SEBI is an important story in India’s search for sound public administration and it was and remains a unique independent regulator, featuring design elements which were not done before or after. It played a key role in a big achievement of economic reform in India – the equity market.

Formed by the Government of India in 1988, under the leadership of Mr. S.A. Dave, then Executive Director, IDBI, the Securities and Exchange Board of India (SEBI) got statutory powers after the SEBI Act was passed by Parliament in 1992. It was the year in which Rs. 5,000 crore Harshad Mehta securities scam hit Indian stock markets and this fixed income and stock market scandal finally prodded the Parliament to enact the SEBI Act.

SEBI was the first time in India that a meaningful establishment of a regulatory body took place. This required numerous amendments to the SEBI Act and to the Securities Contracts Act. SEBI issues regulations which have the status of law. It investigates offences (an executive function), and writes orders (a judicial function). Appeals against SEBI orders go to SAT, which shaped up as a high quality tribunal. This forced SEBI to start writing reasoned orders – which is much more work, but forces better analysis.

REGULATION

In the pre-SEBI days, capital market regulation under the Securities Contracts Regulation Act vested loosely with the Controller of Capital Issues, functioning directly under the Ministry of Finance.

Until the SEBI and the Insurance Regulatory and Development Authority (IRDA) came into being, regulation in those areas was slack, and the RBI, because of its sheer stature, was presumed to have the final say in all matters, even those not directly connected to its core areas of banking and monetary policy.

But since inception, the regulator has played a major role in cleaning up India’s equity cash market, established a modern equity derivatives market, and transformed the primary market through better processes and making the large shift from merit-based approvals to disclosure-based regulations. Besides, it has put in place clear and effective rules (well, mostly) for the segments it regulates. As a result, for instance, participation from foreign institutional investors has grown steadily over time, the takeover process is streamlined, and instead of having one large, malfunctioning mutual fund in the pre-SEBI days, India now has a well-regulated mutual fund industry.

In short, the securities market has gone through a sea change in the 25 years of SEBI’s existence. It has had seven chairmen so far excluding the incumbent U. K. Sinha.

EVALUATION

Twenty-five years are a relatively short period to evaluate a financial sector regulatory institution. The SEBI is considerably junior in age to the Reserve Bank of India (RBI), which has, for a long time (78 years almost), been identified with the financial sector regulation in this country.

Most regulators have a typical life cycle—in the first few years, they are incompetent and clueless. They then get their act together through hard work and creative thinking, leading to some malpractices getting stooped and processes falling into place. As regulators mature, there’s nothing much original left to do, resulting in a highly conservative and bureaucratic organization. SEBI has largely followed this life cycle and has now reached a mature phase where it is left mainly with the extremely painful and thankless job of enforcing regulation.

SEBI ought to be evaluated on different yardsticks — as the circumstances under which it came into being, early handicaps it had to overcome in regulating well-entrenched entities like brokers, some of them, when SEBI came into being, were already more than 100 years old.

Stories of the erstwhile BSE are simply alien to us today. There was a tremendous battle of interests. The old BSE members stood to enjoy rents from perpetuating the old ways, but that arrangement was not good for the people of India.

SEBI pioneered the transformation through experimenting new institutions successfully – NSE and NSDL. Regulatory and supervisory strategies for dealing with unruly private financial firms were setup – which have to be quite different when compared with the cozy dealings between government and PSU firms.

As a new regulator, SEBI had to start from scratch; there was nothing comparable to it before. One of the important handicaps the institution faced — and in many ways continues to face — is in recruiting and training qualified manpower. While its heads, drawn from the highest echelons of the government and public financial institutions, were people of high calibre, it is at the middle levels that the new regulator has faced major problems.

The tumultuous experiences from SEBI – both positive and negative – have generated our learning of financial policy. Here is a look at SEBI’s top achievements, major controversies and key challenges.

TOP ACHIEVEMENTS

Dematerialization of Shares: The market regulator introduced dematerialized holding of shares and securities after the Depositories Act was passed in 1996, which did away with physical certificates that were prone to postal delays, theft and forgery, apart from making the settlement process slow and cumbersome. This also prevented the issue of fake share certificates floating in the market. It enabled electronic trading, with investors and traders even able to work from home.

