This blog post is in continuation of my series of blog posts on RBI Governor Raghuram Rajan's report titled "A Hundred Small Steps" published when he was with the Planning Commission of India.
This post focuses on Chapter 5 of the report, which deals with establishing Efficient and Liquid Markets. This section of the report delves into what could be changed in the structure of the financial markets in India to make them more resilient and liquid. I will try to describe the contents of the report here, with my analysis where possible.
First the definitions. Market efficiency is the degree to which information and forecasts about the future are impounded into financial prices. Liquidity pertains to the ability to transact with low transaction costs. Liquidity has 3 aspects: immediacy, depth, and resilience. Immediacy refers to the ability to execute trades of small size immediately without moving the price adversely (also called low impact cost). Depth refers to the impact cost suffered when doing large trades. Resilience refers to the speed with which prices and liquidity of the market revert back to normal conditions after a large trade has taken place.
The concepts of efficiency and liquidity are linked. In order for markets to be efficient, market participants who obtain information have to be able to trade on that basis and impound that information into the prices. For economic agents to have an incentive to expend resources in information processing and forecasting, markets must be liquid, else any profits from the activity will be dissipated in transaction costs alone. Expensive or infeasible transactions reduce the profits from successful forecasting. This (in turn) inhibits the investments made in information processing and forecasting. Market liquidity is thus a critical precondition for market efficiency. In turn, market efficiency assures uninformed participants that market prices are up to date and reflect fundamentals, so they can trade safely. This in turn provides volumes that ensure liquidity.
The below table highlights the state of the Indian markets from the 3 aspects of liquidity:
A particularly important point to note here is the lack of progress. In the period from 2003 to 2008, 3 elements have come through the onset of immediacy with near money options on index and liquid stocks, the onset of immediacy and depth on the interest rate swap market, and the onset of immediacy on some commodity futures products.
The main reason why so many markets are illiquid and inefficient are listed as follows:
1. Banning of products and markets: Currency futures and commodity options are banned in India. A missing market can hamper the efficiency of other markets also. The absence of interest rate futures can hurt the treasury market.
2. Rules that impede participation of firms and individuals in certain markets for reasons other than sophistication. eg. domestic individuals cannot participate in currency markets (outright ban), banks are prohibited from adopting long positions in interest rate futures (regulatory restrictions on some kinds of activities), all FIIs put together have to keep their ownership of corporate bonds below $1.5 billion (quantitative restriction)
3. Inadequacies of financial firms arising out of their ownership, size and other reasons. The institutional structure of market participants is shaped by the forces of competition and regulation. When firms face competition from market share, they are forced to find new ways of serving customers. It is this pressure that, over time, creates highly competitive companies that are able to bring down costs through technological innovation and better management of resources. The inadequacies of Indian financial institutions can be traced at least partly to the forces that restrict competition.
State ownership of financial institutions is a major factor that inhibits competition. A second factor is restrictions on ownership and shareholding. This applies especially to banks and exchanges, clearing corporations, and depositories. Limits on how many shares an individual can hold and limits on foreign ownership make it difficult for new institutions to be started. This reduces the competition pressure on incumbents, and slows down the pace of development of market institutions.
In short, the deficiencies in Indian financial markets stem from missing markets and missing actors. The way to address this issue is to open the markets, equalize market rules for all participants, and in removing rules that ban specific players only from certain activities. The second problem is deeper and requires more long term efforts, that of improving the capabilities of financial firms. The way to do this is to increase the competitive pressures in the market ecosystem by removing constraints in the way of entry of new players.
4. A silo model of regulation and the structure, incentives, and staffing, of regulatory institutions that results in barriers to innovation and competition.
There are 2 factors of consequence here:
1. India uses a silo model where financial markets are broken up across 3 agencies: SEBI, RBI and FMC. There are are hard constraints that separate firms and players in one silo from operating in other silos. These constraints reduce competition, hamper economies of scale and scope, and impede the flow of successful institutional arrangements and ideas from one part of the financial markets to the other.
2. Steep barriers to innovation are in place. New ideas are banned unless explicitly permitted. A great deal of what would be considered ordinary activities in the world of global finance is incompatible with existing laws and subordinate legislation.
5. Frictions caused by taxes:
Different tax treatment is applied to different types of investments and transactions. Taxation plays an important role in determining the returns generated by trading. When transaction taxes are high, liquidity disappears when the markets go down.
Suggested reforms:
To achieve true economic benefits, we need:
1. The availability of complete markets where agents are able to trade and hedge all the risks that they need to manage, and the existence of adequate liquidity in all these markets.
2. A regulatory structure that protects customers from fraud, but without imposing undue costs and without creating barriers to entry, innovation, and competition.
The reforms that would achieve these objectives have 3 broad elements:
1. Reforms within existing legal and institutional framework.
2. Capital account liberalization.
3. Merger of regulatory and supervisory functions for all organized financial trading into SEBI and strengthening the legal foundations of market regulation.
4. Implement the Debt Management Office.
I will describe these proposals in the upcoming blog posts.
Consider the last 2 weeks turmoil in the financial markets. On Aug 24 the markets dropped by around 1000 points as fears from slowdown in China and the US rate increases created a flight to safety in the markets. As the money moved out of Indian equities, the Rupee dropped to a 12 month low to 67 to a US Dollar. Subsequently, as the rate hike fears in USA were eased and the Chinese government reduced the rates, the markets recovered and so did the Rupee to 65 to a US Dollar. Now suppose we had a robust and liquid corporate bond market open to foreign investors. The money that moved out of equities at the start of the downswing, would have moved into corporate bonds and the Rupee would not have been hit so hard.
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