Can Mumbai become an Can Mumbai become an International Financial International Financial

Centre?Centre?

Joshua FelmanIMF India Presentation to

RiskWorldApril 10, 2007

A disclaimer!A disclaimer!

The views expressed in this The views expressed in this presentation are personal. They are presentation are personal. They are not necessarily shared by the IMF, its not necessarily shared by the IMF, its Executive Board, or its management.Executive Board, or its management.

Roadmap of the PresentationRoadmap of the Presentation

Why do we care?Why do we care?

Where do we stand?Where do we stand?

What needs to be done?What needs to be done?

Roadmap of the PresentationRoadmap of the Presentation

Why do we care?Why do we care?

Where do we stand?Where do we stand?

What needs to be done?What needs to be done?

The importance of financeThe importance of finance

Why focus on finance when there are so many other priorities, Why focus on finance when there are so many other priorities, such as improving infrastructure and social services?such as improving infrastructure and social services?

The answer: Finance is to our century what steel was to the 20The answer: Finance is to our century what steel was to the 20 thth century – the basic building material of a modern economycentury – the basic building material of a modern economy

To understand the centrality of finance, imagine a devastating To understand the centrality of finance, imagine a devastating earthquake, leveling all India’s banks and corporates. Which earthquake, leveling all India’s banks and corporates. Which sector should be rebuilt first?sector should be rebuilt first? If banks are rebuilt, it will be possible to rebuild the corporatesIf banks are rebuilt, it will be possible to rebuild the corporates But the other way around will not workBut the other way around will not work

The importance of finance/quantityThe importance of finance/quantity

The need for long-term finance is great:The need for long-term finance is great: $320 billion will be needed during the 11$320 billion will be needed during the 11 thth Plan Plan

period, just for infrastructureperiod, just for infrastructure Much of this will need to be financed by the private Much of this will need to be financed by the private

sectorsector

Where will they get the money?Where will they get the money?

The importance of The importance of finance/qualityfinance/quality

Over the coming years India will be Over the coming years India will be investing at least one-third of its investing at least one-third of its incomeincome It is important that to do so efficientlyIt is important that to do so efficiently

Consider the following charts of the Consider the following charts of the U.S., Germany, and JapanU.S., Germany, and Japan

Investment in the U.S. is Investment in the U.S. is low…low…

Investment Ratio(In percent of GDP)

10

15

20

25

30

35

40

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

United StatesJapanGermany

……but growth has been but growth has been highhigh

Real GDP Growth(In annual percent change)

-4

-2

0

2

4

6

8

10

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

United StatesJapanGermany

……making for a very low making for a very low ICORICOR

Incremental Capital Output Ratio

0

5

10

15

20

25

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

United StatesJapanGermany

How does the U.S. do it?How does the U.S. do it?

Answer: it has a large financial Answer: it has a large financial system, which allocates capital in an system, which allocates capital in an exceptionally efficient mannerexceptionally efficient manner

Notably, it has a good balance Notably, it has a good balance between its banking system and its between its banking system and its capital market capital market

Its banking system is Its banking system is large… large…

Private Credit by Deposit Money Banks and Other Financial Institutions(In percent of GDP)

0

50

100

150

200

250

1960 1971 1982 1993 2004

0

50

100

150

200

250

United StatesGermanyJapan

India

As is its stock market…As is its stock market…

Stock Market Capitalization(In percent of GDP)

0

20

40

60

80

100

120

140

160

180

1989 1994 1999 2004

0

20

40

60

80

100

120

140

160

180

United StatesGermanyJapanIndia

……and its bond marketand its bond market

Private Bond Market Capitalization(In percent of GDP)

0

20

40

60

80

100

120

1990 1992 1994 1996 1998 2000 2002 2004

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

United States (left scale)

Germany (left scale)

Japan (left scale)

India (right scale)

Domestic or foreign?Domestic or foreign? The need to intermediate a large quantity of The need to intermediate a large quantity of

savings efficiently is a powerful argument in savings efficiently is a powerful argument in favor of building a strong financial sectorfavor of building a strong financial sector

