In an ideal world, prices of all goods and services are determined by markets. Innovators and entrepreneurs rule the world. Limitless opportunity and fulfilment of all wants is the norm. Much of this is, of course, fiction. Even in the most liberalized markets, there are significant frictions that slow things. But as Nobel Prize winners Kenneth Arrow and Gerard Debreu realized decades ago, markets can come close to that ideal world if certain conditions are met.
India, however, is not such a world. In Arrow-Debreu parlance, the country does not have “complete markets” where the present and future prices of goods and services are well determined. In India there is a set of “missing” markets. These missing markets include an active secondary market in corporate bonds, a credit derivatives market, an active interest rate futures market and an active structured products market, among other markets. Should it matter?
It does. One practical example is that of infrastructure funding. Infrastructure projects need to borrow on a long-term basis. Bank borrowing, the preferred route for funding activities in India, does not work here: large-scale borrowing for the long term can lead to asset-liability mismatches in banks. The other option, raising money in equity markets, is expensive. A deep and liquid bond market where such instruments are traded actively can solve this problem.
Why does India lack these markets and other similar questions were addressed in a lecture “Pursuit of Complete Markets—The Missing Perspectives” by Shyamala Gopinath, a deputy governor of the Reserve Bank of India (RBI), last month. In most instances, RBI has a cautious stand: it sees the necessity of having such markets, but is also aware of the formidable problems that underlie the functioning of such markets. These issues transcend quibbling about regulation. A liquid bond market, for example, requires foreign participants with deep pockets. This, in turn, requires that there be convergence between nominal and real interest rates, and a low public debt-to-gross domestic product ratio, among other macroeconomic requirements. In their absence, a crisis situation can lead to flight of capital and speculative attacks. In India, these requirements are systematically violated.
But all this was before the financial crisis. Now there are other objections, such as the danger of financial markets acquiring a life of their own (or being delinked from the real sector). We believe that these risks have been overplayed in the Indian case. Some forward movement is required if we are to power our economic growth.
Are missing financial markets hindering India’s economic growth? Tell us at firstname.lastname@example.org