Europe is in a financial daze. Greece is under severe pressure. Even German banks, normally most stable, are reeling under losses of billions of dollars. Now voters in the US, fed up with joblessness and a deeper recession, are camped out in Wall Street, protesting and demanding reform of politics and finance. The West, once viewed as the dominant nation- and institution-builder, especially by emerging markets and the under-developed world, is unable to follow its own prescriptions for growth and free-markets. Far from it: its economies carry systemic market risks and misplaced incentives which impact societies. They are hardly models for the world to follow.
Then what is?
Try India. India has long exported its ‘soft’ strengths. A thousand years ago, the Chettiars from South India travelled to South East Asia and helped establish banking and money-lending systems in these countries. The overlay of colonialism dissolved many of those systems. But in the last five years, India has once again begun building the financial and regulatory systems of other nations. Since 2006, Mumbai’s Multi-Commodities Exchange (MCX) has set up exchanges in Singapore, Bahrain, Mauritius, Botswana and Dubai. The National Stock Exchange (NSE) has set up the surveillance system for the Colombo Stock Exchange and runs the certification program in derivatives in both Colombo and Mauritius; the two national depositories, NSDL and CDSL, have agreements to share best practices with their counterparts in the US, Japan, Russia, Taiwan, Korea, Malaysia and Euroclear.
This is one area where India leads China. Sure, in many emerging nations, China has taken the lead, readily helping them turn their back on the Western model of development by building their hard infrastructure and extractive industries. But now those same countries – many affected in some form by the wave of recent democracy movements – are looking with urgency at building ‘soft’ infrastructure like markets and regulatory and institutional frameworks. And they are turning their gaze upon India, a similarly developing nation with long experience of capital markets, democratic values and independent regulatory institutions built around affordable and robust structures. More relevant, India’s conservative and ‘inclusive’ financial regulatory system has insulated it from the global financial crisis, making it a compelling case study especially for emerging markets.
India’s financial export model is based on a system at home that has developed affordably and robustly, though cautiously, with Indian government and regulators working to ensure this emerging market does not run ahead of itself. Derivative products were introduced only after extensive consultations between the regulator Securities and Exchange Board of India (SEBI) and central banker Reserve Bank of India (RBI), exchanges, market participants and industry experts. Today, India has a thriving derivatives market in index and single stocks, currencies and interest rate futures. The T+2 settlement system, supported by a daily margin regime that requires even institutional investors to comply, helped Indian stock markets avoid defaults and systemic collapses through the global financial crisis of 2008. The National Stock Exchange and the Bombay Stock Exchange (BSE) currently rank amongst the top five exchanges in the world in terms of trading volumes: From 500,000 trades a year in 1994-95, volumes have grown to over 2.1 billion trades in 2010-11. And India was the first country to glide ahead in retail investor protection – it abolished entry loads on mutual funds back in 2009, way ahead of the UK’s plans to do so in 2012.
India’s adaptable and affordable systems are replicable for similar emerging markets around the world – and there are a swelling number of them, especially in Africa and the Middle East, which are looking beyond the once unassailable western systems. The financial evolution of these emerging markets is important: they are the global GDP contributors of the future.
For now, their systems are infant, and not independent. In Africa, for instance, currently more than 25 countries – up from 10 in 1990 – have stock exchanges, but only 11 have an independent market regulator. In Zimbabwe, Rwanda, Namibia, Mozambique, Ghana, Cameroon and Botswana, the stock exchanges double up as regulator – but are evaluating separation. In the Middle East, which has 14 stock exchanges – up from six just 20 years ago – countries like Lebanon and Kuwait are in the process of establishing independent market regulators. Eight of these markets have been created only in the last 15 years and are trying to evolve into major players by attracting both resident and foreign investors.
These markets share commonalities but are a stark contrast to the rest of the world. They are resource-rich, corrupt and war-torn; income and wealth distribution are skewed. Their experience with risk-taking has been limited to life, not money. In their saving and investing habits, they focus more on ‘return of principal’ than ‘return on principal’ i.e. their ability to take the risk of loss of principal is low.
Central banks often play the regulator’s role across all financial markets. The State is mostly the co-promoter of enterprises along with fledgling private sector entrepreneurs; it is also the dominant player in these economies and, most often, the provider of first and last resort to its people. In short, these countries are not internally ready or geared to adopt the more sophisticated western model of capital markets as ‘pass through’ structures based on caveat emptor where all risk is borne by the investor.
Migration to capitalism and free markets, therefore, needs to be carefully planned with a long term perspective – calibrated to manage the downside risk of instability, while implementing plans to create a vibrant financial market. Because many of these countries are poor, the process has to be inclusive with a focus on the less privileged and more vulnerable. The regulatory framework has to strike a balance between market development and investor protection.
Indian regulators understand this. They remain conscious of the larger role that financial markets have to play and the influence it has over the economy. This alignment protects India from the excesses witnessed by other markets. In the $2.5 billion scam of IT outsourcer Satyam, the Indian government and regulators came together to find a new buyer and protected the interests of stakeholders – investors, customers and employees. This approach to problem-solving, in stark contrast to the all-round loss caused by Enron, will find greater resonance in emerging markets.
Of course, Indian markets have some distance to travel in improving quality and frequency of corporate disclosures (it needs quarterly financial statements including cash flows), strengthening checks on promoters / majority shareholders and migrating to international accounting standards. And India needs to overcome a larger problem: If the Western institutions can be charged with ‘regulatory capture’ by dominant market participants resulting in excesses, their Indian counterparts are considered corrupt and prone to compromising their independence to government influence.
The challenge is to institutionalize islands of excellence and integrity through technology, transparency and stability in policy formulations. India’s globally-respected IT industry has already shown it can achieve these goals. New Delhi now must seriously tackle these issues soonest, or risk losing a new, stellar export: affordable, reliable, robust financial regulation for the emerging markets – and perhaps for the battered financial markets of the West.
K. N. Vaidyanathan is the former Executive Director, Securities and Exchange Board of India. He is also a Member of the Finance Board at IIM, Ahmedabad and is Gateway House’s Senior (Adjunct) Fellow for Geo-economics.
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