Y V Reddy: Reviving confidence in the Indian economy
First Dr S Radhakrishnan Memorial Lecture delivered by Dr Y V Reddy, Deputy Governor of the
Reserve Bank of India, sponsored by University Grants Commission and organized by the University
of Hyderabad, at Hyderabad on 5 September 2001.
* * *
Respected Vice-Chancellor, Professor Rama Rao, distinguished academics and friends,
At the outset, I would like to express my grateful thanks to Professor Rama Rao garu for giving me the
privilege and honour of delivering the first Dr. S. Radhakrishnan Memorial Lecture sponsored by the
University Grants Commission and being organised by the University of Hyderabad on the occasion of
the Teachers' Days this year. So much has been written and said about Dr. Sarvepalli Radhakrishnan,
that any narration by me would do little justice to one of the greatest philosopher-statesman of
independent India. An eminent academician, a versatile writer, a brilliant orator, a renowned
philosopher, a respected diplomat and a remarkable President of India, Dr. Radhakrishnan had a
reputation of weaving a spell on those who heard him. In fact, Bertrand Russell remarked that he had
never heard philosophy better expounded than by Dr. Radhakrishnan. Of particular relevance today is
not only that Professor Radhakrishnan was a great teacher but also the fact that he served in a vast
number of Universities. He had his apprenticeship in Madras and Mysore, went to Calcutta and well
before he was forty lectured on invitation at American universities and also at Oxford. He set up
Andhra University and was also Vice-Chancellor of Benaras Hindu University. The enormity of respect
that he commanded is evident from the fact that the British Government gave him a knighthood; he
was nominated to the League of Nations Committee on Intellectual Cooperation; was called to serve
on the Constituent Assembly and had a memorable stint as Ambassador to Moscow. I had been lucky
as a student to hear Sarvepalli Radhakrishnan in 1954, on a high school sponsored excursion to
Delhi; and I still possess the photograph taken with him. Later, as sub-collector, Ongole, I made
elaborate arrangements at Chinaganjam railway station for him when he was proceeding to Madras in
1967 after laying down his responsibilities as President. In brief, my personal contact was limited but
he remains one of the greatest men I ever met in my life, especially since I started my career as a
teacher and once again, yearn to be a teacher.
Speaking of teachers, let me confess that I am here because of an invitation from someone, who like
Dr. Radhakrishnan has not only been a teacher but many more things - Professor Rama Rao. An
eminent and internationally renowned scientist, a respected head of a regulatory body, a Secretary to
Government remembered even after a decade, a builder of institutions, a great contributor to
advancement of professional bodies and publications, and one of the finest human beings I have
come across. There is lot in common between Prof. Radhakrishnan and Prof. Rama Rao, though one
is from the field of philosophy and the other from the realm of science.
Moving from teachers to teaching, the University and Reserve Bank of India (RBI) have assigned me
the pleasant task of inaugurating the Master of Technology course in Information Technology, devoted
to Banking Technology and Information Security - the first of its kind in India, and perhaps in the world.
The pogramme is being jointly launched by the University of Hyderabad (UoH) and Institute for
Development and Research in Banking Technology (IDRBT). As per the continuing collaborative
activities between the two institutions, a 2 Mbps leased line connectivity has been established
between the UoH and the IDRBT with a view to facilitating better and easy communication between
UoH and IDRBT, sharing library and other resources at UoH and IDRBT and also providing an avenue
for video conferencing. This programme, fully-funded by IDRBT, and open to both direct and
sponsored candidates from the banking and financial sectors is a multi-disciplinary programme that
seeks to merge the new and emerging technologies in Information Technology with the domain
expertise in the ever-changing field of banking and financial services. Providing absolute Information
Security and IS Audit systems is a challenge, and is of immediate relevance and concern to banks,
especially in the context of current as well as changing business environments in banking, like
electronic payment systems, e-commerce, mobile banking, and Internet banking. Deploying of modern
and evolving technologies would require the banks to get equipped with requisite skills on a
continuous basis. Thus, M.Tech. provides an excellent and right mix of the various aspects of
Computer and Information Security that is essential for banking technology to succeed and survive.
The Reserve Bank of India, as a sponsor of IDRBT, is happy to be associated with the pioneering and
path breaking collaboration between academia and practitioners and assures full support in its future
endeavours for mutual benefit.
