FinancialsectorreforminIndia

Bridgingthegulf
Afinancialsystemintendedtopromoteequalityandstabilitynolongerdoes

Nov30th2013|MUMBAI| Fromtheprintedition

SINCEtakingofficeinSeptember

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RaghuramRajan,thegovernorofIndiascentralbank,has
championedfinancialsectorliberalisationasawaytoboost
growthandhelpthepoor.Changeisrisky,hehassaid.Butas
Indiadevelops,notchangingisevenriskier.
Indiasfinancialsystemislikearamshackleenginelovingly
maintainedbyasectofoilspatteredengineersandwearily
toleratedbymostpeoplewhodependonit.AfterIndiraGandhi,
thenprimeminister,nationalisedmostbanksin1969,India

slippedtowardsfinancialsocialism,withacentralbankthat
printedrupeesonpoliticianscommand.WhenIndiaopenedup
in1991awaveofreformtookplace.Thesystemtodayisa
mishmash.Marketforceshavearole,butthestateloomslarge.
Thereareseveralwellrunprivatebanks,
suchasHDFC.Butpublicsectorbanks
(mostofwhicharelistedbutunderstate
control)makethreequartersofallloans.
Foreignbanksmarketshareis5%.
Unlicensedmoneylendersthrive,hintingat
lotsofunmetdemandforcredit.

Inthissection
Bridgingthegulf
Capandtirade
Politicalstaple
Stressedout
Rustproof
Wonderfulwhileitlasted
Computersaysno

TheReserveBankofIndia(RBI)isnowfairly
Areasonablesupply
independentandnolongersetstheratesof
Reprints
interestbankscharge,butitstillmanipulates
theflowofcredittoassistthegovernment
and,atleastnotionally,thepoor.Banksmustinvest23%of
theirdepositsingovernmentbonds,andparkafurther4%with
theRBI.Thiscreatesacaptivemarketforpublicdebt,thebulk
ofwhichisownedbybanks.Some40%ofloansmustbe
directedtowardsprioritysectors,mainlyagriculture.Taken
togethertheserulesmeanthat58%ofthedepositsthebanking
systemraisesaredeployedaccordingtothegovernments
preference.
Aplethoraofrestrictionsmeansthecorporatebondmarketis

tiny.Thishelpsthegovernmentsinceitmeansthatitsbonds
aretheonlygameintownforfixedincomeinvestors.Whereas
thestockmarketisveryopen,capitalcontrolsgoverntheflowof
foreignfundsintothedebtmarketandlimittheuseofcurrency
derivatives.TheRBIintervenesinthemarkettomanage
governmentbondyields.Thishelpsthestatetoborrow
cheaply.
Thishybridsystemisnotanaccidentofhistory.Manyofficials
feelthatfinanceistooimportanttobelefttoeitherfreemarkets
orpoliticians.Afterall,Indiasbubblewrappedsystemwas
unscathedbytheAsiancrisisin199798andtheglobalcrisisin
200709.TheRBIisoneofIndiasbestinstitutionsuncorrupt
andcapable.
Butforallthegoodintentionsthetruthisthatthishybridsystem
maynowpromotesocialinequalityandfinancialinstabilitythe
twinevilsitismeanttoeradicate.Forastart,afterdecadesof
statedirectiononly35%ofadultshavebankaccounts.This
perpetuatespovertyandmakesithardtocollecttaxes.
Baddebtshavebecomeaproblem,too.About11%ofstate
banksloanshavesoured.Thereservestheyholdarelowand
theircapitallevelsaremediocre.BecauseofIndiasweaklegal
system,banksdislikeforcingfirmsintobankruptcy.Partofthe
problemistemporary,reflectingtheeconomicslowdownand
bottlenecksininfrastructureprojects.Butstatebankshave

beenpressedtorollovercreditlinestotroubledbutwell
connectedbigfirmsthatmostprivatebankssteerclearof.This
sortofcronyismmakesthebankingsystemlessstable.Itis
alsounfair:thepublicissubsidisinginepttycoons.
Nannyfinancehasnotcreatedanationalchampion.Indias
biggestlenderbymarketcapitalisation,HDFC,isranked63rd
globally.Nolocalbankyethastheinternationalsavvyofits
Chinese,BrazilianandRussiancounterparts.Allthoserules
havepushedactivityoffshore.Atleasthalfofallrupeetrading
isabroad.CitigroupandStandardChartered,whichalongwith
HSBCarethebiggestforeignbanksinIndia,haveanoverall
exposuretothecountry(includingloans,tradingpositionsand
derivatives)thatis1.9timesthesizeoftheirregulatedIndian
operations.
Thehybridsystemiscomplicitinaborrowingbingebythe
government:thebudgetdeficitisrunningat78%ofGDP.
SincebondyieldsarehelddownartificiallybytheRBI,which
buysbondsitselfandforcesbanksto,politicianscanborrow
heavilywithoutfearofabuyersstrike.
Lowinterestratesandfastrisingpricesmeanthereturnsavers
getondepositsisbelowconsumerpriceinflation(CPI).Some
peoplebuysharesinstead,butmanybypasstheformal
financialsystemandbuygold,strainingthebalanceof
payments.Overhalfofthecurrentaccountdeficitof4.8%of

