Rakesh Mohan: India's financial sector reforms - fostering growth while
containing risk
Address by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at Yale
University, New Haven, 3 December 2007.
Assistance of Michael Patra, Muneesh Kapur and Indranil Bhattacharya in preparing the speech is gratefully
acknowledged.
* * *
I am honoured to be back at Yale where I got my basic economics grounding from James
Tobin, Bill Nordhaus, and Robert Evenson, among others. In all these years, this is my first
lecture at Yale, so I am particularly pleased to have this opportunity. Thank you Professor
Srinivasan.
The turmoil in international financial markets since late July this year and the increased
uncertainty that financial markets are currently experiencing have brought issues relating to
financial sector stability to the fore. In some ways, the recent developments are
unprecedented in their occurrence and in terms of the emerging magnitude of financial sector
losses. The sudden loss of confidence among traditional counterparties reflects extreme
information asymmetry arising from the complex layering of risk diffusion and high
leveraging; and the breakdown of risk assessment by reputed rating agencies and the like.
The speed of contagion and the extensive involvement of large, reputed and regulated
financial institutions are indicative of regulatory shortcomings, which has then necessitated
unconventional responses of central banks. All this has raised serious concerns relating to
the ability and flexibility of national financial systems to withstand shocks emanating from
such unusual developments. It has also spurred some reconsideration on some aspects of
monetary policy and of financial regulation, particularly as they relate to the maintenance of
financial stability.
India has so far remained relatively insulated from these developments and our impact
analyses suggest that our exposure to troubled sub-prime assets and related derivatives is
negligible in comparison to many other economies. Whereas this may be regarded by some
as fortuitous, it is perhaps our nuanced approach to financial sector reform and development
that has served us well; our approach has been marked by conscious gradualism with the
implementation of coordinated and sequenced moves on several fronts that are predicated
on the preparedness for change of the financial system in particular, and of the economy in
general. We have also built in appropriate safeguards to ensure stability, while taking
account of the prevailing governance standards, risk management systems and incentive
frameworks in financial institutions in the country. Overall, these progressive but cautious
policies have contributed to efficiency of the financial system while sustaining the growth
momentum in an environment of macroeconomic and financial stability. Nevertheless, we in
the Reserve Bank are maintaining enhanced vigilance to be able to respond appropriately to
the prevailing heightened uncertainties in global financial conditions. The policy challenge is
to continue to ensure financial stability in India during this period of international financial
turbulence, while maintaining the momentum of high growth accompanied by price stability.
Against this backdrop, I thought I would take this opportunity to review India's approach to
financial sector reforms, the path we have traversed for over almost two decades from a
restrictive, even repressed past, the nuances of our somewhat unorthodox approach to
instituting competition and efficiency in financial intermediation and the challenges we face in
the development of our financial sector in the years ahead.
I. Financial sector reforms and outcomes
In retrospect, the key success of financial sector reforms in India since they were instituted in
the early 1990s has been the maintenance of financial stability through a period marked by
repeated financial crises across the world. The process of reforms is noteworthy not only for
the turbulence around its path but also for the sheer dimensions of the change achieved from
the position where we started.
Until the beginning of the 1990s, the state of the financial sector in India could be described
as a classic example of "financial repression" (MacKinnon 1973; Shaw 1973). The sector
was characterised, inter alia, by administered interest rates, large pre-emption of resources
by the authorities, extensive micro-regulations directing the major portion of the flow of funds
to and from financial intermediaries, relatively opaque accounting norms and limited
disclosure, and dominant public ownership. Compartmentalisation of activities of different
types of financial intermediaries and strong entry barriers thwarted competition resulting in
low levels of efficiency and productivity and severe credit constraints on the private sector,
especially in the absence of any access to external finance. Capitalisation levels were low
due to lack of commercial considerations in credit planning and weak recovery culture which
also resulted in large accumulation of non-performing loans. The predominance of
Government securities in the fixed-income securities market of India mainly reflected the
captive nature of this market as most financial intermediaries were mandated to invest a
sizeable portion of funds mobilised by them in such securities to finance high Government
borrowings at administered/concessional interest rates. In the capital market, new equity
issues were governed by a plethora of complex regulations and extensive restrictions with
very little transparency and depth in the secondary market trading of such securities.
