Financial Policies

The government comes into the financial picture in three ways. First, it has a monopoly of currency supply. Second, it is a substantial borrower. Finally, it regulates financial markets.

In all these three respects, the Indian government's influence on the economy has been negative. It borrows too much; and its borrowing agent, Reserve Bank, wants to keep down the cost of borrowing. So it borrows as much as possible by issuing currency, which are zero-interest bonds that have never to be repaid. Reserve Bank routinely raises money supply by 16-17 per cent a year -- about 10 per cent more than the growth of real production. Even if we add a couple of per cent for increasing monetisation, Reserve Bank, plans for a high rate of inflation. Inflation was 7 per cent till the 1970s, then it went up to an average of 11 per cent. In the past year it has come down to 2-3 per cent; nothing has changed in monetary policy or in the government's policy of pushing up foodgrain policies. There is no change in the Reserve Bank's rate of money creation, so sooner or later inflation is likely to return to its trend level of 10-12 per cent.

 

When it comes to regulation, the government's ownership of banks and financial institutions leads it to favour them. Thus all of them have high levels of bad debts, and are in effect bankrupt. The correct thing to do with bankrupt firms would be to close them down. But because they belong to the government, it has done everything except close them down. The Bank of Karad was milked by sharebrokers who were later caught in the Bank scam; the government merged it with another bank. Then Manmohan Singh poured new capital into bankrupt banks -- capital which ultimately had to be financed by taxpayers in the form of higher taxes or by the general population in the form of higher prices. When the UTI bankrupted its US-64 by injudicious speculation, Yashwant Sinha bailed it out by giving massive tax concessions to investors in shares and in mutual funds. These are not poor people. If they pay less tax, someone else must pay more -- or there must be more inflation, or both.

Reserve Bank has worked actively to ensure that they do not have to face competition. In the first flush of reforms, Manmohan Singh asked Reserve Bank to license new, private banks. It did license some; quite a few of those were owned by government financial institutions. It received over a hundred applications; it is still sitting on them. Then arose a new threat to government banks -- non-banking financial companies. Starting with the report of the A C Shah Committee, Reserve Bank has seen to it that only a handful of the 40,000-odd NBFCs survived; it has effectively contained their threat to the banks.

Apart from the tax concessions on dividends and capital gains, the government has not tampered too much with the equity market; in fact, the market has greatly improved over the 1990s. Two influences have been important: the setting up of the National Stock Exchange, owned by government financial institutions, and the transfer of regulatory powers from the finance ministry to Securities and Exchange Board of India. Both have turned out to be highly positive developments.

Thus, policy mismanagement lies largely on the side of debt, and concerns the government's handling of banks and lending institutions. Here there has to be more, fairer and more equal competition; and there will not be as long as they remain under government ownership. Hence their privatisation must be the first priority of reforms.

However, privatisation must steer clear of two dangers. First, the banks and FIs must not pass under the control of major borrowers -- for instance, industrialists. In many countries -- including Pakistan --government banks were sold to industrialists, who borrowed from them and made them bankrupt, and then went back to the government for a bail-out. It is possible to minimise this possibility by ensuring that a shareholder or a group of them does not dominate a bank; there can also be rules about who may not own bank shares. Reserve Bank knows all about such restrictions, and would have no difficulty in introducing them. But there is another way: namely, to pass on the ownership to depositors. This is the principle of mutual societies, which predate companies. Mutual insurance companies and mortgage banks in the West are being demutualised and turned into corporate institutions under the pressure of their owners; the owners prefer to own saleable shares instead of illiquid units. But mutualisation may be a good first step to ensure that the banks do not immediately fall into the hands of powerful borrowers.

Second, the market structure is all wrong. There are four huge long-term financial institutions. Of them, two -- IDBI and ICICI -- are too large; they need to be demerged into at least half a dozen institutions. One -- IFCI -- is bankrupt; it should be wound down. The last, UTI, is at last facing healthy competition from private mutual funds; although it is too large, it will cease to be so under the force of competition. Amongst the banks, the State Bank is too large, and should be demerged into half a dozen smaller banks. Of the rest, the bankrupt ones like the United Commercial must be sold off piece by piece; those that are not can be left alone.

But the most important point is to introduce open structures -- structures that allow that entry and exit of new banks, financial institutions and insurance companies. Reserve Bank finds this idea highly unwelcome; it would rather limit the numbers in the hope that it can thereby contain competition and stave off bankruptcies. The insurance regulator is equally against competition. But as I have earlier written, the way to stave off bank bankruptcies is not by limiting competition, but by insisting that every bank writes off doubtful debts out of deposits as soon as they arise. Banks would in effect provide two separate services. One would be to hold cash for depositors; on these cash accounts, the banks would pay no interest at all, and may even charge interest. But they would also offer to invest the deposits for their clients, and offer various options of lending them out to borrowers that vary in risk, and of investing the deposits in marketable securities. Thus banks would offer customers a number of investment options just like mutual funds, and like mutual funds, the banks would pass on the capital risk, including the risk of bad debt, to the investors. An investor would wants safety can keep his money in a cash account; if he wants a return, he must take risk, just like an investor in equity. That would eliminate the risk of bank failure -- and the need for Reserve Bank to restrict competition. All it would have to do is to ensure that banks keep proper accounts and promptly write off losses. The banks' depositors, who would bear the losses, would take their money out of inefficient banks and make sure the banks close down.