Indian financial reform: Why Mr Rajan is right
India's financial system prizes stability over vigour. It achieves neither
In India, financial instruments were once things of beauty. People who had no access to banks, or no faith in them, invested their savings in gold necklaces, earrings or waist-chains instead. Now India's prosperous classes favour semi-precious stones for their jewellery and unglittery bank accounts, shares and property for their investments.
This is progress. But some Indian savers might be feeling nostalgic for the shiny investments of the past. The country's wholesale-price inflation rate is at a 40-month high of 7% and its stockmarket has fallen by a quarter from its January peak. The subprime crisis in America and high commodity prices at home have deepened many people's suspicion that financial markets are merely glorified casinos manipulated by speculators. Indeed, the breakdown in markets for many complex securities gives some appeal to an asset that can be made liquid with a crucible and thousand-degree heat.
So this is an inauspicious time to call on India to reform its financial system and shed its suspicion of financial markets. But that has not deterred the committee on financial-sector reform, which was set up by India's government and headed by Raghuram Rajan, a Chicago professor and a former chief economist of the IMF. “Financial sector reform is both a moral and an economic imperative,” argues Mr Rajan. He is right—and he deserves a lot more support than he is likely to get.
As the report makes clear, India is dangerously complacent. Its concerns about over-sophisticated markets resemble a clock that looks right only because it is 12 hours behind. Indian households put only about half of their savings in the bank, and banks funnel less than half of their credit to private firms, says one estimate. The government's financing needs crowd out other borrowers, and state-owned banks account for about 70% of India's financial assets—a share matched only by countries such as Libya, Turkmenistan and China. The cost of these financial failings is probably a percentage point or two of growth. They leave India's savers with too little reward for their thrift, its poorer borrowers with too few alternatives to the moneylender and its incumbent firms with too much protection from upstarts, who cannot raise money to compete.
Procrastination is not prudence
The problem for reformers has always been knowing where to start. For example, India's stunted corporate-bond market might grow if banks and insurance firms were free to buy more corporate debt and less government paper. But then who would finance the fiscal deficit? Perhaps foreigners could be allowed to buy more sovereign bonds. But the inflow of foreign capital would put upward pressure on the rupee. That, in turn, might push India into allowing domestic insurers and provident funds to invest more freely abroad.
Mr Rajan's solution is to move away from the big ideological questions, where India has debated itself into a corner. Instead of starting another endless argument about whether state banks should be privatised, foreign capital welcomed, and lenders forced to serve small businesses, he advocates a few experiments, such as selling some small, underperforming government banks. If they succeed, they will show the way for others. If they fail, the sky will not fall.
This is worth trying, because if America's subprime crisis demonstrates the pitfalls of untrammelled finance, India illustrates the opposite danger. Since its regulators get blamed only for mishaps, not for lost growth and wasted opportunities, they are too conservative. Small, local banks, for instance, might serve the rural poor well, but regulators are reluctant to license such banks in case they go bust. “New ideas are banned unless explicitly permitted,” the report laments.
This helps regulators feel more secure, but it does little for the system's stability. For example, companies are barred from speculating in derivatives, but many have done so anyway. Those that have lost money now cite the very rules they broke as reason to back out of their obligations, saying they should not pay for mistakes they were not officially allowed to make.
India's democracy responds quickly to acute crises, but allows chronic problems to fester for too long. The country has not suffered a famine since independence (because spectacular distress makes headlines, and relieving it wins votes), but many of its citizens are still chronically underfed. Likewise, India has not run into big financial trouble since a balance-of-payments crisis in 1991. But as Mr Rajan's report makes clear, the country still suffers from financial malnutrition. In the long run that may be more damaging.