New Delhi: As the world battles to recover from the worst economic crisis since the Great Depression, Pronab Sen, economist and chief statistician of India, looks back to find out what went wrong. In an interview, Sen cautions against moving towards a universal banking system without putting social safety measures in place. He says the pace of work on big infrastructure projects will largely depend on the revival of global investor risk appetite. Edited excerpts:
What are your thoughts when you look back at what India and the world went through in the last 12 months?
Changing view: Pronab Sen says that the past year’s developments have punctured a lot of assumptions about the financial sector. Ramesh Pathania / Mint
What this year has shown is what is feasible, not just in terms of the financial sector, but in terms of growth and so on, so forth. A lot of the hugely inflated expectations have been moderated. All kinds of new benchmarks were thrown at us. One benchmark was that the world economy should be growing at least by 3.5%. The financial sector is capable of meeting all these demands whether or not the fundamentals of the old world macroeconomics justified that. So, savings rates are no longer the determinants of investments. What the last year has done is it has punctured a lot of those assumptions. Although, my fear is that many of us have not scaled back our expectations.
The second part of it is really a fundamental question regarding the nature of the financial sector. About the expectations of people who make deposits in various financial instruments and, therefore, the counterparty obligation of the financial sector to make sure that those expectations are given due respect. The whole notion of too-big-to-collapse would not have been a real consideration at all if the Glass-Steagall Act (The US Act, designed to curb financial market speculation, which was repealed in 1999) was still there. That is if the small depositor, the risk-averse person was not putting his money into risky, high-return investments, but just wanted to have his savings secure. I think he was let down seriously. One has to really rethink the nature of regulation fundamentally, based upon the reasons underlying the saver’s behaviour. And the regulatory system should mimic that as it is really the protector of the depositors. I think this is really the issue. And the talk about the demise of capitalism is pretty much rubbish.
In a developing country context, particularly India, what does this sober realization mean? You have one side of the argument, which says if you grow at 10%, poverty gets tackled. And on the other hand, you are saying one needs to be pragmatic and not overreach. How does a developing country such as India manage this tradeoff?
In fact the onus on developing countries is even greater. The fact is that since most developing countries do not have a social security system, it is absolutely mandatory to make sure that what people are keeping for bad times and old age is safeguarded. We do require investment banking type of functions, but they should be able to access funds from people who are willing to go to the higher risk, higher return kind of activity. We cannot continue to grow and maintain high rates of growth until we diversify our financial sector. As a country we are grossly underbanked to begin with. To have an economy of our size where total credit works out (to) around 60% of GDP (gross domestic product) is simply not feasible. We need to think of growing the financial sector in a manner that is commensurate with the risk-taking ability of the people who are engaging in it. You cannot ignore that side, when you have no social security system at all, you have no unemployment insurance of any kind. This is where I have serious reservations. We have pointed out this danger in the 9th Plan as well as in the 10th Plan. That we are moving from a narrow banking to a universal banking system without even going through the motions of changing the statutory basis of banking. I think that is wrong. In the US at least, they had to repeal the Glass-Steagall Act. So, they went through the entire process of legislation. We have been trying to do it through the backdoor, which is infinitely more dangerous.
How you think India has fared in the crisis year when you look back?
Well, we have fared rather well. The fact of the matter is (that) other than the normal impact that came through the exports’ side, which was expected as the world economy essentially had a turnaround of nearly six percentage points in terms of growth. But overall we are really talking about an aggregated effect of the whole crisis of a little over one percentage point of growth sacrifice, which is pretty remarkable.
But is it not more to do with the fact that India’s financial sector was not very closely intertwined with the global economy, because of restrictions on the capital account convertibility front?
That is a very large chunk of the reason. We still have very tight control on (the) treasury operations of our banking sectors. That certainly has protected us. We have been trying to convert our commercial banks into universal banks. This process has been on for more than five years now. The RBI (Reserve Bank of India) has continued to keep (a) fairly tight leash on treasury operations. Net result, of course, is that there are important investment banking functions which the Indian financial system cannot perform today. That function was carried out essentially by accessing the international financial system, which is why you saw your external commercial borrowings zooming from $3-4 billion (Rs14,550-19,400 crore today) range, which we have gotten used to, to $29-30 billion over a very short period of time.