Comprehensive exchange control resulted in little depth in the foreign exchange market with
most external transactions governed by inflexible/low limits and prior approval requirements.
Monetary policy was subservient to the fisc. The provision of fiscal accommodation through
ad hoc treasury bills led to high levels of monetisation of fiscal deficit during the major part of
the 1980s. The expansionary effects of fiscal spending were sought to be curbed through
interest rate regulations, credit rationing and high reserve requirements, effectively
preventing the development of financial markets.
Elsewhere, I have attempted to document the various facets of India's experience with
financial sector reforms - the guiding objectives and intellectual/analytical underpinnings; the
choice of pace and sequencing; specific aspects of policy measures for the banking sector,
non-bank financial companies, term lending institutions and other financial intermediaries;
development of financial markets; and changes in the monetary policy framework (Mohan,
2004; Mohan, 2006c). Today, I propose to undertake an evaluation of the financial sector
reforms in terms of actual outcomes.
II.1 Monetary policy
While assessing monetary policy, it would be reasonable to assert that it has been largely
successful in meeting its key objectives in the post-reforms period since the early 1990s.
Inflation has averaged close to five per cent per annum in the decade gone by, notably lower
than the average of 7-8 per cent in the previous four decades. Structural reforms from the
early 1990s coupled with improved monetary-fiscal interface and reforms in the Government
securities market enabled better monetary management from the second half of the 1990s
onwards. A number of other factors such as increased competition, productivity gains and
strong corporate balance sheets have also contributed to this low and stable inflation
environment, but it appears that calibrated monetary measures had a substantial role to play
as well. More importantly, the regime of low and stable inflation has, in turn, stabilised
inflation expectations and the threshold level of inflation tolerance in the economy has come
down significantly (Table 1).
It is encouraging to note that despite the high international crude oil prices, other commodity
prices and elevated food prices, inflation remains low and inflation expectations appear to be
consistent and stable. Consequently, both nominal and real interest rates have fallen. Due to
both financial restructuring and low interest rates in recent years, the growth rate in interest
expenses of the corporates has declined consistently since 1995-96; such decline has
significant implications for the improvement in bottom lines of the corporates sector as a
whole and their resilience to financial shocks.
In terms of the monetary policy framework, India's approach has been somewhat
unorthodox. Traditionally, central banks have pursued the twin objectives of price stability
and growth or employment, while in recent years, greater attention has been given to the
maintenance of price stability through inflation targeting regimes. Although there is no explicit
mandate for price stability in the Indian context, the objectives of monetary policy in India
have evolved as those of maintaining a judicious balance between price stability and
ensuring adequate flow of credit to the productive sectors of the economy. Considerations of
financial stability, however, have ascended the hierarchy of monetary policy objectives in
recent years in view of the increasing openness of the Indian economy, financial integration
and the possibility of cross border contagion. Accordingly, we believe that regulation,
supervision and development of the financial system remain within the legitimate ambit of
overall monetary policy broadly interpreted.
In the wake of financial sector reforms and opening up of the economy in the 1990s, the
Reserve Bank switched over in 1998-99 to a multiple indicator approach whereby
macroeconomic and financial market data on both quantum and rate variables are all
examined, along with output, in framing monetary policy. We believe that the specific
features of the Indian economy, including its socio-economic characteristics, make it
necessary for the monetary authority to operate with multiple objectives and indicators for
some time to come. A single objective for monetary policy, as is usually advocated,
particularly in an inflation targeting (IT) framework, is a luxury that India cannot afford, at
least over the medium term. As regards IT, even though there has been an increase in the
number of central banks adopting IT since the early 1990s, a number of central banks,
notably the Federal Reserve, retain multiple objectives.
Internationally, there is no unique or even best way of monetary policy making and different
approaches or frameworks can lead to successful policies by adapting appropriately to
diverse institutional, economic and social environments (Issing, 2004). Moreover, some
evidence suggests that average inflation as well as its volatility in prominent non-IT industrial
countries has, in fact, been somewhat lower than that in prominent IT industrial countries. IT
is not found to have any beneficial effect on the level of long-term interest rates either
(Gramlich, 2003; Ball and Sheridan, 2003). Furthermore, an IT framework reduces the
flexibility available to a central bank in reacting to shocks (Kohn, 2003). EMEs face additional
problems in an IT regime. These economies are typically more open and it exposes them to
large exchange rate shocks which can have a significant influence on short-run inflation. A
boom-bust pattern of capital flows can lead to substantial movements in exchange rates.
