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‘There Are So Many...'

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Raghuram Rajan is always on a quest. As he skims journals, his mind races on to extensions, corrections, models and new applications of old models. It is a game many economists play; he just happens to play it well.
Some two years ago he started asking himself: Why have Indians, who are such passionate, accomplished democrats, always chosen to be poor? The standard Marxist answer is that a dominant upper class has a vested interest in keeping the rest poor. He thought instead of three classes - employers, managers and workers. Competition would reduce costs and make everyone richer; but employers do not like it. Education would increase workers’ productivity, but it would increase competition for white-collar jobs, so managers do not like it. And without education, workers cannot get jobs that liberalisation generates, so they do not like reforms.
Last year he presented those ideas at a conference in Neemrana where ministers and their advisers hobnob with chiefs of research institutes and their economists. Montek Singh Ahluwalia heard him and thought, this man has a fertile mind. What might he come up with if we recruited him in our battle for inclusive growth? He talked to the prime minister and the finance minister; they joined his crusade. Faced by their combined forces, Rajan agreed. But he would not occupy a room in the Planning Commission; he was wedded to his professorship in Chicago. He would confine himself to the financial sector, his area of expertise. And he wanted a committee that would bring together the best minds and the best informed people in the financial sector. That is how the Committee on Financial Sector Reforms was formed. It put its draft report on the web a fortnight ago. The final report is some time away.

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The government has for fifty years tried to take loans to the poor by forcing banks to open branches in villages and lend to farmers, and by creating institutions specially intended to lend to the poor, small industrialists, and other such desirable characters. The Rajan report is critical of this.

Before villagers and the poor are given loans, they should be taught to open and run bank accounts, to save and to manage savings. Since government banks will not do this, new private banks should be licensed to serve these people. These ideas are anathema to the financial establishment; it has marshalled its forces to shoot down the Rajan mavericks. I thought, let him tell us in his own words.

Tell me why the CFSR chose to have the people it did, rather than the usual bunch of bureaucrats and regulators. Would not their inclusion have made its recommendations more acceptable to the government?
The purpose of the CFSR was to propose serious, needed reforms, not just incremental change, and over a few years, not over the next few months. The belief was that if we had too many regulators and govern-ment officials on the committee, its recom-mendations would be anchored to the status quo. But it was also important that the recom-mendations be practicable, so we had many practitioners on the committee, including Om Bhatt, the reforming SBI chairman, Uday Kotak, one of India’s most knowledgeable financial entrepreneurs, Vijay Mahajan, a pioneer in microfinance, Zia Mody, one of India’s top corporate lawyers, and Jayanth Varma, a financial wizard. The other six members are leaders in their areas too. We spent the best part of a year deliberating, consulting widely with regulators, business-people, researchers, consultants, union leaders, politicians, etc. The report is a collective effort, not just by the committee, but by a wider selfless set of people who devoted considerable time to contribute what they thought was needed for the nation. My sense is that many of the recommendations will be implemented, though perhaps not with the urgency the committee feels.
Is not bad regulation a good argument for capital account inconvertibility? If the Reserve Bank and SEBI are wedded to their rule-based regulation and the government sees no way to reform them, should it not allow the Reserve Bank to manage the capital account with quantitative restrictions and arbitrarily changing rules?
Let me answer in three parts. First, I do believe that strong financial infra-structure can help reduce the costs associated with an open capital account. This includes not just good regulation but also other aspects like an effective bankruptcy code. Real flexibility, for example, on labour, would also help. And allowing more foreign participation in some areas can strengthen the infrastructure. For example, if foreign investors were allowed to set up asset reconstruction companies, we would have a much more resilient system in the event of widespread financial distress. They will have capital to bring in when the Indian financial system is in trouble, much as the US system is being rescued by sovereign wealth funds.

Second, I am not sure why you say arbitrary rules are a good thing when we have an inefficient infrastructure. It can make the system even more capricious.
Third, given that our trade is increasing so fast, and that the capital account is already so open, it is becoming virtually impossible to control flows through quantitative means – there are so many ways controls leak, as the bankers on our committee point out. Rather than experience a total loss of control over time, and also increased distortions as controls are evaded, why not liberalise in a way as to strengthen our systems?

You suggest that the Reserve Bank should confine itself to inflation control by means of interest rates. What about growth? And should it not attempt to control the exchange rate?
As we have seen in recent months, inflation is the prime concern of our political class, as well as the masses. The RBI recognizes this when it says it has an objective of 5% inflation. In addition though, monetary economists since the early 1970s, and now many central bankers, have been saying that the central banks can only deliver on growth by focusing on limiting inflation. This is an intellectual revolution that those who have not read beyond pre-1970s macroeconomics, unfortunately still taught in some classrooms in India, have not absorbed. An inflation objective (and note I do not say target because of the near-religious connotations associated with targeting) is not anti-growth. Indeed, by maintaining inflation close to its objective, the RBI will also deliver on growth. When the economy is growing below potential, inflation will fall, and the RBI will cut rates, and vice versa when it is growing too strongly.

