Financial-Sector Reform in India

Financial-sector reform in India

Bridging the gulf

A financial system intended to promote equality and stability no longer does

Nov 30th 2013 | MUMBAI | From the print edition

SINCE taking office in September RaghuramRajan, the governor of India’s central bank, has championed financial-sector liberalisation as a way to boost growth and help the poor. Change is risky, he has said. “But as India develops, not changing is even riskier.”

India’s financial system is like a ramshackle engine lovingly maintained by a sect of oil-spattered engineers and wearily tolerated by most people who depend on it. After Indira Gandhi, then prime minister, nationalised most banks in 1969, India slipped towards financial socialism, with a central bank that printed rupees on politicians’ command. When India opened up in 1991 a wave of reform took place. The system today is a mishmash. Market forces have a role, but the state looms large.

There are several well-run private banks, such as HDFC. But public-sector banks (most of which are listed but under state control) make three-quarters of all loans. Foreign banks’ market share is 5%. Unlicensed moneylenders thrive, hinting at lots of unmet demand for credit.

The Reserve Bank of India (RBI) is now fairly independent and no longer sets the rates of interest banks charge, but it still manipulates the flow of credit to assist the government and, at least notionally, the poor. Banks must invest 23% of their deposits in government bonds, and park a further 4% with the RBI. This creates a captive market for public debt, the bulk of which is owned by banks. Some 40% of loans must be directed towards “priority sectors”, mainly agriculture. Taken together these rules mean that 58% of the deposits the banking system raises are deployed according to the government’s preference.

A plethora of restrictions means the corporate-bond market is tiny. This helps the government since it means that its bonds are the only game in town for fixed-income investors. Whereas the stockmarket is very open, capital controls govern the flow of foreign funds into the debt market and limit the use of currency derivatives. The RBI intervenes in the market to manage government-bond yields. This helps the state to borrow cheaply.

This hybrid system is not an accident of history. Many officials feel that finance is too important to be left to either free markets or politicians. After all, India’s bubble-wrapped system was unscathed by the Asian crisis in 1997-98 and the global crisis in 2007-09. The RBI is one of India’s best institutions—uncorrupt and capable.

But for all the good intentions the truth is that this hybrid system may now promote social inequality and financial instability—the twin evils it is meant to eradicate. For a start, after decades of state direction only 35% of adults have bank accounts. This perpetuates poverty and makes it hard to collect taxes.

Bad debts have become a problem, too. About 11% of state banks’ loans have soured. The reserves they hold are low and their capital levels are mediocre. Because of India’s weak legal system, banks dislike forcing firms into bankruptcy. Part of the problem is temporary, reflecting the economic slowdown and bottlenecks in infrastructure projects. But state banks have been pressed to roll over credit lines to troubled but well-connected big firms that most private banks steer clear of. This sort of cronyism makes the banking system less stable. It is also unfair: the public is subsidising inept tycoons.

Nanny finance has not created a national champion. India’s biggest lender by market capitalisation, HDFC, is ranked 63rd globally. No local bank yet has the international savvy of its Chinese, Brazilian and Russian counterparts. All those rules have pushed activity offshore. At least half of all rupee trading is abroad. Citigroup and Standard Chartered, which along with HSBC are the biggest foreign banks in India, have an overall exposure to the country (including loans, trading positions and derivatives) that is 1.9 times the size of their regulated Indian operations.

The hybrid system is complicit in a borrowing binge by the government: the budget deficit is running at 7-8% of GDP. Since bond yields are held down artificially by the RBI, which buys bonds itself and forces banks to, politicians can borrow heavily without fear of a buyers’ strike.

Low interest rates and fast-rising prices mean the return savers get on deposits is below consumer-price inflation (CPI). Some people buy shares instead, but many bypass the formal financial system and buy gold, straining the balance of payments. Over half of the current-account deficit of 4.8% of GDP in the year to March 2013 was due to bullion imports. The vicious cycle of borrowing, inflation and gold partly explains the 22% slump in the rupee between May and August. It has since recovered a third of its losses, partly thanks to MrRajan’s soothing presence.

MrRajan’sliberalising vision was outlined in an official report that he wrote in 2008, when he was an academic. It was politely ignored at the time by an establishment that was enjoying a moment of Schadenfreude as Western countries which had hectored India saw their banks implode. Now he is in charge at the RBI he wants to create a blast of competition that will spread finance to more Indians. The RBI will give licences to new banks, probably early next year, and allow foreign banks to expand faster as long as they create local subsidiaries that can be regulated easily. The rules that force banks to buy government debt will be relaxed “in a calibrated way”. MrRajan says he will stop tycoons from exploiting the system and force banks to recognise bad debts. His unspoken hope is probably that state banks will be fully privatised and forced to raise their game.