EMEs may have to manage exchange rates more heavily since they are more
commodityprice sensitive than advanced economies and commodity price fluctuations can wreak havoc
with the forecastability of consumer price inflation (Eichengreen, 2002). An empirical
evaluation of the experience of EMEs that have adopted IT confirms that IT is a more
challenging task in such economies compared to developed economies that have adopted
IT. While inflation in EMEs was indeed lower after they adopted IT, their performance was
not as good as that experienced in developed IT countries. Deviation of inflation from its
targets is found to be larger and more common in EMEs (Fraga, Minella and Goldfaj, 2003).
Inflation targeting by itself is not a sufficient condition for success. In view of the above, the
characterization of inflation targeting as "the gold standard for stabilizing monetary policy" is
misleading. Indeed, in the recent episode of financial market turmoil, even central banks with
explicit inflation targeting or price stability as the predominant objective were forced to scale
down the emphasis on price stability, notwithstanding continued inflationary pressures. Such
central banks had to inject liquidity and reduce policy rates - in some cases, holding back the
earlier expectations of tightening - as they had to lay greater emphasis on financial stability
and growth.
The overall macroeconomic record of the Indian economy since the early 1990s indicates an
acceleration in growth and a significant reduction in inflation. Inflation has averaged below 5
per cent in the current decade so far, substantially lower than that of around 8 per cent in the
preceding two and a half decades. Pre-emptive monetary and prudential measures have led
to this welcome situation of a reduction in inflation and acceleration in growth while ensuring
financial stability. Indeed, a cross-country comparison of major EMEs that have adopted IT
indicates that growth in India has been amongst the highest while inflation remains relatively
low (Table 2). Amongst the sample of G-20 and major Asian countries, growth in India during
2000-2007 was the second highest after China. Inflation in India during the current decade
has halved from that prevailing during the 1990s and is, at present, lower than many
developing economies. A recent survey by McKinsey and Company of CEOs across the
world, in both developed countries and Emerging Market Economies (EMEs), found that
among all the countries surveyed, India had the highest proportion of CEOs, 40 per cent,
who did not expect inflation to increase in coming years (McKinsey Quarterly, 2007). Thus, it
would appear that, at least, among business leaders, inflation expectations are
wellanchored in India. Although there has been above average growth in monetary and credit
aggregates in the past 3-4 years, financial stability has been maintained through a judicious
use of monetary and prudential measures. Thus, the recent record of macroeconomic
management in India is exemplary, even amongst the EMEs that target inflation. The
challenge for monetary policy now is to reduce inflation further in the medium term towards
international levels, while maintaining the momentum of high growth and preserving financial
stability.
II.2 Banking sector
In the post-reform period, banks have experienced strong balance sheet growth in an
environment of operational flexibility. Concomitantly, the financial health of banks has
improved significantly, both in terms of capital adequacy and asset quality. Moreover, this
progress has been achieved while setting the groundwork for the adoption of international
best practices in prudential and accounting norms. Increased competitiveness and
productivity gains have also been enabled by proactive technological deepening and flexible
human resource management. These significant gains have been achieved even while
renewing our commitment to social banking viz., maintaining the wide reach of the banking
system and directing credit towards important but disadvantaged sectors of society. The
banking system's wide reach, judged in terms of expansion of branches and the growth of
credit and deposits indicates continued financial deepening (Mohan, 2006a).
On the liability side, deposits continue to account for about 80 per cent of the total liabilities
while on the asset side, the shares of loans and advances and investments have seen
marked cycles, reflecting banks' portfolio preferences as well as growth cycles in the
economy. In this regard, while the share of loans and advances declined in the second half
of 1990s on account of the industrial slowdown as well as tightening of prudential norms,
banks' credit portfolio has witnessed sharp growth in the period 2003-07.