Even the Reddy RBI has been flipping between holding the nominal exchange rate and letting it go to curb inflation

So what are we giving up when we focus on inflation? Not growth, but the right to be whimsical, especially about exchange intervention. The real issue is when central bankers are whimsical, they confuse markets and lose effectiveness on curbing inflation. This is no commentary on Dr Reddy, who as someone remarked, is a wizard at operating the system. But I do have fears for his successor. And even the Reddy RBI has been flipping between intervening to hold the nominal exchange rate, and letting it go to curb inflation. Ultimately, it is not clear that constant intervention can keep the real exchange rate from moving up to funda-mentals, whether it be through nominal appreciation or through inflation. Many who advocate continued heavy intervention are living in the past, when such intervention may have worked.
Also, let us not offer a blanket indictment of exchange rate appreciation. Real exchange rate appreciation is part of development. It will lower import costs, especially of capital equipment. And exporters can offset it through higher productivity, as many seem to be doing in India. Of course, the export lobby has an incentive to holler for sops, but we need to take a good look at the figures to know if they have really been damaged.
This is not to say we want the exchange rate to become overvalued. I personally think a slightly undervalued exchange rate might be beneficial if we could have it. I just don’t think intervention helps achieve it in the medium term, and the costs of having huge reserves are mounting.

Can you see anyone in India – personal or corporate investors, insurance companies, pension funds, and rational investors – who would be inclined to invest in foreign debt or equity markets? If you do not, do you see any way of opening up the capital account without substantial appreciation?
Inflows will slow as the currency appreciates and India is less of a one-way bet. But clearly, it would be preferable if we had outflows taking the pressure off appreciation. As I argued earlier, there are limits to the central bank building reserves and providing the outflows. Better let the rest of India take the money out. But few want to do so today. This reflects the strong returns of the Indian market in the past, a natural fear of investing abroad, and high transactions costs of moving money. As the Indian market stops going only one way, the value of international diversification will become clearer. It certainly makes sense for provident funds and pension funds to maintain a better diversified portfolio across the world, and an education campaign for those who control these funds would be useful (I have a vested interest in this as a finance professor). And it makes sense for the government to reduce the transactions costs for middle class households to diversify internationally – you still can’t walk into your bank and say I want to invest Rs 50,000 in an Asian equity index. The “home bias” in people’s investment is falling rapidly across the world, and I see no reason why India should be an exception.
No doubt it will take time, So everything we advocate is measured – start increasing investment limits for foreigners, more rapidly so when inflows from other sources are quiet.
Cannot a market be created for the debt of smaller firms? Would it not be simpler than securitization?
Small firms are starved of finance. Across the world, they find it difficult to issue debt in markets because arm’s length investors do not know enough about them, and do not trust them to repay. This is why securitization may work, much as warehouse receipts may expand credit to farmers. The point is that both small firms and farmers are sitting on good assets – the receivables of large firms in the former case, and crops in the latter. While lenders may not lend directly to the firm or the farmer, they will lend against the asset, if it can be “ring-fenced” from the owner. With technology, so much more is possible. The kind of securitization we advo-cate is not complicated. It works in Mexico.
Do I see traces of lazy xenophilia that I used to find so common amongst unthinking bureaucrats? When they wanted to argue in favour of something, they would say it was being done in some good country like Japan or US or whatever. Should something be done in India simply because it is being done in Mexico?
No, of course not! This report is by Indians thinking about what is good for India. But the most progress is made when we borrow with discrimination. The times India and China have really gone backwards is when they turned their backs on the world. Let us learn from the Chinese here – they are never afraid to listen to what is happening round the world, they pick what might work, and then they experiment to see if it works in China.

Should priority given to particular sectors in lending be dismantled at some point? At which point? Has the point arrived in any sector?

The Chinese are never afraid to listen to what is happening round the world, pick what might work, and experiment to see if it works in China

We believe that the only possible role for the priority sector is for those who do not have access. The costs of servicing that sector are high. But instead of mandates, we should move to incentives. The report outlines a scheme by which we can achieve priority sector objectives efficiently by rewarding those who make loans to that sector (not just banks). We also believe too much attention is given to credit, and too little to other aspects of financial inclusion such as micro-payments and savings accounts. Indeed, if the poor are brought into the system by these means, they can eventually become creditworthy.
You say in Chapter 4 that banking licences should not be based on minimum capital but on criteria of competence. But you reject giving licences to big industrialists without any argument; today there are industrialists like Sunil Mittal and Mukesh Ambani with thousands of crores not knowing what to do with them. Do you rate the risk that they would loot their banks so high?
No, actually we were making the case that small banks could be effective even without a large capital base, not talking about entry requirements for large banks – indeed, I do not think that there is that much correla-tion between being large and being honest. You have cited some respectable industrialists, I can also cite some who are rich and crooked. The real issue is not outright thievery, but serious conflicts of interest. We do not have adequate mechanisms to prevent self-dealing as yet, that is why the committee proposed not allowing industrial groups to own banks. Giving a banking license to someone who will manage 3000 crores in assets (the entry level for large banks) is a far more serious risk than allowing entry to someone with 30 crores.
In Chapter 4 you have supported the RBI view, taken in the context of the ICICI Bank, that banks may be subsidiaries of other companies, but not the other way round. Do you not thus implicitly support the idea that fragmentation of regulation requires fragmentation of the financial industry?
Not really. I think the recent crisis in the West indicates the difficulties in creating large universal banks. That said, I think there is ample scope for different subsidiaries of a holding company to cross-sell products through each other’s distribution networks. What is constrained is the commingling of capital and obligations – each regulator must know exactly what obligations are being backed by which assets. Also, problems in one corner cannot easily infect the whole holding company, which may be systemically important, and thus have a claim on the government purse.
(Businessworld issue 22-28 April 2008)

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