But the Mistry Report makes another But the Mistry Report makes another argument, that India needs to build an argument, that India needs to build an international financial centre (IFC)international financial centre (IFC)

An IFC is a financial centre that caters to An IFC is a financial centre that caters to customers outside its own jurisdiction, in customers outside its own jurisdiction, in addition to domestic customersaddition to domestic customers Global IFCs such as London and New York Global IFCs such as London and New York

provide the widest array of international provide the widest array of international financial services (IFS) to clients from all over financial services (IFS) to clients from all over the worldthe world

The case for an IFCThe case for an IFC

The fundamental logic is straightforward, The fundamental logic is straightforward, namely that opening up to global competition namely that opening up to global competition will be the fastest and surest way to develop will be the fastest and surest way to develop the sectorthe sector In other words, India should do to the financial In other words, India should do to the financial

sector what was done to the real sector in 1991sector what was done to the real sector in 1991

But there is an additional, more subtle, But there is an additional, more subtle, argument based on the path of India’s argument based on the path of India’s developmentdevelopment India is globalizing rapidly, much more rapidly than India is globalizing rapidly, much more rapidly than

most people realizemost people realize Consider the following chartsConsider the following charts

The export sector has become The export sector has become more important than more important than

agriculture…agriculture…

0

5

10

15

20

25

3019

90

1992

1994

1996

1998

2000

2002

2004

Exports (% GDP) Agriculture (% GDP)

……and capital inflows have and capital inflows have soaredsoared

0.0

0.5

1.0

1.5

2.0

2.5

2000-2001 2001-02 2002-03 2003-04 2004-05 2005-06

FDI (%GDP)

Portfolio (% GDP)

India is globalizing India is globalizing rapidlyrapidly The statistics on India’s financial integration The statistics on India’s financial integration

with the rest of the world are astonishing:with the rest of the world are astonishing: Total two-way gross flows on balance of Total two-way gross flows on balance of

payments transactions were $101 billion in payments transactions were $101 billion in 1992/931992/93

They were $237 billion in 2001/02They were $237 billion in 2001/02 And $657 billion in 2005/06And $657 billion in 2005/06

In other words:In other words: Doubling took nine yearsDoubling took nine years Near-tripling took only fourNear-tripling took only four

India’s globalization India’s globalization

More statistics:More statistics: External flows were 47 percent of GDP External flows were 47 percent of GDP

in 1992/93in 1992/93 And 91 percent of GDP in 2005/06.And 91 percent of GDP in 2005/06.

Conclusion: While India is growing Conclusion: While India is growing rapidly, it is globalizing even faster!rapidly, it is globalizing even faster!

So, India’s “operating So, India’s “operating manual” needs to changemanual” needs to change

Previously, India was the Previously, India was the quintessential closed economyquintessential closed economy

What happened in the rest of the What happened in the rest of the world mattered little to India, and world mattered little to India, and what happened in India mattered little what happened in India mattered little to the rest of the world.to the rest of the world.

But times have changed...But times have changed...

……India now matters very India now matters very much!much!

Seizing the opportunitySeizing the opportunity India’s globalization has presented a India’s globalization has presented a

significant opportunity for the financial significant opportunity for the financial sector:sector: The Mistry Report estimates the size of the IFS The Mistry Report estimates the size of the IFS

market at $13 billion in 2005/06market at $13 billion in 2005/06 It conservatively projects that domestic demand for It conservatively projects that domestic demand for

IFS will grow to $48 billion by 2015IFS will grow to $48 billion by 2015 Right now, almost none of this demand is met Right now, almost none of this demand is met

locallylocally Failure to respond to this demand is forcing Indian Failure to respond to this demand is forcing Indian

customers to go abroad, e.g. Tata-Coruscustomers to go abroad, e.g. Tata-Corus With demand far outstripping supply, one could With demand far outstripping supply, one could

say that there is financial sector “overheating”!say that there is financial sector “overheating”!

Roadmap of the PresentationRoadmap of the Presentation

Why do we care?Why do we care?

Where do we stand?Where do we stand?

What needs to be done?What needs to be done?

