«I ndia and China are both large, poor countries that have benefited from greater integration into the world economy; both are still at an early but ...»
Domestic Financial Liberalization and
International Financial Integration: An
SUMAN BERY AND KANHAIYA SINGH*
I ndia and China are both large, poor countries that have benefited from
greater integration into the world economy; both are still at an early
but crucial stage of their development path. In both countries, financial
systems were relatively controlled for a long period: while they played an important role in resource mobilization, they were not accorded an important independent role in resource allocation. In both countries, the formal financial system remains dominated by publicly owned, depositmoney banks.
In both countries, increased international linkages of the wider economy have put a repressed financial system under strain. Domestic firms require financing at close to international terms in order to be competitive. Greater international trade and human links open up opportunities for de facto movement of capital, providing competition for domestic financial institutions. As planning gives way to the market, financial institutions have a potentially important role to play in investment project selection and monitoring. In brief, the whole machinery of rising productivity, which motivates market-led liberalization and of which gloSuman Bery is Director-General, National Council of Applied Economic Research, and Kanhaiya Singh is a Fellow at the Indian National Council of Applied Economic Research.
146 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATIONbalization is now an essential part, requires liberalization of the domestic financial system.
Contemporary systems of global production are driven increasingly by investment rather than just trade. Such foreign investment creates its own pressures for the financial system. Foreign capital needs to be able to enter and leave under predictable rules; pressures soon develop for domestic firms to enjoy similar privileges. Freedom for capital flows, in turn, has implications for the monetary and exchange systems.
Yet wholesale liberalization of capital flows also carries its own risks, both apparent and real. These include the risk of appreciation of the real exchange rate, the risk of sudden reversals of flows, and the risks of inflation. These risks of liberalization were noted early on (Diaz-Alejandro,
1985) even with respect to domestic liberalization. In the 1990s, financial crises in many emerging markets created a similar caution regarding the speed of external financial liberalization, although it continues to be considered a desirable final goal.
This chapter attempts to describe the links between domestic liberalization and financial integration for India, a journey which is still incomplete. The goal is to make accessible and transparent, particularly for an interested Chinese audience, the issues of sequencing that have arisen along the way. It may be mentioned that the Reserve Bank of India (RBI) has also provided considerable documentation on these issues;
for example, Chapter VI of the Report on Currency and Finance 2004–05 (RBI, 2005b).
In India’s case there are two additional, linked, considerations that have begun to influence the debate on external financial integration. The first is the aspiration to develop Mumbai as a regional financial center; the second is for India to participate in broader initiatives for financial integration in Asia. These twin initiatives would both stimulate, and benefit from, greater integration between India’s financial market and that of the region and of the rest of the world.
India’s ambitions for Mumbai are, in turn, derived from two perceptions of India’s underlying comparative advantage. The first is that finance is a skill-intensive service industry where India may be able to provide quality offshore services at a competitive price in software development and information-technology-enabled services. The second is that there is considerable talent of Indian origin in financial institutions worldwide. As China has successfully tapped the Chinese diaspora across Asia to strengthen its capabilities in manufacturing, India could succeed in doing the same in financial services. Indeed, it is perhaps not too fanciful to expect that, as China’s own need for sophisticated financial services increases, Mumbai Suman Bery and Kanhaiya Singh 147 could offer an alternative to both Hong Kong SAR and Singapore for the provision of these services.
Domestic Financial Liberalization The Origins of Financial Repression Prior to its independence in 1947, India enjoyed a relatively liberal domestic financial system with capital account convertibility within the sterling area; indeed the Indian rupee was a medium of exchange throughout the Persian Gulf region. Exchange controls were introduced as a wartime measure (RBI, 2005b). The large sterling balances that India had accumulated during the war were blocked as Britain struggled to balance her external accounts with various creditors, notably the United States. Domestically, India’s financial system was relatively sophisticated, with established stock and commodity exchanges, and domestic and foreign banks largely under private ownership.
A series of landmark events between the mid-1950s and the late-1960s transformed what had been a relatively liberal system into a highly repressed one. It may be mentioned that this evolution was in keeping with the larger world-wide intellectual trends of the time that were influenced by the work of John Maynard Keynes and the apparently successful modernization of the Soviet Union, which accorded the state an important role in manipulating the financial system to achieve the goals of planned development. This global consensus was reflected in the World Bank’s active support of state-guaranteed development finance institutions (DFIs) in the 1950s and 1960s.
In 1955, the State Bank of India, India’s largest bank, was nationalized;
in 1956, independent India encountered its first foreign exchange crisis, leading to an intensification of both import and exchange controls. It was the beginning of a siege mentality with regard to foreign exchange availability that is only now slowly receding, 50 years later. The private banking system was criticized as the tool of the major industrial houses and for being insufficiently oriented to the needs of an agrarian country embarking on planned development. This perception led to the nationalization of 14 of the largest private domestic banks in 1969 as part of a populist move by then Prime Minister, Mrs. Indira Gandhi. (For a further account of the India’s growth experience since independence, see Singh and Bery, 2005.) Foreign banks, though heavily controlled, were not nationalized. A further 6 smaller banks were nationalized in 1980.
148 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATIONFollowing nationalization, there was significant branch expansion. The number of bank branches rose from about 8,800 in 1969 to about 60,600 in 1991, and the share of rural branches increased from about 22 percent to 58 percent (Mohan and Prasad, 2005). This helped the government in mobilizing household savings. The ratio of broad money to GDP increased from 24 percent of GDP in 1970–71 to 46 percent in 1990–91, and 73 percent in 2004–05.
