Radical change in policy approach

Written by Saugata Bhattacharya | Updated: Oct 28 2013, 09:01am hrs
A day before RBI Governor Raghuram Rajans first major review of monetary policy (MP), it is useful to consider the medium term implications of broader financial sector reforms. Rate actions (repo, MSF, CRR, SLR, refinance, etc) get the most attention during a MP review, owing to the immediate consequences on bond yields, banks lending rates, the rupee, banks profits, etc. Most analysts are focused on this. But the actions also need to be evaluated over the years and across sectors, with a view to setting a context of future actions.

Statements and comments from Rajan and his team suggest a major change in approach to financial sector reforms. Some of these steps will be incremental, advancing measures already taken, others will be more radical and unconventional. Some of this will get reflected in the forthcoming report of the committee on monetary policy reform; some, in the final version of the paper on structure of the banking sector; and some more, in the ongoing implementation of the Financial Sector Legislative Reforms Commission (FSLRC). Coincidentally or otherwise, the various strands appear to be converging towards the recommendations of the report of Committee on Financial Sector Reforms (CFSR), Hundred Small Steps, then chaired by the current Governor. What are the practical consequences of this line of thought

The following are ten major facets of change in Indias financial sector we think are likely to happen over the next couple of years (with some help from Rajans statements).

1. The most immediate signal will be inflation. Inflation will become the primary target of monetary policy, with other components of Multiple Indicators becoming more diffused. Right up front in Rajans very first statement on the day he assumed office: The primary role of the central bank, as the [RBI] Act suggests, is monetary stability, that is, to sustain confidence in the value of the countrys money. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures. In other words, inflation is inflation!

* A shift to greater rule-based versus (at least a perception of) the discretionary approach to monetary policy. This will enhance Governor Subbaraos lasting legacy of having introduced greater transparency and communication. [RBI] should be a beacon of stability as to its objectives (and) the public should have a clear framework as to where we are going, and understand how our policy actions fit into that framework. Key to all this is communication. Wait to see if the new Governor is distinct from past.

* Deepening capital markets, for multiple reasons, including enabling quicker transmission of monetary policy. Too many risks in the Indian economy gravitate towards commercial banks even when they should be absorbed by arms length financial markets. But for our financial markets to play their necessary roles of providing risk absorbing long term finance, and of generating information about investment opportunities, they have to have depth. Cash-settled Interest Rate Futures: Speculation is not a dirty word. We cannot create depth by banning position-taking, or mandating trading based only on well-defined legitimate needs. Money is fungible so such bans get subverted, but at some level, all investment is an act of faith and of risk-taking.

* The economy will be opened to foreign currency flows more holistically than the piecemeal measures on external commercial borrowing and portfolio debt limits. Internationalisation of the rupee pushing for more settlement [of Indias growing trade] in rupees is key. Proposals to issue Indian foreign currency sovereign bonds overseas, thereby permitting inclusion in global benchmark indices, is probably as much a philosophical inclination as a measure to pull in more foreign currency funds.

* Markets will be moved onshore; Better that investors take positions domestically and provide depth and profits to our economy than they take our markets to foreign shores, allowing portfolio investors to hedge their positions onshore and allowing more players to increase depth and liquidity.

* The approach to banking sector development will move away from ownership towards segmentation, geographies. Contributing to Indias integration with the global economy foreign banks will be encouraged to increase their Indian presence. RBI will encourage qualifying foreign banks to move to a wholly owned subsidiary structure, where they will enjoy near national treatment [like permission for new branches, but simultaneously levelling the playing field for Priority Sector Lending (PSL) obligations].

* Reduction of financial repression, gradually, yet more speedily than before, enfeebling instruments of sequestration like SLR, CRR, while strengthening the financial sector with greater reliance on capital, liquidity, leverage, etc: This also has implications for incentivising fiscal discipline and consolidation as a means of providing monetary policy a larger space for monetary stability.

* Changing the role of the central bank towards greater focus on monetary policy, while relinquishing the function of being the investment banker for the governments borrowing programme: This, even though a surmise at present, will be a fairly significant change in RBIs inclination towards supporting a separate Debt Management Office (the middle office dealing with risk management of the governments issuance and portfolio).

* Enhancing financial sector efficiency through making payments electronic and digital: The new RTGS platform inaugurated last week, the proposal to introduce Electronic Bill Factoring Exchanges for MSMEs for prompt payments, setting up a GIRO-based Indian bill payment system, promoting mobile banking and many other measures are likely to give India leapfrogged-capabilities in an advanced payments ecosystem.

* Greater emphasis on resolution and recovery mechanisms: This includes not just the legislative framework (the recommendations of FSLRC are under consideration), but a deeper change in reduced regulatory tolerance of willful default. The Governor has repeatedly underlined his thinking on this, starting with his inaugural statement and then in various interactions. Promoters do not have a divine right to stay in charge regardless of how badly they mismanage an enterprise, nor do they have the right to use the banking system to recapitalise their failed ventures [yet] the system has to be tolerant of genuine difficulty while coming down hard on mismanagement or fraud.

One emphasis not included is the use of market based mechanisms to achieve financial inclusion and access to credit for SMEs, using innovative mechanisms. We think more radical approaches will be tried. One such mooted in the CFSR is the introduction of Priority Sector Lending Certificates. It is likely that current Committee on Financial Inclusion will deliberate and recommend measures to speed up greater access to remote areas using trading of entitlements and obligations relating to improving access to banking and credit.

Monetary policy is not just about financial market reactions; it is about fostering stability, something which all investors cherish. Reducing volatility in this environment requires sound macroeconomic fundamentals. Whatever the individual measures now, Indias financial sector will be transformed. This is important not just for meeting Indias voracious need for capital to finance growth, but also to move the country towards emerging as a major international financial centre to intermediate global transactions. Even more encouraging, there are signs that the Ministry of Finance is working with RBI and gearing up to provide a stable macroeconomic framework which is the critical underlay for a dynamic, modern financial sector.

The author is senior vice president and chief economist, Axis Bank. Views are personal