TWN Info Service on Finance and Development (Apr11/03)
18 April 2011
Third World Network

South should factor in ‘development' in financial reforms
Published in SUNS #7130 dated 14 April 2011

Geneva, 13 Apr (Kanaga Raja) -- Reforms in the institutional structures of the advanced economies have been essentially in terms of reactions to the financial instability that they have faced, and when developing countries design their regulatory institutional frameworks, they will have to give equal emphasis to stability and developmental issues.

This view was voiced by Dr Yaga Venugopal Reddy, former Governor of the Reserve Bank of India and now Emeritus Professor at the University of Hyderabad, at a multi-year expert meeting on services, development and trade, which took place on 6-8 April at the UN Conference on Trade and Development (UNCTAD).

Dr Reddy was speaking at a session that reviewed recent trends in infrastructure services and their regulation, including the growing importance of infrastructure services sectors in international trade and employment as well as the impact of technological advancements and climate change.

According to information provided by UNCTAD on its website, the objective of the multi-year expert meeting, which examined the regulatory and institutional dimension of services, development and trade, was to assist developing countries, especially African countries and least developed countries, as well as countries with economies in transition, in establishing regulatory and institutional frameworks and cooperative mechanisms to support the strengthening of their domestic services capacity and its efficiency, competitiveness and export capabilities.

UNCTAD said that the purpose of the meeting was to bring together experts and practitioners from governments, sector regulators and competition authorities, services policymakers, trade negotiators, research institutions, civil society and the private sector to address the development implications of regulatory and institutional frameworks in infrastructure services sectors, and to identify and clarify the key issues and relevant policy options to enhance the capacity of developing countries to benefit from services, development and trade.

According to an UNCTAD Secretariat background note for the expert meeting, infrastructure services development fosters economic growth and development, thus contributing to the attainment of the Millennium Development Goals (MDGs). Infrastructure development is an essential component of countries' crisis mitigation measures and post-crisis integrated growth and development strategies.

"Sound regulatory and institutional frameworks (RIFs) engender beneficial effects of infrastructure services sectors (ISS) - energy, transport, telecommunications and financial services (FS) - in achieving socially efficient and equitable outcomes, addressing market failures particularly in financial sector and internalizing the costs of climate change mitigation and adaptation," it summarizes.

According to the note, the global combined annual revenue of ISS (infrastructure services sectors) stood at $14 trillion in 2009, or 24% of the world output. Developing countries represent 30% of global ISS output and its importance has increased with the rise of emerging economies. ISS represent over 35% of world services exports valued at $1.3 trillion. For 2002-2008, world ISS exports expanded at 17.6%, a faster pace than total services sectors. Developing countries' share in this trade climbed from 21.4% in 2002 to 25.4% in 2008 with their exports outpacing the world average (21.1% and 17.6% respectively).

While the global crisis had smaller effects on global services trade than merchandise trade, its effects on infrastructure services sectors were significant, said UNCTAD. World exports of transport and financial services, and infrastructure-related construction services, all fell by 20-30%, while the decline in communication services was smaller. The continued growth (7.7%) of the global ICT market was driven by outsourcing, system and software development. By mid-2010, export levels remained 20-25% below pre-crisis values for all sectors except communication. Energy services are expected to have been resilient due to the low income elasticity of energy.

According to the UNCTAD note, ISS (infrastructure services sectors) is an important determinant of trade and competitiveness. Low-cost and reliable communication, transportation, logistics, capital and energy are essential for financing, sourcing, production and marketing of goods and services, including those conducted within international supply chains. The significance of supply chains is evidenced by increased share in world trade of intermediate goods and services particularly ISS and related services (56% and 73%, respectively). Furthermore, energy, water, transport and logistics costs represent some 30% of total production costs of manufactures.

UNCTAD said that the global financial crisis demonstrated the critical shortcomings in financial RIFs (regulatory and institutional frameworks). It was an apparent case of regulatory failure in addressing rampant market failure, and challenged the efficient market hypothesis, thereby calling for reviewing the role of the State in financial regulation. Ultimately, the success of the regulatory reform would be judged by whether it could address the root causes of the crisis and prevent future crises, and restore a well-functioning financial system that allocates capital to useful productive and real economy activities.

It noted that many developing countries were relatively de-coupled from the financial crisis as they had pursued a prudent regulatory approach and/or were not fully integrated in the global financial markets. Since many developing countries are yet to adopt the Basel II framework and Basel III is not mandatory, it is important that they are able to adjust the rules to national circumstances so that implementation of the new rules does not risk their financial stability or developmental objectives, it said.

The background note concludes that development of ISS must be anchored in a comprehensive, integrated and coherent strategy for growth, development and trade, which will require close coordination with complementary policies. RIFs need to be continuously adapted to rapidly changing market conditions, technological developments and pressing global challenges.

