The draft report of the Committee on Financial Sector Reforms, chaired by Raghuram Rajan, follows on the earlier Mistry committee report on developing Mumbai as an international financial centre. The reports are complementary in their focus—on domestic and international markets, respectively—and very similar in perspective and recommendations.
Despite current global financial uncertainties, and a potential backlash against financial liberalization, the two reports have done a great job of agenda-setting, which will be extremely fruitful in coming years.
The agenda of the latest report is politically more urgent since it addresses financial inclusion and domestic financial development, but this also means that the political challenges of implementation will be greater. Even when reform consists of “a hundred small steps,” the complementary nature of many of these steps, and the need for foundational changes in systemic underpinnings complicates the process. Beyond debating the merits of particular proposals in the report, it is therefore important to analyse the categories of proposed reforms and identify a feasible core that can be pursued immediately.
The recommendations on the macroeconomic framework are likely to be the most controversial and most resisted. Inflation targeting and a floating exchange rate are very far from current Indian practice. The viewpoint embodied in these proposals accords with the weight of academic opinion, but is not unanimously held or empirically ironclad. The debate will likely continue for some time, but it is critical to recognize that most of the financial sector reform proposals in the Rajan report do not depend on or require changes in the macroeconomic framework, even if the present approach seems a bit like muddling through.
Similarly, there are several recommendations for modifying the current regulatory architecture, designed to improve coordination, coverage and quality. A key idea is the reduction of micromanagement. Certainly, structural changes can help improve regulatory incentives, but again there is a danger of getting bogged down in setting up new institutions or making legislative changes. Indeed, the report acknowledges a “sound regulatory framework” exists, albeit with deficiencies. My own sense is that much can be accomplished by an attitudinal change in the Reserve Bank of India (RBI), which has considerable leeway to streamline regulatory implementation within existing laws and institutions.
Where RBI will need outside help is in creating an appropriate credit infrastructure. This is one of the most important parts of the report. Credit markets require mechanisms for building and assessing reputations, providing collateral and enforcing agreements. Clear and streamlined procedures for default and bankruptcy are also critical. All of this is an area where several small steps are feasible, and clearly laid out in the report. However, key changes in bankruptcy law, already proposed by an earlier committee (chaired by J.J. Irani in 2005) should be a high priority. Another important aspect of improved credit infrastructure will be doing a better job of informing, educating and protecting small participants in financial markets—this is, in fact, the chief microlesson of the US subprime crisis, and is an important area for regulatory reform.
The current approach to protection of market participants is very different— various transactions, markets and participants are simply banned. This brings one to the heart of needed reform. India can progress by building on its demonstrated success of creating modern, efficient markets in financial instruments. The report provides clear and blunt guidance in this area: encourage the introduction of missing markets; stop creating investor uncertainty by banning markets; have consolidated membership of exchanges for qualified investors; encourage the setting up of “professional” markets and exchanges for sophisticated products and investors; and create a more innovation-friendly environment, speeding up the process for approval of new financial products.
Doing all this won’t automatically increase financial inclusion, but it will begin to create a modern financial sector. Ultimately, exchange-traded financial securities reduce the costs of more traditional and idiosyncratic forms of borrowing and lending. Again, putting aside the fraud and negligence behind the current subprime crisis, securitization of mortgages and trading of those securities has been crucial in reducing costs in, and expanding access to, the US mortgage market. Banks and other retail financial institutions still have to exist, and can be made more efficient: increased entry and competition, smaller burdens on public sector banks, improvements in organization and in use of technology, and consolidation are all rightly recommended in the Rajan report.
Finally, it is good to remind ourselves that real sector reforms are also necessary, as the report points out. Thus, better insurance coverage in areas such as agriculture and health is needed, but so are irrigation and preventive health care, as ways of reducing the actual risks. The optimistic way to look at the broad canvas of reforms in India is that there is so much potential to make things better.
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at firstname.lastname@example.org