Change of guard at Mint Road: old dilemma, new hope

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: This year, the release of the Reserve Bank of India (RBI) “Report on Currency and Finance 2006-08”, on the theme “The banking sector in India: emerging issues and challenges'' serves more than one purpose.

Apart from summing up various developments, along with specific dilemmas and concerns from a banking regulation and supervisory point of view, it holds clear briefings for the new RBI governor Duvvuri Subbarao from where to pick up the reins of RBI, after five years of the Reddy era. A few days ago, during the same week, the annual report released by the central bank had outlined economic and fiscal concerns, where, quite obviously, keeping a check on the ongoing double-digit inflation was the dominant issue.

It would be interesting to watch Subbarao - with his vast exposure in the area of economic and financial policy-making - address these issues with his own touch and thinking. Analysts, some of whom did not expect a change of guard at RBI at all at this critical juncture -- were of the opinion that the Reddy regime was conservative and has left an unfinished reform agenda, which may have to be completed within a deadline.

Subbarao, who was the finance secretary before being selected to head RBI for the next three years, is not new to the core issues of RBI's functioning, as he has acted as an interface between the government and the banking regulator.

In fact, Subbarao, as finance secretary, had made it clear that the monetary policy was the first line of defence to check runaway inflation. Though inflation has seen a downward trend in the past two weeks, settling at 12.34% at last count, experts still see a tough road ahead for the new governor. Taking a cue from his earlier statements, experts opine that Subbarao's possible action plan may be predictable and would, necessarily, be hawkish, as policymakers seek to bring down inflation to RBI's targeted 7% level by March 2009. And as Subbarao assumed charge last Friday, his first comments seemed to show that RBI-watchers were not on the wrong track. Said Subbarao on his priorities: “The immediate priority will be to manage inflation and anchor inflation expectations. The priority in the short-to- medium term will be, of course, to pursue financial sector reforms in the context of financial stability, price stability and above all, an ear firmly to the ground on real sector reforms.”

Earlier this week, the government made the crucial appointment to the top job at RBI. Some market-watchers had speculated that Reddy would have his tenure extended, but a three-year term was given to Subbarao.

The new governor likely carries a strong tightening bias, according to his recent comments on inflation and interest rates. Although inflation has shown signs of easing in the recent weeks, it is insufficient to stop the central bank from further raising interest rates and cash reserve requirements in the October monetary policy review-the most it can do is to prevent intermittent monetary tightening, says Sherman Chan, an economist at Moody’s.

Inflation apart, the agenda for Subbarao will have many other aspects, which will need RBI's attention.

Explaining the need for pushing reforms fast in the banking sector, RBI says that over the years, banking systems all over the world have witnessed a significant transformation underpinned by various factors such as deregulations, technological innovation and globalisation. These developments have resulted in increased competitive pressures.

Banks, therefore, have been introducing innovative products, seeking newer sources of income, diversifying into non-traditional activities and economising on capital. All these developments have posed several regulatory and supervisory challenges. Highlighting the new trend, the RBI report also mentions a shift in the regulatory focus from micro regulation to macro management based on prudential elements, with a view to strengthening the banking sector and providing it with greater operational flexibility.

The blurring of distinction among banks and non-banks, the emergence of financial conglomerates and introduction of several innovative financial products have also posed several regulatory and supervisory challenges.

Another major challenge is to bring the people who have remained financially excluded within the banking fold, says RBI. However, an assessment of the progress in financial inclusion is hampered by the lack of relevant data/information. The report has also revealed that banks in India have had increased exposure to the infrastructure sector in recent years. However, increased credit intensity of the industry could not be explained by increased exposure to infrastructure alone.

Credit growth to the SME sector, which slowed down significantly between 1996-97 and 2003-04, picked up sharply from 2004-05. However, the share of the SME sector in total non-food bank credit declined almost consistently from 15.1% in 1990-91 to 6.5% in 2006-07 and also in total priority sector advances from 43.6% at end-March 1998 to 17.9% at end-March 2006. It picked up marginally to 18.6% at end-March 2007.

According to RBI, this suggests that it is the large corporates that have increased their dependence on the banking sector. The major development that has taken place over the last decade is the diversification of credit in India towards retail credit. The share of retail credit comprising housing loans, credit to individuals, credit cards receivables and lending for consumer durables, in total bank credit increased from 6.4% in 1990 to 22.3% in 2007. On the whole, agriculture, large corporates and the retail sector, benefited from credit expansion, while credit growth to the SME sector remained tepid until recently.

Another key issue is government ownership in banks. The issue of ownership in public sector banks needs to be viewed against the changed operating environment. The ownership of public sector banks is not an issue from the efficiency viewpoint, as public sector banks in India now appear to be as efficient as new private and foreign banks, as revealed by various measures. However, the operating environment for banks has been changing rapidly and banks need flexibility to respond to the evolving situation.

Another issue that needs to be considered is the funding of capital requirements of public sector banks, given the present floor of 51% on government equity in public sector banks. In the medium-term, this can become an issue, hampering the growth of public sector banks, if the government is not able to provide adequate capital for their expansion, the RBI report said. The roadmap of foreign banks is due for review in 2009. This would involve several issues. The increased presence of foreign banks, by intensifying competition, may accelerate the consolidation process that is underway. However, at the same time, this may also raise the risk of concentration if mergers/amalgamations involve large banks. The experience of some other countries also suggests that the emergence of large banks due to consolidation has resulted in reduced lending to small enterprises significantly. All these issues would need to be carefully weighed at the time of review.

Also, the policy relating to ownership of banks by commercial interests may have to take full account of international practices, given the issues relating to a potential conflict of interests, increased potential of contagion effects and increased concentration.

Moreover, the trading in currency futures might have been kick-started, but a lot needs to be done to develop a sound forex market.

Subbarao’s predecessor, however, has spelt out why he could not - or did not - achieve some expected milestones. On whether he could have developed other financial markets like interest rate futures, the outgoing governor replied: “Certainly it is possible. But with an inadequate, imperfect spot market, how far will an interest rate futures market help?”

If things have changed swiftly in the last five years when Reddy took charge of the apex bank as governor, there would doubtless be further twists and turns in the next three years, as the financial markets get more dynamic and challenging, testing RBI to the hilt.

Dwelling on his dilemmas, Reddy said: “We constantly question ourselves and are able to have course corrections. There are dilemmas. GDP has grown 50% in five years. There would be very few cases. Apart from China, I can't think of any. This is a different dilemma from Jalan saab's dilemma, which is a different dilemma from Dr Rangarajan’s.”

Surely, with expectations running high, Subbarao has many challenging tasks ahead. Or, as Reddy prefers to put in a lighter vein: “Every governor seems to be able to manufacture his own challenges.”