Oct 18, 2008

India - Global financial crisis;reflections on its impact on India

S. Venkitaramanan

The relative freedom from the contagion spreading from the global tsunami on the Indian financial system owes much to the wise and judicious policies of our central bank and the Government of India.

The U.S. financial crisis has had its reverberations on both developed and developing world. It is not possible to insulate Indian economy completely from what is happening in the financial systems of the world. Effectively speaking, however, the Indian banks and financial institutions have not experienced the kinds of losses and write-downs that even venerable banks and financial institutions in the Western world have faced.

By and large, India has been spared the panic that followed the collapse of banking institutions, such as Fortis in Europe, and Merrill Lynch, Lehman Brothers and Washington Mutual in the U.S.

The relative freedom from the contagion spreading from the global tsunami on the Indian financial system owes much to the wise and judicious policies of our central bank and the Government of India.

Discussions on this subject have proceeded on two lines. One is to point out that the Indian banks have taken less risks than their peers abroad. The less risk you take, the more will be safer you are. This, however, begs the question, “Why did the Indian banks take less risks?”

The answer lies in the wise regulations and meticulous supervision by the RBI. At a time when total deregulation was the order of the day in the 90s, Dr. Manmohan Singh as the Finance Minister authorized a path-breaking study of the Indian financial system by an experienced central banker, M. Narasimham. He had the wisdom to foresee that the financial system had to be placed on a well-regulated basis. Mr. Narasimham’s classic reports gave the policy framework for the Government of India and the RBI to formulate the structure of India’s banks and financial institutions. Mr. Narasimham’s model was based on adequate capitalisation, good provisioning norms and well-structured supervision. Government of India and RBI accepted these recommendations and proceeded to implement them.

What was, indeed, important was that the model did not allow investment banking on the pattern of the American paradigm. In a sense, RBI enforced its own version of the U.S.’ Glass-Steagal Act of 1933, which insulates banks from capital market exposures. The RBI enforced strict capital adequacy requirements and if any financial institution or bank exceeded the specified limits of exposure to stock markets, it would have to provide more capital. This effectively insulated the banks and financial institutions from volatility of the bourses. Enforcement of the above instructions has paid good dividends. Erosion of capital of the banks and financial institutions has been reduced. These exposure limits, however, deserve to be reviewed from time to time.

The RBI must be congratulated for imposing Basel-II norms impartially and in a flexible manner. They have kept it in line with the Indian financial system. Observation of these limits, however difficult it may be in practice, will definitely help the Indian financial system to escape the kind of trouble, which is afflicting the financial system in other countries.

There is another observation, which has to be kept in mind in judging the relative freedom of Indian banking system from the catastrophic mess in the U.S. This is based on the important fact that the Indian banking system is basically owned by the public sector. The State owns many of the banks and financial institutions in the country. There is greater confidence of depositors in a state-owned bank than in a privately-owned bank. This is evident from the fact that in the latest version of the rescue package in the U.S., the government has come forward to infuse capital into distressed banks and financial institutions. Maybe, we can congratulate ourselves that India had already done what Washington is now doing in the midst of the crisis and therefore escaped much of the confidence problems.

Credit is also due to the Government of India and the RBI for having avoided the temptation of total capital convertibility. Had we embarked on total capital convertibility, we would have been exposed to much greater contagion from the current mess than we have been so far. The lesson is that in economic reforms, we have to proceed with caution. Striking the right balance between boldness and caution is where wisdom lies.

A continuing process

It is, however, fair to point out that we should not be complacent in regard to the process of reform. Reform is a continuing process. The latest contribution to the process of reform is a report produced by Dr. Raghuram G. Rajan, former Counsellor of IMF and at present Professor at Chicago Business School. The report incorporates a number of useful suggestions. Although one may have differences of approach with certain aspects, the report deserves to be examined and implemented to the extent possible to keep the Indian financial system modern and efficient.

In this connection, it is only appropriate to refer to the stabilising role of the Securities and Exchange Board of India (SEBI) in managing the difficult task of regulating our stock markets. Especially, attention has to be drawn to the role of Participatory Notes. In the present context in which private capital from abroad has been responsible for many problems in the Indian stock markets, SEBI must be congratulated for its cautious line on this subject, making appropriate relaxations as needed.

While the RBI is to be congratulated for its cautious and nuanced stance in regard to its regulation, one can argue that its regulation can sometimes be a little bit oriented towards management of banks. Whether it is appropriate for the central bank of a country to decide on where the branch of a bank should be located is a matter for discussion. In a recent debate, Dr. Raghuram Rajan had pointed out that a well-known foreign bank, which had applied for opening its branch in a rural area, was refused permission, notwithstanding the fact that no Indian bank had asked for permission to open a branch in that area. It is perhaps time to put a stop to such management of minutiae by the central bank, which should have its hands full with other more pressing issues.

While the RBI may legitimately pride itself on better regulation than the U.S. Federal Reserve, there are two topics on which it has to follow the example of U.S. Federal Reserve. One is concerning the distribution of profits of the central bank. The U.S. Federal Reserve had a profit of nearly $39 billion in 2006-07 out of which it had transferred $34 billion to the U.S. Treasury. This is in sharp contrast to the behaviour of the RBI, which appropriates the bulk of its profits of nearly Rs.50,000-60,000 crore to the so-called contingency fund and transfers only Rs.10,000 crore to the Government. If the RBI could follow the example of the U.S. Fed in this matter, Mint Street can fix half the fiscal problems of the North Block.

Another issue on which the Federal Reserve offers a good example to follow is regarding the measurement of inflation. U.S. Federal Reserve measures inflation on the basis of consumer price index and not on the basis of wholesale price index. This makes a substantial difference. In the U.S., in the last year the consumer price index increased only by 2 per cent, measured on the basis of what the Fed calls “headline inflation,” excluding fuel and food. Even if the consumer price index including fuel and food is considered in India, the RBI will come out with an inflation of 7 per cent as against the figure of 12 per cent, on the basis of wholesale price index. If we follow the consumer price index in measuring inflation, India can afford to have an interest rate of roughly 5 per cent lower than the one in force at present. This can make a significant difference to the fiscal fortunes and the growth of the Indian economy.

(S. Venkitaramanan is a former Governor of the Reserve Bank of India.)

1 comment:

Adi said...

Oes Tsetnoc one of the ways in which we can learn seo besides Mengembalikan Jati Diri Bangsa. By participating in the Oes Tsetnoc or Mengembalikan Jati Diri Bangsa we can improve our seo skills. To find more information about Oest Tsetnoc please visit my Oes Tsetnoc pages. And to find more information about Mengembalikan Jati Diri Bangsa please visit my Mengembalikan Jati Diri Bangsa pages. Thank you So much.
Oes Tsetnoc | Semangat Mengembalikan Jati Diri Bangsa