India became increasingly politically aligned with the Soviet bloc in the 1970s. This was largely in response to U.S. foreign policy in that era, both toward the subcontinent and in Southeast Asia. India’s foreign policy stance manifested itself in domestic financial sector policies, which increasingly became populist, rigid, and directive. Although the implementation of such policies was facilitated by public ownership of the main banks, they were, in principle, applicable to all commercial banks. Interest rates ceased to have a significantly allocative role, and competition among banks was suppressed in favor of publicly managed consortia. Fiscal policy remained relatively prudent until the 1980s; nonetheless, public debt was administratively placed through compulsory portfolio requirements imposed on the banks and on other institutions such as insurance companies and provident funds. Capital markets remained privately owned and operated. Although the secondary market was relatively free, primary capital issues were subject to government control and scrutiny. Monetization of the fiscal deficit took place through the automatic acceptance by the RBI of what were known as ad hoc treasury bills; as these accumulated, they were packaged as dated securities. Finally, the exchange regime essentially remained the Bretton Woods system of adjustable pegs, with periodic, brusque adjustments usually associated with exchange crises (RBI, 2005b).
Before leaving this era of financial repression (whose heyday lasted from 1970 until the late 1980s, but whose influence can be felt even in 2006), a few observations are perhaps in order. First, throughout, important sectors of the financial markets (and institutions) remained in private hands. Thus the skill base was by and large retained, although the pressures for financial innovation were slight. Second, the Indian allergy to inflation ensured that the damage done by these policies was more at the microeconomic than the macroeconomic level. Third, as the Indian nonfinancial private sector continued to survive, if not thrive, the assets of the public sector banks remained free from dominance of public-sector corporations, in contrast to the experience of China and the COMECON countries.
Suman Bery and Kanhaiya Singh 149 Liberalization, 1985–91 Moves toward liberalization initially came out of concerns for monetary management, signaled by the so-called Chakravarty Committee report of 1985 (RBI, 1985). The committee recommended a gradual deregulation of banking system interest rates so that monetary policy could be conducted using more modern, market-oriented instruments rather than the blunt portfolio controls of that time. In addition, a working group was set up to analyze money market issues. Both committees continued to regard social goals and priority sectors as appropriate guiding principles for their recommendations, rather than issues of competition, innovation, stability, and soundness. They accordingly recommended a continuation of the overall administered rate structure with calibrated cross-subsidization.
Despite these new instruments, the repression of the financial system continued to be enforced through quantitative controls, specifically the cash reserve ratio (CRR) meant for containing liquidity growth and the statutory liquidity ratio (SLR) a tool of captive financing for the government.1,2 At the end of 1990–91, the CRR and SLR stood at 15.5 and
38.25 percent, respectively; the two requirements together preempted more than half of the net demand and time liabilities. The actual ratio exceeded 60 percent because public sector banks preferred to hold excess SLR in preference to commercial loans. Owing to the absence of transparent, international standards for income recognition, the true quality of bank assets was not known widely outside the RBI—then, as now, the sole banking regulator for the scheduled commercial banks (RBI, 2005b, Chapter V).3 1Since 1962, the RBI has been empowered to vary the CRR between 3 and 15 percent of the total demand and time liabilities. CRR in excess of 3 percent is currently remunerated at 4 percent per annum (Reddy, 1999).
2Over and above the CRR, banks are required to maintain a minimum amount of liquid assets in cash, gold, and government securities, amounting to a specified share of their demand and time liabilities.
3The RBI is vested with regulatory and supervisory authority over commercial banks and urban cooperative banks (UCBs), DFIs, and nonbanking financial companies (NBFCs).
On March 31, 2005, there were 289 commercial banks (89 Scheduled Commercial Banks), 196 Rural Regional Banks (RRBs), and 4 Local Area Banks, 1,872 UCBs, 8 DFIs, and 13,187 NBFCs. The Board for Financial Supervision has been constituted as a Committee of the Central Board of the RBI since November 1994 and is headed by the Governor with a Deputy Governor as Vice Chairperson and other Deputy Governors and four Directors of the Central Board as members. In respect of state and district central cooperative banks, while the RBI is the regulator, supervision is vested with the National Bank for Agriculture and Rural Development. The Insurance Regulatory and Development Authority regulates
150 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATION
Domestic Liberalization (1991–2005)
The process of reform India’s financial sector liberalization since 1991 has been a comprehensive program involving issues related to banking, capital markets, fiscal policy, and international financial integration. Issues of linkage and sequencing between these areas have been central. India makes heavy use of expert commissions to float and develop ideas and agendas. In apparent contrast to China, there is little formal use made of foreign advisors.
The two key regulators, the RBI and the Securities and Exchange Board of India (SEBI) have increasingly taken to inviting comments and discussion on major regulatory and market development issues through the Internet, press debate, and conferences/meetings with stakeholders. The finance ministry initiates and drafts needed legislation for parliamentary review.
An important stimulus for reform has been provided by a series of market frauds (or scams) that resulted in improvements in market institutions and infrastructure.
Responding to the balance of payments crisis in 1990, wide-ranging economic reforms were introduced in 1991. Two important committees were constituted in the financial sector: the Committee on Financial Systems (CFS), and the Committee on Banking Sector Reforms (CBSR)4.
The CFS took note of excessive administrative and political interference in internal management and credit decision making in public sector banks and observed that the economic reforms in the real sectors of the economy could not realize their full potential without reform of the financial sector.
The CFS and CBSR (henceforth the first and the second Narasimham Committees) provided the blueprint for reforming the financial system.