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Can Mumbai become an
International Financial Centre?
Joshua Felman
IMF India
Presentation to RiskWorld
April 10, 2007
A disclaimer!

The views expressed in this presentation are
personal. They are not necessarily shared by the
IMF, its Executive Board, or its management.
Roadmap of the Presentation

Why do we care?

Where do we stand?

What needs to be done?
Roadmap of the Presentation

Why do we care?

Where do we stand?

What needs to be done?
The importance of finance

Why focus on finance when there are so many other priorities,
such as improving infrastructure and social services?

The answer: Finance is to our century what steel was to the 20th
century – the basic building material of a modern economy

To understand the centrality of finance, imagine a devastating
earthquake, leveling all India’s banks and corporates. Which
sector should be rebuilt first?


If banks are rebuilt, it will be possible to rebuild the corporates
But the other way around will not work
The importance of finance/quantity

The need for long-term finance is great:
$320 billion will be needed during the 11th Plan
period, just for infrastructure
 Much of this will need to be financed by the private
sector


Where will they get the money?
The importance of finance/quality

Over the coming years India will be investing at
least one-third of its income


It is important that to do so efficiently
Consider the following charts of the U.S.,
Germany, and Japan
Investment in the U.S. is low…
40
Investment Ratio
35 (In percent of GDP)
United States
Japan
Germany
30
25
20
15
10
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
…but growth has been high
10
Real GDP Growth
8 (In annual percent change)
United States
Japan
Germany
6
4
2
0
-2
-4
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
…making for a very low ICOR
25
Incremental Capital Output Ratio
20
United States
Japan
Germany
15
10
5
0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
How does the U.S. do it?

Answer: it has a large financial system, which
allocates capital in an exceptionally efficient
manner

Notably, it has a good balance between its
banking system and its capital market
Its banking system is large…
250
250
P rivat e Credit by Deposit Money Banks and
Ot her Financial Inst it ut ions
(In percent of GDP)
200
200
United States
Germ any
Japan
India
150
150
100
100
50
0
1960
50
1971
1982
1993
0
2004
As is its stock market…
180
160
180
St ock Market Capit alizat ion
(In percent of GDP)
160
United States
Germ any
Japan
India
140
140
120
120
100
100
80
80
60
60
40
40
20
20
0
0
1989
1994
1999
2004
…and its bond market
120
1 .6
P riv at e Bo n d Mark et Cap it alizat io n
(In p ercen t o f GDP)
1 .4
100
1 .2
80
1
60
0 .8
0 .6
40
0 .4
Un ited S ta tes (left sca le)
20
Germ a n y (left sca le)
0 .2
Ja p a n (left sca le)
In d ia (rig h t sca le)
0
0
1990
1992
1994
1996
1998
2000
2002
2004
Domestic or foreign?



The need to intermediate a large quantity of savings
efficiently is a powerful argument in favor of building a
strong financial sector
But the Mistry Report makes another argument, that
India needs to build an international financial centre
(IFC)
An IFC is a financial centre that caters to customers
outside its own jurisdiction, in addition to domestic
customers

Global IFCs such as London and New York provide the
widest array of international financial services (IFS) to clients
from all over the world
The case for an IFC

The fundamental logic is straightforward, namely that
opening up to global competition will be the fastest and
surest way to develop the sector


In other words, India should do to the financial sector what
was done to the real sector in 1991
But there is an additional, more subtle, argument based
on the path of India’s development


India is globalizing rapidly, much more rapidly than most
people realize
Consider the following charts
The export sector has become more
important than agriculture…
30
25
20
15
10
5
Exports (% GDP)
2004
2002
2000
1998
1996
1994
1992
1990
0
Agriculture (% GDP)
…and capital inflows have soared
2.5
FDI (%GDP)
2.0
Portfolio (% GDP)
1.5
1.0
0.5
0.0
2000-2001
2001-02
2002-03
2003-04
2004-05
2005-06
India is globalizing rapidly

The statistics on India’s financial integration with the
rest of the world are astonishing:




Total two-way gross flows on balance of payments
transactions were $101 billion in 1992/93
They were $237 billion in 2001/02
And $657 billion in 2005/06
In other words:


Doubling took nine years
Near-tripling took only four
India’s globalization

More statistics:
External flows were 47 percent of GDP in 1992/93
 And 91 percent of GDP in 2005/06.