Faster Settlement Process: SEBI is credited with quickly moving from a T+5 settlement cycle in 2001 to T+2 in 2003. Demat, T+2 settlement and the development of electronic markets are major achievements and we were ahead of several markets in all these fronts. With T+2, we are still ahead of the Western markets. The regulator is currently looking at reducing the settlement cycle to T+1, enabling investors and traders to take positions faster.

Stronger and Clearer Regulations, Orders: In the early years, powerful brokers’ lobbies controlled share price movements and could afford to ignore SEBI. SEBI has created fear and respect in the market, both among domestic and international market intermediaries. The quality of orders has improved materially over the past 25 years.

Recent instances of this include the orders against two Sahara group entities that were upheld in the Securities Appellate Tribunal and the Supreme Court and the case of front running by HDFC mutual fund.

Fostering Mutual Fund Industry: While the Indian mutual fund industry has grown manifold from being a monopoly until the early 1990s—when Unit Trust of India, set up in 1964, was the only game in town—their reach remains low outside India’s top 20 cities. SEBI has taken several steps to increase the popularity of mutual fund products and prevent mis-selling of products by distributors.

One of those steps is banning entry loads for mutual fund schemes in 2009, as investors would now only voluntarily pay the distributor for advisory services. Another initiative was relaxing ‘Know Your Customer’ (KYC) norms for small investors and widening the distribution network in rural India by roping in postal agents.

Foreign Institutional Investors: The Indian equity markets were opened to FIIs, in 1993 and they are now the key driving force behind stock movements. FIIs investment ceiling was raised to 49% in March 2001 while the dual approval process for FII registration, by the RBI and SEBI, was scrapped in 2003, when they came under the remit of the capital market regulator. Since 2004, SEBI has been consistently revising the FIIs investment limit in both corporate as well as government debt.

While the chunk of foreign money came in through offshore derivative instruments such as participatory notes (P-notes) where the identity of the end beneficiary is not traceable, SEBI has been consistently pushing to encourage holders of such securities to enter the market as registered FIIs.

MAJOR CONTROVERSIES

ULIPs: In 2010, SEBI issued show-cause notices to a dozen life insurers and asked them to stop introducing unit-linked insurance plans, or ULIPs, without its permission as these hybrid insurance products mimicked mutual fund schemes that are regulated under SEBI’s collective investment scheme, or CIS, norms. The order gave rise to a battle between the capital markets regulator and the insurance regulator—Insurance Regulatory and Development Authority, or IRDA. The President of India had to pass an ordinance amending the CIS norms and keeping ULIPs under IRDA. Subsequently, IRDA went on an overdrive for a complete makeover of ULIP regulations.

Mutual Funds: In August 2009, soon after the panel headed by Dhirendra Swarup recommended abolishing agent commission for distribution of financial products, SEBI ordered scrapping of entry fees in mutual funds. The move was criticized by the industry and legal experts and the order forced thousands of mutual fund advisers to sell other products that offered better incentives, resulting in stagnation of assets under management.

Participatory-Notes: In October 2007, in the wake of an appreciating rupee, SEBI proposed to curb issuance of participatory notes (P-notes), a favourite investment route used by FIIs. SEBI was concerned about the quality of money flowing into India through P-notes but many say it was an attempt to curb excessive dollar flows. The BSE’s benchmark Sensex crashed 1,700 points the very day after the announcement and it led to suspension of trading for an hour. The crash forced the finance minister to clarify that the government was not against FIIs and there would be no immediate ban on P-notes.

Sahara Case: In November 2010, SEBI barred two Sahara group firms from raising money from the public in any manner, citing violations of capital-raising norms. Another directive followed in June 2011, asking Sahara firms to return money to investors with 15% interest. This marked the beginning of a legal battle between the regulator and the company as the latter argued that since unlisted entities were raising funds, SEBI has no jurisdiction over them. The case was heard in the Securities and Appellate Tribunal and later went up to the Supreme Court, which directed Sahara to refund the money.

MCX-SX: In a bid to ensure compliance of exchanges with market infrastructure regulations, SEBI got into a bitter legal spat with India’s newest stock exchange MCX-SX in 2009. The regulator fought a three-year long battle with the promoters of the exchange, alleging the latter violated norms by attaching put options in its share purchase agreement with investors and not following permissible routes for capital reduction. Later, MCX-SX was given a licence to start equity trading and given three years to reduce promoter holding in the exchange.