In fact, IDRBT has already established a Corpus Fund with a seed amount of Rs. 50 lakh to promote
Higher Education and Research in Banking Technology and Management as a core area. Banks and
other financial institutions are expected to contribute significantly to the growth of this Fund.
It is customary to devote a Memorial Lecture to a theme, which has fundamental significance and
contextual relevance. After consulting with the organisers and keeping in view the interests of the RBI,
the subject chosen for this occasion is:"Reviving Confidence in the Indian Economy". It is necessary to
recognise that India remains one of the best performing economies in the world, in spite of the current
indications provoking a debate on the need for revival of the economy. It can be gathered from the
analysis that it is important to revive confidence in the economy in any attempt to improve the
performance. An approach in this regard can be discerned from the latest Annual Report of the RBI. In
the true spirit of philosophical explorations and interpretations propounded by Dr. Sarvepalli
Radhakrishnan, the concluding part of the lecture will be devoted to select structural issues critical to
restoration of confidence in the Indian economy.
Performance of Indian economy
India today is rated as the fifth largest economy in the world, measured in Purchasing Power Parity
terms. Only the U.S., Chinese, Japanese, and German economies are larger than ours. In terms of
Gross Domestic Product (GDP) growth rates, India was one of the ten fastest growing economies in
the world during the 'eighties, and moved up to the eighth fastest during the period 1980 to 1998. In
regard to growth of GDP in per capita terms also, India's performance during the period is among the
top ten.
Furthermore, on the basis of data on income or consumption distribution (World Development Report
1998-99) for about 80 countries, and using both the 'Gini' coefficient and the share of the poorest 20
per cent as a measure of distribution, there are only 15 countries in the world, which have a better
consumption/income distribution than India.
While growth is considered to be a key measure of macroeconomic performance, economic stability is
indicated by inflation. In the 'eighties, India's average inflation rate was close to Asian developing
countries, above developed ones and lower than the average for all developing countries. In the
'nineties, inflation has been relatively low in the second half of the decade.
In the external sector, India, along with China, has been described as "an island of stability amidst
seas of turbulence" in international currency markets in the recent years.
The ratio of debt to GNP in 1999 was 21.3, the only other developing country with a more favourable
ratio being China. India had the lowest proportion of short-term debt to total debt at 4.3, while for
China, it was 11.5.
In regard to fiscal position, however, India's fiscal deficit is currently among the highest out of 74 major
countries with population more than 10 million. And of these only two are higher than India.
Furthermore, public savings in the 'nineties in India, which reached its peak of 2.0 per cent of GDP in
1995-96, became negative 1.2 per cent of GDP by 1990-2000. The average rate of financial saving of
the household sector and of private corporate sector generally moved up during 'eighties and 'nineties.
There is also evidence of decline in the incremental capital output ratio (ICOR) from 4.2 in the 1980s
to 3.9 in 1993-2000.
There has also been an appreciable decline in poverty. The all-India poverty ratio fell to 27.09 per cent
in rural areas, 23.62 per cent in urban areas and 26.10 per cent at the all-India level in 1999-2000
from 53.1 per cent, 45.2 per cent and 51.3 per cent recorded during 1977-78.
Life expectancy has also moved up from 50.4 years in 1980-81 to above 61 years in the 1990s. There
has been an improvement in the life expectancy at birth for males from 50.9 years to 60.4 years and
for females from 50 years to 61.8 years.
The overall literacy has increased from 43.7 per cent in 1980-81 to 63.1 per cent in 1998-99.
Moreover, for the first time in four decades, population growth has decelerated to below 2 per cent and
this has been accompanied by a decline in the mortality rate from 12.5 per 1000 in 1980-81 to 8.7 per
1000 in the 1998-99.
Yet, there is a sense of impatience if not despondency at our economic policies. The reasons are fairly
obvious. We start from a low base of GDP from which impressive rates of growth are noticeable. India
still accounts for a very large concentration of poverty and of illiteracy, and hence fruits of development
either may not reach or are inadequate. While employment in organized sectors has virtually
stagnated, in recent times, insecurity in employment has crept in. Skill-irrelevance of most of the
manpower to the emerging needs has a depressing influence, especially when coupled with
downsizing. Moreover, significant and accelerating expectations have been created. There is
widespread awareness of the capacity of the economy to grow rapidly and they see no apparent
reason for slower than possible growth.
