The politics of Indian financial sector reform

Context

Even after about two decades of economic liberalisation, India’s financial sector remains a bastion of government regulation. Foreign investment is restricted, state-owned banks predominate and the government channels lending to favoured sectors. Deregulation has been taking place slowly over the years but any momentum towards further reform appears to have been halted by the global financial crisis. However, the story is more complicated than that and not all progress is at a standstill. In this note we provide a broad outline of the changes that are needed, and in many cases proposed, for the financial system, together with an analysis of their political feasibility.

Further reform is necessary

The government’s view of the role played by the financial system has changed in recent years. Following the nationalisation of major banks in 1969, the government adopted a statist approach that treated the financial sector primarily as a source of public finance. Lending was directed towards preferred sectors via sector quotas and interest rate controls on both private and state-owned banks. Although productivity and efficiency suffered, the system did succeed in creating a vast network of bank branches that made credit available to customers nationwide and helped divert household savings away from small-scale moneylenders to formal channels for investment.

Efficiency considerations gained ground in the early 1990s when the government began gradually to deregulate banks and insurance firms by easing restrictions and permitting private and foreign banks to expand. Government securities began to be auctioned at market prices and most interest rates on deposits and lending were freed. The Reserve Bank of India (RBI) tightened financial supervision, depoliticised lending to reduce non-performing assets and recapitalised and modernised state-owned banks. Stock exchanges were brought up to modern standards and transaction costs fell throughout the financial system, promoting efficiency and contributing to faster growth. The broad reduction in fiscal deficits freed up a greater proportion of savings for private investment (although some of this progress has lately been reversed as we explain in our June 2008 note The populist trap).

However, India’s financial sector continues to labour under a regulatory burden:

• Foreign investment in several financial subsectors such as commodity exchanges, asset reconstruction, insurance and credit information is capped at a maximum of 49 per cent of equity. This contrasts sharply with the 100 per cent FDI allowed in most other sectors. Foreigners can own up to 74 per cent in local banks but their voting rights are capped at 10 per cent.
• State-owned banks continue to dominate the financial landscape and hold about 71 per cent of all deposits. Branch expansion by private and foreign banks is restricted.
• Bond, currency and derivative markets remain fragmented and underdeveloped in comparison with the equity market. This inhibits the mobilisation of domestic savings for long-term debt investment, creating a perverse dependence on foreign commercial borrowings in sectors such as infrastructure.
• The RBI imposes “priority lending” quotas on banks to direct lending into favoured areas such as agriculture, small industries and education. This amounts to 40 per cent of deposits for local banks and 32 per cent for foreign banks.
• Controls on rupee convertibility on the capital account have been eased, but not yet lifted.
• Commodity markets remain heavily regulated despite their recent growth and expansion (see our September 2007 note Back to the futures for a more detailed look).

The cumulative impact of these controls is to inhibit the development of efficient and liquid markets that meet the financial demands of a large and growing economy. As is clear from its commissioning of various reform proposals, the government broadly agrees with this diagnosis. But as our trusted source, a senior government official, explains, the uncertainty resulting from the global financial crisis has led to a postponement of major reform decisions as the government grapples with its consequences. But once the crisis plays itself out in the next two-three months, the political landscape will determine the course of financial sector reforms.

Political landscape

As we have described in our December 2007 note Left outflanked, the process of gradual reform continues in India despite resistance from several quarters. In the financial sector, liberalisation is promoted by top political leaders, officials in key economic ministries and the broad business community. The resulting momentum is underpinned by a middle-class consensus in favour of growth and globalisation. Countervailing forces include ideological opponents such as the Communists and interest groups such as organised labour, political activists, business lobbies and consumers/voters who are angered by price rises and subsidy cuts.

This last group is especially influential in India’s democratic system: in response politicians have repeatedly resorted to questionable measures such as banning futures trading in certain commodities (for fear that it feeds inflation) and of course holding fuel prices low despite a big expansion in the fiscal deficit.

Opposition is most effective when policies need to pass through various veto points such as parliament. It is least effective when the rules permit the government to implement changes administratively; this applies particularly to incremental policy changes whose overall impact is either benign or, if not, difficult for voters to discern. For example, the gradual movement towards full rupee convertibility by lifting the annual cap on exporting capital for individuals to US$200,000, allowing mutual funds to invest abroad, and freeing overseas direct investment by firms to up to 400 per cent of their net worth (or more, with special permission) as occurred in September 2007 has elicited little opposition beyond critical editorials in left-wing journals.

