Joseph Mariathasan explores how India might get its financial house in order after a botched currency demonetisation
India’s radical and many would say misguided move to ban “high-denomination” notes overnight on 8 November during the peak wedding season in a largely cash economy has caused chaos and will reduce GDP in the short term by significant amounts. Moreover, the notes that were banned – Rs.500 and Rs.1000 – are not that high a denomination and account for 86% of currency in circulation. It is not analogous to withdrawing $500 bills or €500 notes in Europe or the US, which are hardly used.
Whether India will benefit in the long term remains to be seen. Prime minister Narendra Modi’s aims were certainly laudable – to attack corruption and the ‘black economy’ with a surprise and bold move. It is likely to also benefit the exchequer, as much of the money may never be exchanged.
One real problem, though, is that it has not been just the corrupt who have suffered but the mass of the general population. Arguably, the big-time crooks would have been storing undocumented and untaxed wealth in other assets such as gold and property rather than cash.
The events are happening against a backdrop of massive changes in India that still leave much to be done. China is experiencing a financial Big Bang that is transforming its economy. But in India, more people have mobile phones than bank accounts. The cost of finance is exorbitant for everyone bar the very largest companies. As economist Ajay Shah argues, in India, the financial system is simultaneously hostile to innovation and competition, and vulnerable to crises.
India has seen major reforms in certain sectors after 1991, such as telecommunications. Import restrictions were loosened for manufacturing, which led to major improvements. But in finance, Shah argues the existing laws were built for a different age and need to be reorientated to the needs of the India of the next 20 years. So far, only the equity market has been “fixed”. The rest of finance is mostly unchanged – banking, for example – or has new parts that are as yet small, such as the New Pension System.
Modi is halfway through his term. Shah believes there have been six wins in Indian finance that bode well for the future. The full solution for the country lies in the draft Indian Financial Code (IFC), put together between 2011 and 2015.
Enacting and implementing the IFC at one shot has not happened. But a lot has, says Shah: Commodity futures have been classified as securities and are now regulated by SEBI. This should lead to convergence of financial markets and big gains to the economy.
A basic concept of the rule of law is that orders of a financial agency should be subject to judicial review. After 2015, a tribunal hears orders against all financial agencies other than RBI. RBI is now the only financial agency where orders are not subject to judicial review.
The Indian system of capital controls has failed. The first step towards fixing this was taken in February 2015, where the power to write regulations for non-debt capital flows (both in-bound and out-bound) shifted from RBI to the Ministry of Finance.
Two new agencies envisaged in the IFC are the Financial Data Management Centre (FDMC) and the Resolution Corporation (RC). The FDMC will, for the first time, make possible a full view of Indian finance and thus an assessment of systemic risk. The RC is a specialised bankruptcy code for financial firms. If high-quality laws are enacted, and the implementation plans in hand are pulled off, this will give two big steps in reform.
Inflation targeting and the monetary policy committee were once heretical ideas when they were in committee reports and in the IFC. In February 2016, for the first time in its history, RBI had an objective (4% inflation) and power shifted from the governor to the MPC.
At this historic moment in RBI’s history, the new governor, Urjit Patel, will now refashion RBI as an agency that will consistently deliver on its objective. This is harder than merely announcing the target. For Shah and others, there are grounds for optimism that he will be able to get this done. It may, however, be dependent on his surviving the fallout from the botched currency demonetisation.
Joseph Mariathasan is a contributing editor at IPE