Conclusion: While India is growing rapidly, it is
globalizing even faster!
So, India’s “operating manual” needs
to change

Previously, India was the quintessential closed
economy

What happened in the rest of the world
mattered little to India, and what happened in
India mattered little to the rest of the world.

But times have changed...
…India now matters very much!
Seizing the opportunity

India’s globalization has presented a significant
opportunity for the financial sector:



The Mistry Report estimates the size of the IFS market at
$13 billion in 2005/06
It conservatively projects that domestic demand for IFS will
grow to $48 billion by 2015
Right now, almost none of this demand is met locally


Failure to respond to this demand is forcing Indian
customers to go abroad, e.g. Tata-Corus
With demand far outstripping supply, one could say that there
is financial sector “overheating”!
Roadmap of the Presentation

Why do we care?

Where do we stand?

What needs to be done?
India has considerable potential

The Mistry Report argues that Mumbai has four key
advantages:




Hinterland, a large and rapidly growing economy, creating a
substantial demand for IFS (the projected $48 billion)
Human capital, including the extensive use of English,
generations of financial experience, and strong IT skills
Location, the ability to transact with Asia and Europe
though the trading day
Democracy and rule of law, including open expression of
views
But creating an IFC is demanding

IFCs require a highly developed Bond-CurrencyDerivative (BCD) nexus

Every IFS customer generates a currency transaction


IFCs attract global bond issuers into the domestic market


This requires liquid currency market, with a full range of currency
derivatives
This requires a liquid and arbitrage-free yield curve, backed by interest
rate and credit default protection derivatives
The BCD nexus is bound together by arbitrage

The currency forward curve is but a reflection of interest rate
differentials
Where does India stand?

The currency and bond markets are
underdeveloped:
Indian currency spot turnover seldom exceeds $5
billion per day, compared with $125 billion per day
in Singapore
 The corporate bond market is small and not very
liquid, even when compared to other Asian emerging
markets

India’s small bond market
Missing derivatives markets
Many of the important derivatives markets do not
exist at all.
 For example:

There are no Indian counterparts to key interest rate
contracts in the U.S. – Eurodollar futures, Fed funds
futures, Treasury notes, Treasury bonds
 India has only one successful stock index contract, the
Nifty
 The trading of currency futures is banned

IFCs also require a strong
institutional investor base

Institutional investors command enormous
pools of capital

They bring sophisticated analytical tools to bear
on the task of price discovery

They link domestic finance with the rest of the
world
Where does India stand?

The institutional investment base is small

For example, mutual funds have assets under
management of just 9 percent of GDP, not
large enough to influence price formation

Pension funds and insurance companies are also
small
Roadmap of the Presentation

Why do we care?

Where do we stand?

What needs to be done?
Mistry Report Recommendations

Key recommendations include:
Removing capital controls
 Ensuring macroeconomic stability by reducing
public sector debt from the current 80 percent of
GDP to perhaps 50-65 percent of GDP
 Spurring the BCD nexus, including by creating the
“missing markets”
 Developing the investor base

Developing the investor base

There has long been discussion of developing the investor base

The focus so far has been on encouraging domestic investors


The IMF has strongly supported the introduction of the New Pension
system, which could bring considerable funds into the capital market
But there’s another possibility: the investment base could be
extended to foreigners
Domestic or foreign?

Actually, foreigners already participate in the Indian
bond market – through ECBs!

