The Hindu Business Line : Banking on the unattainable

The background to the Planning Commission constituting the Raghuram Rajan Committee on financial sector reforms is unclear. Dominated by bankers, the panel has offered them a Christmas tree studded with all the gifts they have been pining for. In its draft report, there is no attempt to study institutional linkages or constraints. It claims to base its findings on “a new paradigm in the financial sector.”

The Committee explains that the role of the government is to create an enabling environment for the private sector by building sound infrastructure.

It is inspired by the transformation of the telecom and IT sectors and hopes that a shift in paradigm could usher in similar revolution in the financial sector. On all accounts, the parallel is inappropriate.

Countries have evolved different banking systems and practices dating back to their past. Efforts to impose the Anglo-Saxon model on all other nations have failed. There are also differences in regulatory structures. The panel’s views about the current turmoil might interest the US Treasury. It says that the meltdown was not a sign of the market’s failure but an instance where “markets and institutions do succumb occasionally to excesses!” It advises the regulators to be more vigilant but exercise a right balance.

Even as the Committee expresses its faith in the market to reduce vulnerabilities, it does recognise that all markets are not the same. It admires the way the US market has withstood the turmoil and contrasts it with the Indian stocks which have been beaten down. It does not follow the same logic when it deals with FII flows, and recommends that there should be no restriction.

It is not practicable to cover all the issues included in the report. However, an attempt is made to deal with them selectively.

Fundamentalist view

The panel has a fundamentalist view of the Asian crisis and the responses to it. It explains that the crisis was not caused by foreign capital or banks but by poor governance, poor risk management, and so on, which led to ‘second generation’ reforms.

Ten years after the crisis, there is a better understanding or agreement on the causes leading to the crisis. It is idle to pretend that foreign banks had no role.

The crisis was caused by the undue haste in liberalisation without creating the infrastructure for absorbing the capital and strengthening regulation. By ignoring this history, the Committee provides a recipe for disaster.

The same logic leads to its deconstruction of the regulatory framework put in place by the RBI over the years.

The gradualism in financial opening adopted by the RBI and the Central Government has been admired globally, including by the IMF economists. However, Dr Rajan, at a press meet after delivering the Palkhiwala Memorial Lecture on January 13, 2005, denied that India’s economic reforms were calibrated to avoid serious crises. He said they were the result of a “sclerosis.”

Later, in a speech at the University of Pennsylvania, he referred to the RBI “beating its drums” that it had no crises. (India@Wharton, Raghuram Rajan on ‘Rewriting the Rules for Indian Banks,’ November 15, 2007).

He went on to say that he would settle for a few crises on the way to higher growth as in Korea. He would be disheartened to know that Korea has since banned the entry of foreign banks.

Disturbing framework

It is the macroeconomic framework that is disturbing. There is a karmic view of foreign flows leading to the recommendation that there be no effort to affect the exchange rate. This is based on the belief that capital flows leave the country with “the Hobson’s choice of taking inflation or nominal exchange rate appreciation.” There is no third way!

In the panel’s view, the RBI’s intervention confuses the market. In short, the RBI and the government should abdicate their roles and give the market a free hand. Even bankers would be uneasy with such a paradise. As in the US and Europe now, they would seek succour from the US Fed or the ECB.

The same framework leads to its version of monetary policy. It urges the RBI to concern itself only with interest rates. Rather, interest rate should be on autopilot and driven by inflation rates.

Central banks the world over would be aghast at such a suggestion after the recent turmoil, when globalisation has played havoc with prices and rates.

The suggested framework would decimate the multiple policy approach of the RBI to grapple with the ‘Impossible Trinity.’ It tries to do this without any evidence of bad management or dysfunction. It is overwhelmed by its desire to uphold the primacy of the market.

The panel’s reliance on capital flows to lift the economy and lead to greater financial inclusion is misconceived. Economists are a chastened lot now and have lost faith in the impact of capital on growth.

In a profound study by Easwar Prasad, et al, the authors conclude that empirical evidence has not established that financial integration enhances growth in developing countries. (Financial Globalisation, Growth and Volatility in Developing Countries, NBER Working Paper No.10942, December 2004). They advise countries to experiment with different paces and strategies in pursuing financial integration.

The other faith is that foreign bank entry would ensure greater financial inclusion. This issue is fairly covered in several studies. Some of them are by Dr Rajan along with his colleagues.

They explain how when foreign banks deal with local firms, there are information asymmetries that lead to reduction in access to credit. By and large, foreign banks have crony relations with FDI. Like trade following flags, banks follow FDI.

There is evidence that foreign banks do not meet the credit needs of all domestic investors. They engage in “cherry picking” or “cream-skimming” and leave the high-risk creditors to domestic banks and weaken them.

An interesting study on India by Prof Todd Gormley of Washington University at St. Louis. (The impact of Foreign Bank Entry in Emerging Markets: Evidence from India, December 10, 2007) shows that foreign banks financed only a small set of profitable firms and there is a systemic drop in domestic loans.

These studies on foreign bank operations in emerging economies question the assumption of the Committee that foreign bank entry will lead to greater financial inclusion.

Story of wishes and horses

According to the panel, India’s financial salvation is through the development of a bond market. Sadly, it is a story of wishes and horses. Some of the senior bankers in the Committee could have moderated its zeal by drawing attention to efforts made in the past and the constraints in promoting a healthy bond market. After the Asian crisis, there have been pressures by reform enthusiasts to promote bond markets. Foreign banks wished to shift the risk attached to loans through bond issues.

However, the bond market requires a corporate culture and infrastructure that do not exist in developing countries. High savings rate and abundant liquidity militate against bond issues. Corporates, for their own reasons, opt for equity, foreign currency loans, depository receipts or other variants.

The Committee wants a level playing ground for banks and suggests that the special advantages of public sector banks be removed. Though it would like all of them to be privatised, it bows to public opinion and wants under-performing banks to be sold through strategic sales.

There are reworked themes on improving the management of public sector banks. These are of the B-School variety. Among others, it expects public sector banks to be taken out of the purview of the Central Vigilance Commission and also Parliament.

While it does not opt for a supreme regulator, it recommends the establishment of a statutory Financial Sector Oversight Agency (FSOA).

This can create more problems with other agencies. It cannot be an improvement over the current elegant set-up of the High Level Committee on Capital Market. It is chaired by the RBI Governor with access to the Finance Minister to resolve differences, if necessary.

Finally, the panel hangs its coat on the Percy Mistry Committee Report on ‘Making Mumbai an International Financial Centre; and hopes for a rewriting of all legislation on financial sector regulation.

Bankers may not be able to digest all the gifts hanging from the Christmas tree. Wiser bankers may be aware that they are unattainable for other reasons.

(The author is a former Finance Ministry official with extensive experience in international, financial and trade issues.)

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