Trade agreements have raised concerns regarding the impact of trade rules on national regulatory autonomy, as well as development of ISS. To improve regulatory and pro-development outcomes, multi-stakeholder interaction including policymakers, regulators, trade negotiators, civil society, and private sector is important, it says.

In his presentation at the multi-year expert meeting, Dr Reddy provided some insights relevant to the regulation of the financial sector.

Firstly, he said, the race to the bottom in financial regulation, particularly in international financial centres, may not have ended. Many regulatory proposals in the United States and the United Kingdom are being resisted by the financial market participants. Their main argument is that they would relocate their financial intermediation activity to some other jurisdictions. Policy-makers are taking the threat seriously, and are fine-tuning the regulatory regimes that are proposed, he added.

Secondly, all financial regulation is at the national level and the regulatory authorities as well as monetary policy authorities have a clear mandate to maintain financial stability as also price stability, along with output and employment maximization. "In other words, the mandate of the national institutions is the national interest at any particular point of time. The global interest can be taken into account only if it is consistent with the national interests."

This issue, Dr Reddy pointed out, came to the fore in the context of Quantitative Easing by the US Federal Reserve. In these circumstances, "global coordination is possible, desirable and feasible, but not assured in the short run or in all circumstances since each national regulation is mandated to serve national interests," he said.

Thirdly, he noted, the recent uneven recovery as between different countries leading to divergent policy actions indicate that economic cycles are predominantly national, though increasingly they are becoming globally interconnected. Many developing countries have to adopt their policies consistent with the state of cycle in the domestic economy, and to be able to do this.

Fourthly, there may be recourse to financial repression in some of the countries in future, particularly in advanced economies. The public debt for many of the advanced economies is large, and the capacity of many of the economies to raise tax resources or have expenditure cuts in order to manage their debts is not unlimited, and hence, both financial repression and inflation financing should not be ruled out in their jurisdictions.

Fifthly, said Dr Reddy, the principle of un-level playing field in financial markets has been accepted when systemically important financial institutions are sought to be identified, and higher capital provision is being suggested.

Once the principle of un-level playing field has been accepted, it can be used, if necessary, to design differentiated regulatory regimes to different segments in financial markets, as long as there is reasonable discrimination, Dr Reddy added.

Sixthly, several arguments are advanced to hold that financial flows will move away from countries which have taxation on the financial sector, or have restrictions on the capital flows, but these assertions are not empirically established, he said.

Large capital inflows have been taking place to China and India where it is generally held that there are elements of capital controls and financial repression. In other words, financial markets look at several factors, and not merely the regulatory burden on financial intermediation.

Seventhly, he said, the argument that requirement of higher capital would always involve higher cost to the customer or would affect funding of economic growth, has not been empirically established. That inadequate regulation would result in disproportionate benefits or bonuses to the financial sector is well established.

However, there is no evidence of direct relationship between sophistication in development of financial sector and the level of savings or their efficient allocation. That excessive financialisation results in adverse consequences is well established. There is obviously an optimal level of regulation; and the optimal level is specific to each country while globally agreed norms are meant to be minimal standards only.

Eighthly, the problem of capital flows may not be restricted to the developing countries, Dr Reddy said, noting that Fed Chairman Ben Bernanke, in a recent paper, explained that the financial instability in the US was partly on account of excessive capital inflows.

Further, the problem of excessive capital inflows cannot be managed satisfactorily at the destination of such inflows, unless there are appropriate policies at the origin, as illustrated by experience with Quantitative Easing in the US. More important, Dr Reddy said, the problem for public policy is not so much the size of the capital flows, as that of excessive volatility. Often solutions suggested such as appreciation of the exchange rate and fiscal measures do not address the problem of excessive volatility.

Further, there is a general acceptance that the prudential regulation of the financial sector should be the preferred option of managing capital flows.

Finally, if intervention of the government or the regulatory regime is required in order to maintain financial stability, it is not clear how it is presumed that the financial sector would permit growth without appropriate interventions to ensure growth. In this regard, there may be need to differentiate between provision of financial services such as retail commercial banking in which financial inclusion will be the main focus and financial intermediation. Providers of financial services should be regulated on par with an essential service or a public utility. (Former Fed Chairman Paul) Volcker's rule supports this view and it is of special significance for enabling, inclusive development, Dr Reddy said.

Apart from highlighting some of the financial reforms being undertaken by the US, the United Kingdom, and the European Union, Dr Reddy also pointed to some financial reforms taking place in India. He noted that the Indian financial sector was not seriously affected by the crisis, and there were no visible infirmities in the Indian structure that are comparable to the seriously affected countries like the US and the United Kingdom. In fact, many of the reform measures that are being considered in advanced economies are in the nature of rolling back excessive deregulation that had taken place earlier. In India, such extensive deregulation had not taken place in the past.