India has considerable India has considerable potentialpotential

The Mistry Report argues that Mumbai has The Mistry Report argues that Mumbai has four key advantages:four key advantages: HinterlandHinterland, a large and rapidly growing , a large and rapidly growing

economy, creating a substantial demand for IFS economy, creating a substantial demand for IFS (the projected $48 billion)(the projected $48 billion)

Human capitalHuman capital, including the extensive use of , including the extensive use of English, generations of financial experience, and English, generations of financial experience, and strong IT skillsstrong IT skills

LocationLocation, the ability to transact with Asia and , the ability to transact with Asia and Europe though the trading dayEurope though the trading day

Democracy and rule of lawDemocracy and rule of law, including open , including open expression of viewsexpression of views

But creating an IFC is But creating an IFC is demandingdemanding IFCs require a highly developed Bond-IFCs require a highly developed Bond-

Currency-Derivative (BCD) nexusCurrency-Derivative (BCD) nexus Every IFS customer generates a currency Every IFS customer generates a currency

transactiontransaction This requires liquid currency market, with a full range of This requires liquid currency market, with a full range of

currency derivativescurrency derivatives IFCs attract global bond issuers into the domestic IFCs attract global bond issuers into the domestic

marketmarket This requires a liquid and arbitrage-free yield curve, This requires a liquid and arbitrage-free yield curve,

backed by interest rate and credit default protection backed by interest rate and credit default protection derivativesderivatives

The BCD nexus is bound together by arbitrageThe BCD nexus is bound together by arbitrage The currency forward curve is but a reflection of interest The currency forward curve is but a reflection of interest

rate differentialsrate differentials

Where does India stand? Where does India stand?

The currency and bond markets are The currency and bond markets are underdeveloped:underdeveloped: Indian currency spot turnover seldom Indian currency spot turnover seldom

exceeds $5 billion per day, compared exceeds $5 billion per day, compared with $125 billion per day in Singaporewith $125 billion per day in Singapore

The corporate bond market is small and The corporate bond market is small and not very liquid, even when compared to not very liquid, even when compared to other Asian emerging marketsother Asian emerging markets

India’s small bond market India’s small bond market

Missing derivatives Missing derivatives marketsmarkets

Many of the important derivatives Many of the important derivatives markets do not exist at all.markets do not exist at all.

For example:For example: There are no Indian counterparts to key There are no Indian counterparts to key

interest rate contractsinterest rate contracts in the U.S. – in the U.S. – Eurodollar futures, Fed funds futures, Eurodollar futures, Fed funds futures, Treasury notes, Treasury bonds Treasury notes, Treasury bonds

India has only one successful India has only one successful stock index stock index contractcontract, the Nifty, the Nifty

The trading of The trading of currency futurescurrency futures is banned is banned

IFCs also require a strong IFCs also require a strong institutional investor baseinstitutional investor base Institutional investors command Institutional investors command

enormous pools of capitalenormous pools of capital

They bring sophisticated analytical They bring sophisticated analytical tools to bear on the task of price tools to bear on the task of price discovery discovery

They link domestic finance with the rest They link domestic finance with the rest of the worldof the world

Where does India stand?Where does India stand?

The institutional investment base is smallThe institutional investment base is small

For example, mutual funds have assets For example, mutual funds have assets under management of just 9 percent of under management of just 9 percent of GDP, not large enough to influence price GDP, not large enough to influence price formationformation

Pension funds and insurance companies Pension funds and insurance companies are also smallare also small

Roadmap of the PresentationRoadmap of the Presentation

Why do we care?Why do we care?

Where do we stand?Where do we stand?

What needs to be done?What needs to be done?

