Suman Bery: The State and the Financial Sector

India should be part of the debate on government's role in the financial sector.

In last month's column ("The Nine Percent Economy") I had indicated that my columns this year would periodically review a range of public policy issues covered in the Eleventh Plan. This month's column addresses the issue of financial sector strategy, a topic which is central to the Plan's vision, but one which does not in fact merit its own chapter. Financial sector policies have typically been seen as belonging in the domain of the Finance Ministry and the Reserve Bank of India.

The omission this time is nevertheless noteworthy as the Planning Commission is the sponsor of the Committee on Financial Sector Reform. That committee, on which I serve, is chaired by Professor Raghuram Rajan of the Chicago Graduate School of Business (and former Chief Economist of the International Monetary Fund). In placing the committee under the Planning Commission, the government was presumably animated by the belief that many of the Plan's strategies for achieving inclusive growth depend critically on the development and performance of the domestic financial sector.

The links between the financial sector and inclusive growth are of course many. These links operate at both the economy-wide and micro level, have an influence on both households and firms and have the potential to be both benign and destructive. A well-functioning financial system, operating in a relatively undistorted domestic economy, is critical for transforming both domestic and external capital into efficient and productive investment as part of a private-sector led growth strategy of the kind that the new Plan embodies. The absence (or inadequate development) of such capacities in domestic intermediation leads to the anomalies we see today, exporting capital in the form of short-dated (and low-yielding) reserves, while attracting more risk-loving foreign capital into domestic infrastructure projects despite their difficulty in carrying the associated exchange risk.

As Prof Rajan has pointed out in his book on the U.S. financial system ("Saving Capitalism from the Capitalists"), innovations in finance since the war, generated by a competitive financial sector operating in an appropriate and effective legal framework have been a very powerful force in democratising access to financial services. Similar concerns for "financial inclusion", discussed more fully below, have been a central feature of Indian policy debate since the beginning of the twentieth century.

And yet, and yet... were it all so simple. There is sharp division among economists as to the right template for the development of the financial sector, or even whether such a template exists. Nor is the debate restricted only to developing countries. In more settled times Joseph Stiglitz had observed that the degree of public intervention in US financial and credit markets was extensive and profound, and that invocation of a free market paradigm was both analytically unjustified and empirically unwarranted.

As readers of these pages are aware, governments and public opinion in the OECD countries are in turmoil and disarray on the appropriate role of the government in financial markets. While earlier concerns focused on the systemic risk posed by the activities of unregulated entities such as hedge funds, what has been particularly embarrassing, indeed frightening, has been the central role of major regulated financial institutions (banks and brokerage houses) at the very heart of international finance.

Stimulated in part, once again, by the writings of Prof. Rajan, sober and responsible commentators such as Martin Wolf have been calling for public regulation of the compensation policies of investment banks and a sharp overhaul of the minimum capital requirements of international banks. Others have pointed to the "overdevelopment" of finance in the Anglo-Saxon countries, particularly the U.S. as culpable in the present crisis, over and above quite apart from any criticism of over-zealous monetary policy first under Alan Greenspan, and now under Ben Bernanke.

While aggressive monetary policy actions stimulated a mighty asset price boom (and unleashed a tsunami of capital in the direction of the emerging markets) financial innovation (home equity loans; securitisation of mortgages) led to a drastic decline in the household savings rate in the U.S. and to a great (and highly inclusive!) appetite for risk on the part of American financial institutions. The existing risk management devices (external ratings; regulatory capital) were themselves suborned in the boom of the past five years.

The difficult issue is to know what conclusions should be drawn for the future of the Indian financial system from this debacle. What is clear is that the existing financial system is not doing a great job in fostering financial inclusion, despite the broad range of efforts made by successive governments over the years.

This history is well recounted in a recent speech by Vijay Kelkar*, who recounts the broad array of initiatives undertaken by governments over the years, from the cooperative movement, to bank nationalisation, to priority sector lending, to the creation of regional rural banks, and finally to the self-help group-commercial bank linkage model encouraged by the Reserve Bank and supported by NABARD. Yet, as Kelkar points out using National Sample Survey data, the overall outcome is disappointing. Out of 89 million farm households in the country, more than 40 million had no access to finance, formal or informal. And of 45 million households who have contracted debt 40% of the outstanding debt comes from non-formal institutions, such as money-lenders.

Similar findings are suggested by more up-to-date data series including NCAER's own recent publication ("How India Earns, Saves and Spends: Results from the Max New York Life-NCAER India Financial Protection Survey", released last week by the Deputy Chairman of the Planning Commission, reporting on the situation in 2004-05). To a surprising degree both urban and rural households keep their liquid savings at home rather than entrusting them to a bank.

Given this disappointing experience it is not surprising that the Finance Ministry has commissioned the Chairman of the Economic Advisory Council of the Prime Minister, Dr C. Rangarajan to lead a task force on financial inclusion, which released its report last week. The report suggests a series of regulatory and administrative measures to induce greater outreach by the existing structure.

So the present outcome is unsatisfactory, the international environment none to favorable, and domestic politics not very supportive of any dramatic changes in the financial sector in the remaining life of this government. Nonetheless, despite these unfavorable auguries I would expect the Finance Minister to take up financial sector reform in a big way in his forthcoming budget. No doubt it will be modest and incremental. But given what we are seeing around the world, maybe that is all that can be expected.

*Financial Inclusion for "Inclusive Growth". N.P. Sen Memorial Lecture. Administrative Staff College of India, Hyderabad, India. January 2008

The author is Director-General, National Council of Applied Economic Research. Views expressed are personal