While we can feel proud of ourselves for escaping the full trauma of New York, London and Berlin, we also have to realise that much remains to be done to make India’s financial system a true participant in the economic expansion.

S. Venkitaramanan

The reverberations of the US financial collapse on the various economies of the world have been far-reaching. Particularly, we are witnessing the collapse of leading banks in Europe. This has led many observers to reflect on the comparative freedom from the crisis that the Indian banks are enjoying.

Discussions in newspapers and the visual media have followed two streams of thought. One stream claims that Indian banks have escaped the crisis because of the excellent regulation by the RBI and the decision by the central bank not to allow investment banking on the US model. Credit is being given to the fact that the RBI has insisted on adequate provisioning norms and enforced them strictly, without fear or favour.

It has also been pointed out that one of the reasons that prevented the collapse of Indian banks has been that the majority of them are in the public sector. The confidence of the public in a state-owned institution is definitely more than in a privately-owned institution, even a foreign one. Risk will obviously arise only when India’s financial institutions develop a capacity to enter new areas. Innovation has to be nurtured.

Much may be said in favour of the point of view that Indian banks are well-provided, well-capitalised and have little risk of collapse because they do not over-extend themselves in lending against securities or real-estate.

But in a modernised financial system, one may need our banks to take on some new activities, albeit with some prudential limits. The RBI has enforced certain Glass-Steagal regulations regarding exposure of banks and financial institutions to capital markets and when these banks or financial institutions exceed the limit of exposure, they need more capital. These restrictions have proved to be the saviours of the Indian financial system.

Credit to PM, SEBI

Credit has to be given to the role played by our present Prime Minister. He initiated various reforms and reviews of the Indian financial system by the veteran central banker M. Narasimham. In the midst of the 1991 financial crisis, the Government and the RBI undertook a far-reaching review of the banking system. The various recommendations made by the Narasimham Committee were, by and large, accepted and implemented.

In particular, the capital adequacy norms, the provisioning requirements and the need to recapitalise the banks were recognised. The present relatively healthy state of Indian banks is due to the initiatives taken by Dr Manmohan Singh, in particular, setting up of the Narasimham Committee and the implementation of its recommendations.

Reform is a continuing process. There has been further refinement of studies on the Indian financial system. Not the least important is the Committee under Prof Raghuram Rajan, formerly Counsellor of the IMF, and at present Professor at the Chicago Business School. The recommendations of this Committee are under process.

Comparatively, the security market of India has also been stable, notwithstanding the volatility consequent on the recent financial scenario in the US and the rapid pullout of private capital from abroad. The Securities and Exchange Board of India (SEBI) must also be congratulated for having played a calibrated role in managing the flow of money from abroad.

The controversies with regard to Participatory Notes are hopefully being resolved by SEBI. The Government and the RBI took a calculated decision not to venture into full capital account convertibility. Otherwise, the Indian markets would have been much more exposed to variations in the international meltdown.

New reforms needed

While much credit is due to the policy-makers, it is important to ensure that the reforms are not suspended. In a recent debate, Prof Raghuram Rajan pointed out that the expansion of branch network is an absolute imperative in India if financial deepening of the economy is to be achieved. He was wondering whether it is at all appropriate to restrict the expansion of foreign banks in India when the India-owned banks are not showing sufficient alacrity in expanding their branches.

Recently, a foreign-owned bank asked for permission to open branches in rural areas, which was refused. Is branch licensing itself an appropriate inducement to financial sector expansion in India? Obviously, the intervention of the central bank was much deeper.

While we may be proud of ourselves for escaping the full trauma of New York, London and Berlin, we may also have to realise that much remains to be done to make the financial system of India a true participant in the economic expansion of India.

This requires a new generation of reforms, which will keep financial stability and safety in mind while encouraging innovation or expansion. This is an important take-away from the recent debate on the financial situation in the US.

Lessons offered by Fed

In this context, I was interested to take a look at the Annual Report of the Federal Reserve System of the US. I was particularly interested in what the report shows about the stance of the Federal Reserve on price inflation and the distribution of profits.

The Fed offers an important lesson on both inflation management and distribution of profits to Government. The annual report clearly brings out that the focus of the Federal Reserve is not on wholesale price index but on consumer price inflation, excluding energy and food.

The difference between the RBI and the Federal Reserve in this context is important. If the US Federal Reserve had adopted the RBI’s model of WPI, it would have estimated inflation in the US at nearly 12 per cent instead of 2 per cent. The Federal Reserve would then have found it difficult to justify interest rate policy at nearly 2 per cent as is maintained now. There is a lesson for the RBI to learn here.

Another point that I have stressed in my review of the annual report of the RBI for 2006-07 is distribution of profits. The Federal Reserve has a profit of nearly $39 billion in 2006-07 and it has transferred $34 billion to the US Treasury. I cannot find in the report any provision for contingency reserve. This is unlike the situation in India where the bulk of the profits of nearly Rs 50,000 to Rs 60,000 crore of the RBI are appropriated towards contingency reserves and only the balance of Rs 10,000 crore is credited to the Government of India. The RBI has to learn this much from the experience of the Federal Reserve. Mint Street can fix the fiscal deficit of India to a large extent if it transfers bulk of its profits of nearly Rs 50,000-60,000 crore directly to Government of India instead of consigning it to its contingency reserves. It can also assist India’s fiscal management if it focuses on consumer price inflation instead of WPI.

The annual rate of increase of CPI in India is nearly 5 per cent lower than that of WPI. This would imply that the change of focus to CPI, interest rates in India, especially the borrowing rates of the Government, can be 5 per cent lower. This makes a lot of difference to the State and Central Fisc.

These are the reflections arising from the recent financial imbroglio of the US. I hope Mint Street and the Government of India will give them due consideration.

( blfeedback@thehindu.co.in)

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(This article was published in the Business Line print edition dated October 13, 2008)
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