Mistry Report Mistry Report RecommendationsRecommendations

Key recommendations include:Key recommendations include: Removing capital controlsRemoving capital controls Ensuring macroeconomic stability by Ensuring macroeconomic stability by

reducing public sector debt from the reducing public sector debt from the current 80 percent of GDP to perhaps current 80 percent of GDP to perhaps 50-65 percent of GDP50-65 percent of GDP

Spurring the BCD nexus, including by Spurring the BCD nexus, including by creating the “missing markets”creating the “missing markets”

Developing the investor baseDeveloping the investor base

Developing the investor baseDeveloping the investor base

There has long been discussion of developing the investor baseThere has long been discussion of developing the investor base

The focus so far has been on encouraging domestic investorsThe focus so far has been on encouraging domestic investors The IMF has strongly supported the introduction of the New Pension The IMF has strongly supported the introduction of the New Pension

system, which could bring considerable funds into the capital marketsystem, which could bring considerable funds into the capital market

But there’s another possibility: the investment base could be But there’s another possibility: the investment base could be extended to foreignersextended to foreigners

Domestic or foreign?Domestic or foreign?

Actually, foreigners already participate in the Indian Actually, foreigners already participate in the Indian bond market – through ECBs!bond market – through ECBs!

Consequently, firms can now choose whether to issue Consequently, firms can now choose whether to issue domestically or abroaddomestically or abroad

Domestic issuance has many disadvantages:Domestic issuance has many disadvantages: As noted earlier, market size is smallAs noted earlier, market size is small Illiquid, with little secondary market tradingIlliquid, with little secondary market trading Interest rates are higher than abroadInterest rates are higher than abroad

The ECB route – and its The ECB route – and its problemsproblems

Many firms consequently favor ECBsMany firms consequently favor ECBs

But there is a problem: foreign exchange But there is a problem: foreign exchange borrowing, for example for infrastructure borrowing, for example for infrastructure projects, can create a currency mismatch projects, can create a currency mismatch on balance sheetson balance sheets

This is aThis is a risk management problem risk management problem, so , so severe that it has become known as severe that it has become known as “original sin”“original sin”

Called a “sin” because unhedged foreign Called a “sin” because unhedged foreign borrowing coupled with false perceptions of borrowing coupled with false perceptions of currency risk has caused serious economic currency risk has caused serious economic problems, in Asia as well as Latin Americaproblems, in Asia as well as Latin America

Latin America is eliminating Latin America is eliminating “original sin” “original sin”

Most EM countries are trying graduate Most EM countries are trying graduate out of “original sin” and have their local out of “original sin” and have their local currency bonds accepted into global currency bonds accepted into global portfoliosportfolios

Until a few years ago, it seemed that Until a few years ago, it seemed that there was no way to do this (that’s why it there was no way to do this (that’s why it is called “is called “originaloriginal sin”) sin”)

But times have changedBut times have changed Mexico graduated in 2003Mexico graduated in 2003 Brazil graduated in 2005Brazil graduated in 2005 Other countries are following Other countries are following

Perhaps India could follow Perhaps India could follow their paththeir path

Rather than encouraging firms Rather than encouraging firms to borrow abroad, India could to borrow abroad, India could invite foreign investors to invite foreign investors to participate more in the participate more in the domestic market.domestic market. Current limits on foreign Current limits on foreign holdings of corporate bonds are holdings of corporate bonds are a very modest $1.5 billiona very modest $1.5 billion

Should India go down this Should India go down this road?road?

Three considerations:Three considerations:FeasibilityFeasibilityDesirabilityDesirabilityRisksRisks

Feasibility: Is there a demand?Feasibility: Is there a demand?

If Latin America can do it, why not If Latin America can do it, why not India?India? Investor interest has grown as India’s Investor interest has grown as India’s

economy has started to take offeconomy has started to take off It was boosted further recently when Indian It was boosted further recently when Indian

bonds became investment gradebonds became investment grade In February, there was a significant In February, there was a significant

development: a rupee bond was issued development: a rupee bond was issued offshore using the non-deliverable offshore using the non-deliverable forward marketforward market

Why not bring such activity on-shore? Why not bring such activity on-shore?

Desirability: benefits for Desirability: benefits for India?India?

Increasing foreign participation would Increasing foreign participation would reduce “original sin”, since foreigners reduce “original sin”, since foreigners would then be assuming currency riskwould then be assuming currency risk

It would also extend the investor base, It would also extend the investor base, increasing demand and reducing increasing demand and reducing domestic interest ratesdomestic interest rates

It would shift IFS revenues to IndiaIt would shift IFS revenues to India

Desirability: benefits for Desirability: benefits for India? India?