Institutional incentives also matter. The RBI is responsible for financial stability as well as financial development, and therefore tends to err on the side of caution. The bank took many long years to introduce currency and interest rate derivatives and its officials have repeatedly shown a reluctance to deregulate too quickly. This innate conservatism can be a strength, as was demonstrated by the RBI’s early decision months ago to reduce credit to risky sectors such as real estate and consumer loans; arguably, this has helped Indian banks avoid their Western counterparts’ fate. But it also means that financial innovation is slow when left to the RBI.

Change is faster when the central government takes ownership of an issue – as it did in 2006 with the development of domestic debt markets. Unlike the RBI, the Securities and Exchange Board of India (SEBI) is known to move quickly to implement regulatory changes, in part because it is more closely linked to market preferences.

Political blockages

In the financial sector, the most difficult policies to implement are those that face widespread political opposition, such as the dilution of government equity in state-owned banks from 51 per cent to 33 per cent. Equally complex are those that need to be passed by parliamentary vote, such as bills to make foreign shareholder voting rights in domestic banks commensurate with their shareholdings, to raise FDI in insurance from 26 per cent to 49 per cent, and to establish statutory regulators in pensions and commodity markets. These regulators are required to facilitate private investment, and opponents hope that blocking these bills will prevent this from happening. The Indian National Congress-led coalition decided in 2004 not to dilute its holdings in state-owned banks below 51 per cent, but its efforts to pass the other bills mentioned have been foiled by Communist opposition.

Following the withdrawal of Communist support for the ruling coalition in July 2008, the government has presented the banking and insurance reform bills to parliament. Given their late introduction, however, they will not be passed until the next parliament following elections in the next six months. Tensions with the opposition Bharatiya Janata Party (BJP) have also delayed their passage since the BJP, which in theory supports these bills, has vowed to oppose the government on all fronts.

But the government has sought to bypass parliamentary opposition where it can. In 2004 it introduced a Chilean-style defined contribution pension plan for government employees that it hoped to implement nationwide once a statutory regulator was in place. But the bill to give statutory enforcement powers to the current regulator has been stalled in parliament, forcing the government to develop the necessary infrastructure in anticipation of eventual private sector involvement, but without initial private participation (for more on this plan, see our June 2007 note Paying for the old). Officials have decided in recent weeks to extend the scheme to the private sector in the absence of a statutorily empowered regulator through contracts with private fund managers to enforce compliance with the rules. The regulator plans to start this process in April 2009.

Where progress is possible

The good news is that not all reforms require policymakers to negotiate their way through a political thicket. As suggested by the favourite phrase of the Committee on Financial Sector Reforms – which presented its draft report “A Hundred Small Steps” to the government in April 2008 – it is equally important to push ahead with incremental measures that accumulate over time to transform Indian financial markets. (The head of this committee, former IMF Chief Economist Raghuram Rajan, has since been appointed an adviser to the prime minister.)

The ongoing effort to develop Indian debt markets is one example. The corporate debt market has long lagged its equity counterpart in volume, sophistication and liquidity. Most companies have chosen to borrow money via more manageable private placements or by going overseas, which is insufficient to finance the private demand for debt in India. In the infrastructure sector in particular, projects have suffered from a lack of long-term financing and from the problem of maturity mismatch; most bank loans have a tenor of three-five years, while cash flows from infrastructure often begin to build up only after 10 years. This either deters investment or leads to an unhealthy loading of user charges up front.

The development of debt markets has required concerted action among the Ministry of Finance, RBI, SEBI and state governments. Although some deeper structural issues – such as the lack of a strong bankruptcy code (to strengthen claims on collateral) and a slow judicial system (as described in Judging the judiciary) – have slowed the growth of collateralised bond markets, the bulk of the action has been appropriately focused on smaller regulatory changes to get this segment moving.

Minister of Finance Palaniappan Chidambaram announced in February 2006 that the government would accept the recommendations of an expert committee and initiate a series of reforms to develop the corporate bond market. A number of policy changes have since been introduced:

• In January 2007 the government clearly defined regulatory powers. It made SEBI solely responsible for the corporate debt market and gave the RBI responsibility for market-making repo operations. However, no decision has yet been taken on who will regulate bond issues by unlisted entities.
• In July 2007 Bombay Stock Exchange and National Stock Exchange (NSE) bond trading platforms became operational with both over-the-counter (OTC) and exchange trades reported. A third OTC platform run by the Fixed Income Money Market and Derivatives Association of India began operations in September 2007.
• In February 2008 the government eliminated tax deduction at source for corporate bonds, making them more attractive to investors and bringing them on par with government bonds that are much more actively traded.
• In May-June 2008 SEBI streamlined listing norms and disclosure requirements to make bond issuance competitive with private placements and equity issuances.
• In October 2008 the government raised the overall cap on foreign investment in corporate bonds from US$3 billion to US$6 billion. The volume of corporate bonds traded in the first half of FY2008-09 was Rs507 billion (US$11 billion), about the same annualised level as FY2007-08.

