Following the global crisis, some fundamental factors have been identified as being critical to the efficiency and stability of the financial sector. Where does India stand in this respect? Some of these important factors are discussed here. For instance, mutual funds are meant for the individual investor and they have tax benefits - yet corporates and banks invest in them. Another important factor is the multiplicity of transactions in the financial sector raising the possibility of excessive financialisation. Yet another question must be asked about commercial bank lending to profit-seeking microfinance institutions. And with limited lending to the real sector there seems to be a hollowness emerging in commercial bank services in India.

COMMENTARY

India’s Financial Sector in Current Times

Y V Reddy

Following the global crisis, some fundamental factors have been identiﬁed as being critical to the efﬁciency and stability of the ﬁnancial sector. Where does India stand in this respect? Some of these important factors are discussed here. For instance, mutual funds are meant for the individual investor and they have tax beneﬁts – yet corporates and banks invest in them. Another important factor is the multiplicity of transactions in the ﬁnancial sector raising the possibility of excessive ﬁnancialisation. Yet another question must be asked about commercial bank lending to proﬁt-seeking microﬁnance institutions. And with limited lending to the real sector there seems to be a hollowness emerging in commercial bank services in India.

This is a slightly modiﬁed text of the S Guhan Memorial Lecture delivered in Chennai on 29 October 2009. I am grateful to the organisers, namely, Citizen Consumer and Civic Action Group, for extending the invitation to deliver the lecture. S G uhan’s reputation as a distinguished scholar, as a thorough gentleman, as an outstanding civil servant, as a respected authority in applied economics and above all as one committed to highest values in life, are well known.

Y V Reddy was governor, Reserve Bank of India (2003-08).

Economic & Political Weekly

november 7, 2009

he global ﬁnancial crisis, which is still underway, has replaced past assertions of what the right model of the ﬁnancial sector should be and has imparted great uncertainty to what it should ideally be. Most countries, especially those who were leading the way for others like the United States (US), the United Kingdom (UK), and continental west Europe have embarked on a mission to reform their ﬁnancial sector, while a group of 20 of the leading countries of the world is attempting coordination of policies at the global level. In this scenario of heightened uncertainty and simultaneous search for optimal models of the ﬁnancial sector in the global community and at the national level, it is useful to look at where we in India stand and what we should be doing or not doing.

Currently, there are several responses to the question what next for India’s ﬁnancial sector? I will list a few of them here and brieﬂy comment on each of them.

First, some say that India has been saved from the ﬁnancial crisis only because policy was conservative and did not act to improve the efﬁciency of the system. Hence, the prescription is to act now.

This view is not right simply because I ndia was active in policy interventions in both the monetary and ﬁnancial sectors. The Reserve Bank of India (RBI) adopted an active countercyclical policy, while many others failed to intervene. There is another problem with acting rapidly or comprehensively now for reform – because there is no agreement on the right model for the ﬁnancial sector.

It is, therefore, desirable to look carefully and pragmatically at speciﬁc and urgent issues that need attention and not to proceed with what I would call yesterday’s beliefs on what is good for tomorrow.

Second, some say that we have had good growth, stability and have withstood the crisis. Hence, let us proceed with what we already have in place. In my view,

vol xliv no 45

inaction across the board is wrong since there are several inadequacies in our ﬁnancial system, ranging from the creditculture to ﬁnancial exclusion and poor service. Serious inﬁrmities that could cause a crisis may not exist in our system, but the ﬁnancial sector is yet to fully serve

the needs of the real sector. The needs of the real sector can be met only when there are synch ronised reforms in both the real and ﬁnancial sectors.

A thoughtful and pragmatic approach to segment or sector-speciﬁc interconnected issues of the real and ﬁnancial sectors in India is needed, not inaction. This point may be illustrated with housing ﬁ nance. Housing should be a priority for India, in view of demographics, the growth trend and urbanisation. Hence, housing ﬁnance ought to be encouraged. But for housing ﬁnance to be viable and efﬁcient, there should be reasonably good housing markets, and preferably liquid markets. However, the current nature of formal and informal construction activity as well as ﬁnancing models, high transaction costs in terms of registration fees, difﬁcult tenancy laws, non-standardised layouts, inadequate processes of price discovery, unrealistic loan to rental value ratios, etc, all make the housing markets in general very complex and illiquid at this juncture. Thus, developments and reform in housing products and housing ﬁnance products should be reviewed together while focusing on increasing housing ﬁnance and innovating related products.

Third, some feel that our ﬁnancial system needs improvements and there are reform proposals already announced such as in the Union Budget and Economic Survey. They argue that these should be implemented but with changes in view of the lessons from the global ﬁnancial crisis.

We should recognise that the lessons that we are in the process of learning are of a fundamental nature and not merely incremental. The intellectual basis of some of the reforms under consideration in India prior to the crisis is now being questioned. Let me illustrate with the attitude to the Tobin Tax on global ﬁnancia l ﬂows. This was considered by many to be retrograde and unpractical till recently both in India and globally. Now, eminent persons in ﬁnance such as former

COMMENTARY

US Fed chief Paul Volcker and current chief of the UK Financial Services Autho rity, Adair Turner suggest consideration of such a tax even for domestic ﬁnancial transactions. Brazil has actually announced a few measures, including the imposition of a 2% tax on capital inﬂows. The G-20 has recognised the need for capital controls, if temporary.

