The RBI needs a course correction

Two developments suggest that a review of the state of the financial sector in India would be timely. First, corporate indebtedness has risen significantly.

One estimate places it at 50 per cent of GDP. If this is accurate, it is high indeed. Rising indebtedness has continued even as growth has slowed in the past five years. .

Second, increased indebtedness is most noticeable among India’s largest corporate houses. From a policy perspective we would want to avoid being saddled with a “too big to (be allowed to) fail” situation. The mirror image of the growing indebtedness is a rise in the non-performing assets of public sector banks in particular.

The RBI has initiated steps to reform the banking sector. The PJ Nayak Committee has made some bold recommendations on the governance of public sector banks, perceived to be in poor shape. The public want to know how Kingfisher Airlines was given such a long rope in the form of credit lines. They are very likely aghast at the state of affairs at Syndicate Bank whose chairman has been charged with accepting a bribe from a financially weak client.

There is also a perception that the government has forced the public sector banks to increase their lending to the infrastructure sector so that its own funds can be used for expanding welfare schemes. This strategy is inherently risky, given the maturity structure involved and the fact that banks have little expertise in such a line of business to separate good projects from bad. Is it surprising, then, that public sector banks have larger NPAs than their counterparts in the private sector?

It is with this as background that we should approach the implications for India of the evolving debate on the objectives of central banking. Following the global financial crisis, there is near unanimity that macroeconomic policy cannot afford to focus on inflation alone. Macroeconomic stability from 1990 masked a crisis in the financial sector -- brought upon the western economies by the wilful acts of their banks.

A sanitised description would be that banks had taken on excessive risk. A stronger appraisal would be that they had pushed poor quality loans to increase profits.

Either way, it is accepted by now that there should be far greater regulation of banks, and that ensuring financial stability represented by some measure of leverage, credit aggregates or asset prices should form part of a central bank’s objectives.

At the same time there is recognition that the policy interest rate, which alone is under the control of the central bank, is a blunt instrument when it comes to controlling these variables. The upshot is that more targeted ‘macro prudential’ instruments would have to be used. Examples of such instruments are pro-cyclical capital-asset ratios and loan-to-value caps.

However, even as financial stability is explicitly being added to the central bank’s objectives, there is no consensus on how it is to be implemented. One source of difficulty stems from a possible tension between the pursuit of financial and macroeconomic stability at the same time. The standard example is that when the policy rate is lowered to stimulate employment it could encourage excessive risk taking, thus jeopardising financial stability.

Interestingly such a trade-off could arise even as the interest is raised. For instance, when the interest rate is raised to quell inflation it can contribute to financial instability by turning once-secure financial positions into risky ones, if not actually into Ponzi schemes.

A Ponzi scheme is a financial position in which liabilities exceed receivables for the foreseeable future. There could be situations then, when balance would have to be struck between macroeconomic and financial stability. This is best achieved when the monetary authority is also the financial regulator.

In general in India, concern for inflation has received far greater attention than financial stability. The Centre has made the Reserve Bank accountable for inflation but has left financial stability to a Financial Stability and Development Council in which the Finance Ministry calls the shots.

Separate agencies for macroeconomic stability and financial stability may end up not co-ordinating on the first best solution. Hence, the case for a single body. The political economy argument is that leaving the regulation of the financial sector to the ministry of finance opens up the possibility of influence peddling.

Memoirs of a most highly regarded Governor of the RBI speak of pressure having been put on him by the executive to grant a licence to a dubious international bank which was a marriage between middle-eastern money and south Asian management. The licence, we are told, was granted soon after he demitted office. The bank had gone on to collapse spectacularly on the world’s stage.

Historically the RBI’s record on banking supervision is quite good. Only recently it has concluded the issuance of new bank licences, potentially a landmine, without a footfault. It is today headed by an economist of the highest class who also brings to the table considerable international experience. So, there is a serious case for vesting all powers with respect to financial stability with the RBI.

However, inflation is an altogether different matter. The Bank’s t takes far too much credit for the current downward trend in the price rise. This has come after 3 years of declining industrial production. The Bank hardly ever refers to this. If inflation is down it is so because industrial production was negative in 2013-14, thus lowering demand for agricultural goods. The year just past has also been one of agricultural growth higher than the trend which may be expected to have a dampening effect on the price rise.

The Bank has actively encouraged the belief that it can control inflation by adopting ‘inflation targeting’. The Government of India is happy to go along with this construction as it absolves it of all responsibility. A rising price level is, however, the outcome of the interaction of the actors in the economy. A credible economic policy would tackle it at its source.

The writer is a professor at the Centre for Development Studies, Thiruvananthapuram

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