Raghuram G Rajan, the Eric J Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business, is no stranger to the Indian financial sector. He headed the Planning Commission-appointed committee on financial sector reforms, which, among other things, suggested a change in the Reserve Bank of India’s role and mandate apart from sowing the seeds for the Financial Stability and Development Council (FSDC) that is being pushed by the government. Rajan, who is also an honorary economic advisor to Prime Minister Manmohan Singh, spoke to Sidhartha about financial sector reforms and regulatory challenges. Excerpts:
Given the experience in the US, what is the best way forward for opening up the financial sector?
India is so far from that situation. It is clear that having an extremely sophisticated financial sector does require a fair amount of careful regulation. There are so many things we can do to improve the resilience of our system. For example, one of the problems is that we do not have a corporate bond market. As a result, almost all the risk goes to the banking system. Take MFIs (micro-finance institutions); you are assuming that they, and not the banking system, are giving all these high-risk loans to very poor people. But it is the banking system that is lending to the MFIs. The case with non-banking financial companies (NBFCs) is similar. In the case of infrastructure, banks are lending to the sector for the long term, but the liability (deposits) is short term. This is one example of macro-financial regulation increasing instability rather than decreasing it.
The notion some people have that it is good that we were underdeveloped is so wrong. We should be a little careful about taking a lot of credit for escaping the crisis. It has more to do with the nature of the real economy, which is quite independent of the US. Also, we were 8,000 miles away from the epicentre of the crisis and many of our banks did not actually hold those (complex) securities. There were some reasonable policies that the Reserve Bank of India (RBI) followed in limiting our exposure to real estate and so on. But you could well ask the question: if a crisis of a similar magnitude hit India and you had a substantial number of banks that were affected, would we have been able to resolve it with limited pain, like the US? There is some fragility in the system of which we need to be aware. For instance, we still do not have a proper bankruptcy code. Our process has been to coax banks into mergers but can we actually shut some of the problematic ones down?
Are we prepared for instruments such as credit default swaps?
There are good and bad things. Allowing CDO Cubed is probably going too far. But you have a number of MFIs that are securitising their loans. In expanding access, the use of finance, financial innovation and technology are important tools. You have to be careful that you do not go overboard. You have to manage risks but not taking risks is not the answer.
In the chapter on India in your latest book, you have devoted considerable space to the impediments to growth — land acquisition, the link between the well-connected and politicians, job creation and so on. Which would you rank as the biggest problem?
One has to be very careful and my concern is that it should be interpreted in the right way. India has warmed to the idea of creating wealth, which is extremely beneficial for society. We should celebrate the stories of the Narayana Murthys, the Nilekanis and many lesser-known entrepreneurs who are doing a great job. My fear about the nexus between businessmen and government is two-fold. One, it brings back the bad name that businessmen had acquired during the licence-permit raj, which is all about rent-seeking and corruption and less about creating wealth. What you would want is for people to get their wealth from competition rather than through influence. Two, in the longer run, the nexus can limit competition and stifle growth by keeping out other entrants and drive government policy in a way that it favours incumbents. Countries have succumbed to this in the past and one example is Mexico, which has what they call the Carlos Slim problem. It is important that we ensure that industry after industry has a number of large players and is not dominated by a handful of them.
You have talked about how US monetary policy is influenced by political considerations. What is your assessment of the Indian situation given the debate about the autonomy of regulators? How much influence does the Indian government have over RBI policy actions?
If it chooses to exercise it, the government can have a lot of influence. It depends on the precise relationship among the finance minister, the prime minister and the RBI governor. Earlier, it was said that the RBI governor served at the pleasure of the finance minister. So, if there is a finance minister who wants something done, he can exercise some threat. In practice, however, the relationship has been one of mutual respect and a tradition has evolved in which the RBI governor takes into account the finance minister’s thinking but makes an independent decision on monetary policy.
As far as financial stability goes, there are two differences from the conduct of the monetary policy. For monetary policy, it is important for the RBI to be independent from political forces. That helps it focus on the objectives of growth, stability and inflation. But monetary policy is different from some of the other policies that are needed for stability, which can span regulators. There are entities that cut across various markets. So, having an oversight agency in which all the regulators come together is not a bad idea, especially when it comes to systemic stability discussions.
Also, in the final analysis, if there is a need for fiscal resources to deal with stability issues, the government is involved. Even if the RBI has to provide the money, the risk is being taken on the government’s balance sheet. In that sense, there is a definite role for the government on issues of financial stability — of coordination and, ultimately, putting taxpayers (money) to work, which has to be a political decision. So, the idea that the government has no role in financial stability is not realistic. The key issue here is how these bodies function. So much is made of a single regulator, multiple regulators or a body of regulators, but ultimately it works well if there is mutual respect and people understand the areas for interaction and the taboos.
For the finance ministry to use these agencies to achieve some political aims would be problematic. But to use it for a useful dialogue on stability or to reduce conflict between regulators is perfectly acceptable. Now, there are people who are raising fears that the FSDC may turn into a device to serve political goals. I can understand the fears but there are so many ways that the government can effect political aims if it chooses to do so. To argue that this is the Trojan horse seems to be a little far-fetched.
So, you support the proposal on the Financial Stability Development Council?
It was in our report. The details may differ a little but the idea that it helps coordination among regulators and systemically large entities could be a way forward. Clearly, regulators have concerns that their sphere of activity is getting affected. But as the economy moves away from a purely bank- oriented system to banks plus markets plus various other kinds of institutions, we need to have better dialogue between regulators.
Given that the housing sector was responsible for the crisis in the US, is it a potential threat for India too since you have talked about how the government there encouraged people to buy houses and given India’s tax breaks on housing loans?
Any strong subsidy to any sector is something to worry about. You do have to ask, why has the system developed if resources are not flowing there naturally? The experience from the US has been that pushing credit to people who do not have incomes can be very dangerous. We should take this to heart. Our entire focus on financial inclusion has been on pushing credit, subsidised or otherwise. We have to worry and ask whether we are creating a culture of indebtedness. We have to be careful about raising income as opposed to raising debt. If the debt helps raise incomes, it’s okay. If it helps fulfil some consumption needs, that’s okay but debt as a substitute for income is extremely dangerous and some of our schemes are doing that. I would favour focusing more on ways to increase access to finance rather than increasing credit.
(A review of Raghuram Rajan’s latest book Fault Lines appears in the Weekend section tomorrow)