The case of bond market development shows that administrative micro-measures to facilitate financial market development are as important as the big steps. No sector entirely escapes the shadow of politics, of course: efficiency still requires different state governments to reduce and standardise the plethora of stamp duties on bond issuance, a less controversial goal that the central government has to pursue more vigorously. The passage of insurance and pension reforms in parliament will help deepen the market for corporate bonds, as will any reduction in government borrowing. The RBI will also have to be proactive in offering corporate bond repos to promote liquidity rather than wait for every other institution to first complete its obligations. But the main task in this area is to implement a system, not simply to lobby parliament or play politics.

As elements of modern markets are put in place, they will reinforce each other. As stated by the Committee on Making Mumbai an International Financial Centre in February 2007, bond, currency and derivative markets “are interwoven by interest rate and currency arbitrage”. Therefore a domestic bond market cannot operate optimally in the absence of an established rupee yield curve that is arbitrage-free, liquid and well traded along very short (seven days) and very long (up to 50 years) maturities.

Increased openness to foreign investment and the introduction of currency and interest rate derivatives for hedging purposes will facilitate this integration. Exchange-traded interest rate futures were inaugurated on the NSE in August 2008, and in October 2008 the RBI permitted banks to take long and short positions on exchange-traded interest rate futures. Despite the uncertainties flowing from the immediate crisis and the forthcoming elections, we believe policy momentum will continue.

Trusted Judgement

Policy changes on hold for now, but tough decisions lie ahead

A senior adviser to the prime minister

So far as the reforms go, we will stick to the gradualist, low-profile approach. Passing contentious legislation remains difficult and subject to political calculations. Non-legislative changes can continue, and many of these are small enough so as not to attract political or serious interest group opposition. This process is ongoing. But essentially there will be little movement on major policies until the elections are over, although the prime minister may be able to push one or two measures through before that.

Financial reforms will have to wait until things become clearer in the next two-three months with respect to global financial markets. We are also keen to make sure that we do not overreach and take steps in a panic that will hurt us down the line. So we will be conservative in the coming months. But nothing stops us from implementing smaller policy steps over time.

However, something will have to give after the elections because our fiscal situation is unsustainable. We will need action on the subsidy front and regarding pricing. But the political will needs to be there first.

Small changes add up

Draft report of the Committee on Financial Sector Reforms, April 2008

There has been an enormous amount of attention paid to issues like capital account convertibility, bank privatisation and priority sector norms. While important, there are many other areas in which reforms are less controversial, but perhaps as important.

As an example of the kind of reforms we would support is the trading of warehouse receipts. With the promulgation expected soon of the Warehousing (Development and Regulation) Act, 2008, warehouse receipts will become a negotiable instrument. They will become a new, reliable form of collateral in the agricultural sector, where till now there was no other security except land. The advent of the warehousing receipt system will result in a lower cost of financing and an increase in liquidity for agriculture, and is a break from a focus of the last few decades on targeted lending as a way to energise agricultural credit. In addition, the Act encourages scientific warehousing of goods, improved supply chains, enhances rewards for grading and quality and encourages better price risk management. Assuming that at any given time about 10-15 per cent of the annual agricultural produce is stored in warehouses, the Act has the potential to inject over US$30 billion in agricultural credit.

This is the kind of reform the country can easily achieve. Instead of focusing primarily on a few large – and usually politically controversial – steps, we also need to take a hundred small steps in the same direction that will collectively take us very far.

Wrap

A hundred small steps to reform

We believe the “hundred small steps” approach has merit, and is a good approach because bigger reforms face political obstacles. These impediments have been strengthened by the financial crisis and approaching elections, as our trusted source explains. Policy clarity awaits the results of parliamentary elections and the formation of a new government. It would seem at this point that a future coalition government will once again be formed around either the Congress Party or the BJP, suggesting broad continuity with the gradualist reforms model. However, specifics will depend on the exact composition of a new government, and it is too early to speculate on what shape that might take.

Some of the pending reform bills could well be passed by the next parliament. Even if the logjam continues, however, considerable progress is still possible but will require consistent effort by all actors. Limits on foreign investment in various sectors will continue to be lifted. Measures will be taken to deepen debt markets and introduce hedging products such as various futures and options. The timing could be affected by the RBI’s conservatism or by lack of attention from a preoccupied government. We nevertheless expect the basic impetus for reform to flow from top political leaders, an economic bureaucracy keen to deregulate and a middle class that sees benefits in globalisation.