Heady Days For Finance

The Economic Times today carried an Op-ed piece written by me. Here it is.

Heady Days For Finance

Exciting proposals to overhaul the financial services sector are on the table — implement them

The financial services sector could be in for exciting times, if proposals now on the table are anything to go by. Many changes are being proposed and if these get implemented, the sector is in for massive churn. Spoiler alert: some legal hurdles could still play spoilsport.

First out of the gates is likely the issue of new bank licences. A range of new players is likely to get a shot at opening new banks. Banking is still considered a coveted business segment in India despite many risks and overwhelming regulation. This is because of two reasons. One, a growing economy will need credit to expand and build new infrastructure. In India only banks can offer savings bank deposits, which work out cheaper than other sources of finance. 

The real fun and games can be expected to kick off when the changes suggested by the Finance Sector Legislative Reforms Commission, a body set up by the finance ministry to look into the raft of laws and structures in financial services and suggest ways to recast them, are implemented. Going by the approach paper released by the commission recently, some of the changes have the potential to be a game-changer.

Under the proposed structure, the financial sector will have seven main pillars. Two proposals stand out. One is to convert the Reserve Bank of India into a pure-play monetary authority (with debt management of government bonds housed in a separate, independent office), one that will enforce consumer protection and micro-prudential laws in banking and payment systems. The second is to create a unified financial regulatory agency by collapsing different financial sector regulators into it: Sebi, Irda, PFRDA and the Forward Markets Commission.

The proposed structure is likely to create a completely new architecture for financial services regulation. The new design will be achieved primarily through re-visiting the sector’s existing legal framework, which is at odds with the changed financial landscape. As the approach paper mentions, the sector is governed by 60 Acts and multiple rules and regulations. According to the paper: “The superstructure of the financial sector governance regime has been modified in a piecemeal fashion from time to time, without substantial changes to the underlying foundations... The piecemeal amendments have generated unintended outcomes including regulatory gaps, overlaps, inconsistencies and regulatory arbitrage.” 

In all the changes being contemplated, there are two legislation-related challenges. 

• The commission is duty-bound to re-examine legislation governing central banking. The RBI Act was enacted in 1934 and is still a ‘temporary’ piece of legislation. But the real issue seems to be designing the right framework that enhances RBI’s independence as a monetary authority, insulated from the executive’s short-term outlook and pressures.

The commission does promise to “…draft a monetary policy law emphasising the issues of independence, enumerated objectives, enumerated powers, and accountability mechanisms.” The RBI Act has to be overhauled since it seems to have been designed to give control to the government, like the power to appoint the governor and his deputies, power to vary their tenure, power to issue directions (after ‘consultation’ with the governor), and so on. The challenge, of course, is marrying independence with accountability. The approach paper says that one of the strategies used globally is inflation targeting. However, RBI has rejected this time and again primarily because most of the factors influencing inflation in India are outside the central bank’s controls.

RBI’s website says: “The formulation, framework and institutional architecture of monetary policy in India have evolved around these objectives – maintaining price stability, ensuring adequate flow of credit to sustain the growth momentum, and securing financial stability.” Enumerating these can be tricky; as goalposts, they need to be moved around every time the landscape alters. 

• The commission has to remember that states also have varying degrees of interest in financial services. These could have a disruptive influence on the normal functioning of financial services. The Andhra government’s intervention in microfinance is a recent example.

The confusion arises because of the legal framework. The Constitution empowers states to legislate on moneylending and moneylenders. As a consequence, there are 22 Acts on money-lending enacted by different states (some states like Andhra and Orissa, have two Acts). However, provisions of these acts, which deal mainly with registering, licensing and regulating moneylenders, are mostly ignored, especially when the moneylenders are politically connected. The conflict heightens when the formal banking system encroaches. A technical working group was set up by RBI in 2006 to study the legislative framework for moneylenders. This group mentioned the need to modify existing legislation, but shied away from suggesting an overhaul of the framework. The commission now has the chance to do so, even if that requires Constitutional amendments. 

Blind-Sided By A Rate Cut

In the frenzied build-up to the Reserve Bank's mid-quarter policy review on July 31 and the drumming up of expectations about a rate cut, everybody took their eyes off the other niggling problem looming in the distance -- slowing down deposits growth.