The overall capital position of commercial banks has witnessed a marked improvement
during the reform period (Table 3). Illustratively, as at end-March 2007, all 81 scheduled
commercial banks operating in India maintained CRAR at or above 9 per cent relative to the
Basel I norm of 8 per cent. For the Indian banking system, the ratio of capital to risk weighted
assets works out to 13 per cent currently. While improved capitalisation of public sector
banks was initially brought through infusion of funds by government to recapitalise these
banks, subsequently, public sector banks were allowed to raise funds from the market
through equity issuance subject to the maintenance of 51 per cent public ownership. As a
result, ownership in public sector banks is now well diversified.
Despite tightening prudential norms in terms of classification of non-performing assets, the
resulting measured asset quality of banks has improved considerably as the share of
nonperforming loans (NPLs) (as ratios of both total advances and assets) have declined
substantially and consistently since the mid-1990s. In fact, the ratio of net NPLs to net
advances at 1.0 per cent in India is now comparable to that of several advanced economies
(Table 4). Improvement in the credit appraisal process, upturn of the business cycle, new
initiatives for resolution of NPLs (including promulgation of the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act),
and greater provisioning and write-off of NPLs enabled by greater profitability, have
contributed to the reduction in incremental NPLs.
Efficiency gains are reflected in containment of the operating expenditure as a proportion of
total assets (Table 5). This has been achieved in spite of large expenditures incurred by
Indian banks in installation and upgradation of information technology and, in the case of
public sector banks, large expenditures under voluntary pre-mature retirement of nearly 12
per cent of their total staff strength.
In consonance with the objective of enhancing efficiency and productivity of banks through
greater competition, there has been a consistent decline in the share of public sector banks
in total assets of commercial banks. Nevertheless, public sector banks appear to have
responded to the new challenges of competition, as reflected in their increased share in the
overall profit of the banking sector. This suggests that, with operational flexibility, public
sector banks are competing relatively effectively with private sector and foreign banks.
Shares of Indian private sector banks, especially new private sector banks established in the
1990s, in the total income and assets of the banking system have increased considerably
since the mid-1990s (Table 6).
Indian private sector banks, particularly new private sector banks, have made rapid progress
in terms of increasing their income and asset size since the mid-1990s. In terms of branch
expansion, the compound growth rate of private sector banks over the period 2002-07 was
almost three times that of all scheduled commercial banks and more than four times that of
public sector banks (Table 7). Among the private sector banks, the four big banks viz.,
Centurion Bank of Punjab, HDFC Bank, ICICI Bank and UTI/Axis bank have experienced
rapid branch expansion in the range of 16-46 per cent per annum in terms of compound
growth rates. While private sector banks, as a group, have recorded a compound growth of
24 per cent per annum in their staff, public sector banks have witnessed a decline in the staff
strength over the same period reflecting, inter alia, restructuring facilitated by greater use of
technology and computerisation. In terms of growth of capital and reserves and surplus, the
new private sector banks experienced annual growth in the range of 30-68 per cent, while
deposits and advances have increased by 32-51 per cent and 39-71 per cent, respectively.
Net profits recorded a compound annual growth of 27-36 per cent. In terms of all these
parameters, private sector banks grew much faster than the existing private sector banks, as
might be expected.
There has been some discussion in recent times on the policy of branch licensing of banks
by the Reserve Bank of India: that it could have restricted competition and growth of new
banks. These data exhibit the very high growth experienced by the leading private sector
banks and it is arguable whether there could have been much faster expansion without
impairing their prudential quality and integrity of their balance sheets.
What is most encouraging is the very significant improvement in the productivity of the Indian
banking system in terms of various productivity indicators (Mohan, 2006a). These
improvements could be driven by two factors: technological improvement, which expands the
range of production possibilities and a catching up effect, as peer pressure amongst banks
compels them to raise productivity levels. Here, the role of new business practices, new
approaches and expansion of the business introduced by the new private banks have been
of the utmost importance.