KEY CHALLENGES

Enforcement Processes: Despite statutory powers on par with a civil court, SEBI hasn’t made much headway when it comes to enforcement. The regulator needs to engender greater confidence among investors and display greater consistency when it comes to enforcement of laws.

Some violations are ignored or go unnoticed due to the regulator’s limited access, insufficient resources or government intervention. SEBI should shed the image that big fish are spared and only small fish are caught. This is the worst allegation against SEBI. This does not mean catch big fish without any case and ultimately lose in SAT (Securities Appellate Tribunal).

In recent months, the regulator has been seeking to strengthen insider trading norms, expand its presence through branch offices, work with police and local enforcement agencies, improve corporate governance norms and boost control over deposit-taking firms.

SEBI should focus on clarity. Regulations on investment advisors and collective investment schemes are very vague even in their fundamental scope and coverage.

Deepening Capital Markets: SEBI needs to deepen the capital market. It has taken several measures to widen the scope of investment for all categories of investors—retail, corporate, foreign institutional investors and high-networth individuals in capital markets. The number of retail investors and the share of household savings flowing into the capital market haven’t risen by much. In real terms, the amount of resources raised through public issues is less nowadays than it used to be in the 1990s.

To create an equity culture, SEBI has simplified mutual fund investment norms; abolished mutual fund entry loads; eased investment norms for initial public offerings (IPOs) and other public issues; unified Know-Your-Client (KYC) norms; simplified disclosures by companies to help investors take informed decisions and most recently issued a discussion paper to introduce a mandatory safety net for retail investors in IPOs.

SEBI should work on deeper participation in equity by pension, superannuation and gratuity funds, developing a vibrant retail debt segment and reducing the cost of transactions drastically to improve investment markets in India.

SEBI needs to indemnify the fraudulent loss of investors. An investor, losing any money for whatever reason, except for market loss or his own negligence, and not compensated by the negligent or defrauding party or from the investor protection funds, must be indemnified.

Corporate Debt and Securitization: Despite numerous working committees and liberalization of listing and trading norms for debt securities, this remains unfinished business. Perhaps the most significant development on the corporate bond market was the migration from physical certificates to dematerialized holdings in 2000. This improved debt market volumes to an extent then but failed to attract sufficient liquidity in the following years.

Even after allowing the trading of interest rate derivatives on exchanges and the listing of securitized debt papers recently, the regulator has not been able to do much to create a liquid and efficient corporate debt market and these largely has remained part of the over-the-counter, or OTC, market.

Matching up to Global Standards: With the capital markets growing rapidly, regulators need to keep abreast of global standards. Key areas to focus on are establishing self-regulatory organizations (SROs), a better and transparent consent order mechanism, and rules over market intermediaries.

SEBI is just too small to regulate such large industries as distributors, investment advisors and sub-brokers, not to mention Ponzi schemes. An SRO like the Financial Industry Regulatory Authority of the US, overseen by the SEC, creates and enforces rules for members based on the federal securities law. An independent SRO that creates and enforces routine regulations gives the regulator time to focus on bigger issues. SEBI has started moving in this direction and recently notified regulations to set up an SRO for the mutual fund industry. It needs to extend this to other products and services.

CONCLUDING THOUGHTS

The market regulator continues to face challenges in enforcing rules, some markets such as corporate bonds and interest rate derivatives are yet to take off, and while the exchange-traded markets seem liquid, many of them lack depth.

But this doesn’t at all suggest that what SEBI has achieved isn’t praiseworthy.

A rich ecosystem has developed: with participation by individuals and securities firms from all over India, and mutual funds with free entry, and foreign firms present in both the securities industry and mutual funds. The achievements in financial reform here dwarf the rest of Indian finance. With the success of the equity market, India looks like a good financial system among emerging markets.

And just as how the regulator has in the past been energetic and creative in setting right the equity cash and derivatives markets; it must pursue the formation of other markets, similarly, tackling the issue of market depth means getting the critically important government-run pension funds to invest in equity markets. Besides, doing away with the distortive securities transaction tax and regulating collective investment schemes effectively will first require clear regulations from the government.

It can find motivation from its own history—as an example, replacing the badla market with a modern equity derivatives market involved battles against powerful and entrenched market participants and steering changes in law through the parliamentary process.

