Liberalization of Financial Services under GATS: The Indian Experience

Introduction

The term ‘financial services’ is broadly used for a set of
services provided to ensure efficient mobilization and
allocation of funds towards the overall growth of an
economy. By directing investment funds to their most
productive use, an efficient financial services sector can
significantly promote growth and income. As a result, the
effective provision of these services is a basic prerequisite
for a dynamic and modern economy. Across most
developing countries, including India, financial services
constitute part of the regulatory system that manages inflow
and outflow of foreign capital, reduces exchange rate
volatility and provides credit to socially desired sectors.
Countries such as the United States, Japan, as well as some
members of European Union have, over the years, been
vocal demandeurs of liberalization of different financial
services, arguing that barriers to entry hinder economic
progress and financial stability. They also have welldeveloped
financial service industries that stand to benefit
from access to international markets. However, the rapid
flow of money out of developing countries in the aftermath
of the Latin American crisis in 1980s and the East Asian
crisis in 1997, demonstrated that liberalizing financial
markets sans proper planning and management of
investment is not a recipe of success. In fact, given their
immense importance in overall stability of an economy,
there is a broad disagreement among various countries
about further liberalization of financial services. These
disagreements range from both liberalization in additional
financial services sector as well deeper liberalization in a
particular sector.
Liberalization of financial services at a multilateral level is
largely governed by the General Agreement on Trade in
Services (GATS) under the World Trade Organization
(WTO). By the time official negotiations under the Uruguay
Round were over in 1993, negotiations on financial services
remained unfinished. These negotiations continued for two
more years and an interim agreement was reached in 1995.
The negotiations again reopened in April 1997 and a revised
set of commitments in financial services by 70 member
countries was agreed on December 1997, and annexed
to the GATS as the Fifth Protocol. GATS also required
WTO Members to restart negotiations on service
liberalization after the fifth year of its implementation. The
current round of negotiations has therefore started in 2000,
with the objective of further liberalization of trade in all
services, including financial services. Under these
negotiations, India submitted its revised offers in August
2005.

