Every episode of financial mass destruction is followed by the use of public money to clean up the mess and then calls for tough regulation. It is likely to be so this time around as well — in the US and elsewhere.

Illustration: Jayachandran / Mint

India has been far away from the epicentre of trouble, though there are tremors in the local financial markets. The question is: What are the policy lessons for us?

The combination of cheap money, light regulation and perverse incentives in trading rooms has conspired to lead the Western financial system into this crisis. It is likely that this will lead to fresh queries about the need for a more open financial system here in India. We should take care not to throw the baby out with the bath water.

The financial sector should ideally ensure that the savings in a country are put to the best economic use. It requires freedom to do so — but also oversight to ensure that the bets do not resemble those in a casino. It is easy to forget that India once was a classic case of financial repression. It satisfied all the six dimensions mentioned by economists Ronald McKinnon and Edward Shaw in 1973: The government directed credit, set interest rates, controlled the entry of new financial players, owned most of banks, decided internal salaries and kept a tight control on inflows and outflows of capital.

We have come a long way since then, thanks to more than 15 years of reforms. The reforms have led to better capital allocation. Financial sector reforms have to move ahead, though only gradually. There is an internal logic at work. For example, the rupee will be more volatile once the Reserve Bank of India reduces its intervention in the foreign exchange market. Companies will need currency futures to hedge against the movements in the rupee. They will seek these hedges offshore if they are not allowed domestically.

The challenge will be to pick and choose intelligently. It has happened not too long ago. The consensus after the Asian crisis of 1997 was that India was spared the worst because it had a closed capital account. Yet, in the 10 years since that crisis, India has gradually reduced barriers for capital inflows and outflows. Similar movement will be needed to ensure that there is greater variety in the financial system — in terms of both participants and instruments.

The big problem then will be how to regulate this more complex system. And let’s face it: Nobody has a convincing answer right now.

Should India still move ahead with financial sector reforms? Write to us at views@livemint.com