Finmin, RBI should join hands on inflation

Finmin, RBI should join hands on inflation

Last year’s Budget had two surprises for the Indian financial sector. First, finance minister Pranab Mukherjee’s announcement that the Reserve Bank of India (RBI) would soon issue licensing norms for new private firms in the banking space and, second, the formation of the Financial Stability and Development Council (FSDC).

On both issues, I am told RBI was consulted only a few days ahead of the budget. And, on both, the Indian central bank had reservations. It had been talking about consolidation in the banking sector, and not entry of new companies, till Mukherjee said this in his budget speech in February 2010.

Even though the stated objective of FSDC is to “strengthen and institutionalize the mechanism for maintaining financial stability" and it plans to monitor macro-prudential supervision of the economy, including the functioning of large financial conglomerates, and address inter-regulatory coordination issues “without prejudice to the autonomy of regulators", both RBI and the capital market regulator are distinctly unhappy and they see it as a dent on their autonomy.

The first draft on FSDC, circulated by the ministry, evoked strong reactions from RBI. It was circulated just before the promulgation of an ordinance by the President of India that sought to resolve the face-off between the stock market and insurance regulators.

The 18 June ordinance, the Securities and Insurance Laws (Amendment and Validation) Ordinance, 2010, which later became a law, empowers the finance ministry to resolve all future regulatory disputes, including those involving RBI.

Faced with stiff resistance from RBI, the ministry made cosmetic changes in the structure of FSDC and the regulatory dispute resolving law, but it did not budge an inch from its resolve to push through these issues.

One wishes that it shows same resolve to address other financial sector related issues, some of them are a decade old.

Successive Union budgets have promised reforms, but very few of these promises have been kept. For instance, in 2000 then finance minister Yashwant Sinha promised to bring down the government holding in public sector banks to 33%. More than a decade later, the government continues to hold 51% stake in these banks. Many of them need fresh capital infusion as they grow their business, but since they cannot tap the market for money, the government has no choice but to infuse capital despite running high fiscal deficit.

Similarly, it has not been able to remove the cap on voting rights for private banks. Both Sinha and Jaswant Singh, his successor, announced the removal of 10% cap on voting rights in private sector banks. P. Chidambaram, another finance minister, too, promised this in 2005, but the necessary amendment to the Banking Regulation Act, 1949, is still awaited. Yet, another contentious issue is foreign investments in Indian banks. While private banks can offer up to 74% stake to foreign investors, such investments are capped at 20% for public sector banks. This affects the valuation of public sector banks that roughly account for the 70% of the industry.

Finally, there’s the issue of foreign holding in insurance firms. The sector opened for private firms early this century with a 26% foreign stake. Many budgets discussed the proposal of raising it to 49%, but post the 2008 global crisis, nobody is talking about this. Till the clarity emerges on this, insurance firms are unlikely to go for public floats even though they need capital.

These are all critical issues, and in some cases, laws need to be changed to address them. For that a political consensus is needed. Then, there are other relatively easy ones. Take, for instance, the different tax structures for different savings instruments. There’s no need to pay tax on dividend earnings from investments in mutual funds. Similarly, there is no capital gains tax if one stays invested in the stock market for a year. But bank deposits are subject to tax.

This means return on bank deposits is limited. Even when a bank is offering as much as 9.5% on term deposits, a person who belongs to the highest tax bracket earns less than 7% after paying tax. Till a level playing field is created, banks will always find it difficult to attract savvy savers’ money vis-a-vis mutual fund and direct investment in equities.

This is bankers’ headache. RBI governor D. Subbarao’s headache is the high fiscal deficit and the government’s high annual market borrowing to bridge this fiscal deficit. RBI bears the brunt of both.

In the December review of monetary policy, the governor said monetary policy alone cannot fight inflation unless the government pares the fiscal deficit. The real measure of fiscal consolidation lies in improving the quality of expenditure and only when that happens, the bottlenecks that contribute to supply-side inflationary pressures can be tackled.

Analysts expect the government to borrow at least 3.6 trillion next fiscal, net of redemption of old bonds. When the government soaks up this amount of money from the financial system, private firms will find it difficult to raise loans, and there will be pressure on interest rates. RBI has raised rates seven times since March 2010, but high rates alone cannot fight inflation.

The biggest threat to growth is high inflation and it can be contained only when the finance ministry and RBI mount a joint offensive, through fiscal and monetary measures. Mukherjee can make a beginning, using the budget 2012 as a platform.