The result was that when the crash happened it did not impact our banking sector because the banking sector was not exposed to that, but it did impact the people who were exposed to the international sector because of the counterparty problem. The Indian financial sector got impacted indirectly through their clients, who were borrowing at both ends. But the effect was relatively low. Nevertheless, the effect was there. Now, whether you can entirely mitigate that effect, the answer is no. I am not even sure whether you should. Because as I said there are lots of functions that the Indian financial sector will not be able to do in the next few years. You will have to continue to rely on the international financial system.
Was it through only this intermediation or do you think the negative sentiment also affected in a big way how India’s economy performed in the last 12 months?
Well, there were no real negative sentiments as such. At least none that I could discern. In two areas you may call it negative sentiments. One is the obvious, the flight of international portfolio capital, which led to a lot of uncertainty in the stock market that led to a certain amount of negative sentiment among Indian investors. But frankly, in terms of the Indian macroeconomy, that did not add up to a whole lot. The second area where there was negative sentiment was among bankers. The reason for that was the bankers were uncertain of what the other liabilities of their clients were. Did they have so much exposure in the international market that they would get impacted? Fortunately, that did not last very long. In terms of job losses, there was actual job loss, but by and large there was very little effect on the sentiments where people were actually scared of losing their jobs. What was much more pronounced was a feature that was driving the economy for a while, which is a huge amount of confidence that our children would be getting high quality jobs, that vanished. It was really the incremental job market that was being questioned rather than the incumbent.
Looking ahead, the 6% growth rate that we are talking about for the current fiscal, is it a baseline projection or would it go down further?
Now, I think the dangers have receded. If the September rains were not strong, then the rabi (winter) crop would have been under threat. And two successive crop failures (kharif, or summer, and rabi) would have pushed you down below a 6% growth rate. Perhaps, it would have taken us down close to a 5% growth rate. Now that the threat of a bad rabi crop has receded, it has done two things. One, of course, is the window of opportunity for people to make money on commodity markets has got restricted. It is now no longer open-ended. Secondly, the government’s stock of foodgrains now looks a lot more credible. The government can actually start acting aggressively on the foodgrain market today, which perhaps it might not have been able to, had the rains really not recovered.
But interest rates will be the key for going ahead.
Interest rate is certainly an issue. The impact of a prospective bad rabi would have been that inflationary pressure would have continued to grow. And sooner or later RBI would have had to act. But now RBI does not necessarily have to go in for strong monetary contraction for pulling down inflationary expectation. So, on the monetary policy side also, the rains have provided us some relief.
So, you mean to say inflation will not be an issue for at least the next six months?
No, inflation is an issue. We need to be very careful on this front, which is just the base effect is going to drive inflation up very rapidly. It is almost certain we are going to enter into positive territory in September itself. Once we cross into positive territory, it is going to increase rapidly. So, the reported year-on-year inflation figures will be looking horrendous. The point is—do you react to that? We know last year was an abnormal year and to use last year as a base for determining policy this year is completely wrong. What we really should be looking at is where were we, are relative to two years ago which was a relatively normal year. So, the year-on-year is a bad way of thinking about policy making.
What in your view is the single biggest macroeconomic risk potentially that the country may face in next six months to one year?
Potentially, I think there are two major risks. The first is the kind of investment that is needed, which is infrastructure and a fair amount of heavy industry investments like mining, basic chemicals and metallurgical industries. Much of that kind of investment depends upon the availability of long-term capital, which simply we don’t have in this country. We don’t have a corporate bond market, banks are not willing to lend. So, for all you are really dependent on is what happens in the developed markets. As the global economy starts coming back, I don’t have doubts in my mind that both the ability and the desire of the global financial system to start financing will go up.
The question will be what kind of risk exposure they would be willing to open up and at what pace. If you recall, at the peak of global euphoria, Reliance (Industries Ltd) raised 100-year money. I don’t see that happening. The point is: will that sort of negativism affect the investment requirements for 15 to 20 years? If it does, then this whole business of actively encouraging public-private partnership in infrastructure is going to get slowed because companies that come into infrastructure have to depend on global markets for their long-term capital requirement. The second risk is the fiscal deficit. At the moment I don’t think the fiscal deficit is a huge issue. On the revenue side, because of tax cuts, we have taken a significant hit and that is reversible. But on the expenditure side, I think we are going to find it terribly difficult to go back to earlier levels because these are precisely the kinds of things which have huge political content and they also tend to create vested interests So, the real test of the government is whether they will be able to rein in on the expenditure side.