Raghuram Rajan couldn’t have found a more inopportune moment to present his blueprint for financial sector development in India.
It was in August that the Indian government had asked Rajan, formerly chief economist at the International Monetary Fund and now a finance professor at the University of Chicago, to come up with a road map for change. Back then, the subprime mortgage crisis was just beginning to surface; the collapse of Bear Stearns Companies Inc. was not in sight; there wasn’t a whiff of a run on Britain’s Northern Rock Plc.
At the time, it seemed that Public Enemy No. 1 for India, as it rapidly integrated with the world, was financial weakness of the kind that had made the 1997 Asian currency crisis so painful for the Tiger economies.
That was then.
Now, at least in some Indian intellectual circles, the face of the villain has changed. It is a more developed financial system—one that has a full range of markets for hedging of risks along with free mobility of capital across national borders and regulatory forbearance for financial innovation—that has to be resisted.
It’s now fashionable to be pessimistic and to argue that the Reserve Bank of India’s (RBI) “let’s-ban-whatever-we-can’t-manage” approach is the right one, and that market participants and the finance ministry are wrong to push for change. That’s the new dogma.
Those who hold such a view don’t see any need for rocking the boat. The Indian economy is growing strongly; and although inflation at a three-year high of 7% is uncomfortably above RBI’s tolerance limit, it’s still more under control than in other places in Asia where there’s no monetary policy either by design (such as Hong Kong) or by default (such as China or Vietnam).
But there are inherent weaknesses in the Indian system.
The state-dominated banking industry is tiny and seems to exist only to help the government finance its budget deficit; the usurious moneylender remains the mainstay of farm credit; corporate bond markets are moribund; some of the controls on capital flow, such as the restrictions imposed last year on companies borrowing overseas, are draconian.
The Rajan committee, which released a draft of its report on Monday, has delivered the goods. Its advice on collateral registration, creditor protection and a new bankruptcy code are top-notch; its proposal on small, local banks is worth a try if India has to make millions of people, who don’t even have a savings account, a part of formal finance.
The panel’s proposal on creating a market, where banks can buy rights to undershoot the priority lending targets imposed on them by the government (such as unprofitable working capital loans to farmers) is innovative. It’s a much superior alternative to banks meeting priority-lending targets by buying, say, securitized tractor loans in which they end up assuming credit risk they don’t really want.
Rajan’s suggestions on unifying regulatory control of all financial trading will lead to healthier markets with fewer distortions. The panel has also offered sound advice against separating banking supervision from monetary management and against selling state-owned banks to business houses.
This is by no means an agenda for recklessness.
The draft report also makes a case for RBI to stop managing the exchange rate and formally adopt inflation control as its sole objective. The panel is right in saying that India can’t resist real appreciation in the currency; if the country holds down the exchange rate, inflation will accelerate.
But is India really ready for inflation targeting? I’m no longer as sure as I was three years ago. It requires an extremely nimble economy to weather the kind of sharp exchange rate adjustments that may occur when the world is awash with liquidity and the central bank’s inflation target gives traders near-perfect predictive power over the future interest rate path. Thailand paid a price for such predictability when it had to impose capital controls.
There’s no denying that monetary management in India needs an overhaul, but a move to inflation targeting should perhaps come after there has been more financial development so that RBI’s short-term policy rate has greater power to affect domestic prices.
Finally, political acceptance of change is more important than how the intelligentsia may view the choices between a developed and an underdeveloped financial system.
It ought to be clear to anyone who reads the report that the Rajan panel’s agenda is not driven by the self-interest of an Indian elite that’s trying to sneak in undesirable changes.
The reform the panel is suggesting is aimed at the middle class, the distressed farmer and the urban poor. Will politicians be able to translate that message into words their voters will understand? Should they even bother?
With the general election due next year and perhaps even sooner, the present government has made known its preference for populist farm debt waivers and large pay increases to civil servants. Meaningful improvements in the structure of the economy, such as those suggested by the Rajan panel, may have to wait for a more opportune time.
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