Of course, the list of “to-dos” mentioned is not exhaustive. For instance, there’s a lot to do in the area of investor education; depth in most markets needs to improve. In sum, however, both SEBI and policymakers must reject the premise that all is well the Indian securities market. While SEBI has done well, thus far, there’s more left to be done.

In summary, over the last 25 years, SEBI was at the crucible of progress in Indian finance. When it started, there was no sensible finance in India; SEBI and the equity markets are the laboratory where India learned how to do finance.

Overall SEBI has done a decent job with some hits and misses and some failures, but what we need is a complete relook at financial sector legislation. Indian policy makers, learning from SEBI’s strengths and weaknesses, have guided the Indian Financial Code, and when it is enacted, who knows what will be the fate of SEBI and SEBI Act.

Through this article, we’ll discuss today the much debated mystery of inflation and will try to seek the possible solution.

Most of the debates revolve around the theory that there is a trade-off between growth and inflation. This theory has its roots in conventional economic ideologies.

On the other hand, now a days, there are people those are the proponent of the idea that there is no tradeoff between growth and inflation.

Let’s have a look on these thoughts one by one.

First we’ll delve into the thoughts of old school which says that there is a trade-off between growth and inflation. Here are some thoughts from the Executive Director, RBI, Mr. Deepak Mohanty:

The conventional view
India is a moderate inflation country. In the eight year period from 2000 to 2007, the world inflation averaged 3.9% per annum. Even the emerging and developing economies (EDEs) which traditionally had very high inflation showed an average annual inflation at 6.7%. India’s inflation performance was even better at 5.2 % as measured by WPI and 4.6% measured by the consumer price index (CPI-IW).

In 2008 the global financial crisis struck following which inflation rose sharply both in advanced countries and EDEs as commodity and oil prices rebounded ahead of a sharp “V” shaped recovery. Thereafter, inflation rate moderated both in advanced economies and EDEs. In India too the inflation rate rose from 4.7% in 2007-08 to 8.1% in 2008-09 and fell to 3.8% in 2009-10, however, it backed up and stayed in double digits during 2010-11 and 2011-12 before showing some moderation in 2012-13. Given India’s good track record of inflation management, the persistence of elevated inflation for over two years is apparently puzzling.

Deceleration of growth and emergence of a significant negative output gap has failed to contain inflation. It is understandable if inflation goes up in an environment of accelerating economic growth. There could be a situation when the real economy is growing above its potential growth that could trigger inflation what economists call an overheating situation.

During a boom, economic activity may for a time rise above this potential level and the output gap becomes positive. During economic slowdown, the economy drops below its potential level and the output gap is negative. Economic theory puts a lot of emphasis on understanding the relationship between output gap and inflation. A negative output gap implies a slack in the economy and hence a downward pressure on inflation. So, India’s current low growth-high inflation dynamics has been in contrast to this conventional economic theory. Real GDP growth has moderated significantly below its potential. Yet inflation did not cool off.

Reserve Bank raised its policy repo rate 13 times between March 2010 and October 2011 by a cumulative 375 basis points. The policy repo rate increased from a low of 4.75 % to 8.5 %. Still it did not help contain inflation. Interest rate is a blunt instrument. It first slows growth and then inflation. But the growth slowdown has not been commensurate with inflation control.

With the persistence of near double-digit inflation in 2010 and 2011, the medium to long-term inflation expectations in the economy have risen, underscoring the role of higher food prices in expectations formation. If inflation is expected to be persistently high, workers bargain for higher nominal wages to protect their real income. This creates a pressure on firms’ costs and they may in turn increase prices to maintain their profits.

Only in an environment of price stability, a step up in investment accompanied by productivity improvements could bolster potential growth. Even when the supply side factors dominate the inflationary pressures, given the risks of spillover into a wider inflationary process, there is need for policy response. While monetary policy action addresses the risk of unhinging of inflation expectations, attending to the structural supply constraints becomes important to ensure that these do not become a binding constraint in the long-run, making the task of inflation management more difficult. By ensuring a low and stable inflation, the Reserve Bank could best contribute to social welfare. (Excerpts from the speech delivered on January 31st 2013).

So, here is the fact that despite raising interest rates progressively RBI failed to put a check on inflation and moreover puzzled by intrigue behaviour of it being high contrary to the low growth rate. At last, Mr. Mohanty opined on the supply side constraints for it being the culprit behind current high inflation.

