I am greatly honoured by the invitation to deliver S. Guhan Memorial Lecture. I am grateful to the organisers namely, Citizen Consumer and Civic Action Group, for extending the invitation. Mr. Guhan’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. Personally I had the privilege of meeting him on several academic and policy fora and, interacting closely with him. In fact, I was deeply touched when he invited me, about twenty years ago, to consider heading the Madras Institute of Development Studies. So, there are many good reasons for my being here and paying a personal tribute to Mr. Guhan and his lasting contributions to a better informed and more civilised society.
I have chosen the subject for today’s lecture, keeping in view both the contemporary relevance and fundamental importance of issues relating to the financial sector. The global financial crisis which is still underway, has replaced assertions of what is the right model of financial sector and has imparted great uncertainty to what it should ideally be. Most countries, especially those who were leading the way for others like U.S.A, U.K, and Europe have embarked on a mission to reform their financial sector, while a group of 20 of leading countries of the world is attempting coordination of policies at global level. In this scenario of heightened uncertainty and simultaneous search for optimal models of financial sector, in global community and at national levels, 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 this question of what next for India’s financial sector? I will state a few of them and briefly comment on each of them.
First, some say that India has been saved from the financial crisis only because the 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 India was active in policy interventions in both monetary and financial sector. RBI adopted 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 right model for 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 crisis. Hence, let us proceed with what we already have in place.
In my view, inaction across the board is wrong since there are several inadequacies in our financial system, ranging from credit-culture to financial exclusion and poor service. Serious infirmities that could cause a crisis may not exist in our system but financial sector is yet to fully serve the needs of real sector. The needs of the real sector can be met only when there are synchronised reforms in both real and financial sector.
A thoughtful and pragmatic approach to segment or sector specific inter connected issues of real and financial sectors in India is needed; and not inaction. This point may be illustrated with housing finance. Housing should be a priority for India, in view of demographics, 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, preferably liquid markets. The nature of formal and informal construction activity as well as financing models; high transaction costs in terms of registration fee etc; difficult tenancy laws; non-standardised layouts etc; inadequate processes of price discovery; unrealistic loan to rental value ratios etc., 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 of 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 budget, economic survey etc. 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 are being questioned now. Let me illustrate with attitude to Tobin Tax. 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 U.S. Fed Chief Paul Volcker and current chief of U.K. F.S.A, Lord Turner suggest consideration of such a tax even for domestic financial transactions. Brazil has actually announced a few measures. G-20 has recognised the need for capital controls, if temporary.
What does this mean for India? This idea could be examined for forex market and also suitably modifying securities transaction tax system and extending them 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 the global debates. I will now pose some of these possible questions and comment on the status.
First Question: Is macro economic management reasonably balanced?
The answer is obviously yes – by and large. We have no excessive current account 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 Finance – external. In regard to fiscal, the quality of management and subordination of monetary policy continue to be issues. On external sector, the quality of capital flows will continue to be an area of concern. In particular, quality of FDI (Foreign Direct Investment) also deserves a close look, in terms of extent to which FDIs are financing green field projects.
Second Question: 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 respectability globally. The successful management of 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 capital account; and reliance on whole sale price index as headline inflation in contrast to the practice in the rest of the world.
Third Question: Are there suitable mechanisms for regulatory coordination in financial sector?
The answer is broadly yes, but with some scope for improvement. A high level committee (assisted by inter regulatory technical committees) on financial markets presided over by Governor, RBI with membership of other regulators and Ministry of Finance is in place. The interesting feature, however, is that the secretariat to this committee is provided by the Ministry of Finance while RBI is expected to assume responsibilities for financial stability.
Fourth Question: Are there incentive systems that are inappropriate for stability of the financial system and the interests of depositors or investors?
Perhaps a systematic study may be needed on this before we make any conclusions. Let me illustrate this with mutual fund industry which could be a potential area for a serious study. Mutual funds are institutions meant to serve the interest of several small investors who may not have 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 any mutual fund, corporates, non-bank financial companies and banks are permitted to invest in these funds and they enjoy tax benefits also. 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. Infact, 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.
Fifth Question: Is there evidence of conflicts of interests in financial sector?
This is another area in which study is needed to make an assessment. Events in India during the crisis have shown that extra-ordinary liquidity facilities had to be provided by RBI 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 fire walls, 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 reassurance that serious conflicts of interests with systemic consequences are not pervasive.
Sixth Question: Is there evidence of excessive financialisation?
Excessive financialisation may be occurring due to the proclivities of financial markets and institutions to multiplicity of transactions since they obtain 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 face there may be no reason to suspect excessive financialisation, but eternal vigilance is a 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. IIFCL is a hundred percent Government of India owned agency to fund infrastructure. 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 getting the refinance for IIFCL, while retaining attendant risks for themselves. In this arrangement, the primary risk remains with the bank and overall risk with 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 the systemic stability, in view of the size of the transactions.
Seventh question: Is there any evidence of irresponsible lending, like the sub prime in U.S.A.?
There is no direct evidence of any large scale 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 money lending or usury. Micro-finance is an area of respectability, and 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 detailed 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 MFI-PS are growing too rapidly and making too much profits for comfort.
Eighth question: Are there any concerns relating to integrity of financial markets?
There are no visible signs of lack of integrity. However, a deeper study of integrity 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 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 conflicts of interests and systemic stability.
Ninth and last question: 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 a broad agreement about 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 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 towards 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 advances. 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 on this emerging hollowness in 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 to distribute model of lending by banks in other countries.
Now, I look forward to the benefit of interaction with this august gathering here.
Let me conclude by thanking the organisers for the honour conferred upon me and for all courtesies extended to me and reiterating my highest regard to the values cherished by Mr Guhan.