"However, it was considered appropriate to learn lessons from the crisis while at the same time pursuing [an] agenda of reforming the financial sector to keep pace with the demands of a growing real sector," he said.

Firstly, the Financial Stability and Development Council (FSDC) has been established through an administrative notification. The Council, chaired by the Finance Minister, is expected to address issues relating to: (a) Financial stability; (b) Financial sector development, including financial literacy and financial inclusion; ( c) Inter regulatory coordination; (d) Macro-prudential regulatory framework, including regulation of systemically important financial institutions; (e) Interface with international regulatory bodies in the financial sector; and (f) any other issue considered appropriate by the Chair (of the Council).

While there could be differences in regard to the composition and powers of the FSDC, it is necessary for all developing countries to appreciate that a high level national body would be desirable to address issues relating to financial stability and development, and in particular to ensure coordination among the regulators.

Such an institutional set-up may be redundant if the central bank is placed as the apex body responsible for stability, development and consumer protection, said Dr Reddy.

Secondly, a new law has been passed to settle jurisdictional disputes in regard to hybrid instruments. The relevant point to note is the recognition of the need for managing jurisdictional disputes in regard to hybrid financial market instruments. It is possible to argue that an apex body like the one envisaged in the Bank of England would avoid such issues. It is also possible to argue that informal or formal mechanisms to avoid disputes should ideally be with the central bank. In fact, it can be legitimately held that ideally mechanisms for coordination should subsume such adjudication rather than treat jurisdiction to be a matter for arbitration.

Thirdly, a working group of the Reserve Bank of India (RBI) has suggested a new law for regulating financial holding companies, which may have one of its arms, a bank. Despite the emphasis on the Volcker rule, emergence of financial conglomerates should be recognized. There is merit in having an appropriate uniquely designed legal framework for regulating holding companies involving a bank as one of its arms.

Fourthly, amendments to the Banking Regulation Act are being proposed, which strengthen the regulatory and supervisory powers of the banking regulator, namely RBI. The enhanced regulatory powers will facilitate effective, graded and prompt preventive-corrective actions, Dr Reddy added.

Fifthly, he said, the government has announced that the mergers and acquisitions in the banking sector will not be subject to the jurisdiction of the Competition Commission, but will be decided by the RBI.

Finally, the constitution of a Financial Sector Legislative Reforms Commission has been announced. The Commission is expected to study and recommend on the total architecture of the legislative regulatory system of the financial sector.

"A longer term view and careful deliberation on legislative changes relating to financial sector has much to commend for itself, if a country has no immediate stress on financial sector," said Dr Reddy.

On some issues that are relevant to the regulatory institutional framework, Dr Reddy said that firstly, reforms in the institutional structures of advanced economies have been essentially in terms of reaction to the financial instability that they have faced. However, in designing the institutional framework, developing countries will have to give equal emphasis to stability issues and developmental issues.

Secondly, he added, the reforms highlight the importance of coordination among the regulatory agencies and also between the government, central bank and other regulatory agencies.

The developing countries have to emphasize coordination because the financial sector plays an important role in structural transformation. Further, in view of the limited skills and often small size of several developing economies, it may be desirable to have several regulatory functions concentrated in a single institution such as a central bank.

Thirdly, in all coordinated mechanisms related to the financial sector brought about in advanced economies, central banks have a critical role, and in some cases they do have a leadership role. In particular, the central role of central banks relative to governments in crisis situations may have to be recognized, particularly in developing countries where financial sector crisis and political instability often happen together.

Fourthly, a mechanistic approach for devising counter-cyclical policies may not be adequate for developing countries since it is difficult to differentiate between structural and cyclical components in rapidly growing economies. Further, coordination with other policies also warrants judgements and accommodation of several points of view. Hence, discretion becomes as important as rules, and the institutional framework should provide for this.

Fifthly, the innovations in financial products call for significant skills. Hence, it may be desirable for developing countries to have a positive list of financial products that will be permitted in the financial sector.

Only the financial products which have proven to be non-toxic in advanced economies may be included in the positive list in developing countries, he said.

Sixthly, said Dr Reddy, in many economies, the financial intermediaries, in particular banks, may not be too big to fail, but they may be too powerful to regulate, particularly in view of the diplomatic pressures that often accompany financial intermediaries with a multi-national presence.

There may be merit, he added, in restricting the presence and activities of such powerful entities through legal provisions and regulatory prescriptions.

Finally, there is need for special resolution mechanisms for financial intermediaries that are under stress. It may also be desirable not to subject the mergers and acquisitions in the financial sector to the jurisdiction of the Competition Commission, since the financial sector has unique externalities. Thus, ensuring competition in the financial sector could be within the jurisdiction of the financial sector regulators, he concluded. +