Now let’s have a look on the other side of the story and see the perspective of opponent of above-mentioned conventional theory, who says that there is no trade-off between growth and inflation. Here are the views of eminent economist Mr. Ajay Shah, Professor, National Institute for Public Finance and Policy:

The counter-view
All of us are aware of India’s inflation crisis. It is very disappointing, how we lost our grip on stable 4-5% inflation which was prevailing earlier. From February 2006 onwards, in every single month, the y-o-y CPI-IW inflation has exceeded the upper bound of 5%.

We also agree that there is something insidious when 10% inflation effectively steals 10% of the value of my wallet or fixed income investments. In India, however, we often hear the argument “Yes, this is bad, but if high inflation is the way to get to high GDP growth, let’s get on with it”. It is, then, important to ask: Why is low inflation valuable?

Nominal contracting is very important
Complex organisation of economic life involves myriad written and unwritten contracts involving households and firms. The vast majority of these contracts are written in nominal terms, i.e. in rupee values that are not adjusted for inflation.

Inflation is an acid that corrodes all nominal contracts. Two people may have agreed on a contract two years ago at Rs.100, but that contract is thrown out of whack because of 10% inflation per annum. That contract has to be renegotiated. Bigger values of inflation corrode personal relationships also, given that there are many financial ties within friends and family.

Inflation messes up information processing
Essence of a market economy is adjustments to relative prices, reflecting changes in tastes and technology. Firms learn about the viability of alternative investments by watching relative prices change. Inflation messes up this information processing. It increases the `background noise’ by making a large number of prices change at once. This makes it harder to discern which price change is fundamentally driven, and merits a response in terms of increased or decreased production.

Impact upon pre-existing nominal savings
For a person at age 60 who expects to live to age 85 or 95, fixed income investments are absolutely crucial in the financial planning of these 25-35 years. These calculations can be destroyed by a short bout of inflation.

Impact upon relationship with banks
When households expect inflation will be 12%, they will see a 4% interest rate paid by the bank as yielding -8%. This has many consequences. On one hand, households and firms expend excessive (wasteful) effort on minimising their holdings of low-yield cash. In addition, they tend to shift away from fixed income contracting with the formal financial system. Both these distortions are caused by inflation, and exacerbated by flaws in the financial system.

These may seem to be small things but they actually are fairly large effects.

But is there not a tradeoff between growth and inflation?
For a brief period, the empirical evidence in the US suggested that there was a tradeoff between inflation and unemployment. Here’s the classic picture, for the 1960s in the US:

Graph shows a nice relationship where higher inflation has gone with lower unemployment. This evidence has led many people, particularly those concerned with the plight of the unemployed, to advocate higher inflation.

A look at the same evidence for the US, over a longer time period, shows no such tradeoff:

The proposition that there is a trade-off between inflation and unemployment was pretty much dead by the late 1970s. One by one, as central banks moved to inflation targeting, aiming and delivering 2% inflation, unemployment went down, not up. Hawkish central banks are the central story about how the stagflation of the 1970s was broken.

There is no tradeoff between inflation and growth. High inflation damages growth and one element of India’s growth crisis is India’s inflation crisis.

It is important to think carefully about the accountability of the central bank. RBI is not in charge of India’s welfare. RBI is in charge of India’s fiat money. The one thing that RBI should be held accountable for is delivering low and stable inflation, i.e. for holding CPI-IW inflation within the 4-5% range.

So that we have seen both the perspectives, it is pretty much clear that high inflation is not a freebie rapped up only in the name of high growth rate. On the same note, the reason identified by Mr. Mohanty held its ground that supply side constraints are the key responsible factor behind this bout of high inflation.

And now, on the solution front, we can’t expect RBI to perform the duties of the Govt. and involve in the state affairs of distribution and supply of the resources. Government, rather than forcing and looking towards RBI to ease interest rates, should do their work sincerely.

All of us are aware of the wastage of the resources; be it rotten grains in the custody of FCI, unused frequency of bandwidth lying with BSNL and MTNL or for that matter line-loss percentage in power transmission. If they can only use these scarce resources effectively and devise a plan and implement the same to bring down the wastage gradually, our Finance Minister, Union of India, would need not to trade the path of growth alone, on the contrary RBI and entire nation would accompany him.

