This series of articles will be on one particular aspect of Indian policy making – it’s sui generis logic. The title is derived from a conversation with a senior policy maker, a friend, who in the heat of an argument several years ago, said "Surjit, if you ask for logic, we won’t help you". I am still looking for logic, and I would invite readers to contribute their experiences. By and large, this "logic" series will be concerned about the functioning of capital markets in India. It is not an exaggeration to state that the Indian capital market remains the most under-reformed sector of the Indian economy – and its most uncompetitive. One of the salient lessons of the East Asian crisis was the signal given to policymakers – capital markets can only be ignored at the economy's peril. India's East Asian neighbors are in a capital market reform overdrive, and will soon have transparent, efficient and productive capital markets. The question remains – will India again lag behind?

There are three major aspects of a capital market - foreign exchange, debt andequities. The mistake made by Indian policy makers is to think of these threemarkets as separate rather than part of a single financial market. This mistakewas in abundance last year. Recall what happened - there was a nuclear blastand investors felt that the rupee would depreciate. Since our foreign exchangemarket is completely controlled (an honor we share with totalitarian China),investors could not hedge their exposure in the Indian stock market. The onlyoption left for Foreign Institutional Investors was to sell their stock holdings;which they did, and helped bring the market down to seven year lows - andhelped "cause", after the scam of 1992, the biggest domestic financial crisis.

This UTI crisis was then blamed on the foreigners when it was properlyattributable to one of the more illogical policies of the Indian financial sector -the prevalence of guaranteed nominal returns for investments in equity. This isnot to argue that an open capital market would not have led to stock marketdeclines; rather, it is to assert that a closed, controlled, capital market wasunable to blunt the severity of the decline. And that the joint culprit was theregulator (Securities and Exchange Board of India or SEBI) guaranteed returns. Today that illogic is a distant memory. The stock market has already breachedthe upper bound of a narrow 3000-4500 range in the Sensex that had prevailedsince 1992. The economy is likely to grow over 7 percent, and WPI inflationlikely to stay below 4 percent, marking inflation this year as the lowest since 1982.

How many times has India, and its markets, flattered to deceive? Every year forthe last seven years. So why should now be any different? Because while theremight still be political uncertainty, (i.e. which alliance will rule) there is no morepolicy uncertainty. All political formations are now for economic reform. This isthe big picture change as the economic policy choice has become a vote forTweedledum vs. Tweedledee.

There is one major caveat, however. While India will continue to muddle along,its leap into a genuine economy, (and one which can be a strategic equal toChina), will not be possible unless interest rates are market determined. Asevery Babu shouts himself hoarse saying they already are, and every marketparticipant laughingly cries at this "Yes, Minister" absurdity, the economycontinues to pay a heavy price. Indeed, the single most important reason whyIndian reforms have led to only a sluggish increase in growth is because realinterest rates (defined as nominal interest rate minus expected inflation) in Indiaare very high - at double digit levels for the best Indian corporates - and havestayed that way for most of this decade.

What do the policy makers do when confronted with this shameless record?They either point to the fiscal deficit (which primarily results from interest ratesnot being market determined - interest payments today account for the entirefiscal deficit) or they go into elaborate pyrotechnics to defend their misguided,Babu-knows-better policies.

A telling example of this tendency are the recent expected inflation ratecalculations of the distinguished ex-Deputy Governor of the Reserve Bank ofIndia, Mr. S.S. Tarapore. Writing in the Business Standard, Aug. 6, 1999, hecontended that expected inflation was not close to 2 percent (as indicated byinflation data over the last few months) but close to 6 percent. How is thisinflated number derived? " it is necessary to use a weighted average inflationrate with a distributed lag i.e. a greater weightage for the recent period and aprogressively lower weightage for the more distant period". As is well known, theweights can be chosen by an analyst to suit any number. The real logical flawwith Mr. Tarapore's method is that it relies on a bureaucrat's assertion of whatthe expected inflation is, rather than the verdict of the "market" (something thatIndian policy makers are loathe to recognize the existence of, especially wherefinancial markets are concerned.)

How can the market tell you what expected inflation is? By looking at thedifference in yields of "nominal" and "real" interest rate securities. Over the lastfew years, sovereign debt securities in England and the US have been traded inboth nominal and real terms. And what is the rate of expected inflation yielded bythese securities? At each point in time, expected inflation is virtually identical tothe most recently observed year on year (yoy) inflation rate; (low "bases" andother Indian inventions notwithstanding!) The point is simple - the bestinformation that the market has at any point in time is the yoy inflation rate. Andif the market's verdict is accepted, then expected inflation in India is close to 2percent.

The point is not that the expected inflation rate is constant - it will change withevery change in the inflation rate. The point is rather that the market, and themiracle of arbitrage, ensures that the best estimate of expected inflation is thatprovided by the yoy inflation rate. But all of these wonders are not possible if theinterest rate is Babu determined.

The second example of humorous illogic holding sway was the recent front pageannouncement " SEBI sets up Committee on Venture Capital". Lets think aboutit. We are talking about venture capital, and a regulatory (nee licensing) body isgoing to set up a committee to advise on how to encourage venture capital!?Venture capital is the flow from an investor to an entrepreneur on a high riskproject. Clearly, India has laws governing buy and sell transactions, so what newguidance will a committee provide? Further, some might argue for tax benefitsto be given to venture capital; if so, that is a Ministry of Finance decision, not thedecision for an overarching licensing authority for brokers.

A more logical role for SEBI would be to analyze why investments made byordinary mortals in mutual funds are treated as venture capital in India. Recenttax policy (on SEBI's recommendation?) makes investments in rip-off mutualfunds tax-free, but all stock market investments made outside of mutual fundsare taxed at a 30 percent rate! In other words, if you make a profit in the stockmarket through a middleman mutual fund you pay zero tax; if you make a profitthrough your own intelligence, you are penalized with a 30 percent tax rate.

If you think it doesn't get funnier, just wait for the other articles in this series.

The author is Director, Oxus Fund Management, a New Delhi based emergingmarkets advisory and asset management firm.