To sum up, significant improvement in the performance of public sector banks has been
witnessed over the past decade or so, facilitated by the phased introduction of wide-ranging
financial sector reforms since the early 1990s. Gradual introduction of best international
practices and norms, refinements in the supervisory practices, tightening of risk
weights/provisioning norms in regard to sectors witnessing high credit growth, greater market
discipline brought about by raising of capital from the capital markets and listing on the stock
exchanges, interest rate deregulation, and scaling down of statutory pre-emptions are
amongst the key factors that have led to better performance. Concomitantly, greater
competition has been induced in the domestic banking sector by successful introduction of
new generation private sector banks. Despite strong growth in balance sheets of the new
banks, the banking system has exhibited remarkable stability. Although there have been a
few instances of weaknesses in a few new private sector banks, pre-emptive measures in
the form of the mergers of such banks with stronger banks, or infusion of new capital and
change in ownership, on a voluntary or involuntary basis, have contributed to the strength of
the domestic banking system, engendered confidence in the depositors and enabled
maintenance of overall financial stability. Notwithstanding the substantial improvement, the
domestic banking system will need to be further strengthened to face greater external
competition and introduction of financial innovations and fuller capital account convertibility.
II.3 Financial markets
The most notable impact of financial sector reforms is clearly discernible in the development
of various segments of financial markets in India. The reforms since the early 1990s have led
to a regime characterised by market-determined interest and exchange rates, price-based
instruments of monetary policy, current account convertibility, substantial capital account
liberalisation and vibrant government securities and capital markets. Derivative instruments
have been cautiously introduced in a phased manner, both for product diversity and, more
importantly, as a risk management tool. All these developments have facilitated the process
of price discovery in various financial market segments.
There has been a significant increase in trading volumes and market liquidity (Table 8).
Illustratively, average daily turnover in the money market has increased from Rs.427 billion in
1997-98 to over Rs.888 billion by 2006-07. The operations under the liquidity adjustment
facility (LAF) have largely been able to steer overnight rates within the corridor set by the
policy rates. Under the LAF, the Reserve Bank absorbs (reverse repo) as well as injects
(repo) liquidity, depending upon the liquidity conditions and consistent with the overall
monetary policy stance. Changes in fixed reverse repo/repo rates set by the RBI from time to
time for the conduct of LAF, under which the central bank conducts daily auctions for the
banks, have emerged as the main instruments for interest rate signalling in the Indian
economy.
Inter-bank turnover in the foreign exchange market has nearly quadrupled between 2000-01
and 2006-07 to Rs. 840 billion. Average daily turnover in the foreign exchange market
(interbank as well as merchant) has increased from US $ 5 billion in 1997-98 to US $ 23 billion by
2006-07. The exchange rate of the Indian rupee has exhibited significant two-way
movements in the recent years. Efficiency in the foreign exchange market has also improved
as reflected in the decline in bid-ask spreads.
In the government securities market, the issuance of long-term securities has enabled the
development of yield curve across 30-year maturity. In the government securities market, the
drop in turnover in 2004-05 and 2005-06 could be attributed to factors such as "buy and hold"
tendency of the participants such as insurance companies, which now hold a substantial
portion of government securities, particularly those of longer maturities. Furthermore, certain
regulatory changes introduced in late 2004 allowing banks to hold a larger proportion of their
investment portfolio in the "held to maturity" (HTM) category reduced the proportion of
portfolio used for trading, thereby affecting the magnitude of G-sec trading. The decline could
also be attributed to the increase in interest rates over the period, which prompted banks and
other players to hold rather than trade, so as to avoid trading losses. To keep the markets
liquid and active, the Reserve Bank has recently allowed short selling in government
securities among eligible participants, and trading in the "when issued" segment, but these
facilities have not seen much activity yet. Efforts are also on to increase liquidity through the
active consolidation of existing securities.
The derivatives market has also gained vibrancy during the last couple of years. The total
notional principal amount outstanding has more than trebled between March 2005 and June
2007 led by a significant jump in interest rate related contracts. Over this period, while the
notional amount under interest rate related contracts quadrupled, that in foreign exchange
contracts nearly trebled (Table 9). Certain legislative changes in 2006 provided clear legal
legitimacy to OTC derivative contracts, which was somewhat ambiguous earlier.
