amounts of capital and placing these overseas. This restriction is notional in that domestic residents have not even availed of the facilities made available to them so far to park their savings abroad. We are still in a phase where riskaverse individuals have not yet moved in a big way from bank deposits to domestic capital markets. From domestic to international markets would be a big leap.

    The residual restrictions on capital movements in a few years’ time would largely relate to situations or contingencies that could potentially trigger a huge outflow of capital. Why these limited restrictions should seriously cramp the creation of an IFC is not clear. (It is worth reminding ourselves that London had emerged as an IFC even when it did not have full convertibility.) The report should have outlined precisely which set of financial

    Economic and Political Weekly June 9, 2007 services cannot exist in the absence of full convertibility.

    The foregoing is by no means a comprehensive review of the HPEC’s recommendations on economic and financial policy. There are many more. But, even if the entire gamut of recommendations were implemented through some miracle, the challenges of urban governance in Mumbai alone could prove a big obstacle, something the report itself acknowledges.

    The HPEC proposes world-class infrastructure for Mumbai; major publicprivate partnerships (PPPs) to finance such infrastructure; removing obstacles posed by the Urban Land Control Regulation Act (ULCRA) and the Rent Control Act; and, not least, the creation of a “City Manager” directly accountable to the city’s citizensand residents. The only thing left out is a magic fairy that will grant all these wishes with a wave of her wand! Is it possible at all that Mumbai can become a place that attracts people from all over the world without the rest of the country attaining a certain level? If the infrastructure improves as suggested and if there is an explosion in jobs along the lines envisaged then it is very likely that migration into Mumbai would rise to a point where the improvements would be well nigh negated.

    Vision or delusion? The last point above gives us an indication of what is wrong with this report. Policies and outcomes in many respects are indeed moving in the directions indicated by the report. The Indian financial sector is evolving rapidly. The pull of the Indian market is bound to draw in big international players. But the case for expediting matters in order to facilitate the arrival of an IFC in Mumbai is weak; indeed, attempts to expedite matters with such an objective in view can prove counterproductive.

    Economic policy must be set in relation to broader growth and other objectives. We need to ask: what would it take to sustain growth in the range of 8-10 per cent? We already have a set of policies that can be expected to meet this objective. It is not that without an IFS in Mumbai, this objective will not be met. An IFS has its place but it must be an outcome of what is happening in the economy at large, it cannot be the pace-setter for the economy. The finance tail cannot be allowed to wag the economy dog.



    Economic and Political Weekly June 9, 2007

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