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
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?
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.
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