Indian economy: When good banking regulation is simply not enough

  • Subir Roy
  • Updated: Jan 12, 2016 21:45 IST
The poor state of banking, particularly in the public sector, is casting its shadow on India’s financial institutions. (REUTERS Photo)

The world economy is not passing through good times but the Indian economy is in a safe zone. This is the overall message from the Financial Stability Report of the Reserve Bank of India (RBI) that was released last month. But since then things have changed somewhat. China is in a spot of trouble.

If you look at the risks ahead, identified in the report, then the foremost that hangs over the global scene is the volatility of financial markets. What will happen to it when the US Federal Reserve goes further ahead with its rate rise agenda is wide open, says the report, but there is immediacy in wondering how the Chinese troubles will pan out. To this has to be added the downside from the now long-standing slow pace at which global trade is moving.

In comparison, the list of domestic risks outlined is longer. Foremost comes the uncertainty created by the monsoon whose waywardness for the second year running has resulted in considerable rural distress. But there is little that the government can do by way of distributing palliative largess because of fiscal tightness.

You can’t do much about the weather, but where policy intervention can produce faster results — in the corporate and financial sectors — the outlook is depressing. The corporate sector is in poor health, afflicted by low demand and capacity utilisation. This has put paid to investment plans. The adverse impact of all this on corporate earnings and the servicing of obligations to financial institutions have dealt a major blow to the institutions’ quality of assets.

If there is any one issue that dominates the outlook for the financial sector, then it is the current poor state of the banking sector in general and public sector banks in particular.

Unfortunately, not much solace can be derived from fall in the level of stressed assets formation of the banking sector in the first half of the current financial year (2016) to 3.3% compared to 5.6% in the corresponding part of financial 2015. The RBI has allowed some leeway to banks under the ‘5/25 scheme’, which allows them to spread repayment obligations over a longer period, depending on the cash flow of the project.

Plus, banks are allowed to reset the refinance scheme every five or seven years. But for this dispensation, banks’ stressed assets formation would have remained at a high of 5.5-6%, according to a computation by ICRA. What this means is that, yes, banks are in poor shape but the figures would have been worse if the RBI had not shifted the goalposts (not arbitrarily, of course) to their advantage.

Two major points stand out when we look for a recovery path on which banks can be set. Recapitalisation is a must but will not help in the long run. What will work is changing the way banks are run and that is as big a systemic issue as any. Public sector banks should be run professionally, fending for themselves at the marketplace without any intervention from the government. But bank managements are steeped in the culture of seeking ‘guidance’.

The second point is, how has China managed to achieve enough financial stability for its currency to be recognised as one of the select reserve currencies, when its financial sector has the long shadow of its shadow banking phenomenon looming over it? To this add the lack of global confidence implicit in the latest outflows.

The answer lies, of course, in the strength of China’s real economy, which has resulted in its current account surplus and high level of reserves. This surplus has derived from its trade surplus which captures its manufacturing competitiveness.

India can improve its manufacturing competitiveness (it has prowess in services but that does not carry enough weight) by easing the hurdles in the way of doing business.

But this is often crucially dependent on passing new legislation and the political logjam there is too well known. China, on the other hand, under its totalitarian setup, has been able to implement a consensus on domestic reforms, which has yielded it enormous dividends. But the willingness to intervene has been unable to keep financial turmoil at bay.

For India, where financial regulation can make a difference, it has. Short-term external debt as a proportion of reserves has gone down in the last two years, after peaking in 2013. This has added to financial stability. It is almost a similar story with volatile capital flows as a percentage of reserves. These had risen sharply from the outbreak of the 2008 financial crisis till 2013 and then flattened out after falling slightly.

But undue volatility continues to plague the stock markets (this affects overall sentiment, as also the prospects of disinvestment) from very small movements in foreign capital flows.

Ending this should be an important agenda ahead, particularly in the current context. But for that the equity cult has to spread further in India, something the currently dim earnings prospects of the corporate sector does not help.

The overall contradiction is that despite having a robust and well-regulated financial sector, compared to China, India faces the level of risk to its financial stability that it does. The risk to the banking sector has increased since the previous financial stability report in tandem with the decline in the quality of bank assets. Will the RBI see less risk next time around?

(Subir Roy is a financial journalist and has also worked in the SBI. The views expressed are personal)

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