By KV Kamath

The Reserve Bank of India has indicated that effective fiscal 1999, the credit policy would serve as a policy document providing direction in respect of structural reforms in the financial sector, rather than just being confined to mere credit policy announcements pertaining to interest rates and regulatory issues.

As the present momentum has been spurred by some powerful structural forces, viz. economic and financial deregulation and continued technological and financial innovation, this shift in perspective could not have come at a more opportune time. The forces of globalisation are affecting all markets and any discussion on structural reforms in the Indian financial sector has to be viewed in the backdropof the economic turmoil and currency crisis in East Asia. Their experience throws light on the factors affecting financial systems despite having well-developed markets and throws up several strategic implications for Indian banks and financial institutions. Based on the same, appropriate benchmarks have to be created in India. All this has to be viewed in the context of the Indian socio-political environment that encompasses every entity in the system.

The Indian Imperative: A key objective of India's liberalisation programme has been employment creation and poverty alleviation. Accordingly, India has adopted a middle path aimed at reducing the social cost and pains of liberalisation. No strategy of economic reform and regeneration in India can succeed without sustained and broad-based policy initiatives aimed at diverse sections of the economy.

This has meant that it has been much harder to reach political consensus on the need to reduce fiscal imbalances and on exit options for poorlycapitalised and overmanned financial intermediaries. The credit policy initiatives have to be viewed in this context.

Benchmarking the Indian financial sector

The East Asian crisis is a classic example of how the absence of a robust domestic financial system results in a systemic breakdown of the economy. The East Asian crisis has not been proof of the failure of global capitalism as much as evidence of globalisation itself.

Although several factors are responsible for the crisis in East Asia, the most striking is the failure of financial intermediation. The banking crisis was the result of the rapid expansion in credit leading to highly leveraged corporates, short-dated foreign currency exposures, high concentration of exposures, large exposures to real estate and stockmarkets and ineffective regulatory supervision. A major lesson from the East Asian crisis has been that while there are benefits to be gained in open capital markets, there are potential risks given the increasing volume andvolatility of capital flows.

In order to reap the full benefits of open capital markets while reducing the risk of disruption, the domestic financial and banking systems should be strong. They should be well capitalised, well supervised, and subject to internationally accepted prudential standards.

India's economic cycle is different from East Asian economies owing to its lower reliance on export-led growth. In India, banking credit exposures do not pose systemic risks to the country and are far less serious than the situation faced by banks in East Asia. Domestic bank credit in India accounts for only 21 per cent of GDP as against about 150 per cent in East Asian economies like Thailand. Interest expenses of domestic banks constitute only three per cent of GDP as against around 20 per cent in East Asian economies like Thailand.

Moreover, banks have no direct exposure to property markets and minimal exposure to the stockmarket. However, notwithstanding the fundamental differences from our regionalcounterparts, what is pertinent to the Indian economy is that the existing structure of the domestic financial system has to be reviewed to make it stronger and more efficient.

Changing structure of banks and FIs

As India integrates with the global economy, and users of financial services become more sophisticated and demanding, there will be a shift towards those entities that will offer customised products in the most innovative and cost-efficient manner. In the light of this emerging scenario as well as international experience, there is a need to progressively eliminate product market restrictions on all financial intermediaries and move closer to the model of universal banking.

This would also provide the other benefits of reducing the risk of financial instability inherent in any single product concentration, and enhance efficient deployment of capital. As a result, most FIs have transformed themselves in one way or another into banking entities while retaining a focus on providing termloans. This process has to be facilitated for implementation over a short time frame of 12-18 months.

Increased accountability and transparency Sound accounting and disclosure practices are essential to ensure the enhanced transparency needed to facilitate the effective supervision and market discipline of banks and financial institutions. Various international bodies, including the Basle Committee, have called for progress in accounting and disclosure practices for banks' lending business and related credit risk. The Basle Committee of Banking Supervision has provided guidance to banking supervisors on recognition and measurement of loans; establishment of loan loss provisions, credit risk disclosures and related matters.

The prescribed standards have been implemented and/or are being implemented in a large number of countries. Therefore, it is essential for all commercial banks and FIs in India to meet these standards as early as possible. The RBI on its part has to effect these standards at theearliest.

Accounting treatments generally, and loan accounting treatments specifically, can significantly alter the accuracy of financial and supervisory reporting and related capital calculations. One approach to mitigate this problem could be alignment of Indian accounting practices in line with international accounting standards like US GAAP and IAS over an 12-18 months timeframe.

Developing competitive edge Cost inefficiencies, poor credit management, outdated technology and large dysfunctional bureaucracies that are slow in their response to change have led to the emergence of weak banks. Though several recommendations have been made regarding the future of weak banks--asset reconstruction companies, write-offs, narrow-banking--no specific measure has been adopted so far to resolve the problem. It is essential that an active solution for weak banks be adopted and implemented.

Another key area is the role of technology in the financial markets today. Complete computerisation and connectivity canenable any financial intermediary to offer the complete range of products and provide a paradigm shift in delivery of service to the individual. The experiences of new banks in other emerging markets have clearly shown that it is possible to penetrate the retail market and gain substantial marketshare through the effective use of technology, thereby effecting a substantial reduction in intermediation cost. The RBI should take immediate steps towards initiating a competitive repositioning for Indian banks.

Interest rate and exchange rate management Although the GDP is growing at 5 per cent-plus levels, the economy is operating well below potential, thereby calling for a reduction in interest rates to boost domestic demand and sustain growth. In the absence of a strong fiscal correction, the large government borrowing programme is likely to put upward pressure on interest rates.

Further, as the decline in nominal interest rates has not kept pace with the decline in inflation, real interest rates have goneup since December 1998.In the scenario of declining inflation, RBI has to support a policy of lowering nominal interest rates further to keep real interest rates low which would trigger investment activity and growth. In view of the above, the RBI should take explicit steps over the next one year aimed at reducing interest rates by about 200 basis points, particularly at the longer end of the maturity spectrum.

While it is well known that financial stability rests on the ability to maintain a stable currency, the cost advantage of East Asian economies following their currency depreciation have put Indian exports at a major disadvantage. Given the currency depreciation levels witnessed in the region, ranging from 25 per cent to 250 per cent vis-a-vis the Indian rupee, the exchange rate policy of India has to be reviewed in line with the anticipated economic benefit of higher export growth.

The exchange rate, therefore, has to be kept at competitive levels, keeping in mind the imperatives of globalcompetition. The aforesaid steps if initiated over a time frame of 12-18 months would result in a stronger corporate India.