Gaps in RBI’s policy framework

An economy is only as strong and efficient as its financial system, which influences the pattern of production, distribution, consumption, investment, credit flow and, thereby, the nature and level of economic activities. Financial system reforms and building up of institutional and legal infrastructure have been undertaken since 1991 to to help create a stable, resilient and efficient financial sector.

Despite these, the financial system is systemically more vulnerable and unstable today than ever before. Growing imbalances between the financial and real sectors affect the ‘India Growth Story’ despite sound fundamentals, proactive policy measures and high growth potential.

Repeated non-realisation of the growth numbers and false starts to green shoots underscore limitations of policy-makers’ insight into growth-impacting factors and solution thereof. Anxiety and uncertainty are growing among businesses; more so among smaller ones. How long should one wait for the ‘India Growth Story’ to come good? Why do well-intended policy measures remain less effective and even counterproductive? Persistent under-performance of the economy, large gaps between planned/projected targets and outcomes and growing vulnerability of the financial system indicate that some basic lacuna in the policy-making exercises.

Missing factor

The RBI’s policy framework is primarily bank-centric. However, a major portion of the nation’s credit, savings and investment are managed by non-bank finance channels . Being bank-centric would mean not getting an integrated view of the financial system.

The non-banking channels (trade credit, finance firms, moneylenders, businesses’ own equity/capital, etc) are the predominant source of business credit. The Subramanian Committee on Revenue Neutral Rates under GST, 2015 found that 94.3 lakh units registered with the income tax department had total goods and services turnover of ₹240 lakh crore in FY14. So the average quarterly sales of these units were ₹60 lakh crore.

The total working capital outstanding from banks was about ₹20 lakh crore in FY14. Assuming an average working-capital cycle of three months, bank credit meets only a third of the working capital needs of these units; two-thirds come from non-bank channels.

Also, bank finance is minuscule vis-à-vis the turnover in the farm products sector, goods and services produced by units below the income-tax threshold and unaccounted transactions. If these are added, working capital financing from banks form a very small base (far less than one-third) of aggregate business turnover financing volume. The third and fourth All India Census of SSIs/MSMEs found that only 5 per cent of the MSMEs had institutional credit.

Policy disorder

The financial system policy framework and its understanding are predominantly bank-centric. Working dynamics of banks and other non-bank financing channels are different. Further, the two-way interaction and feedback loop between banks and non-bank channels do impact the dynamics of bank finance. As such, even the bank finance picture is diluted/distorted.

A sound and stable financial sector framework cannot be built on such a narrow and distorted base. Due to this, the outcome of well intended policy reforms is muted — in some cases they even aggravate the problems they intend to cure.

A case in point is the faltering of bank-centric development financing strategy for MSMEs. Adequate and timely credit to the sector remain elusive. Even after 70 years, MSMEs are worse of now than ever before. Protracted deterioration in their NPA (non-performing asset) position shows dysfunctionality of various remedial/recovery measures taken over the last two decades.

Payment, liquidity and credit risks in the banking and non-bank financing channels are interlinked and interdependent. They form an integrated financial base of a business. A default/delay in realising trade debts impacts a firm’s ability to meet commitment to its bank. Late payment or default in non-bank channels can set in chain reaction. Bank-centric NPA policy will remain less effective till the payment system is set right in non-bank channels.

Over the last 24 years (starting from PLR in 1994 followed by BPLR, Base Rate, MCLR), the RBI is yet to arrive at a suitable monetary policy base which can improve monetary policy transmission. Real changes in credit volume, liquidity and interest rates — the transmission channels — are determined more by the cumulative effects of millions of day-to-day credit-based business transactions than changes in money market variables.

Flawed financial sector policy framework leads to a perverse financial intermediation and risk-return structure which incentivises trading, import, cash purchases, financial investment and retail loans rather than production, capex, and business credit. It impacts the financial structure of firms, fund flows across firms/sectors, credit creation/distribution and ultimately output growth.

Big Data gaps

Disconnect between the world of finance and economics, segmented and distorted understanding of the financial system and limited ground-level experience have impacted RBI’s skill to contextualise/decipher Big Data.

The RBI seems to be indifferent to anomalous and unusual trends in its time series data and findings of its own studies/reports. Some of the glaring gaps in the RBI’s Big Data analytics include:

The RBI has been carrying out annual study of financials of private corporate sector on sample basis for the last 68 years. This data form the base for estimation of capital formation in the private corporate sector. There are large variations from the long-term trend in the composition of assets — steady increase in share of financial investment (annual average of 22 per cent in the 2000s against 12 per cent in the 1990s) and corresponding decline in fixed assets’ share in the total assets (annual average of 67 per cent in 1990s against 59 per cent in the 2000s).

These have serious implications on the industry’s output, productivity, competitiveness. These are also reflected in the RBI’s own specific corporate financial studies, which carry this data without any meaningful explanation.

The RBI has not read the clear warning signals emanating from abnormal growth trends in certain variables such as corporate deposits with banks and Chinese imports. The other areas of concern are the impediments to circular flow of funds between banks and corporates during 2004-08; surge in sub-PLR lending share in bank credit from 2001 to 2007; steady increase in the share of big-ticket loans; and persistent rise in cash economy despite spread of digital banking, financial inclusion, mass opening of Jan Dhan accounts, etc.

Insight into interconnectedness of risks among financial sector, real sector and non-bank financial channels can be helpful in diagnosing growth-impacting factors. Besides taking an integrated view of the financial system, the RBI needs to strengthen market intelligence, convert Big Data analytics into actionable-knowledge, and improve its understanding of ground realities.

The writer is a former DGM of SIDBI.

COMMENT NOW