The draft report of the committee on financial sector reforms headed by Prof. Raghuram Rajan was released in April. In sync with last year’s Percy Mistry report, it recommended sweeping changes to the banking and financial system, both domestic and external.
Illustration: Jayachandran / Mint
While the focus of the Rajan report is on financial inclusion, the underlying philosophy is that comprehensive, all-at-once changes are necessary to ensure much-needed reform. In my opinion, whether a comprehensive or a piecemeal approach is suitable depends on the specifics of the situation. When policies are connected through arbitrage or similar conditions, they must be introduced together, as for exchange rates and interest rates. In general, however, rushing unconnected policies through together is a mistake. By contrast, introducing policies piecemeal allows enough time for the proposals to be carefully evaluated, before decisions are made. A thousand small steps are a big march, and need not be undertaken all at once.
Some of the report’s recommendations are very sound and clearly reflect a deep concern for the poorest of the poor. The suggestion to introduce trading of warehouse receipts for agricultural produce will greatly facilitate the flow of agricultural credit by creating collateral. This suggestion, in a “Sotonomics” mould, should be unequivocally endorsed. (Sotonomics is a term I have been using for a few years to categorize the path-breaking approach of Hernando de Soto. Among other things, de Soto stresses the availability and quality of collateral for small businesses as a main driver of inclusive growth.)
The report’s forceful critique of the huge inefficiencies of the public sector banks is valid, and some associated suggestions about how to tackle these problems are sound. But, some of the proposed remedies need to be treated with caution. A private banking system needs to be firmly regulated to avoid what is now happening on Wall Street, and can easily happen here.
Ironically, the final recommendations were submitted just as the Lehman Brothers was going bankrupt. An extremely naïve optimism about financial markets permeates the report. Consider excerpts from a passage, written this April: “While indeed the risk that has infected world markets started in the US subprime sector...despite its proximity and exposure the US financial system has weathered the losses thus far surprisingly well... Even while banks are hamstrung by overloaded balance sheets, hedge funds and private equity players are entering the market for illiquid assets and establishing a bottom.”
It is still not too late to backtrack or go slow on some of these proposals, and the finance ministry and the Reserve Bank of India should do so. Two proposals — introducing rupee futures trading, which has already started, and raising the limit for FII investment in the debt market — are dangerous.
On rupee futures, for starters, the report is absolutely correct that an exchange rate target must be abandoned. In general and certainly for a country as large as India, a flexible exchange rate is better. We should note that the three greatest macroeconomists of the last century (Irving Fisher, John Maynard Keynes and Milton Friedman) were in unison that a flexible rate is better. Unfortunately, some influential economists favouring greater convertibility in India have also been, in their columns, repeatedly defending sustained forex intervention, in violation of the impossible trinity condition. It can happen only in India, to cite one of them!
However, a flexible exchange rate does not at all imply we should also have a full bond-currency-deriative (BCD) nexus that the Mistry report has been so gung-ho about and that is being endorsed by the Rajan report as well. Derivatives are proving to be, with a vengeance, weapons of mass destruction, or WMDs, as Warren Buffett has been proclaiming for years. Others share this view, such as Satyajit Das, an authority on derivatives and author of a widely used four-volume reference work on swaps, etc., followed by a damning indictment of the whole business (Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives, 2006). He could have been consulted about the benefits of the BCD nexus.
As for increasing the limits for foreign investors in our government bonds, have we not learnt anything from 1998? Russia encouraged foreign purchases of GKOs (short-term treasury bills) and long-term bonds, OFZs. Foreign investors, who bid up the Russian stock market to almost double its value in 1997, the best performer that year, also held almost 40% of its government debt. But in August-September 1998, the rouble collapsed, inflation soared and Russia defaulted on its debt.
When the exchange rate is flexible, how do firms cope with currency risk if futures are not allowed? Last June, I had outlined a set of intertwined proposals for a flexible exchange rate with such low volatility that latent demand to hedge currency risk will be minimal.
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With RBI imposing moderate capital controls, a “random walk” exchange rate band has the potential to ensure an exchange rate that is flexible but not volatile. For the random walk band to work, inflation must be reduced in India so that our long-term nominal interest rates come down to European levels. This, in turn, will remove the underlying steady pressure for one way debt inflows such as external commercial borrowings.
Overall, the Rajan report’s policies will have a huge impact on the economy. Firms will face potentially huge currency swings that can devastate them, as happened last April. The Confederation of Indian Industry, let alone small exporters and importers, is not aware of the full ramifications. It has the clout to spearhead legislation to block the report’s external financial sector proposals and should do so.
Vivek Moorthy is professor of economics at IIM Bangalore. Comment at firstname.lastname@example.org