There are, thus, discernible reasons for the current debate on revival of the economy, centering
around the recent deceleration in the rate of growth, and certainly going beyond the simple exhaustion
of animal spirits of the business community in the country.
Why the current debate on revival of Indian economy
First, the deceleration of economic activity for the second year in succession has raised some
concerns about the feasibility of rapidly moving the economy to a higher growth path in the medium
term. Added to this is the public perception that India is not immune to the slowdown phase of the
global business cycle.
Second, the agricultural sector has exhibited considerable volatility and recorded absolute declines in
the last two quarters of 1999-00 and again in the first quarter of 2000-01. Agricultural production
registered a negative growth on top of a decline in the previous year.
Third, the growth of industrial production decelerated during 2000-01and further to 2.1 per cent in the
first three months of 2001-02 from 6.1 per cent in April-June 2001.
Fourth, services sector, which accounted for a major share of GDP, exhibited a lower growth of 7.5 per
cent in 2000-01 as against 9.4 per cent in 1999-00.
Fifth, there has been lower off-take of nonfood credit from the banking system, especially since
January 2001.
Sixth, imports declined by 0.2 per cent in 2000-01 as against an increase of 17.3 per cent during
1999-00. Non-oil imports declined by 8.5 per cent as compared with the increase of 3.2 per cent in
1999-00.
Seventh, export growth decelerated sharply to 1.7 per cent in April-June 2001-02 from 26.6 per cent in
the three months of 2000-01.
Eighth, considerable uncertainty, arising from turbulence in stock exchanges and apprehensions of
liquidity/payments problems, the problems in some cooperative institutions and the largest mutual
fund, the downgrading of the rating of a major development financial institution and the repayment
problems faced by another financial institution, has affected investor sentiment.
There are, however, some favourable developments in the economy that need to be highlighted to get
across the major thrust of the argument viz., the current issue is significantly one of confidence,
especially on the prospects.
First, real GDP growth when viewed in the context of the growth of other countries, is still one of the
highest in the world.
Second, inflation has remained stable and low.
Third, the financial sector has experienced declining interest rate environment.
Fourth, despite turbulence in the stock markets, the other segments of the financial markets have
remained stable and there have been no serious threats to systemic risks.
Fifth, the external sector is clearly sustainable with the current account deficit continuing to be less
than 1 per cent of GDP.
Sixth, foreign investment sentiment does not seem to have been affected with FII inflows recording
about $750 million during April-July 2001 as compared with $ 150 million during April-July 2000.
Seventh, the record level of foreign exchange reserves at nearly $ 45 billion on August 24, 2001,
stable exchange rate and money market rates provide less risky business environment.
Eighth, foodstocks have reached an all-time high, improving food security and immunising the
economy from transient supply shocks.
An approach to revival of confidence
It is customary for the Reserve Bank of India to present an Annual Report each year and that Report
for 2000-01, was approved by its Board of Directors on August 16. The Chapter on Assessment and
Prospects sets out a carefully constructed statement of the RBI Board's perspective and this provides
a useful starting point to debate what needs to be done to revive confidence in the economy.
While noting the comfortable position of external sector and the possible moderate impact of global
developments, the need for addressing the predominantly domestic factors is flagged.
The present state of the economy reflects a combination of cyclical and structural factors with different
weights assignable.
The implication is that any solution should address both the cyclical and structural issues, though the
relevant importance and sequencing of the various components will have to be well crafted.
In regard to structural factors, a particular mention is made of the operation of the institutional
constraints on growth. The suggestion is that the legal framework and institutional arrangements
would have to be accorded priority in the structural component.
As regards the relative role of macro economic and micro economic considerations, it is made clear
that both require to be addressed, but the Report focuses on importance of micro economic aspects in
as much as they are closely linked to institutional factors.
The balancing of the reform in financial and non-financial sectors is also highlighted and the
importance of accelerating the reform in real sector, particularly agriculture, is stressed.
More specifically, recognising that a large segment of the population is dependent on agriculture and
its performance in the recent past has been of considerable concern, the importance of augmenting
public investment in agriculture is emphasised.