Foreign investors would also promote Foreign investors would also promote secondary market development, since secondary market development, since they are more willing to trade than they are more willing to trade than pension/insurance companiespension/insurance companies

Greater liquidity means that those who Greater liquidity means that those who buy bonds know they will be able to sell buy bonds know they will be able to sell them if they need, at reasonable prices them if they need, at reasonable prices

This will encourage demand, reducing This will encourage demand, reducing interest rates and thereby spurring interest rates and thereby spurring more primary issuesmore primary issues

Risks: financing the Risks: financing the government deficitgovernment deficit

Would opening up hamper the government’s ability to finance Would opening up hamper the government’s ability to finance its deficit?its deficit?

Actually, it could help, by opening up a new financing Actually, it could help, by opening up a new financing channel, enabling the government to ease financially channel, enabling the government to ease financially repressive policies repressive policies

If global fixed income investors allocated 2 percent of their If global fixed income investors allocated 2 percent of their portfolios to India (in line with the country’s weight in world portfolios to India (in line with the country’s weight in world GDP), this amount would exceed the required government bond GDP), this amount would exceed the required government bond holdings of domestic institutionsholdings of domestic institutions

Greater foreign participation could also allow maturity Greater foreign participation could also allow maturity extensionextension

Starting in 2003, Mexican government issued 20-year Starting in 2003, Mexican government issued 20-year bonds in pesos, marketed to foreignersbonds in pesos, marketed to foreigners

But it would also increase market discipline on the But it would also increase market discipline on the government, potentially causing financing strains if investors government, potentially causing financing strains if investors become concerned about risks become concerned about risks

Risks: any dangers to Risks: any dangers to monetary policy? monetary policy?

Opening up could encourage Opening up could encourage additional capital inflows, which could additional capital inflows, which could complicate monetary policycomplicate monetary policy

But the extent of the increase in But the extent of the increase in inflows is not clear, as foreign inflows is not clear, as foreign purchases of rupee bonds may just purchases of rupee bonds may just substitute for ECBssubstitute for ECBs

A possible strategyA possible strategy

Participation could be liberalized Participation could be liberalized gradually, to “test the waters”gradually, to “test the waters”

RBI is already allowing FII RBI is already allowing FII participation in government securities participation in government securities to expand graduallyto expand gradually

Tarapore Committee proposed allowing Tarapore Committee proposed allowing FIIs to purchase one-quarter of FIIs to purchase one-quarter of corporate bonds corporate bonds

ConclusionConclusion

India is globalizing at an astonishing pace, India is globalizing at an astonishing pace, it is truly creating a “new India”it is truly creating a “new India”

This new India requires new ways of This new India requires new ways of thinking, about opportunities, risks, and thinking, about opportunities, risks, and the appropriate ways to manage these risksthe appropriate ways to manage these risks

On the opportunity side, globalization is On the opportunity side, globalization is creating the chance for the financial sector creating the chance for the financial sector to grow to meet the demand for IFSto grow to meet the demand for IFS

But at the same time, it is creating a risk of But at the same time, it is creating a risk of unhedged foreign borrowing, known as unhedged foreign borrowing, known as “original sin”“original sin”

ConclusionConclusion

How should this risk be managed?How should this risk be managed? The days when it could be managed through The days when it could be managed through

restrictions and compliance checklists are long restrictions and compliance checklists are long gone – if they ever really existedgone – if they ever really existed

The best way to deal with this risk is not to The best way to deal with this risk is not to impose more controls, but through more impose more controls, but through more liberalizationliberalization Remove the distortion: the restriction on foreign Remove the distortion: the restriction on foreign

purchases of rupee bonds purchases of rupee bonds This solution may seem counter-intuitive, but This solution may seem counter-intuitive, but

that is precisely why we gather together for that is precisely why we gather together for conferences such as RiskWorld—to leave aside conferences such as RiskWorld—to leave aside our “operating manuals”, open our minds, and our “operating manuals”, open our minds, and look at things in a different way! look at things in a different way!

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