As a result, while the Reserve Bank governor's policy statement on July 31 contained some nuanced messages -- in keeping with the hallowed tradition of subtle, implicit messaging from the central bank -- most of the public read the message only literally.

So next day, predictably, everybody voiced their disappointment at the absence of a rate cut and expressed their surprise at the SLR cut. This was my piece in next day's ET (read here) highlighting some of the cues in the policy document.

But, two days after the policy, this article by Sugata Ghosh (read here) in ET really spelt out the problem, at which I had only hinted and which the Reserve Bank governor tackled without triggering off any alarm bells.

It may be instructive for market participants to get over their obsession with interest rate cuts and try to see the big picture once in a while. In the absence of any credible policy action, a rate cut seems to have become the default solution. The bitter truth is that there are no magic bullets left for the country's economic problems.

Petrol On Fire

In all fairness, the government shouldn't be blamed for policy paralysis. They have acted with such alacrity. Petrol prices were hiked by Rs 7.5 per litre as soon as Parliament went into recess. So, no shouting brigades, no loud thumping of desks, no rushing into the well of the House, no hectoring or haranguing, and no "pliss-pliss". Good only, no?

Actually, the petrol price increase raises two other issues. One, we can expect to finally see the extent of the increase pared down by Rs 2-3 per litre. The protests from allies has already started acquiring a high decibel level. By Wednesday evening, both Mamata Banerjee and Karunanidhi had voiced their displeasure over the increase. SP's Mulayam Singh Yadav, who is being courted assiduously by Congress as a counter-weight to Didi, also expressed his opposition to the price hike. Ditto for RJD's Laloo Prasad Yadav. So, once all these protests reach a crescendo, and acquire some kind of a shrill heft, we might expect to see the Congress top brass relenting and "rolling back" the hike partially. My bet? By Rs 2-3 per litre.

Even The Economic Times is betting that the price rise might finally be tempered somewhat (read here), though for a different reason. Their take: oil prices in the Singapore bulk market have been cooling off a bit.

But, ironically, BJP and CPI(M) have been misleading the public from every forum. By the way, isn't it strange how the right and left get into bed conveniently when they want to squeeze out the centre? Their beef: petrol price hike has a cascading effect and is likely to have a spiralling impact on inflation. That's a load of nonsense. Here's why. Petrol has a negligible weightage (1.09%) in the wholesale price index and its ability, therefore, to bump up headline inflation remains marginal. Also, bulk goods movement --such as essential commodities -- are moved by modes of transport that use diesel as fuel (think trucks) and not petrol.

Are there any reasons to protest against the petrol price increase? Of course, shiploads of reasons to crib about the price rise, but certainly not on account of its impact on headline inflation. The current hike comes on top of the existing inflationary pressures weighing down the middle class. And, this current episode of high inflation and inflationary expectations has its roots in the survival strategy crafted by the government in the aftermath of the 2008 global financial freeze, but let it stay on for far too long. In short, this lifeline to the economy should have been withdrawn much earlier. Plus, of course, the government has been loath to either cut down on wasteful subsidies, or re-align its expenditure strategy which is actually ending up further fuelling inflation. And, let's not even get started on this business about governance deficit. So, of course there's plenty to cry about, but not because a petrol price increase will lead to inflationary pressures as the voices from the right and left are asserting.

The government should have increased prices of diesel along with petrol prices if it really wanted to bring down the current account deficit and stabilise the rupee value. A diesel price hike might certainly be seen as inflationary, but at least these high prices would've curbed demand for the commodity. In return, it might have squeezed the import bill a bit, checked the runaway current account deficit and pulled up the falling rupee.

It is well known that fuel prices needed to be increased, and even the Reserve Bank governor's statements have alluded to the fact about how domestic fuel prices lagging international prices does lead to a build-up of inflationary expectations.

But, guess why diesel prices cannot be increased immediately, though news reports suggest the government will be meeting tomorrow to consider the possibility? The answer: it's summer in this part of the world and, with kharif sowing to begin soon (in the next 30-45 days), pols can't afford to get farmers cross about high diesel prices. In many parts of the country, farmers will need to run their pumps at full tilt, even though we've been told to expect a normal monsoon.

If there was any reason to carp, the grouse should have been why the government didn't spend on improving irrigation infrastructure in the 60 years since Independence. And guess what MPs and MLAs are mostly concerned about? Getting a red beacon on their cars!