Politics of India’s Capital Market Reform…

John Echeverri-Gent of Virginia Univ (Politics Dept, is an India political eco expert) writes this interesting paper.

He ponders over this q on why India’s equity market developed so much but corporate bond markets still remains weak:

Economic historian Douglass North has observed, “it is a peculiar fact that the literature on economics … contains so little discussion of the central institution that underlies neoclassical economics – the market.”[i]  Until recently, this neglect was particularly true for analysis of how markets change.  Though more recently, economic historians like Douglass North, John McMillan, and Avner Grief have documented the changes in markets over time, the analysis of how markets change is still in early phases of development.[ii]  My paper takes advantage of the uneven nature of capital market reform inIndiato offer some modest steps towards advancing our thinking.   It poses the question: “Why have India’s equity markets experienced such dramatic reform while its market for government securities have lagged behind, and the limited reforms in the market for corporate debt have failed miserably?” 

Before this, a fascinating discussion on markets. What is markets?
Implicit in this question is a distinctive and somewhat fine-grained definition of “market.”  While economists have delivered great insights on the functioning of markets, comparative economics has not always carefully defined the concept of markets.  Many analysts talk about market economies as a national unit of analysis.  They compare market vs. non-market economies or different varieties of capitalist markets.  Other analysts conceptualize markets in sectoral terms, at either the international or national level. They examine energy markets, agricultural markets, financial markets, etc.  Still others discuss regional markets.  For the purposes of this papers analysis, I define markets in terms of the technologies and rules that regulate the transactions of market participants.  I distinguish market along three dimensions: 1) the technologies and rules that structure the transactions of market participants, or what I call market design; 2) the nature of the goods that are exchanged; and 3) the identity of the participants.
What is market development?

Following from this definition is a conceptualization of how to measure market development.  I measure market development along three dimensions.  Markets develop as they adopt more efficient market designs.  The efficiency of market design has two indicators.  A more efficient market will have lower transaction costs.  It will also have more efficient price discovery.  Secondly, more advanced markets will have more efficient competition.  My idea of more efficient competition differs from notions of “perfect competition” in that the number of participants that achieve efficient competition will vary with the nature of the good being traded.  Finally, I measure market development in terms of the sophistication of its regulation.  The sophistication of regulation is measured in terms of the extent to which the regulation facilitates efficient competition and innovation in terms of market design and goods traded.

He then looks at how markets have developed along these lines..

What is the reason for financial market development? What led to the reforms? He analyses this from three perspectives:

First, is the Legal Origins Perspective.[i]  The premise of the legal origins perspective is that founding legal systems on different principles creates systematic variation in legal systems across countries with the basic variation being between Anglo-Saxon common law traditions and continental European civil law traditions. Variation between these legal traditions can be quantified and has a significant impact of economic outcomes.   Common law traditions because of its greater judicial independence and pragmatic approach to resolving legal problems provides greater legal protection for minority shareholders, better contract enforcement, and thus support more rapid financial development in times of stability.   Civil law is associated with less flexible dispute resolution, greater government intervention and associated corruption and therefore leads to less respect for private property and the development of less efficient financial markets.

 Second is the “Constructivist Crisis” perspective.[ii]  This perspective views crises as critical junctures that provide opportunities for dramatic change.  Rather than characterizing crises as exogenous shocks to equilibrated systems or events that dramatically alter balances of power, recent proponents have highlighted how crises disrupt and delegitimize norms and cognitive understandings of circumstances.  Consequently, crises provide opportunities for agents construct meanings which in turn structure understandings of interests and the evaluation of policy alternatives.  The approach highlights the role of ideas in shaping actors’ perceptions of their interests, and ultimately, the responses to economic crises. 

 The third perspective is the political power approach.   It began with a focus on the role of political institutions in restraining the arbitrary abuse of government authority and bolstering its credible commitment to property rights.[iii]  More recently advocates have added a focus on institutions that promote political competition such as separation of powers, federalism, and electoral suffrage.[iv]   Advocates working in the tradition of this perspective have recently endeavored to extend their analysis “beyond formal institutions of competitive elections and political checks and balances.

Which one do you think was more important?

This paper argues that though law plays a crucial role in the development of financial markets, the legal origins perspective is not well suited to explain the variation of market reform and development inIndia’s equity, government securities, and debt market.  It contends that while interpretation of economic crises played an important role in shaping the development of India’s capital markets, their impact was structured by the configuration of political power – in particular the power and authority of state agencies like the Reserve Bank of India and the Ministry of Finance – and the structure of institutional capabilities that comprised the context of the reforms. 

The paper points to this interesting point. The Harshad Mehta scam exposed major flaws in the bond market. However, the reform impetus was mainly on equity markets. Why?

By any objective account the central cause of the scam lies with the banking sector and the pathetic supervision performed by the RBI.  Why then did the scam give more impetus for reform of the equity market than the government securities market, and why did it lead to excessive regulation that impeded reform in the corporate bond market?  The constructivist perspective provides some persuasive answers.  Most of the information about the scam came from the RBI investigations. While these made the breakdown of the clearing system clear, they underscored the role of the brokers.  The story was made more plausible by the larger than life image Harshad Mehta, the flamboyant broker, with fleet of Mercedes Benz, whose meteoric rise put him on the covers ofIndia’s financial press. 

The RBI and the financial press constructed a narrative that resonated with the cynicism about brokers that was widely held among the public in a manner that is consistent with Seabrooke’s argument that elite elaborated narratives must resonate with popular values.  Ultimately, only brokers and a few lower level banking officials were ever punished.   By focusing the attention on the brokers and the stock markets it gave impetus to equity market reform.  In the name of protecting investors, SEBI implemented strict requirements for listing and disclosure.  Ironically, these requirements created the incentives that reinforced the preferences for private placement in the corporate debt market. 

Hmmm…This narrative is interesting in India’s history. Not read much on this.

He blames RBI for most ills in financial sector:

Why have powerful sectors within the RBI remained conservative opponents of reform?  In addition to the desire not to give up power, answers might be found in the central bank’s organizational history.   After extensive state interventions in financial markets such as the 1969 Bank Nationalization Act and the 1974 Foreign Exchange Regulation Act the RBI grew to be the largest central bank in the world in terms of number of employees.  Divisions such as the Exchange Control Department, the Banking Supervision Department have a deep-rooted distrust of markets. From the perspective of many, it is one thing to liberalize equity markets where the costs of mistakes will be paid by the private sector.  It is another to liberalize the market for government securities, where the costs will be paid by the state.

I don’t really buy this criticism of RBI. RBI has been conservative on financial development as it perhaps understood this game of financial regulation and development much better than other regulators. It has followed the slow and gradual policy based pretty much on how India has approached reform in general. Unlike other countries, big bang approach is very difficult to do in India given the large number of diverse stakeholders. And moreover, we are no more really sure what financial development means. Lots of economists have given RBI full marks on its financial regulation mandate.
Though this does not mean all is well with RBI. For instance, it could clearly do a lot more in research and explaining key concepts to the public.  Just paraphrasing the author ” it is one thing to crticise RBI’s monetary policies and recent policy decision.  It is another thing to criticise it for playing a role in non-development of the financial sector.” You need stronger facts to prove the latter point.
Overall, a nice intriguing paper…

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