What does this mean for India? This idea could be examined for the forex market and also suitably modiﬁed for the securities transaction tax system and extend to transactions in participatory notes, though they are traded abroad. Similarly, issues of tax arbitrage and residents are being revisited globally, and need to be revisited by India also.

Finally, as a result of the crisis, there are some fundamental factors that have been identiﬁed as being critical to the efﬁciency and stability of the ﬁnancial sectors. I subscribe to the view that it is essential to assess our ﬁnancial system with reference to these critical factors or questions that have been ﬂagged in global debates. I will now pose some of these possible questions and comment on the status.

(i) Is macroeconomic management reasonably balanced?

The answer is obviously yes – by and large. We have no excessive current a ccount surplus or deﬁcit; no excessive dependence on exports or external demand; no excessive reliance on investment or consumption expenditure; and, no excessive leverage in most households or corporates or ﬁnancial intermediaries.

We are, however, vulnerable to shocks on four fronts: fuel, food, ﬁscal, and (external) ﬁnance. In regard to the ﬁscal, the quality of management and subordination of monetary policy continue to be issues. On the external sector, the quality of capital ﬂows will continue to be an area of concern. In particular, the quality of f oreign direct investment (FDI) also d eserves close scrutiny. The discussion on foreign capital inﬂows often makes a distinction between FDI, external commercial borrowings and investments by foreign institutional investors. The usual o bservation is that FDI is the most stable and most valued of these inﬂows because it ﬂows to manufacturing/service companies.

However, it is time to assess the difference in size and role played by two types of FDI: that used for mergers and acquisition of running companies and that which ﬁnances green ﬁeld projects.

(ii) Is monetary policy sound and well equipped?

The answer is yes – by and large. The objectives of growth, price stability and ﬁnancial stability have been delivered and our regime of multiplicity in indicators, objectives and instruments has gained r espectability globally. The successful management of the impossible trilemma has also been noticed.

There are, however, some challenges which will continue to confront monetary policy: ﬁscal dominance, public policies especially on administered interest rates that inhibit transmission of monetary measures, management of the capital account, and reliance on the wholesale price index as headline inﬂation in contrast to the practice in the rest of the world.

(iii) Are there suitable mechanisms for regulatory coordination in the ﬁnancial sector?

The answer is broadly yes, but there is scope for improvement. A high level committee (assisted by inter regulatory technical committees) on ﬁnancial markets presided over by the governor of the RBI with membership of other regulators and the Ministry of Finance is in place. The i nteresting feature, however, is that the secretariat to this committee is provided by the Ministry of Finance while the RBI is expected to assume responsibilities for ﬁ nancial stability.

(iv) Are there incentive systems that are inappropriate for the stability of the ﬁnancial system and go against the interests of depositors or investors?

Perhaps a systematic study may be needed on this before we come to any conclusions. Let me illustrate this with the mutual fund industry which could be a p otential area for a serious study. Mutual funds are institutions meant to serve the interest of several small investors who may not have the time, experience, expertise or means of managing their investment portfolio directly. So savings of individual investors are pooled into a fund with a genuine mutuality. Contrary to this objective of a mutual fund, corporates, non-banking ﬁnancial companies (NBFCs) and banks are permitted to invest in the funds and they enjoy tax beneﬁts as well. If the mutual funds, which are meant to service individuals are permitted to raise funds from other institutions, the incentives in the whole management could serve the interests of these large institutions only. In fact, if such funds are sponsored by such institutions, the incentives may be to dilute the focus on individuals’ interests, to the point of their subordination to interests of other institutions and markets with systemic consequences.

(v) Is there evidence of a conﬂict of interest in ﬁnancial sector?

This is another area where a study is needed to make an assessment. Events in India during the crisis have shown that e xtraordinary liquidity facilities had to be provided by the RBI in late 2008 for mutual funds and to NBFCs, which may be indicative of their vulnerabilities. It is also noteworthy, that some mutual funds and NBFCs have close afﬁliations with large corporates or banks. No doubt, there could be what may be technically termed as ﬁrewalls, but a detailed study of their interlinkages, actual operations in concert or clusters with each other and in the equity and corporate bond markets would help give reassurance that serious conﬂicts of interests with systemic consequences are not pervasive.

For the Attention of Subscribers and Subscription Agencies Outside India

It has come to our notice that a large number of subscriptions to the EPW from outside the country together with the subscription payments sent to supposed subscription agents in India have not been forwarded to us.

We wish to point out to subscribers and subscription agencies outside India that all foreign subscriptions, together with the appropriate remittances, must be forwarded to us and not to unauthorised third parties in India.

We take no responsibility whatsoever in respect of subscriptions not registered with us.