In particular, the advantage of shifting public expenditures from subsidies to investment as a means of
efficiency, equity and regional balance is pointed out. Furthermore, desirable measures for the
creation of an efficient system of market intermediaries, quality-enhancement, perhaps through
certification, introducing insurance mechanisms, developing nation-wide multi commodity exchanges,
etc., are listed out. In a sense, therefore, the emphasis is on attaining a quantum jump in the
agricultural sector to meet global standards as a means of withstanding global competition and taking
advantage of emerging opportunities in international trade.
With regard to industry, the fact that public sector enterprises still dominate the economy is noted and
a strong plea is made to end uncertainties in regard to the future of public sector enterprises. In
particular, the complementarities in public and private sector are emphasised.
The thrust is that enhanced resources should be made available to select public enterprises, which
have strategic significance or strong public purpose, while clearly and promptly disinvesting
Government's equity in the other enterprises. At the same time, the creation of a conducive
environment for industrial revival warrants an appropriate regulatory framework to improve
infrastructure. By implication, one of the approaches advocated is that if labour has to be
compensated, it should be done directly rather than incurring open-ended non transparent expenses
in the name of revival, through tax concessions, sacrifices by financial institutions and incentives to
induce sickness.
Finally, in the context of the new economy, the emphasis is on removal of procedural and institutional
constraints, thus warning against bureaucratization in the name of creating enabling environment.
In the external sector, there is considerable cause for comfort emanating from reasonable level of
reserves, low current account deficit and adequate level of capital flows, but the need for continued
caution and vigil is rightly noted. Above all, in the current account, improving the export performance
and in the capital account, attracting FDI are highlighted as necessary for medium-term sustainability.
By all accounts, the major constraints in regard to both these appear to be the institutional framework
and uncertainties in regard to the policy framework, both of which need to be tackled urgently as part
of confidence boosting measures.
On fiscal policy, the major thrust is towards fiscal empowerment in contrast to fiscal enfeeblement to
realise the objective of durable fiscal consolidation. This would call for several steps to increase the
tax revenues, abolish tax exemptions, enhance the non-tax revenues by ensuring cost recovery, etc. A
case is thus made out for either obtaining adequate return on investments in public sector enterprise
or for disinvestment, unless a specific purpose in the interest of the public at large is served better by
public ownership.
In regard to public debt, a point is made that the size of government borrowings, though most visible,
is not the only one element in public debt management. Keeping in view the fact that only 80 per cent
of the central government's liabilities are covered by assets even as per the government accounting
system which is cash based, the health of public finances is linked to the both formal guarantees, and
implicit guarantees. In other words, wherever the government is owner, directly or indirectly, there is
an inevitable obligation on the part of the government to the discharge of liabilities in order to avoid
reputational risk while declaring a government owned enterprise as insolvent. In brief, a holistic view of
assets and liabilities as well as incomes and expenditures of the public sector as a whole is canvassed
in the report, which would warrant significant importance to accounting practices, disclosure
standards, and a degree of transparency in public sector as a whole.
In the matter of interest burden, the Annual Report makes a reference to several proposals under
consideration to focus on instruments that currently result in very high effective cost to the
Government. Another area of concern, though not elaborated in the Report is the element of a Ponzi
scheme in small savings at high cost to the Government with a tendency to finance the ballooning
fiscal needs of State Governments, while imposing serious mismatches in the asset-liability maturity
profile of the Central Government.
The concept of fiscal impairment is clearly of special significance for States since the bedrocks of
socio-economic welfare viz. law and order and social services are in the state sector. The actions
needed would, therefore, be in terms of expanding public goods and social services including
anti-poverty programmes with concomitant roll-back of fiscal activism in commercial activities.
In regard to monetary policy, the major emphasis is on flexibility of interest rates in the financial
system as a whole. The global developments in terms of oil prices and the domestic developments in
terms of inflation emerge as important areas to monitor in the conduct of monetary policy. While a
number of instruments have been devised and operating procedures have undergone significant
changes, it is very clear that considerable sophistication and skill are essential in successful conduct
of monetary policy.