Consequently, firms can now choose whether to issue
domestically or abroad

Domestic issuance has many disadvantages:



As noted earlier, market size is small
Illiquid, with little secondary market trading
Interest rates are higher than abroad
The ECB route – and its problems
 Many
firms consequently favor ECBs
 But
there is a problem: foreign exchange
borrowing, for example for infrastructure projects,
can create a currency mismatch on balance sheets
 This
is a risk management problem, so severe
that it has become known as “original sin”

Called a “sin” because unhedged foreign borrowing
coupled with false perceptions of currency risk has
caused serious economic problems, in Asia as well as
Latin America
Latin America is eliminating “original sin”
Most EM countries are trying graduate out of
“original sin” and have their local currency bonds
accepted into global portfolios
 Until a few years ago, it seemed that there was no way
to do this (that’s why it is called “original sin”)
 But times have changed




Mexico graduated in 2003
Brazil graduated in 2005
Other countries are following
Perhaps India could follow their path
 Rather
than encouraging firms to
borrow abroad, India could invite
foreign investors to participate more
in the domestic market.
Current limits on foreign holdings of
corporate bonds are a very modest $1.5
billion

Should India go down this road?
 Three
considerations:
Feasibility
Desirability
Risks
Feasibility: Is there a demand?
 If
Latin America can do it, why not India?
 Investor
interest has grown as India’s economy has
started to take off
 It was boosted further recently when Indian bonds
became investment grade
 In
February, there was a significant
development: a rupee bond was issued offshore
using the non-deliverable forward market
 Why not bring such activity on-shore?
Desirability: benefits for India?

Increasing foreign participation would reduce “original
sin”, since foreigners would then be assuming
currency risk

It would also extend the investor base, increasing
demand and reducing domestic interest rates

It would shift IFS revenues to India
Desirability: benefits for India?



Foreign investors would also promote secondary
market development, since they are more willing
to trade than pension/insurance companies
Greater liquidity means that those who buy bonds
know they will be able to sell them if they need,
at reasonable prices
This will encourage demand, reducing interest
rates and thereby spurring more primary issues
Risks: financing the government deficit

Would opening up hamper the government’s ability to finance its deficit?

Actually, it could help, by opening up a new financing channel, enabling the
government to ease financially repressive policies

If global fixed income investors allocated 2 percent of their portfolios to India
(in line with the country’s weight in world GDP), this amount would exceed the
required government bond holdings of domestic institutions

Greater foreign participation could also allow maturity extension
 Starting in 2003, Mexican government issued 20-year bonds in pesos,
marketed to foreigners

But it would also increase market discipline on the government, potentially
causing financing strains if investors become concerned about risks
Risks: any dangers to monetary policy?

Opening up could encourage additional capital
inflows, which could complicate monetary policy

But the extent of the increase in inflows is not
clear, as foreign purchases of rupee bonds may
just substitute for ECBs
A possible strategy

Participation could be liberalized gradually, to
“test the waters”

RBI is already allowing FII participation in
government securities to expand gradually

Tarapore Committee proposed allowing FIIs to
purchase one-quarter of corporate bonds
Conclusion




India is globalizing at an astonishing pace, it is truly
creating a “new India”
This new India requires new ways of thinking, about
opportunities, risks, and the appropriate ways to manage
these risks
On the opportunity side, globalization is creating the
chance for the financial sector to grow to meet the
demand for IFS
But at the same time, it is creating a risk of unhedged
foreign borrowing, known as “original sin”
Conclusion



How should this risk be managed?
The days when it could be managed through restrictions
and compliance checklists are long gone – if they ever
really existed
The best way to deal with this risk is not to impose more
controls, but through more liberalization


Remove the distortion: the restriction on foreign purchases of
rupee bonds
This solution may seem counter-intuitive, but that is
precisely why we gather together for conferences such as
RiskWorld—to leave aside our “operating manuals”,
open our minds, and look at things in a different way!
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