Financing a recovery

It needs a deeper bond market, not a subsidised bank

India’s economic recovery depends crucially on restoration of private sector investment. However, there are serious blockages in the investment pipeline. In particular, the widespread and severe asset quality crisis in public sector banks may be causing a lending slowdown. In 2016-17, the rate of growth of bank credit fell to just over 5 per cent — the lowest in 60 years. The obvious way to fix this blockage is to address head on the problem of non-performing assets. However, other viewpoints are also receiving their day in the sun, such as creating new financial institutions specialising in wholesale and long-term finance (WLTF). These WLTF banks “will focus primarily on lending to the infrastructure sector and small, medium and corporate businesses”, and increase liquidity in priority sectors, according to a recent discussion paper from the Reserve Bank of India.

The arguments for such banks appear straightforward. For one, commercial banks are not set up to be the primary financiers of long-gestation infrastructure projects. Such a system has an inbuilt instability, thanks to the asset-liability mismatch in terms of time: Commercial banks rely on short-term deposits and ought not to be lending to long-term projects. In addition, project appraisal is an increasingly arcane skill; the average commercial bank may not have the specific concentrations of human capital or risk appraisal processes necessary to make a success of such lending. WLTF banks can serve to collect and incubate such expertise. The power of these two reasons means that such institutions are not unknown. They helped power East Asia’s growth — Japan’s Long Term Credit Bank was crucial to the country’s industrial development after World War II, for example. In India, organisations such as the Industrial Finance Corporation of India (IFCI), the Industrial Credit and Investment Corporation of India (ICICI) and the Industrial Development Bank of India (IDBI) fulfilled that role in the pre-liberalisation era and contributed a large share of the capital consumed by the manufacturing sector. It is appealing, in this age of Make in India and giant infrastructure projects, to seek to revive such bodies — suitably updated for the post-reform era, of course.

However, the hope that WLTF banks will repair the errors of the rest of the financial sector might be misguided and is certainly backward-looking. Subsidised capital funnelled by government policy to such institutions was wisely phased out in the 1990s. That policy had tended to cause reckless lending, and the build-up of an NPA problem — something also seen with Japan’s LTCB, which collapsed when that country’s asset price bubble burst. There is no reason to suppose new institutions along the same lines will behave differently; they would just add another source of financial instability. What India needs instead is a greater role for markets; to be precise, a better developed and bigger bond market. The ratio of bank deposits to the GDP is about two-thirds but that of outstanding corporate bonds to GDP is usually well below a fifth. This is much lower than global standards. It is through a private bond market that capacity can be created for project appraisal, and liquidity restored to the markets for long-term capital. A new, subsidised institution will not help, only fiscal restraint will.