As regards financial sector, several problems warranting attention are brought out. These relate to
perception of implicit sovereign guarantee in regard to all financial intermediaries, and lack of arms
length relationships and lack of clear demarcation between ownership and regulation. In particular,
there is a reference to complexities arising out of existence of various types of financial intermediaries
with differing charters owing their origins to prereform strategies, which virtually calls for a thorough
revamping of the interface of government and Reserve Bank with financial intermediaries that they
own. Above all, the inadequacies in the present banking system, particularly in the cooperative sector,
in meeting the credit needs of agriculture as well as small and medium industries necessitate a
fundamental change in the systems of their governance and functioning.
Exploration of some measures
There is a strong consensus among international observers that there is a weak reform process in
India, which expresses itself in the form of relatively slow implementation of policies. Another view is
that the "tyranny of ten per cent", namely the workforce of the organised sector, continues to resist any
change. Yet another view is that in any democracy, reform is generally a slow process since the
sacrifices of the vociferous minority come upfront while the benefits to the vast but relatively silent
majority accrue with a time lag. Perhaps, there are elements of truth in each of these views, but
without doubt, the relevant issues are essentially in the nature of political economy and not merely
matters for technical analysis. Yet, there is merit in exploring some drastic measures, which could
demonstrably improve the current sentiment.
Reviving the economy requires boosting of confidence by combining both structural and other
cyclically relevant measures. While the latter are desirable, such measures must be combined on a
credible basis with structural measures. In this address, it is not proposed to elaborate on either
cyclically relevant measures or the process of integrating them with structural measures, but confine to
structural issues.
It is possible to be illustrative and certainly not exhaustive even in regard to the structural measures.
The intention is to express purely exploratory technical views in five of the areas that are critical,
namely, financial sector, regulatory framework, public enterprises, delivery of public services, and
overhang issues. These do not in any way constitute the official position of RBI.
Advisory on financial sector restructuring
It is useful to understand some features of the financial system in India. Most of the financial savings
still comprise deposits to the banking sector, with some perceptible flow to life insurance, mutual
funds, government small savings and Provident Funds. About three quarters of the banking deposits
go to government owned banks that currently have invested over one-third of the assets in
government securities and a perceptible amount in PSU bonds, development financial institutions
cooperatives and government guaranteed enterprises. This gives place to a criticism that government
owned banks are operating as instruments to finance high public sector deficits. Similar arguments
can be advanced in respect of the largest mutual fund, viz., the Unit Trust of India and the insurance
giant Life Insurance Corporation of India not to mention the General Insurance Corporation. While
Industrial Development Bank of India is a public sector statutory corporation, Industrial Finance
Corporation of India's major shareholding is by government owned Institutions. Industrial Credit and
Investment Corporation of India is a public financial institution and hence has a special status
accorded by Government.
While public tend to repose confidence in these institutions by virtue of their status as
Government-owned or backed entities, there is corresponding implicit direct obligation on the part of
the Government to protect the interests of depositors/investors. In other words, any vulnerability in
regard to these institutions has an impact on government's finances. Such a reasonable expectation is
not only justified on the consideration of the concept of "holding out" a backing, but also by the
obligations discharged in the past by Government of India in several cases including the case of
CanFina through Canara Bank.
The regulators of financial sector have some additional complexities in relation to public sector entities.
First, in the case of statutory bodies including public sector banks, there are certain regulatory
constraints. For instance, both for reasons of legality and reputational risk, the regulator cannot cancel
a licence, say to a public sector bank, even if it fails to meet capital adequacy norms. The recourse
open to the regulator in the case of owner's unwillingness to inject capital to meet capital adequacy
standards is unclear and this often leads to regulatory forbearance. Second, as in the case of UTI and
Development Financial Institutions, the legal basis of jurisdiction of regulators is somewhat ill-defined.
Thirdly, Government tends to be closely involved in some operations of many of these institutions' and
overlapping of accountability is plausible. Fourthly, as long as these institutions function without
reference to sound principles of corporate governance though consistent with their individual statutes,
inherent weaknesses persist. In fact, where there has been disinvestment and consequently some
shares are held by the public, minority shareholder interests are not seriously factored in. Fifthly, the
Government expects the regulator to often function as an agent of owner (Government), which further
complicates accountability. Finally, the regulatory focus in respect of these institutions as set out by
Government itself is not well defined and diffused. The issue is whether defining the respective roles
and making their transactions more transparent would improve confidence in the financial sector by
avoiding the criticism that they often take recourse to lending, investment, rescheduling and bailouts,
and extending guarantees as behest operations. It is against the above background that institutions
tend to be somewhat less than responsive to regulatory regime as well as market discipline.