All this is easier said than done. Letting private shareholders own a majority of state banks would require an act of parliament. India’s politicians like the power they have over these lenders. Palaniappan Chidambaram, the finance minister, has been urging them to lend more to revive the economy. The public-sector banks are unionised and resistant to change.

Private banks, meanwhile, are not charities. Some struggle to gather enough deposits, limiting their growth. A huge expansion in the number of branches would help, but might not be profitable. These institutions prefer to lend to yuppies than to farmers and infrastructure projects. If the RBI gave new licences to industrial houses such as Reliance Group, they might use their powerful brands to attract a surge of deposits. But that would further concentrate power in the hands of a few, and lead to accusations of cronyism.

Nor are foreign banks saints. HSBC and Standard Chartered make 70-90% of their Indian profits from investment and corporate banking. Citi and HSBC, along with Barclays, have already burned their fingers in a push to lend to individuals. In 2006-10 they led a frenzy in unsecured consumer loans and collectively lost $3 billion. Too-big-to-fail foreign banks might be keen to take over lenders in India. But their jumpy regulators in the West might object.

World trade

The Indian problem

Opposition to a global trade deal risks hurting the very countries India claims it is trying to protect

Nov 23rd 2013 | From the print edition

INDIA, home to a third of the world’s extremely poor people, takes pride in being a champion of the poor. But words are one thing, deeds another. Right now, India stands in the way of a deal that members of the World Trade Organisation (WTO) are hoping to do in less than two weeks’ time—and its stubborn opposition could deliver a serious blow to the poorest countries in the emerging world.

Negotiators meet on the Indonesian island of Bali in early December in a final attempt to salvage the Doha round of world-trade talks. Since its start in 2001 Doha has stumbled from impasse to impasse, then to a collapse in 2008. Revived talks aimed for a slimmed-down deal. It would focus on “trade facilitation”: efforts to ease trade through simplified customs rules, which almost everyone can support. But a fierce disagreement over agriculture is tangling up the talks and threatening a breakdown in Bali. India is mostly to blame.

Its objections are not exactly surprising. Like many other developing economies, India strengthened “food security” policies in response to recent swings in food prices, stepping up subsidies to meet production goals. Those subsidies may soon grow large enough to violate WTO rules. A club of developing economies, led by India, is demanding a rule change. Rich countries are reluctant to give ground.

Domestic politics is part of the problem. Manmohan Singh, India’s prime minister, would like a deal. But his government faces a general election in the first half of next year. The leader of his Congress party, Sonia Gandhi, is sure to resist efforts to weaken the food-security law. India’s truculence is also rooted in its self-image as a torch-bearer for the interests of the world’s poor.

In election season, politicians often object to sensible but unpopular reforms. Yet such short-sightedness can prove costly. And in this case it is India and other developing countries that will pay the highest price. The trade-facilitation measures in the Bali package would add an estimated $68 billion a year to global output, with much of the gain concentrated in poor countries. More important, failure would destroy the credibility of the WTO, a body which boosts the developing world’s bargaining power.

The WTO already has the look of a vestigial institution. Richer countries are pushing forward with ambitious new regional deals—including a Trans-Pacific Partnership and a Trans-Atlantic Trade and Investment Partnership—that exclude the biggest emerging markets. Still poorer economies in Africa and Latin America rely on the WTO to get their voices heard.

Your own special dreams in Bali

India may consent to a temporary expedient: a “peace clause” that would waive WTO rules for a few years. But that would be a shoddy compromise, yet another sign that the global forum cannot deliver meaningful agreements. India should instead bring its law within the trade body’s rules: a hard choice, but one likely to pay dividends over time. Such a deal in Bali would enable the WTO’s new director-general, Roberto Azevêdo from Brazil, to blaze an ambitious path for liberalisation. A post-Bali agenda would almost certainly include a binding schedule for elimination of rich-country farm subsidies—something the developing world has long desired.

India’s malnourished

A mess of pottage

A huge cheap-food scheme to influence voters will not end malnutrition

Aug 24th 2013 | DELHI | From the print edition

“HISTORIC” and “unparalleled” were the words Sonia Gandhi, boss of the ruling Congress party, used to describe India’s new food law at a launch in Delhi on August 20th. She promised an end to hunger for the poor. More accurate terms for the law and its introduction would be “expedient” and “chaotic”. The scheme aims to reach 800m of India’s 1.2 billion people, giving each a monthly dole of 5 kilos of rice or wheat, at a nominal price. That makes it the world’s biggest serving of subsidised food. Yet it has been launched amid confusion, cynicism and claims of fiscal irresponsibility.

