Reforms: A Retrospective and Prospective View

I feel quite honoured to be in the midst of this distinguished guests and share a few of my rambling thoughts on the ongoing financial reforms in my country and the opportunities and challenges thrown open by them. I, for a better appreciation of the ongoing reforms, their context and relevance, may have to briefly describe the economic scene of the country immediately after independence and the growth philosophy pursued.

To quote economists, developing countries like India are caught in the “vicious cycle” of low capital formation, leading to low investment and consequential low income. Agriculture continues to be the life blood of our economy with a share of 56.5% in the NDP of 1950-51. Around two-third of the Indian workforce is directly engaged in agriculture for its livelihood. It, therefore, needed a big “push” or a “critical minimum” effort by way of capital injection to break the vicious circle of “poor” and embark on high growth path.

This assumption, coupled with the fear that markets are more prone to fail in directing investments for achieving faster growth, resulted in the belief that economic development without systematic planning would be difficult. All this resulted in five-year plans religiously pursued by Government of India till late 80s, of course, each having focused on specific plan targets.

This, of course, resulted in “closed” economy with stress on “import substitution” while relegating “export promotion” to background. Thus “elasticity pessimism” over-rode thinking of planners of early 50s and 60s. It is worth noting that till 70s, it was strongly believed in the Indian power centres that state intervention is essential in the initial stages of economic growth and thus the Government became all pervasive in many areas of economic activity.

This inward-looking industrialization process did result in high rates of industrial growth between 1955 and 1966. However, several weaknesses of such a process of industrialization soon became evident as inefficiencies crept into the system and the economy turned into an increasingly high cost one.  As a consequence, India’s share in the total world trade has come down from 1.91% as of 1950 to 0.53% by 1992.

During the late 60s and early 70s, the country had witnessed an interesting shift in growth strategy towards specific poverty alleviation programs as it was felt that the trickle- down effect of growth may not reach the bottom income deciles of Indian population. In its hurry to improve the economic lot of 48% of the population that was estimated to be living under the poverty line and realizing the importance of finance as a critical input in the growth process, the Government had adopted the “supply leading model” for augmenting institutional credit support system.

This approach led to rapid expansion of banking services across the length and breadth of the country. The total number of bank branches which stood at 8,262 as of June 1969 touched a figure of 63,513 by June 1997 reducing the average population per branch from 64,000 as on June, 1969 to 15,000 by June 1997. This geographical spread of banking to rural areas widened the scope for availability of institutional form of credit to the hitherto neglected rural poor. This system, having been subsequently supplemented by the establishment of RRBs, had emerged as a product of both evolution and intervention in the process of rural development. This intervention resulted in phenomenal growth of credit disbursal to priority sector comprising of agriculture, small-scale industries and other priority sector advances—paving the way for quantum jump in number of accounts from 2.6 lakh as on June 1969 to 3.34 lakh as on March 1997, while the outstanding credit has gone up from 441 crore as on June 1969 to 79,131 crore by March 1997.

By 80s, however, the country witnessed gradual opening up of Indian economy to external competition. It was, however, slow and also lacked self-sustaining character. But the then prevailing external payment crises threatening macroeconomic stability in 1991 led to encouragement of private enterprises and opening up of the economy to the forces of competition. This shift ultimately placed greater reliance on market forces in encouraging competition and liberalization of trade regime with an accent on integrating Indian economy with the rest of world.

Financial sector reforms that are currently set in motion are to be seen as one of the components of the overall structural reforms that have emerged to fight against the dismal economic scene of 1991, viz., liberalization and deregulation of domestic investment, opening up of key infrastructural areas, opening up of economy to foreign competition and re-align the tax system. Deployment of resources towards more efficient producers being sin qua non for reaping full benefits from the proposed structural reforms financial system is expected to play a crucial supportive role and this is precisely what the financial reforms are aimed at.

The ongoing financial reforms are basically aimed at promoting a “diversified, efficient and competitive” financial sector that can efficiently allocate its resources for increased returns on investment while promoting accelerated growth of the real sector of the economy. The salient features of the ongoing reforms can be broadly categorized and discussed under the heads:

Policy Framework

External factors like regulated interest rates, high levels of preemption of resources mobilized by banks and directed lending being the critical factors having a direct say on the profitability of the banking system obviously became the prime target of reforms.

Interest Rate Policy 

To obviate the retrains, the Central Bank has put forward major efforts to simplify the structured interest rates by making banks free to determine interest rates on domestic term deposit for 30 days and above, effective from October 22, 1997. The lending rates are also made free other than for export financing and loans up to 25,000/- and between 25,000/- and 2,00,000/-. The money market rates have been completely freed and bank rate is being developed as an instrument to transmit signals of monetary policy for ultimately influencing the direction of interest rate movement in the economy. But the real issue is: Do the banks have the wherewithal to price their loans correctly to ensure that they stay in profit?

Preemption of Deposits 

Our banking system is known to operate, that too, since long with a high level of reserve requirements both under Cash Reserve Ratio and Statutory Liquidity Ratio, the cumulative of these two stood at one time as high as 63.5%. Of course, this was more because of high fiscal deficit and high degree of monetisation of deficit. Presently, the Cash Reserve Ratio has been brought down to 10%, while Statutory Liquidity Ratio has been brought down to 26.7% resulting in a fall of 26.3%. Simultaneously, to facilitate the development of a more realistic rupee-yield curve and term money market, reserve requirements on inter-bank liabilities have also been removed.

