A schizophrenic government

Government and the central bank display confusion on key policy issues

Two years ago, foreign investment of up to 98 per cent was allowed in private Indian banks. This month, it was cut to 74 per cent.

On external commercial borrowings (ECBs) by Indian corporations, it took the government just two months to reverse its decision. A severe clampdown on overseas borrowings in November last year was followed by relaxation in the norms in January this year.

These are only two of the many symptoms of schizophrenia from which the finance ministry suffers. In medical terminology, schizophrenia is a long-term mental disorder that involves a breakdown in the coordination between thought, emotion and behaviour, leading to faulty perception, inappropriate actions and feelings, and withdrawal from reality into fantasy and delusion. All these symptoms fit the government to a T when it comes to financial sector reforms.

First, let's look at what happened in these two areas and the impact of the government's yes-today-no-tomorrow-don't-know-another-day approach in some key policy areas.

On May 21, 2001, a press note from the ministry of commerce and industry said foreign direct investment (FDI) of up to 49 per cent from all sources would be permitted in private sector banks on the automatic route, subject to conformity with the guidelines issued by the Reserve Bank of India (RBI) from time to time.

The RBI took nine months to notify the development. On February 16, 2002, the central bank issued the notification after "receiving some inquiries". Since portfolio investment was not a part of FDI, industry got the impression that the foreign stake in private banks could go up to as much as 98 per cent.

How? It was simple arithmetic. The FDI quota was raised to 49 per cent while the existing norms permitted banks to raise the limit of investment by foreign institutional investors (FIIs) to 49 per cent with board approval.

At the time, sources in the central bank indicated "" confidentially "" that the FII limit was outside the FDI cap. The RBI notification was ambiguous on this critical issue. The ambiguity was perhaps deliberate because it was not sure of the finance ministry's stance. The RBI had, in fact, asked the ministry for further clarification on this issue.

It took two years for the ministry to come up with the next clarification. On January 16, the finance ministry said FIIs can acquire up to 49 per cent stake in private banks but within the 74 per cent overall foreign investment ceiling.

This effectively cut the foreign holding in private banks from 98 to 74 per cent! The RBI has not issued a notification on this because it is yet to hear from the ministry. No one knows how long that will take.

It's another matter that the players on the turf get affected by this ambiguity. For instance, the strategic investors in Centurion Bank will now have to rework their investment plans in the bank. They will have to decide whether to take the FDI route or the FII route to invest in Centurion.

While the 74 per cent combined FDI and FII limit will offer Centurion's new stakeholders manoeuvrability, ICICI Bank and ING Vysya may have to take a re-look at their capital structure because there is little headroom for increasing foreign holdings in these banks. The total foreign holding in ING Vysya is now 73.7 per cent. In ICICI Bank, it is around 72 per cent.

In the case of FDI in banks, it took the ministry two years to make its stance public (this may not be the end of the story, since the RBI notification is still pending). In the case of ECBs, the ministry took exactly two months to do a volte-face. Perhaps the schizophrenic symptoms are intensifying with elections round the corner.

On November 12 last year, the ministry clamped down on ECBs by imposing end-use restrictions on loans over $ 50 million. The guidelines made it mandatory for corporations to park unused ECB funds abroad.

Besides, borrowers were told to hedge green channel foreign loans. The guidelines also said that ECBs over $ 50 million could be raised only for financing equipment import and meeting the foreign exchange requirements for infrastructure projects.

Until that time, the only restriction on the end-use of ECBs was on speculative investments and in real estate. The crucial part of the guidelines was a sharp reduction in the interest spread for raising money overseas "" from 300 to 450 basis points (one basis point is one-hundredth of a percentage point) to 150 to 300 basis points.

In other words, corporations that could earlier raise a foreign loan at 300 to 450 basis points over Libor (an international benchmark rate), can now do so only if the rates are finer (150 to 300 basis points over Libor). This makes it impossible for a non-AAA outfit to raise money abroad.

The reasons for such stringent norms were the growing foreign exchange reserves (which topped $ 92 billion then) and low credit offtake from domestic banks, among others. The ministry, however, candidly admitted that the "measures were temporary until further review".

The "review" took place on January 9. The ECB norms were relaxed and corporations were allowed to raise loans up to $ 500 million through the automatic route! What's more, the spread was raised to the old level to ensure that small and medium enterprises can borrow abroad, too.

Has anything happened in the two months (between mid-November 2003 and early January 2004) to warrant a 180-degree shift in the finance ministry's stance on ECB norms? Has there been a sharp drop in country's external loan burden in these two months, which made the ministry so bold in its approach? Did domestic liquidity suddenly dry up?

Nothing of the sort. In fact, forex reserves since then have crossed $ 100 billion. Corporations are still shying away from banks for loans. Even Moody's action in raising India's foreign currency rating to investment grade cannot be used as an excuse for the change in the ministry's stance; the news came a week after the sudden change in ECB norms.

At best, it's schizophrenia and at worst, this signifies ad hoc-ism in the financial sector. We believe the RBI conducted a study on the country's external debt burden in December and advised the government that there is no need to restrict the ECB flow now.

For the growth of the real sector, the report said, even medium enterprises should be allowed to tap the cheap overseas loan market since domestic banks are still charging high interest rates.

The point is taken. But couldn't the study have been undertaken a few months before the government's clampdown on ECBs? Or wasn't it wise for the government to wait until the study was complete before announcing a change in ECB norms?

By making unnecessary haste in clamping down on ECBs, the government created problems for both corporations and banks. Many an overseas fund-raising plan was spiked in November, throwing India Inc's expansion plans out of gear. Companies are now treating the clampdown as a bad joke and reviving their plans.

Similarly, banks, anticipating higher interest income (the reduction in spread would have forced companies to knock at their doors), are now left high and dry as even the relatively-smaller companies can now tap the overseas market.

The list of ad hoc actions is pretty long. For instance, the government repeatedly promised to raise the voting rights of stakeholders in private sector banks over the last two years but it has done nothing on this head so far.

The finance minister in his 2002 Budget first said that the voting rights in private banks would be made commensurate with the holdings in the bank. Going by the current guidelines, voting rights are capped at 10 per cent, irrespective of the holdings.

Similarly, the FDI-FII story is meant only for the private sector banks. Even after divesting its stake in the public sector banks, the government is in no mood to allow foreign stakes in this group to go beyond 20 per cent.

By doing so, the government is creating two sets of rules for the banking industry. Following this, private sector players will always enjoy an advantage over their public sector counterparts on the bourses.

Unless the government treats its malaise, the financial sector will continue to suffer. The sooner it finds a cure, the better for the system. With elections round the corner, it may not have time to do so now.

The posts of at least two bank chairmen and an RBI deputy governor have been vacant for months. Obviously, the government's priorities are different.