The Government and the Securities and Exchange Board of India along with the Reserve
Bank are taking steps to activate the corporate debt market. As has been experienced
elsewhere, among the various financial markets, the corporate debt market is indeed the
most difficult to develop for a variety of reasons. The expansion of the pension fund and
insurance industries will progressively result in the presence of a larger financial investor
base, which will help in the overall expansion of financial markets and in particular the
corporate debt market.
It is quite apparent that there exist well-functioning, deep, liquid, and well-integrated markets
for bonds, currency and derivatives in India, contrary to what is often asserted. The trading
volumes have generally witnessed significant growth in the various segments of the financial
market. It is noteworthy that the increase in foreign exchange market turnover in India
between April 2004 and April 2007 was the highest amongst the 54 countries covered in the
latest Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity
conducted by the Bank for International Settlements (BIS). According to the survey, daily
average turnover in India jumped almost 5-fold from US $ 7 billion in April 2004 to US $ 34
billion in April 2007; global turnover over the same period rose by only 66 per cent from US $
2.4 trillion to US $ 4.0 trillion. Reflecting these trends, the share of India in global foreign
exchange market turnover trebled from 0.3 per cent in April 2004 to 0.9 per cent in April
2007. In view of the above, comments that are often made regarding missing financial
markets are rather misleading. Moreover, empirical evidence points towards greater market
integration (Mohan, 2007c). A good deal of development has indeed taken place in the
government securities market, the forex market, OTC interest rate derivatives and the like.
The corporate bond market is indeed in its infancy; and, more efforts have to be made to
develop various exchange traded derivative markets.
It, however, needs to be recognised that financial markets are often governed by herd
behaviour and contagion. Deregulation, liberalisation, emergence of financial conglomerates
and globalisation of financial markets pose growing risks to financial stability. In this regard, it
needs to be stressed that volatility in currency and bond markets can have significantly more
adverse employment, output and distributional consequences compared to volatility in equity
markets. Premature liberalisation of money and bond markets can lead to large and volatile
capital inflows, which could potentially exacerbate complications for macroeconomic and
monetary management. Furthermore, excessive fluctuations and volatility in financial
markets can mask the underlying value and give confusing signals, as has happened in
developed markets, thereby hindering efficient price discovery (Mohan, 2006c). As large
segments of economic agents in India may not have adequate resilience to withstand
volatility in currency and money markets, the Reserve Bank's policy approach has been to be
increasingly vigilant and proactive to any incipient signs of volatility in financial markets.
Notwithstanding the progress made since the early 1990s, the Reserve Bank recognises that
domestic financial markets need to develop much further, especially in order to support the
recent acceleration in growth momentum of the Indian economy and in the context of the
envisaged move towards fuller capital account convertibility. The Indian experience
demonstrates that development of markets is an arduous and time consuming task that
requires conscious policy actions and effective implementation. Without real sector
development in terms of the physical infrastructure and improvement in supply elasticities,
the financial sector can misallocate resources, potentially generate bubbles and possibly
amplify the risks. Hence, financial sector reforms have complementarity with the pace and
process of reforms in the real sector in India.
Given the large weight on stability, especially in view of low income levels for a large
segment of the population, the careful and cautious approach to development of financial
markets followed so far would need to be pursued in the coming years. The pace of further
progress would depend upon the development of the necessary expertise in the public sector
banks, further expansion of private sector banks and foreign banks. We recognise the need
to develop further various segments of the domestic financial market to help in better risk
management by various market participants. The demand for various risk management tools
could be expected to increase, especially in the presence of potentially larger fluctuations in
exchange rate and interest rates in the future. In recognition of the need to widen the range
of instruments available to market participants, the Reserve Bank has placed draft guidelines
on introduction of credit derivatives in the country. More recently, a draft report on the
introduction of currency futures in India has also been put in the public domain for comments
and feedback; and work is in progress on the introduction of interest rate futures.
Summing up, it is widely recognised that the Indian financial sector over the last decade has
been transformed into a reasonably sophisticated, diverse and resilient system delivering a
wide variety of financial services efficiently and profitably, with a spectrum of financial market
segments in which financial institutions are able to participate with operational and functional
autonomy in an environment of increasing deregulation and international competition. The
acceleration of growth in the real economy suggests that the financial system has served
well the overall needs of the economy. During this period, while the global financial
environment has become more risky in the