Current Levels of Liberalization and Ongoing Negotiations under WTO

In the Financial Services Annex to the GATS Agreement,
India undertook commitments under various sub-sectors
within financial services, mostly in Mode 3. In the banking
sector, India committed to allow establishment of branch
operations of a foreign bank subject to a license limit of 12
per year. However, India retained the option of restricting
entry of foreign banks if their market share exceeded 15
per cent. Apart from this, the foreign banks were also
allowed to install ATMs at branches and other places. It
also allowed licensed foreign bank branches to invest in
other financial services up to a certain limit. The foreign
banks were required to constitute a Local Advisory Board,
the Chairman and Members of which had to compulsorily
be Indian nationals. Finally, public sector banks could invest
their surplus funds in term deposits only with scheduled
commercial banks in India.
Within the insurance sector, India allowed foreign insurers
to insure goods in transit to and from India. Foreign reinsurers
were also allowed to take reinsurance but only
that part of the risk that was left as residual after statutory
placements domestically with Indian insurance companies.
This part of the reinsurance could be placed with foreign
insurers through overseas brokers. These brokers were
also allowed to have resident representatives and
representative offices to procure reinsurance business from
Indian companies. However, these representatives and
offices were not allowed to undertake any other activity in
India and their expenses were to be entirely met by
remittances from abroad.
Though these commitments signaled some improvement
over the original commitments made in 1993, they were
well short of the existing regime in 1997. Consequently, in
the current round of negotiations India’s trading partners
made several liberalization requests to India, both under
the bilateral request-offer mode as well as under the
plurilateral collective requests. In February 2006, India
received plurilateral requests for liberalizing trade in financial
services from a number of developed and developing
countries.2 Some of the major demands made in the banking
sector included: undertaking full market access and national
treatment commitments in Modes 1 and 2 for all subsectors,
removal of restrictions on preferred form of
presence, numerical quotas, monopolies, exclusive service
suppliers, use of foreign capital and equity ceilings and
investment by public sector utilities in foreign banks. Foreign
service providers also expressed the desire for removal of
the priority sector lending requirement as well as restrictions
on land acquisition by foreigners and ‘discriminatory’
regulations affecting income tax, solvency ratios and
borrowing limits.
In the insurance sector, other Members requested India to
undertake full market access and national treatment
commitments in Mode 1 and 2 for marine, aviation and
transport insurance, reinsurance, insurance intermediation
and insurance auxiliary services. They have expressed a
desire for removal of restrictions on the choice of the form
of commercial presence and partner for foreign service
providers as well as limitation on equity participation. They
asked for greater transparency in the development and
application of domestic regulations.
In the current round of talks India has offered to further
open up this sector provided other WTO Members make
substantive and satisfactory offers in sectors and modes
of supply where India has indicated its interests. Within
the financial services, India has requested developed
countries like Australia, Canada, European Communities
and United States to liberalize restrictions on market access
and national treatment for data processing of financial
services under Mode 2. India has also made several
country/member specific requests. For e.g. India has
requested Australia to allow bank branches to accept retail
deposits and remove the requirement of approval of
Australian authorities for setting up of bank branches of
parent banks where a single shareholder holds 15 per cent
or more share. In the case of European Community, India
has requested that a bank subsidiary incorporated in any
one of the member states be accepted as incorporated
within the EC and be authorized to render financial services
in entire EC. In United States, the form of commercial
presence, i.e. bank branch or bank subsidiary, depends
on individual state regulations and India has requested the
removal of such restrictions as they restrict provision of
financial services.
India’s conditional revised offer for banking services is
largely guided by RBI’s Roadmap for Presence for Foreign
Banks in India.4 The roadmap has divided further
liberalization into two phases. During the first phase,
between March 2005 and March 2009, foreign banks will
be permitted to establish presence by way of setting up a
wholly owned banking subsidiary (WOS) or conversion
of the existing branches into a WOS. Consistent with the
Roadmap, India has offered to allow foreign banks to enter
through branch operations or wholly owned subsidiary of
a foreign bank. Given that the number of branches
permitted each year has been higher than the WTO
commitments, India has agreed to offer up to twenty
licenses per year, both for new entrants and existing banks.
The minimum start-up capital requirement for these WOS
would be Rs 3 billion ($ 73 million) and they have to
maintain a capital adequacy of 10 per cent. India has also
offered to allow WOS of foreign banks to hold surplus
funds of public sector utilities as term deposits, subject to
guidelines by RBI.
India has also agreed to allow foreign banks to invest in
private sector banks through the FDI route subject to
foreign equity ceiling of 49 per cent. However, the
combined foreign equity (through FDI, FII and NRI routes)
is capped more liberally at 74 per cent.
The resource allocation requirements will be applicable to
the foreign banks on a non-discriminatory basis. While
public and Indian private sector banks have to ensure that
40 per cent of their net bank credit goes to the priority
sector, the limit is only 32 per cent for foreign banks. Finally,
India has offered to replace the Local Advisory Board
requirement with guidelines on the composition of the board
of directors.
In the case of insurance, for both life and non-life insurance
as well as reinsurance and retrocession, India has offered
to allow foreign equity up to 26 per cent. This is in
concordance with the existing regime in India, although an
amendment to increase the restriction to 49 per cent is
under consideration. In the case of auxiliary services like
consultancy, actuarial and risk assessment, foreign equity
up to 51 per cent has been allowed. Moreover, India has
offered to impose no national treatment limitations on
foreign players in life and non-life insurance.
Roadmap for Future
The revised offer on financial services signals a substantial
improvement on what was committed in the Uruguay
Round. Across most sectors India has offered to bind the
existing trade and investment regime. However, India has
been shy of making pre-commitments in certain areas where
further reforms are in India’s own interest. In the insurance
sector, increasing the FDI investment limit up to 49 per
cent over the next 3 years will allow greater infusion of
capital, introduction of new instruments, market expansion
and deeper penetration of insurance services. India can
also undertake pre-commitments for merger and
acquisitions between foreign banks and Indian private
sector banks, especially as RBI’s Roadmap envisions
foreign banks entering into mergers and acquisitions with
Indian private sector banks after 2009, subject to the 74
per cent investment limit.
Another area where pre-commitment would send a positive
signal to India’s trading partners would be regarding
provision of national treatment to foreign banks involving
solvency ratios, income tax, borrowing limits etc. These
would again be consistent with what has been outlined in
the Roadmap. Such pre-commitments would signal
direction of future reforms and give domestic service
providers and regulators time to prepare themselves for
competition and put in place the required regulatory regime.
Finally, given the move towards greater capital account
convertibility and the advent of e-commerce in financial
services, it would be advisable for India to undertake some
commitments in Mode 1 and 2 across most financial
services. This would also strengthen India’s case as it
demands that developed countries provide full market
access and national treatment commitment in Mode 1 and
data processing of financial services under Mode 2
Reforms to Strengthen the Financial Services Sector
While liberalizing the financial services sector undoubtedly
provides greater opportunities for mobilization and efficient
allocation of resources, it is extremely important to have a
proper regulatory structure in place along with opening up
of the economy. Perhaps in no other sector can imprudent
regulations cause more damage than the financial sector
which enjoys strong linkages with the rest of the economy.
Financial sector irregularities were a prime cause of several
recent crises, like the Tequila Crisis (1994), Asian Crisis
(1997) and Argentine Crisis (2001).
As India opens its doors to a large number of global banks,
some of which have assets comparable to India’s GDP,
steps must be taken to strengthen the Indian banks to be
able to compete with these banks as well as generate
greater international presence. These would include further
deregulation of interest rates, reduction in pre-emption of
banks’ resources through Statutory Liquidity Ratio (SLR)
and Cash Reserve Ratio (CRR) among others. With greater
international presence there will be overlaps and potential
conflicts between home country regulators of foreign
service providers and host country regulators. A mechanism
needs to be set in place to resolve such conflicts.
India must also meet the deadlines it has imposed on itself
to conform to the Basel II norms. Currently, foreign banks
operating in India and Indian banks having presence outside
India are required to migrate to the standardized approach
for credit risk and the basic indicator approach for
operational risk under Basel II with effect from 31 March
2008. All other scheduled commercial banks are
encouraged to migrate to these approaches under Basel II
in alignment with them but in any case not later than 31
March 2009.
Public sector dominance in insurance companies also needs
to be lowered to allow greater level playing field between
all players. Resources of these companies must be freed
so that they can undertake investment in long term
infrastructure projects with market determined returns.
More capital needs to be encouraged into the sector as
current rates of insurance penetration in India are well
below the international average.
(by Abhijit Sengupta in WTO News and Views)