Directed Credit 

Looking to the imperfections in the credit market, disproportionate distribution of wealth among the haves and have-nots, and around 80% of the population being dependent on agricultural-related activities, etc., the policy prescription of 40% of net bank credit towards priority sector is retained. However, priority sector borrowers with credit needs of Rs.2,00,000 and above are to be governed by the general interest rate prescriptions so that the viability and profitability of banks do not get affected.

 Improvement in Financial Health

Introduction of prudential norms and regulations aimed at ensuring safety and soundness of financial system, imparting greater transparency and accountability in operations, had raised credibility of and confidence in the financial system. Under these reforms, banks are now required to classify assets into four broad groups—standard, sub-standard, doubtful and lost—and make provisions ranging from 10-100% depending on the category and age of NPA. Simultaneously, banks were asked to mark-to-market even government securities to the extent of 50% held by them.

 Institutional Strengthening

Besides introduction of prudential norms, the Central Bank has also initiated measures of re-capitalization, improving the quality of loan portfolio, instilling greater element of competition and strengthening the supervisory process. Autonomy is being granted to sound commercial banks in a phased manner to tone up their administrative competencies. NBFCs have been brought under the regulatory plane of RBI. They have to meet net-worth and capital adequacy criteria. Steps were taken for development of Government Securities Market. Central Bank has also issued guidelines to banks for retailing of Government Securities to non-banker clients. Central Bank has also succeeded in fixing a cap on market borrowings by the Government.

An array of Capital Market reforms were also introduced: 

• Passing of Depository Act, 1996
• Formulation of SEBI (Depository & Participants) Regulations, 1996
• Tightening of Entry Norms for Equity Issues by Companies
• Debt Issues not accompanied by Equity Component permitted to be sold entirely by Book Building Process
• FIIs permitted to invest up to 10% in the Equity of any Company to invest in unlisted companies, to set up pure debt funds and to invest in Government Securities
• Stock Lending Scheme

Financial Reforms: Challenges

Reforms have no doubt introduced competition which is welcomed by everyone concerned believing it would make banks more responsive to market forces and thereby become effective and efficient allocators of financial resources for achieving the growth of economy. However, one cannot lose sight of the structural impediments like— 

• extensive branch network with excessive staff—high overheads
• unions inflicting inelastic-administration cost structure
• fixed pay schemes leading to poorly motivated employees and
• little scope for rapid automation

that are coming in the way of toning up the managerial efficiency.

Banking by definition is a business of taking informed risks. But, the perceived feeling across the rank and file is that no one is willing to jeopardize their promotion or pension by being implicated in a perceived “risky” loan—in short, risk averse managers have become the hallmark of the system even at times of ample liquidity and to that extent, the system is over-hung with liquidity at the cost of profitability.

Risks, other than credit risks, have become intense, necessitating improved systems of portfolio monitoring sans a properly evolved term market rate/yield curve.

Exchange risk becoming apparent with more and more corporates going for ECB route for funds mobilization and the proposed CAC would only further accentuate it.

Directed lending to an extent of 40% of net credit at such interest rates that defy market forces is likely to threaten the viability of credit institutes. In one of his addresses, the former RBI governor observed that although a total amount of Rs.159 bn along with Rs.100 bn by way of subsidy from government has been provided under IRDP ever since it was launched to 49 million families living below the poverty line till end of February 1996, the impact of the program has been uneven. But recovery of credit continues to be abysmal under this sector, eroding the profitability of commercial banks.

Problems of over-dues are discussed thoroughly by number of authorities and on several occasions. Part of the blame though can be placed on the lapses on the part of the lending institutions—lapse in project preparation, timing of release of credit, amount of credit sanctioned, etc.—the very vulnerability of such people with no capital base nor with necessary technical skills to fail in servicing their debt cannot be wished away. At the same time, severe demographic pressures operating on the Indian economy perhaps do not permit the system to be ignorant of the aspirations of these segments. 

Yet, as the full impact of reforms unfolds, the emerging issues such as the following call for immediate attention of the policy makers: 

• Should the principle of directed lending at subsidized interest rates be accepted as a long-term reality or only as a transitory measure?
• What type of autonomy should the banking system be granted and how the accountability be ensured?
• What should be the role of Government of India, RBI and NABARD in monitoring these credit institutions?
• What role could be assigned to NGOs/SHGs in disbursal of credit?
• What should be the future role of RRBs?
• Can RRBs be merged with the rural branch network of commercial banks and federated into Zonal level banks with specialization to exclusively cater to the needs of the priority sector? 

A more formidable obstacle to the reforms of public sector banks is the political clout of organized workforce of the industrial undertakings that are thwarting the implementation of flexible employment/exit policies and, in turn, holding up huge resources in sick industries instead of being released for productive redeployment elsewhere. The irony of the situation is this weakness of the system is indeed holding back more resources in the non-viable ventures. This requires reforms of far-reaching nature—to dismantle the structures of protection and privileges, and tackle successfully the problems of industrial sickness, promotion of successful industries and introduction of competition in the organized sector through open entry and exit as well withdrawing, of course, in phases, the protection offered against international competition.

  

Over the last 5-6 years, the Indian banking system has demonstrated visible resilience and buoyancy and in general has responded well to the challenges thrust by the ongoing reforms. However, managing the change, that too with the old legacy not being totally replaced while competition is heating up from the new entrants, continues to be the biggest challenge the banking system is facing today. On the whole, the economy has performed better where reform efforts have been most thorough and far-reaching. We must learn from the experience as we march ahead to meet the future.

Than Q.

PS... Excerpts from a talk given in the late 90s, which incidentally sounds relevant even to date.