When India started trying to build a mature market economy in 1991, at first, it felt like a sophisticated financial system would emerge, which would both, serve India and start competing for the global market. From 1993 to 2001, India achieved a remarkable revolution in the equity market. This increased optimism in the ability of India to understand problems, to achieve change and to maintain high ethical standards.

It now seems that those hopes were premature. The revolution in the stock market used to be one of the best success stories of economic reforms in India. It might have fallen apart in recent month and years. The more likely scenario could be one where India-linked finance will happen offshore, while our regulators and government squabble over a minor and inconsequential onshore financial system that is riddled with ethics problems. In the short term, onshore Indian finance is suffering from one setback after another.

Business as usual, in India, is taking us to a destination where RBI, SEBI & company will preside over a minor and inconsequential financial system. The bulk of India-linked finance is taking place overseas, and the overseas market will dominate price formation for India-related financial products.

Why might this happen?

Money always follows the path of least resistance; therefore orders that used to come to India are easily being switched to other venues. An array of other venues has now come up:

• Nifty futures trade in Singapore on the SGX and in USA on the CME.
• An array of sophisticated derivatives on Nifty trade on the OTC market offshore (also termed `the PN market’).
• Derivatives on the rupee trade overseas on the exchange traded market and OTC market (linear contracts are termed `the NDF market’).
• Trading in individual stocks is taking place on the ADR and the GDR market.

Mistakes of domestic policy are giving a substantial shift in India-related finance to overseas locations. The two most important pillars of the Indian financial system are trading in the rupee and in the Nifty, and with both these, India is rapidly losing ground. If present policy mistakes continue, the role of the onshore market will continue to decline, for both the rupee and Nifty.

The plight of the Nifty

Let’s focus on Nifty – the most important financial product in India. The success and survival of the onshore securities markets is fundamentally about NSE. NSE faces an array of problems rooted in domestic policy whereas the overseas markets offering India-linked financial products are already developed financial centres and face no such problems. In the baseline scenario, Indian policy-making will meander on clueless and unconcerned and NSE will continue to lose ground.

Things are neither that much simple nor only stop here. First, NRIs pioneered sending order flow to overseas venues, and made them liquid. Next are Indian MNCs, who run global treasuries, who easily patronize the overseas venues. And then there are HNI residents, who can take $200,000 per year per person outside India. In addition, the richest 1% of India would systematically shift money out of the country through various means fair and foul.

With these kinds of possibilities, Singapore’s appeal goes beyond just the type of markets it offers. For one, India demands new investors deal with a thicket of documentation. While opening a foreign institutional investment account in most countries takes a few days, in India it is up to six weeks. So the start itself is a hurdle.

And then, there is taxation. We, as India, should not tax the activities of non-residents. For a global investor, sending orders to the Nifty futures on SGX is tax-efficient as Singapore follows a residence-based taxation system. Sending orders to India is inefficient today (owing to the STT and the stamp duty) and is apprehensive about tomorrow (if GAAR is used to abrogate the Mauritius treaty).

The bigger hurdle is India’s more severe taxation. Singapore does not tax capital gains and its tax on interest income allows for certain exemptions, such as foreign-sourced dividends. Whereas, India has a 15% short-term capital gains tax on listed securities. Most domestic debt instruments carry a 20% tax on income earned, which according to many market experts is the “biggest showstopper”.

The obvious choice

Put these factors together, and suddenly Nifty futures on SGX are a credible option. And this is exactly how things have worked out. In 2008, before these troubles had come together, SGX open interest was 59.78% of NSE. By 2012, where all these problems have come together, SGX open interest has come to 101.77% of NSE’s. It is astonishing to see that for the biggest Indian product – Nifty – an overseas exchange has got superior open interest.

Things changed when SEBI banned Participatory Notes (P-notes) in October 2007. SGX’s share in the total open interest (outstanding positions) in the Nifty futures product rose to around 50% from as low as 6% before the ban. A year later, the market regulator lifted the P-note ban, which led to a fall in SGX’s share to around 25%. But since then, SGX’s share has been rising steadily again. SGX now enjoys a 68% share in the total open interest on Nifty futures contracts.

