“The RBI needs a course correction”, ‘Business Line’, September 28, 2014

Two developments suggest that a review of the state of financial sector in India would be timely. First, corporate indebtedness has risen significantly. One estimate places it at 50 percent of GDP. If this is accurate, it is high indeed. Rising indebtedness has continued even as growth has slowed in the past five years. When an economic entity’s debt rises in relation to its income its ability to repay the debt incurred emerges as a consideration. Secondly, increased indebtedness is most noticeable among India’s largest corporate houses. From a policy perspective we would want to avoid being saddled with a “too big to (be allowed to) fail” situation. The mirror image of the growing indebtedness is that where business houses have borrowed from the banks there is a rise in the non-performing assets of banks. This is most pronounced in the public sector banks.

            The RBI has initiated steps to reform the banking sector. Though thus far only a committee report, the P.J. Nayak Committee has made some bold recommendations relating to the governance of public sector banks. This could not have come too early as governance of the public sector banks is perceived to be in poor shape when it is not seen as having fully collapsed. The public want to know how Kingfisher Airlines were given such a long rope in the form of credit lines. They are very likely aghast at the state of affairs at Syndicate Bank whose chairman has been charged with accepting a bribe from a financially weak client. There is also a perception that the government has forced the public sector banks to increase their lending to the infrastructure sector so that its own funds can be used for expanding welfare schemes. This strategy is inherently risky given the maturity structure involved and the feature that banks have little expertise in such a line of business to be able to separate good projects from bad. Is it surprising, then, that public sector banks have larger NPAs and poorer indicators than their counterparts in the private sector?

            It is with this as background that we should approach the implications for India of the evolving debate on the objectives of central banking. Following the global financial crisis there is near unanimity that macroeconomic policy cannot afford to focus on inflation alone. This is based on the global experience that macroeconomic stability for close to a decade and a half from circa 1990 has masked a crisis that was building up in the financial sector. The crisis was brought upon the western economies by the willful acts of their banks. A sanitised description of these acts would be that banks had taken on excessive risk. A stronger appraisal would be that they had pushed poor quality loans to increase their profits. Either way, it is accepted by now that going forward there should be far greater regulation of banks, and that ensuring financial stability represented by some measure of leverage, credit aggregates or asset prices should form part of a central bank’s objectives. At the same time there is recognition that the policy interest rate, which alone is under the control of the central bank, is a blunt instrument when it comes to controlling these variables. The upshot is that more targeted ‘macro prudential’ instruments would have to be used. Examples of such instruments are pro-cyclical capital-asset ratios and loan-to-value caps.

            However, even as financial stability is explicitly being added to the central bank’s objectives, there is no consensus on how it is to be implemented. One source of difficulty stems from a possible tension between the pursuit of financial and macroeconomic stability at the same time. The standard example is that when the policy rate is lowered to stimulate employment it could encourage excessive risk taking, thus jeopardizing financial stability. Interestingly such a trade-off could arise even as the interest is raised. For instance, when the interest rate is raised to quell inflation it can contribute to financial instability by turning once-secure financial positions into risky ones, if not actually into Ponzi schemes. A Ponzi scheme is a financial position in which liabilities exceed receivables for the foreseeable future. There could be situations then, when balance would have to be struck between macroeconomic and financial stability. This is best achieved when the monetary authority is also the financial regulator.

            In general in India, concern for inflation has received far greater attention than financial stability. The Centre has made the Reserve Bank accountable for inflation but has left financial stability to a Financial Stability and Development Council in which the Finance Ministry calls the shots. This arrangement can be criticized on grounds of both the strategic design of institutions and political, respectively economy. WhiIe in principle there need be no problem in such a separation, where each policymaker cares primarily about her objective, separate agencies for macroeconomic stability and financial stability may end up not co-ordinating on the first best solution. Thus is made the strategic case for a single body. The political economy argument is that leaving the regulation of the financial sector to the ministry of finance opens up the possibility of influence peddling. Memoirs of a most highly regarded Governor of the RBI speaks of pressure having been put on him by the executive to grant a licence to a dubious international bank which was a marriage between middle-eastern money and south Asian management. The licence, we are told, was granted soon after he demitted office. The bank had gone on to collapse spectacularly on the world’s stage.

            Historically the RBI’s record of banking supervision is quite good. Only recently it has concluded the issuance of new bank licences, potentially a landmine, without a footfault. It is today headed by an economist of the highest class who also brings to the table considerable international experience. So, there is a serious case for vesting all powers with respect to financial stability with the RBI. However, inflation is an altogether different matter. The Bank’s pronouncements on the current inflation should be taken with a large dose of salt. For a start it takes far too much credit for the current downward trend in the price rise. This has come after 3 years of declining industrial production. The Bank hardly ever refers to this. If inflation is down it is so because industrial production was negative in 2013-14, thus lowering demand for agricultural goods. The year just past has also been one of agricultural growth higher than the trend which may be expected to have a dampening effect on the price rise. Secondly, the Bank has actively encouraged the belief that it can control inflation by adopting ‘inflation targeting’. The Government of India is happy to go along with this construction as it absolves it of all responsibility. The mistake is to assume that as the central bank prints a nation’s currency and inflation implies a decline in its value this must have been brought about by the bank’s own actions. This is a naïve view. A rising price level is the outcome of the interaction of the actors in the economy. A credible economic policy would try and tackle it at its source.