About a month ago, India’s Ministry of Finance (MOF) reported that after the first nine months of the fiscal year, the central government’s fiscal deficit stood at 95 percent of the full-year target. I tweeted that it looked impossible for the government to avoid exceeding its target in the remaining three months. This month, the figure for the first 10 months stood at 101.6 percent of the full-year target. It appears my guess was correct, but I have now revised my view. Among other explanations, I realize that India’s finance minister P. Chidambaram gained tremendous policy freedom from the certainty that the Congress Party will lose the upcoming election.
The past few months have seen extraordinary progress in financial sector reform in India. Not all reforms will reach fruition before the next government is formed at the end of May. However, there is enough to give shape to a veritable tidal wave of financial liberalization. It begs the question: Why now, as the Indians say, at the “fag end” of the current government’s term?
There are two reasons. First, Chidambaram has no chance of continuing as finance minister beyond May. Like any short-timer, this frees him to do as he pleases. He speaks to private audiences about the need to support reforms regardless of who forms the next government. The second reason is that, fortunately, Chidambaram has chosen to use his last few months to push through reforms that have been stalled for years. One could say he is the only cabinet member still working. On financial sector reforms, he has assembled a dream team of officials, starting with Raguram Rajan as governor of the Reserve Bank of India (RBI), and including key personnel in the Department of Economic Affairs in his own ministry. They are seasoned doers who are genuinely excited to push these measures through. The MOF and RBI have been trading support for each other’s priorities in a virtuous circle of progress. On the budget deficit, Chidambaram faces little pressure from Congress to sacrifice his intellectual integrity in the interest of political expediency. Recall the ridiculous farm loan waiver that originated from his office during the last election in 2009. That giveaway cost only 0.27 percent of GDP directly, but much more indirectly as the damage to rural credit culture led to high levels of bad agricultural loans at public sector banks. Perhaps defending Chidambaram’s intellectual integrity strains my own. After all, he also created the off-budget oil subsidy bonds in his previous go-round as finance minister, and this time he has been scouring the government books for assets he can convert into current revenues. So far, public sector unit firms’ surpluses and the RBI’s deposits at the IMF have been sacrificed.
Chidambaram’s freedom from political pressure explains part of my optimism that India’s Ministry of Finance will meet the deficit target — despite having already breached it — with two months to go. Another part comes from a little-noticed policy move the ministry made when Chidambaram was struggling to meet the deficit target last year: It began to enforce a long-ignored requirement that other ministries show receipts (Utilization Certificates or UCs, to be exact) to demonstrate they had actually spent their money before the MOF would release the funds to reimburse them. This was combined with a concerted shift by to eliminate delays in reimbursement for ministries that complied. In the past, bureaucrats worried that the MOF would not reimburse them quickly. In fear of finding their coffers empty if they faced unexpected expenses, they would hold off on spending until the end of the fiscal year. This resulted in highly skewed expenditures lumped into the final quarter. Requiring UCs not only gives the MOF better control over expenditure quality, but has also smoothed out expenditures across the fiscal year. Last year, expenditure and revenue more or less moved together throughout the year, including the last-quarter surges. The new pattern should display a much smaller expenditure surge relative to revenues, implying a last-minute rescue of the deficit target.
Returning to the financial sector liberalization plans, which have caused an outbreak of grins among chronically curmudgeonly economists, here is my list of what is coming down the pike that will make a big difference for debt capital markets:
- Depository receipts (ADR/IDR) of any Indian security: This move has the potential to completely open Indian markets to foreign investors. The MOF proposal would allow Level-1 DRs (for any old security already being traded, as opposed to current regulations that only allow DRs for specially issued securities). If an Indian resident wants to sell a G-sec bond to a foreign investor, they can sell it to a depository. The depository then sells a receipt to a foreign entity. So as long as the depository system works well (I do not claim to be an expert) and the Indian tax system will work with nonequity securities, the market opens wide.
- External commercial borrowing (ECB) on a hedged basis: RBI would only require full hedging of currency risk to borrow abroad. No more quantity, maturity or interest rate restrictions. Foreign purchases of rupee-denominated corporate bonds would be unrestricted because they are hedged. While RBI has historically been uncomfortable with unlimited ECBs, the new requirement of full hedging appears to have won them over. This proposal has the added benefit that it will create a much stronger domestic constituency pushing for improved functioning of India’s foreign exchange derivatives markets.
- Nonlegislative implementation of the Financial Services Legal Reform Committee (FSLRC) recommendations: Many parts of the FSLRC do not require any changes to the law to be implemented. The MOF has already started to apply what could be called an FSLRC filter to new regulations issued by financial regulators. In other words, every new rule must satisfy the FSLRC requirements of 1) undergoing a cost-benefit analysis, 2) allowing a public comment period and 3) registering with Parliament as an official regulation. Rules can no longer change through arbitrary announcement of regulations, circulars, notices or press notes.
- Empowering the Forward Markets Commission (FMC): Now that it has been moved from the Ministry of Consumer Affairs to the Ministry of Finance, the FMC is allowed to hire outside law firms. Suddenly they are winning cases; they have teeth. This is particularly important in light of the National Spot Exchange scam, which raised questions about the quality of commodities market oversight. The MOF has largely abandoned its long-standing goal of amending the FMC Act, which would further strengthen FMC, because the legislative component of the FSLRC suggests folding FMC into the Securities and Exchange Board of India.
- Euroclear facility for Indian domestic bonds: This will allow foreign entities much greater ease in trading Indian securities offshore. It also represents a big step on the way to including India in global domestic currency bond indices. MOF has been talking to Euroclear, but two hurdles remain. First, India still applies withholding tax on coupon payments made to foreign entities. Euroclear surely does not want to become the tax agent for foreign bondholders. Most advocates of bond market development hope the withholding tax for foreigners will go away, and perhaps the need to accommodate Euroclear will finally overcome the political obstacles. (Nobody actually pays the tax, so eliminating the tax is revenue-neutral. Taxable bondholders sell their bonds to a tax-exempt entity the day before the coupon payment and buy them back after.) Second, Euroclear will need to establish an onshore custodial presence. Who will regulate them, RBI or SEBI? Rumor has it RBI does not want to allow Euroclear a special purpose bank license, so the path forward is not clear.
- Global bond index inclusion: The benefit of joining a global bond index extends beyond a one-time capital infusion as global bond funds take positions in Indian debt markets. It also makes that capital much stickier and less likely to flee in stress periods, even if it mostly lands in short-term government bonds. The Finance Ministry’s motivation to achieve this goal has greatly diminished along with the threat of a current account crisis. But all of the other items listed above are steps in this direction, so I remain optimistic that India will get here, even if not by design. And I suppose that’s the best way to get there — when the authorities believe in the steps as much as the goal.
Russell A. Green, Ph.D., is the Will Clayton Fellow in International Economics at Rice University’s Baker Institute. Green spent four years in India, where he served as the U.S. Treasury Department’s first financial attaché to that country. His engagement in India primarily focused on financial market development, India’s macroeconomy and illicit finance, but included diverse topics such as cross-border tax evasion and financing global climate change activities.