And the recent blunder that added to the misery is the GAAR fiasco that resulted in exodus of foreign investors’ from the Indian regulatory boundaries. And while the government has softened its stand on GAAR considerably, foreign investors now seem increasingly concerned about the uncertainties of Indian policymaking.

The predicament of Rupee

The Indian rupee has grown rapidly to becoming the 16^th most traded currency in the world. From less than 0.2% of the world forex turnover in 1998, it has grown rapidly to constitute about 0.9% of the world forex turnover in April 2010. It is one of the biggest emerging market currencies with the Korean Won, Russian Ruble, Chinese Renminbi and the Mexican Peso being its close competitors.

Trading in the rupee is composed of the following elements of the market:

The rupee-dollar is the most important price of the Indian economy. The overall market for the rupee is roughly $70 billion a day out of which roughly one-third is spot, and the rest is derivatives. The offshore market today is as big as the onshore market, as roughly half of rupee trading takes place in India.

In its 2010 triennial central bank survey on foreign exchange and derivatives market activity, Bank for International Settlements (BIS) also pointed out that about half of the dollar-rupee market was overseas.

Though the RBI has done away with many capital controls, access to the currency market onshore still has some restrictions giving rise to offshore currency trading. Having said that, it must also be noted that most emerging market currencies are traded heavily in prominent currency trading centres such as Singapore, Hong Kong, the UK and the US. This is an inherent feature of currency trading. Of course, countries which have capital controls tend to push a larger proportion of trading offshore.

The development in the Rupee market

InterContinental Exchange Inc. and CME Group Inc., among the world’s largest futures exchanges, have launched rupee-dollar futures contracts in the month of Jan 2013. This clearly shows the growing importance of the rupee in the global currency market.

Needless to say, large electronic exchanges will do their best to both capture market share and increase the size of the market. And given their advantage over domestic competitors of access to foreign market participants, as well as freedom with product design, the share of offshore trading could continue to rise.

Rupee trading on other markets does not necessarily mean that trading in local markets is shrinking. Though it may be the case that the cake is enlarging, but our slice isn’t.

As India internationalizes, domestic customers of financial services, and the foreign order flow, will increasingly shift their business to providers abroad considering the problems in the local financial system. NRIs do not like to send orders to India given that India as yet lacks a residence-based taxation framework; they would rather send their orders to US (on ICE & CME), Dubai (on DGCX) or London.

The obvious implication

When foreign investors send an order to India, there is an entire chain of activity where revenues are generated. This includes brokerage companies, accountants, lawyers, hotels, aviation services, etc. When the same foreign investor sends this order to Singapore instead, this entire chain fuels the Singapore economy instead. And as global interest in Indian derivatives surges, it is Singapore, not Mumbai that is reaping the benefits.

The swing shows how deeply a tax gaffe last year damaged foreign investor sentiment and the cost to an economy that has seen growth tumble to around 5.5% following the sharpest slowdown in a decade. India is now paying the price for poorly written rules last year aimed at ensnaring tax evaders, ironically including those routing investments through Singapore, which instead sparked outcry among foreign investors and an outflow of funds.

What worries India is that Singapore markets are now attracting flows in other derivatives, creating not only a missed opportunity for India, but also the risk of a parallel overseas market offering arbitrage opportunities that distort domestic prices.

Last but not the least, prospects of Bombay, emerging as an international financial centre will subside. If we can’t even hang on to market share for Nifty or the rupee, where is the question of competing against overseas financial firms or markets on things that aren’t India-linked?

Some steps in the right direction

Since all taxes are distortionary and a basic principle of public finance is that we should have a low rate that is spread across a large tax base; our first priority should be to achieve a low rate, a wide base, and the minimal distortions. Reduced rates will always yield welfare gains. The Budget 2013-14 makes progress on two fronts (reducing STT from 1.7 to 1 basis point, and reducing distortions between equities and non-agricultural commodities).

One more announcement from the budget was in best of the spirits: FIIs are allowed to trade in currency futures. This will also give more liquidity and depth to currency futures and there are two reasons for expecting this, taxation of commodity futures and the entry of FII orders flow.

Future finance ministers will need to navigate the difficult landscape of gradually scaling down taxation of transactions while retaining low taxation of capital gains (which has unfortunately come to be seen as a linked issue in the Indian discourse). There is much more waiting to be done: integrating currencies and fixed income, bringing sense to options, and getting away from the very high rates on the equity spot market.