Not Good Enough Steps: Financial Express 29th April 2008

‘Hundred Small Steps’ may sound good and practical, but the Rahugram Rajan Committee report on financial reforms does not offer anything new. If anything, there appears to be a proclivity towards liberalisation for the sake of liberalisation. This is only to be expected, as Joseph Stiglitz might put it, considering that the committee was headed by an ex-IMF official. At first sight, the report appears balanced, offering both sides of the issue, but invariably settles for the obvious, with the caveats that there should be strong institutions and governance. But the problem with any financial crisis is institutional failure and unreliable governance. This is where radical approaches falter. The requisite institutions are never built before allowing the game to begin. One question remains unanswered: who regulates hedge funds or securitisation, for that matter?
Financial liberalisation tends to lead to recklessness, which is serious, since it involves other people’s money. Still, the committee appears to prefer the IMF solution of opening up regardless of whether or not it is appropriate. In fact, if the Indian system has stood the test of time, it is because of conservative financial policies. The so-called “dynamic participants” have been often caught in a trap, but this has never been highlighted.
The composition of the Committee deserves comment. It has 11 members, excluding a convener, of which seven are from the private sector, two are academics, one from the IMF and one from the public sector. A committee without participation from the RBI, IBA or Sebi appears to be distorted, to begin with. The virtual absence of the public sector makes it one-sided, and the exclusion of financial service users pushes it further into a corner. It seems to be a view of “market participants” rather than “regulators” or “users of the market”. It is not surprising that the conclusion reached is unbridled liberalisation, with a few cautionary qualifications thrown in.
There are seven issues that have been discussed which provoke comment. The report favours inflation targeting, which is monetarist in spirit, as monetarism holds that excessive money supply is what causes inflation. But, given that monetary policy affects growth, RBI’s current stance of growth with stability appears a better option. In fact, ideally, we should have two numbers that must be targeted: one for growth and the other, inflation.
The committee also favours the use of the repo or reverse repo rate to control inflation. However, in the Indian context, these rates appear to be merely indicative and seldom do banks follow these rates when it comes to deciding their own benchmark rates. It is better to pitch for the CRR, which has the direct impact of affecting potential inflationary liquidity.
Opening up the debt market to foreign investors is a known and good idea, but the RBI approach of caution is preferable. Foreign funds have already poured in $80 billion into the country’s equity market, and at the present value of a multiple of 3:4, actually hold significant potential as a threat in times of distress. Further, allowing provident funds to invest overseas would not make sense, as Indian Markets anyway provide higher yields in comparison with western Markets, which are more secure than the emerging ones.
The report also talks of letting in more private banks. This option has been experimented with, and we have already seen a number of private banks folding up. There is a contradiction here, as we are talking of consolidation on one hand (on grounds of economies of scale) and creating new small banks, on the other. In fact, the creation of universal banks has already created a new problem of long-term funding, which ironically will need the creation of new institutions which will resemble the ones that became universal banks, to begin with!
Further, the issue of priority sector loan certificates (PSLC) is absurd, to say the least. If there is commitment to the priority sector, one has to follow it. Once we accept such lending, banks should be penalised upon failure, instead of allowing inter-bank trade. Given that priority sector loans have a higher probability of turning into NPAs, erring banks could simply fall short of their targets and get away by paying off other banks. The RIDF scheme is a better option.
The report speaks of how banks have been forced to invest in government paper. This is an exaggerated claim. Today, despite an SLR of 25%, banks are stuffed with over 30% government bonds. They offer reasonably good returns and capital appreciation, and are less risky, with a lighter capital burden. Banks are not being “forced” to support the fiscal deficit.
Lastly, the suggestion of a single trading regulator is debatable. Market complexities demand specialisation, and no single regulator could have such wide expertise.
The report, to be fair, is comprehensive. There are some anomalies which need to be reviewed. Its approach to the free market Economy is quite textbookish, its chief failing. Free Markets work well when conditions are perfect. But, since they are not, RBI’s approach of gradualism is worth adhering to.