Furthermore, the non-performing assets (NPAs) arising out of priority sector lending, which is in the
nature of directed lending and those covered by the Bureau of Industrial and Financial Restructuring
(BIFR) together account for well over fifty per cent of total non-performing assets of the banking
system. The number of companies referred to the BIFR by three major Development Financial
Institutions (DFIs) stood at 694 with a total loan outstanding of about Rs.6,275 crore as at end-March
2000. Above all, in view of their close interrelationships, the risks of contagion are high and hence the
need to overhaul them to inspire confidence.
It is essential to recognize the constraints under which these entities are operating in a highly
competitive environment induced by the reform process. Apart from the issues of diffused
accountability to the Government and regulator and multiple objectives to be pursued in order to justify
public sector nature, their management style is occasionally cramped by extraneous interventions. As
a consequence of all these factors, at operating levels of these entities, there may be a strong
incentive to inaction than action.
It would be totally inappropriate to conclude that these institutions are more vulnerable now than
before. In fact, their vulnerabilities were neither defined nor measured in the past and the pressure
built on them by the financial regulators in the recent past has enabled them to improve their
functioning and disclose their real status. The dimension of the problem which were concealed is
being revealed and there is perhaps a strong case for admitting and assessing the real status, and
take corrective actions to meet the overhang issues and design strategies to make the future
operations efficient, stable and accountable.
In regard to private sector banks including cooperatives, vulnerability of some of them is no longer an
impossible contingency. Hence, an interesting question that can arise is the appropriate response that
is justifiable in case there is a run on such a bank. The primary responsibility of the regulator is
two-fold, viz., protection of small depositors and avoidance of contagion resulting in systemic risk. In
case of such problem, the regulator should attempt to identify whether it is due to illiquidity or an
insolvency problem. In case it is assessed as an illiquidity problem, the regulator may in exceptional
cases act as a Lender of Last Resort and consider infusing temporary liquidity to such a bank to tide
over the problem of mismatch. In case it is assessed by the regulator that a bank is insolvent or the
bank itself closes its branches for banking operations, the logical requirement would be liquidation
unless a serious contagion resulting in systemic risk is anticipated. A prompt liquidation operation,
whenever warranted by these considerations would ensure two aspects. First, retail or small
depositors upto Rs. 1 lakh would be able to recover their deposits quickly (perhaps in matter of days)
and secondly, depositors with over Rs. 1 lakh deposits would need to book losses. In particular,
corporates or institutions that have placed deposits in banks may have vested interest in prolonging
the matter even at the cost of small depositors in order to avoid disclosure of losses in their balance
sheets. Under these circumstances, the regulator has to make difficult decisions/judgments at short
notice, often with incomplete information. Sometimes, liquidity and solvency issues get intermingled
with discomfort to the respective regulatory arms.
In India, very often, in case of such banks, for a variety of reasons, a softer approach is taken and
sometimes legal hurdles are faced. It is possible to argue that this soft approach has resulted in a
typical situation of moral hazard when the management tends to become inefficient and depositors do
not exercise adequate prudence. The depositors in banks should be encouraged to exercise at least
as much caution, attention and time when they place deposits as they do when they purchase
vegetables. Thus, a clearer enunciation of effective policy in regard to vulnerable banks would enable
swift action by the regulator and exercise of more caution by depositors. In this context, insistence on
greater disclosure and the regime of Prompt Corrective Action would be relevant.
To put it differently, the current priority for policy should be to clarify the relationships between the
regulator, regulated, owner and government as well as a well-defined regulatory focus to enable
healthy development of financial markets. Perhaps, this needs even more urgent attention than a
debate on single versus multiple regulators. My experience as Chairman of Standing Committee on
International Standards and Codes has provided a clue for this purpose in the form of Advisory
Groups. On the same analogy, the highest level in the country say the Prime Minister or the National
Development Council could constitute an independent Advisory Group on Financial Sector
Restructuring with eminent non-officials as members and the officials should be available only to
facilitate the work of such bodies. Such an advisory body should be able to produce a blue print within
few months since substantial international experience and domestic research are already available in
this direction.
Zero regulation
As mentioned, one