GDPintheyeartoMarch2013wasduetobullionimports.The
viciouscycleofborrowing,inflationandgoldpartlyexplainsthe
22%slumpintherupeebetweenMayandAugust.Ithassince
recoveredathirdofitslosses,partlythankstoMrRajans
soothingpresence.
MrRajansliberalisingvisionwasoutlinedinanofficialreport
thathewrotein2008,whenhewasanacademic.Itwas
politelyignoredatthetimebyanestablishmentthatwas
enjoyingamomentofSchadenfreudeasWesterncountrieswhich
hadhectoredIndiasawtheirbanksimplode.Nowheisin
chargeattheRBIhewantstocreateablastofcompetitionthat
willspreadfinancetomoreIndians.TheRBIwillgivelicences
tonewbanks,probablyearlynextyear,andallowforeignbanks
toexpandfasteraslongastheycreatelocalsubsidiariesthat
canberegulatedeasily.Therulesthatforcebankstobuy
governmentdebtwillberelaxedinacalibratedway.MrRajan
sayshewillstoptycoonsfromexploitingthesystemandforce
bankstorecognisebaddebts.Hisunspokenhopeisprobably
thatstatebankswillbefullyprivatisedandforcedtoraisetheir
game.
Allthisiseasiersaidthandone.Lettingprivateshareholders
ownamajorityofstatebankswouldrequireanactof
parliament.Indiaspoliticianslikethepowertheyhaveover
theselenders.PalaniappanChidambaram,thefinanceminister,

hasbeenurgingthemtolendmoretorevivetheeconomy.The
publicsectorbanksareunionisedandresistanttochange.
Privatebanks,meanwhile,arenotcharities.Somestruggleto
gatherenoughdeposits,limitingtheirgrowth.Ahugeexpansion
inthenumberofbrancheswouldhelp,butmightnotbe
profitable.Theseinstitutionsprefertolendtoyuppiesthanto
farmersandinfrastructureprojects.IftheRBIgavenew
licencestoindustrialhousessuchasRelianceGroup,they
mightusetheirpowerfulbrandstoattractasurgeofdeposits.
Butthatwouldfurtherconcentratepowerinthehandsofafew,
andleadtoaccusationsofcronyism.
Norareforeignbankssaints.HSBCandStandardChartered
make7090%oftheirIndianprofitsfrominvestmentand
corporatebanking.CitiandHSBC,alongwithBarclays,have
alreadyburnedtheirfingersinapushtolendtoindividuals.In
200610theyledafrenzyinunsecuredconsumerloansand
collectivelylost$3billion.Toobigtofailforeignbanksmightbe
keentotakeoverlendersinIndia.Buttheirjumpyregulatorsin
theWestmightobject.
MrRajanistryingtoreformatalowpointintheeconomic
cycle.Thatcreatesitsownproblems.Wouldhereallybe
preparedtotriggerawaveofdefaultsinordertocleanup
Indiasbaddebts?Itseemsunlikely.Ifheraisedinterestrates
aboveCPI,saverswouldapplaudbutgrowthwouldfallfurther.

Andjustmonthsafterafinancial
panicandadangerousspikein
yields,itwillbenearimpossiblefor
theRBItoderegulatethebond
market.InmidNovemberhesaid
theRBIwouldagaininterveneto
preventliquiditytightness.The
centralbanknowownsatleast
17%ofallcentralgovernment
bonds,thehighestlevelsincethecrisisyearsoftheearly
1990s.Itnowownsmoreofitslocalbondmarketthanthe
FederalReserveafteryearsofquantitativeeasing(seechart).
Foraquickjolttothesystem,MrRajansbesthopeisto
embracelowcostmobilebanking.IndiahaslaggedAfricain
embracingthistechnology.Buttoreformthebondmarketand
traditionalbankinghewillfirsthavetochangetheRBI.Todayit
isthehonourableguardianofthestatusquo.Tomorrowitcould
beaforceforreformthattakesrisksandpersuadespoliticians
thatanimblerfinancialsystemwillmakeIndiaricherandmore
stable.Confrontingvestedinterestsandingrainedthinkingwill
beaslogbuttherewardscouldbeimmense.
Fromtheprintedition:Financeandeconomics