There is a grand paradox in the annals of contemporary economic policy. A crisis in the real economy usually brings deregulation in its wake, while a financial crisis usually leads to greater regulation.

In one instance, the state is rolled back; in the other, it advances.

The interesting question then is: Will the recent turmoil in the credit and derivatives markets in many rich countries push back financial sector reforms in India? Will we have people standing up to say: “We’re better off not allowing our banks and investors to deal in credit derivatives and other fancy stuff. Just look at what has happened to Bear Stearns and Goldman Sachs. Do you want that to happen here?"

Don’t dismiss the possibility just yet. Let’s step back to 1997. In the February of that year, finance minister P. Chidambaram announced a bold plan to push India towards capital account convertibility. Then disaster struck in East Asia a few months down the line. Countries across the region participated in a spectacular tumble—first of currencies, then of markets, and finally of entire economies.

India and China were the only two major developing Asian economies to survive the carnage that followed. Why? One argument that has been bandied about since then is that these two countries were protected by a closed capital account. Vigilante traders, moving billions across the world with the tap of a few computer keys, could eventually wreak little havoc in India and China because capital controls in these two countries kept them at bay. Even IMF eventually came around to the view that capital account convertibility should be handled with care.

Beliefs such as these were one reason why big-bang financial liberalization was put on hold in India after 1997. While the authorities gradually removed most of the obstacles in the way of capital inflows after 2001, and also encouraged Indian companies and individuals to invest in dribs and drabs abroad, dramatic change was avoided. It took nine years for the government to put capital account convertibility back on the policy agenda.

That is the big worry. And we could see a repeat of 1997 once again. Take financial derivatives. There have been some moves in recent months to open up the domestic derivatives market. For example, banks could soon be able to buy and sell products such as credit default swaps in the months ahead. The domestic market for many bond market derivatives is sluggish, but it could change as the economy evolves. The Percy Mistry committee on making Mumbai into an international financial centre has also argued in favour of a larger derivatives market in India.

The issue right now is not whether India needs more radical financial sector reform or not. That’s a completely different debate. The issue right now is what can happen to domestic reform in case there is a huge derivatives blowout in the US. Let’s not write off the possibility of such a blowout, despite the Fed’s cut in its discount rate last week. Let’s say a medium-sized bank in the US or Europe stumbles because of its derivatives portfolio. Will it be long before the same question asked in 1997 reappears: “Aren’t we better off without all these fancy financial products?"

Some would argue that perhaps India could continue to ban derivatives, while keeping the door open for capital inflows. That’s not very practical. Increased exposure to free capital flows will ensure that exchange rates and interest rates will bob up and down—unless RBI goes back to a fixed exchange rate and generalized financial repression, both of which are unlikely. So, companies, banks and individual investors will need derivatives to protect themselves, and profit from, the inevitable volatility that will come with financial sector deregulation and openness.

I wouldn’t be surprised if the current chaos in the global financial markets leads to demands for stricter policing of banks and investment activity —not just in India, but in many other countries as well.

Most economists agree that the theoretical case for free markets in goods and services is far stronger than that for free markets in capital. Even ardent supporters of free trade such as Jagdish Bhagwati argue in favour of controls on capital flows. In a research paper written in 2006 for IMF, M. Ayhan Kose, Eswar Prasad, Kenneth Rogoff and Shang-Jin Wei argue that the benefits for financial liberalization are not as direct as is commonly assumed—that capital inflows will directly boost investment and growth.

These economists argue that financial globalization mainly yields “collateral benefits"—there is more macroeconomic discipline, corporate governance improves, financial markets develop, etc. The economy does benefit in the long run, but the immediate benefits are less clear. This could make financial globalization an easy target in the months ahead.

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