Shankar Acharya: The Rajan Report on Finance

A PIECE OF MY MIND

The draft report of the committee on financial sector reform, chaired by Raghuram Rajan (professor of finance, Chicago Business School), has been placed on a website and comments have been invited. I am accepting this invitation with some trepidation. Last year, when Percy Mistry persuaded me to do a column on his "Mumbai as an International Finance Centre" report, he got a bit huffy when I mixed my praise with a few criticisms. Raghu I expect is made of sterner stuff. That emboldens me to use the limited space of this column to focus on some of the key weaknesses of the draft Raghuram Rajan Report (henceforth RRR), while recognizing that there is much that is sensible and interesting in the document.

To begin with, there is a structural flaw in the committee's composition. And I am not referring to the heavy dominance of finance wizards over representatives of the real economy (none) and macroeconomists (one). Far more important is the total absence of senior people from either the RBI or the Finance Ministry. Indian experience suggests that there is serious follow through on financial sector reports only when both MoF and RBI "own" the document. If composition is any guide, that may not happen here. But that's water under the bridge. Let's turn to substance.

RRR's treatment of the "macroeconomic framework" is curiously academic and aloof from the realities of the Indian macroeconomic setting and experience. There seems to be little understanding of the potential and possibilities of macroeconomic policy in a developing country with an "intermediate" exchange rate regime of managed flexibility and partial capital controls. This might have been excusable if India's macroeconomic outcomes in terms of growth and inflation had been bad in recent years. In fact, of course, India has done remarkably well in comparison to all developing countries. So, monetary and exchange rate management couldn't have been as bad as RRR's calls for system change suggest (contra the old adage "if it ain't broke, don't fix it").

To take just one example, RRR believes that capital inflows lead to inevitable appreciation of the real exchange rate, leaving the country with "the Hobson's choice of taking it as inflation or nominal exchange rate appreciation." This view is, at best, misleading and, at worst, plain wrong. The third and better option, pursued by government and RBI (except in spring 2007), has been to add to forex reserves and partially sterilize the increment (note that in recent years RBI has added well over $200 billion of reserves while the cumulative MSS bonds outstanding are a little over $40 billion equivalent). This avoids unwanted nominal and real appreciation of the exchange rate as well as inflationary pressure. Of course, sterilization imposes fiscal costs but most studies indicate they are a small fraction of the real GDP costs exacted by an over-appreciated exchange rate.

RRR's narrow view of macroeconomics leads it to a surprisingly adventurist recommendation: that "RBI should have a single objective...of low inflation...". It's one thing for youthful columnists to peddle a recent academic fashion. It's quite another for a serious, high level committee to make this their first recommendation. Just consider what this means: that the RBI should drop the other objectives which currently also inform its policies, namely, the level and growth of the country's economic activity, the nation's financial stability and the level and volatility of the exchange rate, which is generally regarded as the single most important price in a developing country. RRR is not particularly educative on who should take on these responsibilities and how, especially given the well-known constraints on counter-cyclical fiscal policy in India. This is not to deny that the model of an inflation-targeting central bank may have worked in some (mostly developed) countries at some times. It's simply to recognize its obvious inappropriateness for current (and medium-term) Indian conditions. Note also that the world's largest economy with, arguably, the most developed financial system, the US, mandates its central bank to pursue multiple objectives. Nor was the Bank of England solely focused on targeting inflation when it announced various policies to cope with the Northern Rock fiasco last autumn.

Turning to RRR's discussion of the regulatory structure, I am pleased that it has resisted the siren song of the "single regulator" model. Unfortunately, it has submitted a couple of weird proposals. The first is for a statutory Financial Sector Oversight Agency (FSOA), composed of "chiefs of regulatory bodies" and armed with a "permanent secretariat" to "monitor ...large, systemically important financial conglomerates,...defuse inter-regulatory conflicts", etc. RRR hugely underestimates the dangers of spawning a new regulatory institution in a country which loves such multiplication and where bureaucratic turf battles usually take precedence over problem-solving. If the issue is inter-regulatory coordination, it's not obvious that an FSOA will provide anything more than another venue for discord. A better solution, generally favoured the world over, is to accord primary authority to the central bank and sort out coordination and overlap issues through semi-formal institutions such as the High Level Committee on the Capital Market (chaired by the RBI Governor), with occasional recourse to the finance minister to resolve particularly knotty issues.

I have similar qualms about the proposed Financial Development Council (FDC), to be chaired by the finance minister, to handle "macro risk assessment and developmental issues". Once again, the danger is of bureaucratization and excessive governmental control over relatively autonomous financial sector regulatory institutions. Better to stick with the present system where ministerial direction and guidance is conveyed through less structured channels. Incidentally, it would be good to know which other countries boast similar institutions (as the proposed FSOA and FDC) and how they have worked in practice. Or is India to be RRR's guinea pig?

Similarly, the proposal for more formal Parliamentary oversight of time-bound, structured mandates to regulators may lead to far more pervasive and intrusive political intervention in the discharge of professional regulatory responsibilities than RRR may have foreseen. My suggestion would be to tread very cautiously in this domain.

In pursuit of the worthy goal of greater financial inclusion, RRR recommends resurrection of small, local area private banks. The dangers of capture by local private-political vested interests are noted by RRR, but it nevertheless considers the initiative worthwhile. I wonder if RRR may have underestimated the enormous regulatory challenges involved, especially in a multi(in dozens!)-party federation with declining governance standards. Just recall the chequered history of urban cooperative banks.

These are some of my concerns with the rich and provocative agenda for change proposed by RRR. Long years have taught me not to expect significant report revisions as a result of comments. Never mind. I have done my dharma.

The author is Honorary Professor at ICRIER and former Chief Economic Adviser to Government of India. The views expressed are personal