The food scheme became law in July when the prime minister, Manmohan Singh, Mrs Gandhi’s factotum, introduced it as an ordinance—a rarely used executive power to which Parliament eventually has to agree. Mrs Gandhi fears a thumping at a general election due by the end of May, so Congress is now rushing to push the scheme through. Parliament still has to be persuaded. She sought to tie the bill to the memory of her husband, Rajiv Gandhi, who was assassinated two decades ago and whose ballyhooed birthday was chosen as the day of the launch.

Opponents tried everything to stop the bill being discussed, but debate was set for August 22nd. The opposition BharatiyaJanata Party dares not block the bill for fear of being cast as anti-poor. The party’s de facto leader, NarendraModi, who used to talk of the need for small government rather than populist handouts, attacked it for promising too little in the way of rations.

The new law is good in parts. It makes sense to enshrine a national obligation to give children a daily hot lunch and new mothers a six-month stipend. It is wise to promote better nutritional help and health care for under-sixes, especially girls, using the existing Integrated Child Development Services. Helping populous states with most of the poor is overdue. Hints that cash transfers might one day replace help-in-kind are also welcome.

But much is rotten about the food scheme. It is too costly. India already spends 900 billion rupees ($14 billion) a year on a bloated system of grain procurement. Half is badly stored and rots, or is stolen. With many new recipients, the cost will rise by nearly two-fifths, to 1% of GDP. That is equivalent to what India spends on public health.

Some argue that it is not a given that the money will always be badly spent. Jean Drèze, a development economist, says that the system will improve because a wider pool of recipients can insist on better service. He cites the experience of recent programmes in Chhattisgarh state.

Yet given the chronic abuse of procurement and food schemes elsewhere, massive theft and waste will surely continue. The food scheme is also badly targeted. Surveys suggest that 2% of Indian households are hungry at some point in the year. Just over 20m people, many in tribal areas or rural bits of northern states, need more help. Yet two-thirds of India’s total population will get the new food aid. That broad splurge of handouts is driven more by raw politics than by development priorities.

It would be better to deal with pitifully bad nutrition than plain hunger. Walk around any north Indian village where grain seems adequate, and stick-thin people offer evidence of how few nutrients are being absorbed. Roughly half of all children under five are malnourished. Save the Children, a British charity, said in June that over 60m children, aged five or younger, are stunted. The consequences can be grim: damage to young brains, a reduced capacity to learn, even death.

Yet helping children requires more than a supply of base calories. A lack of protein or vitamins in diet, dirty water, neglect of girls, lack of education on hygiene and ill-nourished mothers who get pregnant too often: all contribute to the problem. ArvindVirmani, a prominent economist, argues that cleaning up water supplies, especially by building sewage systems, would do far more good against malnutrition than doling out more grain. Just a simple hand-washing campaign could be of huge help.

Even some backers of the new food act admit, in private, that more spending on public health is the greater need. UNICEF, the UN children’s agency, says that diarrhoea kills over 400 young children in India every day. Two-thirds of Indians lack proper sanitation. Some estimates suggest that 70% of drinking water is seriously polluted with sewage. No wonder, says MrVirmani, infected people fail to absorb nutrients, whatever their diet. Only when votes are in supplying lavatories, and politicians clamour to lend their names to sewage systems, will that change.

MrRajan is trying to reform at a low-point in the economic cycle. That creates its own problems. Would he really be prepared to trigger a wave of defaults in order to clean up India’s bad debts? It seems unlikely. If he raised interest rates above CPI, savers would applaud but growth would fall further. And just months after a financial panic and a dangerous spike in yields, it will be near impossible for the RBI to deregulate the bond market. In mid-November he said the RBI would again intervene to prevent “liquidity tightness”. The central bank now owns at least 17% of all central government bonds, the highest level since the crisis years of the early 1990s. It now owns more of its local bond market than the Federal Reserve after years of quantitative easing (see chart).

For a quick jolt to the system, MrRajan’s best hope is to embrace low-cost mobile-banking. India has lagged Africa in embracing this technology. But to reform the bond market and traditional banking he will first have to change the RBI. Today it is the honourable guardian of the status quo. Tomorrow it could be a force for reform that takes risks and persuades politicians that a nimbler financial system will make India richer and more stable. Confronting vested interests and ingrained thinking will be a slog but the rewards could be immense.