MANAGER

november 7, 2009 vol xliv no 45

Economic & Political Weekly

COMMENTARY

(vi) Is there evidence of excessive ﬁnan

cialisation? Excessive ﬁnancialisation may be

o ccurring due to the proclivities of ﬁnancial markets and institutions to create a multiplicity of transactions since they

o btain incomes through margins on trading. Generally speaking, when multiplicity in ﬁnancial transactions take place with no visible signs of redistributing risk or more efﬁciently reallocating resources, it amounts to excessive ﬁnancialisation.

In the absence of large-scale derivatives, structured products, etc, prima facie there may be no reason to suspect excessive ﬁnancialisation, but eternal vigilance is the price to be paid to ensure stability.

I can think of one area, which may need study and this relates to the ﬁnancing of infrastructure. Consider one scenario in this regard. The India Infrastructure Finance Company Ltd (IIFCL) is a 100% government of India owned agency to fund infrastructure. The IIFCL issues bonds to raise resources for lending to infrastructure. Possibly commercial banks, especially public sector banks, subscribe to a large chunk, say 70% of these bonds. The IIFCL, in turn, offers to reﬁnance the banks to the tune of say 70% of their lending to infrastructure. Since there is only reﬁnance to banks, implicitly the lending risk is borne by the banks. Banks thus lend to infrastructure by ﬁrst giving resources to IIFCL and again get the reﬁnance for IIFCL, while retaining the attendant risks for themselves. In this arrangement, the primary risk remains with the bank and overall risk with the government which may or may not guarantee bonds but owns both IIFCL and public sector banks. There is no evidence of additionality of funds, but there could be transaction costs for issue of bonds and trading in bonds, adding to the multiplicity of ﬁnancial transactions. To this scenario may be added the additional dimension of guarantees extended by banks, especially public sector ones, to the external commercial borrowings by the same entity that is being ﬁnanced by the bank. These may be hypothetical scenarios but studies relevant to excessive ﬁnancialisation would give comfort to systemic stability, in view of the size of the transactions.

(vii) Is there any evidence of irresponsible lending, like the sub-prime in US?

There is no direct evidence of any largescale lending in India that could be characterised as irresponsible lending. But, a study should be made of commercial banks’ lending and support to micro-ﬁnance institutions which are proﬁt-seeking (MFI-PS). Here also, one can describe a possible scenario. A commercial bank may legitimately prefer to lend to an MFI-PS at a rate far higher than it is permitted to lend to its low-income customers. Bank lending to MFI-PS gets the beneﬁt of treatment as priority sector lending. The MFI-PS, in turn, charges market-based rates of interest, while not attracting the jurisdiction of laws relating to moneylending or usury. Micro-ﬁnance is an area of respectability, and the impressive proﬁtability of MFI-PS in India is attracting investments from private equity funds globally, with a huge premium.

There may therefore be merit in a d etailed analysis in a sort of supervisory review of the incipient tendency towards irresponsible or usurious lending through MFI-PS: It is useful to note that these M FI-P S are growing too rapidly and making too much proﬁt for comfort.

(viii) Are there any concerns relating to the integrity of ﬁnancial markets?

There are no visible signs of a lack of i ntegrity. However, a deeper study of i ntegrity of two of the markets may add to the comfort of the analysts. First, the corporate debt market continues to be dominated by private placement and select players, and the process of price discovery is yet to gain full credibility. Second, in the money markets, short-term instruments exchanged between corporates, insurance companies and mutual funds may be large in magnitude, posing issues relating to a conﬂict of interest and systemic stability.

(ix) Is the banking system sound, resilient, efﬁcient and performing the functions expected of the system?

India, like many developing economies, has a bank-dominated ﬁnancial system. There is broad agreement about the strength and resilience of banks in India, while there are debates on the level of efﬁciency in the context of externally imposed policy constraints and governance standards. However, in my view, we have to assess whether there is a hollowness in the provision of banking services in our country. I am not referring to the issue of ﬁnancial inclusion or efﬁciency of customer service, though both are important and need attention. I am referring to the main functions of a bank, namely, taking deposits, and providing credit, especially for working capital and for other productive sectors. Over a quarter of the asset base of banks is already earmarked for government securities. Banks are encouraged to participate in bond markets, establish private equity or venture capital subsidiaries and step up lending to infrastructure, as well as housing. They are also allowed in equity. The banks also invest in mutual funds. As a result, there is a reduction in advances for working capital and other funding, especially to agriculture, small business, and small and medium industry. But these are the sectors that need the funding of banks most and their access to the new forms of funding through capital markets is limited. Banks are expected to have special retail skills to make such a dvances. The main justiﬁcation for issuing a banking licence is primarily to conduct traditional retail banking activities that are vital to facilitate economic growth at our stage of development. A study of this emerging hollowness in the traditional lending pattern is essential.

There is a need to consider policies that will promote a banking system that serves India’s needs at this stage of development. Such policies would mean emphasis on lending directly to real sector activities by banks. Banks’ subscribing to further ﬁnancialisation of the funds that depositors place in the bank needs to be viewed with disfavour and indeed curbed at this stage. Approaches in this direction should also avoid the pitfalls that were observed in the extensively practised originate-todistribute model of lending by banks in other countries.